To Our Shareholders:

To say that 2001 was a difficult year is to vastly understate the challenges faced by our corporation and the community we call the civilized world. Our end markets weakened, the economy declined and the world changed.

The year began with our markets experiencing their worst deterioration since the early 1980s. And this decline continued at an increasing rate through the first eight months of 2001. Then the markets, the economy, and the world were further shaken by the tragic events of September eleventh. We all will long remember this horrific day.

I am proud of the collective resolve of the employees of Eaton who helped those directly affected by these senseless acts of terrorism and rededicated themselves to the principles of freedom and the power of an inclusive culture. The courage shown by our employees–by returning immediately to normal activities in their family lives, jobs, and communities–was a powerful demonstration of leadership at a time when leadership was sorely needed.

Leadership is always a precious resource for an enterprise, but it is especially critical during a period of dramatic economic change, like the one we experienced in 2001. We are working to ensure that our strategy is clear, our operational objectives are broadly understood and the execution is increasingly crisp.

Our strategy remains the same: to reposition Eaton Corporation as a premier diversified industrial enterprise. As an important element of this transformation, we have changed our management model. We now run our corporation as an integrated operating company and are working hard to capture the full benefits of the scale and scope within the entire enterprise. Our performance in 2001 benefited directly from this approach and the implementation of the Eaton Business System.

Beginning in late 2000, we took swift and decisive actions when we foresaw a continued, dramatic weakening of the North American industrial economy. Our operating plan focused on three critical elements: outgrowing our end markets, resizing the corporation and strengthening our balance sheet.

While our sales and earnings declined substantially during 2001, we achieved very credible results:

• We were again successful in outgrowing our end markets in each of our four business segments. The weighted average of our end markets declined by approximately 15 percent during 2001, while Eaton sales declined by only 12 percent. We also garnered important new business commitments during the year in each of our business segments, which will contribute to our ability to continue to outgrow our end markets in 2002.
  
• We resized our resources to ensure that Eaton could continue to compete successfully at far lower levels of economic activity. Aggressive actions were taken throughout the year, including a total of $119 million of restructuring activities, the closing of 17 manufacturing plants and an 18 percent reduction in our total employment.
  
• During a period of depressed end markets, lower sales and reduced profitability, we strengthened Eaton's balance sheet markedly. We repaid more than $560 million of debt, improving our net debt to capital ratio from 55 percent to below 47 percent. The outstanding cash flow generation from our operations reflects continued improvement in our manufacturing processes and the benefits of our new business model's increased involvement with strategic suppliers. We also successfully divested several non-core businesses during 2001.
  
• The value of the changed Eaton is beginning to be recognized by the financial markets. During a year when the Dow declined by 7.1 percent, the S&P 500 by 13 percent and the NASDAQ by 21.1 percent, Eaton's 2001 all-in return was 16.9 percent. For our shareholders who elected to hold the shares of Axcelis, which they received at the end of 2000, the combined all-in return was an impressive 21.7 percent.

We are operating in a period of increased uncertainty. While the North American markets may be at the bottom of the cycle, markets in Europe, South America and parts of Asia-Pacific are weakening.

We expect 2002 to be a transitional year during which our end markets will remain depressed in the first half, with the prospect of a mild recovery at the end of the year. Eaton is ready for the challenge. We have significantly improved our competitive position. We have resized our enterprise to compete successfully at lower levels of activity. And we have strengthened our balance sheet considerably. As a better balanced, leaner, and more focused enterprise, Eaton is well positioned to take full advantage of the coming upturn in our end markets.

Our vision remains the same–we are committed to our goals of 10 percent growth through the economic cycle, a 30 percent improvement in the rate of profitability and a further 15 percent improvement in our working capital velocity. While 2001 has been a disappointing year in terms of the decline in our end markets and the resultant decline in our earnings, we remain confident in Eaton's potential and committed to our heightened performance targets.

Alexander M. Cutler
Chairman and Chief Executive Officer