Over the last decade Rockwell Automation (ROK -0.97%) has treated income investors to market-beating returns, courtesy of its strong dividend growth.
ROK Dividend data by YCharts
There are three reasons I think this industrial free cash flow growth machine might remain a great income stock in the long term: strong growth in emerging markets, improving profitability, and continued strong dividend increases.
Emerging markets are a growth catalyst
Rockwell's last conference call revealed strong sales growth in key emerging market economies that bodes well for its future. For example, Latin America reported 18% organic sales growth in the first quarter on the back of 10% growth in both Brazil and Mexico.
The reason for this strong growth in Latin America is partly due to that region's heavy exposure to mining and mineral extraction.
Rockwell's integrated architecture and intelligent motor control systems are proving popular in the mining sector because they help operators maximize energy efficiency and reduce costs. This allows miners to reduce their break even costs and become more competitive in global commodity markets.
While China's 2% quarterly organic growth decline probably wasn't a surprise to investors who have monitored the nation's slowing industrial growth rate but India prove a strong counterweight, with organic growth up 9% year over year.
Strong growth from India is partially a result of improved sales of workforce training software -- important in India's fast growing IT industry -- that helps employers improve their workforce by detailing an individual employee's weaknesses and generating improvement plans.
Improving profitability is growing its free cash flow margin
Management is guiding for roughly 4% organic sales growth in 2015, but expects that growth to be offset by a stronger dollar. That means it's critical that Rockwell improve its profitability and free cash flow, which fund the generous buyback program and growing dividend.
As this chart shows, over the last five years Rockwell has consistently grown its margins and free cash flow.
ROK Free Cash Flow (TTM) data by YCharts.
For 2015, Rockwell expects operating margin to improve another 20 basis points to 21%, which should help drive free cash flow margin -- the percentage of revenue converted to free cash flow -- to yet another new record from its already strong 14.8% in the last quarter.
In the last decade Rockwell's free cash flow margin has improved 37%, from 10.8% to 14.8%, which has allowed it to convert slow 2.8% CAGR sales growth into 5.8% CAGR free cash flow growth.
I expect this trend to continue because Rockwell has proven itself very good at reducing costs and generating stellar -- and improving --gross margins over time. For example, in the last quarter alone its Architecture & Software segment generated gross margins improved 90 basis points to 31.3%, while its Control Products & Solutions segment's gross margin improved 150 basis points to 14.5%.
Exceptional shareholder cash return program should drive market-beating returns
ROK Stock Buybacks (TTM) data by YCharts.
The best way for a slow growing free cash flow generating company to maximize shareholder value is to return it to shareholders in the form of buybacks and dividends. By cutting down the number of shares, free cash flow per share rises. This means faster dividend growth can be achieved, which numerous studies show is the key to growing the share price over the long term.
Over the last decade Rockwell has reduced its share count at an impressive 3.1% annual rate, which has helped free cash flow per share to grow by 8.2% -- three times faster than sales.
Even more important, the company has $884 million remaining in its existing shareholder buyback program, which at its current annual repurchase rate of $668 millionwould take just over five quarters to complete and reduce the share count by an additional 5.8% at the current share price.
With improving gross margins Rockwell's free cash flow should improve this year and allow for its aggressive buyback plan to repurchase 4.4% of its shares in the next year -- an acceleration from its already-impressive 10-year buyback rate. That in turn should allow the company to continue growing its dividend by 11% to 12%, as it has in the past year, and over the last decade.
The Foolish takeaway: Despite headwinds, Rockwell's share price has strong growth catalysts
Don't get me wrong, potentially slowing industrial demand in the U.S. -- especially from its oil and gas segment -- and a strengthening dollar mean 2015 isn't likely to be a year of record sales growth for Rockwell. However, its continued strength in developing markets, improving margins (particularly a strong free cash flow margin), and continued large share buybacks and dividend growth should inspire confidence in long-term income investors that Rockwell has what it takes to beat the market over the long haul.
