Eaton Corporation Part 2: We Recommend To Hold It Again

| About: Eaton Corp. (ETN)
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Summary

The stock price of Eaton Corp. has increased by more than 19% since our previous recommendation.

Despite positive moments (e.g. high net profit margin and FCF yield, good level of operating cash flow) we see negative moments (mostly related to future revenue growth).

According to our revised DCF model, Eaton Corp. looks much better. However, fair stock price is lower than current share price level. EV/EBITDA is also too high.

We again recommend investors to HOLD this stock. Our target price range is $52-65 per share.

Introduction

Eaton Corporation (NYSE:ETN) is the company which we strongly recommended holding last year. As you may remember, we set a target price range at a level of $44-57 per share. During this period, the stock price has performed much better that S&P Composite and has shown the profitability of 19% (see Diagram 1). Current price is $63.29 which is a lot more than a higher border of our earlier recommendation. You can read our previous article here.

Diagram 1

Source: Nasdaq.com

Current tendencies

The main tendency to be considered when making the investment decision is the potential revenue growth. Sales have fallen by 7.5% in 2015. Current TTM values show a 3.4% decline, while latest 10-Qs suggest a worse result - decline of 5%-6%. Hence, our forecast for 2016 is a 4% revenue decline. Revenue CAGR for the period until 2022 is -0.76% per year, which is based on our assumptions about the future revenue decline.

However, we expected such a revenue decline and even worse. Moreover, we expected margins to be less. As a result, net profit margin in 2015 was 9.5%, while our forecast was more conservative - 8.6%. Nevertheless, current trends are pessimistic. We think that in the nearest future, the effect of revenue decline will also lead to a decline in net profit margin. Based on these assumptions, we expect the net profit margin of Eaton Corp to touch 8.6% by 2019.

We have also improved our assumptions about free cash flow yield (FCFF/revenue ratio). Our previous estimates were: 6.8% in 2015, 7.3% in 2021. However, in 2015 FCF yield was 15%, twice more than our forecast. Hence, we significantly improve our forecast. We expect FCF yield to be 11.9% in 2016. However, the decline in net profit margin will cause the decline in FCF yield. Our forecast for 2022 is 9.4% which is 2.1 percentage points more than in our previous estimates.

Another positive trend is the level of dividends and stock repurchases. As you can see from Diagram 2, proceeds from these operations totaled 98% of net profit. It is still less than operating cash flow. Moreover, OCF's level has significantly improved approximately to $3000M. The ability of Eaton Corp. to pay dividends and provide buybacks is a good sign of financial stability.

Diagram 2

Source: Morningstar.com, calculations of Societe Financiers

Discounted Cash Flow Analysis

Our discounted cash flow model can be downloaded in the Excel file format, which you can access with this link. In Diagram 3, you can see how different metrics of the company are expected to change during the forecast period. During the modeling process, we had to make several assumptions, which can be examined by the readers in the "Assumptions" tab of our Excel file.

Our model shows that, after subtracting the market value of debt, minority interest and adding back cash and investments, the market value of equity is approximately $28.2B in the Base scenario. Consequently, the fair value per share is $61.07. It is 8% lower than the current share price ($63.29 per share).

Diagram 3

Source: infographics by Societe Financiers

Sensitivities

The sensitivity tables are presented in Diagram 4. We find the suitable price range for the stock to be between $51.8-$65.42 per share. This price range represents a (-18%)-3% potential for the stock.

Diagram 4.

Source: DCF model by Societe Financiers

Comparative Analysis

Our comparative analysis results are presented in Diagram 5. All the ratios show that the stock price is undervalued by 30% on average. The Current EV/EBITDA multiple is at 11.7x, which is extremely expensive when compared with the industry's average of 9.87x (according to Damodaran's tables).

Diagram 5.

Source: infographics by Societe Financiers

Opinion

Eaton Corp. is an arguable type of investment at the moment. On the one hand, its efficiency is much better than we expected. Net profit margin and FCF yield have been substantially upgraded. On the other hand, current share price level is near the fair price level according to DCF analysis. Comparative analysis based on P/E, P/S, and P/BV shows that the stock price is extremely low, while EV/EBITDA is very high.

As you can see from our Football Field in Diagram 6, DCF analysis represents the most conservative case. We think following this type of analysis is the safest and the most reasonable decision. Hence, we recommend investors to HOLD this stock. Our target price range is $52-65 per share.

Diagram 6

Source: infographics by Societe Financiers

Risks related to our opinion

Eaton Corp. bears currency risks, interest rate risks, macroeconomic, and geopolitical risks. Since these risks are mostly unpredictable, we recommend investors to hedge their positions using different financial instruments. Our valuation of the company is based on current and medium-term business trends and does not include the probability of a force majeure. On the other hand, by using our Excel model, you can change the key parameters in line with your personal assumptions and expectations.

Societe Financiers is an investment research team focused on long-term, long- and short-only ideas. Our research objective is to cover equities in various regions, such as North America, EMEA, Asia, Australia, and Emerging Markets.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.