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Cecilia Chen

ETN AT A GLANCE

P/E ► 19.2 HIGH EV/EBITDA ► 10.2 LOW ROA ► 3.6% LOW ROE ► 6.5% LOW Debt to Equity ► 1.44 LOW Current Ratio ► 1.46 LOW Interest Coverage Ratio ► 3.97 LOW

 

 

 

 

 

 

Eaton Corporation (NYSE: ETN) manufactures components and systems for use in automobiles, trucks, aerospace, agriculture, and fluid power systems. Once highly dependent on making drivetrains and other engine parts for the auto and heavy trucks sectors, Eaton has cut auto and truck related sales to just 28% of the parts supplier's revenue in 2008 (down from 38% in 2000), shifting its focus to areas like power management, hydraulic systems, and aerospace and defense .^[1] Eaton is based in Cleveland, Ohio, but is geographically spread out, with strong international growth and 55% international exposure, selling its products in over 150 countries.^[2]

Eaton reported improved earnings per share in 2007 with sales over $13 billion despite stringent new carbon emissions criteria introduced in 2007 in Europe and the US. These highly anticipated criteria stipulated that all diesel engines produced starting 2007 must comply with cuts of 50 percent for NOx and diesel soot by 90 percent, leading to a sharp dip in the North American commercial truck market.^[3] Due to its diversification, Eaton posted new records for sales, net income, and earnings per Common Share during 2007 as well as setting new records in sales, operating profits, and operating margin for Electrical and Fluid Power segments.^[4] Although sales in the Truck segment fell in 2007 relative to 2006, Eaton has already made progress in diversifying to higher growth sectors, such as electrical, hydraulics, aerospace, and other fluid power.

Furthermore, Eaton acquired nine businesses in 2007, for a combined net cash purchase price of $1,433 million. The majority of purchases were in Eaton's highest priority markets, aerospace and electrical power quality, in order to continue diversification into higher-growth sectors.^[5] Eaton continues to look for other acquisitions, stated Eaton CEO Alexander M. Cutler in a Dow Jones Newswires interview, because Europe and Asia are still underrepresented regions for Eaton.^[6]

Company Overview

Eaton Corporation is a global diversified industrial manufacturer of electrical systems and components for power distribution and control; fluid power systems for industrial, mobile and aircraft equipment; intelligent truck drivetrain systems; as well as automotive related components.^[7]

While ETN's operations used to be highly cyclical, its improved business model, comprised of a broader range of products and services, has led to less earnings volatility by exposing the company to more higher-growth markets, which garnered two-thirds of sales as of 2006.^[8] As of 2006, Eaton is building scale and breadth in each of its segments, in particular Electrical and Fluid Power. In fact, 2007 net sales were a record $13.0 billion, 7 percent more than those of 2006 while net income was also a record $994 million, 5 percent more than in 2006. Operating earnings per share rose to $6.90 in 2007, 8 percent higher than in 2006.^[9] These growth rates are attributed to three main factors. For instance, sales growth of 10 percent in the fourth quarter of '07 were gained through acquisitions (4%), higher exchange rates (4%), and organic growth (2%).^[10]

Net income over the years 2005-2007 were also related to the company's increased acquisition integration, incurring after-tax (acquisition integration) charges of $42 million for 2007 and $27 million for 2006.^[11]

Business and Financial Metrics

Source: ETN 2007 10-K^[12]

Eaton's net sales have steadily increased over the past 5 years (2002-2007) as a result of its operations diversification, especially into fluid, electricity, and general power while cutting back on its truck and automotive sectors in reaction to market conditions. The move away from its truck and automotive sector has proven to be beneficial, as 2007 business segment operating margin was a record 12.8 percent, with the Electrical and Fluid Power businesses representing over 65 percent of overall segment operating profit.^[13] In addition, it has made returns on its acquisitions each year, with 2007 sales growth of 3% over 2006 attributable to acquisitions of businesses.^[14]

Eaton posted higher first-quarter operating profits on April 14, 2008, with net income increase of 5.6% to $247 from a year earlier,^[15] and reaffirmed its FY 2008 expectations for a 25% sales increase and operating earnings of $7.80 to $8.30 per share (EPS) on May 28, 2008.^[16]

Source: ETN 2007 10-K^[17]

Business Segments

Source: ETN 2007 10-K^[18]

Eaton is a diversified, integrated operating company, with sales and revenue coming from five different business segments:

• Electrical (37% Revenue): Eaton is a manufacturer in power distribution and protection equipment, such as circuit breakers, panelboards, switchboards, busway, voltage switchgear, and fuses. ^[19] It provides electrical equipment to a range of customers, from custom industrial and commercial assemblies to simple, innovative residential components.^[20] The electrical business follows seasonal changes, where the business gets much stronger in the second, third, and fourth quarter. ^[21]

• Hydraulics (part of Fluid Power segment: 34% Revenue): Eaton designs, manufactures and markets hydraulic systems and components for use in earthmoving, agriculture, construction, mining, forestry, utility and material handling applications. ^[22] This sector includes Eaton's Filtration, Golf Grip and Airflex industrial clutch and brake businesses.^{[23] [24]}

• Aerospace (part of Fluid Power segment: 34% Revenue): Eaton makes advanced hydraulic systems, fuel systems, motion control systems, propulsion sub-systems and cockpit interface and circuit protection applications for commercial and military programs. Eaton provides hydraulic power generation and fuel system components on almost every commercial airline Airbus and Boeing aircraft fleet.^{[25] [26]}

• Truck (16% Revenue): Eaton works with fleet owners, freight companies and truck manufacturers globally to manufacture drivetrain and safety systems. Among its designs and manufacturers are: transmissions, clutches, collision warning systems, hybrid electric powertrain systems, etc. Its research and development goals are focused on fuel economy, safety, ease of operation, reliability and uptime.^[27]

• Automotive (13% Revenue): Eaton develops and designs automotive-related components and equipment to improve fuel efficiency, emissions, safety, and performance. Products include superchargers, engine valves and valve actuation systems, cylinder heads, slip differentials, mirror actuators, transmission controls, engine controls and fuel vapor components.^{[28] [29]}

Key Trends and Forces

Raw Materials Shortages or Commodity Price Increases Impact (Increase) Operating Costs

Eaton Corporation uses raw materials and components in its production process; thus, significant shortages or prices increases would raise operating costs and adversely impact the competitive position of Eaton products. It requires the most raw materials in the form of iron, steel, copper, nickel, aluminum, brass, silver, molybdenum, titanium, vanadium, rubber, plastic, and insulating materials. The company's 2007 gross profit was partially offset by the increase in prices of certain raw materials, supplies, and basic metals.^[30] Silver, for instance, had hovered around $13 during the first two quarters in 2007, but shot up to $21 by March 2008.^[31] Iron prices rose steeply through 2007 as well, from $76 to $132.2 during the period from 2006 to 2008.^[32] Steel saw approximate $50 increases (~25% increase) in heavy melt, shredded auto scrap, and index prices^[33] while nickel spiked mid-year 2007, from $15 to $24.^[34] These prices increased dramatically mostly due to raw materials supply shortages from increased global demand. Eaton CEO Alexander M. Cutler believes that high commodities and steel input prices are here to stay, as long as worldwide demand stays strong.^[35] In response, Eaton has continued to maintain appropriate levels of raw materials inventory ($674 million, or 45.4% of inventory)^[36] to hedge against basic metal shortages or fluctuating prices. ^[37][38]

Downturns in Eaton's End Markets Bring Uncertainty to Eaton's Operating Results

Unforeseen volatility in Eaton's end markets can lead to decreased operating margins. In the truck segment for instance, further declines in the North American commercial truck market, following a decline of 44% in North American heavy-duty truck market in 2007 (due to more stringent emission standards effective 2007^[39]), would adversely impact Eaton.^[40] Luckily, Eaton has taken measures to tamper this volatility through diversification of markets and geographic expansion.^[41] Furthermore, the increased calls for lowering emissions, fuel efficiency and environmental protection have increased demands for hybrid vehicles, fuel economy, and environmental safety, all of which Eaton is well positioned to handle. The question remains whether earnings in Eaton's expanding Electrical and Fluid Power businesses are be able to make up for the decline in the Truck and Automotive production in the coming years. The next emissions standard change is in 2010, a policy that promises to greatly reduce emissions.^[42]

Difficulties Arising in the Acquisitions and Joint Ventures Undertaken by Eaton

From 2005 to 2008, Eaton has aggressively sought to expand through strategic acquisitions and joint ventures, and plans to continue doing so in the future. In fact, the 5.6% rise in first quarter '08 net income was largely due to overseas acquisitions sales growth.^[43] Eaton needs to successfully identify, price, finance, and complete these transactions or arrangements, integrating them seamlessly into current operations.^[44] This leaves room for problems to crop up, especially during the integration phase, incurring higher than expected acquisition integration charges.

Competition

ETN is considered a diversified industrial company, especially after its 2006-2008 efforts to reduce the cyclicality of its truck and automotive businesses through diversification. In the diversified industrials group, Eaton faces many established competitors, such as United Technologies (UTX), Danaher (DHR), American Standard Companies (ASD), Rockwell Automation (ROK), Textron (TXT), and Cooper Industries (CBE)^[45].

• Johnson Controls (JCI) - Johnson Controls provides automotive interiors, products and systems that aim to optimize energy usage in buildings, automobile batteries, and hybrid electric cars. Johnson operates globally in three main businesses: building efficiency, automotive and power systems.^[46] Johnson's building efficiency sector competes directly with Eaton's Electrical sector.^[47]
• Honeywell International (HON) - Honeywell operates as a diversified technology and manufacturing company worldwide through four segments: Aerospace, Automation and Control, Specialty Materials, and Transportation Systems, offering products and services that overlap substantially with those of Eaton.^[48]. In July 2007, Honeywell completed the acquisitions of Enraf Holding B.V., of the oil and gas industry, and Dimensions International, a defense logistics business. In December 2007, it acquired Maxon Corporation, an industrial combustion business.^[49]
• Illinois Tool Works (ITW) - Illinois Tool Works is a worldwide manufacturer of engineered products and equipment, with 852 operations in 52 countries. These are organized into eight segments: Industrial Packaging, Power Systems & Electronics, Transportation, Construction Products, Food Equipment, Decorative Surfaces, polymers & Fluids and All Other. The operations serve end markets such as construction, general industrial, automotive, food institutional/restaurant and service, food and beverage, consumer durables, electronics, primary metals and others on a worldwide basis. In March 2008, the Company acquired VS Acquisition Holding Inc. In June 2008, the Company acquired Quipp, Inc.^[50]
• ITT Corporation (ITT) - ITT makes various engineered products and services in the US and internationally. Its focus is on three distinct segments as well. ITT's Fluid Technology sector designs, develops, produces, and markets fluid systems for residential, municipal, commercial industrial, and agricultural applications; its Defense Electronics and Services segment provides systems integration, communications, engineering and technical support services; Motion and Flow Control designs and manufactures products for communications, industrial, transportation, military/aerospace, and consumer markets.^[51] As of 2007, ITT is the world's largest supplier of pumps and systems to transport, treat and control fluids and is among the top 10 U.S. defense contractors.^[52]
• Parker-Hannifin (PH) - Parker-Hannifin is a full-line diversified manufacturer of motion control products, including fluid power systems, electromechanical controls and related components. The Company also is a producer of fluid purification, fluid and fuel control, process instrumentation, air conditioning, refrigeration, electromagnetic shielding and thermal management products and systems. Its operations are located in 35 states and 42 countries, and are not quite geographically diversified as ETN. Parker-Hannifin products are classified into three segments: Industrial, Aerospace, and Climate & Industrial Controls. In April 2008, the Company acquired Vansco Electronics and Ventrex Inc.^[53]

References

1. ↑ Seeking Alpha, "Eaton: Unappreciated New-Age Stock - Barron's," 6/1/08
2. ↑ Seeking Alpha, "Eaton Scores First for Industrials," 4/16/08
3. ↑ "Tougher Emission Norms to Dent 2007 Truck Market," 9/20/2006
4. ↑ ETN, 2007 10-K, Item 7: Highlights of Results for 2007, Page 56-57
5. ↑ ETN, 2007 10-K, Item 7: Highlights of Results for 2007, Page 57
6. ↑ The Wall Street Journal, "Eaton CEO: Open For Other Acquisitions Following Moeller Buy" 6/12/08
7. ↑ ETN, 2007 Annual Report, Item 1. Business, Page 3
8. ↑ ETN, 2007 10-K, Item 1A: Risk Factors, Page 6
9. ↑ Eaton Corporation News, "Eaton Reports Fourth Quarter Net Income Of $1.71 Per Share, Up 8 Percent," 1/22/08
10. ↑ Eaton Corporation News, "Eaton Reports Fourth Quarter Net Income Of $1.71 Per Share, Up 8 Percent," 1/22/08]
11. ↑ ETN, 2007 Annual Report, Item 7. Other Results of Operations, Page 63
12. ↑ ETN, 2007 10-K, Item 6: TEN-YEAR CONSOLIDATED FINANCIAL SUMMARY, Page 79
13. ↑ ETN, 2007 10-K, Item 7: Results of Operations - 2007 Compared to 2006, Page 62
14. ↑ ETN, 2007 10-K, Item 7: Results of Operations - 2007 Compared to 2006, Page 62
15. ↑ MarketWatch, "Earnings Watch: Updates, advisories and surprises" 4/14/2008
16. ↑ Reuters, Key Developments For Eaton Corp
17. ↑ ETN, 2007 10-K, Item 7: GEOGRAPHIC REGION INFORMATION, Page 56
18. ↑ ETN, 2007 10-K, BUSINESS SEGMENT INFORMATION, Page 54
19. ↑ "Electrical" 7/25/2008
20. ↑ Eaton Business Segments 7/2/08
21. ↑ Eaton Q1 FY08 Conference Call, Alexander M. Cutler - Chairman and Chief Executive Officer; President 4/14/08
22. ↑ "Hydraulics" 7/25/2008
23. ↑ Eaton Business Segments 7/2/08
24. ↑ Eaton Hydraulics 7/2/08
25. ↑ Eaton Business Segments 7/2/08
26. ↑ Eaton Aerospace 7/2/08
27. ↑ Eaton Business Segments 7/2/08
28. ↑ "Automotive" 7/25/2008
29. ↑ Eaton Business Segments 7/2/08
30. ↑ ETN, 2007 10-K, Results of Operations, Page 62
31. ↑ Findata: SI
32. ↑ Econ Stats: Iron Ore
33. ↑ Ohio Department of Transportation: Steel Price Index, 6/1/08
34. ↑ Kitco Base Metals
35. ↑ Eaton Q1 FY08 Conference Call, Alexander M. Cutler - Chairman and Chief Executive Officer; President 4/14/08
36. ↑ ETN, 2007 10-K, Other Information: Inventories, Page 54
37. ↑ ETN, 2007 10-K, INFORMATION CONCERNING EATON'S BUSINESS IN GENERAL, Page 5
38. ↑ ETN, 2007 10-K, Item 1A. Risk Factors, Page 7
39. ↑ [A. G. Edwards & Sons, Inc., "Eaton Corp: Equity Research Recent Development Report" 3/7/06, Page 15]
40. ↑ ETN, 2007 10-K, Item 7. HIGHLIGHTS OF RESULTS FOR 2007, Page 56
41. ↑ ETN, 2007 10-K, Item 1A. Risk Factors, Page 6
42. ↑ [A. G. Edwards & Sons, Inc., "Eaton Corp: Equity Research Recent Development Report" 3/7/06, Page 7]
43. ↑ The Wall Street Journal, "Eaton's Net Income Rises 5.6% On Acquisitions, Global Sales," 4/14/08
44. ↑ ETN, 2007 10-K, Item 1A. Risk Factors, Page 7
45. ↑ [Credit Suisse "Eaton Corporation" 1/17/06, Page 5]
46. ↑ Reuters, "Johnson Controls Inc. Company Profile: Full Description," 7/3/08
47. ↑ Reuters, "Eaton Corp. Company Profile: Full Description," 7/3/08
48. ↑ Reuters, "Honeywell International Inc.," 7/3/08
49. ↑ Reuters, "Honeywell International Inc. Company Profile: Full Description," 7/3/08
50. ↑ Google Finance: ITW Summary, 7/3/08
51. ↑ Yahoo Finance: ITT Corporation Profile "Business Summary" 7/3/08
52. ↑ ITT Corporation Home, "ITT at a Glance," 7/3/08
53. ↑ Google Finance: PH Summary, 7/3/08