Eaton Offers Broad Exposure To Recovery And Acyclical Growth Stories

 

Eaton (NYSE:ETN) has been one of my favorite industrials for a while now, and it hasn’t disappointed. Up almost 20% since my last update, the shares have continued to outperform the broader industrial space, with even bigger positive performance gaps on a year-to-date, one-year, and two-year comparison. Simply put, the Street loves how management has used M&A to refine the business mix, while also positioning the company for some attractive long-term growth opportunities in multiple industries and further operating leverage.

I don’t think Eaton is cheap anymore, but then the list of quality industrials that are is very short. About the best that I can do is stay that a 2-point premium to the larger multi-industrial group on ’22 EV/EBITDA (around 17x versus 15x) doesn’t seem unreasonable for a company with attractive long-term growth opportunities. Right now I’m torn between the less attractive long-term prospective returns at this valuation and the “don’t get off a winner” lessons I’ve learned in the past; at best I’d approach Eaton with some caution if I were considering a new investment, even though this is still one of my favorite long-term stories.

 

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Eaton Offers Broad Exposure To Recovery And Acyclical Growth Stories

Eaton Still Looks Like The Pick Of The Litter

It’s been a little while since I’ve thought Eaton (ETN) was truly cheap, but like Parker-Hannifin (PH), I’ve stayed positive on Eaton as a “best of breed” among increasingly richly-valued industrials. In particular, I’ve favored Eaton for its strong leverage to electrification, as well as longer-term leverage to vehicle electrification and an aerospace recovery.

Up more than 20% since my last update, and still beating both the S&P 500 and its peer group, the valuation argument isn’t getting any easier. Management’s recent investor day did make me feel a little better about my growth expectations, though, and I still lean positive on Eaton for its leverage to long-term secular growth themes, though I do see the long-term annualized expected return as pretty pedestrian now.

 

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Eaton Still Looks Like The Pick Of The Litter

Eaton Still Standing Out On Execution And Strong Electrical Drivers

Eaton (NYSE:ETN) has been one of my favorite industrials for a while, and I can't say I regret those calls, as the shares have done quite well relative to other industrials (not to mention the S&P) over the last three months, 12 months, and three years. I've been particularly impressed by the company's execution on costs/efficiency; an effort that began a few years prior to COVID-19 but has continued to deliver better-than-expected results, even with the challenges of the pandemic and integrating a large deal.

Looking ahead, the valuation isn't the clear-cut bargain I wish it were, but the relative valuation is still fairly attractive. While I think it will take a few years for aerospace and oil/gas to fully recover, I don't see either market getting worse from here, and Eaton should also benefit from improvements in light vehicle and heavy vehicle production. Best of all is the leverage to electrical products, which gives Eaton exposure to a growing residential construction market, strong data center demand, healthy utility spending, and future investments in manufacturing and logistics automation, as well as green building retrofits.

 

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 Eaton Still Standing Out On Execution And Strong Electrical Drivers

A Slimmer, Trimmer Eaton For The Downturn

Eaton’s (ETN) management has been busy – selling the largely disliked (at least by the Street) lighting and hydraulics businesses, buying an aircraft connectors business, and reprioritizing around long-term drivers like electrification (including smart grid, automation, and electric vehicles) and air travel growth. None of that immunizes Eaton to the current downturn, but it does give Eaton a less-cyclical, higher-margin business to take into the recovery.

Eaton has continued to outperform, and I can’t say the shares are dramatically undervalued. They are, however, priced pretty well in the context of quality industrials, and in my mind they’re sitting right on that “buy/hold-and-buy-more-on-a-pullback” line. With opportunities to bulk up the electrification, EV, and aerospace businesses even further through M&A, this is a company I still like in the multi-industrial space.

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A Slimmer, Trimmer Eaton For The Downturn

Eaton Continues To Shift To A Steadier, Higher-Growth, Higher-Margin Model

For a stock that many sell-side analysts have described as “controversial” or “a battleground”, Eaton (ETN) has continued to perform well. I’ve liked this stock for a while now, and it continues to outperform – up another 10% from my last article (beating its peer group by around 6%) and up closer to 30% over the last year (beating its peers by more than 10%). Now with the company announcing the sale of its Hydraulics business, there’s not much argument left that management is attuned to the need to craft a new model that is less cyclical, higher margin, and with stronger long-term growth potential.

Selling the Hydraulics business will boost margins and returns on assets and invested capital, and the share price move after the announcement was almost spot-on with what my margin/return-driven EV/EBITDA model says should have happened. Now the questions for Eaton are more about the health of its underlying end-markets in 2020 and what businesses management may target for further M&A.

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Eaton Continues To Shift To A Steadier, Higher-Growth, Higher-Margin Model

Longer-Cycle Businesses Supporting Eaton

Eaton (ETN) has been one of my preferred industrial names for a little while now, partly due to the company’s particular end-market exposures, but also due to what I thought was a general underappreciation of the company’s positive qualities. That position has held up fairly well, as Eaton shares have outperformed its industrial peers over the last six months, including well-loved Honeywell (HON), and continued to report relatively healthy results in an increasingly difficult market.

I do expect Eaton’s growth to slow, but margins are holding up better and I still see some upside in the shares. I always encourage investors to shop around, and I’m a little concerned about overall valuation levels in the sector, but Eaton still looks no worse than okay.

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Longer-Cycle Businesses Supporting Eaton

Parker-Hannifin Not Quite Paused, But Growth Has Slowed

Parker-Hannifin's (PH) fiscal third quarter (calendar first quarter) earnings reflected a lot of my concerns about slowing short-cycle markets, with management noting weakness in "general industrial", machine tool, autos, upstream oil & gas, power gen, and semis - something I've been outlining for a little while now. What's more, with destocking continuing through the June quarter and the possibility for an intensified tariff trade war with China looming, I'm still concerned that the short-cycle markets could decelerate further, even though Parker-Hannifin reported some improvement in orders in April.

I thought Parker-Hannifin shares offered some interesting upside when I last wrote about them if at the cost of some elevated short-term risk. The shares have outperformed the broader industrial space a bit since then, and my feelings about the stock remain more or less the same - this is one of the relatively rare reasonably-priced (if not slightly undervalued) quality industrials, and although I do think there's economic cycle risk over the next 12-24 months, I think this is a solid name for long-term ownership.

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Parker-Hannifin Not Quite Paused, But Growth Has Slowed

Eaton Keeping Its Ducks In A Row And Still Undervalued

In the context of my general view of "long-cycle good, short-cycle bad", Eaton's (ETN) performance was largely as I expected in the first quarter. The stock performance also continues to support my general idea that Eaton, along with Honeywell (HON) is a better-than-average choice right now, as the shares have outperformed its industrial peers since the fourth quarter report (though not keeping pace with Honeywell!).

I still have my worries about shorter-cycle industrial markets, but I think Eaton's broad exposure to a wide range of end markets across a wide range of geographies helps insulate it somewhat, and I think the company is well-placed to benefit from growth opportunities in areas like data centers, aerospace, and perhaps some renewed vigor in oil & gas. The shares aren't dramatically cheap but still offer relatively decent upside in a sector where a lot of names have gotten pricey and where expectations have gotten more and more demanding.

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Eaton Keeping Its Ducks In A Row And Still Undervalued

Strong Energy Management Providing A Spark For Schneider Electric

I’ve liked Schneider Electric (OTCPK:SBGSY) for a little while now, as I’ve thought the Street hasn’t fully appreciated what I think may be the best energy management/electrification business out there and an underrated automation business that is getting stronger in hybrid/process and is well-placed to benefit from expanding IoT adoption.

Although these shares have lagged peers/rivals like Rockwell (ROK) and Eaton (ETN) (another stock I’ve liked for a while) over the past year, as well as the broader industrial segment, the relative performance has been much stronger on a year-to-date basis and since my last update in mid-February. With the move in the share price, I think Schneider looks more fully and fairly valued now, but it’s still a name that I believe is worth holding and it’s definitely a name to look at again if there’s a market/sector sell-off.

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Strong Energy Management Providing A Spark For Schneider Electric

ABB Balancing The Reality Of Familiar Problems And New Leadership Opportunities

ABB (ABB) continues to be a relatively underwhelming, if not disappointing, player in the multi-industrial space, as the company largely missed out on the recent up-cycle due to various execution issues. While process automation and electrification are still performing relatively well, a global slowdown in discrete manufacturing and automation is creating some near-term challenges, and there is a lot left to do in M&A integration and margin improvement.

The announcement of the departure of the CEO could improve the tone somewhat, but this change is not coming from a place of strength and it is going to take time for the next CEO to make meaningful positive impacts – assuming the board lets that happen. While I do still see avenues for ABB to do better, the upside I see is certainly “at risk” and I don’t regard this as a core holding at this point.

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ABB Balancing The Reality Of Familiar Problems And New Leadership Opportunities

ABB Still Has A Lot To Do And A Lot To Prove

Owning ABB (ABB) has not been a particularly rewarding experience. While the company's decision to sell its Power Grids business to Hitachi is a sound one, and the company has attractive opportunities across its business units, a long history of underperformance relative to the opportunities available is not something investors should just ignore.

Valuation, and the idea that ABB can be/do better than this, remain the best arguments for sticking with the stock, but that's an increasingly unconvincing argument to me, and I can't really say that you should favor ABB over Eaton (ETN), Schneider (OTCPK:SBGSY), and Honeywell (HON), let alone a long list of other industrial names.

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ABB Still Has A Lot To Do And A Lot To Prove

Schneider Slowing, But May Be Better Positioned For The Downturn Than The Street Thinks

Concerns have been growing about the health and durability of the short-cycle upturn, and the performance of the stocks of companies like Schneider Electric (OTCPK:SBGSY) have reflected at least some of that. While a strong post-earnings run has lifted Schneider’s performance over the average industrial and peers like Eaton (ETN) and Rockwell (ROK) since my last update, the shares spent most of the second half of 2018 lagging broader industrial indices.

I’ve made no secret of my concerns about a slowdown in the global economy, and as it pertains to Schneider, I am concerned about the near-term outlook for non-residential construction and factory automation. On the other hand, Schneider isn’t as short-cycle-dependent as in the last cycle, and the company’s position in process automation, oil/gas, grid automation, and data center could help offset some of the weakness. With a long-term growth outlook roughly similar to Emerson (EMR), and sandwiched between Eaton and Rockwell, I do think these shares are undervalued, but 2019 could be a tricky year for the stock as sentiment has seemingly shifted to a point where there is a “show me” story.

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Schneider Slowing, But May Be Better Positioned For The Downturn Than The Street Thinks

As Cyclical Headwinds Rise, Rexnord Not Getting Much Love

Between the rally in industrial stocks from December and what appears to be rising headwinds in many end-markets, I don’t think investors are exactly spoiled for choice for great ideas in the industrial sector, but Rexnord’s (RXN) case stands out a bit for me. I wasn’t crazy about the shares back in May of 2018, and the stock has lagged the sector by about 10% since then, but the shares seem oddly valued relative to a decent motion control business and growing water business. I am worried about a slowdown in factory capex spending as well as shrinking growth in U.S. commercial construction, but those concerns seem magnified in Rexnord’s valuation.

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As Cyclical Headwinds Rise, Rexnord Not Getting Much Love

Parker Hannifin: Long-Term Opportunity At The Cost Of Short-Cycle Risk

I thought the valuation at Parker Hannifin (PH) was getting interesting back in August, and the shares outperformed a bit relative to multi-industrial peers until reporting fiscal second quarter (calendar fourth quarter) earnings. Not unlike Eaton (ETN), Parker Hannifin offers some challenging trade-offs between a relatively bullish management team, further opportunities for margin improvement, and interesting valuation against what I think is a tricky short-cycle set-up that could see weaker results and expectations as 2019 rolls on. I think investors will sleep better in general with names like Honeywell (HON) and Emerson (EMR) (and maybe Ingersoll-Rand (IR) ), but the valuation on Parker Hannifin could make those short-term risks worth taking for investors with a longer-term orientation.

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Parker Hannifin: Long-Term Opportunity At The Cost Of Short-Cycle Risk

Eaton Hitting Its Marks, But Still A Controversial Name

This fourth quarter earnings and guidance season has gone a little better than expected, with many companies having fine-tuned their guidance before the end of 2018 and defanging some of the potential disappointment here in January and February. Even so, there is still a lot of uncertainty regarding the health of the U.S. and global economies, with multiple multi-industrials (including Honeywell (HON), Illinois Tool Works (ITW), and 3M (MMM) ) establishing some rather low numbers for the low end of their 2019 growth outlooks.

I continue to like Eaton (ETN), even if more on a relative, “it’s not that bad” basis. I am definitely concerned about the risk of slowing demand in “general industrial”, trucks, off-road machinery, and non-residential construction, but management’s guidance for the year was fairly encouraging and markets like aerospace and data center are still looking healthy. With skepticism already seemingly built into the valuation, Eaton is a name that could surprise if 2019 proves to be better than expected for the U.S. and global economies.

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Eaton Hitting Its Marks, But Still A Controversial Name

Applied Industrial Technologies Starting To See The Slowdown

Wall Street hates uncertainty and there’s plenty of that when it comes to distributors in general and Applied Industrial Technologies (AIT) in particular. With two-thirds of Applied Industrial Technologies’ verticals still growing and macroeconomic metrics like manufacturing capacity utilization, PMI, and industrial production still favorable but weakening, there’s plenty of uncertainty as to just how well the U.S. (and global) economy will perform in 2019.

AIT has done a lot to build up its business, and particularly its higher-margin fluid power business, and this a company with a strong ROIC record. I’m concerned about slowing momentum in 2019 and the possibility of further revisions to near-term guidance, but I do see a path for mid-single-digit revenue growth and double-digit FCF growth that can support a higher share price from here.

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Applied Industrial Technologies Starting To See The Slowdown

ABB Still Spinning Its Wheels

Every investor has their “enough” point, and I’m getting there with ABB (ABB). Despite a pretty healthy environment for electrical and automation products in general, and strong market positions in many of those markets, ABB has spent a lot of its recent history going nowhere fast, pulled down by weakness in the Power Grids business, weak utility demand, and a series of ongoing restructuring and M&A integration initiatives. Comparisons to companies like Honeywell (HON) aren’t really fair, but it has been a while since ABB investors really had a lot to cheer about, and third quarter results don’t really seem to represent a break with that trend.

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ABB Still Spinning Its Wheels

Schneider Electric's Business Is Outperforming, But The Stock Really Isn't

I can’t say that Schneider Electric (OTCPK:SBGSY) has been a terrible call this year, but I expected better from this European specialist in electrical and automation products than just sector-matching performance. Even though Schneider continues to outperform its peers in terms of its financials, and management continues to offer a pretty solid near-term outlook, the Street is most definitely not all-in on this name, as concerns about the health of end-markets like commercial construction and utilities remain in place and concerns are building about factory automation demand.

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Schneider Electric's Business Is Outperforming, But The Stock Really Isn't

Eaton's Challenges Look More Sector/Sentiment-Specific

The call I made earlier this year for preferring Honeywell (HON) and Eaton (ETN) in the industrial/multi-industrial space had been working pretty well through October, but looks more “okayish” now that more machinery-oriented industrials like Eaton have lost some luster. Eaton’s third quarter results had some air bubbles in it, but overall there wasn’t much that worried me and I still think this is an above-average idea in the industrial space. That said, there are growing signs that the cycle is slowing and liking Eaton now means fighting the tape to at least some extent.

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Eaton's Challenges Look More Sector/Sentiment-Specific

Allison Transmission Running Over The Bears

Whatever the future may look like for Allison Transmission (ALSN) and its role in a post-electric truck world, the company is executing remarkably well today. With solid growth in its core North American truck business augmented by improving demand from energy and mining applications, as well as share gains in trucks outside North America, Allison is posting exceptional incremental margins and forcing bearish sell-siders to trot out “we’re not wrong… we’re just early” calls.

I’m not in the “the sky is going to fall” camp with Allison, but it’s a tough story to model out given the likelihood that electric trucks eventually will grab share in strong core Allison markets like dump trucks, refuse trucks, and other vocational applications like drayage. I believe a key question is whether Allison can continue to gain share in overseas markets (where penetration is low) and whether they can fight off competition from other transmission alternatives like the Cummins (CMI)/Eaton (ETN) JV.

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Allison Transmission Running Over The Bears