Emerson Electric's(NYSE:EMR) stock is down 7.6% year to date, as I write. With that said, there are signs the company could finish 2014 on a strong note. The global economy is set for a better second half, and management is actively restructuring the business in order to generate earnings growth. Does the dip in the share price create a buying opportunity for investors?
The story of 2014
Readers looking for some background material on this manufacturing and technology company can read a recap of its last conference call here, along with the bull and bear cases for the stock.
In a nutshell, management has been doing a pretty good job in raising its operating margin to a record level, and the company's cash flow conversion remains strong. However, a combination of geopolitical uncertainty and weaker than expected global growth has slowed customer spending. As such, Emerson's sales growth is trending toward the low end of its full-year target for 3%-5% growth.
Geopolitical developments (such as strife in the Middle East and Ukraine) matter a lot to Emerson Electric. Not only does it sell directly to many emerging market countries, but it also tends to sell solutions that require a long-term commitment to infrastructural spending -- something that governments and companies are cautious about in situations of uncertainty.
For example, its process management segment (which delivered 42.5% of segmental profit in 2013) reported an 11% decline in its Middle East/Africa sales in the third quarter -- negatively contributing to the weak-looking 2% underlying sales growth in the segment. The question is whether this is a short-term reaction, or whether this is going to be a longer-term issue.
What to expect next, and valuation matters
Looking ahead, the buildup in backlog -- due to orders outpacing sales-- has put the company in a position to have a strong fourth quarter just by reducing that backlog. In other words, as that list of orders is reduced, Emerson Electric will start booking revenue. Obviously, this requires customers willing to receive deliveries on projects. The good news is that the ongoing strength in the order book (management expects orders to be up 5%-7% in the fourth quarter) suggests that the underlying picture is still positive -- Emerson just needs customers to pick up the pace of their current spending. In a sense, the company needs that positive outlook, as it has missed analyst estimates for the last two quarters--an earnings beat would reassure investors that the company is back on track.
Meanwhile, the fall in the stock price has made shares look slightly undervalued.
The principle valuation metric is enterprise value (market cap plus debt), or EV, over free cash flow. Basically, this represents the return that an acquirer would make if it bought the company tomorrow. Free cash flow is important because it is used to pay dividends and buybacks (a key part of the company's strategy to return cash to shareholders).
Emerson trades at a lower valuation compared to fellow industrial conglomerates like Honeywell International (NYSE:HON) or Eaton Corp (NYSE:ETN) and it's arguably a less risky stock. For example, we already know the aerospace sector is traditionally its largest profit generator, and with around 40% of the segment's revenue coming from defense & space based activities, it's subject to a lot of uncertainty around future defense budgets. Meanwhile, Eaton Corp recently lowered full-year guidance, mainly due to margin pressures in its core electrical systems and services segment.
Emerson Electric's operating margin growth has been impressive in recent years, as the company's ongoing restructuring efforts (including divestitures) have paid off. However, this has come at the expense of flagging sales growth.
Is Emerson Electric a good value?
Analysts have the company growing revenue and earnings at 4.6% and 11% respectively in 2015, and if free cash flow grows in line with earnings, then the EV/free cash flow multiple would be closer to 15x -- making the stock look cheap on a recent-year basis. A quick look at the first chart above reveals that the stock's EV has traded between 15-17.5 times free-cash flow in recent years.
There is a good case for the argument that Emerson Electric is slightly undervalued. It looks a good value relative to its peers, and the company's sluggish revenue growth is actually masking some pretty impressive margin improvements. Management appears to be making all the right steps, but the company's prospects remain dependent on global growth conditions, an abating of geopolitical risk, and the avoidance of a hard landing by the Chinese economy. If you are positive on the global economy, then Emerson Electric offers more upside than downside in the coming year. Throw in a useful 2.7% dividend yield, and the stock is attractive.
Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Emerson Electric. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.