Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

Well, good morning for those of you in New York, and I guess it's good afternoon for those of you in Europe. I'm Andrew Obin, BofA Multi Industrials Analyst. And I have a pleasure of introducing Rick Fearon, who is Vice Chairman and Chief Financial and Planning Officer for Eaton Corporation. A little bit of history. Rick was the first meeting that I was allowed to take as a senior analyst like 15, 20 years ago. So that's where it started. And Rick has been one of the most interesting people I got to work with during my career on Wall Street. So I really, really appreciate his thoughtfulness and just somebody I've learned a lot from just observing him. And I believe this is the last or one of your last meetings that you can help sort of discuss how I just don't see Rick slowing after departing Eaton. So it's definitely somebody's gain. And Eaton is our top pick despite Rick leaving. So with that, I think we're going to jump straight into Q&A.

Just the way we're going to do it is I have some prepared remarks. People have been very good about sort of pinging me on Bloomberg or you can participate through Veracast. Or you can ping [ Fitz ], our SPAC sales guy. And we'll definitely try to incorporate your questions into our discussion. So look, first question, I'm sure nobody has asked you this in the past couple of weeks, but commercial and institutional, there is investor debate on the direction of commercial and institutional construction, which is 29% of the electrical business. What is Eaton seeing in its market and how quickly could quoting and design activity pick up?

Yes. Obviously, an area of keen investor interest. And if you look at the institutional side, which is about 10 points out of that 29% that you quoted, Andrew, we're seeing a lot of strength in a couple of areas: water, wastewater, health care, actually very strong. And so -- and the institutional tends to have multiyear spending programs. And so that has not shown significant weakness. On the commercial side, warehousing has been strong, as you would imagine, with all of the new Amazon-like web deliveries models that have -- people are using. And the weakness we've seen in commercial has been more in what we'd call traditional commercial of hotels, offices, retail. But we're starting to see some signs that things are picking up. So for example, if you look at things like the Dodge Momentum Index, which are items -- which are projects that are entering the planning stage, that was up about 7% in February compared to January. And year-over-year, it was up about 3.5%. If you look at the backlog that Associated Builders and Contractors, a trade association, maintains of its members, I think in February, the backlog ended at 8.2 months. And that was the highest backlog since February a year ago. And so we are seeing glimmers of things starting to accelerate. And I think that's consistent with the pandemic's grip lessening. We've seen vaccinations in the States pick up dramatically. We have seen just a comfort level that the world is going to repair itself over the next 6 months and certainly in the U.S. and a little bit later in Europe, given some of the vaccination challenges that the EU has. But it seems to us that we are going to start seeing the market to improve. And of course, there -- you well know that there are other nonresidential areas that are continuing very strong, like data centers. I mean, we're seeing continued, really strong strength in the data center area. And utilities, also very strong. And so it's really just the small parts of the commercial -- traditional commercial that has lagged. And I might add that if you go around the world, Andrew, you look at -- if you look at Europe, you're seeing pretty good strength still in building. In China, hard to tell the comparisons because remember, the pandemic hit them first. But if you looked at the year-over-year improvements in China in nonresi, resi, up dramatically, like 50% improvements January, February over a year ago. So all in all, we felt pretty good about the general tone of the electrical markets.

This is something that actually came out in a prior meeting. Somebody was highlighting, I did not appreciate that, as part of the school reopening, there is some money allocated to improving ventilation systems. I would imagine that you guys would participate in that as well. I do have -- we will talk later about just the overall green infrastructure push under the new administration. But did you see anything in the latest stimulus bill that could benefit you in the near term?

Yes. I mean, there are several things in the new bill. The new bill has, I think, more programs than most people realize are built into it.

I did not, that's right.

The stimulus bill -- I mean, you talked about the school ventilation. We provide electrical controls that go on to HVAC equipment. So that's an area where we will see some benefit. In general, the Biden administration has looked for every opportunity to put in green building-type initiatives. And you see some of those in that stimulus bill. And we obviously are a significant beneficiary of that. And so yes, that stimulus bill is -- I think it's maybe a little mislabeled as a stimulus bill. It's many things all wrapped into one.

Okay. And we would expect to see this sort of hitting your revenue in '21, right?

Yes. Yes. I mean, I think that spending will start happening pretty quickly probably even in the second quarter. It might be towards the end of the second quarter. It takes time for some of these projects to get really kicked off. But certainly, in the back half of the year, we should be seeing a benefit from that.

Got you. So maybe data centers, I know you guys have been quite constructive there. So you're projecting high single-digit revenue growth for your data center and distributor IT business, which 17% of electrical. What's your relative positioning within hyperscale, colo and corporate-owned data centers? And also, sort of broader question, you announced Tripp Lite acquisition. How do you plan to integrate this pending acquisition in the overall business?

Yes. Those are 2 good questions. We have a -- quite a similar market position in hyperscale, colo and enterprise. And by the way, all of those segments are growing well. We are seeing large enterprises put in orders for and build new data centers. Obviously, hyperscale is taking a little bit of share from the other areas, but we're seeing strong growth across all 3 of those areas. And to your point, Andrew, the overall market's likely to grow high single-digit this year. And we would expect to outgrow that just because of all the initiatives we have underway. I have some news on Tripp Lite. Tripp Lite, we have gone through the entire regulatory approval process. And so we are in the process of closing that transaction. We expect to close it today, and we'll put out an announcement once that is completed. And Tripp Lite is mainly a distributed IT bet. I mean, they provide power quality equipment that allows you -- for smaller pieces of equipment to have power quality backup. But some of the equipment does go into data centers as well. And so our -- we have the team swinging into action starting tomorrow really effectively, and we are going to integrate it into our distributed power quality business. We already have a significant amount of revenues in that, but our revenues are more oriented towards Asia and Europe than they are the States. And so this will really bulk up that business in the States. And it's also going to add a set of ancillary products, they call them connectivity products, that we don't currently sell. And so we're going to take those products. And we're going to distribute them around our power quality business globally. And so we're excited to add Tripp Lite to the family starting later today.

Well, that's -- I guess, you're leaving -- you can definitely -- didn't want this sort of hanging around. So let's just go to U.S. green infrastructure. Look, as far as we can tell, so far, green energy plans have focused on adding renewable production versus grid modernization, although I'm curious what's going to happen after Texas. So can you just talk about, a, from Eaton's perspective, what are you looking for in the stimulus and infrastructure plan? And just -- and what's out there already, right? And how do you view the current benefit, the benefits of what's out there already, but also going forward, things like tax credit for energy efficiency retrofits, renewable generation, right, with knock-on effects for grid infrastructure? I know you are very, very thoughtful about it. How do you see it playing out over the next 12 to 24 months?

Well, I guess, I would say that there are 4 areas that we think the green efforts will particularly impact for us. And let me just walk through them. And first of all is an acceleration of the pace of electric vehicle adoption. And as you know, a big part of the Biden platform is to recommit to the Paris climate accord. He also is looking at using the Clean Air Act to reduce greenhouse gas emissions. And there will be a variety of items that I think are going to be put in place to accelerate the adoption of electric vehicles, including, I think, they will step up and do some further tax credit activities. And in some cases, the tax credits have actually fallen off for some producers now. And I think they understand how important tax credits can be to accelerating adoption of electric vehicles. Secondly is this initiative to renovate 4 million buildings in the U.S. That's a significant initiative, and they'll pursue that through the Department of Energy, through states and localities and put in place a variety of programs. Third is to push infrastructure investments in the electric grid and in water, wastewater. Both are -- those areas are areas that have had a woeful lack of investment over the last 20 years, and we're seeing the impact. We're seeing an electric grid that is not resilient enough. We are seeing a water infrastructure that, in too many cases, it has pipes that are either not of the safety standard that we would expect or fundamentally just are leaking and causing other types of issues. And so there'll be a big push there. And then lastly, Biden has said he's going to put a focus on federal R&D in this environmental area. And in fact, I think he said he's planned the largest ever investment in clean energy research and innovation. And so we would expect to be a part of that. I mean, for example, if you look at a variety of these federal R&D programs, and we have various participation in the programs, in some cases, we have grants. And if you look at the big innovation center out in Colorado that they've put together, we're actually on-site of that innovation center. In fact, we're the only company on-site at that innovation center. And so those are the 4 areas where -- that we think will likely happen where we will have a significant role and a benefit.

No. That sounds like a lot. So maybe we can just sort of look at EV charging. So I think you're aiming, if I'm correct, to grow EV charging to somewhere between $700 million to $1.2 billion of revenue by 2030. I think currently, you're partnering with another company, Green Motion, for the EV charger itself and focusing on power, storage, distribution and software. Do you have any interest in bringing the EV charging equipment itself in-house?

Yes. I would say we do and stay tuned. I mean, we talked about our very close relationship with Green Motion. And by the way, Green Motion is an outstanding company. It's been a developer of hardware and software in this charging space for about a decade. It's also the largest charging operator in Switzerland. So it has lots of installations, and we think it just has an outstanding product and software set. And so all I can say is stay tuned. We are -- we have a very close relationship, and I think it will get closer over time and -- because we think EV charging is a significant opportunity, as you outlined. Now we've said $700 million to $1.2 billion. The overall market in the U.S. -- by 2030 in the U.S. and Europe, we think, will be about $12 billion. And so could that be conservative? Potentially. I mean, we don't want to get ahead of ourselves in committing. But if you look at our typical share in the U.S. market, it's north of 30%. And so you could well imagine that we could do even better than we've laid out. But again, 9 years is a long time from now, and there's obviously uncertainty. And so we don't want to get ahead of our skis on this one.

Well, that's -- that sounds very interesting, actually. So maybe it's sort of a bit of a dirty word these days, but oil and gas, which is coming back, but what portion of your electrical business is tied to oil and gas, just to remind, the legacy Crouse-Hinds brand? And what are you seeing in terms of any uptick in demand as oil prices are rebounding? And are your customers thinking about spending differently going forward, just -- not just the level but also what they're spending on going forward?

Yes. Yes. Well, we have about 5% to 6% of our electrical sales in oil and gas. The great majority of those are in the Electrical Global segment, where we put our Crouse-Hinds and B-Line business. And we are definitely seeing things start to improve. I mean, as I look at our order trends, as I look at the sales, we're starting to see a pickup. And that's not too surprising because what drives it is a view that oil prices are going to sustain themselves at a higher level, which I personally think is likely to be the case, given that I think activity levels around the world are going to pick up in so many areas just as the pandemic winds down. And because of that, you're seeing things like rig counts, which in the U.S. dropped to about 250 million at the depth of 2020, are now already over 400 rigs in operation this week. And so as the rigs go into operation, that's when there's a need for our kind of equipment that is used in operating the rigs and in the controls of the rigs, things of that nature. And then if I look at our negotiations on large projects, because we participate in lots of aspects of oil and gas, that's -- the biggest part is actually downstream, not so much upstream. And as the economy has improved and there's shortages of various materials in so many areas, we are seeing more large projects be conceptualized. And so our negotiations have actually improved quite a lot compared to 3 months ago. And so we're modestly optimistic, I would say. I mean, it's -- oil prices do bounce around a lot. So it's not surprising to us that we've gone through this dip, but it does seem to us that we're on the other side of it and pulling out of the dip.

That's actually quite bullish. So maybe we'll go to residential. Can you just describe, remind us what is the largest driver of increased Eaton content per home? And how should we think about increased content? We're thinking sort of maybe 1 to 2 points to underlying market growth in U.S. and Europe. But how should we be thinking about it?

Yes. I think the 1 to 2 points is a good outgrowth expectation. I mean, if you think about what we supply into residential, let's just take the U.S. and Canada, where we would -- many would regard us as a market leader in residential, if not, we would be very, very close with Square D, the other large player in residential in the U.S. and Canada. And what really has helped our business is obviously just the underlying renovation activity that's happening as well as the growth in housing starts. And by the way, the housing starts for February were not quite as strong as some had thought they might be. But of course, you had a lot of not-very-good weather in February. And if you look at permits, you see housing starts or at least future housing would look to accelerate from where we are now. So we continue to think you're going to see strong new building activity in the States. But really, what helps us a lot is the adoption of these new electrical codes. And so the 2020 code has been adopted now in 9 states, but only 9. So you got 41 states that are yet to adopt that. And as these codes are adopted, they insist upon higher-level, more complex breakers and other control equipment. And we are very strong in those kinds of equipment. And so that's really the big driver. It's the embracing by the various states of these more safety-oriented electrical codes, which play right into the product suite that we can supply. And by the way, we -- I think Uday talked a lot about it during our Analyst Day, but we have very strong relationships in the housing industry. I think 7 of the 10 big home builders we supply directly to, and we also have strong relationships in the aftermarket. We talked about our new arrangement with Lowe's, where we've taken over the supply of electrical equipment into the Lowe's facilities.

This is great. So maybe we can just talk about the -- just electrical business overall. Can you just talk to us more about your differences in your go-to-market approach between Electrical Americas and Electrical Global? Interestingly, you have set up 2 recent international JVs, 1 in China, 1 in Middle East. Is this in your model that you're sort of going to be pursuing more actively going forward?

Yes. Well, their -- the approach to going to market in the U.S. and Europe is broadly the same. It's using these electrical distributors, people like Rexel or Sonepar or WESCO, and we use them in North America as well as in Europe. And then we have a certain set of customers that we supply directly, typically very large customers but not a large number we supply directly. We typically service our customers through our distributors. Now obviously, we have a very strong distributor network in North America. And in parts of Europe, we also have very strong network. But there are other parts of Europe where the network is not quite as strong. And that's just simply a function of how long we've been in some of the European markets compared to how long we've been in the North American markets. Once you go to Asia, that changes. The Middle East and Asia, you find that you don't have as sophisticated a set of electrical distributors. You find much more of the volume goes directly to customers, and that was certainly part of our thinking around Abunayyan. Abunayyan gives us a long-established family in Saudi Arabia and a very good entrée into the large customers of Saudi Arabia and the surrounding countries. And so we took advantage of the opportunity to partner with them, and that gives us a much better window into so many different customers. In the case of HuanYu, it's really both their window into large residential contractors but also their product set. I mean, they are a specialist in what we call Tier 2 and Tier 3 products. So these are the less-featured electrical equipment, but the equipment that's used in the majority of residential construction in China. And so our strategy is to get access to these residential developers through HuanYu, to sell HuanYu's equipment but also Eaton equipment, but then also to take the HuanYu products and sell them in other markets outside China, so think of the subcontinent India, Southeast Asia, even Africa, other markets that would use Tier 2 and Tier 3 products as opposed to Eaton's more fully featured and more expensive Tier 1 products.

Got you. That's quite interesting. So maybe we can sort of shift to margins. Can we talk about source of upside or risk to '21 margin targets? And then maybe we can also talk about restructuring, where are we going to see the most pronounced benefits? And as long as we're sort of talking about the margin, inflation is another hot topic. So maybe just sort of throw in the impact of raw material inflation into the conversation. So margin targets, restructuring and how to think about inflation.

Yes. I would say, Andrew, that the upside to the guidance we've given would be volume-based. If we have more volume in total, which it does seem as if there are some signs that, that might be the case, as well as mix. I mean, for example, if, indeed, we see the commercial aftermarket return faster than we had thought, and there are some signs of that, the -- certainly, the volume that went through the TSA over the weekend was the highest it's been since the pandemic started. And as that kind of aftermarket mix improves, that certainly is a source of margin improvement. I think the risks are really that the principal risk is the speed at which the commodity cost increases can be offset through pricing and other cost containment actions, and we certainly have a full-court press on that. And you've seen us deal with spikes in commodity costs many times over the last 20 years. And what we've always said, and I think it's always played out this way, that typically over a couple of quarters, we will offset entirely the commodity cost increases. But you can have a lag sometimes of a quarter or 2 when you haven't entirely offset the increases. And so I think it will play out the same this time around. Our own expectation is that these rapid increases in commodity costs are likely to attenuate and maybe even to retrace a little bit by the time you get to the end of the year. I mean, it's not as if people that make copper and -- or that mine copper and make steel are sitting around not observing that, wow, prices are pretty darn good. And that is likely to draw more supply into the market. That's always what we've seen in the past. And that, over time, will cause some of these price spikes to attenuate. But it will take some time because there's been such a sharp increase. And I think the increase in demand has come about, one, from a realization that the pandemic seems to be getting under control in many places. And hence, there will be more demand for certain products. And I think the increase also is because inventories were too low. And certainly, in a lot of manufacturers, the inventory levels have come down too much. And so they need to rebuild their inventories in order to be at a steady state kind of basis. In terms of restructuring, the program is proceeding exactly as we had laid out. And as we indicated, the majority of the actions will be complete by the end of this year. Now that doesn't mean we'll get all the benefit this year because it's across the year that we're making these actions. But certainly, in 2022, we should get virtually all of that [ mature ] year of $200 million benefit.

Got you. And just thinking about -- I know you think about these things. Do you think -- how is this inflationary cycle going to be different from, let's say, the past 20 years? And what do you think is the best historical analogy to what we are seeing -- to what we're going to see on inflation this decade? Because that seems to be a big debate, right? Some people think because of baby boomers, because of China, inflation is never coming back. And then I have people saying, "Look, it's like the '70s all over again." So what did you come out?

Well, I do think it's a different environment. You -- certainly, the commodity cost increases we saw in the 2000 to 2009 time period were largely driven by China growing so rapidly. But I don't think you're going to see Chinese growth rates anywhere close to what they were on average during that time period just because of population dynamics in China. And so I think what you're seeing, this spike is really just a recovery spike. And I personally have every confidence it will settle down sometime over the next 9 months. It's just hard to tell exactly the pace of that settling. In terms of whether we will see broad inflation, I actually think it may be more of a monetary phenomenon than anything. We've seen the M2 grow dramatically in the U.S. We've seen it grow dramatically in Europe. The stimulus spending, by its nature, should be somewhat inflationary. And so hard to tell. I mean, I can see the arguments on both sides. And certainly, I think all of us are cautious about proclaiming inflation has returned, given that anybody that proclaimed that over the last decade was just plain out wrong. And that has to give you pause, right, that it's a little more complex than simply looking at 1 or 2 factors. But my expectation is that you're not likely to see enduring much higher inflation over the next several years. You might see inflation pick up a little. That would be my base case.

And how should I think about, in an inflationary environment, the balance of inflation for a company like Eaton? On one hand, some of your highest margin businesses make a lot of money in an inflationary environment, also gives you sort of incentive to revisit pricing. You have very strong channel presence versus this raw material pressure. So just -- I tend to think of inflation as a positive for Eaton over the long term because you actually service the right industries, and you have the pricing power in the channel. But what do you think?

Yes. I agree with you. I think over the long haul, we're well structured to deal with inflation. Our channels, by and large, understand how to deal with it. They're used to dealing with it. And we have a product mix that also is used to seeing inflation in inflationary times. So we're not afraid of it. It's just something that has to be managed. And it does take a lot more management to deal with an inflationary time period, at least in the early days. You've got to get the whole system working, making price increases at the right time, not being late in making price increases. And you've also got to manage your supply chain well and not find yourself seeing inordinate price increases as demand is very strong. And so -- but on balance, it's not something we're afraid of.

So maybe this is sort of a new topic that you introduced at the latest Analyst Day. But clearly, you guys have been at it for a while, sort of IoT and software strategy. So how does management differentiate intelligent products' software strategy of -- relative to more well-established automation and industrial IoT players, right? We used the term, I think we sort of discussed it, like a stewardship approach to data management. Can you just provide more context around how you plan to monetize recurring revenue to achieve your $500 million target?

Yes. Our idea, Andrew, and it's maybe just a contrast, somebody that's selling -- that builds a software system, an ERP software suite maybe, and tries to sell that into a customer, what we're trying to do is to take our data and to collect the information from the data. So in a way, we are stewards of that data and then use various techniques, AI and other techniques to draw the patterns from the data and then use those patterns either by embedding it into software or by using it in various predictive-type instruments, including predictive service-type arrangements. And so that's our cut. We already do sell about $1 billion of software and service, a mixture of those 2. The software that we're now selling are mainly related to selling it to utility situations. So for example, about 60% of U.S. utilities use our grid planning software, which is a software that allows you to add or subtract generation sources and users off of a grid and then look at the balance and make sure that it all works. We also have a software that is involved in demand response. That's a software that we use. And also, we have an increasing software implementation into -- that goes into data centers, so DCIS-type software. And so those are software that we currently sell. But what we're trying to add to it is software that takes full advantage of the information that we distill from our currently installed base of equipment, of which we have about 6 billion different installations.

Wow. Maybe another thing, and it's interesting because I think your European counterpart has been quite vocal about it. I think -- but if you look, I think, underneath the hood, it's not that different, ESG. Can you just talk about -- just update us on your internal ESG initiatives? And I think we touched on it sort of revenue opportunities from sort of green initiatives. We sort of talked about it. But maybe you can talk about how do you look your positioning on this ESG, both in terms of your ESG practices and ESG opportunities relative to your global peers/competitors?

Yes. Well, ESG is clearly at the core of what we're all about, I mean, the core of our mission. We always say that our mission is to improve the quality of life and the environment. And our products, broadly speaking, are all targeted at using power in ways that are better for the environment that -- where we use less of a given feedstock, where -- or we use a power source that doesn't have any emissions at all, like wind or solar. And so just pursuing our product development strategy and our product solutions strategy itself is an ESG positive. But then we're working very hard on very specific ESG initiatives as well, whether it be in the R&D that we're working on. We're expecting over the next 10 years to spend about $3 billion on product spending that's targeted at sustainable product solutions. Whether it be on the social element, where we have a very significant initiative underway to improve the diversity of our employee base and actually have made very good progress there. I mean, for example, if you looked at our senior management team, it would probably be amongst the most diverse of any large company in the U.S. or Europe. And if you look at how we run the company day-to-day, if you look at the waste to landfill, if you look at greenhouse gas emissions, we have a significant effort at managing that, reducing the impact of that. And then lastly, on the governance side, we pay a lot of attention to how we manage the company and how we make sure that we're appropriately responsive to shareholders and to outside pressures. And I think these ESG imperatives are not going to go away. Companies that are not embracing them, I think, are making a big mistake. And so our approach is to embrace these ESG initiatives, implement them effectively, successfully and then report on them on a regular basis. And so we're going to report every year in our sustainability report just how we've done so that people can assess, are we making the progress that they would expect?

Well, we are right on time. We are out of time now. So thank you on this note. Thank you so much for joining us. And as I said, I can't wait to hear about the next big things you're going to do because I just don't see you sitting around. So Rick, thanks so much for doing this with us. I really appreciate it. Very special.

You're welcome. Thanks, Andrew. Glad to be here.

Yes. Bye-bye.