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Rockwell’s Battered Shares a Long-Term Opportunity for Patient InvestorsRockwell’s Battered Shares a Long-Term Opportunity for Patient Investors Joshua Aguilar Senior Analyst Analyst Note | by Joshua Aguilar Updated May 03, 2022 Wide-moat Rockwell Automation had a rough fiscal second quarter and meaningfully whiffed on our expectations, but nothing in its latest results alters our long-term, fundamental view of the firm. While we lowered our full-year fiscal 2022 assumptions on the cusp of disappointing results and management’s lowered guidance, time value of money fully offset these effects in our model. Therefore, we maintain our $290 fair value estimate. Given the extent of the supply chain disruptions and inflationary headwinds on Rockwell’s business, as well as the long putt toward the midpoint of 2022 sales and earnings guidance, we model toward the lower end of the revised guide. We now expect nearly $7.8 billion of sales (including organic growth of about 10%), segment operating margins of 19.5%, adjusted EPS of $9.20, and free cash flow conversion of about 85%. Nonetheless, over the long term, we still model mid-single-digit-plus organic sales growth, incremental margins in the lower-30s, lower-double-digit EPS growth, and free cash flow conversion of just over 100%. Rockwell has been struggling to fill orders due to multiple component shortages, particularly in products with significant hardware content. Despite the weak quarter, one thing that gives us confidence is Rockwell’s order strength, demonstrating that demand is strong, and that recent problems are a symptom of the current environment. Therefore, we don’t think revenue is lost but merely pushed out to the back half of the year and into fiscal 2023. Even so, organic sales still grew just over 1%. And Plex, which Rockwell acquired in late 2021, has picked up some significant automotive wins and is partnering with Microsoft Azure in Europe. Finally, Fiix, which Rockwell acquired in early 2021, grew annual recurring revenue over 40%, while Rockwell’s overall organic ARR grew by 17%. Business Strategy and Outlook | by Joshua Aguilar Updated May 03, 2022 We view Rockwell as the highest quality automation player on the west side of the Atlantic based on quality, breadth of offerings, and shrewd strategic partnerships. Today, it’s one of the best-in-breed competitors seeking to gain a stronger foothold where technology meets traditional manufacturing, which Rockwell calls its Connected Enterprise. Rockwell’s signature platform in this strategy is Logix, which consists of programmable controllers and a line of products interoperable with third-party and some legacy applications. The advantage of this platform is multifold. First, Logix can perform multiple automation applications, like discrete (automotive, for example), process (chemicals), and hybrid (pharmaceuticals) on a single platform. Most competitors pursue these automation applications through a piecemeal mix of hardware and firmware platforms. Second, by using a single, easy-to-use platform, Logix reduces training costs and maintenance expenses as well as makes it easier to communicate across different manufacturing cells. We believe training costs will become a greater consideration as technology inevitably becomes increasingly integrated into manufacturing facilities. Ultimately, workers will need to be comfortable with that technology, which can become complicated if they’re forced to learn multiple platforms. Third, because Logix works with third-party applications, customers can make incremental improvements to their facilities without incurring the disruption of an expensive system overhaul. We believe this should allow for cheaper installation and scale-up costs. Finally, like other automation counterparts, the Logix platform offers customers the opportunity to run analytics on the cloud, allowing for improved asset utilization as well as lower total cost of ownership. Predictive maintenance further allows for reduced enterprise risk, while analytics helps customer products get to market faster through optimized throughput. Ultimately, we believe the value offered by solutions like independent cart and partnerships with Sensia and PTC, combined with inorganic opportunities, should allow the firm to remain a premium player in a growing industry. Economic Moat | by Joshua Aguilar Updated May 03, 2022 We believe Rockwell Automation benefits from a wide economic moat thanks to intangible assets and switching costs. Among industrials, we believe wide-moat firms like Rockwell have a large installed base of highly engineered, mission-critical equipment deeply integrated into complex customer processes. In our view, customers can’t overhaul the equipment sold by wide-moat firms for long periods of time without incurring prohibitively expensive downtime. In Rockwell’s case, certain pieces of customer equipment have been installed for over 30 years. According to competitors, Rockwell is historically one of two powerhouses (the other is multi-industrial conglomerate Siemens) in what is known as the “discrete” automation business. Discrete manufacturers focus on assembling highly engineered components into more valuable final product configurations (for example, cars on a factory assembly line). Other competitors like Emerson Electric are more dominant in “process” automation, which refers to manufacturing operations that convert highly variable raw material into consistent and quality finished goods using formulations or recipes (for example, chemicals and oil derivatives). Unlike process manufacturing, the outcome of discrete manufacturing can be reversed since discrete manufacturing employs standard parts and components. For example, a manufacturer can’t extract dye from a paint mix like a piston in an automobile engine. Additionally, another difference is that a programmable logic controller (PLC), which is primarily associated with discrete manufacturing, is used to control a specific component, machine, or process, while a distributed control system (DCS) controls multiple functions in a flow and is commonly associated with process manufacturing. Moreover, while both types of manufacturing require very high levels of sophistication, discrete offerings tend to emphasize after-the-fact (as opposed to real-time) statistical analysis from key performance indicators, financials, and data from production assets to drive continuous improvement. Given their respective historical core competencies, both Rockwell and Emerson face similar challenges but from opposite ends of the spectrum as they attempt to move into what is referred to as the “hybrid” space--or a mixture of both discrete and process manufacturing, as is seen in the pharmaceutical industry. According to one expert, who we find credible given that he worked for both companies, while Rockwell started with smaller control systems, it has been competing for larger plant systems while Emerson has been trying to scale down to smaller control systems. From our understanding, the hybrid landscape is currently controlled by a few players (including Rockwell, Emerson, Schneider, ABB, and Siemens), and we suspect that there is room for increased share gains from both through eventual consolidation. Today, portions of the industrial equipment industry potentially face disruption from new technologies, including a combination of advanced robotics, 3D printing, connected devices, and new data processing and analytic techniques commonly referred to as the industrial Internet of Things. According to General Electric representatives, following productivity gains in the 1980s and 1990s from techniques popularized by firms like Toyota (that is, lean manufacturing and six sigma), productivity gains have recently only averaged a mere .5% per year. Smart devices offer the promise of helping manufacturing customers make better operational decisions, including improving manufacturing lead times, making better maintenance, repair, and overhaul, or MRO, spending decisions, improving environmental and regulatory compliance as well as responding to cybersecurity threats. Yet, according to Rockwell’s representatives, as of 2017 less than 20% of factories were connected. In response, Rockwell is one of a few industrial players and one of the only remaining pure-play automation competitors focusing on creating a single, common software platform that combines a customer’s traditional manufacturing plant floor operations with its information technology functions (that is, “The Connected Enterprise”). The logic is that by integrating both plant assets with the rest of the enterprise value chain, customers can reduce their time to market, lower their total cost of ownership, improve their asset utilization, and better manage their enterprise risks. While the firm does not build robots, it helps customers achieve these objectives by marrying differentiated technology, including routers, switches, and sensors, with deep technical know-how to remotely monitor assembly lines, reduce energy costs, forecast outages, and strive toward continuous production. Rockwell’s differentiated technology is no doubt helped by the firm spending about 5.7% of its sales on research and development as of 2019, or approximately 3 points or so more than the median R&D spend to sales ratio in our diversified industrials coverage. Even so, over the past five year, Rockwell impressively yielded $8.25 in returns on research capital (gross profit over prior year R&D expenditures), by far one of the highest in our diversified industrials coverage, even as the firm ramped up its R&D spend relative to the prior five-year cycle. The firm’s signature platform in its goal to merge operational technology with information technology is Logix. Logix supports both discrete and process manufacturing on the same hardware platform with the same software programming environment. The Logix architecture is scalable because it is built on an open standard communication protocol. In other words, it’s interoperable with both Rockwell’s intelligent motor control offerings (for example, products like electronic motor starters, relays, and timers offered through its Control Products & Solutions segment) as well as third-party applications. Ultimately, we suspect this should allow customers to implement Rockwell’s architecture in a less costly manner relative to competitors. Moreover, we think Logix’s single platform creates a stickier offering relative to competitors. The advantage of the Logix platform is that manufacturing customers are only obligated to teach employees once on both hardware and software with an easy-to-use package. We think this is important because as technology plays an increasing role in the industrial Internet of Things race, having workers trained and comfortable with that technology becomes increasingly critical. Consequently, this allows for reduction in both training and maintenance expenses, and makes it easier to communicate across the different cells of a manufacturing facility. In our view, the lack of a single, easy-to-use alternative augments the firm’s switching costs since we understand most competitors offer multiple applications within a customer’s enterprise. Additional evidence of the firm’s mission-critical services can be gleaned from various examples. An International Paper mill, for example, has a dedicated phone line directly connected to Rockwell engineers, allowing them to spot problems and instruct workers how to fix any operational issues before they may even arise. Without this help from Rockwell, International Paper would be forced to hire another engineer. While International Paper representatives admit the service is expensive, they believe the cost is justified. Other more recent examples of both the firm’s technological differentiation and the mission criticality of its products and services can be identified in the consumer package good space. Kraft-Heinz’ Ore-Ida brand wanted more yield out of its lines, including in cleaning, prepping, frying, freezing, and packaging. Kraft-Heinz produces 800 million pounds of processed potato products and a 1% increase in yield greatly enhances its profitability. While Kraft-Heinz was targeting a 5% increase in yield, Rockwell used an analytic software package that was implemented in real time, examined multiple variables, optimized a complex process, and ultimately improved yield by 10%. The improved yield over a two-year period justified not only the analytic installation, but also the entire upgrade of the equipment, and avoided the capital expense of an additional piece of equipment on top of the cost of the upgrades. Ultimately, we calculate returns on invested capital in the mid-30s between Rockwell’s prior 10-year historical returns and the future five-year projected returns (the difference in management's calculations lie in what we categorize as financial assets in the firm's "other" assets on the books), which is the highest in our diversified industrials coverage. Notably, at its nadir in 2009, post-financial crisis, Rockwell’s ROICs including goodwill only dipped to just over 16%, or just over 750 basis points above our estimated cost of capital, even though its performance is highly correlated to global industrial production, which was severely hampered from the crisis. As such, we believe it’s more likely than not Rockwell can continue to out-earn its cost of capital over the next 20 years. Fair Value and Profit Drivers | by Joshua Aguilar Updated May 03, 2022 After reviewing Rockwell's fiscal second-quarter results, we maintain our $290 fair value estimate. While Rockwell whiffed on our expectations, nothing we saw alters our long-term, fundamental thesis. Given the extent of the supply chain disruptions and inflationary headwinds on Rockwell’s business, as well as the long putt toward the midpoint of 2022 guidance, we model toward the lower end of the revised guide. That said, over the long term, we still model mid-single-digit-plus organic sales growth, incremental margins in the lower-30s, lower-double-digit EPS growth, and free cash flow conversion of just over 100%. We value Rockwell at 31.5 times our adjusted EPS expectations of $9.20 for fiscal 2022. Demand for Rockwell's products and services remains very strong. Orders don’t just dissipate from mission-critical industrials like Rockwell given its large installed base of equipment and complete suite of solutions--key durable competitive advantages. Furthermore, Rockwell’s secular growth trends remain intact, including increasing automation and digitization of manufacturing operations, which we expect will only accelerate from historical experience. Additionally, we think Rockwell can continue to pull on its price lever given its strong intangible assets, though we no longer think it will be enough to offset inflation in fiscal 2022. Over the long run, we think Rockwell's future is bright, particularly in the area of analytics closer to the plant floor where it's more likely to see recurring, subscription-type revenue. We expect Rockwell will continue as a leader in the convergence of IT and OT. A majority of factories are still not fully connected, based on industry reports. In our view, the global automation market will grow based on customer need to drive productivity and efficiency gains. Furthermore, we think Rockwell will continue to benefit from technologies like independent cart technology, digital twin, augmented reality, and cybersecurity, among others. Rockwell's automation equipment can improve a customer's asset utilization and total cost of ownership. Once in a factory, Rockwell stands to benefit from decades of higher-margin aftermarket revenue. Verticals served by Rockwell specifically seek these types of efficiency gains. Finally, we believe Rockwell has a strong breadth of offering thanks to partnerships with PTC and Sensia. We believe bolt-on acquisitions offer Rockwell the opportunity to add just over 1% of sales to its top-line growth. Risk and Uncertainty | by Joshua Aguilar Updated May 03, 2022 We think Rockwell has two primary risks--first, the company’s results are positively correlated to industrial productivity, both in the United States and internationally. This risk is amplified because unlike other industrials, which operate in multiple industries (that is, are diversified), Rockwell is a pure-play automation company with mostly short-cycle sales activities and has few long-cycle sales activities to offset its exposure. This was particularly evident in the mini industrial and manufacturing recession from 2015-16, which no doubt contributed to headwinds in 2016 as evidenced by the firm’s 2016 negative organic sales growth. Second, it’s unclear as to whether Rockwell will possess the requisite domain expertise in process manufacturing to become the preferred provider for an integrated discrete, process, and hybrid solution. Rockwell has long touted the process automation opportunity, but we agree with most market observers who argue that Rockwell lacks the reputation it has in its discrete manufacturing offering given slower growth in the process space (and from a smaller sales base, to boot). Moreover, a lack of capital investment could translate to similar challenges in the race to be the preferred vendor of choice in the industrial Internet of Things race. Other challenges the firm faces include currency risks (even though the firm does hedge this exposure), cybersecurity risks, and rapid shifts in technology. From an environmental, social, and governance, or ESG, standpoint, the biggest potential risks include environment litigation related to its 13 superfund sites cited in the firm's 10-K, legacy asbestos liabilities, potential product recalls of its automation equipment, a possible loss of intellectual property, and human capital risk given Rockwell's need to attract skilled labor. That said, we consider the fallout from these risks relative to Rockwell's operations as very low. Capital Allocation | by Joshua Aguilar Updated May 03, 2022 We assign Rockwell Automation a Standard capital allocation rating. While Rockwell's balance sheet is very strong, and we like its partnership strategy and investments, we think any share repurchases in future would be somewhat dilutive, and arguably believe distributions run a bit on the high side given its organic opportunity set. Blake D. Moret has been CEO and president of Rockwell since July 1, 2016. Moret is a longtime veteran of the company. Previously, Moret spearheaded the former Control Products and Solutions segment as its senior vice president for five years. He started as a salesman back in the early 1990s, and we think he carries the same passion for his job today as he did then. Under Moret’s leadership, moreover, the stock has moved meaningfully ahead of the price returns of the S&P 500 over the same time horizon. There’s a lot to like about Moret’s leadership, even on top of the exceptional market returns Rockwell has garnered during his tenure. For example, Moret oversaw the acquisition of previously private company, Maverick Technologies. Rockwell has long touted the growth potential of process manufacturing arguing it allows the firm to expand its addressable market. That said, we agree with many market observers argue that Rockwell has historically lacked some of the domain expertise (that is, technical know-how) to take significant share in this space. According to ARC Advisory Group, the Maverick acquisition enhances the company’s distributed control solution capabilities, which allow a plant to continue operating in the event a specific section fails, as well as shores up its knowledge gap in process manufacturing. We find this argument credible. Under Moret, returns on invested capital have remained strong in what is already the best ROIC company in our diversified industrial coverage. For over the past 10 years, the board has authorized the company to continuously raise its dividend, which we think is a testament to its ability to convert earnings into free cash flow. From 2009 to 2019, average free cash flow (CFO-capital expenditure) conversion averaged over 125% of earnings on average, and more than doubled earnings in 2018. Free cash flow conversion was likewise very strong in fiscal 2020 at 119%, and adjusted free cash flow conversion (free cash flow over adjusted net income) came in at about 103% during fiscal 2021. However, we have hesitated to award an Exemplary stewardship rating given multiple factors. First and foremost, we express some modest concerns over how we believe the series of Emerson’s unsolicited buyout bids were handled. The board decided it was not in the company’s best interest to even engage in discussions with Emerson. While Emerson handled this poorly by continuing to make additional unsolicited bids after its initial offer, we still believe it was in the interest of Rockwell’s shareholders for Rockwell’s board to engage in discussions with Emerson. Rockwell's board refused to speak with Emerson because: 1) Emerson has historically had a poor track record with integrating companies; 2) Emerson’s stock, which constituted a substantial portion of the deal under each bid scenario, was viewed as poor currency given a recent history of lackluster returns; and 3) Emerson and Rockwell use different platforms, and the combination would have only made them bigger, but not competitively differentiated players. While this argument was not without foundation, Emerson’s final offer was at a considerable premium to our fair value estimate then. Moreover, Emerson’s bids were a premium to Rockwell’s stock, which most analysts viewed as overvalued at the time. That said, Rockwell has produced strong results over time, and its partnerships have positioned it as one of the strongest automation players. We think the firm will demonstrate an increased willingness to pull on its inorganic lever, and it has done an excellent job doing so over the last few years under Moret's stewardship. The board has authorized about $1 billion of share repurchases, and we'd support management repurchasing shares given where the stock trades relative our fair value (about a 26% discount to a share price of $216, as of this writing), provided it can't find acquisitions at attractive valuations. Rockwell announced on Oct. 19, 2020, that CFO Patrick Goris has accepted a position with Carrier. As we expected, Rockwell hired an external CFO, but we were surprised when CFO Nick Gangestad returned to the industrials space after he recently retired from 3M. We think Gangestad will serve as an important strategic partner to Moret and focus more on increasing annual recurring revenue through software sales and bolt-on M&A deals. |
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