Emerson Getting A Strong Push From Recovering Process Automation Markets

Summary

• 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.

The Opportunity

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.

Analyst’s Disclosure: I am/we are 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.

Comments

[Dividend Sleuth]

Thanks for the helpful update!

[user1416]

I wish their quarterly release would include gross sales and net income by geographic region. I am interested in manufacturing automation and connected plant. Seems like a lot of potential in Asia right now. Good article, I will add them to my watchlist.

Added to FTV and KYCCF in this space last month.

[Stephen Simpson]

They give some of that info. AS sales in Asia were up 7%, CRS sales in Asia were up 17%

[Guraaf]

Thanks Stephen. My personal preference is as follows. Waiting for some to fall 5-20% before investing new money. Nothing appears to offer margin of safety right now.

HON
MMM
ITW
ETN
ROK
DHR
ROP
ATLCY
LECO
EMR
WSO
SWK
CFX
IR
ABB
SIEGY

[Jeffrey888]

Would like to see a 10% bump in dividend, not 1% chump change increase

[vooch]

great article

my only comment is Emerson’s Board should keep their powder dry and wait for the next recession before making any acquisitions. Stick to kaizen for the next 24 - 36 months. Accumulate some cash.

pounce later

[Stephen Simpson]

The problem with that is that there aren't too many targets in automation (discrete particularly) that will move the needle. They keep their powder dry too long and there won't be a target worth shooting at.

[vooch]

agreed - I guess I’m just reacting to the insane edifice building ROK attempt.

[User 41156665]

Stephen Simpson,

Excellent article and very astute comment.

[G. Blair Bauer]

Bought 2 years ago when it was paying 2%. My only complaint is it is too rich to buy right now.

[G. Blair Bauer]

Should be 4%.Sigh,fat fingers on a cell phone.

[DG Ruralist]

As a long term ROK holder, I was unimpressed by their current earnings report and subsequent stock price decline. I'd hoped they had some better news since the rebuffed EMR proposal, but so far, I wouldn't say they've "delivered."

Sure the dividend raise is nice, but that's probably due to the tax cuts, and not due to any great business performance.

Here's hoping they can show me something. I do not enjoy watching EMR beat us.

Ruralist

[User 41156665]

DG Ruralist,

6 months ago, when we were resuming our efforts to diversify beyond simply 2 flavors of Conventional Energy; multinational oil and gas or Large-Cap mostly Regulated Utilities, I reckoned it was time to grasp the leading high-tech industrials toward that end. We selected a few and acted on it in an ongoing programmatic way. Emerson, Eaton, Dover and Abb were chosen. ROK seemed to be to pricey for new entrants to get much upside. A great company but NOT a great investment at the time. I was hoping ROK and Emerson might join, because clearly ROK offered Emerson that Synergistic short-cut whose well timed value is often incalculable but accretive and beneficial, going forward.

Lacking 'ROK' we Settled for Emerson and added 'Abb' because their EV charging technology

I added 'Abb' because I want to see their EV charging stations succeed. On our Subdivision there are 3 EV plug-ins, and we live just a few miles from Fort Knox. I know, because naturally people tell newcomers to ask me about pluging in EVs and the like. I was able to get PPL to arrange to install a "Quick Charge" terminal in their attached garage. It only takes 4-6 hours to charge their 2 Chevy Volts using the "Level 2" charging system installed in their garage. It essentially a 220V, 30 Amp system that has an outlet (2 in their case) that looks like the ones that Tesla installed at Holiday World and other massive scale public sites. (except they were Level 3 & DC and Faster)

It wasn't more involved than having a natural gas appliance installed or much more costly, but our new neighbors don't ever have to go to the gas station. Using surplus capacities during off-peak hours, through incentives this is both Environmentally cleaner, "Tailpipe Vs. Smokestack" and more energy efficient, as it doesn't require any added feedstock or generation capacities. At least not at this stage. The best part is this, as increased electric generation is required if a larger proportion of Cars and Trucks are EVs, the new generation facilities are almost entirely comprised of Renewables and Natural Gas. Even in the middle of Coal Country.

Anyway: We Are Picking Sustainable Industrial Investments

Ford, a company whose cars and commercial vehicles I've owned or leased over a dozen times in the 60s, 70s, and 80s and whom I have frequently owned and traded stocks in until recently, won't be included on our buy list if there answer to Global competition is to simply remove the lower margin cars from their line-ups and simply offer high margin, conservation be darned, F Series pickups as car substitutes with their equally anachronistic SUVs for the "Diehard" Crossover Vehicle enthusiasts. Unless they act more environmentally responsible they'll be hitting a brick wall unless the "Trump Digs Coal" movement directs Mr. Trump toward making petrol from Coal using a method perfected by the Germans, under Nazi leadership that North Korea uses today. After all, North Korea has more Anthracite for easy extraction and use than any other country, so they use better coal than we could to make refined petroleum products.

[DG Ruralist]

lwpcolonel,

Thanks for the insight. Certainly, I think there is much money to be made in electric vehicles. Historically, I've known the Auto companies to be poor investments, so I generally stay away from them. Electric utilities make good sense to me to invest in, as they offer both "safety" of capital with the EV growth kicker. Then the question is: where does the utility company get their energy from?

As for the industrials that make EV a reality, I'm not familiar with too many of them. I'll have to research ABB in that regard. I do know that ROK has a significant share of the TESLA factory and engine production. I don't know ROK's market share in that regard, but I do like companies that assist in the underlying manufacturing (the sellers of picks and shovels during the gold rush, if you will).

So to summarize, I'm no expert in EV and I have no idea which companies will win the EV battle. I'll do some more research in ABB, and I'll plan to stick with my diversified industrials.