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Morningstar | Narrow-Moat Eaton Announces Intent to Spin Off Lighting and Sell Automotive Fluid Conveyance

Narrow-moat Eaton announced its intent to spin off its lighting business and sell off its automotive fluid conveyance business at its March 1 investor day. Management expects both deals will close by the end of 2019. Of the two deals, Lighting constitutes a significantly greater portion of Eaton’s business. At $1.7 billion of sales as of end of year 2018, Lighting (which is reported in Eaton’s Electrical Products segment) constitutes about 8% of sales according to our estimates. We await further details of the deal before we model its full impact, but we don’t expect to materially change our fair value estimate of $83 per share.

Including lighting and the automotive fluid conveyance, we estimate $22.5 billion of total company sales in 2020. We expect lighting will grow between low and midsingle digits year over year from 2018 to 2019 (we assume a rate of 3.5%), which implies Lighting reaches nearly $1.8 billion of sales in 2019. Other hints of the deal management alluded to was that the margin performance of Lighting was dilutive. Currently, the firm’s Electrical Products segment (36% of the firm's total operating profit, before corporate and other expenses), operates at a segment operating profit margin of 18.9%. We estimate that Eaton’s lighting business earns just over a 14% segment operating margin (which implies lighting earns about $243 million of electrical products' $1.3 billion in 2018 segment operating profits, or about 19% of segment profitability). We base our estimates partially on the lighting business’ main pure-play competitor Actuity Brands. We would now expect about a 150 basis point improvement in 2020 segment operating profit margins in the electrical products segment (from 19.4% with lighting to 20.9% without lighting), and nearly a 21% segment operating margin in year five of our model.

On the call, management stated that aside from margin dilution from lighting, the ability for lighting to prioritize and fund its growth initiatives was another motivation for the deal. As for the Automotive Fluid Conveyance business within Eaton’s Automotive segment, management states that its business’ set of products are not a market leader, nor does the business align well with Eaton’s portfolio criteria. The business’ margins are also dilutive to Eaton’s Automotive segment’s profitability. As to Lighting, Eaton is one of many companies that compete in the segment. Aside from Acuity and Eaton, competition includes Cree, Hubbell, GE, Osram, and RAB (which is a private entity). The residential and conventional lighting portion of the competitive landscape has no doubt ran into some headwinds, as of late. Lighting came to Eaton as a result of the Cooper acquisition in 2012.

Scuttlebutt from our technology team revealed that Eaton is always on the shortlist for bids, and lighting manufacturers have strong pricing power over the LED suppliers, which is consistent with management’s comments that lighting is a “good business.” Even so, however, lighting manufacturers have been taking it on the chin from their end customers, and residential, which Eaton has some exposure to, is difficult to operate in. There are portions of the market, however, where profits can be made, including national account sales and innovation through different forms of lighting other than conventional white light, such as dynamic lighting, IoT, stadium lighting, and so on However, management stated that the portion of the business it is spinning off deals mostly with conventional lighting and aerospace lighting.