Eaton Corporation (ETN -0.53%) is a $30 billion market cap industrial company focused on "power management." That's purposely nondescript because the company touches markets ranging from consumer autos to planes to power plants. The unifying feature across all of those spaces is a focus on how power is created, transmitted, and used.
This is a vast shift from Eaton's focus at the start of the millennium, which was basically making trucks and industrial equipment. The change involved roughly 50 acquisitions. After all of that, Eaton today is better positioned for long-term growth. And while that's a positive, you still need to watch some issues closely.
Economic swings
Eaton has done a good job of diversifying the markets it serves, which now broadly include electrical (61% of 2013 sales), vehicles (17%), hydraulic (14%), and aerospace (8%). And beneath these are even more sub-segments. For example, the Electrical division includes electrical products and electrical systems and services. There's even more diversification when you dig into each of those businesses. Still, the common theme running through all of the company's businesses is the industrial focus.
That makes Eaton susceptible to economic swings. If the economy is slowing, or heading in reverse, you don't build new power plants, vehicle sales stall, and industrial customers pull back on capital spending. That remains true even though the company's more diversified portfolio has, according to management, "provided the balance to mitigate the impact of volatile economic conditions." Mitigate is the operative word, since it only means soften the blow -- not offset completely.
So as you watch Eaton, you have to watch the global economy. If there's a broad-based downturn, or even in just one key market, Eaton will likely feel a revenue hit, and its shares could fall.
Developed markets
The impact of economic swings dovetails nicely with the company's reliance on developed markets. The United States alone accounts for roughly 50% of revenues, with foreign developed markets kicking in another 26%. Developed markets tend to lumber along at relatively subdued gross domestic product growth (GDP) rates in the low single digits.
That means Eaton's core markets offer slow growth. It's why the company is increasingly focusing on emerging markets (24% of 2013 sales). It hopes to expand its exposure to such fast-growth regions by 25% between 2013 and 2015. But even then, emerging markets will only make up 30% of sales. So, slow and steady remains the norm. Except when it doesn't, since even developed economies hit rough patches -- often at the same time. As much as Eaton plays up high growth markets, developed nations still have an outsized impact on results.
Margins
Another way Eaton has looked to become a better company is by focusing on better businesses. The acquisitions it's undertaken have been focused on "higher-margin, higher-growth market segments." That's a good way to increase growth potential, particularly in developed markets laboring along with single-digit GDP growth rates. But it also make margins an increasingly important issue to monitor.
For example, Eaton's margins have gone from around 10% to nearly 15% over the past decade. Clearly a huge improvement. However, in the second quarter, overall margins fell 6% year over year. The only major end market that didn't see margin compression was electrical products. It's no wonder the company's shares are off over 15% from recent highs.
Margin expansion has been a big benefit, and refocusing around higher-margin businesses is a great long-term plan. But, the downdraft from margin compression can take a notable toll on performance over the short term. Since the second quarter's margin showing was weak, it's time to keep a closer eye on this metric.
Long vs short
Eaton is positioning itself for the long haul, and investors with a long-term view should like what they see. However, Wall Street is a popularity contest over the short term. Heavy exposure to industrial markets and slower growing developed economies are both worth watching. So, too, is the second-quarter profit margin pullback, which could be a leading indicator of further near-term business weakness.
