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Morningstar | Eaton Posts Very Solid Results; We’re Raising Our FVE by $1. See Updated Analyst Note from 31 Jul 2018

Narrow-moat rated Eaton had a strong second quarter, buoyed by organic revenue growth of 7% that was largely broad-based. As a result, we are raising our fair value estimate to $79 per share from $78 per share as we incorporate second-quarter results and what we view as management’s justified new guidance to the upside. Encouragingly, the firm reported accelerating bookings growth across most segments, and highlighted strength in its long-cycle businesses (that is, aerospace and electrical systems and services). Total firm revenue rose about 7% on a year-over-year reported basis. Segment operating margins rose by 140 basis points to 17.0%, allowing segment operating profits to rise by 16% year over year to $932 million.

Turning to the firm's segments, we were most impressed by growth in the hydraulics segment. We suspect that the segment will continue to rise in the low double-digits year over year in the back half of the year given that its backlog is up 26% year to date. Moreover, Eaton reported adding significant capacity to its hydraulic hose business, allowing it to sharply reduce lead times, adding to our confidence that this backlog will further translate to top line results. That said, something that stood out to us in that segment was that bookings were down 1% year over year for the quarter, and we were perplexed as to the discrepancy between bookings and revenue.

The big driver for the reduced bookings was lower EMEA region numbers, which dropped by negative 21%. These are the capacity investments that management said it made to reduce delivery lead times, which the firm claims naturally diminished customer’s needs to place long-dated orders. That said, we are monitoring the firm's ability to keep up with demand, particularly in Europe, which is something analysts rightfully pointed out on the company's earnings call. One encouraging sign is that orders due past three months in Europe were down more than 50%, according to the firm's CFO.

One segment that's run ahead of our near-term expectations is aerospace, but this hasn’t been limited to just Eaton, with several diversified industrials across our coverage also seeing a boost from this business. One bright spot for Eaton, certainly, is that Aerospace is a long-cycle business within its early growth stage. Reasons like this are why we think management has been touting its stock throughout the year as an attractive investment opportunity. While we were at EPG, CEO Craig Arnold unambiguously stated that he thought the stock was undervalued. That said, we think prices for the shares currently represent about full value for the stock.