For the value investor with a longer-term horizon, the recent market correction has beaten down some stocks to attractive levels. One that has moved to the forefront of my screen is Eaton Corporation (ETN).
Eaton Corporation is a diversified power management company. It is engaged in the manufacturing of electrical components and systems for power quality, distribution and control; hydraulics components, systems and services for industrial and mobile equipment; aerospace fuel, hydraulics and pneumatic systems for commercial and military use, and truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety.
Eaton Corporation (ETN) One-Year Price and Volume w/ 50 and 200-Day MAs
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General Investment Thesis
ETN has strong fundamentals, an excellent management team, and a global footprint positioned for growth in key industries: automotive, trucks, and commercial aerospace. The technical charts are on the on the upswing. In addition, the company pays investors a good dividend.
Let's explore this company in some more detail.
The Fundamentals
I like to start by reviewing the balance sheet. This is a strength at Eaton. CEO Sandy Cutler and his staff have demonstrated good capital and debt management.
The debt-to-equity and debt-to-capital ratios are 46 and 30 percent, respectively. I consider these sound figures. A D2E ratio under 50 percent is a positive. Eaton adds gloss to these figures as long-term debt has been stable over the years.
A return-on-assets ratio of seven percent is in-line with peers in the Machinery industry.
The current ratio of 1.7 coupled with $2.59 a share in cash on hand indicates strong liquidity.
Moving on to the income statement, ETN has booked gross margins of 33 percent, well in-line with the competition. Revenue has increased by 4 percent a year over the past five years. This is laudable given the severe business contraction during the 2008-09 Great Recession.
Notably, Eaton management does not miss earning estimates. Going back to 2008, the company has beaten the Street eight times and met forecasts on the remainder. I like to see an experienced management team that makes the mark on guidance consistently.
Cash flows have been solid. However, 2011 has shown a dip in Operating Cash flows, largely due to increases in Working Capital. Reviewing filings and conference calls, I am comfortable with the situation. Eaton has embarked upon a number of initiatives that have driven up these figures with the intent of building long-term investment value. If one backs out changes in Working Capital from the cash flow figures, the bottom line numbers are acceptable. Free Cash Flow is adequate to cover a generous dividend. The current yield is a respectable 3.23 percent. This is at least 120 basis points better than a 10-year U. S. Treasury bond.
Other valuation measures I like to review include Equity / Assets, ROCE (Return on Capital Employed) and EBIT (Earnings Before Interest and Taxes) / EV (Enterprise Value). Using these metrics, Eaton passes the hurdles for a good value investment.
The E / A ratio is 0.45. Benjamin Graham, the father of value investing, offered that a deep value company should an E / A ratio of 0.50. Eaton is close to this marker.
ETN has a six-month ROCE of 6.4 percent. An annualized rate over 12 percent is a strong indication of a management team's ability to generate shareholder returns. For reference, the 2010 full-year ROCE calculation was 10 percent; this is the benchmark for top corporate entities.
As an alternate check, I like to use EBIT / EV. This six-month figure is 4.6 percent, nudging the annualized 10 percent marker to designate another screen for good value stocks.
The Technical Charts
While I tend to focus upon the fundamentals, I do like to review the charts for entry / exit points and to spot trends.
Eaton Corporation reached very oversold levels in early October. Since bouncing off support at $34 a share, the stock has rallied to over $42; nearly a 25 percent increase. This has far outpaced the bounce in the S&P500.
The one-year MACD has turned decidedly bullish. The indicator line crossed over the signal line in early October and has now crossed the “zero” line, another positive development. Meanwhile, the share price has broken well above the 50-day moving average on good volume.
Looking for a bit more perspective, the two-year weekly Slow Stochastic and RSI (Relative Strength Indicators) studies have moved out from oversold levels.
Additional Investment Story Lines
Eaton's board of directors has a history of raising the dividend. The five-year dividend growth rate is 11.7 percent. The ten-year growth rate is likewise nearly 12 percent. Over the years, dividends represent a sizable portion of the investors' total return. If maintained, a double-digit dividend growth rate means the investor would see a doubling of the dividend payout in less than seven years.
The most recent earnings conference call was particularly upbeat. There was no indication of management backing off the full-year EPS guidance. Indeed, it raised such guidance three times this year, despite the uncertainties in the global markets. Over the past three months, analysts following the company have raised 2011 EPS forecasts, and only lowered the 2012 forecast by a few cents per share.
The Bottom Line
Eaton Corporation appears to have rebounded from panic lows and now sits comfortably above its 50-day moving average. For those looking to take a position in the stock, I suggest prudence after a big short-term run up. I do not advocate chasing this stock, but wait for the shares to “come in.” No need to hurry for any stock that has moved so far, so fast, on little specific corporate news or earnings. Indeed, the market has been trecherous. I am not convinced it's blue skys ahead.
Third quarter earnings are due on October 24. I would not try to buy the stock without a pullback and game the earnings.
That said, I believe there is still value left in ETN shares. The stock traded over $52 a share just a few months ago before getting crushed along with many other cyclicals. I suggest this was much overdone in the case of Eaton.
Using a 2011 EPS estimate of $4.00 a share and a 14X P / E multiple, I arrive at a target price of $56. The average five-year P / E is nearly 20X.
The current consensus 2012 EPS is $4.50. Management will talk in detail about 2012 earnings and business expectations upon the earning conference call. I will be listening closely to their guidance.
Under the assumptions that EU banking system does not collapse, the U. S. does not relapse into a major recession, and China maintains reasonable economic growth, this equity offering has significant upside potential. Even if the global economy weakens (but does not tank), ETN should maintain, at minimum, flat 2012 versus 2011 EPS. Placing a conservative 12X multiple on the shares, the stock price target remains $48. Adding a generous dividend simply allows the value investor to get paid while waiting.
Disclosure: I am long ETN.
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