In late 2012 Eaton (ETN -0.53%) completed the acquisition of Cooper Industries, its biggest purchase ever. While it worked to absorb those businesses into its own, it largely stepped back from the bargaining table. However, with the integration process now complete, Eaton has been getting more active on the acquisition and divestiture front. The biggest move was the announcement that it would spin off its lighting business.
But the company just shifted gears, agreeing to sell the division, in a move that should be very good for shareholders. Here's why.
Putting the puzzle together
Eaton is an industrial conglomerate. Its business spans across electrical, aviation, vehicle, and hydraulic products. The over-100-year-old company's history is filled with acquisitions and divestitures as it hones its portfolio to best meet the market's needs at any given time. In that way, it's really no different than its industrial conglomerate peers.
Image source: Getty Images
The whole point of this process is to create a diversified business that benefits from serving multiple markets. Some of those markets will be doing well while others aren't, and the end result is, hopefully, a smoother ride for investors. But times change and technologies come and go. Over time, Eaton will inevitably need to get out from under laggard operations that just don't have the same potential anymore. Add to this the fact that, when you buy a whole company, you get the good with the bad. This, too, forces it to prune its portfolio.
This type of activity is not a sign of weakness in and of itself -- done right, it's just good business. And Eaton has a long history of successfully buying and selling behind it. The company's lighting business is an example of an operation that just wasn't living up to expectations, despite efforts to improve its performance. So it had to go. The original plan was to spin it off to shareholders as a stand-alone company. But now, Eaton is selling it for $1.4 billion. Investors should breathe a sigh of relief.
Keep it simple, please
A spinoff is a messy affair for investors. Since the two resulting entities emerge from one, the value of each is pulled from the old value of the combination. That's easy enough for the newly independent entity, which gets a valuation based on the price of the stock when it is spun off. But the company doing the spinning sees its value reduced by some amount, and that means investors have to change their cost basis. If a company does multiple spinoffs, the math can get complicated. AT&T, which was forced by the government to break itself up into a large number of regional phone companies, is a great example of just how ugly these things can get -- it has a webpage dedicated to helping shareholders figure out their cost basis (including a fill-in-the-blank worksheet).
So it was good to see Eaton make the tough call to jettison the struggling lighting business. But it wasn't so great that it was going to be a spinoff. Then the company announced plans to sell it, generating $1.4 billion in cash. That puts all the work on Eaton and leaves investors free and clear. It is a much better outcome for investors who prefer to keep things simple.
Now the question is what Eaton will do with this cash. In either situation, Eaton was going to be losing the revenue generated by the lighting business. In the spinoff, it would have just had to deal with a smaller top line. Now it has cash that it can use to help offset that hit. And management has been clear about what it wants to do with the money. As CEO Craig Arnold explained during the third-quarter conference call:
The specific question around uses of cash, obviously we will sell the Lighting business for $1.4 billion, and it would be our intention to use those proceeds to buy back shares. We're going to attempt to be smart and strategic in the timing of the buyback program, but the intention would be to use those proceeds, plus our very strong cash flow generating capabilities, to make sure that we fully offset any dilution associated with the divestiture of Lighting.
In other words, investors are going to get the benefit of the cash over time. And it will, largely, be a net neutral event for shareholders. But it isn't a total wash: By jettisoning a weaker business, Eaton will be improving its overall margins, effectively making the total company more profitable. Less complicated for shareholders, any bottom-line impact is expected to be offset by stock buybacks, and it improves the company's overall profitability -- and that's a great big win for investors.
One more reason to like Eaton
Eaton doesn't get the same attention on Wall Street as companies like GE, Emerson Electric, or Honeywell International, but it has a long history of treating shareholders very well. The choice it made with lighting is just one more example of how it thinks, and how it puts investors high up on its list of priorities. For dividend investors looking to add an industrial to their portfolio -- one that yields 3.2% and is shareholder-friendly -- Eaton should be near the top of the list of potential candidates.
