Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

All right. Good afternoon, everyone. We are here in the home stretch of the 8th Annual Credit Suisse Industrial conference. We're very delighted to be joined by Craig Arnold, Eaton's Chairman and CEO. So thank you for being with us. And I believe that we're just going to hop straight into the fireside chat.

I thought maybe the first question, obviously, an announcement yesterday, you announced that Mr. Tom Okray will be joining Eaton as CFO. Maybe you can give us a little bit about the excitement around that announcement?

Yes. Thanks. First of all, it's a pleasure to be with everybody today. And once again, we wish we could be together in person, but I think we've all become very accustomed to operating in this format. And so we look forward to sharing. So, yes, we're absolutely thrilled to announce that Tom Okray will be joining the company in January. As everybody knows, Rick Fearon has been a very effective CFO. He's been with the company now for more than 18 years, and we have a mandatory retirement age of 65 million. Rick will turn 65 sometime in March. And so at the end of March, he'll be leaving us, and we are absolutely thrilled that Tom has decided to join the company. I mean, Tom comes to us with just a wonderful background as a very strong operational finance person, who has a real strong track record around helping companies grow organically, which is obviously one of our top priorities. He has a wonderful understanding of distribution channels, both today's channel and future channels, and he's just got a tremendous reputation as a developer of people. And so, we're absolutely thrilled that Tom has decided to join the company, and we look forward to his contributions.

Excellent. Well, we look forward to getting a chance to meet him when he joins.

And what I will just say on top of that, John, is for the team in general, is that, you can expect our approach to the way we interact with the investors, sell side, buy side, to remain the same. I mean, obviously, different companies have different philosophies around the way they do it. We like the way we engage today with the investor community. And so I would not read anything into Tom coming in. And you can expect us to continue to follow the same strategic approach and essentially, the way we engage with the investor community to remain consistent with past practice.

Excellent. There's a couple of bigger themes I'd like to touch on during our conversation. But maybe just the next question. We're sitting here in early December, not sure if there was anything that you could kind of gleam from November, but wanted to leave it pretty open-ended and see if there was any kind of update on any of the trends you're seeing?

Yes. No, I would say that the fourth quarter for us is really turning out to be very much like what we anticipated. What we guided for Q4 is that the midpoint of our guidance, roughly a 6% decline in our revenues. Very different mix depending upon which part of the business. Our largest business, our Electrical Americas business, we talked about a return to growth in Q3, and we'd expect to see that business grow again in Q4. But by and large, we've not seen anything that would suggest that the guidance that we provided for Q4 would not still be valid today. And so we're absolutely pleased that 6% negative is certainly not a number that we're extremely proud of. But it's better than Q3, better than Q2, and we think we're on the right path. And more encouragingly, as we look out to 2021, we still believe that all of our segments will see end market growth next year. And we think that's really encouraging for the future.

Great. And then I guess, maybe a little bit more around that Electrical Americas, I think last quarter, there was some conversation about what the channel looked like in terms of inventory levels. There's obviously a mix of different verticals that are either growing or contraction as we think about nonresidential construction markets, but maybe you could unpack a little bit where you're seeing that strength come through here on that Electrical Americas segment?

Yes. Happy to do so. And I'll begin with the pieces, the reference with respect to the channel, because our business very much like what you heard reported from others. We did see a little bit of channel restocking that took place in Q3, as inventories were drawn down pretty dramatically, in Q2. So we saw a little bit of restocking. We think inventories today are largely in line with our forward forecast and our distributor partners forward forecast of where we think markets are going in '21. So we don't expect to see significant swings one way or the other as we look forward, and we think inventories are largely in good shape. As you mentioned, yes, you see a very different picture in terms of the growth outlook, depending upon which end market you're talking about. Clearly, data centers continue to be a very strong market. Orders up some 9% year-to-date through September. Residential markets are flying right now. Maybe you read about what's going on in the U.S. today in residential construction. We're seeing a multiple of -- in our businesses in general. And so residential is extremely strong. Utility markets remain very strong as well. And so on the other side of the equation, as we've talked about, the industrial side of our businesses are certainly seeing some weakness. Oil and gas continues to be slow, for sure. Large industrial projects continue to be a little bit slow. And I know there's been a lot of discussion over the years around -- the last year around the commercial piece of our electrical business. And today, the commercial piece of our electrical business is about 20% of the business. Now -- and that's the piece where there's been just concerned about whether there will be some structural change related to COVID-19. And I would say, maybe to give you a little comfort around that one, yes, it's 20% of the business, but within that 20% of the business, 1/3 of that is renovation, the aftermarket. So that business is likely not to be impacted. And then inside of that, also in commercial are things like warehouses as a segment. In the warehouse segment with the growth of places like Amazon, that separate sector is growing quite candidly. So we think, by and large that -- nothing that's happening today with COVID-19 will have any sort of structural impact on the aggregate growth profile of our electrical business.

Yes. That's an interesting point. So when we think about Eaton's data center business, right, it's not just the UPS, but it's the UPS plus all the electrical equipment that goes with it. We had another company earlier talk about a warehouse today is very different than a warehouse 5, 10 years ago. So I'm kind of curious, as you talk about that warehouse segment, is there also an opportunity that now they're just -- they're lot more automated, so there's more need for electrical gear, other things that are going into that warehouse that might not have before?

I mean, you're absolutely right. When we talk about it in the context of the electrical intensity of various applications, and if you look at the electrical intensity of a warehouse today, or quite frankly, if you look at electrical intensity of a warehouse versus, let's say, retail space, the electrical intensity is much greater. So we have a lot more content in a warehouse application than we would, let's say, in a retail store. In fact, the warehouse segment as it accounts for about 5% of that market, whereas, retail would account for about 1% or 2% of the market. So you can see order of magnitude, warehouses for us are a much more important segment than what goes on actually at retail.

Yes. Then one of the things that we've tried to use to help forecast your data center business is take a look at some of the backlogs and some of the public REITs out there. And they're still sitting at pretty high record levels. Lot of focus on the hyperscalers, but how do we think about that kind of wave of backlog that still needs to be executed on? What's the timing? When does that flow through in kind of your orders and then into your revenue?

Yes. I'd say, first of all, you think about the market, you really have to think about data center in these 3 separate markets. There's hyperscale, there are the colos and then there's the on-prem office buildings like the ones that I'm sitting in right now. And colo accounts for about 20% of the market overall. And what you find in general in data centers is the market does tend to be a bit lumpy, in the sense that, if you look at any one of these segments, you could be in a period of build out or you could be in a period where they're actually selling the capacity that they brought online. And so I'd say that the good news is that, when you look at these 3 in aggregate, we've seen a very positive long-term growth trend that we think will continue for a very long time, but it's difficult to really translate from one of these individual markets to extrapolate exactly to what we think the growth is going to be in data center markets in aggregate. But in total, we think the growth prospects are very, very strong. The backlog, as you mentioned, in the colo sector is good. It's typically anywhere from, let's say, 6 to 12 months, depending upon the project between these projects being let. And when our equipment comes in and our equipment, as you can imagine, goes in early. We tend to be in the front of this process when these things are built out, and then they essentially put the racks in down the road as they sell-out the space and these colo data centers.

Great. So one of the things that we would love to kind of get a little bit more of your perspective around -- and I'll wrap it around a broader kind of digital question, but you started to mention what is a bright layer on the last earnings call, and there are some press releases out there around that. Maybe help us understand kind of what you're trying to do in that space and maybe a little bit more about what exactly that bright layer is?

Yes. Great. Appreciate the question. When think about it this way, right, so, in the internet of world, we make the things. And so we make all of these devices and components and systems out there in the marketplace. And they're all becoming intelligent. Switchgear, UPS equipment, fuel pumps that are on airplanes, hydraulic pumps. So everything is becoming intelligent. So everything today is streaming data. And for us, what bright layer is, it's the platform where we actually take data off of all of these distributed devices. We stream the data, and we do it in a very consistent and uniform way across the company. So we build that pipe once. We put cybersecurity around it in a consistent way across the company. But once you have this almost data streaming up, it comes up to what we call the bright layer, and that's where we apply data science, machine learning, is where we take the data and we create new insights. It's also the place where we use for collaboration, collaboration with customers, collaborations with other third parties around how do we find ways to monetize the data that's coming off of our various devices. And so that's generally what bright layer is for us. It's a little bit of a marketing handle as a way of talking about the things that we're doing in a way of digitizing and monetizing data that's coming off of our various devices and solutions in the marketplace.

And then does that ultimately get sold as some type of subscription service? Or are you using the data for yourself to make the products more efficient? Kind of what's -- how does it translate?

Yes, yes and yes. It's really -- it's really -- it's ways, finding ways to monetize the data because we created unique insights. And so it's really a way of creating an opportunity for a subscription service that allows the data that's coming off of our devices that we then created unique insight from and then selling that to customer partners, using it internally to improve the quality of the performance, the reliability, the durability of products. It's really all of that. It's where we also then will create software solutions in and around our particular products and our domain expertise as well.

Got you. And then is there any time frame on when we should think you might start talking about a revenue bucket for some of those services and software?

Yes. Today, I can tell you, we already have very measurable revenues coming off of our devices that we're already monetizing. We have not broken it out separately, and we don't tend to talk about it separately because we do see it as an integrated whole. We sell components and the real value comes from the components and the data and the insights that come off of those devices. And so we typically keep them linked together. So we're not in a position right now to talk about specifically the revenues that we're going to get from the monetization of this data. A lot of this is, quite frankly, future opportunity, but we really think about it as an integrated whole. It's one of the reasons why we think as you look forward, our electrical businesses, our industrial business will grow faster as we think about how do we monetize the data, the insights that are coming off of our devices. And it's one of the things that's really, I think, different about the new Eaton.

And then kind of another -- one of these big topics, right? We've all been trying to figure out what does it actually mean to the numbers or the growth rates, but the clean energy transition, right, more electrification, right? You have a lot of utility products that are playing, going into the grid that are helping integrate renewables. How do we put numbers around that? Or how do you think about the opportunity for Eaton?

Yes. First of all, I think it's -- I appreciate you bringing it up, because as we think about the company today, we really are today, hooked into a number of really important and large secular trends. One of which is the electrification of everything. Everything is becoming more electric. Your homes, buildings, cars, trucks, planes, everything is becoming more electric. And as a result of that, it's bringing additional opportunities to Eaton. I mean if you think about today, the electrical content that goes in a home, the electrical content that goes in a building, everything is becoming, as I mentioned, more electrified. You think about the growth of electric passenger cars, as an example. And so that is an important growth trend that's going to help the company grow certainly faster than we have historically. But you wrap that together with what's going on in this whole energy transition that's taken place with the growth of renewables. And with what we talk about as everything, ultimately, becoming a grid. And what that means is that homes, buildings, cars, if you think about the future of the electrical grid, everything that we interact with will have the ability to both consume and to sell electricity back to the grid. You think about today, think about an electric car today, why can't your electric car also be the backup energy source for your home and also sell electricity back to the grid. And the reason that brings opportunities for a company like Eaton is that, if you think about today, managing the grid, which is, historically been just a one-way flow of electrons from the utility to the point of consumption. So if you start flowing this electricity in both directions, it creates complexity in the grid. And in order to manage that complexity, you need different software solutions, you need different hardware solutions, and that really plays to the sweet spot of where we are as a company. Yes, we've been in the historical space of the utility market. And the utility market, I think, as we look forward, is no longer going to be your sleeping dad's utility market, as they think about hardening the grid, cybersecurity, the liability of the grid. There'll be huge investments that are going to go on. But even more than that, they're going to have to really make changes to accommodate all these renewables that are coming on and all of the electrification that's coming on in and around cars and trucks and building as well. If I can just give you one small example because this is such an important point. In this building, that I'm sitting in right now at Eaton, it's an office building. This office building would accommodate 800 people. We have the ability today to essentially -- we have maybe 7 or 8 charge ports for electric cars. As soon as you go from 7 or 8 to 25 or 30, the electrical infrastructure in this building is no longer adequate to accommodate charging these vehicles and running the building. So that's what's going to take place across buildings and homes, across the U.S., and it's going to be a pretty significant change in growth rates.

Well, yes. No. So that's just -- it also seems like that really drives that renovation, retrofit. I mean there's going to be an upgrade of existing infrastructure on top of whatever comes new.

Exactly.

Interesting. We got a lot of questions after last quarter around, how to think about Eaton's incrementals, right, for next year obviously, you have some restructuring savings, you have some temporary costs. Help us understand what's kind of the ZIP code you think is the right number as we think about next year in incrementals?

Yes. I appreciate that question as well because I think it's -- as we go into '21, we are going to see growth in the company and growth in most of our end markets, and it will be a pleasure to start talking about incrementals again, instead of decrementals but typically, as you noted, we have done a number of things this year, and I complement the organization for being very proactive to get some cost out. And a lot of these costs will tend to be onetime costs. Things like, taking time off without pay and reductions in the bonus plan, these are things that are onetime that will actually come back into the equation for next year. And so we typically talk about incremental rate at this point and let's say, a recovery of 25% to 30%. So it will probably be on the lower end of that, given these onetime costs that account are going to come back, but we'll certainly be in a position to give you more guidance when we lay out a specific plan for '21.

Got you. No, that makes sense. Then maybe, obviously, we have the pending transaction of the sale of Hydraulics kind of -- I'll leave it pretty open-ended. What's kind of the next gate we watch for? Anything to update timing-wise? And then I think, you can probably anticipate the follow-on question. But I'll leave it there for now.

I think I probably could. But just to deal with Hydraulics, first, I'd say, I can tell you that we're making the progress that we expected to make in terms of getting the business ready for sale, all of the work that we have to do internally on our side and all the work that Danfoss had to do internally on your side. That work is progressing as planned. And Danfoss is absolutely thrilled about the prospects of owning the business. And so it's really, in many ways, it's in the regulators' hands now and very much like we anticipated. There's a lot of back and forth between the regulators, both the U.S. and the European regulators. I will tell you, as you will recall, we mentioned before that, Danfoss has basically agreed to hover high water, which simply means that, whatever remedies are required in order to get the transaction closed, they will undertake those remedies. And so there's absolutely no risk here at all about the transaction closing. The transaction will close. It's really a matter of deciding now what do the Europeans and the U.S. regulators require in the form of remedies to ensure that the overall competitiveness of the marketplace remains intact. And that's the normal process that we're working through right now. And so I would say that, COVID-19 has certainly been a challenge for them. As many of these regulators are working from home, very much like all of us. And so we've had a little bit of a delay as a result of that. But the transaction will absolutely close. And as we mentioned, we'll get roughly $2.9 billion of cash from the transaction. We're so pleased. We sold it at a very attractive multiple. It's a great business for Danfoss and an outstanding asset for them in terms of the combination. So we think this is a win all around for everybody.

And then the follow-up on is, obviously, you're going to have that cash infusion, right? You obviously -- how should we think about between debt paydown, potentially using it for other kind of shareholder-friendly actions?

Yes. And I'd say, we'll have that roughly $2.9 billion. But if you think about it over the next 3 years, we'll generate some $11 billion worth of cash between what we generate and what we're going to get from that transaction. So the company's balance sheet has never been in better shape. And as we think about allocating our capital, we've always said that the first priority is organic growth, ensuring that every one of our businesses have the capital that they need to play to win every day. And so we'll continue to invest heavily in organic growth and invest in digital and digital solutions for our businesses. We'll continue to pay an attractive dividend. Our dividend yield today is about 2.5%. We've paid a dividend for the last 100 years. Our dividend growth over the last 20 years or so has averaged the compound growth rate of about 10%. And so we will continue to grow our dividend with earnings. And we'll buy share back -- shares back. We committed to buy back 1% to 2% a year on an ongoing basis. But when that's all said and done, we'll have a lot of cash leftover. So we have optionality around what we do with it. And we would like to deploy that cash in the form of growing the enterprise through M&A and the priorities there continue to be primarily, we focus on electrical, and we are seeing more deals now than we have, quite frankly, in some time. And so we're encouraged by that. We've also said that we still like aerospace as an industry. We like defense, a little better right now than commercial. But we still like aerospace. And if we can find the right asset, it has more of a defense emphasis on it, that's another area that we would certainly consider deploying some capital towards.

And then obviously, just thinking about aerospace markets, right? A lot of debate on the trajectory of a recovery, both on the OE and the aftermarket side of aerospace. Maybe you can provide your perspective and how you're planning for the recovery at aerospace here?

Yes. And this is not an easy one to call for sure. And if you take a look at where most of the industry prognosticators are, they think we're late '23, '24 before the market returns to 2019 levels. And so as our baseline assumption, that's what we're planning for as well. We're hopeful that the market would return faster than that. And we think with these -- with the vaccines that have now been approved and more coming, it looks like every week now, we think the industry may return to growth sooner than that. But that's our baseline assumption. And the restructuring that we've done in the business, it was really designed to deliver a very profitable business at this level of economic activity. And so we're hopeful that the recovery could come faster. And certainly, where we'll see it largely first is, in the aftermarket as revenue passenger miles, revenue passenger kilometers start to increase. But at this point, I really think it's too early to make a call that's different than what you're hearing from most of our large customers, which is really late '23 or '24 before you see a recovery. Now as you know, 40% of our aerospace business is also defense, and the defense business is holding up very well, and we would expect that, that business would continue to perform well.

And it's not always a topic all the time. But I think, Eaton, you've started to make some investments around additive into your own kind of manufacturing processes. What can you tell us about some of the benefits from that? Is that something that you think is really something special? Any -- I'd just love to get your thoughts on that technology?

Yes. Okay. Yes, additive for sure is a transformational technology, where it's the right fit for the market. And so when you think about where does additive really a tremendous value. It's really where you're dealing with complex parts and through additive, that complexity you get for free. So you can grow a part in any shape, size, form that you want. You don't have to machine it out of a big hog of metal and end up with a lot of waste and inefficiency. And so where you have high-value parts that are complex parts like aerospace, for example, that technology just adds tremendous value. And we've done a lot already in that area. We have, obviously, 3D printing machines that are doing legacy stuff that supports tooling for our plants in many different places. But on the more commercial end, we're really putting some of our first investments in aerospace, and we already are -- have additive parts that have been certified and are flying in military platforms already, and we're obviously working very closely with customers on commercial platforms as well. So we do think where you have complexity of parts, where you have high value-added parts, additive can be tremendously helpful and really help you get to market faster, take out tremendous waste out of the system and help add to your profitability.

Great. And then maybe circling one of the last segments we haven't hit yet. Vehicle, maybe get your thoughts around how you're positioned. Well, obviously very strong potential NAFTA Class 8 truck market in front of us, kind of what are you thinking about that? And then obviously, I have to ask the electrification question, right? And obviously, that would play with what you're doing in eMobility. But are you seeing the pace there change of conversation with customers at all?

Yes. First of all, to your point on North America Class 8 truck, we think 2021 will be a very strong year. You probably saw the data that come out -- came out to us. I think, today around orders for the month of November, 51,000 units. And so orders are booming right now. The industry numbers anywhere from 250 to 275 depending upon -- the high-end is 275. And most of the industry is really centered around at least today, 250. We'll see if that number goes up or not off of a base of 200 this year. So it's going to be a very strong year in 2021 in the truck market in North America. And that will be a very good thing for us. But also, the light vehicle market is also going to be a strong market. We think the light vehicle markets next year are going to grow by double-digit off of this year's base. And so I think that's going to also be a very good new story. And to your point, in electrification of passenger cars, the news just keeps getting better. I mean we had some growth numbers out in the early days that people thought we were aggressive in terms of our assumptions. We talked about creating this $2 billion to $4 billion new segment inside of the company. And we may have been conservative, quite frankly, in terms of the size of the market and the rate at which the market adopts electric vehicles. And so momentum has certainly continued to build. Every major automotive OEM around the world, they continue to announce new electric platforms. And so we're absolutely excited about the future of electrification and what it can mean for the company.

Great. And it looks like we've hit there at 30 minutes. But with that, maybe I'll turn it over. See if there's any closing remarks you'd like to make. Otherwise, I would certainly like to thank you taking the time here. Really appreciate it. And we hope that everyone stays safe.

Yes. No, I just want to say thank you. Appreciate the opportunity to interact with everybody. We are absolutely, as you can tell, thrilled about the company's prospects and the work that we've done this year, the restructuring work that we've done and the things that we're going to do to continue to accelerate growth, to expand our margins and really just deliver a much more predictable and consistent company in the future. And so I appreciate the opportunity to interact with everyone, and please stay safe. And we look forward to meeting again sometime soon in person.

Sounds great. Thank you, Craig. Appreciate it.

All right. Thank you.

Take care.

Take care.