Eaton Corporation plc (ETN) — Q2 2016 Earnings Call Transcript

Good morning. I'm Don Bullock, Eaton's Senior Vice President of Investor Relations. Thank all of you for joining us for Eaton's second quarter 2016 earnings call. With me today are Craig Arnold, our Chairman and CEO; and Rick Fearon, our Vice Chairman and Chief Financial Officer. The agenda today as normally includes opening remarks by Craig highlighting the company's performance in the second quarter and our outlook for the remainder of 2016. As we've done in our past calls, we'll be taking questions at the end of Craig's comments. A couple of quick housekeeping items. The press release today from our earnings announcement this morning and the presentation we'll go through have been posted on our website at www.eaton.com. Please note that both the press release and the presentation do include reconciliations to non-GAAP measures and a webcast of the call is accessible on our website and will be available for replay. Before we get started, I want to remind you that our comments today do include statements that are related to expected future results and as a result, are forward-looking statements. Our actual results may differ from this for a wide range of uncertainties and risks, they're described in our earnings release and in the 8-K. With that, I'm going to turn this over to Craig Arnold.

Okay. Thanks, Don. I'm sure you've all had an opportunity to work through the material, and so I'll hit a few of the highlights and add a bit of color to the results. Operating earnings per share, we're really pleased with the results in the quarter at $1.07, $0.02 ahead of our guidance. And as we anticipated, sales in the quarter came in at $5.1 billion, down 5% organically – down 5% – organic revenue down from 4%, and this is really consistent with the normal patterns that we see. Q2 sales are 5% above Q1, and quite frankly, FX was a little better, 1% better than it was in Q1 as well. Segment operating profits came in at 15.4% versus our guidance of between 15% and 16%, and I'd say with particularly strong margins in Electrical Products as well as in Aerospace, both of which came in at 18.6% when you exclude some of the restructuring charges, offsetting a bit of weakness in Electrical Systems and Services. Restructuring costs in the quarter came in right as expected at $35 million and reducing our margins by some 60 basis points. Adjusting for restructuring costs and FX, really strong decremental performance by the company overall in each of our businesses. We're also really pleased with the fact that we had record cash flow in Q2 with cash conversion of 124% of net income, so really strong cash performance in the quarter. We also repurchased some $225 million of our stock back, some 3.7 million shares in the quarter. Turning to the financial summary, we continue to see weakness in the number of our end markets versus 2015, but sequentially revenues were up some, as I mentioned, 6% from Q1. Organic revenue declines and FX headwinds are decelerating. Organic revenue was down some 6% from Q1, but only 4% in Q2, and as I mentioned, FX also mitigating a little bit, down 1% in Q2 versus 2% in Q1. Margins, excluding restructuring costs, were some 16%. That's up 90 basis points from Q1 and an improvement over Q2 of 2015 by some 10 basis points. This is despite some 4% weaker organic revenues, so a real indication that we're getting and we're holding onto the restructuring benefits that we're engaging in across the company. Turning our attention to the Electrical Products segment, a really strong quarter of execution in this business. We're pleased with the Q2 results and we think there's strong overall performance that we continue to see in this business. Modest year-on-year organic growth, up some 1% offset by FX, but in acceleration sequentially with revenues up some 10% from Q1. We continue to see strong execution in the business as evidenced by the significant margin improvement. Excluding restructuring, our operating margins were up some 270 basis points and 150 basis points better than Q1. Bookings were down 2% in the quarter on weakness in the Americas' industrial markets and really broad-based weakness in the Asia Pacific region. We did continue to see strength in U.S. residential housing and in the lighting markets, and in Europe generally. Looking at Electrical Systems and Services, revenues in the quarter were up some 6% from Q1 but 5% worse than Q2 2015. Margins were weaker in Q2 2015 on less favorable mix of projects and also on the impact of a litigation charge that we actually took in this particular business that reduced margins by some 70 basis points. So note margins excluding restructuring costs were in fact flat with Q1. While somewhat offset by lower commodity prices, the pricing environment in this business does continue to be somewhat difficult, and as we've characterized the net between the two, we'd say slightly negative on a net commodity cost basis but certainly manageable and well within our guidance. Bookings are down some 2%, and we're seeing continued weakness here in large industrial projects, weakness in Canada in oil and gas markets, partially offset by strength in three-phase UPS, principally in data centers. Light commercial orders continue to be strong as well as the Service business. In looking at Hydraulics, hydraulics markets, I'd say they appear to be stabilizing, but more importantly, I think our team is executing well here. Organic revenues are up some 7% from Q1, but down 7% from last year. 10% margins in the quarter, but I think importantly 13% when you exclude restructuring costs, and we think this is a real proof point that the restructuring work that's being undertaken in the business is delivering the margin improvements that are really coming through. So ex restructuring costs, profits were essentially flat on 7% lower organic revenue growth, and so we think this is really strong performance. Bookings declined some 2% in the quarter. Really the best quarter that we've seen in bookings in the last two years, particularly driven by strength in EMEA and positive bookings in Asia, with the modest weakness continuing in the Americas. In the quarter, OEM orders were down 4%, distribution orders were down 1%, and really the area of greatest weakness in the business continues to be on the stationary side of the business where we had orders down, in some cases, up to 33%. We did see strength in the quarter in ag, up 23%. Not sure how much of a read-through that is on the total year as we continue to see some concerns there. Construction orders in the quarter were up some 8%. In Aerospace, we think our strong operating result in the quarter. Organic revenues were flat with Q2 2015, principally on lower military OEM sales, offset by strength in both large commercial transport and in aftermarket. Margins were once again very strong at 18.6%, up some 160 basis points over Q2 2015. Bookings were down 1% in the quarter, and this is on particular weakness in the bizjet segment, which was a little bit of surprise weakness for us, but when you just adjust for weakness in bizjet, bookings were up mid-single digits and aftermarket orders continue to be strong, up some 7%. We also continue to see strength in the commercial transport segment, where we saw orders up some 10% in the quarter. In looking at Vehicles, organic revenues were down 14% versus Q2 2015, driven primarily by the 29% decline in Class 8 market and continued double-digit market declines that we're seeing in the Brazilian market. Outside of Brazil, passenger car markets continue to hold up at very high levels and we expect markets in North America to be flat with modest growth in EMEA and in Asia. Margins, when you exclude restructuring costs, were down some 230 basis points versus 2015 but up 70 basis points versus Q1. So we think with or without restructuring costs, we think a strong operating performance in this business is occurring, even with some pretty significant headwinds in terms of the Class 8 market and what's happening in Brazil in general. If we turn to the organic growth outlook for the year, I'll spend a few extra minutes on this slide just to give you some color on the way we see the year unfolding. In general, we think markets on balance are performing as we expected, but we do expect the market to remain sluggish throughout the balance of the year. And looking at Electrical Products, this presents a really mixed story in terms of what's going on in our end markets. We see growth in residential and lighting in the U.S. and growth in Europe, but we continue to see declines in industrial markets in the U.S., Canada, and in Asia. More specifically, we're seeing growth in U.S. residential markets; we think growth in the 5% to 7% range. We're seeing growth in the U.S. lighting market, which we'd say is mid-single digit, and we see growth in Europe, EMEA, growing around 2% to 3%. This is offset by weakness in U.S. industrial markets, which we think will be down mid-single digits; weakness in Canada, which we think is down low single digits; and continued weakness in the Asia Pacific region, which we think is also down within the low-single-digit range. In Electrical Systems and Services, we continue to see declines in large industrial projects in oil and gas, but some growth in three-phase and power quality in the U.S. market and in Europe, with modest growth in Power Systems. More specifically, we see U.S. and EMEA three-phase power quality up low-single digits. We see some real weakness in harsh and hazardous, and we think it's down some 15% for the year. We think industrial projects continue to be down, and light commercial continues to be a source of strength in the business, and once again, Asia Pacific we think will be down low to mid-single digits for the year. Turning our attention to Hydraulics, we had a relatively stronger quarter in Hydraulics, and we think this is really a function of easier comps as we move forward during the course of 2016. We continue to see weakness in mobile, particularly in ag equipment, and see continued weakness in oil and gas equipment markets, with double-digit declines in China construction. Our call on the Hydraulics markets really has not changed materially from the way we originally saw the year. In Aerospace, we're seeing low-single-digit growth in commercial OE and in commercial aftermarket, offset by some significant declines in the bizjet segment, which took orders down in Q2. Some small declines in U.S. defense OEM and modest growth in defense aftermarket. In Vehicle, as we noted, NAFTA Class 8, we think will reach approximately 230,000 units this year, down some 29%. We continue to see weakness in the Brazilian truck and bus market, which we think will be down 20% for the year, offset by low-single-digit growth in NAFTA Class 6 production and some modest growth, as I mentioned, in the light vehicle markets around the world. If we turn our attention to restructuring, the news here is positive. Restructuring programs remain on track, Q2 spending came in right at plan at $35 million, and our projects are clearly on track and we have great line of sight to delivering the benefits that we laid out. We did increase our second half spending by $5 million, primarily in Electrical Systems and Services to deal with the continued weakness that we're seeing in some of our markets, principally oil and gas and industrial markets. We expect to spend $27 million in Q3 and another $20 million in Q4, increasing our total spending for the year to $145 million, but we've also increased our annual benefits by $5 million, resulting in no net change in benefits for the year. So total we now expect the program to cost $404 million in total, with benefits of $423 million, both up $5 million from the prior forecast. Turning our attention to the segment margin expectations, there are no significant changes here overall. On a consolidated basis, it remains unchanged from prior guidance; however, we did make a minor adjustment in guidance for both Electrical Systems and Services and in Aerospace. Electrical Systems and Services is down some 30 basis points on continued weakness, principally in the higher-margin oil and gas and industrial projects. Aerospace is up some 30 basis points, based on ongoing strength in aftermarket and really tight control over development costs. Each of the other businesses are expected to be within the ranges noted, and you'll recall that these guidance numbers do, in fact, include restructuring expenses. Turning our attention to EPS guidance, guidance for Q3 reflects the continuation of the overall softness in several of our end markets. We think organic revenues in Q3 and Q4 are essentially flat with Q2. Flat revenue, but the variances to last year will improve, as a result of, as I mentioned earlier, easier comps. Margin expectations will be between 15.5% to 16.5%, reflecting lower restructuring expenses and increased benefits from Q2 and Q3. We think the tax rate will be 8% to 10% in Q3 versus 11% in Q2, and the midpoint of our guidance remains unchanged at $4.30, but we did narrow the range by $0.05 on both the high side and the low side. In summary, we think we had a really strong quarter in Q2. The teams are executing extraordinarily well. Revenues came in more or less as expected, with strong performance in Electrical Products and Aerospace offsetting some of the weakness that we're seeing in Electrical Systems and Services, and Hydraulics is showing strong margin improvement excluding restructuring charges in the quarter. Once again, importantly, record cash flow as the businesses are really doing a nice job of converting net income to cash. We remain committed to our $700 million of share repurchase. We repurchased 3.7 million shares in the quarter for $225 million. Markets are unfolding as we expected, and the full-year outlook remains unchanged at down 2% to 4%. The restructuring programs are effectively delivering $174 million of incremental profit in 2016 over 2015, and we are set up well to deliver another $120 million of incremental profit in 2017 over 2016. I'll stop here, turn it back to Don, and we'll go to the question and answer.

At this point, our commentator will provide some guidance for you on the Q&A session.

Before we enter into the question-and-answer session today, I did want to note that we have a number of people in the queue for questions. To try to keep things within the constraint of an hour, I would ask you to limit your questions to a single question and a follow-up. As always, we'll be available to go into more detailed questions or others throughout the remainder of the day or otherwise. With that, our first question today comes from Julian Mitchell with Credit Suisse.

Thanks a lot. Hi, Craig. Just firstly on the ESS margins, I think you're implying the second half margins are 14%-ish. Those are up maybe 150 points year on year and sequentially in the half. Revenues though, probably in the second half, probably not doing much year on year or sequentially. So maybe just clarify what you see in ESS that picks up in that second half.

Yeah, I'd say the first adjustment you'd need to make in terms of the underlying run rate of the business is that we did have the legal settlement in ES&S in the quarter which shaved some 70 basis points off of margin. Then secondly, as we move into the second half of the year, we will clearly see a little bit of volume lift but not dramatic. The restructuring benefits that we've been undertaking during the course of the year also start to kick in, and we will see a margin lift as a function of the restructuring benefits that are more backend loaded.

Got it. Thank you. And then just within the Electrical Products business, you did see that bookings turn down in Q2. It looks like the guidance for revenues has an acceleration in organic sales year on year in the second half. Are you seeing something in the bookings in Q3 already that suggests that decline in bookings should be reversed now, giving you visibility on second half revenue?

Yeah, what I'd say on that one, Julian, is that when you take a look at the absolute level of revenue that we're forecasting for the back half of the year, it's really running essentially at Q2 levels. And so we don't have a volume lift that's built into the second half of the year. As I mentioned earlier, the comps in general get easier for all of our businesses. We really saw a fall-off in our revenue during the course of 2015 in Q3 and Q4. We're essentially saying we're going to be running at this current level of economic activity and revenue, and it's a function of the comps versus prior period that appear to be a relatively change in the rate of change, but the absolute dollars don't really move much at all.

Great. Thank you.

Our second question comes from Rob McCarthy with Stifel.

Good morning, Craig, and congratulations on a solid quarter and a good initial start. I guess the first question I would ask, with respect to ESS, aware of the litigation expense there and the margins. But could you talk – you did set the oil and gas exposure there, but could you talk about maybe the trends you're seeing there, oil and gas in general? And then as a follow-up to that, could you talk a little bit about the portfolio's oil and gas exposure beyond what the explicit exposure is – what the implied exposure could be? Because I think what we struggle with sometimes is understanding what the second-order effects of some of these industrials companies' oil and gas exposure are. If you could comment on that, that would be very helpful.

Yeah, so I think there's three questions there. One, regarding the margin impact in ES&S. We had this legal settlement related to a three-year-old commercial negotiation that ended up impacting the Electrical Systems and Services segment, and so that did take our margins down by 70 basis points in the quarter. In terms of the company's exposure to oil and gas, most of our exposure that's inside of the electrical business is in the Electrical Systems and Services business. You'll recall that when we acquired Cooper, we also acquired a very large business called Crouse-Hinds that has a significant exposure to what we call harsh and hazardous markets, including oil and gas. We're certainly seeing an impact in that business as well as in all of our businesses that are exposed to oil and gas. I'd say, in terms of the overall oil and gas market, at this juncture we'd say we certainly have not seen any improvement in oil and gas, and perhaps we've seen a little bit of deceleration in oil and gas. Not material changes from our original assumptions for the year, but clearly we've not seen any indications that that market has turned. To your point around the second derivative and the other markets that are tied to oil and gas, we've been experiencing all year that second derivative impact. It is oil and gas, but in many cases, oil and gas companies, whether it's upstream or downstream, they all live under one roof. So we've seen the other knock-on effects from oil and gas related industries already impact our business and are already reflected in our guidance.

I guess following up to that briefly, do you think you have a number about, for planning purposes and otherwise, how you're thinking about that second-order impact? Because I think you have a headline number for your oil and gas exposure, but do you have a number for about the outer ring of that penumbra?

Yeah, we really don't, Rob. I appreciate the question and what you're trying to get at, but we really don't have a particular number. It's a really tough number to derive and we would just be hazarding a guess. What we try to think about today is, we understand the underlying run rate of our businesses and what we're experiencing today. We know that we're already experiencing the second derivative fall-off, and that's the basis that we use to develop our guidance.

I'll leave it there. Thank you for your time.

Thank you.

Our next question comes from Steven Winoker with Bernstein.

Hey, thanks, and good morning, guys. Just trying to understand here on the margin front, you put up 10 basis points better ex restructuring. That's quite a performance given the volume leverage. So maybe just talk a little bit about what you're seeing; if you could give us some color around – you've mentioned price versus material, productivity versus wage inflation, leverage, mix, some stuff going on in corporate. Just a few of the puts and takes to help us understand how you get there and how sustainable it is.

Yeah. I'd say that principally, if you cut through all the tape, more than anything, it's a function of restructuring benefits, great cost control by the operating teams, and good operational execution. Price versus commodity input costs, we mentioned that we are having a few challenges in Electrical Systems and Services, but if we think about the entire year, we think we're largely on plan and on expectations that there's that little bit of uncertainty around what the future looks like regarding commodity prices, as you read all the same press clippings that I do. We've seen a little bit of an uptick in some commodities in the last 30 days. We've seen others tick down. Overall, we think that commodity prices for the full year will be very much in line with what our expectations were. We're not getting leverage right now in the business because we're not, for the most part, growing volume, and so it really is a function of our business flexing our costs in anticipation of this weak market environment that we're living in.

Okay. All right. We can follow up offline for some – maybe if we could put some numbers around some of that it'd be helpful. But on the cash side, maybe, look, that was also very strong performance. Could you talk about some of the puts and takes around working capital and others?

Yeah, Steve, I'd be happy to. Really, quite a straightforward quarter from a cash standpoint. If you look at the combination of net income and depreciation and amortization, those two were almost $730 million of cash, and then the balance is simply a small positive from working capital. As we've commented earlier in the year, we believe that we have opportunities to continue to take down inventory. We did take inventory dollars down some from Q1 to Q2, but we believe we have further opportunities as we go through the year. It's really just those three items: net income, D&A, and a small positive from working capital.

Great. Okay. Thanks. I'll pass it on.

Our next question comes from Ann Duignan with JPMorgan.

Yeah, good morning. You mentioned a few times some strength in Europe for different businesses. Could you give us a little bit more color on that, where exactly and what segments you're seeing strength?

Yeah, yeah, sure, Ann. Be happy to. I think what we've seen in almost every one of our businesses is relatively, versus our expectations for the year, with all the geopolitical issues and everything else taking place in Europe, we've seen Europe generally perform slightly better than what we anticipated. It really does run the gamut. Certainly, if you take a look at vehicle markets, that’s probably been a big standout this year; light vehicle production and sales have been up mid-single digits all year, so we're seeing real strength there. Hydraulics markets in Europe, while still negative, are less negative than we anticipated. In fact, that market's we think down low single digits this year, which is a better outlook than we anticipated. On the electrical side of the house, once again, we're seeing growth for the most part in many of our end markets in Electrical Products and Electrical Systems and Services, and we think those markets grow slightly this year, we think up, once again, low single digits. So, we'd say it's been a broad-based kind of beat versus our internal expectations, modestly but pretty broad. At this point, it's too early to say, and your follow-up question may be related to what happens with Brexit and the Turkey matter. At this point it's too early to say. On the positive side, we are, today, a net exporter out of the UK, so we don't think that is going to have a big issue, and the same would be true of Turkey. It's been a broad-based, we'd say, beat where Europe in general has performed slightly better than what we anticipated.

And since you answered my follow-up, I'll switch to a different follow-up then. On the Hydraulics side, which specific end markets? Was it mobile, was it industrial hydraulics? Just a little bit of color on the Hydraulics side that was less negative.

Yeah, that's great. It was pretty much primarily the mobile side that came in for the quarter stronger than what we anticipated. Strong ag orders were up 23% in the quarter, with strong construction orders up 8%, offset by ongoing and pretty significant weakness that we still see in the stationary side of the business. The process industries, oil and gas, and large industrial, are very much like what we're seeing on the Electrical side of the business, and that continues to be quite weak.

Okay. I'll leave it there in the interest of time. Thank you.

Thanks, Ann.

Our next question comes from Eli Lustgarten with Longbow Research.

Good morning, everyone. Can we get a little more clarification? You said ag is up 23%, but you said it's weak. Was that – and Europe performance has outperformed what the industry, and the industry was down a bit more than it. Is this picking up share? Was this just the rebalancing of inventories in ag or something with anticipation of planned shut-downs which are coming this summer? Do you view the ag and construction more of a one-off quarter as opposed to sustainability? Can you talk a little bit about pricing there?

Yeah, it's a good question, Eli, and I wish we were really smart enough to be able to call it precisely, but I think it's more the way you articulated. We had a strong quarter of order input in ag and construction. We don't think that's in any way indicative of the underlying market performance, and so it's probably a function of a bit weaker comps that we had last year, and to your point, perhaps some pre-buying taking place in anticipation of summer shut-downs. Our call on the year for Hydraulics hasn't changed. We still think the guidance we provided on the full year is very much consistent with what we're feeling and experiencing in the business. The pricing environment in Hydraulics is just fine. We're not seeing any particular or unusual pressures there regarding the – once again, we always talk about it in terms of the net of commodity input costs and price, and we think it will be net about neutral. Price is not going to be a tailwind for us this year or a headwind.

And just as a follow-up, we're seeing a lot more pressure on input costs in the second half of the year, particularly the steel numbers really haven't changed much. They're up big; maybe less than the spot market, but they're still up significantly. Can you talk about cost price across the business? In the context of the auto numbers that came out that were quite weak today across the board, have you had any concern about some weakness spilling over into Vehicle business besides the truck market, just from North American auto?

You raise an excellent point, Eli, because we've absolutely seen steel prices move materially up on the order of magnitude 50%, a lot driven by some of the duties that have been put on imports coming out of China, and that's had a knock-on effect on steel prices around the world. In the near term we think we're fine regarding the net impact to the company. We did some pre-buying, and we do have some hedges in place. We believe in the near term, we can mitigate the impact of steel price increases. We'll have to wait and see how long these increases stay in effect, whether this is a short-term blip or a long-term issue. In the event that it's a longer-term impact, we'd have to revisit our pricing assumption and find a way to pass it on into the marketplace. We'll do what we've always done in inflationary environments. We'll find a way to pass it on to the customer base. I think it's been well publicized and well understood, so we don't think that poses a risk to our margins. To your point regarding auto weakness, we've certainly seen a lot of reports; we're reading the same ones you have. We continue to take a very cautious view on the outlook for automotive markets. We think North America will be largely flat this year, and Europe and Asia will be up slightly. Like you, we're taking a very cautious view of it, and we're getting prepared that if we have a downturn, we're ready to deal with it. A number of economic forecasters have a view that markets essentially remain at these high levels on into 2017, looking flat or maybe up 1% or so. We're watching it just like you and we'll be prepared in case it goes worse.

Thank you very much.

Our next question comes from Joe Ritchie with Goldman Sachs.

Hey. Good morning, guys, and nice job executing in a tough market. My first question, maybe just starting on Hydraulics for a second, I saw that you didn't take down the organic growth guide, yet one of your largest customers talked this quarter about underproducing real demand in the second half of the year. I'm trying to marry those points. You guys are seeing some stabilization. It seems like things could get a little worse. So talk to us a little bit about what you're seeing and what your expectation is for the second half.

Yeah, and I think generally speaking, we were really pleased with our Q2 performance in Hydraulics, and as we look at the absolute level of change in revenue for the quarter, down some 7%, slightly better than we anticipated, and you take a look at our order input down some 2%. We think these are really strong data points suggesting that if there is a bit of weakness in the back end in certain markets, and we saw the same report that you did that came out of one of our major customers, there's enough breadth in the business and other segments performing a little bit better than that that on net, we think that the year will really align with what our expectations have laid out.

Okay. Fair enough. My follow-up, one of the things that has surprised us from a trend perspective this quarter was that June seemed to have gotten worse for a lot of our companies, especially on the industrial side. So to the extent that you can provide some color on what you saw in sequential trends and specifically talk about industrial, that would be helpful.

From our perspective, industrial has been a source of weakness this year and for the entire quarter. I don't know that June was an especially standout month for us concerning the industrial markets, but we are experiencing the same weakness that others are talking about, and it's one of the reasons why we've taken guidance down in our Electrical Systems and Services (sic). We continue to see some margin challenges in that business. We are experiencing the weakness and I would not say we saw any particular change in the rate of trajectory in June.

Okay. Great. Thanks, guys.

Our next question comes from John Inch with Deutsche Bank.

Thank you. Good morning, everyone. Hey. How did ESS margins in the backlog, how do they look? And the order pricing, is there anything that you could provide us there, Craig, in terms of color?

I'd say there's nothing in the backlog or environment that will in any way materially change the margin assumptions or are highly influencing our assumptions around margins for the balance of the year. Now we did trim the margin guide to ES&S, but that's largely a function of the things that we talked about, predominantly large projects, which are more profitable that we're not selling as many of. We have a negative mix effect, and because of the continued weakness that we're seeing, we're also experiencing a slight negative between commodity input costs and pricing. That was the reason for trimming guidance slightly in ES&S. There's nothing in the backlog suggesting any particular heavy influence on the margins of the business on a go-forward basis.

So other – just by inference then, other companies and not Eaton have called out that what projects are available. And I realize I'm not suggesting it's apples to apples, but just in general, right? What projects are available, but pricing is very tough, as you can imagine, right? Just because of the capacity that's out there for fewer projects. Sounds like that's not happening.

We are, in fact experiencing a bit of price pressure in our Electrical Systems and Services business. On the balance between commodity input costs and pricing, that is negative. So we are seeing exactly what you’re hearing from other companies.

Okay. Okay. And then maybe big picture, how was China in the quarter? Maybe you could dovetail a little of your commentary around construction and just in general in China. Was it stable? Did it get better? Did it get worse? If you could share anything about it, would be fantastic, Craig.

In general what we're seeing in China is ongoing weakness. As you heard the commentary as I talked through the various end markets, but for consumer-related markets and passenger car markets, we continue to see weakness, mid-single-digit weakness in the industrial markets in China. That's affecting our Electrical business, and we continue to see strong double-digit declines in many of the hydraulic-related markets as they continue to work off excess inventory.

I was going to ask you just lastly on inventory in China, I think at the Analyst Meeting earlier this year, there was a broad discussion around just a lot of systemic inventory in China, whether it be construction machines or other equipment. And it's just not Eaton, it's more market. Has that changed at all, do you think? Or is it still this overhang?

I think we're still working through a bit of overhang, and sales versus production continues to impact the inventory overhang in a lot of the capital equipment markets. I think markets like excavators and road rollers and the other things supporting this major building boom that China went through over the last ten years continue to eat into that. Are inventories today at the level needed for the market? I'd say no. They're still working through a bit of an inventory overhang, which is why we're still dealing with these strong double-digit declines in many of the end markets in China.

Yup. Got it. Thanks very much.

Our next question comes from Nigel Coe with Morgan Stanley.

Thanks. Good morning. Good solid quarter here. I wanted to come back to Hydraulics. This quarter, Craig, is the first we've seen any sort of hint of normal seasonality in this business for about three years. I'm wondering maybe – obviously, the orders down 2% is good news, but it's sometimes hard to define the underlying trend from order data alone. I'm just wondering if you could address the issue of normal seasonality at lower levels and how did the book-to-bill this quarter compare to other quarters? Are we at a normal book-to-bill ratio here?

If we take a look at the business this quarter, we built a little backlog in the quarter, which would be expected to the extent that your orders are stronger than your sales out. Once again, I think like you, we don't want to over-read one quarter of results in Hydraulics. It was a stronger quarter than we anticipated in order intake. Is this a turn in the business? We don't know, and it’s too early to call. I think we need to string together more than one data point before we know whether the hydraulic end markets have bottomed out or are prepared for a turn.

Yeah, but stability is good news, I guess. And then, on the restructuring, clearly you're getting some pretty tangible payback on the actions. You've raised your projections by $5 million this year, getting $5 million more, so it's a wash, but for 2017, you gave some color in terms of what you expect, and I'm struggling for the numbers here, but I think it was $130 million of restructuring costs next year and $105 million of payback, incremental payback. Are we still on track for that next year?

We're still on track, and what we said is $120 million of net incremental profit improvement as a function of restructuring. We said it's $120 million, but your numbers are largely correct.

Great. Thanks, Craig.

Okay. Our next question comes from Jeff Sprague with Vertical Research.

Thank you. Good morning, guys. A couple of questions. Craig, on lighting, I think you described it as mid-single digits. I don't know if that was an outlook comment for what happened in the quarter. Could you elaborate on that? I was also wondering if you could bifurcate lighting a little bit. I think you have some harsh and hazardous in there that may be holding that business back a little bit. Any way to think about the underlying truly commercial part of lighting and how that's growing, commercial and residential?

We did say mid-single digits in my commentary. That's really a reflection of what we expect for the entire year and so it's our outlook, but it's largely what we think the market has been performing overall. When we quote the lighting numbers, it does include all of our lighting, which includes harsh and hazardous and the safety business as well, so it's a composite view. Certainly, if you took out harsh and hazardous, the business would be performing slightly better. I don't have the exact number handy, but it would be performing slightly better than that. The really important news is that LED penetration continues to grow inside our overall lighting business, and our LED penetration in Q2 was approaching 70%. We continue to see tremendous growth and penetration in LED lighting, and it has a lot of room to run. We're really pleased with how that business is performing.

Thanks. I appreciate your comment on trying to go after pricing as laws maybe start to work against you a little bit. But can you help us frame that? Perhaps some idea of what percent of your COGS are raw metals or metal related or any kind of ballpark number you could give us there?

It's not a number I have handy, but what I would say is that we'll find a way to offset it like we have historically. We could end up in any given quarter with a little timing challenge around inflation versus pricing in the market. All of that thinking and the current commodity prices are factored into our guidance for the year, so it's all fully baked into 2016 at the current activity levels and at the current inflated levels of steel prices. I don't have the exact number in terms of bifurcating the steel commodity itself from the rest of what we buy.

And just one other quick one. Thinking of Eaton Corp. as a window into what industrial companies are thinking, can you share any view on what you would expect your capital spending to do in 2017?

It's too early for us to make that call. We haven't begun the process of working through our internal plans at this point. So we should be in a position to provide a better look at that at the end of Q3. But at this point, it's too early to call.

All right. Thank you very much.

The next question comes from Jeff Hammond with KeyBanc.

Hey, good morning, guys. Can you hear me?

Yeah, yeah. We got you, Jeff.

Okay. Yep, sorry. I really wanted to focus on EPG order rates. You went from plus 2 to minus 2, and I just want to understand what caused the delta because that was the one area within Electrical that had been more resilient.

We don't have the precise Q1 to Q2 comparison, but as Craig pointed out, if you look at order patterns in Electrical Products, it really was the industrial parts. It was those products that go into industrial controls, for example, and APAC. Those are the two areas that showed particular weakness. Without having the precise numbers, I would characterize those areas as being a bit softer than in Q1.

How about just the non-res piece?

Non-res goes across both segments, and much of non-res in Electrical Products tends to be in the lighter commercial type areas, which experienced good conditions. As Craig mentioned, Europe in general, non-res as well as other markets, experienced pretty good conditions in Q2.

Okay, good. Just on slide 11, you gave quarterly cadence of the restructuring cost. Do you have that similarly for the $190 million in savings?

We don't have it provided other than to say that the savings will generally follow the spending in the business. To characterize the restructuring spending for the back end of the year, I'd say that it will go into the businesses you would expect. Electrical Systems and Services will be the recipient of the most money, followed by Hydraulics and then Vehicles. That’s, if you're thinking about modeling where the restructuring spending will go, that's where we'll direct most of the cost.

Okay. Thanks, guys.

Our next question comes from Andy Casey with Wells Fargo.

Thanks a lot. Good morning. Question on cash flow. Your really strong performance the first half is running about 40% of your annual operating cash guidance, and in most years, it moves around a little bit, but it's usually between 20% and 30% full-year operating cash. Rick mentioned the opportunity to draw down inventory in the back half. Are there any second half offsets of that inventory drawdown that we should consider?

None that we're aware of. Given that, as Craig commented, we think sequentially, revenue stays relatively flat from Q2 to Q3 and Q3 to Q4. That would mean you wouldn't need to build working capital to deal with revenue going up. We’d hope to be able to pull down inventories in that flattish revenue environment. Outside of the normal business characteristics, we wouldn't expect anything else to impact cash flow.

Okay. Thanks, Rick. And if at historical proportion of closer to 40% holds, if full-year guidance ends up being conservative, what sort of allocation priorities should we consider? Would it be an acceleration of maybe share repurchase or restructuring or something else?

As we think about the company's capital priorities, I'd say very much consistent with what we said in New York. Our first priority is to invest in our businesses, to continue to drive organic growth. The second priority is to ensure that we maintain a strong dividend. Third is to buy back shares, especially in this environment where we think our stock price is on sale, and we can create value buying back our shares. The fourth priority would be to pursue M&A. This prioritization has not changed, and it's currently the way we would think about capital deployment.

Okay. Thank you very much.

Our next question comes from Josh Pokrzywinski with Buckingham Research.

Hi. Good morning, guys. Just to come back to Hydraulics and the stationary market. It seems like you guys are trying to signal a bit more of a downbeat tone there, although when you talk about the weakness or fresh weakness in the industrial market, it seems to be directed more at ESS. I'm trying to determine, did you see a further loss of momentum in stationary in 2Q, or is it just trying to signal that some of the mobile markets are hitting easier comps and stationary is now along for the ride? I guess first question, just trying to parse out that difference.

In terms of Hydraulics, I would say the right way to characterize what we're seeing in the stationary markets is that oil and gas markets continue to be weak. They’ve been weak all year, and we have not seen a turn in those markets. We did see a little bit of some weakness in some of the process industries, but those orders tend to be lumpy. We saw some strength in the mobile markets. So I think we’re not necessarily trying to signal a downbeat tone; we're pleased that we posted better revenue than anticipated and better order performance than anticipated. However, it’s important we don't read that through to mean that this is a definitive bottom in the business or that the business has turned. It’s certainly a positive indicator overall.

Got you. And thinking about the potential margin mix of recovery, if mobile starts to look better or bounces off of a bottom here, and stationary stays weak, is that a better outlook for the margins of the business? Is it all about the same? Please help us try to bridge that gap.

The bigger indicator would be what's happening with the OEM business, whether mobile or stationary, and what's happening with distribution. The distribution business tends to be a bit more profitable than the OEM business, and that's what influences the underlying profitability more than anything else. In the quarter, our distribution orders were actually slightly stronger than our OEM orders. This is a positive sign. However, once again, with one quarter, it’s too early to make a call one way or the other.

I guess maybe to ask the question differently, is there more distribution exposure in stationary or mobile?

They really do play across both segments, and our distributors sell mobile applications. They also sell industrial applications, so really they play across both markets.

Okay. Appreciate the question, guys.

Sure.

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

Morning, guys. On Hydraulics, just on the margin side, getting that back to low-teens margins ex restructuring has been a goal of yours. Was this sooner than you expected to get there? Now that you're there, has the 13.1% victory been achieved or was there anything particularly favorable that got you there this quarter?

The business largely performed on expectations for the quarter, and we continue to have work to do in that business regarding restructuring. We're not done, and obviously the 13% at the low point in the cycle was the bottom of our threshold. Obviously, our aspirations for the business are much stronger than that. We're not ready to declare victory. It was a strong indicator that the restructuring work that we're doing is paying off, but we still have work to do in that business to ensure we maintain the minimum of 13% at the bottom of the cycle, and closer to 16% in normal times.

Okay, and then on Vehicle, on the margins, you guys have worked to decapitalize that business and minimize the decrementals. They got a little tougher this quarter. Do you still feel good about the ability to keep modest decrementals in Vehicle?

Absolutely. Quite frankly, we're really pleased with the Vehicle business and how it performed in the quarter. 17.1% return on sales excluding restructuring at a period of time when the North America Class 8 market is down 30%, and the Brazilian markets are at all-time lows. We think that business continues to execute extraordinarily well, and we’re confident we have the right formula. We've decapitalized the business, changed the business model, and moved from fixed to variable. We’re comfortable that the business formula works, and that it will continue to deliver strong margins in very difficult economic environments.

Okay, thanks.

Our next question comes from Deane Dray with RBC Capital Markets.

Thank you. Good morning, everyone. I'd like to touch on Aerospace if we could. Could you provide more specifics on the mix you saw this quarter? The business jet weakness is certainly being felt industry-wide, but could you provide some color on the offsets in the aftermarket, both military and commercial?

The weakness in the bizjet side caught us all off guard, and that's what's driving a bit of underperformance in that business from a revenue and order input standpoint. But offsetting that and helping the margins, we continue to see strong order input and results in aftermarket, commercial OE, and commercial transport continues to be quite strong. It was roughly 10% in the quarter. Military OE was off modestly but very much in line with expectations. Military aftermarket is also growing in the mid-single-digit range, so aftermarket continues to be a real strength, and commercial transport continues to be strong, offsetting some weakness in bizjet and regional jet as well.

Thanks. Just on a bigger picture question, you've now had your first quarter as Chairman and CEO successfully completed. Is there anything different versus your expectations since taking the helm in June?

I'd really say no. The transition between Sandy and myself was over a period of about 12 months, and during that period, we worked closely together. I was in the shadows of all the calls over the last year, and I'd say the job is largely what I expected. The business environment is largely what I expected, and there have been no big surprises. That's the way we like it by the way.

Terrific. Appreciate that. Thanks.

Thanks. On the guide I think I heard revenue flat or sequentially into the third quarter and again into the fourth quarter. That would seem to be favorable in Q4 relative to normal seasonality, if you could comment on that.

It's relatively flat. It might be down just a tiny amount in Q4 possibly, but the reality is that it won't even be a material change. We see the balance of the year laying out as Q2, Q3, Q4 essentially flat revenue.

I appreciate the concern that a number of you are signaling around the second-half volume pace. What we've said all along is that if the volume pace is any different than we anticipate, we'll be more aggressive around the things we will do around managing costs. As you can imagine, we have a contingency plan that we're working through as a leadership team around what happens if we end up with a volume issue in the second half of the year. We are well prepared for that contingency.

Okay. And then just in lighting, I'm wondering if there's been a lot of transition over the last couple of years. One of your competitors talked about a recent change in the competitive and pricing environment; are you seeing anything in that area?

No. With lighting, every year it's a business given that the input costs and the price of LEDs continue to fall, so every year is a business that sheds a bit of price, but also the input costs, the cost of that LED technology continues to drop. So I’d say in that business overall, in its ordinary course, it's a competitive business and the technology cost continues to decline. Our margins in that business, quite frankly, are performing just fine. We had another strong quarter of margins in Q2, so we think that business is fine and very much consistent with the guidance we laid out for products during the course of the year.

Thanks.

Thank you all for joining us today. We're at the top of the hour, and would like to wrap up our call. As always, we'll be available to take questions or follow-up items after the call. Thank you very much for joining us today.

Thank you.