Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

All right. It looks like we are good to go with our next session. Really excited to have here with us today, Tom Okray, Eaton's Chief Financial Officer. Tom, thanks so much for being here with us today.

Yes. Thanks for having me, Joe. Appreciate it.

So before we get going, everybody who's listening in, if you do have any questions, feel free to e-mail me at joseph.ritchie -- R-I-T-C-H-I-E @gs.com.

So with that, Tom, why don't we kick it off? Earnings just ended. So maybe, just start with some key highlights that you'd like to discuss post earnings, and we'll kick it off from there.

Yes. Appreciate it, Joe. Really excited about the strong start of the year. Obviously, the economic environment is quite challenging and unpredictable. So to be able to exceed our organic growth guidance, to be at the high end of our margin guidance and actually, to raise our organic guide for the year and our EPS guide for the year, really, really happy to do that. Now also, very proud of the team and our ability to manage inflation and price/cost. And obviously, that's a key part of the equation in this hyperinflationary environment. And the team is not only doing a good job with availability, but also, managing that dynamic. And as we mentioned on the call, the markets are just incredibly strong in terms of order flow and backlog. So we're encouraged about the prospects going forward. And we relate that to the secular trends that we have in terms of energy transition, electrification and digitization. And I guess what gets me most excited is I think we're demonstrating that on one hand, we're a company that can really manage challenging environments and grind out good results. But on the other hand, we've also got these great secular tailwinds, which I think is going to provide upside for us for quite some time.

Yes. That's great to hear, Tom. Look, obviously, top of mind for everybody has been supply chain. You seemingly are managing it well. I guess, I'm curious, as you kind of think about the -- your guidance for the rest of the year, do you assume that supply chain will continue to improve from here? What's baked into your guide? And is there some downside risk if it doesn't improve?

Yes. No, it's -- everybody is kind of becoming a prognosticator on supply chain. It's obviously quite difficult. I think what we try to do is just be very agile and really adjust to what's coming at us. Because let's be honest, it's very difficult to predict. It's -- and it was very mixed in the quarter where you've got some components, much better availability, some not so much. Electrical components continue to be challenging. And semiconductors and those types of things, we think, are going to happen throughout the year. Although in a whole, we do see things getting better, but we're really measured in terms of our guide. And I think we've baked in enough conservatism that we're comfortable that we would actually have upside if things break in our favor.

That's great to hear. So price/cost, obviously, super important as well. You were positive for the quarter. Talk us through maybe, some of the outlook then for the rest of the year and how you expect that to progress.

Yes. I've had the benefit in my career of sitting on the other side of the table. And I was at a distributor for a while, so I understand the price dynamic from that perspective. And our channel partners are very important to us. But I understand the dynamic of having good communication with them and making sure that they can pass on the price, knowing when I was a distributor, I love to pass on price. And so we have good communication with our distributor partners. And then also, from my auto background, understanding that dynamic as well. So we're trying to be very fair, very collaborative with our partners. But the bottom line is, our job is to grow margins. And we don't want to be left holding the bag while other people are doing very well. So we're working that really hard.

I'm curious, since you brought up your previous job. Is it easier on your side now? Or was it easier on the -- on your previous role?

I think the distributor population has an -- it's probably easier from that perspective because you can always blame the suppliers. And because there, you can kind of play the middle man. I think it's a little bit more challenging from a supplier perspective. Obviously, it varies case by case, and I'm generalizing, but I think in some cases, it's easier to be the middle man. You can point the finger a little bit more.

Yes, that makes sense to me. Since we're on the topic of price, I'm just curious, just as you're thinking through your organic growth guide for the year, how much of it is driven by price versus volume?

Yes, it's a mix and it's a mix by segment, obviously as well. But there's a healthy amount of price in there. And we don't go into specifics as we've said on the call because we just have such a wide variation of customers and products. But it's a good mix, but there's a healthy amount of price in there given the inflationary environment for sure.

Got it. And I guess maybe, just shifting gears into the segments, right, Electrical Americas gets a lot of attention. You put up 10% organic growth for, at least, your expectation. And I'm just curious, like, you saw order acceleration this past quarter. What -- where are you seeing the order improvement? Again, I'm sure some of that is priced as well. So any comments or color that you can give us around that would be helpful.

Yes. And that was, I guess, one of the most encouraging things -- maybe, one of the most surprising things, too, looking at the trailing 12-month data for Electrical Americas. I mean normally, it's a little bit choppy, but it was very, very healthy across all of our end markets. On a trailing 12-month basis, we were, what, 31% up. And the lowest market segment was 28%. So -- and we had some going as high as 34%. So they were all quite high. So that obviously can't all be price, and we were encouraged. And the actual results for the quarter, strong in terms of residential and industrial. And a lot of people think that residential is cooling down with inflation rates and mortgage rates going up and those types of things. But what I would caution is 5%, still, by historical standards is not so high for mortgage rates. And also, there's scarcity of homes. And don't forget, codes change and people are upgrading, and that's good business for us as well. So there's other generators of demand, and that obviously led to a good result in Q1.

And before we move away from Electrical Americas, I have to ask you the margin question, and I know it's related to price/cost as well. In order to hit your margins for the year, you assumed -- you have to assume a pretty good acceleration into the second half. And so maybe, just help provide a framework for Electrical Americas margins in the second half of the year.

Yes. We do assume our margins to get better and that is -- a lot of that's related to price/cost and supply chain. I think we've been very open to say that there has been more challenges in Electrical Americas as it relates to supply chain. And we see that breaking free in the second half, and we've got that reflected in our guide.

Moving on to the other Electrical segment, the Global segment. Again, really strong growth. Your guidance for the year, 9% to 11%. Doesn't seem like you're really factoring much economic weakness from Europe and China. So just any color around that would be helpful.

Yes. China is a relatively small part of our business. It's 5%. Europe is more meaningful, but it's only 20%. 18% organic growth in the first quarter, very, very strong. Order flow, very strong as well, very similar to Americas where, really, across the board, we had 27% trailing 12 months. And again, on the low end, we were 22%, and then on the high end, we're 41%, so again, very, very strong numbers. I will say that we are more cautious in our guide in terms of the second half of the year. We've got tougher compares in terms of the second half of the year. And we're also reflecting some potential headwinds from China and the war in Ukraine.

Makes sense. The margin progression there has been incredible over the last couple of years. I'm just curious, how sustainable is it? And then also, clearly, Crouse-Hinds is in this business as well. How much of a factor is Crouse-Hinds in the improvement that you're seeing in the go forward?

Yes. Crouse-Hinds is definitely a factor. We had some favorable mix in the first quarter. They were coming out of the pandemic last year in Q1, so there was a relatively easy compare. But I think what we're seeing is broad-based strengths in the industrials, right. I mean that's something -- and perhaps it's related to reshoring, perhaps it's related to pent-up demand and people are now spending CapEx. We've seen that with some other companies coming out. And I see Fastenal, which used to be a great competitor of mine in a former life, they have strong industrial sales as well, and that's usually a pretty good barometer. So we think it's going to continue for a while. Arguably, we're facing tougher comps, as I said though, in the second half. And we don't know what's going to happen in Ukraine and in China. Those are very unpredictable. So we've got a reasonable amount of caution built in for that.

Yes. I do want to ask you about orders in a second, but just maybe, just sticking on Crouse-Hinds, I mean, it would seem to me that it's still kind of like early stages of what could be a higher-for-longer oil and gas cycle. And so just talk to us a little bit about like kind of the opportunity there. And where you sell into? And how you see the trajectory of that business going forward?

Yes, I agree with you. Really, the dynamic with the war in the Ukraine and what's happening economically across the world, I think, really is going to give us a long run in the Crouse-Hinds B-Line business. And I think you raise an interesting point, Joe, because a lot of times, people are talking about short cycle and long cycle. I think those are kind of blurred right now. For example, autos. Shifting gears here, autos, people say is normally a short cycle or a vehicle is a short cycle. But now with the pent-up demand we've got, I think we're at 29 days supply in light vehicles in the U.S., which is incredibly low. So I think that's going to run for a while. Obviously, we've got aerospace, which is traditionally a long cycle. I think that's going to run for a while. We're at 85% of pre-COVID. So we think we have a good long run. We've got military spending in aero, which people are talking about going up on. And then, we've got all the grid hardening and utility spend in the bills, which are just starting to percolate. I think that's going to run for a while. So we -- short cycle, long cycle, we think we've done a good job in portfolio in terms of becoming more long cycle, getting rid of Hydraulics and Lighting and those types of things. But I think -- so I think it's becoming a little bit blurred where maybe, there's kind of a no-cycle bucket there. So yes, encouraged -- I know you asked about Crouse B-Line, but I just wanted to take it a little bit broader and really think we have a good, long run in a lot of our businesses.

You're going secular on me, Tom. That's what you're excited about. The -- it's -- so I mean, in talking about the orders, like -- so it is a good segue, because the market is fixated on decelerating orders. And you've had some of your peers come out and put out like backlog members. And I'm sure, as you look at your business as well, the way you just described some of your end markets, your backlog, I'm assuming, is also improving and has improved sequentially. I guess how do you -- I guess, what's the commentary for the rest of the market? And how to think about the order growth and momentum for your business going forward?

Yes. I think we would expect order growth to slow. I mean I don't think it's going to defy gravity and continue at the rate it has been going. I think we're going to see comps get tougher and, obviously, it's going to slow down. You did mention the backlog though. We've got great visibility on our backlog. We obviously scrub it because we want to know that it's real, and we're confident that it is real. We're also confident with our channel partners where we don't think they're restocking. We think that they actually have shortages in some components, like circuit breakers, those types of things. And yes. So it's -- we think it will slow because of the harder comps, but we're confident in our backlog. We're confident that we're going to see strong economic growth going forward.

So clearly, backlogs are elongating and maybe, kind of like outside of the Aerospace business. Historically, you used to provide information differently, right. Like we used to always look at like the products business versus the ESS business. And it didn't seem like there was a lot of longer-cycle pieces to that business. You're typically a couple of quarters. I'm just curious, from like a visibility standpoint, how much more visibility do you potentially have with your backlog? And then also, how do you feel about the pricing that's in the backlog today?

Yes. So let me take the pricing question. We are working with our partners, our customer partners when appropriate to talk about repricing our backlog. And it's not discussions we like to have a lot, but if we feel we're really at a disadvantage and from a data-driven perspective, we're having those discussions, and we have repriced some backlog. And we're doing it because we think it's the right thing to do from a business perspective, and it's the fair thing to do. And obviously, we're being respectful of market dynamics and our customer relationships when we're doing those types of things. In terms of backlog, I think you're getting at the timing of it, and it obviously is growing. And you said a couple of quarters, maybe now, it goes out 3 to 4 quarters, frankly, where you -- and we have a lot of goods in our factories that are waiting for 1 or 2 components to ship, too, which also gives us great confidence in terms of backlog and shippability. And we're working very hard to get those components, obviously, as everybody is. But yes, I think we have good transparency for probably, 3, 4 quarters.

That's helpful. You did make a comment earlier on inventories. So I'm curious, like, what do you think the kind of current level of inventories are among your electrical distributors. And then also, how much is inventory restock baked into your guide for the year?

Yes. I mean we don't see a lot of restocking. We don't think that's happened. As I mentioned, our distributor channel partners, they have shortages in some areas. So they're really happy to take what we can provide, so we don't see a restocking dynamic.

Okay. And then maybe, before I switch gears into some of the other segments. Just on the electrical side of things, data centers has been an incredibly good end market for you. Curious how sustainable you think that is. And then also, you did mention the -- some stimulus packages that have been passed as well. And I'd love to just hear what you think your impact could potentially be in your utility business.

Yes. No, it's -- data centers, I don't meet anybody that isn't working on digitization. I mean I think it's just table stakes. You have to work on digitization and, therefore, people are taking large amounts of data and drawing insights to them and consuming that data. So bottom line, we don't see data center demand slowing down. We think that's going to grow double digits for the foreseeable future. We think that's very strong presently. We've obviously got good relationships with our partners there. So we think that's going to be another part of our business that's going to have a good, long run. In terms of the stimulus packages, we've got great relationships in the government in terms of working to put together those projects and define those projects. And really, that's the stage that we're at right now in terms of defining the projects. And I wouldn't expect those to actually really start to ship until late in '23, more in '24 to 2026. So the good thing about that, again, is that fits into a tailwind for a good, long run, for sure.

That's great. Just that comment on defining the projects. Just help us, maybe, understand that process a little bit more. I mean the dollars -- or at least, the bills have been passed. It sounds to me like the dollars are still really early stages in terms of being spent. What's kind of like, ultimately, the impetus to actually get the dollars flowing into these projects so that it helps your business?

Yes. Well, obviously, there's a lot going on in government these days, to say the least. So there's a lot of distractions, if you like. So I think it's more just getting the machine running and focused. And here's where you've got Eaton really benefits from scale and relationships and knowing the people that are putting together the projects, knowing that we can be counted on and working with the people who are scoping these projects and forming these projects and looking for our input into them. So that's what we're doing at this point.

Got it. That makes sense. And then look, maybe shifting gears to aero, really good growth in Q1. I'm just curious, at this point, where are your current volumes relative to pre-COVID levels. And how are you thinking about the longer-term outlook here?

Yes. We're at about 85% pre-COVID, which again, suggests a common theme for this discussion, a good, long run. At our Investor Day, we estimated that we were going to have about 8% organic growth from '20 to '25. But we think there's a lot of pent-up demand. I mean people want to travel. People have been staying home for quite some time, and we look forward to seeing that happening. We obviously, in the first quarter, had good results in terms of commercial and commercial aftermarket and excited about that.

Great. And then again, also, just kind of your assumptions for this year. Again, you put up, what, mid-teens growth this quarter. I'm just curious like what are your assumptions on the commercial markets versus military for this year?

Yes. In commercial, we think we're going to have high double-digit growth this year. With military, we think we'll have mid-single-digit growth. Military is a little bit difficult to predict just because of what's going on in the world environment, but that's the way we're looking at it right now.

Okay. And before I kind of move on from aero, the margin performance this quarter was really significant, but tremendous, right. Like, good incremental margins, now over 22%. The guidance really doesn't assume much improvement from a -- like, seasonally low level for 1Q. So it seems a touch conservative to me. I just want to make sure that I understand kind of like what's baked into the guidance from a margin standpoint throughout the year.

Yes. I guess we're being somewhat cautious in terms of just material availability. I mean there's a lot of moving parts right now in terms of what's going on in Aerospace. We still have decent margin growth, though, in terms of if you look at our implied guidance for the rest of the year. And if you look at second half to first half, we're probably going to grow aero 200 to 250 basis points.

Okay. Great. And then Vehicle, so I know that there was a change in the outlook for this business. So maybe just talk about some of the margin pressure you saw in this business in 1Q, low single-digit growth. Any color around that would be helpful.

Yes. I think what a lot of people are realizing is how important Ukraine was for particularly the European auto businesses, and lot of suppliers located there, wiring harnesses in particular. We did very strong in our truck business. Obviously, the light motor vehicle business is still struggling on -- we had OEM shutdowns. We had supply chain constraint issues in the quarter, which we're managing through. Also, the pricing dynamic in Vehicle tends to be -- tends to lag just the way the contracts are structured. So all of that contributed in Q1.

Yes. So as you think about the margin ramp embedded in your Vehicle business for the second half, it sounds to me like price/cost, as these contracts start to -- I don't want to say reprice, but you start to get more pricing out of your business going forward and seasonally see an uptick in volumes. Like that's what's driving the improvement in your second half margin outlook.

Yes, that's exactly right. And we'll also have easier compares in the second half from a growth perspective, but -- so that will be a double-pronged factor where, just as you said, we'll have growth going up. And we expect margins to get better as price goes through in the contracts, obviously, and we're able to get more volume to -- in our fixed cost.

Got it. And I know eMobility doesn't get a lot of -- as much attention these days just given the overall contribution to the business. But I would be curious to hear how the integration of Royal Power is doing. I'd also love to hear about any recent wins that you've had in that business.

Yes. Royal Power is doing great. Love the acquisition, not just in eMobility, but across also electrical segments. We like it because it can connect a lot of dots across a number of businesses. We've got strong synergy opportunities. We've got about $600 million in the pipeline today. We've had some key wins in our eMobility business. Our Breaktor product has had some good wins with some key OEMs. We're very excited about that. We think that's got a lot of legs to it. And it really comes back to, I think, when we do these strategic acquisitions, combined with our vehicle pedigree and the good relationships because of that vehicle pedigree with the OEMs, we're seeing that starting to pay dividends.

Yes. No, that's great to hear. And I mean, look, the business today is, I think we have it pegged at like, roughly, $550 million in revs by the end of 2022. It's a business that you want to see grow to $2 billion to $4 billion, right. So how are you kind of seeing both -- what are the competitive advantages that you have today? And then also, how do you think about the improvement in the profitability of this business going forward as well?

Yes, yes. In terms of the top line, we've got approximately $2 billion of opportunities in our pipeline right now. So you combine that with the $550 million, which you quoted, and we're very comfortable with our 2030 projection of, what, $2 billion to $4 billion. And just going back to what I said previously, we really think we have a right to win here. I think people have questioned, well, why are you in the vehicle business? Internal combustion engines are going down. But designing vehicles is a very tough business. And you need to have that expertise, you need to have that relationship with the OEMs to have a right to win. I mean these are highly-engineered components, very much quality-driven, and that vehicle expertise is really, opening the door for us. You combine that with our electrical expertise and acquisitions like Royal Power, and it's really an exciting mixture. And as we really get past the upfront investment in terms of engineering and we start to get into production for these, we're very confident about the profitability as well going forward. So excited what this business is going to become.

Okay. That's helpful. And then just switching gears a little bit. I know we talked on margins across, I think, mostly most of your segments. Incremental margins to start off the year were very strong. I'm just curious, as you kind of think about that 30% incremental number for your guidance for 2022. Again, just given where we sit today, and I know it's early, it would seem like there's potentially some upside there, but how are you feeling about that number?

We still think that's a good number, Joe. I mean incremental margins can be a little bit choppy across quarters. I think when you look at it for the entire year, we think that, that's a good number to plan on. Obviously, we'll try very hard to beat it, but we think 30% is a good number for planning purposes.

And Tom, maybe, just kind of talking about capital allocation for a minute. Obviously, you've got like the potential toggle between buyback and M&A. But maybe just specifically on buyback right now, the market is selling off, right. I'm just -- I'm sure you guys think that the intrinsic value of our shares are higher today. I just -- I'm curious, like in terms of how you're thinking about potentially being more aggressive with the buyback, just given the sell-off that you've seen in your stock.

Yes. I mean if you look at our capital allocation tenets, Joe, and in a situation like this, I think it's easy to move away from those tenets. But you really have tenets for a reason. And we prefer investing in our business for growth, and we prefer M&A, quite frankly. We would rather have a great acquisition than buy back shares. So we guided $200 million to $300 million buybacks, which is a reasonable number. I understand the question and understand where it comes from, but we're more focused on looking at good acquisitions to use that cash.

So obviously, that's a great segue into the next question, which is -- look, you guys have been incredibly active over the last couple of years. I guess as you're looking at your pipeline today, are you seeing more opportunities because of the sell-off? And what are your priorities in terms of M&A deployment?

Yes. We -- I mean, we see a lot of opportunities. Our pipeline is full. We spend a lot of time on it. We have a great process here. Obviously, electrical, Aerospace and eMobility are our priorities. And we continue to scrub through a lot of deals, and we're very confident that we'll have some good ones in the future.

Yes. And on that note, saw that you guys had an acquisition or another JV in China. That's certainly been part of your strategy. You clearly are very fluid in China today, but just tell us more a little bit about that investment specifically. And what it does for your strategy to grow there?

Yes. I mean, Howard Liu, our President of APAC over there, is a great person to have in the job. And one of the things that I've learned being an expat for 15 years is really, having a local in those key jobs makes such a big difference from a relationship perspective. And you've seen in the number of joint ventures that Howard has really been building relationships. And I just want to give him appropriate credit there. In the China market, we were kind of late to the party. And one of the things that's very important is to have affordable components. And one of the fundamentals of product development is it's very hard to take a highly spec-ed product and despec it for affordability reasons. I mean you can do it, but it's just incredibly challenging. And what this JV gives us is lower-spec product, which is most of what is sold in China. And it also gives us opportunities around the rest of the world as well. So it really gives us that bracketing opportunity, and you'll see us continuing to do more of that and really excited about that. We don't consolidate the top line results, but we take the profit.

Makes sense. Tom, getting a question from the audience, and this is around your recession playbook. So know since that Craig took over, his mantra has been higher lows and lower highs, right. Help to try to -- you really kind of have less cyclicality in the business over time and improve the profitability of the business. I'm just curious -- well, this person is curious, is -- does Eaton have the ability to grow in a recession? And then also, how do you think about the -- if you're not growing, how do you think about the decremental margins to your business?

Yes. I mean I think, Eaton -- look, let me take the last part first. I mean I think Eaton proved during the pandemic that -- do a very credible job in terms of solid decrementals through any sort of recessionary crises. First of all, we're not planning -- we're not expecting a recession. Of course, we have a playbook. I think everyone has a playbook, looking at inflation and how long the duration of inflation and liquidity and investing in the business. Bottom line, though, we think we can grow in a recession. Because there are so many fundamentals in the business, which I don't think are up for debate anymore in terms of the secular trends. Electrification, things are getting more electrical. I mean that's -- I don't want to say it's recession proof, but it's kind of recession proof. People are going to use more electricity. You just see it. Energy transition. I think that debate is largely over. OEMs have spoken. We're going to battery electric vehicles. That's going to happen. And the utilities and the homes are going to have to be prepared for that. So recession-proof is a very strong word, but the bottom line, I think we can grow. Data centers. People aren't going to stop. They're going to want to analyze data more. So I think we can grow during a recession. I know that's maybe optimistic, but I think we can.

Tom, we're going to end it there. Really appreciate your time today. Thanks for joining us, and great to see you.

Yes, Joe, great seeing you. Wish it was face to face, but we'll get to that at some point. So thank you so much for the invite.

You bet. Take care, Tom.

Bye-bye.