Emerson Is Better Than It Looks

By Stephen D. Simpson, CFA | February 07, 2012 AAA

Industrial stocks certainly have their ups and downs as the economy goes through its cycles, but proven names like Danaher (NYSE:DHR), Illinois Tool Works (NYSE:ITW) and Emerson (NYSE:EMR) don't often trade at attractive multiples. With investors worried about Emerson's industrial automation and network power businesses, skeptical of its ability to recoup sales lost to a natural disaster, and generally bothered by any company with heavy exposure to Europe and/or China, now may be the time to fight the tide and consider these shares.

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A Bad Quarter Was Expected, but This Was a Little Worse Still
Emerson warned the Street that this was not going to be a good quarter, and results were still a little shy of even those lowered expectations. Revenue fell 4% on an organic basis, as both network power and climate saw 10% declines in reported sales. Tools revenue was up slightly, but this is a tiny business. Industrial automation was a modest 2%, while process management was down a reported 1%.

As has been the case with other companies like ABB (NYSE:ABB), Rockwell Automation (NYSE:ROK) and Eaton (NYSE:ETN), results in Europe were not as bad as feared (flat relative to last year). Surprisingly, though, U.S. sales were down and sales in China fell by a low-teens percentage.

Not only were sales soft, but so too was reported and incremental profitability. Gross margin slid less than half a point, but operating income dropped 18% and virtually all reporting segments had soft operating income performance. (For related reading, see Analyzing Operating Margins.)

How Quickly Can Emerson Recover Lost Sales?
The severe flooding in Thailand had a significant impact on Emerson. While the reported impact of $300 million was not as bad as previously feared, it did manage to wash away what would otherwise have been strong high teens growth in process management.

Management believes that they can recapture a lot of this lost business over the coming quarters. While that may sound aggressive (and at least some analysts seem skeptical), the fact is that there is a lot of spending and activity in markets like oil/gas, chemicals and refineries right now. It's likely that rivals including Honeywell (NYSE:HON), ABB, Rockwell and Tyco (NYSE:TYC) stepped into the breach created by Emerson's flood-related disruptions, but a healthy market should up the odds on a quick recovery.

Other Challenges Seem More Troubling
Emerson probably has its work cut out for it in the network power market. Not only are ABB and Schneider really targeting this market, but weak carrier-spending in the U.S. and tough comps in the data center business are going to be difficult to overcome right away.

At the same time, the company's large climate business is likely not poised for an immediate turnaround. It seems that investors want to believe that companies like United Technologies (NYSE:UTX) and Johnson Controls (NYSE:JCI) are past the worst of it, but the numbers just don't look that good now.

Last and not least, I'm also a little worried about Emerson's comments on the automation market. Emerson management seems a little cautious here, even though European rivals ABB, Siemens (NYSE:SI) and Atlas Copco have all been relatively optimistic. Perhaps this comes down to the differences in customer/end-market exposures, but the threat of some competitive share loss seems like it may be on the board.

The Bottom Line
Although Emerson is one of the only industrials I've seen to post negative organic growth recently, I still believe the company is well-run and has solid long-term prospects. Moreover, strip out the impact of the Thai flooding and the revenue performance was less troubling.

I'm comfortable with the idea that Emerson can deliver compound free cash flow growth in the mid-high single-digits over the next decade. If it can, the stock is cheap enough to consider buying today (particularly when the relatively healthy dividend yield is factored in). Given that ABB also carries an appealing valuation, it's not a slam-dunk choice to go with Emerson, but I do not believe investors will regret owning either name over the long haul. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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