EUR 850.00 For Business Accounts Only

Morningstar | While the Stock Is No Bargain, We Think Emerson Will Continue Leading the Growing Automation Space

After transitioning coverage to a new analyst, we are raising our fair value estimate for Emerson Electric to $80 per share from $75 previously. The primary reasons for our fair value estimate increase relate to increased margin and different working capital assumptions. We are, however, maintaining our wide moat, stable trend, medium uncertainty, and Standard stewardship ratings. Our new fair value estimate implies a 24.5 times multiple to our adjusted fiscal 2018 earnings estimate, and roughly a 13 times multiple to our 2018 adjusted EBITDA estimate. While our forward multiple admittedly appears rich, we point out that Emerson recently rebounded from a trough after a drop in the price of oil from 2014 to 2016. On balance, we believe Emerson will continue leading in the growing automation industry.

In our view, Emerson Electric is the undisputed powerhouse in process manufacturing as seen in the oil and gas, as well as the chemical end markets, among others. The firm boasts the automation industry’s largest installed base at $100 billion and its wide economic moat is primarily supported by switching costs, and secondarily by intangible assets. We think switching costs are high in process manufacturing given the catastrophic risk of failure in its facilities. A long track record of success is imperative given that a breakdown in a plant’s infrastructure can lead to heavy losses for a firm. Properly applied, however, automation affords customers a highly probable chance to expand a customer’s bottom line. Emerson specifically benefits, moreover, because fewer available experts can adequately address these in-demand service requirements. For example, many engineers are well-versed in the theory of vibration monitoring, but lack the practical techniques required to avoid inconsistent measurements or drawing misleading conclusions.

Moreover, infrastructure in process manufacturing lasts for 20 to 50 years, and most companies simply can’t afford a wholesale replacement of existing control systems. We’re enthused by predictive maintenance offerings in the industry, which extends the life of customers’ capital investment and we think will be one of the highest avenues for growth in the industrial "Internet of Things" race. According to some studies, over 80% of machine failures are random as opposed to being caused by age. We think predictive maintenance can translate to increased uptime, increased throughput, improved product quality through optimization, and reduced rework requirements.

After a series of M&A misfires, we like some of Emerson’s most recent purchases, particularly the purchase of Aventics for a price of roughly 12 times forward EBITDA prior to any computation for synergies, which is a discount to comparable peers. While it will take CEO David Farr and company time to shore up its own discrete manufacturing offering to compete against the likes of Rockwell, we’d rather it be done slowly and deliberately than all at once given Emerson’s history of overpayment and lack of success integrating larger offerings. Aventics brings with it a portfolio of pneumatics and intelligent sensors that we think complements the technology in Emerson’s fluid and motion control business. Fluid control monitors the flow of liquids and gas while pneumatics translates pressurized gas into energy and power. This continuum should allow for a more seamless and comprehensive offering.

Finally, Emerson also boasts a commercial and residential solutions platform that consists of its climate technology and tools and home products segments. While Farr is under pressure to break the company apart, we think he’s likely keep the two segments given that he’s added a bolt-on purchase--that is, Textron’s tools and test business--to the latter segment. We also calculate that these are higher returning businesses relative to the more capital-intensive automation business, and Farr can continue to use the cash from Emerson’s commercial and resi platform to both: a) grow the automation business, and b) support the growing dividend, which has consistently increased over 60-plus years.