Rockwell Automation Puts Up A Decent Quarter In A Challenging Macro Environment

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Summary

Automation specialist Rockwell Automation (ROK) reported a decent quarter for its fiscal first quarter (calendar fourth quarter), but Rockwell's valuation isn't predicated on decent results - the valuation embeds expectations of superior growth and margins, and I'm concerned that investors may continue to be disappointed on that front, as the company's reputation can overshadow its reality. On a more positive note, the company's digital industrial initiatives do appear to be gaining some traction.

Rockwell shares are down a little from my late November update, modestly lagging the industrial peer group over that very brief time frame (though Rockwell has also underperformed a bit over the past year). That hasn't brought the shares to what I'd call an undervalued level, but I can say that the shares aren't all that more expensive than many other high-quality industrials these days in terms of prospective returns.

Better Revenue, Weaker Margins

Rockwell reported a 1% contraction in revenue on an organic basis, though that was still enough to beat expectations by about 3%. Both segments saw revenue contraction, with controller, sensor, and software-driven Architecture & Software (or A&S) down a little less than 1% despite a 2% decline in Logix, as Information Solutions & Connected Services (or ISCS) grew at a double-digit rate. In Control Products & Solutions (or CP&S), revenue fell more than 2% on a 5% decline in higher-margin product revenue (motor starters, protection devices, drives, and so on).

Despite good momentum in software businesses, margin performance was not particularly strong. Gross margin declined 330bp year over year, while segment profits declined 10% and missed expectations by about 2%, driving a $0.04/share miss. The A&S business saw a 6% decline in segment profits (margin down 170bp), while CP&S declined 16% (margin down 310bp).

By geography, Rockwell saw a 3% organic decline in North America, 2% growth in Europe, and 6% growth in Asia. At this point, Rockwell's weakness in North America seems about par for the course, and Asia seems to be performing better for many multi-industrials as well (at least relative to expectations).

Some Interesting Details In The Market Performances

As I mentioned in a recent article on Fanuc (OTCPK:FANUY), extrapolating end-market conditions from a single report is always problematic. It's more like assembling a puzzle piece by piece, but Rockwell did at least provide some interesting insights.

The discrete business (around 25% of sales) saw low-single-digit growth which was better than the company had guided and the marketed had expected. The high-single-digit growth in the semiconductor end-market isn't so surprising given reports from companies like ASML (ASML) and Atlas Copco (OTCPK:ATLKY) on improving demand. The mid-single-digit growth from the auto sector was a surprise, though, and I wonder if that is reflective of share growth. Though Fanuc did mention good underlying trends in the North American auto sector, 3M's (MMM) auto performance wasn't strong - admittedly, that's a very different product set, with 3M more volume-oriented and Rockwell capex-oriented.

The hybrid business, which represents about 40% of sales, was weaker than expected with low-single-digit revenue contraction. Life sciences and tires were both up mid single digits, while food/beverage was down low single digits. As I've mentioned in other articles, I put no stock whatsoever in quarter-to-quarter performance from companies like Alfa Laval (OTCPK:ALFVY) and Rockwell that serve the food/beverage vertical - there's just too much idiosyncratic noise to draw useful conclusions, though management did point to growth in packaging as a forerunner/predictor of better food/beverage performance down the line.

In process, which contributes the remaining 35% of sales, Rockwell saw weaker-than-expected revenue, with low-single-digit contraction. The mid-single-digit decline in mining and cement was actually pretty moderate given recent updates from that sector (making me wonder about share gains and/or project-specific growth), and the mid-single-digit growth in oil/gas likewise leads me to conclude share gains were a driver. The double-digit decline in chemicals may look a little alarming for Honeywell (HON) and Emerson (EMR) (which haven't reported as of this writing), but Rockwell is frankly too small in chemicals for me to regard that as a telling indicator.

While not relevant to end-market dynamics, I do want to call out the "strong double-digit" growth in Rockwell's ISCS business, including its first augmented reality project in oil/gas. This is the part of the business where Rockwell's partnership with PTC (PTC) would be expected to drive results, and while it's still early in the partnership's life (and PTC has thus far gotten more leverage from its Microsoft (MSFT) partnership), this is nevertheless a good step for an important growth driver.

The Outlook

I was a little above the Street with respect to 2020 expectations, and it looks like the sell-side will move a little closer to me after this quarter's revenue beat. Management reiterated its EPS guidance for the year, leading me to expect a "higher revenue, weaker margin" type of year, and it did suggest a more second-half weighted evolution of the year. That fits pretty cleanly with the consensus expectation of a second-half 2020 recovery for most short-cycle markets.

In FY 2021 and beyond, my revenue assumptions are still ahead of Street expectations, and I'm expecting long-term revenue growth in the neighborhood of 5%. I'm also still expecting FCF margins to improve toward the high teens versus a long-term trailing average in the low-to-mid teens.

The Bottom Line

Discounting my estimated cash flows back, I believe Rockwell is priced for a mid-to-high single-digit return from here. That's not bad relative to a wide range of quality industrials, but nor is it a compelling entry point. Likewise with my margin and return-driven EV/EBITDA valuation approach. Rockwell remains a very highly respected industrial, even though the arguments about its resistance to cyclicality and superior margins are overstated (though it's legitimately good in terms of FCF generation, return on assets and so on). Were the shares to fall into the $160s, I'd be a great deal more interested. Time will tell if that happens.

Disclosure: I am/we are long 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.