Eaton Corp: My first public stock analysis

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.

15 Responses to “Eaton Corp: My first public stock analysis”

  1. ShortBus Says:

    Your earnings estimates are way too optimistic for my point of view. You are basically discounting the efforts of a massive worldwide depression and assuming a recovery during the 2010-2012 period.

    I would be cutting some of the EPS numbers in half, and taking a deep global depression into account, therefore assuming no recovery in earnings growth until way after 2011.

  2. Joaquin Grech Says:

    ShortBus,
    Thanks for your comments. I really appreciate them.
    I’m working on adding Joel Greenblatt’s Magic Formula into point 12 and I’ll run some calculations later on with your suggestion.
    I promise to post them later.

  3. Joaquin Grech Says:

    I updated the page to represent today’s $37 share price for Eaton. I also added point 12 out of curiosity to see how it fares against other stocks (buy Joel Greenblatt’s book “the little book that beats the market” to understand the reasoning).
    Per suggestion I lowered my outlook for EPS to $3.32 and flat until 2012 even though the current consensus is $4.18.
    The result is still positive compared to the 12% average returns on the market.

  4. ShortBus Says:

    Yikes … consensus !!!! What has the consensus got to do with the future earnings.

    Drop it some more. This is a depression, not your grandmothers recession. Expect to see ETN much lower.

  5. Joaquin Grech Says:

    hmmm well, to what level? I dropped it down to $2 until 2012 and I was getting a 11% return.
    I can drop it down to 0 but we are purely speculating here. I don’t think they will go into a lost and a drop from $6 to $2 seems a decent doomsday assumption. How low would you drop it?

  6. Joaquin Grech Says:

    it seems i’m not alone thinking Eaton is a bargain:
    http://www.fool.com/investing/general/2009/02/27/5-star-stocks-begging-to-be-bought.aspx

  7. ShortBus Says:

    I will not deny that using fundamental analysis metrics of value investing, and using the analyst forward looking earnings and revenue projections this stock looks very cheap.

    I have heard the same arguments with JNJ and PG etc … for the entire years of 2006-2008, but the earnings will not materialise. The death spiral in the economy will take down many with it.

    This company will show up on many peoples screens as cheap, until earnings erode.

    My biggest problem is you projecting all the way out to 2019 assuming a constant increase in dividends, revenue etc … These numbers are too high and you can not possibly predict anything out that far.

  8. Joaquin Grech Says:

    I agree with you that you can’t predict 10 years of revenue. What puzzle me is that the same way you can’t predict whether a number will be too high, you can’t predict whether it will be too low either.

    Although past performance is no guarantee of future performance, when looking at a business I try to see what they did during bad periods and how they came out of it. I average out the good and bad and that way try to arrive to middle consensus. When I also find that management is excellent, that they were able to navigate problematic situations in the past, that earnings have been growing, that they are in an industry that is recession proof, that they have a big economic moat and ultimately, that they have a history of achieving above average returns, the company manages to catch my attention.

    I can’t predict where it will be in 10 years 100% sure, that’s why I reevaluate the decision every so often to see if market situation has changed and how much off/on I was on my predictions.

    Why do you still believe earnings predictions are too high even after lowering it to $2? What do you believe would be a good number? I’m open to a suggestion but it has to be backed by sound reasoning. What is your projected earnings for not 10 years, but 1 year from today and why?

  9. Joaquin Grech Says:

    Disclaimer: I bought ETN at $33. It actually went down to $30 and I wish I had more $ to buy more at that point but at $33 I believe is an excellent buy.

  10. Joaquin Grech Says:

    Six months after my purchase, it’s at $58. A nice 75% return so far. I will reevaluate the company following Bruce Greenwald’s book ‘value investing’ soon and see whether it’s still undervalued.

  11. ShortBus Says:

    yes, Armageddon was averted, congratulations on a very good entry price and nice profits.

    A pity that the FED has ruined their countries future in doing it.

  12. Joaquin Grech Says:

    Thanks shortbus. Well, thank Mr. Buffett, he is the one that got me looking into ETN. I can’t be sure the profits were thanks my analysis, the more I learn, the more I realize what little I know. I want to run an Earnings Power analysis and reproduction cost on it as I learned from the Value Investing book (Bruce Greenwald) and see how it goes but it requires a bit more practice on my part. I’ll post a new entry as soon as I return to Spain (I’m at Columbia in NYC trying to meet Prof. Greenwald in person :)))

  13. Entry on my financial blog: “Eaton Corp: My first public stock analysis” | Joaquin Grech Says:

    […] Entry on my financial blog: “Eaton Corp: My first public stock analysis” Posted on May 25, 2011 by Joaquin Grech var addthis_product = 'wpp-257'; var addthis_config = {"data_track_clickback":true};New entry on Principle Investing: Eaton Corp: My first public stock analysis […]

  14. Entry on my financial blog: “Eaton Corp: My first public stock analysis” | Joaquin Grech Says:

    […] Entry on my financial blog: “Eaton Corp: My first public stock analysis” Posted on February 25, 2009 by Joaquin Grech var addthis_product = 'wpp-257'; var addthis_config = {"data_track_clickback":true};New entry on Principle Investing: Eaton Corp: My first public stock analysis […]

  15. One busy year | Joaquin Grech Says:

    […] my recommendation on Eaton on my blog? “Eaton Corp My First Public Stock Analysis” got some heat for recommending it. ETN today stands at $51, after a 2-1 stock split. In summary, it […]

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