伊頓 (ETN) 2019 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Eaton Third Quarter Earnings Call.

(Operator Instructions) As a reminder, today's call is being recorded.

I'll turn the call now over to the Senior Vice President of Investor Relations, Mr. Yan Jin.

Go ahead, sir.

Okay.

Good morning.

I'm Yan Jin, Eaton's Senior Vice President of Investor Relations.

Thank you all for joining us for Eaton's Third Quarter 2019 Earnings Call.

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

Our agenda today includes the opening remarks by Craig highlighting the company's performance in the third quarter.

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

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

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

A webcast of this call is accessible on our website and it will be available for replay.

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

Our actual results may differ materially from our forecasted projection due to a wide range of risk and uncertainties that are described in our earnings release and the presentation.

They're also outlined in our related 8-K filing.

With that, I will turn it over to Craig.

Thanks, Yan.

Appreciate it.

We will start on Page 3 with a highlight of our Q3 results.

And overall, I'd characterize this quarter's results as really strong earnings results and strong cash flow despite weaker end markets.

Earnings per share, as you saw on the press release, were $1.44 on a GAAP basis, $1.52 excluding transaction costs and acquisition and divestiture and exit of businesses.

At $1.52, our results were 6% above last year, excluding the 2018 arbitration decision, and within our guidance range of $1.50 to $1.60.

However, sales were certainly lower than what we expected, down 1% organically, negative currency impacting us by 1.5 point and acquisitions adding 0.5 point to our results.

We continued to deliver strong margin performance with another record and all-time earnings on margins.

Segment operating margins of 18.7% were an all-time record for Eaton, and this includes records for Electrical Products, for Electrical Systems and Services and for Aerospace.

These margins were also above the high end of our guidance and 110 basis points above last year.

We continued to generate very strong operating cash flows of $1.1 billion, up 8% over Q3 2018 and another quarterly record.

And lastly, as a way of summarizing results, we repurchased $539 million of shares in the quarter, bringing our year-to-date purchases to $949 million or 2.8% of our shares outstanding at the beginning of the year.

Turning to Page 4. We show a summary of our Q3 performance versus prior year, and I'll just point out a few highlights here.

First, we delivered $41 million of increase in segment operating profits despite a 1% decline in organic revenue.

And this was really driven by strong execution, effective cost control and favorable mix in a couple of our businesses.

Second, we incurred $0.08 per share of after-tax costs primarily related to the planned divestiture of our Lighting business.

And lastly, adjusted EPS increased 6% excluding the 2018 arbitration decision.

These results, I'd say, are consistent with our broader message on how we intend to run the company during periods of market weakness: strong execution, proactive cost control and increasing our share repurchases.

On Page 5, we show our quarterly results for Electrical Products segment.

Overall revenues were flat, made up of 1% organic growth offset by 1% negative currency.

We saw revenue strength in both commercial and residential markets in North America, partially offset by softness in industrial controls globally.

Segment operating profits increased 6% and operating margins were up 110 basis points to 20.3%, which was an all-time record for this segment.

We also announced the sale of our Lighting business to Signify for a price of $1.4 billion, and we'd say a good outcome for our shareholders and another example of how we are actively managing the portfolio to create higher margin and higher growth set of businesses for Eaton.

This was a decision that was also good for our employees who will now be part of a larger and more focused lighting company.

The transaction is expected to close in the first quarter of 2020.

And I'd say for our core products business, which now excludes lighting, orders were up 1% led by strength in residential and commercial construction, largely once again in the Americas.

Moving to Page 6. We summarize our results for our Electrical Systems and Services segment.

Revenues increased 3%, 3% organic growth.

We also had 1.5 point of growth from the acquisitions of Ulusoy and Innovative Switchgear Solutions, and 1.5 point of negative currency.

Organic growth here was driven by strength in data centers, commercial construction and actually also in engineering services.

Our ES&S business also produced all-time record margins of 18.3%, which were up 290 basis points from prior year, operating profits increasing some 23% on 3% organic growth.

This business benefited from higher sales, for sure, but also had very good operational execution and conversion.

And on a rolling 12-month basis, ES&S orders were up 5% with growth really across, I'd say, all regions here.

And if you exclude hyperscale data centers, the 12-month rolling average of our orders was up 8%, which is really in line with what we saw in Q2.

So once again, a long-cycle business very much performing at very high levels.

On the next page, we show our results for Hydraulics for Q3.

Revenues were down 10% with an 8% decline in organic revenues and 2% negative currency.

Organic revenue declines were driven primarily by weakness in global mobile equipment markets and in quite frankly destocking that we've seen, both at the OEM level and also within distribution.

Segment operating margins were 11.9%, down 290 basis (sic) [210 basis points] from last year.

But I feel on a sequential basis, margins were actually up 40 basis points despite seasonally lower Q3 revenues that came in about $100 million below Q2.

And our order decline of 14% really as a result of continued weakness as we mentioned in global mobile equipment markets around the world.

Turning to Page 8, we summarize our quarterly results for our Aerospace segment.

Once again, this business posted very strong results with record top line and bottom line performance.

Revenues increased 7% with 8% organic growth and 1% negative currency.

Orders on a rolling 12-month basis increased 13% with particular strength in the military market, specifically for fighters, for rotorcraft and also aftermarket.

We also saw strength on the commercial side in business jets.

We continued to demonstrate strong incremental margins with nearly 60% growth in margins on organic revenues, which drove a 23% increase in operating profits and a 310 basis point improvement in our margins.

And as you recall, we announced the acquisition of Souriau-Sunbank in July, and we expect this transaction to close before the end of the year.

So all things are good in Aerospace.

On the next page, we summarize our Q3 results for the Vehicle segment.

Our revenues were down 13%, which includes a 12% decline in organic revenues and a negative 1% impact from currency.

The organic sales decline was due to a combination of global weakness in light vehicle markets, which we think were down practically 4% in the quarter and primarily the impact of the transfer of revenues into the Eaton Cummins joint venture.

For 2019, the NAFTA Class 8 market remained solid.

We expect production to be roughly 340,000 units this year and up 5% for 2018.

We do, however, expect global light vehicle markets to be down some 4% for the year.

Despite lower organic revenues and volume, operating margins continue to run at very high levels.

At 18.3%, margins were down only 60 basis points from last year.

So our Vehicle team once again did a nice job of flexing spending, which allowed them to deliver decremental margins of approximately 25%.

Moving to Page 10, which show our eMobility results for Q3.

Revenues were down 1% with flat organic revenues and negative 1% from currency.

Flat organic revenues in this case are due primarily to a mix of platforms that we're on.

I'd ask you to keep in mind that this business is really made up of a mix of the new electric and hybrid platforms plus the legacy electrical content that we have on internal combustion engines.

Once again, we increased our R&D spending, which was really the primary reason why operating margins declined 740 basis points to 5.1%.

But we continue to pursue a large number of additional electric and hybrid programs here, and we are very pleased with the progress that we're making to date.

Next, on Page 10, we summarize our outlook for 2019.

We now expect organic revenue growth of approximately 1%.

And as you know, this is down from our prior estimate of approximately 3%.

And this is really based upon reduced global growth, particularly on our short-cycle businesses, but also includes some slow growth in nonres construction as well, still growth, but slow growth, which has impacted our Electrical business.

Within electrical, we now expect full year organic growth of approximately 2.5% for Electrical Products and 4.5% for Electrical Systems and Services.

In Hydraulics, global mobile equipment markets remain weak, and this weakness has being amplified the really stocking in both the OEM and distribution channel.

As a result, we now expect organic revenues to decline approximately 4.5%.

Aerospace remained strong across the board, and we're reaffirming the midpoint of our full year growth estimate of 9.5%.

In Vehicle, global automotive markets remain weak, so we're reducing our organic revenue estimates to be down approximately 10% for the year.

And we've also slightly modified our estimates for eMobility as well, which we think will be a growth of 4% at the midpoint of 2019.

And overall, our long-cycle businesses within ES&S and Aerospace are expected to continue to deliver attractive organic growth rates for the year, while we project low single-digit growth for Electrical Products overall.

Business conditions, I'd say, have clearly been impacted by trade, by the political environment and by, I'd say, a number of one-off events that have weakened our second half outlook.

Maybe as a point of kind of confidence as we look to the future, we'd say, with the fundamentals of the economy still solid: low interest rates, high employment, strong consumer confidence.

And we'd hope that this pullback would be short-lived, but we'll have to wait and see.

Moving to Page 12, we show our margin expectations for the year.

And I think, based upon the strong Q3 margins, we're increasing our consolidated segment operating profit margin guidance 20 basis points to a new range of 17.3% to 17.7%, or 17.5% at the midpoint.

And this includes increasing margins for 3 of our 6 segments: Electrical Products, up by 30 basis points; Electrical Systems and Services, up by 50 basis points; and Aerospace, up by 120 basis points.

And due to expected volume declines, we're lowering margins in 2 of our segments: Hydraulics, by 110 basis points; and Vehicle, by 40 basis points.

With this updated guidance, I'd say that really we're on track to deliver another record year of margins with a strong 70 basis point increase at the midpoint over 2018 despite lower revenues than we anticipated.

And finally, turning to Page 13, we show our guidance of Q4 in 2019.

For Q4, we expect adjusted earnings per share of $1.36 to $1.46.

Other assumptions for Q4 in our guidance include: we think our organic revenue will decline by approximately 2%; we expect segment margins of 17.2% to 17.6%; flat corporate expenses to last year; and an adjusted earnings tax rate of approximately 17%.

We are slightly lowering the midpoint of our full year 2019 adjusted earnings per share guidance to $5.72, $0.09 below the current census due to lower market conditions.

This does still represent a 6% increase over 2018 when you exclude the impact of the arbitration decision.

We're also increasing our operating cash flow guidance by another $100 million.

You recall that we increased it by $200 million so far through this point.

And we now expect to deliver $3.4 billion to $3.6 billion for the year.

This is, I mentioned, the second time that we have increased our operating cash flow guidance, which highlights really the strong cash flow generation capability of our businesses.

For 2019, our free cash flow to adjusted earnings conversion is expected to be over 120%, while free cash flow to sales is expected to -- estimated to reach approximately 14%.

Other full year guidance assumptions include 1% organic growth, $100 million of revenue from the acquisitions of Ulusoy and Innovative Switchgear Solutions; foreign exchange impact of a negative $350 million, and this is actually $50 million worse than our prior guidance; segment margins in the range of 17.3% to 17.7%, up 20 basis points at the midpoint; no change in our tax rate, we think our CapEx spending this year will be roughly $550 million, and this is about $50 million lower than prior guidance.

And we estimate for our share repurchases to be increased to roughly $1 billion, and this is up from our prior guidance of $800 million as we continue to deploy our strong free cash slow.

So overall, I'd say we're very pleased with the company's performance this year.

We’re delivering very strong cash flow, solid EPS growth despite what's turned out to be a much weaker economic environment from any of our end markets.

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

Before we begin the Q&A session for our call today.

I do see we have a lot of individuals that have interest in the queue with questions.

(Operator Instructions) With that, I will turn it over to the operator to give you guys the instructions.

(Operator Instructions)

Okay.

We'll take the first question from Nigel Coe with Wolfe Research.

Obviously, a lot of good detail on the call, but I want -- you did a great job of adjusting to the changing conditions in 3Q, showed us a very nice margin.

You are assuming a margin step down a bit more than normal seasonality into 4Q so I'm just wondering what's driving that, Craig and Rick.

And is there any additional restructuring coming through in 4Q and where do we stand on additional restructuring actions in light of the weaker volumes?

Appreciate the question, Nigel.

And so I mean, to your statement, yes, we absolutely -- we aren't -- if you think about kind of the bridge between Q3 and Q2, where really outstanding performance in Q3.

There's a number of items that are impacting us in Q3 and Q4 that are taking the margins down.

One is a higher level of restructuring, and you could imagine it's largely in those businesses where we're seeing additional market weakness.

We certainly are seeing a higher tax rate in Q4 than we had in Q3.

You saw the operational tax rate of roughly 17%.

In addition to that, there's a few normal factors.

Health care costs tend to run higher in Q4 than in prior quarters.

So there's just a number of kind of, let's say, onetime items that we're dealing with in Q4.

Obviously, we're dealing with the GM strike, it has a little bit of an impact as well in Q4 that take the margins down.

But I'd say that as you think about the outlook for 2020, I'd say a lot of these are onetime items.

And I know that a number of the analysts wrote about extrapolating Q4 into next year, I'd just ask you to keep in mind that there are a number of onetime and seasonal items that are impacting Q4 that you really would not be justified in extrapolating for the full year.

Okay.

That's great color.

We'll dig into the details off-line.

But I do want to just switch to ESS margins, and we were probably 2 years ago thinking that 15% in this business will be a dream, and here you're at 18%.

So I'm just curious, how confident do we feel that you can defend this level of margin going forward and maybe just address what's changed to drive such a high margin?

Yes.

Once again, we agree.

I mean 18.3% is outstanding performance by our team in general.

And as I mentioned in my commentary, really a function of really strong execution by the organization on higher volumes that we saw in the quarter.

And we will clearly need to revisit the long-term margin guidance for our ES&S segment.

If you recall, we talked about the segment performing at 13% to 16% through the cycle.

We're already performing well above those numbers.

And so as we think about giving kind of the outlook for the business and setting expectations, we do believe that this business will perform at that -- at higher levels on a go-forward basis.

Okay.

Good.

Our next question comes from Jeff Hammond with KeyBanc.

So just if you can just talk about kind of where we stand in the destocking for Hydraulics.

And then just are you seeing any destocking in Electrical?

Maybe just speak through where in the guide you're seeing softness within, I guess, particularly EPG?

Yes.

I'd say in terms of Hydraulics, and as we've talked about in our commentary, really we've seen broad-based destocking, significant let's say destocking at the OEM channel as productions continue to run well below retail sales.

And you see that in a lot of the public data.

And also, in distribution, we're seeing the same thing.

I think the question becomes how long did this go on.

We could sit here and attempt to speculate when does this destocking end.

It's really going to be a function of what ultimately happens with the end markets and the end market demand.

I will say that today we take a little confidence in the fact that the end market demand in many of these hydraulic markets around the world are certainly performing okay.

We're talking about, let's say, on average, low single-digit growth in a market like construction, flat to slightly down in markets like ag.

But what we're experiencing as a supplier is our numbers that are much worse than that.

So we take some confidence in that, that we're approaching the end.

But I think ultimately, it will be -- really be a function of what's going to happen with these end markets in terms of destocking in the Hydraulics business.

I'd say in the electrical business, more broadly, at this point we're not really seeing significant destocking in electrical.

What's kind of impacted our growth a little bit in electrical in the quarter was largely project delays, given kind of the uncertain political environment that we're living in right now.

More -- it's been really more of that issue than it's been an issue of destocking.

And certainly, you think about our Electrical Products business, much of which goes through distribution, in periods of uncertainty, they're kind of being cautious around the inventory levels that they're putting on the shelf in general, but not at this point that I'd say a significant amount of destocking.

Okay.

Great.

And then, Craig, I think in past years, you provide kind of initial views on the out-year in the third quarter, and I didn't see anything in there.

Can you just -- anything you can give on kind of how you're thinking about the markets incrementals any kind of nonoperating items and kind of uses of cash around the Lighting sale?

Yes.

I mean your observation is absolutely accurate, Jeff.

We would typically in this call give some kind of insight into 2020.

Given the level of uncertainty in the environment that we're currently dealing with, whether it's trade or geopolitical or some of these one-off customer events, we thought it would be prudent at this juncture not to provide guidance for 2020, to let some of the Q4 play through and that we would then be providing guidance as a part of our earnings call in January.

And so that's kind of the way we're thinking about that.

This question around uses of cash, obviously we sold the Lighting business for -- we will sell the Lighting business for $1.4 billion.

And it would be our intention to use those proceeds to buy back shares.

We'll -- we're going to attempt to be smart and strategic in the timing of the buyback program.

But the intention would be to use those proceeds plus our very strong cash flow-generating capabilities to make sure that we fully offset any dilution associated with the divestiture of Lighting.

Our next question comes from Dave Raso with Evercore.

I apologize, I missed the very beginning of the call.

But for the electrical businesses sort of exiting '19 into '20, the Lighting business is still officially in the guide for fourth quarter for EP, correct?

Just to be clear.

Yes.

Yes.

Okay.

So the orders were up 1% ex Lighting for EP and ESS orders, let's say, overall were probably a little better than people feared.

But can you help us understand what you're seeing beyond the quarter in the sense of are the -- what's in the backlog?

Is that further visibility than normal, shorter than normal?

Just trying to get a sense of can we still count on electrical to start the year healthy?

Because obviously, people are wondering can we get the more cyclical businesses bottoming out at some point in the first half and hope they're all growing together in the end of the year.

Yes.

Appreciate the question, Dave.

The business that obviously we have the greatest visibility to is in our Electrical Systems and Services business.

And I will say that our order input in Q3 was quite strong across the board.

Most of the end markets that we served, I'd say, posted anywhere from mid- to high single-digit order growth in the quarter, which really bodes well, I'd say, for the long-cycle piece of our business with Electrical Systems and Services into 2020.

I think it's too early to make a call on it and that's one of the reasons why we're not providing guidance.

But certainly, if we take a look at the order book and what happened during the course of Q3 in Electrical Systems and Services, we feel very good about the order intake and how 2020 is shaping up.

In Electrical Products, which tend to be much more of a book-and-bill business, as we mentioned, we did see a little bit of conservatism on the part of distribution.

And in that business, it just doesn't tend to be a longer cycle business and so we'll just have to see what happens with some of these other kind of world events and what level of distribution confidence we're taking with us into 2020.

And ex Lighting in the fourth quarter or I should say it the other way, is Lighting down in the fourth quarter?

I'm just trying to -- because I assume that would be out of the business when we give the guide in January and obviously when you're setting up the core business.

What I'd say, and I appreciate the question, Dave, given the fact that we've entered into a transaction and we've signed a -- we would prefer not to comment on Lighting as it's going to ultimately be somebody else's business on a go-forward basis.

And so as we think about lighting on a go-forward basis, we would prefer not to comment on that business given the transaction and the fact that ultimately somebody else is going to own it.

Our next question come from Scott Davis with Melius.

Craig, just to kind of address the elephant in the room, when you have quarters like this where you miss your guidance on the top line, which doesn't happen to this extreme very often, does it make you kind of rethink the portfolio a little bit?

I mean you got Hydraulics and Vehicle that lags you guys around every cycle, and is it worth the headaches?

I mean I'll just leave it at that.

Sure.

I can appreciate the question, Scott.

As we've talked on this call before, we really have, let's say, laid out a criteria for businesses that we like and the conditions under which we think we're going to stay in business and conditions under which we're going to step out.

And I will say that if you take a look at our track record over time, Eaton has done, I'd say, a lot of work around the portfolio, and the Lighting divestiture is the latest example of that.

I will say, at the end of the day.

You think about today, Hydraulics in the quarter delivered 7% of our company profit.

At so at the end of the day, whether Hydraulics grows 5% or shrinks 5%, it really doesn't have a significant impact on the ultimate earnings of our company.

And so we like to think that we're getting some of the execution issues behind us.

And it is a cyclical business, it will always be a cyclical business.

But at the end of the day, what really drives Eaton as we said on the earnings call, 80% of our earnings come from Electrical Systems and Services, Electrical Products and Aerospace, and that's really what drives the company.

And so we will continue to work on our internal plans to improve the execution of Hydraulics.

They know what they need to do in order to continue to deliver and be a value-creating part of the company.

So I'd say, at this point, we're comfortable with the portfolio.

And at the end of the day, we'll continue to focus on the things that we can control inside of the business, recognizing that these will always be cyclical businesses.

And just as a follow-up, I mean I know you mentioned that you've got this $1 billion coming in and you're going to do more buybacks.

But is there -- is this a type of an environment where you want to take another more aggressive look at M&A?

Or is it the type of environment where it's so uncertain that it's better to push it to the right?

We always look at the trade-off, right, in terms of we've been very disciplined over the years around -- in terms of understanding what our cost of capital is, and we think it's roughly 8% to 9%.

And we'd expect the return order of magnitude 200 to 300 basis points over our cost of capital as a minimum.

And so we've been a very disciplined buyer through both -- at all points in the economic cycle.

And we would continue to maintain that, that's the way we'll run the company.

And so for us, it's always going to be a matter of trading off what an acquisition would do for the company, both strategically and in terms of EPS, versus the option that we have of buying back shares at very attractive prices.

Our next question comes from John Walsh with Crédit Suisse.

I wanted to go back to the Aerospace margins, obviously very strong.

I know, a couple of quarters ago, we had a conversation around OE versus aftermarket mix.

But similar to that ESS line of questionings, we are above kind of your through-the-cycle look on that business.

How do you view the sustainability of those really strong Aerospace margins?

Yes.

And I'd say -- I appreciate the question.

And I'd said -- as I've said on prior calls, this has really been a little bit of a Goldilocks period for the aerospace industry overall because you have really strong market demand, you have very strong aftermarket and you have relatively, by historical standards, low program spending.

And so you're seeing the result of that deliver very strong margins.

But that is certainly another one of the segments that we're going to clearly have to take a look at as we provide our, once again, our longer-term outlook for the business in terms of what margins should look like through the cycle.

And clearly, that's one that we'll be revisiting and will likely go up given the level that business is performing at today.

But I'd say today when we think about whether or not 25% margins are pretty extraordinary and the business probably won't perform at that level every quarter, but I will say that we're very comfortable today that the margins in this business will perform at very high levels and very attractive levels for some time to come, and primarily because consumers are continuing to get on planes, and that drives the aftermarket.

The military business is really just kicking into gear right now, and Boeing and Airbus are sitting on very large backlogs and so we think this business will be good for a very long time.

Great.

And then obviously, there's been a lot of questions around capital allocation and the strong cash that's going to be coming in the door.

I know you don't want to get ahead of yourself for next year, but you've historically had this expectation to take down 1% to 2% of float next year.

I mean should we assume that the high end of that is kind of where we should be base-casing it?

Yes.

It's Rick.

I would think of it this way.

Our expectation would be take down 1% to 2% float and then the proceeds from Lighting on top of that.

So you'll end up with considerably more than 1% to 2%.

And this is an important point because one of the things that we committed to you and the investor community in general is that as we think about how we would manage the company during periods of market weakness is that we said that we would use our strong cash flow generation capabilities and our balance sheet to essentially buy back shares to help offset pressures in terms of EPS, and that's clearly what we did in Q3.

And you could expect that, as we look into 2020, depending upon where markets end up, that we'll continue to kind of run the same play.

Our next question comes from Nicole DeBlase with Deutsche Bank.

So maybe just the first question around the increase in the operating cash flow guidance.

I guess key drivers of that?

It looks like the receivables balance is down.

Inventory is up a little bit.

So just trying to reconcile where that's coming from.

You're right.

Working capital was very strong.

If you look at the combination of receivables and payables, the change from Q2 to Q3, you're just shy of $200 million.

And so we have done a good job all year at managing working capital.

We expect that to continue into Q4.

And already, our initial thinking about next year would have further improvements.

There's a variety of programs relating to, for example, correcting any billing inaccuracy that makes a big difference in receivables, but also on payables, making sure that we are paying our suppliers in a commercially reasonable time frame.

And we believe we have further opportunities to improve both receivables and payables.

And to your point, Nicole, inventories actually are up slightly.

And typically, when you're phasing into an economic downturn, we typically take inventories out of the organization.

So we quite frankly have a big opportunity still out in front of us in terms of really reducing our overall inventory levels.

And so to Rick's point, we would expect 2020 to be another year of very strong cash flow.

You actually just pre-answered my second question, so I guess I'll move on.

Any thoughts on the monthly progression of organic growth throughout the quarter?

Did things get a lot worse for you guys in September?

And then I guess anything initial that you have to say on October relative to the guidance that you've provided today for the fourth quarter?

Yes.

I'd say that one of the things -- I was out at the investor conference, Nicole, in Laguna, and I kind of indicated there that we've already seen really in the first couple of months of the quarter some market weakness, which really I'd say persisted throughout the quarter.

So I'd say, no, not particularly.

September wasn't a particularly weaker month than the other 2 months in the quarter in terms of the progression and how it unfolded.

And in terms of October, I'd say what we've seen so far is largely consistent with the forecast that we provided.

Our next question comes from Joe Ritchie with Goldman Sachs.

So Craig, I wanted to touch on the just the disconnect between what you're seeing on the order growth side on ESS and what you're expecting from a growth perspective, and you mentioned in your prepared comments project deferrals.

And so I would love to get a little bit more color on where you're actually seeing project deferrals and how that kind of plays out into 2020.

Yes.

And what you referred to as a disconnect, I would say, largely, if you think about the Electrical Systems and Services business, it does tend to be a longer-cycle business.

And so if you -- probably the best proxy for what we would expect for that business in the fourth quarter probably would have been orders that we received in Q2 of 2019.

And if you recall, we had a relatively weak order intake in Q2, so there is a time lag to that business, but once again, to your point, we did see very strong orders in Q3, and we think that does bode well for 2020.

And so that's really the way I would think about that.

And the second half of your question was with regard to the...

How that plays -- yes, just basically how that played out for 2020.

And I mean I guess if I were to kind of ask a clarifying question, are you seeing any cancellations in your orders at all?

Or is it just really just deferrals at this point?

Yes.

I'd say mostly deferrals.

There's always the oddball cancellation that you would always see in these businesses, but I'd say nothing that increased significantly.

Most of it is really delays.

Okay.

And then I guess...

That's particularly true on the larger industrial projects.

Okay.

Got it.

I guess my one follow-up and somebody asked this earlier, but I wanted to see if we can get some type of quantification.

On the aero margins, what's the expectation for R&D stepping down, both this year and then into 2020?

Yes.

I'd say with respect to R&D, we've already seen the step down in R&D that's currently reflected in our businesses.

And so today I'd say we're probably running with respect to R&D as a percentage of revenue, probably running right now at historically low levels, primarily a function, once again, of new platform development from our customers, both on the commercial and the military side.

And so I would not expect an additional step down in R&D spending.

It's really already reflected in the business's run rate today and in our earnings today.

Our next question comes from Jeff Sprague with Vertical Research.

Just a question on restructuring and I'll wrap it around Lighting a little bit.

I mean is there -- just elaborate a little bit on what you're doing on the restructuring front.

Maybe help us think about how much additional there is in Q4?

And is there kind of a stranded cost element with Lighting that we should be thinking about?

Yes.

I'd say that if you think about kind of the incremental restructuring in Q4, I mean the order of magnitude, Jeff, we're talking about a couple, $0.02 to $0.03 or so on Q4 from where we've been.

And then the Lighting, I think the source of that question is what do you do with the stranded costs, right?

You sell a $1.7 billion business, obviously, there's some stranded costs associated with that.

And we would fully expect to deal with all of the stranded costs.

And so we will obviously -- in the context of the overall restructuring number that we put up and the cost of the exit, we talked about a $200 million of cost associated with the exit of Lighting, embedded in that number was cost to deal with stranded costs, both at the corporate level and also inside of Electrical Products.

And so we would expect to fully deal with the stranded costs inside of the business.

Could you also elaborate a little bit, and I don't know if you need to pull it apart, EP versus ESS?

But just kind of the trajectory of price in your business and just kind of the price/cost algorithm looking into Q4 and the early part of next year?

Yes.

I'd say that what we've always said around price/cost is that we're net neutral.

And that's really today, I'd say, where we ultimately will end up.

We certainly, I think, were slightly positive in Q3, just slightly positive.

But we would expect, once again, on a go-forward basis, that commodity cost inflation, tariff-driven cost increases that the company will fully offset that and we'll do a better job of making sure that we're getting price at the same moment that we're experiencing the cost.

But we'd really expect it to be net neutral to Eaton, overall.

Our next question comes from Andrew Obin with Bank of America.

Yes.

Just great execution.

Just a question on Hydraulics.

As we think about production costs at CAT and D.R., when do those get incorporated into your revenues?

Are we seeing some of them in Q3?

Or is that something we're going to see in Q -- when do we see the bulk of it?

That's what I'm...

Yes.

So we typically -- I appreciate the question, Andrew, as well because it's what we've been dealing with.

We typically would run about 90 days in front of our customers in terms of whatever they're forecasting in Q4, we would have experienced in Q3, just given the lead time all the way back through the supply chain on many of the components that we're sourcing.

And so we -- and this is typical, by the way.

If you take a look at this business over time, we typically see an outsized impact, both on the way up and on the way down when our big OEM customers go through these periods of a market correction.

Got you.

And then a question in terms of shortfall, I know there was a quote from you that you were expecting 3%, you got 1%.

And I know you gave it to us by end markets, but can you just give a big geography buckets, which one disappointed the most?

Unless it's obvious, I mean...

Sure, sure.

I'd say that in terms of end market, specifically, it really was a downshifting in the growth rate, I'd say.

The biggest market for us is always the Americas, the U.S. market.

And I'd say...

Yes, that's what I was referring to.

Yes.

Yes.

And growth, still positive growth for sure across the board.

But certainly, we saw a downshifting in the rate of growth in the Americas.

We saw it in our Electrical Systems and Services business, in large projects.

We saw it in the distribution channel on Electrical Products.

We saw a downshifting in growth in the oil and gas space, specifically in our Crouse-Hinds business.

Our next question comes from Chris Glynn with Oppenheimer.

So on Hydraulics with the restructuring kind of back tailing a little more in the fourth quarter and some comments about moving past inefficiencies.

Just wondering, though, can you raise margins a little on moderately down revs next year and is the 13% kind of the bottom of your through the cycle range?

Do you see that as being attainable?

Yes.

And I think -- I appreciate the question.

And the goal that we set for this business, 13% at the bottom of the cycle, we think is absolutely the right goal for the business and we think it's certainly attainable.

I think the real question becomes where do these markets ultimately bottom out at.

But I think it would not be an unreasonable expectation that the business delivered 13% margins at the level of economic activity that we're seeing right now in the business.

Okay.

And then a bookkeeping one.

Any early kind of notional comments on the corporate guidance for next year?

Should we just leave it comparable?

Well, we've got to work through our planning.

As a general matter, we have been quite successful at holding our corporate costs flat year to year, and in down years, taking it down a little bit.

So that will give you some color.

Our next question comes from Ann Duignan with JPMorgan.

Most of my questions have been answered.

Maybe on -- if I look at the ESS technology momentum index has been weak all year, up a little bit in September.

But that reflects just new projects being considered and should be a good leading indicator for ESS for next year.

Where is the disconnect that you guys are seeing?

Is it maybe not momentum -- the momentum index, but you're seeing the actual Dodge data improve and that's subscribing current orders.

Yes, and I'd say I appreciate the question, Ann, because we spend a lot of time, obviously, internally trying to figure this one out as well.

It is a long-cycle business playing across a very wide set of end markets.

And I'd say that a lot of the macro data, to your point, and what we saw certainly in our own order book in Q3, was quite positive.

And with orders up 5% on a rolling 12 and 8% excluding data centers, those are pretty, pretty strong numbers.

And I'd say you can always find in this business that at any given quarter, you could end up with numbers that vary from the kind of the longer-term or medium-term growth rates.

And I think what we experienced in Q3, as we indicated, was just largely a pullback in large projects and some product delays and a bit of slowdown on oil and gas.

But certainly, what we've seen in Q3 and what we've seen in most of the macro indicators for this business, nonres construction continues to do well across the world.

I mean a little bit of moderation in the growth rates, but still growth.

And so we remain optimistic about the prospects for this business.

Okay.

I appreciate the color.

And then just a follow-up on eMobility.

You normally report the material revenue wins that's accomplished.

Could you update us on that?

Yes.

And in this quarter, Ann, I'd say we haven't had any new material wins in the quarter so what we try to do in this business, as you know, these wins come in large chunks and as we get large material wins, we'll be sure to update you on how we're doing.

But by and large, we continue to be very optimistic.

The business, as we reported historically, we're ahead of the schedule we originally set out for the business.

And we're still extremely confident in our ability to create a $2 billion to $4 billion new segment for the company.

Okay.

And I have from last quarter that your material revenue wins were about $390 million, is that still what I should think about?

Yes.

I mean they would have moved up slightly from that, Ann.

But we'll try to just report material wins.

When the number moves in a material way, we'll give you an update.

Our next question comes from Julian Mitchell with Barclays.

Maybe just a first question around these ESS incrementals.

Very, very good performance.

Just wanted to make sure there was nothing particular you saw around mix or something as a tailwind that you think would fade or whether you think this is just normal course of business and reflects sort of good project discipline.

I'd say that we obviously took a strong look ourselves at this business because the margins at 18.3% are very, very, very high and above our own expectations.

And no, we did not see favorable mix in the quarter.

We looked at that issue specifically and it wasn't mix, it really was largely this strong execution in the quarter.

And obviously, there's always a mix of projects in any given quarter in the ES&S.

And so -- but no, there wasn't -- no particular unusual onetime events that drove the performance.

That's helpful.

And then secondly, maybe switching to Electrical Products, you do have some reasonably large industrial and industrial controls exposure within EP, particularly now that Lighting is coming out.

Maybe talk about that more industrial piece of EP, how you saw demand trends there in recent months and if you're expecting Q4 demand in that industrial piece of EP to be any different in Q4 than Q3.

Yes.

We appreciate the question.

I mean, without a doubt that the weakest piece of the business today year-to-date, and what we're forecasting is really what's going on in industrial markets in the manufacturing sector.

And we generally talk about that being about 1/3 of the business itself and so it's a big material segment for us and we clearly have continued to see weakness in the industrial controls part of the business.

Yes.

And that was true, Julian, both on the sales and the orders in the third quarter.

Our next question comes from Bob McCarthy with Stephens.

Rob McCarthy here.

I guess the first question I would have is in thinking about the sale of Lighting, I mean I think it was 7.5x trailing, it was certainly less than that on a forward basis.

Horseshoes and hand grenades paid between 11 and 12x for Cooper even if that was like at a company average.

I mean, yes, it's good to have certainty of what you're talking about.

But this isn't exactly value-creating if you're buying assets at 12x and then jettisoning them at 7.5x trailing, call it, 7 or 8 years later.

So I mean, do you think that this kind of activity kind of belies the fact that perhaps you should look -- take a look -- a harder look at breaking up the company?

Well, Rob, let me just address that.

I don't think your perspective is exactly correct.

I mean to give you an idea, the Lighting business, when we bought Cooper, was just under $1.2 billion and now it's $1.7 billion, so we've grown the business quite significantly over the time period.

And if you look at and if you sort of disaggregate what we paid for the Lighting business as part of Cooper, it's not an awful lot different than what we sold it for.

And we thought that the business could migrate in certain ways and nailed closer to the broader electrical franchise, and it really has not, and that's one reason we believe it's more appropriate as part of another lighting enterprise or possibly as a public company, which was our original game plan.

But we would argue that we haven't dramatically impacted value in the case of Lighting.

It has happened sometimes, businesses don't end up developing in a way that you expect.

All right.

And then in terms of the cash generation of the businesses, I mean in the context of how you're thinking about your trough and the cash EPS trough, certainly, I think you would highlight, rightly so, strong cash conversion, overall.

Are you still subscribing to the kind of the trough and the way to think about the trough as you articulated earlier in the year?

And has anything changed there with respect to either cash generation in a down cycle or the trough itself?

Can we rely on that as a kind of anchor to win work, particularly as we go into a tougher macroeconomic environment?

If you're talking about, by trough, will our cash flow change markedly in a down year, we still believe it's not likely to.

And simply because we liquidate working capital that offsets the profits lost through a lower volume.

So even if we had a down year at some point in the next couple of years, we don't think you'd see a marked change in cash generation.

And one thing I -- just one other point I would like to make about cash flow, I think it's important.

If you think about our free cash flow in 2019 based on the guidance we've given and you look at the -- that compared to 2018, we're guiding to up 23%, and I think that's a pretty notable number.

At the end of the day, the real value of most businesses is the cash they generate.

And we're generating really attractive increases in cash flow in '19 and we would expect continuity in that cash generation next year.

And absolutely, cash flow is very strong.

I guess what I was alluding to specifically was the framework I believe Craig laid out for a trough scenario.

Are you still subscribing to that?

Yes.

Yes.

Yes.

You're talking about could we -- can we have at least flat EPS in a trough year.

And we continue to believe that, that is the base case plan.

And the only caveat we'd add is that we've said post the spin off or sale of Lighting and post this divestiture of FPD, we expect to have the FPD transaction done by the end of the year and Lighting sometime in Q1.

But post those transactions, we absolutely have the plan and fully are committed to delivering flat EPS, during what we call a typical economic recession, which we define as 2 to 3 quarters of GDP contraction.

Good.

Our last question comes from Deane Dray with RBC.

I was hoping to get a spotlight on a specific geography and a vertical.

What can you tell us about China, the tone of business, the outlook?

And then data centers has come up during the call, any specifics there in terms of the outlook?

Yes.

We appreciate the question, Deane.

I think, China, if you think about across the broad swath of businesses that we deal with, maybe I'll deal with the positive, first.

I'd say kind of the nonres construction and quite frankly even res construction in China actually continues to perform very well.

I mean you see some of this data as well, but office starts in Q3 were actually up 10% and are up 16% year-to-date.

Residential starts are up 6% in Q3 and 9% year-to-date.

And so the whole kind of construction market in China is doing well.

And quite frankly even on the Hydraulics side, excavator sales continued to grow quite nicely in Q3, up 16% in excavators and up 7% in wheel orders, and so that piece of the business in China is actually doing quite well.

By contrast, light motor vehicle production is down quite significantly, down 7% in Q3 and 12% year-to-date as well as heavy-duty truck production is about flat.

And so it really is a very different story depending upon which end market you're referring to.

But in the most important part of our company, let's call it the electrical side, nonres construction in the market is holding up quite well.

And then specifically the data centers, as we mentioned in the opening commentary, in our data center business performed very well in the quarter.

We ended up seeing high-single-digit growth in data centers and so that market continues to perform very well.

And as we've mentioned on other earnings calls that the hyperscale stuff does tend to be lumpy and we continue to see that lumpiness.

But by and large, we continue to see very good growth in data centers.

Great, great.

Just last one for me, the lowering of the CapEx by $50 million, is there any story behind that?

No, I'd say that is really us fine-tuning the outlook for the year.

We -- our businesses tend to be a little optimistic over the course of the planning process around what they can get done.

That's really just largely a true-up.

We've not done anything to put any clamps on our CapEx spending.

We're still spending on every program that we can get done.

Great.

Thank you all.

We have reached the end of our call and we do appreciate everybody's questions.

As always, Chip and I will be available to address any follow-up questions.

Thank you all.

Have a good day.

Yes.

Thank you.

Ladies and gentlemen, that does conclude your conference for today.

Thank you for your participation.

You may now disconnect.