Dividend Review of Eaton Corporation – Should I buy ETN?

Introduction

Eaton Corporation (ETN)  is a Dividend Challenger that was founded in 1911 by Joseph Eaton.

Interestingly ETN has paid dividends for over 90 years but only increased them over the last 10 years. During the last financial crash, while they did not cut their dividend, they did not raise them either until 2010.

Eaton offers a wide range of systems and products in the energy efficiency market which includes electrical, Mechanical and Hydraulic applications.

Eaton operates in 5 main Business Segments

1. Electrical
2. Vehicles
3. Aerospace
4. Hydraulics
5. eMobility

Management

Craig Arnold started his career with GE in 1983 and held various roles including being responsible for sales, marketing, and product management along with GE’s lighting business in Europe and the Middle East.

Arnold joined Eaton in 2000 as a group executive of the Fluid Power Group from General Electric Company. Here he was responsible for Eatons Aerospace and Hydraulics sectors.

 He was appointed Chairman and CEO of Eaton Corporation plc on 1st June 2016. He serves as a Director at University Hospitals Health System, Inc and as been an Independent Director at Medtronic plc since January 26th, 2015. 

Business Analysis

Eaton is a global power management company that operates in 175 countries with more than 97,000 employees. The US is Eaton’s largest market as they make up 55% of sales. Europe makes up 21% followed by Asia, Latin America and Canada.

For those who like companies that are trying to do more for the enviroment than you will be gald to know that they are heavily involved in Sustainable enrgy and have reduced there greenhouse gases by 16% over the last 5 years.

Eaton was also awarded a $3 million research and development grant by the U.S. Department of Energy Solar Energy Technologies Office (SETO) to pursue more widespread adoption of solar
power and energy storage.

Along with sustainable solutions, Eaton is embracing the digital age. Industry 4.0 is a digital revolution is fueled by data and automation and artificial intelligence. This data can provide actionable insights to drive energy efficiency and reducing carbon emissions.

In 2018 they launched their emobililty business specializing in intelligent power electronics, power systems and advanced power
distribution and circuit protection to help with the growing demand that electric vehicles will demand by 2030. They have also introduced eMobility to china which represents 60% of all Electric vehicles globally.

Company Growth

Over the last 9 years revenue has increased with a CAGR of 3.24% but it has pretty much been flat over the last 5 years. During that same period Earnings have increased with a CAGR of 3.27% which is pretty much in line with revenue. There was a sharp increase in earnings in 2017 which came from a gain due to the formation of the joint venture with Cummins Inc

Fiscal 2020 Q2 Earnings Results

Sales decreased 30 percent to $3.9 billion,from $5.6 Billion compared to Q2 2019. The main driver was a drop of 22% in organic growth.

Operating profit dropped 43% and Net income dropped 92%. Adjusted EPS decreased 54 percent from $1.53 to $0.70

Eaton also announced $280M multi-year restructuring program, including $187M in 2Q20, to reduce structural costs in select end-markets.

They also released there 2030 ESG Goals below:

Dividends

Eaton Corporation has an impressive dividend-paying history and has paid its shareholders for the last 90+ years. However, they are only a Dividend Contender because they have only increased the dividend in the last 10 years after they held the dividend steady for 2 years during the last financial crash.

Eaton typically pays dividends in March, May, August, and November. On the 25h of February 2020 the board of Directors approved a 3% increase for a quarterly dividend of $0.43 per share.

Check out the below chart from IOCHARTS.IO

Payout Ratio

The Payout Ratio is a good indicator of the sustainability of dividends. I have discussed the different methods for calculating the Payout Ratio here.

It is nice to see that the dividend is covered by both earnings and cash flow. The earnings payout ratio is currently around 54% and the FCF payout ratio is slightly lower at 42%. Looking at the last 10 years Eaton like to keep the FCF payout ratio under 50% so there is plenty of room for more dividend growth in the future

Dividend Growth

Companies that generate sustainable earnings growth often make the best dividend companies, as it is easier to lift the dividend when earnings are rising.

Part of my Investment thesis is to invest in companies that show a good history of increasing dividends but also show good potential to continue to raise them.

Over the last 15 years ETN had an impressive DGR of 11.7%. however, as you can see from the chart below it is not consistent. I would not be surprised if they held there dividend stagnant next year. This is based on their history in 2000 and 2009.

The latest increase of 3% is well below average. However, bearing in mind that we are in a pandemic , 3% is not bad. I believe we will see future increase around the 5% mark.

Would I buy this company?

Please see my disclaimer before reading on. These are my thoughts and are not to be used as investment advice. I am simply outlining my thought process when deciding if I should buy a company or not. Please do your own due diligence and check all data for your self.

This will be broken into 6 different sections with the maximum points per section are outlined below.

Section	Max Points
Financial Strength & Future Proof	25
Management Quality	15
Dividend Quality	20
Valuation	20
Story of the Stock	15
Momentum (TA)	5
Total	100

A recommendation is than provided based on the over all score out of 100.

European DGI was kind enough to share this model with me and he also has a spreadsheet made that you can find here!

Financial Strength and Future Proof

Eaton scored a respectable 19 out of 25 in this section. At the end of 2019, ETN had a D/E ratio of 0.51, this is better than the industry average of 0.57. Interest coverage is over 11:1 (FCF/Intrest on debt) which is far greater than the 3:1 ratio that I look for.

Cash flow has been strong and stable over the last 10 years and the dividends are covered by both earnings per share and free cash flow.

Morning star grades ETN as an Investment grade BBB+ level which means they are a moderate credit risk.

The only negatives I had in this category is that the earnings per share growth has been flat over the last 5 to 10 years.

Management

ETN management shows good integrity and performed reasonably well over the last couple crashes. I have mentioned before that they did not increase dividends during this time but they have maintained the dividend which is a good sign.

Capex is around 20% of free cash flow. Future growth can be attained through acquisitions and ETN has made 43 in total with the latest being in February 2020 of Power Distribution, which will expand their data center power distribution. They also made a brilliant aqusition of Cooper Industries in 2012 which streghtned their electrical sector.

The main concern in this section is that Eaton has a narrow moat. While it does serve lots of different markets , Eatons products are mainly sold in niche portions of industry with a high cost of failure.

Eaton scored 8 points of 15 here.

High Dividend Quality

ETN ranked a little bit lower than I expected in this section. I have estimated that it will take roughly 4 years to reach a YOC of over 10%. While there current yield is greater than the SP500 by 165%, I require at least 200% here to give full marks

The dividend growth rate has been stable with a respectable 7.71% over the last 5 years

Overall this section earned 14 out of 20.

Valuation

PE ratio

Looking at the current TTM PE ratio, ETN would look slightly overvalued at 26.13 times earnings. This is expected to improve and the forward PE ratio is expected to be around 20 times the earnings. Historically over the last 9 years the average pe ratio has been 13 x earnings. This would make them undervalued from a PE point of view

DDM

Using my multistage discount model the current estimated price is $30.58 which means the company is ETN are massively overvalued. A DCF model was calculated on https://www.stock-analysis-on.net/ which produced a fair value of $61.06.

Overall Eaton Corp appears to be overvalued at current prices and this section scored a disappointing 4/20

Story of the Stock

In this section, I look at the market place in general, is it stable, can the company continue to grow? Do they Innovate and how efficient is there organisation. I also look at the overall share count, Are they reducing this over the last 5 years?

Eaton performed quite well in this section, They seem to be trying to innovate and are embracing technology as we can see with their new eMobility segment and the company can continue to grow due to acquisitions.

ETN are currently Divesting $4B revenue of business that no longer meet their criteria in Hydraulics and lighting.

However, there is a real fear that technology poses a real risk for Eaton, particularly in the Aerospace segment. This means that ETN must keep innovating and advancing in these areas which costs a lot of money. This could depress returns in the future.

ETN performed quiet well in this section with 14/15

Tech Analysis

I call it tech analysis, but really I just check to see if there is a selling climax happening and if the stock if over bought of oversold. In this case the RSI is just above 65 which is close to the overbought area. This section scored 1/5

Recommendation

My Scoring recommendations are as follows

Recommendation	Score
Strong Buy	90 – 100
Buy	70 – 90
Hold	50 – 70
Sell	30 – 50
Strong Sell	0 – 30

With a current score of 60, Eaton gets a Hold recommendation. This has surprised me a little bit but one of the reasons I like this scoring system is that it forces me to be more objective and not let my emotions take over. The company was really let down by its current valuation. It looks to be overvalued in all methods that I have used. I admit buying Quality does come at a premium however there is enough bargins in the market to buy Quailty at a better valuation which can only help your returns in the long run.

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