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Executives

Keith E. Wandell – President, Chief Operating Officer

Stephen A. Roell – Chairman, Chief Executive Officer

R. Bruce McDonald – Executive Vice President, Chief Financial Officer

Denise Zutz – Vice President of Strategy, Investor Relations and Communication

Analysts

Christopher Cerasso – Credit Suisse

Himanshu Patel – J. P. Morgan

Rod Lache – Deutsche Bank Securities

Jonathan Steinmetz – Morgan Stanley

Brian Johnson – Lehman Brothers

Ted Wheeler – Buckingham Research

Patrick Archibald – Goldman Sachs

Johnson Controls, Inc. (JCI) F2Q08 Earnings Call April 16, 2008 11:00 AM ET

Operator

(Operator Instructions) I would now like to turn the call over to Ms. Denise Zutz. Thank you, Ma’am, you may begin.

Denise Zutz

Thank you and good morning, everyone. Thank you for joining us for our discussion of our financial results for the second quarter of our fiscal 2008. Here to talk with you this morning is Steve Roell, our chairman and CEO, Keith Wandell, our president and chief operating officer, and Bruce McDonald, our executive vice president and chief financial officer. They are going to have some opening remarks this morning, probably about 30 minutes, and then we will turn the call over for questions and answers. We would expect that our call would conclude in approximately 60 minutes.

Before we begin I do need to remind you that we are making forward-looking statements during this call pertaining to our financial results for fiscal 2008 and beyond that are based on preliminary data and are subject to risks and uncertainties. All statements other than statements of historical fact are statements that are or could be deemed forward looking and include terms such as “outlook,” “expectations,” “estimates,” or “forecasts.” For those statements the company cautions that numerous important factors such as automotive vehicle production levels (inaudible) energy prices, the ability to mitigate the impact of higher raw material costs, the strength of the US (inaudible) currency exchange rate, cancellation of commercial contracts, changes to domestic and foreign tax rates, as well as other factors discussed in the company’s most recent 10K filing dated November 29, 2007, could affect the company’s actual results and could cause the actual consolidated results to differ materially from those expressed in any forward looking statement made by or on behalf of the company.

And with that I would like to turn the call over to Steve Roell for an overview.

Stephen A. Roell

Okay. Well, thanks, Denise, and good morning. I’m going to start with the second quarter results for 2008. I just have a few comments on that. As our press release indicated, we continued to achieve our growth targets. Our sales were up 11%, a record, to $9.4 billion with all three businesses contributing to that higher growth.

The one item that really should have stood out was the segment income where we were up 29% to $453 million. If you look at the press release again what you’d notice is that our automotive experience group was up 28%, building efficiency 29%, and power solutions 30%. So I think with all three businesses performing exceptionally well the underlying margin expansion in all three businesses yielded a consolidated profit margin increase of 70 basis points over last year’s quarter.

Our income from continuing operations was a record at $289 million. Our earnings per share diluted was $0.48 compared to $0.37 a year ago, up 30%. And as many of you have noted, our EPS was at the high end of the range that we provided to you in the guidance in our January conference call.

In addition to that we continue to enjoy a very strong balance sheet. Our debt to cap is right on top of 30%. We feel very good about where we are as we enter the, from this input of our financial flexibility.

Just to stop for a point here and just thank all of our employees around the world. As you can gauge from our results, we had tremendous performance across all three businesses across many, many geographies. It’s the efforts of 140,000 people that yielded the fine results for the quarter.

If we take a little bit longer look now I’m going to turn to the next page and talk to you about our sustainable profitable growth. We’re executing well on the opportunities. We have growing backlogs. Our building efficiency backlog was up 15% to $4.5 million at the end of the second quarter. We just reminded you here our automotive three-year backlog of $3.9 billion, we’ve not updated that since we shared that with you back in October, but if you recall that was an 11% increase in the prior three-year with that growth actually back ended in 2009 and 2010.

Strong international markets that I would share with you that really our growth across our businesses, as you’ll note, are coming both in our domestic as well as the international markets.

Diversification has been a theme that we’ve talked about for years and years, about how important that’s been to us. It’s extremely important today and it continues to be and I think we’re well positioned in terms of the diversification across our businesses, our geography, as well as our customer base.

One thing we don’t talk about is the fact that our management team is fairly senior. We’ve got a lot of people who have gone through economic changes and shifts and global growth and I think that’s going to bode well for us in terms of how we handle the next three years.

Steve is going to talk to you about our world class continuous improvement processes and cost controls. I think it is a major differentiated and competitive advantage to how we do that.

Now I want to spend some time on building efficiency. We talk about the stability of this business and one of the things that we’ve tried to highlight in the past is that 75% of our revenues come from our service and retrofit business. So if you look at the pie that I provided in the charts you’ll notice we’ve done something that we haven’t done before. We’ve broken out the new construction element. Just to give you a point, the 75% includes our technical services, our global workplace solutions, and our solutions business, which is largely our performance contracting which is driven by energy retrofits. The revenue is recurring. It very rarely can I ever thing of a time when it has ever actually gone backwards. It always is on an improving basis and that’s where we continue to get our growth and that’s the stability and the segment that we need to highlight.

We continue to benefit, if you think about the current and long-term from higher energy prices, the approved pay backs that are associated with our offerings in terms of energy efficiency, our customer’s need for a carbon footprint measurement, and management we continue to see more and more discussion in sustainability and targets of corporations are setting not only for their domestic operations, but for their global operations.

Now if I can revert back to that pie, if you look at that orange, that orange is really the new construction business for North America. We’ve broken out for the first time the international element. What I’d like to highlight again is that orange, there’s a preponderance of our business which is tied to the institutional base: health care, education, and government. Historically and it continues to be much more resilient in times when markets get soft. So again, the exposure that we have there, if you think about it in terms of our legacy controls business, over 60% of our revenues were driven by health care, education, and government. And in terms of the equipment business that we acquired from York, that business, while manufacturing is still one of the major elements, over 40% of our equipment goes to the health care and education markets.

Emerging markets continue to play a major, provide a major opportunity for us. We just highlighted the fact that the trillion dollars of new construction planned for the Middle East, including 850,000 tonnes of district cooling plant under construction. So we continue to see that blue portion of that bar being driven by extremely high growth rates in China, the Middle East, and in Europe.

I’d like to remind you that we’re one of the few, I think we believe we’re unique in the industry relative to being able to bundle systems, HVAC equipment, and service. We’ve talked in the past about the fact that we have the largest service workforce with over 13,000 front end providers to the service industry and we continue to expand that workforce.

Shifting to automotive experience, we’ve highlighted the fact that we’ve got a very diverse customer base with two-thirds of our revenue tied to European and Asian OEs. I would also tell you that our backlog, as many of you may know, in terms of business that we’re going to execute over the next three years is heavily skewed towards the European OEs and the Asian OEs.

We’re seeing double-digit production increases in the emerging markets. I think we’re very well positioned.

With our balance sheet we’re very well positioned to continue to invest in innovation to gain competitive advantage.

And since the beginning of this year we’ve also had a number of gains and new wins. We talk about First Auto Works, Ford, GM, Kia, Nissan, Volkswagen. Those are all new and are adding to our backlog. Some of those will add to the three-year backlog we shared with you last year. Some of those are going to be beyond that into the 2011 timeframe. And again, we update that and provide you more detail when we get to the October meeting, we’ll provide you with our next three-year backlog, but our sense is that we’re doing exceptionally well winning new business and we feel good about the momentum in that business.

From a power solutions standpoint, again a very stable business; 80% of revenues coming from the aftermarket. We continue to see gains in market share gains in Europe, particularly from the OEs. Emerging market growth has been exceptionally strong for us in Asia. We have something we’ve never really talked to you about, which is growing what we call AGM demand. It’s a glass matched type of battery in Europe which is basically being used in the micro-hybrid market. So the German OEs are the ones who are really driving this. If you think about micro-hybrid market, it really is start-stop type functionality. We continue to see the growth and potential in that (inaudible) market and we’ll be investing to take care to respond to that opportunity.

From a hybrid vehicle standpoint, I think in the past we’ve identified the fact that we have 12 development contracts. Now we’re up to 16. Admittedly the last four are not significant in context of size, but they’re significant in terms of the relationships that we’re forming with OEs around the world. We continue to look forward to the launch of the S-Class Mercedes in 2008 and 2009 and shortly after that the BMW launch.

In terms of the full-year 2008 outlook, as many of you noted, we increased our guidance. Our sales growth is now 13% to $39 billion. This would be our 62nd consecutive record year of sales increases. We left our earnings growth unchanged at 18% to approximately a range of $2.45 to $2.50 per share, which would be our 18th consecutive year of record income from continuing operations.

We’ve provided those charts for you just to put this year in perspective with our trend over the last 10 years. I think it really does illustrate the momentum in our business.

We’ve also included something that I thought you might find interesting. We did look at our earnings growth expectations. The 17% you might wonder why it draws on the 18%. The 17% is a first call. Analysts’ consensus right now for our fiscal year. And then we transferred that to that of the multi-industry peers. To give you a sense of who’s in those numbers, that includes 3M, Danaher, Eaton, Emerson, Honeywell, Ingersoll-Rand, United Technologies, Texitron, ITT. And you can see that their growth in this fiscal year is expected to be 11%. And again, as from first call analyst expectations. The point being that we’re extremely pleased that we’re outperforming that sector. It’s something that as a group that we target. It’s a group that we believe we can perform with. I think our results this year certainly show that. Clearly that’s our expectation long term is to be in the upper quadrant of those multi-industry peers that we just mentioned.

With that, I’m going to shift now and ask Keith to pick it up with continuous improvement.

Keith E. Wandell

Thank you, Steve, and good morning to everyone. As Steve mentioned in his earlier comments, we do continue to, in addition to our focus on revenue growth through new products, innovation, and emerging market expansion, we are continuing to drive our margin improvement through our continuous improvement initiatives as well. I think that clearly shows in all of our numbers again this quarter. We’re really pleased with the traction across all of our businesses that our best business practices are really driving. We’ve talked about this before on our calls. It’s really our BBP process, which is really the umbrella around all of our continuous improvement tools and how we drive this through our organization from a cultural change perspective, it’s really core to all of our continuous improvement efforts and we’ve talked in the past, we have an identified gap or what we call opportunity across our businesses of about $2 billion plus that we continue to focus on that and drive the improvements.

It’s really not a singular event or a series of one-offs. It’s really an ongoing concerted effort by all of our businesses around the world to drive foot print optimization, both in manufacturing engineering as well as our share of services. Additionally it’s helping us to drive standardized global products and process architectures, which are really paying dividends for us in all of our businesses, as well as how we manage our supply chain management and our global sourcing. It’s helped us really to also increase our focus on our working capital initiatives in all three of our businesses.

I wanted to take a minute and just discuss sort of how we’re driving the margin improvement through our various businesses through best business practices. If you think about our automotive experience business, we really talk about product engineering just for a minute and what we’ve done with our BBP initiatives to drive to low-cost country engineering footprint. We have driven most of our software engineering for our electronics business, automotive electronics business, to Sofia in Bulgaria and we’ve also opened, as we’ve talked about in the past, a product engineering back room, if you will, in Trenchen, Slovakia, for all of our automotive business in Europe. That business now has grown to over 600 full-time product engineers where we’ve actually transferred the work from higher-cost western European countries to the low-cost countries. And they’re actually now doing full platform engineering.

So we’re just really gaining a lot of traction there and a lot of cost efficiencies. By looking at our best practices and sharing those engineering best practices in automotive we’re seeing annual improvements in the 10s of millions of dollars. So we really feel good about that.

When you think about our building efficiency business and the fact that we’ve just most recently rolled out our BBP metrics in this business as we’ve looked across our whole service and systems branch networks we’ve been able to implement best practices around system implementation on our Medisys System, if you will. As well as how we estimate and do contract tooling for all of our jobs, which gives us a more efficient way to spec our jobs and to procure materials, etcetera. This year alone we’ve seen over $10 million in annual savings through those initiatives.

And in power solutions where the process has a little more time behind it we continue to just really drive our best practices throughout the world in all of our plants. If you think about the power frame roll out and what we’ve done in North America and now in Europe and the low-cost country footprint that we’ve put in place, how we share practices between South America, Mexico, Korea, China, and Europe. We’re saving again over $20 million annually just in those initiatives. So we really feel good that in all three of our businesses our BBP initiatives have gained a lot of traction.

I’d like to talk just a couple minutes about each one of our businesses from a net sales and segment income perspective, starting off with building efficiency. Revenues or net sales were up from $3 billion to $3.3 billion from 2007 to 2008 in the quarter. So that’s up 11%, as Steve mentioned before. If you exclude our UPG, Unitary Products Group, or our residential business, that building efficiency business in the mid-market and large commercial buildings, it’s really up 13%. With double-digit increases at North America Systems, Global Workplace Solutions, and in Europe as well as the rest of the world.

We’re gaining market share in systems in North America and I will just reiterate that the residential business in North America was down 18% quarter over quarter.

From a segment income perspective we’re up 29% in building efficiency. We’ve gone from $137 million to $177 million. Really driven by the higher volume, the higher North American Systems profitability due to our manufacturing efficiencies, and the contracting and service processes improvements that I alluded to earlier. These improvements have more than offset a $20 million negative change in our residential business year over year.

I think Steve mentioned our commercial backlog is up 15% to $4.5 billion with growth in systems, services, and really in every geographic market in the world. Our orders are up strong double digits.

Moving to power solutions, our net sales were up 47% from $1 billion to $1.5 billion. Largely due to the higher (inaudible) basis due to lead pass throughs. If you look at lead in the quarter it ranged anywhere from $2,650 to about $3,450 a tonne. It was an average of about $2,900 a tonne versus $1,800 a tonne in 2007. So we were successful in passing through those lead increases. If you look at the aftermarket on a global basis it was relatively stable. We maintained our market share there. We did enjoy double-digit unit growth in Asia and we were able to pick up new, original equipment business in Europe in our power solutions business.

From a segment income reporting perspective we were up 30% from $93 million to $121 million. Really, again, because if you think about lead pass throughs, that was really neutral to income and negative to margin. So it was really due to the operational efficiency improvements largely gained from, as I mentioned before, our BBP as well as the power frame roll out in Europe and higher equity income from our Asia joint ventures and power solutions.

Lastly, automotive experience, net sales were up 2% from $4.5 billion to $4.6 billion. North America was down 7% largely driven by the industry production being down 8%. For us there were certainly some puts and takes. We had higher volume in the GM Lambda, the Lacrosse and Allure, Ford Edge, and Honda Accord, and lower volume in the GM Trailblazer, Ford Expedition, F150, Chrysler Grand Cherokee, as well as the Nissan full-size pickup.

In Europe our sales were up 9% while industry production was only up 1%. Steve alluded to the fact that we continue to do very well in Europe and gain a lot of business there. We had some puts and takes as well. The Mercedes C-Class were up, as well as the Fiat 500, Ford Focus, and the VW Scoda Octavia. And we had some lower volumes under BMW Mini, the X3, the Daimler-Mitsubishi Colt, and the GM Ariva (sp). In China our unconsolidated sales were up 29% where we continue to win new business and really believe that we’re well positioned with our manufacturing footprint and the various joint ventures that we have in China to continue to gain market share there.

From a segment income perspective we were up 28% in automotive from $121 million to $155 million. This was again in spite of some of the lower production volumes in North America. We’re extremely pleased that our North American turnaround continues to gain momentum and deliver results through continuous improvement. I already talked about our lower engineering costs that are being driven through our BBP initiatives, as well as low-cost country sourcing.

Our increased equity income improvements from our China joint ventures and all these improvements again more than offset the negative impact of the North American supplier strike with American (inaudible).

So with that I’ll turn it over to Bruce McDonald for our financial highlights.

R. Bruce McDonald

Thanks, Keith. As we already emphasized, Steve alluded to earlier we had a record results here for the second quarter, which is a great start to our fiscal (inaudible).

For the quarter our earnings came in at the top end of the guidance that was provided last quarter. Just turning to the revenue side, if we’re really reflective of our business diversification, our international exposure, and the successful implementation of our growth strategies, sales were up 11%. If we back out the foreign exchange out of that number then our underlying sales growth on a year-over-year basis was about 4% to 5%.

As we talked about building efficiency, we saw 11% sales growth with that business being pretty or somewhat adversely impacted by the weakness in the residential sector and that’s something that we don’t see turning around here in the second half of the year. So we sort of built that into our full projections that the residential sector is going to be much softer than we had anticipated at the beginning of this year.

In power solutions our sales were up 47%, though if you back out the lead impact underlying sales growth in power solutions was about 16% compared to 2007.

Lastly, in automotive we reported a sales growth of 2% and backing out foreign exchange we were down about 5% year over year really reflecting a softness in North America, both from a production interruption point of view, but also our exposure to the SUV sector. And then the impact of some vehicles that are sort of long in the tooth in Europe.

Looking to gross profit you’ll see that our margins were comparable to last year at 13.9%. Now that’s got the depressive impact of the lead pass through. We sort of stripped the impact of that. Our underlying margins grew by about 40 basis points in the quarter, which we felt pretty good about.

Looking at SG&A, we’ve continued to control our SG&A counts with just the 3% year-over-year growth as a percentage of our sales. SG&A dropped by 70 basis points to 9.4% and that’s despite the fact that we’re continuing to make investments in the areas of support on growth initiatives, global expansion, and ramping up our spend on innovation in each of the three businesses.

Turning to equity income, we finally started to get the benefit from some of our investments that we’ve been making in our joint venture activities. We had a pretty bit increase in the quarter and that’s something that we guided to last quarter that we expect to see some year-over-year improvement. If you really look at the underlying areas where we got growth here, in this line it’s our exposure to non-Detroit three joint ventures in North America. It’s higher income at some of our power solutions joint ventures. And you’ll recall last year we talked about the lag impact of lead pass throughs being a negative to us in some of our joint venture activities where we haven’t got, I’ll say the same level of sophistication in our leads hedging program.

The power solutions equity income is up despite the fact that we’re increasing our investment in our staff joint ventures to support our hybrid growth initiatives. We expect to see similar levels of year-over-year increases and equity income in the third and fourth quarters here.

Overall our segment income, as we talked about at the beginning, is up 29% with 70 basis points of margin expansion in the quarter.

Moving to slide 14, as you can see, net financing charges declined by $3 million to $66 million in the quarter. Reflecting both the benefits of deleveraging and finally we’re getting some tail wind in terms of falling short-term interest rates, particularly here in North America. Our expectation again is that we’re going to continue to see this trend, the year-over-year improvement start to accelerate here over the second half of 2008 and into next year as we’re sort of shifting some of our financing our mix to shorter term floating rates from fixed rates that we’ve been sort of overly exposed to here for the last few price six to eight quarters. There’s even the York acquisition.

Steve on the tax line with 21% which is consistent with the guidance that we gave at the beginning of the year. You’ll recall that last year we reported a rate of 6%, which included some non-recurring benefits and a year-to-date catch up. So the underlying EPS growth we used 21% in both years, that’s where you get the $0.37 per share rising 30% to $0.48 in the quarter.

Lastly, turning to the third quarter outlook, we’re guiding to, as Steve talked about, concerning our full-year guidance of $2.45 to $2.50, we have listed the revenue target here to $39 billion, which is 13% growth really reflecting the strength of the Euro versus the dollar.

Our Q2 guidance, sorry, Q3 guidance we’re looking at earnings per share of $0.74 to $0.76 a share, which puts us up about 10% to 15%. On revenues we’re about $10 billion to the third quarter.

We did in our press release talk about the impact of a prolonged strike impacting General Motors production. Our outlook here assumes that that strike is settled sometime towards the middle of our quarter. What we have not factored in here is the production interruption spreading to other GM facilities, nor have we figured in the strike lasting the whole quarter. That’s sort of what’s behind our comments in the press release.

For the third quarter we’re expecting to see all three of our businesses report underlying earnings growth. In building efficiency we expect to see our revenue pick up, our revenue growth accelerate as we enter the important summer cooling season here.

In power solutions that business is performing extremely well and we expect to see that, the trends that we’ve seen in the first half of 2008 continue here in the second half.

And then lastly in automotive we anticipate the market remaining challenging in North America. We should start to see here in the third quarter flattish to slightly down revenues in this sector. Our North American turnaround plan is on track. In Europe our business continues to perform well and is offsetting some of the, we’re seeing though some margin contraction in Europe as we ramp up our engineering and product development expenditures to support the big backlog which is heavily skewed to our European operation.

With that, maybe just a couple comments on our balance sheet, which is in great shape. If you look at our return on invested capital, we’re up about 130 basis points versus last year. The strong financial position that we have gives us a lot of flexibility to invest in growth initiatives and take advantage of opportunities that we see in the marketplace.

So with that I’ll turn it back over to Denise.

Denise Zutz

Okay. Thank you. And, Operator, I believe we’re ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Chris Cerasso with Credit Suisse, your line is open.

Christopher Cerasso – Credit Suisse

Thanks. Good morning. I have a couple things. First, on the building business you mentioned some of your end markets, education, health care, etcetera. Have you seen any change in order activity or business activity with schools or other municipal customers that may have trouble with auction rates, securities markets, or maybe they have trouble getting financing?

Stephen A. Roell

Sure, let me, two things. Keith talked about our order rate and if you look at the order rate, which you would have found, Chris, was very strong order demand up from the K through 12, as well as local, state, and federal governments. Okay?

When we look at our pipeline of information, which I’ve referred to in the past, which is business network (inaudible) in the final stages, the largest growing sector right now is K through 12. It’s up strong double digits. Each one of the government categories that I’ve mentioned, state, local, and federal, are up double digit. Health care is up single digit, to give you some idea of the institutional base holding up well.

Now, a month ago I probably would have expressed some concern about financing, but I would tell you that municipal issuance, whether you want to combine it with the auction prefer that used to be in there or not, was at the highest level since June of 2007 and probably at a level in March that was equal to the highest month in the last four years. So there was over $40 billion of municipal issuance. The auction rate, if you recall, is a relatively small portion of the total muni market, okay? So I’m feeling better, particularly with what I’ve seen here in the month of March.

Christopher Cerasso – Credit Suisse

Okay. Can you give us an update on your thinking with regard to commodities? Obviously you’ve had some big increases in the spot market in steel, resin, copper. Was there any change in your outlook for the impact on your results this year?

R. Bruce McDonald

Yeah, I’ll take that one, Chris. It’s Bruce. We’re fairly well hedged out on a copper basis for the remainder of this year. Similarly with steel, we have contracts that sort of lock in most of our pricing at current levels. So for us the impact of commodities is not really a 2008 issue.

Christopher Cerasso – Credit Suisse

Okay. Recently there were some big steel suppliers talking about pushing through surcharges despite contracts. Is that affecting you at all?

R. Bruce McDonald

Not at this point in time.

Christopher Cerasso – Credit Suisse

Okay. One more maybe on the building business. The full-year revenue expectation plus 15%, you’ve been running well below that the first couple of quarters. Do you still think you’re going to do 15% for the year?

R. Bruce McDonald

Chris, we expect to see some better growth out of building efficiency in the second half than the first half, but with the downturn that we’ve seen in the residential sector we’re probably going to fall a little bit short of that.

Christopher Cerasso – Credit Suisse

Okay. But the operating profit guidance is unchanged?

R. Bruce McDonald

Yeah, I think we feel pretty good about our ability to expand the margins and that’s certainly what we talked about at the beginning of the year. It’s a top line story, but it’s also a margin enhancement story and we’ve guided to where we see that business’s margin getting to 10% exclusive of Global Workplace Solutions and with the introduction of an acceleration of the BBP initiatives that Keith’s talked about in that business. We’re off to a great start in terms of attacking the cost base there.

Christopher Cerasso – Credit Suisse

Okay. Thanks a lot.

Operator

Himanshu Patel with J. P. Morgan, your line is open.

Himanshu Patel – J. P. Morgan

Good morning, guys. Two questions. On the auto business, it looked like the revenue growth excluding FX in the European business was actually negative. What are some of the key models? I think you mentioned you’ve got some outgoing models there that are hitting that.

Keith E. Wandell

You know, I don’t have those in front of me, Himanshu, but why don’t we follow that, Glen or Denise can follow that up with you later on. I mean, it’s just basically a bunch of, we had a lot of launch activity sort of three or four years ago. That’s sort of coming to the end of its product life here. We had another big blob of launch activity coming in 2009-2010 area. We can give you some more specifics, but we just don’t have it handy.

Stephen A. Roell

Yeah, I think what we did, Keith, I think when you went through it you did call off some of the models that were there. So I imagine there’s a few more there. Those were the ones that we thought were the more significant ones. If you (inaudible) we talked about the BMW Mini, the X3, and I think the Ariva, the Fords, Kia, and Fiesta. Those are the ones we highlighted were the biggest downturn in terms of the market. Okay?

Himanshu Patel – J. P. Morgan

Okay. And then on building efficiency you’ve got 11% revenue growth on reported revenues and I think 15% growth on the backlog. Can we get both of those numbers exclusive of FX?

R. Bruce McDonald

We don’t have them for you right now, but we can certainly do that, Himanshu. Okay?

Himanshu Patel – J. P. Morgan

Okay. And one related question on that. I think, Bruce, you mentioned that the third quarter would actually see an acceleration in building efficiency revenue because of the summer cooling season. Is that a year-over-year reference or sequential revenue growth reference?

R. Bruce McDonald

Year over year.

Himanshu Patel – J. P. Morgan

Year over year. Okay. So, why –

Keith E. Wandell

We’re very, as you know, the business is heavily skewed towards the summer cooling season. So Q3 is a big quarter for building efficiency and we feel good in terms of where we are with our backlog going in the quarter. We have a little bit more of an inventory build within building efficiency to support our equipment orders in Q3 so we expect the sequential year-over-year of growth improvement in building efficiency here in Q3.

Denise Zutz

And I would add, Himanshu, an additional dimension is we’ve won some new workplace solutions business and that’s going to come on in the third quarter here. So I think we’re going to see, frankly, their growth in the second quarter wasn’t as strong as it was in the first, but we expect to see that coming back. We’ve always got that timing issue in terms of workplace solutions in terms of the timing of new contracts coming on and they’ve got a very strong pipeline here. So they’re going to be a significant contributor to the higher rate of growth in the third quarter as will, we believe, our European business which is going to have a strong revenue quarter.

Stephen A. Roell

Sorry, this is Steve, I just had to say, I misquote you. We did provide, I think, the FX adjusted revenue number. I think, Bruce, you did provide that I think at 5% for BE.

Himanshu Patel – J. P. Morgan

Five percent for BE. And Bruce, do you have that number for the backlog?

R. Bruce McDonald

That number I don’t have.

Stephen A. Roell

That’s the one we didn’t have. Okay?

Himanshu Patel – J. P. Morgan

Okay. And can I just ask a small accounting issue? For the revenues you would use period average FX rates. For the backlog do you use period average or do you use period ending?

R. Bruce McDonald

We would use period ending.

Himanshu Patel – J. P. Morgan

Okay. And then last question. On the cash flow it looks like payables were a lot less favourable than they were in the year-ago quarter and I think there was an adverse from change in other assets and liabilities as well. Can you give us a little bit more colour on what’s going on there?

R. Bruce McDonald

Yeah, in terms of the, if I just sort of take the working capital change in the quarter in total I think we’re at use of about just a shade north of $160 million versus sources say $40 million. So there’s about $200 million negative swing. A couple things I’d point out. First of all, we are making some accelerated payments to support one of our customers in the automotive business that’s in financial distress. So that’s an issue that hit us here in the second quarter that should be resolved here before the end of the year. We have had a little bit higher build of inventory here in the second quarter than we did last year and that’s really in supporting our growth in power solutions. We’ve put in a little bit more inventory here to uplift our service levels in Europe. And we’re carrying I’d say a little bit of an abnormally high level of junk batteries as well.

There’s also an inventory build in BE where we’ve taken the footprint down in our equipment side of our business from say 35 to the low 20s from a manufacturing perspective. We do need to carry a little bit more inventory to bank as we go into the cooling season.

And then lastly, the swing in other current assets and liabilities is really just some timing issues associated with the DAT collections for customer tooling recoveries. There’s a little bit of noise in our numbers last year with the divestment of Bristol that gave us a benefit last year. So those are the main things.

I think the message here is from a working capital point of view we feel pretty comfortable that the use, I’ll say, is behind us and working capital has turned into a source for us over the second half of the year. We will have a small outflow for the full year, but you should see that swing to a positive force here in the second half.

Himanshu Patel – J. P. Morgan

Okay. Great. Thank you, guys.

Stephen A. Roell

Himanshu, if I could just for a second. I want to go back, you mentioned the impact of the FX. I talked about the pipeline and I gave some very general statements about the sectors, the segments for the markets that were doing well. Maybe just a comment that I should provide to the audience is that we do just track our North American construction and service figures. That’s where we have a lot, when I say pipeline, that’s where we have a history that allows us to do that. So it’s really all North American based, US based. And in both our systems work, which is really our new construction, and in our service sector, which is a combination of primarily retrofit work, EC, both of those are up double digits versus a year ago. There’s not FX in either of those numbers when I talk about being up double digits. So we’re seeing good momentum and driven by the sectors that I described to you in both systems and services in North America.

Himanshu Patel – J. P. Morgan

Bruce, I’m sorry, Steve, some of the inbound leading indicators tied to non-res construction, I’m sure you’ve seen the same data. They’re clearly showing some softening and I’m wondering, your institutional business, it looks like when you blend Heritage, ACI, and York together it looks like it’s sort of 50%, but the rest of it is not 50%. I mean, the rest of it is not institutional. I’m just wondering, have you seen any softening on the other side of the business and is it just that the institutional side has actually strengthened to offset that?

Stephen A. Roell

Yeah, we’ve got more exposure on institutional to add it all up. But let me just go back to some of the leading indicators. I think it’s a good point. There was a big discussion, as you’re aware, on the AIA data that talked about a big drop there. But institutional actually is at 54.9. So I mean, you can almost pick and choose what you want to look at. We have seen some softness in the manufacturing arena, but we’re just not exposed to that way. The biggest, you know, if you look at the data, that’s the problem with the data. If you look at the biggest decline, or one of the biggest declines that took place on AIA data, it was multi-family residential. We need to consider that. Okay?

Another thing that would fit with what we are seeing, Himanshu, is the inquiries for new projects. That score was 54.3. So we’re still, the data is bouncing a little bit too much to grab a hold of a lot right now. I think we want to see where this thing goes. But we’re seeing momentum, we’re seeing new projects, we’re seeing PC, which wouldn’t show up any of this data.

Himanshu Patel – J. P. Morgan

I’m sorry for the multiple questions. I want to clarify one thing Bruce said. Bruce, I think on the last quarterly conference call you had suggested that building efficiency revenue growth would see some acceleration in the next quarter and it looks like, it was growing but it was at a comfortable growth rate of around 11%. Was the reason for that discrepancy what Denise mentioned, where some of the GWS orders got deferred into the back end of the year?

R. Bruce McDonald

I would say it’s more a question of the residential, the timing of some of our stocking of the pipeline in the residential space. That one we didn’t see trending down. Our expectation going into the quarter was residential, would kind of be flattish versus last year, Himanshu. If you back that out we were at about 13% growth. I mean, the other factor that hit us negatively in residential was there’s some product returns that flowed through associated with the US air conditioning changing over of our distribution in California last year. So the product was returned which depressed the revenue in that sector. But overall we’ve thought that we’d be flat in there and sort of be in the 13-type range for the quarter.

Himanshu Patel – J. P. Morgan

Great. Thank you.

Denise Zutz

Okay. Yeah, I think we’ll go on to, Himanshu, we gotta go on to the next question.

Operator

Rod Lache with Deutsche Bank, your line is open.

Rod Lache – Deutsche Bank Securities

Good morning, everyone. A couple things that haven’t been asked. Do you have just some rough estimates for the regional organic growth in building efficiency? Just roughly?

Stephen A. Roell

I don’t have that. We could probably go through it. Let us give you a call back with that. We’re going to make sure you get that, okay?

Rod Lache – Deutsche Bank Securities

Okay. But it sounds like you’re seeing still positive numbers in North America. Is that on an organic basis or is that incorrect?

Denise Zutz

Yeah, the growth in North America was double digits.

Rod Lache – Deutsche Bank Securities

Okay. Because you guys said that building efficiency overall was 5% excluding FX. So North America is actually exceeding the international?

Keith E. Wandell

You gotta remember, Rod, you got to take out that number. To Bruce’s point, the residential downturn. Okay?

R. Bruce McDonald

But I mean, I can tell you, if you just look at North America systems, which has no FX in it, is up 15%. Service excluding FX was up 8% or 9%. UPG, our unitary business was down 19%. GWS was up 10%. Europe was down 3%. The rest of the world was up 6%.

Rod Lache – Deutsche Bank Securities

Okay. And is that level of growth, I mean, it sounds like this is well in excess of the industry replacement cycle or energy efficiency drivers, those sorts of things, any way to kind of characterize how you’re doing relative to the market at this point? Is it still York synergies is a big driver? What do you see in terms of relative performance?

Stephen A. Roell

I think it’s a number of things. I think the York synergies is part of it. I just think that it’s back to relationships. But I think we’ve always been strong in those institutional areas that I described to you. So I think the comparison’s tough because I don’t think we have a good, you know, who do you compare us to? Our makeup is much different than Carriere (sp) or Train and even Honeywell in that context. So I think it’s a function that we’ve got more of an inner, two things, we’ve got more institutional and, secondly, I think we’re a little more global than a couple of those competitors.

Rod Lache – Deutsche Bank Securities

Okay. And the operating margin improvement, the 70 basis points. That’s basically all SG&A as a percentage of sales and quite a big improvement on a year-over-year basis versus what you have been seeing, even in the first quarter. Can you just give us any colour on how we should be thinking about that going forward? is this sort of magnitude of improvement something that’s sustainable?

Stephen A. Roell

You’re going to see it flatten out. I mean, Rod, if you sort of look at the detail in Q1 and Q2, I mean, we had pretty good comparisons particularly the North American automotive. So that, if you recall last year, roughly speaking we lost $50 million in Q1, we broke even in Q2, and we made sort of $100 million in the second half. Big picture there. The second half comparisons in North America are flatter than we’ve had the first half of the year.

Rod Lache – Deutsche Bank Securities

Okay. And just my last question is relative to the automotive business and what you’re seeing in terms of your suppliers. There’s been more discussion amongst the tier one guys about the health of the tier twos, particularly with the strike and the downturn in production. How big an issue is this for you this year? How are you monitoring that?

Keith E. Wandell

This is Keith. You know, it hasn’t really been a significant issue for us. I mean, clearly, you know, and particularly in North America, I would characterize the supply base is generally distressed, obviously. But you know, we monitor that very closely. We have an organization within our purchasing group that really monitors the financial health of all of our suppliers and so we remain very close to them. We’ve also over time sort of tried to consolidate our supply base so that we’re really being more selective in who we’re having supply us. So I think in general it’s an issue that we’re aware of and we’re watching very closely, but it hasn’t had a major impact.

Rod Lache – Deutsche Bank Securities

Is it safe to say that this level of cost savings that you’re seeing the auto business has been pretty strong? A lot of that is more kind of internally generated, shifting engineering to low cost markets, things like that, as opposed to taking savings from suppliers at this point?

Keith E. Wandell

Absolutely. Make no mistake about it, we have goals just like everybody else does in terms of our procurement costs, but that’s the majority of the improvement that you’re seeing is being driven internally through the initiatives that I referred to earlier.

R. Bruce McDonald

I would also maybe add to that, if you think about our big suppliers, with our level of vertical integration, it’s the steel mills, it’s the chemical companies, and they’re not in financial distress. Far from it.

Rod Lache – Deutsche Bank Securities

Okay. Thank you.

Operator

Jonathan Steinmetz with Morgan Stanley, your line is open.

Jonathan Steinmetz – Morgan Stanley

Thanks. Good morning, everybody. Can you hear me?

Stephen A. Roell

Yes, we can, Jonathan. You’re fine.

Jonathan Steinmetz – Morgan Stanley

Okay. A few follow ups. First of all on the cash flow. Are you still standing by your $1.1 billion to $1.3 billion full-year free cash flow number and if you could talk maybe a little bit more, I assume you were referring to Plastech just about how much money is sort of trapped there and if you think it really unwinds by year end.

Keith E. Wandell

Sure. First of all, yes, we are still standing by our free cash flow guidance for the year. Okay? Secondly, with respect to Plastech, it’s probably worth about $50 million in terms of us paying us and the other customers paying on pretty much COD, I would say. Pretty much COD. Certainly within a week. That we do expect to see a resolution to the situation here in the second half of the year. And that money will flow back for us.

Jonathan Steinmetz – Morgan Stanley

Okay. And in terms of the commodities, you talked about being hedged through 2008 and I know you’ll do your full guidance in October for 2009, but do we have a margin issue? In other words, do you think you’re getting enough pricing from what you’re seeing real time when those hedges unwind to compensate or is this an ongoing issue going forward?

Stephen A. Roell

Jonathan, I think your point is a little bit too early to interject that. We really need to have a lot of discussion with our customers and just see how this thing plays out. But I mean, it’s only been out there for about six, maybe six weeks. We’re aware of it and we’ll be engaging with our customers as we go into the latter part of 2008 regarding 2009 pricing, okay?

Jonathan Steinmetz – Morgan Stanley

Okay. And what was the EPS or EBIDT effect for currency translation?

R. Bruce McDonald

Versus the last year?

Jonathan Steinmetz – Morgan Stanley

Versus past quarter, yeah, a year ago.

R. Bruce McDonald

Yeah, I’d say $0.04 to $0.05 on that.

Denise Zutz

Oh, I’m sorry. Yeah.

Jonathan Steinmetz – Morgan Stanley

Okay. And lastly, there’s been some articles being Ford taking some of the seat engineering back in-house, or I think it was Jeep trying something in terms of seats out of India. Can you just comment in general whether you’re seeing in North America any type of shift to sort of more in-sourcing of seat engineering and design and/or production eventually and whether you think there’s any ramification? Or is there just a wasp being made out of a few small examples?

Stephen A. Roell

Well, first of all the general answer to that is no. We don’t really see a move toward seat in-sourcing. To talk about Ford specifically, this was really an initiative that they undertook about 2.5 to 3 years ago and really it was, I think it was, and this is just my view of it, but it was really sort of doing sort of the Toyota model, if you will. If you think about what Toyota does and they have what is Arocco (sp) now Boshuku (sp) who’s sort of their internally, if you will, control model and then they outsource the majority of the work then to best in class suppliers in the world, whether it’s seats or whatever it might be. I think Ford really felt like as they had outsourced all their seat engineering they might have given up a little bit too much in terms of internal knowledge and capabilities, so they did in-source the seat structures and seats on the F-Class product, which is really only built in North America. But what we see Ford doing now in the B-Class, the C-Class, and the C- and D-Platforms is really outsourcing all the structures, tracks, seats on a global basis. We are the recipient of a lot of that business. If you think about the Fiesta, the V-Class that’s launching in Europe in June and then in Asia in October, you know, we have the complete seats for that metal, structures, trim, foam, etcetera, in negotiations for North America today. So I think at the end of the day we will be at least neutral if not positive on the revenues being generated in the seating business at Ford.

You know, the other thing you mentioned with Chrysler getting seats out of India, I mean, we really have no comment on that. We’ll just see how that goes.

Jonathan Steinmetz – Morgan Stanley

Okay. Thank you.

Operator

Brian Johnson with Lehman Brothers, your line is open.

Brian Johnson – Lehman Brothers

Thank you. On the service pie chart on page five, could you break down within the pie retrofit product from service-service.

Denise Zutz

Yeah, we certainly can, Brian, but let’s give you a call back. We don’t have that number immediately available to us.

Brian Johnson – Lehman Brothers

Okay.

Stephen A. Roell

Yeah, the (inaudible), Brian, are going to be GWS and the ongoing service business. Our on-call and our scheduled service will be the two largest parts of that pie by far.

Brian Johnson – Lehman Brothers

Okay. And maybe just some colour on the retrofit business. Does it all come from GWS or their replacement air conditioner units that you don’t put in new construction but are retrofit product?

Stephen A. Roell

Well, it’s not from GWS. GWS has some pull through, but it wouldn’t even show up on a piece of paper, okay? In this context. The retrofit, a lot of the retrofit is what used to be in our old controls business. Because really when we go in there’s a building expansion and we change out the building controls and some of the work associated with that. Then there is replacement, of course, for the equipment side. But that’s not unusual. I mean, the equipment side is a long life, as you know. So you’re talking about 15, 20, 25 year replacement cycles on some of that. So most of the retrofit that you’re seeing is the old controls business that we had for years and years. The other piece is there are a lot of reasons why people make retrofits to improve their energy efficiency and change out their equipment for that purpose alone.

Brian Johnson – Lehman Brothers

Is it possible maybe when we follow up to track the retrofit, the air conditioner dive, and the service life from retrofit good business case for energy management?

Stephen A. Roell

I’m sorry, Brian, I’m not sure I understood that.

Brian Johnson – Lehman Brothers

Do you have a sense of how much of the retrofit is end-of-service life versus mid-service life payback for saving energy and putting in a new HVAC?

Stephen A. Roell

I’d be afraid to give you a number. I could be wrong on that. I’d guess most of it is at this point in time upgrades of equipment or expansion as opposed to energy. I think we really haven’t felt the primary benefit from a major energy retrofit yet. That’s still coming, I believe.

Brian Johnson – Lehman Brothers

And then last question. Around the retrofit business, is there a financing partner or set of partners you work with and any kind of change on the horizon in terms of whether landlords can get or building owners can get those projects financed?

Stephen A. Roell

Well, most of our finance, let’s go back. Most of the financing we providing is to schools. Actually we provide, we have a third party. It’s a very large commercial bank that you would feel very comfortable with. So that’s not an issue. In terms of the financing associated with the rest of it, I was pleased with what’s taking place in the muni market and we’re going to have to watch the smaller customers. I mean, I don’t have a good window other than the fact that we continue to see good growth in smaller projects.

Brian Johnson – Lehman Brothers

Okay. Thanks. We’ll follow up on some of this.

Operator

Ted Wheeler with Buckingham Research, your line is open.

Ted Wheeler – Buckingham Research

Thank you. Good morning. Just a couple quick things. You talked about the quote pipeline systems North America up double digit. I don’t want to get too granular, but do you think March is hold, is March experience similar to the average of the quarter?

Stephen A. Roell

Is the March?

Ted Wheeler – Buckingham Research

Well, is the momentum through the quarter consistent? Or did you see a change March on that quote pipeline that you saw?

Stephen A. Roell

Well, we saw, I’m going to separate the systems versus the service. I don’t think there was anything, Ted, let me go back. There wasn’t anything that I saw unusual in March in the systems side. The momentum was pretty stable throughout the quarter. There was a pick up at the end of the quarter on departments contracting.

Ted Wheeler – Buckingham Research

Okay. I was kind of just probing on the systems side. Thank you. You talked also about some carbon footprint measurement issues coming in. Is that a big deal? I mean, is that a big market?

Stephen A. Roell

Well, I think it is. It’s going to be huge. Because I think that most of the corporation, we being one of them, have made a commitment to the EPA to reduce our carbon emissions and greenhouse gas emissions by 2012. So I think companies are looking at what they can do and certainly the building side of this is critical. Manufacturing processes is one that we’re going after in our space, but Ted, that’s what companies are going to be talking about. They’re making commitments certainly on a national basis and I think on a global basis.

Ted Wheeler – Buckingham Research

Well, if you were to have a service contract, I guess it would come through or would it be equipment or maybe both, but would it add a couple percent, 10% to an order to achieve that measurement?

Stephen A. Roell

I don’t think it’s an order. I think it’s why they do it. I think if you go back to say why would somebody do a lighting retrofit? That would be the reason why they would do a job.

Ted Wheeler – Buckingham Research

I gotcha. Okay. Well, do you think we could get a –

Denise Zutz

I mean, again, Ted, just for a perspective, generally speaking you reduce your carbon footprint, you reduce your cost at the same time. So those objectives are perfectly aligned.

Ted Wheeler – Buckingham Research

Oh, yeah, yeah. I’m just trying to get a sense of how big an opportunity it is for you. I guess –

Denise Zutz

Well, I think as always it’s difficult to tell. I mean, certainly everybody talks about it now. You know, we do an annual survey now with people in the market and clearly year over year the percentage of building owners saying they’re really focusing on this issue has increased. So everybody’s fixated on it, I think, speaking domestically. Building owners really haven’t experienced the increased in their total utility costs the way they’re about to. Last year it’s been primarily about oil and oil really isn’t a primary fuel when it comes to a building space. It’s more about electricity and natural gas. So you really can’t, it’s difficult for us to really separate the market drivers and how they’re distinguished around the need to reduce or minimize operating costs versus doing the right thing from the environmental and from the GHG standpoint from, I would add, people simply needing improved quality in terms of their indoor environments as well as demand being created by simply changes in the way people are using their buildings. I mean, frankly, year after year after year it’s part of the consistency and stability in this business in this market. People just want to be comfortable, as well as the fact that every time you change how you’re using a building you add or move people around that causes discomfort and people have to reinvest their building.

Okay, operator, I think we have time for one more question. Thank you, Ted.

Ted Wheeler – Buckingham Research

All right.

Operator

Thank you. Our last question comes from Patrick Archibald with Goldman Sachs. Your line is open.

Patrick Archibald – Goldman Sachs

Hi. Can you hear me?

Stephen A. Roell

Yeah, we can, Patrick.

Patrick Archibald – Goldman Sachs

Yeah, just wanted to get an update on acquisitions coming out of your analyst day last year. You guys had some dry powder and the intention to use it in a couple of your business segments. We haven’t seen much yet. Is that a financing issue or are there other issues that have maybe pushed back some of those initiatives?

Stephen A. Roell

I don’t think it’s so much a finance issue. I think we’ve had a lot of discussion. Some transactions we would like to do are just not available to us right now. Some are in the midst of discussions. But we’re consistent with what we have described here in terms of our areas of interest. But it’s not for lack of trying, Patrick. We just have not been able to, we’re probably pretty selective, number one, and number two, I think we’re just being very disciplined in terms of how we go through the process and in some cases are taking longer than what we would have expected.

Patrick Archibald – Goldman Sachs

And can I just get a sense again, just a refresher, of where you guys were thinking of adding capacity or was it just kind of across the board?

Stephen A. Roell

Just across all three businesses. In automotive it was tied around electronics, some adjacent markets. in power solutions it was geographic growth in Asia and some vertical integration. And in the building efficiencies side it was really a surge of things. It was running our product portfolio and mechanical service (inaudible) markets.

Patrick Archibald – Goldman Sachs

Okay. Thanks. I guess one last one. You increased your revenue outlook by about a billion, but your EPS forecasts or projections are unchanged. Was that mostly cost related or FX related?

R. Bruce McDonald

I’ll take that one, Patrick. It’s a couple things. We’ve clearly got a worse outlook for residential than we had before, but that’s just not going to deliver a bottom line that we had anticipated. Secondly, we are being adversely impacted with the production interruptions here in North America. Our outlook is that that might get settled out here towards the middle of this quarter and we have not factored in, I’ll say, inventories running down or there being an acceleration in that production in the fourth quarter. Which I suppose could happen, but at this point in time that’s not what we’re seeing and that’s not what we’re anticipating.

Patrick Archibald – Goldman Sachs

Okay. Gotcha. All right. Thanks, guys. That’s all I had.

Denise Zutz

Okay. And thank you very much. And we appreciate everyone joining us. If you have further questions please give us a call. And again, thank you.

Operator

Thank you. This does conclude today’s conference call. You may disconnect at this time. Have a great day.

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