Eaton Corporation plc
Q3 2011 Earnings Call Transcript

Published: 24 Oct 2011

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the Eaton Corporation Third Quarter Earnings Call. [Operator Instructions] And as a reminder, today's conference is being recorded. I would now like to turn the conference over to your host, Senior Vice President of Investor Relations, Mr. Don Bullock. Please go ahead, sir.

[Donald H. Bullock:]

Good morning. Welcome to Eaton's Third Quarter 2011 Earnings Conference Call. Joining me this morning are Sandy Cutler, Chairman and CEO; and Rick Fearon, Vice Chairman and CFO. As has been our practice, we will begin today's call with comments from Sandy, followed by a question-and-answer session. The information provided on our conference call today will include forward-looking statements concerning the fourth quarter 2011 and full year 2011 net income per share and operating earnings per share, fourth quarter and full year 2011 revenues, our worldwide markets, our growth in relation to end markets, and our growth from acquisitions. Those statements should be used with caution and are subject to various risks and uncertainties, many of which are outside the company's control. Factors that could cause actual results to differ materially from those in the forward-looking statements are set forth in today's press release and related Form 8-K filing. As a reminder, we've included a presentation on the third quarter results, which can be accessed on the Investor Relations web page. Additional financial information is available in today's press release, which is located on Eaton's homepage at www.eaton.com. At this point, I'll turn it over to Sandy. Sandy?

[Alexander M. Cutler:]

Thanks, Don, and good morning, everyone. I hope you've all had a chance to pull up the earnings release presentation. I'm going to work from that here on our call to kick things off. I'm going to move right to Page 3, the highlights of the third quarter. We had really a terrific third quarter. I think you've all seen many of the numbers

[Operator:]

[Operator Instructions]

[Donald H. Bullock:]

Our first question comes from David Raso with ISI Group.

[David Raso:]

Just trying to equate the '12 GDP and industrial production with kind of how you worked obviously with Jim in equating that kind of growth in the macro into your own business. So thinking about last year at this time, you had global GDP for '11, you were thinking about 3.2% and global industrial production at 5.1%. And then a couple of months later, you gave us January sales guidance for the market that you're in of about 8%, and then you tacked on your own outgrowth. So if I'm now looking at -- today, looking at '12 as slower global GDP of 2.8% versus the 3.2% a year ago looking out to '11 and global IP at 3.9%, again lower than the 5.1% a year ago at this time, would it be inappropriate for me to think -- if the way I think of your markets with that kind of macro from Jim's work, is it kind of an end market outlook then for '12 is roughly around 6% or so? I mean, is that a -- would that be inappropriate to gauge it that way?

[Alexander M. Cutler:]

Yes, I think, David -- and I appreciate what you're trying to kind of track out. It's -- we can't -- one year is not necessarily a direct corollary to the next because you get some differences in the markets, i.e. that Aerospace is on a ramp-up. Obviously, we've seen an enormous pop in the truck markets.

[David Raso:]

It's a growth simplification, I understand. I was trying to think about if where global GDP next -- global IP even for example, roughly 25% lower, right? 4-ish versus 5 or 20% lower, you would think, "Okay, well they're thinking 8% market growth in January this year." When I hear you speak again in January, all else equal, probably thinking about 6%. Is it somewhere in the realm? And if you want to take me through the individual pieces, that would be fantastic.

[Alexander M. Cutler:]

I'll do that for you in January, Dave. No, I appreciate what you're getting at. I think what you can count on generally is if you take manufacturing industrial growth, which generally as you see is higher than GDP, and you can add to it to our expectation of outgrowth, and so take about half of that and add it on top, and then whatever you think we're going to do on top of acquisitions, that's not a bad planning scenario.

[David Raso:]

And when it comes to your outgrowth opportunities for '12 versus how you thought going into '11 or even as you have experienced in '11, I know as the outgrowth come down a little bit of late, can you give us a little bit of an update on how you're positioned?

[Alexander M. Cutler:]

Yes, I think, again, part of the challenge when these markets are oscillating a lot is that the economic indices that we try to use have become what I'll call more approximate than precise, and that's particularly true in the emerging nations where the data is just not quite as robust. But I think for planning purposes, I think you can use a 15% on top of that number. I'd be comfortable with that, Dave.

[David Raso:]

And lastly, for Electrical Rest of World, can you give a little more color? I know the inverter business hurt, but maybe again if you could size the business as it sits today. And what of some of the other trends, because I assume the bookings is down that much? And correct me if I'm wrong; it wasn't just that one business? So if you can flesh that out a little bit would be appreciated.

[Alexander M. Cutler:]

Yes, the -- if you go to the Power Distribution side of the business, we're actually positive and we're quite pleased. I think that the solar inverter, which you have called out, and that's really the residential portion of that, again, just to be clear, has been the area where the markets have really backed up around the world as you have seen less in feed-in tariffs and a series of sort of changes in the technology as well. We're quite confident that will come back. We just think it's going to take some time to get through the inventory. So our view on that again is you won't see the residential solar business for us rebound significantly until we get to the middle of the year, that we think the fourth quarter a rough margin run rate of about 10% is probably about the best view we can give you at this point. Remember, in the first quarter of every year is generally the weakest quarter for our Electrical business, and then we would expect to start to see things rebound next year. But the trends in the Power Distribution business and rest of the world have been good.

[David Raso:]

Well, the reason I asked is the Power Quality business -- I'll throw utility in there. I mean, this year, it's probably $1.4 billion business. I mean, it dominates your rest of world. The resi business is probably sub-$500 million. So how is the one inverter business driving a total company -- or total segment, I should say, down 9% bookings?

[Alexander M. Cutler:]

Yes, what we've seen is that the -- there actually has been in the overall Power Quality business, that the third quarter was a softer quarter than what we've been seeing run this year, and that has been both at the single phase side of the marketplace, which tends to tie into sort of servers, if you will, server in that lower end of the market. And then the very big mega data centers actually slowed slightly in the third quarter. The middle of the market has continued quite strong.

[Donald H. Bullock:]

Our next question comes from Ann Duignan from JPMorgan.

[Ann P. Duignan:]

Just to add quick point of clarification on the mark-to-market. Were there gains on marking to market in prior quarters?

[Richard H. Fearon:]

Ann, it's Rick. Maybe I should just give a little explanation around this. I think it might help. As you know, commodity markets do move around from quarter-to-quarter. Normally, they move in relatively smooth, smooth trends, and what happened that created the loss in the third quarter is that we had an incredible downward move in commodities in the back half of September. In fact, they declined in September in many of the commodities were the largest monthly declines in over a decade. So you had about a 25% decline in copper, 25% in silver, 25% in lead. And many of the contracts require the mark -- the monthly mark-to-market to go through the income statement. And that's typically required where you're buying a metal where you don't have an exact match in the metal you're buying and the goods that you're purchasing, and that causes the need to take it through the income statement. We have had relatively modest gains across many quarters but relatively modest, and what made this quarter so unusual was just the abrupt decline in the third quarter.

[Ann P. Duignan:]

[indiscernible] inventory...?

[Alexander M. Cutler:]

Yes, and I might mention -- yes, inventory. And I'd mention one other thing, too, is that as we've talked about this in any of these time periods -- you may remember when we talked about economics for 2011. We said we anticipated 2011 would be a year of increased volatility, both from a commodity and from a currency point of view. Frankly, we never foresaw, as Rick mentioned, numbers that would occur in the 7- to 10-day time period like we saw at the end of September. And we think because of the fact that it's so volatile -- let me anticipate the next question, is how do you know it's not going to occur in the next quarter? -- is that we're actually pulling back slightly in terms of our exposure, because we're not convinced that while the world is anticipating a relatively slow growth kind of scenario going forward here, that we may not see some more dramatic moves. And we just don't want to have that exposure.

[Ann P. Duignan:]

Okay, that's helpful. And then on the operating side, North America bookings were -- on the Electrical side were obviously very strong. Can you talk a little bit about were there any changes there? Is it pretty consistent with what we've been seeing all year, or maybe a little bit of color on what's going on in that market?

[Alexander M. Cutler:]

Sure. And it is largely consistent, Ann, with what we've been seeing this year, is that oil and gas has remained really, really strong and it's been a great area of activity for us. We started to see, as I mentioned earlier, that the IT distribution market, which tends to be some of the more single-phase area, weakened slightly during the quarter. And again, we saw, again as I mentioned to Dave's question, that server producers weren't kind of seeing the outgrowth they've seen earlier in the year, flat in America. Very, very strong, I mentioned oil and gas. Chemical, very strong. We're starting to see some of the projects up in Canada, for instance, around the oil sands really come back to life and they had been a little bit dormant. Mining quite strong. Industrial markets quite strong. And so I'd say the area that perhaps you will hear a lot of data that is different is you'll hear data around non-residential construction. And you'll hear very different views on this. We think the data, particularly the revised data for the first half that's come out has really confirmed what we've been talking about for the last 12 months, because we're seeing the bookings which come well before the put in place and so we're quite a good indication of watching our bookings is giving a view into what we're seeing really develop here on the commercial side at this point.

[Donald H. Bullock:]

Our next question comes from Andy Kaplowitz at Barclays Capital.

[Andy Kaplowitz:]

Sandy, could you talk about the Truck business in particular? I mean, it seemed obviously there's a lot of strength there in NAFTA. But also, you have a pretty large rest of the world business, especially in Brazil. Could you update us on how much that business contributed to the strength in the quarter and what you see going forward?

[Alexander M. Cutler:]

Yes, both questions here. In North America, we remain convinced that this market could support the 265,000 in terms of production this year if we could get all the supply chains lined up in the industry. But I think what we've been hearing from a number of our customers, and I think you have seen that in writing from them as well, is that some concern about whether everything will get built this year. We'll know that answer when we get to the 31st of December, but that's why we took the 10,000 units out of our forecast for this year. Having said that, and I noted and you referred to it, that our quarter was an all-time record quarter in terms of sales in our Truck business, and so really our business outside of the U.S. has increased very significantly as a percent of our total Truck business. And as you can tell by the margins, it too is a very handsome business. There's no question that Brazil and the businesses that we base out of Brazil are some of the strongest portions of our Truck business we built. And so with a variety of gains in terms of market share and important positions for real key customers, we're really pleased that business has grown very significantly. And that would be the largest kind of year-to-year change, if you would, in terms of that outside. We're active obviously in Asia. We have a smaller business in Europe. But as I was saying, it was our Brazilian business that is the piece that has really grown most significantly.

[Andy Kaplowitz:]

Sandy, do your guys gauge how much of that could be a pre-buy, any of it, some of it? And how do they look at that?

[Alexander M. Cutler:]

Yes, there are different emission standards coming in, but that business that we have in Brazil is fairly broadly based across both heavy duty, medium duty, agricultural equipment, bus markets. And so we don't think there's a material impact in these numbers of what we would refer to in North America as these large pre-buys that we can see every third year.

[Andy Kaplowitz:]

Okay, that's great. And then just one question about acquisition activity. Given the volatility in the market, it seems like it's been a little quieter across the industrial space and acquisitions in 3Q. Is that kind of what you're seeing is a little quieter? Are there good opportunities out there? Do you anticipate accelerating your acquisition activity going forward?

[Alexander M. Cutler:]

Well, we continue to think there are very good opportunities, and there's quite a good flow of opportunities out there. We were very pleased, as you've seen over the last couple of months, to have closed 2 acquisitions in the filtration area. We closed an acquisition in our Electrical business in South Africa. We just added a very small utility-grade solar inverter, and that's the area of the solar market that is expanding relatively quickly. And so we think the activity levels are actually pretty good out there. And -- but at the same time, you obviously saw our view of what became a priority in the third quarter, was with our stock so undervalued, we really thought it was a very prudent time to buy in about $275 million of our stock.

[Donald H. Bullock:]

Our next question comes from Eli Lustgarten with Longbow.

[Eli S. Lustgarten:]

A couple of clarification questions. What's the actual shares outstanding at the end of the quarter? It looks like 338.

[Alexander M. Cutler:]

We'll pull it up here for you in 2 minutes.

[Richard H. Fearon:]

We're 337.

[Eli S. Lustgarten:]

337?

[Richard H. Fearon:]

I'm just double checking but -- yes, 337 at September 30.

[Eli S. Lustgarten:]

Okay. And tax rate for 2013, if you're 18% to 19% in the fourth quarter, does that stay the next year? Or does it...

[Richard H. Fearon:]

For '13 or do you mean '12?

[Eli S. Lustgarten:]

'12, yes.

[Richard H. Fearon:]

I mean, that's really long term guidance there, Eli. It's early. And as you know, we haven't done our profit planning, and mix is a very big determinant of the rate. But I think at this early juncture, Eli, I think it will be in the 16% to 18% range. And how high in that range really will be a function of how much U.S. and Brazilian income, because those are our 2 countries that have the highest -- our 2 large countries with the highest tax rates.

[Donald H. Bullock:]

We'll move on to our next question, Jamie Cook from Crédit Suisse.

[Jamie L. Cook:]

Two quick questions. One, in terms of 2012, you pointed out that pension could be a headwind of $0.10 or so based on your -- what we know today. Are there any other costs that we should think about next year? We can assume what we want in incremental margins, but anything else that -- as we think about modeling for 2012? And then I guess my other question is, you talked about the Chinese construction market improving, I think, by mid-2012. Can you talk about a little more granularly why -- what gives you confidence in what you're seeing in terms of some of the inventory glut issues within China construction?

[Alexander M. Cutler:]

Yes, let me take the second one first, if I might, Jamie. On -- we've been talking obviously with them. We serve not only valued U.S.-based multinationals in China, but we also serve quite strongly all the major manufacturers that are China domestic. And our conversations with them really going back to spring and again this summer and again this fall, it really confirmed, as we do channel checks in some depth in China, that there was a very substantial oversupply, if the markets came to a really big slowdown in the springtime, on many of the construction equipment pieces. That, as we've watched it, didn't burn off really through the summer. It has begun to burn down this fall. You may be aware that there is a mandate to build 10 million new, what we would call, low-income housing units per year in China at this point. To get back to those numbers, that market's got to be turned on during the first half. We think that we will see the government tune construction credit again, just as they have before. They did this in 2008, 2009. And that will lead them for there starting to be demand. That will chew the rest of the inventory up. And that's why we say we think for us, as orders flow through in production, that's probably a second quarter, midyear type of event at this point. So we follow the data pretty -- and we think we've got pretty good data there, but it does mean that we do feel that the Chinese government will restimulate credit in the construction market to ensure this building continues to go on. So that's really what our forecast is based on at this point. I would tell you that this was the -- one of the first things that turned down in 2008, and that's why we've watched it so carefully. It has not accelerated. I mean, it has stabilized at a point at this point. So we take some confidence from that, and I think it's an example of how the government there is really fine-tuning or engineering a soft landing. And coming back to the other cost issue, as Rick mentioned, we've really not finished our operating planning. We're right in the midst of it at this point. The reason we called out pension is that we knew that was an issue very much in people's minds, and we don't have another thumb that's sticking up at this point. So that would be the one I would point to.

[Donald H. Bullock:]

Our next question comes from Josh Pokrzywinski with MKM Partners.

[Joshua C. Pokrzywinski:]

Just want to go back to the commodities question here for a moment if we could. If commodities stay here, what kind of benefit should we wind up into 2012? I guess the feedback we've be getting in the channel is that price is pretty well sticking across the board, and I think other multinationals are seeing that as well. Presumably here, you would roll into a benefit next year. Just order of magnitude, what we should think about.

[Alexander M. Cutler:]

Well, there's so many scenarios that it's a little bit difficult to give you a number. But having taken this mark-to-market loss, if commodity prices do improve and they are up a bit from the end of September -- copper this morning was up about 6% and silver was up about 5% -- there should be some modest benefits. But again, I'd emphasize that Q3 is the abnormality. Normally, these are very modest in any quarter. It's unusual to have such abrupt movements, so I don't think it's going to be a major driving factor in your 2012 estimates.

[Joshua C. Pokrzywinski:]

Yes. I mean, I guess, and then more on the price cost delta versus any kind of hedge accounting.

[Alexander M. Cutler:]

Yes. And there, Josh, we would say that we'll get that out, obviously, when we talk about our guidance in January. But remember, where we are this quarter, 15.2% segment margins if -- without the mark-to-market, which we feel was sort of an atypical event. Remember, our goal is then to get to 16% segment margins. So we're a little bit ahead of plan, if you will be from where we started on this when we announced those goals earlier this year. But I would also say, and many of you have asked the same question about, what should I think about in terms of incremental margins as I start to move year-to-year? Our guidance has consistently been that early in a cycle, we would be at the higher end of our range. Later in the cycle, that will start to move down. So that you recall, we were over 40% in 2010. This year, we guided to 33% and we're hitting those numbers. And this is for core revenue. This doesn't apply to acquisitions or to ForEx, which sometimes can be an error in terms of how you stack up numbers. But I would expect that going into next year, that number will be lower than the 33%, but we don't have a specific number yet.

[Joshua C. Pokrzywinski:]

Understood, that's helpful. And then just one last one. With the strong bookings and record backlog in the Electrical business, how should we think about visibility in Electrical? Or are you pretty well locked in, in terms of the first half, in terms of knowing -- or at least having a good sense of what shipments will be? Or is this more of a first quarter dynamic? Just kind of helping the calibration around visibility.

[Alexander M. Cutler:]

In our Electrical business, the major portion of the backlog, if you will, will be -- and there we're getting visibility that can be 3 to 6 months out -- tends to be in the Power Distribution business project business, or it tends to be in the big 3-phase business for the Power Quality business. Those are not 100% of the business. And so the flow portion of the businesses kind of comes in the same month, goes out the same month. But having said that, we feel pretty good about that forward visibility in the Electrical business at this point, that we've got a pretty good view over the next 3 to 6 months. You can get interruptions month-to-month in the flow business, and that tends to be confidence of distributors on stocking and also sort of short-term projects. But the reason we called it out is that it's -- we think it's a very good indicator that the non-res market is coming back, the industrial market is staying strong and that's really good news for Eaton.

[Joshua C. Pokrzywinski:]

Got you. Sorry, just a follow-up to your comment on distributor confidence. It sounds like, based on what WESCO is seeing out there, that the case is that the distributors are reasonably confident. Is that your sentiment as well?

[Alexander M. Cutler:]

Well -- and again, they are obviously a very good customer of ours and a major business partner, and they do very well in the projects business, and that business has been very strong, just as we're seeing from our backlog. I would say that the thing we've been trying to monitor really since midsummer with distributor and channel partners and most of our businesses are, has their confidence declined because of what I'll call sort of the square dancing in capitals around the world on budget issues? And I think people are being cautious about that but they have not yet thrown in the towel like they did in 2008. So we aren't seeing that kind of behavior. We don't think that there are bubbles in these markets like you were developing in 2008. And as a result, so far, not a material change in demand. But we do believe that we need to see some solution to the sovereign debt problem in Europe. And while that's there, it's going to contribute to daily volatility as you all know better than I. And that's equally true with the square dancing that's going on down in Washington. And so as we get to year end and get to the recommendations with the super committee and then the votes by the 2 houses, as well as the President's signature, these are really important steps in adding or reducing, let me say, volatility in markets.

[Donald H. Bullock:]

Our next question comes from Jeff Hammond with KeyBanc Capital Markets.

[Jeffrey D. Hammond:]

Can you just clarify? In this market outgrowth, you lowered the assumption $100 million. Is there anything to read into that or any specific markets where you're not seeing outgrowth? And if not, why does that normalize into '12?

[Alexander M. Cutler:]

Yes, fair question, Jeff. No, I would say no. We're not concerned about a competitive situation or a technology that's not working out or -- that's not the issue. We really felt that we've worked through this, this year. We try to build a total revenue forecast that's made up of market and ForEx and outgrowth, and our best assessment is what we're providing you with at this point. But we would expect again that for planning purposes, we ought to be working toward that 50% number again in '12.

[Jeffrey D. Hammond:]

Okay, great. And then just the rest of world, if you could just talk specifically about what you're seeing in the Moeller business.

[Alexander M. Cutler:]

Yes, and I think to the spirit of your question, what's really happening in Europe? To date, and we've been watching it very, very carefully, because you can't watch these conversations about Europe and not worry whether Northern Europe begins to be impacted obviously the way that Southern Europe was. And to date, we saw some slowdown in that August time period but then things came back. And as we're watching them now, they're a little stronger than we might have thought they would have been. Having said that, we don't know better than anyone else how long the concern about how Europe is going to finance the sovereign debt problem -- how long will that have to go on before it starts to cause problems? We did see in the October PMIs that came out this morning, that they took a jump down. And that's not Eaton-specific; that's the PMIs. In general, we found that the industrial PMIs are a real good forecaster for markets around the world. And so this morning's news is much stronger than people expected in China. It looks like they are engineering a soft, soft landing. Weaker than people had hoped for in Europe. It looks like that maybe moving it toward, as I mentioned, a tougher first half for Europe, and that's sort of our view under the macro, first half of 2012.

[Donald H. Bullock:]

Our next question comes from Terry Darling with Goldman Sachs.

[Terry Darling:]

Sandy, wondering if you might update us on how you're thinking about capital allocation from here. You typically have a pretty good fourth quarter free cash generating dynamic. You bought some stock back not too far below where we are now. Maybe a little update on the acquisition pipeline as well.

[Alexander M. Cutler:]

Sure. Let me take you through the kind of pieces of it. One, we have -- continue to have really attractive growth opportunities. And so as you can see, we've got a $600 million CapEx spend this year. We haven't cut that back. And I think that view is -- that's a good measure of our confidence in terms of the attractive opportunities we have for the company. Second, dividend. That we obviously had increased our dividend strongly this year. And we remain, I think, very much on track with our dividend philosophy over time to try to increase our dividend in line with our future earnings activity. That then gets us down to the 2 subjects you mentioned, acquisition and buyback. We obviously felt that it was prudent to buy back stock this fall. We've got a strong balance sheet. You're exactly right. The fourth quarter tends to be a very big cash flow quarter. Third and fourth are always our biggest, followed by second. And so we will have a significant -- we already do have significant cash and marketable securities on the balance sheet. And so we think it gives us a lot of flexibility at this point. But that's just what we want in a period of time when there is uncertainty in the marketplace, either to continue to do what I would call accretive, relatively smaller acquisitions that we've been doing through this year and/or buy back stocks. So we really want to maintain the flexibility, Terry, in that regard, because we do think there are these clouds hanging in Europe and hanging over Washington. It doesn't seem to be over the rest of the country but it is over Washington. And we want to be flexible to deal with opportunities that come up in that respect.

[Terry Darling:]

Would you say that the M&A pipeline has gotten better or about the same as you were 3 or 6 months ago, given all the changes in the world today?

[Alexander M. Cutler:]

I'd say it's about the same, Terry. I think and I commented on this publicly in a couple areas, what tends to happen is when global growth numbers get turned down like we saw in the July, August time period this year, buyers tend to want to revalue the likely purchase price. Sellers want to feel that nothing has changed. And so I think to the earlier question of, why might things have been slower generally in industry during the third quarter? I think it takes a quarter or 2 for people to kind of recalibrate and both get on the same page. And so that may have been one of the reasons you saw the third quarter be a little slower as people were dealing with this rate of change.

[Terry Darling:]

Okay. And then good to see the Aero margins bounce back. And I'm just wondering as you sink into the first half of 2012, the comps are very easy from a margin perspective there. But maybe you could talk a little bit about what you're anticipating for R&D next year in Aero year-over-year as you think about how that should progress.

[Alexander M. Cutler:]

I would say the big news in Aerospace for us is that we're on the front end of this, what we think is going to be quite an attractive uptick in commercial build schedules. And we've laid those out a couple of times ago, and they've just been confirmed by people. We're seeing orders lay in for some of the new aircraft finally, which is very good news. And that the aftermarket has been strong, so pleased with each of those. We don't think that there is a significant change in kind of programmatic costs versus our run rates, because we happen to be up at pretty fulsome levels with a lot of projects we're working on. So I guess the best way I could describe it for you, Terry, is that I think our third and fourth quarter this year are a much better indication of what the future will bring than our first and second quarters were.

[Donald H. Bullock:]

Our next question comes from Steve Volkmann with Jefferies.

[Stephen E. Volkmann:]

Just a couple of conceptual questions, if I might. You guys touched a lot of end markets, whether it be construction, ag, truck, et cetera, where we might possibly see a little bit of weakness in the first quarter as this accelerated depreciation kind of fades. Do you have enough visibility to give us any sense of whether we should be thinking along those lines?

[Alexander M. Cutler:]

I don't know that we've got real micro visibility. I suspect some of the major equipment builders have got a better view in that area. But what we are seeing is -- and you saw some strong earnings announced by one of our customers this morning in those segments is, you're seeing dealer inventories increase. You're seeing backlogs increase. So we're not sensing that there is any sort of a kind of a cliff event, if you would, as you get immediately after the year. The production schedules that have been shared with us don't reflect that.

[Stephen E. Volkmann:]

Okay, that's helpful. And then how are you thinking about capital spending next year? I assume you're sort of going through that process now. Is there any chance that you sort of take a little more cautious approach and pull that back a little bit?

[Alexander M. Cutler:]

Well, I think -- Steve, just to the spirit of your question, I think in all areas right now, flexibility is one of the real bywords. And one of the things that we we're pleased about that we think our teams have done a really good job on is we worked very hard during the 2008, 2009 time period to take structural costs out of the company. And they've done a really nice job of keeping it out of the company, which is why we haven't been hiring back a lot and we've been able to increase our volumes significantly. We think that helps us a lot however the economy develops here over the next year. And so that in all these areas, whether it's capital expenditures, R&D, et cetera, we have multiple contingency plans. And I think that's how you have to manage through these time periods. So yes, we'll keep a tight eye on capital and keep a close eye on it as we move into next year. Hopefully, we're all going to be a little better informed as to which way these deficit discussions in Washington turn out, as well as the alternatives they're being discussed in Europe by the time we get into the first quarter. I don't think we're going to get great clarity before year end. And so I think we're all likely to kind of go past this December time period saying is it a -- is it economy A or is it economy B scenario? We think the highest probability is the one I stated earlier in terms of slower global growth. It's slowest in Europe. It may be most difficult in Europe and particularly early in the year. And it's probably best in the emerging nations in the world. And the good news is everyone was tremor-ing about China 3, 4 months ago. It's starting to look like they are being successful in engineering a soft landing, which would be very good news.

[Stephen E. Volkmann:]

Okay, great. And then just one more briefly. As you think about getting into 2012 and starting to make plans and so forth, the difference between your operating EPS and your GAAP EPS is pretty darn small now. At what point do we sort of get one set of numbers and go forward with that?

[Alexander M. Cutler:]

Well, I think our view on that, Steve, has been -- you're right. Right now, it's fairly de minimis because the number of acquisitions we've done, they've been fairly small. If we were fortunate at some time to find a larger transaction which we think created real shareholder value and made sense in these sort of volatile time periods, that number could get larger. And so our view has always been to provide you with both sets of information so you've got insight into both running rate, profitability, as well as restructuring costs, and then to report on those projections on a quarterly basis. So I think from what we've done so far this year, it's likely to be pretty immaterial, but you never know whether there may be an opportunity that creates real value, where that information and that transparency, we think, is important.

[Donald H. Bullock:]

Our next question comes from Jeff Sprague with Vertical Research.

[Jeffrey T. Sprague:]

Sandy, could you elaborate a little bit more on where you're seeing weakness in the 3-phase UPS market and kind of the extent of the weakness? Has it just developed in the last quarter or so? Or what's kind of the order activity in the space?

[Alexander M. Cutler:]

Yes, and I would say, again, it's really -- in the 3-phase segment, it's really in the mega data centers. So what I would call is your more normal-sized data center, there is expansion going on. You've read all the same reports we have that 36% of data centers in North America run out of power in the next 18 months, I mean, so there continues to be real pressure. We think what's happened at the mega data center is it reflects what you see from some customers who -- in other areas as well who has simply said, "Hey, if I'm thinking about a couple of hundred million dollar expenditure, might I put this off for 2 to 3 months until I see how the budget negotiations, et cetera, happen?" The other issue that's out there clearly is there are a lot of discussion about the cloud. And we think what that does is that it gives people a technical question as well as an economic question for why to take the couple of months off. So we don't think this undercuts any of the long-term trends. We think we've just seen one of these soft pockets. And we've seen them before where the mega data center quotation activity and then award activity will get weaker for 3 or 4 months, and then it will pick up. That's our view at this point because we're seeing the flow side, which tends to address the, let me call them, the kind of the midrange data center, continuing to be very busy.

[Jeffrey T. Sprague:]

Do you see cloud as a -- at least, a short term and maybe that in 6 months or 18 months or some period of time where UPS growth slows because you're just squeezing more efficiency out of servers and therefore, you get kind of a pause in the whole server and UPS chain of activity?

[Alexander M. Cutler:]

We don't really because you would see it in the mid as well. I think what's really happened at the big one is that if we're with the economy today and say, "Hey, I think I want to build a new data center," it would be pretty easy for me to say, "Well, let's kind of wait until the volatility settles down. And hey, by the way, get me an update on how the cloud is going to interface with our own proprietary activities." And then would have him off for a month before it could come back to me. And I think that kind of what's going on. I don't mean to push on Rick on that but I think there's a lot of that kind of discussion going on right now. And I do believe it will be back.

[Jeffrey T. Sprague:]

And if you could elaborate a little bit more on solar, Sandy. Just how much is it down? And does it still go lower from here? Or have you found your run rate and the weakness you talked about into next year is now just comp-ing against these lower levels?

[Alexander M. Cutler:]

Yes, it is the latter. We think we are down at that level and we think we are comp-ing against lower levels. And that's why I made the comment that we don't expect to see it come back significantly until we get to the second quarter of next year, because we had -- we're going to have tough comps against what we had in the first half of this year.

[Jeffrey T. Sprague:]

And just a little more elaboration, someone earlier asked you about kind of the lack of outgrowth in Electrical. But is there any vertical market or something that stood out in the quarter that you think you lagged in the formulation of those numbers?

[Alexander M. Cutler:]

No, we don't really see, to your point, a market segment or a set of customers in that regard. But what we saw is that we probably had an outsized position in terms of strength in the residential solar market. And so when it get -- it got hit, we bear a little bit more of impact of that than would be reflected in the global indexes that we try to use to express the global electrical market.

[Jeffrey T. Sprague:]

And then just last one for me, if I could. Last quarter, we had -- kind of had the discussion on the call about non-res, and it was really kind of commercial non-res, but you've kind of introduced on this call maybe the hint that the commercial piece of non-res actually is now maybe gaining a little bit of traction. Can you provide a little more detail on what you're seeing? Is it regional? Is it office? Where are you starting to see some signs of life?

[Alexander M. Cutler:]

Yes, 2 things there, Jeff. One was, as you may recall, there was some fairly massive recasting of government data that was done when they revised GDP for the early part of this year. In that recasting, what you'd see is the total private non-residential construction, actually in the second quarter this year, was revised to being up 4.9%. A lot of people missed that when people were looking at the GDP revisions. So what it was actually saying is the market was already starting to come back this spring. Now that number has held up at that kind of number here for the third quarter this year. And so you see in areas like I had mentioned that the mining structures, petroleum, natural gas quite strong. You saw that the power side and the power and communication structures have been strong each of the last quarter. Interestingly, the other commercial segment, which is one of the 3 segments in commercial and healthcare, has been positive both in the second quarter and this quarter. And when you get into office, which many people point to and say, "Gee, office seems to be a lot of kind of see-through offices," only down 4.2%. And so we are seeing -- now this is what's actually put in place. We're seeing the bookings for what will be put in place over the 6 months, and that's why you're seeing our backlog up strong. So we've been forecasting these numbers would get better back to the third quarter of last year, because we were booking business last year that was going to get shipped early this year. So that's where -- education, vocational only down 1.6% now, having been down 23% if you go back a couple of quarters. So we're pretty clear this is definitely bottoming at this point. And obviously, that's important for our Americas business, which is already performing well.

[Donald H. Bullock:]

Our next question comes from Andy Casey with Wells Fargo.

[Andrew M. Casey:]

Just a couple of questions. Within Truck, you talked about the supply chain issues. Are you hearing about any sort of resolution by year end for those?

[Alexander M. Cutler:]

I can't give you a good specific insight myself because we're not always privy to that information. All I can do is kind of base it upon what's happened historically, is that these are fairly big steps when you go through the rate of quarterly production increase that the industry is going through here in North America. And that we start to have, what I would call, kind of more experience operating at this level. Remember, the first quarter this year was running sort of at a 51,000 rate. Second quarter went to 68,000. Third quarter -- second quarter went to 61,000, excuse me. Third quarter goes to 68,000, fourth quarter to 74,000. And so we successfully got as an industry the 68,000 shipped. As you start to -- these percentage increases aren't as big as they were earlier now. So usually 3, 4 months, you start to kind of stabilize this stuff, and those are the numbers that support the 255,000, the ramp that I just give you. And so I think, another couple of months, you ought to be pretty well through that. But I wouldn't -- any individual one of our customers would have a better view on that than we would. We can tell you what we're seeing on our kind of product and what we're hearing generally, and we're not having a problem. I mean, we pushed very hard to get up to these rates because these were big steps for us too. But we didn't cause anyone a problem.

[Andrew M. Casey:]

Okay. And then back, I guess, on part of Jeff's question in terms of Electrical Americas, the backlog increase. How much, if any, is still related to the stimulus that you've talked about in prior calls?

[Alexander M. Cutler:]

Yes, I would say that's not an issue because, obviously, it's not a positive if I could say at this point, because that's the portion of the market where you're starting to see less activity. And that's why we are -- and of course, we're talking private non-res. All the numbers I just provided to Jeff were private non-res. They weren't the government stuff. So the government stuff, you're seeing the numbers aren't as strong year-on-year at this point. And so while we were very fortunate to do very well in the government activity that helped provide shipments in '09 and '10, we don't -- that hasn't been as big an issue for us -- excuse me, in '10 and early '11, that hasn't been as big an issue in terms of what we're booking for next year at this point. So we think that's actually transitioning very well.

[Andrew M. Casey:]

So basically, the backlog growth, just to be clear, is net of the weaker stimulus impact.

[Alexander M. Cutler:]

Correct.

[Andrew M. Casey:]

Okay. And then one last one, kind of a, I don't know, a longer-term question. You have a little bit slower global growth outlook for the short term. Is there any increased sense of urgency to go out and supplement that with acquisitions to hit the long-term targets?

[Alexander M. Cutler:]

No, I would -- I want to be clear on this one. Thank you for the question. I said no, we don't feel it changes our game plan per se. And we don't feel it's prudent to fall, let me call it, kind of prey to the pressures of, "Gee, we got to slap something in here at higher risk because we can't create our own organic growth." That is not a formula we'll be following.

[Donald H. Bullock:]

Our next question is from Tim Thein with Citigroup. Okay. Well, let's move to Jason Feldman with UBS.

[Jason Feldman:]

So 2 things, I think, pretty quickly. First, for 2012, you talked about the incremental margins on core growth. At this point, at least, it looks currency may be a headwind. How should we think about the margin impact from that, what basically the flow-through margins would be? Are they incrementals on the currency component?

[Alexander M. Cutler:]

We've generally said on currency, and this has been true for a couple of years, Jason, is that, that's more of a 10% type number.

[Jason Feldman:]

Great. And then -- and I don't want to harp on this, but you very precisely talked about the mark-to-market adjustment impact in the third quarter. You characterized the benefits in the first half as modest. When you say modest, are we talking about a rounding error? Are we talking half of the third quarter levels? Just trying to get some sort of quantification.

[Richard H. Fearon:]

It wouldn't be material and it'd be much, much less than this 23%. So it's so immaterial that I, frankly, don't have the numbers with me. But you wouldn't notice it in the rounding.

[Donald H. Bullock:]

Our next question comes from Rob McCarthy with Robert Baird.

[Robert F. McCarthy:]

I gather that -- I mean, given our discussion on commodity prices and how they changed at the end of the quarter, that you didn't have anything like a $0.06 loss from commodity hedges in your expectations for the quarter. So given that you were pretty much delivered dead on target third quarter, where was the offset? Where did you see a little less performance in the quarter than -- I'm sorry; I got that backwards. Where did you see a little stronger performance in the quarter that helped to offset that?

[Alexander M. Cutler:]

Chart 4, Robert, really hints that we had the $0.01 from the lower shares. We had a $0.04 benefit from lower tax rate than we had guided to. And then the balance of the other $0.01 was really our better cost control and better margin performance than...

[Robert F. McCarthy:]

Okay. So it's really the $0.05 that matches up as the unforeseen sort of nonoperating item that matches up again.

[Alexander M. Cutler:]

Yes. And $0.01, obviously, is operating but I would say you're exactly right in terms of your first statement. We did not see this kind of volatility in commodities coming even a month ahead of when it occurred, much less 2.5 months earlier when we gave our guidance.

[Richard H. Fearon:]

And on the tax rate, we also didn't foresee that, because it came from filing all of our tax returns around the world. Most of those returns are due in the third quarter. And as we completed all of the calculations, which are laborious and long calculations to get those tax returns filed, there were some improvements in the amount of tax we were -- that we owed in certain countries. And so we were, I guess, fortunate in a way that there was an offset of the commodity losses with the lower tax rate.

[Robert F. McCarthy:]

The other question I wanted to ask, I think probably maybe it's around the definition of materiality. And my observation is that, Sandy, you made 2 or 3 statements that you've seen no material change in demand conditions in the quarter. But you all did take down your NAFTA second half production outlook by more than 5%, and you talked some about Power Quality softness and bookings in rest of world and -- in part because of those changes, you reduced your forecast for outgrowth for the full year. So is it that these things together don't achieve a definition of materiality? Or is it in part more that in combination with your conviction that certain things are about to bottom, that you saw strength, particularly strength at the end of the quarter relative to how the quarter has gotten underway that gives you more conviction in the near-term outlook?

[Alexander M. Cutler:]

We would describe the fact that we still are talking about 11% growth on our end markets for the full year as the measure of whether we're seeing, on a combined basis across all of many, many individual vertical markets we've participated in, that we have not seen a significant change. What we've tried to provide you with in that chart that's in the packet on markets is where we've seen some slight ups and downs, and as I mentioned when we introduced the chart, more on the order of tuning at this point. We've called out obviously a couple of them because they're issues we've been chatting with you through this year, but I would describe them more as tuning and not significantly different information than we shared with you at the end of the second quarter.

[Robert F. McCarthy:]

So as I look at the change in the 2012 macro outlook as compared to what you talked about a quarter ago, it seems to me that, that will provoke some material change in demand conditions. And so it raises the question of, when do you think you might start to see a broader impact? Is that in fourth quarter bookings? Or are we really talking into early next year?

[Alexander M. Cutler:]

Well, what I said on that one is this is a difficult one to gauge. It's a very good question, and that we've not seen the big change in our markets at this point. However, we too are concerned as we watch what's been going on as governments are struggling with these debt issues. We're not sure when that's going to materialize at this point. So what we provided you with is sort of consensus GDP global numbers at this point. We think they make sense in terms of our planning on a more conservative basis. But the real key is going to be, I think, flexibility here because if those situations are resolved, there's a lot of cash on the sidelines around the world. And could that come back into these markets and really be employed? Hard to know how to discount the government negotiations, both here in the U.S. and Europe. We don't know that we're anymore skilled in that, but we've not seen what so many people had feared, that during the third quarter, we would see markets run off decidedly. That has not happened. And it appears that people are sort of waiting to see what happens out of these discussions.

[Robert F. McCarthy:]

And part of that commentary, I mean, it sort of follows from that, that there was nothing unusual about your September order rates compared to the rest of the quarter.

[Alexander M. Cutler:]

No. We don't see dramatically different trends in one month versus another.

[Donald H. Bullock:]

We want to thank you all for attending the call this morning. As always, I will be available to take your follow-up calls and questions for the remainder of the day and the rest of the week. Thank you again very much for joining us.

[Operator:]

Thank you. And ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using the AT&T Executive Teleconference service. You may now disconnect.