Rockwell Automation is Getting Interesting

For a while now, I’ve had a $145 fair value estimate for Rockwell Automation (ticker: ROK) on my watch list. My fair value estimate looked funny for a while as the stock hovered around $180-$190, but the share price collapsed in May and as of this writing it is down near $148, flirting with my fair value estimate and quite possibly ready to go beneath it.

Rockwell is one of those companies that is very high quality and frequently fully-valued, and thus rarely found at a bargain. However, as an industrial provider, it is highly cyclical and tends to be more volatile than the broader S&P 500, meaning that every 5-10 years or so you can generally find it at an incredible bargain.

We’re not quite at that level yet, but the stock is getting close enough to talk about more seriously to make sure investors are aware of this potential opportunity well ahead of time. So, I want to put Rockwell Automation on your radar as the rest of this economic cycle unfolds.  

Rockwell’s stock is likely to overshoot its fair value to the downside as cyclical stocks often do, perhaps falling much further at some point. So, while the stock is becoming interesting, care should be taken if investors choose to construct a position in the company.

Rockwell Automation: Overview

Rockwell provides integrated hardware and software for industrial automation. Their hardware side has larger revenue, but their software side has higher profit.

Industrial automation is divided into two main types: discrete and process. Discrete automation refers to building individual units, like cars. Process automation refers to more continuous and liquid things, like oil refining or chemical production. Hybrid automation requires some of both.

Rockwell’s platform is arguably the most broadly applicable solution for discrete, process, and hybrid, which gives it such a strong competitive position and makes it the gem of the industrial automation industry. Rockwell is also a pure-play automation company, while many of its larger competitors are conglomerates that are tied down with lower-margin business segments.

Rockwell comes from the discrete side of the business; that is their main strength. Siemens is another strong discrete automation competitor. Emerson Electric is the dominant process automation provider. Rockwell has done a better job expanding into process automation than Emerson has done for discrete automation.

More broadly, I consider Rockwell to be a better-managed company than Emerson. Emerson has had a pattern of poor acquisitions, and has significantly underperformed Rockwell over the past few decades.

In autumn 2017, a little over a year and a half ago, Emerson tried to acquire Rockwell for $225/share at the top of the market cycle, but Rockwell declined. Emerson made multiple rejected bids at increasingly high prices before giving up.

Although this acquisition would have made Emerson the dominant player of both discrete and process automation, I would argue that it is an example of Emerson’s questionable acquisition decisions. Rockwell was clearly overpriced by most analysis methods, and the automation platforms of the two companies are very different, which implies few areas of synergy.

Now, one could argue in hindsight that Rockwell was also incorrect to turn down such a foolishly high offer at that point. However, it makes sense for a stronger, pure-play, unified company to not want to be absorbed by a lower-quality and more diversified business, regardless of price. So, I would argue that Emerson wanting to acquire Rockwell was a mistake (and a telling one), while Rockwell’s decline was understandable.

Next Phase: Connected Enterprise, Smart Manufacturing, IoT

Rockwell benefits from the long shift from human labor to automated manufacturing. This has been going on for decades but there is still a long runway for more automation to occur.

And the next phase is to connect all of that automation technology to the cloud, big data, and machine learning, and other buzzwords that nonetheless point to real changes.

Rather than operating in a silo to complete a specific task, automation will continue to get smarter and more connected. At the current time, only a minority of enterprises are integrated like this, so the majority of the growth is ahead of us. This will improve real-time monitoring and predictive models, resulting in less downtime and higher productivity. 

For those that are interested, I recommend reading the 2019 Manufacturing Trends Report by Microsoft. Microsoft of course approaches this from the cloud side of things, and this white paper describes a lot of the details and benefits of this next wave of interconnection. A particularly relevant snipped for this company is this:

“One company that is revolutionizing how the no-collar workforce operates is Rockwell Automation, which is using Microsoft products to give manufacturing customers real-time insight into their operations. The company uses the Windows 10 IoT Enterprise operating system to design a hybrid automation controller that easily connects to customers’ IT environments and Azure IoT Suite, giving them immediate access to data at the point of operation. These insights allow managers to make changes mid-shift (instead of after operations cease) and reduces decision-making time from hours to milliseconds.”

Near Term Headwinds

Rockwell has a bunch of negative news hitting it at once. This is the sort of situation worth paying attention to, where a high quality company with bullish long-term prospects is covered in mud by shorter-term external problems and economic cyclicality.

First of all, Rockwell has cyclical exposure to the auto manufacturing industry, which as Eric has been covering, is in a significant downtrend. More broadly, it has exposure to the broader manufacturing sector, which makes it vulnerable if the United States or other major markets enter a significant economic downtrend or a recession.

Secondly, Rockwell does a lot of its own manufacturing in Mexico. Rockwell’s stock dropped over 4% on Friday after the president announced a plan for tariffs on Mexico. If the high-end 25% range of those tariffs occur, it would be a strong headwind against Rockwell’s margins, especially at this vulnerable time.

This is the benefit of having a watch list. It’s a good strategy to identify high-quality companies with durable economic moats and long future runways so what when occasional external headwinds materialize, you’re ready to buy when the price is right.

Analysis and Valuation

I have a rather unusual perspective on this company, as I’m one of the few (only?) analysts that cover Rockwell’s stock that have also used their products.

Earlier in my engineering career, I worked for an independent automation company, and used Rockwell’s programmable logic controllers. After that, I worked for another organization designing and building the electrical and control systems of aircraft simulators using some products of Rockwell’s competitors.

Rockwell has a wide moat due to its technology and product differentiation. However, it also benefits from high switching costs. Once engineers put in an automation system, it is a huge hassle to switch to another provider because it requires considerable design expense and re-training. This will become increasingly true as automation extends up the value chain into the cloud, connecting the whole enterprise. Rockwell’s platform also has the flexibility to integrate with numerous external providers, like Microsoft and others.

The forward growth rate for this company is particularly challenging to predict due to its cyclical nature. The company’s software segment is expected to grow at an above-GDP rate, as the company estimates that over 80% of enterprises still have to integrate their industrial automation to their cloud (connected enterprise, smart manufacturing, IoT, etc). In contrast, the company’s hardware segment is expected to grow roughly in line with GDP. So, the shift towards enterprise integration and smart manufacturing is the key growth area.

The stock currently pays a 2.6% dividend yield. Total shareholder yield is in the 4-5% range including net buybacks. The company has a stronger-than-average balance sheet, with a net debt level of about $1.3 billion, or less than a year-and-a-half’s worth of free cash flow. As previously described, the company’s technology and overall solution package is at the top tier in the industry. This is especially true for discrete automation and overall enterprise integration, but the company is also competitive for process and hybrid automation.

Rockwell Automation consistently maintains ROIC over 20%, and management pays attention to this metric. During the bottom of the financial crisis in 2009, Rockwell’s ROIC was “only” 11%, and they were free cash flow positive. So, the stock is cyclical and volatile, but is fundamentally sound.  

Purely from a fundamental perspective, my fair value estimate for Rockwell remains at about $145. In other words, if I were to buy the whole company for its future cash flows and hold it for the foreseeable future from an old-school value investing perspective, that level would likely offer a reasonable risk-adjusted rate of return in my view. If an investor wants a 10% margin of safety, a $130 entry price would be required.  

From a practical stock investor perspective, Rockwell stock historically overshoots its fair value both to the upside and the downside. In other words, I consider the $140’s to be a rational buying zone but would not fill a complete position at that level. There’s a good chance during this economic cycle that it will reach a lower level.

For historical context, the stock is currently 28% off its highs, and most recessions pull it down by over 40%. The particularly bad financial crisis pulled it down over 70% even though the company itself was doing okay.

For example, a 45% drawdown from its high point of about $200/share would imply a low point of about $110/share if we have a typical recession and drawdown in the next few years. That doesn’t mean it will necessarily happen, but that’s a frame of reference to keep in mind when assessing your risk tolerance. That level would be where I’d be happy to fill a full position in my active account. A full-blown crisis could pull it lower than that, while an optimistic scenario may result in the stock never reaching that low.

In my opinion, investors that buy under $145 and hold for ten years will likely look back on it as a good investment. But there will likely be better bargains along that path. 

Active investors may try to catch the bottom of this stock using macro/cycle insights and technical analysis. Investors that have lower-turnover methodologies may be inclined to begin dollar-cost averaging whenever the stock is in the range of reasonable valuation, which it is getting close to.

Either way, keep an eye on this one going forward. It’s a great company benefiting from positive trends but facing external tailwinds related to politics and the economic cycle.