Eaton (ETN): Paying Dividends Every Year for Nearly a Century

While Eaton (ETN) won’t show up on the list of dividend aristocrats, the company has one of the most impressive dividend streaks in the world.

 

Eaton has paid dividends every year for more than 90 years (dating back to 1923) and compounded its payout by more than 10% annually over the past decade.

 

With a dividend yield near 3.4% and a forward P/E ratio below the broader market’s, today is a reasonable time to take a closer look at Eaton to see if it could be one of the better high dividend stocks to consider.

 

Business Overview

Eaton is a large industrial conglomerate with approximately $20 billion in annual sales and an operating history dating back to 1911.

 

The company provides a wide range of energy-efficient products and systems that help customers manage power across electrical, hydraulic, and mechanical applications.

 

Eaton also has a substantial aftermarket business (approximately 20% of total sales) that provides some stability to its business.

 

By geography, the U.S. is Eaton’s largest market accounting for 55% of sales, followed by Europe (21%), Asia-Pacific (11%), Latin America (7%) and Canada (5%).

 

Segments

Electrical Products & Systems (64% of sales; 66% of profit): sells a range of power-related components, circuits, lighting products, and equipment used wherever there is demand for electrical power (e.g. buildings, data centers, hospitals, utilities, factories).

 

Vehicle (16% of sales; 16% of profit): supplies drivetrain and powertrain systems and components used in cars, trucks, and agricultural vehicles. Key products include transmissions, clutches, engine valves, and superchargers.

 

Aerospace (9% of sales; 11% of profit): sells fuel, hydraulics, and pneumatic systems used in commercial and military aircraft. Products include pumps, motors, controls, sensing products, hose fittings, and more.

 

Hydraulics (11% of sales; 7% of profit): sells components and systems such as pumps, motors, valves, and controls that are used in industrial and mobile equipment. Key end markets are oil and gas, agriculture, construction, and mining.

 

 

Business Analysis

Many of Eaton’s competitive advantages are derived from its long operating history since the company has been in power management for more than 100 years.

 

As a result, Eaton has built up a strong reputation for quality, massive distribution channels, an extensive portfolio of well-known products, and long-lasting customer relationships.

 

Smaller and newer players have a hard time competing with Eaton for many of these reasons. They lack Eaton’s economies of scale ($20 billion in annual revenue), which allows the company to maintain a lower manufacturing cost structure.

 

Eaton can also afford to pump about $600 million in research and development activities each year to maintain the broadest, most advanced portfolio of technologies and established brands. Most of Eaton’s R&D investments are now largely focused on digitization initiatives.

 

This is important because many of its products solve the most demanding power needs. The company supplies mission critical products that need to be extremely reliable.

 

In aerospace, for example, Eaton benefits from long product qualification cycles and meaningful aftermarket demand. Once Eaton’s components and systems have proven to be reliable and are designed in, the company enjoys a long stream of high-margin aftermarket revenue.

 

The company’s aftermarket business makes life difficult for new entrants as well. Eaton generates around $4 billion in annual sales from aftermarket products and services, helping it maintain stickier customer relationships and retain its reputation for quality.

 

Aftermarket revenue also tends to carry high margins and allows Eaton to price some of its upfront equipment sales at levels that make it difficult for smaller competitors to earn a profit (a lot of the money is made in equipment support and services).

 

Smaller rivals lack the network needed to service multinational customers, who demand timely service and maximum uptime.

 

Eaton has over 13,000 authorized channel partners and 10,000 commercial resources it can use to efficiently reach customers all over the world. Replicating this network would likely take decades of time and cost tens of millions of dollars.

 

The company’s management team has further solidified Eaton’s advantages through selective acquisitions and divestitures over the years.

 

Eaton has made more than 100 transactions since 2000 that have improved its profitability and served as a major driver of earnings growth.

 

The company’s Electrical segment alone purchased over 30 businesses and divested 11 companies since 2000, helping it improve margins from 10.4% to 17.8% in 2016.

 

Eaton’s most notable deal took place in 2012 when it acquired Cooper for $11.8 billion. Cooper manufactures electrical equipment (e.g. fuses, lighting controls, voltage regulators, circuit-protection equipment) that helps companies save money on energy.

 

The deal gave Eaton a larger product portfolio (its electrical addressable market expanded by $70 billion), more scale, and a denser distribution network to help it compete better with some of its bigger rivals.

 

Cooper was also domiciled in Ireland, which allowed Eaton to incorporate there and enjoy substantially lower tax rates on its corporate profits – Ireland’s tax rate is 12.5% compared with 35% in the U.S.

 

However, investors should note that Eaton’s dividend payments are subject to an Irish withholding tax 20%. Investors residing in the U.S. and several other countries can claim an exemption, if they follow a few steps.

 

Looking ahead, Eaton anticipates having around $1 billion of cash available for acquisitions to help it adapt to changing times, and the company’s reputation and size has enabled it to partner with other firms to remain competitive as well.

 

In April 2017, for example, Eaton announced a joint venture with Cummins International to provide advanced automated transmission technology to their customers.

 

Simply put, Eaton is a dominant force across most of its markets. The company is one of the four largest electrical players in the world and is one of the three biggest hydraulics businesses. Approximately 70% of Eaton’s industrial sector products have a leading global or regional market share.

 

Despite the company’s size, most of its markets remain extremely large and fragmented, providing room for moderate growth. The electrical market is estimated to be $200 billion in size, and hydraulics is another $40 billion.

 

Eaton seems likely to remain a force in its markets for many years to come thanks to its portfolio of well-established brands, strong distribution channels, and commitment to R&D.

 

Key Risks

Like most industrial conglomerates, Eaton’s businesses are sensitive to global economic growth, industrial spending, manufacturing activity, commodity prices, and foreign currency exchange rates. Industrial production growth forecasts have consistently been downgraded in the past few years, but prospects have started brightening more recently.

 

 

An improvement in industrial growth would be good news after some of the company’s segments have experienced softness in many of their markets.

 

Eaton’s hydraulics business has suffered from the downturn in global mining and agriculture markets, as well as the slowdown in Chinese construction projects.

 

Elsewhere, oil and gas markets remain soft and near term weakness in the military is affecting the aerospace market.

 

Foreign currency headwinds have also dented recent growth.

 

While these macro issues have weighed on Eaton’s earnings recently, they seem unlikely to impact the company’s long-term earnings power.

 

Instead, some of the bigger risks long-term investors should consider are the company’s sustainable earnings growth rate and the amount of taxes it pays.

 

The downsides of being such a large conglomerate are that incremental sales growth can be difficult, and some business lines are not going to be fully healthy.

 

Eaton’s 2020 plan targets organic sales growth of just 1-2% per year – hardly anything to get excited about. If the business struggles to get all of its cylinders firing at once, sales could tread water.

 

Companies with minimal growth prospects often deserve to trade at a discount to the market.

 

Instead of relying on the top line for growth, management’s three-year plan (2015-2017) expects restructuring actions to drive about half of Eaton’s annual earnings growth over the next five years.

 

Incremental benefits as a result of restructuring totaled $210 million in 2016. As per the restructuring program, Eaton will spend an estimated $440 million and will generate estimated savings of $520 million during the three years period ending 2017.

 

The company has been closing down plants, reducing the size of its workforce, and improving manufacturing processes to lower its costs. However, there is only so much cutting that can be done to lift earnings – at some point, profitable sales growth is necessary.

 

Eaton can probably continue squeezing out low single-digit sales growth as long as global GDP keeps grinding higher, but investors’ expectations are understandably low.

 

Another risk that could materially impact Eaton’s earnings is its low tax rate, which sits near 10% thanks to its tax inversion following its 2012 acquisition of Cooper.

 

Any change in U.S. tax laws and trade policy could negatively impact Eaton and could even end up punishing the company for moving its registered head office to Ireland.

 

Eaton has already received some heat from Donald Trump over its actions to lower its taxes and shift more production out of America.

 

If the government were to crack down harder on either of these issues, earnings growth could be reduced. This seems like an unlikely scenario, but it would certainly impact Eaton and likely a number of other large multinational companies as well.

 

Overall, Eaton’s business diversification, long operating history, healthy cash flow generation, and slow-changing markets reduce its risk profile.

 

Eaton’s Dividend Safety Score

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

Eaton’s Dividend Safety Score of 73 indicates that the company has one of the safer payouts available in the market today. Despite difficult business trends over most of the last two years, Eaton has maintained healthy dividend payout ratio near 50%.

 

The company’s payout ratios have more than doubled over the last decade (see below), but there is still plenty of cushion for Eaton to continue paying its dividend from operating earnings and cash flow if unexpectedly difficult times were to hit.

 

 

Evaluate how a company performed during the last recession can also reveal clues about the safety of its dividend. Eaton’s sales fell by 19% during fiscal year 2009, and its stock also dropped by 47% in 2008 to trail the S&P 500 by 10%.

 

Not surprisingly, Eaton’s business is sensitive to the broader economy and should be operated more conservatively than other types of businesses that are less cyclical.

 

Despite ever-changing macro conditions, Eaton’s free cash flow generation (which ultimately pays the dividend) has been nothing short of excellent.

 

As seen below, the company has generated positive free cash flow in each of the last 12 years, providing it with the flexibility to pay down debt, increase the dividend, make opportunistic acquisitions, and repurchase shares.

 

Observing a company’s operating margins also helps assess dividend safety. Generally speaking, the safest companies will earn high and stable margins.

 

Aside from the financial crisis, Eaton has earned very consistent operating margins between 8% and 11%. The business has done a great job delivering steady profits in numerous environments, thanks in part to its sizable aftermarket business.

 

Regardless, cyclical companies must maintain healthy balance sheets. If they unexpectedly fall on hard times and need to make substantial principal and interest payments, the dividend could become jeopardized.

 

Eaton’s balance sheet is in better shape than it has been in recent years, but it still contains a relatively high amount of debt. The company’s pension plan is also underfunded by a couple billion dollars.

 

However, as long as the economy doesn’t fall off a cliff, Eaton should be just fine thanks to its excellent cash flow generation.

 

 

Overall, Eaton’s dividend looks pretty good for safety purposes. The company maintains reasonable payout ratios, generates consistent free cash flow, and has proven its commitment to shareholders with consecutive dividend payments since the early 1920s.

 

Eaton’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Eaton’s Dividend Growth Score of 49 suggests that the company’s dividend growth potential is about average. Eaton only raised its dividend by 5% in 2017, reflecting the difficult macro environment, but has historically been a double-digit dividend grower.

 

As seen below, Eaton’s dividend has compounded at an 11.8% annual rate over its last 10 fiscal years and grown at a remarkably consistent clip over longer time periods.

 

While the business is not a member of the dividend aristocrats list, it has paid uninterrupted dividends for over 90 years while increasing its dividend each year since 2010.

 

Future dividend growth seems likely to be in the mid to high single-digits, tracking the company’s underlying earnings growth. This would keep Eaton’s payout ratios near 50%, which is reasonable for an economy-sensitive business.

 

Valuation

Eaton trades at a forward P/E ratio of 15.4 (a discount to the market’s 17.4 multiple) and has a dividend yield of 3.4%, which is higher than its five-year average dividend yield of 3%.

 

Eaton’s management team targets annual earnings per share growth of 8% to 9% from 2016 through 2020. Earnings growth is expected to be driven by restructuring actions (3-4%), share repurchases (3%), organic sales growth (1-2%), and acquisitions (1%).

 

If management’s assumptions are correct, the stock appears to offer annual total return potential of 11.4% to 12.4% per year (3.4% dividend yield plus 8% to 9% annual earnings growth).

 

The stock seems to be reasonably priced, although it will remain tied to macroeconomic developments over the near term.

 

Conclusion

Eaton is a quality business that seems likely to remain relevant for many years to come. The company’s moat is driven by its long-standing market positions, extensive product portfolio, massive distribution channels, and leading technologies. Many of these qualities are shared with some of Warren Buffett’s best dividend stocks.

 

Eaton’s valuation also looks undemanding. Soft market conditions could keep a lid on earnings growth over the near term, but the company’s restructuring programs, bolt-on acquisitions, and presence in many large markets provide potential for better long-term results.

 

For dividend investors seeking a safe, relatively high yield with reasonable growth, Eaton may be an interesting industrials candidate as part of a well diversified income portfolio.