October 2011 Emerson Electric Price: $47 Research Report by Peter Hughes, Check Capital Management Emerson Electric (EMR) was founded in 1890 to manufacture electric motors. Today the company produces complex electrical and electronic products for industrial and commercial markets. EMR has been remarkably consistent, raising its dividend for 54 consecutive years and increasing profits in all but three of the last 52 years. THE BUSINESS $4.00 $3.00 $2.00 $1.00 $0.00 Earnings Per Share and Dividends EPS Dividend/Share * Expected Results for 2011 Emerson continues to make motors and electrical products. Over time, however, the company has added much breadth and sophistication to its offerings. EMR produces many of the things upon which industries are built equipment for factories, power plants, data centers and other facilities. Customers depend heavily on Emerson s products to improve their operations. Most of EMR s offerings have long life-cycles, so they need not be replaced often. Although complex, Emerson products are rarely subject to the rapid change common in many high-tech industries. Thus, the company is very likely to maintain high marketshare for many years and unlikely to be upended by radical innovations. Management has focused on investing EMR s resources in faster-growing businesses while divesting slower-growing, lower-margin businesses. This has taken the company into moredifferentiated, less price-competitive technologies. Management has targeted global megatrends, which it believes can enhance growth for many years. Such megatrends include continued resource scarcity, aging populations and increasing wireless connectivity. Emerson serves markets with annual sales of about $145B, up from $90B in 2000 and indicative of the firm s product expansion. EMR is broadly diversified across many industries, minimizing its dependence on any one sector of the world economy. Emerson is also diversified geographically, deriving 60% of its sales outside the U.S. The company ventured into China and India in the early 1980s, far earlier than many peers. EMR now sells in 150 countries and has design centers in Europe, India and China as well as the U.S. China accounts for 13% of sales, and emerging markets as a whole make up 34% of revenues. 1 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
Diversification and a strong emerging-markets position mitigates Emerson s country-specific risk and should help the company post higher growth in the future. The company has five operating segments, each described below. Besides the Tools & Storage unit, all have high marketshares and are often the top players in their respective markets. Process Management With over $6B in revenues and over $1B in operating income, this is Emerson s 25% largest unit. It designs and fabricates systems, components and services for such industries as energy, chemicals, beverages and power. 15% This segment s output helps 10% to maximize the performance of plants and facilities in 5% those industries. Products include measuring instruments, meters, software, 0% sensors and valves used in industrial processes and manufacturing. Network Power Segment Operating Margin Process Management Climate Technologies Tools & Storage Industrial Automation Network Power Emerson s second-largest segment makes efficiency-boosting equipment for data centers and telecommunications networks. Products include precision Sales by Segment cooling systems, electrical-switching devices, power-backup technology and uninterruptible power supplies. Furthermore, EMR sometimes provides Automation Industrial Network Power on-site management of client systems. 27% Tools & Storage 8% Climate Technologies This unit provides energy efficiency, food safety and comfort to residential and commercial customers. Products include Process Climate Technologies compressors, sensors, temperature Management 17% 28% controls and ventilation systems. Management recently emphasized an example of the Climate Technologies segment: Emerson s design and construction of the air-conditioning system for China s railway infrastructure expansion. 2 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
Industrial Automation Emerson s third-largest segment furnishes tools that allow factories and plants to elevate performance. Products include electric motors, industrial equipment and power systems for manufacturers, energy companies and utilities. Applications include vehicle assembly lines, petrochemical processing, shopping-mall escalators and supermarket checkout stations. Tools and Storage Many of this unit s products are the descendants of Emerson s original offerings, including fans, appliances, water heaters and various tools. This is now the firm s smallest segment and the only one with significant sales to retail markets. MANAGEMENT Emerson Electric s experienced management team adheres to a Deployment of Cash ($ Billions) proven, conservative philosophy. David Farr joined the firm $3 in 1981, becoming CEO in 2000, and all other senior executives have been with the firm for $2 20+ years. Although EMR has made many acquisitions under $1 Farr, they have generally been of the small, bolt-on variety. Farr has safeguarded Emerson s $0 success by avoiding the risk of 2008 2009 2010 2011 YTD big takeovers. As the adjacent Share Repurchases Dividends Capital Expenditures Acquisitions chart reveals, in 2010 the company did make two substantial acquisitions for $2.8B. However, as further outlined in the Financial Metrics section (page 4), Farr s tenure featured measured acquisitions and shareholder-oriented capital allocation. Besides aligning the company with megatrends, management is pursuing growth by continuing its focus on emerging markets. The goal is 45% of total sales arising from these faster-growing economies by 2015. Overall, management expects sales to rise 30%-40% (to $32B-$35B) by 2015, with acquisitions accounting for about one-third of that growth. Long-term goals include 5%-7% sales growth, a 10%-14% free-cashflow margin and a 15%-25% return on capital. Over the past decade, management has made the firm more efficient. Emerson has improved asset utilization, with working capital as a percent of sales and fixed assets as a percent of sales both declining substantially since 2000. During the 2008-09 recession, EMR further reduced costs and streamlined operations. While many peers slashed capital expenditures, EMR cut back only modestly. This positions the company well for an improving global economy. 3 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
Emerson recently reported strong results: Q2 sales rose 16% to $6.3B, organic constant currency growth was 10%, net income grew 17% to $683M and EPS increased 17% to 90. In Q3, order trends have slowed with worries about the global economy but remained positive for all units except Climate Technologies. Given the firm s considerable order backlog, management maintains that revenues should continue to grow for at least the next few quarters. FINANCIAL METRICS Throughout its history, Emerson has consistently increased its income and built shareholder value. By maintaining a solid balance sheet, the firm is able to endure economic slumps. Its financial metrics are strong, with a net profit margin of 10% and a return-on-capital of 16%. Key Statistics (trailing four quarters ending 6/30/2011) Revenue Net Income EPS Net Margin Debt Cash ROC $23.5B $2.5B $3.05 10.5% $5.1B $1.6B 16.1% 25% Financial Metrics Emersion has $11B of intangible assets on its balance sheet (46% of assets). Amortization of intangibles in 2011 will total about $260M, more than 10% of net income. Thus, the firm s true economic earnings are substantially higher than reported income. 15% 10% 5% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Return on Capital Net Profit Margin EMR produces substantial free cashflow and returning it to shareholders is a management priority. Of the $24B in cashflow produced over the past decade, 33% went to dividends, to share buybacks, 25% to net acquisitions and 22% to capital expenditures. Management expects to regularly return 50%-60% of operating cashflow to shareholders, but in the short term more will be allocated to debt reduction and less to share repurchases. Company stock now offers a 3.0% yield. The firm has retired 12% of its outstanding stock since 2000. VALUATION / CONCLUSION Emerson has long proven it can steadily increase shareholder value. The firm boasts a high share of several sophisticated markets, an achievement purposefully built over decades. Although its field is somewhat cyclical, EMR is diversified across many countries as well as industries and should be able to produce a high return-on-capital over the course of an entire business cycle. The company s management experienced and shareholder-oriented has a long-term plan to 4 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
keep the firm growing. Given these factors, Emerson will likely perform well in the long run, prospectively rewarding shareholders with a total annual return of over 10%. $60 $50 $40 $30 $20 $10 Price 15 times Earnings Per Share 25 20 15 P/E Ratio $0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 10 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Because of Emerson s global market position and strong financial metrics, the stock historically receives a premium valuation. As the graph (above right) shows, EMR stock has since 1990 frequently traded at more than 20 times earnings. Over the past five years its median P/E has been 18. However, in recent months shares collapsed on fears that the world economy is faltering. While we cannot predict short-term economic trends, Emerson s stock price appears to undervalue the company s prospects. Thus, this may be an opportune time to buy one of the world s premier industrial companies. [Please see footnotes below] CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness. 5 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777