Eaton Earnings Call INSIGHTS: Electrical Americas’ Strength, Hydraulics Margins

On Monday, Eaton Corp (NYSE:ETN) reported its second quarter earnings and discussed the following topics in its earnings conference call. Take a look.

Electrical Americas’ Strength

Ann Duignan – JPMorgan: Sandy, just on Electrical Americas, it remained strong despite the fact that it likely has exposure to nat gas fracking, either directly or indirectly. We thought that might weigh on the segment. Can you talk a little bit more about where you are seeing the strength both on the non-resi and the resi side of that business?

A Closer Look: Eaton Corp Earnings Cheat Sheet>>

Alexander M. Cutler – Chairman and CEO: Sure. Well, Ann, on the non-res side, again I would reference everybody right back to the same detail we tend to look at, which is looking at the private put in place information and up some just under 4% in the quarter following a very strong quarter in the first quarter. When you go through all the segments there, it’s interesting. The only segments that really jump out to have negatives, where in the communications area where there has been a lot of discussion around telecom. The second is, is surprisingly is in mining, and petrochem, and natural gas, and a little over than a year ago, but virtually the vast majority of all the other segments are positive. So, at a time when people are talking about office; the commercial, they actually grew and we’re seeing quotation activity continuing to be quite strong as well. So, really pleased with the breadth on that area, really continuing on the theme we’ve talked about before. Fracking for us, and has been a little bit more of an issue actually over in our Hydraulics business than it has been on the Electrical side. There are clearly, after a boom in 2011 when we started to look at the impact of some of the discussions in and around regulation, it had slowed down this year, so it’s not quite the boom that we saw a year ago. But we remained really quite positive on what we’re seeing, not only in what we have booked, but more importantly the depth of our quotation logs on the non-residential side. On the residential side, again I heard, say we’re not in a booming takeaway, but these numbers are up over 20%, when you look at all the public data versus a year ago, so we’re beginning to see a recovery there, which is welcome off of the very low levels we’ve been in for couple of years.

Ann Duignan – JPMorgan: Follow-up on the hydraulic business, you noted your potential slowdown in the Ag space, is that something you’re already hearing from OEMs or is that just you gauging the environment, and recognizing that the product is likely to have an impact on farmers’ sentiment?

Alexander M. Cutler – Chairman and CEO: I’d say it’s more of the later, Ann, at this point, and of course there are different theories on what may happen at this point, but we think it’s just prudent planning at this point.

Donald H. Bullock Jr. – SVP-IR: Jeff Sprague, Vertical Research.

Jeffrey Sprague – Vertical Research Partners LLC: Just a couple kind of high-level guidance questions first, obviously you’ve lost a really wide range and we all get kind of the volatility going on out there, but could you characterize to any degree you’re comfort with the range and I guess in particular, although you brought down rest of the world Electrical, it implies kind of an improvement in the back half, I’d like to understand why that happened, then you got Truck kind of flattished up slightly in the back half, look likes should be lower volumes, why does that happen?

Alexander M. Cutler – Chairman and CEO: Couple of comments Jeff, we narrowed our range from $0.40 to $0.30, so we’ve got about a 7% range at this point, so we actually don’t think that, that bigger range for a six-month time period with the kind of volatility that’s been out there, but we felt it was prudent to bring it down by $0.10. On the Electrical Rest of World, it’s obviously been a hard one to call basically what we’re seeing is that Europe has flattened, it hasn’t gotten worse, it’s flattened. We’ve actually seen in Asia. We’ve seen our business up from the first quarter, but we don’t — part of that is the timing of obviously Chinese New Year as well, but we aren’t forecasting mass of increases as we go through the back half. So, we are assuming that what we see today is pretty much what we’re going to get out front. That’s our best call at this point. A quarter ago, you may recall we were talking about that we were hopeful we would see, particularly in China, we would see more of a recovery in the fourth quarter. We’re just not seeing the evidence of that. Having said that, we’ve all been (fooled) before and have seen the Chinese economy in particular change more quickly, but that’s not our expectation at this time. On the Truck market, just a last piece, I think you post a question on there, really it’s due to the order rates and we have not seen the order rates come in during the second quarter that we were hopeful we would see and that’s the reason for the direct bringing it down to 285 number.

Ann Duignan – JPMorgan: You are defending the margins as well on the margin side, it looks like you are pretty confident on defending the margins despite it looks like a kind of a production fix in the third quarter, especially?

Alexander M. Cutler – Chairman and CEO: Yeah, in terms of the trucks specifically you’re talking about?

Ann Duignan – JPMorgan: Yes, on Trucks specifically.

Alexander M. Cutler – Chairman and CEO: Yeah, we’re operating obviously at very attractive levels, and I think a number of people followed us for some time. We’ve build a pretty flexible model in our truck market in terms of being able to ramp ourselves up and down. So, we do believe we can hold this, as we say the full year margins we’ve got in that business, we’ve been operating very well, both in the first and the second quarter, while the volumes are going to be coming off we think a little bit with the market coming down here. We are convinced we can meet these long-term – full year margin goals in Truck.

Ann Duignan – JPMorgan: Just finally and I’ll jump off. Can you actually tell us what dollar euro rate and dollar real rate you’re using in the guidance that we can all kind of reset as the things play out here?

Alexander M. Cutler – Chairman and CEO: Yeah. No, we sure can. You may remember, we started this year thinking that we would see currency negative headwind hit us for about $550 million. We revised down to $300 million at the end of the second quarter in a fit of happiness when we saw things were not quite as bad at the end of the first quarter, and now we’re pretty well back to where we were at negative $500 million. What we’re assuming is that for the balance of the year we’d be in this ($1.20) to ($1.22) range for the euro, and we’d around $2 for reais. I think it’s helpful when you think about how dramatic these changes have been, in the second quarter of this year, the average versus the second quarter of last year for the euro is down about 12%. But in (indiscernible) we track the Brazilian currency as carefully; it’s down 20%. So, these are big impacts, and that’s what’s driving this 5% negative impact on our top line in the quarter.

Hydraulics Margins

Donald H. Bullock Jr. – SVP-IR: Jamie Cook, Credit Suisse.

Jamie Cook – Credit Suisse: First question, I guess on the guidance front again, I guess I was surprised that you were able to keep your Hydraulics margins at the 16% on the lower growth rate. So, can you just help talk about your assumptions behind that? And then in total, what was price material cost in the quarter and what are the expectations for the back half of the year?

Alexander M. Cutler – Chairman and CEO: Yeah, on the guidance, Jamie, remember, we’ve got a couple of things going on within our Hydraulics business. One, we’ve completed a couple of additional acquisitions in our filtration space, and as we’ve commented to you, we were very pleased with those businesses, they’re being integrated, and that’s giving us the benefit of those synergies which is playing into that margin as well. We think at this level of activity, which is attractive level we’re at, so we’re not talking about coming off from where we are at this point, so we can maintain very attractive margins in the business, very pleased with the way the business has been executing. So that’s really the piece behind Hydraulics at this point as we’ve had a very nice first quarter – or excuse me, first two quarters this year getting started the business. I’m sorry; I forgot the second part of your question, Jamie?

Jamie Cook – Credit Suisse: Sorry, just the second point, on price cost in the quarter and then what the expectation – I’m wondering if you get a benefit in the back half of the year.

Alexander M. Cutler – Chairman and CEO: Yeah, it’s hard to know. Again, we’ve said a couple of times here that that the piece (itself) was hard to predict is the difference between futures and spot pricing, because the future prices tend to move with more volatility than due to the spot prices, which is more of where we end up actually purchasing. We have seen, I think, commodities have weakened up as we’ve come into this year. We’re not seeing that pressure to the degree we were and our expectation for this year was that that net between pricing costs for the full year would be approximately zero by the time we work through everything of the year. That’s pretty much what we’re planning still at this point. If it turns out to be better than that, we’d be very pleased, but we’re not assuming a big plus there.

Jamie Cook – Credit Suisse: Did you get a benefit in the quarter?

Alexander M. Cutler – Chairman and CEO: I would say it’s fairly immaterial at this point.

Donald H. Bullock Jr. – SVP-IR: Nathan Jones, Stifel Nicolaus.

Nathan Jones – Stifel Nicolaus: Sandy, in Electrical Americas you saw that non-residential construction as a market showing strength for you. Can you comment on the recent trends in the ABI which tend to suggest that the growth you are seeing now may not be sustainable over the next year or so and talk about what you are expecting in those end markets for Eaton sort of more nine to 12 months out?

Richard H. Fearon – Vice Chairman, CFO and Planning Officer: Yeah. ABI we find, it’s interest in terms of – it’s an insight in terms of looking at about half of the non-residential space. ABI really deals with what we would call commercial construction. It doesn’t tend to deal with the big portions of mining shafts, wells, manufacturing which make up about 50% of what’s out there in the marketplace. So early on in this recovery, the big strength was really in the areas that I just mentioned, and you were not showing ABI move up at all, and we were talking about the non-resi market was going to really bottom and start to increase solidly, but in the middle of last year it in fact did, so we don’t find ABI to be as helpful in this regard as really watching our quote log. So, looking at our quote log at this point, we’re continuing to see a really nice balance of projects that we can see in this next six to nine months. So, our expectation is that we’re still in the midst of a several year recovery in the nonresidential market, it took about 3.5 years for us to trough down, we think it’s reasonable you’re going to see a similar length of opportunity here on the upside. We’re looking out now at projects that are six and nine months out, so we think we’ve got a pretty good view out ahead of us at this point. We’ve not put out a number for 2013, we really won’t do so till we get later in this in year, but we’re very much encouraged with what we’re seeing in the terms of a quote log for that period of time.

Jamie Cook – Credit Suisse: If I could just jump to Electrical ROW, last five quarters in a row you’ve had negative market outgrowth, can you talk about where you think you might be losing share and what you’re doing to address that?

Alexander M. Cutler – Chairman and CEO: The big issue that we’ve referenced over the last year was that we had a very outsized position in residential solar and really that’s for the last four quarters that’s really been the burn off of that particular activity. The second issue is if you go to countries like Australia where we’ve had a really very strong position in the commercial construction side of the business that economy is struggling right now that’s not where the activity is there, so we don’t really think it’s a share activity. We think it was primarily solar and that’s pretty well behind us because we’ve burned-off the year-to-year adjustments in that regard. I’d say the second issue is that our data isn’t – our third issue, our data isn’t as precise in some of the emerging nations as we would yet like it to be. I think it’s getting better, but I have a little less confidence in our ability to call those markets precisely, then they do in the developed nations where we spend years trying to perfect these economic models.

Donald H. Bullock Jr. – SVP-IR: Steve Volkmann, Jeffries.

Stephen Volkmann – Jeffries: I’m wondering Sandy things have deteriorated a little bit here I guess. We’d probably agree there is not a ton of visibility from a macro perspective. Can you just talk a little bit about what sort of contingency plans you guys have available if things do take another leg down and sort of how much restructuring could you do or what types of levers could you pull on and how do you do that planning?

Alexander M. Cutler – Chairman and CEO: Yeah, I would start Steve by saying I think it’s on everyone’s mind and I would start by saying at this point that on a relatively low growth activity right now you’re already seeing us with core growth in the order of 7%, and I think that speaks to the first issue. We have I think evidenced our ability to outgrow these markets, even during very difficult time periods and that’s because the applications we are in, and so whether you start depending on one of these businesses there is an off a lot of regulation that’s driving the adoption of our technologies and I don’t think that will change. I think customers will have to make some trade-offs as to what they spend on but those tend not to be items that you can trade-off and so I think it starts right there in terms of the strength and positioning of the portfolio. Secondly, I would say in this relatively volatile and unstable economic growth time period you are seeing our margins continue to expand and I think that speaks already to the types of steps that we’re taking in terms of how we are positioning our products, how we are able to price them in a way that creates a real value for our customers as well as for shareholders. Then the third is, I think if we found ourselves in a period of real economic weakness like the 2008 time period. You saw us move very quickly at that point to take costs out. Frankly, we’ve not let a lot of those costs creep back into Eaton, and we’ve shared that in our New York Analyst Meeting the last two years, and that’s part of the reason we’re opening up these margins, but if necessary, and we don’t see that necessity today because our margins are, we think, at all time record levels, we can take steps to cut things back, and of course, we will be in the process of integrating a large acquisition here at some point as well, and that also provides additional opportunities.

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