Turn back the clock just five years, and this company was an industrial also-ran. It was neither a household name, nor well-known on Wall Street. Sales growth was both “meh” and volatile, moving in line with the rhythms of the U.S.
The company in question is Eaton (ETN), a maker of power management and electrical equipment. It serves customers in over 160 countries, with the U.S. making up 61% of sales.
Five years ago was back when Eaton’s electrical equipment was just electrical equipment for boring businesses like utilities or real estate firms. Today, its technology is the electrical plumbing that powers the explosive global growth of data centers and artificial intelligence (AI).
Eaton has added about $100 billion of market value since 2019. Most of these gains have come in just the past year, as AI has exploded into investors’ consciousness. It’s now one of the biggest U.S. manufacturing firms by market capitalization — larger than better-known giants, such as Deere (DE) and Lockheed Martin (LMT).
Let’s take a closer look at this metamorphosis.
Eaton’s Booming Business
Eaton still has some vestiges of its conglomerate past. It makes products as varied as oxygen systems for parachutists, zippers for plastic bags, airplane ejection systems, car engine valves, golf club grips, and more.
But forget about those. Eaton is now an AI stock, getting more than two-thirds of its revenue from electrical products like transformers.
The firm's electrical business has power distribution capabilities and assemblies, as well as hazardous duty electrical equipment and related services, and is also a leader in low- and medium-voltage solutions.
Eaton holds the first or second position in numerous markets, including the North American low- and medium-voltage power distribution market, with a sizable installed base.
The company’s products are top-notch, such as its gas-insulated switchgear. Switchgear is the heart of any electrical installation, and is used to protect a customer's power system from power overloads. In contrast to vacuum technology, gas-insulated switchgear in higher voltage allows for a far smaller footprint, as well as lower maintenance costs.
The data centers that store and process that gusher of information crucial to AI need electrical equipment — and a lot of it. Nvidia (NVDA) forecasts that an additional $1 trillion of data center infrastructure will be built around the world in the next four to five years.
In a Powerpoint earnings presentation in April, Eaton forecast a 25% compound annual growth rate in global data center-related demand for electrical equipment between 2022 and 2025. This forecast was raised from a 16% rate back in October 2023. Already, 14% of Eaton’s revenues come from data centers.
It’s easy to see why Eaton raised its outlook. Orders for the company’s equipment by data center customers have doubled over the past year. And it’s negotiating four times as many deals in the U.S. on associated product lines.
In fact, business is too good; it’s more demand than Eaton can currently handle. That’s why the company has pledged to invest $1 billion over the next five years — on top of its normal capital spending — to expand its electrical equipment manufacturing capacity.
Eaton’s CEO Craig Arnold said on a recent earnings call, “Quite frankly, given the demand that we're seeing even today in the business, those numbers [data center demand] will likely go up.”
Can the Breakout Continue?
Can Eaton’s run continue? After all, it is still an industrial company, not an AI one.
Pushing Eaton’s stock market valuation even higher will require convincing investors that the boom-bust days for the electrical equipment industry are truly over. I believe they are.
For example, Eaton now has more protection from the risks of overbuilding capacity because customers are now willing to sign multi-year purchasing agreements in order to lock up supply of electrical equipment. So the company is investing in capacity in line with commitments from customers, with protections in place in the event that they change their mind. That is a completely new dynamic.
Let’s say that data center-related demand slows. Eaton has other “irons in the fire.” The boost from other construction megaprojects, backed by a gusher of government funds intended to grease the wheels of the energy transition, is only starting to bear fruit for Eaton.
Among the $1.2 trillion of North American megaprojects announced since the start of 2021 that Eaton is tracking, only about 15% have broken ground. Of those projects, Eaton says it’s won about $1 billion of orders for electrical equipment and is in negotiations for $1.4 billion more.
Keep in mind that if big construction projects are going to get canceled, that tends to happen before shovels have actually gone in the ground and well before a customer orders a bunch of electrical equipment.
Buy Eaton Stock
Eaton’s stock is a strong buy, even though it is trading at about 31 times projected 2025 earnings per share of $12.00.
The valuation is warranted given the company’s alignment to several megatrends, including global infrastructure spending, manufacturing reshoring, AI-driven data center buildout, and recovering aerospace markets.
Eaton’s latest quarter justifies the optimism. The company posted second-quarter operating earnings per share of $2.73 - up 24% year-on-year - and above consensus estimates by $0.12.
Revenues advanced 8% over the prior year (+9% organically), led by sales in the Electrical Americas business (+13%), on sustained strength in data center as well as industrial endmarkets.
In addition, Eaton raised its 2024 guidance range for both organic growth (8-9% versus 7-8%) and earnings per share to $10.65-10.75 - up 17% versus the previous guidance midpoint.
Finally, its ballooning order backlogs (Electrical Americas up 29%) are a clear indication that elevated interest rates have yet to derail Eaton’s capitalization on secular demand tailwinds.
ETN stock is a buy below $303.
