Industrial giant Eaton Corp (NYSE:ETN) has been buying its own stock like it's going out of style... In fact, in the first quarter alone the company spent roughly $255 million to acquire 3.6 million shares. But here's the thing, the stock is up notably over the past year or so. Are stock buybacks the right move for Eaton?    

Buyback fever

In 2016 Eaton spent roughly $730 million dollars buying back 2.6% of its outstanding shares. That's not chump change, but it's only the tip of the iceberg. That's because the buyback binge kept going in the first quarter, with $255 million used to buy 3.6 million shares (a little under 1% of the float). The goal is to keep buying, too, with a $750 million target for 2017. The larger goal, which the company is well on the way to fulfilling, is to buy back roughly $3 billion worth of stock over the three years through year-end 2018.

A man looking at industrial equipment

Image source: Getty Images.

That's a lot of stock and a lot of shareholder money. The good news is that buybacks boost earnings because net income is spread over fewer shares. That's been important for Eaton lately because it's been working through a weak patch for the types of industrial businesses it runs. To put some numbers on that, net income was $1.86 billion in 2013 and $1.922 billion last year -- a miserly 3% improvement over a three year span.  

There's a longer-term benefit to buybacks, too. That's because fewer shares can add leverage to future results. It's the same idea, every dollar of net income gets spread over fewer shares. But it means that every additional dollar gets spread less thinly, too, as business picks up again. Since Eaton is in a cyclical industry, the current industrial malaise is likely to be temporary. In fact, the company's worst performing segment over the past couple of years, hydraulics, is now expected to see organic growth of 6% to 8% -- up from prior guidance of flat to 2%. Overall, Eaton has upped its 2017 guidance from flat organic growth to growth of 1% to 3%. An upturn appears to be materializing.  

ETN Chart

ETN data by YCharts.

Here's the problem, investors have noticed the shifting winds in the industrial sector. Eaton's stock is up 20% over the past 12 months. And it's advanced nearly 45% since the start of 2016. So management has basically been buying back stock on the way up. It's legitimate for investors to wonder if that's the best use of the company's cash.

Nothing else to do...

To be fair, Eaton's stock is still a few percentage points off of the highs reached in early 2014. So the buying that's taken place to date has been at relatively low prices, overall. But at this point there could be better uses for investors' cash. Only there's a lot of cash... For example, the company reported record operating cash flow in 2016 ($2.6 billion) and set another record in the first quarter ($463 million). In 2016, the company's ratio of free cash flow to net income was 107%!

So despite the industry headwinds, Eaton has been doing a great job generating cash. What could the company to do with that cash? The big ones are dividends, debt repurchases, acquisitions, and stock repurchases. (Eaton is always looking to reinvest in its business, so that use of cash is a given here.)

Eaton upped the dividend 5% in the first quarter and has rewarded investors with an 11% compound annualized growth rate over the past decade. Increasing the dividend too quickly could create an obligation that would be hard to live up to and not worth the risk. Slow and steady is a much better plan. It reduced long-term debt by over 13% in 2016 and another half a percent in the first quarter. But with debt at roughly 30% of the capital structure, there is no big rsh for further debt repayments since too little debt isn't optimal, either.

Of all of Eaton's goals, acquisitions are at the bottom of the list.

Eaton has clear goals for its cash. Image source: Eaton Corp. 

Meanwhile, Eaton has only just finished digesting its 2012 acquisition of Cooper Industries. At $13 billion that was the company's largest deal ever and it kept the company on the sidelines for a little while. Acquisitions are again on management's radar, but it isn't looking to rush into any deals. Smaller bolt on transactions are more likely than big transformative events. That leaves stock buybacks.  

Thumbs up

So when you break it down, Eaton's buybacks aren't a bad use of its solid cash generation. You might prefer the company do something else with the money, like boost dividend growth or bring its debt load down to zero, but even at today's prices buybacks are still a reasonable way to reward shareholders given the other options.