Friday, August 14, 2015

Recent Buy - Emerson Electric (EMR)

Turned out to be another busy month!
The last stock purchase of the month, this one wasn’t actually planned. I was quite content with the four purchases I made in July, all of which were fairly well spread out across the economic sectors and all purchased at what I feel are really solid long-term values.
But value kept on knocking. At some point I just had to answer the door.
And answer I did by adding to one of my older positions for the first time in years. I didn’t anticipate having another opportunity to buy this stock at the same price it was available for about three years ago, but it’s an opportunity I’ll gladly take advantage of.
I purchased 20 shares of Emerson Electric Co. (EMR) on 7/23/15 for $51.66 per share.

Overview

Emerson Electric Co. is an industrial conglomerate that designs and supplies a wide variety of product technology and solutions for industrial, commercial, and consumer markets around the world.
Founded 125 years ago, Emerson Electric is now a $34 billion company that employs 115,000 people across 15 countries.
Emerson’s product and solution lineup is diverse: measurement devices, productivity and control systems, process management systems, electric motors, wind turbine pitch systems, air conditioning compressors, bearings, couplings, and alternators are all among a much larger product and service portfolio.
They operate through five business segments: Process Management (36% of fiscal year 2014 revenue), Network Power (20%), Industrial Automation (20%), Climate Technologies (16%), and Commercial & Residential Solutions (8%).
The company recently announced that it will spin off its Network Power business in a tax-free distribution to shareholders.
International sales represented 58% of total FY 2014 revenue.

Fundamentals

Emerson has one of the lengthiest dividend growth streaks in the world, which is why it’s long held a place in my portfolio. While they’ve had some trouble growing over the last decade, the company is fundamentally sound across the board.
Revenue is up from $17.305 billion to $24.537 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 3.96%.
Meanwhile, earnings per share grew from $1.70 to $3.03 over this period, which is a CAGR of 6.63%. Not outstanding, but also not particularly disappointing considering this is a cyclical company that relies on broader economic demand. In addition, like most companies selling products across the world, currency translation has had a negative effect on recent results.
Significant share repurchases have helped the bottom line’s cause; Emerson reduced the outstanding share count by approximately 16% over the last decade.
S&P Capital IQ predicts that EPS will grow at a compound annual rate of 8% over the next three years, which seems realistic. Continued strong share repurchases will help and S&P Capital IQ believes order rates have bottomed. However, restructuring charges related to the aforementioned corporate change could weigh on near-term results.
They’ve had some recent troubles with underlying growth, which isn’t something real surprising for an industrial firm like Emerson. But what hasn’t been nearly as troubled is the dividend.
First, the amazing track record. The company has increased its dividend for an amazing58 consecutive years.
Think about that. That time frame includes multiple wars, multiple stock market crashes, the invention of the internet, a period of massive inflation, and the Great Recession. If you’re looking for a company that you’re confident will reliably send you an increasing check year in and year out, it’s tough to beat Emerson. I’ve only been a shareholder since 2011, but they sure haven’t disappointed me in regards to growing dividend payments.
Next, the growth. Over the last decade, the company has increased its dividend at an annual rate of 8.1%.
The dividend has grown at a slightly faster rate than underlying earnings lately, but the payout ratio remains a moderate 49.5%. However, Q2 was favorably impacted by a one-time gain of $0.77. Factoring that out, the payout ratio is still reasonable at 62%.
Now, the yield. Currently offering a very attractive yield of 3.64%, that’s difficult to pass up. Not only is that well in excess of the broader market, but it’s also substantially higher than the five-year average yield of 2.7% for EMR.
Looking at the balance sheet, Emerson actually maintains an attractive debt load that’s in line with peers. The long-term debt/equity ratio is 0.35 and the interest coverage ratio is over 16.
Profitability is also well in line for the industry. Over the last five years, Emerson has averaged net margin of 8.93% and return on equity of 20.99%. Speaking holistically, these numbers are fairly robust.

Qualitative Aspects

Emerson’s strength is in the very solutions it offers. By installing process management and productivity measurement/improvement solutions, the company creates long-term business relationships that are tough to terminate. And that’s because their products and solutions are integrated, meaning it can be difficult and costly for a client to switch to a competitor later down the road, giving Emerson fairly excellent long-term revenue visibility.
This installed base gives Emerson an incredible competitive advantage. The larger it grows, the greater the visibility for Emerson’s long-term revenue and cash flow. For perspective, Emerson estimates this installed base to represent approximately $250 billion of infrastructure build-out in 2015, which is an increase of $100 billion since 2005. They expect this to increase to $500 billion by 2025.
That’s emblematic of customers’ willingness to spend on these projects. And that’s also why Emerson’s solutions should remain sticky, as they operate within sizable scale and scope. Minimizing downtime is critical since the very solutions Emerson installs are designed to maximize efficiency and productivity, so digging into infrastructure might not make sense for clients from an economic perspective.
That need for efficiency is important to Emerson. If there’s anything I’ve noticed over the last four or five years, it’s that companies in general and across the economy are constantly interested in improving efficiency. This sometimes results in downsizing, which can be painful for workers. But Emerson’s largest business is focused on improving efficiency through centralized remote management, exact measurement tools, automation, and productivity. This value creation should keep them busy for years to come.
I also believe Emerson’s diversification helps insulate them from any one area of the economy. They’re exposed to a multitude of products and solutions across the industrial space, which probably helps explain why they’ve managed such consistency over such a long period of time.

Risks

The company is exposed to cyclical end markets, which can cause oscillations in its operational results.
In addition, as a global enterprise, currency effects can affect their profitability.
The aforementioned announced spin-off of a major business could weigh on near-term results due to additional costs. There are also execution risks which could play out when the two, separate businesses operate on a standalone basis.
Emerson has significant exposure to the oil & gas industry, which is facing challenges of its own recently.

Valuation

EMR is trading hands for a  P/E ratio of 13.59 right now; however, factoring out a recent one-time gain would increase that to about 17. Either way, the stock is currently trading well below recent historical norms. The five-year average P/E ratio for EMR is 20.2, which is on par with the broader market. In addition, the yield is substantially higher than the recent historical average.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. I think that growth rate is fair considering EMR’s 10-year dividend growth rate, the moderate payout ratio, and forecast for EPS growth moving forward. The DDM analysis gives me a fair value of $67.05.
However you slice it, EMR appears undervalued right now. Perhaps significantly so.

Conclusion

58 years of dividend raises. Mic drop.
Seriously, though, this is about as blue chip as it gets. If you’re after an attractive yield that’s well above the broader market, a dividend that’s growing much faster than inflation, and a track record that’s longer than 99% of other stocks out there, EMR is your huckleberry. On top of all that, the stock appears very undervalued.
The company’s growth has been somewhat troubled over the last few years, which seems to still be stalled as recently as Q2 2015. But the announced spin-off and other possible restructuring could add value. And I think the stalled growth is more than priced into shares – the stock is down more than 20% over the last year, leading to what I feel is a compelling long-term opportunity. Besides, you generally want to buy a high-quality stock when it’s troubled and cheap, not when everything is rosy and it’s expensive.
Diversified operations that focus on automation, efficiency, and productivity should remain in demand for the foreseeable future. Meanwhile, EMR’s huge installed base gives them incredible competitive advantages and provides a lot of value for shareholders.
This purchase adds $37.60 to my annual dividend income, based on the current $0.47 quarterly dividend.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates EMR as a 4/5 valuation, with a fair value estimate of $65.00.
S&P Capital IQ rates EMR as a 3/5 star “hold”, with a fair value calculation of $52.10.
I’ll update my Freedom Fund in early August to reflect this recent purchase.
Full Disclosure: Long EMR.
A shareholder of EMR? Why or why not? Think the value is compelling here? 
Thanks for reading.

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