Record Margins Despite Labor And Supply Constraints
Eaton Corp. (ETN) delivered record operating margins and EPS in their 4Q 2021 results. The company also forecasted even higher margins on top of 7% – 9% organic sales growth for 2022. The company accomplished this in the face of supply chain constraints and pandemic-related labor shortages in some segments. This result is due in part to the high level of portfolio optimization the company undertook in 2021, selling its low-margin Hydraulics business and completing acquisitions across both Electrical segments, Aerospace, and eMobility.
Looking more closely at the segment results, we can see the drivers of this growth. The Electrical Global segment improved its margins, which are now similar to the Electrical Americas segment which experienced more supply chain and labor issues in 4Q. Both electrical segments saw orders grow over 20% and backlog over 50% from one year ago. Residential and data centers continue to be the end markets driving growth.
The Aerospace segment was strong thanks to the recovering commercial aviation business but also benefitted from the acquisition of defense supplier Cobham Mission Systems. Orders and backlog are each up in the teens.
The vehicle segment slowed a bit in the quarter. The heavy truck market continues to be strong but light motor vehicle customers remain affected by supply chain issues. Eaton sees this turning around in 2022 as considerable inventory rebuild will be needed by auto dealers.
2022 looks even better than 2021 in terms of margins, and sales growth will remain healthy at 7%-9%.
The market was not impressed, with the stock trading down 3.7% on the day of the earnings report and leaving it 14% below the highs reached shortly after the release of my last article in November 2021. I rated Eaton a hold in that article based on valuation. Not only has the stock pulled back since then, but the impressive order growth and margin performance have made me more confident the company can continue growing EPS by double-digit percentages. The $185 price target from my November article is still reasonable, but the pullback in the stock since then now makes it a buy with 22.5% upside.
Optimizing The Portfolio
Eaton removed one of the more cyclical, lower-margin businesses from its portfolio when it completed the sale of its Hydraulics segment in August 2021 for $3.3 billion. The company plowed more than this amount back into two large acquisitions and several smaller ones to reduce cyclicality and improve margins.
Eaton bought Tripp Lite in March for $1.65 billion. The subsidiary makes UPS’s (uninterruptable power supplies) and surge protectors and is part of the Electrical Americas segment. This segment had 8% sales growth from acquisitions in 2021.
As noted above, Cobham Mission Systems was added to the Aerospace segment in June for $2.8 billion. Aerospace had 37% sales growth from acquisitions last year.
Eaton also took a 50% stake in two small electrical component manufacturers in China which are accounted for under the Electrical Global segment. The company also bought Green Motion, a Swiss provider of electric vehicle charging hardware and software.
eMobility – A Source Of Future Growth
Eaton’s eMobility segment was still as small as a rounding error on the financial statements in 2020 and 2021, but it will be a significant source of growth. The segment is expected to produce its first operating profit in 2022 but real growth is further out. Eaton made its first acquisition of 2022 in this segment, buying Royal Power Solutions for $600 million in January.
On the earnings call, management alluded to their objective to make the segment “a $2 – $4 billion business inside of Eaton.” That would make it the third largest of the five segments accounting for around 15% of the company’s total sales. The programs already in development within the segment are expected to contribute $800 million per year in sales.
While it will take some time to achieve this level of sales, it is currently an underappreciated source of growth for Eaton that is not reflected in the share price.
Earnings Model Update
I have updated the earnings model I used in previous articles with the company’s 2022 guidance. I used midpoint growth rates from the slide above, except for Electrical Americas and Aerospace where I conservatively used the low-end assumptions to account for ongoing supply chain issues. Similarly, I used midpoint margin assumptions, except for lower end numbers for Electrical Americas and Vehicle. The resulting EPS of $7.70 falls at the top end of the stated company guidance range of $7.30-$7.70, so it appears the company is adding a conservative overview to the overall company guidance. For 2023, I use midpoint assumptions across the board, except for eMobility, where I assume 20% sales growth and 15% margins.
In non-operating expenses, for 2022 I am assuming acquisition amortization expense, interest, and other costs consistent with management guidance. For 2023, I hold these costs constant except I use zero for pension, acquisition, and restructuring charges. Note that amortization, acquisition/divestment costs, restructuring, and other costs are excluded from non-GAAP earnings.
The company guided to a relatively low share buyback of $250 million in 2022. I show that they have about $936 million available free cash flow after dividends and buybacks, but $600 million of this was already spent on Royal Power Solutions. For 2023, I assume no acquisitions, allowing for $1.5 billion of share buybacks. I assume dividend increases of $0.03 per quarter each year.
The resulting non-GAAP EPS projections are $7.70 in 2022 and $8.70 in 2023 which represents a 13% growth rate for the next year. At the closing price on the day of the earnings release, P/E’s on these estimates would be 22.8 times 2021 earnings, 19.6 times 2022, and 17.4 times 2023.
Valuation And Conclusion
In my November article, I calculated a fair value estimate for Eaton using a fair P/E of 28 times 2021 EPS. (PEG ratio of 2 and growth rate of 14%) I got lucky and estimated Eaton’s 2021 EPS correctly to the penny at $6.62, resulting in a fair value of $185 per share.
If I follow the same methodology and roll the base earnings year forward to 2022, we have a current year EPS of $7.70 and an EPS growth rate of 13%, meaning fair value would be $7.70 x 26 = $200 per share. However, due to increasing interest rates and the fact that my EPS estimate is at the high end of the company range, I will leave the fair value estimate at $185.
Compared to close peer Emerson Electric (EMR), Eaton is valued similarly. They also have a similar growth rate over the 2021-2023 period, although Eaton has more growth in the final year.
At $151, Eaton stock has 22.5% upside to my $185 fair value estimate. That is considerably more margin of safety than existed in November. From a technical viewpoint, the share price is near support at the October 2021 lows around $149. Fundamentally, Eaton is a different company than it was 10 or 20 years ago thanks to the high degree of portfolio optimization that management did in 2021. I don’t consider the lower long-term average P/E very relevant in this case. Rising interest rates and slowing growth are a risk for any stock, especially in the Industrial sector. However, Eaton’s ability to continue growing sales and margins through supply chain constraints makes Eaton worth buying now while the stock is on sale.