Expectations Improving Faster Than Results At Emerson

| About: Emerson Electric (EMR)
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I can understand why investors would be excited by the possibility of better results at Emerson (NYSE:EMR). Although this industrial conglomerate has been a middle-of-the-pack performer, the company's high exposure to emerging markets (and China in particular) makes it a good name to turn to when looking for growth or recovery prospects. That said, this quarter shows that Emerson is still Emerson and for every step forward, there seems to always be at least a little simultaneous scoot backwards.

Not A Bad Start To Fiscal 2013

Emerson reported results for the fiscal first quarter that weren't bad, but did have a few flaws to them.

Revenue rose about 5% as reported, with 6% underlying organic growth, which was good for a small beat relative to sell-side expectations. Within that, Process Management revenue rose a gaudy-looking 24%, but balancing out the disruptions in Thailand suggests real growth more on the order of the low-to-mid single digits (if the company is going to use external events to explain away bad results, those have to cut both ways when the comps recover).

Elsewhere, Industrial Automation saw reported revenue decline more than 7%, with a 6% contraction in underlying revenue. Network Power was unimpressive again (down more than 2%), while Climate Technologies rose more than 2% and Commercial/Residential Solutions declined 1% as reported and improved 4% on an underlying basis.

More so than with most industrial companies, a lot of analysts go with "home brew" adjustments to Emerson's reported profit figures. That doesn't necessarily speak well to earnings quality, and your numbers may vary depending upon what you in/exclude.

By my math, gross margin improved a full point, while operating income rose 19% on a 16% improvement in segment-level income. Margins improved more than a point on both lines, though the segment-level operating margin was more than a point below most analyst expectations (and part of the reason I maintain my "it's always something with Emerson" stance). On a slightly more positive note, the margin pressures seemed mostly related to volume-based deleverage and not anything fundamentally structural about the business.

Looking For The Year To Get Better… But How Much, And When?

Earnings quality wasn't so hot this quarter (the company would have missed most estimates by two to three cents on an operating basis), and guidance is likewise a little mixed. Management seemed basically confident about the year ahead and the possibility/probability of better results from China (more than 10% of revenue), but Emerson's performance is going to be somewhat back end-loaded (this quarter covers only about 17-18% of full-year guidance).

Based on the recent comments from United Technologies (NYSE:UTX) and Ingersoll-Rand (NYSE:IR), the climate business is getting better and there could be some upside here. Then again, it's a relatively small part of the company's total income and the residential/commercial spending recovery has proven to be longer and slower than most expected.

The biggest delta is how the automation business performs this year. Process automation is heavily exposed to oil and gas, and those peers that have reported so far (including Honeywell (NYSE:HON), General Electric (NYSE:GE), and Rockwell (NYSE:ROK)) have generally been maintaining their expectations of ongoing spending on large-scale energy projects.

Industrial automation is likely the bigger unknown. While Emerson, ABB (NYSE:ABB), Siemens (SI), and Rockwell should all be looking forward to selling more and more automation products into emerging markets as labor costs shoot up, this kind of capital spending is definitely economically-sensitive. Likewise, with about 40% of this segment's revenue coming from Europe, Emerson needs to start seeing better manufacturing and business confidence data from the Continent.

Did Siemens Just Clear The Way For An Acquisition?

Emerson and Siemens are competitors in the industrial automation market, but Siemens may have nevertheless done its rival a favor. Siemens and Invensys reached an agreement whereby Siemens is buying Invensys' rail automation/signaling business for close to $3 billion.

The reason this matters to Emerson is that it has long been interested in Invensys, but the presence of Invensys' rail and controls businesses created a problem - not only did they increase the size of the bid Emerson needed to make, but they weren't/aren't businesses that Emerson really wants and buying with the intention of selling can complicate deals for European companies (to say nothing of increasing the execution risk for the buyer). Now Siemens has taken care of the rail issue and the controls business is not likely to be a major impediment.

Invensys is a player in process and industrial automation, and one that would fit well with Emerson's existing business. Perhaps most importantly, Invensys would vault Emerson into the worldwide #1 spot in distributed control systems (DCS) and unseat ABB. DCS are vital to modern automated plants, as they control continuous processes (like refining, food/beverage manufacturing, steelmaking and so on) within minimal direct human interaction. They essentially make plants run these days, and it's a key business for ABB, Emerson, and Honeywell, and also Siemens and Rockwell to a lesser extent.

Not only would Invensys expand Emerson's revenue base, product line, and technological capabilities, it would also be a deal with ample synergies - offering Emerson some of the margin-rich growth it could really use. While it's easy to predict deals and much harder to actually do them, I'd keep an eye on Invensys now, as I'd be surprised if Emerson didn't try again (publicly or privately).

Good Growth Prospects, But Better Operational Performance Needed Too

Like most companies with strong positions in the automation field, I think Emerson has a chance at better-than-average growth (at least compared to the larger industrial category). Ongoing energy exploration and development (including the development of natural gas platforms and LNG facilities), new refineries in the emerging market, and increased factory automation all argue for strong revenue potential. To that end, I think Emerson can grow revenue more than 5% over the long-term.

Where Emerson needs to get its act together more is on the operational side. While the company has finally faced reality with its embedded power business, the overall performance of its network power business relative to Eaton (NYSE:ETN) and Schneider has been unimpressive and I wish management would have taken more drastic actions sooner.

To be sure, Emerson doesn't score poorly in areas like operating margins or return on capital, but there has been some slippage over the years and a look at fundamental metrics like cash conversion and incremental margins suggests that management is letting potential profits and cash flow slip away through some cracks. Caulk up these cracks, which I believe management can and will do over time, and I think Emerson could sport a relatively impressive high single-digit free cash flow growth rate over the next e to 10 years.

The Bottom Line

The downside to the Emerson story (apart from the "it's always something" nature of the company) is that investors have already bid up these shares in the general market melt-up. Up about 20% since the fall of 2012, Emerson has closed the gap on its fair value.

Speaking of fair value, an estimate of 8% long-term free cash flow growth (with a somewhat higher growth rate over the next five years) and a slight (50bp) penalty to its discount rate relative to ABB, Siemens, and Honeywell suggests a fair value of about $56 today. Removing the penalty lifts the fair value to $60, but you have to goose the long-term free cash flow growth rate above 10% to get into the high $60s with the fair value - given the amount of competition in the industry, the company's own performance history, and the nature of its business(es), that seems a little bold to me right now.

As a result, Emerson looks like a hold today on the fundamentals. Recognizing that stocks don't always (or often) trade just on fundamentals, I can see how renewed enthusiasm for growth in China and/or improving news from Europe could continue to move these shares. I just wouldn't personally be in a big hurry to pay up for them.

Disclosure: I am 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.