Edgar Filing: Eaton Corp plc

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2016

Commission file number 000-54863

EATON CORPORATION plc

(Exact name of registrant as specified in its charter)



Ireland		98-1059235
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

Eaton House, 30 Pembroke Road, Dublin 4, Ireland		-
(Address of principal executive offices)		(Zip Code)



			+353 1637 2900
			(Registrant's telephone number, including area code)

			Not applicable
			(Former name, former address and former fiscal year if changed since last report)

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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

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):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

There were 451.7 million Ordinary Shares outstanding as of September 30, 2016.

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TABLE OF CONTENTS
PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS	2
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	23
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	29
ITEM 4. CONTROLS AND PROCEDURES	29
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS	29
ITEM 1A. RISK FACTORS	29
ITEM 2. UNRESTRICTED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	30
ITEM 6. EXHIBITS	30
SIGNATURES	31
EXHIBIT INDEX	32
EX-12
EX-31.1
EX-31.2
EX-32.1
EX-32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT

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PART I — FINANCIAL INFORMATION


ITEM 1.	FINANCIAL STATEMENTS.

EATON CORPORATION plc

CONSOLIDATED STATEMENTS OF INCOME



	Three months ended September 30						Nine months ended September 30
(In millions except for per share data)	2016			2015			2016			2015
Net sales	$	4,987		$	5,203		$	14,880		$	15,798

Cost of products sold	3,371			3,597			10,081			10,865
Selling and administrative expense	853			907			2,642			2,723
Research and development expense	146			156			444			472
Interest expense - net	59			59			173			175
Other income - net	(15		)	(3		)	(28		)	(27		)
Income before income taxes	573			487			1,568			1,590
Income tax expense	51			42			151			143
Net income	522			445			1,417			1,447
Less net loss for noncontrolling interests	1			1			1			—
Net income attributable to Eaton ordinary shareholders	$	523		$	446		$	1,418		$	1,447

Net income per share attributable to Eaton ordinary shareholders
Diluted	$	1.15		$	0.96		$	3.09		$	3.09
Basic	1.15			0.96			3.10			3.10

Weighted-average number of ordinary shares outstanding
Diluted	455.6			466.4			457.9			468.5
Basic	453.9			465.1			456.5			466.8

Cash dividends declared per ordinary share	$	0.57		$	0.55		$	1.71		$	1.65

The accompanying notes are an integral part of these condensed consolidated financial statements.

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EATON CORPORATION plc

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME



	Three months ended September 30						Nine months ended September 30
(In millions)	2016			2015			2016			2015
Net income	$	522		$	445		$	1,417		$	1,447
Less net loss for noncontrolling interests	1			1			1			—
Net income attributable to Eaton ordinary shareholders	523			446			1,418			1,447

Other comprehensive (loss) income, net of tax
Currency translation and related hedging instruments	(22		)	(372		)	(57		)	(883		)
Pensions and other postretirement benefits	45			60			132			164
Cash flow hedges	1			—			(33		)	3
Other comprehensive (loss) income attributable to Eaton ordinary shareholders	24			(312		)	42			(716		)

Total comprehensive income attributable to Eaton ordinary shareholders	$	547		$	134		$	1,460		$	731

The accompanying notes are an integral part of these condensed consolidated financial statements.

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EATON CORPORATION plc

CONDENSED CONSOLIDATED BALANCE SHEETS



(In millions)	September 30, 2016		December 31, 2015
Assets
Current assets
Cash	$	494	$	268
Short-term investments	213		177
Accounts receivable - net	3,659		3,479
Inventory	2,328		2,323
Prepaid expenses and other current assets	393		369
Total current assets	7,087		6,616

Property, plant and equipment - net	3,506		3,565

Other noncurrent assets
Goodwill	13,434		13,479
Other intangible assets	5,689		6,014
Deferred income taxes	412		362
Other assets	1,109		960
Total assets	$	31,237	$	30,996

Liabilities and shareholders’ equity
Current liabilities
Short-term debt	$	1	$	426
Current portion of long-term debt	550		242
Accounts payable	1,790		1,758
Accrued compensation	388		366
Other current liabilities	1,866		1,833
Total current liabilities	4,595		4,625

Noncurrent liabilities
Long-term debt	7,881		7,746
Pension liabilities	1,532		1,586
Other postretirement benefits liabilities	429		440
Deferred income taxes	366		390
Other noncurrent liabilities	988		978
Total noncurrent liabilities	11,196		11,140

Shareholders’ equity
Eaton shareholders’ equity	15,404		15,186
Noncontrolling interests	42		45
Total equity	15,446		15,231
Total liabilities and equity	$	31,237	$	30,996

The accompanying notes are an integral part of these condensed consolidated financial statements.

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EATON CORPORATION plc

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



	Nine months ended September 30
(In millions)	2016			2015
Operating activities
Net income	$	1,417		$	1,447
Adjustments to reconcile to net cash provided by operating activities
Depreciation and amortization	700			692
Deferred income taxes	(105		)	(101		)
Pension and other postretirement benefits expense	177			244
Contributions to pension plans	(114		)	(290		)
Contributions to other postretirement benefits plans	(26		)	(24		)
Changes in working capital	(224		)	(184		)
Other - net	89			(155		)
Net cash provided by operating activities	1,914			1,629

Investing activities
Capital expenditures for property, plant and equipment	(346		)	(368		)
Cash received from (paid for) acquisitions of businesses, net of cash acquired	1			(38		)
Sales (purchases) of short-term investments - net	(29		)	76
Proceeds from sale of businesses	—			1
Other - net	3			(44		)
Net cash used in investing activities	(371		)	(373		)

Financing activities
Proceeds from borrowings	633			1
Payments on borrowings	(666		)	(405		)
Cash dividends paid	(780		)	(771		)
Exercise of employee stock options	60			48
Repurchase of shares	(567		)	(454		)
Other - net	(5		)	(8		)
Net cash used in financing activities	(1,325		)	(1,589		)

Effect of currency on cash	8			(30		)
Total increase (decrease) in cash	226			(363		)
Cash at the beginning of the period	268			781
Cash at the end of the period	$	494		$	418

The accompanying notes are an integral part of these condensed consolidated financial statements.

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EATON CORPORATION plc

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Amounts are in millions unless indicated otherwise (per share data assume dilution).


Note 1.	BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of Eaton Corporation plc (Eaton or the Company) have been prepared in accordance with generally accepted accounting principles for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by United States generally accepted accounting principles (US GAAP) for complete financial statements. However, in the opinion of management, all adjustments (consisting of normal recurring accruals) have been made that are necessary for a fair presentation of the condensed consolidated financial statements for the interim periods.

This Form 10-Q should be read in conjunction with the consolidated financial statements and related notes included in Eaton’s 2015 Form 10-K. The interim period results are not necessarily indicative of the results to be expected for the full year. Management has evaluated subsequent events through the date this Form 10-Q was filed with the Securities and Exchange Commission.

During the first quarter of 2016, the Company adopted Accounting Standards Update 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (ASU 2015-03). ASU 2015-03 requires that debt issuance costs be presented in the balance sheet as a direct deduction from the related debt liability rather than an asset. The Company has applied this standard retrospectively. The adoption of ASU 2015-03 resulted in the reclassification of $36 and $35 within the Company's Condensed Consolidated Balance Sheets as of September 30, 2016 and December 31, 2015, respectively, from Other noncurrent assets to a reduction in Long-term debt.

Certain prior year amounts have been reclassified to conform to the current year presentation.

Recently Issued Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2016-02, Leases (Topic 842), (ASU 2016-02). This accounting standard requires that a lessee recognize a lease asset and a lease liability on its balance sheet for all leases, including operating leases, with a term greater than 12 months. ASU 2016-02 will require additional disclosures in the notes to the consolidated financial statements and is effective for annual and interim reporting periods beginning after December 15, 2018. Eaton is evaluating the impact of ASU 2016-02 and an estimate of the impact to the consolidated financial statements cannot be made at this time.

In May 2014, the FASB issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (ASU 2014-09). This accounting standard supersedes all existing US GAAP revenue recognition guidance. Under ASU 2014-09, a company will recognize revenue when it transfers the control of promised goods or services to customers in an amount that reflects the consideration which the company expects to collect in exchange for those goods or services. ASU 2014-09 will require additional disclosures in the notes to the consolidated financial statements and is effective for annual and interim reporting periods beginning after December 15, 2016. In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date (ASU 2015-14). This accounting standard defers the effective date of ASU 2014-09 for one year and permits early adoption as of the original effective date. Eaton is evaluating the impact of ASU 2014-09 and an estimate of the impact to the consolidated financial statements cannot be made at this time.


Note 2.	ACQUISITIONS OF BUSINESSES

Acquisition of Ephesus Lighting, Inc.

On October 28, 2015, Eaton acquired Ephesus Lighting, Inc. (Ephesus). Ephesus is a leader in LED lighting for stadiums and other high lumen outdoor and industrial applications. Its sales for the 12 months ended September 30, 2015 were $23. Ephesus is reported within the Electrical Products business segment.

Acquisition of UK Safety Technology Manufacturer Oxalis Group Ltd.

On January 12, 2015, Eaton acquired Oxalis Group Ltd. (Oxalis). Oxalis is a manufacturer of closed-circuit television camera stations, public address and general alarm systems and other electrical products for the hazardous area, marine and industrial communications markets. Its sales for the 12 months ended December 31, 2014 were $9. Oxalis is reported within the Electrical Systems and Services business segment.

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Note 3.	ACQUISITION INTEGRATION CHARGES

Eaton incurs integration charges related to acquired businesses. A summary of these charges follows:



	Three months ended September 30				Nine months ended September 30
	2016		2015		2016		2015
Electrical Products	$	1	$	5	$	2	$	17
Electrical Systems and Services	—		3		1		10
Hydraulics	—		—		—		2
Total business segments	1		8		3		29
Corporate	—		2		—		4
Total acquisition integration charges before income taxes	1		10		3		33
Income taxes	—		3		1		11
Total after income taxes	$	1	$	7	$	2	$	22
Per ordinary share - diluted	$	—	$	0.01	$	—	$	0.05

Business segment acquisition integration charges in 2016 related to the integration of Ephesus Lighting, Inc. (Ephesus) and

Oxalis Group Ltd. (Oxalis), which were acquired in 2015. The charges associated with Ephesus were included in Cost of

products sold and Selling and administrative expense, while the charges associated with Oxalis were included in Cost of

products sold. Business segment acquisition integration charges in 2015 related primarily to the integration of Cooper

Industries plc (Cooper), which was acquired in 2012. These charges were included in Cost of products sold or Selling and

administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related

business segment. See Note 14 for additional information about business segments.

Corporate acquisition integration charges in 2015 also related to the integration of Cooper. These charges were included in Selling and administrative expense. In Business Segment Information, the charges were included in Other corporate expense - net.


Note 4.	RESTRUCTURING CHARGES

During 2015, Eaton announced its intention to undertake actions to reduce its cost structure in all business segments and at corporate. Restructuring charges for the three and nine months ended September 30, 2016, were $23 and $121, respectively, and were $113 and $127 for the three and nine months ended September 30, 2015, respectively. The charges associated with restructuring activities are anticipated to be $145 in 2016 and $180 in 2017.

A summary of restructuring charges by type follows:



	Three months ended September 30				Nine months ended September 30
	2016		2015		2016		2015
Workforce reductions	$	18	$	99	$	95	$	111
Plant closings and other	5		14		26		16
Total	$	23	$	113	$	121	$	127

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A summary of restructuring charges by segment follows:



	Three months ended September 30					Nine months ended September 30
	2016			2015		2016		2015
Electrical Products	$	1		$	11	$	27	$	12
Electrical Systems & Services	7			26		20		26
Hydraulics	10			25		44		34
Aerospace	(1		)	5		3		5
Vehicle	5			29		22		33
Corporate	1			17		5		17
Total	$	23		$	113	$	121	$	127

A summary of liabilities related to workforce reductions, plant closings and other associated costs follows:



	Workforce reductions			Plant closings and other			Total
Balance at December 31, 2014	$	—		$	—		$	—
Liability recognized	112			17			129
Payments	(59		)	(3		)	(62		)
Other adjustments	1			(14		)	(13		)
Balance at December 31, 2015	54			—			54
Liability recognized	95			26			121
Payments	(89		)	(11		)	(100		)
Other adjustments	(1		)	(14		)	(15		)
Balance at September 30, 2016	$	59		$	1		$	60

These charges were included in Cost of products sold, Selling and administrative expenses or Other income-net, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment. See Note 14 for additional information about business segments.


Note 5.	GOODWILL

A summary of goodwill follows:



	Electrical Products			Electrical Systems and Services			Hydraulics		Aerospace			Vehicle		Total
December 31, 2015	$	6,642		$	4,279		$	1,259	$	956		$	343	$	13,479
Translation	(24		)	(12		)	2		(13		)	2		(45		)
September 30, 2016	$	6,618		$	4,267		$	1,261	$	943		$	345	$	13,434

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Note 6. DEBT

On September 20, 2016, a subsidiary of Eaton issued Euro denominated notes (Euro Notes) with a face value of €550 ($615 based on the September 20, 2016 spot rate), in accordance with Regulation S promulgated under the Securities Act of 1933, as amended. The Euro Notes mature in 2024 with interest payable annually at a rate of 0.75%. The issuer received proceeds totaling €544 ($609 based on the September 20, 2016 spot rate) from the issuance, net of financing costs and discounts. The senior Euro Notes are fully and unconditionally guaranteed on an unsubordinated, unsecured basis by Eaton and certain of its direct and indirect subsidiaries. The Euro Notes contain an optional redemption provision by which the Company may make an offer to purchase all or any part of the Euro Notes prior to June 20, 2024 at a purchase price of the greater of (a) 100% of the principal amount of the respective Euro Notes being redeemed, or (b) the sum of the present values of the respective remaining scheduled payments of principal and interest, discounted to the redemption date on an annual basis at the benchmark Bund Rate plus 20 basis points. In each case, the redemption price will include any accrued and unpaid interest on the Euro Notes being redeemed. At any time on or after June 20, 2024, the Company may redeem the Euro Notes, in whole or in part, at a redemption price equal to 100% of the principal amount to be redeemed plus accrued and unpaid interest. The Euro Notes also contain a change of control provision which requires the Company to make an offer to purchase all or any part of the Euro Notes at a purchase price of 101% of the principal amount plus accrued and unpaid interest. The capitalized deferred financing fees and discounts are amortized in Interest expense - net over the respective terms of the Euro Notes. The Euro Notes are subject to customary non-financial covenants.

On October 14, 2016, Eaton refinanced a $750, five-year revolving credit facility with a $750, five-year revolving credit facility that will expire October 14, 2021. Eaton also maintains a $500, four-year revolving credit facility that will expire on October 3, 2018 and a $750, five-year credit facility that will expire October 3, 2019. This refinancing maintains long-term revolving credit facilities at a total of $2,000. The revolving credit facilities are used to support commercial paper borrowings and are fully and unconditionally guaranteed by Eaton and certain of its direct and indirect subsidiaries on an unsubordinated, unsecured basis. There were no borrowings outstanding under these revolving credit facilities at September 30, 2016 or October 14, 2016.


Note 7.	RETIREMENT BENEFITS PLANS

The components of retirement benefits expense follow:



	United States pension benefit expense						Non-United States pension benefit expense						Other postretirement benefits expense
	Three months ended September 30
	2016			2015			2016			2015			2016			2015
Service cost	$	28		$	31		$	16		$	18		$	1		$	2
Interest cost	31			39			16			18			4			6
Expected return on plan assets	(63		)	(65		)	(23		)	(25		)	(2		)	(2		)
Amortization	23			29			8			10			(2		)	—
	19			34			17			21			1			6
Settlements	24			25			—			—			—			—
Total expense	$	43		$	59		$	17		$	21		$	1		$	6



	United States pension benefit expense						Non-United States pension benefit expense						Other postretirement benefits expense
	Nine months ended September 30
	2016			2015			2016			2015			2016			2015
Service cost	$	83		$	92		$	49		$	55		$	3		$	5
Interest cost	94			117			48			54			13			18
Expected return on plan assets	(188		)	(196		)	(71		)	(75		)	(5		)	(4		)
Amortization	69			89			25			30			(6		)	1
	58			102			51			64			5			20
Settlements and curtailments	63			58			—			—			—			—
Total expense	$	121		$	160		$	51		$	64		$	5		$	20

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Note 8.	LEGAL CONTINGENCIES

Eaton is subject to a broad range of claims, administrative and legal proceedings such as lawsuits that relate to contractual allegations, tax audits, patent infringement, personal injuries, antitrust matters and employment-related matters. Eaton is also subject to asbestos claims from historic products which may have contained asbestos. Insurance may cover some of the costs associated with these claims. Although it is not possible to predict with certainty the outcome or cost of these matters, the Company believes they will not have a material adverse effect on the consolidated financial statements.

In December 2010, a Brazilian court held that a judgment obtained by a Brazilian company, Raysul, against another Brazilian company, Saturnia, which was sold by Eaton in 2006, could be enforced against Eaton Ltda. The judgment was based on an alleged violation of an agency agreement between Raysul and Saturnia. At March 31, 2016, the Company had a total accrual of 100 Brazilian Reais related to this matter ($31 based on June 2016 exchange rates). In June 2016, Eaton signed a settlement agreement and resolved the matter, which did not have a material impact on the consolidated financial statements.


Note 9.	INCOME TAXES

The effective income tax rate for the third quarter and first nine months of 2016 was expense of 9%, and 10%, respectively, compared to an expense of 9% for the third quarter and first nine months of 2015. The increase in the effective tax rate in the first nine months of 2016 was primarily due to more income earned in higher tax jurisdictions.


Note 10.	EQUITY

On October 22, 2013, Eaton's Board of Directors adopted a share repurchase program (2013 Program) that authorizes the repurchase of 40 million ordinary shares. During the first quarter of 2016, 1.5 million ordinary shares were repurchased under the 2013 Program in the open market at a total cost of $82. During the three and nine months ended September 30, 2015, 4.8 million and 7.2 million ordinary shares were repurchased under the 2013 Program in the open market at a total cost of $284 and $454, respectively. On February 24, 2016, the Board of Directors approved a new share repurchase program for share repurchases up to $2,500 of ordinary shares (2016 Program). Under the 2016 Program, the ordinary shares are expected to be repurchased over time, depending on market conditions, the market price of ordinary shares, capital levels, and other considerations. During the three and nine months ended September 30, 2016, 3.7 million and 7.7 million ordinary shares, respectively, were purchased on the open market under the 2016 Program for a total cost of $243 and $485, respectively.

The changes in Shareholders’ equity follow:



	Eaton shareholders’ equity			Noncontrolling interests			Total equity
Balance at December 31, 2015	$	15,186		$	45		$	15,231
Net income (loss)	1,418			(1		)	1,417
Other comprehensive income	42			—			42
Cash dividends paid	(780		)	(2		)	(782		)
Issuance of shares under equity-based compensation plans - net	105			—			105
Repurchase of shares	(567		)	—			(567		)
Balance at September 30, 2016	$	15,404		$	42		$	15,446

The changes in Accumulated other comprehensive loss follow:



	Currency translation and related hedging instruments			Pensions and other postretirement benefits			Cash flow hedges			Total
Balance at December 31, 2015	$	(2,492	)	$	(1,374	)	$	3		$	(3,863	)
Other comprehensive (loss) income before reclassifications	(57		)	33			(35		)	(59		)
Amounts reclassified from Accumulated other comprehensive loss (income)	—			99			2			101
Net current-period Other comprehensive income (loss)	(57		)	132			(33		)	42
Balance at September 30, 2016	$	(2,549	)	$	(1,242	)	$	(30	)	$	(3,821	)

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The reclassifications out of Accumulated other comprehensive loss follow:



	Nine months ended September 30, 2016				Consolidated statements of income classification
Amortization of defined benefit pensions and other postretirement benefits items
Actuarial loss and prior service cost	$	(151	)	¹
Tax benefit	52
Total, net of tax	(99		)

Gains and (losses) on cash flow hedges
Currency exchange contracts	(3		)		Cost of products sold
Tax benefit	1
Total, net of tax	(2		)

Total reclassifications for the period	$	(101	)

¹ These components of Accumulated other comprehensive loss are included in the computation of net periodic benefit cost. See Note 7 for additional information about pension and other postretirement benefits items.

Net Income Per Share Attributable to Eaton Ordinary Shareholders

A summary of the calculation of net income per share attributable to Eaton ordinary shareholders follows:



	Three months ended September 30				Nine months ended September 30
(Shares in millions)	2016		2015		2016		2015
Net income attributable to Eaton ordinary shareholders	$	523	$	446	$	1,418	$	1,447

Weighted-average number of ordinary shares outstanding - diluted	455.6		466.4		457.9		468.5
Less dilutive effect of equity-based compensation	1.7		1.3		1.4		1.7
Weighted-average number of ordinary shares outstanding - basic	453.9		465.1		456.5		466.8

Net income per share attributable to Eaton ordinary shareholders
Diluted	$	1.15	$	0.96	$	3.09	$	3.09
Basic	1.15		0.96		3.10		3.10

For the third quarter and first nine months of 2016, 1.5 million and 1.8 million stock options, respectively, were excluded from the calculation of diluted net income per share attributable to Eaton ordinary shareholders because the exercise price of the options exceeded the average market price of the ordinary shares during the period and their effect, accordingly, would have been antidilutive. For the third quarter and first nine months of 2015, 1.8 million and 1.3 million stock options, respectively, were excluded from the calculation of diluted net income per share attributable to Eaton ordinary shareholders because the exercise price of the options exceeded the average market price of the ordinary shares during the periods and their effect, accordingly, would have been antidilutive.


Note 11.	FAIR VALUE MEASUREMENTS

Fair value is measured based on an exit price, representing the amount that would be received to sell an asset or paid to satisfy a liability in an orderly transaction between market participants. Fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, a fair value hierarchy is established, which categorizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

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A summary of financial instruments recognized at fair value, and the fair value measurements used, follows:



	Total			Level 1		Level 2			Level 3
September 30, 2016
Cash	$	494		$	494	$	—		$	—
Short-term investments	213			213		—			—
Net derivative contracts	148			—		148			—
Long-term debt converted to floating interest rates by interest rate swaps - net	(172		)	—		(172		)	—

December 31, 2015
Cash	$	268		$	268	$	—		$	—
Short-term investments	177			177		—			—
Net derivative contracts	86			—		86			—
Long-term debt converted to floating interest rates by interest rate swaps - net	(94		)	—		(94		)	—

Eaton values its financial instruments using an industry standard market approach, in which prices and other relevant information is generated by market transactions involving identical or comparable assets or liabilities. No financial instruments were measured using unobservable inputs.

Other Fair Value Measurements

Long-term debt and the current portion of long-term debt had a carrying value of $8,431 and fair value of $9,050 at September 30, 2016 compared to $7,988 and $8,231, respectively, at December 31, 2015. The fair value of Eaton's debt instruments were estimated using prevailing market interest rates on debt with similar creditworthiness, terms and maturities, and are considered a Level 2 fair value measurement.


Note 12.	DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

In the normal course of business, Eaton is exposed to certain risks related to fluctuations in interest rates, currency exchange rates and commodity prices. The Company uses various derivative and non-derivative financial instruments, primarily interest rate swaps, currency forward exchange contracts, currency swaps and, to a lesser extent, commodity contracts, to manage risks from these market fluctuations. The 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 instruments are not purchased and sold for trading purposes.

Derivative financial instruments are accounted for at fair value and recognized as assets or liabilities in the Condensed Consolidated Balance Sheets. Accounting for the gain or loss resulting from the change in the fair value of the derivative financial instrument depends on whether it has been designated, and is effective, as part of a hedging relationship and, if so, as to the nature of the hedging activity. Eaton formally documents all relationships between derivative financial instruments accounted for as designated hedges and the hedged item, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking derivative financial instruments to a recognized asset or liability, specific firm commitment, forecasted transaction, or net investment in a foreign operation. These financial instruments can be designated as:

•

Hedges of the change in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability (a fair value hedge); for these hedges, the gain or loss from the derivative financial instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in income during the period of change in fair value.

•

Hedges of the variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability (a cash flow hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss on the hedged item is included in income.

•

Hedges of the currency exposure related to a net investment in a foreign operation (a net investment hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss related to the net investment in the foreign operation is included in income.

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The gain or loss from a derivative financial instrument designated as a hedge that is effective is classified in the same line of the Consolidated Statements of Income as the offsetting loss or gain on the hedged item. The change in fair value of a derivative financial instrument that is not effective as a hedge is immediately recognized in income.

For derivatives that are not designated as a hedge, any gain or loss is immediately recognized in income. The majority of derivatives used in this manner relate to risks resulting from assets or liabilities denominated in a foreign currency and certain commodity contracts that arise in the normal course of business. Gains and losses associated with commodity hedge contracts are classified in Cost of products sold.

Eaton uses certain of its debt denominated in foreign currency to hedge portions of its net investments in foreign operations against foreign currency exposure (net investment hedges). Foreign currency denominated debt designated as non-derivative net investment hedging instruments on an after-tax basis was $99 at September 30, 2016 and $83 at December 31, 2015, and designated on a pre-tax basis was $607 at September 30, 2016.

Derivative Financial Statement Impacts

The fair value of derivative financial instruments recognized in the Condensed Consolidated Balance Sheets follows:



	Notional amount		Other current assets		Other noncurrent assets		Other current liabilities		Other noncurrent liabilities		Type of hedge	Term
September 30, 2016
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	3,765	$	—	$	172	$	—	$	—	Fair value	1 month to 19 years
Forward starting floating-to-fixed interest rate swaps	450		—		—		—		18		Cash flow	12 years
Currency exchange contracts	826		5		1		19		14		Cash flow	1 to 36 months
Total			$	5	$	173	$	19	$	32

Derivatives not designated as hedges
Currency exchange contracts	$	3,991	$	34	$	—	$	15	$	—		1 to 24 months
Commodity contracts	41		2				—					1 to 12 months
Total			$	36	$	—	$	15	$	—

December 31, 2015
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	3,715	$	—	$	96	$	—	$	2	Fair value	2 to 19 years
Forward starting floating-to-fixed interest rate swaps	50		—		—		—		—		Cash flow	12 years
Currency exchange contracts	724		18		1		8		6		Cash flow	1 to 36 months
Commodity contracts	1		—		—		—		—		Cash flow	1 to 12 months
Total			$	18	$	97	$	8	$	8

Derivatives not designated as hedges
Currency exchange contracts	$	4,198	$	27			$	40				1 to 12 months
Total			$	27			$	40

The currency exchange contracts shown in the table above as derivatives not designated as hedges are primarily contracts entered into to manage currency volatility or exposure on intercompany sales and loans. While Eaton does not elect hedge accounting treatment for these derivatives, Eaton targets managing 100% of the intercompany balance sheet exposure to minimize the effect of currency volatility related to the movement of goods and services in the normal course of its operations. This activity represents the great majority of these currency exchange contracts.

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The impact of derivative instruments to the Consolidated Statement of Income and Comprehensive Income follow:



	Gain (loss) recognized in other comprehensive (loss) income					Location of gain (loss) reclassified from Accumulated other comprehensive loss	Gain (loss) reclassified from Accumulated other comprehensive loss
	Three months ended September 30						Three months ended September 30
	2016			2015			2016			2015
Derivatives designated as cash flow hedges
Forward starting floating-to-fixed interest rate swaps	$	1		$	—	Interest expense - net	$	—		$	—
Currency exchange contracts	(3		)	6		Cost of products sold	(4		)	5
Total	$	(2	)	$	6		$	(4	)	$	5



	Gain (loss) recognized in other comprehensive (loss) income					Location of gain (loss) reclassified from Accumulated other comprehensive loss	Gain (loss) reclassified from Accumulated other comprehensive loss
	Nine months ended September 30						Nine months ended September 30
	2016			2015			2016			2015
Derivatives designated as cash flow hedges
Forward starting floating-to-fixed interest rate swaps	$	(18	)	$	—	Interest expense - net	$	—		$	—
Currency exchange contracts	(35		)	16		Cost of products sold	(3		)	11
Total	$	(53	)	$	16		$	(3	)	$	11

Amounts recognized in net income follow:



	Three months ended September 30						Nine months ended September 30
	2016			2015			2016			2015
Derivatives designated as fair value hedges
Fixed-to-floating interest rate swaps	$	(28	)	$	65		$	78		$	62
Related long-term debt converted to floating interest rates by interest rate swaps	28			(65		)	(78		)	(62		)
	$	—		$	—		$	—		$	—

Gains and losses described above were recognized in Interest expense - net.


Note 13.	INVENTORY

The components of inventory follow:



	September 30, 2016			December 31, 2015
Raw materials	$	910		$	885
Work-in-process	431			412
Finished goods	1,083			1,131
Inventory at FIFO	2,424			2,428
Excess of FIFO over LIFO cost	(96		)	(105		)
Total inventory	$	2,328		$	2,323

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Note 14.	BUSINESS SEGMENT INFORMATION

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated on a regular basis by the chief operating decision maker, or decision making group, in deciding how to allocate resources to an individual segment and in assessing performance. Eaton’s operating segments are Electrical Products, Electrical Systems and Services, Hydraulics, Aerospace and Vehicle. Operating profit includes the operating profit from intersegment sales. For additional information regarding Eaton’s business segments, see Note 15 to the Consolidated Financial Statements contained in the 2015 Form 10-K.



	Three months ended September 30						Nine months ended September 30
	2016			2015			2016			2015
Net sales
Electrical Products	$	1,767		$	1,771		$	5,231		$	5,246
Electrical Systems and Services	1,436			1,487			4,207			4,437
Hydraulics	562			599			1,702			1,907
Aerospace	436			449			1,328			1,367
Vehicle	786			897			2,412			2,841
Total net sales	$	4,987		$	5,203		$	14,880		$	15,798

Segment operating profit
Electrical Products	$	331		$	322		$	924		$	858
Electrical Systems and Services	197			164			534			573
Hydraulics	61			44			161			184
Aerospace	88			79			251			233
Vehicle	122			136			377			490
Total segment operating profit	799			745			2,247			2,338

Corporate
Amortization of intangible assets	(99		)	(102		)	(297		)	(306		)
Interest expense - net	(59		)	(59		)	(173		)	(175		)
Pension and other postretirement benefits expense	(18		)	(38		)	(45		)	(99		)
Other corporate expense - net	(50		)	(59		)	(164		)	(168		)
Income before income taxes	573			487			1,568			1,590
Income tax expense	51			42			151			143
Net income	522			445			1,417			1,447
Less net loss for noncontrolling interests	1			1			1			—
Net income attributable to Eaton ordinary shareholders	$	523		$	446		$	1,418		$	1,447


Note 15.	CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

On November 14, 2013, Eaton Corporation registered senior notes under the Securities Act of 1933 (the Senior Notes). Eaton and certain other of Eaton's 100% owned direct and indirect subsidiaries (the Guarantors) fully and unconditionally guaranteed (subject, in the case of the Guarantors, other than Eaton, to customary release provisions as described below), on a joint and several basis, the Senior Notes. The following condensed consolidating financial statements are included so that separate financial statements of Eaton, Eaton Corporation and each of the Guarantors are not required to be filed with the Securities and Exchange Commission. The consolidating adjustments primarily relate to eliminations of investments in subsidiaries and intercompany balances and transactions. The condensed consolidating financial statements present investments in subsidiaries using the equity method of accounting.

The guarantee of a Guarantor that is not a parent of the issuer will be automatically and unconditionally released and discharged in the event of any sale of the Guarantor or of all or substantially all of its assets, or in connection with the release or termination of the Guarantor as a guarantor under all other U.S. debt securities or U.S. syndicated credit facilities, subject to limitations set forth in the indenture. The guarantee of a Guarantor that is a direct or indirect parent of the issuer will only be automatically and unconditionally released and discharged in connection with the release or termination of such Guarantor as a guarantor under all other debt securities or syndicated credit facilities (in both cases, U.S. or otherwise), subject to limitations set forth in the indenture.

During 2015 and 2016, the Company undertook certain steps to restructure ownership of various subsidiaries. The transactions were entirely among wholly-owned subsidiaries under the common control of Eaton. This restructuring has been reflected as of the beginning of the earliest period presented below.




CONSOLIDATING STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2016
	Eaton Corporation plc			Eaton Corporation			Guarantors			Other subsidiaries			Consolidating adjustments			Total
Net sales	$	—		$	1,660		$	1,583		$	3,040		$	(1,296	)	$	4,987

Cost of products sold	—			1,329			1,162			2,173			(1,293		)	3,371
Selling and administrative expense	2			330			197			324			—			853
Research and development expense	—			59			43			44			—			146
Interest expense (income) - net	—			59			4			(3		)	(1		)	59
Other expense (income) - net	(1		)	18			—			(32		)	—			(15		)
Equity in loss (earnings) of subsidiaries, net of tax	(628		)	(173		)	(895		)	(219		)	1,915			—
Intercompany expense (income) - net	104			(47		)	336			(393		)	—			—
Income (loss) before income taxes	523			85			736			1,146			(1,917		)	573
Income tax expense (benefit)	—			(11		)	10			53			(1		)	51
Net income (loss)	523			96			726			1,093			(1,916		)	522
Less net loss (income) for noncontrolling interests	—			—			—			—			1			1
Net income (loss) attributable to Eaton ordinary shareholders	$	523		$	96		$	726		$	1,093		$	(1,915	)	$	523

Other comprehensive income (loss)	$	24		$	24		$	29		$	2		$	(55	)	$	24
Total comprehensive income (loss) attributable to Eaton ordinary shareholders	$	547		$	120		$	755		$	1,095		$	(1,970	)	$	547




CONSOLIDATING STATEMENTS OF COMPREHENSIVE INCOME FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2015
	Eaton Corporation plc			Eaton Corporation			Guarantors			Other subsidiaries			Consolidating adjustments			Total
Net sales	$	—		$	1,755		$	1,664		$	3,105		$	(1,321	)	$	5,203

Cost of products sold	—			1,380			1,269			2,265			(1,317		)	3,597
Selling and administrative expense	2			375			191			339			—			907
Research and development expense	—			65			51			40			—			156
Interest expense (income) - net	—			54			5			(3		)	3			59
Other expense (income) - net	—			11			3			(17		)	—			(3		)
Equity in loss (earnings) of subsidiaries, net of tax	(534		)	(264		)	(888		)	(64		)	1,750			—
Intercompany expense (income) - net	86			(54		)	258			(290		)	—			—
Income (loss) before income taxes	446			188			775			835			(1,757		)	487
Income tax expense (benefit)				17			(15		)	38			2			42
Net income (loss)	446			171			790			797			(1,759		)	445
Less net loss (income) for noncontrolling interests	—			—			—			1			—			1
Net income (loss) attributable to Eaton ordinary shareholders	$	446		$	171		$	790		$	798		$	(1,759	)	$	446

Other comprehensive income (loss)	$	(312	)	$	(24	)	$	(305	)	$	(411	)	$	740		$	(312	)
Total comprehensive income (loss) attributable to Eaton ordinary shareholders	$	134		$	147		$	485		$	387		$	(1,019	)	$	134

CONSOLIDATING STATEMENTS OF COMPREHENSIVE INCOME FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2016

	Eaton Corporation plc			Eaton Corporation		Guarantors			Other subsidiaries			Consolidating adjustments			Total
Net sales	$	—		$	4,842	$	4,793		$	8,983		$	(3,738	)	$	14,880

Cost of products sold	—			3,788		3,554			6,478			(3,739		)	10,081
Selling and administrative expense	6			1,048		583			1,005			—			2,642
Research and development expense	—			176		138			130			—			444
Interest expense (income) - net	—			169		13			(13		)	4			173
Other expense (income) - net	(1		)	34		(3		)	(58