Eaton Corporation plc (ETN) — Q3 2015 Earnings Call Transcript

Good morning. I'm Don Bullock, Eaton's Senior Vice President of Investor Relations. Thank you for joining us for Eaton's third quarter 2015 earnings call. With me today are Sandy Cutler, Chairman and CEO; Craig Arnold, Chief Operating Officer and President; and Rick Fearon, Vice Chairman and Chief Financial Officer. Our agenda today includes opening remarks by Sandy, highlighting the Company’s performance in the third quarter along with our outlook for the remainder of 2015 and some preliminary thoughts on 2016. As we’ve done on our past calls, we’ll be taking questions at the end of Sandy’s comments. The press release from our earnings announcement this morning and the presentation we’ll go through today have been posted on our website at www.eaton.com. Please note that both the press release and the presentation include reconciliations to non-GAAP measures. A webcast to this call is accessible on our website and will be available for replay. Before we get started, I’d like to remind you that our comments today do include statements related to expected future results of the Company and as such, should be treated as forward-looking statements. Our actual results may differ materially from our forecasts or projections due to a wide range of risks and uncertainties, which are described in both the earnings release, the presentation, and in the related 8-K. With that, I’ll turn it over to Sandy.

Great. Thanks, Don, and I’m going to work from the presentation we posted earlier this morning. If I could ask you all to turn to page three of that presentation that’s entitled highlights of Q3 results. A couple of comments in terms of our third quarter results. We’re particularly pleased with our margins; we’re especially pleased with the great cost control and all the restructuring work that’s going on across the Company. This has allowed us to offset the lower volumes that we had outlined in our earnings revision just a week and a half ago, as well as more negative foreign exchange impacts. The big news is that we continued to see weaker markets. As you noted, our weaker bookings have really caused us to drop our second half guidance. I’ll talk more about the implications for that for 2016 as well. Our operating earnings per share reported this morning at $0.97 was in line with our revised guidance. Our sales were down 9%, with 6 points of that decline due to foreign exchange, while the other 3 points were due to organic revenue decline. Segment margins of 14.5% were a bit below the 15% we had initially guided for the third quarter, largely due to the volume impact being lower than expected. The very good news is that when you take out the net restructuring impact, our margins were 16.2%. The net restructuring costs – that’s costs minus benefits – totaled about $98 million in the quarter, about $8 million higher than we had provided in our guidance. So that’s all really due to timing, and as you see as we talk through those results this morning, we’re quite pleased with the overall restructuring program and it’s actually going to drive even more benefits than we had originally shared. We reported a quarterly record operating cash flow of $973 million, which reflects our focus on improving profitability and effectively managing our working capital. During the quarter, we bought back approximately $284 million of shares, bringing our year-to-date repurchases to $454 million. That represents about 1.5% of our outstanding shares, and in 2014, we also bought back approximately 650 million shares. If you could turn to the next chart entitled financial summary. One number I wanted to reference is that our organic sales were down 3%. If we look back at the second quarter, our organic sales were up 1%, and that clearly demonstrates the downshift we’re seeing in several of our end markets. If we turn to the next page and discuss our five reporting segments, I’m on a page titled Electrical Products Segment. We had really great margin performance in this quarter, reporting 18.5%. Excluding the net restructuring costs, the margins were 19%. This demonstrates our strong performance and margin position in this business. This segment represents a third of our Company, so it’s very significant for us. Bookings were flat this quarter, and over the last several quarters, you’ll remember that in the second quarter, bookings were 4%; in the first quarter, they were 5%; and over the previous year, they were 4%, 5%, or 6%. Thus, we’ve clearly seen a downshift. Discussions with many of our distributors around the world indicated that they have been experiencing a slowdown in their end market demand, and they’re currently hesitant to build additional inventory in this soft environment. Although the Americas and Europe remain positive, Asia was particularly weak, not just in China but across the region. We communicated in our second quarter conference call that we would share with you specific restructuring costs and benefits by segment, and they are detailed here. Therefore, I will refrain from repeating them. In terms of bookings, the strength has traditionally been in the residential market here in the U.S. and in lighting activity, with notable weaknesses in industrial and oil and gas. In the Middle East and Europe, the Middle East is performing well, and we also saw decent demand in the single-phase UPS market. Yet, overall, Asia remains weak across the board and is primarily responsible for total bookings being flat rather than slightly positive. Moving on to the next chart labeled Electrical Systems & Services Segment, this is another large segment, accounting for about 28% of the Company. Looking at this particular chart, I want to call out a couple of items. Once again, the organic growth was negative; down 4% last quarter and down 5% this year. Bookings decreased by 3%, and examining trends over the last several quarters, we observed a 7% decline in the second quarter while the first and fourth quarters were both flat. This segment has been experiencing persistent weakness; our Crouse-Hinds business, which has significant oil and gas exposure, is one contributing factor. We’ve also seen a downturn in the power quality market and flat conditions in the utility market. Large industrial projects within the construction sector remain weak, which negatively impacts this business as well. Bright spots this quarter included a substantial increase in our systems business bookings. We typically anticipate this trend in the third quarter, as much work is completed during the fourth quarter for many of our clients, both on the private and government sides. We had a solid quarter of bookings in this area despite relatively flat conditions in the utility space. Our three-phase UPS business, which usually serves larger installations, also had a good quarter of bookings. However, Crouse-Hinds experienced significant downturns, affecting overall margins. In terms of margin comparisons between the third and fourth quarters, margins reported for this quarter were 11.2%. Excluding restructuring costs and benefits, they were 12.8%. However, that’s approximately 180 basis points lower than last year, largely due to the factors I outlined regarding bookings affecting mix and activity. Next, on the chart labeled Hydraulics Segment, which constitutes about 12% of our Company, we have not much new news here, as markets globally remain weak, particularly in commodity sectors. We saw bookings down 13%, with little variation between regions or between OEMs and distributors. Weakness in the mobile area continues to be significant, particularly oil and gas on the stationary side. In the last quarter, organic growth was negative 11%, and it is currently negative 10%. The magnitude of restructuring we are executing in this business reflects the market weakness, significantly impacting reported margins. Moving to the next chart concerning Aerospace, which is 9% of our Company, we had a solid quarter. Margin performance, including the 17.6% reported or 18.7% excluding restructuring costs, reflects positively; however, bookings were down about 16%, consistent with most aerospace companies this quarter. The order placement activity for both commercial and military OEMs was weak. One bright spot was in the aftermarket, which was up solidly by 11%. We’re making progress towards achieving the historic mix of roughly 40% of total sales from the aftermarket. Restructuring efforts in this area remain lower, primarily because programs are tapering off. Moving to the next chart regarding the Vehicle Segment, which makes up approximately 18% of Eaton, we had another strong quarter in margin performance, reporting 15.2%, and 18.2% when excluding restructuring costs. Organic growth was negative 3%, compared to negative 4% last quarter. We are witnessing a decline in the NAFTA heavy-duty truck market build. Commenting on this briefly, our forecast for the year was 330,000 units, which we now expect to drop to 325,000. The anticipated production rate for the third quarter was approximately 83,000 units and we expect it to decrease to about 74,000 units in the fourth quarter, indicating an 11% quarter-to-quarter decline. In chart 10, we see our market reviews for this year, and we expect our organic revenues to shrink by about 1%. This comes as a result of our markets shrinking approximately 2% compared to 2014, allowing us to outgrow them by about 1%. We’ll be glad to address specifics later. For segment operating margin expectations in 2015, while we’ve previously provided margin guidance without considering restructuring costs or benefits, this new guidance accounts for the restructuring impacts. Electrical products margins are affected by about 20 basis points, with Electrical Systems and Services also at 20, Hydraulics at 80, Aerospace at 20, and Vehicle at 60. The consolidated total is an impact of 30 basis points. The most significant restructuring is happening in the Hydraulics and Vehicle segments. Moving to the next chart, I’d like to elaborate on the restructuring efforts to ensure clarity. Our program is on track with the actions previously communicated at the end of the second quarter, producing even more savings than initially shared. We are reducing our workforce by about 2,900 employees and closing eight manufacturing plants. On this chart, we display the costs and savings, illustrating that we experienced a net cost of about $8 million higher than expected in the third quarter compared to our original plan. We expect to see slightly higher net savings in the fourth quarter. Moving on to 2016, we’ll incur about $5 million more than initially estimated but will achieve around $20 million more in savings. Our total restructuring program will result in costs of roughly $153 million, up $8 million, with savings of $150 million. This program will yield year-to-year benefits of $138 million from 2015 to 2016 and $190 million from 2016 to 2017. However, while we anticipate these benefits, please plan around a midpoint estimate because we will likely undertake normal restructuring actions in 2017 as well. I hope this explanation has been helpful, as it’s important in understanding both the initial and the second set of actions. The need for these additional actions is due to market conditions falling off faster than expected in 2016. Next, moving to the chart labeled Operating EPS Guidance, our guidance for the fourth quarter is between $1.05 and $1.15 operating EPS. The two most significant items contributing to this are our expectation that organic revenues will decrease by another 3% from third quarter levels and the tax rate will range from 5% to 6%, which is lower than in prior quarters because we expect a reduced mix of income from high-tax countries. The prudent actions initiated earlier this year will result in a net restructuring benefit between the third and the fourth quarter of $123 million that contributes approximately $0.25, enhancing our fourth-quarter run rate. This brings our full-year guidance to $4.20 to $4.30 EPS, inclusive of the net restructuring charge of $73 million. In the final summary chart for 2015, we see that our previous expectation of organic revenue growth was zero to negative 1%, and we are now anticipating negative 1%. We have been diligently managing all expenses in the Company, including pension, interest, and general corporate expenses. Our updated estimate for such expenses is now $30 million below last year, which is more than previously shared. Our guidance for operating cash flow is still between $2.4 billion and $2.8 billion. In addition, we have reduced our capital expenditures by another $100 million. So, we revised our free cash flow guidance upwards to between $1.9 billion to $2.3 billion. Moving to the next chart, we’ve covered most of these points. The outlook reflects our expectation that organic growth could be at around 1%, assuming our markets reduce further. The restructuring program is expected to impact operating margins by over 30 basis points. We have repurchased 7.2 million shares through the third quarter and anticipate paying down a tranche of $600 million of debt in November, which is great news given our strong cash flow. This positions us well for further share repurchases in the fourth quarter if deemed prudent. Lastly, looking forward, there’s a lot of uncertainty regarding the implications of the second half slowdown and its effect on 2016. We expect our markets to decline slightly compared to this year, probably in the range of 1% to 2%. This year, we experienced a 2% decline. The best assessment, though preliminary, suggests the electrical business is likely to increase slightly, hydraulics will face another downturn of approximately 7%, aerospace will continue to fare well at about 3% growth, and the vehicle division is forecasted to drop about 5%. In the North American heavy-duty Class 8 market, we expect a 15% decrease from this year’s figures of 325,000 units. Thus, it’s prudent for us to plan based on a negative 1 to negative 2 outlook. We will share additional insights as we progress through our profit planning for the forthcoming year. Following this, I will turn things back to Don for questions.

Before we begin the Q&A, we do have a number of individuals queued with questions. Given our time constraints of an hour for the call today and our desire to get as many of those questions voiced, please limit your questions to one question and a follow-up. Thank you for your cooperation. With that, I’ll turn it over to the operator to provide guidance on the Q&A.

Can you share your perspective on your benefits from price cost in the quarter? More importantly, what do you foresee regarding potential price weakness in some of your markets as you look ahead to 2016?

I think let me start with the commodity side. We continue to believe we’re in a period of weak commodity prices which is influencing some demand in our hydraulics business, and we don't anticipate significant pricing actions being successful in the market. Thus, we remain neutral on this front. The key is going to be to understand when the commodity pressure starts to return. As it stands, we haven’t seen any evidence that would indicate a change at present.

And can you quantify the benefit that you saw this quarter on price cost spread?

I wouldn’t say we were seeing a significant benefit; we typically keep our pricing closely aligned with commodity prices. Therefore, we haven’t been achieving significant net price increases.

And just quickly, any color you have for us on U.S. non-res? I mean it seems like it's still reasonably good but your outlook there?

On the light side, it continues to be quite strong and mirrors residential demand. However, on large commercial projects, the activity isn’t as strong. The industrial large projects remain weak. Based on the Dodge reports, bookings weakened throughout the quarter, but we don’t anticipate seeing a negative number from non-res. However, we do believe it may not grow as quickly as it has been.

Our next question comes from Steve Winoker with Bernstein.

Couple of questions. First, on the 2016 thinking, assuming that organic growth does come in, let’s say flat at best or a little bit down for you specifically, what kind of incremental margins do you think you can hold excluding the restructuring and excluding the Cooper synergies?

You’re right on point with the question, Steve, and we haven’t tuned it formally yet. Given the current cycle, we’ve historically maintained about 20% decrementals; however, we think it’s more on the order of 30% now. As we finalize our planning, I believe that’s something to use for forecasts.

And then on the Cooper side, am I correct in looking at the $45 million of integration savings you put on slide 17; is that comparable to the $115 million you discussed before?

Yes, you are correct. However, we are experiencing lower synergies as we reach the end of the four-year period due to lower volumes, scaling effects on procurement, and negative capital expenditures, which also impacts synergies. Furthermore, the oil and gas industry and other regions have slowed significantly more than anticipated. Thus, a more realistic estimate for next year’s synergies is now about $45 million.

Is most of that cost savings being realized now or is there any revenue in that $45 million?

Most of it is coming from large plant closings that we’re finalizing.

Our next question comes from Ann Duignan with JP Morgan.

Just a follow-up, quick question on the Cooper synergies. Can you just remind us, Sandy, what were the synergies for 2015 versus the $150 million that was expected?

We believe they will be around $135 million versus the expected $150 million, and next year’s synergies are projected to be $45 million compared to the initial forecast of $115 million.

And then my question is really around Brazil and the impact that financing programs might have on, particularly on your vehicle business. How are you thinking about that both into year-end and for 2016?

We’ve been bearish on the Brazilian economy for a couple of years. Even though they are seeking ways to stimulate the economy, we expect Brazil to continue weakening next year relative to this year due to numerous macroeconomic issues that need addressing.

And that’s embedded in your hydraulic outlook I presume? Are there any other businesses?

Yes, we’re expecting impacts in both the hydraulic and vehicle segments.

Our next question comes from Jeff Sprague with Vertical Research.

I was wondering, first just on working capital, Sandy or Rick, if you can give us a little bit of color on how much you actually got out in the quarter and what kind of opportunity that presents for next year?

We reduced working capital by just shy of $300 million from Q2 to Q3 through focused efforts on receivables and managing down inventory. We believe there are still significant opportunities for further working capital liquidation next year, especially since sales declines have made it tough to keep inventories aligned.

And then flipping it more to the customer level, Sandy, you made a comment about inventories at the customer level. Do you think your customers are properly sized to the current state of end demand or is there still more inventory liquidation that needs to occur in these channels?

Regarding distributors, I agree with your observation. They may have been over-purchasing inventory in the first two quarters, and as demand weakened, they are now trying to reduce their inventory levels. We believe they still have some work to do before they reach optimal inventory sizes. For end markets, while several have been weak for a while, we expect some to realign. Nevertheless, in declining markets, it often takes time for businesses to adjust accordingly, influencing our forecasts for negative growth next year.

Our next question comes from Julian Mitchell with Credit Suisse.

Your focus on capital deployment appears to be largely centered on buybacks. However, if we take a broader view, the earnings per share has declined somewhat, and next year's earnings are projected to be around four. I'm curious about your satisfaction with the current portfolio state, or do you believe that it makes sense to reduce costs to support buybacks, and then possibly reorganize the portfolio when the macroeconomic situation becomes clearer?

While we are monitoring a variety of operational efficiencies, our primary focus is responding to the current market dynamics and managing costs at the corporate and business levels. We feel it is vital to prepare for productivity growth in 2016 over 2015 by securing proper costs now. That said, we maintain the ability to evaluate portfolio changes as opportunities arise, but today, our main goal is to streamline operations.

And then just a follow-up on the ESS business; the margins are under pressure for those volumes I guess. Is anything occurring there on pricing concerning large projects, or is it primarily a volume-driven mix phenomenon?

A couple of factors are at play here. First, our guidance for oil and gas revenue decline was around 25%, which has come to fruition particularly in the second half of 2015. Although we saw some early bookings weakness this year, that impact is now processing through our shipments. The procurement prices are experiencing more competition, also further impacting margins. While we see some promising projects that could provide solid deliveries next year, industrial construction for major projects has been weaker this year, which complicates our margin situation.

Our next question comes from Jeff Hammond with KeyBanc.

So, I know it’s early on 2016, but can you give some insight on the segments? Given the drop in orders in electrical, what is your level of confidence in achieving growth there?

We are currently deep into our planning and are meticulously examining every detail. The biggest concern lies with distributor destocking’s impact on the electrical segment. Ultimately, at some point, this trend will reverse, and we will surpass this negative influence. While I anticipate continued growth around residential, we need to finalize our reviews of these sectors to gain better insights for next year’s guidance.

Next question comes from Deane Dray with RBC.

With regard to the second phase of the restructuring plan, was there any consideration to implementing some of that now in the fourth quarter and getting a jump start on this?

We’ve certainly considered that option, Deane, but the capacity to execute a large-scale restructuring all at once was a concern. We believe we’re executing the first group effectively, and we’ll initiate the second group most likely in the first quarter, so we’ve positioned ourselves better by segmenting this workload.

And then just to understand how the third quarter played out, can you share with us the cadence of the months in terms of organic performance, and how you realized you needed to negatively pre-announce?

We noticed during both July and August that trends were slow, and by the end of August, we realized that a strong September was essential. Although September strengthened, it didn’t reach our expectations. Component by component, liquidity remains a significant focus as we face typical seasonal strengths. Our observation of the broader markets made us realize we needed to be proactive, hence the negative pre-announcement.

Our next question comes from Shannon O’Callaghan with UBS.

Maybe one for Rick, just initially. You talked about the UK tax change; you also have BEPS going on. Could you provide an update on the implications of recent global tax activity, and how we should consider its effect on Eaton going forward?

You're right to note these changes. Despite the BEPS initiative, some regions like the UK are lowering their tax rates. The impact for us from BEPS will mostly revolve around added compliance requirements and reporting needs for our operations in 2016. We think we have a strong plan to cost-effectively manage these changes. Furthermore, we anticipate increased audit activity as countries seek additional revenues amid their financial situations. Overall, the main driver of our year-over-year tax implications will likely be the mix of income sources, with our current expectation being that our effective rate could slightly rise from where it is presently.

And then on the hydraulic business, with the minus 8% organic guidance for the year, does it imply a somewhat better fourth quarter ahead of a decline next year?

No, and if we take a look at the trends from last year, Q4 in 2014 was also low. We are forecasting that Q4 hydraulics performance will be weaker than Q3, continuing the typical seasonal pattern.

Our next question comes from Nigel Coe with Morgan Stanley.

Sandy, I recognize that you’re still finalizing the plans for next year. However, if the situation doesn’t turn out to be a down 1%-2%, do you feel you’ve taken enough cost out to achieve earnings growth next year?

It's early in the process, and at this stage, we don’t foresee any hindrances affecting growth; however, we must remain vigilant regarding these elements as we move forward.

As we move into October, did some favorable trends from September carry through? What's your confidence level on the predicted down 3% for Q4?

Historically, we have seen major OEMs announce additional shutdown days before the holidays. This sentiment has surfaced in October, and thus our projection for down 3% for the fourth quarter appears more realistic in light of extensive seasonal adjustments. To be prudent, we plan on staying close to that 3% decline.

The next question comes from John Inch with Deutsche Bank.

Could we get a little more color on just the broad-based Asian weakness in electrical? What’s happening there?

Several factors are influencing this. Manufacturing in China is growing at a much slower pace than reported. Most infrastructure projects are being withheld, and manufacturing capacity is concentrated. Consequently, we’ve seen reduced activity in commercial construction, as related export activity like machine tooling has weakened. We haven’t observed much improvement in construction activity in China, and overall regional weakness has increased due to oil price fluctuations. Manufacturing across the continent is certainly restrained.

Sandy, since you’ve been CEO, you’ve seen a couple of U.S. recessions. From your perspective, how does the current situation differ? While your forecast for next year is a small decline, which feels not that severe, what rationale do you have for approaching it this way?

The difference lies in the absence of significant bubbles and a potential financial crisis. Banks are well-capitalized, and there’s no inflationary pressure on the horizon. Market activity in Europe seems to be gradually improving, while India is progressing, but it’s insufficient to create global impact. The major concern remains how China will influence overall economic growth moving forward. The possibilities are uncertain, especially with currency changes and their effects on market activities. We anticipate that industrial sectors will ultimately recover, making it crucial we manage costs and remain forthright about our forecasts. We will remain vigilant in monitoring commodity markets, construction developments, and MRO spending based on expected industrial activity. We believe that while residential and light commercial industries may continue to grow, a close watch on industrial divisions is necessary as these fluctuate.

Unfortunately, we have run out of time for our question session today. Thank you all for joining us. We appreciate your time and look forward to addressing your follow-up questions afterwards.