Emerson Getting Better, But The Market Is In Step

| About: Emerson Electric (EMR)
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Summary

Process management continues to generate double-digit order growth, fueled by strong oil and gas project demand.

Network power should be on its way back to double-digit margins and a more competitive array of products, while organic entry into the discrete automation market will take more time.

Emerson seems pretty fully valued, though a 10x multiple to 12-month EBITDA will generate a $70 fair value.

Investors who bought Emerson (NYSE:EMR) a year or two ago on the expectation that a combination of better execution from management and improving markets would lift the stock have done okay. The shares are up about 17% in the eighteen months or so since I last wrote on the stock, but peers and rivals like Eaton (NYSE:ETN), Rockwell Automation (NYSE:ROK), and Honeywell (NYSE:HON) have all done substantially better (up 30% to 40%) and ABB (NYSE:ABB) would have been in that group as well if problems in its Power business hadn't smacked the stock after first quarter earnings.

Unless Emerson grows well above management's current expectations, the shares look pretty fairly and fully valued today. Process automation orders are picking up nicely and Network Power would seem to have nowhere to go but up, but Industrial Automation could still be a little volatile before settling into a growth trajectory. It's hard for me not to like a "turnaround" story with double-digit returns on invested capital, but I'd rather own Eaton or ABB within the comp group today.

Process Automation Coming Back

Emerson reported May orders about a week ago, and the company continued its streak of 8% yoy order growth, helped by a big surge in orders in March that will roll off next month. Industrial Automation orders have slowed from a 5% to 10% growth pace to 5%, while Climate Tech orders remain volatile (from "0% to 5%" to "5% to 10%" to 5%).

Amidst this, Process Management (the company's process automation business) continues to be a star - with growth accelerating from the low teens to 15% over the past three months (Emerson reports orders on a rolling three-month yoy basis). Management had previously indicated that large orders in upstream and downstream oil and gas were moving forward and this applies some pressure on Honeywell, Siemens (OTCPK:SIEGY), and ABB to keep pace or acknowledge share loss in a market that should have pretty good multiyear growth prospects from projects in the Middle East and shale-related projects in North America and China.

It is worth remembering, though, that orders don't mean revenue right away - Emerson has seen some pushouts in the past and actual organic revenue growth in PM in the fiscal second quarter slowed to 1% despite prior months of strong order bookings.

Network Power Almost Has To Get Better

After years of absorbing poor performance in the Embedded Computing and Power segment of Network Power and over $1 billion in writedowns, the company did sell half of this operation to Platinum Equity late in 2013. Now Network Power is more skewed toward power and services to data center customers. What's more, the company recently won a major contract from Facebook for data center power products in Scandinavia.

Margins in this business are still pretty awful relative to the rest of the business (8.7% in fiscal Q2 versus 16.7%), but they're getting better on an annual and sequential basis. Data center and telecom customers do still have a real need for reliable power systems and thermal management and even for all of its problems Emerson remains a big presence in this market. With the worst part shaved off, Emerson is relatively competitive against Eaton and Schneider and there should be meaningful margin upside - at least to low teens that Eaton achieves.

Aggressive Goals In Automation

I was a little surprised back during Emerson's analyst day when it announced its plans to enter the discrete automation market. Strategically it makes a fair bit of sense - it will offset the very volatile alternator business and move up the value chain into the control plane. Management is saying the right things - it doesn't want to do a large deal, it wants to focus on organic opportunities, and innovative products like motors with integrated PLC and its own discrete PLC products.

On one hand, Emerson does have a large installed base of motors and drives to address and the company has a pretty good history of developing solid software capabilities in other businesses like Process and Network Power. On the other hand, Rockwell, Siemens, and Schneider are waiting for Emerson and it's not going to be easy to gain share in this market. Given management's dicey recent history with large M&A, this was probably the most palatable way to enter the market, but it's going to be challenging all the same.

Good Markets And Opportunities

For its mistakes and missteps, Emerson still compares pretty well to most industrials with operating margins in the mid-teens (depending on which adjustments you make) and low-teens ROICs. Process automation should be a solid market for a number of years and the company's hefty exposure to emerging markets (about 35% of sales) should support growth in process automation, industrial automation, and network power.

I'm looking for long-term annual revenue growth a little above 4% a year, with stronger growth over the next three years and some upside from its foray into discrete automation. I'm also looking for better operating profits and cash flow generation efficiency, with FCF margins in the low to mid teens. That supports solid mid-high FCF growth over the next decade, but that doesn't discount back to a compelling fair value today. The shares likewise don't look all that cheap on the basis of ROE/PBV, but a 10x multiple to 12-month EBITDA (the going rate for a lot of industrials right now) does generate a target closer to $70.

The Bottom Line

I think there's a lot of "want to like" in Emerson shares, and with the strong exposure to automation and emerging markets I don't think that's entirely unreasonable. Add in upside to process automation order growth and network power margins and I can understand the ongoing bullishness. All of that said, I think bullish analysts are stretching their valuation multiples pretty far and the consequences of any meaningful earnings shortfalls will be magnified as a result.

Disclosure: The author is long ABB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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