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Morningstar | Eaton Posts Solid Fourth-Quarter Results in Line With Our Long-Term Outlook

Narrow-moat rated Eaton had a solid fourth quarter, and its results were broadly in line with our expectations. We don’t expect to materially change our $83 fair value estimate for Eaton as we roll our model forward for 2018, although there may be some puts and takes, with slightly higher near-term margin expectations offset by modestly lower near-term top-line growth assumptions. Our fair value estimate implies a 15.5 times multiple to our current 2019 GAAP EPS estimate of $5.81 (slightly below the midpoint of management’s guidance). We’re also maintaining our narrow moat, stable trend, medium uncertainty, and standard stewardship ratings.

At the current market price, the stock now trades at a less attractive discount to our fair value estimate, at only 9%. Fourth-quarter sales rose 5% to $5.5 billion, against our expectations of $5.7 billion. More importantly, however, organic sales were even better, rising 7% year over year (with a 2% headwind from currency). Segment operating profits of $950 million were roughly in line with our expectations of $960 million for the quarter (up 11% year over year), while net income of $631 slightly exceeded our expectations of $604 million. When adjusting for a one-time benefit from last year, net income rose 10% compared with the 2017 fourth quarter.

Turning to the firm’s specific segments, the Electrical Sector showed especially strong growth on its services side through its Electrical Systems & Services segment (ESS). Organic growth was up an impressive 10% year over year on the back of strong order growth of 12%, with particular strong regional growth in both the Americas and EMEA. As for its Industrial Sector, the Aerospace segment saw sales rise 13%, and segment operating profit margins were up 290 basis points. Orders were up 17%, implying a positive book to bill ratio (meaning demand is greater than the speed by which Eaton can fill its earnings), while backlog was up 13%--a useful metric given the long-cycle nature of the aerospace business. We attribute a large portion of the margin improvement in aerospace to aftermarket services, among other factors. Offsetting the strength in these businesses, the Vehicle segment took it on the chin with a 2% year-over-year decline; even after the joint venture with narrow-moat rated Cummins saw revenue rise 45%.

Management gave some good insight on the call regarding its stepdown in organic growth rates from current levels--2019 guidance points to total Eaton organic growth of 4% to 5% versus organic sales growth of 6% in the fourth quarter. These step downs come principally from the Electrical Sector as well as reductions in both Aerospace and Hydraulics. We’re not overly concerned with a slowdown in the Electrical Sector in the front half of the year as this is historically a seasonally weaker business during that time period. Areas of softness we’re looking out for include the NAFTA Class 8 truck market, as well as the Global light vehicle market, which are expected to be continually flat.

Even so, we reiterate our thesis that Eaton has a bright future given that its highly specialized products and services serve vital portions of the world’s infrastructure needs. While some analysts decry Eaton stepping back from the M&A market, we appreciate its capital allocation discipline and its demand to find businesses that contribute to the firm out-earning its normalized cost of capital by 300 basis points, which we currently estimate at 8.3%. In the alternative, we foresee management buying back shares at opportunistic prices for shareholders.