Seeking Alpha
Hedge fund manager, long/short equity, contrarian, value
Profile| Send Message|
( followers)  

As part of the S&P 500 dividend aristocrat club, Emerson Electric Company (NYSE:EMR) enjoys a special place in the income-oriented portfolios. Over the last 50 years, the EMR management has consistently increased the annual dividend with the current dividend yield at 2.85%. However, it might not be sufficient against the 20-30% in capital losses in the next 6-9 months because of potentially disappointing earnings and lower payout in the second half. I believe the full year EPS would be in the range of $2.95-3.15, which is higher than last year's figures but at least 15-20% lower than the company's earnings guidance and consensus estimates. If the impairment charge is similar to the last year's numbers, the earnings would be even lower, and naturally, the price volatility would substantially increase.

The stock is currently trading at an expensive trailing P/E multiple of 20.8x, and as the earnings will be announced during the second half of FY2013, the stock might decline by at least 20-30% from the last close on July 19, 2013. Several factors contribute to the increasing valuation risk and may be worth examining by the investors before deciding to increase or maintain the EMR long position. The article is structured with an estimate on the potential earnings miss, after which it outlines some of the pointers towards a weaker 2H-2013 and then it covers the expensive valuation thesis under different dividend/free cash flow growth scenarios and the catalyst that is expected to trigger the downside.

Potential Earnings Miss in Second Half of 2013

The sales and earnings will be most likely affected by the average 5% decline in order trend during the 3rd quarter (discussed below). As the headwinds develop on the global economic horizon, the order trend might decline even further. However, I will be conservative and assume that the second half revenues decrease by only 5% with similar margins to what EMR achieved during the first half 2013.

It is important to note that last year EMR recorded $529m in goodwill impairment due to weakness in the telecommunication and information technology industry (currently with no signs of any radical improvements from last year). If the management decides to incur more in impairment charges, the earnings will be even lower.

The goodwill and intangibles comprise a sizable $9.74 billion on the EMR balance sheet (41% of total assets and 92.5% of total equity) putting the price to (tangible) book ratio at a whopping 53.5x. EMR may not be as risky as some other companies with lower growth prospects, but it is prudent to take into consideration any downside risks of the current rich valuations.

Global Economic Slowdown

The company generates a significant portion of its revenues through exports to Europe, Asia, Latin America, the Middle East and Africa. Despite the relative economic stability in the past few months, the short-term prospects in these markets appear rather gloomy due to the inherent structural issues.

  • China is expected to post the slowest growth rate in 23 years with a number of analysts anticipating next year's GDP growth near 7.5%, significantly lower than their earlier estimates in excess of 8%. Some analysts even consider the 7.5% growth estimate by the Chinese government to be highly vulnerable due to concerns over the domestic debt issues.
  • As the summer draws closer, there will be a seasonal productivity slowdown in the Middle East, which happens to be the top performing region for EMR in terms of sales growth. The regional business activity is significantly reduced during summer, which also coincides this year with the Muslim holy month of Ramadan when the official business hours are reduced by 25%.

Worsening Order Book

The Global Electro-industry Business Confidence Index has worsened during the last 6 months as depicted in the following graph.

(click to enlarge)

The Jun'13 figures in the above chart should be studied together with the six months expectations in January as given in the chart below;

(click to enlarge)

In line with the industry developments, EMR has also reported a deteriorating order trend during the last five months, and the management does not foresee any major economic catalysts powerful enough to improve the outlook for the next 6 to 9 months. This should serve as a credible warning on the third and fourth quarter earnings outlook.

Highly Optimistic EPS Growth Estimates

During 2007-2012, EMR has registered only 3.0% CAGR in revenues while net earnings declined by an average 2% per annum. As the order trend gradually weakened throughout the third quarter, the company lowered its earnings guidance by 5 cents with FY2013 EPS estimated at $3.48-3.58 while the consensus puts earnings estimates at $3.51.

These EPS estimates appear quite ambitious given the fact that EMR has reported only $1.39 in EPS for the first half, and the management has already warned about a potentially negative sales growth quarter. Therefore, it appears more likely that the company will miss the consensus and its own EPS guidance by a significant margin.

(click to enlarge)

Expensive Valuation

Dividend Discount Model

The current dividend yield is 2.8% and the annual dividend growth has averaged 9% during 2007-2012. Assuming the annual dividend growth continues at the same pace for next five years, the DDM based fair value is estimated at $43.9, at least 25.3% lower than the last close on July 19, 2013. The current price implies a dividend growth rate of 14.3% per annum over the next five years necessitating a more careful assessment of the underlying assumptions.

Free Cash flow Model

The free cash flow has declined by 2.2% per annum during 2009-2012, which is good as long as the company is deploying cash to expand its capacity. However, the subsequent performance should be compared against the expected growth at the time of free cash flow decline. Unfortunately, the decline in the free cash flow during the last five years has not yet translated into revenue and profitability growth.

(click to enlarge)

The current price implies almost 4% annual growth in free cash flow for the next five years. However, during the first half of FY2013, EMR has reported $916m in free cash flow, requiring at least $1,472m in 2HFY13 for zero free cash flow growth this year. It will be interesting to see the numbers in this quarter as the company intends to cope with the anticipated sales decline by holding back on capital expenditure. I have listed below the fair-value sensitivity table under various assumptions on Annual Free Cash flow growth and Discount rate. It can be seen that the current price is based on an assumption of 10% annual free cash flow growth during 2013-2018 at a discount rate of approx. 9% (actual is likely to be even higher given the recent yield curve steepening)

(click to enlarge)

A flat free cash flow trend for the next five years results in a fair value estimate of $41, providing a downside of over 30% from July 19, 2013 close.

Catalyst

The share price will adjust accordingly to the potentially disappointing earnings during the next 4-6 months. The company has already expressed its concerns in the latest earnings conference call, which the market appears to have ignored. Here is what Emerson CEO David Farr told the analysts during that call;

In April and in particularly in the last couple of days, we went out and really pushed hard to find out where things were coming and the orders came in worse than expected, and we quickly realized that based on March, based on April, and what we're seeing with also the push out of improvements in gross fixed investment forecast in the most recent quarter and also the next quarter, we clearly see there's going to be a slowdown on our sales, and potentially, actually a negative sales quarter here that we're facing this quarter.

It is quite possible that the EMR stock price stays deviated from its fair value far longer than anticipated, but it should not be preclude an objective assessment of the growth assumptions behind the expensive valuations. Even for a long-term investor, it is better to book some profits as the opportunity comes by and the re-entry points can be set at lower levels to generate higher alpha.

Upside Risk

  • The order trend is stronger than anticipated during the next 6 months resulting in substantial growth in sales and profitability.
  • No goodwill impairment during the fourth quarter (we assume at least $250m in impairments).
  • Global economic growth picks up rapidly in the next 6 months.

Disclaimer: The opinion in this document is for informational purposes only and should not be considered as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. I do not recommend that anyone act upon any investment information without first consulting an investment professional as to the suitability of such investments for his or her specific situation.

Source: Emerson Electric Co.: Earnings Miss In 2nd Half Will Expose The Expensive Valuation