Emerson Electric (EMR) and Honeywell International (HON) represent two attractive defensive plays. Whereas the former specializes in industrial automation, climate controls, and storage systems, the latter specializes in aerospace and defense. Strong customer loyalty, financial improvement, and ROIC expansion will provide a nice hedge against a stagnant economy.
From a multiples perspective, both firms are at reasonable levels. Emerson trades at a respective 15x and 12.2x past and forward earnings while offering a dividend yield of 3.3%. Honeywell, on the other hand, trades at a respective 16.1x and 11.6x past and forward earnings while offering a dividend yield of 2.9%. Honeywell has gross margins that are 1,600 basis points lower than that of Emerson and it thus has significant opportunities in trimming expenses. SG&A, for example, represents 14.1% of revenue and could easily be slashed.
At the third quarter earnings call, Honeywell's CEO, Dave Cote, noted stellar performance:
"[W]e had another great quarter with better-than-expected operational performance reflecting terrific execution and continued momentum in most of our key end markets, that yielded EPS above the high end of our range …
[W]e're obviously pleased the progress we made in the quarter on new repositioning actions, smartly redeploying book gains and CPG sale proceeds in the third quarter. Dave will take you through more details in a moment but we utilize both the gain on the sale of CPG, as well as the OPEB curtailment gains to fund substantial business repositioning. That will deliver tangible benefits in 2012 and beyond. So our reported sales were $9.3 billion, up 14% or 8% organic, reflecting continued advancement in our new products, high-growth regions and continued healthy end markets overall".
As 2012 gears up to be an inflection point, it is noteworthy that Honeywell has executed well from reinvested profits. In particular, management has taken the appropriate cost cutting measures and is penetrating into high growth markets for a sustainable advantage. Segment margins expanded 50 basis points to 14.7% in the quarter while EPS came out to $1.10, which was up 45% y-o-y and above even the high end of guidance. With a 103% net income conversion, free cash flow was further strong at $884M. And perhaps most importantly, management remains committed to returning free cash flow to shareholders with its high dividend yield.
Going forward, I anticipate that margins will rise by around 400 basis points by 2013 as the top-line grows at a high single digit rate. Over the same time period, ROIC will likely be expanded by 800 basis points and the firm will grow a net cash position of potentially $1.3B. On a more disappointing note, traffic volume deceleration from 5% for the year to date raises concern about growth normalizing below expectations. Inventory levels for aircraft are also rising, creating unexpected pricing pressure.
Consensus estimates for the firm's EPS are that it will grow by 34.7% to $4.04 and then by 9.9% and 11.9% more in the following two years. Assuming a multiple of 15x and a conservative 2012 EPS of $4.35, the rough intrinsic value of the stock is $65.25, implying 26.6% upside. Even if the multiple were to plummet to 13x and 2012 EPS turns out to be 7.7% below consensus, the stock would still appreciate. The Street, accordingly, rates shares near a "strong buy".
Wall Street is less bullish on Emerson due to irregular earnings and poor past execution. Fourth quarter was unexpectedly positive, especially in Industrial Automotive and Climate. EPS came out to $0.98, just slightly beating the consensus. Going forward into 2012, I anticipate improving financial condition and penetration into emerging markets with upwards of 7% sales growth. More share repurchases will follow and be accretive to EPS, thus driving value creation.
Consensus estimates for Emerson's EPS are that it will grow by 11.7% to $3.62 in 2012 and then by 11.3% and 11.7% more in the following two years. Assuming a multiple of 16x and a conservative 2013 EPS of $3.90, the stock has 27.5% upside. Even if the multiple were to fall to 13x and 2013 EPS turns out to be 7.4% below the consensus at $3.75, the stock price would hardly budge. The Street currently rates shares around a "buy".