Eaton's Conservatism Clashes With Street's Enthusiasm

By Stephen D. Simpson, CFA | August 06, 2013 AAA

Wall Street badly wants to believe in the narrative of a strong second half recovery, and companies that don't toe that particular line are seeing their stock prices suffer. While I didn't hear much that was really very new in Eaton's (NYSE:ETN) comments after the second quarter report, the Street took the shares down almost 6% as management's comments took the high end of guidance off the table. Although I do expect Eaton to reap good revenue growth from the Cooper deal, as well as long-term cost benefits and lower taxes, the shares are still no bargain unless you're willing to go with pretty exceptional growth expectations.

Sluggish Growth Continues In Q2
Eaton's peer comps continue to suffer due to the company's particular industry/market exposures. Even so, though, an organic revenue contraction rate of 2% doesn't come off as very compelling relative to ABB (NYSE:ABB), Honeywell (NYSE:HON), and so on.

Revenue rose 38% as reported due to the Cooper deal, but organic/core growth was a negative 2% for the quarter. Aerospace was the strongest (up 3% core), but it's also far and away the smallest business. The Electrical business was up a bit overall on a core basis, with Products flat and Systems and Services up 1%. Vehicle revenue was down 3%, though, and hydraulics was down another 9%.

Eaton's margins were okay, but not as good as the Wall Street bulls were projecting. Gross margin ticked up just a bit (below averaged expectations), while reported operating income rose 34% and the margin declined about 30bp. On a segment level, though, profits were up 46% and only hydraulics saw a worse margin.

Plenty Of Weakness To Go Around
There's plenty to look forward to down the line with Eaton's new electrical business. Not only can the company benefit from cross-selling between the old segments and the Cooper units, but the LED cycle should offer worthwhile upside. What's more, Eaton management seems to believe that PLCs will be less important in the future of industrial automation, and that it is better-positioned for this transition than rivals like Emerson (NYSE: EMR) or Rockwell (NYSE: ROK).

In the meantime, though, there isn't all that much to stoke the business. Eaton's electrical business is growing at around the same pace as WESCO (NYSE: WCC) right now, and the lack of significant momentum in construction is certainly holding things back. Likewise, the hydraulics business has yet to definitively bottom (orders were down 12% this quarter), while the commercial vehicle market is likewise still soft.

Are There More Chairs To Be Moved?
Given Eaton's balance sheet situation and the company's move to a less-volatile business model, I expect chatter to continue as to whether the company will divest its Vehicle segment. Even great companies like Cummins (NYSE: CMI) see a lot of cyclicality in the commercial vehicle market and management may see more long-term advantage in selling the business, using the proceeds to pay down debt, and hoping that investors assign a stronger multiple to an incrementally less cyclical business.

SEE: Is Cummins Building For Bigger Things?

All of that said, the lawsuit with Meritor (Nasdaq: MTOR) likely complicates the process significantly. Meritor is pursuing an anti-trust suit against Eaton, claiming that the company's pricing agreements with truck OEMs is illegal and hoping to wrest significant damages from the litigation. While I think the long-term financial impact to Eaton is not as great as feared, the uncertainty and the drawn out process of courtroom arguments, motions, and appeals, could limit Eaton's flexibility with the Vehicles unit for years.

The Bottom Line
I though Eaton was too expensive after the last quarter and with the post-earnings reaction, the stock has underperformed a bit since then. I still have no real issues with the quality of the company; rather, my problem stems from the Street being too optimistic about how quickly Eaton will reap the benefits of the Cooper deal and how robustly Eaton's markets will rebound. To their credit, management hasn't been egging on analysts to be excessively optimistic.

Adjusting for the Cooper deal, I'm looking for long-term revenue growth of almost 5% and free cash flow growth of close to 12%. Even at that level of growth, though, it's hard to go much above $60 with the fair value and that suggests that the excess capital gains potential of Eaton shares is limited today.

Disclosure – At the time of writing, the author owned shares of ABB

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