Eaton Corp.: A Strong Company With Limited Upside Potential
Summary
- Eaton is a strong company with solid perspectives as it could benefit from both the households and corporate increased focus on energy efficiency and sustainability.
- Company’s guidance on 2021 results indicated the positive perspectives. Organic growth guidance midpoint rose from 5% in February to 8% in May and to 12% in August.
- We believe that the stock is fairly valued at current level, as indicated by our DCF model and by multiple valuation. For this reason, we think that only very long-term investors should consider buying the stock now.
metamorworks/iStock via Getty Images
Eaton Corp. (NYSE:ETN) is one of the Wall Street oldest names, being listed since 1923. As proudly remembered by the company website, Eaton is the 15th oldest company listed on the NYSE.
It is a sign that it was able to evolve over time and to face very tough period having navigated trough two world wars, the 1929 great depression, the 2008 great financial crisis and many others recession and political turmoil. The company has always paid a dividend since the first year of its quotation, another sign of its solidity.
Eaton is active in the power management sector, serving companies and households in managing electrical, hydraulic, and mechanical power more efficiently. Company's operations are dividend in six segments with the following revenue and operating income breakdown.
The electrical Americas segment is the most relevant considering both revenue and operating income, followed by Electrical Global and Vehicle. The latest should increase its weight over the next few years, expanding at a higher pace than company's average for the boom of electrical vehicles.
The stock performance over the last few years has been brilliant. Eaton has overperformed the S&P 500 both over the last 5 years (+171.2% against 120%) and over the last year (53.5% and 39%).
However, following the September correction, the stock has lost relative strength and it is still below the all-time high post on August 25th at USD170.21 albeit the broader market increase to new historical records.
Investment thesis
Eaton is a strong company with solid perspectives as it could benefit from both the households and corporate increased focus on energy efficiency and sustainability. We think that the ongoing energy transition and electrification processes will attract strong investment in the sector, sustaining the companies that supply the final clients. It could also benefit from the digitalization process, especially in the chemical sector.
The company's guidance on 2021 results indicated the positive perspectives. Organic growth guidance midpoint rose from 5% in February to 8% in May and to 12% in August. Segment margin guidance midpoint rose from 17.8% to 18.3% and then to 18.6%.
Source: Eaton Q2 results presentation
Eaton also expects the positive trend to continue over the next few years, with EPS growing at 11-13% CAGR in the period 2020-2025.
However, we believe that the stock is fairly valued at current level, as indicated by our DCF model and by multiple valuation. For this reason, we think that only very long-term investors should consider buying the stock now. In the short-term we see low possibilities that the stock could overperform the S&P500, unless Q3 results due for publication on November 3 show strong positive surprises.
Q3 results should confirm solid perspective but major positive surprises are unlikely
Eaton is going to publish Q3 '21 results on November 3rd. We expect the company to post a 9% revenue increase to USD5bn, led by the positive recovery in all the segments. Despite the improvement from Q3 '20, revenue should still remain below Q3 '19 at USD5.3bn.
Net income should rise from USD446m to USD550m, a 23.3% increase.
We think that investors' focus will be on the possibility that 2021 guidance would be raised once again by the management. As indicated in the chart we published in the investment thesis section, the company raised both the organic revenue growth estimate in May and again in August. Unless a strong positive surprise from Q3 results, we expect a weak reaction.
Valuation
To value Eaton we constructed a DCF model using the following assumptions:
- EBIT growing at 17.8% CAGR in the period 2020/2025.
- Average capex of 2.5% of revenue per year in the period 2021-2025, in line with last few years' average.
- WACC of 7.5%, reflecting the 90% equity/10% net debt capital structure.
- A perpetual growth rate of 2.5%. While we usually adopt a 1.5% perpetual growth rate for industrial company, we think that Eaton deserve a higher rate as the energy transition process will have a long-lasting impact on all the companies that will benefit from it.
Source: RadaEcoWatch estimates
The DCF model based on the previous assumptions returns a USD167.5/share target price, in line with October 29th October close.
A multiple analysis returns a worse picture of the stock. It is trading at a '22 P/E of 31.2x, well above the last 10 years' average of 19x. According to our estimates, the P/E ratio should return to a value in line with last few years' average only in 2024.
The projected '22 dividend yield is also now below historical average (1.9% against the 2011-2020 average of 3.1%). As indicated by the following graph, the dividend yield should remain well below the long-term average for the foreseeable future).
While a higher than historical average valuation depends on low government bond yield, we think that the upside potential in the current scenario is contained.
The view from the "Street"
Despite our skepticism on the short-term upside potential, equity analysts covering the stock at major Wall Street investment banks have a positive view on the stock: 15 out of 25 analysts have a bullish or very bullish view on the stock, while only one analyst has a Sell recommendation.
Source: seekingalpha.com
However, the average target price has been recently revised down to USD172.86, in line with the valuation of our DCF model. It signals that equity analysts also believe that the stock upside potential is limited.
The downward revision EPS projections for both 2021 and 2022 is another sign that analysts' optimism on stock outlook is lower than implied by recommendations.
The Piotroski score confirms a cautious stance on the stock
The Piotroski score also gives a cautious message on the stock in the short-term. Having remained in the bullish territory (index between 7 and 9) for the period 2014-2020, we expect it to decline to six at 2021-end. The index should confirm that Eaton is a solid company, but the possibilities to overperform the S&P 500 are limited.
The Ebit/Enterprise value ratio declined in 2019 and 2020 and it is expected to rebound over the next few years. However, it should not return to pre-Covid levels (average of 8.2% in the period 2012-2020) by the end of 2025. Despite the steady improvement over the next few years, we expect the ratio to remain below the company's WACC.
Conclusion
Eaton is a strong operating company with solid long-term perspectives. However, the short-term upside potential seems limited as the stock is fairly valued according to out DCF model. A multiple analysis, Wall Street equity analysts' consensus valuation and the Piotroski score confirm our view on the stock. For this reason, we think that only long-term investors should consider buying the stock now.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.