Rockwell (ROK) is a pretty well-loved industrial, and particularly when recovery themes take over (as has been the case for a few months). While industrials with short-cycle exposure like Parker-Hannifin (PH) can, perhaps paradoxically, see momentum fade when ISM moves back above 50, Rockwell’s past rallies tend to last a little longer. Add in investor expectations that Rockwell will benefit from a meaningful reshoring trend, and I can’t say I’m surprised that Rockwell shares have stayed pretty strong since my last update.
Valuation is a frequent issue for me with Rockwell. Even though I think quality companies deserve premiums (and Rockwell qualifies), settling for less doesn’t always work well in my experience. On the other hand, with interest rates likely to remain low for a while, maybe investors have to accept that 7% returns are the “new 10%” return and adjust expectations accordingly. Even so, compared to names like Dover (DOV), Honeywell (HON), and Lincoln Electric (LECO), Rockwell screens as relatively more expensive.
A Better Than Expected Quarter, But Not THAT Much Better
Like so many multi-industrials, Rockwell managed to hit the lowered bar for fiscal third quarter (calendar second quarter) results as end-market demand picked up throughout the quarter (after a disastrous April). Revenue was slightly better than expected, while better cost-cutting led to a 4% (or $0.07/share) beat at the segment profit level.
Part of the reason I say “not THAT much better” is that Rockwell still reported an organic revenue decline of more than 17% – a little on the worse side of average for multi-industrials this quarter. A&S segment revenue declined 16% on a 16% decline in Logix and low single-digit decline in ISCS, while CP&S revenue declined 19% on a 17% decline in control products and a 20% decline in solutions.
Gross margin declined 330bp, while operating income declined 47%, with margin declining a steep 820bp, with decremental margin above 60% (versus the low 30%’s many companies are reporting). Segment-level profit declined 42%, with segment margin down 730bp.
A&S was the stronger business on both the top line (4% beat) and segment line ($0.10/share beat), with segment profit down 34% and margin down six points to just under 24%. CP&S segment profit missed by $0.03/share, with profit down 53% and margin down 830bp to 10.6%. On a more positive note, CP&S orders did grow at a double-digit rate, with a 1.05x book-to-bill.
Mostly In-Line Macro Trends, But With A Few Surprises
On the whole, I’d say Rockwell’s commentary on its end-markets was consistent with my expectations, albeit with a couple of points of interest. I also want to note a potentially worrisome trend I’m seeing with other industrials – while sales improved pretty nicely through the quarter, July is trending fairly flat with June. I’m not panicking about that, but I think it’s worth watching particularly given how the market seems to be treating a short-cycle recovery as a done deal.
Discrete markets were down 20%, and the 25% decline in auto sounds very consistent with the reports from companies like Atlas Copco (OTCPK:ATLKY), Dover, Lincoln Electric, and so on. The mid single-digit improvement in semiconductor markets was a little low in my view, though at least some equipment companies have reported a slower order trend in the second quarter. Management did also note that the underlying trend was improving in discrete end-markets.
Hybrid markets were down 10%, with food and beverage (the largest single market for Rockwell) down 10%. Tires were down double digits, while life sciences was down 10%. This is two straight quarters of seemingly weaker-than-trend results in life sciences, and I’m curious as to why Rockwell would be seeing this when companies like Danaher (DHR) and Halma (OTCPK:HLMLY) have reported healthy demand. This could be due to where Rockwell sits in the “food chain,” but it bears watching. Management indicated that hybrid markets were basically stable.
Process markets were down 25%, with oil/gas down 30%, mining/cement down double digits and chemicals down double digits. This is quite consistent with what companies like Honeywell (among others) have said, and Rockwell noted worsening conditions, despite some order growth for the Sensia JV.
A Change That Makes Sense
Rockwell management announced that they would be changing their operating and reporting structure. Rockwell will henceforth be run as three operating segments – Intelligent Devices, Software & Control, and Lifecycle Services.
Intelligent Devices will be mostly hardware, bringing sensors, safety, drives, motion control, and industrial components under one umbrella. Software & Control, as the name suggests, will include the MES/MOM busines, as well as offerings like simulation, visualization, augmented reality, security analytics, discrete/process control, and network infrastructure. Lifecycle Services will include offerings like consulting, Sensia, connected services, and maintenance.
This rearrangement makes abundant sense to me. In particular, I think it may help highlight the growth and value that can be added by the company’s investments in software and “X-as-a-service” offerings, including its IoT, analytics, and simulation offerings.
The Outlook
As I’ve said before, I’m still somewhat skeptical on the onshoring/reshoring theme. I believe it will happen, but I think it will be more “situation-specific” than the general consensus. I believe it makes abundant sense, for instance, to reshore more production capacity for active pharmaceutical ingredients, and I likewise understand the desire to reshore some electronics components. Still, a lot of industries, like autos (10% of sales), food/bev (20% of sales), home/personal care (5%), tires (5%), oil/gas (10%) and other process commodity markets (20%) aren’t likely to move much.
I know Rockwell is working closely with Stanley Black & Decker (SWK) to use automation to allow SWK to bring more manufacturing back to the U.S., and I’m not ruling out the possibility of more companies doing this, but I think investors should temper their expectations. On a positive note, as the leader in the U.S. market, Rockwell would stand to gain meaningful business if there’s a greater wave here than I expect.
I’m still looking for Rockwell to generate long-term revenue growth of over 4% over the next decade – an acceleration from the past decade as more industries adopt automation and as offerings like software grow. I’m also expecting Rockwell to be more profitable, as the mix shifts more towards higher-margin services and software. That, in turn, should support long-term FCF growth in the 6% to 7% range with FCF margins in the high teens.
The Bottom Line
If that FCF growth rate is in the ballpark, Rockwell shares look priced for a mid single-digit return on an annualized basis. I said in the open, maybe investors need to accept lower returns as part of the new normal, but Rockwell’s prospective returns are lower than many other quality industrials, including industrials with good short-cycle recovery exposure and leverage to future reshoring. I don’t believe in betting against Rockwell, but history has shown that patient investors can get opportunities to buy in with better expected returns than what is available today.
Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
