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Why You Should Buy This Undervalued Stock Before Everyone Else Does

Emerson Electric (NYSE: EMR) may have an interesting mix of businesses. But that didn't deter the automation, climate technology, and tools company from crushing its original guidance when it reported its fiscal 2021 (ending Sept. 30) earnings. In addition, Emerson started fiscal 2022 with its three-month trailing orders up 16%, and management guided toward a 19% increase in earnings for 2022.

However, the stock only rose 16% in 2021, significantly underperforming the S&P 500's 27% gain. It's an underperformance that I don't think will repeat in 2022.

Image source: Getty Images.

Why Emerson Electric underperformed

There are probably two reasons:

  • When it comes to the industrial sector, the market is worried about surging raw-material costs (like steel) and supply-chain issues pressuring costs and end-customer demand.
  • The market is fretting about Emerson's exposure to the oil and gas industry and the possibility that upstream-oil capital spending will be restrained in the future.

Both of these fears are overplayed.

Cost headwinds

There's no doubt that the industrial sector faces near-term issues on costs, and the current debate centers around whether the second half of 2022 will see these headwinds turn into tailwinds. Emerson Electric's management believes it will. As per the last earnings release: "Price-cost will turn to a tailwind during the second half and is expected to be approximately $100 million favorable for the year."

While that remains to be seen and is subject to conditions with the pandemic and how governments react to news flow, there's evidence to suggest that underlying industrial demand will remain strong.

For example, the Institute for Supply Management (ISM) publishes the most widely respected survey data on the manufacturing sector. As you can see below, customer inventories are very low (a reading of 50 implies normal conditions). New orders continue at elevated levels (a reading of 52.8% suggests growing manufacturing orders), but prices paid remain at high levels.

This isn't "stagflation." On the contrary, low customer inventories are bullish for future demand, and new orders are in growth mode. (Emerson's three-month trailing orders were up 16% to September.) Moreover, history suggests the supply of raw materials will respond to high prices, and prices will moderate in the future.

Data by YCharts.

Not just oil and gas

The fear over future oil and gas capital spending is understandable. It's one of Emerson's core end markets in its automation-solutions segment (measurement and analytical instrumentation, valves, actuators, regulators, fluid controls, and software). However, it's essential to put some perspective on matters.

First, upstream oil and gas is just one of many end markets. For example, the chart below shows that it only made up 11% of total sales in 2021.

Data source: Emerson Electric SEC filings.

Second, speaking on the last earnings call, CEO Lal Karsanbhai made it clear that upstream oil and gas is a business he's moving away from. "We will continue to divest upstream oil and gas hardware assets," he said. "Secondly, we will action [or, divest] low-growth or commoditized businesses."

Third, it's not that oil and gas is an unprofitable business, so Emerson can still generate profits and cash flow from the businesses to invest in other growth priorities. Indeed, Emerson has always been very good at generating cash, with $3 billion in free cash flow in 2021 and guidance for $3.1 billion in 2022. That should give Karsanbhai plenty of financial firepower to make acquisitions.

Growth prospects

Emerson will continue to be aggressive in investing in a growth business. Karsanbhai said, "[W]e identified four large, profitable, high-growth end markets, each with at least $20 billion of size and projected to grow higher than 4% a year into the future," and industrial software is one.

Indeed, Emerson bought power industry-software provider OSI Inc for $1.6 billion in 2021 and small industrial internet of things (IIoT) and analytics company Progea in 2020. Moreover, Emerson announced a deal to invest $6 billion and contribute its existing software business for a 55% stake in industrial-software company Aspen Technology in 2021, with the deal expected to close in 2022.

Image source: Getty Images.

Is Emerson Electric a buy?

As noted above, management is guiding toward adjusted earnings-per-share growth of 10% to $4.82-$4.97 in 2022, with underlying sales expected to grow 6%-8%, with free cash flow of $3.1 billion. Based on the current market cap of $56.7 billion, Emerson would trade at 18 times full-year 2022 free cash flow, making it look undervalued if you agree a mature industrial conglomerate should trade at 20 times free cash flow.

Throw in a well-supported dividend -- current yield of 2.1% -- and Emerson may be able to generate double-digit returns for investors in 2022.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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