The whole point of equity investment to assess, and discount, the value of tomorrow's earnings into today's dollars. To that end, Eaton (NYSE:ETN) is an interesting story. I believe the company is getting through the worst in the hydraulics and vehicle businesses, and that the electrical business should see many years of solid growth. On the other hand, the market already likes this stock quite a bit, and it looks like investors need to go elsewhere for a bargain.
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First Quarter Results Weren't Good, But That May Be The Worst
There certainly wasn't an abundance of good news in the Eaton first quarter results. Although revenue was up a reported 34%, sales missed the average analyst estimate and organic sales were down 5%.
There really wasn't any strength to be found here. The best result, in aerospace, was just 2% organic growth, while the electrical systems and services business was flat. Electrical products saw a 4% organic decline, while vehicle revenue fell 8% and hydraulics were down 9%.
Margins were so-so, as gross margin declined about 80bp from the year-ago level. Reported operating income was up about 17%, and relatively close to the midpoint of expectations. On a more positive note, though, the synergies from the Cooper deal seem to be coming along nicely, and this will likely go down as a very successful deal.
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One Of The Weakest Industrial Stories, Mostly Because Of Market Exposures
Relative to its industrial peers, Eaton looks quite weak today. Only General Electric (NYSE:GE), Illinois Tool Works (NYSE:ITW) and Atlas Copco (Nasdaq:ATLKY) were meaningfully worse in terms of first quarter revenue performance, and Eaton definitely trailed the performance of peers and rivals like Honeywell (NYSE:HON), ABB (NYSE:ABB), and Emerson (NYSE:EMR).
I think it's important to take note that a lot of this underperformance comes from the different market exposures. In particular, Eaton was hurt by its exposure to the hydraulics and vehicle businesses. Hydraulics saw a big negative impact from the company's exposure to the Chinese construction equipment industry, and the performance here was on par with Parker Hannifin (NYSE:PH), but worse than Honeywell. Likewise in the vehicle business – Eaton underperformed peers like Honeywell and Illinois Tool Works, but largely due to the company's much higher exposure to commercial vehicles.
Up From Here?
Industry surveys and data from manufacturers like Sany has been suggesting that the Chinese equipment market is past the worst. That bodes well for the hydraulics business, and Eaton management did point to a sizable sequential increase in orders. Likewise, while there are risks to light vehicle production numbers (particularly in Europe), most of the commercial vehicle component suppliers are saying that they think this is about as bad as it will get for this cycle.
This optimism could certainly prove to be misplaced, and it's worth noting that when Emerson reported recently, management was pretty skeptical about the much-anticipated second half recovery. Nevertheless, I do believe Eaton's electrical business is slated to see improving demand, both this year and in the years to come. What's more, the company's solid positioning in energy efficiency and alternative energy bodes well for its long-term competitiveness.
The Bottom Line
My biggest complaint about Eaton is one that I've had for some time now – the stock is not cheap. It wasn't cheap at the last quarterly report either, and the stock nevertheless climbed another 10% as the industrial sector continues to attract investors positioning for the eventual recovery. So it's well worth noting that a rich valuation is no obstacle to further appreciation in this bull market.
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On the basis of my model for the company, I think fair value is around $60 today. I'm looking for long-term revenue growth of about 5% and free cash flow growth of nearly 10% - numbers that would make it among the best growth stories I follow in the large industrial sector. Even so, I believe the company will really have to exceed expectations to offer better risk-adjusted total returns than ABB or GE from today's level.
At the time of writing, Stephen D. Simpson owned shares of ABB.