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Morningstar | Eaton Turns In a Solid 3Q Performance

Narrow-moat Eaton had a solid third quarter, but our long-term fundamental outlook remains the same. We are, however, raising our fair value estimate to $80 from $79 because of the time value of money. We’ve also made some slight adjustments to our full-year 2018 forecast based on both recent performance and management’s updated guidance, but the net effect of these puts and takes more or less canceled out one another. For example, the electrical products and hydraulics segments have slightly underperformed near-term expectations, but this has been offset by strength in the aerospace and vehicle segments.

At current prices, the stock trades at about a 10% discount to our estimated intrinsic value. As such, we’re fans of management’s efforts to buy back shares, which by year-end we estimate will amount to about $800 million in share repurchases. We also like that after reinvesting capital for purposes of organic growth, management has explicitly made buybacks a capital allocation priority. Finally, even as we expect full-year organic growth in 2018 at a strong 6% rate year over year, we also believe outperformance can continue over our explicit forecast, which is underpinned by our 5% year-over-year top-line CAGR (which bakes in the effect of acquisitions). Overall, we agree with management’s assessment that an appreciable portion of the firm’s portfolio, like industrial construction and defense aerospace, is in the earlier stages of the economic cycle. Moreover, strong incremental margins of 25% to 30% on organic growth leads us to believe that there is some room for margin improvement.

For the third quarter, the firm grew total organic revenue by 6%, which was offset by both the effect of currency (1% headwind) and dispositions (another 1% headwind). Notably, the firm posted segment margins of 17.6%, a full 120 basis points above third-quarter 2017 levels. The firm also highlighted rising raw material costs and tariffs. As with other diversified industrials we cover, most of the firm’s manufacturing operations and sales are conducted in the same region, which largely negates the impact of tariffs. In instances where raw materials or tariffs are in fact creating cost pressures, management anticipates it can offset these headwinds with pricing.

Finally, we’ve updated our adjusted EPS for the year to $5.38, which is toward the top end of management’s guidance. This adjustment excludes about a $0.49 impact for a previously disclosed arbitration decision back in August stemming for its acquisition of Cooper Industries. We think this is a true one-time charge related to asbestos litigation, and as such, view the adjustment as appropriate.