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Maybe it’s premature, but it finally looks as though the rerating I had been expecting in the industrial sector is finally happening (and no, I’m not saying I was early, I’m saying I was wrong). Rockwell (ROK) is one of the names seeing that, with the shares underperforming the industrial group by around 10%, while the wider industrial group itself has modestly lagged the S&P 500 since my last update on Rockwell.
This is going to be a really interesting year to watch at Rockwell. The Street expects a lot of short-cycle industrial end-markets to start decelerating over the next few quarters, but there are some secular drivers at Rockwell that could offset that. By the same token, expectations are high and management seems to be guiding to a near-term order peak. Against a still-high valuation, that’s a challenging set-up.
My issues with valuation are the biggest concern with Rockwell. Companies like Siemens (OTCPK:SIEGY), Schneider (OTCPK:SBGSY), Emerson (EMR), ABB (ABB) and others are going to be meaningful competitors for years to come, but I like a lot of the strategic moves Rockwell has made. I don’t really expect to see Rockwell become a “value stock” unless something goes grievously wrong, but I do think this pullback is worth watching if you’ve been thinking about Rockwell but are concerned about valuation.
A Solid Quarter …
In what has generally been a strong quarter for the multi-industrials, at least in terms of reported performance, Rockwell had a good quarter as most of the business’s major end-markets are seeing strong recovery growth.
Revenue rose almost 17% in organic terms, well above the median for the large multi-industrials so far this quarter and good for a small (2%) beat versus the sell-side. Intelligent Devices did the heavy lifting, though, with strong demand in areas like motion and sensing, as revenue rose 26% and beat expectations by 9%. The other two segments both missed by 3%, with Software & Control up 8% on good demand in areas like control and visualization, and Lifecycle Services up 10%.
Gross margin declined a point to 40.3%, missing by over a point and a half as even the mighty Rockwell is struggling to use price to offset cost pressures and navigate challenges in the supply chain (particularly in semiconductors). Operating income rose by 16% (up by 10% on a “core” basis), while segment profit rose by 15%. Segment profit beat by more than 4% ($0.11/share), while the margin (down 70bp to 19.1%) came in 70bp to the good.
By segment, Intelligent Devices once again did the work, with profits up 52% (margin up 430bp to 23.7%) and the segment driving a nearly $0.35/share beat. Software & Control profits declined 12%, a $0.14/share miss, with margin down 730bp to 22.9%. Lifecycle Services profits declined 32%, missing by $0.10/share, with margin down 340bp to 5.5%.
Orders were once again strong, rising 40% to around $2.5B, with double-digit growth across the businesses.
… Even With Some Quibbling On Guidance
Coming out of the quarter, it looks like the biggest concerns around Rockwell are centered around how long these strong times can last, and whether or not current guidance / expectations can be maintained and met.
To that end, I did see some bullish analysts quibble a bit that they wanted a stronger guide coming out of this quarter. Fair enough, I suppose, but the comps are going to get more challenging soon enough and I don’t see Rockwell doing itself any favors by extending itself on guidance.
I do have some concern, though, that orders are nearing a cyclical peak. Management guided to $9B in fiscal ’22 orders, suggesting deceleration from this past quarter. Given slowing industrial production (or IP) growth and Rockwell’s historical correlation to U.S. and global IP, it seems like a reasonable enough concern, though I do think there are some meaningful “what if’s” to consider.
While I would expect output to slow as supply chain snafus are worked through and inventories are rebuilt, a lot of companies underinvested in capex prior to the pandemic – a potential counter-cyclical driver for a short-cycle capex play like Rockwell.
In addition, the pandemic has made the need for more automation more obvious in many end-markets and/or accelerated the planned adoption. I’m skeptical we’re going to see full-fledged reshoring of manufacturing, but I do think companies will look to leverage automation to increase manufacturing flexibility and may look to use automation to build smaller “flex-factories” that could help mitigate future global supply chain disruptions.
Still A Lot Of Growth Opportunities Out There
To summarize what I was trying to get at above, I think the short-cycle cycle is going to slow, but I think there could be a longer plateau before a real correction due to that need to catch up on capex and/or adopt automation. At the same time, there are some important secular opportunities for Rockwell.
I just don’t know how secular what’s going on in the semiconductor space will prove to be, but it’s clear that more capacity is having to be quickly brought on line in 2022 and 2023 to ease this supply shortage. That’s a big market for Rockwell (one that was up 25% in FQ1).
I’m more confident that there are secular changes in autos (electric vehicles/batteries), another major market for Rockwell, and logistics/warehousing/e-commerce, and that’s a growth market off a small base for the company. Circling back to that theme of an increased need for manufacturing flexibility, Rockwell is already seeing that in food/beverage and pharma, and I think it will spread.
Another secular trend to watch is a move from hardware-defined automation to software-defined automation. It’s not an “either/or”, but software is undeniably becoming more important, and Rockwell has been moving aggressively to build up its capabilities (including FactoryTalk, Plex, and its PTC (PTC) partnership). If and when more revenue shifts from hardware-based automation sales to software-based, particularly SaaS, that should begin to smooth out some of Rockwell’s historical cyclicality.
The Outlook
I’ve boosted my near-term expectations for Rockwell on the strength of this recovery cycle, and I expect double-digit annualized growth from FY’20 to FY’23, while my long-term revenue growth rate is still around 5%. I’ve discussed Rockwell’s opportunities to improve margins in prior articles, and I’m still expecting FCF margins to improve from the mid-teens recently to 20% over time, driving high single-digit FCF growth.
Not surprisingly, neither my free cash flow assumptions nor my margin/return-driven EBITDA model flag Rockwell as cheap yet. Less expensive than before, yes, but it looks like Rockwell is still priced for a mid-single-digit total annualized return and I don’t think a meaningfully higher re-rating is likely in the near term as industrial sector valuations seem to be retreating from recent multiyear highs.
The Bottom Line
I accept that excellent companies rarely trade at what look like obviously cheap multiples at the time, and I don’t expect to buy Rockwell at multiples that would conventionally look like bargains. Still, I think there is some place for value discipline, particularly when a highly-valued company is looking at increasingly tough comps and potentially slowing end-market momentum. Were this slide to continue further, though, this is definitely a name I’d come back to and consider for purchase.
