UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the year ended December 31, 2006
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Commission file number 1-1396
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EATON CORPORATION
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(Exact name of registrant as specified in its charter)
Ohio 34-0196300
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(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
Eaton Center
Cleveland, Ohio 44114-2584
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(Address of principal executive offices) (Zip code)
(216) 523-5000
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
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Common Share ($.50 par value) The New York Stock Exchange
The Chicago Stock Exchange
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes X
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Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. No X
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months and (2) has been subject to such filing requirements for
the past ninety days. Yes X
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. (Check one): Large accelerated
filer X
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Page 1
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). No X
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The aggregate market value of Common Stock held by non-affiliates of the
registrant as of June 30, 2006 was $11.3 billion.
As of January 31, 2007, there were 146.2 million Common Shares outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2007 annual shareholders meeting are
incorporated by reference into Part III.
Page 2
PART I
ITEM 1. BUSINESS
Eaton Corporation (Eaton or Company) is a diversified industrial manufacturer
having 2006 sales of $12.4 billion. Eaton was incorporated in Ohio in 1916, as a
successor to a New Jersey company incorporated in 1911. The Company is a global
leader in the design, manufacture, marketing and servicing of electrical systems
and components for power quality, distribution and control; fluid power systems
and services for industrial, mobile and aircraft equipment; intelligent truck
drivetrain systems for safety and fuel economy; and automotive engine air
management systems, powertrain solutions and specialty controls for performance,
fuel economy and safety. Headquartered in Cleveland, Ohio, Eaton had 60,000
employees at year-end 2006 and sells products in more than 125 countries. More
information regarding the Company is available at http://www.eaton.com.
Eaton electronically files or furnishes reports pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934 (Exchange Act) to the United States
Securities and Exchange Commission (SEC), including annual reports on Form 10-K,
quarterly reports on Form 10-Q, and current reports on Form 8-K, as well as any
amendments to those reports. As soon as reasonably practicable, these reports
are available free of charge through the Company's Internet web site at
http://www.eaton.com. These filings are also accessible on the SEC's Internet
web site at http://www.sec.gov.
RECENT DEVELOPMENTS
In light of its strong results for 2006 and future prospects, on January 22,
2007, Eaton announced that it was taking the following actions:
- Increasing the quarterly dividend on its Common Shares by 10%, from $.39
per share to $.43 per share, effective for the February 2007 dividend
- Making a voluntary contribution of $150 million to its qualified pension
plan in the United States
- Authorizing a new 10 million Common Share repurchase program, replacing the
1.3 million shares remaining from the 10 million share repurchase program
authorized in April of 2005.
In 2006, Eaton acquired certain businesses in separate transactions for a
combined net cash purchase price of $256 million. The Statements of Consolidated
Income include the results of these businesses from the effective dates of
acquisition. A summary of these transactions for 2006 follows (millions of
dollars):
Date of Business
Acquired business acquisition segment Annual sales
----------------- ------------------ ----------- -------------
Schreder-Hazemeyer December 1, 2006 Electrical $9 for 2006
Eaton acquired the remaining 50% ownership of the
Belgium manufacturer of low and medium voltage
electrical distribution switchgear
Diesel fuel processing technology & associated assets of October 26, 2006 Truck NM
Catalytica Energy Systems Inc.
A U.S. developer of emission control solutions for Trucks
Senyuan International Holdings Limited September 14, 2006 Electrical $47 for 2005
A China-based manufacturer of vacuum circuit breakers
and other electrical switchgear components
Ronningen-Petter business unit of Dover Resources, Inc. September 5, 2006 Fluid Power $30 for 2005
A U.S.-based manufacturer of industrial fine filters and
components
Synflex business unit of Saint-Gobain Performance Plastics March 31, 2006 Fluid Power $121 for 2005
Corp.
A U.S.-based manufacturer of thermoplastic hose and tubing
Marina Power & Lighting March 24, 2006 Electrical $11 for 2005
A U.S. manufacturer of marine duty electrical distribution
products
Page 3
On December 28, 2006, Eaton announced it had reached an agreement to purchase AT
Holdings Corporation, the parent of Argo-Tech Corporation, for $695 million.
This transaction is expected to close in the first quarter of 2007. Argo-Tech's
U.S.-based aerospace business, which had sales for the fiscal year ended October
28, 2006 of $206 million, is a leader in high performance aerospace engine fuel
pumps and systems, airframe fuel pumps and systems, and ground fueling systems
for commercial and military aerospace markets. This business will be integrated
into the Fluid Power segment.
On January 5, 2007, the Company announced it had reached an agreement to
purchase the Power Protection Business of Power Products Ltd., a Czech
distributor and service provider of Powerware and other uninterruptible power
systems, for $2 million. The transaction closed in February 2007. This business,
which had 2006 sales of $3 million, will be integrated into the Electrical
segment.
BUSINESS SEGMENT INFORMATION
Information by business segment and geographic region regarding principal
products, principal markets, methods of distribution, net sales, operating
profit and assets is presented in "Business Segment & Geographic Region
Information" on pages 47 through 51 of this report. Additional information
regarding Eaton's segments and business is presented below.
ELECTRICAL
Seasonal Fluctuations - Sales of this segment are historically lower in the
first quarter, and higher in the third and fourth quarters of a year.
Competition - Principal methods of competition in this segment are performance
of products and systems, technology, customer service and support, and price.
Eaton has a strong competitive position in relation to the many competitors in
this segment and, with respect to many products, is considered among the market
leaders.
FLUID POWER
Seasonal Fluctuations - Sales of this segment are not affected by seasonal
fluctuations.
Competition - Principal methods of competition in this segment are product
performance, geographic coverage, service, and price. Eaton has a strong
competitive position in relation to the many competitors in this segment and,
with respect to many products, is considered among the market leaders.
TRUCK
Seasonal Fluctuations - Sales of this segment are not affected by seasonal
fluctuations.
Significant Customers - Approximately 78% of this segment's sales in 2006 were
made to five large manufacturers of heavy-, medium-, and light-duty trucks and
off-highway vehicles.
Competition - Principal methods of competition in this segment are product
performance, service, and price. Eaton has a strong competitive position in
relation to the many competitors in this segment and, with respect to many
products, is considered among the market leaders.
AUTOMOTIVE
Seasonal Fluctuations - Sales of this segment historically are lower in the
third quarter than in other quarters during the year, as a result of the normal
seasonal pattern of automotive industry production.
Significant Customers - Approximately 56% of this segment's sales in 2006 were
made to six large manufacturers of vehicles and components.
Competition - Principal methods of competition in this segment are product
performance, service, and price. Eaton has a strong competitive position in
relation to the many competitors in this segment and, with respect to many
products, is considered among the market leaders.
INFORMATION CONCERNING EATON'S BUSINESS IN GENERAL
RAW MATERIALS - Eaton's major requirements for raw materials include iron,
steel, copper, nickel, aluminum, brass, silver, molybdenum, titanium, vanadium,
rubber, plastic and insulating materials. Materials are purchased in various
forms, such as extrusions, castings, powder metal, metal sheets and strips,
forging billets, bar stock and plastic pellets. Raw materials, as well as parts
and other
Page 4
components, are purchased from many suppliers and, under normal circumstances,
the Company has no difficulty obtaining them. In 2006, prices increased for some
basic metals purchased by Eaton, and in some cases dramatically, due to raw
materials supply shortages resulting from higher global demand. The Company
maintained appropriate levels of inventory to guard against basic metals
shortages, and did not experience the general availability constraints
experienced in 2005.
PATENTS AND TRADEMARKS - Eaton views its name and mark as significant to its
business as a whole. Eaton's products are marketed with a portfolio of patents,
trademarks, licenses or other forms of intellectual property that expire at
various dates in the future. Eaton develops and acquires new intellectual
property on an ongoing basis and considers all of its intellectual property to
be valuable. Based on the broad scope of Eaton's product lines, management
believes that the loss or expiration of any single intellectual property right
would not have a material effect on the results of operations or financial
position of Eaton or its business segments. Eaton's policy is to file
applications and obtain patents for its new products including product
modifications and improvements.
ORDER BACKLOG - Since a significant portion of open orders placed with Eaton by
original equipment manufacturers of trucks, off-highway vehicles and passenger
cars are historically subject to month-to-month releases by customers during
each model year, these orders are not considered firm. In measuring backlog of
orders, the Company includes only the amount of these orders released by
customers as of the dates listed. Using this criterion, total backlog at
December 31, 2006 and 2005 was approximately $2.2 billion and $2.0 billion,
respectively. Backlog should not be relied upon as being indicative of results
of operations for future periods.
RESEARCH AND DEVELOPMENT - Research and development expenses for new products
and improvement of existing products in 2006, 2005 and 2004 (in millions) were
$321, $285 and $259, respectively. Over the past five years, the Company has
invested approximately $1.3 billion in research and development.
PROTECTION OF THE ENVIRONMENT - Operations of the Company involve the use and
disposal of certain substances regulated under environmental protection laws.
Eaton continues to modify certain processes on an ongoing, regular basis in
order to reduce the impact on the environment, including the reduction or
elimination of certain chemicals used in, and wastes generated from, operations.
Compliance with Federal, State and local provisions which have been enacted or
adopted regulating the discharge of materials into the environment, or otherwise
relating to the protection of the environment, are not expected to have a
material adverse effect upon earnings or the competitive position of the
Company. Eaton's estimated capital expenditures for environmental control
facilities are not expected to be material for 2007 and 2008. Information
regarding the Company's liabilities related to environmental matters is
presented in "Protection of the Environment" on page 41 of this report.
FOREIGN OPERATIONS - Financial information related to Eaton's foreign operations
is presented in "Business Segment & Geographic Information" on page 49 of this
report. Information regarding risks that may affect Eaton's foreign operations
is presented in Item 1A of this Form 10-K.
ITEM 1A. RISK FACTORS
Among the risks that could materially adversely affect Eaton's businesses,
financial condition or results of operations are the following:
DOWNTURNS IN THE END MARKETS THAT EATON SERVES MAY NEGATIVELY IMPACT EATON'S
SEGMENT REVENUES AND PROFITABILITY.
Eaton's segment revenues, operating results and profitability have varied in the
past and may vary from quarter to quarter in the future. Profitability can be
negatively impacted by volatility in the end markets that Eaton serves, although
the Company has undertaken measures to reduce the impact of this volatility
through diversification of markets it serves and expansion of geographic regions
in which it operates. Future downturns in any of the markets that Eaton serves
could adversely affect the Company's revenues, operating results, and
profitability.
EATON'S OPERATING RESULTS DEPEND IN PART ON CONTINUED SUCCESSFUL RESEARCH,
DEVELOPMENT AND MARKETING OF NEW AND/OR IMPROVED PRODUCTS AND SERVICES, AND
THERE CAN BE NO ASSURANCE THAT EATON WILL CONTINUE TO SUCCESSFULLY INTRODUCE NEW
PRODUCTS AND SERVICES.
Page 5
The success of new and improved products and services depends on their initial
and continued acceptance by Eaton's customers. The Company's businesses are
affected, by varying degrees, by technological change and corresponding shifts
in customer demand, which could result in unpredictable product transitions or
shortened life cycles. Eaton may experience difficulties or delays in the
research, development, production and/or marketing of new products and services
which may prevent Eaton from recouping or realizing a return on the investments
required to bring new products and services to market. The end result could be a
negative impact on the Company's operating results.
EATON'S OPERATIONS DEPEND ON PRODUCTION FACILITIES THROUGHOUT THE WORLD, MANY OF
WHICH ARE LOCATED OUTSIDE THE UNITED STATES AND ARE SUBJECT TO GREATER RISKS OF
DISRUPTED PRODUCTION.
Eaton manages businesses with manufacturing facilities worldwide. The Company's
manufacturing facilities and operations could be disrupted by a natural
disaster, labor strike, war, political unrest, terrorist activity or public
health concerns. Eaton's non-United States manufacturing facilities also may be
more susceptible to economic and political upheaval than Eaton's United States
facilities. Any such disruption could cause delays in shipments of products and
the loss of sales and customers, and insurance proceeds may not adequately
compensate the Company.
EATON'S SUBSTANTIAL FOREIGN SALES SUBJECT IT TO ECONOMIC RISK AS EATON'S RESULTS
OF OPERATIONS MAY BE ADVERSELY AFFECTED BY CHANGES IN LOCAL GOVERNMENT
REGULATIONS AND POLICIES AND FOREIGN CURRENCY FLUCTUATIONS.
As noted above in Item 1 "Foreign Operations", a significant portion of Eaton's
sales are outside the United States, and the Company expects sales in foreign
markets to continue to represent a significant portion of its total sales.
Foreign sales and operations are subject to changes in local government
regulations and policies, including those related to tariffs and trade barriers,
investments, property ownership rights, taxation, exchange controls, and
repatriation of earnings. Changes in the relative values of currencies occur
from time to time and could affect Eaton's operating results. While the Company
monitors exchange rate exposures and attempts to reduce these exposures through
hedging activities, these risks could adversely affect the Company's operating
results.
EATON USES A VARIETY OF RAW MATERIALS AND COMPONENTS IN ITS BUSINESSES, AND
SIGNIFICANT SHORTAGES OR PRICE INCREASES COULD INCREASE OPERATING COSTS AND
ADVERSELY IMPACT THE COMPETITIVE POSITIONS OF EATON'S PRODUCTS.
Eaton's major requirements for raw materials are described above in Item 1 "Raw
Materials". In 2006, prices increased for some basic metals purchased by Eaton,
and in some cases dramatically, due to raw materials supply shortages resulting
from higher global demand. The Company maintained appropriate levels of
inventory to guard against basic metals shortages, and did not experience the
general availability constraints experienced in 2005. Significant shortages in
excess of those experienced in 2005 and 2006 could affect the prices Eaton's
affected businesses are charged and the competitive position of their products
and services, all of which could adversely affect Eaton's results of operations.
EATON ENGAGES IN ACQUISITIONS AND JOINT VENTURES, AND MAY ENCOUNTER UNEXPECTED
DIFFICULTIES IDENTIFYING, PRICING OR INTEGRATING THOSE BUSINESSES.
Eaton seeks to grow, in part, through strategic acquisitions and joint ventures
intended to complement or expand the Company's businesses, and will continue to
do so in the future. The success of this strategy will depend on Eaton's ability
to identify, price and complete these transactions or arrangements. Success will
also depend on the Company's ability to integrate the businesses acquired in
these transactions and to develop satisfactory working arrangements with the
Company's strategic partners in the joint ventures. Eaton may encounter
unexpected difficulties in completing and integrating acquisitions with Eaton's
existing operations, and in managing strategic investments. Furthermore, the
Company may not realize the degree, or timing, of benefits Eaton anticipated
when it first entered into a transaction. Any of the foregoing could adversely
affect the Company's business and results of operations.
EATON MAY BE UNABLE TO ADEQUATELY PROTECT ITS INTELLECTUAL PROPERTY RIGHTS,
WHICH COULD AFFECT THE COMPANY'S ABILITY TO COMPETE.
Protecting Eaton's intellectual property rights is critical to its ability to
compete and succeed as a company. The Company owns a large number of United
States and foreign patents and patent
Page 6
applications, as well as trademark and copyright registrations that are
necessary, and contribute significantly, to the preservation of Eaton's
competitive position in the market. Although management believes that the loss
or expiration of any single intellectual property right would not have a
material effect on the results of operations or financial position of Eaton or
its business segments, there can be no assurance that any one, or more, of these
patents and other intellectual property will not be challenged, invalidated or
circumvented by third parties. Eaton enters into confidentiality and invention
assignment agreements with the Company's employees, and into non-disclosure
agreements with Eaton's suppliers and appropriate customers so as to limit
access to and disclosure of the Company's proprietary information. These
measures may not suffice to deter misappropriation or independent third party
development of similar technologies. Moreover, the protection provided to
Eaton's intellectual property by the laws and courts of foreign nations may not
be as advantageous to Eaton as the remedies available under United States law.
EATON IS SUBJECT TO LITIGATION AND ENVIRONMENTAL REGULATIONS THAT COULD
ADVERSELY IMPACT EATON'S BUSINESSES.
At any given time, Eaton may be subject to litigation, the disposition of which
may have a material adverse effect on the Company's businesses, financial
condition or results of operations. Information regarding the Company's current
legal proceedings is presented in "Protection of the Environment" and
"Contingencies" on page 41 of this report.
EATON PARTICIPATES IN MARKETS THAT ARE COMPETITIVE AND EATON'S RESULTS COULD BE
ADVERSELY IMPACTED BY COMPETITORS' ACTIONS.
Eaton's businesses operate in competitive markets. The Company competes against
other global manufacturers on the basis of product performance, quality and
price, in addition to other factors. While Eaton's product development and
quality initiatives have been competitive strengths in the past, actions by
Eaton's competitors could lead to downward pressure on prices and/or a decline
in the Company's market share, either of which could adversely affect Eaton's
results.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains
manufacturing facilities at 202 locations in 32 countries. The Company is a
lessee under a number of operating leases for certain real properties and
equipment, none of which is material to its operations. Management believes that
the existing manufacturing facilities are adequate for operations, and these
facilities are maintained in good condition.
ITEM 3. LEGAL PROCEEDINGS
Information regarding the Company's current legal proceedings is presented in
"Protection of the Environment" and "Contingencies" on page 41 of this report.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding executive officers of the Company is presented in Item 10
of this Form 10-K.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company's Common Shares are listed for trading on the New York and Chicago
stock exchanges. Information regarding cash dividends paid and the high and low
market price per Common Share for each quarter in 2006 and 2005 is presented in
"Quarterly Data" on page 73 of this report. At December 31, 2006, there were
8,868 holders of record of the Company's Common Shares. Additionally, 20,356
current and former employees were shareholders through participation in the
Eaton Savings Plan (ESP) and Eaton Personal Investment Plan (EPIP).
Page 7
Information regarding equity compensation plans required by Regulation S-K Item
201(d) is provided in Item 12 of this Form 10-K.
ISSUER'S PURCHASES OF EQUITY SECURITIES
In fourth quarter 2006, Eaton repurchased 3.341 million Common Shares in the
open market at a total cost of $255 million. These shares were repurchased under
the plan announced on April 18, 2005, when Eaton's Board of Directors authorized
the Company to repurchase up to 10 million of its Common Shares.
Total number of Maximum number (or
shares purchased approximate dollar
as part of value) of shares that
Total number Average publicly may yet be purchased
of shares price paid announced plans under the plans or
Month purchased per share or programs programs
----- ------------ ---------- ---------------- ---------------------
November 2006 2,966,877 $75.49 2,966,877 1,708,019
December 2006 373,800 77.00 373,800 1,334,219
--------- ---------
Total 3,340,677 75.65 3,340,677
========= =========
On January 22, 2007, Eaton announced that it had authorized a new 10 million
Common Share repurchase program, replacing the 1.334 million shares remaining
from the 10 million share repurchase program authorized in April of 2005,
described in the table above. These shares will be repurchased over time,
depending on market conditions, share price, capital levels and other
considerations.
ITEM 6. SELECTED FINANCIAL DATA
Information regarding selected financial data is presented in the "Ten-Year
Consolidated Financial Summary" on page 72 of this report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
"Management's Discussion & Analysis of Financial Condition & Results of
Operations" is presented on pages 52 through 71 of this report.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information regarding market risk is presented in "Market Risk Disclosure &
Contractual Obligations" on page 65 of this report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The report of the independent registered public accounting firm, consolidated
financial statements, and notes to consolidated financial statements are
presented on pages 18 through 51 of this report.
Information regarding selected quarterly financial information for the last two
years is presented in "Quarterly Data" on page 73 of this report.
ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures - Pursuant to SEC Rule 13a-15,
an evaluation was performed, under the supervision and with the participation of
Eaton's management, including Alexander M. Cutler - Chairman and Chief Executive
Officer; President and Richard H. Fearon - Executive Vice President - Chief
Financial and Planning Officer, of the effectiveness of the design and operation
of the Company's disclosure controls and procedures. Based on that evaluation,
Eaton's management concluded that the Company's disclosure controls and
procedures were effective as of December 31, 2006.
Disclosure controls and procedures are designed to ensure that information
required to be disclosed in Company reports filed or submitted under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information
Page 8
required to be disclosed in Company reports filed under the Exchange Act is
accumulated and communicated to management, including the Company's Chief
Executive Officer and Chief Financial Officer, to allow timely decisions
regarding required disclosure.
"Management's Report on Internal Control Over Financial Reporting" is presented
on page 21 of this report.
"Report of Independent Registered Public Accounting Firm" relating to
"Management's Report on Internal Control Over Financial Reporting" is presented
on page 20 of this report.
Changes in Internal Control Over Financial Reporting - During fourth quarter
2006, there was no change in Eaton's internal control over financial reporting
that materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required with respect to the directors of the Company is set forth
under the caption "Election of Directors" in the Company's definitive Proxy
Statement to be filed on or about March 16, 2007, and is incorporated by
reference.
A listing of Eaton's elected executive officers, their ages, positions and
offices held over the past five years, as of January 31, 2007, follows:
Name Age Position (Date elected to position)
---- --- -----------------------------------
Alexander M. Cutler 55 Chairman and Chief Executive Officer; President
(August 1, 2000 - present)
Director (September 22, 1993 - present)
Richard H. Fearon 50 Executive Vice President - Chief Financial and
Planning Officer (April 24, 2002 - present)
Partner, Willow Place Partners LLC (2001-2002)
Craig Arnold 46 Senior Vice President and President - Fluid Power Group
(October 25, 2000 - present)
Stephen M. Buente 56 Senior Vice President and President - Automotive Group
(August 21, 2000 - present)
Randy W. Carson 56 Senior Vice President and President - Electrical Group
(January 1, 2000 - present)
James E. Sweetnam 54 Senior Vice President and President - Truck Group
(July 1, 2001 - present)
William W. Blausey, Jr. 42 Vice President - Chief Information Officer
(January 25, 2006 - present)
Vice President - Information Technology, Fluid Power
(January 1, 2005 - January 24, 2006)
Group Director - IT
(August 16, 2001 - December 31, 2004)
Susan J. Cook 59 Vice President - Human Resources
(January 16, 1995 - present)
Page 9
Earl R. Franklin 63 Vice President and Secretary
(April 24, 2002 - present)
Secretary and Associate General Counsel
(September 1, 1991 - April 23, 2002)
Richard D. Holder 43 Vice President - Eaton Business System
(May 1, 2006 - present)
Vice President and General Manager,
Power Distribution and Assemblies Division,
Electrical Group
(August 1, 2004 - April 30, 2006)
Vice President, Supply Chain and Operational Excellance,
Electrical Group
(July 16, 2001 - July 31, 2004)
Donald J. McGrath, Jr. 54 Vice President - Communications
(January 25, 2006 - present)
Vice President, Corporate Communications,
BASF Corporation (2002 -2005)
Mark M. McGuire 49 Vice President and General Counsel
(December 1, 2005 - present)
Vice President and Deputy General Counsel,
International Paper Company (2003 - 2005)
Associate General Counsel,
International Paper Company (March 2001 - 2003)
John S. Mitchell 50 Vice President - Taxes
(November 22, 1999 - present)
Billie K. Rawot 55 Vice President and Controller
(March 1, 1991 - present)
Ken D. Semelsberger 45 Vice President - Corporate Development and
Treasury (February 22, 2006 - present)
Vice President - Strategic Planning
(April 28, 1999 - February 21, 2006)
Yannis P. Tsavalas 51 Vice President and Chief Technology Officer
(February 14, 2005 - present)
General Manager, Global Lighting Technology,
General Electric Company (2004 - 2005)
Global Technology Leader, GE Lighting,
General Electric Company (2003-2004)
Global Product Line Manager, GE Lighting,
General Electric Company (August 2000 - 2003)
There are no family relationships among the officers listed, and there are no
arrangements or understandings pursuant to which any of them were elected as
officers. All officers hold office for one year and until their successors are
elected and qualified, unless otherwise specified by the Board of Directors;
provided, however, that any officer is subject to removal with or without cause,
at any time, by a vote of a majority of the Board of Directors.
Information required with respect to compliance with Section 16(a) of the
Exchange Act is set forth under the caption "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's definitive Proxy Statement to be filed on
or about March 16, 2007, and is incorporated by reference.
The Company has adopted a Code of Ethics, which applies to the Directors,
officers (including its Chairman and Chief Executive Officer; President,
Executive Vice President--Chief Financial and Planning Officer, and Vice
President and Controller) and employees worldwide. This document is available on
the Company's website at http://www.eaton.com.
Page 10
There were no changes during fourth quarter 2006 to the procedures by which
security holders may recommend nominees to the Company's Board of Directors.
Information related to the Company's Audit Committee, and members of the
Committee that are financial experts, is set forth under the caption "Board
Committees - Audit Committee" in the Company's definitive Proxy Statement to be
filed on or about March 16, 2007, and is incorporated by reference.
ITEM 11. EXECUTIVE COMPENSATION
Information required with respect to executive compensation is set forth under
the caption "Executive Compensation" in the Company's definitive Proxy Statement
to be filed on or about March 16, 2007, and is incorporated by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Information required with respect to security ownership of certain beneficial
owners is set forth under the caption "Share Ownership Tables" in the Company's
definitive Proxy Statement to be filed on or about March 16, 2007, and is
incorporated by reference.
EQUITY COMPENSATION PLANS
The following table summarizes information, as of December 31, 2006, relating to
equity compensation plans of the Company pursuant to which grants of options,
restricted stock, deferred compensation units or other rights to acquire Company
Common Shares may be granted from time to time.
(C)
Number of securities
(A) (B) remaining available
Number of Weighted-average for future issuance
securities to be exercise price under equity
issued upon of outstanding compensation plans
exercise of options, (excluding securities
outstanding options, warrants reflected in
Plan category warrants and rights and rights column (A))
------------- -------------------- ---------------- ---------------------
Equity compensation
plans approved by
security holders (1) 13,647,357(3) $48.01(5) 5,184,978
Equity compensation
plans not approved
by security holders (2) 1,749,829(4) N/A N/A
---------- ---------
Total 15,397,186 $48.01(5) 5,184,978
========== =========
(1) These plans are the Company's 2004 Stock Plan, 2002 Stock Plan, 1998 Stock
Plan, 1995 Stock Plan, and the Incentive Compensation Deferral Plan (the
"IC Deferral Plan").
(2) The 2005 Non-Employee Director Fee Deferral Plan (the "2005 Plan"), the
1996 Non-Employee Director Fee Deferral Plan (the "1996 Plan"), the
Deferred Incentive Compensation Plan (the "DIC Plan"), the Deferral
Incentive Compensation Plan II (the "DIC Plan II") and the Incentive
Compensation Deferral Plan II (the "IC Deferral Plan II") are not
considered "equity compensation plans" requiring shareholder approval under
the rules of the New York Stock Exchange. Under the 2005 Plan, all
non-employee directors are entitled to defer payment of their fees and
allocate the deferred amounts between short-term deferred fees and
retirement deferred fees, which differ in terms of earnings and method and
timing of distribution. Short-term deferred fees are credited with interest
based on the quarterly average yield of the 13-week U.S. Treasury bill and
are distributable in cash. As specified by the director, between 50% and
100% of deferred amounts allocated to retirement deferred fees are
converted into Company share units that earn Company Common Share price
appreciation plus dividend equivalents, and are distributable in Company
Common Shares. The portion of a Director's retirement deferred fees that
are not converted to Company share units earn 10-year U.S. Treasury note
returns plus 300 basis points and are distributable in cash. Under the 2005
Plan, plan participants must elect the method and timing of payment with
respect to the fees that are to be deferred. For short-term deferred fees,
participants may elect to receive distributions in a lump sum or in equal
annual installments over a period not to exceed five years commencing in
the year selected by the plan
Page 11
participant, which cannot be earlier than the second year following the
calendar year in which fees are deferred. For retirement deferred fees,
plan participants may elect to receive distributions in a lump sum or in
equal annual installments over a period not to exceed 15 years following
retirement. Director fees earned subsequent to December 31, 2004 are not
eligible for deferral under the 1996 Plan. Instead, the 2005 Plan is
available for the deferral of these fees. Under the 1996 Plan, the
Governance Committee determines, upon the participant's retirement or other
termination of services as a director, whether fees deferred are
distributable in a lump sum or in equal annual installments and whether the
amounts converted to Company share units are distributable in cash or
Company Common Shares. Both the 2005 Plan and the 1996 Plan provide for
accelerated payout upon the occurrence of certain events, including those
involving a change in control of the Company. Under the DIC Plan,
participants, including officers and other eligible executives, were able
to defer receipt of their annual incentive compensation award as either
short-term deferrals (to be paid out in five years or less) or retirement
compensation. Amounts deferred as retirement compensation earn the greater
of Company share price appreciation plus dividend equivalents or 13-week
U.S. Treasury bill returns until paid. This determination is made at the
time of each payment, whether made in a lump sum or installments.
Short-term deferrals earn 13-week U.S. Treasury bill returns. Amounts
deferred as retirement compensation which are converted to Company share
units are payable in Company Common Shares, either in a lump sum or
periodic installments, as determined by the Company's Corporate
Compensation Committee which is comprised of Company officers. Annual
incentive compensation earned subsequent to December 31, 2004 is not
eligible for deferral under the DIC Plan. Instead, the DIC Plan II is
available for the deferral of this compensation. Compensation deferred
under the DIC Plan II is credited with earnings in the same manner as the
DIC Plan, as described above. However, participants under the DIC Plan II,
prior to the beginning of each calendar year, must elect the method and
timing of payment with respect to the compensation to be earned in that
year that is subject to the deferral election. Similarly, long-term
incentive compensation earned subsequent to December 31, 2004 is not
eligible for deferral under the IC Deferral Plan. Instead, the IC Deferral
Plan II is available for the deferral of this compensation. Under the IC
Deferral Plan II, participants, including officers and other eligible
executives, may defer the receipt of awards received under long-term
incentive compensation plans as either short-term deferrals (to be paid out
in five years or less) or retirement compensation. As selected by the
participant, between 50% and 100% of awards deferred as Retirement
Compensation are credited as Company share units that earn Company Common
Share price appreciation plus dividend equivalents and that are distributed
in the form of Company Common Shares. The portion of a participant's
Retirement Compensation that is not converted to Company share units earns
interest at a rate equal to the average yield on 10-year U.S. Government
Treasury Notes plus 300 basis points. Amounts deferred as short-term
deferrals earn interest at a rate equal to the quarterly average yield of
13-week U.S. Government Treasury Bills. Under the IC Deferral Plan II,
prior to the beginning of any award period for which an award may be
earned, participants must elect the method and timing of payment with
respect to compensation to be earned during that award period and that is
subject to the deferral election. Participants were able to defer the full
amount of eligible cash compensation under the 2005 Plan, the 1996 Plan and
the EIC Plan. To the extent cash compensation is deferred pursuant to any
of the Plans described herein, the Company may be able to preserve the
deductibility of the compensation under Section 162(m) of the Internal
Revenue Code that otherwise may be unavailable.
(3) Includes an aggregate of 228,965 restricted shares, 1,988,714
performance-vested stock options and 441,897 shares underlying stock units,
payable on a one-for-one basis, credited to accounts as of December 31,
2006 under the Incentive Compensation Deferral Plan.
(4) Represents shares underlying stock units, payable on a one-for-one basis,
credited to accounts as of December 31, 2006 under the 2005 Plan, the 1996
Plan, the DIC Plan, the DIC Plan II and the IC Deferral Plan II.
(5) Weighted average exercise price of outstanding stock options; excludes
restricted stock and deferred compensation share units.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None required to be reported.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required with respect to principal accountant fees and services is
set forth under the caption "Audit Committee Report" in the Company's definitive
Proxy Statement to be filed on or about March 16, 2007, and is incorporated by
reference.
Page 12
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) (1) The report of the independent registered public accounting firm,
consolidated financial statements and notes to consolidated financial
statements, included in this report are included in Item 8 above:
Report of Independent Registered Public Accounting Firm - Page 18
Statements of Consolidated Income - Years ended December 31, 2006, 2005 and
2004 - Page 22
Consolidated Balance Sheets - December 31, 2006 and 2005 - Page 23
Statements of Consolidated Cash Flows - Years ended December 31, 2006, 2005
and 2004 - Page 24
Statements of Consolidated Shareholders' Equity - Years ended December 31,
2006, 2005 and 2004 - Pages 25 and 26
Notes to Consolidated Financial Statements - Pages 27 through 51
(2) All schedules for which provision is made in Regulation S-X of the SEC
are not required under the related instructions or are inapplicable and,
therefore, have been omitted.
(3) Exhibits
3(i) Amended Articles of Incorporation (amended and restated April 27,
1994) - Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
3(ii) Amended Regulations (amended and restated April 26, 2000) -
Incorporated by reference to the Form 10-Q Report for the six months
ended June 30, 2000
4(a) Instruments defining rights of security holders, including indentures
(Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to
furnish to the Commission, upon request, a copy of the instruments
defining the rights of holders of long-term debt)
10 Material contracts
(a) Master Purchase and Sale Agreement by and between PerkinElmer,
Inc. and Eaton Corporation dated October 6, 2005 - Incorporated
by reference to the Form 10-K Report for the year ended December
31, 2005
(b) Purchase Agreement between V.G.A.T. Investors, LLC and Eaton
Corporation dated as of December 24, 2006 - Filed in conjunction
with this Form 10-K Report
(c) Executive Incentive Compensation Plan (effective January 1,
2005) - Incorporated by reference to the Form 10-K Report for the
year ended December 31, 2005
(d) 2005 Non-Employee Director Fee Deferral Plan (effective January
1, 2005) - Incorporated by reference to the Form 10-K Report for
the year ended December 31, 2004
(e) Deferred Incentive Compensation Plan II (effective January 1,
2005) - Incorporated by reference to the Form 10-K Report for the
year ended December 31, 2004
(f) Excess Benefits Plan II (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
Page 13
(g) Incentive Compensation Deferral Plan II (effective January 1,
2005) - Incorporated by reference to the Form 10-K Report for the
year ended December 31, 2004
(h) Limited Eaton Service Supplemental Retirement Income Plan II
(effective January 1, 2005) - Incorporated by reference to the
Form 10-K Report for the year ended December 31, 2004
(i) Supplemental Benefits Plan II (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
(j) Form of Restricted Share Award Agreement - Incorporated by
reference to the Form 10-K Report for the year ended December 31,
2004
(k) Form of Stock Option Agreement for Executives - Filed in
conjunction with this Form 10-K Report
(l) Form of Stock Option Agreement for Non-Employee Directors -
Incorporated by reference to the Form 8-K Report filed January
26, 2007
(m) 2004 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 19, 2004
(n) Amendment to the Plan (originally adopted in 1985) for the
Deferred Payment of Directors' Fees (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
(o) Plan for the Deferred Payment of Directors' Fees (originally
adopted in 1985 and amended effective September 24, 1996, January
28, 1998, January 23, 2002, and February 24, 2004) - Incorporated
by reference to the Form 10-Q Report for the three months ended
March 31, 2004
(p) Limited Eaton Service Supplemental Retirement Income Plan
(amended and restated January 1, 2003) - Incorporated by
reference to the Form 10-K Report for the year ended December 31,
2002
(q) Vehicle Allowance Program (effective January 1, 2003) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2003
(r) 2002 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 15, 2002
(s) 1996 Non-Employee Director Fee Deferral Plan (amended and
restated effective January 1, 2005 ) - Filed in conjunction with
this Form 10-K Report
(t) Form of Change of Control Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(u) Form of Indemnification Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(v) Form of Indemnification Agreement entered into with directors of
Eaton Corporation - Incorporated by reference to the Form 8-K
Report filed January 26, 2007
(w) Executive Strategic Incentive Plan I (amended and restated
January 1, 2007) - Filed in conjunction with this Form 10-K
Report
Page 14
(x) Executive Strategic Incentive Plan II (effective January 1, 2001)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
(y) Deferred Incentive Compensation Plan (amended and restated March
31, 2000) - Incorporated by reference to the Form 10-K Report for
the year ended December 31, 2000
(z) 1998 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 13, 1998
(aa) Incentive Compensation Deferral Plan (amended and restated
October 1, 1997) - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2000
(bb) Trust Agreement - Officers and Employees (dated December 6, 1996)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
(cc) Trust Agreement - Outside Directors (dated December 6, 1996) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
(dd) 1995 Stock Plan - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(ee) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 1992
(ff) 1991 Stock Option Plan - Incorporated by reference to the Form
10-K Report for the year ended December 31, 2002
(gg) Excess Benefits Plan (amended and restated effective January 1,
1989) (with respect to Section 415 limitations of the Internal
Revenue Code) - Incorporated by reference to the Form 10-K Report
for the year ended December 31, 2002
(hh) Supplemental Benefits Plan (amended and restated January 1, 1989)
(which provides supplemental retirement benefits) - Incorporated
by reference to the Form 10-K Report for the year ended December
31, 2002
12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this
Form 10-K Report
14 Code of Ethics - Incorporated by reference to the definitive Proxy
Statement to be filed on or about March 16, 2007
21 Subsidiaries of Eaton Corporation - Filed in conjunction with this
Form 10-K Report
23 Consent of Independent Registered Public Accounting Firm - Filed in
conjunction with this Form 10-K Report
24 Power of Attorney - Filed in conjunction with this Form 10-K Report
31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 302) - Filed in conjunction with this Form 10-K Report
31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 302) - Filed in conjunction with this Form 10-K Report
32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 906) - Filed in conjunction with this Form 10-K Report
32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 906) - Filed in conjunction with this Form 10-K Report
Page 15
(b) Exhibits
Certain exhibits required by this portion of Item 15 are filed as a separate
section of this Form 10-K.
(c) Financial Statement Schedules
None required to be filed.
Page 16
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Eaton Corporation
Registrant
Date: February 28, 2007 /s/ Richard H. Fearon
----------------------------------------
Richard H. Fearon
Executive Vice President -
Chief Financial and Planning Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the date indicated.
Date: February 28, 2007
Signature Title
--------- -----
* Chairman and Chief Executive Officer;
---------------------------------------- President; Director
Alexander M. Cutler
* Vice President and Controller;
---------------------------------------- Principal Accounting Officer
Billie K. Rawot
* Director
----------------------------------------
Christopher M. Connor
* Director
----------------------------------------
Michael J. Critelli
* Director
----------------------------------------
Charles E. Golden
* Director
----------------------------------------
Ernie Green
* Director
----------------------------------------
Ned C. Lautenbach
* Director
----------------------------------------
Deborah L. McCoy
* Director
----------------------------------------
John R. Miller
* Director
----------------------------------------
Gregory R. Page
* Director
-----------------------------------------
Victor A. Pelson
* Director
----------------------------------------
Gary L. Tooker
* By /s/ Richard H. Fearon
-----------------------------------
Richard H. Fearon, Attorney-in-Fact
for the officers and directors
signing in the capacities indicated
Page 17
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors & Shareholders
Eaton Corporation
We have audited the accompanying consolidated balance sheets of Eaton
Corporation as of December 31, 2006 and 2005, and the related statements of
consolidated income, shareholders' equity, and cash flows for each of the three
years in the period ended December 31, 2006. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Eaton Corporation
at December 31, 2006 and 2005, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
2006, in conformity with United States generally accepted accounting principles.
As discussed in "Retirement Benefit Plans" in the Notes to the Consolidated
Financial Statements, effective December 31, 2006, the Company adopted Statement
of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for
Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB
Statements No. 87, 88, 106, and 132(R)".
As discussed in "Stock Options" in the Notes to the Consolidated Financial
Statements, effective January 1, 2006, Eaton adopted Statement of Financial
Accounting Standards (SFAS) No. 123(R), "Share-Based Payment".
We also have audited in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Eaton
Corporation's internal control over financial reporting as of December 31, 2006,
based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued
by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated February 23, 2007 expressed an unqualified opinion thereon.
Ernst & Young LLP
------------------------------------
Cleveland, Ohio
February 23, 2007
Page 18
MANAGEMENT'S REPORT ON FINANCIAL STATEMENTS
We have prepared the accompanying consolidated financial statements and related
information of Eaton Corporation included herein for the three years ended
December 31, 2006. The primary responsibility for the integrity of the financial
information included in this annual report rests with management. The financial
information included in this annual report has been prepared in accordance with
accounting principles generally accepted in the United States based on our best
estimates and judgments and giving due consideration to materiality. The opinion
of Ernst & Young LLP, Eaton's independent registered public accounting firm, on
those financial statements is included herein.
Eaton has high standards of ethical business practices supported by the Eaton
Code of Ethics and corporate policies. Careful attention is given to selecting,
training and developing personnel, to ensure that management's objectives of
establishing and maintaining adequate internal controls and unbiased, uniform
reporting standards are attained. Our policies and procedures provide reasonable
assurance that operations are conducted in conformity with law and with the
Company's commitment to a high standard of business conduct.
The Board of Directors pursues its responsibility for the quality of Eaton's
financial reporting primarily through its Audit Committee, which is composed of
five independent directors. The Audit Committee meets regularly with management,
the internal auditors and the independent registered public accounting firm to
ensure that they are meeting their responsibilities and to discuss matters
concerning accounting, control, audits and financial reporting. The internal
auditors and independent registered public accounting firm have full and free
access to senior management and the Audit Committee.
Alexander M. Cutler Richard H. Fearon Billie K. Rawot
------------------- ----------------- ---------------
Chairman and Chief Executive Vice President - Vice President and
Executive Officer; Chief Financial and Planning Controller
President Officer
February 23, 2007
Page 19
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors & Shareholders
Eaton Corporation
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that Eaton
Corporation maintained effective internal control over financial reporting as of
December 31, 2006, based on criteria established in INTERNAL CONTROL -
INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Eaton Corporation's management is responsible for
maintaining effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over financial reporting.
Our responsibility is to express an opinion on management's assessment and an
opinion on the effectiveness of the Company's internal control over financial
reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that Eaton Corporation maintained
effective internal control over financial reporting as of December 31, 2006, is
fairly stated, in all material respects, based on the COSO criteria. Also in our
opinion, Eaton Corporation maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2006, based on the
COSO criteria.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
Eaton Corporation as of December 31, 2006 and 2005, and the related statements
of consolidated income, shareholders' equity, and cash flows for each of the
three years in the period ended December 31, 2006 and our report dated February
23, 2007 expressed an unqualified opinion thereon.
Ernst & Young LLP
------------------------------------
Cleveland, Ohio
February 23, 2007
Page 20
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Eaton Corporation is responsible for establishing and
maintaining adequate internal control over financial reporting (as defined in
Exchange Act rules 13a-15(f)).
Under the supervision and with the participation of Eaton's management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of the Company's internal control
over financial reporting as of December 31, 2006. In conducting this evaluation,
we used the framework set forth by the Committee of Sponsoring Organizations of
the Treadway Commission in INTERNAL CONTROL - INTEGRATED FRAMEWORK. Based on
this evaluation under the framework referred to above, management concluded that
the Company's internal control over financial reporting was effective as of
December 31, 2006.
The independent registered public accounting firm Ernst & Young LLP has issued
an audit report on management's assessment of the effectiveness of the Company's
internal control over financial reporting as of December 31, 2006. This report
is included herein.
Alexander M. Cutler Richard H. Fearon Billie K. Rawot
------------------- ------------------ ---------------
Chairman and Chief Executive Vice President - Vice President and
Executive Officer; Chief Financial and Planning Controller
President Officer
February 23, 2007
Page 21
EATON CORPORATION
STATEMENTS OF CONSOLIDATED INCOME
Year ended December 31
--------------------------
(Millions except for per share data) 2006 2005 2004
------- ------- ------
NET SALES $12,370 $11,019 $9,712
Cost of products sold 9,050 7,936 7,002
Selling & administrative expense 1,946 1,753 1,583
Research & development expense 321 285 259
Interest expense-net 104 90 79
Other (income) expense-net (40) (33) 21
------- ------- ------
INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES 989 988 768
Income taxes 77 189 128
------- ------- ------
INCOME FROM CONTINUING OPERATIONS 912 799 640
Income from discontinued operations, net of
income taxes 38 6 8
------- ------- ------
NET INCOME $ 950 $ 805 $ 648
======= ======= ======
NET INCOME PER COMMON SHARE ASSUMING DILUTION
Continuing operations $ 5.97 $ 5.19 $ 4.07
Discontinued operations .25 .04 .06
------- ------- ------
$ 6.22 $ 5.23 $ 4.13
======= ======= ======
Average number of Common Shares outstanding
assuming dilution 152.9 154.0 157.1
NET INCOME PER COMMON SHARE BASIC
Continuing operations $ 6.07 $ 5.32 $ 4.18
Discontinued operations .25 .04 .06
------- ------- ------
$ 6.32 $ 5.36 $ 4.24
======= ======= ======
Average number of Common Shares outstanding basic 150.2 150.2 153.1
CASH DIVIDENDS PAID PER COMMON SHARE $ 1.48 $ 1.24 $ 1.08
The notes on pages 27 to 51 are an integral part of the consolidated financial
statements.
Page 22
EATON CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31
-----------------
(Millions of dollars) 2006 2005
------- -------
ASSETS
Current assets
Cash $ 114 $ 110
Short-term investments 671 226
Accounts receivable 1,928 1,785
Inventories 1,293 1,099
Deferred income taxes 267 243
Other current assets 135 115
------- -------
4,408 3,578
------- -------
Property, plant & equipment
Land & buildings 1,083 1,003
Machinery & equipment 3,863 3,652
------- -------
4,946 4,655
Accumulated depreciation (2,675) (2,480)
------- -------
2,271 2,175
Goodwill 3,034 3,139
Other intangible assets 969 626
Deferred income taxes & other assets 735 700
------- -------
$11,417 $10,218
======= =======
LIABILITIES & SHAREHOLDERS' EQUITY
Current liabilities
Short-term debt $ 490 $ 394
Current portion of long-term debt 322 240
Accounts payable 1,050 810
Accrued compensation 305 277
Accrued income & other taxes 149 305
Other current liabilities 1,091 942
------- -------
3,407 2,968
------- -------
Long-term debt 1,774 1,830
Pension liabilities 942 632
Other postretirement liabilities 766 537
Other long-term liabilities 422 473
Shareholders' equity
Common Shares (146.3 million outstanding in
2006 and 148.5 million in 2005) 73 74
Capital in excess of par value 2,114 2,013
Retained earnings 2,796 2,376
Accumulated other comprehensive loss (849) (649)
Deferred compensation plans (28) (36)
------- -------
4,106 3,778
------- -------
$11,417 $10,218
======= =======
The notes on pages 27 to 51 are an integral part of the consolidated financial
statements.
Page 23
EATON CORPORATION
STATEMENTS OF CONSOLIDATED CASH FLOWS
Year ended December 31
-------------------------
(Millions) 2006 2005 2004
------- ------- -----
NET CASH PROVIDED BY OPERATING ACTIVITIES
Net income $ 950 $ 805 $ 648
Adjustments to reconcile to net cash provided by
operating activities
Depreciation & amortization 434 409 400
Deferred income taxes 37 (20) (133)
Pension liabilities 198 145 86
Gain on sales of businesses (56)
Other long-term liabilities (45) 4 55
Other non-cash items in income 33 (1) (1)
Changes in working capital, excluding
acquisitions & sales of businesses
Accounts receivable (40) (104) (218)
Inventories (129) (28) (102)
Accounts payable 185 25 143
Accrued income & other taxes (149) 27 46
Other current liabilities 72 (29) (122)
Other working capital accounts 77 (37) 76
Voluntary contributions to United States &
United Kingdom qualified pension plans (119) (64) (93)
Other-net (17) 3 53
------- ------- -----
1,431 1,135 838
------- ------- -----
NET CASH (USED IN) INVESTING ACTIVITIES
Expenditures for property, plant & equipment (360) (363) (330)
Cash paid for acquisitions of businesses (256) (911) (627)
Proceeds from sales of businesses 65
(Purchases) sales of short-term investments-net (418) (4) 606
Other-net (42) 10 18
------- ------- -----
(1,011) (1,268) (333)
------- ------- -----
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES
Borrowings with original maturities of
more than three months
Proceeds 706 393 75
Payments (617) (63) (248)
Borrowings with original maturities of less than
three months-net, primarily commercial paper (35) 392 (33)
Cash dividends paid (220) (184) (163)
Proceeds from exercise of employee stock options 108 68 138
Income tax benefit from exercise of employee stock
options 28
Purchase of Common Shares (386) (450) (250)
Other 2
------- ------- -----
(416) 158 (481)
------- ------- -----
Total increase in cash 4 25 24
Cash at beginning of year 110 85 61
------- ------- -----
Cash at end of year $ 114 $ 110 $ 85
======= ======= =====
The notes on pages 27 to 51 are an integral part of the consolidated financial
statements.
Page 24
EATON CORPORATION
STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumu- Total
Common Shares Capital in lated other Deferred Share-
---------------- excess of Retained comprehen- compensa- holders'
(Millions) Shares Dollars par value earnings sive loss tion plans equity
------ ------- ---------- -------- ----------- ---------- --------
BALANCE AT JANUARY 1, 2004 153.0 $76 $1,856 $1,816 $(585) $(46) $3,117
Net income 648 648
Foreign currency translation and related hedging
instruments (including income tax benefits
of $5) 99 99
Unrealized loss on available for sale investments
(net of income tax benefits of $1) (2) (2)
Deferred loss on cash flow hedges (net of income tax
benefits of $1) (2) (2)
Minimum pension liability (net of income tax benefits
of $25) (48) (48)
------
Other comprehensive income 47
------
Total comprehensive income 695
Cash dividends paid (163) (163)
Issuance of shares under employee benefit plans,
including tax benefit 4.5 3 188 (2) 10 199
Issuance of shares to trust 2 (2)
Purchase of shares (4.2) (2) (53) (195) (250)
Other-net 8 8
----- --- ------ ------ ----- ---- ------
BALANCE AT DECEMBER 31, 2004 153.3 77 1,993 2,112 (538) (38) 3,606
Net income 805 805
Foreign currency translation and related hedging
instruments (including income taxes of $33) (53) (53)
Deferred gain on cash flow hedges (net of income
taxes of $2) 6 6
Minimum pension liability (net of income tax benefits
of $36) (64) (64)
------
Other comprehensive loss (111)
------
Total comprehensive income 694
Cash dividends paid (184) (184)
Issuance of shares under employee benefit plans,
including tax benefit 2.1 1 104 (2) 10 113
Issuance of shares to trust .1 8 (8)
Purchase of shares (7.0) (4) (92) (354) (450)
Other-net (1) (1)
----- --- ------ ------ ----- ---- ------
Page 25
BALANCE AT DECEMBER 31, 2005 148.5 74 2,013 2,376 (649) (36) 3,778
Net income 950 950
Foreign currency translation and related hedging
instruments (including income tax benefits of $16) 95 95
Deferred gain on cash flow hedges (net of income
tax benefits of $3) (5) (5)
Minimum pension liability (net of income tax benefits
of $1) (8) (8)
------
Other comprehensive income 82
------
Total comprehensive income 1,032
Adjustment to initially apply SFAS No. 158
Pensions (net of income tax benefits of $85) (163) (163)
Other postretirement benefits (net of income tax
benefits of $119) (119) (119)
Cash dividends paid (220) (220)
Issuance of shares under employee benefit plans,
including tax benefit 3.1 2 176 (2) 13 189
Purchase of shares by trust (5) (5)
Purchase of shares (5.3) (3) (75) (308) (386)
----- --- ------ ------ ----- ---- ------
BALANCE AT DECEMBER 31, 2006 146.3 $73 $2,114 $2,796 $(849) $(28) $4,106
===== === ====== ====== ===== ==== ======
The notes on pages 27 to 51 are an integral part of the consolidated financial
statements.
Page 26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Dollars in millions, except per share data (per share data assume dilution)
ACCOUNTING POLICIES
CONSOLIDATION & BASIS OF PRESENTATION
The consolidated financial statements include accounts of Eaton and all
subsidiaries and other controlled entities. The equity method of accounting is
used for investments in associate companies where the Company has a 20% to 50%
ownership interest. These associate companies are not material either
individually, or in the aggregate, to Eaton's financial position, results of
operations or cash flows.
Eaton does not have off-balance sheet arrangements or financings with
unconsolidated entities or other persons. In the ordinary course of business,
the Company leases certain real properties and equipment, as described in "Lease
Commitments" in the Notes below. Transactions with related parties are in the
ordinary course of business, are conducted on an arm's-length basis, and are not
material to Eaton's financial position, results of operations or cash flows.
FOREIGN CURRENCY TRANSLATION
The functional currency for substantially all subsidiaries outside the United
States is the local currency. Financial statements for these subsidiaries are
translated into United States dollars at year-end exchange rates as to assets
and liabilities and weighted-average exchange rates as to revenues and expenses.
The resulting translation adjustments are recorded in Accumulated other
comprehensive income (loss) in Shareholders' equity.
INVENTORIES
Inventories are carried at lower of cost or market. Inventories in the United
States are generally accounted for using the last-in, first-out (LIFO) method.
Remaining United States and all other inventories are accounted for using the
first-in, first-out (FIFO) method. Cost components include raw materials,
purchased components, direct labor, indirect labor, utilities, depreciation,
inbound freight charges, purchasing and receiving costs, inspection costs,
warehousing costs, internal transfer costs, and costs of the distribution
network.
In first quarter 2006, Eaton adopted Statement of Financial Accounting Standards
(SFAS) No. 151, "Inventory Costs". SFAS No. 151 amends the guidance in
Accounting Research Bulletin No. 43, Chapter 4, "Inventory Pricing", to clarify
the accounting for abnormal amounts of idle facility expense, freight, handling
costs, and wasted material (spoilage). The effect of the adoption of SFAS No.
151 was not material to the Company's financial position, results of operations,
or cash flows.
DEPRECIATION & AMORTIZATION
Depreciation and amortization are computed by the straight-line method for
financial statement purposes. Cost of buildings is depreciated over 40 years and
machinery and equipment over principally 3 to 10 years. At December 31, 2006,
the weighted-average amortization periods for intangible assets subject to
amortization were 14 years for patents, 18 years for tradenames, 28 years for
distributor channels and 18 years for manufacturing technology and customer
relationships. Software is amortized over a range of 3 to 5 years.
Long-lived assets, except goodwill and indefinite life intangible assets as
described in the Notes below, are reviewed for impairment whenever events or
changes in circumstances indicate the carrying amount may not be recoverable.
Events or circumstances that would result in an impairment review primarily
include operations reporting losses, a significant change in the use of an
asset, or the planned disposal or sale of the asset. The asset would be
considered impaired when the future net undiscounted cash flows generated by the
asset are less than its carrying value. An impairment loss would be recognized
based on the amount by which the carrying value of the asset exceeds its fair
value.
GOODWILL & INDEFINITE LIFE INTANGIBLE ASSETS
In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets", Eaton
does not amortize goodwill and indefinite life intangible assets recorded in
connection with business acquisitions. Indefinite life intangible assets
primarily consist of trademarks. The Company completed the annual impairment
tests for goodwill and indefinite life intangible assets required by SFAS No.
142. These tests confirmed that the fair value of the Company's reporting units
and indefinite life intangible assets exceed their respective carrying values
and that no impairment loss was required to be recognized.
Page 27
FINANCIAL INSTRUMENTS
In the normal course of business, Eaton is exposed to fluctuations in interest
rates, foreign currency exchange rates, and commodity prices. The Company uses
various financial instruments, primarily foreign currency forward exchange
contracts, foreign currency swaps, interest rate swaps and, to a minor extent,
commodity futures contracts, to manage exposure to price fluctuations.
Financial instruments used by Eaton are straightforward, non-leveraged
instruments for which quoted market prices are readily available from a number
of independent sources. The risk of credit loss is deemed to be remote, because
the counterparties to these instruments are major international financial
institutions with strong credit ratings and because of the Company's control
over the size of positions entered into with any one counterparty. Such
financial instruments are not bought and sold solely for trading purposes,
except for nominal amounts authorized under limited, controlled circumstances.
No such financial instruments were purchased or sold for trading purposes in
2006, 2005 and 2004.
All derivative financial instruments are recognized as either assets or
liabilities on the balance sheet and are measured at fair value. Accounting for
the gain or loss resulting from the change in the financial instrument's fair
value depends on whether it has been designated, and is effective, as a hedge
and, if so, on the nature of the hedging activity. Financial instruments can be
designated as hedges of changes in the fair value of a recognized fixed-rate
asset or liability, or the firm commitment to acquire such an asset or
liability; as hedges of variable cash flows of a recognized variable-rate asset
or liability, or the forecasted acquisition of such an asset or liability; or as
hedges of foreign currency exposure from a net investment in one of the
Company's foreign operations. Gains and losses related to a hedge are either
recognized in income immediately to offset the gain or loss on the hedged item
or are deferred and reported as a component of Accumulated other comprehensive
income (loss) in Shareholders' equity and subsequently recognized in net income
when the hedged item affects net income. The ineffective portion of the change
in fair value of a financial instrument is recognized in income immediately. The
gain or loss related to financial instruments that are not designated as hedges
are recognized immediately in net income.
WARRANTY EXPENSES
Estimated product warranty expenses are accrued in Cost of products sold at the
time the related sale is recognized. Estimates of warranty expenses are based
primarily on historical warranty claim experience and specific customer
contracts. Warranty expenses include accruals for basic warranties for products
sold, as well as accruals for product recalls and other related events when they
are known and estimable.
ASSET RETIREMENT OBLIGATIONS
In 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional
Asset Retirement Obligations" (FIN 47), to clarify the term "conditional asset
retirement" as used in SFAS No. 143, "Accounting for Asset Retirement
Obligations". FIN 47 requires that a liability be recognized for the fair value
of a conditional asset retirement obligation when incurred, if the fair value of
the liability can be reasonably estimated. Uncertainty about the timing or
method of settlement of a conditional asset retirement obligation would be
factored into the measurement of the liability when sufficient information
exists. Eaton believes that for substantially all of its asset retirement
obligations, there is an indeterminate settlement date because the range of time
over which the Company may settle the obligation is unknown or cannot be
estimated. A liability for these obligations will be recorded in the period when
sufficient information regarding timing and method of settlement becomes
available to make a reasonable estimate of the liability's fair value.
STOCK OPTIONS GRANTED TO EMPLOYEES & DIRECTORS
As described in "Stock Options" in the Notes below, effective January 1, 2006,
in accordance with SFAS No. 123(R), "Share-Based Payment", Eaton has recorded
compensation expense under the "fair-value-based" method of accounting for stock
options granted to employees and directors. The Company adopted SFAS No. 123(R)
using the "modified prospective application" method and, consequently, financial
results for periods prior to 2006 were not restated for this accounting change.
Under the modified prospective method, compensation expense for stock options
includes expense for all options granted prior to, but not yet vested as of the
end of 2005, and expense for options granted beginning in 2006, based on the
grant date fair value of the options. Expense is recognized on a straight-line
basis over the period the employee or director is required to provide service in
exchange for the award. Prior to 2006, as allowed by SFAS No. 123, "Accounting
for Stock-Based Compensation", stock options were accounted for using the
intrinsic-value-based method in Accounting Principles Board (APB) Opinion No.
Page 28
25. Under that method, no compensation expense was recognized on the grant date,
since on that date the option exercise price equaled the market price of the
underlying Common Shares.
REVENUE RECOGNITION
Sales are recognized when products are shipped to unaffiliated customers, all
significant risks of ownership have been transferred to the customer, title has
transferred in accordance with shipping terms (FOB shipping point or FOB
destination), the selling price is fixed and determinable, all significant
related acts of performance have been completed, and no other significant
uncertainties exist. Shipping and handling costs billed to customers are
included in Net sales and the related costs in Cost of products sold. Other
revenues for service contracts are recognized as the services are provided.
ESTIMATES
Preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions in certain circumstances that affect amounts reported in the
accompanying consolidated financial statements and notes. Actual results could
differ from these estimates.
FINANCIAL PRESENTATION CHANGES
Certain amounts for prior years have been reclassified to conform to the current
year presentation.
ACQUISITIONS OF BUSINESSES
In 2006, 2005, and 2004, Eaton acquired certain businesses and formed joint
ventures in separate transactions for a combined net cash purchase price of $256
in 2006, $911 in 2005 and $627 in 2004. The Statements of Consolidated Income
include the results of these businesses from the effective dates of acquisition
or formation. A summary of these transactions for 2006 and 2005, and larger
transactions in 2004, follows:
Business Annual
Acquired business Date of acquisition segment sales
------------------ ------------------- ----------- -----------
Schreder-Hazemeyer December 1, 2006 Electrical $9 for 2006
Eaton acquired the remaining 50% ownership of the Belgium
manufacturer of low and medium voltage electrical distribution
switchgear
Diesel fuel processing technology & associated assets of October 26, 2006 Truck NM
Catalytica Energy Systems Inc.
A U.S. developer of emission control solutions for Trucks
Senyuan International Holdings Limited September 14, 2006 Electrical $47 for
A China-based manufacturer of vacuum circuit breakers and 2005
other electrical switchgear components
Ronningen-Petter business unit of Dover Resources, Inc. September 5, 2006 Fluid Power $30 for
A U.S.-based manufacturer of industrial fine filters and 2005
components
Synflex business unit of Saint-Gobain Performance Plastics Corp. March 31, 2006 Fluid Power $121 for
A U.S.-based manufacturer of thermoplastic hose and tubing 2005
Marina Power & Lighting March 24, 2006 Electrical $11 for
A U.S. manufacturer of marine duty electrical distribution 2005
products
Aerospace division of PerkinElmer, Inc. December 6, 2005 Fluid Power $150 for
A U.S.-based provider of sealing and pneumatic systems for the year
large commercial aircraft and regional jets ended June
30, 2005
Page 29
Aerospace fluid and air division of Cobham plc November 1, 2005 Fluid Power $210 for
A U.K.-based company that provides low-pressure airframe 2004
fuel systems, electro-mechanical actuation, air ducting,
hydraulic and power generation, and fluid distribution
systems for fuel, hydraulics and air
Assets of Pringle Electrical Manufacturing Company October 11, 2005 Electrical $6 for
A U.S. manufacturer of bolted contact switches and other 2004,
specialty switches one-third
of which
were to
Eaton
Industrial filtration business of Hayward Industries, Inc. September 6, 2005 Fluid Power $100 for
A U.S.-based producer of filtration systems for industrial the year
and commercial customers ended June
30, 2005
Tractech Holdings, Inc. August 17, 2005 Automotive $43 for
A U.S.-based manufacturer of specialized differentials and 2004
clutch components for the commercial and specialty vehicle
markets
Morestana S.A. de C.V. June 30, 2005 Automotive $13 for
A Mexican producer of hydraulic lifters for automotive engine 2004
manufacturers and the automotive aftermarket
Eaton Electrical (Zhongshan) Co., Ltd. (a 51%-owned joint June 17, 2005 Electrical NM
venture)
A China-based manufacturer of medium-voltage switchgear
components, including circuit breakers, meters and relays
Winner Group Holdings Ltd. March 31, 2005 Fluid Power $26 for
A China-based producer of hydraulic hose fittings and 2004
adapters
Pigozzi S.A. Engrenagens e Transmissoes March 1, 2005 Truck $42 for
A Brazilian agricultural powertrain business that produces 2004
transmissions, rotors and other drivetrain components
Walterscheid Rohrverbindungstechnik GmbH September 1, 2004 Fluid Power $52 for
A German manufacturer of hydraulic tube connectors and 2003
fittings primarily for the European market
Powerware Corporation June 9, 2004 Electrical $775 for
A U.S.-based supplier of Uninterruptible Power Systems (UPS), the year
DC Power products and power quality services for computer ended
manufacturers, industrial companies, governments, March 31,
telecommunications firms, medical institutions, data centers 2004
and other businesses
FAW Eaton Transmission Co., Ltd. (a 50%-owned joint venture) March 31, 2004 Truck NM
Manufacturer of medium-duty transmissions for the China
market
The allocations of the purchase prices for acquisitions in 2006 are preliminary
and will be finalized in 2007.
Page 30
On December 28, 2006, Eaton announced it had reached an agreement to purchase AT
Holdings Corporation, the parent of Argo-Tech Corporation, for $695. This
transaction is expected to close in the first quarter of 2007. Argo-Tech's
U.S.-based aerospace business, which had sales for the fiscal year ended October
28, 2006 of $206, is a leader in high performance aerospace engine fuel pumps
and systems, airframe fuel pumps and systems, and ground fueling systems for
commercial and military aerospace markets. This business will be integrated into
the Fluid Power segment.
On January 5, 2007, the Company announced it had reached an agreement to
purchase the Power Protection Business of Power Products Ltd., a Czech
distributor and service provider of Powerware and other uninterruptible power
systems, for $2. The transaction closed in February 2007. This business, which
had 2006 sales of $3, will be integrated into the Electrical segment.
As described above, on June 9, 2004, Eaton acquired Powerware Corporation, the
electrical power systems business of Invensys plc, for a final cash purchase
price of $573, less cash acquired of $27. Powerware's assets and liabilities
were recorded at estimated fair values as determined by Eaton's management. The
allocation of the purchase price for this acquisition is summarized below:
Current assets $302
Property, plant & equipment 35
Goodwill 397
Other intangible assets 96
Other assets 53
----
Total assets acquired 883
Total liabilities assumed 337
----
Net assets acquired $546
====
Other intangible assets of $96 included $24 related to trademarks that are not
subject to amortization. The remaining $72 was assigned to patents and other
intangible assets that have a weighted-average useful life of 8 years. Goodwill
of $397 relates to the Electrical segment, substantially all of which is
non-deductible for income tax purposes.
Eaton has undertaken restructuring activities at acquired businesses, including
workforce reductions, plant consolidations and facility closures. In accordance
with EITF Issue No. 95-3, "Recognition of Liabilities in Connection with a
Purchase Business Combination," liabilities for these restructuring activities
were recorded in the allocation of the purchase price related to the acquired
business. A summary of these liabilities, and utilization of the various
components, follows:
Workforce Reductions Plant
-------------------- closing
Employees Dollars & other Total
--------- -------- ------- -----
Balance at January 1, 2004 763 $ 22 $ 63 $ 85
Liabilities recorded in 2004 175 9 35 44
Utilized in 2004 (555) (18) (48) (66)
----- ---- ---- ----
Balance at December 31, 2004 383 13 50 63
Liabilities recorded in 2005 789 25 27 52
Utilized in 2005 (228) (14) (40) (54)
----- ---- ---- ----
Balance at December 31, 2005 944 24 37 61
Liabilities recorded in 2006 417 17 28 45
Utilized in 2006 (285) (8) (43) (51)
----- ---- ---- ----
Balance at December 31, 2006 1,076 $ 33 $ 22 $ 55
===== ==== ==== ====
In accordance with EITF Issue No. 95-3, the Company finalizes its restructuring
plans no later than one year from the date of the acquisition.
Page 31
ACQUISITION INTEGRATION & EXCEL 07 PLANT CLOSING CHARGES
ACQUISITION INTEGRATION CHARGES
In 2006, 2005 and 2004, Eaton incurred charges related to the integration of
acquired businesses. These charges were recorded as expense as incurred. A
summary of these charges follows:
2006 2005 2004
---- ---- ----
Electrical $ 7 $ 21 $ 33
Fluid Power 23 7 8
Truck 5 4
Automotive 5 4
---- ---- ----
Pretax charges $ 40 $ 36 $ 41
==== ==== ====
After-tax charges $ 27 $ 24 $ 27
Per Common Share $.17 $.15 $.17
2006 CHARGES
Charges in 2006 related to the integration of primarily the following
acquisitions: Powerware, the electrical power systems business acquired in 2004
and the Pringle electrical switch business; several acquisitions in Fluid Power
including the acquired operations of Synflex, PerkinElmer, Cobham, Hayward,
Winner, and Walterscheid; and the Pigozzi, Tractech, and Morestana businesses.
Charges in the Electrical segment consisted of $7 for plant consolidations,
integration and other expenses.
Charges in the Fluid Power segment consisted of $20 for plant consolidations,
integration and other expenses, and $3 for workforce reductions.
Charges in the Truck segment consisted of $5 for plant consolidations,
integration and other expenses.
Charges in the Automotive segment consisted of $5 for plant consolidations,
integration and other expenses.
2005 CHARGES
Charges in 2005 related to the integration of primarily the following
acquisitions: Powerware and the electrical division of Delta plc; several
acquisitions in Fluid Power, including Winner, Walterscheid and Boston
Weatherhead; and the Pigozzi and Morestana businesses.
Charges in the Electrical segment consisted of $20 for plant consolidations,
integration and other expenses, and $1 for workforce reductions.
Charges in the Fluid Power segment consisted of $7 for plant consolidations,
integration and other expenses.
2004 CHARGES
Charges in 2004 related to the integration of primarily the following
acquisitions: Powerware; the electrical division of Delta plc; and Boston
Weatherhead.
Charges in the Electrical segment consisted of $32 for plant consolidations,
integration and other expenses, and $1 of workforce reductions.
Charges in the Fluid Power segment consisted of $8 for plant consolidations,
integration and other expenses.
EXCEL 07 PLANT CLOSING CHARGES
In first quarter 2006, Eaton announced, and began to implement, its Excel 07
program. This program was a series of actions concluded in 2006 intended to
address resource levels and operating performance in businesses that
underperformed in 2005, and businesses that were expected to weaken during
second half 2006 and in 2007. As part of the Excel 07 program, charges were
incurred related to plant closings in all four business segments, including
three significant plant closings announced in third quarter 2006 for the
heavy-duty truck transmission manufacturing plant in Manchester, United Kingdom;
the engine valve actuation manufacturing plant in Saginaw, Michigan; and the
engine valve manufacturing plant in Montornes del Valles, Spain. A summary of
charges incurred by each segment in
Page 32
2006 related to Excel 07 plant closings, including workforce reductions, plant
integration and other charges follow:
Electrical $ 12
Fluid Power 15
Truck 29
Automotive 50
----
Pretax charges $106
====
SUMMARY OF ACQUISITION INTEGRATION AND EXCEL 07 PLANT CLOSING CHARGES
A summary of acquisition integration and Excel 07 plant closing charges, and
utilization of the various components follows:
Workforce reductions Plant
-------------------- closing
Employees Dollars & other Total
--------- ------- ----------- -----
Balance at January 1, 2004 21 $ 2 $ 8 $ 10
Charges in 2004 10 1 40 41
Utilized in 2004 (31) (3) (45) (48)
----- ---- ---- ----
Balance at December 31, 2004 0 0 3 3
Charges in 2005 173 4 32 36
Utilized in 2005 (7) (1) (34) (35)
----- ---- ---- ----
Balance at December 31, 2005 166 3 1 4
Charges in 2006 2,339 85 61 146
Utilized in 2006 (902) (39) (56) (95)
----- ---- ---- ----
Balance at December 31, 2006 1,603 $ 49 $ 6 $ 55
===== ==== ==== ====
The acquisition integration and Excel 07 plant closing charges were included in
the Statements of Consolidated Income in Cost of products sold or Selling &
administrative expense, as appropriate. In Business Segment Information, the
charges reduced Operating profit of the related business segment.
DISCONTINUED OPERATIONS
As part of the Excel 07 program, in third quarter 2006, certain businesses of
the Automotive segment were sold, resulting in a $35 after-tax gain, or $.23 per
Common Share. The gain on sale of these businesses, and other operating results
of these businesses, were reported as Discontinued operations in the Statement
of Consolidated Income.
SHORT-TERM INVESTMENTS
Eaton invests excess cash generated from operations in short-term marketable
investments and classifies these investments as "available-for-sale" under
Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for
Certain Investments in Debt and Equity Securities". In accordance with SFAS No.
115, available-for-sale investments are recorded at fair market prices, with the
unrealized gain or loss recorded in Accumulated other comprehensive income
(loss) in Shareholders' equity. A summary of the carrying value of short-term
investments at December 31, 2006 follows:
Time deposits & certificate of deposits with banks $323
Bonds issued by foreign governments 149
Money market investments 138
Corporate & agency bonds 60
Other 1
----
$671
====
The fair market value of short-term investments approximates the cost of these
investments.
Page 33
GOODWILL & OTHER INTANGIBLE ASSETS
A summary of goodwill follows:
2006 2005
------ ------
Electrical $1,039 $1,016
Fluid Power 1,689 1,811
Truck 144 145
Automotive 162 167
------ ------
$3,034 $3,139
====== ======
The net decrease in goodwill in 2006 was due to the final allocation of purchase
price to acquisitions of businesses completed prior to 2006, partially offset by
increases in goodwill for businesses acquired during 2006. These transactions
are described in the "Acquisitions of Businesses" Note above.
A summary of other intangible assets follows:
2006 2005
------------------------- -------------------------
Historical Accumulated Historical Accumulated
cost amortization cost amortization
---------- ------------ ---------- ------------
Intangible assets not subject to
amortization (primarily trademarks) $430 $381
==== ====
Intangible assets subject to amortization
Patents $208 $107 $191 $ 90
Technology and customer
relationships 337 57 101 26
Other 204 46 108 39
---- ---- ---- ----
$749 $210 $400 $155
==== ==== ==== ====
Expense related to intangible assets subject to amortization for 2006 was $51.
Estimated annual pretax expense for intangible assets subject to amortization
for each of the next five years is $50 in 2007, $49 in 2008, $47 in 2009, $44 in
2010 and $40 in 2011.
DEBT & OTHER FINANCIAL INSTRUMENTS
Short-term debt of $490 at December 31, 2006 included $472 of short-term
commercial paper for operations in the United States and $18 for operations
outside the United States. Borrowings for operations in the United States
included 200 million of Euro denominated commercial paper. The foreign exchange
translation gain or loss related to the Euro denominated commercial paper is
recorded in Accumulated other comprehensive income (loss) in Shareholders'
equity since these borrowings serve as a hedge of the Company's net assets of
operations in Europe. Borrowings for operations outside the United States were
largely denominated in local currencies. The weighted-average interest rate on
the $472 of short-term commercial paper was 4.4% at December 31, 2006. The
weighted-average interest rate on short-term debt for operations outside the
United States was 2.7% at December 31, 2006. Operations outside the United
States have available short-term lines of credit aggregating $399 from various
banks worldwide.
A summary of long-term debt, including the current portion, follows:
Page 34
2006 2005
------ ------
1.62% Yen notes due 2006 $ 43
8% debentures due 2006 86
8.90% debentures due 2006 100
6% Euro 200 million notes due 2007
(100 million converted to floating rate by interest rate swap) $ 263 236
7.37% notes due 2007
(converted to floating rate by interest rate swap) 20 20
7.14% notes due 2007 3 3
6.75% notes due 2007
(converted to floating rate by interest rate swap) 25 25
Euro 100 million floating rate notes due 2008
(3.991% at December 31, 2006 - EURIBOR+.375%) 132 118
7.40% notes due 2009
(converted to floating rate by interest rate swap) 15 15
Floating rate senior notes due 2009
(5.53% at December 31, 2006 - LIBOR +.08%) 250
5.75% notes due 2012
($225 converted to floating rate by interest rate swap) 300 300
7.58% notes due 2012
(converted to floating rate by interest rate swap) 12 12
5.80% notes due 2013 7 7
12.5% British Pound debentures due 2014 11 10
4.65% notes due 2015
(converted to floating rate by interest rate swap) 100 100
7.09% notes due 2018
(converted to floating rate by interest rate swap) 25 25
6.89% notes due 2018 6 6
7.07% notes due 2018 2 2
6.875% notes due 2018 3 3
8-7/8% debentures due 2019
($25 converted to floating rate by interest rate swap) 38 38
8.10% debentures due 2022 100 100
7.625% debentures due 2024
($25 converted to floating rate by interest rate swap) 66 66
6-1/2% debentures due 2025 145 145
7.875% debentures due 2026 72 72
7.65% debentures due 2029
($75 converted to floating rate by interest rate swap) 200 200
5.45% debentures due 2034
($100 converted to floating rate by interest rate swap) 150 150
5.25% notes due 2035
($50 converted to floating rate by interest rate swap) 90 100
Other 61 88
------ ------
Total long-term debt 2,096 2,070
Less current portion of long-term debt (322) (240)
------ ------
Long-term debt less current portion $1,774 $1,830
====== ======
Eaton's United States operations have long-term revolving credit facilities of
$1.5 billion, of which $300 will expire in May 2008, $700 in March 2010 and the
remaining $500 in August 2011. One of the Company's international subsidiaries
has a long-term line of credit of Euro 100 million. The Euro 100 million
floating rate notes due 2008, which have a U.S. dollar equivalent of $132 at
December 31, 2006, were borrowed under this line of credit.
Aggregate mandatory annual maturities of long-term debt for each of the next
five years are $322 in 2007, $133 in 2008, $268 in 2009, $1 in 2010 and $6 in
2011. Interest paid was $151 in 2006, $113 in 2005 and $96 in 2004.
Eaton has entered into fixed-to-floating interest rate swaps to manage interest
rate risk. These interest rate swaps are accounted for as fair value hedges of
certain of the Company's long-term debt. The
Page 35
maturity of the swap corresponds with the maturity of the debt instrument as
noted in the table of long-term debt above. A summary of interest rate swaps
outstanding at December 31, 2006, follows (currency in millions):
Interest rates at December 31, 2006
--------------------------------------------
Fixed
interest Floating Basis for contracted
Notional rate interest floating interest
amount received rate paid rate paid
-------- -------- --------- ---------------------
E 100 6.00% 4.10% 6 month EURIBOR+0.54%
$ 20 7.37% 9.85% 6 month LIBOR+4.47%
$ 25 6.75% 6.89% 6 month LIBOR+1.50%
$ 15 7.40% 7.34% 6 month LIBOR+1.95%
$225 5.75% 6.39% 6 month LIBOR+0.78%
$ 12 7.58% 7.15% 6 month LIBOR+1.76%
$100 4.65% 5.47% 6 month LIBOR+0.12%
$ 25 7.09% 7.79% 6 month LIBOR+2.40%
$ 25 8.88% 9.20% 6 month LIBOR+3.84%
$ 25 7.63% 7.85% 6 month LIBOR+2.48%
$ 75 7.65% 7.98% 6 month LIBOR+2.58%
$100 5.45% 5.83% 6 month LIBOR+0.43%
$ 50 5.25% 5.52% 6 month LIBOR+0.17%
The carrying values of cash, short-term investments and short-term debt in the
balance sheet approximate their estimated fair values. The estimated fair values
of other financial instruments outstanding follow:
2006 2005
----------------------------- -----------------------------
Notional Carrying Fair Notional Carrying Fair
amount value value amount value value
-------- -------- ------- -------- -------- -------
Long-term debt & current portion
of long-term debt (a) $(2,096) $(2,213) $(2,070) $(2,221)
Foreign currency principal swaps $192 (5) (5) $ 83 (2) (2)
Foreign currency forward
exchange contracts (23) (6) (7) 12 5 5
Fixed to floating interest rate
swaps 829 (15) (14) 1,080 12 12
(a) Includes foreign currency denominated debt.
The estimated fair values of financial instruments were principally based on
quoted market prices where such prices were available and, where unavailable,
fair values were estimated based on comparable contracts, utilizing information
obtained from established, independent providers. The fair value of foreign
currency principal swaps, which related to the Euro and Pound Sterling, and
foreign currency forward exchange contracts, which primarily related to the
Euro, Pound Sterling, Japanese Yen and U.S. Dollar, were estimated based on
quoted market prices of comparable contracts, adjusted through interpolation
where necessary for maturity differences. These contracts mature during 2007
through 2009.
RETIREMENT BENEFIT PLANS
ADOPTION OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 158
On December 31, 2006, Eaton adopted Statement of Financial Accounting Standards
(SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other
Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and
132(R)". SFAS No. 158 requires employers to recognize on their balance sheets
the net amount by which pension and other postretirement benefit plan
liabilities are overfunded or underfunded. SFAS No. 158 replaces SFAS No. 87's
requirement to report at least a minimum pension liability measured as the
excess of the accumulated benefit obligations over the fair value of plan
assets. Under SFAS No. 158, all actuarial gains and losses and prior service
costs are
Page 36
recognized, with an offsetting increase in accumulated other comprehensive loss
in shareholders' equity, net of income tax benefits. SFAS No. 158 does not
change the amounts recognized in the income statement as net periodic benefit
cost. The incremental effect on Eaton of applying SFAS No. 158 on individual
line items in the Consolidated Balance Sheet at December 31, 2006 follows:
Effect of adopting
SFAS No. 158
-------------------------
Before Other
adoption postretire- After
of SFAS Pension ment adoption of
No. 158 liabilities liabilities SFAS No. 158
-------- ----------- ----------- ------------
Non-current deferred income tax assets $ 303 $ 85 $ 119 $ 507
Other assets 182 (26) 156
----- -----
Total assets 11,239 $ 59 $ 119 11,417
===== =====
Other current liabilities $(1,089) $ (10) $ 8 $(1,091)
Non-current liabilities
Pensions (730) (212) (942)
Other postretirement benefits (520) (246) (766)
----- -----
Total liabilities (6,851) $(222) $(238) (7,311)
===== =====
Accumulated other comprehensive loss
in Shareholders' equity $ 567 $ 163 $ 119 $ 849
----- -----
Total Shareholders' equity (4,388) $ 163 $ 119 (4,106)
===== =====
RETIREMENT BENEFIT PLAN LIABILITIES AND ASSETS
Eaton has defined benefit pension plans and other postretirement benefit plans.
Components of plan obligations and assets, and recorded liabilities and assets
follow:
Other postretirement
Pension liabilities liabilities
------------------- --------------------
2006 2005 2006 2005
------- ------- ----- -----
Changes in benefit obligation
Benefit obligation at beginning of year $(2,782) $(2,601) $(873) $(896)
Service cost (144) (119) (17) (16)
Interest cost (147) (141) (45) (48)
Actuarial (loss) gain (165) (190) (9) 3
Benefits paid 224 206 97 97
Prescription drug subsidy received (5)
Foreign currency translation (97) 83
Business acquisitions (4) (13) (2)
Other (10) (7) (2) (11)
------- ------- ----- -----
Benefit obligation at end of year (3,125) (2,782) (854) (873)
------- ------- ----- -----
Change in plan assets
Fair value of plan assets at beginning
of year 1,916 1,852
Actual return on plan assets 246 204
Employer contributions 161 97 97 97
Benefits paid (224) (206) (97) (97)
Foreign currency translation 66 (50)
Business acquisitions 13
Other 8 6
------- ------- ----- -----
Fair value of plan assets at end of year 2,173 1,916 0 0
------- ------- ----- -----
Funded status (952) (866) (854) (873)
Contributions after measurement date 3 2 7 8
Unrecognized net actuarial loss 1,053 246
Unrecognized prior service cost 23 (7)
------- ------- ----- -----
Amount recognized in Consolidated
Balance Sheet $ (949) $ 212 $(847) $(626)
======= ======= ===== =====
Page 37
Amounts recognized in the Consolidated Balance Sheet, which reflect the adoption
of SFAS No. 158 at December 31, 2006, follow:
Other postretirement
Pension liabilities liabilities
------------------- --------------------
2006 2005 2006 2005
----- ----- ----- -----
Non-current assets $ 3 $ 27
Current liabilities (10) $ (81) $ (89)
Non-current liabilities (942) (632) (766) (537)
Accumulated other comprehensive loss 817
----- ----- ----- -----
Amount recognized in Consolidated
Balance Sheet $(949) $ 212 $(847) $(626)
===== ===== ===== =====
Amounts recognized in Accumulated other comprehensive loss at December 31, 2006,
before income tax benefits, follow:
Other
Pension postretirement
liabilities liabilities
----------- --------------
Net actuarial loss $1,051 $245
Prior service cost 23 (7)
------ ----
Total before income tax benefits $1,074 $238
====== ====
Prior to December 31, 2006, SFAS No. 87 required recognition of a minimum
liability for those pension plans with accumulated benefit obligations in excess
of the fair values of plan assets at the end of the year. Accordingly, in 2006,
2005 and 2004, Eaton recorded non-cash charges in Accumulated other
comprehensive loss of $9, $100 and $73, respectively, ($8, $64 and $48 after
income tax benefits, respectively) related to the additional minimum liability
for certain underfunded pension plans. As a result of the adoption of SFAS No.
158, at December 31, 2006, Eaton recorded non-cash charges in Accumulated other
comprehensive loss in Shareholders' equity of $248 ($163 after-tax) for pension
benefits and $238 ($119 after-tax) for other postretirement benefits as a
one-time adjustment to initially apply the new Standard. Pension funding
requirements are not affected by the recording of these charges.
PENSION PLANS
The measurement date for all pension obligations is November 30. Effective for
fiscal years ending after December 15, 2008, SFAS No. 158 will require year end
measurements of plan assets and benefit obligations, eliminating the use of
earlier measurement dates currently permissible. Assumptions used to determine
pension benefit obligations and costs follow:
United States &
non-United States
United plans (weighted-
States plans average)
------------------ ------------------
2006 2005 2004 2006 2005 2004
---- ---- ---- ---- ---- ----
Assumptions used to
determine benefit
obligation at year-end
Discount rate 5.60% 5.75% 6.00% 5.39% 5.51% 5.81%
Rate of compensation
increase 3.50% 3.50% 3.50% 3.67% 3.67% 3.60%
Assumptions used to
determine cost
Discount rate 5.75% 6.00% 6.25% 5.51% 5.81% 6.11%
Expected long-term
return on plan
assets 8.75% 8.75% 8.75% 8.35% 8.41% 8.50%
Rate of compensation
increase 3.50% 3.50% 3.50% 3.67% 3.60% 3.60%
Page 38
The expected long-term rate of return on pension assets was determined
separately for each country and reflects long-term historical data, with greater
weight given to recent years, and takes into account each plan's target asset
allocation.
The components of pension benefit cost recorded in Statements of Consolidated
Income follow:
2006 2005 2004
----- ----- -----
Service cost $(144) $(119) $(103)
Interest cost (147) (141) (134)
Expected return on plan assets 166 166 179
Amortization (67) (49) (26)
----- ----- -----
(192) (143) (84)
Curtailment loss (10) (1) (2)
Settlement loss (41) (34) (31)
----- ----- -----
Costs recorded in Statements
of Consolidated Income $(243) $(178) $(117)
===== ===== =====
Other changes in plan assets and benefit liabilities recognized in Accumulated
other comprehensive loss, before income tax benefits, follow:
2006 2005 2004
------ ---- ----
Accumulated other comprehensive loss at
beginning of year $ 817 $717 $644
Change prior to adoption of SFAS No. 158 9 100 73
Change due to adoption of SFAS No. 158 248
------ ---- ----
Accumulated other comprehensive loss at end of year $1,074 $817 $717
====== ==== ====
The estimated net loss and prior service cost for the defined pension plans that
will be recognized from Accumulated other comprehensive loss into net periodic
benefit cost in 2007 are $106 and $3, respectively.
The total accumulated benefit obligation for all pension plans at December 31,
2006 was $2,899 and at year-end 2005 was $2,544. The components of pension plans
with an accumulated benefit obligation in excess of plan assets at December 31
follow:
2006 2005
------ ------
Projected benefit obligation $3,101 $2,771
Accumulated benefit obligation 2,876 2,533
Fair value of plan assets 2,150 1,902
United States pension plans represent 67% and 70% of benefit obligations in 2006
and 2005, respectively.
The weighted-average pension plan asset allocations by asset category at
December 31, 2006 and 2005 are as follows:
2006 2005
---- ----
Equity securities 80% 79%
Debt securities 17% 18%
Other 3% 3%
--- ---
100% 100%
=== ===
Investment policies and strategies are developed on a country specific basis.
The United States plan represents 68% of worldwide pension assets and its target
allocation is 85% diversified equity, 12% United States Treasury
Inflation-Protected Securities, and 3% cash equivalents. The United Kingdom plan
represents 25% of worldwide pension assets and its target allocation is 70%
diversified equity securities and 30% United Kingdom Government Bonds.
Page 39
Contributions to pension plans that Eaton expects to make in 2007, and made in
2006, 2005 and 2004, follow:
2007 2006 2005 2004
---- ---- ---- ----
Voluntary
United States $150 $100 $50 $75
United Kingdom 27 19 14 18
Other 37 43 33 41
---- ---- --- ----
$214 $162 $97 $134
==== ==== === ====
At December 31, 2006, expected pension benefit payments for each of the next
five years and the five years thereafter in the aggregate are, $190 in 2007,
$198 in 2008, $207 in 2009, $217 in 2010, $230 in 2011 and $1,351 in 2012-2016.
The Company also has various defined-contribution benefit plans, primarily
consisting of the Eaton Savings Plan in the United States. Total contributions
related to these plans charged to expense were $55 in 2006, $48 in 2005, and $44
in 2004.
OTHER POSTRETIREMENT BENEFIT PLANS
The measurement date for all other postretirement benefit plan obligations is
November 30. Effective for fiscal years ending after December 15, 2008, SFAS No.
158 will require year-end measurements of plan assets and benefit obligations,
eliminating the use of earlier measurement dates currently permissible.
Assumptions used to determine other postretirement benefit obligations and cost
follow:
2006 2005 2004
---- ----- -----
Assumptions used to determine benefit obligation at
year-end
Discount rate 5.60% 5.75% 6.00%
Health care cost trend rate assumed for next year 8.80% 9.60% 10.00%
Ultimate health care cost trend rate 4.75% 4.75% 4.75%
Year ultimate health care cost trend rate is achieved 2014 2014 2014
Assumptions used to determine cost
Discount rate 5.75% 6.00% 6.25%
Initial health care cost trend rate 9.60% 10.00% 9.00%
Ultimate health care cost trend rate 4.75% 4.75% 5.00%
Year ultimate health care cost trend rate is achieved 2014 2014 2007
The components of other postretirement benefits cost recorded in Statements of
Consolidated Income follow:
2006 2005 2004
---- ---- ----
Service cost $(17) $(16) $(17)
Interest cost (45) (48) (53)
Amortization (11) (10) (9)
---- ---- ----
(73) (74) (79)
Curtailment loss (2) (1)
---- ---- ----
Costs recorded in Statements
of Consolidated Income $(75) $(74) $(80)
==== ==== ====
Other changes in other postretirement benefit liabilities recognized in
Accumulated other comprehensive loss at December 31, 2006 were $238, before
income tax benefits. Estimated net loss and prior service cost for other
postretirement benefit plans that will be recognized from Accumulated other
comprehensive loss into net periodic benefit cost in 2007 are $12 and $(1),
respectively.
Assumed health care cost trend rates may have a significant effect on the
amounts reported for the health care plans. A 1-percentage point change in the
assumed health care cost trend rates would have the following effects:
Page 40
1% Increase 1% Decrease
----------- -----------
Effect on total of service and
interest cost $ 1 $ (1)
Effect on other postretirement
liabilities 22 (20)
At December 31, 2006, expected other postretirement benefit payments for each of
the next five years and the five years thereafter in the aggregate are $92 in
2007 and 2008, $91 in 2009, $89 in 2010, $93 in 2011 and $419 in 2012-2016. The
expected subsidy receipts related to the Medicare Prescription Drug,
Improvement, and Moderation Act of 2003 that are included in the other
postretirement benefit payments listed above for each of the next five years and
the five years thereafter in the aggregate are, $8 in 2007, $9 in 2008, 2009 and
2010, $10 in 2011 and $49 in 2012-2016.
PROTECTION OF THE ENVIRONMENT
Eaton has established policies to ensure that its operations are conducted in
keeping with good corporate citizenship and with a positive commitment to the
protection of the natural and workplace environments. For example, each
manufacturing facility has a person responsible for environmental, health and
safety (EHS) matters. All of the Company's manufacturing facilities are required
to be certified to ISO 14001, an international standard for environmental
management systems. The Company routinely reviews EHS performance at each of its
facilities and continuously strives to improve pollution prevention at its
facilities.
As a result of past operations, Eaton is involved in remedial response and
voluntary environmental remediation at a number of sites, including certain of
its currently-owned or formerly-owned plants. The Company has also been named a
potentially responsible party (PRP) under the Federal Superfund law at a number
of waste disposal sites.
A number of factors affect the cost of environmental remediation, including the
number of parties involved at a particular site, the determination of the extent
of contamination, the length of time the remediation may require, the complexity
of environmental regulations, and the continuing advancement of remediation
technology. Taking these factors into account, Eaton has estimated (without
discounting) the costs of remediation, which will be incurred over a period of
several years. The Company accrues an amount consistent with the estimates of
these costs when it is probable that a liability has been incurred. At December
31, 2006 and 2005, the balance sheet included a liability for these costs of $64
and $75, respectively.
Based upon Eaton's analysis and subject to the difficulty in estimating these
future costs, the Company expects that any sum it may be required to pay in
connection with environmental matters is not reasonably likely to exceed the
liability by an amount that would have a material adverse effect on its
financial position, results of operations or cash flows. All of these estimates
are forward-looking statements and, given the inherent uncertainties in
evaluating environmental exposures, actual results can differ from these
estimates.
CONTINGENCIES
Eaton is subject to a broad range of claims, administrative proceedings,
and legal proceedings, such as lawsuits that relate to contractual
allegations, patent infringement, personal injuries (including asbes-
tos claims) and employment-related matters. Although it is not pos-
sible to predict with certainty the outcome or cost of these matters,
the Company believes that these matters will not have a material ad-
verse effect on its financial position, results of operations or cash flows.
SHAREHOLDERS' EQUITY
There are 300 million Common Shares authorized ($.50 par value per share), 146.3
million of which were issued and outstanding at year-end 2006. At December 31,
2006, there were 8,868 holders of record of Common Shares. Additionally, 20,356
current and former employees were shareholders through participation in the
Eaton Savings Plan (ESP) and Eaton Personal Investment Plan (EPIP).
On January 22, 2007, Eaton announced that it had authorized a new 10 million
Common Share repurchase program, replacing the 1.3 million shares remaining from
the 10 million share repurchase authorization approved in April 2005. The shares
are expected to be repurchased over time, depending
Page 41
on market conditions, share price, capital levels and other considerations.
During 2006, Eaton repurchased 5.286 million shares in the open market at a
total cost of $386.
During 2005, Eaton repurchased 7.015 million shares in the open market at a
total cost of $450. During 2004, 4.249 million Common Shares were repurchased in
the open market at a total cost of $250.
Eaton has plans that permit certain employees and directors to defer a portion
of their compensation. The Company has deposited $31 of Common Shares and
marketable securities into a trust at December 31, 2006 to fund a portion of
these liabilities. The marketable securities were included in Other assets and
the Common Shares were included in Shareholders' equity at historical cost.
STOCK OPTIONS
Under various plans, stock options have been granted to certain employees and
directors to purchase Common Shares at prices equal to fair market value on the
date of grant. Substantially all of these options vest ratably during the
three-year period following the date of grant and expire 10 years from the date
of grant. During 1997 and 1998, stock options were granted that have a provision
for accelerated vesting if the Company achieves certain earnings per Common
Share targets or certain Common Share market price targets. One-half of these
options vest based on the achievement of earnings per share targets and the
other half vest based on the achievement of Common Share market price targets.
If the targets are not achieved, these options vest 10 days before the
expiration of their 10-year term. Subsequent to the issuance of these options,
the Common Share price targets were achieved and the related options vested. As
of December 31, 2006, 1.8 million stock options with earnings per share targets
were outstanding that have not vested, because the earnings per share targets
have not been achieved. Of these options, 1.4 million became exercisable, and
were exercised during the second and third weeks of January 2007.
Effective January 1, 2006, in accordance with SFAS No. 123(R), "Share-Based
Payment", Eaton began to record compensation expense under the
"fair-value-based" method of accounting for stock options granted to employees
and directors. Expense for stock options in 2006 was $27 pretax ($20 after-tax,
or $.13 per Common Share both assuming dilution and basic). Additionally, the
adoption of SFAS No. 123(R) reduced cash provided by operating activities by $28
in 2006 and increased cash provided by financing activities by $28, because the
new Statement requires, for the first time, certain income tax benefits
resulting from exercises of stock options to be included in cash provided by
financing activities.
The Company adopted SFAS No. 123(R) using the "modified prospective application"
method and, consequently, financial results for periods prior to 2006 were not
restated for this accounting change. Under the modified prospective method,
compensation expense for stock options includes expense for all options granted
prior to but not yet vested as of the end of 2005, and expense for options
granted beginning in 2006, based on the grant date fair value of the options.
Expense is recognized on a straight-line basis over the period the employee or
director is required to provide service in exchange for the award. Prior to
2006, as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation",
stock options were accounted for using the intrinsic-value-based method in
Accounting Principles Board (APB) Opinion No. 25. Under that method, no
compensation expense was recognized on the grant date, since on that date the
option exercise price equaled the market price of the underlying Common Shares.
The fair value of stock options granted was estimated using the Black-Scholes
option pricing model. A summary of the assumptions used in determining the fair
value of options follows:
2006 2005 2004
----------- ----------- -----------
Expected volatility 25% 27% 28%
Expected option life in years 5 5 5
Expected dividend yield 2.0% 2.0% 2.5%
Risk-free interest rate 4.3% to 5.0% 3.7% to 4.4% 3.1% to 3.8%
Application of the Black-Scholes option pricing model involves assumptions that
are judgmental and affect compensation expense. Historical information was the
primary basis for the selection of expected volatility, expected option life,
and expected dividend yield. Expected volatility was based on the most recent
historical period equal to the expected life of the option. The risk-free
interest rate was based on yields of U.S. Treasury zero-coupon issues with a
term equal to the expected life of the option, on the date the stock options
were granted.
Page 42
The weighted-average fair value of stock options granted per option was $16.80
in 2006, $16.73 in 2005, and $13.29 in 2004. The total fair value of stock
options vesting was $29 in 2006, $24 in 2005 and $21 in 2004. As of December 31,
2006, the total compensation expense not yet recognized related to nonvested
stock options was $38, and the weighted-average period in which the expense is
expected to be recognized is 1.5 years.
A summary of stock option activity for 2006 follows (shares in millions):
Weighted-
average
Weighted- remaining Aggregate
average price contractual intrinsic
per option Options life in years value
------------- ------- ------------- ---------
Outstanding January 1 $42.95 14.4
Granted 68.67 1.9
Exercised 35.82 (3.1)
Canceled 62.73 (.2)
----
Outstanding December 31 $48.01 13.0 5.3 $352
====
Exercisable December 31 $42.25 7.3 4.9 $239
Reserved for future
grants December 31 5.2
The aggregate intrinsic value in the table above represents the total pretax
difference between the $75.14 closing price of Eaton Common Shares on the last
trading day of 2006 over the exercise price of the stock option, multiplied by
the number of options outstanding and exercisable. Under SFAS No. 123(R), the
aggregate intrinsic value is not recorded for financial accounting purposes and
the value changes based on the daily changes in the fair market value of the
Company's Common Shares.
Information related to stock options exercised follows:
2006 2005 2004
---- ---- ----
Proceeds from stock options exercised $108 $68 $138
Income tax benefits related to stock options exercised
Reported in operating activities in statement of cash flows 8 21 44
Reported in financing activities in statement of cash flows 28
Intrinsic value of stock options exercised 102 74 142
Prior to 2006, Eaton applied the disclosure-only provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation". If the Company accounted for its
stock options under the fair-value-based method of SFAS No. 123, net income and
net income per Common Share would have been as follows:
2005 2004
----- -----
Net income
As reported $ 805 $ 648
Stock-based compensation
expense, net of income taxes (18) (13)
----- -----
Assuming fair-value-based method $ 787 $ 635
===== =====
Net income per Common Share assuming dilution
As reported $5.23 $4.13
Stock-based compensation
expense, net of income taxes (.12) (.08)
----- -----
Assuming fair-value-based method $5.11 $4.05
===== =====
Net income per Common Share basic
As reported $5.36 $4.24
Stock-based compensation
expense, net of income taxes (.12) (.09)
----- -----
Assuming fair-value-based method $5.24 $4.15
===== =====
Page 43
ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The components of Accumulated other comprehensive income (loss) as reported in
the Statement of Consolidated Shareholders' Equity follow:
2006 2005
----- -----
Foreign currency translation and related hedging instruments (net of
income tax benefits of $22 in 2006 and $6 in 2005) $ (22) $(117)
Deferred (loss) gain on cash flow hedges (net of income tax benefits
of $1 in 2006 and income taxes of $2 in 2005) (1) 4
Pension liabilities (net of income tax benefits of $367 in 2006 and $281
in 2005) (707) (536)
Other postretirement liabilities (net of income tax benefits of $119) (119)
----- -----
$(849) $(649)
===== =====
A discussion of the adjustments related to pension and other postretirement
benefit liabilities is included in the "Retirement Benefit Plans" Note above.
INCOME TAXES
For financial statement reporting purposes, income from continuing operations
before income taxes is summarized below based on the geographic location of the
operation to which such earnings are attributable. Certain foreign operations
are branches of Eaton and are, therefore, subject to United States as well as
foreign income tax regulations. As a result, pretax income by location and the
components of income tax expense by taxing jurisdiction are not directly
related. For purposes of this note to the consolidated financial statements,
non-United States operations include Puerto Rico.
Income from continuing
operations before income taxes
------------------------------
2006 2005 2004
---- ---- ----
United States $152 $201 $115
Non-United States 837 787 653
---- ---- ----
$989 $988 $768
==== ==== ====
Income tax expense for
continuing operations
----------------------
2006 2005 2004
---- ---- -----
Current
United States
Federal $14 $ 69 $ 129
State & local (9) 3 5
Non-United States 14 140 126
--- ---- -----
19 212 260
--- ---- -----
Deferred
United States
Federal 25 (9) (132)
State & local 24
Non-United States 9 (14)
--- ---- -----
58 (23) (132)
--- ---- -----
$77 $189 $ 128
=== ==== =====
Reconciliations of income taxes from the United States Federal statutory rate to
the effective income tax rate for continuing operations follow:
2006 2005 2004
----- ----- -----
Income taxes at the United States
statutory rate 35.0% 35.0% 35.0%
United States state & local income taxes 1.5% 0.5% 0.7%
Other United States-net (0.9%) (3.7%) (0.9%)
Non-United States operations (earnings taxed
at other than United States tax rate) (18.6%) (12.7%) (14.2%)
Adjustment of worldwide tax liabilities (9.2%) (3.9%)
----- ----- -----
7.8% 19.1% 16.7%
===== ===== =====
Page 44
In 2006 and 2004, Eaton recorded income tax benefits of $90 and $30,
respectively, resulting from the favorable resolution of multiple income tax
items. The income tax benefit in 2006 reduced the effective income tax rate for
full year 2006 from 17.0% to 7.8%. The income tax benefit in 2004 reduced the
effective income tax rate for full year 2004 from 20.6% to 16.7%.
Eaton has manufacturing operations in Puerto Rico that operate under certain
United States tax law incentives related to the repatriation of earnings that
expired at the end of 2005. Income tax credits claimed under these incentives
were $33 in each of 2005 and 2004. The elimination of these repatriation laws
did not have an adverse impact on the Company's effective income tax rate.
Significant components of current and long-term deferred income taxes follow:
2006 2005
------------------- -------------------
Current Long-term Current Long-term
assets assets assets assets
------- --------- ------- ---------
Accruals & other adjustments
Employee benefits $ 74 $ 725 $ 85 $ 470
Depreciation & amortization (329) (288)
Other accruals & adjustments 213 55 147 52
Other items 1 14 12
United States Federal income tax
credit carryforwards 51 110
United States state & local tax loss
carryforwards and tax credit
carryforwards 92 91
Non-United States tax loss
carryforwards 96 92
Valuation allowance (20) (201) (3) (187)
---- ----- ---- -----
$267 $ 490 $243 $ 352
==== ===== ==== =====
At the end of 2006, United States Federal income tax credit carryforwards of $51
were available to reduce future Federal income tax liabilities. These credits
include $5 that expire in 2025 through 2026, and $46 of which are not subject to
expiration. United States state and local tax loss carryforwards with a future
tax benefit of $63 are also available at the end of 2006. Their expiration dates
are $9 in 2007 through 2011, $7 in 2012 through 2016, $25 in 2017 through 2021,
and $22 in 2022 through 2026. A full valuation allowance has been recorded for
these state and local tax loss carryforwards. There are also United States state
and local tax credit carryforwards with a future tax benefit of $29 available at
the end of 2006. Their expiration dates are $8 in 2007 through 2011, $11 in 2012
through 2016, $6 in 2017 through 2021, and $4 in 2022 through 2026. A valuation
allowance of $26 has been recorded for the state and local tax credit
carryforwards. A valuation allowance of $37 has also been recorded for certain
other state and local deferred income tax assets.
At December 31, 2006, certain non-United States subsidiaries had tax loss
carryforwards aggregating $331 that are available to offset future taxable
income. Carryforwards of $146 expire at various dates from 2007 through 2021 and
the balance has no expiration date. A deferred tax asset of $96 has been
recorded for these tax loss carryforwards and a valuation allowance of $90 has
also been recorded for these tax loss carryforwards.
No provision has been made for income taxes on undistributed earnings of
consolidated non-United States subsidiaries of $2,530 at December 31, 2006,
since it is the Company's intention to indefinitely reinvest undistributed
earnings of its foreign subsidiaries. It is not practicable to estimate the
additional income taxes and applicable foreign withholding taxes that would be
payable on the remittance of such undistributed earnings. On October 22, 2004,
the American Jobs Creation Act of 2004 (the Act) was signed into law. The Act
provided for a special one-time tax deduction of 85% of certain foreign earnings
that are repatriated (as defined in the Act) in 2005. In fourth quarter 2005,
Eaton recorded income tax expense of $3 for the repatriation of $66 of foreign
earnings under the Act.
Worldwide income tax payments were $129 in 2006, $171 in 2005 and $161 in 2004.
Page 45
In June 2006, the Financial Accounting Standards Board (FASB) issued
Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109", which Eaton will adopt in first
quarter 2007. FIN No. 48 clarifies the accounting for uncertainty in income
taxes by establishing minimum standards for the recognition and measurement of
income tax positions taken, or expected to be taken, in an income tax return.
FIN No. 48 also changes the disclosure standards for income taxes. Eaton's
historical policy has consistently been to enter into tax planning strategies
only if it is more likely than not that the benefit would be sustained upon
audit. For example, the Company does not enter into any of the Internal Revenue
Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4.
Consequently, the Company does not expect the adoption of FIN No. 48 to result
in the recording of a material cumulative effect of a change in the accounting
principle in 2007.
OTHER INFORMATION
ACCOUNTS RECEIVABLE
Accounts receivable were net of an allowance for doubtful accounts of $23 and
$21 at December 31, 2006 and 2005, respectively.
INVENTORIES
The components of inventories follow:
2006 2005
------ ------
Raw materials $ 570 $ 469
Work-in-process 321 265
Finished goods 504 442
------ ------
Inventories at FIFO 1,395 1,176
Excess of FIFO over LIFO cost (102) (77)
------ ------
$1,293 $1,099
====== ======
Inventories at FIFO accounted for using the LIFO method were 52% and 51% at the
end of 2006 and 2005, respectively.
WARRANTY LIABILITIES
A summary of the current and long-term liabilities for warranties follows:
2006 2005 2004
---- ---- ----
Balance at the beginning of the year $157 $152 $125
Current year provision 91 93 108
Business acquisitions 1 3 12
Claims paid/satisfied (83) (87) (94)
Other 10 (4) 1
---- ---- ----
Balance at the end of the year $176 $157 $152
==== ==== ====
LEASE COMMITMENTS
Eaton leases certain real properties and equipment. Minimum rental commitments
under noncancelable operating leases, which expire at various dates and in most
cases contain renewal options, for each of the next five years and thereafter in
the aggregate were, $87 in 2007, $70 in 2008, $50 in 2009, $39 in 2010, $28 in
2011 and $49 thereafter.
Rental expense was $124 in 2006, $115 in 2005, and $112 in 2004.
Page 46
NET INCOME PER COMMON SHARE
A summary of the calculation of net income per Common Share assuming dilution
and basic follows (shares in millions):
2006 2005 2004
------ ------ ------
Income from continuing operations $ 912 $ 799 $ 640
Income from discontinued operations 38 6 8
------ ------ ------
Net income $ 950 $ 805 $ 648
====== ====== ======
Average number of Common Shares
outstanding assuming dilution 152.9 154.0 157.1
Less dilutive effect of stock options 2.7 3.8 4.0
------ ------ ------
Average number of Common Shares
outstanding basic 150.2 150.2 153.1
====== ====== ======
Net income per Common Share assuming dilution
Continuing operations $ 5.97 $ 5.19 $ 4.07
Discontinued operations .25 .04 .06
------ ------ ------
$ 6.22 $ 5.23 $ 4.13
====== ====== ======
Net income per Common Share basic
Continuing operations $ 6.07 $ 5.32 $ 4.18
Discontinued operations .25 .04 .06
------ ------ ------
$ 6.32 $ 5.36 $ 4.24
====== ====== ======
BUSINESS SEGMENT & GEOGRAPHIC REGION INFORMATION
Eaton is a diversified industrial manufacturer with 2006 sales of $12.4 billion.
The Company is a global leader in the design, manufacture, marketing and
servicing of electrical systems and components for power quality, distribution
and control; fluid power systems and services for industrial, mobile and
aircraft equipment; intelligent truck drivetrain systems for safety and fuel
economy; and automotive engine air management systems, powertrain solutions and
specialty controls for performance, fuel economy and safety. The Company had
60,000 employees at the end of 2006 and had sales to customers in more than 125
countries. Major products included in each business segment and other
information follows.
ELECTRICAL
Low and medium voltage power distribution and control products that meet
ANSI/NEMA and IEC standards; a wide range of circuit breakers, and a variety of
assemblies and components used in managing distribution of electricity to
industrial, utility, light commercial, residential and OEM markets; drives,
contactors, starters, power factor and harmonic correction; a wide range of
sensors used for position sensing; a full range of operator interface hardware
and software for interfacing with machines, and other motor control products
used in the control and protection of electrical power distribution systems; a
full range of AC and DC Uninterruptible Power Systems (UPS); power management
software, remote monitoring, turnkey integration services and site support
engineering services for electrical power and control systems
FLUID POWER
All pressure ranges of hose, fittings, adapters, couplings and other fluid power
connectors; hydraulic pumps, motors, valves, cylinders, power steering units,
tube connectors, fittings, transaxles and transmissions; electronic and
hydraulic controls; electric motors and drives; filtration products and
fluid-evaluation products and services; aerospace products and systems --
hydraulic and electrohydraulic pumps, and integrated system packages, hydraulic
and electromechanical actuators, flap and slat systems, nose wheel steering
systems, cockpit controls, power and load management systems, sensors, fluid
debris monitoring products, illuminated displays, integrated displays and
panels, relays, valves, sealing and pneumatic systems for large commercial
aircraft and regional jets, products for aircraft engines, fuel systems, cabin
air and de-icing systems, hydraulic systems, low-pressure airframe fuel systems,
electromechanical actuation, air ducting, hydraulic and power generation, and
fluid distribution systems for fuel, hydraulics and air; products for industrial
equipment; clutches and brakes for industrial machines; golf grips and precision
molded and extruded plastic products
Page 47
TRUCK
Heavy-, medium-, and light-duty and agricultural mechanical transmissions;
heavy- and medium-duty automated transmissions; heavy- and medium-duty clutches;
and a variety of other products including gears and shafts, transfer boxes,
gearshift mechanisms, rotors, electronic diagnostic equipment for commercial
vehicles, and collision warning systems
AUTOMOTIVE
Engine valves, valve actuation components, engine displacement control
components; advanced valvetrain and fuel management systems to enhance fuel
economy and emissions; cylinder heads, superchargers, superturbo compounding;
advanced air and hydrogen management devices for fuel cells; limited slip and
locking differentials; electronically controlled traction modification devices;
off road performance and racing differentials; precision gear forgings;
compressor control clutches for mobile refrigeration; mirror actuators and
powerfolding actuators; transmission controls; on-board vapor recovery systems;
fuel level senders; exhaust gas recirculation valves for heavy-duty engines;
turbocharger waste gate controls; and intake manifold control valves
OTHER INFORMATION
The principal markets for the Electrical segment are industrial, non-residential
and residential construction, commercial, government, institutional, and
telecommunications customers. These customers are generally concentrated in
North America, Europe and Asia/Pacific; however, sales are made globally. Sales
are made directly by Eaton and indirectly through distributors and manufacturers
representatives to such customers.
The principal markets for the Fluid Power segment are original equipment
manufacturers and after-market customers of off-highway agricultural vehicles,
construction vehicles, aircraft, and industrial and stationary equipment. These
manufacturers are located globally and most sales of these products are made
directly to such manufacturers.
The principal markets for the Truck and Automotive segments are original
equipment manufacturers and after-market customers of heavy-, medium-, and
light-duty trucks and passenger cars. These manufacturers are located globally
and most sales of these products are made directly to such manufacturers.
No single customer represented more than 10% of net sales in 2006, 2005 or 2004.
Sales from United States and Canadian operations to customers in foreign
countries were $709 in 2006, $568 in 2005 and $504 in 2004 (6% of sales in 2006,
and 5% of sales in 2005 and 2004).
The accounting policies of the business segments are generally the same as the
policies described under "Accounting Policies" above, except that inventories
and related cost of products sold of the segments are accounted for using the
FIFO method and operating profit only reflects the service cost component
related to pensions and other postretirement benefits. Intersegment sales and
transfers are accounted for at the same prices as if the sales and transfers
were made to third parties.
In accordance with SFAS No. 131, for purposes of business segment performance
measurement, the Company does not allocate to the business segments items that
are of a non-operating nature or corporate organizational and functional
expenses of a governance nature. Corporate expenses consist of corporate office
expenses including compensation, benefits, occupancy, depreciation, and other
administrative costs. Identifiable assets of the business segments exclude
goodwill, other intangible assets, and general corporate assets, which
principally consist of cash, short-term investments, deferred income taxes,
certain accounts receivable, certain property, plant and equipment, and certain
other assets.
Page 48
GEOGRAPHIC REGION INFORMATION
Segment
operating Long-lived
Net sales profit assets
--------- --------- ----------
2006
United States $ 8,556 $1,145 $ 1,188
Canada 337 44 16
Europe 2,423 80 579
Latin America 1,090 120 318
Asia/Pacific 898 92 170
Eliminations (934)
------- -------
$12,370 $ 2,271
======= =======
2005
United States $ 7,666 $1,018 $ 1,191
Canada 315 48 16
Europe 2,084 110 533
Latin America 1,036 136 298
Asia/Pacific 797 80 137
Eliminations (879)
------- -------
$11,019 $ 2,175
======= =======
2004
United States $ 6,806 $ 778 $ 1,215
Canada 261 37 16
Europe 1,922 138 547
Latin America 774 107 244
Asia/Pacific 679 79 125
Eliminations (730)
------- -------
$ 9,712 $ 2,147
======= =======
Net sales and segment operating profit are attributed to geographical regions
based upon the location of the selling unit. Long-lived assets consist of
property, plant and equipment-net.
Business segment operating profit was reduced by acquisition integration
charges, as follows:
2006 2005 2004
---- ---- ----
United States $23 $17 $22
Europe 7 7 18
Latin America 6 4
Asia/Pacific 4 8 1
--- --- ---
$40 $36 $41
=== === ===
Page 49
BUSINESS SEGMENT INFORMATION
2006 2005 2004
------- ------- ------
Net sales
Electrical $ 4,184 $ 3,758 $3,072
Fluid Power 3,983 3,240 3,098
Truck 2,520 2,288 1,800
Automotive 1,683 1,733 1,742
------- ------- ------
$12,370 $11,019 $9,712
======= ======= ======
Operating profit
Electrical $ 474 $ 375 $ 243
Fluid Power 422 339 338
Truck 448 453 329
Automotive 137 225 229
Corporate
Amortization of intangible assets (51) (30) (25)
Interest expense-net (104) (90) (79)
Minority interest (10) (5) (6)
Pension & other postretirement benefit expense (152) (120) (75)
Stock option expense (27)
Other corporate expense-net (148) (159) (186)
------- ------- ------
Income from continuing operations before income taxes 989 988 768
Income taxes 77 189 128
------- ------- ------
Income from continuing operations 912 799 640
Income from discontinued operations, net of income taxes 38 6 8
------- ------- ------
Net income $ 950 $ 805 $ 648
======= ======= ======
Business segment operating profit was reduced by acquisition integration
charges, as follows:
2006 2005 2004
---- ---- ----
Electrical $ 7 $21 $33
Fluid Power 23 7 8
Truck 5 4
Automotive 5 4
--- --- ---
$40 $36 $41
=== === ===
Page 50
BUSINESS SEGMENT INFORMATION continued
2006 2005 2004
------- ------- ------
Identifiable assets
Electrical $ 1,669 $ 1,454 $1,469
Fluid Power 2,007 1,787 1,527
Truck 1,015 1,064 940
Automotive 890 960 974
------- ------- ------
5,581 5,265 4,910
Goodwill 3,034 3,139 2,433
Other intangible assets 969 626 644
Corporate 1,833 1,188 1,088
------- ------- ------
Total assets $11,417 $10,218 $9,075
======= ======= ======
Expenditures for property, plant & equipment
Electrical $ 74 $ 59 $ 55
Fluid Power 121 76 83
Truck 66 99 90
Automotive 79 108 91
------- ------- ------
340 342 319
Corporate 20 21 11
------- ------- ------
$ 360 $ 363 $ 330
======= ======= ======
Depreciation of property, plant & equipment
Electrical $ 79 $ 84 $ 83
Fluid Power 105 94 91
Truck 77 70 61
Automotive 77 84 79
------- ------- ------
338 332 314
Corporate 22 19 23
------- ------- ------
$ 360 $ 351 $ 337
======= ======= ======
Page 51
MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF
OPERATIONS
Dollars in millions, except for per share data (per share data assume dilution)
OVERVIEW OF THE COMPANY
Eaton is a diversified industrial manufacturer with 2006 sales of $12.4 billion.
The Company is a global leader in the design, manufacture, marketing and
servicing of electrical systems and components for power quality, distribution
and control; fluid power systems and services for industrial, mobile and
aircraft equipment; intelligent truck drivetrain systems for safety and fuel
economy; and automotive engine air management systems, powertrain solutions and
specialty controls for performance, fuel economy and safety. The principal
markets for the Electrical segment are industrial, non-residential and
residential construction, commercial, government, institutional, and
telecommunications customers. These customers are generally concentrated in
North America, Europe and Asia/Pacific; however, sales are made globally. Sales
are made directly by Eaton and indirectly through distributors and manufacturers
representatives to such customers. The principal markets for the Fluid Power
segment are original equipment manufacturers and after-market customers of
off-highway agricultural vehicles, construction vehicles, aircraft, and
industrial and stationary equipment. These manufacturers are located globally
and most sales of these products are made directly to such manufacturers. The
principal markets for the Truck and Automotive segments are original equipment
manufacturers and after-market customers of heavy-, medium-, and light-duty
trucks and passenger cars. These manufacturers are located globally and most
sales of these products are made directly to such manufacturers. The Company had
60,000 employees at the end of 2006 and had sales to customers in more than 125
countries.
HIGHLIGHTS OF RESULTS FOR 2006
Eaton experienced continuing strong economic conditions in 2006 in most of its
end markets and posted record financial results. Sales of the Electrical, Fluid
Power and Truck business segments improved in 2006 compared to 2005, setting new
records. Sales of the Automotive segment were lower than 2005 due to declines in
the North American and European automotive markets. Operating profit for the
Electrical and Fluid Power segments were also new records in 2006. During 2006,
Eaton continued to make progress towards key corporate goals of 1) accelerating
organic growth by outgrowing end markets, 2) acquiring and integrating new
businesses and 3) proactively managing its capital.
In first quarter 2006, Eaton announced, and began to implement, its Excel 07
program. This program was a series of actions undertaken in 2006 intended to
address resource levels and operating performance in businesses that
underperformed in 2005 and businesses in which markets were expected to weaken
during the second half of 2006 and 2007. This program included plant closings,
as well as costs of relocating product lines and other employee reductions. The
Excel 07 program, which also included savings generated from the actions noted
above, gains from sales of non-strategic product lines, and other corporate
actions, including the favorable resolution of multiple income tax items, had a
net positive impact on net income for 2006, as described below.
The following are highlights of 2006:
2006 2005 Increase
------- ------- --------
Continuing operations
Net sales $12,370 $11,019 12%
Gross profit 3,320 3,083 8%
Percent of net sales 26.8% 28.0%
Income before income taxes 989 988 --
Income after income taxes $ 912 $ 799 14%
Income from discontinued operations, net of income taxes 38 6
------- -------
Net income $ 950 $ 805 18%
======= =======
Net income per Common Share assuming dilution
Continuing operations $ 5.97 $ 5.19 15%
Discontinued operations .25 .04
------- -------
$ 6.22 $ 5.23 19%
======= =======
Return on Shareholders' equity 23.0% 22.2%
Net sales in 2006 were a new record for Eaton, surpassing the previous record
set in 2005. Sales growth of 12% in 2006 consisted of 6% from organic growth, 5%
from acquisitions of businesses, and
Page 52
1% from foreign exchange rates. Organic growth included 5% from end-market
growth and 1% from outgrowing end markets.
Gross profit increased 8% in 2006 primarily due to sales growth, the benefits of
integrating acquired businesses and continued productivity improvements driven
by the Eaton Business System (EBS). These improvements in gross profit were
partially offset by costs of plant closings and other expenses associated with
the Company's Excel 07 program, higher acquisition integration charges,
increased pension expense, and higher prices paid for raw materials, supplies
and basic metals.
Net income and net income per Common Share assuming dilution for 2006 were new
records for Eaton, increasing 18% and 19%, respectively, over 2005. These
improvements were primarily due to sales growth; the benefits of integrating
acquired businesses; continued productivity improvements driven by EBS; and a
lower effective income tax rate. These factors leading to the increase in net
income were partially offset by increased pension expense; higher prices paid
for raw materials, supplies and basic metals; and expense for stock options
recorded for the first time in 2006. Earnings per share also benefited from
lower average shares outstanding in 2006 compared to 2005, due to the repurchase
of 5.286 million shares in 2006, at a total cost of $386. The positive net
impact on net income and net income per share of the Excel 07 program in 2006,
as described above, was after-tax income of $8, or $.05 per Common Share. Pretax
costs of this program for plant closings, relocating product lines and other
employee reductions, offset by savings generated from these actions, were $154.
These costs were offset by gains on the sale of businesses that totaled $35
after-tax, which were reported in the Statement of Consolidated Income as
Discontinued operations, and by $90 of income tax benefits resulting from the
favorable resolution of multiple income tax items during the year.
In 2006, Eaton acquired various businesses in separate transactions. The
Statements of Consolidated Income include the results of these businesses from
the effective dates of acquisition. These acquisitions are summarized below:
- On December 1, 2006, Eaton acquired the remaining 50% ownership in
Schreder-Hazemeyer, a Belgium manufacturer of low and medium voltage
electrical distribution switchgear. This business had 2006 sales of $9 and
is included in the Electrical segment.
- On October 26, 2006, Eaton acquired diesel fuel processing technology and
associated assets of Catalytica Energy Systems Inc., a developer of
emission control solutions for Trucks. This business, which has no sales,
is included in the Truck segment.
- On September 14, 2006, the Company acquired Senyuan International Holdings
Limited, a China-based manufacturer of vacuum circuit breakers and other
electrical switchgear components. This business had 2005 sales of $47 and
is included in the Electrical segment.
- On September 5, 2006, the Company acquired the Ronningen-Petter business
unit of Dover Resources, Inc., a producer of industrial fine filters and
components. This business had 2005 sales of $30 and is included in the
Fluid Power segment.
- On March 31, 2006, the Company acquired the Synflex business unit of
Saint-Gobain Performance Plastics Corporation, a manufacturer of
thermoplastic hose and tubing. This business had 2005 sales of $121 and is
included in the Fluid Power segment.
- On March 24, 2006, Eaton acquired Marina Power Lighting, a manufacturer of
marine duty electrical distribution products. This business had 2005 sales
of $11 and is included in the Electrical segment.
In addition to the business acquisitions described above, on December 28, 2006,
Eaton announced it had reached an agreement to purchase AT Holdings Corporation,
the parent of Argo-Tech Corporation, for $695. This transaction is expected to
close in the first quarter of 2007. Argo-Tech's U.S.-based aerospace business,
which had sales for the fiscal year ended October 28, 2006 of $206, is a leader
in high performance aerospace engine fuel pumps and systems, airframe fuel pumps
and systems, and ground fueling systems for commercial and military aerospace
markets. This business will be integrated into the Fluid Power segment.
Cash generated from operating activities of $1,431 in 2006 was a new record for
Eaton, increasing by $296, or 26%, over cash generated from operating activities
of $1,135 in 2005. The increase was primarily due to higher net income in 2006,
which rose $145 in 2006 over 2005 and a net reduction of
Page 53
$162 in working capital funding due to changes in accounts receivable, accounts
payable and in several other working capital accounts in 2006. Cash and
short-term investments totaled $785 at the end of 2006, up $449 from $336 at
year-end 2005.
Total debt of $2,586 at the end of 2006 increased $122 from $2,464 at year-end
2005. Changes in debt included the issuance in August 2006 of $250 of floating
notes due 2009, the repayment of $244 of notes and debentures in 2006 and a $96
increase in short-term debt. The net-debt-to-capital ratio was 30.5% at the end
of 2006 compared to 36.0% at year-end 2005. The improvement in this ratio was
primarily due to the increase of $328 in Shareholders' equity and the $327
decrease in net debt (total debt less cash and short-term investments) largely
due to the $449 increase in cash and short-term investments. The increase in
Shareholders' equity was due to net income in 2006 of $950. This increase was
partially offset by the repurchase of 5.286 million Common Shares in 2006 at a
total cost of $386; the recognition at year-end 2006 of $282 of after-tax
adjustments for pensions and other post-retirement benefits due to the adoption
of Statement of Financial Accounting Standards No. 158; and cash dividends of
$220 paid during 2006.
Net working capital of $1,001 at the end of 2006, increased by $391 from $610 at
year-end 2005. The increase was primarily due to the $449 increase in cash and
short-term investments, which largely resulted from strong cash flow from
operations of $1,431; the $143 increase in accounts receivable resulting from
increased sales; and the $194 increase in inventories to support higher levels
of sales. These increases in working capital were partially offset by a net
increase of $178 in short-term debt and current portion of long-term debt, and a
net increase of $217 in accounts payable and several other working capital
accounts to support higher levels of operations. The increase in current
portion of long-term debt was primarily due to the reclassification to current
liabilities of the 6% Euro 200 million Notes that will mature in March 2007
(U.S. dollar equivalent of $263 at December 31, 2006) and $48 of other long-term
debt that will mature in 2007, partially offset by the repayment of $244 of
notes and debentures in 2006. The current ratio was 1.3 at the end of 2006 and
1.2 at year-end 2005.
In light of its strong results and future prospects, on January 22, 2007 Eaton
announced that it was taking the following actions:
- Increasing the quarterly dividend on its Common Shares by 10%, from $.39
per share to $.43 per share, effective for the February 2007 dividend.
- Making a voluntary contribution of $150 to its qualified pension plan in
the United States.
- Authorizing a new 10 million Common Share repurchase program, replacing the
1.3 million shares remaining from the 10 million share repurchase
authorization approved in April of 2005.
RESULTS OF OPERATIONS - 2006 COMPARED TO 2005
2006 2005 Increase
------- ------- --------
Continuing operations
Net sales $12,370 $11,019 12%
Gross profit 3,320 3,083 8%
Percent of net sales 26.8% 28.0%
Income before income taxes 989 988 --
Income after income taxes $ 912 $ 799 14%
Income from discontinued operations, net of income taxes 38 6
------- -------
Net income $ 950 $ 805 18%
======= =======
Net income per Common Share assuming dilution
Continuing operations $ 5.97 $ 5.19 15%
Discontinued operations .25 .04
------- -------
$ 6.22 $ 5.23 19%
======= =======
Return on Shareholders' equity 23.0% 22.2%
Net sales in 2006 were a new record for Eaton, surpassing the previous record
set in 2005. Sales growth of 12% in 2006 consisted of 6% from organic growth, 5%
from acquisitions of businesses, and
Page 54
1% from foreign exchange rates. Organic growth included 5% from end-market
growth and 1% from outgrowing end markets.
In first quarter 2006, Eaton announced, and began to implement, its Excel 07
program. This program was a series of actions in 2006 intended to address
resource levels and operating performance in businesses that underperformed in
2005 and businesses in which markets were expected to weaken during the second
half of 2006 and 2007. This program included plant closings, as well as costs of
relocating product lines and other employee reductions. The net impact of this
program also includes savings generated from the actions noted above, gains from
sales of non-strategic product lines, and other corporate actions, including the
favorable resolution of multiple income tax items. The total net positive impact
of the Excel 07 program in 2006 was after-tax income of $8, or $.05 per Common
Share. Pretax costs of this program for plant closings, relocating product lines
and other employee reductions, offset by savings generated from these actions,
were $154. These costs were offset by gains on the sale of businesses that
totaled $35 after-tax, which were reported in the Statement of Consolidated
Income as Discontinued operations, and by $90 of income tax benefits resulting
from the favorable resolution of multiple income tax items during the year. Net
pretax costs of plant closings and other actions associated with the Excel 07
program were included in the Statements of Consolidated Income primarily in Cost
of products sold, with additional amounts in Selling & administrative expense or
Other (income) expense-net, as appropriate. In Business Segment Information, the
net pretax impact of the Excel 07 program was included in Operating profit of
the related business segment, as separately discussed in the results of each
business segment below.
Gross profit increased 8% in 2006 primarily due to sales growth, the benefits of
integrating acquired businesses and continued productivity improvements driven
by the Eaton Business System (EBS). These improvements in gross profit were
partially offset by costs of plant closings and other expenses associated with
the Company's Excel 07 program, higher acquisition integration charges,
increased pension expense, and higher prices paid for raw materials, supplies
and basic metals.
RESULTS BY GEOGRAPHIC REGION
Segment operating profit Operating
Net sales ---------------------------- margin
---------------------------- Increase -----------
2006 2005 Increase 2006 2005 (Decrease) 2006 2005
------- ------- -------- ------ ------ ---------- ---- ----
United States $ 8,556 $ 7,666 12% $1,145 $1,018 12% 13.4% 13.3%
Canada 337 315 7% 44 48 (8%) 13.1% 15.2%
Europe 2,423 2,084 16% 80 110 (27%) 3.3% 5.3%
Latin America 1,090 1,036 5% 120 136 (12%) 11.0% 13.1%
Asia/Pacific 898 797 13% 92 80 15% 10.2% 10.0%
Eliminations (934) (879)
------- -------
$12,370 $11,019 12%
======= =======
Growth in sales in the United States of 12% was primarily due to higher sales in
Fluid Power, which resulted from growth in end markets; sales from businesses
acquired in 2006, including the thermoplastic hose and tubing business of
Synflex and the industrial filtration business of Ronningen-Petter; and the full
year effect on sales of businesses acquired in 2005, including the aerospace
division of PerkinElmer Inc., the aerospace fluid and air division of Cobham
plc, and the industrial filtration business of Hayward Industries, Inc. Higher
sales in the United States in 2006 were also due to increased sales in
Electrical, largely resulting from growth in end markets, and higher sales in
Truck, as a result of strong end market demand for heavy-duty trucks. These
increases in sales were partially offset by a sales reduction in Automotive,
primarily resulting from the decline in the North American (NAFTA) automotive
market. The 12% increase in operating profit in the United States was mainly due
to strong operating profit of Truck; higher operating profit of Fluid Power,
which included profit from businesses acquired in 2006 and the full year effect
of businesses acquired in 2005; increased operating profit of Electrical; and
the benefits of integrating acquired businesses. These increases in operating
profit were partially offset by costs of plant closings and other expenses
associated with the Excel 07 program, as described above, and reduced operating
profit of the Automotive segment.
In Canada, sales growth of 7% in sales was primarily due to improved results in
the Electrical businesses. The 8% reduction in operating profit was mainly due
to the costs of relocation of certain businesses in the Electrical segment.
Page 55
Sales growth in Europe of 16% was primarily due to higher sales in Fluid Power,
which reflected growth in end markets and the full year effect on sales of the
businesses acquired in 2005, including the aerospace fluid and air division of
Cobham plc, the aerospace division of PerkinElmer Inc., and the industrial
filtration business of Hayward Industries, Inc. Higher sales in Europe in 2006
also reflected increased sales in Electrical, largely due to growth in end
markets. The 27% decrease in operating profit in Europe reflected reduced
operating profit of Automotive and Truck, which primarily resulted from plant
closings associated with the Excel 07 program, partially offset by improved
results of Electrical and Fluid Power, due, in part, to the full-year effect of
the Fluid Power acquisitions completed in 2005, and the benefits of integrating
acquired businesses.
In Latin America, growth of 5% in sales was largely due to higher sales in
Truck, Automotive and Fluid Power. The 12% reduction in operating profit in
Latin America was attributable to Excel 07 program expenses and an adjustment to
Brazilian inventories in the Truck business, partially offset by improved
results of Electrical, which included a gain on the sale of the Brazilian
battery business.
Growth in Asia/Pacific of 13% in sales and 15% in operating profit was primarily
due to higher sales in Fluid Power and Electrical, which were the result of
growth in end markets and sales from businesses acquired in 2006 and 2005.
Acquisitions of businesses included the Senyuan China-based medium-voltage
electrical business acquired in September 2006 and the Winner hydraulics
business acquired in 2005.
OTHER RESULTS OF OPERATIONS
In 2006 and 2005, Eaton incurred charges related to the integration of acquired
businesses. Charges in 2006 related to primarily the following acquisitions:
Powerware, the electrical power systems business acquired in 2004, and the
Pringle electrical switch business; several acquisitions in Fluid Power
including the acquired operations of Synflex, PerkinElmer, Cobham, Hayward,
Winner, and Walterscheid; and the Pigozzi, Tractech, and Morestana Truck and
Automotive businesses. Charges in 2005 related to primarily the following
acquisitions: Powerware and the electrical division of Delta plc; several
acquisitions in Fluid Power, including Winner, Walterscheid, and Boston
Weatherhead; and the Pigozzi and Morestana businesses. A summary of these
charges follows:
2006 2005
---- ----
Electrical $ 7 $ 21
Fluid Power 23 7
Truck 5 4
Automotive 5 4
---- ----
Pretax charges $ 40 $ 36
==== ====
After-tax charges $ 27 $ 24
Per Common Share $.17 $.15
Acquisition integration charges in 2006 included $23 for the United States, $7
for Europe, $6 for Latin America and $4 for Asia/Pacific. Charges in 2005
included $17 for the United States, $7 for Europe, $4 for Latin America and $8
for Asia/Pacific. These charges were included in the Statements of Consolidated
Income in Cost of products sold or Selling & administrative expense, as
appropriate. In Business Segment Information, the charges reduced Operating
profit of the related business segment.
In first quarter 2006, Eaton announced, and began to implement, its Excel 07
program. This program was a series of actions in 2006 intended to address
resource levels and operating performance in businesses that underperformed in
2005 and businesses that were expected to weaken during second half 2006 and
2007. This program included plant closings, as well as costs of relocating
product lines and other employee reductions. The program also included savings
generated from these actions. The net costs incurred by each segment in 2006
related to the Excel 07 actions follows:
Electrical $ 17
Fluid Power 23
Truck 60
Automotive 52
Corporate 2
----
Pretax charges $154
====
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Excel 07 net costs incurred in 2006 included $69 for the United States, $77 for
Europe, $5 for Latin America, $2 for Asia/Pacific, and $1 for Canada. The net
costs associated with the Excel 07 program were included in the Statements of
Consolidated Income primarily in Cost of products sold. In Business Segment
Information, the charges reduced Operating profit of the related business
segment.
Pretax income for 2006 was reduced by $65 ($42 after-tax, or $.28 per Common
Share) compared to 2005 due to increased pension expense in 2006. This reduction
primarily resulted from the lowering of discount rates associated with pension
liabilities at year-end 2005 and the effect of increased settlement costs in
2006.
Effective January 1, 2006, in accordance with Statement of Financial Accounting
Standards (SFAS) No. 123(R), "Share-Based Payment", Eaton began to record
compensation expense under the "fair-value-based" method of accounting for stock
options granted to employees and directors. Expense for stock options in 2006
was $27 ($20 after-tax, or $.13 per share both assuming dilution and basic). The
Company adopted SFAS No. 123(R) using the "modified prospective application"
method and, as a result, financial results for periods prior to 2006 were not
restated for this accounting change. This change in accounting is further
explained in "Stock Options" in the Notes to the Consolidated Financial
Statements.
The effective income tax rates for continuing operations for 2006 was 7.8%
compared to 19.1% for 2005. The lower rate in 2006 was primarily due to income
tax benefits of $90 resulting from the favorable resolution of multiple income
tax items. Excluding the income tax benefits resulting from the favorable
resolution of income tax items, the effective income tax rate for continuing
operations for 2006 was 17.0%. The change in the effective income tax rate in
2006 compared to 2005 is further explained in "Income Taxes" in the Notes to the
Consolidated Financial Statements.
As part of the Excel 07 program, in third quarter 2006, certain businesses of
the Automotive segment were sold, resulting in a $35 after-tax gain, or $.23 per
Common Share. The gain on sale of these businesses, and other operating results
of these businesses, were reported as Discontinued operations in the Statement
of Consolidated Income.
Net income and net income per Common Share assuming dilution for 2006 were new
records for Eaton, increasing 18% and 19%, respectively, over 2005. These
improvements were primarily due to sales growth; the benefits of integrating
acquired businesses; continued productivity improvements driven by EBS; and a
lower effective income tax rate. These factors leading to the increase in net
income were partially offset by increased pension expense; higher prices paid
for raw materials, supplies and basic metals; and expense for stock options
recorded for the first time in 2006. Earnings per share also benefited from
lower average shares outstanding in 2006 compared to 2005, due to the repurchase
of 5.286 million shares in 2006, at a total cost of $386. The total net positive
impact on net income and net income per share of the Excel 07 program in 2006
was $8 and $.05 per Common Share, respectively, as described above.
RESULTS BY BUSINESS SEGMENT
ELECTRICAL
2006 2005 Increase
------ ------ --------
Net sales $4,184 $3,758 11%
Operating profit 474 375 26%
Operating margin 11.3% 10.0%
Sales of the Electrical segment reached record levels in 2006. Of the 11% sales
increase, 9% was due to organic growth, 1% was from acquisitions of businesses,
and 1% from foreign exchange rates. End markets for the Electrical segment grew
approximately 5% in 2006 with strong growth in non-residential construction
markets offsetting weakness in the residential market.
Operating profit rose 26% in 2006, and was also a new record for this segment.
The increase was largely due to growth in sales, the benefits of integrating
acquired businesses, continued productivity improvements, a gain on the sale of
the Brazilian battery business, and lower acquisition integration charges. These
improvements in operating profit were partially offset by net costs of the Excel
07 program, and higher prices paid for raw materials, supplies and basic metals.
Operating profit in 2006 was reduced by net costs of $17 related to the Excel 07
program, which reduced the operating margin
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by 0.4%. Operating profit was also reduced by acquisition integration charges of
$7 in 2006 compared to $21 in 2005, which reduced the operating margin by 0.2%
in 2006 and by 0.6% in 2005. Acquisition integration charges in 2006 primarily
related to the integration of Powerware acquired in June 2004 and the Pringle
electrical switch business acquired in 2005. Acquisition integration charges in
2005 largely related to the integration of Powerware and the electrical division
of Delta plc acquired in 2003. The incremental operating margin on overall sales
growth in 2006 was 23%. Net costs of the Excel 07 program and acquisition
integration charges lowered the incremental operating margin (increase in
operating profit for the year compared to increase in sales for the year) by 1
percentage point.
On January 5, 2007, the Company announced it had reached an agreement to
purchase the Power Protection Business of Power Products Ltd., a Czech
distributor and service provider of Powerware and other uninterruptible power
systems, for $2. The transaction closed in February 2007. This business had
sales of $3 in 2006.
On December 1, 2006, Eaton acquired the remaining 50% ownership in
Schreder-Hazemeyer, a Belgium manufacturer of low and medium voltage electrical
distribution switchgear. This business had sales of $9 in 2006.
On September 14, 2006, the Company acquired Senyuan International Holdings
Limited, a China-based manufacturer of vacuum circuit breakers and other
electrical switchgear components. This business had sales of $47 in 2005.
On March 24, 2006, Eaton acquired Marina Power Lighting, a U.S. manufacturer of
marine duty electrical distribution products. This business had sales of $11 in
2005.
FLUID POWER
2006 2005 Increase
------ ------ --------
Net sales $3,983 $3,240 23%
Operating profit 422 339 24%
Operating margin 10.6% 10.5%
Sales of the Fluid Power segment were at record levels in 2006. The 23% increase
in sales in 2006 over 2005 consisted of 16% from acquisitions of businesses, 6%
from organic growth and 1% from foreign exchange rates. Acquisitions of
businesses in 2006 included the Ronningen-Petter filtration business acquired in
September and the Synflex thermoplastic hose and tubing business acquired in
March, as described below. Acquisitions of businesses in 2005 included the
aerospace operations of PerkinElmer, Inc., the aerospace fluid and air division
of Cobham plc, the Hayward industrial filtration business, and the Winner
hydraulic hose fittings and adapters business. Growth in the global hydraulics
markets in 2006 was driven by continued investment in industrial and
construction equipment worldwide. Fluid Power markets grew 6% compared to the
same period in 2005, with global hydraulics shipments up 8%, commercial
aerospace markets up 14%, defense aerospace markets down 1%, and European
automotive production down 1%.
Operating profit rose 24% in 2006, and was also a new record for this segment.
The increase in operating profit was due to growth in sales, continued
productivity improvements, implemented price increases, the benefits of
integrating acquired businesses, and favorable business mix. These improvements
in operating profit were partially offset by net costs of the Excel 07 program,
higher acquisition integration charges, and higher prices paid for raw
materials, supplies and basic metals. Operating profit in 2006 was reduced by
net costs of $23 related to the Excel 07 program, which reduced the operating
margin by 0.6%. Operating profit in 2006 was also reduced by acquisition charges
of $23 compared to charges of $7 in 2005, reducing operating margin by 0.6% in
2006 and 0.2% in 2005. The 2006 charges primarily related to the acquired
operations of Synflex, PerkinElmer, Cobham, Hayward, Winner, and Walterscheid.
Acquisition integration charges in 2005 largely related to the Boston
Weatherhead fluid power business. The incremental operating margin on overall
sales growth in 2006 was 11%. Net costs of the Excel 07 program and acquisition
integration charges lowered the incremental operating margin on overall sales
growth by 5 percentage points. The incremental operating margin for acquired
businesses was 14%.
On December 28, 2006, Eaton announced it had reached an agreement to purchase AT
Holdings Corporation, the parent of Argo-Tech Corporation, for $695. This
transaction is expected to close in the first quarter of 2007. Argo-Tech's
U.S.-based aerospace business, which had sales for the fiscal year
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ended October 28, 2006 of $206, is a leader in high performance aerospace engine
fuel pumps and systems, airframe fuel pumps and systems, and ground fueling
systems for commercial and military aerospace markets.
On September 5, 2006, the Company acquired the Ronningen-Petter business unit
of Dover Resources, Inc., a producer of industrial fine filtration systems. This
business had sales of $30 in 2005.
On March 31, 2006, Eaton acquired the Synflex business unit of Saint-Gobain
Performance Plastics Corporation. This business manufactures thermoplastic hose
and tubing. This business had sales of $121 in 2005.
TRUCK
Increase
2006 2005 (Decrease)
------ ------ ----------
Net sales $2,520 $2,288 10%
Operating profit 448 453 (1%)
Operating margin 17.8% 19.8%
The Truck segment posted record sales in 2006, growing 10% compared to 2005. Of
the sales increase in 2006, 8% was due to organic growth and 2% from foreign
exchange rates. Organic growth was attributable to strong end-market demand,
primarily in NAFTA heavy-duty truck production, which rose 11% in 2006 to
378,000 units. NAFTA medium-duty production was up 9% compared to 2005, European
truck production was up 5%, and Brazilian vehicle production was up 2%.
Operating profit decreased 1% in 2006 primarily due to net costs of the Excel 07
program, partially offset by operating profit generated by growth in sales.
Operating profit in 2006 was reduced by net costs of $60 related to the Excel 07
program, which reduced the operating margin by 2.4%. The Excel 07 costs included
costs related to the closing of the heavy-duty truck transmission plant in
Manchester, United Kingdom. Operating profit in 2006 and 2005 was also reduced
by acquisition integration charges of $5 and $4, respectively, related to the
Pigozzi agricultural powertrain business, which reduced the operating margin by
0.2% in 2006 and 2005. Net costs of the Excel 07 program and acquisition
integration charges lowered the incremental operating margin on overall sales
growth by 26 percentage points.
On October 26, 2006, the Company announced the acquisition of the diesel fuel
processing technology, research and development facility and associated business
assets of Catalytica Energy Systems Inc. for $2. Catalytica, which has no sales,
is engaged in the design and development of emission control solutions for
Trucks.
On September 29, 2006, Eaton announced the closure of its heavy-duty truck
transmission manufacturing plant in Manchester, United Kingdom, by the end of
2006. Aggregate estimated pretax charges associated with this closure were $25.
Total costs consist of cash charges of $16 for severance costs, charges of $3
related to pension costs, and $6 for other costs. This facility had 299
employees.
AUTOMOTIVE
2006 2005 (Decrease)
------ ------ ----------
Net sales $1,683 $1,733 (3)%
Operating profit 137 225 (39)%
Operating margin 8.1% 13.0%
Sales of the Automotive segment decreased 3% in 2006. The reduction in sales
reflected a 6% drop in sales volume, offset by a 2% increase from acquisitions
of businesses and a 1% increase due to foreign exchange rates. The decline in
sales was primarily due to automotive production for NAFTA declining by 3% in
2006 compared to 2005, while European production was down 1%. Sales were also
affected by the continued loss in market share of domestic automobile
manufacturers. The increase in sales reflected the full year effect of
acquisitions of businesses in 2005, which included the Tractech traction control
business and the Morestana engine lifters business.
The 39% decrease in operating profit in 2006 was largely due to net costs of $52
related to the Excel 07 program, which reduced the operating margin by 3.1%. The
decline in operating profit also
Page 59
reflected lower automotive production volumes in North America and Europe.
Operating profit in 2006 was also affected by acquisition integration charges of
$5 compared to charges of $4 in 2005, which reduced the operating margin by 0.3%
in 2006 and 0.2% in 2005. These charges related to the acquired operations of
Tractech and Morestana.
On September 29, 2006, Eaton announced its engine valve actuation manufacturing
plant in Saginaw, Michigan, would close by second half 2008. Aggregate estimated
pretax charges associated with this closure are expected to be approximately
$21. Total costs consist of cash charges of $3 for severance costs, charges of
$4 related to pension costs, $4 for the write-down of fixed capital, and $10 for
other costs. This facility has 277 employees.
On September 25, 2006, the Company announced the closure of its engine valve
manufacturing plant in Montornes del Valles, Spain, by the end of 2006.
Aggregate pretax charges associated with this closure were $21. Total costs
consist of cash charges of $15 for severance costs, $2 for the write-down of
fixed capital, and $4 for other costs. This facility had 154 employees.
As part of the Excel 07 program, in third quarter 2006, certain businesses of
the Automotive segment were sold, resulting in a $35 after-tax gain. The gain on
sale of these businesses, and other operating results of these businesses, were
reported as Discontinued operations in the Statement of Consolidated Income.
CORPORATE
Amortization of intangible assets of $51 in 2006 increased from $30 in 2005 due
to amortization of intangible assets associated with recently acquired
businesses.
Pension and other postretirement benefit expense included in Corporate increased
to $152 in 2006 from $120 in 2005. This increase primarily resulted from the
lowering of the discount rate associated with pension and other postretirement
benefit liabilities at year-end 2005, and the impact of increased settlement
costs in 2006.
Effective January 1, 2006, in accordance with Statement of Financial Accounting
Standards (SFAS) No. 123(R), "Share-Based Payment", Eaton began to record
compensation expense under the "fair-value-based" method of accounting for stock
options granted to employees and directors. Pretax expense for stock options was
$27 in 2006. This change in accounting is further explained in "Stock Options"
in the Notes to the Consolidated Financial Statements.
CHANGES IN FINANCIAL CONDITION DURING 2006
Throughout 2006, Eaton maintained a focus on management of its capital. Net
working capital of $1,001 at the end of 2006 increased by $391 from $610 at
year-end 2005. The increase was primarily due to the $449 increase in cash and
short-term investments, which largely resulted from strong cash flow from
operations of $1,431; the $143 increase in accounts receivable resulting from
increased sales; and the $194 increase in inventories to support higher levels
of sales. These increases in working capital were partially offset by a net
increase of $178 in short-term debt and current portion of long-term debt, and a
net increase of $217 in accounts payable and several other working capital
accounts to support higher levels of operations. The increase in current
portion of long-term debt was largely due to the reclassification to current
liabilities of the 6% Euro 200 million Notes that will mature in March 2007
(U.S. dollar equivalent of $263 at December 31, 2006) and $48 of other long-term
debt that will mature in 2007, partially offset by the repayment of $244 of
notes and debentures in 2006. Cash and short-term investments totaled $785 at
year-end 2006, up $449 from $336 at year-end 2005. Accounts receivable days
outstanding were 56 days at the end of 2006 and 2005. Inventory days on hand at
the end of 2006 were 51 days, up from 47 days at year-end 2005. The current
ratio was 1.3 at the end of 2006 and 1.2 at year-end 2005.
Cash generated from operating activities of $1,431 in 2006 was a new record for
Eaton, increasing by $296, or 26%, over cash generated from operating activities
of $1,135 in 2005. The increase was primarily due to higher net income in 2006,
which rose $145 in 2006 over 2005 and a net reduction of $162 in working capital
funding due to changes in accounts receivable, accounts payable and in several
other working capital accounts in 2006.
Total debt of $2,586 at the end of 2006 increased $122 from $2,464 at year-end
2005. Changes in debt included the issuance in August 2006 of $250 of floating
notes due 2009, the repayment of $244 of
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notes and debentures in 2006, and a $96 increase in short-term debt. The
net-debt-to-capital ratio was 30.5% at the end of 2006 compared to 36.0% at
year-end 2005. The improvement in this ratio was primarily due to the increase
in Shareholders' equity of $328 and the $327 decrease in net debt (total debt
less cash and short-term investments) largely due to the increase in cash and
short-term investments of $449. The increase in Shareholders' equity was due to
net income in 2006 of $950. This increase was partially offset by the repurchase
of 5.286 million Common Shares in 2006 at a total cost of $386; the recognition
at year-end 2006 of $282 of after-tax adjustments for pensions and other
post-retirement benefits due to the adoption of Statement of Financial
Accounting Standards No. 158; and cash dividends of $220 paid during 2006.
In September 2006, Eaton entered into a new $500 long-term revolving credit
facility, which will expire in August 2011. Eaton has long-term revolving credit
facilities of $1.5 billion, of which $300 will expire in May 2008, $700 in March
2010 and the remaining $500 in August 2011, as described above.
On July 19, 2006 Moody's Investors Service changed its outlook on Eaton to
stable from negative. Moody's awarded Eaton a long-term rating of "A2". In June
2005, Standard & Poor's raised the Company's corporate credit rating to "A" from
"A-minus" and its commercial paper rating to "A-1" from "A-2".
On January 22, 2007, Eaton announced that it was increasing the quarterly
dividend on its Common Shares by 10%, from $.39 per share to $.43 per share,
effective for the February 2007 dividend. This increase is in addition to the
increase announced in July 2006, when the Company raised the quarterly dividend
on its Common Shares by 11%, from $.35 per share to $.39 per share, effective
with the August 2006 dividend, and the 13% increase in the dividend, from $.31
per share to $.35 per share, which was announced in January 2006.
On January 22, 2007, Eaton announced that it was authorizing a new 10 million
Common Share repurchase program, replacing the 1.3 million shares remaining from
the 10 million share repurchase authorization approved in April 2005. The shares
are expected to be repurchased over time, depending on market conditions, share
price, capital levels and other considerations. Under the April 2005
authorization, 5.286 million shares were repurchased in the open market in 2006
at a total cost of $386.
As of December 31, 2006, Eaton adopted Statement of Financial Accounting
Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and
Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and
132(R)". SFAS No. 158 requires employers to recognize on their balance sheets
the net amount by which pension and other postretirement benefit plan
obligations are overfunded or underfunded. This new requirement replaces SFAS
No. 87's requirement to report a minimum pension liability measured as the
excess of the accumulated benefit obligations over the fair value of plan
assets. Under SFAS No. 158, employers are required to recognize all actuarial
gains and losses, prior service costs, and any remaining transition amounts from
the initial application of SFAS Nos. 87 and 106 when recognizing the plans'
funded status, with an increase in accumulated other comprehensive loss in
shareholders' equity. The effect on Eaton of applying SFAS No. 158 on the
consolidated balance sheet at December 31, 2006 was an increase in the liability
for pensions of $248 ($163 after-tax) and an increase in the liability for
postretirement benefits other than pensions of $238 ($119 after-tax). These
adjustments increased Accumulated other comprehensive loss in Shareholders'
equity by a combined amount of $282, reducing total Shareholders' equity by a
like amount. This change in accounting is further explained in "Retirement
Benefit Plans" in the Notes to the Consolidated Financial Statements.
The Pension Protection Act of 2006 (the Act) was signed on August 17, 2006. The
Act establishes new minimum funding standards that become effective in 2008.
Under the new law, a plan's funding shortfall (the amount the funding target
exceeds the actuarial value of assets) will be amortized over seven years, and
the minimum required contribution will be the sum of the target normal cost and
the amortization charge. Eaton cannot reasonably estimate the funding status in
future periods as it is dependent on the interest rates used to determine the
funding target and the future return on assets. Eaton has made voluntary
contributions to its United States pension plan of $50, $100, and $150 in 2005,
2006, and 2007 respectively. Future minimum required contributions are expected
to be within a similar range.
OUTLOOK FOR 2007
As Eaton surveyed its end markets for its business segments in mid-January 2007,
it expected an overall decline of approximately 3.5% for full year 2007,
primarily as a result of the expected dramatic decrease in the NAFTA heavy-duty
Page 61
truck market. This is roughly 1.5% lower growth in end markets than had been
expected one year ago, as the Company now sees the slowdown in the overall
manufacturing sector experienced in the second half of 2006 extending into the
early portion of 2007. Eaton expects to outgrow end markets in 2007 by
approximately $200, and to record approximately $300 of additional sales in 2007
from the full-year impact of the six acquisitions completed in 2006, and the two
acquisitions announced in December 2006 and January 2007, but not yet completed.
As a result of the expected decline in end markets in 2007 being offset by
additional sales in 2007 from out-growing end markets and from acquisitions of
businesses, the Company anticipates sales in 2007 will be flat compared to 2006.
For 2007, in the Electrical segment, Eaton expects markets to grow 4%, with
growth in the nonresidential markets offsetting a decline in the residential
market. Operating margins are expected to improve as a result of the additional
volume, a reduced impact from commodity costs, and the benefits from the Excel
07 actions taken in 2006. For Fluid Power, the Company expects growth in the
construction equipment markets to be lower than in 2006, while agricultural
equipment markets are expected to grow for the first time in three years.
Industrial markets are likely to post lower growth than in 2006. Growth in the
commercial aerospace market is expected to be solid, while defense aerospace
markets are expected to post modest growth. In total, the Company believes the
Fluid Power markets will grow 4% in 2007. Fluid Power operating margins are
expected to improve in 2007 as a result of the additional volume and the
benefits from the Excel 07 actions taken in 2006. In the Truck segment, Eaton
expects that production of NAFTA heavy-duty trucks in 2007 will be between
205,000 and 210,000 units, down approximately 44% from 2006. Truck operating
margins will be lower due to the expected reduction in the end market for
heavy-duty trucks in NAFTA, but the benefits from the Excel 07 actions taken in
2006 will help to cushion the overall sales reduction. For the Automotive
segment, NAFTA automotive production is expected to weaken, and production in
Europe is expected to be flat. Margins for the Automotive segment are expected
to improve as a result of the substantial benefits from the Excel 07 actions
taken in 2006.
The significant restructuring of operations in 2006 resulting from the Excel 07
program is expected to offset much of the effect on net income in 2007 from the
expected overall decline in end markets. Eaton believes the benefit to net
income in 2007 now expected from the Excel 07 program will be $.60 per Common
Share, double the target announced when the program was started in January 2006.
With the Excel 07 program completed at the end of 2006, the Company believes its
operations are well positioned for the balance of the decade.
Eaton's guidance for net income per Common Share for full year 2007 is $6.05 to
$6.25, after charges to integrate recent acquisitions and joint ventures of $.25
per share. For the first quarter of 2007, the Company anticipates net income per
Common Share of $1.30 to $1.40, after acquisition integration charges of $.05
per share.
FORWARD-LOOKING STATEMENTS
This Annual Report to Shareholders contains forward-looking statements
concerning Eaton's first quarter 2007 and full year 2007 net income per Common
Share, worldwide markets, growth in relation to end markets, growth from
acquisitions and joint ventures, and the benefits from Excel 07. These
statements should be used with caution and are subject to various risks and
uncertainties, many of which are outside the Company's control. The following
factors could cause actual results to differ materially from those in the
forward-looking statements: unanticipated changes in the markets for the
Company's business segments; unanticipated downturns in business relationships
with customers or their purchases from the Company; competitive pressures on
sales and pricing; increases in the cost of material and other production costs,
or unexpected costs that cannot be recouped in product pricing; the introduction
of competing technologies; unexpected technical or marketing difficulties;
unexpected claims, charges, litigation or dispute resolutions; acquisitions and
divestitures; unanticipated difficulties integrating acquisitions; new laws and
governmental regulations; interest rate changes; stock market fluctuations; and
unanticipated deterioration of economic and financial conditions in the United
States and around the world. Eaton does not assume any obligation to update
these forward-looking statements.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires Eaton's management to make
estimates and use assumptions in certain circumstances that affect amounts
reported in the accompanying consolidated financial statements. In preparing
these financial statements, management has made their best estimates and
judgments of certain amounts included in the financial statements, giving due
consideration to materiality. For any
Page 62
estimate or assumption there may be other reasonable estimates or assumptions
that could have been used. However, the Company believes that given the current
facts and circumstances, it is unlikely that applying such other estimates and
assumptions would have caused materially different amounts to have been
reported. Application of these accounting policies involves the exercise of
judgment and use of assumptions as to future uncertainties and, as a result,
actual results could differ from estimates used.
REVENUE RECOGNITION
Sales are recognized when products are shipped to unaffiliated customers, all
significant risks of ownership have been transferred to the customer, title has
transferred in accordance with shipping terms (FOB shipping point or FOB
destination), the selling price is fixed and determinable, all significant
related acts of performance have been completed, and no other significant
uncertainties exist. Shipping and handling costs billed to customers are
included in Net sales and the related costs in Cost of products sold. Other
revenues for service contracts are recognized as the services are provided.
IMPAIRMENT OF GOODWILL & OTHER LONG-LIVED ASSETS
Statement of Financial Accounting Standards (SFAS) No. 142 "Goodwill and Other
Intangible Assets" provides that goodwill and indefinite life intangible assets
must be reviewed for impairment, in accordance with the specified methodology.
Further, goodwill and intangible assets are reviewed for impairment whenever
events or changes in circumstances indicate the carrying amount may not be
recoverable. During 2006, Eaton completed the annual impairment tests for
goodwill and indefinite life intangible assets as required by SFAS No. 142.
These tests confirmed that the fair value of the Company's reporting units and
indefinite life intangible assets exceed their respective carrying values and
that no impairment loss was required to be recognized. Goodwill and other
intangible assets totaled $4.0 billion at the end of 2006 and represented 35% of
total assets. These assets resulted primarily from the $1.6 billion acquisition
of Aeroquip-Vickers, Inc., a mobile and industrial hydraulics business, in 1999;
the $1.1 billion acquisition of the electrical distribution and controls
business unit of Westinghouse in 1994; and the $573 acquisition of Powerware
Corporation, the electrical uninterruptable power systems business, in 2004.
These businesses, as well as many of the Company's other recent business
acquisitions, have a long history of operating success and profitability and
hold significant market positions in the majority of their product lines. Their
products are not subject to rapid technological or functional obsolescence.
These factors, coupled with continuous strong product demand, support the
recorded values of the goodwill and intangible assets related to acquired
businesses.
Long-lived assets, other than goodwill and indefinite life intangible assets,
are reviewed for impairment whenever events or changes in circumstances indicate
the carrying amount may not be recoverable. Events or circumstances that would
result in an impairment review primarily include operations reporting losses, a
significant change in the use of an asset, or the planned disposal or sale of
the asset. The asset would be considered impaired when the future net
undiscounted cash flows generated by the asset are less than its carrying value.
An impairment loss would be recognized based on the amount by which the carrying
value of the asset exceeds its fair value.
INCOME TAX ASSETS & LIABILITIES
Deferred income tax assets and liabilities have been recorded for the
differences between the financial accounting and income tax basis of assets and
liabilities, and for certain United States income tax credit carryforwards.
Recorded deferred income tax assets and liabilities are described in detail in
"Income Taxes" in the Notes to the Consolidated Financial Statements.
Significant factors considered by management in the determination of the
probability of the realization of deferred tax assets include historical
operating results, expectations of future earnings and taxable income, and the
extended period of time over which certain temporary differences will reverse. A
valuation allowance of $221 has been recognized for deferred tax assets, because
management believes there is a low probability of the realization of deferred
tax assets related to certain United States Federal income tax credit
carryforwards, most United States state and local income tax loss carryforwards
and tax credit carryforwards, and tax loss carryforwards at certain
international operations.
In June 2006, the Financial Accounting Standards Board (FASB) issued
Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109", which Eaton will adopt in first
quarter 2007. FIN No. 48 clarifies the accounting for uncertainty in income
taxes by establishing minimum standards for the recognition and measurement of
income tax positions taken, or expected to be taken, in an income tax return.
FIN No. 48 also changes the disclosure standards for income taxes. Eaton's
historical policy has consistently been to enter into tax planning strategies
only if it is more likely than not that the benefit would be sustained upon
audit. For example, the Company
Page 63
does not enter into any of the Internal Revenue Service (IRS) Listed
Transactions as set forth in Treasury Regulation 1.6011-4. Consequently, the
Company does not expect the adoption of FIN No. 48 to result in the recording of
a material cumulative effect of a change in the accounting principle.
PENSION & OTHER POSTRETIREMENT BENEFIT PLANS
The measurement of liabilities related to pension plans and other postretirement
benefit plans is based on management's assumptions related to future events
including interest rates, return on pension plan assets, rate of compensation
increases, and health care cost trend rates. Actual pension plan asset
performance will either reduce or increase pension losses included in
accumulated other comprehensive loss, which ultimately affects net income.
The discount rate for United States plans was determined by constructing a
zero-coupon spot yield curve derived from a universe of high-quality bonds as of
the measurement date, which was designed to match the discounted expected
benefit payments. The bond data (rated Aa or better by Moody's Investor
Services) was obtained from Bloomberg. Callable bonds with explicit call
schedules were excluded and bonds with "make-whole" call provisions were
included. In addition, a portion of the bonds were deemed outliers and excluded
from consideration.
The discount rates for non-United States plans are appropriate for each region
and are based on high quality long-term corporate and government bonds.
Consideration has been given to the duration of the liabilities in each plan for
selecting the bonds to be used in determining the discount rate.
At the end of 2006, certain key assumptions used to calculate pension and other
postretirement benefit expense were adjusted, including the lowering of the
assumed return on pension plan assets from 8.35% to 8.31% and the discount rate
from 5.51% to 5.39%. At the end of 2005, the assumed return on pension plan
assets was lowered from 8.41% to 8.35%, and the discount rate from 5.81% to
5.51%. At the end of 2004, the assumed return on pension plan assets was lowered
from 8.50% to 8.41% and the discount rate from 6.11% to 5.81%.
The changes in these assumptions in 2005 and 2004 resulted in increased pretax
pension and postretirement benefit expense of $66 in 2006 compared to 2005.
These changes increased pretax pension and other postretirement benefit expense
$55 in 2005 compared to 2004. Pretax pension and other postretirement benefit
expense are expected to be flat in 2007 compared to 2006.
A 1-percentage point change in the assumed rate of return on pension plan assets
is estimated to have approximately a $24 effect on pension expense. Likewise, a
1-percentage point change in the discount rate is estimated to have
approximately a $44 effect on pension expense. A 1-percentage point change in
the discount rate is estimated to have approximately a $1 effect on expense for
other postretirement benefit plans. Additional information related to changes in
key assumptions used to recognize expense for other postretirement benefit plans
is found in "Retirement Benefit Plans" in the Notes to the Consolidated
Financial Statements.
As of December 31, 2006, Eaton adopted Statement of Financial Accounting
Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and
Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and
132(R)". SFAS No. 158 requires employers to recognize on their balance sheets
the net amount by which pension and other postretirement benefit plan
obligations are overfunded or underfunded. This change in accounting is further
explained in "Retirement Benefit Plans" in the Notes to the Consolidated
Financial Statements.
PROTECTION OF THE ENVIRONMENT
As a result of past operations, Eaton is involved in remedial response and
voluntary environmental remediation at a number of sites, including certain of
its currently-owned or formerly-owned plants. The Company has also been named a
potentially responsible party (PRP) under the Federal Superfund law at a number
of waste disposal sites.
A number of factors affect the cost of environmental remediation, including the
number of parties involved at a particular site, the determination of the extent
of contamination, the length of time the remediation may require, the complexity
of environmental regulations, and the continuing advancement of remediation
technology. Taking these factors into account, Eaton has estimated (without
discounting) the costs of remediation, which will be incurred over a period of
several years. The Company accrues an amount consistent with the estimates of
these costs when it is probable that a liability has been incurred. At December
31, 2006, the balance sheet included a liability for these costs of $64. All of
Page 64
these estimates are forward-looking statements and, given the inherent
uncertainties in evaluating environmental exposures, actual results can differ
from these estimates.
CONTINGENCIES
Eaton is subject to a broad range of claims, administrative proceedings,
and legal proceedings, such as lawsuits that relate to contractual
allegations, patent infringement, personal injuries (including asbes-
tos claims) and employment-related matters. Although it is not pos-
sible to predict with certainty the outcome or cost of these matters,
the Company believes that these matters will not have a material ad-
verse effect on its financial position, results of operations or cash flows.
STOCK OPTIONS GRANTED TO EMPLOYEES & DIRECTORS
Effective January 1, 2006, in accordance with SFAS No. 123(R), "Share-Based
Payment", Eaton began to record compensation expense under the
"fair-value-based" method of accounting for stock options granted to employees
and directors. The Company adopted SFAS No. 123(R) using the "modified
prospective application" method and, consequently, financial results for periods
prior to 2006 were not restated for this accounting change. This change in
accounting is further explained in "Stock Options" in the Notes to the
Consolidated Financial Statements.
OFF-BALANCE SHEET ARRANGEMENTS
Eaton does not have off-balance sheet arrangements or financings with
unconsolidated entities or other persons. In the ordinary course of business,
the Company leases certain real properties and equipment, as described in "Lease
Commitments" in the Notes to the Consolidated Financial Statements. Transactions
with related parties are in the ordinary course of business, are conducted on an
arm's-length basis, and are not material to Eaton's financial position, results
of operations or cash flows.
MARKET RISK DISCLOSURE & CONTRACTUAL OBLIGATIONS
To manage exposure to fluctuations in foreign currencies, interest rates and
commodity prices, Eaton uses straightforward, non-leveraged, financial
instruments for which quoted market prices are readily available from a number
of independent services.
The Company is exposed to various changes in financial market conditions,
including fluctuations in interest rates, foreign currency exchange rates, and
commodity prices. Eaton manages exposure to such risks through normal operating
and financing activities.
Interest rate risk can be measured by calculating the near-term earnings impact
that would result from adverse changes in interest rates. This exposure results
from short-term debt, which includes commercial paper at a floating interest
rate, long-term debt that has been swapped to floating rates, and money market
investments that have not been swapped to fixed rates. A 100 basis point
increase in short-term interest rates would increase the Company's net, pretax
interest expense by approximately $15.
Eaton also measures interest rate risk by estimating the net amount by which the
fair value of the Company's financial liabilities would change as a result of
movements in interest rates. Based on a hypothetical, immediate 100 basis point
decrease in interest rates at December 31, 2006, the market value of the
Company's debt and interest rate swap portfolio, in aggregate, would increase by
$137.
Foreign currency risk is the risk that Eaton will incur economic losses due to
adverse changes in foreign currency exchange rates. The Company mitigates
foreign currency risk by funding some investments in foreign markets through
local currency financings. Such non-U.S. Dollar debt was $701 at December 31,
2006. To augment Eaton's non-U.S. Dollar debt portfolio, the Company also enters
into forward foreign exchange contracts and foreign currency swaps from time to
time to mitigate the risk of economic loss in its foreign investments due to
adverse changes in exchange rates. At December 31, 2006, the aggregate balance
of such contracts was $169. Eaton also monitors exposure to transactions
denominated in currencies other than the functional currency of each country in
which the Company operates, and periodically enters into forward contracts to
mitigate that exposure. In the aggregate, Eaton's portfolio of forward contracts
related to such transactions was not material to its financial position, results
of operations or cash flows during 2006.
Other than the above noted debt and financial derivative arrangements, there
were no material derivative instrument transactions in place or undertaken
during 2006.
A summary of contractual obligations as of December 31, 2006 follows:
Page 65
Payments due by period
---------------------------------------
2008 2010
to to After
2007 2009 2011 2011 Total
------ ----- ---- ------ ------
Long-term debt $ 322 $401 $ 7 $1,366 $2,096
Interest expense related to
long-term debt 106 196 174 968 1,444
Reduction of interest
expense from interest rate
swap agreements related
to long-term debt (3) (3) (5) (57) (68)
Operating leases 87 120 67 49 323
Purchase obligations 412 171 43 20 646
Other long-term liabilities 225 26 25 34 310
------ ---- ---- ------ ------
$1,149 $911 $311 $2,380 $4,751
====== ==== ==== ====== ======
Long-term debt includes obligations under capital leases, which are not
material. Interest expense related to long-term debt is based on the fixed
interest rate, or other applicable interest rate related to the debt instrument,
at December 31, 2006. The reduction of interest expense due to interest rate
swap agreements related to long-term debt is based on the difference in the
fixed interest rate the Company receives from the swap, compared to the floating
interest rate the Company pays on the swap, at December 31, 2006. Purchase
obligations are entered into with various vendors in the normal course of
business. These amounts include commitments for purchases of raw materials,
outstanding non-cancelable purchase orders, releases under blanket purchase
orders and commitments under ongoing service arrangements. Other long-term
liabilities include $214 of contributions to pension plans in 2007 and $96 of
deferred compensation earned under various plans for which the participants have
elected to receive disbursement at a later date. The table above does not
include future expected pension benefit payments or expected other
postretirement benefit payments for each of the next five years and the five
years thereafter. Information related to the amounts of these future payments is
described in "Retirement Benefit Plans" in the Notes to the Consolidated
Financial Statements.
RESULTS OF OPERATIONS - 2005 COMPARED TO 2004
2005 2004 Increase
------- ------ --------
Continuing operations
Net sales $11,019 $9,712 13%
Gross profit 3,083 2,710 14%
Percent of net sales 28.0% 27.9%
Income before income taxes 988 768 29%
Income after income taxes $ 799 $ 640 25%
Income from discontinued
operations, net of income
taxes 6 8
------- ------
Net income $ 805 $ 648 24%
======= ======
Net income per Common Share
assuming dilution
Continuing operations $ 5.19 $ 4.07 28%
Discontinued operations .04 .06
------- ------
$ 5.23 $ 4.13 27%
======= ======
Sales for 2005 grew 13% compared to 2004 and were a record for Eaton. Sales
growth in 2005 consisted of 7% from organic growth, 5% from acquisitions of
businesses (primarily the full-year effect of the Powerware electrical power
systems business acquired on June 9, 2004), and 1% from foreign exchange rates.
Organic growth of 7% was comprised of 5% growth in Eaton's end markets and 2%
from outgrowing end markets.
Gross profit increased 14% in 2005, primarily due to sales growth, the benefits
of integrating acquired businesses, continued productivity improvements driven
by the Eaton Business System (EBS), and the full-year effect of the acquisition
of Powerware. Improved gross profit in 2005 was also partially due to reduced
acquisition integration charges in 2005, which were $36 compared to $41 in 2004.
These increases in gross profit were partially offset by higher pension costs
and higher prices paid, primarily for basic metals, in 2005.
Page 66
RESULTS BY GEOGRAPHIC REGION
Segment operating profit Operating
Net sales -------------------------- margin
--------------------------- Increase -----------
2005 2004 Increase 2005 2004 (Decrease) 2005 2004
------- ------ -------- ------ ---- ---------- ---- ----
United States $ 7,666 $6,806 13% $1,018 $778 31% 13.3% 11.4%
Canada 315 261 21% 48 37 30% 15.2% 14.2%
Europe 2,084 1,922 8% 110 138 (20%) 5.3% 7.2%
Latin America 1,036 774 34% 136 107 27% 13.1% 13.8%
Asia/Pacific 797 679 17% 80 79 1% 10.0% 11.6%
Eliminations (879) (730)
------- ------
$11,019 $9,712 13%
======= ======
Growth in sales in the United States of 13% was due to higher sales in
Electrical, which included the full-year effect of the acquisition of Powerware;
sharply higher sales in Truck due to strong end market demand; and, to a lesser
extent, increased sales in Fluid Power from acquisitions completed in second
half of 2005, including the aerospace division of PerkinElmer, Inc., the
aerospace fluid and air division of Cobham plc, and the industrial filtration
business of Hayward Industries, Inc. These increases in sales were partially
offset by a sales reduction in Automotive. The 31% increase in operating profit
in the United States was primarily the result of strong sales in Truck; higher
profit of Electrical, including the full-year effect of the acquisition of
Powerware; the benefits of integrating acquired businesses; and, to a lesser
extent, increased profit of Fluid Power and Automotive.
In Canada, growth of 21% in sales and 30% in operating profit were due to the
full-year effect of the acquisition of Powerware and improved results in other
Electrical businesses.
Sales growth in Europe of 8% was due to higher sales in Electrical, largely the
result of the full-year effect of the acquisition of Powerware; to a lesser
extent, growth in Fluid Power, which included sales of the aerospace fluid and
air division of Cobham plc; and growth in Automotive and Truck. Lower operating
profit of 20% in Europe was primarily the result of a significant reduction in
revenues in Fluid Power's automotive fluid connectors business, and reduced
profit of Automotive, which included costs incurred in the fourth quarter to
start-up new facilities in Eastern Europe.
In Latin America, growth of 34% in sales and 27% in operating profit were
largely due to significantly higher sales in Truck, which included the Pigozzi
agricultural powertrain business acquired in March 2005; to a lesser extent,
higher sales in Electrical, including the full-year effect of the acquisition of
Powerware; and sales growth in Automotive, which included the Morestana
hydraulic lifters business acquired in June 2005.
Growth of 17% in sales of Asia/Pacific was due to the full-year effect of the
acquisition of Powerware and higher sales of Fluid Power, which included the
Winner hydraulics business acquired in March 2005. The 1% increase in operating
profit primarily related to the full-year effect of the acquisition of Powerware
and improved results of Fluid Power, partially offset by lower profit in
Automotive and by start-up losses related to new operations of Truck.
OTHER RESULTS OF OPERATIONS
In 2005 and 2004, Eaton incurred acquisition integration charges related to the
integration of primarily the following acquisitions: Powerware, the electrical
power systems business acquired in June 2004; the electrical division of Delta
plc; several acquisitions in Fluid Power, including Winner, Walterscheid, and
Boston Weatherhead; the Pigozzi agricultural powertrain business; and the
Morestana automotive lifter business. A summary of these charges follows:
2005 2004
---- ----
Electrical $ 21 $ 33
Fluid Power 7 8
Truck 4
Automotive 4
---- ----
Pretax charges $ 36 $ 41
==== ====
After-tax charges $ 24 $ 27
Per Common Share $.15 $.17
Page 67
Acquisition integration charges in 2005 included $17 for the United States, $7
for Europe, $4 for Latin America and $8 for Asia/Pacific. Charges in 2004
included $22 for the United States, $18 for Europe and $1 for Asia/Pacific.
These charges were included in the Statements of Consolidated Income in Cost of
products sold or Selling & administrative expense, as appropriate. In Business
Segment Information, the charges reduced Operating profit of the related
business segment or were included in Other corporate expense-net, as
appropriate.
Pretax income for 2005 was reduced by $55 ($35 after-tax, or $.23 per Common
Share) compared to 2004 due to increased pension and other postretirement
benefit expense in 2005. This primarily resulted from the effect of the lower
discount rates used in determining pension and other postretirement benefit
liabilities at year-end 2004, coupled with the impact of declines during 2000
through 2002 in the market related value of equity investments held by Eaton's
pension plans.
The effective income tax rate for 2005 was 19.1% compared to 16.7% for 2004. The
lower rate in 2004 was primarily due to an income tax benefit of $30 resulting
from the favorable resolution in the fourth quarter of 2004 of multiple
international and U.S. income tax issues. In fourth quarter 2005, Eaton recorded
income tax expense of $3 for the repatriation of $66 of foreign earnings under
the American Jobs Creation Act of 2004. This distribution did not change the
Company's intention to indefinitely reinvest undistributed earnings of its
foreign subsidiaries and, therefore, no U.S. income tax provision has been
recorded on the remaining amount of unremitted earnings. The change in the
effective income tax rate in 2005 compared to 2004 is further explained in
"Income Taxes" in the Notes to the Consolidated Financial Statements.
Net income and net income per Common Share assuming dilution for 2005 were new
records for Eaton, increasing 24% and 27%, respectively, over 2004. These
improvements were primarily due to sales growth and other factors described
above. These improvements leading to the increase in net income were partially
offset by higher interest expense and a higher effective income tax rate in
2005. The increase in earnings per share also reflected lower average shares
outstanding for periods in 2005 compared to 2004, due to the repurchase of 7.015
million shares in 2005, at a total cost of $450.
RESULTS BY BUSINESS SEGMENT
ELECTRICAL
2005 2004 Increase
------ ------ --------
Net sales $3,758 $3,072 22%
Operating profit 375 243 54%
Operating margin 10.0% 7.9%
Sales of the Electrical segment grew 22% in 2005. Of the 22% sales increase, 11%
was from acquisitions, 10% was due to volume growth, and 1% from foreign
exchange rates. Acquisitions included the Powerware electrical power systems
business acquired on June 9, 2004. Operating results for 2005 and 2004 include
the results of Powerware from the date of acquisition. Volume growth of 10% in
2005 was driven by growth in end markets of approximately 6% and sales above
end-market growth of an additional 4%.
Operating profit rose 54% in 2005. The increase was largely due to growth in
sales, continued productivity improvements, the full-year effect of the
acquisition of Powerware, benefits of integrating Powerware, and favorable
product mix. These improvements in operating profit were partially offset by
higher prices paid, primarily for basic metals. The operating margin on overall
sales growth was 19%. Increased sales from acquisitions generated a 6% operating
margin. Increased sales from organic growth generated a 29% operating margin.
The improved operating margin in 2005 also reflected reduced acquisition
integration charges in 2005. Acquisition integration charges in 2005 were $21
compared to $33 in 2004, reducing operating margins by 0.6% in 2005 and 1.1% in
2004, and reducing the incremental profit margin by 1.7%. Acquisition
integration charges in 2005 and 2004 related primarily to the integration of
Powerware as well as the electrical division of Delta plc acquired in January
2003.
On October 11, 2005, Eaton acquired the assets of one of its suppliers, Pringle
Electrical Manufacturing Company. This business manufactures bolted contact
switches and other specialty switches and had sales of $6 in 2004, with
one-third of these sales to Eaton.
Page 68
On June 17, 2005, Eaton signed an agreement to form a joint venture with
Zhongshan Ming Yang Electrical Appliances Co., Ltd. to manufacture and market
switchgear components in southern China. Eaton has 51% ownership of the joint
venture, which is called Eaton Electrical (Zhongshan) Co., Ltd. The joint
venture began operations in third quarter 2005.
On June 9, 2004, Eaton acquired Powerware Corporation, the power systems
business of Invensys plc, for a final cash purchase price of $573, less cash
acquired of $27. Powerware, based in Raleigh, North Carolina, is a supplier of
Uninterruptible Power Systems (UPS), DC Power products and power quality
services that had sales of $775 for the year ended March 31, 2004. Powerware has
operations in the United States, Canada, Europe, South America and Asia/Pacific
that provide products and services utilized by computer manufacturers,
industrial companies, governments, telecommunications firms, medical
institutions, data centers and other businesses.
FLUID POWER
2005 2004 Increase
------ ------ --------
Net sales $3,240 $3,098 5%
Operating profit 339 338 --
Operating margin 10.5% 10.9%
Sales of the Fluid Power segment grew 5% in 2005. The increase in sales in 2005
over 2004 was due to acquisitions of businesses in 2005 and 2004 contributing
5%, with growth in end markets contributing another 3%, driven by strength in
end markets for hydraulics and commercial aerospace, partially offset by
weakness in end markets for defense aerospace and automotive fluid connectors.
Sales in 2005 also reflected a significant sales decrease in the automotive
fluid connector business reflecting the impact of expiring programs.
Acquisitions in 2005 included the following businesses, which are described
below: the aerospace operations of PerkinElmer, Inc. and the aerospace fluid and
air division of Cobham plc; the industrial filtration business of Hayward
Industries, Inc.; and the hydraulic hose fittings and adapters business in China
of Winner Group Holdings Ltd. The sales increase also reflected the full-year
effect of the acquisition of Walterscheid, a German manufacturer of hydraulic
tube connectors and fittings, in September 2004. Growth in Fluid Power markets
during 2005 was mixed, with global hydraulics shipments up 8%, commercial
aerospace markets up 10%, defense aerospace markets down 7%, and European
automotive production down 2%. Growth in the mobile and industrial hydraulics
markets in 2005 slowed from 2004. In particular, agricultural equipment sales
were sluggish due to a combination of drought conditions and reductions in farm
income in several markets around the world.
Operating margins were helped by the operating profit of acquired businesses,
which generated incremental profit of 13% on the sales contributed, benefits of
restructuring actions to integrate acquired businesses, and continued
productivity improvements. Operating profit and margins were also affected by
the significant reduction in revenues in the automotive fluid connectors
business, which had a 26% reduction in operating profit on the lost volume.
Additional program costs within the aerospace business, sluggish demand in the
agricultural equipment sector, and higher prices paid, primarily for basic
metals, also contributed to the lower operating margin. Acquisition integration
charges in 2005 related to acquired businesses were $7 compared to $8 in 2004,
reducing operating margins by 0.2% in 2005 and 0.3% in 2004. These acquisition
integration charges related to the integration of recent acquisitions including
Winner, Walterscheid acquired in September 2004, and Boston Weatherhead acquired
in November 2002.
On December 6, 2005, Eaton acquired the aerospace division of PerkinElmer, Inc.,
which is a provider of sealing and pneumatic systems for large commercial
aircraft and regional jets. This business had sales of $150 for the 12 months
ended June 30, 2005.
On November 1, 2005, the Company acquired the aerospace fluid and air division
of Cobham plc. This business provides low-pressure airframe fuel systems,
electro-mechanical actuation, air ducting, hydraulic and power generation, and
fluid distribution systems for fuel, hydraulics and air. This business had sales
of $210 in 2004.
On September 6, 2005, the industrial filtration business of Hayward Industries,
Inc. was acquired. Hayward produces filtration systems for industrial and
commercial customers. This business had sales of $100 for the 12 months ended
June 30, 2005.
Page 69
On March 31, 2005, Eaton acquired Winner Group Holdings Ltd., a producer of
hydraulic hose fittings and adapters for the Chinese market. This business had
sales of $26 in 2004.
TRUCK
2005 2004 Increase
------ ------ --------
Net sales $2,288 $1,800 27%
Operating profit 453 329 38%
Operating margin 19.8% 18.3%
Sales of the Truck segment grew 27% in 2005. Of the 27% sales increase in 2005,
21% was due to organic growth, 5% from foreign exchange rates, and 1% from the
acquisition of Pigozzi, as described below. Organic growth was attributable to
strong end-market demand, primarily in NAFTA heavy-duty truck production, which
rose 27% in 2005 to 341,000 units. Other markets also grew in 2005, with NAFTA
medium-duty truck production increasing 16% in 2005 compared to 2004, European
truck production increasing 7%, and Brazilian vehicle production increasing 10%.
Operating profit grew 38% in 2005. The incremental profit margin on the
increased sales volume was 25%, partly reflecting the benefits of productivity
improvements. These improvements in operating margin were offset by higher
prices paid, primarily for basic metals. Operating profit in 2005 was also
reduced by 0.2% due to acquisition integration charges of $4 related to the
integration of Pigozzi.
On March 1, 2005, Pigozzi S.A. Engrenagens e Transmissoes, a Brazilian
agricultural powertrain business that produces transmissions, rotors and other
drivetrain components, was acquired. This business had sales of $42 in 2004.
AUTOMOTIVE
2005 2004 (Decrease)
------ ------ ----------
Net sales $1,733 $1,742 (1)%
Operating profit 225 229 (2)%
Operating margin 13.0% 13.1%
Sales of the Automotive segment decreased 1% in 2005. The reduction in sales
reflected sales volume that was lower by 2% in 2005, offset by a 1% increase due
to foreign exchange rates. Automotive production in 2005 for NAFTA was flat
compared to 2004, and in Europe decreased 2% from 2004. The change in sales also
reflected additional sales volume from the acquisitions in 2005 of Tractech
Holdings, Inc. and Morestana S.A. de C.V, as described below.
The 2% decrease in operating profit in 2005 resulted from the reduction in sales
in 2005, costs incurred to start-up new facilities in Eastern Europe and to exit
a product line, and $4 of acquisition integration charges related to the
acquisition of Morestana described below. Operating profit in 2005 was helped by
continued productivity improvements, but was also hurt by higher prices paid,
primarily for basic metals. Acquisition integration charges related to the
integration of Morestana reduced operating margin by 0.2% in 2005.
On August 17, 2005, Tractech Holdings, Inc., a manufacturer of specialized
differentials and clutch components for the commercial and specialty vehicle
markets, was acquired. This business had sales of $43 in 2004.
On June 30, 2005, Morestana S.A. de C.V., a Mexican producer of hydraulic
lifters for automotive engine manufacturers and the automotive aftermarket, was
acquired. This business had sales of $13 in 2004.
CORPORATE
Pension and other postretirement benefit expense included in corporate increased
to $120 in 2005 from $75 in 2004. The increase primarily resulted from the
effect of the lower discount rates used in determining pension and other
postretirement benefit liabilities at year-end 2004, coupled with the impact of
declines during 2000 through 2002 in the market related value of equity
investments held by Eaton's pension plans.
Page 70
Other corporate expense-net in 2005 was $159 compared to $186 for 2004. The
reduction was largely attributable to a charge of $13 for contributions to the
Eaton Charitable Fund that was recorded in 2004, with no similar expense in
2005.
Page 71
TEN-YEAR CONSOLIDATED FINANCIAL SUMMARY
(Millions except for per share data) 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997
------- ------- ------ ------ ------ ------ ------ ------ ------ ------
Continuing operations
Net sales $12,370 $11,019 $9,712 $7,966 $7,123 $7,207 $8,219 $7,915 $6,276 $7,019
Income before income taxes 989 988 768 492 384 262 537 929 602 713
Income after income taxes $ 912 $ 799 $ 640 $ 375 $ 271 $ 158 $ 353 $ 593 $ 421 $ 515
Percent of net sales 7.4% 7.3% 6.6% 4.7% 3.8% 2.2% 4.3% 7.5% 6.7% 7.3%
Extraordinary item - redemption of
debentures (54)
Income (loss) from discontinued
operations, net of income taxes 38 6 8 11 10 11 100 24 (72) (51)
------- ------- ------ ------ ------ ------ ------ ------ ------ ------
Net income $ 950 $ 805 $ 648 $ 386 $ 281 $ 169 $ 453 $ 617 $ 349 $ 410
======= ======= ====== ====== ====== ====== ====== ====== ====== ======
Net income per Common Share assuming
dilution
Continuing operations $ 5.97 $ 5.19 $ 4.07 $ 2.49 $ 1.89 $ 1.12 $ 2.43 $ 4.02 $ 2.90 $ 3.29
Extraordinary item (.35)
Discontinued operations .25 .04 .06 .07 .07 .08 .69 .16 (.50) (.32)
------- ------- ------ ------ ------ ------ ------ ------ ------ ------
$ 6.22 $ 5.23 $ 4.13 $ 2.56 $ 1.96 $ 1.20 $ 3.12 $ 4.18 $ 2.40 $ 2.62
======= ======= ====== ====== ====== ====== ====== ====== ====== ======
Average number of Common Shares
outstanding assuming dilution 152.9 154.0 157.1 150.5 143.4 141.0 145.2 147.4 145.4 156.4
Net income per Common Share basic
Continuing operations $ 6.07 $ 5.32 $ 4.18 $ 2.54 $ 1.92 $ 1.14 $ 2.46 $ 4.09 $ 2.95 $ 3.35
Extraordinary item (.35)
Discontinued operations .25 .04 .06 .07 .07 .08 .70 .17 (.50) (.33)
------- ------- ------ ------ ------ ------ ------ ------ ------ ------
$ 6.32 $ 5.36 $ 4.24 $ 2.61 $ 1.99 $ 1.22 $ 3.16 $ 4.26 $ 2.45 $ 2.67
======= ======= ====== ====== ====== ====== ====== ====== ====== ======
Average number of Common Shares
outstanding basic 150.2 150.2 153.1 147.9 141.2 138.8 143.6 145.0 142.8 153.6
Cash dividends paid per Common Share $ 1.48 $ 1.24 $ 1.08 $ .92 $ .88 $ .88 $ .88 $ .88 $ .88 $ .86
------- ------- ------ ------ ------ ------ ------ ------ ------ ------
Total assets $11,417 $10,218 $9,075 $8,223 $7,138 $7,646 $8,180 $8,342 $5,570 $5,497
Long-term debt 1,774 1,830 1,734 1,651 1,887 2,252 2,447 1,915 1,191 1,272
Total debt 2,586 2,464 1,773 1,953 2,088 2,440 3,004 2,885 1,524 1,376
Shareholders' equity 4,106 3,778 3,606 3,117 2,302 2,475 2,410 2,624 2,057 2,071
Shareholders' equity per Common Share $ 28.07 $ 25.44 $23.52 $20.37 $16.30 $17.80 $17.64 $17.72 $14.34 $13.86
Common Shares outstanding
146.3 148.5 153.3 153.0 141.2 139.0 136.6 148.0 143.4 149.4
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QUARTERLY DATA
Quarter ended in 2006 Quarter ended in 2005
--------------------------------------- ---------------------------------------
(Millions except for per share data) Dec. 31 Sept. 30 June 30 March 31 Dec. 31 Sept. 30 June 30 March 31
------- -------- ------- -------- ------- -------- ------- --------
Continuing operations
Net sales $3,102 $3,115 $3,162 $2,991 $2,817 $2,767 $2,808 $2,627
Gross profit 802 802 874 842 775 784 788 736
Percent of net sales 25.9% 25.8% 27.6% 28.2% 27.5% 28.3% 28.1% 28.0%
Income before income taxes 239 225 274 251 246 247 262 233
Income after income taxes $ 241 $ 213 $ 252 $ 206 $ 211 $ 197 $ 207 $ 184
Income (loss) from discontinued
operations, net of income taxes 35 1 2 (1) 2 2 3
------ ------ ------ ------ ------ ------ ------ ------
Net income $ 241 $ 248 $ 253 $ 208 $ 210 $ 199 $ 209 $ 187
====== ====== ====== ====== ====== ====== ====== ======
Net income per Common Share assuming
dilution
Continuing operations $ 1.59 $ 1.39 $ 1.63 $ 1.35 $ 1.39 $ 1.29 $ 1.35 $ 1.17
Discontinued operations .23 .01 .01 (.01) .01 .02 .02
------ ------ ------ ------ ------ ------ ------ ------
$ 1.59 $ 1.62 $ 1.64 $ 1.36 $ 1.38 $ 1.30 $ 1.37 $ 1.19
====== ====== ====== ====== ====== ====== ====== ======
Net income per Common Share basic
Continuing operations $ 1.62 $ 1.42 $ 1.66 $ 1.37 $ 1.42 $ 1.32 $ 1.38 $ 1.20
Discontinued operations .23 .01 .01 (.01) .01 .02 .02
------ ------ ------ ------ ------ ------ ------ ------
$ 1.62 $ 1.65 $ 1.67 $ 1.38 $ 1.41 $ 1.33 $ 1.40 $ 1.22
====== ====== ====== ====== ====== ====== ====== ======
Cash dividends paid per Common Share $ .39 $ .39 $ .35 $ .35 $ .31 $ .31 $ .31 $ .31
Market price per Common Share
High $78.38 $74.86 $78.89 $73.29 $67.82 $67.55 $65.04 $71.13
Low 69.53 63.00 69.80 64.48 56.68 60.13 57.55 64.17
Earnings per Common Share for the four quarters in a year may not equal
full-year earnings per share.
Page 73
Eaton Corporation
2006 Annual Report on Form 10-K
Exhibit Index
Exhibits
3(i) Amended Articles of Incorporation (amended and restated April 27,
1994) - Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
3(ii) Amended Regulations (amended and restated April 26, 2000) -
Incorporated by reference to the Form 10-Q Report for the six months
ended June 30, 2000
4(a) Instruments defining rights of security holders, including indentures
(Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to
furnish to the Commission, upon request, a copy of the instruments
defining the rights of holders of long-term debt)
10 Material contracts
(a) Master Purchase and Sale Agreement by and between PerkinElmer,
Inc. and Eaton Corporation dated October 6, 2005 - Incorporated
by reference to the Form 10-K Report for the year ended December
31, 2005
(b) Purchase Agreement between V.G.A.T. Investors, LLC and Eaton
Corporation dated as of December 24, 2006 - Filed in conjunction
with this Form 10-K Report
(c) Executive Incentive Compensation Plan (effective January 1, 2005)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2005
(d) 2005 Non-Employee Director Fee Deferral Plan (effective January
1, 2005) - Incorporated by reference to the Form 10-K Report for
the year ended December 31, 2004
(e) Deferred Incentive Compensation Plan II (effective January 1,
2005) - Incorporated by reference to the Form 10-K Report for the
year ended December 31, 2004
(f) Excess Benefits Plan II (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
(g) Incentive Compensation Deferral Plan II (effective January 1,
2005) - Incorporated by reference to the Form 10-K Report for the
year ended December 31, 2004
(h) Limited Eaton Service Supplemental Retirement Income Plan II
(effective January 1, 2005) - Incorporated by reference to the
Form 10-K Report for the year ended December 31, 2004
(i) Supplemental Benefits Plan II (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
(j) Form of Restricted Share Award Agreement - Incorporated by
reference to the Form 10-K Report for the year ended December 31,
2004
(k) Form of Stock Option Agreement for Executives - Filed in
conjunction with this Form 10-K Report
(l) Form of Stock Option Agreement for Non-Employee Directors -
Incorporated by reference to the Form 8-K Report filed January
26, 2007
Page 74
(m) 2004 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 19, 2004
(n) Amendment to the Plan (originally adopted in 1985) for the
Deferred Payment of Directors' Fees (effective January 1, 2005) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2004
(o) Plan for the Deferred Payment of Directors' Fees (originally
adopted in 1985 and amended effective September 24, 1996, January
28, 1998, January 23, 2002, and February 24, 2004) - Incorporated
by reference to the Form 10-Q Report for the three months ended
March 31, 2004
(p) Limited Eaton Service Supplemental Retirement Income Plan
(amended and restated January 1, 2003) - Incorporated by
reference to the Form 10-K Report for the year ended December 31,
2002
(q) Vehicle Allowance Program (effective January 1, 2003) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2003
(r) 2002 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 15, 2002
(s) 1996 Non-Employee Director Fee Deferral Plan (amended and
restated effective January 1, 2005) - Filed in conjunction with
this Form 10-K Report
(t) Form of Change of Control Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(u) Form of Indemnification Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(v) Form of Indemnification Agreement entered into with directors of
Eaton Corporation - Incorporated by reference to the Form 8-K
Report filed January 26, 2007
(w) Executive Strategic Incentive Plan I (amended and restated
January 1, 2007) - Filed in conjunction with this Form 10-K
Report
(x) Executive Strategic Incentive Plan II (effective January 1, 2001)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
(y) Deferred Incentive Compensation Plan (amended and restated March
31, 2000) - Incorporated by reference to the Form 10-K Report for
the year ended December 31, 2000
(z) 1998 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 13, 1998
(aa) Incentive Compensation Deferral Plan (amended and restated
October 1, 1997) - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2000
(bb) Trust Agreement - Officers and Employees (dated December 6, 1996)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
(cc) Trust Agreement - Outside Directors (dated December 6, 1996) -
Incorporated by reference to the Form 10-K Report for the year
ended December 31, 2002
Page 75
(dd) 1995 Stock Plan - Incorporated by reference to the Form 10-K
Report for the year ended December 31, 2002
(ee) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992)
- Incorporated by reference to the Form 10-K Report for the year
ended December 31, 1992
(ff) 1991 Stock Option Plan - Incorporated by reference to the Form
10-K Report for the year ended December 31, 2002
(gg) Excess Benefits Plan (amended and restated effective January 1,
1989) (with respect to Section 415 limitations of the Internal
Revenue Code) - Incorporated by reference to the Form 10-K Report
for the year ended December 31, 2002
(hh) Supplemental Benefits Plan (amended and restated January 1, 1989)
(which provides supplemental retirement benefits) - Incorporated
by reference to the Form 10-K Report for the year ended December
31, 2002
12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this
Form 10-K Report
14 Code of Ethics - Incorporated by reference to the definitive Proxy
Statement to be filed on or about March 16, 2007
21 Subsidiaries of Eaton Corporation - Filed in conjunction with this
Form 10-K Report
23 Consent of Independent Registered Public Accounting Firm - Filed in
conjunction with this Form 10-K Report
24 Power of Attorney - Filed in conjunction with this Form 10-K Report
31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 302) - Filed in conjunction with this Form 10-K Report
31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 302) - Filed in conjunction with this Form 10-K Report
32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 906) - Filed in conjunction with this Form 10-K Report
32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of
2002, Section 906) - Filed in conjunction with this Form 10-K Report
Page 76