Source: Company Reports, Vertical Research Partners and Bloomberg Consensus 

Source: Vertical Research Partners

Top Notch Company with Fully Charged Valuation

We are Initiating coverage of Eaton Corporation with a Hold rating. Eaton (ETN) is a $12 billion company on 2010 revenues that reports in six segments including Electrical Americas, Electrical Rest of the World, Hydraulics, Aerospace, Truck and Automotive.  The company operates globally with 47% of its revenue generated outside of the U.S.  ETN employs approximately 70,000 people in more than 50 countries and sells products in over 150 countries.

Source: Vertical Research Partners

Eaton is a strong operating company that has methodically improved its portfolio and upped its performance.  The growth of its Electrical businesses as a percentage of the portfolio reduces volatility and supports a valuation framework above where the stock has historically traded.  However, the portfolio remains volatile and the stock has recently surged on the upside of that volatility as the Truck business rebounds from losses in 2009 and Automotive rebounds from near break even.  Collectively those 2 businesses experienced a profit drop of $562mm or roughly $3.30/share from 2007 to 2009.  The stock has now rebound strongly on the leverage created by the robust recovery in those businesses.  While we see a secular case for further operational improvement, the stock is now fairly valued versus Electrical and Diversified peers.

Portfolio Has Transitioned Toward Electrical

Eaton has dramatically altered its portfolio over the last 10 years, building on it legacy Cutler-Hammer electrical franchise to create a diversified global Electrical business.  The company is now a leader in global power quality markets competing against Emerson and Schneider.

Source: Vertical Research Partners

ETN’s Short/Mid Cycle Exposure Set Stage for Revenue Growth

While ETN is experiencing a recovery in its short and mid cycle businesses management recognizes this is not a typical recovery and economic growth may be slower than normal.  Despite this, ETN’s goal is to grow sales at more than three times global GDP growth over the next five years.  Estimated global GDP growth over the next five years is estimated at 3.5%.  This implies ETN will target sales growth of 12-14% over the same period.  The company plans on achieving this strong growth target by expanding its presence in developing markets, M&A, innovation to penetrate new markets and higher core growth.

Historically, ETN’s core revenue growth was

4%. However in 2009 core revenue reached 5% and appears to be accelerating off of what looks to be trough.  Through three quarters of 2010 organic revenue growth was 5.6% in Q110, 16.3% in Q210 and 17.7% in Q310.  Clearly much of the acceleration is cyclical, but there is also a secular underpinning to growth in Electrical and Aero markets. The company has stated that 2009-2014 core revenue growth should average 7%.  We expect strong core revenue growth in Q410 and Q111 as the last of the easy comparisons lapse and economic activity continues to improve.  From that point on, it will be much clearer if ETN is succeeding in accelerating its core growth because purely cyclical forces will be of reduced importance.

Figure 4: ETN Long Term Revenue Water Fall 

Source: Eaton Estimates

ETN is also investing in R&D to drive innovation and increase sales by entering new markets.  For example ETN has invested and developed new products to expand into Wind and Solar as well as products for energy conservation and services.  The company has developed electrical nacelle components and gearbox substitutes as well as space saving, cost effective switchgear for the Wind Power market which is expected to grow 20-25% on a secular basis (although near term the business is under severe pressure).  On the solar power side, ETN has developed commercial/utility scale photovoltaic inverters and other products for this business which is estimated to grow 25-35%.  On the Industrial side of the portfolio, ETN has been developing new products for the hybrid vehicle market.  This market is expected to grow 50-60%.

ETN is also looking to developing economies to help it reach its core growth targets.  The revenue CAGR for ETN in developing economies from 2002 to 2009 was 24%.  In 2009, approximately 22% of ETN’s sales came from developing economies.  ETN’s goal is to increase sales to developing economies from 22% in 2009 to 30% by 2014.

Source: Vertical Research Partners

Eaton Targets – Aiming High 

Eaton (ETN) has historically stated that it can grow revenue 10% per year.  This consisted of 4% end market growth, 2% of market outgrowth and approximately 4% from acquisitions.  However as mentioned above, ETN is now guiding 12-14% annual revenue growth over the next five years.  This new target assumes market growth of 7% from 2009-2014, growth from innovation and new market entry of 1.5%, growth from developing economies of 1.5% and 2-4% from acquisitions.  On the margin side, ETN believes operating margins will exceed the prior peak margin of 12.8% by 200bps in the next cycle.  Approximately, 120bps of this margin expansion will be driven by a greater focus in more profitable businesses, which will positively impact mix as well as leverage on higher volumes.  The remaining 80 bps of the margin improvement will come from a more efficient cost structure and integration and synergies from acquisitions.  During 2009 and 2010, restructuring benefits contributed $0.30 per share in each year.  Operating EPS should surpass the prior peak of $6.50 in 2011.  Lastly, ETN believes it can generate approximately $2 billion of free cash flow by 2014.

Over $10 EPS in 2014? Maybe 2013

If we assume revenue grows at 13%, which is the mid-point of the range, through 2014 and margins expand 200 bps above the prior peak to 14.8% we see the potential for more than $10 of EPS in 2014.  If we apply the historical 10 year forward P/E of

15x multiple to our estimated 2014 EPS of $10.45, we arrive at a value of $157.  If we discount this value back 3 years using a 10% discount rate we arrive at a present value of $114, which is basically in line with our $112 target.  We actually see the potential for ETN to reach $10 by 2013 and if that’s the case the stock still has good upside from here.  As mentioned above, ETN will generate

$2 billion of free cash flow by 2014.  Our analysis does not assume any share repurchase or M&A.

Figure 6: Potential ETN Valuation Based on Provided Targets

Source: Vertical Research Partners

Restructuring

Through a shift toward a more profitable business mix, greater exposure to international markets as well as volume leverage, ETN believes operating margin can expand at least 200bps above its prior peak.  Restructuring benefits are estimated to contribute 80bps plus to the 200bps of margin expansion.  ETN targeted $140mm of restructuring benefits for 2010 from 2009 restructuring actions.  The remaining 120bps plus of margin expansion over the prior peak will come from better mix and volume leverage.

Eaton Business Systems – EBS

The Eaton Business System (EBS) is a lean/six sigma type program that permeates the company.  EBS drives ETN’s ability to consistently outgrow its markets and achieve operational excellence.  ETN’s EBS starts at Eaton University where employees acquire the tool necessary to deploy best practice concepts and develop prescriptive processes that are continuously assessed across the businesses.  This helped ETN generate record free cash flow in 2009 by managing working capital efficiently.  EBS helped ETN capture planned synergies in the Moeller and Phoenixtec acquisitions.

Pension – Headwind Muted by Year End Move in Rates and Equities

The discount rate for ETN as of Q310 was hovering around 5%-5.25% which represents a 75-100bps decline in the discount rate versus the same period a year ago. As we closed out 2010, discount rates have increased suggesting the 2011 pension headwind may not be as material as previously thought.   A 25bps move in the discount rate increases ETN’s pension expense by

$9mm.  Indices of AA and AAA corporate bonds finished the year only 18bps and 24bps lower than last year, respectively.  While there are other variables, the snap back in yields and strong equity market performance suggest Eaton’s pension headwind should be fairly minimal in 2011.  Currently, ETN is considering whether to make an additional contribution in 2011, although the 2010 10K states that ETN is not required to make a pension contribution in 2011.  We assume it chooses not to make a contribution, because the favorable interest rate and return dynamic at year end would have substantially reduced pressure on funded status.  At the end of 2009 the company had a $1.6 billion pension deficit.  We expect this will have narrowed slightly on at year end 2010 given the 2010 contribution and the favorable change in other inputs.

Low Tax Rate Often a Point of Debate.  It’s Valuable If Sustainable.

Eaton has a low tax rate relative to our coverage list.  The final 2010 rate is expected to come in at 12%, which is even lower than our 3 foreign domiciled companies (IR, CBE and TYC).  Eaton attributes its tax rate to business mix, excellent planning/structure and management incentives.  First, on mix, 55% of profits are now generated outside the U.S. up from 5% in 2000.  Currently 2/3rds of Eaton employees are outside the U.S. The average tax rate where Eaton operates offshore is 15-20%.  Taxes in the U.S. are held down by deductions for corporate expense, interest and pension.  On the planning side, Eaton has special agreements in place in many foreign jurisdictions that run 15-25 years.  Finally, the profit component (other components include cash and revenue growth) of operating management incentives are measured on an after tax basis.  This is a fairly unique approach.  It is much more typical to see profit incentives aligned on operating profit or some similar metric.

Figure 7: Eaton Has the Lowest Tax Rate in our Group — 2011 Estimates 

Eaton has operational tax people embedded in all businesses.  More typically, this would just be a corporate function at most companies. Eaton’s approach causes business leaders to think about their operations holistically, with one eye on optimizing where and how acquisitions are purchased and integrated.  The same focus comes to bear when considering capital expenditures, where to deploy R&D, plant locations, etc. Putting all these factors together, management sees its natural tax rate in the range of 15-18%. The lower 12% level in 2010 reflects the still relatively depressed level of profits.  We are estimating a 16% tax rate in 2011 due to higher U.S. earnings.

Source: Vertical Research Partners

Investors often want to look at Eaton on some kind of adjusted fully taxed P/E. While we understand the thought process, Eaton is already fully taxed at its current rate if its structures are sustainable.  Given Eaton’s long term success with tax rates we have to conclude they are largely sustainable.  That said, we augment our valuation approach on Eaton (and our entire group) with EBITDA, FCF and other metrics and in so doing it does not look as inexpensive.  A lower tax rate has economic value because it improves cash flow.  However, even allowing for that benefit Eaton’s FCF/Sales is solid, but below average relative to our coverage list.

ETN Valuation Full Relative to History/Peers

ETN is currently trading at 11.7X on a trailing EV/EBITDA basis using Baseline consensus data.  The 10 year median EV/EBITDA is 8.4X.  Many of the economic factors that impact ETN’s businesses such as residential construction, non-residential construction, aerospace, truck and auto markets are recovering and barring a double dip recession will continue to improve going forward.  However, relative to our Electrical Equipment/Multi-Industry (EE/MI) group, ETN is currently trading at a premium. Given the similar strong recovery at other companies in our group, on a relative basis Eaton looks ahead of itself.

Full Value on Sum of the Parts