Warren Buffett Stock Picks: Eaton (ETN)

November 17, 2008 | Comments (13)

Berkshire’s latest 13-F reveals a new position of 2.9 million shares in Eaton Corp (ETN). This is a small stake when compared to Berkshires other purchases. As George from Fat Pitch Financials mentions, the question remains as to whether this is a Buffett pick or from a subsidiary.

Eaton is a company I had a brief look at in late 2007 when it was trading in the 80′s, I thought I’d take a quick review to see the status of the company today.


Berkshire’s latest 13-F reveals a new position of 2.9 million shares in Eaton Corp (ETN). This is a small stake when compared to Berkshires other purchases. As George from Fat Pitch Financials mentions, the question remains as to whether this is a Buffett pick or from a subsidiary.

Eaton is a company I briefly looked at in late 2007 when it was trading in the $80′s, I thought I’d take a quick review to see the status of the company today.

Business Summary

The company is a diversified industrial manufacturer and operates in 4 business segments.

  1. Electrical - electrical systems and components for power quality, distribution and control
  2. Hydraulics - fluid power systems and services for industrial, mobile and aircraft equipment
  3. Aerospace - intelligent truck drivetrain systems for safety and fuel economy
  4. Automotive - automotive engine air management systems, powertrain solutions and specialty controls for performance, fuel economy and safety.

The great thing about ETN is that it is a highly diversified company with business all over the world. Not just US dependent.

Valuation

From a numbers point of view, Eaton is a very solid company. Since 2001, ETN has improved and made progress in its operations.

  • Gross, operating, net margins are stable at around 27%, 9%, 7% respectively
  • Book value has been increasing at a good pace
  • Throws off positive FCF for the past 10 years, although it has reduced during 2007 and 2008
  • Cash is generated from its core business rather than other businesses
  • The median CROIC for the past 10 years has been at 9%, ROE at constant 17%, ROA at 6%
  • Excellent inventory turnover at 7.0

Take a look at the below images to see what I mean.

The numbers point to a capable management team who understand their business. The cash generation of the business can also support the current dividend yield of 4.7% along with a history of increasing dividends.

I’ve applied a 15% discount rate due to rising inflation and my strong preference for present day dollars as to future cash. This is ever more true in this environment. A growth rate of 6% yields a share value of around $77 with the buy price set at $38.

Potential Warnings Signs

If it wasn’t for the recent acquisition spree and debt levels, I would probably have bought some shares already, but upon further analysis, the quality of earnings isn’t as high as I anticipated.

Within a 2 year timeframe starting Feb 2007, Eaton has made 14 acquisitions with the latest on Oct 2, 2008. I like growth, but not through so many acquisitions.

“Sales growth of 25% in the third quarter of 2008 over the third quarter of 2007 consisted of 19% from acquisitions of businesses within the last year, 4% from organic growth, and 2% from foreign exchange.”

The question is, will Eaton continue to eat companies in order to gain market share and keep up with earnings in the future?

Due to all the acquisitions, Eaton’s long term debt has ballooned to just under $3 billion along with $5.9 billion in goodwill and $1.9 billion in intangibles. Although Eaton should be able to meet its obligations, I’ll prefer to be cautious and wait to see how the acquisitions impact the business and whether they were worth overpaying for. With a “significant slowdown” expected over the coming year, watching for another quarter or two may be a good idea.

Although it is getting close to the buy price, I think I will just keep an eye on ETN for now.

Disclosure: No positions of any stocks held at time of writing.

[tags] berkshire, eaton, etn, valuation [/tags]

  • http://www.nurseb911.com Nurseb911

    This is a stock I’ve owned since late September at $57 and have added as recently as $45. Its a long-term holding in my US portfolio and a well diversified company. While debt has gone up significantly via acquisitions their book value growth has been stellar (one of my focal points as a value investor).
    The company’s valuation has continued to weaken but if/when it dips down to $40 again I will be adding again to my position. It sells what the world needs and while that may have slowed currently I think over the next 15-20 years the company is well positioned for more growth organically & through smaller acquisitions.

  • http://www.oldschoolvalue.com Jae Jun

    I like the company and I agree that its a business which is needed, especially if growth in emerging countries picks up again later on.

    I’m just going to keep my eye out to see at what rate they pay back debt. However, it’s good to see that management is seeking strategic acquisition directly related to its business rather than veering off into other industries.

  • Ryan

    I like the modification you did to the spreadsheet. Any chance you could send that to me?

  • Ryan

    Ignore my last comment. I see that you have them for sale.

  • John

    When you calculate increase in book value, do you strip out the growth in intangible assets, such as goodwill? Thanks.

  • http://www.oldschoolvalue.com Jae Jun

    John,
    I checked my spreadsheet and it counted intangibles as well.
    Intangibles should be disregarded and it should be changed to Tangible Shareholder Equity.

    I’m making the modification now. Thanks for catching this.

  • http://www.oldschoolvalue.com Jae Jun

    From the morningstar premium membership, ETN is rated 5 stars with a fair value of $81. Very similar to my $77 target.

  • http://dividendtree.blogspot.com/ Dividend Tree

    JJ: I looked at ETN last week (didn’t know you had looked at it in Nov08). Qualitatively, I made the same conclusion: Although it appears to be a great company with good business model/products, it has become debt heavy. Growth is coming from acquisitions (which in turn is coming from debt). And guess what: CEO was on Cramerica yesterday, attempting to convince audience why/how ETN can sustain dividends.

    Dividend Tree’s last blog post..Is Buffett a Dividend-Growth Investor?

  • http://www.oldschoolvalue.com Jae Jun

    I didnt know he made a guest appearance for Cramer lol.

    If Eaton shows that it is able to lower its debt smartly without taking on additional financing or diluting shares, I will definitely be looked at again.

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