Eaton Corporation: Current Price Offers A Good Entry Point

May. 7.14 | About: Eaton Corp. (ETN)

Summary

Eaton Corporation topped analysts’ estimates by reporting a rise in first quarter profits.

Forecasts provided for the second quarter were somewhat disappointing and caused the share price to decline.

Eaton is expected to undergo some restructuring to enable its business to run smoothly despite uncertain economic situations due to the crisis in Ukraine and slowed growth in China.

Eaton Corporation (NYSE:ETN) sells products across consumer and industrial markets including hydraulics for construction equipment, auto parts lighting for homes and buildings and electrical goods. This gives the company a wide range of opportunities for economic growth. The company reported its first quarter results at the end of April 2014. By virtue of net earnings, Eaton managed to beat analysts' estimates but the forecast reported by the company for the second quarter appeared disappointing as it lagged behind what analysts were expecting. This article will try to ascertain what investors' stance should be depending on the company's current financial situation and its road ahead.

Latest Quarter Results

In the latest quarter Eaton earned a 16% rise in its income year over year. Eaton reported a profit of $439 million or 92 cents per share up from $378 million or 80 cents per share a year earlier. Excluding acquisition charges and other items, per share operating earnings increased 20% from 84 cents to $1.01. Thus the company managed to marginally beat its own projection of $1 operating earnings per share (on average). However, this rise was due to lower than expected costs during the quarter because the company generated revenues of $5.49 billion during the quarter that reflected a 3.4% increase year over year. The revenue increase met analysts' expectations as polled by Thomson Reuters. The recent acquisition of Cooper Industries, an electric gear maker, also contributed to the rise in the top and bottom lines of the company.

Source: Eaton Earnings Release

The graph above portrays the segment-wise performance of Eaton Corporation. According to the graph three of the company's segments achieved growth in terms of margins while the rest experienced declines in their margins. The Aerospace segment recorded negative margin growth but its outlook is positive since during the quarter bookings were up 2% and aftermarket orders were up 15%. Moreover the company is divesting two of its aerospace businesses during the second quarter of this fiscal year. This would allow the company to focus on high profit generating segments. The hydraulics segment also experienced 9% higher bookings during the first quarter of this year leveraged by the construction OEM (original equipment manufacturer) activity in the USA and Europe. Sales from electrical services and custom designed electrical systems for buildings were up 0.2% to $1.52 billion but the bookings for the segment were down 6%. This segment's performance was also negatively affected by the weather and weakness in the US and Canadian markets.

The Road Ahead

For the second quarter of 2014 Eaton provided projections that lagged behind analysts' expectations. According to the company the operating earnings per share will fall in the range of $1.05-$1.15 while analysts had estimated the same metric to be $1.29 for the quarter. However, the company has reiterated its earnings projections for the full year of 2014. During the second quarter of this fiscal year Eaton is expected to incur restructuring costs of $40 million for its hydraulics, aerospace and vehicle businesses. Restructuring costs will affect earnings per share by almost 8 cents during the second quarter. The company is also facing tough challenges on a macroeconomic scale in terms of the worsening Ukraine crisis and slower than expected growth in China. According to the company the restructuring is aimed at bringing efficiency to its businesses to maintain the resilience of profit margins despite the plunging sales markets. This restructuring is expected to save $35 million for the company in 2015. This was evident in the first quarter results where low costs resulted in better than expected profits for the company. However it is uncertain how long the company will be able to grow its bottom line leveraging on cost control measures. However, while the following graph illustrates the fact that Eaton has earned a higher profit margin in this quarter compared to the same period a year earlier the company's margins have been demonstrating a downward trend over the past four quarters.

Source: Bloomberg

Diversification: A Plus Point Or A Matter Of Concern?

Eaton is a diversified company with too many operations running under one single company. Therefore is exposed to difficult markets like construction and mining machinery and commercial trucks. These industries are facing some uncertainties because the miners are facing an oversupply of the basic materials they mine and this has caused a declining pressured on their product prices. Companies like Eaton Corporation and Caterpillar have been negatively affected by this pricing situation because miners are cutting their capital expenditures by not buying new mining equipment. Moreover the macroeconomic factors like the crisis in Ukraine have also played their role in creating uncertainties for the businesses exposed to the arena. China serves as a huge market and is going to surpass the USA as the biggest economy in the world but it is also experiencing slowed growth. Eaton is exposed to the problems in China and generates revenues from the country through all of its segments. China's Purchasing Managers' Index (CPMINDX) dropped to 50.5 in January this year and that was deemed the lowest level since July. This index is a manufacturing measure and has now risen to 50.6 indicating the fact that the manufacturing economy is generally expanding. However it is still below the highest level of 51.40 seen in November last year.

Eaton acquired Cooper for $11.8 billion in 2012 and this paved the way for expansion in the electric business lines. This acquisition, up to some extent, diluted Eaton's susceptibility to highly cyclical industrial sectors. This acquisition is expected to deliver synergies of $95 million and $150 million in 2014 and 2015. The electrical products segment has also experienced outgrowth because the distributor channel conversions and bookings during the quarter were up 6%. The USA and EMEA regions were high growth markets while in terms of products LED represented 37% of lighting sales in the first quarter.

Source: Eaton Presentation

Eaton Corporation expects its consolidated market to grow at a rate of 3% this year while the vehicle market growth will outperform all of the other markets in which the company deals.

Final Stance

Eaton is a diversified manufacturer but it has been divesting some of its businesses to focus on those that offer lucrative markets and growth forecasts. Eaton is selling two of its aerospace businesses and the deals will be closed in the second quarter of this year. The divestiture will allow the company to focus its strengths on more profitable segments. Wall Street has set its average price target for Eaton's stock at $82.29 indicating a 14% upward potential for the stock. The stock has seen its price decline by 4.5% this year. Despite the decline I believe the stock should be considered a potential investment at its current depressed price level.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Gemstone Equity Research research analyst. Gemstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Gemstone Equity Research has no business relationship with any company whose stock is mentioned in this article.