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Eaton's Buybacks Are a Better Deal Than You Might Think for Dividend Investors

Reuben Gregg Brewer, The Motley Fool

Globally diversified industrial giant Eaton Corp. (NYSE: ETN) has been doing a great job of turning revenue into cash flow lately. It's been using that money to reward investors with dividend increases and large share repurchases. But to understand how big this news really is for dividend investors takes a little bit of digging. Here's what you need to understand to see just how great the stock buybacks have been for income investors.

Returning value

Eaton generated $3 billion of operating cash flow in 2018, with earnings up 16% over 2017. That comes after a strong showing in 2017, with operating cash flow of roughly $3 billion and an earnings increase of around 10%. It expects strong results in 2019 as well. 

A hand holding a pen that is tracing a candlestick chart above financial tables

Image source: Getty Images.

There are a few ways that a company like Eaton can return value to its shareholders, the most notable being investing in its business, paying dividends, and buying back stock. The company is doing all three. It has, for example, built a new division around electric vehicles in which it is spending on research and development efforts to stay ahead of a changing vehicle market.

Eaton's dividend increased roughly 6% in 2017 and another 10% in 2018. And based on the solid performance last year and expectations for 2019, the dividend was increased 7.5% in the first quarter. So, clearly, Eaton is rewarding investors with dividend growth. 

It has also been buying back stock at a rapid clip. In 2017, it repurchased roughly 2.5% of its outstanding shares. In 2018, that number jumped to 4%, with the company using the market downdraft in the fourth quarter to opportunistically buy 2.3% of its outstanding shares in just that three-month span. It has plans for more buybacks in 2019, too. 

So far, so good, but it gets better

Eaton buying Eaton stock is great for shareholders. But there's an interplay between stock buybacks and dividends here that deserves a little extra attention. Normally, investors are fond of buybacks because they spread net income over a smaller number of shares. That, in turn, boosts earnings per share, which is a net positive, assuming there are no better uses for the cash. Eaton was very clear during its first-quarter 2019 conference call that it intends to remain disciplined on the acquisition front, ensuring that any money it spends will earn a generous return. So, buying stock with the extra cash it is generating today is really a solid use of the money.

ETN Average Diluted Shares Outstanding (Quarterly) Chart

ETN average diluted shares outstanding (quarterly) data by YCharts

Eaton could, of course, use the cash to push the dividend even higher. But that might result in a dividend that isn't sustainable over the long term. Income investors don't like dividend cuts, so that's not a great plan. Once again, stock buybacks are a winner.

Here's the interesting thing: While stock buybacks do, indeed, help boost earnings growth, they also have another impact. In 2017, the dividend per share went up 6%, but if you look at the cash flow statement, Eaton paid out only 3% more on a total dollar basis. Dividends per share rose 10% in 2018, but Eaton paid out only 7.6% more on a dollar basis. With fewer shares outstanding, Eaton doesn't actually have to pay out as much cash to support the dividend boosts. It's kind of the opposite side of the earnings boost, and it makes growing the dividend that much easier. In other words, there's more than one reason for dividend investors to like Eaton's buybacks.   

A good steward

Ultimately, Eaton's use of cash has proven that management cares greatly about its shareholders. Some might argue that stock buybacks aren't the best use of cash. A sizable bolt-on acquisition that spurs long-term growth would obviously be a better option. But just because you have cash doesn't mean you'll find a worthwhile opportunity. Until Eaton finds something big to invest in, sizable stock buybacks, and the hidden dividend benefit they afford, should make most income investors pretty happy.

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Reuben Gregg Brewer owns shares of Eaton. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.