Eaton Corporation plc (ETN) — Q2 2019 Earnings Call Transcript

Good morning. I'm Yan Jin, Eaton's Senior Vice President of Investor Relations. Thank you all for joining us for Eaton's second quarter 2019 earnings call. With me today are Craig Arnold, our Chairman and CEO; and Rick Fearon, Vice Chairman and Chief Financial and Planning Officer. Our agenda today includes opening remarks by Craig highlighting the Company's performance in the second quarter, and as we have done in 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 we will go through today have been posted on our website. Please note that both the press release and the presentation include reconciliations to non-GAAP measures. A webcast of this call is accessible on our website and will be available for replay. Before we get started, I would like to remind you that our comments today will include statements related to expected future results of the Company and are therefore forward-looking statements. Our actual results may differ materially from our forecasted projections due to a wide range of risks and uncertainties that are described in our earnings release and the presentation. They are also outlined in our related filing. With that, I will turn it over to Craig.

Okay. Thanks, Yan. Appreciate it. And let's start with Page 3, and a highlight of our Q2 results, and I'd say, overall we delivered solid Q2 financial performance, and on the back of what I'd really call good execution across the company. Earnings per share of $1.50 on a GAAP basis and $1.53 excluding transaction and integration costs related to the acquisitions and divestitures. So at $1.53 per share, our results are 10% above last year and at the high end of our guidance range, which was $1.45 to $1.55. Our sales of $5.5 billion were up 2.5% organically, partially offset by 1.5% of negative currency, and similar to Q1, we continue to deliver strong margin performance. Segment margins of 17.9% are an all-time record for Eaton including records for Electrical Products, Electrical Systems & Services, and Aerospace. Our margins were also above the high end of our guidance range and 90 basis points above the prior year. We also generated very strong cash flow - operating cash flow of $880 million, up some 76% over Q2 of 2018, and once again, our second quarter record. And lastly, we repurchased $260 million of our shares in the quarter, bringing our year-to-date purchases to $410 million or 1.2% of our shares outstanding at the beginning of 2019. Turning to Page 4, we provided a summary of our income statement versus the prior year, and I'll only highlight a couple of points here. First, we're very pleased with our incremental margins which were about 50% on the organic growth that we delivered in the quarter, so, once again, strong execution. Second, we incurred about $0.03 per share of after-tax costs, primarily related to the spin-off of our Lighting business. And finally, adjusted earnings increased 7%, and as we noted, adjusted EPS increased some 10%. Moving to Page 5, we summarized the quarterly results of our Electrical Products segment. Revenues were up 2%, which includes 4% organic growth, partially offset by 2% negative currency. Organic growth was driven by growth in both commercial and residential markets largely in the North American market. Orders increased 1% led by continued growth in residential and commercial construction in the Americas, partially offset by softness in some of the industrial markets, and our backlog was up 4%. Segment operating profits grew 8% and operating margins were up 110 basis points to 19.6%, which was once again an all-time record. So we continue to be pleased with how well the segment is performing, both in terms of organic growth and in margin performance. On the next page, we summarized results for our Electrical Systems & Services segment. Revenues were up 5% with 5% organic growth and 1% growth from Ulusoy acquisition and 1% negative currency impact. Organic growth was driven by strength in the industrial projects as well as in commercial construction markets. On a rolling 12-month basis, Electrical Systems & Services orders were up 3% with growth really across all regions. It's worth noting here that prior year orders included an unusually high level of orders in hyperscale data centers. Excluding hyperscale data center orders, rolling 12-month orders were up some 8%, which is in line with our order growth in Q1. Additionally, our backlog continues to grow and it increased some 2% in the quarter. Electrical Systems & Services also produced all-time record margins of 17.4%, which were up some 240 basis points from prior year. The strong operating performance included solid operating leverage with profits up some 22% on 5% organic growth. Page 7 has our Hydraulics results for Q2. Revenues were down 3% and that's flat organic growth with 3% negative currency. Similar to Q1, we had tough comps with 13% organic growth in Q2 of '18, but revenue continued to slow. Flat organic revenues reflect growth in industrial equipment largely offset by declines in agriculture and construction equipment. Our orders declined 8% from continued weakness in global mobile equipment markets around the world and our backlog declined some 12%. Segment operating margins were 11.5%, in line with Q1, but certainly down some 200 basis points from last year. We continue to work through some inefficiencies and costs related to repositioning the business during the quarter, but we made significant progress and we expect a better second half of the year. On the next page, we show our Q2 results for our Aerospace business. Similar to Q1, the business continued to perform at a very high level, delivering record performance on almost every metric. Revenues were up 12%, with 13% organic growth, negative 1% currency. Orders on a rolling 12-month basis increased 15% with particular strength in commercial transport, military fighters and commercial aftermarket. Our backlog continues to remain robust and it increased from 17% in the quarter. Again, we demonstrated strong incremental margins which led to a 41% increase in operating profits and a 520 basis points improvement in margins. Operating margins of 24.6% were another all-time high for the business. In addition to volume growth, we also experienced some favorable product mix in the quarter. Lastly, we're very excited to have announced in July, Eaton's commitment to acquire Souriau-Sunbank Connection Technologies for $920 million. Souriau is a leader in aerospace connectors and provides us with the capability to more effectively serve more electric aircraft systems, which is a trend in the industry. Beyond Aerospace, we also have a significant opportunity to expand the distribution of Souriau's products to our large electrical wholesale network, and as the whole world just becomes more electric, we think this technology and capability really becomes a growth platform for Eaton. Souriau has grown historically in mid-single-digit levels over the last several years and we think we're paying a very attractive multiple of 11.8 times EBITDA before synergies and 7 to 8 times EBITDA on an after-synergy basis. Moving to Page 9, we summarized our Vehicle segment. Our revenues were down 11%, which includes a 9% reduction in organic growth and negative 2% from currency. Similar to Q1, organic sales declined 2%, driven by a combination of decline in light vehicle markets, which we think were off some 7% and the impact of revenues that transferred into the Eaton-Cummins Joint Venture. I will point out that the revenues in the joint venture increased some 11% in the quarter. And also similar to Q1, we had tough comps, organic growth in Q2 of 2018 were up some 11%. For the year, we continue to expect NAFTA Class 8 production to be roughly flat at 324,000 units, and we expect global light vehicle markets to remain weak, and as a result, we've lowered our market outlook for the year. Operating margins were 16.9%, which were down some 160 basis points from the prior year, but I would point out, up 180 basis points sequentially despite slightly lower revenues versus Q1. So once again, really strong execution in our Vehicle segment. Lastly, we summarized our eMobility segment on Page 10. Revenues were up 1%, which includes 2% organic growth, partially offset by 1% negative currency. The slower organic growth is made up of continued double-digit growth in the EV passenger market, partially offset by slower internal combustion engine markets. You should note that in this segment today, around two-thirds of our revenue goes into legacy internal combustion engine and commercial vehicle markets. This will certainly change dramatically as the electric vehicle segment continues to grow, but for right now, it is still two-thirds legacy ICE markets. As planned, we continue to accelerate R&D spending, which increased some 70% in the quarter, and as a result, segment margins declined to 8%. We're also extremely pleased to announce that we won another large program valued at $160 million of mature year revenue for a high voltage inverter for a new plug-in hybrid platform. This was our second significant win since we created the segment just over a year ago and we certainly referenced this in our press release, but this brings our total new wins to $390 million since the segment was formed in 2018. We're ahead of our original schedule, and once again, well on our way to creating a $2 billion to $4 billion segment of the company. Moving to Page 11, we turn to our outlook for 2019. We now expect organic revenue for all of Eaton to grow approximately 3%, down from our prior estimate of 4%. This reflects moderating global growth, particularly in Europe and in China, and specific weakness in our short cycle businesses, very much like you've heard from other companies. We're lowering our organic growth rate by 3% for both Hydraulics and the Vehicle segment. In the Hydraulics segment, we continue to see slow growth expectations in global mobile equipment markets and so, we now expect roughly flat organic growth for the year. In the Vehicle segment, after a weak first half, we expect organic revenues to be down some 7% to 8% due to continued weakness in global automotive markets. Please remember once again that we are seeing strong growth in our Eaton-Cummins Joint Venture. We are also lowering our organic growth for our eMobility segment from 11% to 12% down to 5% to 6% due to slower growth in legacy internal combustion engine platforms. We've not changed Electrical Products, Electrical Systems & Services or Aerospace as our long cycle businesses continue to perform in line with our guidance. On Page 12, we summarized our margin expectations for the year. Our Eaton consolidated segment margin guidance remains unchanged with a range of 17.1% to 17.5% or 17.3% at the midpoint. We've narrowed the range for each of our segments to be plus or minus 20 basis points since we've delivered the first half of the year and it's behind us at this point. We do have some puts and takes in margins with a 70-basis point increase in ESS and 90-basis point increase in Aerospace, offsetting a decline in the Hydraulics segment, and the midpoint of our margin for the other segments remains unchanged. Our full year guidance for Q3 and 2019 are summarized on the last page, Page 13. For Q3, we expect adjusted earnings per share of $1.50 to $1.60 per share. At the midpoint, this represents an 8% increase over last year, excluding the impact of the arbitration decision in 2018. Other assumptions in Q3 guidance include approximately 3% organic growth, margins of 17.7% to 18.1%, flat corporate expenses, and a tax rate of 16% to 17%. For the full-year 2019, we're maintaining the midpoint and narrowing our adjusted EPS guidance range by $0.05 at both the bottom and the high end of the range. Our new range is $5.77 to $5.97 per share, and at the midpoint, $5.87. This once again represents a 9% increase over 2018 excluding the impact of the arbitration decisions last year. Other full year guidance assumptions include organic revenue growth of 3%, $100 million of revenue from the Ulusoy acquisition, foreign exchange impact of a negative $300 million, unchanged from our prior forecast, segment margins of 17.3% at the midpoint, also unchanged, and we've narrowed the guidance range for our full-year tax rate to 14.5% to 15.5%. Once again, no change at the midpoint, but narrowing the range. However, our strong first half cash flows are allowing us to increase our operating cash flow and free cash flow guidance for the year by some $200 million. Operating cash flows will now be between $3.3 billion and $3.5 billion, and free cash flow will be between $2.7 billion and $2.9 billion. We're also increasing our share repurchases from $400 million to $800 million for the year. So, overall, I step back and say, we had a really strong start to the year, a strong first half, we're well positioned for another year of good results, and our teams are doing a great job of executing in the face of the opportunity in front of us. And so with that, I'll turn it back to Yan and open it up for Q&A.

Okay. Thanks, Craig. Before we begin the Q&A section of our call today, I do see we have a number of individuals in the queue with questions. Given our time constraint of an hour today, please limit your opportunity to just one question and a follow-up. Thanks for your cooperation in advance. With that, I will turn it over to the operator to give you the guidance.

Okay. We will take our first question from Jeff Sprague with Vertical Research.

Thank you. Good morning, everyone.

Hi, good morning, Jeff.

Hey, good morning. First, just thinking about Hydraulics and Vehicle, this is obviously the second quarter in a row now we've marked down the top line and marked down the margin outlook a little bit. Would you say, the forecast as you've laid it out here, is kind of a run-rate forecast on what you see over the balance of the year? Or are you making some underlying assumption that things pick up? And I was wondering if you could also just, as part of that, elaborate on how we get comfortable with the Hydraulics margins given kind of the recent trajectory there?

I appreciate the question, Jeff. I think you've characterized it the right way. It's really a look at kind of run rate in those two businesses, specifically with respect to growth. Certainly in Vehicle markets, global markets around the world have been weak in the first half of the year and we're essentially assuming that we see a similar picture for the balance of the year, perhaps with a little bit of a pickup in the China market, given kind of the depth of the fall that we experienced in the first half of the year. But other than that, it's really largely a run rate in both of those businesses, and specifically in Hydraulics, today what we continue to see in Hydraulics is we can only see inventory correction take place in the channel both in distribution as well as in OEMs and we're also clearly seeing today our lead times have been reduced and so there is a fairly sizable inventory correction taking place across the board, and the economic activity, if you take a look at kind of retail sales, those numbers are much better than what we're seeing certainly in the underlying order intake.

And maybe then as my follow-up to all that, Craig, thank you, is just on the inventory correction that you are seeing, do you have any way to kind of gauge how far along we are in that process? How much in excess inventory it might be out there? And how many quarters it takes to run its course?

It's really challenging to estimate accurately, Jeff, as this largely depends on everyone's outlook on market trends. With the ongoing economic and trade uncertainties, everyone is trying to navigate how much genuine underlying demand exists versus how much of the current situation is just general apprehension stemming from these external factors. It's quite difficult to make a definitive judgment. Looking at the inventory levels in the channel, we observed a broader trend, including in our electrical business, of some inventory corrections. However, it's hard to determine whether this process is complete, if there's more to come, or if we are at a point where we feel comfortable rebuilding inventory in the system.

Great. Thank you.

Our next question comes from Jeff Hammond with KeyBanc.

Hey, good morning, guys.

Good morning, Jeff.

Just a few questions on the electrical side. One, you had talked about the big step-up in ESS margins, congrats there, just no real revenue change, what's really driving the step-up there? And then just any update on the Lighting spin, when do we expect like a Form 10 et cetera? Thanks.

Yeah, I'll take the first half, and then I'll let Rick take the second. But in terms of ES&S and the margin step-up, I'd say, in a word, it's strong execution. Our teams are just doing an outstanding job of converting on the opportunities in front of us and running our facilities better. As we've talked about in the past, we've done some work around the portfolio and where we're choosing to compete, and those things are paying off in the form of higher margins inside of the business. So we're very comfortable with the level of margin guidance that we provided and taken the margins up, and our teams are just doing a great job of executing, and we'd expect that to continue.

And on the Lighting spin, Jeff, we've had initial comments from the SEC, relatively modest set of comments and so we would expect to get the Form 10 filed towards the end of the third quarter, might just lap into the beginning of October. But that's the time frame.

Okay, and then just as a follow-on on the Souriau acquisition, you gave kind of the adjusted valuation with synergies. Can you kind of expand on where you think those opportunities are? I recall the business has a fairly large France footprint, and so I know sometimes those costs are onerous to take out. Thanks.

Yeah, I appreciate the question, once again, Jeff. And I think today they run a very effective operation in France by the way, and so we have no intentions of closing any of the French manufacturing facilities, if that is the basis of your question. Today, we operate as Eaton in France and we operate very successful businesses in the country. We're very comfortable with their manufacturing operations in France. Right now, we are in the period of obviously putting into some of the finishing touches on what our exact integration plans are going to be. We've not communicated those plans for the organization yet, and so clearly before we'd make any public statements, we'll obviously need to work through our own internal announcements. But specifically as it relates to manufacturing in France, very comfortable with that team, very comfortable with their capabilities and how effectively they've managed that business over a very long period of time.

Okay, great. Thanks, Craig.

Our next question comes from Scott Davis with Melius Research.

Hi, good morning, guys.

Good morning.

I wanted to just follow up a little bit on the questions around visibility, inventories, et cetera. I mean, can you give some granularity on what types of projects you're seeing in non-res in your backlog?

I'd say that when we think about kind of what's going on today in Electrical Systems & Services, I'd say, particular strength certainly in the US, commercial construction continues to be quite strong, orders were up some 6% in Q2. Industrial orders were also up nicely in the quarter. We're seeing pretty broad-based strength in our Electrical Systems & Services business, we had a really strong quarter of orders in the US as well. If we look around the world, in terms of what's going on in other regions of the world, where Europe, what we call EMEA, Europe, Middle East, Africa, India, we saw big projects in industrial also in data centers; in data centers in Europe were up strongly in Q2, Crouse-Hinds business, oil and gas had a very strong Q2 as well as our Engineering Services business in Europe also strong. In Asia where we saw the strength primarily was in power quality markets, which were up double-digit in the quarter. In Electrical Systems & Services, we're seeing generally speaking, nice growth in almost all of the end markets other than what we talked about, which was a highly cyclical piece of the segment, which is kind of the hyperscale data centers where those orders just tend to be lumpy and we're really anniversarying some really huge numbers from the Q1 and Q2 of 2018. Other than that, we're seeing pretty good strength across residential, commercial, data centers and industrial buildings.

Seemingly so, but does it scare you at all, Craig, when you look across just across more broadly across industrials, I mean the quarter has been pretty weak overall, and you guys have had decent numbers of course, but is there a recession playbook that you guys are dusting off? Are you - is there any internal plans to delay hiring or do anything to kind of play a little bit more defense versus offense?

I think it's reasonable to say that we have noticed a general slowdown in the macro economy during Q2, which has led us to take a moment to assess the market and where we believe it's heading. We always have a restructuring plan ready, and we encourage our teams to consider their response in the event of an industrial recession. Our teams are actively thinking about this and have strategies prepared, but for now, we are still observing growth in our end markets. We have contingencies in place, and if we do face an economic downturn, we plan to utilize our strong balance sheet and cash flow, and we would increase our share repurchases. We have already outlined our approach for such a scenario, as discussed during our Investor Day event, and we believe we are well-prepared for any potential economic slowdown or industrial recession.

Thank you. Good luck, guys.

Thank you.

Our next question is from John Walsh with Credit Suisse.

Hi. Good morning.

Hi.

Question around the Aerospace margins, obviously another very strong quarter taking the margins higher again, I think last quarter you alluded to some favorable mix, but just wanted to get your thoughts around where the Aerospace margins are going to exit this year and kind of the sustainability of that?

I'd say that we've got a number of different positive events that are taking place in Aerospace. Number one, I begin with once again our teams and how effectively they are executing, and we are just doing an outstanding job across that business and really converting on the opportunities in front of us and running our facilities very efficiently, and that's giving us a bit of a margin lift. In addition to that, we're seeing today, quite frankly, as we talked about in prior years, there simply are fewer big aerospace programs that we're spending R&D dollars on and that's paying a dividend and I don't anticipate that changing dramatically unless the big OEs and commercial platforms decide to launch some major new program, that's not currently on the horizon. The third element is, aftermarket continues to be quite strong. The aftermarket segment of the business continues to grow nicely and we're converting on margin upgrade opportunities. We really do think that this business is going to be performing at much higher levels of profitability than it has historically, and if you think about the guidance that we provided for the year, you can expect the business to continue to perform at those levels.

Thank you. And then I guess maybe just some color around the acquisition pipeline. I guess we've had now one deal strengthened on each side of the house, you're going to generate very strong free cash flow, you have a balance sheet, kind of what does the pipeline look like? And what's the appetite continuing to deploy it for M&A?

The pipeline, I'd say, today is much more robust than it's been historically. Certainly, much more robust than we've seen in the last 3 to 5 years. We are certainly looking. I'd say, at more opportunities than we ever have. Having said that, I will also point out though, valuations in many cases are still quite elevated, and we're going to continue to be disciplined as we think about how we deploy our capital. What we've said continues to be our priority; we'll focus on largely our Electrical business, our Aerospace business, and perhaps on certain opportunities around eMobility. Those continue to be the company's priorities in terms of how we think about deploying our M&A dollars. The pipeline is more robust today than it's been in quite some time.

And I could just add one thing. We've actually announced three transactions, Ulusoy and Electrical Intelligent Switchgear, a much smaller transaction, and then, this new Souriau transaction. To Craig's point, the first two were at multiples of 7 times to 8 times EBITDA, and Souriau higher, but it will come down to levels close to that after we enact the integration program.

Good. Our next question comes from Nicole DeBlase with Deutsche Bank.

Yeah, thanks, good morning, guys.

Hi.

So maybe starting with the short cycle businesses, it's been clearly a pretty common theme this quarter end, we've heard from a lot of companies that things to decelerate a little bit in June and that's kind of continued into July. So just curious about anything you're willing to share on the monthly trends within the short cycle piece of your portfolio?

I'd say that the call story is not terribly different than that. The month of June really was weaker than what we were anticipating, and once again, your question, there's a lot going on in the global environment in the month of June, whether it's around trade and additional tariffs, or whether it's just around the general direction of the overall economy. To what extent did a lot of our customers and distributors put things on pause in the month of June, we'll have to wait and see. I will say that, so far in the month of July, things are playing out largely as we anticipated and so very much consistent with the guidance we provided. We don't think necessarily that June kind of is the new standard. But we did in fact see a slowdown in the month of June, consistent with what other companies have reported.

Got it. That makes sense, Craig, thanks. And then for my follow-up just around data centers if you could provide a little bit more of an update of what you're seeing there? We've heard increased concerns about push-outs from the hyperscale players. So would love to hear what Eaton's seeing.

For us, we always talk about data centers being a long-term growth market where we think the market will continue to grow within our long-term trend basis, high single digits. We think it's a great space to be in, and Eaton has a great strategic position in data centers, both on the equipment side as well as on the power quality side, but there is this fairly large segment of the market called hyperscale that is very lumpy and it's been historically and probably will continue to be lumpy in the future. If you look back at what happened in our business in the first half of 2018, we got very large multi-year orders from a number of data center hyperscale players. As a result, we anniversary that in the first half of the year and we'll have a better second half comparable for sure, but that business is lumpy today, and it will continue to be lumpy, but we think data centers long-term, and quite frankly in the near term is a great space to be in and will continue to be a real growth engine for the company.

Thanks, Craig.

Our next question comes from Joe Ritchie with Goldman Sachs.

Thanks, good morning.

Good morning, Joe.

So maybe just kind of taking that Aero margin question slightly differently. Obviously, the first half of the year, the margins were incredibly strong. If I take a look at your guidance for the full year, the implied guidance for the second half, would be that second half Aero margins are going to be lower than first half Aero margins. And so my question is, was there anything specific about the first half that really helped boost margins or anything that’s potentially going to impact margins in the second half on the Aero side?

The simple answer to that question, I'd say is, no. We certainly outperformed our expectations in the first half of the year. We certainly saw very positive aftermarket mix in the first half of the year where the question is going to continue into the second half? At this point, I think it's tough to say. We have lifted margins overall, likely going back to our historical view of OE aftermarket mix, but other than that, there were absolutely no one-time items or other things that drove the improvement in margins outside of the strong execution in our businesses, strong aftermarket, and quite frankly, lower R&D spending.

Got it. That makes sense, and good to hear there, Craig. I guess my follow-on question, and this is something I think I've asked you on prior calls, is really just around Hydraulics and how you're thinking about that business longer term? You've taken down the margin guidance, it's now below the longer-term thresholds for that business. How are you thinking about the - I guess the trajectory of this business as part of the portfolio, given the performance that we've seen recently?

I appreciate the question. It's clearly a business today that we're not pleased with the way it's performing. We're not pleased with the way we've converted on the opportunity in front of us. The margins are below the overall guidance for the Company. I'd say that today, Hydraulics accounts for 8% of our Company. We delivered 17.9% all-time record margins despite the fact that we have one of our businesses not firing on all cylinders, and I look at that as saying, wow, what an opportunity for what this company will look like once we get Hydraulics performing at the level that we know that they're capable of. As we think about the first half of the year, we were still working through some repositioning costs, some inefficiencies, as I mentioned, and will likely have a better second half of the year. We're very much confident in the plan that the team laid out, but we have work to do and we have something to prove in our Hydraulics business. In a company as large and diverse as Eaton, it's unusual to find every single business firing on all cylinders. It's a testament to the strength of the company. We can still deliver record all-time margins across the board, despite having one cylinder not firing completely.

Fair enough. Thank you.

Our next question comes from Dave Raso with Evercore.

There was some concern going into the quarter on ESS orders and the organic for the second half, but obviously your comments about ex-hyperscale that your orders didn't even slow on a year-over-year basis and the rest of the year, you're implying organic for that business as strong as you saw in the first quarter. So it seems like you're very comfortable with the top line. Can you help us a bit with the margin in the back half of the year, like what's in the backlog when it comes to mix, any price cost you can help us with, I see the incremental in the back half of the year is about 36%. It's actually a little lower than the first half. So it doesn't seem that challenging, but can you just help us a bit with what's in the backlog to gain comfort with that important business?

Our backlog is reflective of what we experienced in the first half of the year. The guidance we provided incorporates what we have visibility into our backlog. In our Electrical Systems & Services business, like some other parts of the company, the team is executing well on the opportunity in front of us. If you think about price versus cost, we will be net neutral. We're getting price in places where we're dealing with inflation and tariff-derived cost increases, and our businesses are managing that effectively. We think that's going to be a net neutral, and the margin expansion will come from our ability to manage the portfolio in terms of where we choose to compete, as well as bringing out inefficiencies inside of our businesses.

So nothing unique in the backlog help or hurt the margin from what we've seen?

No, very much consistent with what we experienced in the first half.

That's great. Thank you very much.

Our next question comes from Ann Duignan with JPMorgan.

Hi, good morning, everybody.

Good morning, Ann.

A lot of my questions have been answered, but Craig, I think on Hydraulics you commented that you're seeing more broad-based slowdown in agriculture geographically. I think last time you were saying just North America. Maybe you could just update us on that and what you're seeing more broadly?

I think that's fair, and I'd say whether it's in ag markets and construction equipment markets, we've seen a general slowdown really around the world in most of the mobile equipment markets, particularly in terms of the absolute rate of growth. We see that, and some of the big OEMs have already reported their numbers. The other big thing that’s taking place clearly across the businesses is inventory correction that we're seeing both in the OEM channel as well as in the distribution channel and probably largely in anticipation of a slowdown. We're dealing with both of those factors right now, and that's one of the reasons we lowered the revenue outlook for the Hydraulics business this year.

Okay, I appreciate that. And then on the Vehicle side, your outlook for NAFTA heavy-duty production is flat this year and the OEMs are all still quite upbeat about end market demand and we know where orders are, we know where backlogs are, but what are you hearing, feet on the street, that's making you more cautious than your OEM customers?

It's very possible the market can be stronger than what we're calling right now. We know we're calling it flat, and we do know there's others out there who are calling for some modest growth in North America Class 8 trucks this year. We'll have to see how that plays out, but we take a look at the general level of the economy overall. We are seeing slowing and elevated inventory levels today, so we'll just have to wait until that plays out. To your point, there are a couple of others out there who have more robust forecasts for North America Class 8 truck than we have.

Okay. So it's more erring on the side of caution rather than anything you're hearing specifically?

Yeah, absolutely. It's really more erring on the side of caution, recognizing that in the event of a general slowdown in the economy, businesses tend to move quite quickly and so we think this erring on the side of caution is probably a prudent place to be. Keep in mind, for us, it might be a good point to make, so much of our revenue today goes through the joint venture. We're really trying to de-risk Eaton from its exposure to North American Class 8 truck markets. So you’ll see that volatility largely in the joint venture. You'll see very little of that volatility in our own results. It's an important point to emphasize; it was a deliberate part of our strategy. You'll see that largely in the JV, you’ll see very little of that show up in Eaton's results.

Okay. So the margin reduction in vehicle was primarily auto-related?

Yeah, that's where we're seeing the weakening. We held the margins, by the way, just to clarify this point; we actually held the margin guidance. We narrowed the range, but we held the midpoint, despite seeing a slowdown in our automotive markets around the world. That is largely the reason why we reduced the revenue guidance, but the fact that we held margins goes back to our teams and their ability to execute in a declining revenue environment.

Okay, third point I'll leave it there. Thank you.

Our next question comes from Deane Dray with RBC.

Thank you. Good morning, everyone.

Good morning, Deane.

Hey, I'd like to go back to the Souriau deal if we could. And Craig, since this is the largest deal you've done since becoming CEO, some color in terms of how did the deal come together? The structure is a bit unusual; maybe you can comment on that. And then whether there is an opportunity in that funnel to do larger deals like this?

I'm not sure specifically in terms of the structure being unusual. I think it's a pretty straightforward deal; there are some unique rules with respect to the way deals are announced in France in terms of the unions having to approve transactions. We think that's largely a matter of form over function, and we think the deal will close in good stead and we think it will close by the end of the year, no later than. We don't think there's anything other than that that's unusual about the deal. We strategically really love this deal. If you think about the whole world becoming more electric, including aircraft, considering Eaton being a big electrical company, we think we have a great opportunity to take their technology and their products into different applications in our core electrical business. Quite frankly, everything we do as the world becomes more electric, we think the electrical connectors that Souriau manufacturers give us a great growth platform.

And then just I had also asked whether that's maybe emboldens you to do bigger deals?

Actually bigger deals for us are a function of where the opportunities lie and whether we can acquire them with the right kind of financial returns. We wouldn't shy away from strategic acquisition of scale if we feel like we can buy it at the right price and add significant shareholder value. The deal doesn't embolden us to do bigger deals, but there is nothing that prevents us from taking a bigger swing if the asset is strategically important and we feel we can add value.

Got it. And then just the follow-up question on Lighting, and the extent to which you can comment on this. There was some discussion that you would entertain bids for the company as opposed to a spin. What has been the interest along those lines, and any color there would be appreciated.

We are in discussions with multiple parties and we'll see how that plays out, Deane. We'll obviously take the course of action that is value maximizing for Eaton shareholders.

Our next question comes from Nigel Coe with Wolfe Research.

Thanks guys, good morning. So the channel corrections in Electrical is a bit of a new development. I think Lighting was an area where we expected to see it and one of your competitors called out commercial as an area where there is a little bit of headwinds. So maybe just dig into that and address the extent to which you think this is caused by the price increases and tariffs versus just general end market weakness and the normal destocking activity? Any color there would be very helpful.

I wish we had clearer and more definitive answers for you. The truth is we and many others are speculating in terms of what caused the slowdown. There is a lot of geopolitical uncertainty in the world right now. It probably reached a high point in June around trade disputes between the US and China and Mexico. We just had enough out there in the month of June for people to pause and take stock of where they were at, but beyond that, we'd really be out on a limb speculating exactly what caused the slowdown. As we look at the back half of the year, we factored in what we saw in June into our forecasts. This can go either way. We think there's a higher probability of a return to normalized growth rather than a deceleration. Our businesses are focusing on contingency plans in the event of a severe economic slowdown.

Thanks for that Craig. The question is more on the competitive impact, but we can take it offline, thanks a lot.

Our next question comes from Josh Pokrzywinski with Morgan Stanley.

Okay, then we take the next one from Steve Volkmann with Jefferies.

Great. I'm here.

Hi, good.

Just a couple of quick cleanups, I guess if I may. I was curious about the price cost question from a different perspective. We're starting to hear a little bit of signs of people sort of pushing back on price increases due to slower growth, due to lower material costs, and I'm just curious what your view of the price cost over the next couple of quarters is.

Our point of view on this issue is largely where we've always been. We think about price cost in the near term as neither being a headwind nor a tailwind for the business, and we try to manage it to be neutral. That’s been our position and that's really where we're still parked. In some cases, there are equations that drive what we’re able to pass on to our customers and where prices go up and down based on a basket of commodities. Other cases, it's a function of the backlog and negotiated prices. Our view is that net neutral pricing cost for 2019 will neither be a positive nor negative for the Company.

Okay, great. Thank you. And then, sorry if I missed this, but any update on the fluid conveyance divestiture?

Yeah, that's proceeding as well and we are hopeful that it would close towards the end of the third quarter, perhaps the beginning of the fourth quarter.

Great, thank you guys.

Good. Our next question comes from Rob McCarthy with Stephens.

Can you hear me guys?

Yes.

The first question I have is in light of the current challenging conditions. Could you explain how you perceive your potential lowest earnings could look if this year is the peak? Is there any way you could respond to that qualitatively or otherwise, Craig?

We touched on this during our Investor Day earlier this year. As we consider Eaton's new structure post-divestiture of Lighting and removal of FCD, and given our strong free cash flow, we aim to maintain a company that can keep earnings flat even in a typical economic recession, which we define as two to three quarters of GDP contraction. This is still our goal, and our teams are focused on it. For instance, in our Vehicle segment, even though revenues have decreased significantly, we are managing to hold our margins. That’s our objective, and our robust cash flow enables us, in the event of an economic downturn, to buy back more stock. This is the strategy we are pursuing.

That makes sense. And then, forgive me for this other question, it's a little impolitic. In terms of your new announcements of the sector heads, obviously, Uday and Heath are very well regarded internally and externally and from all channel checks. But the one thing I get in terms of the feedback anonymously was the fact that as good as Heath is, he's never run anything explicitly at a segment level, I mean, do you think he is up to this? Obviously, you think he is up to the challenge. But how do you think about that going forward, or is that a risk to management or execution for Eaton?

The first thing I'd say is that Heath is an outstanding leader who has been around for a long time inside of Eaton and inside Cooper before that. He's an outstanding leader with outstanding judgment, outstanding decision making. If you think about the way we're organized, we have three businesses. Within these businesses, we have presidents who run the day-to-day, who are great operators and know how to execute. What we're looking for in the sector job is really strategic thought leadership. Heath, by the way, has that as does Uday. I would tell you that he is exactly what we need for the business at this point in time. The business is going through a fair amount of strategic repositioning in all three cases with a lot of moving parts. What our businesses need is a partner who can work with them on how to think about the future of these businesses and what strategic moves we should be making to maximize our results and performance.

Thanks for taking my questions.

Hey, guys. Thanks for squeezing me in. Just a question on, first on China, could you describe in more detail what the trend has been through the quarter? It appears that something happened in June and I wonder if you've seen a slowdown in June? If you could just describe the intra-quarter trend in China? Thank you.

Yeah, I can't say that we saw anything specific at all in June. In the short cycle businesses, specifically in automotive and Vehicle markets, we clearly saw a weak quarter. We saw a little bit of a weaker quarter in Hydraulics for sure in China. The long cycle businesses, non-residential construction, residential construction continue to be strong during the quarter. This kind of bifurcation of these two different markets has been a pattern we've seen out of China for most of this year. In Q2, the month of June wasn't much different. We are optimistic that with some infrastructure-related spending and the stimulus initiatives that have been put into the China market, we could have a better second half of the year, but at this point, we didn't see anything significantly different in China versus the pattern we experienced all year.

And I apologize if I missed the question. Could you just comment on the growth rate within ES&S? What's the growth rate for Services, what was that in the quarter? And what are the big trends there?

As I mentioned, we had a really strong quarter of orders in our Electrical Systems & Services business, which were up strongly in the US, some 15%, Europe was also up close to 15%. So, Services was one of the standout performers for orders in the second quarter and we continue to be optimistic about the outlook for Services overall.

Terrific, thanks for fitting me in.

Good. Thank you all. We have reached the end of our call, and we appreciate everybody's questions. As always, Craig and I will be available to address any follow-up questions. Thank you for joining us today.