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Eaton Corporation: Portfolio Transformation and The Cost of Capital

Harvard Business School Case 221-006
HBS Courseware #221-704

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Created 9/8/20
Revised 2/10/2021
Revised 6/23/2021

1
Exhibit 1: Eaton Corporation Income Statement, 2018 and 2019 (in millions)
Source: Casewriter analysis using data from S&P Capital IQ, accessed 7/14/20.

Fiscal Year Ending Dec. 31

2018 2019

Revenue $21,609 $21,390

Cost of Goods Sold $14,511 $14,338
Gross Profit $7,098 $7,052
Operating Expenses $4,126 $4,201
Operating Profit $2,972 $2,851
Net Interest Expense ($271) ($236)
Other expenses ($277) ($24)
Profit before Taxes $2,424 $2,591
Income Tax Expense $278 $378
Profit after Tax $2,146 $2,213
Minority Interest ($1) ($2)
Net Income $2,145 $2,211

Avg. Basic Shares Out 434.3 419.0

Dividends per Share $2.64 $2.84

Revenue Growth 5.9% (1.0%)

Profit Margins
Gross Margin 33% 33%
Operating Margin 14% 13%
Net Margin 10% 10%
Return on Equity (EOY) 13% 14%
Tax Rate (Average Paid) 11.5% 14.6%
Interest Coverage 11.0 12.1
Deprec. & Amortization $521 $517
Research & Dvlp. Expense $584 $606

Equity $16,142 $16,133

Exhibit 2: Eaton Corporation Balance Sheet, 2018 and 2019 (in millions)
Source: Casewriter analysis using data from S&P Capital IQ, accessed 7/14/20.

Fiscal Year Ending Dec. 31

2018 2019

Assets
Cash & Short-term Securities $440 $591
Accounts Receivable $3,952 $3,541
Inventory $2,785 $2,805
Other Current Assets $413 $1,791
Total Current Assets $7,590 $8,728

Net PP&E $3,467 $3,932

Goodwill $13,328 $13,456
Other Intangibles $4,846 $4,638
Other Long-term Assets $1,861 $2,051
Total Assets $31,092 $32,805

Liabilities
Accounts Payable $2,130 $2,114
Accrued Expenses $521 $526
Current Portion of LT Debt $340 $369
Short-term Debt $414 $255
Other Current Liabilities $1,749 $1,868
Total Current Liabilities $5,154 $5,132
Long-term Debt $6,797 $8,192
Pension & Other Benefits $1,625 $1,790
Other Long-term Liabilities $1,374 $1,558
Total Liabilities $14,950 $16,672
Equity $16,142 $16,133
Total Liabilities & Equity $31,092 $32,805

Market Capitalization $29,084 $39,148

Total Shares Outstanding (mil) 423.6 413.3
Year-end Stock Price ($) $68.66 $94.72
Total Debt $7,551 $8,816
Net Debt (less Cash & ST Investments) $7,111 $8,225
S&P Corporate Credit Rating (long-term) A- A-
Leverage Ratios
Debt-to-Total Capital = D/(D+E) 32% 35%
Net Debt-to-Total Capital (at book value) 31% 34%
Net Debt-to-Value (at market value) 20% 17%
Current Ratio 1.47 1.70
Number of Employees 99,000 101,000
Exhibit 3: Eaton Corporation Segment Financials in 2019; Excludes Corporate Expenses ($ in millions)
Source: Casewriter analysis, Eaton 2019 Annual Report pp. 69-70.

Percent
Net Operating Capital Deprec. of Total
Segment Sales Profit Assets Expend. & Amort. Sales

Electrical Products $7,148 $1,390 $2,201 $162 $126 33%

Electrical Systems/Services $6,287 $1,027 $2,532 $108 $87 29%
Hydraulics* $2,552 $286 $1,439 $90 $66 12%
Aerospace $2,044 $495 $1,362 $47 $27 10%
Vehicle $3,038 $460 $2,145 $127 $102 14%
eMobility $321 $17 $141 $8 $5 2%
Segment Totals $21,390 $3,675 $9,820 $542 $413 100%
Corporate Expenses $0 ($807) $45 $52
Corporate Total $21,390 $2,868 $587 $465

Note: The Hydraulics Segment included two other business units (Filtration and Golf Grips) which accounted for 14% of the segment's sales.
es ($ in millions)

2-Year
Operating Sales
Margin Growth

19% 3%
16% 11%
11% 3%
24% 17%
15% (9%)
5% 13%
17% 5%

13%

ted for 14% of the segment's sales.

Exhibit 4: Danfoss Corporation and Segment Financials in 2019 (millions of Euros and US Dollars)
Source: Case writer analysis using data from Danfoss’s 2019 Annual Report, pp. 50, 57. Converted to USD based on the
exchange rate of €1.000 = US$1.120 at 12/31/19 from OandA.com.

FY 2019 in Euros (mil) FY 2019 in USD (mil)

Power
Power Solutions Power
Solutions as % of Total Solutions
Corporate Division Corporate Corporate Segment

Net Sales € 6,285 € 2,197 35% $7,039 $2,461

Sales Growth 3% 4%
Operating profit € 695 € 391 56% $778 $438
Operating Margin 11% 18%
Profit Before Tax € 662 $741
Taxes € 160 $179
Net Income € 502 $562
Total Assets € 6,096 € 1,481 24% $6,828 $1,659
Implied Tax Rate 24%
Number of Employees 27,871 7,826 28%
Exhibit 5: Value of Eaton’s Hydraulics Business Excluding the Filtration & Grips Businesses ($ mil)
Source: Case writer estimates based on analyst forecasts and historical segment performance. Reports include: UBS Global Research,
Initiation of Coverage on Eaton Corp. PLC, by M. Mittermaier et al., 12/11/19; and Jefferies Equity Research, Eaton, by S. Volkmann et
al., 12/23/19.Both available on Thomson One, accessed 8/17/20.

2019 2020E 2021E 2022E 2023E

Model Assumptions
Revenue Growth Rate 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%
EBIT (Operating) Margin 9.5% 9.5% 9.5% 9.5% 9.5% 9.5%
Deprec. & Amort. / Sales 3.5% 3.5% 3.5% 3.5% 3.5%
Net Working Capital (NWC) / Sales 20.0% 20.0% 20.0% 20.0% 20.0%
Total NWC ($) $440 $449 $458 $467 $477
CapEx / Sales 3.5% 3.5% 3.5% 3.5% 3.5%

Total Segment Revenue $2,552

Retained (Grips & Filters) Revenue $350
Divested (Hydraulics) Revenue $2,202 $2,246 $2,291.0 $2,336.8 $2,383.5

EBIT (Operating Profit, Hydraulics business only) $209.2 $213.4 $217.6 $222.0 $226.4
Less Taxes 12.5% $26.1 $26.7 $27.2 $27.7 $28.3
Earnings before Interest after Taxes (EBIAT) $183.0 $186.7 $190.4 $194.2 $198.1
+ Deprec. & Amortization $77.1 $78.6 $80.2 $81.8 $83.4
- Change in Net Working Capital ($440.4) ($8.8) ($9.0) ($9.2) ($9.3)
- Capital Expenditures ($77.1) ($78.6) ($80.2) ($81.8) ($83.4)
= Free Cash flow (FCF) ($257.4) $177.9 $181.5 $185.1 $188.8
Terminal Value = Growing Perpetuity
TV Growth Rate (g) 2.0%
TV24 = [FCF24 * (1+g) ] / (Discount Rate - g)
Discount Rate (IRR for the offer) 7.5%
Discount Factor 1.000 0.930 0.865 0.805
PV of FCF at Year-end 2020 (Expected Close 12/31/20) $169 $160 $152
Total Present Value (Set Equal to Danfoss Offer) $3,300

Sensititivity Analysis $3,300

10.0%
10.5%
11.0%
11.5%
12.0%
12.5%
13.0%
13.5%
14.0%
14.5%
15.0%
de: UBS Global Research,
Eaton, by S. Volkmann et

2024E

2.0%
9.5%
3.5%
20.0%
$486
3.5%

$2,431.2

$231.0
$28.9
$202.1
$85.1
($9.5)
($85.1)
$192.6
$3,571.7

0.749
$2,819
Exhibit 6: Current Capital Markets Data as of 12/31/19
Source: Federal Reserve Board, Report H15 Selected Interest Rates, FRED Economic Data, Federal
Reserve Bank of St. Louis, Accessed 7/14/20. Debt betas are from “Capital Structure and Systematic
Risk,” by M. Schwert and I. Strebulaev, Appendix Table A1, Stanford Graduate School of Business,
working paper, 4/6/14.

Credit Spread
Yield on Over 10-Year Estimated
US Treasury S&P Credit US Treasury Debt Betas
Maturity Securities Rating Yield by Rating

1-month 1.48% AAA 0.52% 0.04

3-month 1.55% AA 0.53% 0.05
1-year 1.59% A 0.76% 0.05
5-year 1.69% BBB 1.29% 0.10
10-year 1.92% BB 2.02% 0.24
20-year 2.25% B 3.56% 0.31
30-year 2.39% CCC & Lower 10.08% 0.43
Exhibit 7: Market Risk Premium Estimates in 2019 (Annual Percent, %)

Forward-Looking Estimates

[1] Survey Data (212 Chief Financial Officers in 2018) 4.4%

[2] Survey Data (1,200 Economists, Analysts, and Executives in 2019) 5.6%
[3] Implied from Gordon Growth Model (Equity Cash Flows as of Jan. 2020) 5.2%
Average of the Estimates 5.1%

Historical Stock Market Returns: 1926 to 2018

[4] Large-Cap Stocks minus Long-Term Government Bonds 6.0%

[4] Large-Cap Stocks minus Short-Term Treasury Bills 8.5%

Sources:
[1] Graham, J.R., and C. R. Harvey, The Equity Risk Premium in 2018, Duke University working papers, available at:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3151162, accessed 8/11/20.
[2] Fernandez, P., M. Martinez, and I. Fernandez Acin, “Market Risk Premium and Risk Free Rate for 69 countries in 2019:
A Survey, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3358901, accessed 8/11/20.

[3] A. Damodaran, Damodaran Online, Historical Implied Equity Risk Premiums, January 2020, available at:
http://pages.stern.nyu.edu/~adamodar/, accessed 8/11/20.
[4] 2019 SBBI Yearbook (Stocks, Bonds, Bills, and Inflation), R. Ibbotson and Duff & Phelps, US Capital Markets
Performance by Asset Class, 1926-2018 (2018).
 ers, available at:

or 69 countries in 2019:
sed 8/11/20.

ailable at:

pital Markets
Exhibit 8A: Financial Data on Firms that Manufacture or Purchase Hydraulic Equipment
Source: Case writer analysis of data contained in S&P Capital IQ database, accessed 7/8/20.

Market Value
Year Ending 12/31/19 S&P 2-Year Leverage Ratios
Operating Credit Equity = Net Debt
Firm Name (Ticker Symbol) Assets Revenues Margins Rating Betas (a) to Value (b)

Eaton Corp (ETN) $32,805 $21,390 13.3% A- 1.09 18%

Parker Hannifin (PH) $21,044 $14,201 14.5% BBB 1.42 17%

Helios Technologies (HLIO) $1,022 $555 17.0% n/a 1.72 18%
Enerpac Tool Group (EPAC) $909 $643 11.6% BB 1.51 16%

Caterpillar (CAT) $78,453 $53,800 15.1% A 1.52 28%

Note a: The equity betas were calculated using two years of weekly returns regressed against returns on the
S&P 500 Index.

Note b: The market value leverage ratios are the average quarterly ratio over two years starting 4Q17 and ending
ending 4Q19 (9 observations). The net debt-to-value ratio = (Debt – Cash) / (Debt - Cash + Equity). It was
calculated using the book value of debt and the market value of equity.