Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

Good morning, and welcome to Day 2 of Morgan Stanley's Laguna Conference. I'm Josh Pokrzywinski, the firm's U.S. multi-industry analyst. Joining with me for the next presentation is Eaton Chairman and CEO, Craig Arnold. Craig, thanks for joining us. Just before we get started here, I do need to read a quick disclaimer. Please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that, Craig, thanks for joining us this morning. Good to make the time. Apologies, it's not on the beach this year, but good to hear your voice all the same.

Yes. Great. But hopefully, next year, we'll all be back on the beach together again. So -- but I appreciate it as well, Josh. And maybe just a couple of opening comments from me before we get into the to the meat of the matter, the Q&A, and just try to keep us all focused kind of more on kind of the strategic outlook for Eaton as a company. We talked about this transformation that we're going through inside of Eaton right now, which is another transformation in our many year history as we transition the company to what we call an intelligent power management company, which is really essentially adding intelligence to all the various components and devices that we make. And so that is what we're trying to do longer term. And we think it's really important to recognize it. It's also supported by what we think are really important secular growth trends that support our company. And you begin with this whole idea of electrification that's taking place across society, electrification of vehicles, of homes, of trucks. Everything is becoming more electric, and we are very well positioned to participate in that. And then the third element other than connectivity and devices is this energy transition. We are a big player today in power management. We're a big player in power systems. And as the whole world moves to renewables, Eaton is very well positioned to participate in that growth trend today. If you think about the company today, today, Eaton Electrical accounts for 70% of the company's profits. Just some 10 years ago, it was probably 30% of our profits. And so we continue to transition the company to being a more electrical organization, and with the exit of Lighting and the impending sale of Hydraulics, that journey continues. And then we -- lastly, we continue to build scale and cost advantage. And one of the reasons why we made the announcement to do the restructuring program so we can continue to expand margins and improve the financial outlook of our company overall. We set very specific goals around what we're trying to do to create a company that is delivering higher secular growth, with higher margins, with more earnings consistency. And we've set very specific goals back in our investor meeting in New York around organic growth, 2% to 3%, 20% segment margins, 8% to 10% EPS growth and $3 billion of free cash flow, all of which remain our goals as we move forward as an organization. COVID-19 has put a little bit of a kink in that, but these are still the right goals and we think we'll be back on track beginning in 2021. In the meantime, we continue to deliver very strong free cash flow, 129% free cash flow in 2019. 2020 will be well above this number. We'll generate some $11 billion of free cash flow over the next 3 years and we include the sale of Hydraulics. So the company's balance sheet has never been in better shape, overall. And we -- lastly, I'd say we continue to be very good stewards of capital. Our net debt to EBITDA, 2.3x as of the end of June. We pay a very strong dividend, a dividend that's increased 10% a year over the last 10 years. The current dividend yield is some 2.8%. And so the company just had been very disciplined when it comes to how we deploy capital. We've been a very disciplined acquirer and targeting very attractive returns on deals that we do make. And so I'll just stop with those opening comments, Josh, and look forward to answering the questions from the organization and the team.

Excellent. Well, I appreciate some of those opening comments, Craig. And then I think a lot of things you touched on there are worth following up on in terms of some of the structural elements of Eaton, going forward. Before I get into those, though, maybe just some overall macro observations. You're able to make them in terms of how are you seeing across the portfolio that has some shorter-cycle businesses, some longer-cycle businesses, exposure all the way from consumer into capital-intensive industries. Clearly, 2Q looks like the trough. Are you seeing kind of continued improvement? And what's your characterization of how customers are kind of returning to normal in their own way?

Yes. I appreciate that question. I mean I think what's interesting is that the world really is playing out very much like what we anticipated and shared during our Q2 earnings call. If you think about the largest businesses out of our companies, obviously, our Electrical Americas business, and that business really did hold up fairly well even in the midst of kind of the worst of the pandemic and the economic retrenchment. And we've exited the quarter growing just modestly, and that was kind of the guidance for Q3 that we'd be close to flattish. And so that business is performing very much in line with that. And a lot of the discussion that's taking place around the impact of the commercial market. But if you think about our business today, the commercial market accounts for about 20% of our electrical business. And most of what we call non-res construction is going into other markets, many of which are holding up just fine, whether that's data centers or utility markets, whether that's things like warehouses or fast food restaurants. And so that business continues to hold up very well. What we said specifically about our Electrical Global business, which is the second-largest segment inside the company, that's the business where we actually report our revenues from Crouse-Hinds, which is where we get most of our oil and gas exposure. That business, as we said, would decline roughly low double digits. And that's, once again, very much consistent with what we have seen in the quarter-to-date. And so no surprises at all there. To your point, on the short-cycle businesses, that's where we probably have seen businesses come back faster than what we originally anticipated. North America Class 8 truck, I'm sure you've probably seen some of those numbers. But that market has come back very nicely and faster than what we originally anticipated. As has the light vehicle market. The passenger car market, really, around the world, has come back a little faster than what we anticipated. And you saw the numbers out of China where passenger cars are up about 10% in the month of August. But even in North America, the August SAAR was 15.1 million cars, which is still down modestly, but better than what we certainly anticipated in terms of the recovery of that market. And in Aerospace, that's the one market I would say that, very much like we talked about in Q2, is going to be a longer-term recovery kind of path as we move forward. We don't think that market returns to 2019 levels into maybe '23 or '24. And that market continues to labor very much in line with our expectations. But that market continues to be down pretty significantly.

And then I guess -- and that's great color, Craig. I appreciate that. The one element that I think is potentially poised to make a turn here is if you look across distribution, it appears that inventories are fairly low. Obviously, that means a lot, depending on the end market and customer you're selling into. But across Eaton's distribution partners, would you characterize that as being low? And how would you think about maybe timing of a restock there?

Yes. No, I'd say that's -- there's been a lot of discussion about inventory levels in the channel and then where we are at this point. And what we're hearing mostly from our distributors is that inventory levels are about where they want them to be. I mean I think that question is always a function of what your outlook is for future revenue, right, in terms of whether you have the appropriate amounts of inventory. What we didn't see a lot is destocking, Josh, in -- during the midst of the downturn, nor do we expect, at least at this point, any significant restocking. I mean we could be surprised on the upside, and that would be a great thing to occur. But at this point, our -- what we're hearing from our distributors, our inventories are largely in line with where they want them to be, need them to be, and we are not anticipating, at this point, any significant restocking.

Understood. So just pivoting into kind of the businesses themselves and bridging off some of the opening comments you made. I think most of the folks on the call are aware, or hopefully aware, that Eaton's definition of nonresi is perhaps a bit broader than commercial construction in the way other folks might think about it. Given that there is some backlog and a longer-cycle nature to some of those elements, how would you characterize visibility sitting now versus where you would be in kind of a normal September? Is it cloudy as a function of maybe some of those smaller troubled pieces? Or does this feel like, all things considered, not too far off of a normal year, especially given the backdrop?

Yes. And I'd caveat these comments with the assumption that we don't end up with a second wave, which, obviously, the pandemic could -- which means all bets would be off. But I would say, by and large, these markets in general have held up better than what we anticipated. We continue to have reasonably solid bookings. Our backlogs continue to be very attractive in these markets. And so I would say that we're feeling that, pretty much consistent with historical patterns of what we're seeing in our business right now. I don't -- to what extent did you get a little bit of a snapback from a weaker Q2? Tough to determine. But by and large, we feel pretty good today about most of these end markets. And to your point around the definition, I do think this broad definition of non-res is probably not useful. But we really do think about managing the business really in the segments of commercial, institutional, utility, data centers. We really do run our business and really think about it in some of these more refined segments. In fact, we go further. We think about commercial, which is a market that's getting a lot of attention these days, even that market is subdivided into some segments that are performing well and are expected to perform well. Think about warehouses, you think about fast food restaurants, offsetting perhaps some weakness in the office segment, perhaps some weakness in hospitality. And so we do run our company and run our business by these various verticals, and all of which are performing, I'd say, reasonably well right now. But it is the diversity of all these different end markets that we serve, we think, that's helping our electrical business hold up fairly well.

And I -- just digging into one of those verticals that's been particularly topical on the utility side. Obviously, that space has become pretty attractive given modernization investments and renewables and grid hardening and, obviously, some of the tragedies on the West Coast. How has that business performed, I guess, against that backdrop? Clearly strong, but maybe characterize visibility and some characterization, if you wouldn't mind, on how are customers buying this stuff? Is it big chunky spend, large projects? Or does it tend to be more of a consistent kind of small-ticket purchases that just keep adding up?

Yes, fair enough. Yes. In the utility market, first of all, I'd say that utility, for us, it is an important segment. It's about 15% of our electrical business. And so it is an important segment for us. And it has held up, it has held up reasonably well. And we can talk about low double-digit growth and low -- excuse me, single-digit growth in the market right now. But the big opportunity, we think, is still out in front of us, Josh, with respect to what's going on in utility, whether it's grid resiliency or grid hardening or dealing with some of the downstream implications of some of the fires and other things that have caused outage issues or just sheer global warming and what that's meaning for various utilities around the world. And so we do think that the best days for the utility market are, quite frankly, out in front of us. There's a lot of conversations taking place today around things -- that utilities would like to do. As you know, they need rate increases, and there's a fairly comprehensive regulatory process that they need to go through in order to get the funding to do the things that they, quite frankly, need to do. So we do think that the utility market, as we look out over the next 5 to 10 years or so, continues to be a very attractive space, and we really are just in the front end of some of these newer technologies, including renewables and how that's going to impact the grid as we talk about this energy transition that's taking place. But every one of these things will put additional pressure and challenges on utilities that will require them to make investments in capital equipment.

And I guess within that, are there natural white spaces that Eaton doesn't participate in today that perhaps it could or should going forward? I know there is some software exposure within that, and clearly, hardware as well, both from yourselves and what came over with Cooper. But are there other areas in between that would give you a stronger position that maybe we should think about as a target for M&A?

Yes. And I'd say that -- what we said was that our top priority for M&A is electrical. And so I think it would be reasonable to assume that things that are in and around the utility space would be a part of that overall kind of mix as we look at opportunities in utilities, for sure. But I'd say you're right, we do play very broadly in the utility space, both in the hardware and in the software side. For example, one of our software offerings is something we call Sign, which is used today by 60% of all the utilities who do, essentially, planning in and around their grids. And so we do look to this utility space as an attractive market that will deliver better future growth prospects than it has perhaps, historically, and as they go through this transition. And so we can find a way to pull off a transaction in that space and once again meet our return expectations. It's certainly something that we would be willing to take a look at.

Understood. And then just kind of switching in one of the other big topical verticals within electricals, data center has clearly been very strong. Anything you see changing over the next couple of years, either strategically, competitively or just sheer bottlenecks in the ability to keep growing this market off of what's a pretty large base now?

Yes. I really don't. I mean I think this market is going to grow almost indefinitely. I mean if you think about, once again, this whole idea of the world just continues to generate, consume, process, store more and more data. Everything is becoming smarter, right? Homes, buildings, offices, cars, trucks, aircraft, everything is becoming more intelligent. Everything is streaming, consuming, processing more and more volumes of data. And I just think that growth trend that is supporting the underlying growth in data centers just will continue for an indefinite period of time. And we haven't begun to hit kind of the next big inflection point, which is, as you think about autonomous and machine-to-machine communication. So I think data centers continues to be a very attractive space for a very long period of time. As you know, we are a major player in this market. We will continue to look at M&A opportunities in this space. We acquired this company earlier this year called PDI, which was a bit of a tuck-in acquisition, but a very important one for us in serving the data center market.