伊頓 (ETN) 2018 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Eaton Second Quarter Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded.

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

Please go ahead.

Good morning.

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

Thank you all for joining us for today's -- for Eaton's second quarter 2018 earnings call.

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

Our agenda today includes opening remarks by Craig, highlighting both the performance in the second quarter and our outlook for the remainder of 2018.

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

Before we do, I want to remind you of a couple of things.

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

Please note that the press release and the presentation both include reconciliations to any non-GAAP measures.

And a webcast of today's call is going to be accessible on our website and is available for replay for those who are unable to join us.

Before we get started, I do want to remind you that our comments today will include statements related to expected future results of the company and are, therefore, forward-looking statements.

Actual results can differ materially from those forecasted projections due a whole range of risk and uncertainties that are described both in the earnings release and our presentation and our related 8-K.

With that behind us, I'll turn it over to Craig to go through our presentation.

Okay.

Thanks, Don.

I appreciate it.

Just before we get started with Q2 results, I did want to take an opportunity to once again emphasize the 3 primary elements of our corporate strategy.

I'm sure you worked through most of the financials already.

But first and foremost, we remain focused as a company on delivering organic growth, and our initiatives are very specific by business.

But generally, they include investing to create industry-leading products and technologies; leveraging partnerships with distributors and third parties; creating value products and services that allow us to more fully participate across the opportunities we see.

So in short, what we're trying to do is find opportunities to say yes more often and doing it in a way that solves customer problems but also delivers attractive returns.

Second, we continue to expand our margins by improving productivity in our factories and in our functions and by selectively undertaking restructuring initiatives that allow us to eliminate redundancies, eliminate waste and really being more selective in how we spend our time, moving away from marginal activities but, just as importantly, doubling down on those areas where we have the right to win with attractive returns.

Third, we'll maintain our disciplined approach to capital allocation, which begins with investing to win in all of our existing businesses.

We'll also consistently return cash to shareholders in the form of industry-leading dividends, share repurchases and by maintaining our rigor as we evaluate M&A opportunities against our hurdle rates.

We think by continuously delivering on these components, we'll generate superior value for our shareholders both in the short term and the long term.

And in the context of that kind of strategic overview, we also thought we'd take an opportunity to just highlight, once again, this quarter a number of places where we've made a bit of progress against these strategic initiatives.

And on Page 4, I've highlighted a few of the examples.

First, in our efforts to grow, I'd point to our presence in the fast-growing data center market, which continues to pay off.

In fact, we booked record orders the first half of the year.

We're seeing strong global demand for new facilities in hyperscale and Internet 2.0 applications.

And importantly, we're winning in this space.

We also have entered into a new joint venture with Shaanxi Fast Gear for light-duty transmissions to serve the Chinese market.

The JV combines Eaton's broad transmission technology with leading -- with the leading transmission company in China and allows us to participate in the world's largest light vehicle market.

We also made solid progress on our digitization initiatives.

And while too many to note, I would point out a few examples of progress made in the quarter.

We launched an IoT-enabled home lighting solution.

We deployed an IoT-enabled hydraulics system in sugarcane harvest applications as well as in hydraulic fracturing.

We formed an industry cybersecurity partnership with the Rochester Institute of Technology, which allows us to advance the common and secure IoT platform that we intend to deploy on all of our products.

And so really solid progress as we continue to digitize the company and focus on opportunities to grow with these new technologies.

And while just getting started, we did secure our first high-voltage converter order in our newly formed eMobility segment.

And lastly, we added significant capacity to our hydraulics hose business, enabling us to sharply reduce lead times to -- and expand our presence in the high-volume segment of the market.

So while not on a complete list, these are examples that hopefully provide you with a sense of how we're moving our strategic priorities forward and how we're also investing in the future.

Now turning to our financial results for Q2 on Page 5. I'll just add some context to what you've already seen in the results.

First of all, we think a very strong quarter of performance by our businesses.

Earnings at $1.39, up 21% over Q2 of '17 and at the high end of our guidance range.

Our performance was driven by both strong revenue and record margins.

Organic revenue of 7% was the -- actually, the highest reported growth since Q4, 2011.

FX added 1%, offset by 1% in divestitures.

Bookings accelerated in most segments, but especially in Electrical Systems & Services and Aerospace, which were both up solid digit -- double-digit.

We generated all-time record segment margins of 17% based upon strong volume growth and strong incrementals, and we think, once again, demonstrated the ongoing benefits of our multiyear restructuring program and how those benefits are coming through.

Operating cash flow was $499 million in the quarter.

And while not as strong as you might have expected, cash was impacted by adding working capital to support the increased growth as well as by selectively pre-buying inventory to mitigate the impacts of the trade tariffs.

And finally, we repurchased $300 million of shares in the quarter, bringing year-to-date purchases to $600 million, 1.7% of shares outstanding at the start of the year.

So we think really strong balanced performance across the company.

Turning to Page 6, I'll provide a summary of the consolidated results for the quarter.

And here, I'd just highlight a couple of elements of the income statement.

We talked about the sales increase which really allowed us to increase segment operating margins by 16% and net income by 18%; earnings per share, up 21% in Q2, and this compares to 15% in Q1; and lastly, we did deliver 11.1% after-tax margins in the quarter.

Moving to the segments.

I'll start with Electrical Products.

Our revenues were up 4%, 3% coming from organic growth.

And this is up from the 1% growth we reported in Q1.

In the quarter, we saw particular revenue strength in industrial markets especially in the Americas and the EMEA market, Europe, Middle East, Africa, India -- Europe, Middle East and Africa, excuse me.

Total bookings were up 4% in the quarter.

And excluding Lighting, bookings were actually up 7%, which is a step-up from Q1 bookings, where, also excluding Lighting, they increased 2%.

So this business is also ramping favorably.

Order strength was broad, driven by both industrial and residential markets.

And I would also note that lighting markets appear to have stabilized, and we expect to see low single-digit market growth in the second half of the year.

Importantly, our margins in the quarter were up 120 basis points to 18.5%, which was a second quarter record, so strong conversion in our Electrical Products business.

Next, the results for our Electrical Systems & Service business is on Page 8. Revenues increased a solid 7% in the quarter.

And this is up from the 2% growth that we saw in Q1.

ForEx added -- foreign exchange added 1%, which was offset by a negative 1% from a small divestiture in a joint venture.

In the quarter, we saw revenue strength in industrial projects, in data centers and solid growth in harsh and hazardous markets.

We generate very strong bookings growth, up 15%, with strength in the Americas and Asia Pacific.

And bookings were especially strong in large industrial projects and in data centers.

And our backlog continued to grow, increasing 14% in the quarter, and we think positioning the business well for the continued growth in the second half of '18 and certainly into 2019 as well.

Operating margins were 15%, up 130 basis points.

And we delivered strong leverage as the 7% sales increase resulted in a 17% increase in operating profits.

Moving to Page 9. Here, we cover the Hydraulics results.

Sales increased 14% in the quarter, 13% organic, 1% positive FX.

Revenues were strong with both mobile OEMs and across the distribution channel.

Bookings were actually down 1% in the quarter.

And this does take a little bit of an explanation, but this included Asia Pacific, up 15%; the Americas, up 4%; offset by EMEA, down 21%.

And while impacting orders, the lower EMEA number is actually the result of our operational improvements in capacity investments that we've made to shorten delivery lead times.

And this has reduced naturally our customers' need to place long-dated orders.

And certainly, when we take a look at our backlog, it has increased, up some 26% year-to-date, and this certainly gives us confidence that this market remains strong.

Margins at 14% were up 230 basis points.

So we continue to see the benefits of our restructuring efforts here as well as leverage from a higher volume.

However, I would note, as we discussed on private calls, we continue to experience challenges as we ramp up production to support these strong growth levels.

And most of the challenges are coming from the supply base, which has really struggled to keep pace with the higher demand.

Next, our Aerospace business is listed on Page 10.

Sales were up 6%, all organic.

The sales growth was driven by strong activity in military OE across all segments, bizjets and commercial aftermarket.

Orders were even stronger, up 18%, with strength in both military and commercial aftermarket, business jet, military fighters and military rotorcraft.

Our backlog also remains strong and is up 13% over prior year.

And lastly, operating margins were once again very strong, 19.4% and up 90 basis points over the prior year.

Turning to Page 11.

Our Vehicle business had another strong quarter.

Sales increased 6%.

Organic revenues were actually up 11%, and the divestiture impact of the joint venture that we formed with Cummins was a negative 5%.

NAFTA heavy-duty truck production was up 15% in Q2, following more than 40% in Q1.

So this market continues to be very strong.

We continue to expect NAFTA heavy-duty truck production to be at 295,000 units for 2018, which implies a modest, modest growth in the second half of the year on more difficult comps.

And I'd also note that the industry is seeing a few supplier challenges that will likely limit second half production but pushing production into 2019.

And in the automotive markets, both Europe and China are stronger than we originally anticipated, and the U.S. market is really coming in about on expectations, so really broad strength in our Vehicle business.

I'd also note that the Eaton Cummins joint venture is doing well.

Revenues grew to $141 million in the quarter, so very strong growth in our joint venture.

And margins were at 18.5%, up 180 basis points from prior year on strong revenue.

And finally, results in our eMobility segment are shown on Slide 12.

Sales in the quarter were up 15%, 14% organic.

And having just formed the business in Q1, we're pleased to announce that we have, in fact, won our first high-voltage converter order, one of the key products that we've just begun selling into the electrical vehicle market.

And our pipeline of opportunities, perhaps more importantly, is 2x what it was in Q1.

So we continue to see tremendous growth in the opportunities that we're having an opportunity to quote on for customers.

Margins were 16.9%, down 120 basis points, reflecting, really, the additional R&D investment but very much in line with our expectations.

On Page 13, we've updated our organic growth outlook for 2018.

Our end markets continue to grow above our original expectations on a number of our businesses, and so we're increasing our full year organic growth estimate from 5% to 6%.

The continued strength in orders from Electrical Systems & Services has led to an acceleration of organic growth, and we're now forecasting growth of 6%.

We're also increasing the organic growth outlook for our Aerospace business to 6% on its strength in both military and commercial markets.

And finally, our Vehicle business continues to perform at a high level, and we are increasing our organic growth guidance to 6% for the full year as well.

You will also recall that we increased our Vehicle segment organic growth estimate following a strong Q1 as well.

Overall, a 1% change for Eaton, and this is on top of the 1% increase that we provided as a part of our Q1 guidance.

Moving to Page 14, we'd like to provide just a bit of perspective on where we think our businesses are in the economic cycle, and why we think conditions are setting up well for the second half 2018 and really going into 2019.

Now, as this chart demonstrates, we think that our end markets are currently -- where our end markets are currently at, in terms of the economic cycle.

As you can see, most of our end markets are in the early to mid-growth strange, which we think bodes well for continued market growth.

The majority of Eaton's revenue comes from businesses that are in the early to mid-part of the growth cycle, and this includes many of our larger businesses like long-cycle Electrical Systems & Services segment.

So overall, we think our businesses will continue to have a market tailwind for some time to come, and we would expect to as well grow faster than our end markets.

On Page 15, we provide an update on our thoughts regarding raw material inflation as well as the estimated impact from tariffs.

As we communicated at the beginning of the year, we continue to execute on our strategy of offsetting raw material and logistics cost inflation with price and cost-out actions.

We moved quickly with pricing actions in the first half of 2018 and, as a result, we expect no negative EPS impact in 2018 from additional commodity inflation.

With regards to tariffs, we think there will be a very modest cost impact for our businesses overall, some $65 million.

But we also fully expect to mitigate this increase through actions that are currently underway or will shortly be implemented in our businesses.

So I won't go through the tariff details in a lot of detail, but I would emphasize kind of the 2 main points.

And one, our long-term strategy has been and continues to be to manufacture in the same zone in which we sell, and this certainly reduces the tariff impact on Eaton.

And secondly, we're committed to moving swiftly to take pricing actions to offset any tariff impact that we do see in our businesses.

Moving to margin guidance on Slide 16.

We're increasing margins for 3 of our segments where we're seeing stronger-than-expected organic growth and solid performance.

These include: Electrical Systems & Services, up 20 basis points; Aerospace, up 30 basis points; and Vehicle, up 50 basis points.

We are lowering our guidance for Hydraulics to a range of 13.7% to 14.3%, which is a 50 basis points reduction at the midpoint.

This is in response to supply chain challenges and inefficiencies as volume continues to grow at these strong paces.

And our full year margin guidance remains in the range of 16.4% to 17% and really places us on a solid trajectory to achieve our 17% to 18% margin targets that we set for 2020.

And finally, on Page 17, we provide a summary of our Q3 and 2018 guidance.

For Q3, we expect EPS between $1.35 and $1.45.

And this assumes 7% organic growth.

We expect margins to be 16.9% to 17.3% and a tax rate of 13% to 14%.

For the full year 2018, we are again increasing our full year EPS guidance to a range of $5.20 to $5.40, which is a 10% increase at the midpoint.

Organic revenue growth is now expected to be up 6% versus 5% previously.

Foreign exchange is now expected to be only a $50 million positive, which is down from the $200 million that we had in our prior efforts -- our prior estimate.

Segment margins will be in the 16.4% to 17% as earlier noted.

No change in our cash flow or free cash flow guidance.

And corporate expenses, tax rate, CapEx, share repurchase assumptions, all remain unchanged from prior guidance.

So just before I hand it back to Don, I did want to, once again, take this opportunity to summarize why we think Eaton is an attractive investment opportunity.

As you can see and we talked about, our markets have returned to growth.

The next few years will be much better than the last few.

In addition, we have a number of really attractive organic growth initiatives that we think will allow us to continue to grow faster than our end markets.

And our restructuring is paying off.

Our 2018 margins will be at an all-time high, and we have plenty of room to continue to improve them.

Our balance sheet is in great shape.

Net debt-to-capital is at 30% and our pension plan is now 96% funded.

Our cash flow continues to be strong and we expect to consistently deliver free cash flow at or above 100% of net income while generating some $8 billion of free cash flow over the next 3 years.

We're also returning cash to shareholders through a high dividend yield, 3.3% today; and buying back shares, 1% to 2% on an ongoing basis.

And lastly, as we committed, we'll deliver 11% to 12% EPS growth over the next 3 years.

And so we think once again, solid performance this quarter, a positive outlook and we think a really compelling story for investing in Eaton.

So with that, I'll stop and turn it back to Don for Q&A.

Our operator is going to provide guidance on participating in the Q&A.

(Operator Instructions)

Before we jump in to the Q&A, well, we do see we have a number of people on the call and we also have a number of calls going on simultaneously at this time, so I want to be very sensitive to the timing of that.

(Operator Instructions) And with that, our first question comes -- question and a follow-up question, excuse me.

And our first question comes from Jeff Sprague with Vertical Research.

Great momentum.

I think one interesting question, given that you guys report a little later than others, is what you're seeing in July.

I'd say it's somewhat implicit in your Q3 guidance, obviously.

But was there some element of pre-buying or other activity in June as people were looking at tariffs and did you see any letup in July?

Yes.

I think the short answer to the question, Jeff, is no.

I mean, we really did not see any pre-buy of any measure.

And what we've seen to date in July is very much consistent with the patterns that we've been seeing.

So absolutely everything that we've forecasted in the outlook for the company is very much consistent with the way the businesses have been performing.

Right.

And then just to be clear on price cost, are you -- what you're saying is kind of underlying price cost, you're caught up or have visibility on being caught up, but there's still actions that need to be taken on tariffs in your core products?

There's still a fair amount of uncertainty as it relates to the implementation of 301.

And so what I would tell you is that what we know about to date and what has been announced to date, we have very much either announced or implemented plans to offset that impact.

There's a lot of uncertainty as you think about step 2, step 3 of 301 and what actually happens that obviously, we don't have visibility into.

And those actions, if they are implemented as speculated, then we would have to take additional actions down the road.

But everything that we've seen to date and everything that's been announced to date is very much already baked into our guidance and plans are very much already in the -- implemented or in the phase of being implemented.

Our next question comes from Joe Ritchie of Goldman Sachs.

So organic bookings in ESS, obviously, really good to see the progress that you're seeing there and finally seeing some of that growth materialize.

Craig, my first question is maybe touch on what you're seeing from like a leading indicator perspective on the data center stuff, the industrial projects.

And how do you feel about that business on the go forward?

I appreciate your question.

I mean, certainly, the few big businesses that are inside of Electrical Systems & Services would include our power distribution and controls assemblies, our commercial distribution assemblies, our power quality business and also Crouse-Hinds.

And I'd say in all 4 of those very large businesses, we are seeing very strong order growth across the business and so each 4 of those -- all 4 of those businesses are performing well.

We talked about the fact that the backlog is up from 15%, and we saw strong orders.

And those are the 4 businesses that are essentially driving the growth.

And so, very much as we anticipated for our Electrical Systems & Services business, perhaps even a little ahead of schedule, those businesses are late-cycle businesses, but are ramping right now.

And we expect to continue to perform for some time to come.

Okay, that's great to hear.

And then my second question, maybe following up on Jeff's trade tariff question and more broadly on cost inflation.

When you think about the different segments and your ability to offset cost inflation across the segments, where are you finding it the easiest or are you finding it difficult in some of your segments, basically a question around pricing power and your ability to offset.

Sure, and I'd say it's pretty much no different this cycle than it is any cycle.

And to the extent that we're selling through distribution, distribution always tends to be a little easier.

Price increases are good for our distributors and they have the ability to pass it forward into the marketplace relatively easier.

It's always more challenging with the big OEMs.

But I would tell you that our plans and -- are to pass it forward every place, including in those places that have historically been a little bit more challenging.

And so -- but I just think more generally speaking, distribution tends to be a bit easier than large OEMs, but we're not differentiating between the 2. We're passing price increases equally through to all of our customers.

Our next question comes from Scott Davis with Melius Research.

The positive benefit of putting up these kind of numbers is you're kicking off a lot of cash.

And we've seen some of your peers have a fairly active M&A pipeline and some direct comp, some not.

But what do you think as far as priority is concerned?

I mean, with the amount of cash you're kicking off, it almost doesn't feel like buybacks can really keep up to the -- can almost not keep up to the growth.

But is M&A something that you think will come back this year?

As we've stated in prior quarters, having paid down the last tranche of debt associated with the Cooper acquisition, the company is certainly in a position today where, both from an organizational capacity standpoint and from a cash standpoint, that we are in the ability -- we have the ability today to re-enter the M&A market.

And today, I can tell you that we are looking at more opportunities than we have in quite some time.

But having said that, we'll be disciplined, and as we think about how we value and price these transactions that we talk about a cost of capital being 8% to 9% and saying we want a minimum of 300 basis points over our cost of capital.

So we intend to be disciplined as we look at these opportunities, but having said that, we will not allow cash to build up on the balance sheet.

To the extent that we're not able to land acquisitions, which we would hope to do, we'll certainly look for other ways of returning cash to shareholders.

Fair enough.

And as a follow-up, in the Lighting business, you mentioned a return to growth in the back half of the year.

Is that -- is there also a sense of price stability that you're finally seeing in that market explicitly?

Yes.

I would say that as we talk about our own Lighting business and our own strategy with respect to Lighting is that we have made a decision to be perhaps more selective than others around business that we're chasing.

And we've made some adjustments in terms of where we focus our efforts.

And I can tell you that as we think about the segments of the markets where we think are attractive and the places that we want to play, you generally see better pricing power, better pricing stability.

I can't say if you think about the entire market, at the low end of the market that, that dynamic has changed dramatically.

But the places that we anticipate playing and the places where we think we have an opportunity to sell differentiated value-added solutions, we do have a lot better pricing power in those markets.

Our next question comes from Nigel Coe with Wolfe.

So you called out data center as a strong end market, which shouldn't be a huge surprise, but I think it's the first time you've really specifically called out data center end-market strength.

So I'm wondering, is this pretty broad across geographies?

Or is it 1 or 2 supersized data centers that you're starting to see coming through?

And then, just thinking about the ESS margins and we're starting to tilt now towards larger projects.

Do you think that mix becomes a headwind as we go into the second half of the year, maybe '19?

Yes, I'd say to your first question around data centers and to your point, Nigel, it's one of the big secular trends that we certainly think bodes well for Eaton and will help generate long-term growth for our company.

And it is broad.

We're seeing growth in the data center markets really around the world and as you move to hyperscale and co-load a

And as the world just generates more and more data, we think that trend will continue for some time and will continue broadly.

To your other question around margins, no, we don't anticipate that margins will be under pressure in this business, and I'd say, quite frankly, today, if we take a look at where the industry sits today in electrical assemblies, for the most part, we have capacity constraints.

Some of the demand that we're seeing today in our business is really pressing us and others to really deal with a lot of volume that we're looking at, and we're certainly looking at potentially adding capacity to deal with some of this increased demand.

And so no, I don't anticipate at all that margins will come under pressure.

And given the balance of capacity and demand, I think the market's in a great position today to actually get price.

Great.

And a quick follow-on...

I just want to add one other thing, that we've seen a bigger, larger proportion of complex large industrial type projects, and those tend to have higher margins.

Inherently, there are fewer people that can actually pursue projects of that nature, so that's another element to the margin outlook.

Great.

And then quickly on the EP, it looks like Lighting was down roughly 10% in the quarter.

Maybe you can clarify that.

But what was the impact on operating leverage?

You obviously had very strong margins at EP.

But if we look at ex Lighting margins, how does that look?

Yes, I mean, I'm not sure of your math, but we think -- we know Lighting was down closer to 4% in the quarter, not 10%.

But I'd say that today, I could just tell you that it's better.

I mean, we've not given specific margin numbers for our Lighting business, and I would just tell you that the margins in Lighting are certainly below, well below the average for the Electrical Products segment.

And so they certainly have a negative impact on the overall margins for the segment.

But inside of that, we have a fairly large Lighting business and still posted 18.5% margins in Electrical Products, which I think is a real testament to the strength of the franchise.

Our next question comes from Nicole DeBlase with Deutsche Bank.

So I guess I want to start on ESS.

If we look back into history since the Cooper acquisition, we've never really seen a real ESS recovery.

So I guess if you can give us an idea of how order growth translates to revenue growth, because it seems to me from the past 3 quarters that an acceleration in revenue growth could be in the cards.

Yes.

No, that would be our expectation as well.

And if you maybe think about it today, what's in the backlog, typically, I'd say what's in the backlog, most of that becomes consumed within the next 12 to 15 months, probably 75% to 80% of it.

And so it is a longer lead time business from project to delivery, but it's not 2 years out or 18 months out.

It's much near term than that.

And so we do anticipate that these strong orders that we're seeing in our Electrical Systems & Services business convert in a relatively short period of time into higher revenue growth.

Okay, got it.

That's helpful.

And then maybe just one on Aerospace.

Orders were also really, really strong there this quarter.

I know that's a business that tends to see a lot of lumpiness.

So if you could just frame the strength a little bit, where the growth was the strongest and what your expectations are for the next several quarters?

Yes, I appreciate your comment, too.

It is a place where orders tend to be a bit lumpy.

But we really did see, I'd say in this quarter, with respect to orders, pretty broad strength.

A lot of that came out of military markets; certainly, pretty broad across all segments of military.

And so you're seeing some of the increase in U.S. federal spending come through in fleet readiness and dealing with some of the historical underspending perhaps in our military.

But also, we saw very strong strength in aftermarket.

Both military and commercial aftermarket were both up strongly.

And that's revenue passenger kilometers, people keep getting on planes flying, and that's translating into higher aftermarket growth as well.

So I'd say it's been a fairly broad-based strength.

The one place you'd look at the biggest segment, which is commercial transport, you have very strong numbers being posted by Boeing, Airbus a little less so, but we think that Boeing -- if Airbus, excuse me, delivers their second half of the year, there's probably more strength there as well.

And so we think it's a pretty broad-based increase in our Aerospace business.

And as you know, these big commercial OEs are sitting on record backlogs that are growing every day.

So it was a very successful Paris Air Show where both companies booked very strong orders.

And so we really think the aerospace industry is really set up for growth for an extended period of time.

Our next question comes from Steven Winoker with UBS.

So I just wanted to go back to Scott's question on the M&A front.

Craig, you talked about kind of the usual 8% to 9% cost of capital plus 300 basis points over that, that you're looking for.

Just what kind of time frame are you thinking about that you want to achieve those things?

Given the step up in M&A activity across a lot of your segments, I'm just trying to get a sense for the kind of competitive positioning that you have there.

Typically, if you look at how our past acquisitions have done, we typically start a little bit below that 300 basis points over the cost of capital.

But then, we end up by year 3 or so at the cost of capital and then above that as we get past year 3. So that's as you work the synergies into the equation.

But your discipline commentary means that you're not willing to see that stretch out these days because, I think, we are seeing that stretch out for a lot of M&A.

Well, we are -- we've always said we're cash-on-cash buyers.

We look at the cash we put out and the cash that comes in and the time value of money makes a difference.

And so all of that goes into our thinking.

And I think what Craig was trying to communicate is we will remain disciplined.

If we believe there are significant synergies that are truly actionable, then that will factor into our numbers.

But we also -- with all the experience we've had, we know that it sometimes takes longer than you think to generate them.

And it's always a matter of what the alternatives are as well.

And so we'll always look at -- as we think about discretionary cash and the acquisitions will compete like everything else against other options for other investments that have also very strong returns.

And I'd say, we have a number of -- whether it's organic growth or other ways of improving the effectiveness of the business, we have plenty of opportunities, we think, to deploy cash in value-creating ways.

Okay.

And Craig, can you just comment on the -- a little more on that Hydraulics order rate in EMEA?

I know it's capacity investment to reduce lead times and such, but between that and some of the other supply base commentary, just want to get a sense of the organization's kind of ability to keep up with demand and across your network.

And I would say, we are, in fact, seeing improvement, so we don't want to overplay that.

We're seeing improvement in our ability.

We're seeing improvement in the supply base.

But having said that, it's come slower than what we anticipated.

With respect to the orders in Europe, and what we do is when we take a look at our orders internally, we take a look at when orders are due, and we look at things within -- due within the next 3 months, due within the next 6 months, due within the next 6 to 12 months.

And what we've seen in Europe specifically is a significant reduction in orders that are basically the long lead time orders.

And we think while it doesn't show up favorably on our orders chart, that's really a confirmation and a testament to the fact that we're getting better operationally in delivering.

We've made big investments in new capacity.

And so our customers today are actually placing orders that are more close to what the real demand is.

And if I could just add a couple of nuances to that.

If you look in Europe, orders that we had in the second quarter due within 3 months were actually up.

Orders due past 3 months were down more than 50%.

And so that -- we believe that that's because you no longer have to put these capacity reserving orders in, we simply have capacity.

And we've added more than 10% capacity in our very large conveyance facility in Europe.

And we think the end markets continue to be strong.

You obviously have seen a number of the companies in this space report.

And at this point, we think those markets continue to perform very well.

And the underlying demand we think is still very strong.

The next question comes from Ann Duignan with JP Morgan.

Because we've had multiple companies reporting this morning, I'm going to ask you a simple a math question.

You've taken up your organic growth outlook, but you've maintained your margin guidance.

So what is your revised incremental profit outlook versus the 40% you had guided to?

The way I would think about really kind of maintaining the margin range is that we provide a range because, essentially, it gives us a fair amount of ability to move within that.

And so I would not read or overread much into the fact that we haven't changed the range.

Certainly, our expectations are to be within that range.

And certainly, the midpoint can move one way or another, depending upon what your assumptions are.

So I would say, with respect to the fact that we didn't change the margin guidance, I would not overread that.

There is, in fact, a fair amount of uncertainty around the second half of the year.

And I think, more than anything, the fact that we didn't move that is a reflection of the uncertainty that we see in the marketplace with respect to trade and other variables that it's really difficult to predict and control which way it's going to hit.

Okay.

But you are confident enough, given your backlog and your orders, to raise the organic growth outlook.

Is that the way we should read that?

Exactly.

That's exactly right.

I mean, the backlog is, as we talked about, in a number of our businesses, whether it's Aerospace or Hydraulics or Electrical Systems & Services, the ones that build big backlogs continue to ramp.

And so we think the backlog certainly provides a lot of confidence in our ability to continue to grow.

Okay.

And just a quick follow-up.

Just on your early stage growth, mid-stage and late stage, I wonder if you could give us more color on why you think that U.S. nonresidential construction is only in mid-stage?

I mean, we've been expanding for 8 years.

It certainly feels like we're not going to fall off a cliff in the near term, but it certainly feels like we're in the later stages of expansion in U.S. nonresidential construction.

So if you could clarify that, I'd appreciate it.

Yes, I guess, I'd cite 3 things, Ann.

First of all, the expansion we've seen in nonresi thus far in this cycle has been quite modest, much more modest than you typically see in expansion cycles.

So that's point one.

Point two, if you look at this growth in oil and gas spending, typically, oil and gas spending flows into a variety of nonresidential categories, and we think that you will see that occur again this time, just as you've seen in the past sometimes, it flowed downward when oil and gas activity goes down.

But now we're, in our view, pretty clearly in an up cycle in the oil and gas markets.

And then, thirdly, if you look at more minutely at the Dodge contract data, it is signaling that you're going to see acceleration as we get to the back half of this year and into '19.

And so those are the 3 elements that give us confidence that you're going to see some pretty good conditions in nonresidential construction.

And any of the subsegments within nonresidential you'd expect more acceleration or less acceleration?

And I'll leave it there.

I think you're going to see more acceleration in the -- what I'd call, the heavier, the industrial, the oil- and gas-related type activities.

Obviously, you're also seeing it in things like data centers.

Our next question comes from Jeff Hammond with KeyBanc.

So a lot of discussion on supply chain.

It seems like you've kind of alleviated some bottlenecks in Hydraulics yourselves.

Just maybe talk about any signs of supply chain improving within Hydraulics and truck as we move through.

And then, conversely, any other businesses where you see it becoming a bigger problem?

I'd say that we are, in fact, seeing signs of improvement, both in Hydraulics and in truck.

And you obviously, Jeff, have heard what others in this space have said around some of the specific bottlenecks in truck and how those things are finding a way of working theirselves through.

But I'd say, typically, in a lot of these industries, you could be 6 months away from -- in worst case, from a demand signal that says something is changing to the ability to flow all that demand back to the supply chain base.

And so we obviously have seen both of these markets really ramping over the last 18 months, and we've been chasing it for 18 months.

But I think, today, we're on top of it and we have a much better sense for where these markets are going.

So in simple terms, I'd say, we have seen signs of improvement every place.

We are getting better.

Our suppliers are getting better.

We're doing a much better job of shortening lead times.

And we talked about that a little bit in Hydraulics business in Europe, which is giving our customers confidence.

But at this point, I'd say that we certainly -- it took us longer to get here than we'd hoped, and that's why we're experiencing some of these inefficiencies.

So I'd say, overall, I think things should be better going forward.

Okay.

And then, just in EPG, I mean, it seems like Lighting has been clouding the growth rates for some time, and think you're pointing to a little bit of growth in the second half.

Is it -- just looking at the other businesses, is there an opportunity to see some growth acceleration in EPG just as the Lighting comps get easier?

Yes.

I think the Lighting comps get easier, and I think our own business in Lighting actually has a better second half of the year.

I mean, you saw the acceleration of EPG when you compare Q1 to Q2.

And we would anticipate, as you go into the back half of the year, that Lighting performs, relatively speaking, better.

To some extent, easier comps.

But the business, underlying business, performs better, and as a result, EPG performs better.

And remember, Jeff, you still have a fair number -- a fair amount of industrial components in EPG in their products segment.

And those parts of that business are going to benefit, of course, by growth in the commercial and industrial assembly businesses as well as just oil and gas activity.

Our next question comes from Steve Volkmann with Jefferies.

A couple of quick follow-ups.

It feels to me like you guys actually ought to have pretty good visibility into 2019 when you look at some of this data center stuff we've talked about, ESS orders, Aerospace, some of the truck stuff that got pushed out.

Can you just give us a sense of how you're feeling about your visibility into 2019 relative to, say, a year ago?

Well, I mean, certainly much better than a year ago.

And as you've noted, a lot of the long-cycle businesses that we anticipated to turn positive have turned positive.

And so we certainly feel much better about our visibility into '19 today than we did even 3 months ago.

But having said that, in terms of guidance specifically for 2019, we think our markets grow.

And we don't think that we're at the top of the cycle in many of our businesses.

There's certainly a few extraordinary events in 2018 that are pushing markets up.

But we think, when you look at it in terms of the long-term trend, we think many of our businesses, as we talked about in the context of where they are in the cycle, are either at the early point or the middle part of the cycle.

And we continue to see growth into 2019.

Okay.

And then, just to go back on Lighting for a second, it's nice to see that sort of stabilizing.

But as you mentioned, it's still sort of mixes your margin down.

And I'm just curious if you've changed the way you think about Lighting as kind of a core business of Eaton going forward and is there any chance to perhaps find another way to kind of deal with that going forward?

Yes, we're focusing on winning in the marketplace.

We have made a slight adjustment to our strategy for Lighting in terms of how we think about kind of some of the more commoditized piece of this space.

But other than that, no change at all in our strategy with respect to Lighting.

We think it's got a lot of great underlying technology.

It is very complementary with what we do in the rest of our Electrical business.

And so no change in strategic direction.

And do you have a way to improve margins going forward?

Yes.

Part of the things that we're doing to improve margins is, as we talked about, where we focus and how we decide to participate or not in some of the more commoditized parts of the business.

So there is that element of it.

In our Lighting business, no different than the rest of our organization, we have undertaken a number of restructuring initiatives to get at some fixed cost and structural cost.

And we'll continue to invest in the high-end of Lighting in the area of controls and connected Lighting, and that segment of the market tends to have more attractive margins.

Our next question comes from Deane Dray with RBC.

For Rick, I'd like to get some more color regarding the working capital dynamics you touched on.

Not surprised to see some working capital build with the increased order levels.

But maybe some color on the pre-buy, on the inventory ahead of the tariff noise, and maybe you could size that for us.

Yes.

Well, I think, a simple way to think about it, Deane, and maybe to put it into context is that if you looked at our classic working capital at end of June, namely receivables, inventory, less payables, and you compared -- that number was about $4.7 billion, and if you compared that to our annualized sales in Q2, our working capital as a percentage of sales was 21.2%.

For most of the last couple of years, it's been between 19% and 20%.

And the reason it's higher is exactly as you say.

The growth in sales, particularly in some of these longer-cycle project type businesses, caused receivables to increase.

But we also both positioned inventory for the continued sales growth but also took some positions in order to forestall having to pay higher prices.

And the kind of numbers you're talking about in inventory increase are in the order of $100 million-ish kind of dollars.

And so -- but if you run through the math, of 21.2% compared to 19% to 20% on average, you'll see that we definitely have opportunity to bring the working capital levels down as the year progresses.

That's real helpful.

And then, as a follow-up, I don't think I've heard data centers get called out so many times in a positive way in quite a while, so just want to circle back on this one.

Is there any share gains in the quarter?

And then, maybe just if you could, Craig, touch on the approach to servicing the hyperscale customer.

They require a completely different set of architecture, hot switchovers and so forth.

So what's working well in serving that part of the market?

Yes, and I think to your point, I mean, quite frankly, 2017 was a little bit of a surprise and a disappointment in terms of what happened in data centers, given the underlying demand and the underlying growth in data generation and data consumption.

So there's probably a little bit of catch-up taking place this year in the market.

But the long-term growth trend for data generation, I mean, it's growing at more than a 20% compounded rate a year.

And so we think the long-term growth rate in data centers and hyperscale continues to be very, very positive.

I'd say that to your point around a lot of the big hyperscale data center companies, they all have very unique architecture around the way they protect their data centers and the way they configure their data centers.

And they will sometimes go through periods where they'll take a pause and they'll rethink the way their data centers are laid out.

And so, I think you find -- you'll find that some of that took place during the course of 2017, and there's perhaps new configurations that are coming out there today.

But we're seeing very strong demand across all the major players in data centers as they really build out their capability for this underlying growth in the market.

We do think we're taking some market share, but always difficult to tell for certain exactly where this is going to end up.

But we, as a company, are very well-positioned in terms of our global footprint, certainly in the UPS space, but more importantly, in getting the switchgear space.

Our company is very well-positioned.

We have a very strong reputation with all the data center companies.

And we think it's a place where we're going to continue to grow for some time to come.

The next question comes from Mig Dobre with Baird.

I guess we'll move on to Andy Casey with Wells Fargo.

A question around the implied Q4 organic expectations.

I'm backing into a deceleration of somewhere in the 2% to 4% range, but I know this can get thrown off by rounding in Q4 '17 comps.

Can you comment on what's included in the current guidance for Q4?

Well -- sorry, Rick.

Do you want to take it?

I was going to say, Andy, if you just look at the full year guidance we've given and the third year -- and the third quarter guidance, you would see that the rate of growth on higher comps will not be quite as high in Q4.

That's our expectation at the present time.

Now normally, as you know there, you do have sometimes a seasonal impact in Q4.

We'll just have to see whether that seasonal impact occurs this year, given how strong the underlying markets are.

Okay.

So Rick, I should just look at that as kind of a placeholder, given all the uncertainty?

Yes.

Our next question comes from Julian Mitchell with Barclays.

My first question would just be around the backlog.

You called it out a lot more in this call and in the slides than prior calls.

Classically, I guess, your backlog is worth less than 1 quarter's worth of sales.

I think it was about $5.2 billion at the end of March.

Again, sales in Q2 of $5.5 billion.

So I guess, within ESS, Hydraulics and Aerospace, specifically where you call out the backlog, give us some idea of how much visibility you have in those 3 businesses in terms of that backlog, please.

I can take a stab at it.

First of all, there are various businesses like Vehicle where we don't have backlogs, or at least we don't regard them as stable, so we don't report them.

So you'd need to factor that in.

But in general, if you look at our businesses and you look at backlogs over the ensuing 12 months, the backlogs, particularly in project businesses, can be 30% to 40% of the next 12 months.

In a case like Aerospace, the backlog will be really high.

I can't give you a precise number, and the reason is that the orders are placed well in advance.

And so it's a mixed bag.

In Vehicle, we typically say we don't have backlogs.

We do sort of have a general idea, but we don't have specific backlogs.

In Aerospace, it's very highly locked in.

In larger project businesses, it's probably 30% to 40%.

And then in Electrical Products, it tends to be much more of a flow type business, so the backlogs are much, much lower coverage of the next 12 months' revenue.

And Julian, I'd say, the reason we probably put more emphasis on backlog this time than perhaps in prior calls is there's been a lot written and speculated about where we are in the economic cycle.

And so we're also looking at this thing just to get a sense for while we continue to grow our backlog and build strength into the future or are things moving in a different direction.

And we come away from our own assessment of the backlog and the fact that we're growing backlog in most of our businesses, very positive around the outlook for the second half in 2019.

That color, it's very helpful.

Maybe following up, Rick, you touched on Vehicle where the concept of a backlog is not particularly useful.

So maybe just flesh out a little bit the guidance for Vehicle.

You grew low double digits in the first half.

The growth for the year is, I think, penciled in at about 6% organically.

Maybe give us any help on how you're thinking about truck in Brazil and North America versus light vehicle in terms of your second half growth rates.

Well, you can see with the full year guidance we've given and our -- for Vehicle, that the growth rate in the back half of the year will be less than in the front half of the year.

A lot of that has to do with prior year comparisons.

It also has to deal with some constraints on production that we're seeing in various parts of the market.

So we -- as I think Craig mentioned, you saw very strong Class 8 growth in the first half of the year.

It won't be as strong in the second half of the year.

So those are some of the factors.

But I'll -- and if you step back and look at the underlying direction of the vehicle markets, we see continued good growth in Class 8 in NAFTA.

We see continued strength in the South America markets.

And broadly, the automotive markets have performed a little bit better than we thought this year, with growth in Europe and APAC, and a little bit of a decline in the U.S., as expected.

So we feel pretty good about the underlying tonality of the vehicle markets.

Our next question comes from Andrew Obin with BofA.

Just a question on Hydraulics.

Our channel checks indicated that on longer lead items, I think lead times went up from months to over a year.

And I'm just wondering, now that your capacity has caught up, how long will it take to sort of adjust things in the channel?

And I guess, what I'm concerned about, are we going to see multiple quarters of negative orders or significant sort of volatility in growth rates?

How long will it take to clear it through the system?

That's a little bit of a difficult question to speculate on, Andrew.

We certainly appreciate why you're asking it.

I'd say -- for the most part, I'd say these changes take place relatively quickly.

And as evidenced by what happened in our own business in Europe where a lot of the long lead time orders, the placeholders, if you will, that are put out 6 months to 9 months out where people are just trying to hold the slot, those orders are relatively very quickly adjusted and changed.

And so I don't anticipate that it's going to take very much time at all for those adjustments to be made in the ordering pattern, whether it's through our OEMs where you see it more strongly, or with distribution.

So I think it's a relatively short adjustment.

Got you.

And then, just a follow-up question on Aerospace.

One of the themes at Farnborough, I think, was that somebody described it as this bear hug from Boeing where Boeing is basically going to supply chain, asking for significant price concessions, asking for share of MRO business, particularly to participate on NMA or 777X.

Can you sort of comment on what you guys are experiencing and how should we think about the profitability of the Aerospace business long term, given Boeing's demands?

I'd say we've learned to dance with the bear, I'd say.

We have certainly been involved with both Boeing and Airbus and the things that they're trying to do strategically.

And I'd say that, suffice it to say, that we have very effective working relationships with both Boeing and Airbus.

We understand what their objectives are, and we think that there's plenty of room for win-win solutions with both Boeing and Airbus, finding ways to continue to grow our business and participate more fully in what they do and also be responsive to what their requirements are.

So we don't think that the initiatives that are taking place today inside of Airbus or Boeing, we don't think either one of those 2 will be problematic for our teams to manage in the course of business.

So no structural change to profitability going forward with new contract structure?

No.

No, none whatsoever.

Our last question today comes from Mig Dobre.

Looks like we had a little problem with the queue earlier, Mig.

We'll turn it over to you for the last question of the day.

Great.

Can you hear me now?

Yes, perfect.

Okay, perfect.

Perfect.

So one last question on Lighting for me.

One of your competitors mentioned that this might actually be one area that benefits from 301 tariffs.

And I know that, obviously, you're not at the lower end of the market.

But I'm wondering what your perspective is as to how industry dynamics might change here.

And is it feasible to think that, broadly speaking, pressure on profitability sort of shifts and you actually get some tailwinds into 2019?

Yes.

No, I mean, we certainly have looked at 301 in the context of that same issue and whether or not it should be a net benefit to our Lighting business.

I think, at this juncture, I would say that it's too early.

It's very possible that with tariffs being put on lighting products coming out of China and a lot of the low-end lighting coming from China, that there is, in fact, a bit of tailwind and help for the market in the industry overall.

But I would just say the way we think about it today is it's just too early to judge whether it's going to play out that way.

And it's not baked into our forecast that way.

And if it turns out to be a net positive, it certainly would be a bit of upside for us.

With that, we'll wrap up our call with the question-and-answer today.

As always, Chip and I will be available for any follow-up questions you might have afterward.

And thank you very much for joining us today.

That does conclude your conference for today.

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