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Morningstar | Near-Term Top-Line Softness in Portions of Eaton’s Portfolio Doesn’t Alter Our Long-Term Thesis

Narrow-moat rated Eaton had a decent 2019 first quarter, and nothing in its latest results alters our long-term view of the firm. The market reacted negatively to reduced top-line guidance, mostly as a result of its weak Vehicle segment results. That said, the firm’s stock price of about $82 trades in line with our fair value estimate, and we think most of these cyclical effects are baked into our valuation. Our fair value estimate of $83, which we plan to maintain, is slightly less (about 7%) than the median consensus price target of $89. Eaton has historically traded at a depressed multiple (about 14 times our 2019 EPS estimate), and we think the market will continue to hesitate rerating it as long as its comparably shorter-cycle Industrial group (with the exception of Aerospace, which is clearly long-cycle), is kept together with its longer-cycle Electrical Sector portfolio. Nevertheless, even with comparably weaker Vehicle segment and Hydraulic segment results, our fundamental long-term thesis for the firm remains intact. We also maintain our narrow moat, stable trend, standard stewardship, and medium uncertainty ratings.

Overall first-quarter sales at the consolidated level rose 1% year over year (4% on an organic basis), still very strong organically despite pockets of weakness. While the Vehicle segment saw sales decrease 9% year over year (negative 6% organically), we had a precursor of things to come with pockets of automotive end market weakness across broad swaths of our diversified industrial coverage--including at 3M, ITW, and Rockwell, which reported in the fourth week of April 2019. Eaton reported that global light vehicle markets, specifically, were down 4% to 5% in the first quarter (year on year basis). We expect light vehicle builds will remain weak through the year, as confirmed by management’s lowered top-line guidance for the segment.

Encouragingly, however, the Eaton Cummins joint venture saw revenue rise 27% year over year during the quarter, combining the technological expertise of both narrow moat rated firms. Even with the slowdown, moreover, the Vehicle segment still managed to grow its segment operating profits at 30 basis points year over year and contained organic decremental margins to less than 20%. We think it highlights how the Vehicle team is experienced with managing costs during economic slowdowns. Hydraulics also saw a slowdown in its top-line results, with both orders (down 11% year on year) and backlog down (6% year on year). Some of the weaker Hydraulic segment results were really a result of self-inflicted wounds due to site transitions and other restructuring efforts. Management highlighted some order improvement growth in China during the month of March and heading into the second quarter, and we expect some of this weakness to abate.

CEO Craig Arnold provided some details around the acquisition of switchgear provider Ulusoy, which closed April 15, and should provide about $100 million of additional revenue and about 2 cents of EPS accretion. Offsetting this would be the intended spin-off of Lighting, set to take place at the end of 2019. While management was asked about a potential sale, and the company confirmed receiving inbound inquiries on the business, management stuck with the company line that it intends to continue with its spin-off plans.

Finally, on the positive side of the organic ledger, Aerospace had a blowout quarter, with organic sales up 11% year on year, orders up 18% on a rolling 12-month basis, backlog up 21%, and a record segment margin of 23.1%. Nevertheless, we think some of these effects were due to mix (comparably greater aftermarket sales versus the OE channel), and we expect some of the benefits accruing in the first quarter will abate during the back half of the year.