Good day, and welcome to the Emerson First Quarter 2019 Earnings Conference Call. All participants will be in listen only mode. Please note this event is being recorded. I would now like to turn the conference over to Tim Reeves. Please go ahead, sir.
Hey, Chad. Thank you very much. I'm joined today by David Farr, Chairman and Chief Executive Officer and Frank Dellaquila, Senior Executive Vice President and Chief Financial Officer. Welcome to Emerson's Q1 2019 earnings conference call. Please follow along in the slide presentation, which is available on our website.
I'll start with the Q1 summary on Slide 3. Sales in the Q1 of $4,100,000,000 increased 9% with underlying sales up 4.5%. End markets remained strong for us globally with the notable exception of our heating and air conditioning business in Asia. Commercial and Residential Solutions was down 1% underlying and was up 7%, excluding the Climate Asia Business. Automation Solutions was up 7%.
Trailing 3 month underlying orders remained in the 5% to 10% expected range through the quarter, with December up 7%. GAAP EPS was $0.74 up 21% and stronger than our guidance in November. 1st quarter cash flow was down versus prior year, impacted by accounts payable and accruals timing, which is expected to reverse in 2019. We've repurchased 800,000,000 of shares in the quarter. And through January, we've completed our $1,000,000,000 repurchase target for the full year, acquiring more than 15,700,000 shares.
Turning now to Slide 4. 1st quarter gross margin was up 20 basis points on higher sales, and EBIT margin was up 110 basis points, including 60 basis points of dilution from the Aventics and Tools and Test acquisitions. Leverage on higher sales, lower incentive comps and favorable other deductions drove strong EBIT margin performance. The tax rate of 20.9 percent benefited from several favorable discrete items in the quarter. Turning now to Slide 5.
The Q1 underlying sales growth was led by the Americas, where growth was strong across both Emerson platforms.
And I would like to call out my Latin America team, who I've been pretty tough on the last 3 years relative to their negative growth, but I said to them, if you guys delivered 10 plus percent growth this quarter and each quarter this after, I'll call you out on the call. But again, I want to thank all the Latin America team for making it happen, and I look forward to seeing this continue at least 10% plus for the rest of this fiscal year. Thank you.
So Automation Solutions in Latin America was up double digits and Commercial and Residential Solutions up mid single digits. Europe growth was stable across both platforms, and Q1 marked the 3rd quarter of steady growth of Automation Solutions and the 9th quarter for Commercial and Residential Solutions' steady growth in Europe. Asia, Middle East and Africa was down 2% due to the Asia Climate business, which was down more than 20% on slower heating and air conditioning markets. Turning now to Slide 6. Total segment margin was down 110 basis points and was down 50 basis points, excluding the Aventics and Tools and Test acquisitions.
Segment margin declined due to unfavorable price cost impact at Commercial and Residential Solutions and certain timing items that impacted Automation Solutions. This was in line with our expectations, and we continue to expect the 2019 segment leverage target of 30%, excluding the Aventics and Tools and Test acquisitions. Capital expenditures were up as we made progress on previously announced facility expansions and upgrades in our Climate Technologies, Final Control and Measurement and Analytical Instrumentation businesses in the U. S, China and Southeast Asia. Trade working capital improved 10 basis points, driven by receivables and inventory performance.
Turning now to Slide 7 to talk about Automation Solutions, where underlying sales were up 9% in the quarter sorry, Automation Solutions sales were up 9% and up 7% on an on
strong
on strong December bookings and a successful enterprise system upgrade across the business that resulted in the planned loss of several shipping days, the impact of which was approximately 1 point of growth in the quarter. Strong demand for MRO and brownfield upgrade and expansion projects continued to drive growth. All world areas were positive, and we continue to see favorable trends in our in capital formation for investments in LNG Midstream Infrastructure as well as downstream capacity as sovereign interest trend toward increased energy, chemical and refining self sufficiency. Segment margin was down 50 basis points and was up 10 basis points, excluding the Aventics acquisition. This improvement was driven by leverage and favorable price cost, offset mainly by the carryover impact of growth investments that were ramped up in the second half of twenty eighteen.
These investments were to expand KOB1 project capacity and our global service organization capabilities. The incremental impact of these investments was approximately $20,000,000 in the Q1 and will lessen as we go through the year and comparisons normalize. In addition, the new revenue recognition rules reduced sales and profits in our software business by approximately $6,000,000 which we will recover in the year. This is the adoption of new software revenue recognition accounting rules. For the full year, we continue to expect incremental margins of 30%, excluding the Aventics acquisition.
Turning now to Slide 8. Commercial and Residential Solutions underlying sales were down 1% in the quarter. December trailing 3 month underlying orders were down 2%. The decline in Commercial and Residential Solutions was driven by slower heating and air conditioning markets in China, a trend that began in mid-twenty 18. Importantly, we see a path to return to growth in the second half of twenty nineteen as comparisons ease and spending recovers in China.
Growth in the Americas was driven by strong demand in cold chain and residential air conditioning markets and solid momentum in professional tools markets. Margin decreased 150 basis points, excluding the Tools and Test acquisition, due mainly to unfavorable price cost, which was in line with our expectations for the quarter. We expect that the price cost trend will reverse and provide a tailwind to margins in the second half of 2019. Over the past year, we've successfully implemented price increases behind strong material cost inflation and tariff headwinds. Going forward, we expect pricing actions to catch up and to outpace material inflation as cost pressures ease.
For 2019, we continue to expect full year incremental margin of 30%, excluding the Tools and Test acquisition. Let's turn now to Slide 9. Our 2019 guidance framework is updated to include the impact of recent acquisitions and provides our Q2 expectations. Underlying sales guidance remains unchanged, and the net sales guidance is updated to reflect the impact of the AE Valves acquisition, which closed in December and the GE Intelligent Platforms acquisition, which closed at the end of January. The EPS guidance range has increased $0.05 for the Q1 tailwinds and includes $0.03 dilution from recent acquisitions, which mostly hits us in the Q2.
We expect the full year tax rate to be 24% to 25%. In the 2nd quarter, we expect 6.5% underlying sales growth and EPS of $0.84 plus or minus 0 point 0 $2 The EPS guidance builds in $0.02 of headwinds from recent acquisitions. So please turn to Slide 10, and I will hand the call over to Mr. David Farr.
Tim, thank you very much. I appreciate everyone joining us today, and I also look forward to talking and meeting all of our key investors in New York City on February 14, 2019. If you have not signed up for the meeting, please do right away because we do have limited space where we're having the meeting in the New York Stock Exchange. I also want to thank all of the global employees and especially our new acquisition members who are learning to work and play and plan month to month like we do within Emerson. These are great additions, and I truly appreciate the support and efforts they're putting forth, be it the Pentair valves and controls business, be it Avanfix, be it the Textron, Greenlee Tool and Clouke, now the AE valves in Belgium and now our newest member, the GE Intelligent Platform in VA, Virginia and Germany and worldwide.
I will also be visiting for you GE people, I'll be visiting Charlottesville in March 1 to see what's going on and get an update firsthand. So if you look at Slide 10, first thing you got to notice is Rocket got his first Emerson Stock Certificate last night. It was his 5th anniversary. And so we issued a share, and he got that. He goes pretty excited about that, you can see.
And unfortunately, he's not very good with the crayon quite yet, but we're still teaching him how to do that. You can see from the orders, our order trend line is in line with what we've been talking about for starting last year, this 5% to 10% range. Please keep in mind that we will bounce within this range, sometimes at the high end, sometimes at the low end. And don't be surprised, like last year, we could touch bottom or even slip out for a month or so. It's the way orders go in lumpiness.
You'll also notice that the preliminary January numbers, which we're just getting in, I thank Frank and his team for pushing this to get this information to us, but they're in line with the overall trend line around the 7% range. Also, both Commercial and Residential has ticked up and moving up towards the positive line, and Automation Solutions numbers stay at the high elevated layer but still doing extremely well and trending very much like we thought when we talked to you in November. You will remember I talked to you about a slowdown in China. I talked to you about a slowdown in Asia Pacific. I talked to you about what we saw happening since June of 2018, and it's been baked into our schedule.
And we are starting to and we'll talk further about the sort of upturn that we're starting to see in Bob Sharp's business, in particular around the Commercial Climate Technology Business in China and Asia Pacific. We went out on Chart 11 earlier this month with information to counter misinformation based on our media's drive to drive a recession in North America. As you could see, our global orders and automation solutions have been trending quite strongly across broad base, and I'll have more to say about that. But I think you know what we saw in the last 3 months, plus 12% across all areas. I'd like happy to tell you today, too, I heard Golden Pass is going to move forward, a big Exxon project with Qatar.
I understand it's a big part of Exxon's big expenditure in North America of over $50,000,000,000 And clearly, we'll be participating in that program one way or another. But clearly, orders are very good for us. They're consistent for us. The January order trend line is moving this way. I had made a comment when I was in visiting investors in the month of December early January that I would communicate a little bit differently in the 1st 2 months around what we're seeing as I and my team are watching very, very closely what's going on in this marketplace.
So far, we are seeing the trend lines we thought. We are not seeing any fundamental slowdown. We will discuss this in great detail at the presentations coming up on February 14. I have expanded the presentations and the presenters so you can get a little bit different insight. Not just listen to Dave Farr speak, which you guys have listened to for 20 plus years now, but give you some different insights.
But clearly, our World Area orders are holding in very nicely. Let's talk about Slide 12 and a different cycle. The cycle, as we see it right now, is slightly different from the last cycle when the price of oil was running at $70 to 100 dollars per barrel. You can see in the 2010 to 2014 major project awards very, very heavy upstream oil and gas investments, oil investments in particular, less in LNG, a little bit less in refining, less in chemical. As the price of oil went up, they really overinvested.
In this cycle, when we're seeing the price of oil is going to be bouncing between $45 $70 per barrel, we see a different cycle. Our customer base is talking differently. They are being much more cautious. And you can see what we see at this point in time as we look at the funnel laid out for the next couple of years, we're seeing a little bit less in the upstream oil. We're seeing more midstream.
We're seeing a lot more LNG, I. E, Golden Pass, I. E, the investment that was just announced up in Canada and on Mozambique. There's a lot of investments coming down the road in LNG. We're seeing more in refining, which will be out further in this cycle, not this year per se, but probably 'twenty, 'twenty one, 'twenty two.
And we're seeing very good investment in Chemical and Life Sciences. We see a much more balanced play here for us, which is good for us from the standpoint of longer term order trends and also profitability. It is a different cycle than the last cycle. We'll talk more about that, but my investors need to understand we do pay attention to cycles. We do understand cycles, and this one is a lot different and more favorable to us from, I'd say, a consistency standpoint and especially as we drive our KOB 3 aftermarket business and try to stay above 50%, which we have seen for the last 12 to 18 months.
On Chart 13 is the trend line of Commercial and Residential Solutions orders. You can see that we saw this trend line dropping off in Asia. This is Asia, driven a lot by China. And we saw this start to drop off in the May, June of last year. We talked about it.
We communicated it. Maybe people didn't believe it. There is a reason why we had a 4% at the low end of our underlying sales growth rate. We said it would be 4% to 7%. We're starting to see this trend line move up.
You can see the star on the commercial residential Asia numbers trending upwards from there. You can also see the total commercial residential getting very close to 0. China is the same way. The issue for us is we've looked at the last 4, 5 weeks, the week after week after week improvement, we're starting to see the improvement relative to orders coming out of China. Product is starting to sell through.
The channel is being cleansed. And we're also starting to see government incentives go in around the products that we sell and serve into that China marketplace. The government understands that they pulled back, and they understand they probably went too far. And they're now going to start investing in certain segments, which are good for us relative especially around heating, cooling and environmental areas. If you look at our core coal chain, if you look at our other businesses in China, they are still growing quite rapidly, and Bob will talk about that in on February 14.
But there is no guarantee. But there's one thing about Emerson is, as people have to understand, we do track, and this is not something that's surprising to us. We've been seeing this, and we sense it's going to trend line back up. Right now, we've entered right into the Chinese New Year, so we have a little less information coming out. But clearly, what I see right now says, I feel comfortable with the second half that we mapped out when we laid out our forecast in November for our shareholders.
If you look at Chart 14, this is the Commercial and Residential Solutions' price cost expectations. As you know, we as we go through the cycle, we got squeezed with higher material costs. Our price cost structure got out of kilter. It takes us time to get it back in with our large customer base. We are now moving forward.
In the first half of this year, we still have not got the price cost totally in line. It will be there by the second half of the year, as you can see this chart, where the favorable price is now starting to help make up for the margin that we lost and absorbed and ate the cost structure over the last 4 or 5 quarters. The first half of this year, in particular the Q1, we got hit now in the down volume but also the deleverage impact of the higher material costs. Pricing is going in. It helps but not enough.
From quarter to quarter, you're going to start seeing, as you look at 1st quarter, 2nd quarter margins, you will start seeing the benefit of this improvement. So incremental margins between Q1 and Q2 between Commercial and Residential will be positive, will be moving up 30 plus percent. As you move into the second half, they will make up for what they lost in the Q1. I we feel very comfortable about this right now. We've been working very closely with our customers.
This is a cycle we go through. We know how to manage this cycle, and I feel very good about this. The same thing can be said about Automation Solutions. When you look at the Q1, our volume was slightly less than we thought because of what Tim laid out relative to the new system that we put worldwide, relative to the new revenue rec rules, relative to a couple of other things. However, when we come out of a fiscal year like 2018, where we have our highest sales in 3rd Q4, our costs are going in.
So we're putting the costs in because of investments we see going forward in 2019. Then you go into your lowest quarter. We have those investments that we made in the second half of twenty eighteen that we have to absorb in a lower volume. Therefore, our margin gets hurt in the Q1. It is normal.
It is expected. And then as we move into the 2nd quarter and the third quarter and the 4th quarter, Lal and his team will start delivering higher than 30% incremental margins to make up for the higher cost structure that was built in. Key point. If volumes or businesses start weakening, we obviously clearly have to take action because our volume is based on what we're laying out here, based on the orders, based on everything we're seeing at this point in time. So either Bob's business or Lal's business, if the volumes don't recover, then we will start taking actions from the cost line.
We do not see that. The market is unfolding exactly as we thought it would in the 1st couple of months in the quarter, and we feel very good about that. If you look at Slide 15, again, I want to welcome the newest members of Emerson, the GE Intelligent Platform acquisition. It clearly is going to add about $125,000,000 sales this year. With the accounting impact and investments we're making, we're going to be hurt about $0.03 EPS.
With the price cost resetting of our performance shares, the long term compensation plan with a dramatic drop off in the Q1 of stock price. We've clearly had a benefit in the Q1, and it's helped us for the whole year, which helps us offset this dilution. So we raised our EPS guidance for the year. And by the way, folks, this is nothing new. Last year in Q1, we had a hit of $40,000,000 on fee shares.
We have a variable long term performance based plan in stock, and it's based on variable targets. If the growth rates go up, our targets go up. If the growth rates go down, our targets go down. So every quarter, we're marking to market. We're a little bit different.
I firmly believe you have to have some adjustment to what the markets are doing, both up or down, and therefore, we mark to market every quarter. This is just an extraordinary quarter. The stock price dropped from $79 to the low $50 s, and we got hit pretty hard from that point. But the benefit side is we picked up, obviously, the P and L, which is a true P and L, which we allowed flow through net of the EPS impact of the acquisitions. Mike and his team are Mike Train and also Lal and those guys are working very hard with the new acquisition here.
We'll be talking to you. Mike Train will be giving a specific presentation in New York on February 14 of what our initial expectations are with GE joining our Systems and Solutions business. This is unique technology and a capability that we're really welcoming in, and we're looking forward to building out and installing over the next 3, 4, 5 years. This is not going to be a 1 year move. It's going to be a multiple year move.
So I'm very excited about it. So again, I want to step back and say the quarter is online what we expected. It came in a little bit different than when you look at the pieces. If you look at the whole year, we still feel very comfortable with our year, both in the sales growth, a profitability standpoint. Clearly, we the order pace is there.
From the Commercial and Residential space, it's starting to turn up. North America was strong. It's primarily China, Asia and the Middle East, it was weak. Automation Solutions is very strong around the world, which is a good thing to see at this point in time. So with that, I'll open the mic to take some questions, Q and A from our participants.
Thank you very much, everybody. Who's our lead off hitter here? Lead off hitter, who's number 1?
The lead off is Deane Dray with RBC Capital Markets.
Oh, man.
He's batting 250. Okay, Deane. Lead off hitter.
Good afternoon. I've checked my batting average much better than that, Dave.
Are you a 300 hitter now?
We all aspire, but that does mean 300, you failed twice out of 3 times. So that's not such a good thing.
I'm about a 100 here then. Okay. Dean, it's good talking to you, my friend. What do you have in your mind?
I don't recall a time ever where you've broken into Tim's script to interrupt in a shout out. So Well, you
have to understand that I was pretty upset with my Latin America team. They know that. I called them dead cats. And for 3 straight years, down orders and sales. And so I said, if you have a bounce this quarter, I'll let you have it, and I gave it to him.
So it is unique, Dean. You're right.
That's about as big a shout out as I've seen you do. So those guys hopefully appreciate that. Just on the first question, hopefully you can expand on the comments on the oil cycle and why it's different. And you said specifically you'd see less upstream activity. And here we are in a quarter where you are seeing some strong upstream.
Do you think that fades? And maybe just clarify that the point about seeing less.
I think it's going to be more balanced. I think what happened last cycle, Deane, is the oil and gas oil companies and integrated oil companies felt very compelled to really go out and get more reserves when the stock the oil price was sitting at $90 to $100 and there was this huge surge in of spending that was overwhelming the industry and obviously overwhelmed us. As you know, our orders and sales in oil and gas got up to well over 40% in that cycle. So I think they're being more careful about this. And also, they're investing much more in gas.
There is a shift going on relative to the market energy use in the marketplace from pure oil to more gas. And I think that what's happening is there's more of a balanced approach here. And to be honest, I think the investors were very intense on our oil company CEOs about, Hey, guys, be more careful. And I think that we still see this good level of investments, but I my look at it right now, it's going to be spread out over multiple, multiple years. And I see the initial wave, and we're going to talk a little bit about this in New York, is a lot more investments coming on the LNG side at this point in time.
So it's still going to be a good number if you look at the total, but it's going to be spread out, and the oil companies are going to take smaller bites. I mean I'll give you an example. In our Q1, our largest KOB1 order was $99,000,000 That's it, 1st quarter. There's still we're still looking at smaller bites of apples, a lot of KOB 3, KOB 2. The KOB 1 are starting to be built out and built booked, but they're being more cautious, which I like.
I really do like that.
Great. And just as a follow-up, we've got the State of the Union tonight. Maybe just refresh us on the current, as you see it, impact from tariffs, anything on the shutdown? And hopefully, we can contain it to that.
Relative to shutdown, there's been there's very little impact to us relative maybe some of our customers, but not there's not really anything significant relative to shutdowns. I don't like shutdowns, but it really wasn't any impact at all from our perspective. On the tariff side, it's pretty it's very well contained. The President has made it very clear the way he lays them out. And so as he telegraphed them back in 'seventeen 'eighteen, we got ourselves positioned relative to cost, relative to backups.
We have continued to work that issue. I firmly believe we will not see another significant increase in tariffs. We might see a little bit here and there, but we're getting ready for it in case something does happen. But the cause the impact of tariffs right now is well contained in our pricing actions, both on the automation side and the commercial residential side. And so I feel that we have that pretty well set for this 2019 at this point in time.
And hopefully, nothing new will come up out of the woodwork, as you said, Dean.
Yes. Great. See you on 14.
Thank you very much. I'm glad you hit opening. You'll clean up. Who's going to get clean up there? I don't know.
Our next question comes from Gautam Khanna with Cowen.
Yes, there's a 225 for sure. 225 is not. I got the Stan Musial bat in here, and I even think you can swing it. I don't think you're quite strong at a swing it.
I'm not quite ready for baseball season. I'm still reveling in the glow of the Patriots 6 championships.
That was a good win. I enjoyed that. I'm not too big on the St. Louis Rams. Oh, I'm sorry, the L.
A. Rams. We can blame you. Okay, Guy. What can I do for you, my friend?
Yes. So just to expand on
the project pipeline, obviously, the market swooned pretty dramatically, like you mentioned, in the December quarter. It looked like people were very worried about the macros. But I did want to just get a sense for, has anything slipped in your project pipeline of note? Is there any trend to discern on things that might actually be at risk that you are seeing delays on? Or is it steady as she goes?
Right now, the project is steady as you go. What we need to watch and that's why I'm communicating a little bit deeper and broader. I mean, I'm not going to give as much detail next time we communicate relative to the list that we did this time, as you know, Gautam. But I'm watching a lot on KOB 3 right now. That's what will be the sign from us.
It's not going to be KOB 2 or KOB 1. It's going to be KOB 3 initially. The projects will move forward. We'll do the work. We'll make awards.
We'll do this all the fee work, everything like that. And then that will come down the pipe. We should start seeing some significant project bookings this quarter and the Q3 and the Q4 well into 2021. We're going to lay out a couple of charts for you because there's very questions in the meeting on 14th, which we see base by world area where the projects, the major projects are going to flow because it's very difficult. And going back to what Dean said earlier, this is a different cycle, and we want to lay out by industry what we see at this point in time when these projects will be flown.
It's going to be much later in 2019 19 and early 2021. You'll see this by both the systems and controls. And so we haven't seen anything push yet, but I'm watching KOB 3. If the CEOs are going to make the decisions, my customer base are going to make the decisions relative to spending, Let's say they're going to spend $10,000,000,000 for the whole year. Normally, they would spend maybe $2,000,000,000 in the Q1 and sequentially spend a little bit more.
Are they going to tap that 2% down a little bit to see make sure everything's okay? So that's what we're watching right now because our KOB 3, as you know, has been running quite strongly. It's what this our pace is right now. And I want to make sure that, that's where the first sign is. And we haven't seen it yet, and we're going to keep watching it, and we'll keep communicating and when we put orders out and talking to investors.
So we'll get a feel for it. But that's where you're going to see it first, okay?
That sounds good. And just a quick follow-up on capital allocation. You've already done $1,000,000,000 of buybacks. What should we earmark for the year?
$1,000,000,000 When we laid out our financial plan last year, we laid out for a 3 year plan, dollars $2,000,000,000 $1,000,000,000 We laid out $x for acquisitions. And until we see the X dollars for acquisitions, which we'll talk about when we're in New York, we're not going to make any changes. Frank and I talked to the Finance Committee and the Board today about this very issue, that we're staying positive $1,000,000,000 assuming there's no dramatic drop off in the marketplace. Now if there's a dramatic drop off, I will reopen that subject very quickly with my Finance Committee. But right now, assuming no dramatic drop off, we're going to hold to $1,000,000,000 We're going to reevaluate our acquisitions that we do here in 2019.
And if we see something changing, I. E, up or down, then we'll adjust our capital allocation based on that. But I try not to adjust my capital allocation too rapidly, maybe typically looking at every 12 or 18 months. So that's where you sit at this point in time, Gautam.
Thank you.
Next is Scott Davis with Melius Research. Please go ahead, Scott.
Here's a 3.10 hitter.
Good morning or afternoon, I should say. I'm having a couple of questions.
Bob, is yours Karl Yastrzemski, aren't you Karl Yastrzemski? That's what
I'm not sure I could carry his bat bag, but nonetheless. It's been almost 2 years, Dave, since you did the Pentair valve deal. I think you did around April 2017, if memory serves me right, but
You're right on the mark, exactly right.
Okay. And I think business conditions were still pretty tough for a couple of quarters after you closed that. But do you think are you back kind of on the deal model or ahead of the deal model or behind? I mean, what's kind of the state of the union
on that? I think I'm going to ask Ram to update you guys. Ram is going to present. He's going to present. And part of his presentation will just briefly be on that because it's an important thing we made.
It's a big acquisition for us. From my perspective, we are ahead of the plan relative to sales, profits and cash. Ram and his team have done a phenomenal job. The market clearly has turned our way. We are in a period right now, which Ram will talk about, is that we're making significant capital investments in that company relative to globalizing its manufacturing base.
So manufacturing in the U. S, manufacturing better manufacturing in China, better manufacturing in India, better manufacturing in Eastern Europe, better manufacturing in Middle East. And the issue is we're trying to as you know, we have a much more global manufacturing strategy than B and C did, and they're more worried about tax planning. So we're ahead of that. And if the orders keep holding up, which they are right now, I think I feel very good about this acquisition and the impact we're seeing relative to our Final Control business.
Okay. That's good news. And then just to follow-up, I don't know I'm looking at Chart 13 where you've got the commercial and resi Asia quarters. I don't remember
You weren't looking at Chart 10 with Rocket, but what's wrong with you? You have no sense of humor, Scott. That's your problem.
No, that's one of my many problems, Dave. Okay, got you. 1213. That's my
one of the things.
Okay. I
can do that.
If you go back, I mean, you know this business a lot better than we do. I mean, if you go back long history, these huge order swings, late early 2018 way up, now way down, I mean, are they almost I mean, is it more of just massive inventory swings in the channel that the customers just aren't as evolved as the Western guys and make a lot of emotional inventory decisions? Or is there really that much of a sell through delta when you look at No.
I mean, what happens is you're exactly right. We have these swings. We've always had these swings in this side of the business. The automation solutions cycle in China is typically more up for a long time than drifts back down. This business, as you well know, went basically 7 quarters of 20 plus percent growth.
Now what happens is the government has incentivizes changes relative to efficiencies, changes relative to environmental issues. And the government makes major investments in incentives into the country for the consumer and the industrial workforce or the industrial customers. And then all of a sudden, the government makes a decision out of the blue to stop. And so what happens is the channel is stopped because they see it coming and see it coming. And then all of a sudden, what happens is we that backlogs and it gets purged.
The difference between the U. S. And China is our U. S. Government does not put the incentives out there to cause this.
Yes, our channel is probably more disciplined. But right now, the channel is being worked off. Plants have been pushed back. And what we're doing is we're optimizing our facilities right now for the next wave. And the next wave will start coming as we move out of this fiscal year going into the second half of the year.
So it's a pretty normal situation. I can't always tell which quarter it's going to happen, but we know it always does. And but this was pretty clear. We could see starting to see in May June, we started hearing the government's backing off. The discussions between our two governments didn't obviously created a little bit more of a tension there, too.
So I think that's where we are at this point in time. But the channel is starting to shrink its inventory, and orders are starting to come as they start building out. So I think the cycle started. I can't guarantee anybody that. But as you said, we've been in the business a long time.
We're marking our 40th year in China and this year. So I feel good that cycle is just starting to pick back up. I don't see it going to 20 plus percent, though. I think until the government really motivates it, I don't see it going that high again. Okay.
That's great color. Good luck, Dave. See you in the year. Thanks.
The next question will be from John Walsh with Credit Suisse. Please go ahead.
The cleanup hitter. Yes.
Hi. How are you? Good afternoon.
Do you play baseball, John? Do you play baseball? Did you play baseball? I
have not in quite some time. I was I played rugby, so a little different game.
We cannot charge the pitcher, okay. John, it's good to know. What can I do for you?
Yes. So I guess a question here around free cash flow and just the timing of when you get back the accounts payables and the accruals and just to kind of set expectations on the conversion ratios going forward here?
No, it's from our perspective, it I think it's going to be more in the second half. We'll start getting a little bit better improvement in the second quarter. Typically, we had a slow start. We have to work our way through it. Frank and I, we've analyzed the heck out of this thing.
We have Frank and I have our neck out with the Board and with our investors at $3,200,000,000 And the fact that we want to get to 2.5 percent free cash flow this year is a very important number for us. We'll talk about it. So I feel very good that we'll get back, but I think it's going to be more in the Q3, Q4 we start seeing it. It's going to be one of these years that I think we're going to be more rear end loaded than we were historically. Sometimes, we're more front end loaded, but that's where we are.
The one thing different this year because capital took a while, just like spending last year took a while to get ramped up in the 3rd into the 3rd Q4, Capital was the same way. So capital has got ramped up in the second half, and we have a strong investment profile in the first half. So our capital is going to be more front end loaded this year than it was last year. So I think it's going to be more Q3, to be honest, before I start seeing the catch up. That's where I am right now.
Okay, great. And then I guess just maybe another question around capital allocation. Can you give us some flavor around how the deal funnel looks just in terms of size of the acquisitions that you'd be looking at?
In 2019, we have we're looking at around $500,000,000 of acquisitions. And right now, our funnel would say that's about what we're going to be doing. We don't see we are working, courting and developing acquisitions for the $1,000,000,000 level and $2,000,000,000 level, dollars 3,000,000,000 level in 2020, 'twenty one and combined together. Those are definitely not maturing as fast as we wanted. But then again, we just went through a lot of acquisitions the last 2.5 years, and we're trying to digest that.
So right now, it looks like 500,000,000 dollars this year, maybe $400,000,000 Next year, maybe $1,000,000,000 $1,200,000,000 and the year after, around the $2,000,000,000 range based on what we're seeing activity that we're engaging. And I just think that the funnel has slowed down at this point in time and not unusual, and I expect that to start increasing as we get back into late 2019, early 2020. Going back to my previous comments that Frank and I talked to the Finance Committee this morning is, as we look out at and we're sitting in 2020 and we see the funnel still not forming enough for this $1,000,000,000 or $2,000,000,000 that we're talking about, then we're going to have to revisit that capital allocation. And but we'll do that at the appropriate time.
The next question comes from Nicole DeBlase with Deutsche Bank. Please go ahead.
No baseball jokes for me.
I'm trying to think. I'm trying to think. Yes, you can be a I'm trying to think your we need a 2nd baseman, 225, 250. No, that's
okay. I
played softball when I was 6, and that was the last time I've played sports.
6? You'll kill it perfectly with 2nd base. I'm catching it. I can't throw to 2nd base anymore. My arm's gone bad, so you'll have to get it on 3 bounces.
I like it. So I guess on to business. On the 2Q outlook, when we look at the acceleration to 6.5% versus what you saw in the Q1, I guess just the level of confidence around that and the expectation for each segment?
I feel pretty good about the 6% to 6.5%. This is the big issue we're going to boil down to. Historically, we look at from sequentially somewhere around 250 dollars to $300,000,000 sequentially. We're looking from Q1 to Q2. We are looking at a $500,000,000 sequential, primarily because of the improvement we're seeing in commercial, residential and primary climate technology.
So therefore, that's going to be something that we're staying very close to and we must stay communicating to our shareholders on because the cycle is a little bit different from Bob Sharp's business. And that I feel comfortable right now based on what I'm seeing. And the key issue for me is this Bob's sequential orders coming from China and Asia Pacific continue to hold up as they're starting to build. And if they do, then I feel good that we'll make that in the Q2. From the backlog and the order pace that we see right now in Automation Solutions, I feel very comfortable with that one.
The wild card for me is the one you want to ask Bob in New York when he's there, the one you're going to keep asking us as you talk to Tim, is are we seeing the China Asia Pacific orders come that firm up for us that gives us a little bit higher delta from the 1st or second quarter? That's the key issue for us right now.
Okay. And as a follow-up, so you talked about how this cycle is different within AS. I guess, what does that mean for margin mix? So does like if we look over the next several years, does it mean that the typical margin headwind that you guys see from large projects coming into the mix isn't as bad as you've seen in cycles before?
I think what it means is the large cycle the projects will start hearing our margins, but they'll take a while to hit it. It. They might take a little longer. They might be spread out. Based on what I'm seeing right now, it means that as you get into the 2020, 2021 time period, if the projects fall up, well, I think that the impact of that negative margin will be less and less, won't be as dramatic as we saw historically.
The key issue for us right now is the mix and where things happen, which industries. If the KOB 3 stays up, which is our drive, we want to get that stay above 50%, that helps us. We're making investments to do that. So what it tells me is that our margin progression, excluding the acquisitions, should be a little bit easier this time than it was back in the last cycle. That's where I see right now.
Okay. See you all later, Nicole.
The next question comes from Steve Tusa with JPMorgan. Please go ahead.
He's a golfer. You can't use your 9 iron on the golf on the baseball team, Tusa. No 9 irons on the baseball team.
I'm just worried about Rocket. He got stuffed with some stock a buck higher and it wasn't even his really choice. So he's already down his trade.
Well, I told you that my boy my son is already bad about this. You got to understand his base is in 0. We got it from dad. What the heck?
Put out some good orders, give Rockets in stock and then stocks down on
the print. It's tough. Oh, wow! Tusa, Tusa, I may not let you on my team on that one. Oh, man, that's a local.
I can't even buy it. You
got plenty of players on here. Just a question on the price cost stuff. I know last quarter you talked about $125,000,000 or something like that of I think you mentioned of like headwinds from tariffs and stuff, but this chart suggests that it is not quite as bad as that, maybe I'm comparing apples and oranges. And then am I right as far as the price is concerned and how that phases in given you guys are like a little bit more into the component kind of supply chain that you have to generally kind of wait for the right time to to go to the OEMs with your kind of annual price increases as opposed to the OEMs who can kind of dictate whenever they want to their distribution channel?
We there are a couple of things here. 1, we've already worked with the OEMs, so the price is built in for the year along this line here. This is the $125,000,000 number for the total company is still a good number, Steve. That has not changed. This is one piece of it.
Okay, got it.
Section 301. And so I think what we've laid out across the board is pretty consistent, and we have the $125,000,000 match. I think that all said and done, as we get into as the year unfolds, our price cost numbers will be slightly I mean neutral to slightly green, not much different. But everything is pretty well laid out, and it's been discussed. The channel which we obviously have with AAS, the Automation Solutions business, we've got that laid out.
And then the commercial residential, they did the heavy lifting late last year with their OEMs and got that built in. And as you you're right, we have to plan out with our OEMs over multiple quarters, but we've been doing this for a long time. The same thing will happen if the price the cost goes the other way, we'll have to plan that back out, too. So I think we're in pretty good shape. I feel good about that right now, Steve.
Okay. That makes sense. And then just to so this basically all means when you look at kind of the comps on like acquisition related charges, I mean, your 4th quarter comp on margins when you think about price cost and the deals that you've kind of done here. I mean, that should really kind of unmask a really positive trend line into kind of 2020, correct?
That's the game plan. That's exactly right. Our Q4, based on what we're laying out right now, assuming our order patterns happen the way we want to happen, we should go into 2020 in a good pace, exactly right.
The next question is from Josh Pokrzywinski with Morgan Stanley. Please go ahead. Good afternoon, guys.
Good afternoon, Josh. What position you want to play? You want to play left field?
I'm just here for the hot dog race and maybe Dave Farr commitment of bobblehead night.
That's a hell of
a lot of I'm wondering if we could tell
that We might do that at the conference. That is good. Oh, God. Josh, you got me on that one, man. I don't know if I can top out of it.
So the first question on the
I can't believe you've given my dog a high basis stock. Run the stock up, give my dog stock at a high price and then trash it. I mean, that is a low blow.
Okay. I'll be there. On the project funnel you defined a couple of quarters ago, yes, I think we stood at $6,800,000,000 the last time you showed us the number. And maybe this will wait until the analyst meeting. But a lot of what you're talking about with KOB 3 sounds like it wouldn't really fill the funnel in with a large number of dots, maybe more dollars.
But any way you could size where that stands today? Or if there's maybe a pause in that funnel?
Yes, I can. And we are going to we're going to give you a lot of details. I've been trying to figure out ways to communicate the phasing of the funnels. And as you all know, none of our customers, our competitors do this. But I think it's important.
It's important for people to understand this how we look at it. So the number is over $7,000,000,000 right now. Tim, what is the number? $7,600,000,000 7,600,000,000 dollars And what we're going to show you is how this unfolds the next 2, 3 years and how it goes by first half, second half. We're trying to phase that by industry and by world area.
It's something I'm trying to help you all and help myself so I can communicate to you on a consistent basis. As you well know, it's an assumption based on what we're seeing, but we've been in this business a long time. So I think we're coming up better ways, and we're going to try to lay that out for you in February 14. So be prepared for a lot of bubbles, and be prepared for a lot of charts and numbers like that by industry. And you may want to bring someone to write down faster with you because I guarantee I won't be giving this chart out.
And right now, I think there's only one page that's going to be with any information on it. It's going to be a page with Rocket's picture, and the rest is going to be blank. I mean, so I think that's what this is a Dave Fart approach. You know that.
Of course. And then just shifting over to some of the M and A you've done lately. Obviously, trying to build out a discrete platform, made that very clear last year what the progress should look like. But I just want to be clear as we lap these acquisitions that I would imagine reengaging with some of these customers that maybe you guys did business with when you still own the Drives brand businesses. It requires a bit of investment to kind of rebuild in that channel, reinvest in the product.
Should we expect that to still be in investment mode as we head into next year as even as we kind of lap some of the accounting components of the M and
A? Yes. We're going to have Mike put out some preliminary discussion along this line here. We see the GE acquisition. GE made some good technology investment in this acquisition.
It's from a technology standpoint, it's pretty good. We've got to make some critical investments relative to not only a stand alone PLC type of control or intelligent control, We're also going to have to figure out how to embed that with relative to our Ovation's platform, the Power and Water and our Delta V within the process side. And then what we need to do is build work in the channel work. So we're going to be in a good investment mode here for the next couple of years. It's not going to be a huge number to overwhelm it, but this acquisition more is from a standpoint of a technology, product and channel, and we're going to have to create a hybrid approach to this channel not to absorb it all within a process channel, all within a power channel.
We've got to as you said, we've got to keep that discrete channel out there and rebuild that channel. So Mike is going to be talking about what we're seeing from investment mode in the initial stages, but this is something that will unfold with you all over the next couple of years because this is all about investment and rebuilding a presence for us to grow out of going forward for the next 3, 4, 5 years, well beyond the Dave Farr
era.
The next question comes from Nigel Coe with Wolfe Research.
Hey, Dave.
How are
you doing? We're looking for a catcher with an arm. My arm is gone. I'm old and my knees are gone. My arm is gone.
So can you catch?
I can catch something, but I can't catch too many balls these days.
Yes. I don't like you
catching the flu or anything. I don't want the flu.
I can definitely catch that. So Dave, thanks for the incremental color here on the slides, really helpful. You mentioned LNG a number of times and you've talked about LNG being a bigger mix going forward than it's been in the past. Would you agree that LNG is probably your biggest growth opportunity in automation? And would you also agree that you haven't seen much of that growth yet, so therefore, it's all on the come?
Yes. I think it is incrementally for the couple of years, it is our biggest growth opportunity, and we're going to talk about that on 14. And yes, the projects are just starting to unfold. There's 3 been announced already, the one in Canada, one in Mozambique. We've got the project down south here in Golden Pass, which was basically said formally said it's going to be funded by Qatar and ExxonMobil today.
We know of at least 3 more coming down the pike. Saudi Aramco want to make huge investments in gas. And so we see a good wave relative to gas. And what we like about gas, you'll see the makeup in gas, it's a very broad portfolio of our products. So when a project goes in, it's a huge project.
We could get several $100,000,000 of systems, instrumentation, control software in an ongoing basis for a long, long time. And so it is something that's really good for us relative to the long haul. It's something we build out over the years from an acquisition standpoint. So I like what we see, and I think we're going to have a good run at it here. Okay.
And then addressing Nicole's question in a different way. If we're going to have less upstream, less E and P type projects going forward, more LNG, more refining, more chem, What does that do to the nature of the project in terms of dollar size, in terms of Amazon content? Any appreciable margin next things we should think about there?
We're still doing some work on the margin. In my opinion, the project size, we're going to be smaller overall when you look at them all different, Nigel, and that's something we're going to we're trying to size. We're still working that issue. Tim and I have been pushing our people to try to come up with that because that's a very relevant question on the cycle. So the project so therefore, I like the project size being smaller because it doesn't mean it's less volatile from the big chunks that you get in the business and the orders that we saw last cycle.
If it's going to be heavy LNG, it's going to be heavier chemical, a little bit of refining. That's a better long term margin profile for me, and I'm just we're just working our way through that right now. But it should be a better margin profile based on the big, big heavy oil type of projects. But that's something we're working on, and I want to have something to show you guys, guys and gals, in February 14 on that very, very question because it's a very relevant question.
The next question is from John Inch of Gordon Haskett. Please go ahead.
Good afternoon. Hey, John.
I know you're a baseball player.
We play hockey in Canada. So,
sorry, you just raised the balloon. Well, I do have I was up in Canada last week and you'll be happy to know I've got an Edmonton Oilers, right here in my conference room. It's number 19, player number 19, was a very good hockey player. And unfortunately, the last thing that's so far, I don't play hockey.
So but I had to
wear that when I talked to the sales organization up in Canada last week.
Dave, you're never too old to learn. You know what I mean?
My knees are too friggin old, John.
You seem to be doing pretty well from my vantage point.
Okay. What can I do for you, my friend?
Yes. So A and S, are you still signed up for the 19% margins with the deals you've done? I think as you've been talking about it, it's 2021. Does that still feel about right?
It's we're going to push hard to get to. Right now, I get be very truthful to you, I'm probably a tad less than 'nineteen by 2021 with some of the deals. GE doesn't help me because the GE margin is not plus. So but I our target is still to get to 20% to get to that 19%, and that's where we're trying to drive this whole mix basis that we're just talking from the last question coming out of Nigel. But that's still our goal.
I still feel good that we get real close to it. And so that's where we are at this time.
And then to get to the C and RS guide, it looks like margins in the back half maybe have to exceed the back half twenty eighteen margins. Does that seem reasonable based on the flip you're going to see with respect to cost?
Yes. These guys are quickly looking at it. Frank says yes. Jim says yes. And
we're going to have to ramp in the second half.
The answer is
yes. All right.
So that's reasonable. And then maybe this is maybe a question for Frank.
You got to do it. For all the people out there, you guys got to deliver that margin in the second half in the Emerson team. I just want to remind the guys that listen to this call, deliver.
They heard it. One more question for Frank. Trying to put the $63,000,000 of corporate swing into a context, is this an accrual adjustment for the entire year that flows through the Q1 or fiscal quarter? And what actually happens, for instance, if a stock were to shift or swing up or down, I don't know, dollars 10 to $15 Like if it went up, for instance, do you have to all of a sudden record a big double sort of expense in the corporate line or how does
that work?
Because we have a plan where the target is variable, we have to mark to market every quarter. As Dave said, we've had big marks in the past, but this one is unusually big because of the stock price move in the Q1. So essentially, all of that was due to the incentive comp, about $60,000,000 $60 odd 1,000,000 of it was due to incentive comp. We've already given some of it back here and we will give some of it back in the Q2 if we stay near these levels. And as the price goes up, we will then again have to run some of that through the P and L.
So So it really depends on what you assume about the stock price, but in any reasonable assumption, we'll give some of it back, but there will be probably a significant part of this that will flow through the year.
Yes, John, what we do is we look at a model based on the trend lines, and we typically have the stock going up in each quarter. So what happens what we build into the quarter, we thought the stock would I mean, we didn't think the stock was going to stay at $79,000,000 but we didn't think it was going to go to 50 dollars 56,000,000 So we probably had somewhere around $75,000,000 built in there. And so as the stock dropped off, we got the big pickup. Right now, we if you look at the plan, we have that stock going up for the rest of this year. But right now, we've already given part of the gain back.
But we feel comfortable what we picked some of that we picked up and we flowed it through for the year. So that's how it works. We're unique in this regard. We've always had a variable plan, and we like keeping it that way. I want to have our people if growth rates go up, I want our growth relative growth rates to go up with that and have tougher targets.
So would you expect corporate expense to be kind of the one to go back to this 140, 150 zone for the coming of the 3 quarters or
Yes. Is that correct?
Yes, I would.
Yes, John. I would.
That's probably a good estimate in terms of where
we think we're going to
be in total for corporate. You got it.
Got it. Okay. Thank you very much.
See you
next week or 14th, not quite next week, 14th.
Yes, 14th, Valentine's Day.
Have a sweetheart.
The next question comes from Robert McCarthy with Stephens. Please go ahead.
Hi, Robert.
From the ridiculous to
the sublime, how are you doing, Dave?
Oh, God, you're not going to be on my team at all. I mean, you got any cheap jokes about I'm on your team,
Dave. Don't worry. I'm on your team. All right. In any event, I wanted to ask, I guess, maybe since you're not shy and you're on the sidelines.
Yes, I don't think you're shy. What do you think about what's going on with Carrier and the spend here? And do you think it changes the environment overall with respect to the OEMs? And do you expect consolidation in the space from your vantage point? What do
you expect to happen over the next couple of years?
My vantage point right now says the consolidation does not happen, and we'll have an independent carrier out there and that we'll be managing the similar type of customer base for the next several years. Does something happen 4, 5, 6 years out? It's possible. But my feel right now is UTC is headed towards the spin very hard. They've worked this Mark and his team have worked this very, very hard.
And I know by the way, I know how hard it is. I took out 40% of Emerson that way. It's a lot of work. And so that's what I feel right now, Rob. I don't see consolidation in this move.
And just to follow-up, in terms of China overall, away from commercial and resi, which is pretty clear that there's this channel adjustment that's going on. How would you say what you're seeing there? And I think in my conversations with you prior, you kind of contrasted some of your more industrial facing or automation solutions facing business versus the more bleeding edge of consumer and residential where you would expect a little more stable. I mean, what's your outlook there excluding this kind of channel correction we've seen? And can you kind of talk to the growth you're seeing in China, excluding that?
You take out this channel, we're growing south 15%, 20% with this piece. I mean Bob will show you the breakdown. I know he put the chart up at the Board today because our Board asked the same questions. We dissect the what I call we call the heating and cooling business within China, which is down 30%, 40%. The other two segments were up, I think, Frank, didn't you show 20%, 30%?
Yes, they were up big. And for the quarter. So we have clearly built out a strong, more balanced business in China than, say, 5 or 6 years ago, but we're still not there yet because this 8 this heating and ventilating and cooling business was up 30%, 40%, and it's a big business now dropped off. But over time, what we're trying to do is we're trying to build up a more balanced portfolio of businesses in China and across Asia that gives us that a little bit more smoothing than we would see right now. It's smoother today than 10 years ago, but it's not smooth enough to stop from hurting us from a quarter standpoint.
So but we're making great progress, and Bob is going to talk about that because this is our investment direction that we're making to try to have the other parts of business be a bigger and bigger chunk of the Asia business to give us a little bit more smoothing, in fact.
The next question comes from Andrew Kaplowitz with Citi.
Hey, Andrew. How are you doing?
Good. You need a pitcher, right?
Yes. You want a pitch?
Yes, I mean, I've got a that allows me to have a pretty low batting average. You won't yell at me if I do. You won't call me a dead cat like those LatAm guys, right?
I definitely shit, I'll definitely call you a dead cat. Don't worry about it. I mean, if you throw a couple of gopher balls up there, the home run call, you'll be a dead cat for sure.
I understand. It would be warranted.
Okay, Andrew, hit me.
So in Europe, Europe was up 3% in both of your businesses in Q1, which seems like actually a good result after 2% growth last year, especially given some slowing in the major European economies. You mentioned last quarter that you see some unique opportunities in Europe in FY 2019. So did these opportunities end up leading you to outperform in Europe? And do you still think Emerson grows in Europe in the 2% to 3% range for 'nineteen?
Our fundamental goal is to be closer to 5. And there's a couple of things going on in Europe from a technology shift relative to commercial residential and then also some incremental investments. And so I'd say the new generational power area is different than the past as we participate in. So our goal this year actually is to see a number closer to 4% to 5% for Europe. And that's what we're trying to get to from the standpoint of overall sales.
And I think that the order pattern is there at this point in time, and we feel good about it. Now clearly, we got to see this we got to see a little bit better number than 3% in the second quarter. It should be more like 4%. But right now, my team is holding pretty tight to that 4%, 5% for Europe for us. Even a weaker GFI number in Europe, we just happen to be in a couple of segments which are investing.
And some of our customers in Europe, which are exporting products, say, Middle East and Africa, see some upside from that perspective. So right now, my Europe business looks decent.
Okay. Yes, that would be quite good. And then you do seem confident that Asia orders have bottomed in Commercial and Residential Solutions. What do you need to see in orders here over the next few months to support that 3% to 5% sales growth that you have for the year? What kind of upticks you would look at?
Because obviously, the deceleration has stopped, but the orders are still negative.
Yes. We've got to see on a map, we've got to see this thing go positive in the second quarter from an order standpoint. I think we're forecasting underlying growth for commercial res still close to flat, Frank, in the second Yes. So what we need to see is our order pattern turn up in the second fiscal quarter, which is the 1st calendar quarter and moving above that line, which is pretty close to it. And so from my perspective and so right now, these guys are telling me these guys that we're going to be plus low single digit.
I was wrong. Low single digit, driven by U. S. And driven by Europe. But I think that what I'm watching for is Asia.
And does Asia get back up to that 0 line and above that line? If it does, then I feel very good that our commercial residential for the year can do this 3%, 4%, 5% type of growth, and that's what I'm seeing right now short term. I'm watching on the Automation Solutions side, I'm watching KOB 3 in a couple of industries. On the Commercial and Residential side right now, I'm watching China and Southeast Asia relative to their HVAC type of orders. So that's what I'm watching.
Thanks, Dave. See you on the 14th.
You're welcome. See you. That's time for one more call here. One more call.
All right. And that question comes from Rich Kwas with Wells Fargo Securities. Please go ahead.
Glad to beat the buzzer. Good afternoon, Dick.
I got to get going to my next meeting. We've got how many calls is this? 15, 14? We'll go one more. We'll go 15.
We'll go for 15. Whoever is the 15th in line, you're good. You're going to make the cut. And so we'll go 15. I may see also who's 15 people on a call, but we're going to do it here, okay?
Let's go, Rich.
So 2 for me on investment. If AS order growth continues at this pace, double digits, any incremental investment here later in the year that you have to make relative to what you have budgeted or is that more of a 'twenty phenomenon in terms of incremental investment?
If Automation Solutions orders stay above 10%, then we're going to be they're going to be pushing us pretty hard as we leave the year on 2 things: a global execution sales and engineering group, service organization group that we're going to have to start putting in very rapidly in the Q4 going to the first quarter, which will raise the cost in the 4th and raise the cost in the first and the slowdown in the smaller quarter. That will be the pressure point there. And secondly, what will happen is Lal will be coming to Frank and I and say, Guys, we've got to pull back in some capital and for capacity in a couple of places. And I know Lal and his team look at that, and Frank and Steve Pelch, Frank from the CFO and Steve from the COO, had this constant dialogue going relative to that. But Rich, to your point, if we see orders staying 10%, 12% for another couple of quarters, then we're going to have to do some incremental investments in AF to be able to serve that.
And right now, we're not banking on that based on our forecast, but that would be good news to deal with. But that clearly, that will create some tension for Frank and I relative to our free cash flow and allocation standpoint. So that's what we see. Okay.
And then just a bigger picture question on U. S. Resi. I mean, I know you don't have a lot of direct exposure to new construction, new U. S.
Resi construction, but obviously the HVAC business is somewhat tied to that. What do you see right now? There's some consternation out there with regards to where we are in the cycle. From your vantage point, it doesn't seem like you're concerned about U. S.
Resi, but what are you watching for as you go through the next few quarters?
From our perspective, right now, the upgrade marketplace has still been very strong. If we start seeing that the upgrade, the repair market, the incremental expansion of homes, if that slows down, then which hasn't yet, not the new homes but the upgrades, then that would bother us down the road. The channel is in very good shape right now. Our customer base is in very good shape right now. So I feel decent relative to the cycle.
And as we get into every month, our customers are very short term oriented relative to the U. S. We're talking U. S. Here.
And so we see their order pattern month or week after week after week, and it continues to fill in. And Bob keeps Frank and Steve informed on this because that's important relative to us. But I'm not worried as long as the if the consumers' incomes are still going up, employment is still high, they're going to spend money on the current homes, which is what we see right now in the United States, which is a good thing. Are you going to be there 14, which I guess is next week? I will be there.
Okay, good. Okay, good. Let's go to the last person here, whoever this person is, who's last?
All right. The next question then will come from Jeffrey Sprague with Vertical Research Partners. Please go ahead.
Okay, Jeff. You're batting up cleanup. We got a guy in 1st and 3rd. We're down 1. We need a hit, Hardner.
They've been the best for last. That's the way
I like it. It. The best for you to clean up. Let's see if you
can give
me a hit. I know you can't run the bases, so it better be out of the infield. Yes.
No, I need to walk off Homer, Dave, because I can't
Okay. We don't need all I need is a freaking single, okay? I got to get the guy home, okay?
Okay. There was a little beating around
the bush or maybe not even beating around the bush, kind of trying to get to this project mix over time and how it kind of plays on your margins. One of the things you said that I thought was interesting is that you're working to keep the KOB 3 above 50% throughout the horizon. And I'm just wondering, in the past, when you've gotten into big spikes of project activity, how far down in the mix does KOB 3 really play? And should we expect a significant margin differential because of that?
Okay. Historically, it would drop down to 45%, 46%. And we with the investments we're making both in the distribution organization and the sales service organization around the world, which are significant, we started it last year. Ram is doing even more this year and the next year. We have a unique situation right now where several of our competitors, both on Final Control and some of our systems competitors, are pulling back in certain marketplaces, and we have a unique opportunity to gain some aftermarket share.
So what we've we're incentivizing the organization from the standpoint of making these investments and going after that installed base is to try to keep that KOB at 50%, keep a 5% in front of it. Will it be 50%, 51%, I'll take a 50%. And what that will do is that will smooth our margins somewhat as the bigger projects come into play. It also means we're gaining market share, aftermarket. And one of the areas that several acquisitions we made really did not have the aftermarket infrastructure or the aftermarket focus that we have.
And so they did not they lost some of that business, and they didn't maintain that business. So what we're working at, Jeff, and we've really been hard at this with Ram and his team and also Jim Nyquist, is really focusing how do we regain more and more of that aftermarket. Some of our competitors are
a little bit weaker right
now, and we're trying to take that we're trying to take it to them right now when the window is open. I think the window is going to be open for another 18 months, and I've told Ram we've got to get it done. And so talk to him about this when you see him in New York, and he's going to be talking about it in his presentation because this is this strategically long term is good for us from a profitability standpoint and smoothing out the cycle curves a little bit, too.
Yes. That's really interesting. That's an interesting nuance. And then just one little follow-up on this investment spending question that a couple of people asked. I get it if the sales are running a lot hotter, you're going to have to spend more to kind of accommodate those sales.
But just looking at this year and kind of the headwind you had to kind of get through in Q1, are you at kind of run rate investments now? Is it kind of in the base, so to speak, and not a significant headwind?
Yes. As we would in the 2nd quarter, we're running we're in the run rate. I think the question was, our run rate structure from an 8% to 10% top of order base here. And I think the question is that if that order base stays at 10%, 12%, 13% for the rest of the year, the concern will be as we move into 2020, will we have the infrastructure to deal with that? And the answer is we will have to make some incremental investments.
But right now, from where we see at this run rate, we're in good shape for this year. They've got to execute in the Q2. Lal knows that. The Q2 is very important from a profitability standpoint, and that will set up a much stronger second half for us. And I want to thank everybody for joining us, and I appreciate everyone letting me have a little fun with baseball.
I don't know why it went to baseball other than my Stan Musial bat right here and the rally monkey staring Tim down. He's always staring Tim down. But I appreciate everyone joining us today asking the questions and the engagement, which is I find enjoyable. And I look forward to seeing everybody next week in New York, we're going to have a little bit expanded presentation from several players to give you a little bit more insight relative to our businesses, both businesses which are very strategic to us. Thank you very much, and thanks.
Bye.
Thank you, sir. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.