Emerson Electric: Goodbye Low-Margin Businesses, Hello $5 Billion In Acquisition Funds

| About: Emerson Electric (EMR)

Summary

The company, during its most recent earnings report, lowered fiscal 2016 revenue and earnings estimates as it continues to face adverse business conditions.

The company expects continued weak global economic circumstances, with a strong U.S. dollar, depressed industrial spending and weakness in emerging and mature economies.

The company, however, has been focusing on driving revenue and earnings growth by exiting low-margin businesses and focusing on higher-margin businesses.

The company is in the midst of multiple business divestitures raising billions in acquisition funds that will finance a substantial acquisition of a higher-margin business in a growth market.

Investors should consider the company’s shares for an over 3.5 percent dividend as the company transforms by acquiring businesses with higher margins to drive revenue and earnings growth.

In recent years, Emerson Electric's (NYSE:EMR) transitional strategy towards higher margin businesses in growth markets has been in place as a weak global economy and deeply depressed oil prices have decimated its revenue and earnings results. (We have pointed out previously that commentators have noted that depressed oil prices have adversely affected EMR's largest division, which provides software and instruments for controlling and measuring liquids that assist oil explorers to efficiently pump oil).

Initial steps in EMR's strategy have involved the divestiture of lower margin businesses through the outright sale such businesses. To date, as noted below, EMR has announced the divestiture of multiple business units for over $5 billion. The proceeds from such divestitures will soon be added to EMR's war chest to fund acquisitions of businesses participating in higher-margin markets. In addition to the company's reshuffling of its business units, EMR continues to review, assess and realign its corporate services and structure given its planned smaller scale. EMR's upcoming divestiture of multiple business units noted below is a continuation of the company's strategy to: 1) exit many of its weaker-performing businesses, and 2) allow it to improve the growth of its better-performing divisions through acquisitions. In a previous article, we noted that EMR would engage in a strategy to grow long-term through acquisitions. (For a more detailed discussion of EMR's acquisition options, see this article).

In recent years, however, EMR has not announced any significant acquisitions. Rather, the company has focused on improving revenue and earnings growth by exiting low-margin businesses, focusing on higher-margin businesses and restructuring initiatives. Investors, however, have grown frustrated with EMR's efforts and now believe the company must make more substantial acquisitions to boost revenue and earnings growth.

Analysts and investors have suggested the company grow its business in discrete automation (the equipment and software for assembly lines) through acquisitions of companies or business divisions such as: 1) National Instruments Corporation (NASDAQ:NATI), 2) Mitsubishi Electric Corp.'s factory-automation division, or 3) Rockwell Automation Inc. (NYSE:ROK).

EMR's most recent earnings report revealed that the ongoing adverse business conditions it has faced continue to depress its operational results. The company expects global economic circumstances to remain difficult, with a strong U.S. dollar, depressed industrial spending and weakness in emerging and mature economies. The company also projects a decrease in near-term profitability due to volume deleveraging arising from weakness in underlying sales and the impact of restructuring initiatives.

Further, EMR expects the oil and gas markets it sells into to remain significantly depressed thereby constraining spending levels by participants in such market. EMR also expects: 1) about $200 to $250 million in related to its spinoff and business unit divestitures, 2) a loss of about $100 million in relation to the sale of its Leroy-Somer and Control Techniques business units, and 3) to incur restructuring expenses of about $90 to $100 million in 2016.

Positive near-term factors also exist for the company as it moves forward. The company expects its cost cutting and restructuring initiatives to boost its results as it moves forward. In addition, the company expects robust order trends in the data center and telecommunications infrastructure markets to aid sales results as well.

We believe that the company's portfolio repositioning strategy, as it seeks to focus on its core Automation Solutions and Commercial & Residential Solutions businesses, will enable it to leverage its growth platforms and drive long-term revenue and earnings growth.

We also believe that the company will take more significant steps to jump start revenue and earnings growth through more substantial acquisitions using the more than $5 billion in divestiture proceeds noted elsewhere in this article. We further believe that investors should consider EMR's shares during an overall market selloff and collect an over 3.5 percent dividend to reinvest until the company announces further steps to drive growth in the intermediate term.

Fiscal third quarter 2016 earnings

In early August 2016, EMR announced adjusted earnings of 80 cents per share, a 4.8 percent decrease from the year-ago quarter due to weak demand conditions in key markets and global economic uncertainty. Results did, however, benefit from restructuring initiatives and strong margin improvement in the company's network power, commercial and residential solutions and climate technologies divisions.

Net sales decreased 7 percent from the year-ago quarter to $5.126 billion due to negative global underlying sales growth except for flat European results. The company attributed its continued sales decline to ongoing challenging macroeconomic conditions and a significant decrease in global customer spending in the oil and gas and industrial markets.

EMR's process management division net sales decreased about 13.4 percent to $1.804 billion due to low order rates given depressed global oil and gas industry spending. The company's industrial automation division recorded a 10.8 percent decrease in net sales to $883 million due to ongoing weakness in industrial spending and upstream oil and gas markets.

The company's network power division, however, reported a net sales increase of 8.1 percent to $1.111 billion due to strong data center and telecommunications infrastructure spending. Net sales for the climate technologies division decreased 2 percent to $1.102 billion due to strong demand in the U.S. air conditioning and commercial refrigeration market. Net sales for the commercial and residential solutions division decreased 16.1 percent to $400 million due to the company's divestiture of its commercial storage business.

EMR expects fiscal 2016 net sales to decrease 9 percent to 10 percent, a decrease from prior estimates of 5 percent to 8 percent. The company also expects adjusted earnings per share for fiscal 2016 to be between $2.90 and 3.00, a decrease from prior estimates of $3.05 to $3.25 per share.

The company increases acquisition funds by divesting multiple businesses

In early August 2016, EMR announced the sale of its Leroy-Somer and Control Techniques business units to Nidec Corporation for $1.2 billion. Upon announcement of such sale, EMR noted that the transaction represented another step in its "strategic repositioning to restructure and align our business amidst a challenging global macroeconomic environment. Upon completing the transaction, EMR noted it will be better positioned to "accelerate growth and value creation over time."

The Leroy-Somer and Control Techniques business units, which have been leading manufacturers and suppliers of alternators, drives, and motors, had combined fiscal year 2015 revenue of about $1.7 billion. The sale of such business units were not the only sales EMR announced in early August 2016.

EMR also announced its agreement for the sale of its Network Power division to Platinum Equity and a group of co-investors for about $4 billion and that it will retain a subordinated interest in such division. In regard to its sale of such division, EMR noted that such sale is part of its ongoing plan to streamline itself into "a more focused company with significant opportunities for growth and profitability in our core served markets." The Network Power division, which had revenue of about $4.4 billion in fiscal 2015, is a leading provider of thermal management, A/C and D/C power, transfer switches, services and information management systems for the data center and telecommunications industries.

With each of the above-announced divestitures, EMR is executing its plan to raise capital to strengthen its balance sheet to provide it increased capacity for strategic investments. In recent years, the company has been focusing on driving revenue and earnings growth by exiting low-margin businesses and focusing on higher-margin businesses.

We expect EMR to announce acquisitions within the next 12 to 18 months to further such strategy of driving growth through higher margin businesses participating in markets experiencing growth.

Our view

It is only a matter of time until EMR announces a major acquisition. That time, however, is likely to occur at the earliest in late 2016, or more likely in 2017 after the above-noted divestitures are complete and the company has over $5 billion cash in hand. An investor can approach this scenario in two ways. First, an investor can invest in EMR shares and collect a sizeable dividend until an acquisition is announced.

Subsequent to such acquisition, an investor will continue to likely recognize moderate share price appreciation and improved dividend increases resulting from the company's shift in its business portfolio towards higher-growth higher-margin businesses. The second approach to this scenario is to acquire shares in companies such as NATI, ROK or others that an investor believes is likely to be an acquisition target. This article, however, focuses more on scenario one.

EMR's most recent earnings report showed it reducing its revenue and earnings estimates yet again for fiscal 2016 due to a continued weak global economy, a depressed oil and gas industry and costs arising from restructuring and divestiture efforts. The company is experiencing pockets of improvement, however, due to restructuring efforts and an improved operational performance as the company continues to fight weakness across most of its businesses and weak revenue growth.

The company expects adverse operating economic conditions to continue, but does recognize signs of demand stabilization and improving order trends. The company also expects a continued weak global economic environment, a strong U.S. dollar, depressed industrial spending and weakness in emerging and mature economies. Further, EMR expects lower near-term profitability due to weakness in sales and restructuring initiative costs. The company's cost cutting and restructuring efforts, however, are improving margins and cash flow and will continue to benefit the company.

Despite EMR focusing on driving revenue and earnings growth by exiting low-margin businesses and focusing on higher-margin businesses, it will likely need to announce more substantial acquisitions to allow for revenue and earnings growth. We believe that the company needs to take more significant steps to drive growth. Strategic acquisitions in growing markets that enjoy higher margins would allow EMR to expand its presence in growing industries while decreasing its overall reliance on its oil-price-pressured process management division.

EMR's free cash flows from its business operations added to cash already held when added to cash received from any divestitures or spin-offs will provide more than adequate funds to make medium or large-sized acquisitions. In addition, we should note that the company halted its share repurchase plan in its fiscal second quarter 2016 to increase its cash on hand in anticipation of funding possible acquisitions.

EMR's current price-to-earnings ratio is about 19.05, and the forward price to earnings ratio is 18.35 based on the company's fiscal 2016 earnings estimate of $2.93, and 18.30 based on the company's fiscal 2017 fiscal year earnings estimate of $3.10. We should note that earnings estimates for both years have decreased significantly in recent months. We recommend that investors consider purchasing EMR shares during an overall market sell off between $45.00 and $49.00 or they can purchase potential acquisition targets NATI or ROK as noted above.

Finally, we continue to note that in recent years, a few EMR insiders have made what we consider substantial insider purchases that are a sign to us of such insiders' belief in the company's transformation plan. In the near term, EMR investors will be paid an over 3.5 percent dividend yield to reinvest as the company transforms. Over the long term, we believe EMR's transformation will reward investors with increasing dividends, substantial share repurchases, and share price appreciation from revenue and earnings growth due to upcoming acquisitions and restructuring initiatives.

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Disclosure: I am/we are long EMR, NATI.

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.