Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

Good afternoon, everyone. This is Joe Ritchie, Head of U.S. Multi-Industry Research at Goldman. Really excited to have our next fireside chat with Eaton Corp. We have Craig Arnold, Chairman and CEO of Eaton. Craig, thanks so much for being with us -- being here with us today.

My pleasure, Joe. Thank you for inviting us. And I'm happy to run the anchor leg for you, by the way. So it's been a long time since I've run anchor, but happy to.

Yes. Well, I'm happy that you're doing it as well. And yes, definitely some cocktails or margaritas or something will entail -- will ensue after this. But I know that you kind of wanted to start with just a few minutes of some initial thoughts. So why don't you take the lead, and then we'll jump to the fireside chat.

Great. Happy to do it, and it's great to be with everyone, even if it's in this virtual format that we're all kind of getting accustomed to dealing with, but I did want to just take a minute and maybe to share kind of a broad outline in terms of our company and the way we're thinking about things. And I'd say, the first thing I'd begin by saying is that Eaton has a strong history of living through, working through kind of these economic downturns and have done so many times in our history. And it's one of the reasons I'd say, as a company, it's been founded in 1911. We've been able to exist as long as we have, and they tell me, I think we're like the 14th oldest listed company on the New York Stock Exchange. And I'd say, over the last 20 years, it's really been no different. It's been a period of continuous change and adaptation, and it's one of the things that I think our company does extraordinarily well, and we're clearly going to another of these dynamic periods, but the company is taking the needed steps that we need to take to remain what we think is an attractive investment alternative for you. Certainly, we're proud of the last kind of 20 years. $1 invested in Eaton back in 2000 would be worth $10 today, and so that's a pretty attractive 12.5% annual growth rate. Our strategic direction continues to become an intelligent power management company, and that really means adding intelligence to all the devices that we make. And I always say, think an iPhone, and we think about all the components and the devices that we make has the potential to be the equivalent of an iPhone as we embed intelligence and capabilities. We think our company continues to be supported by a number of really helpful secular growth trends. That includes electrification, including e-mobility, energy transition, IoT, blended power. Today, in our company, I'd say we're mostly an electrical company. Electrical today accounts for 70% of the company's profits, if you exclude the recently divested lighting business as well as the upcoming divestiture of Hydraulics. And then we continue to just leverage the scale of the company for cost and execution advantages. The financial objectives that we shared during the New York investment meeting continues to guide the company. Our goals are to create a company that is really positioned to take advantage of secular growth trends. We continue to put together a company that delivers higher margins with better earnings consistency, and the goals that we laid out in New York are still the goals that we think are relevant for our company. And what we said was 2% to 3% organic growth, 20% segment margins, 8% to 10% EPS growth and $3 billion of free cash flow. And so while clearly, COVID-19 may push some of these goals to the right, we do think they remain the right financial target for the organization. In the meantime, we continue to deliver strong free cash flow conversions, 129% in 2019. And 2020 will be well above this number, with a free cash flow yield of 7.6%, assuming our $2.5 billion free cash flow at the midpoint, is a pretty attractive yield, we believe. We'll have $11 billion of cash available for us over the next 3 years. $8 billion that we'll generate through free cash flow plus $3.3 billion from the sale of Hydraulics. And so cash flow remains strong, and we think it will be strong in both good and bad times. And we continue to be good stewards of our capital. Our balance sheet is in good shape. Our net debt-to-EBITDA is 2.1x. We've increased our dividend by 10% a year over the last 10 years, and we've actually paid a dividend for our entire 100-year history as a listed company. Current dividend yield is 3.7%. We've grown our dividend by an average of 10% a year, as I said, over the last 10 years. And certainly, I'd say, we have a strong track record of being a disciplined acquirer as well. We continue to use roughly 11% to 12% return as the target for our acquisition. We don't play games with the cost of capital. And so we will continue to use our balance sheet to evolve our portfolio, better growth, higher margins and more consistency. And I think the Cummins JV, the Lighting divestiture, Hydraulics divestiture as well as the acquisitions that we've done this year in Electrical and Aerospace are good examples of that. So overall, we think the company continues to trade at an attractive multiple at 13.2x of 2020 free cash flow. And despite the pandemic, we continue to move our strategic agenda forward as well as improving the long-term financial prospects of the company. And so Joe, I'm going to stop with those few opening comments and open it up to you for whatever questions that I can answer for you.

Thanks, Craig. No, I appreciate the opening remarks. Always helpful to kind of set the table. And then before we get going on the fireside chat, I'll just remind investors that if you do have any questions, feel free to shoot me an e-mail at [email protected], or you can also send me questions via the Web link if you're on the webcast. So maybe with that, one of the things that you mentioned, Craig, in your opening remarks was just the strong free cash flow of the company. And coming out of the quarter, there was a lot of emphasis around the new guidance that you gave, the updated guidance of $2.3 billion to $2.7 billion. So maybe just start by telling us like what gives you the confidence that you can hit that range, given the midpoint is only down, call it, $0.14 from the prior guide?

Sure. I appreciate the question. And I'd say we have a long history, quite frankly, of managing through economic downturns. And what we're guiding to actually in terms of free cash flow at $2.5 billion is actually slightly below the level at which we performed at during other economic downturns. If you take a look at 2008 and 2009, free cash flow actually rose 22%. Between '15 and '16, free cash flow rose 9%. And largely, this is a function of our ability to essentially reduce working capital, which certainly offsets, in most cases, the reduction in profits that we see. And the other thing I would tell you, and it's a bottoms-up number. This is a number that in our monthly forecasting process that comes from our businesses, it's a number that's very much supported by the way we're running the company today. And so yes, we believe $2.5 billion at the midpoint is the right place to be, and we have a high level of confidence that we'll deliver that number.

That's helpful, Craig. And it's helpful to put it in the context of your -- the prior experience of the company. It's interesting, right? So I know that you only reported 2 weeks ago. But obviously, the environment is -- changes pretty rapidly. And at the time, I think you guys talked about April month-to-date trends being down about 30%. So I guess is there anything just on the margin that you would call out that is discernibly different from what you guys described to us 2 weeks ago?

And I'd say, by and large, I'd say, no, Joe. Things, essentially in the month of April, as you know, we're close to the end of the month anyway, ended up largely in line with our expectations. If you take a look at orders insofar May, orders are actually holding up a bit better than what we expected. And in fact, if you take a look at the backlog in a lot of our longer-cycle businesses, the backlogs are still holding up fairly well. And in some cases, flat or slightly up versus the same period of time last year. We continue to see acceleration in China. We all hope that China is a proxy for what we would see in the rest of the world, but China's holding up, and it's been especially strong in construction and footprint in the data center market. So we had hoped to be in a position by the time we get to the end of Q2 to have a little more clarity around what the world looks like and provide guidance at that time. But largely, things are unfolding the way we expect it.

Got it. Okay. That's helpful. And then, I guess, maybe just thinking about this just a little bit longer term and in the context of everything that has been going on. I mean has your outlook for any of the other growth trends that you outlined at your Investor Day really changed? I mean we talked -- you talked a little bit in your prepared comments around electrification, energy transition. Everything as a grid was definitely a theme that kind of came out of your Investor Day as well. And I'm also wondering, as you kind of think about this experience that you've had with COVID-19, does that change potentially investments that you're making as well?

Yes, Joe. I'd say it's -- we spent obviously a lot of time thinking through kind of where we're trying to head as a company and really trying to latch on to what we think were going to be secular growth trends that will help the company grow faster in our end markets. And we do still believe strongly that electrification will continue to be a really important one. And you're seeing it every place as we talked about in New York. It's not just electric vehicles, but it's also more electrical content in your homes. If you think about a home built today in the amount of electrical content and the value of electrical as a percentage of the total home, those numbers continue to go up because of additional functionality and capability, but also because codes and regulations are now requiring, for example, as you all know, more ground-fault circuit protection on various circuits in a home. And so one of the reasons why we've seen, over a very long period of time, the residential market grow at a rate that's much faster than the rate at which housing stock is growing is because the content for home continues to go up. So in our core electrical building, whether it's in a home or a building or an industrial facility, the amount of electrical content in these buildings continues to grow. And so in electrification, it's obviously broader than building. It's cars, it's trucks, it's airplanes. Everything is becoming more electrified. And so we think that trend continues to be an important one. And then certainly, energy transition. And we're really excited about energy transition and the opportunities that it's going to reflect. And we believe that despite this period of time when we're seeing, relatively speaking, low oil prices, we still think energy transition continues to be one of the more important long-term trends that will take place around the world. And it will certainly highly benefit Eaton, given our position today, both as an electrical provider, but also in terms of what we do on the grid. And then digital solutions is really kind of the technology that's being put on top of everything. I talked about this example of the iPhone. Everything that we make today is becoming smarter. Everything is -- we're adding firmware and software. We're connecting to the Internet and finding ways to bring value to our customers based upon this technology. And so we think those trends continue to be important ones. And in fact, I'd argue that in this environment, you think about an electrical business, where you're talking about safety, resilience, you're talking about the growth of data centers, building electrification, I think that stuff, in some cases, may be even more important as we move forward. Now the other part of your question was long-term kind of COVID-19 experience. I'd say, this one, I'd say, managing through this and the dislocations really hasn't changed the long-term vision because, quite frankly, I'd say that a lot of it is early. We don't really know how this thing is going to play out, right? We all have different beliefs, and we can all speculate, but the truth is we're not really sure at this point how this is going to fundamentally change society. There likely will be changes. Some of those changes, I would venture to say, will be a positive for Eaton. Some of those changes could be detrimental to some of our businesses. But I think, by and large, it's early to really make the call on whether or not it's going to impact the long-term vision of the company. So for right now, we're really focusing on the more fundamental things that we can do, which is to continue to focus on things that deliver higher growth, things that deliver higher margins and things that increase the earnings consistency of the portfolio overall in the context of really, as we talked about, being this intelligent power management company. So we're really focused on, as we talked about, our priorities with respect to our M&A dollars, with respect to where we invest organically. It really is in and around the secular growth trends that we think are going to position the company well for the future.

No, that makes a ton of sense. And maybe kind of segueing there on one of the positive trends that has already occurred in your business and maybe could be improved from this is just like what's happening on the data center side. So you noted that there were some strength in orders in Q1 for data centers, up mid-teens globally. How well positioned are you to continue to take advantage of this trend? And then, again, just as we kind of think about the backdrop of this pandemic, has anything changed on the longer-term trajectory really for this particular business?

Yes. Clearly, data center has been a source of strength for a very long time inside of our business, and we think that if anything, COVID-19 accelerates that growth. And I think it's for all the reasons that are just intuitively logical for all of us. As you think about this whole stay-at-home environment that we've all been living in, and the way we've all had to rely upon technology to essentially remain effective at doing our jobs, that's just one of many trends that are underlying this fundamental growth that we're seeing in the data center market. Eaton is clearly a leader in this space. We think we're either #1 or #2, depending upon the market that we participate in. We offer a full suite of equipment and services and software solutions. And it's an attractive space. And I think as you think about just some of the third-party data that's out there today, there's one third-party estimates that cloud could increase by up to 50%, cloud computing could increase by up to 50% by 2022. I don't know how big that number is going to be. But what I do know is the world continues to generate, consume, process, have a need to store increasing amounts of data. The data center market will continue to grow. And I would argue one more point is that I don't know that we've even hit the sweet spot yet for the acceleration of growth because we're still today living in a world where, fundamentally, you have people interacting with machines, which is driving this explosive growth. I don't think we're long away from the future where you have devices and devices talking to each other, machines talking to machines. You think about the level of automation that's going to take place in society overall. And so I still think there's a lot of positive growth out in front of us in the data center market.

Yes. No. That's great to hear. And I guess maybe the flip side to your answer from earlier was really just around the end markets that could potentially be hurt a little bit harder from this pandemic. And what comes to mind, and it's been very topical for investors, has been what's happening in the commercial aerospace market. And so maybe talk a little bit about your portfolio, how it's structured today and what you think the longer-term value-creation opportunity is within aero?

Yes. I appreciate the question, and it's another one where I'd say it's one that we're clearly watching closely. And certainly, if you take a look at what's happening here in the near term, it's been certainly one of the hardest-hit segments of the economy, and lots of industry pundits speculating around what the shape of the recovery will look like. Now I -- my own personal point of view is that the long-term prospects for Aerospace will continue to be positive. I do think it's going to take a while before we return to kind of historical growth rates and get back to the levels of, let's say, activity that we experienced in 2019. But I do believe that the fundamentals of the industry continue to be positive. I think we need, first of all, effective therapeutics. We need a vaccine. I mean the traveling public need to feel like they can be safe. And no different than what we experienced, I'd say, in 9/11. In 9/11, the flying public was concerned, for very legitimate reasons, and stopped getting on planes. And once we got to the point through TSA and others in the U.S. and other mechanisms to create a safe environment for passengers, they started getting back on planes again. And so I do believe that we'll probably be living in that kind of transitional period with respect to at least the commercial side of the aerospace market. Now the military side, and as you recall, military is 40% of the business for us. Military continues to do very well and may even do better during this period of time. Certainly, we saw some real strength in our military business, both commercial and aftermarket, in the first 4 months of the year. And we expect that piece to continue to hold up nicely. But we're watching it. We're not being Pollyannish about it. We recognize that we will likely have to take some steps in the near term to make sure that we are rightsized and deal with potential cost-related issues that we have in the business. And our team, I can tell you, is all over that and has plans in place to do so. But we do believe, once again, that the emerging economies, especially places like China and India, where you have large middle-class populations, many of whom have never been on a plane before, we think there is this secular fundamental force in the industry that says that at some point, we believe people get -- start getting back on planes and that market returns to historical growth. But it's clearly one that we're watching and making sure that we're watching with a clear eye view.

Yes. No, that makes sense, and appreciate the thoughtful answer. I'm going to go -- there's a question from the audience, a follow-up question based on the discussion we had earlier on free cash flow. And this individual specifically wants to know, what does free cash flow look like beyond this year? Meaning, in prior downturns, when you're coming out of prior downturns, you didn't really -- you didn't see much of an acceleration in free cash flow. How do we think about what free cash flow could look like beyond 2020?

Yes. No, I appreciate the question. One of the things we laid out in New York as we talked about what does free cash flow look like for Eaton kind of per year over a planning horizon, we talked about a number of $3 billion a year. And I'd say that the company today is -- the makeup of the company is different than the company was 5 years ago, 10 years ago or even 20 years ago. And as a result of that, the -- so as we think about some of the big capital-intensive businesses in our company that are heavy machining, a lot of what we do today, as I said, 70% of the profits coming of electrical tends to be more of an asset-light business model. There's a lot of assembly and test, but we don't spend anywhere near the capital and the capital intensity in a lot of those businesses. And so -- and they tend to be much more effective businesses in terms of working capital. So I'd say that we are -- we remain absolutely convinced in our ability to generate $3 billion a year in free cash flow. Even coming into this year, long before COVID-19, we talked about the fact that the company built up a fairly sizable pile of inventory during the course of 2019. And a lot of that inventory went into the system because of -- we were dealing with trade-related, supplier-related concerns. And so we built some inventory intentionally to protect kind of the downside. And so we think, order of magnitude, COVID-19 aside, $400 million or $500 million worth of inventory that's just sitting in the system where we're just not running today or operating today as efficiently as we know we can and should. So we think 2021 is another very good year of free cash flow.

No, that's nice to hear. And great that there's that opportunity as well kind of on a go-forward basis. Craig, at the quarter, and obviously, given the backdrop, you talked about the cost actions that you were taking. I guess, maybe talk a little bit about how you're balancing the mix of temporary versus structural costs?

Yes. Once again, one of the things that we try to do always inside of our company is that flex our businesses. It's one of the reasons why we talked about this year, despite what's been a pretty hard and sudden downturn, a 25% to 30% decremental. And that's because the company knows how and very effectively flexes our variable manufacturing costs. And so that's -- the only way we can get to those levels is that we very quickly take out the variable element of our manufacturing costs. With respect to fixed costs, the permanent costs, we -- every year, as I think this group is aware, we spend about $60 million to $70 million in restructuring. And that restructuring goes at structural fixed cost. And that program was part of the base plan for 2020 long before we had a COVID-19 pandemic. And that's on top of, by the way, we spent $456 million between 2015 and 2018 to take structural costs out of the company, one of the reasons why margins have expanded the way they have. But having said that, we have an opportunity to do more. And what we've always said is if we take a look at kind of our company, I think we have an infinite capacity, quite frankly, to take cost out. And the pacing items have generally always been capacity to do it internally, customers' capacity to allow us to do it. And so -- and we said that in periods of economic downturn when we all have more time and capacity, that we could look at potentially accelerating some of these restructuring programs that we have kind of on the docket for some of the out years. And so we're going through a lot of work right now internally to assess and evaluate and decide whether or not we want to pull forward some of these other restructuring plans that we have, kind of what we call shovel-ready and ready to go. But I would say that I'd just like to be confident and knowing that the company has a plan, that we won't let structural costs get in the way of essentially our ability to run the company and to run it effectively. And we fully expect every one of our businesses to be flexing their costs commensurate with the change in the economic environment.

That makes sense, Craig. And I guess the way to think about that is, I guess, with these kind of like shovel-ready cost opportunities, the way to think about that is really kind of really demand dependent. So if the recovery looks more like an L, we would start to see you guys accelerate some of those plans. Is that fair?

Yes. That would be a fair way to think about it. And at this juncture, I mean, I'm willing to say we're working through those longer-term, medium-term views now in terms of what we think the ultimate picture's going to look like. And our teams are working through it right now. And we've always said as well, we don't want to get out in front of our organization and make announcements before we've actually talked to the organization internally. And keep in mind, one of the things that we've done historically is we've said -- every year, we do restructuring. And every year, we're going to spend a certain amount, and we said we're not going to call out restructuring if it's kind of part of the base plan. We're going to just do this every year. We're going to report it as a part of our results. And so the only time we'd ever call it out as a separate event is if we decided to do something big, large multiyear. And so I think that's also the right way to think about it that if we actually did something big and large, we'd probably call it out as well as a separate event.

Got it. No, that's good to know. Maybe shifting gears just a little bit. You referenced the Hydraulics sale earlier in your prepared comments. I think until it's executed, I think folks are going to wonder if there's any risk associated with that. So maybe just address that a little bit on this call?

Yes, I can imagine it's certainly a topic that's on many people's minds. And I'd say no, we remain extraordinarily confident that the deal will close. And at this point, we have every hope and expectation that it will close on the original time schedule, which we said was the end of the year. And I'd say that for a couple of reasons. One, I'd tell you that from a contract standpoint, and we obviously filed the contract, so you can read the terms and conditions, the contract is essentially consistent with ensuring that the deal will close. They've agreed to essentially undertake any remedies that would be required from an antitrust perspective. There's no financing contingencies. And I think even more importantly than that, strategically, and we're talking to them, by the way, every week, we have teams working together, there's been absolutely no backup. There's been absolutely no concerns at all on the Danfoss side about how strategic they view this deal as they look at the future of their business. And so they are absolutely leaning in as much today as they were 2 months ago in terms of doing everything we can to accelerate and get the deal closed as soon as possible. So no, the deal will absolutely close, and we have a high degree of confidence that it will close. And we'll see whether or not COVID-19 ends up delaying things slightly or not, but we have extraordinarily high level of confidence that the deal will close.

Got it. Okay. And so just we've got a few minutes left. I've got a couple of questions from the audience here. So maybe I'll get right to them. So the first question was just around your willingness to maybe operate with more leverage, and how you're thinking about the balance sheet in the context of capital allocation, just given the uncertainty in the markets?

Yes. I'd say that one of the things that I'd say gives us a lot of confidence with the ability to operate with leverage in general is the fact that through how, really, the history of the company, the company generates very strong free cash flow in both good times and bad. And so we've taken a look at this over many different cycles, and our free cash flow doesn't change dramatically in an environment where it's growing dramatically or whether markets are retreating dramatically, our free cash flow is fairly consistent as we work through these changes in working capital. And so that gives us kind of a lot of confidence in terms of our ability to if we found the right strategic deal and we could buy it at the right price, maintaining our pricing discipline, that we have no issue with taking on leverage on behalf of doing a deal. We -- as we said, we'll generate a lot of free cash flow this year, around $3.3 billion coming in with the close of Hydraulics at the end of the year. And so our balance sheet is in outstanding shape. And we have lots of optionality around what we do with that. And that's why, unlike many other companies have said they're basically not going to do any share repurchases, we've said that optionality for Eaton remains. We won't allow cash just to build up on the balance sheet. We're not going to sit on a bunch of cash. And so we'll be comfortable in the event that a deal doesn't materialize, that it's attractive strategically and financially, we're comfortable reinstituting and continuing to buy back shares during the course of the year. It will likely be more of a second half call just due to more of the uncertainty around where markets are. We want to be opportunistic in the purchases, but share buyback is on the table as well as doing a transaction if we can find the right one.

Got it. That makes sense. Okay. Two-part question, 2 themes that are -- been very top of mind for investors. The first one is just around ESG in-house, how your vision and strategy is aligned with kind of broader sustainability goals globally? And then the second question is your thoughts on reshoring. I mean, this has been a very hot topic over the course of the last few days and how that impacts both internally, how you think about your own manufacturing and supply chain, but also your potential opportunity with customers.

So what was the term you said? You said rewind? I missed it.

Oh, reshoring or onshoring. So basically localizing.

Reshoring. Got it. Okay. Got it. First, maybe take the ESG question first. And I said, one of the good things is that if you think about Eaton as a company, I mean, we are an ESG company. If you think about fundamentally what we do today and even the vision of the company, right, is to improve the quality of life in the environment through the use of power management. So everything that we do as a company really aligns extraordinarily well with the various sustainability initiatives that are taking place around the globe. You think about today all the products that we make, all the solutions that we sell are in this power chain someplace. And it is our responsibility in the components that we sell to ensure that power is safe and reliable, but also that power is efficient. And it's kind of core to what we do. So if you just take as an example in a building today, whether it's the use of electric vehicles in preparing the infrastructure around electric vehicles, or whether it's enabling an industrial plant to maximize its resilience through a micro grid and the ability to essentially use multiple energy sources, solar, wind, the utilities and how you optimize that for maximum efficiency, or if it's designing electric vehicles and what we do today in our e-mobility part of the company, or even in some of the technologies and the things that we're doing today in our manufacturing plants and the use of additive manufacturing to reduce weight on aerospace parts as an example. And so ESG for Eaton has always been and will continue to be a very good thing. If you're looking for an environmentally friendly solution to a technical or a commercial problem, it really does play to the technical strengths of our company. And so we will continue to work on all of those initiatives. The piece around reshoring, bringing -- how it's going to impact ultimately the manufacturing footprint, I think that's another one where I'd say it's too early to know how this plays out. On the one hand, I think we've all learned a lot during the COVID-19 pandemic around where the soft spots are in our supply chains, where we are perhaps single sourced where we'd rather be double sourced or stuff that's been shipping around the globe. But I will tell you that even during this economic downturn, the biggest issue we had have -- has not been supply chain. We probably have not lost one order today because of the supply chain. The bigger issue we've dealt with is really the demand destruction that's taken place as governments around the world and governors around the U.S. have basically shut down local economies. I mean, that's really been the bigger issue more than it's been whether or not we can essentially, on the margin, optimize the supply chain. We have a little bit of a problem today on the Mexico border, as many of you probably have read about, as those industries in the U.S. have been -- that have been deemed essential aren't necessarily the same industries in Mexico. And we're working through that. But even there, we've not today lost any business as a result of it as we've been able to move some of that demand to other facilities that happen to sit in the U.S. or in other geographies. So I think it's another one where we're going to step back once we get through this particular pandemic and do a comprehensive assessment. And we'll probably learn some things around where we need better redundancy or better resiliency in the supply chain. But I'd say that probably the bigger takeaway for me is that our suppliers and the supply chain has performed amazingly well through this particular event. And a lot of what was feared early on about the massive dislocations in the supply chain really never came to fruition.

And on that note, it's super interesting, Craig. Thank you for being with us today and really appreciate your participation in the conference. I hope you have a great weekend.

You as well. Appreciate the time. And like any time you want to talk, we're here.

I'll take you up on that. Thank you.

Got it. Thank you.