ROK - Rockwell Automation: Positioned To Build Back America

Summary

• Rockwell Automation has scarcity value as the leading pure-play automation company in the United States.
• Its strategic value is likely to increase as U.S. leaders make a concerted effort to rebuild America's manufacturing base.
• However, it continues to trade a premium valuation with consensus estimates highly uncertain due to a weakening macroeconomic environment.

Rockwell Automation ( ROK ) is the leading player in the automation industry in the United States, based on its high-quality products, comprehensive offerings, and strategic partnerships. Currently, Rockwell is one of the top competitors in the intersection of technology and traditional manufacturing, which the company refers to as its "Connected Enterprise" strategy. Following a meaningful underperformance over the past year, the stock's relative valuation is becoming interesting again.

In this article, we will systematically examine the company's business fundamentals, strategy, risks, financials, and valuation to help readers arrive at a more informed position to assess the risk and rewards of owning the stock.

Note: This article is for educational purposes only and does not constitute financial or investment advice. Please do your own due diligence and consider your unique financial needs and constraints before buying any stock.

Business Overview

Rockwell Automation is a multinational corporation that provides industrial automation and information solutions. The company was founded in 1903 as the Compression Rheostat Company, which manufactured and sold rheostats, a type of electrical resistor used to control the flow of electric current. In the early 1920s, the company changed its name to Allen-Bradley Company, and it expanded its product offerings to include industrial control and automation products such as timers, counters, and relays.

In 1985, Allen-Bradley was acquired by Rockwell International, a diversified technology and manufacturing company, and became a subsidiary of Rockwell. In 2001, Rockwell International spun off its automotive and aerospace businesses to focus on its industrial automation and information businesses, and the company was renamed Rockwell Automation.

Today, Rockwell Automation is one of the leading providers of industrial automation and information solutions, serving customers in a wide range of industries, including automotive, food and beverage, life sciences, and renewable energy. The company's products and services include control systems, sensors, machine safety products, and software for plant-wide control and information management. Additionally, Rockwell Automation offers training, consulting, and support services to help customers optimize their use of the company's products and solutions.

Rockwell Automation is historically one of the leading companies in the "discrete" automation business, alongside Siemens ( SIEGY ). Discrete manufacturers focus on assembling highly engineered components into more valuable final product configurations, such as cars on a factory assembly line. Other competitors like Emerson Electric ( EMR ) are more dominant in "process" automation, which refers to manufacturing operations that convert highly variable raw materials into consistent and quality finished goods using formulations or recipes. The outcome of discrete manufacturing can be reversed, as discrete manufacturing employs standard parts and components and programmable logic controllers (PLCs) primarily associated with discrete manufacturing are 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.

Competitive Advantage

Rockwell Automation has a sustainable competitive advantage in my opinion, driven by its intangible assets and switching costs. As a highly competitive firm among industrials, Rockwell has a large installed base of highly-engineered, mission-critical equipment deeply integrated into complex customer processes. This makes it difficult for customers to replace the equipment for long periods of time without incurring prohibitively expensive downtime. In some cases, Rockwell's equipment has been installed for over 30 years.

Strategy

A lot of what Rockwell has been talking about over the last few years is creating new ways to win, new ways to provide value for customers, and new ways for the company to grow faster and increase performance. This is being done through the introduction of new technology. The company has an unprecedented amount of new product introductions, innovations, hardware, software, and high-value services to bring it all together and to create positive outcomes. The company is also expanding into more industries and strengthening its position in traditional markets. Additionally, new business models, such as recurring revenue through Software-as-a-Service and subscription-based models, are becoming increasingly important to the company's overall value. Rockwell is in the process of transforming itself and the industry as a whole.

Internally, this strategy is referred to as the "Swoosh slide" and was introduced in 2018. Despite the four years that have passed, it still holds relevance as it was introduced during a different time. The core of the company continues to generate the majority of revenue and profits, and the importance of information solutions and connected services as a part of the company's value has grown.

Execution

Rockwell reports that, four years after setting a vision, the company has successfully transitioned to execution. Despite facing various macroeconomic challenges, such as navigating the COVID-19 pandemic, supply chain disruptions, and inflation, Rockwell has remained focused on achieving its original goals.

The company's $9 billion revenue target is not the end goal, but rather a measure of the progress that has been made. By looking back to 2016, it can be seen that Rockwell has achieved growth in all fundamental areas. From 2018 to the present day, the company's core has grown at a rate of 2.3 times industrial production, an improvement on its previous rate of less than 2. This success can be attributed to adding new capabilities, embracing disruption, expanding into new markets and verticals, and pursuing a more aggressive strategy outside of the US.

Rockwell Automation has recently implemented strategies to increase its software content and value-added capabilities in order to provide more comprehensive solutions and become a deeper partner in the digital transformation journey of various industries. Despite facing headwinds, such as semiconductor shortages, which pose a significant threat to shipments and cash flows, the company recognizes its integral role in keeping the world running through automation in various industries such as vaccines, food packaging, electric vehicles, and battery production. Furthermore, the company is seeing a significant difference from previous cycles as it currently holds an enormous backlog of over $5 billion, representing over two quarters' worth of shipments. This, coupled with low unemployment and a tight labor market, presents a positive outlook for automation as companies look to optimize scarce human resources with the technology provided by Rockwell Automation.

Risks

Macro: Rockwell aims to grow at over 2x IP, which implies greater risk-taking and may lead to over 2x IP to the downside as well. Demand for products, solutions, and services is also affected by changes in production and the financial performance of major industries it serves, such as oil and gas, which are sensitive to commodity prices, production costs, and environmental regulations. Given the highly uncertain macro environment, we have little confidence in the accuracy of consensus estimates.

Increased Investments: Many investors have expressed skepticism about Rockwell's ability to achieve its strategy of accelerating growth by new product introduction and becoming more of a software company. These investors seem to view Rockwell as a sleepy company operating in the mature and slow-moving manufacturing industry. If the company's increased investments do not lead to increased spending by customers, the company will likely miss both revenue and margin expectations.

M&A: Over the past 20 years, Rockwell has mainly avoided acquisitions, focusing instead on its current structure and partnerships. However, it appears that the company's Board of Directors is now more open to mergers and acquisitions and the shift towards cash earnings per share further supports this stance. The company's ability to generate the desired ROI as well as ability to integrate the acquired assets remains a "show me" story.

Financials & Valuation

Rockwell Automation has a stable and healthy balance sheet with low risk of default, as supported by its strong cash position and credit risk assessment. The company's net debt to EBITDA and interest coverage ratio are within healthy levels at roughly 2x and 11x, respectively.

The company's free cash flow conversion, which is often over 100%, is an indication of its financial strength. The free cash flow margin also tends to be in the mid-teens, which we expect to improve in the future, despite a decline in fiscal 2022 due to supply chain disruptions.

Consensus estimates for FY23 forecast a robust 8.9% revenue growth and a 12.6% EPS growth.

At nearly 26x forward 1-year EPS, ROK remains somewhat of an expensive stock relative to its own 5-year history and to industrial peers. Emerson, its direct competitor, trades at just over 23x forward EPS.

ROK's premium valuation held despite underperforming EMR by ~16% points over the past year, possibly reflecting the market's preference for the more value-oriented opportunity in EMR.

Conclusion

Rockwell Automation has scarcity value as the leading pure-play automation company in the United States. Its strategic value is likely to increase as U.S. leaders make a concerted effort to rebuild America's manufacturing base. Following a year of underperformance, the stock is becoming more interesting from a valuation perspective. However, it continues to trade at a premium valuation with consensus estimates highly uncertain due to a weakening macroeconomic environment. As a result, we will watch on the sidelines until more clarity can be had.

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