Capital goods tend to be more volatile than the broader market. This creates the opportunity for higher risk-adjusted returns. In this article, I will run you through my DCF model on Emerson Electric (EMR) and then triangulate the result with a review of the fundamentals against Honeywell (HON), General Electric (GE), and Boeing (BA). I find that Emerson is meaningfully undervalued.
First, let's begin with an assumption about the top-line. Emerson finished FY2011 with $24.2B in revenue, which represented a 15.1% gain off of the preceding year: acceleration. I model growth trending from 11.4% to 9% over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 60.5% of revenue versus 22% for SG&A, 3.6% for R&D, and 2.55% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -0.1% over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $66.83, implying 26.9% upside. The market seems to be factoring in a WACC of 11.7%, which is, in my view, overly bearish.
All of this falls within the context of disappointing performance:
Fourth quarter sales were down 4% to $5.3 billion, caused by several near-term challenges. Our supply chain disruption caused by the Thailand flooding impacted results by approximately $300 million. U.S. telecommunications carriers deferred investments, awaiting the outcome of potential industry consolidation. HVAC OEMs in the U.S. and China pushed inventories very low on economic uncertainty, and there was broad European economic weakness.
Operating profit margin declined 220 basis points from the prior year quarter to 13.2%, which is primarily driven by volume deleverage. Earnings per share of $0.50 was down 21% from the prior year quarter.
From a multiples perspective, however, Emerson is still attractive. It trades at just a respective 16.9x and 13.2x past and forward earnings. This compares to corresponding figures of 24.4x and 12.3x for Honeywell, 16.2x and 11.2x for GE, and 13.5x and 13.7x for Boeing.
Consensus estimates for GE's EPS forecast that it will grow by 13.1% to $1.55 in 2012 and then by 13.5% and 17.6% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $1.72, the stock would hit $24.08 for 21.7% upside. This conglomerate has become largely a financial through GE Capital, so the fundamentals are being discounted mostly due to a significant degree of perceived risk. No matter, analysts still rate the company around a "strong buy" according to NASDAQ.
Consensus estimates for Boeing's EPS forecast that it will decline by 14.6% to $4.55 in 2012 and then grow by 24.6% and 15% in the following two years. Much of the perceived in this industrial stems from uncertainty surrounding cuts to the Department of Defense. But, as I have illustrated in the past here, the company still has sustainable streams of free cash flow that the market is not fully appreciating.
Consensus estimates for Honeywell's EPS forecast that it will grow by 11.1% to $4.50 in 2012 and then by 11.8% and 12.7% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $4.98, the stock would hit $69.72 for 13.8% upside. The company is also rated around a "buy" on the Street. Thus, I strongly recommend investing in all four of the companies highlighted in this article.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.