Shares of Eaton Corp. (ETN, Financial) have returned 91%, 68% and 119% over the past one-year, two-year and five-year periods. The stock has outdistanced the S&P 500 by approximately 30 percentage points for each time period.
As with many industrial companies, Eaton's business did struggle last year as the Covid-19 pandemic weighed heavily on demand for many products in 2020. The company does expect growth to be much improved for the current year, which has helped fuel the rally in the stock.
That being said, the stock's valuation is expensive right now, which mores that outweighs any of the positives that the company has going for it. Let's look closer at Eaton to see why.
Recent earnings results
Eaton reported fourth-quarter and full-year earnings results on Feb. 2. For the quarter, revenue was down 10.5% to $4.7 billion, but did manage to beat Wall Street analysts' estimates by $70 million. Adjusted earnings per share was lower by 9 cents, or 6.6%, to $1.28, but did come in 4 cents above expectations.
For 2020, revenue declined almost 17% to $17.9 billion. Adjusted earnings per share fell $1.52, or 25%, to $4.24.
The Electrical Americas segment generated revenue of $1.7 billion, which was an 18% decrease from the year-ago period. Nearly all of this weakness was due to divestitures made since the prior year. Organic sales were down just 1% due to the Covid-19 pandemic's impact on demand in many end markets, though leadership did note that residential and data center markets were strong as more people transitioned to work and learn at home. This segment's backlog did grow 12% from the previous year. Eaton announced that it had agreed to acquire Tripp Lite, a leading supplier of power products, for $1.65 billion in late January. This transaction should close by mid-year.
The Electrical Global segment's sales fell 5% to $1.25 billion. Organic sales were down a high single-digit percentage while currency exchange was a 2% tailwind. Oil and gas and industrial end markets remained weak during the quarter as demand was lower due to the pandemic. On the plus side, data center and residential demand was considerably higher and the backlog grew 14%. Given how energy prices have increased since the last quarter, (WTI Crude is up almost 30% over the last three months), it is likely that this segment is seeing much improved demand.
Hydraulics sales improved 2% to $485 million. This segment saw heightened demand in mobile equipment markets as orders from customers surged 25%. In January of 2020, Eaton announced it was selling its hydraulics business to Danfoss A/S, a privately held Danish industrial company, for $3.3 billion.
Aerospace sales were down 13% to $542 million as Covid-19 travel restrictions greatly reduced results. Orders fell by a third on a rolling 12-month basis due to sharp declines in commercial markets travel. The backlog was down 14% as well. Eaton announced on Feb. 1 that it had agreed to buy Cobham Mission Systems, which makes products primarily for defense customers, for $2.83 billion. This helps improve Eaton's presence in military markets, which have held up much better than commercial aerospace. The deal should close by the second half of 2021.
Revenue for the Vehicle segment was down 7% to $620 million, though nearly all of this decline was related to a selling off non-core businesses. Lower truck production was responsible for much of the remaining weakness.
EMobility sales improved 13% to $85 million as strength was seen in all regions. It is by far the smallest component of Eaton, but one the company believes could see substantial growth due to its focus on parts and systems for electric vehicles.
Rounding out the quarter, organic revenue decreased 5% overall, divestitures lowered results by 8% and acquisitions were a slight tailwind to quarterly sales. Segment margins fell 40 basis points to 17.4%, a decent result given the declines in almost all business segments.
Eaton's total assets at the end of the year stood at $31.8 billion, with current assets of $9.2 billion and cash and equivalents of $1.1 billion. Total liabilities were $16.9 billion, with current liabilities of $5.9 billion. Total debt was $8.4 billion, with just over $1 billion due within the next year. Eaton had free cash flow of $2.6 billion in a year that was very difficult. It is likely that the company's 2021 will be much improved and free cash flow generation should remain strong, which should allow Eaton to meet its obligations.
The company's guidance for 2021 is evidence of a leadership expectation of return to growth. Overall, Eaton expects organic revenue growth of 4% to 6%, with every segment expected to be higher from the prior year. Vehicle and eMobility are both expected to produce at least low double-digit growth, while both electrical businesses are projected to grow 3% to 5%. Adjusted earnings per share are expected in a range of $5.40 to $5.80 per share. Achieving the midpoint would represent a 32% increase from 2020. Eaton would also take out its 2019 earnings highs at the upper end of guidance, an impressive feat given the difficult operating environment that the company faced last year.
Dividend and valuation analysis
Eaton shareholders received a 4.1% dividend increase for the Nov. 20 payment, extending the company's dividend growth streak to 12 years. This raise is slightly more than half of dividend's compound annual growth rate of 7.9% since 2011. Considering the impact of the pandemic on results and the decline in earnings per share, this appears to be a fair raise.
The company paid out 69% of earnings per share in the form of dividends in 2020. Eaton's earnings per share payout ratio has been mostly rangebound over the past 10 years, often between 40% to 50%. If the company's guidance is accurate, then the payout ratio should return to a much more normal level. Eaton's annualized dividend of $3.04 results in a payout ratio of 54% using the midpoint of company guidance. Eaton yields 2.2%, which is a full percentage point below the stock's average yield since 2011, which could imply that the stock is currently overvalued.
The dividend also looks safe when using free cash flow. Eaton distributed $1.18 billion of dividends last year while producing free cash flow of $2.56 billion for a payout ratio of 46%. This is lower than the free cash flow payout ratio of 48% that the company averaged in the three previous years.
Where Eaton starts to look unappealing is when examining the stock's valuation relative to its historical average price-earnings ratio and intrinsic value.
Using Thursday's closing price of $139.49 and the company's guidance, Eaton has a forward price-earnings ratio of 24.9. Shares have had an average price-earnings ratio of just over 15 over the last 10 years. To add additional context, since at least 2005, Eaton hadn't averaged an earnings multiple above 20 until last year. The expected price-earnings ratio for 2021 is higher than even this figure.
Using GuruFocus's measure of intrinsic value, referred to as the GF Value, Eaton's valuation looks even worse.
Eaton has a GF Value of $74.86. Using the current share price gives the stock a price-to-GF Value of 1.86. As you can in the chart above, the price-to-GF Value is almost off the charts. Shares would have to decrease 46% to trade with the GF Value. As a result, Eaton is rated as significantly overvalued.
Final thoughts
Eaton, like a lot of industrial companies, had a difficult 2020 as the Covid-19 pandemic upended customer demand. The company does have some positives working in its favor, such as maintaining a leadership position in many of the end markets that it services, making strategic acquisitions to bolster the core business and divesting non-core and underperforming assets. Leadership also expects a rapid recovery from 2020 numbers. Finally, Eaton has a market beating dividend yield, albeit one that is lower than the decade-long average.
Considering all of these factors makes Eaton look like an attractive investment option at the right valuation for those looking for exposure to the industrial market. I would consider the stock for purchase if not for the incredible premium that Eaton trades with compared to both the historical price-earnings ratio and the stock's intrinsic value. For this reason, I would take profits if I owned the name or wait for a significant pullback before starting a position.
Disclosure: The author has no position in any stocks mentioned in this article.
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