Emerson Electric Company (EMR) — Q3 2021 Earnings Call Transcript

Thank you so much. Good morning, everyone, and thank you again for joining us for Emerson’s third quarter earnings and conference call. Today, I’m joined by President and Chief Executive Officer, Lal Karsanbhai; Chief Financial Officer, Frank Dellaquila; and Chief Operating Officer, Ram Krishnan. I’d also like to introduce and welcome the new leader of Emerson Investor Relations, and certainly an upgrade for the role, Colleen Mettler. Colleen joins us from the Automation Solutions finance organization, and will be your main point of contact going forward, as I try to transition to a new role in the operating business units. Many thanks to you all for your support and friendship over the past couple of years. It’s been fun. I certainly wish you health and success. As always, I encourage everyone to follow along with the accompanying slide presentation, which is available on our website. Please join me on Slide 2. As always, this presentation may include forward-looking statements, which contain a degree of business risk and uncertainty. Please turn to Slide 3. And I will turn the call over to Colleen to introduce herself and cover some exciting developments within Emerson.

Thanks, Pete. I certainly have big shoes to fill. As Pete mentioned, I’m coming into this role from our Automation Solutions finance organization, and I’ve been with Emerson for over 13 years. I’m certainly excited and humbled to be joining the Investor Relations team during this dynamic time for our organization. I look forward to speaking with all our investors and partners very soon. Now, I would like to take a moment to highlight two areas of real ESG impact within Emerson. First, on Slide 3, and keeping with the environmental sustainability framework of greening of, by, and with Emerson that we introduced in February, our first topic is about Greening by Emerson. It is a great example of how Emerson solutions are relevant in enabling our customers’ sustainability initiatives. Emerson recently signed a multi-year agreement with PureCycle Technologies, which has a novel technology and process for fully recycling plastic number 5, polypropylene back to a clear pellet. As some of you may know, polypropylene is a common form of plastic that has not had great recycling options. Emerson is serving as their born digital automation partner going forward with the initial plant project in Ohio, Georgia and a remote operations center in Florida. Now, please join me on Slide #4. Our second topic is a Greening with Emerson example. Leveraging our Helix Innovation Center in Dayton, Ohio, Emerson has collaborated with the Department of Energy and their Oak Ridge National Laboratory to advance next-generation HVACR technology, expanding the applicability of heat pump technology, redesigning refrigeration architectures to maximize efficiency and food retail, and working to minimize energy used and leaked in commercial HVAC applications are just a few of the exciting areas of cooperation. We have a number of collaborations with the Department of Energy and their labs. We look forward to continuing to build these relationships and support the development of novel solutions and a real sustainability roadmap going forward. Now, please turn to Slide 5, and I will turn the call over to our CEO, Lal Karsanbhai.

Thank you, Colleen. I want to share a few thoughts before handing it over to Frank for the financial data. First, Pete, thank you and best wishes in your new role. We’re all very excited for you and grateful for your hard work. Welcome, Colleen. It’s wonderful to have you here. Colleen and I have spent a couple of years together in Automation Solutions, and we’re fortunate to have her join our Investor Relations team. I want to thank the leadership teams, management, and our employees worldwide for what has been a very well-executed quarter. We have a lot of energy and momentum, which has been exhilarating to witness over the last three months. I also want to extend my gratitude to our shareholders. I’ve had the pleasure of meeting many of you over the past six months, and I look forward to meeting more of you as the year progresses. I appreciate your ongoing confidence, your challenges, and your investments. I want to mention a few non-financial matters to the team. Our cultural initiatives are progressing well, and we will announce our new Chief People Officer later this month. We are all thrilled about this selection process, which will involve an outside hire who will help us navigate challenges and shape Emerson’s culture for the future. Additionally, our portfolio review is complete, and we’re preparing to present it to the Board at the October meeting. We briefly discussed it with the Board yesterday, and we've outlined several paths for driving greater underlying sales growth and diversifying the portfolio. We are excited about the exhaustive process we embarked on, exploring various options in broad markets with high growth and opportunities for M&A and organic activities. On the M&A front, industrial software remains essential as we consider our market share and opportunities for growth acceleration. Our OSI acquisition is performing exceptionally well, exceeding our internal synergy plans, which is impressive. What stands out most to me is the team's execution. There were market tailwinds, particularly noticeable in Automation Solutions and across our commercial residential businesses. While these factors are important, the team's execution was outstanding. They overcame numerous challenges this quarter, such as material inflation and availability, qualifying new suppliers, managing logistics worldwide, and dealing with labor availability issues in the United States. The team handled it excellently. Lastly, the cost reset initiatives are progressing well, and we’re nearing completion. Despite these operational challenges, we see the benefits of this work reflected in the Company's performance. The operating and profit leverage at 34% was robust, providing us with the opportunity to accelerate investments in differentiating technologies. I’ll share more details on this as we continue through the year. Now, I’ll hand it over to Frank and will speak towards the end of the call.

All right. Thank you, Lal. Good morning, everybody, and thank you for joining us. We’re especially pleased with the results in the quarter, especially in light of the operational challenges that Lal just described, and Ram will talk about them later in the call. Please go to Slide 6. Continued recovery in our end markets, combined with the benefits of the cost reset actions, drove strong operating performance and financial results in the third quarter. Adjusted EPS was $1.09, up 36% from the prior year. Demand continues to strengthen as sales came in ahead of our expectations with an underlying growth of 15% and June trailing three-month orders were at 26%. Automation Solutions notably turned positive this quarter in both sales and orders, up 9% in sales and 17% on an underlying basis. Commercial & Residential Solutions continues to experience robust demand across the business and geographies with 29% sales growth and 43% orders growth on an underlying basis. The cost reset benefits continued to be realized as planned, flowing through to the margins. Adjusted segment EBIT growth was 40%, with a 280 basis points increase in margin to 19.6%. Cash flow continues to be very strong with operating and free cash flow approximately 30% year-over-year, and free cash flow conversion exceeding 150% of net earnings. We’re continuing to implement the remaining elements of the cost reset program. In this quarter, we initiated $32 million of restructuring actions. The program is on schedule and delivering the projected savings, as we planned. Please turn to Slide 7. There’s a bridge of the earnings per share increase from the prior year. The operational performance was very strong. The noteworthy thing on this chart is the green bar. Operations added 33% to adjusted EPS, balanced between the platforms. They both delivered strong profit leverage on the strength of volume increases and cost reduction benefits. Tax, currency, and pension stock compensation amounted to a $0.05 headwind, with a minor favorable impact from share purchases. In total, adjusted EPS was $1.09, up 36%. Please go to Slide 8. Adjusted EBIT margin was 18.4%, up 310 basis points. Our effective tax rate was 19.2% versus 11% in the prior year. Last year, we had several favorable discrete items, mostly around R&D credits that we described at the time. This was a $0.10 headwind year-over-year that we overcame. Adjusted EPS was $1.09 versus $0.80 last year. If you go to Slide 9, adjusted segment EBIT again increased 40%, with leverage on volume and cost reset benefits offsetting material cost headwinds in the Climate Technologies business. Adjusted pretax earnings increased 350 basis points to 17.6%. Operating cash flow was very strong, up 31% at $1.1 billion. Free cash flow was $977 million, also up a little over 30%, driven by strong earnings growth and effective working capital management. Lastly, the trade working capital ratio improved to 15.4% of sales. Turning to Slide 10, we’ll look at Automation Solutions. Underlying sales turned positive this quarter at 8%. Trailing three-month orders accelerated to 17%. The improvement in the Americas is particularly encouraging and notable with continued momentum in life sciences, food and beverage, and medical markets and a return to growth more broadly across the traditional process automation markets and sustainability-related business. The platform continues to implement the comprehensive restructuring actions that have been ongoing, and the benefits are flowing through to the financial results. Adjusted EBIT margin increased 320 basis points and 310 basis points at adjusted EBITDA, driven mainly by the flow-through of the cost reset savings and volume leverage. Backlog increased to $5.5 billion, up 17% year-to-date. We’ll talk a bit about the project funnel and other opportunities later in the call.

Thanks, Frank. Clearly, as you can see, our operating environment remains very challenging as commodity inflation, electronic supply, and labor availability continue to impact our global operations. Steel prices are at record highs with 11 months of consecutive increases and, in our estimation, have not peaked yet. Plastic resin prices remain elevated as our global teams have maneuvered quickly to define alternatives to maintain supply. While copper pricing has receded off record highs, it is still up over $1.40 a pound year-over-year. Our hedge positions lessened the impact to 2021, but the inflation impact in terms of copper will carry over into most of 2022. Electronic shortages are proliferating in most of our businesses, impacting both platforms, and supply is expected to remain constrained well into 2022. Very little component inventory on microprocessors, controllers, and linear integrated circuits is available in the open market, and the number of shortages faced by our EMS suppliers is growing, severely impacting lead times. Labor availability continues to be an issue across many industries in the U.S., impacting our businesses as well. Our V-shaped demand recovery in many of our Commercial & Residential Solutions businesses, local competition driven by tight labor markets in many cities, and rolling labor constraints as waves of COVID disruptions impact our sites, has added a new level of complexity to our operational plans. It is important to note that price cost remains at an unfavorable $75 million as we estimated last quarter. No change, but we expect the maximum impact of commodity inflation to be felt in the next two quarters. Despite these challenges, turning to Slide 13, I’d like to highlight some of the outstanding work by our global supply chain and operations teams to combat these challenges and help deliver phenomenal operational results to date as they remain flexible, creative, and nimble in a dynamic environment to serve the needs of our customers. Our supply chain teams have worked tirelessly in this environment to ensure continuity of material supply to our global plants. As you can see on the chart, many creative solutions are being implemented on a real-time basis, quickly and effectively. Our regional footprint, both on the manufacturing side as well as supply chain that we spent many years developing, has certainly been an advantage for us in these challenging times. Many of our global plants are producing at record levels while ramping up capacity to meet surging demand and, in many cases, in-sourcing critical elements of the supply chain to address sudden disruptions. I want to take this opportunity to sincerely thank our global teams for delivering an outstanding operational quarter. With that, I’ll turn it over to Lal to walk through our full-year guidance and outlook.

Thank you, Ram. Let’s turn now to Slide 15. We are improving our sales outlook for the year, based on the continued strength in our orders, the pace of business, and the year-to-date profit performance. We now expect underlying sales growth to be near the top of our May guidance of approximately 5% to 6%, Commercial Residential above their range in May at 15% to 16%, and Automation Solutions closer to the top of their range at 0% to 1%. The strong volume and improved cost base will flow through to margins. Our estimates are now 50 basis points above the previous guidance, increasing adjusted EBIT margin and adjusted EBITDA by 0.5% to approximately 18% and 23%, respectively. There’s no change to the restructuring, tax rate, capital spend, or dividend. Strong profitability and working capital performance enabled an increase in our operating cash flow and free cash flow estimates, both of which increased by $300 million. We are also raising our adjusted EPS guidance to $4.07, plus or minus $0.01. Our price/cost headwind for 2021 currently remains as estimated in Q2 and covered at $75 million, despite the current challenges that were highlighted. We continue to manage this through containment and selective price actions, but the recent market developments will be a challenge through the next two quarters as we navigate them. Stock compensation impact increases to $125 million. Let’s go over to Slide 16, and I’ll just frame the order environment that we’ve experienced through the last three months. Emerson’s trailing three-month orders continue to be very strong and have momentum from the last update we gave you in the second quarter, with Commercial & Residential Solutions continuing to climb higher in their order run rates and Automation Solutions turning sharply positive to the high-teens in June.

Hi. Good morning, and I look forward to working with you, Colleen. In terms of, I suppose, Lal, the Automation Solutions sort of revenue outlook. So, a lot of very good color in the slides. It looks like the guidance is embedding sort of mid-single-digit type growth in the fourth quarter in Auto Sol organically. When we take your comments together in terms of a sort of stable funnel since February and maybe an ongoing sort of subdued oil and gas CapEx backdrop, should we take that as a good sort of medium term or into next 12 months sort of placeholder that mid-single-digit type Auto Sol growth rate?

Hi. Good morning, Julian. Thank you. Thanks for the question. I think that’s fair. Look, the recovery has been largely fueled by modernizations and MRO spend across facilities. There has been, as I indicated, some KOB1, but that’s not what’s going to drive us going forward. What I would expect is that conversion in those two segments of the business into sales will continue. I think that’s a fair assumption.

Thanks very much. And then, maybe switching to the margin aspect, can you clarify how much of that $75 million price-cost headwind falls into the fourth quarter? And when we look at Com Res margins in that context, can that business sustain a sort of 20-plus percent incremental margin the next six months, or does it get pushed below that by the price-cost headwinds?

Great question as well, Julian. Clearly, that’s where the challenge is going to be on incrementals in Commercial Residential for the next six months. The team is working both sides of the equation, price and cost. We’re getting creative in terms of the contract structures and the negotiations with our major customers. But we also have opportunities to continue to work on the availability of materials and sourcing from different areas around the world. That’s where the biggest challenge is, and I would suggest that your assertion is correct that the incrementals in that business are going to be the most challenged as we go over the next six months.

I have a couple of questions. First, regarding the additional funnel contributions, especially in decarbonization, it's great to see that increase. Can you provide more details on this? On one hand, some of your long-standing customers are significant emitters. Are they feeling more pressure to diagnose, measure, and improve their emissions, or is the focus of your funnel tracking leaning more towards green technologies, such as hydrogen? Which area is making a bigger impact, and which one do you believe will have a larger influence in the medium term?

Yes, great question. I think there’s a little bit of both in the funnel. If you look at the traditional $6.3 billion funnel, there was already embedded in that a lot of the biofuel conversions and emissions monitoring work that’s being done downstream, particularly in refining and other parts. What’s in the new opportunities are significantly incremental investments. These are driven by sustainable feedstocks or the investments in hydrogen. Our core integrated oil customers are all spending incremental dollars on emissions, sustainability, reliability, and productivity efforts to drive to their ESG commitments. That can come in the frame of conversions or optimizing current processes.

Yes. So, I’ll take that. From a pricing perspective, as Lal mentioned, our Commercial & Residential teams are diligently working on price. Many of the pricing, particularly with the large OEMs, will happen in October, but most of it will happen in the January timeframe. So, you’ll expect the pricing to kick in, in a significant way into our second quarter. In terms of the steel and copper pricing, certainly, the copper hedges will flow through the year. We’ve modeled that out. On the steel side, we do expect the next three to six months to be pretty tough, but outside of that, we’ll start seeing better pricing on steel come through as well. I would say, from a pricing perspective, a lot of the pricing from our perspective is modeled in the January timeframe.

Yes, it does extend into the next fiscal year. Ram mentioned that the next two quarters will be particularly challenging, which is accurate. Therefore, the balance will really be reached in the first calendar quarter of 2022, corresponding to our second fiscal quarter of 2022.

Good morning. Can you hear me now?

Yes.

Sorry. You guys usually have the call in the afternoon. So, I sleep in these days. So, I just kind of fell asleep there for a second during the Q&A. Just to clarify some of this price-cost, what was price-cost in the quarter? And then, what has it been? Just remind us of what that’s been year-to-date?

So, price-cost in the quarter, total enterprise is roughly about negative $50 million. We were positive in the first half. We’ll see that intensifying in the fourth and the first quarter, as both Ram and Lal have said. We’re going to have to work through that right through the second quarter of next fiscal year. But, it was around $50 million in the third.

Yes. I continue to assert that 30% number for long-term. You’ll see that flex up and down, but that’s the target. As we execute the cost reset plan, that’s how we frame that with the businesses. There will be quarters, as we saw with automation, where we’ll print higher than 40%. And there will be quarters as we sell commercial residential that we’ll print lower than 30%. So, it is flexible, but 30 is how I’m thinking about it.