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Call Start: 08:30

Call End: 09:34

Tyco International Ltd. (TYC)

Q1 2012 Earnings Call

January 31, 2012 8:30 am ET

Executives

Ed Breen – Chairman, Chief Executive Officer

Frank Sklarsky – Chief Financial Officer

Patrick Decker – President, Flow Control

Antonella Franzen – Vice President, Investor Relations

Analysts

Jeff Sprague – Vertical Research

Steve Tusa – JP Morgan

Scott Davis – Barclays Capital

John Inch – Bank of America

Deane Dray – Citi Investment Research

Nigel Coe – Morgan Stanley

Steven Winoker – Sanford Bernstein

Operator

Welcome to the Tyco First Quarter Earnings conference call. All participants have been placed on listen-only mode until the question and answer session. At that time, please press star, one on your touchtone phone. Today’s conference is being recorded. If you have any objections, please disconnect at this time.

I will now turn the call over to Antonella Franzen, Vice President of Investor Relations. You may begin.

Antonella Franzen

Good morning and thank you for joining our conference call to discuss Tyco’s first quarter results for fiscal year 2012 and the press release issued earlier this morning. With me today are Tyco’s Chairman and Chief Executive Officer, Ed Breen; Tyco’s Chief Financial Officer, Frank Sklarsky; and Tyco’s Flow Control President and future CEO of the standalone flow control company, Patrick Decker. As we continue to move closer to the separation, we look forward to having each of our new CEOs join us on upcoming calls.

I would like to remind you that during the course of today’s call, we will be providing certain forward-looking information. We ask that you look at today’s press release and read through the forward-looking cautionary informational statements that we’ve included there. In addition, we will use certain non-GAAP measures in our discussions and we ask that you read through the sections of our press release that address the use of these items.

The press release issued this morning and all related tables, as well as the conference call slides, can be found on the Investor Relations portion of our website at tyco.com. Please also note that we will be filing our quarterly SEC Form 10-Q later today.

Certain items to be discussed during today’s call, including those related to the Company’s proposed separation, will be addressed in a proxy statement to be filed with the Securities and Exchange Commission. Before making any voting decisions, investors are urged to read the proxy statement regarding the proposed separation and any other relevant documents carefully in their entirety as they become available because they will contain important information about the proposed separation. Three copies of the proxy statement, when available, and other documents filed with the SEC by Tyco can be obtained through the SEC’s website as well as through Tyco’s website.

In discussing our segment operations, when we refer to changes in average revenue per user, backlog and order activity, these figures exclude the impact of foreign currency. Additionally, references to operating margins during the call exclude special items and these metrics are non-GAAP measures. Again, these non-GAAP measures are reconciled in the schedules attached to our press release.

Additionally, I would like to call you attention to the realignment of our business segments. Beginning with the second fiscal quarter of 2012, we are managing the businesses and will publicly report our results in a manner consistent with our post-separation segment structure. This will consist of three business segments, including ADT North America Residential and Small Business, Commercial Fire and Security, and Flow Control. We will continue to report corporate as a segment in its historical format in Tyco’s consolidated results.

The results presented in our press release today are based on Tyco’s historical presentation. Our comments on today’s call will address both the historical presentation as well as future expectations on a realigned basis. In an effort to provide some comparable information, concurrent with the filing of our press release earlier this morning, we have also filed in 8-K which recasts the quarters of fiscal 2011 and the first quarter of fiscal 2012 in the new segment format.

Now let me quickly recap this quarter’s results. Revenue in the quarter was 4.2 billion and was consistent with our previous guidance. This represents a 4% increase year-over-year, excluding the contribution from the electrical and metal products business in the prior year quarter. Organic revenue grew 4% in the quarter. Foreign currency negatively impacted revenue by less than 1%. Earnings per share from continuing operations attributable to Tyco common shareholders was $0.71 and included charges of $0.13 related to special items. Earnings per share from continuing operations before special items was $0.84 compared to our previous guidance of about $0.77, led by strong operating results across all businesses.

Now let me turn the call over to Ed for some opening comments.

Ed Breen

Thanks, Antonella, and good morning everyone. We are off to a solid start to 2012, highlighted by strong operating margin performance. Growth in our large and stable base of recurring and service revenue, which represented 45% of our revenue in the quarter, coupled with good operating leverage in our manufacturing businesses, helped drive the operating performance this quarter. Additionally, we continued to benefit from our restructuring and cost containment initiatives, which also contributed to the 100 basis point improvement in operating margin year-over-year.

We exited the quarter feeling encouraged by both our performance and our order activity. It’s important to keep in mind that our North America residential business, which represents about 20% of total revenue, has continued to achieve quarterly organic revenue growth over the past several years, including the period throughout the economic downturn. From an orders perspective, order growth relates to the remaining 80% of our portfolio, which has continued to see positive momentum.

To quickly recap our recent order activity, year-over-year orders improved 5% in the first quarter of fiscal 2011, followed by 7% growth in each of the second, third and fourth quarters; and in the first quarter of fiscal 2012 that we just exited, orders grew 8% year-over-year. Additionally, we saw a nice increase in backlog in both our fire and flow control businesses during the first quarter.

Now let me give you a quick overview of our results for each of our businesses. Starting with security, our operating performance in the quarter was strong. Our global recurring revenue base continues to perform well. Additionally, all of our key metrics – growth in our account base, average revenue per user, and improvement in attrition – continue their positive momentum. On the non-recurring revenue side in security, organic revenue grew for the seventh consecutive quarter.

In fire, we continue to focus on growing our service revenue and strengthening our position in key vertical markets. The actions we have taken over the past year to improve the mix in our fire business coupled with the benefits of cost containment initiatives drove significant operating margin improvement year-over-year.

In flow control, the ramp-up of orders over the past few quarters has translated into solid organic revenue growth and sequential operating margin improvement.

Turning to the separation, I am pleased to report that we are making very good progress, particularly in areas of finance and legal, which as I have mentioned before is where most of the heavy lifting takes place. We have filed our U.S. and international tax ruling requests, made significant progress in preparing the carve-out financial statements, and we will be meeting with the rating agencies in February. Additionally, we are nearing completion in filling out the management teams and boards of directors for each of the companies.

We expect to file the initial Form 10s which are required for the two spincos, ADT North America Resi and Flow Control, with the SEC on late March. At the same time, we expect to file a preliminary proxy statement related to the required shareholder vote on the separation. The proxy will include pro forma information on the remaining commercial fire and security company as a standalone entity.

Also, as Antonella mentioned, beginning with the second quarter we have realigned our segment reporting structure and management teams to coincide with the proposed public company structure. George Oliver is now managing the worldwide commercial fire and security business, ADT North America Residential continues to report to Naren Gursahaney, and Patrick Decker continues to manage the Flow Control business.

Overall, we are pleased with the progress we are making on the separation and remain on track to have the transaction completed by the end of the fiscal year. While the separation requires significant effort, I want to assure you that we remain very focused on delivering on our performance commitments for fiscal 2012.

With that, let me turn it over to Patrick for a more detailed review of flow control’s results, and then Frank will review the results for security and fire, as well as a few other important items.

Patrick Decker

Thanks, Ed, and good morning everyone. Before I walk you through our results for the quarter, I’d like to provide you with a little background about the flow control segment. As many of you may be aware, this business has three main platforms: an industrial valves controls business, a thermal controls and heat tracing business, and a water infrastructure business.

Just to give some perspective, approximately 80% of our revenue is derived from the markets outside of the United States, with a substantial presence in emerging markets. In fact, almost 30% of our revenue is generated from emerging markets such as China, the Middle East, India, and Latin America, just to name a few. We’re well positioned in these markets and have been investing both organically, adding sales and engineering talents, and inorganically with a few targeted strategic acquisitions over the past couple of years.

In addition to our geographic diversity, the flow control business is also well positioned across a number of very attractive end markets. Whether it is energy needs driving the oil and gas or power sectors, global demand for commodities driving chemical and mining applications, or the need to move and distribute water over vast distances, we provide a broad portfolio of products and services and stand ready to partner with our customers to help them meet their objectives.

Our customers are looking for someone with whom to partner, not just during the initial installation phase of a project but over the entire life cycle of an application. They’re looking for someone who possesses broad global capabilities in the areas of aftermarket service, repair and replacement, as well as a highly technical engineering expertise to help them develop innovative and improved applications. Each of our three platforms is very focused on consistently delivering this value proposition.

Now I just want to spend a few minutes on each of the platforms, starting with our largest business, valves and controls, which accounts for about 60% of our revenues. The valves industry is very fragmented. There are literally thousands of valve manufacturers around the world. What differentiates us in this industry is that we focus on the design, manufacture and service of highly engineered valves, actuators, and controls for use in the most demanding environments, such as extreme pressure, extreme temperature, and those used for mission critical applications. Our brands are established market leaders with strong reputations in the industries they serve.

Given the breadth of products in our portfolio coupled with our global scale and aftermarket service capability, we are also well positioned to partner with some of the largest customers in our industries in developing global frame agreements, and we expect these global agreements will continue to be an attractive source of future growth. In addition, as evidenced by our most recent results, this is a strong global business and one that has been accelerating over the past several quarters as late cycle markets have improved.

Next is our thermal controls business which comprises about 20% of our revenue. This business is very similar to the valves controls business in terms of the end markets and customers we serve; in fact, we often sell into the same projects. Over the years, we’ve developed our engineering, design and service expertise and have evolved into a full turnkey solution partner in lieu of being solely a product provider. Rather than simply selling a standard self-regulated heating cable or related product, we work closely with our customers throughout the lifecycle of a particular customer project site. We do upfront design to determine, in partnership with the customer, the best way to manage the temperature of materials they are processing. We install and insulate the pipes being heat-traced, and we provide ongoing maintenance and monitoring of temperature to ensure compliance to the established heating specifications. In doing so, we aim to provide our customers with solutions for highly effective end-to-end processes at lower lifecycle costs as compared to other traditional alternatives.

One important distinction between the thermal business and the valves business is the typical conversion time from bookings to revenue. While the valve business generally has up to nine month lead times, the thermal business generally converts its orders to revenue within roughly 30 to 60 days. A clear exception to this, however, would be when we are working on a large turnkey project which is sometimes executed over multiple years, depending upon customer requirements and size and scale of the project.

The final business in this portfolio is our water business, which is largely concentrated in the Pacific region. Our competence in this business is the design and manufacture of large diameter water transmission pipes that are typically used in high pressure applications and pipelines spanning very large distances. This business consists of an ongoing base business of smaller projects as well as occasional large scale projects. The periodic nature of these large projects can cause variability in order rates, revenue and earnings from quarter to quarter. That said, over the longer term cycle, this business carries attractive margins and good returns on investment.

While the end markets have been soft this past year, our customers are now launching some significant new pipeline projects and we have already booked a few midsized projects this past quarter which are reflected in the strong orders growth we reported. In addition, we remain confident we will book some larger orders each in the 50 to $100 million-plus range over the remainder of this fiscal year. These projects will begin shipping in the second half of 2012 and throughout 2013.

Now let me turn to our results for the first quarter. Overall revenue of $923 million increased 12% year-over-year with organic revenue growth of 10%. Revenue growth in the quarter was driven by strong sales in valves, controls and thermal businesses partially offset by lower revenues in water. Operating income before special items was $113 million and the operating margin was 12.2%.

Turning to each of our three platforms, valves and controls grew 13% organically in the quarter and operating leverage from the incremental volume gave us good year-over-year improvement in operating income. Orders growth in the quarter remained strong with a 21% increase year-over-year. Order activity was positive in all end markets, led by strong growth in oil and gas, and power.

In thermal controls, the first quarter is seasonally the strongest quarter due to the cold winter months. Organic revenue grew 28% year-over-year, driven by the continuation of a large turnkey project that is now nearing completion. We are currently pursuing a couple of similar large turnkey projects that will positively impact revenue and earnings in fiscal 2013.

In the water segment, organic revenue declined 15% as a result of having benefited in last year’s first quarter from the Australian desalination project, which was completed in the first quarter of fiscal 2011. We expect revenues and operating margins in water to improve in the second half of fiscal 2012.

Overall, total flow control orders in the quarter increased 16% year-over-year and backlog of $1.8 billion increased 4% on a quarter sequential basis. Continued leverage from organic revenue growth in the valves and controls business combined with an improvement in water margins gives us the confidence that we will achieve a 14% operating margin rate sometime during the second half of fiscal 2012.

Now, let me turn it over to Frank.

Frank Sklarsky

Thanks, Patrick, and good morning everyone. I will now cover the securities solutions and fire protection results along with a few other items.

Let me start with security solutions. Revenue for the quarter increased 2% to $2.2 billion with 3% organic growth. Recurring revenue, which represented 58% of securities total revenue in the quarter, continued to perform well with 4% organic revenue growth. ARPU expansion coupled with a higher number of accounts drove the organic revenue growth in this category. The remaining 42% of revenue, which is non-recurring in nature, grew 1% organically as growth in the Asia Pacific and Latin America regions was partially offset by a modest decline in North America and EMEA. The products business also contributed to the positive organic growth in non-recurring revenue.

From a profit perspective, operating income before special items was $375 million and the operating margin improved 70 basis points year-over-year to 17.4%. Growth in our higher margin recurring revenue and the continued positive impact of restructuring and cost containment initiatives drove the improvement.

Now let me walk you through the regional performance of securities solutions for the quarter. Starting with North America residential and small business, where nearly 90% of revenue is recurring, we had another strong quarter. Organic revenue grew 4% with higher average revenue per user and an increase in the number of accounts both contributing to the year-over-year growth. The North America residential and small business account base of over 6 million customers increased 2% from the prior year. Average revenue per user grew 3% year-over-year as new accounts were added to the base at a higher monthly revenue rate per account, partly driven by the increased penetration of Pulse.

During the quarter, we saw continued momentum in the Pulse take rate, which increased to 28% of new accounts added by our internal sales force; and beginning this quarter, we expect to expand the rollout of Pulse to our dealer network.

Attrition improved 20 basis points on a quarter sequential basis and improved 30 basis points year-over-year to 12.8%. In our North American commercial business, organic revenue declined 2% due primarily to softness in the retail end market; however, orders momentum continued in the first quarter and backlog grew 3% on a quarter sequential basis.

In the EMEA region, organic revenue was down 1%; however, we continued to see substantial improvement in the operating margin in this region as past restructuring actions drove a 150 basis point improvement year-over-year to 13.2%. The Asia Pacific and Latin America region had another strong quarter with organic revenue growth of 12%.

Turning now to some of our key metrics for the global recurring revenue business, our account base of 9.1 million customers grew 3% year-over-year and global average revenue per user grew 2% on a constant currency basis to $45.57. Average revenue per user continues to benefit from our broader product offerings. Lastly, our worldwide attrition rate improved 20 basis points sequentially and 30 basis points year-over-year to 12.4%.

In security products, revenue in the quarter of $108 million grew 5% organically. This business also significantly improved its operating margin year-over-year while increasing its investment in R&D.

Moving to fire protection, overall revenue in the quarter was $1.1 billion with organic revenue growth of 2%. Service revenue in the quarter of $434 million represented 38% of fire’s total revenue and grew 2% organically year-over-year. Systems installation revenue of $344 million was down 5% on an organic basis as growth in Asia Pacific was more than offset with declines in North America and EMEA due to continued softness in the non-residential construction market. The remaining portion of our fire protection business, fire products, which encompasses the fire protection products and life safety businesses, reported revenue of $352 million in the quarter with organic revenue growth of 8% as we continue to experience strong demand in our key end markets for these products.

Operating income before special items for total fire protection was $147 million in the quarter and the operating margin increased 140 basis points year-over-year to 13%. Increased leverage from higher volume in the product businesses, coupled with a higher mix of service revenue and gains from productivity and cost containment initiatives, drove the operating margin improvement year-over-year. Year-over-year total fire orders grew 6%. Backlog of $1.2 billion increased 4% on a quarter sequential basis.

Within fire, we continue to focus growing service revenue as well as driving new product innovation. We expect this to be enabled by both organic and inorganic investments; for example, we have recently completed or are very close to completing a handful of acquisitions in fire for an aggregate purchase price of approximately $130 million. These are smaller, strategic, bolt-on acquisitions which will strengthen our presence and expand our footprint and customer base in growth markets like China, the Middle East and Korea. Additionally, these acquisitions will strengthen our product portfolio and service offerings in key vertical markets in the more developed countries.

Let me now touch on a few other important items. First, our cash position and overall balance sheet remains strong. In the quarter, we generated cash flow from operating activities of $338 million. Typically, the first quarter is a low point in terms of free cash flow, and this year is no different. We had a free cash outflow of $36 million in the quarter which included $49 million of cash paid for special items primarily related to restructuring and separation activities. It is also important to note that we are increasingly focused on investing in the future growth of our businesses, and as a result, we increased our capital expenditures and dealer spend by about $65 million in the quarter on a year-over-year basis. This increased spending is also reflected in the cash flow results.

Additionally, during the first quarter we repurchased 4.7 million shares for $200 million. Still, we ended the quarter with a healthy cash balance of about $1 billion, and through the end of January we have repurchased an additional 2.1 million shares for $100 million.

Next, corporate expense before special items was $86 million in the first quarter. As we look ahead to the second quarter, we expect corporate expense to be approximately $95 million. As you know, this expense varies from quarter to quarter, and we still expect corporate expense for the total year to be similar to last year, as previously communicated.

Our effective tax rate for the quarter before the impact of special items was 19.4%, and we expect the tax rate in the second quarter to be approximately 20%. We continue to expect a 19 to 20% effective rate for the full year.

Turning to overall restructuring and separation activities, each of the leaders are focused on streamlining their operations while ensuring the appropriate structure is in place to operate as a standalone public company. We’re making good progress on this initiative and continue to expect the aggregate of corporate expense for the three new companies to be approximately equal to Tyco’s current annual corporate cost. We expect our restructuring and separation spend to be in line with our original guidance with a ramp in spend in the second half of the year.

Now let me turn things back over to Ed to wrap up this morning’s call.

Ed Breen

Thanks, Frank. Before we open up the lines for questions, I want to spend a few minutes on our guidance for the second quarter and our expectations for the second half of the year.

As Antonella mentioned earlier, this guidance is based on our new segment structure and we have filed an 8-K this morning providing historical information on the same basis. Based on our current order rates and backlog, we expect organic revenue growth of approximately 5 to 6% in the second quarter. As you know, exchange rates have been extremely volatile. Based on our recent exchange rates, we are expecting a 2% headwind to revenue on a year-over-year basis. In total, we expect second quarter revenue of approximately 4.2 billion.

In ADT Residential and Flow Control, we expect revenue and operating margin in the second quarter to be similar to the first quarter. In commercial fire and security, the normal seasonality of our business results in a typical sequential decline in revenue and operating income from the first quarter to the second quarter. Recent acquisitions in commercial fire and security, although individually small, are expected to contribute approximately 75 million of revenue in the second quarter, more than offsetting the normal seasonal decline. Additionally, the second quarter operating margin will include a 50 basis point headwind related to purchase accounting. As a result, we expect the operating margin in the second quarter to be approximately 11.7%, which is still a 30 basis point improvement over the prior year quarter.

Overall, normal seasonality in the businesses coupled with the non-cash purchase accounting will cost us about $0.04 of earnings on a quarter sequential basis. Lastly, as Frank mentioned, we expect sequential headwinds related to increase in both corporate expense and the tax rate in the second quarter in comparison to the first quarter. These increases will cost us about $0.03 per share sequentially.

From an earnings perspective, this is expected to result in second quarter earnings per share from continuing operations before special items of approximately $0.77 per share. This represent about an 8% decrease in sequential earnings per share, which is right in line with our historical performance over the last three years. On a year-over-year basis, this represents an $0.08 improvement in operations partially offset by a $0.04 headwind related to corporate and below-the-line items.

As we look to the balance of the year, there are a few items that we expect to be tailwinds in the second half of the year as compared to the first half of the year. First, our commercial fire and security business has a seasonal increase in revenue and income in the third and fourth quarter. Additionally, order activity and flow over the last few quarters and improved operating performance in our water business is expected to increase flow’s earnings contribution in the second half of the year. Also note that our history has shown that we generate about 45% of our earnings in the first half of the year with an acceleration in earnings in the back half of the year, and we expect this trend to continue.

With that said, we continue to expect full-year revenue in the range of 17.5 to 17.7 billion, including a year-over-year currency headwind of over 400 million. Given our first quarter results, current momentum in order activity, and our business expectations for the remainder of the year, we are increasing the low end of our guidance by $0.05 and expect our full-year earnings per share to be in the range of $3.55 to $3.60.

Thanks for joining us on the call, and Operator, if you could please open the line up for any questions.

Question and Answer Session

Operator

Thank you. As a reminder, to ask a question, please press star, one on your touchtone phone and record your name when prompted.

Our first question today is from Jeff Sprague with Vertical Research.

Jeff Sprague – Vertical Research

Thank you. Good morning everyone. A couple things – Ed, first, could you comment a little bit more on ADT? The margins are looking extraordinarily strong there, and I guess you would attribute a lot of that to Pulse and ARPU. But if you could give us a little more granularity on how things are playing out there, it would be helpful.

Ed Breen

Yeah, it’s the recurring business doing very well, Jeff, and you could see every metric performed with positive momentum, so ARPU going up clearly is helping. And I think you can see the Pulse take rate in the quarter was now up to 28%, so we’re seeing nice momentum on the ARPU side and still see a couple points of growth on an account basis. But you have a good mix going on in the business also—

Antonella Franzen

The EMEA margin, Jeff, you should also keep in mind, is up like 150 basis points year-over-year—

Ed Breen

Yeah, and that’s all commercial, Jeff; so we’re having nice momentum, really good progress on our restructuring and cost containment – really in every region, but I would say highlighted by the EMEA region.

Jeff Sprague – Vertical Research

And then on the—

Ed Breen

Those margins, Jeff, just to highlight, were over 13% this quarter – I think right at 13.2%.

Jeff Sprague – Vertical Research

No, it’s an amazing improvement from where you were a few years ago. The install businesses, both on fire and commercial, are still sluggish obviously, as you pointed out. A lot of the shorter cycle electrical guys this earnings seasons have actually been pointing to better commercial trends, and I’m wondering if you’re starting to see any of that in your early bid and proposal activity, or anything that would suggest that some of those later cycle commercial install businesses might be at least near firming up, if not turning strongly.

Ed Breen

Yeah Jeff, I think it’s clearly the bottom has hit and it’s starting to firm up a little bit. I mean, we’ve been kind of saying that we thought we’d start seeing it about now, and I think it is firming up. If you look at the architectural reports, they’ve turned slightly positive now which, by the way, we see six, seven, eight months later. So I think there is a little bit of momentum that we’re going to see some lift now off of what’s been an ugly bottom; but I would also point out to all of you that when you look at our commercial businesses and our service businesses, remember we were impacted this past quarter by a dead week with the holidays. Last year, it was in the second quarter; this year, it’s in the first quarter. So it’s hard to do the math on that, but there’s a couple points of growth lacking because every day you miss – you don’t do something in service, you don’t do something in install to bill against. So just bear that in mind, and that anomaly obviously goes away in the second, third and fourth quarter.

Antonella Franzen

And Jeff, the only thing I would add to that is if you look at our products business, both on the fire side and the securities side, you could see nice growth there in both of them. And as we move forward, I think you’ll start to see a little bit more improvement on the systems install side.

Frank Sklarsky

And we’re getting good uptake on the verticals, so that’s where we’re strong. We do think we’re holding and maintaining our share in the rest of the business, and of course we’re focusing on the mix area where we’re getting good margins.

Jeff Sprague – Vertical Research

And maybe just one last one, since we have Patrick on the line today – can you give us an update on—you mentioned the frame agreements, but are you near anything that’s significant? How many things are kind of in the pipeline? Can you give us any sense of how significant those might be as we look into the back half of this year and into next year?

Patrick Decker

Sure, yeah. Thanks, Jeff. I guess the couple ways I’d answer that – one, absolutely feeling confident about we’ve got a couple of large frame agreements that we’re very nearing completion, and I think you’ll expect to hear some announcements on those over the coming, probably, few weeks here to a few months. That’s really going to benefit our valve business, for the most part; but we’re also very nearing completion on signing some agreements on another large megaproject for our thermal controls business. It won’t begin to benefit us until probably late 2012 and into 2013 and beyond. And then certainly in our water business, we’re feeling very good about a handful of large projects that are out there that we expect to bring into backlog over the next two quarters, and then really begin shipping out second half this year into 2013.

Jeff Sprague – Vertical Research

Great, thanks a lot.

Patrick Decker

And you’ll be hearing some announcements on those over the coming weeks here.

Jeff Sprague – Vertical Research

Terrific, thank you, guys.

Operator

Thank you. Our next question is from Steve Tusa with JP Morgan.

Steve Tusa – JP Morgan

Hey, good morning. Just on the—first of all on the ADT resi stuff, you talked about having a margin kind of—I think you said consistent with the first quarter. What’s the revenue growth rate for the second quarter there?

Antonella Franzen

If you look at it organically, it will be relatively similar to where we were this past quarter, around the 4%.

Steve Tusa – JP Morgan

Okay. So I’m kind of backing into those numbers, and I get an incremental margin that’s kind of in the high teens, I guess, after doing something like 50% this past quarter, 40% in the fourth quarter, 50% in the third quarter. I mean, why would that kind of—what why that incremental go down to that level in this business?

Antonella Franzen

Well, you’ve got to remember the continued investments that we’re making in the business, and the more you grow – especially on the direct side – it is a little bit of margin headwind because of the investment that you put in. Remember, this is all subscriber assets that we have and there are certain period costs that you have each quarter as you continue to grow.

Frank Sklarsky

It’s still a very strong IRR business in Pulse, and we think it’s going to be stickier, too, from an attrition perspective.

Steve Tusa – JP Morgan

Right. I would just think that there would be—you know, that incremental you’ve proven to be pretty strong. So that makes sense – kind of lumpy investment in there, I guess.

Antonella Franzen

The 4% organic growth is a year-over-year growth number. We expect the revenue to be relatively similar to where we were first quarter.

Ed Breen

Sequentially similar to the first quarter.

Steve Tusa – JP Morgan

Right, okay. When you—you guys mentioned the dynamics around water and other. I mean, is water—given that you didn’t have a ton of revenues there this quarter, is the water profitability still pretty bad? I mean, are you making money in water, and—

Ed Breen

It’s mid-single digits, Steve, but that picks up, as Patrick said, now in the third. And when we get to the third and fourth quarter—because Patrick did book some midsize projects—I mean, pretty nice sized, but not the couple big, big ones we’re looking at, and we are going to see the benefit in the second half of the year.

Steve Tusa – JP Morgan

Right, so you said the revenues will start to cover some of that cost. And then one more question just on the fire dynamics – the order pickup, obviously you guys really had a kind of stars align around mix with the products growing. What is that—does that backlog just represent the products, or is there systems and install in that backlog?

Ed Breen

It represents everything. The only thing you don’t really see when we report orders is the recurring revenue of ADT. All the fire stuff is in there – it’s install, it’s service, and it’s products.

Steve Tusa – JP Morgan

Okay. So how was the products growth? When you look at that 6% fire segment increase in orders, were the products above or below that 6%?

Frank Sklarsky

It was above, and that’s of course a very nice margin.

Steve Tusa – JP Morgan

Was that double digit?

Ed Breen

About 9%, I think, if I remember the number, Steve. And the margins are now up in the high teens in the business, but I do think we’re gaining share with some of our new products. I think as you look at others reporting in this area, which most of our competitors are product, by the way, because they don’t have a service arm. They have not been growing organically at the rates we’ve been seeing, and I really think it’s attributable, as we’ve talking about, to some of these products—

Steve Tusa – JP Morgan

Right, and again—and then one last question—

Ed Breen

There is a lot of retrofit and upgrade business with some of these new products where people want the features.

Steve Tusa – JP Morgan

Right. And then one last question, just a quickie – you beat by $0.07. You’re kind of tweaking the low end of the range. I guess there are some moving parts around corporate, but it seems like pretty clean; so why not raise the high end a little bit more, given what you just did in this quarter?

Ed Breen

Well, Steve, let’s just wait another quarter and see how we feel, how the world is looking, and what FX is doing as an example. We’ll see how we feel.

Steve Tusa – JP Morgan

Right, so—okay. Great, thanks a lot.

Ed Breen

Thanks, Steve.

Operator

Thank. Our next question is from Scott Davis with Barclays Capital.

Scott Davis – Barclays Capital

Hi, good morning everyone. I wanted to get back—you mentioned you were rolling out Pulse to your dealer network. What’s that mean for your growth rate? Is there enough pent-up demand out there per se that you could actually see a material difference, or is this something that just slowly works through the system and you don’t really see much of an improvement?

Ed Breen

Scott, I think it slowly works through the system. I do think that dealers will launch a little bit slower than our direct channel, for a whole bunch of reasons; but we’ve been training them now for, I don’t know, four or five months. We’ve been in pilots with them in certain regions in the country, so we’ve done an awful lot of training and work in this area. So they’re ready to roll out. I’d say you’ll see the impact of this more next quarter because we’re actually rolling out towards the end of this quarter with the dealer network. Remember, the dealers are about half of our sales, so I think you can do the math on that; but I would maybe mute it just a little bit slower take-up than what our direct sales force would be. But I think we eventually get to the same type of percentages that we see on the direct side.

I’d also point out just over time, the more that we launch, obviously, Pulse now across our whole channel, the more that helps attrition over the years because it’s clearly a stickier account.

Antonella Franzen

Yeah, Scott, the only thing I would add to that is if you kind of take a look at our take rate that we’ve had over the quarter as related to Pulse, remember we’re at a 28% take right now but the first quarter we rolled it out, we were closer to a 14% take rate. So the sales folks do get more and more comfortable as they’ve been selling the product for a period of time.

Ed Breen

Well, just a quarter ago we were 23%; now we’re 28. So as Antonella said, we’ve been ramping every quarter and I clearly think—I won’t put a timeframe on, but we said 30% was our goal. I think you can see we’re nicely on our way to 30 here.

Scott Davis – Barclays Capital

And the other part of that is you have kind of—at least last I checked online, you have three offerings, kind of a good-better-best offering with Pulse. Have you seen any change in shift as those take rates have gone up, either—

Ed Breen

Well you know, Scott, we did about a quarter—two quarters ago, we saw a nice pickup to about 25% of the sales were now going to the high end, and that was running about 10 to 15%. But if you just look sequentially from our fourth quarter, our first quarter, the mix was almost identical. It was 24% took the high-end package and the other kind of 75% took the other two packages. So the mix was very similar, so there was no change there sequentially; but there was a change from 23% up to 28% in the take rate.

Scott Davis – Barclays Capital

Okay, and last question just related to ARPU – I mean, you’ve had, I think in the neighborhood of this 2% ARPU for a long time, which is obviously very helpful. But when you think about what drives that, and maybe this is too granular for this kind of a call, but how much does Pulse drive that versus increased—let’s just say increased offerings like carbon monoxide, things that just over time you’d increase, versus going out to your installed base when their contracts run out and raising price then on a same store sales basis. I mean, is there any way to think about that? And I guess kind of the reason why I ask the question is I wonder as your take rates get higher, is there a chance that we start to see something in the neighborhood of a 3% ARPU?

Ed Breen

Right, right.

Scott Davis – Barclays Capital

You get what I’m saying?

Ed Breen

Yeah, Scott, it’s probably a conversation that goes deeper than this call. I think when you see—Naren and the ADT team will obviously talk a little more granular, but just let me give you one of the items, I think, that goes to where your question goes. Look, obviously penetration of Pulse helps; but I think one of the bigger things over time is mining the 6 million unit installed base that we have in North America. If you go back to the numbers we’ve highlighted before, we’re getting about $50 per Pulse account on average right now. On the new accounts we’re getting at ADT ex-Pulse – you know, when we bundle carbon monoxide and all that – we’re averaging about $43. So Pulse has given us a $7 lift; but remember our kind of installed heritage ADT base is in at $36 and Broadview Brinks base is at $33, so I think there’s price elasticity here over time and I think that’s one of the areas as we—as you hear the new teams go out and talk, you’ll hear us talk about each of these categories, including that. That’s probably where one of the nice opportunities is.

Frank Sklarsky

Yeah, just the arithmetic around the replacement of the net replacement of the attrition is going to accrete the ARPU because you’re rolling off accounts in the 30s, you’re rolling in accounts at an average of 43 enabled by Pulse at 50. And then with the attrition rate coming down and with the Pulse accounts being stickier, that also will help us accrete over time. So you’re right – going from 2% to 3% is certainly a reasonable assumption over time.

Scott Davis – Barclays Capital

Very good. Congrats, guys, and thank you.

Ed Breen

Thanks, Scott.

Operator

Thank you. Our next question is from John Inch with Bank of America.

John Inch – Bank of America

Thanks. Good morning, everyone. First, just kind of as a bit of a nitpicky question, what was the $0.03 of asset impairment? I mean, I realize you’re excluding this, but some companies exclude it, some don’t. What was it again?

Antonella Franzen

It was more separation related. If you take a look at it, it actually relates to one of our systems, and as we’ve talked before, we plan on doing some back office integration between security and fire, so this is kind of part of that back office integration. There’s a system that we’re no longer going to be using and moving more over to a certain fire platform, so that was the impairment charge we took in the quarter.

Frank Sklarsky

And going on with that, some of the CAPEX increases on systems architecture improvement and rationalization, and the three companies are going to see some really nice benefits of that over time after separation.

John Inch – Bank of America

Can I ask you guys – I mean, as we kind of move toward separation and given Tyco’s legacy, should we be anticipating some sort of very large series of asset impairments as part of this process that maybe aren’t reflective of the efforts that you’re trying to do but are simply reflective of the – you know what I’m saying – the legacy of Tyco and all this sort of stuff? How should we be thinking of this as we roll toward the timeline here?

Frank Sklarsky

I don’t think we’re going to be seeing any really large impairments. You might see some periodic things of the nature we saw in the first quarter, but largely what we’re going to be seeing is maybe some modest increase in CAPEX associated with some new systems and rationalized systems as we go around more rationalized ERP platforms and whittle away at some of the legal entity complexity. So a little more of that.

Impairments – I mean, we look at this every quarter. We’re required to look at it every quarter. We don’t see anything really massive on the horizon there, but you’ll see some things in various regions where we might take a modest impairment, but nothing major.

Ed Breen

But John, we’re still looking at the same separation costs we told you last quarter. Nothing’s changed in aggregate.

John Inch – Bank of America

Yeah, no, I wasn’t sure if asset impairment, though, was part of that process. That’s all. And obviously that could include goodwill and other things.

Let me ask you, Ed – you kind of gave us a little bit of an update in terms of the process towards separation. Is there any way to sound bite basically what has thus far gotten better? And also I realize you’re positive with the progress, but what’s also been a little bit more of a struggle or has taken a little bit longer than you expected?

Ed Breen

Actually, nothing has taken longer. I would say we’re within a week or so. We have a chart that schedules everything out by week, and we’re where we wanted to be. We’ve always wanted to file in March. We’re going to definitely file in March the Form 10, and that’s a big event because that gets the clock going. And by the way, maybe I think where we’re actually better than I would have thought is that filling out the management teams with some of the public company openings we had. And by the way, I’m very impressed with where we’re at on the boards. One of the boards, we have completed. One of the other boards, we only have one opening – we’re looking for a specific type of talent; and I think the other one, we have two openings. So we’ve made great progress on filling those out, and I’m actually excited when we get to the point where we can tell you the names of the board members we’re going to have on the three boards. So that’s actually, I’d say, a couple months ahead of schedule.

And then the timeline from our filing, then, is really how long does it take us in review with the SEC, do we get a second review. We have baked a second review into our schedule that we’ve given you. Does that go faster or not? Who knows, because you’re really not 100% in control of that, but we’ve baked all of that into the timeline that we’ve talked to you about. And then on top of that, we do have a shareholder vote we have to do because we’re a Swiss-incorporated company, and we need to give 30 days notice on that, so that’s also baked into the schedule which is one nuance different than a U.S.-incorporated company.

John Inch – Bank of America

So rationalizing all these legal entities, of which I believe, Patrick, you have quite a lot of them, right, if I’m not mistaken, in your segment. That hasn’t proven to be more tricky because of, who knows, regulatory issues or geographic issues? It sounds like that’s all sort of on-plan. Is that correct?

Patrick Decker

Yeah, I think to that point on the—you know, having gone through the separation last time around, we actually have fewer entities this time than we did then because of the rationalization effort. So a lot of the tax work that needs to be done is, if anything, probably maybe slightly less than last time around. But it’s going to continue to be a focus area for us, to rationalize. We too are putting a SAP around the world. We’ve been on that path for a few years now, so that will only make things simpler and more efficient as we go forward.

Frank Sklarsky

Yeah, and the tax ruling requests are right on track in terms of our timeline and what we need to submit and so on; and keep in mind, this whole legal entity rationalization is occurring now. It will continue to occur after the separation. It’s not something that’s going to impact our separation timeline.

John Inch – Bank of America

Which is still August timeframe, is that correct?

Ed Breen

September.

John Inch – Bank of America

I’m sorry—right, right. September officially, but possibly sooner.

Ed Breen

We’ll see.

John Inch – Bank of America

Yeah. Okay, thank you.

Operator

Thank you. Our next question is from Deane Dray with Citi.

Deane Dray – Citi Investment Research

Thank you. Good morning everyone. For Patrick, I’d love to hear from you what you think is the long-term value proposition for flow as standalone entity; and then specifically, are there white spaces that you think would be attractive for the business? Do you like the mix today just versus where flow stands today within Tyco?

Patrick Decker

Sure. I think first of all, I’d say we definitely like the portfolio that we’ve got. These are all market-leading assets and businesses. We like the breadth of the portfolio. We like the fact that the markets that we serve in terms of the end markets are very attractive. We like the diversity that we have in those end markets – it helps us buffer when there are cyclical downturns. So in terms of portfolio and the markets we serve, feel very good about what we have. I think there will be opportunities for us to—you know, over time, as we’re out there and we’ve demonstrated continued performance, there will be opportunities to do some bolt-on acquisitions over time, given that we are a leader in the markets that we serve. But it’s really, in our case, it’s going to be a big focus on margin expansion. It’s going to be focused on growth, and by way of that, we have a good base in the emerging markets today but we continue to make investments there, both organically and inorganically, and that really is where the bulk of our end market activity is occurring, is in some of those big emerging markets. So we’ll focus on those for growth. We’ll focus on the developed markets, as well, from an after-market service standpoint, big installed base there. We continue to expand on our after-market service network. We’ve got about 66 service centers around the world today, and we continue to add to that, and that really is one of the key investments that’s also allowed us to win some of these global frame agreements that we’ve recently announced.

Deane Dray – Citi Investment Research

Are you feeling any opportunity to start doing some bundling in some other product lines – let’s say pumps, because you’re right in the mix there in those projects, and you could see where bundling might be an opportunity. Does that look attractive?

Patrick Decker

It’s a great question. I think we’ve evaluated the pump space over the years, and I think that where we’ve landed and where we certainly are today is that it’s an attractive market, but you’re selling into very different parts of the customer and so the only opportunity you really have there is more of a kind of C-suite enterprise sell. We’re doing some of that today within our own portfolio, especially between thermal controls and valves; but we feel that we have the portfolio and the breadth right now to be able to do some of that selling without necessarily adding pumps to the portfolio.

Deane Dray – Citi Investment Research

And then just last one from me, Patrick – are you closer to a decision point on where flow might be domiciled?

Patrick Decker

Yes, we actually will be domiciled in Switzerland, so we’re going to continue to be domiciled there.

Deane Dray – Citi Investment Research

Great, thank you.

Patrick Decker

Thank you.

Operator

Thank you. Our next question is from Nigel Coe with Morgan Stanley.

Nigel Coe – Morgan Stanley

Thanks, good morning. I’m sorry if I missed it, but what is the Pulse subscriber base right now?

Ed Breen

In units?

Nigel Coe – Morgan Stanley

Yes.

Ed Breen

About 105,000 units.

Nigel Coe – Morgan Stanley

105,000 units. And with the takeaway of 20%, that’s about 25, 30,000 adds per quarter?

Ed Breen

Yeah, somewhere in that range, yes.

Nigel Coe – Morgan Stanley

Okay, great. And when do you start mining the install base?

Ed Breen

That will happen towards the end of this fiscal year, because what we want to do right now is obviously continue the momentum we have with the existing Pulse product, with our sales force. Nigel, I don’t know if you were on – we’re getting ready to launch at the end of this quarter with our dealer network, which again is about half of our salespeople out there. So we want to get that really humming along, good momentum, trained well and all that, and then we have the opportunity to go back and look at what’s the real marketing plan as we’ve been testing, by the way, on the installed base.

By the way, if someone from the installed base calls us up and wants to get Pulse, we are obviously going to do it because we have a lot of advertisements out there now; but we’re not proactively working that yet.

Nigel Coe – Morgan Stanley

Okay. And why does it take so long? I mean, it seems that—you know, is it just a sequential process, you want to make sure the dealers are trained, that they actually get it, and then you go back into the installed base? Because selling to the installed base, that’s a direct sale and you already have those sales teams—

Ed Breen

Yeah, it’s just time. It’s really—the number of people we have to train, bring them up to speed. Look, we clearly want to get in new accounts. We already have the other ones in our installed base, and yes, we certainly want to go back and mine it – don’t take that as a lackadaisical comment. But we want to get the new ones first, and then as everyone’s up and trained, we’re selling it well, we’ll have the manpower and the wherewithal to go back to the installed base and go mine that. So no, it’s clearly one of our big goals.

Look, back to an earlier question – what moves the needle? Well, 6 million subscribers, if you can convert some percent of those, that moves the needle and that would be taking someone from $36 or $33 a month up to $50, depending on if they were a Broadview or an ADT account. So it’d be very nice movement for us in the installed base.

I think it’s just proving out right now – a 30% give or take of people, once they kind of start hearing about this, want the service; so I don’t know why that would necessarily be that much different with the installed base over time. We already know they were interested in security because they have it, so I think that is a big opportunity.

But Nigel, let me just say also – ADT has a phenomenal reputation in the marketplace and when you’re in the security business, you don’t jeopardize it. So we don’t just launch just to launch and kind of figure it out as we go. We really want to make sure we’re in a position when we do launch, everyone is ready, they’re trained, we’re not tripping; because your reputation is everything in this business.

Patrick Decker

Including the electricians and everything else. It plays right into Tyco’s core competence.

Nigel Coe – Morgan Stanley

Oh sure, absolutely. On the intelligence on that 105,000 base, how do the characteristics and demographics compare to your legacy base? Are they younger, are they richer? How do they compare?

Ed Breen

I don’t think they’re much different from what we’ve seen so far. I think that’s a pretty good track record so far.

By the way, I do think – and this more anecdotally – we’ve talked to our ADT team about the younger professionals that have their own home. They certainly get this because they love it, being in control from their iPhone, their iPad. I mean, they’re into the whiz-bang of it; but I think when you look at it on a percentage basis, it’s really not that much different from the installed base. However, let me add one point – I do think we’re going to figure out here over time that this product is going to expand the category, and I think one of the areas which you have seen, we haven’t really promoted yet, is the energy savings. I mean, we advertise about it but we haven’t demonstrated it to the consumer yet, the savings you can get from efficiently using the system. When we get to that point, I think that’s another demarcation between the insurance break you can get, the energy savings you can get. A lot of this system pays for itself and you still get security and peace of mind. So I think there’s a few more steps to come here that expand the pie.

Nigel Coe – Morgan Stanley

Oh, no, it’s a great story. And then just one final one of the share repos – I think your authorization is down to about $400 million now. Any reason why you wouldn’t go back to top that up? I know it’s a Board decision, but any reason why that wouldn’t happen?

Ed Breen

Well Nigel, the only thing we want to wait on—we’re going to be a little cautious here over the next 60 days. We ended the quarter with a billion dollars of cash, which is exactly where we said we’d like to hold our cash position; and remember, we’re going to split it between three companies. But one of the big things we have coming up is the rating agencies. Those meetings are in February, so we’re going to be doing those this month, and we’ll see where the outcome of all that is. Remember, we are spending another 130 million on acquisitions. There won’t be acquisitions in the back half of the year because we want to let things sit with the filings, so I don’t know if I want to say the word crammed them in earlier, but we got them done earlier. So between that, having the rating agencies conversations, we just want to see where we’re at and then we’ll decide what we do.

Nigel Coe – Morgan Stanley

Thanks, Ed.

Antonella Franzen

Operator, we have time for one more question.

Operator

Thank you. Our final question today is from Steven Winoker with Sanford Bernstein.

Steven Winoker – Sanford Bernstein

Thanks for fitting me in – appreciate it. So the first question I ask, I think, every quarter now is on the new entrant point and around a lot more activity now that I’m monitoring with regard to Comcast, Time Warner Cable. You’ve got Alarm.com, so you’ve got other folks trying to do this, and I know you’ve talked about your differentiation; but again, are you seeing any inroads on pricing, on the installed base, anything that would lead you to believe that these guys are going to have traction? And if so, are there any kind of partnership opportunities or other things you might do or think about that we might put this in a different frame to not be as concerned about them?

Ed Breen

Well Steve, it’s not much different than maybe I described a quarter ago, but thanks for the question again. Look, we track every single market very closely. We know where there’s cable guys competing with us, and there is no difference in any of our metrics in those markets compared to any other market. I’m not going to say numbers, but I know approximately—you know, you can tell pretty close what people have, what they’re getting in a marketplace, and I feel very good about our competitive position.

As I have felt all along, and I’ve said this, people will try the business and then will there be partnerships that potentially come out of it or not will be a question for the future; but as I’ve said before, we have talked to the cable players. We do talk to the cable players. We do talk to telecos. If there’s an opportunity that makes sense, we clearly will look at it; but we’re in no rush. We like our position, and we’ll see how things evolve.

Steven Winoker – Sanford Bernstein

Okay. And you may have said this before, but just remind me – the ADT brand and commercial fire and security, how are you arranging for that between them and North America resi?

Ed Breen

Yeah, ADT North America resi will own the name and have the exclusive right to it in the North America footprint, which is where their business is; and in the commercial fire and security business, the ADT name will belong to commercial fire and security in all the markets outside of the North America footprint.

Steven Winoker – Sanford Bernstein

What about the commercial business, not the small commercial but any of the medium, larger stuff in North America? Is there any overlap there?

Ed Breen

No, no. Commercial fire and security business will have to brand separate from ADT; but remember, we’ve got the Tyco name, which is very strong in the market, and we’ve got the Simplex Grinnell name. So we’ve done a lot of market research around it, and by the way, it’s not a residential business, right? So the big customers know who they’re dealing with, and we have plenty of time to make sure we work on that, so it’s a nice way to split it.

Steven Winoker – Sanford Bernstein

And then just for Patrick – Patrick, when I think about the valves business in China and the visits I’ve had there, how is that progressing and growing? Is that part of the investment in terms of the incremental margins and all that, that we saw this quarter? Any update on that?

Patrick Decker

Sure, yeah, that’s a great question. Absolutely part of our core focus area is in China as one of our key markets. Continue to be very pleased there with the growth we’re getting, both in bookings as well as in revenue. We—just by way of some specific investments we’ve made, just recently I was over there a couple months ago. We opened up one of our largest factories, new valve factory in Chengdu, and not only does that again expand our footprint in China – we have multiple factories there already – but it was actually for us going after the more western part of China, which is really where the bulk of industrial expansion is occurring. We have a plan to continue to add a number of after-market service centers there to complement what we already have to go after each one of the key industries there. So short answer is yes, and those are just a few specifics on the investments we’re making.

Steven Winoker – Sanford Bernstein

Fantastic. Thank you.

Patrick Decker

Thank you.

Antonella Franzen

Operator, that concludes our call.

Operator

Thank you. This does conclude today’s conference. Thank you for participating. You may disconnect at this time.

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