Keep Calm And Rock(Well) On

| About: Rockwell Automation, (ROK)

Summary

Rockwell outperformed expectations for the December quarter, but guidance spooked the Street and investors are worried about a typical cyclical decline and greater margin deleverage.

Rockwell's product quality and attractive market exposures won't evaporate, but there are a lot of warning signals in the broader economy for the near term.

Rockwell looks undervalued on the basis of mid-single digit long-term FCF growth, but a full-blown recession will take the shares lower.

Cynical and sarcastic as I am, I'm nevertheless surprised when Wall Street collectively punts on a story they once dearly loved . I can understand worries that Rockwell Automation's (NYSE:ROK) margins in Architecture & Software are going to slide with weak revenue, but I can't quite fathom where the surprise about that comes from. Be that as it may, it looks like sell-side analysts are diving toward the bottom of the guidance range and taking a much more cautious approach.

It doesn't help that Rockwell management seemed more conservative on the outlook for its end-markets than the likes of ABB (NYSE:ABB) or Emerson (NYSE:EMR). Going back to that "cynical and sarcastic", I'll just mention here that the two worst-performing companies in the sector are more optimistic about the near-term outlook and the better performers (Emerson and Honeywell (NYSE:HON)) seem a little more cautious to me.

What Rockwell is hasn't changed - it's still an excellent player in industrial/process automation, with a strong presence in PLCs and strong mid-teens-to-20% share in the North American automation market. Buying Rockwell now certainly involves the risk that the automation market gets worse before it gets better, but I still think there's a compelling long-term argument here.

A Beat, But Lower Margins And Guidance Are The Takeaway

Most of the automation players actually did better than expected for the December quarter, and Rockwell was no exception. Revenue fell about 3% on a core basis, but that was about 3% better than expected. Architecture and Software (A&S) sales were down a little less than 3%, with process initiative sales down 14% and Logx down 6%. Control (or CPS) was down about 4%, with motor control product sales down 1% and solutions/services sales down 6%.

Gross margin declined 80bp on volume deleverage and segment profits were down 15%. Segment margin was actually a little better than expected (20.7% versus an average estimate of 20.5%), but I suspect that the Street was spooked by the roughly four-point decline in A&S margins (on a 20% decline in segment profits). CPS earnings were down 5% with an 80bp margin improvement for the quarter.

Orders were reported down mid-single digits (versus down 2% at ABB and recent double-digit order declines at Emerson) and management noted a worsening of conditions in markets like oil/gas. With that, management lowered guidance for organic revenue growth in FY 2016 by 1% (to a range of down 5% to down 1%) and also lowered its EPS forecast range (to $5.70 - $6.20).

Mixed Markets

The oil/gas industry is a major customer for process automation companies and we all know that sector is struggling, but Rockwell's report of a 30% decline in sales to oil/gas customers in the U.S. is a pretty bracing sign of just how bad things are. Although consumer and auto markets were better "about flat" is not nearly enough to absorb the kind of weakness the company is seeing in the oil/gas sector. All told, U.S. revenue was down about 6% in the quarter, while revenue in China was down 10%. In part because of the ongoing weakness in oil/gas, management is looking for industrial production to be negative in the U.S. for its fiscal year.

Given the magnitude of capex cuts that are being announced in the oil/gas sector (25% at Chevron (NYSE:CVX), one-third at Anadarko (NYSE:APC), and 66% at Continental Resources (NYSE:CLR)), that industry isn't going to be any help in calendar 2016. Metal and mining are likewise down, and growth in pulp/paper and food/beverage isn't going to be enough on its own. While ABB talked about growth in the auto sector, Emerson talked about flat conditions and I'm still worried that auto OEM spending on capex could decline this year (after a prolonged stretch of spending); Rockwell should be poised to take some share from Siemens, but it may not be enough to deliver much growth.

Still Strong; Still Appealing

Rockwell's website highlights how the company recently won 32 of 53 first place industry category awards in reader's choice awards process from Control Magazine. I don't usually get too excited about these things, but it's hard to ignore that Rockwell swept the categories for food/bev and metals/mining and nearly swept plastics/rubber and water/wastewater (missing out one category to Honeywell and Schneider, respectively) in "best in control". All told, Rockwell (and Emerson) come out of this looking pretty good.

I would also note Rockwell's clean balance sheet provides flexibility. The company has generally preferred to partner than to buy (including a key partnership with Endress+Hauser), but the company did just acquire MagneMotion, a manufacturer of intelligent conveying systems. No terms were discussed, so I would assume it is a relatively small deal. Thinking bigger picture, Rockwell has strong share in the North American and Latin American discrete and process automation markets, but mid-single digit share in Europe. Perhaps acquisitions aimed at increasing its market exposure in Europe would be worth considering. On the other hand, Rockwell itself isn't so large that it couldn't still find itself the target of ABB, Emerson, or GE, though that is not my expectation.

Nothing really changes about my outlook given the December quarter results, as I was already a little low relative to the Street and the changes I have made are more "fine-tuning". I'm still looking for long-term revenue growth of around 3% to 4% a year and mid-single digit FCF growth. Discounted back, that ought to be worth around $107.50 today.

The Bottom Line

It's pretty clear that the industrial economy is not in good shape right now and not really pointing up. ABB and Emerson sounded optimistic with respect to their market/economy outlooks, but I think investors need to consider the possibility that 2016 remains ugly for industrials, as well as the risk that it spills over into the consumer in 2017. I don't say this to spook investors away from Rockwell, but just to frame the risk a little more explicitly. I think Rockwell will be fine over the long term, but not all investors have the patience to see a stock position go red for an extended period.

I still like Rockwell, though I own ABB myself. ABB looks cheap, Honeywell looks undervalued, and Rockwell looks somewhere in the middle - which is probably fair given that it is a superior company to ABB in many respects but not a true blue-chipper like Honeywell. Given that Rockwell is often pretty pricey during the good times, this looks like a buy-the-dip opportunity to consider, even with the risk that the dip gets deeper from here.

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.