It's never easy being an investor, and it's no simple task in the current environment. While the events of 2020 may seem awhile away now, they are still having a significant and complicated impact on matters going into 2024, which can be seen in the trends in Rockwell Automation (ROK 1.15%). Here's why and what investors must consider before putting money to work here.
The considerable debate going into 2024
The question facing investors, and mainly those interested in a cyclical sector like industrials, is this: We know the manufacturing and industrial sector is slowing, and high interest rates curtail economic activity, so it's natural to expect some slowdown. Indeed, the data and anecdotal evidence from leading companies suggests a slowing. However, how much is it due to economic forces extending through 2024, and how much is due to temporary factors caused by the aftermath of actions taken during the pandemic?
The problem is that the headline data will look the same in both cases, but the outcome in 2024 will differ depending on which factor has more weight. If it's mainly due to end-demand weakness, then companies could continue to report disappointing earnings. At the same time, if it's primarily due to an inventory correction, orders will grow again -- something Rockwell's management expects will happen for its business.
How the pandemic distorted orders growth
By "temporary factors," I'm referring to the supply chain crisis created by the lockdowns and the distorting impact on the economy caused by political decisions. The difficulty of obtaining key components (not the least, semiconductors) led to extended lead times for product delivery at companies like Rockwell and vast swaths of the industrial sector.
When customers (including product distributors) see extended lead times for equipment, they tend to increase orders to ensure they have enough products available for use/sale. That is precisely what happened with industrial automation companies like Rockwell.
You can see just how much its backlog grew from 2019 to 2022 in the chart. CEO Blake Moret addressed the issue on the earnings call in November 2022: "We have about 60% of the full year in backlog. Typically, we have about a month."
Clearly, that kind of orders and backlog growth is not sustainable, and it's reasonable to expect both to correct as lead times correct. Indeed, CFO Nick Gangestad prepared investors for the possibility for a decline in orders and backlog in 2023: "If we started to see some reduction in the backlog driven by reductions in our lead times, we would see that as healthy."
Data source: Rockwell Automation.
As the chart demonstrates, there was a decline in the backlog to the end of fiscal 2023 (Rockwell's year ends Sept. 30).
But here's the critical point: The decline in orders and backlog is more than management previously estimated, implying that end-market conditions are worse than expected. The table shows the progression of guidance, actual full-year orders, and year-end backlog.
|
Full-Year 2023 |
April Estimated |
August Estimated |
Actual |
|---|---|---|---|
|
Orders |
$9 billion |
$8.5 billion to $9 billion |
$8.2 billion |
|
Backlog |
$5 billion |
$4.5 billion to $5 billion |
~$4.1 billion |
Data source: Rockwell Automation presentations.
What Rockwell Automation's management said
Moret believes its recent fourth quarter represents a trough in its orders and sees orders recovering in the first two quarters of fiscal 2024, with overall orders increasing by low single digits in 2024. It's a view supported by the order progression through its fourth quarter (July/August/September), with Moret noting, "We saw orders exit at a higher rate than at the beginning of Q4, and then with a good uptick from that sequentially in October."
In addition, Moret noted that its distributors' incoming orders from their customers are "higher than what they're, in turn, placing on us," implying end demands are good. Furthermore, if Rockwell Automation were seeing deteriorating end-market conditions, then its order cancellation rate would be increasing.
Indeed, two of the best analysts in the industrial sector, Vertical Research's Jeffrey Sprague and J.P. Morgan's Stephen Tusa, both asked about the issue on the earnings call, with Moret replying to Tusa, "The cancellations were in a similar range to what we've been talking about, which is to say they were not the major contributor to the orders decrease."
Image source: Getty Images.
What does it all mean for investors?
It's a confusing picture, and the 2024 outcome will also depend on economic developments. That said, it's worth noting that the $4.1 billion in current backlog represents "over 40% coverage of annual sales, which is still well above pre-pandemic levels," according to Moret.
As such, I think there's potential for order growth to disappoint expectations in the coming quarters as customers continue to run down inventory, and Rockwell's backlog has the potential to decline previous levels in relation to sales.
All of this is not to question the long-term outlook for Rockwell; it remains excellent. Moreover, if its distributors continue to see sales growth and order cancellations aren't rising, then Rockwell's end markets appear to be in good shape.
However, if you buy into the stock and other industrial companies, you have to be willing to ride some potential for bad news over the near term -- the inventory correction may not be over just yet.
