EMR’s stock price has plunged by more than 25% in 2015. Many of the company’s markets are being impacted by falling oil prices, sluggish industrial spending trends, manufacturing weakness in China, and a strong US dollar. We believe the company’s dividend is very safe and will continue to grow each year, maintaining EMR’s status as one of the 52 dividend aristocrats.
Beyond the dividend, we think EMR’s current stock price offers attractive returns for long-term dividend investors who are willing to wait out volatility in the company’s markets. With so much attention being given to EMR’s challenging markets and dismal outlook for the next year, we believe the company’s restructuring activities, significant portfolio realignment, and opportunity for long-term earnings growth are being underappreciated. Trading at less than 15x forward earnings estimates, EMR is one of our top dividend stock ideas.
EMR was founded in 1890 as a regional manufacturer of electric motors but has grown into a global manufacturer of a wide variety of industrial and technical equipment. Its products include valves, wireless sensors, compressors, various precision instruments, server enclosures, software, and much more. EMR’s main expertise is in bringing together technology and engineering to provide solutions for customers in the process, industrial, commercial and residential markets.
Over the summer, EMR announced a plan to spin or sell off non-core assets to refocus on its highest-margin, fastest-growing segments. Once these actions conclude by September 2016, EMR will be left with businesses mostly focused on equipment for controlling industrial processes and various components used in heating and air conditioning systems.
While EMR’s 2014 sales base would decline from $24.5 billion to $16.3 billion, its EBIT margin would improve from 16.5% to 19.7% and underlying sales growth from 2010-2014 would have been 6.9% per year rather than the 4.5% annualized rate EMR recorded. While there is some uncertainty regarding the value EMR will receive for these non-core assets, we are excited by the higher quality mix of assets the company will be left with and management’s increased ability to focus more on the factors that have made EMR a great company for more than a century.
Once these moves are complete, EMR will be left with strong positions in two market segments totaling $130 billion in size:
Process and Industrial (65% of sales, 5-7% market growth) provides automation and electrical technology and services to oil & gas, chemical, life sciences, food & beverage, mining, power, petrochemical, and water & wastewater markets. EMR has number one market share in measurement devices, control valves, wireless devices, and fluid control.
Commercial and Residential (35% of sales, 4-6% market growth) provides infrastructure and tools used for commercial buildings, retail sites, contractors, and homeowners. EMR has number one market share in residential & commercial compressors, commercial controls, plumbing tools, wet/dry vacs, and food waste disposers.
By geography, EMR generated 46% of its 2014 sales from the United States and Canada, 22% from Asia, 20% from Europe, and 12% from the Middle East, Africa, and Latin America.
Few companies have been in business as long as EMR. Not surprisingly, the business contains numerous attributes that allow it to generate high returns on invested capital. From a product perspective, EMR is well diversified. However, many of its products share a common, profitable characteristic – they represent a small percentage of an end good’s total cost but are part of a mission-critical piece of functionality. In other words, customers are happy to pay up for reliability and dependability.
For example, EMR sells many advanced instruments to oil well operators. These pieces of equipment immediately obtain pressure, temperature, flow rates, and valve position, providing operators with real-time information they need to reach quickly to any change in the condition of the well. Some of the company’s industrial valve products might also be used in deep-water oil extraction, requiring a high level of precision. Given the operational differences between customers, many of EMR’s solutions are customized and solve complex challenges. This requires an employee base composed of engineers, researchers, and other specialists.
Beyond the products’ reputation for quality and dependability, EMR sells most of its products through a direct sales force and employs thousands of field engineers to work directly with its customers to enhance their processes. These long-standing customer relationships improve EMR’s brand and stickiness. As a result, EMR has maintained a number one market share position across most of its key products – measurement devices, control valves, wireless devices, fluid control, compressors, commercial controls, plumbing tools, wet/dry vacs, and food waste disposers.
Of course, EMR’s sheer size provides benefits as well. The company maintains a large portfolio of products and services and operates all around the world. This makes it a one-stop shop for just about any infrastructure solution a customer is seeking, from process automation to plant optimization to climate control and more. Smaller competitors cannot match EMR’s breadth of business. EMR’s size also allows it to invest heavily in R&D and acquire complementary product offerings to sell around the world. EMR has invested more than $500 million per year in R&D each of the last three years, racking up nearly 2,000 patents last year alone.
Finally, EMR has built up a massive installed base. In just the past 10 years, EMR built a global installed base of $65 billion in its process management segment alone. While the installed base provides high-margin aftermarket business (maintenance & repair work) and increases customer stickiness, it will likely become an even bigger asset in future years as the “industrial internet” ramps up – this is also one reason why we bought GE in July 2015.
EMR benefits from this theme because many of its business lines are directly tied to the number of digital devices in the field. EMR’s wireless sensors, instrumentation, and software can help digital field devices run real-time monitoring and diagnostics across many types of production processes. EMR’s predictive maintenance software can then alert customers when issues are detected, enabling appropriate correction before operation are impacted. EMR launched its first wireless product in 2003 and generated over $300 million in wireless sales last year. While it is a smaller piece of the story today, we view EMR’s installed base as an important asset that could provide numerous high-margin revenue opportunities in years to come as industrial analytics grow in use.
Read through any of EMR’s recent earnings call transcripts, and a dismal economic picture will be painted for you pretty quickly. EMR expects overall business trends will remain weak for the next year and is working quickly to adjust labor costs in response to lower demand levels.
The factors impacting EMR are lower oil prices, sluggish global industrial spending, a sharp drop in sales to China, and a strong US dollar. Unless you have been living under a rock, these issues are well known and at the center of almost every question EMR receives from investors.
While none of this sounds very good, it is important to remember that the stock market is forward-looking and has already cut EMR’s price by nearly 30% this year. For this reason, we like to ask ourselves, “What could the next big downside surprise be that causes EMR to fall another 20%?”
Given the pessimism currently surrounding the stock, we think further downside would most likely be caused by another step down in order growth, which analysts hope is bottoming out (see the chart below). There is also risk that oil prices continue to drop, resulting in cuts to some of EMR’s high-margin aftermarket business. We view both events as lower probability occurrences, but your guess is as good as ours.
Source: EMR Investor Presentation
To put some numbers behind EMR’s revenue exposure to some of these unfavorable trends, the company generated 12% of its 2014 sales from upstream oil & gas markets (7% oil, 5% gas; seeing significant weakness), 6% from midstream, 16% from downstream (performing well but lower margins than upstream), 12% from China (sales fell a surprising 14% last quarter – fixed investment is decelerating as economy rebalances), and 2% from Russia. Putting it all together, that’s about 25% of EMR’s business which is seeing significant pressure from falling oil and a weakening China / Russia.
A strong US dollar is also hurting reported sales growth, taking away 5% of growth last quarter, but there is minimal profit risk because EMR’s sales and manufacturing costs are aligned regionally. As a result, the bigger currency risk is EMR’s competitors in Europe and Japan being able to undercut on price, which they have done some of in recent quarters. Again, we don’t see this impacting EMR’s long-term earnings growth profile. Just another bump in the road.
Aside from macro trends, there is also some uncertainty surrounding the planned spinoff of EMR’s $5 billion network business, which continues to see significant sales declines (its sales are already down 30% from 2011). If its ultimate value is much less than investors expect or realize, there could be another bout of weakness in the stock next year. However, this transaction has no bearing on EMR’s long-term earnings growth potential. We would view any weakness as a buying opportunity.
Taken together, it’s easy to see why investors are frustrated with EMR’s recent results. Sales fell 13% last quarter (organic sales were down 5%), and the company expects full year 2015 sales to be down 9% (organic sales down 2%). Numerous macro factors are working against the company and haven’t shown any signs of correcting. Management also believes the next year will remain weak and is undertaking restructuring actions to reposition the business for weak markets (see below – projected savings would boost 2014 earnings before taxes by 7%+).
Source: EMR Investor Presentation
There’s not much EMR can do about the unfavorable climate it is dealing with today. However, we think the stock, which sports a forward P/E ratio less than 15x, has largely discounted many of these risks. Barring a global recession or plunge in oil prices below $30, we think patient investors willing to hold EMR for 3-5 years will be rewarded.
In 2009, the stock traded down to $25 per share, representing an 11x price-to-earnings multiple off of 2009’s trough-level earnings per share of $2.27. Heading into 2009, EMR’s sales were several billion dollars lower and its cost structure was much more bloated than it is today. If we assume another crash happens, GAAP earnings drop to $2.60 per share (15% higher than the 2009 trough), and the stock trades at 11x trough earnings, we would see a low stock price of about $29. Before factoring in today’s 4.1% dividend yield, the downside risk would be 35%. For a high quality business like EMR with great long-term earnings and dividend growth potential, that is a risk we are willing to take.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. EMR’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
EMR recorded a Safety Score of 45, suggesting its current dividend payment is safer than 45% of all other dividends available in the market. Falling oil prices, softness in China, sluggish industrial spending, restructuring costs, and a strong US dollar have dented EMR’s recent business results and work against its dividend’s safety. However, the company remains very healthy financially and appears to be in solid position to raise its dividend once again despite the current macro environment.
Over the trailing twelve months, EMR’s dividend has consumed 52% of its GAAP earnings and 62% of its free cash flow. These levels are healthy and continue to provide a nice cushion if EMR’s cyclical markets unexpectedly weaken further.
Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, EMR’s payout ratios have remained below 60% each year over the past decade. We like to see stable and sub-70% payout ratios for dividend growth stocks, just like EMR has demonstrated.
Source: Simply Safe Dividends
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Recession Performance Analyzer tool shows how much sales and earnings fell for a company during the financial crisis. EMR’s reported sales fell 15% in fiscal year 2009, and its GAAP earnings dropped by 26%, not bad for a company sensitive to cyclical industrial spending trends. EMR’s sizeable aftermarket business provides some stability when its customers pullback on capital expenditures. EMR is further enhancing its recession-resistance with a $220 million restructuring plan expected to be completed in the first half of 2016. EMR expects to realize at least a 1:1 payback period within one year since the cost improvements are mostly labor-related.
Source: Simply Safe Dividends
High quality companies are able to generate free cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. As seen below, EMR has generated very healthy free cash flow each of the past 10 years and managed to double free cash flow per share from about $2 in 2005 to more than $4 last year. Despite operating more than 200 manufacturing facilities around the world, the high-value nature of EMR’s products and its lucrative aftermarket business allow it throw off substantial cash each year.
Source: Simply Safe Dividends
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well. When times get tough, a healthy balance sheet can continue funding a company’s dividend. Looking below, we can see that EMR has maintained a conservative balance sheet over the past decade. For companies like EMR that have greater sensitivity to macro factors such as industrial spending, we prefer to see debt to capital ratios no more than 50%. EMR has kept its debt to capital balance below 35% for a long time, providing plenty of safety for the dividend.
Source: Simply Safe Dividends
Looking at the balance sheet, EMR again appears to be in great shape. We can see that EMR maintains a very flexible balance sheet, holding more than $3.3 billion in cash compared to total book debt of about $7.5 billion. The company also generates several billion in free cash flow each year, more than enough to easily cover the $1.2 billion in dividends paid out last year while continuing to reinvest in the business.
Source: Simply Safe Dividends
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
EMR’s Growth Score is 51, meaning its dividend’s growth potential ranks higher than 51% of all other dividend stocks we monitor. Despite recent headwinds across several of its important end markets, the company continues generating solid cash flow, maintains a flexible balance sheet, and remains committed to dividend growth. EMR has increased its dividend each year for nearly 60 years and has grown its dividend at a compound annual rate of 11% since 1956. More recently, we can see that EMR has increased its dividend payments at a high-single digit compound annual rate over most time periods:
EMR currently trades for less than 15x forward earnings estimates. Unless its orders and end markets drop off even further, it seems likely that the savings generated from the company’s substantial restructuring initiatives will be enough to maintain or grow earnings per share next year.
While no one knows what will happen next year and conditions are expected to remain very challenging for EMR, it is important to keep the big picture in perspective. After its strategic actions are complete one year from now, EMR’s remaining markets will still be greater than $130 billion in size and growing at least in line with GDP over time. The company’s market share will be less than 15%, providing it with a long runway for continued sales growth.
EMR’s 4.1% dividend yield is good for a Yield Score of 74, meaning its yield is higher than 74% of all other dividend stocks. Unless the world enters into another recession, oil prices plunge to $30 a barrel, or China heads for a hard landing, we believe EMR’s stock offers considerable value for long-term dividend investors at today’s price.
From a total return perspective, we think it is reasonable to assume that EMR will continue growing its earnings per share by at least 5-8% per year over long enough time periods. This assumption is supported by EMR’s large markets, 125+ year track record of profitable growth, recent earnings growth (11% compound annual growth rate from 2009-2014), and higher-margin, faster-growing businesses remaining after its strategic actions are complete by September 2016. Adding EMR’s 4.1% dividend yield to our expected earnings growth rate of 5-8% suggests total annual return potential of 9% to 12% going forward. The stock’s P/E multiple could also rise from its current 14.4 level, adding further upside. However, we prefer to remain conservative and exclude any benefit from multiple expansion, if and when earnings resume growth.
EMR is a highly durable industrial business that has weathered numerous ups and downs throughout its 125+ year history. The company’s wide assortment of mission-critical products, diverse end markets, global operations, meaningful aftermarket business, and conservative capital allocation practices have allowed it to raise its dividend for nearly 60 consecutive years, a remarkable feat matched by fewer than 20 total companies. The recent challenges impacting EMR’s business do not seem likely to prevent the company from growing earnings over the next 3-5 years – we expect the company to ride out this storm like it has every other, coming out on the other side even stronger. Trading at 14.4x forward earnings and offering a safe 4.1% dividend yield, EMR’s stock appears attractive for long-term dividend investors.