Eaton Corporation plc (ETN) — Q1 2018 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 first quarter 2018 earnings call. With me today as usual are Craig Arnold, our Chairman and CEO and Rick Fearon, our Vice Chairman and Chief Financial and Planning Officer. Our agenda today includes opening remarks by Craig, highlighting the company's performance in the first quarter along with our outlook for 2018. As we've done on our past calls, we'll be taking questions at the end of Craig's comments. The press release from our earnings announcement this morning and the presentation are posted on our website at www.eaton.com. Please note that the press release and presentation include reconciliations to non-GAAP measures. A webcast of the call will be accessible on our website and will be available for replay. Before I get started, I do want to remind you that our comments today will include some statements on expected future results of the company and therefore are forward-looking statements. The actual results may differ from those forecasted due to a whole wide range of risks and uncertainties that are described in both the earnings release and the presentation and are also outlined in our 8-K. With that I'll turn it over to Craig to go through the presentation.

Okay. Thanks, Don. Appreciate it. Hey, before I dive into Q1 results this morning, I thought I'd take a moment to just reiterate three key elements of the strategy that we've been working on as a company and how we're focusing on growing the company, expanding margins and effectively allocating capital. First, our organic growth initiative is focused on new technology, leveraging our channel and service capabilities, creating products that play across the entire spectrum of our customers' requirements, what we call delivering superior value. Next, we intend to continue to expand our margins by restructuring to eliminate fixed costs, driving operational improvements across our plants and functions, and being more selective in where we invest; what we call fixing the tail and growing the head. Finally, we continue to be good stewards of capital, investing in our existing businesses, playing to win in every business that we're in, returning cash to shareholders through dividends and share buybacks while maintaining discipline in our approach to M&A. By consistently doing these three things well, we believe we'll drive superior value for our shareholders both in the short term and over the long term. We made solid progress in Q1. A few examples that we've noted on page four. We launched our new eMobility segment targeted at growth in electric vehicles. A $2 billion to $4 billion opportunity for Eaton, and we're clearly working on this opportunity with over 30 pursuits that we're currently managing. We continue to make progress towards our goal of digitally enabling our product portfolio, including addressing necessary infrastructure needed to ensure industry approvals and security protocols. We launched a new Microgrid initiative in Africa, combining our expertise in Microgrid management with energy storage. Additionally, we had a very successful quarter, growing our penetration in hyperscale data centers, with over $60 million of new wins in the quarter. We launched a new Power Xpert circuit breaker product line for the harsh, hazardous and corrosive circuit protection market, a market that we believe is valued at $500 million, presenting us with a new opportunity. Lastly, we continued to execute on our ongoing restructuring actions and completed three site closures in the quarter. While this is not an exhaustive list, it is helpful to provide a few notable examples of the progress we're making towards our strategy. Now turning to our financial results for Q1 on page five, I'll add a bit of color to what you've already seen in our reported results. Earnings per share were $1.10, up 15% over Q1 2017 and at the high end of our guidance range of $1 to $1.10. Our results were primarily driven by strong revenues, up 8% over Q1. This was driven by 6% organic growth, the highest growth that we reported since Q4 of 2011. Foreign exchange added 3% or approximately $150 million to reported revenues. We previously expected $150 million of forex for the entire year, so this represents a strong start. Booking strength continued in the quarter with notable growth in Hydraulics and another quarter of strength in Electrical Systems & Services. Our operating cash flow for the quarter was $339 million. If you recall, Q1 is typically our weakest quarter of cash flow generation. Additionally, we're adding working capital to support higher growth and a stronger outlook for the year. We repurchased $300 million of our shares in the quarter and are on track to repurchase $800 million in shares for the full year. Finally, we increased our dividend by 10%. This is consistent with our long-term goal of growing our dividend in line with our long-term earnings. Now, turning to page six, we show a summary of the income statement for the quarter. Here I point out that our 8% growth was made up of 6% organic, 3% FX, offset by negative 1% due to the divestiture in Electrical Systems & Services and the formation of the Eaton Cummins joint venture last year. Margins were at 15.2%, an 80 basis point increase over the prior year and a Q1 record. We consider this to be a good indication that our restructuring plans are paying off. Consistent with our plans, our incremental margins on organic growth were approximately 30% for the quarter, and we remain confident in our ability to achieve 40% incrementals for the full year. We did see good volume leverage during the quarter, generating 12% net income growth on 2% organic growth, and we expect this relationship to improve as the year unfolds. Moving into the segments, I'll begin with Electrical Products. Our revenues were up 5% with 1% organic growth. Sales in this segment were impacted by our Lighting business, which was down approximately 10% in the quarter. Excluding the impact of Lighting, organic growth in the segment was 6%, which indicates strong growth excluding Lighting. A word on Lighting weakness: The weakness was driven primarily by reported weak markets. There were also a number of large projects included in last year's results, along with management's decision not to chase some unattractive projects during the quarter. We expect Lighting to improve over the next three quarters. Consistent with our guidance, we think the business will decline mid-single-digit for the year. In the remainder of the business, we saw strength across various end markets, particularly in industrial applications. Geographically, we saw strength in Europe and North America. Bookings were down 2% overall, primarily due to Lighting weakness. Excluding Lighting, bookings were up 2%, driven by strength in Power Distribution Components and Industrial Controls. Notably, our margins in the quarter were up 30 basis points over the first quarter, which is also a record for this quarter. The results for Electrical Systems & Services are on page eight. Revenues were up 4% in the quarter with organic growth at 2.3%. We rounded it to 2% on the chart. Foreign exchange increased by 2.2%, and we also rounded it to 2%. The divestiture of our stake in a small joint venture reduced revenues by approximately 1%. In the quarter, we saw market strength in services for harsh and hazardous environments and power distribution assemblies for industrial markets. Geographical strength was notable in the U.S. markets. Bookings for the quarter were up 8% due to strength in industrial projects and services. As mentioned in Q4, our backlog for industrial projects continued to expand, and we expect organic growth to accelerate starting in the second quarter. It is also worth noting that our operating margins improved by 50 basis points in this segment. Next, examining the Hydraulics business, sales were very strong, up 21%, with organic revenues increasing 16% and foreign exchange contributing an additional 5%. In the quarter, all regions experienced significant growth, particularly in construction equipment and through the distribution channel. Bookings rose by 14% this quarter, led mainly by OEM customers across all end markets, with strength witnessed in all regions. Given our strong backlog, we anticipate that this market will remain robust throughout 2018. Margins were at 12.7% for the quarter, an increase of 250 basis points from Q1 2017, showcasing the impact of our restructuring efforts along with better revenue generation. We continue to face some challenges as we ramp this business amidst high demand, but we expect improvements to begin in Q2, and we're on track to meet our full-year margin guidance for the segment. For Aerospace, we had another strong quarter, witnessing 7% sales growth, with 6% organic growth. Sales growth was primarily driven by strength in military, which rose by 13%. The military strength extended across all categories, including the military aftermarket. Always-variable orders in the quarter increased by 1% on aftermarket, while strength in rotorcraft offset weakness in both military and commercial transport. Margins were at 19.4%, reflecting a 90 basis point increase over last year and again, a record for Q1. We also had a very strong quarter in the Vehicle business, with sales increasing by 14%, of which organic revenues climbed 13%. Foreign exchange added 3%, while the negative impact from the joint venture formation with Cummins was 2%. NAFTA heavy-duty truck production rose by 45% in the quarter, and Brazil truck and bus production experienced nearly a 6% increase. Thus, significant strength was observed in our truck business worldwide. Moreover, we sustained order strength through the quarter, now expecting NAFTA heavy-duty production to hit 295,000 units in 2018, surpassing our earlier estimate of 275,000. The U.S. and China light vehicle markets are projected to remain stable for the year, while Europe shows a slight improvement, and strong growth is forecasted for emerging markets, particularly India and Brazil. Margins stood at 14.8% in the quarter, reflecting an 110 basis point increase due to better than expected revenue levels and results from prior restructuring. Although margins were favorable, they faced some setback from higher restructuring costs this quarter, but we expect to see improvements in the subsequent quarters. On page 12, we present a first look at the financial results of our eMobility segment. You will find 2016 results for eMobility, including the restatement of our Electrical Products and Vehicle segments in our 10-Q, which will be available later today. Sales for the quarter reached $77 million, an increase of 22% year-over-year, with 19% attributed to organic growth. The organic growth in the quarter was a result of new European electric vehicle penetration and growth in electrical products utilized in traditional internal combustion engine applications across North America. Margins for this quarter stood at 14.3%, down from the previous year due to increased R&D investments and spending on specific customer programs. This segment excites us, and we expect to see double-digit growth in the foreseeable future. Before moving into the remainder of the year, I want to give additional context on our new eMobility segment for anyone who may not have been present at our investment conference in New York. eMobility is a strong example of how we are capturing synergies across the company, currently pursuing emerging market opportunities in electric vehicles. How are we doing this? Essentially, we are amalgamating our unique industry knowledge, customer relationships, and application insight from our Vehicle business with the proven technology we've developed in our Electrical business. All necessary technologies and products supporting electric vehicles are already sold in homes, factories, and offices through our Electrical business. Although we will require more development and customer-specific adaptations, this is exactly what our Vehicle business excels at. Electrification presents a fantastic opportunity for Eaton; our addressable content per vehicle is 8 to 10 times greater for electric vehicles compared to internal combustion engines. Turning to page 14, the electrification of vehicles is poised to become a substantial market, and we have decided to center our focus on areas where we can effectively compete with unique technology. On this page, we feature the specifics of our focus areas: power electronics, conversion, power distribution, and circuit protection. These technologies are vital for ensuring the safe and reliable operation of vehicles. Notably, we already possess a significant business in both technologies across our electrical markets. We are a market leader in power conversion from our UPS business and in power distribution and circuit protection from our Bussmann fuses as well as our traditional circuit breaker business. We are already selling many electrical products into both electric vehicles and internal combustion engines, and we look forward to exploring the potential expansion as the electric vehicle market grows. On page 15, we present our 2018 outlook, expecting revenues of approximately $320 million and 12% organic growth. We anticipate the segment to deliver margins around 12% and 13% for the full year. Our margins decreased compared to 2017 due to a significant spike in R&D spending, with approximately $30 million expected for the year. More importantly, we foresee a market set to grow to over $33 billion in the next ten years, with Eaton aiming to capture an additional $2 billion to $4 billion in revenue during that same timeframe. We are currently collaborating with multiple global OEMs, and we are certainly eager about the opportunity eMobility presents as a meaningful part of the company. Turning to our overall outlook on page 15, we expect organic revenues to grow by 5% this year, an uptick of 1% from previous estimates driven by increases in Hydraulics and Vehicle sectors. We forecast a further 3% increase in Hydraulics, now expecting a total 13% growth for the year, while Vehicle is projected to see a 4% increase. Additional segments remain unchanged from prior guidance. On page 17, we are raising our segment margin guidance for Eaton from 16.4% to 17%, or 16.7% at the midpoint, up from our former guidance of 16.6% at the midpoint. We also adjusted the margin expectations for our Vehicle segment to range from 16.5% to 17.1% for the year. We stated last year that we intend only to change margin guidance for our segments when they move outside the previously provided guidance, which justifies the increase in Vehicle. Other segments remain consistent as our expectations for the year continue to fit within prior ranges. On page 18, a summary of Q2 guidance and our 2018 expectations are provided. For Q2, we expect EPS to be in the range of $1.25 to $1.35, assuming a 5% organic growth, margins of 16.2% to 16.8%, and a tax rate between 11.5% and 12.5%. For the full year, we now expect EPS of $5.10 to $5.30, up $0.10 at midpoint from earlier guidance; organic revenues are projected at 5%, which is up 1%. We anticipate foreign exchange will positively impact by $250 million, which is $100 million above prior guidance. Segment margins are also expected to be 16.4% to 17%. Corporate expenses will be slightly higher than earlier forecasts by $10 million over 2017. The prior guidance was flat. We expect a slight decrease in our tax rate, projected to fall to 12.5% to 14.5%, compared to previous guidance of 13% to 15%. Cash flow, CapEx, share repurchases, and restructuring cost assumptions remain unchanged from earlier guidance. Before I return it to Don for Q&A, I want to summarize why we believe Eaton is an appealing investment opportunity. First, our markets have returned to growth, and we anticipate the next three years will outperform the last three. Additionally, we have attractive organic growth initiatives that we believe will enable us to expand faster than our end markets. Our restructuring efforts are yielding results, our margins are set to reach all-time highs in 2018, and we foresee continued margin improvements. Our balance sheet is strong, with net debt-to-capital below 30%. Our pension plan is now funded at over 95%. Our cash flow remains robust, with expectations to consistently deliver cash flow at or above 100% of net income, while generating $8 billion in free cash flow over the next three years. Furthermore, we continue to return cash to shareholders through a high dividend yield, currently above 3.5%, alongside ongoing share buybacks. Lastly, we anticipate delivering 11% to 12% EPS growth over the next three years. We believe this presents a compelling opportunity, providing excellent reasons to reevaluate how you perceive the stock. With those opening comments, I'll pause and turn it back to Don for Q&A.

Operator is going to provide you instructions for the Q&A. But before I do, I would like to remind you that we have a large number of questions on the call today, and I'd ask you to try to keep it to an hour today by limiting your questions to a single question and a follow-up. With that, I'll turn it over to the operator to provide instructions.

Our first question today comes from Joe Ritchie with Goldman Sachs.

Hey, good morning, guys.

Morning.

Craig, can we maybe just start on Lighting for a second? It's been a bit of a drag on growth in orders for the last several quarters, and I'm curious about how you guys are thinking about this business internally from a strategic perspective. How important is it to the overall portfolio?

I appreciate the question. First of all, I'd say that the Lighting results in Q1 were certainly below our expectations as a company but aligned with our outlook for the year. As we noted back in New York, we anticipated that this would be the only segment under pressure this year. We still believe a low single-digit decline is in line with our thinking as we set our plan at the beginning of the year. Regarding the strategic view of Lighting, like the rest of the company, it must meet our expectations for what an attractive business should be. We hope to see businesses lead in their markets, grow above GDP, deliver attractive returns on sale, and yield a minimum level of profitability. The Lighting business at Eaton today has many positive aspects but also has room for improvement. Therefore, we are investing in what we believe are attractive prospects, but we recognize we need to prove ourselves in this business.

That's helpful color, Craig. For my second question, I'd like to focus on ESS growth in orders. Clearly, the order momentum is present with large project activity picking up. So, can you provide insight into your thoughts on growth for the remainder of the year and the anticipated acceleration in Q2? Could we potentially exceed guidance given the current order momentum?

At this point, I'd say it’s early in the year, and perhaps too early to alter the guidance. However, we are witnessing very strong growth in our Electrical Systems & Services business, driven by power distribution and large assemblies as well as harsh and hazardous markets. As we noted earlier this year, we are experiencing more robustness, particularly in our three-phase power quality business. Solid order negotiations are also up for Q1. We are hopeful this business continues to grow as expected, and we will reassess in Q2. But we believe the current guidance we provided is prudent, and we’re optimistic about growth in 2018 and beyond for our Electrical Systems & Services business.

Good to hear. Thanks, guys. I’ll get back in queue.

Our next question comes from Steve Winoker with UBS.

Thanks. Good morning, everybody.

Hi.

Can you provide more insight into the incremental walk that you're discussing for the rest of the year? I know you're dealing with restructuring and also facing pricing actions related to material and wage inflation along with productivity imagery.

Yes, our incremental performance in Q1 was largely in line with our expectations from our profit plan, which we were quite pleased with overall. Regarding future improvements, I would highlight two components: the restructuring benefits that will continue to increase as we move through the year and our net pricing against commodity inflation, which will also improve. Volume growth in certain businesses will contribute as well, but those two factors are significant contributors to the margin lift as the year progresses.

I expect that volume leverage will also be significant, considering the large step-up you're projecting for the rest of the year.

Absolutely. We also anticipate benefits from volume leverage.

Following your pricing comments, can you shed light on the actions taken versus those being phased in for the rest of the year? Would you say you're about a quarter of the way through those pricing actions, or have you implemented more?

Sure. First, to revisit what we said in New York regarding anticipated Section 232 impacts, our initial estimate was around $50 million, but that has significantly reduced due to all the exceptions regarding which countries are no longer in scope. That number reduced to around $10 million. Additionally, within our businesses, we have taken or announced price increases in every business unit to neutralize or exceed commodity inflation we're seeing at this point. While commodities are indeed running higher than our original plans, our teams have proactively addressed it with price increases, and we don't expect commodity price inflation to negatively impact margins this year.

Thanks, Craig. I'll hand it back.

Our next question comes from Ann Duignan with JPMorgan.

Hi, good morning.

Morning.

Most operational inquiries have been addressed, so I'd like to focus on your comments related to eMobility. Craig, I think you said the content opportunity for Eaton represents 8 to 10 times that of an internal combustion engine. Was that reference aimed solely at gasoline engines, or does it also encompass diesel engines? I recall that you likely have more content on a diesel engine than on a spark-ignition engine.

To clarify, we don't have significantly more content on diesel compared to gasoline engines. Our content on both platforms is competitive, and regarding your query about diesel trends in Europe, it won't significantly affect us. Whether they move towards gasoline or stay with diesel, we’ll be positioned equally. Furthermore, as the world transitions towards more electric vehicles, our opportunity set increases by 8 to 10 times, providing a far greater electrical content per vehicle than what is typically associated with internal combustion engines. Hence, we view this as an exciting market opportunity and a motivation for launching our eMobility initiative, enhancing our investments.

I may be asking an unfair question on a conference call, but are there any lessons learned from the LED lighting penetration that could be applied to eMobility? I observe companies like others in the industry already establishing eMobility segments. Are there lessons from the conversion of industries that could be beneficial here?

Absolutely, Ann. I believe there are valuable lessons to be learned. If you'd engage with our Lighting team, they would advocate the strategy of making early investments and betting on winning technology. We are applying this same approach to eMobility. This is why we're investing heavily in this segment, thus resulting in a margin decline for 2018. We are committed to winning in this global opportunity and our team is enthusiastic about the prospects ahead.

Thanks, I appreciate it.

Thank you.

Our next question comes from Scott Davis with Melius Research.

Hi, good morning, guys.

Morning.

Following up a bit with Ann on eMobility, I’m curious about the scale here. While it is still early days, do you believe you have sufficient traction? You have an excellent product portfolio in circuit protection and power conversion, but there are numerous other electrical components in vehicles. Will this influence your M&A strategy or push your team to explore acquisitions?

As we look into power conversion and power distribution, I can assure you we are leveraging our existing technologies and utilizing the strength of our Electrical business. This puts Eaton ahead of competitors who might be starting from scratch. That being said, there will naturally be customer-specific modifications necessary, which may require additional investment. We remain open to potential M&A opportunities or partnerships, but we're starting from a firm base of technology and expertise driven by customer relationships in our Vehicle portfolio.

That makes sense. To build on Ann’s earlier questions about Lighting, after Eaton acquired Cooper, many believed you might divest your Lighting business due to its apparent potential for consolidation. Do you think you need to stay invested in the lighting space? And how much time do you intend to give this business to turn around?

I must say that we hold an attractive Lighting business, being arguably the second largest LED supplier in North America. We maintain a comprehensive product line that gives us a solid standing. The Lighting business remains an attractive segment within our competitive landscape. Can it exist independently? It would largely depend on its performance and profitability. Each of our businesses must meet our criteria to remain aligned with Eaton's goals. We're actively working to enhance Lighting and if we discover that it doesn't meet our expectations, we won't hesitate to make necessary adjustments.

Good answer. Thanks, guys, and best of luck.

Thanks.

Our next question comes from Jeff Sprague with Vertical Research.

Hi, thank you. Good morning, everyone.

Hi.

I apologize for circling back to Lighting, but I have a few points to clarify. Craig, in your opening remarks, you mentioned that you expected it to decline mid-single digits for the year. However, it seems you mentioned low in response to a question. Can you clarify that?

I would say parsing these numbers now seems trivial, but I believe a low-single-digit decline accurately reflects our outlook for the business.

I was curious about the size of the Lighting business. To imply a 5-point organic growth impact with a 10% decline suggests the business could exceed $3 billion in revenue. Are you adjusting anything in your analysis that justifies this outlook?

I’m not entirely certain how you arrived at your figure, but it’s not close to $3 billion in revenue. With respect to our Lighting business, we see revenues creeping between $1.5 billion to $1.75 billion.

Let me add, it's in the neighborhood of $1.5 billion to $1.75 billion.

That's what I thought. Thank you.

Our next question comes from Mircea Dobre with Baird.

Yes. Thanks. Good morning, everyone. Returning to eMobility, Craig, help us understand the opportunity better. You're investing extensively in R&D; to succeed in this market, will it require displacing existing players? What might that process look like over time, and how should we think about incremental margins here beyond 2018?

Great question, and I'd argue that eMobility is a unique opportunity where we don't necessarily need to displace established companies, as this market is still relatively open without a broad set of competitors. We believe Eaton has as good a chance as any to emerge as a leader, given our capabilities in the Electrical business. That said, there will be significant upfront investment over the longer term in this segment, but we also expect attractive margins to align with the performance of the rest of the company.

Regarding guidance, could you provide insights into the magnitude of price cost drag experienced in Q1? Are you projecting to achieve a neutral status by year-end 2018?

We won't specify exact numbers for Q1, but to address your point, the price-cost equation will improve dramatically as we move to the second half of the year. We will achieve neutral by year-end, and commodity costs won't impact us this year.

Our next question comes from Julian Mitchell with Barclays.

Hi. Good morning. Regarding Electrical Products, I believe the margin guidance for the year suggests an increase of around 100 points at the midpoint. Q1 started below that level. I recognize that Lighting's recovery will positively influence margins, but historical instances suggest that Lighting growth was a mix headwind. How should we perceive the momentum in EP margins improving over the next three quarters? Is Lighting set to help or hinder?

Bear in mind that there's historically a fair amount of cyclicality in this area. Our Electrical business generally sees higher volumes in the second half of the year, while Q1 is usually the weakest; hence, margins are generally less favorable this quarter. The improvement in margins will be the result of seasonality, enhanced pricing dynamics, and additional restructuring benefits as the year unfolds.

So, the impact from Lighting revenue changes should remain neutral?

Correct, the changes in revenue from Lighting won’t materially affect our margins.

Thank you. Moving on to capital allocation, you've retained guidance for an $800 million share buyback for the entire year, having already spent $300 million in Q1. Given current share prices, should we adjust our expectations regarding this buyback, or are you pursuing an opportunistic approach?

Our plans remain the same; we aim to generate substantial cash this year and avoid unnecessary cash accumulation on our balance sheet. Our top priority is investing in our businesses, maintaining dividend commitments, and executing the $800 million share buyback. Should circumstances allow us to capitalize on favorable share prices, we will certainly consider accelerating such buybacks, but that is subject to evaluation in light of other potential M&A opportunities.

Thank you.

Our next question comes from Deane Dray with RBC.

Thank you. Good morning, everyone.

Hi.

I’ll avoid a follow-up on Lighting. Instead, I'd like some clarity on the accomplishments highlighted at the beginning of the call regarding your increased penetration in the hyperscale data center market. This space has changed significantly over recent years; customers’ expectations and uses of UPS systems differ quite a bit from conventional data centers. How have you successfully engaged this market? Has it been through new products or services? What does the long-term opportunity look like?

That’s a great observation. Today, much of our revenue streams into the data center space comes from our core electrical distribution business. While we do possess a significant footprint in power quality, this is underpinned by robust market fundamentals and societal trends driving the need for more infrastructure. The differentiation lies not solely in new products but rather is heavily influenced by our clients scaling their operations to accommodate the massive influx of data consumption and generation we see today.

Great. As for Rick, could you comment on the reduced tax rate? Is this related to further clarifications on tax reform or something company-specific?

This change is primarily company-specific. We've had time to thoroughly digest the complexities of the tax bill, allowing us to clarify our structure and plans, ultimately leading to a lower tax rate.

Understood. Thank you.

Our next question comes from Steve Volkmann with Jefferies.

Good morning. I risk being penalized here for the follow-up on Lighting. Are there particular segments of Lighting that are performing well? If you had to implement restructuring to manage operational controls, are there feasible adjustments that could enhance this business?

Indeed. We constantly strive to optimize our business operations, focusing resources on areas with unique propositions and promising margins. The strategy we leverage is consistent across all sectors, Lighting included, where we differentiate strengths while managing less favorable segments.

Thank you. On ESS, previously when that business experiences backlog growth, it traditionally creates opportunities to enhance pricing and improve margins associated with that backlog. Currently, do you observe similar patterns, and should investors prepare for better margins within the backlog?

While I won’t comment specifically on backlog margins, your premise holds weight. Our current environment, where our Electrical Systems & Services business is witnessing growth and resulting in increased backlog, positions us favorably for pricing opportunities. We're fortunate to be in a situation where the market demands are on our side, culminating in a conducive backdrop for improved pricing.

Our next question comes from Christopher Glynn, with Oppenheimer.

Thanks. Regarding Hydraulics, I noted reported incrementals were around 24%, contingent on FX changes. That's somewhat lower than the comprehensive Eaton target of 40%. I would assume there have been market ramp inefficiencies. How much should we expect incrementals to reflect internal expectations absent these inefficiencies?

Your quoted number reflects the situation accurately. We view the 40% incrementals as the right level for our Hydraulics business. Right now, we’re overcoming some ramp inefficiencies as orders have rapidly risen, straining our supply chain's response capabilities. This involves expediting processes and increased overtime work, leading to suboptimal efficiency. However, we forecast improvements in consistency as we move onward.

Understood. Additionally, I'll incur the penalty and revisit Lighting. As you observe volume declines, how do you differentiate the relative impacts of the large project comps versus being more selective in your market approach? It appears the latter may yield more stability or margin enhancement.

Both large project repeats and our decision to be selective contributed to the overall decline in Q1. As we progress, we believe that much of these challenges have now subsided, and we remain confident in our forecasts for the year.

Our next question comes from Jeff Hammond with KeyBanc.

Hey, good morning, guys.

Hi.

I’d like to discuss EPG. Besides Lighting, the orders appear sluggish, especially regarding industrial projects. Could you elaborate on the construction sectors for both residential and non-residential markets to gauge any irregularities with order flows?

Thus far, we have not observed any dramatic changes in the Electrical Products sector, aside from Lighting performance. Current projections suggest industrial markets are progressing upwards between 3% and 4%, while residential markets continue solid growth in the mid-single digits. Overall, our outlook for the year remains consistent with our original forecasts for the Electrical Products business.

Moreover, it is early to draw conclusions, but initial reports from our April orders seem quite robust, indicating persistent strong conditions in the product segment.

Thank you. Returning to eMobility margins, should we expect low double digits for the foreseeable future as you make these investments? Or will you start returning to previous levels?

During this investment cycle, which we expect to be a multi-year investment profile, we will maintain lower margins until revenues increase significantly.

Thanks, guys.

Our last question for the day comes from Rob McCarthy with Stifel.

Good morning, everyone. I have two questions to follow-up. First, regarding Lighting, my calculations suggest that core declines could approach 15% to 20%, which is quite substantial. Do you foresee needing to engage in additional restructuring or internal adjustments that could hinder operating margins? Additionally, could you shed light on the degree of decremental leverage observed throughout that decline?

I’m unclear how you reached those numbers. Our Q1 Lighting revenues declined by only 10%, while our profitability remained stable. We expect subsequent quarters to present a more favorable outlook for Lighting, leading us toward our original expectations for margins without concern for decremental margin implications.

Thank you. I will follow up offline on those topics. As a second question, recognizing the drag on the operations, I see that with the current market setting and your strong balance sheet alongside significant cash flow generation capabilities, do you foresee an inclination to enhance the buyback given the current share price environment? It appears there's a good market opportunity to filter investment and capital allocation across the board.

We will not allow excess cash to accumulate on our balance sheet and intend to prioritize growth investments, dividends, and our $800 million share buyback commitment. If market conditions remain favorable, we wouldn’t hesitate to accelerate our buyback program, although all decisions would also consider potential M&A opportunities.

Our last question today comes from Chris Laserinko with Wells Fargo.

Hey, guys. This is Chris Laserinko on behalf of Andy. I have a few follow-ups and am hoping to broaden the discussion. In reviewing orders within the release, there seems to be a slight deceleration compared to the previous quarter's growth rates. Is this primarily due to comparisons or are you experiencing any sequential weakening as you manage the backlog?

We aren’t witnessing any sequential weakening; on the contrary, our metrics are solid through April. The data centers are demonstrating prospective orders from last year. For example, Hydraulics had a robust 22% rise in Q1 last year, and we saw a continued 14% ascent this quarter. The observed variations are likely cyclical, influenced by previous performance; we’re pleased overall with our trajectory.

Glad to hear it. Can you confirm if the target incrementals of 40% hold true for the company overall? Moreover, could you elaborate on what specifically contributed to the under-leverage seen in Q1? Is it more volume related, influence from price-cost adjustments, and how do those elements break down?

The 40% target incrementals remain. Factors impacting Q1 performance included volume leverage, product pricing, and our restructuring ventures, which collectively underpinned our margin development. As demonstrated, our incremental margins delivered for Q1 align with the guidance advocating for an annual target of 40% incrementals.

Finally, regarding eMobility, could you elaborate on your revenue projection for the rest of the year and any upcoming product launches that might bear significance? How might leveraging of current technologies play out over the next two years?

Sure. For eMobility, we're not expecting a drastic ramp just yet, but we are working diligently on multiple customer projects that may influence future spending. As for our current project timelines, much hinges on large OEMs introducing their electric vehicle platforms.

There won't be a large-scale ramp, but rather a gradual increase as we proceed through the quarters, dependent on the progress of customer engagements.

Effectively, pace will be dictated by the speed at which our customers launch their new electric platforms, which will control when we observe significant revenue shifts.

Thank you for your insights.

This wraps up our call for today. As always, Chip and I will be available for follow-up questions for the remainder of the day and throughout the week. Thank you for your time.