By The Valuentum Team
Emerson Electric (NYSE:EMR) is among the oldest industrial goods companies, giving voice to the firm's staying power and ability to adjust to varying economic cycles in its 125+ year history. The company serves a variety of industrial, commercial and consumer markets, some of which are cyclical, but many of which have long-term secular trends supporting them.
However, Emerson has hit a bit of a rough patch as of late, as suppressed oil prices and slow growth in global industrial capital spending significantly impacted order growth in recent quarters. Both of these headwinds are expected to continue providing pressure to the firm's businesses as crude prices remain suppressed, global economies continue to fail to show core strength, and uncertainty surrounding Brexit could continue to weigh on the capital spending trends of a material portion of the developed world.
As a result of such weakness, Emerson has issued guidance for fiscal 2016 that leaves a great deal to be desired. The firm expects "Conditions to remain challenging, but demand has begun to stabilize or improve in certain markets." Underlying sales are projected to be down 2-5% when ignoring the impact of currency headwinds and recently completed divestitures. Adjusted earnings per share guidance has been issued in a range of $3.05-3.25 compared to $3.17 in fiscal 2015.
Despite near-term headwinds, we are still high on Emerson's dividend prospects, a main draw for investors considering its ~3.6% yield. The firm has increased its dividend for each of the past 59 years, earning it a place on the coveted list of Dividend Aristocrats. Strong free cash flow generation has been the base on which Emerson has built this impressive dividend track record, and though free cash flow suffered in fiscal 2015, it has averaged well over $2.5 billion in annual free cash flow generation over the past three years. We think this free cash flow generation and a reasonably healthy balance sheet will support continued dividend increases moving forward, and management will not let its track record go easily.
Emerson Electric's Investment Considerations
• Emerson offers a wide range of products and services in the industrial, commercial and consumer markets through its Process Management, Industrial Automation, Network Power, Climate Technologies, and Commercial & Residential Solutions businesses. The company was founded in 1890 and is headquartered in St. Louis, Missouri.
• Current market conditions are weighing on top-line results, as the uncertainty in oil prices and slow growth of capital spending across the globe have forced management to reevaluate its expectations. The firm is reviewing its cost structure and cutting jobs, which will result in significant SG&A savings.
• Underlying sales trends have not been encouraging in recent quarters. Global economies are not displaying much core strength as industrial capital spending has been weakened. The firm remains well positioned for a rebound in residential construction in North America, and regulatory changes can offer short-term boosts in demand.
• Reported top-line numbers aren't too indicative of the strength of Emerson's core business. For example, in fiscal 2015, reported net sales fell by 9% to $22.3 billion, but underlying sales dropped a mere 2% in the period. Currency and divestitures are impacting performance, and we're not sure when currency headwinds will subside.
• You can't talk about Emerson without mentioning its fantastic dividend growth profile. The firm's dividend yield and Dividend Cushion ratio offer an excellent combination. It is a former holding in the Dividend Growth portfolio.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Emerson Electric's three-year historical return on invested capital (without goodwill) is 40.1%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Emerson Electric's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.8 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Emerson Electric's free cash flow margin has averaged about 10.7% during the past three years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Emerson Electric, cash flow from operations decreased about 31% from levels registered two years ago while capital expenditures expanded about 1% over the same time period.
Through the first half of fiscal 2016, Emerson Electric reported cash from operating activities of $929 million and capital expenditures of $359 million, resulting in free cash flow generation of $570 million, representing a more than 40% decrease from the year-ago period.
This is the most electric portion of our analysis. Below, we outline our valuation assumptions and derive a fair value estimate for shares.
We think Emerson Electric is worth $51 per share with a fair value range of $41-$61. Shares are currently trading at ~$51, very close to our fair value estimate. This indicates that we feel there is a similar amount of upside potential and downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our top- and bottom-line expectations for fiscal 2016 and 2017 are very similar to consensus estimates for Emerson Electric. Uncertainty in the energy markets and suppressed growth in industrial capital spending around the world are expected to weigh on near-term results. The company is working to optimize its cost structure as a result, which should help earnings performance rebound more quickly than revenue in fiscal 2017 and beyond. We're anticipating ongoing investments into its business, however.
Our model reflects a compound annual revenue growth rate of 0.4% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of -3%. Our model reflects a five-year projected average operating margin of 18.1%, which is above Emerson Electric's trailing three-year average.
Beyond Year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Emerson Electric, we use a 9.7% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $51 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Emerson Electric. We think the firm is attractive below $41 per share (the green line), but quite expensive above $61 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Emerson Electric's fair value at this point in time to be about $51 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Emerson Electric's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $63 per share in Year 3 represents our existing fair value per share of $51 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.