The Eaton's Second Quarter 2023 Conference Call is underway, hosted by Yan Jin, Senior Vice President of Investor Relations. Craig Arnold, Chairman and CEO, and Tom Okray, Executive Vice President and Chief Financial Officer, are present to discuss the company's performance in the second quarter. The press release and presentation are available on the website, and a webcast of the call is accessible for replay. Craig Arnold is pleased to report that the company has had one of its strongest performances ever, which is supported by strong markets and good execution.

Eaton posted a record quarter of financial performance with strong revenue, margins, and earnings growth. They raised their 2023 guidance for organic growth, margins, and adjusted EPS. Highlights of the quarter included a growing backlog of 22% in electrical and 26% in aerospace, strong operating and free cash flow, and a book-to-bill ratio of 1.2 for both electrical and aerospace. Eaton discussed the megatrends impacting their end markets and how they plan to talk about them in the future.

This paragraph discusses the Inflation Reduction Act, its increased spending, and its impact on infrastructure. It also looks at Eaton's position in the utility and aerospace markets, and highlights their double-digit growth outlook, as well as their new win on the Bell V-280 Valor platform. Finally, it provides an updated look at the estimated spending due to the IRA, which is expected to continue to grow and provide a strong catalyst for infrastructure spending.

The utility segment of the Americas business accounts for 15% of Electrical Americas revenue and is expected to grow at a CAGR of 9% over the next decade. The value of announced mega projects has increased by 20% between March and June. Utilities will be spending 60% of their CapEx on distribution, with an expected 11% CAGR over the 2022-2025 period. Sustainability initiatives have boosted this number. Electrical content is expected to be between 3-5%.

Eaton is investing in capital investments to address the growth of electrical needs and has committed to new capacity in transformers, voltage regulators, and line insulation products. In North America, Eaton has a broad position in the market, providing grid planning software, design and engineering services, critical utility products, automation software, project management expertise, digitally enabled hardware, grid edge controllers, distribution planning software, distribution and substation automation, and smart grid communication centers and demand management.

The company is well-positioned in the aerospace industry with double-digit growth expected in the next five years. This growth is driven by the rebound in commercial OEM, commercial aftermarket, and increased defense spending. Airbus and Boeing are both significantly increasing production on their most important platforms, and global passenger air travel is expected to return to 2019 levels by the end of this year. The company is especially well-positioned on key defense platforms, both those targeted from their organization and new platforms that are being ramped up. Key platforms driving growth in the near term include those listed on Slide 10.

In Q2, Craig reported record growth and financial results for the company. Organic growth was up 13%, operating profit increased by 21%, and segment margins expanded 150 basis points to 21.6%. Adjusted EPS increased to $2.21, and for the first half of the year, organic growth was up 14%, segment margins increased by 130 basis points, incremental margin was up 30%, and adjusted EPS growth was 17%.

In the Electrical Americas business, organic sales growth was 19% and operating margin was 26.4%. Orders grew 7%, backlog increased 30%, and the major project negotiations pipeline was up 17% year-over-year and 9% sequentially. This has led to a 600% increase in free cash flow in the first half of the year. Data center, utility, industrial and commercial and institutional end markets have seen especially strong growth.

The Electrical Global segment posted record sales of $1.6 billion and organic growth of 6%. Operating margin was 18.5%, up 20 basis points sequentially but down 40 basis points compared to the prior year. The Aerospace segment also posted record sales and operating profit, with organic growth of 14% and operating margin of 22.5%. Orders and backlog in both segments remain strong.

In Q2, Eaton's Aerospace segment saw strong organic growth of 26%, with a book-to-bill ratio of 1.2 times. The Vehicle segment saw organic growth of 6%, with operating margins of 15.3%. The eMobility business saw organic revenue growth of 18%, with margin improvement of 100 basis points. Eaton has won new programs with mature year revenues of over $450 million, positioning them to exceed their 2025 target of $1.2 billion in revenue. These wins demonstrate Eaton's ability to leverage capabilities across their portfolio, such as brake torque, power protection, and bus man fuses.

Eaton is raising their organic growth and operating margin guidance for 2023, expecting organic growth in Electrical Americas of 14-16%, a 600 basis point improvement from the starting 2023 guidance, and a total company midpoint of 11%, up from 10%. The total Eaton margin guidance range has also been increased by 40 basis points to a range of 21.1-21.5%. The increased outlook is supported by strong end market growth, an expanding negotiations pipeline, and building backlog.

Electrical Americas has seen a strong performance in the first half of the year, prompting a raise in full year EPS range to $8.65 and $8.85. Q3 guidance has been set at organic growth of 9-11%, segment margins of 22-22.4%, and adjusted EPS of $2.27 to $2.35. Additionally, the growth expectation for the utility, residential, commercial, institutional, and data center markets have all been increased to strong double-digit growth.

Craig Arnold of Electrical Americas discussed the company's positive outlook for their markets, citing solid execution of the quarter and increased backlog. He also discussed the large data center wins that the company booked into orders, and when asked about the implications of generative AI, he appreciated the question.

Craig Arnold states that the data center market has been strong and growing at double digit and that the big wins booked during the quarter have nothing to do with AI yet. He also notes that the emergence of generative AI will likely keep the market strong for a long time and that the company is well-positioned for it. Arnold is unable to provide guidance for 2024 at this time.

Tom Okray and Craig have discussed the historically high backlog the company has which gives them good visibility into the future. They have done modeling scenarios to look at various order intake declines and with robust organic growth they are confident they will not hit their historical backlog coverage timing until two to three years out. Joe Ritchie asked for an update on the mega projects and IRA announcements which are not in the order book.

Craig Arnold of Electrical discusses the impact of government stimulus spending on their order book and revenues, which have not yet been seen. He notes that they have visibility to $2 billion in infrastructure projects, of which they have won $1 billion, but this is only a small piece of the total spending. He is encouraged by the long-term structural shift in the business and will continue to report out on a quarterly basis. Josh Pokrzywinski then follows up with a question about whether the shorter cycle parts of Electrical are seeing lead time normalization in orders, which some peers have reported.

Craig Arnold and Josh Pokrzywinski discussed the Inflation Reduction Act and its effect on orders and lead times for Eaton's short-cycle businesses. Arnold believes that orders related to the IRA will start to show up in 2024 and that they will likely be for long-term, mega projects. Lead times have already decreased in the short-cycle businesses as a result of the slowdown in orders.

Craig Arnold explains that the infrastructure spending that Eaton participates in will have the most impact on their Industrial segment, due to investments in EV factories, battery factories, and chemical space. Chris Snyder then asks about the lag time between the start of the project and when it starts generating revenue for Eaton, to which Craig Arnold responds that Eaton has spent a lot of time internally trying to answer that question, and that it takes time from the announcement to the negotiation, negotiation to an order, and order to a shipment.

Tom Okray explains that the company raised their EPS guidance by a considerable amount, but kept their free cash flow guidance the same. The majority of the increase in EPS was from working capital optimization and earnings. The company is pleased with their 600% improvement in cash conversion cycle, but wants to continue to improve their free cash flow margin.

Craig Arnold and Tom Okray of the company discussed their non-resi vertical, and the end market segments on Slide four. They have seen a slowdown in distributed IT and MOEM segments, but the growth in the other verticals has more than offset that weakness. They have also seen a slight slowdown in other verticals, but the first half of the year has seen organic growth in all end markets. Resi is doing much better than anticipated, and MOEM is also up for the first half of the year.

Craig Arnold explains that one of the reasons for the slowdown in growth between the first half and second half of the year is due to a strong comparable. He states that the growth is essentially the same when looking at a two-year stack, normalizing for the strong back half of the year which was largely due to pricing. Arnold also discusses that the Electrical Americas business is shipping a lot of backlog, and they don't expect it to have a material impact on the underlying performance of the business. Lastly, he explains that the guide for the back half of the year includes volumes and supply chains are improving.

Craig Arnold and Tom Okray discussed the demand drivers in Electrical Americas, with Craig Arnold noting that the company is getting more contributions from volume than from price in the second half of the year. Tom Okray added that the company has raised organic growth in Electrical Americas by 600 basis points since the original guide, and the fiscal year guide is 15%. Craig Arnold also noted that Electrical Global is not growing at the same rate as Electrical Americas, but he would not call those markets weak.

Craig Arnold of Eaton commented on the company's electrical Europe business and its mix challenges in Q2, which held back margins. He is confident that these issues will not repeat in the second half of the year, and that the business will return to a more normal level of profitability. He also mentioned that the company is counting on higher volume and better manufacturing productivity in the back half. Julian Mitchell asked for a sense of the pace at which the backlog to sales may normalize, to which Craig Arnold replied that it is impossible to know given the uncertainty of the future.

Eaton is unique in its breadth of portfolio and end markets, which are benefiting from megatrends. Eaton is a massive infrastructure player and has a nice mix of going through the channel and direct to the customer. Its backlog is up 220% since the end of 2019, and it is different from other electrical companies in terms of the end markets it plays in.

Craig Arnold and Julian Mitchell discuss the impact that the ramp in OE will have on margin mix over the next three to five years. Craig Arnold states that both OE and aftermarket are ramping and that they do not anticipate a negative mix impact from this ramp on the OE side.

Eaton is making sizeable investments in capital equipment to accommodate the strong growth of the electrical industry. This includes investments in transformer capacity, line insulation products, and circuit breaker capacity. The level of investment is estimated to increase by 0.5-1% of sales, which is manageable in the context of the overall growth of the company.

Craig Arnold discussed the growth of electrification, the growth of EV charging infrastructure, and the investments being put in to support the growth and demand for electricity on the grid. He mentioned retrofit activity in the C&I end markets and discussed the difficulty of quantifying the impact of retrofits versus new builds.

Craig Arnold states that there is no sign of weakness in the data center market, whether it is the hyperscalers, colo, or on-prem. He acknowledges that AI will have an impact on data center configurations, as they will require more power and increased power density in the racks. However, it is still too early to tell what the exact effects will be.

Craig Arnold of Eaton Corporation is discussing the company's second half of the year projections for volume and price contributions to growth. Arnold states that the big price increases of last year have already been taken into account, and that the second half of this year will have more of a contribution from volume than from price.

Craig Arnold and Tom Okray both discussed the sustainability of the team's performance and how it could be used as a jumping off point for the business in 2024. They also mentioned that they are expecting to do better than the implied segment margins. Finally, they discussed the initial assumption of a mild recession this year, which has been pushed out due to the current economic climate.

Eaton is feeling confident about their growth for the year and believes that even in the event of a mild recession, it will not have a material impact on their growth. Tom Okray and Deane Dray have discussed the potential for downturns in order intake, but Eaton is confident they can power through due to their backlog and the megatrends. Craig Arnold has mentioned that the industry is better than it was this time last year, but there are still certain markets and verticals that are challenged with extended lead times, such as the utility market.

Craig Arnold discussed Eaton's relative performance in the utility market, noting that they have a broader portfolio of solutions than their competitors. He believes they are well-positioned to grow at or faster than the market, but their growth is currently limited by capacity constraints. Tom Okray then discussed the growth of major projects in the quarter.

Craig Arnold discussed lead times and how they have improved in some shorter-cycle businesses such as residential, OEM, and distributed IT. However, for bigger project-related stuff and utility markets, lead times have not improved much. Arnold also noted that they are sold out and don't have much excess capacity to handle the faster growth in industrial-centered product lines and businesses.

Chip and Tom discussed the backlogs and lead times, noting that until capacity comes online, the lead times won't get materially better. They also mentioned that barring a significant slowdown in the markets, the backlogs would stay elevated for some period of time. Tom suggested that the two to three year period he quoted in a turndown situation may be conservative. Joe thanked them for their answers and Yan concluded the call.

This summary was generated with AI and may contain some inaccuracies.