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Edited Transcript of ETN earnings conference call or presentation 4-Feb-20 4:00pm GMT

Q4 2019 Eaton Corporation PLC Earnings Call

DUBLIN Feb 8, 2020 (Thomson StreetEvents) -- Edited Transcript of Eaton Corporation PLC earnings conference call or presentation Tuesday, February 4, 2020 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Craig Arnold

Eaton Corporation plc - Chairman & CEO

* Richard H. Fearon

Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer

* Yan Jin

Eaton Corporation plc - SVP of IR

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Conference Call Participants

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* Andrew Millard Casey

Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst

* Christopher D. Glynn

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* David Michael Raso

Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team

* Deane Michael Dray

RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment

* Jeffrey Todd Sprague

Vertical Research Partners, LLC - Founder & Managing Partner

* John Fred Walsh

Crédit Suisse AG, Research Division - Director

* Joseph Alfred Ritchie

Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst

* Joshua Charles Pokrzywinski

Morgan Stanley, Research Division - Equity Analyst

* Julian C.H. Mitchell

Barclays Bank PLC, Research Division - Research Analyst

* Markus Mittermaier

UBS Investment Bank, Research Division - Co-Head of European Capital Goods Research for EMEA and Executive Director

* Mircea Dobre

Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst

* Nicole Sheree DeBlase

Deutsche Bank AG, Research Division - Director & Lead Analyst

* Nigel Edward Coe

Wolfe Research, LLC - MD & Senior Research Analyst

* Scott Reed Davis

Melius Research LLC - Founding Partner, Chairman, CEO & Research Analyst of Multi-Industry Research

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by. Welcome to the Eaton fourth quarter earnings call. (Operator Instructions) Also as a reminder, today's teleconference is being recorded. At this time, I'll turn the conference over to your host, Senior Vice President of Investor Relations, Mr. Yan Jin. Please go ahead.

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Yan Jin, Eaton Corporation plc - SVP of IR [2]

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Hey, good morning, everyone. I'm Yan Jin, Eaton's Senior Vice President of Investor Relations. Thank you all for joining us today for Eaton's Fourth Quarter 2019 Earnings Call.

With me today are Craig Arnold, our Chairman and CEO; and Rick Fearon, Vice Chairman and Chief Financial and Planning Officer. Our agenda today includes opening remarks by Craig, highlighting the company's performance in the fourth quarter. As we have done in our past calls, we'll be taking questions at the end of Craig's comments.

The press release from our earnings announcement this morning and also the presentation we'll go through today have been posted on our website at www.eaton.com. Please note that both the press release and the presentation including reconciliation to non-GAAP measures. A webcast of this call is accessible on our website and will be available for replay.

Before we get started, I would like to remind you that our comments today will including statements related to the expected future results of the company and are, therefore, forward-looking statements. Our actual results may differ materially from our projected future earnings due to a wide range of risks and uncertainties that are described in our earnings release and the presentation. They're also outlined in our related 8-K filing.

With that, I will turn it over to Craig.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [3]

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Okay. Thanks, Yan. Appreciate it. And we'll start with Page 3 with recent highlights.

2 weeks ago, as everybody knows, we announced the agreement to sell our Hydraulics business to Danfoss with $3.3 billion, which represents a 13.2x 2019 EBITDA. This decision is part of the ongoing transformation of Eaton into a company with higher growth, higher margins and more consistent earnings. So we're really pleased with that. We believe this transaction will create substantial value for our shareholders and allow our Hydraulics employees, importantly, to become part of a company that has a strong commitment to the hydraulics industry.

Our team has made significant progress on other portfolio actions, including closing the acquisition of Souriau-Sunbank and the sale of our Automotive Fluid Conveyance business at the end of the year.

The sale of our Lighting business is expected to close in Q1. And as you've read, we just announced the acquisition of Power Distribution, Inc. Power Distribution, Inc. is a $125 million company that serves the data center market and will become part of our Electrical Systems & Services business.

Switching to our Q4 results. And I'd summarize the quarter's performance as one with strong earnings, record margins, strong cash flow despite a slower-than-expected growth in our end markets.

Organic revenue, excluding Lighting and Hydraulics, was down 2%. Earnings per share of $1.49 on a GAAP basis and $1.46, excluding $0.28 of acquisition and divestiture costs and $0.09 for costs we expect to incur related to vehicle warranty. At $1.46, our results were flat with last year and at the high end of our guidance range of $1.36 to $1.46.

Our sales of $5.2 billion were down 4% organically with negative currency of 0.5%, offset by 0.5% from acquisitions. We continue to generate strong margins and delivered a Q4 record of 17.8%, excluding acquisition divestiture costs and the expected vehicle warranty costs. These margins were above the high end of our guidance range and 40 basis points above prior year. And we're also pleased with our operating cash flow, which were $937 million in the quarter. So stepping back, I think we'd all agree that it's been a busy and a very productive period for Eaton.

Turning to Page 4. We summarize our Q4 financial performance, and I'll note just a few highlights on this page. First, we increased our adjusted segment operating margins by 40 basis points. And our team, I'd say here, executed well, and we had decremental margins of less than 10%.

Second, our adjusted segment operating profits were $933 million, down 2% despite 4% lower organic sales. Net income of $452 million was down 28%, and this was primarily due to acquisition and divestiture costs of $114 million and vehicle warranty charges of $39 million. And both of these numbers, I would note, are on an after-tax basis.

Similar to Q3, these strong results are, I think, a good indication of how we intend to manage the company during periods of market weakness, running our operations efficiently, proactively managing costs and accelerating our share repurchases.

Moving to Page 5. We'll start with our segment summaries with Electrical Products. Revenues were down 2%, and excluding Lighting, organic revenue increased 1%. Strength was driven by residential markets in the Americas, our distribution business in Canada. Adjusted segment operating profit increased 9%, and adjusted operating margins were up 210 basis points to 20.3%, a Q4 record.

The sale of our Lighting business to Signify for $1.4 billion, that remains on track, and we expect to close in Q1. Excluding Lighting, orders down 2% with strength in residential, commercial construction markets in the Americas, and this was really offset by industrial markets globally.

Turning to Page 6. We show a summary of our Electrical Systems & Services segment. Revenues increased 4% with 2% organic and 2% from the acquisition of Ulusoy and Innovative Switchgear solutions. Organic growth was driven by strength in the North America utility and commercial construction markets primarily. Adjusted segment operating profit increased 7% with adjusted margins of 17.1%, up 50 basis points over prior year.

And on a rolling 12-month basis, our Electrical Systems & Services orders increased 2.5% with growth really across all regions of the world. Excluding hyperscale data centers, the 12-month rolling average of orders was up some 4%.

And just yesterday, we announced the acquisition of Power Distribution, Inc., which is a leading supplier of mission-critical power distribution, switching and power monitoring equipment for the data center market. Power Distribution, Inc., really builds on our strong position in the fast-growing data center market and adds new capabilities in the area of overhead busway and power distribution. So we're really pleased with the prospects of what PDI will add to our Electrical Systems & Services business.

Moving to Page 7. We summarize our Hydraulics results for Q4. Revenues were down 13%, with orders down 11%, and this is driven by continued weakness in global mobile equipment markets and destocking that continues at both OEM and also with our distributors. And as I mentioned earlier, we're really pleased to have announced that we're going to sell the Hydraulics business at Danfoss for $3.3 billion, and we expect this transaction to close at the end of the year.

And as announced, we are retaining our Filtration and Golf Grip businesses. We expect cash taxes from the sale of Hydraulics to be approximately $450 million. So our net proceeds will be approximately $2.85 billion.

And a number of you have asked how we intend to use proceeds. And I'd say that the options of additional acquisitions and share repurchase are both on the table. For M&A, but also that our pipeline remains very active. And so it's great to have this optionality as we look forward.

On Page 8, we summarize our results for our Aerospace segment. Revenues were up 3%, including 2% organic and 1% from acquisitions. We experienced in this segment continued strength in commercial OEMs and also in commercial aftermarket. Orders on a rolling 12-month basis increased 6% with particular strength in military and aftermarket and bizjet. Certainly, strong execution in this segment led to a 9% increase in adjusted segment operating profit and 130 basis point improvement in adjusted margins, which were 24.2%.

And I'll just say here that the business delivered another quarterly record, capping what's been a very strong year.

We're also pleased to have closed the acquisition of Souriau in late December. We welcome the Souriau team to Eaton, and our integration teams have already begun working to deliver the synergy plans, which includes the opportunity to take our new electrical connectors capabilities into our core electrical markets.

Turning to Page 9. We summarize our Vehicle business for Q4. Revenues were down 19%, and this includes 18% organic and 1% from currency.

Declines here were due to a number of factors: the GM strike; Class 8 OEM orders, in fact, Class 8 production was down some 20% year-over-year; continue -- and continued global weakness in light vehicle markets, which were down 9%.

And I'd say here and a clear example of our grow the head and fix the tail strategy, which is really about how we really focus the company, we completed the sale of our Automotive Fluid Conveyance business at the end of the year.

During the quarter, we also took a $50 million pretax charge for expected warranty costs. This charge is being undertaken to correct the performance of one of our products that incorporated a defective part from a supplier, and we're actively looking for ways of recouping these costs as well.

Adjusted operating margins were 17% at a very high level, but down 90 basis points from prior year.

Next up on Page 10, we summarize the results for our eMobility segment, revenues were down 6%. And I say here, while growth in electric vehicle platforms, this was more than offset by weakness in legacy internal engine -- internal combustion engine platforms.

Operating margins declined to 1.3% due to a significant step-up in research and development as well as manufacturing start-up costs associated with electric vehicle programs here. I would like to highlight that since the formation of this segment in the first quarter of 2018, the maturity of revenue from new wins is expected to be $450 million. And so this segment continues to run ahead of our own internal expectations. And as you can imagine, we're pursuing a large number of additional programs as the industry continues to make the transition to electric vehicles.

Before turning to 2020 guidance, I want to take a minute just to summarize the results of 2019, which are shown on Page 11. First, we generated all-time record margins of 17.6%, which were up 80 basis points over 2018, excluding acquisition, investor costs and the expected warranty costs. In fact, over the last 3 years, our segment margins have increased 260 basis points, which we see as a strong validation of our strategy.

Earnings per share of $5.76, excluding the onetime items I just mentioned, was up 7% over 2018. We set all-time records for both operating cash flow of $3.5 billion and free cash flow of $2.9 billion, with growth of 17% and 20%, respectively.

Our free cash flow to sales was 13.4%, and our free cash flow and net income conversion was 129%. And this continues to be a key strength for Eaton and something that you can expect from us in the future.

And as we noted, 2009 (sic) [2019] was a year of significant progress on our journey to transform Eaton into a company with higher growth, higher margins and more earnings consistency. We closed 3 deals for $1.2 billion: Ulusoy, Innovative Switchgear in Electrical and Souriau-Sunbank in Aerospace. We announced 2 divestitures, with Automotive Fluid Conveyance closed in 2019 and Lighting scheduled to close in Q1. And our robust cash flow allowed us to return $2.2 billion to shareholders, including $1.2 billion of dividends and $1 billion in share repurchases.

I'd also note that we purchased these shares at an average price of $80 a share. And finally, it was a very good year for our shareholders, who had a 43% total return, 50 basis points over the median of our proxy peer. So overall, I'd say another record year, and I'm clearly very proud of what our team was able to deliver.

Turning to Page 12. We provide our revenue and margin guidance for 2020. Overall, we expect organic growth to be anywhere from down 1 to up 1, with weakness in the first half and a bit stronger in the second half as a result of easier prior year comps.

Beginning with Electrical Products, we expect to see 1% to 3% organic growth with continued strength in residential and data center markets, flat commercial construction markets and continued weakness in industrial markets.

In Electrical Systems & Services, we anticipate 0% to 2% organic growth with strength in utility markets, flat commercial construction and weakness in industrial facilities and particularly in oil and gas markets.

For Hydraulics, we're forecasting organic revenue declines of 4% to 6% driven by weakness in global mobile equipment markets.

And in Aerospace, we expect organic growth of 2% to 4% with continued strength in military OEM markets, solid aftermarket growth for both commercial and military markets, partially offset by expected weakness in commercial OEM markets.

For Vehicle, we see organic revenue declines of 7% to 9%, and this is mostly due to the 33% decline that we're forecasting in NAFTA Class 8 truck market, but also some weakness in global light vehicle markets as well.

And for eMobility, organic growth is expected to be up 3% to 5%, and we're seeing double-digit growth for our electrical vehicles markets, offset by some modest declines in internal combustion engine platforms.

Now turning to segment operating margins, operating margins for Eaton. We expect Eaton to be 17.8% to 18.2% at the midpoint, a 40 basis points improvement from 2019.

And in taking a look at our segments, Electrical Products, we think, will be 21.2% to 20 point -- 21.8%. At the midpoint, 180 basis point improvement from 2019, and this is primarily a result of the Lighting divestiture.

For Electrical Systems & Services, we're forecasting 16.4% to 17%, up 10 basis points at the midpoint. Hydraulics at 11.7% to 12.3%, up 80 basis points at the midpoint. Aerospace at 22.9% to 23.5%, down some 110 basis points, and this is largely due to the acquisition of Souriau. And Vehicle, we expect to be between 15.7% and 16.3%, down 80 basis points and largely as a result of lower volumes. And eMobility at 2.5% to 3% as we continue to invest heavily in R&D and start-up costs in new manufacturing capabilities.

And on Page 3, we pick up -- Page 13, excuse me, we pick up the balance of our 2020 guidance. And here, I'd say we expect full year adjusted EPS to be between $5.60 and $5.90 at the midpoint of $5.75. This is essentially flat with 2019 when you exclude the onetime items noted on previous slides.

Organic growth is expected to be essentially down 1% to up 1%, with acquisitions adding 2% and divestiture negatively impacting sales by 7.5%. We expect our corporate costs, including pension, interest and other corporate costs to be flat with 2019 levels, and our tax rate to be between 14.8% and 15.8%.

Operating cash flow is expected to be between $3.4 billion and $3.6 billion and CapEx of approximately $550 million. And with strong cash flow plus the proceeds from the Lighting sale, which we think will be $1.4 billion, we plan to significantly increase our share repurchases. And at this point, we expect to spend between $2.4 billion and $2.8 billion in share repurchases.

And if I can just summarize our Q1 guidance, we expect EPS to be between $1.16 and $1.26. We expect organic revenues to be down 3%, 2% from acquisitions and 3% from divestitures. Segment margins are expected to be between 15.8% and 16.2%, and our tax rate should be between 15% and 16%.

So overall, I'd say we expect really another solid year in 2020 with strong margins and cash flow. We have a lot of confidence in the Eaton Business System and our ability to continue to execute strongly. We think the changes that we've made and announced will position Eaton for higher growth and higher margins and better earnings consistency as we go forward. And with our strong cash flow and proceeds from the Hydraulics sale, we have outstanding optionality as we think through the best approach to create additional shareholder value.

So with that, I'll stop there and turn it back over to Yan for questions.

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Yan Jin, Eaton Corporation plc - SVP of IR [4]

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Thanks, Craig. (Operator Instructions) With that, I will turn it over to the operator to give guys the instruction.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question will come from Jeff Sprague with Vertical Research Partners.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder & Managing Partner [2]

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Okay. Two things for me. First, on Hydraulics, given just kind of the slippery slope that the end markets are on, certainly great to see it go at that valuation. But are you guys subject to any kind of holdback or performance that could affect kind of the ultimate price that you receive for the assets?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [3]

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Yes. No, Jeff, we're not. I mean, and I think we actually posted our documents. And so that information is certainly available for public consumption. And the $3.3 billion number is firm, and we fully expect to close, as Danfoss has also agreed, to take whatever remedies would be required in order to ensure that the transaction closes.

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Jeffrey Todd Sprague, Vertical Research Partners, LLC - Founder & Managing Partner [4]

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Great. And just a guidance question, too. I was just wondering on ESS specifically, 0% to 2%. Does that sort of imply you're going to be up a bit in the first half and then down in the second half? Or how do you see that really playing out relative to what's going on in your backlog?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [5]

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I think we see it almost, Jeff, just the opposite of that. I mean we -- given what we've seen certainly in our order intake and negotiations, we think that the back half of the year will be slightly stronger than the first half of the year and as we take a look at what we're experiencing today, one of the reasons why we guided to our overall revenues being down 3% in Q1. And so we do think at the back half of the year, we'll be slightly stronger. And a lot of that, I'd say, quite frankly, is a function of easier comps when you look at the year-over-year comparisons.

And from an EPS standpoint, we're really pretty much well balanced in terms of where -- what we've been historically, where some 47% of our EPS is generated in the first half of the year and 53% in the second half. And so that's very much consistent with our guidance this year as well.

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Operator [6]

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And our next question in queue, that will come from Joe Ritchie with Goldman Sachs.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [7]

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Craig, maybe just kind of starting off on Hydraulics, and congratulations there, obviously. I guess as you think about the pipeline, you mentioned very active. I'd love to hear how you're thinking about potential prioritization of acquisitions? And then also, you've been very active from a divestiture standpoint. Are we done at this point?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [8]

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Yes. I appreciate the comment, Joe. And as I mentioned in my opening commentary, we think it's an outstanding outcome for all parties. We think it's great for Eaton and our shareholders. We think it's outstanding for our employees and great for Danfoss as well.

I'd say the priority for us really haven't changed. What we've said historically is that our priorities, from an M&A perspective, continue to be growing our Electrical business, Aerospace and also selectively, we're looking at things that we could potentially do in this new space for us called eMobility. And so those priorities really have not changed.

As I mentioned in my commentary, we are seeing today kind of a more active pipeline than we've seen historically. And so as we think about the optionality of what we do with that cash, certainly, M&A is an option, buying back shares is an option. So we're very much comfortable with where we sit in terms of making sure that we maximize shareholder value as we think about how we deploy that -- those proceeds that will come in.

And with respect to portfolio, we like where we sit. I mean it's -- at this point, if you think about the remaining parts of our company, and I know there's been a lot of speculation about Vehicle. So I'll go ahead and address that right upfront. We like our Vehicle business. It delivers extraordinary margins, and they tend to be at the very top of their industry with respect to returns. The business today, given what we've done today with our joint venture in Cummins, will be a lot less cyclical as we go forward. It certainly helps us as the whole world moves towards this more electric outcome to getting the volume and scale that we need to really drive dividends across the organization. And so yes, we absolutely like our portfolio and where we sit today.

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Joseph Alfred Ritchie, Goldman Sachs Group Inc., Research Division - VP & Lead Multi-Industry Analyst [9]

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That's helpful. And then just one quick one on Aero. I don't recall you guys having much exposure to the MAX. But can you maybe just talk about that specifically as it relates to your guidance, and also how you think about margins in the Aero segment as well in 2020, just given the strength in 2019?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [10]

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Yes. I think the MAX is an important program for Eaton as well. I think anybody in the aerospace industry, I'd say the MAX is going to be an important program for them. And so our content tied to the MAX at the OEM level is, order of magnitude, just north of $100 million.

And what we've done as a part of the Aerospace forecast in our guidance is we've essentially taken what Boeing has given us in terms of their current build schedule, and that's what's reflected in our Aerospace guidance. One of the reasons why we're not seeing more robust growth in our Aerospace business in 2020 is clearly the impact of the MAX.

I will tell you, as you think about the margin implications for the MAX, what you typically trade-off with OEM volume, is aftermarket volume. And so we think from a margin perspective, independent of what happens with the MAX, we think the margins will be just fine. We think we'll be just fine from an EPS standpoint, but it could have certainly an impact on revenue.

So our Aerospace margins as we provided guidance, 2019 was a record year with really extraordinary improvement in our margins. The margins will be down slightly in 2020. And this, as we mentioned, was largely a function of the acquisition of Souriau. But also, we were running at very frothy levels in 2019 in terms of the margins of the businesses. So we think the guidance that we provided for 2020 are very much in line with where we think the business should be.

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Operator [11]

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Our next question, that will come from John Walsh with Crédit Suisse.

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John Fred Walsh, Crédit Suisse AG, Research Division - Director [12]

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And congrats on Hydraulics. I'll echo everyone's comments. Can you help us or can you tell us what the exiting share count was? And then how we should be thinking about the cadence of the repurchases through 2020?

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [13]

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Yes, I will -- I'll address that. The total share count for Q4 was 415 million. It was not very different right at the end of the year.

In terms of repurchases, we are going to do as we've done in the past. We decided against doing an accelerated repurchase, and we're going to execute the transactions on our own. We do have the ability to buy about $70 million worth a day based on the safe harbor. So we can make significant moves fairly quickly. And we will be executing those repurchases as we deem it most effective for our shareholders, obviously, taking into account market conditions.

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John Fred Walsh, Crédit Suisse AG, Research Division - Director [14]

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Great. And then as we think about the EP orders ex Lighting down 2%, can you maybe help parse that out between end market and if you're still seeing any kind of destocking at your distributor partners?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [15]

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Yes. Appreciate the question. I mean if we think about markets, I mean, as we provided a little bit of color on it, we think today that we still see growth in nonres construction. We did mention the fact that commercial construction, we think, is flat. We think industrial controls will be down, but residential continues to be up nicely, we think mid-single digit. And the IT piece of data centers, which is reported through Electrical Products, we think it'll also be up low single digit.

And so we think on balance, these markets continued to kind of bounce around the low kind of single-digit growth kind of neighborhood. And we're hopeful, once again, that as some of this uncertainty continues to ebb away as it relates to trade, as it relates to the North American trade agreement that, that continues to buoy confidence in our customers in general.

And I think in general, distribution is fine. I mean distribution, certainly in Q4, held in there. And our distributors are generally pretty positive around 2020. So we think distribution continues to be a strong point as well.

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Operator [16]

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Our next question in queue will come from Nigel Coe with Wolfe Research.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [17]

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Obviously, there's a lot of moving pieces on the portfolio. Just to be clear, so given the buyback you got in place for 2020, does that offset the dilution completely from Lighting, but you still have some dilution, obviously, coming in the first half of the year?

And then, Rick, on the tax rate, does the portfolio move have any significant impact on the tax rate, both ex Lighting, but also ex Hydraulics?

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [18]

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I can answer both those questions. Yes, the buyback does offset the dilution, so that's why we're able to keep earning EPS flat between the years.

And then the tax rate, we don't think will be changed from these portfolio actions. So we still think it'll be between 14% and 16%.

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Nigel Edward Coe, Wolfe Research, LLC - MD & Senior Research Analyst [19]

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Okay. Great. And my follow-up question is regarding distributor consolidation. Obviously, WESCO's an important channel partner for Eaton. How does -- feel about larger distributor partners impact your business the way you go to market?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [20]

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Yes, I think it's obviously a question of which distributor combinations we're talking about. And as it relates to WESCO's acquisition of Anixter, which is maybe the one that's prompted the question, we think that's an outstanding combination for Eaton and our relationship with WESCO as we go forward. And so we think that one is really positive for Eaton, and we have a very strong relationship with WESCO, as you know. And we have a very strong relationship with Anixter. So we think that combination bodes extremely well for our future together and certainly is positive for Eaton.

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Operator [21]

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The next question in queue will come from Scott Davis with Melius Research.

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Scott Reed Davis, Melius Research LLC - Founding Partner, Chairman, CEO & Research Analyst of Multi-Industry Research [22]

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A lot of good questions have been asked already, but I would love to hear your view, Craig, as you walk around the world, what markets you think are going to be or what geographies, I guess, more specifically, are going to be better or worse than perhaps 2019 run rate?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [23]

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Yes. Yes, I appreciate the question. And I think in many ways, Scott, that is the $64,000 question in terms of what the future economic outlook looks like. And I'd say, if you'd asked me that question maybe 3 weeks ago before the coronavirus, I would say, China, for sure. I mean clearly, we saw a much stronger Q4 in China, and that economy had continued to strengthen. We'll see what the coronavirus does in terms of the impact in China, and really, the impact that it has around the world. We clearly see somewhat slowing growth in the U.S. But there are certainly pockets of strength.

Residential markets continue to be quite strong. Data center markets continue to be strong. Utility markets continue to be strong. We think South America will have a better year than they had in 2019 as they work through some of their historical issues. And so we're clearly seeing some strengthening in South America.

We think Europe slows a bit overall. We think India had a really tough year in 2019. We think India is better as well. And if you think about a lot of the emerging markets around the world, we think they generally have better years in 2020 than they did in 2019.

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Scott Reed Davis, Melius Research LLC - Founding Partner, Chairman, CEO & Research Analyst of Multi-Industry Research [24]

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Okay. Helpful. And the one thing that -- I know eMobility is small, but what are you thinking over the next kind of 3 years we should be tracking and caring more about? Is it the backlog that you're building in the business? Would you start to get a sell-through in 2021 that's meaningful? That, that segment starts to move the needle with some sort of margin attached to it? And just a sense of is this a 5-year out, 3-year out or start to see progress kind of a year-and-change from now?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [25]

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Okay. I appreciate the question, Scott, and it's one that we get from others as well. And we'd say that -- and the real inflection point for eMobility will be around 2022. We -- a lot of these new electric vehicle platforms will launch in 2021. And so we think it's really 2022 before you get to the point where you start to see revenues that have a meaningful impact on our eMobility segment, and for Eaton overall.

But as you think about the underlying assumption and what's going on in electrification in general, we think the story around electrification is obviously much bigger than what's going on in eMobility and passenger cars as we think about the more electric everything. Homes are becoming more electrified, commercial facilities, planes, trains, everything is becoming more electric.

And one of the real advantages we think we have with respect to our eMobility segment is that anytime you're dealing with automotive kinds of scales, you're now also creating real advantages that you can then take back into your core business as well. And so we think there's a much bigger story and a much bigger play for Eaton as we think about how we play in eMobility than just what happens in the light vehicle market.

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Operator [26]

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And our next question, that will come from Nicole DeBlase with Deutsche Bank.

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Nicole Sheree DeBlase, Deutsche Bank AG, Research Division - Director & Lead Analyst [27]

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So I just want to start with a clarification. Just -- I'm 99% sure this is the way you guys are doing your guidance. But Lighting is excluded beginning in the like, first day of the second quarter. Is that correct?

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [28]

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Where -- we actually have put it in for 2 months, sort of the middle of the first quarter.

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Nicole Sheree DeBlase, Deutsche Bank AG, Research Division - Director & Lead Analyst [29]

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Okay. That's helpful, Rick. And then when we think about rolling forward the calendar on free cash flow after you guys complete the Hydraulics sale, would that create a major change in your free cash flow relative to how you guys have guided for 2020?

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [30]

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Well, first of all, we expect the sale to conclude at the end of the year. So it shouldn't have really any impact on 2020.

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Nicole Sheree DeBlase, Deutsche Bank AG, Research Division - Director & Lead Analyst [31]

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Right. But I'm thinking about like framing 2021 free cash flow.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [32]

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Yes. What I'm seeing -- Nicole, with respect to Hydraulics, I mean, I think what you'll see from the company in general, post-Hydraulics is a company that will deliver, once again, more consistent free cash flow as a function of that industry, in general. The cash flows in Hydraulics are about as volatile as the industry itself. So I think what you'll see from Eaton post the divesture of Hydraulics is a company that delivers, once again, very strong free cash flow, and you'll see a lot more consistency overall.

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Operator [33]

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The next question in queue, that will come from David Raso with Evercore ISI.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [34]

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I just want to check whether I have the math correct backing out Lighting and looking at the Electrical Products margin improvement. The guidance shows 180 bps, and it depends on exactly the revenues for the 10 months that you won't have Lighting. I'm using about $1.4 billion (inaudible). I know we don't have the exact margin on Lighting but obviously, it was below the segment average. So I'm just trying to back into what is the margin improvement just excluding Lighting from 10 months? I mean I'm getting as much as 140 bps, 130 bps. And then that leads to kind of legacy Electrical Product not really having to expand margins much to hit the target?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [35]

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Yes, I think that's a fair way of thinking about it, Dave. Something just north of 100 bps of improvement from Lighting and some underlying improvement in the business is the right way to think about it.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [36]

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And that said then, if the margins are, let's say, run rating close to 21, just getting rid of Lighting, I know 2% organic is not that robust, but still the margin improvement is a bit modest at least relative to your recent performance. Is there something within electrical mix, price/cost, whatever it may be, that's not allowing a little more expansion versus recent history?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [37]

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No, no. I'd say that we certainly had a very strong year in 2019 and posted very strong margin improvement. At this point, as we look at the year, we think this is the best way to think about the segment for the year. Could we be a little better than that? We hope so. But at this point, we think this is the right way to think about the segment and the appropriate guidance.

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David Michael Raso, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Industrial Research Team [38]

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And I might have missed this, I apologize. But the assets that are left in Hydraulics after the sale, are those potential opportunities for further sales during the course of this year? Or is it all just TBD for right now?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [39]

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Yes. So if you think about what's remaining, and we did disclose a bit kind of in the context of the Hydraulics close, these are really attractive businesses that have great positions in their respective industries. We like those assets, and we intend to retain them.

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Operator [40]

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The next question will come from Julian Mitchell with Barclays.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [41]

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Maybe just the first question around the data center market. I heard that the outlook is pretty good in the EP side. I wonder if there was any nuance or difference within ESS? And really, the reason I ask is that the commentary, perhaps as always, from different people is mixed. Some of the Internet service providers sound fairly optimistic. Some of the equipment suppliers like Regal or Cummins talked about pushouts in data center activity this morning. So I just wondered what your core assumption was for that market for this year in the medium term?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [42]

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Yes, Julian, we appreciate the question. And not surprising, by the way, that you do hear commentary around the segment that, in some cases, could be in conflict depending upon where every supplier is in the timing of some of these large projects; and where you are in terms of your exposure to hyperscale and other pieces of the market. I'd say for us, we do think that data center market, based upon everything that we've seen, grows kind of low single-digit in 2020, which, given kind of some of the underlying trends around data generation and consumption is a relatively modest number.

We did, in fact, see a better second half of the year in hyperscale specifically, and data centers continue to be a growth segment for us overall. But I'd say that, no, I mean, Electrical Systems & Services which, as you know, and more the 3 phase that we report as a part of ES&S and more of the single phase that we report in Electrical Products, but we think that data centers largely, as a category, continues to be a very attractive category. And then -- but it will be lumpy. There will be periods of time when you see extraordinary growth, and there will be periods of time when some of the hyperscale guys essentially take time out to absorb kind of what they've actually done and will pause in their purchases.

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Julian C.H. Mitchell, Barclays Bank PLC, Research Division - Research Analyst [43]

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And then a second question for you, maybe a slightly broader one. You've certainly surprised me with the success on the margin ramp the last couple of years. It's really been extraordinary. Just wondered if you were at all worried that, that focus on the cost out hurt the organic growth profile of Eaton at all, and how satisfied you are with that. If we look at the last 5 years or last 10 years, the organic sales CAGR was about 1% company-wide. Do you think that the company is now poised for that to move higher in the medium term?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [44]

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Maybe I'll deal with the margin question first, Julian, because I will tell you that if you think about where the margin expansion has come from inside of our company, it really has been essentially around eliminating operational inefficiencies in our company. And so we've not, in any way, sacrificed growth opportunities for the sake of margin. I think it's really around a lot of the portfolio work that we're doing as we talk about what is it that drives the margin expansion in Eaton, we talked about running our factories more efficiently. We talked about leveraging our scale. And we talked about also where we focus, this idea of grow the head and shrink the tail.

And so those are the things that we've been doing as a company to accelerate margin expansion, and quite frankly, we're not done. There's more opportunities there.

On the organic growth front, I'd say we, too, have not been pleased with our organic growth. It's one of the reasons why we've really set that as the #1 priority for the organization and we've been investing heavily in organic growth inside of our organization. And so we think that organic growth relative to the markets that we've been, we think we've been fine.

And in fact, overall, public data that we get says that we've actually gained a little share in many of our businesses, but we need to do better than that. And so that continues to be the #1 priority for the organization to drive organic growth.

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Operator [45]

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The next question in queue, that will come from Andy Casey with Wells Fargo Securities.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [46]

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Within ESS ex the hyperscale data centers that you just went through, in the past, I think you talked about some project deferral in them. Incorporating the first half, second half directional comments, I understand those. But are you seeing any thought in the uncertainty driven project deferral at this point?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [47]

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Yes. I'd say, Andy, maybe not really. We continue to see, I'd say, projects deferred. I would -- I'd say that the rate has not escalated from what we've seen in prior quarters, but there remains a fair amount of uncertainty around the global economy. And so I think to the extent that we're dealing in this uncertain environment, whether it's trade or most recently, the coronavirus; with Brexit, I mean there's been a whole host of geopolitical events that have caused many of our customers in and around large projects, specifically, to wait and see a bit, and then that continues to be the case. But not necessarily at an increasing rate, more like in line with what we've seen during the course of much of the second half of 2019.

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Andrew Millard Casey, Wells Fargo Securities, LLC, Research Division - Senior Machinery Analyst [48]

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Okay. And then secondly, on potential acquisition opportunities. Can you talk about whether the pipeline is full at this point? And relative to what you saw maybe last year, the valuation is becoming any more attractive.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [49]

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Yes. I'd say the pipeline is certainly more active than we've seen a year ago, and our teams are busy working through a number of potential opportunities.

I think with respect to valuations, I'd say that not really. Valuations, I think, for the most part, continue to be quite sporty, and what we commit to you is that we will maintain our discipline. And we have a very clear view on what our cost of capital is and what our expected returns are. And so we will make sure that as we think about deploying our ample free cash flow that we're smart in the way we do it, and we continue to be very comfortable with the option of buying back stock.

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Operator [50]

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The next question in queue will come from Josh Pokrzywinski with Morgan Stanley.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [51]

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Craig, just a question for you on EP. One of your competitors this morning had some tariff exemption that helped out their electrical business and got a bit of a clawback going into even 2018. Anything that you guys qualified for in the EP portfolio, and any benefit that was recognized?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [52]

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No, none at all. There was no onetime benefits. We'd be interested to know what that was and we'll find out who that was and see if we missed something. But no, there's been -- there were no onetime benefits associated with tariff exemptions in our EP results at all.

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [53]

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And Josh, as we've commented that we produce in region for region. So we don't have large shipments coming out of China into other parts of the world. So it wouldn't be something where there would be a big opportunity for us.

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Joshua Charles Pokrzywinski, Morgan Stanley, Research Division - Equity Analyst [54]

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Got it. That's helpful. And then just a follow-up on the acquisition pipeline. I think you guys have been very clear on your role in the data center kind of being end-to-end electrical and not really wanting to stray too far from that. I guess, Craig, are there any gaps in that? Or are there other pieces that you could add on to either on the front end or closer to the rack? And as this market has evolved, are you seeing other product sets within the data center that just given the attractiveness of the end market start to look more interesting to you as you build out the portfolio?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [55]

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Josh, I appreciate the question. I'd say on the margin, we have a great portfolio today that we offer and sell into data centers from all the power distribution equipment to the power quality equipment.

We think this acquisition of PDI, by the way, as we mentioned, $125 million business that goes into the data center market is very much about filling a product portfolio. And also, in this case, giving us better access to the co-located -- the colo operators of data centers.

And so on the margins, there are some minor things that we can do, and we'll continue to look at. But by and large, we think our position in data centers is very well -- very well situated, and no big gaps at all.

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Operator [56]

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The next question in queue, that will come from Christopher Glynn with Oppenheimer.

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Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [57]

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Congrats on an excellent 2019.

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [58]

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Thank you.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [59]

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Thanks.

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Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [60]

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Just wanted to kind of hit on Jeff's question about the ESS splits transferring that to Vehicle on the down 8% organic. I want to make sure we can get the magnitude in the first half right. So I'm wondering how you're seeing that linearity.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [61]

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I'm sorry, can you -- so the -- transferring it to Vehicle. I'm not sure if I understand the...

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Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [62]

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Sorry. Just the same question, yes.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [63]

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Okay. Yes, I'd say that if you think about kind of our guidance with respect to revenue, we do think that the second half of the year will be a bit stronger on an [EV] basis versus the first half. And I would say, but more than that, I would just say, it's really more a function of the comps and the comparables year-over-year. If you take a look at -- the second half of 2019 was clearly a much weaker period of time for us than the first half. And so I think it's really a function of the comparables more than it is we're anticipating anything dramatically different in terms of the seasonality that we historically see in our business with respect to our own revenue growth.

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Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [64]

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Okay. And then on the eMobility comments you made a couple of quarters in a row now about being ahead of plan. I'm wondering if you're seeing that in terms of the pace of design cycles or your win rates?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [65]

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Yes, I think there's probably a little bit of both. But on that one in terms of I think that every major automotive OEM around the world and commercial vehicle customer around the world. Everybody today has an initiative around electrification of their fleet, and that has certainly gained momentum, and we've been a benefactor of that. And at the same time, our team has done an extraordinary job from a standing start really building a whole broad range of product capabilities that have enabled us to really be an effective alternative and a viable alternative in this particular space. And so I think it's really been a combination.

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Operator [66]

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And the next question in queue will come from Markus Mittermaier with UBS.

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Markus Mittermaier, UBS Investment Bank, Research Division - Co-Head of European Capital Goods Research for EMEA and Executive Director [67]

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Improvements over the years. You've been closing the gap, to a large extent, across the electrical businesses to some of your global peers, particularly if you look at the European low voltage players. Now how should we think about this going forward? I mean are there any structural reasons why these margins shouldn't align to where some of your peers are? I mean it's already mentioned that if I take out sort of the Lighting impacts in EP ex Lighting, you are basically already at the margin levels that you're guiding for. So how should we structurally think about this, maybe not into 2020, but sort of medium term, how much upside is that closing that gap to the peers fully?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [68]

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Yes. I guess, Markus, I mean, the first thing I would say with respect to our Electrical business, I'd say, we don't believe there is a gap. In fact, we think, today, when you take a look at our Electrical business relative to most of our peers that our margins are actually as good as or better than most of them. You got to really think about it in the context, I'm not sure which companies you're referring to, but our Electrical Products business, for example, which is largely a components business that goes to distribution. And those margins, we think, compare very favorably to the industry overall. And in Electrical Systems & Services, I'd say, once again, that business performs very favorably. And I think it's really -- you got to really think about the peers in the context of we play across the whole spectrum of electrical.

Some of the peers that maybe you're referencing tend to be more niche. Maybe they're an electrical products business only or they're a components business only. But when you look at in aggregate against our primary peers, the ones who play across the whole spectrum in electrical, I would argue that our margins are as good or better than almost any of our competitors. And by the way, I would acknowledge that we're not done. We think we have opportunity that remains to continue to expand margins, and that's clearly what we expect to do. And we'll -- as a part of our investor meeting in the first week of March, we'll provide some guidance around what we think the future outlook looks like.

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Markus Mittermaier, UBS Investment Bank, Research Division - Co-Head of European Capital Goods Research for EMEA and Executive Director [69]

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Sure. Great. That's very helpful. And then just briefly as a follow-up on aviation aftermarket OE, what was that split sort of in the -- in Q4? And what's embedded in the guide for 2020 here?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [70]

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Yes, I'd say you can think about our business as 60-40: 60% OE, 40% aftermarket. And those numbers vary slightly depending upon what quarter you're talking about or what year you're talking about. But kind of the long-term view, a 60-40 split is generally where we're at.

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Operator [71]

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The next question, that will come from Mig Dobre with Baird.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [72]

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And congrats on a good 2019. I wanted to go back to ESS as well and maybe ask a couple of things. On Power Distribution, can you give us some color on margin for that business? And then how do you think about the cadence of the segment's margin through the year, given that you've got some pretty difficult comps on incrementals in Q2 and Q3.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [73]

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Our power distribution margins inside of Electrical Systems & Services, I'd say, are largely in line with the segment overall. So I don't know that we see significant differences in the margins in power distribution assemblies overall, though, obviously, projects can impact that perhaps a little bit more than some of the other parts of the business.

In terms of cadence, I mean this business always tends to be a little bit back-end loaded. And if you think about the company's split of revenue first half, second half, Electrical Systems & Services always tends to be a little bit of a back-end loaded business. And as a result, you get higher volume and higher margins in the second half of the year. And I think that's just very much consistent with what we've seen from this business over a very long period of time.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [74]

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Yes, Craig, just to clarify, I was talking about the acquisition, Power Distribution acquisition?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [75]

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Oh, PDI. Okay. Yes. PDI's margins, I would say, today are below the average for Electrical Systems & Services. We -- obviously, we like the business. We like the space. We think we have an opportunity to clearly expand margins, but they do come into the company at slightly below the margins of the segment overall.

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Richard H. Fearon, Eaton Corporation plc - Vice Chairman and Chief Financial & Planning Officer [76]

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And we'll make some improvement in terms of synergies this year, but probably more so in 2021 in PDI.

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Mircea Dobre, Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research and Senior Research Analyst [77]

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Sure. And then lastly, on Hydraulics, just looking at your guidance, your margin guidance for 2020 and kind of comparing it to what we've seen exiting 2019. How do you think about the drivers for margin expansion here? And what's different going forward than what we've seen in 2019?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [78]

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I think the answer in Hydraulics -- and we've spent a lot of time over the last couple of years talking about the level of inefficiencies that we were driving in the Hydraulics business as we dealt with this pretty significant market ramp in the midst of a -- perhaps the biggest restructuring program in the history of the business. And so as I mentioned in prior calls, we were kind of caught in the middle of doing this massive restructuring and movement of parts and pieces when the industry ramped. And we had a lot of inefficiencies that were in the business as we were halfway complete in terms of many of these restructuring programs.

And so as we think about 2020 and where the improvement comes from, it's largely a function of getting these things completed and behind us. And we're very confident in our ability to deliver the margin guidance that we've laid out for Hydraulics.

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Operator [79]

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The next question, that will come from Deane Dray with RBC Capital Markets.

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Deane Michael Dray, RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment [80]

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Just got a couple of quick ones here. First, when I look at the 2020 guidance, the organic revenue growth of minus 1 to plus 1 seems a bit tighter than I would have expected, just given the macro uncertainty. So maybe some -- reflect on that, if you could. And is there any impact now with the recast portfolio earnings, better earnings consistency? Does that reduce some of the cyclicality, and might that explain some of the tighter range?

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [81]

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Yes. I think the first thing, Deane, to your point, I mean, we agree, it's a fairly tight range, and we could have said approximately flat. There always is a fair amount of uncertainty, in general, in these businesses.

And so I'd say I wouldn't overread at least for 2020 the fact that the range is minus 1 to plus 1 other than to say that we think our markets are going to be approximately flat for the year, is really the right way to think about that. And to your point, lots of uncertainty. We'll see how the year unfolds, but that's really where we've landed at as an organization.

I do think, to your point, though, as we go forward, once we get beyond 2020 into 2021 and we get Hydraulics divested, there's no question that there'll be a lot more earnings and revenue consistency inside of the organization when you go forward. And so very much consistent with the strategy that we laid out around driving better consistency of earnings, Hydraulics will help tremendously in that regard.

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Deane Michael Dray, RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment [82]

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Great.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [83]

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I wouldn't overread the minus 1 to plus 1.

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Deane Michael Dray, RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment [84]

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Good. I promise not to overread. And then just last question would be, it's interesting how many questions you've had today on data center. Obviously, some of it from Network Power acquisition. But what do you make of the new ownership of the former Emerson Network Power? And does that change, in any way, expectations about some of the competitive dynamics, maybe some more price competition? Be interested in your thoughts there.

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Craig Arnold, Eaton Corporation plc - Chairman & CEO [85]

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No. I mean, I'd say, appreciate the question, Deane, and I could -- I know Dave Cote well. I used to work for him, by the way. So it's -- I can imagine that he will certainly bring some strong leadership to that business. But no, we'd say, we love our position in data centers.

Today, if you think about where we play, and first of all, we don't overlap completely with Vertiv. I mean we play in, in some -- many cases, different parts of the market than they do. But we think we're clearly #1 or #2 in the world depending upon where you're at in data centers. We like our strategic position there.

We think at the end of the day, competition is good. It will make us all better. But we like our position in data centers, and we think we're well positioned. We think we continue to do extraordinarily well in that market. And so no, we don't think it changes the competitive dynamic at all.

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Yan Jin, Eaton Corporation plc - SVP of IR [86]

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Good. Thank you all. We have reached the end of the call, and we do appreciate everybody's questions. As always, Chip and I will be available to follow-up. Thank you all for joining us today.

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Operator [87]

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Thank you very much. And ladies and gentlemen, that does conclude your conference call for today. We do thank you for your participation and for using AT&T's conferencing service. You may now disconnect.