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The most important takeaway in Eaton's (NYSE:ETN) third quarter 2013 results is the rebound in organic sales, which grew 3% year over year, from a decline of 2% in the previous quarter. Eaton was able to increase booking for its entire business segment, notably in its Hydraulics, Aerospace, and Electrical Products segments. One of my primary concerns in the third quarter was the declining sales of its hydraulics business, but the company has been taking initiatives to offset this decline.

Reorganization in distribution model

Eaton has designed a new channel partner model to improve its services in the hydraulic business across Europe, the Middle East and Africa, or EMEA, region. It has reorganized its EMEA partners in three different groups, Eaton Distribution Partners, Eaton System Partners, and Eaton Service Partners. Each of the channel partners is allotted a Primary Focus Area, or PFA. The PFA is a combination of product groups, territory or market segments, and customer categories. These channel partners will raise awareness about Eaton's portfolio of products to target more customers, and will ultimately benefit end-customers, as they will receive better support for Eaton's products.

(click to enlarge)The hydraulics segment had a difficult quarter, with revenue declining 3% year over year to $739 million in the third quarter of 2013, and operating profit decreased 1% year over year to $97 million. Meanwhile, operating margin improved by 30 basis points to 13.1%, as operating expenses decreased more than the revenue decline. Eaton expects the hydraulics market growth to be negative 6% in the U.S. and negative 5% outside the U.S. for 2013, mainly due to softness in the U.S. and Chinese construction equipment markets. However, Eaton has made several acquisitions in the last few years, including the acquisition of Cooper Industries and Chilean Electrical Manufacture last year, which will help the company achieve rapid growth in its product portfolio and geographical reach. With the help of the new distribution channel strategy, I expect the hydraulics business to return to growth in 2014.

Tapping Australian mining industry

Eaton has undertaken its largest acquisition of Cooper Industries in November last year, and it has been working to integrate it into its existing operations. It wants to leverage the latest technology of Cooper Industries to increase cost and energy efficiency, as well as improve safety at every stage of the mining operation in Australia. Due to the rising operating costs in Australia, mining companies are focusing on improving efficiency and maximizing productivity. Australia has been the biggest beneficiary of the Chinese commodities market boom in the last decade. Since China's economy is in a slowdown, mining activity is set to suffer from the ripple effect.

Australia's mining industry has increased from $24 billion in 2003 to $147 billion in 2012 due to rapid growth in iron ore and coal exports. Going forward, it is expected to grow at an annual growth rate of 4.3% through 2017 to reach $181 billion by 2017. There are signs of bright times ahead, as the U.S. market recovers and China's demand for metals grow due to the rise in urban migration.

Eaton will offer comprehensive service to mining companies to meet the demand for cost and energy efficient products. The acquisition of Cooper Industries has given Eaton a broad range of products and services, thus expanding its ability to cater to the varying needs of the customer from energy saving technology to safety. The Cooper Industries acquisition has significantly increased Eaton's sales exposure to new industries, and its synergies will continue to accelerate Eaton's future earnings growth.

Annual pre-tax synergies from Cooper Industries

(in million)

2013

2014

2015

2016

Sales Synergies

$10

$35

$70

$115

Cost Synergies

$105

$175

$280

$325

Total Synergies

$115

$210

$350

$440

What are competitors doing?

Eaton competitors ABB Ltd. (NYSE:ABB) and Siemens (SI) are also investing and providing service to energy and mining companies in Australia. On November 20, ABB signed a service agreement with QGC for maintenance for its LNG project in up and mid-stream facilities in Queensland, Australia. This project is the world's first coal-steam gas process to convert coal-steam gas to liquefied natural gas, or LNG. ABB will provide an on-site team to maintain automation and safety systems. The agreement also includes maintaining spare parts for upstream, liquefaction, and export for midstream.

This region holds importance for QGC, as it expands exploration and development in major areas of Queensland. In addition, Coal steam gas is a better substitute for coal, as coal steam emits 40% less carbon dioxide compared to coal. The contract with QGC is valued at $33 million for a four-year period, and ABB can extend it for ten years.

Meanwhile, Siemens is also planning to open a service center for repairs and maintenance for coalfields in Queensland. This center will be equipped with a 50 ton crane for serving over-sized equipment. The decline in commodity prices has put intense pressure on margins in mining operations. There is a greater demand for productivity improvements, as it is only way mining operators can control their cost, and this led Siemens to invest in this region. Siemen's service center is one of the few OEM workshops in the Bowen, Galilee, and Surat Basins region, and it will provide local mining operations with access to specialized engineering services, equipment, and spare parts.

Siemen's total orders in the Americas, Asia, and Australia have increased, but both segments' revenue declined in fiscal year 2013. Siemens expects fiscal year 2014 to be challenging, but recovery in businesses should happen in the second half of 2014.

Bottom-line

The primary concerns for Eaton were low vehicle sales growth and negative growth of its hydraulics business in the third quarter. Eaton has designed a new distribution channel to expand its presence and support services. I believe the hydraulics business is on the edge of positive sales growth as the industrial recession comes to an end. With the help of its biggest acquisition, Cooper Industries, Eaton can provide energy and cost efficient solutions to mining operations. I view the stock favorably due to bright the prospects for its hydraulics business, and belief that ETN could potentially achieve a higher growth as well as increased longer-term earnings.

Source: What Lies Ahead For Eaton?