Eaton Corporation plc (NYSE:ETN) Q4 2022 Earnings Call Transcript February 8, 2023
Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Eaton fourth quarter earnings call. . I would now like to turn the conference over to Mr. Yan Jin, Senior Vice President, Investor Relations. Please go ahead.
Yan Jin: Good morning, everyone. Thank you all for joining us for Eaton’s Fourth Quarter 2022 Earning Call. With me today are Craig Arnold, our Chairman and CEO; and Tom Okray, Executive Vice President and Chief Financial Officer. Our agenda today includes opening remarks by Craig, then we will turn it over to Tom, who will highlight the company’s performance in the fourth quarter. As we have done on our past calls, we will be taking questions at the end of Craig’s closing commentary. The press release and the presentation we’ll go through today have been posted on our website. This presentation includes adjusted earnings per share, adjusted free cash flow and other non-GAAP measures. They’re reconciled in the appendix. A webcast of this call is accessible on our website and will be available for replay.
I would like to remind you that our comments today will include statements related to the expected future results of the company and are therefore forward-looking statements. Our actual results may differ materially from our forecasted projections due to a wide range of risks and uncertainties that are described in our earning release and the presentation. With that, I will turn it over to Craig.
Craig Arnold: Thanks, Yan. We’ll begin with the highlights of the quarter on Page 3. And I’ll start by noting that we again delivered very strong results in the quarter and record performance for the year. We generated adjusted EPS of $2.06 for the quarter and $7.57 for the year, both all-time records in each period. Our Q4 adjusted EPS was up 20% from prior year. Our sales were $5.4 billion, up 15% organically and for the second quarter in a row with particular strength in utility, industrial, commercial institution, data center markets for electrical and commercial aerospace, vehicle and eMobility markets on the industrial side. And we continue to post strong margins. Q4 margins of 20.8% were up 150 basis points from prior year, near the high end of our guidance range.
And incremental margins were 33% in the quarter. For the full year, we delivered record segment margins of 20.2%, up 130 basis points from prior year. And as noted here, orders continue to remain very strong. On a rolling 12-month basis, Electrical orders were up 25% and Aerospace orders increased 24%, which led, quite frankly, to record backlogs as well, up 68% in Electrical and up 21% in Aerospace. Now lastly, in what was an otherwise challenging year, we generated record free cash flow in the quarter with adjusted free cash flow up 41%. And our free cash flow as a percentage of sales was 18.1% in the quarter. While improved cash flow in the second half of the year, it wasn’t enough to really achieve the full year cash flow targets. As we indicated, we continue to prioritize supporting higher organic growth, winning new orders and protecting our customers, which all contributed to higher levels of working capital.
But we still have work to do and with a focus on those areas that don’t impact revenue growth. On Page 4, I summarize our performance highlights for last year. Overall, I’d say, in a challenging operating environment, our team delivered strong financial results. And as noted here, we exceeded three of our four key financial metrics. First, for organic revenue, we posted 13% growth, which was actually more than 60% above our original guidance at the midpoint. Throughout ’22, we raised our organic revenue growth in all segments, and the team delivered on the organic growth expectations that we set. It’s worth noting that our largest business, Electrical Americas, delivered 16% organic growth, 2x the midpoint of our original guidance. Second, I’d note that we continue to demonstrate our ability to drive profitable growth with record margins of 20.2% in 2022, which was 10 basis points above our original guidance at the midpoint.
Third, adjusted EPS of $7.57 was $0.07 higher than the midpoint of our original guidance. And I’d note that we fully offset the impact of some $500 million of unfavorable currency or roughly $0.20 a share. Lastly, I’d note that we did miss our free cash flow guidance for the year. Most of this miss went into working capital to support higher levels of sales and orders and the record backlogs. But I’d say here, once again, I know we can do better. As you might expect, supply chain disruptions and our decision to prioritize protecting customers with higher inventory played a major role in this inventory growth over the year. But overall, I’d say it was a good year despite a year filled with inflation, labor shortages, supply chain disruptions and FX headwinds, and the team delivered record financial results and we go into 2023 with positive momentum.
So turning to Page 5. I hope at this point, you would agree that 2022 wasn’t an exceptional year but just another year of delivering what we promised. And that it reflects the fundamental changes that we’ve made to the company over the last decade. We are a very different company today than we were 10 years ago. We’ve embraced the realities of a changing world and a necessity for us to change as well. We’re now in attractive growth-oriented end markets, and we have a proven formula for how we run the company better through the Eaton Business System. With this transformation, we’ve become a stronger company that has delivered higher growth, higher margins and better earnings consistency. And we continue to be a good steward of your capital. The end result is the new Eaton where some 90% of our profits now come from Electrical and Aerospace businesses.
But once again, when I’m done, we’ll continue to apply our operational model, our strategic framework and our potential criteria, and we’d expect to continue to maximize value to all of our stakeholders. And as you can see on Page 6, what this transformation has delivered to our shareholders. As you would expect, our strong results have translated into very strong financial results. And for the sake of comparison, we charted total shareholder returns for 3, 5 and 7 years. And we’ve compared our results with the S&P 500, the medium of our peer group and the XLI Industrial Index. And in every case, Eaton has significantly outperformed our benchmarks. And as I’ll explain in the next few slides, we do believe our best days are still in front of us.
Turning to Page 7. Our transformation into a global intelligent power management company has positioned Eaton at the center of some of — what we think are some of the most important trends that we’ll see in our lifetime. The most significant being climate change and all the downstream implications that it brings. As we all know, climate change is driving the need to transition from fossil fuels to renewables, and increased regulations are driving the demand for new solutions. These solutions will require tremendous investments in renewables and grid infrastructure for both new and existing buildings. This trend is also closely coupled to need to electrify the economy. Cars, trucks, planes, buildings are all requiring more electrical content.
And as we move away from fossil fuels, this allows us to take advantage of renewables. And digitalization is providing us access to data and insights that are allowing us to be more connected, more productive and more efficient than ever. It’s also, by the way, creating a need for more data centers, an important end market for Eaton. Additive to these trends, we’re also on the front end of an aerospace recovery cycle that will drive growth in both our commercial and military markets. I don’t know about you, but I can tell you, I don’t — I can’t think of a company with a better set of market dynamics than Eaton. And while we’re not ready to change our long-term growth goals, I’d be surprised if we didn’t exceed our previously announced targets of 5% to 8% annual growth.
Next, on Page 8, we highlight how these megatrends are supported by unprecedented government stimulus spending really around the world. In fact, these programs will have a direct impact on the growth rate of more than half of our end markets. And in the U.S. alone, the Infrastructure Act from 2021 and the Inflation Reduction Act from 2022 will fund some $450 billion of grid modernization and other climate-related programs. And of particular importance to Eaton is the $88 billion that are set aside for power grid updates and EV charging networks and incentives. In Europe, the EU recovery plan recovers — provides, excuse me, $244 billion of green energy transition, which member states are now working on implementing. And in China, the government has set clear goals to lower carbon emissions.
They’ve laid out plans to strengthen their grid by 2025, including investments in more wind and solar. China also continues to lead the world in the adoption of electric vehicles. But even if you exclude China, we still estimate that between the U.S. and EU programs will expand Eaton’s addressable market by some $11 billion to $14 billion over the next 5 years. And I’d say this is just another powerful tailwind that supports our confidence in the growth outlook of the company. Tom will pick it up here and take you through the numbers.
Tom Okray: Thanks, Craig. On Page 9, I’ll begin with highlighting a few key points regarding our Q4 results. Revenue was up 12% with organic growth of 15%, partially offset by a 4% foreign exchange headwind and a 1% favorable net impact from acquisitions. This outcome illustrates our focus of prioritizing growth in our customers. With total revenue growth of 12%, we posted solid operating leverage. Operating profit grew 21% and adjusted EPS grew 20%. Further, excluding the $0.05 impact from foreign exchange, growth in adjusted EPS would have been 23%. All in, strong organic growth and margins enabled us to report all-time record adjusted earnings of $825 million and adjusted EPS of $2.06, which was above our guidance midpoint.
Lastly, I’d like to note that we continue to raise the bar with our Q4 records for both segment operating margin and segment operating profit. Moving on to the next chart, we summarized strong financial performance for our Electrical Americas business. For yet another quarter, we have set all-time records for sales, operating profit and margin. Further, we’ve also set all-time records for these metrics for the full year. Organic sales growth accelerated from 18% in Q3 to 20% in Q4 with robust growth in every end market and particular strength in utility, data center and commercial and institutional markets. Operating margin of 23.7% was up 450 basis points versus prior year, benefiting from higher volumes. In addition, incremental margins were quite strong at 47%.
We continue to manage price effectively to more than offset inflationary pressures. Further, it should be noted that Electrical Americas outperformed their original 2020 guidance by 100 basis points. Orders in backlog continued to be very strong. On a rolling 12-month basis, orders were up 34%, which remains at a high level with strong growth across the board and particular strength in data center, utility and industrial markets. Backlog ended the year up 87% versus prior year and increased sequentially from Q3. In addition to the robust trends and orders in backlog, our major project negotiations pipeline in Q4 was up nearly 100% versus prior year from especially strong growth in manufacturing, data center, industrial and utility end markets.
Overall, Electrical Americas had a strong quarter to round out a very good year and continues to be well positioned as we start 2023. Moving to Page 11, we show results for our Electrical Global segment, which produced another strong quarter, including records for Q4 and full year records for sales, operating profit and margins. Organic growth was up 8%, which was entirely offset by headwinds from foreign exchange of 7% and divestiture of 1%. With respect to organic growth, we saw strength in utility, industrial and data center end markets. On a regional basis, we posted high single-digit organic growth in IEMEA and mid-single-digit organic growth in APAC. Operating margin of 18.7% was down 80 basis points versus prior year, primarily due to foreign exchange headwinds.
We continue to see good order intake. Orders were up 11% on a rolling 12-month basis with strength in data center and commercial and institutional markets. Backlog growth of 17% also remains strong. Before moving to our industrial businesses, I’d like to briefly recap the combined Electrical segments. For Q4, we posted organic growth of 15%, incremental margins of 44% and operating margin of 21.8%, which was 250 basis points of year-over-year margin improvement. For the full year, our Electrical segments grew 15% organically, generated 33% incremental margin, increased margin 140 basis points, posted 25% rolling 12 months order growth and increased backlog 68%. We are confident that we’re well positioned for continued growth with strong margins in our overall Electrical business.
The next chart recaps our Aerospace segment. We posted all-time record sales and operating profit for both the quarter and on a full year basis. Organic growth accelerated to 11% with a 4% headwind from foreign exchange. This growth was driven by strength in commercial markets with commercial aftermarket up 35% and commercial OEM up more than 20%. Relative to profit, operating margin was strong at 24.5%. And it’s worth noting that Aerospace outperformed their original 2020 guidance by 100 basis points. Order growth and backlog are very encouraging. On a rolling 12-month basis, order acceleration continued, up 24% compared to 22% in Q3 and 19% in Q2 with strength across all end markets. Similar to Q3, we saw especially strong growth in military OEM orders, up 80% in the quarter, which positions us well for growth in 2023 and confirms our expectations for increased defense spending, including breakout performance in 2024.
Photo by Remy Gieling on Unsplash
Year-over-year backlog increased from 17% in Q3 to up 21% in Q4. Moving on to our Vehicle segment on Page 13. Vehicle had strong revenue growth in the second half of the year. In Q4, revenue was up 16% with 18% organic growth and 2% unfavorable foreign exchange. This coming off 19% organic growth in Q3. We saw growth across all markets with particular strength in North America and South America light vehicle. We also saw double-digit growth in APAC. Operating margins came in at 15.2% with unfavorability to prior year, primarily due to manufacturing inefficiencies. As expected, we were able to completely offset the impact of inflation with pricing in Q4. We also secured wins in new and sustainable technologies, such as EV gearing and transmissions, with a large and growing opportunity pipeline.
On Page 14, we show results for our eMobility business. We generated very strong growth in the quarter. Revenue was up 58%, including 17% from organic growth and 44% from the acquisition of Royal Power, partially offset by 3% negative foreign exchange. Margin improved 780 basis points versus prior year driven by higher volumes and the impact from Royal Power. We remain encouraged by the growth prospects of the eMobility segment. Since 2018, we’ve won $1.4 billion of mature year revenues in this business, including a recent $400 million win for power protection and distribution units with a European customer. This is a major new program win in both U.S. and European markets with production starting in 2024. This win demonstrates Eaton’s ability to leverage our capabilities across our entire portfolio, including core technology in both electrical and industrial businesses.
We partnered with our customer to electrify their mobile platform with solutions, including Breaktor and Bussmann fuses. We also leverage our extensive vehicle expertise and added content from our Royal Power acquisition. Overall, we continue to make progress toward our long-term goal to create a $2 billion to $4 billion business with 15% margins by 2030. We are now on track to exceed our expectation to deliver $1.2 billion of revenue and 11% margin by 2025. Moving to Page 15. I’m going to unpack a theme that Craig mentioned at the top of the call related to our strategic investments in working capital to support strong orders and backlog, which enables accelerated organic growth. Overall, in spite of supporting surging orders and backlog, we are driving working capital improvements.
To illustrate the trend, I’ll provide a couple of examples. Net working capital to orders and inventory as a percentage of backlog. Focusing on the left side of the chart, the average value of our Electrical and Aerospace quarterly orders in 2022 was more than 20% higher than 2021 and 33% more than 2019. However, to support these increasing orders, we have only slightly increased the absolute value of our working capital. The result is shown in the graph on the left side of the page. Our ratio of net working capital at year-end to trailing 12-month orders has stepped down significantly from 2019 to 2022. Moving to the right side of the chart. Another way to look at working capital efficiency is comparing backlog growth to inventory growth. At the end of 2022, our Electrical and Aerospace backlog reached approximately $11 billion, which is up almost 160% since the end of 2019.
However, to support this much larger backlog, inventory for our Electrical and Aerospace businesses has only increased by 38% since 2019. The graph on the right side of the slide highlights the significant improvement since 2019. Our inventory as a percentage of backlog has been roughly cut in half from the end of 2019 to the end of 2022. We are supporting a much larger backlog with a smaller percentage of inventory. In summary, we have prudently prioritized taking care of our customers and capturing growth, which has required investments in working capital and has impacted free cash flow metrics in the short term. That said, we are managing working capital more efficiently. The 2023 guidance on Page 16 shows that we are well positioned for another strong year of financial performance.
Our organic growth guidance for 2023 is a range of 7% to 9% with particular strength in Electrical Americas and Aerospace with organic growth rates of 8% to 10%. eMobility is also a standout with 35% organic growth guidance at the midpoint tied to the ramp of new programs. These organic growth rates correspond to our end-market growth assumptions that we provided on our Q3 earnings call and that Craig will update in a few slides. The end-market growth, combined with increased backlog, provides tremendous visibility and confidence in our 2023 outlook. For segment margins, our guidance range of 20.7% and 21.1% is a 70-basis points improvement at the midpoint from our 2022 all-time record margin of 20.2%. In addition to projecting strong organic growth for 2023, we’re also growing margins and continue to invest in future organic growth.
Moving to Page 17. We have the balance of our guidance for 2023 and Q1. I’ll touch on some highlights. For 2023, we are guiding adjusted EPS in the range of $8.04 to $8.44, which has a midpoint of $8.24 is 9% growth over 2022. We expect continued foreign exchange headwinds, which we estimate between $100 million and $200 million adverse. For operating cash flow, our guidance of $3.2 billion to $3.6 billion is a 34% increase at the midpoint over 2022. The key drivers here are a combination of higher earnings and improved working capital, particularly lower inventory levels as supply chains normalize. While our plan includes significant improvement in free cash flow during 2023, I’ll note that we anticipate due to higher interest expense and CapEx in Q1 as well as timing-related headwinds such as taxes that free cash flow in Q1 will be relatively flat year-over-year.
For share repurchases, we anticipate a range of $300 million to $600 million. Moving to Q1. For Q1, we are guiding organic growth of 8% to 10%, segment margins between 19.5% and 19.9%, and adjusted EPS in a range of $1.72 to $1.82. Now I’ll hand it back to Craig to walk us through the market outlook and wrap up the presentation.
Craig Arnold: Thanks, Tom. Turning to Page 18, we provide a look at our current market assumptions for the year. This chart has been updated from what we shared in our Q3 earnings call, but we really don’t see any material changes here. I’ll remind you that we do expect a mild recession in 2023. But given the secular growth trends that we’ve talked about, our strong orders and healthy backlog, we would expect to see growth in most of our end markets with six of our end markets representing some 70% of the company up nicely. And these markets are also, by the way, supported by a very strong negotiation pipeline. Of note, we now expect even stronger growth within our commercial and institutional segment given the relatively strong orders growth in the quarter and the continued strength in Dodge nonresidential construction contracts.
The only down market is expected to be residential, which only accounts for 8% of our revenue. In total, we’re encouraged to report that 85% of our markets are expected to see positive growth in 2023. And lastly, let me close on Page 19 just with a few summary comments. First, I’d say our thesis for Eaton as a changed company has continued to pay even better than we expected. Second, the growth trends, the right investments have delivered better top line growth, and we continue to run the company better. We delivered 13% organic growth with record orders and backlog. And despite supply chain challenges, an inflationary environment and significant FX headwinds, 2022 was a year of record profits, record margins, record adjusted earnings and adjusted EPS.
And I’m particularly encouraged by our 20% increase in adjusted EPS growth in Q4, which I see as a positive indicator for 2023. So despite the macro concerns, we expect 2023 to be another very strong year. And the company is on track and likely ahead of schedule for delivering our 2025 goals for revenue, margins, free cash flow and adjusted EPS. So I’ll stop here and open things up for any questions that you may have.
Yan Jin: Thanks, Craig. . Thanks in advance for your cooperation. With that, I will turn it over to the operator to give you guys the guidance.
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