Eaton (ETN) - Valuation Analysis

Description

Eaton Corporation (Eaton) 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. On January 1, 2011, it closed the acquisition of the Tuthill Coupling Group, which is a division of the Tuthill Corporation. It has five segments: Electrical Americas and Electrical Rest of World; Hydraulics; Aerospace; Truck, and Automotive. On October 12, 2010, it acquired Chloride Phoenixtec Electronics. On October 1, 2010, it acquired CopperLogic, Inc. On August 25, 2010, it acquired Wright Line Holding, Inc. On July 15, 2010, it acquired EMC Engineers, Inc. In May 2011, it acquired Internormen Technology Group.

Source: Reuters

Valuation

Key assumptions included:

                Terminal growth rate: 5.0%

                Risk-adjusted discount rate: 13.5%

                Cost of sales: 70.0%

                Selling, general, & administrative costs as % of sales: 18.0%

                Research & development as % of sales: 3.0%

                CAPEX as % of sales: 4.0%

                Depreciation as % of sales: 4.5%

                Effective tax rate: 8.0%

                Day sales in receivables: 60

                Day sales of inventory: 57

                Days payable outstanding: 53

At a 13% growth rate (bull case), I estimate the intrinsic value of ETN to be $40.59 per share.  With a risk-adjusted margin of safety of 12.6%, the target purchase price is $35.47 per share.  This is below the $40.65 per share MMM is currently trading at.  At $40.65, ETN is trading at 0.2% premium to the intrinsic value indicating it is a value in this scenario.

At a 6% growth rate (bear case), I estimate the intrinsic value of ETN to be $23.92 per share.  With a risk-adjusted margin of safety of 19.3%, the target purchase price is $19.32 per share.  This is below the $40.65 per share ETN is currently trading at.  At $40.65, ETN is trading at 70.0% premium to the intrinsic value.

Dividends

ETN pays a quarterly dividend.  From 2001 to 2010, ETN’s dividend has grown from $0.44 per share to $1.08 per share.  Dividend growth appears to have slowed in recent years.  The compound annual dividend growth rate is as follows:

                Ten years: 10.5%

Five years: 14.9%

                Three years: 7.9%

With the dividend appears to be growing slower earnings, the dividend appears to be sustainable.  Based on net income, the dividend payout ratio has exceeded 50% once in the past five years.  A dividend payout ratio of less than 50% is a positive allowing for sustainable growth and a cushion for short-term earnings volatility.  Below is the dividend payout ratio for the past five years:

                2006: 23.2%

                2007: 25.3%

                2008: 30.2%

                2009: 87.2%

                2010: 39.1%

In the book, The Ultimate Dividend Playbook, Josh Peters discusses a model to calculate a stock’s prospective return.  The model is called the Dividend Drill Return Model (DDRM).  It is based on the premise that the dividend total return is equal to the yield plus dividend growth.  Dividend growth is then broken into core growth (the rate of growth for total profits) plus share change (reduction of shares due to share repurchase). 

Given a core growth rate of 13.0% and current dividend yield of 3.3%, ETN’s cost of growth is $2.87 per share.  After reducing this amount and dividends of $2.20 per share, the funding deficit is $1.46 per share; this amount is forecasted to have a -3.6% impact on share price.  As a result, the DDRM forecasts the projected total return for ETN to be 12.8%.  Below is a breakdown of the total return:

                Core growth rate: 13.0%

                Dividend yield: 3.3%

                Funding surplus: -3.6%

                Total return: 12.8%

Summary

In a bull case, based on a valuation $40.59, shares are trading at a 0.2% premium to their intrinsic value.  In a bear case, base on a valuation of $23.92, shares are trading a 70.0% premium to their intrinsic value.  ETN has a history of dividend increases and the dividend appears semi-sustainable as the payout ratio is less than 50%.  Based on the DDRM, the projected total return for ETN is 12.8%.

Disclosure: I am not long ETN.