Edgar Filing: EATON CORP

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ETN 09.30.2011 10-Q

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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, 2011

Commission file number 1-1396

EATON CORPORATION

(Exact name of registrant as specified in its charter)



Ohio		34-0196300
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)

Eaton Center, Cleveland, Ohio		44114-2584
(Address of principal executive offices)		(Zip Code)



			(216) 523-5000
			(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 334.2 million Common Shares outstanding as of September 30, 2011.

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TABLE OF CONTENTS
PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 6. EXHIBITS
SIGNATURES
Exhibit Index
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

CONSOLIDATED STATEMENTS OF INCOME



	Three months ended September 30						Nine months ended September 30
(In millions except for per share data)	2011			2010			2011			2010
Net sales	$	4,123		$	3,571		$	12,016		$	10,052

Cost of products sold	2,900			2,480			8,444			7,068
Selling and administrative expense	668			651			2,031			1,842
Research and development expense	104			104			316			308
Interest expense-net	29			33			92			102
Other income-net	(10		)	(2		)	(30		)	(11		)
Income before income taxes	432			305			1,163			743
Income tax expense	65			36			172			89
Net income	367			269			991			654
Less net income for noncontrolling interests	(2		)	(1		)	(3		)	(5		)
Net income attributable to Eaton common shareholders	$	365		$	268		$	988		$	649

Net income per common share
Diluted	$	1.07		$	0.78		$	2.86		$	1.90
Basic	1.07			0.80			2.90			1.93

Weighted-average number of common shares outstanding
Diluted	341.9			340.6			344.4			340.1
Basic	338.1			335.2			339.7			334.7

Cash dividends paid per common share	$	0.34		$	0.29		$	1.02		$	0.79

Net income per common share, weighted-average number of common shares outstanding and cash dividends paid per common share have been restated to give effect to the two-for-one stock split. See Note 1 for additional information.

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

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EATON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS



(In millions)	September 30, 2011		December 31, 2010
Assets
Current assets
Cash	$	278	$	333
Short-term investments	536		838
Accounts receivable-net	2,549		2,239
Inventory	1,769		1,564
Other current assets	601		532
Total current assets	5,733		5,506

Property, plant and equipment-net	2,537		2,477

Other noncurrent assets
Goodwill	5,571		5,454
Other intangible assets	2,253		2,272
Deferred income taxes	971		1,001
Other assets	562		542
Total assets	$	17,627	$	17,252

Liabilities and shareholders’ equity
Current liabilities
Short-term debt	$	86	$	72
Current portion of long-term debt	321		4
Accounts payable	1,527		1,408
Accrued compensation	401		465
Other current liabilities	1,445		1,284
Total current liabilities	3,780		3,233

Noncurrent liabilities
Long-term debt	3,368		3,382
Pension liabilities	1,182		1,429
Other postretirement benefits liabilities	634		743
Deferred income taxes	456		487
Other noncurrent liabilities	461		575
Total noncurrent liabilities	6,101		6,616

Shareholders’ equity
Eaton shareholders’ equity	7,723		7,362
Noncontrolling interests	23		41
Total equity	7,746		7,403
Total liabilities and equity	$	17,627	$	17,252

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

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EATON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



	Nine months ended September 30
(In millions)	2011			2010
Operating activities
Net income	$	991		$	654
Adjustments to reconcile to net cash provided by operating activities
Depreciation and amortization	419			413
Contributions to pension plans	(341		)	(378		)
Contributions to other postretirement benefits plans	(150		)	(61		)
Changes in working capital	(290		)	(70		)
Other-net	60			169
Net cash provided by operating activities	689			727

Investing activities
Cash paid for acquisitions of businesses	(298		)	(172		)
Capital expenditures for property, plant and equipment	(384		)	(207		)
Sales (purchases) of short-term investments-net	272			(47		)
Other-net	1			(6		)
Net cash used in investing activities	(409		)	(432		)

Financing activities
Borrowings with original maturities of more than three months
Proceeds	352			55
Payments	(14		)	(59		)
Payments with original maturities of less than three months-net (primarily commercial paper)	(38		)	(19		)
Cash dividends paid	(348		)	(265		)
Exercise of employee stock options	66			60
Repurchase of shares	(343		)	—
Other-net	(4		)	2
Net cash used in financing activities	(329		)	(226		)

Effect of foreign exchange rate changes on cash	(6		)	(14		)
Total (decrease) increase in cash	(55		)	55
Cash at the beginning of the period	333			340
Cash at the end of the period	$	278		$	395

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

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EATON CORPORATION

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 (Eaton or 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 generally accepted accounting principles 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 2010 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 SEC.

On January 27, 2011, Eaton’s Board of Directors announced a two-for-one stock split of the Company’s common shares effective in the form of a 100% stock dividend. The record date for the stock split was February 7, 2011, and the additional shares were distributed on February 28, 2011. Accordingly, all per share amounts, weighted-average shares outstanding, and equity-based compensation presented in the condensed consolidated financial statements and notes have been adjusted retroactively to reflect the stock split.

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


Note 2.	ACQUISITIONS OF BUSINESSES

In 2011 and 2010, Eaton acquired businesses and entered into a joint venture in separate transactions. The Consolidated Statements of Income include the results of these businesses from the dates of the transactions or formation. These transactions are summarized below:



Acquired businesses and joint venture	Date of transaction	Business segment	Annual sales
IE Power, Inc.	August 31, 2011	Electrical Americas	$5 for 2010
A Canada-based provider of high power inverters for a variety of mission-critical applications including solar, wind and battery energy storage.


E. Begerow GmbH & Co. KG	August 15, 2011	Hydraulics	$84 for 2010
A Germany-based system provider of advanced liquid filtration solutions. This business develops and produces technologically innovative filter media and filtration systems for food and beverage, chemical, pharmaceutical and industrial applications.


ACTOM Low Voltage	June 30, 2011	Electrical Rest of World	$65 for the year ended May 31, 2011
A South Africa manufacturer and supplier of motor control components, engineered electrical distribution systems and uninterruptible power supply (UPS) systems.


C.I. ESI de Colombia S.A.	June 2, 2011	Electrical Americas	$8 for 2010
A Colombia-based distributor of industrial electrical equipment and engineering services in the Colombian market, focused on oil and gas, mining, and industrial and commercial construction.


Internormen Technology Group	May 12, 2011	Hydraulics	$55 for 2010
A Germany-based manufacturer of hydraulic filtration and instrumentation with sales and distribution subsidiaries in China, the United States, India and Brazil.


Eaton-SAMC (Shanghai) Aircraft Conveyance System Manufacturing Co., Ltd.	March 8, 2011	Aerospace	New joint venture
A 49%-owned joint venture in China focusing on the design, development, manufacturing and support of fuel and hydraulic conveyance systems for the global civil aviation market.

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Acquired businesses and joint venture	Date of transaction	Business segment	Annual sales
Tuthill Coupling Group	January 1, 2011	Hydraulics	$35 for the year ended November 30, 2010
A United States and France-based manufacturer of pneumatic and hydraulic quick coupling solutions and leak-free connectors used in industrial, construction, mining, defense, energy and power applications.


Chloride Phoenixtec Electronics	October 12, 2010	Electrical Rest of World	$25 for the year ended September 30, 2010
A China manufacturer of UPS systems. Eaton acquired the remaining shares to increase its ownership from 50% to 100%.


CopperLogic, Inc.	October 1, 2010	Electrical Americas	$35 for the year ended September 30, 2010
A United States-based manufacturer of electrical and electromechanical systems.


Wright Line Holding, Inc.	August 25, 2010	Electrical Americas	$101 for the year ended June 30, 2010
A United States provider of customized enclosures, rack systems, and air-flow management systems to store, power, and secure mission-critical IT data center electronics.


EMC Engineers, Inc.	July 15, 2010	Electrical Americas	$24 for 2009
A United States energy engineering and energy services company that delivers energy efficiency solutions for a wide range of governmental, educational, commercial and industrial facilities.


Note 3.	ACQUISITION INTEGRATION AND RESTRUCTURING CHARGES

Acquisition Integration Charges

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



	Three months ended September 30				Nine months ended September 30
	2011		2010		2011		2010
Business segment
Electrical Americas	$	3	$	—	$	7	$	2
Electrical Rest of World	—		6		1		20
Hydraulics	1		—		1		—
Aerospace	—		1		—		3
Total integration charges before income taxes	$	4	$	7	$	9	$	25
After-tax integration charges	$	2	$	4	$	6	$	16
Per common share	$	0.01	$	0.01	$	0.02	$	0.05

Charges in 2011 were related primarily to CopperLogic, Wright Line Holding and EMC Engineers. Charges in 2010 were related primarily to Moeller and Phoenixtec. These charges were included in Cost of products sold or Selling and administrative expense, as appropriate. In Note 13. Business Segment Information, the charges reduced Operating profit of the related business segment.

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Workforce Reduction and Plant Closing Liabilities

The following table summarizes the liabilities related to acquisition integration, plant closing charges, and other workforce reduction actions:



	Workforce reductions					Plant closing and other
	Employees		Dollars			Plant closing and other			Total
Balance at January 1, 2011	327		$	11		$	5		$	16
Liabilities recognized	79		2			7			9
Utilized	(258	)	(7		)	(10		)	(17		)
Balance at September 30, 2011	148		$	6		$	2		$	8


Note 4.	GOODWILL

A summary of goodwill follows:



	September 30, 2011		December 31, 2010
Electrical Americas	$	2,059	$	2,061
Electrical Rest of World	1,001		985
Hydraulics	1,111		1,007
Aerospace	1,041		1,037
Truck	150		151
Automotive	209		213
Total goodwill	$	5,571	$	5,454

The increase in goodwill in 2011 was primarily due to businesses acquired during 2011, partially offset by the impact of foreign currency translation. For additional information regarding acquired businesses, see Note 2.

Assessing Goodwill for Impairment

In September 2011, the Financial Accounting Standards Board issued a revised standard on testing goodwill for impairment. The revised standard allows an entity to first assess the carrying value of goodwill based on qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than the reporting unit's carrying amount. If, based on a qualitative assessment, the fair value of a reporting unit is more likely than not lower than its carrying value, the entity must then test goodwill from a quantitative perspective similar to prior guidance. This standard is effective for 2012, with early adoption permitted. Eaton elected to adopt this standard for its 2011 annual impairment testing.

Goodwill is tested for impairment annually as of July 1 at the reporting unit level, which is equivalent to Eaton's operating segments. As disclosed in Eaton's 2010 Form 10-K, impairment testing for 2010 was performed from a quantitative perspective using a discounted cash flow model to estimate the fair value of each operating segment. For 2010, the fair value of Eaton's reporting units substantially exceeded the respective carrying values.

Impairment testing for 2011 was performed by assessing certain qualitative trends and factors, including projected market outlook and growth rates, forecasted and actual sales and operating profit margins, discount rates, industry data and other relevant qualitative factors. These trends and factors were compared to and based on the assumptions used in the quantitative assessment performed in 2010. For 2011, it is more likely than not that the fair value of Eaton's reporting units continues to substantially exceed the respective carrying amount.


Note 5.	DEBT

On June 16, 2011, Eaton issued $300 floating rate senior unsecured Notes due June 16, 2014 (the Notes). The Notes bear interest annually at a floating rate, reset quarterly, equal to the three-month LIBOR rate for U.S. dollars plus .33% (33 basis points). Interest is payable quarterly in arrears. The Notes contain a provision which requires the Company to make an offer to purchase all or any part of the Notes at a purchase price of 101% of the principal amount plus accrued and unpaid interest if certain change of control events occur. The Notes are subject to customary non-financial covenants.

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Eaton refinanced a $500, five-year revolving credit facility in June 2011 (the Facility). This refinancing maintains long-term revolving credit facilities at a total of $1.5 billion. The revolving credit facility is used to support commercial paper borrowings. The Facility will expire June 16, 2016, replacing a $500 facility that had been set to expire on September 1, 2011.


Note 6.	RETIREMENT BENEFITS PLANS

The components of retirement benefits expense follow:



	Three months ended September 30
	United States pension benefit expense						Non-United States pension benefit expense						Other postretirement benefits expense
	2011			2010			2011			2010			2011		2010
Service cost	$	23		$	20		$	12		$	10		$	4	$	4
Interest cost	33			33			19			17			10		11
Expected return on plan assets	(41		)	(39		)	(17		)	(15		)	—		—
Amortization	19			13			3			2			3		3
	34			27			17			14			17		18
Curtailment loss	—			—			1			—			—		—
Settlement loss	5			4			—			—			—		—
Total expense	$	39		$	31		$	18		$	14		$	17	$	18



	Nine months ended September 30
	United States pension benefit expense						Non-United States pension benefit expense						Other postretirement benefits expense
	2011			2010			2011			2010			2011		2010
Service cost	$	69		$	60		$	37		$	29		$	12	$	12
Interest cost	99			99			59			51			30		34
Expected return on plan assets	(123		)	(117		)	(53		)	(46		)	—		—
Amortization	57			39			9			6			9		8
	102			81			52			40			51		54
Curtailment loss	—			—			1			—			—		—
Settlement loss	12			13			3			—			—		—
Total expense	$	114		$	94		$	56		$	40		$	51	$	54

During the second quarter of 2011, Eaton contributed $100 into a Voluntary Employee Benefit Association trust for the pre-funding of postretirement Medicare Part D prescription drug benefits for the Company's eligible United States employees and retirees. The contribution was made as part of the Company's strategy to improve the funding of its pension and postretirement obligations. As part of that strategy, in the first quarter of 2011, the Company contributed $250 to its United States qualified pension plans.


Note 7.	LEGAL CONTINGENCIES

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. This judgment is based on an alleged violation of an agency agreement between Raysul and Saturnia. At September 30, 2011, the Company has a total accrual of 67 Brazilian Reais related to this matter, comprised of 60 Brazilian Reais recognized in the fourth quarter of 2010 ($32 based on current exchange rates) with an additional 7 Brazilian Reais recognized in 2011 ($4 based on current exchange rates) due to subsequent accruals for interest and inflation. The Company expects that any sum it may be required to pay in connection with this matter will not exceed the amount of the recorded liability. In 2010, Eaton filed motions for clarification with the Brazilian court of appeals which were denied on April 6, 2011. Eaton Holding and Eaton Ltda. filed appeals on various issues to the Superior Court of Justice in Brasilia. On September 27, 2011, the Superior Court of Justice accepted two of the appeals and will hear those appeals in due course. Another appeal remains pending in the lower appellate court.

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On October 5, 2006, ZF Meritor LLC and Meritor Transmission Corporation (collectively, Meritor) filed an action against Eaton in the United States District Court for Delaware. The action sought damages, which would be trebled under United States antitrust laws, as well as injunctive relief and costs. The suit alleged that Eaton engaged in anti-competitive conduct against Meritor in the sale of heavy-duty truck transmissions in North America. Following a four week trial on liability only, on October 8, 2009, the jury returned a verdict in favor of Meritor. Eaton firmly believes that it competes fairly and honestly for business in the marketplace, and that at no time did it act in an anti-competitive manner. During an earlier stage in the case, the judge concluded that damage estimates contained in a report filed by Meritor were not based on reliable data and the report was specifically excluded from the case. On November 3, 2009, Eaton filed a motion for judgment as a matter of law and to set aside the verdict. That motion was denied on March 10, 2011. On March 14, 2011, Eaton filed a motion for entry of final judgment of liability, zero damages and no injunctive relief. That motion was denied on June 9, 2011. On August 19, 2011, the Court entered final judgment of liability but awarded zero damages to plaintiffs. The Court also entered an injunction prohibiting Eaton from offering rebates or other incentives based on purchasing targets but stayed the injunction pending appeal. Eaton has appealed the liability finding and the injunction to the Third Circuit Court of Appeals. Meritor has cross-appealed the finding of zero damages.

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 (including asbestos claims), antitrust matters and employment-related matters. 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.


Note 8.	INCOME TAXES

The effective income tax rate for the third quarter of 2011 was 15.2% compared to 11.7% for the third quarter of 2010 and 14.8% for the first nine months of 2011 compared to 12.0% for the first nine months of 2010. Higher effective tax rates in both the third quarter and first nine months of 2011 were primarily attributable to greater levels of income in high tax jurisdictions, particularly in the United States and Brazil, due to improved economic and market conditions. The effective income tax rate for the third quarter of 2011 was also favorably impacted by positive adjustments to the tax provision for 2010 tax returns filed during the third quarter in the United States and international tax jurisdictions.


Note 9.	EQUITY

Eaton has a common share repurchase program (2007 Program) that authorizes the repurchase of 10 million common shares. During the first nine months of 2011, 8.3 million common shares were repurchased under the 2007 Program in the open market at a total cost of $343. On September 28, 2011, Eaton's Board of Directors approved a common share repurchase program (2011 Program) which replaced the 2007 Program and authorizes the purchase of up to 20 million shares, not to exceed an aggregate purchase price of $1.25 billion. The common shares are expected to be repurchased over time, depending on market conditions, the market price of common shares, capital levels and other considerations. No common shares were repurchased in the open market in the first nine months of 2010.

The changes in Shareholders’ equity follow:



	Eaton shareholders’ equity			Noncontrolling interests			Total equity
Balance at December 31, 2010	$	7,362		$	41		$	7,403

Net income	988			3			991
Other comprehensive loss	(67		)	—			(67		)
Total comprehensive income	921			3			924
Cash dividends paid	(348		)	(7		)	(355		)
Issuance of shares under equity-based compensation plans-net	131			—			131
Business divestiture	—			(14		)	(14		)
Repurchase of shares	(343		)	—			(343		)
Balance at September 30, 2011	$	7,723		$	23		$	7,746

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Comprehensive (Loss) Income

Comprehensive (loss) income consists primarily of net income, foreign currency translation and related hedging instruments, changes in unrecognized costs of pension and other postretirement benefits, and changes in the effective portion of open derivative contracts designated as cash flow hedges. The following table summarizes the components of Comprehensive (loss) income:



	Three months ended September 30						Nine months ended September 30
	2011			2010			2011			2010
Net income	$	367		$	269		$	991		$	654

Foreign currency translation and related hedging instruments	(449		)	419			(111		)	(64		)
Pensions and other postretirement benefits	34			4			69			51
Cash flow hedges	(20		)	7			(25		)	(2		)
Other comprehensive (loss) income	(435		)	430			(67		)	(15		)
Total comprehensive (loss) income	(68		)	699			924			639
Adjustment for comprehensive income attributable to noncontrolling interests	(2		)	(1		)	(3		)	(5		)
Total Comprehensive (loss) income attributable to Eaton common shareholders	$	(70	)	$	698		$	921		$	634

Net Income per Common Share

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



	Three months ended September 30				Nine months ended September 30
(Shares in millions)	2011		2010		2011		2010
Net income attributable to Eaton common shareholders	$	365	$	268	$	988	$	649

Weighted-average number of common shares outstanding-diluted	341.9		340.6		344.4		340.1
Less dilutive effect of stock options and restricted stock awards	3.8		5.4		4.7		5.4
Weighted-average number of common shares outstanding-basic	338.1		335.2		339.7		334.7

Net income per common share
Diluted	$	1.07	$	0.78	$	2.86	$	1.90
Basic	1.07		0.80		2.90		1.93

For the third quarter and first nine months of 2011, 2.7 million and 1.1 million stock options, respectively, were excluded from the calculation of diluted net income per common share because the exercise price of the options exceeded the average market price of the common shares during the period and their effect, accordingly, would have been antidilutive. For the third quarter and first nine months of 2010, 7.0 million and 8.8 million stock options, respectively, were excluded from the calculation of diluted net income per common share because the exercise price of the options exceeded the average market price of the common shares during the period and their effect, accordingly, would have been antidilutive.


Note 10.	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 is 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		Quoted prices in active markets for identical assets (Level 1)		Other observable inputs (Level 2)		Unobservable inputs (Level 3)
September 30, 2011
Cash	$	278	$	278	$	—	$	—
Short-term investments	536		536		—		—
Net derivative contracts	25		—		25		—
Long-term debt converted to floating interest rates by interest rate swaps	67		—		67		—

December 31, 2010
Cash	$	333	$	333	$	—	$	—
Short-term investments	838		838		—		—
Net derivative contracts	69		—		69		—
Long-term debt converted to floating interest rates by interest rate swaps	42		—		42		—

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 recognized using unobservable inputs.

Other Fair Value Measurements

Long-term debt and the current portion of long-term debt had a carrying value of $3,689 and fair value of $4,324 at September 30, 2011 compared to $3,386 and $3,787, respectively, at December 31, 2010.


Note 11.	DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES

In the normal course of business, Eaton is exposed to certain risks related to fluctuations in interest rates, foreign currency exchange rates and commodity prices. The Company uses various derivative and non-derivative financial instruments, primarily interest rate swaps, foreign currency forward exchange contracts, foreign 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 hedges and the hedged item, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking all 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 income (loss) and reclassified to income in the same period when the gain or loss on the hedged item is included in income.

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•

Hedges of the foreign 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 income (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.

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. During the third quarter and first nine months of 2011, Eaton incurred losses associated with commodity hedge contracts of $23 and $19, respectively. These losses were incurred due to significant declines in metal prices during primarily the last two weeks in September. Gains and losses associated with commodity hedge contracts are reported in Cost of products sold.

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 long-term assets		Other current liabilities		Type of hedge	Term
September 30, 2011
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	540	$	—	$	67	$	—	Fair value	2 to 23 years
Foreign currency exchange contracts	331		5		—		12		Cash flow	12 to 36 months
Commodity contracts	50		—		—		12		Cash flow	12 months
Total			$	5	$	67	$	24

Derivatives not designated as hedges
Foreign currency exchange contracts	$	2,845	$	24			$	25		12 months
Commodity contracts	114		—				22			12 months
Total			$	24			$	47

December 31, 2010
Derivatives designated as hedges
Fixed-to-floating interest rate swaps	$	540	$	—	$	42	$	—	Fair value	2 to 23 years
Foreign currency exchange contracts	227		4		—		5		Cash flow	12 to 36 months
Commodity contracts	39		8		—		—		Cash flow	12 months
Cross currency swaps	75		2		—		—		Net investment	12 months
Total			$	14	$	42	$	5

Derivatives not designated as hedges
Foreign currency exchange contracts	$	2,777	$	20			$	19		12 months
Commodity contracts	102		17				—			12 months
Total			$	37			$	19

The foreign currency exchange contracts shown in the table above as derivatives not designated as hedges are primarily contracts entered into to manage foreign 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 foreign currency exchange contracts.

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Amounts recognized in Accumulated other comprehensive income (loss) follow:



	Three months ended September 30
	2011						2010
	Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)			Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)
Derivatives designated as cash flow hedges
Foreign currency exchange contracts	$	(7	)	$	(1	)	$	3		$	1
Commodity contracts	(12		)	2			5			—
Derivatives designated as net investment hedges
Cross currency swaps	—			—			(16		)	—
Total	$	(19	)	$	1		$	(8	)	$	1



	Nine months ended September 30
	2011						2010
	Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)			Gain (loss) recognized in Accumulated other comprehensive income (loss)			Gain (loss) reclassified from Accumulated other comprehensive income (loss)
Derivatives designated as cash flow hedges
Foreign currency exchange contracts	$	(6	)	$	(1	)	$	2		$	1
Commodity contracts	(13		)	7			2			5
Derivatives designated as net investment hedges
Cross currency swaps	1			—			(12		)	—
Total	$	(18	)	$	6		$	(8	)	$	6

Gains and losses reclassified from Accumulated other comprehensive income (loss) to the Consolidated Statements of Income were recognized in Cost of products sold.

Amounts recognized in net income follow:



	Three months ended September 30						Nine months ended September 30
	2011			2010			2011			2010
Derivatives designated as fair value hedges
Fixed-to-floating interest rate swaps	$	23		$	13		$	25		$	49
Related long-term debt converted to floating interest rates by interest rate swaps	(23		)	(13		)	(25		)	(49		)
	$	—		$	—		$	—		$	—

Gains and losses described above were recognized in Interest expense.

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Note 12.	INVENTORY

The components of inventory follow:



	September 30, 2011			December 31, 2010
Raw materials	$	747		$	651
Work-in-process	243			229
Finished goods	907			800
Inventory at FIFO	1,897			1,680
Excess of FIFO over LIFO cost	(128		)	(116		)
Total inventory	$	1,769		$	1,564


Note 13.	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 Americas, Electrical Rest of World, Hydraulics, Aerospace, Truck and Automotive. For additional information regarding Eaton’s business segments, see Note 14 to the Consolidated Financial Statements contained in the 2010 Form 10-K.

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EATON CORPORATION BUSINESS SEGMENT INFORMATION

	Three months ended September 30						Nine months ended September 30
	2011			2010			2011			2010
Net sales
Electrical Americas	$	1,074		$	967		$	3,071		$	2,663
Electrical Rest of World	755			707			2,285			1,980
Hydraulics	717			583			2,130			1,641
Aerospace	420			390			1,218			1,136
Truck	715			534			1,964			1,479
Automotive	442			390			1,348			1,153
Total net sales	$	4,123		$	3,571		$	12,016		$	10,052

Segment operating profit
Electrical Americas	$	156		$	141		$	432		$	366
Electrical Rest of World	62			81			209			183
Hydraulics	109			76			335			207
Aerospace	71			60			166			157
Truck	139			74			349			179
Automotive	62			39			167			120
Total segment operating profit	599			471			1,658			1,212

Corporate
Amortization of intangible assets	(47		)	(46		)	(143		)	(134		)
Interest expense-net	(29		)	(33		)	(92		)	(102		)
Pension and other postretirement benefits expense	(35		)	(30		)	(105		)	(91		)
Other corporate expense-net	(56		)	(57		)	(155		)	(142		)
Income before income taxes	432			305			1,163			743
Income tax expense	65			36			172			89
Net income	367			269			991			654
Less net income for noncontrolling interests	(2		)	(1		)	(3		)	(5		)
Net income attributable to Eaton common shareholders	$	365		$	268		$	988		$	649

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Amounts are in millions of dollars or shares unless indicated otherwise (per share data assume dilution).

TWO-FOR-ONE STOCK SPLIT

On January 27, 2011, Eaton’s Board of Directors announced a two-for-one split of the Company’s common shares effective in the form of a 100% stock dividend. The record date for the stock split was February 7, 2011, and the additional shares were distributed on February 28, 2011. Accordingly, all share and per share data have been adjusted retroactively to reflect the stock split.

COMPANY OVERVIEW

Eaton Corporation is a diversified power management company with 2010 sales of $13.7 billion. The Company 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 73,000 employees in over 50 countries, and sells products to customers in more than 150 countries.

Eaton acquired certain businesses that affect comparability on a year over year basis. The Consolidated Statements of Income include the results of these businesses from the dates of the transactions or formation. For a list of business acquisitions and joint ventures impacting the comparative periods, see Note 2 to the Condensed Consolidated Financial Statements.

A summary of Eaton’s Net sales, Net income attributable to Eaton common shareholders, and Net income per common share-diluted follows:



	Three months ended September 30				Nine months ended September 30
	2011		2010		2011		2010
Net sales	$	4,123	$	3,571	$	12,016	$	10,052
Net income attributable to Eaton common shareholders	365		268		988		649
Net income per common share-diluted	$	1.07	$	0.78	$	2.86	$	1.90

RESULTS OF OPERATIONS

The following discussion of Consolidated Financial Results and Business Segment Results of Operations includes certain non-GAAP financial measures. These financial measures include operating earnings, operating earnings per common share, and operating profit before acquisition integration charges for each business segment, each of which excludes amounts that differ from the most directly comparable measure calculated in accordance with generally accepted accounting principles (GAAP). A reconciliation of each of these financial measures to the most directly comparable GAAP measure is included in the table below and in the discussion of the operating results of each business segment. Management believes that these financial measures are useful to investors because they exclude transactions of an unusual nature, allowing investors to more easily compare Eaton’s financial performance period to period. Management uses this information in monitoring and evaluating the on-going performance of Eaton and each business segment.

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Consolidated Financial Results



	Three months ended September 30								Nine months ended September 30
	2011			2010			Increase		2011			2010			Increase
Net sales	$	4,123		$	3,571		15	%	$	12,016		$	10,052		20	%
Gross profit	1,223			1,091			12	%	3,572			2,984			20	%
Percent of net sales	29.7		%	30.6		%			29.7		%	29.7		%
Income before income taxes	432			305			42	%	1,163			743			57	%
Net income	$	367		$	269		36	%	$	991		$	654		52	%
Less net income for noncontrolling interests	(2		)	(1		)			(3		)	(5		)
Net income attributable to Eaton common shareholders	365			268			36	%	988			649			52	%
Excluding acquisition integration charges (after-tax)	2			4					6			16
Operating earnings	$	367		$	272		35	%	$	994		$	665		49	%

Net income per common share-diluted	$	1.07		$	0.78		37	%	$	2.86		$	1.90		51	%
Excluding per share impact of acquisition integration charges (after-tax)	0.01			0.01					0.02			0.05
Operating earnings per common share	$	1.08		$	0.79		37	%	$	2.88		$	1.95		48	%

Net Sales

Net sales in the third quarter of 2011 increased by 15% compared to the third quarter of 2010. The sales increase was due to an increase of 11% in core sales, 2% from acquisitions of businesses, and 2% from the favorable impact of foreign exchange. Net sales in the first nine months of 2011 increased by 20% compared to the first nine months of 2010. The sales increase was due to and increase of 14% in core sales, 4% from the favorable impact of foreign exchange, and 2% from acquisitions of businesses. The increase in core sales in both the third quarter and first nine months of 2011 reflects the continuing global expansion of the Company's markets, which increased 11% in the third quarter of 2011 compared to the same period in 2010, and the global economic recovery from the depressed levels of 2009. Eaton continues to anticipate that its end markets will grow by 11% for all of 2011.

Gross Profit

Gross profit increased by 12% in the third quarter of 2011 compared to the third quarter of 2010. Gross profit margin decreased 0.9 percentage points from 30.6% in the third quarter of 2010 to 29.7% in the third quarter of 2011. Gross profit increased by 20% in the first nine months of 2011 compared to the first nine months of 2010. Gross profit margin was 29.7% for the first nine months of both 2011 and 2010. The gross profit margin in both the third quarter and first nine months of 2011 was positively impacted by higher sales volumes and the benefits of substantial changes in the Company’s cost structure implemented in the past two years. These benefits were partially offset by higher raw material and commodity costs, including losses incurred of $23 associated with commodity hedge contracts due to significant declines in metal prices primarily during the last two weeks in September. For additional information related to derivatives, see Note 11 to the Condensed Consolidated Financial Statements.

Income Taxes

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Net Income

Net income attributable to Eaton common shareholders of $365 in the third quarter of 2011 increased 36% compared to net income of $268 in the third quarter of 2010, and Net income per common share of $1.07 in the third quarter of 2011 increased 37% over Net income per common share of $0.78 in the third quarter of 2010. Net income attributable to Eaton common shareholders of $988 in the first nine months of 2011 increased 52% compared to net income of $649 in the first nine months of 2010, and Net income per common share of $2.86 in the first nine months of 2011 increased 51% over Net income per common share of $1.90 in the first nine months of 2010. The increase in both the third quarter and first nine months of 2011 was primarily due to higher sales and the factors noted above that affected gross profit.

Business Segment Results of Operations

The following is a discussion of net sales, operating profit and operating profit margin by business segment which includes a discussion of operating profit and operating profit margin before acquisition integration charges. For additional information related to integration charges see Note 3 to the Condensed Consolidated Financial Statements. For additional information related to acquired businesses see Note 2 to the Condensed Consolidated Financial Statements.

Electrical Americas



	Three months ended September 30								Nine months ended September 30
	2011			2010			Increase		2011			2010			Increase
Net sales	$	1,074		$	967		11	%	$	3,071		$	2,663		15	%

Operating profit	156			141			11	%	432			366			18	%
Operating margin	14.5		%	14.6		%			14.1		%	13.7		%

Acquisition integration charges	$	3		$	—				$	7		$	2

Before acquisition integration charges
Operating profit	$	159		$	141		13	%	$	439		$	368		19	%
Operating margin	14.8		%	14.6		%			14.3		%	13.8		%

Net sales increased 11% in the third quarter of 2011 compared to the third quarter of 2010 due to an increase of 9% in core sales, an increase of 1% from the acquisition of businesses, and an increase of 1% from the favorable impact of foreign exchange. End markets increased 11% in the third quarter of 2011 compared to the same period in 2010. Net sales increased 15% in the first nine months of 2011 compared to the first nine months of 2010 due to an increase of 11% in core sales, an increase of 3% from the acquisition of businesses, and an increase of 1% from the favorable impact of foreign exchange. The increase in net sales in both the third quarter and first nine months of 2011 was due to strong growth in the markets served by the Electrical Americas segment. Eaton now anticipates its Electrical Americas markets will grow by 8% for all of 2011.

Operating profit before acquisition integration charges in the third quarter of 2011 increased 13% from the third quarter of 2010. Operating profit before acquisition integration charges in the first nine months of 2011 increased 19% from the first nine months of 2010. The increase in both the third quarter and first nine months of 2011 was largely due to higher net sales as noted above. This increase was partially offset by higher raw material and commodity costs, including losses associated with commodity hedge contracts due to significant declines in metal prices primarily during the last two weeks in September. These losses reduced operating margin before acquisition integration charges by 1.0 percentage points.

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Electrical Rest of World



	Three months ended September 30						Increase (decrease)		Nine months ended September 30						Increase (decrease)
	2011			2010			Increase (decrease)		2011			2010			Increase (decrease)
Net sales	$	755		$	707		7	%	$	2,285		$	1,980		15	%

Operating profit	62			81			(23	)%	209			183			14	%
Operating margin	8.2		%	11.5		%			9.1		%	9.2		%

Acquisition integration charges	$	—		$	6				$	1		$	20

Before acquisition integration charges
Operating profit	$	62		$	87		(29	)%	$	210		$	203		3	%
Operating margin	8.2		%	12.3		%			9.2		%	10.3		%

Net sales increased 7% in the third quarter of 2011 compared to the third quarter of 2010 due to an increase of 7% from the favorable impact of foreign exchange, an increase of 2% from the acquisition of a business, offset by a decrease in core sales of 2%. End markets grew 1% in the third quarter of 2011 compared to the third quarter of 2010. Net sales increased 15% in the first nine months of 2011 compared to the first nine months of 2010 due to an increase of 8% from the favorable impact of foreign exchange, an increase in core sales of 6%, and an increase of 1% from the acquisition of businesses. Eaton now anticipates its Electrical Rest of World markets will grow by 6% for all of 2011.

Operating profit before acquisition integration charges in the third quarter of 2011 decreased 29% from the third quarter of 2010. Operating profit in the third quarter was negatively impacted by a large decrease in the residential solar market and losses associated with commodity hedge contracts due to significant declines in metal prices primarily during the last two weeks in September. These losses reduced operating margin before acquisition integration charges by 1.5 percentage points. Operating profit before acquisition integration charges in the first nine months of 2011 increased 3% from the first nine months of 2010 primarily due to higher sales.

Hydraulics



	Three months ended September 30								Nine months ended September 30
	2011			2010			Increase		2011			2010			Increase
Net sales	$	717		$	583		23	%	$	2,130		$	1,641		30	%

Operating profit	109			76			43	%	335			207			62	%
Operating margin	15.2		%	13.0		%			15.7		%	12.6		%

Acquisition integration charges	$	1		$	—				$	1		$	—

Before acquisition integration charges