伊頓 (ETN) 2016 Q2 法說會逐字稿

Welcome to the Eaton second-quarter 2016 earnings call.

(Operator Instructions)

As a reminder, this conference is being recorded.

I'd now like to turn the conference over to our host, Senior Vice President of Investor Relations, Mr. Don Bullock.

Please go ahead, sir.

Good morning.

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

I thank all of you for joining us for Eaton's second-quarter 2016 earnings call.

With me today are Craig Arnold, our Chairman and CEO, and Rick Fearon, our Vice Chairman and Chief Financial Officer.

The agenda today, as normally includes, opening remarks by Craig, highlighting the Company's performance in the second quarter and our outlook for the remainder of 2016.

As we've done on our past calls, we'll be taking questions at the end of Craig's comments.

A couple of quick housekeeping items.

The press release today from our earnings announcement this morning and the presentation we'll go through have been posted on our website at www.eaton.com.

Please note that both the press release and the presentation do include reconciliations to non-GAAP measures, and a webcast of the call is accessible on our website and will be available for replay.

Before we get started, I want to remind you that our comments today do include statements that are related to expected future results, and as a result, are forward-looking statements.

Our actual results that may differ from this for a wide range of uncertainties and risks that are described in our earnings release and in the 8-K.

With that, I'm going to turn this over to Craig Arnold.

Okay, hey, thanks Don.

I'm sure you've all had an opportunity to work through the material and so I'll hit a few of the highlights and add a bit of color to the results.

Operating earnings per share, we're really pleased with the results in the quarter at about $1.07, $0.02 ahead of our guidance.

We, as we anticipated sales in the quarter came in at $5.1 billion, down 5% organically, down 5%, organic revenue, down some 4%.

And this is really consistent with the normal patterns that we see, Q2 sales at 5%, above Q1 and quite frankly, FX was a little better, 1% better than it was in Q1 as well.

Segment operating profits came in at 15.4% versus our guidance of between 15% and 16%, and I'd say particularly strong margins in Electrical Products as well as in Aerospace, both of which came in at 18.6% when you exclude some of the restructuring charges and offsetting a bit of weakness in Electrical Systems & Services.

Restructuring costs in the quarter came in right as expected at $35 million and reducing our margin by some 60 basis points.

Adjusting for restructuring costs and FX, really strong decremental performance by the Company overall in each of our businesses.

And we're really pleased with the fact that we had record cash flow in Q2, with cash conversion of 124% of net income, so really strong cash performance in the quarter.

We also repurchased some $225 million of our stock back, some 3.7 million shares in the quarter.

Turning to the financial summary, we continue to see weakness in the number of our end-markets versus 2015, but sequentially, revenues were up some, as I mentioned, 6% from Q1.

Organic revenue declines and FX headwinds are decelerating.

Organic revenue is down from 6% in Q1, but only 4% in Q2, and as I mentioned, FX also mitigating a little bit, down 1% in Q2 versus 2% in Q1.

Margins excluding restructuring costs, were some 16%.

That's up 90 basis points from Q1 and an improvement over Q2 of 2015 by some 10 basis points.

And this is despite some 4% weaker organic revenues, so a real indication that our getting and we're holding on to the restructuring benefits that we're engaging in across the Company.

Turning our attention to Electrical Product segment, a really strong quarter of execution in this business.

We're pleased with the Q2 results, and we think strong overall performance that we continue to see in this business.

Modest year-on-year organic growth, up some 1% offset by FX, but an acceleration sequentially, with revenues up some 10% from Q1.

We continue to see strong execution in the business, as evidenced by the significant margin improvement, excluding restructuring.

Our operating margins are up some 270 basis points and 150 basis points better than Q1.

Bookings were down 2% in the quarter on weakness in the Americas industrial markets and really, broad-based weakness in the Asia-Pacific region.

We did continue to see strength in US Residential housing and the Lighting markets, and in Europe, generally.

Looking at Electrical Systems & Services, revenues in the quarter were up some 6% from Q1, but 5% worse than Q2 2015.

Margins were weaker in Q2 2015, on less favorable mix of projects, and also on the impact of a litigation charge that we actually took in this particular business that reduced margins by some 70 basis points.

So note margins, excluding restructuring costs, were, in fact, flat with Q1.

While somewhat offset by lower commodity prices, the pricing environment in this business does continue to be somewhat difficult, and as we've characterized kind of the net between the two, we'd say slightly negative on a net commodity cost basis, but certainly, manageable and well within our guidance.

Bookings are down some 2%, and we're seeing continued weakness here in large industrial projects, weakness in Canada, and oil & gas markets partially offset by strength in three-phase UPS, principally in data centers, light-commercial orders continue to be strong as well as the service business.

In looking at Hydraulics, Hydraulic markets, I'd say they appear to be stabilizing, but more importantly, I think our team is executing well here.

Organic revenues are up some 7% from Q1, but down 7% from last year.

10% margins in the quarter, but I think importantly, 13% when you exclude restructuring costs, and we think real proof point that the restructuring work that's being undertaken in the business, delivering the margin improvements is really coming through.

So ex restructuring costs, profits were essentially flat on 7% lower organic revenue growth, and so we think really strong performance.

Bookings declined some 2% in the quarter, and it's really the best quarter that we've seen in bookings in the last two years, and particular strength in EMEA and positive bookings in Asia, with some modest weakness continuing in the Americas.

In the quarter, OEM orders were down 4%, distribution orders were down 1%, and really, the area of greatest weakness in the business continues to be on the stationary side of the business, where we had orders were down, in some cases, up to 33%.

We did see strength in the quarter in Ag, up 23%.

Not sure how much of a read-through that is on the total year as we continue to see some concerns there and construction orders in the quarter were up some 8%.

In Aerospace, we think a strong operating result in the quarter, organic revenues were flat with Q2 2015, principally on lower military OEM sales, offset by strength in both large commercial transport and in aftermarket.

Margins were, once again, very strong at 18.6%, up from 160 basis points over Q2 2015.

Bookings were down 1% in the quarter and this a particular weakness in the Biz Jet segment, which is a little bit of some surprise weakness for us.

But when you adjust for weakness in Biz Jet, bookings were up mid single digits and aftermarket orders continued to be strong up some 7%.

We also continue to see strength in commercial transport segment, where we saw orders up some 10% in the quarter.

In looking at Vehicles, organic revenues were down 14% versus Q2 2015, driven primarily by the 29% decline in Class 8 market and continued double-digit market declines that we're seeing in the Brazilian market.

Outside of Brazil, passenger car markets continue to hold up at very high levels, and we expect market to North America to be flat, with modest growth in EMEA and in Asia.

Margins, when you exclude restructuring costs, we're down some 230 basis points versus 2015, but up 70 basis points versus Q1.

But we think with or without restructuring costs, we think strong operating performance in this business, and where you're really dealing with some pretty significant headwinds in terms of the Class 8 market and what's happening in Brazil in general.

If we turn to the organic growth outlook for the year, maybe I'll spend a few extra minutes on this line, just to give you some color on the way we see the year unfolding.

In general, we think markets on balance are performing as we expected, but we do expect the markets to remain sluggish throughout the balance of the year.

In looking at Electrical Products, we'd say here, a really mixed story in terms of what's going on in our end-markets.

We see growth in Residential and Lighting in the US, growth in Europe, but we continue to see declines in industrial markets in the US, Canada, and in Asia.

More specifically, we're seeing growth in US residential markets.

We've seen growth in the 5% to 7% range.

We're seeing growth in the US Lighting market, which we'd say is mid single digit, and we see growth in Europe, and we think Europe/EMEA grows some 2% to 3%.

This is offset by weakness in US industrial markets, which we think will be down mid single digits; weakness in Canada, which we think is down low single digits; and continued weakness in the Asia-Pacific region, which we think is also down low single-digit range.

In Electrical Systems & Services, we continue to see declines in large industrial projects in oil & gas, but some growth in three phase and power quality in the US markets and in Europe, with modest growth in power systems.

More specifically, we see the US and EMEA three-phase power quality up low single digit.

We see some real weakness in Harsh and Hazardous; we think down some 15% for the year.

We think industrial projects continue to be down and light commercial, continue to be a source of strength in the business and, once again, Asia Pac, we think will be down low- to mid-single digits for the year.

Turning our attention to Hydraulic, and certainly, we had a, relatively speaking, stronger quarter in Hydraulics, and we think, in many ways, this is really a function of easier comps, as we move forward during the course of 2016.

We continue to see weakness in mobile, particularly in Ag equipment.

We see certainly continued weakness in oil & gas, equipment markets, double-digit declines in China construction.

So our call on the Hydraulics market really has not changed materially from the way we originally saw the year.

In Aerospace, we're seeing low single-digit growth in commercial OE and in commercial aftermarket, offset by, as I mentioned earlier, some pretty significant declines in the Biz Jet segment, which really took orders down in Q2.

Some small declines in US Defense, OEM and some modest growth in Defense aftermarket.

In Vehicle, as we noted, NAFTA Class 8, we think 230,000 units this year, down some 29%, and we continue to see weakness in the Brazilian truck and bus market.

We think down 20% for the year, offset by low single-digit growth and NAFTA Class 6 production into modest growth as I mentioned in the light-vehicle markets around the world.

If we turn our attention to restructuring, really good news here.

Restructuring programs remain on track.

Q2 spending came in right at plan at $35 million, and our projects are clearly on track, and we have a great line of sight to delivering the benefits that we laid out.

We did increase our second-half spending by $5 million, primarily in Electrical Systems & Service to deal with some of the continued weakness that we're seeing in our markets, particularly oil & gas and industrial markets.

We expect to spend $27 million in Q3 and another $20 million in Q4, increasing our total spending for the year to $145 million, but we've also increased our annual benefits by $5 million, and so really no net change in benefits for the year.

In total, we now expect the program to cost, $404 million in total, with benefits of $423 million, both up $5 million from prior forecasts.

Turning our attention to the segment margin expectations.

Not much in the way of change here, overall, on a consolidated basis; unchanged from prior guidance.

However we did make a minor adjustment in guidance for both Electrical Systems & Services and in Aerospace.

(Inaudible) down some 30 basis points.

On continued weakness principally in the higher margin oil & gas, and industrial projects, and Aerospace up some 30 basis points on the basis of ongoing strength and aftermarket, and really tight control on development costs inside of the business.

Each of the other businesses are expected to be within the ranges noted, and you'll recall that these guidance numbers do, in fact, include restructuring expenses.

Turning our attention to EPS guidance, guidance for Q3 reflects continuation of the current overall softness in a number of our end-markets.

We think organic revenues in Q3 and Q4 are essentially flat with Q2.

Flat revenue, but the variances to last year will improve as a result, as I mentioned earlier, easier comps.

Margins expectations will be between 15.5% to 16.5%, reflecting the lower restructuring expenses and increased benefits from Q2 and Q3.

We think the tax rate will be 8% to 10% in Q3 versus 11% in Q2, and the midpoint of our guidance remains unchanged at $4.30, but we did, in fact, narrow the range by $0.05 on both the high side and the low side.

Turning our attention to the outlook for 2016, the summary table that we normally provide in these calls.

I'd say here the key changes are, once again, we updated Q3 guidance, $1.10 to $1.20.

A slight increase in foreign exchange negative benefit, by $25 million, and as I mentioned before, simply narrowing the range about holding the guidance at $4.30.

So in summary, we think really a strong quarter in Q2.

The teams are executing extraordinarily well.

Revenues came in, more or less, as expected, with strong performance in Electrical Products and Aerospace offsetting some of the weakness that we're seeing in Electrical Systems & Services, and Hydraulics really showing strong margin improvement, excluding restructuring charges in the quarter.

And, once again, really importantly, record cash flow as the businesses are really doing a nice job of converting net income to cash.

We remain committed to our $700 million of share repurchase.

We repurchased 3.7 million shares in the quarter, $225 million.

Markets are unfolding as we expected, and the full-year outlook is unchanged at down 2% to 4%, and the restructuring programs are basically delivering, $174 million of incremental profit in 2016 over 2015, and it's setting up well for us to deliver another $120 million of incremental profit in 2017 over 2016.

So I'll stop here, turn it back to Don, and we'll go to question and answer.

At this point, our commentator will provide some guidance for you on the Q&A session.

(Operator Instructions)

(Conference instructions)

Our first question of the day comes from Julian Mitchell with Credit Suisse.

Thanks a lot.

Hi Craig, so just firstly on the ESS margins, I think you're implying the second-half margins are 14%-ish, those are up maybe 150 points year on year and sequentially in the half.

Revenues, though, probably in the second half, probably not doing much year on year or sequentially.

So maybe just clarify, what it is you see in ESS that picks up in that second half?

Yes, I'd say, the first adjustment, we'd say you need to make in terms of the underlying run rate of the business is the fact that we did have a legal settlement in ESS in the quarter; that shaved some 70 basis points off of margin.

And then secondly, as we move into the second half of the year, we will clearly see a little bit of volume lift but not dramatic, but the restructuring benefits that we've been undertaking during the course of the year also start to kick in, and we will see a margin lift as a function of the restructuring benefits that are more back-end loaded.

Got it.

Thank you.

And then just within the Electrical Products business, you did see that bookings turn down in Q2.

It looks like the guidance for revenue has an acceleration in organic sales year on year in the second half.

Are you seeing something in the bookings in Q3 already that suggests that, that decline in bookings should be reversed now, and that gives you the visibility on second-half revenue?

What I'd say on that, Julian, is that when you take a look at the absolute level of revenue that we're forecasting for the back half of the year, it's really running essentially at Q2 level, and so we don't really have a volume lift that's built into the second half of the year.

And as I mentioned earlier, the comps in general get easier for all of our businesses.

As you recall, we really saw a fall-off in our revenue during the course of 2015 in Q3 and Q4.

So principally, we're saying we're going to be running at this current level of economic activity and revenue and it's the function of the comps versus prior period that appear to be kind of a relatively change in the rate of change, but the absolute dollars don't really move much at all.

Right.

Thank you.

Our second question comes from Rob McCarthy with Stifel.

Good morning, Craig, and congratulations on a solid quarter and a good initial start.

I guess the first question I would ask is, with respect to ESS, I mean, where of the litigation expense are they in the margins.

But could you talk, you did say the oil & gas exposure there, but could you talk about maybe the trends you're seeing there, oil & gas, in general?

And then as a follow-up to that, and this will constitute my follow-up, could you talk a little bit about the portfolio's oil & gas exposure beyond with the explicit exposure, what the implied exposure could be?

Because I think what we struggle with sometimes is understanding what the second-order effects of some of these industrial companies, oil & gas exposure is.

So if you could comment on that, that would be very helpful.

Yes, so I think there's three questions there, one in terms of the margin impact at ESS.

We had this legal settlement related to a three-year-old or so commercial negotiation that ended up impacting the Electrical Systems & Services segment, so that did take our margins down by 70 basis points in the quarter.

Just commercial settlement from a prior matter.

In terms of the Company's exposure to oil & gas, most of our exposure that's inside of the Electrical business is in the Electrical Systems & Services business.

You'll recall that when we acquired Cooper, we also acquired a very large business called Crouse-Hinds, that has a very big exposure to what we call Harsh and Hazardous markets, including oil & gas.

So we're certainly seeing an impact in that business as well as in all of our businesses that are exposed to oil & gas.

I'd say in terms of, the overall oil & gas market, I think at this juncture, we'd say we certainly have not seen any improvement in oil & gas and maybe we've seen a little bit of deceleration in oil & gas, not material changes from our original assumptions for the year, but clearly, we've not seen any indication that, that market has turned.

And to your point around the second derivative and the other kind of markets that are tied to oil & gas, I think we really have been experiencing all year, that second-derivative impact.

So yes, it's oil & gas, but it's in many cases, oil & gas companies, whether it's upstream or downstream, they all live under one roof until we've seen kind of the other knock-on effects from oil & gas-related industries, and already impact our business and is already reflected in our guidance.

And I guess following up to that just briefly, I mean, but do you think you have a number about for planning purposes and otherwise, how you're thinking that second-order impact?

Because I think you have a headline number for your oil & gas exposure but do you have a number of about the outer ring of that penumbra?

We really don't.

I appreciate the question of what you're trying to get at but we really don't have a particular number and, once again, it's a really tough number to derive, and we would just be hazarding a guess.

So what we try to think about today is, we understand the underlying run rate of our businesses and what we're experiencing today.

We know that we're already experiencing, the second derivative fall-off and that's the basis that we use to develop our guidance.

I'll leave it there.

Thank you for your time.

Thank you.

Our next question comes from Steve Winoker with Bernstein.

Thanks, and good morning guys.

So just trying to understand here, the margin front, you put up 10 basis points that are ex-restructuring, that's quite a performance given the volume leverage.

So maybe just talk a little bit about what you're seeing if you could give us some color around -- you mentioned price-versus-material, productivity-versus-wage inflation, leverage, mix some stuff going on in corporate.

Just a few of the puts and takes to help us understand how you get there and how sustainable it is?

Yes.

I'd say that, principally, maybe if you cut through all the tape, it's more than anything, it's a function of restructuring, benefits, great cost control by the operating team, and good operational execution.

Price-versus-commodity input costs.

We mentioned that we are having a few challenges in Electrical Systems & Services, but if we think about the entire year, we think we're largely on plan and on expectations that there's that little bit of uncertainty around what the future looks like around commodity prices as you read all the same press clippings that I do.

And we have seen a little uptick in some commodities in the last 30 days; we've seen others tick down.

We think, largely speaking, that commodity prices for the full year will be very much in line with what our expectations were.

We're not getting leverage right now in the business because we're not, for the most part, growing volume and so it really is a function of our business is doing a good job of flexing our costs, in anticipation of this weak market environment that we're living in.

Okay.

All right.

We can follow-up offline for some -- maybe if we could put some numbers around some of that, it would be helpful.

On the cash side, maybe, look, that was also a very strong performance.

Maybe talk about some of the puts and takes there around working capital and others?

Yes, Steve, I'd be happy to really quite a straight-forward quarter from a cash standpoint.

If you look at the combination of net income and depreciation and amortization, those two were almost $730 million of cash and then the balance is simply a small positive from working capital.

As we've commented earlier in the year, we believe that we have opportunities to continue to take down inventory.

We did take inventory dollars down some from Q1 to Q2, but we think we have further opportunities as we go through the year.

So it's really just those three items, net income, D&A as well as a small positive from working capital.

Great.

Okay, thanks.

I'll pass it on.

Our next question comes from Ann Duignan with JPMorgan.

Yes, good morning.

You mentioned a few times some strength in Europe for different businesses.

Could you just give us a little bit more color on that, where exactly and what segments that you're seeing strength?

Yes, I mean, yes, sure, Ann.

I'd be more than happy to.

I think what we've seen in almost every one of our businesses is, relatively speaking, versus our expectations for the year and all the geopolitical issues and everything else taking place in Europe.

We've seen Europe generally perform slightly better than what we anticipated, and so it really does run the gamut.

Certainly, if you take a look at Vehicle markets and that's probably been a big standout this year, light-vehicle production and sales has been up mid single digit all year.

So we're seeing real strength there.

Hydraulics markets in Europe, while still negative, less negative than we anticipated.

In fact, that's market is, we think down low single digits this year which is a better outlook than we anticipated.

On the Electrical side of the house, once again, we're seeing growth, for the most part, in many of our end-markets in Electrical Products and Electrical Systems & Services, and we think those markets grow slightly this year.

We think up once again low single digits.

So it's, really, we'd say been a broad-based beat versus our internal expectations.

Modest but pretty broad.

At this point, it's too early to say.

Your follow-up question may be in terms of what happens with Brexit and the Turkey matter.

At this point, it's too early to say.

On the positive side, we are today a net exporter out of the UK, so we don't think that is going to have a big issue.

And the same thing would be true of Turkey.

Really, it's been a broad-based, we'd say, beat where Europe, in general, has performed slightly better than what we anticipated.

Since you answered my follow-up, I'll switch to a different follow-up then.

On the Hydraulics side, which specific end-markets was the mobile, was it Industrial Hydraulics?

Just a little bit of color on the Hydraulics side (inaudible) negative.

That's great.

It's pretty much, primarily the mobile side that came in for the quarter stronger than what we anticipated.

As I mentioned, strong Ag orders, up some 23% in the quarter, strong construction orders up 8% offset by ongoing and pretty significant weakness that we still see in the stationary side of the business.

The process industries, oil & gas, large industrial, very much like we're seeing in the Electrical side of the business, and that continues to be quite weak.

Okay.

I'll leave it there in the interest of time.

Thank you.

Thanks Ann.

Our next question comes from Eli Lustgarten with Longbow Securities.

Good morning, everyone.

Can we get a little bit more fabrication?

You just said Ag up 23% but you said it's weak.

Was that -- and Europe performance has outperformed what the industry and the industry was down a bit more than it.

Is this picking up share?

Was this just rebalancing of inventories in Ag or something because the markets were -- not in anticipation of planned shutdowns, as you're coming this summer.

Do you view the Ag and the construction more as a one-off quarter as opposed to sustainability and can you tell us a little bit about pricing there?

Yes, it's a good question Eli, and I wish we were really smart enough to be able to call it precisely, but I think it's more the way you articulate it.

We had a strong quarter of order input in Ag and construction.

We don't think that's, in any way, indicative of the underlying market performance.

And so it's probably a function of a bit weaker comps that we had last year, and to your point, perhaps some pre-buying that's taking place in anticipation of summer shutdowns.

So that's why our call on the year for Hydraulics hasn't changed, and we still think that the guidance that we provided on the full year is very much consistent with what we're feeling, and experiencing in the business.

The pricing environment, Hydraulics is just fine.

We're not seeing any particular or unusual pressures there with respect to, that, once again, we always talk about it in terms of the net of commodity input costs and price, and so we think it will be net, about neutral.

Price is not going to be a tailwind or, for us, this year or a headwind.

And this is a follow-up.

We're seeing a lot more pressure on input costs in the second half of the year, particularly the steel numbers really haven't changed much.

They're up big, maybe less than the spot market, but they're still up significantly.

Can you talk about cost price and cost of business?

And in the context with the auto numbers that came out that were quite weak today across the board, do you have any concern about some weakness going over in the Vehicle business besides the truck market just for North American auto?

You raise an excellent point, Eli, because we've absolutely seen steel prices move materially up, order of magnitude, 50%.

A lot of that driven by some of the duties that have been put on imports coming out of China.

That's had a knock-on effect of steel prices around the world.

In the near term, we think we're fine in terms of the net impact to the Company.

We did some pre-buying.

We do have some hedges in place.

So we think in the near term, we have the ability to mitigate the impact of steel price increases.

We'll have to wait and see how long these increases stay in effect, whether this is a short-term blip or it's a long-term blip, and any blip that's on a longer term impact, we'd have to actually revisit our pricing assumption, and we'd find a way to pass it on into the marketplace.

And so we think, once again, on balance, we'll do what we've always done, in inflationary environments, we'll find a way to pass it on to the customer base.

It's been well-publicized.

It's well understood, so we don't think that poses a risk to our margins.

To your point around auto weakness, we certainly have seen a lot of the reports reading the same as that you have.

We continue to take a very cautious view on the outlook for automotive markets.

We think North America will be largely flat this year, and Europe and Asia will be up slightly, but like you, we're taking a very cautious view of it, and we're getting prepared that in the event that we do have a downturn, we're going to be well-prepared to deal with it.

I will add that there's a number of economic forecasters who do have a view that's already out for 2017.

And we're not sure if they're right or wrong, but you know, whether it's IHS or some of the other economic forecasters, they think that the markets essentially continue at these high levels on into 2017 that are essentially but flat or maybe up 1% or so, 1% or 2%, but we're watching it just like you, and we'll be prepared in the event that it takes a turn for the worse.

Thank you very much.

Our next question comes from Joe Ritchie with Goldman Sachs.

Good morning, guys.

And nice job executing in a tough market.

My first question, maybe just starting on Hydraulics for a second.

I saw that you didn't take down the organic growth guide yet.

One of your largest customers talked this quarter about under-producing real demand in the second half of the year.

So I'm trying to marry those points.

You guys are seeing some stabilization.

It seems like things can get a little bit worse.

So talk to us a little bit about like what you're seeing and what your expectation is for the second half?

I think, generally speaking, we were really pleased with our Q2 performance in Hydraulics.

If you look at the absolute level of change in revenue for the quarter, down some 7%, slightly better than we anticipated and you take a look at our order input, down some 2%.

So we think a couple of really strong data points that would suggest that, if there is, in fact, a little bit of weakness in the back end in certain markets and we saw the same report that you did that (inaudible) major customers.

There's enough breath in the business in other segments that are performing a little bit better than that, that on net, we think that the year will be very much in line with what our expectations have laid out.

Okay.

Fair enough.

And I guess maybe my follow-up, one of the things that has kind of surprised us from a trend perspective this quarter was that June seemed to have gotten worse for a lot of our companies, especially on the industrial side.

So to the extent that you maybe can provide some color on what you saw in sequential trends and specifically talk about Industrial, that would be helpful.

I think from our perspective, Industrial really has been a source of weakness, really, this year and for the entire quarter.

I don't know that June was an especially standout month for us in terms of the industrial market.

We are, in fact, seeing the same weakness that others are talking about.

And it's one of the reasons why in our Industrial Systems and Services business that we've taken the guidance down, and the reason why we continue to see some margin challenges in that business.

So we are absolutely seeing the weakness and experiencing it.

I would not say that we saw any particular change in the rate of trajectory in the month of June.

Okay.

Great.

Thanks guys.

Our next question comes from John Inch from Deutsche Bank.

Thank you.

Good morning, everyone.

Hey, how did ESS margins in the backlog, how do they look and the order pricing, is there anything that you could provide us there, Craig, in terms of color?

I'd say there's nothing in the backlog or in environment that will, in any way, materially change.

The margin assumptions are highly influencing our assumptions around margins for the balance of the year.

Now, we did, in fact, trim the margin guidance in the ESS, but that's largely a function of the things we talked about.

We talked the fact that large projects, large industrial projects, which tend to be more profitable, we're not selling as many of them.

So we have a negative-mix effect and that's the one business where we are seeing a slight negative on the balance between commodity input costs and pricing.

So that was the other reason we trimmed the guidance slightly in ESS.

But there's really nothing in the backlog that would suggest any particular heavy influence on the margins of the business on a go-forward basis.

So other, just by inference then, other companies and not Eaton have called out that what projects are available and I realize I'm not suggesting it's apples-to-apples but just in general, right?

What projects are available, the pricing is very touch as you can manage right, just because of the capacity that's out there for fewer projects.

It sounds like that's not happening.

No, no, I think what we said is that price, in that particular business, the net of price and commodity import prices, that is negative, so we are, in fact, experiencing, a bit of price pressure in our Electrical Systems & Services business.

So we are, in fact, saying exactly what you're hearing from other companies.

Okay.

And then maybe big picture.

How was China in the quarter?

Maybe you could dovetail a little bit of your commentary around construction and just in general in China, right, was it stable?

Did it get better?

Did it get worse?

Just if anything you can tell us about it would be fantastic?

Thanks.

I'd say, in general, what we're seeing in China is largely ongoing weakness.

I think as you heard the commentary, as I talked through the various end-markets, but for, let's call it, the consumer-related markets and passenger-car markets, we continue to see weakness, mid single-digit weakness in the industrial markets in China that's affecting our electrical business, and we continue to see strong double-digit declines in many of the Hydraulic-related markets, as they continue to work off excess inventory.

I was going to ask you just lastly on inventory in China, I think at the Analyst Meeting earlier this year, there was a broad discussion around just a lot of systemic inventory in China, whether it be construction machines or other equipment.

Is that the -- do you think -- this is not Eaton, it's more of market.

Does that change at all, do you think or is it still kind of this overhang?

I think we're still living through a bit of overhang and in sales versus production, I think continues to eat into the inventory overhang that we're dealing with in a lot of the capital equipment markets.

Principally, I think markets like excavators and road rulers and the other things are really supporting this major building boom that China went through over the last ten years, but they continue to eat into it.

Are inventories today at the levels that I'd say are where the market needs in the (inaudible)?

I'd say, no, I think they're still working through a bit of an inventory overhang, and that's why we're still dealing with these strong double-digit declines in a lot of the end-markets in China.

That's very much what we're forecasting.

Got it.

Thanks very much.

Our next question comes from Nigel Coe with Morgan Stanley.

Thanks.

Good morning, and, good solid quarter here.

Just want to come back to Hydraulics.

This quarter, Craig, is the first we've seen, any sort of hint of normal seasonality in this business for about three years.

I'm wondering, maybe, obviously the orders down 2% is good news, but it's sometimes hard to define the end-line trend from order data alone.

So I'm just wondering, maybe address the issue of normal seasonality at lower levels, and how did the book-to-bill this quarter compare to other quarters?

Are we at a normal book-to-bill ratio here?

Yes, I'd say that if we take a look at the business this quarter, we've built a little backlog in the quarter, which would be expected, to the extent that your orders are stronger than your sales out.

And so, but once again, I think like you, we don't want to over-read one quarter of results in Hydraulics.

And so it was a bit of a stronger quarter than we anticipated in the order intake.

Is this a turn in the business?

We don't know, and I think it's too early to call.

I think we need to string together more than one data point before we know whether or not the Hydraulic end-markets, the big important markets in this business, which are Ag and construction and oil & gas and mining, have these markets bottomed out?

Are they ready for a turn?

We're reading all of the same customer data that you read, which would suggest that we're still living in this period of really low economic activity.

So I'd say, in general, it's too early to call whether or not these markets have reached bottom and are prepared for a turn.

Yes, but stability is good news, I guess.

And then on restructuring, clearly, you're getting some pretty tangible payback on the actions.

You've raised by $5 million this year, you're getting $5 million more so it's a wash.

But 2017, you gave some color in terms of what you expect, I'm struggling for the numbers here, but I think it was $130 million of restructuring cost next year and $105 million of payback, net of payback.

Are we still on track for that next year?

Yes, we're still on track.

And what we said was $120 million of net.

So if you think of the net profit improvement as a function of restructuring, we said it's $120 million, but your numbers are largely correct.

Great.

Thanks, Craig.

Okay.

Our next question comes from Jeff Sprague with Vertical Research.

Thank you.

Good morning, guys.

Just a couple questions.

Craig, on Lighting, I think you described it as mid single digit.

I don't know if that was an outlook comment or what happened in the quarter.

Could you just elaborate on that?

And I was wondering if maybe you could bifurcate Lighting a little bit?

I think you have some Harsh and Hazardous in there that maybe is holding that business back a little bit?

Any way to think about kind of the underlying truly commercial part of Lighting and how that's growing, Commercial and Res?

Yes, so we did say mid single digit in my commentary.

It truly a reflection of what we expect for the entire year so it's our outlook but it's largely the way we think the market has been performing overall.

When we quote the Lighting numbers, it does, in fact, include all of our Lighting, which could include Harsh and Hazardous and the Safety business as well.

It's a composite view, and then certainly, if you took out Harsh and Hazardous, the business would be performing slightly better.

I don't have the exact number handy, but it would certainly be performing slightly better than that.

We think the really important news is that LED penetration continues to grow inside of our overall Lighting business, and LED penetration in Q2 was approaching 70% so we continue to see tremendous growth and penetration in LED lighting, and we think that has a lot of room to run.

And we're really pleased with the way that business is performing.

Thanks, and Craig, I appreciate your comment on trying to go after freight, as raws maybe start to work against you a little bit.

But can you help us bring that perhaps some idea of what percent of your COGS are raw metals or metal related, or any kind of ballpark number you could give us there?

Yes, it's not a number I have handy.

It's what I would just say is, you can, what we'll do is we'll find a way to offset it like we have historically.

We could end up in any given quarter with a little timing challenge around inflation versus pricing in the market.

But all of that thinking and the current commodity prices are factored into our guidance for the year.

It's all fully baked into 2016 at the current activity levels, at the current inflated levels of steel prices.

I don't really have the numbers in terms of, specifically, the steel commodity itself and how much in terms of by bifurcating that from the rest of what we buy.

Just one other quick one.

Just thinking of Eaton Corp., there's maybe a window on what industrial companies are thinking.

Can you share any view on what you would expect your capital spending to do in 2017?

It's really too early for us to make the call.

We haven't really begun the process of working through our internal plans at this point.

So it's -- we'll certainly be in a position to give you perhaps a better look at that at the end of Q3, but at this point, it's just too early to call.

All right.

Thank you very much.

The next question comes from Jeff Hammond with KeyBanc.

Hey, good morning guys.

Hey, can you hear me?

Yes, we got you, Jeff.

Yes, sorry.

Okay, so I really wanted to focus on EPG order rates.

You went from kind of plus 2% to minus 2%, and I just want to understand what caused the delta?

Because that was the one area within Electrical that had been more resilient.

Well, we don't have that precise Q1 to Q2 comparison, but as Craig pointed out, if you look at the order pattern in Electrical Products, it really was the industrial part.

Those products that are in that segment that go into industrial controls, for example, in APAC.

Those are the two areas that showed particular weakness, and so without having the precise numbers, I would characterize those areas as being a bit softer than in Q1.

And how about just the non-Res piece.

Non-Res, of course, goes across both segments, and so much of non-Res and Electrical Products tends to be in lighter commercial type areas and that experienced good conditions, and as Craig mentioned, Europe in general, non-Res as well as other markets experienced pretty good conditions in Q2 orders.

Okay, good.

And then on slide 11, you gave the quarterly cadence of the restructuring costs.

Do you have that similarly for the $190 million in savings?

We don't have it particularly for savings, and we haven't provided it other than to say that in the savings, we'll generally follow the spending in the business and maybe to deal with kind of the maybe the follow-on questions.

As you think about characterizing the restructuring spending for the back end of the year, I'd say that it's going into the businesses that you would likely expect.

And so Electrical Systems & Services will be the recipient of the most money followed by Hydraulics and then Vehicle, so that's -- if you're thinking about modeling where the restructuring spending is going, that's really the way the current numbers line out in terms of where most of the costs will go.

Okay.

Thanks guys.

The next question comes from Andy Casey with Wells Fargo.

Thanks a lot.

Good morning.

Question on cash flow, your really strong performance the first half, it's running about 40% of your annual operating cash guidance.

And in most years, it moves around a little bit, but it's usually between 20% and 30% full-year operating cash.

And Rick mentioned the opportunity to draw down inventory in the back half.

Are there any second half offsets of that inventory drawdown that we should consider?

None that we're aware of.

We think that given that, as Craig commented, we think sequentially, revenue stays relatively flat going from Q2 to Q3 and Q3 to Q4.

That would mean you wouldn't have a need to build working capital to deal with revenue going up and so we would hope that we would be able to hold down a bit of inventories in that flattish revenue environment, but other than just the normal business characteristics, we wouldn't expect anything else to impact cash flow.

Okay.

Thanks, Rick, and if that historical proportion were more closer to 40% holds, if full-year guidance ends up being a little bit conservative, what allocation priorities should we consider?

Would it be an acceleration of maybe share repo or restructuring or something else?

I'd say that as we think about the Company's capital priorities, I think very much consistent with we said in New York and our message all along is as we think about capital allocation, we say the first priority is to invest in our businesses, continue to invest to drive organic growth.

The second priority we said is, in fact, to ensure we continue to maintain a very strong dividend.

The third priority we said was to buy back shares, especially in this environment.

We think that our stock price is on sale, and we think we can create a lot of value of buying back our shares, and then the fourth priority would be to do M&A.

So that prioritization has not changed.

That's currently the way we would think about capital deployment.

Okay.

Thank you very much.

Our next question comes from Josh Pokrzywinski from Buckingham Research.

Hi, good morning guys.

Just to come back to Hydraulics and the stationary markets.

It seems like you guys are trying to signal a bit more of a downbeat tone there, although when you talk about the weakness or the fresh weakness in industrial markets, it seems to be directed more ESS.

So I guess I'm trying to determine, one, in 2Q did you see further loss of momentum in stationary or is it just trying to signal that, some of the mobile markets are hitting easier comps and stationary is now along for the ride.

First question, just trying to parse out that difference.

I'd say in terms of Hydraulics, I think the way, the right way to characterize what we're seeing in the stationary markets is that in the oil & gas markets continue to be weak.

They've been weak all year, and we really have not seen a turn in those markets.

We did see a little bit some weakness in some of the process industries, but those orders tend to be lumpy, and we saw some strength in the mobile markets, and so I'd say the way we characterize Hydraulics is that not a downbeat tone at all.

We're very much pleased with the fact that we posted better revenue than we anticipated, and we had better order performance than what we anticipated.

We do think it's important that we don't read that through to mean that a definitive bottom in the business, in that the business has turned, but it's certainly a positive indicator for the business overall.

Got you.

And thinking about the potential margin mix of recovery.

If mobile starts to look better or bounces off of a bottom here and stationary stays weak, is that a better outlook for the margins of the business?

Is it all about the same?

Maybe help us try to bridge that gap.

Yes, I think the bigger indicator would be what's happening with the OEM business, whether it's mobile or stationary and what's happening with distribution.

The distribution business tends to be a bit more profitable than the OEM business, and that's really more of what would influence the underlying profitability than anything else.

In the quarter, our distribution orders were actually slightly stronger than our OE orders, and so that's a positive sign.

But once again, with one quarter, really, too early to really make a call one way or the other.

I guess maybe to ask the question differently, is there more distribution exposure in stationary or mobile?

Yes, they really do play across both segments.

So our distributors sell mobile applications.

They sell industrial applications, so really, they play across both markets.

Okay.

Appreciate the question, guys.

Our next question comes from Shannon O'Callaghan with UBS.

Morning, guys.

Hey, on Hydraulics, just on the margin side, getting that back to low teens margins ex restructuring has been a goal of yours.

I mean was this sooner than you expected to get there and now that you're there, is the 13.1% victory been achieved or anything particularly favorable that got you there this quarter?

No, I'd say the business largely performed on expectations for the quarter and we certainly continue to have work to do inside of that business with respect to restructuring.

We're not done and obviously, the 13% at the low point in the cycle was the bottom of our threshold, and obviously, our aspirations for the business are much stronger than that, so I'd say, no, we're not done.

We're not ready to declare a victory.

It was a strong indicator that the restructuring work that we're doing is paying off.

But we clearly still have work to do in that business, at different volume levels to ensure that we can maintain the minimum of 13% at the bottom of the cycle, and obviously, numbers that are closer to 16% in normal times.

Okay.

And on Vehicle on the margins there, you guys have worked to decapitalize that business and try to minimize the decrementals.

They got a little tougher this quarter.

Do you still feel good about the ability to keep modest decrementals in Vehicle?

Absolutely.

Quite frankly, we're really pleased with the Vehicle business and the way it performed in the quarter.

17.1% return on sales, excluding restructuring, at a period of time when the North America Class 8 market is down 30%, at a time when the Brazilian markets are at all-time lows.

We think that business continues to execute extraordinarily well.

And we're very much confident that we have the right formula and to your point that you raised, it has been a formula of decapitalizing the business, changing the business model, moving more costs from fixed to variable.

So we're very much comfortable that the business formula works there and that business will continue to deliver strong margins in a very difficult [economic] environment.

Okay.

Thanks.

Our next question comes from Deane Dray with RBC.

Thank you.

Good morning, everyone.

I'd just like to touch on Aerospace, if we could.

Some more specifics on the mix that you saw this quarter.

The Business Jet weakness is certainly being felt industry-wide.

But maybe some color on the offset of the aftermarket, both military and commercial.

As we said, Deane, if it breaches the question, then I think it's the weakness in Biz Jet that caught us all a little bit off guard and naturally what's driving a little bit of underperformance in that business from a revenue of orders input standpoint.

Offsetting that and helping the margins, we continue to see strong order input and results in aftermarket, commercial OE, commercial transport continues to be quite strong.

[It was about] 10% in the quarter.

Military OE was off modestly but very much in line with expectations and in military aftermarket, also growing in the mid single-digit range, and so aftermarket continues to be a real source of strength.

Commercial transport continues to be a real source of strength offsetting some weakness in Biz Jet and a little weakness in Regional Jet as well.

Thanks, and then Craig, just on a bigger picture question, you now have your first quarter as Chairman and CEO successfully completed.

Is there anything different versus your expectations since taking the helm in June?

Deane, I appreciate that question as well.

I'd really say no.

As you know as well, the transition between Sandy and myself was really over a period of about 12 months, and during that period of time, we worked closely together and I was in the shadows of all the calls that have taken place over the last year or more, and so I'd say the job is largely what I expected.

The business environment is largely what I expect and there's really been no big surprises.

It's the way we like it by the way in the job so far.

Terrific.

Appreciate that.

Thanks.

Our next question from Chris Glynn with Oppenheimer.

Thanks.

On the guide, I think I heard revenue flattish sequentially into the third quarter and again into the fourth quarter.

That would seem to be a favorable in the fourth quarter relative to normal seasonality, if you can comment on that?

It's relatively flat.

It might be down just a tiny, tiny amount in Q4 possibly, but the reality is that it won't even be a material change and so as we see the balance of the year laying out, just Q2, Q3,Q4 are essentially flat revenue.

And I appreciate the concern that a number of you are signalling around the second half volume basis, and what we've said all along is that in the event that the volume [cases are any] different than what we anticipate, that we'll be more aggressive around the things that we will do around managing costs and so as you can imagine, we have a contingency plan that we're working through as a Leadership Team around what happens, if, in fact, we end up with a volume issue in the second half of the year (technical difficulties).

Okay.

And then just in Lighting, I'm wondering if there's been a lot of transition over the last couple of years.

Plenty of competitors talked about recent change in the competitive and pricing environment.

Have you seen anything in that area?

No, I'd say Lighting, I mean every year, it's a business given that the input costs and the price of LEDs has continued to fall.

Every year it's a business that basically sheds a bit of price, but also the input costs and the costs of that LED technology continues to drop, so I'd say in that business overall, ordinary [force] is that it's a competitive business and the technology costs continue to decline and our margins in that business, quite frankly, are performing just fine.

And we had another quarter of strong margins in Q2.

We think that business is fine and very much consistent with the guidance that we've laid out for products during the course of the year.

Thanks.

Thank you all for joining us today.

We're at the top of the hour to [wrapping] and would like to wrap up our call.

As always, we'll be available to take questions or follow-up items after the call, and thank you very much for joining us today.

And that does conclude the conference for today.

Thanks for your participation.

You may now disconnect.