Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

It's Deane Dray, RBC senior analyst covering the multi-industry electrical equipment group. We're delighted to host Eaton for our next presentation. And presenting from the company, we have Rick Fearon. Rick is Vice Chairman. He's CFO. And I also see he includes Planning Officer among his many titles. I've known Rick forever. Good afternoon, Rick. Thanks for participating, and where are you joining us today?

Well, Deane, today, I'm in my office and outside Cleveland. We have most of the senior management team back into our office, and things are going fine. Occasionally, some of us will work out of our home office, but we find we're a lot more efficient out of our main office.

Good for you. I appreciate it. I've got a little bit of office envy of you right now because I kind of wish I had something that's a little bit more normal than my home office here in Connecticut, and I also admire that you've got a stand-up desk, too.

Yes. Well, it helps. When you work long days, it's best to try to stay in shape.

Good for you. It seems to be working.

Hey, let's just jump right in. And one of the themes that we're hearing, and it started last week in the kickoff of the conference season, more companies talking about this continuation of monthly sequential improvements in the macro. And certainly, it's dependent on which businesses you're in, which geographies. But from Eaton's standpoint, how does that match up to the things that you're seeing?

Yes. I would say that we're definitely in the camp that our business is showing steady improvement. And some of our businesses are showing more dramatic improvement. Our electrical business, as you know, was not hit as hard. For example, in Q2, Electrical Americas, our largest segment, had sales down 9%. And we commented that by June, we actually had positive year-over-year sales growth in all regions of the world in electrical, and that trend has continued in electrical. So the business has continued to show the resilience that it showed in the second quarter. But we've seen much stronger conditions in our Vehicle business, in particular, seeing some more strength in other parts of the industrial businesses. In Aerospace, that's one area where the strength has been a little bit hard to come by, on the commercial side. But on the military side, it has remained strong really all year long. I'd just add a couple of data points, Deane, that I think are notable. If you look at our Vehicle business and you look at heavy-duty trucks in NAFTA, which you know we still have a sizable presence in, most of the forecasters in the second quarter, we're estimating the market might be 125, 130. And most forecasters have now moved their estimates up to 200,000 for 2020. And also, if you look at light vehicles, light vehicle sales in China were up 14% in August, 11% in July. And so we are seeing good strength in both the commercial and the light vehicle side. And just one last comment here. If you think about the shape of this recovery, the shape in China has clearly been a V-shaped recovery. I mean, very markedly V-shaped recovery. I mean if you look at things like production of heavy-duty trucks, the last 4 months have seen all-time records in 3 of the last 4 months, all-time records, excavator production, wheel loaders. If you look at housing starts, if you look at residential -- I'm sorry, commercial starts, all of those have shown very significant growth in China. And I would say the U.S. is second behind China in the shape of the recovery. Europe has also shown a recovery, not quite as strong as the U.S. And of course, where we're lagging a bit is in Latin America, which is struggling through a lot of conditions.

That's a great tour by business, by platform and by geography. So that's really helpful. On the China comment, the V shape, the other comment I've heard is FIFO since China was first in to COVID and first out. But has the strength surprised you on the strength of the recovery in China?

I would say it's been stronger than we would have guessed. We thought it would be a strong recovery, but this has been even stronger than that. And I think it's largely a function of governmental stimulus and the efforts of the broad governmental entities around China to boost their economy, and it's working. It's very clearly working.

And speaking of putting actions and seeing results, you all were pretty quick on restructuring actions, getting out in front of this. You could see it in the decrementals being contained. Just kind of size for us what you've done, how much is structural, how much is permanent. And where does that go from here?

Yes. We pulled out the playbook that we had put together in the '08-'09 downturn, and it worked, I have to say, quite well, including things like daily meetings, and in a whole set of cost-containment actions. And those actions allowed us to post quite good decrementals in Q2. We think the decrementals in Q3 will be maybe a little bit higher, not a lot, but a little bit, mainly because some of these cost savings that we've done in Q2 are -- we're going to have to put some of those costs back in. Just for example, travel costs in Q2 were 10% of what our original budget was 10%. And obviously, as the world economy has started to markedly heal, we're going to have to spend more on travel. So that's just one example. In terms of next year, and maybe that's the easiest way to talk about it, we think our decrementals next year -- our incrementals next year will probably be in the 25% to 30% range. And I don't know where we are in a typical cycle, but 25% to 30% is the typical mid-cycle kind of incremental. And helping the incremental will be the big restructuring program that we've embarked upon the $280 million cost, $200 million mature year savings. We expect to be well over half of those mature year savings, the run rate by the end of next year. So we'll get a bunch of those savings as next year rolls out. Having said that, we'll have to put in some of these temporary costs, things like salary increases, things like bonuses, things that we have taken out this year. And so as we think about next year, probably good planning right now without us having done our plan, which we haven't yet probably towards the bottom end of that 25% to 30%. Simply be -- by the way, these temporary cost increases net out against the restructuring savings. But still, 25% incremental, I think, would still turn out to be pretty good performance next year.

Given what we've been through, especially first quarter, second quarter, to ages, to be talking about incrementals again as very comforting. And if you just start projecting out what the recovery looks like, it certainly makes sense. What will be very different is your portfolio in terms of the Hydraulics going out the door. So should I be nervous at all that the closing got pushed out? It certainly seems COVID could be just delaying some of the logistics and approvals from the regulatory standpoint, but give us an update there.

Yes. I have little concern about that transaction closing really for 2 reasons. One, the contract is structured in a way that there are no legal outs, really. I mean there is no regulatory out. There's no financing out. There's no material adverse effect out that would apply in this situation. And so legally, the deal will close. But I would say maybe, even more importantly, is that the buyer is highly enthusiastic. And you know what? This makes a whole lot of sense for them. The time to buy a cyclical business is during a downturn because the owner has to deal with -- we are the owner now has to deal with managing through the downturn and then they get the benefit of the upturn. And so I think there's little likelihood that the transaction doesn't close. I mean I've been doing this for 40 years, buying and selling companies, and this is one that I would put an extremely high probability of close on. Now having said that, it's hard to predict a precise month that closes because a lot of the regulators, in fact, most of the regulators, are working from their homes. They don't have their files with them. In many cases, the files are not electronic. So they've got to send people in to pull documents out of their files. And it just is taking longer than we had originally thought. And so we think this will close in the first half of next year, hopefully, the first quarter, but it's just hard to pick the precise month.

It's -- when I think back of how long this has been on our wish list for divestiture, waiting a couple of extra months is perfectly fine. And just on that perspective, Rick, is maybe 5 years ago, because I cover multi-industry, and certain of the businesses that like Hydraulics have more of a legacy machinery flavor to them is it seems as though the portfolio moves now are coming sooner and more deliberately. And just how is that -- how is it happening now? I'm thrilled that it's happening because I think it's the company, portfolio composition, the mix, the growth, the resilience like the electrical is so much more powerful with this mix as we go forward. But why did it take so long? Is that a fair question?

Yes. No, it's very fair. I mean first of all, to put it in context, and let's go back 20 years, and I've in this position basically 20 years, so I can speak pretty authoritatively as to what happened. We started on a program back right around the turn of this millennia to change the portfolio. And you've got to remember, we were mainly a vehicle component company 20 years ago. And so our strategy was to move more heavily into areas that would have higher growth, higher margins and less volatility. So that's what we're trying to do. And so fast forward 20 years, we've done 71 acquisitions. We've done 50 divestitures. We have markedly changed the company. We're a company now, post the Hydraulics divestiture. We will have 70% of our profits from the electrical space. And so that's obviously a very changed company. If you look back around 2000, it would have been more like 20% to 25% of our profit, and so we feel good about that. I mean our TSR over the last 20 years has averaged 12.5% for 20 years. So you'd have to say that, that's pretty respectable. What has happened as we've marched into the last half of this decade is that we've taken a hard look at what we think the long-term future of different industries is and whether we're the ideal owner of certain of these properties, in other words, whether other people are better owners. And we've concluded that we have enough momentum going on around the company that we can afford to take out certain of these units like Hydraulics, like Lighting, like our Automotive Fluid Conveyance business, and that we're confident we'll be able to redeploy the capital in a way that will continue on this journey. And I think it's working pretty well. If you look at our TSR over the last 3 years ending December 31, 2019, it was 16%, and that was about 3% higher than the median of the DI peers that we track. And if you look at our TSR year-to-date, it's about -- up about 12%, and that's about 5 or 6 points better than our DI peers. So it does seem to be working all of this portfolio change. And I think you'll see us continue to take the hard decisions about units that we think are better off owned by others. But at the same time, we're also going to do it very objectively. As we look at our Vehicle business and we look at all the changes we've made, we've created one of the highest margin vehicle components companies out there. We've sold half of the heavy-duty business to Cummins in creating this JV. We sold Automotive Fluid Conveyance. We've heavily gone into eMobility. And so we've really created a business that we think will end up being a good performer over the next 5 to 10 years.

That's great to hear. And look, those decisions, it requires also getting someone else to the table and saying yes. Some has to work for them. And so anyway, I think you guys have done a great job at reshaping the portfolio. Maybe talk about the non-res construction outlook and how that -- is there an air pocket on the other side of these current projects? Will CEOs green light new projects? What's your thinking at this time?

Our business is holding up quite well. And I think I mean to give you an example, Electrical Americas, our backlog at the end of June was up 11% year-over-year. And so we still have quite a big backlog. And it's not as if we're just winning a few small projects, we're continuing to win sizable projects. And so if you look at the mix, Deane, I think that helps explain it. First of all, about 40% -- let's look at the electrical business [ with large ], about 40% of the electrical business [ with large ], is growing quite nicely. That's, for example, residential. If you look at residential electrical in North America, it's very strong. In fact, our challenge, and that's about 10% of our overall residential, about 10% of our overall electrical business. And our challenge in North America really is adding enough capacity to meet the demand. It's because of all of the refurbishment going on, all of the new house construction that we've seen start recently. Secondly, utility. And of course, you know what's going on with the changes in generation and also the need for more resiliency. So you've got a lot of work on the grid going on, and utility is about 15% of our overall electrical business. And then data centers, data centers, 16%, 17% of our electrical business, and it's very strong, not just in hyperscale. Hyperscale is strong, but also enterprise, also colo data center. So that's about 40% that I would put in the actual strong growth category. Then you've got about 20% that's in what we -- what most people call commercial construction. So that's office, that's retail, that's hotels, that's warehousing. Not all of it is weak. The warehousing is actually quite strong, but the other parts are prospectively weak. They're not so weak immediately. But as some of these projects end, you can imagine that they are not likely to be replaced in the same magnitude of those that are ending. Having said that, I will tell you that these low interest rates create a very different set of incentives for a lot of developers. And there's an old axiom in the development industry, the time to start a project is during a downturn. It's not during the upturn. It's during the downturn so that you open up when the markets turned. And so it's hard to predict exactly how some of these commercial segments trend. Then I would say that there are a variety of institutional segments that are going in various directions, like there's health care, there's education. The two of those are about 5% of our electrical business. There's government, that's about 3%. And of course, you might tell a story that it's going to soften slightly because of tax revenues. I haven't seen it yet, but you could tell that story, but it's only 3%. And then infrastructure with things like water, wastewater, which very strong and because of the enduring needs, I think will continue. And then lastly, 30% is industrial. And other than oil and gas, which is defined there are definitely on the weak side. Other than oil and gas, we're seeing relatively good strength in industrial as a lot of manufacturers are investing to deal with some of the changes around this whole COVID crisis, around the changing trade situation. And so if you think about that mix, you see there aren't that many pockets of definite weakness, and there are some pockets of really market strength, and that's why we think that the electrical business is likely to be quite resilient over the next year or 2.