To Our Shareholders:

Signs of Growth at Eaton

2003 was a very good year for Eaton, marked by a number of positive signs:

• Shareholders' equity exceeded $3 billion for the first time, and our all-in return to you, our shareholders, was 41.3 percent!
• Our revenues exceeded $8 billion.
• For the third consecutive year, our growth was significantly better than that of our end markets—$314 million in 2003.
• We achieved better-than-expected levels of profitability and return on assets.
• We continued to reap the benefits of several years of repositioning actions.

While each of these achievements is notable, perhaps the most exciting and fundamentally important accomplishment is that we have proven that Eaton can grow even when our end markets do not. Eaton wants to deliver exceptional results for shareholders, innovative and cost-effective solutions for customers, an outstanding workplace for employees, a great opportunity for suppliers, and enhancements to the communities in which we operate. Eaton is driven to achieve these goals regardless of where we find ourselves in the economic cycle.

Many of our markets have started to rebound. Although the weighted average growth of our end markets continued to decline during the first three quarters of the year, there was growth in the fourth quarter.

In view of our increasingly positive operating results, strengthened balance sheet and the improving outlook for our end markets, in January 2004 we announced a two-for-one stock split, a 12.5 percent increase in our quarterly dividend rate from $.48 per share to $.54 per share on a pre-split basis, and a plan to repurchase 2.1 million shares on a pre-split basis to offset the shares issued during 2003 from the exercise of stock options.

For industrial manufacturers, it feels like the economic clouds are lifting. And we believe the new Eaton – a diversified industrial enterprise united by the Eaton Business System – is capable of consistently outperforming our competition. We proved it during the past three years of contracting business conditions, and we will prove it in the emerging economic recovery as well.

To prompt and sustain growth, we have made significant changes over the past several years in the way we manage our enterprise. This includes a more balanced mix of businesses, a new and energized leadership team and aggressive implementation of the Eaton Business System.

Building upon the momentum of these value-creating changes, we confirmed and honed our Vision, Mission, Values and Ethics statements during 2003 because we believe that organizations without these commitments are prone to losing their way. As part of this, we also conducted refresher training on our Code of Ethics during the year for our 51,000 employees around the world.

While some organizations may regard statements of ethics and values as superfluous, we do not. One need only scan the corporate landscape to see countless examples of organizations that have wandered into the wasteland of poor values, reckless execution and the destruction of shareholder value.

We believe that "doing business right" is the essence of good corporate governance and ethics, and a prerequisite for growth. It is all about a higher standard, one that is, in fact, the soul of any values-based enterprise. And it is the practical application of our company's values, ethics and beliefs that makes a real difference in how Eaton people conduct business and how we measure success.

The way we manage our enterprise and our business activities is based on the following foundation elements of the Eaton Business System:

• Vision - To be the most admired company in our markets. We gauge our progress in three ways:
  • When customers say: "We want to do more business with Eaton."
  • When shareholders say: "Eaton is one of my best investments."
  • When employees say: "I am proud to be part of the Eaton team."
• Mission - To be our customers' best supplier, providing distinctive and highly valued products, services and solutions.
• Commitment - We care about how we get results and are committed to the highest principles as represented in:
  • Eaton's Code of Ethics
  • The Eaton Philosophy of Excellence Through People
  • Our concern for our communities and environment
• Eaton as One Company - We strengthen our overall enterprise and our individual businesses through our integrated operating company philosophy embodied in the Eaton Business System.

Eaton won numerous awards throughout the year that demonstrate a growing international recognition of our integrity and business excellence. From being named one of the Best 100 Places to Work in Brazil, to being named Clean Corporate Citizen in Michigan; as the recipient of the Business Excellence Award in the United Kingdom and the Innovation Award for Process Excellence through Lean Manufacturing in Canada; as Best Employee Friend, and Best Employee Team, selected by the Government of Shanghai Pudong New Area.

We appreciate such acknowledgements of our efforts, but are particularly gratified by the pride and sense of ownership felt by our own employees. It's apparent in the 96 percent response rate to the 2003 Eaton Employee Survey, an annual measure of employee engagement and manager effectiveness. And it shows in the survey's documentation of an improving level of employee confidence in the company's strategies and in a 17 percent increase in favorable responses to the statement, "I feel proud to work for Eaton." That's good news regarding our progress toward achieving our Vision.

Signs of Growth in Our Results

It's easy to understand why Eaton employees feel proud – all of us worked hard in 2003 to make a real difference in Eaton's performance. You can see the impact of everyone's efforts in these results:

• We successfully integrated our acquisitions of the Boston Weatherhead business of Dana Corporation, the aerospace circuit breaker product line of Mechanical Products Inc., the power systems business of Commonwealth Sprague Capacitor Inc. and the electrical division of Delta plc.
• We formed two important new joint ventures: Intelligent Switchgear Organization LLC with Caterpillar Inc. to provide a total systems approach for electric power generation, sales and service worldwide; and Eaton Fast Gear (Xi'an) Co., Ltd. with Shaanxi Fast Gear Co., Ltd. and Xiang Torch Investment Co., Ltd. to produce heavy-duty truck transmissions for the growing Chinese market.
• We delivered impressive balance sheet results. We lowered our inventory days-on-hand at year-end by three days and maintained our less fixed-capital-intensive business model. We also reduced debt by $135 million and improved our cash and short-term investments by $437 million, even while funding $252 million in acquisitions and joint ventures. In the past three years, in spite of weak economic conditions, we have reduced debt by nearly $1.1 billion, ending the year with a net-debt-to-total-capital ratio of 25.9 percent. And in 2003, we achieved our second highest level of cash flow from our operations.
• The all-in return to our shareholders of more than 41 percent meant that Eaton outperformed the Dow Jones Industrial and S&P 500 indices for the third year in a row. We believe this reflects a fundamental revaluation of our enterprise.

Signs of Growth Ahead

We enter 2004 feeling upbeat, anticipating improvement in our end markets around the world. We are confident that the new Eaton is well positioned to take full advantage of a global economic recovery and the revival of our markets.

Even though the capital goods markets are beginning to show increased strength, we are mindful of the lessons of the all-too-recent recession. You can be assured that we will maintain our focus on being cost competitive. That our capacity will be well attuned to the dynamics of the full business cycle. That we will target our innovation at the high-value opportunities of our customers. And that we will conduct our business according to the values that have always been a hallmark of our corporation.

2003 provides ample testimony to the energy, skills and creativity of the individuals who make this enterprise work. Eaton employees are the source of our success, and I extend my personal thanks to each member of our global Eaton team. All of us look forward to 2004 as another year when we will deliver continued growth and new achievements.

I also express my appreciation to all of our shareholders for your collective confidence in Eaton. Consistent with our Vision, we want to be your best investment and will work hard to meet or exceed your expectations in 2004.

Alexander M. Cutler
Chairman and Chief Executive Officer