By The Valuentum Team
Rockwell Automation (NYSE:ROK) has confidence in its long-term business plan, and we agree with the firm that automation is a solid market. A number of long-term trends are expected to drive demand for its products, and we are big fans of the firm's economic value creating abilities. Nevertheless, near-term weakness can be expected due to pressure in its end markets served, such as oil and gas, and emerging markets.
Rockwell Automation's strong return on invested capital and stable free cash flow generation have enabled it to grow not only its business but also its dividend at a solid pace in recent years. As it relates to its dividend prospects, the company's debt load is manageable given its free cash flow generating ability, and it registers a solid Dividend Cushion ratio, indicating that we expect meaningful growth in the payout moving forward. The dividend's yield of ~2.6% is solid and is likely on its way higher, in our opinion.
Though die-hard track record focused income investors may be quick to point out that Rockwell was forced to cut its dividend in 2001, we find it hard to point out material flaws in its dividend prospects with so much going right with its business model. Despite our fondness for the company's business model and dividend potential, shares are not attractive to us at current price levels. Rockwell Automation currently registers a 6 on the Valuentum Buying Index.
Rockwell Automation's Investment Considerations
• Rockwell Automation is the world's largest company dedicated to industrial automation. The firm's flagship Allen-Bradley and Rockwell Software product brands are recognized for innovation and excellence. It operates in two segments, Architecture & Software and Control Products & Solutions. The company was founded in 1903 and is headquartered in Wisconsin.
• We agree with Rockwell that automation is a great market. The firm benefits from a number of tailwinds: an aging installed base, the need for productivity, the growing middle class in emerging markets, and wage inflation.
• Rockwell Automation has some noteworthy long-term goals. The firm is targeting annual sales growth of 6-8% and double-digit yearly earnings per share growth. It expects to generate 20%+ annual return on invested capital and convert more than 100% of net income to free cash flow. By 2017, it plans to generate ~60% of sales outside of the US.
• The company is facing a number of challenges, and reported revenue is expected to face some pressure. Rockwell Automation's full year guidance for revenue growth and adjusted EPS have both been revised lower, the latter to a range of $5.70-$6.20 in fiscal 2016.
• The reduction in guidance for 2016 was due to an increase in currency headwind expectations, continued softening of the industrial economy, ongoing weakness in oil prices, and the lack of a catalyst for meaningful improvement in key emerging markets.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Rockwell Automation's 3-year historical return on invested capital (without goodwill) is 45.3%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Rockwell Automation's free cash flow margin has averaged about 12.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Rockwell Automation, cash flow from operations increased about 44% from levels registered two years ago, while capital expenditures expanded about 1% over the same time period.
In fiscal 2015, Rockwell Automation reported cash from operations of ~$1.2 billion and capital expenditures of ~$123 million, resulting in free cash flow of ~$1.1 billion. This represents a nearly 20% increase from 2014.
This is the most important portion of our analysis. Below we outline our fair value assumptions as well as derive a fair value estimate for shares.
We think Rockwell Automation is worth $100 per share with a fair value range of $80-$120. Shares are currently trading at ~$110, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our top-line forecasts for fiscal 2016 and 2017 are slightly more optimistic than consensus estimates. However, we are expecting a downturn in the firm's revenue in the near-term due to the pressure on certain industrial end markets, as well as concerns over global economic expansion, particularly in key emerging markets (including China) for Rockwell. Nevertheless, we are anticipating a return to growth in fiscal 2017, and our earnings projections follow a similar course to that of revenue. After the slight bump in the road in the near-term, our forecasts for Rockwell Automation paint a bright picture for the future of the firm.
Our model reflects a compound annual revenue growth rate of 0.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.3%. Our model reflects a 5-year projected average operating margin of 20.2%, which is above Rockwell Automation's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Rockwell Automation, we use a 10.3% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $100 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Rockwell Automation. We think the firm is attractive below $80 per share (the green line), but quite expensive above $120 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Rockwell Automation's fair value at this point in time to be about $100 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Rockwell Automation's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $127 per share in Year 3 represents our existing fair value per share of $100 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.