Emerson Electric - Divestments Are Completed, Now What?

| About: Emerson Electric (EMR)
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Summary

Emerson Electric announced two major divestitures, part of its plan to become more focused.

While proceeds seem reasonable given the low margins reported by those segments, multiples are quite low as tax costs are high.

The unleveraged core now trades at market multiples but has real organic growth challenges.

I require a larger margin of safety before buying into the shares at the moment.

Emerson Electric (EMR) announced two divestitures in one go thereby completing the divesting part of its major transformation. Following the sale of these underperforming assets, Emerson is now debt free if you net out cash holdings.

The new focused company is smaller, but posts greater margins and has potential to focus on growth areas given the renewed strength of the balance sheet. While Emerson has traditionally been very good at portfolio management, the sales multiples for the sold assets are not very high.

A 17 times pro-forma earnings multiple, a strong balance sheet and the track record as dividend aristocrat does not make Emerson look very expensive. The trouble is however that organic growth is highly disappointing, with sales being down by the high-single digits. Given this weakness and the disappointing track record over the past decade, I am not willing to pull the trigger yet.

Slimming Down

Emerson announced the sale of the Network Power business to a group led by Platinum Equity in a $4 billion all-cash deal. Network Power provides thermal management, AC and DC power and transfer switches, used by data centers and telecommunication companies. All in all, the business generated revenues of $4.4 billion in 2015.

While the 0.9 times sales multiple is not very high, margins came in at just 5.2% in 2015 and around 9% in the years before as sales were falling. These poor margins have been a key reason behind the rationale to divest the business, as Emerson failed to grow a powerhouse following numerous bolt-on deals made in the past.

It should be noted that the company continues to maintain a 15% ownership in the business. While it is not a typical equity stake, it is some sort of earn-out potential in case the new owners might decide to transfer ownership of the business in the future.

The second deal involves the sale of the Leroy-Somer and Control Techniques business. Japanese firm Nidec will acquire these businesses for a sum of $1.2 billion. These two European businesses were acquired by Emerson over two decades ago and combined post sales of $1.7 billion a year. The sale price suggests that Emerson fetched a mere 0.7 times sales multiple, although the actual profitability of these businesses has not been released by Emerson.

A Massive Restructuring

With the $5.2 billion sale of two major parts of the business, Emerson will lose over $6 billion in annualized sales. This is significant as the company posted revenues of $22.3 billion in 2015, and given the headwinds in 2016, this revenue base will only shrink further.

With the sale of Network Power, one of the 5 existing business units will be completely divested as Emerson aims to become a more focused business. The main focus going forward is on automation as well as commercial & residential solutions.

Given the $5.2 billion proceeds from the divestitures and the $3.5 billion in cash held as of the second quarter, pro-forma cash holdings stand at $8.7 billion. Total debt stood at $7.3 billion for the quarter as pension liabilities amount to roughly a billion. It is safe to say that Emerson is now debt-free following this move. One important consideration is that Emerson will not receive $5.2 billion for the assets, which are sold, as it will have to pay $800-$900 million in taxes related to these deals.

The company did post revenues of $5.5 billion in the second quarter, but this number still includes $1.03 billion in Network Power revenues, as well as an estimated $425 million in revenues from Leroy-Somer and Control Techniques. Excluding these businesses, revenues came in at $4.0 billion.

Reported operating earnings came in at $796 million, including a very modest $37 million contribution from Network Power. It is likely that EBIT will only fall to $750 million, as I do not believe that Leroy-Somer and Control Techniques are very profitable given the low sales multiple at which they are sold.

If we annualize the current revenue number, we end up with a business which generates sales of $16 billion and operating profits of $3 billion. Note that modest interest charges have already been included into this profit number. With a tax rate of 30%, pro-forma earnings could come in at $2.1 billion, equivalent to $3.25 per share with 647 million shares outstanding. This values equity at 16-17 times earnings and the business at 2.1-2.2 times sales. The sales multiples do indicate that Emerson most likely obtained a fair price at less than 1 times sales, but the proceeds were not extremely good, certainly, if we take into account the tax considerations.

Note that dealmaking is likely to be in the works. On the second quarter conference call, management has indicated its desire to return to a revenue base of $20 billion in the coming years. That will involve some decent organic growth and dealmaking with pro-forma revenues now running at just $16 billion. Even when this is achieved, Emerson continues to shrink on a long-term basis, after revenues peaked at $25 billion in 2008. It should be said that part of this shrinkage has been offset by buybacks, as Emerson retired a fifth of its outstanding shares.

Weighing It All Together

Less is more, a corporate mantra often heard in today's world in which many companies focus on the core again. While the multiples at which Emerson is selling some of its businesses are not very high, margins are poor as the divestiture proceeds allow the company to reduce the net debt level completely in one go.

The more focused business surely has challenges ahead. The underlying business posted a 5% fall in organic sales in the third quarter. Ironically, the Network Power division, which has now been sold was the only unit which posted growth, with revenues increasing 10% on an annual basis. Notably, process management and industrial automation posted double-digit revenue declines, not boding well for the future of Emerson.

On the other hand, the business is unleveraged and trades at a 6% earnings yield (inverse of 17 times price-earnings ratio). The trouble is that sales are shrinking, but Emerson has traditionally been an excellent steward of shareholder capital, that applies to multi-decade time periods. The 3.4% dividend yield is probably a major driver behind the enthusiasm from investors, as the relative yield versus interest rate products remains attractive. The flight to dividend quality and recovery of some industrial names have been key drivers behind shares trading near the highs of the trading range of the last year.

Given the troubled organic growth rates, which are falling by high-single digits, a 17 times earnings multiple might be too high. I would like to see some stabilization and better understanding of the growth plans before I am ready to pay today's prices. A retreat to the mid-forties, in terms of the share price level, could convince me to initiate a stake.

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.