By: Scott Davis
ETN is a stock we’ve been recommending since our October 2017 launch, but has fallen out of favor despite overall solid results the last 2 years. Historically, ETN has been a name that investors have struggled to identify with. It’s considered too much of a traditional conglomerate, with a range of quality in the portfolio, from the lower quality lighting business and basic metal bending, to the higher quality data center and harsh/hazardous electrical franchises. It has deeper cyclical machinery characteristics in the hydraulics and auto/truck businesses that investors are avoiding at present. And it lacks the M&A angle of names such as Fortive and Honeywell.
However, longer cycle capex remains the most powerful cycle theme at present, and ETN is more levered here than most. While investors have tended to fixate on problems in Hydraulics and peak-ish N. America heavy truck markets, 80% of ETN’s business is in more capex-related markets. Non-res construction remains healthy, led by data centers, industrial construction (e.g. warehouses) and oil & gas. Even utility, which has had little growth for years, is seeing an inflection in spend around grid infrastructure. And Aerospace is firing on most cylinders.
“New” CEO Craig Arnold (now 3 years into the role) is also driving changes that seem underappreciated. Craig has brought a new organizational focus to organic growth, and while it’s still early days, top-line growth has improved to peer average levels from well below average in predecessor Sandy Cutler’s final years. Margins have continued to steadily expand, and there is significant opportunity at the factory level and across ETN’s sprawling manufacturing footprint. Largely a function of ETN’s acquisitive past and a tax strategy that often made for inefficient factory placement decisions.
On the portfolio, Craig has also proven willing to jettison problem assets and recently announced the spin/sale of the lighting and auto fluid connector assets, while pursuing creative partnerships (e.g. Cummins truck JV) to de-risk the more cyclical businesses. A larger scale break-up is not needed for the stock to work at this low valuation, but we would be highly favorable toward a bigger announcement. ETN could learn from Honeywell’s re-valuation post its spin-offs. On the flip side, ETN generates a lot of cash, pays a big dividend, and B/S leverage is as low as it’s been since the 2012 Cooper deal. ETN has been more disciplined than peers around M&A in an expensive deal environment. Maybe too disciplined, though that may prove the right strategy if the macro falters. In the near-term we do worry about headwinds in Hydraulics, but we really like the much larger Electrical and Aero businesses. At this valuation, you really get the lower quality businesses for free and that should be enough to justify buying today.