Eaton (NYSE:ETN) has embarked on a globalization and portfolio optimization strategy over the past decade, moving significantly into international and emerging markets. It has altered its product mix, made substantial acquisitions (Cooper Industries in 2012 as a notable one), and moved its headquarters to Ireland as part of a tax optimization strategy. By and large, the company has executed solidly on all of these initiatives.
While it has made sound, logical business moves under outgoing CEO Alexander Cutler. The reins have been handed over to new CEO Craig Arnold, and I am curious to see which direction the company moves in next. Eaton has always struck me as a jack of all trades when it comes to industrials. When it comes to growing earnings, all the methods companies in this sector can employ (mergers and acquisitions, margin expansion, innovation) Eaton has done successfully, but not necessarily to the degree of other industrial peers. Nonetheless, the company's electrical and industrial end markets have typically held up fairly well when it comes to revenue and margins, even during downturns like the one markets experienced from 2007-2009. In fact, both have strengthened significantly over the past six years.
*Eaton Investor Presentation
Reconciling Long-Term Guidance With Short-Term Headwinds
Craig Arnold is stepping into a company that has set some large expectations for itself. Eaton management has guided for 8-9% earnings per share growth from 2015-2020 - a lofty goal for any industrial facing the current macroeconomic outlook both domestically and abroad. At the bottom end of that guidance, that puts diluted earnings per share at $6.30 by the end of 2020. Substantially all of this growth is set to come from restructuring and operating margin expansion, not from revenue growth. This means the company needs to set higher and higher segment operating margins, all in a competitive environment. How does it plan to achieve those targets?
First off is the company's restructuring plan. The current $400M restructuring initiative is set to break-even in 2018, yielding $400M in annual benefits thereafter. At current results, this would yield more than 200bps in operating margin expansion. Attainable? Potentially. Aggressive? Certainly seems that way, but management believes there is a lot of room to make improvement.
The rest of the growth (1.5% annual earnings benefit) will have to come from operating margin expansion not driven by restructuring. The company intends to increase margins organically, mirroring the strategy of other industrials like Illinois Tool Works (NYSE:ITW): cut the fat at the bottom, focus on the high margin top. Of course, cutting the fat will inevitably cut the top-line as well, creating some headwinds on the top line.
2016 is not off to a great start, at least from a demand perspective. We're already halfway through the year, and it is safe to say at this point that 2016 will be a dead year for earnings growth. The company's Hydraulics and Vehicle segments are both set to contract double digits, with Hydraulics being impacted by weakness in large agricultural equipment and the general hard mineral commodity slump, and Vehicles being down on significant weakness in Class 8 trucks and deep drops in demand in Latin America as some countries in the region endure commodity-driven recession. Overall, full year guidance in 2016 is for $4.15 - $4.45/share; basically flat compared to 2015 results. The company will need a significant turnaround in global health if it has any chance of reaching its goals, no matter how well the company can execute on trimming excess costs.
Like most plays in the industrial space, Eaton has caught a bid from the market throughout 2016. It still remains firmly entrenched, valuation-wise, with its peers like Honeywell (NYSE:HON) and Dover (NYSE:DOV). Street-wide valuations in the industrials sector are the highest they've been since 2014, and I think it is worth taking a precautionary view on most of the large caps in this space. They simply aren't priced for outsized returns unless we see an incredibly sharp turnaround globally in industrial product demand. Today more than ever, I think investors have to step away from some of these names and explore smaller, less known companies if they want to hit home runs in this space.
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