Donald H. Bullock - Eaton Corp. Plc Craig Arnold - Eaton Corp. Plc Richard H. Fearon - Eaton Corp. Plc.

Jeffrey Todd Sprague - Vertical Research Partners LLC Nigel Coe - Wolfe Research LLC Joe Ritchie - Goldman Sachs & Co. LLC Jeffrey D. Hammond - KeyBanc Capital Markets, Inc. Nicole DeBlase - Deutsche Bank Securities, Inc. Steven Winoker - UBS Securities LLC Mircea Dobre - Robert W. Baird & Co., Inc. Joshua Charles Pokrzywinski - Morgan Stanley & Co.

LLC Stephen Edward Volkmann - Jefferies LLC Andrew Burris Obin - Bank of America Merrill Lynch Deane Dray - RBC Capital Markets LLC Andrew M. Casey - Wells Fargo Securities LLC Ann P. Duignan - JPMorgan Securities LLC John Walsh - Credit Suisse.

Ladies and gentlemen, thank you for standing by and welcome to the Eaton Third Quarter Earnings Call. At this time all the participant lines are in a listen-only mode. There will be an opportunity for your questions and instructions will be given at that time. As a reminder, today's call is being recorded. I'll turn the call now to, Mr.

Don Bullock, Senior Vice President of Investor Relations. Please go ahead, sir..

Good morning. I'm Don Bullock, Eaton's Senior Vice President of Investor Relations. Thank you for joining us for today for Eaton's third quarter 2018 earnings call. As all of you that are on the call have noticed, today our call is occurring at 11 AM versus our traditional 10 start.

We moved our call today to allow those of you who follow Cummins to participate in their call, which occurred at 10 AM this morning. With me today are Craig Arnold, our Chairman and CEO; and Rick Fearon, our Vice Chairman and Chief Financial and Planning Officer.

Our agenda today as typical includes opening remarks by Craig, highlighting the performance in the third quarter along with our outlook for 2018 and a preliminary look at 2019. As we've done on our past calls, we'll be taking questions at the end of Craig's comments.

The press release from the earnings announcement this morning and the presentation we'll go through today have been posted on our website at www.eaton.com.

Please note that both the press release and the presentation include reconciliations to non-GAAP measures, and a webcast of this call is going to be available on our website and will be available for replay after the earnings is complete.

Before we get started, I want to remind you that our comments today will include statements related to forward-looking future results of the company and are therefore by definition forward-looking statements.

The actual results can differ from those forecasted projections due to a range of items covered in the uncertainties covered in our press release, presentation and on the 8-K. And with that, I'll turn it over to Craig..

Okay. Thanks, Don. Hey, let me begin with a quick summary of our Q3 results. And overall it was a solid quarter where our balance across multiple end markets really allowed the company to deliver strong results and so we're really pleased with our Q3 results.

Earnings per share of $0.95 on a GAAP basis or $1.43 excluding the impact of the arbitration decision we previously announced in August. This is towards the upper end of our guidance range of $1.35 to $1.45 and up 14% above prior year, excluding naturally the gain from the JV that we formed last year in Q3.

Our sales were $5.4 billion, up 4%, and this was comprised of 6% organic growth offset by 1% each from both currency and some small divestitures we had during the course of last year. We're very pleased with our strong margin performance, which included an all-time record margins of 17.6%.

Our teams really executed well, which led to all-time record margins in three of our segments including; Electrical Products, Electrical Systems & Services, and Aerospace. And finally, we produced solid operating cash flows of $1 billion in the quarter.

On page 4, we compare our performance of the quarter versus prior year and I'll just highlight a couple of items here. Notice that sales were up 4% and strong execution, segment operating margins were up 120 basis points over prior year and we posted 11% increase in segment operating profits.

We did have two unusual items impacting the year-over-year comparisons, the gain from the formation of the Eaton Cummins joint venture in Q3 2017 and the expenses from the arbitration decision in Q3 2018. Excluding these items, net income was also up 11%. On page 5, we summarize the quarterly results of our Electrical Products segment.

Revenues were flat with organic growth of 1%, offset by 1% currency. And I'll just note here that revenues in the quarter were negatively impacted by the Lighting business.

As we discussed in prior calls, in the Lighting business organic revenues declined slightly in the quarter, in line with declines that we've seen in Q2 and excluding Lighting, Electrical Products had 3% organic growth. In the quarter, we saw revenue strength in North America with particular strength and solid growth in the industrial end markets.

We had expected our Lighting sales to turn positive in the quarter and we do believe this will happen next quarter. This assumption is also supported by the growth that we saw in our orders during the course of Q3. Overall orders increased 3% for the segment with solid growth in industrial and residential markets in North America.

And our backlog is up some 16% over last year. So we're pleased to see the really strong strength and building backlogs during the course of the quarter. Segment operating profits increased 4%, with operating margins up 70 basis points to once again an all-time record of 19.2%.

On page 6, we outline the results of our Electrical Systems & Services segment. Organic growth was 9% in the quarter, an acceleration from Q2, which was up 7% and Q1 which was up 2%. Foreign exchange and the divestiture of a small joint venture each reduced revenues by 1% in the quarter.

We saw strength in industrial markets and data centers and geographically we saw strength in North America and also in the Asia-Pacific region. Bookings were up 4% with strong growth in EMEA, Asia-Pacific, and with data center orders up double-digit globally. We did see a degree of caution in late September in U.S., especially in large project orders.

We've seen this kind of caution in the past on periods of economic uncertainty and so we do think that impacted our orders a bit in the quarter and at the end of the month of September. Notably, our backlog was up 12% versus last year. Operating margins of 15.4% were up 160 basis points and were an all-time record for the segment.

On page 7, we cover our Hydraulics segment. Here revenues were up 6%, 7% organic growth offset by 1% from currency. We had strength with multiple OEMs in both construction and ag markets and also in the distribution channel.

Orders increased 4% with geographic strength in Asia and in the Americas, and this is on top of very strong comps from Q3 of 2017 which were up some 22% last year. So we saw end market strength in both construction and also in agriculture – with agriculture OEMs. Geographically, orders were up 12% in the Americas, up 9% in Asia and down 16% in EMEA.

Similar to last quarter, orders in EMEA were down due to largely reduced lead times. Our shorter lead times and better delivery performance continues to reduce the need for customers to place long-dated orders in the Europe market.

Our Europe orders for deliveries in the three month period, so those shorter lead-time orders, were actually up again this quarter. We continue to have a strong backlog, which was up 24% from last year, operating profits increased 18% and our margins were 14% and 140 basis point improvement over last year.

Next on page 8, we summarize Aerospace's performance in the quarter. The Aerospace segment accelerated nicely from 6% organic growth in Q2 to 9% growth in Q3.

In the quarter we saw strength across many platforms including military fighters, rotorcraft, regional jet, biz jets, and in both military and commercial aftermarket, so really broad-based strength in our Aerospace business.

Orders remained strong in the quarter, up 12%, with particular strength in commercial transport, commercial aftermarket, as well as in military rotorcraft. Our backlog is also up strongly, up some 15% in the quarter. And operating leverage here was really outstanding with profits increasing 25% to an all-time record.

Margins of 22% and up some 280 basis points over prior year. In addition to solid execution, I will acknowledge as well that we had favorable mix in the quarter, which positively impacted margins, largely as a result of strength in the commercial aftermarket business which grew faster than the overall segment.

Moving to page 9 in the Vehicle segment, in Q3, our organic growth was 7%, and this organic growth was offset by 3% from FX and 2% from the formation of the Eaton Cummins joint venture last year. The NAFTA Class 8 market continues to perform well.

We've increased our production forecast for 2018 from 295,000 units to 320,000 units and this is being offset somewhat by weakness in light vehicle markets in China and a bit in Europe as well. Operating profits increased 11% while operating margin stepped up 140 basis points to 18.9%. Overall, another very strong quarter in our Vehicle business.

And wrapping up our segment summaries, we move to the eMobility segment on page 10. Organic growth was 7%. As anticipated we're ramping up our R&D investment in this business and therefore segment margins stepped down to 12.5%, which is really in line with our full year margin guidance for the segment.

In Q3 we secured an additional contract win for a new eMobility program, which reinforces our optimism for this fast-growing market. And we're also currently in discussions with a large number of additional customers and so our long-term growth outlook for this segment remains quite optimistic. Now moving to page 11.

With three quarters behind us and heading into the final quarter of the year, we're fine-tuning our segment expectation for 2018 for both organic revenue growth and for operating margin.

Our end markets continue to experience solid growth; we're reaffirming both our full-year organic growth target of 6% and our operating margins of between 16.4% and 17%. While the overall organic growth expectation remains unchanged, we are adjusting our growth estimates for four of the segments.

In Electrical Products, we're adjusting it down by a half a basis point (sic) [half a point] (11:01) from 3% to 2.5%, and this is mostly due to softness in Lighting, which we say – think has extended one quarter longer than what we originally anticipated.

But with orders turning positive in Q3, we're really confident that this headwind for the segment has now abated and we expect to see better growth going forward. We're also reducing Hydraulics down 1% from 13% to 12%.

We had previously raised our outlook in Q1 from 10% to 13%, reflecting the strength in orders over the last 18 months, so this change from 12% to 13% we think reflects just some fine-tuning with three quarters behind us now. We're also raising our revenue outlook in two segments.

We're taking Aerospace up 2%, from 6% to 8% for the year, really on broad-based strength in a number of our end markets, and for Vehicle, we're raising our organic growth forecast by 1%, reflecting the increased production levels in NAFTA Class 8 market in 2018, moving it from 295,000 to 320,000 units.

For segment operating margins, we're fine-tuning some of the targets in a number of the segments, but overall, segment margins for Eaton overall remain unchanged. So we think a strong year of conversion. And just turning to page 12, we've taken an opportunity here to summarize our thoughts around our raw material cost and tariffs.

As we outlined in Q2, we expect the tariff impact for 2018 to be modest, and as background, it's important to note that we do manufacture in zone of currency, and as a result, we don't have large material flows that would disproportionally be affected by tariffs.

Where we are affected we've been focused on taking both price increases and operational actions to ensure that we stay ahead of this issue and our performance today certainly reflects this in the margin strength that we're delivering in our businesses.

As we look to 2019, we remain confident in our ability to mitigate the latest round of tariff impacts with both pricing actions and other supply chain changes.

As we take a look at the latest round of 301 tariffs that have been now finalized, we expect about $110 million of additional tariff cost in 2019 and we are in the midst of taking actions now that will ensure that the tariff related cost increases are once again fully offset by pricing and other additional supply chain changes.

And so we're confident as we look forward just as we look backward that we have plans in place to fully mitigate any tariff related cost increases. And next on the next page, we provide our Q4 guidance, and an updated guidance on the full year.

For Q4, we expect EPS of $1.38 to $1.48 and this assumes 6% organic growth, it assumes margins of between 17% and 17.4% and a tax rate of between 12.5% and 13.5%. And as we take a look at the full year for 2018, for the third time this year, we're increasing the midpoint of our full year EPS guidance to a range of $5.30 to $5.40.

This naturally excludes the arbitration decision impact. The midpoint of our EPS guidance is increasing 1% from $5.30 to $5.35. We now expect corporate expenses to be $20 million above 2017 levels compared to $10 million that we previously noted and this is largely the result of slightly higher interest expenses.

The tax rate for 2018 is now expected to be between 11% and 12%, reflecting really the impact of the arbitration decisions in Q3 that we noted earlier. And consistent with prior guidance, we're expecting operating cash flows of between $2.9 billion and $3.1 billion.

This does exclude the $300 million impact from the arbitration decision in Q3, and also unchanged, our free cash flow is expected to be between $2.3 billion and $2.5 billion, once again, excluding the impact of the arbitration decision. Our assumptions for CapEx and restructuring costs are unchanged from prior guidance.

However, certainly given the recent pullback in the stock market, we would expect our share repurchases to range from $800 million to $1 billion for the full year and year-to-date our share repurchases have been roughly $600 million. So we'll certainly view this is a buying opportunity given the pullback that we've seen recently.

Lastly, at the midpoint of our EPS guidance, we would expect to generate 2018 EPS growth of roughly 15% excluding the impact of the arbitration decision and the 2017 gain from the formation of the Eaton Cummins JV and the income arising from the 2017 tax bill.

Hey, just turning to page 14, and I know this is one of the big questions that's on everybody's mind, during last quarter's earnings call we provided a view of our key end markets and really split by three categories, parts of our businesses that we were basically in the early to mid-part of the growth stage, those that were in the middle part of the growth stage and the late stage of growth.

And our conclusion then is still our conclusion today, the majority of our businesses are in the early to mid-part of the economic growth cycle. While we do expect the rate of growth to slow somewhat, given the strong 2018 results. We also anticipate that we'll see solid growth in 2019.

This view of our end markets is consistent with our initial outlook for 2019 and our assumption that our end markets will grow between 3% and 4% next year.

And just turning the page 15, while we provide specific guidance on our Q4 earnings call in January – we will provide specific guidance on our Q4 earnings call in January, we thought it would be helpful also to share some high-level assumptions around 2019. As I noted, we think our end markets will grow 3% to 4%.

At this point in the cycle we'd expect incremental margins on core growth to be between 25% and 30% and this does include any impact associated with tariffs. And our preliminary estimate on corporate costs, including pension, interest and other corporate, suggests that they'll be flat with 2018.

We expect our tax rate to be between 14% and 15%, consistent with our expected long-term tax rate, and lastly we continue to see opportunities for attractive returns and restructuring opportunities and we anticipate restructuring spending for 2019 will be generally in line with 2018.

So with that, I'll turn the meeting back over to Don Bullock and we're happy to answer any questions that you may have..

Before I have the operator provide you with instructions for the Q&A, I did want to note that we do have a number of individuals in the queue for questions today. Given our time constraints of an hour and our desire to get as many of these questions as possible addressed, please limit your questions to a question and a follow-up. Thanks in advance.

With that, I'll turn over to the operator to provide you with instructions for the Q&A..

.

Our first question today comes from Jeff Sprague with Vertical Research..

Thank you. Good morning, everyone..

Good morning..

Craig, I was wondering if you could actually address capital deployment a little bit more directly, and what you're thinking. The spirit I'm asking the question is what seems some plausible speculation you guys were poking around at Esterline.

I don't expect you to address that specifically, but maybe you could give us some thoughts on what your appetite is for bigger deals and how you might kind of play that card as we look into 2019?.

Yeah. Thanks, Jeff, certainly appreciate the question, and as you noted, we don't comment on any potential acquisitions. I would say that our capital deployment strategy is largely unchanged with where we've been.

We've said that our first priority in our call on cash is going to be invest in our businesses and to invest in organic growth, and we continue to see really lots of tremendous opportunities to do that.

We'll continue to pay a very healthy dividend and buy back shares, and in this environment, as I noted, we'll certainly be much more aggressive in buying back our shares where we think this is a tremendous buying opportunity, and we'll generate a lot of cash over the next several years, and we have the opportunity to deploy that cash in certainly value-creating acquisitions, and there we've said our priorities continue to be in our Electrical business, in our Aerospace business, and also in our new eMobility segment.

But having said that, what we've said all along as well, we are not going to lose our pricing discipline, that we have a very structured approach to the way we take a look at deals and those opportunities, and we think our cost of capital is 8% to 9%, and we talk about delivering a minimum of 300 basis points over the cost of capital.

And so we intend to remain very disciplined as we take a look at opportunities and how we price them, recognizing that we always have an opportunity to go out and buy our stock back and essentially create tremendous shareholder value. So, we will continue to be disciplined as we have been in the past around the way we think about capital deployment..

Right. And by the same token, any other thoughts about just the portfolio overall? I think that probably is something you are always discussing internally, or thinking about internally.

Do you think the structure, combined structure still makes sense for Eaton here?.

Yeah, I think in simple terms the answer is yes, we like the structure of the company today, we like the makeup of the company today, but having said that, as we've shared with this group in the past, we are always evaluating and assessing.

We have laid out a very specific criteria for what's required to be a part of Eaton and the type of characteristics that businesses need to have and the type of results that they need to deliver, and to the extent that we have businesses that are not measuring up to those requirements, there are specific actions in place to improve.

And obviously they are on the clock, and they have to improve within a certain period of time. And if they don't improve, we'll do what we've done in the past, and we've always been willing to divest parts of the portfolio that don't live up to the company's expectation.

And I can assure you that we have a very thorough process with our board where we review all of our businesses, including nonperforming businesses on a regular basis, and so I would tell you that we will continue to be smart and diligent in assuring that the things that are part of the company pass the criteria or have a path to it, or we'll take other action..

Right. Thank you..

Our next question comes from Nigel Coe with Wolfe Research..

Thanks. Good morning..

Good morning, Nigel..

Hi..

Yeah, no one told me about the 10 o'clock, I actually dialed in quite early.

So just want to dig in a little deeper on the projects pause, I think you called out, specifically within ESS, and I'm just wondering what are you hearing from customers here? Is this more inflation and having to back to the drawing board to reassess project returns? Is it just uncertainty around the macro? Any color there would be helpful.

And any end market color in terms of where the project delays are coming from?.

Yeah, what I see, Nigel, we did see it, as I mentioned, largely in large projects in the month of September, in the Americas primarily, and it was – certainly caught us by a little bit – by surprise as well, but I do think it's just simply the environment that we're in right now which is filled with lots of uncertainty, whether it's geopolitical issues, or it's the elections or it's tariffs, quite surprisingly, we were clocking along just fine and were surprised in the month of September, but we do think that it's a temporary pause, and if you take a look at the macro data, whether it's the C30 data or you take a look at some of the key end markets that we serve, there's nothing that would suggest that the fundamentals are not still very much intact.

And so we'll have to see what Q4 brings, but at this point, there's nothing that would suggest that the underlying strength that we anticipated to see in our Electrical Systems & Services business would abate at this point..

Okay. That's helpful. And then just on China, obviously there's a lot of push and pull going on in China with – obviously, we're seeing a slowdown in the data, the stimulus measures coming through. Feels like the construction markets are pretty healthy over there.

Obviously you play quite strongly into the construction markets, but any comment in terms of what you're seeing in China would be helpful..

Yeah, I think, without a doubt we definitely saw a slowdown in China during the course of Q3. Principally, we saw that slowdown in vehicle markets which I think have been largely widely reported and we saw that slowdown as well, although we did deliver solid growth ourself in China in Q3 based upon a number of new wins.

And so I do think that as we think about the project business or commercial construction in China, at this point, we think that market continues to be fine. There's nothing that we're seeing in the overall economy that would suggest a significant pullback, although, clearly, there's some uncertainty in the China market as well.

I think the tariff impact and the uncertainty that that's creating, I just – I spent about a week in China myself a couple weeks ago, had an opportunity to meet with a lot of our customers and CEOs of local Chinese companies, and they, too, are feeling this period of uncertainty and I do think there's a little bit of a pause taking place in that market, as well, pending our elections and the ultimate resolution of the trade dispute between the U.S.

and China..

Okay. Thanks, Rick..

Our next question comes from Joe Ritchie with Goldman Sachs..

Thanks. Good morning, everyone..

Hi..

So maybe just following up on that question on just the large project pause in North America, I guess I'm just trying to understand, did you guys have a sense that these projects were going to be awarded in September and then the customers decided to pause on the decision? Or was this more of like just a gap in the market from the strength that you'd been seeing in the most previous quarters?.

Joe, I'll take that one. It really was the former. We had expected contracts to be signed by the end of September and due to the uncertainties that Craig talked about, there are various customers that delayed committing to projects. We think it's temporary.

These are projects that are quite far along, so it's not likely that they won't go forward, but it seemed to be that phenomenon, really, just in the last two weeks of September..

And I'd say that that position is really buttressed a little bit by the fact that if you take a look at our backlog in both our Electrical Systems & Services business, as well as in our Electrical Products business, the both of them were up quite strongly in the quarter, up 12% in Electrical Systems & Services and up 16% in Electrical Products.

And so I think that that thesis is really borne out by the increase in our backlog..

Got it. That's helpful. And perhaps my follow-on question, Craig, you mentioned earlier just initial thoughts into 2019 on the contribution margin of 25% to 30%, so that includes the tariff related impact.

I'm just wondering, how much are you anticipating to get back of the $110 million in tariffs? And then, also, if you think about just like cadence from a pricing perspective, like how are you guys thinking about that as you progress through 2019?.

Yeah, I'd say that – once again, appreciate the question. The 25% to 30% does include the impact of tariffs and while we fully expect to recover all $110 million of the tariff related cost increases, what's obviously problematic is trying to get an incremental on top of a tariff.

And so the incrementals that we're talking about for 2019 are somewhat muted as a result of what we think will be an inability to get an incremental margin on a tariff related cost increase, but we certainly expect to fully recover those costs and we expect to be out in front of it and ensure that as we go through the quarter, that the tariff related cost increases are not a headwind to margins..

Understood. Thank you..

The next question comes from Jeff Hammond with KeyBanc..

Hey, good morning, guys..

Hi..

Hey. So just a couple questions here, truck, big revision here.

Is that being driven by the supply chain improving there, any kind of color?.

Yeah, I'd say, one, Jeff, absolutely. There were some supply chain constraints that we experienced early in the year and there was some concern that we and others had about the industry's ability to actually deliver against the underlying demand that was in the marketplace.

And certainly, those constraints have been largely eliminated during the course of the year. And so that's certainly part of what drove us to revise our forecast up, as well as the market has just continued to be very robust.

And I'd say the really good news even about some of the order intake that we continue to see in the North America Class 8 market, is that in all likelihood, all of these orders are not going to be delivered during the course of 2018 and they'll spill off into 2019.

And so we think 2019 will be another growth year for North America Class 8 on top of a very strong year in 2018..

Okay. Great. And then data center, I think you cited as been strong, certainly it's been red hot in 2018.

If you just look at backlog and quoting activity, what does that suggest for that data center market into 2019?.

Yeah, right now we enter, we will enter 2019 with a pretty decent backlog and certainly there are continued discussions for some large orders next year. So we would expect 2019 would be another robust year.

Right now it's a little bit hard to say will it be as robust as 2018, 2018 after all did step up dramatically, but it should be another strong year..

Okay. Thanks, guys..

Our next question comes from Nicole DeBlase with Deutsche Bank..

Yeah, thanks. Good morning, guys..

Good morning, Nicole..

Hi..

Hi. So just I don't want to harp too much on this ESS order issue but just had one more point to clarify.

I guess when you think about the customer conversations that you're having and the fact that they're kind of pushing out signing contracts, is there any visibility at all on how long they're pushing out? Like is this oh, we'll delay until 4Q because we want to get this into our CapEx year? Or are these contracts more likely to be signed in 2019 once we get past this next stage of tariffs?.

Yeah, I think it's really difficult to say precisely, Nicole, how much of a delay we're talking about, but with these projects in general you can't delay them for that long, right? I mean, as they're tied to other underlying requirements for facilities and buildings.

And so we don't anticipate that this is going to be a long delay and we would hope to see in the course of this year in the fourth quarter and certainly by time we get to Q1, that this thing rights itself..

Okay. That's helpful. Thanks, Craig. And then second question just around Hydraulics margins, you guys had to take down guidance again.

I guess what's going on there? Maybe a little bit more color and is this just a structurally less profitable business than you thought? Or is this just really attributed to price cost and other issues that are more transitory? And I guess, does Hydraulics have a place in Eaton's portfolio given what we've seen with the margin performance year-to-date?.

Sure. First of all, I'd say we too are disappointed in the fact that we've got to take margins down again in Hydraulics, but I'd say the underlying margin issue in Hydraulics is largely a function of supply chain and operational inefficiencies that we're experiencing throughout the system.

They're not structural, they're absolutely fixable but we have continued to struggle with the ability to work through supply chain, we're spending a lot more than we anticipated in premium freight and expedite and overtime as the industry has ramped up and our ability, and quite frankly our suppliers' ability to deal with this ramp in orders and sales.

And so I'd say structurally speaking, nothing has changed, but having said that, as I've said with all of our businesses, Hydraulics is on the clock.

And there are certain things that we have to do to demonstrate that the Hydraulics business can be a consistent performer in the company in terms of underlying margins and underlying growth rate and reduced cyclicality.

And so all of the criteria that we've laid out for every part of the company also applies to Hydraulics and they have some work to do to demonstrate that we can create the kind of business that we want to own long term inside of Eaton..

Understood..

But structurally speaking, no concerns. And they're operational issues that we have to work out with our supply base. But the business remains largely on target..

Thanks, Craig..

Our next question comes from Steve Winoker with UBS..

Hey, thanks, and good morning..

Hi..

Hey.

Just on the 2019 overall market growth of 3% to 4% that you're calling out, are you still thinking about your own outgrowth of that generally and kind of the one and a half times or two times? Or how are you guys thinking about your own performance relative to that?.

Yeah, I think at this point, Steve, we're still in the midst of doing our own planning internally, but you have the thesis right. The 3% to 4% is market and we would anticipate our businesses growing in excess of market.

And so as we get through our own internal profit planning for 2019 and we provide guidance in January, we'll give you a sense for what we think the overall growth rate of the company will be. But it will be something on top of market growth..

Okay. And I just want to make sure I'm crystal clear on your comments on that delay that you talked about so much on the call.

The order delays around ESS, are those projects that are already in the backlog that you saw the risk or just new? And if they are already in the backlog, are you – can you think about sort of this is 12 to 18-month projects; I assume these are sort of shorter term ones?.

No, I would put – these are really largely in the category of negotiations that did not result in an order, so, therefore, are not in the backlog..

Okay.

So, therefore, you're not seeing or calling out any incremental risk to what's already in the backlog?.

Absolutely not..

All right. Thanks, I'll pass it on..

Our next question comes from Mig Dobre with Baird..

Yes. Good morning. I just want to go back if we can, to your 2019 tariff comments.

Can you maybe give us a little bit more color on which segments might be impacted more than others? And I'm also wondering if Section 301 essentially gets taken all the way, what would be the incremental impact, if you know it, or you had a to calculate it versus what you've got in the pipe today?.

Sure. I'd say – first of all, I'd say that, to answer maybe to your last question first. Most of the stuff that we do in terms of trade between China and the U.S. has already been captured in the current proposed wave of tariffs. And so if they ended up tariffing 100% of what came out of China into the U.S.

it would have an immaterial impact on our company. So most of it's been captured in what's already been announced. And in the context of what's already been announced by segment, I'd say most of it will largely be in our Electrical segments. We had some earlier – some of the earlier stuff caught our industrial businesses.

And this last wave, most of that will be in the Electrical sector. But we will have some smattering of impacts across the other businesses as well..

I see. That's helpful.

And again, looking at 2019 incremental margin comments, 25% to 30%, based on what you just said about tariff impact, is there a way to maybe rank the various segments in terms of where you see opportunity for incremental margins? What's above-average? What would be below average? How do you think about it?.

Yeah, we certainly appreciate the question, and I'd just say this once again, it's a little bit early for us to provide that level of detailed guidance, as we've not worked through our own internal profit plans. And so perhaps in January we can provide you a bit more insight.

But for right now I think if you use 25% to 30% for the overall company, it should help you at least do some preliminary modeling..

All right. Thanks..

Our next question comes from Josh Pokrzywinski with Morgan Stanley..

Hi. Good morning, guys..

Good morning, Josh..

Hi..

Just to maybe dig on EP here, I know you guys have talked at length in the past about an implicit attachment rate between EP and ESS. Craig, you mentioned in some of your opening remarks that the industrial side of EP was doing a little bit better.

So I would assume that attachment rate is still holding, but when I think about the deceleration in the quarter, Lighting was cited as a bit of an issue. And I would imagine in 2Q that was an issue as well. So I'm just trying to figure out what inside of EP feels different sequentially, understanding that maybe Lighting isn't moving around as much..

Yeah, let me take a stab at it. I would say the fundamentals of the business, let's take Lighting out, that's a separate set of issues. The fundamentals feel not very different than in Q2. The tone of the market, the momentum.

What we did see, though, right towards the end of September, is we did see a similar slowing in some of our flow goods in various parts of the business and I would attribute it to the same kind of caution that we saw in ESS, in the orders in ESS.

It's just that in a flow good type business, you tend to see it in sales because it just – it's an immediate impact as opposed to simply an order being placed..

Got it.

And then just to go back to the outgrowth question that was asked earlier on 2019, could you maybe frame up how you think about the 6% for 2018 and what that represents of outgrowth versus markets just so we can kind of level set how that has trended?.

I can take a stab at it. I mean, it's really hard..

Don't stab too much, it's close to Halloween, Rick..

Yeah, yeah..

Right..

The way I would think about it – first of all, the way I would think about the general growth in our revenues, 2018 was a year of growth in many of our markets. It was probably above trend and what you're seeing in 2019 is you're coming back towards a more trend-like rate of growth.

And our outgrowth in 2018, it's hard to know your markets, particularly in this tumultuous time very exactly, but at 6% organic growth, we're probably a point or so, maybe a little more than a point, of outgrowth.

And so if you think about 2019, you could take the 3% to 4% and add something, a point to a point and a half, maybe, roughly, outgrowth and get some kind of rough estimate of what kind of organic revenue growth we're likely to have.

It'll be a little less in 2019 than in 2018, but that's to be expected, you come back to a more trend like market growth..

I think you just answered the question, Rick, that I said I wasn't going to answer..

Sorry about that..

Appreciate the color..

Our next question is from Steve Volkmann with Jefferies..

Hi. Good morning, guys. I was hoping to pile on just a little bit on your thinking around 2019 and when you see overall market growth of 3% to 4%, it feels like half to three-quarters of that's probably available in terms of pricing, which would imply a fairly low growth rate on sort of a unit level. And I'm curious sort of how you think about that.

And then the follow-on would be on incremental margin. I guess I would have assumed that 25% to 30% is a good base level, but you would have had some sort of restructuring benefit on top of that.

And so, recognizing you probably don't want to put numbers around that, just sort of how do we think about that qualitatively?.

Inventories in the market..

Yes. There is a holding number for price in our 2019 market outlook, but it's really preliminary and I wouldn't read too much into that. Does the 3% to 4% need ultimately, to be adjusted for price? Maybe, but it's just too early to have a good feel for that..

And the incremental margin?.

I'd say the way I would think about the incremental margins is that – keep in mind that a lot of the restructuring stuff that we've done, really, we got a lot of those benefits in 2018 and we'll be spending more – a similar level of restructuring expenses in 2019.

And so I think you saw the pop in incremental margins in 2018, but as you think about just the timing of programs and expense versus benefits, as you take on more and more programs, the profile of cost versus benefit changes.

And so I'd say that the 25% to 30% is a good number to use right now and the restructuring programs will have good paybacks, but the – as you look at every incremental program, the length and the payback pushes out a little bit..

I think it's fair to say we have not yet gone through the detailed restructuring initiatives for next year. So until we do that, we can't be really precise about the benefits next year from those programs..

Fair enough. Thank you..

Our next question comes from Andrew Obin with Bank of America..

Yes. Good morning..

Hi..

Just a question on taxes.

Given where taxes ended up for this year, why do we think the tax rate will go up next year, particularly as you're working to reduce it longer-term?.

Well, there – 2018 is still a transitional year with some changes in the regulations associated with the tax bill. And so we, as we look at those changes including a step-up in the rate of the BEAT tax next year, we believe that the tax rate will naturally move a bit higher.

Now 11% to 12% we say is the overall rate, but mind you, that rate's a little lower than it would be because of the Pepsi arbitration. That was a U.S. expense, and of course a U.S. expense pulls with it the U.S. relatively higher tax rate than the rest of the world, and so that pulls the overall rate down.

If you look at the rate without that Pepsi expense, the rate is going to be higher by something on the order of a point to a point and a half. And so the difference isn't as great as it seems..

Got you. And then another question. How should we think – you guys sort of broke out eMobility.

And how volatile should we expect this segment to be, both in terms of profitability and top line?.

Yeah, I'd say that we can expect a fair amount of volatility in this business. Largely, if you think about the top line, is programs and program wins will naturally be lumpy, and they come in very large chunks when you win a program.

So I think from a standpoint of the revenue growth – and once again, the revenue growth we're still saying is going to be out a couple years or so. But it will naturally be lumpy, just by virtue of the type of business and the growth phase that we're in, in this particular industry. And we will continue to invest heavily in R&D.

I mean, we talked about the underlying profitability being, order of magnitude 12% as we continue to invest heavily in R&D. As we win programs, each of those will require a level of R&D investment, and so I think you can expect a fair amount of lumpiness in the segment as we move forward..

Okay. Thank you..

The next question comes from Deane Dray with RBC..

Thank you. Good morning, everyone..

Morning, Deane..

Hi..

Hey. Craig, was hoping you could expand on your comments regarding that you thought most of your businesses were still in the early to mid-stage of the cycle. So what are you basing that on? Are there some bellwether verticals that give you good indications of that as to the size of projects? But some color there for starters, would be helpful..

Yeah, I mean, and once again, everybody has their own kind of sense of forecasting, but one of the things we certainly look at in our largest segment, we look at the census data and we looked at consensus forecasts.

And when you take a look at consensus forecasts, whether it's Dodge or IHS or Moody's or Associated Builders and Contractors, and we have an economic forecast. And there's also a number of economic forecasters and prognosticators who basically have a view of what 2019 is going to look like.

And I'd say, their consensus numbers would suggest that 2019 will look not terribly different from 2018. A little bit of moderation in growth on average or looking at the median, but you're still talking about growth in the 3% to 4% range when you look at this consensus body of forecasters.

And when you – if you talk to customers, you look at negotiations, you take a look at where we are in the economic cycle versus our historical cycles. You put all these factors together. We take a look at an aerospace business that continue to do extremely well on commercial with a big backlog. You look at increased defense spending.

You look at the type of orders that we're experiencing today in our North America Class 8 truck business and the type of – kind of backlog that they'll carry into 2019. So we think it's really only the vehicle markets around the world that have shown clear evidence of sales retrenchment.

And most of the other markets that we serve, whether we're looking at the current view or the outlook for our markets would suggest that we continue to see growth.

And even for us, if you think about some of the headwinds that we've experienced this year in the context of even Lighting, we don't expect those headwinds to necessarily be there next year.

And so once again, we think it's the forecast that we laid out, that our markets will grow 3% to 4% next year, is supported by all the economic data that we take a look at and supported by what we're hearing and seeing from customers as well..

I appreciate all that color. And then just follow-up on the free cash flow question, was there any sort of prebuying done? We talked about this last quarter, but pre-buying ahead of the tariffs, and maybe also for what you all may have done in terms of inventory building.

But anything unique or an impact on the quarter that we would see?.

I would say for sure we did, as I think we talked about a little bit last quarter, we did some pre-buying in terms of inventory to get out in front of the tariffs and protect our customers, and so we did build a little bit of inventory during the course of Q3 that we'd expect to unwind in Q4, and as we go forward.

But nothing that I would say is material. Our cash flow numbers in the quarter, $1 billion dollars of free cash flow, and we are maintaining our guidance for the year, and so everything that we've done, we expect to largely unwind it during the course of the year..

Yes, one way to think about it, Deane, is that if you look at simple way of thinking about amounts of working capital. So receivables inventory less payables divided by annualized sales were at about 21.5%, and most of the time we've operated more like 19%.

So there is an opportunity to bring that down, it's largely in the inventory area because of some of the need to take positions to deal with the tariff issues. We have not yet done that, but certainly we have plans to take down this inventory back to more normal levels.

We hope to make some of that progress in Q4 and some will probably extend into the first quarter of next year..

That's real helpful. Thank you..

The next question comes from Andy Casey with Wells Fargo..

Good morning, everybody..

Hi..

Wanted to dig into the pause you discussed in some the Electrical markets and look into another vertical, Hydraulics.

Did you see any similar pause in that business, specifically in energy and mining?.

I'd say in Hydraulics, no, we really did not see any particular pause in energy and mining and one of the great proxies for what's going on for example in mining, you see the Cat data that's out there, which was, once again, very strong in Q3, and so material prices, the commodity prices are up, that's generally a very good thing for mining overall, very good for the equipment manufacturers.

So no, we really did not see any pause in that market at all. China is a big piece of construction equipment and in China in Q3 we continue to see very strong numbers in excavator sales and wheel loaders, and so no, we have not seen a pause in those markets..

Okay. Thank you, Craig. And then separately, Eaton's historically had a really good feel for the NAFTA Class 8 truck market. And we're seeing customers having to wait a real long time for truck deliveries.

Are you guys seeing any sign of double ordering within that backlog?.

No, I think at this point we'd say no, we've seen no evidence of that. The market is good right now and obviously rates are up, capacity is up, and we are actually in a replacement cycle based upon trucks that were basically sold, and it peaks eight, nine years ago.

And so right now, I'd tell you it all feels good, Andy, and that market as you know, it's subject to be volatile, but everything that we're hearing today from customers and seeing in the market would suggest that no double ordering, and 2019 will be another growth year on top of an extraordinary year in 2018..

Okay. Thank you very much..

The next question comes from and Ann Duignan with JPMorgan..

Thank you. Most of my questions have been answered by now.

But maybe you could expand on the project win you talked about in eMobility, where is it, what is it, what's the timeline, just some color on that would be great?.

Yeah, it was largely, I'd say, Ann, if it was a win in the commercial vehicle segment, and it was a relatively modest win in that particular business.

And so I'd say today, not one that's big enough for us to make a lot of noise over at this point, we are still bidding on a number of very interesting opportunities in eMobility, but I'd say that one was largely in commercial vehicles with some of our existing customers, and really not one that I'd say that's worthy of a lot of discussion at this point..

Okay. And then as a follow up, I think when I was with you earlier in the quarter and European construction was showing some signs of weakness, and yet on page 14 it's listed as mid-growth stage. I would think that that's one end market that may be at the later growth stage just given how long that market has expanded.

Could you just discuss that a little bit?.

We actually, a quarter or two ago would have said it was not yet into even mid, it was sort of late early stage and we think it's moved into the mid stage. But barring political issues in Europe, we think you'll have another year or two of reasonable growth in European construction, Ann. So that's our thinking as to why it's in the mid stage..

And any regional color, Eastern Europe, Western Europe, Germany versus other regions? I'm just trying to get a sense of where you're seeing the growth. Thank you..

I have to say, Ann, that I can't give you that off the top of my head but certainly Don can follow up with you on that..

Yeah, okay. No problem. And then the only other segment that I think I would disagree with is ag equipment, but we can talk about that offline also given the Chinese tariffs. I'll leave it there for now. Thank you..

Okay. Thanks, Ann..

We're probably going to have time for one last question as we want to wrap up on the hour. So we've got John Walsh with Credit Suisse..

Hi, thank you for fitting me in here..

Great..

So just going back to the initial thoughts on 2019 and as we think about pension and where rates are and I think there's a little bit of a refi benefit potentially in 2019, is there something in corporate to call out? Or is it just it's early days and flat's just the appropriate way to think about it today?.

I'd say first of all, it is early, and we think it will broadly be flat. But secondly, you do have short interest rates rising and we, like other most large corporates have roughly half of our debt swapped into floating. And so as the short rates rise, our interest costs go up. And so it's really those two factors.

As a general matter, it'll be pretty flat, but secondarily, we do know at least of one factor that's likely to increase expenses slightly..

Okay.

And then I guess thinking about data center and what the growth looks like from here is there any discernible mix benefit or headwind to call out as we kind of see the shift to colo and edge over hyper and what that impact is to Eaton?.

I'd say not. I'd say that we have a very strong position as a company in hyperscale, and that is the fast-growing segment of the market. And so I think if anything, the advantage goes to Eaton as you look at these larger, more complex hyperscale data centers..

Okay. Thank you..

With that, we'll wrap up the call for the day. I do want to remember that we will be available for follow up for the remainder of the day and in the days and weeks following this. Thank you all for joining us on the call today..

Ladies and gentlemen, that does conclude your conference. Thank you for your participation. You may now disconnect..