ABLZF - Rockwell Automation: Narratives Don't Match Numbers

2023-03-14 04:47:34 ET

Summary

• Industrial automation is a mega-trend but if you invest purely on this logic, you are prone to suffering gut-wrenching drawdowns.
• The market is bullish on supportive manufacturing policies.
• But leading indicators suggest a slowdown in manufacturing activity.
• Rockwell's product lead times remain elevated contrary to easing supply chain narratives.
• The stock is very expensive.

Introduction

I had written a note on ARK Autonomous Technology & Robotics ETF ( ARKQ ) i n January this year. Now, I dig in deeper and evaluate Rockwell Automation ( ROK ) as an investment opportunity:

Undoubtedly, industrial automation is a mega-trend. And there has been a massive surge of supportive manufacturing policies in the US, driven especially by a revamp in US semiconductor manufacturing. However, I believe Rockwell is very expensive at current prices without strong near-term catalysts to justify its valuations. As such, I hold a 'sell' rating on ROK stock.

The market is bullish on supportive manufacturing policies

The current US government has implemented multiple supporting policies to boost manufacturing in the United States as part of a broader Reshoring Initiative . Some of the key policies include the CHIPS Act , the Infrastructure Act and the Inflation Reduction Act .

Altogether, this has amounted to at least $322 billion in manufacturing capex over multiple years. I say at least because the data does not count incremental manufacturing capex such as Tesla's ( TSLA ) $700 million Gigafactory expansion .

How much of the $322 billion manufacturing capex is attributable to equipment spends?

This is an important question as equipment spends are a better proxy for Rockwell's addressable opportunity. Considering 57% of the total manufacturing capex is associated with semiconductor fabs, I use semiconductor fab economics as a proxy:

I asked some of my friends with decades of experience in the semiconductor industry what % of total semiconductor plant capex would be attributable to equipment spends. They said 40% to 70%, depending on the specifications. According to SemiWiki - an open forum for semiconductor professionals - 45% of total capex was suggested to be attributable to equipment-related capex.

Thus, I estimate a 50% mix of the $322 billion manufacturing capex to be related to equipment spends. That amounts to $161 billion.

What incremental industry tailwind relates to this $161 billion of estimated equipment capex?

According to the US Census Bureau's 2021 Annual Capital Expenditures Survey, $1053 billion was spent in equipment related capex. Therefore, a $161 billion increment on top of this implies an incremental 15% growth opportunity that will be manifested over the next few years.

This is meaningful for Rockwell Automation since 60% of its total revenues comes from North America, with the majority of that being in the US.

But leading indicators suggest a slowdown in manufacturing activity

Despite the supportive policies outlined above, leading indicators of new manufacturing plant starts activity paint a more subdued outlook. According to 2023 Construction Outlook published by Dodge Data and Analytics (North America's industry analytics provider for the construction and manufacturing industry), North American manufacturing starts is expected to see a sharp decline in 2023:

Nevertheless, after a massive run-up in activity during 2022, manufacturing will see steep declines in 2023: starts will plunge 43% to a still-elevated $51.2 billion, and square footage will drop 17% to 122 [million] sf.

- 2023 Construction Outlook, page 6 (Author's bolded emphasis)

Moreover, the Institute for Supply Chain Management's PMI numbers continue to display slowing activity in the manufacturing sector in February 2023 - despite all the bullish commentary:

My previous article on a Global X Autonomous & Electric Vehicles ETF ( DRIV ) show how this slowdown in manufacturing activity is a common trend worldwide as well.

Overall, I anticipate this to lead to lower order inflows for Rockwell Automation.

Rockwell's product lead times remain elevated contrary to easing supply chain narratives

Rockwell publishes the manufacturing lead times for its products every fortnight. My analysis of this data shows that despite narratives about easing supply chains , the reality is that Rockwell's lead times remain elevated:

Rockwell's median lead time for up to 130 different products remains high at 126 days. I believe this is likely to lead to negative surprises in revenue conversion going ahead.

The stock is very expensive

Comparable Valuation

Peer-set includes other global automation companies such as Honeywell International ( HON ), Siemens ( OTCPK:SIEGY ) ( OTCPK:SMAWF ), ABB ( ABB ) and Fanuc ( OTCPK:FANUY ) ( OTCPK:FANUF ).

As can be seen from the chart above, Rockwell trades at a pricey LTM EV/EBIT of 27.0x. This corresponds to a 32.5% premium to the sector median multiple of 20.4x.

I believe premium multiples are harder to justify when the macro conditions suggest a subdued picture.

Historical Multiples Valuation

Relative to its own historical NTM PE multiples, Rockwell is currently trading at 25.2x, which corresponds to an approximate 31% premium to its 23 year average multiple of 19.3x. Such an average is important to consider as it illustrates a cross-cycle picture in a cyclical industry.

Although I recognize the tailwinds of supportive manufacturing policies and the long term automation trends, I believe the 31% premium is too high since the current data on manufacturing activity and high lead times do not support the long term bullish commentaries and narratives.

Assuming a moderate premium to the long term average of 15%, I get a target NTM multiple of 21.9x. Taking the FY23 consensus EPS estimate of $11.24 , this yields an implied target value of $246.16, corresponding to a 17.4% downside in the stock from its current price of $289.07.

Takeaway

As it derives 60% of its business from North America, Rockwell Automation's business is linked to the region's capex spends in the manufacturing sector, especially on equipment purchases. My estimates show that supportive governmental policies give a 15% incremental boost to Rockwell's addressable market, driven by initiatives such as the CHIPS Act, Infrastructure Act, and the Inflation Reduction Act.

However, these bullish macro drivers just don't seem to be translating into revenue conversion yet. Leading industry data predicts manufacturing starts to decline by 43%. The easing of the supply chain everyone's talking about? I can't see it in the numbers as Rockwell's lead times continue to remain near peak levels. All of this is amid a manufacturing sector that has been slowing down in the US and globally.

Finally, Rockwell's valuation is very pricey as it trades at an almost 33% premium to other global automation peers and 31% above its long term valuation multiples.

Due to these factors, I would sell Rockwell Automation here. I would be interested to buy at lower valuations, especially if it is supported by genuine reductions in product lead times and a pickup in manufacturing activity.

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