2023-09-06 03:23:40 ET
Summary
- Eaton's stock has performed well, outperforming the S&P 500 by about 120 percentage points since our last update on Seeking Alpha.
- In light of the firm's massive share-price advance from April this year, we think the company's equity may have run too far too fast.
- Eaton's long-term outlook is positive, but there are better investment opportunities available at the moment, in our view.
By Valuentum Analysts
We haven't written about Eaton ( ETN ) on Seeking Alpha for quite a while, so we thought it was time to provide an update on our thoughts. Our last article on Eaton on Seeking Alpha was written all the way back in May 2016. Back then, we talked about Eaton's then-recent acquisition of Cooper, how the company was focused on margin expansion, and its debt-reduction efforts. Shares were trading about in-line with our fair value estimate back then, but it's fair to say the company has done a fantastic job driving value creation over the years, as our fair value estimate today is a number of times that of a number of years ago. In this article, we'll do a deep dive into Eaton's financials and explain how we arrive at our updated fair value estimate for shares.
Since our last update on Seeking Alpha, the company's shares have endured the ups and downs of the global economic cycle, a once-in-a-century pandemic and more. Through all of this, Eaton has managed the external environment quite well, and shares reflect that. Over this time period, Eaton has outperformed the S&P 500 ( SPY ) by about 120 percentage points, which is impressive given the cyclicality of its industrial end markets. Its strong share-price run from April of this year, however, has driven its equity to a level greater than our updated fair value estimate, suggesting that, at least for the moment, Eaton's stock isn't as attractive as others on the market.
There are a number of risks to our thesis on Eaton, which can be summarized by saying that the company's shares have run too far too fast. For starters, the company can continue to deliver on value-generating acquisitions, which we do not embed within our valuation infrastructure, as we typically assume within our valuation model that any future unannounced acquisitions will be net-neutral to its underlying fair value. This is standard practice with respect to valuation as the price paid for any future unannounced target is something that we cannot possibly know. In the event that the global economic environment performs better than our expectations or if Eaton drives upside in its operating margin relative to our forecasts, an upward fair value estimate revision may also be warranted. In any case, while we like Eaton, we prefer ideas in this article instead.
For those not familiar with Eaton, the company delivers power management solutions that make electrical, hydraulic, and mechanical power operate more efficiently. The firm serves the electrical, hydraulics, aerospace, truck, and automotive end markets. Electrical and aerospace offerings account for a significant percentage of its profits. The company was founded in 1916 and is headquartered in Ireland. Multiple secular trends are driving Eaton's business over the long haul: population growth is pushing electricity demand higher; environmental concerns and increased regulation are requiring increased innovation, as is the case with the push for greater energy efficiency; and intelligent products and connectivity are driving new avenues for value creation.
Eaton's operating margins are expected to rebound significantly going forward versus subdued levels seen during the worst of the COVID-19 pandemic. The company is targeting a free cash flow conversion ratio of approximately 100%, which we're huge fans of. Eaton remains highly acquisitive, something that we're okay with given how much value it has generated from recent deals, namely its Cooper transaction. Recent deals include its acquisition of Tripp Lite in 2021 for ~$1.65 billion and Royal Power Solutions in 2022 for ~$0.6 billion. Eaton sold its 'Automotive Fluid Conveyance' business in 2019 and its 'Lighting' business in 2020. With all of these moving parts, Eaton's net debt load is something to watch closely. We generally prefer companies with net cash positions because net cash is an add back to the present value of discounted enterprise free cash flows within the discounted cash-flow process.
Eaton's longer term outlook is quite bright as it caters to the "electrification of everything" trend. Inflationary, labor, and logistical challenges have created significant hurdles for its business in the near term, but organic growth trends have been robust. For example, in its recently-reported second quarter results , the company put up record quarterly earnings per share, strong double-digit organic growth, material segment margin expansion, impressive free cash flow growth, and meaningful backlog expansion. However, within our valuation infrastructure, we're building in some strong expected free cash flow expansion (please view the pro forma cash flow statement at the bottom of this article), and our fair value estimate still comes up short compared to Eaton's current share price.
As is commonly accepted in finance, one of the best measures of a company's ability to create value for shareholders is expressed by comparing its return on invested capital [ROIC] with its weighted average cost of capital [WACC]. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Eaton's 3-year historical return on invested capital (without goodwill) is 18.7%, which is above the estimate of its cost of capital of 9.1%. As such, we assign the firm a ValueCreation rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line (above) reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Eaton's free cash flow margin has averaged about 10.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow [FCFF], which we use in deriving our fair value estimate for the company. At Eaton, cash flow from operations decreased from levels registered two years ago, while capital expenditures expanded over the same time period. However, our valuation model assumes considerable free cash flow generation in the coming years. For this year, we're expecting free cash flow of ~$3.1 billion, for next year ~$3.9 billion, and over $5 billion the year after that.
We think Eaton is worth $193 per share. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. The next couple years don't account for much when it comes to intrinsic value (see image below), so we tend to come in about in-line with consensus estimates and management guidance to varying degrees across our coverage universe within our discounted cash-flow infrastructure.
Our valuation model reflects a compound annual revenue growth rate of 6.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1%. Our valuation model reflects a 5-year projected average operating margin of 19.7%, which is above Eaton's trailing 3-year average. Organic growth continues to be strong at Eaton with the company expecting 10%-12% expansion in 2023 alone. The company lists the following growth megatrends, too: Electrification, Energy Transition, Digitalization, Infrastructure Spending, Reindustrialization, and Green Regulations.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity (we use 3% as a standard long-term perpetuity growth rate across our coverage). The growth rate from years 6 through 20 represents a fade in the growth rate from Year 6 through the perpetuity growth rate. Though long-term forecasting is fraught with estimation risk, the company's strong Electrical sector and Aerospace backlog help support such a view. For Eaton, we use a 9.1% weighted average cost of capital to discount future free cash flows, which we think adequately reflects its risk profile.
In the chart above, we show the build up to our estimate of total enterprise value for Eaton and the break down to the firm's total equity value, which we estimate to be about ~$77.5 billion. Eaton's market cap stands north of $90 billion at the time of this writing. The present value of the enterprise free cash flows generated during each phase of our model and the net balance sheet impact is displayed. We divide total equity value by diluted shares outstanding to arrive at our $193 per share fair value estimate.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Though we estimate the company's fair value at about $193 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Eaton. We think the firm is attractive below $154 per share (the green line), but quite expensive above $232 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
The application of a margin of safety helps readers conceptualize the risk to any long-term forecasting with the discounted cash flow model, but there are more general risks to industrial entities, too. In particular, demand for products in the industrial electrical equipment space is highly cyclical, and Eaton is exposed to volatile raw-material costs, which at times can be difficult to pass along to customers. Product development and quality initiatives are sources of competitive strengths, but rivals often compete aggressively on price to gain share. Consistent with our long-range forecasts, the industrial electrical equipment market should grow at a GDP-like pace in the developed world and a multiple of that trajectory in emerging markets.
We estimate Eaton's fair value at this point in time to be about $193 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Eaton's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $243 per share in Year 3 represents our existing fair value per share of $193 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range. Patient long-term investors in Eaton may be okay as its equity value is expected to advance over time, but we think there are better opportunities out there for consideration, at least for now. We may revisit Eaton in the event its price-to-fair value estimate becomes more attractive.
For further details see:
Eaton Has Run Too Far Too Fast