Eaton – Well-Balanced, But Forever A Bridesmaid?

By Stephen D. Simpson, CFA | October 27, 2011 AAA

Even granting that Eaton (NYSE:ETN) has never had the greatest return on invested capital of industrial conglomerates, nor the highest conversion rate of revenue into free cash, the company and stock seem often overlooked. After all, this is a company that is well-balanced between many industrial markets and across the economic cycle. Yet, analysts and institutional investors seem to always be looking to move the brass ring just a little further out of reach.

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A Respectable Third Quarter
Perhaps part of the problem with Eaton is that they don't post the eye-popping growth that investors get from Cummins (NYSE:CMI) or Caterpillar (NYSE:CAT). After all, growth in the third quarter was a bit under 16% as reported and about 11% on an organic basis - clearly less than that seen at CAT/CMI, though in line with others like Parker Hannifin (NYSE:PH) and Honeywell (NYSE:HON) that compete in many of the same end markets.

While the company's electrical business is still far and away the largest single business, reported growth was led by the hydraulics and truck segments at 23 and 34%, respectively. Electrical and aerospace came in as the laggards, with growth of 9 and 8%.

Like seemingly ever other company in the sector, Eaton is seeing some profit compression. Gross margin dropped about a point, hurt by factors like increasing input costs and foreign exchange. Overall profitability was strong, though, as the company saw operating income rise 34% and segment operating profit rise almost 35%. While profitability in the electrical segment was down (about 3%), profits were up strongly in hydraulics, autos and trucks.

Mixed End Markets
One of the supposed advantages of Eaton's business model is that it smooths out the ups and downs of individual markets. To wit, while demand in industrial power isn't bad, plenty of other companies like Cooper Industries (NYSE:CBE), Honeywell, Schneider, Emerson (NYSE:EMR) and Siemens (NYSE:SI) have seen challenges from the soft commercial building market (though emerging market construction is on fire). At the same time, the demand for construction, mining and agricultural equipment from Caterpillar, CNH (NYSE:CNH) and Deere (NYSE:DE) is a boon for the company.

Along similar lines, while the North American market for cars and trucks has eased a bit, Eaton is still seeing strong demand from customers like Daimler, Ford (NYSE:F) and Scania in emerging markets like China, Brazil and India.

Sooner or later, the emerging market growth will slow. At that point, though, perhaps the North American building market will be in recovery mode. Likewise, maybe the solar inverter market (which is not doing well now) will rebound, or the aerospace industry will be in the middle of one of its cyclical uptrends. (For more, see The Ups And Downs Of Investing In Cyclical Stocks.)

The Bottom Line
For all the talk of whether companies like Eaton, Caterpillar, Honeywell or Siemens are "early-stage," "mid stage," or "late stage," the fact remains that they all need a healthy economy (or at least healthy segments of the economy) to prosper. Right now, most of Eaton's businesses are doing fairly well, even if some are lagging a bit. The risk, though, is that order momentum seems to be softening across the board and there are multiple warning signs that margins may have peaked for the sector as a whole. That is a troubling headwind for a stock that the Street seems to often discount.

All of that said, investors in Eaton can take some solace in the relatively unchallenging valuation. Mid-single-digit revenue growth and only modest improvement in free cash flow conversion should position the stock to perform meaningfully better than the broader market over the next three to five years.

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