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Morningstar | Lighter Than Expected Fiscal 2Q 2019 Results Don’t Alter Our Long-Term Emerson Thesis

Wide-moat-rated Emerson’s top-line results for the fiscal second quarter of 2019 came in slightly below our run-rate near-term expectations, specifically on the commercial and residential platform side of the business. As a result, we think management rightly lowered its top line guidance (both on an underlying and net basis) in commercial and residential. We’ll likely also moderate our expectations in that platform, both on an organic and overall basis. Even so, we’re not making a material change to our fair value (which we may lower by $1) given that we still expect free cash flow to come in line with our prior expectations. We also expect a healthy and best in class free cash flow conversion of greater than 100%; this is also why we maintain our current 2019 EPS estimate of $3.67. The stock was punished contemporaneously with its May 7, 2018 earnings announcement, but we think the market over-reacted to the lowered guidance. As Emerson now trades in the mid-60s in terms of stock price, the stock trades well into 4-star territory, and is nearing our “consider buy” price in the high-50s.

Pockets of softness are developing in certain portions of Emerson business. We’re not surprised by some of these areas, including in discrete manufacturing end markets. We had a prelude to this impact with Rockwell Automation’s earlier earnings announcement. Other areas we’re watching closely include order weakness in North America, as well as the market environment in China, particularly in the HVAC market. Heating and cooling in China particularly saw quarterly sales drop 21% year over year. That said, one item that we’re encouraged by is steady project mix among greenfield, brownfield, and the comparably higher-margin aftermarket, or MRO, revenue.

Automation Solutions also should see margin expansion heading into the back half of fiscal 2019 on backlog conversion, as well as additional seasonal volume flowing in through the back half of the year. Our thesis relies comparably more on this segment, and we think recent results confirm our belief that demand will continue since a large portion of the total addressable market remains unserved. A recent visit with a Emerson competitor leads us to reaffirm our belief that switching costs in the process automation business are strong given the long-life of these assets. Moreover, demand is helped by less available skilled labor in manufacturing.

On the commercial and residential side, CEO David Farr confessed on the call that it was “a quarter that unfolded a lot different than anyone thought.” Even so, we see elements of green shoots in China, and we expect that the slow recovery there is mostly a question of timing. While heating and cooling sales did drop precipitously in China, the year-over-year trend was a big improvement from the first quarter which saw sales in that market nosedive over 40% year over year. On the positive side of the ledger, North America demand in the HVAC market remains high, and the global tools professional market also remains strong (5% year-over-year underlying sales growth). We expect improvements in the commercial and residential platform as we head into the back half of 2019.