Emerson Looks Right - Right Place, Right Assets, Right Time, Right Valuation
- Emerson offers leverage to accelerate mid-to-late-cycle end-markets, but also growing exposure to secular opportunities like hybrid automation and industrial software/digitalization.
- I like the structure of the tie-up with Aspen, as it leaves the company with a high-multiple asset to leverage in future software M&A.
- Management is already in the process of transitioning away from a heavy reliance on fossil fuel-driven process automation projects, but there are a lot of details left to fill in.
- I expect a greater commitment to hybrid automation, including areas like controls, sensors, machine vision, and precision control.
- Emerson shares look undervalued on the basis of long-term mid-single-digit growth and potentially transformative M&A.
At this point in the cycle, it’s pretty common for short-cycle industrials to slow and pass the baton on to companies with greater mid-to-late cycle exposure, and a process automation company like Emerson (NYSE:EMR) fits that bill. On top of that, I like Emerson’s commitment to restructure around core secular growth opportunities, gradually shift away from oil/gas, and pursue long-term 30% incremental margin targets.
I was neutral on Emerson back in September largely on valuation (a bit on cycle timing too), and the shares are down about 10% since then, underperforming the larger industrial space, but holding up against other automation and HVAC/refrigeration names. While Russia’s invasion of Ukraine puts a great deal more macro risk on the table, and Emerson isn’t the cheapest industrial out there, I think the pieces are coming together to make this a more exciting idea now.
Four New Target Growth Markets – But What Are They?
Management has let investors know that the board has identified four target growth markets for the long term, but hasn’t yet tipped its hand on what those are. While an upcoming analyst day could provide some insight, the company may be reluctant to signal its intentions too clearly, as M&A will be a part of building the new Emerson.
One of the four has already been revealed, with the combination with Aspen Technology (AZPN) in the fall of 2021, underlining the company’s ongoing commitment to industrial software. I like the Aspen deal, and I think using a structure similar to what Schneider (OTCPK:SBGSY) has used with AVEVA (OTCPK:AVVYY) is a good move, giving Emerson control of the company, but benefiting from a cleaner software-appropriate multiple for Aspen and giving the company a high-multiple currency to use in future software M&A.
I don’t think more deals of this size are likely in the near term, but then I wasn’t really expecting a deal of this magnitude relatively soon after the large OSI deal. What I do expect, though, is more tuck-in deals that will add particular capabilities and end-market exposures, especially in higher-growth end-markets like life sciences.
I would think that discrete and hybrid automation would be something of an “open secret” as another area of growth focus (whether they count it as one or two of the four). Indeed, management has been clear about their intentions to build this business, with a particular interest in higher-growth markets like life sciences.
Emerson has a lot of options for pursuing growth here. I don’t think the company is interested in what I’d call “old-school hardware” like motors and drives, and instead, I think the company may look in directions like software-defined controls, machine vision, robotics, sensing, and precision control (think IDEX (IEX), IMI Group (IMI.L), or Festo as far as markets/products).
Assuming that Emerson wants more industrial software and discrete/hybrid automation exposure seems pretty straightforward, but beyond that … it gets a little more interesting. Electrification could be an area of interest given the growth potential there, but I don’t know that the company would look to go head-to-head with companies like Eaton (ETN), Schneider, or Siemens (OTCPK:SIEGY) across the range of their products.
Instead, an area like building controls (similar to Honeywell’s (HON) business) could make sense, particularly as Emerson already has strong commercial HVAC controls. Likewise, Emerson could look to build on its position in HVAC (compressors, sensors, and controls) with more content in areas like indoor air quality.
Cycle Vs. End-Market Risk
As I said in the open, looking at where macro metrics like Industrial Production is today, it’s not a stretch to think the market is already transitioning from short-cycle plays to longer-cycle plays, and indeed I’ve noted sentiment risk as a meaningful consideration for a lot of recently-underperforming (but otherwise high-quality) shorter-cycle industrials.
At Emerson, process markets are starting to perk up, but aren’t quite there yet – the automation business posted 5% year-over-year growth in FQ1, lagging the average multi-industrial growth rate of 8%, but orders were up 19% and several companies with exposure to process automation have said they see business improving as 2022 plays out.
The “but” is whether this cycle will be different due to a global push on decarbonization and renewables. Over a third of Emerson’s automation business is based in the oil/gas sector, and that goes over 50% when you include refining and chemicals. While I don’t see the same risks to the chemical sector, I do see a lot of evidence that oil & gas companies are being more cautious on their capex budgeting, with more than one company explicitly saying they won’t chase prices.
Emerson is going to have to transform, and that process is underway. There are already meaningful projects in the pipeline tied to hydrogen, carbon sequestration, and biogas, and there are still meaningful nearer-term opportunities like LNG for the company to pursue. At the same time, the company is already starting to look to divest hardware assets pertaining to upstream oil/gas. I believe there’s a plan in place to transition the company away from its historical reliance on fossil fuel projects, but any plan of that scale carries risk.
While oil and gas may not be as much a part of Emerson’s future as before, it is nevertheless a significant market today and one that is recovering in response to high energy prices. Beyond that, end-markets like life sciences, chemicals, power, and discrete automation are strong today, and I expect that strength to continue for some time.
In the mid-term, I’m bullish on Emerson’s leverage to opportunities like the electrification of European heating (particularly with its heat pump assets) and retrofits of commercial buildings, as well as ongoing growth in automation markets like life sciences and in industrial software.
I do expect meaningful M&A activity, and I think Emerson will also face calls to be clearer on the plans for the Climate & Residential Solutions business – I think Emerson could choose to build onto/around the Climate operations, but Residential Solutions looks like a candidate for sale.
Based on improving trends in process and hybrid automation markets, I’ve modestly boosted my 2022-2024 revenue estimates (by around 1% to 3%), and I’m now a little ahead of the Street across that time period (around 2% to 3%). Emerson appears to be doing better than most with price/cost, and I’ve kept my margin assumptions stronger as a result. After 22% EBITDA margin in FY’20 and 23% in FY’21, I’m looking for 25% to 26% margins across the next three years, as well as FCF margins in the mid-teens.
The Bottom Line
On a long-term basis, my mid-single-digit revenue and FCF growth rates support a total annualized return in the high-single-digits today, while margins and returns support a forward EBITDA multiple of a little over 14x and a fair value close to $110.
While industrials are not in favor right now, and the war in Ukraine does create meaningful new risks, I think Emerson has the right exposure for this place in the cycle, the right strategy to reposition the company for long-term growth, and the right valuation. I could hope for a higher expected return on my cash flow model, but I do think Emerson stands out as a company to consider at this phase of the cycle.
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