Eaton Corporation plc (ETN) — Q1 2021 Earnings Call Transcript

Good morning, everyone. Thank you all for joining us for Eaton's first quarter 2021 earnings call. With me today are Craig Arnold, our Chairman and CEO; and Tom Okray, Executive Vice President and Chief Financial Officer. Our agenda today includes opening remarks by Craig highlighting the Company’s performance in the first quarter. As we have done in past calls, we'll be taking questions at the end of Craig's comments. The press release and the presentation we'll go through today have been posted on our website at www.eaton.com. This presentation includes adjusted earnings per share, adjusted free cash flow, and other non-GAAP measures that are reconciled in the appendix. A webcast of this call is accessible on our website and will be available for replay. I would like to remind you that our comments today will include statements related to the expected future results of the Company and are therefore forward-looking statements. Our actual results may differ materially from our forecasted projections due to a wide range of risks and uncertainties as described in our earnings release and presentation. With that, I will turn it over to Craig.

Thanks, Yan. I appreciate it. We'll start on Page 3 with recent highlights. First, I just want to say we had a terrific quarter, and we're significantly increasing our full year guidance, as you can see. Our teams have done an outstanding job of managing through this dynamic market environment, which is reflected in our strong results. Q1 adjusted earnings per share of $1.44 were a solid 15% increase year-over-year and 18% above the midpoint of our guidance. Our Q1 revenues of $4.7 billion were up 0.5% organically, which was well above the high end of our guidance range of down 3%. This outperformance was driven primarily by the two electrical segments as well as our Vehicle business. We also posted a Q1 record for segment margins of 17.7%. And looking at our incrementals, we generated $73 million of higher profits despite having $97 million of lower revenues. This was the result of strong execution, ongoing improvements in the cost structure from the multiyear restructuring program that we announced in the second quarter of 2020 as well as closely managing price and inflation in the quarter. Our cash flow was also very strong. Adjusted operating cash flow increased by 42%, and our adjusted free cash flow increased by 62%, and we had another successful quarter of M&A, closing three deals. We are also making good progress towards the closure of the previously announced acquisition of Cobham Mission Systems as well as the divestiture of Hydraulics. Finally, we recently announced the agreement to acquire 50% of Jiangsu YiNeng Electric busway business in China, an important part of our growth strategy for the Asia Pacific region. Having been quite busy on the M&A front, we thought it would be helpful to provide a summary of these three recent deals. We covered Tripp Lite and Cobham Mission Systems acquisitions in depth during investor meetings, but each of these three deals certainly advances our strategic growth objectives in our electrical business. First, Green Motion, based in Switzerland, expands our capabilities in the electrical charging market, where we expect to see significant growth over the next decade linked to energy transition. Their proven charger designs and advanced power management capabilities, along with their software, are valuable additions to our existing energy storage and power distribution offerings that support our view of everything as a grid. We also closed our previously announced investment in Hanyu, a company based in China, which provides a strong portfolio of products that will create significant growth opportunities in our business throughout Asia Pacific. They make cost-effective circuit breakers and contactors that give us access to Tier 2 and Tier 3 markets in Asia Pacific. Finally, last week, we're pleased to announce the agreement to acquire 50% of Jiangsu YiNeng Electric busway business in China. YiNeng's strong busway capabilities in China, combined with Eaton's broad portfolio of products, will position us well to participate in the high-growth data center, industrial, and high-end commercial segments, allowing us to pull through related electrical products. The Hanyu and YiNeng transactions also significantly expand our addressable market in China and Asia Pacific, allowing us to accelerate our growth rate in the region. Moving to Page 5. We summarize our Q1 financial results, and I'll note a couple of points here. First, acquisitions increased sales by 1%, but this was more than offset by the divestiture of Lighting, which reduced sales by 5.5%. And you'll recall that we sold the Lighting business in March of 2020. Second, segment margins of $831 million were 10% above the prior year, and this is despite a 2% decline in total revenue. This is largely the result of solid execution, restructuring savings, and our ability to effectively manage price and inflation during the quarter. We expect the inflation impact to worsen in Q2, but we will more than fully offset this for the full year. Lastly, our adjusted earnings of $577 million were up 12%, and when combined with our lower share count, we delivered a 15% increase in our adjusted EPS. Turning to Page 6, you see the results for our Electrical Americas segment. Revenues were up 2% organically, driven by strength in data centers, residential, and utility markets, which offset weakness in industrial and commercial markets. The acquisition of Tripp Lite and PDI added 2% of revenues, while the divestiture of lighting reduced revenues by 14%. We are pleased to have closed the Tripp Lite acquisition sooner than planned. Operating margins increased sharply, up 330 basis points to 20.5%, a quarterly record. Profits were $24 million higher on significantly lower revenues. These results once again were driven by good execution, cost savings, and a favorable mix due to the divestiture of lighting. We are also pleased with the 11% orders growth in the quarter, driven by strength in data center and residential markets. Our backlog was actually up 23% versus last year, also due to ongoing strength in those markets. We see large orders in select commercial markets, perhaps a sign that these markets, too, are beginning to turn positive. While it's difficult to judge, we think the order strength could be due to some concern about supply chain shortages. Next, on Page 7, we show the results for our Electrical Global segment. We posted a 5% organic growth with a 5% favorable impact from currency, largely due to the weaker dollar. Organic revenue growth was driven by strength in data centers, residential, and utility markets. We also delivered a 250 basis points increase in operating margins and posted a new Q1 record of 17%. Our incremental margins in the segment were also strong, more than 40%, driven by good cost control measures and savings from actions taken from our multiyear restructuring program. Orders grew 7% in the quarter, and like sales, the primary contributors to the growth came from data centers, residential, and utility markets. However, orders have declined 5% on a rolling 12-month basis due to earlier COVID-related declines. Lastly, our backlog was up 17% versus last year, driven by the same three end markets. Moving to Page 8, we summarize our Hydraulics segment. Revenues increased 11%, with strong 9% organic growth and a 2% positive currency impact. Operating margin stepped up significantly to 15%, a 420 basis point improvement over last year. Our Q1 orders were also very strong, up 53%, driven primarily by strength in mobile equipment markets. As we anticipated, Danfoss received conditional regulatory approval from the EU to acquire the Hydraulics business, an important step in the process, and we still expect this sale to close in the second quarter here. Turning to Page 9, we have the financial results for our Aerospace segment. Revenues were down 24%, including a 26% organic decline, driven by the continued downturn in commercial aviation. Currency also added 2% to revenues. Operating margins were down 310 basis points to 18.5%, though still at very attractive overall levels. Our team did move quickly to flex the business, delivering better than normal decremental margins of approximately 30%. Orders were down 36% on a rolling 12-month basis due to the ongoing downturn in commercial aerospace markets. However, sequentially, we are starting to see some improvement as orders were up 14% from Q4. Our previously announced acquisition of Cobham Mission Systems remains on track, and we expect the transaction to close at the beginning of Q4 2021. Next, on Page 10, we show the results of our Vehicle segment. Revenues increased 9% and were much stronger than anticipated. The strongest growth came from global commercial vehicle markets and from the Chinese light vehicle market. North American Class 8 production was up approximately 12%. Operating margins also improved significantly here to 17.3%, another quarterly record and a 380 basis point increase, with incremental margins nearing 60%. The strong margin performance was driven by increased volume and savings from the multiyear restructuring program. Despite volumes still being below pre-pandemic levels, this business is approaching our target segment margins of 18%, thus making substantial progress. Additionally, one noteworthy development in this segment was the introduction of the new automated transmission for the heavy-duty truck market in China through our Eaton Cummins JV. This product is already gaining great traction and seeing strong growth in the market. Turning to Page 11, we summarize our e-mobility segment. Here, revenues increased 15%: 13% organic and 2% from currency. We experienced solid growth in global vehicle markets, driven by high and low-voltage products. Operating margins were a negative 8.4%, as we continue to heavily invest in R&D. As I have reported in the past, we are managing a robust pipeline of opportunities. In Q1, we secured a multiyear agreement with a leading global automotive customer to buy our next-generation circuit protection technology for battery electric vehicles. This award represents $33 million in material revenue sales, and we hope to be awarded additional vehicle platforms using the same technology. This win really highlights the strength of our electrical pedigree and how we're leveraging this strength to grow in the e-mobility markets. On Slide 12, we've updated our organic revenue guidance for the year. As you can see, we're significantly increasing our organic revenue growth for the year with our strong Q1 results. We are optimistic about the remainder of 2021. Our strong order book and growing backlog indicate that market demand is improving across most of our end markets. We now expect overall Eaton organic growth to be up 7% to 9%, up from 4% to 6% previously. While we're experiencing some supply chain issues, we have confidence in our team's ability to manage through these temporary challenges. We've kept our forecast for aerospace unchanged. The vehicle segment has increased by 600 basis points, Electrical Globals increased by 400 basis points, and all other segments have increased by 300 basis points. Encouragingly, our Electrical segment is seeing higher-than-expected demand across all of our markets except for utility, which remains in line with our original outlook of mid-single-digit growth, indicating a robust performance in the electrical segments. Moving to Page 13, we show our updated segment margin guidance for the year, where we're also significantly increasing our guidance. For Eaton overall, we're raising segment margins by 50 basis points at the midpoint, with a range of 17.8% to 18.3%. We've raised our margin guidance in each of our segments, except for Aerospace and e-mobility, which remain unchanged. Compared with our original guidance, we expect to deliver better incremental margins due to this higher volume. For the full year, we continue to expect net pricing versus inflation to be neutral. On Page 14, we have the balance of our 2021 guidance. We are raising our full year adjusted EPS by $0.50 to a range of $5.90 to $6.30, with a midpoint of $6.10. This represents a 9% increase over our prior guidance and a 24% increase over 2020. With our recent M&A activities, we now expect a net 4% headwind from acquisitions and divestitures, down from our prior outlook of 8%. It's also worth noting that our segment margin guidance of 18.1% to 18.5% reflects a 190 basis points increase at the midpoint over 2020 and will be an all-time record. This is significant as it's above our pre-pandemic margins of 17.6% posted in 2019, which was also an all-time record. We're off to a strong start and well on our way to achieving our longer-term targets of reaching 21% segment margins. The remaining components of our full year 2021 guidance remain unchanged. Lastly, for Q2, our guidance is as follows: we expect earnings between $1.45 and $1.55, organic revenue to be up 24% to 28%, and segment margins to come in between 17.5% and 17.9%. Finally, on Page 15, I'll wrap up with a high-level summary of why we believe Eaton remains an attractive long-term investment. Our intelligent power management strategy positions us to capitalize on key secular growth trends: electrification, energy transition, and digitalization. We're gaining traction in these areas, with several new wins. Our technology solutions, including our Brightlayer platform, are well received by customers. As a result, we expect higher-than-historical organic growth rates for the Company. Over the next five years, we reaffirm our outlook of 4% to 6%. This accelerated growth, combined with our proven ability to deliver margin expansion, will allow us to achieve an average annual EPS growth of 11% to 13% over the next five years. We will continue to generate strong free cash flow, providing the flexibility to invest in organic growth, pursue strategic acquisitions, and return cash to shareholders. Our commitment to ESG remains strong, as we develop sustainable solutions for our customers and the environment we all share. With that, I'd like to turn it back to Yan. We are very pleased with a strong start to the year and look forward to addressing your questions.

Thank you, Craig. I would appreciate it if you could ask just one question and one follow-up. Now, I'll hand it over to the operator for further instructions.

Maybe we could start with a clarification question, as we're getting a lot of inquiries from investors about this. When we look at the guidance today relative to where you were a few months ago, what's been added concerning Hydraulics into the second quarter? Also, could you clarify the incremental earnings associated with Tripp Lite closing early?

I appreciate the question, Nicole. It's been a very busy quarter with many positive moving pieces. Our current assumption for Hydraulics is that it will close in the second quarter. You could think about a couple of months at about $0.05 a month for Hydraulics. Specifically related to Tripp Lite, we were anticipating adding about $0.07 for Tripp Lite, and there's a couple of cents negative associated with the acquisition of Green Motion. So approximately $0.15 between the M&A activity.

Got it, Craig. That's very clear. Could you also discuss price costs? I know you stated it to be neutral for the full year. But as we think about the phasing of margins throughout the year, are there certain quarters where we will face more of a price cost headwind? Should we factor that into our segment margin assumption?

I appreciate that question as well; it's one of the bigger topics we're dealing with internally. In Q1, we managed to offset much of the commodity inflation that we experienced through hedges, working out of inventory, and other agreements. The biggest impact for us will be in Q2, which may explain why our Q2 guidance may seem slightly muted given the strong Q1. This quarter is when we expect to face the largest impact of material cost inflation. Although we're getting price in the marketplace, it typically takes a quarter or two to fully implement pricing adjustments. Hence, Q2 will be the most challenging quarter, but we expect improvements in Q3 and Q4 compared to Q2.

You guys completed these deals in China, which seems quite remarkable. Can you share more detail on how these deals came to fruition and the potential for completing more in China?

Thanks for the question, Andrew. We're thrilled with what our local team has achieved in China. I emphasize our local team that has been in the market for years, building strong relationships with local electrical companies. We successfully executed attractive deals due to our willingness to partner. These are JVs where we hold 50%, allowing us to consolidate revenues as we grow these businesses outside China. Our local team has a significant reputation for successful partnerships, and we are optimistic about additional similar transactions. We are exploring more opportunities to fill product gaps, whether technological or cost-based, to compete effectively in the local market.

Just a question for clarity on data centers. How much visibility do you have in hyperscale enterprises, and by region? Do you have visibility for one quarter, six months, or a year?

The data center market has been one of the hottest sectors in the electrical space, projected to grow by low double digits over the next several years. We generally have 6 to 12 months of visibility in hyperscale. Historically, hyperscale can be relatively lumpy, with significant order sizes arising in certain quarters, but the broader market remains very attractive, and we are confident in our position and opportunities for future growth.

Regarding Electrical Americas, can you provide more detail about the strong margin leverage? You mentioned residential and data center markets, but is there any mix impact involved?

To your point, Nigel, we typically achieve higher margins in the industrial side, with a lower margin in commercial markets. We have not experienced any positive mix in Electrical Americas; the margin records we post stem from our execution, restructuring, and volume increase. We expect more room to grow in margin expansion as industrial markets recover.

You mentioned that all end markets are improving, except for utilities, which remains mid-single digits. Can you provide more detail regarding U.S. utility space and whether there are slightly softer trends in the first half of the year?

Utility markets are performing in line with our expectations of mid-single-digit growth. The market continues to show stability. The distinction between global and U.S. reflects our original expectations. We're optimistic that the utility segment will serve as an important growth vector for the Company moving forward.

Are you observing early signs of recovery within your industrial sector? What feedback are you getting from customers and the channel?

While it's early to declare victory, we are seeing early signs in industrial markets beginning to recover. For context, negotiations in our industrial segments have increased significantly since the fourth quarter, indicating encouraging green shoots. There’s an ongoing trend towards reshoring manufacturing, particularly in sectors like semiconductors, where large capital investments are being made domestically. We’re feeling good about these early signs as they could signal a broader recovery.

Regarding M&A and Green Motion, could you clarify the thought process behind taking the company out in full?

Green Motion is a relatively new company that started in 2009, with modest revenues at this point. Strategically, they perfectly align with our objectives around electrification and energy transition. They have hardware, software technology, and billing systems that are critical for the future growth of our business. The technology has been effective in Nordic countries and will be re-integrated into our North American market strategy. This acquisition significantly accelerates our organic growth plans.

Could you rank the supply chain issues you're facing right now? Is it about higher raw material costs or freight?

We're managing a combination of challenges, including high commodity costs. We’re seeing inflation across key raw materials like copper, aluminum, and steel at unprecedented levels. Freight rates globally have increased dramatically, and we’re facing intermittent availability issues with components like semiconductors, affecting our vehicle and electrical businesses. Our teams are dealing with these challenges effectively and overall demand remains strong. We anticipate improvements beginning in Q3 and into Q4.

Can you clarify the electrical content in semiconductor fabs compared to average factories?

The energy requirements of a semiconductor facility tend to be higher than typical commercial projects, resulting in higher electrical intensity. Similarly, we are seeing growth in water and wastewater markets that require more electrical content.

Is aerospace appropriately right-sized for a rebound in commercial flight, or will you need to rehire staff?

Our aerospace business is positioned well for a rebound in commercial aerospace. The biggest challenge will be ensuring our supply chain is prepared for the necessary ramp-up. We took restructuring actions to right-size our business primarily around fixed costs that will not be reinstated. We're ready for recovery in '23 and '24, with shaping our operations accordingly.

Tom, in your first 90 days, what opportunities have you identified for Eaton?

I see tremendous opportunity, especially in organic growth. The team's professionalism in managing ongoing challenges has been remarkable, and I'm enthusiastic about the leadership's commitment to winning.

Can you address the lagging commercial construction and oil and gas sectors? What are your thoughts on those end markets compared to a few months ago?

Commercial construction remains a laggard in our electrical business, expected to be flat to slightly up this year. Certain segments like warehousing are thriving. Oil and gas markets are improving, with increasing rig counts and MRO projects. While we're seeing green shoots, overall, these markets are still considered laggards compared to our electrical market. Regarding the vehicle segment, we've raised our outlook significantly due to a strong Q1, although supply chain issues persist, particularly around semiconductors. However, OEMs are prioritizing the production of more expensive vehicles, which helps mitigate some of the challenges we face in our supply chain, particularly in the light vehicle market. The semiconductor shortage is expected to impact revenues by about 2% to 3%, but overall, we're managing these challenges effectively.

You mentioned some order surges in March amidst the supply chain issues. How much of the 23% backlog growth is atypical versus underlying demand?

It's challenging to ascertain the exact nature of order behavior at this point. We likely did see some order surges last March, particularly in response to anticipated price increases and supply shortages. However, we believe the underlying demand driving our growth in the Electrical business is real, and our customers are not over-ordering. We wish for more inventory levels to manage the strong demand we are experiencing.

In the context of electrification trends discussed during the Analyst Day, are you observing increased content in the projects you’re bidding on?

We're seeing both project velocity increasing and greater electrical content per project. For instance, in residential construction, the adoption of electronic circuit breakers is driving added electrical content. Our products are becoming integral to many projects as the trends of digitization and energy efficiency expand across various sectors.

Craig, regarding e-mobility investments, how do you view the current environment, especially considering ABB’s announced carve-out?

Every company's strategy is driven by its goals. We see the e-mobility business as an essential growth platform for Eaton, with synergies tied to our electrical business. We are focused on integrating technology across our segments. We regard it as key growth area and expect to leverage electrical technologies to drive e-mobility growth, consistently seeking opportunities that align with our strategic focus.

Can you describe April's performance relative to the intra-quarter trends observed in Q1?

We had a strong April, with better performance than anticipated given the modest comparisons from COVID-19 last year. We are pleased with our progress and remain optimistic for a strong Q2.

Can you comment on state and local government activities regarding infrastructure modernization and renewable energy retrofitting? Are you seeing any signs of increased interest?

The infrastructure needs are vast, and the funding from current stimulus programs is anticipated to have a significant impact on state and local governments. We've began seeing some projects due to approved funding, but we believe the larger impact is still forthcoming. If these investments shift to areas of energy consumption and electrification, it could lead to increased growth for our Company as the administration focuses on strengthening the electrical infrastructure.

Regarding Green Motion, what differentiates it in the rapidly commoditizing charging infrastructure market?

While hardware may be seen as commoditized, the real differentiation lies in software solutions for managing charging infrastructure. The value comes from the ability to control charging loads in a complex environment. Green Motion's experience and solutions cater to this shift, aligning with our strategy of integrating hardware with effective load management and billing systems.

I wanted to ask about free cash flow; your guidance remains unchanged despite an increase in adjusted net income. What accounts for this discrepancy? Is it working capital headwinds influencing that?

The working capital component is that it's very early in the year, and uncertainties around the supply chain might necessitate building additional inventory. We achieved strong Q1 free cash flow that exceeded our plans. Overall, we do not foresee factors affecting our ability to generate cash flow but prefer to err on the side of caution given the number of uncertainties.

On aerospace, your margin guidance suggests a significant step-up from Q1. Could you clarify assumptions regarding commercial aftermarket sales growth?

We expect to see a lift in the aftermarket as we move into the second half of the year, greatly contributing to margin improvements. The restructuring efforts and cost control measures are built into our guidance. The margins we delivered in Aerospace during Q1 were strong, even with lower volumes, demonstrating our resilience in this sector.

Thanks for all the questions. Chip and I will be available for any follow-up inquiries. Have a good day.

Thank you.

Thank you, everyone. Goodbye.