Rockwell Automation, Inc. (ROK) Earnings Call Transcript & Summary

Well, thanks very much, everyone, for attending this first fireside chat of the Barclays Industrials Conference. My name is Julian Mitchell, the multi-industry analyst at Barclays. It's my pleasure to have here from Rockwell Automation, Nick Gangestad, CFO; and Brian Shepherd, who heads up the Software & Control division at Rockwell. You'll see up there, there's the QR code behind you. Please, if you can open it up, there's half a dozen questions that will take maybe 30 seconds to fill out, if you wouldn't mind doing that. And any questions, you can submit through that portal as well, and I'll read them out or else put up your hand, and you can just ask it directly and we'll go from there. So with that out of the way, I think we'll start off with a couple of questions around firstly being demand environment.

And so maybe, Nick, I realize Rockwell is a fairly short cycle business, but you have a good backlog now. It's a very global business in different industries. So maybe characterize for us how you see this demand outlook playing out. The last 10 or 15 years were kind of quite choppy for industrial spending, 2 years up, 1 year down for various reasons. Does this up cycle feel different to that trend? Any broad thoughts on that, please?

Yes, Julian, thanks for having us, and thanks for the question because we do actually think that this one feels different. We've been saying for 2 or 3 quarters now that we think we're in a period of several years of expansion in the automation space. And there's a few things causing that for us to have that view. First is there's some secular things going on of what we're finding with our customers and their need for labor and the availability of labor, the availability of -- the precedent of higher wages, that's just causing what we think is a secular higher demand and interest in automation of places that they haven't looked at automation before. Also, from the pandemic, we've seen customers looking for more agility and resilience in their own manufacturing that what they saw in the last couple of years has caused them to see there's some things they want to change in how they manufacture and the need to have more agility that if something else happens to them that they're able to keep putting their throughput in a way that they saw themselves constrained this year or in the last 2 years. So those are some of the secular things we see going on. From a cycle standpoint, we still see ourselves early in the cycle. We still see ourselves early in the cycle because many of the industries that we are serving, semiconductor, electric vehicles, battery, pharmaceutical, e-commerce, these are all places where the amount of announced committed capital is a very high level, and it's not just for the next 1 or 2 years, these are the next 5-plus years that they've talked about the amount of capital that they're putting into this and the preponderance or the -- of automation as a part of that, to us, appears to be going up. So those are a lot of the things that cause us to see this one feels different than other cycles we've been through.

Perfect. And then in the very short term -- sorry, just stay where you are. In the very short term, Rockwell has had outstanding orders growth for several consecutive quarters. I think everyone is trying to figure out how much double ordering in there or excess ordering and how quickly then could we see that pace of orders growth decelerate over the balance of the calendar year. I realize you don't formally guide for orders normally, you have given some color on it this time, which I think is very interesting. So any sort of views around that pace of orders slow down?

Yes. Again, thanks for bringing that question up. And you're correct in saying we don't normally guide on orders. Normally, in a normal economic pattern, there's a close enough correlation between our demand and orders being placed with us and what we're seeing with revenue that we don't often give that type of color. But in the last year, 1.5 years, we felt the need to be very clear about what we're seeing on the order side as well as what we're seeing on the revenue side because I think both are important things for our investors to be understanding. In the first quarter, our first quarter of our fiscal year, we saw orders of $2.5 billion, which was a noticeable record for Rockwell. And what our analysis of we went through, how much of this do we feel is -- are orders being placed in advance of when they normally would be by -- because of extended lead times we have on some of our products, where -- what is our data telling us about the amount of those orders that we think really are out of period and are a pull-forward into the first quarter. Our analysis going out in a couple of different ways indicated we think about 10% of that $2.5 billion was really orders that normally would have been in future periods. So the underlying, I'd say, we felt was $2.25 billion of orders related to current demand. And then we also guided that -- for the first time, we guided that we now expect orders to exceed $9 billion -- $9 billion plus in 2022. And that could continue at the very run rate that we're at now, it could go up even more. In terms of some of the pull-forward that we've seen of orders, we don't -- partly, we're saying we don't know exactly when to expect that to reverse. It could be later this year, it could be in '23. It might be never in some scenarios that it stays that way. So we're not trying to indicate that we see a peak in order demand and then it's going to start to come down. But we do see in almost in every scenario we go through for '22, we will certainly be building backlog, that we're seeing our order demand exceeding our ability to ship out, thus increasing our backlog in '22.

And I think related to that point on backlog, many of the industrial companies at this conference, including Rockwell, you've seen your sort of inventories building up, not just in dollar terms, but as a proportion of revenue. And obviously, it has implications for working capital, but I was asking about inventory more in the perspective of when you think about your customers, your channel partners, do you worry that there are pockets out there of high inventories on their end? Or do you think it's more of an issue of the manufacturers waiting for the customers to get certain chips or components and then everything can kind of go out the door?

Well, first of all, in Rockwell, we have, in most parts of the world, really good visibility of what's in the channel of our products. And we feel that continues to be lean, and that's understandable, given where we are with supply chain constraints and many of our distributors as soon as we're able to give -- ship a product to them, they're almost immediately then shipping it on to the end customer. So we're not seeing any kind of build of inventory within the channel. In fact, I'd call it on the lean end of what we're seeing there. In terms of inventory that our customers have been holding, we see no indication of that, that there are -- things are tight enough with supply chain that everything that we are shipping out is going into real projects. And we're not seeing a propensity to build up inventory of our products. Now once we get a little further through the semiconductor supply chain constraints that we have, I think in another -- like in another year or 2, I think we could be seeing some customers saying, "You know what, I'm going to start to hold just a little bit of inventory of some of these products that I didn't use to before because I used to always count on getting it from a distributor almost immediately." But I think that's sometime in our future where we'd be seeing that, Julian.

Yes. And then maybe just one more sort of near-term one and then bring in Brian on to talk about software and competition. But the theme of onshoring is very relevant to Software & Control, relevant for Rockwell in aggregate. It's been a popular topic of discussion since mid-2020, very different sort of economic backdrop today versus then. How much evidence do you see is sort of reshoring of capital investment in North America? Which industry verticals do you think are lending themselves most susceptible to that trend right now?

So 1.5 years ago, when we were looking at this, and it was being talked about or even a year ago, it seemed to me to be a bit more anecdotal or theoretical. In the last year, Julian, that's changing. We are seeing really tangible evidence that there is increased capital investment related to North America and shoring there. And there's industries such as semiconductor, you've read all the things I've read on that and the amount of capital going on there within the United States. Electric vehicles, battery, seems a very clear indication of we wanted to situate this manufacturing in the United States. Pharmaceutical, another example of keeping things in the United States, we're seeing that. So those are some of the industries where we're seeing very clear data that tells us that.

Perfect. And then maybe one more for Brian around competitive landscape. Your division is very interesting inside Rockwell, there's aspects of hardware, control capability and sort of raw or pure software. So you see sort of the full gamut of Rockwell's customer offering in that sense. When you think about competition, is that placing a lot of pressure on you to do a lot more acquisitions, take up R&D? Or is the pace of change in industrial automation gradual enough that you can kind of do it in a measured way and the competitive landscape isn't moving that fast.

Yes. I think we're in a position now of a technology adoption cycle that's laid over top of the CapEx cycle that we've just been discussing. And so I think really the time is now, and we're seeing that with customer buying behavior on adding capabilities to their automation systems, that could be additional hardware, additional software for shared services. And we all know in our personal lives or our professional lives, the best products or that seamless integration of hardware and software and services. And so that's a big focus on our portfolio and how we're building out that portfolio.

And if you look at software specifically, I suppose Rockwell had, had this view that most of it should be on-premise for kind of security and latency considerations. The Plex acquisition last year marks a sort of step into the cloud-based world. Maybe talk us through how Rockwell's thinking on that point evolved and how you see that kind of cloud based versus on-premise software capability.

Yes. That's a great question. And we take the customer perspective on that point. So I think when you consider the layers of the manufacturing architecture, the ones closest to production, the closest to real-time control, that needs to be on-premise software. And the analogy we always use is you and your car don't want the airbag software residing in the cloud, right? You need that in real-time control. That being said, there's tremendous economic advantage and scalability and cost of ownership and time to value of being in the cloud for applications that don't have that real-time requirement and can take advantage of cloud capabilities like near-infinite scalability, right? So that's where operations management applications like the Plex Smart Manufacturing Platform in the cloud makes perfect sense. So with that acquisition, we think Rockwell is leading the charge to take manufacturing to the cloud for that set of applications that make sense in the cloud.

And if you look in terms of, say, industry verticals, and this is maybe a question for both of you. You've seen some of the automation companies with more of a process background, ABB, Emerson, Honeywell, for example. They're all talking and trying to move more aggressively into the discrete automation world, which obviously is where Rockwell initially is strongest. Rockwell itself had talked about expanding more into process a few years ago, but maybe our impression may be mistaken is that, that emphasis has -- adds a little bit. So maybe just give us an update on Rockwell's ambitions in the process world, and are you concerned at all about these process players moving more into your domain in discrete?

That's a great question. Let me start with kind of the competitive environment that we see. Of course, we're in a competitive environment and that we never take that lightly. That being said, in our home field, if you will, of discrete and hybrid, we have a pretty good advantage, and we see customers choosing the Logix platform, our control platform, over and over again for a series of technical differentiation reasons, things like integrated motion, integrated safety, a unified software environment for programming across the whole range. Those technical differentiators are not easily overcome. It's a multiyear, not cheap proposition to go after that. But in addition to that technical differentiation of the Logix platform, we have our ecosystem, our big network of distributors. Those relationships go back decades in many cases, a big stable of system integrators. Our own services business that puts thousands of feet on the floor at our customers every day. All of those things, combined with the technical differentiation, make us feel like that home field for us is a great place to build from, and that kind of fuels some of our aspirations for growth in the process industry.

I'll just add a couple of things. We have launched new products and are expecting to launch additional new functionality where our hardware is able -- and our controller is able to handle hybrid, discrete and process. We are estimating that we think process will grow 15% for us this year. It's an important part of our growth story. And we're pleased to see, in fact, just in 1 quarter, it was the only part of the markets where -- of the industries where we actually moved up our view of what we expect in '22.

Perfect. And then just within the software and control division, you mentioned the Logix business just now, a crucial part of Software & Control. Where are we on that path of kind of worrying about the PLC's role on longer term? And that, again, is something that people's concern about that oscillates over time, how satisfied are you with the sort of the software layer that Rockwell is putting on top of that to keep the PLC relevant at the center of plant control?

Yes. I think for a long time to come, there is a role for specialized hardware and factory control, the requirements for safety and redundancy, the requirements for reliability that in a factory environment, for example, consider a tire plant as 1 example, right, not a clean room environment there. And we're also seeing more and more demand for higher-end compute in the control infrastructure, right? So you want to do more edge analytics like right there in the control backplane. So I feel like the hardware trajectory for control, it's on a good path and will remain important for a long time. The software stack on top is an area of considerable investment for us. We do think that there's an ability to do more of that work in the cloud, not needing on-prem software for the design of the factory. And that includes things like digital twin. We have a set of products, including Emulate3D, a new FactoryTalk software offering called Echo that allows customers to build these digital twins of their -- production system of their whole control system and validate that before ever purchasing hardware, investing in machines and laying out the factory floor. So it's a whole life cycle view of factory automation.

Perfect. And then one of the most notable strategic things Rockwell has done in recent years around software has been the PTC relationship. I realize it's also a public company so that limits the amount you want to talk about that relationship. But maybe give us a flavor of kind of where it stands today. It's been 3.5 years, I think, since inception. And also on the PLM sort of cross-selling aspect in particular in software, how much customer update has there been for that? And are you surprised in either direction about the degree of cross-selling synergy advantage having PLM and then a Rockwell control capability?

Yes. Well, that's a great question for me after spending 20 years of my career at PTC. I know that portfolio and technology stack quite well. For a long time, I knew it better than my own portfolio at Rockwell. So I think the synergy between the portfolios, the valuable offerings that PTC provides into the Rockwell go-to-market channels and customer relationships are fantastic. Just before I touch on the PLM part of your question, we've made some improvements there with PTC on packaging, real solutions based on the PTC architecture, things like Vuforia Expert Capture and Instruct or ThingWorx Digital Performance Management. Those are packaged solutions. So it allows Rockwell sellers to take a real solution to market, not a platform, which is maybe where ThingWorx and Vuforia were further back in time, right? So that's a better fit for our channel, direct and partner-based distribution. And then Julian, as I was describing our increased focus on the design part of our customers' production system, there's a true need there for the PLM type products from PTC. But that's in the context not of product design, but in production system design, new machines, new cells, new lines, whole new factories, but that is a system engineering. It is a design problem and PTC's products are great for that.

And how do we think maybe, Nick, at the corporate level about the sort of the shareholding and the Board seat like has -- where are we on that broader?

Yes. We see value in having Blake on the board there. That's something that we place value on. And -- but we did several months ago announced based on the strength of the commercial relationship and our belief that we're in a very solid position there that we have the ability at the right price to be trimming some of our ownership stake. And that's where we changed our filings to say we're now prepared at the right price to take some of that capital that we have invested there and use it in other ways. So our view is we feel this relationship is strong enough that we don't need the same level of ownership that we've had in the past. But we still very much value the Board seat and the leadership relationship we have there.

Perfect. And then maybe one more around software and annual recurring revenue is something that Rockwell has talked a lot more about in the past 18 months or so. I feel like different companies, whether industrials or software, have different definitions of ARRs, so maybe just any succinct way of describing how Rockwell...

Yes, I'll take that.

And then just sort of growth aspirations, how satisfied are you, either of you, with the pace of growth in your ARR business?

So when we started on this, we did quite a bit of benchmarking. And I would agree, there are some variations in how it's measured. We settled on what we feel is the closest to industry standard, if there is such a thing, around ARR. For us, for all our subscription-based contracts that we have of recurring revenue, it's the annualized portion of that at one particular time. And so we snapped the chalk line at a particular time. What are all the contracts we have that have a longer-term aspect of recurring revenue? It also has to meet a criteria that there's a high probability of renewal. If it's just a 1-year contract that we think is going to end, we don't count that as part of the annual recurring revenue. It has to have this high probability of being renewed. And our aspiration is that this grows in double digits for the foreseeable future. We haven't put an end time on that. It may reach a point where we say a different aspiration. But for the next few years, I think that's a pretty good way to think about where we're trying to move that.

Perfect. And then maybe looking at margins for a second, sort of a short-term and a longer-term component. I suppose in the shorter term, Rockwell was later than any companies to see the impact of inflation coming through in its cost of goods sold. You have a lot of component buy in, not people dumping rolled steel at factory doors. So that explains the lag. But where are we on that headwind? How quickly does Rockwell come out of that headwind on cost side impacting margins? And then maybe switching to the longer term, as you get more ARR, Software & Control, maybe is a bigger and bigger piece of the entire company's earnings, that should give a lot of upwards pressure when we think on that 30%, 35% core operating leverage kind of placeholder because the gross margin goes up. So any thoughts around where that operating leverage should be if what Rockwell wants to do on ARR and software plays out?

Yes. I'll take those in 2 different sections, Julian. First, on the short term in terms of inflation, pricing, margin, what we're seeing. We started the year with an expectation that we'll raise margins 150 basis points in our fiscal year '22. We still think that's the right expectation, the right plan for us. In terms of inflation and pricing, what we're seeing, we started the year with an expectation that we would raise price enough to offset what we're seeing for input cost inflation. And the 2 biggest places we're seeing input cost inflation is with semiconductors and logistics costs. Those are the 2 biggest components where we're seeing that. And we are -- as we started the year, we had our own view of how much that inflation would be. We've actually ratcheted up that expectation which caused us in the last month or 2 to announce our third price increase that we've had in the last 6 months. Still to keep on track that for the full year, we will be fully offsetting what we see of input cost inflation with price increases. In terms of the quarterization though, it's a different story. In the first quarter, we were -- it was dilutive to our margin. Second quarter, it's going to be even more dilutive to our margin. In total, for the first half on the last earnings call, I said it would be 200 basis points dilutive to margin in the first half. That flips to being positive to income and margin in the second half of the year to bring us to neutral for the full year. That's partly one of the things that's driving margin change as we go throughout the year is the price cost dynamic. The second part of it is also there is a volume aspect of the selling volume. As we see that improvement as we go through the year of our revenue, we see some increases in access to semiconductor chips as we progress through '22. That added volume also helps our margin throughout '22. So we'll be exiting '22 probably at our highest margin of the year. In terms of the longer term and the -- we've had -- as part of our financial framework, a core conversion expectation that we expect to be between 30% and 35% core conversion. Julian, I think for the time being, even with the software component and the growth we're seeing there, I still think that's a good framework to think about us. And let me explain why. Yes, there are factors like that the gross margin of what we're seeing in our ARR business is very, very attractive and accretive to the company. However, where we started the conversation this morning, we also see ourselves at a pretty important time of, are customers looking to be investing in what's the right next stage in their own digital transformation in their own investments they're making in software on the factory floor. And we don't think now is the right time to underinvest in that. And that was part of our plan in '22 is we did increase our investment spend because of where we see ourselves in that cycle and the opportunity there. And that's why I'd say, I think still that 30% to 35% is the best way think about our core conversion in the next foreseeable future.

Perfect. And then maybe one last one, and we'll run through the results of the audience participation later on. And so the -- I suppose it's really on capital deployment around M&A. Rockwell paid a full and fair price for Plex. I'll characterize it as how do we think about the M&A funnel from here? Does Plex represent kind of just the going rate for good software assets with decent growth outlooks? And that's the type of multiple we should expect from Rockwell?

I think it depends on the assets we're buying. What I've seen in the last few months, there's been a little contraction in multiples. Rockwell has an active pipeline, and it remains part of our strategy, where we're continuing to look for what we think are things that fit in with what we already have in Rockwell. We've talked about the priorities there around advanced material handling, IS/CS, software as well as expanding our presence in Europe and Asia. So those are all things that we are -- continue to look at, and we do have an active pipeline. And maybe just a little bit of multiple contraction from a year ago.

Perfect. Great. Well, I think we're out of time. Thanks very much, Nick, and of course, Brian and for the audience for being here.

Thank you.

Thank you.

Thank you very much.