Emerson Electric (EMR 0.79%) has never quite had the same name cachet as industrial peer General Electric. Right now that's actually a good thing, since today GE is making headlines because it has fallen on hard times. But Emerson has its own devils to deal with. At the moment, that includes a slowing global economy and an activist shareholder that's looking to shake things up at the over 100-year-old company. The thing is, there's not a whole lot left to change at this nearly 3%-yielding industrial icon.
Moving things around
A couple of years ago, Emerson decided to shift its portfolio a bit more toward growth. One key step on that path was to sell a division that provided power systems to data centers, along with the divestitures of some smaller businesses. Following those moves, management reorganized the company into two groups: automation solutions and commercial and residential solutions. It's been adding to these businesses since, with bolt-on deals like the acquisition of GE's programmable logic controllers business on the automation front.
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The end goal here was to simplify and focus on higher-margin, growing operations. Automation, which accounts for around two-thirds of the top line, has an earnings before interest and tax (EBIT) margin of around 16%. Commercial and residential, accounting for roughly a third of revenue, has an EBIT margin in the low 20% range. That said, automation is expected to grow sales in the low-to-mid single digits in 2019, while commercial and residential is hoping to simply match year-ago sales results.
Those projections are down from earlier expectations and below year-ago levels, as the global economy has been weakening as fiscal 2019 has progressed. To put some numbers on that, automation had sales growth of 10% in fiscal 2018, with commercial and residential's sales increasing by 4%. All told, it hasn't been a particularly great year for industrial companies like Emerson. That said, with only one quarter left in the fiscal year, management is still expecting earnings to hit its guidance of $3.60 to $3.70 per share. (The company reports full-year fiscal 2019 earnings on Nov 5.) A lower tax rate is projected to help offset top-line weakness.
Emerson is muddling through a difficult period and its share price reflects that. Year to date through late October, Emerson's stock is down around 5% compared to a roughly 7% gain for the S&P 500 and 6% growth for its industrial peer group, using Vanguard Industrials ETF as a proxy. That's actually an improvement for Emerson, which saw its shares off by as much as 20% at two different times this year. The most recent uptick, meanwhile, was helped along by activist investor D.E. Shaw's announcement that it had taken a roughly 1% stake in Emerson.
Shaking the tree
Following the news of Shaw's investment and stated desire to see changes made at the industrial giant, Emerson quickly announced that it was happy to talk with its shareholders. Since that point, Shaw has been fairly public about its thoughts.
For example, Shaw believes Emerson could trim $1 billion from its expenses (noting it could sell some of the eight airplanes it owns). Furthermore, it suggests that investors could see a $20 billion increase in shareholder value if Emerson conforms to all of its requests. While Emerson has noted that it is happy to listen to Shaw's ideas, that doesn't mean that it will act on any of them or that the proposed changes are feasible or even desirable.
The biggest -- and perhaps most difficult to achieve -- demand is Shaw's call for Emerson to break up its business. After a series of big changes in recent years, there's not a whole lot left to do from a big-picture perspective with Emerson. So breaking up the company can only mean splitting in two. Automation would be the larger and arguably more desirable of the two businesses, given its top-line strength. That remains true even though its margin isn't quite robust as slow-growing commercial and residential. But how great a plan would this really be?
On the surface, having two more-focused companies would allow the management teams of each to hone in on their businesses. But the whole point of putting disparate industrial businesses under one roof is to create a balanced portfolio of assets. That allows giant industrial companies to benefit from a diversified set of businesses to better manage through the inevitable rough patches that each will experience. That's been Emerson's model for decades, as it has used the conglomerate structure to smooth top- and bottom-line performance over time. The results so far in fiscal 2019 show the power of that.
Although sales at both automation and commercial and residential are slowing, automation's growth is still a bright spot. And the higher margin in commercial and residential provides a solid foundation -- and stream of cash -- for Emerson to use to invest in its business (such as continuing to expand automation with bolt-on deals) while returning a growing stream of cash to shareholders (the company has increased its dividend for an incredible 62 consecutive years).
And while Shaw hints at big cost savings, breaking up would mean that each business has to start paying for services they benefit from sharing today, such as accounting. From that perspective, cutting some fat away would probably do more for the combined entity than it would for a broken-up Emerson. This doesn't even take into consideration the costs that would be associated with a massive corporate restructuring (breaking up is actually quite hard to do on Wall Street). And what happens to the dividend in a breakup scenario is another big question mark that income investors should be worried about.
Neither is a great option right now
It's hard to suggest that having a dissident shareholder pushing for change at Emerson is a bad thing (eight airplanes does seem a bit excessive). But Shaw appears to be asking for a lot with its breakup request. Emerson has already made big moves to streamline in recent years and going any further will mean shifting from a conglomerate structure (which comes with notable benefits for investors, despite some negatives) to shareholders owning two focused businesses -- both of which investors would need to track individually.
Investing is difficult and it can be easy to get caught up in the Wall Street hype machine. This is just one of many examples where you need to step back, look past the numbers being tossed about, and think about what's best for your portfolio. If you appreciate diversification, Shaw's demands will probably be a net negative for your portfolio. So if Emerson kowtows to Shaw, you might be better off buying a competitor that's planning to stick with the conglomerate structure. Investors need to watch the next few earnings reports very closely for a hint of where Emerson is heading.
