Rockwell Automation (NYSE:ROK) recently released first-quarter 2015 earnings that substantially beat Wall Street's expectations. However, the real story is one that Wall Street is all but ignoring -- and it's why I think this under-the-radar dividend-growth industrial company deserves a spot on your income investing radar.
Rockwell announced slightly better than expected sales of $1.574 billion -- 1% above analyst expectations and down 1% from last year due to a strongly appreciating dollar hurting the company's overseas segments. However, the story, as far as Wall Street is concerned, was the company's 11% EPS growth, which came in at $1.56, 10% above expectations.
Incredibly strong where it matters most
While Wall Street may be focused on short-term earnings and sales, I advise investors to focus on what matters in the long term: profitability and free cash flow.
On the margin front, Rockwell reported gross margins increasing by 200 basis points to 43.7%. Meanwhile, net margins increased by 110 basis points, from 12.4% to 13.5%.
This 4.7% and 8.9% respective growth in gross and net margins was made possible by a 4% decrease in cost of sales, strong productivity growth, and a low 0.2% offset caused by an increase in general and administrative expenses.
However, what I'd like to focus most on is the metric Wall Street is ignoring but that represents one of the most important metrics to dividend-growth investors: free cash flow.
Rockwell's growing free cash flow margin spells great news for future dividend growth
Free cash flow is what's left of the money flowing into the company after all expenses have been paid and future growth invested in. It's what helps build a company's store of cash from which to return cash to shareholders in the form of buybacks and dividends.
An often ignored metric is the free cash flow margin, or percentage of sales converted to free cash flow. Rockwell's latest quarter saw free cash flow soar 30.2% from $179 million in last year's quarter, to $233 million today. This indicates that the company's FCF margin jumped from 11.2% to 14.8%, a 360-basis-point, or 32.1%, increase.
What really gets me excited is that Rockwell has a long history of improving its FCF margin. In fact, between 2005 and 2014, its FCF margin has increased at an annual compound rate of 2.26% -- from 10.8% to 13.5%.
This quarter's figure of 14.8% gives me confidence that Rockwell will continue its 10-year trend of growing free cash flow 80% faster than sales, 5.11% per year versus 2.85%, respectively.
Now, you might be wondering why I'm getting excited over what seem like pretty small growth rates. The answer lies in the fact that Rockwell is doing what I believe most stable, slow-growth, free cash flow-rich companies should be doing to maximize shareholder value: boosting its free cash flow per share through the use of aggressive share buybacks. In fact, over the last decade, the share count has declined by an annual compound rate of 2.85%. This has caused free cash flow per share to soar 8.22% per year, from $2.90 per share in 2005 to $6.39 per share in 2014.
This growth in free cash flow per share, along with a low FCF dividend payout ratio of 36%, has allowed Rockwell to convert 2.85% sales growth into 12.8% compound annual dividend growth over the last decade.
Risks to watch going forward
As much as I admire how this slow-growing industrial company has managed to reward shareholders so richly in the past, there is one thing in particular that concerns me about Rockwell's future: the damage the rising dollar poses to the company's performance. Management is forecasting that a strong dollar in 2015 will negatively impact sales by 4.5%. The strong dollar is courtesy of quantitative easing, or QE measures, in Europe and Japan that are weakening the euro and yen, respectively.
With the yen and euro facing weakness because of central bank money printing, I think the dollar might strengthen in 2015 more than Rockwell's management is currently planning for. This is because the U.S. Federal Reserve recently reiterated its plan to be "patient" but still raise interest rates later in 2015. This would likely only increase the dollar's appreciation against competing currencies and potentially hurt Rockwell in the future more than it expects.
While it's logical to assume that management has planned its guidance around this expected interest rate increase, depending on how Europe's and Japan's QE programs affect their currencies, there is a risk that the anchor of a stronger-than-expected dollar might drag down full-year results. While I am not concerned with a single year of currency-induced sales weakness at Rockwell, several years of strong currency headwinds might hurt not only sales, but also the company's ability to grow free cash flow and, ultimately, the dividend.
Bottom line: A strong quarter for profit and free cash flow, but currency worries are growing
Rockwell delivered strong growth in earnings per share, but blew it out of the water with free cash flow margin, where I think it matters most. This points to strong growth in the company's efficiency at reducing costs and maximizing productivity, and it bodes well for long-term dividend growth. However, potential and current investors need to be aware that the strengthening U.S. dollar poses a growing threat of unspecified duration that could impact the company's sales and, eventually, free cash flow and dividend growth.
Adam Galas has no position in any stocks mentioned but one day hopes to own shares of Rockwell Automation when his financial situation improves. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.