Home > Technology > Emerson: Rising Valuation Coming As It Builds Its Software Business – Seeking Alpha

Emerson: Rising Valuation Coming As It Builds Its Software Business – Seeking Alpha

I first bought Emerson Electric (EMR) stock at the beginning of 2016. Since then, it had a nice run, and was taking on the appearance of a steady compounder – and a Dividend Aristocrat one at that. However, Covid-19 shook things up. Emerson stock briefly fell back to the 2016 lows, and even now remains well off its 2018 highs:

Data by YCharts

In hindsight, the crash in March this year was a generational buying opportunity on this Dividend Aristocrat. Of course, March prices are long gone for most high-quality stocks.

However, even at this price, Emerson is still trading at or below where it did for much of 2018 and 2019. As such, it’s actually not that expensive – it trades at 21x trailing and 20x forward earnings as of this writing. That’s not great though certainly not expensive for a high-quality industrial stock in this current environment.

There’s a few things that make Emerson stand out today. For one, it derives around a quarter of its business from companies with exposure to the energy markets, including oil producers. This has been, needless to say, a drag on results for years. With even Exxon (XOM) struggling to maintain its dividend, even the energy majors are a tough sell at this point. But the likes of an Emerson allow you to own a low-risk Dividend Aristocrat that will get a big uplift in profit margins and revenue outlook when oil prices finally do recover.

Second, as a 63-years and counting member of the annual dividend increase club, Emerson is a good candidate for treating as a fixed income vehicle if you have a long time horizon. Sure, it’s an industrial and people think it’s highly cyclical. But it’s less that than you’d expect, and cyclicality is dropping more and more as the business evolves.

Emerson’s Software Kick

Which brings us to the main attraction today: Emerson’s further moves into software.

As you may know, I’ve recommended Roper (ROP) as a software company that is undervalued in no small part because it is still classified as an industrial company. Yet, over the years, Roper has gone from actually making things to primarily producing software.

Roper’s valuation is now in-between those worlds. At 31x forward earnings and 8x sales, Roper would be one of the most expensive industrial companies out there. If you view Roper as a SaaS company in disguise however (which is fair, as its gross margin is now up to an eye-popping 64%) it looks cheap in this frothy tech market.

Speaking of gross margins, as you can see, Roper’s has soared from 50% to 64% over the past fifteen years. This is how you get massive earnings boost and P/E expansion at the same time, setting up a home run for shareholders. Emerson, by contrast, had steadily rising margins until 2015, but they’ve rolled over since oil collapsed. We could be at the turning point for Emerson now though, for reasons I’ll explain:

Data by YCharts

As that may be, if Emerson follows Roper’s footsteps and becomes a software-led automation company, the stock could have dramatic upside from here.

Let’s say Emerson grows earnings at a fairly conservative 7%/year over the next decade, and manages to boost its P/E ratio from 20x to 30x as investors reward it for becoming more predictable and subscription-based. EPS jumps to $7/share at the end of the decade, and you have a $210 stock price. That’s a triple on today’s stock price, and that’s before you throw in a 3% annual dividend yield on there for good measure as well.

Remember, that’s based on modest 7% earnings growth. Emerson used to grow more quickly than that, even before the software angle came into the picture.

Bears can rightly point out that Emerson has only grown at 3.5%/year over the past five years. However, that was during the massive oil & gas slump that we discussed above. Earnings growth should head back up simply as energy stabilizes, even before you account for faster software-driven growth as well. If Emerson can get EPS growth to 9-10%/year along with healthy P/E expansion, the stock could be a four or five bagger by 2030.

Open Systems

Emerson recently announced a $1.6 billion deal to buy Open Systems, an industrial software company for the utilities market. Stephen Simpson did a great article covering this acquisition, so I’ll defer to that analysis for the specifics.

As you might imagine, any company that prides itself on being the leader in automation has some exposure to software already even before Open Systems.

This is hardly Emerson’s first acquisition in software either. For example, it picked up Paradigm, a software company for oil & gas, for $505 million in 2017. It bought that one for only 3x sales, which is obviously a much better price than the 9.5x multiple on this deal. On the other hand, it’s oil and gas, so who knows when that segment will see growth again.

More broadly, there is a form of alchemy that you get when a low multiple company like Emerson buys into a hot sector like automation software. Theoretically, if Open Systems or a similar business IPOed, it could get significantly higher than 10x sales multiple. In the past, software companies with less trendy businesses didn’t get huge valuations, but now with the recent success of very niche plays in sectors like insurance software, it shows that investors are willing to underwrite just about anything SaaS-related.

Most value or growth at a reasonable price investors wouldn’t be excited about buying a software company outright at 10x sales, at least not unless the growth prospects were outstanding. However, in the form of a bolt-on acquisition to a stable company like Emerson, you get an additional growth vehicle built into your reasonably priced stock that already pays a healthy dividend. And, over time, as the software chunk of your business grows, investors will give the whole company a higher multiple as your earnings quality improves.

CEO Change Could Cause Multiple Expansion

David Farr has been CEO of Emerson since 2000, and he’s only its third since the mid-1960s. He will be retiring in 2021, and that could bring substantial change to Emerson. While Farr has had some shortcomings (significantly overpaying for some acquisitions throughout his career, for example), on the whole, he’s led the company well. The stock returns prove that out:

Data by YCharts

Emerson outperformed the market from the moment Farr took over, and usually by a wide margin. As you can see, Emerson is at much less of a premium to the market than usual, which is part of why it’s on my radar again — the last similar dip in 2016, I bought to great success.

In any case, Farr’s departure could shake things up.

One interesting point on this subject is that Emerson is effectively two pretty different businesses right now. It’s the clear leader in automation products and software, at least in the Americas. It also has its home tools and appliances in categories such as hand tools and compressors. The latter line of business is increasingly detached from what Emerson is most skilled at, and could potentially by sold or spun off once Farr steps down.

That, in turn, is how you potentially get dramatic upside in the nearer-term. Automation, as you can guess, will be increasingly driven by software and AI in coming years. Emerson will buy and build more software to maintain and extend its leadership in this category. Over time, as Emerson evolves into a more stable (as opposed to cyclical) company with recurring revenues, it will get a more Roper-like valuation. Roper, by contrast, currently goes for 31x forward earnings, instead of Emerson’s 20x.

Roper, like Emerson, is also a Dividend Aristocrat. However, ROP stock offers a dividend yield of just 0.5%, despite more than 25 years of consecutive growth at a double digit annual rate. Roper simply grows so quickly — and remains at such a high valuation — that its dividend yield never quite catches up to the stock price.

Now, a skeptic could argue that Emerson is not a fast dividend grower anymore and thus deserves to be treated more like a bond (i.e. requiring a much higher dividend yield than Roper). And that’d be true:

Emerson’s dividend history | Seeking Alpha

The company’s dividend growth streak is now 63 years (the above table is inaccurate in that regard), however, its recent growth has been dramatically slower. Over the past five years, in fact, Emerson has barely kept up with inflation in terms of dividend hikes.

I suspect the dividend growth slowdown has been due to oil & gas exposure, and as that reverts to normal, Emerson sill start putting up faster dividend growth — particularly as the software side charges up. And, on the other hand, no one buys Roper for the starting dividend yield, whereas Emerson’s 2.9% yield is high enough to appeal as a bond alternative today, even if the dividend hikes remain modest.

Emerson: Significant Potential Upside For A Low-Risk Blue Chip

The various outcomes here skew significantly toward the favorable. Emerson should enjoy rising earnings going forward simply from several of their industrial markets — such as oil and gas — returning to normal. Throw in software acquisitions they can fund with cash or close to no-cost debt, and you have an upside kicker that also provides rising margins and stability going forward (catnip to Wall Street).

Then take the Dividend Aristocrat angle into account, and that people will increasingly view EMR stock as a 3%-yielding bond with an inflation protection kicker. That utterly annihilates 10-year treasuries at a 0.7% yield.

Over time, particularly as the quality of Emerson’s business rises, look for the dividend yield to move from 3% to 2%. To use the easiest math possible, consider a theoretical stock at $100 paying $3/year in dividends – 3% yield. To get to a 2% yield, the stock price has to rise to $150, resulting in a 50% capital gain (in addition to the dividend which we already established greatly beats bonds).

Data by YCharts

The good news is that this dividend yield element is a free upside option. You see, EMR stock has historically yielded 3% for the past decade, even back when there were expectations of higher interest rates returning again at some point in the future.

As such, investors have often agreed that 3% is a fair dividend for this stock. So if we don’t do a chase to quality with zero interest rates forever, it should be no harm no foul – Emerson continues to pay its 3% and we’re fine. However, if the rush into Dividend Aristocrats happens (particularly as Emerson transitions to a less cyclical business model), yield tags 2% over the next couple of years and we get a near-term 50% capital gain.

I’m always looking for situations like this where we can get something with a favorable set-up but not take much risk if it doesn’t pan out.

If interest rates are really going to zero for an extended period, Emerson’s stock is going to yield less in the future. That results in big gains for shareholders that buy in now as that rerating occurs. There’s a good chance of that being the model we head down.

And if interest rates go up again, is that a big deal? EMR stock yielded 2.7% even in 2018 at the height of the last rate hike cycle. The stock is still priced as if we’re in 2017 or 2018 now, even as we’re in fact on the edge of U.S. treasuries potentially tipping into negative yields over the next 6-12 months.

There aren’t too many large low-risk companies with 63 year annual dividend increase streaks out there. Emerson has scarcity value in an income-starved world seeking sound blue chips.

And hey, if nothing happens with interest rates, you own a strong industrial with a fast-growing embedded software business at 21x earnings. You could do far worse in this market.

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Disclosure: I am/we are long EMR,ROP,XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.