The world’s major industrial companies are approaching a tipping point that is beginning to transform the fortunes of the major players.
One example is the digitalization drive that is transforming the fortunes of industrial automation giants such as Honeywell International (HON), making them more profitable and less vulnerable to market cycles, according to ratings agency Moody’s.
The consultancy McKinsey estimates that the industrial automation market as a whole will be worth $115 billion by 2025. It expects the fastest growth in the development of cloud-based software and “industrial internet of things” (IIoT) platforms facilitating connectivity.
Moody’s analysis of the margins of 24 global industrial giants with a credit rating of A or above found the average earnings margin (before interest, tax, and amortization) rose to 16.4% last year, from 13.1% in 2013.
The improvement was not universal, but enough companies improved their business profile that Moody’s believes the improvement was structural.
One stock in particular stands out…
Wheeling and Dealing
One reason for this is that many industrial companies have undergone major restructurings, selling off many low-profit businesses, as they’ve bought higher-margin businesses like automation software firms.
These improvements mean that even as end-markets have looked much more uncertain for industrial companies this year, as recession fears grow, valuations of the big industrial companies have held firm.
This change from stodgy, boring industrial firms into more growth-oriented companies led Moody’s to recently upgrade the credit ratings of industrial players such as Eaton (ETN). And valuations for most of these companies’ stocks are still reasonable: if viewed over a 10-year period, industrial sector valuations are only a little bit higher than midway through an economic cycle.
Using comparisons further back in history are not really useful since industrial companies’ profit margins, return on capital employed, and their return on equity have moved significantly higher in the last 10 years. So, while many investors still consider industrial stocks cyclical, they are now far less cyclical from an organic growth perspective than they were in the past.
Let’s now take a closer look at one of the industrial giants that has undergone a transformation, the aforementioned Eaton.
Eaton has undergone a re-rating over the past year or so because of its role in meeting the drive to net-zero goals.
The company’s website gives a nice summary of what Eaton actually does…
We help customers meet the demands of the world’s ever-growing need for power through improving efficiency and uptime, meeting regulatory requirements and protecting people and equipment. Our electrical products help utilities generate, transmit and distribute power. And once that power is distributed, we help people use it efficiently and safely, whether in a building, industrial facility, data center or home. Our solutions range from circuit breakers to switchgear to machine controls. We offer a full portfolio of backup power and surge protection…. In hazardous environments, we help protect people with explosion-proof enclosures, signaling, notification and surveillance systems. Our comprehensive portfolio of end-to-end electrical solutions is complemented by full-scale engineering and support services.
Our customers span a wide range of markets, including residential, commercial and institutional buildings, industrial facilities, utilities, data centers, oil and gas, mining and machine original equipment manufacturers (OEMs).
Eaton and other companies that make the transformers, switchgear and other components required to upgrade electric grids worldwide are in a sweet spot, thanks to electric networks facing greater demand from the growing usage of electric vehicles, heat pumps, and hydrogen electrolysers, Bank of America analysts said in July.
Grid capital expenditures are forecast to rise from around $70 billion in the U.S. in 2022 to $122 billion by the end of the decade, according to Bloomberg New Energy Finance.
More specifically with regard to Eaton, its shares have jumped by almost 40% year-to-date as it is a major supplier to the data center market. Thanks to generative AI, data centers now consume 1% of all the world’s electricity. And where data centers are clustered, the effect is really noticeable. In Virginia, with 27% of data center capacity in the U.S., these centers gobble up 20% of all the electricity available. Add it all up and the current environment should spark demand for both new-build and retrofit work for Eaton, according to many Wall Street analysts.
Of all of Eaton’s businesses, I’m most bullish on its electric grid business. On October 16, Eaton broke ground on a $100 million expansion of its Nacogdoches, Texas manufacturing facility. Announced in August, this project will double production capacity of Eaton voltage regulators and three-phase transformers to meet surging utility demand for solutions accelerating grid modernization. Per the press release:
The Texas expansion frees up capacity at the company’s largest Wisconsin manufacturing facility in Waukesha. Eaton is investing $22 million in equipment there to increase manufacturing capacity of three-phase transformers for utility, data center, large commercial and industrial applications.
I expect Eaton to increasingly align its portfolio of offerings with secular growth trends, including grid modernization, clean energy transition, manufacturing reshoring, and electrification.
The 2021 infrastructure bill and the Inflation Reduction Act are accelerating investment in power grid modernization and electric vehicle charging networks, markets in which Eaton is well-positioned to benefit. The company could also capture some of the rising spending on reshoring of manufacturing into the U.S. Finally, Eaton should be able to support its free cash flow growth by the ramping up of commercial aircraft production lines, and higher defense spending in the wake of the wars in Ukraine and Gaza.
All of this should back top-line and market share expansion over the next several years.
And like its industrial peers, Eaton should enjoy gross margin expansion of nearly 200 basis points to about 35% in 2023. The company has a history of consistently expanding margins, even amid a challenging inflationary environment like now.
With the recent stock market sell-off, Eaton’s stock has fallen from its 52-week of $240.44 to around $202. Any price under $200 is a bargain, but you can buy the stock up to $213 a share.