Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

Hi. Good morning. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 3 of our 19th Annual Laguna Conference, virtual this year, in person next year. I promise. I think I have a -- someone joining me this morning, who will gladly meet up in Laguna as well. So [ we're in for one. ] But joining me next for our fireside is Eaton Corporation and Chairman and CEO, Craig Arnold. Craig, thanks for joining us as always. Good to see you. Thanks for making the time. Before we jump into it, I have a few opening remarks. I do need to remind everybody about a few disclaimers. So for our research disclosures, please see our research disclosure website at morganstanley.com/researchdisclosures. And for all other questions, please reach out to your Morgan Stanley salesperson. So with that, Craig, welcome again. Thanks for making the time. Why don't you lead us off here, talk about a little bit what you guys are focused on and seeing out there, and we'll dive into it on the Q&A side.

Great, Josh. It is great to be with you this morning. And I'd love to share some opening comments that -- before we kind of dive too deeply into Q3 and the well-documented supply chain challenges that we're all facing. I just really wanted to remind the group why we feel so good about the long- and medium-term prospects for our company. And I want to begin with this growth trend that we think will be favorable for many years to come. And it's really beginning to show up on our order book. And as we all know, much of this is tied to climate change and how it's driving an unprecedented level of government spending and regulations that are designed to reduce the carbon footprint and to improve our aging infrastructure. As a result, we're seeing significant growth, as you know, in renewables, it's estimated that some 75% of power generation to come from solar and wind over the next 30 years. This growth in renewables requires additional electrical infrastructure, all the things that we make and sell. This is also leading to what we talked about as an energy transition. So you have more electrical content and everything from cars to buildings and really everything in between. And as the sources of power become more distributed, what we call Everything as a Grid, it requires more of the things that we sell, like circuit protection, microgrid controllers and software. The other major trend is, obviously, digitalization of the economy, more intelligent products, it's this explosive growth in data and the need for more data centers and age computing and solutions that monetize the insights from this data, something that we do through the Brightlayer platform and the data that we generate. So once again, more of the things that we make and sell at Eaton. And in our industrial businesses, we also see attractive growth. The growth in eMobility is well-documented by now. We'll see growth in the market of the automotive industry, where today, they've hit historical lows in inventory. We think it could take up to 2 years for even inventories to get back to historical levels and an eventual recovery in the commercial aerospace market as we put COVID-19 behind us. And on top of these factors, the prospects of a fairly significant infrastructure build that's not even baked in will accelerate each of these trends. As a result, we think the growth prospects of Eaton have never been better. Each of these trends fit perfectly into what we're doing as an intelligent power management company. Our internal plans, as you know, call for 6% to 8% growth over the next 5 years. We've hedged this back in our plans to 4% to 6%. So if things go well, we can see some upside from what we're planning on. And we'll continue to expand our margins. Over the last 20 years, we talked about some 600 basis points improvement. As we look forward, we're going to expand our margins by 400 to 500 basis points, and we'll continue to go achieve these goals by really driving the business system, driving operational excellence in our manufacturing sites and in our support functions, and we'll continue to improve our portfolio. And lastly, I'd just say that we'll continue to deploy capital wisely. We'll generate some $9 billion of free cash flow over the next 5 years. We'll continue to pay a strong dividend, which has increased by 10% a year over the last 10 years. And we'll continue to pursue value-creating acquisitions focused in our Electrical and Aerospace business. And so as a result of this, we talked about 11% to 13% EPS growth over the next 5 years. And so what I said is that there have never been a better time to be an investor in Eaton. So with that opening, I'll turn it over to you, and we'd love to address your questions.

Excellent. Thanks for that, Craig. So I'd be remiss if I didn't start on kind of the topic of the day or certainly the topic of the week as well on supply chain. And I think even running up into our conference, I saw a number of folks out there, including some folks that overlap with you guys, cite some issues. How is that going at Eaton? Where are you seeing kind of the biggest bottlenecks, whether it's on price cost or availability of product or labor? And then maybe talk through what you think the resolution looks like.

Yes. No, I'll take them in order of significance. I mean, clearly, the big challenge for us is really supply chain availability. Again, it's been well-documented, the issues around semiconductors, resins, various types of metals that we source. And so coming into Q3, we really expected that we'd start to see some improvement in some of the supply chain bottlenecks. And much to our surprise and to the surprise, really, I think, of everybody in the industry, we've seen that things actually got materially worse in Q3. And specifically, as I think about it across the Eaton portfolio businesses, a lot of this is really in our Electrical Americas business that tends to use a lot of these types of components, whether it's the semiconductors that are going into our kind of intelligent components for our products or in the resins that we use and the products that we make. So a lot of the challenge really has been -- I'd say, is pretty broad-based, as you know, across the portfolio of businesses that we're in. You've seen it with a lot of our end-market customers, announcing challenges around supply chain. And so yes, it is pretty significant. It's pretty broad-based, but I'd say more than anything, it's really focused on our Electrical Americas business in terms of our ability to support customers. But the demand levels are strong, in fact, maybe even stronger than what we imagine that they would be. Secondly, to the point about labor, yes, we are having some challenges in and around labor. I'd say more than us specifically, Eaton as a company, I think the bottleneck really is showing up in a lot of our suppliers who can't get labor to make parts to ship to us. I think it's really where we're seeing the biggest issue. I think that does resolve itself, though, in the near term, and I don't think the labor shortage issue is going to be a big challenge as we move forward. And then to your point around price cost, I mean, yes, it's never easy in the context of getting price in the marketplace. But I'd say as challenges go, there's probably never been a better time in the market to get priced in right now given the commodity inflation we're seeing, given the overall shortage of supply, given the fact that demand is clearly outstripping our ability to produce at this point in time.

Got it. And I guess, how do you think about the resolution on some of that product availability? It seems like it's the most acute problem. Is that something you think resolves itself by year-end?

Yes. I'm hopeful that by the time we get to the end of this year, things have settled a bit. But I acknowledge as well, we got it wrong -- I think we all got it wrong with respect to -- we thought some of this would resolve itself in Q3. And so I really don't think it -- depends upon which particular commodity you're talking about. If you think about some of the challenges around semiconductors, that will probably be with us for much, I think, of -- through the end of this year and into much of next year. Some of the other resin-based shortages, some of the other metal-based shortages that we're seeing, I think they do resolve themselves certainly by the Q1 of next year or so.

Got it. And because Eaton does have quarterly guidance in addition to annual, should we think about maybe 3Q being -- kind of bearing the brunt of that, but some opportunity to kind of hold the line on full year? How would you kind of sensitize some of the things that you've talked about?

Yes. I appreciate the question. As we think about the quarter itself, the first thing I'd say is that you could certainly expect us to be within the range on earnings per share, and earnings will be in the range. We're going to have some challenges, though, with respect to our revenue. And I'd say that if you think about the revenue guidance, we'll probably be slightly below the low end of the range on our revenue guide, largely as a function of the inability to serve the demand that we're getting. And a lot of that will be really focused, I'd say, more than anything in our Electrical material -- Americas business. The global business is doing fine, and they've done a better job of getting out in front of this, but it seems like a lot of these supply chain-related challenges are really centered in the U.S. and in our Americas business.

Got it. And I appreciate the color on that. So it's really helpful context in this environment. Now I would imagine the other thing we'll be able to see as a consequence of this is probably some good order uptake and some good backlog numbers in that as well. Is that sort of the other side of the coin?

Yes. Very much consistent with what we saw in Q2. I mean record backlog, orders will be very strong. And it's not a demand issue at all. I mean demand is really strong across the board and, as I indicated, perhaps even stronger than what we imagined to be dealing with right now. But demand is strong across really the multitude of end markets that we participate in.

Got it. And then just on the cyclical recovery at large, and this will touch on a lot of things you mentioned in your opening remarks that you're kind of in this handoff of the cycle transition and some of the broader elements of electrification, which kind of go beyond the immediacy of what industrial production or PMIs are doing. Data center and resi have sort of led the charge right now. I think you talked about in 2Q, starting to see some of the C&I elements picked up more. Are you seeing that shift continue as we've kind of gone through the year? And how would you think about the secular elements contributing to that as we start to get into kind of the business of expansion versus COVID recovery?

Yes. And I think today, we're probably seeing contributions in terms of this order growth on both sides, both kind of the cyclical recovery as well as some of the secular growth trends that we were experiencing. But I would say that we're really in the early innings, which I've said before, with respect to some of these secular growth trends. And we've not yet really seen the real benefit and power that's going to come as we work through these really secular growth trends of energy transition and the more electrification of the economy. We're really in the early innings of that, and the benefit of that, I'd say, today is really not even showing up in any significant way in even in our order book. Yes, we're seeing some early wins. And as we talked about in some of the earlier meetings, Josh, there will become an inflection point in these industries. And I think one of the things to watch is really the electrification of the automotive industry as an indicator of when you're going to hit these inflection points, when there is no longer going to be enough capacity on the grid to support the demand, as you think about what's going on with buildings, as you think about some of these regulatory changes that are coming down the pike and some of these dollars that are being spent in places like Europe. So I think we're really in the early innings of a lot of these secular growth trends that we think are going to really accelerate our growth as we look forward.

Got it. And I guess one sort of halfway house along the way in that transition that you didn't mention is nearshoring. So not quite secular, not quite cyclical, maybe somewhere in between. But I think one of your bigger customers, if not your biggest, talked about that as maybe a potential driver of their business farther down in that electrical chain. Is that something that you guys see and expect to benefit from?

I mean it's another one of these -- I'd say we're in the very early innings. We've seen some specific examples where -- in certain industries, putting capacity in North America. You can think about semiconductors as a good example of that. But absolutely, that's another one of these trends. I think what we've all learned as we come through COVID-19 and these fairly massive disruptions in our supply chain is that you need to be local. Now Eaton has always believed in manufacturing and zone of currency. So today, our footprint is pretty well situated around the world. But for many of our customers, there is a lot of discussion around should we be bringing production back, should we be building more resilience in our supply chain. A lot of that is going to mean that on a relative basis, North America benefits. And to the extent that North America benefits, and it will, that is a really good thing for Eaton because we have much higher relative market shares in North America than we do in other regions of the world.

Got it. Got it. And then just on some of these longer-term drivers on electrification, there's a handful of things. And I -- certainly, something we've talked about a lot, and I know you guys feel the same way that it's not one thing, right? It's not just EV infrastructure or distributed power or grid modernization. It's a lot of things pulling together. Where do you see kind of the tip of the spear there? It seems like utility has picked up in recent years. So maybe it's that. But how do you see that progression of maybe some of those areas of spending from a time line perspective?

Yes. And as I've mentioned, I really believe that the tip of the spear really is the automotive industry and the electrification of cars. And if you take a look around the world, you go to a place like Norway, for example, which today probably has the highest penetration of EVs anywhere in the world. And what you saw once, say, the automotive fleet reached some 10% electric vehicles, you saw the step-function changes in investments that were required at the utility level, at the community level, at businesses to provide charging infrastructure for employees as they come into the buildings or charging infrastructure in your homes. And so I really believe that the real tip of the spear, the industry to watch, to really understand when this thing is going to really inflect in a really meaningful way, is the automotive industry. I think even today, if you think about on the building side, I mean, there's code-driven changes. And so today, there's more electrical content going into every building that's built, every home that's built because the electrical codes are changing. And those electrical codes, AFCI, ground fault circuit protection, are driving more electrical content in buildings. But then you also have trends of the move away from carbon base, so moving from electric -- from gas cooking to electric cooking. So these trends are taking place, and they're showing up today in new buildings. But I think the big thing is really going to be this adoption of electric vehicles. And as you see in all the headline news, every day, there's another example of another automotive OEM who says that we're phasing out production of internal combustion engines. And so that will be the big one that I'd say that will be kind of the indicator that things have changed in a really fundamental way.

Got it. So maybe that's a good segue into a broader discussion on the portfolio. I mean Eaton sort of has a foot on both sides of the riverbank there. How do you view that transition in terms of your own portfolio allocation? Obviously, some of that is commercial vehicles and maybe that time line is longer. But does vehicles start to get a brighter spotlight put on it, just as a function of that transition being so critical to the asset?

Yes. What I'd say is that, I mean, clearly, we're heavily focused on our eMobility business. And you see in our numbers, we're investing heavily in eMobility. And we think, as we said, we create a $2 billion to $4 billion business in eMobility over the next, let's say, 10 years or so. But in terms of the legacy business, first of all, there will be a lot of internal combustion engines around for a long time, right? And what we do today is we provide energy-efficient solutions for the internal combustion engine. We provide environmental-friendly solution for the internal combustion engine. And so even in that business, I would tell you that we're very well situated. We are a niche player in the area of that industry that is really getting the little investments that are taking place. And so we think that, that business is just fine. And it's a good business. It's out of the portfolio today. It's great to have a foot in both sides of these camps, especially as the industry makes this transition from internal combustion into electrification. We have a seat at the table. We have relationships with every one of these automotive OEMs, and it really helps our eMobility business. But even more than that, we talked about this a little bit in the earnings call, Josh, in last quarter that, even in the legacy business, the legacy things that we've done, there are technologies that we will take out of that business: transmissions, gears, track and control devices. That business, there's a piece of it that's tied to the internal combustion engine, but there's a piece of it that also has a really strong play in eMobility. And so we said -- what we said in the last earnings call is that we think we've opened up about a $5 billion market opportunity, even in the legacy types of components that we make in our Vehicle business to be sold in an electric vehicle platform. And so we've really expanded our view as well of that opportunity. And so we're excited about some of these technologies that we have that will be relevant in the eMobility space as well.

Got it. And not to leave Aerospace out of the discussion, I think it's worth the anecdote that I had 2 flights canceled in the last couple of months because of maintenance issues where hydraulics were specifically specified. So clearly, there's some parts out there that need some work. That sounds like you're building a little backlog just based on the Pokrzywinski household anecdote. But how are you seeing kind of the aftermarket situation there evolve? Has Delta played a role at all? And you still think that kind of that '23, '24 time line is the right time to think about normalization of the aftermarket side of the portfolio?

Yes. And we've really said that we think the industry doesn't really get back to 2019 levels to maybe the '24 time frame. It's where we're at, and I think it's where the industry is parked logically. But I'd say, for us, aftermarket really follows revenue passenger miles, revenue passenger kilometers. And so passengers, consumers need to be getting on planes, they need to be putting hours on these planes, and that's what fundamentally drives the aftermarket. And certainly, we've seen, as you've -- been widely reported, a bit of a slowdown over the summer. We still think the long-term prospects for the industry are extremely good. We do think that there is some pent-up maintenance required as planes are brought back into the fleet. There's maintenance that's required. There's shop time required for engines and overhauls and the like, which will obviously be a good thing for Eaton. And so we do think that prospects of that industry remain attractive. We'll get back to growth, but we do think we're probably going to be in this kind of period of, let's say, choppy demand until we get beyond the COVID-19 pandemic.

Got it. And then just on the military side of the house or, I guess, mostly military. Cobham closed not too long ago. I guess how is the integration going? How do people -- should people think about profitability in that business? I know that there's kind of a steady ramp that you guys have talked about as part of the deal. Everything proceeding as planned so far? Any surprises along the way?

Yes. No surprises. It's all good. And just as a quick point of reference, you'll recall that Cobham had revenues that were just over $700 million. That business will grow to north of $1 billion over the next 5 years, just based upon programs that they've won on existing platforms. And so it's a defense business and you like -- you generally think about our defense business as a small growing business. But in this case, the most important thing in any aerospace business is are you on the right platform? And then what's your content on those platforms? And in the case of Cobham, we bought a very profitable business that has great content on all the right platforms. And so it really is a growth play for the company in terms of platforms that it's on. And it's also -- as you know, it was a very profitable business and more profitable than our company overall. So it will be very accretive to earnings. So we think we bought a great asset at a good price.

Got it. Understood. And then just coming back to Electrical, you mentioned software playing a bigger role. You guys have the Brightlayer product that takes advantage of that. And I think conceptually, it makes sense, right? There's more grid complexity, and software is kind of intertwined with complexity at some level. But there are some pretty good-sized growth ambitions for Brightlayer. Can you maybe just talk through what a use case looks like? How does the business grow and make money? Because software is certainly buzzy, but this is kind of a newer vector for Eaton.

Yes. Yes. And what I'd say is the way we think about it is we think about it as not simply software. We think about it as how do you monetize data? And in the Internet of Things world, it's all about data, and it's about how do you create insights from data that you can then create value for your customer. And so in the Internet of Things, I've also said it's great to make the things. And so we make the devices at the end of the edge that are basically out there generating data. And we take this data, and we put it into our Brightlayer platform. And inside the Brightlayer platform, we can monetize the data in different ways. We can monetize this data by essentially selling the data to third parties. We can monetize the data by creating software that we would then sell onto the marketplace. And so for us, it really is about beginning with the data, beginning with the things that we make and then finding ways to monetize the value through the insights that we create by using machine learning and artificial intelligence and everything else on top of the data. And so for us, it's not simply about software, although software is an important piece of it. And we do have a number of different software solutions out there today in data centers, in industrial applications, in buildings. And so software is certainly going to be a piece of it, but it is more than simply software. And like we said, we're going to -- we said $500 million of incremental revenue, essentially leveraging the data that comes off of our devices. Some of that will be in software. Some of that will be in simply selling data or selling insights from the data to third parties. So it's, in many ways, complementary to a lot of the other companies who perhaps are playing at more of an enterprise level.

Got it. Got it. That's helpful context. So switching over to the cost side. You guys did a great job on incremental margins last year, pulled a lot of levers. Didn't necessarily have to pay for this year, still pretty healthy incrementals with the added back cost, probably a few stranded costs along the way with Hydraulics and adding in Cobham and some of that integration. What changed for Eaton to sort of get to this structural commitment closer to 30%? Because I think that was always the ambition, but at some point, the cycle decelerated and incrementals kind of came down closer to the mid-20s. Anything that you guys have specifically done that has enabled that shift?

Yes. I think there's been a lot of things that we've done to enable that shift. And we talked about really -- Josh, really going back more than 5 years, this focus that we had inside of our company on driving operational improvements. And so as we think about how do we expand margins, we really think about it in these 3 buckets of, one, we have a lot of manufacturing facilities and how do we run these manufacturing facilities better by driving excellence in our operations. We've -- as you know, we've undertaken a lot of restructuring as a company, including another restructuring program that we launched last year. And these restructuring programs are all focused on getting structural costs out of the company, things -- the fixed costs that don't come back as volume changes. And the third bucket is really around the portfolio work that we've done. And I -- we always talk about the fact that the world is a normal distribution. Every business has a head and a tail, and we are really focused on ensuring that we continue to not only do portfolio management at the level of the reporting segments that you see, but also within our businesses. And so really, it's the combination of these 3 things that have allowed the company to continue to expand our margins and to deliver better incrementals.

Got it. That's helpful perspective. Just coming back to supply chain, I think if I look at the Americas business, I think in the first half, you mentioned some inventory replenishment in some of those channels as being a partial driver. I would imagine sort of conversely, as we've gotten into a tighter environment, is that sort of gone the other direction where maybe there's passive destocking because folks can't meet demand based on what's getting shipped? Do you think that's sort of in the mix right now?

Yes, I think it is. I mean I think, clearly, today, we have more demand than we can serve. And unfortunately, that's meant that there's probably been some sell-down in distributor inventories across the board. And certainly in certain segments of the market, that sell-down has been quite dramatic. And so I do think at some point, there will be some restocking that takes place when we are in a position where we can actually handle because -- this increased demand as the supply chain issues work their way through the system.

Got it. And then just thinking about the duration of those issues, and I'll confess this is deliberately a bit of an unfair question because a lot of things go into supply chain. It's not just one button to push or lever to pull. But relative to the growth plans you have over the next couple of years, do you think the supply chain can handle that 6% to 8% growth ambition, not as a function of market demand, just a function of our ability to kind of move product through that chain more broadly?

Yes. Yes. I don't -- I think if you think about the mid-term, the longer-term growth objectives that we set for the company, I think we will work through -- we and the industry will work through the supply chain bottlenecks. And I think that the one that will be probably the biggest challenge is probably in and around semiconductors, which you've heard a lot about from lots of different companies. But even that one, there's more capacity coming online. And so I do think what we're dealing with right now is a near-term dislocation, a function of an industry and industries in general that are ramping pretty significantly, coming off of an enormous downturn, with labor challenges in some cases that will right themselves, but -- with logistics-related challenges, as you probably read about as well, and just getting containers through the system have been a challenge as well. So it's not -- hasn't simply been getting the components themselves, but even finding containers and getting containers to move goods has been one of the bottlenecks as well. But all of these things will work themselves out, I think, for sure over the next 12 months or so. And I think the growth that we've laid out, which is really -- we've committed 4% to 6%. We have an internal plan of 6% to 8%, and we think those numbers are very much in hand.

Got it. So I want to close out here on a high note with something you guys have talked about a lot over the past year or so, with sustainability and decarbonization, something that I think the electrical portfolio plays a roll in, in a lot of different ways that you've discussed already. Is that something that you're having live conversations with customers about today? I think the longer-term ambitions and kind of societal goals are pretty clear, but is that something in customers' minds? Are they still kind of in recovery management mode?

Yes. No, I would say that we're having very real conversations today with customers in and around their sustainability goals and objectives. I think it's a conversation today that's happening in every boardroom, including my own, around sustainability and business continuity. And so I think it is absolutely real, and it's being led out of Europe, which is not -- probably not a big surprise to you where the Europeans are probably a number of years ahead of the U.S. But I can tell you, we're having those conversations every place, and we are -- engaging in real initiatives and real work today with customers to deal with how do they get to their own goals around net-zero, x percent reduction in their carbon footprint. That is absolutely real. And it's another one of these growth vectors that we think is going to really help the company grow much faster into the future.

Excellent. I see we're out of time, Craig. So thanks for making the time. Promise we'll all do it with a better backdrop than our own office lighting next year. But in the meantime, be well. Thanks for joining us.

Look forward to it, Josh. You as well. Thank you.