3 Electrifying Free Cash Flow Targets In Electrical Equipment

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Includes: EMR, PH, PNR
by: Valuentum
Summary

The fragmented electrical equipment industry includes firms that primarily provide flow control and electrical components, and these business can be subject to notable cyclical forces.

Some industry participants have tabbed slowing economic growth in China as a cause for concern in the near term, and raw material and freight inflation could impact margin performance.

However, each of the companies included in this writeup target impressive free cash flow conversion rates through the course of the economic cycle.

Let's take a look at some of our favorite ideas within the electrical equipment industry. Included in this article are Emerson Electric, Parker-Hannifin, and Pentair.

Image Source: Emerson

By Valuentum Analysts

Introduction

The fragmented electrical equipment industry includes firms that primarily provide flow control and electrical components. Order trends and backlog are largely driven by the overall health of the economy, while all constituents must deal with volatile raw material prices. Most operate high fixed-cost business models, where operating leverage should be monitored closely, and face intense global competition. Still, we like the group's exposure to recurring maintenance, repair, and overhaul revenue, and its large and growing emerging market opportunities. We're generally neutral on the industry's structure.

The group is not insulated from concerns over a potentially slowing Chinese economy, and though Emerson Electric's (EMR) management remains optimistic over order and sales trends in the country, it noted, "As expected, our Commercial & Residential Solutions business felt the crosswinds of weakening consumer demand in China that began in the second half of 2018." The impact of tariff-related costs should be monitored, and raw material and freight cost inflation has the potential to eat into margin performance in the near term.

Regardless of the potential cost pressures, Emerson, Parker-Hannifin (PH), and Pentair (PNR) continue to target impressive levels of free cash flow conversion rates, and we love what these targets mean for dividend growth potential. Whether it be materially diversified end markets or a significant portion of revenue coming from the generally more stable replacement markets, these companies continue to work to mitigate the impact of the inherent cyclical nature of their businesses. With these goals in mind, let's dig into three of our favorite ideas within the electrical equipment space.

Emerson Electric - Dividend Yield: ~2.9%

Image Source: Emerson Electric earnings presentation

Emerson offers a wide range of products and services in the industrial, commercial and consumer markets through its 'Automation Solutions' and 'Commercial & Residential Solutions' segments, the latter of which is made up of its 'Climate Technologies' and 'Tools & Home Products' businesses. The company was founded in 1890 and is headquartered in St. Louis, Missouri.

There are a number of moving parts in Emerson's business. The firm recently sold its network power division for $4 billion and its motor and generator business for $1.2 billion, and it purchased Pentair's valves and controls business for $3.15 billion. It also acquired Textron's (NYSE:TXT) Tools & Test business for $810 million and smart pneumatics technology producer Aventics for €527 million.

Emerson expects global demand trends to continue improving, with strength in North America leading the way. Organic growth will be bolstered by bolt-on acquisitions, including its purchase agreement for GE's (NYSE:GE) Intelligent Platforms business, which should boost its position in automation. In fiscal 2019, Emerson is expecting underlying sales growth of 4-7% to be primarily driven by its 'Automation Solutions' segment. GAAP EPS guidance has been set in a range of $3.55-3.70 (3%-7% growth over 2018), and operating cash flow is expected to be ~$3.2 billion. 100%+ free cash flow conversion is being targeted in the year.

You can't talk about Emerson without mentioning its fantastic dividend growth profile and impressive track record. Management plans to reduce its dividend-to-free cash flow ratio to less than 50% by fiscal 2020 from 56% in 2017. The firm's dividend yield and Dividend Cushion ratio offer an enticing combination.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think the upside might be limited based on our fair value estimate (see image that follows):

Key Strengths

Emerson serves a variety of industrial, commercial and consumer markets, some of which are cyclical, but many of which have long-term secular trends supporting them. The company has increased its dividend for each of the past 60+ years, earning it a place on the Dividend Aristocrat list. Strong free cash flow generation has been the base on which Emerson has built this impressive dividend track record, and though free cash flow dipped in fiscal 2017, it averaged roughly $2.05 billion in annual free cash flow generation over the past three fiscal years. We think this free cash flow generation and a reasonable balance sheet will support continued dividend increases moving forward. Management will not let its track record go easily.

Potential Weaknesses

Even though Emerson has strong free cash flow generating potential, fiscal 2017 levels were suppressed due to ongoing struggles in a complex and volatile marketplace and operational adjustments, which highlights the risks of its business though its cash conversion rate remains strong. The company can be expected to continue pursuing acquisitions, which could allocate billions of dollars in capital away from dividends. However, free cash flow generation will benefit from a focus on improved working capital performance and the reduction of capital spending. All things considered, we are not anticipating any material weakness in Emerson's payout anytime soon, and the firm is dedicated to returning 50%-60% of operating cash flow to shareholders.

Image shown: Emerson Electric is currently trading at $68 per share, which is firmly in the upper half of our fair value range. We don't see too much potential in terms of valuation upside in shares at the moment.

Parker-Hannifin (PH) - Dividend Yield: ~1.8%

Image Source: Parker-Hannifin presentation

Parker-Hannifin is the world's leading diversified manufacturer of motion and control technologies and systems. There remains ample opportunity for growth in this $120+ billion global market. The firm has increased its annual dividends paid to shareholders for more than 60 consecutive fiscal years. It was founded in 1918 and is headquartered in Cleveland, Ohio.

When it comes to industrial entities, Parker-Hannifin is among the strongest. It boasts top quartile performance in free cash flow generation and return on invested capital. Investors should keep a close eye on the company's operating margins as well, which have expanded nicely as of late. Parker-Hannifin has set the following targets for fiscal 2023: organic sales growth of 150 basis points above the broader industrial market growth, an operating income margin of 19%, an EPS CAGR of 10%+, and free cash flow conversion at or above 100% of net income.

Parker-Hannifin acquired Clarcor for ~$4.3 billion, combining Clarcor's solid US presence with Parker-Hannifin's international strength. Annual run rate cost synergies of $160 million and revenue synergies of $100 million are expected by fiscal 2020. However, after the US DoJ filed an antitrust lawsuit, the firm has agreed to divest its Facet filtration business, which includes Clarcor's aviation fuel filtration assets. Parker-Hannifin now expects ~55% of its revenue to be generated via its aftermarket business thanks to its purchase of Clarcor, the integration of which has exceeded expectations thus far.

The company's free cash flow conversion (free cash flow divided by net income) is consistently fantastic and has been more than 100% of net income each year since fiscal 2002. It defines free cash flow as cash flow from operations less capital spending plus discretionary pension contributions.

Here's what we say about the company's payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):

Key Strengths

Parker-Hannifin serves a wide range of end markets, and roughly half of its business comes from maintenance, repair, and overhaul operations, both factors helping to mitigate cyclicality to a degree. The company has raised its dividend for 60 consecutive years, and it has grown the payout at an impressive rate in recent years. Parker-Hannifin has produced $1+ billion in free cash flow in each fiscal year since 2010, and free cash flow conversion is consistently greater than 100%. Efficiency initiatives are projected to help expand operating margins to 19% by fiscal 2023 from nearly 15% in fiscal 2017. This margin expansion is anticipated to fuel a 10% CAGR in EPS through 2023, which will only add to the firm's dividend potential.

Potential Weaknesses

With such a strong Dividend Cushion ratio, it can be difficult finding material weaknesses in Parker-Hannifin's dividend. Competing uses of cash have the potential to impact the firm's pace of dividend expansion moving forward. For example, the company is in the midst of a robust share repurchase program and bought back ~$1.3 billion in shares in fiscal 2015-2018. The firm is tied to a number of cyclical end markets, and coinciding troughs in these markets' economic cycles could impact free cash flow generation and the trajectory of dividend growth. Though Parker-Hannifin is expecting pressure in a number of its end markets in the near term, we aren't concerned about the health of its dividend due to its strong free cash flow generation.

Image shown: Parker-Hannifin is currently trading at ~$170 per share, which is firmly in the lower half of our fair value range. We think shares have upside potential based on our fair value estimate of $181 per share.

Pentair - Dividend Yield: ~1.8%

Image Source: Tony Webster

Following the spin-off of its Electrical business, Pentair is now a pure play water company focused on smart, sustainable water and fluid processing applications. It provides solutions for residential (~60% of revenue), commercial (20%), and industrial and agriculture (20%) applications. The company has 130 locations in 34 countries around the world, and it was founded in 1966 and is based in the UK. An enhanced strategic focus, simplified corporate structure, and improved clarity into business performance are key selling points of the spin-off, and geographic expansion remains a growth opportunity. The Electrical business has been named nVent Electric and trades under the ticker NVT.

Pentair is working to transform its business into one that is more predictable via simplification and standardization initiatives, which are expected to help drive net income margins along with pricing initiatives in coming years. Following the spin-off, management estimates that ~70% of Pentair's revenue comes from replacement/aftermarket.

Pentair's long-term financial goals include 2-4% annual core sales growth, 6-8% segment income growth, and 8-10% adjusted earnings per share growth as it takes advantage of operating margin and share buyback opportunities. The company targets free cash flow to be ~100% of adjusted net income, which could lead to $2+ billion in cumulative free cash flow through 2022. This level of free cash flow generation will help in its capital allocation plan that includes a focus on tuck-in and bolt-on M&A activity as it embraces the shift toward 'smart' technologies. The company has grown its dividend for 40+ years, as adjusted for the spin-off.

Here's what we say about the company's payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands in the lower half of our fair value range (see image that follows):

Key Strengths

The new Pentair boasts a significantly stronger Dividend Cushion ratio than its predecessor, thanks in part to a materially lower debt load. The company also has ~70% of its revenue tied to replacement/aftermarket demand, which should make its business less sensitive to the economic cycle compared to the old Pentair. Its long-term financial goals include 2%-4% annual sales growth, 6%-8% segment income growth, and 8%- 10% adjusted earnings per share growth as it works to take advantage of operating leverage. Free cash flow is targeted at ~100% of adjusted net income in any given year, which would help drive its dividend potential. We're expecting ongoing growth in the dividend.

Potential Weaknesses

A lower debt load and what should amount to a business that is less sensitive to changes in the economic cycle are two key factors in Pentair's improved dividend profile. If management is able to deliver on its goal of achieving free cash flow of ~100% of adjusted net income on a consistent basis, there isn't much that will derail the dividend, in our view. However, competing capital allocation options are present as the company has a $750 million share repurchase program that expires in 2021, and we'd like to get a better read on what its financial performance as a standalone, pure play water company look like before drawing a final conclusion.

Image shown: Pentair is currently trading at ~$42 per share, which is roughly in line with our fair value estimate. While we view shares as fairly valued at current price levels, the upper bound of our fair value range sits at $52 per share.

Conclusion

We love that each of the three companies discussed in this article has such high targets (and impressive track records) for free cash flow conversion, and such targets bode well for dividend growth. However, cyclical end markets can impact the sustainability of such performance, and the potential for softness in China to impact near-term performance should not be discounted. As it relates to dividend health, we like the potential for all three companies to continue growing their respective quarterly payouts. However, Emerson holds a significant advantage in terms of current dividend yield.

Parker-Hannifin boasts the most attractive valuation opportunity of the three based on our fair value estimates, but we're keeping an eye on what management called, "signs of moderating end market demand," in its fiscal 2019 second quarter report. Nevertheless, management expects to be able to navigate any such weakness, thanks in part to its optimized cost structure, and it does not expect changing market dynamics to impact its fiscal 2023 targets.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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.