Eaton Corporation A High-Yield Dividend Growth Opportunity

2015-07-24

Introduction

Finding high-quality dividend growth stocks in today’s market is challenging at best.  For those investors most interested in income, I believe that a 3% or better yield represents a sweet spot in today’s market.  However, it’s getting very difficult to find attractively valued blue-chips that can provide that kind of income while simultaneously offering some growth.

If you examine the “All Dividend Growth” portfolio of dividend paying research candidates provided as part of your subscription to MisterValuation, you will notice virtually everything carrying a yield above the 3% sweet spot mentioned above, either contains higher risk or is only available in low growth companies such as utilities.

A good way to judge this is to click on the portfolio and then organize the dividend yield column in the order of highest yield to lowest.  Almost every company with a yield above 3.5% either carries risk, or offers little growth.  When I went through this process myself looking for something to evaluate, the first company that caught my eye was Eaton Corporation (ETN).  The company is an industrial company that was founded in 1916 with a legacy of growth through acquisitions.

Like most industrials, there is a certain amount of cyclicality from the perspective of earnings and cash flows, but their dividend record has been solid since 1996.  Over that timeframe both their average dividend growth rate and compound annual dividend growth rate have exceeded 9%.  For additional perspective, the company froze their dividend over the timeframes 1998-2002 and 2008-2009, but the dividend was never cut since 1996.

Eaton acquired Cooper Industries on November 30, 2012, and it was the largest acquisition in their more than one hundred year history.  The transaction resulted in the formation of a new holding company Eaton Corporation plc, and their headquarters moved from Ohio to Ireland.  Since the new holding company is incorporated in Ireland, it created a certain amount of confusion regarding the taxation of their dividend relating to Ireland’s tax laws.  The bottom line is that US residents are exempt from the 20% Irish withholding tax.  The following explanations taken directly from the company’s website should clarify those issues:

Return of Capital Distributions FAQs

  1. A majority of the dividend payable on March 22, 2013 will be treated as a return of capital to U.S. shareholders. Why is Eaton making this change? The acquisition of Cooper resulted in Eaton reincorporating to Ireland.   This change in the capital structure of Eaton changed the U.S. tax treatment of cash distributions to U.S. shareholders.  In some cases, these distributions are treated as a return of a portion of a shareholder’s original investment (return of capital), and in others this distribution is a return of profits. The portion of the distribution that is treated as a return of capital versus a return of profits is dependent upon the capital structure of the company.
  2. How is a return of capital distribution treated for income tax purposes in the U.S. and Ireland? For U.S. income tax purposes, the return of capital portion of the distribution is non‐taxable and treated as a reduction in the tax basis of the Eaton Corporation plc shares of U.S. shareholders. Once the tax basis is exhausted, it is treated as a capital gain.  For Irish income tax purposes, the return of capital distribution is treated as a regular dividend and is taxable to Irish shareholders. Shareholders are encouraged to consult their own tax advisors regarding their particular income tax consequences of the distributions.

Dividend Withholding Tax Information

Eaton Corporation plc has established tax residence in Ireland, and as such, dividends are considered Irish source income and Irish dividend withholding tax (“DWT”) rules apply. Beginning with the dividend payable on March 22, 2013, payments will be subject to an Irish withholding tax of 20% of the amount of each dividend unless the shareholder that is beneficially entitled to the dividend is a resident of the United States or a resident of a country listed as a “relevant territory”, and has ensured that the required information is on file with their broker, bank, qualifying intermediary or transfer agent (see below for more detail). With these rules, the vast majority of Eaton’s shareholders and beneficial owners are entitled to an exemption from DWT.

Beneficial U.S. Shareholder DWT Exemption Requirements:

U.S. shareholders that are beneficial owners of Eaton Corporation plc shares held in the Depository Trust Company (“DTC”) through a bank, broker or qualifying intermediary, must have a valid U.S. address on the records of their bank, broker or qualifying intermediary on the record date of the dividend to be exempt from DWT.

For those not familiar with Eaton Corporation plc the following long business description courtesy of S&P capital IQ will provide insights into what the company does:

Long business description courtesy S&P Capital IQ

“Eaton Corporation plc operates as a power management company. The company provides solutions that help its customers manage electrical, hydraulic and mechanical power. The company has operations in approximately 60 countries and sells products to customers in 175 countries.

Segments

The company operates in the following segments: Electrical Products and Electrical Systems and Services, Hydraulics, Aerospace, and Vehicle.

Electrical Products and Electrical Systems and Services

The Electrical Products segment consists of electrical components, industrial components, residential products, single phase power quality, emergency lighting, fire detection, wiring devices, structural support systems, circuit protection, and lighting products. The Electrical Systems and Services segment consists of power distribution and assemblies, three phase power quality, hazardous duty electrical equipment, intrinsically safe explosion-proof instrumentation, utility power distribution, power reliability equipment, and services. The principal markets for these segments are industrial, institutional, governmental, utility, commercial, residential, and information technology. Sales are made directly to original equipment manufacturers, utilities, and certain other end users, as well as through distributors, resellers, and manufacturers’ representatives.

Hydraulics

The Hydraulics segment offers hydraulics components, systems and services for industrial and mobile equipment. The company offers a range of power products, including pumps, motors and hydraulic power units; a range of controls and sensing products, including valves, cylinders and electronic controls; a range of fluid conveyance products, including industrial and hydraulic hose, fittings, and assemblies, thermoplastic hose and tubing, couplings, connectors, and assembly equipment; filtration systems solutions; heavy-duty drum and disc brakes; and golf grips. The principal markets for the Hydraulics segment include oil and gas, renewable energy, marine, agriculture, construction, mining, forestry, utility, material handling, truck and bus, machine tools, molding, primary metals, and power generation.

Aerospace

The Aerospace segment is a supplier of aerospace fuel, hydraulics, and pneumatic systems for commercial and military use. Its products include hydraulic power generation systems for aerospace applications, including pumps, motors, hydraulic power units, hose and fittings, electro-hydraulic pumps and power and load management systems; controls and sensing products including valves, cylinders, electronic controls, electromechanical actuators, sensors, displays and panels, aircraft flap and slat systems and nose wheel steering systems; fluid conveyance products, including hose, thermoplastic tubing, fittings, adapters, couplings, sealing and ducting; and fuel systems including fuel pumps, sensors, valves, adapters and regulators. The principal markets for the Aerospace segment are manufacturers of commercial and military aircraft and related after-market customers.

Vehicle

The Vehicle segment is engaged in the design, manufacture, marketing, and supply of drivetrain and powertrain systems and critical components that reduce emissions and improve fuel economy, stability, performance, and safety of cars, light trucks and commercial vehicles. Its products include transmissions, clutches, hybrid power systems, superchargers, engine valves and valve actuation systems, cylinder heads, locking and limited slip differentials, transmission and engine controls, fuel vapor components, compressor control clutches for mobile refrigeration, fluid connectors and hoses for air conditioning and power steering, underhood plastic components, fluid conveyance products, including hose, thermoplastic tubing, fittings, adapters, couplings and sealing products for the global vehicle industry. The principal markets for the Vehicle segment are original equipment manufacturers and aftermarket customers of heavy-, medium-, and light-duty trucks, SUVs, CUVs, passenger cars and agricultural equipment.

Research and Development

Research and development expenses for new products and improvement of existing products in 2014 were $647 million.

Significant Events

In 2014, the company sold the Aerospace Power Distribution Management Solutions and Integrated Cockpit Solutions businesses.

History

Eaton Corporation plc was founded in 1916.”

Summary and Conclusions

The analyze-out-loud video attached to this article will cover my views and initial analysis of Eaton Corporation plc’s valuation and investment opportunity based on fundamentals.  The company will report second-quarter 2015 earnings on Wednesday, July 29.  Consequently, I thought it would be interesting to take a look at the company prior to that announcement.

The stock price has been weak over the past couple of months which has brought valuation to attractive levels, assuming earnings and cash flow estimates are accurate.  However, I believe it would be prudent to wait for the second quarter results before initiating a position.  There is a certain amount of short-term risk in doing that if the numbers come in strong.  On the other hand, depending on how the market reacts to the announcement, the opportunity could also be better by waiting.  I will let each of you that might be interested decide for yourselves.

Category: Research Articles

Tagged:

Disclaimers: F.A.S.T. Graphs, Inc. is not a broker-dealer or a registered investment adviser. Under no circumstances does any information on Fastgraphs.com constitute a recommendation to buy or sell a security, nor does it give investment advice. This is to include any publications or articles on Fastgraphs.com. Fastgraphs.com is a research tool to be used by its subscribers in conjunction with the subscribers’ additional research and due diligence. The information on this site is in no way guaranteed for completeness or accuracy.