HON - Eaton And The Never-Ending Debate Over How Much To Pay For Growth

2023-05-04 11:14:06 ET

Summary

• Eaton posted good first quarter results, with revenue and segment income outperformance and upgraded full-year revenue growth guidance, but segment-level margins were mixed.
• The Electrical business remains the primary growth driver for Eaton and while a global economic slowdown is a modest near-term threat, the multiyear growth outlook is exceptional.
• The biggest issue I have with Eaton is that high expectations and high valuation could crimp long-term returns from here despite above-average growth potential.

I continue to believe that Eaton (ETN) is not only a well-run company, with a management team that is focused on both organic growth and margin opportunities and has been savvy with capital allocation, but a company with among the best multiyear secular growth outlooks in the industrial group. The challenge, as is often the case with stocks like this, is just how much of a premium investors should pay for that superior outlook.

Eaton shares are about flat since my last update in early March, and given that I did have some concerns about valuation in the near term, I can't say that the slight underperformance versus the wider group (as well as individual stocks like ABB (ABB), Hubbell (HUBB), Schneider (SBGSY) surprises me too much. I still believe in the long-term outlook, but I do note that the shares already price in a lot of success.

Mixed Trends In Q1, With Good Revenue And Backlogs, But Some Margin Turbulence

Expectations were high for Eaton going into this quarter, and I would say that the results presented (and the update to guidance) were quite good but perhaps not so exceptional in the context of those elevated expectations.

Revenue rose 15% in organic terms, which was good for a nearly 5% beat versus expectations. Eaton's Electrical business once again drove a lot of the upside, with overall sales up 16%, including Americas up 22% (beating by 7%) and Global up 8% (beating by 4%). This growth matched that of ABB's Electrification business (up 16%), while Schneider did even better with nearly 18% growth.

Aerospace revenue grew 12% organically, with a 4% beat suggesting that the Street is better dialed in to this business after several misses. Honeywell ( HON ) did a little better with 14% growth, as did Parker Hannifin ( PH ), but I wouldn't say this was a poor result. Vehicle revenue rose 11%, beating by 4%, a little less than the 12% growth at BorgWarner ( BWA ), but better than the 10% at Dana ( DAN ) and the 9% at Allison ( ALSN ). Organic sales in the eMobility business rose 18%, missing by about 10%.

Gross margin improved 190bp yoy and 30bp qoq, beating by over a point, and improved supply did help the business in the quarter. Adjusted operating income rose 23%, with margin up 400bp to 17.3%, while segment income rose 19%, beating by more than 4%, with margin up almost one point to 19.7%.

Segment-level results were a little more mixed relative to expectations. The Electrical business grew 25% (margin up almost two points to 21.1%), but while the Americas segment margin (22.9%) beat by almost 140bp, the Global segment (18.3%) missed by more than a point. Likewise, Aero (profits up 13%, margin up 30bp to 22.4%) was 40bp short of expectations, while Vehicle (profits down 5%, margin down 230bp to 14.5%) missed by two points and eMobility (negative 2.7%) missed by close to four points.

The Near-Term Outlook Has Some Slowdown Risk, But The Long-Term Outlook Is Bright

Thus far second quarter industrial earnings have generally been pretty good, with industrial demand holding up reasonably well despite some weak indicators (like the PMI) and growing weakness in consumer-facing businesses. Caution is still the order of the day, though, with many industrial company CEOs and CFOs warning that there could still be more obvious weakness on the way in the second half.

Eaton management raised their revenue growth expectations for the year by about 200bp to 9%-11%, and both the Electrical and Aerospace businesses look well-set for good results. Guidance was softer on margins (maintained despite the higher revenue base).

Electrical orders were up 12% on a trailing 12-month basis (Americas up 18%, Global up 4%), which is a marked slowdown from the 34%/11% growth seen in the prior quarter and does support a somewhat more cautious near-term outlook as construction activity comes under more pressure and data centers go through a digestion phase. Aerospace remains strong, though, with a 21% increase in trailing orders this quarter.

I do believe that a weaker economy and weaker new-build trends in non-residential construction are short-term risks for Eaton, but I believe they're manageable risks. Likewise, there could be some modest downside to aerospace and vehicle recoveries if the global economy slows further.

Longer term, though, I have few worries. Eaton remains exceptionally well-leveraged to growth in electrical equipment demand for years to come. I've talked before about Eaton's leverage to commercial building renovation (supported in part by the Inflation Reduction Act) and its leverage to automation through electrification, and I believe both are multiyear trends.

I'm also still bullish on data traffic-driven growth in data centers, as well as the electrification of many industries (including cement, metals, and so on). Eaton is also leveraged to near-shoring, as companies building new factories and facilities in North America and Europe will generally be investing in state-of-the-art facilities as well as automation. Likewise, the growth of certain categories of manufacturing, like semi fabs and battery factories in North America and Europe, should drive healthy demand for Eaton's electrical products.

The Outlook

It wasn't all that long ago when Eaton was targeting 1% to 2% top-line growth, but the transformation of electrification opportunities has been a game-changer for the company, and management has likewise pivoted away from slower-growing opportunities in favor of building up its leverage to electrification (including vehicle electrification) and aerospace. At the same time, management has credible targets in place to drive segment-level margins over 21%.

I'm still comfortable with a long-term revenue growth rate of over 5%, and I expect Eaton to exceed that for several years. I also expect improved free cash flow conversion/generation, with adjusted FCF margin improving from a historical trailing average around 10% to closer to 15%, helping drive low double-digit annualized FCF growth. My biggest concern here is whether or not there's really as much upside left in margins as management expects, but this is a concern I have about many industrials after years of rigorous margin-improvement efforts.

Discounting those cash flows back, I believe Eaton is priced for a long-term annualized return in the mid-single-digits. That's not an exceptional return, I usually want a prospective return in the high single-digits or better, but I can appreciate that Eaton gains a premium given the recent strength of its execution and the well above-average outlooks for its major addressed markets. I do also note, though, that the shares trade at over a three-point premium to what would normally be a "fair" EBITDA multiple based on margin and returns (ROIC, et al).

The Bottom Line

The worst things I can say about Eaton is that expectations are already high, the growth opportunities are well-understood by the Street, and there could be some near-term softness in the global economy that ultimately weighs on Eaton's revenue and order growth. I still believe this is a top-tier industrial company, but the question of whether it's a top-tier investment idea is more debatable - I support the idea of paying up for quality, but even with the best companies/stocks there can be a point where those premiums ultimately weigh on future returns.

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