Rockwell Builds a Wide Moat With Prudent Investments

We have long considered  Rockwell Automation (ROK) to be one of the higher-quality industrial companies we cover because of its consistently high profitability and a management team attuned to creating value for shareholders. After re-evaluating Rockwell's stance with its customers, power against its competitors, and inherent industry structure, we upgraded our economic moat rating for the firm to wide from narrow because of a high degree of customer switching costs. This is a direct result of the company's successful Logix platform and expansion into new markets.

Rockwell's Moat More Durable Than We Previously Thought
We have admired Rockwell's underlying business, but we've also expressed concern that the company's success in stretching from traditional discrete automation processes into process automation would attract competition, diluting the company's margins or growth potential over the long term. That threat still exists, but we now believe that we failed to place enough significance on the fact that changing automation vendors is a decision not made lightly by a manufacturer; the organizational disruption caused by the change creates a number of potential costs for the customer, making sticking with the status quo the lower-friction choice. As a result, an automation firm like Rockwell has a heavy incumbency advantage, building meaningful barriers to successful entry.

The strength of Rockwell's advantages has played out in its financials. With an average annual return on invested capital of 21% over the past 10 years, the company continues to benefit from investments in Logix, its cornerstone control platform. The flexibility of Logix to handle a variety of different manufacturing processes, from packaging to brewery and dairy processes, has helped the company slowly extend beyond its discrete automation roots, providing additional growth opportunities and displacing customers' homegrown and legacy systems. As the company adds more capability within Logix, the ability for it to cross-sell improves, potentially deepening the relationship with an existing customer.

Why Doesn't a Competitor Just Replicate Rockwell's Strategy?
A company with significant capital and a long time horizon could build a competing platform to rival Logix, but the heavy incumbency advantage garnered from high switching costs makes market share gains glacial in nature. Implementing a new automation system in any factory typically involves shutting down all affected operations, often disabling the entire plant for the installation period. This is followed by a retraining period for employees who interact with the affected processes. In many respects, this switching cost is akin to those displayed by enterprise reporting platform vendors like Oracle and SAP.

In Rockwell's case, the company enjoyed incumbency advantages in several of its discrete end markets but wanted to integrate the ability to oversee these different disciplines into one primary controller. In doing this, Rockwell made the explicit investment to add flexibility in the controller to work not only with its products, but with other manufacturers' products as well. Through the natural upgrade cycle, the company was able to sell this product to existing discrete customers that also had processes controlled by other vendors. In some cases, customers were willing to buy a new platform because the incumbent elected not to support the existing platform as part of a legacy product phaseout. Approaching firms making greenfield investments where the customer was not limited by existing technology vendors proved to be valuable for Rockwell. The firm was the first to market with this multidiscipline approach, inherently blocking followers from customers where Rockwell had already had made significant inroads. Rockwell's first-mover advantage coupled with the industry's high switching costs makes a me-too strategy less profitable than it may seem at first glance.

To a lesser extent, sticky customers and five- to seven-year product cycles make gaining share a time-consuming process. Rockwell was able to navigate this barrier by bringing Logix's open architecture to existing discrete automation customers, extending the control platform to other parts of the factory floor. The incremental economic cost for the customer was lower than the cost of changing to another supplier because plant managers typically had familiarity with the Logix platform and the open architecture meant that customers did not have to change out all existing machinery to be compatible with the new Logix controller, reducing the necessary capital outlay. A successful new product not only is unlikely to get placed in a facility that just began operating in the last couple of years, but also may find it difficult making inroads with a multinational manufacturer that has several plants on the same control platform. Rockwell was able to make this investment because automation and control is its only line of business, and to stay relevant over the longer term, it wanted another dimension for growth. Firms like ABB and Siemens, which seem to have a natural extension like Rockwell, have a number of other projects to invest in, many of which probably boast payback periods faster than investing in and marketing a new control platform. While investment in a Logix-like competitor may be a positive net present value project, we think the payback period may be prohibitive for firms looking for organic growth.

Moat Is Deep as Well as Wide
While high switching costs and a meaningful head start on competitors help build our case for a wide moat, the company needs to convert those advantages into economic profits in order to return value to shareholders. Rockwell's competitive strengths are visible in its strong economic profits. In 2012, the company delivered earnings before interest of $1.1 billion on a $4.2 billion invested capital base, resulting in a 26% return on invested capital. We estimate the company's weighted average cost of capital is 8.3%.

In 2012, Rockwell's EBI margin was 17.4%, which is close to peak levels for the company; our longer-term projection is 13.0%. Assuming the invested capital base stays flat, EBI margins would need to fall to 5.6% to neutralize the company's economic profits. For reference, EBI margins in 2009 dipped to 9.8% even as revenue declined 24%, allowing Rockwell to outearn its cost of capital. In our opinion, catalysts that would lead to this type of margin degradation, aside from self-inflicted pricing missteps, include product quality issues and the emergence of a new competitor that has no vested interest in maintaining the current level of industry profitability. While this scenario could play out, high switching costs and customer inertia lead us to believe such a disruption in the market would be fairly visible, with Rockwell slowing appreciably in top-line growth, sacrificing revenue for margin, or sacrificing margin for revenue in the case of a decline in margin.

We estimate that it would take a nearly $9 billion increase in invested capital with no earnings contribution from that investment to negate the firm's economic profits, given Rockwell's current EBI and WACC. We calculate current invested capital to be just more than $4 billion; if we project Rockwell will raise its capital base so that returns merely match its cost of capital, its invested capital would need to be $13 billion, assuming constant EBI. While mathematically this is possible, this magnitude of invested capital bloat is unlikely to occur in a short time frame, given Rockwell's size and the amount of external capital it would need. Additionally, this would be highly out of character for Rockwell given that the company has not spent more than $250 million on acquisitions in any of the past 10 years. Absent a change in management or overall corporate strategy, we don't view this as a threat to Rockwell's economic profits.

Economic Uncertainty Weighs on Shares
At 15 times 2013 earnings, Rockwell may not be the cheapest industrial name we cover, but it is at the lower end of its historical trading range of roughly 15-20 times earnings. We think uncertainty about growth in the global economy has led the market to undervalue Rockwell's shares modestly. The long-term growth rate implied by the current market price (using our cost of capital assumption) is less than 4%, very different from the company's historical performance and growth potential, in our opinion. Our fair value estimate of $90 per share assumes average annual revenue growth of nearly 6.5% and earnings growing just under 7% during the next five years as modest share repurchases are offset by moderation in the operating margin.

During the past several years, Rockwell has built a $1.2 billion balance of cash and marketable securities, approximately $8.75 per share. Albeit a high-quality problem to have, this cash balance has long been on our radar as fodder for either an acquisition or a special dividend. Rockwell has raised its dividend an average of 10% annually over the past five years. The firm currently is paying out approximately 35% of earnings as a dividend, resulting in a dividend yield of 2.2% relative to the current price.