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Rockwell Automation (ROK) Thomas F Harris CPA,CA Completed CFA L3
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Rockwell Automation is Mr. Buffett’s next buy Rockwell Automation (ROK) is a great company at a fair price. Mr. Buffett would be
happy to own it for at least 10 years. It passes his tests with flying colors:
1. Circle of Competence
Simple ROK helps business customers to automate their manufacturing or production
processes. Automation lowers costs and improves quality.
The company primarily sells electric components, which are added on to the
customer’s production equipment.
Platforms are a comprehensive packaged solution of products. Software can be
used to program advanced applications.
Non tech ROK uses technology to enhance its product offerings, but it is not susceptible to
rapid change.
Scalable ROK has customers across all industries and all geographies. The products are
modular. They can be customized to nearly any business. Scalability is high.
2. Historical Moat
High ROE Past 10 years: Consistently high ROE of 34%. EPS growth of 12.3%, with only 1
year of decline (in 2009).
Low capex Past 10 years: R&D of 3.7% of sales. Capex of 2.3% of sales. Capex was only 21%
of CFO. The company is a FCF machine.
3. Future Moat
Network effect Internal network effect. Rockwell’s products are highly compatible with each
other. The products work together to perform functions which are crucial for the
customer. Often, platforms (comprehensive packages) are customized to specific
automation processes for a specific company in a specific industry.
Switching costs Switching costs are high. Customers become dependent on the automated
process. Removing it is like removing part of the human brain. Modularity makes
it easy to install, but network effects make it difficult to remove. Integration with
software and data systems further increases switching costs.
4. Management
Capital Allocation Management returned 72% of CFO to shareholders in past 5 years via dividends
and buybacks. Divested Power Systems division in 2007 at a cyclical peak.
Ownership mentality Long term oriented. Customer oriented. Consistently widening the moat by
improving quality and developing new products.
5. Margin of Safety
Fair price Price of $112.81 is fair compared to $129.71 DCF intrinsic value estimate.
Expected 10 year internal rate of return of 12-15% is excellent.
Charlie Munger Test
With $5 billion, could Mr. Munger create a hypothetical competitor from scratch? To create a true competitor to
ROK would require start investment in: R&D for >300,000 hardware and software products, sales, distribution,
manufacturing, industry experts, and switching costs. Running through his mental models and asking “what could go
wrong”, Mr. Munger would classify this as a wonderful company.
Rockwell Automation (ROK) Thomas F Harris CPA,CA
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1. Circle of Competence
“You don’t have to be an expert on every company, or even
many. You only have to be able to evaluate companies within
your circle of competence. The size of that circle is not very
important; knowing its boundaries, however, is vital.” – Warren
Buffett
“There are a lot of things we pass on. We have three baskets: in,
out, and too tough...We have to have a special insight, or we’ll
put it in the ‘too tough’ basket.” – Charlie Munger
Simple
The first, and most basic test, is the “too hard” pile. If Mr. Buffett believes that the
company is too difficult to analyze, it is discarded. We will ask simple questions. If
the business is simple, we expect to quickly understand the nature of the
business.
What is the function of the business?
Rockwell Automation helps businesses to automate manufacturing and
production processes.
How do they accomplish this?
ROK primarily sells a wide range of electrical components which are added on to
existing machinery. Combined with software, the business is better able to
design, monitor, and control the process.
Why is this needed?
Automation addresses several business needs simultaneously. The initial benefits
of installation include:
Speeding up the process
Reducing errors
Improving quality
Increasing safety
Furthermore, there are second order benefits. The hardware components gather
data which was previously unavailable. This data allows employees to further
analyze the process and make incremental improvements and adaptations.
As such, automation provides a clear ROI. The investment is low risk, and offers
high upside as well. It is a small investment compared to the overall expenses of
these businesses.
The investment is easy to justify from both the bottom-up perspective of
employees (e.g. cost and efficiency metrics, ease of monitoring), and the top-
down perspective of management (e.g. data leads to transparency, quality
improvement versus competitors, makes company more consistent and
adaptable).
Operations
Revenues: How are revenues generated?
ROK sells hardware, software and services. Hardware consists of electrical
components which add-on to machinery. These components can be sold
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separately, but they are more often combined into packages and control
platforms. Platforms are combinations of various components and software.
Rockwell sells software which is used to help in process design, control of the
automation process, and integration of data. Services help the customer through
the entire product life cycle. Approximately 2/3 of sales is hardware.
Expenses: What are the costs?
Rockwell’s costs include manufacturing, sales, R&D, and service costs.
The company has low capital intensity, as both capex and R&D costs are low.
Input costs of manufacturing are commoditized raw materials. It seems that the
majority of Rockwell’s costs are related to employees: labor, service, R&D, SGA.
For capex, please note that depreciation is included in COGS. Thus, depreciation
is a good approximation for capex for ROK.
Customer base: Who is buying?
The customer base is highly diversified across size, geography and industry
vertical. The following industry vertical estimates are from Credit Suisse:
Generally, automation is categorized as either “Process Automation” or “Factory
Automation” (aka Discrete Automation). Process Automation is used on industrial
sites to control a continuous flow, such as water or oil. Products include DCS,
valves, and other flow products. Factory Automation is used to control
manufacturing facilities where component parts are assembled into a final
product. Products include drives, robots, PLCs.
Historically, Rockwell Automation focused on Factory automation. In recent years,
they have successfully expanded into Process Automation with a new product
called “Logix”, which allows for integration across all Automation types.
2.1%
4.4%
23.7%
54.0%
0% 10% 20% 30% 40% 50% 60%
Capex
R&D
Sales, General and Admin
Cost of Goods Sold
Expenses as a % Sales (2014)
source: company data
5%
8%
8%
12%
13%
23%
31%
0% 5% 10% 15% 20% 25% 30% 35%
Other
Metals
Mining
Transportation
Oil and Gas
Heavy industry
Consumer
End market revenue split
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Among Rockwell’s major industry verticals are those which can be considered
“Hybrid” industries: those with elements of both Process and Factory automation,
such as Life Sciences, Food and Beverage and Metals.
Rockwell is also diversified globally, with roughly 50% of sales coming outside of
the United States.
Sales and Distribution
70% of sales are made through independent distributors, who typically do not
carry competing products. Direct sales and service agreements tend to come
from customers in emerging markets, where the distribution channel is less
developed.
Technology
A key consideration is Mr. Buffett’s low regard for technology companies.
Technology is based on change; and change is really the enemy
of the investor. Change is more rapid and unpredictable in
technology relative to the broader economy. To me, all
technology sectors look like 7-foot hurdles – Warren Buffett
Although Rockwell Automation develops technology to improve its product
offering, the company is not a technology company at its core.
Rockwell’s software works very closely with the hardware components. It is the
interaction between Rockwell’s software, hardware, and the customer’s machinery
which adds value.
Therefore, the core of the business is not susceptible to rapid technological
change the way that Facebook and Samsung are. Rockwell Automation is similar
to Precision Castparts (held of Berkshire Hathaway) in its use of technology.
Favourable Business model
In assessing the boundaries of Mr. Buffett’s circle of competence, it is helpful to
compare ROK to Mr. Buffett’s past investments based on business model
characteristics.
Repetitive
Mr. Buffett is familiar with the repetitive business model of a Coca-Cola, Gillette,
or Wal-Mart.
8.3%
13.4%
20.0%
6.6%
51.7%
0% 10% 20% 30% 40% 50% 60%
Latin America
Asia Pacific
EMEA
Canada
United States
Geographic Revenue split (TTM)
source: Company data
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Rockwell claims an average product life of 20 years, so it is nowhere close to the
ideal repetitive business model. However, purchase is far more frequent than this
number suggests. Customers require a high volume of hardware components.
When changes are made to the manufacturing or production process, new
hardware is often required.
Furthermore, a key part of Mr. Buffett’s interest in repetitive business models is
their “habit forming” nature. Although Rockwell’s customers purchase less
frequently, they actually use the products on a daily basis. This is particularly true
for Rockwell’s Automation software, which is used constantly by employees.
Scalable
Mr. Buffett is also familiar with businesses which are scalable. Coca-Cola has been
a terrific investment because the product can be consumed by every person on
Earth. Furthermore, the lack of an after-taste, and thirst quenching appeal in hot
climates, means that people can drink it multiple times per day without tiring of
it.
Rockwell’s offerings are similar in this regard. Since the products are modular,
they can be combined to form customized solutions for every type of
manufacturing and production business around the globe. Rockwell’s customer
base, fragmented across industry and geography, already reflects this universal
appeal.
Conclusion
Rockwell Automation is a simple and understandable business. Although the
company uses technology to add value, the core business is not susceptible to
rapid change like Facebook and Samsung. Rockwell Automation is clearly within
the boundaries of Mr. Buffett’s circle of competence.
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2. Historical Moat
The number one idea is to view a stock as an ownership of the
business and to judge the staying quality of the business in terms
of its competitive advantage. – Charlie Munger
Mr. Buffett and Mr. Munger refer simply to “moat”. I prefer to break the analysis
into two parts. The existence of a moat is examined in this section, focusing on
historical data. Once the existence of a moat has been established, we will go
deeper to determine how durable it will be in the future.
Profitability
Mr. Buffett requires consistent profits.
EPS consistency
Earnings consistency increases the probability that a moat exists. It also improves
predictability of future cash flows. Rockwell Automation has a consistent EPS
history. Over the past 10 years, ROK has increased EPS every year but one: 2009.
Furthermore, a 10 year EPS growth rate of 12.3% is excellent.
High ROE
With an ROE of 34% over the past 10 years, Rockwell’s efficiency is superb. Mr.
Buffett considers 20% to be an excellent mark, so Rockwell’s ROE is exceptional.
The consistently high ROE suggests that Rockwell has a strong moat. Only in
2009 did ROE fall below 28%.
1.85
2.77
3.49 3.53 3.90
1.53
3.06
4.80 5.14
5.37
5.92
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Diluted EPSsource: Company data
28%
38%
30%33%
13%
33%
48%
42% 41%
32%
0%
10%
20%
30%
40%
50%
60%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Return on Equity 10 yrsource: Company data,
my calculations
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To ensure that the company is achieving high Return on Equity without the aid of
excessive leverage, Mr. Buffett requires a high Return on Total Capital as well. The
company has averaged a ROTC of 25% over the past 10 years. This supports the
high ROE numbers. Calculation: (Net Income + Interest Expense) / (Equity + Debt
+ Employee Benefits)
Low debt
Beyond the distortion of ROE, Mr. Buffett does not like companies with high debt
levels because it increases business risk.
With 827m in 2014 Net income, Rockwell Automation could pay down the 1.4B
debt in less than two years.
Furthermore, the company holds 1.9B in Cash and ST securities, which offsets the
entire 1.4B debt.
Mr. Buffett would consider Rockwell’s balance sheet to be strong.
Capital Intensity
Mr. Buffett has stated repeatedly that a business with high capital intensity will
never be a wonderful business. Rockwell has low capital intensity in terms of both
capex and R&D.
Low capex requirements
Over the past 10 years, capex has averaged 2.3% of Sales. This equates to just
21.4% of Cash Flow from Operations (CFO).
Furthermore, depreciation is a good approximation of capex for the company.
This improves Mr. Buffett’s ability to predict future cash flows.
21%24%
22%
26%
11%
21%
31%29% 30%
33%
0%
5%
10%
15%
20%
25%
30%
35%
1 2 3 4 5 6 7 8 9 10
Return on Total Capital 10 yrsource: Company data,
my calculations
Capex
Depreciation
-
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Capex vs Depreciationsource: Company data
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Low R&D requirements
R&D is considered to be a capital expenditure, because R&D is often compulsory
for the company to stay abreast of the competition.
According to the 2014 EU Industrial Scorecard, Rockwell’s recent spending of 4%
of Sales would be consistent with R&D expenses for the average “Electronic and
Electrical equipment” business. However, a large part of R&D for Rockwell is
more akin to “Technology Hardware & Equipment”, where the average is 8.0% or
“Software & Computer services” at 10.4%.
Considering Rockwell’s recent EPS growth and ROE, it appears that the company
is highly efficient with its R&D expenditures.
Cash Flow Generation
A company can use earnings manipulation to boost EPS and ROE. Since Mr.
Buffett’s intrinsic value calculation depends on expected future cash flows, it is
wise to check that earnings are generating Free Cash Flow (FCF). FCF is calculated
as CFO less capex and business acquisitions.
The ratio of FCF / Net Income from continuing operations has been 88% over the
past 5 years. Given the growth in EPS, this is excellent FCF generation. Earnings
are quickly being converted into Cash.
Note: In 2007, FCF is abnormally high due to divestiture of the company’s Power
Systems segment. 2008-2009 cash flow numbers are distorted by the company’s
volatile working capital numbers during the financial crisis.
Industry profitability
As an industry, Automation is highly profitable. Rockwell has only a few
competitors which are as large and diversified. The comparisons are imperfect
because Rockwell is one of the few companies which generates 100% of its
2.8% 2.7%
3.3% 3.4%
3.9% 4.1% 4.2%4.0% 4.1%
4.4%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
R&D / Sales
100%78%
319%
59%
184%
91%69% 77%
104% 98%
0%
50%
100%
150%
200%
250%
300%
350%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
FCF / Net Income
Rockwell Automation (ROK) Thomas F Harris CPA,CA
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revenue from Automation. The point is that these companies are consistently
profitable, with high ROE. Furthermore, Automation tends to be one of the most
profitable segments.
10 yr ROE Auto % Rev Auto % EBIT Automation
EBIT margin
ABB 22% 42% 49% 12.6%
Emerson 23% 56% 64% 19.6%
Siemens 17% 13% 31% 13.2%
Rockwell 34% 100% 100% 17.8%
Automation is driving high returns across the industry. Each of these businesses is
able to maintain strong profit margins, so it seems that competitive rivalry is low
and the companies are not competing on price.
Furthermore, the consistently high ROE across the industry suggests that there
are strong barriers to entry.
Pricing power
The nature of the business gives Rockwell Automation a reasonable amount of
pricing power.
The input costs for hardware components are commodities such as copper, and
labor. Most of Rockwell Automation’s costs are related to employees, whose
wages are sticky.
Rockwell has increased gross margins for 5 years in a row, from 36% in 2009, to
41.6% in 2014. It is useful to note that R&D has been rising faster than Sales, and
Rockwell includes R&D in COGS. As such, the Gross margin numbers may be
understating Rockwell’s pricing power.
Conclusion
Rockwell Automation strong evidence of a moat over the past decade. The
company has consistently grown EPS, with a high ROE, and generated plenty of
cash flow. There appear to be industry level barriers to entry as well, which
increases our confidence in the existence of a moat.
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3. Future Moat (durability)
So we think in terms of that moat and the ability to keep its
width and its impossibility of being crossed as the primary
criterion of a great business. And we tell our managers we want
the moat widened every year. That doesn’t necessarily mean the
profit will be more this year than it was last year because it
won't be sometimes. However, if the moat is widened every year,
the business will do very well. When we see a moat that's
tenuous in any way-it's just too risky. We don’t know how to
evaluate that. And, therefore, we leave it alone. – Warren Buffett
Rockwell Automation has a strong moat. However, Mr. Buffett will not invest
unless he is confident that this moat will not erode in the near future.
Nervous system
To get a deeper understanding of how Rockwell’s moat functions, an analogy is
helpful.
Think about how the brain functions in the human body. The brain allows the
body to function efficiently by automating processes. In fact, almost every
function is automated with the help of the nervous system.
Take driving for example. It probably took significant practice to learn how to
drive. At first each movement took conscious effort, but eventually the brain
automated nearly every process involved.
To make a right turn, you automatically turn your head to look for people, cars
and traffic signals. At the same time, your arms turn the steering wheel, and your
foot presses the gas pedal. These separate processes are further coordinated by a
higher layer automatic process which runs them at the correct time, in the correct
sequence.
Now, can you imagine removing even one of these processes? If your brain was
unable to automatically turn the steering wheel, you would have to consciously
focus on how much the wheel was turning as you were executing the turn. This
would take a significant amount of cognitive energy, and it would distract you
from every other part of driving. Your ability to drive might be severely impaired,
and at the very least it would be very slow.
Rockwell provides automation in a similar fashion. Rockwell sells hardware
components, which are similar to the nerve cells. Each product works with certain
types of machinery. Just as an optical nerve is differentiated to function in the
eye, a range of differentiated controllers and sensors can be customized to a
specific type of machines.
Furthermore, Rockwell software which helps to link each of these components to
the employees. This compares to the individual nerves linking back to the brain,
and then the interactions between different regions of the brain.
Rockwell Automation (ROK) Thomas F Harris CPA,CA
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Network Effects
To further the analogy, the communication between a group of Rockwell’s
components is like the communication between nerves. Simple parts send signals
back and forth to achieve an advanced function. Rockwell’s components work like
a network, whose value is greater than the sum of its parts.
Compatibility
Since communication between the components is important, the internal network
effect encourages the consistent use of one brand to ensure compatibility.
The higher the volume of components, and more complex the functions that they
perform, the greater the network effect. As the network size increases, so does
the incentive for the customer to stick with the Rockwell brand. Indeed, larger
customers tend to install entire “control platforms” of components from the same
brand.
Although weaker than the external network effects of a company like EBay,
Rockwell’s internal network effects strengthen the moat.
Distribution
As previously mentioned, 70% of Rockwell’s sales are through independent
distributors. These independent distributors tend to sell only Rockwell’s products.
This makes sense, because Rockwell’s customer base is highly fragmented across
both geography and industry.
This is important to the moat for two reasons. First, it lowers the buyer power,
which allows Rockwell to maintain high profit margins.
Second, it creates a barrier to entry. A new entrant would be unable to steal
market share without significant time and cost.
Switching Costs
Integration
One of Rockwell’s areas of focus has been integration.
Rockwell sells packages of its products called “control platforms”. The company’s
diverse range of products can be highly customized to the customer’s business. A
platform means that the customer is using the same brand for an entire factory.
Even more integrated, Rockwell’s “Logix” controllers are information-enabled.
They collect data which can be programmed with software to perform more
advanced functions, which increases integration.
The ultimate level of integration is what Rockwell calls the “Integrated Enterprise”.
This is achieved when Rockwell’s Operations Technology (OT) is integrated with
the customers Information Technology (IT). This gives the customer the highest
degree of control over their manufacturing and production systems.
In the nervous system analogy, removing highly integrated, automated processes
would be like undergoing a lobotomy. This is an excruciating thought for the
customer. If an automation platform is running smoothly, there is little to gain by
switching to a competitor. Yet, there is much to lose by tampering with key
functions.
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High benefit to cost
Not only is switching a painful thought, the cost of each component is low
compared the overall production equipment. Unless a full overhaul is necessary,
it is unlikely that a customer would even think about switching.
Brand
Consistent
This has a bearing on a key attribute that Rockwell
must focus on: consistency. If the customer cannot
depend on each part functioning in the same way as
the previous part, it ruins their incentive to pay more
for the brand.
Evaluating Rockwell on this dimension, we see that the
company has done an excellent job in this regard.
Differentiation
Rockwell appears to be keenly aware of this consumer
behavior. Customers highly value the ability to take a
component and confidently add it to the network.
The company has focused on this customer need as a
way to widen their moat. In fact, it has become the
main point of differentiation from its competitors.
Rockwell has the most modular hardware and software.
The architecture is open source, which allows it the
flexibility to work with almost any production process.
Furthermore, Rockwell’s Logix controllers bridged the
gap between factory and process automation. In their
2014 annual report, they state:
Our integrated control and information
architecture, with Logix at its core, is an
important differentiator. We are the only
automation provider that can support discrete,
process, batch, safety, motion and power
control on the same hardware platform with
the same software programming environment.
Our integrated architecture is scalable with
standard open communications protocols
making it easier for customers to implement
more cost effectively.
By pushing the boundaries of modularity and
integration, Rockwell has improved its brand
perception. The “Control Readers Choice Awards”
(right) shows that Rockwell has increased their brand
perception in Process Automation from 2011 to 2015.
The “Control Readers Choice Awards” reveals Rockwell’s
improvement in Process Automation. This is based on a
survey of 1000 respondents:
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Future Growth
Rockwell’s next step in widening its moat is by further integrating Automation
with the rest of the company. Rockwell’s new marketing focuses on the
“Connected Enterprise”, which integrates Operational Technology (Rockwell) with
Information Technology. Cisco is partnering with Rockwell for this opportunity.
A major technological trend known as the “Internet of Things” has been the
subject of much hype and speculation. Per Gartner:
“The Internet of Things (IoT) is the network of physical objects
that contain embedded technology to communicate and sense or
interact with their internal states or the external environment.”
This sounds very similar to integrated systems that Rockwell has been promoting
in recent years. Rockwell seems to be well ahead of this curve. The trend should
fit neatly into the strategy that Rockwell is already pursuing, and make Rockwell’s
marketing efforts easier.
Mr. Buffett is generally skeptical of growth forecasts. In this case, the investment
thesis does not rely on optimistic growth. Investors have priced ~5% growth into
the stock. Rockwell is a wonderful company, regardless of the “Internet of
Things”.
Considering the Internet of Things as a threat, Rockwell’s strong moat is unlikely
to be eroded by this trend. Putting internet technology in a home lighting system
would clearly cause disruptive change in that market, because it is an untapped
market which is relatively homogenous.
But it is less dangerous to Rockwell. The company is already providing this level
of integration. To disrupt Rockwell, a competing technology would need to be
applicable to a range of highly fragment production and manufacturing
processes, in various industries.
Conclusion
Rockwell’s strong moat includes network effects, switching costs, and brand
loyalty. The diversified range of factors which create this moat translates into
lower risk of erosion. The company is making continuous efforts to widen its
moat.
Rockwell Automation appears to have a sustainable competitive advantage.
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4. Management
“When we own portions of outstanding businesses with
outstanding managements, our favorite holding period is
forever.” – Warren Buffett
CEO
Keith Nosbusch has been CEO since 2004. Prior to this, he was president of
Rockwell Automation Control Systems, since 1998. He began his career with
subsidiary Allen-Bradley, in 1974.
This is a long tenure as CEO, which increases the likelihood that he is motivated
by long term goals for the company.
This is also a very long tenure as an employee of the company. Mr. Nosbusch has
an extensive amount of operating experience in the field of Automation. He also
played a key role in the development of the Logix controllers in the 1990s.
This should give Mr. Buffett confidence that the CEO has high capability as an
operator.
Management Incentives
Executive compensation is mostly based on metrics which align with
shareholders. However, these incentives are generally short term in nature:
2014 CEO
pay ($mm) Explanation
Salary 1.2 Base salary
Stock awards 2.2 75% Performance shares. Based on ROK stock price
performance compared to S&P500
25% RSUs. 3 year vesting period.
Option awards 2.3 Stock options. 1/3 vest in 1, 2, 3 years
Incentive plan 1.3 Incentives based on measurable goals. Goals include
Sales, EPS, ROIC, EBIT, FCF
Pension 1.4 Pension
Other 0.1 -
Total 8.5
The majority of compensation is based on 1 year of performance. It is only the
RSUs and 1/3 of the stock options which take 3 years to vest. This represents just
16% of total compensation.
It is a positive sign that ROIC and FCF are part of the “Incentive plan”. However,
their impact is only 6% of total compensation.
The best management incentive is the Stock Ownership policy, which an
executive must abide by within 5 years. The CEO must own Common shares
worth at least 5x base salary. Other executives must own at least 3x base salary.
To some degree, this offsets the short term nature of Rockwell’s executive
compensation.
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Capital Allocation
Rockwell is a Cash Flow machine, so capital allocation is crucial. Thankfully, the
Executives are excellent capital allocators.
A key indicator of good management is the consistently high EPS and ROE
numbers shown earlier. A ten year average ROE of 34% is far beyond what Mr.
Buffett considers to be excellent (15-20%).
Rockwell Automation would probably be a good business with only mediocre
management. Having excellent management is what accounts for the stellar
results.
Dividends and Buybacks
Management is eager to return capital to shareholders. They returned 72% of
CFO to shareholders in past 5 years via dividends (32% of CFO) and buybacks
(39% of CFO).
Mr. Buffett has said that his ideal company can both generate high returns on
capital, and employ large amounts of capital. Since invested capital is producing
30-40% returns, it is tempting to criticize management for not retaining more
capital.
There may be some merit to this, as Revenue has grown at 4.1% over the past 10
years. However, I believe that Mr. Buffett would be satisfied with a company that
is excessively efficient.
Acquisitions
In the past 5 years, Management has spent 5% of CFO on acquisitions. The
company clearly states its acquisition strategy in the 2014 Annual Report:
Acquisitions that serve as catalysts to organic growth by adding
complementary technology, expanding our served market,
enhancing our domain expertise or continuing our geographic
diversification
Capital Allocation Summary 2010 2011 2012 2013 2014 avg
Cash Flow from Operations 494,000 643,700 718,700 1,014,800 1,033,300
Allocated to:
Purchase of ST securities (4,100) - 350,000 22,200 257,900
% CFO -1% 0% 49% 2% 25% 15%
Capex 99,400 120,100 139,600 146,200 141,000
% CFO 20% 19% 19% 14% 14% 17%
Business acquisitions - 45,900 16,200 84,800 81,500
% CFO 0% 7% 2% 8% 8% 5%
Dividends Paid 173,600 211,000 247,400 276,300 320,500
% CFO 35% 33% 34% 27% 31% 32%
Debt repaid (Raised) - - (157,000) (22,000) (146,000)
% CFO 0% 0% -22% -2% -14% -8%
Equity bought back (Raised) 118,800 298,700 259,400 402,700 485,700
% CFO 24% 46% 36% 40% 47% 39%
Total 387,700 675,700 855,600 910,200 1,140,600
% CFO 78% 105% 119% 90% 110% 101%
Rockwell Automation (ROK) Thomas F Harris CPA,CA
16 of 22
Recent acquisitions appear to fit with this acquisition strategy:
2014: Jacobs, US, a leader in intelligent tracking motion for OEMs.
2013: vMonitor, UAE, global technology solution for wireless in Oil and Gas.
2012: Harbin Jiuzhou Electric, China, a leading manufacturer of medium voltage drives,
direct current power supplies, switch gear and wind inverters.
2012: SoftSwitching Technologies Corporation, an industrial power quality detection and
protection systems provider in the United States.
These companies were not large enough to be acquired for the purpose of
“empire building”.
Divestiture of Power Systems business
Far from empire building, in 2007, management divested the Power Systems
segment. The Power Systems segment was smaller, and less profitable. In the
years prior to the sale, EBIT margin was much lower:
2001 2002 2003 2004 2005 2006
Control
Systems
12.7% 10.5% 12.0% 14.4% 18.4% 19.2%
Power
Systems
5.0% 7.2% 7.5% 9.0% 12.5% 16.1%
The segment was sold for 1.8B, or roughly 11.1 x EBIT. Considering how high
2006 EBIT was compared with prior years, this was probably an excellent price to
sell at. Regardless, the sale allowed management to focus on the more profitable
Automation segment.
Management’s track record and stated strategy suggest that large, high risk
acquisitions are unlikely.
Ownership mentality
Management is long term oriented. They are consistently taking action to widen
the moat. The CEO seems to highly responsive to customer needs.
The company has focused on improving quality and using technology to create
new product offerings. Within the last 3 years, management has focused on
enhancing value for the customer by adding virtualization, remote asset
monitoring, and cloud based applications.
Management also saw the customer benefit to making their products as modular
and flexible as possible.
Trust
The CEO is quite candid. On earnings calls, he clearly states when he is
disappointed with results. He seems to respond frankly to all questions which he
is asked. The CFO is also straight forward.
Conclusion
Management is excellent. They are trustworthy, have an ownership mentality, are
excellent capital allocators, and aim to consistently widen the moat.
Rockwell Automation (ROK) Thomas F Harris CPA,CA
17 of 22
5. Margin of Safety
“When we buy business, we try to look out and estimate the cash
it will generate and compare it to the purchase price. We have to
feel pretty good about our projections and then have a purchase
price that makes sense.” – Warren Buffett
Equity Bond
Mr. Buffett looks at the business as an Equity Bond. From this perspective, the
EPS that the business produces each year is like the coupon on a bond.
With 2014 EPS of 5.92, and price per share of 112.81, ROK’s initial rate of return is
5.25% (5.92/112.81). Each year, this EPS coupon will grow larger.
We will now use two methods to calculate an internal rate of return for the Equity
bond.
1. ROE method
In the ROE method, we calculate the future value produced by assuming that the
recent level of ROE will hold over the next 10 years.
Taking the 5 year average ROE of 39% and multiplying by the retention ratio of
19%, we expect a Book Value growth rate of 8% (39% * 19%).
Compounding over 10 years, BV should be 39.34.
If BV is 39.34, if we multiply by ROE of 39%, in 10 years EPS will be 15.44.
Based on this EPS, we apply a P/E multiple to determine the stock price in 10
Book value per share 19.03
ROE (5 yr avg) 39%
Retention ratio (5 yr avg) 19%
Book value growth rate 8%
BV in 10 years 39.34
EPS in 10 years 15.44
5 year average P/E 16.87
Current P/E 19.06
Stock price in 10 years (avg PE) 260.45
Stock price in 10 years (current PE) 294.22
Total dividend pool 85.47
Total Value in 10 years (avg PE) 345.92
Total Value in 10 years (current PE) 379.69
Current stock price 112.81
IRR (avg PE) 11.9%
IRR (current PE) 12.9%
Rockwell Automation (ROK) Thomas F Harris CPA,CA
18 of 22
years. For a low estimate, we use the 5 year average P/E of 16.87x. For a high
estimate, we use 19.06x.
Applying these multiples, the stock price should be between 260.45 and 294.22
To determine the total future value in 10 years, we need to add the total dividend
pool of 85.47. This leave us with the Total Value in 10 years.
Finally, we determine the rate of return necessary to grow from the stock price of
112.81 to the total future values of 345.92-379.69.
The result is an internal rate of return in the range of 11.9% to 12.9%.
2. EPS growth method
In the EPS growth method, the assumption is that EPS growth is maintained at
the historical rate for 10 years.
Starting with EPS of 5.92, we apply the 12.3% historical EPS growth rate for 10
years. This yields EPS in 10 years of 18.90.
To calculate the stock price in 10 years, we apply the 5 year average PE of 16.87x
for a low estimate, and the current PE of 19.06x for a high estimate. Therefore,
the stock price in 10 years will be 318.96 to 360.32
Adding the dividend pool of 95.69, the Total Value in 10 years is 414.65 to
456.01.Since the current stock price is 112.81, we can calculate the rate of return
necessary to grow to the future values.
The result is an internal rate of return in the range of 13.9% to 15.0%.
Conclusion
Using these 4 IRR estimates, Mr. Buffett would expect a return of 11.9% – 15.0%
over the next 10 years. This is an excellent return considering the current 2.3%
return on long term bonds.
EPS growth rate - historical 10 yr 12.3%
Beginning EPS 5.92
Projected EPS 18.90
5 year average P/E 16.87
Current P/E 19.06
Stock price in 10 years (avg PE) 318.96
Stock price in 10 years (current PE) 360.32
Dividend pool 95.69
Total Value in 10 years (avg PE) 414.65
Total Value in 10 years (current PE) 456.01
Current stock price 112.81
low IRR 13.9%
high IRR 15.0%
Rockwell Automation (ROK) Thomas F Harris CPA,CA
19 of 22
Discounted Cash Flow model
I made the following assumptions: 9% discount rate, 5% revenue growth, 1%
increase in gross margin over 5 years, 4% terminal growth rate. My calculations
show an intrinsic value estimate of $129.70. At the current price of $112.81, this
represents a margin of safety of 13.0%, or potential gain of 15.0%.
Thus, $112.81 represents a fair price for Rockwell Automation.
2013 2014 2015E 2016E 2017E 2018E 2019E
Revenue 6,351,900 6,623,500 6,954,675 7,302,409 7,667,529 8,050,906 8,453,451
Growth %: 1.5% 4.3% 5.0% 5.0% 5.0% 5.0% 5.0%
Cost of sales 3,778,100 3,869,600 4,033,712 4,220,792 4,408,829 4,613,169 4,826,920
COGS % Revenue: 59.5% 58.4% 58.0% 57.8% 57.5% 57.3% 57.1%
Gross Profit 2,573,800 2,753,900 2,920,964 3,081,616 3,258,700 3,437,737 3,626,530
Gross margin 40.5% 41.6% 42.0% 42.2% 42.5% 42.7% 42.9%
Operating expenses:
Selling, General and Admin 1,537,700 1,570,100 1,669,122 1,752,578 1,840,207 1,932,217 2,028,828
EBIT - Operating income 1,036,100 1,183,800 1,251,842 1,329,038 1,418,493 1,505,519 1,597,702
Interest expense: Debt (60,900) (59,300) (52,559) (27,655) (17,875) (17,875) (17,875)
Other Income (expense) 5,700 9,700 2,000 2,000 2,000 2,000 2,000
Income before provision for income taxes 980,900 1,134,200 1,201,282 1,303,383 1,402,618 1,489,644 1,581,827
Tax rate 22.9% 27.1% 27.0% 27.0% 27.0% 27.0% 27.0%
Provision for income taxes 224,600 307,400 324,346 351,913 378,707 402,204 427,093
Net Income from continuing operations 756,300 826,800 876,936 951,470 1,023,911 1,087,440 1,154,734
Unlevered Free Cash Flow (FCFF) 831,256 854,428 895,247 897,073 952,536 1,006,369 1,064,437
Present Value of unlevered FCFs 821,327 755,049 735,532 712,937 691,811
Discount rate 9.0%
Terminal EBIT Multiple 12.00 x
Terminal Value Growth rate 4.0%
Terminal Value 22,140,289
Sum of present value of cash flows 3,716,656
PV of Terminal Value 14,389,669
Enterprise value (PV) 18,106,325
Terminal Value % EV 79%
BS adjustment (deducting debt) (484,702)
Implied Equity Value 17,621,623
Implied Price per share 129.71
Margin of safety 13.0%
Potential gain 15.0%
Diluted Equity Value (in thousands) 15,326,147
less cash (1,291,900)
less marketable securities (620,800)
less other Hidden assets / Redundant assets
plus debt 1,413,600
plus minority interest
plus preferred stock
plus pension 767,900
plus other liabilities 215,902
Enterprise Value 15,810,849
Rockwell Automation (ROK) Thomas F Harris CPA,CA
20 of 22
Charlie Munger Test
“With respect to margin of safety, Charlie frequently suggests
that investors can benefit from following the ‘Big Idea Model’ of
redundancy from engineering. Bridges are designed with backup
systems and extra capacity to prevent failures – so too should
investing strategies” – Poor Charlie’s Almanack
Hypothetical competitor?
In Charlie Munger’s 1996 talk “Practical Thought About Practical Thought” he
reinvents Coca-Cola from first principles. I think it is useful to ask an analogous
question. With a large sum of capital, $5 billion for instance, how difficult or easy
would it be to create a competing business?
A true competitor to ROK would require an investment in: R&D for >300,000
hardware and software products, sales, distribution, manufacturing, industry
experts, and switching costs.
These seem like extraordinary obstacles to overcome. The biggest problems are
the fragmented nature of both the product portfolio and the customer base. It
would not just take money, it would a great deal of time to enter this market.
What could go wrong?
“Invert, always Invert” – Carl Jacobi (and repeated by Munger)
Mr. Munger uses his mental models to search for disconfirming evidence.
Inflation
As discussed earlier, it seems that Rockwell has some degree of pricing power.
The company’s increasing Gross Margins give some comfort the Rockwell would
be able to pass on costs to the consumer.
Deflation / Economic downturn
Deflation would likely be a cause for concern. Deflation would likely hurt the
ability of Rockwell’s customers to pay for capex.
In 2009, organic sales fell 19%. However, the company took quick action to
manage inventories, receivables, and capex. This allowed the company to earn a
profit in 2009, despite the harsh environment.
Rockwell’s dependence on its customer’s capex is unavoidable, so the company
will be exposed declining sales during the next crisis. However, the company’s
low capital intensity, high FCF generation, strong balance sheet, and high margins
will reduce the pain.
Foreign currency
The company receives revenue in foreign currency, but it also manufacturers
abroad. To some degree FX risk is mitigated this way. Furthermore, the company
does not have major exposure to any one country aside from the US.
Black or Grey swan in manufacturing
A black or grey swan in manufacturing would be a concern. What could possibly
destroy Rockwell’s moat?
Rockwell Automation (ROK) Thomas F Harris CPA,CA
21 of 22
Could artificial intelligence disrupt the need for employees? Imagine IBM had a
version of Watson which could manage a manufacturing process. Could IBM
disrupt Rockwell? This seems unlikely because of the fragmented and
heterogeneous nature of Rockwell’s customer base.
3D printing
Will 3D printing revolutionize the manufacturing process? Currently, 3D printing
is mostly used for custom parts (like a piece of an airplane) and prototypes. One
of the issues is that 3D printers are too slow for manufacturing. This may change
with time and changes in technology.
There are many other challenges for 3D printing to overcome. The materials used
for 3D printing can be expensive, and are limited in scope. It is unclear whether
3D printers can eventually become more economical than a machine automated
process.
In any event, 3D printers are unlikely to affect Rockwell’s business in the next
decade.
A change in the 1 or 2 key factors in the business
What is the most important factor for Rockwell? Perhaps it is the continued
integration of technology into product offerings. Rockwell seems to be the leader
in the industry in this regard.
Accounting issues
The accounting for Rockwell Automation is relatively transparent. The risk of
earnings manipulation is low because the company converts Revenue to FCF very
quickly.
Low capital intensity reduces the risk of asset impairment.
Acquisitions have been negligible, which means relatively low accounting
complexity, lower business risk, and reduced risk of Goodwill impairment.
Environmental
The company has contingent liabilities related to claims of personal injury from
exposure to asbestos. Asbestos was used in some components in the past. These
claims have existed for a long time. So far, they have not lead to significant
charges, nor does it appear that they will.
Are there hidden environmental issues? Food safety regulation is generally a
good thing for Rockwell. Could Rockwell be blamed for anything in their
products which is potentially toxic, like BPA in plastic? Even if these risks exist, the
likelihood that damages would be exorbitant are low.
Pension
Rockwell has a large pension. One of the biggest concerns is that the Expected
return on plan assets is 7.5%. If the Pension is unable to meet this return, the
funding shortfall will be a large unexpected cost.
Risk is mitigated to some degree by the company’s strong balance sheet, and FCF
generation. However, there is pressure on the Pension to meet the return
expectations.
Rockwell Automation (ROK) Thomas F Harris CPA,CA
22 of 22
Competitors
Rockwell’s competitors are large and global. If competition increases, could a
price war start? For this to happen, the industry growth would have to disappear.
What could cause industry growth to slow that much? There are still many
opportunities for growth in emerging markets. Slowed growth is unlikely for at
the least the next few years.
Are there any large, resourceful companies who might be interested in entering
the market? Perhaps a technology company seeking to capitalize on the Internet
of Things. The fragmented nature of the products is a tough barrier to crack, even
for a large company.
Could Amazon compete with Rockwell? Amazon is a reseller. They may be able to
encourage some Chinese brands to sell online. However, Amazon is better at
replicating the model of brick and mortar resellers. If Rockwell outsourced and
resold their hardware, then perhaps Amazon would be able to compete. But it is
much harder for Amazon to compete in this market because they do not have
manufacturing abilities, or the industry expertise to sell the product.
Investor psychology
Is the stock hyped? Are optimistic growth assumptions priced in? No. The current
stock price implies a roughly 5% revenue growth rate.
Employee psychology
Are employees satisfied? Are they treated respectfully? Rockwell Automation has
a rating of 3.8 / 5.0 on Glassdoor.com from over 400 reviews. This is a good
score. The CEO gets a 90% approval rating.
Consumer psychology
What could change about consumer psychology? In a prolonged economic
downturn, would companies consider the purchase of lower quality,
commoditized versions of the Rockwell’s products from China? A prolonged
downturn would certainly hurt Rockwell, but it is not likely that customers would
quickly turn to low quality. Rockwell’s products integrate with key parts of the
customer’s value chain. Rockwell would probably be one of the last places that
the customer thinks of cutting costs.
Conclusion
After carefully considering what could go wrong with business, I think Mr.
Munger would be happy with Rockwell Automation’s risk profile.
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