Following a strong run in 2017, the stock price of Rockwell Automation (ROK +5.37%) corrected a bit following the third-quarter earnings report. In general, it's been a good year for the industrials sector, as U.S. industrial production growth has picked up, creating earnings tailwinds for companies such as Rockwell that have heavy exposure to cyclical capital spending.
That said, the industrials sector could face a tricky period in the second half of 2017. Does that mean it's time to sell stock in Rockwell Automation?
Potential headwinds
Looking into the back half of 2017, there are a few potential developments that investors in the industrial sector ought to look out for:
- A bunch of industrial companies benefited from China GDP growth of 6.9% in the first two quarters -- the government's target is for full-year GDP growth of 6.5% -- and growth may slow in the second half.
- According to industry analysts, global automobile production growth will slow in the second half and turn negative in North America -- not good news for companies like Rockwell Automation.
- After a good recovery in 2017, it's possible that U.S. industrial growth has peaked and may tail off, which could create headwinds for industrial stocks.
China
The company's sales in Asia grew more than 20% in the third quarter -- China growth was itself around 20% -- and contributed 30% of overall growth. Things could always slow down in China, but Rockwell CFO Patrick Goris argued that the country's growth was "more balanced than before," with heavy industries set to grow strongly and support already strong consumer and transportation growth.
Image source: Getty Images.
Automotive
Rockwell's transportation sales were up strongly in the third quarter, with automotive-derived sales up more than 20%, according to CEO Blake Moret on the earnings call.
The question is, what happens to Rockwell's growth if automotive sales and production slow down? Moret acknowledged that falling car sales would affect the company over time, but he also mentioned a couple of secular growth drivers that could mitigate matters.
Moret argued that U.S. automotive has "been a particularly a fertile ground for us in the information and connected enterprise pilots." "Connected enterprise" refers to the process whereby companies connect smart devices to monitor and optimize their industrial operations, and it's the key long-term secular trend driving growth at Rockwell.
In addition, Moret referred to the "the diversity" of where Rockwell's auto related growth was coming from. He mentioned electric vehicles and demand coming from customers making "model changes and expansion geographically." In other words, Rockwell could generate growth from these particular growth drivers rather than purely relying on global automotive sales and production growth.
Industrial activity
Looking at Rockwell's exposure to overall industrial activity -- as measured here by the Institute for Supply Management's (ISM) Purchasing Managers Index (PMI), where a reading above 50 indicates growth -- it's not hard to see a correlation:
ISM Purchasing Managers Index data by YCharts
And here is Rockwell's organic sales growth:
Data source: company presentations. Chart by author
Responding on the earnings all to a question about long-term growth, Moret had this to say:
The macroeconomic indicators are solid, so PMI continued strong in most spots around the world. Industrial production continues largely unchanged from the last quarter. So we do feel like we're in a period of expansion.
What to do with Rockwell's stock
The potential headwinds are a cause for concern, but aside from the fact that they might not even occur, there are two reasons to feel optimistic. First, Rockwell has underlying and secular growth prospects from the Industrial Internet of Things and the diversity of its earnings drivers.
Second, I would argue that Rockwell's valuation is undemanding on a cash flow basis. Management's updated full-year 2017 adjusted EPS guidance assumes $6.70 at the midpoint, and the company expects to convert 115% of income into free cash flow, up from a previous estimate of 105%, implying that Rockwell will generate around 4.9% of its enterprise value -- market cap plus net debt -- in 2017. That should help limit the downside just in case Rockwell faces some near-term earnings headwinds. Meanwhile, its long-term prospects remain very positive.
