Seeking Alpha
Long only, deep value, value
Profile| Send Message|
( followers)  

Summary

  • Management is focused on transforming the company to increase profitability in the intermediate term.
  • Divesting of low-margin businesses and focusing on higher-margin businesses should increase profitability.
  • A rising dividend payout and substantial share repurchases will reward shareholders while waiting for the business transformation to lift profitability.

Emerson Electric's (NYSE:EMR) shares have not participated in the overall market's rise to new highs in 2014. The shares are down about 7 percent in 2014, as the company reported in its latest quarterly earnings, a lower-than-expected quarterly profit and sales pointing to "persisting economic challenges," indicating that its full-year results would be at the low-end of the company's estimates. The company's shares currently yield about 2.5 percent, and the company has a long history of yearly dividend increases. While no stock should be considered a "safe stock" without any risk, EMR shares are relatively safe in comparison to many high-profile stocks, and should be strongly considered as a building block of any long-term investor's portfolio. The company is beginning to transform its portfolio of businesses to focus on higher-growth and higher-profit businesses. In the intermediate and long term, shareholders will benefit. In addition, some insiders purchased large amounts of EMR shares in 2014 at prices higher than the current share price.

Background

EMR is an industrial conglomerate operating in five business segments: 1) process management; 2) industrial automation; 3) network power; 4) climate technologies; 5) and commercial and residential solutions. The company generated about 55 percent of revenues in the U.S. and Canada during fiscal year 2013, with 23 percent from Asia, 12 percent from Europe, 6 percent from Latin America, and the remainder from Middle East and Africa. Those divisions produce and/or provide services as follows: 1) the process management division produces process management software and systems, analytical instrumentation, valves, control systems for measurement and control of fluid flow, and integrated solutions for process and industrial applications; 2) the industrial automation division manufactures industrial motors and drives, transmissions, alternators, and controls for automated equipment; 3) the climate technologies division manufactures home and building thermostats and compressors (cooling components used in heating and air conditioning units and refrigerators); 4) the commercial and residential solutions division manufactures household appliances, handheld tools, piping and other related equipment, and storage solutions; and 5) the network power division manufactures power systems and precision cooling products used in computer, telecommunications and Internet infrastructure sold mainly to large data centers.

Fiscal 2014 third-quarter earnings

In August 2014, EMR announced that sales for the fiscal 2014 third quarter decreased 1 percent, including a divested business. Underlying sales grew 3 percent. Sales in North America and Europe were up 4 percent, and Asia was up 3 percent, as business conditions continued to improve slowly and unevenly across markets and geographies. Growth in mature markets was stronger than in emerging regions, reflecting global political instability and economic uncertainty in some developing countries. Earnings per share were $1.03, and grew 6 percent. Share repurchase activity remained high, with over $700 million completed year-to-date.

The CEO of EMR characterized the market conditions as follows: "Fundamentals continue to gradually strengthen, but persisting economic challenges in some markets and rising geopolitical tension have hampered growth, which is not expected to improve in the near term. In light of the sluggish conditions, operations executed well in the quarter, driving margin expansion, generating robust cash and maintaining focus on strategic investment programs, emphasizing our commitment to investing for long-term growth." Each division of EMR performed as follows: 1) process management net sales grew 6 percent, supported by stable and sustained levels of investment in the global energy and chemical industries; 2) industrial automation net sales increased 1 percent as demand for industrial goods continued to recover slowly, but trends across markets and geographies was mixed; 3) network power net sales declined 18 percent (reflecting the impact of a divested business), as growth was strong in the global telecommunications infrastructure business, led by double-digit gains in Asia; 4) climate technologies net and underlying sales increased 6 percent, as growth was balanced across all geographies and the global refrigeration business remained strong, with double-digit growth; and 5) commercial and residential solutions' net and underlying sales grew 4 percent, with sequential improvement reflecting the impact of harsh winter weather in North America in the previous quarter.

EMR indicated that despite areas of ongoing uncertainty around the world, economic momentum continues to improve gradually but unevenly. With the end of the 2014 fiscal year approaching, the company expects results in financial performance to trend to the low-end of previously estimates of 3 to 5 percent underlying sales growth, with earnings per share in the range of $3.68 to $3.80. The company's CEO indicated, however, that "robust orders growth in the spring has driven backlog to a record level, supported by large projects with long lead times, and strategic investment programs continue to progress well, providing a foundation for a more favorable growth environment next year."

Intention to divest additional business announced

About a week after the earnings announcement, EMR announced its intention to sell its power transmission solutions business in a deal that could be worth more than $1 billion. EMR is preparing for an auction in the fall, and is in the early stages of contacting potential buyers, including other industrial companies and buyout firms. The power transmission business is estimated to have earnings before interest, tax, depreciation, and amortization of around $120 million, and could be valued at about 10 times that amount in a sale. Emerson's decision to divest the division is the continuation of a trend by large conglomerates to streamline their business lines and focus on high-growth areas.

Large insider purchases in 2014

One of the most positive signs to a potential investor in a company's stock is an insider purchase of shares on the open market that is substantial, and not just a mandatory token purchase required by the company. Earlier in 2014, two insiders made substantial purchases of EMR shares on the open market. On May 8, 2014, EMR directors Randall Stephenson and Arthur Golden bought 7,455 and 3000 shares of the stock respectively on the open market. The stock was purchased at an average price between $67.06 and $67.12 per share, for total transactions of $499,932 for Mr. Stephenson and $201,360 for Mr. Golden.

Competitors and risks

Some of EMR's competitors include ABB Ltd. (NYSE:ABB), General Electric (NYSE:GE), Hitachi, Honeywell (NYSE:HON), Danaher Corp. (NYSE:DHR), Cooper Industries (CBE), Rockwell Automation (NYSE:ROK), Roper Industries (NYSE:ROP), Ametek (NYSE:AME), Siemens AG (OTCPK:SIEGY), and Schneider Electric SE (OTCPK:SBGSY). The U.S. electrical equipment industry is divided into two areas, electrical components & equipment and heavy electrical equipment. The electrical components & equipment segment includes manufacturers of small-scale electrical equipment, such as motors, electric heating, and cooling systems, small generators, storage batteries, and related equipment. The heavy electrical equipment segment includes manufacturers of power-generating equipment and other equipment, such as power turbines, machinery for fixed-use, and large electrical systems. The industry is cyclical, and manufacturers distribute their products to other manufacturing industries, wholesalers, and the construction industry.

The industry may incur significant expenditures going forward because of the need to produce manufacturing equipment with lower carbon dioxide emissions. Low interest rates may boost capital expenditure and mergers and acquisitions in the domestic market. Demand for electrical transmission and distribution equipment is expected to grow due to anticipated increases in non-utility generation and regulatory activities, which will spur investment in the electric grid.

Analysts' views and our views

Analysts believe that EMR is well-positioned to benefit from any strengthening in the global economy. They also indicate that the company's shares are fairly valued at recent levels. The outlook for global fixed investment remains subdued, but orders across EMR's business divisions, including those in Europe and Asia, have bottomed. In addition, analysts see increased construction spending in North America and continued global energy investments. Overall, analysts recommend EMR shares for the long term on valuation grounds, as many of the recent company's challenges are beginning to fade. Analysts' ratings in the near term are mixed about evenly between "hold" and "buy" ratings for EMR, with price targets ranging from $68.00 to $76 a share.

We tend to agree with analysts and their intermediate- and long-term outlook for EMR. Management of EMR is working to transform EMR by exiting low-margin businesses and focusing on higher-margin businesses. This transformation is ongoing, and the results will become more appreciated by Wall Street and individual investors in the next 18 to 24 months. EMR's current price-to-earnings ratio is about 22.5, its fiscal 2014 year (ending September 2014) earnings estimate is $3.69, and its 2015 fiscal year earnings estimate is $4.11. The company's forward price-to-earnings ratio is about 15.3, based on fiscal 2015 year earnings estimates. We believe that now is time to initiate a long-term position in EMR shares to take advantage of the company's ongoing business portfolio transformation. Our confidence in such recommendation is strengthened by large EMR insider share purchases earlier this year at prices higher than the current share price. Over the long term, EMR will reward investors with increasing dividends, substantial share repurchases, and a rising share price.

Source: Emerson Electric: A Business Transformation Play And Increasing Dividends