Inside the Mind of a Strategic CFO

Using his background in corporate planning, Rich Fearon has helped Eaton Corp. cut its auto-industry exposure and boost its involvement in the elec...
David KatzNovember 5, 2009

There are two routes to becoming a corporate CFO, says Richard Fearon, vice chairman and chief financial and planning officer for Eaton Corp., a $15.4 billion industrial manufacturer.

Twenty years ago, most CFOs came through the accounting and controller route, recalls Fearon. Today, “you’d probably find a more even mix between folks that have come up through the controller and accounting route and folks that have come up through a more general management route,” says the executive, a planner and forecaster cut very much from the latter mold.

Indeed, look into his prior jobs and you won’t see a hint of traditional finance. Fearon joined Eaton from Willow Place Partners, a Menlo Park, California-based corporate advisory firm he founded in 2001. From 1995 through 2000, he was with Transamerica Corp., where he was most recently senior vice president of corporate development. From 1990 to 1995, he was general manager, corporate development, for Singapore-based NatSteel Ltd. and vice chairman of NatSteel Chemicals.

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Fearon believes his background in strategy has enabled him to foresee which business areas are headed for trouble and which are bound to bloom — and help Eaton act accordingly. For example, before the auto industry completely tanked, he foresaw trouble and pushed for a strategy that went elsewhere; similarly, he foresaw potential in electrical efficiency, and the company is now hoping to parlay that into success and stimulus money in the blossoming environs of energy.

While the finance and planning chief grants that the challenge of building sustainable revenue looms for the company, he thinks the worst of the recession’s effects are over. To be sure, the company’s third-quarter sales were down 26% from the same quarter in 2008, and net income was $193 million compared with $315 million in 2008, a decrease of 39%.

EatonCFO Fearon“The biggest risk we face is that the economic rebound will be followed by another leg down, where we see that there isn’t sustainability in the recovery.” — Richard Fearon, vice chairman and chief financial and planning officer, Eaton Corp.

Still, Eaton delighted some analysts by spawning operating earnings of $1.21, beating the midpoint of its operating profit guidance by 26 cents. Even more promising was its operating cash flow of $471 million for the third quarter and $1.6 billion in the past 12 months. On October 21, in a wide-ranging interview just two days after the company’s quarterly earnings call, Fearon talked to about the outlook for his company and the country — often in strategic terms. An edited version of the interview follows.

How has your strategy background been helpful at Eaton in your role as finance chief?
I’ve had a great deal of experience in different sectors of the economy that’s extremely helpful in making those kinds of strategic decisions. Over the past years, ever since I started in 2002 at Eaton as CFO, we’ve been pursuing a change in our business portfolio. We’re driving at a portfolio that is more consistent in its earnings, has higher returns on capital, and has a higher growth rate. In pursuit of that, we’ve significantly altered our mix of business, both by industry sector and geography.

We have, for example, very significantly expanded our exposure to the electrical industry. In 2003 our electrical business was 29% of our sales, and in 2008 it was 45% of our sales. And that 2008 number doesn’t include the full-year benefit of two very large acquisitions in the electrical space, one of which closed toward the end of February and the other April 1. If you annualize that, the electrical sales would be about half the portfolio.

We also greatly expanded our exposure to non-U.S. markets. Today about 55% of our products end up outside the United States. In 2002 about 30% of our sales were outside the United States. As part of that geographic expansion, we’ve also greatly expanded sales into emerging markets. Very close to a quarter of our sales are into developing markets.

On the other hand, you’ve decreased your exposure to the automobile industry.
Yes. That’s been a very concerted strategy to really focus in our auto segment only on those product areas where we felt we had true technological advantage and where we believe that we either had or could develop a market position that gave us a clearly sustainable edge over the competition. And so we have selectively sold product lines that did not fit those characteristics. Our automotive business in 2003 was 26% of our sales, and in 2008 it was 12%.

Your auto-industry strategy seems to have been prescient. Did you know something that everybody else didn’t know?
Maybe one of the benefits of coming into this position from a strategy orientation is that it was apparent to me and to others on our senior team that the structure of the auto industry was going to create challenges. Fundamentally, you have too many [original equipment manufacturers], very few of which have market positions that are clearly sustainable. You have an incredible amount of competition occurring, and at the same time you have a market that is growing at 1% to 2% a year. That is below global GDP growth. A slow-growth market with customers that have a set of challenges appeared to us to be a recipe for difficulty. However, given our heritage in the technologies that we have developed over the years, we believe that we can create a niche in that industry that can still enjoy good returns.

What is that niche?
Engine components that drive better fuel economy and lower emissions and that have a lot of technology built into those components. There’s a secondary focus on safety-oriented components, such as traction-modifying equipment. Those components are critical to the performance of vehicles. They’re highly attractive to the end purchasers of vehicles, and because of that they are going to enjoy a higher growth rate than the overall growth rate of car units.

What was the strategy behind your push into the electrical area?
The electrical industry worldwide is a very large industry space. There are a wide variety of electrical components, ranging from the simplest low-voltage components all the way up to the high-voltage equipment used in generating stations. Depending upon how you measure it, the space is something around $50 billion in market size. Our focus has really been on low and medium voltage. We believe that there are a great many ways to differentiate products technologically and that if we built the business carefully, we could acquire other technologies and knit it all together so that we could begin to sell systems.

Typically, the electrical space is also around or slightly above GDP, and that’s particularly true for electrical components highly oriented toward energy efficiency. Given rising energy costs — which we have believed for some time would be rising relatively rapidly — we tried to focus our portfolio on a set of products that were highly energy efficient. And that gave us a growth rate even greater than the average for the electrical space.

The last element is that the larger players in the electrical space have typically been very well thought of by the financial community.

What part have you played in this change of product mix?
I’m chief financial and planning officer, meaning that in addition to the traditional financial functions — accounting, tax, treasury, internal audit, investor relations, IT — I also have the corporate planning and corporate development teams. On the corporate planning side, we have spent a great deal of time thinking about the characteristics of our industry spaces, adjacent spaces, and the characteristics of spaces that we’re not directly in but where some of the skills we now have would perhaps give us some competitive advantage.

It’s through that kind of thought process that we’ve identified opportunities like the power-quality business. In 2002 we had a business that was focused on low and medium voltage power-distribution equipment. But we didn’t really have any significant exposure to equipment that monitored and controlled power quality. And we identified over the course of a couple of years after I joined that that would be a high-growth space, particularly as energy costs continued to rise and as the world became more computerized. We said it would be desirable to find a way in.

One thing I’ve learned in my 20-plus years in acquisition strategy is that it’s not enough simply to find an area of opportunity. You then need to find a practical and economic way to enter that area. One of the things that I did when I joined was to put in place a more systematized acquisition process. First of all, we lay out a very systematic way of prospecting, initial negotiations, more-detailed negotiations, contract negotiations, and closing integration. As part of that process, we even put in a set of metrics. For example, we measure what we call “quality at-bats” in a given year.

An “at-bat” is a true, substantive negotiation with the business owner about the terms of buying a company — as opposed to just sitting down and saying, “Gosh, tell me about your company.” A quality at-bat is where you’re actually in discussions about agreeing on price, deal structure, timing: it’s a real negotiation to buy a business. And what we find is if you measure things on an ongoing basis and you hold your teams accountable to go out and find opportunities, you’re much more successful. As a result of our process, in the past seven or eight years we completed close to 50 acquisitions. If you looked at our quality at-bats, it would be in the 200-plus category.

From your perspective as CFO, how has the recession affected Eaton?
Pretty severely. We do a lot of economic forecasting and planning, and we have never really put together a scenario that was as negative as this downturn turned out to be. Frankly, I don’t think we’re alone. As I talk to other CFOs around the country, I find that most had a very similar experience. Because of the sharpness with which things declined and because of how deep the declines were, all of us around Corporate America were forced to make relatively abrupt and drastic moves in order to deal with the loss of sales and loss of volume. At Eaton we’ve reduced our global workforce by about 15% — roughly 13,000 employees in the past year.

The good news, if there is good news in a situation like this, is that we have recast our cost structure so that at the present volume levels, we can operate with relatively attractive profitability. Should volume come into the system — and we think it is starting to come into the system — we think there will be relatively attractive incremental profits on that new volume.

What are your biggest challenges now as CFO?
I would have said nine months ago that the challenge was twofold: insuring that there was adequate liquidity to deal with an as-of-yet unknown decline, and getting the cost structure in position to deal with what appeared to be a potentially much lower-volume environment. At this juncture, at least for Eaton, I believe that we have those two challenges well in hand and so are feeling reasonably good about things.

The challenge right now is to ensure that as volume comes back into the system, we realize the full economic benefits of that volume. That we don’t allow costs that we just took out of the system at relatively great expense and pain to creep back into the system without an explicit agreement that that’s appropriate to do so.

Number two, as we begin to see the outline of this recovery, [is] trying to get enough visibility into it to decide to what extent there are any fundamental changes needed to the strategy we had been pursuing, going forward. For example, as you look at the six segments we’re in, have any been impacted in a way that suggests that the fundamentals of those segments going forward are not going to be the same as they have been. There may be more opportunities in some segments and fewer in others.

How were you able to get your liquidity in hand?
I would characterize it as an attempt focused on working capital management. We have made it a great rallying cry around Eaton to pull working capital out of the system as our sales declined. Through a series of meetings and metrics and just constant focus we have achieved great progress. To give you an illustration, since the end of last year we’ve pulled about 13 days on hand of inventory out of the system. In addition to the inventory simply coming out because sales are going down, we’ve greatly improved our inventory efficiency by pulling down the days on hand.

To give another illustration, in the fourth quarter of last year through this third quarter, our operating cash flow has been about $1.6 billion. That’s actually the highest operating cash flow we’ve ever had in a four-quarter period. And it is made up of a whole lot more working capital liquidation than would be typical in a four-quarter period. We’ve made up for the shortfall in earnings by pulling substantial amounts of working capital out of the system.

How did you pull that inventory and decrease your working capital like that?
Through a very systematic month-in-month-out focus on it. For example, we’ve instituted a whole series of reviews, in some cases a monthly and other cases a literally weekly basis. We review incoming orders, inventory levels, and at what point we should be reordering raw materials. In some cases, we’ve elected to look at order levels and even adjust them because we didn’t believe that they were really going to come to pass at the end of the day; i.e., we believed that there might be cancellations in orders that had already been made. Through what I call an almost nitty-gritty tactical approach to managing inventory, we’ve been able to get the kinds of efficiencies that I just outlined.

What would you say would be your biggest nightmare now; the worst thing that could happen?
The biggest risk we face is that the economic rebound will be followed by another leg down, where we see that there isn’t sustainability in the recovery. [That might be] because the recovery was too much based upon stimulus; at some point, these governments around the world which have taken on so much leverage to provide the stimulus are going to not be able to keep indebting themselves to the extent they have been. Whether it’s due to the stimulus going away or simply because the household balance sheets around the world are not sufficiently robust to convince households to stop husbanding their resources, you might have another letdown.

Then there’s a longer-term risk we all need to be cognizant of. I don’t think it’s a very likely scenario. But any of us who have lived through the episode of high inflation in the ’80s knows that you have to always be vigilant about whether these highly stimulative policies could unintentionally result in a bout of much higher inflation than we’ve seen over the past 15 or 20 years. And you know, that would certainly be a concern. Inflation is a very distorting condition under which to run large, capital-intensive businesses, and it creates a great deal of complexity.

But haven’t the stimulus programs of various countries benefited Eaton? If so, how as CFO are you making them work best for the company?
You’re certainly correct that the stimulus offers opportunities. It is new sales, and we have put a very concerted focus on realizing at least our fair share and hopefully beyond our fair share of the stimulus programs. We’ve created separate, dedicated teams — one in the electrical sector, one in the industrial sector — made up of a series of individuals, some of whom are full time. Their focus is on identifying spending authorized under stimulus programs in the whole variety of countries that we operate in, ensuring that we participate in marketing our products into those programs. And the results thus far have been quite positive for us.

For example, in the United States, we have a whole tracking system [that shows] those contracts we have been awarded. Thus far, we’ve been awarded $95 million of contracts in our electrical business from the U.S. stimulus program. Another area where we’ve had significant wins is in our hybrid commercial-vehicles line in the industrial sector, where we’ve won very significant contracts in many countries around the world — China being our largest set of stimulus sales.

Of course, hybrid vehicles have been a focus of certain countries’ stimulus programs, particularly in those countries that have had significant environmental issues, like China, and we’ve been able to take advantage of stimulus dollars that have gone into those programs. Our expectation for 2010 and 2011 is that we’re likely to generate revenues of about $500 million in each of those years in our American electrical business from the stimulus program in the States.

If you look at the $787 billion stimulus program that was authorized under the Obama Administration, only a relatively modest amount of that has actually been released. It’s our belief that you probably won’t even have 20% of that $787 billion program in that released status before the end of this year. So the great majority of that stimulus is as yet really to be put into the system.

So that will benefit you as a source of growth?
Yes, it will. For us it’s clearly a benefit, and for the economy overall it’s clearly a benefit. But at the end of the day it’s going to act like a pump primer. It’s got to prime other economic activity because the government can’t continue to simply spend money that it borrows. I mean if you do that for too long, you’ll end up with some of the difficulties that countries such as Japan have experienced, where their debt loads have risen to extremely high levels relative to GDP.

Eaton generated $1.6 billion of operating cash flow over the past four quarters. What are you planning to do with all that cash?
Thus far this year, we’ve just been paying down debt. But we have seen the risk to the financial system. That suggests to me, as it has to many other CFOs, that whatever level of leverage we were comfortable operating at in the past is probably higher than we’re now comfortable operating at now. So we’re simply taking that cash and paying down debt, which will put us into a [ratio] of debt to total capital that we think is appropriate given the current state of the world economy and of financial institutions.

What’s an appropriate ratio of debt to capital?
How we often think about this is net debt to total capital, with net debt defined as debt less cash on hand and total capital defined as net debt plus equity. That gives you an idea of how much you’ve relied on debt as part of your long-term capital structure. Over the past five years, we’ve been comfortable with that number on average being somewhere in the neighborhood of 35%. Given the known risks that are out there in the world economy and given a financial sector that still is not repaired from this downturn, we think it’s probably prudent to be operating at around 25%.

What do you see on the horizon in terms of genuine revenue growth, rather than growth that comes from such things as cost-cutting?
Your first task is to have a business size such that it can earn attractive returns in whatever market environment you’re in. And so we’ve accomplished that. Even if the market doesn’t recover, the returns we earn will be reasonably attractive. But you’re right, over the long haul, if you’re going to create real value you need to find ways to grow your top line. Based on our assessment of what most economists believe, you’re going to have global GDP growth next year on the nature of 3.1 %. Our kind of business is dependent upon global production more than global GDP. Typically, industrial production declines more in the downturn and increases more in an upturn. And the general view of economists is that industrial production next year is likely to grow by something like 6% globally.

Because we have focused on such segments as electrical energy efficiency, we think we are likely to be able to grow faster than the overall market. So, for example, if you assume growth in industrial production of 6% globally, and you assume that we could outgrow that by 50%, that would suggest something just shy of 10% revenue growth next year, absent any currency impact. So the most likely case is moderate revenue growth in 2010. While I think we all would desire a stronger recovery, it’s nonetheless going to feel a whole lot better than the past 12 months have felt.