August 12, 2008

Cooper Industries: Plugged into Global Markets

Houston-based Cooper Industries (CBE; recent price, $44) is a diversified, worldwide manufacturer of electrical products, tools, and hardware. We expect the company to generate more than $6.7 billion in revenues in 2008 and more than $7.2 billion in 2009. Our 5 STARS [strong buy] recommendation is based on several factors, including a belief that the company has a favorable product and regional-business mix, margin-enhancing opportunities, and a valuation at attractive levels.

In the near term, we think economic growth in developing markets will help offset a currently weak U.S. economy, and that global markets will prove complementary once the U.S. economy strengthens. We see profits expanding via greater operating efficiencies, as evidenced by the second quarter's improvement in gross and operating margins, despite higher commodity costs and a soft U.S. environment. We think internal cash-flow generation and available credit facilities will support growth via acquisitions and through core product and regional initiatives.

For the longer term, we expect sales and profits to expand at double-digit rates through a combination of acquisitions and internal growth. Even before acquisitions, we think sales growth can outpace U.S. gross domestic product [GDP] gains by a couple of percentage points per year on average, as we believe the pursuit of high growth platforms -- including international infrastructure build out; oil and gas; energy efficiency; and utilities -- will help drive long-term revenue growth. We think efforts to expand in countries with overall high economic growth and a great need for infrastructure development will be an important driver to Cooper's long-term revenue expansion.

Company Background Electrical products contributed 87% of Cooper's revenues in 2007, and tools and hardware provided 13%.

The Electrical Products segment manufactures, markets, and sells electrical and circuit-protection products, including fittings; support systems; enclosures; specialty connectors; wiring devices; plugs; receptacles; lighting fixtures and controls; hazardous-duty electrical equipment; fuses; emergency lighting; and fire detection and mass notification systems and security products for use in residential, commercial, and industrial construction, maintenance, and repair applications. The segment also manufactures, markets, and sells products for use by utilities and companies involved with electrical power transmission and distribution, including distribution switchgear; transformers; transformer terminations and accessories; capacitors; voltage regulators; surge arresters; energy automation solutions; and other related power systems components.

The Tools segment manufactures, markets, and sells hand tools for industrial, construction, electronics, and consumer markets; automated assembly systems for industrial markets; and electric and pneumatic industrial power tools, related electronics, and software control and monitoring systems for general industry, primarily automotive and aerospace manufacturers.

The company is focused on leveraging strong brand-name recognition by broadening its product line; strengthening its manufacturing and distribution systems to lower costs and improve customer service; expanding globally via acquisitions and joint ventures to participate in expanding global economies; and improving working capital efficiency and increasing cash flow to fuel future growth.

Markets for Cooper's products and services are worldwide, though the U.S. is its largest market. About 29% of 2007 sales came from outside the U.S. We expect the percentage of international revenues to rise over time.

The countries that generate the most international revenues for Cooper are Canada, Germany, Mexico, and Britain. The company has several small joint ventures operating in China.

Cash flow from operations in 2007 was $795 million, up from 2006's $601 million and 2005's $574 million. We expect further increases in 2008 and 2009.

Strategy The company's core growth strategy includes diversified exposure to such long-term growth areas as oil and gas, utilities, international infrastructure build-out, energy efficiency, and safety, fire-safety, and mass-notification systems. Cooper looks to benefit from process efficiencies and technology, as well as from innovation, customer loyalty, and globalization. Its acquisition strategy includes adding complementary operations to existing product platforms for strategic fit, adding significant technology or new lines, and enhancing its global footprint. While the company did not make any acquisitions in 2005, it purchased four businesses in 2006 for approximately $280 million. Cooper then spent $336 million on acquisitions in 2007. During the first half of 2008, the company completed two acquisitions, notably that of MTL Instruments Group for about $325 million, including assumed debt. In 2008, about two-thirds of revenue from the two acquired businesses was derived from outside the U.S.

Cooper has shown historically that it adjusts its capital spending to the economic environment. Capital spending totaled more than $115 million in 2007, a level we believe CBE will exceed again in 2008 and 2009.

Company Outlook Although we continue to see weak U.S. economic growth for 2008, we still expect more favorable economic conditions abroad. We look for revenue growth of almost 14% in 2008, following 2007's 14% increase, as we expect Cooper to outperform industry sales growth for most of its segments. We also anticipate margin improvement from cost-cutting efforts and efficiencies. Our earnings-per-share estimates reflect the relatively low tax rates the company enjoys as a Bermuda-based corporation. We expect sales to rise in the high single digits in 2009, but we think acquisitions could boost upside to the low double digits.

Our 2008 EPS estimate of $3.75 is 19% above 2007's adjusted EPS of $3.14, which accounts for special items. For 2009, we see EPS advancing 12%, to $4.19. All estimates exclude residual income that may be received from Belden and from special items. The company periodically receives income from Belden (BDC), a former Cooper division, in connection with certain tax-payment arrangements established at the time of Belden's 1993 initial public offering.

We forecast that free cash flow [net income before depreciation, but after capital expenditures] will exceed net income in 2008. We think a focus on cash generation will help boost cash flow and allow for share repurchases and acquisitions. Long-term debt, including current maturities, amounted to 28% of total capitalization at the end of 2007.

Long-term debt [excluding current maturities] as a percentage of capitalization has trended downward, from 41% in 2000 to 24.37% in 2007. While our financial-performance projection favors a reduction in this ratio, we think increased acquisition activity, or share repurchases, could mitigate this trend.

As of Dec. 31, 2007, long-term debt totaled $1.3 billion [including $330 million of long-term discontinued operations liability and $100 million of current maturities]. Debt of $1.3 billion for 2007 was roughly unchanged from $1.3 billion as of Dec. 31, 2006 [which also included $330 million of long-term discontinued operations liability and $300 million of current maturities]. As of June 30, 2008, long-term debt totaled approximately $1.5 billion [including $330 million of long-term discontinued operations liability, but there were no significant current maturities as of this date].

We expect the company's returns on sales, assets, and equity to continue following the improving trend from lows reached in 2002.

Second quarter 2008 earnings, reported in July 2008, exceeded Cooper's initial sales and earnings guidance. In addition, the company raised 2008 EPS guidance to a range between $3.61 and $3.71 on a revenue-growth projection of from 12% to 14%. For the third quarter, the company is guiding to an EPS of between $0.92 and $0.97 and sees sales rising from 12% to 15%. Our forecast of $3.75 for 2008 is above company guidance.

In April 2008, the company had said that most of its segments had first-quarter orders that exceeded first-quarter revenue. Also at this time, management revised EPS guidance for 2008 to a range of $3.51 to $3.65, including currency gains and discrete items of $0.05 per share and integration and reorganization costs of $0.02 to $0.03 per share. Again, we note that management raised guidance in July.

Valuation Cooper's price-to-earnings [p-e] and price-to-free-cash-flow multiples are toward the low end of peer group ranges, while its projected p-e-to-growth ratio and net margin of 10% are within the peer ranges.

Our use of a p-e multiple of 12.5 times our 2009 EPS estimate reflects peer and historical p-e multiple comparisons and implies a value of about $52. Our discounted cash-flow [DCF] model produces an intrinsic value of nearly $63. Based on a combination of our p-e and DCF analyses, our 12-month target price is $57.

Corporate Governance Our view of Cooper's corporate governance is favorable. Corporate-governance factors we view positively include the board of directors being controlled by a supermajority [more than 90%] of independent outsiders. In addition, the compensation and executive committees are comprised solely of independent outside directors. Moreover, the outside directors meet without the CEO.

However, an area of concern is that a supermajority vote of shareholders is required to amend certain provisions of the charter and bylaws, and a supermajority is also needed to approve certain types of mergers and business combinations. Generally, we would prefer to see fewer requirements for shareholder actions.

Investment Risks Risks to our recommendation and target price include weaker-than-expected industrial demand and economic growth. Also, while we view potential exposure to asbestos liabilities stemming from the 2001 Federal-Mogul bankruptcy filing as a risk, we see this as less of a concern than in the past. Federal-Mogul recently emerged from bankruptcy protection, and the courts are reviewing two possible plans of action. Plans under review vary greatly: One could result in cash proceeds to Cooper and the other would mean cash outflow from Cooper.