Eaton Corporation (ETN): Manufacturing Safe Dividends Since 1923

Eaton Corporation, PLC Ordinary Shares (NYSE:ETN) shares several characteristics with some of the companies we hold in our Top 20 Dividend Stocks portfolio.

The company scores well for Dividend Safety and Dividend Growth, has paid dividends every year since 1923, generates excellent free cash flow, and has a relatively high dividend yield near 3.7%.

Eaton’s stock also trades at a forward price-to-earnings multiple of 14.2, which is a discount of approximately 15% compared to the broader market.

Let’s take a closer look at Eaton and see if it makes the cut as one of our favorite blue chip dividend stocks.

But first, let’s see how top investors have been trading the stock of late. 39 funds out of the 786 tracked by Insider Monkey were long Eaton Corporation on December 31, with $748.97 million in holdings amounting to 3.1% of the company’s float. The first two figures were down from 41 funds with $985.05 million in holdings on September 30. More recently, sentiment does not appear to have improved, as three funds have so far reported new long positions in the company during the current 13F filing period, while seven have reported closing positions in the stock. Steve Galbraith’s Herring Creek Capital was one of the funds to sell off its Eaton long position during the first quarter, which had contained 293,402 shares on December 31.

Business Overview

Eaton is a large industrial conglomerate with over $20 billion in annual sales and an operating history dating back to 1911.

The company provides a wide range of energy-efficient products and systems that help customers manage power across electrical, hydraulic, and mechanical applications.

Eaton also has a substantial aftermarket business (approximately 20% of total sales) that provides some stability to its business.

By geography, about half of Eaton’s sales are made outside of the U.S. with approximately 25% of total sales derived from emerging markets.

Segments

Electrical Products & Systems (62% of sales; 62% of profit): sells a range of power-related components, circuits, lighting products, and equipment used wherever there is demand for electrical power (e.g. buildings, data centers, hospitals, utilities, factories).

Vehicle (18% of sales; 20% of profit): supplies drivetrain and powertrain systems and components used in cars, trucks, and agricultural vehicles. Key products include transmissions, clutches, engine valves, and superchargers.

Aerospace (9% of sales; 10% of profit): sells fuel, hydraulics, and pneumatic systems used in commercial and military aircraft. Products include pumps, motors, controls, sensing products, hose fittings, and more.

Hydraulics (12% of sales; 8% of profit): sells components and systems such as pumps, motors, valves, and controls that are used in industrial and mobile equipment. Key end markets are oil and gas, agriculture, construction, and mining.

Business Analysis

Many of Eaton’s competitive advantages are derived from its lengthy operating history. The company has been in power management for more than 100 years.

As a result, Eaton has built up a strong reputation for quality, massive distribution channels, an extensive portfolio of well-known products, and long-lasting customer relationships.

Smaller and newer players have a hard time competing with Eaton for many of these reasons. They lack Eaton’s economies of scale (over $20 billion in annual revenue), which allow the company to maintain a lower manufacturing cost structure.

Eaton Corporation, PLC Ordinary Shares (NYSE:ETN) can also afford to pump more than $600 million in research and development activities each year to maintain the broadest, most advanced portfolio of technologies and established brands.

This is important because many of its products solve the most demanding power needs. The company supplies mission critical products that need to be extremely reliable.

In aerospace, for example, Eaton benefits from long product qualification cycles and meaningful aftermarket demand. Once Eaton’s components and systems have proven to be reliable and are designed in, the company enjoys a long stream of high-margin aftermarket revenue.

The company’s aftermarket business makes life difficult for new entrants as well. Eaton generates over $4 billion in annual sales from aftermarket products and services, helping it maintain stickier customer relationships and retain its reputation for quality.

Aftermarket revenue also tends to carry high margins and allows Eaton to price some of its upfront equipment sales at levels that make it difficult for smaller competitors to earn a profit (a lot of the money is made in equipment support and services).

Smaller rivals lack the network needed to service multinational customers, who demand timely service and maximum uptime.

Eaton has over 13,000 authorized channel partners and 10,000 commercial resources it can use to efficiently reach customers all over the world. Replicating this network would likely take decades of time and cost millions of dollars.

The company’s management team has further solidified Eaton’s advantages through selective acquisitions and divestitures over the years.

Eaton has made more than 100 transactions since 2000 that have improved its profitability and served as a major driver of earnings growth.

The company’s Electrical segment alone purchased over 30 businesses and divested 11 companies since 2000, helping it improve margins from 10.4% to 15.3% in 2015.

Eaton’s most notable deal took place in 2012 when it acquired Cooper for $11.8 billion. Cooper manufactures electrical equipment (e.g. fuses, lighting controls, voltage regulators, circuit-protection equipment) that helps companies save money on energy.

The deal gave Eaton a larger product portfolio (its electrical addressable market expanded by $70 billion), more scale, and a denser distribution network to help it compete better with some of its bigger rivals.

Cooper was also domiciled in Ireland, which allowed Eaton to incorporate there and enjoy substantially lower tax rates on its corporate profits – Ireland’s tax rate is 12.5% compared with 35% in the U.S.

Today, Eaton is a dominant force across most of its markets. The company is one of the four largest electrical players in the world and is one of the three biggest hydraulics businesses. Approximately 70% of Eaton’s industrial sector products have a leading global or regional market share.

Despite the company’s size, most of its markets remain extremely large and fragmented, providing room for moderate growth. The electrical market is estimated to be $200 billion in size, and hydraulics is another $40 billion.

We expect Eaton will remain a force in its markets for many years to come thanks to its portfolio of well-established brands, strong distribution channels, and commitment to R&D.

Eaton’s Key Risks

Like most industrial conglomerates, Eaton’s businesses are sensitive to global economic growth, industrial spending, manufacturing activity, commodity prices, and foreign currency exchange rates.

The company’s hydraulics business has suffered from the downturn in global mining and agriculture markets as well as the slowdown in Chinese construction projects.

Foreign currency headwinds have also dented recent growth.

While these macro issues are weighing on Eaton’s earnings today, they seem unlikely to impact the company’s long-term earnings power.

Instead, some of the bigger risks long-term investors should consider are the company’s sustainable earnings growth rate and the amount of taxes it pays.

The downsides of being such a large conglomerate are that incremental sales growth can be difficult, and some business lines are not going to be fully healthy.

Eaton’s 2020 plan targets organic sales growth of just 1-2% per year – hardly anything to get excited about. If the business struggles to get all of its cylinders firing at once, sales could tread water.

Companies with minimal growth prospects deserve to trade at a discount to the market and don’t really excite us much.

Instead of relying on the top line for growth, management’s 2020 plan expects restructuring actions to drive about half of Eaton’s annual earnings growth over the next five years.

The company has been closing down plants, reducing the size of its workforce, and improving manufacturing processes to lower its costs. However, there is only so much cutting that can be done to lift earnings – at some point, profitable sales growth is necessary.

We think Eaton can continue squeezing out low-single digit sales growth as long as global GDP keeps grinding higher, but our expectations are admittedly low.

Another risk that could materially impact Eaton’s earnings is its low tax rate, which sits near 10% thanks to its tax inversion following its 2012 acquisition of Cooper.

Eaton has received some heat from Donald Trump and Hilary Clinton over its actions to lower its taxes and shift more production out of the country.

If the government were to crack down harder on either of these issues, earnings would be reduced. We view this as a very unlikely scenario, but it would certainly impact Eaton and a number of other large multinational companies.

Overall, Eaton’s business diversification, long operating history, healthy cash flow generation, and slow-changing markets reduce its risk profile.

Dividend Analysis: Eaton

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Eaton’s long-term dividend and fundamental data charts can all be seen by clicking here.

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Eaton’s Dividend Safety Score of 53 is about average. Despite difficult business trends in recent quarters, Eaton has maintained healthy dividend payout ratios near 50%.

The company’s payout ratios have more than doubled over the last decade (see below), but there is still plenty of cushion for Eaton to continue paying its dividend from operating earnings and cash flow if unexpectedly difficult times were to hit.

Source: Simply Safe Dividends

We also evaluate how a company performed during the last recession to assess the safety of its dividend. Eaton’s sales fell by 19% during fiscal year 2009, and its stock also dropped by 47% in 2008 to trail the S&P 500 by 10%.

Not surprisingly, Eaton’s business is sensitive to the economy and should be operated more conservatively than other types of businesses that are less cyclical.

Despite ever-changing macro conditions, Eaton’s free cash flow generation has been nothing short of excellent. As seen below, the company has generated positive free cash flow in each of the last 10 years, providing it with flexibility to pay down debt, increase the dividend, make opportunistic acquisitions, and repurchase shares.

Observing a company’s operating margins also helps assess dividend safety. Generally speaking, the safest companies will earn high and stable margins.

Aside from the financial crisis, Eaton has earned very consistent operating margins between 8% and 10%. The business has done a great job delivering steady profits in numerous environments.

Cyclical companies must maintain healthy balance sheets. If they unexpectedly fall on hard times and need to make substantial principal and interest payments, the dividend could become jeopardized.

Eaton’s balance sheet is in better shape than it has been in recent years, but it contains a little more debt than we prefer to see. The company’s pension plan is also underfunded by a couple billion dollars.

Fitch assigned a “BBB+” credit rating to Eaton in mid-2015, which seems about in line with our analysis. As long as the economy doesn’t fall off a cliff, Eaton should be just fine.

Overall, Eaton’s dividend looks pretty good for safety purposes. The company maintains reasonable payout ratios, generates consistent free cash flow, and has proven its commitment to shareholders with consecutive dividend payments since the early 1920s.

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Eaton’s Dividend Growth Score of 65 suggests that the company’s dividend growth potential is above average. The company only raised its dividend by 4% in 2016, reflecting the difficult macro environment, but has historically been a double-digit dividend grower.

As seen below, Eaton’s dividend has compounded at a 13.5% annual rate over its last 10 fiscal years and grown at a remarkably consistent clip.

While the business is not a member of the dividend aristocrats list, it has paid uninterrupted dividends for over 90 years while increasing its dividend each year since 2010.

We expect future dividend growth to be in the mid- to high-single digits, tracking the company’s earnings growth. This would keep Eaton’s payout ratios near 50%, which is reasonable for an economy-sensitive business.

Valuation

Eaton Corporation, PLC Ordinary Shares (NYSE:ETN) trades at a forward price-to-earnings multiple of 14.2 and has a dividend yield of 3.7%, which is higher than its five-year average dividend yield of 3.1%.

Eaton’s management team targets annual earnings per share growth of 8-9% from 2015 through 2020. Earnings growth is expected to be driven by restructuring actions (3-4%), share repurchases (3%), organic sales growth (1-2%), and acquisitions (1%).

If management’s assumptions are correct, the stock appears to offer annual total return potential of 11-13% per year.

The stock seems to be very reasonably priced, although it will remain tied to macroeconomic developments over the near term.

Conclusion

Eaton is a quality business that will remain relevant for many years to come. The company’s moat is driven by its long-standing market positions, extensive product portfolio, massive distribution channels, and leading technologies. Many of these qualities are shared with some of Warren Buffett’s best dividend stocks.

Eaton’s valuation also looks undemanding. Soft market conditions could keep a lid on earnings growth over the near term, but the company’s restructuring programs, bolt-on acquisitions, and presence in many large markets provide potential for better long-term results.

For dividend investors seeking a safe, relatively high yield with reasonable growth, Eaton may be an interesting candidate.

Disclosure: None