Eaton Corporation plc (ETN) Earnings Call Transcript & Summary

All right. Good morning, everyone. We're going to keep things rolling here with Craig Arnold, Chairman and CEO of Eaton. See a nice full room. So Craig, I think people have kind of sniffed out that things are going well.

Yes, it's really. We had noticed -- no, absolutely, things are going well. And as I said, you can't pick a better time to be associated with our company and certainly with our industry in general, given all of the tailwinds that are at our back. So yes, it's a great time to be here.

Excellent. Maybe just start us off with, what are you guys seeing? What are you focused on? I mean, at some it's kind of an embarrassment of ridges. There's a lot of different things going in the right direction. But how do you prioritize? And what's sort of catching your -- most of your attention these days?

Well, you can never have too many ridges. So we're not embarrassed at all by them. But I think for us, the real key becomes how do we execute against this opportunity that's in front of us. This is really, in many ways, kind of a once in a lifetime opportunity when you have so many significant tailwinds, megatrends that are essentially pushing the company forward. And the real challenge for us as we think about the messaging that we're delivering internally to our organization is that we have to execute well in the face of this opportunity. We have to execute on our own facilities. We have to execute commercially. We have got to execute with our extended supply chain. And so today, the messaging that we're really delivering and focus on as an organization is that make sure that we are prepared for the ramp as you noticed in the number of our announcements, we're making some rather sizable investments to put capacity into places where we have bottlenecks. And -- but it's much broader than what we're doing inside of our 4 walls. We have to really work with the broader industry and the value chain to make sure they're ready as well. And so if you think about all these extended supply chains that we deal with and the labor challenges that we deal with in a market that's growing at the rate that ours are growing, everybody has to execute well across the value chain, and that's the stuff that we're focused on.

Where do you see sort of the biggest leakage in that? I mean, it's certainly not price, but what would constitute sort of the biggest execution risk in your mind going through some of these larger projects?

Yes. And to your point on price, I mean, great environment. Obviously, when there's more demand than there is supply, it certainly gives you the ability to get price and hold price. And so the conversations with our customers are very different today than they've been historically. It is about supply and getting ready for the ramp and where is my order, where are my shipments as opposed to contractual price negotiations. And so as I think about the things that we worry about, it's, one, labor. I mean, if you -- one example -- for example, and just the capacity for some of these industries, take data center as an example, they're sitting today on about $100 billion backlog of projects in the data center space. And if you look at it historically, that's about a 6-year build to consume $100 billion worth of data center construction projects. And obviously, the industry has got a ramp in order to do more than that going forward because once again, the orders continue to come. Our orders -- as we talked about in our Q2 earnings call, orders were up some 25% overall in data centers and that's before you really have any of this impact of AI into the system. And so what we worry about beyond what's happening inside of our own 4 walls is that is the industry ready? Where is the choke point going to be in the industry around dealing with some of these growth trends? And I think one of the big challenges will be labor. Skill trades, whether you're an electrician or a plumber, whether you're -- any of these skilled trades of welders, they are in tight supply today. And so I think the gating item ultimately will be for some of these industries will be can you get the labor that you need to deal with the real demand that's in the marketplace?

Is that something that in your mind kind of forms a framework of where volumetrically limited to grow 10% a year in any given year. I just think of all the different pieces from -- I think I've been in the Asheville facility. There's a lot of panel building very manual, obviously, electrician trade labors manual. Is there a ceiling that you think of as regardless of the backlog, hey, we can only get x amount out the door any given year?

Yes. I think as we think about Eaton, I think we're going to be able to solve our constraints. So I think you're right, labor is tough to find. We're having to pay up for labor. I think we can solve the constraints inside of our own 4 walls. What we worry about more broadly is that you've talked about building. In the building industry, it only takes one of these value chains to not being able to keep up and that project won't be completed. And so I do think there's ultimately going to be a gating either more in growth in some of these industries because the weakest link is going to be the limiting factor. I don't think it's going to be Eaton. I think we're going to get out in front of this. We're making the investments that we need to make. But I do think, ultimately, the constraining item will be labor and the ability to get the skilled trades that you need to get all of these projects done.

And then I want to tenant over to backlog, if we could. You guys have been in sort of the enviable position of -- you built a lot of backlog during sort of the supply chain crunch. And then as that is normalized, you haven't seen the reversion, if anything, a lot of these trends have strengthened since then. You report on kind of that funnel from the start activity of mega projects. How do we think of the time to convert from those starts into your order book? Some of that stuff is tied to things like IRA . But is that something that's happening on a linear basis? Or are we going to have a period where maybe the private stuff or the normal non-mega project business plateaus before we get kind of this next leg?

That's kind of the $64,000 question, Josh, in many ways. If you think about this mega project kind of trend that we've been seeing going back to 2021, as we reported in our Q2 earnings call, we were around $686 billion of projects through, let's say, the end of last month. That number is now $800 billion. And so mega projects continue to grow. There was -- in the month of August alone, $41 billion of mega projects, 14 projects that accounted for some $41 billion of opportunity in these industries that we participate in. And the question becomes, is that going to crowd out, to your point, some of these other projects because there's other constraints around labor and other factors. And I'd say that TBD, the growth is there. And a lot of that, as you know, is in fact subsidized by a lot of the stimulus spending that's taking place today in the U.S. and around the world. You have the Inflation Act -- Reduction Act, you have the Infrastructure Bill. And what I would tell you, once again, most of what we're seeing today in these project announcements, in our order book today doesn't really represent the impact of most of these projects. If you think about this number of $800 billion, about 21% of that today has started. The other 80% or so hasn't even started. We're seeing some of that in our negotiations as we reported in the last earnings call. We've actually -- we've seen about $2 billion worth of projects, of which we bid on $1 billion. We've won $0.5 billion. So we're just in the early innings of really participating in some of this infrastructure build-out related to reassuring related to energy transition. And so that really is largely a future. And once again, we are concerned about the ability for the industries to keep up with these projects. And as you know, if you think about the Inflation Reduction Act, the IRA, it's time limited. These projects have to be built. The dollars have to be deployed in order to get the credits. And so there is a kind of a mad dash, if you will, to wrap for the dollars. And so we'll have to see how that all plays out in terms of the ability to get it all done and whether or not it will crowd out the ability to do some of the more smaller flow projects.

Is that something you see on the stimulus front, really starting to ramp up into '24?

Yes, absolutely. We're starting to see it now. And certainly, we're going to get -- as we go throughout '24 and into '25 and '26, this is going to have a very kind of extended tail to it. And I think probably what's going to happen is that if you think about this expansionary phase that we're in, because there are going to be constraints, I just think the cycle goes on for a much longer period of time than you would traditionally imagine it, it would as these projects will be extended out. They'll get done, but I just think they will get done perhaps over a more extended period of time.

How do you think about that in terms of your own strategy with backlog? I mean, obviously, visibility is good. I guess you can never have too much. But having something booked for 3 years from now, probably doesn't feel too comforting just given that it's so far away. Is there sort of an ideal length of time that you would like to keep backlog to? And how do you think about gating factors like price or something else to make sure that you're not going out too far for its own sake?

Yes. No. And it's certainly having lived through this inflationary period of time, we had to essentially really rethink our pricing strategy. And as many of you know in the room, we actually went out and had to reprice a lot of these long-term projects to deal with the inflationary environment that we're in. And so it's not something that we like to do. But clearly, we took the steps that were needed given this inflationary environment. So I would say that today, backlog is at a very high level for sure. We don't think that the backlog will continue to grow at certainly given where we've been. The backlog today is up 3x where it's been running historically. And so it's really at a level today where I would not expect the backlog to continue to grow. I wouldn't expect that the orders to continue to grow given this high level that we're at today, and we just don't have the ability to take more and ultimately speaking, unless you can deliver stuff, doesn't make sense for customers to give you more orders when you're still backlog doing a lot of the orders that they've given you already. So I do think there'll be a natural reversion to the mean with respect to the order intake. And I do think that the backlog, though, will stay essentially. We're running today about $9 billion of backlog. And I think that backlog will be at that level for some time to come. And I don't expect that we'll be able to materially eat into the backlog. I don't think we'll be able to materially get back to historical levels, but I do think this backlog will be kind of at a high level for an extended period of time. But I do think the orders that we've certainly seen it already, orders will certainly begin to moderate. We're anniversarying some really big numbers, 25%, 30% order growth in the second half of last year.

But it sounds like even with sort of a reversion to the mean on orders and sort of the tyranny of the math on comps that like still high confidence that you can grow this business on the better side of maybe even double digits in the next few years.

Yes. I mean double digits in the next few years is a tall number and it's one that I'd say today, we're in the midst of thinking through what our guidance is going to be for 2024 and beyond. I would say that today, we obviously have a lot of confidence in what's happening in Electrical Americas, given the sheer size of the backlog in that business. I think what's going on today. Most of you are aware that the picture in Europe is a little different. The picture in China is a little different. And so I'd say that very high confidence in double-digit growth in businesses like Aerospace and Electrical Americas, some of our bigger businesses. I think the story in Europe and the story in China today is a little bit of a TBD. Most of the economic data coming out of Europe has been weak. Fortunately, the Electrical space has performed better than the overall market, but still on a relative basis, Europe has been a bit of a disappointment for sure. And China has been a bit of a disappointment. We're still seeing growth, for example, in China, but we're not seeing the growth maybe that everybody anticipated as the government came back from COVID. So I would say that to the specific question around can we grow the company double digit over the next few years? I would say that's a very tall order. What we've provided in the form of guidance, as we said, our original guidance was some 5% to 8%. We talked about being an [exert] rate of growth this year that's more like 7% or 8%, which we thought was kind of more -- a good starting point for the way to think about 2024.

Excellent. Yes. To be clear, I meant more of the marquee businesses like Americas and an era where there's a lot of visibility, but I think that all makes sense. I guess on the flip side, there's a few sort of related talking points here that I think maybe an older version of Eaton would have experienced differently, namely what's going on in parts of non res like commercial real estate and the weakness there that you're clearly able to shrug off? And the same notion in electrical distribution, where you're seeing some destocking, and I don't think that's really played into your business either. Maybe just spend a few minutes if you wouldn't mind talking about how your exposure to those phenomenon have changed?

Yes. I mean when you say commercial real estate, everybody defines that category a little bit differently. Sometimes people use the term non res, which means it's everything other than residential, which is basically most of our business. I mean residential for Eaton maybe accounts for, I don't know, what's the number less than 10% of our total business. And so -- and it's been residential, that's been relatively weak. Overall, you see the data as well as I do in terms of what's happening in single-family housing as interest rates have risen. So that's a very small piece of our total business, and we have seen some weakness there. But even in that market, as we talked about in the last Q2 earnings call, we said we think that market is going to be relatively flat this year, despite everything that's going on in the housing market and rising interest rates, largely because in that market as well, the electrical intensity continues to increase. Codes are changing. The adoption of EV, the IRA, all of these things are driving more electrical content even into the weaker parts of our businesses. But most of the business is nonresidential. So you think about the utility markets growing dramatically, double-digit growth last year, double-digit growth this year, double-digit growth probably for the foreseeable future. We talked about in our Q2 earnings call that market we think grows at about 11% rate between 2022 and 2025. If you think about today what's happening in perhaps the one segment that's going to see the greatest growth is really in what we're calling kind of institutional -- excuse me, industrial, all of the reassurance that's taking place, all of the investments that's going into manufacturing, new EV plants, new battery plants, new LG -- liquid natural gas facilities, renewables, I mean, there's just massive investments that are coming into this particular piece of the industrial side of our business that will drive significant growth into the future. And then, obviously, you have data centers, which continues to be very strong, robust growth. And so I'd say that -- once again, that's largely a North America story. The story around the world, I'd say, Europe, is seeing a lot of the same trends that we're seeing here in the U.S. with respect to renewables, with respect to energy transition, electrification, but there's some real weakness on the manufacturing side that's biting today in Europe that's offsetting some of this real strength that we have in energy transition. And in Asia, very much similar, still growth. We're seeing growth today, certainly, in our Asia business, but perhaps not nearly as robust as it is here in the Americas. And so by and large, Josh, I'd say that a good set of problems to deal with some real challenges today and certainly the ability to keep up as an industry, but we're optimistic.

So just trying to highlight the difference between, say, U.S. and Europe and Asia, obviously, your portfolio and your own category there differ a little bit. If I were to transplant the North America portfolio into those other parts of the world, would that drive an uptick just because you're exposed to some of these higher performing areas? I guess how much of this is macro versus where Eaton plays in some of these markets?

Yes, I'd say that there is a little bit of both. So clearly, if you think about today, the legacy part of our business is, obviously, we grew up as a U.S. company, and we have higher shares in North America. And quite frankly, the strongest market in the world for our kinds of businesses is the U.S. market. And it is the strongest market in the world, and we have the best market share. So we are certainly advantaged because of those two factors. And then there are some segment-specific where we have great -- take the utility market, for example. We're a major player in the utility market in North America, the broadest player in the industry. We don't have the same portfolio, let's say, in Europe. And so there's an opportunity to do some things differently in and around Europe to build a better position, let's say, in the utility market. We have a great position, for example, in the utility market in China. And so we're doing well there because once again, our portfolio is strategically advantaged in terms of where we have a presence. So I think it's a combination of both. It's a combination of where we have a unique portfolio advantage and a different mix of our businesses. And it is, in fact, the macro around, quite frankly, the U.S. market right now is just that much stronger than the rest of the world.

Got it. So I promised myself I wouldn't lead off of this too early because I know it's a suspenseful topic for people, but I hear this AI thing is sort of important. And data centers, in particular, have obviously been strong for Eaton. Can you maybe give us just some context as you've seen the market evolve here what that high-performance data center or kind of GPU-based data center looks like in terms of an opportunity perhaps relative to what this business has been at other points in time?

Yes. I know that's the question that's on everybody's mind. It's certainly one that we spent a lot of time as an organization working with our hyperscale customers trying to figure out exactly what this new AI world is going to look like and how do you configure a data center for GPUs versus CPUs, there will be a combination of both. And I will tell you that today, a lot of that sorting out is yet to be done. We know that it's good -- it's going to drive more demand. We know that it's going to drive an increased requirement for power. We know it's going to likely drive an increased requirement for backing up data in our UPS business. But how it's all going to play out exactly and how it's going to fit within the broader context of a market that's already very hot. As I talked about, $100 billion backlog already 6 years of construction projects. You have this now layered in on top of it. And so I think it's still early to really sort through what the impact is going to be. It's going to be helpful. How helpful? I think once again, because of these other constraints, I think what it will ultimately do is that it will extend these cycles. We're going to see strong growth in data centers. I talked about 20%, 25% growth kind of that we've been experiencing. Can that number be significantly greater than that? I think, once again, the industry has got to sort through a lot of bottlenecks in order for that reality to take place. So I think the most likely way it plays out, from my perspective, becomes a cycle that just gets extended to an even longer period of time than we originally anticipated. And we were already saying at least a 10-year cycle. I mean this is -- the world will continue to generate consumer processes to increasing amounts of data, and that's going to mean you have more data centers. And that was the premise long before ChatGPT and AI really took hold.

Now I know these things are notoriously power hungry. I would assume that your content sort of scales up with the amount of power they consume. Any way, just even in kind of a bigger than a bread box kind of analogy to say, these things are consuming 2x the power, 5x the power or anything to dimensionalize would probably just be helpful to level set?

Yes. I'd say there's countervailing forces. GPUs typically are more efficient. So on the one sense, I need less power because they run more efficiently. On the other hand, they consume a lot more and do a lot more processing, so they need more power. So there's puts and takes on this. And I'd say that today, what we'd be comfortable doing, and we're obviously working today on a number of projects, and quite frankly, we're working with our big data center customers today with much longer lead time and much better visibility into the future. Once we get one configured and one we'll share with this group exactly, okay, here's a real example of a new data center that's been configured for this GPU world. And here's the real implications of it in terms of what the math looks like. And we just -- we're just not at that point today where we have enough of these variables to find that we can really put our finger on exactly what it's going to be. So we're not going to get out there making promises and statements that we really can't back up with hard examples of where we've actually worked through the math with our customers.

Understood. Makes sense. Maybe turning the same logic over to Utility, where there's a little less ambiguity. But I do know there's sort of different constituent groups in different product categories that maybe have some different phenomenon going on. I think everyone talks about transformers. Now they're sold out for years on end at this point. But I guess where are you seeing the growth relative to something like transformer substation versus more of the pole-mounted kind of traditional transmission. Are there pockets that are more or less interesting to you? And do you participate in the pockets that you think are the most interesting?

Yes, I'd say that we participate really across the full spectrum. As I talked about in our Q2 earnings call, we're -- the industry is kind of broader supplier into the utility market. Everything from, to your point, yes, very broad supplier of transformers and regulators and electrical switch gear, obviously, and software and services. And so we are a really broad player in that industry. And as a result of that, if something is happening in the utility market, we are benefiting from that. And so I'd say, today, if you think about that industry, and I talked about 11% growth between '22 and 2025, it's another industry. As you mentioned, that is there are capacity constraints. And you've heard us make a number of announcements around new investments that we're putting in to deal with some of these capacity constraints. We talked about a $500 million investment in capacity. You'll see more from us as well other investments that we're making to build capacity in. And I can tell you the other thing we're doing today is we're working with these customers with also long-term commitments to make sure that as we make these investments in capacity that we have customers there committed to make sure that these facilities are full. But -- so I'd say good problem to have. Utility market is, historically, as you know, has not been the most exciting end market that we participated in, but we're in a very different world today with respect to climate change, energy transition, you've all seen experiencing some of these global events, whether it's fires or floods. So grid hardening, grid resiliency. There's a lot of dollars today that are being put into the distribution side of the utility market, which is where we play. We're not on the power generation side. For the most part, we're on the distribution side, which is where most of the capital dollars are going. And we're seeing the same thing by the way, in other regions of the world. We're seeing that in Europe. We're seeing that in China as well.

Maybe pivoting over to the Aero side of the portfolio. Obviously, a good story there as well, both growth and margin. But you do have a mix phenomenon that's going to be more acute here over the next several years. How do you think about that relative to where we are on margins today? Is that something that's a headwind? Or can we sort of stabilize here even with that higher OE growth?

Yes. The quick answer is we'll absolutely continue to expand margins in our Aerospace business. But you're right. I mean we're in the midst in the very early stages of a fairly significant ramp on the OE side. You saw from the announcements from Airbus. You're going to be going from 45 A320s to 75. Boeing is moving from 30 a month on the 737 to 50. You see the same thing, even bigger growth in things like the 787 and the A350, where these numbers are growing quite significantly over the next 3 or 4 years. And so we are going to see a big ramp on the OE side. But we're also seeing a big ramp as well in aftermarket. If anybody has gotten on a commercial plane, lately, you know that these seats are full. And so the aftermarket side of the business is also growing. In addition to that, on aftermarket, we're also doing some things in the area of modifications, upgrades and retrofits that also is driving the aftermarket business. And so as we think about our Aerospace business, you should assume that the margins will continue to expand. We talk about it as a company of kind of 30% incremental. We think that's still a good number for planning purposes. And so you should expect that as the Aerospace business improves, that those margins will improve as well. And the other big self-help opportunity we have not just in Aerospace but really across the entire company are the things that we can do to improve our own operating efficiency. As I said before in one of the earnings calls that we had a very strong year in 2022, record financial results. But at the same time, it was one of our worst years ever in terms of our operating efficiencies internally. Massive inefficiencies driven by supply chain and other challenges that we had in our own operations. And so we have a huge self-help opportunity in our Aerospace business in our company to deal with some of these inefficiencies that would have been driven by some of the supply chain challenges that we had.

Understood. It sounds like we're going to need to revisit some of the segment margin targets here before too long.

I think we'll give you some new targets to think about as we give you guidance for 2024. But I do think, to the broader question that, yes, you should expect Aerospace margins to continue to expand.

Excellent. Well, I see we're out of time. Craig, I always appreciate the time.

Sure.

Great to have you here, and thanks for showing up.

Thank all of you.