Hydraulic equipment-maker Eaton ( ETN) disappointed investors with its third-quarter report Monday, which sent the shares down 4% that day. The company earned $1.67 a share (excluding one-time items), which was a penny below the consensus analyst estimate. Revenue grew 7% year over year to $3.3 billion, which was $60 million ahead of expectations, but management's fourth-quarter profit guidance of $1.65 to $1.75 a share was well short of the previous $1.85 consensus estimate. Eaton blamed slower demand in the heavy-duty truck market and weak new-home construction activity for the lower earnings. That said, the stock has bounced back, closing Wednesday's at $95.67 on the back of two analyst upgrades. While trading 9% off their 52-week highs, Eaton shares remain up 29% for the year. Given Eaton's bumpy ride of late, I'm here to answer readers' questions: Should you buy shares in Eaton? Is it time to buy Eaton's stock on a pullback, or do the shares have further to fall?
Through acquisitions, Eaton has become a leading manufacturer of everything from engine components and control systems for automotive and aerospace customers to being a top maker of golfclub grips. According to Bloomberg, the company has made 11 acquisitions in the past year. And management said on Monday's conference call that it's eyeing more potential acquisitions. But even as these purchases are growing Eaton's top line, the company's earnings growth is slowing. Following the latest guidance cut, Eaton is now expected to deliver just 7% profit growth this year, compared with 19% in 2006 and 25% in 2005.
So what's the culprit? Slow organic growth, just 1% in the third quarter, because of a 4% average decline in Eaton's end markets. The fluid power (hydraulics) and electrical business segments accounted for 70% of total revenue the past two quarters, but the electrical division is heavily levered to new construction -- both residential and commercial. The company's other troubled segment, the truck division, accounts for about 16% of total revenue, and declined 16% year over year in the third quarter. On the brighter side, the company has a large 65% debt-to-equity ratio, and its bonds receive a healthy "A" rating from the major agencies. Eaton is also a major beneficiary of the weak dollar, generating more than 30% of its 2007 revenue overseas. Management also said that foreign-exchange gains accounted for 3% of the 7% revenue growth posted in the third quarter. In addition to a 43-cent quarterly dividend (1.8% yield) that can be covered four times with expected 2007 earnings of $6.83 a share, the company also has about 6 million shares (4.1% of the company) remaining on its current stock-repurchase program. Both of these shareholder-friendly actions could support the stock, which currently trades at 14 times expected full-year earnings. That is on par with Eaton's historical valuation, but represents a 14% discount to the benchmark S&P 500.
Still, I believe that readers should avoid the stock at current levels. The company's earnings growth has decelerated four straight years, and with its end-markets shrinking, Eaton is currently dependent on acquisitions to muster what little growth it has generated in 2007. History has shown that growth through acquisitions is an unsustainable model, and with heavy dependence on the capital-intensive truck business and slowing domestic construction market, Eaton will trade down toward $80 before it returns to the 52-week high of $104.12.