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Eaton Corp reported earnings this morning.  This is one of my absolute favorite companies to watch as I try to gauge the strength of the real economy.   The company provides electrical components and systems for power quality, distribution, and control; hydraulics components, systems, and services for industrial and mobile equipment; aerospace fuel, hydraulics, and pneumatic systems for commercial and military use; and truck and automotive drivetrain and powertrain systems for performance, fuel economy, and safety.  In other words, they are a major supplier for all things in the real economy.  In addition to being a major component of the real economy Eaton’s management is superb.  This is a global company that is well-run and has their finger on the pulse of the real economy.

Eaton reported a better than expected quarter (which is not surprising because their management tends to under promise and over deliver).   What is a bit more shocking is Eaton’s change in optimism.  Eaton is now seeing significant strength in the global economy and government stimulus programs.  Despite this, they still see their full year earnings down by 22% year over year.

Eaton’s earnings were better than expected almost entirely because of their extraordinary cost cutting measures.  Sales grew just 4% year over year and actually missed analysts expectations:

Alexander M. Cutler, Eaton chairman and chief executive officer, said, “We are pleased with our third quarter results, which significantly exceeded our guidance. The results reflect the impact of the substantial enterprise-wide reductions in costs we have enacted during the past year. Our revenues in the third quarter grew 4 percent over the second quarter, reflecting equally the very early stages of recovery in our end markets and benefit from the strengthening of currencies against the dollar.

Sales were relatively abysmal again, but the company is beginning to see some early signs of stability:

“The sales decline of 26 percent in the quarter consisted of a 23 percent decline in core sales and a 3 percent decline from exchange rates compared to the third quarter of 2008,” said Cutler. “Our end markets declined by 24 percent in the quarter.

Of course, it was the margin boost which helped the company outperform:

“Our margin performance in the third quarter was much improved, with our segment operating margin rebounding to 10.9 percent from 8.2 percent in the second quarter,” said Cutler. “We realized significant improvements in the margins of our Electrical Rest of World, Truck, and Automotive segments.

Like many companies that have been cutting back and saving cash, Eaton is in an extraordinarily strong cash flow position.  This is not unique to Eaton and should provide companies with further M&A fuel.

“Our operating cash flow in the third quarter was $471 million and free cash flow was $431 million,” said Cutler. “In the last four quarters, operating cash flow totaled $1.6 billion – the highest we have ever had in a four quarter period. This strong cash flow has allowed us to pay down debt and improve our liquidity, as has been our plan.

Eaton sees a continued recovery, though muted at best.  They still see end markets declining substantially for 2009:

“As we look at our end markets, we expect the economic recovery we are beginning to experience in our early cycle markets will continue,” said Cutler. “For the full year, we still believe our end markets will decline by 21 to 22 percent.

Eaton knows how to play the game as well as anyone.  Their superb management knows exactly how to toy with the Wall Street analysts.  The current environment continues to be characterized by analysts that are far too negative and need to catch-up with reality.  This is most evident in Eaton’s ability to boost guidance going forward despite a less than spectacular quarter:

“We anticipate fourth quarter net income per share will be between $1.00 and $1.10 and operating earnings per share, which exclude charges to integrate our recent acquisitions, will be between $1.15 and $1.25,” said Cutler. “Accordingly, for the full year, we anticipate that net income per share will be between $2.05 and $2.15, and operating earnings per share will be between $2.40 and $2.50.”

The global economy and government stimulus should provide the biggest boost to the bottom line going forward:

“Global automotive production improved in the third quarter, to a large extent as a result of the governmental stimulus programs,” said Cutler. “We were pleased with the 7.1 percent margin we earned in Automotive in the third quarter, representing a major improvement over the negative (7.0) percent margin in the second quarter.”

For now, Eaton is a good barometer of the overall situation.  Revenues are weak, but cost cutting is providing companies with an earnings cushion.  In addition, analysts are still far too negative which is giving companies the ability to boost guidance.  Most importantly, the global economy appears to be strengthening while domestic markets remain relatively weak.  Government stimulus is still providing a substantial boost to the overall economy and could become a major question mark heading into 2010.

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