We are hiking our price target on Eaton as demand for AI computing power heats up

Eaton delivered beats on the top and bottom lines on Tuesday but saw its stock slip as investors took profits after a 30% gain so far this year. We see a buying opportunity. 

• Revenue increased 8% year over year organically to a new first-quarter record of $5.94 billion, outpacing analyst expectations of $5.91 billion, according to estimates compiled by LSEG.
• Adjusted earnings per share advanced 28% to $2.40, also a first-quarter record and beating the $2.29 consensus.
• Segment margin, similar to an adjusted operating income margin, expanded 340 basis points to a first-quarter record of 23.1%, well ahead of both the 21.6% estimate and the high end of management’s guidance. 

Eaton is positioned to benefit from huge secular growth trends that need its power management solutions, including electrification and infrastructure spending. This quarter backed up that thesis. Sales, earnings, segment profit margin, and organic growth all came in ahead of expectations, despite some minor misses in certain operating segments.

In addition to the strong headline results, Electrical Americas, its biggest division, realized another record for sales, segment profit, and segment margins — driven partly by data center demand for AI computing power. This demand isn’t a short-term factor either. Management updated its multi-year growth outlook for the data center end market. In the third quarter of 2023, the team was forecasting a compound annual growth rate (CAGR) of 16% from 2022 to 2025 for Eaton’s global addressable market. The company now forecasts a CAGR closer to 25%.

On the post-earnings call with investors, CEO Craig Arnold said: “Here [AI data center demand], orders on a trailing 12-month basis have more than doubled. And our negotiations in the U.S. have increased by more than 4 times.”

Despite the macroeconomic uncertainty, Eaton noted that 42 mega-projects, those valued at $1 billion or more, representing $130 billion total, were announced in the first quarter in North America alone. That brings the total number of mega-projects announced since January 2021 to 415, valued at roughly $1.2 trillion. Only 16% of those projects are now underway and Eaton’s win rate on these projects is about 40%. As a result, Eaton has won over $1 billion in new orders and the runway for growth extends out several years.” In contrast to what many are seeing in the macro economy, we continue to expect growth in 80% of our end markets and much of this growth is supported by the large backlog numbers,” Arnold said.

Shares of Eaton slipped 2% in Tuesday’s session, a pullback that has nothing to do with its quarterly results but is a pause for some profit-taking. As a result, we see a good entry point to buy more shares. We reiterate our 1 rating and are bumping up our price target to $350 from $330 given the stronger-than-expected demand and significantly improved profitability in North America.

Results under the hood were mixed, but the positives far outweighed the negatives.  

Electrical Americas achieved yet another record for sales, segment profit, and segment margins with management noting strength in the data center market. The segment backlog also ended the quarter at a record high, increasing 31% organically versus the year-ago period.

Sales at Electrical Global, Eaton’s second-largest business, were unchanged versus the prior year’s result as a 1% organic increase in sales was entirely offset by a 1% currency headwind. The backlog for the unit increased by 12%.

On a combined basis, the two electrical businesses posted 11% organic revenue growth, a 25.3% segment margin (up 430 basis points), and a book-to-bill ratio of 1.2 on a 12-month rolling basis exiting the quarter. (A book-to-bill ratio above one is a sign of strong demand since it shows orders are coming in faster than they can be filled.)

Another highlight was the Aerospace division, which notched a first-quarter record for sales, segment profit, and segment profit margin on the back of strong demand in commercial OEM (original equipment manufacturer), commercial aftermarket, and defense aftermarket. The segment’s backlog ended the quarter up 11%. The book-to-bill ratio was a solid 1.1 on a 12-month rolling basis exiting the quarter.

Vehicle segment revenues dipped 2% as a 3% organic decline was only partially offset by a 1% currency tailwind. And Eaton’s relatively small eMobility business realized a first-quarter sales record. However, operating losses were unchanged from a year ago, at $4 million, “reflecting the timing of program start-up costs to support future volume growth.”

Eaton management raised its guidance based on the strong first-quarter results. For full-year 2024, it now expects organic sales to increase 7% to 9%, up from 6.5% to 8.5% previously and versus Street estimates of about 8.2%.

Segment operating margins are now expected to come in between 22.8% and 23.2%, up from a prior range of 22.4% to 22.8% and better than the 22.7% consensus, even on the low end. As a result, adjusted earnings per share are now expected at between $10.20 and $10.60 per share, up from the prior range of $9.95 to $10.35 and well ahead of the Street’s $10.25 at the midpoint.

These upward revisions come as a result of stronger-than-expected demand and profitability in Electrical Americas as a result of higher-than-expected demand resulting from the AI data center buildouts.

The segment assumptions driving this outlook are as follows:

• Electrical Americas: Organic growth of 10% to 12% (up from 9% to 11%), operating margin of 27.8% to 28.2% (up from 26.8% to 27.2%)
• Electrical Global: Organic growth of 2.5% to 4.5% (unchanged), operating margin of 19.4% to 19.8% (unchanged)
• Aerospace: Organic growth of 9% to 11% (unchanged), operating margin of 23.3% to 23.7% (unchanged)
• Vehicle: Organic growth of -4% to 0% (unchanged), operating margin of 16.3% to 16.7% (unchanged)
• eMobility: Organic growth of 25% to 35% (unchanged), operating margin of 1% to 2% (unchanged)

In the second quarter, Eaton expects organic revenue to grow 6.5% to 8.5%, a bit short of the midpoint expectation of 7.8%. Management expects a segment margin of 22.4% to 22.8%, ahead of the 22.4% midpoint estimate. That would lead to an adjusted earnings result of $2.52 to $2.62 per share, ahead of the $2.52 midpoint estimate.

(Jim Cramer’s Charitable Trust is long ETN. See here for a full list of the stocks.)

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