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Why Eaton’s Aerospace Deal Is a Good Move

Reuben Gregg Brewer, The Motley Fool

Global industrial giant Eaton Corporation (NYSE: ETN) has finally completed the integration of Cooper Industries, its largest deal ever. And with that process behind it, the company has started to rework its portfolio again -- the biggest move to date is its plan to spin off its lighting business.

And it just announced a billion-dollar acquisition in the aerospace sector. Eaton is picky about what it buys. Here's why it decided to do this aerospace deal.

Not just any deal

During Eaton's second-quarter conference call, CEO Craig Arnold was asked about the acquisition environment. He explained:

I'd say, the pipeline today is much more robust than it's been historically. Certainly, much more robust than we've seen in the last 3 years to 5 years. And so we are certainly looking. I'd say, at more opportunities than we ever have. Having said that, I will also point out though, valuations in many cases are still quite elevated, and we're going to continue to be disciplined as we think about how we deploy our capital...

A man looking at industrial equipment

Image source: Getty Images

So for Eaton to pull the trigger on a deal is no small event. That's why its decision to buy the Souriau-Sunbank Connection Technologies business from TransDigm Group Incorporated for $920 million is noteworthy. The company clearly sees something worthwhile here, and it must be pretty material since Eaton was willing to pay 12 times trailing 12-month EBITDA to get the deal done -- the company normally looks for deals with EBITDA multiples in the mid-to-high single digits. So what's the attraction?

Hitting the sweet spot

The first and most obvious reason that Eaton likes the Souriau-Sunbank Connection Technologies deal is that most of the business serves the aerospace segment. Eaton's aerospace division makes up around 9% of overall revenue, but the company is looking to expand that in response to strong demand, noting that orders were up 15% on a rolling 12-month basis in the first quarter and that the company's backlog of work to be completed was up 17% year over year in the quarter. Those numbers are better than numbers from any of the company's other divisions right now. And equally important, the margins in the segment are higher than those of any of the others. This is the type of business that Eaton wants to see grow.

The size of the deal is also attractive. Souriau-Sunbank's revenue over the past year was roughly $363 million. Not all of that is directly tied to aerospace, so let's round that down to $300 million to make the math easier. Using the second-quarter revenue of $517 million as a run rate, Eaton's aerospace business generates about $2 billion a year. Adding this new business will grow the division's revenue by around 15%. That's a significant number.

Eaton 2Q Revenue and Margin Overview

 

Revenue (billions)

Operating Margin

Total Company

$5.533

17.9%

Electrical Products

$1.849

19.6%

Electrical Systems & Services

$1.582

17.4%

Hydraulics

$0.698

11.5%

Aerospace

$0.517

24.6%

Vehicle

$0.803

16.9%

eMobility

$0.084

8.3%

Data source: Eaton Corporation

The 12-times EBITDA valuation, meanwhile, is likely to come down over time as Eaton integrates and streamlines the new business. In fact, management believes that it can get the valuation down into the 7-to-8-times range. Eaton has a solid history of living up to its cost-cutting plans, so there's little reason to doubt that it can achieve this over time.

And, sort of icing on the cake, the portion of Souriau-Sunbank's revenue that isn't tied directly to aerospace is also an opportunity. Eaton expects these products to benefit materially from being integrated into its global distribution system. Thus even the "other stuff" in this deal should be a net benefit for the industrial giant.

More to come?

Eaton is a careful company, as the Souriau-Sunbank deal demonstrates. It is in the right business, is material in size, and was made at what should eventually be a good price, and even the products that don't fit well in aerospace should end up benefiting Eaton. Investors should be pleased.

That said, with so many assets for sale today, it's likely that Eaton will be doing some more bolt-on deals in the near future. So watch to see how this acquisition plays out, but expect more activity to come.

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Reuben Gregg Brewer owns shares of Eaton. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com