This is part three of a four-part interview with Abhay Deshpande of Centerstone Investors. The interview is part of ValueWalk’s Value Fund Interview Series.
Throughout this series, we are publishing weekly interviews with value-oriented hedge funds, and asset managers. All the past interviews in the series can be found here.
Centerstone is a new firm established by Abhay Deshpande, former Portfolio Manager of the First Eagle Global and Overseas strategies. The firm is a New York-based, privately owned SEC-registered investment advisor offering niche investment vehicles. The Centerstone strategies are very similar to what Abhay practiced in the early days at First Eagle.
The team describes itself as business analysts not “equity” analysts a more holistic approach which includes the entirety of the firm’s capital structure allowing the manager to more accurately gauge the prospects for impairment in business value.
The Abhay Deshpande interview has been divided into several parts and will be downloadable as a PDF at the end of the series. So stay tuned for the rest of the series as well as the downloadable PDF!
Interview With Abhay Deshpande [Pt. 3]
Given the stakes, if something goes wrong, it’s also no surprise that service reliability is extremely important to the customer and a major factor in who they choose to buy equipment from. Emerson has a huge advantage in this regard as its massive global installed base – they’ve sold over $80 billion of equipment in just the past 10 years – gives them the scale to support a vast global service network, which in turn ensures the customer will be able to have their Emerson equipment serviced no matter where in the world the site is located. Having a well-developed service footprint not only helps you win the customer in the first place, it also makes it very hard for the customer to switch: sure, someone else may be able to sell you the equipment, but what happens when the equipment needs to be serviced and the new supplier doesn’t have anywhere near the service coverage that Emerson does? In fact, a big part of Emerson’s strategy is to co-locate their service facilities with major customer sites; that geographical proximity means it would be very hard for a competitor to provide service as effectively and cost-efficiently as Emerson can. Another benefit of having a strong aftermarket business – now more than 30% of consolidated revenue – is that the less discretionary nature of customer spending adds an element of resiliency to Emerson’s results; after all, recession or no recession, it isn’t really an option to stop having the equipment serviced.
Emerson also enjoys strong competitive advantages outside of Process Management, but the company’s edge in these segments generally has less to do with switching costs and more to do with scale. For example, in markets like air conditioning compressors and garbage disposal units, Emerson is several times the size of their next closest competitor, which makes it virtually impossible for anyone else to serve the market as cheaply. In other areas, ever more stringent regulatory requirements and industry standards make it extremely difficult for new entrants to penetrate the market. This is especially true in the Climate Technologies segment, where increasingly stringent emissions and energy-efficiency standards have forced existing players to continuously improve their technology. This gives Emerson and the other existing players a very significant advantage versus a new entrant that hasn’t spent the last few decades improving their technology and would effectively be starting from scratch.
Can you walk us through your investment thesis here?
Emerson’s earnings have declined by approximately 25% over the past two years, with the company hit hard by a combination of factors, including a downturn in the oil & gas sector, lackluster fixed investment globally and a strong US Dollar. This has in turn caused a chain reaction for Emerson’s stock price, with the shares now trading at around $52, down from a peak of approximately $70 at the end of 2013. However, we believe the sell-off has presented an excellent buying opportunity for those willing to hold Emerson with a long-term investment horizon. On the one hand we remain confident in Emerson’s competitive position and that they have the balance sheet to endure a protracted down cycle, as net debt to EBITDA currently stands at a mere 0.6x. On top of that, we believe the slowdown in Emerson’s end markets is temporary and that when these end markets recover, earnings may improve and the intrinsic value of Emerson’s franchise will become much more readily apparent to the market.
We also believe that near-term headwinds are causing the market to overlook the transformation currently underway at Emerson, as the company sheds the commoditized network power, motors and drives businesses in order to focus on areas like Process Management where they have much more of a competitive edge. This re-positioning dramatically improves the margin and return profile of the business. The company estimates the 2015 pro-forma operating margin was 18% compared to the 15% that was reported and the pro-forma return on capital was 28% compared to the 18% that was reported. With the business now more uniformly high quality in our view, a potential premium multiple shouldn’t be at all hard to justify. Thus, assuming only a modest recovery in the business lines that have significant oil & gas exposure we believe the shares are worth significantly more than where they are currently trading.