Emerson and AspenTech: Software Deal Unlocks Value for Both (NASDAQ: AZPN)

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As a global automation player, Emerson Electric (New York Stock Exchange: EMR) that helps manufacturing companies to optimize their production and improve their competitiveness is already well known. Less known is AspenTech (NASDAQ: AZPN) with whom Emerson entered into a software deal in October last year that saw recent stocks soar, as shown in the orange chart below.

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Data by YCharts

By contrast, Emerson shares have been trending lower, as shown in the blue chart below, and at a P/E of 15.5x, versus 33.67x for AspenTech, many investors must be wondering if it’s time to buy the shares of the electric drive game. Thus, the objective of this thesis is to assess the valuations of the two companies given the Emerson software divestiture that was part of the transaction concluded in May.

First, I explain how the power company navigates through supply chain bottlenecks when looking at its second quarter 2022 financial results.

Revenue growth and profitability

Emerson’s control systems include many integrated electronic components ranging from sensors to control devices, and the company has more than 20 factories in China. Despite being hit by supply chain disruptions resulting from Covid-related lockdowns, the company saw revenue growth of 8.12%.

However, since the restrictive measures were applied on March 27 and only lifted at the beginning of last month, it is Emerson’s third quarter results from April to June that should be most affected. There could be a drop in production volumes in case logistical delays prevent components from reaching assembly plants. Alternatively, the company could meet its sales targets, but at the expense of profitability due to the payment of additional expedited shipping charges. Additionally, the war in Ukraine has led to an inflationary commodity environment.

Thus, margins could suffer, to improve in the second half thanks to higher sales volumes and better pricing of products sold. The increase in sales in the third quarter is supported by the fact that inventories hit a high of $2.4 billion in the second quarter, compared to just $2 billion in the same period last year.

With respect to pricing power, Emerson is able to pass the majority of the incremental costs it incurs to its customers, including large utilities, which depend on it for their control systems, upon commissioning. work and throughout the life cycle of the product until dismantling. This is also an industry where switching costs (to competitors) remain high and companies are typically tied to multi-year contracts with Emerson for maintenance and upgrades.

Yet, it remains a competitive market with other big players like Schneider (OTCPK:SBGSY), Siemens (OTCPK:SIEGY), Eaton (ETN) and Mitsubishi Electric (OTCPK:MIELY) as shown in the table below.

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Comparison with peers (www.seekingalpha.com)

Tight competition means relatively slower organic growth and Emerson’s solution to this problem was to buy smaller competitors, but this resulted in a higher debt ratio as shown above. That’s why the cash and stock deal, which also saw Emerson bring its industrial and geological software businesses to the ‘new AspenTech’, is to be applauded. It’s worth mentioning that the US company’s move goes in the opposite direction to Schneider, which instead acquired Rib Software in 2020.

Unlocking value with AspenTech

In exchange, Emerson received a 55% stake in AspenTech. At that time, valued at around $8.3 billion, the software company now has a market capitalization of nearly $12.5 billion. During this period, there were about $4.2 billion (12.5-8.3) in value gains, of which about $2.1 billion (55%) went to Emerson. For investors, this represents a way to unlock value without necessarily selling an asset.

As for AspenTech, with Emerson’s asset optimization, network modernization and industrial AI software, it now has an end-to-end product offering that can be offered to its existing customer base. This means less marketing spend and, conversely, more profitable growth. Additionally, leveraging Emerson’s life science portfolio of more than 3,000 installed controlled systems and 1,000 engineers and consultants, AspenTech has the ability to optimize annual spend by having less need to recruit from the tight labor market.

In this regard, the company generated $187.8 million in the third quarter, as shown in the table below, an increase of 15.4% compared to the same period last year, while the spending rose only 2.4% to $655 million. Thus, non-GAAP EPS of $1.38 was a $0.03 beat from a year ago.

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AspenTech Third Quarter Income Statement (www.seekingalpha.com)

These good results can be explained by the strengths of the oil refining, chemical and renewable energy industries. In this regard, the company is benefiting from the capital expenditures of large refiners increasing their capacity in the United States and Europe, and this trend is expected to continue over the next 3 to 5 years. Telling numbers, around $1.5 trillion of capital expenditures were made in the global energy sector in 2021 and this is expected to continue through 2030.

Additionally, given the additional expertise brought by the Emerson deal, AspenTech has access to the carbon capture and sequestration market, which is expected to be worth $4 trillion by 2050.

Ratings and Key Takeaways

As I mentioned earlier, the deal unlocked approximately $2.1 billion in value for Emerson through the merger of its software unit with AspenTech. This represents approximately 4.4% of the current market capitalization which has not been valued in the stock as its shares have been trending lower. Adjusting accordingly, I get a share price of $84.24, and that’s even before the merger synergies have started.

However, I don’t view Emerson as a buy at this point, as higher inventory led to a reduction in operating cash flow to $442 million for the second quarter, down 45% from the first. trimester. This in turn led to a 53% drop in free cash flow, and it’s important to look for improvement in Q3 earnings before buying the stock.

That said, I remain optimistic for the long term due to the additional LNG delivery mechanisms required by Europe to compensate for reduced Russian supply, requiring more control systems. In this regard, the automation potential of the company’s liquefaction facilities in the United States and regasification terminals in Europe, as well as in Asia, is estimated at $1 billion over a five-year period.

As for AspenTech, it has a free cash flow margin of 22.8%. This is already above the IT industry median as shown in the table below, and with the integration of Emerson’s software suite, the company should benefit from a substantial FCF.

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Profitability and cash flow indicators (www.seekingalpha.com)

Along the same lines, its overall profitability score should also benefit as it forecasts approximately $110 million in total EBITDA synergies by 2026-2027, including $40 million in cost savings. In comparison, only $27.9 million of EBITDA was generated in fiscal 2021.

On valuations, despite its high EV/EBITDA ratio, AspenTech has gained 23% since the start of this year while the broader IT sector has lost over 25% of its value as it became clear that the US central bank should aggressively raise interest rates to control inflation. Now, high interest rates mean more pain for tech stocks, as they need to generate more EBITDA to justify their high valuations. Here, the fact that the industrial software game has outperformed suggests investors are banking on the Emerson tie-up to create more value for customers and shareholders.

So, after an 8% pullback since early June and as a high-momentum stock, shares of AspenTech could rise again to the $200 level when fourth-quarter financial results are announced in the last week of this month. Conversely, expect some volatility in the event of revenue loss, as the company is now more exposed to industries that may be affected by supply delays.

Finally, valuations show that Emerson has indeed unlocked value through the deal, but given this large exposure to China, expect short-term share price volatility up to that the company is able to generate cash from inventory. On the other hand, software is relatively less prone to supply chain issues, so an investment in AspenTech makes sense at this point.

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