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Morningstar | ROK Updated Forecasts and Estimates from 09 Nov 2018

Wide-moat-rated Rockwell turned in a solid fiscal 2018 fourth quarter that was in line with our expectations. Specifically, segment operating earnings for the fourth quarter of $1.443 billion matched up neatly in sync with our expectations of $1.444 billion. Management reported that heavy industries was the largest growth driver this year, with almost all verticals contributing, including strength in its consumer vertical. Free cash flow conversion was an impressive 121%, indicating the strength of Rockwell’s asset-light business model.

Even though the company has yet to issue its 2018 annual report, we do have partial financial statements and have updated our model for fiscal 2019. After revisiting our long-term assumptions on the heels of Rockwell’s continued strong performance, we raise our fair value estimate to $169 from $160 previously (about $2 of which was due to time value of money). While we like the company and the firm’s management, as well as the underlying fundamentals, we think the market has largely recognized the firm’s upside potential.

Rockwell is one of the only pure-play automation players, and we continue to see the firm leading in the discrete (for example, automotive, electronics) automation space. Encouragingly, the firm saw strong 11% year-over-year process growth (such as chemicals and oil) in the fourth quarter off a tough comp. We see the total overall addressable automation market growing over mid-single digits (between a 7% and 8% compound annual growth rate) to nearly $315 billion overall by 2023. We expect Rockwell to participate in this upward trajectory, with strong tailwinds including increasing demand for fast production capacities in Rockwell’s verticals.

Other growth drivers include innovative solutions like the firm’s independent cart technology, which is a product developed by the firm’s MagneMotion acquisition. We were able to see this offering up close at the International Manufacturing Technology Show in Chicago in September and were impressed with its speed and the ability of the components to avoid collision through use of magnets, as well as its ability to adapt to different packaging styles.

At a current market price of $179 (or about 18.5 times our 2019 adjusted EPS estimate) and a price/fair value ratio of 1.06, however, we think the 3-star-rated name’s market value more than adequately prices in its long-term growth prospects. Our adjusted EPS of $9.19 is toward the upper range of management’s $8.85 to $9.25 guidance for 2019. Additionally, our segment operating margin projection for 2019 of 21.5% versus management’s 22% projection, and year-over-year top-line growth projection of 4.5% overall is toward the top of management’s 2.7% to 5.7% range. Finally, we model incremental margins of 30% to 35% during the length of our explicit forecast.

All of this leaves us scratching our heads as to how the top end of consensus sees a fractional interest in the firm worth $233, greater than what analysts previously found an expensive valuation when Emerson bid up Rockwell’s stock to $225 last year. It’s also quite a good deal above our bull-case scenario. We think the future looks significantly brighter for Rockwell than the past and are encouraged by the firm’s increased research and development investment as a percentage of sales (we’re expecting this figure to rise to 5.7% of sales in 2019) and strong backlog (up double digits year over year). That said, we think the top end of the market is acting like economic cycles no longer exist.

Management gave great details that caught our ear during the call. Rockwell’s growth has traditionally been driven by automation of basic processes to remove repetitive physical labor in operations. Over time, however, Rockwell and its customers have come to recognize the potential of converging informational technology with operational technology. The PTC partnership offers Rockwell the opportunity to gain a stronger foothold higher up the automation pyramid and use data to elicit insights, which in turn translate into additional productivity. Ultimately, we agree with Rockwell’s representatives which candidly express to us that it doesn’t require “building everything to be successful.”