Short-cycle names have done pretty well of late in the market, and Eaton’s (ETN) nearly 25% share price move since my last write-up has kept it a bit ahead of industrials in general, though not to the same extent as Parker-Hannifin (PH) and a few other short-cycle names. In any case, I believe there’s more to the Eaton story than just a short-cycle recovery in 2021 and an eventual, longer term, recovery in markets like non-resi construction, aerospace, and oil/gas. Eaton is leveraged not only to data center growth and utility upgrades, but also an increased focus on building efficiency and possible reshoring.
Eaton’s performance fits with my earlier call of it as a “borderline buy” where I leaned positive mostly because of the near-term drivers I saw. I’d say that’s still largely true. There aren’t many out-and-out bargains in high-quality industrials anymore, but I like Eaton’s leverage to electrification, as well as some self-help on margins. With a prospective return on par with other high-quality industrials, but a better “story” in my opinion, I think this is still a name to consider if you must buy into what I think is a pricey sector.
A Quick Review
Eaton reported almost a month ago, so I’ll just touch on some of the highlights of the quarter that was. Revenue beat expectations by almost 6%, with Electrical nearly 12% ahead of expectations, Aero about 8% ahead, and the sold-but-not-closed Hydraulics business inline. Vehicle and eMobility were both below expectation, with Vehicle missing by 15% in a quarter where most of its peers did better.
Overall revenue declined 22%, with Electrical holding up well (down 11%, with Americas down 9%), Aero down 35%, Vehicle down 52%, and eMobility down 33%. Segment-level profits beat expectations by almost 20%, led by a 34% beat in the Electrical business. Vehicle and eMobility both went into the red this quarter, but Electrical margins stayed flat.
Bookings declined 13% in the Aero business and actually rose slightly in the Electrical Americas business.
Electrical Is The Spark
Like Schneider (OTCPK:SBGSY), Eaton saw good strength in the residential market this quarter, and like both Schneider and ABB (ABB), Eaton pointed to healthy trends in the data center and in utilities, and T&D companies continue to upgrade their grids. As you might imagine, oil & gas was weak, but Eaton is more leveraged to global markets, where spending has held up relatively better than for U.S. onshore.
Management also indicated that Electrical was now likely to be the focus on their R&D efforts. I would think that Eaton would be interested in select assets in the low-voltage market, as well as in control assets and portfolios pertaining to the data center (especially assets in cooling).
One of the reasons I’m still pretty bullish on Eaton is because of the leverage in the Electrical business to ongoing energy efficiency moves around the world. Biden’s platform includes a comprehensive climate plan that includes modernizing 4 million buildings, and even in the absence of any sort of federal mandate, there has been increasing interest among property owners to retrofit buildings for enhanced automation and electrical efficiency – not only does this save money, but clients are increasingly demanding it. This isn’t just a U.S. effort, as there are similar dynamics at work in Europe. I also like Eaton’s leverage to ongoing grid automation and upgrades, both of which also feature in part in Biden’s plan.
Eaton could also have some modest leverage to potential reshoring. Although I’ve been skeptical about the magnitude of likely reshoring, whatever there is will likely involve heightened automation and more demanding electrical needs, which suits Eaton’s leverage to industrial electrification markets.
Looking At The Other Assets
While I understand management’s shift in focus to Electrical in the short term, management had previously identified eMobility and Aero as areas of M&A interest, and I hope management hasn’t completely abandoned that plan. I believe the eMobility business needs more scale and there is definitely customer interest in off-road markets for increased vehicle automation, efficiency, and electrification. For Aero, while finding a buyer willing to sell at distressed/depressed valuations may make deals harder to do, there could well be some companies pushed to the brink with respect to liquidity, and I think Eaton could execute on an opportunistic deal.
As far as the roads back for these businesses, I believe the Vehicle and eMobility segments will see better demand in 2021 (Vehicle in particular), with improving commercial machinery demand later in 2021/2022. Aero is going to take more time, but with airlines getting more aggressive on retiring older planes to save on maintenance during this downturn, the demand for new jets will be there as air travel demand eventually recovers, though demand and production could be under pressure for a while.
I still expect underlying growth around 3% to 4% from Eaton over the long term (closer to 4%), and I see meaningful opportunities in the Electrical business over the next five years on data center investments, utility upgrades, and building retrofits. I’m still expecting FCF margins to improve into the mid-teens, driving mid single-digit FCF growth.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I can’t say that Eaton screens out as cheap these days, with a prospective return in the mid-single digits. That’s on par with other high-quality industrials though, and I believe Eaton has a better “story” than many of its peers over the next three to four years. I still like stocks like Columbus McKinnon (CMCO), ITT (ITT), and Parker, but I think Eaton is a name to consider if you still want to add industrial exposure at this point in the cycle.
Disclosure: I am/we are long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.