Description

Background

Emerson (EMR) is a global producer of electrical equipment producer that has vastly transformed their portfolio in the last decade, having gone from 5 discrete business lines to two from 2010 to 2021 as seen in the chart below:

https://www.emerson.com/documents/corporate/2021-investor-conference-presentation-en-us-7363258.pdf

When incoming CEO Lal Karsanbhai took over in 2021, he further transformed the company by announcing the following strategic actions

1. Sale of InSinkErator (i.e., consumer sink garbage disposal) to Whirlpool for $3bn
2. Sale of majority stake in Climate Tech (Copeland) to Blackstone for $14bn
   1. Commercial refrigeration systems (i.e., fridges at a grocery store) and consumer controls (i.e., at home smart thermostat)
3. Acquisition of majority stake in AspenTech for $6bn
   1. Provider of software and services for process industries (i.e., chemical plants and refineries)
4. Acquisition of National Instruments (NATI) for $8.2bn
   1. Software focused test equipment, and virtual instrumentation products (i.e., instead of an array of physical test meters, National Instruments converts them into digital meters) often used in process automation.

After these transformations, Emerson will transition into a 100% automation solutions company with exposure to secular growth trends in discrete and process automation as a result of high labor costs and US reshoring themes.

While the level of complexity involved in some of the business transformations has made Emerson more difficult to understand, which I believe is part of the reason why it trades at a discount to peers, I believe that after the businesses are fully integrated and simplified, EMR should trade at a multiple closer to its automation comps like Rockwell (ROK) and Ametek (AME) and Eaton (ETN).

Automation Primer

Automation is a fast-growing industry but a simple primer is instructive to get a better understanding of Emerson after the transformation. Automation broadly falls into two groups, Discrete and Process automation. In its simplest form, Discrete automation typically refers to more complex products that require assembly lines like cars, iPhones, sneakers, while Process automaton refers to high volume continuous production lines like drugs, beer and chemicals.

In the coming years, global discrete automation will outgrow process automation because of their exposure to labor shortages and reshoring of manufacturing and is expected to grow by 8% CAGR through 2026 with major players ABB and Rockwell corroborating this view. That said, process automation should grow at a GDP++ pace as companies transition towards digital.

After the transactions, Emerson will have exposure to both segments in at an 80/20 split on process/discrete automation.

Valuation Gap and Thesis

Currently, Emerson trades at a 30% discount to their electrical and automation peers and I believe the Emerson valuation gap exists for two primary reasons:

1. Concern that National Instruments was acquired at the peak and that decelerating orders will make the EPS accretion look aggressive.
2. Concern over execution at AspenTech and whether Emerson will buy-out the minority stake, incurring further leverage or cash outlays.

Prior to the acquisition, National Instruments grew backlog by 70% between 2022 and 2021 and has recently seen some moderation in order activity with recent orders trending down 15-20% and management having affirmed those estimates during an NDR in December. Management is confident that even if revenues were to decline LDD vs the current MSD decline embedded in FY24’s guide, they can still hold the NATI EPS contribution of 35-40c, with ~10-15c of synergy cushion to be realized.

AspenTech is a software solutions provider for process automation and is 55% owned by Emerson after an acquisition in 2021. AspenTech’s stock declined 25% in April 2023 largely due to poor execution, leading to a surprise decline in orders. Investors were concerned that the order trends signaled a peak on demand but since then, execution has stabilized, and orders have recovered.

I believe that post integration of National Instruments and the realization of synergies, the true earnings power of the transformed Emerson will be evident, with MSD+ organic growth and 40%+ incremental margins which should lead to HSD EPS growth for the foreseeable future. I expect this will manifest in Emerson being a beat and raise story for FY24, where they guided FY24 EPS in the range of $5.15-$5.35 and consensus sits below the midpoint at $5.22. I believe EMR can achieve $5.40+ of EPS in FY24 through upside in incremental margins and organic sales underpinned by rebounding orders at both NATI and legacy Emerson.

I believe Emerson is a show-me story and they should only need to hit the top-end of their guide range for the valuation gap to close and if they exceed their guide range, it would imply upside to EPS estimates and valuation.

Valuation and Price Target

Emerson expects to grow EPS by 10% CAGR between 2023 and 2025 on a pro forma organic basis compared to the average multi-industrials CAGR of 5% and an average 2024 P/E of 19x. However, post transformation, I believe EMR should trade closer to their higher margin and growth peers like ROK, AME, and ETN who are exposed to automation and electrification themes.

I believe a 30% discount is too wide for a high-quality company that just needs to execute on the plan. Should they achieve this, I believe the valuation gap to the group would close to a 1-2x multiple discount vs current 5x, implying a 22-23x 2024 P/E and a price target range of $124-$130 (25%-31%).

Risks to the Thesis

If the synergies from NATI do no materialize from integration challenges, the valuation discount will persist.

Catalyst

beat and raise over the next few quarters.