Emerson Electric: An 8.9% Yield Or Double-Digit Gain

| About: Emerson Electric (EMR)

Summary

Emerson Electric's share price has declined materially as of late.

This is the sort of thing that long-term investors who believe in the company ought to be interested in.

This article describes a way to both own shares and see a much higher starting yield.

Emerson Electric (NYSE:EMR) turned out to be one of the "worst" performing dividend aristocrats of 2015, as the share price declined more than 20% over the course of the year. For the short-term speculator, surely this would be troublesome news. For the long-term owner, who is also apt to be a long-term net buyer, I'd contend this isn't as awful as it appears. If you're buying shares in the coming years - either with "fresh" capital, reinvested dividends or on your behalf via share repurchases - it's lower prices, not higher, that ultimately provide a benefit.

Of course the lower share price is also indicative of upcoming (or ongoing) concerns, or at the very least the perception of such. Emerson Electric was able to grow its earnings-per-share by nearly 9% per annum over the past decade. Just three times from 1999 through 2014 did the company see lower year-over-year earnings. Yet this happened again in 2015 and indeed earnings are expected to stagnant or even decrease once more for 2016.

In the short-term there are always concerns. Presently that means exposure to the energy sector, international currency headwinds, generally cyclical customer industries and so on. Of course it's the long-term that will ultimately drive the value of the business. As such, you have to make some assumptions about the future viability of the company. If you believe the business is in store for a continued long-term decline, naturally you wouldn't be interested. On the other hand, if you suspect that the company can bounce back as it often has, a lower share price makes the "investment bar" a bit lower. Emerson Electric doesn't need spectacular growth for an investment to work out reasonably well.

With that in mind, let's suppose that you're interested in partnering with the company and are content holding shares for years. You could simply do that, collecting a sizable dividend along the way. Yet you could also hold shares and simultaneously agree to sell at a higher share price. This isn't a recommendation, merely an illustration of what is out there. I find it prudent to explore a variety of alternatives in the investing universe. It's hard to know if you're making the best personal decisions if you don't know what all of your decisions could be.

When it comes to dividend increase streaks, it's hard to beat Emerson Electric. The company has not only paid but also increased its dividend for just shy of six decades. Had you invested any time in the last half century, each and every subsequent year you would have received more income. Although the last increase was lackluster (just 1%), the payout has grown by an average compound rate of about 8% during the past decade.

Based on today's price - call it $42.75 - the $0.475 quarterly dividend equates to a yield of about 4.4%. You could own shares, collect this above average dividend yield and see what happens in the coming years. Of course there is a way to increase this income component if you're looking for an even higher cash flow. For instance, you could sell a covered call and receive an upfront premium. Let's see what this could look like.

As of this writing the January 20th 2017 call option with a $47 strike has a bid of about $2, call it $1.90 with transaction costs. So this means that you could receive an entire year's worth of expected dividend payments today for agreeing to sell your shares at a price of $47 anytime in the next year.

There are two basic outcomes that could be derived from this option: either it is exercised or it is not. If the option is not exercised, you would continue holding shares of Emerson Electric just as you had planned on doing all along. You collect the dividend payments and you still have the same underlying ownership claim on the business. The difference is that you also received ~$190 for making the agreement. In total your cash flow would equal ~$380 (perhaps more with a dividend increase) good for a yield of 8.9%. The option premium could be taxed as ordinary income, but it's clear that selling the option is the preferred outcome if the share price remains below $47.

The second possibility is that the option is exercised, as would likely be the case if the share price were to be above $47. In this scenario, you would collect $4,700 for your shares to go along with the ~$190 worth of option premium that you started with. Additionally you could collect dividends along the way, but we'll first look at the lesser case. With just the sold shares and premium, your total gain from today's share price would be about 14%. If you also received dividend payments, this gain could be closer to 18.4% (including transaction costs).

Those are the two basic outcomes in that scenario. Either you collect a nearly 9% cash flow yield or you agree to sell your shares with a gain in the 14% to 18.4% range. Given that high single digit returns are often gauged as reasonable, both alternatives appear to be somewhat compelling.

Of course that's certainly not to suggest that risks are not involved. The first point to be made relates to the possibility of a negative total return. Should shares decline say 20%, your total return with selling the covered call would still be negative 11% or thereabouts. Selling covered calls do not prevent a potential "loss." However, if you planned on owning shares anyway, your "downside protection" is going to be higher. In that same situation of a 20% decline in the share price without selling a covered call, your return would be closer to negative 15.5%.

A secondary risk relates to "capping your gain." For instance, let's say that shares trade at $52 by the end of the period. Had you simply held the shares, your total gain would have been about 26%. By selling a covered call (assuming you received dividends as well) your maximum gain would be "just" 18.4%. There exists the risk of "sellers remorse" whereby you agree to an 18% return, but shares jump up 20%, 30% or 40%. In this regard its paramount to be content with either outcome.

In short, the material decline in Emerson Electric's share price ought to look more appealing for those that believe in the long-term economics of the business. If considering a partnership decision today, you have a 4%+ dividend yield along with a solid ownership claim. Alternatively, you could look at both owning shares and selling a covered call such as the example above. There are many more varieties, but in this scenario you could double your income yield or else agree to a 14%+ annual gain.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.