Eaton's CEO Discusses Q2 2011 Results - Earnings Call Transcript

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Eaton (NYSE:ETN)

Q2 2011 Earnings Call

July 25, 2011 10:00 am ET

Executives

Richard Fearon - Vice Chairman and Chief Financial & Planning Officer

Donald Bullock - Senior Vice President of Investor Relations

Alexander Cutler - Executive Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Analysts

Ann Duignan - JP Morgan Chase & Co

Edward Wheeler - Buckingham Research Group, Inc.

Joshua Pokrzywinski - MKM Partners LLC

Stephen Volkmann - Jefferies & Company, Inc.

Brian Rayle - Northcoast Research

Jeffrey Hammond - KeyBanc Capital Markets Inc.

Terry Darling - Goldman Sachs Group Inc.

Jason Feldman - UBS Investment Bank

Eli Lustgarten - Longbow Research LLC

Andrew Casey - Wells Fargo Securities, LLC

Peter Chang - Crédit Suisse AG

Jeffrey Sprague - Citigroup

Mark Koznarek - Cleveland Research Company

Christopher Glynn - Oppenheimer & Co. Inc.

Operator

Ladies and gentlemen, thank you for standing by, and welcome to Eaton Corporation Second Quarter Earnings Call. [Operator Instructions] And as a reminder, this call is being recorded. I'll now turn the conference over to Senior Vice President, Investor Relations, Don Bullock. Please go ahead.

Donald Bullock

Good morning. I'm Don Bullock, Senior Vice President of Investor Relations. Welcome to Eaton's Second Quarter 2011 Earnings Conference Call. Joining me this morning are Sandy Cutler, Chairman and CEO; and Rick Fearon, Vice Chairman and CFO. As has been our practice, we will begin today's call with comments from Sandy, followed by a question-and-answer session.

The information provided on our conference call today will include forward-looking statements concerning the third quarter 2011 and full year 2011 net income per share and operating earnings per share; third quarter and full year 2011 revenues; our worldwide markets; our growth in relation to end markets; and our growth from acquisitions. Those statements should be used with caution and are subject to various risks and uncertainties, many of which are outside the company's control. Factors that could cause actual results to differ materially from those in the forward-looking statements are set forth in today's press release and related Form 8-K filing.

As a reminder, we include a presentation on second quarter results, which can be accessed on the Investor Relations web page. Additional financial information is available in today's press release, which is located on the Eaton's homepage at www.eaton.com. At this point, I'll turn it over to Sandy. Sandy?

Alexander Cutler

Thanks, Don, and good morning, everyone. Thanks for joining us this morning. We're completing obviously a very strong second quarter, which for us signified a strong first half and what we expect to be a record year in both sales and profits in our 100th anniversary year. I'm sure you've all had the chance to read our press release, our operating earnings per share of $0.97, up 47% versus last year, $0.04 higher than the midpoint of our guidance that we provided in our April call, and with the tax rate in line with our guidance that we did provide in April.

Net income per share was also $0.97, up 47%. Sales were up some 21% at $4,090 million, confirmation of strong continued momentum in our markets. The markets were up some 12% from a year ago in the quarter. 26% of our sales came from developing countries, and the year-to-year increase on those sales from developing countries were some 30%. And our quarterly segment profit margin of 13.9% was an all-time record, and obviously underpinned what had been our full year guidance of 14% for segment margins. As you'll see, as we go through this pack that we're raising it to 14.5% for the full year, this year.

We turn to Chart #4, entitled Comparison to Second Quarter Guidance. Obviously, the midpoint of our guidance that we provided in our April conference call was $0.93. We saw a just marginally lower markets than we had expected that accounted for about $0.01, and an improved performance for our cost of operations at $0.05. And that's what led us to the $0.97 reported operating earnings per share of just over 4% versus the midpoint of our second quarterly guidance.

If we move to Chart 5. You saw many of these figures, obviously, in the press release. Our sales were up some 8% from the first quarter, which we think references the continued strong momentum in our marketplaces. The 13.9% operating margin does encapsulate the roughly $25 million of uncovered commodity costs that we had shared with you in the April conference call that we expected during the second quarter. It came in very much in line with that, and that's about 0.6 point.

Market growth of 12%. We outgrew by about 2 points (sic) [2%]. Acquisition revenues accounted for 1 point (sic) [1%] and then ForEx accounted for about 6 points (sic) [6%]. And that's the overall elements that led to the 21% increase in year-to-year sales during the quarter.

Moving into the individual segments. If we move to Chart #6, the Electrical - Americas segment. Sales of just over $1 billion in the quarter, up some 7% from the first quarter. 16% year-to-year of strong, we think, revenue performance. Market was up about 10%, and you can see the elements of outgrowth, acquisition and ForEx. 14% operating margin in the quarter. Bookings up some 9%. The great strength we're continuing to see here is more on the industrial side of the marketplaces. We believe the U.S. nonresidential markets are close to a bottom and that's very much reflected in the bookings that we're seeing here during the second quarter, and the fact that our bookings year-to-year are up quite strongly in the nonresidential marketplace.

And then we were pleased to complete the acquisition of a small business in Colombia, which strengthens our business in South America. Absent the uncovered commodity costs that I referenced, the margins are up at about 33%. Incremental is very much in line with our full year guidance and that's not including FX and acquisition. We are really quite pleased with the pricing that we've been able to put in place and are very confident at this point that the uncovered commodity costs, which we had experienced during the first half, will not be experienced direct in the second half, and then, obviously, it's implicit in our margin guidance full year for this segment.

Moving to Chart #7, entitled Electrical - Rest of World. Overall volumes up some 18%. You can see the strong impact of ForEx had in the quarter of 13%. Since the first quarter, or comparing the second quarter to first quarter this year, revenue's up some 6%, overall margin of 9.9%. Markets up 6% around the world. Looking at the bookings, they, however, declined by 4% in the second quarter compared to a year ago. We referenced here the large drop in solar inverters that was really driven primarily by the reduction of feed-in tariffs that saw this market drop dramatically this year versus a year ago.

If you take out that drop in the solar inverters and some exiting of some low-priced product lines that we decided to exit, as well as the fact that we booked a couple of very large projects during the second quarter of 2010, the overall bookings would've been more on the line of 6% so we really see this weakness in the solar markets being fairly transitory.

And then we were very pleased to complete the acquisition of the ACTOM low-voltage business that we had announced during in the year. We actually did get it closed during the quarter. Once again, if we look at the margin performance in this segment, that absent the commodity cost -- uncovered commodity costs and the currency cost, the FX lower margins, the overall margins would've been at about 33% incremental, very much in line with our expectation.

Moving to Chart 8, Hydraulics segment. Obviously, this segment has continued to have a terrific year this year. Sales up 28% on an 18% market growth, all-time record margins, 16.5%. As a result, we're increasing our full year guidance in this segment. Bookings continue to be very strong, up some 20%. And we're very pleased with both the closing of the Internormen Technology Group, as well as the announcement of our deal on the Begerow business, both of which will significantly enlarge our filtration business as we've pointed out in our release.

If we move to Chart 9, which is the Aerospace segment. Sales up 11%, stronger than market. You see the progression quarter-to-quarter where our second quarter sales were up 5% from the first quarter. Margins at 12.2% compared to the 11.6% in the first quarter, very much in line with what we had indicated when we told you at the end of the first quarter that we expected that the higher development costs that we had encountered in the first quarter would continue through the second quarter this year.

Aftermarket bookings up 7%, stronger on the commercial side than on the military side. And bookings declined overall by about 1% in the second quarter compared to a year ago, really driven by the military market weakness that obviously, I think, you've all been reading about.

If we move to Chart 10, the Truck segment, very strong, continued surge in sales, up some 37%. Second quarter was 17% higher than the first quarter this year. Strong margin performance of 17.8%, that compared to the 15.6% in the first quarter. As a result of the strong performance, we're raising the full year margin guidance for this year. We're maintaining our NAFTA heavy-duty market forecast at 265,000. I know some of you have read and heard about supply chain weaknesses not affecting Eaton but affecting our customers during the quarter and expected for the remainder of the year. That's the reason that as you recall, going back to the April conference call, that we kept our forecast at 265,000 although, we're convinced the actual demand is stronger than that. And we don't -- do also now expect a little higher growth in the markets outside of NAFTA so that you'll see that we have changed our market growth forecast as well.

Turning to Chart 11, Automotive segment, strong segment. You may recall that when we've talked last in our April conference call, there was a lot of concern being expressed about whether automotive franchises would see stronger sales in the second quarter than the first quarter. Our sales were 3% stronger than the first quarter sales at $460 million, up 18% from a year ago. A very handsome 12% margin, again up from the first quarter level. We're raising our full year margin guidance based upon our strong performance. And we saw, as I think, the overall industry saw that the impact to the Japanese supply disruption turned out to be less than some of the early dire forecasts that were around in the April-time period.

So if we move to Chart 12, which is labeled the End Market Growth 2011. You can see that in 2 of our market -- or 2 of our business segments, both from the Truck area and the Automotive area, we've increased our sales up 3 points (sic) [3%], as a market forecast, up 3 points (sic) [3%] from 22% to 25% in Truck; up 3 points (sic) [3%] in Automotive, from 6% to 9%. And that's what causes the 1% increase from our 10% previous forecast to now 11% for the weighted average of our global markets this year. We think a very positive development.

Moving to Chart 13. You can see that we have some slight tweaks in terms of how we think the segment margins were laid out this year. No change in Electrical Americas; down 1 point (sic) [1%] in Electrical Rest of World, really due to this weakness we've seen on the solar side here this year; up 0.5 point (sic) [0.5%] in Hydraulics; up 1 point (sic) [1%] in Truck; up 1 point (sic) [1%] in Automotive. And that's what leads to the 14.5% margins, which we think is really a quite strong evidence of our ability to move ourselves toward the 16% goal for segment margins by 2015, again on a year where there's been a fair amount of commodity inflation this year. So again, we think we're doing a good job here on the ability to generate a real premium margins.

If we move to Chart 14, 2011 EPS Guidance. And the big news here is that we're increasing our full year guidance for the third time this year. This time by $0.15 or about 4%, so very much in line with the stronger performance we saw here in the second quarter. And you can see the midpoint for our operating earnings per share guidance for the third quarter is $1.08.

If we move to Chart 15, a quick reconciliation for our third quarter, starting with the base of our second quarter. Obviously, we just reported $0.97 operating earnings per share. We expect to get about $0.08 from incremental volume in the third quarter compared to the second quarter, and that's a blend of the seasonal impact of higher revenues at our 33% incremental and then additional FX with the acquisition volume that's at a lower margin of about 10%. We do expect, as I've mentioned a couple of times this morning, to be recovering what we had in terms of uncovered commodity costs, both from the first and second quarter, they ran about $25 million. We expect to eliminate that in the third quarter.

Our Aerospace margins, as I mentioned to you, that had been depressed both from the first quarter and the second quarter are programmatic expenses. We expect to recover that in the third quarter. That's about $0.02. And we do expect a higher tax rate in the third quarter and then I would say also in the fourth quarter, but the impact for the third quarter at about an 18% tax rate, compared to the 14.7% tax rate that we had in the second quarter, is about a negative $0.05. And that higher tax is -- or level of taxes is really being driven by the growth of profits in the higher tax jurisdictions such as United States. That leads to $1.08, as I mentioned, as our third quarter operating earnings per share guidance in the midpoint.

If we turn to Chart 16. A quick recap of our 2011 EPS compared to 2010. What changed on this chart from the last time we shared it with you? We've increased the market forecast to 11% from 10%, that added about $0.12. We increased ForEx sales, that increased about $0.06 so the top category that is footnote -- or excuse me, that is totaled at $1.93. That's $0.18 higher than what we showed you at the end of the first quarter.

And if you go to the several negatives section. There's an additional $0.01, both in the number of shares outstanding, in pension expense and the other, so a total of $0.03. That's $0.01 on each of those lines. So the plus $0.18 minus the negative $0.03 is how you get to the $0.15 increase in our full year guidance to get the total of $4 for midpoint.

Chart 17. Just a way of keeping you up-to-date with each of these elements that drive our guidance this year. As you can see, the changes between July and April, a 1 point (sic) [1%] pasture market growth. You can see about $65 million of additional revenue from acquisition that comes from the several deals that we have closed this year. You can see $200 million of higher ForEx sales, all leading to about a 15% increase in the midpoint. And then if you drop to the very last line item on the page, free cash flow, you see that it's about $50 million less than it was. And that's because we're actually signing additional attractive investments this year in terms of new product releases and capital expenditures. So we've increased our CapEx forecast to about $600 million from what had been about $550 million.

All this leads to, as I -- as we mentioned in our press release, increased sales of approximately 19%, increased operating earnings per share full year of 42%. So once again, we think a very, very strong year in the midst of what many people have described as somewhat uncertain economic conditions.

Then the $64 question. I think from all of our minds was -- this kind of a strong, strong year here in 2011 is as we peer into 2012, or what can we start to utilize as a way to kind of guide our thinking and planning going into next year, and I would stress these are, again, initial thoughts, not formal guidance. We think 2012 will be a solid year. And the consensus here, as we look out there in terms of global GDP now, is about 3.7%. And more importantly, when we look at global manufacturing industrial production, the consensus out there is about 5.2%, a pretty good environment for industrial manufacturing companies like Eaton. But we think there are couple of additional reasons that it may be even in a little bit more attractive than that [ph] for Eaton because our late-cycle markets are just beginning to accelerate. U.S. nonresidential is a good example of that. We've obviously seen much stronger activity in terms of the large data center markets now than we witnessed during the first half, in terms of shipments. And clearly, we've all seen the schedule for commercial aerospace ramp ups, which are quite substantial in the next couple of years.

And then somewhat of an odd fashion, many of the early- and mid-cycle businesses started to recover, I would call it, out of pattern, from traditional economic recoveries. So we're still seeing the industrial markets recovering, whether that be in the Electrical or in the Hydraulics market. We're continuing to see growth in the global side of the Hydraulics market as well. NAFTA Class 8, clearly, is in the midst of a several year ramp up, and we've talked about our view that we think 2012 is a year that starts with the 3, in terms of NAFTA heavy-duty.

And the global Automotive market place is continuing to recover, not just in the emerging nations but in mature economies such as the U.S. All that leads us to believe that '12 is going to be a solid year of economic growth, and we would expect again to outgrow and then to have positive acquisition, have revenue on top of that.

So with that, well, Don, I'll turn things back over to you for questions.

Donald Bullock

Thank you, Sandy. At this point in time, we will open for questions.

Question-and-Answer Session

Operator

[Operator Instructions]

Donald Bullock

Our first question is from Jeff Sprague.

Jeffrey Sprague - Citigroup

Andy (sic) [Sandy], I wonder if you could actually give us a little bit more color on your thoughts on the non-res market and may be split it kind of commercial non-res versus other non-res, if there is a distinction to be drawn there? Obviously, the actual sizzle to this construction market is still very stressed [ph] But maybe some color on what you're seeing, if there's energy retrofit? Or what it is that is giving you some confidence in the pickup?

Alexander Cutler

Sure. And Jeff, as you know, the market segments in non-res continue to be quite different by the individual verticals. And again, your observation's right. About 50% of this market is in the noncommercial side. And ABA -- ABI, excuse me, really contributes or addresses the commercial side. I'd say, we're continuing to see our wastewater treatment seems very strong. Oil and gas is up a couple of times from 2010. Mining and metals continues strong. Industrial continues strong. Utility is starting to uptick. We think healthcare universities are going to be a little higher in the second half than they were in the first half. And the small commercial construction side that continues to be a little weaker. We're also seeing the data center side pick up here for the second half versus the first half. So the way we think about it, if we look at our backlog in non-res construction, we're up some 15% from a year ago. And we think that, that's a strong indication in terms of what we've already got in the backlog. And that our backlog and large projects businesses is up a little higher than that. So we think we're in this process where we're seeing very solid evidence about the recovery. And while it's hard to be able to predict exactly which month of the year that the whole segment will go -- the whole reported segment will go positive, we're fairly encouraged of what we've seen so far. So we're bullish for the second half and going into 2012.

Jeffrey Sprague - Citigroup

Thanks. And could you provide a little more color on what you're actually seeing on price? It sounds like you do feel like you're caught up. Is there any residual lag as it relates to being caught up, as we think about Q3 and into Q4?

Alexander Cutler

We think to the best that we can forecast all this, and obviously a lot of moving pieces in this, but we think we've seen the 2 quarters of the noncovered commodity costs that were roughly the total of $50 million having occurred in the first half. We have announced our price increases in most of our businesses over the last 6 months and actually a couple of rounds. So we feel like we're pretty well caught up at this point so our expectation is that our commodity costs will be fully covered -- our increased commodity costs be fully covered in the second half.

Jeffrey Sprague - Citigroup

And just finally for me and I'll pass it on, is there any regional distinction in what you're seeing in your data center business, developed world versus developing?

Alexander Cutler

No. I would say, you tend to find the really big data centers tend to be a little bit more located in the developed nations of the world at this point, so there's that difference. But even that, it's starting to close. So no, I wouldn't say nothing regional in that respect.

Donald Bullock

Our next question is from Jamie Cook.

Peter Chang - Crédit Suisse AG

It's actually Peter Chang in for Jamie. I had a question on the FX forecast. Actually, how much did FX benefit the first half of your year in terms of EPS because it looks like you took that up from $0.05 to $0.11?

Richard Fearon

Peter, it's Rick. It is to the tune of about $200 -- a little over $250 million.

Peter Chang - Crédit Suisse AG

But that's on the sales line, right?

Richard Fearon

Yes.

Peter Chang - Crédit Suisse AG

But how on the -- for flow-through to the earnings line, do you know what that number or what that positive impact may have been?

Richard Fearon

Well, I'd have to grab the number but I can tell you for the second quarter, it was a benefit of about $20 million of profit. And it was $7 million in the first quarter. So it's about, generally, it comes in at about 10%.

Peter Chang - Crédit Suisse AG

Okay. So you've seen about a little over half of the FX positive impact in the first half of the year?

Richard Fearon

Yes, based on our expected $400 million of FX revenues for the full year.

Peter Chang - Crédit Suisse AG

Okay, great. And I know it's early but if we are thinking about 2012, it looks like it's shaping up to be a pretty solid year in terms of the macro, based on your assumptions, what should we be thinking about in terms of an incremental flow-through? Is 33% going to be a good number to use for modeling purposes?

Richard Fearon

Yes, I think, it's just a little early for us, obviously. We've not gone through our whole planning. What we've talked about generally is that through the cycle, that we like to see margins that are discern [ph] of 30% to 35%. But it's -- I think, we'll defer on that until we get out to a little later in the year.

Donald Bullock

Our next question comes from Ann Duignan.

Ann Duignan - JP Morgan Chase & Co

Maybe just trying if you could give us some color also on Rest of World, Truck volumes being up, I think that, that business is being -- in Rest of World, being Brazil, both Commercial Truck and Agriculture. Can you just give us some color on what's going on in those regions? And why you took up your numbers there?

Alexander Cutler

Part of it is what's already occurred in the year this year. Ag, actually in Brazil, is not driving this. The ag market has not been showing a positive growth as compared to 2010. But what we are seeing is in markets like India, for example, we're seeing strength there and that we've continued to do very well on a number of large programs are actually based out of Brazil but shipping to other areas of the world as well. I'd say that's the primary thing. And I would describe the change as it's a tuning change at this point. It's not a gigantic change.

Ann Duignan - JP Morgan Chase & Co

Okay. And then similar question on your Electrical Rest of World. The solar business that you noted, the inverter business, can you talk about how much of the business that is? And I haven't heard you talk very much about that business in previous quarters. Can you just, again, a little bit more color on what's going on there? I mean, we understand what's going on in the solar market in places like Germany.

Alexander Cutler

Yes, Ann, the best qualification we can give you is we've been talking really for the last year. It's been one of the fast-growing segments. It's one of our -- we have some particular expertise and really coming out of the inverter technology that will require as part of Phoenixtec. We don't break it out as an individual vertical in terms of our public reporting, but as I mentioned, it was the single biggest factor that caused us to have this drop in the second quarter in terms of bookings. We do think you're going to see solar, again, turn positive. We think part of this was an inventory challenge in the channels since the markets slowed down. But we also think, when you look at larger Rest of World, like Europe, Germany in particular, that pulled back the feed-in tariffs, they now are faced with how they're going to replace their nuclear power industry here in a very short number of years. And so we think you're likely to see a real push on alternative energies again as they have to try to close that gap. That's why how we think this is a more transitory weakness at this point, and we'll see this world reestablish itself.

Donald Bullock

Our next question is from Jeff Hammond.

Jeffrey Hammond - KeyBanc Capital Markets Inc.

Just back on the power quality and data center market, there's been some recent press on some significant shutdowns of government data centers. I just wanted to get your broader -- how does that impact you? How big is your government business? And I mean, what's the risk that we get to an overbuilt point on the commercial side as well?

Alexander Cutler

Yes. We certainly are not seeing the risk of overbuilt at this point. The first half has been a very busy half in terms of large data center, of both quotations and wins. And so our expectation is in the shipping side. Now things that are own shipments will increase materially in the second half compared to the first half. We're continuing to see the drivers of so much of what's going on, whether this is online video or whether it's just a lot -- or streaming video or much more online storage that is continuing to push this. And then the other big, big driver in here is the efficiency angle, where these larger, more cost-effective data centers are just where people have to move to. Having said that, Jeff, there clearly is an element and not just in data centers, but I would say, in municipal and in federal level government spending that is slowed down for all the reasons we well understand. You're seeing these positive numbers we're reporting in spite of that. So I think we've got that breadth and diversification, which allows us to move pretty well between these segments. So that this, in fact, is not a concern for us at this point.

Jeffrey Hammond - KeyBanc Capital Markets Inc.

Okay. And quick on Aerospace, how big of an impediment is this military dynamic? To what would be another rise as a snap back in the Aero business in '12, '13?

Alexander Cutler

Again, remember, our balance, a little bit more than 60% on the commercial side, a little bit less than 40% on the military side. I think almost anybody's military forecast has to be a lower number than it would've been 2 years ago. And, yes, ours obviously is, but what we're seeing is, is a very big ramp up on the commercial side. And you see all the public figures that are available there from both Airbus and from Boeing. So we're on the front end of a pretty exciting ramp up, which we're convinced there's -- it's going to provide solid overall growth from the Aerospace market, and we'll begin to feel those orders in our shipments really at least a quarter ahead. So if they want to ramp up in January, February, we're going to be shipping out in this fall which is again one of the reasons we've talked about our growth in that marketplace. Why we feel it's a late-cycle business and that it's going to do well over the next couple of years.

Donald Bullock

Our next question is from Steve Volkmann.

Stephen Volkmann - Jefferies & Company, Inc.

I wanted to ask if we could frame 2012 a couple of ways. The first one, I guess, is I'm thinking about incremental margins. I know there was a question about the 33%, but I guess I'm just trying to think more directionally, you're sort of in the low 20s here, but the growth is clearly going to slow a little bit next year. Can we get higher incrementals even though the growth rate's slowing in 2012 and maybe the key buckets that kind of drive that?

Alexander Cutler

Well, I think maybe the best way we can help you frame it, and I understand, you're really trying to approximate our rate of improvement, is that we still feel comfortable with the 16% segment margins in 2015. And so, yes, as you think about the inevitable trade-off of volume and margins, I think you can wrap that fairly incrementally or ratably over the same time period. We've not increased that 16% projection for 2015 at this point. So we're obviously going to outgrow these markets as we have been, and that ought to be part of what you think about as you think your way through your guidance. So you could take that 5% industrial production plus we hope something because in late-cycle businesses, we think, are going to do a little better. And work on your thoughts about our outgrowth and what our net year-to-year incremental acquisition revenues will be, I think it gives you a pretty handsome potential look at revenues.

Stephen Volkmann - Jefferies & Company, Inc.

Okay, I guess that's helpful. But what about -- how do we think about 2012 with respect to the stimulus spending? I think you've talked about the $500 million benefit this year. Is that sort of conceptually a headwind next year or not?

Alexander Cutler

Yes, I think the $500 million that we expect this year is right on these non-res numbers. So no, I would say you're -- you can almost kind of drop it out of a separate line of analysis because it's really been put right into the non-res numbers at this point here in '11.

Stephen Volkmann - Jefferies & Company, Inc.

But does that mean we're going to lose $500 million in 2012?

Alexander Cutler

We don't think Eaton does and because we've been very successful, as I mentioned, with these kind of breadth for the end market segments. So that because of our very large footprint, we cover virtually all these verticals well. So we aren't seeing -- it's something that is going to be a headwind for us going into '12.

Donald Bullock

Our next question is coming from Andy Casey.

Andrew Casey - Wells Fargo Securities, LLC

A couple of questions on Aerospace. Could you clarify what the total hit related to the program cost in the quarter was? And then does any of that type of headwind fall into second half as well?

Alexander Cutler

No, we only address the second part first, Andy. We think that it is gone by the second half. You may recall what we said in the first quarter conference call is that these serious scope changes and delays and execution issues, we thought would impact both the first and the second quarter. We actually saw the second quarter margins just a little bit stronger than we thought they might have been when we came out of the first quarter. It's on the order of $6 million in this quarter. I think you can see that, that puts us back in pretty handsome margins in terms of the segment. But we believe we should be returning ourselves to margins from the second half. As you recall, we've not changed our margin guidance for the Aerospace segment. So that -- I think, you can pretty well get an expectation looking at where we've been on the first half, the kind of rates we've got running at the second half to hit that overall margin, and we do think we will hit it.

Andrew Casey - Wells Fargo Securities, LLC

And then the rest -- Electrical Rest of World, it looks like your guidance is -- for the market is kind of flattened out in the second half. Is that accurate? And do you think it's a short term issue or could that continue for a while with all of that conversations and the like?

Alexander Cutler

Yes. We've got the market forecasted at 6%.

Richard Fearon

7%.

Alexander Cutler

7%, excuse me. And yes, we'll see if we end up being a little bit conservative as the year goes on. But to us, it's sort of a prudent number as we look through the changes that are going on. And that's actually in line with what we're seeing in the Americas market as well at this point.

Andrew Casey - Wells Fargo Securities, LLC

Okay. And then one broader, last question. You have all this uncertainty going around on the various macro indicators, have you seen any of that seep into particularly the distribution channel in terms of their access to capital?

Alexander Cutler

Have not yet but I think it's more of kind of a frictional loss in terms of people's confidence, I think, is what's happened. So we haven't seen it as much on the issue people's access to capital, not that they couldn't change but more about a hesitancy to make that larger or longer commitment. And I think that's affecting consumers and I think it's affecting businesses. I don't think there's any question about that. Our view from Eaton is that it's one of the reasons we have a highly liquid balance sheet. It's one why we've got our financing strategy is one that is tiered and we think in a very prudent way. So answering the question, you didn't answer or didn't ask, I think we're well-equipped to be able to deal with what may come out of, either some action or lack of action over the next couple of weeks.

Donald Bullock

Our next question is from Josh Pokrzywinski.

Joshua Pokrzywinski - MKM Partners LLC

Just to kind of -- go out the question about that Jeff asked about, the components of Electrical, a little bit differently on the non-res side. Maybe can you talk about some of the different sub-verticals in there and where we're at relative to peak? So, I think, as you guys talk about non-res, a lot of industrial buckets get lumped in there as well. Certainly, the building aspect, whether it be commercial or institutional as well off-peak, but how are we on the industrial side relative to kind of the '07, '08 timeframe?

Alexander Cutler

Yes, to get your back though at '07, '08, I think we'd have to get some more data to do that. We've tended to kind of look at this year-over-year but I'd say where you've seen the strongest activity has been oil and gas. And for all the reasons we understand, those numbers are up really quite strongly. I think you've seen the mining segment has been strong as well for all the commodity reasons that we all understand as well there. Clearly the much weaker areas and the small commercial. It's been what you tend to see in and around retail. It's been weakened in the office market segment. And of course, those are big contributors into what you see with the ABI information that comes out. So and our mechanical [ph] is kind of behind the export side. It is done a while again and that gets you back to the manufacturing side. Having said that, if you take the whole marketplace, I don't know, Rick, you may be got the numbers there, we're probably down 30%, 35% from peak. And that's a pretty good planning number so what's happened over the last several tops to peaks. That's why we really believe as we look into the all this year that, let me call it the noncommercial side of the marketplace has been getting stronger, it's been the commercial side that's been lagging that. But we're seeing that rate of decrease get less as we go quarter-to-quarter. That plus the bookings we have on hand is what gives us confidence about the second half.

Joshua Pokrzywinski - MKM Partners LLC

Got it. So the bookings on the smaller commercial side are starting to improve?

Alexander Cutler

Well, they're a little weaker right now. And so I would say that, that's a part of the market that has been a little weaker in the latter part of this quarter.

Joshua Pokrzywinski - MKM Partners LLC

Okay. And then just shifting over to the Hydraulics for a moment. It sounds like there is some persisting type supply dynamics in that market place, maybe affording you a bit more opportunity on the pricing side. Any competitive elements that you're aware out there? Any changes in the market coming to where it maybe that supply starts to loosen up and pricing becomes a little bit more normalized?

Alexander Cutler

Again, I stepped back and I'd say that what we've seen is -- was a very rapid decline and we've seen a really rapid rebuild. Lead times in the industries are a little longer but we're not seeing demand abate. And so that we think we kind of go around the world and it's still very strong on the mobile side. Industrial side has begun to catch up but mobile is still tending to lead this marketplace. And I think that the piece that probably we all have to rethink as we think our way through this kind of cycle on Hydraulics is that we're seeing a lot more construction activity in many, many new parts of the world than what was around during the last cycle. And we think that it's contributing to longer and higher strength than perhaps history would have told us.

Joshua Pokrzywinski - MKM Partners LLC

Would is it fair to say that as demand to snap back quickly and maybe there've been some pinch points in the supply chain that you've been able to deal a little bit more forward in price in Hydraulics than some of the other businesses?

Alexander Cutler

No, I wouldn't say so. I think again, each of these businesses has seen very significant commodity pressure over the last 6 to 9 months, I'd say. Hydraulics is not much different from the rest of our businesses. So we've been working that issue. Obviously, different businesses have different cycles for how fast price increases get in place. And so no, I wouldn't single it out.

Donald Bullock

Our next question from Terry Darling.

Terry Darling - Goldman Sachs Group Inc.

Still trying to understand the arithmetic on the Electrical Americas end market and then sort of how that ties in with your revenue forecast there. So 14% end-market growth in the first quarter, 10% in the second, 7% for the full year. I think, it means you got to be more like 2% or 3% in the back half, which to get to the kind of revenue numbers you're talking about, I think, it means you've got a lot of outgrowth in the second half of the year, but can you just clear me up on that?

Alexander Cutler

Yes, I'd have to go back and look through each of our numbers, Terry, but I think what our expectation has been that things start to look fairly significant in the second half last year too. So that we got a little bit year-to-year in that regard. Rick, have you got a number of that thing?

Richard Fearon

Yes. Part of the problem is you've got the comparisons year-over-year changing as well. So it's probably easiest, Terry, if we just deal with that outline to give you a better comparison. But we do think that as Sandy has pointed out that the non-resi is likely to bottom anytime now and begin to show modest improvement over the course of the year. And whereas we see continued strength in the industrial parts in particular, I'm talking about the Americas right now. But we can give you a comparison that puts it all together off-line.

Alexander Cutler

And Terry, let me just add too. It's not unusual to see Eaton significantly outgrow in the non-res market place as it comes back because that's an area that Eaton has had a very, very large footprint. So I suspect part of it is right in that point you make.

Terry Darling - Goldman Sachs Group Inc.

Yes, and you mentioned a big increase in data center shipments in the back half so that's probably part of what's going on there. So and then on Automotive index, when I look at global build forecast, I mean, if I pull out Japan, which I suspect is not in your index, the 9% growth for this year is as much higher than the build forecast, even adjusting for Japan mix. And I'm just wondering what might be driving that? Maybe I'm not appreciating the Asian mix at this point, or the Eastern European mix. Any other thoughts on why Auto Europe end market forecasts would be so much stronger than the global build?

Alexander Cutler

Yes, our own feeling here again, Terry, was that the first half of the year, we were perhaps a little bit conservative in terms of our market outlook, and that had to do -- we were cautioned a little bit by what we saw occur obviously in Japan. And we're pretty comfortable with 9% at this point here. I think our numbers in the U.S., Rick, are on the order of 15%. And we're seeing stronger third quarter build schedules than we would normally see in the seasonally weak third quarter. And that's got us feeling that we're going to see these markets be a little stronger than we have thought.

Richard Fearon

And Terry, we have our view on markets outside the states as we think European growth is going to be on the order of 6% this year, Asian growth x Japan, and you're right, we don't include Japan in our market index because we serve that market through our investment in Nittan Valves, that's publicly-traded Japanese valve company. So Asia growth x Japan, we think, is going to be on the order of 8%. And so we feel pretty comfortable with these market forecasts.

Terry Darling - Goldman Sachs Group Inc.

Okay. And then lastly, on the downtick in the Electrical Rest of World margins, is that just the effect of the -- what's going on in the solar market? Is there some other dynamic there? And Sandy, has your longer-term thinking on where Electrical Rest of World margins can go in that 2015 range changed at all?

Alexander Cutler

Let me answer the latter part first. No, they have not, changed, in terms of our expectations and I'd say, currently, it is the solar issue but it's also, as we mentioned, the impact of rising Asian currencies and we had some of that in the first quarter as well. We believe that starts to attenuate at this point but that was the other element for the impact to the margins. And I should mention we had commodity pressure in there as well. Those were the 3 issues.

Donald Bullock

Our next question is from Eli Lustgarten.

Eli Lustgarten - Longbow Research LLC

Can we talk about the EBIT commodity impact? I mean, you cited the $25 million in recovery, and I think you were referring mostly in Electrical Rest of World than Electrical Americas. But copper has also now gone back up to $4.40-plus as opposed to $4.10. Can you talk about how much affected each sector in the first -- in the second quarter? And well, again, that in Hydraulics, would you expect to get it both back -- both sectors back in the second half?

Alexander Cutler

Eli, as I mentioned, just in the first quarter, the biggest impact was really in our 2 Electrical sectors but we had impact in each of the other businesses that deal with the vehicle markets as well. What we have been doing, though, as I think you're aware, through both the winter and the spring and early part of the summer had been announcing additional price increases. And those price increases are either in effect or go into effect quite shortly. And as a result, that's why we're confident that this approximately $25 million that we incurred both in the first and the second quarter, because you're right, we did have some additional increases in the second quarter, will be totally covered in the third and the fourth quarter.

Eli Lustgarten - Longbow Research LLC

But can you give us some impact of what is -- how was it related to your Electrical businesses? I mean, how much higher with margin would that recovered?

Alexander Cutler

Well, as I mentioned, if you step back for the company at this point, our margins with FX, and acquisition included, were about 22% for the quarter. If you take out the FX and the acquisition margin, they're almost 30%. It's a little over 29%. And then if you deal with the impact, obviously, the $25 million, that's about 5 points. It's like, it gives you a feel for how much the uncovered commodities are impacting us. The biggest portion of that commodity pressure has occurred really in our Electrical segments.

Eli Lustgarten - Longbow Research LLC

Okay. And one final, can you talk about comparisons in the Hydraulic sector for the rest of the year. I mean, Hydraulic market was red-hot in the first half. I mean, your short to invest 35%, 40% gain, industry-wide, across-the-board. So we're looking at much tougher comparisons as we go through the year. And are we going to still see double-digit gains in the second half of that business?

Richard Fearon

Yes, we do. The rate of growth, Eli, is likely to be a little bit less than in the first half as you point out but we still think it will be double-digit.

Donald Bullock

Christopher Glynn, our next question.

Christopher Glynn - Oppenheimer & Co. Inc.

On the Aerospace biz, just wondering if we could dive in a couple of the pieces starting with the military. How would you qualify the degree of visibility you have in the back half? And then just comparing your aftermarket trends versus the OE on the commercial side?

Alexander Cutler

Yes, on the visibility issue, we do get, we call it reasonable visibility outside on this 3- to 6-month time period. I think that the bigger question is it's not so much an issue for 2011 as it is an issue sort of in the '12 to '14 time period. That's in some of the major programs. Not so much will they be canceled but how much will they be downsized under the budget pressure. And there are lots of numbers floating out there. We've tried to take into account what we think is a reasonable estimate of what those will be. And the strength of our Commercial business will allow us still to have a handsome growing business but until we get through this budget debate, I don't think anybody can be sure what the U.S. defense budget is going to look like. But -- second part of your question, I'm sorry, Chris?

Christopher Glynn - Oppenheimer & Co. Inc.

Yes, just the aftermarket.

Alexander Cutler

Oh, aftermarket. On the aftermarket side, we like, I think, most people saw a very strong quarter on the commercial side. And as the real squeeze is going on at the military side, we actually saw a very weak quarter in terms of aftermarket on the military side. And I think that, that's not a bad expectation for what may occur while all the government budgets are being really heavily impacted right now and everybody's looking for discretionary ways not to spend money in the government right now.

Christopher Glynn - Oppenheimer & Co. Inc.

Okay. And then just switching over to Electrical. Sounds like a lot of outgrowth still in place in the back half. But how do you break that $500 million stimulus? And is that largely a first half realization?

Alexander Cutler

No, first, we were not breaking it out here this year like we were last year but the expectation was that we would see it pretty much like we saw last year, that the spending patterns were pretty even through last year, and that's our expectation for this year. So I really think and as you try to think through your model for the year, you can almost take that out and really just simply look at nonresidential recovery and use that as a stronger surrogate so that you'd be seeing against the negative that was still occurring in the first half, that we go flat and begin to go marginally positive in the second half in terms of the end markets.

Donald Bullock

Mark Koznarek.

Mark Koznarek - Cleveland Research Company

Struggling a little bit here with the Electrical Rest of World margin outlook and the implications for the second half suggests some pretty sharp sequential pick up into the like 12.5% margin versus under 10% here in the first half. What is going to be different in the second half?

Alexander Cutler

I'd say one of the big elements there, Mark, is price versus commodity costs. And that's clearly a key element in this. And we feel comfortable where we are in that regard now.

Mark Koznarek - Cleveland Research Company

In terms of the pricing that's already been put in place for the second half?

Alexander Cutler

Correct.

Mark Koznarek - Cleveland Research Company

Okay. And so there's not an expectation about this solar inverter thing, and you're not expecting that to come back and that has particular profit characteristics?

Alexander Cutler

I don't think we're going to see an enormous short-term snap back. I mean, we're still supportive obviously of our position in that market place. But I think it'll take a little while to see some of these feed-in tariffs really put back in place and then get the market reaction and fill the channels. And so I don't think that's a second half 2011 issue.

Mark Koznarek - Cleveland Research Company

Okay. And then in China, you've got a lot more businesses besides that solar inverter thing, and there's a lot of controversy and interests in -- to the momentum of the overall Chinese economy. And I'm wondering if you can give us some color on what you're seeing across the breadth of businesses, setting aside this one-time element of the inverters?

Alexander Cutler

If you step back and you look at the economy, I think most people agree that the Chinese GDP number was somewhere over 10% last year. Our own approximation, it was about 10.3%. We think this year, it's going to be over 9%. Our best approximation is that it's to be around 9.5%. I recognize any estimate of the Chinese economy within 0.5% is probably unduly precise. What we've seen is that there are segments in the market that are still growing very quickly. There are segments, I think, cooled. Not unlike what we've seen elsewhere around the world. The truck industry scenario obviously that had a booming year last year and has cooled very significantly this year. Auto has seen some months of slowdown but is up at a pretty high level, and then you've seen some evidence out of the Hydraulics end market that some of the individual competitors are doing very well, some others are not doing so well. And I think that's more of a reordering of competitive position than it is simply an end market issue. We're continuing to see pretty good activity on the Electrical business as you go through the whole power distribution area. And if you remember, going back to the first quarter, there were articles being written that you were seeing weakness in that kind of Power Distribution area. That seems to have come back a little bit, and the utility spending has come back a little bit. So a little different segment-by-segment but we still think there's positive growth there, and I would say on the larger issue of the great countries. We think they're being responsible doing what they've got to do with interest rates. And that has -- and I mean, that's increasing them. And so that means that we have seen some slower rate of market growth, but as I mentioned in my opening comments, our sales were actually up 30% in the emerging nations in the second quarter versus a year ago and so we're continuing to see strong growth.

Donald Bullock

Jason Feldman.

Jason Feldman - UBS Investment Bank

So you touched on the supply chain impacts at Hydraulics. But have you seen more broadly, any continued supply chain issues related to Japan in the Electrical or any of the other segments?

Alexander Cutler

No, we've really not. And really, this supply chain issue, I mentioned earlier, is really more of a North American heavy-duty truck supply chain issue with the strong ramp up in volumes that have been terrific from that perspective, not unlike other historic ramp ups. The industry is starting to see some challenges with getting balanced inventories into the OEMs. This is not an Eaton issue. It's more of an industry issue, and that's why we feel that 265,000 is still a good number in terms of production here.

Jason Feldman - UBS Investment Bank

Okay. And then also, you spent a fair amount of time on this call talking about the nonresidential construction trends. Has there been any change on the residential side within Electrical?

Alexander Cutler

I think there, we'd be talking about tunings of 8 versus 10 houses. No, not much. It's still this is obviously a very stressed segment and so we would say not anything that's material to Eaton.

Donald Bullock

Brian Rayle.

Brian Rayle - Northcoast Research

Most of the questions have been answered. But I guess the one question I'd ask on the 2015, 16% target margin. Within the Electrical segment, how close are you expecting those 2 segments to come to parity? Do you expect in that 16% that the Rest of World is pretty close through the North American or even equal?

Alexander Cutler

We said that we thought there would be about a 3-point difference between the 2, with the Electrical Americas being higher and the Electrical Rest of World just behind it. And that's pretty typical for what you see in most global electrical companies where their so-called home market margins are a little higher than they are in the areas they're expanding into.

Brian Rayle - Northcoast Research

So I guess a follow-up on that is do you expect, in that 16% margin, do you expect your North American Electrical business to be more profitable than it is today, in a meaningful way? Or are we going to see the improvements in the other segments?

Alexander Cutler

Yes, we said that Electrical Americas, obviously, would be higher than the average in terms of our total margins.

Brian Rayle - Northcoast Research

I guess, I see to where it's higher than the overall average it is now, just to get an idea of how much higher it would be or we can expect would be -- I guess, a better way to ask that would be is the Rest of World Electrical margin, would you expect that to be in line with the corporate average?

Alexander Cutler

No, we'd said it would be slightly below. In January, we had indicated that we would be 16% for Electrical Americas and 13% for Electrical Rest of World.

Brian Rayle - Northcoast Research

Okay. So there's no change to that at all?

Alexander Cutler

No.

Donald Bullock

Ted Wheeler.

Edward Wheeler - Buckingham Research Group, Inc.

Just a lot of questions on margins but I guess I'll try one more. If I look at your year end -- full year estimate for margin, it sure feels like it's 15%-ish for the second half. And then we take a linear progression to 16% over 3 years. It's just -- in your reported margin, it will be 14.5%. So it just feels like the '12 margin will be better than the linear progression if I kind of just look at what's happening in the back half run rate?

Alexander Cutler

Yes, I think the issue, Ted, there to keep in mind, though, is that the first quarter is always the seasonally weakest. So that I would just encourage you as you think through what feels appropriate to you that you're reflecting in your own thinking that the seasonal first quarter is always, always the lowest. And so generally, you're going to see at second half, that's stronger than the first half from us.

Edward Wheeler - Buckingham Research Group, Inc.

Yes, and I guess, well, okay, but your -- the commodity issue was like 60 basis points. So even with that, it just does feel like we might see better than a linear progression next year but I guess you want me to hold it there for now?

Alexander Cutler

Yes, and nothing would be more pleasing to us. It's just a little early at this point.

Donald Bullock

Thank you, all, very much. With that, we will conclude our call this morning.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Executive TeleConference service. You may now disconnect.

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