Back in June, we recommended Eaton (ETN) as a timely buy after the late-spring selloff. Investors had questioned the company's upcoming earnings outlook due to a weakening global macroeconomic climate and concerns regarding the upcoming acquisition of Cooper Industries (CBE).
The basis of our recommendation was that Eaton, with its shares trading below $40, was significantly oversold. At that point, the stock had traded for less than 9x earnings valuation, and at that price it had offered investors a compelling entry price point. Even now, with Eaton at above $46, we continue to think there is meaningful upside potential in this name and we are upbeat on the stock for the next six to 12 months.
Here's why. After our recommendation, Eaton reported second-quarter earnings of $1.15 per share, better than estimates of $1.05. That was thanks to stronger operating margins, which arose from cost-cutting. Simultaneously, management reiterated guidance for the remainder of the year. Eaton is expected to release third-quarter numbers early next week.
Revenue should continue to be challenged due to slower global demand. However, proactive cost-cutting efforts should offset these weaker revenue trends. To investors' surprise, Cooper Industries -- which, again, Eaton is acquiring -- reported both a better-than-expected second quarter and a solid third quarter. This is significant, given that the market has feared that both Eaton and Cooper would post disappointing earnings as a reflection of the weak macro environment.
Even though we continue to like ETN and are very comfortable holding it, for prospective investors we suggest waiting until the company reports its earnings -- due next week -- before we start a new position. This recommendation reflects a lack of conviction in both the upcoming quarter and in the company's short-term outlook.
Two primary issues concern us in this regard. First, in the past week some of Eaton's industrial peers gave cautious outlooks, among them Honeywell (HON), Ingersoll Rand (IR), Parker-Hannifin (PH). Further, several industrial companies have recently discussed additional slowing in Europe during September. I admit that this softness is partially offset by the expectation among the three firms that the current slowdown in China will start to pick up by year-end.
Secondly, the Eaton-Cooper deal is being voted on later this week, and the merger is expected to close shortly thereafter. While Eaton is buying Cooper, the acquisition will be a taxable event for Eaton shareholders as well. As a result, taxable investors who buy before the closing will probably receive a short-term capital gain or loss.
However, looking past these two short-term considerations, we are very bullish on Eaton for the next six to 12 months. Earnings guidance should be favorable for 2013. The merger is expected to produce $375 million of synergies, $160 million of which should be realized within a year of the closing.
The valuation level of the combined firm is favorable, and we think the acquisition makes good strategic sense. The combined company should be able to earn $4.70 per share in 2013. Historically, Eaton has traded at 11x earnings, while Cooper has traded at 14x earnings (thanks to a more stable earnings stream). Combining these metrics, Eaton could support a 12x to 13x earnings multiple going forward, or a $60-plus share price vs. the $46.10 quote as of Monday's close. The company should also continue to pay a healthy dividend, currently at 3.3%, vs. the current 2.1% average dividend yield of S&P 500 companies.
Again, beyond some very short-term overhangs, Eaton looks attractive for both its capital appreciation potential and for its current dividend -- which investors can collect as they wait.