- Eaton's 7% organic revenue decline in the first quarter may be on the lower end of the average, but outsized exposure to vehicles and hydraulics also explains it.
- Eaton has a relatively attractive business mix for the recovery, with opportunities in data centers, building retrofits, and industrial electrification offsetting longer-cycle exposures.
- These shares have continued to outperform peers, making Eaton more of a "borderline" buy call, but definitely a name to keep in mind if the markets pull back again.
Eaton’s (NYSE:ETN) management has been busy – selling the largely disliked (at least by the Street) lighting and hydraulics businesses, buying an aircraft connectors business, and reprioritizing around long-term drivers like electrification (including smart grid, automation, and electric vehicles) and air travel growth. None of that immunizes Eaton to the current downturn, but it does give Eaton a less-cyclical, higher-margin business to take into the recovery.
Eaton has continued to outperform, and I can’t say the shares are dramatically undervalued. They are, however, priced pretty well in the context of quality industrials, and in my mind they’re sitting right on that “buy/hold-and-buy-more-on-a-pullback” line. With opportunities to bulk up the electrification, EV, and aerospace businesses even further through M&A, this is a company I still like in the multi-industrial space.
An In-Line Quarter
More than a few industrials have reported noticeably better revenue and margin results relative to recently-lowered expectations, but Eaton was pretty much right on target. Call it a relative disappoint if you like, but I’d say it not really a thesis-changing situation.
Revenue declined 7% in organic terms, with management commenting that the underlying organic contraction would have been around 3% without the impact of Covid-19. The electrical businesses did alright on a comparable basis, with the Americas business down 2% and the Global business down 6% (compared to a 7% decline at ABB (ABB), a 3% decline at Hubbell (HUBB), and a 6% decline at Schneider (OTCPK:SBGSY)). Aero declined 1%, while Vehicle declined 12% and eMobility declined 12%. Hydraulics, where the sale to Danfoss has not closed, saw a 14% decline.
Gross margin declined 150bp, which was okay relative to expectations, but I’m a little surprised that American industrials haven’t seen more tailwind from raw material cost reductions (relative to European companies). Segment income declined 11%, coming right in line with expectations and with 20bp of margin contraction. All business segments saw declines in profits and margins, except for Electrical Americas which did manage a 30bp margin improvement (helped by the lighting sale).
Bracing For A Sharp Decline, And Then … ?
Eaton echoed the commentary from many other companies that April was abysmal and that the second quarter is going to be exceptionally weak. The bigger question now is what the recovery is going to look like.
Eaton’s electrical businesses are, like those at ABB and Schneider, leveraged to healthy spending in data centers (Schneider was down this quarter in DC, but that sounded like more of a timing and year-ago comp issue), and I don’t expect that to change much in the near future. Likewise, both ABB and Schneider called out healthy utility spending that I believe will continue at least into 2021.
Non-residential construction is more problematic and more complicated. I believe we could see a meaningful multiyear downturn in non-residential construction, but Eaton has leverage to retrofit activity that can at least partly offset weakness in newbuilds. On the industrial side, I expect a relatively quick turnaround for most of Eaton’s electrical business, though markets like oil/gas are not going to recover quickly.
Eaton’s aerospace exposure is also a little complicated. Relative to many aerospace companies, Eaton is more leveraged to defense and aftermarket parts. Although I expect aftermarket parts for commercial aerospace are going to get hit very hard this year (as flight hours have plummeted), they’ll come back before OE production. With defense, I don’t see much reason to expect any meaningful downturn.
The Vehicle segment was already getting hit by the cyclical downturn in Class 8 trucks, and I expect that downturn is going to continue at least into 2021. With passenger vehicles, though, I expect a quicker rebound and a more V-shaped recovery. Eaton’s eMobility business is primarily off-road at this point, and I think the market for off-road equipment will be weak into and through 2021.
What Comes Next?
Assuming Eaton completes the sale of Danfoss at some point in 2020, the company will have more financial flexibility to make further moves. While management has reiterated a commitment to returning capital to shareholders, they also made it clear that they are on the hunt for more M&A opportunities, with priorities including electrical (especially smart grid and industrial electrical), aerospace, and components pertaining to vehicle electrification.
Obviously companies won’t be eager to sell at current depressed multiples, but if the Covid-19 recession proves to be deeper and/or longer than presently expected, Eaton may have some opportunities with otherwise good businesses/products that simply cannot find enough liquidity to stay independent.
I expect 2020 will be a bad year for Eaton, though not much worse than its peer group. I do think Eaton has some exposure to longer-cycle businesses that could stretch out the recovery a bit, but I actually think Eaton now has an attractive mix of short-cycle, long-cycle, and acyclical business opportunities. Markets like commercial aerospace, non-resi construction, and oil/gas will probably need more time to recover, but opportunities like building retrofits, utility upgrades, data center newbuilds, and so on will offset that.
Longer term, I like the prospects for Eaton to grow at a 3%-plus rate (on revenue); management is targeting a 2% to 3% organic growth rate, and I think there will be further M&A to boost that growth. I also expect the changes made to the business will help boost FCF margins into the mid-teens, driving low-to-mid single-digit FCF growth.
The Bottom Line
As I said in the open, I now regard Eaton’s valuation as “borderline Buy”. The high single-digit prospective return is a little better than I see with names like Atlas Copco (OTCPK:ATLKY) and Dover (DOV), but not as good as what I see with Emerson (EMR) or Schneider. At a minimum, it’s still a stock I’d hold if I already owned, and if the market falls again, it’s a name to consider picking up.
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