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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, 2004
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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
------------------------ ------------------------------------
(State of incorporation) (I.R.S. Employer Identification No.)
Eaton Center, Cleveland, Ohio 44114-2584
- ---------------------------------------- ----------
(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
- ------------------------------ ---------------------------
Common Shares ($.50 par value) The New York Stock Exchange
The Chicago Stock Exchange
The Pacific Exchange
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 twelve months and (2) has been subject to such filing requirements
for the past ninety days. Yes X
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. Yes X
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X
The aggregate market value of Common Stock held by non-affiliates of the
registrant as of June 30, 2004 was $9.8 billion.
As of January 31, 2005, there were 152.9 million Common Shares outstanding.
Documents Incorporated By Reference
Portions of the Proxy Statement for the 2005 annual shareholders' meeting are
incorporated by reference into Part III.
Part I
Item 1. Business
- -----------------
Eaton Corporation (Eaton or Company) is a global diversified industrial
manufacturer with 2004 sales of $9.8 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 fluid
power systems for industrial, mobile, and aircraft equipment; electrical systems
and components for power quality, distribution and control; automotive engine
air management systems, powertrain solutions and specialty controls for
performance, fuel economy and safety; and intelligent truck drivetrain systems
for safety and fuel economy. Headquartered in Cleveland, Ohio, Eaton had 55,000
employees at year-end 2004 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 (Commission), 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
Commission's Internet web site at www.sec.gov.
Recent Developments
- -------------------
In light of the strong results for 2004 and continuing momentum in most of its
markets, on January 24, 2005 Eaton announced that it was taking the following
actions:
- - Increasing the quarterly dividend on its Common Shares by 15%, from $.27
per share to $.31 per share, effective for the February 2005 dividend;
- - Initiating a plan to repurchase $250 million of shares to help offset
dilution from the shares issued during 2004 from the exercise of stock
options;
- - Contributing $50 million to its qualified pension plans in the United
States during 2005.
On June 9, 2004, Eaton acquired Powerware Corporation, the power systems
business of Invensys plc, for $560 million of cash, less cash acquired of $27
million. Powerware, based in Raleigh, North Carolina, is a global leader in
Uninterruptible Power Systems (UPS), DC Power products, and power quality
services. Powerware had revenues of $775 million 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. Eaton's operating
results for 2004 include Powerware from the date of acquisition. This business
is included in the Electrical segment.
On September 1, 2004, Eaton acquired Walterscheid Rohrverbindungstechnik GmbH
(Walterscheid) from GKN plc for $48 million of cash. Walterscheid, a
manufacturer of hydraulic tube connectors and fittings primarily for the
European market, had 2003 sales of $52 million and is located in Lohmar,
Germany. Its products are used in mobile and industrial hydraulic markets such
as construction and agricultural equipment and machine tools. Eaton's operating
results for 2004 include Walterscheid from the date of acquisition. This
business is included in the Fluid Power segment.
Also in September 2004, Eaton contributed $28 million of cash to purchase a 50%
interest in a new medium-duty truck transmission joint venture located in
Changchun, China. The partner in this venture is FAW Jiefang Automotive Co.,
Ltd., which is the commercial vehicle subsidiary of China First Auto Works Group
Company (FAW), the largest manufacturer of commercial vehicles in China. Eaton's
operating results include this joint venture, which is accounted for under the
equity method, beginning in September 2004. This business is included in the
Truck 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 F-34 through F-39 of this Form 10-K. Additional
information regarding Eaton's segments and business is presented below.
Fluid Power
- -----------
Significant Customers - Approximately 12% of this segment's net sales in 2004
were made to four original equipment manufacturers of vehicles in the United
States and Europe. Two of these customers are also significant customers of the
Automotive and Truck segments. Also, approximately 6% of this segment's net
sales in 2004 were made to two manufacturers of off-highway agricultural and
construction vehicles.
Competition - Principal methods of competition in this segment are price,
geographic coverage, service and product performance. 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.
Electrical
- ----------
Significant Customers - Approximately 12% of this segment's net sales in 2004
were made to one customer, located in the United States, which is not a
significant customer of any other segment.
Competition - Principal methods of competition in this segment are price,
geographic coverage, service and product performance. 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 the Automotive 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 net sales in 2004
were made to divisions and subsidiaries of five large original equipment
manufacturers of vehicles and one automotive component supplier. All of these
customers are concentrated in North America and Europe. Three of these customers
are also significant customers of the Truck and Fluid Power segments.
Competition - Principal methods of competition in this segment are price,
service and product performance. 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
- -----
Significant Customers - Approximately 75% of this segment's net sales in 2004
were made to divisions and subsidiaries of five original equipment manufacturers
of heavy-, medium-, and light-duty trucks and off-highway vehicles, concentrated
in North America, Europe and Latin America. Two of these customers are also
significant customers of the Automotive and Fluid Power segments.
Competition - Principal methods of competition in this segment are price,
service and product performance. 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 - Principal raw materials used are iron, steel, copper, nickel,
aluminum, brass, silver, rubber, plastic and insulating materials. Materials are
purchased in various forms, such as pig iron, metal sheets and strips, forging
billets, bar stock and plastic pellets. Raw materials, as well as parts and
other components, are purchased from many suppliers and, under normal
circumstances, the Company has no difficulty obtaining them. In 2004, due to raw
materials supply shortages resulting from higher demand, Eaton paid higher
prices primarily for basic metals. At the end of 2004, the Company purchased
additional inventory to guard against basic metals shortages.
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. However,
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 operation 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. While
patents generally expire 20 years after the patent application filing date, new
patents are issued to Eaton on a regular basis.
Order Backlog - Since a significant portion of open orders placed with Eaton by
original equipment manufacturers of cars, trucks and off-highway vehicles are
historically subject to month-to-month releases by customers during each model
year, such orders are not considered firm. In measuring backlog of orders, the
Company includes only the amount of such orders released by such customers as of
the dates listed. Using this criterion, total backlog at December 31, 2004 and
2003 was approximately $1.5 billion and $1.3 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 2004, 2003 and 2002 (in millions) were
$261, $223 and $203, respectively. Over the past five years, the Company has
invested approximately $1.2 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 2005 and 2006. Information
regarding the Company's liabilities related to environmental matters is
presented in "Protection of the Environment" on pages F-26 and F-27 of this Form
10-K.
Foreign Operations - Eaton's foreign operations are subject to a variety of
risks that may affect such operations, including, among other things:
- - Currency fluctuations and devaluations,
- - Exchange controls and currency restrictions, and
- - Changes in local economic conditions.
While the impact of these risks is difficult to predict, any one or more of them
could adversely affect the Company's operations in the future.
Item 2. Properties
- ------------------
Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains
manufacturing facilities at 187 locations in 29 countries, including 31
light-manufacturing and fabrication facilities. 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 such facilities are
maintained in good condition.
Item 3. Legal Proceedings
- -------------------------
Information regarding the Company's legal proceedings is presented in
"Protection of the Environment" and "Contingencies" on pages F-26 and F-27 of
this Form 10-K.
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 and Related Stockholder
Matters
- -------------------------------------------------------------------------
The Company's Common Shares are listed for trading on the New York, Chicago and
Pacific stock exchanges. Information regarding cash dividends paid and the high
and low market price per Common Share for each quarter in 2004 and 2003 is
presented in "Quarterly Data" on page F-61 of this Form 10-K. At December 31,
2004, there were 9,641 holders of record of the Company's Common Shares.
Additionally, 22,016 current and former employees were shareholders through
participation in the Eaton Savings Plan (ESP) and Eaton Personal Investment Plan
(EPIP).
Information regarding equity compensation plans required by Regulation S-K Item
201(d) is provided in Item 12 of this Form 10-K.
Item 6. Selected Financial Data
- -------------------------------
Information regarding selected financial data is presented in the "Nine-Year
Consolidated Financial Summary" on pages F-62 and F-63 of this Form 10-K.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
- -------------------------------------------------------------------------------
"Management's Discussion & Analysis of Financial Condition and Results of
Operations" is presented on pages F-40 through F-60 of this Form 10-K.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
- ------------------------------------------------------------------
Information regarding market risk is presented in "Market Risk Disclosure &
Contractual Obligations" on pages F-53 and F-54 of this Form 10-K.
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 F-1 and F-5 through F-39 of this Form 10-K.
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 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, 2004.
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 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.
Changes in Internal Control Over Financial Reporting - During fourth quarter
2004, 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.
"Management's Report on Internal Control Over Financial Reporting" is presented
on page F-2 of this Form 10-K.
"Report of the Independent Registered Public Accounting Firm" on "Management's
Report on Internal Control Over Financial Reporting" is presented on pages F-3
and F-4 of this Form 10-K.
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 18, 2005, and is incorporated by
reference.
A listing of Eaton's executive officers, their ages, positions and offices held
over the past five years, as of January 31, 2005, follows:
Name Age Position (Date elected to position)
- ---- --- -----------------------------------
Alexander M. Cutler 53 Chairman and Chief Executive Officer; President
(August 1, 2000 - present)
President and Chief Operating Officer
(September 1, 1995 - July 31, 2000)
Director (1993 - present)
Richard H. Fearon 48 Executive Vice President - Chief Financial and
Planning Officer (April 24, 2002 - present)
Partner, Willow Place Partners LLC (2001 - 2002)
Senior Vice President - Corporate Development,
Transamerica Corporation (1997 - 2000)
Craig Arnold 44 Senior Vice President and Group Executive - Fluid
Power (October 25, 2000 - present)
Corporate Vice President of General Electric and
President of GE Lighting Services Ltd.
(1999 - 2000)
Stephen M. Buente 54 Senior Vice President and Group Executive -
Automotive (August 21, 2000 - present)
Operations Vice President - Automotive Controls
(1999 - 2000)
Randy W. Carson 54 Senior Vice President and Group Executive -
Electrical (January 1, 2000 - present)
James E. Sweetnam 52 Senior Vice President and Group Executive -
Truck (July 1, 2001 - present)
Vice President - Heavy-Duty Transmission, Clutch
and Aftermarket (2000 - 2001)
Kristen M. Bihary 51 Vice President - Communications
(July 28, 1999 - present)
Susan J. Cook 57 Vice President - Human Resources
(January 16, 1995 - present)
Earl R. Franklin 61 Vice President and Secretary
(April 24, 2002 - present)
Secretary and Associate General Counsel
(September 1, 1991 - April 23, 2002)
J. Robert Horst 61 Vice President and General Counsel
(January 1, 2000 - present)
James W. McGill 49 Vice President - Eaton Business System
(July 16, 2004 - present)
Vice President and General Manager - Industrial
Controls Division (January 1, 2001 - July 2004)
Director OEM Segment - Electrical Components
(September 1, 1999 - December 31, 2000)
John S. Mitchell 48 Vice President - Taxes
(November 22, 1999 - present)
Robert E. Parmenter 52 Vice President and Treasurer
(January 1, 1997 - present)
Billie K. Rawot 53 Vice President and Controller
(March 1, 1991 - present)
Robert L. Sell 54 Vice President - Chief Information Officer
(August 11, 2003 - present)
Senior Vice President, Chief Information Officer,
Moore Wallace Incorporated (2002 - 2003)
Vice President, Chief Information Officer,
Brunswick Corporation (1999 - 2001)
Ken D. Semelsberger 43 Vice President - Strategic Planning
(April 28, 1999 - present)
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.
Eaton has a separately designated standing audit committee established in
accordance with Section 3(a)(58)(A) of the Exchange Act. The current members of
the Audit Committee are Victor A. Pelson (chair), Deborah L. McCoy, John R.
Miller and Kiran M. Patel. The Board of Directors of Eaton has determined that
John R. Miller and Kiran M. Patel are audit committee financial experts as
defined by Item 401(h) of Regulation S-K of the Exchange Act and are independent
within the meaning of Item 7(d)(3)(iv) of Schedule 14A of the Exchange Act.
The Company has adopted a Code of Ethics, which applies to the Directors,
officers (including its Chairman and Chief Executive Officer, Executive Vice
President--Chief Financial and Planning Officer, and Vice President and
Controller) and employees worldwide. The Code of Ethics is included as an
exhibit in the Company's definitive Proxy Statement to be filed on or about
March 18, 2005, and is incorporated by reference. The Board of Directors has
also approved charters for the Board's Audit Committee, Compensation and
Organization Committee, Finance Committee and Governance Committee, as well
as the Board of Directors Governance Policies. These documents are available on
the Company's website at http://www.eaton.com. Printed copies are also available
free of charge upon request. Requests for printed copies should be directed to
the Company's Investor Relations Office, Eaton Corporation, 1111 Superior
Avenue, Cleveland 44114-2584.
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 18, 2005, 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 18, 2005, and is incorporated by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholders 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 18, 2005, and is
incorporated by reference.
Equity Compensation Plans
- -------------------------
The following table summarizes information, as of December 31, 2004, 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
Remaining
(A) Available
Number of (B) for Future
Securities Weighted- Issuance
to be Average Under Equity
Issued Upon Exercise Compensation
Exercise of Price of Plans
Outstanding Outstanding (Excluding
Options, Options, Securities
Warrants Warrants Reflected in
Plan category and Rights and Rights Column (A))
- ------------- ------------ ----------- -------------
Equity compensation
plans approved by
security holders(1) 15,298,846(3) $37.97(5) 8,972,685
Equity compensation
plans not approved
by security holders(2) 1,645,755(4) N/A (2)
---------- ------ ---------
Total 16,944,601 $37.97(5) 8,972,685
========== ====== =========
(1) These plans are the Company's 2004 Stock Plan, 2002 Stock Plan, 1998 Stock
Plan, 1995 Stock Plan, 1991 Stock Option Plan, and the Incentive Compensation
Deferral Plans.
(2) The 1996 Non-Employee Director Fee Deferral Plan and the Deferred Incentive
Compensation Plan are not considered to be "equity compensation plans" which
require shareholder approval under the rules of the New York Stock Exchange.
Under the 1996 Non-Employee Director Fee Deferral Plan, all non-employee
directors were entitled to defer payment of their fees at a rate of return
depending on whether the director deferred the fees as retirement compensation
or as short-term compensation. At least 50% of retirement compensation, or any
greater portion which the director elected, was converted to Company share units
and earns Company share price appreciation and dividend equivalents. The balance
of retirement compensation earns 10-year U.S. Treasury note returns plus 300
basis points. Short-term compensation earns 13-week U.S. Treasury bill returns.
These arrangements provide for accelerated lump sum or installment payments upon
a failure by the Company to pay, or termination of service in the context of a
change in control of the Company. After retirement or other termination of
services as a director, the Governance Committee determines whether fees
deferred under the Plan are to be paid in a lump sum or periodic installments
and whether the amounts converted to Company share units are to be paid in cash
or Company common shares. Under the Deferred Incentive Compensation Plan,
participants, including officers and other eligible executives, were able to
defer receipt of their annual incentive compensation award as either short-term
deferrals (5 years) 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 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. Participants were able to defer the full amount
of eligible cash compensation under these Plans. To the extent that cash
compensation is deferred pursuant to these Plans, or pursuant to the Incentive
Compensation Deferral Plan, the Company may be able to preserve the
deductibility of the compensation under Section 162(m) of the Internal Revenue
Code. However, in some circumstances cash compensation paid to executive
officers is not deductible by the Company.
(3) Includes an aggregate of 231,070 restricted shares, 2,865,800 of
performance-based stock options and 396,421 shares underlying stock units,
payable on a one-for-one basis, credited to stock unit accounts as of December
31, 2004 under the Incentive Compensation Deferral Plans.
(4) Represents shares underlying stock units, payable on a one-for-one basis,
credited to stock unit accounts as of December 31, 2004 under the 1996
Non-Employee Director Fee Deferral Plan and the Deferred Incentive Compensation
Plan.
(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 18, 2005, and is
incorporated by reference.
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 Item 8 above, are filed as a separate section
of this Form 10-K:
Report of Independent Registered Public Accounting Firm - Page F-1
Statements of Consolidated Income - Years ended December 31, 2004,
2003 and 2002 - Page F-5
Consolidated Balance Sheets - December 31, 2004 and 2003 - Pages F-6
and F-7
Statements of Consolidated Cash Flows - Years ended December 31, 2004
2003 and 2002 - Page F-8
Statements of Consolidated Shareholders' Equity - Years ended December
31, 2004, 2003 and 2002 -Pages F-9 and F-10
Notes to Consolidated Financial Statements - Pages F-11 through F-39
(2) All schedules for which provision is made in Regulation S-X of the
Securities and Exchange Commission are not required under the related
instructions or are inapplicable and, therefore, have been omitted.
(3) Exhibits
3(a) Amended Articles of Incorporation (amended and restated as of
April 27, 1994) - Incorporated by reference to the Form 10-K for
the year ended December 31, 2002
3(b) Amended Regulations (amended and restated as of April 26, 2000) -
Incorporated by reference to the Form 10-Q 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)
4(b) Rights Agreement (Dated as of June 28, 1995) - Incorporated by
reference to Registration Statement 333-74355 filed on March 12,
1999
10 Material contracts - Each of the following is either a management
contract or a compensatory plan or arrangement:
(a) Deferred Incentive Compensation Plan (amended and restated
as of March 31, 2000) - Incorporated by reference to the
Form 10-K for the year ended December 31, 2000
(b) Executive Strategic Incentive Plan I (Amended and Restated
as of January 1, 2001) - Incorporated by reference to the
Form 10-K for the year ended December 31, 2002
(c) Group Replacement Insurance Plan (GRIP), effective as of
June 1, 1992 - Incorporated by reference to the Form 10-K
for the year ended December 31, 1992
(d) 1991 Stock Option Plan - Incorporated by reference to the
Form 10-K for the year ended December 31, 2002
(e) 1995 Stock Plan - Incorporated by reference to the Form 10-K
for the year ended December 31, 2002
(f) Incentive Compensation Deferral Plan (amended and restated
as of October 1, 1997) - Incorporated by reference to the
Form 10-K for the year ended December 31, 2000
(g) Form of Change of Control Agreement entered into with
officers of Eaton Corporation - Incorporated by reference to
the Form 10-K for the year ended December 31, 2002
(h) Form of Indemnification Agreement entered into with officers
of Eaton Corporation - Incorporated by reference to the Form
10-K for the year ended December 31, 2002
(i) Limited Eaton Service Supplemental Retirement Income Plan
(amended and restated as of January 1, 2003) - Incorporated
by reference to the Form 10-K for the year ended December
31, 2002
(j) Supplemental Benefits Plan (amended and restated as of
January 1, 1989) (which provides supplemental retirement
benefits) - Incorporated by reference to the Form 10-K for
the year ended December 31, 2002
(k) 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 for the year ended December 31, 2002
(l) Executive Incentive Compensation Plan (Effective as of
January 1, 2003) - Incorporated by reference to the Form
10-K for the year ended December 31, 2003
(m) Plan for the Deferred Payment of Directors' Fees (Originally
adopted in 1985 and amended effective as of September 24,
1996, January 28, 1998, January 23, 2002 and February 24,
2004) - Incorporated by reference to the Form 10-Q for the
three months ended March 31, 2004
(n) Plan for the Deferred Payment of Directors' Fees (Originally
adopted in 1980 and amended and restated in 1989 and 1996) -
Incorporated by reference to the Form 10-K for the year
ended December 31, 2002
(o) 1996 Non-Employee Director Fee Deferral Plan (amended and
restated as of October 22, 2002) - Incorporated by reference
to the Form 10-K for the year ended December 31, 2002
(p) Trust Agreement - Outside Directors (dated December 6, 1996)
- Incorporated by reference to the Form 10-K for the year
ended December 31, 2002
(q) Trust Agreement - Officers and Employees (dated December 6,
1996) - Incorporated by reference to the Form 10-K for the
year ended December 31, 2002
(r) 1998 Stock Plan - Incorporated by reference to the
definitive Proxy Statement dated March 13, 1998
(s) 2002 Stock Plan - Incorporated by reference to the
definitive Proxy Statement dated March 15, 2002
(t) Executive Strategic Incentive Plan II (Effective as of
January 1, 2001) - Incorporated by reference to the Form
10-K for the year ended December 31, 2002
(u) Vehicle Allowance Program (Effective as of January 1, 2003)
- Incorporated by reference to the Form 10-K for the year
ended December 31, 2003
(v) 2004 Stock Plan - Incorporated by reference to the
definitive Proxy Statement dated March 19, 2004
(w) 2005 Non-Employee Director Fee Deferral Plan (Effective
January 1, 2005) - Filed in conjunction with this Form 10-K
(x) Deferred Incentive Compensation Plan II (Effective January
1, 2005) - Filed in conjunction with this Form 10-K
(y) Incentive Compensation Deferral Plan II (Effective January
1, 2005) - Filed in conjunction with this Form 10-K
(z) Supplemental Benefits Plan II (Effective January 1, 2005) -
Filed in conjunction with this Form 10-K
(aa) Excess Benefits Plan II (Effective January 1, 2005) - Filed
in conjunction with this Form 10-K
(bb) Limited Eaton Service Supplemental Retirement Income Plan II
(Effective January 1, 2005) - Filed in conjunction with this
Form 10-K
(cc) Amendment to the Plan (originally adopted in 1985) for the
Deferred Payment of Directors' Fees (Effective January 1,
2005) - Filed in conjunction with this Form 10-K
(dd) Form of Stock Option Agreement for Non-Employee Directors -
Filed in conjunction with this Form 10-K
(ee) Form of Stock Option Agreement for Executives - Filed in
conjunction with this Form 10-K
(ff) Form of Restricted Share Award Agreement - Filed in
conjunction with this Form 10-K
12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this
Form 10-K
14 Code of Ethics - Incorporated by reference to the definitive Proxy
Statement to be filed on or about March 18, 2005
21 Subsidiaries of Eaton Corporation - Filed in conjunction with this
Form 10-K
23 Consent of Independent Registered Public Accounting Firm - Filed in
conjunction with this Form 10-K
24 Power of Attorney - Filed in conjunction with this Form 10-K
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
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
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
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
(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.
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: March 10, 2005 /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: March 10, 2005
Signature Title
- --------- -----
*
- -------------------
Alexander M. Cutler Chairman and Chief Executive Officer; President
Director
*
- -------------------
Billie K. Rawot Vice President and Controller;
Principal Accounting Officer
*
- -------------------
Michael J. Critelli Director
*
- -------------------
Ernie Green Director
*
- -------------------
Ned C. Lautenbach Director
*
- -------------------
Deborah L. McCoy Director
*
- -------------------
John R. Miller Director
*
- -------------------
Gregory R. Page Director
*
- -------------------
Kiran M. Patel Director
*
- -------------------
Victor A. Pelson Director
*
- -------------------
Gary L. Tooker Director
*By /s/ Richard H. Fearon
--------------------------------------
Richard H. Fearon, Attorney-in-Fact
for the officers and directors signing
in the capacities indicated
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, 2004 and 2003, and the related statements of
consolidated income, shareholders' equity, and cash flows for each of the three
years in the period ended December 31, 2004. 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, 2004 and 2003, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
2004, in conformity with United States generally accepted accounting principles.
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, 2004,
based on criteria established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
and our report dated February 11, 2005 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
---------------------
Cleveland, Ohio
February 11, 2005
F-1
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, 2004. In conducting this evaluation,
we used the framework set forth by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO) 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, 2004.
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, 2004. This report
is included herein.
/s/ Alexander M. Cutler /s/ Richard H. Fearon /s/ Billie K. Rawot
- ----------------------- ---------------------------- -------------------
Chairman and Chief Executive Vice President - Vice President and
Executive Officer; Chief Financial and Planning Controller
President Officer
February 11, 2005
F-2
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, 2004, 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, 2004, 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, 2004, 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, 2004 and 2003, and the related statements
F-3
of consolidated income, shareholders' equity, and cash flows for each of the
three years in the period ended December 31, 2004 and our report dated February
11, 2005 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
---------------------
Cleveland, Ohio
February 11, 2005
F-4
EATON CORPORATION
STATEMENTS OF CONSOLIDATED INCOME
Year ended December 31
------------------------
(Millions except for per share data) 2004 2003 2002
------ ------ ------
Net sales $9,817 $8,061 $7,209
Cost of products sold 7,082 5,897 5,272
Selling & administrative expense 1,587 1,351 1,217
Research & development expense 261 223 203
Interest expense-net 78 87 104
Provision to exit a business 15
Gain on sale of business (18)
Other (income) expense-net 13 (5) 32
------ ------ ------
Income before income taxes 781 508 399
Income taxes 133 122 118
------ ------ ------
Net income $ 648 $ 386 $ 281
====== ====== ======
Net income per Common Share assuming dilution $ 4.13 $ 2.56 $ 1.96
Average number of Common Shares outstanding
assuming dilution 157.1 150.5 143.4
Net income per Common Share basic $ 4.24 $ 2.61 $ 1.99
Average number of Common Shares outstanding basic 153.1 147.9 141.2
Cash dividends paid per Common Share $ 1.08 $ .92 $ .88
The notes on pages F-11 to F-39 are an integral part of the consolidated
financial statements.
F-5
EATON CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31,
-----------------
(Millions of dollars) 2004 2003
------- -------
ASSETS
Current assets
- --------------
Cash $ 85 $ 61
Short-term investments 211 804
Accounts receivable 1,612 1,190
Inventories 966 721
Deferred income taxes 216 192
Other current assets 92 125
------- -------
3,182 3,093
------- -------
Property, plant & equipment
Land & buildings 959 897
Machinery & equipment 3,526 3,326
------- -------
4,485 4,223
Accumulated depreciation (2,338) (2,147)
------- -------
2,147 2,076
Goodwill 2,433 2,095
Other intangible assets 644 541
Deferred income taxes & other assets 669 418
------- -------
$ 9,075 $ 8,223
======= =======
LIABILITIES & SHAREHOLDERS' EQUITY
Current liabilities
- -------------------
Short-term debt $ 13 $ 45
Current portion of long-term debt 26 257
Accounts payable 776 526
Accrued compensation 270 204
Accrued income & other taxes 283 298
Other current liabilities 894 796
------- -------
2,262 2,126
------- -------
Long-term debt 1,734 1,651
Postretirement benefits other than pensions 617 636
Pensions & other liabilities 856 693
Shareholders' equity
Common Shares (153.3 million outstanding
in 2004 and 153.0 million in 2003) 77 76
Capital in excess of par value 1,993 1,856
Retained earnings 2,112 1,816
Accumulated other comprehensive loss (538) (585)
Deferred compensation plans (38) (46)
------- -------
3,606 3,117
------- -------
$ 9,075 $ 8,223
======= =======
F-6
The notes on pages F-11 to F-39 are an integral part of the consolidated
financial statements.
F-7
EATON CORPORATION
STATEMENTS OF CONSOLIDATED CASH FLOWS
Year ended December 31
----------------------
(Millions) 2004 2003 2002
----- ----- -----
Net cash provided by operating activities
- -----------------------------------------
Net income $ 648 $ 386 $ 281
Adjustments to reconcile to net cash
provided by operating activities
Depreciation & amortization 400 394 376
Deferred income taxes (133) (54) (51)
Pensions 94 34 (4)
Other long-term liabilities 12 27 (14)
Other non-cash items in income (1) 11 17
Changes in working capital, excluding
acquisitions & sales of businesses
Accounts receivable (218) (51) 59
Inventories (102) 79 13
Accounts payable 143 (41) 41
Accrued income & other taxes 46 35 101
Other current liabilities (122) 32 (14)
Other working capital accounts 76 (12) 47
Contribution to United States qualified
pension plans (75)
Other-net 70 34 48
----- ----- -----
838 874 900
----- ----- -----
Net cash used in investing activities
- -------------------------------------
Expenditures for property, plant & equipment (330) (273) (228)
Acquisitions of businesses, less cash acquired (627) (252) (153)
Sale of business 92
Sales (purchases) of short-term investments-net 606 (436) (135)
Other-net 18 (8) 9
----- ----- -----
(333) (969) (415)
----- ----- -----
Net cash (used in) provided by financing activities
- ---------------------------------------------------
Borrowings with original maturities
of more than three months
Proceeds 75 419
Payments (248) (155) (635)
Borrowings with original maturities
of less than three months-net (33) (39) (228)
Cash dividends paid (163) (134) (123)
Proceeds from exercise of employee stock options 138 113 45
(Purchase) sale of Common Shares (250) 296
----- ----- -----
(481) 81 (522)
----- ----- -----
Total increase (decrease) in cash 24 (14) (37)
Cash at beginning of year 61 75 112
----- ----- -----
Cash at end of year $ 85 $ 61 $ 75
===== ===== =====
The notes on pages F-11 to F-39 are an integral part of the consolidated
financial statements.
F-8
EATON CORPORATION
STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumulated Total
Common Shares Capital in other Deferred Share-
---------------- excess of Retained comprehensive compensa- holders'
(Millions) Shares Dollars par value earnings loss tion plans equity
------ ------- ---------- -------- ------------- ---------- --------
Balance at January 1, 2002 139.0 $ 70 $1,348 $1,412 $(299) $(56) $2,475
Net income 281 281
Other comprehensive loss (400) (400)
------
Total comprehensive loss (119)
Cash dividends paid (123) (123)
Issuance of shares under
employee benefit plans,
including tax benefit 2.0 (a) 61 (2) 8 67
Issuance of shares to trust .2 5 (5) 0
Other-net (1) 3 2
----- ---- ------ ------ ----- ---- ------
Balance at December 31, 2002 141.2 70 1,413 1,568 (699) (50) 2,302
Net income 386 386
Other comprehensive income 114 114
------
Total comprehensive income 500
Cash dividends paid (134) (134)
Issuance of shares under
employee benefit plans,
including tax benefit 4.2 2 141 (2) 5 146
Issuance of shares to trust .1 3 (3) 0
Sale of shares 7.4 4 294 (2) 296
Other-net .1 5 2 7
----- ---- ------ ------ ----- ---- ------
Balance at December 31, 2003 153.0 76 1,856 1,816 (585) (46) 3,117
Net income 648 648
Other comprehensive income 47 47
------
Total comprehensive income 695
Cash dividends paid (163) (163)
Issuance of shares under
employee benefit plans,
F-9
including tax benefit 4.5 3 188 (2) 10 199
Issuance of shares to trust 2 (2) 0
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
===== ==== ====== ====== ===== ==== ======
(a) Balance less than $1.
The notes on pages F-11 to F-39 are an integral part of the consolidated
financial statements.
F-10
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" 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.
In November 2004, the Financial Accounting Standards Board (FASB) issued
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). SFAS
No. 151 will be effective for Eaton in 2006 and is expected to have an
immaterial effect on Eaton's financial position, results of operations and 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 three to 10 years. Intangible assets
subject to amortization, primarily consisting of patents, tradenames
F-11
and distribution networks, are amortized over a range of five to 30 years.
Software is amortized over a range of three to five years.
Long-lived assets, except goodwill and indefinite life intangible assets as
described 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 Statement of Financial Accounting Standards (SFAS) No. 142,
"Goodwill and Other Intangible Assets", Eaton does not amortize goodwill and
indefinite life intangible assets recorded in connection with current and
previous 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.
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 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. Such financial instruments are not bought and sold
solely for trading purposes, except for nominal amounts authorized under
limited, controlled circumstances. No financial instruments were purchased or
sold for trading purposes in 2004. Such transactions resulted in an immaterial
net loss in 2003 and an immaterial net gain in 2002. 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.
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
F-12
recognized in income immediately to offset the gain or loss on the hedged item;
or deferred and reported as a component of 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.
Stock Options Granted to Employees & Directors
- ----------------------------------------------
Stock options granted to employees and directors to purchase Common Shares are
accounted for using the intrinsic-value-based method. Under this method, no
compensation expense is recognized on the grant date, since on that date the
option price equals the market price of the underlying shares.
In 2002, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure". SFAS No. 148 amended SFAS No. 123,
"Accounting for Stock-Based Compensation", to provide alternative methods of
transition when a company voluntarily changes from the intrinsic-value-method to
the fair-value-based method of recognizing expense in the income statement for
stock-based employee compensation, including stock options granted to employees
and directors. As allowed by SFAS No. 123, Eaton had adopted the Statement's
disclosure-only provisions and did not recognize expense for stock options
granted to employees and directors. If the Company accounted for stock options
under the fair-value-based method of expense recognition in SFAS No. 123, net
income per Common Share assuming dilution would have been reduced by $.08 in
2004, $.08 in 2003 and $.10 in 2002, as described further in "Shareholders'
Equity" below.
In December 2004, Statement of Financial Accounting Standards (SFAS) No. 123(R),
"Share-Based Payment" was issued by the Financial Accounting Standards Board.
SFAS No. 123(R) eliminates the alternative to use the intrinsic-value-method of
accounting that was provided in SFAS No. 123 as originally issued. SFAS No.
123(R) requires entities to recognize the cost of employee and director services
received in exchange for stock options based on the grant date fair value of
those awards, with limited exceptions. That cost will be recognized over the
period during which an employee or director is required to provide service in
exchange for the award. As required by SFAS No. 123(R), Eaton will begin to
recognize costs related to stock options in third quarter 2005. The Company
estimates that the adoption of SFAS No. 123(R) will reduce net income per Common
Share assuming dilution in the second half of 2005 by $.06.
F-13
Revenue Recognition
- -------------------
Substantially all revenues are recognized when products are shipped to
unaffiliated customers and title has transferred. 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
- --------------------------
Eaton acquired businesses and formed joint ventures for a combined net cash
purchase price of $627 in 2004, $252 in 2003 and $153 in 2002. The Statements of
Consolidated Income include the results of these businesses from the effective
dates of acquisition or formation.
On June 9, 2004, Eaton acquired Powerware Corporation, the power systems
business of Invensys plc, for $560 of cash, less cash acquired of $27.
Powerware, based in Raleigh, North Carolina, is a global leader in
Uninterruptible Power Systems (UPS), DC Power products and power quality
services. Powerware had revenues 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. The acquisition of
Powerware is providing new products and solutions, along with strong brand
recognition and expanded channels, for Eaton's global electrical business. This
business is included in the Electrical segment.
Powerware's assets and liabilities were recorded at estimated fair values as
determined by Eaton's management based on information currently available and on
current assumptions as to future operations. The Company is in the process of
completing its purchase price allocation, including the finalization of
valuations of certain intangible assets and deferred tax assets and liabilities.
The allocation of the purchase price for this acquisition is preliminary and
will be finalized by the end of second quarter 2005. The preliminary allocation
is summarized below:
Current assets $306
Property, plant & equipment 44
Goodwill 313
Other intangible assets 95
Other assets 47
----
F-14
Total assets acquired 805
----
Current liabilities 263
Other liabilities 9
----
Total liabilities assumed 272
----
Net assets acquired $533
====
Other intangible assets of $95 acquired as part of Powerware included $24
related to trademarks that are not subject to amortization. The remaining $71
was assigned to patents and other intangible assets that have a weighted-average
useful life of nine years. Goodwill of $313 relates to the Electrical segment,
substantially all of which is non-deductible for income tax purposes.
Unaudited pro forma results of operations for 2004 and 2003, as if Eaton and
Powerware had been combined as of the beginning of those periods, follow. The
pro forma results include preliminary estimates and assumptions, which Eaton's
management believes are reasonable. However, the pro forma results do not
include any cost savings or other effects of the planned integration of
Powerware, and, accordingly, are not necessarily indicative of the results which
would have occurred if the business combination had been in effect on the dates
indicated.
Pro Forma Results of Operations
-------------------------------
2004 2003
------- ------
Net sales $10,153 $8,824
Net income 636 396
Net income per Common Share
Assuming dilution $ 4.05 $ 2.62
Basic 4.16 2.67
On September 1, 2004, Eaton acquired Walterscheid Rohrverbindungstechnik GmbH
(Walterscheid) from GKN plc for $48 of cash. Walterscheid, a manufacturer of
hydraulic tube connectors and fittings primarily for the European market, had
2003 sales of $52 and is located in Lohmar, Germany. The allocation of the
purchase price for this acquisition is preliminary and will be finalized by the
end of third quarter 2005. This business is included in the Fluid Power segment.
In September 2004, Eaton contributed $28 of cash to purchase a 50% interest in a
new medium-duty truck transmission joint venture located in Changchun, China.
The partner in this venture is FAW Jiefang Automotive Co., Ltd., which is the
commercial vehicle subsidiary of China First Auto Works Group Company (FAW), the
largest manufacturer of commercial vehicles in China. Beginning in September
2004, Eaton's operating results include this joint venture, which is accounted
for under the equity method. Sales of this venture were not material in 2004.
This business is included in the Truck segment.
On January 31, 2003, the electrical division of Delta plc was acquired for
approximately $215 of cash. This business has operations in Europe and in the
F-15
Asia/Pacific region and had sales of $326 in 2002. This business is included in
the Electrical segment.
In November 2002, the Boston Weatherhead business of Dana Corporation was
purchased for $130 of cash. This business, which had sales of $211 in 2002,
manufactures hose, tubing, and fluid connectors for fluid power systems. This
business is included in the Fluid Power segment.
EXIT & SALE OF BUSINESSES
- -------------------------
In December 2004, Eaton announced that it would exit its legacy tire and
refrigeration valve manufacturing business within the next year. The Company
incurred charges of $15 ($10 after-tax, or $.06 per Common Share) principally
for the write-down of fixed assets and workforce reductions. This business is in
the Automotive segment. In the Statements of Consolidated Income and Business
Segment Information, these charges were reported as a separate line item.
In July 2002, the Navy Controls business was sold for $92 resulting in a pretax
gain of $18 ($13 after-tax, or $.09 per Common Share). The net gain on the sale
of this business was reported as a separate line item in the Statements of
Consolidated Income and Business Segment Information.
RESTRUCTURING CHARGES
- ---------------------
2004 Charges
- ------------
In 2004, Eaton incurred restructuring charges related to the integration of:
Powerware, the electrical power systems business acquired in June 2004; the
electrical division of Delta plc, acquired in January 2003; and the Boston
Weatherhead fluid power business, acquired in November 2002. In accordance with
generally accepted accounting principles, these charges were recorded as
restructuring expense as incurred.
Restructuring charges in the Fluid Power segment consisted of $8 for plant
consolidations and other expenses.
Restructuring charges in the Electrical segment consisted of $32 for plant
consolidations and other expenses, and $1 of workforce reductions. The charges
primarily related to downsizing plants in Chadderton, United Kingdom, Neuss,
Germany and Necedah, Wisconsin, along with other integration actions.
2003 Charges
- ------------
In 2003, Eaton incurred restructuring charges related to the electrical division
of Delta plc acquired in January 2003 and the Boston Weatherhead fluid power
business acquired in November 2002. In accordance with generally accepted
accounting principles, these charges were recorded as restructuring expense as
incurred.
Restructuring charges in the Fluid Power segment consisted of $13 for plant
consolidations and other expenses, and $1 for workforce reductions of 82
employees. The charges primarily related to the closure of facilities in Norwood
and Mooresville, North Carolina.
F-16
Restructuring charges in the Electrical segment consisted of $20 for plant
consolidations, primarily the Ottery St. Mary, United Kingdom plant, and other
expenses, and $2 of workforce reductions for 145 employees.
2002 Charges
- ------------
In 2002, Eaton incurred restructuring charges to reduce operating costs across
its business segments and certain corporate functions. The charges in 2002 were
primarily a continuation of restructuring programs initiated in 2001.
Additional restructuring charges related to past acquisitions were incurred in
Fluid Power. The charges consisted of $22 of workforce reductions for 841
employees and $4 of asset write-downs, plant consolidation and other
expenses. The charges primarily related to the closure of facilities in
Glenrothes, Scotland and Livorno, Italy, and for the closure of the Mooresville,
North Carolina facility, which was announced in third quarter 2002 and was
completed in first quarter 2003.
Restructuring charges in the Electrical segment consisted primarily of $13 of
workforce reductions for 449 employees and $3 for asset write-downs, plant
consolidation and other expenses.
Restructuring charges in the Truck segment consisted of $6 for workforce
reductions of 251 employees and $10 for asset write-downs, plant consolidation
and other expenses. The charges primarily related to the closure of the
heavy-duty transmission plant in Shelbyville, Tennessee due to depressed
conditions in the truck industry during 2002 and 2001 and Eaton's efforts to
rationalize manufacturing capacity to better manage the cyclical nature of the
truck industry.
Restructuring charges related to corporate staff consisted of $3 of workforce
reductions for 133 employees.
Summary of Restructuring Charges
- --------------------------------
2004 2003 2002
---- ---- ----
Fluid Power $ 8 $ 14 $ 26
Electrical 33 22 16
Automotive 1
Truck 16
---- ---- ----
41 36 59
Corporate restructuring charges 1 3
---- ---- ----
Pretax charges $ 41 $ 37 $ 62
==== ==== ====
After-tax charges $ 27 $ 24 $ 41
Per Common Share $.17 $.16 $.29
The restructuring 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 restructuring charges reduced Operating profit
F-17
of the related business segment or were included in Other corporate expense-net,
as appropriate.
A comparison of restructuring charges and utilization of the various components
for 2004, 2003 and 2002 follows:
Workforce reductions Plant
-------------------- consolidation
Employees Dollars & other Total
--------- ------- ------------- -----
Balance remaining at
January 1, 2002 344 $ 21 $ 2 $ 23
2002 charges 1,994 45 17 62
Utilized in 2002 (1,844) (55) (14) (69)
------ ---- ---- ----
Balance remaining at
December 31, 2002 494 11 5 16
2003 charges 227 3 34 37
Utilized in 2003 (700) (12) (31) (43)
------ ---- ---- ----
Balance remaining at
December 31, 2003 21 2 8 10
2004 charges 10 1 40 41
Utilized in 2004 (31) (3) (45) (48)
------ ---- ---- ----
Balance remaining at
December 31, 2004 0 $ 0 $ 3 $ 3
====== ==== ==== ====
CONTRIBUTION TO EATON CHARITABLE FUND
- -------------------------------------
In 2004, a charge of $13 was recorded for a contribution to the Eaton Charitable
Fund ($8 after-tax, or $.05 per Common Share). In 2002, a similar contribution
of $10 was recorded ($6 after-tax, or $.04 per share). In the Statements of
Consolidated Income, the charges were included in Other (income) expense-net. In
Business Segment Information, the charges were included in Other corporate
expense-net.
OTHER INTANGIBLE ASSETS
- -----------------------
A summary of other intangible assets follows:
2004 2003
------------------------- -------------------------
Historical Accumulated Historical Accumulated
cost amortization cost amortization
---------- ------------ ---------- ------------
Intangible assets not
subject to amortization
(primarily trademarks) $404 $ 24 $373 $ 24
==== ==== ==== ====
F-18
Intangible assets subject
to amortization
Patents $198 $ 80 $205 $ 96
Other 194 48 135 52
---- ---- ---- ----
$392 $128 $340 $148
==== ==== ==== ====
Expense related to intangible assets subject to amortization for 2004 was $25.
Estimated annual pretax expense for intangible assets subject to amortization
for each of the next five years is $28 in 2005, $27 in 2006, $27 in 2007, $26 in
2008, and $25 in 2009.
DEBT & OTHER FINANCIAL INSTRUMENTS
- ----------------------------------
Short-term debt of $13 at December 31, 2004 related to lines of credit of
subsidiaries outside the United States, primarily in Brazil, and was largely
denominated in foreign currencies. The weighted-average interest rate on
short-term debt was 15.7% at December 31, 2004, which includes the effect of $10
of debt in Brazil with an interest rate of 18.2%, and 6.3% at December 31, 2003.
These subsidiaries have available short-term lines of credit aggregating $212
from various banks worldwide.
A summary of long-term debt, including the current portion, follows:
2004 2003
---- ----
6.95% notes due 2004 $250
1.62% Yen notes due 2006 $ 49 47
8% debentures due 2006
($25 converted to floating rate by
interest rate swap) 86 86
8.90% debentures due 2006
(converted to floating rate by
interest rate swap) 100 100
6% Euro 200 million notes due 2007
(converted to floating rate by
interest rate swap) 273 252
7.37% notes due 2007
($20 converted to floating rate by
interest rate swap) 21 21
7.14% notes due 2007 3 3
6.75% notes due 2007
(converted to floating rate by
interest rate swap) 25 25
7.40% notes due 2009
($15 converted to floating rate by
interest rate swap) 16 16
5.75% notes due 2012
($225 converted to floating rate by
interest rate swap) 300 300
7.58% notes due 2012
($12 converted to floating rate by
interest rate swap) 13 13
5.80% notes due 2013 7 7
7.09% notes due 2018
F-19
($25 converted to floating rate by
interest rate swap) 26 26
8-7/8% debentures due 2019 38 38
8.10% debentures due 2022
($50 converted to floating rate by
interest rate swap) 100 100
7-5/8% debentures due 2024
($55 converted to floating rate by
interest rate swap) 66 66
6-1/2% debentures due 2025
(due 2005 at option of debenture holders) 145 145
7-7/8% debentures due 2026 81 81
7.65% debentures due 2029
($75 converted to floating rate by
interest rate swap) 200 200
5.45% debentures due 2034
(converted to floating rate by
interest rate swap) 75
Other 136 132
------ ------
Total long-term debt 1,760 1,908
Less current portion of long-term debt (26) (257)
------ ------
Long-term debt less current portion $1,734 $1,651
====== ======
On January 28, 2005, Eaton issued $75 of 5.45% Senior Debentures which mature in
2034. These Debentures were converted to a floating interest rate of 3.1% by an
interest rate swap. This transaction brings the total amount of outstanding
5.45% Senior Debentures due in 2034 to $150 and will form a single series with
the $75 of 5.45% Senior Debentures due in 2034 issued on October 21, 2004. The
Company used the proceeds for general corporate purposes.
Eaton has long-term credit facilities of $700, of which $400 expire in April
2005 and $300 expire in May 2008.
Aggregate mandatory annual maturities of long-term debt for each of the next
five years are $26 in 2005, $241 in 2006, $327 in 2007, $2 in 2008, and $17 in
2009. Interest paid was $96 in 2004, $105 in 2003, and $116 in 2002.
Eaton has entered into interest rate swaps to manage interest rate risk. A
summary of these instruments outstanding at December 31, 2004, excluding certain
immaterial instruments, follows (currency in millions):
Interest rates(b)
Interest Hedge Notional ----------------- Floating interest
rate swaps (a) type amount Receive Pay rate basis
- -------------- ----- -------- ------- ---- ------------------
Fixed to floating Fair value $ 25 8.0% 6.53% 6 month LIBOR+4.61%
Fixed to floating Fair value $ 100 8.9% 5.81% 6 month LIBOR+3.89%
Fixed to floating Fair value Euro 200 6.0% 2.75% 6 month LIBOR+0.54%
Fixed to floating Fair value $ 20 7.37% 6.78% 6 month LIBOR+4.47%
Fixed to floating Fair value $ 25 6.75% 3.82% 6 month LIBOR+1.50%
Fixed to floating Fair value $ 15 7.40% 4.27% 6 month LIBOR+1.95%
F-20
Fixed to floating Fair value $225 5.75% 2.48% 6 month LIBOR+0.78%
Fixed to floating Fair value $ 12 7.58% 4.08% 6 month LIBOR+1.76%
Fixed to floating Fair value $ 25 7.09% 4.72% 6 month LIBOR+2.40%
Fixed to floating Fair value $ 50 8.10% 4.36% 6 month LIBOR+2.44%
Fixed to floating Fair value $ 55 7.63% 4.36% 6 month LIBOR+2.16%
Fixed to floating Fair value $ 75 7.65% 4.72% 6 month LIBOR+2.36%
Fixed to floating Fair value $ 75 5.45% 2.47% 6 month LIBOR+0.28%
(a) The maturity of the swaps correspond with the maturity of the hedged item
as noted in the long-term debt table.
(b) Interest rates are as of December 31, 2004.
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:
2004 2003
----------------------------- -----------------------------
Notional Carrying Fair Notional Carrying Fair
amount value value amount value value
-------- -------- ------- -------- -------- -------
Long-term debt &
current portion of
long-term debt(a) $(1,760) $(1,975) $(1,908) $(2,132)
Foreign currency
principal swaps $ 72 (8) (8) $ 13 (4) (4)
Foreign currency
forward exchange
contracts 151 (5) (5) 288 3 3
Interest rate swaps
Fixed to floating 975 50 50 1,154 42 42
(a) Includes foreign currency denominated debt.
The estimated fair values of financial instruments were principally based on
quoted market prices where such prices are 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 forward exchange contracts, which are primarily related to the Euro,
Japanese Yen and Swiss Franc, and foreign currency principal and interest rate
swaps which mature during 2005 through 2007 were estimated based on quoted
market prices of comparable contracts, adjusted through interpolation where
necessary for maturity differences.
RETIREMENT BENEFIT PLANS
- ------------------------
Eaton has defined benefit pension plans and other postretirement benefit plans.
Components of plan obligations and assets, and Eaton's recorded assets
(liabilities), follow:
F-21
Other
postretirement
Pension benefits benefits
----------------- --------------
2004 2003 2004 2003
------- ------- ----- -----
Changes in projected benefit obligation
- ---------------------------------------
Benefit obligation at beginning of year $(2,304) $(1,996) $(937) $(878)
Service cost (103) (96) (17) (15)
Interest cost (134) (129) (53) (56)
Actuarial loss (165) (119) (5) (73)
Benefits paid 188 192 99 97
Plan amendments (7) (10) 18 (10)
Foreign currency translation (55) (76)
Business acquisitions (14) (66) (2)
Other (7) (4) (1)
------- ------- ----- -----
Benefit obligation at end of year (2,601) (2,304) (896) (937)
------- ------- ----- -----
Change in plan assets
- ---------------------
Fair value of plan assets
at beginning of year 1,670 1,480
Actual return on plan assets 194 234
Employer contributions 134 48 99 97
Benefits paid (188) (192) (99) (97)
Foreign currency translation 34 47
Business acquisitions 2 48
Other 6 5
------- ------- ----- -----
Fair value of plan assets at end of year 1,852 1,670 0 0
------- ------- ----- -----
Benefit obligation in excess of plan assets (749) (634) (896) (937)
Unrecognized net actuarial loss 1,005 894 247 250
Unrecognized prior service cost 26 21 (5) 13
Other 2 11 8 9
------- ------- ----- -----
Net amount recognized $ 284 $ 292 $(646) $(665)
======= ======= ===== =====
Amounts recognized in the balance sheet consist of:
Other
postretirement
Pension benefits benefits
---------------- --------------
2004 2003 2004 2003
----- ----- ----- -----
Prepaid asset $ 29 $ 28
Accrued liability (488) (402) $(646) $(665)
Intangible asset 26 22
Accumulated other comprehensive loss 717 644
----- ----- ----- -----
Net amount recognized $ 284 $ 292 $(646) $(665)
===== ===== ===== =====
F-22
Statement of Financial Accounting Standards No. 87 requires 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 the fourth quarters of 2004, 2003 and 2002, Eaton recorded non-cash charges
of $73, $27 and $586, respectively, ($48, $17 and $386 after-tax, respectively)
related to the additional minimum liability for certain underfunded pension
plans, which increased Accumulated other comprehensive loss in Shareholders'
equity. Pension funding requirements are not affected by the recording of these
charges. These charges did not impact net income and will reverse should the
fair value of the pension plans' assets exceed the accumulated benefit
obligation.
The total accumulated benefit obligation for all pension plans at December 31,
2004 was $2,329 and at year-end 2003 was $2,052. Pension plans with an
accumulated benefit obligation in excess of plan assets at December 31 follow:
2004 2003
------ ------
Projected benefit obligation $2,523 $2,242
Accumulated benefit obligation 2,260 1,996
Fair value of plan assets 1,773 1,600
The measurement date for all pension and other postretirement benefit plans is
November 30. Assumptions used to determine pension benefit obligations at
year-end follow:
United States &
non-United States
United States plans
plans (weighted-average)
------------- ------------------
2004 2003 2004 2003
---- ---- ---- ----
Discount rate 6.00% 6.25% 5.81% 6.11%
Rate of compensation increase 3.50% 3.50% 3.60% 3.60%
United States pension plans represent 69% and 72% of the benefit obligation in
2004 and 2003, respectively.
The components of pension benefit cost follow:
2004 2003 2002
----- ----- -----
Service cost $(103) $ (96) $ (76)
Interest cost (134) (129) (126)
Expected return on plan assets 179 181 213
Other (26) (7) (8)
----- ----- -----
(84) (51) 3
Curtailment loss (2) (1) (4)
Settlement loss (31) (34) (21)
----- ----- -----
$(117) $ (86) $ (22)
===== ===== =====
F-23
Assumptions used to determine net periodic pension cost for the years ended
December 31 follow:
United States &
non-United States
United States plans
plans (weighted-average)
------------------- ------------------
2004 2003 2002 2004 2003 2002
---- ---- ----- ---- ---- ----
Discount rate 6.25% 6.75% 7.25% 6.11% 6.53% 6.56%
Expected long-term
return on plan assets 8.75% 8.75% 10.00% 8.50% 8.71% 9.85%
Rate of compensation
increase 3.50% 3.75% 4.00% 3.60% 3.73% 3.74%
The expected long-term rate of return on pension plan 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 weighted-average pension plan asset allocations by asset category at
December 31, 2004 and 2003 are as follows:
2004 2003
---- ----
Equity securities 80% 81%
Debt securities 19 18
Other 1 1
--- ---
100% 100%
=== ===
Investment policies and strategies are developed on a country specific basis.
The United States plan represents 72% of worldwide pension assets and its target
allocation is 85% diversified equity, 12% United States Treasury
Inflation-Indexed Securities, and 3% cash equivalents. The United Kingdom plan
represents 22% of worldwide pension assets and its target allocation is 70%
diversified equity securities and 30% United Kingdom Government Bonds.
In 2004, Eaton made voluntary contributions to pension plans of $75 in the
United States and $18 in the United Kingdom, as well as other contributions of
$41. In 2005, Eaton expects to make voluntary contributions to pension plans of
$50 in the United States, which was announced in January 2005, and $14 in the
United Kingdom, as well as other contributions of $31.
At December 31, 2004, expected pension benefit payments for each of the next
five years and the five years thereafter in aggregate are $158 in 2005, $169 in
2006, $176 in 2007, $183 in 2008, $193 in 2009, and $1,130 in 2010-2014.
F-24
The components of other postretirement benefit cost follow:
2004 2003 2002
---- ---- ----
Service cost $(17) $(15) $(15)
Interest cost (53) (56) (60)
Other (9) (9) (4)
---- ---- ----
(79) (80) (79)
Curtailment loss (1)
Settlement loss (2)
---- ---- ----
$(80) $(80) $(81)
==== ==== ====
Assumptions used to determine other postretirement benefit obligations and cost
follow:
2004 2003 2002
----- ----- -----
Assumptions used to determine benefit
obligation at year-end
- -------------------------------------
Discount rate 6.00% 6.25% 6.75%
Health care cost trend rate
assumed for next year 10.00% 9.00% 10.00%
Ultimate health care cost trend rate 5.00% 5.00% 5.00%
Year ultimate health care cost trend
rate is achieved 2014 2007 2007
Assumptions used to determine cost
- ----------------------------------
Discount rate 6.25% 6.75% 7.25%
Initial health care cost trend rate 9.00% 10.00% 8.00%
Ultimate health care cost trend rate 5.00% 5.00% 5.00%
Year ultimate health care cost trend
rate is achieved 2007 2007 2007
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:
1% Increase 1% Decrease
----------- -----------
Effect on total of service
and interest cost $ 1 $ (1)
Effect on other postretirement
benefit obligation 23 (21)
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the
Act) was passed on December 8, 2003. The Act provides for prescription drug
benefits under Medicare Part D and contains a subsidy to plan sponsors who
provide "actuarially equivalent" prescription plans. Eaton recognized the effect
of the Act in 2004. The accumulated postretirement benefit obligation decreased
by $51, with an offsetting change in unrecognized net actuarial loss. The
reduction was attributable to the Federal subsidy and an expected reduction
F-25
in the number of retirees electing coverage under the Company's other
postretirement benefit plans. The Act also reduced net periodic other
postretirement benefit costs by $6 in 2004. Eaton has certain plans that are
non-contributory and that the Company believes satisfy the "actuarially
equivalent" test and will receive the subsidy. The reduction in the accumulated
postretirement benefit obligation and ongoing net periodic cost did not require
a modification or amendment of the Company's benefit plans. However, if certain
plans were amended, the Act could further reduce both the accumulated
postretirement benefit obligation and ongoing net periodic cost.
At December 31, 2004, expected other postretirement benefit payments for each of
the next five years and the five years thereafter in aggregate are $96 in 2005,
$100 in 2006, $102 in 2007, $101 in 2008, $101 in 2009, and $482 in 2010-2014.
The expected subsidy receipts related to the Act that are included in the other
postretirement benefit payments listed above for each of the next five years and
the five years thereafter in aggregate are $0 in 2005, $3 in each of 2006
through 2009, and $13 in 2010-2014.
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 $44 in 2004, $40 in 2003, and $38
in 2002.
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, 2004 and 2003, the balance sheet included a liability for these costs of $69
and $65, respectively.
Based upon Eaton's analysis and subject to the difficulty in estimating these
future costs, the Company expects that any sum it may be required to pay in
connection with environmental matters is not reasonably likely to exceed the
liability by an amount that would have a material adverse effect on its
F-26
financial position, results of operations or cash flows. All of these estimates
are forward-looking statements and, given the inherent uncertainties in
evaluating environmental exposures, actual results can differ from these
estimates.
CONTINGENCIES
- -------------
Eaton is subject to a broad range of claims, administrative proceedings,
and legal proceedings, such as lawsuits that relate to contractual
allegations, patent infringement, personal injuries (including asbes-
tos claims) and employment-related matters. Although it is not pos-
sible to predict with certainty the outcome or cost of these matters,
the Company believes that these matters will not have a material ad-
verse effect on its financial position, results of operations or cash flows.
SHAREHOLDERS' EQUITY
- --------------------
On January 21, 2004, the Board of Directors of Eaton declared a two-for-one
split of the Company's Common Shares effective in the form of a 100% stock
dividend. The record date for the stock split was February 9, 2004, and the
distribution date was February 23, 2004. Accordingly, all Common Share data and
per shares amounts presented have been adjusted to reflect the stock split.
There are 300 million Common Shares authorized ($.50 par value per share), 153.3
million of which were issued and outstanding at year-end 2004. At December 31,
2004, there were 9,641 holders of record of Common Shares. Additionally, 22,016
current and former employees were shareholders through participation in the
Eaton Savings Plan (ESP) and Eaton Personal Investment Plan (EPIP).
In January 2004, Eaton initiated a plan to repurchase 4.2 million of its Common
Shares to offset the shares issued during 2003 from the exercise of stock
options. During first quarter 2004, the shares were repurchased at a total cost
of $250.
In June 2003, Eaton sold 7.4 million shares for net proceeds of $296, which were
used to pay down commercial paper and for general corporate purposes.
Eaton has plans that permit certain employees and directors to defer a portion
of their compensation. The Company has deposited $34 of Common Shares and
marketable securities into a trust to fund a portion of these liabilities. The
marketable securities are included in Other assets and the Common Shares are
included in Shareholders' equity at historical cost.
Stock Options
- -------------
Stock options have been granted to certain employees and directors, under
various plans, to purchase Common Shares at prices equal to fair market value on
the date of grant. Historically, the majority 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, Eaton granted special performance-vested stock options
with a 10-year vesting term in lieu of more standard employee stock options.
F-27
These options have a provision for accelerated vesting if and when the Company
achieves certain net income and Common Share price targets. If the targets are
not achieved, these options become exercisable 10 days before the expiration of
their 10-year term. As of December 31, 2004, 2.8 million special
performance-vested stock options were outstanding of which 1.0 million were
exercisable.
A summary of stock option activity follows (shares in millions):
2004 2003 2002
----------------- ----------------- -----------------
Average Average Average
price price price
per per per
option Options option Options option Options
------- ------- ------- ------- ------- -------
Outstanding January 1 $33.22 17.2 $31.70 19.2 $29.98 19.8
Granted 59.12 2.4 35.46 2.6 40.42 2.2
Exercised 30.78 (4.6) 27.43 (4.2) 23.34 (2.0)
Canceled 41.34 (.3) 35.28 (.4) 35.28 (.8)
---- ---- ----
Outstanding December 31 $37.97 14.7 $33.22 17.2 $31.70 19.2
==== ==== ====
Exercisable December 31 $33.65 8.2 $31.50 10.5 $29.44 12.6
Reserved for future
grants December 31 9.0 4.0 6.2
The following table summarizes information about stock options outstanding and
exercisable at December 31, 2004 (shares in millions):
Weighted- Weighted-
Weighted- average average
average exercise exercise
Options remaining price per Options price per
Range of exercise out- contractual outstanding exerci- exercisable
prices per option standing life (years) option sable option
- ----------------- -------- ------------ ----------- ------- -----------
$20.90 - $22.81 .6 .7 $22.16 .6 $22.16
$29.44 - $30.91 5.1 3.4 30.81 3.6 30.77
$31.93 - $39.68 4.9 6.2 36.15 2.8 36.30
$40.58 - $40.60 1.7 7.0 40.60 1.0 40.60
$40.98 - $47.88 .2 6.3 42.99 .2 43.07
$59.07 2.2 9.2 59.07
---- ---
14.7 8.2
==== ===
Eaton has adopted the disclosure-only provisions of Statement of Financial
Accounting Standard (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:
F-28
2004 2003 2002
----- ----- -----
Net income
- ----------
As reported $ 648 $ 386 $ 281
Stock-based compensation expense, net of income taxes (13) (11) (14)
----- ----- -----
Assuming fair-value-method $ 635 $ 375 $ 267
===== ===== =====
Net income per Common Share assuming dilution
- ---------------------------------------------
As reported $4.13 $2.56 $1.96
Stock-based compensation expense, net of income taxes (.08) (.08) (.10)
----- ----- -----
Assuming fair-value-method $4.05 $2.48 $1.86
===== ===== =====
Net income per Common Share basic
- ---------------------------------
As reported $4.24 $2.61 $1.99
Stock-based compensation expense, net of income taxes (.09) (.08) (.10)
----- ----- -----
Assuming fair-value-method $4.15 $2.53 $1.89
===== ===== =====
The fair value of each option grant was estimated using the Black-Scholes option
pricing model with the following assumptions:
2004 2003 2002
------------ ------------ ------------
Dividend yield 2.5% 2.5% 2.5%
Expected volatility 28% 28% 29%
Risk-free interest rate 3.1% to 3.8% 2.2% to 3.5% 2.6% to 4.3%
Expected option life in years 5 5 4
Weighted-average per
share fair value of options
granted during the year $13.29 $7.84 $9.17
Preferred Share Purchase Rights
- -------------------------------
In 1995, the Board of Directors of Eaton declared a dividend of one Preferred
Share Purchase Right for each outstanding Common Share. The Rights become
exercisable only if a person or group acquires, or offers to acquire, 20% or
more of the Company's Common Shares. The Company is authorized to reduce that
threshold for triggering the Rights to not less than 10%. The Rights expire on
July 12, 2005, unless redeemed earlier at $.005 per Right.
When the Rights become exercisable, the holder of each Right, other than the
acquiring person, is entitled 1) to purchase for $125, one two-hundredth of a
Preferred Share, 2) to purchase for $125, that number of Eaton's Common
F-29
Shares or common stock of the acquiring person having a market value of twice
that price, or 3) at the option of the Company, to exchange each Right for one
Common Share or one two-hundredth of a Preferred Share.
Accumulated Other Comprehensive Loss
- ------------------------------------
The components of Accumulated other comprehensive loss as reported in the
Statement of Consolidated Shareholders' Equity follow:
Unrealized Deferred Minimum
Foreign gain (loss) gain pension
currency on available (loss) on liability
translation for sale cash flow adjust-
adjustments investments hedges ment Total
----------- ------------ --------- --------- -----
Balance at
January 1, 2002 $(274) $ 1 $ (5) $ (21) $(299)
2002 activity,
net of income taxes (15) 1 (386) (400)
----- --- ----- ----- -----
Balance at
December 31, 2002 (289) 1 (4) (407) (699)
2003 activity,
net of income taxes 126 1 4 (17) 114
----- --- ----- ----- -----
Balance at
December 31, 2003 (163) 2 0 (424) (585)
2004 activity,
net of income taxes 99 (2) (2) (48) 47
----- --- ----- ----- -----
Balance at
December 31, 2004 $ (64) $ 0 $ (2) $(472) $(538)
===== === ===== ===== =====
A discussion of the minimum pension liability adjustment is included in
"Retirement Benefit Plans" above.
INCOME TAXES
- ------------
For financial statement reporting purposes, income before income taxes, based on
the geographic location of the operation to which such earnings are
attributable, is summarized below. 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
before income taxes
-------------------
2004 2003 2002
---- ---- ----
United States $124 $ 78 $ 56
Non-United States 657 430 343
F-30
---- ---- ----
$781 $508 $399
==== ==== ====
Income tax expense
-------------------
2004 2003 2002
----- ---- ----
Current
- -------
United States
Federal $ 131 $ 97 $123
State & local 5 17 6
Non-United States 128 70 42
----- ---- ----
264 184 171
----- ---- ----
Deferred
- --------
United States (131) (67) (71)
Non-United States 5 18
----- ---- ----
(131) (62) (53)
----- ---- ----
$ 133 $122 $118
===== ==== ====
Reconciliations of income taxes from the United States Federal statutory rate to
the effective income tax rate follow:
2004 2003 2002
----- ----- ----
Income taxes at the United States statutory rate 35.0% 35.0% 35.0%
United States state & local income taxes .6 3.2 1.4
Other United States-net (5.1) (1.4) 1.4
Non-United States operations (earnings taxed at other
than United States tax rate) (13.5) (12.8) (8.3)
----- ----- ----
17.0% 24.0% 29.5%
===== ===== ====
In fourth quarter 2004, Eaton recorded an income tax benefit of $30 resulting
from the favorable resolution of multiple international and United States income
tax items. This income tax benefit reduced the effective income tax rate for
full year 2004 from 20.8% to 17.0%.
Eaton has manufacturing operations in Puerto Rico, which operate under certain
United States tax law incentives related to the repatriation of earnings that,
at this point, are not expected to be available after 2005. Income tax credits
claimed under these incentives were $33 in 2004, $32 in 2003 and $33 in 2002.
Management believes the elimination of these repatriation laws will not have an
adverse impact on the Company's effective income tax rate.
F-31
Significant components of current and long-term deferred income taxes follow:
2004 2003
---------------- ----------------
Long- Long-
Current term Current term
assets assets assets assets
------- ------ ------- ------
Accruals & other adjustments
Employee benefits $ 57 $ 427 $ 63 $ 382
Depreciation & amortization (5) (279) (4) (412)
Other 161 80 130 59
Other items 3 8 3 (1)
United States Federal income
tax credit carryforwards 86 77
United States Federal tax loss
carryforwards 7
United States state & local tax loss
carryforwards 52 46
United States foreign tax credit
carryforwards 21
Non-United States tax loss carryforwards 80 51
Valuation allowance (132) (109)
---- ----- ---- -----
$216 $ 329 $192 $ 114
==== ===== ==== =====
At the end of 2004, United States Federal income tax credit carryforwards of $86
are available to reduce future Federal income tax liabilities. These credits
include $47 which expire in 2021 through 2024, and $39 of which are not subject
to expiration. There are also United States state and local pretax income
loss carryforwards with a future tax benefit of $52 available at the end of
2004. These carryforwards are available to reduce future state and local income
tax liabilities and their expiration dates are $13 in 2005 through 2015, $18 in
2016 through 2020, and $21 in 2021 through 2025. A full valuation allowance has
been recorded for the state and local income tax loss carryforwards.
At December 31, 2004, certain non-United States subsidiaries had pretax income
loss carryforwards aggregating $261 that are available to offset future taxable
income. Carryforwards of $122 expire at various dates from 2005 through 2014 and
the balance have no expiration date. A valuation allowance of $80 has been
recorded for the deferred tax effect of these tax loss carryforwards.
No provision has been made for income taxes on undistributed earnings of
consolidated non-United States subsidiaries of $1,598 at December 31, 2004,
since the earnings retained have been reinvested by the 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 provides for a special one-time tax deduction of 85% of
F-32
certain foreign earnings that are repatriated (as defined in the Act) in 2005.
Eaton has not fully evaluated the effects of the repatriation provision and,
therefore, has not determined if the Act will materially change its foreign
earnings reinvestment plan. A full evaluation of the plan is expected to be
complete by June 30, 2005.
Worldwide income tax payments were $161 in 2004, $137 in 2003 and $61 in 2002.
OTHER INFORMATION
- -----------------
Accounts Receivable
- -------------------
Accounts receivable were net of an allowance for doubtful accounts of $32 and
$23 at December 31, 2004 and 2003, respectively.
Inventories
- -----------
The components of inventories follow:
2004 2003
------ ----
Raw materials $ 398 $301
Work-in-process 206 173
Finished goods 412 279
------ ----
Inventories at FIFO 1,016 753
Excess of FIFO over LIFO cost (50) (32)
------ ----
$ 966 $721
====== ====
Of the $1,016 of inventories at FIFO at year-end 2004, $572 were accounted for
using the LIFO method. Of the $753 of inventories at FIFO at year-end 2003, $432
were accounted for using the LIFO method.
Warranty Liabilities
- --------------------
A summary of the current and long-term liabilities for warranties follows:
2004 2003 2002
---- ---- -----
Balance at the beginning of the year $125 $127 $ 128
Current year provision 108 81 129
Business acquisition 12
Claims paid/satisfied (94) (82) (119)
Other 1 (1) (11)
---- ---- -----
Balance at the end of the year $152 $125 $ 127
==== ==== =====
Lease Commitments
- -----------------
Eaton leases certain real properties and equipment. Minimum rental commitments
for 2005 under noncancelable operating leases, which expire at various dates
F-33
and in most cases contain renewal options, were $97 and decline substantially
thereafter.
Rental expense was $113 in 2004, $115 in 2003, and $102 in 2002.
Net Income Per Common Share
- ---------------------------
A summary of the calculation of net income per Common Share assuming dilution
and basic follows (shares in millions):
2004 2003 2002
------ ------ ------
Net income $ 648 $ 386 $ 281
====== ====== ======
Average number of Common Shares
outstanding assuming dilution 157.1 150.5 143.4
Less dilutive effect of stock options 4.0 2.6 2.2
------ ------ ------
Average number of Common Shares
outstanding basic 153.1 147.9 141.2
====== ====== ======
Net income per Common Share
assuming dilution $ 4.13 $ 2.56 $ 1.96
Net income per Common Share
basic $ 4.24 $ 2.61 $ 1.99
In 2002, employee and director stock options to purchase Common Shares of 6.0
million were outstanding but were not included in the computation of net income
per Common Share assuming dilution, since they would have had an antidilutive
effect on earnings per share.
BUSINESS SEGMENT & GEOGRAPHIC REGION INFORMATION
- ------------------------------------------------
Eaton is a global diversified industrial manufacturer with 2004 sales of $9.8
billion. The Company is a leader in the design, manufacture, marketing and
servicing of fluid power systems for industrial, mobile, and aircraft equipment;
electrical systems and components for power quality, distribution and control;
automotive engine air management systems, powertrain solutions and specialty
controls for performance, fuel economy and safety; and intelligent truck
drivetrain systems for safety and fuel economy. The Company had 55,000 employees
at the end of 2004 and sells products to customers in more than 125 countries.
Major products included in each business segment and other information follows.
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, motors, electric motor pumps, hydraulic
F-34
motor driven generators 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 and valves; clutches and brakes for industrial machines; golf grips and
precision molded and extruded plastic products
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
Automotive
- ----------
Engine valves, valve actuation components, engine displacement control
components, cylinder heads, superchargers, limited slip and locking
differentials, precision gear forgings, engine sensors and controls, mirror
actuators, transmission controls, on-board vapor recovery systems, fuel level
senders, exhaust gas recirculation valves for heavy-duty engines, flow and
pressure controls for direct injection diesel engines, engine oil manifold
controls, turbocharger waste gate controls, intake manifold control valves, and
air control valves
Truck
- -----
Heavy-, medium-, and light-duty mechanical transmissions; heavy- and medium-duty
automated transmissions; heavy- and medium-duty clutches; and a variety of other
products including gears and shafts, traction control systems, transfer boxes,
power take-off units, splitter boxes, gearshift mechanisms, transmissions for
off-highway construction equipment, and collision warning systems
Other Information
- -----------------
The principal markets for Fluid Power, Automotive and Truck are original
equipment manufacturers and after-market customers of off-highway agricultural
and construction vehicles, industrial equipment, passenger cars, heavy-,
medium-, and light-duty trucks, and customers involved with aerospace products
and systems. These manufacturers are located globally and most sales of these
products are made directly to such manufacturers.
The principal markets for Electrical are industrial, construction, commercial,
automotive and government 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.
F-35
No single customer represented more than 10% of net sales in 2004, 2003 or 2002.
Sales from United States and Canadian operations to customers in foreign
countries were $504 in 2004, $437 in 2003 and $503 in 2002 (5% of sales in 2004
and 2003 and 7% in 2002).
The accounting policies of the 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.
Identifiable assets exclude 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.
F-36
GEOGRAPHIC REGION INFORMATION
- -----------------------------
Segment
Net operating Long-lived
sales profit assets
------ --------- ----------
2004
- ----
United States $6,843 $ 774 $1,215
Canada 261 37 16
Europe 1,990 150 547
Latin America 774 107 244
Asia/Pacific 679 85 125
Eliminations (730)
------ ------ ------
$9,817 $1,153 $2,147
====== ====== ======
2003
- ----
United States $5,758 $ 546 $1,264
Canada 209 28 16
Europe 1,581 94 491
Latin America 516 65 205
Asia/Pacific 504 64 100
Eliminations (507)
------ ------ ------
$8,061 $ 797 $2,076
====== ====== ======
2002
- ----
United States $5,605 $ 483 $1,338
Canada 185 15 13
Europe 1,110 65 351
Latin America 403 45 160
Asia/Pacific 358 43 93
Eliminations (452)
------ ------ ------
$7,209 $ 651 $1,955
====== ====== ======
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.
Segment operating profit was reduced by restructuring charges as follows:
2004 2003 2002
---- ---- ----
United States $22 $22 $49
Europe 18 11 10
Asia/Pacific 1 3
--- --- ---
$41 $36 $59
=== === ===
F-37
BUSINESS SEGMENT INFORMATION
- ----------------------------
2004 2003 2002
------ ------ ------
Net sales
- ---------
Fluid Power $3,098 $2,786 $2,456
Electrical 3,072 2,313 1,993
Automotive 1,847 1,690 1,594
Truck 1,800 1,272 1,166
------ ------ ------
$9,817 $8,061 $7,209
====== ====== ======
Operating profit
- ----------------
Fluid Power $ 338 $ 247 $ 187
Electrical 243 158 149
Automotive 243 224 225
Truck 329 168 90
------ ------ ------
1,153 797 651
Corporate
- ---------
Amortization of intangible assets (25) (21) (23)
Interest expense-net (78) (87) (104)
Minority interest (7) (12) (14)
Pension & other postretirement
benefit expense (75) (52)
Provision to exit a business (15)
Gain on sale of business 18
Other corporate expense-net (172) (117) (129)
------ ------ ------
Income before income taxes 781 508 399
Income taxes 133 122 118
------ ------ ------
Net income $ 648 $ 386 $ 281
====== ====== ======
Income before income taxes was reduced by restructuring charges as follows:
Fluid Power $ 8 $14 $26
Electrical 33 22 16
Automotive 1
Truck 16
Corporate 1 3
--- --- ---
$41 $37 $62
=== === ===
F-38
2004 2003 2002
------ ------ ------
Identifiable assets
- -------------------
Fluid Power $1,527 $1,422 $1,439
Electrical 1,469 1,072 847
Automotive 974 872 819
Truck 940 690 605
------ ------ ------
4,910 4,056 3,710
Goodwill 2,433 2,095 1,910
Other intangible assets 644 541 510
Corporate 1,088 1,531 1,008
------ ------ ------
Total assets $9,075 $8,223 $7,138
====== ====== ======
Expenditures for
property, plant & equipment
- ---------------------------
Fluid Power $ 83 $ 60 $ 53
Electrical 55 37 34
Automotive 91 86 75
Truck 90 71 56
------ ------ ------
319 254 218
Corporate 11 19 10
------ ------ ------
$ 330 $ 273 $ 228
====== ====== ======
Depreciation of
property, plant & equipment
- ---------------------------
Fluid Power $ 91 $ 92 $ 91
Electrical 83 80 70
Automotive 84 77 69
Truck 61 54 54
------ ------ ------
319 303 284
Corporate 23 19 22
------ ------ ------
$ 342 $ 322 $ 306
====== ====== ======
F-39
MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
- ------------------------------------------------------------------------
Dollars in millions, except for per share data (per share data assume dilution)
OVERVIEW OF THE COMPANY
- -----------------------
Eaton, a diversified industrial manufacturer, is a global leader in the design,
manufacture, marketing and servicing of fluid power systems for industrial,
mobile, and aircraft equipment; electrical systems and components for power
quality, distribution and control; automotive engine air management systems,
powertrain solutions and specialty controls for performance, fuel economy and
safety; and intelligent truck drivetrain systems for safety and fuel economy.
The principal markets for the Fluid Power, Automotive and Truck segments are
original equipment manufacturers and after-market customers of off-highway
agricultural and construction vehicles, industrial equipment, passenger cars,
heavy-, medium-, and light-duty trucks, and customers involved with aerospace
products and systems. The principal markets for the Electrical segment are
industrial, construction, commercial, automotive and government customers. The
Company had 55,000 employees at the end of 2004 and sells products to customers
in more than 125 countries.
HIGHLIGHTS OF RESULTS FOR 2004
- ------------------------------
Improved economic conditions in 2004 set the stage for Eaton to post record
financial results, with each business segment reporting improved performance
during 2004. During the year, 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) further strengthening the
balance sheet.
2004 2003 Increase
------ ------ --------
Net sales $9,817 $8,061 22%
Operating profit 1,153 797 45%
Operating margin 11.7% 9.9%
Net income 648 386 68%
Net income per Common
Share assuming dilution $ 4.13 $ 2.56 61%
Return on Shareholders'
equity 20.1% 14.4%
Net sales in 2004 were at a record level for Eaton, surpassing the record set in
2003. Sales growth of 22% in 2004 consisted of 12% from organic growth with 8%
from end-market growth and 4% from outgrowing end markets; 7% from acquisitions
of businesses; and 3% from foreign exchange rates. In each quarter of 2004 there
was positive growth in end markets served by the Company, and, in 2004, Eaton's
businesses outgrew their end markets by approximately 50%.
Operating profit in 2004 was a record for Eaton. The growth in operating profit
was largely due to sales growth and the benefits of restructuring actions taken
in recent years to improve profit performance of the Company. These increases
F-40
were partially offset by higher prices paid primarily for basic metals in 2004.
The impact of higher metals costs, partially offset by increased selling prices
to recover these higher costs, was a 1.0 point reduction in operating margin.
Net income and net income per Common Share assuming dilution were also records
for Eaton in 2004. These record results were primarily due to the sales growth
in 2004 and the benefits of restructuring actions taken in recent years. In
addition, lower net interest expense and a reduction in the effective income tax
rate helped the Company to post improved net income. These increases in net
income in 2004 were partially offset by higher prices paid primarily for basic
metals, higher costs for pensions and other postretirement benefits in 2004, a
provision of $15 to exit a business, and a $13 contribution to the Eaton
Charitable Fund.
On June 9, 2004, Eaton acquired Powerware Corporation, the power systems
business of Invensys plc, for $560 of cash, less cash acquired of $27.
Powerware, based in Raleigh, North Carolina, is a global leader in
Uninterruptible Power Systems (UPS), DC Power products, and power quality
services. Powerware had revenues 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. Eaton's operating
results for 2004 include Powerware from the date of acquisition. This business
is included in the Electrical segment.
On September 1, 2004, Eaton acquired Walterscheid Rohrverbindungstechnik GmbH
(Walterscheid) from GKN plc for $48 of cash. Walterscheid, a manufacturer of
hydraulic tube connectors and fittings primarily for the European market, had
2003 sales of $52 and is located in Lohmar, Germany. Its products are used in
mobile and industrial hydraulic markets such as construction and agricultural
equipment and machine tools. Eaton's operating results for 2004 include
Walterscheid from the date of acquisition. This business is included in the
Fluid Power segment.
Also in September 2004, Eaton contributed $28 of cash to purchase a 50% interest
in a new medium-duty truck transmission joint venture located in Changchun,
China. The partner in this venture is FAW Jiefang Automotive Co., Ltd., which is
the commercial vehicle subsidiary of China First Auto Works Group Company (FAW),
the largest manufacturer of commercial vehicles in China. Eaton's operating
results include this joint venture, which is accounted for under the equity
method, beginning in September 2004. This business is included in the Truck
segment. The Company also acquired other smaller businesses in 2004 for an
aggregate investment cost of $17. The sales of these businesses were immaterial
in 2004.
Throughout 2004, Eaton maintained a strong focus on strengthening the balance
sheet. Total debt of $1,773 at the end of 2004 was reduced by $180 from $1,953
at year-end 2003, due to a net repayment of debt totaling $206, partially offset
by a $22 increase in long-term debt denominated in foreign currencies due to
movement of foreign exchange rates in 2004. Shareholders' equity of $3,606 at
the end of 2004 was a new record, rising $489 from $3,117 at year-end 2003. The
net-debt-to-total-capital ratio was 29.1%, below the Company's target of 35 to
40%. Net working capital of $920 at the end of 2004 was down $47 from $967 at
year-end 2003, in spite of the increase in working capital due to acquisitions
of Powerware and other businesses. The current ratio was 1.4 at both year-ends.
F-41
Cash and short-term investments totaled $296 at the end of 2004, down from $865
at year-end 2003, reflecting the use of $627 to finance the acquisitions of
Powerware and other businesses, the repurchase of 4.2 million Common Shares at a
total cost of $250, a $75 contribution to the Company's United States qualified
pension plans, and a net repayment of debt of $206, partially offset by strong
cash flow from operations.
Cash generated from operating activities of $838 in 2004 continued to be strong,
as a result of sharply higher net income in 2004, but was slightly lower than
$874 in 2003, principally due to a $75 contribution to the Company's United
States qualified pension plans and $57 of higher capital expenditures in 2004.
Operating cash flow less capital expenditures (free cash flow) was $508 in 2004,
down from $601 in 2003, reflecting the $75 contribution to the United States
qualified pension plans.
In light of the strong results for 2004 and continuing momentum in most of its
markets, on January 24, 2005 Eaton announced that it was taking the following
actions:
- Increasing the quarterly dividend on its Common Shares by 15%, from
$.27 per share to $.31 per share, effective for the February 2005
dividend
- Initiating a plan to repurchase $250 of shares to help offset dilution
from the shares issued during 2004 from the exercise of stock options
- Contributing $50 to its qualified pension plans in the United States
during 2005
TWO-FOR-ONE STOCK SPLIT
- -----------------------
On January 21, 2004, the Board of Directors of Eaton declared a two-for-one
split of the Company's Common Shares effective in the form of a 100% stock
dividend. The record date for the stock split was February 9, 2004, and the
distribution date was February 23, 2004. Accordingly, all Common Share data and
per share amounts presented have been adjusted to reflect the stock split.
RESULTS OF OPERATIONS - 2004 COMPARED TO 2003
- ---------------------------------------------
2004 2003 Increase
------ ------ --------
Net sales $9,817 $8,061 22%
Operating profit 1,153 797 45%
Operating margin 11.7% 9.9%
Net income 648 386 68%
Net income per Common
Share assuming dilution $ 4.13 $ 2.56 61%
Sales for 2004 were up sharply compared to 2003 and were a record for Eaton.
Sales growth of 22% in 2004 consisted of 12% from organic growth, 7% from
F-42
recently acquired businesses, and 3% from foreign exchange rates. Organic growth
of 12% was comprised of 8% growth in Eaton's end markets and 4% from outgrowing
end markets.
Operating profit in 2004 was also a record for Eaton. The growth in operating
profit was due to sales growth and the benefits of restructuring actions taken
in recent years. These increases were partially offset by higher prices paid
primarily for basic metals in 2004. Operating margins were reduced by .4% in
both 2004 and 2003 due to restructuring charges. Operating margins in 2004
increased compared to 2003 despite higher prices paid primarily for basic metals
and the addition of the Powerware business, whose margins are currently lower
than the rest of the Electrical segment. The operating results of each business
segment are further discussed below, under "Results by Business Segment".
RESULTS BY GEOGRAPHIC REGION
- ----------------------------
Operating
Net sales Operating profit margin
-------------------------- -------------------------- -----------
2004 2003 Increase 2004 2003 Increase 2004 2003
------ ------ -------- ------ ------ -------- ---- ----
United States $6,843 $5,758 19% $ 774 $546 42% 11.3% 9.5%
Canada 261 209 25% 37 28 32% 14.2% 13.4%
Europe 1,990 1,581 26% 150 94 60% 7.5% 6.0%
Latin America 774 516 50% 107 65 65% 13.8% 12.6%
Asia/Pacific 679 504 35% 85 64 33% 12.5% 12.7%
Eliminations (730) (507)
------ ------ ------ ----
$9,817 $8,061 22% $1,153* $797* 45% 11.7% 9.9%
====== ====== ====== ====
* A reconciliation of operating profit to net income is included in "Business
Segment Information" in the Notes to the Consolidated Financial Statements.
Growth in sales in the United States was due to higher sales in Electrical,
largely the result of the acquisition of Powerware in June 2004; sharply higher
sales in Truck due to rapid growth in many of Truck's markets; and, to a lesser
extent, increased sales in Fluid Power and Automotive. The increase in operating
profit in the United States was primarily the result of strong sales in Truck,
the acquisition of Powerware, the benefits of restructuring actions taken in
recent years, and integration of recently acquired businesses. In Canada, growth
in sales and operating profit were due to the acquisition of Powerware and
improved results in other Electrical businesses. Sales growth in Europe was due
to higher sales in Electrical, largely the result of the acquisition of
Powerware; growth in Fluid Power, Automotive and Truck; and from foreign
exchange rates. Higher operating profit in Europe was the result of increased
sales and the benefits of restructuring actions taken in recent years that were
reflected in improved returns in each of the Company's four business segments.
Growth in sales and operating profit in Latin America were due to sharply higher
sales in Truck, the acquisition of Powerware adding sales in Electrical, and to
a lesser extent sales growth in Fluid Power and Automotive. The growth in sales
in Asia/Pacific was due to the acquisition of Powerware and the strong
performance of Fluid Power and Truck. The increase in operating profit in
F-43
Asia/Pacific primarily related to the acquisition of Powerware and improved
results of Fluid Power.
In 2004, Eaton incurred restructuring charges related primarily to the
integration of: Powerware, the electrical power systems business acquired in
June 2004; the electrical division of Delta plc, acquired in January 2003; and
the Boston Weatherhead fluid power business, acquired in November 2002. In 2003,
restructuring charges related primarily to the integration of the electrical
division of Delta plc and the Boston Weatherhead fluid power business. A summary
of these charges follows:
2004 2003
---- ----
Fluid Power $ 8 $ 14
Electrical 33 22
---- ----
41 36
Corporate 1
---- ----
Pretax charges $ 41 $ 37
==== ====
After-tax charges $ 27 $ 24
Per Common Share $.17 $.16
Restructuring charges in 2004 included $22 for the United States, $18 for Europe
and $1 for Asia/Pacific. Restructuring charges in 2003 included $23 for the
United States, $11 for Europe and $3 for Asia/Pacific. The restructuring 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 2004 was reduced by $31 ($20 after-tax, or $.13 per Common
Share) compared to 2003 due to increased pension and other postretirement
benefit expense in 2004. This resulted from the decline over the last several
years in the market value of equity investments held by Eaton's pension plans,
coupled with the effect of the lowering of discount rates associated with
pension and other postretirement benefit liabilities at year-end 2003. These
increased costs were partially offset by the effect of the Medicare Prescription
Drug, Improvement, and Modernization Act of 2003, as further explained in
"Retirement Benefit Plans" in the Notes to the Consolidated Financial
Statements.
In December 2004, Eaton announced that it would exit its legacy tire and
refrigeration valve manufacturing business within the next year. The Company
incurred charges of $15 ($10 after-tax, or $.06 per Common Share) principally
for the write-down of fixed assets and workforce reductions. This business is in
the Automotive segment. In the Statements of Consolidated Income and Business
Segment Information, these charges were reported as a separate line item.
In 2004, a charge of $13 was recorded for a contribution to the Eaton Charitable
Fund ($8 after-tax, or $.05 per Common Share). In the Statements of Consolidated
Income, the charge was included in Other (income) expense-net. In Business
F-44
Segment Information, the charge was included in Other corporate expense-net.
The effective income tax rate for 2004 was 17.0% compared to 24.0% in 2003. The
lower rate in 2004 was primarily due to an income tax benefit of $30 resulting
from the favorable resolution of multiple international and U.S. income tax
items in fourth quarter 2004, higher earnings in international tax jurisdictions
with lower income tax rates, increased use of foreign tax credit carryforwards,
and implementation of international tax planning initiatives. The change in the
effective income tax rate in 2004 compared to 2003 is further explained in
"Income Taxes" in the Notes to the Consolidated Financial Statements.
RESULTS BY BUSINESS SEGMENT
- ---------------------------
Fluid Power
- -----------
2004 2003 Increase
------ ------ --------
Net sales $3,098 $2,786 11%
Operating profit 338 247 37%
Operating margin 10.9% 8.9%
Sales of the Fluid Power segment were at record levels in 2004. The majority of
sales growth in 2004 resulted from the strong performance of mobile and
industrial hydraulics markets. The commercial aerospace market also began to
recover in 2004, growing in the fourth quarter at its fastest rate in over two
years. The 11% increase in sales includes 3% due to foreign exchange rates and
reflects the growth in Fluid Power's markets of 8% over 2003, with global
hydraulics markets up an estimated 13%, commercial aerospace markets up 3%,
defense aerospace markets up 7%, and European automotive production up 1%.
Operating results for 2004 included Walterscheid from the date of acquisition,
as discussed in "Highlights of Results for 2004" above, with less than 1% of the
increase in sales attributed to this acquisition in 2004.
Operating profit in 2004 was also a record. Higher operating profit in 2004 was
largely due to sales growth, the benefits of restructuring actions to integrate
acquired businesses, and continued productivity improvements, partially offset
by higher prices paid primarily for basic metals. Restructuring charges in 2004
were $8 compared to $14 in 2003, reducing operating margins by .3% in 2004 and
..5% in 2003. The restructuring charges in 2004 and 2003 related primarily to the
integration of the Boston Weatherhead business acquired in late 2002.
In January 2004, Eaton acquired Ultronics Limited with its advanced
electro-hydraulic valve system technology that is utilized in mobile
applications in construction, forestry, agriculture and other markets. In early
2004, Eaton invested in Eaton Senstar Automotive Fluid Connector (Shanghai) Co.,
Ltd. This business, 55%-owned by Eaton, was formed with Changzhou Senstar
Automobile Air Conditioner Co. Ltd. to produce automotive air conditioning hose
and tube assemblies and power steering hose and tube assemblies in Shanghai for
Volkswagen's China operations. The purchase prices and annual sales of these
businesses were immaterial in 2004.
F-45
In November 2004, Eaton announced that it signed an agreement to purchase the
businesses of Winner Group Holdings Ltd., a China-based company which is the
largest manufacturer of hydraulic hose fittings and adapters in China. This
business had sales in 2003 of $28. The purchase is expected to be completed in
late first quarter 2005.
In November 2004, Eaton announced that its aerospace business began work with
Lockheed Martin to increase the Company's role on the F-35 Joint Strike Fighter
by expanding its scope of work on the wing fluid delivery system. The expanded
wing fluid delivery work and increased technical assistance will increase
Eaton's potential revenue on the F-35 by $1 billion, based on production of
2,600 aircraft over the life of the program, which is expected to continue
through 2027. The $1 billion increase brings the expected Joint Strike Fighter
related revenue over the life of the program to almost $3 billion, including the
hydraulic power generation system, general actuation and the expanded wing fluid
delivery system work.
Electrical
- ----------
2004 2003 Increase
------ ------ --------
Net sales $3,072 $2,313 33%
Operating profit 243 158 54%
Operating margin 7.9% 6.8%
Sales of the Electrical segment in 2004 reached record levels. Of the 33% sales
growth, 24% was from acquisitions, including Powerware acquired in June 2004, as
discussed in "Highlights of Results for 2004" above, and Electrum Group acquired
in March 2004, as discussed below. Sales for the full year of 2004 from the
electrical division of Delta plc acquired in January 2003, and the business
formed with Caterpillar in August 2003, also contributed to this growth from
acquisitions. Eaton's operating results for 2004 include the results of acquired
businesses from the dates of acquisition. End markets for the electrical
business grew about 4% during 2004 with sales above end-market growth
contributing an additional 3% to growth. Sales in 2004 improved by 2% due to
foreign exchange rates.
Increased operating profit in 2004 was largely due to growth in sales, the
benefits of restructuring actions to integrate acquired businesses, and
continued productivity improvements, partially offset by higher prices paid
primarily for basic metals. These improvements were partially offset by
increased restructuring charges in 2004. Restructuring charges in 2004 were $33
compared to $22 in 2003, reducing operating margins by 1.1% in 2004 and 1.0% in
2003. Restructuring charges in 2004 related primarily to the integration of
Powerware and the electrical division of Delta plc acquired in January 2003.
Restructuring charges in 2003 related largely to the integration of the
electrical division of Delta plc.
In March 2004, Eaton acquired the Electrum Group Ltd. which provides power
management services and web-based software for telecommunications, data center
and government applications. The net sales and purchase price of this company
were immaterial.
F-46
During second quarter 2004, the Electrical business was awarded a contract from
the U.S. Postal Service to test and maintain electrical switchgear, which is
anticipated to generate between $12 and $15 of revenue annually over the next
four years, and a contract worth $10 to supply distribution and control
equipment for a new power plant being constructed by Hitachi.
Automotive
- ----------
2004 2003 Increase
------ ------ --------
Net sales $1,847 $1,690 9%
Operating profit 243 224 8%
Operating margin 13.2% 13.3%
Sales in the Automotive segment reached a new record in 2004, above the record
set in 2003, by growing 9%. The growth in Automotive's sales considerably
exceeded its end markets throughout the year. Automotive production for 2004 in
NAFTA was lower by 1% and in Europe increased 1% compared to 2003. Growth above
2003 was attributable to new program launches and new contract wins. Sales in
2004 also improved by 3% due to foreign exchange rates.
Increased operating profit in 2004 was the result of increased sales and
productivity improvements, partially offset by higher prices paid primarily for
basic metals.
In first quarter 2004, Eaton won contracts to supply locking differentials to
Hyundai and Kia for several new vehicle programs. Revenues from these contracts
are expected to total approximately $150 over the next six years.
Truck
- -----
2004 2003 Increase
------ ------ --------
Net sales $1,800 $1,272 42%
Operating profit 329 168 96%
Operating margin 18.3% 13.2%
The Truck segment posted record sales in 2004, with revenues up 42% compared to
2003. This was attributable to end-market growth, primarily NAFTA heavy-duty
truck production of 263,000 units, an increase of 48% compared to 2003. NAFTA
medium-duty truck production increased 24% in 2004 compared to 2003, European
truck production increased 7%, and Brazilian vehicle production increased 20%.
Operating profit and operating margin in 2004 were also records. Increased
operating profit in 2004 reflected increased sales throughout all geographic
regions, as well as productivity improvements, partially offset by higher prices
paid primarily for basic metals.
Eaton made significant progress during 2004 on both of its recently announced
new truck businesses in China. The joint venture with FAW Jiefang Automotive
Co., Ltd. formally started production in September 2004 with Eaton contributing
F-47
$28 of cash to purchase a 50% interest in the venture, as described in
"Highlights of Results for 2004" above. Operating results of this venture were
immaterial in 2004.
In addition, the Company started production in the Eaton Fast Gear (EFG)
heavy-duty truck transmission business in fourth quarter 2004. The formation of
EFG was announced in third quarter 2003. Eaton's partners in EFG are Shaanxi
Fast Gear Co., Ltd. and Xiang Torch Investment Co., Ltd. This business will
produce transmissions for the growing Chinese market. Eaton has 55% ownership of
the business. The purchase price and annual sales of this company were
immaterial in 2004.
On March 1, 2005, Eaton acquired Pigozzi S.A. Engrenagens e Transmissoes, an
agricultural powertrain business located in Caxias do Sul, Brazil. Pigozzi
produces agricultural powertrain products, including transmissions, rotors and
other drivetrain components, for tractors and harvesters. The business had 2004
sales of approximately $42. The purchase price for the business was $29.
Corporate
- ---------
Net interest expense of $78 in 2004 fell by $9 from $87 in 2003. The decrease
largely related to the $180 net reduction in total debt from the end of 2003 to
the end of 2004, offset by a slight increase in floating interest rates in 2004.
Pension and other postretirement benefit expense included in corporate increased
to $75 in 2004 from $52 in 2003. The increase primarily resulted from the
decline over the last several years in the market value of equity investments
held by Eaton's pension plans, coupled with the effect of the lower discount
rates used in determining pension and other postretirement benefit liabilities
at year-end 2003. These increased costs were partially offset by the effect of
the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, as
further explained in "Retirement Benefit Plans" in the Notes to the Consolidated
Financial Statements.
In December 2004, Eaton announced that it would exit its legacy tire and
refrigeration valve manufacturing business within the next year. The Company
incurred charges of $15 principally for the write-down of fixed assets and
workforce reductions.
Other corporate expense-net in 2004 was $172 compared to $117 for 2003. The
increase was largely attributable to a charge of $13 for contributions to the
Eaton Charitable Fund, foreign exchange expense, and higher corporate
administrative costs, as well as favorable legal settlements in 2003.
CHANGES IN FINANCIAL CONDITION DURING 2004
- ------------------------------------------
Throughout 2004, Eaton maintained a focus on strengthening the balance sheet.
Net working capital of $920 at the end of 2004 was down $47 from $967 at
year-end 2003, in spite of the increase in working capital due to the
acquisitions of Powerware and other businesses. The current ratio was 1.4 at
both year-ends. The decrease in net working capital was largely due to the
reduction in cash and short-term investments from $865 at the end of 2003 to
$296 at the end of 2004. The reduction of cash and short-term investments
F-48
reflected the use of $627 to finance the acquisitions of Powerware and other
businesses, the repurchase of 4.2 million Common Shares at a total cost of $250,
a $75 contribution to the Company's United States qualified pension plans, and a
net repayment of debt of $206. These uses of cash and short-term investments
were offset by increased working capital due to business acquisitions, higher
accounts receivable resulting from increased sales in 2004, and strong cash flow
from operating activities in 2004. Inventory days on hand at the end of 2004
increased to 46 days compared to 43 days at year-end 2003, since the Company
purchased additional inventory to guard against basic metals shortages and, for
Truck operations, in anticipation of continued strong market demand in early
2005. Accounts receivable days outstanding increased to 55 days at the end of
2004 compared to 51 days at year-end 2003, due in part to the acquisition of
Powerware and significantly higher sales in fourth quarter 2004.
As a result of higher net income in 2004, cash generated from operating
activities of $838 continued to be strong, but was slightly lower than $874 in
2003, principally due to a $75 contribution to the Company's United States
qualified pension plans. Operating cash flow less capital expenditures (free
cash flow) was $508 in 2004, down from $601 in 2003, reflecting the $75
contribution to the United States qualified pension plans and $57 of higher
capital expenditures in 2004. Expenditures for property, plant and equipment
were $330 in 2004 compared to $273 in 2003. Capital expenditures for 2005 are
forecasted to be between $375 and $425.
Total debt of $1,773 at the end of 2004 was reduced by $180 from $1,953 at
year-end 2003, due to a net repayment of debt totaling $206, partially offset by
a $22 increase in long-term debt denominated in foreign currencies due to
movement of foreign exchange rates in 2004. Shareholders' equity of $3,606 at
the end of 2004 was a new record, rising $489 from $3,117 at year-end 2003. The
net-debt-to-total-capital ratio was 29.1%, below the Company's target of 35 to
40%. In March 2004, Eaton entered into a new $50 long-term revolving credit
facility which will expire in May 2008. Eaton has long-term revolving credit
facilities of $700, of which $400 expire in April 2005 and $300 expire in May
2008.
On January 28, 2005, Eaton issued $75 of 5.45% Senior Debentures, which mature
in 2034. This transaction brings the total amount of outstanding 5.45% Senior
Debentures due in 2034 to $150 and will form a single series with the $75 of
5.45% Senior Debentures due in 2034 issued on October 21, 2004. The Company used
the proceeds for general corporate purposes.
OUTLOOK FOR 2005
- ----------------
As Eaton surveyed its end markets in January 2005, it anticipated growth of
approximately 5% for full year 2005. The Company expects to outgrow its end
markets by about 50%, as it did in 2004, and also to record additional growth
from the full-year impact of the Powerware and Walterscheid acquisitions, the
ramp up of the Eaton Fast Gear heavy-duty truck transmission business in China,
and the acquisitions of Pigozzi S.A. and Winner Hydraulics, which is expected to
close late in the first quarter. As a result, Eaton anticipates overall growth
in sales in the range of 12 to 14% in 2005. The Company's guidance for net
income per Common Share for the full year of 2005 is $4.90 to $5.10, after
restructuring charges of $.20 per share. For the first quarter of 2005, Eaton
anticipates net income per share to be $1.10 to $1.20, after restructuring
charges of $.05 per share.
F-49
In Fluid Power, Eaton anticipates that growth in the mobile equipment markets
will continue in 2005, although at more modest levels than in 2004, while growth
in the industrial markets will accelerate. The commercial aerospace market grew
in the fourth quarter of 2004 at its fastest rate in over two years and the
Company believes growth in commercial aerospace is likely to improve further in
2005. Electrical's end markets grew 4% in 2004, and Eaton expects these markets
to grow at about the same rate in 2005. In Automotive, the Company anticipates
slightly weaker markets for both NAFTA and European automotive production in
2005 than in 2004. For Truck, the Company believes demand will remain strong
throughout 2005. For all of 2005, Eaton believes that the NAFTA heavy-duty truck
market is likely to total 310,000 units.
FORWARD-LOOKING STATEMENTS
- --------------------------
This Annual Report to Shareholders contains forward-looking statements
concerning Eaton's first quarter 2005 and full year 2005 net income per share,
worldwide markets, growth in relation to end markets, the anticipated closing of
a new acquisition, growth from acquisitions of businesses and joint ventures,
results of newly awarded contracts, and the repurchase of Common Shares. 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; failure to close, or delay in the closing of, acquisitions;
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 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.
F-50
Revenue Recognition
- -------------------
Substantially all revenues are recognized when products are shipped to
unaffiliated customers and title has transferred. Other revenues for service
contracts are recognized as the service is provided.
Impairment of 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, intangible and other long-lived assets are reviewed for
impairment whenever events or changes in circumstances indicate the carrying
amount may not be recoverable. Goodwill and other intangible assets totaled $3.1
billion at the end of 2004 and represented 34% of total assets. These assets
resulted primarily from the $1.1 billion acquisition of the electrical
distribution and controls business unit of Westinghouse in 1994, and the $1.6
billion acquisition of Aeroquip-Vickers in 1999. 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. These
businesses have a long history of operating success and profitability and hold
leading market positions in the majority of their product lines. Their products
are not subject to rapid technological or functional obsolescence. This, coupled
with continuous strong product demand support the book values of the goodwill
and intangible assets related to these businesses.
Deferred 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 other postretirement health care liabilities
will be paid. Management believes there is a low probability of the realization
of deferred tax assets related to tax loss carryforwards at certain
international operations and United States state and local income tax loss
carryforwards. Therefore, a valuation allowance of $132 has been recognized for
the full value of these deferred tax assets.
On October 22, 2004, the American Jobs Creation Act of 2004 (the Act) was signed
into law. The Act provides for a special one-time tax deduction of 85% of
certain foreign earnings that are repatriated (as defined in the Act) in 2005.
Eaton has not fully evaluated the effects of the repatriation provision and
therefore has not determined if the Act will materially change its foreign
earnings reinvestment plan. A full evaluation of the plan is expected to be
complete by June 30, 2005.
F-51
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 unamortized pension losses, which
ultimately affects net income.
At the end of 2002, 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 9.85% to 8.71% and the discount rate
from 6.56% to 6.53%. At the end of 2003, the assumed return on pension plan
assets was lowered to 8.50% and the discount rate was lowered to 6.11%. The
changes in these assumptions, coupled with the effect of the decline over the
last several years in the market value of equity investments held by Eaton's
pension plans, resulted in increased pretax expense of $63 in 2003 compared to
2002 and increased pretax expense of $31 in 2004 compared to 2003. At the end of
2004, the assumed return on pension plan assets was lowered to 8.41% and the
discount rate was lowered to 5.81%. These changes are expected to result in
increased pension and other postretirement benefit expense of approximately $60
in 2005 over 2004.
Certain key assumptions related to the measurement of pension and other
postretirement benefits were adjusted in 2004 to reflect current economic
conditions. Changes in key assumptions reflected the continued reduction in the
interest rates and an increase in the medical trend assumption in accordance
with Eaton's estimates of future medical costs. A 1-percentage point change in
the assumed rate of return on pension plan assets is estimated to have
approximately a $20 effect on pension expense. Likewise, a 1-percentage point
change in the discount rate is estimated to have approximately a $36 effect on
pension expense. 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.
Protection of the Environment
- -----------------------------
Eaton's operations involve the use and disposal of certain substances regulated
under environmental protection laws. On an ongoing, regular basis, certain
processes continue to be modified in order to reduce the impact on the
environment, including the reduction or elimination of certain chemicals used
in, and wastes generated from, operations. Liabilities related to environmental
matters are further discussed in "Protection of the Environment" in the Notes to
the Consolidated Financial Statements.
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.
F-52
Stock Options Granted to Employees & Directors
- ----------------------------------------------
In December 2004, Statement of Financial Accounting Standards (SFAS) No. 123(R),
"Share-Based Payment" was issued by the Financial Accounting Standards Board.
The Statement eliminates the alternative to use the intrinsic-value-method of
accounting that was provided in SFAS No. 123 as originally issued. The amended
Statement requires entities to recognize the cost of employee and director
services received in exchange for stock options based on the grant date fair
value of those awards, with limited exceptions. That cost will be recognized
over the period during which an employee or director is required to provide
service in exchange for the award. Eaton will begin recognizing expenses related
to stock options in third quarter 2005. As described in "Shareholders' Equity"
in the Notes to the Consolidated Financial Statements, if the Company had
accounted for stock options under the fair-value-based method of expense
recognition in SFAS No. 123, net income per Common Share assuming dilution would
have been reduced by $.08 in 2004, $.08 in 2003 and $.10 in 2002. The Company
estimates that the adoption of SFAS No. 123(R) will reduce net income per Common
Share assuming dilution in the second half of 2005 by $.06.
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, 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 $3.
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, 2004, the market value of the
F-53
Company's debt and interest rate swap portfolio, in aggregate, would increase
by $175.
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 $333 at December 31,
2004. 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, 2004, the aggregate balance
of such contracts was $120. 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 2004.
Other than the above noted debt and financial derivative arrangements, there
were no material derivative instrument transactions in place or undertaken
during 2004.
A summary of contractual obligations as of December 31, 2004 follows:
Payments due by period
------------------------------------
2006 2008
to to After
2005 2007 2009 2009 Total
---- ---- ---- ------ ------
Long-term debt $ 26 $568 $ 19 $1,147 $1,760
Operating leases 97 122 53 33 305
Purchase obligations 298 53 33 15 399
Other long-term liabilities 105 23 23 32 183
---- ---- ---- ------ ------
$526 $766 $128 $1,227 $2,647
==== ==== ==== ====== ======
Long-term debt includes obligations under capital leases that are not material.
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 $95 of contributions to pension plans in 2005 and $88 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
found in "Retirement Benefit Plans" in the Notes to the Consolidated Financial
Statements.
F-54
RESULTS OF OPERATIONS - 2003 COMPARED TO 2002
- ---------------------------------------------
2003 2002 Increase
------ ------ --------
Net sales $8,061 $7,209 12%
Operating profit 797 651 22%
Operating margin 9.9% 9.0%
Net income 386 281 37%
Net income per Common Share
assuming dilution $ 2.56 $ 1.96 31%
Sales for 2003 rose to $8,061, 12% over 2002. Sales growth of 12% in 2003
consisted of 6% from recent business acquisitions, net of the effect of the sale
of Navy Controls in July 2002, 3% from higher foreign exchange rates, and 3%
from organic growth. Eaton outperformed its end markets, as the Company
estimated that its overall end markets declined 2% in 2003 compared to 2002.
Growth reflected increased sales resulting from acquisitions of businesses,
which added approximately $500 of sales in 2003.
Increased operating profit in 2003 was primarily due to higher sales, the
benefits of restructuring actions taken in recent years and lower restructuring
charges in 2003. Operating margins were reduced due to restructuring charges by
..4% in 2003 and .8% in 2002. The operating results of each business segment are
further discussed below, under "Results by Business Segment".
The increase in net income was primarily due to higher sales in 2003 and the
benefits of restructuring actions taken in 2003 and prior years.
RESULTS BY GEOGRAPHIC REGION
- ----------------------------
Operating
Net sales Operating profit margin
-------------------------- ----------------------- -----------
2003 2002 Increase 2003 2002 Increase 2003 2002
------ ------ -------- ---- ----- -------- ---- ----
United States $5,758 $5,605 3% $546 $483 13% 9.5% 8.6%
Canada 209 185 13% 28 15 87% 13.4% 8.1%
Europe 1,581 1,110 42% 94 65 45% 6.0% 5.9%
Latin America 516 403 28% 65 45 44% 12.6% 11.2%
Asia/Pacific 504 358 41% 64 43 49% 12.7% 12.0%
Eliminations (507) (452)
------ ------ ---- ----
$8,061 $7,209 12% $797* $651* 22% 9.9% 9.0%
====== ====== ==== ====
* A reconciliation of operating profit to net income is included in "Business
Segment Information" in the Notes to the Consolidated Financial Statements.
Sales in the United States rose primarily due to the acquisition of the Boston
Weatherhead fluid power business in fourth quarter 2002, partially offset by the
sale of the Navy Controls business in second half 2002. Higher operating profit
F-55
in the United States primarily resulted from increased sales, the benefits of
restructuring actions taken in recent years, lower restructuring charges in
2003, and modest profits from the Boston Weatherhead fluid power business
acquired in late 2002. In Canada, the growth in sales and operating profit were
substantially related to foreign exchange rates and the strong performance of
Electrical. Sales in Europe rose primarily due to the acquisition of the Delta
electrical business, the improved performance of Eaton's other business
segments, and foreign exchange rates. Higher operating profit in Europe
primarily resulted from increased sales and the benefits of restructuring
actions taken in recent years. The growth in sales and operating profit in Latin
America was primarily due to recent wins by Fluid Power of new
automotive-related production contracts and the strong performance of Truck.
Sales and operating profit rose in Asia/Pacific due to the acquisition of the
Delta electrical business and the strong performance of all of the Company's
business segments.
As a result of actions taken in 2003 and earlier years to restructure operations
and integrate acquired businesses, Eaton incurred restructuring charges in 2003
of $.16 per Common Share, compared to similar charges in 2002 of $.29 per share.
The Company's results in 2003 were aided by the results of these actions, which
delivered an additional $26 of savings in 2003 that were over and above $130 of
savings delivered in 2002. Additionally, $15 in synergies were achieved through
integration of acquired businesses. These savings, coupled with higher sales in
2003, lower net interest expense and a reduction in the effective income tax
rate, helped the Company to post significantly higher net income. These
increases in net income were partially offset by additional pension expense and
other postretirement benefit expense in 2003, which reduced net income by $.27
per share compared to 2002. The Company reported no gains on the sales of
businesses in 2003 compared to a gain of $.09 per share in 2002. The sale of 7.4
million shares in June 2003 reduced net income per share by approximately $.06
in 2003.
In 2003, Eaton incurred restructuring charges related to the integration of the
electrical division of Delta plc, acquired in January 2003 and the Boston
Weatherhead fluid power business, acquired in November 2002. In 2002, the
Company incurred restructuring charges to reduce operating costs across its
business segments and certain corporate functions. The charges in 2002 were
primarily a continuation of restructuring programs initiated in 2001. A summary
of these charges follows:
2003 2002
---- ----
Fluid Power $ 14 $ 26
Electrical 22 16
Automotive 1
Truck 16
---- ----
36 59
Corporate 1 3
---- ----
Pretax charges $ 37 $ 62
==== ====
After-tax charges $ 24 $ 41
Per Common Share $.16 $.29
F-56
Restructuring charges in 2003 included $23 for the United States, $11 for Europe
and $3 for Asia/Pacific. Restructuring charges in 2002 included $52 for the
United States and $10 for Europe. The restructuring 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 2003 was reduced by $63 ($41 after-tax, or $.27 per Common
Share) compared to 2002 due to increased pension and other postretirement
benefit expense in 2003. This resulted from the decline over the last several
years in the market value of equity investments held by Eaton's pension plans,
coupled with the effect of the lowering of discount rates associated with
pension and other postretirement benefit liabilities at year-end 2002.
In July 2002, the Navy Controls business was sold resulting in a pretax gain of
$18 ($13 after-tax, or $.09 per Common Share). The net gain was reported as a
separate line item in the Statements of Consolidated Income and Business Segment
Information.
The change of $37 in Other (income) expense-net for 2003 compared to 2002 was
primarily due to a gain of $3 in foreign exchange in 2003 versus a loss of $8 in
2002, a charge of $10 in 2002 for the contribution to the Eaton Charitable Fund,
and various other items including $11 of reduced legal expenses and favorable
legal settlements in 2003. The charge of $10 for the contribution to the Eaton
Charitable Fund ($6 after-tax, or $.04 per Common Share) was recorded in the
third quarter of 2002.
The effective income tax rate for 2003 was 24.0% compared to 29.5% for 2002. The
lower rate in 2003 reflects many factors, including higher earnings in
international tax jurisdictions with lower income tax rates and increased use of
international tax credit carryforwards. The change in the effective income tax
rates in 2003 compared to 2002 is further explained in "Income Taxes" in the
Notes to the Consolidated Financial Statements.
RESULTS BY BUSINESS SEGMENT
- ---------------------------
Fluid Power
- -----------
2003 2002 Increase
------ ------ --------
Net sales $2,786 $2,456 13%
Operating profit 247 187 32%
Operating margin 8.9% 7.6%
Sales for Fluid Power, Eaton's largest business segment, were a new record.
Sales increased by 13% with 6% from business acquisitions, 4% from foreign
exchange rates and 3% from existing product lines. This compares to a decline of
2% in Fluid Power's markets, with North American fluid power industry shipments
down 3%, commercial aerospace markets off 12%, and defense aerospace markets up
by 13%. The traditional mobile and industrial hydraulics markets began to
recover in fourth quarter 2003, reflecting the pickup in capital goods
expenditures.
F-57
In 2003, Fluid Power's results were positively impacted by the full year results
of two businesses acquired late in 2002. The Boston Weatherhead fluid power
business was purchased in the fourth quarter of 2002. This business, which had
2002 sales of $211, manufactures hose, tubing, and fluid connectors for fluid
power systems primarily for the industrial distribution, mobile off-highway and
heavy-duty truck markets. In addition, the aerospace circuit breaker business of
Mechanical Products was purchased during that same quarter. This business had
annual sales of $12 in 2001.
Operating profit in 2003 was a new record and increased primarily due to higher
sales in 2003, the benefits of restructuring actions taken in recent years to
resize this business, and reduced restructuring charges in 2003. Restructuring
charges in 2003, which primarily related to the acquisition of the Boston
Weatherhead business, were $14 compared to $26 in 2002. Restructuring charges
reduced operating margins by .5% in 2003 and 1.1% in 2002.
Electrical
- ----------
2003 2002 Increase
------ ------ --------
Net sales $2,313 $1,993 16%
Operating profit 158 149 6%
Operating margin 6.8% 7.5%
In Electrical, sales growth in 2003 was primarily the result of business
acquisitions. Sales increased by 15% due to the acquisitions in January 2003 of
the electrical division of Delta plc and the power systems business of
Commonwealth Sprague Capacitor, as well as the new business formed with
Caterpillar Inc. in August 2003, net of the effect of the sale of the Navy
Controls business in July 2002. Sales in 2003 were up 1% from organic growth.
End markets for the electrical business remained weak during 2003, with an
estimated 2% decline in the markets for this business compared to 2002.
In 2003, Electrical added three key businesses. On January 31st, the electrical
division of Delta plc was acquired. This business, which had sales of $326 in
2002, includes major electrical brands such as MEM(R), Holec(TM), Bill(TM), Home
Automation(TM), Elek(TM) and Tabula(TM). The Delta business represents a
significant addition to the capabilities and geographic footprint of Electrical.
Also, in January the power systems business of Commonwealth Sprague Capacitor,
which had annual sales of $6 in 2002, was acquired. In August, a new business
was formed with Caterpillar Inc. to provide switchgear products under the Cat(R)
brand name. The business operates under the name Intelligent Switchgear
Organization LLC and is 51%-owned by Eaton.
Increased operating profit in 2003 was primarily due to the benefits of
restructuring actions taken in recent years to resize this business, partially
offset by increased restructuring charges in 2003. Restructuring charges in
2003, which related to the acquisition of the Delta electrical division, were
$22 compared to $16 in 2002. Restructuring charges reduced operating margins by
1.0% in 2003 and .8% in 2002. The profitability of the base electrical business
improved significantly during 2003, as operating margins for this business in
the second half of 2003 were 7.6%, after reflecting a 1.3% reduction due to the
acquisition of the Delta electrical division and the new business with
F-58
Caterpillar Inc., and a 1.2% reduction due to restructuring charges.
Automotive
- ----------
2003 2002 Increase
------ ------ --------
Net sales $1,690 $1,594 6%
Operating profit 224 225 --
Operating margin 13.3% 14.1%
Sales in Automotive were a new record and considerably outpaced its end markets
in 2003. The increase in sales reflected several new program launches, the
continued strong performance of the North American and European automobile
markets and higher foreign exchange rates. NAFTA light vehicle production
declined 3% to 15.9 million units in 2003 and European production declined 1% to
16.3 million units, compared to 2002.
Operating margin in 2003 was lower than 2002 primarily due to increased costs
related to new product launches and several facility relocations.
Truck
- -----
2003 2002 Increase
------ ------ --------
Net sales $1,272 $1,166 9%
Operating profit 168 90 87%
Operating margin 13.2% 7.7%
Sales growth of Truck reflected higher sales in Latin America, Asia/Pacific and
in the aftermarket in North America. NAFTA heavy-duty production was down 2% in
2003 to 177,000 units compared to 2002, and NAFTA medium-duty production was
flat. European medium-duty production was down 7% and Brazilian vehicle
production was flat.
Increased operating profit in 2003 was primarily due to increased sales in 2003
and the benefits of restructuring actions taken in recent years to resize this
business. No restructuring charges were incurred in 2003 compared to $16 in
2002. Operating profit in 2002 was reduced by 1.4% due to restructuring charges.
Corporate
- ---------
Net interest expense of $87 in 2003 fell by $17 from $104 in 2002. The decrease
was primarily related to the reduction in debt of $487 from the end of 2001 to
the end of 2003, the conversion of fixed rate debt to floating rate debt through
interest rate swaps, and a slight reduction of floating interest rates in 2003.
Pension and other postretirement benefit expense included in corporate increased
by $52 in 2003. This primarily resulted from the decline over the last several
years in the market value of equity investments held by Eaton's pension plans,
coupled with the effect of the lowering of discount rates associated with
F-59
pension and other postretirement benefit liabilities at year-end 2002.
Corporate expense-net in 2003 was $117 compared to $129 for 2002. The decrease
was primarily the result of various items including $11 of reduced legal
expenses and favorable legal settlements in 2003.
F-60
QUARTERLY DATA
- --------------
(Unaudited)
Quarter ended in 2004 Quarter ended in 2003
-------------------------------------- --------------------------------------
(Millions except for per share data) Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31
------- -------- ------- ------- ------- -------- ------- -------
Net sales $2,633 $2,543 $2,403 $2,238 $2,083 $2,026 $2,027 $1,925
Gross margin 734 707 677 617 578 547 529 510
Percent of net sales 28% 28% 28% 28% 28% 27% 26% 26%
Income before income taxes 194 211 203 173 145 142 122 99
Net income 183 170 161 134 114 107 93 72
Net income per Common Share
- ---------------------------
Assuming dilution $ 1.16 $ 1.09 $ 1.03 $ .85 $ .72 $ .69 $ .64 $ .50
Basic 1.19 1.12 1.06 .87 .74 .70 .64 .51
Cash dividends paid per Common Share $ .27 $ .27 $ .27 $ .27 $ .24 $ .24 $ .22 $ .22
Market price per Common Share
- -----------------------------
High $72.64 $65.88 $64.84 $62.13 $54.70 $47.72 $42.60 $40.50
Low 59.49 59.20 54.23 52.74 44.58 38.74 34.70 33.01
F-61
NINE-YEAR CONSOLIDATED FINANCIAL SUMMARY
- ----------------------------------------
(Millions except for per share data) 2004 2003 2002 2001 2000 1999 1998 1997 1996
------ ------ ------ ------ ------ ------ ------ ------ ------
Continuing operations
- ---------------------
Net sales $9,817 $8,061 $7,209 $7,299 $8,309 $8,005 $6,358 $7,104 $6,515
Income before income taxes 781 508 399 278 552 943 616 730 428
Income after income taxes 648 386 281 169 363 603 430 526 305
Percent of net sales 6.6% 4.8% 3.9% 2.3% 4.4% 7.5% 6.7% 7.4% 4.7%
Extraordinary item - redemption
of debentures (54)
Income (loss) from discontinued
operations 90 14 (81) (62) 44
------ ------ ------ ------ ------ ------ ------ ------ ------
Net income $ 648 $ 386 $ 281 $ 169 $ 453 $ 617 $ 349 $ 410 $ 349
====== ====== ====== ====== ====== ====== ====== ====== ======
Net income per Common Share
assuming dilution
- ---------------------------
Continuing operations $ 4.13 $ 2.56 $ 1.96 $ 1.20 $ 2.50 $ 4.08 $ 2.96 $ 3.36 $ 1.94
Extraordinary item (.35)
Discontinued operations .62 .10 (.56) (.39) .29
------ ------ ------ ------ ------ ------ ------ ------ ------
$ 4.13 $ 2.56 $ 1.96 $ 1.20 $ 3.12 $ 4.18 $ 2.40 $ 2.62 $ 2.23
====== ====== ====== ====== ====== ====== ====== ====== ======
Average number of Common Shares
outstanding assuming dilution 157.1 150.5 143.4 141.0 145.2 147.4 145.4 156.4 156.4
Net income per Common Share basic
- ---------------------------------
Continuing operations $ 4.24 $ 2.61 $ 1.99 $ 1.22 $ 2.53 $ 4.16 $ 3.01 $ 3.42 $ 1.96
Extraordinary item (.35)
Discontinued operations .63 .10 (.56) (.40) .29
------ ------ ------ ------ ------ ------ ------ ------ ------
$ 4.24 $ 2.61 $ 1.99 $ 1.22 $ 3.16 $ 4.26 $ 2.45 $ 2.67 $ 2.25
====== ====== ====== ====== ====== ====== ====== ====== ======
Average number of Common Shares
outstanding basic 153.1 147.9 141.2 138.8 143.6 145.0 142.8 153.6 154.8
Cash dividends paid per
Common Share $ 1.08 $ .92 $ .88 $ .88 $ .88 $ .88 $ .88 $ .86 $ .80
F-62
- ----------------------------------------------------------------------------------------------------------------------
Total assets $9,075 $8,223 $7,138 $7,646 $8,180 $8,342 $5,570 $5,497 $5,290
Long-term debt 1,734 1,651 1,887 2,252 2,447 1,915 1,191 1,272 1,062
Total debt 1,773 1,953 2,088 2,440 3,004 2,885 1,524 1,376 1,092
Shareholders' equity 3,606 3,117 2,302 2,475 2,410 2,624 2,057 2,071 2,160
Shareholders' equity per Common Share $23.52 $20.37 $16.30 $17.80 $17.64 $17.72 $14.34 $13.86 $14.00
Common Shares outstanding 153.3 153.0 141.2 139.0 136.6 148.0 143.4 149.4 154.2
- ----------------------------------------------------------------------------------------------------------------------
Common Shares outstanding and all per share data have been restated to give
effect to the two-for-one stock split effective February 23, 2004.
F-63
Eaton Corporation
2004 Annual Report on Form 10-K
Exhibit Index
Exhibits
3(a) Amended Articles of Incorporation (amended and restated as of April
27, 1994) - Incorporated by reference to the Form 10-K for the year
ended December 31, 2002
3(b) Amended Regulations (amended and restated as of April 26, 2000) -
Incorporated by reference to the Form 10-Q 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)
4(b) Rights Agreement (Dated as of June 28, 1995) - Incorporated by
reference to Registration Statement 333-74355 filed on March 12, 1999
10 Material contracts - Each of the following is either a management
contract or a compensatory plan or arrangement:
(a) Deferred Incentive Compensation Plan (amended and restated as of
March 31, 2000) - Incorporated by reference to the Form 10-K for
the year ended December 31, 2000
(b) Executive Strategic Incentive Plan I (Amended and Restated as of
January 1, 2001) - Incorporated by reference to the Form 10-K for
the year ended December 31, 2002
(c) Group Replacement Insurance Plan (GRIP), effective as of June 1,
1992 - Incorporated by reference to the Form 10-K for the year
ended December 31, 1992
(d) 1991 Stock Option Plan - Incorporated by reference to the Form
10-K for the year ended December 31, 2002
(e) 1995 Stock Plan - Incorporated by reference to the Form 10-K for
the year ended December 31, 2002
(f) Incentive Compensation Deferral Plan (amended and restated as of
October 1, 1997) - Incorporated by reference to the Form 10-K for
the year ended December 31, 2000
(g) Form of Change of Control Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
for the year ended December 31, 2002
(h) Form of Indemnification Agreement entered into with officers of
Eaton Corporation - Incorporated by reference to the Form 10-K
for the year ended December 31, 2002
(i) Limited Eaton Service Supplemental Retirement Income Plan
(amended and restated as of January 1, 2003) - Incorporated by
reference to the Form 10-K for the year ended December 31, 2002
(j) Supplemental Benefits Plan (amended and restated as of January 1,
1989) (which provides supplemental retirement benefits) -
Incorporated by reference to the Form 10-K for the year ended
December 31, 2002
(k) 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 for
the year ended December 31, 2002
(l) Executive Incentive Compensation Plan (Effective as of January 1,
2003) - Incorporated by reference to the Form 10-K for the year
ended December 31, 2003
(m) Plan for the Deferred Payment of Directors' Fees (Originally
adopted in 1985 and amended effective as of September 24, 1996,
January 28, 1998, January 23, 2002 and February 24, 2004) -
Incorporated by reference to the Form 10-Q for the three months
ended March 31, 2004
(n) Plan for the Deferred Payment of Directors' Fees (Originally
adopted in 1980 and amended and restated in 1989 and 1996) -
Incorporated by reference to the Form 10-K for the year ended
December 31, 2002
(o) 1996 Non-Employee Director Fee Deferral Plan (amended and
restated as of October 22, 2002) - Incorporated by reference to
the Form 10-K for the year ended December 31, 2002
(p) Trust Agreement - Outside Directors (dated December 6, 1996) -
Incorporated by reference to the Form 10-K for the year ended
December 31, 2002
(q) Trust Agreement - Officers and Employees (dated December 6, 1996)
- Incorporated by reference to the Form 10-K for the year ended
December 31, 2002
(r) 1998 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 13, 1998
(s) 2002 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 15, 2002
(t) Executive Strategic Incentive Plan II (Effective as of January 1,
2001) - Incorporated by reference to the Form 10-K for the year
ended December 31, 2002
(u) Vehicle Allowance Program (Effective as of January 1, 2003) -
Incorporated by reference to the Form 10-K for the year ended
December 31, 2003
(v) 2004 Stock Plan - Incorporated by reference to the definitive
Proxy Statement dated March 19, 2004
(w) 2005 Non-Employee Director Fee Deferral Plan (Effective January
1, 2005) - Filed in conjunction with this Form 10-K
(x) Deferred Incentive Compensation Plan II (Effective January 1,
2005) - Filed in conjunction with this Form 10-K
(y) Incentive Compensation Deferral Plan II (Effective January 1,
2005) - Filed in conjunction with this Form 10-K
(z) Supplemental Benefits Plan II (Effective January 1, 2005) - Filed
in conjunction with this Form 10-K
(aa) Excess Benefits Plan II (Effective January 1, 2005) - Filed in
conjunction with this Form 10-K
(bb) Limited Eaton Service Supplemental Retirement Income Plan II
(Effective January 1, 2005) - Filed in conjunction with this Form
10-K
(cc) Amendment to the Plan (originally adopted in 1985) for the
Deferred Payment of Directors' Fees (Effective January 1, 2005) -
Filed in conjunction with this Form 10-K
(dd) Form of Stock Option Agreement for Non-Employee Directors - Filed
in conjunction with this Form 10-K
(ee) Form of Stock Option Agreement for Executives - Filed in
conjunction with this Form 10-K
(ff) Form of Restricted Share Award Agreement - Filed in conjunction
with this Form 10-K
12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this
Form 10-K
14 Code of Ethics - Incorporated by reference to the definitive Proxy
Statement to be filed on or about March 18, 2005
21 Subsidiaries of Eaton Corporation - Filed in conjunction with this
Form 10-K
23 Consent of Independent Registered Public Accounting Firm - Filed in
conjunction with this Form 10-K
24 Power of Attorney - Filed in conjunction with this Form 10-K
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
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
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
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