Don't Underestimate Eaton

By Ashish Sharma - August 24, 2012 | Tickers: CBE, CMI, ETN, HON | 0 Comments

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Last month, Eaton Corporation (NYSE: ETN) reported 2Q12 earnings which were below expectations given weakness in China and Europe, as well as FX headwinds.  Operating EPS was $1.15 vs. consensus estimates of $1.09. On a business unit basis, Electrical Americas offset softening in Electrical Rest of World and the Industrial businesses also showed some weakness.  I believe that investors should remain focused on the pending transformational Cooper Industries (NYSE: CBE) deal. Despite the near-medium term headwinds and the fairly high price for Cooper, I believe that Eaton’s fundamental undervaluation at this level provides opportunity for investors to buy a solid industrial stock at a discount price.

EPS growth over the next several years should be supported by likely growth in non-residential construction, commercial aerospace, Hydraulics and Automotive despite getting little offset by Truck and Automotive segment.

Electrical Americas – 27% of Revenue

Sales of $1.1B grew 10% YoY and operating margin of 16.9% was higher than 1Q12 at 15.0%. I believe that the strong improvement in margins was primarily driven by improved volume of high margin technology products. The performance of the Electrical- Americas business is important given it is a later cycle business segment to which most Machinery peers do not have comparable exposure; and most of the pending Cooper acquisition revenue will be additive to this segment.

Electrical ROW – 18% of Revenue

Sales of $683M fell 13.0% YoY and operating margin of 8.1% declined from 8.3% last quarter.  Eaton should not expect an uptick in non-US markets as Europe appears to have flattened, while expectations are that China will not recover until early ’13. I expect that FX will continue to be a headwind in the near term and weakness in this segment is expected to persist for the foreseeable future.

Hydraulics – 18% of revenue

Sales grew 6.0% YoY and operating margin of 16.4% was higher than Q1 at 15.0%.  I believe that there are several factors which are likely to benefit this segment during 2H12 including:-

• The end of start-up cost at a new hydraulic point in China
• Recently closed two hydraulic acquisitions
• Potentially lower material input cost.

Since the beginning of April, the three primary crop prices have performed as follows: Corn (+11.6%), Soy Bean (+11.0%) and Wheat (+27.7%). I expect that U.S. net farm income will decline in 2012 given moves in key crop prices. However, I believe the real driver for this piece of the business is the cycle in India and Brazil. I expect a shift toward products that have increased hydraulic content to drive growth in coming years.

Truck – 16% of revenue

Sales declined 7.0% YoY and operating margin of 19.2% grew from Q1 at 18.4. Eaton has revised its NAFTA Class 8 production lower from 300K to 285K units, with the majority of decline to take place in 2H12. While uncertainty will continue relative to Eaton’s near term Truck outlook, I believe Truck revenue push out this year will be recovered in 2013. Even Cummins (NYSE: CMI) hasn't sounded too optimistic about a big near-term improvement in trucks, but that may not be as bad for Eaton as there is an aftermarket component to their trucks business.

Recently, key regulatory hurdles in the acquisition of Cooper industries have been cleared. Last month, Cooper Industries reported EPS of $1.17; 5.5% organic revenue growth and an adjusted 16.8% operating margin.  I expect Cooper, with a solid management team; strong business diversity and an attractive valuation will be solidly accretive to EPS by late 2013 and to free cash flow upon deal closure in late this year. Further, I believe that the acquisition will be 5-7% accretive in FY14.

I am optimistic about Eaton’s fundamentals and growth outlook. I believe the stock will increasingly become attractive to longer-term investors given  removal of most of downside risks to near-term earnings expectations; improving demand trends for Electrical-Americas and other late cycle business segment; strong dividend yield of approximately 3.3%; and a potential for longer-term valuation multiple expansion due to the Cooper acquisition. Eaton is trading with a forward PE of 9.64 and the company is expected to post EPS growth of 11.5% in FY13. It is trading at a discount its multi industry peers which are expected to post relatively slower growth. For example, Honeywell (NYSE: HON) is trading at a higher forward PE of 11.90 whereas its expected FY13 EPS growth of 10.8% is relatively less. Moreover, Eaton provides better dividend yield as compared to Honeywell’s 2.6%. Thus, I believe the company is undervalued and investors are underestimating the company’s ability to grow revenues through the cycle. Hence, I believe the recent weakness in Eaton shares presents an opportunity to acquire shares of this solid industrial stock at a value price.

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