Eaton Hitting Its Marks, But Still A Controversial Name

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About: Eaton Corp. plc (ETN), Includes: CR, EMR, HON, IR, MMM, PH, RXN
by: Stephen Simpson, CFA
Summary

Eaton delivered a modest beat and healthy top-line growth guidance for 2019, but the market is still not convinced.

Aerospace and data center should be strong in 2019, but non-residential and "general industrial" are bigger question marks and likely the main focus of the bears/skeptics.

Honeywell may be a safer call, but Eaton looks undervalued even relative to what I think are a conservative set of expectations.

This fourth quarter earnings and guidance season has gone a little better than expected, with many companies having fine-tuned their guidance before the end of 2018 and defanging some of the potential disappointment here in January and February. Even so, there is still a lot of uncertainty regarding the health of the U.S. and global economies, with multiple multi-industrials (including Honeywell (HON), Illinois Tool Works (ITW), and 3M (MMM) ) establishing some rather low numbers for the low end of their 2019 growth outlooks.

I continue to like Eaton (ETN), even if more on a relative, “it’s not that bad” basis. I am definitely concerned about the risk of slowing demand in “general industrial”, trucks, off-road machinery, and non-residential construction, but management’s guidance for the year was fairly encouraging and markets like aerospace and data center are still looking healthy. With skepticism already seemingly built into the valuation, Eaton is a name that could surprise if 2019 proves to be better than expected for the U.S. and global economies.

A Small Beat And Few Weak Spots

Eaton’s fourth quarter was pretty good in my view, with not a lot of areas of weakness and some healthy guidance for the full year even if first quarter 2019 guidance wasn’t so strong.

Revenue rose a little less than 5% as reported, but around 6.5% on an organic basis, coming in more than 1.5% above sell-side expectations. The performance of Eaton’s electrical businesses was split, but even the slightly-below-5% growth of Electrical Products wasn’t bad, as healthy demand from industrial and residential customers was complemented with a return to growth at the lighting business. Energy & Safety Systems grew better than 9%, helped by ongoing growth in power distribution and data centers.

Hydraulics was quite healthy (up more than 8%), while Aerospace grew almost 13%. Vehicle was up very slightly, and eMobility was up more than 10%, though this remains a tiny business.

Margin performance was more mixed, although not really worrisome. Gross margin rose 60bp from last year and came in a little better than expected, but the company more than gave that back with higher spending at the SG&A line. Segment income rose 11% and segment margin improved 100bp, but the beat here was less than 1% relative to sell-side expectations.

As was the case with revenue, there was a split in segment-level profits in the electrical business, with EP up less than 3% (margin flat), the biggest miss among the segments, while ESS was up a stronger-than-expected 19% (margin up 160bp). Aero was also better than expected, with 30% profit growth and 290bp of margin expansion, while Hydraulics was up 15% (margin up 90bp). Vehicle profit was up less than 4% (margin up 90bp), while eMobility profit declined 10% (240bp margin decline) but at less than 1% of segment profits, it just doesn’t matter all that much.

Eaton’s booking results throw more mud into an already cloudy outlook for various segments. The EP business, which does a lot of business in non-residential construction and industrial markets, saw 3% order growth, while the ESS business (which also has industrial and non-resi customers, but more data center and utility) saw 12% order growth. Hydraulic orders were down 4% on weaker demand from Europe, and this was possibly the most troubling part of Eaton’s report. Aero orders were up 17%, while vehicle orders were flat as management expects the first half of 2019 to benefit from a build up of Class 8 truck orders before a more significant deceleration.

A Tough Call Amid Conflicting Signals

Although the fourth quarter earnings cycle has gone a little better than I’d expected, it hasn’t really provided all that much incremental certainty about where several key end-markets are headed. Auto and electronics are weak … but that was already largely accepted as fact, and even there there are still companies doing a little better (like 3M).

As it relates to Eaton, management here is still relatively more bullish than most, asserting that the economy is still “mid-cycle” and guiding for a healthy 4% to 5% revenue growth for 2019.

On the positive side, Eaton definitely has some attractive market exposures. Data center demand (largely for power supply/protection) is healthy, and power distribution demand likewise looks pretty strong. Aero is one of the most attractive end-markets right now, and that’s a definite positive for Eaton, as well as companies like Honeywell and Crane (CR), and Eaton has a good mix across commercial OEM, aftermarket, and defense.

On the less positive side, I’m still cautious on non-residential. True, several companies with significant non-resi exposure had good quarters, and I think there are segments like HVAC (where Ingersoll-Rand (IR) and Emerson (EMR) have exposure) that are still attractive, but guidance from companies like Honeywell and Kone does suggest that some caution is still in order. I’m inclined to believe that Eaton’s particular exposures to non-residential are comparatively positive, but I’d still keep a close eye on non-resi metrics like ABI and Dodge Momentum Index.

I’m also really not sure what to make of hydraulics and companies with exposure to “general industrial” and off-road machinery. Eaton management thinks the weak order number this quarter was an aberration, but Parker-Hannifin (PH) and Rexnord (RXN) were comparatively more cautious and Crane’s commentary on Fluid Handling wasn’t unreservedly positive. I’d also note that Eaton could be vulnerable to some de-stocking risk as 2019 rolls on which could further complicate guidance and forecasting.

The Outlook

I haven’t changed my 2019 numbers at all, while I’ve pushed a little revenue out of 2020 and into 2021. I’ve made a few housekeeping adjustments to margins, but all in all my outlook for Eaton really hasn’t changed. Given my conservative skew, that would leave some upside for Eaton if the year develops to the midpoint of management’s current expectations range.

Capital deployment likely won’t be a key driver in 2019. Management would like to do some deals, and did announce a attractive (but small) deal for a Turkish medium-voltage electrical products company, but will redirect the capital to buybacks if deals can’t be struck at attractive multiples. I don’t expect any of these deals to be large, but instead will be tuck-ins for the electrical, aerospace, and possibly the hydraulics segments.

I don’t think I expect all that much from Eaton, as my long-term revenue growth target is close to 2.5% and my long-term FCF growth target is around 4%. Those cash flows still support a fair value in the mid-$80’s, though, and that makes Eaton priced pretty attractively relative to many, if not most, industrials. The shares are look conservatively-valued on EV/EBITDA, as the shares could trade to $85 and still be below what would otherwise be a “fair” multiple based on the company’s margins, ROIC, and ROA (though none of these metrics are exceptional).

The Bottom Line

When things get tough, I tend to like to own higher-quality companies; names like Honeywell and 3M certainly come to mind. I think the market exposures/opportunities for Emerson and Ingersoll-Rand make them interesting names to consider now too, but I do still like Eaton. Although Eaton doesn’t have as much “quality” as I might like, expectations seem beatable and these shares could outperform if the U.S. economy proves more resilient than I expect in 2019.

Disclosure: I am/we are long MMM. 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.