Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Eaton Corp. may be just about the only one who thinks its vehicle-components business is "core."

That mantra got repeated on Monday even as Eaton announced it's contributing automated transmission operations to a joint venture with truck-engine maker Cummins Inc. in exchange for 50 percent interest and $600 million of cash. It's a smart deal that creates a stronger, more integrated competitor in a growing part of the transmissions market. Cummins, not Eaton, will consolidate the results on its balance sheet.

Eaton stressed the deal isn't an indication that it's trying to distance itself from the vehicle parts altogether. Nor does it mean Eaton can't distance itself from the vehicle parts if it wants to. Ok….

Shifting Gears
Following the Cooper transaction, the vehicle unit was marginalized and Eaton got the majority of its revenue from electrical products
Source: Bloomberg

The $34 billion industrial company can say what it wants, but analysts and investors are generally looking at a spinoff or sale of the vehicle business as a when, not if, situation. Because while Eaton is right that the unit can be quite profitable and should benefit as the truck market recovers, it's still a naturally more cyclical business that's been a drag on the company's valuation.

The fate of the truck and automotive parts operations has long been a source of speculation so a bit of background is helpful. In 2012, former Eaton Chief Executive Officer Sandy Cutler tried to diversify his way to a multiple more in line with multi-industrial peers with the $12.8 billion acquisition of lighting-gear maker Cooper Industries. That deal marginalized the vehicle business to about a fifth of Eaton's revenue. For many investors, the logical next step to achieving the company's valuation goal was to separate out the truck and automotive business altogether. Management initially indicated this was at least a technically possible scenario. 

Surprise!
Eaton fell more than 8 percent after management said the Cooper deal would prevent it from doing a spinoff until five years after closing
Source: Bloomberg

But in 2014, Eaton said that actually it couldn't do a spinoff until five years after the closing of the Cooper deal without incurring a massive tax liability and that the company had been "well aware of this all along." Potato, potatoe. Also Eaton didn't want to do a spinoff anyway because there are synergy benefits from keeping all its power-management operations together -- i.e. vehicle is a "core" unit.

Mind the Gap
Eaton trades at a discount to multi-industrial peers and its 2012 acquisition of Cooper hasn't helped it catch up in a sustainable way
Source: Bloomberg
Peer group is derived from the Bloomberg Intelligence Multi-Industry Competitive Peer Group Index, excluding Eaton.

So the vehicle business stayed and now Eaton trades for about 16.7 times its earnings in the past year, compared with about 24 times for a basket of top North American multi-industrial companies. That roughly 30 percent discount is comparable to the differential that existed before Eaton announced the Cooper takeover that was supposed to close said gap.

It might have been wider but for the almost 20 percent rally in Eaton's shares in the wake of President Donald Trump's November election victory and optimism that his economic policies will help restart capital spending. The surge has also helped narrow the stock's discount to RBC analyst Deane Dray's sum-of-the-parts estimate of about $80 a share, but it's a fair question whether all of that rally was justified given the uncertainty about Trump's economic policies and an industrial rebound.

Work to Do
Eaton's vehicle unit is trailing its margin targets, while most of its other businesses are on their way to hitting theirs
Source: Eaton

Segment margins of about 15 percent at the vehicle unit in 2016 are actually better than the average for Eaton's self-selected peer group. But they trail the company's own so-called through-the-cycle targets that are supposed to represent consistent profitability. You could call that an opportunity, as Eaton does, or you could call that a sign that the business isn't living up to the company's own criteria for what's worth keeping under its corporate umbrella.

By contrast, Eaton's electrical products, aerospace and electrical systems units have already hit or are set to hit their 2020 targets this year. The hydraulics division is another laggard and parts of that business could be divestiture candidates as well.

With the five-year post-Cooper waiting period drawing to a close this winter, Eaton will need to follow through on its promises to turn its vehicle and hydraulics businesses around. If it doesn't, an activist investor may decide it knows better than management what's "core" to the company. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Demand is weaker for the manual transmission products Eaton is keeping because they're less fuel-efficient and more difficult for drivers to operate.

  2. For what it's worth, at least one tax lawyer said there are ways to get around this five-year waiting period issue depending on which business was spun off and how it was packaged. For example, when Pfizer Inc. was trying to buy Allergan Plc, the two companies planned to make a decision on whether to spin off Pfizer's established products business (and likely some Allergan assets) only two years after the deal was set to be completed. That merger was ultimately torpedoed by Treasury Department regulations aimed at cracking down on inversions, without a specific verdict on the spinoff. 

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net