My investing world feels more normal now that Rockwell Automation (NYSE:ROK) is back to a point of generous, if not excessive, valuation. While the shares offered investors a rare opportunity a year or so ago, the stock has been strong as industrial markets have started to turn in the company’s favor.
There’s a lot to like about Rockwell, as it touches multiple popular themes like manufacturing reinvestment/capex recovery, reshoring, potential favorable tax changes, natural resource recoveries, and the industrial internet of things (or IoT). Moreover, management seems to be more willing to consider M&A as a means of rounding out its offerings and enhancing its addressable market.
Valuation has been a challenge with Rockwell in the past and so again today. With the shares already pricing in close to 10% long-term free cash flow growth, I don’t think you can say that the company is underrated. Good companies have a way of outperforming, and Rockwell certainly qualifies, but I’d really like to get another crack at this at a lower valuation.
Not Back To Normal, But Definitely Better
With core revenue growth of 7% in this first calendar quarter (Rockwell’s fiscal second quarter), Rockwell is not only a standout among automation peers like ABB (NYSE:ABB), Emerson (NYSE:EMR), Honeywell (NYSE:HON), Siemens (OTCPK:SIEGY), and Schneider (OTCPK:SBGSY), but also the larger industrial sector as a whole where only a handful of names (GE (NYSE:GE) and Parker-Hannifin (NYSE:PH)) have had comparably strong quarters.
Rockwell saw 14% underlying growth in its Architecture and Software business, with Logix up 13%. Control was weaker, up 1%, but at least the results continue to improve. Margins were mixed. Gross margin improved by a point, but operating income declined about a half-point, with segment margins down about 30bp due to a two and a half point decline in the Control segment. Architecture and Software was strong, with segment profits up 23% and margin above the mid-20%s.
Although Rockwell has a significant skew toward heavy industry, that’s not really driving the growth at this point (though I would argue that “significantly less bad” is still a meaningful change). Auto remains very strong for Rockwell. Auto volumes are softening, but companies continue to spend on retooling and Rockwell seems to be benefiting from growth efforts in areas like powertrain. Consumer was also strong, with management pointing again to food/beverage as well as life sciences (interesting, given the lackluster results at Danaher (NYSE:DHR), though the businesses are very different).
M&A – From Prey To Predator?
Rockwell has long figured prominently in discussions of automation M&A, and why not? Rockwell has a very high-quality business (strong in PLC, drives, motor/motion control, and software) and has managed to successfully cross the discrete/process divide in automation.
I’ll come back to the prospects for Rockwell getting a bid, but I think it is interesting that Rockwell itself is taking a more forward stance on M&A. That’s a big switch for a company that has long been skeptical about the benefits of broad diversification. To that point, Rockwell has only spent around $300 million on M&A this decade, and about half of that was spent in fiscal 2016.
What does Rockwell want? Even though plenty of analysts have suggested they might want to buy a PLM or ERP software business, management has explicitly said they don’t want to do that, as they think the synergies between such software and controls, instruments, and so on is more limited that commonly thought.
Based on what they have said, though, I think sensors, safety, and instrumentation could be on the menu. The company has a long working relationship with Endress + Hausser (a strong player in instruments), but I could also see other European companies like Balluff, Beckhoff, HIMA, IFM Efector, and Pepperl + Fuchs possibly holding some interest. With substantial cash assets stuck overseas, a deal outside the U.S. for a company with a strong position in sensors, connectivity, or so forth could make a lot of sense.
Now, as for Rockwell being a target… ABB’s acquisition of B+R took away arguably one of the most motivated buyers, but Schneider has reportedly been interested in this asset for a long time. Emerson could also be a very interested party (Rockwell would fill some notable gaps), but I’m not sure they could afford the deal given their pending deal with Pentair. Honeywell could likewise use Rockwell to fill gaps, but Honeywell has historically pursued a specialist strategy akin to Rockwell where they don’t try to be all things to all customers.
To throw one more name out, how about General Electric? General Electric has made a big deal about being a player in the growing industrial IoT opportunity and Rockwell would definitely lend more credibility to those efforts. What’s more, GE’s business mix hasn’t generated much for shareholders for a while and this management/board has never been shy about overpaying for assets they think are strategic.
Making The Connection
Rockwell has its own initiatives underway in IoT, under the heading of “Connected Enterprise.” In fact, Rockwell looks like one of the strongest players among the automation companies, with only Siemens and Schneider really looking serious contenders (though I’m sure ABB would argue strongly with that). Given its ability to straddle discrete and process automation, as well as its strong position in controls and software, Rockwell certainly has a serious opportunity here (even more so when you consider the amount of factory data flowing through their controllers).
Rockwell’s approach is multi-armed. In addition to its strong control technology, Rockwell has its manufacturing software platform, network infrastructure (in collaboration with Cisco (NASDAQ:CSCO)), and scalable computing resources in conjunction with Microsoft (NASDAQ:MSFT), as well as info management/analytics capabilities (with several data analytics pilot studies underway in a variety of industries) and strong visualization capabilities.
Rockwell doesn’t have everything, though. The company’s position in sensors is not as strong as it probably needs to be, and I think you could make the same argument with instrumentation. Hence, I think Rockwell’s larger-scale M&A activity will be in those directions. I don’t expect the company to do much on its own in robotics, though its partnership with Fanuc has been fruitful so far and the company can work with numerous small robot companies without needing to own its own platform.
The Opportunity
Even with a recent change at the top (a new CEO was named in mid-2016), I don’t think Rockwell is going to change all that dramatically. The new CEO is a Rockwell veteran and the company had been telegraphing a greater willingness to consider M&A prior to the transition. I’m still a little concerned that the head of Architecture and Software, Frank Kulaszewicz, could be a target for a competitive hire-away since he didn’t get the top spot, but I’m not going to get hung up on a theoretical risk.
I know there are investors who largely scoff at modeling and instead believe in buying good companies and holding them long term (or at least through a cycle). Rockwell certainly qualifies, and I acknowledge the limits of modeling, but I would note that the company is still quite cyclical and tied to the health of the underlying industrial economy (particularly in the U.S.).
I’m looking for long-term revenue growth of around 5%, and larger-scale M&A could swing that a little higher. Rockwell already generates strong margins relative to other automation players, but I believe FCF margins in the mid-teens are attainable on an extended basis, supporting FCF growth in excess of 6%.
The Bottom Line
As I said earlier, Rockwell shares already seem to be pricing in close to 10% long-term FCF growth. I don’t think that’s an absurd notion, but I think that means a pretty bullish outlook is already in the shares. I would definitely like to get another shot at these shares at a lower valuation, but with Rockwell checking the box on so many bullish trends today, I don’t necessarily expect to get that chance right away.
Disclosure:I am/we are long ABB.
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.
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