Description

Eaton is a global manufacturer of highly engineered products in five cyclical business segments: Industrial/Commercial Controls (26% of total), Automotive Components (20%), Truck Components (18%), Fluid Power (29%) and Semiconductor Equipment (7%). ETN has significant market share in all business segments (for example, Industrial/Controls--20% share in North America, Auto Components--shares leadership in engine valves with TRW, Truck Components--80% share in transmission, #1 in clutches, etc., Fluid Power--#1 in Hydraulics, Semiconductor-- shares leadership position with Varian with 40%-45% each); ETN has a strong balance sheet and operations. Industrial cyclical companies are expected to undergo tough comps, especially those that compete in the truck and auto part sectors. As a result, they are all cheap--selling at private-equity valuations. I am convinced that if you are going to own these types of companies, the best ones to own are companies that have an identifiable, potent catalysts. ETN generates plenty of free cash. Free cash flow last year was $387M and $41M this year, EV/EBITDA-CapX of $714M in 1999 and is expected to generate $852 this year. For fiscal year 2000 ending December 31st, the company is trading at 5.2x EV/EBITDA, 8.2x EV/EBITDA-Capx with a P/E of 9.2x. If you look at ETN on a trading valuation basis the valuation becomes more compelling. Putting a comparable 6.7x multiple on the Industrial/Commercial controls segment, 4.7x multiple on the Auto segment, 3.5x on Trucks and a 5.6x on the Fluid Power business (which is on the verge of a turn around) and include all debt and cash, you get a price of $63 for Eaton's stock. This DOES NOT INCLUDE the company's 84% stake in Axcelis (ticker: ACLS @ $12) which adds another $13 per ETN share.

Finally, I particularly like this idea because of what I believe to be temporary negative catalysts: Ford's problems, the trucking/auto-part cycle and the impact of the Euro. While visibility is limited regarding theses factors, I believe value investors who buys ETN below $63 will be rewarded for their patience. The key items to monitor over the next nine to twelve months are:
1) the company's use of cash,
2) its market share gains, and
3) the effectiveness of its cost cutting program

While the there are clear unknowns (i.e., the Euro, truck cycle), I believe owning ETN in the low 60's (or cheaper) provides a strong margin of safety given its balance sheet, market leadership and cash flow generation.

Catalyst

There are five key catalysts:
1) ETN will be spinning off (or may even decide on doing a split-off) of its semi conductor company, Axcelis by year-end;
2) Selling assets (so far, a $330M rev business has been announced);
3) New management with a relentless focus to create shareholder wealth;
4) Company is buying back $500M of its own stock;
5) The trucking disaster is a temporary, negative catalyst. The industry will turn.