Despite Cyclical Headwinds, Emerson Appears Well Positioned to Capture Secular Automation Trends

Equity Analyst

Krzysztof Smalec

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In our view, Emerson Electric is the undisputed powerhouse in process manufacturing on the west side of the Atlantic. Despite near-term headwinds, we believe the firm is poised for several years of positive organic growth. Its total addressable automation market, both served and unserved, totals over $200 billion, of which approximately 59% is in hardware and services, 32% in control product software, and 9% stand-alone software. Even as Emerson holds either first or second share in a variety of product categories, established firms' share remains somewhat fragmented (depending on the category, Emerson holds roughly midteens market share), suggesting a large runway for growth. 

We believe automation can add more to manufacturing firms’ bottom lines than many other investments. Additionally, we think predictive analytics will augment these results, given the mission-critical nature of Emerson's products and services. We believe Emerson will benefit from fewer available experts than can adequately address in-demand automation services; industrywide share of mind as evidenced by a multitude of awards from various trade publications; and most importantly, its large installed base, which allows the company to benefit from decades of higher-margin aftermarket revenue. 

Once David Farr relinquished the helm, we expected CEO Lal Karsanbhai and the board would revisit a potential breakup close to Emerson's 2022 investor day. While our thesis was confirmed, it was only partially so: Management sold portions of climate technologies to Blackstone but retained its tools business. We think this somewhat undermined the sale as a catalyst, because we don't believe rolling tools into automation makes much strategic sense. Conversely, we think the purchases of a majority of AspenTech and National Instruments make strategic sense, even though Emerson clearly overpaid for the latter.

Business Strategy & Outlook

We assign Emerson Electric a wide economic moat based primarily on switching costs and secondarily on intangible assets. We view its automation business as a wide-moat business. Our assessment hinges on our degree of confidence in the business’ competitive position.

Emerson’s automation business is built on the automation industry’s largest installed base of $120 billion. Process manufacturing infrastructure (as seen in oil and gas, chemical, and refining facilities)—what Emerson is most known for—has a 20- to 50-year life span. Switching costs are strong because most companies can’t afford a wholesale replacement of their existing control systems. Switches to lesser-known competitors are uncommon from a risk management standpoint, given the catastrophic cost of failure. Shutting down a continuous process is risky. Many operators and maintenance technicians often get a chance to stop, service, and restart a continuous process only once every seven years. Given this dynamic, Emerson increasingly benefits from fewer available industry experts that can appropriately address service requirements. Moreover, operators’ lack of practice and familiarity with required procedures often leads to heightened chances of accidents and waste, and a breakdown in a plant’s existing systems can translate to heavy losses (some estimates peg up to $1 million in losses per plant). While it’s cheaper in the short term for firms to operate a run-to-failure strategy, over the long run, plant facilities that fail to implement preventative maintenance end up spending more. In addition to the cost of unplanned downtime, a firm’s failure to maintain its facilities shortens the life span of its capital investment. In the event of a sudden plant shutdown, not only do individual components fail, but so do secondary systems, like shafts or motors.

Regulation reinforces these switching costs. The US Occupational Safety and Health Administration places increasing emphasis on recognized and generally accepted good engineering practices. As such, it’s no longer acceptable to assign blame for catastrophic incidents on prior plant owners. Equipment and service providers like Emerson can implement systems that lead to meaningful reductions in the number of alarms triggered by machine failures (some figures indicate reductions of up to 70%), allowing operators and technicians to focus on the root causes of machine failure. Moreover, some studies reported in automation trade magazine stress the need for predictive maintenance over preventive approaches. Only 18% of machine failures are caused by age, while the remaining 82% are random events. Aside from reducing the cost of maintenance, predictive maintenance tools translate into increased uptime, increased throughput, improved product quality through optimization, and reduced waste and rework.

That said, while manufacturing facilities may have predictive maintenance tools in place, they may not be using them to their full capabilities. In addition to lack of experience from technicians and operators, customers’ staff do not have the time or resources to sift through an abundance of diagnostic data. As a result, plants depend on experts from established firms like Emerson to mine the data given their comprehensive expertise around control valves, physical metering, and systems health monitoring. For example, many plant engineers are well versed in the theory of vibration monitoring (which can be used to detect loose bearings, for example), but these techniques are not always applied correctly, leading to inconsistent measurements and misleading conclusions drawn from data. These are highly skilled techniques which require experts to consider vibration range and sensitivity, frequency, and temperature.

Skilled services like these are generally provided under long-term agreements and have allowed Emerson to move from purely an equipment and traditional service business, to increasingly providing consulting services. We believe this has borne out quantitatively—Emerson’s public transcripts, from our understanding, reveal that these types of services constitute greater than 25% of segment sales. This type of service revenue is higher margin than Emerson’s product business, which incidentally provides the firm more ammunition for capital spending, allowing it to extend its already massive installed base. According to multiple experts, customers benefit because automation correctly applied can add more value to the bottom line than any other business investment. Furthermore, Emerson estimates that the total addressable market for automation is $204 billion, suggesting a large runway for growth. Even so, competitors attempting to catch Emerson would struggle replicating the firm’s installed base. Based on Emerson’s experience and those of its closest competitors, it would likely take an opposing firm 10-20 years to become a credible player in the automation space. 

The technology that affords competitors’ and Emerson’s components a high degree of measurement accuracy is often only the cost of entry. However, we think what differentiates Emerson is its ability to provide customers a comprehensive solution of both software and component products and services. In part, we think this is helped by Emerson spending over $300 million a year on research and development. On the product side, smart instrumentation like the kind Emerson offers can drive meaningful (up to triple-digit) increases in identifying defects and efficiency of certain energy systems. For example, its Coriolis flowmeters, which measure mass flows of liquids, and are widely used for custody transfer applications of petroleum liquids, can lower customers’ total cost of ownership in critical applications, despite their higher capital cost. 

One such use case for flowmeters is titanium dioxide, which is added to fine white paper to help meet requirements for brightness and whiteness. Customers that use too much titanium dioxide incur substantial costs, while those that use too little produce off-spec paper. Magnetic flowmeters cause inaccurate measurement in this use case, which can result in a 15% rejection rate for either insufficient brightness or whiteness. A Coriolis meter interfaced with a control system can save a facility up to $250,000 per year, conservatively computed. Emerson, furthermore, has continued its product innovation by eliminating complex installations with an all-welded spool design that doesn’t require an orifice plate. This design supports up to four individual flow transmitters, and further tolerates extreme temperature conditions, whereas previous iterations would have broken down the instrumentation. These types of incremental product innovations allow the firm to extract higher price points from its products.

Other product innovations have taken place at the controller level. Traditionally, Emerson’s offerings are associated with its strength in process manufacturing, such as distributed control systems required for continuous or complex batch processes. A DCS is highly reliable, but historically expensive, large, and complex to implement. This contrasts with Rockwell’s strength, for example, in programmable logic controllers, which are traditionally associated with discrete manufacturing (for example, as in autos or electronics) and are more flexible. These traditional distinctions have blurred over time. For example, Emerson has developed a controller that allows it to autoconfigure and decouples it from traditional inputs and outputs but acts like a node in its DeltaV network (the firm’s DCS architecture). In other words, this type of innovation provides customers with the flexibility of a PLC, but with the reliability of a DCS as required in certain hybrid offerings like life sciences. We suspect this could also provide Emerson with positive optionality in the form of additional use cases. 

Additional product innovations include Emerson’s Asco Numatics zoned safety valve island, which can be specifically configured to shut down a specific group of valves without requiring an operator shut down an entire machine and incur expensive downtime. These islands further reduce the required number of components, save space, improve design flexibility, from our understanding. Finally, we’re enthused by digital twin technology, which uses simulation to allow customers to test new plant control designs. In one use case, a large petrochemical company identified efficiency and cost savings on the order of millions of dollars but couldn’t shut down the plant to test these ideas. This simulation allowed the firm to test ideas which resulted in an immediate payoff of $500,000 in energy costs saved, as conservatively estimated by the customer.

Emerson also benefits from a strong reputation in automation, as well as a high share of mind. Control Global magazine, which solicits nominations from engineer respondents based on fill-in-the blank nominations, rated Emerson number one in both device and plant asset management in 2018. Emerson’s Plantweb was similarly ranked number one in Control Engineering magazine for software diagnostics. We think these types of recognitions are important. According to Boston Consulting Group, 40% of Internet of Things customers prefer to use traditional and well-established companies for Internet of Things solutions. We estimate returns on invested capital (inclusive of goodwill) for the segment typically and consistently range from 10% to 15%. While the excess returns spread is not large for the segment (given the capital-intense nature of the business), we’re confident in the firm’s position in the automation space. Only when oil dropped from $105 in 2014 to $26 in 2016 do we estimate that the segment’s returns dropped to cost of capital, even as the firm’s installed base had over 30% exposure to upstream and midstream oil and gas. Given that the segment’s installed base is making incremental pivots away from oil and gas, coupled with the fact we would not expect a 75% drop in oil prices to become a normal occurrence, we have a high degree of certainty of a normalized excess spread over our calculated cost of capital. 

Finally, the firm’s tools business (now housed within safety and productivity) primarily benefits from strong brands, like Ridgid tools. Ridgid is a franchise business with over 95 years in existence and a strong reputation, particularly among plumbers, given the brand’s strong historical association with the pipe wrench. The brand competes with other well-known brands with similar historical pedigrees, including DeWalt, Ryobi, Makita, and Milwaukee. Based on perception from several tool reviews, we understand it’s considered a strong value, providing budget-friendly but professional-grade tools that are well designed and durable. The brand boasts a Net Promoter Score of 73, comparable to products made by Apple, which we think is evidence of the brand’s stickiness. Finally, we think modest switching costs exist with the Emerson’s tools for two reasons: Ridgid works with fitting companies for specific plumbing applications, and Emerson providers contractors technical training on its tools, which we think contributes to the brand’s high NPS.

(Nov. 27, 2023): Previous versions of this report referred incorrectly to the Occupational Safety and Health Administration.

Wide

Economic Moat

Emerson Electric

Emerson Electric Co. is a global technology and engineering company, which designs and manufactures products and delivers services that bring technology and engineering together to provide innovative solutions for customers in a wide range of industrial, commercial, and consumer markets. It operates through the following segments: Automation Solutions, AspenTech, Commercial and Residential Solutions, Climate Technologies, and Tools and Home Products. The Automation Solutions segment is involved in the process, hybrid, and discrete manufacturers to maximize production, protect personnel and the environment, reduce project costs, and optimize their energy efficiency and operating costs through a broad offering of integrated solutions, software, services and products, including measurement and analytical instrumentation, industrial valves and equipment, and process control software and systems. The AspenTech segment focuses on the asset optimization software that enables industrial manufacturers to design, operate, and maintain their operations for maximum performance through a combination of decades of modeling, simulation, and optimization capabilities with industrial operations expertise and apply advanced analytics to improve the profitability and sustainability of production assets. The Commercial and Residential Solutions segment offers products and solutions that promote energy efficiency and sustainability, enhance household and commercial comfort, and protect food quality and sustainability through heating, air conditioning and refrigeration technology, as well as a broad range of mechanical, electrical, utility and do-it-yourself tools that promote safety and productivity. The Climate Technologies segment provides products, services, and solutions for all areas of the climate control industry, including residential heating and cooling, commercial air conditioning, commercial and industrial refrigeration, and cold chain management. The Tools and Home Products segment consists of tools for professionals and homeowners that promote safety and productivity. The company was founded by Charles Meston and Alexander Meston on September 24, 1890, and is headquartered in St. Louis, MO.

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Emerson Electric Co. is a global technology and software company, which engages in the provision of solutions. It operates through the following segments: Final Control, Measurement and Analytical, Discrete Automation, Safety and Productivity, Intelligent Devices, and Software and Control. The Final Control segment focuses on providing control, isolation, shutoff, pressure relief, pressure safety valves, actuators, and regulators for process and hybrid industries. The Measurement and Analytical segment involves the instrumentation measuring the physical properties of liquids, gases, pressure, temperature, level, flow, acoustics, corrosion, pH, conductivity, water quality, toxic gases, and flame. The Discrete Automation segment includes solenoid, pneumatic, valve position indicators, pneumatic cylinders and actuators, air preparation equipment, pressure and temperature switches, electric linear motion solutions, programmable automation control systems and software, electrical distribution equipment, and materials joining solutions. The Safety and Productivity segment consists of pipe-working tools: pipe wrenches, pipe cutters, pipe threading and roll grooving equipment, battery hydraulic tools for press connections, drain cleaners, tubing tools and diagnostic systems, including sewer inspection cameras and locating equipment. The Software and Control segment processes by collecting and analyzing information from measurement devices in the plant and using that information to adjust valves, pumps, motors, drives, and other control hardware. The company was founded by Charles Meston and Alexander Meston on September 24, 1890, and is headquartered in St. Louis, MO.

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