Jul 16, 2007
TRANSCRIPT SPONSOR
Executives
William C. Hartman - VP of IR Alexander M.
Cutler - Chairman, CEO and President Richard H. Fearon - EVP - Chief Financial and Planning Officer
Analysts
David Raso - Smith Barney Citigroup Ann Duignan - Bear Stearns Terry Darling - Goldman Sachs Robert LaGaipa - CIBC World Markets Andrew Casey - Wachovia Securities Jeffrey D. Hammond - KeyBanc Capital Markets Andrew Obin - Merrill Lynch Martin Sankey - Neuberger Berman Ned Armstrong - Friedman, Billings, Ramsey Group, Inc Jamie Cook - Credit Suisse Mark Koznarek - Cleveland Research Joel Tiss - Lehman Brothers
Operator
Ladies and gentlemen, thank you for standing by. Welcome to the Eaton Corporation Second Quarter 2007 Earnings Call.
For the conference, all the participant lines will be in a listen-only mode. However, there will be an opportunity for your questions.
[Operator Instructions]. As a reminder, today's call is been recorded.
I would now like to turn the conference over to the Vice President, Investor Relations, Mr. Bill Hartman.
Please go ahead, sir.
TRANSCRIPT SPONSOR
William C. Hartman - Vice President of Investor Relations
Thank you, John, and good morning everyone and welcome to our second quarter earnings conference call. Joining me this morning are Sandy Cutler, Chairman and CEO; Rick Fearon, Executive Vice President and CFO.
As has been our longstanding practice, we will begin today's call with comments from Sandy followed by a question and answer period. Information provided on our conference call this morning will include some forward-looking statements concerning the third quarter of '07 and full year '07, net income per share and operating earnings per share, statements on our worldwide markets, our growth in relation to those, our growth from acquisitions and joint ventures.
These statements should be used with caution as they 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 these forward-looking statements are set forth in today's press release and the latest Form 8-K filing.
Additional financial information is available in today's press release which is located in the Corporate News heading on Eaton's home page at www.eaton.com. With that, I would like to turn over the meeting to Sandy Cutler.
Sandy?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Great. Thanks Bill and good morning everyone.
Thank you for joining us. I am going to assume that you've all had the opportunity to read our press release, so I am going to try to highlight a few areas of it, talk a little bit about our operating results here on the second quarter, give you a quick update on our outlook for the economy this year and then some early confirmation of our outlook for 2008.
We are obviously very pleased with our second quarter results, some $0.25 above the midpoint of our guidance. And as we itemized in our earnings release, about $0.08 of that came from improved operating results and about $0.17 from a lower tax rate.
Record sales for the quarter, up some 4%, our sixth quarter in a row over $3 billion. We finished the quarter strongly with a record month of sales for the month of June.
Our end markets were down by about 4% this year. We'll come back and talk about that in some more detail.
Very significantly, our fully diluted EPS tied our all-time record for a second quarter, and you all well understand the significance of that at a time when the heavy-duty market for the truck industry had dropped some 51% and we ourselves had forecast that our earnings would be down this quarter. So really very, very pleased with the balance.
And I think if there is one message out of this quarter's earnings, it's that Eaton's diversification and all of our work on the Excel 07 program to restructure our cost base in the company are really paying off and that the prospects for us having obviously increased profits this year over last year look to be very much in hand at this point. We are also pleased that the operating earnings excluding acquisition integration were actually up $0.02 from a year ago.
If you go through our quarters... excuse me, go through our individual segments, I am also confident each of you saw that this is the first time that we have had all four of our segments over 12% operating margins and we'll come back and talk about each of those; very pleased with that.
As I mentioned, our markets were down about 4%. We had about a 3% impact of acquisitions helping our sales exchange of about 2% that were positive.
And then we outgrew our end markets by about 3 points to give you a sense for the sources of growth. If we turn to bookings to try to get a sense for what's going on in our end markets at this point, our Electrical segment bookings, another quarter of record...
a record quarter here in the second quarter with segment bookings up about 7%. If you look at our hydraulics business, orders up by 4% to 5% and the story is consistent with what we have shared with you before that while North America is down slightly, the rest of the world is up quite strongly.
And then we really had another booming aerospace order quarter with bookings up some 19%, so continued strong sales in that arena. You'll recall at the end of the first quarter I spoke to you about working capital and that we had seen our inventories swell as a result of many of the moves that we were undertaking as part of Excel 07 as well as some of our acquisitions.
We are very pleased that our days on hand came down about 3 days from the end of the first quarter. Our accounts receivable came down about 1 day as well, and that in spite of our having a very big shipment month in the month of June, the final month of the quarter.
We entered the market with about 494... end of the quarter, it was about $494 million of cash and marketable securities.
We did repurchase 1.4 million shares during the second quarter at a cost of about $131 million. We are pleased with the operating cash flow and free cash flow of $352 million and operating cash flow of $276 million in free cash flow, a very strong second quarter for us, obviously, at a time when we had one of our businesses coming down quite steeply, that being the Truck business.
Let's switch just quickly to our segments. I mentioned Electrical, very strong results, all-time record sales quarter, up 11%; operating profits of 12.2%, up 1 point from a year ago; very strong incrementals.
If we strip away the acquisition impact, we are seeing Electrical margins on the order of 36% incremental from a year ago. You'll recall we talked about 30% as being a reasonable target in the business.
So quite pleased with our results in the Electrical business. I mentioned strong bookings really confirmation of our strong outlook for non-residential construction and power quality.
On a Fluid Power side, sales up some 12%; overall markets up from 2%, really being led by the strength in the aerospace business. We can come back and talk about each of those elements.
Very pleased also with the operating profits of 12.3%, up from 11% a year ago. This was the seventh quarter in a row we have been over the 11% range in this business, really developing a nice sense of consistency.
And when you look at those margins on an incremental basis excluding the acquisitions up some 30%, a very solid quarter at a time when we saw some weakness in the North American hydraulics business. If we switch to the Truck business, clearly, a lot of reason to be pleased with the results in our Truck business.
While the sales were down some 23%, led by the 51% decrease in the NAFTA heavy-duty business and a 27% decrease from the NAFTA medium-duty business, our operating profits at 15% compared to some 21% a year ago, great performance. And very pleased that that much more balanced operating model in terms of our manufacturing footprint as well as our geographic exposure is really paying off.
And then if we switch last to our Automotive business, up some 7% and really pleased with that growth in the business because the market clearly is not growing that quickly. With the market down about a percentage, our operating profits of 14% versus just under 10 a year ago, real confirmation of both our business model as well as all the work that had been done in terms of recasting this businesses capacity through the Excel 07 program that we did last year.
We have raised our guidance by some $0.30 for the quarter... excuse me, for the year.
And just to break that down for you in terms of the pieces, the individual pieces of that $0.05 really come from a $0.02 negative from suspending our repurchase plan for the remainder of this year, and that... then we'll talk more about.
It's really the result of our financing plan for the MGE acquisition. So you'll recall in our guidance for this year, we have planned on repurchasing about $100 million of shares per quarter.
We are suspending that repurchase for the last two quarters of this year. About $0.04 of acquisition cost that are related to the MGE acquisition and probably a little bit more heavily in the fourth quarter than the first quarter for those...
fourth quarter than the third quarter for those $0.04. We are reducing our second half tax rate from the 17% guidance that we had provided to you to more in the 15% to 16% range, and then about $0.06 of improved operating results as we have both in the first and second quarter operated a little bit better than we had anticipated this year.
That's the total of the extra $0.05. So when you add that $0.05 to the higher $0.25 that we achieved here in the second quarter, it is how you get to the $0.30 in improved guidance for the full year.
Obviously, with the guidance that we have provided to you for the third quarter, you can deduce what our estimates are for the fourth quarter. And really as you think about that, it is both the continued benefits of Excel 07, which is on track and we told you would have more savings in the second half than the first half acquisition integration and then a mild expansion of the heavy-duty truck business in the fourth quarter over the third quarter and the continued strength of our Electrical business.
I think I'll stop there and we'll be glad to answer additional questions from you. Again, we are very, very pleased.
We think that the balance of the business model is really reflecting our performance for the quarter and we did exceed our own expectations, as I mentioned, by about $0.25 for the quarter. So with that, Bill, we'll open up for questions.
William C. Hartman - Vice President of Investor Relations
Okay, John, are you still with us so we can have the Q&A period?
Question And Answer
Operator
Certainly. [Operator Instructions].
William C. Hartman - Vice President of Investor Relations
Okay. The first name that's popped on the screen is David Raso.
Good morning, David.
David Raso - Smith Barney Citigroup
Hi, good morning.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hey David.
David Raso - Smith Barney Citigroup
A question on the guidance. Just trying to think of the moving parts here, the $0.06 operational results.
Can you give us some feel for the net savings from Excel 07 that we have seen so far and how much more will be in the second half than first half? Because if there is going to be more in the second half and you believe Trucks may get better later in the year, you cite the Electrical end market might have better growth in the second half than first half, I am trying to understand why the operational results are up only $0.06 on the guidance.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Let me address the first part of your question David. Our view on Excel 07 is that it's consistent with the original guidance that we laid out.
It's not a change from that. And so just slightly more in the second half than in the first half.
I think as we cite the fact that we think the electrical markets will be slightly stronger in the second half than the first half, that generally is the pattern that you see seasonally in a year for our Electrical business. On the other side, you'll recall you see significantly weaker markets in the second half for our Automotive business because of the third quarter shutdown and we are continuing to see some weakness in the hydraulics business.
So while we are hopeful that we'll see some improvement really driven by the ag business, but again, that's a fairly small segment of our overall hydraulics business. That business in the U.S.
is remaining flatter than we had anticipated this year. So that's our best view at this point is that we think we could see roughly $0.03 in each of those quarters better than we had originally anticipated.
David Raso - Smith Barney Citigroup
And you've mentioned in the past '08 end markets up 5%. Just trying to think for '07 and '08, obviously, today the Truck margins were powerful.
So if people are going to leave today, try and figure out how much of that Truck margin was very one-time in nature with the Excel 07 savings, obviously ready for the truck downturn that's obvious in '07. How do we extrapolate that Truck margin into '08?
Are we still thinking end markets up 5% as you've said before? And of course the tax rate, if it's 15, 16 this year, how should we think about that going into '08?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Well, maybe a couple of items as we think about 2008. We still think a market rebound in the weighted average of Eaton's markets of roughly 5% is our best guess at this point.
And that's anchored by kind of a 275 market in terms of the North American heavy-duty truck market. We do think from a tax perspective, we are faced with slightly lower taxes running this year than we had anticipated this year.
We think our original guidance of 18% for next year probably should be modified to 17% to 18%. We've talked about that if our end markets grow by 5%, we still think it's reasonable to believe that we can grow by 50% more than that.
So that would be 2.5 points and that our best view today on acquisition-related additional revenue is that in the deals we have completed so far this year or have announced and expect to complete this year, we have about $300 million of additional revenue for 2008 already in hand. Offsetting that, we obviously announced the divesture of our mirror controls business in our automotive business during the quarter.
And that's likely to take out on the order of about $90 million of net sales year-to-year. So kind of what's in hand, we have about $210 million of incremental acquisition revenue.
And you will recall that, compared to this year when we set our guidance for the year of 2007, we had said we would have probably on the order of about $300 million of incremental revenue. So we think that general model of base end market of 5, being able to get 2 net points of growth on top of that, something more than $200 million in net acquisition/divestiture growth is likely to be about our top line, and then a slight modification, I mentioned, of a little lower tax rate and then we had felt that our pension cost will decline next year on the order of about $10 million from 2007 levels.
David Raso - Smith Barney Citigroup
And that Truck margin question?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, the Truck margin area, obviously, with the strong second quarter we have had, and we obviously provided guidance during 2007 for about 14% margin in our Truck business, we think depending upon how the second half shapes up, that could be in the 15% to 16% range this year, offset by perhaps a 0.5 point weaker margin in our Fluid Power business because the hydraulics business isn't growing as much in terms of the U.S. end market.
And so if indeed we can have those kind of margins in our Truck business, we have always said as you start to ramp up, you ought to be getting kind of 30% type margins. And so hopefully that gives you some feel from our 215 forecast of this year for North American heavy-duty ramping up to 275 next year at a 30% type margin.
David Raso - Smith Barney Citigroup
Just a clarification on the Truck margin again. The question we used to speak of second quarter success would be high single digits.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Right.
David Raso - Smith Barney Citigroup
You came in at 15. Can you give us a roadmap of how you came out with nearly 500 to 600 basis points higher than you thought?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
I think the big pluses obviously come right back to the same things we have been chatting with you about is it's the tremendous balance within the franchise and our light medium business is performing very, very well. And so at this time in the market with North American heavy-duty down and our light medium business being not just the U.S.
business, but a very big business outside of the U.S., we are getting increased contribution really out of that light medium business. And that's really the great strength of the business currently.
David Raso - Smith Barney Citigroup
I appreciate it. Thank you.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes.
William C. Hartman - Vice President of Investor Relations
Andnext up we have Ann Duignan. Good morning, Ann.
Ann Duignan - Bear Stearns
Hi. Good morning guys.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Good morning, Ann.
Ann Duignan - Bear Stearns
Well done to the Truck group. That was clearly a significant beat versus our expectations.
My question is on the margins, again, going forward in the Truck group. I was down in Brazil last week and had a chance to tour AGCO's Massey Ferguson plant on Friday where they noted that your Pigozzi transmission business was a bottleneck for that group during the quarter as it ramped up production capacity.
I guess my question is does this business become a tailwind going forward and provide some upside in the back half to margins and margin mix, given that your outlook for heavy-duty truck build in North America is flat sequentially? Is that business going to be tailwind to operating profits as we go forward?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
I think that we said in context, Ann, is that the Brazilian ag market began to take off significantly in the fourth quarter of last year, and we are very fortunate that many of our customers have been experiencing significantly higher demand and it teemed quite quickly. As a result, the industry is generally sort of straining to stay up with capacity.
We had a very good second quarter in catching up on a bunch of that. But the demand continues to grow, and our own forecast is that we think the Brazilian agricultural equipment market this year is growing on the order of 22%.
Now, one can never be precise to a number. Let me just tell you it's a big number.
And yes, it is helpful in terms of our providing more volume, but I would say the offset to it, and it's sort of a subtlety going into both yours and David's previous question is that you normally at this time in the cycle, what you are seeing is weakening of after market demand in North America. And it tends to always lag a little bit behind the OEM demand dropping off.
And that's really one of our questions to keep an eye on here in the second half and is why we say we think our overall margin achievement could be in the 15% to 16% area. A key element in understanding that, and we have spoken to you all before about it is that the after market tends to be a profitable portion.
It's an important part of the business, a mixed balance within our business and that we think there is some likelihood that the after market may be slightly weaker before the market then starts to ramp up. That is generally what's happened in the past.
So we are really operating off of our kind of historical knowledge. Whether it will be true this cycle or not remains to be true, but...
remains to be seen. But I would say that's the piece that may offset a little bit some of this ag strength.
Ann Duignan - Bear Stearns
Okay. And by after market in Truck, I presume you are implying mostly the clutch business?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
No. No, I am talking about heavy-duty as well as the clutch business, heavy-duty transmission to be specific.
Ann Duignan - Bear Stearns
Okay. And just to follow up on your outlook, do you have baked in the gain on the sale from the Automotive business?
And if so, what's the magnitude of that gain, or if we are trying to estimate what that could be, what kind of a tax rate should we apply to the gain?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Ann, it's Rick. The gain has been baked in and we would anticipate that we would have a modest gain, but we also anticipate making a contribution to our charitable fund in the third quarter.
We often do that with one-off gains from acquisitions. So that has been built in and will not be much of a factor in the third quarter earnings.
Ann Duignan - Bear Stearns
Okay. So we shouldn't bake anything into our models either in that?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes. That's correct.
Ann Duignan - Bear Stearns
Okay. And I know you said that you have $0.04 of costs mostly in the fourth quarter related to acquisitions.
Is that the net impact of acquisitions or is there also some positive impact on operating profit?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
I would say when you go through most of the smaller ones that we have been involved in, really not much material impact this year. Really what we were calling out is a number of the costs in and around closing the MGE acquisition.
Our anticipation is that we are going to close that in the third quarter, but more of that impact will occur in the fourth quarter, the costs I am speaking about than in the first quarter... in the third quarter, excuse me.
So that's our best net at this point.
Ann Duignan - Bear Stearns
Okay. Would that show up in restructuring costs or will it show up --?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
No. That will show up right in the operating margin.
Ann Duignan - Bear Stearns
Okay, okay. Thank you.
I will get back in line.
William C. Hartman - Vice President of Investor Relations
Thank you. Next we have Terry Darling.
Good morning, Terry.
Terry Darling - Goldman Sachs
Thanks. Good morning, gentlemen.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hello.
Terry Darling - Goldman Sachs
Just wanted to follow up on the degradation and the outlook on the Fluid Power business in the second half of the year related to construction equipment weakness in North America, which I assume a number of others are seeing. And I guess I am trying to get a sense as to whether this is...
that you are seeing your customers signal lower production than they were signaling previously or whether you think that you had a more optimistic outlook for what would happen, and so this is just Eaton revising its own expectations down.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Well I think I would say that we have tried to have our own expectations kind of tied into what's actually happening out there. And we look back at the second quarter reductions and aren't seeing a significant change on this.
So while the quarter-to-quarter comparisons are getting slightly better in terms of construction equipment because it was starting to... its rate of increase was decreasing at the back end of last year, we still think this is a good reflection of not only our own forecast but what we are hearing from our customers.
So early in the year I think people are a little bit more bullish in terms of what might happen. I think people now are seeing far more contraction.
Terry Darling - Goldman Sachs
So at the margin, it sounds like your customers are talking about production coming down versus their own expectation?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, and you'll recall... I think that is correct, and I think as people has hoped, you'd see some of the low-end equipment start to strengthen and it like the residential side is continuing to be soft.
We ourselves don't think you're seeing much of a pop back in that during the balance of this year and maybe into early next year. Now conversely, on the other side, we are all hearing a little bit more positive numbers in terms of the ag side, but keeping in mind the construction market is maybe three time the size of the ag market, so you need to keep that in mind when you think about us waiting.
Terry Darling - Goldman Sachs
Okay. And then the growth in your Fluid Power business...
I understand the commentary in the press release on the end markets, but I am more interested in what's happening with your aerospace and defense top line growth second half versus first half. Is there an acceleration there or is it about comparable or...
color can you provide there?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, with the very strong bookings that we've had over the last couple of quarters and the ramp up of a number of the programs, a reason [ph] it seems we have all been talking about for four or five years are actually now coming into production. We would expect to see our aerospace business as a percentage of the total Fluid Power business expand slightly here during the second half versus the first half.
Terry Darling - Goldman Sachs
Okay, a slight uptick then. Okay.
And then lastly, I guess when I look at your strong cash flow, strength of the balance sheet currently, it's not clear to me why you couldn't finance MGE and continue the repurchase. And so as we think about your acquisition revenues for 2008 or at least the potential thereof, is this not really a signal that you are looking at some potential to make some more acquisitions in the back half of the year?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
So let me give you an answer and I'll ask Rick to add to it. One never knows what lays out ahead of us and neither do we.
And our own feeling was when we looked at the financing of this particular deal, it was the prudent thing to do as we continue to look at a cash flow forecast, which, for Eaton, is obviously stronger in the third and the fourth quarter, but we are still working at bringing inventories and receivables down from the levels that we've been at right now. We do think by year end, with having suspended the repurchase in the last two quarters, we are going to be at very attractive numbers in terms of the leveraging of our balance sheet.
So you may feel it's a little conservative; we felt it was the prudent thing to do at this point. Rick, do you want to add to that?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Terry, I would just say it's a temporary digestion situation. You've probably noted that we ended with just shy of $500 million of cash on the balance sheet in June, and we will use most of that cash plus a little bit of debt to close the MGE transaction.
And that will elevate our gross debt ratio probably by about 1 point at the time of the close, and then we would expect to work that down such that by the end of the year we'll frankly be at debt ratios that are a little bit better than where we ended June. So it's just a temporary situation and certainly, as we get towards the back of the fourth quarter, we should be in a much better position and could conceivably take some further action.
Terry Darling - Goldman Sachs
Thanks very much.
William C. Hartman - Vice President of Investor Relations
Okay. Next we have Bob LaGaipa.
Are you there Bob?
Robert LaGaipa - CIBC World Markets
Hi, good morning.
William C. Hartman - Vice President of Investor Relations
Good morning, Bob.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Good morning, Bob.
Robert LaGaipa - CIBC World Markets
Hey, I just had a few questions. Obviously, a great performance in Truck.
I guess two of my questions were one, you mentioned the Fluid Power being about 0.5 point lower for the margins there. I guess that's relative to the 13 to 14, so now you are looking at 12.5 to 13.5, is that correct?
Unidentified Company Representative
Correct.
Robert LaGaipa - CIBC World Markets
Okay. And now Electrical, the 12 to 13, is that still possible?
I mean you mentioned a little bit of an acceleration at the back half of the year. I mean you start out 11.3, 12.2.
I mean that would require a significant acceleration. Are you still comfortable with that?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, we are because the second half tends to be a stronger quarter Bob. You will recall that seasonally in the Electrical business, both in the base power business as well as in the power quality business, the first quarter is always the weakest quarter.
So, yes, we are comfortable with it.
Robert LaGaipa - CIBC World Markets
And then the other question I had was with regard to Auto. You had mentioned in the first quarter, I think, mix, light truck et cetera had benefited the Auto segment, but still in the second quarter here, very good performance with a14% margin.
Can you just talk about how the mix has changed? Is it the same and what you are expecting from a margin perspective at the Auto business moving forward?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, just to talk about the mix issue, recall in the first quarter we had talk about the light truck segment that compared to the passenger car segment in the first quarter with just under 57% compared to about 55% the year before. That same trend continued in the second quarter when it was actually just under 59% below truck compared to passenger cars.
That makes this a favorable mix for us. It allows us to have a lot a content on some of these CUVs, SUVs and light trucks.
So that is a positive mix issue for us. The issue relative to a higher percentage of imported engines continues, and I am sure you have read a number of the announcements that have been in many, many papers over the last several months about localization plans being postponed here for imported cars.
We have been able to offset much of that. So we are really pleased with the growth side.
In terms of the individual guidance for the margins, though, we have not changed our guidance. We tend have a stronger first half than second half from a margin percentage in the Automotive segment.
And that's particularly true in the third quarter, which is almost perennially the seasonally weakest quarter in the automotive business.
Robert LaGaipa - CIBC World Markets
And last question just on the tax rate. Now the reason for the tax benefits that you are seeing, Rick, I mean this quarter, last quarter, moving forward, the fact that the tax rate is going to be a little bit less, I mean is there one specific item that's causing the tax rate to come down or is it just a variety of different things?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Bob, if you look at the factors in Q2, there were, I guess I would cite three one-off type items. One was we actually won a tax case in a foreign country and that will...
that allowed us to reverse a reserve that we had. Secondly, there was a change in the state tax law, and of course hard to anticipate changes in state tax law.
And third we, at this point, now have completed the preparation of many of our '06 returns, and upon doing so, and it's a very complicated set of calculations, we determined that we were a little over accrued. Those are really what I would characterize as one-off largely not forecastable type items.
But then there were a couple of items that really feed into our guidance that the rate for the back half of the year is going to be more like 15 to 16. And that is that due to the strength of our overseas non-U.S.
operations, the mix is a little more favorable. And also the impact of the acquisitions including Argo-Tech and the way we have structured those, has also served to bring down the rate.
So the way I think about it is there were several one-off items, but looking at the sustaining type items, the rate for the balance of the year at 15 to 16 is very much in line with the same rate that we had for the first half if you take out all the one-off items because the rate in the first half was 15.5% excluding those one-off items.
Robert LaGaipa - CIBC World Markets
Great. Thank you very much.
William C. Hartman - Vice President of Investor Relations
Okay. Next we have Andy Casey.
Good morning, Andy.
Andrew Casey - Wachovia Securities
Good morning, Bill. Good morning, everybody.
William C. Hartman - Vice President of Investor Relations
Hello.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hi Andy.
Andrew Casey - Wachovia Securities
If I could go back to Truck a little bit and look at the revenue line, it was much more positive than I expected, and I was wondering if that had to do with any positive mix shifts in North America.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Not really Bob... or excuse me, Andy.
I think the real issue there is that North America behaves pretty much as we had anticipated from a revenue perspective. From the market perspective, it came in just about where we had provided guidance for the second quarter.
I would say the change is in our light medium business, which, again, is a bigger international play, and it's really consistent with the broad theme for Eaton that about 50% of our revenue is now being influenced by international markets. The strength of international markets are really a benefit to us, and that was particularly true here again in our Truck business.
So our light medium business showed pretty handsome growth between the second quarter and the first quarter. And again to the earlier question, that's helped the balance of profitability performance as well.
Andrew Casey - Wachovia Securities
Okay, thanks for that. And then on Fluid Power, did you have any one-time items in the quarter that affected the margin?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
No. You are really seeing the performance of the business, and again what we'd be highlighting there is the year-to-year improvement of over 1 point in margins in spite of the fact that we are not seeing the U.S.
or North American hydraulics market be very strong, primarily impacted by the pull back in the construction side of the economy.
Andrew Casey - Wachovia Securities
Okay.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
The construction equipment, excuse me. Yes.
Andrew Casey - Wachovia Securities
Okay. Thanks a lot guys.
William C. Hartman - Vice President of Investor Relations
Okay. Next is Jeff Hammond.
Good morning, Jeff.
Jeffrey D. Hammond - KeyBanc Capital Markets
Hi, good morning.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Good morning, Jeff.
Jeffrey D. Hammond - KeyBanc Capital Markets
Just some clarification on the truck margins. I think you said 15%, 16% for the year is kind of how you are seeing it?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Correct.
Jeffrey D. Hammond - KeyBanc Capital Markets
And first half, you are running kind of 17% margins. And I would have thought that 2Q would have been your most disruptive quarter, and as you kind of got production normalized to that lower level, you would see actually some sequential expansion.
What's kind of the offset that margins would actually degrade into the second half from 2Q?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, a couple of items Jeff. Let's just kind of review the North American heavy-duty market: first quarter, 74,000 units; second quarter, 45,000 units; third quarter, 45,000 units; fourth quarter, 51,000 units.
That's how you get to 215. So what's influencing that first half, obviously, is the big 74 in the first quarter and the 18.6% margin.
We think the third quarter looks a lot like the second quarter in terms of North American demand blessed with some weakening after market content within it. And then we started to come back just marginally in the fourth quarter with 6000 higher units, again, likely to have some weaker after market in it.
Now that's kind of the heavy-duty picture. In the light medium business, terrific quarter in the second quarter.
The first quarter tends not to be as strong as the second and third quarter historically. And so those are your kind of three big elements if you will.
You have got the difference in terms of how heavy-duty lays out over the year, you have got the difference in terms of after market and then third, well, you've got the lighter fourth quarter than third quarter in the light medium business.
Jeffrey D. Hammond - KeyBanc Capital Markets
And then on 2Q, I mean was there any quantifiable disruption costs from just ramping down your plants to that lower level of production or not really?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
No, not really. As we have talked, we have been really preparing for this change for a number of years and the team's really, we believe, done an outstanding job in terms how they've managed this process.
And so I think the real kind of economic question now is when does the market get off the bottom of 45,000 units? When do we start to see order patterns move up from this 12,000 level per month?
And from our own perspective, we need to see these order patterns start to pick up to the 15,000 to 18,000 level in probably the September timeframe. And so we think that's one of the kind of key issues to watch as we try to determine do we fill in the fourth quarter production schedules and do we start to get the basis for a ramp that would bring things up in the first and second quarter of 2008.
Jeffrey D. Hammond - KeyBanc Capital Markets
Okay. And then final question on '08.
Seems like your end market growth rate assumptions are unchanged. Any different view to how you see rate cuts within that, either...
are they less... you see them likely or how does that impact kind of the growth rate into '08?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
You recall, Jeff, when we came into this year, we did believe we would see a rate cut and perhaps two. At the end of the first quarter, we said no, we think there'll only be one, and it would likely be in this kind of September timeframe.
Our best forecast at this point is there will not be a rate cut and then there will not be a rate increase during calendar year 2007. We think that inflation rates were a little higher earlier in the year, they appear to be coming into a little better kind of zone of management at this point.
We think at the present time the kind of numbers we were talking about for 2008are realistic. Obviously, if we got a rate increase at the end of the year, we think it would have an impact probably second half of 2008 and we'd probably use a 6 to 8 month kind of lag for this.
Jeffrey D. Hammond - KeyBanc Capital Markets
Okay. Thanks guys.
William C. Hartman - Vice President of Investor Relations
Next we have Andrew Obin. Hello Andrew.
Andrew Obin - Merrill Lynch
Yes, hi guys. How are you?
William C. Hartman - Vice President of Investor Relations
Good.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hi.
Andrew Obin - Merrill Lynch
A nice surprise on Trucks. Just a question on currency.
Somebody actually showed me this morning a very interesting chart on U.S. dollar actually hitting a 15-year low versus other major currencies.
And the first thing I want to understand, if it makes a structural difference of how you think about your manufacturing footprint at least for the next 12 to 24 months. And the second part of the question, if you could quantify the impact of the currency on your net income, and I apologize if I missed that, in the quarter?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes,maybe two perspectives Andrew. A lot of the work that we did last year in terms of Excel 07 was addressing both cost issues, but also our philosophy that you ought to be in the zone of currencies for manufacturing.
So really, the weak dollar scenario was one that we had very much in line for our multiple year forecast, and that's why we did a lot of the moves that we did last year. So our own view is that this weak dollars says that export order stays strong well through 2008, we are going to continue to see strength in international markets, we are going to see flat interest rates with some taming of inflation inherent in that.
So the yield curve looks better from a growth perspective. We think currencies are pretty stable with the exception probably being in Japan and China where we think they may come back a bit.
And in the last couple of pieces kind of fit in all of our thinking of this is the purchasing managers are showing increased confidence, corporate profits and cash flow, are darn good and all that is tending to offset kind of four negatives where you've got tightening going on with the central banks in Europe, you have U.S. housing market weakness, obviously sub prime gets written about every other week and then there are fuel concerns out there.
But we think the balance is positive. And so if we think about the core of your question in terms of what's the structural issue for us, doesn't cause any more plant relocations on, we think we have done that work here in the last year and a half.
We think we are well positioned to participate in these international markets, and it's where a lot of our acquisitions have been and that's where we have now got 50% of the company's revenues being influenced there. And in terms of quantifying the impact the currency exchange has had up to this year, that was in the 2 points of growth that we said came out in terms of our growth here this quarter.
So it has been a positive in terms of driving little higher revenues for us.
Andrew Obin - Merrill Lynch
But what about bottom line?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
It... Andrew, it added about $0.03.
Andrew Obin - Merrill Lynch
Okay.Thank you very much.
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes.
William C. Hartman - Vice President of Investor Relations
Next we have Martin Sankey. Good morning, Martin.
Martin Sankey - Neuberger Berman
Hey, hi.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hi Martin.
Martin Sankey - Neuberger Berman
Quick question. In looking at the $0.17 in terms of how it breaks down from the favorable tax rate, would it be fair to look at it from the standpoint of $21 million or $0.14 being attributed to the various tax items and then the remaining $5 million to the lower base tax rate assumption?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
I am not sure I understand breaking the $0.17 --
Martin Sankey - Neuberger Berman
Okay. If you go into the footnotes, and there is...
and excluding the second... the tax rate, income tax rate for the second quarter would have been 14.4%.
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
I... the way I'd think about it Martin, or the simple way to think about it is about two-thirds of the reduction from the $0.17 is due to one-off items.
The one-third is due to fundamental structural... structurally lower rate, and that's why we think we can now get down to about 15.5.
Martin Sankey - Neuberger Berman
Alright, okay. Okay, so part of that...
so when I look at the 14.4% in the second quarter, there is basically... that's a little bit of catch up from the first quarter and then the other tax item than the other tax items?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes, that's right. As you know, you are always marking the rate for the whole year and so the 14.4% gets us back to what we think is the year rate between 15% and 16%.
Martin Sankey - Neuberger Berman
Now the other thing too is when... you mentioned a contribution to the Eaton Foundation in the third quarter.
Unidentified Company Representative
Yes.
Martin Sankey - Neuberger Berman
How should we look at that, because the gain is going to come in discontinued operations and then you will make the... and the contribution will come out of SG&A in continuing operations?
Is that how we should model it?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes, that's correct. It will be on two different...
the contribution will be on a different line item from the gain on the discontinued operation.
Martin Sankey - Neuberger Berman
Okay. And lastly, the M&A restructuring charges kick up rather significantly in the third quarter versus what you've done in the past.
Could you put some dimensions on it? And also, two, you have done $0.10 a share...
or excuse me, you've done $0.11, $0.12 a share in the first half plus $0.10 in the third, and you are only using 20 for the year. It seems like you are...
there is going to be some restructuring in the fourth quarter as well. Should we be kicking up the restructuring cost estimate?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
In coming up with these estimates, Martin, we are just rounding to the nearest $0.05, and the increase in the third quarter is a reflection of particularly on some of these Fluid Power transactions plus some of the more recent Electrical transactions where we are entering into a more active period in terms of the integration plan. And there will be some further acquisition charges to your point and acquisition integration charges in the fourth quarter.
But in total, we believe that the differential of the $0.20 differential that we have stated in the release should be an accurate numbers for the whole year... $0.25, I am sorry, the $0.25 differential should be accurate for the whole year.
Martin Sankey - Neuberger Berman
Okay. Thank you.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Thank you, Martin.
William C. Hartman - Vice President of Investor Relations
Next we have Ned Armstrong. Good morning, Ned.
Ned Armstrong - Friedman, Billings, Ramsey Group, Inc
Yes, good morning. Thank you.
I had a couple of questions about the markets in which your customers operate. First, with respect to the commercial construction cycle, I know that you have seen several of these in your Electrical businesses over the years, but what's your sense of where we may be in that cycle?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, we have... we obviously have spent quite a bit of time on this one, and there are a lot of public sources of data here.
But as I mentioned, we have recorded a record in terms of bookings for the quarter, and we have really not seen weakness, in fact in the non-res area with one exception, and that being the large... several of the large big box retailers are now growing at a slower rate of expense then they were earlier.
And you have seen a number of those announcements. They are still growing, but they've cut back.
But virtually all the other segments remained pretty strong. And so you whether it's the office building market, there are some pretty hot industrial segments like oil and gas and mining and the entire quality telecom data center area is quite warm.
We tend to get about a nine month view out ahead of us in terms of our kind of quotation cycle, and we are not seeing that weaken up at this point. Having said that, we would have expected that with residential as weak as it's been that we would have seen more contraction in the small retail store area.
And that has not yet happened in terms of what we are seeing in our expectation... in terms of our own quotes.
As we look out over the next couple of years, normally you have seen these be kind of three to four years cycles up. And we obviously had a strong year last year in terms of the non-res market.
We are having a strong year this year. We think that 2008 will also be quite a strong year in that regard.
Ned Armstrong - Friedman, Billings, Ramsey Group, Inc
And have you seen or experienced any delays in big projects due to raw material worries or has that subsided?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
I think that's pretty well through at this point. A year ago, May, we were talking about copper pricing, and that's kind of to stabilized.
Obviously, the fuel stabilized and most of your wood products have been... come back into alignment.
So no, we are not saying that being an issue.
Ned Armstrong - Friedman, Billings, Ramsey Group, Inc
And then with respect to your Fluid Power business, you mentioned in the release that the North American industrial hydraulics market was weak or soft any way and you expect, if I read it right, you expected that to continue throughout the course of the year. Can you provide a little bit more color on that and why you think that's the case, particularly in light of some pretty strong macro numbers that we have seen?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes, we have seen both, and this affects a piece of our electrical business and it affects a piece of our hydraulic business that kind of industrial capital spending has been... and I am talking about the non-facility side, has been weaker than we anticipated coming into this year.
We originally thought we were going to see some very modest growth in that area, and we actually are seeing some modest contraction. So our own view is that the first half has been negatively impacted in both our hydraulics business, and it's a big segment in our hydraulics business and in Electrical business due to weak industrial or kind of stationary equipment demand here.
With all the macros that you referred to in terms of the economy being strong, demand being strong, but still our feeling is there is some pent-up demand there that we'll start to see. But we have not seen it yet.
Ned Armstrong - Friedman, Billings, Ramsey Group, Inc
So have you been able to pinpoint any particular industry that's driving that softness or is it more of an across the board?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
It's very broad with the exception of a couple of areas that are quite hot like oil and gas, mining, et cetera.
Ned Armstrong - Friedman, Billings, Ramsey Group, Inc
Okay, good. Thank you very much.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Certainly.
William C. Hartman - Vice President of Investor Relations
Alright, next to have Jamie Cook. Good morning, Jamie.
Jamie Cook - Credit Suisse
Hi. Good morning guys.
Congratulations.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hello. Thank you.
Jamie Cook - Credit Suisse
I guess my first question, Sandy, can you just talk a little bit about in the first quarter you mentioned some of the inventory issues. You though by the end of the first quarter, getting into the second quarter that the de-inventorying issue would be over.
I guess, can you talk about sort of what you are seeing now? And have you seen...
as you'd looked at the quarter on a sequential basis by month, have you seen any improvement from April versus May versus June sequentially?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, and be glad to, yes. We definitively did positively see month-to-month progress, and your memory is exactly right, we were not pleased with where our inventories ended up at the end of the first quarter with quite a focus, renewed focus upon it, it came down three days here during the second quarter.
And I am very much satisfied that the positive momentum we have there is going to help drive very strong cash flow here in the third and fourth quarter. Equally, we have made some progress on receivables down a day from the end of the first quarter as well.
So important elements in terms of our overall cash flow for this year.
Jamie Cook - Credit Suisse
But at the distributor level too, you feel comfortable with the inventory levels?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
Yes, I think when you look at the inventory liquidations in the economy and then when you get down to the kind of micro issue in terms of own end markets, yes, I think it's in much better balance than we thought in kind of the fourth and first quarter where people had experienced some slower growth than they had anticipated, and frankly their inventories had piled up a little bit. And I can tell you in our conversations with a number of our customers that are feeling better about where they are and they've completed their inventory liquidation, I think we are more likely to see the demand come through.
Ag is a good example of that. Now, you look at the retail sales in the ag market here in spring, and some very big numbers.
And those numbers have not all yet come true in terms of the production side, which is why we mentioned we thought there is a pretty good likelihood we'll see some model strengthening of ag production here in the second half.
Jamie Cook - Credit Suisse
And then I guess just my last question, can you talk about... I mean one of the things I think that's been helping a lot of these companies is just the strength overseas and how you guys have changed, not as North American focused as you were in the past.
I mean not to get too far out beyond 2007, but can you talk about sort of your more detail on what are you seeing in Europe? Whether you think the growth that we are seeing over there is sustainable and can it continue into 2008 or is this sort of the...
2007 sort of the peak there?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Well, I think maybe a couple of points of reference there. If you think about it, where part of the stronger North American truck orders came early in the year than people expected, it came out of sales into South America and Mexico.
And that was becoming because European produced trucks were more expensive than the North American produced trucks and so this... and you see that time after time, this low value of the dollar deposit.
So if you talk about Europe, we actually think Europe is growing faster than we thought it was going to. We think there are some good prospects.
The negative is their ability to export with the currencies where they are; the positive is the tremendous growth going on in Eastern Europe and now Russia. And so one of the reasons we are very excited about our MGE small UPS Systems business is it gives us some more content into fast growing markets at this point.
South America continuing to do quite well for us and Asia doing quite well. So we think we are likely to see a situation where you see continued strong international growth with a strengthening U.S.
economy modestly, but the stronger part of the improvement here in the U.S. would be the manufacturing side of the economy, not the consumer side.
All that plays into this environment that we feel is a good environment for manufacturers, particularly those like Eaton who have at least 50% of their revenues being driven by outside of the U.S.
William C. Hartman - Vice President of Investor Relations
Okay. Next we have Mark Koznarek.
Mark?
Mark Koznarek - Cleveland Research
Hi, good morning.
William C. Hartman - Vice President of Investor Relations
Good morning.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hi.
Mark Koznarek - Cleveland Research
I am not sure if perhaps I missed this, but you talked about Electrical core growth for the quarter was up 4%. And I am wondering if you can just divvy that up into some of the components we have been talking about, the non-res piece, the residential and then the power quality.
And then if you can flip that to the full year outlook is now a little better than that original 4% that you talked about. Again, if you could delineate what are the components of that overall for the year as well?
Thanks.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, Mark, the growth in terms is a little bit better for the balance of the year. We are really thinking instead of it being more 4%; we think it might be 4% to 5%.
So it's a fairly modest change in that regard. I'd say what has kind of changed in our own thinking, if you through the year is that with the U.S.
housing start, and everybody has been reading the same information, has been getting weaker. It's down at a fairly low level and we think not likely to come back substantially.
So if we compare to where we started off this year, we were thinking you might see a 16% decline in non-res than we thought at the end of the first quarter it would be 17%. We now think it's on the order of 19%.
On the non-residential, we started the year at 5; end of the first quarter, we took it up to 7, now we think it's closer to 8. So the earlier question on industrial equipment capital spending, we entered the year I think and we might see on the order of 3%.
We revised it down to 1 at the end of the first quarter and now really it's kind of flat for the year. Not much change in the primary markets which drive our power quality business.
That's pretty much in line with our kind of 7% thinking. And then to the question just a moment ago from Jamie on Europe, we think Europe is now instead of maybe 3%, if it moves to 4, we think that market may be closer to 6 this year.
So that's sort of the mix of changes in our terms of our thinking. I think it's consistent with our overall view that we are saying international markets be a little stronger, we're saying resi be weaker, we are seeing industrial be softer and then we are saying non-res be a little stronger.
Mark Koznarek - Cleveland Research
Okay. And then one follow up on the Excel 07 program.
Given the momentum that you are experiencing there, what kind of carryover net improvement would be reasonable to think about for '08 over '07?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, we have really not gotten Mark into trying to forecast 2008 discretely yet. We'll be going through that obviously this fall as we do our planning.
We said we thought there might be some, but we have not quantified it yet and until we've completed our whole work this year and have a chance to kind of peer into next year, but we are just not ready to kind of share that.
Mark Koznarek - Cleveland Research
Okay. But it does appear there will be something, some positive number.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes.
Unidentified Company Representative
Yes.
Mark Koznarek - Cleveland Research
Okay, very good. Thanks.
William C. Hartman - Vice President of Investor Relations
Okay. Next we have Joel Tiss.
Good morning, Joel.
Joel Tiss - Lehman Brothers
Hi, how is it going?
William C. Hartman - Vice President of Investor Relations
Hi Joel.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Hi.
Joel Tiss - Lehman Brothers
I didn't think I was going to make it. I just...
most of them have been answered for me. I just had one sort of nuance question.
In your hydraulics business, you talk about construction being weak and an industry... in Electrical, sorry, you talk about construction being strong.
So I am just wondering, maybe it's too nuance, but can you just dig a little bit deeper into what are the pieces or is it just more of an inventory reduction on the--?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
No, there are a couple of pieces in there Joe. Line up of the small and of the construction equipment business with what goes on in the residential.
So you're skid steers, your mini axles, that type of equipment, pretty tight tie there. Obviously, both are quite weak.
Your big construction equipment, really, you think of it as having, and I am taking out of mining when I say this, think about it having kind of two elements: the North American demand and then the international demand. The international demand for that equipment is quite strong, again, going back to the dollar play issue, a lot of export and a lot of export over to Asia right now.
Now hop into the mining side, the mining side continues to be quite strong. Our comments about the construction market are really kind of North American-oriented, and so it's that part that has been weaker.
It's been weaker on the low end and it's been a little weaker in some of the big equipment here in North America than we had thought we would see.
Joel Tiss - Lehman Brothers
Okay. And just a follow up, can you give us any sense in the third quarter if we could see less seasonality in your results just because of how strong Europe is?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Again, I think you have to take it a little bit differently by businesses. Electrical, that tends to be one of the very big quarters for Electrical and that is our expectation.
Fluid Power, we commented earlier, we've got some building strength on the aerospace side from a shipment point of view, kind of the back up of all of the very strong orders we've had. A question in our mind whether we see much of a rebound on the ag side, but we believe we will see some stronger shipments there.
So that should be a little bit of a help there. In terms of the filtration business, kind of an industrial play more than anything else, but probably pretty steady in terms of how we have been experiencing it this year.
And then if you... if I switch to our Automotive business, you are going to have the seasonal weakness that happens just because of the shutdowns in the third quarter, and I don't see that changing.
I think you still will see weakest quarter be third quarter. And then on the Truck business, we talked a little bit about it earlier is that we think you'll see similar heavy-duty demand in North America on the OEM side, but probably a little weaker after market business.
And then we think pretty good business outside of the U.S., so probably on the order of what we were seeing in our light medium business in the third quarter to what we saw in the second quarter. So not a lot of change to our normal seasonal in that regard.
Joel Tiss - Lehman Brothers
Okay, thank you very much.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Sure.
William C. Hartman - Vice President of Investor Relations
Next we have Steve Sergul [ph]. Are you there Steve?
Unidentified Analyst
Yes, good morning,
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Good morning.
William C. Hartman - Vice President of Investor Relations
Good morning.
Unidentified Analyst
I was wondering, one, how much you compete directly with GM's Allison unit and two, if you expect any changes with then now being owned by private equity.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
It's... where we would compete with Allison would be primarily in the medium-duty range of product, where they obviously have their automated transmission.
So not as much of an overlap in the heavy-duty market and obviously not in our clutch business, and really not as much in our light medium business outside of the U.S. So, in terms of do we see an impact, no, although we feel it with a very handsome price that was paid.
And I think it ought to be confirmation of the value of our own truck franchise. But...
and I think that as we think about the second quarter within this context, we think we have really improved now that the historic evaluation discount that's been applied to our truck business is no longer valid, because if you look at the valuation difference given to an Allison, which was perceived as a less cyclical business, we have just shown our business is not cyclical either. And so we really feel we have now got a business which is likely to earn 15% to 22% through the economic cycle without much cyclicality any more and we think that that's very positive.
Unidentified Analyst
Okay. And with respect to the financing plan with the UPS acquisition, is it safe to assume you are just going to do that with CP and just pay that down going into year end or would you think about maybe terming some of that out with some more debt issuance?
Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer
The largest part of the purchase price will just be based on cash on hand, and then there will be some modest additional CP we take down. But we do not have plans to term anything out right now.
Unidentified Analyst
Okay. Thank you.
William C. Hartman - Vice President of Investor Relations
And lastly on the board here is Dan Dowigan [ph]. You there Dan?
Unidentified Analyst
I am. Good morning.
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Good morning.
Unidentified Analyst
Well I will try to make this quick because we have covered most of it. But I would love for you to just comment on what's really been driving the margin expansion in the electrical power business and also how you see this evolving in the back half of '07 and into '08?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Yes, in our total electrical business, a couple of items, obviously, where our revenues are up significantly. And as I mentioned before, we are really pleased that we achieved mid 30% incremental on that when you don't include the acquisition in terms of how they impact the quarter.
So we think that the business was being run very well on the cost side. In terms of what's driving the top line, our business if you try to think of kind of...
these are very broad kind of generalities. But probably 40% of the business is driven by the power equipment business, about 40% of it being driven by the power quality side and the remainder is sort of the residential utility and other pieces.
Power quality is very strong, data center is continuing to be very hot currently, lots of demand around the world, the telecom business that we've participated into a smaller degree has got some real points of strength. And that's not just new demand; I am talking about power quality, it also is for retrofit of existing businesses.
So we continue to think that that's a very attractive end growth market. On the more traditional kind of power equipment side of the business, again, we are not in the...
we do not make power generating equipment, we don't make transmission and distribution in the T&D segment [ph]. We are really in the equipment that handles power after it's really coming through the substation.
And there that business has got a very strong drive from the non-residential construction market today, which is quite strong. And within that, the medium voltage equipment is growing quite quickly as you have major industries like oil and gas and mining investing right now.
And that's good for us as well. So those are a number of the issues that are really growing the fast growth and we see that continuing into the end of 2008.
Unidentified Analyst
And do you see a continuing mix shift towards power quality businesses?
Alexander M. Cutler - Chairman, Chief Executive Officer and President
Well, obviously, this acquisition we just did of MGE is another area that adds to those revenues. And so it's an area we have been quite bullish on and we've said that we'd like to continue to grow and so we are continuing to apply our acquisition dollars for that area.
Unidentified Analyst
Terrific, thank you.
William C. Hartman - Vice President of Investor Relations
Great. That completes all the Q&As.
So we appreciate your attention and as always, I will be available the rest of the day for follow-up questions. Thanks a lot for participating.
Operator
Ladies and gentlemen, that does conclude your conference. Thank you for your participation.
You may now disconnect.
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