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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Ladies and gentlemen, thank you for standing by and welcome to the Eaton Fourth Quarter Earnings. [Operator Instructions] I would now like to turn the conference over to the Senior Vice President of Investor Relations, Don Bullock. Please go ahead.
Good morning. I am Don Bullock, Eaton’s Senior Vice President of Investor Relations. Thank you for joining us for Eaton’s fourth quarter 2017 earnings call. With me today are Craig Arnold, our Chairman and CEO and Rick Fearon, our Vice Chairman and Chief Financial Officer.
As is typical, our agenda today will include opening remarks by Craig highlighting the performance in the fourth quarter and our outlook for 2018. As we have done in our past calls, we will be taking questions at the end of Craig’s comments. The press release from our earning announcement this morning and the presentation will be posted on our website or have been posted on our website at www.eaton.com. Please note that both the press release and the presentation do include reconciliations to non-GAAP measures. A webcast of the call was also accessible on our website and will be available for replay.
Before we dive into the details, I would like to remind you that our comments today will include statements related to expected future results of the company and are therefore by definition forward-looking statements. The actual results may differ from those forecasted projections due to a wide range of risk and uncertainties that were all described in our earnings release and the presentation also outlined in our 8-K.
Before I turn it over to Craig, I do want to highlight a change that you may have noticed in our press release and presentation today. Since about 2001, we have used the term operating earnings and operating earnings per share in description of our financial results. Those terms have consistently been used to describe net income and net income per share less acquisition integration and transaction costs. The reconciliation of those measures to GAAP measures of net income and net income per share have also historically been provided on our website. Going forward, the term operating earnings and operating earnings per share will be replaced with adjusted earnings and adjusted earnings per share. The definition of those measures, remain the same for Q4 that is the net income and net income per share minus any acquisition integration and transaction charges. We will continue to provide you with reconciliations to the GAAP measures of net income and net income per share on our website.
With that, let me turn it over to Craig to go through the results.
Okay. Hey, thanks Don. I will begin on Page 3 where we highlight our Q4 results. And overall I’d say we are very pleased with our fourth quarter results. And just as important, the momentum that we are carrying into 2018, we generated net income and adjusted earnings per share of $1.43 and this includes as we noted $62 million of income from the Tax Cut and Jobs Act. You will recall that we issued guidance in late December and we estimated that the impact of tax reform would lead to a one-time charge of between $90 million and $110 million.
As we completed Q4 and worked with the details of the tax reform bill, this turned into a $62 million benefit. The adjustment of our deferred tax assets and liabilities to the lower tax rate created $79 million of income, which was partially offset by a $70 million charge for the mandatory repatriation tax. Excluding these one-time items, our net income and adjusted earnings per share were $1.29, $0.05 above the midpoint of our guidance and up 15% over last year, so really results that we are pleased with. Sales were also strong in the quarter, up 7%, of which 7% was organic. And as noted, orders were also strong across all of our segments. Segment operating margins increased to a record 6.5% and excluding restructuring costs, we posted operating margins of 17.1%, which was up 80 basis points from prior year. And given the strong orders, we decided to actually accelerate some of our restructuring initiatives, which resulted in a spending $41 million in the quarter and this was some $16 million above our prior guidance.
We also continue to generate robust cash, operating cash flow in the quarter, which was $879 million. Our free cash flow to net income was 112% and excluding the $62 million of one-time income from the tax bill it was 124%, so once again very strong performance. In last we repurchased $61 million of our shares during the quarter which brought our full year share repurchase to $850 million.
Turning to Page 4, we summarized the key income statement items and I want to just highlight a few key metrics here. We have covered some of this data already. So first I will highlight our segment operating margins were up 21% and excluding restructuring costs margins were 17.1%, up 80 basis points year-on-year on the 5% organic growth. And this reflects naturally the benefit that we are seeing from the restructuring program as well as incremental profits on our revenue growth. I would also note that our $41 million of restructuring expense in the quarter was $36 million in the business segments and $5 million at corporate.
Turning our attention to the segments, I will begin with Electrical Products. Our Electrical Products business grew 6% in Q4, 3% of the growth was organic and 3% from positive currency and our orders increased 5% with strength in both the Americas and the Europe region what we call EMEA. In the Americas specifically, we experienced particularly strong growth in industrial and large commercial markets as well as in residential products and in the Canadian market. And in Europe we saw strength in our power quality business, industrial markets as well as in large commercial projects. And so by and large we are pleased with the order growth that we saw in the Products segment in the fourth quarter.
On Page 6, we summarized results from the Electrical Systems and Services segment where we really have a very positive story unfolding. First the business has returned to growth both in revenue and the orders in the quarter. Sales were up 3%, 2% organic growth, 2% from positive currency which was partially offset by 1% from the divestiture of a joint venture that we had. I would add here that the organic revenue turned positive slightly ahead of our expectations on strength largely in harsh and hazardous, the Canadian market and in power distribution assemblies business which was primarily in the Americas. Perhaps more significantly orders in Q4 were up 12% over prior year and once again with strong growth in the Americas. As we have seen for the last several quarters we saw particularly strength in large power distribution assemblies, parts and hazardous systems in our electrical services business which also posted strong growth in the quarter.
Operating margins also improved nicely. Excluding restructuring costs, margins increased 140 basis points to 15.6%. And this improvement was primarily the result of incremental margins on the revenue growth, but also the benefits from the restructuring actions that we have been taking. You will also notice that we referenced a small divestiture here was taken a joint venture during the quarter. And I would say the way to think about this is it really represents the work that’s ongoing across the company to continue to review our portfolio for strategic fit and also for performance.
Turning the page, we are also very pleased with the improvements that we are seeing in our hydraulics business. We continue to generate strong growth, 18% in the quarter, 17% of which was organic and 1% from currency. And the improvement I can only say that’s very broad base with both distribution and OEM sales up both in the mid-teens and we continue to experience really strong order growth increasing 25% in the quarter with solid growth in all regions. And the growth in the quarter really matches our growth for the year both coming in at up 25%. Operating margins also continued to expand reaching 13% and this number excludes restructuring costs and represents a 150 basis point improvement over last year. And I’d say we were pleased that after several years of significant restructuring and hard work by hydraulics team that margins excluding restructuring costs are now operating within the margin target range that we set for the business, up 13% to 16%. We certainly have work to do in this segment but we fully expect to continue to see margin improvements and to be solidly within the target margin range that we set for the business as we move forward.
As I noted last quarter, the business also continues to experience a significant ramp up in orders. As you can see we are addressing these issues and making progress. On Page 8, we cover aerospace. Our sales increased 4%, 2% coming from organic and 2% from positive currency and we also had another quarter of strong bookings, up a solid 9% with strength across almost all end markets and I would specifically note aftermarket bookings were up 9% and we saw very strong order growth in military OEM markets. Operating margins continue to represent strong performance and excluding restructuring costs increased 20 basis points to as you can see 20.2%.
Moving to our vehicle business, you will note that we once again had a very strong quarter with sales growth of 13%, 12% coming from organic growth, 3% from positive currency, and 2% reduction as a result of us forming the Eaton Cummins joint venture. The strong order growth was driven primarily by strength in NAFTA classic truck markets, which were up 37% and this was somewhat muted by global light vehicle markets, which were flat during the quarter. Operating margins, excluding restructuring costs, were up a solid 250 basis points from prior year and reached 17.3%. Unlike other businesses this segment is really benefiting by delivering the incremental margins on the change in volume, but also benefiting from the restructuring initiatives that have been undertaken in this segment.
Before we turn to page completely on 2007, I thought it would be helpful to briefly summarize some of the notable highlights at what we think was a great year of progress and our thoughts are summarized here on Page 10. First, our markets returned to growth with modest acceleration as we saw in the second half of the year. This resulted in 3% organic growth for the year. It would also appear that we are in a period of we call it synchronous global growth and we really have all seen the enthusiasm associated with the U.S. tax bill. So, we think these two factors are really setting the global economy and Eaton up for modest acceleration as we entered 2018.
Our net income and adjusted earnings per share was $6.68 and this includes naturally the gain from the formation of the joint venture with Cummins as well as the income on the tax changes. Excluding these one-time items, our adjusted EPS was $4.65 and this was $0.20 above the midpoint of our original guidance and up 10% over 2016. As we continue to generate strong operating cash flow of $2.7 billion, 2017 was a record year for the company and this by the way is after making a $350 million voluntary contribution to our U.S. qualified pension plan, so very strong cash flow during the year. I would also add that our U.S. qualified pension plan was funded at 95% at the end of the year and as of last Friday actually was funded at 98% and so despite really having the lowest discount rates that we have seen in several decades, our pension plans are really close to fully funded. So, we really feel good about getting that issue behind us.
Lastly, we completed our third year of our full year share repurchase program repurchasing $850 million of our shares during the year and this was 11.5 million shares or 2.5% of our shares outstanding as of the beginning of the year. And between dividend and share repurchase, we actually returned $1.9 billion to shareholders in 2017. So, overall, I would say I am very proud of the entire Eaton team in the year that we had. We delivered on our commitments to shareholders and we continue to advance the mission that we saw for the company.
Turning our attention to 2018, Page 11 is the summary of growth and margins assumptions for Eaton overall and for each of our segments. We expect organic revenue growth in the electrical products business to grow approximately 3% and our forecast of 3% organic growth in Electrical Products is about the same as we experienced in 2017 with really broad growth in all geographies. In electrical systems and services, that business is really in the early stages of a rebound and we expect to see 4% growth in the year. Our forecast reflects growth in the America is driven by power distribution assemblies, harsh and hazardous systems and moderate growth in the rest of the world. For hydraulics, we really anticipate another very strong year of double digit organic growth of approximately 10%. The 10% organic growth compared to 12% in ‘17 and is certainly supported by the order book in the backlog that we carry into 2018. And the growth I would say here really continue to be driven primarily by the strength that we are seeing in construction markets around the world.
Our aerospace business is expected to grow approximately 3% and we expect to see strong growth in commercial OEM markets as well as in commercial aftermarket. We also expect military OEM markets to grow modestly and this is compared to a slight decline that we experienced in 2017. And finally, vehicle business is expected to see 1% organic growth and the strongest market is once again expected to be not the Class 8, which is expected to grow some 9%. And it’s important I think to note here that much of this growth will be reflected in the Eaton Cummins joint venture where we don’t consolidate revenue. And so some of you may have been a little bit surprised by the relatively muted growth number for vehicles and that’s largely because much of this growth is being captured in side of the joint venture.
And in the global light vehicle market should grow 1% to 2%. Yes, with these rates of organic growth and in the benefits of the multi-year restructuring program we expect to see certain margins in the ranges that you see noted on the page. For Eaton overall, our segment margin guidance is in the range of 16.3% to 16.9%. And this includes the net impact of any restructuring actions. And so all of our restructuring expenditures are embedded in this number, so at a midpoint of 16.6% this represents an 80 basis point improvement over 2017. And looking at our segments, vehicle year-to-year margins are expected to be flat with other segments improving between the low of 30 basis points in aerospace to a high of 280 basis points in hydraulics. So we think 2018 will be another year of solid progress and the year in which we took another step forward towards delivering the 17% to 18% segment margins that we have committed as a part of our 5-year financial goals.
And page 12 our final slide, we summarized our full year guidance for 2018. Our guidance for net income and adjusted earnings per share is in the range of $5 to $5.20 a share at the midpoint of $5.10 which represents a 10% increase over 2017 and this obviously excludes any of the one-time items that benefited 2017. On revenues, we have already gone through the details behind the 4% organic growth outlook. But I would note here that we also expect to see $150 million of positive impact from currency, but this will be largely offset by $150 million negative associated with the impact of the joint ventures. And this includes both the formation of the Eaton Cummins joint venture in vehicle and as well as the dissolution of the joint venture that we referenced in electrical systems and services. And as noted we expect segment margins to be in a range of 16.3 to 16.9. And we think corporate expenses will be flat during the year.
We are also updating our prior December ‘17 commentary on the impact of U.S. tax reform in 2018. After further review we expect our tax rate to be between 13% and 15% instead of the 14% to 16% previously announced. And importantly here, very important here I think we expect our tax rate for 2019 onwards to stabilize in the 14% to 16% range. So we think it – as we think about tax reform, we are pleased that that particular uncertainty has not been taken off the table as we move forward. We also expect another year of record operating cash flow between $2.9 billion and $3.1 billion. We expect to spend $575 million in capital expenditures with resulting free cash flow of $2.3 billion to $2.5 billion. And you recall that 2018 is also the year that we complete the final leg of our full year $3 billion share repurchase program and as a result we are planning to repurchase $800 million of our shares during the year. So in summary I would say we are very pleased with our Q4 and 2017 results. We expect 2018 to be another strong year and to continue to deliver on our commitments to shareholders that we outlined as a part of our 2016 to 2020 goals.
So at this point, I will stop and I will open it up for questions.
Our operator will provide you with the questions – with the instructions for the question-and-answer.
[Operator Instructions]
Our first question comes from David Raso with Evercore.
Hi, good morning.
Hi.
The obvious star of this report here is the ESS orders, can you flush that out for us a little bit more this top in orders and like the core guidance is pretty healthy at 4% for that division, looking you will you help us a little bit with the cadence of this kind of order strength as you see it’s starting the year further into ‘18 and maybe some timings is there some lag on those orders translating into revenue growth?
Yes. I would we are very pleased with the strength that we are seeing in electrical system and services orders. And as I noted in my opening commentary we think this recovery is coming roughly maybe a quarter even earlier than what we originally anticipated. But I would say we are really – we continue to see with oil prices rising and we continue to see a return to growth in our harsh and hazardous, our Crouse-Hinds business. That business is picking up nicely. And in the one – the large piece of that business that we had really been under a lot of pressure over the last a couple of years or so our large projects. And so our large systems business, really not just this quarter, but last quarter as well have started to improve markedly and so we are seeing that come through obviously in stronger orders in Q4. As you think about the timing of orders these are obviously big projects. They tend to have longer lead time until – as we think about 2018, we think the business starts a little slower in the first half of the year and picks up in the second half of the year and that’s just a function of the timing of a lot of these large projects.
And just two clarifications if you don’t mind, the impact on the LIFO, FIFO change on the inventory for the 2018 EPS and also if I missed that I apologize, the restructuring charge the total for ‘17 and what we expected to be in ‘18 the restructuring costs going through?
Yes. I will address the first one Dave, it’s Rick. The impact on LIFO in the fourth quarter was $0.01 out of the 129, so it was not at all significant. And typically and as we look back at past years LIFO has ranged between positive $10 million, minus $10 million, so really $0.01 to $0.02 timing impact. And just to comment, because I did see in analyst report somebody asked why did you make this change, well, the great majority of our peers are only on FIFO. And in fact in most of the rest of the world you have to be on FIFO. The reason that our U.S. operations have been on LIFO is that up until a couple of years ago for income tax purposes we run LIFO. And the rule was if you run LIFO for income tax, you had to be on LIFO for book purposes. But as we looked at all of our peers being mainly or most of our peers being on FIFO and we looked at the extra time and trouble it took to make these complex calculations to go on the LIFO it seem to us that the better move was simply to move everything to FIFO would have $0.01 to $0.02 impact in any given year. And we will in our K we will show you the impact over the last 5 years, but it is $0.01 to $0.02 positive, negative in any given year. The last comment I will make just so people don’t misunderstand our segment results that we have been reporting all of these years have always been on FIFO. So the only impact on LIFO is in corporate. We take a LIFO charge or LIFO income and it shows up in our corporate numbers.
That’s really helpful. And the restructuring costs…
Yes. It’s a different restructuring, we have spent a $116 million in restructuring in 2017 and embedded in our guidance for 2018 we are going to spend $90 million. And so that’s a little bit up from I know some of the prior guidance. And I think you were to see that as a really positive thing. The reality is we simply see lots of opportunities to continue to improve the company and we continue to make those investments that have very attractive returns and I will remind you once again that all of restructuring cost is fully embedded in the guidance that we provide. Now as we mentioned before, we were on this multiyear restructuring program, where we were every quarter talking about restructuring and calling it out. What we would intend to do going forward is that simply be embedded on our business, it will be embedded in our results and so we would not intend to talk about restructuring as we think about the reporting our results during the course of 2018.
Craig, that’s way more impressive, because I don’t think the restructuring would be that high in ‘18 so you are still sticking to your 40% incremental, but you are taking a bigger hit on the restructuring like in a way the year-over-year help from lower restructuring is not as helpful as I thought. Did you bump up the savings or the saving still supposed to be around 50%?
Yes. I mean, if you think about some of the newer items that we are taking on many of those benefits will be in the out years and so we would not necessarily expect to see a very big increase in restructuring savings in the year on the increment, but I think it’s simply a reflection of the fact that the underlying growth rates will be a little stronger than what we anticipated and we took this opportunity to continue to reinvest in the business and to reinvest in programs that were going to have future benefits.
So your implied 39.2% incrementals here are a little “cleaner” right, they are not necessarily so much a year-over-year reduction in restructuring?
Absolutely. That’s the way to think about it.
Alright. No, I appreciate that. Thanks for the color.
Our next question comes from Scott Davis with Melius Research.
Hey, good morning guys.
Hi.
I was trying to reconcile a little bit that the comments about global synchronous recovery in the guide on Electrical Products side, I mean, particularly given bookings up 5%. I know the quarter, which is up 3%, but your comps are relatively easy. I mean, what gives you – I mean other than just being conservative, I mean, is there anything else there that leads to some cautiousness as far as that ramp – that 2018 ramp versus 2017?
Yes, I would say, your reference to the comps being easy, I’d say our Electrical Products business during the course of 2017 had a solid year of growth and so it grew 3% in 2017. And I think post the growth in each of the quarters and so I don’t know that the comps are necessarily easy, but maybe a little color on those markets that we think will perhaps grow a little faster and those that will grow a little slower as we think about the end markets, we think going into 2018 our industrial markets and large commercial business inside of Electrical Products will be above the average of that 3%. We think the components that we sell even in this segment into the oil and gas markets and applications will be above that number. We think that products going into smaller commercial applications could be a little below that number as well as single phase power quality and the other piece we report our lighting segment inside of Electrical Products and that business is very much like you have seen from some of the others in the industry, we think the lighting business in 2018 is more like flat to down slightly than it is growth. And so that’s also probably having a muting effect at least on the overall growth of our Electrical Products segment.
That’s really helpful. And then as a follow-up, Craig, there is always a lot of chatter around your portfolio and lots of company’s peers of yours going through different stages of de-conglomeration and such. I mean, is this the portfolio that you plan writing or can we expect further changes in 2018?
Yes. The way I would answer that question is guys, every one of our business today are measured against our criteria and we have laid that out in New York last year and the year before and we will talk about it again this year. And so one of the big changes as I think about the portfolio in the company is that we used to talk about the fact that we had a portfolio and the way this portfolio of businesses work together would enable us to create a company that was good for the cycle. Well, the big pivot that we made was that we said today, every business had to be a good business in its own right. And we have laid out a criteria that says here is the criteria, you have to be global business, you have to grow faster than GDP, you have to deliver mid to high returns. And with sales, you have to deliver mid 20s return on assets and if you are in a cyclical market you have to deliver a minimum of 13%. And so we laid out the criteria for each of our businesses. And I can tell you that each of our businesses today is making great progress towards those objectives the extent that they are not necessarily meeting them today. So we like the portfolio today, but having said that, we will always look at it. Throughout our history we have always continued to be tough minded about businesses and things that made sense and things that don’t. So we will always continue to look at the portfolio and to make changes where we think it makes sense from a shareholder value creation. The way we think about portfolio management is more around the margins of what we do in our businesses and that’s where we talked about a number of small divestitures things that we are stepping out of, things that we are going to manage the portfolio inside of the businesses that we do have, you can rest assure we will keep looking at it.
That’s good color, okay. Thanks guys. Good luck to you. I will pass it on.
Our next question comes from Joe Ritchie with Goldman Sachs.
Hi, good morning guys. Maybe just starting on ESS margins for a second in the guidance of 20 basis points to 80 basis points, obviously the fourth quarter was very strong and part of that may have been a little bit of less restructuring actions, but is this business is to add tough times and slow growth for quite some time and you think the incrementals on this business as even if even 4% turns out to be the right number from a growth standpoint next year or in 2018 you should expect incrementals on this business to be very strong, so maybe talk a little bit about that within the context of your guidance your margin guidance like what the puts and takes for margins in 2018?
I would say the electrical systems and services business is what we provided in the form of guidance is that we expect 40% incremental rate all in for Eaton inclusive of the restructuring benefit. And I would say that business does tend to perform a little higher than that and others inside the business perhaps are a little lower. But I would say that all of the benefits associated with the restructuring and the 4% ramp that we are seeing there fully baked into the guidance that we are reflecting inside the company. As we do continue to invest in the business across the board and we think that the numbers that we are proposing in terms of the guidance for 2018 are very much reflective on what we would expect from the business at this point in the cycle.
Okay, that’s helpful Craig. Maybe asking this a little bit differently, I guess if I would think about potential headwinds for 2018 and specifically as it relates this business I would think perhaps price cost you still have commodity inflation, so I would be curious to hear how you guys are managing that and whether 2018 should be better than 2017. And I guess secondly the other thing we are just kind of seeing just from a logistics perspective it seems like things are getting a lot tighter from a truck capacity perspective, so any commentary on like freight costs as well would be helpful?
I think it’s clear that as we think about price versus costs going into 2018, we think 2018 is a better year and easier year than 2017. You recall that we experienced a bunch of unanticipated material cost inflation in 2018 and we are basically chasing it all year. But you see the same reports that I do. We are not really seeing commodity prices let up at all, but I can tell you that the businesses today are very well positioned to react and respond and to manage in this increasing environment of commodity cost increases. And so as we think about 2018 we don’t expect commodity prices for the full year create an issue for us as our teams work on plans and initiatives to either pass it through to the marketplace or to offset it with a number of different cost on productivity initiatives that we have inside of the business. And to your point around truck capacity, absolutely we are seeing a little tightness there and that’s part of I think what you see in the form of the strength in the North America Class 8 market as orders continue to drive up strongly. And that’s because there is a bit of capacity tightness there and it is being reflected in freight rates and so that’s once again though all fully baked into the guidance that we provided.
Helpful color. Thanks guys. Nice quarter.
Our next question comes from Steven Winoker with UBS.
Hi, thanks and good morning all.
Alright.
Hey, just Craig you just finished this multiyear restructuring program as you noted and that was an enormous effort that you have been talking about for years and really one of the main focuses of the organization. So, it begs the question on that front what’s next around continuous productivity and additional restructuring, are you finished or where are you on the path now?
Yes, what I’d say is no, we are not finished. And then as we noted earlier that we said it, you don’t always want to think about an underlying rate of restructuring spending in the business and we originally targeted a number of $60 million to $70 million. And as we talked about on our guidance for 2018, well it’s been $90 million. And so we really do believe there is infinite capacity to continue to improve things to do things better or different to be more efficient. And so I don’t think we ever really run out of an opportunity for the foreseeable future to continue to find good programs to invest in, that results in us reducing our costs and building a more efficient organization. And so it’s too early to give you a guide beyond 2018, but I think you can count on us just with a consistent cadence of spending dollars of restructuring to continue to drive margin expansion.
Focused in any particular business units though?
Yes. I think you can generally think about in the context of the high, the margin business, the less need there is for restructuring. I think you get to a point in some of these businesses where you over-toggle. So I just think – you just think about in the context of the margins and the lower the margins the probably the higher participation those businesses will be in the restructuring programs. And keep in mind it will always be fully embedded in the guidance that we provide.
Great. And that is best practice. And I know on ES&S, you last I think hit what 14.4% or so in 2013, so you are getting there. You would be thinking go beyond it?
Yes, absolutely. I mean, we can keep in mind and that business is just starting to cycle up too in terms of some of the key end markets that we participate in. So, we fully would expect – we are not going to give you another range, right, we have provided a range of 13% to 16% as a range through the cycle for that business. And so we are not in a position yet to change that range, but absolutely, we would expect it to continue to improve.
And sorry, one last, any detail behind the lower incrementals on the products front in this last quarter, I know it’s a high-margin business, but there are any particular dynamics that work?
I appreciate the question and we are overall pleased with the margins. There were really two things inside of our Electrical Products that impacted us in Q4. One, we had a mix issue in our European business and nothing to worry about, we just had a number of very large shipments at the end of the year of products that has carried a much lower margin than we typically see in that business, but once again, a one-time kind of event. And the other thing if you recall we highlighted earlier that we would be dealing with in Q4 some of the fallout of the hurricanes that we experienced in Puerto Rico and that also impacted our margin. So, when you factor in, factor out those two events, our margins would have been 19.6% and a 20 basis point improvement versus prior year.
Okay, very helpful. I am glad to see that the good work in Puerto Rico that you guys did. Thanks.
Thank you.
Our next question comes from Jeff Sprague with Vertical Research.
Thank you. Good morning, everyone.
Hi.
Just wanted to get just drill into the couple businesses, first maybe back to ESS, so in the opening remarks, you didn’t mention utility at all or if you did I missed it, what do you see playing out in the utility space here as we exit 2017 and then what are you expecting for 2018?
We see the utility markets continue to be in the low single-digit kind of growth range. And so if you think about that in the context of the overall electrical systems and services business and maybe it’s a slight deduct from the 12%, but not much and that’s really what we experienced during the course of 2017 in the U.S. market to specifically and that’s really what we expect going forward.
And then on lighting, I mean, what you are saying is definitely not inconsistent with what we have heard from others, but what is your view on the disconnect if you will between relatively healthy commercial activity in lighting continuing the lag is the channel, is it share loss at the low end across the industry and you have a review on when lighting might reconnect with what’s going on in the construction related markets?
It really has been a bit of a conundrum, the market that has pretty consistently grown and grown faster than many of the other end markets that we saw this period of retrenchment or flatness in 2017. And it’s really kind of consistent with our view going forward. I would say there is probably a couple of things going on and once again very much consistent with what you heard from others. We do think the market itself is probably more competitive today than it has been in the past as LED technology becomes more proven and more of a standard. We think certainly if you are probably seeing more competition, more price competition in that market than we have seen historically. And so we will have to wait and see how that plays through. We are certainly continuing to see the ramp in connected and controlled lighting. In fact our growth in that segment of the market was very handsome and very much consistent with what you heard from others, but it’s not yet a big enough piece to offset the decline in the legacy part of the lighting. The other thing I would say on the positive side despite the fact that lighting overall as a category has been a little bit flattish, we continue to see growth in LED. In fact our LED business continue to grow nicely in Q4. Today LEDs represent 79% of our revenues and so that continues to be a positive for us. But it really is a bit of a wait and see story. We take a lot of confidence in the fact that buildings are built, they need lights and the end markets that we are serving continue to be quite robust, so where I think we are going to a little bit of a transition period right now and we will have to wait and see how it plays out longer term.
And one last one for me just on hydraulics, could you comment a little bit on hydraulics China and also are you to keep this good track of what’s going on in the channel, any concern that maybe people are double ordering or anything here as we have kind of a scramble upward here?
Specifically with respect to hydraulics China and what we are seeing there is very much consistent what we are seeing in the global hydraulics market which is a very significant ramp in the construction equipment market and the excavator market in China has been up over 100%. The rail loader market has been up 50%, so really strong growth that we are seeing out of China overall. And I do think to your point overall there is always a risk when you end up at this point in the cycle when lead times are starting to push out is always a risk that gets a little bit of over of ordering or booking early in the process. One of the reasons why you would say why 10% growth in hydraulics or orders about 25, because we do believe there is a little bit of timing associated with what’s going on inside of that market. We will have to wait and see, I mean we really are encouraged by some of the retail sales numbers that you are seeing from some of the major equipment companies where retail sales are growing quite nicely. So it is a little bit of a wait and see in that market as well. But we think 10% is a number that’s very much supported by what we have seen in other cycles and what we think we are ultimately delivering the business during the course of year.
Thank you very much.
Our next question comes from Jeff Hammond with KeyBanc.
Hi, good morning guys.
Hi.
Just back on ESS, I mean any good lumpiness in the orders in 4Q that wouldn’t repeat. And then just maybe as you think of quoting and talking to customers just the sustainability of this uptick you have seen in large projects and Crouse-Hinds?
Yes. I would say not really. I wouldn’t say that we have seen any particular one-time orders or things that would be suggest that the underlying order rate is not sustainable in our order book. And so no particular concern is there in the systems – large systems business or in Crouse-Hinds. And so the other – I am sorry the other part of your question was?
Based on quoting and customers as you look forward, sustainability around Crouse-Hinds in these large projects have upticked?
I’d say I would point to you one of the things that we track as we track negotiations. And so I would say that very much consistent with what we are seeing in our order book. Our negotiations for the year in that business which is a prerequisite for an order were actually up running up as well kind of mid-teen levels. And so we are also seeing overall economic activity negotiations to be essentially growing at the same rate as the underlying orders and that’s really encouraging for the future.
That’s great. And then just on the – to understand on the comments Eaton JV, so the JV income is that going to run through Vehicle segment Op income and just update us on when you think that the income from that JV starts to ramp?
The ramp is yes, it will run through the Vehicle segment. And in terms of when the incomes starts to ramp know, I can tell you today that we are investing heavily in the joint venture. One of the big kind of reasons why we have made the decisions to partner with Cummins in this particular space is because we saw an opportunity to really accelerate our growth by introducing some new products and doing some things that would allow us to expand beyond our historical customer base. And so at this point we are not prepared to give you a longer term forecast of an income while the new say we were still significantly in the investment mode and so we would not expect in 2018 to see income come out of a joint venture as we continue to invest for growth.
And yes, we have already built in the expectations of that investment into this 2018 guidance.
Okay, great. Thanks Craig.
Sure.
Our next question comes from Deane Dray with RBC.
Thank you. Good morning. This is Andrew Krill on for Deane. I was hoping can you give us some of your big picture views on non-resis for 2018, I think a lot of people have been concerned it could be choppy, but it seems to continue to grind higher, so any color you can give there? Thank you.
I could say in terms of non-resi markets, I would say that the way we think about it is that it’s kind of no real change from what we experienced during the course of 2017. We think little magnitude. We think growth in the 4% range is kind of the consensus number out there as well from the other forecasting organizations. And so like we think in many ways, it’s almost a little bit of a repeat from what we experienced in 2017. The one thing that could be a potential upside to that if we end up with an infrastructure bill at some point in the U.S., some of these numbers could get better down the road. But right now we are planning on pretty much a repeat of what we experienced in 2017.
Okay, got it. And then just a follow-up, I think one or your other like foreign domicile peers also know the dynamic where their tax rates should kind of go up in the out years, can you just give us any more insight into like the technicalities driving that? Thank you,
Yes. I will address that. As we said we believe our rate for ‘18 will be 13% to 15%. We think ‘19 and beyond it only goes up one percentage point, so to a rate of 14% to 16%. And it goes up partly because the tax bill does have some elements that do ramp in. In ‘18 there is a partial ramp and then in ‘19 there is a larger ramp. But we think that stabilizing in the 14% to 16% range seems to us to be a pretty good result and will be we think relative to most other multinationals an attractive rate. I would make one other or maybe two other comments here, because there have been some things written on our taxes that we are just not correct. I want to make sure everybody understands. I saw one analyst that suggested that because of the tax bill that we might need to change our manufacturing footprint and that is just not correct. We don’t believe that there will be any need to make any significant changes of the footprint as a result of the tax bill. And secondly, there was a comment that our – the treatment of our dividend from a tax perspective would change and that isn’t correct either because, at least in the intermediate term we continue to believe that our dividend will be 100% return of capital. And that means for U.S. shareholders there will be no present tax owed down it. And then at some point in the future, if our dividend ever became other than return of capital, the taxation of that dividend, the rates applied to it would be the same as applied in the other corporation based in the United States. And so I just wanted to make those clarifications.
Okay, great. Thank you, guys.
Our next question comes from Tim Thein with Citigroup.
Great. Good morning, just going back to that the comments earlier on the JV with Cummins, on the truck orders for – in North America on the heavy duty side, Craig what’s the split or what are you anticipating the split to be in terms of AMTs versus manuals, just thinking about how your underlying growth will track this normal build rates?
Yes. I don’t have that exact split, but clearly AMTs are continuing to grow and manuals are continuing to decline. I can get you the further details through Don after the call.
Okay, understood. And then and maybe you touched a lot of markets within ES&S, but maybe just a word on power quality more broadly, obviously impacting both single and 3-phase but just curious in terms of what’s embedded in the outlook here for 2018?
Yes. And thanks for the question. Certainly power quality was one of the more disappointing market in 2017. And as we take a look at 2018 the single phase is the power quality. I think you will recall that we report it to our electrical products business. And the three phase will report to our systems and services business. And we think the power quality markets in 2018 we think grow in the range of low single-digit, so we think they have a better year than they had in 2017. And we think that’s another one of the positive kind of year-over-year impetuses for growth is certainly our electrical systems and services business.
Okay. Thank you.
Our next question comes from Andy Casey with Wells Fargo.
Good morning everybody.
Good morning Andy.
Can you – I guess can you comment on capital redeployment specifically on whether the acquisition pipeline activities picked up because the balance sheet is net debt to total cap solidly mid-20s, pension fully funded, heavy lifting from a management capacity for margin improvement seems to be down, I am just wondering where we should expect some of the improved cash flow to be allocated other than share repo?
Andy, it’s Rick. We are spending much more time looking at targets and evaluating situations. Valuation levels are high as you well know and you also know that we have been incredibly disciplined and we will continue to be incredibly disciplined as we look at acquisitions. So I can’t tell you exactly what we might get done this year, but rest assure that we understand that we have very adequate capital. And we would like to find ways to augment our growth and to augment the strategic position of our various businesses. But it’s just hard to figure out exactly what will economically make sense over the course of the year.
Having said that, I would just add that what we have always said is that the first call on capital is to reinvest in our businesses to drive organic growth. And we certainly look forward to sharing with this group one way to get over New York some of the organic growth initiatives that we are investing in that really take advantage of some of the secular trends that are impacting our businesses. And so we think we have some exciting opportunities to invest in are internally to drive organic growth that perhaps can help bridge some of that gap.
Okay. Thank you. And then a little bit more specific on vehicle, you anticipate a part of the question on revenue, but even with that flat margin year-to-year at the midpoint seems a little bit muted, is that flat performance due to the accelerated investment into the JV that you mentioned or do you expect vehicle to see a little bit more restructuring this year than it did last year?
What I would say the way to think about it, once you can appreciate the question is it’s really investment, I mean it’s investment and we will talk a little about this. And when we get together in New York it’s really investment in some new technologies and electrification and so we are really taking this opportunity to reinvest in the business to really position the business to generate organic growth going forward.
Okay, thank you very much.
Our next question comes from Mig Dobre with Baird.
Yes, good morning. Thanks for squeezing me in. Just a clarification, so the guidance implies $26 million lower restructuring cost in ‘18 versus ‘17 can you remind us what the incremental savings are?
Mig, what we have said is that we really going forward are not going to try to reconcile costs – restructuring costs and savings every year. It frankly is just everyday activity. And so we simply wanted to note that we had earlier said perhaps we would on a regular basis spend $60 million to $70 million on restructuring and we are going to spend a little bit more than that, but we are just going to treat it as regular operations and not get into the details on expected savings.
And the way to think about as we said at this point in the cycle, we would typically perhaps deliver a 25% incremental and one of the reasons why we are delivering a 40% incremental is because those restructuring benefits are flowing through. So, our way of thinking about calibrating the benefits that we are seeing in company.
Yes. I am trying to understand when I look at your first quarter guidance talking about 40 basis points on margin expansion versus the full year. I am trying to figure out how the costs and the savings and whatnot are coming through to net debt?
Yes. I mean, certainly, we always – I mean, if you think about the restructuring in general it’s always more front-end loaded than it is back-end loaded. So, I think you are probably seeing some of the impact associated with just timing of spending and benefits throughout the year.
Okay. Then last question for me back to ESS margins, so if I look at your revenue in this segment down something like $800 million over the last 3 years, things were difficult. I guess when you look at that 13% to 16% target range that you put out there for margin, I am wondering at what revenue level do you think it’s appropriate for us to be thinking that you can reach the high-end of that range?
We will address that in a little more detail at our New York conference. We have not modeled that exactly at this point, but clearly you are going to need a step up in revenues from what we expect this year given how far revenues have fallen in that business.
Alright, thanks.
Our next question comes from Ann Duignan with JPMorgan.
Hi, good morning.
Hi.
Hi, just on vehicle, your outlook for organic growth of 1%. I had always assumed that on the transmission side for our heavy duty north market trucks that you were still going to be kind of contract manufacturing and therefore your volume in trucks should be similar to the industry volume growth. Am I missing something?
It’s in the way to think about the impact of the joint venture and then how it impacts the vehicle businesses. First of all, there is a year-over-year deduct right because the joint venture was formed at the middle part of last year. And so you have to take out the revenues that we enjoyed in 2017 out of 2018 as those revenues will now be reported and started a joint venture and Cummins will consolidate. And the other thing I would think about is that a lot of the growth that we are seeing in our markets in 2018 is coming out of North America Class 8 truck and that growth once again will show up not in Eaton’s revenue, it will show up in joint ventures revenue where we don’t consolidate. And so we do participate slightly because we are selling components into the joint venture, but the denominator, the base of that is quite small. And so that’s why you probably see a number that’s perhaps more muted than you would have modeled for the vehicle segment.
Okay. So, I guess when I was liking at organic revenue growth guidance, I was thinking that you had with apples-to-apples, but I should take into consideration?
You really have to deduct the JV revenues and then you have to factor in how much of the growth is going to show up in the joint venture not in our vehicle business.
Yes, okay. I got it. That’s helpful. Thank you. And then just a quick kind of more philosophical question, do you need to be in the lighting business long-term, I mean is there strategic reason why you would need to be in that business?
The way we think about lighting is no different in the way we think about the rest of the portfolio. We have set very specific goals with respect to every one of these businesses have to be good businesses in their own right. They have to stand on their own two feet. And so lighting is no different than the way we view hydraulics or vehicle or anything else. And we constantly look at these businesses and say is it a good business in it’s own way, will it add to our growth, can it deliver the margin targets that we anticipate and so every one of our businesses go through that screen. Are there some synergies associated with going through similar distributors, sure there are some. But even having said that, every business has to stand on its own two feet and that’s the way we view lighting and it’s very much consistent with the way we view every piece of the portfolio.
Okay, I appreciate it. Thank you.
At this point, we want to wrap up the call. I know there are a number of other callers today. We want to be respectful of those we have got to move on to other calls. So, we are going to wrap up the call today here at 11.00. I do want to as always we are available for follow-up questions. Thank you very much for joining us today.
Ladies and gentlemen, that does conclude your conference for today. Thank you for your perspiration and thank you for using AT&T Executive Teleconference service. You may now disconnect.