If there's a benefit to reporting earnings later in the cycle, it may be in that investors have time to adjust their expectations as other companies report. That would seem to be the case for Eaton (NYSE:ETN), as the market's reaction to a small quarterly miss and lower guidance has gone along the lines of "well, it could have been worse. While it's going to take time for Eaton to get on a better track (probably not until the second half of 2013) and valuation is not that compelling today, investors should still keep an eye on this quality diversified industrial.
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Eaton Reports a Weak Quarter
Although Eaton did technically miss expectations on both the top and bottom lines this quarter, the trend of analyst revisions (not to mention reports from comparables such as Cummins (NYSE:CMI), Honeywell (NYSE:HON) and General Electric (NYSE:GE)) should have had investors pretty well prepared for this result. Revenue fell 4%, as reported, with core revenue down 2%.
The Electrical Americas business was the standout this quarter, as revenue grew 6%. That concludes the good news portion; Aerospace was flat, while Electrical ROW was down 3% (core), Hydraulics was down 4% (core), Auto was down 12%, and Truck was down 23%. Relative to expectations, Electrical did all right, while Hydraulics, Auto and Truck were surprisingly weak.
Eaton did relatively better on the margin side, though there were a lot of moving parts. Gross margin improved by nearly a point, while segment operating profit worsened by about 5%. While Eaton's segment operating margin was pretty close to the average sell-side expectation, surprising strength in the Electrical business helped offset worse results in Hydraulics, Auto and Truck.
No Good News Today...and Probably Not Tomorrow
Looking ahead from the third quarter, Eaton management was cautious. Looking at the end markets that the company serves, management revised growth expectations lower across the board (except for Electrical ROW and Aerospace), with Hydraulics, Auto and Truck all unsurprisingly seeing the largest downward revisions.
To be clear, this was not a terrible quarter, at least not on a relative basis. Honeywell reported similar softness in hydraulics and auto, while a host of companies including GE, Siemens (NYSE:SI), Parker Hannifin (NYSE:PH) and Cummins would back up the company's caution on Hydraulics, Electrical, Auto, Truck and Aerospace. For those interested, Eaton is still most bullish on the Electrical Americas and Aerospace end markets, where management sees growth of 6% and 4%, respectively.
Looking ahead, management called for fourth quarter revenue to largely match third quarter results. While that suggests about 6% downside to prior sell-side estimates, the strength in Electrical (and signs of recovery in residential and commercial construction) should mitigate the disappointment, as will (I imagine) the probability that most analysts expected some sort of negative revision.
The Bottom Line
Although there is a risk that Europe doesn't right itself until 2014 and the upcoming "fiscal cliff" gut-punches U.S. growth in 2013, Eaton is still a well-run company operating in several attractive businesses. Along those lines, I expect that management will continue to target select tuck-in acquisitions across various emerging markets (the company has bought businesses in Chile, Turkey and Korea in the last five months) and continuing executing on its long-term plan.
The downside for investors is that the Street is pretty well aware of that long-term plan and happens to like it. Consequently, even mid-single digit revenue growth and significant improvement in free cash flow (FCF) margin (which combine to point to low teens free cash flow growth) isn't enough to generate a price target much past the mid-$50s. Although a sharper pullback (which I don't really expect), would certainly lead me to revisit Eaton shares, there are other industrials out there today that are just as good and significantly cheaper.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.