Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

Good morning, everybody. Welcome back. Next up for Laguna Fireside Chats, we have Eaton Corporation and Chairman and CEO, Craig Arnold. Craig, thanks for joining us. I want to dive into all the exciting areas of electrification, something that we've done a lot of work on. I just need to remind folks very quickly on the disclosure side that if you have any questions about our research disclosure, please check the according website or reach out to your salesperson. So with that, Craig, like I said, thanks for joining. It's the pleasure to see as always, again and in person finally after a few years off. Maybe before we dive into some of the media discussion, you can just sort of give us some context and overview of what you guys are looking at Eaton and focused on.

Yes. No. I appreciate being here, Josh, and like you, it's great to be back in person again and doing these events. Maybe just a quick elevator speech on kind of the state of affairs with Eaton right now. I'd say -- the first thing I'd say for those who haven't followed the company, the company has changed pretty dramatically over the last number of years, and we've done a lot of portfolio moves, really trying to build a company that's higher growth, higher margin and with more earnings consistency. And when you think about growth, I mean, we are very well positioned to really take advantage of the secular growth trends that we're going to spend some time talking about, beginning with energy transition. The world is basically going through this transition away from fossil fuels. And every time they do that, every time you move from a source of gas or oil to renewable, it creates an opportunity for electrical content, which is the stuff that we do. Every time the grid becomes more distributed, and you move from a central source of power to a distributed source of power, you have to manage electricity differently and that creates opportunities for our company. And with that, the only way you get value from renewables is obviously to electrify the economy. You have to move your vehicles from gas to electric. You have to move your household heating and cooking from gas to electric. In factories as well, I think about any major factory process today that's a heavy user of gas, you have to move to electric. And so everything in the economy, as we know it today, is being electrified, even the aircraft industry is moving to more electrics even in that particular industry. And so that just creates, once again, these fairly sizable growth opportunities for us, and we're seeing it today across, not only kind of the end points that we talked about, but obviously, the utility market, which, for us, is about 15%, 16% of the company, they're having to make very big investments to support this electrical infrastructure. And then the other one is really digitization. And the world continues to generate, consume and process increasing amounts of data. I think data centers is a great example. Today, data centers is 17%, 18% of our company, huge market that will just continue to grow. And so the company is just extremely well positioned for growth in our core Electrical business. The other thing I would add, though, is it's not just in our Electrical business, even in some of the more cyclical businesses in our portfolio, big aerospace, I mean, not necessarily cyclical business, but going through a cyclical rebound on the commercial side. Defense, given what's going on in the world, certainly becomes more an attractive market. And then oil and gas, from our exposure to oil and gas through our Crouse-Hinds business, that business is going to grow nicely as well. The other thing we talk about is how we expand margins, and we certainly have a strong track record historically of expanding our margins, and we'll continue to do that. It's what we -- we leverage our Eaton Business System to really drive efficiency in our operations and in our functions. And it's the way we really run the company and define what good looks like and continue to march forward with improvement opportunities. And then you think about the other big thing, certainly the one that's on your mind is how do we deploy capital? And it's really much embedded in the way we run the company. First, in the way we decide what businesses we're in, and what businesses we're not in, and hence, a lot of the portfolio changes that we've talked about, but it's also in the way we think about leveraging other people's capital. Think about some of the JVs that we've done in China over the last number of years, which is really about how do you leverage capital that's already in place and not use our capital to take advantage of some of these markets through JVs. And the last one, I'll stop here and say that we also think that the culture of the company and the leadership is a real competitive advantage. I mean we have a group of passionate leaders who have high expectations for winning. They are accountable, and as a result of that, we think the company is very well positioned to grow faster than we've ever grown, to expand margins at a faster rate, and, ultimately, that results in better returns for our shareholders.

That's a helpful overview. And I want to spend a lot of time on electrification because we could probably spend 4x as much time just have a little mini Analyst Day on it. But understanding, we're kind of at this moment where maybe there's a cycle within a longer up trend. You guys do have some exposure to property markets in places like Europe and Asia. How do you sort of judge that push and pull of maybe some of the macro factors those folks are going through on a near-term basis relative to kind of the longer-term secular appeal?

Yes. We always -- we think about this question around what do you have to believe in order to believe that these secular tailwinds are going to be true over the long term? And I would add that we're really in the early part of this upturn cycle. And most of the goodness that we talk about is still out in front of us. And so there will be cyclical and macro things that impact the market overall. But -- and I think the undeniable trend is the fact that the world is electrifying, and I'm not sure if anybody here has bought an electric vehicles recently, but if you did, you had to change the electrical infrastructure in your home in order to accommodate it. And you think about what's going on in the regulatory environment. Governments around the world are all regulating this transition to electricity. And so we have the regulators that are helping, they're putting stimulus dollars behind it, and that's really happening around the world. And so I think independent of what's happening, let's say, in some of these shorter-term dislocations that we're dealing with, the long-term trends just continue to be compelling. And we see it today, a lot of it today on the industrial side of the house. A lot of big investments today going into certainly semiconductors, but also anything EV-related, large battery plants and large industrial plants that are in and around the energy sector and every one of those, once again, creates big opportunities for our company.

Does the -- does that sort of hand off where maybe right now, there's kind of a few cross currents weigh on that secular element? Or are you guys able to power through it because the secular is that much more powerful?

Yes. No, I can tell you, if our order book is any indication, I mean, we're powering through it in great shape. As we talked about at the end of our Q2 earnings call, our order book in Electrical is up 75%. And I can tell you that, through the first part of this quarter, there's been no letup. Markets continue to be very strong. And I am clear, we're not immune to what's happening in the world. Today, everybody is anticipating a reduction on the resi side. Resi today accounts for about 15% of our business. At some point, that market will slow down. I can tell you that we haven't seen it yet. Even on the residential side of the business, we continue to see very strong strength. One of that is because what you're finding today across every one of these end markets that we serve is that there's more electrical content than ever that's going into the existing stock of buildings, whether that's a home, an office, a factory, there's simply, the electrical intensity of these applications is going up. Some of it is driven by regulations, and, in some cases, it's driven by this energy transition. You think about for a second of today, what we're talking about in terms of the world, we're talking about, in many ways, resiliency. How do you build resiliency into the electrical grid? Certainly, you're dealing with this issue at the level of nation states. Think about what's happening today in Europe. They're talking about how do we build more resiliency into our ability to support our own electrical requirements. You see companies doing the same thing. As you think about brownouts and these issues we're having today with other climate events, whether it's fires or others in one of the major utilities today, out on the West Coast is talking about undergrounding 10,000 miles of their electrical infrastructure. And we're clearly in a great position to...

That sounds super cheap, by the way.

Yes. And it's super expensive. But given climate change and the fires and the other things that they're dealing with, they have no option if they intend to fulfill their remit of providing electrical power. And that's a massive opportunity for us as we provide the transformers and the other stuff that allows them to do that. And so we're just seeing this in every aspect of the economy.

So one thing you touched on there that, I think, is sort of unique to the electrical industry relative to other industrials is that it's not like a retrofit industry normally like prior to this. Like there's no rotating parts, the stuff sits in the closet or behind the chain link fence for long periods of time without people thinking about it. Like is that really what this comes down to is a retrofit opportunity in an industry that normally doesn't have retrofit, so like this is all incremental?

Yes, I think it's fair to say that compared to maybe some other industries, we don't have a huge retrofit. But today, some 25% of our business is really retrofit. So you think about -- there are parts that wear out, the electronic components and capacitors and batteries and other things that do wear out, that need maintenance. So there is that piece of the business. But you're absolutely right. In order to deal with this essential challenge that we're facing around resiliency, around energy transition, it will require that individuals, consumers, countries, companies make changes. Sitting still and doing nothing really is not an alternative. If you think about -- one of the examples I always -- I like to use is the growth of EVs, which I think, in many ways, is the tip of the spear. And today, we're at the very early stages of EV adoption. Although in California, you see maybe they're a little further advanced than others, but that's very early stages. Every major automotive OEM, but they've already committed to basically phase out the internal combustion engine. As you know, here in California, they've regulated it. By 2035, no internal combustion engines could be sold in terms of new cars and then there's a phaseout process that takes place in earlier years. But with that regulation or not, the world is already committed to move to electrification. And the amount of energy that will be required, the amount of infrastructure that will be required to deal with a fleet of electric cars around the U.S. and around the world is just requiring massive capital investment.

Is that sort of the biggest kind of visible opportunities today because electrification doesn't mean one thing, right? It's like kind of these pretty diverse set of benefits. But seems like EV infrastructure is kind of the biggest and most imminent. Is that sort of how you guys see it? Or are there other things that are front of mind as well?

No, I'd say that EV infrastructure and all that entails is certainly a big one. But it really does begin with the fact that we're moving from essentially greenhouse gas producing resources to renewables. And so you put solar on your roof, which, by the way, is a law here in California. If you build a new home in California, you have to have solar. You put solar on your roof, you need more electrical infrastructure to support the solar on the roof. The more sophisticated homeowners are putting not only solid solar, but they're putting battery systems in as well to take advantage of the fact that you can store this power. So -- I mean so as you move and you put renewables into the equation, it creates a big growth opportunity for us. And then obviously, in order to take advantage of these renewables, you need to turn this renewable power into electric power. And that's where you have this transition to the more electrification of the economy that's taking place. But the other thing when I talked about is just simply resiliency. And resiliency, today, we're seeing it a lot of investment going in, a lot of utilities making big investments just to build resiliency into the system itself today due to the downstream impact of these climate change events. So it's really across a pretty wide part of the economy and in the places in which we participate.

So I guess thinking about that in the Eaton portfolio because you aren't just one set of products in Electrical. You kind of have soup to nuts capability. Does it vary a lot? Like is this a long-cycle business sort of benefit or just a short cycle business, a little bit of everybody? Like how do you think about the performance difference between those 2 because the order book would sort of say everything is working, but is electrification really focused on one element of that?

I mean, electrification, I think, cuts across the entire spectrum. I say, today, most of what we do today in Electrical, we think about it and even the company is largely -- given the portfolio changes that we've made over the last several years, we are much more of a mid-, long no-cycle company. Some 70% of our revenue today would really be tied to longer cycle, about 30% of the company would be in short cycle. And a lot of that, to your point, is really in our industrial businesses. Businesses like we're still in the Vehicle business, for example. Even that business, by the way, given where we are today in the cycle, and the inventory levels that we're dealing with, we think even that business does fairly well and contract uncharacteristically well, even in a bit of a recession because they have to rebuild inventories that have been drawn down too much over the year. But in our core Electrical business, it really does play across the board. And I would not say that we see significant differences in terms of these various end markets. We're seeing really strength every place. And including data centers, which is really kind of this whole digital data generation world that we're living in today. So there's lots of investments going into data centers and/or there just continue to be very robust. And data centers have really a unique ability as well to do things to help regulate the grid as they can do things like frequency regulation, taking advantage of this installed base that they already have of batteries. And so it's just across the board, I'd say today.

So you mentioned data centers, and I was going to bring that up later, but there's no time like the present. It seems like there's always some kind of period of volatility in the hyperscale guys that comes up from time to time. Are we seeing anything like that today? Is that something that kind of across your end markets is maybe a bigger focus? Or is kind of content plus maybe the breadth of the brand getting you guys out of that?

Yes, no. I'd say that the hyperscale segment of the market, which is about half the market, by the way, there's a lot bigger market than just hyperscale. There's obviously the colos and the on-prem. And so it's a much bigger market than hyperscale. But hyperscale does tend to be lumpy. They build projects, and they'll put a lot of capacity in, and they'll take a break and put capacity and take a break. Today, we're not seeing, quite frankly, any softness in hyperscale. We're not seeing any softness in data centers in general. And as we've reported in our Q2 earnings call, orders were up very strongly in Q2, and we continue to see that strength in -- here in Q3 as well. And so while hyperscale does tend to be lumpy and can be lumpy, we have not seen -- in fact, if you take a look at what most of the hyperscales have announced in terms of capital spending this year, I think the number is between 25% and 30% in our kinds of equipment. So we think that market continues to be strong for a long time and not just hyperscale, but really across the board.

So we've talked a lot about kind of the strength of the order book. I guess the foil to that is the wounding effects of supply chain, what you guys have seen for the past year or so. How would you sort of score that in terms of rate of improvement? And -- do you have sort of an idea in your mind when the business is really governed more by demand like it normally would be rather than what you can get out the door?

Yes. No, it's certainly been a pretty extraordinary period that we've all gone through living through supply chain challenges. And I would say that we've seen some improvement. We've seen improvement in commodities like resins and certain types of steel and other aerospace commodities that are important to us and copper. So we've seen some improvement. We still have pretty significant challenges, like I think everybody else does. And anything electronic-based, semiconductors. We still have challenges really on the labor side. That's one of the things that we're dealing with and many of our suppliers are also dealing with. But I would say we're probably still -- if I had to guess, and I've been wrong at least twice before, Josh, actually take this with a grain of salt. So I think we're still probably 12 months away from getting back to some normalcy in supply chain. And as you can imagine, that's driving just big inefficiencies for all of us that we're having to cover and still post very attractive earnings growth.

Does the contractor base that is ultimately installing the product and those aren't Eaton employees, and I think in most cases, those are pretty fragmented folks? Is that a limiting factor that we're going to see down the road? It seems like the product side is kind of the limit right now, but I can't imagine that the contractor population is increasing as fast as demand is.

Yes. I mean, I think we're seeing limitations even on the labor side today in terms of what it means for project completions. We are seeing today restrictions in the labor pool as well, especially for skilled trade. And so we do think that we will continue to see some challenges on the labor side, especially for skilled trade electricians and the like.

And just switching over to price/cost. I mean, I think everyone could have eyeballed this maybe a few months ago when steel started to come down that, at some point, understanding your business doesn't really give price back that you would build up a bit of a price/cost benefit. I think last quarter, maybe we started to see that in the Americas. What length of time do you think we sort of reach kind of like what spot rates or that price/cost gap should look like? Does that take a couple of quarters? Or are we kind of in the eye of the storm now in terms of what those benefits could be?

I'd say that as we think about where we are, we've always said that as we think about margin expansion for the company that we don't think that price versus commodities would be essentially neutral, that our goal would be to earn our margin expansion through the way that we run the company and the efficiencies that we generate and not do it on the back of our customers. And so what we've been largely doing is essentially recovering the cost of commodity inflation in our business. And to your point, we've certainly -- through Q2, we've done that. And we do think we're probably reaching a point of normalcy now. Still some issues we have in certain commodities, but some others have rolled off a little bit as well. But so -- but we would expect that the margin expansion that we're going to generate as a company will largely come from our ability to run the company better, our ability to get leverage on the volumes that we generate inside the organization.

That being said, you probably wouldn't say no to a little price/cost through?

No, no, we never would say no, yes...

And just so I'm clear, like you guys don't -- the PPI data would sort of say that prices don't really go down in this industry. Is that sort of how it applies to Eaton as well?

Yes. I mean, I think that's absolutely true. If you look at the history of pricing in the electrical industry in general, price is very sticky. We have the benefit. A lot of it goes through distribution. And as you know, price is good for distributors. They like price as long as the market moves up. And so what we've seen historically, and we would expect the same thing through this cycle is that price will be sticky, and we'll be able to hold on to it independent of what happens with commodities.

Just shifting over to the -- like the fiscal policy environment. You have infrastructure that's starting to kick off. You have IRA that just went in. Anything particular among those that you would view as particularly rich for Eaton? I mean IRA just seems kind of like a different brand of electrification. But like what are you guys sort of trying to really focus on winning in those opportunities?

Yes. I mean lots of stimulus spending around the world, and yes, it's called IRA, but in many ways, there is an IRA obviously component of it, but it is also a very stimulus component of it, if you're in the right industries, which we happen to be in. Some $370 million -- or $370 billion of those dollars that have been approved will go towards essentially energy transition, things that improve this journey that we're taking around climate change. And so that's certainly a good thing for our company because all those dollars, they're going to be going into incentives for companies and consumers to basically move to renewables, to improve their energy efficiency, including, as you saw, very specifically called out in this bill, upgrading their electrical infrastructure. Because you can't really move down this journey, whether you're in a home or whether you're in a business without also improving the electrical infrastructure that supports it. And so there's big dollars attached to that. And I think, to your point, it's simply going to help accelerate the trend. It's going to certainly give it much longer staying power, and it's going to really make it affordable for a lot of companies and individuals who otherwise would not have the ability to do so. And so, yes, it's another really helpful initiative that we certainly are focused on to make sure that we get more than our fair share of those dollars. Think about the U.S. Postal Service, for example. $3 billion to electrify their fleet of vehicles. They're going to need, obviously, electric vehicles. We're in that market. Just as importantly, perhaps more importantly, they're going to need the electrical infrastructure to support charging those vehicles.

Is that something because there's a lot of complexity in all of these bills that you guys need to work with your customers to sort of educate them in how to take advantage of it? Or is the customer base sophisticated enough to say, like, we'll place the order, we can figure out how to get the tax advantage or stimulus money or whatever on the back end?

Yes. Yes. I don't know that getting the stimulus dollars, I don't know if we're necessarily better educated to tell them how to access the stimulus dollars. Well, we provide value is saying, "Here's how you solve the problem." So you need the electrical infrastructure that is going to allow you to support charging your fleet of electric vehicles. We can come in and provide a turnkey solution whether that's putting in battery storage, the electrical equipment, whether that's helping them with their solar, we can basically help them with a turnkey solution that delivers the benefits that are required in order to qualify for the stimulus.

Got it. That's helpful. Just shifting over to Europe because your market position there is a little different. And then I think a good chunk of your exposure came from Moeller in, let's say, 2008 or 2009, something like that. Mostly Eastern Europe, you have obviously some big incumbent competitors there, more in Western Europe. How do you go about approaching that market? And given that like your home base is maybe closer to where the action is with Ukraine, does that put you in a tougher spot either logistically or just where those markets are at in the macro?

Yes. And I'd say just maybe a bit of a correction. The Moeller business really has a strong footprint throughout Europe. And their revenue base is very much consistent with the size of the economies in Europe. So not in any way bias to the eastern part of Europe. In fact, if you think about our exposure to Ukraine and Russia and some of those other parts of the world, it was an immaterial piece of our business in terms of our exposure. But, yes, Moeller was certainly -- it's a material part of our business in Europe, a business that's doing very well, but we also have a lot of other things going well for us in Europe in general. And I'd say that's another market where, despite all the concerns about what's going on in the economy, in and around the -- whether it's the war or the issue around energy, our business in Europe is holding up very well. And we're still seeing very positive growth in Europe. I think, once again, tied to the fact that they, perhaps more than anyone, really need to think about this issue around energy dependency and what do they do? The big answer, and as you know, there's been a big European stimulus bill that's already been passed. A big part of their answer is to more renewables, more electrification of the economy, and they're putting a lot of dollars behind it that we are certainly taking advantage of.

Got it. Just looking over the portfolio, and I think you sort of touched on this in your opening remarks in terms of evaluating which businesses you want to be or not be in. I mean Vehicle sort of looks increasingly like the odd man out, talking about electrification, having like this fossil exposure there. What is kind of the premise or the thesis behind like why that fits? I think there's some cyclical opportunities to sort of replenish inventory. But is there like a longer-term secular kind of knowing that's going on in kind of the board level where that becomes more focused on?

Yes. I expected to get this question. I get it a lot. The first thing for us, we would say, is it a good business? I mean if you take a vehicle and you call it something else, call it Fred, right? Does it have the right already...

Please don't re-segment to call it, Fred.

Does it have the right characteristics? And we say, we want businesses that are leaders in their markets, and we want businesses that have high margins, high returns on assets. We want businesses that are not cyclical. And so you'd say, does the business have the right set of characteristics such that it's a good business in its own right. And this is a good business in its own right. So, first of all, I'd say that it's a good business, and it passes the financial hurdles that we've set for any of the businesses that we want to be part of the portfolio. We look at the intrinsic value of what vehicle means to Eaton versus what it would be worth if we sold it, by the way. And the intrinsic value is worth more to Eaton than it would be if we sold it. Now having said that, Vehicle is no different than any other part of the portfolio. We go through a process every year, and we look at the business and we say, do we like it today? Are we going to like it 5 years from now? And if we conclude that we don't like the business in the future, then we'll do what we've done in the past. We've pivoted on hydraulics. We've pivoted on lighting. We pivoted on a lot of our businesses where we say these businesses no longer fit in the portfolio. But I could tell you that, that applies to every part of the portfolio. And when we think about portfolio management, we don't think about it only in these 5 or 6 reportable segments. We think about it in the context of where we can make an independent decision about whether or not we're in or out. So right now, we like the Vehicle business. It helps us for sure in terms of the things that we're doing today in the eMobility segment. You recall that we launched this new segment called eMobility, where we committed to build a $2 billion to $4 billion new segment of the company in eMobility. It is enormously valuable to have a seat at the table with all of the customers who are making these decisions. It's enormously valuable in eMobility to be able to leverage technology that we've generated in our Electrical business into the eMobility segment. So when we said that this eMobility segment is a place where we have the right to win. It was really based upon: one, we have a seat at the table where the customers are making the decisions; and 2, we have the technology from our Electrical business to bring to bear into this new growing space of electrification of cars.

Perfect. Well, I see we're out of time. Craig, always pleasure. I appreciate you making the trip out. We'll leave it there.

All right. Thank you. Great.

Thanks.