Eaton (ETN +1.35%) has been a great investment for me. I've owned it since 2015, when it was still working on integrating Cooper Industries. That acquisition, and subsequent fine tuning, has been hugely important to Eaton's development as a business. In five years, I expect Eaton to be an even better business than it is today.
What did Cooper do for Eaton?
Eaton is an over 100-year-old industrial company that has long focused on power management. It started life selling truck transmissions, which it still does today. But the business took a major directional shift when Cooper was acquired. Cooper's primary focus was on managing the flow of electricity, and it materially increased Eaton's exposure to this niche of power management.
Image source: Getty Images.
After integrating Cooper, which was a multiyear effort given the size of the deal, Eaton shifted its efforts to streamlining. It was still making bolt-on deals, which are basically a constant for the industrial giant (it is one of the largest industrial companies on the planet), but it also started to exit some historically important operations. One big move was to exit the highly cyclical hydraulics sector, which managed fluid-based power systems and sold into heavy construction markets. Construction equipment is highly cyclical, with demand rising and falling along with economic activity.
There were really three big goals during this period. First, set the business up for long-term growth. Second, shift toward higher-margin operations. And third, move toward a business model that would be more consistent through the economic cycle. That last one is the one that will be most evident in five years' time.
What has Eaton achieved?
Aside from a fairly impressive stock price advance since I've owned Eaton stock, I've also watched as the company has altered its business in dramatic fashion. Today, electricity-related businesses make up around 70% of the top line on its income statement. And, as the chart above highlights, the company's profit margins have been generally heading higher.
Management is, basically, doing what it set out to do. That said, in the next five years, there's likely to be a stress test. The longer-term goal is to create a business that is more resilient to the economic cycle. That won't be proven out until there is a longer recession. The recession during the coronavirus pandemic was short and driven by the health scare, so it is hard to count it as a real test.
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Key Data Points
To be fair, I expect Eaton's business to suffer during a recession. It is an industrial company, and even the best-positioned industrial business will see revenue and earnings crimped during an economic downturn. But I also expect Eaton to better weather a future downturn than it has managed past economic downturns.
ETN Operating Margin (TTM) data by YCharts
What that looks like isn't clear just yet and will partly depend on how bad the next recession is. But a look back at the recession during the dot.com crash and the Great Recession (between 2007 and 2009) provides a yardstick. As the chart above highlights, the pandemic-driven recession wasn't as bad for Eaton's business. But it was short lived and unusual, so I want to see a more difficult test of the business before I'm willing to say management has succeeded on this front. I'm confident, however, that Eaton is more resilient today than it was at the turn of the century.
Eaton isn't a new company, but it is a changed company
Eaton is still focused on managing power, but the power it manages has changed greatly over time. Along with the recent shift toward electricity, the company has tried to fine-tune its business at a more fundamental level. I believe it has achieved important strides on that front, with higher and more consistent margins. I think we'll see a full test of that in the next five years, and I expect Eaton to pass the test in relative stride.
