2023-10-31 11:15:28 ET
Summary
- Eaton Corporation plc stock jumped 3% after reporting strong Q3 earnings, with adjusted EPS beating expectations and revenue increasing by 11%.
- The company's solid management, strong balance sheet, and favorable product mix have helped it remain resilient to concerns over an industrial downturn.
- Eaton's key end-market exposure in electrical is data centers, which are experiencing secular growth due to increasing reliance on the cloud.
Shares of Eaton Corporation plc ( ETN ) have been a strong performer over the past year, rallying in excess of 30%, and those gains continued on Tuesday as the stock jumped 3% in response to strong Q3 earnings . Eaton has proven particularly resilient to concerns over an industrial downturn, thanks to solid management, a strong balance sheet with just $9.1 billion in debt, and a favorable product mix.
In the company’s third quarter , Eaton earned $2.47 in adjusted EPS, besting consensus by $0.13 as revenue jumped by 11% to $5.9 billion. EPS rose about twice as quickly, up 22%, thanks to strong margin expansion. Segment margins rose 240bp to 23.6% powered by 46% incremental margins. Alongside these strong results, ETN raised full year guidance to $8.95-$9.05, representing 19% growth. This implies about $2.44 in Q4 earnings.
While revenue rose by $567 million from last year, cost of products sold rose by just $139 million. That speaks to the operating leverage ETN is enjoying (aided by normalization in some input costs). Factories, of course, have substantial fixed cost, and with increasing demand, ETN has been able to increase capacity utilization, leading to lower per-unit costs and strong margins. Overall, organic growth was 9% with 2% FX benefits. Importantly, R&D spending is up 11% this year. ETN continues to invest aggressively in the business even as it shows solid cost discipline.
Drilling into operating results further, its Electrical Americas segment had a 19% revenue jump to $2.6 billion while profits rose 41% as margins expanded by 420bp. While orders were down 3%, it lapped some favorable comps, and its backlog is also 19% higher, consistent with its sales growth. As you can see below, its backlog has grown tremendously over the past three years as demand for electrification has increased.
This backlog provides about three quarters of future revenue, providing ample cash flow certainly. That would assume no net orders, which is clearly excessively conservative as orders continue to outpace actual sales, leading to backlog growth. What I like about Eaton is that it is tied to U.S. construction & electrification trends more than global ones. Its business is benefitting from government incentives within the Inflation Reduction Act and Bipartisan Infrastructure Bill to improve energy efficiency and build. As you can see below, non-residential construction has surged since 2021. With these government programs still ramping up, I expect to see this elevated level of non-residential construction activity to persist.
Eaton’s key end-market exposure in electrical is data centers, and here there is secular growth as the world becomes increasingly digital, relying ever-more on the cloud. It is difficult to see this trend reversing. Management sees the end market for its power management solutions rising 16% per year. Considering the fact that energy usage by large data centers has been growing over 20% per year with Amazon (AMZN), Meta (META), Microsoft (MSFT), and Alphabet ( GOOG ) doubling their electricity use from 2017-2021, this seems like a reasonable, if not slightly conservative outlook.
Overseas, electric sales rose 1%, but profits were up 8% as margins expanded by 120bp. Orders also rose by 1%. There has not been the same tailwind in terms of government incentives overseas, which is a reason why growth here has been slower and why I view Eaton’s U.S.-centricity as a positive. However, there has been talk in Europe of increasing incentives to better compete with the U.S., following the IRA, which would provide an accelerant to growth.
Among smaller segments, aerospace saw a 13% rise in revenue and profits as orders rose 16%, sending its backlog up 22%. Impressively, profits are now at a record here. Autos rose 1% with 5% profit growth. The record in aerospace is impressive, considering airplane production is still down 10% from 2017 levels as Boeing ( BA ) is yet to fully recover. This speaks to Eaton increasing its content per plane. Given further room for recovery in this sector, I would anticipate ongoing growth.
This strong revenue and profit growth is translating to strong cash generation. During the quarter, Eaton had $1.1 billion in operating cash flow. It is now guiding to full year free cash flow of about $2.9 billion, which gives shares a 3.7% free cash flow yield at its current share price and a 22.9x current multiple.
Below, Eaton provided a view of how it sees its key end-markets performing next year. On a weighted average basis, this demand points to ongoing organic sales growth in the very high single-digits if not low-double digits. The world is electrifying, with U.S. non-residential construction a particular bright spot, and Eaton is sitting at the center of this trend supplying the products and power management tools to enable it.
While we may not see the same degree of incremental margin strength, I would continue to expect earnings growth to exceed revenue growth, looking for 12-15% growth or about $10.20/share in 2024 earnings. Considering consensus was just $9.75 pre-earnings, I expect a wave of upward revisions in coming days as this quarter is digested. This should also translate to about $3.15-$3.2 billion of free cash flow next year.
The electrification and data center trend powering Eaton’s business is a long-term one, not set to slow anytime soon. At 20x forward earnings, Eaton is not cheap. But with sustaining double-digit growth, ETN can support and grow into that multiple. I believe ETN can sustainably grow free cash flow north of 7% over the next five years, which when combined with its 3.7% starting free cash flow yield, should support 10+% returns over the medium term.
Much is priced in, but Eaton Corporation plc can provide low double-digit returns for long-term investors, and I expect shares to return to 52-week highs and pass $225 over the next year.
For further details see:
Eaton Delivers A Spectacular Q3 With Strong Secular Growth