When it comes to world class long-term wealth compounders, often the best choice isn’t the next great hyper-growth tech stock, but something far duller.
Take, for example, industrial companies such as 3M (MMM), which have legendary track records of consistent outperformance and dividend growth that span over half a century.
Emerson Electric (EMR) is another such legend, a venerable dividend king with 60 consecutive years of payout growth to its name. Investors can view data on all of the dividend kings here.
However, in recent years Emerson has faced some very serious growth headwinds.
Let’s take a closer look to see just what has made Emerson such a great business in decades past, what investors can expect going forward, and whether or not you might want to add it as a core holding to your own diversified dividend portfolio at this time.
Founded in 1890 in St. Louis, Missouri, Emerson Electric is a global industrial conglomerate that serves the oil and gas, refining, chemicals, power generation, pharmaceuticals, food and beverages, pulp and paper, metal and mining, and municipal water supply sectors.
Emerson Electric essentially brings together technology and engineering to provide solutions for customers in the process, industrial, commercial and residential markets.
Previously, the company had five operating segments. However, Emerson Electric is in the process of selling its network power segment and restructuring the company from four divisions (see below) to just two.
Process Management: valves, actuators, regulators, measurement and analytics software that helps companies monitor their operations and maximize safety, and efficiency.
Industrial Automation: fluid power and control systems, electrical distribution systems, precision motors, and industrial cleaning systems.
Climate Technologies: builds temperature monitoring and control systems for residential and commercial clients.
Commercial & Residential Solutions: tools for homeowners and professional contractors.
After the restructuring, Emerson will have just two business segments: Automated Solutions (industrial clients) and Commerical & Residential Solutions (non-industrial sales).
These businesses are focused on providing equipment for controlling industrial processes and different components used in heating and air conditioning systems.
As you can see, once the restructuring is complete the majority of Emerson’s revenue will come from its industrial automation division. However, the Commercial & Residential division’s superior margins make it well worth holding onto.
|Post Restructuring Business Segment||Q4 2016 Revenue||% of Revenue||EBIT Margin|
|Automated Solutions||$2.926 billion||66%||16.0%|
|Commercial & Residential Solutions||$1.49 billion||34%||22.5%|
Source: Q4 Earnings Presentation
Geographically, the company remains dependent on its core North American business. However, it is making great strides into diversifying its sales to faster-growing overseas markets.
Very few companies have been in business as long as Emerson Electric has, and even fewer can boast such a lengthy dividend growth streak. The company’s track record speaks to its durability, disciplined capital allocation, and numerous competitive advantages.
Emerson sells thousands of different products, but almost all of them account for just a small percentage of an end product’s total cost.
Most of Emerson’s products provide mission-critical functionality, such as gauging the pressure and flow rate of an oil well. The company’s customers need reliability, and Emerson’s longevity gives it a trusted reputation.
Unlike many other industrial companies, Emerson sells many of its products through a large direct sales force and also has thousands of field engineers working directly with its customers.
These efforts further solidify its favorable brand and customer relationships; deepening switching costs and helping the company continuously deliver innovative, rigorous solutions that solve customers’ most challenging problems.
Thanks to the company’s selectiveness with which product niches it enters and its focus on quality, reliability, and strong customer relationships, Emerson has been able to maintain a leading market share position in many core categories – control valves, fluid control, measurement devices, compressors, wireless devices, and more.
Holding onto top market share positions for 100+ years has many benefits, including a massive installed base in the tens of billions of dollars.
Having a huge installed base really helps smooth out results because it provides more reliable (and high-margin) aftermarket business – customers need to keep their equipment up and running.
Furthermore, a lot of Emerson’s industrial automation products (e.g. wireless sensors, software, instrumentation) are tied to the “industrial internet” theme. As this technology continues advancing, Emerson has potential to better monetize its installed base.
However, industrial companies are still cyclical, with growth in sales, earnings, and cash flow generally tied to that of the broader global economy.
Unfortunately for Emerson, the last few years have not been kind, with CEO David Farr declaring a “global industrial recession” in the first quarter of 2016.
A large part of this can be blamed on the worst oil crash in over 50 years, which has resulted in a massive decrease in orders from energy companies who have slashed capital spending in recent years.
Sadly, there are no signs that this industrial downturn is slowing. As you can see below, orders from Canada, which is highly dependent on oil production, have fallen off a cliff.
In addition, slowing economic growth in Asia, especially China, has also hurt sales and margins in recent quarters.
Meanwhile, decreased Chinese demand for commodities has, in turn, resulted in severe economic downturns in Latin America, which depends heavily on exporting commodities.
Source: Emerson Q4 Earnings Presentation
Now in fairness to Emerson, its management is world class, as represented by President, Chairman, and CEO David Farr, who has been with the company for over 30 years.
Since taking the top spot in 2000, he has done an admirable job of selling off low margin businesses, acquiring more profitable divisions, and expanding into developing markets, which will be a key for sustaining long-term growth.
With decades of experience in both good business cycles and bad, Farr has managed to use disciplined cost cutting to keep Emerson’s margins and returns on shareholder capital far above its peers.
|Company||Operating Margin||Net Margin||FCF Margin||Return On Assets||Return On Equity||Return On Invested Capital|
Perhaps most importantly, Emerson has maintained a high free cash flow (FCF) margin that has continued to support its dividend and allowed continued dividend growth even through numerous lean periods, including now.
However, management doesn’t expect orders to bottom and start increasing until the end of 2017, assuming that energy prices continue to recover.
In addition, due to the restructuring the company is undertaking, which includes sales of large divisions such as network power, as well as divestitures of Leroy-Somer and Control Techniques businesses (part of its old industrial automation division), the next few years are expected to be characterized by very slow growth, especially of the company’s FCF.
In fact, dividend investors need to be prepared for continued deterioration in sales, earnings, FCF, and margins for the next few years.
Until the global industrial recession finally ends, and/or the company can acquire enough new bolt on businesses (such as the recent $3.15 billion acquisition of Pentair’s valves and control business) to recover its previous revenue, lean times will likely continue.
That being said, while Emerson and most of its industrial rivals may be in for some lean years ahead, we can’t forget to look at the long-term fundamentals of the company.
Specifically, after the Pentair (PNR) acquisition closes Emerson will own 16% of the global industrial automation market, in which it has created a wide moat for itself thanks to a reputation for high quality and reliable products.
This creates not just more reliable customers, but also allows Emerson stronger pricing power and better profitability.
As for the Commercial & Residential segment, Emerson is among the leading innovators when it comes to energy efficient heating and cooling systems.
This explains this business segment’s impressive margins, and with a continued recovery in U.S. housing construction in the coming years, this business segment will likely represent one of the most important growth drivers for Emerson.
There are two main risks to be aware of before investing in Emerson.
First, even after the restructuring the company will be very heavily exposed to the oil & gas sector. In fact, almost 50% of its sales will come from this highly cyclical and still struggling industry.
In addition, keep in mind that although geographic diversification is good in the long-term, as Emerson expands more overseas and into developing markets, its exposure to potentially negative currency effects will increase.
In the past year, the strong U.S. dollar has hurt sales and earnings by 2%, and that headwind could rise to 3% annually if the company is able to diversify to the point that U.S. sales represent just a third of total revenue.
Given that the U.S. economy is growing faster than many of its major rivals (such as the EU, Britain, and Japan), rising U.S. interest rates could keep the dollar strong or strengthening for at least the next few years.
Fortunately, Emerson’s sales and manufacturing costs are fairly well aligned regionally, minimizing the risk to its actual profits. However, the company’s foreign competitors are better able to undercut the company on price when the U.S. dollar is strong.
This shouldn’t impact Emerson’s long-term earnings power, but it could weigh on the stock any given quarter or year.
Dividend Safety Analysis: Emerson Electric
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Emerson Electric has a Dividend Safety Score of 81, indicating that its current dividend is very safe and dependable.
This shouldn’t come as a surprise given Emerson’s dividend king status, as its proven itself dedicated to not just maintaining its dividend for 60 years, but also growing it through both good economic times and bad.
One reason for this is management’s conservative approach to increasing the company’s payout.
Specifically, Emerson has historically maintained a low EPS and FCF payout ratio of around 40% to 50%, giving its dividend plenty of security padding during lean times.
Relatively low payout ratios are particularly important for cyclical companies. During the financial crisis, Emerson’s sales dropped by 15% and its earnings declined 26% in 2009.
Many industrial companies performed much worse, as Emerson’s large aftermarket business helped cushion the blow.
While the company is not recession-resistant, and its business mix will be different following the transformation work it has taken on the last few years, Emerson seems likely to be able to continue paying dividends during the next downturn as well.
Emerson’s dividend is also protected by the gobs of free cash flow its business consistently generates, which is made possible by the company’s high-value products and lucrative aftermarket business.
Emerson has recorded positive free cash flow each year for more than a decade, and its free cash flow per share has nearly doubled since 2005, supporting healthy dividend growth.
The other important factor to Emerson’s rock solid dividend is the company’s historically conservative approach to debt. In fact, the balance sheet is one of the strongest in its industry; a very good thing given the cyclical nature of this industry.
Emerson’s strong current ratio, low leverage ratio, low debt/capital, and strong interest coverage ratio, mean that the company should have no problems servicing its debts or short-term liabilities.
Meanwhile, the cash on its balance sheet is enough to pay the dividend for 2.6 years all by itself.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
Overall, Emerson’s dividend is very safe. The company’s healthy payout ratio, superb free cash flow generation, rock solid balance, and dividend-friendly culture all provide great support to the payout.
Recent restructuring actions should further improve Emerson’s business quality and dividend safety as well.
Dividend Growth Analysis
Our Dividend 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.
Emerson Electric has a Dividend Growth Score of 37, meaning that in the short to medium-term dividend investors can expect slightly below average dividend growth.
That should come as no surprise, given the ongoing industrial recession as well as the oil crash that has dragged on longer than most people expected.
In addition, thanks to the ongoing restructuring, Emerson’s own dividend growth guidance of 2 cents per share per year (about 1% annual growth) means that the coming years will prove disappointing from a historical dividend growth perspective.
As you can see below, Emerson had increased its dividend by 7.4% annually over the last decade and by 5.8% per year during the last five years.
However, the good news is that with its strong brand, growing presence in developing markets, wide moat, and the secular trend towards industrial automation, Emerson should be able to, in the long-term, return to its historic mid- to high-single digit annual dividend growth rate.
Regardless, Emerson’s impressive dividend growth streak and dividend aristocrat status are not likely to end anytime soon.
Despite sluggish short-term dividend growth expectations and deteriorating fundamentals, shares have risen strongly (39%) in the past year.
This has largely been due to two factors. The stock’s surge has also been driven by excitement for a domestic industrial revolution, following the election of Donald Trump.
Second, yield-starved investors searching for safe bond alternatives have bid up the price of almost anything with a decent dividend and excellent payout security.
Emerson’s dividend yield has compressed from nearly 4.5% in early 2016 to just 3.2% today.
That’s not to say that Emerson’s current valuation is nearly as bad as the market’s far frothier trailing P/E of 26.1.
But as you can see, Emerson’s current P/E is significantly higher than its historic median. While it’s true that the current yield is higher than its historic norm, we can’t forget that the next few years are likely to see little growth of that dividend.
|P/E||13-Year Median P/E||Yield||13-Year Median Yield|
For a cyclical, low-growth turnaround such as Emerson, valuation becomes very important to determining your short to medium-term total returns.
Considering the stock’s recent price surge, relatively high valuation multiple, and seemingly slow earnings growth outlook the next couple of years, investors might be best waiting for a pullback to initiate or add to their positions.
That’s especially true given that Emerson is up over 10% since Donald Trump won the election, due to bullish hopes that the new administration’s promised $1 trillion in new infrastructure spending will help boost industrial demand.
In reality, there is little chance that all of that promised spending will happen, and it could take years for whatever new spending occurs to actually make its way through Congress and affect Emerson’s order book.
In other words, Emerson’s recent run up could likely reverse and offer a far better buying opportunity later in 2017.
A stock price below $50 would be more enticing and offer a starting dividend yield closer to 4%, better compensating for Emerson’s lower earnings growth rate.
Closing Thoughts on Emerson Electric
When it comes to safe, reliable, industrial dividend blue chips, Emerson Electric deserves its place in the pantheon of great long-term investments.
The company’s dedication to consistent dividend growth, conservative and highly adaptable management, and 126-year operating history prove that this is a true “Sleep Well At Night,” or SWAN, blue chip.
Given the ongoing industrial recession, Emerson’s large exposure to the struggling oil and gas sector, and the stock’s strong rally over the past year, I’m not in a rush to add to my position in the company.
However, as a long-term shareholder, I plan to continue holding onto our position in Emerson in our Top 20 Dividend Stocks portfolio for many years to come.