Rockwell Automation's (ROK -1.85%) $2.2 billion deal to buy industrial cloud software company Plex Systems is the latest in a long line of industrial companies buying software entities. And if industrials are not buying software companies -- like Rockwell and trailblazer Roper Technologies (ROP 0.15%) have -- they are investing internally to develop software capability, just as Honeywell International (HON 0.38%) is doing. What's going on, and why is it a "thing"? Let's take a closer look.
Digitization is driving the growth strategy of three industrial companies. Image source: Getty Images.
Why the investments matter
The software investments are essential and positive for investors for two reasons:
- They are a natural and necessary development, as more of the productivity in industrial companies' solutions are likely to come from the software side due to the growth in the Internet of Things (IoT) and digitization.
- The shift toward more software revenue usually means higher margin, higher recurring revenue, and should translate to investors valuing these businesses somewhere between a traditional industrial company and a software company.
Roper Technologies
Let's dwell on the second point for a moment. As noted above, Roper Technologies is somewhat of a trailblazer in the shift to software, and as you can see below, its valuation and gross margin rose over the last decade as a consequence.
Data by YCharts.
Indeed, a decade ago, Roper Industries (as it was known back then) was primarily an industrial products company. The shift in the company's emphasis shows up in the change in segments and revenue generation over the years.
|
2021 Segment |
2021 Revenue |
2011 Segment |
2011 Revenue |
|---|---|---|---|
|
Application Software |
$1.8 billion |
Industrial Technology |
$737 million |
|
Network Software & Systems |
$1.74 billion |
Energy Systems & Control |
$598 million |
|
Measurement & Analytical Solutions |
$1.47 billion |
Medical & Scientific Imaging |
$611 million |
|
Process Technologies |
$519 million |
RF Technology |
$851 million |
|
Total |
$5.527 billion |
Total |
$2.78 billion |
Data source: Roper Technologies.
The exciting thing about the shift is that it's come about organically and partly due to following Roper's business model. In a nutshell, management buys leading businesses in asset-light, niche industries with high margins. The businesses are then run on a decentralized basis, but the cash flow generated from the disparate businesses is then deployed centrally to make more acquisitions.
It's a business model that's resulted in a shift toward software, and management is clear that its acquisition targets are "primarily software and networks." An excellent example is the $5.35 billion acquisition of Vertafore, a provider of property and casualty insurance software-as-a-service, in the fall of 2020.
Image source: Getty Images.
Rockwell Automation
The shift toward software at Honeywell and Rockwell is also coming about through an organic process, namely the explosion in growth in digitization and industrial IoT. Through internet-enabled devices embedded in physical assets, factories and building owners can digitally model, monitor, and analyze their performance. As such, Rockwell can add value to its automation solutions by integrating with digital technologies.
That's the reason Rockwell has invested in a partnership with industrial software company PTC. Similarly, the acquisition of Plex (with its smart manufacturing platform) is a complementary fit and adds value to Rockwell's automation solutions.
Rockwell is unlikely to be priced as a software company anytime soon. Still, over time you can expect its margin and valuation to rise as the quotient of its sales in digital applications increases.
Data by YCharts.
Honeywell International
CEO Darius Adamczyk wants Honeywell to be known as a software-industrial company. It's an aim that highlights the investment Honeywell has been making in digital capability, not least in its software and digital solutions capability, known as Honeywell Forge. A company that makes everything from power units on airplanes to building controls, process automation, chemicals, safety equipment, and warehouse automation is never going to be viewed as a software company.
However, Honeywell Forge's solutions cut across the whole swath of the company's industrial businesses and add value to all of them. For example, by analyzing aviation data, Honeywell Forge can increase airline profitability. In addition, buildings can be made more efficient (not least to meet emissions aims), and industrial data helps generate actionable insights to improve asset performance.
Stocks to buy?
On the one hand, Roper, Honeywell, and Rockwell don't look like cheap stocks right now, and this might not be the best time to initiate a position.
Data by YCharts.
On the other hand, they all look likely to increase margins and their revenue and earnings growth in the future by increasing their software applications. In addition, recurring revenue from software and services means their earnings will be more stable. All these things suggest these companies should be valued at a premium to traditional industrial companies.
In other words, investors can see their stocks rise because earnings are growing and the price that the market is paying for those earnings (valuation) is going up too.
