EMR - Emerson Electric: Transforming For Growth

Summary

• Emerson Electric Co. is a leading player in the process manufacturing industry, and is expected to experience positive organic growth after a slow recovery in early 2021.
• Overall, Emerson Electric is trading at a reasonable valuation given its strong position to monetize the mega automation trend.
• Concerns over the company's oil & gas holdings seems overblown given the rising value of energy assets.

Emerson Electric Co. ( EMR ) is a leading player in the process manufacturing industry. Despite facing challenges in fiscal 2020 due to low levels of gross fixed investment and disruptions related to geopolitical uncertainty and the COVID-19 pandemic, the company is expected to experience positive organic growth after a slow recovery in early 2021. We believe this strength is evidence of the increasing importance of industrial automation, driven by secular labor shortages, geopolitical considerations, and proven return on investment of automation projects. Emerson is trading at a reasonable valuation given its strong position to monetize the mega automation trend.

In this article, we will systematically examine the company’s business fundamentals, strategy, risks, financials, and valuation to help readers arrive at a more informed position to assess the risk and rewards of owning the stock.

Note: This article is for educational purposes only and does not constitute financial or investment advice. Please do your own due diligence and consider your unique financial needs and constraints before buying any stock.

Business

Emerson Electric Co. is a global company that designs and manufactures products and delivers services in industrial, commercial, and consumer markets. The company operates through three segments: Automation Solutions, Climate Technologies, and Tools & Home Products.

The Automation Solutions segment offers products and integrated solutions for process, hybrid, and discrete manufacturers to maximize production, protect personnel and the environment, and optimize energy efficiency and operating costs. The Commercial & Residential Solutions segment provides products and solutions for energy efficiency, comfort, and food quality and sustainability through heating, air conditioning, and refrigeration technology, as well as a range of tools and appliance solutions.

The Company sells products and solutions that support customers in a variety of different end markets. Overall, sales by end market were as follows: oil and gas (19%), residential (15%); chemical (11%), power (10%), commercial (9%), discrete and industrial (9%), cold chain/refrigeration (8%), refining (6%), life sciences and medical (3%), and other (10%).

Emerson was incorporated in Missouri in 1890 and has evolved through internal growth and portfolio shaping. Emerson has a history of integrating acquisitions as a means of expanding its product offerings and creating value. In 2018, the company acquired Paradigm, a provider of software solutions for the oil and gas industry, and Aventics, a global provider of smart pneumatics technologies, which are reported under its Automation Solutions segment. Additionally, the company made strategic acquisitions to strengthen its Commercial & Residential Solutions segment, including Textron's tools and test equipment business, a manufacturer of electrical and utility tools, diagnostics, and test and measurement instruments. In 2019 and 2020, the company continued to acquire smaller businesses to expand its Automation Solutions product portfolio and further its ability to help customers in various industries digitize operations and improve efficiency and reliability.

The company also evolves through divestures, which helps sharpen the company's strategic focus and provide funding for acquisitions. The largest pending divesture is a 55% stake in its Climate Technologies business to Blackstone for $14 billion. This transaction is expected to close in the first half of 2023.

Market & Strategy

The total addressable automation market for Emerson is over $200 billion, with the majority of this being in hardware and services (59%), control product software (32%), and stand-alone software (9%). While Emerson holds a strong market share in various product categories, the market remains fragmented with other established firms also holding significant share. This suggests potential for further growth in the industry.

As a global leader in the automation industry, Emerson is well positioned to capture significant investments driven by the key megatrends of digital transformation, energy security and affordability, sustainability and decarbonization, and near-shoring. The Company's strengths include being a leading automation partner for customers, an undisputed technology leader across the technology stack, deep domain expertise across Process, Hybrid, and Discrete end markets, and unmatched customer relationships. These factors position the Company to continue to drive growth in the automation industry.

The company's organic growth framework, with a target of 4% to 7% growth in a 2% to 3% market, is driven by growth platforms such as equipping the energy transition, accelerating in industrial software, and advancing their position with the AspenTech platform, as well as scaling in Priority, Discrete, and Hybrid end markets. These growth platforms, with a total addressable market of $140 billion plus, represent 30% of Emerson's current sales, and they are uniquely positioned to scale as these markets benefit from the secular tailwinds of digital transformation, energy security and affordability, sustainability and decarbonization, and near-shoring.

Risks

Energy Commodity: excluding the divested Climate business, "New Emerson" has ~30% revenue exposure to the oil & gas industry, skewing heavily towards upstream, which tends to be much more volatile than downstream. This is problematic for a company that wants investors to view it as a secular grower leveraged to the automation trend. The recent strength in oil & gas stocks does not diminish the go-forward risk of the industry, especially given the highly uncertain macroeconomic and geopolitical environment.

Succession: The CEO handoff at Emerson has begun, with Lal Karsanbhai taking over as the new leader. However, there is a risk that the leadership transition may lead to operational errors. CEO David Farr will retire Feb. 5, stepping down from the role he has held for about 20 years.

M&A Risk: As Emerson has had a varied history of performance, investors are worried that the company may spend too much on a significant acquisition that may not yield desirable outcomes. This risk is heighted given the company's accelerated bets on green energy and automation, two dynamic markets that are subject to surprising changes.

Financials & Valuation

Management expects "New Emerson" to grow 4-7% through-the-cycle with 35% incremental margins, leading to double-digit EPS growth and 100% free cash flow conversion.

FY23 will be noisy given the divestiture of its Climate business and an uncertain macro environment. Consensus estimates expect revenue to decline 23.7% y/y and EPS to decline 22.2%, driven by the divesture. Automation Solutions, which is expected to be $12.3 billion out of a total of $15.0 billion, is expected to grow 4.7%.

Looking at a hopefully more "normalized" FY24, consensus expects revenue to grow 5.5% and EPS to grow 11.7%, right in-line with management's value creation framework.

The stock of Emerson is currently trading at a multiple of 23x its forward 1-year earnings per share, which is at the upper end of its five-year range. Additionally, when evaluating the company's enterprise value to forward EBITDA, it is trading at a multiple of nearly 18x, which is the highest in the past five years. While this may seem high given the current economic climate and the increase in discount rates, it is likely due to the company's significant exposure to the energy sector, particularly oil and gas, as well as its growing presence in growth-oriented areas such as automation.

Conclusion

Emerson Electric is a leading player in the process manufacturing industry, and is expected to experience positive organic growth after a slow recovery in early 2021. Overall, Emerson Electric Co. is trading at a reasonable valuation given its strong position to monetize the mega automation trend. Concerns over Emerson Electric Co.'s oil & gas seems overblown given the rising value of energy assets. However, as always, readers should do their own due diligence and consider their unique financial needs and constraints before buying any stock.

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