The industrial sector has shown much momentum over the past three years. However, since the start of this year, industrial stocks have been tumbling due to the deceleration of economic growth across the globe. In addition to the sudden downturn in the oil and gas industry, large multinational companies are also experiencing currency exchange challenges due to the strengthening of the dollar. All these factors are negatively impacting sales and earnings targets across the board. As a result, at the end of the second quarter, we have seen that several industrial companies have reduced their full-year sales and earnings forecasts.
Eaton Corporation (NYSE:ETN) has also slashed its full-year outlook due to significant currency fluctuations and the slow economic environment. The depression in emerging markets and slow growth in the European region are key drivers for its currency devaluations. These concerns led the IMF to lower their full-year outlook to 3.4% which is lower than the growth in the previous year. Nevertheless, Eaton's management is working out the right strategies to curb costs and enhance their margins to offset the impact on sales.
In addition, its end markets are not as depressed as Emerson's (EMR) and the company has great potential to repel these short-term headwinds. In my recent article, I advised defensive investors to avoid Emerson's stock because of its extensive exposure towards the extremely depressed energy sector. In the case of Eaton, the reason behind its declining sales growth is primarily negative currency translations, which are always short term in nature. At present, Eaton is offering a quarterly dividend of $0.55 per share, yielding around 4.35%, a very strong dividend yield when many other companies are slashing their dividend.
Let's take a look at Eaton's business fundamentals and revenue base along with cash generation to gauge its potential to sustain its dividends. In addition to this, it is also very important to pick the stock at the right time to increase the expected rate of return from share price appreciation. In this article, I will also try to point out the best time to purchase Eaton's stock.
Revenue base and business fundamentals
Figures in million | Q2/2015 | Q2/2014 |
Electrical Products | $1,784 | $1,832 |
Electrical Systems and Services | $1,502 | $1,628 |
Hydraulics | $643 | $787 |
Aerospace | $454 | $486 |
Vehicle | $989 | $1,034 |
Source: SEC filings
Eaton has a diversified revenue base with less exposure to depressed end markets such as oil and gas and their associated companies. In the last quarter, Eaton's overall sales decreased 7%, consisting of 6% from currency devaluation and 1% in organic sales. This shows that the company's sales growth declined mainly due to currency fluctuations and nothing is wrong with its end markets. In addition, bookings for the company's major electrical products business segment is increasing; its bookings increased 4% compared to the same quarter of last year. Its vehicle segment is also on track with an organic growth of 4% in the last quarter. Prospects for the vehicle segment are strong as the auto industry is booming at present.
On the other hand, its other three segments are experiencing slow growth. The Electrical Systems and Services segment has exposure to oil and gas businesses, which is lowering forecast for its future growth. Therefore, this segment is likely to remain dim in the short term. However, on the earnings side, this segment is generating improved profits quarter over quarter on strong cost-cutting initiatives. In the first half of this year, the company posted operating profits of $409 million compared to $363 million despite declining sales.
The major pain for the company is its Hydraulic business segment where both sales and earnings are declining sharply. This segment is generating a significant portion of sales from the agricultural industry and construction equipment in China. Due to the falling prices of agriculture products, these companies are lowering their spending on agricultural equipment. On the other hand, demand for construction equipment from China is likely to remain mild in the short term due to volatility in their overall business environment. So, we can expect this business segment to remain a painful area for the company.
Overall, despite the 7% decline in sales, Eaton's management did very well on the cost side, generating an operating profit growth of 5%. The company is aggressively looking to remove unnecessary costs and has started working on a restructuring program of $145 million to reset its entire cost structure. This is the right strategy at the right time, allowing the company to adjust costs and enlarge margins, as I believe that the prevailing business environment is creating many hurdles for multinational companies.
Capital allocation and cash generation
Eaton has recently announced a capital allocation strategy that I believe favors investors. The company is looking to return 4% to 5% of its market cap to investors in the form of dividends and share repurchases. Along with dividend payments, the company is aggressively looking to lower its outstanding shares, which I believe will have a positive impact on its share price, dividends and earnings per share. The company is further looking to invest its remaining capital in its existing businesses, along with working on acquisitions
Figures in million | Q2/2015 |
Operating cash flow | $579 |
Capital expenditure | $141 |
Free cash flows | $438 |
Source: SEC filings
Eaton's cash flow generating potential is also strong since free cash flows are providing complete cover to its existing dividends. At present, the company offers a quarterly dividend of $0.55 per share, yielding around 4.29%. This is a very strong dividend yield in a challenging business environment. In the latest quarter, Eaton generated an operating cash flow of $579 million. After capital outlays of $141 million, the company was left with a strong free cash flow of $438 million while dividend payments stand at around $263 million. This huge gap between free cash flows and dividend payments will allow it to make a dividend increase in the comings days.
So, with strong business fundamentals, new capital allocation strategy, and healthy free cash flows, its dividends are not only safe, but the company has the potential to make an increase in the comings days.
Initial Investment
Due to the significant decline in shares and continued growth in earnings, its share price appears to be undervalued based on a price-to-earnings ratio of 10.9% where the industry average is high around 30 times to earnings. For that reason, we can say that its share price has strong upside potential. In addition, its business fundamentals are strong despite pressure on sales, as earnings are likely to grow at a respectable rate.
However, it is still important to pick the stock at the right time to lower risk. I believe that its share price could remain volatile over concerns related to the impact of currency devaluations, worries in China and overall negative sentiment about the stock market. I recommend dividend investors to look for buying opportunities in this company before and after its third-quarter results.
Bottomed Out
Eaton has a much lower exposure to the oil and gas markets, and its sales are declining primarily because of negative currency translations. The majority of its end markets are also not depressed which reduces risk to its revenue base. Despite slow sales growth from the Hydraulic segment, the company still generates strong earnings and cash growth. Eaton's focus on buying back outstanding share will also give strength to its share price and dividends. Therefore, its dividends are not only safe, but the company can safely sustain its history of dividend increases.
