Eaton Corporation plc (ETN) — Q1 2016 Earnings Call Transcript

Good morning. I'm Don Bullock, Eaton's Senior Vice President of Investor Relations. Thank you all for joining us for this morning's first quarter 2016 earnings call. With me today are Sandy Cutler, our Chairman and CEO; Craig Arnold, President and Chief Operating Officer; and Rick Fearon, Vice Chairman and Chief Financial Officer. The agenda this morning includes opening remarks by Sandy, highlighting the performance in the first quarter along with the remainder outlook for 2016. As we've done in our prior calls, we'll be taking questions at the end of Sandy's comments. The press release and the earnings announcement 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 some reconciliations to non-GAAP measures, and a webcast of this call is accessible on the website and will be available for replay later today. Before I get started, I want to remind you that our comments today will include statements related to the future results of the Company and are therefore forward-looking statements. Any areas of uncertainty around those will be outlined in our Form 8-K. And with that, I'll turn the comments over to Sandy.

Great, thanks Donny. Good morning, everyone. Thanks for joining us. I'll be working again from the presentation that was posted earlier this morning, and why don't we turn to Page 3, it's entitled Highlights of Q1 Results. I think as you saw from our earnings release, our quarter was slightly ahead of original expectations, coming in the upper half of our range. It positions us very much on plan for our full year guidance, and really not much has changed in terms of our view of either how markets will progress this year or how we see our prospects for this year. You saw the operating earnings per share were $0.88. Our sales of $4.8 million were down 8% from a year ago; organic revenue was down 6%. You may recall, as compared to the fourth quarter, we had said that we had expected our first quarter sales to be down about 5%. We actually came in a little bit better than that. And then the Forex impact was down 2%. Really strong segment margins, exactly in line with what we outlined in terms of our guidance, and when you exclude the restructuring costs that are part of our three-year restructuring program, margins were actually 15.1%, which are really quite strong for our business mix in the first quarter. Very pleased with our cash flow; for the first quarter, it was $371 million. We were able to purchase back $100 million. We recall our full year plan as a $700 million buyback, and then we announced a dividend increase, a 4% increase in February. If we move on to Page 4 and just for comparison to our guidance, it’s pretty simple. Higher revenue than we expected, primarily organic, a little bit from FX for $0.02, and then we did spend a little bit less than we had anticipated. We had shared with you that we were going to spend on the order of $70 million in the first quarter for restructuring expense; that total came in closer to $63 million. So that contributed about a $0.01 on the upside. I'll mention in just a couple of minutes that we do expect to spend those dollars later in the year, and I'll come back and talk a little bit more about that. But overall, $0.88 is a great start for the year. Turning to Page 5, I think you saw most of these numbers in the press release. I would remind you that our fourth quarter volume, fourth quarter 2015, was $5.057 billion. As you can see, we came off just a little bit less than the 5% we had guided to. Our organic growth in the fourth quarter was 4%. Here in the first quarter, it was a negative 6%. We anticipate this is the worst quarter in terms of the year-over-year, you know that our full year guidance is a negative 2% to a negative 4%. Clearly, the comparisons in the second half get quite a bit easier than they are here in the early part of the year. If we could flip to the individual segments, we'll start with the Electrical Products segment, you'll find that on Page 6 of the packet. Clearly, a very good quarter. A number of you commented on that already this morning; we're very pleased with the 16.1% operating margin, 17.1% without restructuring costs. If you look at our organic sales growth, it was zero or flat this quarter; it was a negative 1% last quarter. We're encouraged that our bookings in the first quarter were up 2%. You may recall that in the fourth quarter of last year they were negative 1% and they were flat in the third quarter of last year. So a little bit of an acceleration. As you look around the world, and I'm sure you're all interested in terms of trying to understand the tenor of the business and where the strengths or weaknesses lie around the world, the US continues to be stronger than the average of 2%. We're very pleased with what we saw and may have begun to tick up a little bit; I think that’s in line with what you saw in some releases last night and early this morning about more economic strength in the European region. The weakness continues to be in Asia, where we've seen double-digit declines. I think not only us, but you've heard from other companies that conditions in Asia continue to be quite weak. Among the individual products, we had talked to you that generally the theme we've been seeing over the last nine months has been weakness in industrial markets, more strength in residential and non-residential construction. We actually had a very good quarter in our single-phase power quality, along with our comments when we get to systems and services. We also did well in our three-phase in that area. If we flip to the next chart, Chart 7, our Electrical Systems and Services segment, the volume of $1.342 billion was down about 10% from the fourth quarter. You remember the fourth quarter was $1.494 billion. As we told you, a good way to think about this segment in terms of shipment and prospective shipment volumes is to look at bookings. Bookings were down 2% this quarter; you recall in the fourth quarter they were also down 2%, in the third quarter they were down 3%. We continue to see weakness here, with a number of traces to some of the macros that we've all discussed. Our Crouse-Hinds business has significant oil and gas exposure in this segment. Some of the large industrial projects that we tend to work on are in this area. We continue to see those weak as well. As we continue to look to the year, I'll talk to you a little bit about segment margins. We started off a little lower than we had anticipated. That’s why we revised our margins for the year. I'll comment more on that as we get to the next couple charts. Within the regional area, again, the US and EMEA are being stronger areas, with our weaker areas being Asia Pacific at this point. So our common theme, and you'll hear that in a number of our businesses. Moving to the next chart, Chart number 8 or Page 8, our Hydraulics segment. Sales were $551 million, virtually flat with what we saw in the fourth quarter; you remember it was $552 million at that point. You'll see the operating margin at 7.4%, and when you exclude the restructuring, it's 10.3%. Clearly, we're doing a lot of work in this segment, as we shared with you and as Craig and his team outlined at our February New York Analyst Meeting. The organic sales were down 14%; we recall they were down 12% in the fourth quarter. Bookings were down some 10%, and here we saw weakness in the US, as well as in Asia Pacific. I don't think the story is much different in terms of seeing weakness on both the distributor and on the OEM side. We've experienced weakness on both the stationary and the mobile side. So, to answer the question, we have not seen the bottom in our hydraulic end markets. We don't have the visibility to see that it has bottomed at this point. We're comfortable and we've shared with you some revised views of market growth in this area, and so our plan is very much the same to continue to restructure this business during 2016 and not to count on an upturn in terms of volume. Turning to Page number 9, our Aerospace segment, volume is up just slightly from the fourth quarter, down from a year ago, but we saw terrific results in terms of our operating margins; 18% in the quarter, 18.9% without the restructuring. This is a very solid second quarter in a row, bookings were up 6%. Our aftermarket was down in this particular quarter, but we really believe that's more of an issue from having had a very large quarter of aftermarket booking in the first quarter of 2015. So we don't think this is a trend; we think it's much more of a comparable issue. Organic growth was down 3%, from positive in the fourth quarter at about 2%. So we saw a little lower growth, but really strong margins and strong bookings. If we turn to Page 10, our vehicle segment. Clearly, we're beginning to see some of the impact of our original forecast of the North American heavy-duty truck market coming down to 250. We've actually now changed our full year forecast down to 230,000 units. The first quarter was relatively strong, but as we can talk more in the Q&A, we've seen production schedules and orders progress into this year. Our sense is that this market is going to be closer to the 230 range than the 250 range, and all of this is already in our guidance. Strong margin performance; you see the organic sales down some 13%. We recall they were down 6% in the fourth quarter, as we've begun to see this kind of rollover in the heavy-duty market. If we move to the next page, Page 11, there's no change in terms of our view of total organic revenues for this year. We still believe they'll come down 2% to 4%. Obviously, for the first quarter, we were down 6%. This does anticipate and we believe, that we'll see much better comparisons as the year goes on, so the center point of negative 3%. As we looked at our first quarter experience and our update of looking at individual markets, you'll see two changes on this page from the guidance we provided to you earlier this year. We've raised the guidance in terms of organic growth in electrical products. We had a great first quarter, with residential markets stronger than we originally anticipated. Those were the two big contributors to our increasing our guidance for electrical products. Then in the vehicle markets, really two changes. The North American heavy-duty market, as I mentioned to you, would be down at about 230,000 units of production versus the 250,000 we had originally anticipated, which is about a 29% reduction from last year. Latin America continues to be weak, and clearly, we are all informed of the tremendous problems in Brazil currently, which has only weakened markets further, those being the two changes within the vehicle market. Overall, sales are projected to decline by 2% to 4%. A quick update on our restructuring actions on Page 12. We'll recall again our three-year program. That is the work being done by teams across the company, and it is very well done. We did, as I mentioned in my original comments this morning, incur about $63 million of restructuring expense versus the guidance we had provided you of roughly $70 million. We have moved that $7 million of expense to the second half. We've got one project that's moved from Q1 to Q3, but overall, we think that we will still be at about $140 million through restructuring costs. As you look at the $42 million in the second half, just to give you some sense for pacing, we project that about 70% of that will occur in the third quarter, with the remaining approximately 30% occurring in the fourth quarter. Importantly, our overall year-to-year incremental annual benefits of $185 million remain unchanged. Some of you may ask how we can have a project move out and it doesn't change your overall benefits. Remember that these incremental $185 million of savings included both carryover benefits from actions we had taken last year in 2015, as well as new actions we've taken in 2016. It was in that overall mix; there are obviously projects moving ahead and back and a lot of activity overall. We're very comfortable with $185 million still being realized here in 2016. On Page 13, titled segment operating margins expectations, I mentioned to you that we made a couple changes here that relate to changes in the market. Our electrical products, as you can see, we've moved our guidance up to 17.4% to 18.0% for margins after the very strong first quarter that we've had. You recall it was 17.0% to 17.6%. In our electrical systems and services, we've moved down to 13.1% to 13.7%, which previously had been 13.7% to 14.3%. This was driven by a couple of factors: a little bigger commercial mix, a little weaker industrial mix, and continued pressure in the oil and gas markets. There is no change in hydraulics and no change in aerospace. As for our vehicle business, we’ve moved it down to 16.2% to 16.8%, it was 16.7% to 17.3%, and that’s the impact of the 230,000 units of production for NAFTA heavy-duty Class 8 versus our earlier forecast of 250,000 units. Looking ahead to the second quarter, after what we think is a very solid and good start to the year in the first quarter, Page 14 is titled EPS guidance. For the second quarter, our guidance is in the range of $1 to $1.10 for operating EPS, and it’s virtually the same as net income because we don’t have acquisition restructuring expense. Organic revenue is sequentially moving up 5% from Q1 2016 to Q2 2016. As we've talked about in the last couple of years, that is a pretty normal season for us, it's that 5% step up from the first quarter to the second quarter. The first quarter is always our weakest quarter in terms of revenue. We expect that this FX is turning out to be less than we had forecast earlier this year, so that we expect we’ll get about a point bump from Forex too, so likely revenue is up on the order of 6%. Our segment margins, including all the restructuring expenses and the restructuring benefits as well as the incremental on the higher volume in the second quarter, are between 15% to 16%, and a tax rate that will be between 10% to 12%. Our guidance for the year remains unchanged, and each of the comments underneath the guidance on this page are the same you saw from us in our first quarter guidance, so no change there as well. If we move to Page 15, in 2016 outlook summary. Again, the only changes that you will find on this page are minor tweaks, which I call the mix under a couple of these numbers. Once again, the operating EPS for this year is flat with a year ago, and the net income per share is up some 2%. If you move to Page 16, here is a quick summary of our report today. Once again, we think this is a really strong start to the year, solid first quarter, record first quarter cash flow, and continuing to buy back shares, as well as obviously having a dividend increase. For 2016, as I mentioned earlier, we really don't see the year much differently than we did when we laid out the guidance earlier this year and detailed our operating plan. That's why we're continuing to work on our $400 million restructuring plan and the $3 billion share buyback plan, as I think they are exactly what's needed during a period of this type of economic weakness. We tuned out two things within 2016. One is the modestly weaker NAFTA heavy-duty production forecast, and the second is that we think Forex is now likely to impact our revenues negatively by $200 million versus the original negative $400 million. I’m sure we’ll have questions about why our full-year EPS guidance hasn't changed, and the easiest way to think about this is that the reduction in Forex's negative impact on sales and profit basically offsets the lower market expectation now for the NAFTA heavy-duty truck forecast. Our restructuring program is full of good news here, continues to be very much as we thought, being able to realize the potential. Our teams are really creating great results around the world, and our full-year incremental benefits remain unchanged at $185 million, and the costs remain unchanged at $140 million. As I said several times already this morning, our capital allocation plan to buy back $700 million worth of shares following the $682 million that we bought back last year remains unchanged. So with that, Don, I'll turn things back to you.

With that, I'll turn it to the operator, who will then provide instructions for our question-and-answer session.

Our first question this morning comes from Steve Winoker with Bernstein.

I appreciate you moving that with lightning speed. And Sandy, I want to of course start by congratulating this might be your last earnings call as CEO. Retiring and moving on. So fantastic, I think the stock is up like four times since you took over or more. So well done. I guess I'll just start also with tax and the treasury rules and regulations. Haven't really got a clear picture on how you're thinking about how your tax rate may be impacted by this, the timing of intercompany loans, etc., on a perspective go forward basis. If those proposed rules become final.

Great, thanks. Steve. I'll ask Rick to pick that up; it's obviously something we've given a lot of consideration to.

Hi, Steve. We’ve obviously studied this at some length, and the conclusion we come to is that we don’t see any material financial impact to Eaton from the new regulations. We believe our guidance for 2016 will not be impacted, and in fact, the guidance I gave on the last call longer term, which is a tax rate between 10% and 15%, with the rate stepping up slowly from the 9% to 11% for this year. We think it’s still the appropriate guidance for later years. So in sum, we don’t see any material financial impact from the regulations. We do, however, see the need for additional administrative actions to meet the documentation requirements for the new regulation for new debt that you put in place. I think as you know, the regulations only impact new debt; they don’t impact debt already in place. But those administrative actions won’t have any material financial impact on Eaton.

Okay, that's good to hear. Could you maybe dig into the electrical product improvement that you're seeing? I'm trying to get a sense also for what is and in this, probably goes some of the other segments? What sort of comp driven versus really fundamental demand changes? In this case, obviously LED penetration, large projects. Maybe just give us a stance for where the strength is business wise as opposed to just geography.

I'll be glad to. As I mentioned, the couple of areas clearly the residential businesses have been doing very well for us, and so that's both in terms of the load center circuit breakers, pull outs as well as wiring devices. Lighting continues to be quite strong; the single-phase power quality which we report in our electrical products area has been strong as well and it has helped. What we've seen over the last couple of years is we've seen strength in these areas in the US that haven't seen much strength in Europe in that regard. Europe had a far better quarter in that regard as well. So I would point to those as being the areas of real strength. The areas that have offset it look at at 2% and say that's not kind of growth we were seeing a couple years ago. The industrial markets are still the weak spots, both industrial MRO and industrial OEM continued to be weak, and we see that on a number of our products we sell directly into those markets.

Okay, all right. Thank you. I'll pass it on.

Our next question comes from Ann Duignan with JP Morgan.

Can we dig into the vehicle business a little bit Sandy or whomever wants to address it? That business, that Brazil piece is trucks and agriculture. Can you just talk about what you're seeing in the fundamental both of those businesses? Are either of them reaching trough? Any signs of life standard in either of those end markets, please.

Yes, I think its signs of life is maybe the right way to describe it. Obviously, the political and economic situation is so difficult in the country right now, and to say that we've got better transparency than anybody else on what's going to happen there, we often overestimate our capabilities to have those insights, so we continue to see this year being a year that is actually declining in Brazil. In our view of Brazil at this point, where our vehicle markets are as I mentioned upfront are worse than it was starting the year. So no, we're not seeing a turn in Brazil.

Okay, thank you. And then just a follow-up. Asia is a large place. When you talk about Asia across your different businesses, is it all China or are there any other markets that are worth noting?

I think China is clearly one of the big players in that regard. We have for several years felt that the China economic data was maybe a little bit more bullish than we were actually seeing at the street level. That continues to be true, but we're not seeing our business in China growing at this point; in fact, we've seen it pull back slightly. In certain segments, you're seeing in our electrical business for example, some of the utility activity in China has pulled back. In our vehicle businesses, the markets on the light vehicle side have stayed relatively strong, but they've been pretty choppy in the commercial vehicles over the last couple of years.

No, I think you've covered it. I mean, I think there are maybe a green shoot or two in terms of what's going on in some of the hydraulic markets. It's too early to really call that we've hit bottom. But we certainly saw in the month of March and probably some of the other data that you follow as well, that perhaps there’s some bottoming in some of the construction equipment markets in Q1, but once again, probably too early to call if we’ve really reached bottom or not.

The one area maybe I didn’t mention Ann, is that the aerospace markets really outside the US and that does include Asia, remain strong.

Right, thank you. That was pretty broad. So I'll leave it at there.

Our next question comes from Julian Mitchell with Credit Suisse.

Just on the vehicle segments again. Obviously, you went through last year in hydraulics, and in each quarter you were cutting the sales and/or margin guidance as you went through the year. One quarter in for vehicles you've cut the sales and the margin guidance. What issues do you think are different for this year, when you're looking at vehicles, guidance and the assumptions behind it, versus where you were on hydraulics one year ago?

Maybe I'll grab that one, Sandy, if you're okay with that. But I say Julian, the big change for us in the vehicle segment this year really centers largely on North America Class 8 truck. The other market by and large are performing as we anticipated. The light vehicle market in China is doing fine. Europe's in light vehicle is doing well. Yes, we had some perhaps a little bit of another leg down in South America, but at this point the denominator is so small that it doesn’t matter a lot. And really, it's a function of the North America Class 8 market and coming into the year we had a 250 number out there for the market, which was quite frankly one of the weaker numbers from anybody forecasting the market coming into the earlier part of this year. It appears that we have about 20,000 units of inventory overhang that is fundamentally affecting the North America Class 8. If you take a look at truck tonnage, where some of the key markets are the indicators for those markets for the longer term, those markets are doing okay and so we're really engaging in a bit of inventory correction right now in North America Class 8, and that’s principally why we revised our forecast. And that 230, we think again we have one of the more conservative numbers out there. So at this juncture, we think we're well positioned in terms of the year, and so we don't think that there's going to be a case of every quarter another down revision.

Thanks, Craig and then just my follow-up with the electrical businesses. Just wondered if you saw any change in demand trend as you went through the last few months in any of the major regions or verticals?

Yes, we've seen nothing substantial, Julian. I think a number of people, I'm sure are curious about how do we see March different from January and February, and I'd say that not significantly different than we would normally see in the first quarter. So we have not seen an acceleration in demand that has been unusual in the month of March. If we go back to the comments we made right at the beginning of the call, we see the year laying out very much as we did, a number of you thought we were conservative in terms of our economic outlook for this year. But when we see US GDP coming up, the kind of numbers that did the other day, we think it's more confirmation that this is likely to be a slow growth year on the industrial side, and the real premium has to be placed upon getting costs out and then trying to buy back shares. That’s very much what our plan is built around.

Very clear, thank you.

Our next question comes from Scott Davis with Barclays.

We've seen a bit of a pop-up in steel prices, copper, things like that. I think at least in the US, your LIFO accounting, I think. Memory serves me right. But are we at the point of the cycle where you can go out and get price even potentially a little bit more than just a pass-through? Or are we still just trying to get a pass-through here? And can you probably get a pass-through? Particularly when you think about things like vehicles or hydraulics?

It may be these things have issues of timing, and there is usually some sort of lag. I think when I’ll ask Craig to comment as well. We’re more of a view at this point that we're getting slight positives in terms of margins as we mentioned our guidance this year from the tailwind. Yes, some things have picked up, but I think you have to see the pick-up a little longer in before you'd really see price traction from commodities. I don't know, Craig. How do you feel?

I completely agree with Sandy. Despite the fact that we’ve seen a little bit of pickup over the last 30 days from a planning standpoint, we’re still many cases below our original assumptions for the year regarding where commodities are going to go. So at this point, I think it would be clearly premature to think about us moving into an inflationary piece of the cycle. The only balance we’ve set in the past is that we think our net between material costs coming down in price are about a net neutral for the company, and we continue to believe that's where we're positioned.

Got it, fair enough. And I don't think you guys mentioned M&A in your prepared remarks. At least I didn't hear, and no one's asked about it yet. But are there transactions out there that you guys could perceive getting done by the end of the year?

Yes, I'd say on the M&A front, what we've said from a priority standpoint today is that we’re really focused on first and foremost investing in our businesses to drive organic growth. We think we have plenty of opportunities to do that. Secondly, we said we're really focused on making sure that we maintain a strong dividend, and then we also said that share buyback in this environment where our stock is trading below the valuation that we think is fair is the priority. At this juncture, we continue to be focused on those priorities. We've committed to buy back $700 million worth of stock this year. And quite frankly, given our priorities right now, we don’t think there’s going to be a lot of latitude from the balance sheet standpoint to do much in the M&A front. There are always things that we're looking at on the margin and we'll continue to look, but today that's not the priority.

I'll pass it on to Sandy. Congratulations on your retirement, and it’s been a pleasure. So I'll pass it on.

Thanks, Scott.

Our next question comes from Eli Lustgarten with Longbow Securities.

I'm sorry, can you hear me?

Yes.

My best wishes to Sandy upon retirement, and I just hope you need to survive this summer.

Thank you.

Other things also. We just started talking about, we're hearing a lot of price competition coming in a lot of markets in a break. Can you give us some idea, I mean there's a lot of mentality among competitors that nobody wants to lose a deal, and pricing particularly outside this country is getting very, very competitive in what we're hearing. Can you give us some idea? I know you just talked about these, but you're still kind of neutral, but are we seeing any real changes in pricing competition around the markets?

I think if you see our margins in the first quarter, that's maybe the best way to give you some sense. I'd say not that we haven't anticipated, and with the benefit of all the work we're doing on restructuring, I think you're seeing our decrementals be extraordinarily low. There’s no question when commodities come down you're going to see some impact. We discussed that in our last calls, but I don't think it's anything that we haven't really anticipated at this point.

I agree completely, Sandy. Certainly, in the negotiated project piece of the business, there's always on the margins of some places where you're being more or less competitive, and there's some regional differences. But on balance, and across the company, nothing that would not be consistent with the guidance that we provided. No indications that anything has changed.

Okay, not much going on. One of the things we're hearing a follow-up from a lot of companies is that orders are getting better but are decelerating declines across the market. Are you seeing things stabilizing even in the oil and gas sector? The question is, when do we anniversary the big declines that things begin to be more stable across the company?

I think the best way to think about our volume forecast for this year is while you've seen an organic decline for us in the first quarter of 6%, and then I mentioned to you, if you looked at our guidance for the second quarter, and if you were to calculate it versus a year ago because I gave it to you versus the first quarter, it will be less than the 6%. The comps for the second half get a lot easier, and that's how we get to this down 2% to 4%. Now that's kind of quarter-to-quarter look, but I don't think we're saying that we're seeing markets begin to accelerate at this point. So we think we're kind of cruising down towards the bottom, if you will, and we don't see a significant market growth at this point, and so that's the kind of tough scenario we find ourselves in this low-growth global environment. That’s why again we put the premium on taking this time to do the restructuring and do the share buybacks.

All right. Thank you very much.

Our next question comes from Nigel Coe with Morgan Stanley.

Just wanted to hold on electrical. Firstly, on the systems side, the down 2% to 3% order trends, I guess over the last two or three quarters. What should we expect revenue growth to recouple to that kind of cadence? Second part of that question would be on the Canadian Dollar. We've seen a pretty sharp strengthening of the Canadian Dollar, and I remember last year, you had some struggles with margin deleverages due to that weakening. So I'm just wondering, does the reversal of that trend help you on the margin front?

Yes, first on the volume level and looking ahead, I do think as we mentioned, Nigel, you correctly referenced it as looking at our bookings is a pretty good way to think about what's coming out ahead of in terms of the electrical systems and services segment. There is a portion of that business that does come in during the quarter and go out, and that's the piece that’s a little higher for us to forecast. In some cases, that is MRO for oil and gas. So that's an area that's a little harder for us to look ahead. I think we entered this year thinking oil and gas will be down on the basis of 15%. It’s every bit of that, whether it turns out to be more than that, I guess we’ll know come year-end. But even though we've seen oil move up to the mid-40s, that segment is just not investing right now, and there's still very much in a cutting-back mode at this point. It's going to take some time before we see that start to come back from the other direction. I say the other issue for us to keep an eye on here is whether we start to see confidence in and around reinvestment in industrial projects, and we're really not seeing that to date. We think that's likely to take more time as well. You're right that the pricing in Canadian Dollar versus the US because most of our production is in the US that we serve Canada with. It did hurt us last year. If it stays on a sustained basis and that’s the key here, that will start to help us from a margin perspective.

Okay, that's great. And then just quickly. You gave us some good color on the end markets within electrical. You didn't talk about utility, which is I think about 10% of your electrical sales, a bit more within systems. It seems like distribution spending is coming back a little bit. I think first of all, have you seen that and how much of that’s weather, what is your view going forward on distribution spending in the US?

Yes, we did see a little better quarter on bookings. It comes in obviously bookings first on the distribution side. So you're correct. We frankly saw that from a couple of our peers as well. There are some other issues going on within what we call our Power Systems business currently, and you may recall there were regulations that were put in place about transformers last year. That caused a pop-up in bookings on the fourth quarter, but a little bit of an overhang in the first quarter. We expect to see that stabilize as we go through the year. Our original guidance of 0% to 2% for utilities, we did better than that in the first quarter.

Great. Thank you very much.

Our next question comes from Josh Pokrzywinski with Buckingham Research.

Just maybe to go back to some of the earlier questions on the complexion of business. Sandy, you touched on not a lot of appetite in the marketplace for project business. Are you seeing more stability though on the MRO and piece parts side? How would you characterize kind of the price or mix dynamics between those as well?

Yes, I'd start and let me ask Craig to comment on this too. But I'll start with a couple of high-level issues. Construction is better than industrial activity. So industrial activities around the user or the OEM side is weaker. But I've got to say construction is better on commercial than it is industrial and it's strong on residential. When you get inside commercial, it’s better in light commercial than it is in heavy commercial, and that has been pretty much our experience through much of last year, as well as what we're seeing now. So we're not seeing strengthening on the industrial side in either the MRO or the user side. I think you've seen that parallel on a number of our peers who reported quite recently, and their big weakness has been on the industrial side, both user and OEM. And the large industrial project side has also been weak, whereas strength has been in the construction side, particularly light construction in residential.

And would you characterize the light construction and I guess residential, not as much as the business? But is that light construction profit mix favorable? Because there’s more lighting in there, and maybe a lower engineering content that it does hold down the margins, and some of the strengths we’re seeing are really unrelated to that.

Again, I would say a lot of this industrial MRO and user tends to flow into products, and you typically in the industry see products as higher margin compared to systems and services. So it does play a little bit that way.

All right, great. Thanks a lot, guys.

And that is more of a reason for the margin guidance we provided in electrical systems and services. Basically, those margins got squeezed, really because of that issue with industrial sides of business. The MRO side tends to be a little more profitable, and we're seeing relative weaknesses there and strength on the commercial side.

Our next question comes from Jeff Hammond with KeyBanc.

Just back on the conversion changes, maybe two questions there. One, how do you think differently or not differently about tax re-spins and wanting or not wanting to do that beyond December 17? And then as you look at deals perceptively, how should we think about the ability? How do we look differently or the same at tax synergies within that?

Yes, let me jump on that, Jeff, and I'll deal with your second question first. The new debt regulations, as I said a bit earlier, mainly impact us in having to have a more comprehensive documentation around newly issued intercompany debt, and it doesn’t seem likely those requirements would significantly impact any financings we would undertake as part of any new acquisition. So we don’t see much impact on future acquisitions. In terms of the impact on spins, those regulations haven't changed. It's a five-year period from the time that you undertake a transaction like the Cooper transaction. So as we get to the end of next year, we will be able to undertake a spin tax-free. Again, there may be some more documentation for some of the financing around that, but we don't believe that the fundamental transaction will be impacted.

Okay, great. And then Sandy or Craig, can you give us the quarterly cadence of NAFTA truck production? How are you thinking about that?

That was 64 in the first quarter, and we expect it to be approximately 60 in the second quarter and then approximately 54 in the third quarter and then 52 in the fourth quarter.

All that's obviously in our guidance.

Best guess, recognizing there could be a little bit of imprecision.

Our next question comes from Deane Dray with RBC.

And Sandy, you may have answered part of this question in your response to Josh's question. But it was interesting; one of your big electrical products should be there as yesterday talked about being a little more cautious on non-res calling it flattish. I'm wondering how you would reconcile those comments among your distributors.

Obviously, we have many, many distributors across the country and Canada, and most of my comments really to the NAFTA region is that, again for people participating in really, really big projects on either the commercial side or the industrial side, it is not as strong. It’s really a quite a mixed issue in terms of where you're exposed. Once again, it's the lighter commercial activity that's the stronger side of commercial, and everyone's individual exposure will be little different depending upon which market and how they're rated in terms of services. We continue to see non-res as a pretty good year. We've talked about this kind of 3% to 5% growth here. So we're not talking about 10% year, but a good solid year. As we look at our negotiations, we’ve talked about this, Deane, over many years. Because of our very large sales force, we get a pretty good look at the projects that are out ahead of us as well. That 10% feels pretty good at this point.

Great, and then just a second question. You called out the decremental this quarter, and when we look at those, they really jump out as a positive in terms of tough markets in declining revenues. If you can manage somewhere in around a 25% decremental and you handedly did that. So what were the actions you had to take within the quarter to manage to that, those numbers or were those prior restructuring?

It's both. I mean, thanks for asking the question because I think it’s important for us all to remember that out of that $185 million of incremental savings year-to-year, a bunch of that is from actions we took last year. Remember we pivoted at the end of the first quarter, and Craig and the whole team put in place a very aggressive set of restructuring. We obviously got benefits from that in the fourth quarter, we got benefits from that in the first quarter, and we’ll carry those through this year. So in addition to that, now we've also kicked off a whole set of additional actions here in 2016. We would not be able to have those low decrementals unless we'd been working on this for some time at this point.

Great, thank you.

Our next question comes from Jeff Sprague with Vertical Research.

Just wondering if we could just go back one more time to tax. In particular, just thinking about the potential for spin-off dynamics. I appreciate that the five-year period may have not changed, but I was also under the impression that perhaps there was just the high level of complexity if you wanted to go down that path. I'm wondering if that complexity and kind of disentangling of structures that you have in place currently, particularly in light of the treasury regulations, would make a spin especially difficult, if not uneconomic.

Yes, let me answer that. These new regulations really don't fundamentally affect a spin. Disentangling any subsidiary to spin is always a complicated exercise because sometimes the assets are not owned in a separate legal entity. Sometimes you need to sell a legal entity to another entity in order to create one vehicle you could spin. If you look at other companies that have gone through spins, it usually takes a period of months, sometimes even as much as a year to disentangle all that. But it's really just a function of getting all the assets and businesses into a single legal entity, and these new debt regulations won't have any significant impact on what you need to do.

Before we go too far down the path around this magical line of demarcation that happens at the end of 2017. So we don't read too much into that. As we've said in New York, we have a game plan for all our businesses. We have a game plan that we like. We laid out a plan around how we get these businesses to deliver significant market margins through the economic cycle, due certainly to participating in certain businesses that are most cyclical than others. But we’re not sitting around waiting for 2017 to make some magical decision around what we do with our businesses. We have a game plan that we like, and we think each of these businesses will continue to contribute positively to the company as you’ve seen this year and in prior years. We know how to manage cyclical businesses and we know how to deliver growing margins despite the fact that our markets are performing poorly right now. So as we think about the company overall, we have a plan to run these businesses, and I don't want to get too much into thinking that, come the end of 2017, we're going to announce some big transaction. We have a plan that we like; there's certainly risk in some of our markets, as you saw in the vehicle discussion just recently. Clearly, we have some markets that are a little weaker than what we anticipated, but we are not done with restructuring. In the event that markets are a little weaker, we have lots of programs and plans lined up to do more restructuring if we need to. So we’re very confident that we can deliver the margin targets that we laid out for each of our businesses independent of what happens with some of these end markets.

Thank you. Could I just have a little more color on lighting? I think Sandy just characterized it as strong, which I’m sure it is, but can you give us a little bit of color on how quickly it's growing, whether the LED penetration is, a couple of metrics around the business?

Sure, maybe two metrics that might be helpful to you, Jeff, is that our LED business is now over 60% of our total lighting business and so we really see it continuing to lead in that respect. That LED business grew over 30% in the quarter, and so it continues to be a very fast-growing and exciting area. Part of the advantage, and you've seen a lot of reports come out after light, is that every one of our competitors has its own unique strengths and weaknesses. We again are the only company that's really able to combine all the advantages of independent lighting with the full power control and distribution system in the building, and that's really where we think we build very unique value for our customers.

Thank you very much.

Our next question comes from David Raso with Evercore.

Two questions on cash flow. I thought the cash flow in the first quarter was pretty strong. Definitely one of your strongest first quarters on record, I think you said. The cash flow to the full year, I'm surprised it was an increase. I think from the analyst meeting, one of the more interesting statements was how much stronger you expect the cash flow to be during this five-year period versus the prior. What was going out with the lack of cash flow increase?

I would, David, really say this about a number of elements out of the first quarter. It's still early. We're at the end of the first quarter and that we really, what we're seeing the danger in the kind of slow economic times is just assuming that everything continuously gets better. I think by the time you get to the end of the second quarter or middle of the year it's probably a more appropriate time to look at this.

Okay, so it's fair to say that cash flow year-to-date is ahead of plan?

We had said that remember, a full year is that we would have a cash efficiency ratio of one or better, and that's still very much our plan.

Okay, one last just housekeeping. Maybe I missed it. The net savings or if you want, even lay out the cadence of the $185 million of savings over the four quarters. How did it play out in the first quarter and the rest of the year?

Yes, we’ll give you a full accounting on this by quarter when we get to the end of the year. But I think the best way to think about this is approximately 45% of the savings is in the first half, approximately 55% in the second half. You might say, how could you get that much in the first half? Remember part of it is the carryover for the full year benefit for actions that were initiated in 2015 that was our plan coming into the year. It's built into our quarterly guidance and so again, hopefully that plus the layout we gave you for the restructuring expenses on the charts in the presentation gives you a sense for how the costs and benefits lay out over the year.

So the net actions in the first half are still slightly negative compared to the positive delta of the second half?

Yes, I think so. Correct.

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

On hydraulics margins. Maybe just a little bit more color on how you feel the actions there taking hold and when do you think you can get those to kind of low teens expectation extra structuring? When does the demarcation line for them to be required to get there?

Yes, that’s a great question, and as you appropriately pointed out, it’s a question of how much restructuring we're doing across the company today, and going back into 2015 is absolutely focused on the hydraulics business. Today we have margins that are running as you see in the 10% to 11% when you look at both Q1 and Q4, less restructuring, and I’d say we're about half-way through the restructuring opportunities we’re working through. By the time we get to the end of this year or early next year, we ought to be having a business at this level of economic activity, not banking on any significant recovery in markets that is running at low-teen rates.

Okay, great, that's really helpful. And then Rick, sorry to beat the tax thing to death here, but you know a lot about this. Is the fact that there is not an impact and you're still, your 10 to 15 is still holding, is that because potentially differing treatment within equity and things like that, it doesn’t have an impact? Or is it because you’ve already incorporated some tax-free into your range in the first place when you say 10 to 15?

Well, we had very carefully put together our financing plan for Cooper and really all the financings we've done over the years. We've been very careful to be compliant with all the different IRS Safe Harbors and IRS Regulations, and so these new debt regulations don’t really impact if you follow carefully those prior rules, and that’s why it doesn't have much impact on us.

Okay, great. Thanks a lot.

Our next question comes from Andrew Owen with Bank of America.

Sandy, congratulations for great work over your tenure.

Thank you.

Just a question on aerospace aftermarket. Bookings were down in the first quarter, is it a tough comp or what's driving it? Is there any risk to aerospace margin in the second half of 2016 from lower aftermarket?

Really a tough comp on the aerospace aftermarket. We had a really exceptional first quarter last year with a number of our large aerospace distributers. So we're not concerned that this is a bigger trend.

In fact, we take a look at what happened with revenue passenger miles, and generally in Q1, it feels like the consumer is very much in the economy jumping on planes, and those numbers were up solidly and perhaps a little stronger than we originally anticipated starting the year. So it's an encouraging sign that consumers continue to get on planes and ultimately that's a good thing for aftermarket.

And just a follow-up question on China, particularly on the electrical side. The way I think about the cycle, by the time machine manufacturers place orders for your equipment, by the time you ship it, things are probably have been turning for a while. What are the leading indicators that you guys use internally to gauge the state of the Chinese market, particularly on the electrical side?

So I'd say that maybe there are a couple there. There's a large project business obviously that goes on, it has a lot to do with utility and infrastructure. There you get some look. An awful lot of our business in China though is a daily flow business. Whether that's on power quality or whether it's in the power distribution side, that’s a lot harder to gauge because it has a lot to do with how inventories are distributed and whether the OEM or the construction side of the market is moving very quickly. So we don’t get a lot of lead time in China. We probably get a better view here in the US than we do in China in terms of future outlook.

Thank you very much.

With that, we're going to have time for one more question this morning, and I'll ask Andy Casey with Wells Fargo.

Good luck to you, Sandy.

Thanks very much, Andy.

Question on the ESS; you talked about weak industrial markets in the current period, but I'm wondering if what you mentioned in the past conference calls about some of the large industrial projects maybe starting to come on during the second half. I'm wondering if that's still the case, or have they just been pushed out again?

Yes, I would say outside of projects that we're committed to, there were some natural gas projects in that sector, and they may not like their contract so much today. I'd say we aren't seeing the big projects come on for the second half.

Great. Thank you very much for your time today, everyone. We will be here for follow-up questions throughout the remainder of the day, and we appreciate your continued interest in Eaton.

Thank you for joining us today and have a great day ahead.