Has Eaton Corp. Become A Growth Stock? (NYSE:ETN)

The Value To Growth Transition

Sometimes a value stock with a low to average P/E ratio turns into a growth stock because management had the foresight to reposition the company to take advantage of secular trends. That appears to be the case with Eaton Corp. (NYSE:ETN) based on the stock performance this year. I have owned and covered Eaton all four years I’ve been on Seeking Alpha. For a long time, I have been saying that Eaton was making smart moves to transition from a cyclical to a secular growth company by selling businesses like its Hydraulics segment and making acquisitions that fit within its Electrical and Aerospace segments.

Despite that recognition, it is still hard as a value investor to keep a Buy rating on a stock once it begins to exceed its historical valuation range. Since I went from Buy to Hold in February, Eaton stock has returned over 34%, more than 3 times the return of the S&P 500 (SP500).

While I’m happy I did not rate ETN a Sell, a Strong Buy would have been more appropriate. I had a similar history with Albemarle (ALB), which I rated a hold during a big runup despite knowing the secular growth potential for lithium. I even discussed the value to growth transition in a Feb. 2021 article.

On the other hand, it’s also easy to get sucked into a growth story when a company just happens to be in the right place at the right time but the conditions for rapid growth turn out to be temporary. That was the case with Target (TGT) which had impressive margin expansion during the pandemic but fell back to earth as consumer behavior went back to normal. While Target’s merchandising and supply chain innovations make it a better retailer than it was in 2019 and earlier, it’s clear now that the temporary change in consumer behavior was a bigger driver of stock performance.

Coming back to Eaton, the company’s 2Q 2023 results continue to set records for sales, margins, and earnings. Also, strong backlog growth and a book-to-bill ratio of 1.2 indicates potential for the strong performance to continue. Management has also begun selling the growth thesis to analysts, with much of the earnings call devoted to the new growth drivers. When it comes to rating Eaton stock, It’s important to first decide if these growth drivers are sustainable and then to determine if they are already priced in.

The Growth Drivers

The first growth driver cited is the Inflation Reduction Act’s tax incentives to support energy security. Eaton is in the sweet spot for tax incentives supporting not only electric vehicles and charging, but electrical upgrades to residential, commercial, and industrial buildings as well. The slide deck notes that the total tax incentives were originally estimated at $271 billion, a figure that agrees with a 2022 white paper from the US Treasury Department. However, Eaton refers to a “rescoring” expanding the value of these tax incentives 2.5x to $663 billion. It appears they are referring to a June 2023 opinion from the Internal Revenue Service on “elective payment” which allows local governments and other tax-exempt organizations to receive these investment tax credits even though they don’t pay any taxes.

While even the original level of tax incentives can generate business for Eaton, some caution is warranted. On the earnings call, the CEO stated that late 2024 was a reasonable estimate for projects supported by these incentives to start showing up as sales. Whether or not you believe government incentivizing clean energy is a good thing, giving them essentially a blank check to do so is another question. I expect the legality of this interpretation to be questioned at some point, or for a future administration to instruct the IRS to interpret the law more narrowly.

Next mentioned was the broader trend of “reindustrialization”. This refers to reshoring and expanding manufacturing in North America. Eaton measures this by corporate announcements of “mega projects” costing $1 billion or more. Since the start of 2021, there have been $686 billion worth of such projects announced, 3x the typical rate. These include not only clean energy generation, infrastructure, and EV manufacturing, but also other strategic industries like chemicals, LNG, semiconductors, and data centers.

This trend seems more sustainable than the IRA tax credit-driven spending. While it is also boosted by some legislation such as the Chips and Science Act and the Infrastructure Investment and Jobs Act, there seems to be more bipartisan consensus on reshoring of manufacturing for both economic and national security reasons.

A third trend Eaton noted was growing demand from electric utility customers. This vertical makes up about 15% of Electrical Americas sales and has historically grown at a low single digit rate. Eaton now expects 11% growth from utilities over the next 3 years. Grid resiliency is part of this demand, as is the need to manage the more widely distributed and variable renewable power generation going into the grid. Loads will also increase, with demand from EV charging and electric heating.

Finally, aerospace is also growing above historical levels. Passenger travel is expected to return to pre-2020 levels by the end of this year, as I have also noted in my recent article on (RTX). While this may be just a rebound that soon returns to trend growth, aerospace is also supported by the defense market. This demand is not just tied to the number of aircraft produced, but also because the content of Eaton’s products within each plane is increasing compared to the older models being replaced. The content growth ranges from 1.5x – 3x in planes to as much as 5x in the V-280 helicopter.

Evaluating the growth trends overall, the expanded IRA spending and commercial aerospace might still be cyclical or tied to a changeable government incentive. However, the general trends toward reshoring and electrification look more like sustainable growth trends. Eaton deserves some higher growth assumptions than they had in the past, but we still need to determine if these are already priced in.

Earnings Model Update

Based on the growth outlook, I made some updates to the earnings model I have been using in these articles. For 2023, I am now using the latest management guidance for segment sales growth. Electrical Americas got the biggest bump (from 9% to 15%) but Electrical Global (5% to 7%) and Aerospace (9% to 11%) received bumps as well. eMobility was revised down to 30% from 35%. On margins, Electrical Americas was upgraded 100 basis points to 24.4%. My resulting non-GAAP EPS estimate of $8.69 for 2023 falls within company guidance of $8.65 – $8.85.

The company is not yet providing guidance for 2024-25, however I have raised sales growth assumptions for Electrical Americas, Electrical Global, and Aerospace. When it comes to margins, the CEO noted on the earnings call that at least for Electrical Americas, 2H 2023 margins would be a good starting point to estimate 2024 margins. Since we know 1H 2023 actual margins as well as FY 2023 guidance, we can calculate implied 2H margins. The CFO chimed in to say that margins might be even better than this, but I am going with the implied 2H 2023 margins for 2024. For 2025, I am leaving margins for the Electrical and Aerospace segments flat with 2024, taking Vehicle segment margins back down and increasing them for eMobility.

Putting these assumptions into the model, I get non-GAAP EPS estimates of $10.02 for 2024 and $11.02 for 2025. These values are higher than the current analyst consensus but below the high estimates. This is a growth rate of 12.6% over the next 2 years, an improvement over the 8.5% growth estimated in my February article.

Valuation

At $221, Eaton is valued at 25.4x 2023 earnings and 20.1x 2025 earnings. This is more expensive than Emerson Electric (EMR) but cheaper than Rockwell Automation (ROK). Compared to Swiss company ABB, Eaton is more expensive on current year earnings but cheaper on 2025 earnings.

The PEG (price / earnings growth) ratio is an unscientific way to normalize the P/E for earnings growth. It’s not always appropriate, such as for low or zero growth stocks, which still have value as long as they are producing some cash flow. It’s also not useful for startups or ultra-fast growers where earnings are near zero or negative. For established companies just entering growth territory, however, it can be useful. Based on projected 2023-25 growth, Eaton’s PEG ratio is 2.0. This is generally considered the top end of the fair value range, but it is still lower than the PEG of both slower-growing Emerson and Rockwell.

Conclusion

Eaton is not a bargain at a 25.4 P/E. However, the improved growth assumptions give it a PEG of 2.0, at the top end of the fair value range. Buying here gets you what Warren Buffett (BRK.A) (BRK.B) might call “a great company at a fair price”. Waiting for a great price might cause investors to miss out on it completely, though.

The growth trends discussed here appear to be real and sustainable for the most part. As I’ve seen with other companies in the value to growth transition, it can be profitable to loosen valuation criteria and pay more for growth. While I will continue to hold my position, I would no longer dissuade anyone from starting a position at these levels.