江森自控 (JCI) 2016 Q2 法說會逐字稿

Welcome to Tyco's second-quarter 2016 earnings call.

(Operator Instructions)

This call is being recorded.

If you have any objections, please disconnect at this time.

I will now turn the call over to Antonella Franzen, Vice President of Investor Relations.

Good morning, and thank you for joining our conference call to discuss Tyco's second-quarter FY16 results, and the press release issued earlier this morning.

With me today are Tyco's Chief Executive Officer, George Oliver, and our Chief Financial Officer, Robert Olson.

I would like to remind you that during the course of today's call, we will be providing certain forward-looking information.

We ask that you look at today's press release and read through the forward-looking cautionary informational statements that we've included there.

In addition, we will use certain non-GAAP measures in our discussion, and we ask that you read through the sections of our press release that address the use of these items.

Today's call is not intended, and does not constitute an offer to sell, or the solicitation of an offer to subscribe for, or buy securities of Tyco or Johnson Controls.

Select subject matter discussed on today's call is addressed in a joint proxy statement and prospectus that has been filed with the SEC.

We urge investors to read it in its entirety.

Information regarding the participants in the proxy solicitation is contained in each Company's annual proxy materials, filed with the SEC.

The press release issued this morning and all related tables, as well as the conference call slides, which George and Robert will refer to, can be found on the Investor Relations portion of our website at Tyco.com.

In discussing our segment operations, when we refer to changes in backlog and order activities, these figures exclude the impact of foreign currency and divestitures.

Additionally, references to operating margins during the call exclude special items, and this metric is a non-GAAP measure, and is reconciled in the schedules attached to our press release.

Also, I would like to remind everyone that beginning last quarter, restructuring and repositions charges are included within our reported earnings per share before special items.

These charges are shown as a separate line item below segment operating income.

The prior-year results have been recast to conform to the current-year presentation.

The quarters of FY15, including restructuring and repositioning charges, as well as the related tax impact, are included in the appendix to the slides.

Now, let me quickly recap this quarter's results.

Revenue of $2.3 billion in the quarter declined 4% year-over-year on a reported basis, driven primarily by a 4% headwind from changes in foreign currency.

Organic revenue declined 1% in the quarter, and net acquisition and divestiture activity contributed 1 point of growth.

Earnings per share from continuing operations attributable to Tyco ordinary shareholders was $0.33, and included net charges of $0.12 related to special items.

These special items were primarily composed of a loss on a divestiture, and merger-related costs incurred in the quarter.

Earnings per share from continuing operations before special items was $0.45 per share.

Now, let me turn the call over to George.

Thanks Antonella, and good morning, everyone.

Before we get into the details of the quarter, let me spend a few minutes on our proposed merger with Johnson Controls.

Starting with slide 5, integration planning is well underway, and we have made significant progress towards our day one plan.

The integration teams are very engaged, and are working extremely well together, as we begin setting the foundation of the combined Company.

The preliminary Form S-4 was filed with the SEC in early April.

We received HSR approval in the US, and we are if the process of obtaining approval with all necessary regulatory authorities around the globe.

Additionally, the debt financing related to the cash consideration component of the transaction is in place.

It is ready to be executed upon close.

As we confirmed in last week's 8-K filing, we are proceeding with the merger, and remain highly confident in achieving the $650 million of previously-announced synergies within the first three years.

The strength of this transaction is the compelling value created by the strategic combination of the leading player in commercial HVAC and building controls, with the leading player in commercial fire and security.

It's through this combination that we will be able to solve customer problems, via enhanced service offerings, including increased use of data analytics.

In addition to the commercial benefits at the customer level, there is also significant value created for both Tyco and Johnson Controls shareholders, through the $650 million of synergies, and the stronger financial profile of the combined Company.

We have spent a lot of time with Johnson Controls' management and employees over the last few months, and are more excited now than ever regarding the value creation potential of the new combined Company.

Shifting gears to the quarter, let's move to slide 6. Organic revenue declined 1% in the second quarter, driven by pressure in our short cycle product businesses.

This resulted in mix pressure, on top of typical volume deleverage.

Our integrated solutions and services teams delivered better than expected margin performance in the quarter, offsetting some of the volume and mix headwinds within our global product segment.

Notwithstanding the revenue decline and difficult year-over-year comparisons in several of our higher-margin businesses, the underlying segment margin before special items improved 10 basis points over the prior year, when adjusting for non-cash purchase accounting.

We remain disciplined on controlling costs and focused on productivity initiatives to mitigate pressure to the bottom line.

Turning to slide 7, let me spend a few minutes on what we are seeing in a few key regions.

We saw continued momentum in the US market, with stable growth in non-residential construction verticals year-over-year.

We had another strong quarter of install order activity, with solid growth in our commercial, government, and institutional verticals.

As expected, activity in Western Canada remains soft, due to the high hazard heavy industrial end markets.

Over the last few years, our North America teams have done an impressive job of improving operating margins, taking significant actions to improve the efficiency of our operations, while positioning the business for growth.

During the second quarter, we executed the next phase of integration, with significant structural changes combining fire and security into a simplified organizational structure, taking the business to the next level of margin expansion.

This frees up resources to be reallocated into the commercial structure, which we are starting to see the benefits of in our order rates.

The new organizational structure will position the business to better drive growth, increase profitability, and improve customer satisfaction.

Moving to Europe, although the macroeconomic environment remains sluggish, we are seeing improved order activity, which coupled with the existing backlog, should drive second-half revenue growth.

Additionally, we expect the actions that we have taken to streamline the businesses to lever quite nicely, to deliver incremental earnings in the second half.

In Asia, although recent economic indicators out of China have improved, business conditions across the region remain challenged.

We are seeing particular softness in the high hazard, heavy industrial space, as well as the hospitality vertical.

Although we do not expect improving market conditions in the region, year-over-year comparisons do ease as we progress during the year.

Lastly, Latin America continues to be an area of strong execution and organic revenue growth, driven by our subscriber business.

Now, let me spend a few minutes on our growth investments.

We continue to make great progress, despite the global macroeconomic environment.

We remain committed to a higher pace of new product innovation and introduction.

Let me mention a few examples on slide 8. Just last week, I participated in a launch event for Scott Sight, an industry-first in-mask thermal imaging system, used by first responders.

Scott Sight integrates a small camera and infrared screen into the face mask.

This allows the firefighter increased visibility in dark and smoke-filled rooms, leaving their hands free to perform critical rescue operations.

Scott Sight is the first commercial product resulting from our Firefighter of the Future initiative, utilizing our adopted lean startup culture.

This creates a platform to accelerate future capabilities to provide enhanced situational awareness for first responders.

Within fire protection products, we continue to launch new reformulated fire suppression foams, to conform to new industry standards, with a chemistry mix that is better for the environment.

Our history as a leader in this space is continuing, as we make our products the safest in the market for first responders, and among the safest in the market for the environment.

We also launched several new security products during the quarter, some of which were debuted at ISC West in early April.

Within our access control portfolio, we launched a new version of our software house C-Cure 9000 enterprise security management platform, the industry's fastest and most secure credential management solution.

This software platform allows you to integrate all aspects of fire, security and other building management capabilities for streamlined event management, and better command and control when time matters.

This upgrade enhances the user experience, and reduces operating cost.

In addition to our product launches, we are progressing well within the new rollout of our salesforce.com platform, which we refer to as E3.

Phase one of our two-year rollout began in our UK business in October, and early results are very encouraging.

More recently, we have expanded the E3 rollout to our Continental Europe businesses.

In summary, we continue to make significant strides in improving the fundamentals of the business.

We are investing for future growth for a streamlined organization in North America, with a combined focus on service and installation, accelerating our product and service innovation, and expanding and executing our E3 program, driving commercial excellence.

As a result of these initiatives, our order pipeline and backlog continue to build, which position us well for increased growth in the second half of this fiscal year.

With that, I'd like to turn the call over to Robert to walk through the details of our second-quarter results.

Thank you, George, and good morning everyone.

Let's begin with an overview of the quarter, starting on slide 9.

Revenue of $2.3 billion declined 4% year-over-year on a reported basis, including a 4% headwind from foreign currency.

Acquisitions contributed 4 percentage points of revenue growth, which was mostly offset by a 3% decline from divestitures.

As George mentioned, organic revenue declined 1%, driven by softness in our global products segment.

Before special items, segment operating income was $311 million, and the operating margin was 13.3%, which included a 40 basis point headwind related to non-cash purchase accounting.

Excluding purchase accounting, the segment operating margin improved 10 basis points year-over-year, as net productivity benefits more than offset the negative mix.

Overall, earnings per share before special items decreased $0.05 over the prior year, primarily related to a $0.04 discrete tax benefit in the prior-year period.

Excluding the discrete tax item in Q2 FY15, EPS before special items declined by $0.01, primarily due to volume deleverage and mix.

Productivity savings and lower restructuring in corporate expenses helped to offset the impact of FX and incremental purchase price accounting.

Turning to orders on slide 10, total orders increased 7% year-over-year, with 3% growth in service, a 16% increase in integrated solutions, and 3% growth in products.

Total backlog of $4.65 billion increased 2% on a quarter sequential basis, and 7% year-over-year.

Excluding acquisitions, backlog increased 3% on a year-over-year basis.

Now, let's get into the details of each of the segments.

Starting first with North America Integrated Solutions & Services on slide 11, revenue in the quarter of $947 million was relatively flat on a reported basis.

Organic revenue was slightly positive in the quarter, driven by 1% growth in integrated solutions.

A 1% contribution from acquisitions was fully offset by the negative impact of the weaker Canadian dollar.

Before special items, operating income in the quarter was $131 million, and the operating margin improved 60 basis points year-over-year to 13.8%, including a 20 basis point headwind related to non-cash purchase accounting.

Underlying margin expansion of 80 basis points resulted from the improved execution, and the benefits of productivity initiatives.

Total orders grew 7% year-over-year, representing another solid quarter of growth.

This included a few large jobs in the quarter.

However, when you adjust for prior year as well, base order momentum is in the 6% range.

Total backlog of $2.57 billion increased 4% year-over-year, and 2% on a quarter sequential basis.

Turning to slide 12, rest of world Integrated Solutions & Services, revenue of $768 million decreased 9% year-over-year, driven by a 9% unfavorable impact from FX.

Organic revenue declined 1%, as 1% growth in service was more than offset by a 3% decline in integrated solutions.

Acquisitions contributed 8% to revenue growth, which was mostly offset by a 7% headwind from divestitures.

Before special items, operating income was $77 million.

The segment operating margin declined 60 basis points year-over-year to 10.0%, including a 40 basis point headwind related to non-cash purchase accounting.

The underlying margin decline of 20 basis points was driven by the mix of revenue decline, partially offset by productivity benefits.

On a sequential basis, the operating margin expanded 50 basis points off a lower revenue base.

We continue to expect increased margin expansion on a sequential basis as we progress through the second half of the year.

Turning to order activity in rest of world, year-over-year orders increased 11%, with 6% growth in service, and 18% growth in integrated solutions, driven primarily by acquisitions.

On an organic basis, rest of world orders increased 3% year-over-year.

Backlog of $1.91 billion grew 13% on a year-over-year basis and 3% on a quarter sequential basis.

A majority of the improvement in the year-over-year period was driven by the consolidation of our joint venture in the Middle East.

On an organic basis, backlog increased 5% year-over-year.

Turning to global products on slide 13, revenue of $616 million declined 4% on a reported basis.

A 2% benefit to revenue from net acquisition activity was more than offset by a 3% decline related to FX.

Revenue declined 3% organically, partly due to a difficult comparison of 7% growth in the prior-year period.

You may recall that Q2 FY15 was the last quarter that benefited from the timing impact of the Scott Air-Pak X3 shipment in the life safety business.

As George noted, we saw a bit of pressure in our short cycle businesses within life safety and fire protection products, related to some delay in municipal spend, as well as additional softness in the high hazard heavy industrial sector.

We are seeing signs that this has stabilized, and we expect product organic revenue growth to be flat to up 1% in the second half.

Before special items, operating income was $103 million, and the operating margin declined 150 basis points to 16.7%, including a 50 basis point headwind related to non-cash purchase accounting.

The underlying margin decline of 100 basis points was driven by volume deleverage and product mix.

Product orders increased 3% year-over-year, driven by acquisitions.

Now let me touch on a few other items on slide 14.

First, corporate expense before special items was $46 million for the quarter, a bit better than we expected.

We now expect corporate expense before special items to be approximately $200 million for the year.

Next, our effective tax rate before the impact of special items was 17.3% for the quarter.

We expect a similar tax rate in the second half of the year.

Moving to restructuring and repositioning activities, we incurred charges of $16 million for the quarter, of which $9 million was related to restructuring actions.

We expect restructuring and repositioning charges in the third quarter to be approximately $20 million.

For the full year, we now expect restructuring and repositioning charges to be in the range of $70 million to $85 million.

Turning to cash flow, we continued to make progress in converting our income to cash.

We generated adjusted free cash flow of $242 million in the quarter, representing 126% conversion rate.

Year-to-date, we have generated $411 million in adjusted free cash flow, which represents 111% of adjusted net income from continuing operations.

Before I turn it back over to George, let me provide you with a quick update on the IRS litigation.

We continue to work closely with the IRS on finalizing our agreement to resolve the previously-disclosed intercompany debt issue.

With respect to the tentative resolution, we made a cash payment of $122 million in the quarter, pursuant to the tax sharing agreement.

We expect final resolution within the next few months.

Now, let me turn things back over to George.

Thanks, Robert.

Let's turn now to our outlook for the balance of the year.

As I noted earlier, we expect our results to be stronger in the second half of the year, driven by incremental revenue and increased productivity.

Starting with the third quarter on slide 15, we expect organic revenue growth to accelerate to the 1% to 2% range, driven by backlog conversion in our integrated solutions and services businesses.

Given current exchange rates, we expect a year-over-year FX headwind of approximately $80 million, or 3%.

In total, we expect revenue of approximately $2.4 billion.

We expect the segment operating margin before special items to be similar to the prior year, including a 20 basis point headwind related to non-cash purchase accounting.

Excluding purchase accounting, we expect the segment operating margin to improve approximately 20 basis points year-over-year.

On a sequential basis we expect operating margin improvement in all three segments.

Taking all of these assumptions into account, as well as the expectations for corporate expense and restructuring and repositioning that Robert provided, we expect earnings per share before special items in the third quarter to be in the range of $0.52 to $0.54, based on a weighted average share count of 429 million shares.

Turning to slide 16, I want to remind everyone that the full year and fourth quarter of FY16 include an extra week of results compared to the prior year.

In order to reflect the true underlying organic growth of the businesses, the impact of the 53rd week is not included in organic revenue.

We expect that the addition of a 53rd week will contribute approximately $90 million of incremental revenue and $0.04 to $0.05 of earnings per share.

Based on our first-half results and our expectations for the remainder of the year, we are tightening our full-year earnings per share before special items guidance to a range of $2.05 to $2.10 as noted on slide 17.

Thanks for joining us on the conference call this morning.

And with that, operator, please open the lines for questions.

(Operator Instructions)

Our first question is from Mr. Jeffrey Sprague of Vertical Research Partners.

Your line is open.

George, I was hoping I could drill into products a little bit more, and just want to understand the trajectory from here primarily.

But if I look at Q2 on a year-over-year basis and try to adjust for the purchase accounting, it looks like the decrementals were in the 40s, which sounds reasonable.

But you did have actually a pretty meaningful profit lift sequentially on similar revenues.

And then as I look into Q3, in aggregate, you're not talking about a lot of margin improvement, and I'm just wondering if you could piece together for me how to think about products moving forward and really what role products is playing in the margin outlook for Q3?

Sure.

What I would start with, Jeff, is to look at the total year first half, second half.

And so in the first half, in our product businesses, we were estimating that we'd be down 1% to 2%.

We're down 1% to 2% with modest increase in the second half.

First quarter played out a little bit better.

Second quarter didn't play out as expected, which has created the pressure here in the second quarter.

When you look at the margins we had on the volume deleverage and mix, it would equate to about 140 basis points of impact with that reduced volume.

And then within that, we also had 40 basis points of productivity.

So that 100 basis points net, combined with the 50 basis points of purchase price accounting, is what led to the margin decline in the second quarter.

Now, looking forward, we get back into roughly -- we start to grow in the third and fourth quarter for the total year, to be the second half, up about 1%.

And so as we begin to go forward, we have continued productivity coming through.

We get the leverage of the volume.

We've got a number of new products that are being launched, that are priced at a higher price, higher margin.

And as you play out the second half, we truly believe that we're positioned to get back to roughly a total year margin rate of about 18%.

Okay, and then maybe just switching gears for Robert, I understand you're trying to finalize with the IRS, but do the Treasury rules that were announced on April 4 in any way change the dialogue, change the rules of engagement on trying to get this settled and wrapped up with them?

Yes, Jeff, they don't change that dialogue.

Our dialogue with the IRS has been very positive, and we're moving forward to revolving that completely.

As you might recall, the Treasury regulations, the proposed regulation are on a go-forward basis, so they don't impact the disputes on the intercompany debt, which was related to a prior period.

Thank you.

Thank you.

Our next question is from Josh Pokrzywinski of Buckingham.

Your line is open.

Just kind of following up on your earlier comments, George, on some of the early integration planning wins with Johnson Controls, maybe talk about specifically where you are seeing enhanced opportunity.

Obviously, it's fairly early in the process, but both yourselves and JCI sound a bit more sanguine on some of those opportunities.

Anything specific to call out, as maybe being a driver of that?

Josh, as I said, I'm very pleased with the progress we're making.

I'm very impressed with the team that we put together, especially with the JCI participants.

Through the process, Alex and I are developing a very strong relationship, and are staying very close to all of the teams we put into place.

We've got a regular cadence working with each of these teams, and the more that we learn and the more that's coming out of these teams, the more excited I am relative to the opportunities that I see.

And so as we laid out the synergies, the $650 million of synergies, we start with $150 million of tax synergies, and then operationally, you can break down the $500 million, which are $150 million of corporate cost headquarters type costs, that get eliminated.

We get about $100 million of leverage with the combined buy, which is significant, and then there's roughly about $250 million of synergies across the operations.

What I would tell you is within each of our teams that we have working across each of the functions, as well as our go-to-market team that's working closely with getting a better understanding on how we begin to get revenue synergies, we're making great progress, and I think the pipeline that we have not only gives me confidence that not only we'll deliver on the $650 million, but potential more opportunities beyond that.

That's great.

Just to follow up a little bit on Jeff's earlier question, just with the margin bridge, 3Q to implied 4Q, anything in North America or rest of world that we should keep in mind as a moving item 3Q to 4Q?

The one thing to keep in mind is the impact of the 53rd week.

Clearly, there will be more volume across all three segments that will give you more leverage across the board.

Also, as you noted in the bridge that we have in the slides of the first half, second half, the other thing to keep in mind is there's incremental productivity in the second half of the year versus the first half of the year, and that also stretches across all three segments and will help the margin.

All right.

Thanks a lot.

Our next question is from Steve Winoker.

Your line is open.

I just wanted to follow up on those existing topics that have been raised.

First, on the tax front, just making sure I understand this.

That $3.9 billion payment to JCI shareholders, how are the Treasury rules that have been issued in any way affect the treatment of that payment, insofar as the ownership structure is concerned?

Steve, this is Robert.

The regulations don't affect that, and that is external debt.

So that wouldn't be affected by the proposed regulations.

Okay.

Fine.

And earnings stripping rules going forward, as you're thinking about tax rate?

We've given guidance in the 17% to 18% range, and I think that's still very good guidance for the foreseeable future.

We don't think the earnings stripping issue will impact us for several years.

I would add that when we think about tax rates and tax planning, it's really a global effort, and remind everyone that we file taxes in over 60 countries.

So while the US is important, it's just one of the 60 countries.

Okay.

Fine.

And George, on global products, on the top line side of this, and maybe it's a more strategic question here, I know you were comping, what was it mid-teens in security products, and you had the Scott Pak headwind.

But when you think about the pace of growth here and the new product introductions, the examples that you gave, what does it take to get this business unit to start to see the financial organic growth live up to what seems like a bunch of very strong secular drivers.

How much of this is this just end market headwind, in harsh and hazardous?

When can we as shareholders expect to see a meaningful step-up?

Steve, as you know, over the last -- up until last year we had a great track record going on products, where both organically, as well as with the acquisitions we made, we were delivering strong mid to upper single digit growth.

And what has happened here is that the end markets, mainly the heavy industrial, high hazard, it makes up about 25% of our products.

And so last year, we certainly saw the impact initially from oil and gas, but that has expanded across pretty much that revenue base.

And so as we get into the second half of the year, we certainly have a better compare.

And then with the investments we've been making into new products, and the lift that we begin to get from those new products, we should be able to get back to, with a normal compare, get back into, as we get into 2017, into low to mid single digit organic growth, and then complement it with the acquisitions we've made.

I've been around these product businesses for 10 years.

These product businesses are executing extremely well.

We'll have a record number of new product launches this year.

And so if it weren't for this one segment of the product businesses, this heavy industrial high hazard segment, with the pressure that we're seeing today, we'd be positioned to deliver very nice growth across the rest of the pace.

And so I'm still very bullish.

We're investing, we're making great progress with the launches.

You might have seen all of the press that we got with the Scott Sight launch that we did last week, and we have similar launches planned across the rest of the portfolio over the course of the year.

Okay.

That's helpful.

If I could just squeeze one more in for a fine point.

You did split again out that $650 million between $500 million and $150 million for operational and tax.

I would have thought there would have been increased risk to the $150 million and increased opportunity for the $500 million.

Is that -- you're not thinking about it that way, it sounds like.

Steve, this is Robert.

I think the $150 million for tax is still approximately the right ballpark, and I think that we do think that there's potential for upside on the operational side.

Okay.

Thanks.

Next question is from Gautam Khanna.

Your line is open.

So I was wondering first if you could calibrate us on where we are within the global products high hazard industrial business.

I mean, it seems like we've been going down for a while, so how much is that business down now, relative to where it was prior to oil cracking?

And where do you think we are, with respect to that cycle right now, in terms of your orders and what have you?

Let me start with oil and gas.

We said last year that overall for the Company we were down about 15%, and on a run rate basis was down roughly 25%.

For the year, last year, that average is 15%.

As we plan for this year though, we plan for another reduction of about 10% through the course of the year.

Based on what we saw in the second quarter, mainly in our product businesses, and the pressure that we see not only incremental in the oil and gas, but more across the heavy industrial, now instead of a 10% decline this year, we're looking to see potentially a 15% to 20% decline.

Now, we do believe that on the run rate that we see, that we're stabilizing and that going forward, based on the opportunities that we're currently working on, that will then -- that baseline will then grow as we get into 2017.

Okay.

But just to put a finer point on it, this is not simply oil and gas related operators, this is a second derivative impact, if you will, industries that touch oil and gas?

So it's different than what you saw last year which was more direct.

Is that fair?

Let me clarify.

Of the 25% of the product revenues that are tied to what we call heavy industrial high hazard, only about a quarter of that is directly tied to oil and gas.

And so, when we segment high hazard and heavy industrial together with the impact that it's had, it's impacting about 25% of our product revenues.

Okay.

That's very helpful.

And then on the integrated solutions piece, where you saw big order growth, I was wondering if you could parse the organic orders within that business, and if you could comment on the timing to convert to sales on those orders, why we're not seeing the organic growth sooner in the year?

We've been improving our order rates sequentially, and they've been accelerating as we've been going forward.

and a lot of that has been tied to our commercial excellence initiatives.

So we've been putting additional salespeople in place.

We've been making sure we have the right structure, the right competencies, the right compensation.

And through that process we've been seeing sequential improvement.

This has been our best order quarter that we've seen, up 7%, about 3.5% of that organic.

And so when you look at how that converts, we have backlog that we were building the end of last year, early this year, that will convert in the second half of this year.

So as we're building that backlog, our typical conversion on average is 9 to 12 months, and it depends on obviously the cycle time of the projects that we take on.

But I feel very good about the progress we've made on the sales front, the order rate that we're achieving, the organic pickup that we're seeing, and our ability to be able to convert that revenue in the second quarter to support the guidance that we provided.

And more important, to continue the order rate and continuing to build backlog that positions us for accelerated growth in 2017.

Okay.

Last one, and George, I appreciate the color.

Any early read on revenue synergies with the JCI business?

Maybe if you've had any anecdotal discussions with customers, or what have you, on how that might actually play out and when you'd actually start to see some top line synergies?

What I love about this deal is when you think about the strategic value, it does start with customers, and all of the customers that I've engaged see an opportunity where we can combine our capabilities, differentiate what we can do, provide better service, and certainly create more value for them, which allows us to be able to accelerate growth for the combined Company.

The other big element of the excitement is what's going on in the field.

There isn't a person that I engage with, within our organization, that isn't totally excited about the combination, which will enable or enhance their capabilities to be able to better support their customers.

So the combination gives me a lot of confidence that with the work that we're doing with the go-to-market team, and the opportunities that we're identifying between our two companies, are going to start to hit day one.

Now, we're working through categorizing what those opportunities are, accumulating those so we can give better color at EPG and other conferences during the course of the year.

But I'm very excited about the short-term prospects, being able to leverage our combined structure, and more important longer term, the combination of our capabilities, being able to change the game in how we sensorize the buildings, how we deploy our unified software platforms, that enables us to be able to solve the bigger problems for the customer base that we serve, and by doing so, that's going to position us for acceleration of growth.

Thanks, and good luck.

Our next question is from Nigel Coe of Morgan Stanley.

Your line is open.

Just wanted to come back to the backlog, and obviously good news in both rest of world and North America.

For rest of world, can you just call out what regions and countries are driving the backlog performance?

And in North America, are you seeing any change in the mix of end markets, and in particular are you seeing an uptick in education and healthcare?

Let me start, Nigel, just by talking about backlog in general.

The backlog is broad-based, that it's a result of all of the work that we've done to streamline our commercial structure, to put additional resources in the field, selling, to get the right compensation structure, all of that in place.

We're beginning to see the productivity that we've been generating, we've been putting a lot of that back to work, and supporting our commercial initiatives.

And we're starting to get real traction, pretty much across the board.

And so if you were to start in Europe, in the UK, in Continental Europe, this is where we have deployed our E3 initiative, enabling not only, after getting the right structure in place, but now enabling that structure with the salesforce.com platform.

And already through that, with the connectivity that we're getting with our sales force, with our technicians, we're getting an uplift of leads.

So 5% to 10% improvement in leads, and then the conversion, 10% improvement from leads to orders, and so we're already seeing the benefits of that.

So even though we've got pressure in the UK because of oil and gas, we are starting to see some real improvement.

Continental Europe seems to be better, pretty much across the board, and it has been sequentially getting better since last year, and if you look at our order performance there, it continues to be very positive, and I'm very excited about the work that we've done there.

If you go to Asia, although we've been pressured with the heavy industrial high hazard end markets, doing the same, getting the right resource footprint in place to be able to expand elsewhere, whether it be in the commercial space, in some of the other segments, the subscriber base that we can build there, and so that is continuing to make improvement.

And then the last would be in Latin America.

We have, in spite of some of the economic pressures that we've continued to expand our footprint, we're executing well.

We're building our subscriber base.

And so therefore, that's what's generating the order growth there.

So what I'm excited about, Nigel, is that it's broad-based, that we're making great progress with the commercial excellence initiatives, that's creating and the pipeline is even better.

So the pipeline that we have that we're converting on, I feel good that the order rate that we see in the second quarter is going to continue pretty much across the board, and it's a result of the progress that we've made in putting the commercial resources in place.

And North America?

North America continues to perform extremely well.

As I said, the new organization structure, and this has been a multi-year plan that we've been on with our North America improvement plan, so as the businesses were driving fundamentals, we're getting to a similar structure within our commercial security business, with our fire business.

You might recall last year, I brought in Girish Rishi to lead the combined business.

Part of that plan was to then go into one leaned out North America structure that enabled us to be able to free up a lot of resources to put more resources on the front end of the business, driving growth, while we're still positioned to expand margins going forward.

That all happened.

We had over 400 key leaders, both in operations as well as sales be redistributed over the last quarter, and we didn't miss a beat.

And with the structure we have in place today, gives me confidence that we'll continue that order growth through the course of the year, and more important now is our ability with the resources that we have put into the field to convert, that we'll be able to convert into revenue growth in the second half and beyond.

And Nigel, your comment on the specific verticals, within North America, we did see good activity in institutional, particularly in higher education, as well as in healthcare, and some of the activity there was also driven by just general commercial, as well as government and banking were all more positive in the second quarter.

Wow, banking, that's surprising.

That's great color.

Just one quick follow-on.

So looks -- maybe this is better a question for JCI.

Looks like the spin is taxable rather than tax free.

Just a quick question.

Was that understood at the time of the announcement, or was that something that became clarified during the process.

Nigel, this is Robert.

Yes, this is something that the JCI team and the Tyco team, we discussed that at length as we were going through the deal process.

So we knew about this, and not a surprise at all.

Okay.

Great.

Thanks.

Our next question is from Steve Tusa from JPMorgan.

Your line is open.

Can you update us on the net productivity ins and outs?

It sounds like it's in line, but anything moving around there when you talk about whatever it was, the $180 million to $200 million in productivity, and the inflation in sales and marketing?

Anything moving around there?

This is Robert.

So I think the gross productivity you mentioned, we had given guidance of $180 million to $210 million.

That's on track.

Probably mid to upper end of that range.

That's offset by inflation, which we had estimated at $60 million, that's about where it's coming in.

And then the last that gets you down to your net productivity is the investment level that -- we had originally given guidance at $70 million to $90 million.

We think we're going to be at the low end of that range now, and that's part of the productivity benefit you see on slide 16.

That's what's driving that.

Okay.

And then as far as -- I can't believe I'm going to use this term, but any impact from Brexit on your UK business?

Is there any way to figure out what's oil and gas and what may be some tremors around that, whatever you want to call it, what's going on over there?

We're not seeing any impact from Brexit.

And then one last question, just on free cash flow.

A pretty strong start to the year.

I don't think you react to the 90% to 100% of net income explicitly in here.

Maybe you did.

But anything that got pulled into this first half?

Obviously, I think we're not counting on 125% conversion for the full year, but usually, your second half is seasonally comfortably above 100.

Anything unusual seasonally that's happening this year, or are you just kind of finally getting at some of this working capital, whatever else is going on that was depressing free cash flow?

I don't think there's anything unusual seasonally but I do think -- as you know, quarterly cash flow bounces around, so any given quarter it's pretty hard to peg.

But long-term, 90% to 100% is a good metric.

I think that we're going to try to do better.

We've gotten a good start to this year, and we're pushing very hard.

With that being said, we're achieving these results largely just through intensity, not -- we haven't yet fixed the process all the way that we'd want to.

I think we're in the middle innings on the process fixes.

But again, the worst I can see going back a couple years in the exchange is kind of 95% conversion, and the second half as high as 150%.

And you remove the 90% to 100% in your guidance for this year.

Can we assume it is for this year put you up there as saying it is going to be better than 100% this year?

We're tracking towards the upper end, and we're pushing to get even better.

Okay.

Thanks.

Next we have Deane Dray of RBC.

Your line is open.

Just to go back to global products, there was a mention of some delays in municipal spending.

Maybe you can flesh out that point?

What specifically have you seen and what's baked into guidance?

Deane, I'll take that.

What we saw there is that there a number of opportunities that we're pursuing, that we had planned, that were going to come through in the second quarter, that have been pushed out to third, in some cases, fourth quarter.

We see, realizing we were -- when we launched the X3, we were the leader and had built our backlog and pretty much fulfilled that backlog last year.

We've got a nice rate going now on a run rate basis, and it has picked up here a little bit in April.

So we're confident that these orders will come through, it's just a matter of timing.

And you might have seen, as I mentioned earlier, we had a big launch last week with the in-mask thermal imaging capability, and that's going to position us well as we pursue these new opportunities, and potentially upgrade the existing fleet that's out in the field.

Although we had some pressure in the quarter with the municipality funding that came through, going forward, I believe there will still be a run rate that, based on the forecast that we have today, that we'll be able to support.

Thanks.

On that mask, on the thermal imaging mask, has that already been NFPA approved?

We're in the final stages of the approval and we expect approval here within the next 30 days or so.

Great.

And then for Robert, on the FX guide, Tyco looks to be one of the only companies that would be seeing higher FX headwinds in the back half of this year.

So how does that math work?

It's all related to the timing of when we give guidance, remember, because we're a fiscal year start one quarter earlier.

We go off of that base, and that base gives us a different profile than companies that start the year January 1.

And the biggest change there, maybe on the Canadian dollar, looks to be the benefit as well?

The Canadian dollar and the pound were the two bigger drivers from what when we originally gave our FX guidance back in November, to the updated FX guidance.

But in terms of first half, second half of the year, keep in mind, you do have a bit of a tailwind related to FX in the second half of the year.

Got it.

Thank you.

Next is Shannon O'Callaghan of UBS.

Your line is open.

George, can you give a little more color, specifically on the service piece, and how the efforts are going there to sort of drive better attachment rates, and what's tracking sort of better or worse than -- or making progress or not that you're targeting?

Let me start by -- in the second quarter, we were relatively flat, and that was mainly a result of when you look at our calendar, we have a 13-week calendar, and there was two equivalent days less of service within our quarter, so that had a slight impact on our volumes.

We are making great progress across the board.

We're expanding service pretty much across the regions, across the end markets, with the exception of oil and gas, because of the current status of that end market.

It's a result of the investments we've been making to differentiate our solutions, as well as putting additional resources within the commercial structure, as well as additional technicians to be able to be positioned to fulfill the service.

And so as I look at where we are today, going forward for the year, we are going to be closer to the 2% service growth for this year, and more important now, as we project the future, we'll be able to build from that growth rate going forward in 2017 and beyond.

And so it's been -- we have made a lot of progress.

We've gone through most of the headwind with the remix of the portfolio, and with the investments we're making, we're going to be positioned well to be able to continue to grow.

Okay.

Thanks.

And then, just in terms of the guidance gets withdrawn with the publishing of the prospectus, maybe just a little color on what else you're limited in, and also maybe just a little more specifics, I know you don't normally give all the segment specifics by quarter, maybe a little more color on the third quarter, since we're not going to really have much update from then on how that fits to what you were thinking for the year?

Yes, Shannon, this is Robert.

The withdrawal of guidance is just according to the Irish security laws.

In fact, if you've seen other Irish companies involved in acquisitions, this is pretty standard practice, so it's nothing unusual.

And the timing of that is really just tied to when the S-4 becomes effective, really.

I mean, that's what drives the timing.

And then just in terms of the segments for 3Q, any specifics on just margins by segment, things that you're thinking a little more closely there?

Does products go straight through 19% or 20% in the third quarter.

Maybe a little more flavor.

Shannon, this is Antonella.

A couple things to think about in terms of the segment operating margin for the third quarter.

Overall, we do expect it to be similar to last year.

That will include 20 basis points of purchase accounting in there.

So ex the PPA, it's up about 20 basis points, and how that shakes out is, specifically to your point on products, we do expect products to go up to like 18% to 18.5% rate for the third quarter.

So keep in mind on a year-over-year basis that's the first quarter that is not an incremental PPA impact, because of the timing when we did the acquisitions last year.

So that's why the year-over-year will be better in terms of the products business.

Rest of world will probably shake close to the 10.5%, and think of North America as close to 16%.

Great.

Thanks a lot.

Next question is from Julian Mitchell of Credit Suisse.

Your line is open.

I just wanted to focus on the EPS guidance.

Because I guess versus when you last updated it in January, the midpoint's come in $0.05, FX is $0.02 less of a headwind, so you've got a $0.07 cut organically.

Is that all related to global products, or is there something else that also is coming in a little bit light?

Julian, this is Robert.

It is all related to global products.

As you know, that business leverages nicely on the upside.

It also deleverages on the down side.

Got it.

Thanks.

And I just wondered, on orders to sales conversion, is there anything in the lead times that has changed or there's orders that are booked and then maybe fall out before being billed?

Because in 2014 your organic orders were up about 4%, 2015 they were up low single digit, and yet the organic sales growth last year and this year is around zero.

So I wonder if there was you just something on lead times, the nature of the industry, or something that's changed.

Julian, this is Robert again.

So the orders I think you're referring to are probably inorganic orders.

On the conference call, we usually provide both organic and inorganic.

This has been a great quarter for orders growth.

7% total orders growth, 3% to 4% organic orders growth.

Sure.

Okay.

So nothing's changed.

Because your organic orders were up 4%, and then I think about 2% the last two years.

So there's nothing that's changed in lead times or conversion?

No, nothing's changed.

Okay.

Thank you.

Operator, I'd like to turn the call over to George for some closing comments.

Thanks again for joining our call this morning.

I want to thank all of our employees for their continued hard work and commitment in serving our customers, while positioning the Company for the merger with Johnson Controls.

I remain confident in our ability to drive continued improvement across all of our fundamentals as we execute on the year.

This, combined with the merger with Johnson Controls, makes me extremely excited about the opportunities ahead, creating enhanced value for customers, employees, and shareholders.

I look forward to seeing many of you at the EPG conference on May 16, and operator, that concludes our call today.

That concludes today's conference.

Thank you all for joining.

You may now disconnect.