There's not a lot more left to say about the state of multi-market industrial conglomerates that I haven't already said. Companies that have outsized exposure to commodity/resource markets and emerging markets, and that definitely includes Emerson (NYSE:EMR), are getting hit hard and there isn't much relief in sight. Although Emerson's CEO believes that orders will bottom in the spring of this year, that's well outside of the norm of what most peer company CEOs are saying and the company's lack of exposure to relatively healthier markets like aerospace, auto, food/bev is a drawback.
Emerson has been going through tough times longer than its peer group and management seems more realistic about the need for capacity curtailments. Even so, I think the company could find it hard to get full value for its Network Power business and the Industrial Automation assets it has targeted for sale. Emerson scores well for its margins and returns on capital, but it's hard for me to see how the company generates enough revenue growth to really drive an attractive fair value from here.
It Wasn't Good…But It Was Better Than Expected
Those companies exposed to the automation sector actually did better than expected this quarter, but Emerson's outperformance is overshadowed by the ongoing challenges in the market.
Revenue fell 16% as reported, but 9% on a "core" basis, and beat the average sell-side estimate by a bit (less than 2%). Most of the performance was driven by Network Power (down 1% core, more than 6% ahead of expectations), though, and I think most investors and analysts have largely written off this business by now.
In those businesses that I'd consider core to Emerson, automation and Climate, the performance was not as robust. Revenue in Process was down 11% on a core basis, about 5% better than expected, but Industrial Automation was down 15% and about 5% below expectations. All told, automation was about 2% better than expected - ABB's (NYSE:ABB) automation business was 3% ahead, Rockwell Automation (NYSE:ROK) was about 3.5% ahead, but Siemens (OTCPK:SIEGY) was about 2% below expectation. Climate was down 10%, and Commercial and Residential Solutions was down 2%.
Gross margin weakened by 70bp and segment profits were down about 25%, leading to about two points of margin compression. Profits in both Process and Industrial were down sharply, but the company's segment margins were still better than those of ABB (helped by a richer mix of field instrumentation and controls). The other businesses all saw double-digit declines, but none worse than the 17% in CRS.
Exposures Telling The Tale
I definitely believe that some of Emerson's performance was due to its product mix. Field instrumentation was a weak area in process automation (it was weak at Honeywell (NYSE:HON) too) and Emerson does seem to be holding up a little better than Pentair (NYSE:PNR) with its valves and controls. Still, it was a weak performance all around relative to Honeywell, ABB, Rockwell, and Yokogawa (OTCPK:YOKEF), and Emerson's heavy exposure to the oil and gas business is clearly taking a toll - Rockwell talked about a 30% decline in its sales to U.S. oil/gas customers, and Emerson's exposure is about twice the norm for process automation companies.
Emerson also seems to be paying the price for a brief stretch of outperformance last year in its Climate business. Emerson jumped ahead of companies like Ingersoll-Rand (NYSE:IR) and Regal Beloit (NYSE:RBC) last year, but that's reversing now as inventories related to the SEER 13-14 transition are getting worked out.
On the brighter side, management has been pretty forthcoming about what's going on in the businesses. Better still, the CEO seems to think that orders could bottom in April. That sounds more optimistic than the outlooks from Honeywell and Rockwell, but ABB at least does see "some positive signs" in the U.S. at this point in 2016.
How Much Can Management Do To Drive Better Results?
When it comes to the health of the oil/gas, power, chemical, and refining markets in automation, there's very little that Emerson management can do. E&Ps are slashing their capex budgets and weakness in E&P has been flowing into chemicals and refining. I do think power is looking better but that's a strong spot for ABB. It's also too late now for Emerson to turn to the software products that are helping Honeywell and Rockwell to offset the weakness in field instrumentation.
Looking further ahead, Emerson has challenges that go beyond automation. Does anybody look at SPX FLOW (NASDAQ:FLOW) or Knowles (NYSE:KN) and feel excited about the prospects for Emerson's network power business on a standalone basis? Selling the business would be a better outcome, but this doesn't look like a market that's conducive to Emerson getting good value; while it will aggravate some shareholders, maybe Emerson is better off trying to hang on a little longer. Likewise with the parts of Industrial Automation that management has targeted for sale - I don't know if it's going to be possible to get good value for motors and drives right now. I also don't think that Emerson's current balance sheet supports big-time M&A, so any improvement-by-acquisition is likely to be modest.
I do think management has done better at taking costs out of the business, and I think this is a higher-quality business than it sometimes gets credit for - while take "reader's choice" awards for whatever you think they're worth, the recent Control Magazine awards saw Emerson score pretty well behind Rockwell.
I still think that generating exciting top line growth is a real challenge for Emerson. I'm looking for around 2% to 3% growth from the starting point of last year and close to 4% growth from this year and I think management can still drive incrementally higher FCF margins. That gives an outlook for around 7% annualized FCF growth, which is basically what I'm expecting from ABB and Honeywell. That's only worth about $48 per share in fair value, though, and my ROE-driven model likewise gives me a $45 target on a 26% ROE (and still just $52 on a 30% ROE).
The Bottom Line
I see Emerson as doing the best it can in a tough spot. I suppose an argument can be made that the company's automation assets could be run better, but the company's over-reliance on oil/gas and process (versus discrete) are drawbacks. Maybe Emerson can find a way to get better value for the Network Power and select Industrial Automation assets, but failing that (and/or a faster, stronger recovery in oil/gas) it's hard to get excited about this stock.
Disclosure: I am/we are long ABB.
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.