Written by Kent Lucas, Editor Taipan's Safe Haven Investor
As my first addition to the Taipan's Safe Haven Investor portfolio, I want to add a high-quality idea that offers significant upside potential. This is an exciting story in part because of this well-run company’s focus on fast-growing power, alternative energy and developing country end-markets.
Roughly 15% of the world’s population is without electricity. Most of this void is in emerging markets, which tend to grow at 5%-10%. One-third of the world currently uses close to 60% of the globe’s electricity needs, based on kilowatt usage at five times the rate of the remaining two-thirds. That means at least 4.4 billion people will have sharply increasing power usage needs over the next decade!
Countries in Asia, South America and Africa, for example, have major power infrastructure demand. They simply can’t build fast enough to keep up with their high economic growth rates. India alone has power needs for over 400 million people.
The world needs many more power plants, large electrical grids, transmission lines, and other forms of power infrastructure to support such growth. Power uncertainty hinders growth and development, discourages (foreign direct) investment and can even cause civil unrest in places like China and sub-Saharan Africa.
Over the next 10 years, Morgan Stanley estimates that these countries will invest over $20 trillion in infrastructure! Additionally, given the global recession and the worldwide economic stimulus efforts flowing from that, there is even greater investment taking place.
From stimulus funds alone, this month’s Safe Haven Investor pick expects up to $1 billion in incremental revenue from the money going towards global infrastructure — particularly energy efficiency, modernization and new construction spending.
This company’s components serve power distribution, power reliability and power management areas. It has dramatically increased sales to these power-needy emerging markets.
In addition to this emerging markets power play, this pick is also a:
- Transformation story: The company has been steadily shifting its business into value-added, less cyclical, more global end-markets and products. That includes serving the fast-growing global alternative energy sectors.
- Great Value Idea: The stock is cheap, with a 4.7% dividend yield, and out of favor by Wall Street. We’re “getting paid to wait” and we are in good company…
With a depressed stock price due to the dismal global economic environment and weak 2009 earnings, I expect more than 45% upside on this pick over the next 18 months.
Transformation Underway
The company is Eaton Corporation (ETN:NYSE). Headquartered in Cleveland, Ohio, Eaton has historically been classified as a “traditional” industrial company. It started out in 1911 as a small truck parts supplier, and has come quite a long way since then. For decades, the company has been diversifying out of its exposure to cyclical markets such as the truck, automotive and aerospace industries.
Eaton’s CEO, Sandy Cutler, is committed to diversifying into being a premier, globally focused power management company. Cutler is adamant about reducing the cyclicality of the business through diverse international sales and more value-added, faster growth — not to mention more stable end-markets and customers.
Eaton has dramatically increased its business in Asia and South America. The company has also negotiated key deals with large utilities, along with vehicle and equipment manufacturers serving emerging markets. In just five years, Eaton’s developing market share has grown from 10% of sales to 21%, while overall U.S.-based sales have gone from 66% of the total down to 45%. I expect 60%-65% of sales to be non-U.S. by 2012! This shows that Eaton really “gets it.” It sees the future prosperity and growth to be had in fast-growing emerging markets, and it is set to take prime advantage.
Power On! Eaton’s Electrical Business
The company’s Electrical segment had $6.9 billion in 2008 sales and grew at 25% from 2003-2008, with a good chunk of that growth coming from acquisitions. Over that same period, margins of this business went from roughly a little over 2% to close to 12% — proving the company is great at operational execution, cost reductions and acquisition integration. Management is leveraging its electrical component competencies and growing its global exposure to traditional and alternative energy markets, which in turn are growing at a rapid pace.
Eaton specializes in electrical components and systems that provide power quality, distribution and control for electrical, hydraulic and mechanical customers and markets. Eaton’s electrical products serve power sources like utilities and power users such as trucks, airports, water systems, industrial buildings, airplanes, light vehicles and data centers. Its products include switches, sensors and motor starters, variable speed drives, microprocessor-based controls, circuit breakers, voltage assemblies, substations and transformers.
Importantly, the company is having great success offering broad power management applications and selling its products to alternative energy markets such as wind, solar and alternative energy vehicles. For example, Eaton has been increasing content on several of the latest medium-duty hybrid service vehicles for corporate fleets such as FedEx.
Industrial Hodgepodge
In the Industrial segment, Eaton makes the stuff you don’t see but that is critical to the function of vehicles, equipment or aircrafts. The segment, divided into four groups, had $8.5 billion in 2008 revenues. The largest segment is Hydraulics, which serves traditional end-markets: industrial, agriculture, and construction and infrastructure. Hydraulic products and components are only getting more complex — another bonus for Eaton, as the company is a technology innovator and market leader.
In the cyclical truck segment, it is a leading manufacturer of transmissions (over two-thirds of segment sales) for heavy-duty or Class 8 trucks (i.e. the big 18-wheelers). Eaton has recently built transmission plants in China and India and has won new business in Brazil — further proof of its aggressiveness in emerging markets.
Eaton is also a dominant player in automotive valve trains and makes other core engine components, serving almost all of the dominant global vehicle manufacturers. Over 75% of automotive sales are not to the traditional Big Three in Detroit. Think global!
In the Aerospace segment, Eaton is outstanding at providing systems in various critical areas: cockpit, fuel, conveyance, hydraulics and motion control. In general, systems sales have higher margins and higher sales than the component business. About 40% of its Aerospace business is to the military (e.g. F-35 Joint Strike Fighters) and a good chunk of its business serves large transport aircraft — also a growing global business. But when you think of its Aerospace segment, also think about the aftermarket — where 40% of sales are steady because they are replacement parts, a steady, less cyclical, higher-margin business, not dependent on new aircraft orders.
“He Likes It! Hey Mikey!”
You might recall a classic Life cereal commercial in the 1970s and 1980s. Remember the finicky but cute little kid, Mikey, who hated everything but never said a word — and ended up liking the cereal, to everyone’s surprise? That commercial actually ended up being one of the longest-running commercials of all time.
Well, in this example, Warren Buffett is playing the role of “Mikey.” The Oracle of Omaha is famously picky about the stocks he buys. And so it’s notable that “Mikey,” I mean, Warren Buffet, likes Eaton. Buffett added Eaton Corp. to his portfolio last fall in the third quarter — and he did so at a significantly higher buy-in price than the one we’ll get. Buffett’s average price, according to guru-focus.com, was $71! Even further, he added more shares of Eaton in the fourth quarter at a lower average price, somewhere in the $50s.
Now, while Buffet is the first to admit he made some bad investments in 2008, I am a Buffet devotee and I still like his odds of success — and more importantly ours, investing alongside of him (at a better price). Furthermore, Bill Gross, the fixed-income king and manager of the world’s largest bond fund, recently made comments recommending “stable dividend paying equities” along with bonds.
Straw Hats in Winter and Wall Street Surprises
This is one of my favorite investment proverbs, confirming a simple but critical contrarian view. You find the best deals on bikinis and swim trunks (and straw hats) in the dead of winter in the back section of the clothing store — at 50% off! In other words, the best investors buy stocks when no one else wants them. Eaton and many other industrial stocks are in the off-season right now, unloved and out of favor.
Specifically, I try to find stocks where the Street has mostly HOLD or SELL recommendations, like Eaton, which has 14 HOLD recommendations, two SELLs, and only two BUY recommendations. So when the momentum shifts, Wall Street analysts will upgrade Eaton to BUY, lifting the stock price.
When companies like Eaton come out of an economic down cycle, the earnings momentum, given their operating leverage, is almost always better than expected. Wall Street estimates will then likely be too low and have to be revised up. The time when Wall Street changes its recommendations on Eaton will be the time when the earnings estimates have to be revised upwards and the stock price will fly.
Earnings momentum should be powerful as the earning trough of ~$2 this year will accelerate back up to normalized earnings of approximately $5 in 2011 and 2012. On the other side of the coin, management has had to reduce its 2009 earning guidance twice this year from over to $4.50 to the low $2 range (Wall Street consensus is now at $1.93). Given comments from the company, a first quarter 2009 upside surprise, and mildly favorable economic data, I expect that to be the last downward earnings guidance — and Eaton’s exposure to the early and middle stages of the cycle provides great earnings leverage.
Getting Paid to Wait… But It Shouldn’t Be That Long
Eaton has the cash flow to at least maintain its dividend going forward, even in more difficult environments. In the recession of 2000-2001 it maintained its dividend steady although the payout ratio got up to 75%. While management’s earnings guidance has come down dramatically this year, as noted above, I believe they will do whatever they can to maintain their $2/share dividend payout. So you have to like a 4.7% yield while we wait for this cycle and this stock to turn around.
If I’m wrong with Eaton, then we’re probably going to have more major concerns in all investment areas, as this recession will be much worse from today. Eaton’s end-markets are currently bad, soft, weak, depressed — you name it. But there are signs of economic life among the mixed signals I referred to in my June 19 hotline. If Eaton’s 2009 earnings come in a lot lower than the ~$2 that I expect, that could put the dividend in jeopardy. But with that said, I feel confident that we’ve seen the worst economically. And if the economic weakness persists, I’m certain management will do its best to maintain the dividend through such troubled times.
So, to conclude, we’re getting a high-quality company, with a high-quality management team and business model, focused on reducing cyclicality and increasing top-line growth by ramping up sales to developing world countries and the broad-based power and alternative energy end-markets. Sizzle with the steak!
As I mentioned, this stock is so cheap largely because of the terrible economic climate and the downward revisions to 2009 and 2010 earnings. But normalized earnings are around $5 and future earnings potential is higher, given that Eaton earned $6.90 in 2007 operating earnings per share.
Conservatively, if Eaton can earn above $4 in 2011 — which is where street estimates are at — then applying a forward P/E of 15 implies a $60 stock, over 40% upside in 18 months or a 25% annualized return!
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