Eaton Corporation: A Good Company With A Limited Upside Potential

seekingalpha02-09

Capital investments in the US are set to increase after decades of decline, with state and local investments already on the rise.Eaton Corporation plc is a global power management company that may ...

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JHVEPhoto Capital investments as a share of GDP have been decreasing for decades in the US, this trend will reverse since the implementation of the Bipartisan Infrastructure Law (BIL). State and local capital investment already increased in the past 2 years by the largest amount not seen since 1979 and will continue to grow in the coming years.   State and Local Capital investment as share of GDP (home.treasury.gov) I would like to have a deep dive into the companies that may be a beneficiary of these investments, providing a series of articles devoted to the sector. Today I am going to talk about Eaton Corporation plc (NYSE:ETN). The company's share price performance was consistently beating the S&P Infrastructure Index raising a question of continuing momentum. With the multiples higher than its 5-year average and overpriced compared to peers, I will dive deeper into its valuation analyzing the company statements and coming to the conclusion that all the growth perspectives are already priced in.   ETN share performance compared to S&P index and S&P Industrials index (The company`s statements) Company Overview Eaton Corporation is a global power management company. It operates in 3 sectors: Electrical, Aerospace, and Mobility. With the recent purchases, the company confirms its strategy to concentrate on clean-energy technology. BIL itself has a goal to rebuild and develop “supply-side economics” and deliver cleaner energy to households and businesses. This includes billions invested in mega projects, making the sector to be a beneficiary for the several coming years. The company saw an increase in operational performance since the adoption and continued a series of strong results with the recent fourth quarter.   ETN operational performance and leverage (Own author`s calculations based on the company`s statements) Peer analysis           ETN Sector Median 5Y Average   P/E GAAP (FWD) 29.35 21.4 24.35   P/S (FWD) 4.33 1.44 2.70   P/B (TTM) 5.69 2.62 3.42   P/E GAAP (TTM) 33.81 22.52 26.95   Div Yield 1.27% 1.44% 2.22%   Click to enlarge Source: author`s calculations based on SeekingAlpha data With performance expectations high, ETN is trading higher compared to the sector median, with the multiples above its 5-year average. The growth rate expectations may be too high, I will define it later on with an alternative valuation technique. The dividend yield is lower compared both to the average and sector median which may be a good sign that the returns are reinvested at a higher interest rate with increasing company`s operating figures. Latest Quarterly Results The company performed well with both increasing the gross margin and decreasing operational expenses in inflation conditions. It seems that the company`s long-term plan for cost optimization is working and will be taken into consideration in calculations later on.   Year 2023 2022 2021 2020 2019   Operating revenue 100% 100% 100% 100% 100%   Cost of sales 64% 67% 68% 69% 67%   Gross margin 36.4% 33.2% 32% 31% 33%   Sales and administrative 16.4% 15.6% 16.6% 17.2% 16.8%   Research and development 3.3% 3.2% 3.1% 3.1% 2.8%   Total operating expenses 19% 19% 20% 21% 20%   Click to enlarge Source: author`s calculations based on the company`s statements This resulted in higher profit margins and increased return on net operating assets.   ETN 2023 Financial Highlights (ETN presentation) Actual numbers are higher than the company provided in its guidance, The Electrical Americas Segment increased by 16%, contributing to overall sales increase and operating profit.   Year 2023 2022 2021 2020 2019   Operating assets             Cash and cash equivalents 0.1% 0.1% 0.1% 0.1% 0.1%   Accounts receivable, less allowance for doubtful accounts 12.5% 11.8% 9.8% 10.3% 11.1%   Inventories 10.4% 9.9% 8.9% 7.5% 9.1%   Property, plant and equipment, net 9.8% 9.1% 9.1% 10.5% 11.3%   Goodwill 41.8% 42.9% 44.0% 45.7% 43.6%   Identifiable intangible assets 14.2% 15.9% 17.5% 14.8% 15.0%   Deferred income taxes and other assets 9.4% 8.6% 9.2% 9.7% 8.3%   Operating lease assets 1.8% 1.7% 1.3% 1.5% 1.4%   Total operating assets 100% 100% 100% 100% 100%                 Operating liabilities             Accounts payable - non-interest bearing 35% 35% 32% 25% 27%   Accrued liabilities 9% 7% 9% 9% 10%   Pension liabilities 8% 7% 10% 20% 19%   Deferred income taxes and other liabilities 48% 51% 49% 47% 43%   Total operating liabilities 100% 100% 100% 100% 100%   Click to enlarge Source: author`s calculations based on the company`s statements Accounts receivables and inventories had a slight increase, but it is in line with the previous year's trend. The company announced a restructuring plan that could bring benefits to the shareholders, this will be closely monitored in the coming years. Risks The performance of the recent acquisitions may not result in a positive synergy. As the company is performing worldwide, geopolitical tensions and war may significantly affect its future performance and growth prospects. Changes in tax regulations and foreign exchange fluctuation may affect effective tax rate prospects, resulting in lower profit margins. Further interest rate spikes may result in increasing costs of sales and operational results. Changing conditions in the US economy may significantly negatively affect sales. Valuation methodology I used the same methodology as in my previous article. I forecasted balance sheets till 2029 to take into consideration the accelerated growth of the sector and taking into consideration cost optimization. The required return is WACC-calculated but based on the expectations for lower interest rates soon. Balance inputs depend on the sales figures of the company. The terminal growth rate is 4%. Valuation inputs and results With the sales increasing double-digits and past years of around 9% yearly on average, I presume they will continue to rise at an accelerated rate for several coming years. New products, growing demand, and a restructuring plan with decreasing costs will add value. Effective income tax is used instead of the tax federal statutory rate which increases the profit margins. The required return equals 7%, which is lower than the current rate, assuming a decrease in interest rates.               2023 2024E 2025E 2026E 2027E 2028E 2029E and after   Income statement                 Sales 23196 25284 27559 30039 32743 35690 36404   Cost of sales 14762 15170 16536 18024 19973 22663 23116   Gross margin 8434 10113 11024 12016 12770 13027 13287                     Residual Operating Income ((ReOI)) 1524 2769 3006 3276 3314 2913 3029   Cost of operations 7.00%               Total Present Value (PV) of ReOI to 2024 12493               Continuing value (CV) 100970               PV of CV 71990               Value of common equity 103552               Number of shares outstanding 397.8               Value per share $260.31               Click to enlarge In Thousands of US Dollars (USD) except per share items Click to enlarge Valuation risk The growth rate is based on past accelerated performance averages (since BIL implementation), even a slight change will affect the price. If the growth rate continues to rise this year, it will result in a higher price target. Calculations don’t include options outstanding and minority interest which will lower slightly the price target. The calculation includes the effective tax rate (provided in the company guidance), this number may be volatile and affect the value. Due to accounting principles, some of the figures I used in my reformulation might be slightly off, but I tried to minimize their influence. The latest quarter statements and annual statements lack some disclosure, making it difficult to forecast the performance -- although this had only a minor effect on my calculations. WACC calculations are outsourced, but reasonably match my own and adjusted for possible rate decreases. Conclusion With the current market price of $271, it seems to me overvalued. My price target of $260.31 doesn’t include options outstanding and minority interest. Moreover, the calculations include upper-bound sales growth with low (compared to current) cost of operations and a 4% terminal growth rate, which sounds too optimistic to me. Taking into consideration all written, it seems to me that all is already priced in leaving limited upside possibilities, but opening the door for correction. The company's performance was great, but I would wait for a lower price to jump in. The maximum rating that I can give right now is “HOLD”.  With the current market price of $271, it seems to me overvalued. My price target of $260.31 doesn’t include options outstanding and minority interest. Moreover, the calculations include upper-bound sales growth with low (compared to current) cost of operations and a 4% terminal growth rate, which sounds too optimistic to me. Taking into consideration all written, it seems to me that all is already priced in leaving limited upside possibilities, but opening the door for correction. The company's performance was great, but I would wait for a lower price to jump in. 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