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By Daniel Holland

Since the market trough in March 2009, automation stocks have averaged annual growth near 60%. While this track record will be near impossible to match, there is good reason to believe that these industrial products firms can still perform well as manufacturers bring more capacity on line. An improvement in technology is one of the principle ways to deliver economic growth, presenting an opportunity for manufacturers that specialize in technology improvements.

A Tight Bond with Customers Drives Economic Moat
While the growth story is compelling, we tend to like these firms because of their sticky customer relationships, and value-enhancing products for customers, which lead to stronger, more resilient operating margins. High customer switching costs represent the source of the moat for these companies. Installing an automation platform is timely, and often involves moving many critical processes onto a central control system. The initial growing pains are similar to implementing a new enterprise reporting platform across a large company. With many parts of the system talking to each other, the opportunity for error is large, and the costs of mistakes are higher. As such, many companies elect to stay with an incumbent product for several years, rather than convert to something new, irrespective of the technology improvement.

Moving Outside of the Box
The manufacturing floor continues to evolve, with more firms pursuing integrated activities across the plant, and the capability to monitor and measure operational processes at any point in time, from any location. Traditionally, discrete automation firms, specializing in applications like automobile manufacturing and packaging, remained separate from process automation firms, which focus on applications for breweries and refineries. Instead of staying in their respective boxes, discrete players began encroaching on some process applications, allowing them to offer more services to customers with diverse needs. As a result, process players are starting to see greater competition for new business.

Interestingly, process automation suppliers are unlikely to encroach on discrete markets, since that would require process folks to open up their currently closed systems and compete with other suppliers at the component level. Simply put, process suppliers have little competitive response to discrete firms like Rockwell (ROK) and Siemens AG (SI) from entering their markets. This impacts growth more than profitability since incumbent suppliers have good success holding their position, but new projects will have more potential bidders, making growth more difficult. The installed base is large enough at incumbent firms that it will take several years for newer firms to materially set back established companies.

Rockwell Automation Leading the Charge into Process Automation
Rockwell's strength is multidiscipline controls, and the company's investment in its control solution, Logix, is enabling it to branch away from discrete applications, faster and easier than competitors. The beauty of the solution is that it enables customers to maintain hardware and systems from other manufacturers, but still use the Logix brain. Typically, an automation upgrade would require a complete overhaul by the customer, proving to be timely and expensive. In fact, Logix is proving to negate the main barriers protecting process automation manufacturers, giving Rockwell access to their customers. While Rockwell has a slim margin of safety, further success penetrating process markets as well as robust capital spending could boost our opinion of the company's near and long-term prospects.

The Road Ahead Looks Bright for Automation Firms
We think capital spending will remain high as manufacturers continue to establish a footprint in Asia, and as incremental investments in capital prove more fruitful than adding workers. As multinational firms expand eastward, they traditionally take their suppliers with them, creating new markets abroad. While local firms have related technologies, it has proven difficult to break the bond between to a manufacturer and the firm that essentially drives their manufacturing operations. Even though the margin of safety on these stocks has diminished appreciably over the last several months, we think the long-term fundamentals favoring the companies warrant investor attention in the event prices retreat.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Improved Spending Portends Growth in Automation Sector