Fitch Affirms Eaton's Debt Ratings; Changes Outlook to Positive

    CHICAGO--June 26, 2003--Fitch Ratings has affirmed Eaton Corp's (Eaton) debt ratings at 'A-' for senior unsecured and 'F2' for short-term debt and changed the Rating Outlook to Positive. The ratings affirmations reflect Eaton's ability to generate solid free cash flow from operations based on leading product lines with market share and/or technological advantage which allow for growth greater than the cyclical end markets Eaton serve. Also, such operating characteristics have helped Eaton better preserve its profitability margins selling into price sensitive markets. As a supplier to the vehicle markets, for instance, Eaton sustains comparatively higher margins. The Positive Rating Outlook reflects the significant debt reduction Eaton has achieved by using the free cash flow generated from operations to bring balance sheet leverage down and the expectation that the proceeds from the recent equity offering will further reduce leverage. While the various end markets served by Eaton are at differing stages of demand cycles, Fitch believes that Eaton is well positioned to continue generating free cash flow from operations well in excess of investment requirements. Of some concern, however, is the underfunded pension obligations which have swung from fully funded in 2001 to underfunded by $425 million on a PBO basis at 2002 year-end due mainly to poor asset returns. Further, while the various end markets Eaton sell into have exhibited some buffering effects in their collective cyclicality, individually, these end markets are cyclical in nature and may overlap in cyclicality swings with other key end markets.
    For the three months ended March 31, 2003, Eaton posted total sales of $1.9 billion, a 12% increase versus the prior year, with all operating segments reporting increases, reflecting gains from market share growth, acquisitions, and favorable exchange rates. Consolidated operating income of $126 million for the quarter was much higher compared to the year ago period due to lowered restructuring charges incurred in the period, cost savings accruing from earlier restructuring actions, and greater efficiencies realized from higher sales, which were offset to some extent by increased pension and other retirement benefit expenses.
    After hitting a peak of over $3 billion in total balance sheet debt at year-end 2000, Eaton has achieved nearly a billion of debt reduction since, using strong cash flow generated from operations, aided by working capital as well as capital expenditure reductions. The working capital reduction gains reflect Eaton's effort to tighten up on all areas of working capital, especially in integrating the bolt-on strategic acquisitions. Capital expenditures, which as a percentage of total sales declined to 3.2% in 2002 from 4.7% in 2000 and 7.3% in 1998, is reflective of Eaton's strategic efforts to position its businesses in less capital intensive and more technology and R&D oriented businesses.
    The debt reduction and attendant de-leveraging of the balance sheet have improved debt holder protection. Core credit metrics such as Debt-to-EBITDA leverage (on a latest twelve months basis) and EBITDA coverage of interest expense have improved to 2.2 times (x) and 8.7x , respectively, at March 31, 2003 versus 3.1x and 5.4x at March 31, 2002. In addition to the debt reduction achieved through operations, Eaton recently issued around $300 million of equity which was primarily intended for further debt reduction. Fitch expects that barring major debt funded acquisitions, Eaton's debt levels should decrease further during the balance of the year, as the back half of the year had typically seen higher seasonal cash flow.
    In addition to the $102 million of cash on hand at March 31, 2003, Eaton had access to a recently closed $250 million revolver maturing in May 2008 and another bank line of $400 million maturing in April 2005 for liquidity. With the retirement of $150 million of notes in April 2003, the next material piece of debt, $250 million of notes, comes due in November 2004.
    Fitch believes that Eaton's pension contribution requirements are manageable and can be made with discretionary cash flow even going through an extended low interest rate and low equity return environment. Eaton has the flexibility not to make any funding contributions until 2005, when a small contribution amount is likely to be required, followed by more substantial amounts in the following years. Also, while pension expenses are expected to increase markedly, Fitch expects that Eaton's cost saving measures will largely offset some of these cost headwinds.
    Eaton Corporation, headquartered in Cleveland, Ohio, is a diversified global manufacturer of highly engineered products such as electrical controls, truck and light vehicle drive train components, engine and hydraulic components for the industrial, vehicle, construction, commercial, and aerospace markets.