By: Scott Davis
Emerson stock has sold off (like most industrials) on concerns over macro weakness, tariffs, and lower oil prices. And our call volume on the name has turned sharply negative of late. Now that tariff risk is declining we see a pathway for increasing strength in Emerson’s longer cycle businesses – and positive earnings revisions from here. EMR remains one of our top ideas – particularly on a risk/return basis vs. other industrials.
Here’s the investment case: Emerson has upside from the integration of its acquisitions, upside from its new focused portfolio, and has further B/S to deploy. Its earnings quality is high, and it is one of the few names we cover to still report under GAAP earnings. Its earnings are still cyclically depressed (automation profits just now back to 2015 levels), its FCF yield is over 7% and rising, its dividend yield is 3% and rising. The company has made many mistakes in the past, notably in its tech/telecom businesses, but those assets have been sold and earnings reset lower ($2.64 in 2017). The earnings power of this portfolio is north of $5.00 and cash earnings of $5.50 vs. the $3.46 earned in F2018 (Sept year-end). At a $68 stock price on Friday’s close, we could have upside closer to $100 as earnings ramp. The earnings power moves closer to $6.00 if the B/S is utilized. The key to the thesis is automation and our view that automation assets will garner a meaningful premium to the market due to secular trends and the scarcity of assets to play it. Note that Rockwell Automation is the only pure-play and trades at a premium to EMR (ROK at 19x P/E). And ROK is exposed to more at-risk consumer-based end-markets (e.g. auto) and has fallen out of favor as macro risks have heightened.
To back up a bit, the “new” Emerson is 2/3 automation and 1/3 HVAC/miscellaneous other – which we will explain in a bit. The most volatile/cyclical business is process automation and we have tremendous conviction in the outlook here. Cycle timing and pent-up demand will keep this business strong. There is recession risk, but we see far less risk in this business than perceived. The HVAC business also has recession risk, but we are less concerned about non-res construction and resi construction than other consumer verticals like auto/electronics.
Process automation is dominated by rational competitors, notably Emerson, Honeywell, ABB, and Yokogawa. The largest end-markets are oil/gas/refining (18%), chemical (16%), power utility (15%), food/bev (10%) and water (8%). These end-markets are highly favorable we think. Oil & gas is still coming out of a terrible recession and based on comments by the majors the under-investment of the past few years will need to reverse. Note the Middle East still in recession and we see upside as the region’s investment spend recovers. Refining should benefit from new regulation around emissions (notably ships), and that will require spend. The recent slide in oil prices has folks worried, and we understand. Part of our more positive view on EMR is that we do not think oil prices will fall materially from here and we do not think the oil majors can hold spend at these lower levels. But we understand investor skepticism – the entire world seems a bit upside down right now.