Copyright

Eaton Corporation: Portfolio Transformation and The Cost of Capital

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

This courseware was prepared solely as the basis for class discussion. Cases are not intended to
serve as endorsements, sources of primary data, or illustrations of effective or ineffective
management. Copyright © 2020, 2021 President and Fellows of Harvard College. No part of this
product may be reproduced, stored in a retrieval system, used in a spreadsheet or transmitted in any
form or by any means—electronic, mechanical, photocopying, recording or otherwise—without the
permission of Harvard Business School.

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.
s ($ in millions)

2-Year
Operating Sales
Margin Growth

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

13%

ed 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%
EBIT (Operating) Margin 9.5% 9.5% 9.5% 9.5% 9.5%
Deprec. & Amort. / Sales 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%

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) $213.37 $217.6 $222.0 $226.4
Less Taxes 12.5% $26.7 $27.2 $27.7 $28.3
Earnings before Interest after Taxes (EBIAT) $186.7 $190.4 $194.2 $198.1
+ Deprec. & Amortization $78.6 $80.2 $81.8 $83.4
- Change in Net Working Capital ($8.8) ($9.0) ($9.2) ($9.3)
- Capital Expenditures ($78.6) ($80.2) ($81.8) ($83.4)
= Free Cash flow (FCF) $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) $178 $169 $160 $152
Total Present Value (Set Equal to Danfoss Offer) $3,478

Sensititivity Analysis $3,478

5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
 e: 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) The Value of the Hydra
$192.6 = Free Cash flow (FCF)
$3,571.7
TV Growth Rate (g)
TV24 = [FCF24 * (1+g) ] / (Discount Rate - g)

0.749 Discount Factor

$2,819
Total Present Value based on Company WACC
 The Value of the Hydraluics Division
$177.9 $181.5 $185.1 $188.8 $192.6 = Free Cash flow (FCF)
#REF!
2.0% TV Growth Rate (g)
TV24 = [FCF24 * (1+g) ] / (D
#REF!
1.000 #REF! #REF! #REF! #REF! Discount Factor
$178 #REF! #REF! #REF! #REF!
Company WACC #REF! Total Present Value base
 The Value of the Hydraluics Division
= Free Cash flow (FCF) $177.9 $181.5 $185.1 $188.8 $192.6
#REF!
TV Growth Rate (g) 2.0%
TV24 = [FCF24 * (1+g) ] / (Discount Rate - g)
#REF!
Discount Factor 1.000 #REF! #REF! #REF! #REF!
$178 #REF! #REF! #REF! #REF!
Total Present Value based on Company WA #REF!
Exhibit 5: Value of Eaton’s Hydraulics Business Excluding the Filtration & Grips Businesses ($ 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%
EBIT (Operating) Margin 9.5% 9.5% 9.5% 9.5% 9.5%
Deprec. & Amort. / Sales 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%

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) $213.37 $217.6 $222.0 $226.4
Less Taxes 12.5% $26.7 $27.2 $27.7 $28.3
Earnings before Interest after Taxes (EBIAT) $186.7 $190.4 $194.2 $198.1
+ Deprec. & Amortization $78.6 $80.2 $81.8 $83.4
- Change in Net Working Capital ($8.8) ($9.0) ($9.2) ($9.3)
- Capital Expenditures ($78.6) ($80.2) ($81.8) ($83.4)
= Free Cash flow (FCF) $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 (WACC) 8.5%
Discount Factor 1.000 0.922 0.849 0.783
PV of FCF at Year-end 2020 (Expected Close 12/31/20) $178 $167 $157 $148
Total Present Value (Set Equal to Danfoss Offer) $2,969

Sensititivity Analysis $2,969

5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
10.0%
 e: 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
$3,021.7

0.722
$2,319
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).
able at:

untries in 2019: A
0.

kets Performance by
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.