There are times in life when you try to fix something you've owned for a long time, but it just can't be saved. That's exactly the situation in which Eaton Corp. (NYSE:ETN) has found itself with its hydraulics division. The company is finally making the tough call. Here's why investors should be pleased with that outcome.
A piece of the whole
While not a household name like General Electric, $40 billion market-cap Eaton is one of the world's largest industrial companies. It has an impressive history that dates back over 100 years and includes transitioning from being primarily a supplier to the vehicle industry to one that's focused on electrification. Hardly a "wheeler dealer," Eaton does have a long history of buying and selling assets over time. Today its business is broken up into electric products (33% of revenues), electrical systems & services (30%), vehicle (14%), aerospace (10%), a new eMobility division (less than 1%), and hydraulics (the rest).
Eaton is now planning to sell its hydraulics division for $3.3 billion. Notably, this group serves the heavy equipment industry. It's been a tough business since the deep 2007 to 2009 recession, when construction markets turned lower. Then, when commodity prices plunged in 2014, the mining sector started to pull back, too, adding to the difficulties in the hydraulics space. Tough farm markets of late have been a drag, as well. The division has been in a funk for years at this point.
The industrial giant did what it always does in these situations, it restructured operations. Cutting costs and trimming production, however, just didn't do enough to right the situation. The operating margin in the third quarter fell 2.1 percentage points year over year to 11.9%. That's well below the company average of 18.7%. The only division with a worse operating margin is eMobility, which Eaton is building from scratch and is still just a tiny operation. Hydraulics' laggard performance, however, isn't odd, it's the norm. The division's operating margin pulled up the rear a year ago, too.
After putting in a lot of effort over a long period of time, Eaton has decided it's time to throw in the towel. According to Eaton CEO Craig Arnold: "Today's announcement is part of the ongoing transformation of Eaton into a higher growth company with better earnings consistency. We believe this transaction will create substantial value for our shareholders..."
Clearly the big story is that Eaton is jettisoning a laggard business that has taken up a lot of management's time and effort -- with little to show for it. The low operating margin is the most visible evidence of that. Pulling out the business with the worst margins will help improve the company's overall operating results, that's pretty simple to see. But this is just one piece of understanding Eaton's decision.
Arnold highlighted growth and earnings consistency when he spoke about the sale. This is about more than just getting rid of a low margin business. True, there should be a notable boost to operating margins from jettisoning the business, but the longer-term issue is that the hydraulics business continued to face tough end markets. Orders were down 14% in the third quarter, driven by "continued" end-market weakness. That's been an ongoing story, with only brief periods of improvement. Sure, things could turn for the better, but aerospace orders increased by 13% in the quarter and the eMobility division is trying to capitalize on the potentially huge growth opportunity in the electric vehicle space. Where would you rather spend your time, effort, and money -- on fixing a perennial laggard or on divisions with material growth prospects?
Then there's the issue of "better earnings consistency." Industrial companies, which generally sell to other companies, tend to see results ebb and flow with the economy. It's pretty simple: Companies pull back when the economy is weak and that flows through to industrial companies' sales and earnings. They are, thus, considered cyclical stocks. But some businesses are more cyclical than others. The hydraulics division serves customers selling into some of the most cyclical end markets around: construction and mining. Getting out of this business will allow Eaton's other businesses, most of which don't usually have such wild ups and downs, to shine a bit brighter through the cycle.
What to do now?
All in, Eaton appears to be making a good call here. (You could legitimately argue that it should have pulled the trigger sooner.) The end result will be a better company, overall, and investors should be pleased with the outcome. The next question is what does management do with the $3.3 billion once the deal is sealed. It's going to discuss that a little bit more during its third-quarter conference call on Feb. 4. Current shareholders and those looking at the stock should pay close attention, noting that Eaton has recently become a little more active with the way it manages its portfolio of businesses.