Eaton's leverage, adjusted to include the impact of the Cooper acquisition, is weak for the ratings, but Fitch anticipates the company will use available cash primarily to reduce debt and return credit metrics to stronger levels within two to three years. Fitch estimates debt/EBITDA will decline toward 2.75 during 2013 and below 2.5x by the end of 2014. Leverage could be around 2.0x or lower by the end of 2015. Eaton could reduce leverage more quickly if it realizes expected cost and revenue synergies with Cooper and sees a recovery in its end markets. However, the anticipated reduction in leverage could be delayed if economic conditions weaken further or if margins improve more slowly than anticipated across the combined company, possibly contributing to a further downgrade of the ratings.
Eaton's 12-month pro forma free cash flow after dividends, including Cooper, was nearly $1.1 billion at Sept. 30, 2012. Free cash flow should benefit from ongoing actions to improve margins at Eaton's existing businesses and the absence of Eaton's $154 million contribution to a VEBA trust in 2011. After 2012, cash flow and profitability should improve as Eaton integrates Cooper. Eaton estimates cost synergies at $260 million annually within four years, and estimates annual cash management and tax benefits of approximately $160 million. Eaton also expects to realize sales synergies. These benefits will be offset by estimated acquisition integration costs totaling $200 million through 2015.
FCF will continue to reflect material pension contributions associated with Eaton's U.S. pension plans which were underfunded by $1.2 billion at year end 2011. Non-U.S. plans were underfunded by $516 million. Cooper's net pension liability was much smaller at $137 million.
Both Eaton and Cooper have solid operating profiles. The combined company can be expected to generate consistent profits and free cash flow over the long term, although exposure to cyclical end markets can temporarily affect short-term results. Slightly more than half of Eaton's pro forma revenue will be in the electrical sector, and approximately 25% of sales of the combined company will be located in emerging markets. Both companies make a wide range of electrical components used in industrial, utility, commercial and government applications with minimal product overlap. Cooper's revenue, margins and free cash flow are benefiting from demand related to global industrial and energy projects, offset by weakness in Europe and in U.S. utility markets.
Eaton's liquidity at Sept. 30, 2012 included $1 billion of cash and short-term investments, approximately half of which was located overseas where it is considered to be permanently reinvested. Liquidity included full availability under three revolvers totaling $2.0 billion. The revolvers will remain in place following the acquisition of Cooper. The facilities include a limitation on debt-to-capitalization of 0.6x that becomes effective if Eaton's ratings, as defined in the agreements, are lower than 'A-'. Eaton also has a $6.75 billion bridge facility which is available to provide temporary liquidity during the Cooper acquisition process.
Liquidity was offset by $415 million of short-term debt and current maturities at Sept. 30, 2012. Pro forma liquidity will be supported by proceeds to be received from the divestiture of Apex Tool Group expected to close in the first half of 2013 for a total price of approximately $1.6 billion. Apex is a tool business operated as a joint venture and owned equally by Cooper and Danaher Corporation.
WHAT COULD TRIGGER A RATING ACTION
Positive: An upgrade is unlikely in the near term, but future developments that may, individually or collectively, lead to a stable rating outlook include:
--Stronger earnings and FCF that would enable Eaton to reduce leverage consistently during the next 12-18 months;
--An effective integration of Cooper that supports growth in combined market share and improved competitive position;
--Realization of higher, sustainable margins across the combined company.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--Slower-than-anticipated reduction in leverage that could result from reduced free cash flow or material discretionary spending for acquisitions or share repurchases;
--A further slowdown in Eaton's end markets that could impair financial results;
--Failure to realize expected acquisition synergies, or unexpected challenges integrating Cooper.
Fitch rates Eaton as follows:
--Issuer Default Rating (IDR) 'BBB+';
--Senior unsecured bank credit facilities 'BBB+';
--Senior unsecured long-term debt 'BBB+';
--Short-term IDR 'F2';
--Commercial paper 'F2'.
Approximately $4.1 billion of debt was outstanding at Sept. 30, 2012.