Good day, and welcome to the Emerson first quarter 2019 earnings conference call. All participants will be in listen only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your telephone keypad. To withdraw your question, please press star, then two. 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 am 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 first quarter 2019 earnings conference call. Please follow along in the slide presentation which is available on our website. I will start with the first quarter summary on slide three. Sales in the first quarter of $4.1 billion, increased 9% with underlying sales up 4.5%. End markets remain strong for us globally, with the notable exception of our heating and air conditioning business in Asia. Commercial & Residential Solutions was down 1% underlying and was up 7% excluding the climate Asia business. Automation Solutions was up 7%. Trailing three-month underlying orders remained in the 5%-10% expected range through the quarter, with December up 7%.
GAAP EPS was $0.74, up 21%, and stronger than our guidance in November. First quarter cash flow was down versus prior year, impacted by accounts payable and accruals timing, which is expected to reverse in 2019. We repurchased $800 million of shares in the quarter, and through January, we completed our $1 billion repurchase target for the full year, acquiring more than 15.7 million shares. Turning now to slide four. First 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 & Test acquisitions. Leverage on higher sales, lower incentive comp, and favorable other deductions drove strong EBIT margin performance. A tax rate of 20.9% benefited from several favorable discrete items in the quarter. Turning now to slide five.
The first quarter underlying sales growth was led by the Americas, where growth was strong across both Emerson platforms.
I would like to call out my Latin America team, who I've been pretty tough on the last three years relative to their negative growth. I said to them, "If you guys deliver 10+% growth this quarter and each quarter that's after, I'll call you out in the call." 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+% for the rest of this fiscal year. Thank you.
Automation Solutions in Latin America was up double digits, and Commercial & Residential Solutions up mid-single digits. Europe growth was stable across both platforms, and Q1 marked the third quarter of steady growth of Automation Solutions and the ninth quarter for Commercial & Residential Solutions steady growth in Europe. Asia, Middle East, and Africa was down two % due to the Asia climate business, which was down more than 20% on slower heating and air conditioning markets. Turning now to slide six. Total segment margin was down 110 basis points and was down 50 basis points excluding the AVENTICS and Tools & Test acquisitions. Segment margin declined due to unfavorable price cost impact at Commercial & Residential Solutions and certain timing items that impacted Automation Solutions.
This was in line with our expectations. We continue to expect the 2019 segment leverage target of 30%, excluding the AVENTICS and Tools & 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 ten basis points, driven by receivables and inventory performance. Turning now to slide seven to talk about Automation Solutions, where underlying sales were up nine % in the quarter. Sorry. Automation Solutions sales were up 9% and up 7 % on an underlying basis.
December trailing three-month underlying orders were up 12%. December backlog increased modestly versus September 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 one 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. We continue to see favorable trends in capital formation for investments in LNG midstream infrastructure, as well as downstream capacity, as sovereign interests trend toward increased energy, chemical, and refining self-sufficiency. Segment margin was down 50 basis points and was up ten 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 2018. These investments were to expand KOB one project capacity and our global service organization capabilities. The incremental impact of these investments was approximately $20 million in the first quarter 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 million, 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 eight. Commercial & Residential Solutions underlying sales were down 1% in the quarter. December trailing three-month underlying orders were down 2%.
The decline in Commercial & Residential Solutions was driven by slower heating and air conditioning markets in China, a trend that began in mid-2018. Importantly, we see a path to return to growth in the second half of 2019 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 & 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 & Test acquisition. Let's turn now to slide nine. Our 2019 guidance framework is updated to include the impact of recent acquisitions and provides our second quarter 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 is increased $0.05 for the first quarter tailwinds and includes $0.03 dilution from recent acquisitions, which mostly hits us in the second quarter. We expect the full year tax rate to be 24%-25%.
In the second quarter, we expect 6.5% underlying sales growth and EPS of $0.84, ±$0.02. The EPS guidance builds in $0.02 of headwinds from recent acquisitions. 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. I also look forward to talking and meeting all of our key investors in New York City on February 14th, 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. I truly appreciate the support and efforts they're putting forth, be it the Pentair Valves & Controls business, be it AVENTICS, be it the Textron Greenlee and Klauke, now the AE Valves in Belgium, and now our newest member, the GE Intelligent Platforms in V.A., Virginia, and Germany and worldwide.
I will also be visiting for you GE people. I'll be visiting Charlottesville in March first to see what's going on and get an update firsthand. If you look at slide 10, first thing you got to know is, Rocket got his first Emerson stock certificate last night. It was his fifth anniversary. We issued a share, and he got that. He was pretty excited about that, you can see. 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 starting last year, this 5%-10% range. Please keep in mind that we will bounce within this range, sometimes at the high end, sometimes the low end.
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. Both Commercial Residential has ticked up and moving up towards the positive line, and Automation Solutions numbers stay at the high elevated layer. 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.
It's been baked into our schedule, and we are starting this. We'll talk further about the sort of upturn that we're starting to see in Bob Sharp's business, in particular around the Climate Technologies businesses in China and Asia Pacific. We went out on chart 11 earlier this month with information to counter misinformation based on the 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. I'll have more to say about that, but I think you know what we saw in the last three months, plus 12% across all areas.
I'm happy to tell you today too, I heard Golden Pass is going to move forward, a big ExxonMobil project with Qatar. I understand it's a big part of ExxonMobil's big expenditure in North America of over $50 billion. Clearly, we'll be participating in that program one way or another. Clearly, orders are very good for us. They're consistent for us. The January order trend line is moving this way. I had made comments when I was visiting investors in the month of December and early January, that I would communicate a little bit differently in the first two months around what we're seeing, as I and my team are watching 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 14th. 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. 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-$100 per barrel. You can see in the 2010-2014 major project awards, 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 over-invested.
In this cycle, when we're seeing the price of oil is going to be balanced 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 is 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 in 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 2020, 2021, 2022. 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 III aftermarket business and try to stay above 50%, which we have seen for the last 12-18 months. On chart 13 is the trend line of Commercial & Residential Solutions orders. You can see that we saw this trend line dropping off in Asia. This is Asia, driven a lot by China. 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 was a reason why we had a four at the low end of our underlying sales growth rate. We said it would be 4%-7%. We're starting to see this trend line move up. You can see the star on the Commercial & Residential Solutions Asia numbers trending upwards for the area. You can also see the total Commercial & Residential Solutions getting very close to zero. China's the same way. The issue for us is we look at the last four or five 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's being cleansed, and we're also starting to see government centers 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 cold chain, if you look at our other businesses in China, they are still growing quite rapidly, and Bob will talk about that on February 14th. There is no guarantee. But there's one thing about Emerson, 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 our forecast in November for our shareholders. If you look at chart 14, this is the Commercial & Residential Solutions, the price cost expectations. As you know, 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 four or five quarters.
The first half of this year, in particular the first quarter, we got hit, not only the down volume, but also the deleverage impact of the higher material cost. Pricing is going in. It helps, but not enough. From quarter to quarter, you're going to start seeing, as you look at first quarter, second quarter margins, you will start seeing the benefit of this improvement. Incremental margins between first quarter and second quarter, between Commercial Residential, will be positive, will be moving up 30-plus %. As you move into the second half, they will make up for what they lost in the first quarter. 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 could be said about Automation Solutions.
When you look at the first quarter, 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 other things. However, when we come out of a fiscal year like 2018, where we have our highest sales in third and fourth quarter, our costs are going in. We're putting the costs in because of investments we see going forward in 2019. You go into your lowest quarter. We have those investments that we made in the second half of 2018 that we have to absorb in a lower volume. Therefore, our margin gets hurt in the first quarter.
It is normal, it is expected. As we move into the second quarter and the third quarter and fourth quarter, Lyle 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. Either Bob's business or Lyle's business, if the volumes don't recover, 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 first 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 Platforms acquisition. It clearly is going to add about $125 million 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 and long-term compensation plan, with a dramatic drop-off in the first quarter of the stock price, we've clearly had a benefit in the first quarter, and it's helped us for the whole year, which helps us offset this dilution. We raised our EPS guidance for the year. By the way, folks, this is nothing new. Last year in the first quarter, we had a hit of $40 million on P-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. Every quarter, we're marking the 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 the market every quarter. This is just an extraordinary quarter. The stock price dropped from $79 to the low $50s, and we got hit pretty hard from that point. The benefit side is we picked up obviously the P&L, which is a true P&L, which we allow to flow through net of the EPS impact of the acquisitions. Mike and his team, Mike Train and also Lyle 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 three, four, five years. This is not going to be a one-year move. It's going to be a multiple year move. I'm very excited about it. Again, I want to step back and say the quarter's online, what we expected. It came in a little bit different 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, profitability standpoint. Clearly, the order pace is there from the commercial Residential space. It's starting to turn up. North America was strong.
It's primarily China, Asia, and the Middle East that was weak. Automation Solutions is very strong around the world, which is a good thing to see at this point in time. With that, I'll open the mic to take some questions, Q&A from our participants. Thank you very much, everybody.
Thank you, sir. We will now begin the question-and-answer session. To ask a question, you may press star then one on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster.
Who's our leadoff hitter here? Leadoff hitter. Who's number one?
The leadoff is Deane Dray with RBC Capital Markets. Please go ahead.
Oh, man, he's batting 250. Okay, Deane. Leadoff hitter.
Good afternoon. Checked my batting average. Much better than that, Dave.
Oh, are you a 300 hitter now?
We all aspire, that does mean 300, you failed twice out of three times, that's not such a good thing.
Oh, shit. I'm about a 100 hitter. Okay. Deane, it's good talking to you, my friend. What do you have on your mind?
Dave, I don't recall a time ever where you've broken into Tim's script to interrupt in a shout-out.
Well, you have to understand that I was pretty upset with my Latin America team. They know that. I called them dead cats. For three straight years, down orders and sales. I said, "If you have a bounce this quarter, I'll let you have it," and I gave it to them. It is unique, Deane, you're right.
That's about as big a shout-out as I've seen you do. Those guys hopefully appreciate that. Hey, just on the first question, hopefully you can expand on the comments on the oil cycle and why it's different. 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? Maybe just clarify the point about seeing less.
You know what? 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 or the oil price was sitting at $90-$100, and there was this huge surge of spending that was overwhelming the industry, and obviously overwhelmed us. Because our orders in sales in oil and gas got up to well over 40% in that cycle. I think they're being more careful about this, and also they're investing much more in gas. There's a shift going on relative to energy use in the marketplace from pure oil to more gas. I think that what's happening is there's more of a balanced approach here.
To be honest, I think the investors were very intense on our oil company CEOs about, "Hey, guys, be more careful." I think that we still see this good level of investments, but my look at it right now, it's going to be spread out over multiple years. I see the initial wave, and we're going to talk a little about this in New York, there's a lot more investments coming on the LNG side at this point in time. 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'll give you an example. In our first quarter, our largest KOB-1 order was $9 million. That's it. 1st quarter. 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 a lot more cautious, which I like. I really do like that.
Great. 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 the shutdown, there's very little impact to us relative, maybe some of our customers, but 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 very well contained. The pResident's made it very clear the way he lays them out, so as he telegraphed them back in 2017 and 2018, we got ourself 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. The impact of tariffs right now is well contained in our pricing actions, both on the automation side and the commercial Residential side.
I feel that we have that pretty well set for this 2019 at this point in time. Hopefully nothing new will come up out of the woodwork, as you said, Deane.
Yes. Great to see you on the 14th.
Thank you very much. I'm glad you hit opening for your cleanup. Who's going to get cleanup here? I don't know.
Our next question comes from Gautam Khanna with Cowen. Please go ahead.
Yeah. There's a 225 way for sure. 225 way with a sure, Gautam.
Oh.
I got the Stan Musial bat in here. I don't even think you can swing it. I don't think you're quite strong enough to swing it.
You know, I'm not quite ready for baseball season. I'm still reveling in the glow of the Patriots sixth championship.
That was a good win. I enjoyed that. I'm not too big on the St. Louis Rams. I'm sorry, the L.A. Rams.
Yeah. Who can blame you?
Okay, Gautam, what can I do for you, my friend?
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'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. 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 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 third quarter and the fourth quarter well into 2021.
We're going to lay out a couple charts for you because of this very question in the meeting on the 14th, which we see based by world area, where the major projects are going to flow. It's very difficult. Going back to what Deane 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 flowing. It's going to be much later in 2019 and early 2021. You'll see this by both the systems and controls. 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 billion for the whole year.
Normally, it would spend maybe $2 billion in the first quarter, and sequentially spend a little bit more. Are they going to tap that $2 billion down a little bit to see, make sure everything's okay? That's what we're watching right now. Because our KOB-3, as you know, has been running quite strongly. It's what our pace is right now. I want to make sure that that's when the first sign is. 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. That's where you're going to see it first, okay?
That sounds good. Just a quick follow-up on capital allocation. You've already done $1 billion of buybacks. What should we earmark for the year?
$1 billion. When we laid out our financial plan last year, we laid out for a three-year plan, $1 billion, $1 billion, $1 billion. We laid out X U.S.D for acquisitions. Until we see the X U.S.D 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 padded $1 billion, assuming there's no dramatic drop-off in the marketplace. If there was a dramatic drop-off, I would reopen that subject very quickly with my finance committee. Right now, assuming no dramatic drop-off, we're going to hold to $1 billion. We're going to reevaluate our acquisitions that we do here in 2019. If we see something changing, i.e., up or down, then we'll adjust our capital allocation based on that.
I try not to adjust my capital allocation too rapidly, maybe typically looking at every 12 or 18 months. That's where we sit at this point in time, Gautam.
Thank you. I'll work on the batting average.
You're welcome. All the best to you.
Thank you.
Next is Scott Davis with Melius Research. Please go ahead, Scott.
Here's a 310 hitter.
Good morning or afternoon, I should say. I'm having a cup of coffee.
You're Carl Yastrzemski. Aren't you Carl Yastrzemski?
I'm not sure I could carry his bat bag, but nonetheless. It's been almost two years, Dave, since you did the Pentair Valve deal. I think you did it around April of 2017, if memory serves me right.
You're right on the mark. Exactly right.
Okay. I think, business conditions were still pretty tough for a couple of quarters after you closed that. 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'm going to ask Ram to update you guys. Ram's going to present. He's going to present part of his presentation. Just briefly beyond 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. Manufacturing in the U.S., better manufacturing in China, better manufacturing in India, better manufacturing in Eastern Europe, better manufacturing in Middle East. The issue is we're trying, as you know, we have a much more global manufacturing strategy than B and C did, and they were more worried about tax planning.
We're ahead of that. If the orders keep holding up, which they are right now, I feel very good about this acquisition and the impact we're seeing relative to our Final Control business.
Okay, that's good news. 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 seeing-
You weren't looking at chart 10 with Rocket? 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. But
Okay, got you. Chart 13.
I'll talk to my wife about that.
Okay. You do that.
If you go back, you know this business a lot better than we do. If you go back long history, these huge order swings, early 2018 way up, now way down. 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 that?
No. 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 seven quarters of 20%-plus growth. What happens is the government incentivizes changes relative to efficiencies, changes relative to environmental issues, the government makes major investments in incentives into the country for the consumer and the industrial workforce or the industrial customers. All of a sudden, the government makes a decision out of the blue to stop. What happens is the channel is stopped because they see it coming, and see it coming. All of a sudden what happens is 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. What we're doing is we're optimizing our facilities right now for the next wave. The next wave will start coming as we move out of this fiscal year going into the second half of the year. It's a pretty normal situation. I can't always tell which quarter it's going to happen, but we know it always does. This one is pretty clear. We could see starting to see in May and June, we started hearing the government was backing off. The discussions between our two governments obviously created a little bit more of a tension there too.
I think that's where we are at this point in time. The channel is starting to shrink its inventory, and the orders are starting to come as they start building out. I think the cycle started. I can't guarantee anybody that, as you said, we've been in the business a long time. We're marking our 40th year in China this year. I feel good that the cycle's just starting to pick back up. I don't see it going to 25%+ 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 New York.
Thanks.
The next question will be from John Walsh with Credit Suisse. Please go ahead.
Oh, the cleanup hitter.
Yeah. 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 played rugby, so a little different game.
We cannot charge the pitcher, okay? John, it's good seeing you. What can I do for you?
Yeah. 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.
From our perspective, 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. Frank and I have our neck out with the board and our investors at $3.2 billion, and the fact that we want to get to $2.5 free cash flow this year is a very important number for us, and we'll talk about it. I feel very good that we'll get back, but I think it's going to be more in the third quarter, fourth quarter, 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, that's where we are. One thing different this year, because capital took a while, just like spending last year took a while to get ramped up into the third and fourth quarter. Capital was the same way. Capital has got ramped up in the second half, and we have a strong investment profile in the first half. Our capital is going to be more front-end loaded this year than it was last year. I think it's going to be more third quarter, to be honest, before I start seeing the catch-up. That's where I am right now.
Okay, great. 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're looking at around $500 million of acquisitions. Right now our funnel would say that's about what we're going to be doing. We are working, courting, and developing acquisitions for the billion level and $2 billion level, $3 billion level in 2020, 2021, 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 two and a half years, and we're trying to digest that. Right now it looks like $500 million this year, maybe $400 million. Next year, it may be a billion two, and the year after that, around the $2 billion range, based on what we're seeing activity that we're engaging.
I just think that the funnel has slowed down at this point in time, not unusual, I expect that to start increasing as we get back into late 2019, early 2020. Going back to my previous comment that Frank and I talked to the finance committee this morning is, as we look out at, we're sitting in 2020, we see the funnel still not forming enough for this billion or $2 billion that we're talking about, we're going to have to revisit that capital allocation. We'll do that at the appropriate time.
Great. Thank you. See you in a couple of weeks.
See you, Mark. Thank you very much, John.
The next question comes from Nicole DeBlase with Deutsche Bank. Please go ahead.
Yeah. Hi, Dave. Good afternoon.
Good afternoon, Nicole.
No baseball jokes for me, huh?
I'm trying to think. We need a second baseman, 225, 250.
No, that's okay. I played softball when I was six, and that was the last time I've played sports.
Six. You'll fill in perfectly for second base. I'm catching. I can't go to second base anymore. My arm's gone bad, so you'll have to get it on three bounces.
I like it.
Shoot.
On the 2Q outlook, when we look at the acceleration to 6.5% versus what you saw in the first quarter, I guess just the level of confidence around that and the expectation for each segment.
I feel pretty good about the 6%-6.5%. The big issue it's going to boil down to, historically, we look at from sequentially somewhere around $250 million-$300 million sequential. We're looking from first quarter to second quarter. We are looking at a $500 million sequential, primarily because of the improvement we're seeing in commercial, Residential, and primary Climate Technologies. 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. The key issue for me is, does Bob's sequential orders coming from China and Asia Pacific continue to hold up as they're starting to build? If they do, then I feel good that we'll make that in the second quarter.
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 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 first to second quarter? That's the key issue for us right now.
Okay. Thanks, Dave. As a follow-up, you talked about how this cycle is different within A&S. I guess, what does that mean for margin mix? 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 hurting our margins, but they'll take a while to hit, or 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 out, why 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 to stay above 50%, that helps us, and we're making investments to do that.
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.
That's great. Thanks, Dave. See you next week.
Okay. See you all, Nicole.
The next question comes from Steve Tusa with JP Morgan. Please go ahead.
He's a golfer. You can't use your nine iron on the baseball team, Tusa. No nine irons for 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 his choice. He's already down on his trade.
Well, I told you that my son has already bragged about this. You got to understand his base is in zero. He got it from dad. What the heck?
Put out some good orders, give Rocket some stock, Stock's down on the print. It's tough. Tough break for Rocket.
Oh, wow. Tusa. Tusa, I may not let you on my team on that one. Oh, man, as a local.
That's all right. You got plenty of players.
I can't wait till Rocket races leg on you, man.
You have plenty of players on here. Hey, just a question on the price cost stuff. I know last quarter, you talked about $125 million or something like that.
Yeah.
I think you mentioned of headwinds from tariffs and stuff. This chart suggests that it is not quite as bad as that. Maybe I'm comparing apples and oranges. Then, am I right as far as the price is concerned, and how that phases in, given you guys are a little bit more into the component kind of supply chain that you have to generally kind of wait for the right time to go to the OEMs with your kind of annual price increases as opposed to the OEMs.
Yeah.
Kind of dictate whatever they want to their distribution channel?
There are a couple of things here. One, we've already worked with the OEMs, the price is built in for the year along this line here. The 125 number for the total company is still a good number, Steve. That has not changed. This is one piece of it.
Okay, got it.
This is Section 301.
Yep.
This is Section 301. I think what we've laid out across the board is pretty consistent, we have the 125 matched. I think that if all is said and done, as the year unfolds, our price cost numbers will be neutral to slightly green, not much different. Everything's pretty well laid out, and it's been discussed. The channel, which we obviously have with A&S, the Automation Solutions business, we've got that laid out. Then Commercial Residential. They did the heavy lifting late last year with their OEMs and got that built in. 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 cost goes the other way. We'll have to plan that back out, too. I think we're in pretty good shape.
I feel good about that right now, Steve.
Okay. That makes sense. This basically all means when you look at kind of the comps on acquisition related charges, your fourth quarter comp on margins, when you think about price cost,
and the deals that you've kind of done here, that should really kind of unmask a really positive trend line into 2020, correct?
That's the game plan. That's exactly right. Our fourth quarter, 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.
Okay, great. Thanks a lot.
Thank you very much, Steve. I'll see you next week, and you can definitely join my baseball team. Just don't bring your nine iron.
Thanks.
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 commemorative bobblehead night.
That's a hell of an idea.
I'm wondering if we could talk about
We might do that at the conference.
Not too late.
I love it. That is good. Oh, God. Josh, you got me on that one, man. Okay. What part do you have, though?
The first question on the project funnel.
I can't believe you accused me of giving my dog a high basis stock. Run the stock up, give my dog stock at a high price, then trash it. I mean, that is a low blow.
Can't help you there. On the project funnel you defined a couple of quarters ago, I think we stood at $6.8 billion the last time you showed us the number. Maybe this will wait until the analyst meeting, a lot of what you're talking about with KOB III sounds like it wouldn't really fill the funnel in with a large number of dots, maybe more dollars. Any way you could size where that stands today, or if there's been any pause in that funnel?
Yeah, I can, 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, as you well know, none of our competitors do this, I think it's important for people to understand this, how we look at it. The number is over $7 billion right now. Tim, what is the number?
7.6.
$7.6 billion, what we're going to show you is how this unfolds the next two, three years, how it goes by first half, second half. We're trying to phase that by industry and by world area. 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, we've been in this business a long time, I think we're coming up with better ways, we're going to try to lay that out for you on February 14th.
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 that write down faster with you, because I guarantee I won't be giving this chart out. 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 think this is the Dave Farr approach. You know that.
Of course. Then just shifting over to some of the M&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. I just want to be clear, as we lap these acquisitions that I would imagine re-engaging with some of these customers that maybe you guys did business with when you still owned 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, even as we kind of lap some of the accounting components of the M&A?
Yes. Yeah. 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. From a technology standpoint, it's pretty good. We've got to make some critical investments relative to not only a standalone PLC type of control or intelligent control. We're also going to have to figure out how to embed that relative to our Ovation platform in the power and water and our DeltaV within the process side. Then what we need to do is build work on the channel work. 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, overwhelming.
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. As you said, we got to keep that discrete channel out there and rebuild that channel. Mike is going to be talking about what we're seeing from an 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 three, four, or five years, well beyond the Dave Farr era.
Got it. Thanks, Dave.
Thank you very much.
The next question comes from Nigel Coe with Wolfe Research. Please go ahead.
Hey, Dave.
Hello, Nigel. How 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's gone. Can you catch?
I can catch. I can catch something, I can't catch too many balls these days.
Yeah. I don't want you catching the flu or anything. I don't want the flu.
I can definitely catch that. Dave, thanks for the incremental color here on the slides. It's 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? 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 next couple of years. It is our biggest growth opportunity, and we're going to talk about that on the 14th. Yes, the projects are just starting to unfold. There's three been announced already, the one in Canada, one in Mozambique. We've got the project down south here in Golden Pass, which was basically formally said it's going to be funded by Qatar and ExxonMobil today. We know of at least three more coming down the pipe. Saudi Aramco want to make huge investments in gas. We see a good wave relative to gas. What we like about gas, you'll see the makeup in gas, it's a very broad portfolio of our products. When a project goes in, it's a huge project.
We could get several hundred million dollars of systems, instrumentation, control software in an ongoing basis for a long, long time. It is something that's really good for us relative to the long haul. It's something we've built out over the years from an acquisition standpoint. I like what we see, and I think we're going to have a good run at it here.
Okay. Addressing Nicole's question in a different way. If we're going to have less upstream, less E&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 Emerson content? Any appreciable margin next things we should think about there?
We're still doing some work on the margin. My opinion, the project size are going to be smaller overall when you look at them all different, Nigel. That's something 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 this cycle. Therefore, I like the project size being smaller because it doesn't mean there's less volatile from the big chunks that you get in the business and the orders we saw last cycle. If it's going to be heavy LNG, it's going to be heavier chemical, a little bit of refining, it has the better long-term margin profile for me. We're just working our way through that right now.
It should be a better margin profile based on the big heavy oil type of projects. That's something we're working on, and I want to have something to show you guys and gals in February 14th on that very question because it's a very relevant question.
Okay, Dave. See you next week.
See you next week, Nigel. You're in catcher. Don't bring that cricket bat with you, though.
Bye, Dave.
The next question is from John Inch of Gordon Haskett. Please go ahead.
Good afternoon to you.
Hey, John. I know you're a baseball player.
Well, we play hockey in Canada, so
Oh.
Sorry to deflate the balloon.
Well, I was up in Canada last week, you'll be happy to know I got an Edmonton Oilers shirt right here in my conference room. It's number 19. Player number 19 was a very good hockey player. Unfortunately, the last name says Farr, and I don't play hockey. 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 freaking old, John.
You seem to be doing pretty well from my vantage point.
Okay. What can I do for you, my friend?
A&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's 2021. Does that still feel about right?
We're going to push hard to get to it. Right now, if I could be very truthful to you, I'd probably a tad less than 19% by 2021 with some of the deals. GE doesn't help me because the GE margin is not plus. Our target is still to get to that 19%, and that's where we're trying to drive this whole mix basis that we were just talking from the last question coming out of Nigel. That's still our goal. I still feel good that we get real close to it. That's where we are at this time.
To get to the C&RS guide, it looks like margins in the back half maybe have to exceed the back half of 2018 margins. Does that seem reasonable based on the flip you're going to see with respect to price cost?
Yeah, these guys are quickly looking at it. Frank says yes, Tim says yes.
Yeah.
And-
You're going to have to ramp in the second half.
The answer is yes.
All right. That's reasonable. Maybe this is maybe a question for Frank.
For all the people out there, you guys got to deliver that margin in the second half from the Emerson team. I just want to remind the guys that listen to this call, deliver.
They heard it.
Yeah, they got it.
One more question for Frank. Trying to put the $63 million of corporate swing into a context. Is this an accrual adjustment for the entire year that flows through the first quarter or fiscal quarter? What actually happens, for instance, if the stock were to shift or swing up or down, I don't know, $10-$15?
Sure.
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? 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 first quarter. Essentially, all of that was due to the incentive comp. About $60 odd million 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 second quarter if we stay near these levels. As the price goes up, we will then again have to run some of that through the P&L. It really depends on what you assume about the stock price. 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.
Yeah, John, what we do is we look at a model based on trend lines, we typically have the stock going up in each quarter.
Yeah.
What happens, what we build into the quarter, we didn't think the stock was going to stay at $79, but we didn't think it was going to go to $50, $56. We probably had somewhere around $75 built in there. As the stock dropped off, we got the big pickup. Right now, 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. We feel comfortable with some of that we picked up and we floated through for the year. That's how it works. We're unique in this regard, that we've always had a variable plan, and we like keeping it that way.
If growth rates go up, I want our relative growth rates to go up with that and have tougher targets.
Would you expect corporate expense to be kind of the one to go back to this $140, $150 zone for the coming three quarters?
That's a good question.
Yeah.
Is that what-
Yes, I would.
Yes, John.
I would.
Okay.
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.
Thank you.
See you next week. 14th. It's not quite next week, 14th.
Yeah, 14th. Valentine's Day.
Have a sweetheart.
The next question comes from Robert McCarthy with Stephens. Please go ahead.
Is it next week?
From the ridiculous to the sublime. How you doing, Dave?
Oh, God. You're not going to be on my team at all. You got any cheap jokes about-
Oh, I'm on your team, Dave. Don't worry. I'm on your team. All right.
Okay.
In any event, I wanted to ask, I guess maybe since you're not shy, and you're on the sidelines.
Me?
Yeah. I don't think you're shy. What do you think about what's going on with Carrier and the spend here? Do you think it changes the environment overall with respect to the OEMs? 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. We'll have an independent Carrier out there, that we'll be managing the similar type of customer base for the next several years. Does something happen four, five, six years out? It's possible. My feel right now is UTC is headed towards the spend very hard. Mark and his team have worked this very, very hard. By the way, I know how hard that is. I took out 40% of Emerson that way. It's a lot of work. That's what I feel right now, Rob. I don't see consolidation in this move.
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 it a little more stable. What's your outlook there, excluding this kind of channel correction we've seen? Can you kind of talk to the growth you're seeing in China excluding that?
You take out this channel, we're growing 15%, 20%. With this piece. Bob will show you the breakdown. I know he put the chart up at the board today because our board asked the same question as we dissect what 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 he show 20%, 30%?
Yeah. They were up big.
For the quarter. We have clearly built out a strong, more balanced business in China than, say, five or six years ago. We're still not there yet because this heating and ventilating and cooling business was up 30%, 40%, and it's a big business now dropped off. 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.
We're making great progress, and Bob's 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 impact.
Thanks for your time.
Thank you. I'll see you next week, Rob. Appreciate it.
The next question comes from Andrew Kaplowitz with Citi. Please go ahead.
Okay.
Good afternoon, guys.
Hey, Andrew. How you doing?
Good. You need a pitcher, right? I think you need me as pitcher.
Yeah, you want to pitch?
Yeah. 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?
Shit, I'll definitely call you a dead cat. Don't worry about it. If you throw a couple gopher balls up there in the home run trot, you'll be a dead cat for sure.
I understand. It would be warranted.
Okay, Andrew, hit me.
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. Did these opportunities end up leading you to outperform in Europe? Do you still think Emerson grows in Europe in the 2%-3% range for 2019?
Our fundamental goal is to be closer to 5%. There's a couple of things going on in Europe from a technology shift relative to commercial Residential and then also some incremental investments. I'd say the new generational power area is different than the past as we participate in. Our goal this year actually is to see a number closer to 4%-5% for Europe. That's what we're trying to get to from the standpoint overall sales. I think that the order pattern is there at this point in time, and we feel good about it. Clearly, we got to see a little bit better number than 3% in the second quarter. It should be more like 4%. Right now, my team is holding pretty tight to that 4% or 5% for Europe for us.
Even a weaker IFO number in Europe, we just happen to be in a couple segments which are investing, and some of our customers in Europe which are exporting products to, say, Middle East and Africa, see some upside and from that perspective. Right now, my Europe business looks decent.
Okay. Yeah, that would be quite good.
Yes, it would.
You do seem confident that Asia orders have bottomed in Commercial & Residential Solutions. What do you need to see in orders here over the next few months to support that 3%-5% sales growth that you have for the year? What kind of uptick should we look at? Obviously, the deceleration has stopped, but the orders are still negative.
Yeah. We've got to see on a map, we've got to see this thing go positive in the second quarter from order standpoint. I think we're forecasting underlying growth for Commercial res still close to flat, Frank, in the second quarter.
Yes.
What we need to see is our order pattern turn up in this second fiscal quarter, which is the first calendar quarter, and moving above that line, which is pretty close to it. From my perspective, right now these guys are telling me we're going to be + low single digit. I was wrong. A low single digit, driven by U.S. and driven by Europe. I think that what I'm watching for is Asia, and does Asia get back up to that zero line and above that line? If it does, then I feel very good that our Commercial & Residential Solutions for the year can do this 3%, 4%, 5% type of growth. That's where I'm seeing right now short term. On the Automation Solutions side, I'm watching KOB 3 in a couple industries.
On the Commercial & Residential Solutions side right now I'm watching China and Southeast Asia relative to their HVAC type of orders. That's where I'm watching.
Thanks, Dave. See you on the 14th.
You're welcome. See you. Have time for one more call here? One more call.
That question comes from Rich Kwas with Wells Fargo Securities. Please go ahead.
Glad to beat the buzzer. Good afternoon, Dave. Of course.
I got to get going to my next meeting. How many calls is this? 15? 14?
Yeah.
We'll go one more. We'll go 15. We'll go for 15. Whoever's the 15th in line, you're good. You're going to make the cut. The 14th. So we'll go 15. Not many CEOs will do 15 people on a call, but we're going to do it here, okay? Let's go, Rich.
Two from me on investment. If A&S 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 2020 phenomenon in terms of incremental investment?
If Automation Solutions orders stay above 10%, they're going to be pushing us pretty hard as we leave the year on two 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 fourth quarter going into the first quarter, which will raise the cost in the fourth and raise the cost in the first and slow down the smaller quarter. That will be the pressure point there. Secondly, what will happen is, Lyle will be coming to Frank and I and saying, "Guys, we've got to pull back in some capital for capacity in a couple of places." I know Lyle and his team look at that, and Frank and Steve Pelch, Frank from the CFO and Steve from the COO, have this constant dialogue going relative to that.
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 A&S to be able to serve that. Right now, we're not banking on that based on our forecast, but that'd be good news to deal with. That clearly will create some tension for Frank and I relative to our free cash flow and allocation standpoint. That's what we see.
Okay. Then just a bigger picture question on U.S. Resi. 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, which hasn't yet, not the new homes, but the upgrades, then that would bother us down the road. The channel's in very good shape right now. Our customer base is in very good shape right now. I feel decent relative to the cycle. As we get into every month, our customers are very short-term oriented relative to the U.S. We're talking U.S. here. We see their order pattern week after week after week, and it continues to fill in. Bob keeps Frank and Steve informed on this because that's important relative to us. I'm not worried.
If the consumers' incomes are still going up, employment's 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.
Yep. All right. See you next week.
Are you going to be there on the 14th, which I guess is next week? If I stand corrected.
I will be there.
Okay, good.
See me in person.
Okay, good. Let's go to the last person here, whoever this person is. Who's last?
All right. The next question will come from Jeffrey Sprague with Vertical Research Partners. Please go ahead.
Okay, Jeff, you're batting up cleanup. We got a guy in first and third. We're down one. We need a hit, partner.
Saving the best for last. That's the way I like it.
Oh, the best. Well, you're the cleanup. Let's see if you can give me a hit. I know you can't run the bases, it better be out of the infield.
Yeah, no, I need the walk-off homer, Dave, because I can't.
Oh, okay. All I need is a freaking single, okay? I got to get the guy home, okay?
I'm for the walk-off.
Okay.
Hey, 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 KOB3 above 50% throughout the horizon. I'm just wondering, in the past when you've gotten into big spikes of project activity, how far down in the mix does KOB3 really play? Should we expect a significant margin differential because of that?
Historically, it would drop down to 45%, 46%. 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. We're incentivizing the organizations from the standpoint of making these investments and going after that install base is to try to keep that KOB at 50%, keep a five in front of it. Will it be 50, 51? I'll take a 50. 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. In 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 lost on that business, and they didn't maintain that business. 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 it to them right now when the window's open. I think the window's going to be open for another 18 months, and I've told Ram we've got to get it done.
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 strategically long-term is good for us from a profitability standpoint and smoothing out the cycle curves a little bit too.
Yeah, that's really interesting. That's an interesting nuance. 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. 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?
Yeah.
Not a significant headwind?
Yes. As we move into the second quarter, we're in the run rate. I think the question was our run rates sort of structured from an 8%-10% type of order base here. 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? The answer is we will have to make some incremental investments. 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 second quarter. Lyle knows that. The second quarter is very important from a profitability standpoint, and that will set up a much stronger second half for us.
Great. Thank you. See you next week.
Take care. I want to thank everybody for joining us, and I appreciate everyone letting me have a little fun with them baseball. I don't know why I went to baseball other than my Stan Musial bat right here and the rally monkey staring Tim down. He's always staring Tim down. I appreciate everyone joining us today, asking the questions and the engagement, which is I find enjoyable. I look forward to seeing everybody next week in New York, and 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.