Eaton Corp plc (NYSE:ETN) recently reported second-quarter earnings that were decent though not spectacular. And the weaknesses within the numbers and markets the industrial company serves have led management to reduce guidance and push for change. Here's the story.
CEO Alexander Cutler was quick to point out that Eaton did fine in the second quarter, calling it a "solid high-quality quarter." Operating earnings were $1.16 per share, up from $1.13 last year. That included better than expected margins and solid cost containment.
But the bigger issue was the 7% drop in sales. That's not good, but it's worse than it looks. Exchange rates were responsible for about six percentage points of that. That means organic sales were down 1% in the quarter after being up 1% in the first quarter. So, there's something not so good going on here even though it wasn't as bad as it looked.
The U.S. is the high point
Within the company's global business, the U.S. remains the top-performing region. In fact, according to Cutler, "[We] continue to do very well in the Americas. That continues to be the region that is stronger for us. More flattish conditions as you get to Europe and Asia-Pacific."
The "Americas," of which the U.S. is the main component, accounts for roughly half the company's business, so this strength is a good thing. But with the other half "flattish," there's clearly reason to be concerned. Moreover, the big lingering weak spot, hydraulics (roughly 13% of sales), continues to be a lingering weak spot despite efforts to restructure the business. Sales there were down 18%, with 11% taking out the impact of currency shifts, as agriculture and the Chinese construction markets remain weak.
Not quite what we were expecting
So, while Cutler said, "Our second quarter results we believe were solid," he went on to add that the first half results and trends reduce "the likelihood of more robust revenue growth in the second half." In other words, the second quarter was OK, but Eaton will likely see a weaker second half than originally planned.
At the start of the year, Eaton was calling for organic growth to come in as high as 4%. By the end of the first quarter it was calling for growth between 2% and 3%. And now it estimates second half growth to be between zero and 1%. Clearly things aren't going the right way here.
Time to tighten the belt
And this is why Cutler noted, "[I]n this context, we think that we're in an environment where cost control, operational excellence and structural cost reduction are really critical." He went on to highlight Eaton's new $145 million cost-reduction program.
But the CEO made a distinct point of telling investors that this program "is aimed at structural, not variable cost reduction." The company's going to be cutting jobs, closing facilities, and consolidating internal operations. The point is to pull as much as $125 million a year out of the company's expense structure. That will help, but there are up-front costs that mean the real benefit won't be felt until 2016 at the earliest. So, that's a positive, but not so much for the rest of this year.
We're refocusing around you
Which is probably why Eaton also made a renewed commitment to its shareholders, as Cutler explained:
Now we're targeting an A- long-term credit rating, and that is a change for us. And that really is centered then around allowing us to return 4% to 5% annually to our shareholders through maintaining a commitment to a strong dividend, and then repurchasing shares, and that starts here in the second half of this year, as well as every year going forward.
That's a bit of a change for the company, which is still integrating the largest acquisition in its history. But now that debt levels have been brought down, many investors were expecting an A credit rating and a renewed effort to do bolt-on acquisitions. Clearly, Eaton is willing to sacrifice the credit-rating upgrade to reward shareholders while it deals with business weakness.
And while acquisitions are a third priority for the company, based on the weakness it's seeing, Cutler wants investors to know they won't be forgotten in a blind pursuit of growth. In fact, Cutler provided context for acquisitions, noting that Eaton will undertake "value creating M&A, if we see the right opportunities, and if we see the right pricing to really create value."
Weakness to come
So, while Eaton did, indeed, hold up well in what was a less than great quarter, it's openly admitting that the future won't be as good as it originally hoped. It is, however, making changes to adjust to that and still reward investors. So overall, there's a lot to like for long-term shareholders. Those with shorter time horizons might want to stay on the sidelines because the rest of 2015 isn't likely to be so good.