Emerson Electric Company (EMR) — Q3 2015 Earnings Call Transcript

Thank you, Tim. I'm joined today by David Farr, Chairman and Chief Executive Officer of Emerson and Frank Dellaquila, Executive Vice President and Chief Financial Officer. Today's call will summarize Emerson's third quarter 2015 results. The conference call slide presentation will accompany my comments and is available on Emerson's website. A replay of this conference call and slide presentation will be available on the website for the next 90 days. I will start with the third quarter summary as shown on page two of the slide presentation. Net sales in the quarter decreased 13% to $5.5 billion with underlying sales down 5%. The continued pressure from lower oil prices has resulted in further capital spending reductions by global oil and gas customers, particularly those in upstream markets. Industrial spending remains sluggish on a global basis, but most significantly, in energy-related and commodity markets. The strength of the U.S. dollar continues to be a significant headwind for our businesses. The third quarter order rates reflected the continuation of difficult economic conditions as the trailing three-month underlying order rates have been down in a range of 8% to 10% over the past four months. Order rates were under pressure by the sustained headwinds from lower oil and gas prices, capital spending weakness across many of our global manufacturers, weakness in data center and global telecommunications infrastructure investment and the effect of the U.S. residential air conditioning customer pre-build. Turning to slide three, gross profit margin declined 120 basis points to 40.6% driven by volume deleverage as we adjust production and inventory levels, unfavorable business mix, and the impact of the stronger U.S. dollar on operations. Overall, profit margins remain at a significantly positive level. Restructuring expense totaled $36 million in the quarter and $89 million on a year-to-date basis. A significant level of restructuring expense is expected in the fourth quarter. Reported earnings per share decreased 18% to $0.84. The current market conditions require focus on execution of the strategic programs including global cost reduction actions. Turn to slide four for the third quarter P&L summary. As mentioned, net sales decreased 13% versus the prior year, with underlying sales down 5%. EBIT margin reflects the impact from accelerated restructuring costs. In the quarter, approximately 11 million shares were repurchased. Turning to slide five, underlying sales growth in the quarter was down 5% excluding unfavorable currency translation of 5% and the impact of divestitures of 2%. Global demand was mostly down with the Middle East and Africa being the exception, up 3%. Across the other regions, the U.S. and Asia were both down 7%, Europe was down 2%, and Latin America was down 10%. Turning to slide six, business segment margins declined 220 basis points to 15.5% primarily due to volume deleverage, unfavorable mix and increased restructuring expense. Operating cash flow in the quarter decreased due to lower operating results and taxes paid on the gain from the divestiture of the power transmission solutions business. Trade working capital performance was affected by the overall business slowdown. Over the next three months to six months, the global operations teams will be undertaking additional actions to align trade working capital with business conditions. Turning to slide seven for the Process Management segment results. Process Management underlying sales declined by 4% with a 6% reduction from currency translation, resulting in a net sales decrease of 10% in the quarter. Oil and gas capital spending remained weak as a result of lower oil prices. Upstream markets remained under the most pressure, while downstream activity in chemical and power markets continues to provide growth opportunities. Demand in the Middle East and Africa grew by 5% reflecting favorable activity levels across the region, particularly in midstream and downstream markets, while demand in Asia was down 7% with growth in emerging markets offset by slowing conditions in China and continued weakness in Australia. Europe was down 1% with strong growth in emerging markets offset by declines in mature Western European markets. Margins were down 250 basis points due to volume deleverage, unfavorable mix, the impact of the stronger dollar on operations and increased restructuring. Demand is expected to remain weak through at least the first half of the fiscal 2016 and given the continued downward trend in commodity prices, a significant recovery will not be experienced until 2017. Turning to slide eight for the Industrial Automation segment results. Industrial Automation net sales decreased 23%, as currency translation deducted 7% and divestitures deducted 11%, resulting in an underlying sales decline of 5% versus the prior year. The third quarter sales reflected continued softness in European demand, upstream oil and gas and industrial spending, specifically in energy-related and commodity markets. Demand was down in all regions with North America down 11%, Europe down 2%, and Asia down 1%. Margin decreased 80 basis points, reflecting volume deleverage and unfavorable mix. Market conditions will remain challenging with a gradual improvement in Europe and sustained headwinds from upstream oil and gas. Business capital spending plans are expected to remain weak given the softness in the global economies and global GDP is expected to be less in 2015 than it was in 2014. Turn to slide nine for the Network Power segment results. Network Power's net sales decreased 17% as currency translation deducted 5% and divestitures deducted 1%, resulting in an underlying sales decline of 11%. The third quarter reflected continued weakness in the global demand for data center infrastructure and telecommunication investments, with North America and Asia telecommunications spending down significantly. The difficult conditions were felt across the regions, as demand in China was down 28%, North America down 10%, and Europe down 4%. Margins decreased 510 basis points, reflecting volume deleverage, lower price, unfavorable mix, and increased restructuring. We expect demand to remain mixed in the near term with areas of opportunity in data center infrastructure and telecommunications power. Turn to slide ten for the Climate Technologies segment results. Climate Technologies net sales decreased 6% as currency translation deducted 3%, resulting in an underlying sales decline of 3%. Demand in North America was down 6%, driven by a double-digit decrease in U.S. residential air conditioning compressors, as customers continue to work through remaining pre-built inventory. Asia was up 3%, as growth in India and Southeast Asia air conditioning and refrigeration businesses more than offset slowing demand in China. Segment margin decreased 130 basis points primarily due to volume deleverage, higher warranty expense, and unfavorable mix. When normalizing for the North American residential AC pre-build, the 12-month rolling sales growth is in line with the industry. We expect fourth quarter sales to be down modestly. Turn to slide eleven for the Commercial & Residential Solutions segment results. Commercial & Residential Solutions underlying sales grew by 1% with a 2% reduction for currency translation and a 2% deduction for the transfer of a product line to another segment, resulting in a net sales decline of 3%. Sales growth in the quarter was driven by favorable trends in U.S. construction, growth in the food waste disposers and wet/dry vacuums more than offset declines in professional tools and storage businesses. U.S. consumer spending has been lackluster as recovery has been muted. Modest growth is expected in the fourth quarter, as favorable trends in U.S. construction markets are expected to continue. Turn to slide twelve for the 2015 outlook. Little change is expected in market conditions for the remainder of our fiscal year. Underlying sales will continue to be affected by reduced levels of capital spending in oil and gas markets, most significantly in upstream project activity, a continued broad slowdown in industrial spending, particularly energy-related and commodity markets, a general weakness in capital spending by global manufacturers, and sluggish growth in certain emerging and mature markets. As a result, underlying sales expectations will be lower, placing continued volume deleverage pressure on profitability. Restructuring expense is now expected to be in the range of $160 million to $180 million for the year. Based on the continuation of the difficult current trends and their increasingly negative impact on results, we've revised our 2015 outlook as follows: Net sales will be down approximately 9%, with a 5% deduction from currency translation and a 2% deduction from divestitures, resulting in underlying sales that will be down approximately 2%. Reported earnings per share are expected to be $3.97 to $4.07, which includes a divestiture gain of $0.77 per share. And with that, I will now turn it over to Mr. David Farr.

Thank you very much, Craig. Clearly, an extremely tough quarter, and it got tougher as the quarter went on as we got into June. The big negative surprise for us in the month of June was the extreme weakness in China. We saw China drop over $100 million from prior year, down 14%-plus versus prior year. The bottom fell out in many of the core markets in China, and we do not see that recovering anytime soon. Our oil and gas investments continued to weaken as the price of oil and the price of gas has continued to slide. We now expect pretty weak orders in this space for at least the next 12 to 15 months, and we're a bit concerned about the pace of recovery. So what we're focused on right now is getting our restructuring done, getting the company right-sized to a slower pace of business, and making sure that we can improve profitability even with the lack of underlying sales. As Craig mentioned, year-to-date restructuring is around $90 million. Operations have geared up and are very active right now. I would expect the number, to be honest, somewhere between $70 million and $100 million in the fourth quarter, which will probably be in the $160 million, $180 million, maybe a little bit higher if we get the work done. There's a lot underway around the world. From my perspective, the restructuring from when we started it back in early February – from when we started this to when we finish this sometime early 2016, you're going to see SG&A and personnel headcount down 8% to 10% from beginning to end, so a major undertaking around the world as we continue to reposition the company for a weak market. Not much I can do about the market at this point in time. We faced the other issue of obviously strong competition coming out of the weaker currency markets, in particular out of Europe and Japan. Those things we have to deal with, and that's why we've got to get our cost structure in line. As you've seen, the orders have continued to stay weak, in the negative 8% to 9% range. I would expect that to continue for the next quarter at least. We have not seen any indication to say that things are going to get much better. So we're focused on dealing with weak orders, weak sales, and obviously, weaker production throughout our facilities. So production's coming down, inventories will be adjusted, and we will get the cash flow back, most likely a cash flow we top as we go into the fourth quarter, but we'll get that into that fourth calendar quarter, our first fiscal quarter. We'll start recovering that as we get that production back in line, and we start liquidating the inventories that have been built up over the last 12 to 18 months as the slowdowns happen. The global teams are acting fast. The global teams, obviously, are clearly focused on the short term and the restructuring necessary to get our costs back in line, to get our production back in line and to make sure that we can improve our profitability even with an environment that we're seeing right now that we're going to see minimal if any type of growth for the foreseeable future. At the same time, the teams are very focused on dealing with what we announced at the end of June from Network Power. Also, our Industrial Automation, LEROY-SOMER Control Techniques business, and the continued divestiture of InterMetro business, as we continue to structure the company, the focus on segments that we want to invest and grow over the long term. In the short term, we're very much focused on execution around costs, execution around getting our balance sheet back in shape, and then, we'll continue to move forward at the right time and the right pace, as we see the core markets recover, and as we see some other investment opportunities in the two business segments that we're focusing on going forward. Net-net, obviously, not a pleasant quarter, one to deal with and one to report. Fourth quarter's going to be equally as challenging as we've had sessions with the operating leaders here in the last couple of weeks, and again, we're going to be meeting with them again on Thursday, Friday this week. It's all about getting the actions necessary to get the cost down, to get the production down, and deal with the marketplace that we're dealing with right now. From our perspective, we're not losing this market; it's just a tough market for us, and there's no way to color it other than that. It's tough, and we're dealing with that toughness at this point in time, and that's where we are. And so, with that, I'll open the floor up for questions.

Thanks and good afternoon, everyone.

Good afternoon.

So I guess, Dave, look, it's – the fundamentals just continue to get worse; the market's not getting any better. I'm just wondering, like how do you feel comfort that you guys are doing enough from a restructuring standpoint, at this point?

You give your best shot, as we look at the forecast, as we look at where we see things going, and we bite off as much as we can do. And what's underway right now is a lot, and we're impacted with a big chunk of this company with a lot of costs, and it's not really facilities we're dealing with. Our overhead structure right now, trying to get it down, and at the same time, we're going to have to deal with our overhead structure as we go into a smaller company, as we move out of 2016. So I firmly believe we've spent a lot of time on this. I feel that we have the right actions underway, and we're taking the right amount of costs out.

Okay. And I guess like the $225 million that you expect to spend by the first quarter of next year, I know you've talked about a payback of one-to-one. Can we see the – will we see all of the payback by fiscal year 2016 or is some of that going to bleed into 2017?

We're hoping to get close to $200 million in that fiscal 2016. Our game plan here is to get our costs down in a very difficult volume environment, so we can improve profitability, improve earnings in a tough marketplace. That's why we're taking this hard and quick action we're taking, and you're dealing with people here. And this is – we're not – there's not a lot of facilities we're rationalizing here, because our facilities are pretty well rationalized. What we're dealing with is an overhead structure of trying to get their costs out so we can drive that profitability to the bottom line. That's how you get that – the savings so fast.

Okay. Fair enough. Maybe one last question and I'll get back in queue. I know it's still early, but any thoughts yet on, you just announced that the strategic alternatives for a few of your businesses. Any progress yet, any interest in those businesses, just any color there would be helpful.

It's pretty – it's early. I mean we've obviously had some interest, but it's too early to deal with that. We're working down the spin route right now. It's too early to talk about it. I think it's going to be worked here for the next three months, four months, five months, six months, and we'll spend that from that standpoint. InterMetro action, most likely will be done sometime before the end of this calendar year. We're targeting sometime in October.

Okay. Thanks. I'll get back in queue.

Good afternoon, everyone. Dave?

Yes.

Yeah, so the first question is, I mean really kind of challenging numbers across the board globally. Do you think there's an issue of share loss here in addition, because we have seen very weak numbers globally, but not to the extent maybe in this variance for the quarter. So how do you speak to that or can you speak to the – are you leveraged to a particular end market or sub-end market, particularly with respect to China? Just anything, any narrative around that would be helpful.

Yeah, I mean our China business has held up reasonably well for the last 18 months. In China, we don't firmly believe we're losing business at this point in time. I mean we don't see any indication of that. But we're – in China, we have very strong markets relative to the state-owned enterprises, which have really cut back on spending this last three or four months as that government has ratcheted back some of the issues they're dealing with. So if you look at our Process business, and if you look at some of the other Climate businesses, we're seeing these where the state-run enterprises have really curtailed, stopped spending, and they did it very suddenly. So I mean this is something new from our perspective to see that type of drop-off that quickly and until we see some kind of stabilization within the China market, the China government, I'm a little bit nervous about China and the recovery there. So we're expecting the next couple quarters to be pretty tough there, but that's what it is. It's around that China – it's just those spending at our key customer base.

And then I guess as a follow up, Dave, I know it's early and you get the restructuring, but just conceptually thinking about 2016, do you have a visibility to say, hey, we could be close to the bottom here in terms of EPS degradation or just too early to tell? I mean what's your view of 2015 versus 2016? Is it possible for you to grow in 2016?

I think the big issue for me right now is we had a very strong first fiscal quarter of 2015. We're up almost 5.5% underlying growth. We're up very strong earnings, double-digit earnings, and I think the visibility right now is very challenging, because I know I got that big hill I've climbed sitting right out in front of me and that – the fourth quarter was very strong for us last year and our first fiscal quarter is strong. So it's a little bit early for us to see how we come out of that as we get through these next two quarters.

This is – yeah.

I mean that's the big issue right now. The next two quarters, we're looking at the huge walls we have to get through and see what from an order standpoint and backlog can we get up there to get some kind of growth in the second half of next year.

And how do you think about M&A in this environment when the prospects of a cyclical rollover and the bid/ask maybe get widening between seller expectations and buyer expectations? Do you think this cools your potential appetite for M&A or your capability to get things done of size?

No. And if the right thing comes along, we have the capability of doing it. Right now, we're looking at divestitures and spend. If the right opportunity came along from an acquisition standpoint, we'd jump on it pretty quickly. I don't think that has any issue for us. We understand that.

Thanks for your time, Dave.

Okay, you're welcome.

Hi. Thanks for taking my question. Just another question on the share with Emerson, just specifically with Network, that high single-digit underlying order decline, that does seem worse than some of the peers. I guess more peers exposed to power management are not seeing severe declines. Can you maybe speak to, is it the data center and telco specifically or how your power management sub-business is holding up?

Yes. I mean the core business is holding up. We had a very strong – we had some big project wins last year at this point in time. We also had – we have a very strong presence in China, which is unique, in our telco space in China, and North America telco has really cut back in spending. So that's why you see those numbers are a little bit more drastic than our competitors. Underlying business is pretty much in line with that, but the telco spend, both in China and North America, is very difficult.

Right. Very helpful. And then just could you give us an update on the inventory on the Climate side and when that might be worked down?

We could relook through the cycle, because from the standpoint, we look at 12 months, it's pretty well trending. I would say right now, our estimate – not estimate we know 1.1 million units were pulled forward. I would say they're probably 80% through that right now. We should start seeing some North America refilling. Production is really – our inventories right now, production levels are low, so we expect to start seeing that flow through in the fourth quarter. However, the issue for us, the comparison will be very difficult because last year was when we were selling it both in the fourth and the first quarter, but we're seeing it come back in. If you look at the underlying, I would say pace is improving in North America. So I'd say they're getting through it pretty quickly.

Thank you.

Hey, guys. Thanks for taking my question. Just can you comment, Dave, around the competition out of Japan and Europe? Is that partly reflected in sort of the pricing environment, and is that on the Process side? What are you kind of seeing there from competitive pricing perspective?

I mean we have Japanese and European competitors across most of our businesses, both on the Process side, Industrial side and Climate side. And clearly, with the weaker currencies, they have the opportunity to price, to drive that business their way. We're working extremely hard. And one of the reasons we're working so hard on the costs is because we do not want to lose any position in this situation where we are at a huge disadvantage with a stronger dollar against our European and Japanese competitors. So the pricing is definitely tougher. And from our standpoint, we're dealing with it. The one advantage we do have is we get into the 2016 environment is with the weaker commodity environment, the weaker material environment, we will start getting benefit from that as we get into the first half of next year. And that's a big advantage for us and will help us offset this price cost. Right now, I'd say we are still – as you understand, we look at this price and cost, we're staying probably pretty close to being neutral or slightly green, and the key issue for me is to stay ahead of this power curve. Yes, we have price pressures, in particular from the weaker currencies out there, but the commodity supply side guys are working extremely hard right now to get the respective cost reductions to help keep us price costs green as we get into this tougher price environment in 2016. So that's where the war is right now and I feel good about the battle and I feel good about where we are.

Okay. Thanks. And then sticking with Process, from a vertical perspective, obviously upstream oil and gas staying pretty weak, but some of the downstream businesses like Chemical and Power actually seem to be holding up relatively well. Maybe you could talk about what you see there in terms of quoting activity and how you see those verticals holding up into 2016?

The downstream, in particular the Power, has held up extremely well, and certain chemical segments held up extremely well. The order pace is at record levels. It creates a little mix shift for us a little bit, but the pressure is on profitability. But that activity is very, very good right now, and we feel good about that, in particular, both in North America and in Europe. Asia is not that good. India is good for us right now. But downstream in Power and downstream in the petrochemical area we see good pricing. We're a little bit nervous right now relative to – there's been a lot of actions by major global oil and gas companies here in the last two weeks and that will obviously start flowing back as they continue to get pressure on their capital spend. And that could possibly have an impact on what we would call their MRO, the repair business. If they get a lot of pressure on cutting their capital even more, they'll cut back in certain areas in the MRO area and we'll start feeling that. That's another concern I have right now with the continued weakness of the price of oil and gas, which – where's the price of oil today? Down $45 – where is it, $45? So that bothers me a little bit there.

Okay. All right. Thanks, guys.

You're welcome.

Thanks. Good afternoon, guys.

Good afternoon, Steve.

Hey, Dave. If we go to 2016, just following up one of your earlier comments, if in fact revenue did go negative next year and was say down 1% or so, could you still drive margin expansion in that environment with all the puts and takes that you’re talking about?

That's the goal. That's the goal.

And...

That's the aim.

Yeah, go ahead. Sorry.

That's the aim. That's what we're trying to do. Every operation guy's trying to figure out how to deliver improved profitability with no growth or slightly negative growth.

Right. And the kind of – I mean if we sort of think about what's possible in that goal given all the restructuring that you're doing, when you're calling out restructuring, it sounds like through at least the first quarter, but clearly in the environment that you're describing, it's kind of hard to imagine that you wouldn't be restructuring through much of the year. Is that a fair comment?

What we're trying to get done will do some in the first half of next year, but we're trying to get it done so we can stabilize the business. And we've identified where we want to go with the restructuring, we've identified the costs, we have a map of where we think things are going to head out, and that's where we're focused right now. I don't – my objective is to get the major work done as we get into that second fiscal quarter next year.

Right. And I guess if I also compare everything that you're going through right now compared to what you went through in 2008-2009, one difference it seems, maybe – I don't know if I'd call it a bright spot, is that at least the order rates are not getting decelerating any faster it seems from the – but is that just a temporary thing? I mean based on what you're seeing in the front lag and all these quoting activities that there could be another step down from here?

I'm glad you saw a bright spot in there, Steve. I'd give you – I'm going to give you... I owe you a glass of wine for that one. I don't know if there are any bright spots here, but...

I'm looking.

You're getting half a glass of wine on that one. Okay. At this point in time, we do not see it stepping down on the order pace. We look at the trend lines, we look at the various businesses; it looks like it's bouncing around this bottom. The question is, is there anything that's going to pull it back up? We know what the comparisons are like for the next couple of quarters, but I mean I don't think – I don't see it as a step-down at this point in time. I mean it looks like it's trying to bottom here. And I mean I've called this before and I've got my ass kicked, to be honest, and that's not a swear word, Steve, you know. It's kickboxing here. I've been kicked around the ring a couple of times here this year. And it looks like it's forming; I don't see another step-down at this point in time.

Okay. And then finally, non-res, just, you spoke about the res pressure, what are you seeing on the non-res side?

Non-res North America is – we've had a decent environment. It's continued to weaken. I mean the actual – what I would call the capital spending, the type of products that we sell have not been all that exciting. There's been some non-res construction, but the basic capital spending environment has not been very good in North America and – in the industries we serve. We don't serve the automotive industry, and so it's been pretty anemic at best, and there's been very little recovery. And then you see a lot of drop-off as any – all the industries that support the broad oil and gas industry, both here in North America and in Latin America and around the world, so it's been pretty broad and it's been business-by-business. If you look at the segments that we look at, this is pretty broad across very many businesses here.

Okay. Okay. Great. Thanks, Dave.

Thanks, Steve. I owe you half a glass of wine for that slight positive you gave me there. With that, I want to thank everybody. Again, it clearly was an extremely challenging quarter and not pleasing to see. We are facing another extremely challenging quarter again, probably for the next two quarters. The organization is very much focused on getting our costs and our production down in line relative to the pace of business we're seeing right now, and we're making good headway. And we would expect to see improvement in profitability here in the fourth quarter, which will give us – set us well as we move into that first quarter. So thank you very much for your time today, and I appreciate your support. Bye.