Can Eaton Outrun the Recession?


A smart diversification beyond cars and trucks hasn't been able to fully protect the manufacturing giant

While the bailout of the auto industry garners most of the headlines these days, the woes of the U.S. manufacturing sector extend far beyond Detroit.

Factory activity hit a 28-year low in December, according to a survey from the Institute for Supply Management, while new orders and production indices dropped to their lowest levels since the survey began in 1948. "It's a time of greater uncertainty than I think any of us have ever experienced or lived through," Honeywell International (HON) Chief Financial Officer Dave Anderson told investors on a conference call Dec. 15.

To protect themselves from downturns in any one area, most U.S. manufacturers have broadened their product offerings. Few have done so more aggressively of late than Eaton (ETN) of Cleveland, a onetime truck-axle maker. Its dizzying array of about 900,000 industrial devices are embedded in everything from General Electric's (GE) MRI machines to Boeing's (BA) 787 Dreamliner to Hewlett-Packard's (HPQ) data centers.

Reducing Exposure to Detroit

The diversification strategy, spearheaded by Chief Executive Sandy Cutler, hasn't completely inoculated Eaton against the downturn. But it has made Eaton far less reliant on sales to struggling carmakers, which in 2007 comprised just 13% of its $13 billion in sales, down from 17% in 2000. Today, 70% of sales and profits are in the electrical and so-called fluid power categories (such as high-pressure hydraulics for aircraft). And, for the first time, more than half of Eaton's sales are to international markets.

Cutler's plan really paid off when the North American heavy-duty trucking sector collapsed in 2007, yet Eaton was still able to boost overall profits, something it had not done in many decades. "It was a pretty savvy move," says Morningstar (MORN) analyst John Kearney.

So savvy, in fact, that it even enticed Warren Buffett to buy 2.91 million Eaton shares last year, the only new addition to Berkshire Hathaway's (BRKA) portfolio at the time. (Buffett declined to comment.)

A Steep Descent in Demand

However, the precipitous decline in manufacturing is one that not even Buffett, the so-called Oracle of Omaha, could foresee. And the irony of being so diversified in such an environment is that Eaton is now feeling the pain on all sides. On Dec. 16, Eaton slashed its fourth-quarter operating profit expectations nearly in half, from $1.70 to $1.80 a share to around $1.05 a share, citing what Cutler calls a "dizzying" deceleration in demand for its auto and truck products in December.

More worrying, though, was the falloff in commercial real estate development, which could potentially sap demand for Eaton's electrical power management systems found in high-rise office buildings—a segment that grew 14% in 2007. Meanwhile, the strike at Boeing, which has caused yet another delay in the Dreamliner and a decline in orders for luxury business jets, has threatened Eaton's high-flying aerospace unit, which has grown at a double-digit clip. "You're starting to see a slowdown in areas where the growth was supposed to come from," says Jim Sourges, vice-president in Capgemini's (CAPP.PA) manufacturing consulting practice.

"In this environment, there's no one area that is untouched," says Cutler, who is now in his 31st year at Eaton.

"No Place to Hide"

Eaton is not alone. The recessionary fog has manufacturers like Honeywell, Illinois Tool Works (ITW), and United Technologies (UTX) bracing for big declines in sales and profits this year as their customers sharply reduce orders. Even stalwarts like GE and 3M (MMM) have struggled. Meanwhile, the Federal Deposit Insurance Corp. on Dec. 14 backed $2 billion in debt issued by Deere (DE) to help farmers purchase its tractors and other equipment.

As the recession spreads, overseas demand is drying up for U.S. goods that had sustained manufacturing growth. American exports have declined for three straight months, and in China imports dropped an alarming 17.9% in November from a year earlier. "Business is falling off faster than anybody anticipated," says Tom Runiewicz, an economist at IHS Global Insight. "It's a global manufacturing recession, and there's no place to hide."

Despite Eaton's current struggles, Cutler, a sprinter on the track team during his Yale days, believes the company is in good shape for the long run. Its debt levels are reasonable, and some sectors, like utility and medical center construction, have remained "surprisingly strong," he says. "When companies delay purchases, that brings an up-cycle. We don't think that up-cycle will be in 2009. We are in the belly of the beast right now. But we will start back up, and our array of businesses has us well situated."

Counting on a Rebound

One recent bright spot for the company is its work with shipping giant UPS (UPS) on more fuel-efficient hydraulic hybrid delivery trucks, powered by pressurized fluid, not electricity. UPS trucks using Eaton's new hydraulic power system, which achieved up to a 50% improvement in fuel economy during testing, will roll out in Minneapolis early this year.

Because of such advancements, manufacturing experts remain largely sanguine about Eaton. Analyst Eli Lustgarten of Longbow Securities, for one, has kept his "buy" rating on the stock. "I think they will not only survive but will be in a good position to thrive once the global recession is over," says University of Michigan manufacturing professor Wally Hopp.

Buffett presumably is one of those investors who is counting on it: He bought his shares at an average price of $71, and Eaton closed at 51.92 on Jan. 5.


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