Rockwell Automation: Buying Growth Story, Nibbling At Stock – Seeking Alpha

by admin on May 20, 2022

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The COVID-19 pandemic, the latest supply chain disruptions caused by lockdowns in China, and national security concerns put the spotlight on various countries’ manufacturing capabilities. These multiple crises are leading to supply chain diversification and reshoring efforts. Rockwell Automation (NYSE:ROK) should benefit from these trends. The company’s increased focus on generating more revenue from software and software-related acquisitions bodes well for its future. Although Rockwell Automation looks fully valued at this time, I like its focus on industrial software, and this may give it a competitive advantage in the long term. I have invested in this stock, and I would put more money to work if it sells off further. I plan to hold it for the long term.

Revenue Growth Should Resume Once Supply Chain Disruptions Fade

Organic sales grew by just 1% year-over-year due to supply chain constraints but, the organic revenue growth was an excellent 9% for the first six months. The company’s Independent Devices segment saw organic sales decline by 3% year-over-year due to supply disruptions. The company’s software and control business saw organic sales increase of less than 1%. Its Lifecycle Services saw organic sales grow by 11%, with the Sensia business within this unit seeing revenue growth of 24%. The company mentioned that its total orders increased 37% year-over-year in Q2 FY 2022. The company saw segment operating margin decline by 630 basis points in Q2 FY 2022, which led to a 79% decline in free cash flow in the quarter (Exhibit 1). Supply chain constraints and cost inflation led to this pressure on margins.

Exhibit 1: Rockwell Automation Q2 FY 2022 Financial Performance

Rockwell Automation Q2 FY 2022 Financial Performance

Rockwell Automation Q2 FY 2022 Financial Performance (Rockwell Automation Earnings Presentation)

Exhibit 2: Rockwell Automation FY 2022 Revenue and Earnings Guidance

Rockwell Automation FY 2022 Revenue and Earnings Guidance

Rockwell Automation FY 2022 Revenue and Earnings Guidance (Rockwell Automation Earnings Presentation)

Based on its latest estimates provided in April, the company is guiding for organic revenue growth of 10% at the low end (Exhibit 2). This growth rate is lower than the guidance provided earlier. But, any company that can grow revenues at a 10% clip should be applauded in this uncertain economic environment. The company is also projecting that its segment operating margin will improve to 20%. That would be a good 430 basis point improvement over the Q2 FY 2022 segment operating margin.

Rockwell’s Focus on Industrial Automation and Software Will Pay Dividends

Automation is crucial for reshoring manufacturing in the U.S. market. The ongoing labor shortage and labor cost make it imperative for companies to look at automation to increase productivity and keep costs low. As companies around the globe rethink their supply chain and manufacturing capabilities, they are also looking at increasing automation in their factories. The aging population worldwide will make it harder for companies to find workers for their factories. The company is investing heavily in its software business and is looking to generate more revenue from software and reduce its reliance on low-margin hardware. It has been aggressively acquiring and investing in companies (Exhibit 4), and this strategy should increase software subscription revenue, higher profits, and margins. Its Software & Control business segment boasted an operating margin of 27% in FY 2021 compared to 21% for its Intelligent Devices and 9% for lifecycle services (Exhibit 3). As the company increases its share of total revenue from software from its current 27%, it should see higher overall margins. But, this transition will take time, and investors should be patient.

Exhibit 3: Rockwell Automation’s Segment Operating Margin

Rockwell Automation's Segment Operating Margin

Rockwell Automation’s Segment Operating Margin (SEC.GOV)

Exhibit 4: Rockwell Automation’s Software Acquisitions

Rockwell Automation's Software Acquisitions

Rockwell Automation’s Software Acquisitions (SEC.GOV)

China’s Onerous Lockdowns are Good for American Manufacturing

The world has changed forever due to the events of the past decade. The U.S. tariff and trade war against China was already causing grief and anxiety for many American companies during the years of the Trump administration. Some expected a quick return to normality in trade relations with China when Biden was elected to the presidency. But, President Biden has largely kept President Trump’s tariffs in place. But the rising consumer prices in the U.S. is putting pressure on President Biden to reconsider the tariff on China.

The COVID-19 pandemic upended just-in-time inventory and manufacturing practices across the globe. The onerous lockdown of Shanghai has led to widespread manufacturing and supply chain disruptions in many Fortune 500 companies. Companies took Supply chain resiliency for granted before the pandemic; now, this is a board-level topic on the agenda for every board meeting.

Cisco’s CEO, Chuck Robbins, talked about how his company could not ship more than $300 million in products due to factory shutdowns in Shanghai. Cisco is most likely looking to diversify its supplier base and even consider moving some manufacturing closer to its end markets. Rockwell Automation has a slide in its earnings call that talks about the resiliency actions they are taking to improve their supply chain resiliency (Exhibit 5). They are making investments in a new capacity with redundant manufacturing lines. They are qualifying new suppliers to diversify their supplier base. Every company in the U.S that is involved in selling physical products is taking actions similar to that taken by Rockwell Automation. Many companies are building new manufacturing or bringing back manufacturing to the U.S. National security concerns also play into these reshoring efforts. For example, the U.S. Congress is looking to subsidize semiconductor manufacturing in this country. These actions bode well for the long-term order and revenue growth at Rockwell Automation.

Exhibit 5: Supply Chain Resiliency is Top of Mind at Rockwell Automation

Supply Chain Resiliency is Top of Mind at Rockwell Automation

Supply Chain Resiliency is Top of Mind at Rockwell Automation (Rockwell Automation Earnings Presentation)

The company may be beginning to see the benefits of the ongoing reshuffling of global trade. Its outlook for FY 2022 shows its orders are approaching $10 billion. It also sees total sales growth of 11% to 15% (Exhibit 6).

Exhibit 6: Rockwell Automation Can Deliver on its Revenue and Earnings Forecasts

Rockwell Automation Can Deliver on its Revenue and Earnings Forecasts

Rockwell Automation Can Deliver on its Revenue and Earnings Forecasts (Rockwell Automation Earnings Presentation)

Valuation Multiple Might Go Higher a Business Transitions to Software

The company is currently valued at a forward GAAP PE of 24x compared to its five-year average of 27x. It trades at a forward EV to EBITDA multiple of 16x compared to its five-year average of 17x. Pure-play software companies in the industrial space, like PTC (PTC) and ANSYS (ANSS), trade at a much higher valuation than Rockwell Automation. PTC trades at a forward GAAP PE of 43x and its five-year average is 240x. ANSYS, which has industry-leading operating margins of about 27%, trades at a forward GAAP PE of 45x with a five-year average of 54x. So, compared to companies in the industrial software space, Rockwell Automation trades at a discount.

But, investors need to remember that the company generates just 27% of its revenues from software. I would consider the company fully valued at this time. But, given that Rockwell Automation may always trade at a premium I bought a few shares during the recent market sell-off at an average price of 196.79. The company also offers a decent dividend yield of 2.2% compared to the S&P 500 (VOO) dividend yield of 1.5%.

Conclusion

Rockwell Automation’s increased focus on revenue from software bodes well for its future. The company may even command a higher valuation multiple when its software revenues make up most of its total revenue. The company should also benefit from reshoring efforts underway across the globe. The company has capabilities that competitors cannot easily replicate. Given these reasons, this company may make a good holding in a long-term portfolio.

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