Eaton Q2 2021 Earnings Call Transcript

Quartr
Provided by Quartr
August 2, 2021

There are 13 speakers on the call.

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Eaton Second Quarter Earnings Conference Call. At this point, all the participants are in a listen only mode. However, there will be an opportunity for your questions. An operator will assist you offline. As a reminder, today's call is being recorded.

Operator

I'll turn the call now over to Yan Jin, Senior Vice President, Investor Relations. Mr. Zheng, please go ahead.

Speaker 1

Hey, good morning, guys. I'm Yanjun, Eaton's Senior Vice President of Investor Relations. Thank you all for joining us Eton's Q2 2021 earnings call. With me today are Craig Arnold, our Chairman and CEO and Tom Ocray, Executive Vice President and Chief Financial Officer. Our agenda today includes the opening remarks by Craig highlighting the company's performance in the Q2.

Speaker 1

As we have done on our past We'll be taking questions at the end of Craig's comments. The press release and the presentation we'll go through today have been posted on our website www.eton.com. This presentation including adjusted earnings per share, adjusted free cash flow and other non GAAP measures that are reconciled in the appendix. A webcast of this call is accessible on our website and will be available for replay. I would like to remind you that our comments today will include statements related to the expected future results of the

Speaker 2

company and are therefore forward looking statements. Our actual results may differ materially from our forecasted projections due to a wide range of risks and uncertainties that are described in our earnings release and presentation. With that, I will turn it over to Craig. Okay. Thanks, Jen.

Speaker 2

So we'll start on Page 3 like we normally do with highlights of the quarter. And I'll summarize by saying that we had another very strong quarter with And we're seeing significant increases obviously in our market. And as a result of that, we're taking our 2021 guidance up for the 2nd time. Our teams continue to perform at a very high level despite significant supply chain disruptions and rising commodity costs. Q2 adjusted earnings of $1.72 were Q2 record, 15% above the midpoint of our guidance And earnings were up nearly 100% versus last year and importantly 20% sequentially.

Speaker 2

Our sales were $5,200,000,000 up 35%, 27% organically and above the midpoint of our guidance. For the Q2 in a row, we delivered record segment margins. Q2 margins were 18.6%, up 3.90 basis points from prior year and up 90 basis points sequentially. We're also pleased with our incremental margins of 30%. We think strong results given the material cost headwinds that we're facing.

Speaker 2

Our order growth was perhaps the biggest highlight of the quarter. Orders were up more than 40% in each of our Electrical segment And both ended the quarter with record backlogs and our portfolio transformation continued. We closed the acquisition of Cabo Mission Systems and our 50% ownership in Jiangsu Yining's electric business in China. We're also pleased to have completed the sale of Hydraulics Danfoss yesterday for $3,300,000,000 The sale of Hydraulics is certainly a successful outcome for Eaton, Our shareholders and for Danfoss, who we think will be an excellent owner of the business. We want to thank our former Hydraulics employees for their loyal service to Eaton, And we wish them well under the leadership of Dan Fox.

Speaker 2

Lastly, we continue to make strong progress on our strategic growth initiatives And I'll point out just a few highlights on the next slide. So turning to Page 4, you've heard us talk about the 3 most important Secular growth trends for the company, electrification, energy transition and digitalization. We're making significant progress in all three areas and we're seeing Strong results. Highlighting a few notable examples, I'll begin with electrification where we've had significant wins in both our electrical and Vehicle Businesses. In vehicle, we delivered $50,000,000 of new wins for electric vehicle powertrains, which includes EV Transmission, EV Gearing and EV Differential.

Speaker 2

And I'm noting this example because it demonstrates that Even in an area where many of you think about as our traditional vehicle business, electrification is creating very large growth opportunities for the company. In electrical, as you would expect, our team secured attractive wins tied to renewable energy and residential applications. In this case, We're noting a win with a leading solar and energy storage OEM. In energy transition, we recently won a large distributed energy management project for a leading financial services company. This is a greenfield project and a great example of building as a grid solution.

Speaker 2

Eaton will be providing the low and medium voltage switchgear, our ForeSeeer Electrical Power Monitoring Software and our microgrid controller. In digitalization, our Brightlayer team delivered a win in the industrial market with a leading global chemical processing company to provide remote monitoring software solution. In this application, our solutions really leverage Eaton's portfolio of electrical hardware Along with our expertise in power management, provide the customer with real time operational data, alarms and insights that are delivered directly to their mobile devices. In addition to the operating benefits, the customer will be able to use Brightlayer's industrial trending and Measurement Data to Optimize Energy Usage. So it's an exciting time to be at the center of these three growth trends and we'll certainly keep you updated as we continue to progress in this area.

Speaker 2

Moving to Page 5, we summarize our future results and I'll point out just a couple of highlights here. First, On 35% total revenue growth, we delivered a 71% increase in operating profit, so very strong operating leverage. 2nd, our adjusted earnings of $690,000,000 increased by 99%. We're also effectively managing our corporate costs. Overall, our teams are certainly executing at a very high level.

Speaker 2

They're efficiently managing supply chain constraints, Increasing productivity and delivering the expected benefits from our multiyear restructuring program and a trend that we expect to continue for the balance of the year. Turning to Page 6, we summarize the results of our Electrical America segment. Revenues were up 15% organically, driven by strength in residential and data center markets, but we also had solid growth in commercial and institutional markets as well. The acquisition of Triplight added 8% and favorable currency added 1%. Looking at our sequential growth, we were up 8% over Q1.

Speaker 2

And historically, we would have seen a 5% lift between the quarters. So I'd say our growth rate is accelerating here. Our operating margins increased 60 basis points to 21.3%, a Q2 record. This is 190 basis points above pre pandemic levels in Q2 of 2019. Our portfolio changes, the sale of Lighting and the acquisition of Triplight, solid execution and benefits once again from our multiyear Restructuring program all contributed to the improvement.

Speaker 2

We're also pleased with the 43% growth in orders in the quarter, 13% increase on a rolling 12 month basis. This led to also a 43% increase in our backlog, which now sits at record level. We had broad order strength in all end markets with particular strength once again in data centers, residential and commercial and institutional. You'll recall that at the end of Q1, we started to see some large orders in select commercial markets. This pattern strengthened in Q2 and our negotiation pipeline in the commercial market was up significantly.

Speaker 2

Data, all data which suggests that the second half of the year and really going into 2022 should be solid growth. Turning to Page 7, you'll see the financial summary of our Electrical Global segment. And as you can see, we had strong organic growth here, up 22% And currency added some 6%. Like the Americas, organic revenue growth was driven by residential and data center markets, But we also have broad based strength in commercial and institutional and utility and in industrial markets as well. We posted strong operating margins of 18.3 percent, once again a Q2 record, up 2 30 basis points from last year and up 130 basis points sequentially.

Speaker 2

The incremental margins on an organic basis were solid at 32%, Results once again of good cost control and benefits from our multiyear restructuring program. Orders were also very Strong, up from 46% from last year and up 10% on a rolling 12 month basis. Once again, we had strength across all markets with particular strength in data center and residential markets. And we ended the quarter with record backlog, up from 50% from last year. Moving to Page 8, we show the results of our Aerospace segment.

Speaker 2

While we have a long way to go, we're starting to see signs recovering this market, which posted 17% growth in the quarter. As you know, we closed the Cobham transaction on June 1st And the business delivered solid results in the month of June adding 16% to our quarterly revenue. Currency also added 3%. Operating margins were 21%, up 600 basis points from last year and 2 50 basis points sequentially. With improving volumes, the team executed extremely well, delivering 50% incremental margins on an organic basis.

Speaker 2

Orders on a rolling 12 month basis are still down from 16%, but this is an improvement from down 36% in Q1. In fact, sequentially orders were up 12%. The commercial industry is seeing increase in leisure travel, especially in domestic markets, But international travel continues to be down sharply. We think the market will grow over the next several years, We don't expect to return to 2019 levels until 2024. Lastly, our backlog here has stabilized Next on Page 9, you see the financial results of our Vehicle segment.

Speaker 2

Organic revenues more than doubled with strength in all regions. Operating margins were 17.9% And we delivered very strong incremental margins, which were over 40%. The margin performance was driven by higher volumes certainly, but also once again from the benefit from the multi restructuring program and despite volumes still being down from 10% to 15% below pre pandemic levels, The business is really already sitting on the cusp of achieving our long term margin target of 18%. Now turning to page 10, we show a summary of our eMobility business. Revenues were up 57%, 54% organically, 3% from positive Currency.

Speaker 2

The organic revenues were driven by strong growth really in all eMobility markets around the world. Operating margins were negative 6.8% And they continue to be depressed by heavy investments in new programs. As you know, we're investing in this segment In high voltage power electronics and power distribution and power protection, but you should also be aware that we have significantly expanded our view of the market here. We now see large opportunities for our traditional business in the eMobility segment. These technologies include EV Gearing, EV Transmissions and Torque Control Solutions.

Speaker 2

As I noted earlier, and we already have wins in these areas. In fact, our traditional products have increased the size of the addressable market for e mobility that we think some $5,000,000,000 and so continues to be a really exciting segment and a big part of the company's future. Moving to Page 11, we've updated our guidance for 2021 on organic revenue. And as you can see, we are significantly increasing our organic revenue growth for the 2nd time this year with an increase in most segments. In fact, we're raising the midpoint of our organic growth guidance by 400 basis points from 8% to 12%.

Speaker 2

And this is on top of a 300 basis point increase that we took in Q1. The largest increases are in Electrical Global and Vehicle With smaller increases as you can see in the Americas and eMobility. With very strong first half, Robust order book and a growing backlog. We're comfortable with the 11% to 13% growth outlook for the year. This is despite quite frankly some of our market that remain in which they were in the early stages of recoverably notably commercial construction, industrial, Oil and Gas and Commercial Aerospace.

Speaker 2

We expect to see certainly continued recovery in these markets over the balance of this year and we think it bodes well for 2022. Next on page 12, we show an update on our segment margin guidance for the year. For Eaton overall, We're increasing segment margins by 30 basis points at the midpoint from 18.3% to 18.6%, which We'll once again be an all time record for the company. The 30 basis point increase, as you know, follows the 50 basis point increase that we reported following our Q1 earnings call. And we've raised the margin guidance in each of our segments with the exception of new mobility.

Speaker 2

We continue to expect organic incremental margin of around 30% and for price and commodity costs to be approximately neutral for the year. Our team has certainly been very effective at managing through these complexities related to price increases and supply chain constraints And we would expect this to continue through the balance of the year. And on page 13, we have the remaining items of our 2021 guidance. We're raising our full year adjusted earnings per share by $0.53 to a range of $6.58 to $6.88 At the midpoint $6.73 this is a increase of 10% over our prior guidance and a 30 7% increase over 2020. You'll recall that we raised guidance by $0.50 in Q1.

Speaker 2

With this increase, we're now forecasting a 20% increase from the midpoint of our original guidance, which was $5.60 With our recent M and A activities, We now see net headwinds of 1% from acquisitions and divestitures and this is down from our prior outlook of 4%. And we now expect positive currency of $350,000,000 up from our prior forecast of $200,000,000 And we're also raising our guidance for adjusted operating cash flow and adjusted free cash flow, both up $200,000,000 at the midpoint. The increase is really driven by a combination of higher profits on organic growth and sales, the timing of acquisitions and divestitures, But also partially offset by some investments that we're making in working capital given the current constrained supply chain environment. The remaining components of our full year guidance remain unchanged. And lastly, our Q3 guidance is as follows.

Speaker 2

We expect earnings to be $1.72 to 1 82 for organic revenues to be up 11% to 13% and for segment margins to come in between 19% 19.4%. And lastly, I'll wrap up the presentation on Page 14. Now you've heard us talk for the last few years about Eaton's transformation into an intelligent power management company. This strategy is built on the belief that there is a few secular growth trends, Electrification, energy transition and digitalization that allow the company to grow at a much faster rate than we have historically. And every day we get confirmations that we're on the right path.

Speaker 2

We're seeing it in the growing importance of sustainability initiatives in society. We're seeing it in government spending and we're certainly seeing it in our opportunities and in our wins. We're pleased with the progress that we've made on the portfolio. Each move has been consistent with our objectives of delivering a company that has faster growth, higher margins and better earnings consistency. And you've seen our track record on margin expansion.

Speaker 2

The Eaton Business System is what provides the consistent approach How we run the company, how we execute and how we expand margins and it's working. And this enables us to be on track to expand margins by 400 basis points to 500 basis points over the 5 year planning period. And as you can see, we're running ahead of plan. And we're committed to our sustainability goals. They reflect the right thing to do for society, but just as importantly, sustainability is at the core of what's driving our growth.

Speaker 2

I'd also note that we published our 2020 Sustainability Report and our 1st Task Force on Climate Related Financial Disclosure Report at the end of June. It encouraged those of you who have a special interest in sustainability to read it. I think they're Extremely well done and reflect the direction the company is headed in. Lastly, we continue to generate very attractive cash flow. We'll continue to generate very attractive cash flow, over $9,000,000,000 through 2025, which will allow us to return cash to shareholders And also make investments to grow the company.

Speaker 2

And as you can see, we're off to a very strong start in 2021. At the midpoint of our guidance, Once again, revenue is expected to grow 12% and earnings by 37%. So with that, I'll turn it back to Yun and open the line for questions.

Speaker 1

Okay, great. Thanks, Craig. For the Q and A section of our call today, we would like to ask you to limit your opportunity to just one question and one follow-up. Thanks in advance for your cooperation. With that, I will turn it over to the operator to give you guys the introduction.

Operator

Thank you. And first, we're in line with Josh Pokrzywinski with Morgan Stanley. Please go ahead.

Speaker 3

Hi, good morning, guys.

Speaker 2

Good morning, Josh.

Speaker 4

Craig, I was wondering if you could talk a little bit about

Speaker 3

the composition in orders in Electrical. Clearly pretty solid there, but hoping for A little bit more color on maybe the cyclical momentum versus the secular kind of electrification. So I appreciate the examples on slide 3, but really trying to get at how much of this is sort of illustrative versus something that you see really moving the needle here In the short to medium term?

Speaker 2

I'd say it's really a combination To your point, Josh, both of those in the order were really strong across all geographies and end markets with as I mentioned the highest growth coming in data centers and residential. When we talk about the secular growth trends that will be such an important part of the future of the company, we still believe strongly that we're just in the early innings of Really seeing a material impact from some of these bigger secular growth trends that are going to drive, we think the future of the organization. We're not seeing any benefits in around government kind of infrastructure spending yet. And so I'd say a lot of what you're seeing today, I just think is Reflection of the broader strength in many of our end markets and certainly we always talk about data centers is a great example of the world keeps So I think a lot of what you're seeing today is restocking because markets have certainly It's been strong in many of our end markets and inventories were taken down pretty hard during the pandemic last year. And so I'd say once again, Broad based strength, we talked about the fact that there's been a lot of stuff written about what's going to happen with commercial construction.

Speaker 2

Commercial construction has come back very strongly and we had outstanding orders as well as negotiations in the commercial and institutional side of the business as well. So it really has been a story of really broad based strength in orders across Almost every end market and every geography. So at this juncture, we think we're at the very front end of what should be Pretty exciting runway as we look forward as some of the longer cycle businesses we talked about whether that's commercial construction or oil and gas Some of these other markets, large projects start to come back into the business. We think this should go on for a while or so.

Speaker 4

Got it.

Speaker 3

And then just on the incrementals, you

Speaker 4

guys are going

Speaker 3

to be in the kind of low to mid-30s this year coming off of really great Decremental margin control last year, presumably some strain in the cost for hydraulics and I think pretty well documented inflationary environment. I mean, is the normalized range once we kind of clear some of the noise out of that Still in this 30% to 35% or can we go higher as maybe some of these headwinds normalize or dissipate?

Speaker 2

We think the 30% incremental for planning guidelines still makes sense at this As you think about modeling the company on a go forward basis, clearly, we're having to make some fairly sizable investments in the business right now as we deal with A revenue growth outlook that's more robust than what we've seen historically. So we'll be putting some investments in the business. We'll Obviously investing pretty heavily right now in electrification in places like eMobility and as well as in other aspects of the business like in The Brightlayer platform that we're bringing online. So we think that that 30% incremental number is still a good planning guideline as you think about modeling the future of the organization. And it's largely, I think, on the basis of the investments that we're going to be making in the business that perhaps will hold back what could be An incremental story that would expand, but given the investments that we think are important to make for the future growth of the company, we think 30% makes a lot of sense.

Speaker 4

Understood. Appreciate all the color. Thanks.

Speaker 2

Thank you.

Operator

And next question is from Andrew Obin with Bank of America. Please go ahead.

Speaker 5

Hi, guys. Good morning.

Speaker 2

Good morning, Andrew.

Speaker 5

Yes. Just maybe to go into a little bit more depth on commercial For second half in twenty twenty two, what are you hearing from the customers? And just trying to get a sense how much visibility Is there into 2022?

Speaker 2

Yes. I appreciate your question on commercial construction. That's obviously been a point of a lot of debate In general, and so as we talked about in Q2, our order growth for commercial structure was really in line with the rest of the business with more than 40% growth for the entire sector and with quite frankly particular strength in the global segment as well. And so we continue to see positive signs in commercial construction markets and we don't think there's any reason why There should be any letter from those markets that we think about going into the second half of this year or into 2022. Our negotiation pipelines, which as we talked about on prior calls precedes in order optically and our negotiation pipeline For both light commercial as well as large commercial projects, including commercial buildings was up very strongly year on year and up actually very strongly Sequentially as well.

Speaker 2

And so at this juncture, we're optimistic that commercial construction We'll come back and we think the second half of this year and into next year should post fairly strong growth.

Speaker 5

Thank you, Craig. And just my follow-up question. This has been a strange recovery, but your industrial customers, Do you see them thinking about CapEx differently? I think you did highlight before your high content incentive out facilities. So that's Once a cycle of growth driver, but what kind of longer term conversations are you having?

Speaker 5

And do you think people are thinking differently about CapEx needs This cycle versus the prior decade. Thank you.

Speaker 2

Yes. I think it's fair to say that on the industrial side of the house in general Really across many of our end markets, there's probably been historically some underinvestment. So I think that on the one hand, there's going to be some catch up that needs to take place. Then I think the big challenge that everybody is dealing with is fairly sizable labor shortages in many of the markets around the world. And so Investments in industrial and automation and the like tend to be what follows.

Speaker 2

And so we think the industrial markets are another one of these markets that I In the relatively early stages of recovery, there's been relative underinvestment in manufacturing over the last number of years. And so we think that market should do well into 2022 and really quite frankly beyond.

Speaker 5

Thank you so much.

Operator

Next, we'll go to Scott Davis with Melius Research. Please go ahead.

Speaker 4

Hi. Good morning, guys. Good morning.

Speaker 2

Thanks, Scott.

Speaker 4

Craig, can you talk a little bit about where you guys what's your strategy in EV charging, whether kind of content with being a sub supplier into it or whether you want to perhaps take a bigger role there or what I'll just leave it at that.

Speaker 2

Yes, yes. This is certainly very much at the core of our strategy for our Electrical business and Udi Jadav and the team spent some I'm doing our Investor Day really taking you through strategically what we're trying to get done there. And it's one of the reasons why we made the acquisition of Green Motion. We acquired Green Motion, which is a European company that does everything from the physical hardware of charging all the way through the ChargePort Operating and Billing Systems. And so we think that e charging, whether that's at Residential, commercial buildings or really more on a grid scale or in the bigger industrial application It's going to be an important part of what we're trying to do inside of our electrical business.

Speaker 2

Those markets as you've seen and you see it reflected in some of the Infrastructure bills that are being proposed in the U. S, you see fairly sizable investments that have taken place in Europe and in Asia. So we do think e charging both in the physical hardware as well as in the software will be an important part of what we're going to try to get done in our electrical business. So it's an exciting space. It's going to grow dramatically and we'd expect to be a part of it.

Speaker 4

Okay, helpful. And then just as a Just a follow-up on eMobility. I mean, can you give us a sense of kind of the on the wins that you're getting, What is kind of a content what does good look like on a content story for you guys on electric It can just be an illustration or example if you want, but trying to get a sense of that. Thanks.

Speaker 2

Yes. And it's tough It's comfortable to pick a typical eMobility vehicle, but I will tell you that as we talked about once again on our Investor Day that The content opportunity for Eaton in an eMobility application is a huge multiple of What we saw in our legacy business and whether that's in some of the new electronic based Inverters, inverters, power distribution, but I said also even in our legacy vehicle business and that's what we're really highlighting This quarter that you think about this legacy business that we had and you say what's going to happen to that business in the context of the world's transition to electric vehicles. When we say, hey, there's a huge growth opportunity in gears, in differential, Transmission hybrid transmissions for our legacy business as well. And so those opportunities for us And we laid out a goal of getting to $2,000,000,000 to $4,000,000,000 between now and 2,030. But the opportunity set is much larger An order of magnitude 5, 10 times greater than it would be for our traditional vehicle business where we're doing valve and valve actuation And some charging.

Speaker 2

So it's tough to pick a typical vehicle. I can tell you where we have wins, we have headwinds. Once again, these wins and these opportunities are coming once again in multiples of 5x to 10x what we would have on an historical vehicle platform.

Speaker 4

Good luck, Craig. Thank you.

Speaker 2

Thank you.

Operator

Our next question is from Joe Ritchie with Goldman Sachs. Please go ahead.

Speaker 6

Thanks. Good morning and congrats on the quarter.

Speaker 2

Thanks, Joe. Appreciate it.

Speaker 6

Craig, maybe just I know you talked about Yes, the price cost equation basically being neutral for the year. But I'm just curious like as it relates to 2Q and the rest of the year, like What did that look like in 2Q for you guys? And then is there any particular quarter where we should expect any headwinds? Just any thoughts around like how far ahead you are

Speaker 7

of inflation at this point?

Speaker 2

Yes. Appreciate the question. We're obviously dealing with fairly sizable challenges in and around supply chain and probably no secret to any of that on the call. When we provided our Q2 earnings guidance at the end of Q1, we had an expectation around the amount of commodity inflation that In the business and commodity prices quite frankly have only gone up and in some cases fairly significantly since that time. We've naturally as an organization have had to continue to work to offset additional commodity price inflation more than what we anticipated.

Speaker 2

And I do really think about that whole thing maybe even shifting a whole quarter in terms of the pressure points that we expected to see in the business. And so At this juncture, when we think about the year, we're calling the year neutral. We don't think it gets worse in terms of The impact in our company on the balance between price and cost, but we think the year is neutral And we think the pressure points in Q3 are going to be probably as great as what we expected in Q2 As a result, quite frankly, of seeing commodity prices continue to run. And once again, we're running to obviously catch up with that in terms of the things that we're doing around Taking prices up in the market as well as working on things to take cost out of the organization. So neutral for the year, things have probably shifted a quarter to the right based upon the fact that commodity prices have continued to run.

Speaker 6

Got it. That's helpful context. And I guess maybe my quick follow on question. One area that really surprised us to the This quarter was your Aero margin. So I was wondering if you can maybe try to help parse out what really kind of benefited Aero this quarter?

Speaker 6

And should we start thinking about 20 plus as like a baseline as we start to see the recovery in the commercial aero business?

Speaker 2

Yes. And I think if you think about in simple terms, our team when we were dealing with kind of this pretty dramatic downturn last year And setting an expectation that we would not see these markets come back to 2024. The team very proactively and aggressively Put in a number of restructuring programs to take out some of the fixed costs that we knew would be a challenge on a go forward basis. And so I would really attribute it to The team being proactive, putting in the restructuring early in the downturn and then really doing an effective job Running the business as well as managing costs. In terms of the expectation going forward, yes, I think it's reasonable to say that As this business improves, we approached 25% return on sales in our Aerospace business back in 2019 prior to the downturn.

Speaker 2

And our goal is certainly to get back to those numbers. But I do think something north of 20% is where really we'd expect this business to form. And certainly as volume comes back to work our way back towards the 24%, 25% return on sales that we used to be at.

Speaker 6

Makes sense. Thank you.

Operator

Next question is from Nigel Coe with Wolfe Research. Please go ahead.

Speaker 4

Hey, Craig. Hey, this is Brandon Reagan on for Nigel Co. I just want to piggyback off of that Arrow comment. Also kind of not in the spotlight on the top line, but certainly very strong performance on the margin. Maybe just Some more color on the components of Aerospace, like how did commercial OE, commercial aftermarket, defense perform in 2Q?

Speaker 4

And maybe just a follow-up would be what is the outlook for defense? Has it changed at all since our last update? Thank you.

Speaker 2

Yes. Appreciate the question. And I'd say that our aerospace business probably is not too much of an outlier from what you've seen from others In the market, clearly, the commercial side of the house continues to be under pretty significant pressure. While we're certainly seeing revenue passenger kilometers return, those markets are still running well below where they ran in 2019. We did see a little bit of an improvement in aftermarket in the quarter as that business certainly off Dramatically last year.

Speaker 2

And so I'd say that commercial OE continues to be weak, commercial aftermarket still weak versus where we've been Historically, but improving and really on the military side of the house, I'd say pretty much no change. And we think you think about That business being kind of a low single digit grower is kind of our outlook for the military market and we think that's Pretty much consistent with what we think the outlook is going to be over the near term as well. So a lot of the once again the margin piece really I'd say is Mostly a function of our team's ability to execute wasn't in any way driven by, let's say, a dramatic mix shift To aftermarket business overall.

Operator

Our next question is from Jeff Sprague with Vertical Research. Please go ahead.

Speaker 5

Hey, thank you. Good morning, everyone.

Speaker 2

Good morning, Jeff.

Speaker 7

Hey, good morning. Maybe just a question Kind of backlog conversion and also just kind of the scramble going on in the channel. Craig, you mentioned you did Thank you. Saw some channel inventory rebuild out there. We've heard a lot of mixed things from other companies on that.

Speaker 7

Things like people would like to rebuild inventory, but can't because there's not availability, etcetera. But maybe you could just give us a little bit of color on that Dynamic and do you think we're somewhat caught up on inventory relative to where the demand is?

Speaker 2

The way I'd characterize it today is as we think about kind of going to channel check with our distributor partners, I'd say on balance In aggregate, inventory levels probably match the outlook for the demand that we expect. But then there are certainly certain segments of the market We're willfully short and good point case in point would be what's happening today in the residential market. Currently in the residential markets in electrical, We're well short of where we should be and our distributors have not been able to restock. I think the fact that we're building fairly sizable backlog Is a reflection of the fact that some of these end markets would like to have more inventory than they're currently sitting on. But in aggregate, I do think that inventories are probably largely in line with our view and our outlook and our And I attribute the outlook for the market going forward other than in certainly certain of the subsegments of the market.

Speaker 7

And so the backlog growth you would attribute mostly or sounds like completely to the demand side as Opposed to your maybe inability to deliver a few things in the quarter?

Speaker 2

No, I think there's a combination. I think as we mentioned, there are these certain subsegments The market where clearly we there's more demand in residential construction as an example than we have the ability to ship. So I think it's a combination of the 2, but I think on aggregate, once again, Markets are good. The underlying demand is good in most of these end markets and there's certainly no inventory buildup taking place in the channel. But I do think that the fact that the backlog has grown to the extent that it has, once again, record backlogs in both the Americas and Global, Up some 40 plus percent in both segments, I'd

Speaker 8

say is mostly a function

Speaker 2

of the fact that the markets are We're bounding quite nicely right now.

Speaker 7

Great. And maybe just a follow-up, if I could. Just on the you called out at the end of your remarks with your commentary on your deal capacity. Things are Heating up and obviously you guys have been super busy yourself. Maybe you could just comment a little bit on the pipeline whether the organization Can do more, is ready to do more and what might be actionable or is there something else actionable before year end here?

Speaker 2

Yes. No, I appreciate the comment and the team has been, I'd say, very successful, really betting down a number of acquisitions at Very strategic at very attractive multiples we think as well. And it is to your point, I'd say the deal activity is certainly heated up and The pipeline today is probably about as full as it's been in some time. And I'd say we do have capacity depending upon what segment of the business you're talking about. I'd say that one of the good things about being Kind of an organization that works across multiple businesses and industries is that and doing the deals the size that we've done is that None of these deals are going to be so big that they're going to really consume the capacity of the entire company.

Speaker 2

And so if you're talking about some of the things that we've done recently In Aerospace, yes, they may be a

Speaker 8

little bit full on the fuel and motion side of

Speaker 2

the business, but we have capacity maybe on the other side. And the same thing would be true in electrical. We really haven't done very large deals in electrical. We've done very strategic deals. We've done deals that I think are Outstanding additions to the portfolio, but I'd say by and large in our Electrical business, we have plenty of capacity organizationally We go out and find opportunities and to bring them in and integrate them in.

Speaker 2

And that will not be a bottleneck or a limiter in terms of our ability to actually go out and transact. And we continue to say from a priority standpoint, we continue to be focused on electrical and

Operator

Next, we go to Nicole DeBlase with Deutsche Bank. Please go ahead.

Speaker 8

Yes. Thanks. Good morning, guys.

Speaker 2

Good morning, Nicole.

Speaker 8

Can we just clarify a couple of things in the guidance? I guess, how much of the raise to EPS came from the early close of Cobham And hydraulics being in for an extra quarter. And then can you just also clarify, did you include 1 month of hydraulics in the 3Q guidance given that the deals Closed in August or has that been removed from 3Q?

Speaker 2

We just maybe I'll work backwards. Certainly, we own Hydraulics For the month of August. And so for that month, we did in fact include Hydraulics in the guide. And so that would add 4 to Maybe I can take a pass. It's Craig.

Speaker 2

So if you look at

Speaker 9

the $0.63 guide increase, First of all, we flowed through the $0.22 beat. And within that $0.22 beat, we had about $0.07 that's related to M and A timing, dollars 0.04 hydraulics, $0.03 Cobham. And then we had another $0.13 which was $0.04 for Hydraulics and $0.09 Cobham. So in total, M and A timing was $0.20 of the $0.35 which is the $0.22 flow through And the $0.13 for the remaining timing. And then the remaining $0.28 is related to operational performance.

Speaker 8

Okay. That's really clear. Thanks for that clarification. And then I guess, can we just talk a little bit about what you guys are seeing in China? Obviously, a lot of noise with What's going on from a data perspective and questions about stimulus from here, but have you seen any slowing in your business?

Speaker 2

Yes. No, I'd say no, no. I mean, our business in China grew quite strongly. We reported as a part of our Electrical Global segment. But I would say that that underlying strength that you saw in our Electrical Global segment is also reflective of what we've seen in our China business as well.

Speaker 2

The market is and we'll see what the future holds, but the market to date has performed extremely well and our team has performed Extremely well in addition to that. One of the things for us, we've always believed in manufacturing and being local in local markets One of the reasons why we've made these investments in these joint ventures, 2 of them that we've done so far in China to really expand our access To the market, the huge Tier 2 and Tier 3 markets in China that we've historically not participated in. These 2 JVs, I'd tell you, really create An exciting opportunity for our company as we move forward to really participate in the largest segment of that market with really strong partners in China. So for us, I'd say market is important. Perhaps even more important than the market is really our opportunity to penetrate the market and grow market share on the basis of really now participating in these very large segments of the market that historically have been closed to us.

Speaker 8

Thanks, Craig. I'll pass it on.

Operator

Next, we'll go to David Raso with Evercore ISI. Please go ahead.

Speaker 10

Hi. Thank you for the time. On the electrical focus for M and A, can you help us think through where the areas of focus Moving forward, is it more geographic? Is it vertical? I guess ideally a technology that can cross geography and verticals.

Speaker 10

But Just give us a sense of where you see the portfolio from here still having opportunities and maybe some holes. And then I just wanted to follow-up on the Strong doubling of organic sales growth guide for Electrical Global. Maybe a little more color on what's accelerating so much from your thoughts 3 months ago? And maybe update us if you could on just currently the geographic sales mix of Electrical Global.

Speaker 2

Yes. So on the M and A focused question specifically, I'd say that if you just think about it, strategically we've laid out As a company, these 3 kind of major secular growth trends of electrification, energy transition, digitalization, So that will be kind of a good kind of framework when you think about where we're likely to deploy M and A dollars I want to in terms of following the strategic kind of growth factors that we think are important to the company. You think about acquiring a company like Green Motion, Think about acquiring a company like Triplight, which is really in data centers And 5 gs expansion. So as you think about what we've done, they ought to be really Thought about it as an expressions of the strategy in the areas that we said that we'd like to really take the future of the company. In addition to that, if you think about it geographically, We have huge opportunities outside of the Americas market to really round out the business portfolio And participate as we mentioned like in China and some of these very large markets that have been historically close to us.

Speaker 2

We have those kinds of opportunities in In Asia Cell, we have some of those opportunities that still remain in Europe. And so there will be some geographic plays where we'll actually do things to augment, Supplement the portfolio as a way of participating in markets that we have historically essentially not played in as fully As we do, let's say, in the North America market. So I think you're going to find that there's a pretty wide Set of opportunities that we have to continue to look at ways of growing the company through M and A in our Electrical business based upon these broader strategic platforms as well as the geographic expansion and filling some of these product gaps and some of these other Emerging Markets of the World. The other question that you had with respect to kind of the global Business and why the increase in the guide. I'd say 1, I mean, you just think about it on a relative basis, the global market fell More than the Americas business, so the comp is a little easier there.

Speaker 2

But also in some of these global markets, specifically in Europe, for example, They're now coming back. The reopening of these markets is also coming into the business at a time when once again The markets are ramping and so the same kind of reopening kind of phenomenon that took place in the U. S. Off of a higher base because they didn't close as much It's now starting to take place in markets that are offshore. And as I said, it's every place.

Speaker 2

I mean, it's not just in These historical hot segments of data centers and residential, we're seeing it in commercial and institutional, we're seeing it industrial, we're seeing it in utility. So really it's a broad set of end markets that are really responding nicely In Europe and quite frankly in Asia as well as the economies continue to open. I think our underlying growth in Asia and our underlying growth in the European pieces that make up the global business. Those markets, I'd say, both performed very well. This is the one segment that if Recall that we report inside of Global that tends to be or will be more of a later cycle play will be what's happening in our Kraft Heinz business, which is kind of the place where we really get most of our oil and gas exposure.

Speaker 2

That market is starting to see a number of green shoots, So certainly not back to levels that it was at historically, but we think second half of this year and into 2022, That market also starts to come back and should help continue to drive growth in the global segment. And so it's really Kind of a broad range of these end markets, most of which that are doing well right now.

Speaker 10

Obviously, it's pretty broad, but maybe you can help us Just some numbers update us geographically the current mix. And I assume Kraft Heinz right that is within the industrial piece within Electrical Global. If you can remind us, we're up as a size of Kraft Heinz nowadays.

Speaker 2

Yes. So maybe we can take that offline, Dave, you could talk to Jan about what we've given historically in terms of that business. Just want to make sure we Consistent with what we provided historically in terms of splitting out the global segment, so we don't end up with a selective disclosure issue. So

Speaker 10

That's fine. Thank you very much. I appreciate the time.

Speaker 2

Thank you.

Operator

Next, we'll go to John Walsh with Credit Suisse. Please go ahead.

Speaker 11

Hi. Good morning, everyone.

Speaker 2

Good morning.

Speaker 11

Wanted to build upon a couple of earlier questions. Appreciate the price cost commentary for the balance of the year, but just Wondering as you look across your portfolio and as we think about incrementals next year, where you think price will be most sticky? And maybe you can just remind us the historical experience coming off of the last deflationary cycle. I think Under the prior segments, products held a little bit more price than the systems business, but any color there would be helpful.

Speaker 2

Yes. Appreciate the question on price cost and it's in many ways we're kind of all kind of working through this Period of unprecedented commodity inflation and learning together in terms of where it's actually going to land. As I said earlier, we anticipated that we would have seen the worst of it in Q2 and it looks like a lot of those pressure points have been pushed out into Q3 Into the second half of the year. And once again, I think as a general rule, we talked about being neutral between pricing costs and I don't think there's any reason To suggest that that won't be the case that price cost will continue to be neutral. It does, as you can imagine, put a little pressure on our incrementals as well, As you don't typically get a normal incremental on commodity inflation, and so in terms of how it impacts incrementals, It obviously puts downward pressure on incrementals.

Speaker 2

But having said that, we still think 30% from a planning perspective It's the right way to think about incrementals for the company. On price stickiness, I'd say that Typically speaking, if you're in an inflationary environment and the commodity costs are up, the price is going to be sticky. And so in this kind of environment, It's never easy to get price, but I'd say in this kind of environment, it's very understandable that prices are going to go up. It's Very well publicized. Everybody is dealing with the same challenges.

Speaker 2

And so I would imagine that price will be very, very sticky in this environment, Given the supply shortages across the board, the fact that markets are doing well really today, I'd say almost across the board. And so that is never easy, but this is probably one of the easiest times at least in my Professional career to actually pass on price because essentially the environmental factors We're seeing labor inflation as well. And so all of these things Bode well for at least the price environment and suggesting prices will likely be sticky through this part of the cycle for some time to come.

Speaker 11

Great. And maybe just a follow-up to that. A lot of color given about Geography is the last question, but we've seen very strong organic growth from a lot of your competitors as well. I was just curious if you're noticing any discernible share shifts that you would call out Or if it's more kind of the strength of the market? Or do you think there might be some pockets where you're gaining share?

Speaker 11

Thank you.

Speaker 2

Yes. I'd say that if you think about it today, I'd say largely we think shares are pretty much holding Across the board, there's always going to be quarterly timing depending upon what companies do in various end markets and segments or The geographic mix, but I would suggest to you that probably at this point in time, given the fact that so many of us are dealing with supply chain challenges and there's Probably more business out there than any of us can handle and we're building pretty large backlogs and probably other companies are as well. So my speculation would be that there's probably not large share changes taking place at this point in the market. So we're probably Holding market share, in terms of our core businesses and we would imagine that Really until you get to the point where you actually have enough capacity to serve the underlying demand overall and you stop building backlog, That share shift is probably not going to be something that's a big part of the picture at least in the near term.

Speaker 11

Great. Thanks for taking the questions.

Operator

Next, we'll go to Julian Mitchell with Barclays. Please go ahead.

Speaker 12

Hi, good morning. I just wanted to ask about cash flow as I don't think that's been touched on yet. I saw the free cash flow guide went up. If I look at the year's numbers in aggregate, it looks like you're guiding for about an 11% free cash flow margin this year. And the adjusted sort of conversion from net income is maybe in the mid or low 80% range.

Speaker 1

So just wondered if you

Speaker 12

could sort of remind us what are some of those major headwinds on the Free cash flow margin and or conversion at present. And if there are any specific items, Maybe CapEx coming down next year or working capital headwinds easing When we're thinking about cash flow margins and conversion into 2022.

Speaker 9

Julian, if you look at last We finished the year at $2,600,000,000 in free cash flow, which was Considered a strong year. This year we care for us it is a transitory year. Having said that, We're going to spend roughly $200,000,000 more in CapEx this year, which will take us down to 2.4 Which compares to the midpoint of our guide, dollars 2,200,000,000 I'd put that additional $200,000,000 in Investments in working capital given the environment that we're

Speaker 2

It turns out, as you think about 2022 and beyond, I mean, getting being above 100% On free cash flow conversion, it's certainly where you'd expect the company to perform. And as Tom mentioned, this is really kind of a transition year Due to inventory build and increase in restructuring spending, increase also in CapEx.

Speaker 9

I think it's also important to note on an operating cash flow basis year to date, we're a little bit ahead of last year. So we feel good about our cash flow performance this year.

Speaker 12

Thanks for clarifying. And then On the top line side, just wanted to try and understand what you're seeing in the utility markets at the moment. There is a lot of sort of Chatter out there anytime there's a storm or something about grid hardening and all the rest of it. So just wondered if you could Give us an update on the utility piece and how the utility market growth looks this year relative to your overall sort of electrical revenue growth guides, which I think sort of average out globally in the low Teams type range. Thank you.

Speaker 2

No, I appreciate the question on the utility market because as we've said before, this is A very different market segment in terms of what it represents for Eaton and what it represents for growth than it has historically. And historically a market that's really been kind of a very low single digit growth market. We think as we look into the future for the utility market, we think it becomes One of the faster growing segments inside of the company. And so maybe that growth is mid single digit in the near term. As you think about some of the big investments that have to go into energy transition first, which is obviously a really big And then that obviously involves things like grid hardening and grid resiliency due to climate change and some of the weather related events that we've seen.

Speaker 2

And so we like the utility market and we think that that market will certainly be a growth market into the future. I will say that we've not yet seen Once again, these big inflection points that we would expect to see in the utility market, we think most of that growth is still out in front of Those markets, as you know, they tend to move more slowly. We have over the last number of years seen more investments going into The distribution side of utility, which certainly plays to our strength, but the bigger plays that we think around Grid hardening, grid resilience, energy transition, the things that utilities are going to have to make fairly sizable investments in, We think most of that growth is still out in front

Speaker 12

of us. Great. Thank you.

Operator

Our final question will be from Ann Duignan with JPMorgan. Please go ahead.

Speaker 8

Yes. Thank you. Appreciate you Pleasing me in. Most of my questions have been answered, but maybe Craig a similar question on data center demand. How you saw it progress through the Quarter just from an orders perspective, maybe versus start of the year?

Speaker 8

And then maybe regionally also what you're seeing going on in data center Thank you. And I'll leave it there.

Speaker 2

Yes. Thanks, Ann. Appreciate the question. And it's obviously one of the most exciting segments that we're in And certainly the acquisition of a company like Triplight just strengthens our hand there in terms of what data centers represent for the company overall. And I'd say it's the one market I'd say that we have very clearly for some time now seen global strength.

Speaker 2

We see it In every region of the world and we see it across really almost every segment of data centers, whether that's The on prem, whether it's the colo operators, whether it's the hyperscale data center market just continues to Surprise to the upside. And as we've said before that those markets that can be lumpy, there could be a quarter or 2 or even A year or so where a particular hyperscale player will take the time to consolidate and not expand. So the business can be lumpy at least specifically in hyperscale, but the projections for that market and what we've experienced is that It continues to surprise on the upside with respect to growth. I think this year we're talking about high teens kind of growth in the data center market. And as I said, as we've looked at that market, we've looked at our own forecast for that market, it's a big piece of what's performing better than what we originally anticipated when we put our guidance out for the year.

Speaker 2

And once again, this whole idea of more data, more storage, More compute, the world's more connected. And so we think it's just a trend that's going to continue for a very long time into the future.

Speaker 1

Okay, good. Thanks guys. As always Chip and I will be available to do any follow-up questions. Thank you and join us. Have a good day.

Speaker 2

All right. Thank you. Thank you.

Operator

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

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Earnings Conference Call
Eaton Q2 2021
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