As a firm believer of an enterprise’s inner strength when confronted with external factors like supply chain disruptions and tariffs due to geopolitical tensions, I have been following Rockwell’s (NYSE:ROK) cost savings plans right from the start of the pandemic.
In this connection, my investment theses on BASF (OTCQX:BASFY) and Corteva (NYSE:CTVA) were aimed at exploring the inner strength as a counterbalance to external uncertainty.
Rockwell, as a leading provider of industrial automation solutions used by companies in the automobile, Oil & Gas as well as healthcare sectors, has gone a step further by rapidly carrying out a reorganization of its organization structure to be more aligned with customer needs.
The stock price, on the other hand, has lagged significantly behind peer ABB (NYSE:ABB) since mid-April of this year by more than 25% while trending slightly higher than the Vanguard Industrials ETF (NYSEARCA:VIS).
Figure 1: Comparing Rockwell’s stock price with peer ABB and Vanguard Industrials.
Financial efficiency, strength in key automation areas and reorganization synergies now position the company to deliver on earnings guidance for FY-2020.
Q3-2020 earnings beating consensus
Rockwell’s Q3-2020 earnings have been impacted by COVID, but on the other hand, the company managed to beat consensus by $0.10.
Looking at the wider perspective, the automation company has maintained its earnings beat run during the last four quarters except for Q1-2020 when there was a draw.
Figure 2: EPS figures
Source: Seeking Alpha
Now, the adjusted EPS of $1.27 for Q3-2020 did beat consensus, but is down 47% compared to the third quarter of fiscal 2019. This is in sharp contrast with the EPS for Q2-2020 which not only beat expectations but was also up 19% compared to the second quarter of fiscal year 2019. Therefore, this must have played into the morale of investors as they dumped the stock, resulting in a 3% downside following earnings results on July 28.
Looking into the rear-view mirror, the executives had already warned that earnings for Q3-2020 would be a “little over $1” and that it would be the worst quarter with organic sales projected to decline by around 20%. The dire projections have been confirmed with the exception of sales which have fared better (minus 17.6% instead of minus 20% as projected). I will come back to this point later, but right now, I look into the finances.
First, the primary reason for upbeat earnings in Q2-2020 was due to cost savings as a result of lower incentive compensation expenses. Also, some COVID-19 windfall gains resulting in higher sales for the Architecture & Software segment and Control Products & Solutions in the second quarter are absent in Q3-2020.
For this quarter, the company has benefited from some percentages of growth from acquisitions.
Figure 3: Q3-2020 segment results
Source: Seeking Alpha
However, there have been lower sales in the company’s Solutions and Services business with the book-to-bill deteriorating to 1.05 due to projects being delayed. Interestingly, from a longer-term perspective, there have been no cancellations, and this is a good sign for the fourth quarter. Even to a lesser degree, the company continues to suffer from supply chain inefficiencies which has led to higher freight expenses.
Rockwell is also exposed to the whims of the auto industry where the road to recovery is viewed as tough. Also, little improvement was seen in the process markets (optimization of control processes by industrials) which were down 25%. Oil & Gas sales were also weaker.
Figure 4: COVID windfall gains
Source: Image built from Q2-2020 transcripts data
The company ended the quarter with cash equivalents of $910 million, up from $640 million in the last quarter. Debt totaled $2.4 billion, $300 million up from the last quarter. As per the SEC filings, in April 2020, Rockwell entered into a $400 million senior unsecured 364-day term loan credit agreement. As a result, leverage was 1.8x at June 30, 2020, up from 1.3x at March 31, 2020.
Next maturity for long-term debt of $2 billion is in 2025. Additionally, there is a $1.25 billion credit facility. Free cash flow was $310 million, down from the $323 million in Q3-2019. Cash flow from operations was $346 million compared to $341 million in Q2-2020 was recorded. This is sufficient liquidity for a business with a 17.6% decrease in sales and suggests further flexibility to cut down on capital expenditures for aligning with lower revenue in the short term.
However, this is not enough for making a wise investment decision and more solid arguments are necessary in terms of strengths and challenges.
Digging deeper for strengths and challenges
Products constitute two-thirds of Rockwell’s business with the remaining third comprising software and services. Moreover, the company has an extensive supply chain covering China, which means that it had to maintain relatively higher inventory levels of China-sourced components to cater for contingencies.
Now the fact that the gross margins are on the higher side at 40% compared to peer ABB’s 32% (figure 7) means superior production efficiency.
Figure 5: Quarterly income statement with revenues and expenses in millions of USD.
Source: Seeking Alpha
Exploring this further, the fact that Rockwell’s employees could not have access to sites for commissioning of projects due to COVID stay-at-home orders has contributed to revenue shortfalls especially in the process markets where more hands-on interaction is required. Therefore, the company has not benefited fully from the work-from-home momentum as only the non-manufacturing workforce has been working from home.
However, Rockwell has used technology in innovative ways with one example being the increasing leverage on augmented reality for testing, training and customer support.
Looking forward, there should be further cost efficiencies especially those enabled by acceleration in rendering the supply chain more flexible and enhancing the level of factory automation.
Interestingly, one of the ways in which a higher degree of automation can be achieved is through the use of IT tools. In this context, Rockwell has accelerated the usage of Microsoft’s (MSFT) Dataflex Pro to increase the degree of automation of mundane and time-consuming business processes. By using this tool, its engineers are engaged in streamlining workflows, thereby gaining on productivity.
According to Chris Wagner, analytics architect at Rockwell Automation:
As part of Rockwell’s digital transformation, we are focused on transforming everyone across the organization into engineers who can leverage technology to automate and simplify their jobs. We look at the Power Platform as a highway to turn all 23,000 employees into engineers. Microsoft Dataflex Pro is the data backbone that enables people to store their data in a scalable and secure environment dynamically.“
This transformation can now be viewed concretely through the three newly-setup operating segments with one of the corporate aims being to add software talent and accelerate profitability.
Figure 6: Rockwell’s new structure
Source: Seeking Alpha
Still, in an economic scenario which is beyond the grasp of many, it is important to identify other challenges with the most important one being currency headwinds stemming from Rockwell’s global footprint.
The company faced larger-than-expected headwinds due to a stronger U.S. dollar which impacted sales by 1.9% which is considerable.
Figure 6: US dollar Index
Now, with the US dollar index currently in the mid-90s, far from its value of above 100 during most of the second and third quarters, there could be positives in the next quarter.
Since the guidance for FY2020 excludes the impact of currency, there is possibility for some positive surprises in terms of earnings for the last quarter. This is supported by some other positives.
First, there is the fact the company expects the full cost reduction measures for this year amounting to $150 million only starting to make a real difference in terms of earnings as from Q4-2020. Also, Rockwell is in the process of reducing its global real estate footprint which should reduce monthly rental charges.
Second, there have been exceptional costs related to supply chain inefficiencies related to the pandemic and acquisitions charges. Absence of exceptional costs and cutting down on expenses should result in sequential improvement in the fourth quarter.
In this respect, the full-year outlook of $7.40-7.60 (midpoint of $7.50) provided this month is higher than the initial value of $6.90-7.70 (midpoint of $7.30) provided back in April.
I now work out a valuation aware that cost savings alone are not going to generate earnings.
When compared to ABB, the trailing price-to-earnings (GAAP) and price-to-sales ratios provide a mixed picture of the valuations. However, the margins, return on total capital and employee productivity provide a clearer picture of Rockwell’s much better operational efficiency.
Figure 7: Comparing Rockwell and ABB
Source: Seeking Alpha
Therefore, compared to ABB, Rockwell should be more richly valued, but this is not the case when considering the price evolution in the last three months (figure 1). Moreover, taking into consideration that the stock price has already known better growth than the industrial average and persistence of some confinement measures, my target price would be for a moderate $230 in the medium term. This is above analysts’ target of $207.
I further support my target by providing some key points about Rockwell.
Figure 8: Rockwell’s positions of strength which are likely to be transformed into sales opportunities
Source: Table built from transcripts data
Therefore, this is a company which can play a significant role in automation of industry processes, thereby reducing the labor component as a factor of production. There have been strategic wins spanning several industries including Life Sciences, Food & Beverage, and Oil & Gas. These wins are considered as strategic as the company was not the incumbent supplier.
One of the more notable wins was for Brazil’s largest exporter of instant coffee. Furthermore, there have been strong sales in the European, Middle East and African (EMEA) regions derived from PPE (medical protection equipment) manufacturers. There has also been significant demand for Rockwell’s Information Solutions and Connected Services business from the EMEA region.
Orders are also coming from machinery builders in Europe and life sciences companies in the U.S. Furthermore, Rockwell’s IoT (Internet of Things) offering can be used to increase efficiency of pumping activities as well as help in the maintenance of pipes and wells in the Oil & Gas industry. This is important for bringing down the break-even oil price. Also, automation features reduce the need for touching surfaces and help in saving lives.
Finally, dollar weakness if sustained could be highly beneficial to the company’s earnings taking into consideration that there was $0.15 to $0.10 negative currency impact in the second and third quarters respectively.
Rockwell can be considered as an essential business as it supports critical infrastructures required to produce goods at scale.
Its advanced automation capabilities is proving essential in supporting healthcare companies like Johnson & Johnson (NYSE:JNJ) in expanding North American manufacturing footprints through flexible, collaborative and robotized chains of production. Shareholders should be comfortable owning Rockwell’s shares. The leverage should revert back to the 1.3x level in Q4-2020.
It pays a healthy dividend yield of 1.8%. The current payout ratio is 54% with a cash payout ratio of 40%. For potential investors looking for an entry point, current volatility provides an opportunity to get on board with a nice margin of safety. There could be a drop to the $215 level in the aftermath of the third quarter earnings and some political tussle over the coronavirus stimulus package.
This is a stock to have on the watch-list as it is on a path to convert COVID constraints into opportunities. Rockwell is a buy with a possibility of the $215 level being reached.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ROK over the next 72 hours. 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.
Additional disclosure: I am long BASF. This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing.