Eaton Corporation plc (ETN) — Q3 2020 Earnings Call Transcript

Good morning, everyone. I'm Yan Jin, Eaton's Senior Vice President of Investor Relations. Thank you all for joining us for Eaton's Third Quarter 2020 Earnings Call. With me today are Craig Arnold, our Chairman and CEO; and Rick Fearon, Vice Chairman and the Chief Financial and Planning Officer. Our agenda today includes opening remarks by Craig highlighting the company's performance in the third quarter. As we have done on our past calls, we'll be taking questions at the end of Craig's comments. The press release and the presentation we'll go through today have been posted on our website at www.eaton.com. Please note that both the press release and the presentation, including reconciliations to non-GAAP measures, and webcast of this call is accessible on our website and will be available for replay. I would like to remind you that our comments today will include statements related to the expected future results of the company and are, therefore, forward-looking statements. Our actual results may differ materially from our forecasted projection due to a wide range of risks and uncertainties that are described in our earnings release and our presentation. They're also outlined in our related 8-K filing. With that, I will turn it over to Craig.

Okay. Thanks, Yan. Let's start on Page 3 with a highlight of our Q3 results. I am really pleased with how the entire Eaton team has continued to deliver and perform during this ongoing pandemic and economic downturn. Our results, while below last year in absolute terms, were much better than our guidance for the quarter: Q3 earnings per share at $1.11 on a GAAP basis and $1.18 on an adjusted basis, which excludes the $0.05 of charges related to acquisitions and divestitures and $0.02 related to a multiyear restructuring program. Our Q3 revenues were $4.5 billion, down 9% organically compared with last year but up 16% versus Q2. Segment margins were 17.6%, 290 basis points above Q2 levels. Our decremental margins of 25% were at the low end of our guidance range. Our organization is doing an outstanding job of managing discretionary costs. We also generated strong cash flow in the quarter, with operating cash flow at $921 million and free cash flow at $832 million. As a result, we are reaffirming our 2020 guidance for cash flow, with a midpoint of $2.5 billion in free cash flow and narrowing the range to $2.4 billion to $2.6 billion. Lastly, we repurchased $177 million of shares in the quarter, totaling $1.5 billion year-to-date. Turning to Page 4, we summarize our Q3 results. Acquisitions increased sales by 2%, but this was offset by an 8% impact from our divestitures, primarily the Lighting business. Our segment margins at 17.6% were down versus last year but still at healthy levels, considering the reduction in revenue. All charges related to acquisitions, divestitures, and restructuring costs are now recorded at the corporate level, making it easier for you to model our results in the future. On Page 5, we show our results for the Electrical Americas segment. Our largest operating segment returned to positive organic growth of 3% during the quarter, exceeding the high end of our guidance range. This strength was driven by residential and utility markets. Revenues were impacted by the sale of the Lighting business, reducing sales by 19%, with negative currency affecting sales by 1%. Operating margins increased 280 basis points to 22.2%, favorably impacted by the divestiture of Lighting and ongoing cost containment actions. Our Americas business showed resiliency, evident in our orders and backlog. Orders were down 1% on a rolling 12-month basis, excluding Lighting, with strength in residential and data center markets. On a rolling 12-month basis, residential orders were up 14%, and data center orders saw mid-single-digit growth. Q3 orders were up 16% from Q2, and our backlog increased 11% from last year, driven by strength in residential, data centers, and utility markets, benefiting from investments in Smart Grid and the energy transition. On Page 6, our Electrical Global segment showed revenues down 8%, with a 10% decline in organic revenues, partially offset by a 2% currency tailwind. Organic sales decreased mainly due to weakness in oil and gas and industrial markets. Excluding these sectors, our European business was slightly negative, while Asia showed slight positive growth. Operating margins declined 280 basis points to 16.6% but increased 60 basis points sequentially. Orders dropped 6% on a rolling 12-month basis, driven by oil and gas and industrial markets, though we saw strength in residential, data centers, and utility markets, with data center orders increasing 40% on a rolling 12-month basis. Orders grew 12% sequentially from Q2, and our backlog increased 7% versus last year. Turning to Page 7, our Hydraulics segment showed revenues down 15% organically, though this was an improvement from the 25% organic decline anticipated in our Q3 guidance, as end markets rebounded quicker than expected. Operating margins were flat at 9.8%. We witnessed an 8% increase in Q3 orders, driven by agricultural and construction equipment markets. We remain on track to close the Danfoss sale by the end of Q1 next year. On Page 8, we report on our Aerospace segment, with revenues declining 13% and down 26% organically, somewhat offset by a 12% increase from the acquisition of Souriau and a 1% positive currency impact. Organic declines were primarily due to challenges in commercial aviation, partially mitigated by military growth. On a sequential basis, organic revenues were up 15% from Q2. Operating margins declined to 18.5% due to lower sales volume but increased 370 basis points from Q2 as the business effectively managed costs. Orders were down 22% on a rolling 12-month basis, and backlog fell 11%. On Page 9, we summarize our Vehicle segment results, with revenues down 25%, including a 20% organic decline. The divestiture of the Automotive Fluid Conveyance business impacted revenues by 4%, alongside a 1% currency headwind. The 20% organic decline was better than expected, given our prior guidance of a 32% decline. Light motor vehicle and truck markets have rebounded faster than anticipated. Organic revenues increased by 75% from Q2. While global light vehicle production dropped 4%, Class 8 OEM builds were down 34% in Q3, but we now project NAFTA Class 8 truck production of 200,000 units for the year, up 14% from our previous forecast. Operating margins were 14%, down 430 basis points year-over-year but up 20 basis points from Q2, with 31% decremental margin performance given the revenue reductions. On Page 10, we have our eMobility segment results, with revenues flat and organic revenues declining 1%, offset by a 1% positive currency impact. Operating margins were negative 2.5% as we increased R&D investments in this segment. We focus on executing key program wins and managing a multibillion-dollar pipeline of opportunities, seeing electrification as a significant growth area with a projected recovery. On Page 11, we provide our Q4 outlook on organic revenues. For Electrical Americas, we expect organic revenues to be flat or up 3%, driven by residential, utility, data centers, healthcare, warehousing, and water/wastewater, while industrial markets face some weakness. For Electrical Global, we estimate organic revenues will decline between 7% and 10%, with strength in Asia and data centers offset by weaknesses in Europe and oil and gas markets. For Aerospace, we project organic revenues down between 23% and 26%, with military growth but continued weakness in commercial aviation. For Vehicle, we expect organic revenues to decline between 7% and 10%, with strong demand in recovering markets. For eMobility, we estimate revenues flat or up 3%, with a strong recovery in global vehicle markets, especially in electric vehicles. Lastly, for Hydraulics, we expect a decline of 6% to 9%. Overall, we estimate organic revenues down between 5% and 7%, indicating another quarter of sequential improvement as the global economy recovers. On Page 12, we note our Q4 and full-year outlook. We expect organic revenue declines between 5% and 7%, with modest sequential improvements compared to Q3. Our Q4 decremental margins are expected to be 25%, at the low end of our prior guidance range. The Q4 tax rate on adjusted earnings is projected to be 14%. For the full year, we reaffirm our $2.5 billion midpoint for 2020 free cash flow guidance, narrowing the range to $2.4 billion to $2.6 billion. Our free cash flow is expected to exceed 2019 figures, which stood at 13.4%. Our free cash flow-to-adjusted earnings ratio is 142% year-to-date, well above the 120% seen in 2019. We have effectively managed working capital, reducing net working capital by over $350 million year-to-date, primarily through inventory reduction. We plan to repurchase $200 million to $400 million of shares in Q4 and reaffirming our full-year guidance between $1.7 billion and $1.9 billion. Our cash flow generation remains resilient, positioning us well for the upcoming economic recovery. On Page 13, we present our preliminary 2020 outlook by end market within the electrical and industrial sectors. Data centers, utility, residential, and institutional infrastructure end markets account for about 50% of our revenue, expected to continue growing. Industrial end markets represent around 30%, with mixed outlooks, showing strength in machinery and industrial facilities but weakness in oil and gas. There are concerns regarding commercial construction growth, but it only represents 20% of electrical sector revenues, with growth in warehousing that can offset weakness in office and lodging segments. Retail is just 2% of total commercial construction markets, while warehousing constitutes about 5%. Our preliminary outlook for 2020 predicts growth in all industrial end markets, particularly in truck and electric vehicles. Lastly, as we navigate short-term pandemic challenges, we remain focused on our strategic and financial goals, highlighted on Page 14. We aim to evolve into an intelligent power management company leveraging secular growth trends such as electrification, energy transition, IoT connectivity, and digitalization. The Brightlayer digitalization initiative exemplifies this transformation, utilizing data from intelligent devices to generate insights and software while partnering with customers for innovative solutions. Our overarching goals include fostering better secular growth, achieving higher margins and consistent earnings, and managing free cash flow wisely through investments in organic growth, dividends, share buybacks, and disciplined acquisitions. Our long-term financial targets of 2% to 3% organic growth, 20% segment margins, 8% to 9% EPS growth, and $3 billion in annual free cash flow remain unchanged. I will now turn it back over to Yan to open up for questions.

Thanks, Craig. I appreciate your cooperation. Now, I'll hand it over to the operator for further instructions.

A couple of things. First, just on cash flow, Craig. The numbers have been very robust, and thanks for kind of reiterating your longer-term target. I am wondering, though, as we think about this 2021 you've laid out with a kind of a return to growth, if those greens and yellows are correct, do you see the ability to actually grow free cash flow in dollars next year? Or does kind of the natural working capital swing and maybe other things coming back into play mute the ability to grow cash flow? I would assume the conversion would still be pretty good but really talking about absolute dollars.

Yes, the conversion will remain strong. We have significant amortization that reduces net income, which is noncash. We believe we can make further progress with days on-hand inventory, which we have improved significantly. So far this year, we've generated over $300 million, and we believe we can extract another couple of hundred million from that over time as an efficiency improvement. We will need to allocate some back into receivables to support sales growth. However, if Hydraulics closes at the end of March, we will lose the free cash flow from that segment, which will reduce our overall free cash flow. Despite this, we think the overall factors will allow us to maintain free cash flow at similar levels as before.

And as we've shared in the past, I mean, our free cash flow is remarkably consistent through periods of economic expansion and contraction as the higher net income that we generate tends to be the offset for the increased consumption or use of working capital. And so we do think that next year will be a very good year as well for free cash flow.

And maybe on the topic of Hydraulics. I don't know if there's anything else to say about the closing time line. But what is your thinking in terms of, for lack of a better term, kind of replacing those earnings, whether it's kind of more of a running start on share repurchase in the early part of 2021 or perhaps the M&A pipeline is active? Just you're probably not working to precisely manage the ins and outs, but it'd still be interesting to hear how you see that playing out in 2021.

Thank you for the question, Jeff. As we consider our strategy for the immediate and future growth of the company, our main focus is on reinvesting funds for expansion. We prioritize the electrical business while remaining interested in the aerospace sector, especially if we can acquire assets with higher defense exposure and favorable valuations. However, we have committed to not letting cash accumulate on the balance sheet. If we do not see clear opportunities for significant mergers and acquisitions, we will continue to repurchase shares to return cash to shareholders. Looking ahead to 2021, we will not immediately use the approximately $2.9 billion in proceeds for share buybacks. Instead, we intend to be more opportunistic with our share repurchase program and make purchases in the market at the right moments.

Craig, you spoke about restructuring and rightsizing in Aerospace. Can you clarify what rightsizing means and what the new normal looks like? How are you planning for it? I noticed Aerospace is marked as positive on your chart on Slide 13. Is there a specific target you are aiming for, like a 20% or 15% reduction, or are your factories flexible enough to adjust production levels? The decremental margins in that business were quite difficult in the last quarter.

Yes, when considering our various end markets, the aerospace sector is currently the most challenged and has the least certainty regarding future improvements. We expect some modest growth in the commercial aerospace market next year, although it will be from a very low starting point. This is why we are optimistic about that market, while the military sector is likely to continue performing well. We have already adjusted our business to align with the current level of economic activity in aerospace, having taken decisive actions since Q2 to rightsize for the present conditions. We anticipate that the aerospace market won't return to 2019 levels until late 2023 or 2024, so we are prepared for an extended downturn. Despite these challenges, we have structured the business to maintain attractive margins, which I would describe as very favorable in the context of today's economic situation. We have ensured that the business is capable of delivering solid margins moving forward.

Okay. Moving on to the grid, what does Smart Grid mean for your company? In relation to historic growth rates, I understand that utility growth has typically been around 2% to 3% for you. Does Smart Grid provide a significant boost to that historic growth rate, or is there simply a reallocation of spending without changing the overall growth rate in utility?

We believe that the energy transition we're experiencing, which includes Smart Grid, contributes significant growth to the traditional utility business. Currently, with the investments being made in renewables, everyone has become both a consumer and a seller of electricity. As we consider the concept of Everything as a Grid, which I discussed in our investor meeting, we recognize that substantial investments will be necessary to strengthen the grid, enhance its resilience, and adapt to a landscape where electricity flows in multiple directions. This requires a different approach to power management. The rise of electric vehicles will also increase the demand on the grid, necessitating smarter management of the various loads. This creates more opportunities for our electrical equipment, software, and solutions. Although the utility market has historically been a slow-growth sector, we foresee an attractive future for it, at least in the near to mid-term.

Actually, Craig, maybe along similar lines but a different region. You mentioned in your comments that Electrical Global Europe was still very weak. Are you seeing any signs of life in that region in terms of the huge investments they're considering making in things like hydrogen and all the infrastructure that would have to be built out to support that? And also more recently, they announced their intention to retrofit all old buildings. I'm just curious whether all of those investments that they're talking about in Europe are going to be years out and require private funding or whether you're hearing any signs of life over there on the back of any of these humongous secular changes that they're talking about?

Thank you for the question, Ann. Regarding hydrogen, it's still early for us to gauge its overall role in the energy landscape, despite significant investments being made. On the broader topic of building electrification, this presents a substantial opportunity for Eaton both in Europe and the U.S. As you likely know, buildings account for approximately one-third of energy consumption and nearly 40% of direct and indirect CO2 emissions. As we noted at our Investor Day in the context of energy transition growth, we believe this shift and the evolving electrical power value chain are leading to what we refer to as Everything as a Grid. This will generate considerable opportunities for us. As customers begin to produce, sell, and consume electricity, the complexity of the environment will increase, necessitating our equipment and solutions. Specifically in the EU, the legislation focused on climate-friendly investments and building innovation provides a strong growth market for Eaton. With the EU Green Deal committing EUR 550 billion to climate-friendly projects, much of which will target building renovations and increased spending on energy storage and digital solutions, these developments are highly advantageous for our company, and we are well positioned to benefit from this growth.

And so you do think you have the portfolio well enough positioned to take advantage of those opportunities when they arrive?

Yes. Yes, we do. And I'd say there's certainly some work that we need to do around some of these things, that we're making those investments in things like energy storage and software solutions to be able to manage the power. But I'd say by and large, we are well positioned to participate and take advantage of it.

Can we maybe start with Electrical Americas? I was pretty impressed by the margin performance there during the quarter. I'm just curious how you think about the stability of the margins that you're currently seeing there into the fourth quarter and into 2021, particularly given that some of these temporary cost cuts start to come back?

Yes. No, appreciate the question. And we did, like some of the other companies, put in place quite a few cost measures as we dealt with the pandemic. And I'd say there were a few of those cost measures that were in place in Q3 that were not as many in Q2, and there'll be fewer in Q4 than there were in Q3. But for the most part, our base assumption is that most of those costs largely come back during the course of 2021. But having said that, the margin story in our Electrical Americas business, I'd say you should be expecting margins that are in this range for this business into the foreseeable future. A lot of what we're doing is around improving our execution. As you know, we've also, as a company, already taken a number of restructuring programs that we would expect that would deliver benefits to offset some of the one-time cost measures, although some of those could be more back-end loaded. But no, I would think that the margins that you're seeing today in the Americas business is very much in line with the way we expect that business to perform.

Got it. Craig, that's really helpful. And then for my follow-up, just thinking about channel inventory, and I guess did you guys start to see any early signs of restocking in the channel, particularly in the electrical business in the quarter? Or maybe you could characterize just overall inventory levels as well.

Yes, we did observe a significant inventory reduction in our Electrical Americas business during Q2. In Q3, we noted some restocking among our distributors. As we approach Q4, distributor inventories are aligned with historical levels. When comparing the number of days of inventory on hand now in Q4 to Q1, they are quite similar. We believe current inventories are well-suited for the economic activity we anticipate for Q4 and next year. Therefore, we do not expect any further inventory buildup, nor do we foresee a continued inventory decline; it appears to be well-balanced at this time.

And Nicole, I'd like to add that the only area where inventories haven't really been rebuilt is in auto dealer lots. Auto inventories are currently at about 50 days, while normally they would be in the mid-60s. Due to strong sales, auto manufacturers have struggled to produce enough cars to restock the lots. Therefore, you can expect to see some improvement in Q4 and possibly into Q1.

I wanted to go back to the 2021 framework, if that's the right words. And obviously, industrial is one of the amber end markets. And obviously, that's not a monolithic end market. There's lots of different parts of that. Is the caution just tied to oil and gas and maybe heavy industrial markets? So would machine tool OEM be sort of a flash number as well? I mean any kind of color you can give us on the different end markets there would be great.

Yes, I believe you captured it well in your comments, Nigel. Everyone is aware of the current situation in the oil and gas markets and some industrial sectors. However, we anticipate that the manufacturing segment of the market will turn positive during 2021, which contributes to our overall belief that the market will continue to grow. Additionally, concerning data centers, the orders have increased by about 40% in the quarter, indicating that the data center market remains very strong.

Right. Yes. I mean I just would have put industrial as a green, but just I was curious what drove it down to be an amber. And then...

Yes. I mean largely, it's oil and gas.

It's mostly oil and gas and petrochemical. Overall, if you consider everything together, it's likely to be down, but not significantly.

Okay. That's fair. That's very fair. My follow-on question is sticking with 2021, the outlook for Aerospace and military. There are some question marks around military with DoD budget constraints. I'm just wondering kind of how good is your visibility into sort of the next year for military. And are there any constraints on commercial aero recovery? I mean there's a lot of, again, concerns around parked planes and cannibalized parts from parked planes. Do you think that's a risk for '21?

Yes. Regarding the military aspect of your question, we generally have good visibility, as military orders typically have longer lead times. We also supply to depots servicing the military market, which is more short-term in nature. Overall, we have a solid outlook based on the defense budget and spending, which we don't expect to change significantly in the near future. The military market appears stable, with steady growth anticipated, although not explosive. In commercial aerospace, it’s evident that many planes are currently grounded. Historically, many of these inactive planes do not return to service and are often parted out, affecting the aftermarket. Currently, due to low activity levels in terms of revenue passenger miles and kilometers, we haven't witnessed significant cannibalization of these grounded aircraft. However, we do expect that as the market improves and some older aircraft remain out of service, this trend will likely resume as the economy recovers. Therefore, our view on the aerospace market for next year is relatively cautious. We foresee some modest growth following a challenging downturn this year, and we have already incorporated these expectations into our yearly outlook.

So Craig and Rick, many of the temporary costs, if not most, will return next year. What kind of incrementals are you considering? I'm asking this in light of the fact that your incrementals or decrementals have been outperforming expectations. Given all the cost reductions you've implemented and the operationally strong segments like the vehicle division in your portfolio, you should be anticipating significant incrementals despite the return of some temporary costs next year. What framework should we consider in this regard?

Thank you for the question. We are currently addressing several aspects of our internal plans for next year, which are still in progress. It's important to highlight that we have removed significant one-time costs this year, many of which are temporary and will return next year. This reintroduction of costs will likely reduce our incremental margins for the upcoming fiscal year. However, we have some mitigating factors, including the restructuring program we recently announced, which will positively contribute to our incremental margins year-over-year. As we prepare for planning, we will provide more guidance after our Q4 earnings call. For now, you might want to anticipate that the incrementals will be somewhat lower than usual due to the return of those one-time costs we are currently addressing.

That makes sense, Craig. As a supplement to my question, are you managing toward incrementals at this point? I mention this because Fortive has a framework that suggests a 35% incremental rate, and if it exceeds that, they will allocate funds differently. Is that how you are approaching it? In other words, if due to vehicle and other operational factors you experienced a better-than-expected recovery with significant incrementals, would you allow those to flow through? Or would you prefer to take that money and use it to keep the incrementals within a certain range?

Yes. I mean if I understand the question, I mean, every one of our businesses has a normal incremental rate, a percentage of fixed versus variable costs. And so every business is expected to essentially manage their business in a very proactive way, to manage margins on the way up and the way down, flexing our variable cost. And so I think that expectation is absolutely built into every one of our businesses. And then to the extent that we do better than that because we go beyond, we're more effective or more efficient, those benefits would tend to flow through, and which is why we're delivering better-than-normal decremental margins this year. But the results are the results. They flow through as they come. We don't, I mean, we don't really have much latitude around managing them other than that.

No. That makes sense. And then maybe just as a follow-up. This might be for Rick. If Biden and the Democrats win, their platform is to jack up corporate tax rates. I think they're trying to go after the GILTI tax. Startling that you guys as an Irish company are far better positioned than other companies that are U.S. based or domiciled. Rick, do you have any preliminary thoughts about how you respectively might manage this to try and keep your tax rate down, which has obviously been very value additive to shareholders over the past several years?

Well, no, you're exactly right, John, to point out that as an Irish-domiciled company, we don't really have issues with things like GILTI. Our non-U.S. earnings are essentially not taxed at U.S. rates or by U.S. provisions. And so the only real impact of what has been suggested by Biden, that the corporate rate comes up, is that our income in the United States would face a higher tax rate, but our income outside the U.S. would really not be affected at all. And that's very different than a typical U.S.-domiciled company that would see both its U.S. income and its non-U.S. income affected by the Biden proposals.

I think we can say confidently that we have an advantage today, and that advantage at least maintains if not improves in the event of a...

It should improve by several points.

Yes.

More near term. I was curious why the Electrical Americas organic sales growth rate in the fourth quarter is a little slower than the third quarter. I mean it feels in the channel, residential is accelerating. It seemed like utility maybe is as well. And I'm just trying to understand why the slower growth rate. Is data center starting to come off a bit? Or is industrial not even showing a second derivative improvement? I'm just trying to understand in case I'm missing something there.

Thank you for your question, Dave. There is some uncertainty about the final outcomes, but the main difference between Q2 and Q3 is the inventory rebuild we observed in the distribution channel, especially in the Americas. We did see some restocking in the Electrical Americas business, which is slightly affecting the growth trajectory on a quarter-over-quarter basis. However, we have not noticed any slowdown in the key markets that are performing well, such as residential, data centers, and utility. Those markets continue to do well. The growth rates we expect for the quarter align closely with what we saw at the end of September and into October.

Just to clarify your comment about the margins for Electrical Americas at the 22% level, do you believe that, all else being equal including any seasonality in the first quarter, there should be a two-handle on the operating margin? Or is the mix, perhaps influenced by restocking and strength in data centers, providing a sufficiently positive mix? Should we interpret your comment less literally? I want to ensure I understood your point correctly.

No. If you consider the factors driving the current margins, one significant aspect is the sale of the Lighting business. Divesting this dilutive Lighting segment has positively impacted the margins in the electrical business. Our teams are effectively managing operations and reducing discretionary costs. While we're not ready to make predictions about a specific quarter, we believe that on a 12-month basis, the level of profitability we anticipate aligns well with the expected performance of the business.

Maybe just following up on John's question from earlier. Obviously, a big day here in the U.S. And I know his question was kind of limited to the tax implications. But I'm curious, Craig, just to hear your views on election outcomes and what that could potentially mean for your business over the next 12 to 24 months.

Yes, it is currently speculative since we are uncertain about the proposals from either administration. However, I believe infrastructure spending is a priority for both. We are optimistic and expect some form of an infrastructure bill from one of the candidates. Many of the trends affecting our industry, such as electrification, digitization, and energy transition, are significant and extend beyond the U.S. and its administration. Despite the current administration not focusing much on green initiatives, we continue to see rising investments worldwide in energy transition and the greening of the economy. These growth trends in the global economy transcend any U.S. administration and should positively impact us regardless of who holds the presidency.

Got it. That's helpful, Craig. And then maybe just my one follow-on. I know we've talked a little bit about incrementals and decrementals but just maybe honing in on the Electrical Global business, which saw decrementals tick up in 4Q. Maybe just a little bit more color what's happening there and whether we should see just kind of improved performance on the decrementals going forward.

Yes. I would say that we expect a 25% decremental for all of Eaton. In any given quarter, depending on the business dynamics and comparisons to the previous year, there can be some variations within our individual segments. However, there is nothing specific to be concerned about regarding the Electrical Global business. That segment is performing well. The incrementals might fluctuate slightly higher or lower than the overall company average depending on the quarter. Overall, we remain confident in the guidance we provided and in achieving the 25% decrementals in Q4.

Maybe, Craig, circling back to your comments around slightly lower-than-normal incrementals next year. So is the way to think about that, that your gross margin is around 30%? And so a slightly lower-than-normal incremental is something in the sort of low mid-20s? Is that a reasonable sort of placeholder for now?

Yes, I would say it would be higher than that. Our typical incrementals would likely be above the number you mentioned. So it would definitely be more than that figure. Additionally, we are still finalizing our plans for next year, and we hope to provide a more definitive number during our Q4 earnings call. However, it is certainly higher than the figure you just referenced.

And then just homing in perhaps on the Aerospace segment and the margins there. Understood they were down a fair amount year-on-year. But I suppose what I found most interesting was very high sequential incremental margin in Aerospace, 40%-plus. So I just wondered, you're at that high-teens margin run rate in the third quarter. Is that good sort of baseline now when you look out to your end-market prognosis and the cost actions that I imagine a fair proportion of those are in the Aerospace division? And also, related to that, longer term, you talked about the aero market top line getting back to the old peak maybe in 3 to 4 years' time. Should we assume aero can get back to prior peak margins perhaps before that? And what do you think the peak margin entitlement is for that business?

Yes. Yes, I would say that if you think about the margin expectations for the business as we go forward and we're dealing at these levels of economic activity, I think it's reasonable to assume that the most recent quarter is probably a good predictor of where that business is expected to perform at, at this level of economic activity and this level of revenues. To the question around the longer term, without a doubt, we would certainly expect this business to get back to prior peak margins that the business posted, which were close to 25%, as the market recovers. Whether or not we can get back there earlier or not, I think it's really going to be a function of, in many ways, what happens with the underlying mix of the business and what happens principally with aftermarket. And as I think everybody understands, in the aerospace world, that most of the margins are made in aftermarket, which means revenue passenger miles, which means consumers have to get on planes and starting. And so I think it really will be a function of to what extent does the aftermarket business return? And are consumers and businesses comfortable putting people on planes and flying again? And so too early to call at this juncture in terms of when it returns. We certainly know that will return. But at this juncture, just too early to ascertain when.

I have a question regarding eMobility. You mentioned some interesting points about potential revenue growth for the fourth quarter. Looking at the long-term, what kind of growth should we anticipate over the next few years? Additionally, you've referenced the investment cycle. How long is this cycle until the business starts making a significant impact on Eaton's profitability?

Yes. As you understand, Andrew, the automotive industry has lengthy product development cycles, typically around five years, especially when introducing new technology. Overall, we estimate a complete cycle from start to finish could take about ten years before it significantly impacts the company's profitability. The speed at which automotive OEMs introduce new vehicles will largely influence the ramp-up. Considering the timeline from inception to when it begins to deliver substantial margin contributions, a range of five to ten years seems like a reasonable expectation.

Got you. And sustainability of the revenue ramp near term?

You said the sustainability of the revenue ramp?

Yes. And, Andrew, one way to think about it is probably the easiest way to think about it. About 2/3 of the revenues that are now in eMobility go into internal combustion cars. So this is electrical equipment going into that. And 1/3 goes into the battery electric and hybrid cars. And so you're going to have different growth rates in those two. But right now, we're in a big recovery period from the sharp down of Q2. And so you're going to see pretty good growth in both of those two categories over the next several quarters.

Got you. And just a follow-up question on capital allocation and M&A. I know you guys said that electrical and Aerospace are a focus. But there are a couple of deals in the industry, I guess, both OSI companies that went at very, very high multiples. How does Eaton think participating in these kind of deals? And how do you think about just M&A in the software and IoT space? Is that an option given where the multiples are?

No. I mean I appreciate your reference to the M&A. And one of the things that we've prided ourselves on over many, many years is the fact that we try to be a very disciplined acquirer. And recognizing for sure that software companies grow faster, they trade at higher multiples in the two deals that you referenced and understanding those businesses and seeing the multiples that they went for, we just think that there are much better ways of deploying capital and creating shareholder value than the kind of multiples that those two transactions went at. I mean they just went in extraordinary multiples, and we just think we have better, more attractive alternatives than that, that will deliver a better return for our shareholders. But we will say our capital allocation strategy continues to be focused on electrical, and we are, in fact, looking at a number of opportunities there. There's nothing, obviously, that is imminent, but we have, in fact, seen the deal pipeline pick up a bit. We continue to look at things in and around Aerospace. And once again, as I mentioned, valuations would have to come in line and be reflective of the current reality and uncertainty in that market before we would do anything. But we're obviously having some conversations and discussions in that space as well and we always have the option of buying back stock. I mean it's not the first choice. We would love to grow the company. But once again, if we're not able to deploy capital in a shareholder-friendly way towards an acquisition, we don't have to do a deal. We're very comfortable with our ability to invest in the company organically, grow the company organically. And acquisitions are a way of accelerating a strategy, of augmenting a strategy, but the prime path for us will continue to be the things that we're doing to focus on growing the company organically.

Just on data center, the order rates have been really strong. And I know this is a good secular market, but there tends to be these lulls from time to time. Anyanything you can speak to in the quoting activity that would point to continued strength or any kind of lull into '21?

Yes, we had a very strong quarter. Our global data center orders were up about 9%. Recently, we've seen a return of hyperscale, which can be inconsistent. Orders can fluctuate significantly and arrive in large quantities. However, we haven't observed any signs indicating that the market is slowing down. Given the current environment where remote working is prevalent, and with tools like Zoom, WebEx, and Teams being widely used, the demand for connectivity is increasing. This trend is further bolstered by the ongoing digitization and the arrival of 5G technology, which we believe will continue to drive momentum in the data center market. Therefore, we see this as a highly attractive market for the foreseeable future.

Okay. Can you give us an idea of how your truck business within Vehicle is performing, especially considering the joint venture structure, as the truck cycle seems to be changing?

Yes. One of our main objectives with the joint venture is to reduce the impact of significant cyclical fluctuations and external factors affecting our truck business in North America on the overall company. You can expect that during a downturn, the company's impact will be much smaller. Similarly, during a significant upswing, the effects will also be less pronounced. It's important to note that the joint venture currently focuses on North America Class 8 automated transmissions. We still retain ownership of the other global aspects, including the clutch and aftermarket businesses. We anticipate attractive growth in our Vehicle business as the market recovers into 2021 and through the fourth quarter.

Okay. Good. Thank you all. I think we reached the end of our call, and we do appreciate everybody's questions. As always, Chip and I will be available to address your follow-up questions. Thank you for joining us today and have a great day.