Eaton Corp (ETN) shares several characteristics with some of the companies we hold in our Top 20 Dividend Stocks portfolio.
The company scores well for Dividend Safety and Dividend Growth, has paid dividends every year since 1923, generates excellent free cash flow, and has a relatively high dividend yield near 3.7%.
Eaton’s stock also trades at a forward price-to-earnings multiple of 14.2, which is a discount of approximately 15% compared to the broader market.
Let’s take a closer look at Eaton and see if it makes the cut as one of our favorite blue chip dividend stocks.
Eaton Corp – Business Overview
Eaton is a large industrial conglomerate with over $20 billion in annual sales and an operating history dating back to 1911.
The company provides a wide range of energy-efficient products and systems that help customers manage power across electrical, hydraulic, and mechanical applications.
Eaton also has a substantial aftermarket business (approximately 20% of total sales) that provides some stability to its business.
By geography, about half of Eaton’s sales are made outside of the U.S. with approximately 25% of total sales derived from emerging markets.
Electrical Products & Systems (62% of sales; 62% of profit): sells a range of power-related components, circuits, lighting products, and equipment used wherever there is demand for electrical power (e.g. buildings, data centers, hospitals, utilities, factories).
Vehicle (18% of sales; 20% of profit): supplies drivetrain and powertrain systems and components used in cars, trucks, and agricultural vehicles. Key products include transmissions, clutches, engine valves, and superchargers.
Aerospace (9% of sales; 10% of profit): sells fuel, hydraulics, and pneumatic systems used in commercial and military aircraft. Products include pumps, motors, controls, sensing products, hose fittings, and more.
Hydraulics (12% of sales; 8% of profit): sells components and systems such as pumps, motors, valves, and controls that are used in industrial and mobile equipment. Key end markets are oil and gas, agriculture, construction, and mining.
Eaton Corp – Business Analysis
Many of Eaton’s competitive advantages are derived from its lengthy operating history. The company has been in power management for more than 100 years.
As a result, Eaton has built up a strong reputation for quality, massive distribution channels, an extensive portfolio of well-known products, and long-lasting customer relationships.
Smaller and newer players have a hard time competing with Eaton for many of these reasons. They lack Eaton’s economies of scale (over $20 billion in annual revenue), which allow the company to maintain a lower manufacturing cost structure.
Eaton can also afford to pump more than $600 million in research and development activities each year to maintain the broadest, most advanced portfolio of technologies and established brands.
This is important because many of its products solve the most demanding power needs. The company supplies mission critical products that need to be extremely reliable.
In aerospace, for example, Eaton benefits from long product qualification cycles and meaningful aftermarket demand. Once Eaton’s components and systems have proven to be reliable and are designed in, the company enjoys a long stream of high-margin aftermarket revenue.
The company’s aftermarket business makes life difficult for new entrants as well. Eaton generates over $4 billion in annual sales from aftermarket products and services, helping it maintain stickier customer relationships and retain its reputation for quality.
Aftermarket revenue also tends to carry high margins and allows Eaton to price some of its upfront equipment sales at levels that make it difficult for smaller competitors to earn a profit (a lot of the money is made in equipment support and services).
Smaller rivals lack the network needed to service multinational customers, who demand timely service and maximum uptime.
Eaton has over 13,000 authorized channel partners and 10,000 commercial resources it can use to efficiently reach customers all over the world. Replicating this network would likely take decades of time and cost millions of dollars.
The company’s management team has further solidified Eaton’s advantages through selective acquisitions and divestitures over the years.
Eaton has made more than 100 transactions since 2000 that have improved its profitability and served as a major driver of earnings growth.
The company’s Electrical segment alone purchased over 30 businesses and divested 11 companies since 2000, helping it improve margins from 10.4% to 15.3% in 2015.
Eaton’s most notable deal took place in 2012 when it acquired Cooper for $11.8 billion. Cooper manufactures electrical equipment (e.g. fuses, lighting controls, voltage regulators, circuit-protection equipment) that helps companies save money on energy.
The deal gave Eaton a larger product portfolio (its electrical addressable market expanded by $70 billion), more scale, and a denser distribution network to help it compete better with some of its bigger rivals.
Cooper was also domiciled in Ireland, which allowed Eaton to incorporate there and enjoy substantially lower tax rates on its corporate profits – Ireland’s tax rate is 12.5% compared with 35% in the U.S.
Today, Eaton is a dominant force across most of its markets. The company is one of the four largest electrical players in the world and is one of the three biggest hydraulics businesses. Approximately 70% of Eaton’s industrial sector products have a leading global or regional market share.
Despite the company’s size, most of its markets remain extremely large and fragmented, providing room for moderate growth. The electrical market is estimated to be $200 billion in size, and hydraulics is another $40 billion.
We expect Eaton will remain a force in its markets for many years to come thanks to its portfolio of well-established brands, strong distribution channels, and commitment to R&D.
Eaton Corp’s Key Risks
Like most industrial conglomerates, Eaton’s businesses are sensitive to global economic growth, industrial spending, manufacturing activity, commodity prices, and foreign currency exchange rates.
The company’s hydraulics business has suffered from the downturn in global mining and agriculture markets as well as the slowdown in Chinese construction projects.
Foreign currency headwinds have also dented recent growth.
While these macro issues are weighing on Eaton’s earnings today, they seem unlikely to impact the company’s long-term earnings power.
Instead, some of the bigger risks long-term investors should consider are the company’s sustainable earnings growth rate and the amount of taxes it pays.
The downsides of being such a large conglomerate are that incremental sales growth can be difficult, and some business lines are not going to be fully healthy.
Eaton’s 2020 plan targets organic sales growth of just 1-2% per year – hardly anything to get excited about. If the business struggles to get all of its cylinders firing at once, sales could tread water.
Companies with minimal growth prospects deserve to trade at a discount to the market and don’t really excite us much.
Instead of relying on the top line for growth, management’s 2020 plan expects restructuring actions to drive about half of Eaton’s annual earnings growth over the next five years.
The company has been closing down plants, reducing the size of its workforce, and improving manufacturing processes to lower its costs. However, there is only so much cutting that can be done to lift earnings – at some point, profitable sales growth is necessary.
We think Eaton can continue squeezing out low-single digit sales growth as long as global GDP keeps grinding higher, but our expectations are admittedly low.
Another risk that could materially impact Eaton’s earnings is its low tax rate, which sits near 10% thanks to its tax inversion following its 2012 acquisition of Cooper.
Eaton has received some heat from