-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HCziGibUa2e6eczaTqcyXJ+ARJNOYqzW5tXupGeDiT6b2pToZ5shCQkFSRSC9d0i OZVz2VtYgX3CUAPH4OeGOg== 0000950152-09-001947.txt : 20090227 0000950152-09-001947.hdr.sgml : 20090227 20090227162332 ACCESSION NUMBER: 0000950152-09-001947 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 11 CONFORMED PERIOD OF REPORT: 20081231 FILED AS OF DATE: 20090227 DATE AS OF CHANGE: 20090227 FILER: COMPANY DATA: COMPANY CONFORMED NAME: EATON CORP CENTRAL INDEX KEY: 0000031277 STANDARD INDUSTRIAL CLASSIFICATION: MISC INDUSTRIAL & COMMERCIAL MACHINERY & EQUIPMENT [3590] IRS NUMBER: 340196300 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-01396 FILM NUMBER: 09643293 BUSINESS ADDRESS: STREET 1: EATON CTR STREET 2: 1111 SUPERIOR AVE CITY: CLEVELAND STATE: OH ZIP: 44114-2584 BUSINESS PHONE: 2165235000 MAIL ADDRESS: STREET 1: 1111 SUPERIOR AVENUE CITY: CLEVELAND STATE: OH ZIP: 44114 FORMER COMPANY: FORMER CONFORMED NAME: EATON YALE & TOWNE INC DATE OF NAME CHANGE: 19710822 10-K 1 l35588ae10vk.txt FORM 10-K 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, 2008 Commission file number 1-1396 EATON CORPORATION (Exact name of registrant as specified in its charter) Ohio 34-0196300 (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) Eaton Center Cleveland, Ohio 44114-2584 (Address of principal executive offices) (Zip code) (216) 523-5000 (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 Share ($.50 par value) The New York Stock Exchange The Chicago Stock Exchange
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. No [X] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past ninety days. Yes [X] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act (Check one): Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ ] (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). No [X] The aggregate market value of Common Stock held by non-affiliates of the registrant as of June 30, 2008 was $14.1 billion. As of January 31, 2009, there were 165.2 million Common Shares outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the 2009 annual shareholders meeting are incorporated by reference into Part III. Page 2 PART I ITEM 1. BUSINESS Eaton Corporation is a diversified power management company with 2008 sales of $15.4 billion. Eaton is a global technology leader in: electrical components and systems for power quality, distribution and control; hydraulics components, systems and services for industrial and mobile equipment; aerospace fuel, hydraulics and pneumatic systems for commercial and military use; and truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety. Eaton has approximately 75,000 employees and sells products to customers in more than 150 countries. For more information, visit www.eaton.com. Eaton electronically files or furnishes reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act) to the United States Securities and Exchange Commission (SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy and information statements, as well as any amendments to those reports. As soon as reasonably practicable, these reports are available free of charge through the Company's Internet web site at http://www.eaton.com. These filings are also accessible on the SEC's Internet web site at http://www.sec.gov. RECENT DEVELOPMENTS In 2008, Eaton acquired certain businesses and entered into a joint venture in separate transactions for combined net cash purchase prices of $2.807 billion. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition. A summary of these transactions follows:
Business Acquired business and joint venture Date of acquisition segment Annual sales - ------------------------------------------------------ ------------------- ---------- ---------------------- Integ Holding Limited October 2, Hydraulics $52 for 2007 A U.K.-based manufacturer of screw-in 2008 cartridge valves, custom-engineered hydraulic valves and manifold systems Nittan Global Tech Co. Ltd. Operational Automotive New joint A joint venture to manage the global design, October 1, venture manufacture and supply of engine valves and 2008 valve actuation products to Japanese and Korean automobile and engine manufacturers. In addition, during the second half of 2008, several related manufacturing joint ventures were established. Engine Valves Business of Kirloskar Oil Engines Ltd. July 31, 2008 Automotive $5 for 2007 An India-based designer, manufacturer and distributor of intake and exhaust valves for diesel and gasoline engines PK Electronics July 31, 2008 Electrical $9 for 2007 A Belgium-based distributor and service provider of single phase and three-phase uninterruptible power supply (UPS) systems The Moeller Group April 4, 2008 Electrical E1.02 billion for A Germany-based supplier of electrical 2007 components for commercial and residential building applications and industrial controls for industrial equipment applications Balmen Electronic, S.L. March 31, Electrical $6 for 2007 A Spain-based distributor and service provider 2008 of uninterruptible power supply (UPS) systems Phoenixtec Power Company Ltd. February 26, Electrical $515 for 2007 A Taiwan-based manufacturer of single and 2008 three-phase uninterruptible power supply (UPS) systems
Page 3 BUSINESS SEGMENT INFORMATION Information by business segment and geographic region regarding principal products, principal markets, methods of distribution, net sales, operating profit and assets is presented in "Business Segment & Geographic Region Information" on pages 47 through 51. Additional information regarding Eaton's segments and business is presented below. ELECTRICAL Seasonal Fluctuations - Sales of this segment are historically lower in the first quarter and higher in the third and fourth quarters of a year. Competition - Principal methods of competition in this segment are performance of products and systems, technology, customer service and support, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. HYDRAULICS Seasonal Fluctuations - Sales of this segment are historically higher in the first and second quarters and lower in the third and fourth quarters of the year. Competition - Principal methods of competition in this segment are product performance, geographic coverage, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. AEROSPACE Significant Customers - Approximately 10% of this segment's sales in 2008 were made to one large manufacturer of aircraft. Competition - Principal methods of competition in this segment are total cost of ownership, product and system performance, quality, design engineering capabilities and timely delivery. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products and platforms, is considered among the market leaders. TRUCK Significant Customers - Approximately 35% of this segment's sales in 2008 were made to two large manufacturers of heavy-, medium-, and light-duty trucks and off-highway vehicles. Competition - Principal methods of competition in this segment are product performance, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. AUTOMOTIVE Seasonal Fluctuations - Sales of this segment historically are lower in the third quarter than in other quarters during the year as a result of the normal seasonal pattern of automotive industry production. Significant Customers - Approximately 27% of this segment's sales in 2008 were made to two large manufacturers of vehicles. Competition - Principal methods of competition in this segment are product performance, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. INFORMATION CONCERNING EATON'S BUSINESS IN GENERAL RAW MATERIALS - Eaton's major requirements for raw materials include iron, steel, copper, nickel, aluminum, brass, silver, molybdenum, titanium, vanadium, rubber, plastic and insulating materials. Materials are purchased in various forms, such as extrusions, castings, powder metal, metal sheets and strips, forging billets, bar stock and plastic pellets. Raw materials, as well as parts and other components, are purchased from many suppliers and, under normal circumstances, the Company had no difficulty obtaining them. In 2008, prices increased for some basic metals purchased by Eaton through the third quarter, with a dramatic drop during the last 60 days of 2008 due to the global economic slow down. The Company maintained appropriate levels of inventory to guard against basic metals shortages, and did not experience any general availability constraints in 2008. Page 4 PATENTS AND TRADEMARKS - Eaton views its name and mark as significant to its business as a whole. Eaton's products are marketed with a portfolio of patents, trademarks, licenses or other forms of intellectual property that expire at various dates in the future. Eaton develops and acquires new intellectual property on an ongoing basis and considers all of its intellectual property to be valuable. Based on the broad scope of Eaton's product lines, management believes that the loss or expiration of any single intellectual property right would not have a material effect on the results of operations or financial position of Eaton or its business segments. Eaton's policy is to file applications and obtain patents for its new products including product modifications and improvements. ORDER BACKLOG - Since a significant portion of open orders placed with Eaton by original equipment manufacturers of trucks, off-highway vehicles and passenger cars are historically subject to month-to-month releases by customers during each model year, these orders are not considered firm. In measuring backlog of orders, the Company includes only the amount of these orders released by customers as of the dates listed. Using this criterion, total backlog at December 31, 2008 and 2007 was approximately $3.2 billion. Backlog should not be relied upon as being indicative of results of operations for future periods. RESEARCH AND DEVELOPMENT - Research and development expenses (in millions) for new products and improvement of existing products in 2008, 2007 and 2006 were $417, $335 and $315, respectively. Over the past five years, the Company has invested approximately $1.6 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 2009 and 2010. Information regarding the Company's liabilities related to environmental matters is presented in "Protection of the Environment" on pages 39 and 40. FOREIGN OPERATIONS - Financial information related to Eaton's foreign operations is presented in "Business Segment & Geographic Information" on page 49. Information regarding risks that may affect Eaton's foreign operations is presented in Item 1A of this Form 10-K Report. ITEM 1A. RISK FACTORS Among the risks that could materially adversely affect Eaton's businesses, financial condition or results of operations are the following: DOWNTURNS IN THE GLOBAL END MARKETS THAT EATON SERVES OR DISRUPTIONS IN THE GLOBAL CAPITAL MARKETS THAT EATON UTILIZES FOR FINANCING MAY HAVE AN ADVERSE EFFECT ON EATON'S BUSINESS RESULTS OR FINANCIAL FLEXIBILITY. The global economy is currently experiencing a period of substantial uncertainty, the effects of which cannot be completely anticipated. One such effect was a decline in certain of Eaton's end markets during the fourth quarter of 2008. Eaton's end markets have continued to decline in the first quarter of 2009 and it is unclear when the end markets will begin to recover. Although Eaton has not experienced any limitations in its access to the capital markets to date, certain other companies have experienced limitations. It is possible that the current world economic crisis could at some point result in some limitations to Eaton's access to the capital markets. Eaton's segment revenues, operating results and profitability have varied in the past and may vary from quarter to quarter in the future. Profitability can be negatively impacted by volatility in the end markets that Eaton serves. The Company has undertaken measures to reduce the impact of this volatility through diversification of markets it serves and expansion of geographic regions in which it operates. Future downturns in any of the markets that Eaton serves could adversely affect the Company's revenues, operating results and profitability. EATON'S OPERATING RESULTS DEPEND IN PART ON CONTINUED SUCCESSFUL RESEARCH, DEVELOPMENT AND MARKETING OF NEW AND/OR IMPROVED PRODUCTS AND SERVICES, AND THERE CAN BE NO ASSURANCE THAT EATON WILL CONTINUE TO SUCCESSFULLY INTRODUCE NEW PRODUCTS AND SERVICES. Page 5 The success of new and improved products and services depends on their initial and continued acceptance by Eaton's customers. The Company's businesses are affected, to varying degrees, by technological change and corresponding shifts in customer demand, which could result in unpredictable product transitions or shortened life cycles. Eaton may experience difficulties or delays in the research, development, production or marketing of new products and services which may prevent Eaton from recouping or realizing a return on the investments required to bring new products and services to market. The end result could be a negative impact on the Company's operating results. EATON'S OPERATIONS DEPEND ON PRODUCTION FACILITIES THROUGHOUT THE WORLD, MANY OF WHICH ARE LOCATED OUTSIDE THE UNITED STATES AND ARE SUBJECT TO GREATER RISKS OF DISRUPTED PRODUCTION. Eaton manages businesses with manufacturing facilities worldwide. In recent years, the Company's operations outside the United States have increased significantly in relative size in comparison to its total operations. The Company's manufacturing facilities and operations could be disrupted by a natural disaster, or labor strike, war, political unrest, terrorist activity or public health concerns. Some of Eaton's non-United States manufacturing facilities also may be more susceptible to economic and political upheaval than Eaton's United States facilities. Any such disruption could cause delays in shipments of products and the loss of sales and customers, and insurance proceeds may not adequately compensate the Company for the losses. EATON'S SUBSTANTIAL FOREIGN SALES SUBJECT IT TO ECONOMIC RISK AS EATON'S RESULTS OF OPERATIONS MAY BE ADVERSELY AFFECTED BY CHANGES IN LOCAL GOVERNMENT REGULATIONS AND POLICIES AND FOREIGN CURRENCY FLUCTUATIONS. As noted above in Item 1 "Foreign Operations," a significant portion of Eaton's sales are outside the United States, and the Company expects sales in foreign markets to continue to represent a significant portion of its total sales. Foreign sales and operations are subject to changes in local government regulations and policies, including those related to tariffs and trade barriers, investments, property ownership rights, taxation, exchange controls and repatriation of earnings. Changes in the relative values of currencies occur from time to time and could affect Eaton's operating results. While the Company monitors exchange rate exposures and attempts to reduce these exposures through hedging activities, these risks could adversely affect the Company's operating results. EATON USES A VARIETY OF RAW MATERIALS AND COMPONENTS IN ITS BUSINESSES, AND SIGNIFICANT SHORTAGES OR PRICE INCREASES COULD INCREASE OPERATING COSTS AND ADVERSELY IMPACT THE COMPETITIVE POSITIONS OF EATON'S PRODUCTS. Eaton's major requirements for raw materials are described above in Item 1 "Raw Materials." Significant shortages could affect the prices Eaton's affected businesses are charged and the competitive position of their products and services, all of which could adversely affect Eaton's results of operations. EATON ENGAGES IN ACQUISITIONS AND JOINT VENTURES, AND MAY ENCOUNTER UNEXPECTED DIFFICULTIES IDENTIFYING, PRICING OR INTEGRATING THOSE BUSINESSES. Eaton seeks to grow, in part, through strategic acquisitions and joint ventures, which are intended to complement or expand the Company's businesses, and expects to continue to do so in the future. The success of this strategy will depend on Eaton's ability to identify, price, finance and complete these transactions or arrangements. Success will also depend on the Company's ability to integrate the businesses acquired in these transactions and to develop satisfactory working arrangements with the Company's strategic partners in the joint ventures. Eaton may encounter unexpected difficulties in completing and integrating acquisitions with Eaton's existing operations, and in managing strategic investments. Furthermore, the Company may not realize the degree, or timing, of benefits Eaton anticipated when it first entered into a transaction. Any of the foregoing could adversely affect the Company's business and results of operations. EATON MAY BE UNABLE TO ADEQUATELY PROTECT ITS INTELLECTUAL PROPERTY RIGHTS, WHICH COULD AFFECT THE COMPANY'S ABILITY TO COMPETE. Protecting Eaton's intellectual property rights is critical to its ability to compete and succeed. The Company owns a large number of United States and foreign patents and patent applications, as well as trademark and copyright registrations that are necessary, and contribute significantly, to the preservation of Eaton's competitive position in various markets. Although management believes that the loss or expiration of any single intellectual property right would not have a material effect on the results of operations or financial position of Eaton or its business segments, there can be no assurance Page 6 that any one, or more, of these patents and other intellectual property will not be challenged, invalidated or circumvented by third parties. Eaton enters into confidentiality and invention assignment agreements with the Company's employees, and into non-disclosure agreements with Eaton's suppliers and appropriate customers so as to limit access to and disclosure of the Company's proprietary information. These measures may not suffice to deter misappropriation or independent third party development of similar technologies. Moreover, the protection provided to Eaton's intellectual property by the laws and courts of foreign nations may not be as advantageous to Eaton as the remedies available under United States law. EATON IS SUBJECT TO LITIGATION AND ENVIRONMENTAL REGULATIONS THAT COULD ADVERSELY IMPACT EATON'S BUSINESSES. At any given time, Eaton may be subject to litigation, the disposition of which may have a material adverse effect on the Company's businesses, financial condition or results of operations. Information regarding the Company's current legal proceedings is presented in "Protection of the Environment" and "Contingencies" on pages 39 and 40. EATON PARTICIPATES IN MARKETS THAT ARE COMPETITIVE AND EATON'S RESULTS COULD BE ADVERSELY IMPACTED BY COMPETITORS' ACTIONS. Eaton's businesses operate in competitive markets. The Company competes against other global manufacturers and service providers on the basis of product performance, quality and price, in addition to other factors. While Eaton's product development and quality initiatives have been competitive strengths in the past, actions by Eaton's competitors could lead to downward pressure on prices and/or a decline in the Company's market share, either of which could adversely affect Eaton's results. ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIES Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains manufacturing facilities at 224 locations in 33 countries. The Company is a lessee under a number of operating leases for certain real properties and equipment, none of which is material to its operations. Management believes that the existing manufacturing facilities are adequate for operations, and these facilities are maintained in good condition. ITEM 3. LEGAL PROCEEDINGS Information regarding the Company's current legal proceedings is presented in "Protection of the Environment" and "Contingencies" on pages 39 and 40. 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 Report. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The Company's Common Shares are listed for trading on the New York and Chicago stock exchanges. Information regarding cash dividends paid and the high and low market price per Common Share for each quarter in 2008 and 2007 is presented in "Quarterly Data" on page 74. At December 31, 2008, there were 8,548 holders of record of the Company's Common Shares. Additionally, 19,987 current and former employees were shareholders through participation in the Eaton Savings Plan (ESP), Eaton Personal Investment Plan (EPIP), and the Eaton Electrical de Puerto Rico Inc. Retirement Savings Plan. Information regarding equity compensation plans required by Regulation S-K Item 201(d) is provided in Item 12 of this Form 10-K Report. Page 7 ITEM 6. SELECTED FINANCIAL DATA Information regarding selected financial data is presented in the "Ten-Year Consolidated Financial Summary" on page 75. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion & Analysis of Financial Condition & Results of Operations" is presented on pages 52 through 73. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information regarding market risk is presented in "Market Risk Disclosure" on pages 66 and 67. 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 16 through 51. Information regarding selected quarterly financial information for 2008 and 2007 is presented in "Quarterly Data" on page 74. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures - Pursuant to SEC Rule 13a-15, an evaluation was performed under the supervision and with the participation of Eaton's management, including Alexander M. Cutler - Chairman and Chief Executive Officer; President; and Richard H. Fearon - Vice Chairman and 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, 2008. 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 SEC'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. "Management's Report on Internal Control Over Financial Reporting" is presented on page 19. "Report of Independent Registered Public Accounting Firm" relating to internal control over financial reporting is presented on page 18. During the fourth quarter of 2008, there was no change in Eaton's internal control over financial reporting that materially affected, or is reasonably likely to materially affect, Eaton's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None. Page 8 PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 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 13, 2009, and is incorporated by reference. A listing of the Company's executive officers, their ages, positions and offices held over the past five years, as of February 1, 2009, follows:
Name Age Position (Date elected to position) - ---- --- ------------------------------------------------ Alexander M. Cutler 57 Chairman and Chief Executive Officer; President (August 1, 2000 - present) Director (September 22, 1993 - present) Richard H. Fearon 52 Vice Chairman and Chief Financial and Planning Officer (April 24, 2002 - present) Craig Arnold 48 Vice Chairman and Chief Operating Officer - Industrial Sector (February 1, 2009 - present) Chief Executive Officer - Fluid Power Group (October 25, 2000 - January 31, 2009) Thomas S. Gross 54 Vice Chairman and Chief Operating Officer - Electrical Sector (February 1, 2009 - present) President - Power Quality and Control Business (April 1, 2008 - January 31, 2009) Vice President and President Operations (October 24, 2007 - March 31, 2008) Vice President - Eaton Business System (July 23, 2003 - October 23, 2007) Richard D. Holder 46 Executive Vice President - Eaton Business System (April 1, 2008 - present) Vice President - Eaton Business System (May 1, 2006 - March 31, 2008) Vice President and General Manager; Power Distribution and Assemblies Division; Electrical Group (August 1, 2004 - April 30, 2006) Vice President, Supply Chain and Operational Excellence, Electrical Group (July 16, 2001 - July 31, 2004) Susan J. Cook 61 Executive Vice President - Chief Human Resources Officer (January 16, 1995 - present) Mark M. McGuire 51 Executive Vice President and General Counsel (December 1, 2005 - present) Vice President and Deputy General Counsel, International Paper Company (2003 - 2005) Thomas E. Moran 44 Senior Vice President and Secretary (October 1, 2008 - present) Assistant Secretary and Managing Counsel, The Dow Chemical Company (2002-2008) Billie K. Rawot 57 Senior Vice President and Controller (March 1, 1991 - present)
Page 9 Kurt B. McMaken 39 Senior Vice President - Corporate Development and Treasury (February 1, 2009 - present) Vice President - Corporate Development and Planning (January 1, 2008 - January 31, 2009) Director - Corporate Planning (April 1, 2006 - December 31, 2007) Director - Corporate Development (October 1, 2004 - March 30, 2006) Manager - Corporate Development and Planning (October 1, 2002 - September 30, 2004)
There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of a majority of the Board of Directors. Information required with respect to compliance with Section 16(a) of the Exchange Act is set forth under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement to be filed on or about March 13, 2009, and is incorporated by reference. The Company has adopted a Code of Ethics, which applies to the Directors, officers and employees worldwide. This document is available on the Company's website at http://www.eaton.com. There were no changes during fourth quarter 2008 to the procedures by which security holders may recommend nominees to the Company's Board of Directors. Information related to the Company's Audit Committee, and members of the Committee that are financial experts, is set forth under the caption "Board Committees - Audit Committee" in the Company's definitive Proxy Statement to be filed on or about March 13, 2009, 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 13, 2009, and is incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Information required with respect to securities authorized for issuance under equity compensation plans is set forth under the caption "Equity Compensation Plans" in the Company's definitive Proxy Statement to be filed on or about March 13, 2009, and is incorporated by reference. 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 13, 2009, and is incorporated by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE Information required with respect to certain relationships and related transactions is set forth under the caption "Review of Related Person Transactions" in the Company's definitive Proxy Statement to be filed on or about March 13, 2009, and is incorporated by reference. Information required with respect to director independence is set forth under the caption "Director Independence" in the Company's definitive Proxy Statement to be filed on or about March 13, 2009, and is incorporated by reference. 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 13, 2009, and is incorporated by reference. Page 10 PART IV ITEM 15. EXHIBITS, 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 the 2008 Annual Report to Shareholders are included in Item 8 above: Report of Independent Registered Public Accounting Firm - Page 16 Statements of Consolidated Income - Years ended December 31, 2008, 2007 and 2006 - Page 20 Consolidated Balance Sheets - December 31, 2008 and 2007 - Page 21 Statements of Consolidated Cash Flows - Years ended December 31, 2008, 2007 and 2006 - Page 22 Statements of Consolidated Shareholders' Equity - Years ended December 31, 2008, 2007 and 2006 - Pages 23 and 24 Notes to Consolidated Financial Statements - Pages 25 through 51 All other schedules for which provision is made in Regulation S-X of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits 3(i) Amended Articles of Incorporation (amended and restated as of April 24, 2008) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2008 3(ii) Amended Regulations (amended and restated as of April 23, 2008) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2008 4(a) Pursuant to Regulation S-K Item 601(b) (4), the Company agrees to furnish to the SEC, upon request, a copy of the instruments defining the rights of holders of its other long-term debt 10 Material contracts (a) Tender Offer for all of the shares of Phoenixtec Power Company Ltd. announced on December 20, 2007 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (b) Share Purchase Agreement between Green Beta S.a.r.l. and Eaton Corporation dated December 20, 2007 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (c) Senior Executive Incentive Compensation Plan (effective January 1, 2008) - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (d) Executive Incentive Compensation Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (e) 2005 Non-Employee Director Fee Deferral Plan (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (f) Deferred Incentive Compensation Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 Page 11 (g) Excess Benefits Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (h) Incentive Compensation Deferral Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (i) Limited Eaton Service Supplemental Retirement Income Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (j) Supplemental Benefits Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (k) Form of Restricted Share Unit Agreement (2 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (l) Form of Restricted Share Unit Agreement (4 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (m) Form of Restricted Share Agreement (2 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (n) Form of Restricted Share Agreement (4 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (o) Form of Restricted Share Agreement (Non-Employee Directors) - Incorporated by Reference to the Form 8-K Report filed January 28, 2009 (p) Form of Stock Option Agreement for Executives (2008) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (q) Form of Stock Option Agreement for Executives - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2006 (r) Form of Stock Option Agreement for Non-Employee Directors (2008) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (s) 2002 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 15, 2002 (t) 2004 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 19, 2004 (u) 2008 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (v) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1985 and amended effective September 24, 1996, January 28, 1998, January 23, 2002, February 24, 2004, December 8, 2004 and, in certain respects, January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (w) 1996 Non-Employee Director Fee Deferral Plan (amended and restated effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2006 (x) Form of Change of Control Agreement entered into with officers of Eaton Corporation - Filed in conjunction with this Form 10-K Report (y) Form of Indemnification Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 Page 12 (z) Form of Indemnification Agreement entered into with directors of Eaton Corporation - Incorporated by reference to the Form 8-K Report filed January 26, 2007 (aa) Executive Strategic Incentive Plan (amended and restated January 1, 2008) - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (bb) Executive Strategic Incentive Plan II (effective January 1, 2001) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (cc) Supplemental Executive Strategic Incentive Plan (effective as of June 25, 2008) - Filed in conjunction with this Form 10-K Report (dd) Deferred Incentive Compensation Plan (amended and restated March 31, 2000) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (ee) 1998 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 13, 1998 (ff) Incentive Compensation Deferral Plan (amended and restated October 1, 1997) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (gg) Trust Agreement - Officers and Employees (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (hh) Trust Agreement - Non-employee Directors (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ii) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 1992 (jj) 1991 Stock Option Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (kk) Excess Benefits Plan (amended and restated effective January 1, 1989) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ll) Supplemental Benefits Plan (amended and restated January 1, 1989) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (mm) Eaton Corporation Board of Directors Policy on Incentive Compensation, Stock Options and Other Equity Grants upon the Restatement of Financial Results - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this Form 10-K Report 14 Code of Ethics - Incorporated by reference to the definitive Proxy Statement filed on March 14, 2008 21 Subsidiaries of Eaton Corporation - Filed in conjunction with this Form 10-K Report 23 Consent of Independent Registered Public Accounting Firm - Filed in conjunction with this Form 10-K Report Page 13 24 Power of Attorney - Filed in conjunction with this Form 10-K Report 31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report 32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report (b) Exhibits Certain exhibits required by this portion of Item 15 are filed as a separate section of this Form 10-K Report. Page 14 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Eaton Corporation Registrant Date: February 27, 2009 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Vice Chairman and Chief Financial and Planning Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Date: February 27, 2009
Signature Title - --------- ---------------------------------------- * - ------------------------------------- Alexander M. Cutler Chairman and Chief Executive Officer; President; Principal Executive Officer; Director * - ------------------------------------- Billie K. Rawot Senior Vice President and Controller; Principal Accounting Officer * - ------------------------------------- Christopher M. Connor Director * - ------------------------------------- Charles E. Golden Director * - ------------------------------------- Arthur E. Johnson Director * - ------------------------------------- Deborah L. McCoy Director * - ------------------------------------- Gregory R. Page Director - ------------------------------------- Gary L. Tooker Director * - ------------------------------------- Michael J. Critelli Director * - ------------------------------------- Ernie Green Director * - ------------------------------------- Ned C. Lautenbach Director * - ------------------------------------- John R. Miller Director * - ------------------------------------- Victor A. Pelson Director
*By /s/ Richard H. Fearon --------------------------------- Richard H. Fearon, Attorney-in-Fact for the officers and directors signing in the capacities indicated Page 15 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders Eaton Corporation We have audited the accompanying consolidated balance sheets of Eaton Corporation as of December 31, 2008 and 2007, and the related statements of consolidated income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2008. 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, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with United States generally accepted accounting principles. As discussed in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements, in accordance with SFAS No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R), Eaton Corporation changed its method of accounting for the funded status of its defined benefit pension and other postretirement benefit plans in 2006 and, in 2008, changed its method of accounting for the measurement date provisions of these plans. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Eaton Corporation's internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2009 expressed an unqualified opinion thereon. ERNST & YOUNG LLP Cleveland, Ohio February 27, 2009 Page 16 MANAGEMENT'S REPORT ON FINANCIAL STATEMENTS We have prepared the accompanying consolidated financial statements and related information of Eaton Corporation included herein for the three years ended December 31, 2008. The primary responsibility for the integrity of the financial information included in this annual report rests with management. The financial information included in this annual report has been prepared in accordance with accounting principles generally accepted in the United States based on our best estimates and judgments and giving due consideration to materiality. The opinion of Ernst & Young LLP, Eaton's independent registered public accounting firm, on those financial statements is included herein. Eaton has high standards of ethical business practices supported by the Eaton Code of Ethics and corporate policies. Careful attention is given to selecting, training and developing personnel, to ensure that management's objectives of establishing and maintaining adequate internal controls and unbiased, uniform reporting standards are attained. Our policies and procedures provide reasonable assurance that operations are conducted in conformity with applicable laws and with the Company's commitment to a high standard of business conduct. The Board of Directors pursues its responsibility for the quality of Eaton's financial reporting primarily through its Audit Committee, which is composed of six independent directors. The Audit Committee meets regularly with management, the internal auditors and the independent registered public accounting firm to ensure that they are meeting their responsibilities and to discuss matters concerning accounting, control, audits and financial reporting. The internal auditors and independent registered public accounting firm have full and free access to senior management and the Audit Committee. ALEXANDER M. CUTLER RICHARD H. FEARON BILLIE K. RAWOT Chairman and Chief Vice Chairman and Senior Vice President and Executive Officer; Chief Financial and Planning Controller President Officer February 27, 2009 Page 17 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders Eaton Corporation We have audited Eaton Corporation's internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). 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 included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, 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. As indicated in the accompanying Management's Report on Internal Control Over Financial Reporting, management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of certain entities that were acquired during 2008, which are included in the 2008 consolidated financial statements of Eaton Corporation and constituted approximately 7% of total assets as of December 31, 2008 and 10% of net sales for the year then ended. Our audit of internal control over financial reporting of Eaton Corporation also did not include an evaluation of the internal control over financial reporting for these entities. In our opinion, Eaton Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, 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, 2008 and 2007, and the related statements of consolidated income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2008 and our report dated February 27, 2009 expressed an unqualified opinion thereon. ERNST & YOUNG LLP Cleveland, Ohio February 27, 2009 Page 18 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, 2008. Our evaluation of internal control over financial reporting did not include the internal controls of certain entities that were acquired during 2008, which are included in the 2008 consolidated financial statements and constituted approximately 7% of total assets as of December 31, 2008 and 10% of net sales for the year then ended. In conducting this evaluation, we used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on this evaluation under the framework referred to above, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2008. The independent registered public accounting firm Ernst & Young LLP has issued an audit report on the effectiveness of the Company's internal control over financial reporting as of December 31, 2008. This report is included herein. ALEXANDER M. CUTLER RICHARD H. FEARON BILLIE K. RAWOT Chairman and Chief Vice Chairman and Senior Vice President and Executive Officer; Chief Financial and Planning Controller President Officer February 27, 2009 Page 19 STATEMENTS OF CONSOLIDATED INCOME
Year ended December 31 --------------------------- (Millions except for per share data) 2008 2007 2006 - ------------------------------------ ------- ------- ------- NET SALES $15,376 $13,033 $12,232 Cost of products sold 11,191 9,382 8,949 Selling & administrative expense 2,513 2,139 1,939 Research & development expense 417 335 315 Interest expense-net 157 147 105 Contribution to Eaton Charitable Fund 16 Other (income) expense-net (30) (27) (45) ------- ------- ------- Income from continuing operations before income taxes 1,128 1,041 969 Income taxes 73 82 72 ------- ------- ------- Income from continuing operations 1,055 959 897 Income from discontinued operations 3 35 53 ------- ------- ------- NET INCOME $ 1,058 $ 994 $ 950 ======= ======= ======= NET INCOME PER COMMON SHARE ASSUMING DILUTION Continuing operations $ 6.50 $ 6.38 $ 5.87 Discontinued operations .02 .24 .35 ------- ------- ------- $ 6.52 $ 6.62 $ 6.22 ======= ======= ======= Average number of Common Shares outstanding assuming dilution 162.3 150.3 152.9 NET INCOME PER COMMON SHARE BASIC Continuing operations $ 6.58 $ 6.51 $ 5.97 Discontinued operations .02 .24 .35 ------- ------- ------- $ 6.60 $ 6.75 $ 6.32 ======= ======= ======= Average number of Common Shares outstanding basic 160.2 147.3 150.2 CASH DIVIDENDS PAID PER COMMON SHARE $ 2.00 $ 1.72 $ 1.48
The notes on pages 25 to 51 are an integral part of the consolidated financial statements. Page 20 CONSOLIDATED BALANCE SHEETS
December 31 -------- ------- (Millions) 2008 2007 - ---------- -------- ------- ASSETS Current assets Cash $ 188 $ 142 Short-term investments 342 504 Accounts receivable 2,295 2,208 Inventories 1,554 1,483 Deferred income taxes 239 291 Other current assets 177 139 -------- ------- 4,795 4,767 -------- ------- Property, plant & equipment-net Land & buildings 1,425 1,175 Machinery & equipment 4,142 4,067 -------- ------- 5,567 5,242 Accumulated depreciation (2,928) (2,909) -------- ------- 2,639 2,333 Goodwill 5,232 3,982 Other intangible assets 2,518 1,557 Deferred income taxes 971 498 Other assets 500 293 -------- ------- $ 16,655 $13,430 ======== ======== LIABILITIES & SHAREHOLDERS' EQUITY Current liabilities Short-term debt $ 812 $ 825 Current portion of long-term debt 269 160 Accounts payable 1,121 1,170 Accrued compensation 297 355 Other current liabilities 1,246 1,149 -------- ------- 3,745 3,659 -------- ------- Long-term debt 3,190 2,432 Pension liabilities 1,650 681 Other postretirement liabilities 703 772 Deferred income taxes 543 224 Other liabilities 507 490 Shareholders' equity Common Shares (165.0 million outstanding in 2008 and 146.0 million in 2007) 82 73 Capital in excess of par value 3,879 2,290 Retained earnings 3,917 3,257 Accumulated other comprehensive loss (1,538) (423) Deferred compensation plans (23) (25) -------- ------- 6,317 5,172 -------- ------- $ 16,655 $13,430 ======== ========
The notes on pages 25 to 51 are an integral part of the consolidated financial statements. Page 21 STATEMENTS OF CONSOLIDATED CASH FLOWS
Year ended December 31 ---------------------------- (Millions) 2008 2007 2006 - ---------- ------- -------- ------- NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES Net income $ 1,058 $ 994 $ 950 Adjustments to reconcile to net cash provided by operating activities Depreciation & amortization 592 469 434 Deferred income taxes (225) (51) 37 Pension liabilities, net of contributions 5 26 79 Gains on sales of businesses (19) (46) (56) Other long-term liabilities (40) (25) (45) Other non-cash items in income 49 38 33 Changes in working capital, excluding acquisitions & sales of businesses Accounts receivable 128 (72) (40) Inventories 118 (79) (129) Accounts payable (208) 27 207 Accrued income & other taxes (31) (41) (149) Other current liabilities (125) 11 136 Other working capital accounts (81) 10 43 Cash received from termination of interest rate swaps 85 19 1 Other-net 110 (119) (70) ------- -------- ------- 1,416 1,161 1,431 ------- -------- ------- NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES Expenditures for property, plant & equipment (448) (354) (360) Cash paid for acquisitions of businesses (2,807) (1,433) (256) Proceeds from sales of businesses 25 119 65 Sales (purchases) of short-term investments-net 100 247 (418) Other-net (69) (39) (42) ------- -------- ------- (3,199) (1,460) (1,011) ------- -------- ------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES Borrowings with original maturities of more than three months Proceeds 1,656 1,652 706 Payments (984) (979) (617) Borrowings with original maturities of less than three months-net, primarily commercial paper (5) 62 (35) Cash dividends paid (320) (251) (220) Proceeds from issuance of Common Shares 1,522 Proceeds from exercise of employee stock options 47 141 108 Income tax benefit from exercise of employee stock options 13 42 28 Purchase of Common Shares (100) (340) (386) ------- -------- ------- 1,829 327 (416) ------- -------- ------- Total increase in cash 46 28 4 Cash at the beginning of the year 142 114 110 ------- -------- ------- Cash at the end of the year $ 188 $ 142 $ 114 ======= ======== =======
The notes on pages 25 to 51 are an integral part of the consolidated financial statements. Page 22 STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumulated Common Shares Capital in other Deferred Total ---------------- excess of Retained comprehensive compensation Shareholders' (Millions) Shares Dollars par value earnings loss plans equity - ---------- ------ ------- ---------- -------- ------------- ------------ ------------- BALANCE AT JANUARY 1, 2006 148.5 $74 $2,013 $2,376 $(649) $(36) $3,778 Net income 950 950 Foreign currency translation and related hedging instruments (including income tax benefits of $16) 95 95 Deferred loss on cash flow hedges (net of income tax benefits of $3) (5) (5) Minimum pension liability (net of income tax benefits of $1) (8) (8) ------- Other comprehensive income 82 ------- Total comprehensive income 1,032 Adjustment to initially apply SFAS No. 158 Pensions (net of income tax benefits of $85) (163) (163) Other postretirement benefits (net of income tax benefits of $119) (119) (119) Cash dividends paid (220) (220) Issuance of shares under employee benefit plans, including income tax benefits of $36 3.1 2 176 (2) 13 189 Purchase of shares by trust (5) (5) Purchase of shares (5.3) (3) (75) (308) (386) ----- --- ------ ------ ------- ---- ------- BALANCE AT DECEMBER 31, 2006 146.3 73 2,114 2,796 (849) (28) 4,106 Net income 994 994 Foreign currency translation and related hedging instruments (including income taxes of $14) 212 212 Deferred loss on cash flow hedges (net of income tax benefits of $3) (5) (5) Pensions (net of income taxes of $101) 214 214 Other postretirement benefits (net of income taxes of $8) 5 5 ------- Other comprehensive income 426 ------- Total comprehensive income 1,420 Cash dividends paid (251) (251) Issuance of shares under employee benefit plans, including income tax benefits of $51 3.7 2 237 (5) 8 242 Purchase of shares by trust (5) (5) Purchase of shares (4.0) (2) (61) (277) (340) ----- --- ------ ------ ------- ---- -------
Page 23 STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumulated Common Shares Capital in other Deferred Total ---------------- excess of Retained comprehensive compensation Shareholders' (Millions) Shares Dollars par value earnings loss plans equity - ---------- ------ ------- ---------- -------- ------------- ------------ ------------- BALANCE AT DECEMBER 31, 2007 146.0 73 2,290 3,257 (423) (25) 5,172 Net income 1,058 1,058 Foreign currency translation and related hedging instruments (including income tax benefits of $68) (722) (722) Deferred loss on cash flow hedges (net of income tax benefits of $12) (23) (23) Pensions (net of income tax benefits of $227) (419) (419) Other postretirement benefits (net of income taxes of $31) 49 49 ------- Other comprehensive loss (1,115) ------- Total comprehensive loss (57) Effects of changing measurement date under SFAS No. 158 (net of income tax benefits of $8) (11) (11) Cash dividends paid (320) (320) Issuance of shares under employee benefit plans, including income tax benefits of $16 1.7 1 109 (1) 5 114 Issuance of shares 18.7 9 1,513 1,522 Purchase of shares by trust (3) (3) Purchase of shares (1.4) (1) (33) (66) (100) ----- --- ------ ------ ------- ---- ------- BALANCE AT DECEMBER 31, 2008 165.0 $82 $3,879 $3,917 $(1,538) $(23) $ 6,317 ===== === ====== ====== ======= ==== =======
The notes on pages 25 to 51 are an integral part of the consolidated financial statements. Page 24 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Millions of dollars unless indicated otherwise (per share data assume dilution) DESCRIPTION OF COMPANY Eaton Corporation is a diversified power management company and a global technology leader in: electrical components and systems for power quality, distribution and control; hydraulics components, systems and services for industrial and mobile equipment; aerospace fuel, hydraulics and pneumatic systems for commercial and military use; truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety. Eaton has approximately 75,000 employees and sells products to customers in more than 150 countries. ACCOUNTING POLICIES CONSOLIDATION & BASIS OF PRESENTATION The consolidated financial statements include accounts of Eaton and all subsidiaries and other controlled entities. The equity method of accounting is used for investments in associate companies where the Company has a 20% to 50% ownership interest. These associate companies are not material either individually, or in the aggregate, to Eaton's financial position, results of operations or cash flows. Eaton does not have off-balance sheet arrangements or financings with unconsolidated entities or other persons. In the ordinary course of business, the Company leases certain real properties and equipment, as described in "Lease Commitments" in the Notes below. Transactions with related parties are in the ordinary course of business, are conducted on an arm's-length basis, and are not material to Eaton's financial position, results of operations or cash flows. REVENUE RECOGNITION Sales are recognized when a sales agreement is in place, products have been shipped to unaffiliated customers and title has transferred in accordance with shipping terms (FOB shipping point, FOB destination or equivalent International Commercial (INCO) Terms), the selling price is fixed and determinable and collectability is reasonably assured, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Other revenues for service contracts are generally recognized as the services are provided. 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. Gains and losses related to foreign currency transactions are recorded in Other (income) expense-net in the Statements of Consolidated Income. INVENTORIES Inventories are carried at lower of cost or market. Inventories in the United States are generally accounted for using the last-in, first-out (LIFO) method. Remaining United States and all other inventories are accounted for using the first-in, first-out (FIFO) method. Cost components include raw materials, purchased components, direct labor, indirect labor, utilities, depreciation, inbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, and costs of the distribution network. DEPRECIATION & AMORTIZATION Depreciation and amortization are computed by the straight-line method for financial statement purposes. Cost of buildings is depreciated over principally 40 years and machinery and equipment over principally 3 to 10 years. At December 31, 2008, the weighted-average amortization periods for intangible assets subject to amortization were 14 years for patents, 18 years for manufacturing Page 25 technology and 20 years for customer relationships, primarily as a result of the long life of aircraft platforms. Software is amortized over a range of 3 to 7 years. Long-lived assets, except goodwill and indefinite life intangible assets as described in the Notes below, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Events or circumstances that would result in an impairment review include operations reporting losses, a significant adverse change in the use of an asset, the planned disposal or sale of the asset, a significant adverse change in the business climate or legal factors related to the asset, or a significant decrease in the estimated fair value of an asset. The asset would be considered impaired when the estimated 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 business acquisitions. Indefinite life intangible assets primarily consist of trademarks. Goodwill is tested for impairment at the reporting unit level and is based on the net assets for each unit including goodwill and intangible assets. The Company completed annual impairment tests for goodwill and indefinite life intangible assets as of July 1, 2008 as required by SFAS No. 142. In addition, based on changes in the global economic environment in the second half of 2008, goodwill and indefinite life intangible assets were also tested for impairment in the fourth quarter of 2008. 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. DERIVATIVE 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 interest rate swaps, foreign currency forward exchange contracts, foreign currency swaps and, to a lesser extent, commodity swaps, to manage exposure to these market fluctuations. Derivative financial instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. Such derivative financial instruments are not purchased and sold solely for trading purposes, except for nominal amounts authorized under limited, controlled circumstances. All derivative financial instruments are recognized as either assets or liabilities in the Consolidated Balance Sheet and are measured at fair value. Accounting for the gain or loss resulting from the change in the financial instrument's fair value depends on whether it has been designated, and is effective, as a hedge and, if so, on the nature of the hedging activity. Financial instruments can be designated as hedges of changes in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability; as hedges of variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability; or as hedges of foreign currency exposure from a net investment in one of the Company's foreign operations. Gains and losses related to a hedge are either recognized in income immediately to offset the gain or loss on the hedged item or are deferred and reported as a component of Accumulated other comprehensive income (loss) in Shareholders' equity and subsequently recognized in net income when the hedged item affects net income. The change in fair value of the ineffective portion of a financial instrument is recognized in net 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 Page 26 for products sold, as well as accruals for product recalls and other related events when they are known and estimable. ASSET RETIREMENT OBLIGATIONS A conditional asset retirement obligation is recognized at fair value when incurred, if the fair value of the liability can be reasonably estimated. Uncertainty about the timing or method of settlement of a conditional asset retirement obligation would be factored into the measurement of the liability when sufficient information exists. Eaton believes that for substantially all of its asset retirement obligations, there is an indeterminate settlement date because the range of time over which the Company may settle the obligation is unknown or cannot be estimated. A liability for these obligations will be recorded in the period when sufficient information regarding timing and method of settlement becomes available to make a reasonable estimate of the liability's fair value. 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. NEW ACCOUNTING PRONOUNCEMENTS EMPLOYERS' DISCLOSURES ABOUT POSTRETIREMENT BENEFIT PLAN ASSETS In December 2008, the Financial Accounting Standards Board (FASB) issued FSP 132 (R)-1, "Employers' Disclosures about Postretirement Benefit Plan Assets." FSP 132 (R)-1 provides guidance on an employer's disclosures about plan assets of a defined benefit pension or other postretirement plan. The guidance addresses disclosures related to the categories of plan assets, concentration of risk arising within or across the categories of plan assets, and fair value measurements of plan assets. This Staff Position is effective for Eaton in 2009 and will have no effect on its consolidated financial position or results of operations. DISCLOSURES ABOUT DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133." SFAS No. 161 provides for enhanced disclosures of how derivative and hedging activities affect an entity's financial position, financial performance, and cash flows. This Statement is effective for Eaton in 2009 and will have no effect on its consolidated financial position or results of operations. BUSINESS COMBINATIONS In December 2007, the FASB issued SFAS No. 141 (R), "Business Combinations." This Statement establishes principles and requires the buyer to: - Recognize, with certain exceptions, 100% of the fair values of assets acquired, liabilities assumed, and non-controlling interests in acquisitions of less than a 100% controlling interest when the acquisition constitutes a change in control of the acquired entity. - Measure shares issued in consideration for a business combination at fair value on the acquisition date. - Recognize contingent consideration arrangements at their acquisition-date fair values, with subsequent changes in fair value generally reflected in earnings. - With certain exceptions, recognize pre-acquisition loss and gain contingencies at their acquisition date fair values. - Capitalize in-process research and development assets acquired. - Expense, as incurred, acquisition-related transaction costs. Page 27 - Capitalize acquisition-related restructuring costs only if the criteria in SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," are met as of the acquisition date. - Recognize in income tax expense changes in income tax valuation allowances and accruals for income tax uncertainties that were recorded in a business acquisition, including acquisitions of businesses completed prior to 2009. This Statement will be effective for Eaton in 2009. Statement 141 (R) will affect Eaton's consolidated financial position or results of operations based on the specific conditions related to future acquisitions. NONCONTROLLING INTERESTS IN CONSOLIDATED FINANCIAL STATEMENTS In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51." This Statement clarifies accounting and reporting for a noncontrolling interest, sometimes called a minority interest, which is the portion of equity in a subsidiary not attributable, directly or indirectly, to a parent company. This Statement will be effective for Eaton in 2009. The Company expects that this Statement will not have a material effect on its consolidated financial position and results of operations. FAIR VALUE MEASUREMENTS In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This Statement defines fair value for financial and non-financial assets and liabilities, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The guidance applies to other accounting pronouncements that require or permit fair value measurements. In 2008, Eaton adopted the provisions of SFAS No. 157 for financial assets and liabilities and for non-financial assets recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). These primarily included short and long-term investments, derivative financial instruments, assets related to defined benefit pension plans, and financial assets and liabilities related to acquired businesses. The adoption of this Statement in 2008 had an immaterial effect on Eaton's consolidated financial position and results of operations. In 2009, Eaton must adopt the provisions of SFAS No. 157 for other non-financial assets and liabilities, primarily goodwill, intangible assets, non-financial assets and liabilities related to acquired businesses, and impairment and restructuring activities. The Company expects that this Statement will not have a material effect on its consolidated financial position and results of operations. ACQUISITIONS OF BUSINESSES In 2008, 2007, and 2006, Eaton acquired certain businesses and formed a joint venture in separate transactions for combined net cash purchase prices of $2,807 in 2008, $1,433 in 2007 and $256 in 2006. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition or formation. A summary of these transactions for 2008 and 2007 follows:
DATE OF BUSINESS ACQUIRED BUSINESS ACQUISITION SEGMENT ANNUAL SALES - -------------------------------------------------------- ------------- ---------- ---------------------- Integ Holding Limited October 2, Hydraulics $52 for 2007 The parent company of Integrated Hydraulics 2008 Ltd., a U.K.-based manufacturer of screw-in cartridge valves, custom-engineered hydraulic valves and manifold systems Nittan Global Tech Co. Ltd. Operational Automotive New joint A joint venture to manage the global design, October 1, Venture manufacture and supply of engine valves and 2008 valve actuation products to Japanese and Korean automobile and engine manufacturers. In addition, during the second half of 2008, several related manufacturing joint ventures were established.
Page 28 Engine Valves Business of Kirloskar Oil Engines Ltd. July 31, 2008 Automotive $5 for 2007 An India-based designer, manufacturer and distributor of intake and exhaust valves for diesel and gasoline engines PK Electronics July 31, 2008 Electrical $9 for 2007 A Belgium-based distributor and service provider of single phase and three-phase uninterruptible power supply (UPS) systems The Moeller Group April 4, 2008 Electrical E1.02 billion for A Germany-based supplier of electrical 2007 components for commercial and residential building applications and industrial controls for industrial equipment applications Balmen Electronic, S.L. March 31, Electrical $6 for 2007 A Spain-based distributor and service provider 2008 of uninterruptible power supply (UPS) systems Phoenixtec Power Company Ltd. February 26, Electrical $515 for 2007 A Taiwan-based manufacturer of single and 2008 three-phase uninterruptible power supply (UPS) systems Arrow Hose & Tubing Inc. November 8, Hydraulics $12 for 2006 A Canada-based manufacturer of thermoplastic 2007 hose and tubing for the industrial, food and beverage, and agricultural markets MGE small systems UPS business from October 31, Electrical $245 for Schneider Electric 2007 2007 A France-based global provider of power quality solutions including uninterruptible power supply (UPS) systems, power distribution units, static transfer switches and surge suppressors Babco Electric Group October 19, Electrical $11 for A Canada-based manufacturer of specialty low- 2007 2007 and medium-voltage switchgear and electrical housings for use in the Canadian oil and gas industry and other harsh environments Pulizzi Engineering June 19, 2007 Electrical $12 for 2006 A U.S. manufacturer of alternating current (AC) power distribution, AC power sequencing, redundant power and remote-reboot power management systems Technology and related assets of SMC Electrical May 18, 2007 Electrical None Products, Inc.'s industrial medium-voltage adjustable frequency drive business Fuel components division of Saturn Electronics & May 2, 2007 Automotive $28 for 2006 Engineering, Inc. A U.S. designer and manufacturer of fuel containment and shutoff valves, emissions control valves and specialty actuators Aphel Technologies Limited April 5, 2007 Electrical $12 for 2006 A U.K.-based global supplier of high density, fault-tolerant power distribution solutions for
Page 29 datacenters, technical offices, laboratories and retail environments Argo-Tech Corporation March 16, Aerospace $206 for 2006 A U.S.-based manufacturer of high-performance 2007 aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets Power Protection Business of Power Products Ltd. February 7, Electrical $3 for 2006 A Czech Republic distributor and service provider 2007 of Powerware(R) products and other uninterruptible power supply (UPS) systems
The allocations of the purchase prices for certain acquisitions in 2008 are not final, and may be subsequently adjusted based on final purchase price allocation reports and other information. As described above, in 2008 Eaton acquired The Moeller Group electrical business and the Phoenixtec electrical business for combined cash purchase prices of $2,695. Assets and liabilities for these businesses were recorded at estimated fair values as determined by Eaton's management based on available information and on assumptions as to future operations. The Company is in the process of completing the purchase price allocations, including the finalization of valuations of certain tangible and intangible assets, and the finalization of integration and income tax liabilities. The preliminary allocations of the purchase prices are summarized below: Current assets $ 702 Property, plant & equipment 447 Goodwill 1,624 Other intangible assets 1,073 Other assets 107 ------ Total assets acquired 3,953 Total liabilities assumed 1,258 ------ Net assets acquired $2,695 ======
Other intangible assets of $1,073 include estimates of $640 of customer relationships having a useful life of 10 to 15 years, $251 related to trademarks having a useful life of 15 to 20 years, and $182 of technology having a useful life of 3 to 13 years. Goodwill of $1,232 for Moeller and $392 for Phoenixtec are non-deductible for income tax purposes. As described above, in 2007 Eaton acquired the Argo-Tech aerospace business and the MGE small systems UPS electrical business for combined cash purchase prices of $1,346. In 2007, the assets and liabilities for these businesses were recorded at estimated fair values as determined by Eaton's management based on available information and on assumptions as to future operations. As completed in 2008, the final allocations of the purchase prices, which did not differ materially from preliminary estimates, are summarized below: Current assets $ 223 Property, plant & equipment 23 Goodwill 899 Other intangible assets 582 ------ Total assets acquired 1,727 Total liabilities assumed 381 ------ Net assets acquired $1,346 ======
Other intangible assets of $582 included $42 related to trademarks not subject to amortization, $436 of customer relationships having a useful life of 5 to 25 years, and $104 of technology having a useful life of 5 to 25 years. Goodwill of $420 for Argo-Tech and $479 for the MGE small systems UPS electrical business are non-deductible for income tax purposes. Page 30 PRO FORMA RESULTS OF CONTINUING OPERATIONS In order to portray the results for Moeller, purchased in April 2008; Phoenixtec, purchased in February 2008; the MGE small systems UPS business, purchased in October 2007; and Argo-Tech, purchased in March 2007, as if they had been acquired and consolidated with Eaton at the beginning of 2007, unaudited pro forma results for continuing operations are presented below. The pro forma results include 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 integrations of these businesses and, accordingly, are not necessarily indicative of the results which would have occurred if the business combinations had been in effect on the dates indicated. These unaudited pro forma results do not include businesses acquired in 2008 and 2007 that were immaterial.
2008 2007 ------- ------- Net sales $15,853 $15,106 Income from continuing operations 1,070 946 Income from continuing operations per Common Share Assuming dilution $ 6.59 $ 6.29 Basic $ 6.68 $ 6.42
RESTRUCTURING LIABILITIES Eaton has undertaken restructuring activities at acquired businesses, including workforce reductions, plant consolidations and facility closures. In accordance with Emerging Issues Task Force (EITF) Issue No. 95-3, "Recognition of Liabilities in Connection with a Purchase Business Combination", liabilities for these restructuring activities were recognized in the allocation of the purchase price related to the acquired business. A summary of these liabilities, and utilization of the various components, follows:
Workforce reductions Plant -------------------- closing Employees Dollars & other Total ---------- ------- ------- ----- Balance at January 1, 2006 944 $ 24 $ 37 $ 61 Liabilities recorded 417 17 28 45 Utilized (285) (8) (43) (51) ----- ---- ---- ---- Balance at December 31, 2006 1,076 33 22 55 Liabilities recorded 282 7 2 9 Utilized (699) (13) (12) (25) ----- --- --- ---- Balance at December 31, 2007 659 27 12 39 Liabilities recorded 52 3 2 5 Utilized (428) (18) (13) (31) ----- ---- ---- --- Balance at December 31, 2008 283 $ 12 $ 1 $ 13 ===== ==== ==== ====
ACQUISITION INTEGRATION & PLANT CLOSING CHARGES ACQUISITION INTEGRATION CHARGES In 2008, 2007 and 2006, Eaton incurred charges related to the integration of acquired businesses. These charges which consisted of plant consolidations and integration, were recorded as expense as incurred. A summary of these charges follows:
2008 2007 2006 ------- ------- ------- Electrical $ 47 $ 12 $ 7 Hydraulics 6 12 11 Aerospace 20 39 12 Truck 5 Automotive 3 1 5 Corporate 1 ---- ---- ---- Pretax charges $ 77 $ 64 $ 40 ==== ==== ==== After-tax charges $ 51 $ 42 $ 27 Per Common Share $.31 $.28 $.17
Page 31 Charges in 2008 were related primarily to the integration of the following acquisitions: in the Electrical segment, Moeller, Phoenixtec and the MGE small systems UPS business; in the Hydraulics segment, Ronningen-Petter and Synflex; in the Aerospace segment, Argo-Tech, PerkinElmer and Cobham; and in the Automotive segment, Saturn and the engine valve business of Kirloskar Oil Engines Ltd. Charges in 2007 were related primarily to the integration of the following acquisitions: in the Electrical segment, the MGE small systems UPS business, Schreder-Hazemeyer, Senyuan and Powerware; in the Hydraulics segment, Synflex, Hayward and Walterscheid; in the Aerospace segment, Argo-Tech, PerkinElmer and Cobham; and in the Automotive segment, Saturn. Charges in 2006 were related primarily to the integration of the following acquisitions: in the Electrical segment, Pringle and Powerware; in the Hydraulics segment, Synflex, Hayward, Winner and Walterscheid; in the Aerospace segment, PerkinElmer and Cobham; in the Truck segment, Pigozzi; and in the Automotive segment, Tractech and Morestana. PLANT CLOSING CHARGES On October 20, 2008, Eaton announced the closure of its automotive engine valve lifters manufacturing plant in Massa, Italy. There were approximately 350 employees affected by the closure decision. The action was taken to better align manufacturing capacity with future industry demand and to improve the competitive position of the valve actuation business. Aggregate pretax charges associated with this closure were $27, which were recognized in the fourth quarter of 2008, when management approved this action. These costs, which consisted of charges of $17 for severance, $7 for the write-down of assets and $3 for other costs, reduced operating profit of the Automotive segment. In first quarter 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions concluded in 2006 intended to address resource levels and operating performance in businesses that under-performed in 2005, and businesses that were expected to weaken during second half 2006 and in 2007. As part of this program, charges were incurred related to plant closings in four business segments in 2006. A summary of charges incurred by each segment related to these plant closings, including workforce reductions, plant integration and other charges, follows:
2006 ---- Electrical $ 12 Hydraulics 7 Truck 29 Automotive 58 ---- Pretax charges $106 ====
SUMMARY OF ACQUISITION INTEGRATION & PLANT CLOSING CHARGES & RELATED LIABILITIES A summary of acquisition integration charges and plant closing charges and remaining liabilities follows:
Workforce reductions Plant -------------------- closing Employees Dollars & other Total --------- -------- --------- ------ Balance at January 1, 2006 166 $ 3 $ 1 $ 4 Liabilities recorded 2,339 85 61 146 Utilized (902) (39) (56) (95) ------ ---- ---- ----- Balance at December 31, 2006 1,603 49 6 55 Liabilities recorded 4 2 64 66 Utilized (1,044) (37) (69) (106) ------ ---- ---- ----- Balance at December 31, 2007 563 14 1 15 Liabilities recorded 422 21 87 108 Utilized (451) (14) (84) (98) ------ ---- ---- ----- Balance at December 31, 2008 534 $ 21 $ 4 $ 25 ====== ==== ==== =====
The acquisition integration and plant closing charges were included in the Statements of Consolidated Income in Cost of products sold or Selling & administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment. Page 32 SUBSEQUENT EVENT - EMPLOYMENT REDUCTION ACTIONS IN 2009 Eaton took significant employee reduction actions in January 2009 due to the severe economic downturn. These actions related to approximately 5,200 employees and will result in a pretax charge of approximately $110 in the first quarter of 2009. DISCONTINUED OPERATIONS In the third quarter 2007, Eaton sold the Mirror Controls Division of the Automotive segment for $111, resulting in a $20 after-tax gain, or $.12 per Common Share. In the third quarter 2006, certain other businesses of the Automotive segment were sold for $64, resulting in a $35 after-tax gain, or $.23 per share. The gains on sale of the Mirror Controls Division and the businesses sold in 2006, and other results of these businesses, are reported as Discontinued operations in the Statements of Consolidated Income. SHORT-TERM INVESTMENTS Eaton invests excess cash generated from operations in short-term marketable investments and classifies these investments as "available-for-sale" under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." In accordance with SFAS No. 115, available-for-sale investments are recorded at fair value, with the unrealized gain or loss recorded in Accumulated other comprehensive income (loss) in Shareholders' equity. A summary of the carrying value of short-term investments follows:
2008 2007 ---- ---- Time deposits & certificate of deposits with banks $237 $198 Bonds issued by foreign governments 63 121 Money market investments 34 174 Other 8 11 ---- ---- $342 $504 ==== ====
The carrying value of short-term investments approximates the fair value of these investments. GOODWILL & OTHER INTANGIBLE ASSETS A summary of goodwill follows:
2008 2007 ------ ------ Electrical $2,834 $1,570 Hydraulics 1,002 984 Aerospace 1,037 1,069 Truck 143 148 Automotive 216 211 ------ ------ $5,232 $3,982 ====== ======
The increase in goodwill in 2008 was due to goodwill for businesses acquired during 2008, partially offset by the final allocation of purchase price for businesses acquired prior to 2008 and foreign currency translation. These transactions are described in the "Acquisitions of Businesses" Note above. A summary of other intangible assets follows:
2008 2007 ------------------------- ------------------------- Historical Accumulated Historical Accumulated cost amortization cost amortization ---------- ------------ ---------- ------------ Intangible assets not subject to amortization (primarily trademarks) $ 525 $ 530 ====== ====== Intangible assets subject to amortization Customer relationships $1,327 $144 $ 690 $ 73 Patents 443 131 192 102 Manufacturing technology 429 50 246 25 Other 190 71 153 54 ------ ---- ------ ---- $2,389 $396 $1,281 $254 ====== ==== ====== ====
Page 33 Expense related to intangible assets subject to amortization for 2008 was $161. Estimated annual pretax expense for intangible assets subject to amortization for each of the next five years is $161 in 2009, $162 in 2010, $158 in 2011, $142 in 2012 and $129 in 2013. DEBT & OTHER FINANCIAL INSTRUMENTS Short-term debt of $812 at December 31, 2008 included $767 of short-term commercial paper for operations in the United States which had a weighted-average interest rate of 2.0%, $7 of other short-term debt in the United States, and $38 of short-term debt for operations outside the United States. Borrowings for operations outside the United States were largely denominated in local currencies. Operations outside the United States have available short-term lines of credit aggregating $437 from various banks worldwide. A summary of long-term debt, including the current portion, follows:
2008 2007 ------ ------ E100 million floating rate notes due 2008 (4.91% at December 31, 2007 - EURIBOR+0.375%) $ 147 7.40% notes due 2009 $ 15 15 Floating rate senior notes due 2009 (2.88% at December 31, 2008 - LIBOR+0.08%) 250 250 Floating rate senior note due 2010 (2.44% at December 31, 2008 - LIBOR+0.25%) 281 281 5.75% notes due 2012 300 300 7.58% notes due 2012 12 12 4.9% notes due 2013 ($50 converted to floating rate by interest rate swap) 300 5.80% notes due 2013 7 7 12.5% British Pound debentures due 2014 8 12 4.65% notes due 2015 ($50 converted to floating rate by interest rate swap) 100 100 5.3% notes due 2017 250 250 7.09% notes due 2018 25 25 6.89% notes due 2018 6 6 7.07% notes due 2018 2 2 6.875% notes due 2018 3 3 5.6% notes due 2018 ($325 converted to floating rate by interest rate swap) 450 4.215% Japan Yen notes due 2018 110 8-7/8% debentures due 2019 ($25 converted to floating rate by interest rate swap) 38 38 8.10% debentures due 2022 100 100 7.625% debentures due 2024 ($25 converted to floating rate by interest rate swap) 66 66 6-1/2% debentures due 2025 145 145 7.875% debentures due 2026 72 72 7.65% debentures due 2029 ($50 converted to floating rate by interest rate swap) 200 200 5.45% debentures due 2034 ($25 converted to floating rate by interest rate swap) 150 150 5.25% notes due 2035 72 72 5.8% notes due 2037 240 240 Other 257 99 ------ ------ Total long-term debt 3,459 2,592 Less current portion of long-term debt (269) (160) ------ ------ Long-term debt less current portion $3,190 $2,432 ====== ======
In February 2008, Eaton borrowed $250 under a 364-day $3.0 billion revolving credit agreement to partially finance the acquisition of Phoenixtec. In April 2008, Eaton borrowed E1.33 billion under the revolving credit agreement to finance the acquisition of Moeller. In order to refinance this debt, Eaton sold 18.678 million of its Common Shares in a public offering in the second quarter of 2008, resulting in Page 34 net cash proceeds of $1.522 billion. In May 2008, Eaton issued $300 of 4.9% notes due in 2013 and $450 of 5.6% notes due in 2018. The cash proceeds from the sale of the Common Shares and from the issuance of the notes were used to repay borrowings incurred to fund the acquisitions of Moeller and Phoenixtec, and to repay commercial paper issued under the $3.0 billion revolving credit agreement. Subsequently, in May 2008 Eaton terminated the $3.0 billion revolving credit agreement. In May 2008, Eaton entered into a new $500 revolving credit facility. The facility replaced the existing $300 facility that expired in May 2008. The facility increased Eaton's United States long-term revolving credit facilities with banks to $1.7 billion, of which $700 expire in 2010, $500 in 2011 and $500 in 2013. These revolving credit facilities support Eaton's commercial paper borrowings. There were no borrowings outstanding under these revolving credit facilities at December 31, 2008. The $281 Floating Rate Senior Note due 2010 was issued by a subsidiary of Eaton in order to refinance short-term borrowings related to the acquisition of Argo-Tech in 2007. As of December 31, 2008, the Note is no longer secured by the assets of any subsidiary and the Note does not restrict net assets of any subsidiary. Aggregate mandatory annual maturities of long-term debt for each of the next five years are $269 in 2009, $281 in 2010, $0 in 2011, $312 in 2012 and $307 in 2013. Interest paid was $206 in 2008, $204 in 2007 and $151 in 2006. Eaton has entered into fixed-to-floating interest rate swaps to manage interest rate risk. These interest rate swaps are accounted for as fair value hedges of certain long-term debt. The maturity of the swap corresponds with the maturity of the debt instrument as noted in the table of long-term debt above. A summary of interest rate swaps outstanding at December 31, 2008, follows:
Interest rates at December 31, 2008 ------------------------------------------------- Fixed Floating interest interest Notional rate rate Basis for contracted Amount received paid floating interest rate paid - -------- -------- -------- --------------------------- $ 50 4.90% 3.32% 6 month LIBOR+0.73% $ 50 4.65% 2.48% 6 month LIBOR+0.16% $325 5.60% 3.82% 6 month LIBOR+1.22% $ 25 8.88% 6.17% 6 month LIBOR+3.84% $ 25 7.63% 6.31% 6 month LIBOR+2.48% $ 50 7.65% 5.16% 6 month LIBOR+2.57% $ 25 5.45% 4.65% 6 month LIBOR+0.28%
The carrying values of short-term debt on the balance sheet approximated estimated fair value. Long-term debt and current portion of long-term debt had a carrying value of $3,459 and fair value of $3,427 at December 31, 2008 compared to $2,592 and $2,661 at the end of 2007. RETIREMENT BENEFIT PLANS ADOPTION OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 158 On December 31, 2006, Eaton adopted SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)." SFAS No. 158 required employers to recognize on their balance sheets the net amount by which pension and other postretirement benefit plan liabilities are overfunded or underfunded, with an offsetting adjustment to Accumulated other comprehensive loss in Shareholders' equity, net of income tax benefits. As a result of the adoption of SFAS No. 158, at December 31, 2006, Eaton recorded a non-cash charge in Accumulated other comprehensive loss in Shareholders' equity of $248 ($163 after-tax) for pension benefits and $238 ($119 after-tax) for other postretirement benefits as a one-time adjustment to initially apply the new Statement. Retirement benefit plan funding requirements are not affected by the recording of these charges. The adoption of SFAS No. 158 did not change the amounts recognized in the income statement as net periodic benefit cost. In 2008, Eaton adopted the measurement date provision of SFAS No.158, which requires measurement of the funded status of all pension and other postretirement benefit plans to be as of the date of the year-end financial statements. Previously, the measurement date for Eaton's pension and other Page 35 postretirement benefit plans was November 30. As a result of the change in measurement dates, in the fourth quarter of 2008, Eaton recorded a charge to retained earnings of $19 for one month of costs ($11 after-tax) related to pension benefits and other postretirement benefits with no corresponding adjustment to net income. RETIREMENT BENEFIT PLAN LIABILITIES & ASSETS Eaton has defined benefit pension plans and other postretirement benefit plans. Components of plan obligations and assets, and recorded liabilities and assets, follow:
Other postretirement Pension liabilities liabilities ---------------------- -------------------- 2008 2007 2008 2007 ---------- --------- ------- ---------- Changes in benefit obligation Benefit obligation at the beginning of the year $(3,092) $(3,125) $(859) $(854) Service cost (137) (147) (15) (15) Interest cost (190) (163) (49) (47) Actuarial gain 67 175 58 3 Benefits paid 287 247 87 90 Prescription drug subsidy received (8) (7) Foreign currency translation 239 (57) 4 (3) Business acquisitions (419) (29) (26) Other (43) 7 3 ------- ------- ------ ----- Benefit obligation at the end of the year (3,288) (3,092) (779) (859) ------- ------- ------ ----- Change in plan assets Fair value of plan assets at the beginning of the year 2,403 2,173 Actual return on plan assets (641) 194 Employer contributions 217 216 87 90 Benefits paid (287) (247) (87) (90) Foreign currency translation (214) 33 Business acquisitions 171 26 Other 25 8 ------- ------- ------ ----- Fair value of plan assets at the end of the year 1,674 2,403 ------- ------- ------ ----- Funded status (1,614) (689) (779) (859) Contributions after measurement date 7 5 ------- ------- ------ ----- Amount recognized in the Consolidated Balance Sheet $(1,614) $ (682) $(779) $(854) ======= ======= ====== =====
Amounts recognized in the Consolidated Balance Sheet follow:
Other postretirement Pension liabilities liabilities ---------------------- ------- ---------- 2008 2007 2008 2007 ---------- --------- ------- ---------- Non-current assets $ 67 $ 10 Current liabilities (31) (11) $ (76) $ (82) Non-current liabilities (1,650) (681) (703) (772) ------- ----- ----- ----- Amount recognized in the Consolidated Balance Sheet $(1,614) $(682) $(779) $(854) ======= ===== ===== =====
Page 36 Amounts recognized in Accumulated other comprehensive loss follow:
Other postretirement Pension liabilities liabilities ---------------------- ------- ---------- 2008 2007 2008 2007 ---------- --------- ------- ---------- Net actuarial loss $1,410 $764 $159 $232 Prior service cost (credit) 3 3 (13) (6) ------ ---- ---- ---- $1,413 $767 $146 $226 ====== ==== ==== ====
Changes in pension plan assets and benefit liabilities recognized in Accumulated other comprehensive loss in Shareholders' equity follow:
2008 2007 ------ ------ Accumulated other comprehensive loss at the beginning of the year $ 767 $1,074 Prior service cost arising during the year 4 (15) Net loss (gain) arising during the year 772 (190) Foreign currency translation (44) 13 Less amounts included in costs during the year (83) (115) Other (3) ------ ------ Net change for the year 646 (307) ------ ------ Accumulated other comprehensive loss at the end of the year $1,413 $ 767 ====== ======
Changes in other postretirement benefit liabilities recognized in Accumulated other comprehensive loss in Shareholders' equity follow:
2008 2007 ------ ------ Accumulated other comprehensive loss at the beginning of the year $226 $238 Prior service cost arising during the year (8) Net (gain) arising during the year (58) (3) Foreign currency translation (3) 2 Less amounts included in costs during the year (11) (11) ---- ---- Net change for the year (80) (12) ---- ---- Accumulated other comprehensive loss at the end of the year $146 $226 ==== ====
PENSION PLANS Assumptions used to determine pension benefit obligations and costs follow:
United States & Non-United States United States plans (weighted- plans average) ------------------ ------------------ 2008 2007 2006 2008 2007 2006 ---- ---- ---- ---- ---- ---- Assumptions used to determine benefit obligation at year-end Discount rate 6.30% 6.00% 5.60% 6.29% 5.96% 5.39% Rate of compensation increase 3.50% 3.50% 3.50% 3.61% 3.68% 3.67% Assumptions used to determine cost Discount rate 6.00% 5.60% 5.75% 5.96% 5.39% 5.51% Expected long-term return on plan assets 8.95% 8.75% 8.75% 8.44% 8.31% 8.35% Rate of compensation increase 3.50% 3.50% 3.50% 3.68% 3.67% 3.67%
Page 37 The expected long-term rate of return on pension assets was determined separately for each country and reflects long-term historical data taking into account each plan's target asset allocation. The components of pension benefit cost for continuing operations recorded in the Statements of Consolidated Income follow:
2008 2007 2006 ------ ----- ----- Service cost $(137) $(147) $(142) Interest cost (190) (163) (147) Expected return on plan assets 198 179 166 Amortization (49) (74) (67) ----- ----- ----- (178) (205) (190) Curtailment loss (1) (1) (10) Settlement loss (35) (41) (41) ----- ----- ----- Costs recorded in the Statements of Consolidated Income $(214) $(247) $(241) ===== ===== =====
The estimated net loss and prior service cost for the defined benefit pension plans that will be recognized from Accumulated other comprehensive loss into net periodic benefit cost in 2009 are $90 and $1, respectively. The total accumulated benefit obligation for all pension plans at December 31, 2008 was $3,083 and at December 31, 2007 was $2,874. The components of pension plans with an accumulated benefit obligation in excess of plan assets at December 31 follow:
2008 2007 ------ ------ Projected benefit obligation $2,819 $2,309 Accumulated benefit obligation 2,663 2,182 Fair value of plan assets 1,168 1,642
United States pension plans represent 65% and 68% of benefit obligations at December 31, 2008 and 2007, respectively. The weighted-average pension plan asset allocations by asset category at December 31, 2008 and 2007 are as follows:
2008 2007 ------ ------ Equity securities 70% 80% Debt securities 24% 18% Other 6% 2% --- --- 100% 100% === ===
Investment policies and strategies are developed on a country specific basis. The United States plan represents 59% of worldwide pension assets and its target allocation is 85% equity securities and 15% debt securities and other, including cash equivalents. The United Kingdom plan represents 33% of worldwide pension assets and its target allocation is up to 64% equity securities with the remainder in debt securities. Contributions to pension plans that Eaton expects to make in 2009, and made in 2008, 2007 and 2006, follow:
2009 2008 2007 2006 ---- ---- ---- ---- United States $190 $115 $150 $100 Other 81 95 70 62 ---- ---- ---- ---- $271 $210 $220 $162 ==== ==== ==== ====
At December 31, 2008, expected pension benefit payments for each of the next five years and the five years thereafter in the aggregate are, $230 in 2009, $237 in 2010, $251 in 2011, $266 in 2012, $277 in 2013 and $1,608 in 2014-2018. Page 38 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 are charged to expense and were $64 in 2008, $59 in 2007, and $55 in 2006. OTHER POSTRETIREMENT BENEFIT PLANS Assumptions used to determine other postretirement benefit obligations and cost follow:
2008 2007 2006 ---- ---- ---- Assumptions used to determine benefit obligation at year-end Discount rate 6.30% 6.00% 5.60% Health care cost trend rate assumed for next year 8.25% 8.30% 8.80% Ultimate health care cost trend rate 4.75% 4.75% 4.75% Year ultimate health care cost trend rate is achieved 2017 2015 2014 Assumptions used to determine cost Discount rate 6.00% 5.60% 5.75% Initial health care cost trend rate 8.30% 8.80% 9.60% Ultimate health care cost trend rate 4.75% 4.75% 4.75% Year ultimate health care cost trend rate is achieved 2015 2014 2014
The components of other postretirement benefits cost for continuing operations recorded in the Statements of Consolidated Income follow:
2008 2007 2006 ---- ---- ---- Service cost $(15) $(15) $(17) Interest cost (49) (47) (45) Amortization (11) (11) (11) ---- ---- ---- (75) (73) (73) Curtailment loss (2) ---- ---- ---- Costs recorded in the Statements of Consolidated Income $(75) $(73) $(75) ==== ==== ====
Estimated net loss and prior service cost (credit) for other postretirement benefit plans that will be recognized from Accumulated other comprehensive loss into net periodic benefit cost in 2009 are $6 and $(2), respectively. Assumed health care cost trend rates may have a significant effect on the amounts reported for the health care plans. A 1-percentage point change in the assumed health care cost trend rates would have the following effects:
1% Increase 1% Decrease ----------- ----------- Effect on total service and interest cost $ 2 $ (2) Effect on other postretirement liabilities 21 (20)
At December 31, 2008, expected other postretirement benefit payments for each of the next five years and the five years thereafter in the aggregate are $87 in 2009, $86 in 2010, $91 in 2011, $88 in 2012, $86 in 2013 and $364 in 2014-2018. The expected subsidy receipts related to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, which would reduce the other postretirement benefit payments listed above for each of the next five years and the five years thereafter in the aggregate are, $9 in 2009, 2010 and 2011, $10 in 2012 and 2013, and $50 in 2014-2018. 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 Page 39 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 the costs of remediation, which will be incurred over a period of several years. The Company accrues an amount on an undiscounted basis, consistent with the estimates of these costs when it is probable that a liability has been incurred. The Consolidated Balance Sheet included a liability for these costs of $85 at December 31, 2008 and $64 at December 31, 2007. Based upon Eaton's analysis and subject to the difficulty in estimating these future costs, the Company expects that any sum it may be required to pay in connection with environmental matters is not reasonably likely to exceed the liability by an amount that would have a material adverse effect on its financial position, results of operations or cash flows. All of these estimates are forward-looking statements and, given the inherent uncertainties in evaluating environmental exposures, actual results can differ from these estimates. CONTINGENCIES Eaton is subject to a broad range of claims, administrative proceedings, and legal proceedings, such as lawsuits that relate to contractual allegations, patent infringement, personal injuries (including asbes- tos claims) and employment-related matters. Although it is not pos- sible to predict with certainty the outcome or cost of these matters, the Company believes that these matters will not have a material ad- verse effect on its financial position, results of operations or cash flows. SHAREHOLDERS' EQUITY There are 500 million Common Shares authorized ($.50 par value per share), 165.0 million of which were issued and outstanding at year-end 2008. At December 31, 2008, there were 8,548 holders of record of Common Shares. Additionally, 19,987 current and former employees were shareholders through participation in the Eaton Savings Plan (ESP), Eaton Personal Investment Plan (EPIP) and Eaton Electrical de Puerto Rico Inc. Retirement Savings Plan. In the second quarter of 2008, Eaton sold 18.678 million of its Common Shares in a public offering, resulting in net cash proceeds of $1.522 billion. The cash proceeds from the sale of the Common Shares were used to repay borrowings incurred to fund the acquisitions of Moeller and Phoenixtec, and to repay commercial paper issued under the backstop provided by a $3.0 billion revolving credit agreement that Eaton terminated in May 2008. On January 22, 2007, Eaton announced that it had authorized a new 10 million Common Shares repurchase program. The shares are expected to be repurchased over time, depending on market conditions, the market price of the Company's Common Shares, the Company's capital levels and other considerations. The number of Common Shares repurchased in the open market and total cost, follows:
Shares (Shares in millions) repurchased Cost - ------------------------------ ----------- ----------- 2008 1.420 $100 2007 4.092 340 2006 5.286 386
The number of stock options exercised and the resulting cash proceeds follows: Page 40
Stock options Cash (Shares in millions) exercised proceeds - -------------------- ------------- -------- 2008 1.240 $ 47 2007 3.713 141 2006 3.083 108
Eaton has plans that permit certain employees and directors to defer a portion of their compensation. The Company has deposited $24 of Common Shares and marketable securities into a trust at December 31, 2008 to fund a portion of these liabilities. The marketable securities were included in Other assets and the Common Shares were included in Shareholders' equity at historical cost. STOCK OPTIONS Under various plans, stock options have been granted to certain employees and directors to purchase Common Shares at prices equal to fair market value on the date of grant. Substantially all of these options vest ratably during the three-year period following the date of grant and expire 10 years from the date of grant. Beginning in 2006, in accordance with SFAS No. 123(R), "Share-Based Payment", compensation expense is recorded for stock options and includes expense for all options granted prior to but not yet vested as of the end of 2005, and expense for options granted beginning in 2006, based on the fair value of the options at the date of grant. Expense is recognized on a straight-line basis over the period the employee or director is required to provide service in exchange for the award. The fair value of stock options granted was estimated using the Black-Scholes option pricing model. A summary of the assumptions used in determining the fair value of options follows:
2008 2007 2006 ----------- ----------- ----------- Expected volatility 27% to 22% 22% 25% Expected option life in years 5.5 5 5 Expected dividend yield 2.0% 2.0% 2.0% Risk-free interest rate 3.6% to 1.7% 4.0% to 4.9% 4.3% to 5.0% Weighted-average fair value of stock options granted $16.59 $17.79 $16.80
Application of the Black-Scholes option pricing model involves assumptions that are judgmental and affect compensation expense. Historical information was the primary basis for the selection of expected volatility, expected option life, and expected dividend yield. Expected volatility was based on the most recent historical period equal to the expected life of the option. The risk-free interest rate was based on yields of U.S. Treasury zero-coupon issues with a term equal to the expected life of the option, on the date the stock options were granted. A summary of stock option activity for 2008 follows:
Weighted- Weighted- average average remaining Aggregate price per contractual intrinsic (Shares in millions) option Options life in years value - -------------------- --------- ------- ------------- --------- Outstanding at January 1, 2008 $56.83 11.2 Granted 82.75 1.9 Exercised 39.68 (1.2) Canceled 78.79 (0.3) ---- Outstanding at December 31, 2008 $62.61 11.6 6.0 $45 ==== Exercisable at December 31, 2008 $54.43 7.9 4.9 $45 Reserved for future grants at December 31, 2008 2.6
The aggregate intrinsic value in the table above represents the total pretax difference between the $49.71 closing price of Eaton Common Shares on the last trading day of 2008 over the exercise price of the stock option, multiplied by the related number of options outstanding and exercisable. Under SFAS No. 123(R), the aggregate intrinsic value is not recorded for financial accounting purposes and the value changes based on the daily changes in the fair market value of the Company's Common Shares. Page 41 Information related to stock options follows:
2008 2007 2006 ---- ---- ---- Pretax expense for stock options $29 $ 30 $ 27 After-tax expense for stock options 20 21 20 Proceeds from stock options exercised 47 141 108 Income tax benefits related to stock options exercised Reported in operating activities in statement of cash flows 4 11 8 Reported in financing activities in statement of cash flows 13 42 28 Intrinsic value of stock options exercised 52 163 102 Total fair value of stock options vesting 31 31 29
As of December 31, 2008, the total compensation expense not yet recognized related to nonvested stock options was $39, and the weighted-average period in which the expense is expected to be recognized is 1.5 years. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The components of Accumulated other comprehensive income (loss) as reported in the Consolidated Balance Sheet follow:
2008 2007 ------- ----- Foreign currency translation and related hedging instruments (net of income tax benefits of $77 in 2008 and $8 in 2007) $ (532) $ 190 Deferred loss on cash flow hedges (net of income tax benefits of $16 in 2008 and $4 in 2007) (29) (6) Pensions (net of income tax benefits of $501 in 2008 and $274 in 2007) (912) (493) Other postretirement benefits (net of income tax benefits of $81 in 2008 and $112 in 2007) (65) (114) ------- ----- Accumulated other comprehensive loss at the end of the year $(1,538) $(423) ======= =====
A discussion of the adjustments related to pensions and other postretirement benefit liabilities is included in the "Retirement Benefit Plans" Note above. INCOME TAXES Income from continuing operations before income taxes is summarized below based on the geographic location of the operation to which such earnings are attributable. Certain foreign operations are branches of Eaton and are, therefore, subject to United States as well as foreign income tax regulations. As a result, pretax income by location and the components of income tax expense by taxing jurisdiction are not directly related. For purposes of this note to the consolidated financial statements, non-United States operations include Puerto Rico.
Income from continuing operations before income taxes ------------------------------ 2008 2007 2006 ------ ------ ---- United States $ 118 $ 52 $150 Non-United States 1,010 989 819 ------ ------ ---- $1,128 $1,041 $969 ====== ====== ====
Page 42
Income tax expense for continuing operations ---------------------- 2008 2007 2006 ----- ---- ---- Current United States Federal $ 36 $ 7 $ 13 State & local 4 9 (9) Non-United States 219 140 9 ----- ---- ---- 259 156 13 ----- ---- ---- Deferred United States Federal (17) (15) 25 State & local (29) (20) 24 Change in state and local valuation allowance (13) Non-United States Local expense (96) (39) 10 Change in valuation allowance (31) ----- ---- ---- (186) (74) 59 ----- ---- ---- $ 73 $ 82 $ 72 ===== ==== ====
Reconciliations of income taxes from the United States Federal statutory rate to the effective income tax rate for continuing operations follow:
2008 2007 2006 ----- ----- ----- Income taxes at the United States statutory rate 35.0% 35.0% 35.0% United States state & local income taxes 0.3% 0.2% 1.6% Other United States-net (0.4)% (1.5)% (1.0)% Non-United States operations (earnings taxed at other than United States tax rate) (18.9)% (20.3)% (18.9)% Adjustments to worldwide tax liabilities and valuation allowances (9.6)% (5.5)% (9.3)% ----- ----- ----- 6.4% 7.9% 7.4% ===== ===== =====
In 2008, 2007 and 2006, Eaton recognized income tax benefits of $108, $57 and $90, respectively, which represented adjustments to worldwide tax liabilities and valuation allowances. The 2008 income tax benefits reduced the effective income tax rate for 2008 from 16.0% to 6.4%. The 2008 benefits resulted from multiple income tax items including a benefit of $44 related to the consolidation of various legal entities and the recognition of $25 of tax credits related to the transfer of operations from Massa, Italy. The 2007 income tax benefits reduced the effective income tax rate for 2007 from 13.4% to 7.9%. The 2007 income tax benefits resulted from multiple income tax items. Included in the tax benefits were a $14 benefit from changes to state tax laws and a favorable revaluation of worldwide deferred tax assets. The income tax benefits for 2006 reduced the effective income tax rate for 2006 from 16.7% to 7.4%. Significant components of current and long-term deferred income taxes follow:
2008 2007 --------------------- --------------------- Long-term Long-term Current assets & Current assets & assets liabilities assets liabilities ------- ----------- ------- ----------- Accruals & other adjustments Employee benefits $ 57 $ 821 $ 85 $588 Depreciation & amortization (3) (692) (461) Other accruals & adjustments 185 100 224 100 Other items (5) (10) United States Federal income tax credit carryforwards 122 75 United States state & local tax loss carryforwards and tax credit carryforwards 104 96 Non-United States tax loss carryforwards 206 82 Non-United States income tax credit carryforwards 52 55 Valuation allowance (280) (18) (251) ----- ----- ----- ---- $ 239 $ 428 $ 291 $274 ===== ===== ===== ====
At the end of 2008, United States Federal income tax credit carryforwards of $122 were available to reduce future Federal income tax liabilities. These credits include $2 that expire in 2017, $17 that expire Page 43 in 2018, $51 that expire in 2025 through 2028, and $52 of which are not subject to expiration. A valuation allowance of $10 has been recorded for these income tax credit carryforwards. United States state and local tax loss carryforwards with a future tax benefit of $60 are also available at the end of 2008. Their expiration dates are $11 in 2009 through 2013, $9 in 2014 through 2018, $20 in 2019 through 2023, and $20 in 2024 through 2028. A valuation allowance of $45 has been recorded for these tax loss carryforwards. There are also United States state and local tax credit carryforwards with a future tax benefit of $44 available at the end of 2008. Their expiration dates are $10 in 2009 through 2013, $17 in 2014 through 2018, $8 in 2019 through 2023, and $9 in 2024 through 2028. A valuation allowance of $31 has been recorded for these tax credit carryforwards. At December 31, 2008, certain non-United States subsidiaries had tax loss carryforwards aggregating $740 that are available to offset future taxable income. Carryforwards of $203 expire at various dates from 2009 through 2028 and the balance has no expiration date. A deferred tax asset of $206 has been recorded for these tax loss carryforwards and a valuation allowance of $171 has also been recorded for these tax loss carryforwards. Tax credits at non-United States subsidiaries of $52 were available to reduce future income tax liabilities. These credits include $3 that will expire in 2015, $41 that will expire in 2016, and $8 that are not subject to limitation. A valuation allowance of $23 has been recorded for these income tax credits. With limited exceptions, no provision has been made for income taxes on undistributed earnings of non-United States subsidiaries of $4,311 at December 31, 2008, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable foreign withholding taxes that would be payable on the remittance of such undistributed earnings. Worldwide income tax payments were $185 in 2008, $141 in 2007 and $129 in 2006. UNRECOGNIZED INCOME TAX BENEFITS Effective January 1, 2007, Eaton adopted FASB Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." FIN No. 48 clarifies the accounting for uncertainty in income taxes by establishing minimum standards for the recognition and measurement of income tax positions taken, or expected to be taken, in an income tax return. FIN No. 48 also changes the disclosure standards for income taxes. Eaton's historical policy has been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4. The net income tax assets recognized under FIN No. 48 at January 1, 2007 did not differ from the net assets recognized before adoption, and, therefore, the Company did not record a cumulative-effect adjustment related to the adoption of FIN No. 48. A summary of gross unrecognized income tax assets follows:
2008 2007 ---- ---- Unrecognized income tax assets at the beginning of the year $ 96 $ 93 Increases and decreases as a result of positions taken during prior years: Transfers from (to) valuation allowances (2) 10 Other increases 11 4 Other decreases, including foreign currency translation (18) (26) Balances related to acquired businesses 30 Increases as a result of positions taken during the current year 35 33 Decreases relating to settlements with tax authorities (18) Decreases as a result of a lapse of the applicable statute of limitations (13) ---- ---- Unrecognized income tax assets at the end of the year $139 $ 96 ==== ====
If all of the gross unrecognized tax assets were recorded, the net impact on the effective income tax rate would be $118. The Company recognizes interest and penalties related to unrecognized income tax assets in the provision for income tax expense. The Company has accrued penalties in jurisdictions where they are automatically applied to any deficiency, regardless of the merit of the position. As of the adoption of FIN No. 48, the Company had accrued approximately $23 for the payment of interest and penalties and at Page 44 year end 2007, $20 was accrued. As of December 31, 2008, the Company had accrued approximately $38 for the payment of worldwide interest and penalties. The resolution of the majority of the Company's unrecognized income tax assets is dependent on uncontrollable factors such as law changes; new case law; the willingness of the income tax authority to settle the issue, including the timing thereof; and other factors. Therefore, for the majority of unrecognized income tax assets, it is not reasonably possible to estimate the increase or decrease in the next 12 months. For each of the unrecognized income tax assets where it is possible to estimate the increase or decrease in the balance within the next 12 months, the Company does not anticipate any significant change. The Company or its subsidiaries file income tax returns in the United States and foreign jurisdictions. The U.S. Internal Revenue Service (IRS) is currently in the process of conducting an examination of the Company's U.S. income tax returns for 2005 and 2006. The Company is also under examination for the income tax filings in various state and foreign jurisdictions. With only a few exceptions, the Company is no longer subject to state and local income tax examinations for years before 2005, or foreign examinations for years before 2003. The Company does not anticipate any adjustments that would result in a material change in financial position. OTHER INFORMATION ACCOUNTS RECEIVABLE Accounts receivable were net of an allowance for doubtful accounts of $38 at December 31, 2008 and $23 at December 31, 2007. INVENTORIES The components of inventories follow:
2008 2007 ------ ------ Raw materials $ 683 $ 674 Work-in-process 285 384 Finished goods 702 533 ------ ------ Inventories at FIFO 1,670 1,591 Excess of FIFO over LIFO cost (116) (108) ------ ------ $1,554 $1,483 ====== ======
Inventories at FIFO accounted for using the LIFO method were 43% and 42% at the end of 2008 and 2007, respectively. WARRANTY LIABILITIES A summary of the current and long-term liabilities for warranties follows:
2008 2007 2006 ----- ---- ---- Balance at the beginning of the year $ 167 $176 $157 Current year provision 95 57 91 Business acquisitions 13 7 1 Claims paid/satisfied (108) (73) (83) Other (2) 10 ----- ---- ---- Balance at the end of the year $ 165 $167 $176 ===== ==== ====
LEASE COMMITMENTS Eaton leases certain real properties and equipment. Minimum rental commitments at December 31, 2008 under noncancelable operating leases, which expire at various dates and in most cases contain renewal options, for each of the next five years and thereafter in the aggregate were, $117 in 2009, $97 in 2010, $73 in 2011, $50 in 2012, $36 in 2013 and $54 thereafter. Rental expense of continuing operations was $173 in 2008, $133 in 2007, and $123 in 2006. Page 45 NET INCOME PER COMMON SHARE A summary of the calculation of net income per Common Share assuming dilution and basic follows:
(Shares in millions) 2008 2007 2006 - -------------------- ------ ------ ------ Income from continuing operations $1,055 $ 959 $ 897 Income from discontinued operations 3 35 53 ------ ------ ------ Net income $1,058 $ 994 $ 950 ====== ====== ====== Average number of Common Shares outstanding assuming dilution 162.3 150.3 152.9 Less dilutive effect of stock options 2.1 3.0 2.7 ------ ------ ------ Average number of Common Shares outstanding basic 160.2 147.3 150.2 ====== ====== ====== Net income per Common Share assuming dilution Continuing operations $ 6.50 $ 6.38 $ 5.87 Discontinued operations .02 .24 .35 ------ ------ ------ $ 6.52 $ 6.62 $ 6.22 ====== ====== ====== Net income per Common Share basic Continuing operations $ 6.58 $ 6.51 $ 5.97 Discontinued operations .02 .24 .35 ------ ------ ------ $ 6.60 $ 6.75 $ 6.32 ====== ====== ======
FINANCIAL ASSETS & LIABILITIES MEASURED AT FAIR VALUE In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This Statement defines fair value for financial and non-financial assets and liabilities, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The guidance applies to other accounting pronouncements that require or permit fair value measurements. In 2008, Eaton adopted the provisions of SFAS No. 157 for financial assets and liabilities and for non-financial assets recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). These primarily included short and long-term investments, derivative financial instruments, assets related to defined benefit pension plans, and financial assets and liabilities related to acquired businesses. The adoption of this Statement in 2008 had an immaterial effect on Eaton's consolidated financial position and results of operations. A summary of financial assets and liabilities that were measured at fair value at December 31, 2008, follows:
Fair value measurement used -------------------------------------------- Quoted prices Quoted prices in active in active markets for markets for Other identical similar unobservable Recorded instruments instruments inputs value (Level 1) (Level 2) (Level 3) -------- ------------- ------------- ------------ Cash $ 188 $188 Short-term investments 342 342 Foreign currency forward exchange contracts 10 $ 10 Commodity contracts (25) (25) Fixed-to-floating interest rate swaps 93 93 Long-term debt converted to floating interest rates by interest rate swaps (93) (93) ----- ---- ---- ---- $ 515 $530 $(15) $ ===== ==== ==== ====
Assets of $1,674 related to defined benefit pension plans were also measured at fair value at December 31, 2008. The estimated fair values of financial instruments were principally based on market prices where such prices were available and, where unavailable, fair values were estimated based on market prices of Page 46 similar instruments, including consideration of the creditworthiness of the counterparties related to the instruments. In 2009, Eaton must adopt the provisions of SFAS No. 157 for other non-financial assets and liabilities, primarily goodwill, intangible assets, non-financial assets and liabilities related to acquired businesses, and impairment and restructuring activities. The Company expects that this Statement will not have a material effect on its consolidated financial position or results of operations in 2009. BUSINESS SEGMENT & GEOGRAPHIC REGION INFORMATION Eaton Corporation is a diversified power management company with 2008 sales of $15.4 billion. Eaton is a global technology leader in: electrical components and systems for power quality, distribution and control; hydraulics components, systems and services for industrial and mobile equipment; aerospace fuel, hydraulics and pneumatic systems for commercial and military use; and truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety. Eaton has approximately 75,000 employees and sells products to customers in more than 150 countries. In the first quarter of 2008, Eaton realigned its business segment financial reporting structure. The Fluid Power segment was realigned into the Hydraulics segment and the Aerospace segment. The Electrical and Truck segments continued as individual reporting segments and the automotive fluid connectors business was transferred to the Automotive segment from Fluid Power. Accordingly, business segment information for prior years has been restated to conform to the current year's presentation. The realignment of the business segments did not affect net income for any of the periods presented. ELECTRICAL The Electrical segment is a global leader in electrical control, power distribution, uninterruptible power supply (UPS) systems and industrial automation products and services. Products include circuit breakers, switchgear, UPS systems, power distribution units, panelboards, loadcenters, motor controls, meters, sensors and relays. The principal markets for the Electrical segment are industrial, institutional, government, utility, commercial, residential, IT, mission critical and original equipment manufacturer customers. These products are used wherever there is a demand for electrical power in commercial buildings, data centers, residences, apartment and office buildings, hospitals and factories. These customers are generally concentrated in North America, Europe and Asia Pacific; however, sales are made globally. Sales in the Electrical segment are made directly and indirectly through distributors, resellers, and manufacturers representatives to these customers. HYDRAULICS The Hydraulics segment is a worldwide leader in reliable, high-efficiency hydraulic components and systems for use in mobile and industrial markets. Eaton offers a wide range of power products including pumps, motors and hydraulic power units; a broad range of controls and sensing products, including valves, cylinders and electronic controls; a full range of fluid conveyance products, including industrial and hydraulic hose, fittings, and assemblies, thermoplastic hose and tubing, couplings, connectors, and assembly equipment; filtration systems solutions; heavy-duty drum and disc brakes; and golf grips. The principal market segments for Hydraulics include oil and gas, renewable energy, marine, agriculture, construction, mining, forestry, utility, material handling, truck and bus, machine tool, molding, primary metals, power generation, and entertainment. Key manufacturers in these markets and other customers are located globally, and these products are sold and serviced through a variety of channels. AEROSPACE The Aerospace segment is a leading global supplier to the commercial and military aviation and aerospace industries. Products include hydraulic power generation systems for aerospace applications, including pumps, motors, hydraulic power units, hose and fittings, electro-hydraulic pumps and power and load management systems; controls and sensing products, including valves, cylinders, electronic controls, electromechanical actuators, sensors, displays and panels, aircraft flap and slat systems and nose wheel steering systems; fluid conveyance products, including hose, thermoplastic tubing, fittings, adapters, couplings, sealing and ducting; and fuel systems, including fuel pumps, sensors, valves, adapters and regulators. The principal markets for the Aerospace segment are manufacturers of Page 47 commercial and military aircraft and related after-market customers. These manufacturers and other customers operate globally, and these products are sold and serviced through a variety of channels. TRUCK The Truck segment is a leader in the design, manufacture and marketing of a complete line of powertrain systems and components for commercial vehicles. Products include transmissions, clutches and hybrid electric power systems. The principal markets for the Truck segment are original equipment manufacturers and after-market customers of heavy-, medium- and light-duty trucks and passenger cars. These manufacturers and other customers are located globally, and most sales of these products are made directly to these customers. AUTOMOTIVE The Automotive segment is a leading supplier of critical components that reduce emissions and fuel consumption and improve stability and performance of cars, light trucks and commercial vehicles. Products include superchargers, engine valves and valve actuation systems, cylinder heads, locking and limited slip differentials, transmission controls, engine controls, fuel vapor components, compressor control clutches for mobile refrigeration, fluid connectors and hoses for air conditioning and power steering, decorative spoilers, underhood plastic components, fluid conveyance products including, hose, thermoplastic tubing, fittings, adapters, couplings and sealing products to the global automotive industry. The principal markets for the Automotive segment are original equipment manufacturers and aftermarket customers of light-duty trucks and passenger cars. These manufacturers and other customers are located globally, and most sales of these products are made directly to these customers. OTHER INFORMATION No single customer represented more than 10% of net sales in 2008, 2007 or 2006. Sales from United States operations to customers in foreign countries were $1,153 in 2008, $986 in 2007 and $988 in 2006 (8% of sales in 2008, 2007 and 2006). The accounting policies of the business segments are generally the same as the policies described under "Accounting Policies" above, except that inventories and related cost of products sold of the segments are accounted for using the FIFO method and operating profit only reflects the service cost component related to pensions and other postretirement benefits. Intersegment sales and transfers are accounted for at the same prices as if the sales and transfers were made to third parties. In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," for purposes of business segment performance measurement, the Company does not allocate to the business segments items that are of a non-operating nature, or corporate organizational and functional expenses of a governance nature. Corporate expenses consist of corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs. Identifiable assets of the business segments exclude goodwill, other intangible assets, and general corporate assets, which principally consist of cash, short-term investments, deferred income taxes, certain accounts receivable, certain property, plant and equipment, and certain other assets. Page 48 GEOGRAPHIC REGION INFORMATION Net sales and segment operating profit are measured based on the geographic location of the selling plant. Long-lived assets consist of property, plant and equipment-net.
Segment operating Long-lived Net sales profit assets --------- --------- ---------- 2008 United States $ 8,775 $ 1,136 $1,136 Canada 428 60 21 Europe 4,002 270 820 Latin America 1,455 160 250 Asia Pacific 1,963 179 412 Eliminations (1,247) ------- ------ $15,376 $2,639 ======= ====== 2007 United States $ 8,556 $ 1,177 $1,161 Canada 371 54 20 Europe 2,624 166 592 Latin America 1,246 150 345 Asia Pacific 1,144 121 215 Eliminations (908) ------- ------ $13,033 $2,333 ======= ====== 2006 United States $ 8,530 $ 1,146 $1,188 Canada 337 44 16 Europe 2,313 65 579 Latin America 1,090 120 318 Asia Pacific 888 93 170 Eliminations (926) ------- ------ $12,232 $2,271 ======= ======
Business segment operating profit was reduced by acquisition integration charges as follows:
2008 2007 2006 ---- ---- ---- United States $45 $27 $23 Europe 22 20 7 Latin America 12 6 Asia Pacific 9 5 4 --- --- --- $76 $64 $40 === === ===
Page 49 BUSINESS SEGMENT INFORMATION
2008 2007 2006 ------- ------- ------- NET SALES Electrical $ 6,920 $ 4,759 $ 4,184 Hydraulics 2,523 2,391 2,203 Aerospace 1,811 1,594 1,295 Truck 2,251 2,147 2,520 Automotive 1,871 2,142 2,030 ------- ------- ------- $15,376 $13,033 $12,232 ======= ======= ======= OPERATING PROFIT Electrical $ 863 $ 579 $ 474 Hydraulics 285 265 221 Aerospace 283 233 182 Truck 315 357 448 Automotive 59 234 143 CORPORATE Amortization of intangible assets (161) (79) (51) Interest expense-net (157) (147) (105) Minority interest (12) (14) (10) Pension & other postretirement benefit expense (141) (164) (152) Stock option expense (29) (30) (27) Contribution to Eaton Charitable Fund (16) Other corporate expense-net (177) (177) (154) ------- ------- ------- INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 1,128 1,041 969 Income taxes 73 82 72 ------- ------- ------- INCOME FROM CONTINUING OPERATIONS 1,055 959 897 Income from discontinued operations 3 35 53 ------- ------- ------- NET INCOME $ 1,058 $ 994 $ 950 ======= ======= ======= Business segment operating profit was reduced by acquisition integration charges as follows: Electrical $ 47 $ 12 $ 7 Hydraulics 6 12 11 Aerospace 20 39 12 Truck 5 Automotive 3 1 5 ------- ------- ------- $ 76 $ 64 $ 40 ======= ======= =======
Page 50 BUSINESS SEGMENT INFORMATION
2008 2007 2006 ------- ------- ------- IDENTIFIABLE ASSETS Electrical $ 3,055 $ 1,960 $ 1,669 Hydraulics 1,132 1,192 1,123 Aerospace 798 852 669 Truck 801 996 1,015 Automotive 947 1,145 1,105 ------- ------- ------- 6,733 6,145 5,581 Goodwill 5,232 3,982 3,034 Other intangible assets 2,518 1,557 969 Corporate 2,172 1,746 1,833 ------- ------- ------- Total assets $16,655 $13,430 $11,417 ======= ======= ======= EXPENDITURES FOR PROPERTY, PLANT & EQUIPMENT Electrical $ 162 $ 82 $ 74 Hydraulics 54 56 83 Aerospace 23 39 25 Truck 69 62 66 Automotive 54 79 92 ------- ------- ------- 362 318 340 Corporate 86 36 20 ------- ------- ------- $ 448 $ 354 $ 360 ======= ======= ======= DEPRECIATION OF PROPERTY, PLANT & EQUIPMENT Electrical $ 110 $ 79 $ 79 Hydraulics 59 62 63 Aerospace 27 26 24 Truck 89 84 77 Automotive 97 94 87 ------- ------- ------- 382 345 330 Corporate 27 23 22 ------- ------- ------- $ 409 $ 368 $ 352 ======= ======= =======
Page 51 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS Millions of dollars unless indicated otherwise (per share data assume dilution) OVERVIEW OF THE COMPANY Eaton Corporation is a diversified power management company with 2008 sales of $15.4 billion. Eaton is a global technology leader in: electrical components and systems for power quality, distribution and control; hydraulics components, systems and services for industrial and mobile equipment; aerospace fuel, hydraulics and pneumatic systems for commercial and military use; and truck and automotive drivetrain and powertrain systems for performance, fuel economy and safety. It has approximately 75,000 employees and sells products to customers in more than 150 countries. In the first quarter of 2008, Eaton realigned its business segment financial reporting structure. The Fluid Power segment was realigned into the Hydraulics segment and the Aerospace segment. The Electrical and Truck segments continued as individual reporting segments and the automotive fluid connectors business was transferred to the Automotive segment from Fluid Power. Accordingly, business segment information for prior years has been restated to conform to the current year's presentation. The realignment of the segments did not affect net income for any of the periods presented. The principal markets for the Electrical segment are industrial, institutional, government, utility, commercial, residential, IT, mission critical and original equipment manufacturer customers. These products are used wherever there is a demand for electrical power in commercial buildings, data centers, residences, apartment and office buildings, hospitals and factories. Customers are generally concentrated in North America, Europe and Asia Pacific; however, sales are made globally. Sales are made directly and indirectly through distributors, resellers and manufacturers representatives to these customers. The principal markets for the Hydraulics segment include oil and gas, renewable energy, marine, agriculture, construction, mining, forestry, utility, material handling, truck and bus, machine tools, molding, primary metals, power generation and entertainment. Customers are located globally, and products are sold and serviced through a variety of channels. The principal markets for the Aerospace segment are manufacturers of commercial and military aircraft and related after-market customers. Customers are located globally, and products are sold and serviced through a variety of channels. The principal markets for the Truck and Automotive segments are original equipment manufacturers and after-market customers of heavy-, medium-, and light-duty trucks and passenger cars. Customers are located globally, and most sales are made directly to these customers. HIGHLIGHTS OF RESULTS FOR 2008 Eaton reported record sales of $15.4 billion in 2008, which grew 18% over 2007, and record net income of $1.06 billion, which rose 6% over 2007. Net income per Common Share was $6.52, a 1% decline from 2007 reflecting a higher number of average Common Shares outstanding in 2008 compared to 2007. Results for 2008 improved over 2007 despite the negative effect on Eaton's end markets of the turmoil in the world credit markets in 2008 and weaker than expected conditions in end markets that fell sharply in the fourth quarter of 2008. The growth in financial results in 2008 was due in part to Eaton's improved business and geographic balance which allowed Eaton to grow despite downturns in certain end markets, especially in the fourth quarter of 2008. Eaton achieved a fundamental repositioning of the business in 2008, as seen by the fact that in the second half of 2008, the Electrical, Hydraulics and Aerospace businesses earned almost 90% of business segment operating profits. During 2008, sales and operating profits for the Electrical, Hydraulics, and Aerospace segments all increased compared to 2007 and were new all-time records, and operating margins for Electrical and Hydraulics in 2008 were also new records. Sales of the Truck segment increased in 2008 compared to 2007, while operating profit for this segment fell 12% in 2008 from 2007. The reduction in operating profit was primarily due to operating inefficiencies related to the inability to absorb fixed manufacturing costs resulting from volatility in end markets in 2008. Sales of the Automotive segment decreased 13% in 2008 from 2007, and operating profit fell 75% in 2008, due to declines in automotive unit production in North American and European end markets, especially in the Page 52 fourth quarter of 2008, and expenses related to the closing of a plant in Massa, Italy announced in the fourth quarter of 2008. The following are highlights of 2008:
Increase/ 2008 2007 (Decrease) ------- ------- ---------- Continuing operations Net sales $15,376 $13,033 18% Gross profit 4,185 3,651 15% Percent of net sales 27.2% 28.0% Income before income taxes 1,128 1,041 8% Income after income taxes $ 1,055 $ 959 10% Income from discontinued operations 3 35 ------- ------- Net income $ 1,058 $ 994 6% ======= ======= Net income per Common Share assuming dilution Continuing operations $ 6.50 $ 6.38 2% Discontinued operations .02 .24 ------- ------- $ 6.52 $ 6.62 (1)% ======= ======= Return on Shareholders' equity 17% 22%
Sales growth of 18% in 2008 over 2007 consisted of 14% from acquisitions of businesses, 3% from organic growth, and 1% from foreign exchange. Acquisitions of businesses were primarily The Moeller Group, acquired in April 2008; Phoenixtec, acquired in February 2008; and the MGE small systems UPS business, acquired in October 2007, all of which are included in the Electrical segment, along with the Argo-Tech aerospace business, acquired in March 2007. These acquisitions further increased the proportion of Eaton's sales outside of the United States. Organic growth included 2% from growth in end markets and 1% from outgrowing end markets. Gross profit increased 15% in 2008 over 2007. This increase was primarily due to sales growth of 18% which included sales of acquired businesses; the benefits of integrating acquired businesses; and continued productivity improvements driven by the Eaton Business System (EBS). These increases in gross profit were partially offset by the impact of rising prices for raw materials, supplies and other commodities, and expense of $27 related to the announced closing in the fourth quarter of 2008 of the automotive engine valve lifters manufacturing plant in Massa, Italy. Net income in 2008 increased 6% over 2007. The increase was primarily due to higher sales and the other factors that affected gross profit discussed above, along with lower income taxes. These increases were partially offset by increases in selling, administrative, research and development, and interest expenses resulting from the inclusions of Moeller and Phoenixtec, and higher levels of expenses to support sales from existing operations. In addition, a $20 after-tax gain on the sale of the Mirror Controls business was included in income from discontinued operations in 2007 that was not present in 2008. Net income per Common Share in 2008 decreased 1% from 2007 due to the factors that resulted in increased net income discussed above, offset by the increase in average shares outstanding resulting from the sale of 18.678 million Common Shares in the second quarter of 2008. In 2008, Eaton acquired six businesses and entered into a joint venture in separate transactions. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition. These acquisitions are summarized below: - - On October 2, 2008, Integ Holdings Limited, the parent company of Integrated Hydraulics Ltd., a U.K.-based manufacturer of screw-in cartridge valves, custom-engineered hydraulic valves and manifold systems, was acquired. The business had sales of $52 in 2007 and is included in the Hydraulics segment. - - Nittan Global Tech Co. Ltd., a joint venture, became operational on October 1, 2008. The new joint venture will manage the global design, manufacture and supply of engine valves and valve actuation products to Japanese and Korean automobile and engine manufacturers. In addition, during the second half of 2008, several related manufacturing joint ventures were established. Page 53 - - On July 31, 2008, the Engine Valves Business of Kirloskar Oil Engines Ltd., an India-based designer, manufacturer and distributor of intake and exhaust valves for diesel and gasoline engines, was acquired. The business had sales of $5 in 2007 and is included in the Automotive segment. - - On July 31, 2008, PK Electronics, a Belgium-based distributor and service provider of single phase and three-phase uninterruptible power supply (UPS) systems, was acquired. This business had sales of $9 for 2007 and is included in the Electrical segment. - - On April 4, 2008, The Moeller Group, a Germany-based supplier of electrical components for commercial and residential building applications and industrial controls for industrial equipment applications, was acquired. The business had sales of E1.02 billion in 2007 and is included in the Electrical segment. - - On March 31, 2008, Balmen Electronic, S.L., a Spain-based distributor and service provider of uninterruptible power supply (UPS) systems, was acquired. The business had sales of $6 in 2007 and is included in the Electrical segment. - - On February 26, 2008, Phoenixtec Power Company Ltd., a Taiwan-based manufacturer of single and three-phase uninterruptible power supply (UPS) systems, was acquired. The business had sales of $515 in 2007 and is included in the Electrical segment. Net cash provided by operating activities was $1,416 in 2008, an increase of $255 over $1,161 of net cash provided by operating activities in 2007. The increase in operating cash flows, which demonstrated the strength of the mix of Eaton's businesses, was primarily due to higher net income of $64, a $123 increase in non-cash depreciation and amortization related to businesses acquired, an increase of $66 in cash received from the termination of interest rate swaps, and $9 in lower working capital funding. These increases were partially offset by the year-over-year changes in non-cash expense for deferred income taxes of $174. Strong cash flow from operations allowed commercial paper to be reduced to $767 at the end of 2008 and allowed Eaton to end 2008 with cash and short-term investments that totaled $530. Net working capital of $1,050 at year-end 2008 compared to $1,108 at year-end 2007, or a net reduction of $58. The reduction in net working capital was primarily due to the net $116 decrease in cash and short-term investments and the $109 increase in the current portion of long-term debt in 2008. These changes were partially offset by the $87 increase in accounts receivable and the $71 increase in inventories, which primarily resulted from the acquisitions of Moeller and Phoenixtec. The current ratio was 1.28 at December 31, 2008, almost the same as the ratio of 1.30 at year-end 2007. In February 2008, Eaton borrowed $250 under a 364-day $3.0 billion revolving credit agreement to partially finance the acquisition of Phoenixtec. In April 2008, Eaton borrowed E1.33 billion under the revolving credit agreement to finance the acquisition of Moeller. In order to refinance this debt, Eaton sold 18.678 million of its Common Shares in a public offering in the second quarter of 2008, resulting in net cash proceeds of $1.522 billion. In May 2008, Eaton issued $300 of 4.9% notes due in 2013 and $450 of 5.6% notes due in 2018. The cash proceeds from the sale of the Common Shares and from the issuance of the notes were used to repay borrowings incurred to fund the acquisitions of Moeller and Phoenixtec, and to repay commercial paper issued under the backstop provided by the $3.0 billion revolving credit agreement. Subsequently, in May 2008 Eaton terminated the $3.0 billion revolving credit agreement. Total debt of $4,271 at December 31, 2008 increased $854 from $3,417 at year-end 2007. The increase in total debt included the issuance of $860 of long-term notes and $796 of commercial paper and other borrowings, partially offset by the repayment of $989 of notes, commercial paper and other debt. The increase in total debt largely resulted from funding the acquisitions of Moeller, Phoenixtec, and other businesses in 2008 for $2,807 and borrowings to fund working capital and other requirements, offset by cash proceeds of $1,522 from the sale of 18.678 million Common Shares in the second quarter of 2008. The net-debt-to-capital ratio was 37.2% at December 31, 2008 compared to 34.9% at year-end 2007, reflecting the combined effect during 2008 of the $854 increase in total debt, the $116 decrease in cash and short-term investments, and the $1,145 increase in Shareholders' equity, which primarily resulted from the sale of Common Shares in the second quarter and from net income of $1,058 for 2008, partially offset by other items. Page 54 On January 21, 2008, Eaton increased the quarterly dividend on its Common Shares by 16%, from $.43 per share to $.50 per share, effective for the February 2008 dividend. RESULTS OF OPERATIONS - 2008 COMPARED TO 2007
Increase/ 2008 2007 (Decrease) ------- ------- --------- Continuing operations Net sales $15,376 $13,033 18% Gross profit 4,185 3,651 15% Percent of net sales 27.2% 28.0% Income before income taxes 1,128 1,041 8% Income after income taxes $ 1,055 $ 959 10% Income from discontinued operations 3 35 ------- ------- Net income $ 1,058 $ 994 6% ======= ======= Net income per Common Share assuming dilution Continuing operations $ 6.50 $ 6.38 2% Discontinued operations .02 .24 ------- ------- $ 6.52 $ 6.62 (1)% ======= =======
Sales growth of 18% in 2008 over 2007 consisted of 14% from acquisitions of businesses, 3% from organic growth, and 1% from foreign exchange. Acquisitions of businesses were primarily The Moeller Group, acquired in April 2008; Phoenixtec, acquired in February 2008; and the MGE small systems UPS business, acquired in October 2007, all of which are included in the Electrical segment, along with the Argo-Tech aerospace business, acquired in March 2007. These acquisitions further increased the proportion of Eaton's sales outside of the United States. Organic growth included 2% from growth in end markets and 1% from outgrowing end markets. Gross profit increased 15% in 2008 over 2007. This increase was primarily due to sales growth of 18%, which included sales of acquired businesses; the benefits of integrating acquired businesses; and continued productivity improvements driven by the Eaton Business System (EBS). These increases in gross profit were partially offset by the impact of rising prices for raw materials, supplies and other commodities, and expense of $27 related to the announced closing in the fourth quarter of 2008 of the automotive engine valve lifters manufacturing plant in Massa, Italy. RESULTS BY GEOGRAPHIC REGION Net sales and segment operating profit are measured based on the geographic location of the selling plant.
Net sales Segment operating profit Operating margin ---------------------------- ---------------------------- ---------------- Increase/ 2008 2007 Increase 2008 2007 (Decrease) 2008 2007 ------- ------- -------- ------ ------ ---------- ------- ------ United States $ 8,775 $ 8,556 3% $1,136 $1,177 (3)% 12.9% 13.8% Canada 428 371 15% 60 54 11% 14.0% 14.6% Europe 4,002 2,624 53% 270 166 63% 6.7% 6.3% Latin America 1,455 1,246 17% 160 150 7% 11.0% 12.0% Asia Pacific 1,963 1,144 72% 179 121 48% 9.1% 10.6% Eliminations (1,247) (908) ------- ------- $15,376 $13,033 18% ======= =======
In the United States, sales in 2008 increased 3% compared to 2007. The increase in sales was primarily due to growth in the Electrical, Aerospace and Hydraulics segments, as well as the acquisitions in 2007 of Argo-Tech and other businesses. These increases were partially offset by reduced sales in the Automotive segment due to the sharp decline in the North American automotive market during 2008, and reduced sales of the Truck segment. The 3% decline in operating profit in the United States reflected improved performance of the Electrical and Aerospace segments due to sales growth from existing businesses and the benefits of integrating acquired businesses, offset by reduced operating profit of the Automotive and Truck segments due to reduced sales resulting from declines in end markets. Acquisition integration charges were $45 in 2008 compared to $27 in 2007. Page 55 Growth in Canada in 2008 of 15% in sales and 11% in operating profit was primarily due to higher sales in the Electrical segment resulting from growth in end markets and from acquired businesses. Sales growth in Europe in 2008 of 53% was primarily due to higher sales in the Electrical segment, which was largely due to the acquisitions of Moeller in 2008 and the MGE small systems UPS business in 2007, as well as growth in end markets. Sales growth was also due to increased sales in the Aerospace, Hydraulics, Truck and Automotive segments largely due to growth in end markets. The 63% increase in operating profit in Europe was largely due to higher operating profits of the Electrical segment resulting from the acquisitions of Moeller and MGE and sales growth from existing businesses. This increase also reflected improved results of the Aerospace and Hydraulics segments. These increases in operating profits were partially offset by reduced operating profits of the Truck and Automotive segments, and expense of $27 related to the announced closing in the fourth quarter of 2008 of the automotive engine valve lifters manufacturing plant in Massa, Italy. Acquisition integration charges were $22 in 2008 compared to $20 in 2007. In Latin America, sales growth in 2008 of 17% was largely due to the Truck, Electrical and Hydraulics segments, primarily due to growth in end markets. The 7% increase in operating profit in Latin America was attributable to higher sales in 2008 and lower acquisition integration charges in 2008 compared to 2007. There were no acquisition integration charges in 2008 compared to $12 in 2007. Growth in Asia Pacific in 2008 of 72% in sales and 48% in operating profit was primarily due to the acquisition of the Phoenixtec electrical business in 2008 and higher sales in the Electrical, Hydraulics, Automotive and Truck segments, mainly resulting from growth in end markets. Acquisition integration charges were $9 in 2008 compared to $5 in 2007. OTHER RESULTS OF OPERATIONS In 2008 and 2007, Eaton incurred charges related to the integration of acquired businesses. These charges, which consisted of plant consolidations and integration, were expensed as incurred. Charges in 2008 related primarily to the integration of the following acquisitions: in the Electrical segment, Moeller, Phoenixtec and the MGE small systems UPS business; in the Hydraulics segment, Ronningen-Petter and Synflex; in the Aerospace segment, Argo-Tech, PerkinElmer and Cobham; and in the Automotive segment, Saturn and the engine valve business of Kirloskar Oil Engines Ltd. Charges in 2007 related primarily to the integration of the following acquisitions: in the Electrical segment, the MGE small systems UPS business, Schreder-Hazemeyer, Senyuan and Powerware; in the Hydraulics segment, Synflex, Hayward and Walterscheid; in the Aerospace segment, Argo-Tech, PerkinElmer and Cobham; and in the Automotive segment, Saturn. A summary of these charges follows:
2008 2007 ---- ---- Electrical $ 47 $ 12 Hydraulics 6 12 Aerospace 20 39 Automotive 3 1 Corporate 1 ---- ---- Pretax charges $ 77 $ 64 ==== ==== After-tax charges $ 51 $ 42 Per Common Share $.31 $.28
Acquisition integration charges in 2008 included $46 for the United States, $22 for Europe, and $9 for Asia Pacific. Charges in 2007 included $27 for the United States, $20 for Europe, $12 for Latin America and $5 for Asia Pacific. The acquisition integration 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 segment. On October 20, 2008, Eaton announced the closure of its automotive engine valve lifters manufacturing plant in Massa, Italy. There were 350 employees affected by the closure decision. The action was taken to better align manufacturing capacity with future industry demand and to improve the competitive position of the valve actuation business. Aggregate pretax charges associated with this closure were Page 56 $27, which were recognized in the fourth quarter of 2008, when management approved this action. These costs, which consisted of charges of $17 for severance, $7 for the write-down of assets and $3 for other costs, reduced operating profit of the Automotive segment. In 2008 and 2007, Eaton recognized income tax benefits of $108 and $57, respectively, which represented adjustments to worldwide tax liabilities and valuation allowances. The 2008 income tax benefits reduced the effective income tax rate for 2008 from 16.0% to 6.4%. The 2008 benefits resulted from multiple income tax items including a benefit of $44 related to the consolidation of various legal entities and the recognition of $25 of tax credits related to the transfer of operations from Massa, Italy. The 2007 income tax benefits reduced the effective income tax rate for 2007 from 13.4% to 7.9%. The 2007 income tax benefits resulted from multiple income tax items. Included in the tax benefits were a $14 benefit from changes to state tax laws and a favorable revaluation of worldwide deferred tax assets. Further analysis regarding the change in the effective income tax rate in 2008 compared to 2007 is found in "Income Taxes" in the Notes to the Consolidated Financial Statements. Net income in 2008 increased 6% over 2007. The increase was primarily due to higher sales and the other factors that affected gross profit discussed above, along with lower income taxes. These increases were partially offset by increases in selling, administrative, research and development, and interest expenses resulting from the inclusions of Moeller and Phoenixtec, and higher levels of expenses to support sales from existing operations. In addition, a $20 after-tax gain on the sale of the Mirror Controls business was included in income from discontinued operations in 2007 that was not present in 2008. Net income per Common Share in 2008 decreased 1% from 2007 due to the factors that resulted in increased net income discussed above, offset by the increase in average shares outstanding resulting from the sale of 18.678 million Common Shares in a public offering in the second quarter of 2008. RESULTS BY BUSINESS SEGMENT ELECTRICAL
2008 2007 Increase ------ ------ -------- Net sales $6,920 $4,759 45% Operating profit 863 579 49% Operating margin 12.5% 12.2%
Sales of the Electrical segment reached record levels in 2008. The 45% increase in sales over 2007 consisted of 37% from acquisitions of businesses, primarily Moeller, Phoenixtec and the MGE small systems UPS business, and 8% from organic growth. End markets for the Electrical segment grew about 4% during 2008 compared to 2007, with both U.S. markets and non-U.S. markets growing 4% during the year. However, due to the economic downturn, end markets for this business grew only about 1% during the fourth quarter of 2008, a slowdown from the 4% growth in the third quarter and the rest of the year. Nonresidential construction spending in the United States held up well in 2008, but Eaton expects it to begin to decline by the second quarter of 2009. Operating profit rose 49% in 2008 over 2007, and operating margin rose to 12.5%, both of which were records for this segment. The increase in operating profit was largely due to growth in sales, results of acquired businesses, and continued productivity improvements. Operating profit was reduced by acquisition integration charges of $47 in 2008 compared to charges of $12 in 2007, which reduced the operating margin by 0.7% and 0.3% in 2008 and 2007, respectively. Acquisition integration charges in 2008 primarily related to Moeller, Phoenixtec and the MGE small systems UPS business. Charges in 2007 related to MGE small systems UPS business, Schreder-Hazemeyer, Senyuan and Powerware. The incremental operating margin for 2008 (the increase in operating profit compared to the increase in sales) was 13%. The operating margin for acquired businesses for 2008 was 14%. New businesses acquired during 2008 in the Electrical segment include the following: - - On July 31, 2008, PK Electronics, a Belgium-based distributor and service provider of single phase and three-phase uninterruptible power supply (UPS) systems, was acquired. This business had sales of $9 for 2007. - - On April 4, 2008, The Moeller Group, a Germany-based business which is a leading supplier of electrical components for commercial and residential building applications and industrial controls Page 57 for industrial equipment applications, was acquired. This business had sales of E1.02 billion for 2007. - - On March 31, 2008, Balmen Electronic, S.L., a Spain-based distributor and service provider of uninterruptible power supply (UPS) systems, was acquired. This business had sales of $6 for 2007. - - On February 26, 2008, Phoenixtec Power Company Ltd., a Taiwan-based manufacturer of single and three-phase uninterruptible power supply (UPS) systems, was acquired. This business had sales of $515 for 2007. HYDRAULICS
2008 2007 Increase ------ ------ -------- Net sales $2,523 $2,391 6% Operating profit 285 265 8% Operating margin 11.3% 11.1%
Sales of the Hydraulics segment reached record levels in 2008. The 6% increase in sales consisted of 3% from foreign exchange, 2% from organic growth and 1% from acquisitions of businesses. Global hydraulics end markets grew 2% in 2008 compared to 2007, with U.S. markets up 1% and non-U.S. markets up 3%. However, global hydraulics markets declined markedly in the fourth quarter of 2008, led by steep production cutbacks by customers around the world. During the fourth quarter of 2008, hydraulics markets declined 8% compared to the same period in 2007, with U.S. markets down 9% and non-U.S. markets down 8%. Operating profit rose 8% in 2008 over 2007, and operating margin increased to 11.3%, both of which were records for this segment. The increase in operating profit was due to growth in sales, the benefits of integrating acquired businesses, and an overall improvement in operating efficiencies. Operating profit was reduced by acquisition integration charges of $6 in 2008 compared to charges of $12 in 2007, which reduced the operating margin by 0.2% and 0.5% in 2008 and 2007, respectively. Acquisition integration charges in 2008 primarily related to Ronningen-Petter and Synflex. Charges in 2007 largely related to Synflex, Hayward and Walterscheid. The incremental operating margin for 2008 was 15%. On October 2, 2008, Integ Holdings Limited, the parent company of Integrated Hydraulics Ltd., a U.K.-based manufacturer of screw-in cartridge valves, custom-engineered hydraulic valves and manifold systems, was acquired. The business had sales of $52 in 2007. AEROSPACE
2008 2007 Increase ------ ------ -------- Net sales $1,811 $1,594 14% Operating profit 283 233 21% Operating margin 15.6% 14.6%
Sales of the Aerospace segment reached record levels in 2008. The 14% increase in sales consisted of 13% from organic growth and 2% from acquisitions of businesses, partially offset by a decrease of 1% from foreign exchange. Aerospace end markets in 2008 grew 3%. Non-U.S. markets grew 11%, driven by strong deliveries from Airbus, while U.S. markets were flat, driven by a decline in deliveries of new aircraft from Boeing as a result of a strike at its manufacturing operations. Operating profit rose 21% in 2008 over 2007 and was a record for this segment. The increase in operating profit was due to growth in sales, the benefits of integrating acquired businesses, and an overall improvement in operating efficiencies. Operating profit was reduced by acquisition integration charges of $20 in 2008 compared to charges of $39 in 2007, which reduced the operating margin by 1.1% and 2.4% in 2008 and 2007, respectively. Acquisition integration charges in 2008 and 2007 primarily related to Argo-Tech, PerkinElmer and Cobham. Despite inefficiencies incurred as a result of the Boeing strike, this segment earned a 15.6% operating margin in 2008. The incremental operating margin for 2008 was 23%. Page 58 TRUCK
Increase/ 2008 2007 (Decrease) ------ ------ ---------- Net sales $2,251 $2,147 5% Operating profit 315 357 (12)% Operating margin 14.0% 16.6%
Sales of the Truck segment increased 5% in 2008 over 2007. The 5% increase in sales consisted of 2% from organic growth and 3% from foreign exchange. End markets were up 1% in 2008 over 2007, with U.S. markets down 5% and non-U.S. markets up 9%. Production of North American heavy-duty trucks in 2008 totaled 205,000 units, a decrease of 3% from 2007, with particular weakness in the fourth quarter. Operating profit of $315 in 2008 was 12% lower than 2007, primarily due to operating inefficiencies related to the inability to absorb fixed manufacturing costs resulting from volatile end markets. In spite of end markets for the Truck segment that performed unevenly in 2008, this segment achieved an operating margin of 14.0% in 2008. AUTOMOTIVE
2008 2007 Decrease ------ ------ -------- Net sales $1,871 $2,142 (13)% Operating profit 59 234 (75)% Operating margin 3.2% 10.9%
The 13% decrease in sales of the Automotive segment in 2008 from 2007 reflected a 15% decrease in sales volume, partially offset by a 2% increase from foreign exchange. In 2008, global automotive markets declined 7% compared to 2007, with U.S. markets down 16% and non-U.S. markets down 2%. The North American markets were weak throughout 2008, and Europe, Brazil and China also weakened dramatically during the year. In addition, the strike at a major U.S. automotive supplier was not fully resolved until very late in the second quarter of 2008, further reducing automotive production in the U.S. in 2008. Additionally, due to the economic downturn in the fourth quarter of 2008, automotive markets dropped sharply around the world, with automotive unit production in the fourth quarter declining by 24%. Operating profit decreased 75% in 2008 from 2007, largely due to the decline in sales volume and changes in product mix. The sharp slowdown in end markets in 2008, as well as continued shifts in mix to smaller vehicles in the U.S, resulted in the inability of this business to absorb fixed manufacturing costs, which severely impacted operating profit. The sudden drop in sales volume during the fourth quarter of 2008 created significant additional manufacturing inefficiencies and necessitated significant reductions in personnel. In addition, an action was taken in the fourth quarter of 2008 to close the Massa, Italy, valve actuation plant, which resulted in a charge in the fourth quarter of $27. Operating profit was also reduced by acquisition integration charges of $3 in 2008 as compared to $1 in 2007, which reduced operating margin by 0.2% in 2008 and 0.1% in 2007. Acquisition integration charges in 2008 related to Saturn and the engine valve business of Kirloskar Oil Engines Ltd. Charges in 2007 related to Saturn. On October 1, 2008, Nittan Global Tech Co. Ltd., a joint venture, became operational. The new joint venture will manage the global design, manufacture and supply of engine valves and valve actuation products to Japanese and Korean automobile and engine manufacturers. In addition, during the second half of 2008, several related manufacturing joint ventures were established. On July 31, 2008, the engine valves business of Kirloskar Oil Engines Ltd. was acquired. This India-based company, which had sales of $5 in 2007, designs, manufacturers and sells intake and exhaust valves for diesel and gasoline engines. CORPORATE Amortization of intangible assets was $161 in 2008, an increase from $79 in 2007, reflecting amortization of intangible assets associated with recently acquired businesses, primarily the Moeller, Phoenixtec and MGE small systems UPS electrical businesses. Page 59 Interest expense was $157 in 2008, an increase from $147 in 2007. The increase was primarily due to borrowings to finance recently acquired businesses, primarily the Moeller, Phoenixtec, MGE small systems UPS electrical businesses, and Argo-Tech. Corporate pension & other postretirement benefit expense was $141 in 2008, a decrease from $164 in 2007. The decrease was primarily due to the effect of updated actuarial assumptions. LIQUIDITY, CAPITAL RESOURCES & CHANGES IN FINANCIAL CONDITION DURING 2008 Net cash provided by operating activities was $1,416 in 2008, an increase of $255 over $1,161 of net cash provided by operating activities in 2007. The increase in operating cash flows, which demonstrated the strength of the mix of Eaton's businesses, was primarily due to higher net income of $64, a $123 increase in non-cash depreciation and amortization related to businesses acquired, an increase of $66 in cash received from the termination of interest rate swaps, and $9 in lower working capital funding. These increases were partially offset by the year-over-year change in non-cash expense for deferred income taxes of $174. Strong cash flow from operations allowed commercial paper to be reduced to $767 at the end of 2008 and allowed Eaton to end 2008 with cash and short-term investments that totaled $530. Net working capital of $1,050 at year-end 2008 compared to $1,108 at year-end 2007, or a net reduction of $58. The reduction in net working capital was primarily due to the net $116 decrease in cash and short-term investments and the $109 increase in the current portion of long-term debt in 2008. These changes were partially offset by the $87 increase in accounts receivable and the $71 increase in inventories, which primarily resulted from the acquisitions of Moeller and Phoenixtec. The current ratio was 1.28 at December 31, 2008, almost the same as the ratio of 1.30 at year-end 2007. Eaton monitors the third-party depository institutions that hold its cash and short-term investments on a daily basis. Its emphasis is primarily on safety of principal and secondarily on maximizing yield on those funds. Eaton diversifies its cash and short-term investments among counterparties to minimize exposure to any one of these entities. Eaton also monitors the credit worthiness of its customers and suppliers to mitigate any adverse impact on it. Capital expenditures for property, plant and equipment were $448, an increase from $354 in 2007. Capital expenditures for 2009 are expected to be $250, which would be 44% below capital expenditures made in 2008. In February 2008, Eaton borrowed $250 under a 364-day $3.0 billion revolving credit agreement to partially finance the acquisition of Phoenixtec. In April 2008, Eaton borrowed E1.33 billion under the revolving credit agreement to finance the acquisition of Moeller. In order to refinance this debt, Eaton sold 18.678 million of its Common Shares in a public offering in the second quarter of 2008, resulting in net cash proceeds of $1.522 billion. In May 2008, Eaton issued $300 of 4.9% notes due in 2013 and $450 of 5.6% notes due in 2018. The cash proceeds from the sale of the Common Shares and from the issuance of the notes were used to repay borrowings incurred to fund the acquisitions of Moeller and Phoenixtec, and to repay commercial paper issued under the backstop provided by the $3.0 billion revolving credit agreement. Subsequently, in May 2008 Eaton terminated the $3.0 billion revolving credit agreement. Total debt of $4,271 at December 31, 2008 increased $854 from $3,417 at year-end 2007. The increase in total debt included the issuance of $860 of long-term notes and $796 of commercial paper and other borrowings, partially offset by the repayment of $989 of notes, commercial paper and other debt. The increase in total debt largely resulted from funding the acquisitions of Moeller, Phoenixtec, and other businesses in 2008 for $2,807 and borrowings to fund working capital and other requirements, offset by cash proceeds of $1,522 from the sale of 18.678 million Common Shares in the second quarter of 2008. The net-debt-to-capital ratio was 37.2% at December 31, 2008 compared to 34.9% at year-end 2007, reflecting the combined effect during 2008 of the $854 increase in total debt, the $116 decrease in cash and short-term investments, and the $1,145 increase in Shareholders' equity, which resulted principally from the sale of Common Shares in the second quarter and from net income of $1,058 for 2008, partially offset by other items. Aggregate mandatory annual maturities of long-term debt for each of the next five years are $269 in 2009, $281 in 2010, $0 in 2011, $312 in 2012 and $307 in 2013. As of December 31, 2008, Eaton had no debt agreements that resulted in any material restriction on the net assets of any of its subsidiaries. Page 60 In May 2008, Eaton entered into a new $500 revolving credit facility. This facility replaced two existing facilities totaling $300 that expired in May 2008. The new facility increases Eaton's United States long-term revolving credit facilities with banks to $1.7 billion, of which $700 expire in 2010, $500 in 2011 and $500 in 2013. These revolving credit facilities support Eaton's commercial paper borrowings. There were no borrowings outstanding under these revolving credit facilities at December 31, 2008. Eaton also had short-term lines of credit of $437 at December 31, 2008. Eaton's ability to access the commercial paper market, and the related cost of these borrowings, is due to the strength of its credit rating and overall market conditions. To date, Eaton has not experienced any material limitations on its ability to access these sources of liquidity. Eaton maintains $1.7 billion of long-term revolving credit facilities with banks in support of its commercial paper program, as discussed above. It has no direct borrowings outstanding under these credit facilities. On January 30, 2009, Standard & Poor's lowered their credit rating for the Company by one notch from A/A-1/Negative to A-/A-2/Stable (long-term rating/short-term rating/outlook). Standard & Poor's rating action was based on their view that weak end market conditions would limit Eaton's ability to return to credit metrics consistent with Standard & Poor's target levels for an A/A-1 rating in the near term. Eaton maintains an A2/P-1/Negative rating at Moody's and an A/F-1/Negative rating at Fitch, the two other credit rating agencies that rate the Company. On December 31, 2008 Moody's issued a report maintaining their rating of the Company. Fitch last reported on the Company specifically on August 14, 2008 at the rating noted earlier. A $281 Floating Rate Senior Note due 2010 was issued in 2007 by a subsidiary of Eaton in order to refinance short-term borrowings related to the acquisition of Argo-Tech in 2007. As of December 31, 2008, the Note is no longer secured by the assets of any subsidiary and the Note does not restrict net assets of any subsidiary. Financial instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains controls over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. On January 22, 2007, Eaton announced it had authorized a 10 million Common Shares repurchase program. The shares are expected to be repurchased over time, depending on market conditions, the market price of the Company's Common Shares, the Company's capital levels and other considerations. Under the share repurchase program, 1.4 million shares were repurchased in 2008 in the open market at a total cost of $100 and 4.1 million shares were repurchased in 2007 at a total cost of $340. On January 21, 2008, Eaton increased the quarterly dividend on its Common Shares by 16%, from $.43 per share to $.50 per share, effective for the February 2008 dividend. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This Statement defines fair value for financial and non-financial assets and liabilities, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The guidance applies to other accounting pronouncements that require or permit fair value measurements. In 2008, Eaton adopted the provisions of SFAS No. 157 for financial assets and liabilities and for non-financial assets recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). These financial assets and liabilities primarily included short and long-term investments, derivative financial instruments, assets related to defined benefit pension plans, and financial assets and liabilities related to acquired businesses. The adoption of this Statement in 2008 had an immaterial effect on Eaton's consolidated financial position and results of operations. OUTLOOK FOR 2009 Eaton's end markets continued to decline during early 2009. Eaton expects its end markets in 2009 to decline through the second, and possibly the third, quarter. Eaton now expects its end markets to decline by between 10% and 11% compared to 2008. It expects to outgrow the end markets in 2009 by approximately $300 of sales, and also expects approximately $400 of sales growth from the full-year impact of the six acquisitions completed in 2008. These increases are expected to offset a decline in foreign currencies of 6%. As a result, sales in 2009 are now anticipated to decline by 11% compared to 2008. Page 61 Eaton took significant employee reduction actions in 2008 in anticipation of the severe economic downturn, and in January 2009 it took further action. The employee reductions in 2008 and 2009 total approximately 10% of the full-time workforce. Net of $110 of severance costs to be incurred in the first quarter of 2009, Eaton anticipates a year-over-year pretax earnings increase in 2009 of $165 from these actions. In 2010, Eaton expects an additional year-over-year increase in pretax earnings of $125. Other cost reduction actions being implemented across the company to deal with the further decline of Eaton's end markets include freezing wages where possible and a reduction of certain benefits provided to employees. In addition, there will be further savings from ongoing acquisition integration activities in 2009. Eaton anticipates the savings from the two largest acquisitions, Moeller and Phoenixtec, to add $0.30 per share to 2009 after-tax earnings. Looking at the first quarter of 2009, Eaton expects that sales will be impacted by plant shutdowns implemented by many of its hydraulics, truck, and automotive customers late in the fourth quarter of 2008, which in many cases are extending into the middle of the first quarter of 2009. These shutdowns will lower sales in the first quarter of 2009 compared to the fourth quarter of 2008. Eaton will be changing business segment reporting in 2009, dividing the Electrical business into two segments. The segments will be based on geography, with one segment focused on the Americas and the other on the Rest of the World. For the Electrical Americas segment, Eaton expects end markets to decline in 2009 by approximately 9%. Nonresidential construction spending in the United States held up well in the fourth quarter of 2008, but Eaton expects it to begin to decline by the second quarter of 2009. For the Electrical Rest of World segment, Eaton expects end markets to decline by 7%. For the Hydraulics segment, in 2009 Eaton anticipates a sharp contraction in markets, with global end markets down approximately 18%. Markets in the U.S. are expected to decline by 21% and non-U.S. markets are expected to decline by 15%. For the Aerospace segment, Eaton expects markets to decline in 2009 by approximately 1%. U.S. markets are expected to grow by 1%, driven by growth in defense markets, while non-U.S. markets are expected to decline by 6%. For the Truck segment, in 2009 Eaton expects its markets to decline by 20%. Its U.S. markets are expected to decline by 22%. North American heavy-duty truck production is expected to be between 145,000 and 150,000 units, as the economic downturn and lack of financing will limit the desire of truck buyers to purchase additional trucks in advance of the emissions law change on January 1, 2010. Non-U.S. markets are expected to decline by 18% in 2009. For the Automotive segment, Eaton expects that global automotive production will likely drop by approximately 16% compared to 2008. Overall 2009 production levels are likely to be broadly similar to the volume levels experienced during the fourth quarter of 2008. FORWARD-LOOKING STATEMENTS This Annual Report to Shareholders contains forward-looking statements concerning Eaton's first quarter 2009 and full year 2009, full year 2009 sales, worldwide end markets, growth in relation to end markets, growth from acquisitions, the benefits due to employee reduction actions, and estimated savings from acquisition integration. These statements or disclosures may discuss goals, intentions and expectations as to future trends, plans, events, results of operations or financial condition, or state other information relating to Eaton, based on current beliefs of management as well as assumptions made by, and information currently available to, management. Forward-looking statements generally will be accompanied by words such as "anticipate," "believe," "could," "estimate," "expect," "forecast," "guidance," "intend," "may," "possible," "potential," "predict," "project" or other similar words, phrases or expressions. These statements should be used with caution and are subject to various risks and uncertainties, many of which are outside of Eaton's control. The following factors could cause actual results to differ materially from those in the forward-looking Page 62 statements: unanticipated changes in the markets for Eaton's business segments; unanticipated downturns in business relationships with customers or their purchases from Eaton; 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; the impact of acquisitions and divestitures; unanticipated difficulties integrating acquisitions; new laws and governmental regulations; interest rate changes; changes in currency exchange rates; 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, future actual results could differ from estimates used. REVENUE RECOGNITION Sales are recognized when a sales agreement is in place, products have been shipped to customers and title has transferred in accordance with shipping terms (FOB shipping point, FOB destination or equivalent International Commercial (INCO) Terms), the selling price is fixed and determinable and collectability is reasonably assured, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Other revenues for service contracts are generally recognized as the services are provided. ACCOUNTS RECEIVABLE The Company performs ongoing credit evaluation of its customers and maintains sufficient allowances for potential credit losses. The Company evaluates the collectability of its accounts receivable based on the length of time the receivable is past due and the anticipated future write-off based on historic experience. Accounts receivable balances are written off against allowance for doubtful accounts after a final determination of uncollectibility has been made. IMPAIRMENT OF GOODWILL & OTHER LONG-LIVED ASSETS SFAS No. 142 "Goodwill and Other Intangible Assets" provides that goodwill and indefinite life intangible assets should be tested annually for impairment in accordance with the specified methodology. Further, goodwill and indefinite life intangible assets should be reviewed for impairment whenever events or changes in circumstances indicate the carrying amount exceeds its fair value. During 2008, Eaton completed annual impairment tests for goodwill and indefinite life intangible assets as of July 1, 2008, as required by SFAS No. 142. In addition, based on changes in the global economic environment in second half of 2008, goodwill and indefinite life intangible assets were also tested for impairment in the fourth quarter of 2008. These tests confirmed that the fair value of Eaton's reporting units and indefinite life intangible assets exceed their respective carrying values and that no impairment loss was required to be recognized. Goodwill is tested for impairment at the reporting unit level and is based on the net assets for each unit, including goodwill and intangible assets. A discounted cash flow model is used to estimate fair value. The model requires the exercise of significant judgments, including judgments about appropriate discount rates, perpetual growth rates and the timing of expected future cash flows. Discount rate assumptions are based on an assessment of the risk inherent in the future cash flows of the respective reporting unit. Page 63 Goodwill and other intangible assets totaled $7.8 billion at the end of 2008 and represented 47% of total assets. These assets resulted primarily from the $2.1 billion (E1.33 billion) acquisition in 2008 of The Moeller Group, a leading supplier of electrical components; the $587 acquisition in 2008 of Phoenixtec, a manufacturer of uninterruptible power supply (UPS) electrical systems; the $614 acquisition in 2007 of the MGE small systems UPS electrical business; the $731 acquisition in 2007 of Argo-Tech, a manufacturer of aerospace, airframe, and ground fueling pumps and systems for commercial and military aerospace markets; the $573 acquisition in 2004 of Powerware Corporation, the electrical UPS business; the $1.6 billion acquisition in 1999 of Aeroquip-Vickers, Inc., a mobile and industrial hydraulics business; and the $1.1 billion acquisition in 1994 of the electrical distribution and controls business unit of Westinghouse. These businesses, as well as many of the Company's other recent business acquisitions, have a long history of operating successfully and profitably and hold significant market positions in the majority of their product lines. Their products are not subject to rapid technological or functional obsolescence. These factors, coupled with continuous strong product demand, support the recorded values of the goodwill and intangible assets related to acquired businesses. Long-lived assets, other than goodwill and indefinite life intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Events or circumstances that would result in an impairment review primarily include operations reporting losses, a significant adverse change in the use of an asset, the planned disposal or sale of the asset, a significant adverse change in the business climate or legal factors related to the asset, or a significant decrease in the estimated fair value of an asset. The asset would be considered impaired when the estimated future net undiscounted cash flows generated by the asset are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value of the asset exceeds its fair value. INCOME TAX ASSETS & LIABILITIES Deferred income tax assets and liabilities have been recorded for the differences between the financial accounting and income tax basis of assets and liabilities, and for certain United States and non-United States tax loss carryforwards and income tax credit carryforwards. Recorded deferred income tax assets and liabilities are described in detail in "Income Taxes" in the Notes to the Consolidated Financial Statements. Significant factors considered by management in the determination of the probability of the realization of deferred tax assets include historical operating results, expectations of future earnings and taxable income, and the extended period of time over which certain temporary differences will reverse. A valuation allowance of $280 has been recognized for certain deferred income tax assets at December 31, 2008, because management believes there is a low probability of the realization of deferred income tax assets related to certain United States Federal income tax credit carryforwards and tax loss carryforwards, most United States state and local income tax loss carryforwards and income tax credit carryforwards, and most non-United States tax loss carryforwards and income tax credit carryforwards. PENSION & OTHER POSTRETIREMENT BENEFIT PLANS The measurement of liabilities related to pension plans and other postretirement benefit plans is based on management's assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and health care cost trend rates. Actual pension plan asset performance will either reduce or increase pension losses included in accumulated other comprehensive loss, which ultimately affects net income. The discount rate for United States plans was determined by constructing a zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, which was designed to match the discounted expected benefit payments. Those bonds rated Aa3 or better by Moody's Investor Services were included. Callable bonds with explicit call schedules were excluded and bonds with "make-whole" call provisions were included. Finally, a subset of bonds was selected by grouping the universe of bonds by duration and retaining 50% of the bonds that had the highest yields. The discount rates for non-United States plans are appropriate for each region and are based on high quality long-term corporate and government bonds. Consideration has been given to the duration of the liabilities in each plan for selecting the bonds to be used in determining the discount rate. Page 64 Key assumptions used to calculate pension and other postretirement benefits expense are adjusted at each year-end. A 1-percentage point change in the assumed rate of return on pension plan assets is estimated to have approximately a $23 effect on pension expense. Likewise, a 1-percentage point change in the discount rate is estimated to have approximately a $33 effect on pension expense. A 1-percentage point change in the discount rate is estimated to have approximately a $2 effect on expense for other postretirement benefit plans. Additional information related to changes in key assumptions used to recognize expense for other postretirement benefit plans is found in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. STOCK OPTIONS GRANTED TO EMPLOYEES & DIRECTORS Application of the Black-Scholes option pricing model involves assumptions that are judgmental and affect compensation expense. Historical information was the primary basis for the selection of expected volatility, expected option life, and expected dividend yield. Expected volatility was based on the most recent historical period equal to the expected life of the option. The risk-free interest rate was based on yields of U.S. Treasury zero-coupon issues with a term equal to the expected life of the option, on the date the stock options were granted. FAIR VALUE In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements." This Statement defines fair value for financial and non-financial assets and liabilities, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The guidance applies to other accounting pronouncements that require or permit fair value measurements. In 2008, Eaton adopted the provisions of SFAS No. 157 for financial assets and liabilities and for non-financial assets recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). These financial assets and liabilities primarily include short and long-term investments, derivative financial instruments, assets related to defined benefit pension plans, and financial assets and liabilities related to acquired businesses. The adoption of this Statement in 2008 had an immaterial effect on Eaton's consolidated financial position and results of operations. In 2009, Eaton must adopt the provisions of SFAS No. 157 for other non-financial assets and liabilities, primarily goodwill, intangible assets, non-financial assets and liabilities related to acquired businesses and impairment and restructuring activities. In 2009, this Statement is not expected to have a material effect on Eaton's consolidated financial position or results of operations. In determining fair value, Eaton uses various valuation techniques and prioritizes the use of observable inputs. The availability of observable inputs varies from instrument to instrument and depends on a variety of factors including the type of instrument, whether the instrument is actively traded and other characteristics specific to the instrument. Eaton assesses the inputs used to measure fair value using a three-tier hierarchy based on the extent to which inputs used in measuring fair value are observable in the market. Level 1 inputs include quoted prices in active markets for identical instruments. Level 2 inputs include quoted prices in active markets for similar instruments. Level 3 inputs are not observable in the market and include management's judgments about the assumptions market participants would use in the pricing the asset or liability, however, Eaton does not currently have any instruments valued with Level 3 inputs. The use of inputs is reflected in the hierarchy assessment disclosed in the "Financial Assets & Liabilities Measured at Fair Value" in the Notes to the Consolidated Financial Statements. Eaton's fair value processes include controls that are designed to ensure that fair values are appropriate. Such controls include model valuation, review of key inputs, analysis of fluctuations between periods, and reviews by senior management. PROTECTION OF THE ENVIRONMENT As a result of past operations, Eaton is involved in remedial response and voluntary environmental remediation at a number of sites, including certain of its currently-owned or formerly-owned plants. The Company has also been named a potentially responsible party (PRP) under the Federal Superfund law at a number of waste disposal sites. A number of factors affect the cost of environmental remediation, including the number of parties involved at a particular site, the determination of the extent of contamination, the length of time the remediation may require, the complexity of environmental regulations, and the continuing advancement of remediation technology. Taking these factors into account, Eaton has estimated the costs of Page 65 remediation, which will be incurred over a period of several years. The Company accrues an amount on an undiscounted basis, consistent with the estimates of these costs, when it is probable that a liability has been incurred. At December 31, 2008, the balance sheet included a liability for these costs of $85. 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. 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 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. Financial instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. Eaton monitors the third-party depository institutions that hold its cash and short-term investments on a daily basis. Its emphasis is primarily on safety of principal and secondarily on maximizing yield on those funds. Eaton diversifies its cash and short-term investments among counterparties to minimize exposure to any one of these entities. Eaton also monitors the creditworthiness of its customers and suppliers to mitigate any adverse impact on Eaton. Eaton's ability to access the commercial paper market, and the related cost of these borrowings, is related to the strength of its credit rating and overall market conditions. To date, Eaton has not experienced any material limitations in its ability to access these sources of liquidity. At December 31, 2008, Eaton had $1.7 billion of long-term revolving credit facilities with banks in support of its commercial paper program, as discussed above. It has no direct borrowings outstanding under these credit facilities. Interest rate risk can be measured by calculating the near-term earnings impact that would result from adverse changes in interest rates. This exposure results from short-term debt, which includes commercial paper at a floating interest rate, long-term debt that has been swapped to floating rates, and money market investments that have not been swapped to fixed rates. A 100 basis point increase in short-term interest rates would increase the Company's net, pretax interest expense by approximately $13. 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 Eaton's best estimate for a hypothetical, immediate 100 basis point decrease in interest rates at December 31, 2008, the market value of the Company's debt and interest rate swap portfolio, in aggregate, would increase by $125. 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 $163 at December Page 66 31, 2008. 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, 2008, the aggregate balance of such contracts was $313. Eaton also monitors exposure to transactions denominated in currencies other than the functional currency of each country in which the Company operates, and regularly 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 2008. Other than the above noted debt and financial derivative arrangements, there were no material derivative instrument transactions in place or undertaken during 2008. CONTRACTUAL OBLIGATIONS A summary of contractual obligations as of December 31, 2008 follows:
2010 2012 to to After 2009 2011 2013 2013 Total ------ ---- ------ ------ ------ Long-term debt $ 269 $285 $ 621 $2,284 $3,459 Interest expense related to long-term debt 170 316 278 1,324 2,088 Reduction of interest expense from interest rate swap agreements related to long-term debt (22) (53) (49) (182) (306) Operating leases 117 170 86 54 427 Purchase obligations 547 120 60 34 761 Other long-term liabilities 286 28 27 65 406 ------ ---- ------ ------ ------ $1,367 $866 $1,023 $3,579 $6,835 ====== ==== ====== ====== ======
Long-term debt includes obligations under capital leases, which are not material. Interest expense related to long-term debt is based on the fixed interest rate, or other applicable interest rate related to the debt instrument, at December 31, 2008. The reduction of interest expense due to interest rate swap agreements related to long-term debt is based on the difference in the fixed interest rate the Company receives from the swap, compared to the floating interest rate the Company pays on the swap, at December 31, 2008. 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 $271 of contributions to pension plans in 2009 and $126 of deferred compensation earned under various plans for which the participants have elected to receive disbursement at a later date. The table above does not include future expected pension benefit payments or expected other postretirement benefit payments for each of the next five years and the five years thereafter. Information related to the amounts of these future payments is described in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. The table above also excludes the liability for unrecognized income tax benefits, since the Company cannot predict with reasonable reliability the timing of cash settlements with the respective taxing authorities. At December 31, 2008, the gross liability for unrecognized income tax assets totaled $139, including interest and penalties of $38. Page 67 RESULTS OF OPERATIONS - 2007 COMPARED TO 2006
2007 2006 Increase ------- ------- -------- Continuing operations Net sales $13,033 $12,232 7% Gross profit 3,651 3,283 11% Percent of net sales 28.0% 26.8% Income before income taxes 1,041 969 7% Income after income taxes $ 959 $ 897 7% Income from discontinued operations 35 53 ------- ------- Net income $ 994 $ 950 5% ======= ======= Net income per Common Share assuming dilution Continuing operations $ 6.38 $ 5.87 9% Discontinued operations .24 .35 ------- ------- $ 6.62 $ 6.22 6% ======= ======= Return on Shareholders' equity 22% 23%
Sales growth of 7% in 2007 over 2006 consisted of 3% from acquisitions of businesses, 3% from foreign exchange, and 1% from organic growth. Organic growth included 2% from outgrowing end markets, offset by a 1 1/2% decline in end markets, principally due to the anticipated sharp reduction in North American commercial truck production. Gross profit increased 11% in 2007 compared to 2006 and improved to 28.0% of net sales, up from 26.8% of net sales in 2006. These increases were primarily due to sales growth of 7%; benefits from the Excel 07 program; benefits of integrating acquired businesses; continued productivity improvements driven by the Eaton Business System (EBS); and net pretax costs of $154 in 2006 related to the Excel 07 program. The Excel 07 program was a series of actions taken in 2006 intended to address resource levels and operating performance in businesses that underperformed in 2005 and businesses that were expected to weaken during second half 2006 and 2007. The improvements in gross profit in 2007 were partially offset by higher prices paid for certain raw materials, supplies and basic metals; and higher acquisition integration charges of $64 in 2007 compared to $40 in 2006. Overall business segment operating margin in 2007 was a record 12.8%, with the Electrical, Hydraulics and Aerospace businesses representing 65% of overall segment operating profit. RESULTS BY GEOGRAPHIC REGION Net sales and segment operating profit are measured based on the geographic location of the selling plant.
Net sales Segment operating profit Operating margin ---------------------------- -------------------------- ---------------- 2007 2006 Increase 2007 2006 Increase 2007 2006 ------- ------- -------- ------ ------ -------- ------- ------ United States $ 8,556 $ 8,530 -- $1,177 $1,146 3% 13.8% 13.4% Canada 371 337 10% 54 44 23% 14.6% 13.1% Europe 2,624 2,313 13% 166 65 155% 6.3% 2.8% Latin America 1,246 1,090 14% 150 120 25% 12.0% 11.0% Asia Pacific 1,144 888 29% 121 93 30% 10.6% 10.5% Eliminations (908) (926) ------- ------- $13,033 $12,232 7% ======= =======
In the United States, sales in 2007 were flat compared to 2006. Sales increases in the Electrical, Aerospace and Hydraulics segments in the U.S. were due to growth in end markets, as well as the acquisitions of Argo-Tech and other businesses. This growth in sales was offset by reduced sales in the Truck segment due to a decline in the U.S. commercial truck market. The 3% increase in operating profit reflected improved sales and performance in the Electrical, Aerospace and Automotive segments, partially offset by reduced operating profit of the Truck segment; benefits of the Excel 07 program; benefits of integrating acquired businesses; and $69 of net pretax costs in 2006 related to the Excel 07 program. Acquisition integration charges were $27 in 2007 compared to $23 in 2006. Growth in Canada in 2007 of 10% in sales and 23% in operating profit was primarily due to higher sales in the Electrical segment, resulting from growth in end markets and sales from acquired businesses. Page 68 Sales growth in Europe in 2007 of 13% was primarily due to higher sales in the Electrical segment, which reflected the acquisitions of the MGE small systems UPS business and other businesses, and growth in end markets. Sales growth also was due to increased sales in the Hydraulics, Automotive and Aerospace segments largely due to growth in end markets. These sales increases were partially offset by reduced sales in the Truck segment due to a decline in end markets. The sharp increase in operating profit of 155% in Europe reflected increased operating profit in the Automotive and Truck segments, largely due to $77 of net pretax costs in 2006 related to the Excel 07 program; sales growth; benefits from the Excel 07 program; and benefits of integrating acquired businesses. These increases were partially offset by higher acquisition integration charges of $20 in 2007 compared to $7 in 2006. In Latin America, growth in 2007 of 14% in sales was largely due to higher sales in the Truck, Electrical, Hydraulics and Automotive segments, primarily due to growth in end markets. The 25% increase in operating profit in Latin America was attributable to higher sales; benefits of the Excel 07 program; an adjustment in 2006 related to Brazilian inventories in the Truck segment; the benefits of integrating acquired businesses; and Excel 07 program expenses of $5 in 2006. These increases were partially offset by higher acquisition integration charges of $12 in 2007 compared to $6 in 2006, and a gain on the sale of the Brazilian battery business in 2006. Growth in Asia Pacific in 2007 of 29% in sales and 30% in operating profit was primarily due to higher sales in the Hydraulics, Electrical, Truck and Automotive segments, mainly resulting from growth in end markets and acquisitions of businesses. OTHER RESULTS OF OPERATIONS In 2007 and 2006, Eaton incurred charges related to the integration of acquired businesses. These charges, which consisted of plant consolidations and integration, were expensed as incurred. Charges in 2007 related to the integration of primarily the following acquisitions: in the Electrical segment, the MGE small systems UPS business, Schreder-Hazemeyer, Senyuan and Powerware; in the Hydraulics segment, Synflex and Hayward; in the Aerospace segment, Argo-Tech, PerkinElmer and Cobham; and in the Automotive segment, Saturn and Tractech. Charges in 2006 related to the integration of primarily the following acquisitions: in the Electrical segment, Pringle and Powerware; in the Hydraulics segment, Synflex, Hayward, Winner and Walterscheid; in the Aerospace segment, PerkinElmer and Cobham; in the Truck segment, Pigozzi; and in the Automotive segment, Tractech and Morestana. A summary of these charges follows:
2007 2006 ---- ---- Electrical $ 12 $ 7 Hydraulics 12 11 Aerospace 39 12 Truck 5 Automotive 1 5 ---- ---- Pretax charges $ 64 $ 40 ==== ==== After-tax charges $ 42 $ 27 Per Common Share $.28 $.17
Acquisition integration charges in 2007 included $27 for the United States, $20 for Europe, $12 for Latin America and $5 for Asia Pacific. Charges in 2006 included $23 for the United States, $7 for Europe, $6 for Latin America and $4 for Asia Pacific. These charges were included in the Statements of Consolidated Income in Cost of products sold or Selling & administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related segment. In the first quarter of 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions concluded in 2006 intended to address resource levels and operating performance in businesses that under-performed in 2005, and businesses that were expected to weaken during second half 2006 and in 2007. As part of this program, charges were incurred related to plant closings in five business segments. The net costs of this program included plant closings, as well as costs of relocating product lines and other employee reductions, partially offset by savings generated Page 69 from these actions. A summary of the net costs incurred by each segment related to this program follows:
2006 ---- Electrical $ 17 Hydraulics 7 Aerospace 1 Truck 60 Automotive 67 Corporate 2 ---- Pretax charges $154 ====
Excel 07 net costs incurred in 2006 included $69 for the United States, $77 for Europe, $5 for Latin America, $2 for Asia Pacific, and $1 for Canada. The net costs associated with the Excel 07 program were included in the Statements of Consolidated Income primarily in Cost of products sold. In Business Segment Information, the charges reduced Operating profit of the related segment. In 2007 and 2006, Eaton recorded income tax benefits of $57 and $90, respectively, which represented adjustments of worldwide tax liabilities. The 2007 income tax benefits reduced the effective income tax rate for 2007 from 13.4% to 7.9%. The 2007 income tax benefits resulted from multiple income tax items. Included in the tax benefits were a $14 benefit from changes to state tax laws and a favorable revaluation of worldwide deferred tax assets. The income tax benefits for 2006 reduced the effective income tax rate for 2006 from 16.7% to 7.4%. Further analysis regarding the change in the effective income tax rate in 2007 compared to 2006 is found in "Income Taxes" in the Notes to the Consolidated Financial Statements. Effective January 1, 2007, Eaton adopted FASB Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109." The net income tax assets recognized under FIN No. 48 at January 1, 2007 did not differ from the net assets recognized before adoption, and, therefore, the Company did not record a cumulative-effect adjustment related to the adoption of FIN No. 48. The adoption of FIN No. 48 is further discussed in "Income Taxes" in the Notes to the Consolidated Financial Statements. In the third quarter of 2007, Eaton sold the Mirror Controls Division of the Automotive segment for $111, resulting in a $20 after-tax gain, or $.12 per Common Share. In the third quarter of 2006, certain other businesses of the Automotive segment were sold for $64, resulting in a $35 after-tax gain, or $.23 per share. The gains on sale of the Mirror Controls Division and the businesses sold in 2006, and other results of these businesses, are reported as Discontinued operations in the Statement of Consolidated Income. Net income and net income per Common Share assuming dilution for 2007 increased 5% and 6%, respectively, compared to 2006. The improvements in 2007 were primarily due to higher sales and the other factors that affected gross profit as discussed above, partially offset by increases in selling, administrative, and research and development expenses; higher interest expense; a contribution to the Eaton Charitable Fund; and a lower after-tax gain on the sale of certain businesses of the Automotive segment in 2007 compared to a similar gain in 2006, which were reported as Discontinued operations in the Statements of Consolidated Income. Earnings per share in 2007 also benefited from a lower number of shares outstanding due to the repurchase of Common Shares in 2007 and 2006 exceeding shares issued from exercises of stock options. Return on Shareholders' equity was 22%. RESULTS BY BUSINESS SEGMENT ELECTRICAL
2007 2006 Increase ------ ------ -------- Net sales $4,759 $4,184 14% Operating profit 579 474 22% Operating margin 12.2% 11.3%
Of the 14% sales increase in 2007 over 2006, 8% was due to organic growth; 3% was from acquisitions of businesses, primarily the MGE small systems UPS business; and 3% from foreign exchange. End markets for the Electrical segment grew about 9% during 2007. The non-residential electrical and power Page 70 quality markets recorded strong growth, offset by the decline in the U.S. residential electrical market, which was negatively impacted by weakness in U.S. housing starts. Operating profit rose 22% in 2007 over 2006. The operating margin of 12.2% was a significant improvement over 11.3% in 2006. The increase in operating profit was largely due to growth in sales; benefits from the Excel 07 program; the benefits of integrating acquired businesses; continued productivity improvements; and net pretax costs in 2006 related to the Excel 07 program that were not present in 2007; partially offset by a gain in 2006 on the sale of the Brazilian battery business. Operating profit reflected acquisition integration charges of $12 in 2007 compared to charges of $7 in 2006, which reduced the operating margin by 0.3% in 2007 and 0.2% in 2006. Acquisition integration charges in 2007 primarily related to the integration of the MGE small systems UPS business, Schreder-Hazemeyer, Senyuan and Powerware, while charges in 2006 related to the integration of Pringle and Powerware. Net pretax costs of $17 related to the Excel 07 program in 2006 reduced the operating margin by 0.4%. The incremental operating margin for 2007 (the increase in operating profit compared to the increase in sales) was 18%. The operating margin for acquired businesses was 13%. New businesses acquired during 2007 in the Electrical segment include the following: - - On October 31, 2007, the Company acquired the MGE small systems UPS business from Schneider Electric. This business is a France-based global provider of power quality solutions including uninterruptible power supply (UPS) systems, power distribution units, static transfer switches and surge suppressors, and had sales of $245 for 2007. - - On October 19, 2007, Eaton acquired the assets of Babco Electric Group, an Alberta, Canada-based manufacturer of specialty low- and medium-voltage switchgear and electrical housings for use in the Canadian oil and gas industry and other harsh environments. This business had sales of $11 in 2007. - - On June 19, 2007, Eaton acquired Pulizzi Engineering, a U.S. manufacturer of AC power distribution, AC power sequencing, redundant power and remote-reboot power management systems. This business had sales of $12 in 2006. - - On May 18, 2007, the Company acquired technology and related assets of SMC Electrical Products, Inc.'s industrial medium-voltage adjustable frequency drive business. - - On April 5, 2007, Eaton acquired Aphel Technologies Limited, a U.K.-based global supplier of high density, fault-tolerant power distribution solutions for datacenters, technical offices, laboratories and retail environments. This business had sales of $12 in 2006. - - On February 7, 2007, the Company acquired the Power Protection Business of Power Products Ltd., a Czech Republic distributor and service provider of Powerware(R) products and other uninterruptible power supply (UPS) systems. This business had sales of $3 in 2006. HYDRAULICS
2007 2006 Increase ------ ------ -------- Net sales $2,391 $2,203 9% Operating profit 265 221 20% Operating margin 11.1% 10.0%
The 9% increase in sales in 2007 over 2006 consisted of 4% from organic growth; 3% from foreign exchange; and 2% from acquisitions of businesses. Hydraulics markets grew 3% in 2007 compared to 2006. Operating profit rose 20% in 2007 over 2006. The operating margin was 11.1%. The increase in operating profit was due to growth in sales, including a more profitable mix of businesses; benefits from the Excel 07 program; the benefits of integrating acquired businesses; overall improvement in operating efficiencies; and net pretax costs in 2006 related to the Excel 07 program that were not present in 2007. Operating profit reflected acquisition integration charges of $12 in 2007 compared to charges of $11 in 2006, which reduced the operating margin by 0.5% in both 2007 and 2006. The acquisition integration charges in 2007 primarily related to the acquired operations of Synflex and Hayward. Charges in 2006 largely related to the acquired operations of Synflex, Hayward, Winner and Walterscheid. Net pretax Page 71 costs of $7 in 2006 related to the Excel 07 program reduced the operating margin by 0.3%. The incremental operating margin for 2007 was 23%. The operating margin for acquired businesses was 13% in 2007. On November 8, 2007, Eaton acquired Arrow Hose & Tubing Inc. This business is a Canada-based manufacturer of specialty thermoplastic hose and tubing for the industrial, food and beverage, and agricultural markets. This business had sales of $12 in 2006. AEROSPACE
2007 2006 Increase ------ ------ -------- Net sales $1,594 $1,295 23% Operating profit 233 182 28% Operating margin 14.6% 14.1%
The 23% increase in sales in 2007 over 2006 consisted of 15% from acquisitions of businesses, primarily the Argo-Tech aerospace business; 6% from organic growth; and 2% from foreign exchange. Aerospace markets grew 4% in 2007 compared to 2006. Operating profit rose 28% in 2007 over 2006. The increase in operating profit was due to growth in sales; the benefits of integrating acquired businesses; and overall improvement in operating efficiencies. Operating profit reflected acquisition integration charges of $39 in 2007 compared to charges of $12 in 2006, which reduced the operating margin by 2.5% in 2007 and 0.9% in 2006. The acquisition integration charges in 2007 primarily related to the acquired operations of Argo-Tech, PerkinElmer and Cobham. Charges in 2006 largely related to the acquired operations of PerkinElmer and Cobham. Net pretax costs of $1 in 2006 related to the Excel 07 program reduced the operating margin by 0.1%. The incremental operating margin for 2007 was 17%. The operating margin for acquired businesses was 30% in 2007. On March 16, 2007, Eaton acquired Argo-Tech Corporation, a U.S.-based aerospace business, which had sales of $206 in 2006. Argo-Tech is a leader in high performance aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets. TRUCK
2007 2006 (Decrease) ------ ------ ---------- Net sales $2,147 $2,520 (15)% Operating profit 357 448 (20)% Operating margin 16.6% 17.8%
Sales of the Truck segment decreased 15% in 2007 from 2006. The reduction in sales reflected an 18% decline in sales volume, offset by a 3% increase from foreign exchange. The decline in sales was due to a reduction in North American commercial truck production in 2007 from 2006, with North American heavy-duty truck production down 44%, and North American medium-duty production down 31%. Brazilian vehicle production was up 17%, Brazilian agricultural equipment production was up 41%, and European medium-duty truck production was down 2% compared to 2006. Operating profit decreased 20% in 2007 from 2006, primarily due to the reduction in sales, partially offset by the benefits from the Excel 07 program, net pretax costs in 2006 related to the Excel 07 program, and an adjustment in 2006 to Brazilian inventories. The operating margin was 16.6% in 2007, down 1.2 percentage points from 17.8% in 2006. Operating profit in 2006 was reduced by acquisition integration charges of $5 related to Pigozzi, which reduced the operating margin by 0.2% in 2006; and net pretax costs of $60 related to the Excel 07 program in 2006, which reduced the operating margin by 2.4%. AUTOMOTIVE
2007 2006 Increase ------ ------ -------- Net sales $2,142 $2,030 6% Operating profit 234 143 64% Operating margin 10.9% 7.0%
Page 72 The 6% increase in sales of the Automotive segment in 2007 over 2006 reflected a 4% increase from foreign exchange, 1% from organic growth, and 1% from acquisitions of businesses. In 2007, North American automotive production declined by 2%, while European production grew 7%. Operating profit in 2007 increased $91 over 2006, largely due to $67 of net pretax costs in 2006 related to the Excel 07 program, benefits from the Excel 07 program in 2007, and sales growth in 2007. Operating profit reflected acquisition integration charges of $1 in 2007 compared to charges of $5 in 2006, which reduced the operating margin by 0.1% in 2007 and 0.3% in 2006. Acquisition integration charges in 2007 primarily related to the integration of Saturn and Tractech, while charges in 2006 related to the integration of Tractech and Morestana. Net pretax costs of $67 related to the Excel 07 program in 2006 reduced the operating margin by 3.3%. On May 2, 2007, Eaton acquired the fuel components division of Saturn Electronics & Engineering, Inc., a U.S. designer and manufacturer of fuel containment and shutoff valves, emissions control valves and specialty actuators. This business had sales of $28 in 2006. In the third quarter of 2007, Eaton sold the Mirror Controls Division of the Automotive segment for $111, resulting in a $20 after-tax gain, or $.12 per Common Share. In the third quarter of 2006, certain other businesses of the Automotive segment were sold for $64, resulting in a $35 after-tax gain, or $.23 per share. The gains on sale of the Mirror Controls Division and the businesses sold in 2006, and other results of these businesses, are reported as Discontinued operations in the Statement of Consolidated Income. CORPORATE Amortization of intangible assets of $79 in 2007 increased from $51 in 2006 due to amortization of intangible assets associated with recently acquired businesses. Interest expense of $147 in 2007 increased from $105 in 2006, primarily due to borrowings to finance cash paid of $1,433 for acquisitions of businesses in 2007. In 2007, corporate expense of $16 was recorded for a contribution to the Eaton Charitable Fund. Page 73 QUARTERLY DATA
Quarter ended in 2008 Quarter ended in 2007 -------------------------------------- -------------------------------------- (Millions except for per share data) Dec. 31 Sept. 30 June 30 Mar. 31 Dec. 31 Sept. 30 June 30 Mar. 31 - ------------------------------------ ------- -------- ------- ------- ------- -------- ------- ------- Continuing operations Net sales $3,487 $4,114 $4,279 $3,496 $ 3,374 $ 3,298 $3,248 $3,113 Gross profit 861 1,150 1,210 964 946 917 902 886 Percent of net sales 24.7% 28.0% 28.3% 27.6% 28.0% 27.8% 27.8% 28.5% Income before income taxes 134 354 354 286 259 263 256 263 Income after income taxes $ 163 $ 315 $ 333 $ 244 $ 252 $ 238 $ 240 $ 229 Income from discontinued operations 3 4 20 6 5 ------ ------ ------ ------ ------- ------- ------ ------ Net income $ 163 $ 315 $ 333 $ 247 $ 256 $ 258 $ 246 $ 234 ====== ====== ====== ====== ======= ======= ====== ====== Net income per Common Share outstanding assuming dilution Continuing operations $ .98 $ 1.87 $ 2.03 $ 1.62 $ 1.67 $ 1.59 $ 1.60 $ 1.53 Discontinued operations .02 .04 .12 .04 .03 ------ ------ ------ ------ ------- ------- ------ ------ $ .98 $ 1.87 $ 2.03 $ 1.64 $ 1.71 $ 1.71 $ 1.64 $ 1.56 ====== ====== ====== ====== ======= ======= ====== ====== Net income per Common Share basic Continuing operations $ .98 $ 1.90 $ 2.07 $ 1.65 $ 1.71 $ 1.62 $ 1.63 $ 1.56 Discontinued operations .02 .03 .13 .04 .03 ------ ------ ------ ------ ------- ------- ------ ------ $ .98 $ 1.90 $ 2.07 $ 1.67 $ 1.74 $ 1.75 $ 1.67 $ 1.59 ====== ====== ====== ====== ======= ======= ====== ====== Cash dividends paid per Common Share $ .50 $ .50 $ .50 $ .50 $ .43 $ .43 $ .43 $ .43 Market price per Common Share High $54.58 $84.33 $96.69 $96.18 $101.26 $102.55 $94.15 $85.53 Low 38.78 53.77 78.94 77.55 85.29 85.12 83.85 73.80
Earnings per Common Share for the four quarters in a year may not equal full year earnings per share. Page 74 TEN-YEAR CONSOLIDATED FINANCIAL SUMMARY
(Millions except for per share data) 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 - ------------------------------------ ------- ------- ------- ------- ------ ------ ------ ------ ------ ------ Continuing operations Net sales $15,376 $13,033 $12,232 $10,874 $9,547 $7,796 $6,983 $7,092 $8,103 $7,789 Income before income taxes 1,128 1,041 969 964 749 463 364 249 520 911 Income after income taxes $ 1,055 $ 959 $ 897 $ 783 $ 626 $ 356 $ 258 $ 150 $ 342 $ 582 Percent of net sales 6.9% 7.4% 7.3% 7.2% 6.6% 4.6% 3.7% 2.1% 4.2% 7.5% Income from discontinued operations 3 35 53 22 22 30 23 19 111 35 ------- ------- ------- ------- ------ ------ ------ ------ ------ ------ Net income $ 1,058 $ 994 $ 950 $ 805 $ 648 $ 386 $ 281 $ 169 $ 453 $ 617 ======= ======= ======= ======= ====== ====== ====== ====== ====== ====== Net income per Common Share assuming dilution Continuing operations $ 6.50 $ 6.38 $ 5.87 $ 5.08 $ 3.99 $ 2.36 $ 1.80 $ 1.07 $ 2.36 $ 3.94 Discontinued operations .02 .24 .35 .15 .14 .20 .16 .13 .76 .24 ------- ------- ------- ------- ------ ------ ------ ------ ------ ------ $ 6.52 $ 6.62 $ 6.22 $ 5.23 $ 4.13 $ 2.56 $ 1.96 $ 1.20 $ 3.12 $ 4.18 ======= ======= ======= ======= ====== ====== ====== ====== ====== ====== Average number of Common Shares outstanding assuming dilution 162.3 150.3 152.9 154.0 157.1 150.5 143.4 141.0 145.2 147.4 Net income per Common Share basic Continuing operations $ 6.58 $ 6.51 $ 5.97 $ 5.21 $ 4.10 $ 2.40 $ 1.82 $ 1.08 $ 2.39 $ 4.02 Discontinued operations .02 .24 .35 .15 .14 .21 .17 .14 .77 .24 ------- ------- ------- ------- ------ ------ ------ ------ ------ ------ $ 6.60 $ 6.75 $ 6.32 $ 5.36 $ 4.24 $ 2.61 $ 1.99 $ 1.22 $ 3.16 $ 4.26 ======= ======= ======= ======= ====== ====== ====== ====== ====== ====== Average number of Common Shares outstanding basic 160.2 147.3 150.2 150.2 153.1 147.9 141.2 138.8 143.6 145.0 Cash dividends paid per Common Share $ 2.00 $ 1.72 $ 1.48 $ 1.24 $ 1.08 $ .92 $ .88 $ .88 $ .88 $ .88 ------- ------- ------- ------- ------ ------ ------ ------ ------ ------ Total assets $16,655 $13,430 $11,417 $10,218 $9,075 $8,223 $7,138 $7,646 $8,180 $8,342 Long-term debt 3,190 2,432 1,774 1,830 1,734 1,651 1,887 2,252 2,447 1,915 Total debt 4,271 3,417 2,586 2,464 1,773 1,953 2,088 2,440 3,004 2,885 Shareholders' equity 6,317 5,172 4,106 3,778 3,606 3,117 2,302 2,475 2,410 2,624 Shareholders' equity per Common Share $ 38.28 $ 35.42 $ 28.07 $ 25.44 $23.52 $20.37 $16.30 $17.80 $17.64 $17.72 Common Shares outstanding 165.0 146.0 146.3 148.5 153.3 153.0 141.2 139.0 136.6 148.0 ------- ------- ------- ------- ------ ------ ------ ------ ------ ------
Page 75 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K EXHIBITS INDEX 3 (i) Amended Articles of Incorporation (amended and restated as of April 24, 2008) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2008 3 (ii) Amended Regulations (amended and restated as of April 23, 2008) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2008 4 (a) Pursuant to Regulation S-K Item 601(b) (4), the Company agrees to furnish to the SEC, upon request, a copy of the instruments defining the rights of holders of its other long-term debt 10 Material contracts (a) Tender Offer for all of the shares of Phoenixtec Power Company Ltd. announced on December 20, 2007 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (b) Share Purchase Agreement between Green Beta S.a.r.l. and Eaton Corporation dated December 20, 2007 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (c) Senior Executive Incentive Compensation Plan (effective January 1, 2008) - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (d) Executive Incentive Compensation Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (e) 2005 Non-Employee Director Fee Deferral Plan (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (f) Deferred Incentive Compensation Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (g) Excess Benefits Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (h) Incentive Compensation Deferral Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (i) Limited Eaton Service Supplemental Retirement Income Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (j) Supplemental Benefits Plan II (2008 restatement) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (k) Form of Restricted Share Unit Agreement (2 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (l) Form of Restricted Share Unit Agreement (4 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (m) Form of Restricted Share Agreement (2 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 Page 76 (n) Form of Restricted Share Agreement (4 year vesting) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (o) Form of Restricted Share Agreement (Non-Employee Directors) - Incorporated by Reference to the Form 8-K Report filed January 28, 2009 (p) Form of Stock Option Agreement for Executives (2008) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (q) Form of Stock Option Agreement for Executives - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2006 (r) Form of Stock Option Agreement for Non-Employee Directors (2008) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (s) 2002 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 15, 2002 (t) 2004 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 19, 2004 (u) 2008 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (v) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1985 and amended effective September 24, 1996, January 28, 1998, January 23, 2002, February 24, 2004, December 8, 2004 and, in certain respects, January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 (w) 1996 Non-Employee Director Fee Deferral Plan (amended and restated effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2006 (x) Form of Change of Control Agreement entered into with officers of Eaton Corporation - Filed in conjunction with this Form 10-K Report (y) Form of Indemnification Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (z) Form of Indemnification Agreement entered into with directors of Eaton Corporation - Incorporated by reference to the Form 8-K Report filed January 26, 2007 (aa) Executive Strategic Incentive Plan (amended and restated January 1, 2008) - Incorporated by reference to the definitive Proxy Statement dated March 14, 2008 (bb) Executive Strategic Incentive Plan II (effective January 1, 2001) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (cc) Supplemental Executive Strategic Incentive Plan (effective as of June 25, 2008) - Filed in conjunction with this Form 10-K Report (dd) Deferred Incentive Compensation Plan (amended and restated March 31, 2000) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 Page 77 (ee) 1998 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 13, 1998 (ff) Incentive Compensation Deferral Plan (amended and restated October 1, 1997) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (gg) Trust Agreement - Officers and Employees (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (hh) Trust Agreement - Non-employee Directors (dated December 6, 1996) -Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ii) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 1992 (jj) 1991 Stock Option Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (kk) Excess Benefits Plan (amended and restated effective January 1, 1989) -Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ll) Supplemental Benefits Plan (amended and restated January 1, 1989) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (mm) Eaton Corporation Board of Directors Policy on Incentive Compensation, Stock Options and Other Equity Grants upon the Restatement of Financial Results -Incorporated by reference to the Form 10-K Report for the year ended December 31, 2007 12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this Form 10-K Report 14 Code of Ethics - Incorporated by reference to the definitive Proxy Statement filed on March 14, 2008 21 Subsidiaries of Eaton Corporation - Filed in conjunction with this Form 10-K Report 23 Consent of Independent Registered Public Accounting Firm - Filed in conjunction with this Form 10-K Report 24 Power of Attorney - Filed in conjunction with this Form 10-K Report 31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report 32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report Page 78 EX-10.10 2 l35588aexv10w10.txt EX-10.10 EXHIBIT 10 (X) EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15 (B) CHANGE OF CONTROL AGREEMENT AGREEMENT by and between Eaton Corporation, an Ohio corporation (the "Company") and _______________ (the "Executive"), dated as of the 16th day of December, 2008. The Board of Directors of the Company (the "Board") has determined that it is in the best interests of the Company and its shareholders to assure that the Company will have the continued dedication of the Executive, notwithstanding the possibility, threat or occurrence of a Change of Control (as defined below) of the Company. The Board believes it is imperative to diminish the inevitable distraction of the Executive by virtue of the personal uncertainties and risks created by a pending or threatened Change of Control and to encourage the Executive's full attention and dedication to the Company currently and in the event of any threatened or pending Change of Control, and to provide the Executive with compensation and benefits arrangements upon a Change of Control which ensure that the compensation and benefits expectations of the Executive will be satisfied and which are competitive with those of other corporations. Therefore, in order to accomplish these objectives, the Board has caused the Company to enter into this Agreement. NOW, THEREFORE, IT IS HEREBY AGREED AS FOLLOWS: 1. Certain Definitions. (a) The "Effective Date" shall mean the first date during the Change of Control Period (as defined in Section 1(b)) on which a Change of Control (as defined in Section 2) occurs. Anything in this Agreement to the contrary notwithstanding, if the Executive's employment with the Company is terminated within the six months prior to the date on which the Change of Control occurs, and if it is reasonably demonstrated by the Executive that such termination of employment (i) was at the request of a third party who has taken steps reasonably calculated to effect a Change of Control or (ii) otherwise arose in connection with or anticipation of a Change of Control (such a termination of employment, an "Anticipatory Termination"), then for all purposes of this Agreement the "Effective Date" shall mean the date immediately prior to the date of such termination of employment. (b) The "Change of Control Period" shall mean the period commencing on the date hereof and ending on the third anniversary of the date hereof; provided, however, that commencing on the date one year after the date hereof, and on each annual anniversary of such date (such date and each annual anniversary thereof shall be hereinafter referred to as the "Renewal Date"), unless previously terminated, the Change of Control Period shall be automatically extended so as to terminate three years from such Renewal Date, unless at least 60 days prior to the Renewal Date the Company shall give notice to the Executive that the Change of Control Period shall not be so extended. 2. Change of Control. For the purpose of this Agreement, a "Change of Control" shall mean: (a) The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 25% or more of either (i) the then outstanding common shares of the Company (the "Outstanding Company Common Shares") or (ii) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); provided, however, that for purposes of this subsection (a), the following acquisitions shall not constitute a Change of Control: (i) any acquisition directly from the Company, (ii) any 2 acquisition by the Company, or (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company; or (b) Individuals who, as of the date hereof, constitute the Board (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least two-thirds of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a Person other than the Board; or (c) Consummation by the Company of a reorganization, merger or consolidation or sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (a "Business Combination"), in each case, unless, following such Business Combination, (i) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Company Common Shares and Outstanding Company Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 55% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Company or all or substantially all of the Company's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination of the Outstanding Company Common Shares and Outstanding Company Voting Securities, as the case may be, (ii) no Person (excluding any employee benefit plan (or related trust) of the Company or such corporation resulting from such Business Combination) beneficially owns, directly or indirectly, 25% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed 3 prior to the Business Combination and (iii) at least a majority of the members of the board of directors of the corporation resulting from such Business Combination were members of the Incumbent Board at the time of the execution of the initial agreement, or of the action of the Board, providing for such Business Combination; or (d) Approval by the shareholders of the Company of a complete liquidation or dissolution of the Company. Notwithstanding the foregoing, a "Change of Control" shall not be deemed to have occurred as a result of any transaction or series of transactions which the Executive, or any entity in which the Executive is a partner, officer or more than 50% owner initiates, if immediately following the transaction or series of transactions that would otherwise constitute a Change of Control, the Executive, either alone or together with other individuals who are executive officers of the Company immediately prior thereto, beneficially owns, directly or indirectly, more than 10% of the then outstanding common shares of the Company or the corporation resulting from the transaction or series of transactions, as applicable, or of the combined voting power of the then outstanding voting securities of the Company or such resulting corporation. 3. Employment Period. The Company hereby agrees to continue the Executive in its employ, and the Executive hereby agrees to remain in the employ of the Company subject to the terms and conditions of this Agreement, for the period commencing on the Effective Date and ending on the third anniversary of such date (the "Employment Period"). 4. Terms of Employment. (a) Position and Duties. (i) During the Employment Period, (A) the Executive's position (including status, offices, titles and reporting requirements), authority, duties and responsibilities shall be at least commensurate in all material respects with the most significant of those held, exercised and assigned to the Executive at any time during the 120-day period immediately preceding the Effective Date and (B) the Executive's services shall be performed at the location where the Executive was employed immediately preceding the Effective Date or any office or location less than 35 miles from such location. 4 (ii) During the Employment Period, and excluding any periods of vacation and sick leave to which the Executive is entitled, the Executive agrees to devote reasonable attention and time during normal business hours to the business and affairs of the Company and, to the extent necessary to discharge the responsibilities assigned to the Executive hereunder, to use the Executive's reasonable best efforts to perform faithfully and efficiently such responsibilities. During the Employment Period it shall not be a violation of this Agreement for the Executive to (A) serve on corporate, civic or charitable boards or committees, (B) deliver lectures, fulfill speaking engagements or teach at educational institutions and (C) manage personal investments, so long as such activities do not significantly interfere with the performance of the Executive's responsibilities as an employee of the Company in accordance with this Agreement. It is expressly understood and agreed that to the extent that any such activities have been conducted by the Executive prior to the Effective Date, the continued conduct of such activities (or the conduct of activities similar in nature and scope thereto) subsequent to the Effective Date shall not thereafter be deemed to interfere with the performance of the Executive's responsibilities to the Company. (b) Compensation. (i) Base Salary. During the Employment Period, the Executive shall receive an annual base salary ("Annual Base Salary"), which shall be paid at a monthly rate, at least equal to twelve times the highest monthly base salary paid or payable, including any base salary which has been earned but deferred, to the Executive by the Company and its affiliated companies in respect of the twelve-month period immediately preceding the month in which the Effective Date occurs. During the Employment Period, the Annual Base Salary shall be increased no more than 12 months after the last salary increase awarded to the Executive prior to the Effective Date, and thereafter at least annually, in each case by a percentage not less than the average annual percentage merit increase in the Executive's base salary during the five (5) full calendar years (or such lesser number of years that the Executive has been employed by the Company and its affiliated companies) immediately preceding the Effective Date. Any increase in Annual Base Salary shall not serve to limit or reduce any other obligation to the Executive under this Agreement. Annual Base Salary shall not be reduced after any such increase and the term Annual Base Salary as utilized in this Agreement shall refer to Annual Base Salary as so 5 increased. As used in this Agreement, the term "affiliated companies" shall include any company controlled by, controlling or under common control with the Company. (ii) Annual Bonus. In addition to Annual Base Salary, the Executive shall be awarded, for each fiscal year ending during the Employment Period, an annual bonus (the "Annual Bonus") in cash in an amount (the "Annual Bonus Amount") at least equal to the Executive's Incentive Potential (as defined in the Eaton Incentive Compensation Plan or any successor plan) for the most recent year for which an Incentive Potential was established before the Effective Date under the Eaton Incentive Compensation Plan or any successor plan, adjusted by the average of the Executive's individual performance rating for each of the three most recent years ended before the Effective Date, but eliminating any Corporate Performance Factor (as defined in the Eaton Incentive Compensation Plan or any successor plan). Each such Annual Bonus shall be paid no later than March 15th of the fiscal year next following the fiscal year for which the Annual Bonus is awarded, unless the Executive shall elect to defer the receipt of such Annual Bonus in accordance with the provisions of the Eaton Deferred Incentive Compensation Plan II or any successor plan. (iii) Incentive, Savings and Retirement Plans. During the Employment Period, the Executive shall be entitled to participate in all incentive, savings and retirement plans, practices, policies and programs applicable generally to other peer executives of the Company and its affiliated companies (including without limitation the Company's Deferred Incentive Compensation Plan, Limited Eaton Service Supplemental Retirement Income Plan, long-term Executive Strategic Incentive Plan and Supplemental and/or Excess Benefits Plans, as and to the extent those plans are in effect from time to time), but in no event shall such plans, practices, policies and programs provide the Executive with incentive opportunities (measured with respect to both regular and special incentive opportunities, to the extent, if any, that such distinction is applicable), savings opportunities and retirement benefit opportunities, in each case, less favorable, in the aggregate, than the most favorable of those provided by the Company and its affiliated companies for the Executive under such plans, practices, policies and programs as in effect at any time during the 120-day period immediately preceding the Effective Date or if more favorable to the Executive, those provided generally at any time after the Effective Date to other peer executives of the Company and its affiliated companies. 6 (iv) Welfare Benefit Plans. During the Employment Period, the Executive and/or the Executive's family, as the case may be, shall be eligible for participation in and shall receive all benefits under welfare benefit plans, practices, policies and programs provided by the Company and its affiliated companies (including, without limitation, medical, prescription, dental, disability, salary continuance, employee life, group life, accidental death and travel accident insurance plans and programs) to the extent applicable generally to other peer executives of the Company and its affiliated companies, but in no event shall such plans, practices, policies and programs provide the Executive with benefits which are less favorable, in the aggregate, than the most favorable of such plans, practices, policies and programs in effect for the Executive at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive, those provided generally at any time after the Effective Date to other peer executives of the Company and its affiliated companies. (v) Expenses. During the Employment Period, the Executive shall be entitled to receive prompt reimbursement for all reasonable expenses incurred by the Executive in accordance with the most favorable policies, practices and procedures of the Company and its affiliated companies in effect for the Executive at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive, as in effect generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies. (vi) Fringe Benefits. During the Employment Period, the Executive shall be entitled to fringe benefits, including, without limitation, tax and financial planning services, payment of club dues, and, if applicable, use of an automobile and payment of related expenses, in accordance with the most favorable plans, practices, programs and policies of the Company and its affiliated companies in effect for the Executive at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive, as in effect generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies. (vii) Office and Support Staff. During the Employment Period, the Executive shall be entitled to an office or offices of a size and with furnishings and other appointments, and to exclusive personal secretarial and other assistance, at least equal to the most favorable of the 7 foregoing provided to the Executive by the Company and its affiliated companies at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive, as provided generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies. (viii) Vacation. During the Employment Period, the Executive shall be entitled to paid vacation in accordance with the most favorable plans, policies, programs and practices of the Company and its affiliated companies as in effect for the Executive at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive, as in effect generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies. 5. Termination of Employment. (a) Death or Disability. The Executive's employment shall terminate automatically upon the Executive's death during the Employment Period. If the Company determines in good faith that the Disability of the Executive has occurred during the Employment Period (pursuant to the definition of Disability set forth below), it may give to the Executive written notice in accordance with Section 14(b) of this Agreement of its intention to terminate the Executive's employment. In such event, the Executive's employment with the Company shall terminate effective on the 30th day after receipt of such notice by the Executive (the "Disability Effective Date"), provided that, within the 30 days after such receipt, the Executive shall not have returned to full-time performance of the Executive's duties. For purposes of this Agreement, "Disability" shall mean the absence of the Executive from the Executive's duties with the Company on a full-time basis for 180 consecutive business days as a result of incapacity due to mental or physical illness which is determined to be total and permanent by a physician selected by the Company or its insurers and acceptable to the Executive or the Executive's legal representative. (b) Cause. The Company may terminate the Executive's employment during the Employment Period for Cause. For purposes of this Agreement, "Cause" shall mean: 8 (i) the willful and continued failure of the Executive to perform substantially the Executive's duties with the Company or one of its affiliates (other than any such failure resulting from incapacity due to physical or mental illness), after a written demand for substantial performance is delivered to the Executive by the Board or the Chief Executive Officer of the Company which specifically identifies the manner in which the Board or Chief Executive Officer believes that the Executive has not substantially performed the Executive's duties, or (ii) the willful engaging by the Executive in illegal conduct or gross misconduct which is materially and demonstrably injurious to the Company. For purposes of this provision, no act or failure to act, on the part of the Executive, shall be considered "willful" unless it is done, or omitted to be done, by the Executive in bad faith or without reasonable belief that the Executive's action or omission was in the best interests of the Company. Any act, or failure to act, based upon authority given pursuant to a resolution duly adopted by the Board or upon the instructions of the Chief Executive Officer or a senior officer of the Company or based upon the advice of counsel for the Company shall be conclusively presumed to be done, or omitted to be done, by the Executive in good faith and in the best interests of the Company. The cessation of employment of the Executive shall not be deemed to be for Cause unless and until there shall have been delivered to the Executive a copy of a resolution duly adopted by the affirmative vote of not less than three-quarters of the entire membership of the Board at a meeting of the Board called and held for such purpose (after reasonable notice is provided to the Executive and the Executive is given an opportunity, together with counsel, to be heard before the Board), finding that, in the good faith opinion of the Board, the Executive is guilty of the conduct described in subparagraph (i) or (ii) above, and specifying the particulars thereof in detail. (c) Good Reason. The Executive's employment may be terminated by the Executive for Good Reason. For purposes of this Agreement, "Good Reason" shall mean: 9 (i) the assignment to the Executive of any duties inconsistent in any respect with the Executive's position (including status, offices, titles and reporting requirements), authority, duties or responsibilities as contemplated by Section 4(a) of this Agreement, or any other action by the Company which results in a diminution in such position, authority, duties or responsibilities, excluding for this purpose an isolated, insubstantial and inadvertent action not taken in bad faith and which is remedied by the Company promptly after receipt of notice thereof given by the Executive; (ii) any failure by the Company to comply with any of the provisions of Section 4(b) of this Agreement, other than an isolated, insubstantial and inadvertent failure not occurring in bad faith and which is remedied by the Company promptly after receipt of notice thereof given by the Executive; (iii) the Company's requiring the Executive to be based at any office or location other than as provided in Section 4(a)(i)(B) hereof or the Company's requiring the Executive to travel on Company business to a substantially greater extent than required immediately prior to the Effective Date; (iv) any purported termination by the Company of the Executive's employment otherwise than as expressly permitted by this Agreement; or (v) any failure by the Company to comply with and satisfy Section 12(c) of this Agreement. For purposes of this Section 5(c), any good faith determination of "Good Reason" made by the Executive shall be conclusive. (d) Notice of Termination. Any termination by the Company for Cause, or by the Executive for Good Reason, shall be communicated by Notice of Termination to the other party hereto given in accordance with Section 14(b) of this Agreement. For purposes of this Agreement, a "Notice of Termination" means a written notice which (i) indicates the specific termination provision in this Agreement relied upon, (ii) to the extent applicable, sets forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the 10 Executive's employment under the provision so indicated and (iii) if the Date of Termination (as defined below) is other than the date of receipt of such notice, specifies the termination date (which date shall be not more than thirty days after the giving of such notice). The failure by the Executive or the Company to set forth in the Notice of Termination any fact or circumstance which contributes to a showing of Good Reason or Cause shall not waive any right of the Executive or the Company, respectively, hereunder or preclude the Executive or the Company, respectively, from asserting such fact or circumstance in enforcing the Executive's or the Company's rights hereunder. (e) Date of Termination. "Date of Termination" means (i) if the Executive's employment is terminated by the Company for Cause, or by the Executive for Good Reason, the date of receipt of the Notice of Termination or any later date specified therein, as the case may be, (ii) if the Executive's employment is terminated by the Company other than for Cause or Disability, the date on which the Company notifies the Executive of such termination and (iii) if the Executive's employment is terminated by reason of death or Disability, the date of death of the Executive or the Disability Effective Date, as the case may be. The Company and the Executive shall take all steps necessary (including with regard to any post-termination services by the Executive) to ensure that any termination described in this Section 5 constitutes a "separation from service" within the meaning of Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"), and notwithstanding anything contained herein to the contrary, the date on which such separation from service takes place shall be the "Date of Termination." 6. Obligations of the Company upon Termination. (a) Good Reason; Other Than for Cause, Death or Disability. If, during the Employment Period, the Company shall terminate the Executive's employment other than for Cause or Disability or the Executive shall terminate employment for Good Reason: (i) except as otherwise provided in this Section 6(a), the Company shall pay to the Executive in a lump sum in cash within 30 days after the Date of Termination the aggregate of the following amounts: 11 A. the sum of (1) the Executive's Annual Base Salary through the Date of Termination, to the extent not theretofore paid to the Executive, (2) the amount, if any, which has been earned by the Executive with respect to any completed Incentive Year under the Eaton Incentive Compensation Plan or any successor thereto, and any completed Award Period under the Eaton Executive Strategic Incentive Plan or any successor thereto, in each case to the extent not theretofore paid to the Executive, and (3) with respect to each Award Period under the Eaton Executive Strategic Incentive Plan or any successor thereto which begins before and ends after the Date of Termination, an amount equal to (x) 100% of the Executive's Individual Incentive Target (as defined in such plan) for such Award Period times (y) a fraction, the numerator of which is the number of days in such Award Period before the Date of Termination, and the denominator of which is the total number of days in such Award Period (the amount described in clause (3), the "Pro-Rata Bonus," and the sum of the amounts described in clauses (1), (2) and (3) shall be hereinafter referred to as the "Accrued Obligations"); and B. the product of (1) the Multiple (as defined below) and (2) the sum of (x) the Executive's Annual Base Salary and (y) the Annual Bonus Amount; (ii) for a number of years after the Executive's Date of Termination equal to the lesser of two and the Multiple, or such longer period as may be provided by the terms of the appropriate plan, program, practice or policy, the Company shall continue benefits to the Executive and/or the Executive's family at least equal to those which would have been provided to them in accordance with the plans, programs, practices and policies described in Section 4(b)(iv) of this Agreement if the Executive's employment had not been terminated or, if more favorable to the Executive, as in effect generally at any time thereafter with respect to other peer executives of the Company and its affiliated companies and their families, provided, however, that if the Executive becomes re-employed with another employer and is eligible to receive medical or other welfare benefits under another employer-provided plan, the medical and other welfare benefits described herein shall be secondary to those provided under such other plan during such applicable period of eligibility, and for purposes of determining eligibility (but not the time of commencement of benefits) of the Executive for retiree benefits pursuant to such plans, practices, programs and policies, the Executive shall be considered to have remained 12 employed for a number of years after the Date of Termination equal to the lesser of two and the Multiple and to have retired on the last day of such period, and for purposes of any reimbursement of eligible expenses to the Executive and/or the Executive's family under the plans, programs, practices and policies described in Section 4(b)(iv) of this Agreement incurred following the first eighteen months of continuation coverage under this Section 6(a)(ii), such reimbursement shall be made on or before the last day of the Executive's taxable year following the taxable year in which the expense was incurred (the amount of continued coverage and benefits that the Company is obligated to provide pursuant to this paragraph in any given calendar year shall not affect the amount of continued coverage and benefits that the Company is obligated to provide in any other calendar year, and the Executive's right to have the Company provide such continued coverage and benefits may not be liquidated or exchanged for any other benefit); (iii) to the extent not theretofore paid or provided, the Company shall timely pay or provide to the Executive any other amounts or benefits required to be paid or provided or which the Executive is eligible to receive under any plan, program, policy or practice or contract or agreement of the Company and its affiliated companies (such other amounts and benefits shall be hereinafter referred to as the "Other Benefits"); provided, however that to the extent that any Other Benefits are deferred compensation within the meaning of Section 409A of the Code and the Treasury Regulations promulgated thereunder and subject to the requirements of Section 409A of the Code, such Other Benefits shall not be paid or provided before the first business day that is six months after the Date of Termination. The "Multiple" means the lesser of (i) three and (ii) the number of years and portions thereof (expressed as a decimal fraction) from the Date of Termination until the Executive's 65th birthday. Notwithstanding the foregoing, the Company shall pay to the Executive the amounts described in (A)(3) and (B) in a lump sum in cash on the first business day that is six months after the Date of Termination. 13 (b) Death. If the Executive's employment is terminated by reason of the Executive's death during the Employment Period, this Agreement shall terminate without further obligations to the Executive's legal representatives under this Agreement, other than for payment of Accrued Obligations and the timely payment or provision of Other Benefits. Accrued Obligations shall be paid to the Executive's estate or beneficiary, as applicable, in a lump sum in cash within 30 days of the Date of Termination. With respect to the provision of Other Benefits, the term Other Benefits as utilized in this Section 6(b) shall include, without limitation, and the Executive's estate and/or beneficiaries shall be entitled to receive, benefits at least equal to the most favorable benefits provided by the Company and affiliated companies to the estates and beneficiaries of peer executives of the Company and such affiliated companies under such plans, programs, practices and policies relating to death benefits, if any, as in effect with respect to other peer executives and their beneficiaries at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive's estate and/or the Executive's beneficiaries, as in effect on the date of the Executive's death with respect to other peer executives of the Company and its affiliated companies and their beneficiaries. (c) Disability. If the Executive's employment is terminated by reason of the Executive's Disability during the Employment Period, this Agreement shall terminate without further obligations to the Executive, other than for payment of Accrued Obligations and the timely payment or provision of Other Benefits. Accrued Obligations shall be paid to the Executive in a lump sum in cash within 30 days of the Date of Termination; provided, however, that the Pro-Rata Bonus shall be paid on the first business day that is six months after the Date of Termination. With respect to the provision of Other Benefits, the term Other Benefits as utilized in this Section 6(c) shall include, and the Executive shall be entitled after the Disability Effective Date to receive, disability and other benefits at least equal to the most favorable of those generally provided by the Company and its affiliated companies to disabled executives and/or their families in accordance with such plans, programs, practices and policies relating to disability, if any, as in effect generally with respect to other peer executives and their families at any time during the 120-day period immediately preceding the Effective Date or, if more favorable to the Executive and/or the Executive's family, as in effect at any time thereafter generally with respect to other peer executives of the Company and its affiliated companies and 14 their families; provided, however that to the extent that any Other Benefits are deferred compensation within the meaning of Section 409A of the Code and the Treasury Regulations promulgated thereunder and subject to the requirements of Section 409A of the Code, such Other Benefits shall not be paid or provided before the first business day that is six months after the Date of Termination. (d) Cause; Other than for Good Reason. If the Executive's employment shall be terminated for Cause during the Employment Period, this Agreement shall terminate without further obligations to the Executive other than the obligation to pay to the Executive (x) the Annual Base Salary through the Date of Termination and (y) Other Benefits, in each case to the extent theretofore unpaid. If the Executive voluntarily terminates employment during the Employment Period, excluding a termination for Good Reason, this Agreement shall terminate without further obligations to the Executive, other than for Accrued Obligations and the timely payment or provision of Other Benefits. In such case, all Accrued Obligations shall be paid to the Executive in a lump sum in cash within 30 days after the Date of Termination, provided, however, that the Pro-Rata Bonus will be paid to the Executive on the first business day that is six months after the Date of Termination.. Notwithstanding the foregoing, to the extent that any Other Benefits required to paid pursuant to this Section 6(d) are deferred compensation within the meaning of Section 409A of the Code and the Treasury Regulations promulgated thereunder and subject to the requirements of Section 409A of the Code, such Other Benefits shall not be paid or provided before the first business day that is six months after the Date of Termination. 7. Termination of Agreement in Connection With Change of Control. In the event of a change of control as defined in Section 1.409A-3(i)(5) of the Treasury Regulations (for purposes of this Section 7 only, a "Change of Control Event"), the Board shall have the authority, in its sole discretion, to terminate the Agreement pursuant to an irrevocable action taken by the Board within the 30 days preceding the Change of Control Event, provided that this Section 7 will only apply to a payment under the Agreement if all agreements, methods, programs, and other arrangements sponsored by the service recipient immediately after the time of the Change of Control Event with respect to which deferrals of compensation are treated as having been deferred under a single plan within the meaning of Section 1.409A-1(c)(2) of the Treasury Regulations are terminated and liquidated with respect to the Executive, so that under 15 the terms of the termination and liquidation the Executive is required to receive all amounts of compensation deferred under the terminated agreements, methods, programs, and other arrangements within 12 months of the date the Board irrevocably takes all necessary action to terminate and liquidate the agreements, methods, programs and other arrangements. Solely for purposes of this Section, where the Change of Control Event results from an asset purchase transaction, the service recipient with the discretion to liquidate and terminate the agreements, methods, programs and other arrangements is the service recipient that is primarily liable immediately after the transaction for the payment of the deferred compensation. If the Agreement is terminated pursuant to this Section 7, the Company shall pay to the Executive in a lump sum in cash within 12 months of the date the Board irrevocably takes all necessary action to terminate and liquidate the agreements, methods, programs and other arrangements, the amount that would have been payable to the Executive if during the Employment Period the Company had terminated the Executive's employment other than for Cause or Disability or if the Executive had terminated his employment for Good Reason in accordance with Section 6(a) of this Agreement. 8. Non-exclusivity of Rights. Nothing in this Agreement shall prevent or limit the Executive's continuing or future participation in any plan, program, policy or practice provided by the Company or any of its affiliated companies and for which the Executive may qualify, nor, subject to the last sentence of this Section 8 and to Section 14(f), shall anything herein limit or otherwise affect such rights as the Executive may have under any contract or agreement with the Company or any of its affiliated companies. Amounts which are vested benefits or which the Executive is otherwise entitled to receive under any plan, policy, practice or program of or any contract or agreement with the Company or any of its affiliated companies at or subsequent to the Date of Termination shall be payable in accordance with such plan, policy, practice or program or contract or agreement except as explicitly modified by this Agreement. Notwithstanding the foregoing, if the Executive becomes entitled to receive severance benefits under Section 6(a) hereof, such severance benefits shall be in lieu of any benefits under any severance or separation plan, program or policy of the Company or any of its affiliated companies to which the Executive would otherwise have been entitled. 16 9. Full Settlement; Legal Fees. The Company's obligation to make the payments provided for in this Agreement and otherwise to perform its obligations hereunder shall not be affected by any set-off, counterclaim, recoupment, defense or other claim, right or action which the Company may have against the Executive or others. In no event shall the Executive be obligated to seek other employment or take any other action by way of mitigation of the amounts payable to the Executive under any of the provisions of this Agreement and except as specifically provided in Section 6(a)(ii), such amounts shall not be reduced whether or not the Executive obtains other employment. The Company agrees to pay as incurred, at any time from the Effective Date through the Executive's remaining lifetime (or, if longer, through the 20th anniversary of the Effective Date), to the full extent permitted by law, all legal fees and expenses which the Executive may reasonably incur as a result of any contest (regardless of the outcome thereof) by the Company, the Executive or others of the validity or enforceability of, or liability under, any provision of this Agreement or any guarantee of performance thereof (whether such contest is between the Company and the Executive or between either of them and any third party, and including as a result of any contest by the Executive about the amount of any payment pursuant to this Agreement), plus in each case interest on any delayed payment at the applicable Federal rate provided for in Section 7872(f)(2)(A) of the Code. In order to comply with Section 409A of the Code, in no event shall the payments by the Company under this Section 9 be made later than the end of the calendar year next following the calendar year in which such fees and expenses were incurred, provided that the Executive shall have submitted an invoice for such fees and expenses at least 10 days before the end of the calendar year next following the calendar year in which such fees and expenses were incurred. The amount of such legal fees and expenses that the Company is obligated to pay in any given calendar year shall not affect the legal fees and expenses that the Company is obligated to pay in any other calendar year, and the Executive's right to have the Company pay such legal fees and expenses may not be liquidated or exchanged for any other benefit. 10. Certain Additional Payments by the Company. (a) Anything in this Agreement to the contrary notwithstanding, in the event it shall be determined that any payment or distribution by the Company to or for the benefit of the Executive (whether paid or payable or distributed or distributable pursuant to the terms of this 17 Agreement or otherwise, but determined without regard to any additional payments required under this Section 10) (a "Payment") would be subject to an excise tax imposed by Section 4999 or to the additional income tax imposed by Section 409A(a)(1)(B) of the Code or any interest or penalties are incurred by the Executive with respect to such tax or taxes (such tax or taxes, together with any such interest and penalties, are hereinafter collectively referred to as the "Excise Tax"), then the Executive shall be entitled to receive an additional payment (a "Gross-Up Payment") in an amount such that after payment by the Executive of all taxes (including any interest or penalties imposed with respect to such taxes), including, without limitation, any income taxes (and any interest and penalties imposed with respect thereto) and Excise Tax imposed upon the Gross-Up Payment, the Executive retains an amount of the Gross-Up Payment equal to the Excise Tax imposed upon the Payments. (b) Subject to the provisions of Section 10(c), all determinations required to be made under this Section 10, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by Ernst & Young LLP or such other certified public accounting firm as may be designated by the Executive (the "Accounting Firm"), which shall provide detailed supporting calculations both to the Company and the Executive within 15 business days of the receipt of notice from the Executive that there has been a Payment, or such earlier time as is requested by the Company. In the event that the Accounting Firm is serving as accountant or auditor for the individual, entity or group effecting the Change of Control, the Executive shall appoint another nationally recognized accounting firm to make the determinations required hereunder (which accounting firm shall then be referred to as the Accounting Firm hereunder). All fees and expenses of the Accounting Firm shall be borne solely by the Company. Any Gross-Up Payment, as determined pursuant to this Section 10, shall be paid by the Company to the Executive within five days of the receipt of the Accounting Firm's determination which in no event will be later than the last day of the Executive's taxable year next following the Executive's taxable year in which the Executive remits the Excise Tax to the United States Treasury. Any determination by the Accounting Firm shall be binding upon the Company and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments 18 which will not have been made by the Company should have been made ("Underpayment"), consistent with the calculations required to be made hereunder. In the event that the Company exhausts its remedies pursuant to Section 10(c) and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Company to or for the benefit of the Executive. (c) The Executive shall notify the Company in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Company of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than ten business days after the Executive is informed in writing of such claim and shall apprise the Company of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which he gives such notice to the Company (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Company notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (i) give the Company any information reasonably requested by the Company relating to such claim, (ii) take such action in connection with contesting such claim as the Company shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney reasonably selected by the Company, (iii) cooperate with the Company in good faith in order effectively to contest such claim, and (iv) permit the Company to participate in any proceedings relating to such claim; provided, however, that the Company shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall 19 indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing provisions of this Section 10(c), the Company shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine; provided, however, that if the Company directs the Executive to pay such claim and sue for a refund, the Company shall advance the amount of such payment to the Executive, on an interest-free basis and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax or income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance; and further provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Company's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. (d) If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 10(c), the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall (subject to the Company's complying with the requirements of Section 10(c)) promptly pay to the Company the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Company pursuant to Section 10(c), a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Company does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance 20 shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 11. Confidential Information. The Executive shall hold in a fiduciary capacity for the benefit of the Company all secret or confidential information, knowledge or data relating to the Company or any of its affiliated companies, and their respective businesses, which shall have been obtained by the Executive during the Executive's employment by the Company or any of its affiliated companies and which shall not be or become public knowledge (other than by acts by the Executive or representatives of the Executive in violation of this Agreement). After termination of the Executive's employment with the Company, the Executive shall not, without the prior written consent of the Company or as may otherwise be required by law or legal process, communicate or divulge any such information, knowledge or data to anyone other than the Company and those designated by it. In no event shall an asserted violation of the provisions of this Section 11 constitute a basis for deferring or withholding any amounts otherwise payable to the Executive under this Agreement. 12. Successors. (a) This Agreement is personal to the Executive and without the prior written consent of the Company shall not be assignable by the Executive otherwise than by will or the laws of descent and distribution. This Agreement shall inure to the benefit of and be enforceable by the Executive's legal representatives. (b) This Agreement shall inure to the benefit of and be binding upon the Company and its successors and assigns. (c) The Company will require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business and/or assets of the Company to assume expressly and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform it if no such succession had taken place. As used in this Agreement, "Company" shall mean the Company as hereinbefore defined and any successor to its business and/or assets as aforesaid which assumes and agrees to perform this Agreement by operation of law, or otherwise. 13. Trust Deposit. 21 (a) Upon the occurrence of a Proposed Change of Control (as defined below) during the Change of Control Period, the Company shall deposit in trust or escrow with a third party cash in an amount sufficient to provide all of the benefits and other payments to which the Executive would be entitled hereunder if a Change of Control occurred on the date of the Proposed Change of Control and the Executive's employment were terminated by the Executive for Good Reason immediately thereafter. Upon such deposit, references hereunder to any payment by the Company shall be deemed to refer to a payment from such trust or escrow; provided, however, that nothing contained herein shall relieve the Company of its obligation to make the payments required of it hereunder in the event any such payment is not made from the trust or escrow. (b) "Proposed Change of Control" means: (i) the commencement of a tender or exchange offer by any third person (other than a tender or exchange offer which, if consummated, would not result in a Change of Control) for 25% or more of the Outstanding Company Common Shares or combined voting power of the Outstanding Company Voting Securities; (ii) the execution of an agreement by the Company, the consummation of which would result in the occurrence of a Change of Control; or (iii) the adoption by the Board, as a result of other circumstances, including circumstances similar or related to the foregoing, of a resolution to the effect that, for purposes of this Agreement, a Proposed Change of Control has occurred. 14. Miscellaneous. (a) This Agreement shall be governed by and construed in accordance with the laws of the State of Ohio, without reference to principles of conflict of laws. The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. This Agreement may not be amended or modified otherwise than by a written agreement executed by the parties hereto or their respective successors and legal representatives. 22 (b) All notices and other communications hereunder shall be in writing and shall be given by hand delivery to the other party or by registered or certified mail, return receipt requested, postage prepaid, addressed as follows: 23 If to the Executive: _________________________ Eaton Corporation Eaton Center Cleveland, Ohio 44114-2584 If to the Company: Eaton Corporation Eaton Center Cleveland, Ohio 44114-2584 Attention: Corporate Secretary or to such other address as either party shall have furnished to the other in writing in accordance herewith. Notice and communications shall be effective when actually received by the addressee. (c) The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement. (d) The Company may withhold from any amounts payable under this Agreement such Federal, state, local or foreign taxes as shall be required to be withheld pursuant to any applicable law or regulation. (e) The Executive's or the Company's failure to insist upon strict compliance with any provision hereof or any other provision of this Agreement or the failure to assert any right the Executive or the Company may have hereunder, including, without limitation, the right of the Executive to terminate employment for Good Reason pursuant to Section 5(c)(i)-(v) of this Agreement, shall not be deemed to be a waiver of such provision or right or any other provision or right of this Agreement. (f) The Executive and the Company acknowledge that, except as may otherwise be provided under any other written agreement between the Executive and the Company, the employment of the Executive by the Company is "at will" and, prior to the 24 Effective Date, the Executive's employment may be terminated by either the Executive or the Company at any time prior to the Effective Date, in which case the Executive shall have no further rights under this Agreement. In addition, this Agreement shall automatically and immediately terminate upon any transfer of the Executive's employment, prior to the Effective Date, to any position with the Company as to which Change of Control Agreements, in the form of this Agreement, have not been made available by action of the Board and, in the event of such transfer of employment, the Executive shall have no further rights under this Agreement. As of the date hereof, this Agreement supersedes the Change of Control Agreement between Executive and the Company dated June 1, 2008. From and after the Effective Date this Agreement shall supersede any other agreement between the parties with respect to the subject matter hereof. (g) Notwithstanding any provision in this Agreement to the contrary, in the event of an Anticipatory Termination, any payments that are deferred compensation within the meaning of Section 409A of the Code that the Company shall be required to pay or provide pursuant to Section 6(a) of this Agreement shall be paid or commence being provided no earlier than the first business day that is six months after the date of the Anticipatory Termination. In the event of an Anticipatory Termination, any payments or benefits that are not deferred compensation within the meaning of Section 409A of the Code that the Company shall be required to pay or provide pursuant to Section 6(a) of this Agreement shall be paid or shall commence being provided on the date of the Change of Control. (h) Within the time period permitted by the applicable governmental regulations, the Company may, in consultation with the Executive, modify this Agreement, in the least restrictive manner necessary and without any diminution in the value of the payments to the Executive, in order to cause the provisions of the Agreement to comply with the requirements of Section 409A of the Code, so as to avoid the imposition of taxes and penalties on the Executive pursuant to Section 409A of the Code. (i) Notwithstanding any other provision of this Agreement to the contrary, any payment required to be made or commence pursuant to this Agreement to a "specified employee" within the meaning of Section 409A of the Code (as determined in accordance with the methodology established by the Company as in effect on the Date of Termination) that is 25 deferred compensation within the meaning of Section 409A of the Code and the Treasury Regulations promulgated thereunder and subject to the requirements of Section 409A of the Code shall not be made or commence prior to the date that is six months following the Date of Termination. IN WITNESS WHEREOF, the Executive has hereunto set the Executive's hand and, pursuant to the authorization from its Board of Directors, the Company has caused this Agreement to be executed in its name on its behalf, all as of the day and year first above written. EATON CORPORATION By ------------------------------------- M. M. McGuire Executive Vice President and General Counsel By ------------------------------------- T. E. Moran Senior Vice President and Secretary 26 EX-10.CC 3 l35588aexv10wcc.txt EX-10 (CC) EXHIBIT 10 (CC) EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15 (B) EATON CORPORATION SUPPLEMENTAL EXECUTIVE STRATEGIC INCENTIVE PLAN (Effective as of June 25, 2008) EATON CORPORATION SUPPLEMENTAL EXECUTIVE STRATEGIC INCENTIVE PLAN 1. PURPOSE The purpose of the Supplemental Executive Strategic Incentive Plan (the "Plan") is to promote the growth and profitability of Eaton Corporation (the "Company") through the granting of incentives intended to motivate executives of the Company to achieve demanding long-term corporate objectives and to attract and retain executives of outstanding ability. 2. ADMINISTRATION With respect to Plan participants who are senior officers of the Company (that is, those officers with at least 2,448 Hay Points), the Plan shall be administered by the Compensation and Organization Committee (the "C&O Committee") of the Board of Directors of the Company (the "Board"), except as otherwise expressly provided herein. With respect to Plan participants other than senior officers of the Company, the Plan shall be administered by the Management Committee of the Company (consisting of the Chairman and Chief Executive Officer, Chief Human Resources Officer and such other officers as may be appointed to the Management Committee from time to time), except as otherwise expressly provided herein. As used herein, the term "Committee" means either the C&O Committee or the Management Committee, depending upon the type of participant involved. Except as otherwise expressly provided herein, with respect to those participants for which it has administrative responsibility, the C&O Committee and the Management Committee shall each have complete authority to: (i) interpret all provisions of the Plan consistent with law; (ii) designate the executives to participate under the Plan; (iii) determine the incentive targets and performance objectives applicable to participants; (iv) adopt, amend and rescind general and special rules and regulations for the Plan's administration; and (v) make all other determinations necessary or advisable for the administration of the Plan. 3. ELIGIBILITY Any executive of the Company designated by the Committee in its sole discretion shall be eligible to participate in the Plan. 4. INCENTIVE TARGETS (A) Establishment of Incentive Amounts and Conversion to Phantom Common Share Units Individual Incentive Amounts for each participant with respect to each Plan Award Period (as defined below) shall be determined by the Committee. Incentive targets will be expressed in the form of Phantom Common Share Units which will be determined by the Committee by: (a) first establishing the Individual Incentive Amount in cash for each participant with respect to each Award Period and (b) then dividing such Individual Incentive Amount by the average of the mean prices for the Company's common shares 2 for the first twenty (20) trading days of each Award Period. In all cases, the resulting Phantom Common Share Units shall be rounded up to the nearest 50 whole units. For purposes of the Plan, "mean price" shall be the mean of the highest and lowest selling prices for Company common shares quoted on the New York Stock Exchange on the relevant trading day. Notwithstanding the foregoing provisions of this Section 4(A), the Committee may, in its sole discretion, use a different method for establishing incentive targets for participants under the Plan. (B) Award Periods Each Award Period shall be the four-calendar year period commencing as of the first day of the calendar year in which the performance objectives are established for the Award Period as described in Section 4(C). A new Award Period shall commence as of the first day of each calendar year, unless otherwise specified by the Committee. (C) Establishment of Company Performance Objectives As soon as practicable at the beginning of each Award Period, threshold, target, and maximum Company performance objectives for such Award Period shall be established by the Committee. Unless otherwise determined by the Committee in its sole discretion, performance objectives will be established using a CFROGC/EPS Growth Performance Matrix which shall use the Company's average cash flow return on gross capital ("CFROGC") for such period along one axis and the Company's cumulative earnings per share ("EPS") for such period along the second axis. Notwithstanding the foregoing, after a Change in Control (as hereinafter defined), neither the Committee nor the Board shall have the authority to modify performance objectives in any manner which could prove detrimental to the interests of the Plan's participants. (D) Determination of Payments For each Award Period, payments ranging from 50% to 200% of the Phantom Common Share Units credited under Section 4(A) will be determined by the Committee for the attainment of performance objectives between either threshold and target or target and maximum. Final Individual Phantom Common Share Unit Awards shall be determined by the Committee as promptly as practicable after the completion of the Award Period by: (a) determining the CFROGC/EPS Growth Matrix Performance Percentage applicable for the Award Period (equal to (i) 50% upon attainment of the threshold performance objective; (ii) 100% upon attainment of the target performance objective; and (iii) 200% upon attainment of the maximum performance; or the applicable percentage for performance between threshold and target or target and maximum); and (b) multiplying such percentage by the number of Performance Share Units credited to the participant. The Final Individual Phantom Common Share Unit Award shall be converted to cash at a market value of Company common shares as determined by the Committee based on the average of the mean prices for the Company's common shares for the final twenty (20) trading days of the Award Period), and distributed to the participate within ninety (90) days, unless the participant has made an irrevocable election to defer all or part of the 3 amount of his or her award pursuant to any long term incentive compensation deferral plan adopted by the Committee or the Company. 5. PRORATA PAYMENTS A participant must be employed by the Company or one of its subsidiaries at the end of an Award Period in order to be entitled to a payment in respect to such Award Period; provided, however, that a payment, prorated for the participant's length of service during the Award Period, may be authorized by the Committee, in its sole discretion, in the event a participant's responsibilities change or the employment of a participant begins during the Award Period or terminates before the end of the Award Period due to death, permanent disability, normal or early retirement, closure or divestiture of a Company facility or any other reason. Notwithstanding the foregoing, upon any termination of the Plan during the term of any Award Period, award payments to all participants will be made, prorated for each participant's length of service during the Award Period prior to the date of Plan termination. 6. OTHER PROVISIONS (A) Adjustments upon Certain Changes In the event of changes to the structure or corporate organization of the Company's businesses which affect the participants and/or the performance prospects of the Company, the Committee may make appropriate adjustments to individual participant Incentive Targets or to the established performance objectives for incomplete Award Periods. Adjustments under this Section 6 shall be made by the Committee, whose determination as to what adjustments shall be made, and the extent thereof, shall be final, binding and conclusive. Notwithstanding the foregoing, after a Change in Control, neither the Committee nor the Board shall have the authority to change established Performance Objectives in any manner which could prove detrimental to the interests of the participant. (B) Change in Control Defined For purposes of the Plan, a Change in Control shall be deemed to have occurred if: (i) a tender offer shall be made and consummated for the ownership of 25% or more of the outstanding voting securities of the Company, (ii) the Company shall be merged or consolidated with another corporation and as a result of such merger or consolidation less than 55% of the outstanding voting securities of the surviving or resulting corporation shall be owned in the aggregate by the former shareholders of the Company as the same shall have existed immediately prior to such merger or consolidation, (iii) the Company shall sell substantially all of its assets to another corporation which is not a wholly-owned subsidiary of the Company, (iv) a "person" within the meaning of Section 3(a)(9) or of Section 13(d)(3) of the Securities Exchange Act of 1934 (as in effect on the effective date of the Plan) 4 shall acquire 25% or more of the outstanding voting securities of the Company (whether directly, indirectly, beneficially or of record). For purposes of the Plan, ownership of voting securities shall take into account and shall include ownership as determined by applying the provisions of Rule 13d-3 under the Securities Exchange Act of 1934 (as in effect on the effective date of the Plan), or (v) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board cease for any reason to constitute at least a majority thereof unless the election, or nomination for election by the Company's shareholders, of each new director was approved by a vote of at least two-thirds of the directors then still in office who were directors at the beginning of the period. (C) Non-Transferability No right to payment under the Plan shall be subject to debts, contract liabilities, engagements or torts of the participant, nor to transfer, anticipation, alienation, sale, assignment, pledge or encumbrance by the participant except by will or the law of descent and distribution or pursuant to a qualified domestic relations order. (D) Compliance with Law and Approval of Regulatory Bodies No payment shall be made under the Plan except in compliance with all applicable federal and state laws and regulations including, without limitation, compliance with tax requirements. (E) No Right to Employment Neither the adoption of the Plan nor its operation, nor any document describing or referring to the Plan, or any part thereof, shall confer upon any participant under the Plan any right to continue in the employ of the Company or any subsidiary, or shall in any way affect the right and power of the Company or any subsidiary to terminate the employment of any participant under the Plan at any time with or without assigning a reason therefore, to the same extent as the Company might have done if the Plan had not been adopted. (F) Interpretation of the Plan Headings are given to the sections of the Plan solely as a convenience to facilitate reference; such headings, numbering and paragraphing shall not in any case be deemed in any way material or relevant to the construction of the Plan or any provisions thereof. The use of the masculine gender shall also include within its meaning the feminine. The use of the singular shall also include within its meaning the plural and vice versa. 5 (G) Amendment and Termination The Committee may at any time suspend, amend or terminate the Plan. Notwithstanding the foregoing, upon the occurrence of a Change in Control, no amendment, suspension or termination of the Plan shall, without the consent of the participant, alter or impair any rights or obligations under the Plan with respect to such participant. (H) Effective Dates of the Plan The Plan was adopted by the Board on and is effective as of June 25, 2008. 6 EX-12 4 l35588aexv12.txt EX-12 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 12 RATIO OF EARNINGS TO FIXED CHARGES
Year ended December 31 ---------------------------------------- (Millions of dollars) 2008 2007 2006 2005 2004 ------ ------ ------ ------ ---- Income from continuing operations before income taxes $1,128 $1,041 $ 969 $ 964 $749 Adjustments Minority interests in consolidated subsidiaries 12 14 10 5 7 (Income) losses of equity investees (11) (6) 1 1 Interest expensed 192 193 139 109 88 Amortization of debt issue costs 2 1 1 1 1 Estimated portion of rent expense representing interest 58 44 41 38 37 Amortization of capitalized interest 13 12 12 12 17 Distributed income of equity investees 1 1 1 4 3 ------ ------ ------ ------ ---- Adjusted income from continuing operations before income taxes $1,395 $1,300 $1,174 $1,134 $902 ====== ====== ====== ====== ==== Fixed charges Interest expensed $ 192 $ 193 $ 139 $ 109 $ 88 Interest capitalized 13 14 14 13 7 Amortization of debt issue costs 2 1 1 1 1 Estimated portion of rent expense representing interest 58 44 41 38 37 ------ ------ ------ ------ ---- Total fixed charges $ 265 $ 252 $ 195 $ 161 $133 ====== ====== ====== ====== ==== Ratio of earnings to fixed charges 5.26 5.16 6.02 7.04 6.78
EX-21 5 l35588aexv21.txt EX-21 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 21 SUBSIDIARIES OF EATON CORPORATION Eaton is publicly held and has no parent corporation. Eaton's subsidiaries as of December 31, 2008 and the state or country in which each was organized are as follows:
Consolidated subsidiaries (A) Where Organized - ----------------------------- --------------- Argo-Tech Corporation Costa Mesa California Eaton MDH Company Inc. California Eaton Aerospace HiTemp Inc. Colorado Aeroquip International Inc. Delaware Eaton Industrial Corporation Delaware Argo-Tech Corporation (Aftermarket) Delaware Argo-Tech Corporation (OEM) Delaware Durodyne Inc. Delaware Eaton Asia Investments Corporation Delaware Eaton Aviation Corporation Delaware Eaton Aviation Products Corporation Delaware Eaton Electrical de Puerto Rico Inc. Delaware Eaton Electrical Inc. Delaware Eaton Filtration LLC Delaware Eaton Hydraulics Inc. Delaware Eaton Hydraulics LLC Delaware Eaton International Corporation Delaware Eaton MDH Limited Partnership Delaware Eaton USEV Holding Company Delaware Eaton Worldwide LLC Delaware EIC Holding I LLC Delaware EIC Holding II LLC Delaware EIC Holding III LLC Delaware EIC Holding IV LLC Delaware EIC Holding V LLC Delaware EIC Holding VI LLC Delaware EIC Holding GP I Delaware EIC Holding GP II Delaware EIC Holding GP III Delaware EIC Holding GP IV Delaware Intelligent Switchgear Organization LLC Delaware Modern Molded Products, Inc. Delaware Tractech Holdings Inc. Delaware Tractech Inc. Delaware U.S. Engine Valve Delaware Vickers International Inc. Delaware Aphel Technologies Inc. Florida Eaton Aeroquip Inc. Michigan Eaton Fuel Vapor Systems LLC Michigan Eaton Inoac Company Michigan Eaton Aeroquip LLC Ohio Eaton Electrical IDT Inc. Ohio Eaton Holding International LLC Ohio Eaton Leasing Corporation Ohio Moeller Electric Corporation Oklahoma Cutler-Hammer de Argentina S.A. Argentina Eaton Power Quality S.A. Argentina Eaton S.A. Argentina Eaton Electric Systems Pty. Ltd. Australia Eaton Industries Pty. Ltd. Australia Eaton Power Quality Pty. Ltd. Australia Moeller Electric (Pty.) Ltd. Australia
Eaton Holding G.m.b.H. Austria Moeller Beteligungen G.m.b.H. Austria Moeller Gebaudeautomation G.m.b.H. Austria Moeller Holding Austria G.m.b.H. Austria Aeroquip-Vickers Assurance Ltd. Barbados Eaton Holding Srl Barbados Eaton Electric S.A. Belgium Eaton Filtration, BVBA Belgium Aeroquip-Vickers International Inc. Bermuda Cambridge International Insurance Company Ltd. Bermuda Eaton Services Limited Bermuda Saturn Insurance Company Ltd. Bermuda Aeroquip do Brasil, Ltda. Brazil Eaton Ltda. Brazil Eaton Power Solutions Ltda. Brazil Moeller Electric Ltda. Brazil Asian Power Devices Ltd. (BVI) British Virgin Islands Phoenixtec International Corp. British Virgin Islands Senyuan International Investments Limited British Virgin Islands Team Achieve Investments Limited British Virgin Islands Winner Hydraulics Ltd. British Virgin Islands Moeller Electric EOOD Bulgaria Bulgaria Aeroquip-Vickers Canada, Inc. Canada Arrow Hose & Tubing, Inc. Canada Eaton ETN Offshore Company Canada Eaton ETN Offshore II Company Canada Eaton Power Quality Company Canada Eaton Yale Company Canada 1057584 Ontario Inc. Canada Aeroquip Financial Ltd. Cayman Islands Cutler-Hammer Electrical Company Cayman Islands Cutler-Hammer Industries Ltd. Cayman Islands Eaton Holding III Limited Cayman Islands Georgetown Financial Services Ltd. Cayman Islands Green Holding Company Cayman Islands Senyuan International Holdings Limited Cayman Islands Changzhou Lanling Electrical Co., Ltd. China Changzhou Senyuan Switch Co. Ltd. China Eaton (China) Investments Co., Ltd. China Eaton Commercial (Shanghai) Co, Ltd China Eaton Electrical Ltd. China Eaton Filtration (Shanghai) Co. Ltd. China Eaton Fluid Conveyance (Luzhou) Co. Ltd. China Eaton Fluid Power (Shanghai) Co. Ltd. China Eaton Hydraulics Systems (Jining) Co. Ltd. China Eaton Industries (Shanghai) Co. Ltd China Eaton Industries (Wuxi) Co. Limited. China Eaton Industrial Clutches and Brakes (Shanghai) Co., Ltd. China Eaton (Ningbo) Fluid Conveyance Co. Ltd. China Eaton Power Quality (Shanghai) Co Ltd. China Eaton Senstar Automotive Fluid Connectors (Shanghai) Co. Ltd. China Eaton Truck and Bus Components Company (Shanghai) Ltd. China Hangzhou Eaton Power Quality Co., Ltd. China Lian Zheng Electronics (Shenzhen) Co. Ltd. China Moeller Electrical Equipment (Suzhou) Co. Ltd. China Moeller Electric Shanghai Co. Ltd. China Phoenixtec Electronics (Shenzhen) Co. Ltd. China Santak Electronics (Shenzhen) Co. Ltd. China Shanghai Eaton Engine Components Company, Ltd. China UPE Electronics (Shenzen) Co. Ltd. China Zhenjiang Eaton Electrical Systems Company Limited China Eaton Electrical S.A. Costa Rica
Eaton Electric S.r.o. Czech Republic Eaton Industries S.r.o. Czech Republic Moeller Elektrotechnika S.r.o. Czech Republic Eaton Electric ApS Denmark Cutler-Hammer, S. A. Dominican Republic Eaton Holec, OY Finland Eaton Power Quality Oy Finland Eaton Aviation S.A.S. France Eaton Electric S.A.S. France Eaton Power Quality Holding S.A.S. France Eaton Power Quality S.A.S. France Eaton Power Solutions S.A.S. France Eaton S.A.S. France Eaton Technologies S.A. France Moeller Electric S.A.S. France Eaton Automotive G.m.b.H. Germany Eaton Filtration G.m.b.H. Germany Eaton Filtration Holdings G.m.b.H. Germany Eaton Fluid Connectors G.m.b.H. Germany Eaton Fluid Power G.m.b.H. Germany Eaton Holding G.m.b.H. Germany Eaton Holding II G.m.b.H. and Co. KG Germany Eaton Holding Investments G.m.b.H. & Co. KG Germany Eaton Industries Holding G.m.b.H. Germany Eaton Moeller G.m.b.H. & Co. KG Germany Eaton Power Quality G.m.b.H. Germany Moeller Eaton Holding G.m.b.H. Germany Moeller Electric G.m.b.H. Germany Moeller G.m.b.H. Germany Eaton Filtration Limited Hong Kong Eaton Power Quality Limited Hong Kong Riseson International Limited Hong Kong Smartwish Intl Enterprise Ltd. Hong Kong Team Billion Investment Limited Hong Kong Vickers Systems Limited Hong Kong Yang Ming Ltd. Hong Kong Moeller Electric Kft Hungary Eaton Fluid Power Limited India Eaton Industrial Systems Private Limited India Eaton Industries Private Ltd. India Eaton Power Quality Private Limited India Eaton Technologies Private Limited India PT. Fluid Sciences Batam Indonesia Tractech (Ireland) Limited Ireland Eaton Fluid Power S.r.l. Italy Eaton S.r.l. Italy Moeller Electric S.r.l. Italy Eaton Filtration Ltd. Japan Eaton Fluid Power Limited Japan Eaton Japan Co., Ltd. Japan Moeller Electric SIA Latvia Eaton Holding S.a r.l. Luxembourg Eaton Holding II S.a.r.l. Luxembourg Eaton Holding III S.a.r.l. Luxembourg Eaton Holding IV S.a.r.l. Luxembourg Eaton Holding V S.a.r.l. Luxembourg Eaton Holding VI S.a.r.l. Luxembourg Eaton Holding VIII S.a.r.l. Luxembourg Eaton Holding IX S.a.r.l. Luxembourg Eaton Holding X S.a.r.l. Luxembourg Eaton Holding XI S.a.r.l. Luxembourg Eaton Moeller Holding S.a.r.l. Luxembourg
Eaton Electric Manufacturing Holdings Sdn. Bhd. Malaysia Eaton Electric Switchgear Sdn. Bhd. Malaysia ETN Asia International Limited Mauritius ETN Holding 1 Limited Mauritius ETN Holding 2 Limited Mauritius ETN Holding 3 Limited Mauritius Eaton Technologies S. de R.L. de C.V. Mexico Eaton Controls, S. de R.L. de C.V. Mexico Eaton Electrical Mexicana S. de R.L. de C.V. Mexico Eaton Industries S. de R.L. de C.V. Mexico Eaton Trading Company, S. de R.L. de C.V. Mexico Eaton Truck Components, S. de R.L. de C.V. Mexico Eaton Power Quality s.a.r.l. Morocco Eaton B.V. Netherlands Eaton C.V. Netherlands Eaton Electric B.V. Netherlands Eaton Holding B.V. Netherlands Eaton Holding I B.V. Netherlands Eaton Holding II B.V. Netherlands Eaton Holding III B.V. Netherlands Eaton Holding IV B.V. Netherlands Eaton Holding V B.V. Netherlands Eaton Holding VI B.V. Netherlands Eaton Holding International I B.V. Netherlands Eaton Holding International II B.V. Netherlands Eaton Industries B.V. Netherlands Eaton International B.V. Netherlands Moeller Electric BV Netherlands Eaton Finance N.V. Netherlands Antilles Eaton Industries Company New Zealand Moeller Electric AS Norway Eaton Automotive Components Sp. z o.o. Poland Eaton Automotive Spolka z o.o. Poland Eaton Automotive Systems Sp. z o.o. Poland Eaton Truck Components Spolka z o.o. Poland Moeller Electric Sp. Z.o.o. Poland Eaton Madeira SGPS Lda Portugal Moeller Electro Prodictie SRL Romania Moeller Electric SRL Romania OOO Moeller Elektrik Russia Moeller Elektrik Produktion Mozhaisk Russia Moeller Electric d.o.o. Serbia Serbia Aeroquip Singapore Private Limited Singapore Asian Power (Singapore) Co.Pte.Ltd. Singapore Eaton Electrical Pte. Ltd. Singapore Eaton Filtration Pte. Ltd. Singapore Eaton Power Quality Pte. Ltd. Singapore Moeller Electric Pte.Ltd. Singapore Vickers Systems Asia Pacific Pte. Ltd. Singapore Eaton Electric Solutions s.r.o. Slovak Republic Moeller Electric s.r.o. Slovak Republic Aeroquip (South Africa) Pty. Ltd. South Africa Eaton Truck Components (Pty.) Limited South Africa Eaton Automotive Controls Limited South Korea Eaton Limited South Korea Aeroquip Iberica S.L. Spain Eaton Power Quality S.L.. Spain Eaton S.L. Spain Productos Eaton Livia S.L. Spain Medex S.L. Spain Moeller Electric S.L. Spain Eaton Holec, AB Sweden
Eaton Power Quality AB Sweden Eaton Industries Manufacturing G.m.b.H. Switzerland Eaton Manufacturing LP Switzerland Eaton Manufacturing III G.m.b.H. Switzerland Moeller Electric AG Switzerland Asian Power Devices Inc. Taiwan Centralion Industrial Inc. Taiwan Eaton Phoenixtec MMPL Co. Taiwan Rubberon Technology Corporation Limited Thailand Moeller Electric Ticaret Ltd. Sirket Turkey D.P. Moeller Electric Ukraine Aphel Ltd. United Kingdom Aphel Technologies Ltd. United Kingdom Carter Ground Fueling, Ltd. United Kingdom Eaton Aerospace Limited United Kingdom Eaton Electric Limited United Kingdom Eaton Filtration Limited United Kingdom Eaton Holding Limited United Kingdom Eaton Holding II Limited United Kingdom Eaton Industries Ltd. United Kingdom Eaton, Limited United Kingdom Eaton Power Quality Limited United Kingdom Eaton Power Solutions Limited United Kingdom Integ Holdings Limited United Kingdom Integrated Hydraulics Limited United Kingdom Moeller Electric Limited United Kingdom Moeller Holding Limited United Kingdom Ultronics Limited United Kingdom Eaton Electrical, S.A. Venezuela Megatec-texenco Electrical Lighting BCC Vietnam
(A) Other Eaton subsidiaries, many inactive, are not listed above. If considered in the aggregate, they would not be material. EX-23 6 l35588aexv23.txt EX-23 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the following Registration Statements of Eaton Corporation and in the related Prospectuses of our reports dated February 27, 2009, with respect to the consolidated financial statements of Eaton Corporation, and the effectiveness of internal control over financial reporting of Eaton Corporation, included in this Annual Report (Form 10-K) for the year ended December 31, 2008.
Registration Number Description Filing Date - ------------ ---------------------------------------------------------------------------- ----------------- 333-152763 Eaton Corporation 2008 Stock Plan - 2.7 million shares August 5, 2008 333-150637 Eaton Personal Investment Plan - 375,000 shares May 5, 2008 333-150636 Eaton Electrical de Puerto Rico Retirement Savings Plan - 75,000 shares May 5, 2008 333-147267 Eaton Savings Plan - Form S-8 Registration Statement - 10,000,000 Shares November 9, 2007 333-136292 Eaton Corporation Incentive Compensation Deferral Plan - Form S-8 Registration Statement - 70,000 Shares August 4, 2006 333-136291 Eaton Corporation - Shareholder Dividend Reinvestment and Direct Share Purchase Plan -1,000,000 Shares -Prospectus August 4, 2006 333-130318 Eaton Corporation - Form S-3 Automatic Shelf Registration Statement December 14, 2005 333-129602 Eaton Corporation Shareholder Dividend Reinvestment Plan - Form S-3 Registration Statement - 75,000 Shares November 9, 2005 333-125836 Eaton Savings Plan - Form S-8 Registration Statement - 9,000,000 Shares June 15, 2005 333-124129 Eaton Corporation Incentive Compensation Deferral Plan II - Form S-8 Registration Statement - 400,000 Shares April 18, 2005 333-124128 Eaton Corporation Deferred Incentive Compensation Plan II - Form S-8 Registration Statement - 750,000 Shares April 18, 2005 333-124127 2005 Non-Employee Director Fee Deferral Plan - Form S-8 Registration Statement - 30,000 Shares April 18, 2005 333-116974 Eaton Corporation Deferred Incentive Compensation Plan - Form S-8 Registration Statement - 750,000 Shares June 29, 2004 333-116970 Eaton Corporation 2004 Stock Plan - Form S-8 Registration Statement - 7,000,000 Shares June 29, 2004 333-104366 1996 Non-Employee Director Fee Deferral Plan - Form S-8 Registration Statement - 33,000 Shares April 8, 2003 333-97365 Eaton Corporation Incentive Compensation Deferral Plan - Form S-8 Registration Statement July 30, 2002 333-97373 Cutler-Hammer de Puerto Rico Inc. Retirement Savings Plan - Form S-8 Registration Statement July 30, 2002 333-97371 Eaton Corporation 2002 Stock Plan - Form S-8 Registration Statement July 30, 2002
333-43876 Eaton Corporation 401(k) Savings Plan - Form S-8 Registration Statement - 500,000 Shares August 16, 2000 333-35946 Deferred Incentive Compensation Plan - Form S-8 Registration Statement - 375,000 Shares May 1, 2000 333-86389 Eaton Corporation Executive Strategic Incentive Plan - Form S-8 Registration Statement September 2, 1999 333-62375 Eaton Corporation 1998 Stock Plan - Form S-8 Registration Statement August 27, 1998 333-62373 Eaton Holding Limited U.K. Savings - Related Share Option Scheme [1998] - Form S-8 Registration Statement August 27, 1998 333-23539 Eaton Non-Employee Director Fee Deferral Plan - Form S-8 Registration Statement March 18, 1997 333-22597 Eaton Incentive Compensation Deferral Plan - Form S-8 Registration Statement March 13, 1997 333-01365 Eaton Corporation Incentive Compensation Deferral Plan - Form S-3 Registration Statement March 1, 1996 33-49393& Eaton Corporation Stock Option Plans - Form S-8 Registration Statement 33-12842 March 9, 1993
/s/ Ernst & Young LLP - ------------------------------------- Cleveland, Ohio February 27, 2009 EX-24 7 l35588aexv24.txt EX-24 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS: That each person whose name is signed below has made, constituted and appointed, and by this instrument does make, constitute and appoint, Richard H. Fearon, Billie K. Rawot or William J. Nowak his or her true and lawful attorney, for him or her and in his or her name, place and stead to subscribe, as attorney-in-fact, his or her signature as Director or Officer or both, as the case may be, of Eaton Corporation, an Ohio corporation, to its Annual Report on Form 10-K for the year ended December 31, 2008 pursuant to the Securities Exchange Act of 1934, and to any and all amendments to that Annual Report, hereby giving and granting unto each such attorney-in-fact full power and authority to do and perform every act and thing whatsoever necessary to be done in the premises, as fully as he or she might or could do if personally present, hereby ratifying and confirming all that each such attorney-in-fact shall lawfully do or cause to be done by virtue hereof. This Power of Attorney shall not apply to any Annual Report on Form 10-K or amendment thereto filed after December 31, 2009. IN WITNESS WHEREOF, this Power of Attorney has been signed at Cleveland, Ohio this 28th day of January, 2009. /s/ Alexander M. Cutler /s/ Richard H. Fearon - ------------------------------------- ---------------------------------------- Alexander M. Cutler, Chairman Richard H. Fearon, and Chief Executive Officer; Chief Financial and Planning Officer; President; Principal Executive Principal Financial Officer Officer; Director /s/ Billie K. Rawot - ------------------------------------- Billie K. Rawot, Senior Vice President and Controller; Principal Accounting Officer /s/ Christopher M. Connor /s/ Michael J. Critelli - ------------------------------------- ---------------------------------------- Christopher M. Connor Michael J. Critelli Director Director /s/ Charles E. Golden /s/ Ernie Green - ------------------------------------- ---------------------------------------- Charles E. Golden Ernie Green Director Director /s/ Arthur E. Johnson /s/ Ned C. Lautenbach - ------------------------------------- ---------------------------------------- Arthur E. Johnson Ned C. Lautenbach Director Director /s/ Deborah L. McCoy /s/ John R. Miller - ------------------------------------- ---------------------------------------- Deborah L. McCoy John R. Miller Director Director /s/ Gregory R. Page /s/ Victor A. Pelson - ------------------------------------- ---------------------------------------- Gregory R. Page Victor A. Pelson Director Director - ------------------------------------- Gary L. Tooker Director EX-31.1 8 l35588aexv31w1.txt EX-31.1 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 31.1 CERTIFICATION I, Alexander M. Cutler, certify that: 1. I have reviewed this annual report on Form 10-K of Eaton Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 27, 2009 /s/ Alexander M. Cutler ---------------------------------------- Alexander M. Cutler Chairman and Chief Executive Officer; President EX-31.2 9 l35588aexv31w2.txt EX-31.2 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 31.2 CERTIFICATION I, Richard H. Fearon, certify that: 1. I have reviewed this annual report on Form 10-K of Eaton Corporation; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 27, 2009 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Vice Chairman and Chief Financial and Planning Officer EX-32.1 10 l35588aexv32w1.txt EX-32.1 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 32.1 CERTIFICATION This written statement is submitted in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. It accompanies Eaton Corporation's Annual Report on Form 10-K for the year ended December 31, 2008 ("10-K Report"). I hereby certify that, based on my knowledge, the 10-K Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C 78m), and information contained in the 10-K Report fairly presents, in all material respects, the financial condition and results of operations of Eaton Corporation and its consolidated subsidiaries. Date: February 27, 2009 /s/ Alexander M. Cutler ---------------------------------------- Alexander M. Cutler Chairman and Chief Executive Officer; President EX-32.2 11 l35588aexv32w2.txt EX-32.2 EATON CORPORATION 2008 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 32.2 CERTIFICATION This written statement is submitted in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. It accompanies Eaton Corporation's Annual Report on Form 10-K for the year ended December 31, 2008 ("10-K Report"). I hereby certify that, based on my knowledge, the 10-K Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C 78m), and information contained in the 10-K Report fairly presents, in all material respects, the financial condition and results of operations of Eaton Corporation and its consolidated subsidiaries. Date: February 27, 2009 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Vice Chairman and Chief Financial and Planning Officer -----END PRIVACY-ENHANCED MESSAGE-----