Rockwell Automation Still Poised Between Excellence And Uncertainty

Summary

• Rockwell remains a high-quality play on automation, but the company's growth isn't dramatically better than its peers and several end-markets could see slower growth in 2019/2020.
• The partnership with PTC is already paying some dividends for Rockwell and allowing the company to better leverage the data generated/handled by its control systems.
• Rockwell shares are a tougher call with ISM slowing and more concerns about the healthy of the industrial cycle.

Looking into 2019, Rockwell Automation (NYSE:ROK) seems to be in familiar territory – nobody’s really questioning the operational excellence of this leader in discrete automation, but there are plenty of concerns about end-market health, where industrials sit in the cycle, and whether Rockwell is as well-positioned for the next phase of automation as it was for the last.

I typically shoot for double-digit returns when I invest, and Rockwell doesn’t seem priced to deliver that unless you think long-term FCF growth can reach that grey area between mid-single-digits and high single-digits – a level of performance that’s not impossible, but certainly not conservative to expect. Although I’m tempted to call today’s potential returns “good enough” for a stock that seldom gets all that cheap unless/until industrial stocks really go fan-ward, I do believe there could be another round of angst and stock weakness early in 2019 that could be an opportunity to pick up high-quality industrials like Rockwell.

Whither The Cycle Goest?

Rockwell did miss expectations in the company’s fiscal fourth quarter (calendar third quarter), and guidance wasn’t perfect, but I can’t fairly call it a bad performance. Organic revenue growth of over 7% compared reasonably well to the peer group in which ABB (ABB) saw 7% and 3% growth in its automation businesses, Schneider (OTCPK:SBGSY) saw a little less than 7%, Emerson (EMR) saw 9%, and Siemens (OTCPK:SIEGY) saw 13% and 5% growth.

Logix was once again a strong positive driver, with revenue up 7%, while the process business was up 11%. Margins improved by about two points in the Architecture and Software business (on an adjusted basis), with a smaller sub-1% improvement in the Control Products & Solutions business.

Rockwell management’s rundown of its end-market commentary was interesting. The 10% decline in the auto business definitely pinches (it’s one of the largest contributors at more than 10% of sales), but weaker auto has been a theme in the automation sector for some time now. I was quite surprised at the double-digit growth in the semiconductor market, but this speaks both to mix and to the fact that spending is not monolithic (companies may not be spending on tools, but they’re still spending to upgrade/improve factories). Strength in mining and life sciences was less surprising, but the high single-digit growth in food/beverage was nice to see, while the flat performance in oil/gas was a little more concerning and maybe not so surprising in the context of the performance at Honeywell (HON) and ABB.

Where the cycle is going from here is a major unknown. There are some clear signs that growth and momentum have slowed, with ISM tracking down yoy and mom in November and distributors like Fastenal (FAST) reporting slower sales growth. Although guidance from industrial companies was largely constructive following third quarter results, there have been a few names like 3M (MMM) and Illinois Tool Works (ITW) that have worried the Street.

Most likely, this is a pause/pullback within a generally healthy ongoing cycle. The catch is that Rockwell has historically done well early in recovery/expansion cycles and slowing/falling ISM is usually not correlated with good stock performance. While orders were healthy in the third quarter, management here and some peers (including Emerson and ABB) sounded a bit more cautious than before. With that, it may well be the case that 2019 and 2020 see weaker growth (without going negative) ahead of a rejuvenated cycle.

Is Rockwell Built For The Next Automation Phase?

Between rejecting Emerson’s acquisition bid and acquiring part of PTC (PTC), there’s been no shortage of debate on Rockwell’s positioning for the future of industrial automation. On its own, Rockwell has rather adroitly maneuvered from a strong position in discrete automation (where it has about 20% share in the U.S., or about 50% more than #2 Siemens) into a healthy and growing presence in hybrid automation. Rockwell has also at least partly addressed the concerns about its digital/software positioning with that PTC alliance.

Even so, questions remain. I’ve seen multiple sell-siders argue that PTC is actually getting the better end of the Rockwell-PTC deal … to which I respond with “so what?” Maybe PTC will benefit more, but Rockwell will still benefit and I think Rockwell’s ability to drive a harder bargain with PTC had to have been constrained by the knowledge that PTC had other options. What’s more, I see the PTC partnership has helping “paper over” years of what you could argue was underinvestment in important areas like software – areas that Siemens, Schneider, and Hexagon have addressed with acquisitions and internal development.

As highlighted at the recent Automation Fair, PTC’s software capabilities complement Rockwell’s controls quite well, adding data connectivity, modeling, and augmented reality capabilities that Rockwell simply didn’t have before. Rockwell’s devices handle large amounts of data and now the company can offer the software tools to do something with them, even if it has to share the benefits with PTC. Rockwell has recently won business with Ford (F) and Schlumberger (SLB) largely because of the PTC capabilities, and I don’t think those will be the only wins.

The Outlook

There weren’t enough surprises in the fourth quarter release to change my basic modeling assumptions all that much, and I continue to believe that Rockwell has attractive long-term growth opportunities in discrete and hybrid automation. I’m still expecting healthy mid-single-digit long-term revenue growth and further FCF margin leverage into the high teens. While the long-term FCF growth rate does decline relative to my last update, that’s only because the base year changed and FY 2018 was a much stronger year for FCF generation than the prior base year.

Discounting back the cash flows I model, I think Rockwell is priced for high single-digit annualized returns from here – not as high as I’d like, but not bad on a relative basis for high-quality industrials. Much as I’d like to buy into Rockwell with a double-digit annualized expected return, those opportunities don’t come often. I’d also note that Rockwell isn’t particularly cheap on an EV/EBITDA basis; the company’s strong margins and ROIC argue for a mid-teens multiple, but the market is already there.

The Bottom Line

As I’ve said multiple times in the past, Rockwell is a good name to consider on cyclical dips. Whether we get one in 2019/2020 or not remains an open question, but as much as I like Rockwell, I’m reluctant to chase the shares when multiple end-markets seem to be slowing (even if Rockwell’s business from those markets hasn’t yet shown that slowdown). Long term, I believe this is a good name to own for its leverage to ongoing automation, but I’d advice patience if you don’t already own it.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long ABB, MMM. 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.