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Investment Thesis
Rockwell (NYSE:ROK) is often criticized for being expensive. Through this article, we will try to understand if such a statement is justified or not. In my view, ROK competitive advantage and its strong catalysts are misunderstood. While being highly profitable and fast growing, the firm has also been distributing a dividend growing consistently during the last 12 years and growing at 8% CAGR during the last 5 years. This should appeal to investors looking for quality, growth and dividends.
Company presentation
Founded in the US in 1903, Rockwell is focused on industrial automation products and digital transformation. The firm is serving a broad range of global industries, such as automotive, semiconductor, oil and gas, life sciences, logistics or food, and beverage. Rockwell operates in more than 100 countries. North America accounts for 61% of sales, Europe, the Middle East, and Africa represent approximately 18% of sales while Asia Pacific represents 14% and Latin America about 7%.
Business Model
Rockwell’s activities can be divided into three segments:
Intelligent Devices
This segment is focalized on manufacturing process data pulling and analysis in order to generate real-time diagnostic data on performance and health. This segment account for 45% of Rockwell’s revenues.
Software & Control
This segment includes a broad portfolio of software and hardware to support enterprise connectivity and analytics. The portfolio is composed of multi-discipline and scalable products. This segment account for 30% of the firm revenues.
Lifecycle Services
The Lifecycle Services operating segment allows benefiting from Rockwell’s specialist automation expertise. Through this expertise, the firm is focusing on various subjects such as growth improvement, productivity optimization, risk management, and environmental protection. This segment represents 25% of the firm global revenues.
Major Catalysts On The Way
Long-Term Catalysts
In a macro-environment that has been characterized by Covid-19, supply chain disruptions and that is now being impacted by economic recession fears under a background of high inflation and rising interest rates, I expect Rockwell to succeed in an industry supported by secular trends and major opportunities.
According to a recent study published by Gartner on the 1st of August 2022:
The worldwide Global robotic process automation (RPA) software market is projected to continue to experience double-digit growth in 2023, growing 17.5% year over year.
According to Yahoo Finance, this market is also expected to grow at a CAGR of 22.5% from 2022 to 2030, setting up huge opportunities for Rockwell.
Automation is driven by many needs as it can improve many processes, especially in the industrial industry.
In a world where companies are trying to optimize their financial performance, automation is playing a key role and can be financially attractive for potential ROK clients in many ways:
- Automation increases the speed and efficiency of a process, leading to increased output and reduced labor costs.
- Automated systems can improve the quality of the end product, reducing waste and defects.
- Automation reduces the need for human labor, resulting in lower wages and benefits expenses.
- Automated systems can run 24/7, increasing overall production time and reducing the need for costly downtime.
- Automation can also improve safety in the work environment by reducing human error and removing workers from hazardous situations.
- It can make it easier to scale a business, as automation systems can be programmed to handle increased production with minimal additional labor costs.
- Systems can be programmed to predict when equipment may fail and schedule maintenance, reducing the need for costly emergency repairs.
After highlighting long-term catalysts, let’s dig into the elements that I believe will support this growth on the short-medium term horizon.
Short-Term Catalysts
Inflationary Wages Pressure
Inflation has a strong impact on input costs. Earlier in 2022, we saw inflation driven essentially by a rise in price regarding raw materials and supply chain costs. I expect inflation to cool down and to come back to lower levels in 2024.
However, while inflation cools down, I also expect to see, just as we saw in 2022, tensions in a tight labor market characterized by pressures on companies pushed by a workforce that has seen its purchasing power eroding in 2022. Furthermore, according to CNBC:
Employers are planning pay increases of 4.6% in 2023, slightly above this year’s 4.2%.
Labor Department
I expect the recent substantial wages increase phenomena to continue within the U.S. in 2023 and to remain one of the last elements slowing the inflation decrease while supporting automation needs.
Energy prices
The recent rise in energy prices strengthened the original wish for better cost management but also for a greener economy. I believe Rockwell is set to benefit from this shift toward a greener and more sustainable economy. The firm is now benefiting from important double-digit growth in the Electric vehicle segment and I expect the company to keep such a pace for the upcoming years. At the same time, the firm is trying to capitalize on this opportunity to broaden its value proposition in order to offer more complete decarbonization packages for energy-intensive industries (e.g., CUBIC M&A). Through such products, Rockwell clients will be able to protect themselves against volatile supply and energy prices which is key.
Massive Investment plans
Major plans have been adopted in 2022 by the White House. The three major budget measures voted by the Biden administration will be key in transforming the U.S. economy while strengthening its industry and automation needs.
These plans are:
-The $280 billion Chips and Science Act promotes domestic semiconductor research and production.
-The $369 billion Inflation Reduction Act supporting clean energy and energy transition
-The $1 trillion infrastructure bill to boost US economic competitiveness.
M&A Opportunities and Infinite Synergies Possibilities
Rockwell operates in a very fragmented market due to the broad range of tools it provides to its customers. This market structure set Rockwell in a position of choice allowing this giant to perfect its portfolio. The firm intentions are now clear especially after the recent acquisition of CUBIC in 2022, a Danish firm specialized in the production and management of solar panels, data, and infrastructure.
With a strong track record and 22 M&A transactions since 2010, I expect Rockwell to capitalize on its strong Cash and Cash Equivalent reserves ($490 billion FY2022) to seize opportunities allowing better synergies whether for the firm but also for its customers.
Valuation: Nothing To Worry About
Many are concerned about ROK’s expensive valuation. In my view, it is justified by the growth prospects and catalysts mentioned above.
First, Rockwell is benefiting from strong advantages. Indeed, with its strong brand recognition, its large portfolio of patents and trademarks, its network effects, its well-established distribution network, and all its strong partnerships with major companies in the industry, the firm is protected by important barriers. Not only does this protect the company’s products and technology from being copied, but also makes it difficult for competitors to gain a foothold in the market, thus attracting new customers through positive word of mouth.
All these elements that are characterized as “Moats” justify this valuation.
When having a closer look, you can even realize that in reality, the firm is not that expensive. Indeed, you have to know that during the last 12 years, the firm average PE has been around 26 while we are now at 27.5. Thus, if you would have found ROK expensive back then, you would have missed a 701% return from 2010 to 2023 vs 371% for the SPX representing an alpha of 330%.
In this case, when looking at ROK and Industrial companies in general, I generally have a look at PMI levels to have an idea of where the company is positioned in the economic/industrial cycle. ROK’s strong profitability pushed by the growth prospects we describe earlier makes it an attractive play.
The Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index (PMI) is a survey-based index that measures the economic health of the manufacturing sector. Industrial firms are linked to the ISM manufacturing PMI because the index is based on the responses of purchasing managers at manufacturing companies.
A movement in the PMI can imply different things for industrial firms, depending on the direction and magnitude of the movement. If the PMI increases, it generally indicates that manufacturing activity is expanding and that industrial firms are likely to see increased demand for their products and services. This could lead to increased revenue and profits for the companies. On the other hand, if the PMI decreases, it generally indicates that manufacturing activity is contracting and that industrial firms may see decreased demand for their products and services. This could lead to decreased revenue and profits for the companies.
ISM PMI now stands at 48 vs a 22-year average of 53 and a 55y average for the last 5 years. Pushed by the Biden administration’s massive investment plans, and potential fed pivot, I expect a return to the mean in a soft-landing scenario preceding a recovery phase that is historically very beneficial to industrial companies.
Encyclopedia Britannica Bloomberg
When looking at the graph above, you might also have noticed that Rockwell’s financial situation and ISM PMI are closely linked. Indeed, the ISM PMI seems to be a leading indicator giving us an indication of the potential evolution of ROK Return on Invested Capital (ROIC).
The ROIC measures how efficiently a company is using its capital to generate profits. It is calculated by dividing the company’s net operating profit after taxes by its invested capital. It indicates how well a company is using its resources to generate returns for shareholders.
ROK’s current ROIC stands at 13 vs an average of 19,6 for the last 22 years. Believing in a macro-soft-landing, I expect the ROIC to increase and thus follow the improvement of the ISM PMI soon.
Note that in the long term, according to the company presentation, the firm is targeting a 20% ROCE which in my view is doable as it represents the last 22 years’ ROCE average.
An Attractive Return To Shareholders Policy
Benefiting from strong execution, good profitability, and visibility while sitting on a mountain of cash, the firm has a very attractive return to shareholder policy and has seen its dividend consistently increase for the last 12 years. This attractive dividend policy is combined with share repurchase programs.
According to Yahoo Finance:
During the first quarter of fiscal 2023, the Company repurchased approximately 0.6 million shares of its common stock at a cost of $156 million. On December 31, 2022, $1.1 billion remained available under Rockwell’s existing share repurchase authorization.
DCF Model
In terms of earnings growth, I expect ROK earnings to grow at 12% per year during the upcoming 7 years which is a bit higher than the earnings growth the firm has experienced during the last 7 years close to 9%. Many investments and M&A have been made since and thus it should play a major role in the improvement of the firm growth and profitability.
With a trailing 12-month EPS of $10.43, I choose a 3.4% perpetual growth rate. This rate represents the average US industrial growth rate from 1920 to 2022 according to CEICDATA. To that, I applied a 9% discount rate being our firm’s WACC. With such assumptions, we reach a target price of $313.17 representing a 12% upside potential without accounting for the 2% dividend.
Risks
Several risks have to be considered regarding Rockwell. They are mainly linked to the probability of facing a recession and not a soft-landing scenario which would have an important impact on the Industrial activity and demand for ROK products. The Forex risk must also be considered as 40% of the firm revenues comes outside of the US. Should the interest rate go higher or remain high for longer than expected, this could weight on the overall economy but especially on the industrial sector which is particularly capital needy while putting pressure on valuation. Finally, being used to acquire new businesses, Rockwell might potentially make a mistake and thus face synergies issues.
Conclusion
Despite undeniable tailwinds and compelling characteristics, Rockwell is often considered as being too expensive. In my view, the current valuation is justified by the firm strong profitability, competitive advantage, and growth prospects in an industry that will be supported over the medium-long term by internal and external catalysts. I expect a 12% upside for 2023 and initiate on ROK with a Buy rating and a target price of $313.