Rockwell Automation Seems To Be Handling This Short-Cycle Air Pocket Well

Short-cycle businesses, Rockwell Automation (NYSE:ROK) included, are likely to have an “interesting” year in 2023, as current demand conditions are pretty healthy, but considerable evidence is pointing to a slowdown as the first half of the year unfolds. On the other hand, Rockwell remains leveraged to industries with better-than-average growth potential (including autos, food/beverage, and life sciences) and is likewise leveraged to acyclical trends like reshoring and automation/digitalization of manufacturing.

Rockwell’s shares are up slightly from my last update, very slightly underperforming the broader industrial group but more or less hanging out in the middle of the comps for other short-cycle and automation stocks. I can’t say that Rockwell is cheap today, but then it seldom is. I will say though that Rockwell’s valuation often troughs around six months ahead of the trough in the PMI, so given that I see that happening in the fall, there could be some additional erosion in the multiple, but the window of opportunity is not likely to be open for all that long.

Better-Than-Expected Results Will Calm Some Nerves

Rockwell’s quarter wasn’t flawless, but it was definitely good enough to ease some of the more immediate concerns about the health of multiple industrial markets. I do think Rockwell will likely sort out as an above-average performer, given leverage to reshoring and so on, but it was still a calming report for a nervous sector that has had only a limited number of industrial earnings reports to digest (good from Crane (CR) and General Electric (GE), not good from 3M (MMM), though the industrial businesses there were okay).

Revenue rose almost 7% as reported and almost 10% in organic terms, beating expectations by about 3%. With price contributing 7% to growth, it’s clear that there is some evidence of a fundamental slowing of demand, particularly as component availability is improving and easing Rockwell’s past production capacity constraints.

By segment, Intelligent Devices delivered 7% organic growth, and that was more or less in line with expectations. Software and Control produced 16% organic growth, beating by 9%, and Lifecycle Services was up 10% (also organic), a modest beat over expectations.

Gross margin rose 80bp yoy but fell 60bp to 41.1%. EBITA rose 15% (and my modified operating income calculation produced 16% growth), while segment profits were up 13%, beating by an impressive 22%, with margin up 110bp to 20.2% (a roughly three-point beat).

By segment, Intelligent Devices profits fell 2% (margin down 130bp to 22.4%), beating by 7%, while Software & Control rose 42% (margin up 630bp to 29.2), beating by 62%. Lifecycle Services declined 1% (margin down 30bp to 5.2%), missing by almost 24%.

I was disappointed with how Rockwell management presented data on orders. While indicating that the book-to-bill was about 1% and that orders rose sequentially, no detail was given about what was very likely a year-over-year decline. If management is going to celebrate (and disclose) the 20%-plus order improvements when times are good, I’d like to see them also disclose the declines during the other half of the cycle.

Segment Guidance Provides Encouraging Data

Rockwell’s commentary across its major end markets was largely positive and seemed to confirm a lot of what I expected to see for industrial markets in 2023, albeit with a slightly more positive skew for Rockwell as the business is poised to continue to grow well ahead of industrial production (Rockwell has grown more than double the rate of industrial production over the last decade, and expects to continue to do so).

Sales to the auto vertical were up a strong 25%, helped by growth in EV programs, and management expects high-teens growth this year; that should be well ahead of underlying growth, but I still see autos as one of the stronger verticals in 2023. I was more surprised to see the 20% growth from semiconductor customers and the projection for mid-teens growth – Rockwell is an invaluable supplier of control systems (and is expanding its share of wallet), and capacity growth continues, but that’s more than I’d expected.

Rockwell’s commentary on e-commerce/warehouse automation was a bigger surprise. The business was down low-teens in the quarter (not a surprise), but management expects low-teens growth this year. That seems robust relative to what companies like Cognex (CGNX) and Honeywell (HON) have prepared the Street to expect, and I wonder if this speaks to Rockwell’s broader exposure (not just primarily an Amazon (AMZN) supplier) and a different position in the foodchain (more full-cycle than upfront).

The commentary on the hybrid markets – tires, food/beverage, and life sciences – was less surprising, with decent growth in the past quarter and double-digit expectations for the year ahead. Again, I don’t expect actual industry growth rates to match Rockwell’s projections but it does support the idea of these as robust, less cyclically-sensitive markets for 2023.

Rockwell’s outlook for its process businesses supports my feelings that these longer-cycle businesses remain healthy, with strong activity in oil/gas, mining, cement, and chemicals.

The Outlook

At this point, I have no real concerns about Rockwell’s ability to execute. I know some analysts and investors are concerned about the money the company is investing in areas like digitalization, including its Design Hub, Maintenance Hub, and Operations Hub efforts, but I believe time will show this to be money well spent as companies look to further automate and digitalize their operations.

I do still have concerns about the broader macro environment. I expect Rockwell to be a “market-plus” grower for the foreseeable future, but I don’t rule out the possibility of a more pronounced slowdown in the economy, particularly if inflation remains stubborn.

As far as the finances go, I still see Rockwell as a roughly 6% long-term grower, leveraged to ongoing adoption of automation and digitalization, and I believe Rockwell will be a key facilitator of what I expect will be a multiyear secular growth cycle. I expect EBITDA margins to move from around 20% to a little over 21% this year and improve toward 24% over the next three years. I expect long-term free cash flow margins to reach 20% (or higher), driving high single-digit FCF growth.

Discounting those cash flows back, Rockwell doesn’t look particularly cheap, and there’s nothing new there. As far as an EV/EBITDA-based valuation goes, again Rockwell trades above what would normally be “fair” for its level of operating margins, ROIC, and so on. I do believe Rockwell belongs among the “compounders”, and while the multiples for many of those companies have shrunk from 20x-plus to less than 17x, I’m still basically comfortable with a 20x-21x multiple on Rockwell, but that only gets me to a fair value range around $290-$300.

The Bottom Line

If you want to buy Rockwell shares at something closer to a traditional bargain, you’re not going to get many chances to do so – it happens once in a while, but not often. I do see a possibility that valuation multiples could contract further, particularly if this downturn is more pronounced than I currently expect, and I’m willing to wait for that, but I also accept that I may just never find many opportunities to buy these shares at an entry price that I like – and while the share price performance over the long term has been good, it hasn’t been head and shoulders above its peers such that I’d argue for ignoring valuation.