Tyco International Plc (TYC) George R. Oliver on Q2 2016 Results - Earnings Call Transcript

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Tyco International Plc (NYSE:TYC)

Q2 2016 Earnings Call

April 29, 2016 8:00 am ET

Executives

Antonella Franzen - Head-Investor Relations

George R. Oliver - Chief Executive Officer & Director

Robert E. Olson - Chief Financial Officer & Executive VP

Analysts

Jeffrey Todd Sprague - Vertical Research Partners LLC

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Gautam Khanna - Cowen and Company, LLC

Nigel Coe - Morgan Stanley & Co. LLC

Charles Stephen Tusa - JPMorgan Securities LLC

Deane Dray - RBC Capital Markets LLC

Shannon O'Callaghan - UBS Securities LLC

Julian Mitchell - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Operator

Welcome to Tyco's Second Quarter 2016 Earnings Call. Your lines have been placed on listen-only until the question-and-answer session. This call 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.

Antonella Franzen - Head-Investor Relations

Good morning, and thank you for joining our conference call to discuss Tyco's second quarter fiscal 2016 results and the press release issued earlier this morning. With me today are Tyco's Chief Executive Officer, George Oliver; and our Chief Financial Officer, Robert Olson.

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 discussion, and we ask that you read through the sections of our press release that address the use of these items.

Today's call is not intended and does not constitute an offer to sell, or the solicitation of an offer to subscribe for or buy securities of Tyco or Johnson Controls. Select subject matter discussed on today's call is addressed in a joint proxy statement and prospectus that has been filed with the SEC. We urge investors to read it in its entirety. Information regarding the participants in the proxy solicitation is contained in each company's annual proxy material filed with the SEC.

The press release issued this morning and all related tables as well as the conference call slides which George and Robert will refer to can be found on the Investor Relations portion of our website at tyco.com. In discussing our segment operations, when we refer to changes in backlogs and order activity, these figures exclude the impact of foreign currency and divestitures.

Additionally, references to operating margins during the call exclude special items and this metric is a non-GAAP measure and is reconciled in the schedule attached to our press release. Also, I would like to remind everyone that beginning last quarter; restructuring and repositioning charges are included within our reported earnings per share before special items. These charges are shown as a separate line item below segment operating income. The prior-year results have been recapped to conform to the current year presentation. The quarters of fiscal 2015 including restructuring and repositioning charges as well as the related tax impact are included in the appendix to the slides.

Now let me quickly recap this quarter's results. Revenue of $2.3 billion in the quarter declined 4% year-over-year on a reported basis driven primarily by a 4% headwind from changes in foreign currency. Organic revenue declined 1% in the quarter and net acquisition divestiture activity contributed one point of growth. Earnings per share from continuing operations attributable to Tyco ordinary shareholders was $0.33 and included net charges of $0.12 related to special items. These special items were primarily composed of a loss on a divestiture and merger-related costs incurred in the quarter. Earnings per share from continuing operations before special items was $0.45 per share.

Now let me turn the call over to George.

George R. Oliver - Chief Executive Officer & Director

Thanks, Antonella, and good morning, everyone. Before we get into the details of the quarter, let me spend a few minutes on our proposed merger with Johnson Controls. Starting with slide 5, integration planning is well underway and we have made significant progress toward our Day 1 plan. The integration teams are very engaged and are working extremely well together as we begin setting the foundation of the combined company. The preliminary Form S-4 was filed with the SEC in early April. We received HSR approval in the U.S. and we are in the process of obtaining approval with all necessary regulatory authorities around the globe. Additionally, the debt financing related to the cash consideration component of the transaction is in place and is ready to be executed upon close.

As we confirmed in last week's 8-K filing, we are proceeding with the merger and remain highly confident in achieving the $650 million of previously-announced synergies within the first three years. The strength of this transaction is a compelling value created by the strategic combination of the leading player in commercial HVAC and building controls with the leading player in commercial fire and security. It's through this combination that we will be able to solve customer problems via enhanced service offerings, including increased use of data analytics.

In addition to the commercial benefits at the customer level, there is also significant value created for both Tyco and Johnson Controls shareholders through the $650 million of synergies and the stronger financial profile of the combined company. We have spent a lot of time with Johnson Controls' management and employees over the last few months, and I'm more excited now than ever regarding the value creation potential of the new combined company.

Shifting gears to the quarter, let's move to slide 6. Organic revenue declined 1% in the second quarter driven by pressure in our short-cycle product businesses. This resulted in mix pressure on top of typical volume deleverage. Our Integrated Solutions & Services teams delivered better-than-expected margin performance in the quarter offsetting some of the volume and mix headwinds within our Global Product segment. Notwithstanding the revenue decline in difficult year-over-year comparisons in several of our higher-margin businesses, the underlying segment margin before special items improved 10 basis points over the prior year when adjusting for non-cash purchase accounting. We remain disciplined on controlling costs and focused on productivity initiatives to mitigate pressure to the bottom line.

Turning to slide 7, let me spend a few minutes on what we are seeing in a few key regions. We saw a continued momentum in the U.S. market with stable growth in nonresidential construction verticals year over year. We had another strong quarter of install order activity with solid growth in our commercial, government and institutional verticals. As expected, activity in Western Canada remains soft due to the high hazard heavy-industrial end markets.

Over the last few years, our North America teams have done an impressive job of improving operating margins, taking significant action to improve the efficiency of our operations while positioning the business for growth. During the second quarter, we executed the next phase of integration with significant structural changes combining fire and security into a simplified organizational structure, taking the business to the next level of margin expansion. This frees up resources to be reallocated into the commercial structure, which we are starting to see the benefits of in our order rates. The new organization structure will position the business to better drive growth, increase profitability and improve customer satisfaction.

Moving to Europe, although the macroeconomic environment remains sluggish, we are seeing improved order activity, which coupled with the existing backlog should drive second-half revenue growth. Additionally, we expect the actions that we have taken to streamline the businesses to lever quite nicely to deliver incremental earnings in the second half.

In Asia, although recent economic indicators out of China have improved, business conditions across the region remain challenged. We are seeing particular softness in the high hazard heavy-industrial space as well as the hospitality vertical. Although we do not expect improving market conditions in the region, year-over-year comparisons do ease as we progress during the year. Lastly, Latin America continues to be an area of strong execution and organic revenue growth driven by our subscriber business.

Now, let me spend a few minutes on our growth investments. We continue to make great progress despite the global macroeconomic environment. We remain committed to a higher pace of new product innovation and introduction. Let me mention a few examples on slide 8. Just last week I participated in the launch event for Scott Sight, an industry-first, in-mask thermal imaging system used by first responders. Scott Sight integrates a small camera and infrared screen into the facemask. This allows the firefighter increased visibility in dark and smoke-filled rooms, leaving their hands free to perform critical rescue operations. Scott Sight is the first commercial product resulting from our Firefighter of the Future initiative utilizing our adopted lean startup culture. This creates a platform to accelerate future capabilities to provide enhanced situational awareness for first responders.

Within fire protection products, we continue to launch new reformulated fire suppression foams to conform to new industry standards with a chemistry mix that is better for the environment. Our history as a leader in this space is continuing as we make our products the safest in the market for first responders and among the safest in the market for the environment. We also launched several new security products during the quarter, some of which were debuted at ISC West in early April.

Within our access control portfolio, we launched a new version of our Software House C-Cure 9000 enterprise security management platform, the industry's fastest and most secure credential management solution. This software platform allows you to integrate all aspects of fire, security and other building management capabilities with streamlined event management and better command-and-control when time matters. This upgrade enhances the user experience and reduces operating cost. In addition to our product launches we are progressing well within the rollout of our Salesforce.com platform, which we refer to as E3. Phase 1 of our two-year rollout began in our UK business in October and early results are very encouraging. More recently, we have expanded the E3 rollout to our continental Europe businesses.

In summary, we continue to make significant strides in improving the fundamentals of the business. We are investing for future growth through a streamlined organization in North America with a combined focus on service and installation, accelerating our product and service innovation and expanding and executing our E3 program driving commercial excellence. As a result of these initiatives our order pipeline and backlog continue to build which positions us well for increased growth in the second half of this fiscal year.

With that, I'd like to turn the call to Robert to walk through the details of our second quarter results.

Robert E. Olson - Chief Financial Officer & Executive VP

Thank you, George. Good morning, everyone. Let's begin with an overview of the quarter starting on slide 9. Revenue of $2.3 billion declined 4% year-over-year on a reported basis including a 4% headwind from foreign currency. Acquisitions contributed 4 percentage points of revenue growth which was mostly offset by a 3% decline from divestitures.

As George mentioned, organic revenue declined 1% driven by softness in our Global Product segment. Before special items, segment operating income was $311 million and the operating margin was 13.3% which included a 40 basis point headwind related to non-cash purchase accounting. Excluding purchase accounting, the segment operating margin improved 10 basis points year-over-year as net productivity benefits more than offset the negative mix. Overall, earnings per share before special items decreased $0.05 over the prior year, primarily related to a $0.04 discrete tax benefit in the prior-year period. Excluding the discrete tax item in fiscal Q2 2015, EPS before special items declined by $0.01 primarily due to volume deleverage and mix. Productivity savings and lower restructuring and corporate expenses helped to offset the impact of FX and incremental purchase price accounting.

Turning to orders on slide 10, total orders increased 7% year-over-year with 3% growth in Service, a 16% increase in Integrated Solutions, and 3% growth in Products. Total backlog of $4.65 billion increased 2% on a quarter-sequential basis and 7% year-over-year. Excluding acquisitions, backlog increased 3% on a year-over-year basis.

Now let's get into the details of each of the segments. Starting first with North America Integrated Solutions & Services on slide 11, revenue in the quarter of $947 million was relatively flat on a reported basis. Organic revenue was slightly positive in the quarter driven by 1% growth in Integrated Solutions. A 1% contribution from acquisitions was fully offset by the negative impact of the weaker Canadian dollar.

Before special items, operating income in the quarter was $131 million and the operating margin improved 60 basis points year-over-year to 13.8% including a 20 basis point headwind related to non-cash purchase accounting. Underlying margin expansion of 80 basis points resulted from the improved execution and the benefits of productivity initiatives. Total orders grew 7% year-over-year representing another solid quarter of growth; this included a few large jobs in the quarter; however, when you adjust the prior-year as well, base order momentum is in the 6% range. Total backlog of $2.57 billion increased 4% year-over-year and 2% on a quarter-sequential basis.

Turning to slide 12, Rest of World Integrated Solutions & Services revenue of $768 million decreased 9% year-over-year driven by a 9% unfavorable impact from FX. Organic revenue declined 1% as 1% growth in Service was more than offset by a 3% decline in Integrated Solutions. Acquisitions contributed 8% to revenue growth which was mostly offset by a 7% headwind from divestitures.

Before special items, operating income was $77 million. The segment operating margin declined 60 basis points year-over-year to 10.0% including a 40 basis point headwind related to non-cash purchase accounting. The underlying margin decline of 20 basis points was driven by the mix of revenue decline partially offset by productivity benefits. On a sequential basis, the operating margin expanded 50 basis points off a lower revenue base. We continue to expect increased margin expansion on a sequential basis as we progress through the second half of the year.

Turning to order activity in Rest of World, year-over-year orders increased 11% with 6% growth in Service and 18% growth in Integrated Solutions driven primarily by acquisitions. On an organic basis, Rest of World orders increased 3% year-over-year. Backlog of $1.91 billion grew 13% on a year-over-year basis and 3% on a quarter-sequential basis. The majority of the improvement in the year-over-year period was driven by the consolidation of our joint venture in the Middle East. On an organic basis, backlog increased 5% year-over-year.

Turning to Global Products on slide 13, revenue of $616 million declined 4% on a reported basis. A 2% benefit to revenue from net acquisition activity was more than offset by a 3% decline related to FX. Revenue declined 3% organically partly due to a difficult comparison of 7% growth in the prior-year period. You may recall that fiscal Q2 2015 was the last quarter that benefited from the timing impact of the Scott Air-Pak X3 shipment in the Life Safety business.

As George noted, we saw a bit of pressure on our short cycle businesses within Life Safety and Fire Protection products related to some delay in municipal spend as well as additional softness in the high hazard heavy-industrial sector. We are seeing signs that this has stabilized and we expect product organic revenue growth to be flat to up 1% in the second half. Before special items, operating income was $103 million and the operating margin declined 150 basis points to 16.7% including a 50 basis point headwind related to non-cash purchase accounting. The underlying margin decline of 100 basis points was driven by volume deleverage and product mix. Product orders increased 3% year-over-year driven by acquisitions.

Now let me touch on a few other items on slide 14. First, corporate expense before special items is $46 million for the quarter, a bit better than we expected. We now expect corporate expense before special items to be approximately $200 million for the year. Next, our effective tax rate before the impact of special items was 17.3% for the quarter. We expect a similar tax rate in the second half of the year.

Moving to restructuring and repositioning activities, we incurred charges of $16 million for the quarter, of which $9 million was related to restructuring actions. We expect restructuring and repositioning charges in the third quarter to be approximately $20 million. For the full year, we now expect restructuring and repositioning charges to be in the range of $70 million to $85 million.

Turning to cash flow, we continue to make progress in converting our income to cash. We generated an adjusted free cash flow of $242 million in the quarter representing a 126% conversion rate. Year to date, we have generated $411 million in adjusted free cash flow which represents 111% of adjusted net income from continuing operations.

Before I turn it back over to George let me provide you with a quick update on the IRS litigation. We continue to work closely with the IRS on finalizing our agreement to resolve the previously-disclosed intercompany debt issue. With respect to the tentative resolution, we made a cash payment of $122 million in the quarter pursuant to the tax-sharing agreement. We expect final resolution within the next few months.

Now let me turn things back over to George.

George R. Oliver - Chief Executive Officer & Director

Thanks, Robert. Let's turn now to our outlook for the balance of the year. As I noted earlier, we expect our results to be stronger in the second half of the year driven by incremental revenue and increased productivity. Starting with the third quarter on slide 15, we expect organic revenue growth to accelerate to the 1% to 2% range driven by backlog conversion in our Integrated Solutions & Services businesses. Given current exchange rates we expect a year-over-year FX headwind of approximately $80 million or 3%.

In total, we expect revenue of approximately $2.4 billion. We expect the segment operating margin before special items to be similar to the prior year including a 20 basis point headwind related to non-cash purchase accounting. Excluding purchase accounting, we expect the segment operating margin to improve approximately 20 basis points year-over-year. On a sequential basis we expect operating margin improvement in all three segments.

Taking all of these assumptions into account as well as the expectations for corporate expense and restructuring and repositioning that Robert provided, we expect earnings-per-share before special items in the third quarter to be in the range of $0.52 to $0.54 based on a weighted-average share count of 429 million shares.

Turning to slide 16, I want to remind everyone that the full year and fourth quarter of fiscal 2016 include an extra week of results compared to the prior year. In order to reflect the true underlying organic growth of the businesses the impact of the 53rd week is not included in organic revenue. We expect that the addition of a 53rd week will contribute approximately $90 million of incremental revenue and $0.04 to $0.05 of earnings per share. Based on our first-half results and our expectations for the remainder of the year, we are tightening our full year earnings per share before special items guidance to a range of $2.05 to $2.10 as noted on slide 17.

Thank you for joining us on the conference call this morning. And with that, operator, please open the lines for questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. In respect of time, we ask you to limit yourself to one question and one follow-up question. One moment please for the first question. Our first question is from Mr. Jeffrey Sprague of Vertical Research Partners. Your line is open.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Thank you. Good morning, everyone.

Antonella Franzen - Head-Investor Relations

Good morning, Jeff.

George R. Oliver - Chief Executive Officer & Director

Morning, Jeff.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Good morning. George, I was hoping we could drill into products a little bit more and just want to understand kind of the trajectory from here primarily but, if I look at Q2 on a year-over-year basis and try to adjust for the purchase accounting, it looks like the decrementals were in the 40s which sounds reasonable. But you did have actually a pretty meaningful profit at least sequentially, right, on similar revenues? And then as I look into Q3, in aggregate you're not talking about a lot of margin improvement. And I'm just wondering, so if you can kind of piece together for me how to think about Products moving forward and really what role Products is playing in the margin outlook for Q3?

George R. Oliver - Chief Executive Officer & Director

Sure. What I would start with, Jeff, is to look at the total year first-half, second-half, and so in the first half our Product businesses we were estimating that we'd be down 1% to 2%; we were down 1% to 2% with modest increase in the second half. First quarter played out a little bit better, second quarter didn't play out as expected, which has created the pressure here in the second quarter. When you look at the margins, we had on the volume deleverage and mix, it would equate to about 140 basis points of impact with that reduced volume.

And then, within that, we also had 40 basis points of productivity. So that's 100 basis points net combined with the 50 basis points of purchase price accounting is what led to the margin decline in the second quarter. Now, looking forward, we get back into roughly – we start to grow in the third quarter, fourth quarter for the total year to be – the second half up about 1%. So as we begin to go forward, we have continued productivity coming through, we get the leverage of the volume, we've got a number of new products that are being launched that are priced at a higher price, higher margin, and as you play out the second half, we truly believe that we're positioned to get back to roughly a total year margin rate of about 18%.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Okay. And then maybe just switching gears, for Robert. I understand you're trying to finalize with the IRS, but do the Treasury rules that were announced on April 4 in any way change the dialogue, change the rules of engagement on trying to get this settled and wrapped up with them?

Robert E. Olson - Chief Financial Officer & Executive VP

Yeah. Jeff, they don't change that dialogue. Our dialogue with the IRS has been very positive and we're moving forward to resolving that completely. As you might recall, the Treasury regulations, the proposed regulation, are on a go-forward basis, so they don't impact the dispute on the intercompany debt which was related to a prior period.

Jeffrey Todd Sprague - Vertical Research Partners LLC

Thank you.

Operator

Thank you. Our next question is from Josh Pokrzywinski of Buckingham. Your line is open.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Hi. Good morning, guys.

Antonella Franzen - Head-Investor Relations

Good morning, Josh.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

Just kind of following up on your earlier comments, George, on the some of the early integration planning wins with Johnson Controls, and maybe talk about specifically where you guys are seeing enhanced opportunity. Obviously it's very early in the process, but both yourselves and JCI sound a bit more sanguine on some of those opportunities there. Anything specific that you call out as maybe being a driver of that?

George R. Oliver - Chief Executive Officer & Director

Josh, as I said, I'm very pleased with the progress we're making. I'm very impressed with the team that we put together, especially with the JCI participants. Through the process Alex and I are developing a very strong relationship and are staying very close to all of the teams that we've put into place. We've got a regular cadence working with each of these teams, and the more that we learn and the more that's coming out of these teams, the more excited I am relative to the opportunities that I see.

And so as we laid out the synergies, the $650 million of synergies, we start with $150 million of tax synergies and then operationally you can break down the $500 million, which are $150 million of corporate costs, headquarters-type costs that'll get eliminated. We get about $100 million of leverage with the combined buy, which is significant, and then there's roughly about $250 million of synergies across the operations. And what I would tell you is within each of the tower teams we have working across each of the functions, as well as our go-to-market team that's working closely with getting a better understanding on how we begin to get revenue synergies, we're making great progress. And I think the pipeline that we have not only gives me confidence that we'll deliver on the $650 million but potential more opportunities beyond that.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

That's great. And just to follow up a little bit on Jeff's earlier question, just with the margin bridge, 3Q to implied 4Q, anything in North America or Rest of World that we should keep in mind as a moving item 3Q to 4Q?

Antonella Franzen - Head-Investor Relations

The one thing to keep in mind is the impact of the 53rd week, clearly there'll be more volume across all three segments that will give you more leverage across the board. And also as you noted in the bridge that we have on the slide, with the first-half second-half, the other thing to keep in mind is there is incremental productivity in the second half of the year versus the first half of the year and that also stretches all three segments and will help the margin.

Joshua Pokrzywinski - The Buckingham Research Group, Inc.

All right. Thanks a lot.

Antonella Franzen - Head-Investor Relations

Operator, next question.

Operator

Thank you. Our next question is from Steven Winoker. Your line is open

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Hi. Thanks and good morning, all.

Antonella Franzen - Head-Investor Relations

Good morning, Steve.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

I just wanted to follow up on those existing topics that have been raised, first on the tax front, just making sure I understand this, that $3.9 billion payment to JCI shareholders, how are the Treasury rules that have been issued in any way affect the treatment of that payment in so far as the ownership structure is concerned?

Robert E. Olson - Chief Financial Officer & Executive VP

Steve, this is Robert. The regulations don't affect that and that is external debt so that wouldn't be affected by the proposed regulations.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Okay. Fine. And earnings stripping rules going forward as you're thinking about tax rate?

Robert E. Olson - Chief Financial Officer & Executive VP

We've given guidance in the 17% to 18% range and I think that's still very good guidance for the foreseeable future. We don't think the earnings stripping issue will impact us for several years. I would add that when we think about tax rates and tax planning, it's really a global effort. And remind everyone that we pay – file taxes in over 60 countries. So while the U.S. is important it's just one of the 60 countries.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Okay. Fine. And, George, on Global Products, on the top line side of this and maybe it's a more strategic question here, I know you're comping over the mid-teens in security products and you had the Scott Pak headwind but when you think about the pace of growth here and the new product introductions, the examples that you gave, I mean, what does it take to get this business unit to start to see the financial organic growth live up to what is, seems like a bunch of very strong secular drivers? And how much of this is just – is this just end-market headwind in harsh and hazardous and when can we, as shareholders, sort of expect to see a meaningful step up?

George R. Oliver - Chief Executive Officer & Director

Steve, as you know, over the last – up until last year we had a great track record ongoing on Products, where both organically as well as with the acquisitions we've made, we were delivering strong, mid to upper single-digit growth. And what has happened here is that the end markets, mainly the heavy-industrial high hazard, it makes up about 25% of our products. And so last year we certainly saw the impact initially from oil and gas but that has expanded across pretty much that revenue base.

And so as we get into the second half of the year, we certainly have a better compare and then with the investments we've been making into new products and the lift that we begin to get from those new products, we should be able to get back to, with a normal compare, get back into as we get into 2017 into kind of low to mid single-digit organic growth and then complement it with the acquisitions we've made. I've been around these Product businesses for 10 years. These Product businesses are executing extremely well. We'll have a record number of new product launches this year and so if it weren't for this one segment of the Product businesses, this heavy-industrial high hazard segment, with the pressure that we're seeing today, we'd be positioned to deliver a very nice growth across the rest of the base.

And so I'm still very bullish, we're investing, we're making great progress with the launches. You might have seen all of the press that we got with the Scott Sight launch that we did last week and we have similar launches planned across the rest of the portfolio over the course of the year.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Okay. That's helpful. And if I could just squeeze one more in for a fine point, you did split again out that $650 million between $500 million and $150 million for operational and tax. I would have thought there would have been an increased risk to the $150 million and increased opportunity for the $500 million. You're not thinking about it that way, it sounds like, one the first part.

Robert E. Olson - Chief Financial Officer & Executive VP

Steve, this is Robert. I think that the $150 million for tax is still approximately the right ballpark and I think that – we do think that there's potential for upside on the operational side.

Steven Eric Winoker - Sanford C. Bernstein & Co. LLC

Okay. All right. Thanks.

Operator

Next question is from Gautam Khanna. Your line is open.

Gautam Khanna - Cowen and Company, LLC

Yes. Thanks. Good morning, guys.

Antonella Franzen - Head-Investor Relations

Good morning, Gautam.

Gautam Khanna - Cowen and Company, LLC

So I was wondering first if you could calibrate us on where we are within the Global Product high hazard industrial business, I mean, it seems like we've been going down for a while so how much is that business down now relative to where it was prior to oil kind of cracking? And where do you think we are with respect to that cycle right now, in terms of your orders and what have you?

George R. Oliver - Chief Executive Officer & Director

Yeah, let me start with oil and gas, we said last year that overall for the company we were down about 15% and on a run rate basis we're down roughly 25%. For the year last year that average is 15%. As we planned for this year that we plan for another reduction of about 10% on – through the course of the year. Based on what we saw in the second quarter mainly in our Product businesses, in the pressure that we see, not only incremental in the oil and gas but more across the heavy-industrial, they're now, instead of a 10% decline this year, we're looking to see potentially a 15% to 20% decline. Now, we do believe that on the run rate that we see that we're stabilizing and that going forward based on the opportunities that we're currently working on that that will then – that baseline will then grow as we get into 2017.

Gautam Khanna - Cowen and Company, LLC

Okay. But just to put a finer point on it, this is not simply oil and gas related operators, this is a second-derivative impact if you will. Industries that touch oil and gas, so it's different than what you saw last year which was more direct, is that fair?

George R. Oliver - Chief Executive Officer & Director

Yeah. Let me clarify that, of the 25% of the product revenues that are tied to what we call heavy-industrial high hazard, only about a quarter of that is directly tied to oil and gas. And so when we segment high hazard heavy-industrial together with the impact it's had, it's impacting about 25% of our product revenues.

Gautam Khanna - Cowen and Company, LLC

Okay. That's very helpful. And then on the Integrated Solutions piece where you saw big order growth, I was wondering if you could parse the organic orders within that business and if you could comment on the timing to convert the sales on those orders, why we're not seeing the organic growth in the year?

George R. Oliver - Chief Executive Officer & Director

We've been improving our order rates sequentially and they've been accelerating as we've been going forward and a lot of that has been tied to our commercial excellence initiatives. And so we've been putting additional salespeople in place, we've been making sure we have the right structure, the right competencies, the right compensation and through that process we've been seeing sequential improvement. Now, this has been our best order quarter that we've seen. Up 7%, about 3.5% of that organic and so when you look at how that converts, we have backlog that we were building the end of last year, early this year, that will convert in the second half of this year.

So as we're building that backlog our typical conversion on average is nine months to 12 months and it depends on the – obviously the cycle time of the projects that we take on. But I feel very good about the progress we've made on the sales front, the order rate that we're achieving, the organic pickup that we're seeing and in our ability to be able to convert that revenue in the second quarter to support the guidance that we've provided and more important, to continue the order rate and continuing to build backlog that positions us for accelerated growth in 2017.

Gautam Khanna - Cowen and Company, LLC

Okay. Last one, George. I appreciate the color. Any early read on revenue synergies with the JCI business? Maybe if you've had any anecdotal discussions with customers or what have you, on how that might actually play out and when you'd actually start to see some top-line synergies?

George R. Oliver - Chief Executive Officer & Director

What I love about this deal is when you think about the strategic value, it does start with customers and all of the customers that I've engaged with see an opportunity where we can combine our capabilities, differentiate what we can do, provide better service and certainly create more value for them which allows us to be able to accelerate growth for the combined company.

The other big element of the excitement is what's going on in the field. There isn't a person that I engage within our organization that isn't totally excited about the combination which will enable or enhance their capabilities to be able to better support their customers. So the combination gives me a lot of confidence that with the work that we're doing with the go-to-market team and the opportunities that we're identifying between our two companies are going to start to hit Day 1.

Now, we're working through categorizing what those opportunities are, accumulating those so that we can give better color at EPG and other conferences during the course of the year. But I'm very excited about the short-term prospects; being able to leverage our combined structure and more important longer-term, the combination of our capabilities, being able to change the game and how we sensorize the buildings, how we deploy our unified software platforms that enables us to be able to solve the bigger problems for the customer base that we serve and by doing so that's going to position us for acceleration of growth.

Gautam Khanna - Cowen and Company, LLC

Thanks, and good luck, guys.

Antonella Franzen - Head-Investor Relations

Thanks.

Operator

Our next question is from Nigel Coe of Morgan Stanley. Your line is open.

Nigel Coe - Morgan Stanley & Co. LLC

Yeah. Thanks. Good morning.

Antonella Franzen - Head-Investor Relations

Good morning.

Nigel Coe - Morgan Stanley & Co. LLC

Just wanted to come back to the backlog and obviously good news in both Rest of World and North America. For Rest of World, can you just call out what regions and countries driving the backlog performance? And in North America are you seeing any change in the mix of end markets and in particular are you seeing an uptick in education and healthcare?

George R. Oliver - Chief Executive Officer & Director

Let me start, Nigel, just by talking about backlog in general. The backlog is broad-based, that is the result of all the work that we've done to streamline our commercial structure, to put additional resources in the field selling, to get the right compensation structure, all of that in place and we're beginning to see the productivity that we've been generating, we've been putting a lot of that back to work in supporting our commercial initiatives and we're starting to get real traction pretty much across the board.

And so if you were to start in Europe, in the UK, in continental Europe, this is where we deployed our E3 initiative enabling, not only after getting the right structure in place but now enabling that structure with the Salesforce.com platform. And already through that, with the connectivity that we're getting with our sales force, with our technicians we're getting an uplift of leads. So 5% to 10% improvement in leads and then the conversion, 10% improvement from leads to orders. And so we're already seeing the benefits of that. So even though we've got pressure in the UK because of oil and gas, we are starting to see some real improvement.

Continental Europe seems to be better pretty much across the board, and it has been sequentially getting better since last year. And if you look at our order performance there, it continues to be very positive. I'm very excited about the work that we've done there.

If you go to Asia, although we've been pressured with the heavy-industrial high hazard end markets, doing the same, getting the right resource footprint in place to be able to expand elsewhere, whether it be in the commercial space and some of the other segments, the subscriber base that we can build there. And so that is continuing to make improvement.

And then the last would be in Latin America. We have, in spite of some of the economic pressures there, we've continued to expand our footprint, we're executing well, we're building a subscriber base and so, therefore, that's what's generating the order growth there. So what I'm excited about, Nigel, is that it's broad based, that we're making great progress with the commercial excellence initiatives that's creating – and the pipeline is even better. So the pipeline that we have that we're converting on, I feel good that the order rate that we see in the second quarter is going to continue pretty much across the board, and it's the result of the progress that we've made in putting the commercial resources in place.

Nigel Coe - Morgan Stanley & Co. LLC

And North America?

George R. Oliver - Chief Executive Officer & Director

North America continues to perform extremely well. As I said, the new organization structure, and this has been a multi-year plan that we've been on with our North America improvement plan, so as the businesses, we're driving fundamentals, we're getting to a similar structure within our commercial security business with our fire business. You might recall last year I brought in Girish Rishi to lead the combined business. Part of that plan was to then go into one leaned-out North America structure that enabled us to be able to free up a lot of resources, to put more resources on the front end of the business, driving growth, while we're still positioned to expand margins going forward. That all happened.

We had over 400 key leaders, both in operations as well as sales, be redistributed over the last quarter and we didn't miss a beat. And with the structure we have in place today, gives me confidence that we'll continue that order growth through the course of the year; and more important now is our ability with the resources that we put into the field to convert, they'll be able to convert into revenue growth in the second half and beyond.

Nigel Coe - Morgan Stanley & Co. LLC

Okay.

Antonella Franzen - Head-Investor Relations

And Nigel, just a comment on the specific verticals, I mean, within North America, we did see good activity in institutional particularly in higher education as well as in healthcare, and some of the activity there was also driven by just general commercial as well as government and banking were all more positive in the second quarter.

Nigel Coe - Morgan Stanley & Co. LLC

Wow, banking, that's surprising. That's great color. Just one quick follow-on. So it looks, and maybe this is better a question for JCI, but it looks like the 46:48) spin is taxable rather than tax-free. Just a quick question, was that understood at the time of the announcement or was that something that became clarified during the process?

Robert E. Olson - Chief Financial Officer & Executive VP

Nigel, this is Robert. Yeah, this is something that the JCI team and the Tyco team, we discussed that at length as we were going through the deal process so we knew about this, and not a surprise at all.

Nigel Coe - Morgan Stanley & Co. LLC

Okay. Great. Thanks.

Operator

Our next question is from Steve Tusa with JPMorgan. Your line is open.

Charles Stephen Tusa - JPMorgan Securities LLC

Hey, guys. Good morning.

Antonella Franzen - Head-Investor Relations

Good morning.

Charles Stephen Tusa - JPMorgan Securities LLC

Can you just update us on the net productivity ins and outs? Sounds like it's in line. But anything moving around there? When you talk about whatever it was, the $180 million to $200 million in productivity, and in inflation, and sales and marketing, just those buckets, anything moving around there for the year?

Robert E. Olson - Chief Financial Officer & Executive VP

Right. Yeah. This is Robert. So I think the gross productivity that you mentioned, we've given guidance of $180 million to $210 million. That's on track, probably mid to upper end of that range. That's offset by inflation, which we had estimated at $60 million; that's about where it's coming in. And then the last, that kind of gets you down to your net productivity is the investment level that we had originally given guidance at $70 million to $90 million. We think we're going to be at the low end of that range now, and that's part of the productivity benefit you see on slide 16; that's what's driving that.

Charles Stephen Tusa - JPMorgan Securities LLC

Okay. And then as far as, I can't believe I'm going to use this term, but any impact from Brexit on your UK business? I mean, is there any way to kind of figure out what's kind of oil and gas and what may be some tremors around that, whatever you want to call it, what's going on over there?

Robert E. Olson - Chief Financial Officer & Executive VP

Yeah, we're not seeing any impact from Brexit.

Charles Stephen Tusa - JPMorgan Securities LLC

Okay. And then one last question just on free cash flow, a pretty strong start to the year. I don't think you react to the 90% to 100% of net income explicitly in here. Maybe you did, but anything that got pulled into this first half? Obviously, I think we're not counting on 125% conversion for the full year, but usually your second half is seasonally comfortably above 100%. Anything unusual seasonally that's happening this year? Or you guys just kind of finally getting out some of this working capital or whatever else is going on that was depressing free cash flow?

Robert E. Olson - Chief Financial Officer & Executive VP

Yeah. I don't think there's anything unusual seasonally, but I do think, as you know, quarterly cash flow balances around, so any given quarter it's pretty hard to peg, but I think long-term 90% to 100% is a good metric. I think that we're going to try to do better. We've gotten a good start to this year and we're pushing very hard. With that being said, we're achieving these results largely just through intensity. We haven't yet fixed the process all the way that we'd want to. I think we're kind of in the middle innings on the process fixes.

Charles Stephen Tusa - JPMorgan Securities LLC

But I guess, again, I mean, the worst I can see going back a couple years, and it's changed, is kind of 95% conversion in the second half, as high as 150%. And you remove the 90% to 100% in your guidance I think for this year. So can we assume that it is for this year, just kind of put you guys up there as saying it is going to be better than 100% this year?

Robert E. Olson - Chief Financial Officer & Executive VP

Like I said, we're tracking towards the upper end and we're pushing to get even better.

Charles Stephen Tusa - JPMorgan Securities LLC

Okay. Thanks

Operator

Next we have Deane Dray at RBC. Your line is open.

Deane Dray - RBC Capital Markets LLC

Thank you. Good morning, everyone.

Antonella Franzen - Head-Investor Relations

Good morning, Deane.

Deane Dray - RBC Capital Markets LLC

Hey, just to go back to Global Products, there was a mention of some delays in municipal spending. Maybe you can flesh out that point. What specifically have you seen and what's baked into guidance?

George R. Oliver - Chief Executive Officer & Director

Yeah, Deane, I'll take that. What we saw there is that there are a number of opportunities that we're pursuing that we had planned that were going to come through in the second quarter that had been pushed out to third quarter and in some cases fourth quarter. We see, realizing that we were – when we launched the X3 we were the leader and had built our backlog and pretty much fulfilled that backlog last year. We've got a nice rate going now on a run rate basis and it has picked up here a little bit in April.

So we're confident that these orders will come through. It's just a matter of timing, and you might have seen as I mentioned earlier, we had a big launch last week with the in-mask thermal imaging capability and that's kind of positions us well as we pursue these new opportunities and potentially upgrade the existing fleet that's out in the field. So, although it's – we had some pressure in the quarter with the municipality funding that came through, going forward I believe that we'll still be at a run rate that based on the forecast that we have today that we'll be able to support.

Deane Dray - RBC Capital Markets LLC

Thanks. On that mask, on the thermal imaging mask, has that already been NFPA-approved?

George R. Oliver - Chief Executive Officer & Director

So we're in the final stages of the approval and we expect approval here within the next 30 days or so.

Deane Dray - RBC Capital Markets LLC

Great. And then for Robert, on the FX guide, Tyco looks to be one of the only companies that would be seeing higher FX headwinds in the back half of this year, so how does that math work?

Robert E. Olson - Chief Financial Officer & Executive VP

Yeah, just – it's all related to the timing of when we give guidance, remember, because we're – our fiscal year start one quarter earlier. We go off of that base and that base gives us a different profile than the companies that start the year January 1.

Deane Dray - RBC Capital Markets LLC

And the biggest change there may be on the Canadian dollar looks to be to benefit as well?

Antonella Franzen - Head-Investor Relations

Yeah, the Canadian dollar and the pound were the two bigger drivers of – from when we originally gave our FX guidance back in November to the updated FX guidance, but in terms of first half, second half of the year, keep in mind we do have a bit of a tailwind related to FX in the second half of the year

Deane Dray - RBC Capital Markets LLC

Got it. Thank you.

Operator

Next is Shannon O'Callaghan of UBS. Your line is open.

Shannon O'Callaghan - UBS Securities LLC

Good morning.

Antonella Franzen - Head-Investor Relations

Good morning.

Shannon O'Callaghan - UBS Securities LLC

Hey, George, can you give a little more color just specifically on the service fees and how the efforts are going there to sort of drive better attachment rates and what's tracking instead of better or worse than or making progress or not, that you're targeting?

George R. Oliver - Chief Executive Officer & Director

Yeah, let me start by, in the second quarter we were relatively flat and that was mainly a result of when you look at our calendar, we have a 13-week calendar and there was two equivalent days less of service within our quarter. So that had a slight impact on our volumes. We are making great progress across the board. We're expanding service pretty much across the regions, across the end markets with the exception of oil and gas because of the current status of that end market, as a result of the investments we've been making to differentiate our solutions as well as putting additional resources within the commercial structure as well as additional technicians to be able to be positioned to fulfill the service.

And so as I look at where we are today, going forward for the year we are going to be close to the 2% service growth for this year, and more important now as we project the future we'll be able to build from that growth rate going forward in 2017 and beyond. And so, at spend we've made a lot of progress. We've gone through most of that headwind with the remix of the portfolio and with the investments we're making we're going to be positioned well to be able to continue to grow.

Shannon O'Callaghan - UBS Securities LLC

Okay. Thanks. And then just in terms of the guidance gets withdrawn with the publishing of the prospectus, maybe just a little color on what else you're limited in and also maybe just a little more specifics. I know you guys don't normally kind of give all the segment specifics by quarter. Maybe a little more color on the third quarter since we're not going to really have much update from then on, how that – what's the – what you're thinking for the year?

Robert E. Olson - Chief Financial Officer & Executive VP

Yes, Shannon, this is Robert. The withdrawal of guidance is just according to the Irish security laws. In fact, if you've seen other Irish companies involved in acquisitions, this is pretty standard practice so it's nothing unusual. And the timing of that is really just tied to when the S4 becomes effective really, I mean that's what drives the timing.

Shannon O'Callaghan - UBS Securities LLC

And then just in terms of the segments for 3Q, any specifics and just sort of, margins by segment, things that you're thinking a little more closely there. I mean, does Products go, I think, trade to 19% or 20% in the third quarter? Maybe just a little more flavor.

Antonella Franzen - Head-Investor Relations

Yup. So Shannon, this is Antonella, so just a couple of things to think about in terms of the segment operating margin for the third quarter. So overall we do expect it to be similar to last year. That will include 20 basis points of purchase accounting in there so ex the PPA it's up about 20 basis points and how that kind of shakes out is specifically to your point on Products, we do expect Products to go up to like 18% to 18.5% rate for the third quarter. So keep in mind on a year-over-year basis, that's the first quarter that there is not an incremental PPA impact because of the timing when we did the acquisitions last year. So that's why the year-over-year will be better in terms of the Products business. Rest of World will probably shake close to the 10.5% and, think of North America as close to 16%.

Shannon O'Callaghan - UBS Securities LLC

Great. Thanks a lot.

Operator

Next question is from Julian Mitchell of Credit Suisse. Your line is open.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Hi. Thank you. I just wanted to focus on the EPS guidance. So I guess first is when you last updated in January the midpoints come in $0.05. FX is $0.02 less of a headwind so you've got a sort of a $0.07 cut organically. Is that all related to Global Products? Or is there something else that also is coming in a little bit light?

Robert E. Olson - Chief Financial Officer & Executive VP

Julian, this is Robert. It is all related to Global Products, and as you know, that business leverages nicely on the upside and it also deleverages on the downside.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Got it. Thanks. And I just wondered on orders to sales conversion, is there anything in the lead times that has changed or there are sort of orders that are booked and then maybe fall out before being billed because in 2014 your organic orders are up about 4%, for 2015 they were up low single-digit and yet the organic sales growth last year and this year is around 0%. So I wonder if there was just something on lead times, the nature of the industry or something that's changed.

Robert E. Olson - Chief Financial Officer & Executive VP

Yeah. Julian, this is Robert again. So the orders I think you're referring to are probably inorganic orders. On the conference call we usually provide both organic and inorganic. This has been a great quarter for orders growth, 7% total orders growth, 3% to 4% organic orders growth.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Sure. But – okay, so nothing's changed because your organic orders were up 4% and then I think about 2% the last two years so there's nothing that's changed in lead times or conversion?

Robert E. Olson - Chief Financial Officer & Executive VP

No, nothing's changed.

Julian Mitchell - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Antonella Franzen - Head-Investor Relations

Operator, I'd like to turn the call over to George for some closing comments.

George R. Oliver - Chief Executive Officer & Director

Thanks again for joining our call this morning. I want to thank all of our employees for their continued hard work and commitment in serving our customers while positioning the company for the merger with Johnson Controls. I remain confident in our ability to drive continued improvement across all of our fundamentals as we execute on the year. This combined with the merger with Johnson Controls makes me extremely excited about the opportunities ahead, creating enhanced value for customers, employees and shareholders. I look forward to seeing many of you at the EPG Conference on May 16, and, operator, that concludes our call today.

Operator

That concludes today's conference. Thank you all for joining. You may now disconnect.

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