Eaton Corporation plc (ETN) Q4 2010 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Eaton Corporation Fourth Quarter Earnings Conference. [Operator Instructions] I'd now like to turn the conference over to your host, Mr. Don Bullock, Vice President of Investor Relations. Please go ahead, sir.

Good morning. I'm Don Bullock, Vice President of Investor Relations. Welcome to Eaton's fourth quarter and full-year 2010 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 call today will include forward-looking statements concerning the first quarter 2011 and full-year 2011 net income per share and operating earnings per share, 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 fourth quarter results, which can be accessed on the Investor Relations webpage. Additional financial information is available in today's press release, which is located on the Eaton's homepage at www.eaton.com. I'll turn it over to Sandy Cutler.

Thanks, Don. I'm going to work off the presentation, which we have out on our webpage so my hope is that you have accessed that at this point. Let me turn to the Chart #3. Don has just covered the forward-looking statements with you. This is a chart that is titled Highlights of the Fourth Quarter Results. In short, we had an outstanding quarter. Operating earnings of $1.69, net income of $1.63. Our sales were up some 17%. Our operating cash flow was $555 million for the fourth quarter, and we did reach $1.3 billion for the full year. We had record segment operating margins in the fourth quarter, which is really notable of 13.7% and, significantly, those operating margins or operating profits represented a 31% incremental from a year ago in the fourth quarter when not including acquisitions. We also had, as you see, quarter-to-quarter sequential margin expansion, moving up from the 13.4% of the third quarter to the 13.7% in the fourth quarter. And when you step back and look at the year increase of the whole year revenues, they were up some 16%, as we noted in our press release. Our sales increase in developing countries, where you know we've been putting quite a point of emphasis, were up some 30%. And we're really pleased that we also exceeded the goal we set some five years ago for our goals in China. Our sales in China in 2010 reached $1.1 billion. If we turn to the second chart, really it’s a reflection of our own confidence in terms of the forward-looking environment at this point, we are increasing our dividend and also splitting our stock. You saw this morning that our intent to raise the dividend by some 17% from $0.58 per share to $0.68 per share. The stock will be split two-for-one, and the record date for both these actions is February 7 of this year. And for those of you have been following our dividend progression, if you look at the increase that we had last July of 2010 and now again in February of 2011, in this short time period, we will have increased our dividend from $0.50 per share to $0.68 per share, a 36% increase. And I think you’ll all note that we did not cut our dividend in 2009. We turn to the third chart, a comparison to fourth quarter guidance, a quick reconciliation versus the guidance. The midpoint of the guidance we gave you for the fourth quarter was $1.60 operating earnings per share. We did have higher end markets through the fourth quarter, and the good news is we think that momentum is carrying into 2011, and it's virtually across-the-board in our businesses and our geographies, and that contributed about $0.16. The R&E [research and experimentation] tax credit passed in December contributed a positive $0.08. We had a slightly lower tax rate, that was $0.01. And we noted in our press release that we took a provision for a Brazilian lawsuit, and I'll comment on that in just a moment in the fourth quarter. That's a negative $0.15. Then our shares were up just slightly, costing us about $0.01, and that's primarily due to option exercises during the fourth quarter. So that's direct reconciliation of the $1.60 to the $1.69. We think a really strong operating quarter. Now if we turn to the next chart, which is titled Normalized Fourth Quarter Results. To give you a better insight into the run-rate, because there were a number of different items, which I just mentioned, that went in different directions in the fourth quarter. I think the simple way to think about this from an operating perspective is that we reported the fourth quarter operating EPS of $1.69. The Brazilian lawsuit, and this was a provision we decided to take, a Brazilian court held that a judgment against a Brazilian company that we sold in 2006 could be enforced against Eaton. We are appealing that decision, but nonetheless took the provision in the fourth quarter. That would add back $0.15, obviously, because it was what we would call a nonrecurring item in that respect. Then the R&E tax credit, because that it was passed in the fourth quarter, the full year R&E tax credit was recorded in the fourth quarter. If you took that $0.08, split it up by the quarters, it would say that approximately $0.06 really pertained to activities in the first to the third quarters. So in this reconciliation, deducted $0.06. Long way of saying is, that we think the adjusted fourth quarter operating EPS, to give you a feel of the run-rate of the business was $1.78 versus the $1.60 guidance that we provided. Again, while you can understand why we feel it was really an outstanding quarter. Just a quick run through the individual segments. If you turn to Chart #7, the financial summary. I think the big take-away on this chart and we highlighted it in our earnings release is that our segment operating margin at 13.7% was an all-time record. Really pleased here in the fourth quarter to achieve that. On sales that were up just about 2% from the third quarter. I think you've seen all the rest of the data on this chart. So to be respectful of people's time, I'm going to move to the individual segments, if we can move to Chart 8. Chart 8 is the Electrical Americas segment. It's really an outstanding quarter. Operating margins of 16.1%, and sales were up about 5% from the third quarter. So good growth sequentially from the third quarter. The margins are back at mid-2009 levels in a year. You remember where this market is not at peak levels yet, and that we'll be seeing this market grow next year as nonresidential. The decline in nonresidential begins to cease, and we're hopeful that we'll actually see by midyear this market flatten out and, perhaps, show some growth in the second half next year. Fourth quarter bookings, up 14%, really solid momentum. And we did, you'll recall, going back a year and a half ago, we announced that we would expect to book about $500 million in bookings that related to the U.S. stimulus program. We actually ended up $516 million. So we reached our goal in that regard. Very solid outgrowth as you can see again continuing the momentum, and you can see the impact of the several small acquisitions that we've done this year contributing about five points to growth. If we turn to Chart 9. This is the chart for Electrical Rest of World. Sales up about 8.5% from the third quarter, 12.2% margin. A record fourth quarter sales and operating profits, as this business continues to accelerate and really pleased with the margin performance here. Bookings up some 10% in this segment. If we turn to Chart 10, Hydraulics segment. Sales down just slightly in the fourth quarter, a fairly normal seasonal pattern for us, they’re off about 2% in the fourth quarter versus the third quarter. Margins are 12.8%. You can see that the strong markets that continue in this area. And we did not note it on this chart, but we did note it in our press release that our bookings were up some 41% in the quarter, really completing four extraordinary quarters of recovery in bookings, reflecting the V snap-back in this market. I would point out, however though, that if we think about the very strong bookings over 100% that we had in the first quarter of this year, the comparables going forward won't have quite this V snap-back nature. So it's been a really great year this year, but as you'll see our guidance for next year is not quite at the level that we experienced during 2010 in terms of growth. We're very pleased to have closed Tuthill Coupling's acquisition on January 1, and I really feel we came through a very strong quarter on our Hydraulics business. If we turn to Chart 11, that's the Aerospace segment. Sales up about 2.5% from the third quarter. As you can see, they were up 5% from a year ago. Fourth quarter bookings up 36%, and continuing the trend that we've been talking to you about since midyear of 2010, aftermarket bookings were up 9%, helping to drive, as you can see, that stronger operating margin now up at 16% in the fourth quarter. If we turn to the Truck segment, which is Chart 12, sales up some 17% from a year ago, off just slightly about 3% from the third quarter. Again, that's a pre-normal seasonal in the business. Very pleased with the 12.7% margin, and I would note that we elected to record about $6 million of nonrecurring operating expenses in the fourth quarter. They're not related to the ramp-up, and so that margin would be slightly stronger on a run-rate basis. Markets are accelerating, and what we're particularly pleased about is we really are now starting to see the evidence of the recovery in the North American heavy-duty truck market. You saw that orders in the fourth quarter were over 70,000 units. We think we're starting to get the rate of ramp that we need to support our forecast for 2011. If we turn to Chart 13, Automotive segment. Sales up some 9% from a year ago, about 1% from the third quarter, a very solid margin of 10.9%. A really strong record of wins in 2010 that we're really pleased with for a couple of our really distinctive products that are going to drive even stronger growth in the '12, '13 time period, as we begin to launch those new platforms. And now, if we turn to cash flow, which is on Page 14. A very strong quarter of cash flow, $555 million operating cash flow. We spent $186 million in terms of capital expenditures. So $369 million in free cash flow. You'll see in the 2010 full year, we basically hit the targets that we’ve set out in that area and are expecting even stronger cash flow in 2011. $1.6 billion to $1.7 billion operating cash flow. Our capital expenditures will be up some 40% year-to-year. A part of that, obviously, is a recovery from the depressed levels in the first-half of 2010 and all of 2009. And if you actually look at our capital expenditure run-rate in the second half of 2010, it basically equates to what we’ll be spending in 2011. And the free cash flow of $1.05 billion to $1.15 billion, so strong expectations. If we turn to Chart 15. We expect margin expansion in spite of commodity pressures. And as you look down each of these, the guidance we're providing you in terms of the individual segments, we expect the Electrical Americas business to be up to 15%, Electrical Rest of the World, 12%; Hydraulics, 14.5%; Aerospace, 15%; Trucks, 16%; Automotive, 11%; Overall, 14% for a 1.3 point expansion of our margins in 2011 versus 2010. We do, and I will coming back and mention this on later charts, expect that we're going to see about $35 million of uncovered commodity expense. What I mean by that is that those expenses have moved up very quickly. Those costs in the December time period, we would expect that we cannot fully recover about $35 million that will be primarily in the first-half, as our actions catch up with them. And I'll detail that more in just a moment. If we turn to Chart 16, a look at our 2011 end-market growth. I'm not going to go through the individual U.S. and non-U.S. growth columns. I'm going to concentrate just on the total, but we provided the information for your background. We expect the Electrical Americas market index to be up about 6%; Electrical Rest of World, 7%; Hydraulics, 12%; Aerospace, 4%; Truck, 20%; Automotive, 6%; Overall, 8%. What's really significant about this is that we began to talk about this in the third quarter. We expected the markets for all six of our segments to be up in 2011. That's really what's going to power this very strong growth and profits that I'll speak to you about just on the next chart, if we turn to Chart 17. Our guidance for operating earnings per share for full year, $7 to $7.60, with a midpoint of $7.30, a 30% increase over our achievement in 2010. First quarter, $1.50 to $1.60, a midpoint of $1.55. I'll let you simply read the guidance in terms of the net income as well. If we flip to Chart 18, a quick look at a guidance bridge to help you understand our guidance in a little bit more depth. We finished 2010 at $5.61. We expect our end markets, as I mentioned, to go up by about 8%. We're using a 33% incremental margin, obviously, the middle of our range of the 30% to 35% incrementals that we quote. A $450 million of outgrowth, again at a 33% margin, that gives you the $1.91 and the $0.78. We are reconciling back the charge of provision we took in the fourth quarter for the Brazilian lawsuit after-tax of $0.15. Now as we mentioned in our press release, we've got about $160 million of incremental revenues from acquisitions we completed, and this is the full-year in impact, incremental impact in 2011, over 2010. They contributes to about $0.08. So overall about $2.92 of positive items. On the other side, the negatives, a higher tax rate. For the year, we're estimating about a 16% tax rate, and that compares to a lower rate in 2010. That's the negative $0.48. An increase in pension expense that will cost us about $0.22. The un-recovered commodity costs, that's the $35 million I mentioned just a moment ago, that's about $0.18, and again, that will occur primarily in the first-half. Increase in a number of shares outstanding, about a $0.10 negative. And the other corporate expense charges, and this is primarily healthcare and additional incorporate expenses that we're investing in developing countries where we're growing very, very quickly, so a total negative of $1.23. You net those out and that's how we get to $7.30, the midpoint of our guidance for next year. Now if you turn to Chart 19, a quick look at reconciling our fourth quarter, a very strong results to our first quarter guidance. You recall that we finished the fourth quarter, $1.69. Let's take back out the provision for the Brazilian lawsuit of $0.15, a higher tax rate, about 14% is where we think we will be in the first-half. In the second half, we think we're going to be closer to about 17% to 18%. That's how you get the overall 16% rate for the year. But for this calculation here for the first quarter, we're assuming 14%. And that is versus about a 6% rate in the fourth quarter. And the way you get to the 6% is that you saw that our rate was 3.3%, the impact of the Brazilian provision, which was an expense, reduced our rate by about three points. So you add those two together and you get 6%. That's how you do the 14% to 16% comparison in this calculation. That's a negative $0.14. And then lowest seasonal volume, which is our norm that our first quarter is a little lower in terms of seasonal volume, and the primary contributor to that is our Electrical business. It's always the weakest quarter for our Electrical business. That's on the order of about $50 million. That takes off about $0.08. Higher pension, this is one quarter of the $0.22 annual higher pension costs, then higher number of shares, $0.01. And so that's how you move from the $1.69 to $1.55, that's the midpoint of our guidance for 2011 first quarter. If we move to Chart 20, in summary, what we're forecasting is or what we're giving in terms of guidance is that our 2011 sales will increase by about 12%. That does take us up to right at record volumes that we achieved in 2008. But that our change in operating EPS reflecting the leverage of continued increased margins will be up 30%. And so summary on Chart 21. We've tried to give you a quick summary of kind of the key elements that underpin our guidance. The market growth of 8%; the market outgrowth, which is $450 million or about 3%; the acquisition revenue of $160 million, which is 1%. So again, the way we get to our 12% growth is 8% market growth, 3% market outgrowth and 1% acquisition revenue. Our tax rate 15% to 17%, a midpoint of 16% for the year. Again, 14% in the first-half, 17% to 18% in the second half. I've already spoken about the operating EPS and the fully diluted EPS guidance. And our operating cash flow, as you can see, up very handsomely both on an operating and a free cash flow basis from 2010 to 2011. So with that, we will open things up for questions. But before I do so, I think you recognize the different voice introducing today's call. Obviously, Doug Bullock has taken over this call, but before we continue with the call, I just want to recognize the many years Bill Hartman's been in that chair. He's here with us today, but we have him sitting in the second chair. But Bill, we want to recognize for all your years of service and contribution. Thank you.

Moving to our first question. Stephen Volkmann?

Stephen Volkmann. [Jefferies & Company]

The question, I guess, I had a couple of real quick ones there. Just as I look at your guidance, I guess the thing that kind of strikes me is Aerospace. I had looked for slightly larger margin. I'm wondering if that's just maybe a mix shift toward more OE? Or maybe Sandy, you can peel back the onion a little and kind of give us what's going on below the surface there?

Well, the volume, we're talking about the market being up some 4% there. And I think you're seeing very different dynamics between the Defense side of the business and the Commercial side. I think many of us have been commenting on the very positive or focusing on the very positive trends that are occurring on Commercial. The aftermarkets I mentioned continued to turn up. But there is pressure on the Defense side. So our 4% anticipates continued pressure on the Defense side. And also, that we're continuing to carry a very high level of recent-year wins, which means we have high levels of development expense. So if we were seeing that military side also be strong, I would be in your camp thinking this thing might go up further. But at this point, we're just a little cautious about the wins that are blowing on the Defense side.

And is that the way to think about it for the sort of medium-term as well, do you think, for next two or three years?

Yes. I think that where we're going to be viewing Defense as being an area that has very muted growth, and that's going to depend a lot on which platforms you're on. But the stronger growth, as we're talking about not only in '11, but some of these line rate increases, particularly on the single aisle side of the market will hit out toward the end of '11 and going into '12. So that I think the Commercial side may actually be a little stronger out toward the end of the year and the early part of next year.

And then just slightly switching gears, you guys have done some tuck-in acquisitions here. Your balance sheet's in pretty good shape. Can you just talk about your appetite for larger acquisitions? There's obviously been some speculation in the press and just in terms of kind of your philosophy, Sandy?

Yes. Let me start and say your observation is correct, that our balance sheet's in very good shape, and that we obviously have the capacity to do acquisitions. We obviously felt comfortable significantly increasing our dividend by another 17%. We have done a couple small acquisitions recently. In our third quarter conference call, we commented that we are back at a more, what I call more normal level of acquisition investigation at this point. It's always hard to say whether you're going to have single, doubles, triples or something larger. Most of our deals tend to be relatively small, but you've seen us do large deals with Phoenixtec, with Moeller, with Powerware, you can go on down the list. So I wouldn't take it off the table, but I also wouldn't say that's necessarily going to be where we end up. I think you can see us returning to an appetite we've historically talked about of trying to add something on the order of $500,000 to sales through our acquisition. That's pretty much what we're averaging before the market went in the tank.

Moving onto our next question, Jamie Cook. [Credit Suisse]

Just a little more color on the material cost issue that you cited. Can you just talk about which segments, in particular, that they're hitting more and how we think about incrementals in the first-half of the year versus back-half, given you said it will be more first-half loaded and then by the back-half, are we recovering it, I guess?

I think and let me answer the second part, Jamie, if I could, your question first. Our assumption is that we have announced price increases on a number of our businesses. We're working on alternative material substitution as well. What really I think has surprised many people was the enormous acceleration that took place at the very end of November and December. It usually will take some time for people to kind of catch up to that fast a spike. And so while we can't forecast this with any accounting precision, it's our expectation it’ll take us a quarter, or a little longer than that, to fully digest all this. So we would expect these 33% incrementals that I mentioned for the full year. We should be getting all of that in the second half. We may have a little pressure here in the first-half, and that's what we'll be working our way through. Clearly, copper is one of those that has moved very quickly as has silver. There is pressure out there in and around steel as well. Copper and silver tend to be used more intensively in our Electrical businesses than they are in the other businesses. But steel, we intend to use a lot of them in all of our businesses.

So more Electrical, and I guess are we passing through price increases or surcharges as well, in case they continue to rise, so we don't have the same -- the catch-up issue all year?

Yes. Again, we would have viewed that sort of as competitive decisions we'll make as we go forward in each of our businesses. But I'd say the net pricing because a lot of our pricing is also transactional pricing that we're bidding on projects on a daily basis. And so some of that is just done in terms of how you set your pricing on a daily basis.

And then just follow-up question. Parker [Hannifin] was one of the first companies to report out of the gate, and they talked about sort of the developed world coming back at a quicker pace than they had originally anticipated. I'm wondering if you're seeing the same thing in any of your businesses? And are you experiencing any issues on the supply chain or operating inefficiencies?

I think we mentioned in the third quarter, Jamie, that Europe had -- the northern part of Europe had done much better in terms of demand and that fee from the machine tools demand, which is very important for us, both in our Electrical and Hydraulics business. And that trend has continued, I think you're seeing it in all the macro data as well. As I said the U.S. economy in the fourth quarter was clearly stronger than we and others anticipated that it might be, and that's been helpful as well. Having said that, the growth has continued to be highly effective in the developing countries as well for us in a year when we are mid-teens overall sales increase for the world. As I mentioned before, our increase in the developing nations was up some 30%. So I don't think it's an either/or. It's really a dual driver for both of us. On your supply chain issues, again, we mentioned in the second and then again in the third quarter, that we were concerned about supply of electronic components. I think you're sharing that in a lot of sectors right now. It has gotten a little better than it was during the middle of this last year, but we still think that, that's going to be an area that's going to be tight through the first-half of 2011.

Our next question is from Ann Duignan [JPMorgan Chase]

I guess, Sandy, a couple of my questions have already been answered, but I'm interested in your outlook for Brazil, in particular, both on-highway and off-highway?

Yes. It's been a tourist market, I think you'd have to describe it during 2010. And our thinking is that you'll see the activities stay up at a pretty high level but the best forecast for sort of the ag market is that it's going to be flat to off on the order of about 2%. And that seems to us to be kind of a reasonable expectation at this point. You know when they took off the tax incentive for vehicles, light vehicles to be precise, you saw some sag in that last year. The market has sort of digested that, as we've gone through this year. And so, we don't think there's going to be a drop in the light vehicle market, per se. We think the bigger flatness really occurs out there in terms of the ag and construction equipment.

And then, on your outlook for 30% to 35% incrementals, I appreciate that that's your normalized outlook. With the combination of the Automotive and Truck business going to one operating unit, and Ken Davis leading that organization, why wouldn't we expect higher incrementals out of that business going forward, just given all the cost synergies?

Well and you got that big pop in 2009 and '10 is where that thing, where we got a lot of the benefits there and take the costs. And now we're doing the incremental up off the top of that at this point. And so I think the structural, the big pop we actually saw occur at this point.

So we should look for more maybe incremental revenue synergies rather cost synergies, is that the way to think about it going forward?

Well, I think we have gotten structural pieces now. What we're really pleased about as I mentioned some of the large wins that we had that will drop into the Automotive segment at this point is I think the rollout of new product and the fact that, particularly, the truck market will start to strengthen, you're going to see that top line grow more quickly than we've seen over the last couple of years. Our forecast, I didn't mention it specifically, but our forecast for the heavy-duty market here in North America this year is about 240,000 units. And so for all the discussions we've had with many people this last year that when we get to 150,000, actually, the market did get to just a little bit over 150,000 in 2010. And we have been talking about a figure that might be in this 230,000 to 250,000 range, with 240,000 is what we're pretty comfortable with at this point. And having had the 72,000 orders come in, in the fourth quarter, we're really feeling like that backlog is in place to have that occur now in 2011.

And with Centurion, that outlook, I have just one final quick one. Your outlook for hybrids?

Yes. The Hybrid markets, I would say, have not grown as quickly as we might have hoped. I think there are a number of different reasons for that. We've had fluctuations in fuel prices up and down and up and down. There have been some availability issues in and around batteries. And frankly, the fastest-growing markets have been in some of the developing nations, where the governments have gotten involved in putting incentives to get it and really drive municipal and city bus activity. The kind of interplay of electric vehicles and hybrid vehicles here in the U.S., the market's not growing as quickly as we would have thought it would have.

And you're not positioned to take advantage of developing market, muni and buses?

Well, that has been where we've been getting most of our growth.

Our next question is from Andy Casey. [Wells Fargo Securities]

A question on the Hydraulics segment. For a couple quarters now, there's been a little bit of underperformance versus the end market. Can you remind us as to why that is going on?

Yes, I think it's the enormity of the size of the increase in the marketplace. And frankly, what's going into inventory, what's not going into inventory has gotten pretty hard to trace right now. And so, our best view trying to get at this is that we're not seeing significant shifts in kind of positioning the marketplace. So we're seeing is a market that's growing just staggeringly strong the recovery numbers, and that's influencing our ability really to do good quarter-to-quarter analysis on under- and over-performance.

Would I be wrong in reading what you just said as some supply chain constraints?

No. I would not say it's supply chain constraint, at least at this time. I would say it's far more about the massive de-stocking that went on and then the inventory restocking that's going on. And again, the strongest part of the Hydraulics market during 2010 has been the mobile side, not the stationary side. That's not to say stationary is not getting stronger because it has gotten stronger as we go through this year. But part of the strength in the mobile side for suppliers like Eaton has been that many of our OEMs had de-stocked so aggressively during 2008 and '09 that if they begun to build up their own production, they're also restocking. And when you get that kind of under-stocking and overstocking going on, it gets very hard to kind of track a specific market indices.

And then to follow up on a previous question about Truck, roughly 240,000 forecast you threw out there. Do you expect or are you seeing any, at this point, supply chain constraints, not from you or larger suppliers but potentially from the small suppliers that could limit that? I know the backlog will probably grow, but I'm just wondering about supply side limitations to hit that number?

Andy, you’ve been around this market for some time as well. We haven't seen them yet, but I think everyone who’s been around the truck market -- we haven't been up at 240,000-type numbers for four, five years here now. And so, I think it's probably a reasonable expectation that there will be a hiccup somewhere, but it's always very hard to know where it is. We don't see it in our own operations. But in past ramp-ups, we've seen different commodities have a problem. And when that happens, it can interrupt a supply. I haven't seen it yet. But we also are trying to keep our eye out for it.

Our next question is from Eli Lustgarten. [Longbow Research]

Let's go back to Truck market for a minute. I mean, the margins in the fourth quarter, given all the demand is a little bit disappointing. Then you mentioned it was $6 million charges in non-operating costs that we don't see anyplace else, except that you mentioned to it. What was that? Is that anything -- because that would bring the margin up closer to 14%, which is what you'd expect, given where the demand is at?

No, you're exactly right. And that's why I mentioned, Eli. There’s nothing there concerning in terms of the run-rate of the business, and you can see what we're doing with our guidance for next year. So we just -- we knew it would be a concern when people looked at it. We felt they were issues we wanted to deal with during the quarter and we did.

So they’re just local issues, it has nothing to do with anything?

Yes, nothing that affects kind of forward run-rates.

And the same thing doing Hydraulics, the margins. Given the strength of the marketplace, the March also was disappointing. So when you're hearing in the field that you've had a lot of production problem getting stuff out the door, at least, what we're hearing from distributors or so. Is that part of what's contributing to the holdback of profitability in that business?

No. I'd say it's a pretty normal decremental, if you actually look at the decremental on the volumes. They are actually a little bit better than our normal decremental because volumes were down a little bit in the fourth quarter to the third quarter. I think your comments in terms of availability of product, we are starting to see people want a product very quickly, and the lead times in the market have moved out a little bit.

But there's nothing going on. It just seems surprising that the strength of the market and what shipments look like in the industry were that strong that, actually, it was normal seasonality down. I mean, I would've thought it would’ve gone up a little bit?

Well, I think, Eli, that's why I made the comment. I appreciate you bringing it up earlier. I think one of the things to be careful about is that we've been talking to you about, quarter-on-quarter, these are year-over-year increases in terms of bookings that have really been eye-popping all year long. We will now start to operate against much better base or tougher comparables, as we're working next year. So when you take our 41% increase in bookings here at the end of the year, one can't simply extrapolate that into 41% increase in volume next year, because it's now going to be comparing to a first quarter and a second quarter and a third quarter that were a lot higher levels. So we look at that, that shipment level. We were slightly down in the fourth quarter versus the third quarter, and the profitability from an incremental-decremental point of view was pretty much in line with what we would have expected. Now having said that, you're seeing the 14.5% guidance that we're providing for next year for our Hydraulics segment, which we think is a very handsome profitability.

Can you give us what you're forecasting for the Auto sector? I think you indicated bills up 6% here. Is that what your actual numbers are for U.S. and Europe?

Yes, U.S. and Europe, wait for one second here, in Automotive we think that what you'll see is, we said there, U.S. is up about 7%; non-U.S. about 5%; and Europe is around 5%.

Our next question is from Jeff Sprague [ph].

Andy, could you give us a little bit more color on what you're seeing specifically in the Power Quality markets, particularly, the UPS market in the U.S.?

Yes. We're continuing to see quite good demand. And if we look at the kind of the single-phase UPS in the mid-range or small data centers, they're showing a pretty good growth. The large data center markets, there have been some project push-outs, and the bids are getting bigger as the individual size of the data centers are getting larger. And so, there, it's really important whether you're winning or losing on them. And I think, as you can see from our outgrowth numbers, Eaton had another really strong fourth quarter. So we're feeling a lot better about the demand levels now than we were a year ago. We see many more data centers being bid, and we've been successful on a bunch of them here in the fourth quarter.

Is there anything in particular in the complexion what's going on? Is it kind of corporate-specific enterprise-related? Or is it more oriented towards kind of the data explosion and kind of broader networking [indiscernible]?

Yes, I would say two drivers. They're both going on. One is the simple need more and all the mobile computing online, the video drive, all that stuff is just, as you know, is a pipe and data hog. And so that's driving a lot of kind of what I call the hosting-type drive. The second drive, which is equally powerful is this enormous energy efficiency push. And everyone is trying to get utilization of servers up from the kind of historical 30% utilization levels. They're trying to figure out, and as you start to run all of these things at higher levels, you potentially create a lot more heat. And so people who can really come up with this efficiency answer, and that's really where Eaton is really leading in that area, or have a real opportunity through here. And again, that's one of the reasons you've seen our share move so significantly.

I’m just looking at Electrical Rest of World, I would have expected the margins to look a little bit better there, sequentially, given the sequential sales rise. It is something to do with a bit more acquisitions, integration costs in there but didn’t seem to fully describe what happened? Is there anything going on there?

Yes, I'd say two issues, Jeff, there. Almost half of that volume increase was related to either FX or joint venture acquisition volume and so the incremental volumes. So that would come in, obviously, at a lower-than-incremental rate. And the second is the comment that, I can't remember who asked earlier about “are there any areas where there are purchasing or procurement or commodity availability issues”? The electronic component area scenario we've been talking about, so that the fair amount of sort of logistical horsing around for availability out there. And that has caused that to be a little lower than we would have expected.

And just finally for me, the cash flow, in an absolute sense, looks obviously very good next year, $1.1 billion free cash flow. But on $15 billion in revenues, at 7% of sales, it's okay but not exceptional. And you're doing that probably on record margins in '11 that are maybe a couple of hundred basis points above mid-cycle margins, last cycle, kind of the '04, the '07 timeframe. So it looks like your cash flow margins in '11 are the same as they were in the middle of the last cycle, but your operating margins might be 200 basis points higher. I don't know if there's pension? Is there something else?

I'd say there's one other big thing to look at, when we set our record profits, which was $6.90 operating earnings per share in 2007, our tax rate was approximately 6%. And what you're seeing now in terms of our guidance, where we were saying that we'll be at record profits here in 2011, we're doing this with segment profits, couple hundred points higher, more pension expense and a tax rate that is over double of what it was at that time period. And so I think that's the missing piece, if you will, less taxes and pension.

Terry Darling.

Sandy, I wonder if we'd come back to the outlook for the Truck margins. I think when we look at similar points of past cycles and from a volume expectation perspective anyway, you were closer to 18% margins. I think you've said in the past earlier in this cycle, you'd expect incrementals to be north of that 30% to 35% range. Are you just being conservative there? Is there a mix differential versus last cycle? Do you expect Truck to take a disproportionate hit from the commodity pressures? If you could you just address that?

The way we think about this again, is we've talked about peak margins in the Truck cycle might approach 20%. It is true that we've been up over 20% some selected quarters, but one of the things we tried to point out over the last couple of years is that our business outside the U.S. is a much larger percentage than it was at one time. Having said that, at this kind of mid-200 level, these mid-teen numbers are generally where we've been, when we start to push ourselves up higher up into the 18%-type area we've got to start to get up in the very high 200s and near 300. We were achieving those absolute peak numbers when the U.S. market was up over, well over 300,000. So we think this is a pretty good representation of likely behavior, both as a result of the likely achievement in light of both the mix change and the fact that we're still only at 240,000 in this. And so by most judgments, people will look at 240,000 and say, "That's slightly below average." We're looking forward to when this thing gets up to a little higher number.

Right, and as you pointed out, with an order run-rate that maybe suggests some upside to that number, right?

Yes, we'll obviously be tracking it. I think, Terry, all of us who have been around the truck market know that we tend to not be able to forecast exactly when this market really accelerates. This is a fairly logical progression in terms of how we think the quarters would work. We'll see at year end, how close we were to, with this being logical or whether it may accelerate more quickly.

And then looking at your Electrical Americas market index, up 6% in total. Just trying to put some pieces together there relative to the orders that were up 10%. So I'm wondering if you could give us some color on sort of the pieces of that order buildup? And then secondly, your comment that maybe non-res starts to turn positive in the second half of the year.

Yes, I think there are a couple of issues to think about. What's in the red-hot part of the North American markets during 2010 for Electrical? It's obviously been what's happened in the industrial control side of the marketplace, where for a couple of years, people weren't buying equipment to really maintain machine tools. And we saw a huge surge in that regard. I think you're seeing that across the electrical industry. That's not going to stay up at these kind of 20%-type of numbers. And so, we think that cools down a little bit. I think you can just put Residential on the side. It's not just big enough to matter anymore, and as we are not bullish on how fast that comes back. We think you'll continue to see very solid growth in the power quality markets. But the real driver in terms of understanding our year-to-year difference in our forecast for this segment is what's going to happen in non-res. I mentioned in the third quarter that we had -- our conference call -- that we had already seen our small project business go positive year-to-year. That is usually a pretty good leading indicator of what's going to happen in the overall non-res market. It's true that when you look at the put-in-place data for the fourth quarter, there was only one large segment that showed increased year-to-year quarterly market increase of over 10%. And that was in the petroleum and mining sector. But what we think is the most likely case and what we're planning upon is that this market will, and you've seen it every quarter this year, the negative has been getting smaller on a year-to-year basis every quarter. We think by the time we get to the middle of 2011, we're likely to be flat with the year-ago activity. And we may see some positive activity then in the second half that might get us to a full year that would be 0% to 2%. That's really probably the critical assumption that we've got within here. And you've seen us be able to outgrow this market, while it's been down substantially during this last year. And I think the last seven-to-eight years of market share gain are a pretty good predictor of where we are for next year.

And then just lastly on your 2011 EPS guidance bridge, the uncovered commodity costs, $0.18, presumably that's a net number that includes some assumption for higher price and wondering if you could share what your higher price assumption would be?

You're right that it is beyond what we would do in terms of cost reduction, material substitution and supply. We have been out with price increases in the fourth quarter in a number of our businesses. Those numbers are all out there publicly. We do not publicly discuss a net price achievement number for competitive reasons.

Our next caller question is from Andrew Obin. [Bank of America Merrill Lynch]

The question on Truck, and I appreciate that the business mix has changed. But if we were to take a look at your earnings progression back from '01 to '04, and if we were to assume that over the next couple years, we have similar recovery in Truck volumes, has anything changed in terms of operating leverage within the Truck business itself to assume that we're going to see a different kind of operating leverage?

Yes, the easy answer is a lot has changed since 2001 to 2004. But I think the premise of your question is that should you expect operating leverage over a multiyear recovery that's driven by the North American heavy-duty truck market, our answer would be yes. And that our own expectation that we would expect to see these volumes ramp up, the fleets, the average age is quite old out there. There are still the pressures around fuel economy, emissions and safety, same drivers. And then I think the other issue, Andrew, that we just have to keep an eye on is, what happens in terms of the mix of who's buying out there? And you got fleets buying, you got vocational trucks flying. And that mix can kind of move here year-to-year. So hard to know precisely what each year is going to have in that regard. But the short answer is yes, if this thing goes up well past 240,000 in the year of 2012, we would expect to do well on it.

And just a follow-up question, in terms of capital redeployment, I mean, you've clearly showing that you want to return cash back in form of dividends, which we like. But how should we be thinking in terms of priorities, in terms of M&A, dividends and share buybacks, given that we're starting to see some share creep?

We did -- thank you for bringing up the point on the share creep, Andrew, we did see some share creep in the fourth quarter. Primarily, as I mentioned, from option exercises. It's our own plan in our own cash plan to go ahead and to buy back on the order of about $150 million to offset option creep at this point, but we don't have any plans beyond that.

So basically, dividends for you guys in terms of returning cash to shareholders take priority over share buybacks. Is that the right way of thinking?

Well, yes. I wouldn't state it quite that flat-footed, what we said is that we’ve wanted to maintain a dividend policy, which increases dividends in line with our future expectation in earnings. And so over these last couple of years, we haven't been quite at our 15% that is our stated goal. That's one of the reasons we had the increase last year and again this year. What we do in terms of looking at the buyback is always, and that's beyond dilution I'm talking about now from option exercising, is that that's where we go into the examination and can create more value for our shareholders through strategic acquisitions. And if we don't think we can, then we buy back shares, and we've done that before. We think at this point, there are plenty of opportunities out there in the acquisition market that we want to be able to investigate, and that's why we're not in a buyback mode.

Our next question comes from Tim Thein. [Citigroup]

Sandy, you have been articulating a goal of, call it, $500 million in stimulus-related revenues in '10 and '11. There wasn't any discussion in terms of an outlook for 2011, and I understand that it’s harder and harder to track in terms of where actually identifying stimulus-related projects. But did you expect any benefit in 2011 in that area?

Yes, we would expect, and I think you saw that in terms of our outgrowth, Tim, during '10 is that we expect we're going to do just as well on '11. We give some pretty good visibility on projects, but thank you for bringing up the point about a challenge of tracking because it's getting harder and harder to track these items at this point. So we don't plan on kind of a monthly or quarterly report on stimulus versus other growth. It's tending to get packed right into the non-res numbers at this point. But we don't see it as a negative year-to-year, which some people have asked. We think this is just continuing our strong momentum. And again, you've seen so many of these areas where we have real particular confidence, whether it be wastewater treatment, whether it be a lot of the work that's being done on military bases, whether it's a lot of the work that's going into solar and wind. We do well in every one of those areas. We expect that to continue.

And then just switching gears to Rest of World. In terms of that 7% growth, you called out the two of the biggest or bigger segments within there, Industrial and Power Quality and kind of the positive outlook -- [Audio Gap] How do each of those segments kind of play into that 7% growth that you're projecting for 2011, just in terms of what you’re actually guiding to for each of those two segments?

Yes, our best view at this point is the power quality market is fairly close to that average number that we see the non-res, obviously, being, as I mentioned, the kind of 0% to 2%. So it's on the low side. The Industrial would be on the high side, still. It's going to be up closer probably to 10% to 11% in terms of that market. So you mix all of that together. I didn't mention Residential because it's getting to be fairly small but the residential market's going to increase and is probably above the average but the numbers are so small that it doesn't do much in terms of the waiting. So I think the way to think about it is Power Quality is probably about the average of that number. Industrial is a little higher and then the non-res is the much lower part, but we think on the verge of going positive.

But Sandy, all of that was for Americas or Rest of World?

That was Americas. When we get outside of Rest of World, I think the best way we can cut it for you is that the 7% there, we think Europe will grow slower than Asia. Asia will be a premium to the 7%. Europe will be a discount to that.

But Tim, we are likely to have power quality markets really around the world growing at a pretty heady pace so the big difference is going to be the power distribution growth rates.

Well, that's why I asked it. I mean, that's 35% in Rest of World growing at that kind of rate. I was just wanting to square up as to why you have the index of 7%.

Our next question is from Robert Wertheimer. [Morgan Stanley]

On the commodity cost recovery, we talked about last time commodity spiked a couple of years back, how you had really sort of re-engineered systems over the last up-cycle to ask for and get pricing faster. Are you feeling more pushback in this recent spike? Or is it just that the spike is faster and it's all -- what's it feel like?

No, I would not say -- I think we're actually in better shape having had the muscle exercise in the 2003 to 2007 time period. That actually was a little bit more challenging upfront, because you'll recall, there really wasn't a lot of material inflation the 15 years before that. I'd say what's happened now is the speed of the additional spike that occurred in the December time period is really where we feel it's prudent that there'll be some lag to catch all of that. But we had some lag the last time as well. This is actually a little shorter lag than we had the last time.

Is the build in 1Q for Truck sufficient to give you a lot of upside to the 240,000 if orders keep coming in? Or is 1Q sort of a doughnut with a lot of the recent orders having been for later in the year and that's one reason the number's not higher?

Yes, our view of the quarters, and this supports the 240,000 is that it would run at about a 46,000 rate in the first quarter, about a 58,000 rate in the second quarter, approximately 64,000 in the third quarter and then get up to 72,000 in the fourth quarter. Now the one thing I can tell you sitting here today is that won't be right. But that's our best view as to how to kind of model this at this point. As is always true, this backlog tends to bill in from the back forward. So people want to fill in that back part of the year. And so that's why we're starting with this little lower activity in our forecast at this time.

Our next question is from Jason Feldman. [UBS]

So a lot of ground’s been covered, but I wanted to follow up a little bit on the comments about non-res Construction and Electricals. You had pretty good Electrical segment sales growth, that's Rest of World and Americas this year, considering how big the headwinds were in residential, non-res construction. Do you think that some of us may have just overestimated how much construction exposure there is in those businesses? Was it really just market outgrowth? Or is it just that the non-construction parts businesses were incredibly strong?

I can't comment on how everyone would've thought about it, but I would say that, I think Industrial came in stronger than both we and others expected it would this year. Power quality, as I mentioned to an earlier question, has stayed well. I think the piece that may have surprise people is that while you were still seeing publicly reported nonresidential data declining, there was a fair amount of activity starting on the small end of the business, and we were doing well there, and we were also doing quite well with a number of these larger stimulus bill-driven projects, where we've got an unusually large front-end to our business and had been in touch with those same contractors and specifiers over many years. And so that gave us a really good visibility into the marketplace.

I mean, I guess the question is when those markets actually do turn around, you have a sense that there's still a fair amount of upside, and that it is likely to result in a further benefit -- a material further benefit, if and when those markets actually do recover?

Yes, I do.

And then real quickly on Aerospace. It finally looks like aftermarket bookings have kind of caught up to flight hours. How much of a lag is there before you really see that flow through the business? Because it's still you have sales growth rates a little bit behind the orders. Is that going to convert pretty quickly?

Yes. I would say within a quarter. I'd say that if you get a significant upturn in let's say, one quarter, I think by the time you're in the second quarter, you're starting to feel that in shipments, yes.

Our next question is from Robert McCarthy. [Robert W. Baird & Co.]

I was a little surprised at the Truck segment revenue level in the fourth quarter, given that truck build in most of your markets, I believe, was up sequentially fourth quarter over third. And while I recognize there's traditionally a seasonal impact, as you guys well know, sometimes that disappears when you're ramping up. So could you talk about what is the missing link in my description of what happened in the fourth quarter, and maybe use that as an opportunity to also update us on what the mix of the business is as you exit 2010 in terms of NAFTA Truck, Rest of World Truck and then non-truck markets?

Yes. The biggest issue, I think, in terms of thinking about third versus fourth is that while activity continues relatively consistently, as you've correctly noted here in the U.S., that's not true in South America. And you'll find in most South American businesses, and we have a large presence in our Truck business in South America, a significant portion of December turns into a vacation. And so you really get kind of two months of activity. That's the biggest driver for us in terms of what drops off. Now the majority of our Truck business is outside the U.S. today. And that's this balance that's different than I think an earlier question that was asked about 2001 to 2004 that there's been a change. Now that starts to come back a little bit in the other direction as heavy-duty starts to recover. I think what you find is if heavy-duty recovers along the lines that we believe it will this year, that the balance of revenues for the business will go back to being slightly more in the Americas than it is in the Rest of World.

But to help us set the base in 2010, can you give us a rough estimate of how big NAFTA Truck is within the segment? Just revenue contribution, rough?

We really break out Americas separately.

But I mean, roughly speaking, you can think of starting the year, you're going to be at roughly 40. Well, if you do all of the Americas, I mean, most of the businesses in the Americas. And so, that's the way to think about it. But obviously, the Brazil business has grown enormously over the last several years. So the NAFTA part is starting at a much lower percentage than it did in the last run-up.

And also to make sure that we're calibrated correctly, in developing your $35 million uncovered commodity cost assumption, I presume that and then that you'll be able to catch up, et cetera, we're assuming that year-end commodity price levels persist through the year? Or have you baked some cushion in terms of inflation into the underlying assumption?

Yes. Our best anticipation of how we think these costs are going to proceed through the year, we've got in our assumptions for the balance of the year.

And our final question is from Nigel Coe. [Deutsche Bank]

Just wanted to take a step back on the guidance. We've seen acceleration in a lot of the lead indicators towards the end of last year. We've got some incentive coming through, which I'm assuming will be more second half in terms of the distributions and allowances. And how do you handicap these factors in your guidance, Sandy?

Well, I think what we've tried to do, Nigel, is obviously take a look at the quarter-on-quarter, not year-to-year, but quarter-on-quarter progression of bookings through this year. We obviously do a lot of work, as you know on, on sort of macroeconomic issues as well. We have increased, based on what happened in the fourth quarter, our own view of the strength in the U.S., but having said that, we still think you have to be founded in some fundamentals. We think global GDP is likely to grow slightly less than 3.5% next year. We think that's a reasonable expectation. We think there is still some uncertainty around sovereign debt situations, particularly, in Europe. And so that has led us to have little lower growth view for Europe. We think the interest rate increases that you've seen in many of the emerging nations are there to cool inflation and will probably slightly cool demand. And as a result, we step back and say, as we look at this overall 8% growth rate for Eaton this year, it's down a couple percent from the end market growth rate that we would have experienced in the first year of this big recovery, where we had V-like recoveries occurring in Hydraulics that were really driving it. So we look at the 8%, and we feel it's well-calibrated at this point for the year. And there are obviously a lot of individual factors, as we mentioned, as we've gone through some of these questions about individual market elements. But that's kind of what I would call the ying and the yang of how we try to think between the micro and the macro to develop these market forecasts.

And then if I can just dig into the Electrical guidance. I think you said 0% to 2% for non-resi, which I think is in the Americas. I wondered, I mean that's a bit lower. I mean, we were seeing some other -- not your direct peers but there's certainly some electrical and HVAC players, that are talking about high growth rates. Is that because you saw some stimulus activity in 2010, and therefore, you've been a bit more cautious there? And then secondly, if you can maybe talk about Europe and what you expect there? Because I'm assuming that's still negative?

No. We don't think there's any kind of negative stimulus impact in these numbers. I think the one thing to be careful of when you talk to people who play in the North American electrical businesses, are they talking about the residential put-in-place market, which is the numbers that we are talking to you about, or are they talking about what's called the NEMA Product Indices, which tend to run a little bit more positive than the actual construction market index. And so we're talking the construction market index here because it’s the one that's most publicly available. Some people will talk to you about what they think the NEMA Product Index will be. That may be the difference you're getting between the two.

And then finally, again, we're seeing from some of the actual players a little bit of price cost pressure coming through on some of the Electrical businesses. Would it be fair to say that you've seen some of the pinch coming through there more than other areas, Sandy?

Well, copper and silver are primarily used in those markets for us out of the whole basket of industrial metals, yes.

Thank you, all, for participating in today's call. As is customary, both Bill Hartman and I will be available for the remainder of the day and later in this week to answer any follow-up calls you might have. Thank you very much.