Emerson Electric Company (EMR) — Q4 2019 Earnings Call Transcript

Okay. Thank you, Mike. I'm joined today by David Farr, Chairman and Chief Executive Officer; Frank Dellaquila, Senior Executive Vice President and Chief Financial Officer; Lal Karsanbhai, Executive President Automation Solutions; Bob Sharp, Executive President, Commercial and Residential Solutions; and introducing Pete Lilly, the incoming and upgraded Director of Investor Relations, who will surely not mispronounce Frank's name. Welcome to Emerson's Fourth Quarter 2019 Earnings Conference Call. Please follow along in the Slide presentation, which is available on our website. I'll start on Slide 3 with the full-year performance report card. 2019 required our organization to be nimble and responsive to a lower growth environment than we had expected a year ago, and we did respond. On our second quarter earnings conference call, we began talking about additional restructuring actions and we did so again on our Q3 call in August. In total, we executed $35 million of additional actions in the second half, and on October 1st, we announced our Board's review of further actions appropriate for the lower growth environment we see over the next couple of years. Underlying sales finished the year up 3% versus our initial guide of 4% to 7%. We saw slower than expected growth across both platforms, Automation Solutions grew 5%, which was mostly driven by efforts targeting our broad installed base. We saw large capital projects start to push out in Q2, and that trend continued through the second half. Commercial and Residential Solutions saw a sharp decline in Asia in the first quarter and was a headwind to growth all year. Cooler weather hampered residential growth in North America, and professional tools and cold chain markets began to slow through the second half as non-residential investment slowed. Despite slower growth, we delivered just above our EPS guidance helped by lower tax rates and lower corporate costs. Importantly, we had strong cash flow for the full year, delivering free cash flow at $2.4 billion, which was up 6% and reflected 105% free cash flow conversion. This drove dividends as a percent of free cash flow down to 50%, a critical milestone. In 2019, we completed our 63rd consecutive year of dividend increases, and returned $2.5 billion to investors, including $1.25 billion of share repurchases, which was above our initial target of $1 billion. Today, we announced a $0.04 dividend increase in 2020. Please turn to Slide 4. Fourth quarter results were above the high end of EPS guidance discussed on the third quarter conference call, helped by a $0.09 discrete tax benefit. Automation Solutions was in line with guidance with 5% underlying growth in Q4 and full-year EBIT margin of 16%, spot on with guidance. Trends in the business continued into Q4 with slowing global discrete markets and soft North American upstream activity. Demand in global process and hybrid markets remained stable. Commercial and residential solutions end markets were slower than expected and the business deleveraged on lower growth. Q4 underlying sales were down 2% compared to our expectation that the business would be up slightly in the quarter. Our fourth quarter free cash flow generation was up significantly versus the prior year, and we completed the $250 million of additional share buybacks announced on our Q3 call. Turning to Slide 5. Fourth quarter gross margin was up 70 basis points to 42.8%, and full-year margins were 42.5%, demonstrating strong price leverage and cost discipline. SG&A cost as a percent of sales fell 180 basis points as our businesses effectively control costs. Operational SG&A spend was lower compared to the prior year and also lowered sequentially compared to the third quarter. Lower corporate expenses also contributed to this improvement, lower stock compensation and the favorable impact of the prior year's one-time 401(k) contributions. Reported EBIT margin was up 140 basis points. In 2020, we will report adjusted margins, which exclude the impact of restructuring charges consistent with our new adjusted EPS framework, which we'll discuss in detail shortly. 2019 adjusted EBITDA margin was up 210 basis points to 22.8%. The quarter benefited from discrete tax items similar to the prior year. Fourth quarter EPS was up 20% excluding these discrete tax items from both years. Turning now to Slide 6. From a geographic perspective, we saw mixed results in Q4. In total, mature markets were down 1% underlying in the quarter and up 2% for the year. U.S. industrial activity softened a bit in Q4, somewhat offset by stronger Western Europe. Emerging markets were up 8% underlying in Q4 and up 4% for the year. Strong fourth quarter emerging market investment activity was led by China, up 9%. Latin America up double digits and Middle East and Africa up 8%. Turning now to Slide 7. Total segment margin was up 10 basis points, including recent acquisitions. Total adjusted segment margin was up 50 basis points to 20.2%. This improvement reflects greater than 40% year-over-year and sequential leverage. We've updated our reporting of corporate and other costs. Previously, we showed two numbers, the differences in accounting methods line, which included a management charge to the operating segments and certain pension and post-retirement costs and the corporate and other line that included corporate operations, total company stock compensation expense, acquisition and related costs and other items. Going forward, we will present three lines to more clearly show the pension and post-retirement cost, the corporate, the stock compensation expense, and the corporate and other line, which includes the cost of corporate net of the charge to the businesses, acquisition related costs, and other items. We believe this presentation provides greater clarity and is more in line with how our peers report. Q4 cash flow was strong. Free cash flow of $1 billion was over 20% of sales, and free cash flow conversion in the quarter was 140%. Turning to Slide 8. Automation solutions underlying sales were up 5% in the quarter and up 5% for the full year. September trailing three-month underlying orders were up 4% excluding two large nonrecurring power projects in the prior year. Strong demand continued to cross MRO spending and brownfield projects supported by primary demand growth programs focused on our installed base. We continue to see long cycle bookings, with the September backlog for final control and systems businesses up 6%; however, our large project funnel continues to stall, as customers' capital spending plans push out due to trade tensions and geopolitical uncertainty. North America underlying sales were down slightly as discrete and upstream markets continued to soften. Strong growth continued in Latin America. Demand in Europe was stable in the quarter, and underlying sales growth accelerated on strong backlog conversion. Asia, underlying growth was broad-based led by China, which was up 18%. Strong growth in Middle East and Africa was driven by long cycle investment activity. Automation Solutions segment margin was up 70 basis points including significant restructuring investments executed in the quarter. Adjusted segment margin was up 140 basis points to 19.5%. For the full year, excluding the dilutive impact of acquisitions, automation solutions delivered over 30% leverage on an adjusted basis. Turning to Slide 9. Commercial and Residential Solutions underlying sales were down 2% in the quarter and down 1% for the year. September trailing three-month underlying orders were down 2%. North America underlying sales were down slightly with cooler weather affecting key HVAC markets. Additionally, slower industrial markets weighed on professional tools and cold chain demand. Latin America demand remained solid. Underlying sales in Europe were down slightly reflecting weaker trends in the cold chain market, somewhat offset by steady growth and heating and commercial air conditioning markets. Asia, Middle East, and Africa were down 7% underlying with China down 9%, primarily reflecting modest declines in commercial air conditioning in the cold chain markets, partially offset by steady growth in professional tools. Commercial and Residential Solutions margin decreased 120 basis points, and adjusted margin decreased 110 basis points. Lower profitability primarily reflected deleverage on lower volume and unfavorable mix, partially offset by favorable price cost. Let's turn to Slide 10, which outlines our 2020 guidance framework. Given the slowing macroeconomic conditions and ongoing geopolitical tensions, we are preparing for a stable no-growth environment in 2020. For the full year, we anticipate underlying sales growth to range from a decline of 2% to an increase of 2%, with Automation Solutions projected to decline by 1% to increase by 3%, and Commercial and Residential Solutions expected to decline by 3% to increase by 1%. We foresee reported sales being slightly down due to a foreign exchange headwind from the stronger dollar. As Emerson has done consistently during economic downturns throughout our history, we have shifted our management and investment focus from pursuing growth to managing costs. We began this transition in the second quarter, resulting in increased restructuring investments to $35 million in the latter half of 2019. On October 1st, the Board announced a review of operations, capital allocation, and portfolio initiatives. The outlook presented does not account for any potential outcomes from the Board's review. At our February Investor Conference, we intend to provide a detailed update on the Board's findings and an updated 2020 outlook. While we anticipate substantial restructuring investments in 2020 because of this review, our adjusted guidance excludes these restructuring charges entirely. Additionally, the adjusted EPS guidance does not incorporate significant discrete tax items. We expect adjusted EPS for 2020 to range from $3.48 to $3.72, compared to a 2019 adjusted EPS of $3.69. This guidance emphasizes operational improvement and margin expansion to enhance earnings growth, which is more than outweighed by $0.29 of headwinds stemming from tax issues, unfavorable foreign exchange, increased stock compensation due to a higher stock price, and higher pension expenses resulting from lower discount rates. In 2020, we expect to achieve another strong cash flow performance as we continue to enhance operational execution and generate incremental cash flow from our recent acquisitions. The operating cash flow for 2020 is projected to be $3.1 billion, with free cash flow conversion exceeding 100%. Please turn to Slide 11, which bridges our 2020 adjusted EPS guidance. The starting point for the bridge is 2019 GAAP EPS of $3.71 and walking across to adjusted 2019 adjusted EPS of $3.69 by excluding $0.14 of favorable discrete tax items and adding back $0.12 of restructuring charges. Now walking from $3.69, we discussed first the $0.29 of headwinds next year. First, tax, the 2019 adjusted tax rate is 21.6% excluding the discrete tax items last year. This is 1.4 points better than expected 2020 rate of 23%, resulting in a $0.06 EPS headwind. Second, FX, the stronger dollar results in an FX translation headwind next year assuming October 31 FX rates hold for the remainder of 2020, we anticipate $200 million unfavorable impact in net sales, resulting in a $0.04 EPS headwind. And finally, stock compensation and pension. Stock comp is up due to higher stock price and pension costs increase this year due to lower discount rates. Partially offsetting these headwinds, we expect to drive $0.08 of operational improvement on flat to down sales, which reflects 30 basis points to 50 basis points of improvement in adjusted total segment margin. We also expect $0.12 of EPS from our improved debt cost structure and strong balance sheet with $1.5 billion of share repurchases. Please turn to Slide 12, which bridges our first quarter 2020 adjusted EPS guidance. For Q1 last year, we add back a penny for restructuring charges to $0.75. There were no discrete tax items in the quarter last year. The 2020 bridge for Q1 looks a lot like the full-year bridge with half of the headwinds we discussed in the full-year impacting the first quarter. This is because Q1 last year benefited from lower stock compensation due to the decline in our stock price in late December, as oil prices fell. In total, we faced $0.13 of headwinds, which were partially offset by $0.02 contribution from operations and $0.03 from shares and interest. These items provide $0.05 of EPS contribution, which is proportional to the $0.20 we expect in the full year. And now, please turn to Slide 13 and I will hand the call over to Mr. David Farr.

Thank you very much, Tim, and thank you very much for your service in Investor Relations and going out on a high note. It's an interesting time we've been having here, and I want to thank all the employees around the world for their support through Fiscal 2019. They accomplished a lot in a very challenging marketplace. I want to welcome everybody on the call today, as we talk about what we're seeing in the marketplace and where we are heading going forward. It's been a very dynamic time period as we all know. It's a challenging time period, but the management team across this Company, both here in St. Louis and around the world, is very focused on delivering increased operational margins and a zero underlying growth period. If the growth is better, that's better for us; if it's not, we are ready for it and that's what we are doing. I also want to thank all the sell-side analysts and shareholders that have met with Tim and me over the last 60 days and discussed with us as we sought your inputs, which we conveyed back to the Board, to ensure the Board understood where our shareholders stand today and what they expect from us. If I look at our current situation, the order pattern in October showed a slight decrease in automation solutions, but it has remained around a 3% underlying growth rate. Bob's business has been relatively stable with a growth rate hovering between negative 1% and 0% for the past couple of months. Overall, as a company, we are currently experiencing a 1% underlying growth rate. As we know, 2020 has presented significant challenges, and we are preparing for it. Throughout my tenure as CEO from 2000 to 2019, we have consistently adapted the company's structure. We have invested in the company while divesting nearly 55% of its assets since I took on this role. We have repositioned and invested in new ventures within our automation business, as well as in new companies in our commercial and residential sectors, leading to strong gross profit levels. Our goal is to increase the gross profit margin back into the 44% and above range over the next few years. From an industrial operations perspective, we are confident in our approach. We know how to invest in technology to drive higher gross profit and to drive what I'd call a renewable type of business model as I look at our aftermarket business going forward. We've had very good underlying growth rates throughout the economic cycle. Yes, there are cycles, and yes, we're facing a cycle right now. I believe this team is focused on how we're going to improve profitability and drive as much growth as we can for our shareholders going forward in the next couple of years. If you look at our EBITDA margin standpoint over the time period, Emerson operates around 21%, while our weighted average peer is around 16%. Our Commercial and Residential Solutions business is a very profitable business, one that runs through cycles a little bit differently. Our EBITDA in that area runs around 25% compared to our peer group around 15%. Our Automation Solutions business, which has been built up over a long time, has an EBITDA around 20% versus our peers at 15%, and we believe we have opportunities here to drive those EBITDA margins back up to peak levels and enhance our profitability as we move forward in the next couple of years. If you look at our digital transformation capabilities today, we now have a very large installed base, close to $120 billion in our automation world. We have a capability with our digital is both from a hardware standpoint and a system standpoint, and we're driving a unique business model around that while creating new business focused specifically on higher tech transformation opportunities. We have a very good start in this business today, and you're going to hear more about that as we start talking about what we are doing, what we have to offer here. It's truly a unique differentiation that we have from our $120 billion installed base, and we're very excited about it. We will continue to invest in that, even through a tough time. I also want to thank Lal and Ram and his whole team in the early years of the Valves and Controls work. It's really created unique shareholder value for us, from an EBITDA standpoint, with a pro forma of $600 million in 2019 and EBITDA margins now up to 16%. We fundamentally have room to go. We made a commitment to our shareholders that we would get to 20%, and we are taking necessary actions to get to that level. It is a step-by-step process and we're underway right now. We've decreased the number of facilities, and you will see more of that in 2020. We've driven out working capital on a combined basis from 50% down to 26%. We're doing a lot of different things here to drive value from both the customer perspective and just as importantly for our shareholder perspective, and there is much more to come from Ram and his team and Lal as they go forward with this integration process. We've continued to drive a lot of cash back to our shareholders. If you look at our Emerson capital allocation over the last 10 years, we paid back to our shareholders $10 billion in share repurchases, $12 billion in dividends, $10 billion in acquisitions, and about $6 billion in capital spending. So we've continued to invest in the Company, continue to invest in technology, and continue to give back to our shareholders. In the last 10 years, that number of 57% of our cash flow goes back to our shareholders. This year we're over 60% as we drove back our dividend and as we increased our share repurchases. We clearly have money to give back to the shareholders, and we did not have as many acquisitions; our intention is to return the money if we can't utilize it internally. On a return basis, our return on total capital over the last 10 years has been 18%. It fluctuates with acquisitions and integration, but generally we drive at high levels of return on total capital; it's a very important metric for us from a cash, sales, and margin standpoint. The only thing I want to point out as we go through the different cycles is we may be facing a downward trend right now. The concern I have looking at 2020 is that the GFI numbers right now are under 1%, indicating a very challenging time period ahead. The catalysts needed to spur growth are not evident, but I firmly believe there will be a bounce back if we can get past the geopolitical and trade issues we are facing currently. We're preparing accordingly for a slow global growth over the next year and the potential challenges ahead. We are currently reviewing operations, capital allocation, and portfolio initiatives with the Board. We have engaged an external consulting firm to examine our cost structure and improve our operational efficiency. We will cover these insights with shareholders in our February Investor Conference and provide updates on our significant restructuring initiatives. While there may be significant restructuring investments in 2020, our adjusted guidance framework excludes restructuring charges entirely. Our objectives focus on driving improved profitability and operational excellence. We're implementing necessary actions now, which includes an anticipated restructuring number of around $70 million in the first quarter. I expect total restructuring to be in the range of $200 to $300 million over the coming years as we align our operations with our growth targets. I will reiterate that our primary role is to ensure Emerson continues on a path of growth and profitability. My strong belief is that with the actions we're taking and the plans we have laid out, we are set to navigate these challenges effectively while ensuring robust returns for our shareholders.

Hi, good afternoon. I wanted to thank Tim for all the help over the past several years. In terms of maybe the first question, David, there's been a lot of back and forth between D.E Shaw and Emerson. How would you characterize where you stand vis-a-vis D.E Shaw right now? Should we expect further board changes in the quarters ahead?

Thank you very much. I want to focus on Emerson and what we're trying to do here. We gather input from every shareholder, and the Board review announced in October was a combination of discussions with the Board over the last six months, consistent with how Emerson addresses a challenging macroeconomic slowdown. The decision was shaped by input from our shareholders. We appreciate your input. The Board still strongly believes in our position as a company and supports our direction.

Looking at other investor suggestions that have been floating around, how do you and the board think about balancing the need for cost efficiency against also the need to keep investing, given a lot of changes that are going on in the automation world right now?

It's very important for the Board that we are not jeopardizing the future of this Company while addressing short-term goals. We have made several large acquisitions in the last few years, and we are focused on integrating those businesses while ensuring our spending ratios are sustainable in areas where we see opportunities.

We've been looking at the weaker environment for some time now. We've been accelerating restructuring across the platform, and as we look at the opportunities today, we are focused on structure across the enterprise and enhancing speed and execution while protecting our customer touch points.

The management team is actively working on programs that will drive growth, focusing on cost control while also maintaining the operational efficiencies we’ve built. We want to ensure we are not jeopardizing our future potential for success and keeping growth in mind.

You talked about slowing growth in North America. Could you provide a bit more update on the situation within automation solution? Is all the weakness essentially still focusing on upstream and discrete, or do you see it spreading?

The weakness that we experienced continues with the discrete market and the upstream oil and gas value chain showing signs of reduced spending in North America. However, I have not yet seen a broader slowdown in process markets, specifically related to MRO spending.

This cyclical downturn presents both challenges and the potential for recovery. While we focus on cost management, we also remain optimistic about growth opportunities as the market stabilizes.

I want to focus on the organic guidance you’ve provided. You mentioned a starting point of negative to positive growth. Given the current environment, what is leading to this range? What is the biggest concern within Automation Solutions?

We know the global GFI numbers have rolled off, which makes us cautious about our growth outlook. My concern is the geopolitical and trade issues driving these weaker numbers, particularly in the North American markets, which is why we are working aggressively on a restructuring plan.

As noted, we are seeing a slowdown in capital spending across the upstream and midstream oil and gas sectors. The discretionary capital spending has slowed even as perceived demand stabilizes in certains markets.

What implications does the lower end of the guidance range have for your short cycle discrete business?

We are looking at a mid-single digit negative growth outlook at the low end of our guidance for discrete business within the broader context of the market dynamics. This is certainly a challenging environment but one we are prepared to navigate. The broader process industry appears stable, driven by strong fundamentals. Many companies are operating within a defined risk framework, focusing on short-term objectives without sacrificing medium or long-term strategic goals.

If we reference the restructuring initiatives presented, should we think that product-related savings will predominantly drop to the bottom line, or are there offsets to account for?

Historically, we have seen a dollar-for-dollar benefit from restructuring and cost efficiency measures. However, it’s advisable to carry a moderate factor into the base expectations while accounting for longer-term investments.

Can you clarify if the $70 million of restructuring in the first quarter will provide any benefits to your current guidance for fiscal 2020?

No, we have not booked any benefits nor costs regarding the restructuring in this guidance. However, we fully expect to see positive results from the restructuring measures higher returns for the fiscal year as we streamline operations.

Are there specific macro scenarios in Asia or North America that would push Emerson to the lower end of its guidance range?

To hit the lower end of our guidance, we would need to see deterioration in macro conditions affecting capital spending notably in North America driven by global uncertainties and geopolitical risks.

Could further trade agreements impact your CapEx growth and lead to improved growth rates in your business?

The markets could face a rapid rebounding due to renewed capital expenditures following successful trade agreements. If we can get through the uncertainty, we expect potential growth in our sectors with clear visibility to capitalize on emerging markets recovery.

Could you clarify the rationale behind external consultations in the restructuring?

The consultation effort is focused on identifying redundancies and optimizing structure within the organization to foster profitability without jeopardizing operational integrity. We're doing this to effectively reposition resources to meet current challenges while maintaining focus on our customers.