Eaton Stock: Positive Outlook But Highly Overvalued (NYSE:ETN)

kckate16/iStock via Getty Images Executive Summary Eaton Corporation (NYSE:ETN) stocks are currently trading well above their fair market price. We expect Eaton to enter its mature phase by stabilising its market share, and further improving its profitability while maintaining low reinvestment needs delivering solid free cash flow generation for its shareholders. Despite the positive outlook, at current prices, our assumptions suggest that Eaton’s risk-reward profile will deliver a negative alpha of -4.7%. Source – BlackNote Investment Business Model Analysis Eaton Corporation is a U.S. company operating in the electrical equipment industry. More specifically, Eaton offers power management solutions used in a wide array of industries like data centres, utility, automotive, and aerospace & defence. Segment Analysis Its business model is divided into three main categories: the Electrical segment, offering power distribution and control solutions such as switchgear and circuit breakers; the Aerospace segment, which provides a comprehensive list of electrical components like pumps, motors, and valves for the aircraft industry; and lastly the Vehicle & e-Mobility segment, offering electrical components used in both traditional and EV vehicles manufacturing. On May 21st, the company announced the acquisition of Exertherm which, as reported by the management, will strengthen Eaton’s position in the thermal management sector: Marks further expansion into continuous thermal monitoring, improving safety and reliability of critical electrical equipment in key markets like data centres The thermal management sector has become extremely relevant in the past year, as data centres – crucial players in the AI industry – require significant heating and cooling solutions to operate at maximum efficiency. With the acquisition, Eaton aims to expand its presence in this growing segment, however, worth mentioning that the segment is very competitive with relevant players of the caliber of Vertiv Holdings (VRT), which already owns a significant market share. Revenue Analysis As of the end of 2023, Eaton’s total revenues stood at $23.2 billion. The primary source of revenue is the Electrical segment, accounting for $16.2 billion or 69.8% of total revenues. The Vehicle & e-Mobility segment follows, contributing $3.6 billion or 15.5%, with the remaining revenue coming from Aerospace, which contributes $3.4 billion or 14.7%. Overall, Eaton’s total revenues increased by 11.8% in 2023, which is better than the industry growth rate of 6.6% registered last year. Source – TIKR Terminal Despite the good performance of 2023, over the past decade, the company’s median revenue growth rate was equal to 3.3%, way lower than the industry median growth rate of 5.5% for the same period. Worth mentioning, however, that post-pandemic Eaton seems to have rediscovered a strong growth momentum – even though is likely generated by the recovery to pre-2020 revenue levels – with revenues growing at a CAGR of 9.1 from 2020 to 2023 and the management is confident in delivering revenue growth in the range of 5% to 8% in the coming years. And the momentum appears to continue in 2024, with the company reporting revenues growing 8.4% y-o-y in Q1, sitting at $5.9 billion compared to the $5.5 billion registered in Q1 2023. Profitability Metrics For the reported period, Eaton’s operating margin stood at 17%, reflecting better performance with the industry median value of 8.9% in 2023. The total operating profit was $3.9 billion, marking an increase of 29.9% year-over-year. Source – TIKR Terminal Despite a good 2023, the median operating margin is slightly lower, equal to 12.3%, though still better than the industry median value of 8.4% registered over the past decade. Source – TIKR Terminal Excluding the 2020 stumble, from 2013 to 2023 Eaton’s operating margin went through a positive upward trend, improving from 10.5% to 17%. In the 2022 investor conference, the management reiterated their focus on improving profitability, driving operating margins towards the 20% range in the foreseeable future. The positive trend seems to be confirmed also for 2024, as in the first quarter of the year Eaton reported an operating margin of 17.1% compared to 14.6% registered in Q1 2023. For such reason, we can expect Eaton’s operating margin to improve to 20% in the next couple of years and remain above it thereafter as the company enters its mature phase. Looking at other measures of profitability, in 2023 the gross margin sat at 36.4%, better than the median value of 32.3%, while the free cash flow margin was 14.4% – also better than the past decade’s median value of 11.7%. Source – TIKR Terminal Excluding fiscal years like 2019 and 2021 – featured by big acquisitions which significantly increased the reinvestment needs – Eaton has been able to deliver solid and consistent free cash flows to the firm (FCFF) to its shareholders over the years, with FCFF sitting at $3.3 billion in 2023, growing 1.4 times since 2013 at a CAGR of 3.6%. Reinvestments & Efficiency Ratios Over the past decade, the median reinvestment margin of Eaton stands at a negative (0.4%), meaning that on average depreciation and positive changes in working capital were higher than capital expenditures, and acquisitions. When considering R&D expenses as capital expenditures due to their long-term value generation, this figure adjusts to 1.6%. Source – TIKR Terminal Eaton’s reinvestments are mostly represented by capital expenditure and seldom acquisitions, especially in recent times as the company is undergoing a restructuring of its product’s portfolio. More relevant than capital reinvestments, are the shareholder rewards programs implemented by the company over the years. Combining both dividends and share buybacks, since 2013 Eaton has returned a median of 8.4% of its annual revenues to shareholders. In terms of efficiency, during the period 2013-2023, Eaton boasts a median ROIC of 9.4% – compared to an industry median value of 11.8% – and a sales to invested capital ratio of 0.86, lower than the industry median value of 1.39. Source – TIKR Terminal Financial Ratios Briefly dwelling on financial ratios as of the most recent reporting period, the net cash position registers a negative value of $7.3 billion. Source – TIKR Terminal The interest coverage ratio greatly improved from a median value of 10.5 to 21 as of the LTM. The current ratio and the debt-to-equity ratio indicate solid financial stability sitting at 1.56 and 0.51, respectively – 2013-2023 median values 1.51 and 0.55 respectively. Industry Overview Market Share and Competitors Analysis The electrical equipment industry is characterized by modest growth and profitability, with a median revenue growth rate of 5.5% and a median gross margin of 26.8%. The median operating margin instead, stands at 8.4%. Eaton, with its $15.9 billion in revenues in 2023, has established a strong presence in the electrical equipment industry, representing 3% of the industry’s total revenues of $764 billion. The electrical equipment industry is highly competitive. Looking at the industry in its entirety, Eaton places itself among primary players like Schneider Electric S.E. with a 5.2% market share, ABB Ltd. with a 4.2% market share, and Emerson Electric with a 2.1% market share. Industry Growth Forecasts From 2013 to 2023, the industry’s revenues grew at a CAGR of 6.5%, increasing 1.9 times from $405 billion to $764 billion. Source – BlackNote Investment The industry is poised for growth relying on secular trends like climate change and energy transition, which focus on replacing traditional energy sources with renewable ones towards electrification and decarbonization, especially as regards buildings, both residential and commercial, and industrial facilities. In recent times, thanks to the blossom of new technologies, new megatrends benefitting the electrical equipment industry have emerged. To foster AI technology development, data centres require significant power and cooling infrastructure supplied by electrical equipment companies, while smart buildings rely on real-time monitoring and energy management solutions developed by electrical equipment companies. To capitalize on such opportunities, over the past decade, collectively the industry registered a median reinvestment margin of 4.4%, which comprises investments made in capital expenditures, R&D, and acquisitions. In terms of efficiency and return on investments, the electrical equipment industry median sales to invested capital in the period 2013-2023 is equal to 1.39, meaning that on every dollar invested the industry generates $1.39 of revenues. Combining both the reinvestments made through the past decade and the industry’s ability to generate a return from the investments made, the 2024 expected growth rate for the industry is 5.82%. A detailed explanation of how we came up with the industry’s expected growth rate, as well as many more useful industry data, can be found on my website BlackNote Investment. By 2033, the electric equipment industry revenues are expected to reach $1.25 trillion, increasing 1.6 times from the $764 billion registered in 2023 at a CAGR of 5%. We projected the industry’s expected revenues 10 years from now, applying the expected growth rate of 5.82% and allowing it to slowly decline as the industry approaches the economy’s perpetual growth rate, represented in this case by the USD risk-free rate. Source – BlackNote Investment Company Growth Forecasts Projecting Eaton’s future market share, over the period 2013-2023, its revenues timidly grew at a CAGR of 0.5% increasing from $22 billion to $23.2 billion, while its market share decreased from 5.4% to 3%. Source – BlackNote Investment To meet the management expectations of revenue growth rates in the range of 5% to 8% by 2025, it would imply Eaton’s market share will have to improve to around 3.1% in the next years. Assuming Eaton will maintain a market share of 3.1% thereafter, by 2033, its revenues are projected to reach $38.3 billion, representing an increase of 1.7 times from the 2023 revenues of $23.2 billion at a CAGR of 5.1%. Free Cash Flows Forecasts Moving on to projecting future cash flows, in the 2022 investor conference, the management set the target for free cash flow margins in the range of 14% for the coming years. Assuming Eaton will maintain its historically low reinvestment needs, with the reinvestment margin sitting around 1.6%, by 2033, the free cash flows to the firm are anticipated to swell to $5.2 billion. This projection represents an increase of 1.6 times from the $3.3 billion reported in 2023, reflecting a CAGR of 4.5%. With these assumptions, over the next decade, the FCFF margin is expected to sit around an average value of 14.6%, in line with management’s expectations. Source – BlackNote Investment Valuation Applying a discount rate of 8.8% for the next 10 years, and a discount rate of 8.2% in perpetuity, we obtain that the present value of these cash flows – after adjusting for debt and cash on hand – is equal to $86 billion or $215 per share. Source – BlackNote Investment Compared to the current prices, Eaton stocks are overvalued by 32.5%. To justify current stock prices, the implied rate of return would be equal to 4%. It implies investing in Eaton at the current prices would deliver a negative alpha of (4.7%) as it would generate lower returns – IRR of 4% – compared to the actual weighted return of 8.7% investors should expect given the assumption on cash flows and risk made so far. Discount Rate To determine the appropriate discount rate, we employ the WACC method, which considers both the cost of equity and the cost of debt. The cost of equity – 9.1% – is derived using the USA equity risk premium of 4.6% – as of May 2024 – the current USD risk-free rate of 4.3%, and the company’s beta of 1.05. The company’s beta is based on the electrical equipment industry’s unlevered beta of 0.73. The cost of debt – 5% – represents the expected return demanded by debt holders and is influenced by the company’s specific risk profile and the broader market conditions. It is computed considering the current USD risk-free rate of 4.3%, the company’s default spread of 0.69%, and the USA default spread of 0%. With a current Equity to Enterprise Value of 94.2% and a Debt to Enterprise Value of 5.8%, Eaton’s discount rate for the next 10 years is 8.8%. However, in a stable growth scenario, where the company is expected to grow at a perpetual rate, both the cost of equity and the cost of debt differ from the high growth phase. The company’s beta, default spread, and capital structure are expected to evolve as it transitions to a stable growth phase, with the adjusted rate reflecting the anticipated lower volatility, reduced credit risk, and different financing mix of the company. As Eaton enters the steady state, both the company’s beta and company default spread are expected to approach the industry’s median values of 0.93 and 1.2%, respectively. Mature companies often have more predictable cash flows and may change their financing strategies. I anticipate Eaton to adjust its Equity to Enterprise Value and Debt to Enterprise Value towards the industry median of 91.3% and 8.7%, respectively, reflecting a more typical capital structure for a stable company. With these assumptions, the discount rate used to discount the cash flows in perpetuity is 8.2%. Conclusion In conclusion, despite the positive outlook, at current prices Eaton results to be highly overvalued as it would generate lower returns compared to the actual return investors should expect given the assumption on cash flows and risk made so far. Eaton is poised to deliver solid free cash flows to its shareholders, however, to justify today’s market prices, an investor willing to buy Eaton’s stocks will have to settle for a modest 4% return on investment while being exposed to the risk of future stock prices correction towards the firm’s fair value. When compared to risk-free investments – like the U.S. 10 Year Treasury – which are currently yielding over 4%, Eaton’s stocks don’t represent a good investment opportunity.

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