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Executives

Joseph M. Hogan - Chief Executive Officer

Michel Demaré - Chief Financial Officer

Analysts

Daniela Costa - Goldman Sachs Group Inc., Research Division

Andreas P. Willi - JP Morgan Chase & Co, Research Division

Mark Troman - BofA Merrill Lynch, Research Division

Olivier Esnou - Exane BNP Paribas, Research Division

James Moore - Redburn Partners LLP, Research Division

William Mackie - Berenberg Bank, Research Division

Martin Wilkie - Deutsche Bank AG, Research Division

Fredric Stahl - UBS Investment Bank, Research Division

Mark Fielding - Citigroup Inc, Research Division

ABB (ABB) Q3 2012 Earnings Call October 25, 2012 7:00 AM ET

Operator

Ladies and gentlemen, good morning or good afternoon. Welcome to the ABB Third Quarter Results 2012 Analyst and Investor Conference Call. I'm Stephanie, the Chorus Call operator. [Operator Instructions] And the conference is being recorded. After the presentation, there will be a Q&A session. [Operator Instructions] At this time, it's my pleasure to hand over to Joe Hogan, CEO of ABB; and Mr. Michel Demaré, CFO of ABB. Please go ahead, gentlemen.

Joseph M. Hogan

Good afternoon. It's Joe Hogan here with the third quarter results, I think. And we'll start off with the presentation today that's on abb.com, and I'm assuming that most of you have it downloaded. We'll start from there.

Chart #2 is our Safe Harbor statement. And nothing's changed there, so we'll move quickly to Chart 3.

Chart 3 is the summary of what we saw in Q3. We wanted to share with you. And consequently, the rest of the slides, they're just a back-up to these thoughts. Base orders were steady in a mixed economic environment. When we say steady, our base orders are actually up 8% in total but about flat organically overall. When you roll out Thomas & Betts, it comes to flat. Remember, base orders are any orders that are $15 million or below.

China, we say, is moving sideways. Everyone, I'm sure, remembers the severe downturn we had in the low-voltage business in China in the first quarter of this year. China stabilized for us since then. In fact, China's business within low-voltage products is actually up for this quarter. But in general, we see China moving sideways. It's about 0% growth, and I'll talk about that on our orders chart.

Operational EBITDA, we see steady versus Q2 2012, just up 1 point. And versus Q3 2011, it's down, and that was a very strong quarter for us. And again, we'll get into that comparison.

Power Products’ operational EBITDA margin is steady for the fourth consecutive quarter, in line with what we discussed at Capital Markets Day. We're telling you that we have a firewall in that business, around 14.5% to 15% operational EBITDA. And we've been able to achieve that in the last 4 quarters, and we feel it gives us a solid foundation to continue that as we go forward.

Our project margin decline in Power Systems, we have a slide on that. We'll walk you through it. We had just good divisional cash from operations. Michel will walk you through the cash piece and where we see a cash conversion at group levels approaching Q2 2012. So we're -- when you look at the true operational cash part of the business and not what we have from a treasury standpoint, we had much better operational cash in 3Q.

Thomas & Betts contributed about $120 million of EBITDA in the quarter and $90 million of cash. It's performing at this point above expectations, which we're really pleased with.

We got a strong balance sheet. We continue with that. I think it's interesting to know that there’s a currency translation. It reduced our reports by about $570 million in revenue and our EBITDA number about $100 million. And also there's a lot of talk about our orders number itself. When you look at our order side, anywhere between 500 and 550 of reduction in orders occurred because of translation in the quarter also. And then operational EBITDA, as Michel explained in the second quarter call and at the Capital Markets Day and the way that's measured is flat in local currencies.

So turning to Chart 4, when you look at the figures, basically, the condensed income statement. You can see that orders of approximately $9.3 billion, which is flat or minus 6% organically. Our order backlog, which is good news of $29 billion, up from third quarter of last year, about 3%. Revenues of $9.745 billion, which is up 10% and about 4% organically. Operational EBITDA of 4.83 (sic) [$1.483 billion], which gives us about 15.3% operational EBITDA. This is down versus last year 6% in total and minus 14% from on organic standpoint. And cash from operations at $768 million. That's minus 5% in dollars. But again, when you look at cash from operations, we felt we had a good quarter, and we anticipate having a very strong quarter in the fourth quarter also.

Just some thoughts behind those numbers. Order development, we had a 30% drop in large orders from our DolWin order last year that came out of Germany. But it's clear in our business that the short, what we call our short cycle, early-cycle businesses are slowing. And we see that in parts of our low-voltage products business. We see it in areas like drive and motors and generators inside our Discrete Automation and Motion business. There's no question we've seen an order slowdown in what we would call the shortest cycle parts of our business.

Our services orders were up about 9% for the quarter. And so when you compare that with base orders down overall, about 6%, that's a very strong performance for our services business, which we're really happy with, that we have that kind of momentum given more difficult economic times that, I think, all of us see if you read the papers right now.

And then operational EBITDA margin, as I mentioned, was against a very strong quarter in Q3. And that was particularly in PP and PS. Last year, Power Products was 17.2%, and PS was 9.7%. So quarter-over-quarter when you compare the years, the biggest discrepancy we have is in the power side.

Reported net income is down a bit slightly, and cash from operations, we'll talk to you in more detail about that.

Moving the next page, which is Chart 5. It gives you a look -- this is our standard chart. I'm looking at our regional development in orders. You could see the Americas is up 38% overall, excluding T&B, up 16%. Power being up 20%, and automation being up 14% when you take Thomas & Betts out too. So a good quarter in the Americas overall. We worry about the economy there. We worry about the fiscal cliff discussions and all those things. But our orders right now reflect good performance in the Americas, and we hope that will continue. When you look at Europe, down 24%. Again that's the DolWin1Project we won last year. But if you exclude that, European power orders are basically flat. And to a certain extent, you can't exclude that because it was so large, but the percentage of large orders in the quarter being about 15 versus 30 last year, I'd say the normal aggregate is about 22% large orders as a percentage of our total. And so we're off in that area in the $400 million range when you think about how much large orders we normally have as part of the total order pattern of ABB.

In Asia, we're minus 13%. On the next chart, we'll talk more about what China looks like in that way, but there's no real surprise there. Middle East and Africa, up 73%. A lot of it has to do with Saudi Arabia and the Middle East being very strong on some large projects we have this year.

So moving over to the next page, which is Chart 6. This just gives you another degree of detail by country more as far as how we're performing. You see that Canada was extremely strong for us. Thomas & Betts is very strong in Canada. But even excluding Thomas & Betts, we're up 10%. In the U.S., up about 13%.

We had some very large orders in Brazil, mainly rail and offshore for oil and gas, which is a really big help in that sense. In Canada, too, we had a $55 million FACTS order. That's for -- we had grid systems in Canada, plus as I mentioned, it's a strong T&B marketplace, too. The U.K. was up exceptionally in all businesses, except the Discrete Automation and Motion. It was really a strong quarter for the U.K. Sweden, up 6% as you can see. When you look at Germany, down 64%. If you take out the DolWin order, automation was up 2% in Germany and minus 6% in power by pulling out DolWin.

I think the other part of this chart that’s important is China was flat. When you break those numbers apart, China was up 17% in power and down 8% in automation. What was affected most in automation was process automation was down pretty significantly, almost 39% for the quarter. In China, they had a couple of large orders last year that didn't repeat.

And then Discrete Automation and Motion was down about 14% in China, mainly on a path of lower renewable kinds of sales, which would be drives and motors and generators associated with wind energy there.

India, down 39%, had a -- India didn't repeat on about a $240 million large order that it had last year. But overall, we think India has been moving in the right direction for us.

And I think the last thing to point to is Southern Europe itself, it was up for us 2%, with Italy being up 3% too, showing that we’re able to find some growth in that region in the world that's been so hard hit by the euro crisis.

So I'd leave this chart by saying it's one of the things, since I've been here at ABB, I've really come to appreciate is our scope and depth around the world in the sense of the number and kind of products that we have and the breadth of distribution that we have across the globe, really helps us in difficult times because we can just -- we can find areas of growth that I think other companies that don't have a similar footprint, which struggle to have that kind of exposure.

So moving to Chart 7, and this is Q3 divisional look. So in Power Products, orders minus 6%. Revenues are flat, operational EBITDA down about 19% versus last year. But again, that critical margin of 14.8%, which is up a tick from last year and being able to hold in that range. Again, this is the fourth consecutive quarter of being able to do that. Hopefully, everyone starts to see that we are confident in our ability to be able to maintain that range.

When you look at the pricing impact on PP, and Michel and I anticipate those kinds of questions coming up when we go to Q&A, the orders for PP, pricing was down 3% to 4%. So basically the same as Q2 2012, we saw the same kind of pressure from a pricing standpoint on orders. On revenues, minus 6. So as we flush some of these lower-priced orders out of backlog, we'll continue to see that. But that's versus 6% to 7% in Q2 2012. So we look forward to that getting better in the upcoming quarters in some way.

As you look at Power Systems, large orders were down $1 billion. Again, it’s a DolWin order was booked in Power Systems last year. So orders are down 27%. Revenues are up 11%. Operational EBITDA was down 41%, and EBITDA itself, it’s 5.9%. We had some order -- we had some project execution issues in this business that we'll get into, particularly around offshore wind. We’ve made some leadership changes in the meantime to be able to address that. We've made some organizational changes with some of the product groups to line them properly between systems and products. And we do expect this to get better in 2013, but right now for 2012, we are unlikely to make our target of 7% to 11% that we've stated. But we expect to be able to recover that in 2013.

Moving on to Chart 8. And this is just -- I’ll quickly go over this. These are successes and challenges in power. I think I’ve covered most of these. I’d like to call out the cost initiatives continue to generate significant savings. You’ll see a majority of the cost savings that we've driven this year that we anticipate to be over $1 billion this year are on the power side. We know that the Power Systems piece, orders are up 25% when you exclude the offshore comparison. So we continue to have a good orders backlog in Power Systems overall. And services growth maintained in line with our strategic targets for Power too.

Challenges are our offshore wind projects listed below. Project underperformance in PS in general and part of that in the power generation group. Some pricing pressure and -- but again, what we're going to do is we'll do our best to leverage technology, software, industrial know-how and our large installed base to bring this thing back.

Moving to the next page, we break out Power Systems a little more detail. And this DolWin1 offshore wind project, the platform sail-away date was postponed because the permits weren't available. Platform substructure, we call it jacket, did sail out. And it was installed where the control and the valve station will be next spring sometime.

We had cost overruns of about $20 million associated with that project and which we booked in the quarter. Look, there's a very complex framework of regulatory and commercial responsibility to exist in this. And I know there's going to be questions as far as what it's going to look like in the fourth quarter. What we're prepared to say is right now, we're looking at -- trying to get a better idea of exactly what's going here and what the charges are. We expect a charge of anywhere between $0 and $50 million for the quarter.

Then last is we got specific project issues in Saudi Arabia and India with our Power Systems business that we're also working through right now too. And down below, I talked about the management changes that we have made. We’ve intensified our project execution, people and skills. And we are in the process of making sure we have much greater projects of activity in price and quality.

So moving on to the next slide, which is Chart 10, we take a look at our automation piece. I think there's probably not a big surprise in these numbers for you, I don't believe. Discrete Automation and Motion are up 1%, revenues up 5%, as you can read. Operational EBITDA, 18.9%. That's down from last year but a little bit up from Q2 2012. We have, as I mentioned, lower industry and renewable orders, offset by some utilities and traction and automobile orders that would be associated with robotics primarily.

We have a good solid order backlog, helped to lift some revenues. And operational EBITDA, there's a big mix piece in that given our drive business is down somewhat from what last year, and that's been a bad mix factor for us also.

Our low-voltage products. Remember, this is our T&B acquisition, so you can see there's discrepancy between the numbers, up 45%, including T&B in orders, minus 1% without T&B. 44% in revenues and minus 2% without T&B, too. Operational EBITDA, up 34%, but just down a tick versus last year from an organic standpoint, a really good performance at 19.5%. And I think what's interesting here is our China business, which is critical, improved when you look at quarter-over-quarter, but I mean as Q3 2011 versus Q3 2012. And then also, we saw some momentum, too, between the second quarter and the third quarter.

Then lastly, process automation, minus 3% in orders, plus 3% in revenues, minus 11% in operational EBITDA, 12.3%. The loss in EBITDA versus last year and also Q2 has mainly to do with more systems flowing through in the quarter versus product down 1 point in that sense. But there's nothing systemically from a price standpoint or a cost standpoint in this business. It's just -- that is just pure mix.

So moving on to Chart 11. From Automation standpoint is -- so we were pleased with the resilient demand, flat on organic order, despite a very mixed marketplace. We had some price improvements in low-voltage products of about 1 point to 1.5. It really helped, and then LP also drove some very strong cost savings after the issues we had in China in Q1. And then you can certainly see that in the figures, in the operational EBITDA figures. Thomas & Betts integration is going well. I'll talk about that in a second. And we have some new products that are helping us in the marketplace, too.

Down below, challenges and actions. There’s an uncertain market. These businesses are hit the first because they are shorter-cycle businesses. So we stay on our toes in the sense of costs and where we have growth opportunities around the world. Thomas & Betts is critical for us, so we continue to focus on that and drive energy. And as we talked about in PA, we'll further optimize the product and systems business as we go forward.

So moving from Chart 11 on to Chart 12 is Thomas & Betts, about a 4% revenue growth in the quarter. Operational EBITDA, up substantially, about 2 points from last year, up 19%. And so overall, we have revenue of $620 million contribution in the quarter, $120 million on EBITDA and $90 million in cash. So really performing well. We're really pleased on what both we see with the leadership team there, with our integration efforts. And truly the scope of what we feel we can do together as a team between T&B and ABB in the United States, but also across the world too, so integration's on track.

And down below, we listed the Q3 PPA amortization pieces of $51 million, $116 million. So full year for 2013, we think will be $120 million. This is pretty close to where Baldor was too, when you think we paid almost the same amount for this business as Baldor. Obviously, the EBIT multiple is a little bit lower in that sense. But when you think about PPA calculations and those things, it's going to be very close to what we had in Baldor. And it -- they were very similar businesses in the sense of hard versus soft assets, and those things would be considered in that kind of analysis.

So with that, I will turn it over -- Chart 13 is our waterfall. I'll turn that over to Michel, and Michel will walk us through that chart. Michel?

Michel Demaré

Yes. Thank you, Joe. Can you hear me?

Joseph M. Hogan

Yes, can hear you fine.

Michel Demaré

Okay, good. So for this quarter, as you can see, starting in between the market forces, we had about $256 million of pricing pressure, out of which Power Products was still the majority of it, but not increasing compared to the previous quarter. Actually the impact on price and product -- on Power Product is quite stable quarter-after-quarter.

We had this time a bit higher project margin differences. You see it's almost $100 million, $98 million. So that obviously takes into account the challenges that we took on the DolWin projects, but as well, some difficult comparison. We mentioned a few order project slippages that we had in the Middle East and in India. But as well last year, we had quite some positive -- we had some insurance recovery, for instance, and some completed projects where we could release provisions, so that also makes the comparison a little bit more difficult. So these 2 obviously represent about $350 million, which are then offset by cost savings of $280 million. So we are left net with a small deficit in terms of market forces.

You see that our sales in R&D investments have increased by $120 million compared to the third quarter last year, but here it was offset by the EBITDA on additional volume of $165 million. Business mix was negative $53 million.

And then in the -- in the other again, the major component of this $133 million is Forex. ForEx has impacted EBITDA by about $100 million this quarter, has impacted all these revenues by about $550 million. We had again very big fluctuation of the U.S. dollar, especially against Brazil and against India. But even against the euro and the Swiss franc, it was a double-digit change.

And so finally, the last component is T&B. T&B has a very good contribution of almost $120 million of EBITDA. And that finally explains the net changes of $97 million for the quarter as compared to the quarter last year. Joe?

Joseph M. Hogan

Great. Moving over to Chart 14, you look at the cost savings. Overall, we had about $280 million this quarter, $820 million to date. We are confident we'll safely exceed the $1 billion that we forecasted for 2012.

Operational excellence, about 50%; direct sourcing, about 35%. That's changed a little bit. The indirect sourcing piece is important because that was an area we really focused on this year, and we had some opportunity, and we're seeing a good yield there. And global footprint, about 5%.

On the right-hand side, you can see the 60-40 ratio between power and automation that I think makes sense given what each business is experiencing from a competitive standpoint.

Okay. And I'll turn it back to Michel to talk to you about the cash flows.

Michel Demaré

Yes, the cash flow. You see the trend again. I hold it now after the Capital Market Day that it is a bit clearer for you, the issue that we have on one side in reporting the cash flows anyway by the divisions. On the other side, the cash flow that is generated or spent by corporate to hedge our different corporate exposures, especially in the balance sheet.

So the good news is that divisions’ cash flow is improved. You see it's a $160 million better now than it was in the third quarter of 2011, so that is going the right way. But on the other side, as long as the U.S. dollar stays strong, that we need to continue hedging our dollar assets to offset the fact that we financed part of these assets with a big chunk of equity in Swiss franc and also still some European currency. That obviously leads to negative cash flows in terms of hedging realization. That one was, as you can see, a delta of about $200 million this quarter. So the cash flow, at first glance, doesn't look good, but in fact, the operating cash flow is really improving from the divisions.

Joseph M. Hogan

Okay. And moving to Chart 16, just a quick close-out on the presentation. So our short-term view, it's hard to call exactly where the economies are going. I think, again, we're all in tune to what's being printed and forecasted around the world right now, and it's really hard to be optimistic in the sense of a big uptick in economic growth. But overall, we -- so we call this a mixed market. We remain confident of our ability to be able to be able to find growth in the markets going forward. But we're going to be cautious on costs, and we're going to make sure that we hit cost savings extremely hard to give us that insurance policy we need to keep the margins in the range that we've committed to you.

We do see some problems with our short-cycle businesses overall. We don't see the bottom dropping out of them, but we're seeing negative 1% to 3% growth in some of the short-cycle businesses, which is an indication that things have softened in the marketplace.

When you think about Q3 and what drives our cautious optimism is -- we see resilient demand in key markets we talked about. We even saw some growth in the Southern part of Europe this quarter on orders, which is great. Our sustainability of EBITDA, margins within Power Products continues for 4 quarters in a row now. We're seeing the same kind of pricing environment being stable for Power Products, which has been a concern. We have no slowing at all in the pace of our cost savings, and we will push that again very hard in 2013. Services orders continue on a good track, and we maintain a very strong balance sheet.

Down below, when you think about our management focus in the months ahead, obviously, Thomas & Betts synergies are critical, and we follow through on those. And then project execution improvements and Power Systems. And also, I'd add, and this is a follow-up to Michel just talked about, is the really strong focus on cash in the fourth quarter as we always have to bring home the kind of cash that we've committed in the business.

And so with that, I will turn it over to you to -- Michel and me can address any questions you might have.

Question-and-Answer Session

Operator

[Operator Instructions] First question from Mrs. Daniela Costa from Goldman Sachs.

Daniela Costa - Goldman Sachs Group Inc., Research Division

Actually, 3 things. The first one, just to clarify on your commentary on the 2013 on the cost savings that you want to continue to be very aggressive. Or I think on the media call, you've said even slightly more aggressive than this year. Tying that with your comments that the pricing pressure is slowly easing, would that imply that going into next year, you expect the cost savings to more than offset whatever is left on pricing in the backlog? That's number one. And then the second one, we've seen some positive commentary out of China that rail and nuclear investment is going to restart. Do you see there are any tenders already? Or it this just still only plans in paper? And then the third one, market share in the U.S., have you seen any positive increments, post the finalization of the antidumping?

Joseph M. Hogan

Starting on the costs side, I mean, we've committed to over $1 billion of costs this year as we go into 2013. Michel and I have kicked that around. And we, obviously, will push hard to do another $1 billion of costs or more in 2013 also. To say if we'll take it up, I'm not quite sure right now as we roll our projects together. But we certainly, given the difficult economic activity out there, we will push harder on costs in 2013 than we even did in '12. But right now, I think the best way for you to think about that in the sense of how you look at ABB and any kind of spreadsheet development or anything is think about $1 billion cost savings, and we’ll just report during the year how we're doing, up or down. Pricing pressure easing. The pricing pressure we talked about easing was really on the order side was consistent, the 3 to 4 to what we saw in the second quarter of this year. We talked -- I talked about pricing pressure easing on the revenue side, and that just is what comes out of backlog. And remember, we have tremendous mix between our transformers business, our medium-voltage business and our high-voltage business, and that can mix around. But right now, I'm not claiming that it's going to ease and ease greatly in the next couple of quarters because these are long-cycle businesses. But it is very favorable that we see the input pricing on the order side actually being better quarter-to-quarter than what we’ve seen in the past, and that's a very good signal. On China rail and nuclear, I’ll look at Michel on this one, too. I don't think we have an uptick right now that we've seen in rail and nuclear. Though like our competitors and other people in the industrial sector, we have heard about this. Most of the time when you hear about something in China, it ends up getting done. So we would remain optimistic that you'd see that kind of investment and that kind of push. The last thing, the market share in the United States, I can tell you that those -- obviously, the tariffs and quotas have kicked in against Korean transformers. That has helped to ease the pricing pressure in the marketplace. It's too soon to say that, that's made a major difference in share gain. But it certainly has changed the composition of large power pricing for transformers in the United States.

Operator

Next question from Mr. Andreas Willi, JPMorgan.

Andreas P. Willi - JP Morgan Chase & Co, Research Division

First question on the cash flow and the guidance, what we should expect for the rest of the year. In terms of working capital guidance, you have the 11% to 14% range, but now mentioning in the press -- in the slide pack that it's going to be at the higher end. So in terms of how much of this hedging loss should we get back in Q4 and kind of what's coming later? The second question on power systems in terms of the outlook for large orders. It's been a while since we had a large order. And obviously, this year looks down pretty significantly on last year. Is there something in the pipeline for Q4? Or is this more a topic for next year? And then the Power Systems issues, you mentioned in India is that the big HVDC line you're building, were there execution issues?

Michel Demaré

Okay, Andreas, Michel here. I will take the first question on the cash flow. Listen, if you look at really the last 3 years of cash flow, unfortunately, we try to always change that, but fact is it's always the fourth quarter that kind of makes the whole year. And if you look in terms of statistics, it has been actually pretty stable. The last 3 years, we have generated between $1.7 billion and $1.8 billion of cash from operation between $1.3 billion and $1.4 billion of free cash flow. I don't see any reason why we can't at least do that this time, first of all, because we have a bit higher over-dues than we had last year the same period, nothing fundamentally the big names, but they're a little bit behind. We have some of this project execution that, obviously, drive the cash flow down. So all we can solve, it was execution. The more we reach milestones that we can bill the customers and get the money as well. So that is the second point that makes me feel quite optimistic that if you look at it from a free cash flow point of view, I think we should be able to generate between $1.4 billion and $1.6 billion in the fourth quarter. If we get that, that means that we would have a year-to-date, a full year kind of free cash flow at $2 billion or even slightly better than that, which should get us to this 70% type of conversion rate that I had already indicated in the Capital Market Day. Obviously, you mentioned the hedging. I need [indiscernible] more for that, because it really depends what the U.S. dollar will be doing this quarter. If the dollar keeps going up, that means that we might have more cash flow, not losses on realized derivatives. If it is stable, it might be a neutral event for this quarter. So that's a little bit difficult to do. The difficult part of this all balance sheet hedging, in fact, it should have never been reported as operating cash flow. But unfortunately, we started that 10 or 12 years ago. And so obviously, we are trying to be consistent here. But at least, we tried to highlight it to you, so you see the difference between the Q [ph] cash flow from operation and the cash flow that comes from hedging.

Joseph M. Hogan

Andreas, on the Power Systems large order question on this year and next, I'd tell you that we have a strong tender backlog. We've had some quotes on some rather large jobs recently in the $900 million to $1 billion range. It's really difficult to say with these things if they're going to stay in the quarter or move out. We might see something this quarter. We might see something in the first quarter of 2013, but certainly within that timeframe, within the next 6 months, we would expect at least maybe one of those to come through. On the India, the issues that we have in India have nothing to do with North-East Agra. Right now, the North-East Agra job is, I think, which you're referencing, has been progressing pretty smoothly for us. Okay?

Operator

Next question from Mr. Mark Troman, Bank of America Merrill Lynch.

Mark Troman - BofA Merrill Lynch, Research Division

Joe, Michel, it's Mark here from Bank of America. Three questions, please. First one, I guess the inevitable one on pricing. You gave some discussion, Joe, in the presentation. Just a little bit more color really what's going on in Power Products. Are there areas where you're really seeing very intense pressure still and the absolute price indices are still going down quite hard and other areas moving? Or is this more a kind of a uniform trend that you're seeing, stabilization? Related to that, it's very hard for us to get data on capacity in T&D. And I was wondering if you spotted any trends in terms of -- is capacity stable or going up or going down versus demand? Second question, just on China. You commentated power orders were up, I think 15, automation down. I just wondered how you saw the short-cycle developments in China, how they deteriorated through the quarter or got a little bit better. I know you talked about low voltage, but just a bit more color on where you think China is going in the mix there. And then finally, just on the wider early-cycle parts of your business, did you see deterioration of that through the quarter? We've seen some of that in the machinery markets, but just on, I guess, on the electrical side. Or was it fairly just a sort of a steady trend through the quarter that you saw?

Joseph M. Hogan

Mark, on the PP, I would just -- I would answer your question as what you mentioned in the latter part of it as it being more uniform. It's really hard to use that term when you think of PP because you have businesses in Power Products like medium-voltage switchgear. It's incredibly so international. I mean, it's all over the place. All these markets are different, the specifications are different or whatever. But those statistically tend to average out over the years to give you the kind of margins that we deliver from a quarter-to-quarter standpoint. We mentioned in the first quarter that we had some issues with medium voltage in China associated with rail and some different areas too. We still have those issues, but we've been able to diversify a significant number of those sales away from that piece and move it into the industry, and that's helped us. The pricing scenario there is different in that sense, and it's a little more stable. On the high-voltage side, you can see extreme pressures in price at times in the Middle East, but much different in Europe and the United States. So I don't see anything that, Mark, from a quarter-to-quarter standpoint is tremendously different, either above or below that. But I can tell you the trend is, when you talk to Bernhard and his team about this, is that we are, like in the Middle East, able to quote certain types of jobs and certain types of products that we wouldn't have quoted 1.5 years ago because the prices were too low. And so I think that's a positive sign, and that relates, I think, to your capacity piece. Whether it's capacity, Mark, or whether it's just sanity in the sense of some of our Asian competitors wanting to make money, but we certainly have seen a better rigor in the marketplace around price than we did if you go back 12 months or 18 months ago. On China and staying with that piece and what we saw in power and automation, in general, and short cycle is, as much as when you think about it, Discrete Automation and Motion was down 14% in the quarter in China. But actually, low-voltage products was up, okay? And when you look at drives and motors in DM and then the broad portfolio in low-voltage products, those are really our best short-cycle businesses. And so you have a contrary -- a comparison there. You have low-voltage products being up, you have DM being down. The one thing I can tell you in DM that we're sure of is a significant amount of that weakness has to do with renewables and, specifically, in wind. And so we know that, and we expect that to recover in the fourth quarter and the first quarter based on signals we get in the marketplace. But we think a lot of consolidation with OEMs is going to go on in China because of the pressure that’s been in that market. On low voltage too, you'll see that quarter-to-quarter, third quarter last year and third quarter this year, there is a marked improvement. But from first -- second quarter 2012 and third quarter 2012, it's flattish, okay, overall. And so the trend for low voltage in China is kind of sideways. And so our comments in our press release about China going sideways are pretty much a mix of looking at all these different businesses and which way they're going or whatever and said, some are up, some are down. There's no big material movements either way. In general, we see China flat to sideways. Then lastly, the early-cycle deterioration, it's really hard to tell anything when you start to come out of the summer. And so you have to -- you always be cautious about those August numbers that you see. As you get into September, short cycle, our short-cycle businesses in the areas that I mentioned, low-voltage products and also DM and whatever, 0 to minus 2, bopping around in that kind of a range over that period of time. Okay?

Operator

Next question is from Mr. Olivier Esnou, Exane BNP Paribas.

Olivier Esnou - Exane BNP Paribas, Research Division

So 3 questions, please. First, on the service business. So I understand you're doing some cleanup of past portfolio to increase the margin. But when I look at the P&L, the gross margin on service is still going down year-over-year. So I was wondering if it's the right way to look at it or not, and if you could comment on that? Secondly, on the Power System business and the execution issue you mentioned, Middle East and so on, do you get a feel that -- I mean, can you maybe explain a bit more what's going on? Is it just poor pricing in the beginning? Or is it more with how you're delivering the project? I just want to get a feel that we're not going into another type of issue like cable, for example, and that you have a good level of understanding and control over what's going on really. And lastly, I think I heard in the press call that you didn't see -- begin M&A out there. And given the strength of the balance sheet, I was wondering whether you were thinking about some cash return strategies that we've seen some of your peers doing share buybacks, special dividends, how do you think -- how do you feel about that?

Michel Demaré

Okay, Olivier. I'll take the first 2 maybe. On the service business, I think you have already given part of the answer because, indeed, you know that we are trying to scale back a little bit on some of these full-service outsourcing contracts that we're doing. And so these contracts first have a much lower gross margin than the life cycle services, and then there's some exit costs related to that as well that weighs a little bit on the gross margin. That is one part. There's also a bit of a mix issue here. For instance, the turbo charging service is a little bit weaker this quarter, and it is a service business that has a very good gross margin. So you can see here some difference if you have a little bit more robotics, a bit less turbo charge that makes a difference. But we are still in the transition deal. There were -- although service orders are now up 9%, it's like a combination of life cycle services that are up double digit and the full service contracts that have actually declined. And so you are not seeing yet the full potential of the gross margin as we hope to show it once we have a clean portfolio there. As far as the Power System execution is concerned, indeed, I think you can't really talk here about the systemic thing because not only is it in different countries, but it's also in different business units. Some of these issues are in substations. Some of them are in Power Generation contracts. So it is a poor pricing for sure, if you see it from the backlog that you compare to the type of margins that we got into these businesses a year ago. But then after that, it's a couple of project management issues and delay in execution. But since it is really disseminated in different geographies, different business units and even different product groups, you can't really see it one issue that is all generated by the same business group. So we have to address it, but I really don't think it is anything systemic here, given the diversity of the problems.

Joseph M. Hogan

Olivier, on the M&A outlook and the subsequent cash, the question is -- we -- what I'm saying is, I don't see anything coming up in the near term, which should be in the fourth quarter, that would be to any large extent, in the $1 billion range or so. We do keep, obviously, a good growth forward process to understand where opportunities might be. And if we see something or something materializes, I mean we'll certainly have the balance sheet to able to pursue that, but I’m not projecting anything now. I think when you start to get out ahead of us, and you start to look at how much cash we’ll generate and what that might be on the balance sheet and how we look at either special dividends or stock buybacks or whatever, just remember, our cash preferences really haven't changed really since Michel and I have been working together. We start with having -- keeping our dividend and keeping a -- maintaining our dividend and, hopefully, bringing it up every year is a key area. I want to make sure that we have enough for CapEx and enough from a restructuring standpoint to do the things we need to do to make the business operate. Next in line comes M&A and what makes sense. And then after that piece would be any kind of special cash dividends or whatever. It would have to be considered at that point in time.

Michel Demaré

Yes.

Joseph M. Hogan

And that's as good as I can do, Olivier.

Michel Demaré

Yes. As we always say, the best mitigation of risk management is to have a strong balance sheet. That always helps.

Olivier Esnou - Exane BNP Paribas, Research Division

Okay. Can I just have one follow-up on the first answer? This cleaning, how long should that last of the past Power Service contract? When will we start to see gross margin going up again in service?

Michel Demaré

Yes, it's difficult to say because first we're not -- we are not going to go completely out of the full service. We'll just be more selective on the industries and the kind of contracts we want to take. So it's not that every quarter we'll have an issue like this. But I think over time, the relative weight of the full service compared to life cycle service will be diluted. So we should really start seeing some progress there. Let's not forget also, we are really pushing service in all the divisions. For some divisions, it is really starting from a low base, which means you pay a certain entry point with a gross margin that you still have to build. So I think it takes a while to start picking up, but we're quite optimistic that we should soon see tangible improvements that will start showing up in the gross margins as well.

Operator

Next question, Mr. James Moore, Redburn Partners.

James Moore - Redburn Partners LLP, Research Division

I have got 3 questions, if I could. On order pricing in PP, you talked about the same 3.5% level. When we go back to last year, I see that the comp was 50% easier. It went from minus 5 to minus 4.5. And I may be reading too much into this, but has there been a touch of a sequential drop-back in order pricing? And can you talk through regionally and product-wise what the trends are there? In automation, I think I get the sense that pricing in revenues in DM has come back a touch. But in LP, it's gone up a bit. Can you give us a rough feeling for what the percentage numbers are for year-on-year pricing in the 3 automation divisions? And then thirdly, R&D sales investment, will you pull back on sales feet on the street given your comments about pushing on savings harder given the macro? How should we think about that number next year? If it's roughly a 500 million headwind this year, how does it look next year?

Michel Demaré

Okay. James, I'll take the first one on the order pricing. So if I compare it sequentially, the 3 categories of Power Products, so high voltage, medium voltage and transformer, are really showing the same trend than what we reported last quarter. And actually even a year ago, it was not a big difference. We were also talking about 3% to 4% or maybe now, a little bit more. It was 4% to 5% a year ago that we had reported. So there's a slight improvement in transformer pricing and a bigger improvement in high voltage compared to a year ago. But compared to the Q2, the 3 segments is, more or less, getting the same impact that what we saw in Q2. For automation, you are right. We see a little bit a pricing deterioration in DM. I think that is also a little bit the impact of the weakness of low-voltage drives in China. That is the renewables demand that Joe mentioned before. So DM is no more contributing a positive impact to pricing. It's not a disaster, but it's a small delta compared to last time. And indeed, LP is now catching up on some price increases that were announced a few months ago. And that, combined was the fact that they initiated some additional cost savings after the first quarter, which you remember was a bit of a crisis, that has helped them now restore the margins to the levels that we have been used to see them deliver.

Joseph M. Hogan

James, on automation pricing, when you take PA, which is the easiest right now, we're not seeing any major deterioration in price there. It goes across a lot of different industries. The biggest issue you have in PA always is how much product comes through in a quarter and how much systems comes through in the quarter. That's primarily why you see that 0.7, 0.8 difference in those 2 businesses year-on-year. When you get to LP, as I mentioned, we think we can get 1 point, 1.5 points of price in that business. Tarak and his team have done well in driving that. That's not saying that we have a robust marketplace in order to push price in out there. It's just the team has gotten much better at understanding selectively where we can get price and being able to hold pretty well in areas where we might have some competition. So it really comes down to Discrete Automation and Motion. And again, I would tell you that within the whole portfolio, and when we talk about that portfolio, you have to think about you have medium-voltage drives, you have power electronics, you have robots, you have generators and motors, and you have drives. And these all have different margin components to them. When I look at those, when I think about the market-backed pressure that we see in those businesses, James, it basically hasn't changed. And when you see a margin drop like this in DM from quarter-to-quarter, it's mainly a mix. It has to do with mix of, in this case, a little more robots, which is still a good margin with drives, which has the highest margin within that business. So in general, don't interpret that as a deterioration in the market out there. It's more in the kind of businesses that are flowing through the income statement and how that mix adds up. I think your last question, James, had to do with the sales and R&D expenses that we show $129 [ph] for the quarter. You should start to see those iron out as we get into 2013. There's a lot of charges that are stuffed in there, it does. So I would say there's a certain amount of adult supervision that you have to use with those numbers. But in general, year-over-year, those are investments that we've made in our sales forces and we've made in our R&D. Some of that have to do with -- we put a lot of salespeople in the Southeast Asia, in different parts of the world, in low voltage in different areas where we haven't had that before. Sub-Sahara Africa, we're seeing some good returns on investments that we've made in that area, too. And in R&D, some of the cost savings that you see in the cost savings side is driven hard by R&D in the sense of redesigning products and putting us up in a position to be more competitive rather than single sourcing, dual sourcing. All that takes R&D work to be able to put that together, too.

Michel Demaré

And I think it is slowing down, James. If you look this quarter, the impact is 120 to 135 in Q2 and 145 in Q1. So you see we are trying to also slow down a bit the pace there.

James Moore - Redburn Partners LLP, Research Division

Could I get back to the order pricing just sequentially? Am I right in saying that it's still flat in Power Products sequentially? And does that -- is that the same through the 3 areas of high, medium and transformer?

Michel Demaré

That's what I said, it's the same, yes. So flat meaning it doesn't accelerate or it doesn't decelerate. [indiscernible] 2% impact.

James Moore - Redburn Partners LLP, Research Division

And all 3 are the same?

Michel Demaré

All 3 are the same.

Operator

Next question from Mr. William Mackie, Berenberg Bank.

William Mackie - Berenberg Bank, Research Division

Will from Berenberg. Three questions, if I might. Firstly, can we go to your biggest market, North America? It seems you've had good integration success with Baldor in the past and now, Thomas & Betts. But perhaps you could throw a little color on how that business and how the region is traded through the quarter. It seems that some businesses in your peer group have seen a slowdown ahead of uncertainty around the elections and the like going into next year. And then coming down to process automation, perhaps given the importance of the metals and minerals and marine end markets for you, and where a number of your peers, again, have seen some quite sharp drops in intake, how do you feel about process automation business going into the back end of this year and into 2013, given what's happening to the end markets? And lastly, in Europe, really great, great result in Southern Europe, really an anomaly against many of the companies we look at. So perhaps, you could just highlight how you've achieved that? And specifically, what's happening in places, like Italy, to allow you to achieve growth?

Joseph M. Hogan

Well, I'll take the first one, Michel will take the second, and then I'll follow-up with what we see in Southern Europe. On the Thomas & Betts and Baldor, I'd tell you that we do got to get a better look at that marketplace because we do have a much stronger footprint there now with those 2. We still see year-over-year growth by quarter in both of those businesses, in both Baldor and both Thomas & Betts. But we have seen a slowdown. There's no mistaking that we don't see the same growth in Baldor that we did this time last year. The comparisons, obviously, are very difficult, but we still see growth in that business. And Thomas & Betts growing about 4 is in line with what they projected, but they would tell you that they felt that the market was a little bit slower in the third quarter than what they experienced in the second quarter, too. So I think the best thing is the -- to talk about that is the uncertainty that’s in the market, once we get past the presidential elections. Hopefully, that would clear up in some way. I think to keep in mind, too, that there are some signs that the construction market's coming alive in the United States. We'll have to keep our eyes on that, but that would obviously be a positive development, too.

Michel Demaré

Then on the process automation, you are right, it was a pretty good quarter in marine and in minerals, which is not always what you read there. And I think it's also important to understand that if you take a business like minerals, we don't know always serve the -- only the CapEx of the customers. There's also a lot of OpEx that these customers spend, including maintenance and service where we have a pretty strong business there. So I think there's 2 reasons first, because we can reach this OpEx portion of the customer spending. And second also, because we still have a market share that I think can be improved quite a lot with the big players in the industry. And so having a smaller market share, it's probably a bit easier to be resilient in this kind of industry when the CapEx starts to be cut down. Marine is still pretty strong. So that is indeed the 2 businesses that are supporting the business for the moment. We have a bit of a weaker quarter in oil and gas and as well in pulp and paper and in turbochargers. But marine, metals and minerals have helped the division to produce the kind of results they are showing here.

Joseph M. Hogan

And Will, on Southern Europe, when you look at Italy being up about 3% or whatever. Will, I don't know -- I'll ask Michel too if he knew. But I know that in low-voltage products, we felt good about breakers in that area, too, exactly where those breakers are going. Industrial versus commercial, I'm not quite sure. But in general, I can't tell you where exactly it comes from, but I look at it more as coming in our shorter cycle businesses than our longer-cycle businesses.

Michel Demaré

Yes. In fact, if I look, for instance, Italy, we were up in Italy almost 20% in the DM division and almost 20% in the Process Automation division. So what you see there, too, Italy still has a pretty robust export industry. And it seems to start reviving a little bit and taking some orders. So the combination of this country is basically, Italy is up; Spain is still down because of the major economic issues are more local like real estate. So I think that will take a little bit more time to happen. And France is about stable, flat. So it's really Italy that has made the difference here and especially on the automation side.

Operator

The next question from Mr. Martin Wilkie, Deutsche Bank.

Martin Wilkie - Deutsche Bank AG, Research Division

It's Martin from Deutsche Bank. A couple of questions. You mentioned earlier about the renewables impact in the Discrete business. But I just had a question more broadly on transmission. We've seen some noises in Germany and also the U.K. that feed-in tariffs and some of these other incentives for offshore may get toned down. And obviously, we know in the U.S. that PTC is expiring. Are utilities already talking to you about what they might do with the CapEx plans related to offshore in the U.S. and in Northern Europe? Or is this something that utilities are really waiting to see what happens to the rules before really making that decision? So that was question number one. And the second question, you talk about selectivity in orders in the Power Products business. Is the scope of orders are of acceptable margin to you? Is that still of broadly constant size? Or do you feel that, that selectivity is going after an ever decreasing market, as some of the competitors get a little bit more aggressive?

Joseph M. Hogan

Martin, on the renewable piece of the feed-in tariffs side, yes, I think the utilities, like with all government changes or regulations or whatever, they're not exactly sure what's going to happen. And each one of these countries, it's different. Germany's wrestling with a different issue than what the U.K.'s wrestling with. And when you talk about offshore also, remember not all of what we talk about offshore is wind. Often, what we're doing offshore is we're connecting one grid to another. And that has just to do with grid reinforcement more than it had to do with dragging renewable energy from a coast based on the wind side. But I think, Martin, specifically to your question, the U.S. has basically no offshore wind business at all. And so that's not an issue there. Anything we quote is usually land based, and those land-based areas are FACTS related some time. Some aspects are static, part compensation. And then within the HVDC area, we had an order in HVDC some -- for renewables in Texas this year down there, too. So I don't know if I'm answering your question, but I mean there's -- obviously, there's a lot of anxiety in the marketplace right now in the sense of if the U.S. are going to increase their production credits or continue their production credits, what's going to happen with offshore? Right now, we have no indication which way that's going to go. On the PP...

Michel Demaré

On the Power side, you want me to take that one, Joe?

Joseph M. Hogan

Yes, Michel.

Michel Demaré

Okay. So I would say for sure Power Products and also Power Systems are as selective as they can on the order intake to make sure that the margin is there. So that has an impact also on Power Product in terms of how much they sell to Power System, which is down quite a lot. If you look at the utilities, let's say, that channel has been more or less flat this quarter. But it's a combination of pretty weak on the distribution side. But in fact, transmission orders were up for this quarter there. And then we still see some good, robust demand from the industry. So you see it's a little bit of a mixed bag. Selectivity is one place and a bit diversity of channels, which is always what the -- helps the division to be resilient when utilities start delaying some of the projects.

Operator

Next question is from Mr. Fredric Stahl from UBS.

Fredric Stahl - UBS Investment Bank, Research Division

It's Frederic here at UBS. I just had one question actually. I was wondering if you could give us a bit of color on the low-voltage margins. They were quite a bit better than what I expected in the quarter and obviously up quite a lot on the earlier previous quarters here.

Michel Demaré

I mentioned it already before. I think there's still some positive effect of price increases that have come through and helped a little bit the top line. But especially, they have increased, quite significantly, the amount of savings they realize, which is one of the conclusions we have taken after the major slowdown that we have seen in the first quarter. And I think this big effort on the cost control is starting to pay off now. And also, a bit of a better pricing from a revenue -- a better mix from a revenue perspective, so a bit less systems revenues of products coming back a little bit.

Fredric Stahl - UBS Investment Bank, Research Division

So it’s fair to assume it's sustainable, or will that be...

Michel Demaré

Well, it's sustainable with the exception as we pointed out that, obviously, the short-cycle businesses are slowing down a little bit. And as you know, that is a business that is high book to bill. So it will depend a little bit on the next month's develop in terms of order intake for short cycle, like wiring accessories and control products.

Operator

The last question for today is from Mr. Mark Fielding from Citigroup.

Mark Fielding - Citigroup Inc, Research Division

Actually again, I'm afraid, 3 questions. Firstly, just in terms of process automation, it would be helpful --last quarter you indicated that an improving margin trend was something you felt was a sort of a sustainable pattern, and obviously, you've taken a step back. You think it's mix related. So just maybe some commentary on whether that mix issue could continue into the fourth quarter or whether you really think it's a one-quarter issue? Secondly, hopefully, a very simple one, just the tax rate looked a bit lower than I expected in the quarter. Maybe some thoughts there on the full year number. And then thirdly, just I'm afraid coming back on the sequential pricing issue, just trying to get my head around that a bit more. Last quarter, you actually quite helpfully gave us a number for the sequential pricing change. I think it was marginally up sort of 1%. Maybe a similar sort of commentary on this quarter in terms of the sequential price impact in the group as a whole.

Joseph M. Hogan

Okay, Mark, first of all, I'll take the PA piece. We do feel that our PA long-term trends, from a margin standpoint that we can push those up over time. We're confident about that, and the plans that we have in place is part of our strategic plan in order to do that. A big part of that plan is end up you having less systems and more product as part of that whole piece. But along the way, we are going to mix up and down periodically as we have done this quarter, as some of this systems business that we take flows through, as I mentioned before. But if you took a line and you drew it now, and you draw it out for the next 2 years, we feel pretty confident we'll be able to push process automations’ margins up, primarily because of product and really driving better margins on product and a higher percentage of products within that business as a percentage of sales with systems. Michel, on the tax rate?

Michel Demaré

Then for the tax rate, you're right, it was a good tax rate this quarter. Sometimes it depends a little bit on timing of tax audits. You get these tax audits. If they are positive, you can release some tax provisions. That has obviously helped this quarter. We keep our guidance of a 27% tax rate for the full year, and I'm quite confident we can achieve this. The third question in terms of sequential pricing, I don't want to enter too much into that. But I would say my feeling is that it has been stable compared to Q2 since the rates on a quarter-to-quarter basis are more or less the same. I think that you could also deduct from there the pricing sequentially as remains stable.

Joseph M. Hogan

And with that, Michel and I thank you for your questions and your interest. We'll be back to you at the end of the first -- or fourth quarter to give you the fourth quarter update, along with the total year summary. So thanks again, and have a good day.

Michel Demaré

Thank you. Bye bye.

Operator

Ladies and gentlemen, the conference is now over. Thank you for choosing Chorus Call, and thank you for participating in the conference. You may now disconnect your lines. Goodbye.

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