Will Eaton Continue Its Shopping Spree to Keep Up with Earnings?

Berkshire’s (BRK.A) latest 13-F reveals a new position of 2.9 million shares in Eaton Corp (ETN). This is a small stake when compared to Berkshire's other purchases. As George from Fat Pitch Financials mentions, the question remains as to whether this is a Buffett pick or from a subsidiary.

Eaton is a company I briefly looked at in late 2007 when it was trading in the $80s; I thought I’d take a quick review to see the status of the company today.

Business Summary

The company is a diversified industrial manufacturer and operates in 4 business segments.

1. Electrical - electrical systems and components for power quality, distribution and control
2. Hydraulics - fluid power systems and services for industrial, mobile and aircraft equipment
3. Aerospace - intelligent truck drivetrain systems for safety and fuel economy
4. Automotive - automotive engine air management systems, powertrain solutions and specialty controls for performance, fuel economy and safety.

The great thing about ETN is that it is a highly diversified company with business all over the world, not just U.S. dependent.

Valuation

From a numbers point of view, Eaton is a very solid company. Since 2001, ETN has improved and made progress in its operations.

• Gross, operating, net margins are stable at around 27%, 9%, 7% respectively
• Book value has been increasing at a good pace
• Throws off positive FCF for the past 10 years, although it has reduced during 2007 and 2008
• Cash is generated from its core business rather than other businesses
• The median CROIC for the past 10 years has been at 9%, ROE at constant 17%, ROA at 6%
• Excellent inventory turnover at 7.0

Take a look at the below images to see what I mean. [click to enlarge]

The numbers point to a capable management team who understands its business. The cash generation of the business can also support the current dividend yield of 4.7% along with a history of increasing dividends.

I’ve applied a 15% discount rate due to rising inflation and my strong preference for present day dollars as to future cash. This is ever more true in this environment. A growth rate of 6% yields a share value of around $77 with the buy price set at $38.

Potential Warnings Signs

If it wasn’t for the recent acquisition spree and debt levels, I would probably have bought some shares already, but upon further analysis, the quality of earnings isn’t as high as I anticipated.

Within a 2 year timeframe starting Feb 2007, Eaton has made 14 acquisitions with the latest on Oct 2, 2008. I like growth, but not through so many acquisitions.

Sales growth of 25% in the third quarter of 2008 over the third quarter of 2007 consisted of 19% from acquisitions of businesses within the last year, 4% from organic growth, and 2% from foreign exchange.

The question is, will Eaton continue to eat companies in order to gain market share and keep up with earnings in the future?

Due to all the acquisitions, Eaton’s long term debt has ballooned to just under $3 billion along with $5.9 billion in goodwill and $1.9 billion in intangibles. Although Eaton should be able to meet its obligations, I’ll prefer to be cautious and wait to see how the acquisitions impact the business and whether they were worth overpaying for. With a “significant slowdown” expected over the coming year, watching for another quarter or two may be a good idea.

Although it is getting close to the buy price, I think I will just keep an eye on ETN for now.

Disclosure: No positions of any stocks held at time of writing.

Comments

[Michael Brisky:]

Nice analysis of Eaton. Interest in the stock has seems to jump a bit due to the Berkshire disclosure. Good point about the fact that it may not even be Buffett buying. I saw an interview with him recently where they asked him about Berkshire selling stakes in BAC, HD, and LOW. He said anytime there are smaller stakes in stocks (which the Eaton stake is), it often isn't him. Quality appears to be there, but they have taken on some added debt, and the exposure to autos is a question mark as well. But, the stock is getting pretty cheap.

2008 Nov 22 11:58 AM

[User 323325:]

What I like about Eaton is the fact that some divisions are doing record buisness and posting record proffits. Plus a good dividend is still expected this year, a little less but still very good. As a footnote I see ETN at the $70.00 within twelve months.

2008 Dec 20 12:06 PM