One of the stocks we are considering adding to our portfolio is Rockwell Automation (ROK, Financial). The company is a leader in industrial automation technology and we believe it will play a critical role in the global economy going forward and the typical Warren Buffett (Trades, Portfolio) style good company at a good price. The company is attractive to both dividend investors with a yield of over 2.5% as of this writing and for investors looking for capital appreciation.
The key investment thesis for Rockwell Automation revolves around the cost and availability of labor around the globe and the role automation will play in the coming decades. The two graphs below show the unit labor cost in a variety of low wage countries and in China (the particular graph shows China versus Mexico).
(Graph via Supply Chain Digest)
(Source: U.S. Dept. of Commerce)
Some of the world’s most populous countries including China (number one in population in the world), Indonesia (4), Brazil (5), the Philippines (12) have all seen wages rise and in some cases rise significantly. I could not find data for Indian (2) labor rates over the same time period, but I did find data from 2003 to 2007, which showed wages rising at a compound rate of 7.6%.
In developed countries, wages have been relatively stagnant but many face a problem of declining population. Export powerhouse Japan is probably well-known as the poster child of this phenomenon as its population has been shrinking for some time. Other countries such as Germany and Denmark have or are facing declining populations in the future (without additional immigration). It’s also worth mentioning that China too will be facing a population decline in the future.
All of this means that automation of manufacturing and other industrial processes will take on increasing importance all over the globe. In countries where labor is cheap, rising labor costs will make automation more cost efficient and in countries with declining populations, the lack of available workers will make automation a necessity.
Additionally, the secular trend of rising income levels in emerging markets will drive demand for more consumer products. The food, beverage and pharmaceutical industries should drive long term secular growth for factory construction and automation.
There are many ways to “play” this investment thesis. Numerous companies provide industrial automation products and services. We like Rockwell Automation for one simple reason: We believe it has one of the widest moats in the space.
Over the past decade Rockwell’s average return on invested capital was 26% compared to an average of 14% for a group of peer industrial companies (EMR, DOV, ITW, HON, MMM, FLS, JCI, SWK, and CR).
We believe there are two main reasons for this. First, Rockwell is a manufacturing and software company and software is a naturally higher margin, higher return business. Second, Rockwell’s automation products have very high switching costs and the sector has high barriers to entry.
Rockwell’s product lines have significant barriers to entry for two very important interrelated reasons. It is very difficult for competitors to break into the industrial automation sector because of the trust Rockwell (and their peers) have built up over the decades. If you were the engineering team designing a $1 billion chemical plant or the latest and greatest food processing plant would you want to trust mission critical parts of that plant to an unknown or little known generic product? No, you want something you know works. The reason is money. Sure, a competitor’s product may cost less upfront but the cost savings pale in comparison to the costs a business would incur if a critical part of a plant failed. This is the main thing that helps Rockwell and its peers stay entrenched. Their products, while expensive on an absolute basis, are extremely cheap on a relative basis when compared to the millions or even hundreds of millions of dollars at stake if something should fail. What management team would want to save a thousand dollars to risk a million dollars?
You can verify the barriers to entry by looking at how stable market share has been in the industry. Rockwell Automation, and American company dominates the North American market for industrial automation. Siemens, a German company, dominates Europe and Japan based Mitsubishi dominates the Asia-Pacific region. The industry is basically split among those three companies while a few others like Schneider, ABB, Omron, Fuji, and GE are minor players.
You can also verify Rockwell’s competitive advantages are based on barriers to entry and high switching costs by examining how the company spends money. The industry does not have high R&D spending requirements and capital spending levels are low. Rockwell spent just 4.87% of sales on R&D expenses during its last fiscal year. Yes, Rockwell conducts R&D and invents and patents new products. But R&D doesn’t serve as the main source of a durable economic moat like it does for the pharmaceutical industry where patent protected drugs allow the companies to earn outsize returns. Likewise low relative capital spending requirements point to economies of scale not being a significant source of an economic moat. Capital expenses have averaged just $136.7 million over the past three years for Rockwell.
We prefer Rockwell Automation over Siemens or Mitsubishi because Rockwell is more of a pure play industrial automation company, while Siemens and Mitsubishi are industrial conglomerates saddled with other lower return on capital businesses. Even though Rockwell’s strength is the North American market and our investment thesis views emerging markets as a significant opportunity, we still believe Rockwell can capture significant market share abroad and it makes a better investment then its competitors.
Risks
While we like Rockwell, the stock is not without risks. The company derives 12% of its revenue from the oil and gas industry. This is more of a short-term risk than a long-term concern for the business. Commodity prices are volatile and oil is sure to rise again (when and how high, I don’t think anyone knows).
The company also derives a significant portion of its revenue from overseas with 45% of revenue for the last fiscal year coming from outside the U.S. Thus, the strength of the dollar and foreign exchange rates can have a significant impact on the company’s future profit growth. The recent appreciation of the dollar has put a dent in Rockwell (and many other industrial companies) earnings. Like the oil and gas issue, this issue is likely to resolve itself for long-term investors. Over a long time horizon, foreign exchange fluctuations are likely to net out to neutral (the foreign exchange market after all is zero sum).
Probably the biggest risk is the cyclical nature of the business. There is just no getting around the fact then when the economy slows or enters a recession businesses cut back severely on opening and modernizing new plants. It isn’t and never will be a stable consumer staples company. Investors buying Rockwell stock will just have to make peace with the fact that there will be many ups and downs on the road of owning stock in Rockwell.
Another area of minor concern is that purchases of Rockwell products are not repetitive in the same way say purchases of food and beverage products are. Indeed, Rockwell’s products are designed to (and do) last several decades. However, very few factories and plants stay in their original configuration and original location for decades. Industrial sites are constantly being opened, closed, and moved around the world. Production lines are being closed, expanded, or upgraded. There is always something going on and Rockwell benefits from the fact that once a customer has installed their products they tend to keep using them as switching costs are high. So, all of the changes across a company’s manufacturing footprint tend to lead to repeat purchases like a consumable even if Rockwell’s products aren’t technically a consumable item.
On the whole we think the long term rewards of owning a stock like Rockwell far outweigh the risks. We haven’t fully completed our due diligence of the company so we haven’t bought the stock yet. If you own Rockwell stock, are thinking about owning it, or have experience with the company we’d love to hear your thoughts. Feel free to respond in the comment section below or send me an email at [email protected].
