伊頓 (ETN) 2014 Q2 法說會逐字稿

Ladies and Gentlemen, thank you for standing by.

Welcome to the Eaton second quarter earnings call.

(Operator Instructions)

As a reminder, this call is being recorded.

I'd now like to turn the conference over to Don Bullock.

Please go ahead.

Good morning.

I'm Don Bullock, Eaton's Senior Vice President of Investor Relations.

Welcome to Eaton's second quarter 2014 earnings Conference Call.

Joining me this morning are Sandy Cutler, Chairman and CEO; and Rick Fearon, Vice Chairman and CFO.

As has been our historical practice, we'll begin today's call with comments from Sandy followed by a question and answer session.

Before we move to that I'd take a moment to draw your attention to the materials on page 2 of the presentation on our website regarding certain forward-looking statements.

Comments included on page 2 in the presentation outline a series of factors that could cause actual results to differ from what we present in these statements.

These factors are also noted in today's Press Release and the related Form 8-K.

In addition, our presentation today includes certain non-GAAP measures as defined by the SEC rules.

A reconciliation of all of those measures to the most directly comparable GAAP equivalent is provided in the Investor Relations section of our website at www.Eaton.com.

At this point I'll turn it over to Sandy.

Great.

Thanks, Don.

I'm going to work from the presentation, which was posted earlier this morning, and I'm going start on page number 3, which is entitled highlights of the second quarter results.

Obviously, a pretty busy quarter.

We released an 8-K a week ago detailing the interaction of the several special or unusual items that we had in the quarter, being the tax -- the gain on the sale of the aerospace business and our several legal settlements.

At that point, we indicated we expected that our operating earnings per share would be in the $1.10 to $1.12 range, and we're pleased this morning came right in the middle of that range at $1.11, about a cent above the original guidance we gave when we began this quarter.

Our sales were right on the button.

We said they would be up 5% compared to the first quarter and they were, and our margins were very much in line with our expectations, and you'll recall that when we gave you margin guidance for this quarter, that was before the $0.08 of restructuring that we took in the industrial sector, so I'll detail how that affects the full year margin guidelines for each of those segments as we go on this morning.

Strong industrial sector, strong electrical product margins offset the weakness in the electrical systems and service margins.

I'll talk a little bit more specifically about electrical systems and services but the breadth of the Company allowed us to come in very much in line, as I mentioned, with our own expectations.

Very strong bookings in electrical, overall.

In both of the two segments' report, obviously in aerospace as well.

We also raised our guidance in terms of where we think the Markets will be for the NAFTA heavy-duty truck business at 290,000, so pretty good market activity in that respect.

And then our integration of the Cooper acquisition, I'll talk a little bit more of that status.

Very much on track at this point.

If we move to chart number 4, just quickly a summary of the impact of really several unusual items in the second quarter.

You'll recall the acquisition integration charges show up on two lines on our P & L.

They obviously show up both in the segments where about $30 million of the overall $37 million expense was shown, and about $7 million at the corporate level, and you could see obviously the subject that we released the 8-K on last week: the Meritor litigation, the Triumph litigation, the associated legal costs, and then the benefit that came from the aerospace business divestitures.

In total after-tax impact of about $0.70, and that's how you get from the $0.41 operating earnings per share reported to the operating EPS excluding these unusual items.

We know with the interplay of all these elements it makes following a tax line particularly challenging in this quarter, so we tried to provide a break out for you for the tax rate as reported.

And obviously, very large negative income as a result of these litigation settlements that took place in the US, and obviously the high US rate.

You can see the tax rate excluding all of the unusual items of about 8%.

A little higher than we've been running, and reflective of the fact that our mix of business has been a little stronger in the US than it has been outside the US.

I think a good reflection on what's happening in the global economy, where generally the US is one of the stronger regions at this point and the weakness we've seen in our end Markets tends to be primarily in the Markets outside of the US.

If you move to page 5, once again, a quarter very much in line with our own expectations.

Sales and margins expected.

Slightly lower corporate expenses offset the slightly higher taxes.

As you can see, simply a $0.01 net of those two items and that lead to the $1.11.

If you move to page 6, this is the overall Financial Summary.

I think the one number I'd want to comment on here is that, if you remember, our first quarter shipment number was $5.492 billion, so when you look at the $5.767 billion that's exactly up 5%.

That's what we thought we would see in terms of growth second quarter from the first quarter.

Overall, again then if you look at the segment operating margin, that 14.6%, when you adjust for the $0.08 of restructuring that we told you would occur in this quarter would be 15.3%.

I'll come back and maybe amplify as we go through each of the individual segments, but overall core growth of 3%.

You'll recall we had core growth of just slightly over 4% in the first quarter, a little stronger year-to-year market activity in the first quarter really happened in terms of the hydraulics market and the vehicle markets, which were not as much of an increase year over year when you look at the second quarter versus the second quarter last year.

Let's move to chart number 7, which is titled Electrical Products segment.

Here again, about 6% growth from the first quarter, where we had revenues of $1.726 billion, up about 4% year over year.

I think again very good news here in bookings.

You'll hear this both in the electrical products and electrical systems and services, where we saw overall bookings up some 8% in the Americas, 8% in Asia-Pacific, and then obviously the area that we've talked about of less strength is pretty flattish conditions still in the European region.

Again we just call out here that what's going on in terms of the LED lighting change in our business, 41% of the overall sales now.

Quite strong obviously as we continue to introduce a lot of new product in that particular area.

And when you get within the three regions, I might comment just on a couple areas of end-market strength that may be helpful for you to understand.

I mentioned lighting is obviously quite strong, residential has continued to be strong for us, overall distributer demand which you're seeing here in this electrical products segment has been strong.

The weak area has been the power quality market and then the Electrical Products segment is where we report the single phase side of that marketplace.

Actual negative growth in that marketplace; continues to be quite weak.

In EMEA, the strength continues to be really a story of weak in the continent, strong in the Middle East and portions of Africa.

And Asia Pacific, recovering strength broadly in our components, which we're very pleased about.

Weakness in the single phase power quality continues to parallel what we're seeing here in the US.

And then we've seen Australia, with the economy continuing to be quite weak there.

If we move to page 8, which is electrical systems and services segment.

A couple highlight comments here is that first, sales up about 7% compared to the first quarter, when it was $1.524 billion.

If you look versus last year, pretty flat.

And that really reflects the slow bookings that we had.

You'll recall, we had a decline in bookings in the first quarter and a number of you asked questions at that time -- would that have a play into the next quarter?

Because generally, you have more of a backlog in this particular segment where you don't have a backlog in the product segment.

Margins obviously a 12.7%.

Pretty flat with the first quarter and down 200 basis points from last year.

A comment on that in just a minute.

If I could just comment on bookings first.

Bookings again up 7%, the strongest in some six quarters.

If you'll remember, the latter three quarters of last year were weak.

We actually had a negative quarter in the fourth quarter and a negative quarter in the first quarter.

We're very pleased with the substantial reversal here.

The strength, as I mentioned from a regional point of view, is pretty much as I mentioned for the products area.

And here we're seeing good strength.

Canada has strengthened, which you've probably heard from a number of competitors in this marketplace, but good activity across most of our products here with the exception of the large end of the power quality market.

So again, a common theme that power quality is weaker than we're seeing on the power distribution side of the business.

Again, weaker in Europe, stronger in Asia-Pacific and Americas.

We talked a little bit about the margin issue.

You'll recall that we had weaker margins in the first quarter, and we had about $13 million that we detailed for you in the first quarter that dealt with a lot of the weather related expediting costs we had in the business.

Different situation here in the second quarter, and we've really rolled it out into our full year guidance for the segment.

I'll talk more about that when we get back to a page a little further in the packet here, but we really saw higher logistics costs on some unfavorable mix, and this is a business where it is a mix of many, many different projects, and some more competitive pricing in the segment.

We believe the second half will be stronger than the first half.

You see that in our guidance.

We have some view into that as a result of the backlog that we now have on hand, and with obviously a very substantial booking quarter here, but we do believe that some of the logistics costs and the unfavorable mix are likely to be with us is how we're seeing the market materialize this year.

The particular location of where those challenges really are -- is it's in the large power distribution and power quality assemblies, where they are more competitive in terms of the pricing environment than they were a year ago.

Those unfortunately did offset the synergies that we did get in this segment.

So we're quite confident about the overall synergies we're getting both in the electrical products, the electrical systems and services, and at the corporate level; but we did have some negatives as we tried to detail here pretty clearly in terms of the impact upon margin.

If we move to the hydraulics segment.

This is Page 9. Up just 1% from the first quarter.

First quarter was $782 million of shipments, up 2% from last year.

The second quarter bookings being down by 2% I think has surprised some people, but you'll recall that we've seen a fairly substantial increase in bookings for the last three quarters, and it is leveling at this point.

And we really point to two key elements.

One I think is -- or both should not really be a surprise.

First is the global agriculture equipment market seems to have gone over top.

We're seeing most OEMs talking of being down in the 5% to10% range this year.

And then, the China construction equipment market continues to be very weak, as you've heard from a number of OEMs who commented on it over the last month or so.

We don't see that turning around here in the month of -- the year of 2014.

As a result, we've reduced the market forecast down for the full year from approximately 3% to 1%, and the real issue as you think about it is that the US is likely to be plus 2%, the rest of the world sort of a zero.

Really brought down by the large construction markets in China.

When we look within our own bookings, the distributer side of the business up on the order of 9%.

The OEM side of the business down on the order of some 15%, basically for the reasons I mentioned with the mobile market being hit by this construction and ag weakness.

You'll recall this was one of the three segments we said we were going to take some restructuring expense in during the second quarter.

You'll see in that first bullet point in the yellow section of the yellow box that it was about 160 basis points.

Without that, this margin is pretty much as it was a year ago: about 14.2%.

If we move to chart 10, which is the aerospace segment.

Up volumes some 5% from the first quarter, when it was $464 million; up 9% from a year ago.

As you can see, we still have some small impact in this segment from the two small aerospace business units we divested in the second quarter, but you can see the bookings up very strongly.

And we're really quite pleased with the 20% increase in after market orders on both, with good, strong activity on both the commercial and the military side of the business.

Once again, restructuring costs taken in this business during the second quarter reduced margins by about 40 basis points.

So again, margins pretty similar, 14.6%, without the restructuring expense.

Turning to page 11, the vehicle segment.

First quarter shipments were about $996 million, so shipments in the second quarter up about 4%, up 3% from last year.

Again, after some large restructuring costs in this segment that we had said we would take at the beginning of the first quarter, they accounted for about 230 basis point decrease in margins.

So, margins would have been 17.3%, so very healthy level in the segment without those.

As we watched the June NAFTA orders come in at almost 27 million units for heavy duty trucks, and now that whole second quarter at about 78,000 units, we've raised our guidance for this segment for the NAFTA heavy duty truck build to 290,000 units.

Coming out of this quarter at about 74,000 units built, it's a pretty flat forecast for the rest of the year, and so we think well within the sweet spot here.

The offset to that is the South American Markets continue to be very weak, and we think are down on the order overall of about 11%.

So, pretty weak activities down in South America.

If we turn to chart 12, really just one change in terms of our overall end market growth.

It's still 3% for the Company, the change within hydraulics was not enough to swing the total number, and again, that change in hydraulics is the global ag market and the construction equipment in China weaker than we had thought.

If we move to page 13, I'd like to spend a couple minutes on this chart because I think it's important in being sure that we're all on the same page in terms of our margin expectations.

You'll recall when we gave margin expectations by segment at the end of the first quarter, we noted that that margin guidance did not include the then expected $40 million of restructuring, and as it turned out in our actuals, you saw $39 million of restructuring actually took place in the third quarter in our hydraulics, aerospace, and vehicle businesses.

We are now taking those restructuring costs, which were already in our earnings guidance for the year, and simply reflecting them in individual segments.

You'll recall we did not do that at the time we shared the $40 million restructuring plan because we have not made announcements to our employees yet and until we did so we didn't want to reflect it in the segments.

As a result, if I can start with hydraulics, the hydraulics $13 million of restructuring was 0.4%.

That explains the difference between the 13.5% and the 13% revised guidance.

In aerospace, the $2 million of restructuring small enough it didn't really affect our 14% guidance that we had beforehand.

In vehicle, the $24 million of restructuring is 0.6%, and that's why we reduced from 16% to 15.5%.

So really, no change in our underlying guidance of margin for those three business segments.

Now let me go back up to electrical systems and services, where we decreased from 14.5% to 13.5%.

You'll recall in the first quarter we had about $13 million of weather related variances.

Second quarter, as I detailed earlier the mix, logistics, and pricing impact.

That's why we've taken a point out of the margins.

Obviously, with having been under 13% in the first two quarters of the year, for us to be feeling we're going to achieve 13.5% for the full year, we are anticipating the second half being stronger.

And as I mentioned, with larger backlog we have and the knowledge of what's in our backlog, we feel comfortable with those projections for the balance of the year, but we are taking the full year down by a point at this point.

So now when you get to the bottom, the Eaton consolidated number of 15.2% versus the 15.7% previously, the $39 million of restructuring expense is worth 0.2%.

The electrical system and services segments impact on the total Company is 0.3%.

That's the difference of the 0.5%.

Hopefully that clarifies for you somewhat of a complex set of numbers in terms of the margins, but really you can trace them to those two sets of actions.

Moving to page 14.

This is our full year guidance.

We did lower the top end of our guidance due to the changed margin outlook in electrical systems and services, and the fact that you'll recall when we gave our guidance for the year, it was based upon a range of market growth numbers of 2% to 4%.

At this point, having had half the year behind us and markets growing at a lower number in these first couple quarters, more on the order of 2%, we don't think a 4% is realistic anymore.

That's why we trimmed the top end, but we've held the bottom end of the range at $4.50.

All the numbers shown on this particular page do exclude the impact of the aerospace divestitures and the items related to the Meritor and Triumph litigation.

If we move to page 15.

This is the full year bridge, and really just two changes on this full year bridge.

What doesn't appear on this page that was there when we gave you guidance the last quarter was we had anticipated that ForEx would have about a $200 million negative impact on revenues this year.

We no longer think that's true as we've seen a number of the currencies move.

We're prepared to talk about that during questions.

So, that negative $0.04 has disappeared off this page.

That negative $0.04 offsets the negative $0.14 that you'll see as the second item listed under the several negatives here that is new on the page here, and that relates to the logistics, mix, and pricing and the electrical systems and services area.

So a net of $0.10, and that's the difference in our mid point, obviously, between the $4.70 that we had had as the mid point of our operating earnings per share and now the $4.60.

No changes on page 16, which are Cooper synergy projections.

We really just provided this for your reference.

If we move to page 17, this is our bridge from our second quarter actual to the third quarter guidance.

Again, starting with the $1.11 that we're reporting today, obviously we removed the industrial sector restructuring expenses of $0.08, that was the $39 million that we incurred during the second quarter.

We expect higher volume of about $150 million, or 3%, very much in line with what we generally see between a second and a third quarter.

We've had additional synergies we'll be realizing from all of the work we're doing in the Cooper synergies of about $10 million.

That's about $0.02.

And then, we've got higher corporate expenses of about $0.04, as generally you'll see the second half of our corporate expenses run higher than they do in the first half.

That's how we get to the $1.25 for our guidance -- mid point of the guidance for the third quarter.

Moving to page 18.

Obviously, when you look at our first half earnings, first and second quarter together, earnings of $2.12.

To reach obviously our full year guidance, that means that it's $2.48 of operating EPS in the second half, and we felt it would be worth chatting a little bit about this.

Let's start with the top line.

Higher volume of about $500 million at the incremental we've been talking about this year, 26%.

Our best estimates are that our markets grew at about 2% versus the first half.

Yes, we see some gathering strength in them, though.

We think they will grow closer to 4% in the second half.

That's how we get to our 3% market guidance.

If you think about -- when you try to think through where does the $500 million of volume come from?

Please remember this is first half versus second half, so one of the big steps in volumes was the $275 million step up between the first quarter and the second quarter.

As I mentioned to you in the previous chart when we detailed the third quarter guidance, we're talking about volumes moving up about $150 million in the third quarter compared to the second quarter, and then it's typical for us with our mix of businesses that volumes decline slightly in the fourth quarter from the third quarter.

That's the exact same pattern that obviously we're talking about that's embedded in our guidance.

We won't have the industrial restructuring expenses in the second half that we had in the first half, about $39 million, $0.08.

Additional Cooper synergies of $0.05, lower pension expenses of about $0.05, lower taxes of about $0.04, and higher corporate expenses as I mentioned before where the second half normally runs higher than the first half, about negative $0.12, and that's how you get to the difference between the first half and the second half.

If we turn to page 19, this is simply the summary we give you.

Kind of key elements supporting our guidance.

Just a few items that have changed here.

If you scroll down to -- I guess it's the sixth item, the tax rate, we've increased that to 6% from 5%, and again, remember all these numbers here exclude the impact of the aerospace divestitures and the items related to Meritor and Triumph.

The real reason for the slightly higher tax rate is that our earnings are higher in some of the higher tax jurisdictions, i.e.

the US for example, and again that goes back to our view of how the economic outlook is laying out this year, with the US being one of the stronger regions and many of the areas outside of the US actually being a little weaker.

Obviously, our operating EPS full year, we lowered that by $0.10 at the mid point by dropping the top end from $4.90 to $4.70.

We kept the $4.50 the same at the low end.

Then you'll notice in the operating cash flow and in the free cash flow, in each case we've lowered them by about $200 million, really reflecting the lower profitability that comes out of our guidance, and also a little higher working capital that we anticipated when we started the year.

No change to CapEx.

So if we turn to page 20, summary.

Second quarter results very much in line with our guidance on revenue and margins.

Either the guidance we gave at the beginning of the quarter or the update we gave through the 8-K of roughly a week ago.

Excluding the unusual items and the restructuring costs in the industrial sector, EPS was up about 9% versus last year.

The Cooper integration remains very much on track.

We're very much in the midst of many of the plant moves that we've discussed with you at this point.

We will deliver the $95 million of incremental benefits compared to 2013 here in the year of 2014, and then another $150 million to 2015.

The industrial sector restructuring is in place and it will yield, as we had told you at the end of the last quarter, about $35 million of benefits next year.

So between the two, about $185 million of benefits next year compared to this year.

And then our best look at pension costs, which we often try to share with you as we get to the middle of a year, is that with the discount rates that we used the last time that we calculated this based upon our fuller funding of these plans and the markets having done a little bit better, it would be on the order of about $35 million less than this year.

Now that I'd like to add one other final note is that -- and it's not in this packet -- but there's been a lot of speculation about whether it would make sense for Eaton to spinoff any of our businesses in light of the transformation that we've been undergoing over the past 14 years, and as I've commented in many different forums, that each of our businesses remain really key contributors to our results and we continue to see real benefits from being able to apply our multiple power management technologies to meet our customer needs in these different verticals.

But, we also wanted to clarify that we are not able to do a tax free spin of any business for five years post the acquisition date of the Cooper transaction, and that limitation means that any spin would result in a very significant tax liability.

And so for the two reasons we think of our power management strategy and obviously this five year kind of prohibition at any form of economic benefit means that there is not really a compelling economic rationale for further portfolio transformation.

So we hope that provides some clarification to a number of questions that a number of investors have either asked or written about over the last month.

So with that, I wanted to really take the time to get through a couple of those specifics around the margins because I know they caused some confusion after our release, but with that, Don, why don't we go ahead and open things up for questions?

(Operator Instructions)

Our first question comes from Steven Winoker with Sanford Bernstein.

Thanks and good morning.

Just first question on ES&S margin decline of about 200 basis points.

You called out logistics, mix, and pricing pressure.

You mentioned power distribution, power quality.

Was there any impact in [crowd] times or power systems from Cooper?

As I said, Steve, and appreciate the question.

First, good morning.

No, it was very much in the area as I mentioned that we see it in the large power distribution assemblies and the power quality business, and that's specifically where we've seen the competitive activity and the logistic issue lays across a number of the businesses, but again, is primarily in those very big assemblies.

Okay, and within that, you'd called out back in -- I recall the February investor presentation road map to about 16% in 2015, and it looked to me like I think 2/3 of that was from synergies, and I'm just talking about this segment, electrical systems and services, and the rest between market and outgrowth.

I assume this changes your outlook on that basis, now?

Or are you making it up someplace else, or how are you thinking about that?

I think you'll recall, we also had increased our margins in Electrical Products and as you see we're pretty consistently hitting that bell both from the revenue and bookings point of view, as well as getting the higher margins.

I think it's a little early to put a number on 2015.

We would really like to get a better sense for how bookings progress here in the third quarter.

Obviously the second quarter was much improved in terms of the magnitude of the bookings, as well as we think the quality of the bookings, so a little early.

I appreciate your question, but I think we'll be in a better position to be able to answer that as we come out of the third quarter.

Okay and just finally on the guidance first half to second half.

I looked backwards and it looked to me like normal seasonal growth first half to second half, was more like a 15% ramp and then you'd called out incremental synergies being weighted towards the back half of that $95 million, and I'm not sure the $0.05 reflects that.

Could you maybe talk through that a little bit more?

There's obviously a lot of -- as you get underneath that $500 million of the higher volume in the second half versus the first half, a couple issues relative to markets.

As I mentioned, we saw the vehicle markets and the hydraulic markets on a year over year basis were far stronger in the first quarter than they were in the second quarter.

I mentioned when we were talking about the vehicle businesses that we think the NAFTA heavy duty business will be relatively flat from this point forward, in that you've had -- we're up at the 74,000 unit production level, which is basically what you need to finish these next two quarters, so won't get as much of an impact there.

So by deduction, and hydraulics you'll recall is generally weaker in the second half than it is in the first half each month, so what really propels this is aerospace and electrical.

And, you saw the very strong bookings in both those segments, 9% in aerospace and the 6% to 7% in each of the two segments in electrical, and so that's where we really are looking for the higher sales levels.

And on the incremental synergy of that $95 million now, first half versus second half?

Yes, and that's the additional Cooper synergies there.

You see, of the about $25 million of additional benefits, that's higher in the second half than it is in the first half.

Okay, thanks.

Our next question comes from Joe Ritchie with Goldman Sachs.

Hi, good morning everyone.

Good morning.

Just saying with the ESS margins for a second, can you clarify a little bit more, Sandy, what you mean by higher logistical costs?

Because it seems like a lot of the unexpected variance was in the legacy Eaton business?

I'm just trying to get a better handle of that.

That's primarily freight costs.

It's been a surprise to us how quickly freight costs moved during the second quarter, and part of this has to do with the size of the equipment that we're shipping.

And it's moved up quite significantly during this time period.

Okay is that something that is expected to continue, just given that you've had now stronger bookings in ESS moving forward?

I would imagine that this isn't something that subsides in the near term.

That's part of the reason why we've moved our guidance.

You're right, that's part of the reasons why we have moved our guidance down for the balance of the year.

Okay, and then I guess one other question on ESS.

You mentioned pricing pressure, and clearly, the bookings number was a positive this quarter, plus 7%.

Talk us through maybe the pricing or competitive dynamics that you saw in the bookings that you put into your backlog this quarter?

Well as I mentioned earlier, we're comfortable at the improvement that we're forecasting.

The second half, really, is driven by what we've been able to successfully book here during the second quarter.

I think if you look back over the last six some quarters in this segment, you saw bookings levels that, when they were positive were in this kind of 1% to 2% range, and then you'll recall they went negative in the fourth quarter -- in the first quarter.

Those tend to have in this kind of a business, which is a backlog based business, tend to be sort of a pre-cursor of what's going to happen in the next quarter, so we're pleased obviously that we had a very strong quarter in all, but what I would say is the large power quality [tightens] because that side of the market continues to be weak, but the power distribution side really in each of the end markets continues to be quite strong.

We're seeing good indications of continued strength in non-residential and oil and gas in particular, so that we're encouraged by what we saw here in the second quarter.

Now, obviously we've got to ship it, and we're pretty comfortable we know how to do that, but we don't think these logistic costs are likely to go away.

It's interesting to me, you think about the margin for the business for the back half of the year.

You're basically implying something north of 14% for ESS, which you were comfortably there last year, and so I guess one last question on ESS.

Can you kind of talk through maybe the puts and takes to the specific margin guidance?

Like, where could you disappoint or potentially be more positive or constructive on in the back half?

I think the guidance that we've provided, I don't know how I can add a whole lot more character to it -- I think that one thing we've always tried to stress for people's understanding is the electrical systems and service business tends to have a higher beta to it, both when the market is expanding or contracting, because it tends to be a lot of large projects that tend to go into expansion if you will.

Equally true in terms of what happens with the mix of projects.

It can change from quarter to quarter, and we've obviously did not have a good quarter in that regard here in the second quarter.

With the knowledge of what we've got in our backlog at this point, our best view is that we're going to see the improvements that you referenced in terms of the second half being a stronger half than the first half, but it's still not to the level that we had anticipated originally this year, and that's why we reduced the guidance for the second half.

Thanks.

I'll get back in queue.

Our next question comes from Scott Davis with Barclays.

Good morning guys.

Good morning, Scott.

Can you give us, Sandy, just a little bit more color on aerospace margins and it's 80 bips down year over year?

And you said that half of that was from structuring.

I would have thought in an up 9% sales environment, you would have been able to get some operating leverage.

Is that just more of a mix issue?

Yes, again it's a whole series of different projects in there, but I would say this is very much in line with our guidance.

I wouldn't be as concerned myself about this thing moving a couple tenths of a point one direction or another.

The real issue that we're particularly pleased with is the after market business is starting to rebound.

You may recall that over the last two years we've talked about that one of the challenges is with the commercial OEM production increasing as quickly as it is, after market hasn't been able to keep up with that.

And, we're now starting to see pieces of that fill in and we think some of the initiatives that our team has under way to help enlarge our after market business are really starting to show up.

So we're not yet seeing a 20% increase in what we're shipping in terms of after market, because this stuff has some lead time in it as well, but we're starting to get to a point where it's a more representative percentage of the total business.

Okay, fair enough.

And then, question on ESS and your comment on pricing pressures, and I guess I'm a little surprised that incrementally power quality particularly in Europe has been weak now for a couple years, a few years.

Why is it incrementally getting worse on price?

Is it just a function of excess capacity, or is there someone in there as an irrational trying to gain share or new entrants?

Anything that's changed?

I don't think the single phase piece that we've talked about, which really is over in the product side, I think those conditions have been fairly similar with the weak server sales around the world.

This tends to parallel or be a pretty good surrogate for the demand that we see then on the accompanying [UPS] and that continues to be much the same issue.

I think here on the larger products, which tend to be the three phase products which tend to appear for us more in this systems and services segment, you've got a couple things going on.

One, we talked when we were at EPG this year about the fact that there's a change in the topology of the power solution in the large data centers.

Now, remember that's not the biggest part of this market, but there you're ending up with a little less power quality equipment, and a little bit more power distribution equipment in an average large data center.

I think that that's going on.

It's not as much of a technology change inside the UPS itself as it is a change in terms of how people are utilizing them.

So I'd say that change is going on, but I would say we still have not seen the large enterprise system data centers accelerate to the extent we've seen the kind of mobile or -- let me call them hyper scale mobile data centers really come on, and so the enterprise have typically been the people like the big financials and large industrials, and they're not spending as they were a couple years ago.

Okay, fair, and then just clarification, Sandy.

You commented about the tax status if you were to do a spin, obviously it's off the table, but is there anything that would impact you selling a business?

No, not versus any other normal sale that you'd make in terms of looking at price and looking at after-tax proceeds.

Okay, fair enough.

Great, and thank you.

Appreciate it.

Our next question comes from John Inch with Deutsche Bank.

Thank you.

Good morning, everyone.

Good morning, John.

So, I realize there's a lot of moving parts, but in a nutshell, so the $500 million plus second half volume, Sandy, if you compare the second half of 2013 versus the first half it was up $222 million, what is bridging the gap?

Is it truck?

Is it something else?

Because you're taking your market forecast down, so I'm just -- In a very high level, what's accounting for the sort of $270 million-ish of delta incremental second half volume this year versus last year?

Well, you're continuing to have growth in the electrical markets.

The markets overall will continue to grow, and obviously, as we look at a 3% number and we're saying overall the first half grew at roughly 2% and second half is going to grow at 4%, you're going to have about 4% growth overall.

We think, again, we're seeing aerospace market continue to grow fairly consistently.

We're seeing hydraulics slow in terms of that growth this year, and better vehicle year-over-year growth, and that's different than we saw in the second quarter, where it was a little stalled, and the rest of it's the electrical business.

Would you characterize your guidance as -- I'm just trying to put this into a context, because obviously we don't want to get to the third quarter and have to cut the forecast again.

Is it an extrapolation of the run rate that you see, or are you leaving yourself any kind of cushion with respect to kind of the 3% and then the 4.5% outgrowth?

Yes, the 3% is our best estimate of these markets, and of course we can be wrong on that, but it's our best estimate at this point.

So we're not trying to build a cushion, John, or be overly aggressive.

It's our best estimate at this point.

Can I ask you about hydraulics?

We had three quarters in a row of high single digit or low double digit bookings, and what exactly -- why did that not manifest itself into some better top line?

Was there any sort of cancellations of orders?

I realize you've got a lot of exposure to say North American ag.

Is there any more color you can give us?

We all know what the China headlines are.

Is there anything else going on that might account for that discrepancy?

Our bookings numbers are net of cancellations, so we don't simply gross book and not report cancellations.

So, we've seen if you go back really you'll recall that a year ago, it was a fairly weak booking number in the same quarter.

Since then, we've seen three quarters that were really quite strong, and then we've seen the second quarter that obviously came down.

I think what we've seen is the industrial activity has been okay, not great, and the biggest increase was occurring in the mobile side of the marketplace.

So, whether these were the ag manufactures who have clearly backed off at this point, and construction equipment is okay in the US, it's not great outside the US, and it's pretty awful in China, and I'd say that's where the difference has been.

China's actually gone down further.

And, John, on the last call we pointed out that often the OEs, when they start ordering, they will place long dated orders, and so that means that you'll have a surge of orders, but they extend out over a long period of time, and that's why we had some of the gains we had in the prior quarters.

But as Sandy mentioned, actually OE orders were down in this second quarter.

Rick, are you suggesting the three quarters of the strength -- that actually can still manifest itself even though it's in future quarters even though the markets are under pressure you just described?

Some of those orders do extend out.

They are subject to cancellation, but some do extend out into the future.

But John, we've mentioned in numerous forms, that often what you'll see large OEMs do is reserve capacity through orders, and they can adjust those but if they come out of a period of weakness, they're trying to ensure they are going to have forward capacity.

What would you say to this question that's out there that with Cooper on the ESS side, you have -- perhaps there has been pressure on you with respect to market share, and so you've actually had to take price action specifically to Eaton versus the market to try and preserve some market share.

Is there aspects of some of that in perhaps some of the mix within the ESS business?

I don't feel so.

I think if you look across the two businesses, the channel based business where you intend to have more of a mix of product, where you'd be presenting a mix of product into a channel, I think you're seeing very solid performance, and I'd say it would have been more likely if your premise was right you would have seen that in the products area.

The other segment tends to be one where you're bidding individual jobs; they are individual transactions, and they don't always have all the products as your premise was, so I would say no.

I think you'd see the reciprocal of this performance if that was true.

Okay, thank you.

Our next question comes from Ann Duignan with JPMorgan.

Hi, this is Mike Toman on for Ann.

I just had two quick questions.

Can you talk about the margins again in electrical systems and services, and I guess if I were to parse the 200 basis point year-on-year decline, how much would you put in each of the three buckets you identified?

They are about equal.

There's not an overload in any one of the three.

Okay, and then following up on that, in aerospace, you mentioned 20% growth in bookings for the after market?

Any idea or color around how much of that might be provisioning related?

Hard for us to know exactly because after market for us really includes spares, repairs, and overhauls.

And so, what we are beginning to see is, we are beginning to see some of the new planes that came into service three years ago start to really get into the after market business, but you're still seeing the commercial -- you're seeing these releases from the large commercial OEMs increase in double digit numbers, and so that continues to put pressure on trying to get after market to catch up with that number.

What we're particularly pleased about in this quarter is the strength was both on the commercial side and the military side, and so pretty broad based strength in that regard.

Okay, thank you.

Next question comes from Andy Casey with Wells Fargo.

Good morning, everybody.

Another question on the margin guidance, I'm trying to build up to the 26% incremental margin embedded in the full year guidance.

After, if I'm doing the math right, what appears to be a first half 19% ex-restructuring in Q2 and you've somewhat addressed the Aero side and ES&S, but also within that it looks like you have a fairly sizeable ramp in Electrical Products.

Is it fair to look at the implied second half Electrical Products incremental margin to be something north of 30%?

I'd have to do the same calculation you're doing, but it's again, remember our guidance for the segment is higher than what we've achieved for the first two quarters.

So I want to be sure we're doing the math the same way, but we are assuming that we continue to have even higher margins in the second half than we had in the first half, and we feel pretty confident of that.

Is that just underlying demand, Sandy, or are there more synergies flowing into the second half than there were in the first half?

There are more synergies in the second half.

As I mentioned, if you go back to the chart, let me reference.

But that's broken out separately, Andy.

So, you have the normal seasonality that you have in the second half of the year, and obviously a big step up from Q1 to Q2 and then you step up again about $150 million into Q3 in revenue, and then just a slight decline in Q4, and what we're saying is we believe that that 26% incremental is appropriate for that revenue increase, second half over first half.

And, we've broken the synergies out as a separate line item.

And then just a higher level -- and thanks for that Rick and Sandy.

A higher level question, if you step back and look at your demand trends just within North America, and we're seeing kind of mixed performance, but in general things continue to get better, but it's a little odd.

You have truck acting well, construction okay but not great, and then what appears to be underlying progressive improvement for the electrical businesses.

What are you seeing out there?

Is it just continued hesitancy for the large projects to get under way, and if so, what's causing that?

I think you describe it right.

It's okay.

It's not super.

I guess you look at the flash PMIs at 56%, orders at almost 60%, manufacturing industrial production was up pretty solidly, high single digits here in the US, here the second quarter.

We are seeing more signals we think around non-residential, that it looks like it's picking up some more -- the residential has drifted a little bit more and you've all seen those numbers.

We don't see utilities moving substantially at this point.

The construction equipment is a little better, but mining is not great.

I think on the ag side, it's weak and if you think about the vehicle markets, class 8 is strong, light vehicle continues to be pretty strong, almost a [$17 million SAAR] in June and then weak government spending.

So you do end up with a little bit of a Ying and a Yang, and that's why we say we think overall you end up with sub par economic growth in the US, but it's better than the rest of the neighborhood.

So when you're looking at Europe still struggling to get its full momentum, South America pretty rugged, China still an attractive overall number, but very inconsistent by market vertical within China, so I would agree Andy, with your general view on it, and that's why we say we still think the 3% is the right number.

We don't think 4% -- I'm talking overall Eaton Markets, we don't think 4% is possible with the start that the year started with.

Okay, thank you very much.

Our next question comes from Julian Mitchell with Credit Suisse.

Hi, thanks.

Just on hydraulics, the bookings numbers have been bouncing around a lot, so I just wanted to check.

The sort of operating earnings ex-restructuring were about the same year-on-year in Q2.

When you're looking at the second half, you basically assume a similar EBIT progression to what you had last year in hydraulics?

Yes, generally, Julian just in our hydraulics business with its more heavy mobile loading, generally the first half is a little stronger.

The third quarter tends to be the weaker quarter for hydraulics when you look through the year, and we don't think that's likely to be substantially different this year.

But will your hydraulics earnings be up or down year-on-year in the second half in your guidance?

Boy, I'd have to go back and do all the full year to year comparisons.

We've really been looking more in terms offer our first half versus our second half.

It should follow the normal seasonality that you saw last year though, Julian.

We don't see any reason for it to be different than that.

Got it.

And then in Electrical Products, as you called out a couple of times, you're looking at a steeper sort of margin jump year-on-year in the second half than what you had in the first half.

Is that solely related to the sequencing of Cooper synergies, or is there something in the underlying business that's also driving that?

Well, you're seeing pretty strong growth.

Again remember second quarter up 6% from the first quarter, up 4% from last year.

You've seen six very attractive quarters in a row of growth above what most people consider the markets to be, so I think you are getting some leverage in the business there in addition to the fact that then we get the synergies to drop in as well.

So I think we've got both of those working for us quite well there.

Thanks, and then just lastly, I hate to come back to this but electrical systems and service.

Is there, at some point, a view on kind of the market segments that it targets or something more strategic?

I guess, you've had it for about a year and a half now.

You moved costs into it back in Q1 out of products, so I guess is there anything changing strategically in how you're viewing what's happening there, or is it just sort of a bunch of bad one off items in the first half, and those should normalize?

I wouldn't say that it's a change in market segments because again we serve with our market share as we serve the very broad array of what's out there.

Clearly, we've made some very substantial progress in oil and gas but it's not that there's a different economics, if you will, to that set of end markets.

I'd say this is more an issue of logistics, this particular mix, and as we said some pricing that really comes that we think from this weaker period of demand, and that's why we're encouraged with what we seen with our bookings here in the second quarter.

I don't want to overplay that, but it's the best set of bookings we've seen in six quarters, and I think that's significant in itself.

Great, thank you.

Our next question comes from Jeff Sprague with vertical research.

Thank you, good morning, gentlemen.

Good morning, Jeff.

Sandy, I was wondering if you could come back to your comments on the spin and maybe just a little color on -- or the difficulty in doing one so to speak -- the color on kind of the controlling regulation or wall that brings you to that conclusion.

And then, I'm also just wondering -- there's obviously been some fresh speculation from myself and others, but these questions have been out there before.

I'm just wondering why we're kind of learning of a five year limitation now.

Does this reflect the fact that you yourselves have dug in and looked at it much more closely and have found the roadblock, or is there some other explanation?

Jeff, let me comment.

Because of the legal steps we had to do to complete the transaction for Cooper, there are a couple of code sections that make it not possible to do a tax free spin for five years, and it's a conclusion our team came to.

It is not a simple analysis, but they came to it and then several outside advisors corroborated that, so we're very certain that that analysis is accurate.

And, Jeff, it's not new knowledge.

We've been well aware of this all along and have tried to indicate that we had no intent to do any such action.

We're just trying to help make it clear for people that it's not simply an issue of will.

It's also an issue of some very technical issues at this point.

And if you were to proceed with a spin or a similar transaction, the spin would just be treated as an asset sale?

You could still spin something but it would be treated as a sale for tax purposes?

It actually would be taxed higher than just an asset sale for some complex reasons.

Okay.

So that has been difficult to make work economically.

Okay, and then just shifting gears back on price.

One of your competitors noted there was some price pressure in lighting and some of the low voltage areas of their portfolio.

Are you seeing that anywhere in lighting specifically, or in any of the other kind of industrial low voltage businesses?

No, and again, our lighting businesses is in our electrical products segment in terms of just thinking where it appears for us, and you can see our margins continue to be quite strong there.

I think as the LED conversion goes on, clearly there -- and we've talked to this on a couple of occasions, there is a payback competition if you will between LED and the traditional lighting sources that we're very comfortable with where we're positioned with our technology leadership there.

Just finally from me just to comment on pension, I get it's an early read, but the bottom market could be in all kinds of gyrations between now and year-end with paper and everything else.

Does your comment reflect something idiosyncratic at Eaton in pension, or is it just a general view on where you think rates and other kind of items might be?

We were simply trying to give some general indication of what would likely happen to our pension expense next year, and the easiest way to do that was simply to say if the discount rate stayed about the same, just based on our asset performance and based on some particular things that happened in 2014, we believe that you would see a reduction in expense of about $35 million next year.

That can change and will change, but it gives you a rough indication of what might happen.

Okay, thank you guys.

Next question comes from Christopher Glynn with Oppenheimer.

Thanks good morning.

Just had a question in the wake of the two legal settlements, if you could comment on if you see any potential for customer backlash and marketplace pushback?

I really can't comment.

We don't expect any at this point, but no further comment.

Okay, and then on the tax rate we have 6% for the year.

There are a number of adjustments obviously, so it would be helpful if you could just address the 3Q and the two -- second half specifically, what we're looking at for tax rate?

We're expecting that the tax rate in the third quarter will be much like the second quarter and it will drop, we believe based on our visibility right now, a bit in the fourth quarter.

Okay, that's all I have, thanks.

Our next question comes from Nigel Coe with Morgan Stanley.

Yes thanks, just a couple of clarifications.

I hate to dive back into ESS margins, but Sandy, can you put a finer point on what's causing the second half improvement versus the first half and you've mentioned price mix and freight, and obviously then we have the higher volumes coming through in the orders.

Is it an expectation of volume leverage on the order pick up, or is it -- are we seeing improvement in price mix?

And it could just be as fine with those -- if you can just give us quite a bit of detail on the price mix delta between second quarter and second half?

I'd say that it's both the items you mentioned.

One is obviously having the far stronger quarter of bookings.

We start the quarter with a full backlog and secondly, we've got I'd say an improved look in that backlog versus what we had as we came through the last quarter.

So, I'd say both those items are what are influencing our thinking relative to the second half being stronger than the first half.

And what's caused the improvement in price mix in the last three months?

It's better pricing.

And I don't mean to be flip about it but it happens to be the mix of projects, and there are hundreds and hundreds of individual projects that are represented in any one month so it's very hard to be -- it's this project or it's that project, but it's the collective mass of what we've seen in terms of projects in the marketplace and what we've landed.

Okay, great.

And then Rick, just coming back to the pension, $35 million, does that bake in the new mortality schedules?

Yes, it does.

Again, this is still half a year away but it does bake that in.

Okay, thank you very much.

We're going to have time this morning for one additional question.

Because of the number of other calls going on simultaneously, we want to be respectful of that.

So, we have time for one more question this morning, and that comes from Jeff Hammond with KeyBanc.

Hi guys.

Most of my questions have been answered.

Can you just talk about what's driving the better Free Cash Flow guidance?

Better?

You mean the slightly lower Free Cash Flow, you mean?

And we reduced both operating cash flow, and Free Cash Flow by $200 million and it's two factors.

It's our working capital performance has not improved to the extent that we had thought it might, and then secondly, the reduction in the mid point of our earnings guidance.

That's what's behind the $200 million change.

And the working capital, is that related to the Cooper deal that you're hoping to get improvement there?

No, it's much more broadly just in terms of where we've really seen receivables and inventory so far this year, so it's really a tuning up based upon where we are at half year.

Okay, thanks.

Want to thank you all for joining us today.

We, as always, will be available for follow-up questions both this afternoon and remainder of the week.

Thank you very much.

That does conclude our conference for today.

Thank you for your participation.

You now disconnect.