Eaton Corporation (ETN): New Analyst Report from Zacks Equity Research - Zacks Equity Research Report

Summary:
We are upgrading our recommendation on Eaton Corporation plc to Neutral from Underperform, primarily on its globally expanded operations, realization of synergies from the acquired assets and focus on introduction of new products through steady research and development activities. Synergy from the acquisition of Cooper Industries plc’s assets also remains attractive. However, slower recovery in non U.S markets and operational risks might deter growth. Eaton’s third-quarter 2014 earnings per share surpassed the Zacks Consensus Estimate and improved year over year primarily on the heels of strong bookings at the Electrical and Aerospace segments.

Overview:

Dublin, Ireland-based Eaton Corporation plc is a diversified power management company and a global technology leader in electrical components and systems for power quality, distribution and control hydraulics components, systems and services for industrial and mobile equipment aerospace fuel, hydraulics and pneumatic systems for commercial and military use and truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety. The company sells its products to customers in more than 175 countries and has approximately 102,000 employees. The company locked sales of $22.04 billion in 2013, the majority of which came from U.S. operations.

Source: Company

In Nov 2012, the company completed the acquisition of Cooper for a total consideration of $13.19 billion. The purchase consideration included cash worth $6.54 billion and Eaton’s shares worth $6.65 billion. In addition, to Cooper, the company also made a few other strategic acquisitions in 2012.

As a consequence of the company’s reorganization of businesses effective 2013, Eaton’s reportable segments are Electrical Products and Electrical Systems and Services (which include the legacy Eaton and Cooper electrical businesses), Hydraulics, Aerospace and Vehicle (which includes truck and automotive drivetrain and powertrain systems businesses).

Electrical Products and Electrical Systems and Services: This segment consists of electrical components, industrial controls, residential products, single phase power quality, emergency lighting, fire detection, wiring devices, structural support systems, circuit protection, and lighting products. The Electrical Systems and Services segment consists of power distribution and assemblies, three phase power quality, hazardous duty electrical equipment, intrinsically safe explosion-proof instrumentation, utility power distribution, power reliability equipment and services.

Vehicle: This segment includes the company’s erstwhile truck and automotive segments. The truck segment designs, manufactures and markets powertrain systems and other components for commercial vehicle markets. The automotive segment produces superchargers, engine valves, valve train components, cylinder heads, locking and limited-slip differentials, fuel, emissions, and safety controls, transmission and engine controls, spoilers, exterior moldings, plastic components and fluid connectors.

Hydraulics: The Hydraulics segment manufactures and markets a comprehensive line of reliable, high-efficiency hydraulic systems and components. The customers for the Hydraulics segment include oil and gas, renewable energy, marine, agriculture, construction, mining, forestry, utility, material handling, truck and bus, machine tools, molding, primary metals and power generation.

Aerospace: This segment is a supplier of aerospace fuel, hydraulics and pneumatic systems for commercial and military use.

Source: Company

Eaton has gradually transformed itself from an automotive and truck component manufacturer into a diversified industrial enterprise occupying leading positions in its core electrical, hydraulic and aerospace market segments.

REASON TO BUY

Eaton operates in a number of markets and faces a wide array of competitors in varied niches. The company produces everything from cockpit controls to hydraulic pumps and therefore, direct comparisons with other companies are difficult. The quality of the products supplied by the company enables it to retain a strong position in the markets of operation. In addition, Eaton’s strategic acquisitions allow it to penetrate new markets and enhance its revenue stream. The most significant acquisition is that of Cooper Industries plc and a strong performance from this acquired asset prompted Eaton to revise its operational synergy forecast. The company’s synergies from the Cooper Industries acquisition remain on track at $210 million for 2014, up around $95 million from the 2013 synergies. In 2015, the company is expected to generate incremental synergies of $150 million from the aforesaid acquisition.

Eaton had previously completed several strategic acquisitions, including Rolec Comercial e Industrial S.A., Jeil Hydraulics Co., Ltd. and Polimer Kaucuk Sanayi ve Pazarlama A.S. These acquisitions have enabled the company to enhance its product portfolio and realize synergies.

Eaton supplies its products to around 175 countries and most importantly none of its customers accounted for more than 10% of its sales in the past three years. This in a sense provides stability to the revenue generation ability of the company, as loss of any customer will not have any significant impact on revenues and margins. Moreover, their diversified product portfolios helps serve a wide customer base providing them with energy efficient solutions.

Eaton has been investing consistently in its research and development (R&D) programs, to introduce new products, including power management solutions which will reduce energy consumption and carbon emissions, and upgrade existing systems to maintain its strong position in the global markets. The company’s R&D expenses during the third-quarter 2014 stood at $163 million. In 2013, Eaton had invested $644 million in R&D activities, marking a 46.7% increase from the prior year.

At the recent 2014 Mid-Atlantic Joint Engineer Training Symposium, Eaton demonstrated a series of products and services to improve energy security, competence and reliability. In Oct 2014, the company unveiled a new set of stacklight solutions, which have the capacity to improve control over important procedures and boost machine availability. Eaton continues to work on the Design for Environment standards to diminish the environmental impact of the products.

Source: Company

In addition to investments in the R&D activities, Eaton takes several initiatives, including the payment of regular dividends and effective share repurchase programs to increase shareholder value. The company has been paying dividends since 1923. In the first nine months of 2014, Eaton paid $700 million as cash dividend, which was 17.3% higher than the year-ago payout.

Eaton also repurchased 3.4 million ordinary shares of its common stock for $225 million during the third quarter, under an ordinary share repurchase program. Year to date, the company had repurchased a total of 4.8 million ordinary shares. In Apr 2013, board of directors of the company had approved a share buyback program to repurchase 40 million ordinary shares. This initiative will enable Eaton to improve its margins, going forward.

Eaton continues to generate a stable cash inflow through its proficient operating activities. During the first nine months of 2014, the company’s operating cash flow stood at around $0.93 billion. In 2013, it had increased 37.3% to roughly $2.29 billion from $1.66 billion a year-ago. In addition to utilizing funds in growth ventures and several other activities, a strong cash generating capacity supports the company’s systematic debt reduction initiatives. As of Sep 30, 2014, the company’s long-term debt decreased 4.3% to $8.59 billion from 2013 end. Long-term debt as of Dec 31, 2013 was $8.97 billion compared with $9.77 billion a year-ago. The decline in debt balance lowered interest expenses by 11.1% at the end of the third quarter from the year-ago level. Reduction of debts backed by strong cash generating capacity allows the company to improve its margins going forward.

REASON TO SELL

Eaton utilizes a variety of raw materials and components in its businesses and has to depend on others for the consistent supply of raw materials. So, any significant shortage, price increase, or supplier insolvencies could increase operating costs and adversely impact Eaton’s competitive position. Rising logistics cost, which impacted second-quarter results, is expected to continue in the second half of the year and affect margins.

Eaton operates in nearly 175 countries and has manufacturing facilities worldwide. This definitely enhances the revenue stream of the company but at the same time exposes it to disruptions like natural disaster, labor strike, war, political unrest, terrorist activity and economic upheaval. Such disturbances could delay shipments and result in cancellation of orders. In addition, the presence of its manufacturing facilities in different geographies subjects Eaton to litigation and environmental regulations. So, the volatility in its end markets could adversely impact the company’s businesses, financial condition or results of operations.

Economic conditions in some of the countries outside the U.S. in which Eaton has a presence are yet to stabilize. Since Eaton generates nearly 50% of its revenues from operations outside the U.S., this softness might have an impact on its global revenue generation. During the third-quarter earnings call, Eaton projected overall market to expand by 2% in 2014, lower than previous projection of 3%. Growth from the U.S. market is estimated at around 2% while the rest of the world will grow 1%.

To conduct its business in an efficient manner, the company depends on its information technology network. These technology networks and systems may be susceptible to damage, disruptions or shutdowns due to failures during the process of upgrading or replacing software, databases or components power outages hardware failures or computer viruses. In addition, cyber attacks and security breaches could impact the operations of the company affecting the financial performance.

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