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Morningstar | Emerson Is an Underappreciated Steady Performer That Trades at a Slight Discount. See Updated Analyst Note from 07 Nov 2018

Wide-moat rated Emerson Electric had a decent fiscal 2018 fourth quarter, but our fundamental long-term outlook remains the same. As we roll our model forward for fiscal year 2019, we raise our fair value estimate by one dollar to $81 per share from $80. Our dollar raise mostly relates to the time value of money. The firm mostly performed as expected for the quarter throughout both platforms, but we ran a little ahead in terms of incorporating the timing of the sales flowing through for the Textron Tools & Test acquisition. Furthermore, the firm slightly underperformed at the EBIT margin level relative to expectations, but most of the shortfall was due to the acquisition, which closed in the fourth quarter.

We continue to view 4-star rated Emerson as one of the more attractively price diversified industrials in our coverage at a price to fair value of about 0.87, for a 13% discount, but we prefer investing with an even larger margin of safety. At a 5-star price of $56.70, we’d be buyers of the stock. Given the firm’s heavy exposure to the oil and gas cycle, the stock does provide occasional opportunities during moments of uncertainty as with the recent market pullback. As of 2017, about 39% of the Automation Solutions segment is exposed to oil and gas through its installed base end markets, while Automation represents about two thirds of sales.

Turning to the firm’s segments, Automation Solutions had net sales increase 11% year over year for the quarter, or up 9% year over year on an underlying basis. More importantly, what we like within this result is that growth reflects both strong maintenance, repair, and overhaul (MRO) demand and brownfield investments (improvements), which are more profitable sources of revenue compared with greenfield projects. We think this confirms our thesis regarding the enviable strength of Emerson’s wide-moat automation installed base.

There is some noise in the calculated total segment incremental margin when using reported figures due to the fourth quarter Aventics and Tools acquisitions, but overall Emerson reported an impressive 30% core incremental margins in the quarter net of these acquisitions. While management continues to target a 30% incremental margin, we’re a little more conservative heading into the 2019 fiscal year, particularly with tariffs looming on the horizon.

That said, we’re encouraged by CEO David Farr’s comments indicating he feels “better about the incremental margins this [fiscal 2019] year” than he did last [fiscal 2018] year. Over a five-year cycle, and net of acquisitions, divestitures, and corporate expenses, we think Emerson can average a 30% incremental segment EBIT margin (slowly rising over time to year 5 in our model). Even with this vote of confidence heading into the new fiscal year, we have a hard time seeing Emerson hit the GAAP minimum of its guidance for 2019, although our adjusted EPS figures top the GAAP range (we adjust for 2019 tax headwinds, slightly offset by a company 401(k) contribution for about a net $0.22 impact for the year).

The firm’s guidance going into the new fiscal year sees underlying sales growth rising 4% to 7% year over year. We target about 5% underlying sales growth, so our view is well within management’s goal posts, and our segment incremental margin of about 28.5% isn’t too far removed from management’s 30% target. We weren’t the only ones who noticed the disparity between EPS guidance and other targets. On the call, Farr explained he hesitated to raise the range given the tension he sees with China, which could lead to a bit of a slowdown in the Asia-Pacific region. To be sure, we’re at the lower end of the range, but the firm is reporting strong order growth (5%-10% range). Moreover, underlying gross fixed investment (GFI), according to Farr, is set to increase about 4%. Thus, we see our one point on top of this figure as reasonable, with potential upside.

In sum, we think the stock’s discount in the market reflects an undeserved conglomerate discount given its disparate business lines. We like that Emerson continues to raise its dividend for over 60 years (which we expect to be $1.96 per share for fiscal 2019), and we anticipate well over $1 billion in share repurchases for the year.