Eaton Continues To Leverage Some Of The Best End-Market Opportunities In The Industrial Space

Looking at, and for, industrials with the best exposure to long-term growth opportunities, it’s hard to do better than Eaton (NYSE:ETN). Growth in automation, building energy efficiency, and renewable energy will feed the company’s electrical business, as will ongoing growth in data traffic and data center infrastructure, and the company also is leveraged to a multi-year recovery in commercial aerospace, increased defense spending, and vehicle electrification.

When I last wrote about Eaton, I had some concerns about the valuation but thought that the above-average growth and margin leverage prospects scored higher than my concerns about valuation. Since the shares have been surpassed by a few multi-industrials, including Parker-Hannifin (PH), but have still outperformed the broader industrial space by close to 10%, as well as other high-quality individual names like ABB (ABB), Dover (DOV), Honeywell (HON), and Schneider (OTCPK:SBGSY).

The valuation argument is basically the same as before, though Eaton stacks up even less favorably in relative value terms. I love the end-market exposures and I’m tempted to stick with a winner, but I do feel like a lot of the positives here are well-known and well-reflected in the share price.

Mixed Results, But A Strong Underlying Core

There were some nits to pick with Eaton’s fourth quarter results. The company actually came in a bit below expectations and didn’t really blow anybody away with guidance, and the Aerospace business has continued to underperform relative to Street expectations (missing in five of the last six quarters, including this one), though at some point that finger has to point back to the inability of analysts to accurately model that business. While margin performance was OK, the company has continued to lag on free cash flow, due in no small part to higher working capital needs given unreliable supply chains.

Revenue rose 15% in organic terms, which was a strong result well above the average for the sector this quarter and among the best of the true multi-vertical industrials. Gross margin improved 130bp yoy to 34.1% and operating income rose 36%, while segment earnings rose 21%, with margin up 140bp to 20.7%. The latter was a small beat relative to expectations, contributing $0.01/share.

The Electrical business grew 15%, with 20% growth in the Americas business and 8% growth in the Global business, and profits rose 26% with margin up 250bp to 21.8%. Orders increased 34% in Americas and 11% in Global, with the Americas backlog nearly doubling from the prior year. Schneider managed to do even better, with 17.5% growth, and nVent (NVT) posted 17% growth in Enclosures and 16% growth in Electrical & Fastening, while ABB saw 6% growth in its comparable segment and Hubbell (HUBB) posted 1% growth.

Aerospace revenue rose 11%, with 20% growth in Commercial Original Equipment and 35% growth in Aftermarket, while profits rose 5% (with margin down 40bp to 24.5%). Orders rose 24%. Eaton lagged its peers this quarter (11% versus average growth closer to 13%), but that was largely due to its higher mix of military/defense business and Eaton’s performance was very similar to that of Honeywell, with Honeywell doing a little better in commercial original equipment, but not quite as well in commercial aftermarket.

Vehicle revenue rose 18%, with profits up 7% (margin down 130bp to 15.1%). BorgWarner (BWA) outperformed (revenue up 21%), while Allison (ALSN) underperformed (revenue up 11%), while Dana (DAN) matched the 18% growth. Looking at the various light vehicle and commercial vehicle supplier results, and considering Eaton’s mix, I’d say they did fine, but not exceptional relative to the market.

Last was eMobility, where sales grew 17% to $139M and the segment loss shrank $8M to $2M.

The Growth Outlook Remains Meaningfully Superior

Guiding to 7% to 9% organic growth in 2023, Eaton’s outlook is notably stronger than the low-to-mid single-digit growth that many multi-industrials are expecting next year. While Eaton isn’t immune to short-cycle pressures, nor pressures in data center capex, the strength of the tailwinds pushing this business is significant.

Management has estimated that various government stimulus efforts in the U.S., Europe, and other markets will add $11B to $14B to its addressable market over the next five years, as the company reaps the benefit of spending on commercial and institutional building upgrades (meant to make them more energy-efficient), power grid upgrades, and the buildout of EV charging infrastructure.

Above and beyond that, Eaton remains leveraged to longer-term trends in industrial automation – while Eaton does not manufacturer robots or control systems, automation requires electricity and adopting automation typically means significant upgrades to electrical infrastructure for a plant/facility. Likewise, above and beyond utility grid upgrades, Eaton remains leveraged to micro-grid projects (individual companies or institutions using on-premises solar, wind, or other renewable power sources). And then there's ongoing growth in data center capex to handle growing data traffic, cloud adoption, and AI – all of which requires electrical infrastructure.

The aerospace recovery cycle is well known and pretty straightforward. Narrowbody commercial aircraft production is already recovering, with a widebody recovery likely to start late in 2023. The commercial recovery will likely be a multiyear cycle, and Eaton is also leveraged to improved defense spending in the coming years, which looks more likely given how geopolitics are trending.

Looking at Vehicles and eMobility, I like Eaton’s leverage to power electronics (inverters, converters, connectors, et al) – these are high-value components where failures can’t be tolerated and where OEMs are ill-equipped to insource. Eaton’s leverage to traditional powertrain and transmission products is at risk over the long term, but it will take quite a while for commercial vehicles like long-haul trucks to fully electrify (if they ever do), and Eaton still has leverage to alternative fuels (long-haul trucking may adopt fuel cells over batteries) and many commercial EV platforms have still used transmissions.

This is 100% speculative on my part, but I do wonder if Eaton may look at BorgWarner’s coming spin of Phinia as an opportunity to do something with its own Vehicle segment – perhaps including a combination with Phinia as a way of further consolidating legacy ICE-powered components and maximizing manufacturing, sourcing, and logistics efficiency.

The Outlook

I do have some concerns about markets that are important to Eaton, including non-residential construction and data centers in 2023, but I think retrofit demand outweighs exposure to a brief downturn in new construction and I don’t think a temporary slowdown in data center capex will move the needle all that much.

As Eaton has come in very close to my own estimates since that last article, I’ve changed little in my model. My FY’23 revenue estimate is a little higher now (by about 2%), but I’m still looking for core growth in the neighborhood of 5%. I’ve modestly increased my operating and EBITDA margin assumptions for the next three years (I expect adjusted operating margin of 18% in FY’25), though I’ve reduced my near-term FCF margin assumptions. Longer term, I still think mid-teens FCF margin is achievable, driving double-digit FCF growth (or closer to 7% on an adjusted basis that smooths the working capital movements).

Discounting those cash flows back doesn’t offer a fair value with particularly robust upside today. Likewise with my margin/return-driven EV/EBITDA approach. Even if I give Eaton a two-point premium to account for its superior growth potential and end-market exposures, I can’t get to an attractive fair value, as the shares already trade at a 350bp premium relative to what the market typically pays for similar profitability.

The Bottom Line

I don’t actually have a problem with the premium here. Unlike many multi-industrials that I see getting robust premiums (names like Roper (ROP) come to mind), I think Eaton’s differentiated organic growth opportunities do actually merit a more robust valuation. My real concern is whether there’s enough “slack” out there to drive even more rerating. I do think a lot is already priced into the shares and I’m not looking to buy today, but I’d also be reluctant to get off this winner if I already owned them.