(Published by Nick McCullum on July 25)
At Sure Dividend, we define blue-chip stocks as companies with 100-year-plus operating histories and 3%-plus dividend yields.
While there is no "perfect" definition of a "blue-chip stock," these criteria fit the term’s intended meaning for the following reasons:
- A long operating history indicates that a company’s business model can endure through time.
- A high dividend yield often means a company is quite mature. Young, fast-growing companies tend to retain their earnings to fund internal growth.
There is a surprisingly large number of stocks that fit our definition of a blue-chip stock. You can see the full list of blue-chip stocks here.
The size of the blue-chip stocks list is surprising.
What is not surprising about the list is the prevalence of certain industries.
The industrials sector is one that is overrepresented on the blue-chip stocks list. Companies in this industry have stable business models, which allow them to operate profitably for generations.
Emerson Electric (EMR, Financial) is one example of an industrials company from the blue-chip stocks list with a particularly impressive track record.
With 60 years of consecutive dividend increases, Emerson Electric is a member of the Dividend Aristocrats (stocks with 25-plus years of consecutive increases) and the even more elite Dividend Kings (stocks with 50-plus years of consecutive dividend increases).
Emerson Electric’s business stability over the long run gives it appeal for conservative, buy-and-hold investors.
Business overview and growth prospects
Emerson Electric is a diversified, multinational industrial services firm.
The company was founded in 1890, has more than 110,000 employees, operates 200-plus manufacturing facilities and has a market capitalization of $38.5 billion.
Emerson Electric operates in two main reporting segments:
- Automation Solutions.
- Commercial & Residential Solutions.
Previously, Emerson Electric operated in five business lines, but it simplified its reporting structure after the significant $4 billion divestiture of its Network Power business in 2016.
Emerson Electric has experienced operating difficulties in recent years that can be traced back to low oil prices.
Many of Emerson’s customers are reliant on the price of oil to do business. While Emerson is not directly affected by low oil prices, the company has still been negatively impacted as its customer orders have meaningfully declined.
Fortunately, the rebound has already begun. The company’s Commercial & Residential Solutions segment has returned to positive order growth, and the companywide order book has reached a noticeable inflection point.
Source: Emerson Electric Presentation at the 2017 Electrical Products Group Conference, slide 2
In the short term, Emerson Electric will continue to feel the effects of its acquisition of Pentair’s (PNR, Financial) Valves & Controls business.
This was a significant transaction for Emerson Electric with a purchase price of $3.15 billion. For context, Emerson Electric’s entire market capitalization is $38.5 billion, which means this acquisition amounted to nearly 10% of the company’s total equity valuation.
Unfortunately, the Valves & Controls acquisition is expected to be slightly dilutive to 2017’s earnings per share with additional effects felt in 2018 and beyond (primarily due to amortization and depreciation charges as well as a $175 million restructuring charge).
Source: Emerson Electric Presentation at the 2017 Electrical Products Group Conference, slide 9
Despite the short-term negatives of this transaction, Emerson Electric still pursued the acquisition because of the additional diversification that it brings to the company’s Automation Solutions segment.
Source: Emerson Electric Presentation at the 2017 Electrical Products Group Conference, slide 10
To sum up, Emerson Electric’s growth over the medium term will be primarily driven by rebounding oil prices and the continued integration of Pentair’s Valves & Controls business. The company has struggled in recent years, but its long-term outlook remains strong.
Competitive advantage and recession performance
Emerson Electric has two major competitive advantages in the industrial manufacturing industry.
The first is its impressive size and global scale. Emerson Electric operates worldwide and realizes many economies of scale that are simply unattainable by its smaller peers.
Emerson can pass these savings onto its customers – creating a pricing advantage – or fix prices and realize higher margins. Either choice results in a win for Emerson’s investors.
The company’s second major competitive advantage is its significant ongoing investment in research development. Emerson Electric's periodic filings with the Securities & Exchange Commission report the company’s R&D investments:
- 2014 research and development expense: $356 million.
- 2015 research and development expense: $336 million.
- 2016 research and development expense: $320 million.
While Emerson Electric’s R&D expenses have declined slightly over the past two years, this is likely because the company is prudently trimming expenses until financial performance recovers. I expect that rising oil prices would see R&D investments return to previous levels.
As an industrial manufacturing firm, Emerson Electric’s financial performance is highly correlated with broad-based economic growth. Accordingly, the company’s earnings will decline during periods of recessions.
The company’s performance during the Great Recession of 2007-2009 can be seen below:
- 2007 adjusted earnings per share: $2.66.
- 2008 adjusted earnings per share: $3.11 (16.9% increase).
- 2009 adjusted earnings per share: $2.27 (27.0% decrease).
- 2010 adjusted earnings per share: $2.60 (14.5% increase).
- 2011 adjusted earnings per share: $3.24 (24.6% increase; new record high).
Emerson Electric’s earnings declined by 27% during the worst of the Great Recession.
The company is not the most recession-resistant Dividend Aristocrat, but it managed to remain profitable during the recessions and (importantly) continued its remarkable streak of consecutive dividend increases.
Valuation and expected total returns
Emerson Electric’s fundamental growth prospects are strong, but the company’s current earnings multiple suggests that value-focused investors should look elsewhere.
The company reported adjusted earnings per share of $2.46 in fiscal 2016. Emerson Electric is trading at a price of $60.04, which equates to a price-earnings (P/E) ratio of 24.4 using 2016’s earnings.
On a forward-looking basis, Emerson Electric’s valuation is slightly better but still not in buy territory.
Analysts expect Emerson Electric to report adjusted earnings per share of $2.60 in fiscal 2017, which represents a growth rate of 5.7% over 2016’s figure. Using the current share price of $60.04, Emerson Electric is trading at a forward P/E ratio of 23.1.
As the following diagram indicates, Emerson Electric is trading at a premium relative to its long-term historical valuation averages.
Source: Value Line
Emerson Electric’s average P/E ratio since 2001 is 18.7. The company is trading well above that level today, which suggests that now is not the best time to buy.
With that said, Emerson is highly likely to deliver adequate earnings growth over long periods of time. The company has grown its adjusted earnings per share at a 4.9% annual rate since 2001.
The company’s full earnings-per-share trend can be seen below.
Source: Value Line
Emerson’s current long-term growth rate is depressed because of the company’s meaningful profit downtrend in the past few years. Case in point: If we stop at 2014, Emerson Electric’s long-term earnings-per-share CAGR improves to 9.2% per year.
Looking ahead, Emerson will deliver adjusted earnings-per-share growth of 6% to 8% earnings growth over full economic cycles.
For dividend investors, what really stands out about Emerson Electric is its above-average dividend yield.
The company trades at a dividend yield of 3.2%, which is rich in today’s low-yield environment. Emerson’s current overvaluation is primarily because investors are bidding up its stock price in the hunt for dividend yield.
Emerson Electric’s dividend yield is also safe. The company’s payout ratio has been consistently low over time with fiscal 2016 being the only year with a payout ratio exceeding 60%.
Source: Value Line
It is highly likely that Emerson’s payout ratio will decline significantly if oil prices resume and its business picks up speed again.
To conclude, Emerson’s total returns – before accounting for valuation changes – will be composed of:
- 6% to 8% annual growth in adjusted earnings per share.
- 3.2% dividend yield.
For expected total returns of 9.2% to 11.2% if Emerson Electric’s valuation remains constant.
Unfortunately, it is highly unlikely that Emerson Electric continues to trade at its elevated valuation for long periods of time. The company is overvalued right now, and better buying opportunities should present themselves in the future.
Final thoughts
Emerson Electric’s high dividend yield and exceptional dividend history – one of the longest increase streaks in the public markets – are two reasons why this company stands out to dividend growth investors.
The company seems quite overvalued right now. A company that typically trades at a P/E of ~19 should not be purchased at a P/E of ~24 unless the fundamental business has changed in some way (which is not the case here).
We pass on Emerson Electric for now, but the high-quality issue remains a hold for existing investors, particularly those with low cost bases held in taxable investment accounts.
Disclosure: I am not long any of the stocks mentioned in this article.
