Longer-Cycle Businesses Supporting Eaton

Eaton (ETN) has been one of my preferred industrial names for a little while now, partly due to the company’s particular end-market exposures, but also due to what I thought was a general underappreciation of the company’s positive qualities. That position has held up fairly well, as Eaton shares have outperformed its industrial peers over the last six months, including well-loved Honeywell (HON), and continued to report relatively healthy results in an increasingly difficult market.

I do expect Eaton’s growth to slow, but margins are holding up better and I still see some upside in the shares. I always encourage investors to shop around, and I’m a little concerned about overall valuation levels in the sector, but Eaton still looks no worse than okay.

Growth Is Fading, But Margins Are Hanging In

There are still several companies yet to report, but it looks like Eaton’s streak of posting above-average organic growth is over as the company slides into its own downturn a little later than the likes of

3M

(MMM),

Parker Hannifin

(PH), and

Regal Beloit

(RBC). Eaton’s revenue missed expectations by about 3%, due in part to weaker short-cycle results, but margins were better than expected and the company posted a $0.01/share beat at the segment earnings line.

Revenue declined 2% as reported and 1% on an organic basis, but gross margin improved by 40bp and segment profits grew by 4% (with an 110bp improvement in margin). Obviously, then, Eaton fell short of growth leaders like

(DHR),

(DOV),

Lennox

(LII), and

United Technologies

(UTX), but still managed a very good result in terms of margins.

Electrical Products posted 1% revenue growth and better than 5% segment growth, with over a point of margin improvement, while Electrical Systems & Services posted 3% revenue growth, 23% segment profit growth, and almost three points of margin improvement. Schneider (OTCPK:SBGSY) continues to outperform in electrical, while ABB (ABB), nVent (NVT), and others have seen slowing industrial demand. Specific to Eaton, non-residential construction is stubbornly hanging in there, and the data center market remains relatively healthy.

Eaton’s Vehicle segment reported a 12% decline in revenue, a 16% decline in segment profit, and 60bp of margin erosion. I’m surprised Eaton didn’t see a stronger benefit from the ongoing strong heavy truck production rates, and I’d also note that Eaton’s contraction here was well in excess of light vehicle production contraction (around 4%). Plenty of industrial companies with exposure to the auto sector have seen significant end-market deterioration, but this seems a little outsized to me given Eaton’s exposure to parts/components versus capex and the results of companies like

Illinois Tool Works

(ITW).

Hydraulics was expected to be weak, and it was, with revenue down 8% and profits down 23%. Business has gotten worse (orders down 14%) on growing weakness in mobile equipment (construction, ag, et. al), and I’d note weak results/lower expectations for companies like

Gates

(GTES) and Parker Hannifin as well.

Aero was a standout for Eaton, as would be expected given the results from companies like Honeywell and UTX. Revenue rose 8%, profits rose 23%, and margins improved more than three points, while bookings increased 13%.

A Worsening Environment, But Long-Cycle Helping

Eaton is definitely seeing a spreading weakness in shorter-cycle businesses, and that appears to be the main reason that management guided for lower revenue in the fourth quarter (with organic revenue contraction of 2%). Cyclical downturns for Eaton usually last around four to six quarters, so the company is still on the earlier edge of the curve.

I hate “it’s different this time” arguments in general, but there are some factors offsetting the short-cycle weakness in areas like industrial Electrical, Vehicle, and Hydraulics. The strength in aero is pretty well-understood, and I expect this to remain an area of strength for Eaton, particularly with the nearly $1 billion deal for

Souriau-Sunbank Connection Technologies

that will make Eaton the #2 player in electrical connections for aerospace. Eaton paid up for this deal, but it is a sound play on a growing trend away from hydraulic and toward electrification in many aerospace systems.

There are also some positive longer-cycle trends in Electrical, including healthy spending in utility/grid markets and ongoing healthy trends in data center (though Schneider seems to be leveraging this opportunity more effectively). Non-residential construction has remained stubbornly (and to me, surprisingly) strong, and companies tied into the commercial HVAC, fire & security, and elevator markets have continued to make generally positive comments on industry trends.

All told, I’d characterize around one-third to 40% of Eaton’s revenue by end-market as longer-cycle. I wouldn’t ignore the weakness in shorter-cycle businesses, though. It’s unclear that the auto market has bottomed, general industrial is still weakening, and heavy trucks and mobile machinery are really just starting the downturn.

The Outlook

Eaton’s sale of its lighting business to

Signify

(OTCPK:PHPPY) was an interesting, if not unexpected, development in my mind. The Street seemed surprised with the valuation (lower than expected), but I’m not sure why they thought a lighting business would get a premium valuation. In any case, I wonder if this will tamp down some of the calls for a more aggressive break-up at Eaton – I am on record as saying I don’t think such a break-up would be value-added and that many analysts and investors were overstating the value-add that would come from such a thing. Maybe this transaction helps bolster that argument.

I’ve moved a few modeling assumptions around since my last article, but not much changes at a high level. I still expect Eaton to be a low single-digit grower on the top line with some margin/FCF leverage leading to a mid-single-digit FCF growth rate.

The Bottom Line

I believe fair value for Eaton is in the low-to-mid $90’s now, with a DCF-based long-term high single-digit annual return expectation. There aren’t a lot of screaming bargains among Eaton’s peer group, and I think the valuation is reasonable, but from a strategic perspective I do have some concerns about what slowing revenue will mean for near-term share price performance. Should Eaton sell off, I’d get more interested in the name, though I still think it’s an okay hold.

Disclosure:

I am/we are long ABB, 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.