Eaton Corporation (NYSE:ETN) is an investment play on growing growth trends in electrification, energy change, and digitalization. Electrical Americas, Electrical Global, Aerospace, Vehicle, and eMobility are the company’s five operating segments. IQ Cleaner Transport ETF (CLNR), Clean Edge Smart Grid Infrastructure ETF (GRID), Self-Driving EV and Technology ETF (IDRV), Smart Transportation & Technology ETF (MOTO), Carbon Transition & Infrastructure ETF (NBCT), and Sustainable Energy II ETF all have ETN as a top holding (SOLR).
Electrical Americas and Global (70% Sales)
Electrical Americas and Global (70% sales) are two segments that manufacture highly engineered electrical components for energy storage and grids that are marketed to a wide range of industrial, government, commercial, and residential end users.
Market drivers (high fuel prices, energy inflation, supply chain bottlenecks, geopolitics, and the urgency of climate change) are driving +10-11% annual sector growth for clean energy and electrical grid products and services, positioned to more than quadruple by 2026-2030. Renewables, grids, and storage account for over 80% of all energy investments. Eaton is working on smart home grids and industrial grid modernization. They estimate the sector to develop 4.6 times faster in 2025 than in 2021.
Aerospace (14% Sales)
Eaton’s Aerospace is the next largest segment (14% of revenue). This section includes commercial and military fuel, hydraulic, and pneumatic systems. Commercial and military end-user markets each account for 50% of revenues.
After experiencing substantial lows due to the epidemic, the aerospace industry is poised to recover, with international flight restrictions being eased and robust demand for air travel. According to Research and Markets, this will result in pre-pandemic or higher levels by 2024, with a CAGR of 9.1% through 2026.
The White House’s defense budget request for FY 2023 of $872 billion is a +8% increase in spending. Speaker Pelosi’s trip to Taiwan, which inevitably resulted in saber rattling, demonstrates the strong bipartisan domestic support for this subject. Rising geopolitical tensions in Europe (Ukraine) and Asia (Taiwan) are prompting historically “dovish” governments to increase military budget pledges. PWC anticipates that 70% of additional global defense spending will be designated as “aerospace” weapon systems.
eMobility (3% Sales) and Vehicle Segment (13% Sales)
The final two segments are the mature Vehicle (13% sales) and fast-rising eMobility (3% sales). Both divisions design and produce vehicle parts to improve power management, fuel efficiency, and performance of automobiles, trucks, commercial vehicles, and off-road vehicles, with eMobility concentrating particularly on vehicle electrification.
With the increasing acceptance of electric vehicles and cars, the eMobility segment is expected to rise exponentially in the future. Eaton predicts a +27% total CAGR for the segment through 2025 in its 2022 investor presentation. Eaton’s eMobility segment’s growth potential will be felt in the future when it is expected to impact the company’s overall revenues and profitability significantly. By 2025-26, this division could have $1 billion in sales and an operating margin of 8%-12%, with a target of $2-$4 billion in sales and a 15% operating margin by 2030.
Slower expansion Eaton’s vehicle segment generates significant cash flow, which it utilizes to reinvest in other, more promising areas. Furthermore, this division could be a contender for sale at the right price.
Valuation Seems Low Relative to Long-Term EPS Growth
If the S&P 500 P/E multiple is at 16-17x in 2022, we believe Eaton warrants a 20x P/E multiple, representing a 25% premium to the market. This premium is supported by the company’s outstanding long-term EPS growth potential and leadership position in its target industrial markets. Eaton might trade at $246/share in 2026 (20x EPS projection of $12.30), delivering +13% annual capital appreciation + 2.5% yield = +15.0%-15.5% annualized returns over the next four years.
Looking at the company from another angle, we believe Eaton may trade with a dividend yield of 2.0%-2.5%. Our forecast payout of $5.90/share would support a stock price range of $236 to $295 (midpoint of $265). This value is significantly higher than the company’s historical yield of 3.0%-4.0%. Still, it is supported by far better secular growth trends in Eaton’s core business sectors and the current low-interest rate environment.
Many Types of Investors Should Find Merit in This Name
Eaton is one of the industry’s full electrification and energy transition players. This rising tide will lift its boat. The company is at a tipping point in sales growth and margin expansion, as seen by management’s higher guidance (twice) in 2022, which investors may not fully comprehend. We believe that the long-term benefits of this attractive industrial category outweigh the short-term problems of a slowing economy.
Investors seeking growth at a fair price (GARP) may consider this company now. In contrast, Value Investors might consider loading up the truck if ETN approaches spring lows of $125-$130. Several long-term secular trends are buried in the fundamentals of this tale, and momentum investors may get enthusiastic if Eaton begins to benefit from recently passed Federal legislation, the Inflation Reduction Act. We believe that dividend growth investors can expect higher-than-expected dividend increases when the payout ratio normalizes over the next three to five years.
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