Global industrial giant Eaton (NYSE: ETN) started a new business in 2018 to take advantage of the shift toward electrification in the vehicle space. If you look at the top-level financial results so far, the eMobility division doesn't look like it's having much success. Step back and take a good look, however, and things seem to be going pretty well. Here's what you need to know to understand why Eaton is pleased with the progress it's making at eMobility despite a massive drop in profits.
A big opportunity
From its inception, Eaton has served the transportation industry. The company's product line has changed over time, but the vehicle segment is still a big contributor to overall results. In the second quarter, this business provided roughly 15% of revenue and had operating margin of 16.9%. Year over year, this margin contracted by 1.6 percentage points, while the division's revenue fell 11%.
Image source: Getty Images.
There were two reasons for the decline. For starters, there was a slowdown in the industry, with Eaton highlighting a 7% decline in global light vehicle sales in the second quarter. But more important was that Eaton peeled off a portion of its vehicle business to form a joint venture with engine giant Cummins. The joint venture, which isn't included in the vehicle division's results, saw a revenue increase of 11% in the quarter. So, all things considered, the vehicle division is an important business for Eaton, and when you include the joint venture, it's doing OK in a tough market.
But there's one more thing to note: eMobility. Eaton clearly sees that the future will include more electric vehicles. To to stake out its position in this emerging industry niche, it brought together parts of its electrical business with parts of its vehicle division and created eMobility in 2018. The company believes it could be a $4 billion revenue operation at some point. The problem is that $4 billion is a long way off right now.
Weak or strong?
In the second quarter, eMobility had revenue of $84 million, which is just 1.5% of Eaton's total revenue for the quarter. That number, meanwhile, was up just 1% year over year -- not particularly impressive. Operating margin in the segment was 8.3%, down more than 50% and less than half of the company's 17.9% overall operating margin. Segment profits, meanwhile, fell 50% year over year, dropping from $14 million to $7 million. And the company cut its 2019 organic growth projections for eMobility by roughly half. At first blush, these numbers look pretty grim.
Eaton eMobility Results Versus Total Company Results, Q2 2019
All of Eaton
Data source: Eaton.
However, there's more to the story. First, eMobility's business today is largely from combustion engines, an area that has been weak (as Eaton's vehicle division results highlighted). Second, this legacy revenue is expected to become less important as the company get its products included in electric vehicle models that will have multiyear life spans. Once included in this process, eMobility will have a stable revenue stream when the vehicles start getting produced.
For better or worse, that means up-front costs for research and development can be large before any revenue gets booked. That's the cost of winning these multiyear contracts. However, once the revenue starts flowing, it will continue for years with little extra cost. The big hit to eMobility's operating margin in the second quarter was R&D spending.
The weak revenue growth in the division needs to be taken with a grain of salt, as well. The eMobility segment has already won two sizable contracts, worth a total of $390 million of "mature year" revenue. That number includes a $160 million contract in the first half of 2019. Simply put, while it hasn't shown up just yet, eMobility is gaining traction in the electric vehicle industry. It's just going to take some time before it starts to flow through to the division's financial results.
A marathon, not a sprint
Right now, eMobility's results look pretty horrible, but Eaton isn't thinking in years -- it's thinking in decades. In fact, Eaton has been around for more than 100 years, and in that time has shown it's capable of adjusting to change. Management sees the shifts taking place in the vehicle space and is moving with the times again, creating a division that serves the emerging electric vehicle market.
This is a long-term trend and one that is expected to be very profitable for Eaton. It will just take some time for the company to build scale and reach. Don't pay too much attention to the division's results right now: It costs a lot of money to build a business from the ground up. That said, keep an eye on its contract wins, which help to show the long-term opportunity. While these early successes have yet to show up in the division's results, they reflect the very real progress being made.
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This article was originally published on Fool.com