2 for Tuesday: Don't Miss Emerson in the Bargain Bin

Whenever capital-goods analysts got nervous about the economy, yet felt like they had to have at least one stock to like (besides GE, of course), that stock was Emerson Electric (EMR).

Boring, yes, but reliable -- defensive, even, in an indefensible group. Emerson never missed a beat, dutifully coughing up consistent earnings per-share growth through good times and bad. From 1991 through 2000, Emerson's earnings per share grew at a 10% compound annual rate.

Then came 2001, arguably a tough year for everybody. But that's no consolation for poor David Farr. He was named CEO in October 2000, after his legendary predecessor Chuck Knight finally felt satisfied he had his man and agreed to bow out. Yet Farr's timing couldn't have been much worse. For the first time in its enviable 43-year streak, Emerson's earnings will decline in 2001 by 9% to $3 a share from last year's $3.30, and face another challenge in 2002.

On a conference call with analysts Monday, Farr said he thought the economy would be weak well into next year, so that "clearly 2002 will be very tough" from an earnings standpoint, especially in the first half. Farr added that he would be back in New York in December with a more refined outlook for the full year. Emerson has never flinched before -- and its stock price has suffered dearly from the grim earnings outlook. It was trading around $49 Monday, off 40% from its 52-week high of $79.75, reached Dec. 8.

Emerson's Struggles Its stock has soured over the past year.

The Valuation Game

Another thing is happening at Emerson that's a rare occurrence: Its stock price is actually cheap. Practically any way you slice it, Emerson is selling at the low end of its 10-year historical valuation range. Take its price-to-earnings ratio, for example. Emerson is trading at 16 times expected fiscal 2002 earnings, compared to its 10-year median of 21 and its 10-year low of 14.2. Admittedly, that 2002 estimate is shaky at this point, but on other measures, Emerson looks similarly cheap. On a price-to-book-value ratio, for example, Emerson is selling at 3.2 times, compared to its 10-year median of 3.8 and low of 2.9. And on a price-to-sales basis, it's selling at just 1.2 times: its 10-year low and well below the median of 1.7.

Sure, things are bad at the company, but they're not in crisis mode. Ironically, what's hurting Emerson most is the business that's key to future growth.

Over the past few years, Emerson was making a big push to juice its growth rate in electronics and telecom (E&T), with products like uninterruptible power supplies and precision air conditioners that are necessities for server farms and Web hosting -- everything that's supporting the information economy. Through a variety of acquisitions, the company put together a strong portfolio of market-leading businesses. This entire division now represents 25% of Emerson's total revenue. But E&T sales are down significantly, thanks to the dearth of spending on IT equipment, with September quarter E&T sales alone dropping 30%. The outlook for next year is murky at best.

But Emerson has been aggressively reorganizing and restructuring these businesses to improve profitability. For example, Emerson recently acquired the leading network power provider in China, which will provide a low-cost manufacturing base as well as a growth platform in the region. In addition, the company announced Monday that it was taking a $375 million pretax charge in the fourth quarter to accelerate cost-saving actions like plant closures and head-count reductions. That's on top of roughly $175 million in restructuring costs that Emerson is running through the income statement on a pay-as-you-go basis this year.

Company Statistics Emerson Electric
Stock Price:	$49.42
52 Week Range:	$44.04 - $79.05
P/E Ratio:	16.05
Market Capitalization:	$21.150 billion
Float:	423.7 million shares
Short Interest Ratio:	3.84
Institutional Ownership:	69%
Sources: Morningstar.com, Yahoo finance

Eyeing the Divisions

Restructuring is something Emerson -- CEO Farr included -- is particularly good at. Before taking the reins as CEO, Farr had run Emerson's Process Control Division, which accounts for 21% of the company's sales and where he drove a major consolidation effort that significantly improved margins. Process is now Emerson's best-performing division, supplying industries like oil and gas with control valves and measurement devices. Process control earnings rose 36.2% for the first nine months of fiscal 2001 on a 10% sales increase. On the conference call, Farr said process sales are still on track to post a 10% increase for 2001 as a whole.

That same cost-cutting strategy is being used on the E&T business, with the goal that operating margins can recover to 14% or 15%. Farr also plans to continue lopping off low-growth business, totaling roughly $1 billion in sales, to augment the company's long-term growth potential. I think these could come from the appliance and tools and industrial automation divisions.

Revenue and Earnings Per Share
	Revenue	Earnings Per Share
1999	$14.270 billion	$3.00
2000	$15.545 billion	$3.30
2001(est.)	$15.651 billion *	$3.01
2002(est.)	$15.556 billion *	$3.01
*Estimates from Emerson and Firstcall Source: Company reports

In the meantime, Emerson's other main business segment, heating, ventilating and air conditioning, or HVAC, is holding its own. Sales were roughly flat through the first nine months of the year, and earnings were down just 3.2%. While Emerson's end markets for HVAC equipment are decidedly weak, particularly in the U.S., the company has been gaining market share with its advanced, highly efficient scroll compressor technology, used in air conditioning equipment.

Tough year for Emerson? No question about that. And next year will likely offer little relief, particularly for E&T. But not often can you buy such a high-quality, diversified industrial company like Emerson at such an attractive valuation by historical measures. Emerson has a solid balance sheet, with a debt-to-capital ratio of 39%. The company has cut back capital spending by about 20% this year and plans to reduce it again in 2002. Free cash flow will still be up from last year, coming in at about $1.3 billion this year. This should enable Emerson to accelerate share repurchases.

For those who have patience to wait out the cycle, $49 is a good price to start a position. If the stock got back below $45, I'd definitely get more aggressive.

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