Eaton Corp Flies On Increased Aerospace Activity (ETN)

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by: Asif Suria

The world of commercial aircraft suppliers is almost a duopoly with Boeing (NYSE:BA) and Airbus competing fiercely for orders. Looking at the state of airline companies in the United States with United declaring bankruptcy and even Jet Blue (NASDAQ:JBLU) declaring a quarterly loss, one has to wonder how good the demand for commercial aircraft is going to be in the coming years.

While the airline industry in the US is mature and reeling under the effects of high oil prices, air travel in countries like China and India is booming. Airlines from these countries and other developing nations are placing a record number of orders for new planes and this trend is likely to continue for years to come. Boeing (BA) has been very successful in wooing large orders over the last few months thanks to the launch of the new 787 Dreamliner and you can view an updated list of 2006 Boeing orders here. The president of China on a recent visit to the United States decided to visit the Boeing factory in Everett, Washington as China plans to buy as many as 2,000 planes from Boeing over the next 15 years.

Based on these orders, I started digging for companies that supply aircraft parts to Boeing. The ideal scenario would be to find a small public company that derives a large part of its revenue through the sale of aircraft parts. This is referred to by investors as a "pure play" company and holds the prospects for excellent returns if the company has not already been discovered. It would be even better if this company were to supply aircraft parts to both Boeing and Airbus.

Finding such a company proved to be a daunting task because Boeing sources its parts from several international suppliers that are not listed on the US stock exchanges or from Boeing subsidiaries. It also appears that like Walmart, Boeing puts pressure on its small suppliers to get the best pricing and this affects their margins. After looking at dozens of public companies, I finally decided on Eaton Corporation (NYSE:ETN) as it is a large company that supplies important aircraft parts to both Boeing and Airbus and has an attractive current valuation. Eaton in partnership with Hamilton Sundstrand won two contracts to supply electrical contactors and hydraulic pumps for the Boeing 787.

With 59,000 employees and customers in over 125 countries, Eaton is truly a diversified industrial company. The four primary business divisions of Eaton include electrical, automotive, fluid power and trucking. Ranked number 227 on the Fortune 500 list, Eaton had 2005 sales of $11.1 billion and reported profits of $805 million, up 24.2% from a year earlier. Eaton recently released first quarter 2006 results with both sales and net profits coming in at 14% above the year ago period and 7 cents per share above analyst expectations. Eaton also increased its full year 2006 forecast to a range of $5.90 to $6.20 per share.

From a valuation perspective, Eaton looks very attractive with a P/E of 14.19, a forward P/E of 12.07 and a Price/Sales of 0.99. The 1.8% dividend yield is in line with the average dividend yield of the S&P 500. The main cause for concern with Eaton is its leveraged balance sheet which carries $2.46 billion in short, current and long term debt when compared to just $336 million in cash and short-term investments. However Eaton is a profitable company generating a profit of $208 million on revenue of $3.01 billion in the first quarter of 2006. A downturn in the economy or a recession is another key risk faced by Eaton on account of the industrial nature of its business.

Eaton is just one example of this long-term theme of increased activity in the aerospace sector and there are many ways to benefit from this theme. Investors could also invest in aluminum producing companies like Alcoa (NYSE:AA) or Alcan (NYSE:AL), invest in airline stocks in emerging countries (if they have access to local markets or the ADRs are listed on the NYSE) or invest in other companies in the aerospace sector. Some of these companies are listed in the "competitors" section below.

Competitors:

Eaton Corp faces competition from other diversified industrial conglomerates like Danaher (NYSE:DHR), United Technologies (NYSE:UTX), Emerson (NYSE:EMR) and Parker-Hannifin (NYSE:PH). I held a position in Danaher (DHR) for a short period of time in 2001 and have often wished that I had held on to the stock longer as it has appreciated more than 100% in the last five years. If you were to consider just the aerospace division, competitors would include Moog Inc (MOGA), Woodward Governor Company (NASDAQ:WGOV), Astronics Corporation (NASDAQ:ATRO) and Crane Co (NYSE:CR).

The Good:

* Eaton sports an attractive valuation with a forward P/E of 12.07 and a Price/Sales of 0.99.
* Eaton recently reported results that were better than analyst estimates and also raised guidance for 2006.
* Eaton designed a hybrid electric powertrain that is currently used in some FedEx (NYSE:FDX) delivery trucks and could gain widespread adoption in the future.

The Bad:

* Eaton's automotive business could be impacted by eroding market share at Ford (NYSE:F) and General Motors (NYSE:GM). However Eaton also counts many other automotive companies amongst its customers and was recently recognized by Honda as an "outstanding" supplier.
* The balance sheet has $2.46 billion in short, current and long term debt.
* Inventory rose by 5.28% to $1.16 billion when compared to the preceding quarter.


The Numbers:
  • P/S 0.99
  • Cash $110 Million
  • P/E 14.19
  • Long Term Debt $1.83 Billion

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