Image Source: Eaton
By Valuentum Analysts
Demand for products in the industrial electrical equipment space is highly cyclical, and industry constituents are exposed to volatile raw material costs, which at times can be difficult to pass along to customers. Tariff-related costs have the potential to impact bottom-line performance as well and should be monitored closely. Product development and quality initiatives are sources of competitive strengths, but rivals often compete aggressively on price to gain share. The industrial electrical equipment market should grow at a GDP-like pace in the developed world and a multiple of that trajectory in emerging markets. We’re neutral on the space.
While the cyclical nature of the end markets served by industrial electrical equipment entities is a key risk, there are some secular trends that are helping drive expected demand growth over the long haul. The growing global population will require an expanding power grid, energy efficiency is a top priority of nations worldwide, and the thirst for productivity is driving demand in industrial automation, which also benefits from factors such as an aging installed base and the low cost of computing and connectivity.
When searching for the best dividend growth ideas, we prefer companies with net cash positions on the balance sheet and robust free cash flow generating capacity. Balance sheet strength is of increased importance to those serving cyclical end markets, as is the case with industrial electrical equipment firms. While we are neutral on the space as a whole, companies can stand out via a track record of execution through the course of the economic cycle and expertise in specialized expertise in an attractive and targeted end market, among other factors. Let’s take a look at three of our favorite ideas within the space and evaluate the attractiveness of their dividend profiles in addition to taking into consideration their potential valuation upside.
ABB (ABB) – Dividend Yield: ~4.3%
Image Source: Juan
ABB is a market leader across its power products and systems portfolio and is among the top 3 global providers in discrete automation, low voltage products, and process automation. ABB is set to benefit from key growth areas, including power grid expansion, emerging market demand, energy efficiency initiatives, and automation business growth. It recently bought GE’s Industrial Solutions business for $2.8 billion and expects annual cost benefits of $200 million from the deal, which will strengthen ABB’s position in North America.
ABB has solid targets for the period 2015-2020. It is targeting revenue growth of 4-7%, which is higher than its total market expected growth of 3.5-5%. The main drivers of this growth are the strengthening of its competitiveness and increased organic growth momentum. Perhaps our favorite target is management’s goal to convert more than 90% of net income to free cash flow. Service momentum is a key building block for profitable growth at ABB, and service order growth has remained solid in recent quarters (up 5% in first half 2018). We like this increasing recurring revenue stream. As of the end of the second quarter of 2018, its total backlog was a robust $24.2 billion.
ABB’s relationship with activist investor Cevian Capital may be worth watching. After defying pressure to spin off its ‘Power Grids’ division, ABB has since agreed to sell an 80% stake in the business to Hitachi. The deal will significantly impact revenue but should boost overall margin performance.
Here’s what we say about its dividend in the dividend report, and as for its valuation, we think there could be material upside for shares based on our fair value estimate range (see image that follows):
ABB is the world’s largest builder of electrical grids and looks set to experience some nice tailwinds in its operations in the coming years. ABB boasts a healthy Dividend Cushion ratio that is supported by the company’s strong free cash flow generation and reasonable balance sheet. We like its target of generating free cash flow of at least 90% of net income. The firm’s solid yield adds appeal to its seemingly safe dividend, but currency exchange rates can impact the payout. Average annual free cash flow generation of more than $2.9 billion from 2015-2017 has been sufficient in covering annual run-rate cash dividend obligations of ~$1.6 billion. Management has stated it has a high priority for maintaining a steadily rising, sustainable dividend.
Faults in ABB’s dividend payout seem to be few and far between. We’re not ruling out more share repurchases in the future, which could impact the pace of dividend expansion moving forward as it increases the magnitude of a competing allocation of capital. Investors should also be aware of the impact macroeconomic and geopolitical uncertainty can have on ABB’s business as its projects often require a degree of visibility in terms of sovereign policies and secular trends. It is important to note the firm’s payout is in Swiss Francs, so US investors should expect volatility due to foreign exchange rates. Otherwise, we feel ABB’s dividend is solid. Its acquisition of GE’s Industrial Solutions business will impact its balance sheet health.
Image shown: ABB is currently trading at ~$19 per share, indicating we see notable upside potential for shares. We think the company’s valuation could reach $29 based the upper bound of our fair value range.
Eaton (ETN) – Dividend Yield: ~3.5%
Image Source: 精選 好東西 熊老闆
Eaton is one of our favorite industrials, and the company is a leader in diversified power management solutions that make electrical, hydraulic and mechanical power operate more efficiently. The firm serves the electrical, hydraulics, aerospace, truck and automotive end markets. Electrical accounts for ~60% of sales.
Multiple secular trends are driving Eaton’s business over the long haul: population growth is pushing electricity demand higher; environmental concerns and increased regulation are requiring increased innovation, as is the case with the push for greater energy efficiency; and intelligent products and connectivity are driving new avenues for value creation. The firm continues to focus on improving segment operating margins via margin-accretive acquisitions, innovative new products, and through restructuring. Management estimates it has reduced earnings volatility through the economic cycle by 40%, and it is targeting a segment operating margin of 17-18% in 2020, up from 15% in 2015-2017.
Eaton expects a majority of its businesses to experience solid growth in their respective end markets in 2019 with overall market growth of ~3-4% expected. It is confident it will be able to offset tariff-related costs, which are projected at ~$110 million in 2019, in the year. Eaton’s 2018-2020 goals include 3-4% organic revenue growth, 1-3% acquisition revenue growth, ~170 basis points of segment operating margin expansion, an EPS growth CAGR of 11-12%, and free cash flow at 10%+ of sales. Share repurchases amount to 1-2% of its market cap per year.
Here’s what we say about the company’s payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):
Eaton’s focus on operating margins through strategic acquisitions has significantly reduced earnings volatility since 2009, which has helped provide additional stability to the firm’s free cash flow generation as well. From 2016 through 2020, management plans to allocate over 30% of its capital to dividends, while attempting to maintain a dividend yield near 3%. A return to pricing growth in 2018 was a welcome development after years of stagnation and is expected to more than offset commodity price inflation as the company remains focused on operating margins (17-18% segment operating margin target for 2020). Looking forward, we expect management to continue growing its dividend, but at a modest rate.
Though Eaton plans to distribute over 30% of its capital to shareholders via dividends, it is focused on driving revenue growth and margin improvements through acquisitions. Eaton will continue to drive revenue growth through acquisitions, and we would be remiss not to be conscious of the impact an acquisition-hungry management can have on the firm’s dividend growth potential. However, as long as the acquisitions are of the value-add variety, its dividend should continue to grow at a slow and steady rate for the foreseeable future. Eaton’s balance sheet weighs on its dividend potential; net debt stood at nearly $7.1 billion (inclusive of short term debt) as of the end of 2018. We’ll be watching the impact of tariff-related cost increases closely.
Image shown: Eaton is currently trading at ~$75 per share, which is firmly in the lower half of our fair value range. We think shares have the potential to reach the ~$97 range based on the upper bound of our estimate of its intrinsic value.
Rockwell Automation (ROK) – Dividend Yield: ~2.3%
Image Source: Greg Heartsfield
Rockwell Automation is the world’s largest company dedicated to industrial automation. It operates in two segments, Architecture & Software (~46% of total sales) and Control Products & Solutions (~54% of total sales). The company operates in more than 80 countries, but the US accounts for ~55% of total sales. Improving GDP and industrial production growth rates and stabilizing commodity prices are among the assumptions factoring into a positive outlook from management in the near term. The company remains focused on innovation and believes its singular focus on automation gives it a leg up. Organic revenue growth is expected to be in the mid-single-digit range in fiscal 2019.
We agree with Rockwell that automation is a great market. The firm benefits from a number of tailwinds: an aging installed base, the need for productivity, the growing middle class in emerging markets, lower cost of computing and connectivity, and IT-OT convergence. Management expects to deliver above-market revenue growth by gaining share in its core platforms, growing at a double-digit rate in information solutions and connected services, and delivering at least one percentage point of annual revenue growth via acquisitions.
Rockwell Automation has some noteworthy long-term goals. The firm is targeting above-market revenue growth and earnings per share growth greater than revenue growth. It expects to generate 20%+ annual return on invested capital and convert more than 100% of adjusted net income to free cash flow each year.
Here’s what we say about the company’s payout in the dividend report, and as for our estimate of its intrinsic value, some upside may exist for shares, which are trading in the upper half of our fair value range (see image that follows):
Rockwell’s strong return on invested capital and stable free cash flow have enabled it to grow its dividend at a solid pace in recent years. The firm’s cash deployment priorities are listed as follows: fund organic growth, acquisitions, dividends, and share repurchases. We love management’s goal to generate free cash flow of at least 100% of adjusted income, a goal it seems to hit routinely (averaged 110%+ over the past ten years). Due to its recent track record and Dividend Cushion ratio, we expect ongoing dividend growth for the foreseeable future. However, we note that its balance sheet flipped from net cash to a net debt position of ~$867 million (inclusive of short term debt) as of the end of fiscal 2018, which has slightly impacted its Dividend Cushion.
With so much going right with Rockwell’s business model, it’s hard to find flaws in its dividend prospects. The firm has been increasing its use of cash for acquisitions and share repurchases, providing increased competition for cash deployment. Though its dividend has performed well in recent years, it does have a blemish on its record. Rockwell first paid a dividend in 1993, and the firm was forced to cut its quarterly payout in 2001. Fortunately, Rockwell’s dividend is back on solid ground, and we don’t expect another cut anytime soon. The company’s solid near-term outlook helps build our confidence in the payout, and management is targeting free cash flow to be 100%+ of adjusted net income on an annual basis.
Image shown: Rockwell Automation is currently trading at ~$168 per share, which is in the upper half of our fair value range. We think shares have the potential to reach the ~$182 range based on the upper bound of our estimate of its intrinsic value.
While the cyclicality of end markets served for industrial electrical equipment entities can impact results in any given period or series of periods, we like the appeal of some of the longer-term trends supporting ongoing demand growth for these companies. An increasingly connected world will require increasingly efficient power solutions, and as the global middle class rises, this trend should strengthen. The added productivity that comes with the solutions companies such as Rockwell Automation provide is of high importance to its customers, which is evident in its expectations for solid near-term organic sales growth.
We like the upside potential we are currently seeing for shares of ABB, and its free cash flow conversion target is notable. Momentum in its Services business is driving an attractive revenue stream, but we’d like to get a better read on the company following the divestiture of its Power Grids business. Eaton is one of our favorite industrials as it has done well in reducing volatility in earnings over the course of the economic cycle, and it serves some attractive end markets. The company’s margin expansion initiatives are noteworthy, but tariff-related costs and the uncertainty surrounding further developments should not be taken lightly.
Rockwell Automation is our favorite company of the three, though its shares may not offer the most attractive price-to-fair value ratio at this time. The company’s target market is just about as attractive as it gets in the industrial electrical equipment space, and its free cash flow conversion performance has been a sight to behold. As a result, we think it has the greatest long-term dividend growth potential of this group, even if its dividend yield may come up relatively short at the moment. Nevertheless, we’re looking for companies that appear set to raise their dividends for decades to come, and robust free cash flow generating capacity is core to this goal.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.