Eaton Corporation plc (ETN) — Q3 2017 Earnings Call Transcript

Good morning. I'm Don Bullock, Eaton's Senior Vice President of Investor Relations. Thank you for joining us today for Eaton's third quarter 2017 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 is typical, includes opening remarks by Craig highlighting our performance in the quarter, the third quarter, and our outlook for the remainder of 2017, and some preliminary comments or thoughts as we look into 2018. As we've done in the past, we'll be taking questions at the end of Craig's comments. Before I turn it over to Craig, a couple of issues. First, I'd like to note that the press release for today's earnings this morning and the presentation we'll go through were posted on our website at www.eaton.com. I'd ask you to note that both the press release and the presentation do include some reconciliations to non-GAAP measures, and the webcast for today's call is accessible through our website and will be available for replay after the call. Before we get started, I do want to remind you that our comments today will include statements related to expected future results of the company and are therefore forward-looking statements. Actual results may differ from those from a wide range of risk items and uncertainties that we describe both in the earnings release and in our 8-K. With that, I'll turn it over to Craig.

Hey, thanks, Don. If you had a chance to read our results this morning, we delivered what we think are very solid Q3 results. Reported EPS was $3.14, which included a $1.89 gain from the formation of the Eaton Cummins joint venture. Excluding the gain from the joint venture, operating EPS was $1.25, which included about $13 million or a $0.03 impact from the natural disaster, so up 9% over Q3 2016. Sales were $5.2 billion. That's up 4.5% in total, of which 3.5% was organic, and we had a 1% positive contribution from FX. The 3.5% organic growth was at the top end of our guidance range. We reported segment margins of 16.4%, an all-time record for the company, up 80 basis points from Q2 2017. Adjusting for $11 million of restructuring costs in the segments, margins were 16.7%. I would add that margins were reduced by another 20 basis points in the quarter as a result of the recent natural disasters. In addition, we had exceptionally strong cash flow in the quarter. Adjusted for the unplanned Q3 pension contribution, operating cash flow was just over $1 billion, once again a quarterly record for the company. Also, we refinanced $1 billion of debt maturing in November at very attractive rates. $700 million was financed with a 10-year tenor at 3.1%, and we had $300 million of 30-year debt at 3.9%. We took advantage of the very strong cash flow and contributed $250 million to our U.S. qualified pension plan, which is now funded at 94%. Lastly, given the share price volatility that we saw during the second quarter, we repurchased $324 million of our shares in the quarter at an average price of $73.29. This brings our total repurchases to $789 million for the year, comparing to our original target of $750 million. In summary, the 3.5% organic growth is really our best result in 11 quarters, and despite commodity cost headwinds, we did improve segment margins by some 40 basis points year on year. We expect a reduction in Q4 profits in this segment of another $8 million as a result of air freight, cleanup costs, and overtime labor that we're running in our facility, but we don’t expect this problem to linger into 2018. We're optimistic about our growth outlook for 2018.

Thank you. Our operator is going to provide you some guidance on the Q&A. But before he does, I do want to note a couple of things. One, recognizing that many of you have several calls today to address and deal with, we're going to hold the call to an hour today. What I'd like to do to make sure that we can do that and represent all the questions on the air, I guess that you please hold your questions to a question and a follow-up. And with that, I'll turn it over to the operator.

Hi, good morning.

Good morning, Julian.

Hi.

Good morning, just a quick question. I guess if I look at your 2018 outlook, one of your peers recently talked about next year being a new normal. If we look at Eaton through that lens, would you think that all segment margins, assuming it is more of a normal year, should be within the corridor that you laid out last year, or are there any specific reasons around input costs perhaps why some of the margins may come in at the lower end?

We appreciate the question, Julian. I would say absolutely, as we laid out during our New York analyst meeting, we set margin expectations for each of our segments, and we would expect all of our businesses to be solidly in that range during the course of 2018. To the specific point around – I think you inferred how we're thinking about commodity input costs in 2018. We think while once again it's early to make a call on commodity prices, we don't think it represents a headwind to the business going into 2018.

Understood, thank you. And then my follow-up would just be around the ESS business. Back at the Analyst Day in February, you talked about an improvement in growth there, 2018 to 2020, based around oil and gas and broader global CapEx. The oil and gas piece seems to be coming back. I just wondered what your updated thoughts were on the global CapEx driver within the ESS top line.

Our point of view with respect to the outlook for 2018 as it relates to ESS really is unchanged. Certainly, if you think about some of the macro indicators, the Dodge data certainly indicates that large projects are coming back, and we're seeing that in our own business. We do expect that commercial projects growth to continue. Power systems, we think inside of our ESS business, we think it will be a low single-digit growth outlook for 2018. Maybe hurricanes provide a bit of upside at some point, but it's too early to call. Our Crouse-Hinds business certainly is setting up for a much better 2018. So our thesis with respect to 2018 being a better year and a growth year for Electrical Systems and Service we think still holds.

Hi. Good morning, guys.

Hi.

Good morning, Scott.

I'm looking to your 3% market growth. I just want to be clear, you say leading to market growth of 3% in 2018. I assume you would imagine you would outgrow the market, so your forecast would be a little bit better than that. Is that how I should look at that?

That's exactly the way we would think about it. It's early, and we'll certainly provide more detailed guidance when we get to our Q4 earnings call, but at this point, that's meant to be a proxy for what we see in the end markets, and we would certainly expect our businesses to grow faster than our end markets.

And if memory serves me right, I don't think you or your peers have really gotten price at all in probably the last four years. Is 2018 setting up as a year where you can go in with particularly some of your electrical products and January 1 price increases, catalog plus realized?

Once again, I think it's early to make a call on the net of price and commodity input costs for 2018. We're still working through our internal planning processes. But I would say that going into 2018, at least on the input cost side, we think the headwinds that we experienced in 2017 are not there in 2018. Once again, early to make a definitive call, and we would expect, like in every year that we go out and we work on getting price in the marketplace. And so I'd say it's too early to call.

Thank you. Good morning, everyone. Just back on ESS, wondering if you could elaborate a little bit more on what you're seeing in utility. Your business mix isn't exactly like Hubbell's, but this feels like two quarters in a row where you're lagging what they're seeing. You did call out APAC. I wasn't under the impression that was that big of a business. So maybe just give us a little bit of the lay of the land on what you're seeing on particularly the domestic utility side of things.

We do have a – with the acquisition of Cooper, we actually did in fact develop a pretty reasonable position in the utility market in Asia as well, and that's really where we saw the weakness during the quarter. Our North America power systems business, we actually saw low single-digit growth, I think pretty much in line with what you're seeing from others in the industry. The real weakness for us really was only in the Asia region, and principally China.

And maybe not to put you on the spot, but everybody on the call here this morning is distracted with this Rockwell-Emerson story. It's kind of interesting from an Eaton standpoint too, right? If you look at your big three electrical competitors, ABB, Schneider, Siemens, they're all big automation houses also. I just wonder how you feel about that strategically. Do you think automation is strategically important to Eaton, and any other comment about how you compete and differentiate in a market that might be consolidating here?

As you know, we're not really an automation company today, and so it's not a space that we participate in today. And as we've talked about it in prior years, we think our business as a standalone without automation as a piece of it, we like our prospects and opportunities to continue to grow and to be successful. We'll wait and see what happens with that particular potential announcement, but we don't think it has any material impact on Eaton at all.

Thanks. Good morning. I think Jeff was asking there if you'd have an interest in Rockwell. It sounds like the answer is no, but I'll leave it there. So just, Craig, you mentioned another $0.03 impact from the hurricanes in 4Q on top of 3Q. Is it fair to assume that most of that would – or ESS would be more impacted given the component supply chain than EP? And does that $0.03 include any insurance recovery, or is that more of a 2018 impact?

The way the business works, as I think you understand, Nigel, today we make components and most of these components are circuit breakers; these circuit breakers are manufactured in Puerto Rico and they feed our Electrical Systems and Services business, but they also feed our distributors, and they go into the Electrical Products segment as well. It does impact both segments in Q4. And the reason we didn't see a material impact in Electrical Systems and Services in Q3 is because we had inventory in the system. It will indeed impact both businesses. We do have insurance, and there are no insurance recoveries baked into our forecasts. We're still working through the whole insurance process.

Hi, good morning. Thank you, another question on ESS. Can you help us understand what's going on in the power quality markets? Those continue to be weak. And I'm wondering if you're seeing any sign of improvement there, or if it's potentially a candidate for accelerate or restructuring.

I'd say to your point, Andy, we have in fact experienced a weaker year than what we anticipated in the power quality markets. We do think this is largely timing as the large customers in this space consolidate activities from prior years as well as look at various architecture changes in the context of the way they configure their data centers. We continue to believe that this market will grow low single digit. Some other industry forecasters are out there with even stronger numbers than that. But we think low single digit makes sense from a planning perspective.

It does. Thank you, and one last question. I'm skipping to Hydraulics. Have you witnessed any supply chain constraints popping up in that channel?

I would say the short answer really would be yes. This V-shaped recovery that we're living through right now in Hydraulics is on the one hand very welcome news and overdue, but it certainly caught everybody by surprise. Orders were up 22% this quarter, 32% last quarter. Certainly coming into the year, we and our suppliers were not anticipating the kind of V-shaped recovery that we're experiencing right now in Hydraulics. As a result, lead times have pushed out a bit. We're ramping up our hiring in our manufacturing facilities right now to deal with this increased demand. It’s a high-quality problem to have, but it caught the industry a little flat-footed.

Hi, good morning, guys.

Good morning.

Hi.

So I just wanted to clarify, Craig, your comment on the 40% incremental margins for next year. If I think about the restructuring spending that's occurring and the benefits that you're getting, it seems like you should have at least a $40 million benefit from less spend, and I think roughly about $105 million in incremental benefits from all of the spending that has occurred. I just want to make sure that I have those numbers straight as I think about that 40% number.

You absolutely do, Joe. What we said is that typically in our businesses, we have ongoing restructuring every year. We think as we go into 2018, we're really closing the chapter on the restructuring program that we've announced. Most of those activities will be behind us by the end of this year. What's manifested going forward are the benefits, so you can plan on roughly a 40% incremental on the change in volume.

Got it. Okay, great. Thanks, guys.

The next question comes from Jeff Hammond with KeyBanc.

Hey, good morning. Craig, you mentioned Crouse-Hinds lifting its head up. Can you just talk a little bit more about what you're seeing there and what the customers are telling you about the outlook into 2018?

As I mentioned, we saw revenue turn positive in Q3, the first time in quite some time, and orders as well. I'm excited that we expect 2018 to be a growth year for Crouse-Hinds. The revenues turning positive are very much consistent with what we expect, given stabilization in oil prices and pent-up demand. At this point, it's premature to quantify how much better it will be, but we do believe in a positive direction.

Thank you, Craig. The next question comes from Steven Winoker with UBS.

Thanks. Good morning, guys.

Hi.

So just on that 2018 initial thoughts, a little clarification. Are you thinking about holding corporate expense flat for next year excluding all the insurance impact and things like that?

I would say we're still in the process of planning, but our general construct is definitely an ambition to hold it roughly flat.

Okay. So if that's true and I ignore the natural disaster recoveries that might come or the year-on-year impact, then based on what you ran through, and it rose a little bit faster than that 3% market growth that you put in and the 40% incremental, it seems like you'd be talking about north of 10% EPS growth if that were to all come together on that page. Is my math somewhere close?

That's close. And in fact, what we talked about is that we said 8% to 9% EPS growth through this planning cycle. And the implications of that is that between 2018 and 2020, it’s 11% to 13%. We're very much on track to deliver that commitment in terms of EPS growth.

I would just say that we have managed our working capital quite effectively so far this year, and of course, our profits are growing as well. We're quite pleased with the cash flow and our ability to generate more than we had even anticipated at the start of the year.

What we said with respect to M&A, we've said number one, it's to reinvest in our businesses to drive organic growth, pay a strong dividend, and complete the share repurchase plan. But after that, we continue to be very much interested in looking at opportunities to acquire strategic capabilities with a priority in Electrical and Aerospace. We will not let cash build up; we'll find opportunities to put the cash to work.

Good morning, everyone. Congratulations on a good quarter. Two questions, and I have a little bit of ADD as do others, so I do apologize if some of this has been covered. But embedded in your expectation for next year, how should we think about the state of play for U.S. non-residential construction? What are you seeing now or what's your prospects for growth?

By and large, if we take a look at most of the consensus numbers for non-residential construction next year, you'd say it's centering around 3% to 4%, perhaps with a little bit of strength on the commercial construction side. We think that number is very much in line with what we're experiencing and expect for the year. Yes, we'll absolutely see higher incrementals for Eaton overall. And that's why we said that instead of what we would think would be normal at 25% at this point in the cycle, we said you can plan on 40%. What the specific incrementals are by business, we're really not in a position to comment on.

Thanks. Just looking at Aerospace, the orders are starting to compound there nicely. Is that business starting to shape up to get into a higher growth profile as you look into 2018?

Yes, we certainly hope so. We're pleased by the double-digit orders this quarter and last quarter, and it's certainly shaping up for 2018 to be a better year.

Hi, good morning, guys.

Hi.

Good morning.

Just on the organic growth investment that you talked about, Craig, where are you guys specifically making some inroads and where can we see externally some of that progress?

It's a big question for the time that we have. As we think about our analyst meeting in 2018, we'll once again take you through our key growth vectors that we're investing in, especially in our electrical businesses. We're investing around embedding intelligence in all the components that we manufacture.

Thank you. Good morning, everyone.

Good morning, Deane.

Hey, Craig, I was hoping you could expand on this high-quality problem of this V-shaped recovery in Hydraulics. How much is mobile versus stationary, and how sustainable is this uptick?

It's been a fairly broad-based recovery across regions and markets, predominantly in mobile markets. We think this point in the cycle that Hydraulics is setting up to be a multiyear growth story, hey, welcome news after the downturn the past couple of years.

Good morning. Most of my questions have been answered by now, obviously. But maybe in Hydraulics, you could talk a little bit about whether you are the bottleneck that's driving the lengthy lead times, or is it your supply chain? Just where exactly are the bottlenecks building?

Most of the bottlenecks, as you know this business fairly well, always end up being in the long lead time components, castings and forgings throughout the supply chain. From a labor perspective, ramping up tends to be much easier to put in place, but we are working on some potential longer-term solutions.

We have time for one last question, and that will come from Andrew Obin with BofA Merrill Lynch.

Hi, good morning, guys. Just a question on the inventory level in distribution both on the Electrical side and the Hydraulics side. Are you seeing anything that would indicate that at last with the macro picking up, dealers are considering restocking inventory in the channel?

What I'd say is that largely in the Electrical business, we have not seen a big change in inventory levels. However, we have seen some replenishment of inventory in the Hydraulics markets, signaling a positive sign of things to come.

Thank you all again for joining us today. This will wrap up our call. As always, we'll be available for your follow-up questions this afternoon and the remainder of the week. Thank you.