I'm starting to feel a little sympathy for the management team at Emerson (NYSE:EMR). While the recent financial performance from this industrial conglomerate hasn't been that great, it increasingly seems to me that a lot of the Street just waves off management's cautious commentary. If the Street is building up expectations ahead of what Emerson's own people say they're likely to do, I can't really fault the management for what happens.
In any case, I still think investors are too bullish on Emerson's prospects. I do believe the Climate business is do for a solid rebound and I like the company's underlying order trends in automation, but I do worry both about the company's long-term competitiveness in automation and whether expectations are still too high. At this point, I'd still not be a buyer of Emerson.
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Another “Miss And Lower” Quarter?
The good news for Emerson shareholders with respect to this quarter is that it seems as though the sell-side was bracing for a tougher quarter as the weeks rolled on, and so there wasn't as much surprise.
Even so, revenue fell 2% as reported and about 1% on an organic basis. Revenue from process automation was up 3%, which was a respectable outcome relative to ABB (NYSE:ABB) and Honeywell (NYSE:HON). Industrial automation was down 7%, though, and that result is harder to spin to the positive. Network power dropped another 5%, Climate fell 2%, and the Commercial/Residential business saw organic growth of 4% for the quarter.
Overall, Emerson's profit performance was not particularly strong. Gross margin was flat with the year-ago period, which actually wasn't bad, but segment profits declined 9%. Only the Climate and Comm/Resi business showed year-on-year margin improvement, and Emerson posted a three-cent miss at the operating line relative to Street expectations.
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Orders Seem To Be Getting Better, But Guidance Isn't
Management once again lowered its expectations for the year, albeit this time the change vis a vis Wall Street expectations wasn't all that consequential. To put this guidance in context, post-Q1, management was talking about 2% to 5% growth for the year. After Q2 that guidance went down to 1.5% to 2.5%, and now it's down to about 1% growth. This really isn't so much different than what companies in similar businesses like Eaton (NYSE:ETN), ABB, Honeywell, and Siemens (NYSE:SI) are seeing/saying, but it does show pretty clearly that the big second half rebound story isn't likely to come to fruition.
A Decent Value For Network Power, But Emerson Has Work To Do
Investors may be cheered to see the valuation that Emerson was able to secure for its Network Power business. This unit has been a laggard for some time now, with competitors like Eaton and Schneider and self-inflicted operational issues leading to poor performance. That said, while an implied value of almost $600 million is more than many expected, the structure of the deal (selling a 51% stake to Platinum Equity) doesn't strike me as the cleanest exit. Still, I imagine Emerson didn't find a crowd of buyers clamoring for this asset, so the company's options were likely limited.
With Network Power more or less resolved, Emerson may now be able to turn to other business. In Climate, I think the story is still a waiting game – I think that there's enough pent-up demand for companies like United Technologies (NYSE:UTX) and Emerson to do well, but it's likely to be a slower, shallower recovery than investors have been hoping for until recently.
Turning to automation, I think Emerson really has some work to do. While the order flow is looking better (process automation orders up about 8%, with industrial automation apparently troughing), I do worry that the company, like Eaton and Rockwell (NYSE:ROK), has over-invested in hardware and under-invested in software. Although Emerson had once approached Invensys (a company with a strong industrial software business) about a merger, it looks as though Emerson may allow Invensys to go to Schneider without challenging the latter's bid. There are still worthwhile properties in the industrial software space that Emerson could buy, but the clock is ticking and a failure to improve its software offerings could compromise long-term growth and competitiveness.
The Bottom Line
I'm presently looking for Emerson to produce about 4% long-term revenue growth and almost 7% long-term free cash flow growth – less than both Honeywell and ABB. I would also say, however, that Emerson has upside if the Climate business recovers faster than I expect and/or if the company can gain share in the process and industrial automation markets. Even so, as is, I think Emerson should trade around the mid-$50s today, and that target is supported by discounted cash flow, EV/EBITDA, and ROE/PBV.
Disclosure – At the time of writing, the author owned shares of ABB