The Fine Print on Eaton
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
On May 21, Eaton Corporation (NYSE: ETN) announced its plans to acquire Cooper Industries (NYSE: CBE) in a cash and stock deal. Since the announcement, Eaton shares fell nearly 10%. With the stock now yielding close to 4% and trading at a price to earnings multiple well below its five-year average (9.5x versus 16x historically), Eaton (more specifically, the new combined company) appears worth a closer look.
The new company, Eaton Global Plc, has many positive attributes. Eaton’s current leadership team, including CEO Sandy Cutler, will lead the new company, and the company’s current strategy of balance across geographies, the economic cycle, and businesses will guide the new company.
Not to be outdone, Cooper Industries brings much to the combined company as well. Eaton Global will get 49% of its sales from the United States, compared to 45% from Eaton Corp. This increase is largely welcomed at a time when investors are willing to pay up for domestic earnings. Moreover, Eaton’s percent of revenues from the less desirable developed international markets (e.g. Europe) will decrease 200 basis points.
Cutler’s operating and earnings projections are also enticing for the combined company. Cutler estimates $260 million in cost savings by 2016 and forecasts $0.55 in operating earnings per share accretion. With Cutler’s goal of 12-14% sales and 20% earnings growth by 2015, the stock is trading at a deep discount relative to growth. Moreover, considering that Cutler has historically exceeded his own guidance (he has raised earnings guidance twice this year from $4.10-$4.50 in January to $4.13-$4.53 in February to $4.23-$4.63 in April), I would not be surprised if these estimates proved conservative.
However, all is not perfect with the Eaton/Cooper deal. The new company will be incorporated in Ireland, resulting in both minor and major consequences for investors. Because Eaton will soon be an international company, some mutual funds whose charters prevent them from owning foreign companies will be forced to sell. It does not appear as though any of the largest fund holders are held to such a mandate, so I expect the forced selling to be insignificant.
Secondly, since Eaton will now be an Irish company, its stock may be more adversely affected by events in Europe. Although its revenue mix will actually be more favorable (i.e. less European based, more US based), I would not be surprised if the newly formed Eaton traded more like a European industrial and was more negatively impacted by European news.
Lastly, the most significant implication for most investors is the tax consequences associated with owning a foreign company. The attractiveness of Eaton’s nearly 4% yield is mitigated by the fact that Ireland will take 20% of it in taxes, leaving the investor with an after-tax yield of 3.2%. Although investors owning the stock in taxable accounts can recoup the lost 20% with some extra paper work during tax season, the same benefit does not exist for those owning the stock in a tax-advantaged account. Moreover, the tax complications involved with owning a foreign security may cause some investors to sell rather than meet with a tax professional (note: now is a good time to mention I’m not a tax expert and you should consult a tax professional before investing based on the information above).
Although, the soon-to-be Eaton Global appeals to me as an investor on many metrics (corporate governance, growth, valuation), the decision to incorporate in Ireland reduces the company’s dividend to the point where it is no longer a must-own for my tax-advantaged account.
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