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Tyco International Ltd. (NYSE:TYC)

F2Q11 Earnings Call

April 26, 2012; 08:00 am ET

Executives

Ed Breen - Chairman & Chief Executive Officer

Frank Sklarsky - Chief Financial Officer

Patrick Decker - President of Flow Control

Naren Gursahaney - President of Tyco Security Solutions

George Oliver - President of Tyco Fire Protection

Antonella Franzen - Vice President of Investor Relations

Analysts

Jeff Sprague - Vertical Research

Scott Davis - Barclays

Steven Winoker - Sanford Bernstein

Ajay Kejriwal - FBR Capital Markets

Gautam Khanna - Cowen

Steve Tusa - JPMorgan

Nigel Coe - Morgan Stanley

Deane Dray - Citi

Operator

Welcome to the Tyco second quarter earnings conference call. At this time all lines have been placed on a listen-only mode until the question-and-answer session. (Operator Instructions).

I’d now like to turn the call over to Antonella Franzen, Vice President of Investor Relations. Thank you. You may begin.

Antonella Franzen

Good morning and thank you for joining our conference call to discuss Tyco’s second 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; and Tyco’s Chief Financial Officer, Frank Sklarsky. Also joining us for today’s conference call are the President’s of Fire and Security, ADT and Flow Control. George Oliver, Naren Gursahaney, and Patrick Decker, who will provide updates on their businesses and also participate in the Q&A sessions following our remarks.

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.

Free 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.

I would also like to remind you that we recently filed a Form 10 registration statement related to the ADT Corporation and posted a slide deck related to the Form 10 to our website. We also intend to file documents with the SEC, related to the Flow Control and chair merger and the Tyco shareholder votes related to the transaction within the next week. Due to the SEC filing process, we are restricted in what we can say with respect to the transactions and therefore ask that you limit your questions during to Q&A session to those related to our quarterly results.

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 our 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.

Now, let me quickly recap this quarter’s results. Revenue in the quarter of $4.4 billion increased 9% year-over-year with organic revenue growth of 7%, nicely ahead of our previous guidance. Foreign currency negatively impacted revenue by less than 1% and acquisitions added three percentage points to our overall year-over-year revenue growth.

Earnings per share from continuing operations attributable to Tyco common shareholders was $0.71 and included charges of $0.15 related to special items. Earnings per share from continuing operations before special items was $0.86.

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

Ed Breen

Thanks Antonella and good morning everyone. Our second quarter performance was highlighted by strong organic revenue growth. Order momentum over the last few quarters, coupled with continued growth in our ADT Residential business continues to drive higher top line growth. Our large and stable base of recovering and service revenue, which represented 45% of our revenue in the quarter, coupled with strong operating leverage led by the Fire and Security manufacturing businesses drove the operating performance of this quarter.

Additionally the benefit from our restructuring and cost containment initiatives helped fund additional investments across our businesses. Overall, operating income before special items increased 15% and earnings per share before special items increased 18% year-over-year.

From an orders perspective, we saw continued acceleration from the 8% year-over-year order growth we saw in the first quarter, to 13% growth in the quarter we just exited, with 9.5% growth in Fire and Security and 21% growth in Flow Control. Our order activity combined with continued growth in our backlog puts us on track for even better operating performance in our seasonally stronger second half.

Now let me give you a quick overview of our results for each of the businesses. Starting with the new Fire and Security segment, the combined portfolio provides the nice mix of service, installation and product offerings. Top line growth in the quarter benefited from both an acceleration in organic growth, as well as the contribution from the various bolt-on acquisitions we recently completed.

Our operating performance in the quarter was strong. Operating income grew twice as fast as revenue, resulting in a 70 basis point improvement in operating margin year-over-year.

In ADT, recurring revenue, which represents almost 90% of ADT’s total revenue continued to growth with a nice increase in both the account base and average revenue per user.

In Flow Control, the ramp up in orders over the past few quarters has translated into solid organic revenue growth. We have been booking some large orders in border, which positively impacted our order rates this quarter. This keeps us on track to achieve at 14% operating margin for the fourth quarter.

With that, let me turn it over to George for some more detailed revenue of Fire and Security.

George Oliver

Thanks Ed and good morning everyone. Before I walk you through our results for the quarter, I would like to tell you about the new Fire and Securities segment. We are a leading global provider of Fire and Security products and services. We serve a variety of markets worldwide, including commercial, industry and retail, as well as residential markets outside of North America to name a few.

Our global market leading position and broad portfolio of products and services is supported by our highly trained worldwide sales force of 7,000 people, market leading brands and innovative technologies. These factors differentiate us from our competitors and it is these strengths that we plan to continue to leverage as we move forward.

Our broad portfolio of products and services allows us to partner with our customers, to help them meet their needs ranging from product design, manufacture and insulation, to maintenance and upgrades. On this systems install and services side, we design, sell and install service and monitor electronic security systems, as well as fire detection and suppression products across the glob.

The combined mix if our products with our worldwide sales, service and instillation footprint is unmatched in the Fire and Security industry. By leveraging our global reach, we plan to continue to take advantage of our ability to provide best-in-class integrated solutions to our diverse customer base.

Our product businesses design, manufacture and sell fire protection, electronic security and life safety products, including fire suppression, intrusion security, access control, anti-theft and video management systems.

Our products are sold directly to customers, as well as through our extensive global network of distributors. We are a technology leader in our industry. Innovation and new product development are critical to our success, its something that our customers expect.

As a result, this is an area that has been and will continue to be a primary focus as we stay ahead of the technology curve through organic investment in our R&D centers, while strengthening our portfolio with a disciplined acquisition process.

In fact, we had a number of very nice strategic bolt-on acquisitions that we completed this past quarter. These investments expand our presence in key high growth markets and developed countries, as well as strengthen our product portfolio and service offerings in key vertical markets.

As an example, this past quarter we acquired a majority of ownership state in Reliance, which is a leading fire protection solutions provider in China. We expect the addition of Reliance’s expertise in fire insulation, as well as their service business will further strengthen our presence in China, and allow us to expand our foot print, customer base and systems installation and service opportunities in the region.

In addition to an attractive portfolio, the Fire and Security business has a very nice cash conversion profile and an attractive return on investment. Our goal is to build upon the solid foundation we have today, but increasing our mix of higher margin service revenue, growing our presence in high growth markets, strengthening our product leadership by driving technology and to provide innovative customer solutions in insuring that we are operate with an efficient cost structure.

Now, let me turn to our results for the second quarter. Overall revenue for the quarter of $2.6 billion increased 5% year-over-year. Organic revenue grew 3.5% with acquisitions adding an additional three percentage points in foreign currency, exchange rates decreasing revenue by a modest 1%.

Focusing on the performance of our global installation service and product businesses, let me start with our global service platform, which is the largest portion of the portfolio. Service revenue represented about 45% of our revenue in the quarter and grew 3% organically year-over-year, with growth in all geographic regions.

Systems installation revenue which represented about 35% of total revenue in the quarter, declined 1% on an organic basis, as growth in Asia Pacific was more than offset by declines in North America and AMEA, due to the softness in the non-residential construction market.

The remaining portion of fire and securities revenues come from our product businesses, which represented about 20% of our revenue this quarter. Organic revenue grew 14% as we continue to experience strong demand across fire protection products, life safety and security products. From a profit perspective, operating income before special items was $309 million and the year-over-year operating margin improved 70 basis points to 12.1%.

Growth of our higher margin service revenue increased volume leverage in the product businesses and the continued positive impact of restructuring the cost containment initiatives drove the improvement.

Year-over-year total orders grew 9.5% with service up 6%, systems installed up 3% and products higher by 33%. Backlog of $4.7 billion increased 5% on a quarter and sequential basis. Old orders and backlog exclude the impact of foreign currency, but include the impact of recent acquisitions.

Looking ahead to the third quarter, we expect continued strong performance in fire and security, with total revenue of approximately $2.7 billion and 4.5% organic revenue increase over the prior year.

From an operating income perspective, we expect the operating margin to improve 30 basis points year-over-year, as we leverage the increased revenue and continue to benefit from our productivity initiatives.

Before I pass it over to Naren, I’d like to thank the Fire and Security team for their continued dedication and successfully operating the business and delivering another solid quarter. I am very pleased with the team’s ability to continue to deliver solid results or making great progress in bringing the new Fire and Security organizations together.

Now, let me turn it over to Naren.

Naren Gursahaney

Thanks George and good morning everyone. Before I walk you through our results for the quarter, I’ll first provide some background on the ADT segment. Today ADT is the leader in the $12.5 billion residential and small business security market. With over 6.4 million customers in North America, we estimate ADTs market share at 25%, a position that makes us several times larger than the next biggest competitor.

The residential and small business security market has proven to be very resilient as industry data shows continued expansion, even through the recent economic downturn. However, we estimate that only about 20% of U.S. households have monitored security system today. In comparison, 65% of homes have broadband services, 85% have paid television services, primarily cable and satellite and 97% of households have wireless. So as successful as we’ve been, four out of five households remain potential new customers.

ADTs leadership position is driven by the most prominent brand in the residential security industry. A network of six fully redundant euro certified, company owned and operated monitoring centers. More than 200 field locations across the U.S. and Canada and more than 16,000 trained security professionals. We are also supported by the industry’s largest dealer network, which now consists of over 400 ADT authorized dealers, who are exclusive to us in the security space.

With over 135 years in the industry, security is not just one of ADTs offerings, it is what we do. With the introduction of ADT Pulse about 18 months ago, we have expanded our offerings from traditional security to interactive home and small business security solutions. Pulse enables our customers to remotely arm and disarm their security system from their Smartphones and other web enabled devices and/or receive notification about events that occur on their premises.

Our new offerings also extend beyond security to home and small business automation, climate and light control and remote video monitoring, all of which can be tailored to an individual customer’s needs. Pulse has quickly become an important part of our portfolio and we continually look to add new features and capabilities.

We built the greatest subscriber base business, with close to 90% of our revenue recurring, driving strong returns and steady cash flows. Our focus is one creating shareholder value by managing client key levers, growing our customer base, optimizing the cost of bringing on new customers, increasing the revenue we received from customers each month, lowering the cost of service delivery and lengthening the time our customers stay with us. We continuously work to balance these value drivers to optimize our returns.

Now, let me turn to our results for the second quarter. Revenue during the quarter was $807 million, an increase of 5% over the second quarter of last year. We achieved recurring revenue organic growth of 5%, which was driven by a 3.5% growth in Average Revenue Per User or ARPU and nearly 2% growth in our customer accounts.

Pulse continued it’s strong momentum with a take rate of just over 35% in our direct channel during the quarter. This compares to the 28% take rate we saw in the first quarter. We are also seeing nice improvements in the Pulse take rate in our small business channel, where the take rate has improved to 19% versus the low teens last quarter, and as Ed mentioned on the call in January, we began the initial roll out of pulse to our authorized dealers this quarter and expect our take rates to pick up in this channel as well.

ARPU was $37.98 for the quarter. As I previously mentioned, this represents a 3.5% improvement year-over-year. Revenue per user on new accounts, which was primarily influenced by the Pulse take rates was up 5% year-over-year to $44.50.

Our annualized attrition rate was 13.2% for the quarter, which is flattened year-over-year, but modestly up 20 basis points sequentially. During the quarter we made the decision to accelerate our planned price escalations. The increased number of escalations in the quarter resulted in a modestly higher number of disconnects; however, this rate was consistent with what we’ve seen with price increases in the past.

Operating income before special items was $199 million and the operating margin was 24.7%, both of which were in line with our expectations. The operating margin was down 40 basis points year-over-year as we continue to invest to grow our business. To put this into context, we’ve added more than 300 sales reps over the past 12 months, representing a 9% increase in our field sales force. To support this growth, we also increased our advertising expense and other lead generation activities. As a result our sales and marketing costs were up 14% year-over-year.

While new sales reps generally take some time to ramp up their productivity, unit sales increased 90% year-over-year and we are confident this investment will continue to pay off going forward. At the same time we continue to be disciplined on our cost structure and a reduced G&A as a percent of revenue by 15 basis points year-over-year.

As we look to the third quarter, for recurring revenue, which represents 90% of our business, we expect organic growth to be consistent with what we saw in the second quarter in the 4% to 5% range. For non-recurring revenue, which represents the remaining 10% of the business, we anticipate a slight headwind as we are planning to begin that change in the ownership model for our Pulse equipment sales.

Historically about 30% of our system sold through our direct channel have been customer owned. As the Pulse systems include proprietary technology, it’s important for ADT to retain ownership of these assets. From a reported revenue perspective, the shift to more ADT owned systems will have a short term negative impact as revenue will be recognized over the life of the customer relationship rather than upfront. Keep in mind that the non-recurring revenues, which include these equipment sales, represent less than 10% of our total revenues.

From an operating income perspective, this change will provide a slight tailwind as the investment is also amortized over the life of the customer relationship, rather than being fully recognized at the time of sale.

On a cash return basis, which is really the important way to evaluate a subscriber business like ADT’s, this change has virtually no impact on our economics. So for the third quarter we expect recurring revenue to continue to grow in the 4% to 5% range and non-recurring revenue to decline about 7% organically, again due to the Pulse ownership change.

Overall, this is expected to result in year-over-year segment organic loan of approximately 3.5% for the third quarter. Our operating margin is likely to be in line with what we saw in the second quarter at about 25%.

Now, let me turn things over to Patrick.

Patrick Decker

Thanks Naren. Good morning everyone. As I provided an overview of Flow Control on the last quarters call, I’ll jump right into the quarter’s results. Overall revenue was $996 million, an increase of 24% year-over-year with 21% organic revenue growth. The revenue increase in the quarter was driven by strong growth in all three platforms.

In valve controls revenue grew 18% organically in the quarter, led by the oil and gas process industries. Incremental volume in this business continues to produce good year-over-year operating leverage.

Orders growth in the quarter remained strong with a 20% increase year-over-year, fueled by growth across the mining, oil and gas and process industries. We are in the part of the cycle where incoming orders are still outpacing outgoing shipments, so backlog continued to grow and we expect revenue to continue to grow in the second half of the year.

In thermal controls, top line growth was boosted by the acceleration of installation work to complete a major capital project that began last year, contributing to the year-over-year organic growth of 32%. Although total revenue was better than we expected, the unseasonably warm winter in North America led to lower product sales, which carry a higher margin.

Organic revenue growth in water was 21% as a result of some new projects coming on-line and an easy compare with the prior year quarter. We continue to expect revenues in our operating margins and water to improve during the second half of fiscal 2012, as double digit order growth over the last two quarters continues to convert into revenue.

Overall total flow control orders in the quarter increased 21% year-over-year, our fourth consecutive quarter of double digit orders growth, so backlog of $1.9 billion increased 4% on a quarter sequential basis.

Operating income before special items was $114 million and the operating margin was 11.4%. The impact of the year-over-year increase in revenue was partially offset by mix in thermal controls related to the warm winter impact on product sales, as well as $4 million of cost associated with the legacy project in water that we retained from a prior divestiture. We estimate that these two items negatively impacted our operating income by about $10 million and our operating margin by 100 basis points year-over-year.

As we move into the second half of the year, we remain confident that significantly improving conditions in water, coupled with converting our order book in valves will drive improved operating margin performance. Specifically in the third quarter, we expect revenue to increase 12% year-over-year to about $1.4 billion with organic revenue growth in the low teens. We expect the operating margin to approach 13% in the third quarter, keeping us on a path to an operating margin of 14% for the fourth quarter.

Now, I’ll turn things over to Frank.

Frank Sklarsky

Thanks Patrick and good morning everyone. Let me quickly touch on a few other important items. First, our cash position and overall balance sheet remains strong. In the quarter we generated free cash flow of $326 million, which included $76 million of cash paid for special items, primarily related to restructuring and separation activities.

Adjusted free cash flow was $402 million. On a year-to-date basis, adjusted free cash flow of $415 million increased to 21% year-over-year. We continue to invest in the future growth of our businesses and as a result we increased our capital expenditures and dealers spend by about $130 million year-to-date and this is reflected in the free cash flow results.

Additionally as we previously disclosed, during the month of January we repurchased 2.1 million shares for $100 million. We were restricted for much of the quarter in our share buyback program, due to the pending announcement of the merger of our flow control business with Pentair. We ended the quarter with $1.1 billion of cash and we expect to resume share repurchase activity during the third fiscal quarter.

Next, corporate expense before special items was $75 million in the second quarter, which was favorable against our original estimates, partly due to the timing of project spend. As we look ahead to the third quarter, we expect corporate expense to increase to approximately $95 million to $100 million. Keep in mind that we traditionally see an up-tick in corporate expense in the second half of the year due to the timing of many of our annual actuary evaluations.

Given the year-to-date favor ability in corporate expense and the fact that we continue to make progress in reducing structural corporate expense with ongoing cost containment initiatives, we now expect corporate expense for the full year, before special items to be approximately $360 million, which compares to our original estimate of $390 million.

Our effective tax rate for the quarter before the impact of special items was 17.2% and we expect the tax rate in the third quarter to be approximately 18%. We continue to expect a 19% to 20% effective rate for the full 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 for our overall guidance for the third quarter and the full year.

We expect revenue for the third quarter to increase just above $4.5 billion. In terms of bottom line results, we expect to see a nice sequential improvement in our third quarter operating results in all three businesses, given recent order rates and improving business conditions and the flows water business. This operational improvement in fire and security, ADT and flow control is expected to contribute $0.11 of earnings on a quarter sequential basis.

As Frank mentioned, we expect the sequential increase in corporate expense to $95 million to $100 million in the third quarter, which compares to $75 million in the second quarter, which is expected to cost us about $0.05 per share on a quarter sequential basis.

When combined, these items result in a net increase of about $0.06 per share on a quarter sequential basis. With an expected average share count of about 470 million shares, we expect earnings per share from continuing operations before special items in the third quarter to be about $0.92.

Based on our year-to-date performance and our guidance for the third quarter, we are increasing our full year earnings guidance to approximately $3.65 compared to our previous guidance of $3.55 to $3.60 per share. Our full year guidance incorporates a share count of approximately 470 million. Lastly I want to thank our teams around the world for their effort in delivering another strong quarter, while at the same time preparing for the separation.

Thanks for joining us on the call and operator, if we can open up the line for any questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from Jeff Sprague with Vertical Research. Your line is open.

Jeff Sprague - Vertical Research

Thank you. Good morning everyone.

Ed Breen

Good morning Jeff.

Frank Sklarsky

Good morning.

Jeff Sprague - Vertical Research

Since we have Naren on the line, a couple of questions for him if I could. Just first on Pulse, two thoughts there Naren; first, it’s not that you scored willing enough to the dealers. Any initial color on the take rate there or their attitude to sell it and install it.

And also I was kind of wondering, you made the comments about evolving this in home automation and other things. What is your capability to go back and resell and up-sell the Pulse customer. We’ve always heard the dialogue that it’s kind of tough to go back and sell Pulse to the legacy customer, but via this set up, in the sense that you can actually dial up the features that have Pulse, kind of after sale down the road.

Naren Gursahaney

Okay, well Jeff, let me start with the first question about Pulse with the dealers. Our real focus during the second quarter was with our largest dealer. We’ve been working very closely with them to make sure that the sales installation and provisioning processes work smoothly.

As I mentioned in the past, this is a very different product configuration for them, it’s a very different sales process for them and a very different install and we are working very closely with them to make sure they get the benefit of the lessons learned when we roll this out through our direct channel and even in our direct channel, we focused on our custom home channel first, because they were more used to selling and installing the more complex systems.

So we’ve got a lot of work to do with our dealers, but they seem very excited by the product and they are very interested in doing it, so I expect that we will see a ramp up, but I think it will be a slow ramp up and we are going to be very methodical to make sure that we do it right and really manage that customer experience, where every customer experience is good one, so I’d expect a slow methodical ramp up. Right now it’s probably only about 1% of our dealers via direct sales at this time. So it will be a ramp up as we move through this year and into next year.

On the second question about taking upgrades out to our existing Pulse customers, actually that will be, yes, will continue to be a big opportunity for us. One is Pulse is very much of a software driven solution, so new capabilities we can push out to our customers, so that they have access to it immediately. In fact, we’ve already pushed out new upgrades to the software that’s out there.

And then as we bring on new hardware into the ecosystem, customers will have the opportunity to buy that hardware from us or go to traditional retail outlets to buy three way enabled devices that they’ll be able to install in their home, enroll into their Pulse system, very much in the same way you add a peripheral to your PC today.

So it should be a very easy install for them depending on the specific hardware and then again, very easy to enroll it in the Pulse system and be able to use it. We are testing new products all the time in our labs, developing the software for it and then the new software we push out, it’s already enabled in there.

Jeff Sprague - Vertical Research

I was wondering on the accounting change on equipment, is that only related to Pulse accounts and is there any change in amortization rates or any other accounting changes for the Pulse specifically, relative to how you’ve been treating accounts historically.

Naren Gursahaney

I would say it’s primarily focused on the Pulse equipment, because of the intellectual property there and there is no changes at all from an accounting perspective. Again, it’s juts whether we treat them as ADT owned or customer owned, so the accounting, the attrition curves, everything remains the same.

Jeff Sprague - Vertical Research

And then just off for a header Frank and then I’ll jump off. Share count of 470 is actually drifting a little north from where you’re at. Could you just provide some color on why that is and you kind of how – I guess sounds like your not really stepping at the share repurchase in a meaningful way, so you’ve got some creep playing into the back half. Is that the way to think about it?

Ed Breen

Well, there’s always some adjustment that takes place in the share account as a result of exercise activity and so on, but we will be back in the market during the third quarter, with sure activity and that will be bring the share count below what it would have been had we not been in the market. So we are at 469 at the end of Q2, 470 is where we think we are going to be as an assumption of the combination of the reverse activity and any other activity including exercise activity.

Antonella Franzen

Jeff, its just the timing of the buybacks as we were at the market for the last couple of months because of the flow control Pentair transaction. So things kind of got pushed into the second half of the year.

Jeff Sprague - Vertical Research

All right, great. Thank you.

Ed Breen

Thanks Jeff.

Operator

Our next question comes from Scott Davis with Barclays. Your line is open.

Scott Davis – Barclays

Hi, good morning guys.

Ed Breen

Hey Scott.

Scott Davis - Barclays

Naren, I just want to follow-up on Jeff’s question, because I think it’s interesting. The whole thought of protecting your intellectual prosperity, I mean is this essentially so that after the three-year contract runs out that somebody can shop around to get their party monitoring services and use your equipment in that process. Is that kind of the thought process here?

Naren Gursahaney

For me that’s clearly a piece of it. We’ll have ownership or those assets, so there could be some restriction there. But again with the amount of intellectual property, I mean the traditional security system was generally off the shelf type of equipment, no real new intellectual property in there, kind of pretty standard stuff that’s been out there. With Pulse we made a significant investment in that technology; we want to make sure that we have adequate control over it.

Scott Davis - Barclays

Yes, no it makes sense. Naren, I wanted to talk a little bit about Brink's and just do a little bit of a look back. I know you don’t consider Brink's as a segment or anything else all integrated, but there was some kind of angst when you did the deal that you might loose some sales folks and accounts. I mean can you give us a sense of a postmortem after the deal of kind of what percentage of the sales guys you are able to keep and what percentage of the accounts you are able to keep and just give us a sense of how that deal’s worked our so far.

Naren Gursahaney

Well, I think it still Scott has been very good deal for us, from the synergies we promised and we committed, we delivered, all of those. The integration I’d say is virtually complete. We still have some kind of backend IT systems that need to be finished from an integration perspective and we have pushed that out a little bit, because some of the work, IT work we have to do to support separation. But operationally everything, there is full integration there.

From a talent perspective, I’d say on the sales side we were able to retain the people there and they continue to be very active members, not just in the sales force, but of our management team and our leadership teams throughout the organization. We did loose a few people, some branch level General Mangers and that was really just because of the difference we have in structure.

We have a sales structure and an operation structure that operate integrated, but separate. So there weren’t as many General Manger roles. We lost a dew people there. We kind of knew that that was going to happen and from an account perspective, we’ve been able to retain those accounts and again it’s an integral part of our customer base.

Scott Davis - Barclays

Okay and just a quick follow-up. How much into your accounts did you purchase in the quarter.

Naren Gursahaney

Our growth in dealer accounts was about 9%, same as the growth we saw in the direct side.

Scott Davis - Barclays

So what is the dollar value of that, or…

Naren Gursahaney

I don’t have that off hand, but we can get back to you with that.

Scott Davis - Barclays

Okay, okay, thanks guys.

Ed Breen

Thanks Scott.

Operator

Our next question comes from Steven Winoker with Sanford Bernstein. Your line is open.

Steven Winoker - Sanford Bernstein

Good morning.

Ed Breen

Good morning Steve.

Steven Winoker - Sanford Bernstein

Let me just lead with the first question on separation cost, $98 million year-to-date. How are you tracking as you think about sort of that bigger, much bigger $700 million I think that you put out there for the full year.

Ed Breen

Yes, we are still tracked in to that number, more than $50 million of it as we rolled it up recently. Remember in there is some restructuring numbers in addition to the other restructuring that we announced of about $125 million to $150 million. So we are tracked in to it, but a lot of hits in the very back half of the year.

Frank Sklarsky

I don’t know if you’re going to add to that, the reason it hits the back half is primarily because of some of the debt refinancing. When we see, the majority of that spend its going to be in the summer time frame when we go though all that activity, so we are on track.

Ed Breen

The debt refinance, frankly that is the single biggest piece by far on a percentage basis and the good news with that is there is some payback on that, because of the rates we’ll get on the refinancing.

Steven Winoker - Sanford Bernstein

I was going to say that might look even better than when you first started talking about it right.

Ed Breen

Yes, it’s slightly better hopefully.

Steven Winoker - Sanford Bernstein

Okay, secondly, a lot of good thing to talk about, but let me just ask about the systems installation decrease, that 1%. George, just may be give me a sense, you talked about soft non-res construction markets versus prior year, but as I recall a year ago, it wasn’t a lot better from an end market perspective. Maybe just give a little color for what you see going on.

George Oliver

I mean we are driven. When you look at the key metrics that drive that segments of our businesses, its really, the lead indicator is the architectural billing index and that has just been just slightly favorable over the last few quarters and so we are seeing that in the market, and so as we’ve said in previous quarters that we continue to be very selective with the projects that we do take on, certainly with the focus on the projects that drive recurring revenue and service, and so when you look at that we continue to win lower volume, continue to expand our margins and making sure that we are positioned from a resource standpoint to be able to grow our service revenue.

Steven Winoker - Sanford Bernstein

Okay, so it sounds like your positive there as you look forward.

George Oliver

In the quarter we are down about 1% on the installed side, but going forward I mean as we look at our orders, our orders are improving slightly in that space. Certainly we’ve been very aggressive on the service growth and that’s beginning to accelerate also. But when you look at the key indices that drive the market as far as products and square footage, the forecast is not for any significant increase going forward. And so we are not banking on a lot of volume there, we are going to continue to be selective and we think certainly that does create the installed base and helps us drive the recurring revenue and the service revenue.

Steven Winoker - Sanford Bernstein

Great and then finally, Ed and Naren, I keep asking every quarter about the cable company response and their beta tests and they are rolling it out. Are you seeing or just once again I want to understand on both pricing and on share in any way, are you guys seeing any king of impact in any of the cities where your co-located with where they have aggressive efforts.

Ed Breen

Yes, note Steve that the cable guys have rolled out some additional markets. I think you might have saw some announcements from them. But when you look at the metrics and the range team tracks them by market, we look at them, I guess Naren looks at them even more than I do I’m sure, but there is no change in any of our metrics in those markets and it think we are feeling very good competitively.

Cable guys have now been some markets for almost 18 months like we have, it’s a pretty decent amount of time to have some tack record and there really is no change in metrics whether its pricing, discount, anything there and with us now rolling out with the dealer networks which will be another almost 4,000 sales people over time, again its going to take time as Naren said, another 4,000 people marketing it, I think we are in a nice position over the next couple of years.

Steven Winoker - Sanford Bernstein

And Naren would you add anything in terms of where your guys are going head to head with the cable guys and coming back with any kind of storage or anecdotes or is there any kind of color here about why you are winning, you’re not getting impacted.

Ed Breen

Well again it’s head-to-head, but kind of a different scenario. Most of them are selling over the phone where we are selling face-to-face, so we are not necessarily head-to-head in the house. But I think our guys still feel very good about the offering we have out there, they feel very good about the reputation we have out there for service.

Clearly we are seeing other competitors be aggressive with their pricing, but I think also people understand promotional pricing has always been aggressive in that industry and I think there are a lot of people who are waiting to see what happens to those prices over the long term. I think especially those who know ADT or have been with ADT for years know that we are very methodical and thoughtful with our price escalation policy.

So I mean our sales reps don’t feel comfortable, but they have what they need to not just to compete, but to compete and win.

Steven Winoker - Sanford Bernstein

All right. Thank you.

Ed Breen

Thanks Steven.

Operator

Our next question comes from Ajay Kejriwal with FBR Capital Markets. Your lien is open.

Ajay Kejriwal - FBR Capital Markets

Thank you. Good morning.

Ed Breen

Good morning.

Ajay Kejriwal - FBR Capital Markets

Naren, you talked about accelerating the pricing escalations in the quarter. So may be if you can talk a little bit about what was the driver, what’s the opportunity there and then also may be any color on the pricing versus attrition economics. How much could you push pricing without attrition kind of increasing to the level that kind of off set the economics there?

Naren Gursahaney

Sure. Well, as I mentioned in my comments, we are always trading off those five drivers of new accounts, subscriber acquisition cost, the revenue for user cost to service and attrition and working hard to optimize that.

During this quarter we made a decision to accelerate, it was about a little over 900,000 customers, so about 15% of our customer base. We generally see about 1% disconnect rate when we make those notifications or escalations. In this case we were very similar to that.

So again when you look at our price increase, it was in 4% to 5% range. So taking up that many customers at that kid of rate, even loosing that 1% which we don’t like to do, the economics were still overwhelming. That was the right thing to do for the overall return of the business. So we’ll continue to look at the all of those different trade-off and understand who we optimize.

I think we are competitive in the market palace from a pricing perspective, so I don’t think there are going to be big moves in the pricing necessarily, but we are going to continue to fine-tune that. We have never been the cheapest player out there, we’ve always been the premium player and we believe that our services and our infrastructure and support behind that justify that, as well as the innovation that we are bringing to make, so we’ll continue to look at that.

Ed Breen

And back to the post comments Naren made, that’s really our favorite way to get increased pricing obviously. We are giving more to the customer or we get a higher price and we are all convinced its going to be a sticker account, which is one of Naren’s five levers, is to keep the account longer. So that’s our preferable and focused way to actually really get price moved up.

Ajay Kejriwal - FBR Capital Markets

Very helpful, thank you and then may be one question for George on the competitive dynamics. So one of your large competitors has publicly talked about execution issues and may be could be shedding assets in Europe. Could you may be talk about what this means in terms of opportunity for you, be it share gains or may be even as a potential buyer of those assets.

George Oliver

Well, as we’ve demonstrated we look at all opportunities, and we’ve been perusing a strategic, a pipeline of strategy bolt-on acquisitions that have added nice revenue and ability to be able to leverage that within our infrastructure and we will continue to do that going forward.

When you look at our performance, a lot of our permanence has been driven by the investments we’ve been making in products, so when you look at the continued investments or increase in those investments, its our ability with our regional footprint across the globe to be able to design and install systems and then even more importantly be able to service.

So I think it’s a combination of those, having a good position in all three segments. It really has provided us to be able to get though this cycle and now with the investments we are making be able to accelerate our growth going forward.

Ajay Kejriwal - FBR Capital Markets

Okay. Thank you.

Operator

Our next question comes from Gautam Khanna with Cowen. Your line is open.

Gautam Khanna - Cowen

Yes, good morning guys.

Ed Breen

Good morning Gautham.

Gautam Khanna - Cowen

Just wanted to ask about the flow order pipeline, obviously its strong showing this quarter, water coming back. I mean is this the high water mark in terms of kind of year-over-year order growth or kind of what is the duration of the pipeline you have out there. How far can you see out?

Patrick Decker

Yes, this is Patrick. The way I would answer that would be, we expect to continue to see robust order growth in the valve control business, that’s really the one, one of the three businesses, but truly is a backlog business.

The other two businesses water and thermal are typically quick turn kind of businesses, expect when these bit major capital products kind of flow through. So I would expect over the back half of the year, valves and water orders will continue to be stronger. We do have the impact here for couple of quarters with the year-over-year compare with this big major capital project in thermal that we completed in this last quarter.

We are currently pursuing two other major capital projects that were close to us earning drills on its well. But those probably won’t hit the order book until either latter part of this fiscal year or even early 2013.

Gautam Khanna - Cowen

Okay and then just to follow up on the prior question about the ADT attrition picking up, to the price increases, that typically happens immediately or is there kind of a multi quarter kind of fall out once you raise price.

Patrick Decker

No, we generally get a pretty quick feedback, some activity in the call center. Some of those we are able to save and some of them we are not. Now again we do have some additional escalations that will happen in 3Q, not to the magnitude that we did in the second quarter, probably 60% to 70% of what we did during the second quarter. So again there could be may be a 10 basis point head wind as we looked at 3Q.

Gautam Khanna - Cowen

Okay, thank you guys.

Ed Breen

Thank you Gautham.

Operator

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

Steve Tusa - JPMorgan

Hey, good morning.

Ed Breen

Hey Steve.

Steve Tusa - JPMorgan

Just on the quarterly, the next quarters guide, is there any specific reason why conversion at ADT Resi would be kind of weaker than it’s been on a sustainable basis. I mean you mentioned some marketing aspects this quarter, may be there’s something to do with the account change that makes the conversion a little bit weaker, because you had a good quarter, on the third quarter last year, I don’t know if that’s seasonally or not and then the flow revenue guidance of about 12% is good, but orders up 21%. Is there something kind of the tail of the backlog?

And then one last question just on corporate, for the last like several years you guys have guided corporate up, for the next quarter and you’ve beaten on corporate. I mean I don’t quite understand the strategy there, because your never really going to get credit for that, so using corporate is kind of like a hedge to our guidance. It doesn’t really seem to make sense. I mean what is going on there and it seems like it’s sustain ably lower over time, but you guys keep guiding it higher every quarter. So just a question on those three items.

Ed Breen

Steve, let me start with the question on the ADT margin rate I guess. You know a part of it really is the business model and I’ll try to do this at a very high level. When we sell a system through our direct channel, I assume that the cost, the net cost to us is about $1000. About $500 of that, all of our marketing spend and all of our fixed cost related to sales, we expense in the current period. So the only thing that would get differed in an ADT owned system is the sales commission, the equipment that goes in the home and the installation cost.

So while from a cash perspective the economics are very good, we do take a P&L hit and actually our margin rate on an incremental account, an ADT owned account is actually negative in the quarter that we had that account. So as we grow there will be that P&L pressure on there. However again, looking at it on a cash basis, the IRR, net present value of those accounts are very attractive and it is creating long-term value for us.

So its an initial hit up front and then as there is amortization and we pull that differed revenue off and we get the recurring revenue, those margins get significantly better over time. So clearly it’s just the account and your treatment of those accounts that we’ve got online.

Steve Tusa - JPMorgan

Okay, got you.

Patrick Decker

This is Patrick. I’ll take the flow question regarding organic growth. So again to put it in perspective, for the full year we are expecting organic growth in the low teens compared to 1% in 2011. So we are beginning to see the turn there.

Just to look at the pieces here Steve and see how the mix works, we are expected continued low teen growth in valves and that really is just a matter of timing of backlog shipments. Again this backlog can turnover a six to nine month timeframe, so that will continue.

We are seeing the pickup in water and that will be a very stronger double-digit growth year-over-year as well, and again more of that will hit us in even Q4 into 2013, which is when we get the full-on impact of those water projects.

And then really what is moderating, some of that revenue growth versus what we would put it in order, I mean most of our thermal business is a quick turn shift within the quarter, but last year we had significantly growth in thermal during 2011 and through the first half of this year and that was really driven largely by the completion of a couple of major capital projects.

So again, you are going to get a tougher year-over-year compare in the second half of the year, so we will show a modest decline in reported revenue for thermal in the second half. But as I mentioned earlier, its not a sign of help in terms of an issue to major projects that we are closely signing that will then benefit their team.

Steve Tusa - JPMorgan

Okay, that makes sense, in the corporate.

Frank Sklarsky

Steve on the corporate side, and this is Frank, two primary items there. When we look out to the third quarter, which is the quarter we normally do our actuarial liability evaluations, we really don’t know exactly what the number is going to be until we complete that analytical process. But we do have an estimate therefore with the trajectory and what we think that will be, that’s one time that impacts the sequential uplift.

The other item is really the timing of project expense, where we see some sequential basis and some additional spending on product related items in the third quarter versus Q2.

Now that said, with respect to the corporate hedge or whatever, that’s why we are saying this time around that before the year it will be $360 million versus the previous estimate we had our there at 390 so to your point, we are defiantly making progress on structural cost within the general and administrative category and the corporate category. So we are comfortable at this time taking that number down to the year in total.

Steve Tusa - JPMorgan

Okay and the one last quick question, this is a backward looking question, about stuff that’s in your prior, your 10-K that was filed several months ago. With regards to all the NOLs that you guys have, first of all, where did most of those come from? I mean there has been a lot of deals in Tyco over time and looks like they kind of carry through, some of them carry through 2030 and I guess specifically the ones in the U.S., the $1.8 billion in the U.S., are those transferable easily and then is it pretty evenly spread out through the next 20 years?

If you could just maybe describe the genesis of those NOLs and then your ability to transfer them, and also if there is a chunk that’s expires near term, maybe just describe that a little bit more. And then that’s a question on your 10-K that was filed every three months ago, four months ago.

Antonella Franzen

Steve we’ve never disclosed where the NOL have been generated and by what business in our filings. The only think I can say about that, I keep in mind our opening comments that we had and we are in the registration period and I know the production is more geared to where they are going.

The one thing that I will point you to is we have disclosed in the ADT From 10 what the expectations thereof are, NOLs that they have and what their future exception is of what they will get of their share of Tyco and we also some information about that disclosed in a slides that we posted in regards to the Form 10, but that’s about all we can say on the right now.

Steve Tusa - JPMorgan

Okay, all right, it was worth a try. Thanks.

Ed Breen

Thanks Steve.

Operator

We have a question from Nigel Coe with Morgan Stanley. Your line is open.

Nigel Coe - Morgan Stanley

Yes, thanks, good morning.

Ed Breen

Hi there.

Nigel Coe - Morgan Stanley

So Naren, you talked about the metrics in the household in the U.S., relatively low compared to cable. I mean in terms of the market research you’ve done, where you think that tenders should make them go and what kind of strategies can you adopt to drive up penetration without using price as a method for doing that.

Naren Gursahaney

Well, I think I would use value as the driver and we believe that over time and it could be a long time to get there, that its actually double to the 20% kind of penetration rate, which is still well below all of the – excuse me, it’s the 40% that would be still well below all the other services that we talked about.

But it really comes down to, can we continue to strengthen the value proposition starting with the security piece, but all the other monitoring we do in the homes, fire, critical conditions, carbon monoxide, etcetera, and then bringing the home automation piece.

At this point in time, with pulse being out there for about 18 months we have anecdotal evidence that it is brining in people who would not have considered a security system in the past, but there is just not enough market data out there to show whether that’s truly moved the needed or not and we’ll continue to keep an eye on that.

Ed Breen

I think a big driver Naren’s team has been looking at here is we haven’t been overly public about it yet is, can we really present to the consumer the savings you can get from using the automation in the system and we’ve mentioned this before, but the utility savings on the home used properly, along with you get a discount on your insurance anyway if you have a security system.

My gut is over time, those two combined is a pretty large number and it covers a lot of the recurring revenue that the consumer would pay us. So promoting that overtime and all those type of things I think does expand the pie. If you can cover a lot of the cost and get the full security system with automation, that’s a pretty attractive propositions. So I think you will be seeing more of that from us in the future.

Nigel Coe - Morgan Stanley

Okay and then, I don’t know if I missed the data point, but can you just throw out there what your ARPU was in your gross adds in ADT this quarter.

Antonella Franzen

The average ARPU was 37.98 and the gross ads were – the account-based ads were about 2%.

Ed Breen

Net was 2%.

Nigel Coe - Morgan Stanley

2%, but the ARPU on gross adds?

Antonella Franzen

3.5% and the average ARPU for the quarter was 37.98.

Frank Sklarsky

Nigel, I’m sorry, were you asking what the ARPU was on the new accounts.

Nigel Coe - Morgan Stanley

The new accounts, yes.

Antonella Franzen

24.50.

Nigel Coe - Morgan Stanley

Okay great. And then you are making some adjustments to the accounting in ADT but how does your accounting compare to some of your accounts. I mean there is not a lot of great public information out there, but some of the comps our there do have higher EBITDA margins and I’m wondering, is that a function of accounting or is there a significantly upside potentially to your EBITDA margins there and I’d love that comments.

Ed Breen

Well, first just a clarification, we are not changing the accounting, we are changing the business model, its really in a mix of ADT owned versus customer owned.

Nigel Coe - Morgan Stanley

That’s clear, sure.

Ed Breen

And from a comp perspective, I guess most of our peers within the security industry are not public companies. And many of them use a dealer model which would be similar I assume to the way we do handle that, where you create the intangible and you amortize it over the life of that customer relationship.

Frank Sklarsky

Yes, this is one Nigel you might be talking about is a security comp that is almost, it is a 100% dealer. So they go to that model, but we have also our direct model, so that is one difference when you look at the accounting of it.

Ed Breen

Going back to the question earlier, on the accounting for our dealer-acquired systems, those would actually be marginally accretive when we buy it. We amortize those over the life of the relationship, it is an accelerated amortization, but we do get the revenues. So it might be in the high 20s to low 30s gross margin, which is lower than our overall gross margins, but again accretive, modestly accretive to our operating margins.

Nigel Coe - Morgan Stanley

Okay. And then one final one for Pat. In the flow business, can you just give us a sense in terms of where the values, water and thermal business are compared to their prior peak levels?

Patrick Decker

Compared to what?

Nigel Coe - Morgan Stanley

Their prior peak levels.

Patrick Decker

In terms of profitability.

Nigel Coe - Morgan Stanley

No, no, in terms of revenues.

Patrick Decker

In terms of revenues, I can’t give you specific numbers on the three splits right now, but I would say just kind of anecdotally I would say valves is getting back closer to where we were pre-crisis levels, but there is still room to go there and I think that we are certainly see very buoyant activity in the market still in terms of project bidding, etcetera. So there is still a very, very nice runway there in front of them.

What obviously is coming out of a trough and so well below what our peak levels were there going forward, and so we are expecting very good growth there. And I could say thermal is kind of flat lying right now, relative to this big project we had over the last year of so, but have some very, very nice projects in front of us that we think will then be a nice booster revenue in ‘13 and beyond.

Nigel Coe - Morgan Stanley

Okay, that’s helpful, thanks.

Antonella Franzen

Operator, we have time for one more quick question, if there is anyone else in the queue.

Operator

Thank you. Our final question comes from Deane Dray with Citi. Your line is open.

Deane Dray - Citi

Thank you. Good morning. I don’t know if it’s a question for Patrick or Frank, could we get some color regarding that charge taken for the divested business. What triggered it and are there any other sort of contingent liabilities related to that divesture.

Frank Sklarsky

I mean that’s one that we’ve had some modest charges in the past. I think as Patrick would agree, that project is nearing completion and will be cleared from anymore significant further liabilities done or there might be a some modest trailing items in the upcoming quarter, but this is one where the project is very much near completion. So we don’t see any more significant items in anything. We do see the modest nature we got a covered in the forecast that Patrick went through.

Patrick Decker

And I would just add, it was a complex project that we inherited as part of a business that we divested and was just getting started at that time that the business was divested. Its proved challenging. We are very close nearing completion. It’s not a project within our suite spot, so we are wrapping it up now and hopefully putting it behind us.

Deane Dray - Citi

Great, thank you and just then just last one from me would be for George. The word selective came up in describing the installation business and I know in the past year there was some initiatives to be more selective about the projects that you were going after. So if you could just give us an updated as to how has that initiative played out, what that means for the installed base and may be in terms of also the profitability of these installations.

George Oliver

I mean I would start by when you look at the installation market it has been down, it really tends to decline back in 2008 and is really still at the bottom and so in spite of that we have continued to maintain our market shares with what we’ve been doing in the installation space.

And so when we say selective, its making sure that from a resource standpoint we are applying our resources, where not only can we drive a profitable project installation, but also it drives recurring services down the road. And so its really around allocation of resources to ultimately drive improved returns over the lifecycle of the project. And so as you’ve seen from the results, we have been very successful in improving the margins not only on the installation side, but also continuing to be positioned to be able to get to recurring revenue just tied to those projects.

Deane Dray - Citi

Great, thank you.

George Oliver

Thanks.

Antonella Franzen

Operator, that concludes our call.

Operator

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

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