- Emerson looks set to remain a revenue growth leader among U.S. multi-industrials as recovering demand in process automation markets like oil/gas feeds Automated Solutions revenue growth.
- Although rebuffed by Rockwell, Emerson has taken several steps to improve its process and hybrid automation businesses, and the growth outlook over the next few years is healthy.
- While Emerson doesn't look cheap on the basis of its cash flows, its stronger near-term growth potential and healthy ROIC support richer fair value targets on near-term forward multiples.
By Stephen D. Simpson, CFA
In a market where many multi-industrials have started to see signs of fading end-market growth, Emerson's (NYSE:EMR) exposure to process automation, and particularly U.S. onshore oil and gas, is helping the company drive noticeably better growth. Better still, management has been positioning this business to be more competitive outside of its core petrochemical end-markets, while also showing that it is committed to supporting its non-automation business as well.
Valuations have slid back for many multi-industrials, but Emerson has been a relative outperformer this year and doesn't look particularly cheap on a cash flow basis. That said, investors pay up for growth and will pay higher near-term multiples for companies with strong ROICs and Emerson is likely to offer both strong top-line growth and robust ROICs for the near-term.
A Better Result Than Most
Emerson was a rare exception this quarter in that the market seemed to like what it saw with the company's fiscal second quarter earnings report. And why not? Not only did the company beat on revenue it also beat on segment earnings and management raised its expectations for both organic growth and earnings per share.
Revenue rose 19% as reported and close to 8% on an organic basis, making this one of the stronger performances in the multi-industrial space. Growth continues to be driven by the recovery in the automation business, as Automated Solutions saw nearly 10% organic growth. Performance in Commercial and Residential Solutions was less impressive at a little under 4% organic growth, though that's actually a comparatively solid report.
Management no longer gives the amount of detail it once did on CRS, though it did say that North American tool sales were strong (consistent with Stanley Black & Decker's (SWK) results) but offset by weaker results in the residential AC business such that overall North American organic growth was just 1%. While that might support the idea that consumer-facing businesses in the U.S. are having a tougher time of it (Emerson's tools business is more professional-oriented), I'd note that Lennox (LII) had a good quarter in residential HVAC (up 8%) and United Technologies (UTX) saw 11% growth in North American residential HVAC, so I think Emerson's results were more reflective of Emerson-specific issues.
Although gross margin weakened slightly, that was due to the Pentair (PNR) valve deal and underlying gross margin actually improved slightly. While Pentair also weighed on Automated Solutions profitability, segment earnings were still up a very strong 17%, with 33% growth in Automated Solutions (and 160bp of yoy margin erosion). Segment profits were up 1% in the CRS segment, with a modest improvement in margins.
Emerson's Automation Business Is Better Now
Emerson is clearly benefiting from a recovery in process automation (the majority of Emerson's automation business is process or hybrid) and particularly, in the petrochemical space. Roughly 40% of Emerson's automation revenue comes from the oil/gas sector, with another 25% coming from related industries like refining and chemicals. These companies have been making up for deferred/delayed maintenance as well as the strong recovery in drilling/production in the U.S. onshore market (where Emerson has a very strong presence). That heavier North American oil/gas/petrochem exposure at least partly explains why Emerson is seeing double-digit organic growth at a time when Honeywell (HON) is growing around 4% and ABB's (ABB) process automation business is still weak.
Looking beyond recovery spending, I think Emerson has improved this business. The company was rebuffed in its attempt to overpay for Rockwell (ROK), but the Pentair deal looks like an unusual deal for Emerson - the right assets at the right time at a reasonable price. The Pentair valve business augmented Emerson's position in markets like flow control, pressure management, isolation, and actuation, and Emerson now has a very strong product line-up in process and hybrid automation (though its software capabilities are still lacking).
Emerson is also looking to expand beyond its historical reliance on the oil/gas/petrochemical sector. Emerson's life sciences business is relatively small today (about 5% of the automation business), but Emerson is already a leader in the DCS segment (ahead of Rockwell and Siemens (OTCPK:SIEGY)), and as outlined by companies like Danaher (DHR), there's good growth potential here as biologics production grows and automates.
Given the stated position of Emerson's management that the automation market is moving inexorably toward an environment where top providers have to have coverage across the board in process, hybrid, and discrete, I expect Emerson to continue to look to improve its discrete automation business. Emerson isn't very strong in PLC, HMI, sensing, instrumentation, or software, and I believe this is why the company was so willing to pay up for Rockwell, as that company would have filled in many of these weaknesses.
I don't believe another bid for Rockwell is likely - after all, how do you strike a deal with a company that basically responded to your M&A overtures by drawing the curtains, turning off the lights, and pretending to not be home (an exaggeration, yes, but Rockwell has never been particularly receptive to M&A bids)? All the same, I think Emerson could target a company like Beckhoff to improve its discrete offerings, and I wouldn't be surprised by a bid for Rotork (OTCPK:RTOXY) - a deal that would build on Emerson's existing strengths.
I like Emerson's deal for Textron's (TXT) Tools and Test Equipment business. Although management will have to work to bring this business's margins up to the level of its existing tools business (currently the acquired businesses have margins around half of Emerson's comparable businesses), building up its specialty/professional tools business looks like a good move.
I believe Emerson is looking at a healthy demand environment in its core automation business, not just in 2018 but out for a few years, as sectors like oil/gas and chemicals catch up on deferred maintenance, replace aging systems, and move forward with postponed growth projects. I likewise see good potential down the line in life sciences and food/beverages, and I expect mining/metals to continue to improve and adopt more automation.
I expect more growth from Emerson (around 5% revenue growth and over 10% FCF growth, annualized) than I do from peers like ABB and Honeywell, but the shares still don't look all that cheap on a DCF basis. On the other hand, near-term valuations (like EV/EBITDA) often correlate strongly to ROIC and Emerson is likely to deliver strong ROICs for the next few years as well as above-average revenue and segment earnings growth.
The Bottom Line
Discounted cash flow is my preferred valuation approach, but it is just one way to value a stock. Although I don't think Emerson is all that cheap on an "intrinsic" level, I recognize that the markets are typically much more focused on near-term metrics and capital gains are gains no matter how you get them. With that in mind, I think Emerson still has some appeal in 2018 but more on the momentum/relatively valuation side of the spectrum.
This article was written by
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