Eaton Corporation: Powering Growth Through Strategic Acquisitions

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 |  About: Eaton Corp. plc (ETN)
by: Poonkulali Thangavelu

Eaton Corp. (NYSE:ETN), a power management company with roots in the automobile industry, is adding electrical equipment supply company Cooper Industries (CBE) to its list of recent acquisitions in a bid to power growth and diversify its offerings.

Eaton has made 28 other acquisitions in the electrical business since 1990, including Phoenixtex, Moeller, Delta Electrical and Powerware.

The Cooper acquisition, which comes with a tab of $11.8 billion, will expand and complement Cleveland-based Eaton's offerings in its electrical business segment and also make for geographic diversification.

Eaton's products help its customers manage their use of hydraulic, electrical and mechanical power. The company derived 45 percent of its 2011 sales in the U.S. By business segment, the electrical business contributed 45 percent of Eaton's sales in 2011, its truck and automotive businesses, whose products provide fuel economy and otherwise enhance vehicle performance, contributed 27 percent, followed by the hydraulics segment at 18 percent and its aerospace segment at 10 percent.

Cooper, a manufacturer of electrical components and tools has a history dating back to 1833 and its brands include Crouse-Hinds and Bussman. Cooper caters to industrial users, commercial and residential real estate markets and to the utilities market.

The company is anticipating growth from trends such as growth in the use of electricity worldwide and the growth in demand for alternative, sustainable and energy-efficient technologies. Cooper expects to benefit from utilities' move to the Smart Grid, a newer version of today's electric grid, as well as the need to protect people and electrical systems, which should create demand for Cooper's safety-oriented products.

Eaton is paying $72 per Cooper share, including a combination of cash and stock in the merged company. This price is a multiple of 11.5 times Cooper's forward earnings, which JP Morgan's Ann Duignan sees as a fair price.

The company formed with Eaton's acquisition of Cooper will be renamed Eaton Global and will be incorporated in Ireland with an eye to tax benefits, but the company's stock will continue to be traded on the New York Stock Exchange.

Eaton expects that the acquisition, which it expects will go through by fall 2012, will be financially beneficial and generate as much as $535 million in synergies by 2016, through $375 million in operating synergies, such as hiking up sales to its existing customer base, and $160 million in tax benefits.

Ireland's corporate tax rate is 12.5 percent, compared with 35 percent for the United States. For income the company derives overseas, it will pay the Irish tax rate post-acquisition. Post-merger, the company expects to derive almost 50 percent of its sales overseas.

Thus, Eaton expects that the acquisition will add $0.35 to its operating earnings per share in 2014, and $0.45 to this measure in 2015, although it will reduce operating EPS by $0.10 for 2013.

On a cash basis, before considering acquisition-related accounting adjustments, the company expects the acquisition will boost its operating EPS by $0.40 for 2013, $0.65 for 2014, and $0.75 for 2015.

Post-merger, Eaton's market participation in the electrical market will be enhanced since it will gain exposure to the power distribution network and also to the electrical load management and lighting control markets.

The power transmission and distribution niche does seem to have potential, with the International Energy Agency looking to global spending of as much as $7 trillion by 2035, including $1 trillion in the United States. Utilities in the U.S need to upgrade and meet regulatory requirements.

Cooper aims to play a role in developing worldwide infrastructure buildup, adding to its presence in developing markets which accounted for half of its international sales in 2011.

For 2012, Eaton is projecting total growth of 5 percent taking into account its different markets. This includes anticipated growth of 9 percent in the U.S. and 2 percent outside the country. The company is anticipating EPS in the range of $4.23 to $4.63 for 2012. This makes for a PE ratio of 10.23 at the company's current price of $43.30, at the lower end of the EPS range.

For the last 12 months, Eaton's PE of 10.9 is in a similar range to the PE of competitors such as Johnson Controls (NYSE:JCI) at 12.91and Parker Hannifin (NYSE:PH) at 11.85. On a forward basis, Eaton's PE ratio is 8.43, which compares favorably with JCI's 9.38 and PH's 10.6.

While Eaton, an S&P-500 company, appears to offer good prospects for growth, as well as a desirable dividend yield of about 3.5 percent, it also faces certain risks.

For one, Eaton and Cooper use commodities, such as aluminum and steel, as raw materials and are subject to fluctuations in their prices. Eaton uses derivatives to manage such risks.

Also, Eaton is subject to various environmental regulations, such as the superfund law, and is involved in some environmental remediation action. And Cooper faces liabilities related to asbestos exposure claims from businesses it owned in the past.

And while Eaton's beta of 1.74 means that it is likely to outperform the overall market in a bull market environment, those who are more bearish will tend to be wary of the stock. The Cooper acquisition is likely to make for a lower beta for the combined company, considering that Cooper has a beta of 1.11.

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