Eaton Corporation plc (ETN) — Q4 2018 Earnings Call Transcript

Good morning. For those of you I’m Donald Bullock, Eaton's Senior Vice President of Investor Relations. Thank you to all of you for joining us for Eaton's fourth quarter 2018 earnings call. With me today are Craig Arnold, our Chairman and CEO and Rick Fearon, our Vice Chairman Chief Financial and Planning Officer. The agenda for today’s call includes our opening remarks by Craig, highlighting the performance in the fourth quarter, our outlook and our guidance for 2019. As we’ve done on our prior calls, we’ll be taking questions at the end of Craig’s comments today. Before we dive into that, I do want to make a couple of quick passing comments. The press release for our earnings announcement this morning and the presentation we’ll go through today have been posted on our website at www.eaton.com. Please note that the press release and the presentation include reconciliations to non-GAAP measures, and a webcast of this call will be accessible on our website and available for replay after today’s call. Before we get started, I do need to remind you that the comments today do include statements related to expected future results of the company and are therefore forward-looking statements. Any results may differ materially from a forecast that could be due to a wide range of risks and uncertainties, and those are described in the earnings release and the presentation, and they will be also outlined in our related 10-Q filing. With that, I’ll turn it over to Craig.

Okay. Hey thanks, Don. I’ll start on page 3 with highlights of our Q4 results, and I’ll start by saying that I’m very pleased with our report this morning and another very strong quarter performance, which really rounded out our solid year overall. Earnings per share of $1.46 a share, up 13% from last year, and above the midpoint of our guidance. This was driven by strong growth in sales, as well as higher margins. Sales are actually $5.5 billion in the quarter, an increase of 5% and this includes 7% organic growth and this was above our guidance of 6% for the quarter. Bookings growth in the quarter was also strong, led by double-digit growth in both Electrical Systems & Services and in Aerospace. We continue to be pleased with our margin performance as well, which increased 100 basis points to 17.4%. We had solid margin performance across all segments and all-time record margins in Electrical Systems & Services and in Aerospace. We also generated very strong operating cash flows at $1.1 billion, up 27% and a quarterly record if you exclude the $300 million arbitration payment that we made earlier this year. Lastly, we reported and repurchased $700 million of shares in the quarter, taking advantage of what we saw as the frequent pullback in financial markets. If you recall, we had planned to purchase $240 million in the quarter to achieve our target of $800 million to $1 billion for the year. You can think of this as an acceleration of purchases that we were planning to make in 2019. However, if markets remain weak, we’ll certainly take advantage of those opportunities as well and buy at higher levels. Moving to Page 4, you’ll see our financial summary for the quarter. You can read these numbers for sure, but I’ll provide just a bit of context here. Our operating segment profits increased 11% and we generated strong incremental margins of almost 40%. Second, segment margins of 17.4% were at the high end of our guidance range, and 100 basis points above Q4 2017. Our net income as reported was flat with the prior year; however, excluding this one-time benefit from Q4 2017, our net income increased 10%. Moving into our segment overviews, starting with Electrical Products, the revenues grew 3% in Q4, which includes 5% organic growth offset by 2% due to currency. This was really a strong finish to the year, and it was actually our highest organic growth rate for Electrical Products since Q4 2014. Growth in our lighting business turned positive and was up mid-single digits, while orders increased 3%, led by solid growth in the Americas. I’d also note here that our backlog increased 15%, and while we generally think about this as a book-and-bill business, this increase suggests that we didn’t see any unusual pre-buying at the end of the quarter. Segment margins were flat with the prior year at 18.2%, largely as a result of some unfavorable product mix between the businesses. Next, we’ll summarize the results of our Electrical Systems & Services Segment. As noted in my opening comments, this segment posted excellent results for the quarter. We posted 10% organic growth in the quarter with strength across all major end markets. This growth represented an acceleration of growth, which was above our Q3 growth rate of 9% and above the Q2 growth rate which was up 7%. Orders were even stronger, up 12% with strong growth in all major end markets in the Americas and in EMEA. Strong growth in Q4 was against a strong comp from last year where orders were up 12%. You may recall from our Q3 earnings call that we noted a pause in orders during September. We had expected that pause was largely project timing and temporary. Things really played out as we expected in this segment. Our backlog continued to increase and was up 13%. So overall, the segment is performing very consistently with what we would expect from this long cycle business. Segment operating profits were up 19%, and we generated all-time record margins in this segment of 16.6% – a very strong quarter across the board. If you turn to page seven, we'll summarize the results of our Hydraulics business. Here, we had another strong quarter of revenue growth with sales up 6%, with 8% organic growth offset by 2% negative currency. We continued to see strength in mobile applications with Industrial OEMs, Construction, and Agricultural markets, so pretty broad-based. Orders were down 4%, which I attribute to tough comparisons; recall that orders were up 25% in Q4 2017. We saw continued strength in Asia with orders up 10%, orders in the Americas were flat but at a very high level. We continue to see order weakness in EMEA with orders down 24% as lead times continue to improve. This region had the most challenging comps, given that orders in Q4 of 2017 were up 38%. Despite this, we feel good overall about activity levels in the hydraulics business. Our backlog remains strong, increasing 6% from last year. Operating profits increased 15% and operating margins increased 90 basis points to 13%. Solid progress in this business is expected to continue into 2019. On page eight, we move to Aerospace, where the business is clearly firing on all cylinders. We note that growth continues to accelerate in Q4 with organic revenue growth up 13%, up from 9% growth in Q3 and 6% growth in Q2. Orders accelerated, increasing 17% with strength in commercial transport military fighters and both commercial and military aftermarket. Our backlog continues to grow by 13%. This business demonstrated strong operating leverage, with profits increasing 30% and delivering record operating margins of 22.9%. Favorable mix contributed to these record margins as aftermarket revenues continue to perform well, along with our team's outstanding execution. Moving to the Vehicle Segment on page 9, we’re pleased with how this segment performed in the quarter. Our revenues were down 2% with flat organic revenues and 2% negative FX. The NAFTA Class 8 truck market remained very strong, reaching 324,000 units for 2018, which is up 27%. Revenues for our automated truck transmission business are now included in the Eaton Cummins joint venture and are not consolidated in our financials. The JV had revenue growth of 45% in the quarter, meaning that our business overall is actually performing extremely well. On the other hand, global light vehicle production was down in Q4, with North America up modestly offset by slight declines in Europe and, as you all heard, particular weakness in China. Despite flat organic revenues, operating profits increased 4% and operating margins increased 90 basis points to 17.9%. Finishing our segment summaries, eMobility is on page 10. Organic revenue growth was 11% offset by 1% negative currency. Operating margins declined to 11.3% as we continue to ramp up our R&D spending. You'll recall that this new segment was created in Q1 last year. At last year’s investors meeting, we told you that eMobility would become a new $2 to $4 billion offset for our company, and I’m pleased to say that we’re on track. 2018 was a busy year and a year where we ended ahead of schedule. We're in ongoing discussions with many customers about new programs, and we remain very optimistic about the long term growth outlook for the business overall. We’re ahead of schedule on new product developments, which are allowing us to quote on a broader range of opportunities, and quite frankly, to move from selling only components to selling systems. We remain very excited about the future of this segment, the work our team is doing, and what it represents as a growth opportunity for Eaton moving forward. Before we turn our attention to 2019, I would like to take a moment to recap some of the key highlights from 2018, which we see as a strong year of progress. First, end markets improved, allowing us to generate 6% organic revenue growth, double the growth rate of 2017 and above our initial estimate for the year, which was 4%. We continued to make good progress on enhancing our margin performance with a 100 basis points improvement, setting an all-time record for the company at 16.8%. As a result, our net income per share of $5.39, excluding the $0.48 impact from the legacy Cooper arbitration decision, was up 16% over 2017. Our teams effectively offset both the impact of tariffs and commodity inflation with incremental pricing. We generated $3 billion of operating cash flow, excluding the $300 million impact from the arbitration payment. This allowed us to return $2.45 billion to shareholders — $1.15 billion in dividends and another $1.3 billion of share repurchases, which represented 4% of our shares outstanding at the beginning of the year. Overall, I’m very proud of the team. We exceeded our financial commitments to shareholders, invested in the future of the business, and built a stronger company. Now turning to 2019, let me summarize our growth outlook. Overall, we’re expecting 4% to 5% organic growth, consistent with our Q3 2018 outlook. For our individual businesses, we expect 4% to 5% organic growth in Electrical Products, with continued strength in industrial and large commercial projects. We expect modest growth in lighting and also modest growth in single-phase power quality and small commercial projects. For Electrical Systems & Services, we see 5% to 6% organic growth, driven by a very strong backlog and expected continued market strength in power distribution assemblies in the Americas and in global datacenter markets. Modest growth is also expected in both the utility and harsher hazardous markets. For hydraulics, growth is expected to be 5% to 6% due to already strong revenue levels, but we see continued strength in mobile markets in Asia and in North America. Aerospace markets are expected to show strength universally, with expectations for 8% to 9% growth driven by OEM and aftermarket strength from both military and commercial customers. Vehicle markets are expected to be flat for both North American heavy-duty trucks and global light vehicles, but we expect strong growth in the Brazilian truck market. Overall, our organic revenues are expected to decline by 2% to 1% for the year, but keep in mind that revenues for automated truck transmissions are expected to grow, as they are now reported as part of the Eaton Cummins joint venture. Lastly, we expect eMobility to grow organically by 11% to 12%, consistent with growth experienced in 2018. Moving on to Page 13, we present our margin expectations for 2019. Overall, we expect segment margins to be between 17% and 17.4%. At the midpoint, this represents a 40 basis point improvement over 2018, placing us solidly within the 17% to 18% range we set as a 2020 goal, one year ahead of schedule. With the exception of eMobility, new investments will be focused on product development. Margins are expected to increase in each of our segments, specifically Electrical Products at 18.6% to 19.2%, representing a 50 basis point improvement; Electrical System & Services at 15.2% to 15.8%, reflecting a 60 basis point increase; Hydraulics at 14% to 14.6%, up 90 basis points; Aerospace at 21.4% to 22%, up 70 basis points; and Vehicle at 17.4% to 18%, up 20 basis points. eMobility, as noted, will be investing heavily, leading to margins reduced to 6.1% to 6.7%, down 70 basis points due to increased R&D investment. Moving on to page 14, we also outline our guidance for 2019. We expect our full-year EPS to range between $5.70 to $6.00 per share. At the midpoint, this represents a 9% increase, excluding the impact of the arbitration decision that reduced 2018 earnings by around $0.48. As we discussed, organic revenue is expected to be up by 4% to 5%, but this growth will be partially offset by around $250 million of negative currency translation. We anticipate our corporate costs, including pension, interest, and other items to remain flat compared to 2018, with a tax rate ranging between 14% and 16%. This guidance will result in operating cash flows between $3.1 billion and $3.3 billion, with CapEx projected at $600 million. As I noted, we accelerated some $400 million of share repurchases into Q4, so the total target purchases for 2019 are now at $400 million. For Q1, we expect EPS to fall between $1.18 and $1.28, representing a 12% increase at the midpoint. For Q1, we also expect organic growth to be approximately 4%, with segment margins of between 55% and 59% and a tax rate between 13% and 14%. Overall, we expect another strong year. This concludes my opening comments, and I’ll hand it back to you to open the line for Q&A.

Thanks, Craig. Before we go ahead to the operator to open up for questions, I do want to make a couple of comments. First, we acknowledge that today is a day with many peers and earnings announcements. We are going to hold our call to an hour. To do that, it’s important that you limit your questions to a question and a follow-up if you would, so we can cover everyone’s questions. With that, I’ll turn it over to the operator to give instructions.

Our first question today comes from Jeff Sprague with Vertical Research.

Thank you. Good morning. Thought very solid Craig, I was wondering if you could provide a little bit of additional color on how you saw things play out during the quarter. Obviously the quarter itself was very strong. But we did have that peculiar slowdown in September. Did you see people tapping the brakes in December as the market got wobbly and what are you seeing here in January?

Jeff, I guess you’re referencing largely what we talked about in the Q3 earnings call regarding Electrical Systems & Services where we noted a pause during September. We indicated at the time that we thought that was a temporary pause, and these products occasionally tend to be lumpy. We expected that would come back in Q4, which it certainly did. Q4 was really consistent, with high levels of economic activity across the quarter. We didn’t see any significant measurable pre-buy, as evidenced by the growth in our backlog. Activity levels have remained quite positive through January, though our Q1 guidance reflects some economic uncertainty. While we feel good about the overall activity levels, there is a slight pause due to these uncertainties.

Thanks, and unrelated. Just on tax, Rick. Your guidance is straightforward, but we’ve heard of a couple of companies getting hit by this IRS change regarding the deductibility of interest. Is that an issue for you or a wild card, or is that fully encapsulated in your guide?

It's fully baked into our guidance. The expected jump in the tax rate from roughly around 13% to 15% in 2019 accounts for the implications of regulations that came out last year, which surprised some companies. We had anticipated these changes and that's why we're comfortable with our 14% to 16% tax rate range for 2019.

Great. Thank you.

Our next question comes from Joe Ritchie with Goldman Sachs.

Thanks. Good morning guys. So Craig, on the EPS range, you have it $0.30 wide versus the typical closer to $0.20. Can you provide insight into why you expanded the range, and what market conditions might drive you toward the higher or lower end?

Yes, Joe. Don’t over-read the fact that the range is a little wider. As our EPS in absolute dollar terms increased, the percentage range naturally widens a bit. The big variables influencing whether we land on the low or high end of the range are largely tied to end market performance. We feel good right now, given the strong fourth quarter results. However, geopolitical concerns around the world could impact performance going into 2019. So while we're optimistic, we are cautious as well.

That's good to hear. As for your citing of power distribution assemblies and data centers as strong growers in 2019, can you talk about the strength you're seeing in data centers and how it corresponds with some of the announcements from chip makers?

The long-term trend indicates that the world generates and consumes more data, which is promising for data center growth. We saw strong double-digit growth in 2018, with many major projects announced. Although the hyperscale side can be lumpy, we anticipate that the existing backlog and pipeline justify our 2019 growth projections, which suggest mid-single-digit growth. It’s important to note that chip maker sentiments don’t always directly correspond to the data center market, as many major data center players are vertically integrating their operations. Thus, we feel very optimistic about the data center market and our positioning.

Okay. Great, thanks Craig.

Our next question comes from Nicole DeBlase at Deutsche Bank.

Morning guys.

Morning, Nicole.

With the Q1 outlook, it seems the step down to 4% organic growth could be conservative. Can you break down the segment contributors to this step down?

Yes, we see a step down in growth rate primarily in Electrical Systems & Services, hydraulics, and also in Aerospace. Economic uncertainties are influencing our conservative approach as we build Q1 guidance. This uncertainty involves issues like Brexit, US government funding, and trade disputes with China. While we anticipate solid underlying performance from our segments, these broader concerns are shaping our forecasts.

Understood. Thanks Craig. Regarding hydraulics, one of your distributors noted a drop-off in solar power demand toward the end of December. What's your outlook on this, and do you see continued strength in the Chinese mobile market?

China has performed extremely well. For example, excavator sales surged more than 20% in Q4. Vehicle orders were also robust, up over 10%. The Chinese construction equipment market continues to show strength. While growth rates may moderate, our assessment indicates that we will see continued growth in the China's mobile market going into 2019, supported by our market share gains and new customer wins. However, regarding your distributor's comments on solar, I can't speak to an isolated situation, but overall, our hydraulics business delivered 8% organic growth and performance remained strong throughout Q4.

Understood. Thanks Craig.

Our next question comes from Ann Duignan with JPMorgan.

Hi, good morning. Craig, can you elaborate on the end markets, particularly Electrical Products? In which industrial markets are you seeing strength, and how about the commercial projects?

In Electrical Products, our lighting business returned to growth in Q4, and we expect to continue that trend into 2019, projecting low to mid-single-digit growth. We also saw solid performance in the single-phase power quality business, which grew mid-single digits in Q4 with orders outperforming that growth. As for power distribution components, they primarily support large and small commercial projects, where recent construction numbers indicate strong growth, projecting strong prospects for Electrical Systems & Services. In the non-residential construction space, the Dodge non-res contracts were up 23% in dollars in Q4, and on a square footage basis were up 10%. We see strength across most non-res construction markets, coupled with robust demand in datacenters. Although we expect some moderation in growth rates moving into 2019, the overall outlook for our segments remains strong with no signs of economic slowdown at this stage.

That’s good color. Can you discuss the sustainability of aerospace margins?

The strong margins in aerospace can be attributed to two factors. Firstly, the aftermarket is performing extremely well, which is key to profitability in this sector. Secondly, we're observing a period of reduced industry investment following the major refresh over the last decade, which means we’re currently seeing elevated margins. However, we must continue investing in technology and product development to sustain high margins in the future. So while our aerospace margins should remain elevated for the next few years, continued success hinges on our preparedness for upcoming platform refresh cycles.

Thank you. I appreciate it.

Our next question comes from Nigel Coe with Wolfe Research.

Thanks, good morning. I'm trying to understand the turnaround in Electrical Systems & Services. While there seem to be economic concerns in the U.S. now compared to last September, what has changed?

We discussed the Q3 earnings call regarding our Electrical Systems & Services business. While we experienced a pause in September, it's common for projects in this segment to exhibit lumpy ordering patterns. Overall, it appears the domain remains in good shape, and we expected a return to strong growth in Q4 — and that’s how it played out. Regarding pull aheads, we have not observed significant instances of pull-ahead orders.

That’s great color. Finally, could you elaborate on the pricing environment, especially in the lighting market?

In general, lighting prices have benefited from decreased pressures, possibly influenced by trade dynamics. We see a somewhat stabilized environment now, so pricing pressures seem abated. Year-over-year, the recent Q4 showed mid-single digital growth. We anticipate the lighting business to have a more positive growth outlook in 2019 compared to prior years.

Thanks Craig.

Our next question comes from Julian Mitchell with Barclays.

Hi. Good morning. On the hydraulics business, could you discuss the margin headwinds related to operating inefficiencies from 2017 and 2018?

This has been a focal point in discussions since we know hydraulics was impacted by a rapid recovery period as suppliers faced hiring challenges. Those inefficiencies influence margin guidance to a degree, and we believe we are largely through those now as we look towards 2019, which leads us to anticipate improved performance in this segment moving forward.

Thank you. Regarding capital deployment, you did some accelerated share buybacks in Q4. How are you balancing buybacks versus M&A?

As we weigh capital deployment strategies, reinvesting in our businesses leads the way. We have been a bit out of the M&A market recently, but given the current environment, we are contemplating more opportunities compared to years past. While we strive to maintain pricing discipline in potential acquisitions, we also intend to use excess cash to buy back shares if M&A doesn't lead to fruitful options.

After Cooper, we brought our debt levels lower than anticipated. With strong expected operating cash flow, after accounting for CapEx and dividends, we expect around $1 billion available, which can be allocated to acquisitions or presumably increasing share repurchases.

In the past four years, we've bought back approximately 13% of shares. We're always ready to step in and capitalize on opportunities in cases of stock price weakness.

Thank you very much.

Our next question comes from David Raso with Evercore.

Hi, good morning. I apologize for phone issues earlier. I’m trying to understand first quarter organic declines versus full year expectations. There’s been strong backlog growth in Electrical Systems & Services, so what’s causing this slowdown?

Our first quarter guidance reflects some economic uncertainty in the market, including geopolitical concerns, thus influencing expectations for performance. The backlog remains strong, but caution as it relates to timing and economic activity introduced into our input is what largely reflects in Q1 guidance.

I appreciate the color. Thank you.

Our next question comes from Steve Volkmann with Jefferies.

Just a follow-up regarding pricing in ESS. How does the order book price outlook appear, especially as orders ramp up?

The pricing environment is now more favorable than before, positively influencing negotiations with customers as capacity across various sectors remains full. Therefore, we anticipate better conditions going forward.

I will leave it there. Thank you.

Next, we have Jeff Hammond with KeyBanc.

A couple of final questions. Your margins in EPG looked a little lighter. Any oversights there?

Yes, margins were a bit lighter due to product mix. As you noted, EPG is a large segment, and margins fluctuated based on faster growth in lower margin segments, such as lighting. Overall, we feel confident about our margin outlook for 2019.

Okay. Vehicle markets are flat while you expect organic declines—what’s the reason? Is it share shift or something around the Cummins JV?

The vehicle revenue guidance takes into account that revenues are shifting to the automated truck transmission business, which is being accounted for within the Eaton Cummins joint venture. As the joint venture declines, it may mean flat revenues for our segment, but it's essential to consider it in conjunction with that increase.

Great. Thanks, Craig.

Our next question comes from Andy Casey with Wells Fargo.

Question on the margin outlook. Does the 2019 guide imply neutral pricing costs?

Yes, our guidance assumes a neutral price-cost balance. We typically lag a quarter or two behind commodity increases; this becomes more evident during a volatile pricing environment. We maintain our outlook on tariffs, estimating a $100 million headwind; however, our teams will seek offsetting prices.

Thank you.

Our next question comes from Mircea Dobre with Baird.

Hi, good morning. Regarding Electrical Products growth guidance, I’m finding it difficult to reconcile this with order growth rates. Are you projecting modest improvement due to lighting demand returning to growth?

Yes, that’s accurate. The return of the lighting business to growth switching from a contraction to positive is one of the major contributors to the improved projections. Overall, we expect consistent growth from other segments as well.

That’s helpful. One more on vehicles: you're anticipating margin expansion despite flat revenues. How do you achieve that?

The joint venture contributes to revenue growth, adding to our overall profitability. The efficiency-focused operational improvements and cost control mechanisms we have executed consistently in our vehicle business can enable continued margin expansion.

Thank you.

Our next question comes from Andrew Obin with BofA Merrill Lynch.

Given the healthy economic cycle, how do you assess your North American capacity? Are there plans to manage high volumes?

We must make investments to expand capacity in many of our businesses responding to high volume conditions. This means continuing to invest in production facilities while evaluating supply chain to achieve efficiency and ensure optimal production capacity.

What’s your outlook on the Chinese market for 2019?

Regarding China, we believe government stimulus will likely emerge, particularly amidst a backdrop of a slowdown in Q4 2018. We anticipate stronger growth in the second half of 2019 compared to the first, but this assessment requires continual monitoring.

Thank you.

Our final question comes from Rob McCarthy with Stephens.

How do you view the risk of your exposure to oil and gas markets moving forward?

Our exposure is primarily in downstream operations, and we anticipate continued stability even after the Q4 reductions in oil prices. We predict sustained activity levels as demand for oil and gas requests show enduring support for equipment and services.

I’ll leave it there. Thanks.

With that, ladies and gentlemen, we’re going to wrap up the call. As always, we’ll be available for follow-up questions following the call. Thank you.