Archive for February, 2009

Eaton Corp: My first public stock analysis

February 25, 2009

This is my first public stock analysis. You are more than welcome to correct me on my calculations and assumptions.

Eaton Corp. (ETN)

History:

I first came across Eaton upon reading Berkshire’s new purchases in the last quarter of 2008. At first glance it seemed a great company and BRK bought it in the $45 – $50 range. ETN is currently trading at $37. I decided to see if this is bargain opportunity.

Company summary:

Eaton Corporation designs, manufactures, markets, and services electrical systems and components worldwide. It offers electrical products for power quality, distribution, and control; fluid power systems and services for industrial, mobile, and aircraft equipment; intelligent truck drivetrain systems for safety and fuel economy; and automotive engine air management systems, powertrain solutions, and specialty controls for performance, fuel economy, and safety. For more info about the company and its cool products check: ool products check: http://www.eaton.com and http://finance.yahoo.com/q/pr?s=ETN

1) Does the company have an identifiable consumer monopoly or brand-name product?

70% of Eaton’s revenue comes from hydraulics and electrical products. 30% from automotive and truck segment (it is the world’s leading manufacturer in this segment). Eaton’s used to focus in the automotive/truck business and it was very dependent on it but the past few years diversification into a more profitable hydraulic/electrical manufacturing business has provided them with a wider diversification against economic downturns and cyclical businesses. Although it does not have an exclusive monopoly, any competitor will encounter significant headwinds to create the factories and equipment and acquire the contracts required to provide similar products and services.

2) Do you understand how it works?

Want to buy a golf club? Eaton is the world’s largest producer of golf club grips.

Need breaks for your truck, factory equipment or a huge boat? Eaton’s Airflex technology is there.

Eaton designs, manufactures, stress-tests, installs, maintains and finally trains your staff on location.

From Oil & Gas excavations, to army/navy, grinding, paper, metal working and mining. These guys are everywhere!

Most importantly, once a product is installed, the customer doesn’t go shopping around for new updates. After all, you can’t change the hydraulics of a dam every week. Customers do keep signing maintenance contracts and buying new pieces for broken machinery.

Eaton’s strategy since Sandy Cutler took charge in 2000 has been to utilize the revenue from its truck and auto business to fund investment in more profitable ventures. It has paid out handsomely and they continue to follow the same strategy.

3) Is the company conservatively financed?

Year 2008 in millions:

Long-term debt:

$2,921

Other LT liabilities:

$2,565

Earnings:

$1,253

It can pay off its debt in: 4.38 Years

4) Are the earnings of the company strong and do they show an upward trend?

Year

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

EPS

$2.97

$3.26

$1.65

$2.19

$2.67

$4.22

$5.38

$6.39

$6.76

$6.65

Growth:

9%

annual rate from 1999 to 2008

Growth:

22%

annual rate from 2001 to 2008

Earnings were affected by the crisis in 2001 but we can see that Sandy Cutler did an excellent job after he took office. Eaton grew earnings at a 22% annual rate.

5) Does the company allocate capital only to businesses within its realm of experience?

Yes.

6) Has the company been buying back stock?

Yes and no. They bought in 2005 and sold in 2008.

I’m looking for the filings but it seems they bought in 2005 at around $65 and sold in 2008 at about $95 which would be all good.

In any case, this is not a major point in favor or against Eaton but with Berkshire on the board, things can improve considerably.

7) Does management’s investment of retained earnings appear to have increased shareholder’s
value?

Year

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

EPS

$2.97

$3.26

$1.65

$2.19

$2.67

$4.22

$5.38

$6.39

$6.76

$6.65

Dividends

$0.88

$0.88

$0.88

$0.88

$0.92

$1.08

$1.24

$1.48

$1.72

$2.00

Dividends growth:

9.55%

Earnings from 1999 to 2008:

$42.14

Earnings Growth:

$3.68

Dividends paid:

$11.96

Retained earnings:

$30.18

Earnings grew from $2.97 to $6.65 ($3.68 growth) thanks to $30.18 in retained earnings.

This translates to:

12.19%
A 12.19% annual rate of return. Pretty good but not fantastic.

If we look at the performance after the 2001 crisis:

Earnings from 2001 to 2008:

$35.91

Earnings Growth:

$5.00

Dividends paid:

$10.20

Retained earnings:

$25.71

Earnings grew from $1.65 to $6.65 ($5.00 growth) thanks to $25.71 in retained earnings.

This translates to: 19.45% annual rate of return. Good.

Either way, it’s a good number during and after the crisis.

8) Is the company’s return on equity above average?

Year

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

ROE

16.70%

15.90%

9.40%

13.70%

12.90%

18.40%

21.90%

23.80%

19.70%

16.50%

Eaton’s Average:

16.89%

ROE

USA Average:

12%

Most importantly. Eaton has consistently earned above average ROE.

9) Does the company show a consistently high return on total capital?

Year

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

ROTC

11.10%

9.50%

6.20%

8.80%

9.30%

13.10%

15.50%

17.40%

14%

12.50%

Eaton’s Average:

11.74%

USA Average:

12%

This is pretty close to American corporations’ average. Nothing to be excited about but nothing horrible either.

10) Is the company free to adjust prices to inflation?

It’s more dependent on manufacturing costs but they do raise contract prices on inflation.

11) Are large capital expenditures required to constantly update the company’s plant, equipment and products?

No. Once a product line is built, it stays the same. In the case of custom built products, they are financed by the customer.

12) How does it rank in Earnings Yield and Return in Capital? (Joel Greenblatt’s Magic Formula)

Playing around with Value Line and Excel, I found that ETN ranked 184 out of 1822 when using 2008 data. If I use the estimated 2009 information, it ranks 148 out of 1822. While not in the top 30, it’s definitely above average.

Conclusion:

I don’t see anything clearly negative so far. I would be happier with a higher ROTC but it’s not a deal breaker either.

Eaton Corp: Price Analysis

1) Compare Eaton to a 10yr government bond:

In 2008:

Estimated 2009:

Eaton’s Earnings:

$6.65

$4.18

10yr Bond:

2.81%

2.81%

Eaton’s relative value:

$236.65

 

$148.75

This means that if you paid $236.65 (or $148 if you use the estimate) a share for Eaton, you’d be getting the same return than a 10 year gov bond.

At today’s price:

$37

Earnings:

$6.65

Return %:

17.97%

 

17.97% return on your investment if earnings don’t fall, which of course, high chances they will this year.

A look at the earnings growth for the past 9 years: 9% for the low range (22% for the high range)

Means that if you bought Eaton today at $37, you’ll be getting the equivalent of a bond paying a 17.97% yield that increases the coupon payments at 9% annually.

Since earnings will most likely fall due to the crisis, the current earnings estimate
for 2009 is $4.18. Doing the same calculation:

Return %:

11.30%

on your investment if you bought it today at $37

and expect it to grow at 9% annually.

2) Eaton as an equity/bond

Equity value per share:

$35.42

book value

If Eaton can maintain its average annual return on equity of 16.89% over the next 10 years and continues to retain a historical 71% of that return, then the per share equity value should grow at:

Retained earnings:

71%

ROE:

16.89%

Growth rate of per share equity:

11.99%

In year 2019:

$109.94
Equity per share value

Growing at 16.89% earnings per share should then be:

$18.57

and if it’s trading at its low P/E of 10, it should be trading at:

$185.70

but if it’s trading at its high P/E of 18 it should be trading at:

$334.25

Projected earnings:

Dividends are growing at 9.55%

Year

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

EPS at 9%

$4.18

$4.56

$4.97

$5.41

$5.90

$6.43

$7.01

$7.64

$8.33

$9.08

$9.90

EPS at 22%

$4.18

$5.10

$6.22

$7.59

$9.26

$11.30

$13.78

$16.81

$20.51

$25.03

$30.53

Dividend

$2

$2.19

$2.40

$2.63

$2.88

$3.16

$3.46

$3.79

$4.15

$4.55

$4.98

Total dividends paid:

$36

If in 2009 it’s trading at its low P/E of 10, it should be trading at:

$98.96

but if it’s trading at its high P/E of 18 it should be trading at:

$549.60

Therefore Eaton should be trading between $98 and $549 in 2019 and paid out $36 in dividends. If you bought shares today at $37:

Lower end return:

14%

annual return

High end return:

32%

annual return

You are beating the market. Still, I think it's better
to use a EPS growth rate of 16% (value line suggest 17%)

In that case:

Year

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

EPS at 16%

$4.18

$4.85

$5.62

$6.52

$7.57

$8.78

$10.18

$11.81

$13.70

$15.90

$18.44

Dividend

$2

$2.19

$2.40

$2.63

$2.88

$3.16

$3.46

$3.79

$4.15

$4.55

$4.98

If in 2009 it’s trading at its low P/E of 10, it should be trading at:

$184.40

but if it’s trading at its high P/E of 18 it should be trading at:

$331.92

Therefore Eaton should be trading between $184 and $331 in 2019 and paid out $36 in dividends. If you bought shares today at $37:

Lower end return:

20%

annual return

High end return:

26%

annual return

 

Also to add margin of safety, a suggestion is to consider a doomsday scenario
where last years earnings are cut in half. Instead of assuming a EPS of $4.18
for 2009 as is the current consensus, I take half of the EPS in 2008: $3.32 and
then set earnings growth flat until 2012:

In that case:

Year

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

EPS at 16%

$3.32

$3.32

$3.32

$3.85

$4.47

$5.18

$6.01

$6.97

$8.09

$9.38

$10.88

Dividend

$2

$2.19

$2.40

$2.63

$2.88

$3.16

$3.46

$3.79

$4.15

$4.55

$4.98

If in 2009 it’s trading at its low P/E of 10, it should be trading at:

$108.84

but if it’s trading at its high P/E of 18 it should be trading at:

$195.92

Therefore Eaton should be trading between $108.84 and $195.92 in 2019 and paid out $36 in dividends. If you bought shares today at $37:

Lower end return:

15%

annual return

High end return:

20%

annual return

A great investment any way you look at it at the current price as long as it can keep up its growth prospect as well as it has done during the past 10 years.

Advertisements

Oh Berkshire

February 19, 2009

I’ve been courting Miss Hathaway for three years. We were introduced by a common friend and I developed an instant crush. I’m not sure her father would approve, but every few months I manage to get the guts to arrive with flowers to her door.

She has hardly noticed me. The always beautiful and refined Berkshire moves in higher circles surrounded by majesty, hedge fund managers and famous CEOs. She is in the A list of every major club. I watch her flirt with Mr. Cola and go out with Miss Eaton and Miss Ir to chic restaurants. Jealousy is killing me. Her status hasn’t deterred me from trying to impress her. I’ve saved money, I’ve let her known about my business education plans and I’ve even written a letter to her father complimenting his work raising her. All I managed to achieve was to take her out for dinner where she gave me a few B-kisses before dropping her back at home. It was a very expensive night with little results.

But times are changing. Her latest flings are provoking envy among her friends. They say she is uptight, that she is expending money unwisely and confident in her status-quo as the most desired lady in town. Some of her closest friends are turning their back on her. They are just jealous of her success. All the while I’m here waiting for her to notice me, enjoying Eaton’s company in private. But my heart belongs to you Berkshire. I hope one day you look down and bring me up to your A list.

Oh Berkshire, when will you notice me?


Berkshire Hathaway lives in Omaha with her adoptive parents Warren Buffett and Charlie Munger. She’s currently offering her services at $80,000