Eaton Corporation plc (ETN) — Q4 2015 Earnings Call Transcript

Good morning. I’m Don Bullock, Eaton’s Senior Vice President of Investor Relations. Thank you all for joining us for Eaton’s fourth quarter 2015 earnings call. With me today are Sandy Cutler, Chairman and CEO; Craig Arnold, President and COO; and Rick Fearon, Vice Chairman and Chief Financial Officer. Our agenda today will include opening remarks by Sandy, highlighting the performance in the fourth quarter along with our outlook for 2016. As we’ve done on our past calls, we’ll take 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. In addition, a webcast of 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 will include statements related to expected future results of the Company and are therefore forward-looking statements. Actual results may differ materially from those forecasted projections due to a wide range of risks and uncertainties that are described in our earnings release and our presentation. They are also outlined in the related 8-K filing. With that, I’ll turn it over to Sandy.

Great, Don. Thanks very much and thank you all for joining this morning. I’m going to work from the presentation that was posted at our investor portal earlier today, and for the sake of brevity, I'll start right on page three, the highlights of our fourth quarter results. As you saw, we exceeded the guidance we gave for our revenue guidance, and we achieved record fourth quarter segment margins. We generated $742 million in operating cash flow and we repurchased $228 million of our own shares. We think it was a very strong quarter in the midst of pretty choppy end markets, and I think it concludes the year on a strong basis. If you flip to the second chart, just a couple of the highlights in terms of the reconciliation to the midpoint of our guidance that we provided for the fourth quarter. You’ll recall the midpoint of our guidance was $1.10. Our volume came in just slightly higher than we had guided to you. Recall we had guided organic sales being down 3% from the third quarter; it actually came in at 2%. The net of our restructuring costs and our savings came in about $0.02 better; we got all the savings and more than we were looking for, and we actually done at a little bit less in costs. Our tax rate did come in a little bit lower, about $0.02, that’s 3.9% versus the roughly 5.5% we had guided to. And then our corporate expenses, reflecting that same orientation towards really getting our structural costs down that you saw also manifest itself in our very strong segment performance, contributed $0.02. So, a $0.07 peak for the quarter, a nice way to finish up the year. If we turn to Page 5, just the overall financial numbers I am sure you had an opportunity to study these. I would just reference one number in particular here because it does tie into a lot of our thinking relative to having increased our restructuring over the next couple of years. The organic growth number, which you see in the green box to the lower left of the chart, was down some 4%; it was down 3% last year. So, in our last quarter, third quarter, we actually started with a first quarter that was slightly up, and then in the second, third and fourth quarters, we've seen our markets weaken. Just a quick run through the individual segments and we’ll get on to the guidance for 2016, which I think most of you are most interested in trying to get some additional color around. Let's start with the electrical product segment that’s on Page 6. As you can see, organic growth was down 1%; it was actually flat in the third quarter. You can see very strong margin performance, 17.7% volume relationship to last year down 5%. And obviously, C4X was four points of that. Looking at the bookings, bookings were down 1% and it’s interesting if you look around the world, there are quite different conditions by regions. Americas were flattish, Europe was up nicely, and Asia-Pacific, both in this segment as well as in our system and services lateral segment, was down significantly. We think that reflects the real weakness that’s been going on in China, and we'll talk a little bit more about that as we go on in the call. Our net restructuring, if you’ll see, had a slight positive to the quarter, a good solid quarter, and as you get down within the individual area clearly we’re continuing to see strength in our lighting products. Our residential sector continues to be strong in the U.S., Canada is weak, the Middle East was quite strong, which was one of the things that helped Europe, and across Asia-Pacific, whether it would be in China or whether it would be in some of the electronic products we supply as well, it was a weaker quarter. If we flip to Page 7, the Electrical System and Services segment, we think had good performance, a nice rebound from the third quarter. If you look at the margins, they were up 13.9%. So one of the stronger quarters we've had this year in that segment. The story is much the same; however, in terms of the markets. If you look at the box in the lower left corner, again the organic sales were down 5%; it was down 5% last quarter as well and the bookings were down 2%. The play out is fairly similar; the real weak region was Asia-Pacific once again. As we have talked over the last couple of years, of course, we see that the bookings over the last couple of quarters are a fairly good predictor of revenue levels in the next several quarters, and so if you look back to the third quarter of 2015, our bookings were down some 3%, now they’re down 2%, and I think that will help you understand our thinking relative to markets when we talk about that and organic for 2016. If we move to the next page, Page eight, our Hydraulics Segment had very strong margin performance here as well in spite of very weak market conditions. You may recall that in the third quarter we reported organic sales down 10%; during the fourth quarter, they were down 12%. Our bookings were down 22%, and that's pretty much a worldwide story. If you go around, whether it would be the Americas or Asia-Pacific, the numbers are all negative and they’re negative also when we look at both the distributor and the OEM cuts. So these markets continue to be very weak, and I think our team has done a really terrific job in terms of really containing cost and driving structural change and that's why you see we think it was stronger than most people expected margins and a segment of 11.2%. If we move to Chart 9, the Aerospace Segment had a great quarter for the Aerospace business as it continued to have really very strong margins. Our bookings were up 6%, and we’re particularly pleased in the aftermarket, which is an area that we've been working hard to continue to bolster, with an increase of about 14%. There's been a lot of discussion over the last couple of weeks about what's happening in the commercial aerospace activity. We’ll talk a little bit more about that when we discuss our guidance for next year, but we continue to see that outlook being strong as we move into 2016 and 2017. If we move to Chart 10, our Vehicle segment had really strong quarter performance from a margin perspective again. I know a number of you have had concerns that as this business begins to turn down, it would have a disproportionate impact upon our margins. I think you see here in the fourth quarter our operating plans and the great job our teams have been doing in structural cost out is really having a positive impact not only here in the fourth quarter but once again in our guidance for next year. NAFTA Class 8 shipments were down in the fourth quarter; they were down 6%, but you see that the margins here in the quarter were 18.4%. As we look into next year we’ll talk a little bit more about it in just a moment, but our forecast is that we’ll see the NAFTA heavy-duty market decline to around 250,000 units, which is down about 23% from this year. So, that is fully incorporated in our planning for next year. If we move to Chart 11, maybe just to kind of cap off 2015, we obviously saw organic growth be negative throughout this year. The second quarter really drove structural cost reductions across the company, which is why you’re seeing the real benefits here in the fourth quarter, and that obviously sets up a really important part of our operating plans for 2016. Segment margins were 15.2%, free cash flows slightly below our target of 100%. As we look at this year, we did repurchase 2.4% of our shares outstanding—that's about $682 million we spent on that during this year. We paid down $1 billion of debt this year and we have completed the Cooper integration, and so as we enter into this next year you’ll see we virtually have no acquisition integration costs anticipated during 2016 as well. 2012 really gives you the kind of breakout on how our restructuring plan laid out during 2015, and as I mentioned upfront our net benefits in the fourth quarter were better than we had laid out for you earlier and reflect the momentum we have with an overall restructuring program. Page 13, titled '2015 Restructuring Cost and Benefit,' really gives you a view of that full year activity more for your historical background as you think of our performance across the segments. Now, jumping to Chart 14, as we start to talk about our thoughts about 2016, with the weaker markets that we had anticipated in October, you may recall those numbers. I'll go back over them for you in a moment on a subsequent chart. We've now accelerated and in fact expanded our restructuring actions, and as our view that a couple of you had commented on in your write-ups this morning, that 2016 and 2017 will remain somewhat challenged time periods in terms of end market growth. Our focus is getting the cost out and using our balance sheet to buy back shares and to really get the company well-positioned in what will be a period of lower growth than we had seen in previous years. What you see in that chart up top, we’ve tried to lay out for your ease, here is our 2015 actuals, our 2016 and 2017 costs and then the incremental benefits that occur in each year; it's incremental to the previous year and you can see the total. The big news here is that we’ve expanded the program to a three-year program. We’re going to spend about $400 million; we’ll get benefits of just over $400 million over this time period. And as you think about 2016, because I know that’s of real interest to you, we’ll spend about $70 million of that $140 million in the first quarter of this year. About 50% of the balance will be spent in the second quarter, and then during the third quarter and fourth quarter, the spending is fairly equal. The benefits, however, not much of those incremental benefits of 185 will occur in the first quarter because we’re just kicking off this second phase of actions, and it builds through the balance of the year. So it is a reasonable expectation that it has a bigger contribution to operating earnings per share in the third quarter and fourth quarter than it would have in the second quarter. Let's jump to Chart 15. I mentioned before our view of our markets and organic growth opportunities are lower than they were when we last discussed this with you in October. You recall that we haven’t laid out a formal forecast, but we had shared with you some early thoughts on 2016 in our October earnings conference call. At that time we talked about organic revenues being down on the order of 1% to 2%. With the benefit of the last several months and I think all the weaker news, it’s not only we but you also have been reading as well our detailed discussions with our customers around the world. We think a better expectation for that decline is that our organic revenues would decline on the order of 2% to 4%. As you go through these individual segments, let me just give you a sense for what has changed. As you can see the rate on the chart, our organic revenue growth projections for the individual five segments we report are as follows: For Electrical Products, we think the organic growth will be in the range of 0% to 2%. In Electrical Systems and Services, we forecast a decline of 2% to 4%. In the Hydraulics sector, we are now forecasting organic growth of negative 9% to negative 11%. In Aerospace, we're predicting 1% to 3%, which is not that much change, while in Vehicle we had thought it would be negative 5% in October; we now think it will be negative 7% to 9%. What are the big drivers here? Let me start from the bottom where I ended with Vehicle. We now think the North American heavy-duty market will decline to about 250,000 units; that's the whole market for NAFTA down 23% from where we finished up just over 320,000 units in 2015. We think light vehicle markets in the U.S. are going to remain strong, kind of flat to 1% up. We think China will continue to progress fairly well in terms of its light vehicle markets. We think Europe is probably up on the order of something like 2%, and we continue to feel that Latin America is a very troubled area, really when we talk about the vehicle market, we’re specifically talking about Brazil, and so those numbers will be down 10% to 15% this year. That’s what brings us to our 7% to 9%. Within the hydraulics market, I would say it’s really a continuation of the negative expectations in terms of the worldwide Ag equipment market and the construction equipment market with not much positivity on the industrial side. I would say again 9% to 11% is our best approximation after talking to our customers, and you've seen many of them release their own guidance for 2016. If you move to Chart 16, titled 'Segment Operating Margin Expectations,' I think it's really noteworthy that in the fourth quarter we increased our operating margins in spite of negative organic growth, and that is indeed exactly our plan again in 2016. In spite of about $1 billion volume decline, and again that's about $600 million in organic growth and about $400 million from Forex, we expect to expand our segment margins. They finished at 15.2% last year, and as you can see the midpoint of our guidance is 15.6%, so about 40 basis points expansion. We can obviously talk about each of these as we field your questions, but I would call your attention to Vehicle because I know many of you are concerned in terms of looking at the year of 2016, that we would see a several hundred point contraction in vehicle margins as the overall marketplace began to decline. As you can see, we’re confident with our operating plan and the benefit of all the restructuring we’re doing and the fine jobs done by our team there; we’re going to hold very attractive margins in that segment. I think it’s a key element in terms of thinking about the evaluation because this is one that you’ve been concerned about historically from a volatility point of view. If we turn to Chart 17, labeled our Multiyear Share Purchase Program, you’ll recall in July we laid out our new capital plan, which outlined an annual basis repurchasing 1% to 2% of our outstanding shares per year. As I mentioned earlier, we paid about $1 billion of debt last year, and we repurchased $682 million, or about 2.4% of our outstanding shares. We have commented through the fall that in this period of time where we're seeing such weakness in equity pricing, and specifically on our own, that we were tilting our balance plan towards spending about 50% on share repurchase and about 50% on acquisitions, tilting it towards buying back more of our shares. What we’re announcing today is that we’re targeting a $3 billion share repurchase program for the years 2015 through 2018, which means, given that we purchased back $682 million last year, this is about $2.3 billion of purchases over these next three years—about 10% of our outstanding shares. That does move us a little closer to kind of an annual buyback that’s now more like 2.5% versus 1.5%. Specifically in terms of 2016, you’ll recall that I just mentioned the numbers in 2015; we bought back $682 million, and we would expect the buyback to be about the same level this year, roughly $700 million. It will, as it normally is for us, be back-end loaded in terms of how our cash flow lays out through the year, but it plays an important part in how we offset a slightly higher tax rate. If you move to Chart 18 to pull this all together in terms of our EPS guidance for 2016, let's start with the first quarter. Our operating and fully diluted EPS this year will be the same because we don’t have acquisition integration costs across this year. We think our organic revenue compared to the fourth quarter—so the actual numbers we just reported—will come down about 5%. For those of you who are calculating that means it’s down about 8% from last year in the first quarter. The tax rate will be between 8% to 10%, and the segment margin, including the restructuring cost of the $70 million, will be somewhere between 13.5% and 14%. That's what supports our $0.80 to $0.90 operating and fully diluted guidance for the first quarter. In terms of the full year, again, no acquisition integration charges so the guidance is $4.15 to $4.45 with the midpoint obviously being $4.30. The guidance does include the full net restructuring benefit that we outlined for you, which is a year-to-year benefit from our restructuring, and the $45 million from the Cooper integration savings, which is primarily the full-year benefit of the plant closings that we were concluding in the back half of last year. So the operating EPS, and I think this is the best way to think about our operating plan, we’ll have flat operating EPS year-to-year, while we’ll actually be up 2% in terms of fully diluted. So, we don’t have acquisition integration charges. But that flat operating EPS year-to-year really incorporates having revenues down $1 billion—$600 million organic, $400 million from FX—margins up 40 basis points, driven by all the restructuring work that we got a good head start on by starting early in 2015, and then the share repurchases of approximately $700 million are basically going to offset the impact of what we anticipate is going to be an increase in the tax rate from roughly 8% last year to roughly 10% as the midpoint of our range this year. If you turn to Page 19, just to recap again organic revenue would be down 2% to 4%. You’ll recall we had a couple of very small acquisitions so we had a little positive in terms of $35 million in terms of additional revenue. We would see 2% negative Forex, which translates to that $400 million top line impact that I mentioned negatively. Operating margins with a 40 basis points expansion from last year, corporate expenses continuing to reflect all of the work that we're doing to reduce our costs not only in our operating units but across the corporation as well. The tax rate will tick up slightly from last year, as I just mentioned, the flat operating EPS and the 2% increase in net income per share. Operating cash flow is targeted at $2.6 billion to $2.8 billion, free cash flow of $2.1 billion to $2.3 billion. Obviously, that looks like it’s been as a cash conversion ratio of greater than 1, and yes, that’s exactly what we’re targeting. CapEx is set at about $525 million, and I can understand some of you may have a question about why that’s pretty similar to what you spent last year. Even with volumes coming down, why are you spending as much CapEx? We do have some capital involved in all of the restructuring actions, and that's really the difference to facilitate getting them done in areas where we may be closing and consolidating facilities. So that’s our outlook for 2016, and we think it's a solid plan. We obviously have had the benefit of looking very hard at these markets, and we’re really confident about the restructuring plan that we put together. So, that restructuring plan and our share buyback are very much in our own control; those are the kind of variables we’re trying to manage as we move into 2016. Don, with that, I’ll turn things back to you for questions.

Before we begin the Q&A session today, I do notice that we have a significant number of questions in the queue. Given our time constraint of an hour for the call, and the desire to get to as many of these questions that you have as possible, I’d ask that you limit your questions to a single question and a follow up. I appreciate your cooperation in advance. With that, we’ll open the questions with Scott Davis from Barclays.

Sandy, you only have I think four months left or so of your tenure and you’ve seen a bunch of cycles. I’d love to get your opinion on how the world gets better? I mean how do we get back to positive growth? What’s it going to take, in your opinion, at least from a world perspective, to have a recovery in sight?

That’s probably almost a difficult question. But I think clearly we’ve got a couple of big issues going on. We’re in a commodity cycle, and it doesn’t matter whether it be oil and gas, whether it be metals, whether it’d be agriculture; we’ve seen that as the world has slowed down, it’s having a fairly profound effect on a lot of these commodities. This will eventually bottom out. We’ve lived through a bunch of these. It’s just our view that we’re not going to see that end in ’16. That’s why we said that it's so important really to take these restructuring actions in ’15 and ’16. Hard to forecast right now, Scott, whether that turn up is in ’17 or ’18; I think most forecasts have always proved to be wrong, but the benefit of where we are right now is that we’re in the second year of this fairly deep commodity cycle. As we pointed out in our earnings release, this is really only the second time that we have seen our end markets be negative in consecutive years, and we got to go all the way back to the 2000-2001 time period. People were pretty mopey then, and by 2002-2003 we popped back out of that. I think you will see this cycle come back out.

And then Vehicle, I’m one of the guys who’ve been skeptical about margins and you’ve proven us wrong here. Help us just understand, is this all a function of restructuring? Are there other benefits here, whether it’s LIFO accounting or mix or something else?

No change in accounting. This is just plain old hard work of running a business really well, and the teams have really been working hard on restructuring and making sure that new products we introduce have attractive value propositions. I’d say it's just doing it the hard way.

So, some of it is new products that are not constrained?

But remember in the automotive business you tend to— we have pretty good automotive and truck businesses. We have pretty good visibility forward-wise in terms of what we win. I think we’ve had another very good year of bookings in 2015 on a global basis. So, we feel comfortable both on that revenue side of how we’re doing with our customers. But I feel really good about the work that’s been done in the business on all of the cost work.

Our next question comes from Ann Duignan with JP Morgan.

Good morning, and thanks for the color on the Vehicle side and Hydraulics side. Sandy, could you give us similar color regarding your subsectors in Electrical Products and Electrical Systems? What you’re seeing in the different end markets?

I think our comments probably aren’t going to sound vastly different from many of our peers who have announced. We’re looking at the residential market in the U.S. as being one that will continue to be positive on the order of say 3% to 4% next year. Non-residential is probably the hardest one of all of those numbers to figure out, particularly here in the U.S. There are so many different opinions on non-residential; we think much of what’s been published is perhaps a little too bullish. We’re more in the 3% to 5%. I know there are some people at 8%, and gosh, I hope they’re right, but that’s not what we’re basing our expectations on. Utilities are a little better than we’ve seen in the last couple of years, but it's still a 0% to 2%. Industrial is quite troubled still in terms of just not seeing a lot passing through that, so that’s probably a 0% to a negative number. As you get into harsh and hazardous applications that have large portions of oil and gas around them, those are numbers that are like negative 15 type numbers. And then when we look at the large power quality areas, I’d say those markets are likely to be slightly negative again this next year. Last comment I would make is that we just don’t see the big large industrial construction numbers that are being so quantitatively reported in many of the government statistics. We’re out there bidding on them all, and we aren’t seeing what they’re talking about. So that’s our view as to how we look.

Thanks for the color, Sandy. And just a quick follow-up, you had mentioned previously that on the manufacturing side in the U.S. the downstream built up from oil and gas. But maybe you start to see orders in that business pick up towards the back end of this year for delivery in '17. Is that still your expectations?

The big natural gas and exploring terminals that we are committed to us, like those are going ahead here in the second half. That’s still our expectations. You are starting to see some of the big integrators are really clashing capital budgets again. That’s why our view has been that you have a second year of negative in the oil and gas industry broadly this year. Once you start these big cycles, it takes a couple of years for them to swing back.

Could you provide more details on the margin front? Considering the ambitious margin expansion planned for next year, my understanding was that decrementals typically range from 20 to 30. You also have pricing and productivity factors influencing costs, whether inflation or deflation. Can you help us understand the components contributing to this? Restructuring appears to be the most significant positive factor, so please explain how you're achieving these margins.

I think, Steve, the way we have watched volumes come down as strongly as they have all the way through '15 and '16 is that those incrementals or decrementals are getting bigger because we’re getting down to points where you really have big knee curves. Our own thinking is that it’s probably about 35% at this point, so that’s how we sort of look at the decrementals. It hasn’t changed in degree for us in terms of Forex, but those are more like 10% to 11% types of numbers. And then the rest basically comes from the cost reductions that we’re getting. Remember, to add in the $45 million of acquisition integration benefits into the two electrical segments.

Okay. And then the other pieces, like pricing, what that in there?

It's fairly neutral, I would say. Our expectation is that we do expect some tailwinds this year, and that’s really because commodity prices have come off as hard as they did in the fourth quarter, and January sure looks that way. All the numbers we can see, commodities didn’t do much recovery in January. So, I’d say a slight tailwind from commodity on margins this year as well.

And just a follow-up. That restructuring for the fourth quarter, I guess you did $2 million of costs and you saved about $10 million more versus planned. Was that all timing in those two line items?

No, I would say that the big issue is that we were able to complete that restructuring at a lower cost than we had thought it was going to take. It wasn’t that we pushed something out; it wasn't that we didn’t take some action. The actual costs turned out to be less than we had originally thought.

Starting with Electrical Products, you are projecting reasonable margin development in 2016, but considering the various factors, lighting is likely to grow faster than the rest. This could negatively impact the mix, as it has in the past, and might pose challenges. What are your thoughts on whether this is due to changes in the mix or if you believe restructuring efforts can lead to improved margins in Electrical Products?

Our numbers are in Electrical Systems and Services. But I would say it's the restructuring, and it’s the benefits from the Cooper. So, remember those first two segments, Electrical Products, Electrical S&S, both benefit from restructuring savings and then you'll have about $45 million to distribute between the two, likely to be pretty equal this year.

Understood. And then my follow-up would be on Vehicle, not so much the margins but just the top-line. So, in Q4 you had a 6% organic decline, NAFTA Class 8 shipments were also down six. For 2016 you are saying that NAFTA Class 8 is down over 20, but your organic sales guide for the year is only down in the high single-digit range for vehicle. So, I guess what's changing in 2016 versus Q4, leaving aside Class 8?

You get a little bit of a seasonal factor here too as well. Remember that in the fourth quarter you have a bit of what I would call second half December shutdowns that occurred. That’s a piece of it. Remember that the North American part of that fall actually occurred in the fourth quarter too. So, of the 23%, we talked about a reduction; you had a 6 points fall off from a year ago occurring in the fourth quarter, and we’re talking about a full year of 23%. But I think it's more seasonal. Craig, any other color on that?

Obviously, you need to look metrics over time. The 6% was the delta from Q3. If you actually take a look at North America Class 8 truck year-over-year, it was down much more in line with what the forecast for 2016 is. North America Class 8 truck number is obviously an important number for the vehicle business, but as Sandy went through, that’s only one of the many segments that make up our vehicle business. We continue to see pretty robust growth in our automotive markets around the world, so just one piece of the equation. Additionally, you have to consider that as we start to anniversary some of the really weak numbers we’ve seen in South America, which is the biggest piece of our Vehicle business— our Company's exposure in South America and Brazil— those comparisons will just get much easier.

Our next question comes from Joe Ritchie with Goldman Sachs.

Good morning. This is actually Evelyn Chan for Joe. Thanks for taking my question. Just wanted to touch on capital allocation and the $3 billion share buyback program. Not to put words in your mouth, but I think the view on the priority of investment has been first to address weaker market conditions and cost out and then if you get to 2017, maybe there are other alternatives for running your business or portfolio that are available to you. So I guess what's the impetus to commit so much of your cash now towards buybacks for the next few years?

Again, it's not all of our capital; we're tilting it towards that. Our view is that this time of relatively weak equity performance and weak market prospects is a time when we can take advantage of really buying back shares and creating value for our customers at a time when I think certainty is something that everyone is looking for. That's our view in terms of tilting over this point.

That makes sense, Sandy. And then I guess maybe switching gears, it looks like booking trends are moving in the right direction, and we've heard a lot of surprisingly positive commentary from the industrial peers on short cycle trends in January. Can you address what you’re seeing in your business here at the start of the year and what you maybe see in your front-log to drive back an 8% year-over-year decline in Q1?

Our view is that there are a couple of distributors that have come out and talked about things being a little bit more positive. Our direct business peers haven't echoed this optimism in the first quarter. I don’t think we're seeing anything at this point that makes us think that markets are better than what we’re forecasting here. We've seen markets coming off each quarter throughout 2015. Typically, our first quarter is seasonally weaker than our fourth quarter; it’s our weakest quarter of the year, and that's how we've laid out our guidance for this year. So I think it's a little early to call the year. Fortunately, we haven’t had a major weather event this year, which hasn’t delivered us a big hit in January, but I’d say we're not seeing anything different than our guidance at this point.

Okay, thanks very much.

Our next question comes from Jeff Sprague with Vertical Research.

Thank you. Good morning everyone. I wonder, Sandy, if you can come back around to price. So I think it was an earlier question on price, and I think you answered it more around kind of cost relief. But when you were saying you see a tailwind there, can you just kind of tie that together for us and provide a little bit of color on the pricing side?

Yes. I would say yes, the price-corrected net— a slight tailwind. The conditions are very different in every one of our market segments; some have long-term contracts, some have price adjusters based on those contracts. We’re not seeing the environment being one where there is undue price competition. Obviously markets are down, things are tough and we see the market behaving pretty well.

And then on the comment about the corporate expenses down maybe towards the $80 million decline, is that all in across corporate options and pension and everything, or is that actually just the corporate expense line?

Yes. So that covers interest, amortization, pension and corporate costs; that's the whole complex of costs.

Great, thank you.

Our next question comes from John Inch with Deutsche Bank.

Look, I realize this is not a direct comp, but Emerson more or less suggested that we were approaching a bottom with respect to its various markets and they expect orders to actually turn positive after March. Sandy, it's kind of dovetailing on Scott's point; I mean do you think we are approaching a bottom? It doesn’t suggest there is recovery coming anytime soon, but do you think we’re approaching an overall bottom? And then what are you thinking about your own orders? Are we looking at a positive inflection at some point this year?

Perhaps it’s the best indication. We’ve talked about this point a lot, John, and our own planning as we put plans together this fall was based on not counting on an economic rebound in the second half. We think that's been a bit of an unwise premise to go into these markets. If it does get stronger, so much the better; we can all scramble up, and we've done that well in the past. But the restructuring actions that we’re taking and this commitment to a three-year restructuring plan says that we think 2016 doesn’t recover when we get to the second half.

First, I wanted to echo some of the other comments. I think your margin performance and the pace of execution are commendable. The one business that does stick out is Hydraulics, right? It appears that, whether it’s due to Asia or pricing or whatever, it's still getting worse. It does appear that your margins are down despite the heavy emphasis on restructuring; your margins are still down a point year-over-year. So what I'd be interested in is really your thought process about— and maybe Craig can add to this— about Hydraulics strategically.

Let me come back to a couple of the elements you mentioned. You are right that we’re not able to do tax-free spins until after the five-year anniversary. We have indicated that we do have the strategic flexibility that if we choose to, we can sell businesses on a taxable basis. That’s exactly what we did last year with the two aerospace businesses that Craig led, because we felt we could manage them better strategically. There’s no question on hydraulics; we’re dealing with a very difficult end market. We commented on that last year, and we don’t think that’s going to change this year. We actually think the margin performance is exemplary in light of where the volumes have been, but we understand it's not at the mid-teen levels we would like to see. We do believe that with the actions that we’re undertaking, and as we get into the later part of this year, you're going to see far more attractive margins than you will see in the early part of this year because we’re taking significant steps within that business. We’re trying to get this business sized so it can perform well without having to rely on a market rebound because again, we think we are in a commodity cycle and clearly we don’t have the benefit of the revenues we had several years ago when it was at the high point. Craig, do you want to add anything to that?

No, the only thing I would add to what Sandy said is we really are living through what I would argue is a truly unprecedented period in the hydraulic markets. You can’t find a hydraulic end market today that hasn’t gone through a pretty significant downturn, whether it's agriculture or it's China construction or its mining and oil and gas. Most recently in anything tied to capital purchases on the industrial side. We view that we haven't seen a period like this in the hydraulics business over the last 15 years, and to say this formally, the business has performed very well in this environment, and we expect that this business will thrive when markets turn. Sandy’s point is accurate; the margins are not where we want them to be, but we are working hard to build a company that can operate effectively and manage the downturns, and if and when we return to growth, I think we will have a very attractive business model.

And to Craig’s point, it’s important to note our focus is on ensuring that this business delivers attractive margins at this level of economic activity. When it turns, the profitability will be more welcoming.

And Craig, would it also be fair to say, I mean Sandy intimated that we’re still dealing with M&A? Even though you’ve stepped up share repurchase— rather than just ride out hydraulics and the cyclicality, would it be fair to say you might want to make up for some of those other deals in terms of timing and do some acquisitions in this space? Is that on the table still?

What we’ve said is, until we get a real sense for where markets are going to bottom out, it’s really difficult at this point in the cycle to really value hydraulic assets. As we think about hydraulics today in M&A, it’s really a piece that’s off the table until we get a sense for where markets have bottomed out and we can predict the future.

Our next question comes from Longbow.

Just following that up, everybody picks on the toughest segment, and every turn people say who benefits. When we talk about hydraulics in front of the rest of the Company, can we talk about where inventories are? What did you see during the quarter as far as inventory liquidation? Is most of it over or are we close to doing it? Where do you think inventories are as you go through this year for you guys into channels, and are we probably coming down some more?

Our best sense in talking about the two segments where there are distributor inventories, is that on the electrical side people have been seeing markets be tighter than they were a number of years ago. So we actually think there hasn’t been substantial change in inventory; they’ve been low. We don’t think we’re either suffering from liquidation or there being a lot more liquidation to go on. On the hydraulic side, clearly the point Craig just made— our distributors have been dealing with this for a prolonged period of time. I think the one segment where you're going to find when you travel regionally and talk to different customers—that, either electrical or hydraulic—if an individual distributor had unusually high exposure to the oil and gas area, they may still be struggling with some inventories. Many of them have got their hatches buttoned down tight and they’re trying to get through a period of time when growth is less than they’d hoped a couple years ago.

So, you're looking at production that will effectively match end-market demand?

It’s pretty similar. I think the major OEMs are very much the same. They’ve been at this for some time as well, and the exception of what I’d call you’ll find in some OEMs the big issue isn't the inventory; it's that the equipment they have shifts are being utilized at very low levels. The utilization rates have to come up before new equipment comes up. But I think it's less of an inventory issue today and more a different discussion on very low utilization.

And just a follow-up, I mean we talked going up a little bit with Emerson's said yesterday in their numbers. But the one market that they pointed to was that datacenter market had bottomed and they talked about improving datacenter markets. I don’t know if you are seeing that, or is that just happening? Is it probably better than what you’re anticipating? Are you seeing movements in the datacenter sector here or in Asia, or is that still a hope that’s happening rather than something tangible?

We had action last fall, and it’s continued for us. During a first half, we had a somewhat disappointing year in terms of significant bookings. We saw really good activity and good wins in the second half of last year that are going to help us with our shipments this year. We've been very pleased with the fact that I think I've mentioned a few times, that we came out with the new high-end three-phase UPS which had an even higher energy-saving component, which was really sized for the web-point— a 2.0 type of datacenter. It’s allowing us to compete very favorably there.

Do you forecast improving datacenter markets as we go through this year as part of the Electrical forecast segment?

Yeah. I’d say that the overall PC market is not that great, but some of that top-end stuff is getting better.

On the follow-up to some of these comments on when we bottom and when comps will be easier, I guess maybe this is still down a little bit, Sandy. Do you think we exit 2016 just given the comp influence of maybe a little bit of destocking? Obviously, not that much based on your last comment on easier comp. Do we start to see a business like hydraulics inflect positive by the fourth quarter?

We are not forecasting it at this point. We’d love to be able to answer that question; believe us, for our own utilization as well. But we just think we're better off planning on the fact that we aren't going to see a rebound at that point. If we do, it will be an upside; there’s so much time between now and the fourth quarter in terms of seeing what happens to crop prices, what happens to commodity prices, and we've seen volatility in these areas. Therefore, we are not able to forecast that, so we are not assuming it's going to occur.

Got you. And then maybe from the margin perspective on the other side of that, as restructuring yields out, by the time we get to the fourth quarter, you should be running well above that 10%, given the timing now and maybe any help you can give on that?

Yeah, definitely. Again, as we go back to the comments I made about the restructuring—if you recall that of the $140 million in restructuring costs that we’re going to incur during 2016, $70 million is in the first quarter, roughly $35 million in the second quarter, and then the balance in the last two. That just helps margins as you get toward the latter parts of this year. If you include the savings, all of the incremental savings will occur over the quarters in two, three, and four; that will get bigger as we move from quarter to quarter. Yes, each of the margins should deal and very distinctly in Hydraulics, back to Craig's position. You will start to see how this plan manifests itself. I think the real big takeaway from your questions is that we are not counting on an economic rebound to drive our plan nor our earnings. What we are counting on are the things that we can control. That’s a very important change we made in the second quarter of last year when we announced that we were going to drive very significant restructuring; we have now added another year to that, and also announced an enlarged buyback. Those are two things we can control, and we think in this environment where there is so much uncertainty, we’re putting a premium on delivering what we can.

Thanks and good morning, and kudos on the cost control. A couple of things, I just wanted to go back to restructuring. Does the nature of the restructuring change over the next couple of years, or do we move from headcount to more facility-based restructuring? And within that, could you comment on CapEx? Although the CapEx comments around restructuring were interesting, I’m wondering if we are seeing some capital effectiveness of labor or just primarily consolidating some of these into larger ones?

Hi Nigel, this is Craig Arnold. Maybe I'll take that one for you. The way we think about kind of this whole roadmap to reducing our costs is we really think about it in three buckets. The first is around facilities—our manufacturing footprint around the world and distribution centers and offices. We have a backlog of opportunities to continue to right-size our facility footprints, and that’s one big bucket of activity that's ongoing and we think that will continue for the next several years. The second bucket is around support costs—management layers, the span of control of our leaders, the size of our corporate infrastructure. That’s a whole area of activity that has done a lot to improve in 2015 and we think that continues in 2016 and perhaps a little bit in 2017 too. The last bucket I would categorize as optimizing where you do what you should do; actually moving more activities to low-cost centers. We are opening up shared services in low-cost countries and positioning various activities that we do today in locations that allow us to do it at much lower costs, using a more efficient model. Those three buckets are what we’re undertaking across the company, and we think they will be part of our goals going forward.

Okay. That's good color. And then secondly, I appreciate the color on cash deployment over the next three years. On free cash conversion of roughly $2.10 for next year, what gives you confidence you can get the working capital other system as your sales are declining 4% or so?

I'll take that, Nigel. There are really two big elements to the improvement in free cash flow from 2015 to 2016. First of all, we are not going to make a U.S. pension contribution, and so that’s an improvement of about $160 million. Secondly, with sales going down, classic working capital is typically about 18% of sales, so as the approximately $400 million of organic sales decline would be around $80 million. We do have inventories that we have built up as part of Cooper that will be liquidated. We ended the year with a bit more inventories than we had hoped for, simply due to the speed of which sales came down. Thus, that leads us to establish the expectation of $160 million from lower pension contributions and roughly $140 million from working capital liquidation to get from $1.9 to $2.2 billion in free cash flow.

Our next question comes from Andy Casey with Wells Fargo.

Sandy, I'm wondering within the non-residential commentary that you gave a little bit earlier whether you've seen any of the weakness being realized in some of your industrial end markets in the U.S. starting to impact any of the non-manufacturing sectors of non-residential construction.

Let me take oil and gas kind of off the table, but from our perspective, we’ve obviously had a very good quarter, fourth quarter in terms of quotations. When we look at all quotations and negotiations we’re involved in, the stronger part of the commercial market has been smaller projects that start from a residential base and escalate up into medium size projects. The really big projects seem to be lagging. You do see a number of significant stadiums being built around the U.S. that began in the second quarter of last year, and that’s going to continue through this year. What I’d say is that the weakness we’ve seen in construction in the U.S. has been towards very large power-consuming constructions where many medium vaults are used and that tends to be more industrial or especially big commercial work. The strength has been gravitating towards the smaller projects.

Thanks. And taking a different view point on it, if we look back at prior cycles, we see some of the things that are weak which are significantly off of peak conditions, like trucks. What sort of probability would you put on the U.S. instead of staying in this stagnation and just starting to go into recession—not this year but maybe next year?

We don’t see that as high probability. We do think that we are in an unfortunately slow environment that can often cause people to use the recession word, but that’s almost more of an emotional issue than a factual basis. We think that GDP is likely to grow in the mid-two's again this year. However, as we are on the industrial side of the economy, we are seeing industrial production numbers that are more like 1. All that we’ve been— I’m just repeating what we probably all read— is that there has been more action on the consumer and services side than there has been on the industrial side, and that's what's leading to the lack of capital investment for this MRO industrial malaise; and that has clearly been affecting ours and many of our peers market. I think I would say that's more of the tone and if you compare the U.S. growth to the rest of the world, it's not significantly different.

Our next question comes from Deane Dray with RBC.

Thank you. I had a question on the Aerospace number of the bookings being up 14%. How does that split between commercial and military, and how much of that will flow into 2016?

The commercial side, Deane, continues to be the stronger side. If we look at the three elements of booking within Aerospace, we were seeing commercial be up on the order of roughly 7%, military was down about 6%, and then aftermarket was up 14%. That’s not a bad way to think about how things work going forward. As we think about a market we’re seeing, they’d be slightly up too next year. You’d expect the commercials to grow slightly faster than that market, while military is going to be slightly slower. We would hope that the aftermarket grows a little faster than average, it won’t be like 14% or 15%, but it’d be slightly above our average number.

And then for Rick, the tax rate for 2016 is seeing a lift from 8% to 10%. Can you comment on what's going on there? Is there any update on what might be the natural rate that Eaton would level out to?

Our rate, as you pointed out, was 8% for 2015, the midpoint of our guidance for 2016 is 10%. That’s really driven from more U.S. income; it's a function of the restructuring actions, a lot of which increase U.S. income. Looking longer term, I continue to believe that the rates will be somewhere between 10% and 15%, and it’ll probably slowly tick up, but I would emphasize slowly, not more than 1 or 2 percentage points in a given year.

Our next question comes from Jeff Hammond with KeyBanc.

Just have a quick follow-up here on corporate expenses. Can you split out of that $80 million how much is restructuring savings that we should put in the restructuring bucket and how much is something else, like lower pension?

I think there is very little that is restructuring at this point. I would regard that as principally the core corporate cost.

So, we can figure that as a separate bucket from the incremental restructuring savings?

No, it's all built into the total number that we gave you. But what I’m indicating is that the actual corporate cost for restructuring in 2016 is very minimal.

How much is pension going to be down year-on-year?

There is going to be a substantial improvement in pension or reduction in pension costs. It’s a number that will be— for two reasons; it will be down on the order of about $50 million, and the biggest part of that is going to be that we moved to split-rate pensions that so many of our peers have moved to, which we think is better accounting. That’s the biggest driver of that. Also, the U.S. discount rate has gone up about 25 basis points, simply a reflection of where interest rates ended the year.

Our next question comes from Chris Glynn with Oppenheimer.

With the kind of commentary on the multiyear share repurchase plan, you opened up to some longer-term outlook. Looking at the capital structure, I think in 2017 you’ve got a hefty debt coming due— a billion of that. Is that extremely low rate? Are we looking at a roll-over to stay consistent with comments on excess cash to repurchase, or is the current 2.5 times leverage still above a sustainable level?

Our expectation, Chris, is that we would refinance the debt coming due in 2017.

And then lastly on the split from the first half to the second half. Given the highly strategic year and period of restructuring program, maybe give color on the ramp of benefits into the second half just in terms of perhaps an earnings split of the first half and the second half within the annual context?

As I mentioned, the restructuring cost is $70 million in the first quarter, $35 million in the second, and then the last $35 million will occur across the last two. The benefits, on the other hand, will show themselves in quarters two, three, and four, building as you progress through the year. So the higher savings will be out in the third and fourth quarters.

Thank you all for joining us today. Unfortunately, we’ve reached the end of our allotted time for the call today. As always, we’ll be available for follow-up calls for the remainder of the day and the rest of the week. Again, thank you very much for joining us today.