To Our Shareholders:

It was not business as usual in 2002.

It was a challenging year in the majority of the end markets that are served by Eaton. Industrial markets declined, there was a necessary period of economy-wide capacity rationalization, and short-term prospects for growth remained subdued. Gone are the halcyon days of the late 1990s, when the rapid expansion of markets allowed companies to accelerate their growth easily. Those prospects of stratospheric growth have evaporated. We are confronted, refreshingly, with a more rational flow of capital – to business models that work, organizations that have a proven capability to perform, products that consistently provide real value, and leadership teams that deliver exceptional returns through the cycle.

During this same period we witnessed week after week of shockwaves from a sharp crisis in corporate governance. Numerous examples of unacceptable abuses led to a rapid erosion of the stature of business and people's trust in corporations. We believe these dual conditions – a more rational economy and flow of capital, coupled with a stronger emphasis on corporate governance and ethical business practices – have actually created an even more favorable environment for Eaton Corporation.

The New Eaton

Eaton is a new company – a diversified industrial enterprise shaped through 50 acquisitions and 48 divestitures during the past 10 years. We also have changed our basic business model to one of an integrated operating company, which allows us to capture the advantages of scale and breadth inherent in our growing, diverse enterprise. The new Eaton is ready and able to achieve the higher performance that current and future business environments demand.

The Eaton Business System (EBS) is the framework for implementing our new business model and the holistic, integrative system by which we manage Eaton. Through the EBS, we are streamlining the resources needed for repeatable processes and common infrastructures, and for consolidating company-wide purchases of goods and services. At the same time, the EBS allows us to deploy increased resources to areas of competitive differentiation, such as marketing and cross-business research and development. Importantly, the EBS also makes Eaton a more successful acquirer of new businesses by providing a common integration system that enables us to promptly realize the benefits targeted by the acquisition. Through the EBS, we also implement our own stringent control and reporting procedures in an acquired business to ensure the accuracy and necessary transparency of results. Additionally, the EBS is the backbone of our curriculum in Eaton University, the company's primary employee development forum.

The Same Eaton

We are the same Eaton where it counts – a company with a strong foundation built on our long-standing standards of ethical business practices, our philosophy of excellence through people and our underlying values. These beliefs are the foundation that underlies everything we do, giving us the flexibility to change our business model, our lines of business, our strategy and our tactics – always guided by the integrity that has served Eaton so well for many years.

I was pleased to certify our financial results as an expression of the care and pride with which we represent our achievements. We stand proud of our record of ethical business practices and our contemporary governance practices. At Eaton, we work hard to achieve exemplary results, but always devote great care to how we achieve them.

For example, I am the only non-independent director on our Board of Directors. Other than the Executive Committee, our Board committees are comprised only of independent directors. Many of the recently codified governance requirements were already in place at Eaton, such as policies about the use of external auditors for non-audit related services, a Board Governance Committee, and verification of financial results at all management levels of the organization to ensure the accurate and honest representation of our results. Nonetheless, we have examined our governance practices even more critically, and are working in concert with our Board of Directors on refinements to ensure that Eaton Corporation's practices remain a benchmark for ethics and governance excellence.

The Eaton Results

While the turmoil surrounding corporate governance and the economy swirled through 2002, we continued to focus upon our shareholders' requirements for results; our customers' demands for cost-effective, high-quality, innovative solutions; our employees' desire for a great place to work; our suppliers' hopes for a growing customer; and our communities' needs for a responsible citizen.

In fact, our results provide the most compelling evidence of the transformation of Eaton – a transformation that must continue in order for us to reach our goal of being a premier diversified industrial enterprise:

• We outgrew our end markets by approximately $300 million.
  
• We acquired the Boston Weatherhead business from Dana Corporation and the aerospace circuit breaker product line from Mechanical Products Inc., and in the first weeks of 2003, acquired the power systems business from Commonwealth Sprague Capacitor Inc. and the electrical business of Delta plc. These four acquisitions are expected to provide more than $500 million of additional revenue growth in 2003.
  
• Our comprehensive restructuring program initiated in late 2001 allowed us to capture $130 million of benefits in 2002, enhancing our ability to achieve higher profitability on lower sales.
  
• The Eaton Business System is driving tangible benefits:
• We lowered our inventory days-on-hand by six days.
• We decreased our accounts receivable days outstanding by three days.
• We successfully implemented a less capital-intensive business model, which has significantly improved our cash flow.
• As a result, we have reduced debt by $352 million and improved our cash and short-term investments by $117 million, even while funding a net expenditure of $57 million for acquisitions/divestitures. In the last two years, despite weak economic conditions, we have repaid $916 million of debt! And in 2002, we achieved an all-time record of $900 million of cash flow from operations!
  
• And significantly, for the second year in a row, Eaton's shareholders benefited from a fundamental revaluation of Eaton. This performance is made all the more impressive in a year when Eaton's all-in return was 7.5 percent, compared with the all-in returns for the Dow Jones Industrials at -15.01 percent, the S&P 500 at -22.1 percent and the NASDAQ at -31.5 percent!

These results were achieved through the focus, commitment and hard work of our leadership team and every one of our employees. I am proud that once again, Eaton people have met the challenges of a weak economy and constricted end markets. We did this with an eye toward the future, not by seeking answers from the past.

Historians and economists like to explain current events in the context of similar historical occurrences. Too often in business we make the mistake of trying to gauge the future by analyzing historical economic cycles, or strategies that had been successful. We at Eaton have a healthy respect for the past and are proud of the traditions that have served our company well. At the same time, we believe strongly that winning requires one to look forward, and demands a willingness to challenge historic precepts and redefine the very basis of competition and successful strategy.

In 2002, we did exactly that. Leveraging the strengths of a diversified, integrated operating company, we challenged ourselves to succeed in one of the toughest operating environments in recent memory – and we were successful. Our results show that our strategy is working.

Looking ahead, we see little evidence of a substantial strengthening in the weighted average of our end markets in 2003. However, we have spent the past two-and-a-half years preparing and positioning Eaton to compete profitably in the context of current market demand. So we can – and will – continue to work with the same intensity. We will not relax our focus, our efforts or our standards.

Even in this significantly more challenging operating environment, we remain committed to the heightened performance goals we intend to reach by 2005: achieving 10 percent growth through the economic cycle, improving profitability by 30 percent and significantly improving our working capital and fixed capital management.

We continue our unwavering commitment to our values and the Eaton standards of ethical business conduct and accurate financial reporting. These principles are as strong and vibrant as ever because we have always cared about how we get results.

Eaton people worked extraordinarily hard in 2002 and are prepared to do the same in 2003. Not just because our end markets will remain depressed, or because we expect growth to be difficult. But because all of us know that successful organizations make their own success; it does not happen by chance.

We know that what it takes to win is ever changing. Today's Eaton has the pulsing life force of a forward-looking, increasingly flexible organization. And we have the will to succeed. More confident than ever of Eaton's heightened potential, the Eaton team welcomes the challenges and opportunities of 2003.

Alexander M. Cutler
Chairman and Chief Executive Officer