Earnings Call Transcript - ETN Q3 2023

Operator, Operator

Conference Call. As a reminder, today’s conference is being recorded. I would now like to turn the conference over to your host, Yan Jin, Senior Vice President of Investor Relations. Please go ahead.

Yan Jin, Senior Vice President, Investor Relations

Good morning. Thank you all for joining us for Eaton’s third quarter 2023 earnings call. With me today are Craig Arnold, our Chairman and CEO; and Tom Okray, Executive Vice President and Chief Financial Officer. Our agenda today includes the opening remarks by Craig, then he will turn it over to Tom, who will highlight the company’s performance in the third quarter. As we have done in our past calls, we will be taking questions at the end of Craig’s closing commentary. The press release and the presentation we’ll go through today have been posted on our website. This presentation, including adjusted earnings per share, adjusted free cash flow and other non-GAAP measures that are reconciled in the appendix. A webcast of this call is accessible on our website and will be available for replay. I would like to remind you that our commentary today will include statements related to the expected future results of the company and are therefore forward-looking statements. Our actual results may differ materially from our forecasted projections due to a wide range of risks and uncertainties that are described in our earnings release and the presentation. With that, I will turn it over to Craig.

Craig Arnold, Chairman and Chief Executive Officer

Okay. Thanks, Yan. We are pleased to report our Q3 results in another record quarter. Our team continued to deliver on our commitments, supported by strong markets and good execution. So, let me begin with some of the highlights on Page 3. As we have shared for some time now, megatrends, including reindustrialization, energy transition, electrification and digitalization are continuing to expand our markets, revenues, orders and negotiations pipeline as these trends are once again evident in our results in the quarter, especially in our Electrical Americas business. We posted another quarter of record financial results with strong revenue, margins, earnings and cash flow growth. While our markets continue to be strong, we’re also continuing to improve on our overall effectiveness, which drove our record operating margins, and we’re once again raising our earnings outlook. We’re raising our ’23 guidance for margins, adjusted EPS and cash flow. Our EPS growth for 2023 at the midpoint of our guidance is now 19%. I’d also like to highlight our growing backlog, which was up 15% in Electrical and 22% in Aerospace. And we continue to have a strong book-to-bill ratio of 1.1 for Electrical and 1.2 for Aerospace. Lastly, we recorded record third quarter operating cash flow of $1.1 billion, up 18% and free cash flow margins of 16%. Tom will share additional details. But overall, as you can tell, we’re pleased with the results and well positioned to close out a record year. Moving to Slide 4. In the last quarter, we shared a framework for how we think about our key market drivers for the company. The chart notes six megatrends that are driving growth capital investments and how they intersect with various businesses within Eaton. As you can see, we’re uniquely positioned in most of our businesses and expect to see accelerated growth opportunities. It’s our intention to cover each of these markets and megatrends during our earnings call and to keep you appraised of progress. In our Q2 earnings call, we provided a summary of progress on infrastructure spending, reindustrialization and the utility market in Electrical and our Aerospace business. Today, we’ll spend a few minutes on how reindustrialization continues to drive a record number of mega projects in North America and how Eaton is positioned to win in the fast-growing data center market. We received an extensive number of questions on each of these topics and hope our updates are helpful as you think about the growth outlook for the company. So let’s begin with Slide 5 in the presentation. We’ve shared this chart previously, and the data is a good proxy for reindustrialization and what we’re seeing inside of many of our markets. You’ll recall this chart summarizes the number of mega projects that have been announced since January of 2021, and a mega project is a project with an announced value of $1 billion or more. Note that this is the North America data, but we’re seeing a similar trend in Europe, although the dollar amounts are not as large. Three key points to note here. One, at $860 billion, this number is 3x the normal rate, which translates directly to future opportunities for electrical markets. As a reminder, the electrical content on these projects ranges from 3% to 5%. Two, this number continues to grow at a faster rate. Announced mega projects grew 25% between Q3 and Q2, and Q2 was up 20% from Q1. This will not go on forever, but there continues to be strong momentum for industrial projects in North America. And third, only 20% of these projects have actually started. For those that have started, we’ve won roughly $850 million of orders with a win rate of approximately 40%. And we’re actively negotiating another $1 billion of electric content on a small subset of these announced mega projects. Turning to Slide 6. We highlight the data center market. I can’t think of many markets that have better secular growth dynamics than data centers. The world’s appetite for data, new insights and software solutions continues to grow at an exponential rate. And natural language processing, like ChatGPT, will only accelerate this trend. This is a very good thing for Eaton as we have a strong portfolio of data center solutions and the data center/IT channel represents 15% of our total revenue. While the numbers continue to be refined, we now think this market grows at a 16% compounded rate between 2022 and 2025 and likely for much longer. As expected, our customers are continuing to expand their data center CapEx build-outs, some of which are being modified to support the adoption of generative AI. Just consider some of these metrics. 120 zettabytes of data have been generated in 2023, a 60-fold increase over the 2 zettabytes generated in 2010. And the amount of data generated is expected to grow to 180 zettabytes by 2025, a 50% increase over 2023. And the AI impact is just starting to show up in our order book. During Q3, we won a large order of approximately $150 million for a new AI training data center and saw a roughly 61% increase in hyperscale orders overall. These AI data centers require both high-power and high-power density and as a result, higher electrical content. Another trend driving higher electric content is the need for solutions that allow bidirectional flow of power back to the grid and the ability to optimize the use of renewable energy to power data centers. So this market and Eaton are well positioned for higher growth for years to come. And on Page 7, we highlight Eaton’s unique positioning in the data center market and note that we have the electrical industry’s broadest portfolio of power manager solutions for data centers. Centralized data centers come in a variety of sizes with incoming power draws between 10 and 500 megawatts with the average data center of 40 to 50 megawatts, which is the variety that we show here on this slide. Eaton, we, support the flow of electrons from where they enter the facility from our transformers to our medium-voltage and low-voltage switchgear through our electrical busway to our uninterruptible power systems all the way into the server rooms, where we offer racks and power distribution units. In addition, we have a broad suite of software and service solutions that provide real-time diagnostics, prognostics and uptime support. As a rule of thumb, Eaton’s market opportunity in data centers is about $1.5 million per megawatt. Here, we’re distinguishing this market from the myriad of smaller data centers that exist to support many different markets and smaller applications. And we continue to improve our position in the market with our Brightlayer for data center suite of software solutions. This platform is the first in the industry to unite asset management, IT and operational device monitoring, power quality metrics and advanced electrical supervision into one single application. This new software provides electrical power, power quality, distributed IT equipment performance management that improves efficiency, data accuracy and uptime. So overall, Eaton is well positioned and continues to build on our strength in this rapidly growing market. Given our broad set of megatrends and our growth outlook, we’re naturally investing to add capacity in many of our businesses, as noted on Slide 8. In fact, on the normal run rate, we’re investing more than $1 billion of capital to support the growth that we see over the next five years. These investments expand our production capacity across a wide range of markets and position Eaton to win more than our fair share of these opportunities. As you have heard, while somewhat improved, our lead times are still longer than ideal. And these investments will address the bottlenecks in our manufacturing sites. The primary investments are being made in utility markets to support transformers, both the regulators and our line insulation and production equipment and circuit breaker capacity to support the rapid growth in industrial projects and to add redundancy to our existing capability and in our global Electrical business to support growth in a number of fast-growing emerging markets, where we’ve been gaining share but have ample opportunities to do significantly more. And of course, we’re building a completely new eMobility business and making significant investments to build out new manufacturing capacity there. These capital investments support higher organic growth, provide excellent return on investment and are indicative of our confidence in the future of the company. We’ve made some of these capital investments this year, while others will be layered in over the next couple of years. Now I’ll turn it over to Tom to cover our financial results and outlook for the year.

Tom Okray, Executive Vice President and Chief Financial Officer

Thanks, Craig. I’ll start by providing a summary of our Q3 results, which include several records. With respect to the top line, we posted an all-time quarterly sales record of $5.9 billion. Organic growth continues to be strong, up 9% for the quarter, building upon six consecutive quarters of double-digit growth and three quarters on a two-year stack of mid-20s growth. Operating profit recorded all-time records on both a margin and absolute basis. Operating profit grew 23%, and segment margin expanded 240 basis points to 23.6%. We posted a very strong incremental margin of 46%, up sequentially from 33% in Q2 and 27% in Q1. Adjusted EPS increased by 22% over the prior year to $2.47 per share, an all-time quarterly record and well above the high end of our guidance range. This performance resulted in a third quarter operating cash flow record. Our $1.14 billion in operating cash flow was 18% higher than the prior year, generating 16% free cash flow margin and over 100% free cash flow conversion. Looking at our results on a year-to-date basis. Organic growth is up 12%. Segment margin is up 170 basis points. We generated incremental margin of 35%, adjusted EPS growth of 19%, a 73% increase in operating cash flow versus prior year and free cash flow up 90% year-over-year. Moving on to the next slide. Our Electrical Americas business continues to execute well and delivered another very strong quarter. We set all-time quarterly records for sales, operating profit and margins. Organic sales growth remained very strong at 19%. Electrical Americas has generated double-digit organic growth for seven consecutive quarters with six of the quarters greater than 15%. On a two-year stack, organic growth is up 37%. In the quarter, there was broad-based growth in nearly all end markets with double-digit growth everywhere except residential and especially robust growth in industrial, utility, machine OEM and data center markets. Record operating margin of 27.7% was up 420 basis points versus prior year, benefiting from higher volumes and effective management of price cost. Incremental margin was 50% for the segment. On a rolling 12-month basis, orders were down 3%. It’s important to note that the dollar value of orders remains high, and the decline needs to be viewed in context of the 36% order growth in Q3 of last year. As discussed on last quarter’s call, order intake is an important metric but needs to be analyzed together with record backlog. Currently, in our Electrical sector, we have backlog coverage of almost three times our historical average. We have looked at multiple scenarios with meaningful order intake decline and are confident in those scenarios, given our backlog coverage, that we can generate robust organic growth for several quarters into 2025. In this regard, Electrical Americas backlog increased 19% year-over-year and 5% sequentially, resulting in a book-to-bill ratio above 1.1 on a rolling 12-month basis. For orders, we had particular strength in data center, industrial facilities and institutional markets. Also, our major project negotiations pipeline in Q3 was up 33% versus prior year and 19% sequentially from especially strong growth in data center, institutional, government and water, wastewater markets. Data center negotiations increased almost four times. On a two-year stack, our negotiation pipeline was up 180%. Overall, Electrical Americas continues to have a very strong year. On Page 11, you’ll find the results for our Electrical Global segment. Despite flat organic growth, we posted a Q3 right sales record. We had strength in our commercial and institutional, industrial and utility markets. Regionally, we saw weakness in EMEA markets that were offset in other markets where growth was in line with expectations. We expect the softness in EMEA to be short-term with organic growth in the segment returning to low to mid-single digits in Q4. Operating margin of 21.8% was up 120 basis points compared to prior year. Operating profit and margin were all-time quarterly records. Margin improvements were primarily driven by effectively managing price cost. Orders were up 1% on a rolling 12-month basis with strength in data center and utility markets. Importantly, book-to-bill remained greater than 1. Before moving to our industrial businesses, I’d like to briefly recap the combined electrical segments. For Q3, we posted organic growth of 11%, incremental margin of 53% and segment margin of 25.5%, which was up 320 basis points over prior year. On a rolling 12-month basis, our book-to-bill ratio for our electrical sector remains very strong at more than 1.1. We remain quite confident in our positioning for continued growth with strong margins in our overall electrical business. The next slide highlights our Aerospace segment. We posted all-time quarterly sales and operating profit records. Organic growth was 10% for the quarter with a 3% contribution from foreign exchange. We’ve posted double-digit growth in six of the last seven quarters in this segment. Growth was driven by broad strength across all markets with particularly strong growth in commercial OEM and commercial aftermarket, which were up 21% and 27%, respectively. Operating margin of 24.1% was up 10 basis points on a year-over-year basis and up 160 basis points sequentially. Growth in orders and backlog continue to be very strong. On a rolling 12-month basis, orders increased 16% with especially strong growth in commercial OEM, commercial aftermarket and defense OEM. Year-over-year backlog increased 22% in Q3 and 4% sequentially, reflecting continued momentum in the Aerospace recovery. On a rolling 12-month basis, our book-to-bill for our Aerospace segment remains very strong at 1.2. Moving to our Vehicle segment on Page 13. In the quarter, organic growth was down 1%. Foreign exchange had a 2% favorable impact. We saw growth in APAC, North American automotive and EMEA markets more than offset by a decline in North American Class 8 and South American markets. Operating margins came in at 17.4%, 60 basis points above prior year driven by effective price cost management, partially offset by lower sales volumes. 17.4% margins represents 210 basis points of sequential increase primarily driven by manufacturing efficiency improvements. We continue to pursue and win new business in growth areas such as EV torque win with a major Chinese OEM. We also have momentum winning program length extensions and volume increases with multiple OEMs globally. On Page 14, we show results for our eMobility business. We generated another strong quarter of growth, including an all-time sales record. Revenue was up 19%, all organic. Margin improved 150 basis points versus prior year to breakeven. The result was mostly driven by higher volumes from ramping programs and improved manufacturing productivity. Overall, we remain very encouraged by the growth prospects of the eMobility segment. So far in 2023, we have won new programs worth $1.1 billion of mature year revenues. This is nearly a 145% increase in new program wins since the $450 million highlighted in last quarter’s earnings call. Through these wins, we continue to find opportunities to leverage expertise and differentiated technologies across segments. Should be noted, we have increased our interim revenue target for 2025 by 25% from $1.2 billion to $1.5 billion. Moving to Page 15. We show our Electrical and Aerospace backlog updated through Q3. As you can see, we continue to build backlog with Electrical stepping up to $9.4 billion and Aerospace reaching $3.1 billion, sequential increases of 5% and 4%, respectively. Both businesses have increased their backlogs by significantly more than 100% since Q3 2020. The backlog build gives us confidence in our order outlook for the quarters to come. On the next page, we show our fiscal year organic growth and operating margin guidance. For organic growth, we are increasing Electrical Americas, lowering Electrical Global and eMobility, while narrowing the range of our total organic growth, resulting in a 50 basis point increase at the midpoint. We now expect organic growth in Electrical Americas to be 16.5% to 18.5%, up 250 basis points from our prior 14% to 16% guidance. This represents 850 basis points improvement from our initial 2023 guidance. For Electrical Global, we’re lowering our organic growth guidance from 6% to 8% to 4% to 6% based on weaker-than-expected end markets in Europe. For eMobility, the midpoint of our organic growth guidance is now 25% versus 35% mostly due to OEM-related delays for their EV platforms. For segment margins, we’re increasing our total Eaton margin guidance range by 50 basis points. This is a result of an improved outlook in Electrical Americas, where we increased the range by 150 basis points on strong demand and continued operational execution. We are lowering margin guidance for Electrical Global 50 basis points due to lower growth. The 21.8% midpoint comfortably exceeds our target to reach 21.5% by 2025 and represents a 160 basis point increase versus prior year. In summary, as we approach the final quarter of 2023, we remain well positioned to deliver another very strong year of financial performance. On Page 17, we have additional guidance metrics for 2023 and Q4. Following our strong year-to-date performance and improved margin expectations, we are raising our full year EPS range to $8.95 per share to $9.05 per share. The $9 midpoint represents 19% growth in adjusted EPS over the prior year. We’re also raising our operating cash flow and free cash flow guidance ranges by $100 million each to reflect our stronger earnings and solid working capital management. For Q4, we are guiding organic growth of 8% to 10%, segment margins of 22.3% to 22.7%, representing 170 basis point improvement at the midpoint versus prior year. Adjusted EPS is a range of $2.39 to $2.49, an 18% increase versus prior year at the midpoint. The next chart summarizes the progression of our guidance in 2023. Throughout the year, we’ve demonstrated the ability to execute on our commitments and raise guidance for all of the metrics shown. We are well on track to deliver our third year in a row of double-digit organic growth with all-time record margins in a $1 billion or nearly 40% increase in operating cash flow. Now I’ll hand it back to Craig.

Craig Arnold, Chairman and Chief Executive Officer

Thanks, Tom. So moving to Page 19 and turning our attention to next year. We provided our initial view on what we expect from our end markets. And first, I would note this as a starting point, we haven’t changed our view on 2023. And as you can see, we’re expecting attractive growth in nearly all of our markets in 2024. We expect strong double-digit growth in data centers and distributed IT segment, in utilities, commercial aerospace and electric vehicles. Additionally, we expect solid growth within industrial facilities, commercial and institutional and defense aerospace. And as you can see, global light vehicle market should be modestly positive with only the residential and commercial vehicle markets experiencing a decline. So it should be another year of significant growth with over 80% of our end markets seeing solid or better growth. Please note that much of this growth is supported by record backlogs, and we’ll provide more detailed color on organic growth as we come together with our 2024 guidance in February of next year. As you can see from the outlook, despite mixed signals in the economy and some historical indicators of growth, Eaton remains very well positioned to deliver what we call differentiated growth in 2024 and beyond. So I’ll close with a summary on Page 20. Last quarter, I noted that we’re feeling good about how our markets are performing. And today, I reiterate that sentiment. We continue to experience powerful megatrends that are driving a higher outlook for our end markets, and we’re seeing it in our negotiations and order book. And once again, we delivered another record quarter of financial results, increased our earnings and cash flow outlook. Our orders continue to come in at historically high levels, and we continue to grow our backlog. I would note that our team is executing well, but we have an opportunity to be better everywhere. So the setup for 2024 is playing out as we expected, and it should be another strong year. With that, we will open it up for any questions you may have.

Yan Jin, Senior Vice President, Investor Relations

Thanks, Craig. With that, I’ll turn it over to the operator to give you the instructions.

Operator, Operator

The first question will come from the line of Andrew Obin from Bank of America. Please go ahead.

Andrew Obin, Analyst (Bank of America)

Hi, guys. Good morning.

Craig Arnold, Chairman and Chief Executive Officer

Good morning, Andy.

Andrew Obin, Analyst (Bank of America)

Just a question on incrementals, just very nice progression in Electrical Americas from first quarter into third quarter and overall for the company. So how should we think about just incremental progression to the fourth quarter and ’24 because I think within your framework, you’ve used a lower number. Just maybe expand what’s driving these strong incrementals and how sustainable it is going forward?

Craig Arnold, Chairman and Chief Executive Officer

I appreciate the question, Andrew. And our team certainly performed extremely well during the quarter, and we’re proud of our teams and how well they executed in the quarter. And certainly, implied in the guidance are pretty attractive incrementals as well. Maybe I’ll answer the last question kind of first with respect to as we think about incrementals going forward in 2024, and we still think 30% incrementals are the right way to think about the incrementals for the company. Clearly, we’re making some investments in the business that are going to moderate incrementals. And certainly, if you think about price versus cost and the tailwinds that they provided during the course of 2023, we’re not expected to see the same order of magnitude of tailwinds in 2024. So we still think 30% is a good planning number for next year. And as we think about Q3 and Q4, we have a pretty strong line of sight to those incrementals that are embedded in our forecast for Q4.

Andrew Obin, Analyst (Bank of America)

Thank you. And just a follow-up question. You keep announcing additional capacity additions. If I look at Slide 19, you sort of give end market growth assumptions. So how should we quantify the outgrowth opportunity or revenue from capacity additions, particularly relative to your end market assumptions? Thank you.

Craig Arnold, Chairman and Chief Executive Officer

This is kind of a really attractive problem to have, Andrew, in terms of the growth that we’re seeing in many of our businesses and having to make some investments to deal with the stronger demand that we’ve seen over the last few years and certainly the demand that we expect to see into the future. And so we talk about kind of this growth outlook for the company in these strong markets. And we need to make some investments in capacity and some key bottlenecks. We talked about the $1 billion in my opening remarks and where it’s going. And I’d say that these investments that we’re putting in will give us the capacity that we need to support the long-term growth outlook for the company and a little headwind above that if markets turn out to be even a bit stronger than what we anticipated. And so we are making the investments that we should be making and we need to make to get out in front of the pretty robust outlook that we have for the company’s growth.

Andrew Obin, Analyst (Bank of America)

Thanks so much.

Craig Arnold, Chairman and Chief Executive Officer

Thank you.

Operator, Operator

The next question is from Joe Ritchie from Goldman Sachs. Please go ahead.

Joe Ritchie, Analyst (Goldman Sachs)

Thanks. Good morning, everyone.

Craig Arnold, Chairman and Chief Executive Officer

Good morning, Joe.

Joe Ritchie, Analyst (Goldman Sachs)

Hey, Craig, can you maybe just talk a little bit about the mega projects for a second? I think you mentioned that 20% of the projects have started. When you think about the timing of when you typically will see a bidding on those projects and the orders coming through, how do you see this kind of playing out based on, again, the projects that have already started and now the funnel is continuing to increase?

Craig Arnold, Chairman and Chief Executive Officer

Yes. I appreciate the question, and it’s certainly something that we’ve spent a fair amount of time internally trying to sort to ourselves. And as you can imagine, inside of this broad array of mega projects, there are very different types of projects that are embedded in those numbers, some of which have essentially a 12-month kind of cycle, others of which could have three-year cycles or longer. So it’s a pretty wide distribution of lead times depending upon the type of projects that we’re talking about. So I’d say that at this juncture, if you had to use a rule of thumb, I’d say you’re probably—because these tend to be the bigger projects unlike our flow business—they are probably a couple of years on average in terms of from when we actually start and price a project to actually showing up in revenue inside of the company. If you can figure on average a couple of years out is the way to think about it. I would say that talking about these mega projects in general, I’d note that 60% of these projects are related to whether it’s IRA, the IIJA or the CHIPS Act. And so these are really big projects. They are different projects. And they are projects that are, quite frankly, being subsidized in many ways by this government spending that’s taking place more broadly inside of the U.S. economy. So we think these projects are solid. They are going to go forward and we think, once again, going to be really attractive growth tailwinds for the company.

Tom Okray, Executive Vice President and Chief Financial Officer

And just to complement that, Craig, those are the mega projects, but we also said in the prepared remarks our negotiated pipeline for the U.S., which was up 33% year-over-year and up 18% sequentially. So a lot of good growth going on in those big projects but less than the $1 billion as well.

Joe Ritchie, Analyst (Goldman Sachs)

Yes, that’s great color, guys. And I guess just my quick follow-on there is just any concern that you have at this point? There is a lot of concern in the market regarding project financing and specifically, I think you guys called out utility CapEx, the market being up double digits next year. Just any thoughts around the project financing issue, higher interest costs and whether that pushes things out a bit.

Craig Arnold, Chairman and Chief Executive Officer

Yes. It’s certainly one of the things that we’re watching and we’re concerned about as well, Joe. It’s perfectly logical to say that some of these projects could be delayed or put at risk, given much higher financing cost. I will tell you that we’ve not seen any material evidence of that to date. But it’s certainly, once again, a potential risk. And that’s why I highlight this issue around 60% of these projects basically being financially supported by these government stimulus plans, which is very new. And the dollars, as you know, are quite substantial. And at this point, we will have to wait and see how it plays out. And we’re going to watch it and make sure that we’re taking the necessary precautions. But to date, we really haven’t seen that impact.

Tom Okray, Executive Vice President and Chief Financial Officer

Joe, year-to-date in the Americas, utility is up over 25%. And if you look at the entire electrical sector year-to-date are up over 20%. So it remains very strong.

Joe Ritchie, Analyst (Goldman Sachs)

Great. Thank you, both.

Operator, Operator

Our next question is from Jeff Sprague from Vertical Research. Please go ahead.

Jeff Sprague, Analyst (Vertical Research)

Thank you. Good morning, everyone.

Craig Arnold, Chairman and Chief Executive Officer

Good morning, Jeff.

Jeff Sprague, Analyst (Vertical Research)

Hi, good morning. Can we pivot a little bit to Electrical Global? And just maybe a little bit more color on kind of the complexion of demand underneath the surface there by geography. And you noted some project activity starting to come to the floor there. It does seem like Europe, in particular, might end up in a bit of a bidding war with the U.S. on project stimulus and the like. So maybe just a little bit of color there on how you see things playing out into the first half of next year, not just Q4, but what kind of pipeline might be building.

Craig Arnold, Chairman and Chief Executive Officer

Appreciate the question, Jeff. If you think about what makes up the global business for us, there is what we do in Asia, there is what we do in GEIS, which was the former Crouse-Hinds business, and then it’s our electrical Europe business. Those are the three pieces that make up global for us. And I will say that we did see a slowdown in our European business during the quarter. We’re a pretty big player into what you call the manufacturing or the OEM segment, and that segment was especially weak. Our business in Asia continued to perform well, growing high single digits. Our GEIS business continued to perform fine, mid-single digit consistent with what we expected. It’s really what took place during the quarter in Europe, specifically in electrical, that drove the miss of our own expectations and the reduction in our outlook. We saw some destocking in the distribution channel and having had a number of conversations in person with some of our large distributors in Europe, it’s clear that they were doing some inventory adjustments, some overbuying that took place over the last 12 months or so. We do think that segment gets back to mid-single-digit growth in Q4. And we think these fundamental trends—electrification, energy transition, digitalization, data centers—are applicable for Europe as well. And so while slower growth than the U.S., we think those markets get back to growth once we work through this inventory correction that we’ve seen here in the third quarter.

Tom Okray, Executive Vice President and Chief Financial Officer

Encouragingly, Jeff, we’ve seen some good order flow in EMEA. So that gives us confidence to go to the low mid-single digits in Q4.

Jeff Sprague, Analyst (Vertical Research)

Great. And maybe just as a follow-up, different topic, thanks for the deep dive on data centers. Can you just speak to how your content is changing? You gave $1.5 million per megawatt. Is your dollar content per megawatt also going up as part of this equation and how so, where has it been and where is it headed in your view?

Craig Arnold, Chairman and Chief Executive Officer

What I would tell you is yes. We are essentially selling more content per megawatt because we’re selling more software solutions and more complete data center solutions into the marketplace. That is true, though it is dwarfed by the overall growth in the market. The market continues to be quite robust. If you look simply at backlog of projects today in data center in the planning stages, it surpassed $100 billion for the first time ever—greater than six years of construction—$12 billion in the month of September alone, starts up some 29% driven by the big four and some $42 billion under construction. The whole market is growing dramatically now and AI is accelerating that. If you think about the content opportunity for electrical equipment alone in an AI-centric data center, it’s five times the opportunity compared to a conventional data center. There are constraints around the industry’s ability to deal with the demand in front of us. Huge backlog, huge negotiations. Historically we operated with about three years of visibility in the data center market. We now have in some cases over five years of visibility. The whole market is performing extremely well and we’d expect it to do so for years to come.

Tom Okray, Executive Vice President and Chief Financial Officer

Year-to-date in data centers, on a negotiation standpoint, up 136%. In the quarter, up four times. So it’s growing faster than it was at the beginning of the year as well.

Jeff Sprague, Analyst (Vertical Research)

Great. Thank you.

Operator, Operator

Our next question is from Scott Davis from Melius Research. Please go ahead.

Scott Davis, Analyst (Melius Research)

Hey, good morning, guys.

Craig Arnold, Chairman and Chief Executive Officer

Hey, Scott. Good morning.

Scott Davis, Analyst (Melius Research)

Not much to pick on, really solid results across the board. But I was wondering if we could talk a little bit about M&A and maybe opportunities to play offense here while cash flow is cooking. I was thinking, in particular, is there any opportunities out there to really scale up the eMobility segment to make either several interesting bolt-ons or something a little bit larger to get that to scale a little faster than maybe the current pace?

Craig Arnold, Chairman and Chief Executive Officer

I appreciate the question, Scott. With respect to M&A more generally, we said our priorities will be Electrical and Aerospace. And on the margin, if we could find the right asset, we would consider an acquisition in eMobility as well. The broader message is we have enormous organic growth opportunities and we don’t need deals to significantly grow the company. That’s true in eMobility. As Tom noted in his presentation, we just had another quarter of huge wins. Each one of these wins in eMobility results in enormous growth. We set a chart of being $2 billion to $4 billion by 2030. We will be selective and focus on where we can leverage our scale, technology and expertise in our core electrical business. That’s where we have the right to win. Expect tuck-ins and digestible acquisitions that fit our strategic aims. We have flexibility—net leverage is about 1.5—and we’re always looking, but we have significant organic growth opportunities.

Tom Okray, Executive Vice President and Chief Financial Officer

Just to add, since last quarter our mature year wins were up 145%. We’ve got a ton of flexibility with net leverage about 1.5. We’re always looking, but we have a lot of food on the table.

Scott Davis, Analyst (Melius Research)

That’s helpful. And just to back up a little bit, historically Eaton has managed price around raw materials, particularly steel and copper. Is the algorithm more likely in the future to be pricing around the value you’re adding or perhaps pricing dislocated from the underlying commodities? Or is that a bridge too far from how customers are conditioned?

Craig Arnold, Chairman and Chief Executive Officer

I’d like to think we were always value pricing, but clearly market dynamics around price and cost have changed. When you’re in a capacity-constrained market, you have more leverage. Our strategy is to earn margin accretion by running the business better, eliminating waste and inefficiencies. We will recover inflation where we see it through price, but margin expansion will rely on volume leverage and improving operating efficiencies. Those opportunities exist despite record profitability. We’re still not running the company nearly as efficiently as we can.

Scott Davis, Analyst (Melius Research)

That’s very good. Helpful, thank you. Best of luck, guys. Thank you.

Craig Arnold, Chairman and Chief Executive Officer

Thanks, Scott.

Operator, Operator

Our next question is from Steve Tusa from JPMorgan. Please go ahead.

Steve Tusa, Analyst (JPMorgan)

Hi, congrats on the good results.

Craig Arnold, Chairman and Chief Executive Officer

Thank you, Steve.

Steve Tusa, Analyst (JPMorgan)

Just trying to reconcile the $850 million in orders with I think you said 20% of the mega projects have started. That’s obviously a pretty big number, but $850 million in orders is relatively small. I guess that just speaks to where you guys are, the thing starts and then you get the order. Can you just reconcile those two numbers?

Craig Arnold, Chairman and Chief Executive Officer

You really can’t reconcile those two numbers because a project start doesn’t mean we’ve had an opportunity to bid or negotiate. Those are different metrics. The win rate of 40% on started projects is a better indicator of what you can expect as these projects play out, but you can’t directly link the 20% started to the $850 million orders. The distribution of timelines and types of projects drive significant variability.

Steve Tusa, Analyst (JPMorgan)

Well, I mean, I think you just did. You basically said it’s out in front of you. I guess you just explained it. And then just one last one on the kind of stock and ship business. I know you do systems-oriented business, but Hubbell today continued to talk about destocking, and there are a lot of other industrials talking about that. Are you guys seeing that in parts of your business, and you’re just kind of blowing through it because the other businesses, the supply-demand equation is just so strong that you’re kind of weathering some destock in some parts of the business? Maybe just talk about those flow businesses and what you’re seeing on the distribution side.

Craig Arnold, Chairman and Chief Executive Officer

We are seeing similar trends in shorter-cycle businesses—residential, channel segments. We have seen some destocking in certain aspects. But strength in systems and large project businesses like data centers and projects is overwhelming those pockets of weakness. In Europe, we did see weakness in our European Electrical business in the quarter, which is why we reduced guidance there. But the strong systems and project-related business in the Americas is offsetting areas of weakness.

Steve Tusa, Analyst (JPMorgan)

Right. So that would actually be an easy comp for next year in those businesses, assuming things recouple the trend line.

Craig Arnold, Chairman and Chief Executive Officer

Given the weaknesses, assuming market stabilizes and inventory destocking is behind us, and we have embedded some of that in our Q4 outlook, it should be a relatively better year for Europe. But nothing is guaranteed and we will watch it closely.

Steve Tusa, Analyst (JPMorgan)

Great. Thanks a lot. Appreciate it.

Operator, Operator

The next question is from Chris Snyder from UBS. Please go ahead.

Chris Snyder, Analyst (UBS)

Hi, thank you. I wanted to follow-up on some of the data center commentary. You said negotiations up four times in Q3, building as the year goes on. Is that increase in conversations all driven by AI? Are you seeing a broadening base of customers talking to you on the data center topic? And then when we think about the AI tailwinds, is there any benefit in 2023? Or is the tailwind from that really more 2024? Thank you.

Craig Arnold, Chairman and Chief Executive Officer

AI has gotten a lot of publicity, but it’s not new. We have historically seen some benefit of AI in the data center market. The AI-centric bids and orders were up four times, but we also had a 61% increase in hyperscale overall, which is across the broader data center market. AI will accelerate growth, but the broader driver is more data and more insights requiring more data centers. Those numbers are large and growing as well.

Chris Snyder, Analyst (UBS)

I appreciate that. And then following up on the intersection of orders and backlog, orders in the Americas have moderated for about a year now and you’ve built electrical backlog each quarter over that time. Looking forward, do you expect the company to start meaningfully working into that backlog? Or are we in a period of sideways backlog levels into 2024? Any color would be helpful. Thank you.

Craig Arnold, Chairman and Chief Executive Officer

Orders have moderated, and we were comping a 36% increase from last year. The backlog continues to grow. Backlog is a function of demand versus ability to satisfy demand. To date we have not materially eaten into backlog. We will at some point—this cannot go on forever. We are adding capacity to resolve lead time and bottleneck issues, which should help satisfy demand. We run a backlog of $9.4 billion in Electrical and $3.1 billion in Aerospace—three times historical backlog levels—so at some point backlogs will turn negative in absolute terms, but we expect it to take time.

Tom Okray, Executive Vice President and Chief Financial Officer

To amplify, we’ve modeled scenarios of meaningful year-over-year order intake decline and given how big the backlog is and the backlog coverage—three times historical—we think even with meaningful order intake decline, we can generate robust organic growth for several quarters into 2025 before backlog returns to historical levels.

Chris Snyder, Analyst (UBS)

Yes, thank you.

Operator, Operator

The next question is from Nicole DeBlase from Deutsche Bank. Please go ahead.

Nicole DeBlase, Analyst (Deutsche Bank)

Can we just talk a little bit about the capacity investments that you guys are making and the cadence of when that’s going to start phasing and coming online over the next several years?

Craig Arnold, Chairman and Chief Executive Officer

Some investments are already made and new capacity is coming on in products like circuit breakers. Other investments—transformer capacity, voltage regulators—are typically 12 to 18 months out. It varies by product. Commitments have been made and we’re looking to expand capacity where backlog and growth exceed our current ability to serve demand. Execution and bringing capacity online will allow continued growth and market share gains.

Nicole DeBlase, Analyst (Deutsche Bank)

Thanks Craig. And then just on free cash flow, thinking about how this progresses into 2024. Can you talk a bit about plans to reduce working capital and other major puts and takes that could influence conversion next year? Thank you.

Tom Okray, Executive Vice President and Chief Financial Officer

Look at year-to-date performance: operating cash flow and free cash flow are up materially—73% and 90%, respectively. Improvement drivers are split between higher earnings and better working capital. Last year we invested in customers and growth; in the back half of the year we became more efficient with working capital. We expect that to continue into 2024. We are happy with our 16% free cash flow margin this quarter but see significant opportunities to improve inventory days on hand, DSO and the cash conversion cycle. We’re not stopping here and have more opportunity for better cash flow going forward.

Nicole DeBlase, Analyst (Deutsche Bank)

Thanks Tom. I will pass it on.

Operator, Operator

The next question is from Julian Mitchell from Barclays. Please go ahead.

Julian Mitchell, Analyst (Barclays)

Hi. Good morning. Maybe I just wanted to ask a quick question about the core revenue or organic revenue outlook. You had that helpful slide on the main end market moving pieces. Should we assume from that that that blends to about 6% to 7% market growth, and you are adding about a point or so of share, and that’s how you get that 7% to 8% organic growth number for next year that you discussed in September?

Craig Arnold, Chairman and Chief Executive Officer

It’s early to give a definitive view for 2024—that will be provided in February—but the framework you described is consistent with how we’re thinking about it. The exit rate of the year in that 7% to 8% range is a good proxy for thinking about 2024, subject to changes between now and year-end. The market outlook slides are consistent with our current view and a reasonable starting point unless things go sideways.

Julian Mitchell, Analyst (Barclays)

That’s helpful. And then on the gap between products and systems on the electrical side: historically those were two sides of one coin. When we think about next year, the gap between products and systems presumably narrows—should we assume they meet in the middle, products improve a bit, systems slow because of comps, or do mega projects mean the systems piece sustains higher outgrowth versus products?

Craig Arnold, Chairman and Chief Executive Officer

The product versus systems distinction is not the most effective way to think about the company. That’s why we changed our reporting structure and focus on end markets. Each large end market can accept products or systems. Differences in performance arise from the end-market mix, not the product/system distinction. For example, U.S. mix has more data center and utility exposure than Europe, where we’re more indexed to MOEM and residential. Think by end market—commercial/institutional, data centers, utilities, residential—rather than a product vs system split.

Julian Mitchell, Analyst (Barclays)

That’s very helpful. Thank you.

Operator, Operator

The next question is from Steve Volkmann from Jefferies. Please go ahead.

Steve Volkmann, Analyst (Jefferies)

Hi. Thank you, guys for fitting me in. Quick follow-up: Craig, is it a reasonable planning assumption that we end 2024 at whatever the new normal is for backlogs that’s slightly higher than the historical number?

Craig Arnold, Chairman and Chief Executive Officer

I wish I had a definitive answer. We didn’t anticipate being able to materially eat into the backlog this year because of underlying orders and capacity. We are bringing on new capacity in 2024 which will help eat into backlog. We would hope to reduce backlog during 2024, which would be a sign of success by shortening lead times, but it depends on market strength and execution. It’s too early to say definitively what the backlog will be at year-end 2024.

Tom Okray, Executive Vice President and Chief Financial Officer

Even reducing backlog, it would be hard to imagine getting back to historical backlog coverage in one year given how large the backlog is now based on the scenarios we’ve modeled.

Steve Volkmann, Analyst (Jefferies)

Great. Thanks. And I’ll pivot to AI: you capture a fair amount of data from IoT devices. Can you comment on where you are in collecting your own data and providing services and systems that leverage that data into new business models over the next few years?

Craig Arnold, Chairman and Chief Executive Officer

This is independent of AI: we’ve been digitizing our company for years. Every new product we develop is expected to have a microprocessor to stream and process data. That has allowed us to create new value propositions to monetize our data—data-as-a-service, software. This is wrapped in our Brightlayer platform—Brightlayer for data centers, Brightlayer for utility markets and Brightlayer for residential. Most devices today can stream data and enable software monetization. We plan to show real examples at our investor meeting and invite investors to our center in Houston to demonstrate software and data solutions we’re selling today.

Steve Volkmann, Analyst (Jefferies)

Great. I look forward to that. Thanks.

Operator, Operator

The next question is from Nigel Coe from Wolfe Research. Please go ahead.

Nigel Coe, Analyst (Wolfe Research)

Hey. Good afternoon and thanks. Slide 19 is helpful. Just to clarify: the 16% CAGR for data center through 2025 is for the market overall, not necessarily Eaton. And when you talk about data center, are you talking about the whole market including on-prem enterprise, or a subset? Also, regarding residential, are you seeing real-time deterioration or is this more driven by macro?

Craig Arnold, Chairman and Chief Executive Officer

Yes, that 16% is our view of the entire market—hyperscale, on-prem, colo. We expect our businesses to grow faster than market and gain share. On residential, we have seen slowdown worldwide—single-family stronger in Q3; multifamily slowing. Europe especially shows declines in housing starts. Residential is not the biggest piece of our market and higher electrical content per new home offsets some unit declines. We are seeing residential weakness but it’s being offset by strength in other end markets.

Tom Okray, Executive Vice President and Chief Financial Officer

Year-to-date, despite slowing, the overall electrical sector is positive from a residential perspective for us.

Nigel Coe, Analyst (Wolfe Research)

One more: eMobility 2025 target of $1.5 billion is a big step-up from $1.2 billion. Does that uplift come in 2025 or is growth more linear, and any implications for margins—your 2025 target of 11% margin, how should we think about that?

Craig Arnold, Chairman and Chief Executive Officer

Vehicle program launches are lumpy. When platforms launch you see step-function revenue increases and then linear growth once in the market. Between now and 2025 the business will grow and some of that growth will be chunky as new platforms come online. We still expect strong growth in 2024 per guidance, but timing is tied to program launches.

Nigel Coe, Analyst (Wolfe Research)

That’s great.

Operator, Operator

The next question is from Phil Buller from Berenberg. Please go ahead.

Phil Buller, Analyst (Berenberg)

Hi there. Craig, following up: how much of the divergence between the U.S. and elsewhere is due to current economic differences versus weighting toward data center and utilities in the U.S. being larger? And is there a market share component? Also, current take on EU policies—will they materialize like U.S. stimulus?

Craig Arnold, Chairman and Chief Executive Officer

I wouldn’t attribute it to market share changes. If you look at multi-year stacks, our growth versus peers is comparable. Differences are driven by the scale and type of mega projects and where we participate. The U.S. has broader opportunities tied to megatrends and stimulus dollars. Europe has commitment to low-carbon transition with regulations and some funding, but Europe faces challenges and legacy business slowdowns. Where we play in Europe—data center, energy transition—that business is up, but overall mix differences and structural issues explain much of the divergence.

Phil Buller, Analyst (Berenberg)

Quick follow: Aerospace no change to 10%–12% range for the year. At nine months you’re up about 13%—does that imply moderation in Q4 from somewhere?

Craig Arnold, Chairman and Chief Executive Officer

I wouldn’t over-read that implied Q4 number. We don’t anticipate a slowdown in Aerospace. Orders and backlog continue to grow and momentum remains strong.

Phil Buller, Analyst (Berenberg)

Thanks very much.

Operator, Operator

The next question is from Joe O’Dea from Wells Fargo. Please go ahead.

Joe O’Dea, Analyst (Wells Fargo)

Hi. I’m interested in how you are evaluating the opportunities on mega projects and whether win rates can’t be as high as historically just because of the magnitude of opportunity out there. Are competitors investing more in these verticals? Where are you directing investment dollars to position yourself for strong win rates across the verticals outlined on Slide 19?

Craig Arnold, Chairman and Chief Executive Officer

Actually, the bigger and more complicated the project, the more likely Eaton will win and garner higher share. For mega projects, our win rate is higher than our underlying market share because we can deliver complete solutions—medium and low voltage, busway, UPS, racks, software—and few competitors have that breadth and scale. Capacity constraints affect most companies, so it’s unlikely a disruptor will suddenly take share. Customers rely on pedigree and mission-critical capability for these projects, and Eaton has that.

Joe O’Dea, Analyst (Wells Fargo)

Appreciate it. Thank you.

Operator, Operator

Next question is from Brett Linzey from Mizuho. Please go ahead.

Brett Linzey, Analyst (Mizuho)

Good afternoon. Just back to the billion-dollar investment: is there any way to think about the mix of what’s expense versus capitalized? And will you provide some quarterly guidance on this program like you have done with other programs in the past?

Craig Arnold, Chairman and Chief Executive Officer

We don’t intend to provide quarterly guidance on that program beyond notifying you when new capacity comes online. There will be a mix of capital and expense embedded in our guidance going forward. Historically we’ve spent about 3% of revenue in CapEx; this may pop to around 3.5%—so maybe a 0.5-point movement in CapEx. There will be some expense associated with the investments, and this is embedded in our 30% incremental planning number.

Brett Linzey, Analyst (Mizuho)

Got it. I will leave it there. Thanks a lot.

Craig Arnold, Chairman and Chief Executive Officer

Alright. Thank you.

Yan Jin, Senior Vice President, Investor Relations

Okay. Thanks, guys. We reached the end of the call. I appreciate everybody’s questions. As always, our team will do a follow-up call with you if you need to have more questions. Thanks for joining us. Have a good day.

Craig Arnold, Chairman and Chief Executive Officer

Thank you.

Tom Okray, Executive Vice President and Chief Financial Officer

Thank you.

Operator, Operator

That concludes our conference for today. Thank you for your participation. You may now disconnect.