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

Excellent. Well, welcome back for the next session here. We keep on going with Rockwell Automation. I'm Markus Mittermaier, the multi-industry and electrical equipment analyst here at UBS, and I'm delighted to have Nick Gangestad with us today, CFO at Rockwell Automation. I think, Nick, you're going to have some opening remarks for us, and then we go straight into Q&A. Just as a reminder for the audience, you have the barcodes on your tables. You can scan those and then submit questions. And I see them on my iPad here. It works. We've seen it in the earlier session, so please feel free to use it. I'll have some questions from the short term to the long term, but please interject at any moment. And with that, Nick, over to you. Thanks so much.

Thank you, Markus. Thanks for having us here, Markus, and thanks for the interest in Rockwell. Rockwell has been around a long time. We're known in the industry by iconic brands such as Allen-Bradley. Rockwell's headquartered in Milwaukee, Wisconsin, and Rockwell is benefiting by some trends going on in the world that's increasing demand for automation solutions that we provide, things happening in the U.S., happening in the world, happening in the industries we serve, and I'll talk more about those. But that's a bit of a -- just a quick view of our company. We're made up of 3 segments where we sell hardware into the automation space. We sell software and controls, and then we provide services to our customers. And we compete in the discrete market, the process market and the hybrid market for automation. And geographically, sales around the world, with the highest percent, almost 60%, situated in North America. I mentioned a bit ago the brands that we have in Rockwell. Allen-Bradley, being the most likely the one people are most familiar with around the -- often the Intelligent Devices that we're putting on factory floors. But we also have FactoryTalk around the software solutions that we're providing and Lifecycle IQ Services for the services that we're providing to our customers as they put manufacturing automation into place or monitor and provide services after it's been put in place. What we are trying to do at Rockwell and what we are working on is we are taking manufacturing to the next level. We're helping manufacturers pick up the pace at which they are adopting new technologies to increase the capabilities of their manufacturing operations. That can include information technologies, can include improved business practices. It can include hardware and solutions that improve their operations. What we are seeing in the manufacturing industry is an increased pace going on, that in the past, there would often be a reluctance to move too quickly. We're seeing it different now, that many of our customers are seeing the need and appetite to increase the pace at which they are automating their operations or using digital technologies on their factory floor to improve their operations. What we are seeing in the market for automation is we're seeing a number of our customers -- we're seeing customers needing to increase the resiliency of their manufacturing, their ability to have a supply chain that can be more agile. Sometimes that involves multiple sources of supply for products. From a resiliency standpoint, the products that we can put in place all the way to solutions such as cybersecurity help them improve their resiliency. When it comes to agility, the ability to interact digitally. And so using our abilities to create a digital twin of their operations to simulate before they put it in place increases their speed at which they can put automation in place. And then in terms of sustainability, working with our solutions to help customers reduce the amount of energy that their operations are consuming, reduce the waste, reduce what's being landfilled out of their operations. So those are some of the dynamics going on that we've been seeing for the last 2 or 3 years that we -- that's changing the face and the demand for automation. This is a slide that we've been using for the last several years in Rockwell. And we talked -- when we first introduced it, we talked about getting to $9 billion of profitable revenue. And at the time that we put this out, $9 billion was quite a ways away for us. And part of our thinking in putting this out was not so much about the number itself, but more about the pace and how we're going to go about growing. So we lay out here's the ways we are going to grow around growing the core part of our business, what we're going to layer in, what we've been layering in around double-digit growth in our Information Solutions & Connected Services. And then finally, inorganic growth. Our expectation of growing 1% or more on average from our inorganic activities to complement what we're doing organically and all the while laying out a financial framework of how we will go about -- and I'll say the discipline in how we will go about achieving this profitable growth. When we first shared this, as I said, it was still far enough out that it was more laying out our longer-term plans. We're reaching a point that this is becoming a reality for what we see from the demand for our products and our solutions. So it's shifting from a vision to execution, and that is part of what we are working on last year and this year of making sure that we have the company in place to be able to do this, making sure we have the supply chain capacity in place to be able to deliver on this, making sure that we have the business systems in place to deliver this type of growth of $9 billion of revenue and beyond. Part of that also includes our partner network. We don't think we can or need to do everything as we work on providing solutions to our customers. In some cases, we own a technology and a vital part of what we're bringing to our customers. There's other times where we partner with a network of partners that we've built up to provide a complete solution to our customers. We've also, as I said, been investing in our operations and then investing in our team ourselves of having the right talent and the right culture to execute on this vision. In summary, we see ourselves as having a place -- an opportune place right now. We are seeing high demand for our products. We're seeing especially high demand in our home market here in North America. We are adding to our resiliency. And by resiliency, in some cases, redesigning products so that we have more agility in the sourcing of input components to be able to weather supply chain constraints even better in the future. We also are introducing new products. In the coming months, we expect to be introducing a number of new products that will be added to our portfolio. And then finally, as we've been working with customers in times of this high demand and to some of the supply chain constraints, working with our customers even more intimately as we know we are a critical part of what they're providing, and we've been using this time to take -- work with our customers to help them themselves become more resilient, more agile and more sustainable. With that, I'll -- let's turn it over to the Q&A time.

Perfect. Great. Thanks so much, Nick, for that initial overview. I think we'll come back to a number of the topics that you've mentioned. Maybe if I start with the demand outlook. You've mentioned it. I mean fiscal Q2 showed a sort of, I think, 37% year-over-year growth in orders against that, obviously, the extremely difficult backdrop on supply chain and input costs. How has that evolved given what's going on in the world, be it Ukraine, be it China lockdowns, reopening, that whole debate that we have. What are you seeing out there at the moment?

Well, first of all, I'm not going to give a new inter-quarter update. But I can reinforce we are continuing to see strong demand across our businesses, across industries, across regions. And as we've -- part of how we guided at the end of -- at our second quarter earnings call, our guidance for the second half of the year, it was really driven by some improvement in what our suppliers will be able to provide us in the second half of the year but also benefiting from increased price realization, also benefiting from our own resiliency actions that I talked about a little. Those are all part of what was embedded into our guidance. In the second quarter earnings call, we also talked about probably one of the more difficult dynamics to be estimating in the short term: the impact of the shutdowns in Shanghai, that we had taken some contingency for what we felt was the risk there. And we're -- our own manufacturing facility in Shanghai was whitelisted and able to be operating through the shutdowns. We're pleased to see those shutdowns being lifted at the beginning of this month. And right now, it's at a point where it's with our suppliers in China and often a secondary or tertiary supplier of what's the speed at which they're going to be able to get back on pace. So far, the messaging seems very much in line with what we were expecting for the balance of the year.

Got it. Okay. Okay. And maybe thinking about sort of like the things that you can control internally, right, around prebuilding, maybe some subassemblies, redesigning your product, just decreasing the turnaround time, quite frankly, with what you have. Is there anything sort of like that you can do incrementally from where you stand now to kind of mitigate the situation? Or are we kind of maxed out there?

We believe we're doing all of those things and maybe more, Markus. We are -- as we see where there's risks of even longer-term inability of our suppliers to be able to be meeting the demands that we're expecting, we've been working on redesigning our products to have a second source of supply or to be able to have a completely different source of supply. So those resiliency efforts have been part of what we've been investing in throughout fiscal year '22, also working on qualifying additional sources of supply. We're also active in the broker market, looking for if the original manufacturer can't do it, in some cases, we can find it through a secondary market to find access to what we can. So those kinds of efforts are going on. We're also, in some cases with some of our suppliers, entering into longer-term agreements to formalize a longer-term commitment that will be committed to them and they'll be committed to us, which has the capability of giving us, I'll say, more privileged access to components in the future.

Got it. And that part with the new supplier that you qualify as sort of like existing longer-term agreements that gives you that visibility into the second half, I suspect, where you know, okay, we get x part by this, on that date, and that's why you feel more confident there in the second half?

So yes, as we guided for the second half of the year, that was built up from the bottom based on discussions with supplier after supplier of what they see themselves able to deliver us, at least in the second half.

Perfect. Great. Maybe on that sort of like first half, second half dynamic, you already alluded to it in your prepared remarks. Obviously, price, sort of like another dynamic where there's more benefit maybe in H2 of the fiscal year as some of these annual customer agreements that you have kind of repriced. How should we think about that dynamic? Sort of like if I take your total kind of backlog, I suspect to have stuff that's more on a short cycle kind of purchase agreement that have longer-term agreements sort of like that reprice. Like what proportion of the total revenue base kind of reprices on that annual basis versus more short term versus maybe longer? And is there any difference between the various businesses there?

First of all, the backlog does not -- almost none of the backlog itself reprices. So we -- for almost everything that we're providing to our customers, the price that we honor at the time of the order is what we will be charging that customer. So in the backlog, we, in essence, know what will be the price. And so starting a year ago, as we were putting price increases in place a year ago then into the fall of last year and then early spring of this year, those price increases along with this annualization of contracts, that's what leads us to see with pretty good clarity the pace at which our price increases will be going into effect. So -- and you are correct. There is a mix that some of them are pretty short in their duration, some of them are longer in their duration, but it's that mix that's factored into what we've guided for price. And for -- and I'll just reiterate a little of what I had said on the second quarter earnings call. Even all the price increases that we've put in place to date, by the end of this fiscal year, we still anticipate we'll only be experiencing approximately half of the total benefit from those price increases. The second half of that benefit, we'll be experiencing in fiscal year '23.

Okay. Got it. Okay. Perfect. No, that's helpful. So we have to distinguish between the annual reprice of an agreement, right, versus the backlog, which is the price that you already have in the backlog. Okay. Great. Maybe switching a bit to kind of free cash flow and margins. You kind of lowered the guide a little bit for the full year on the conversion to 85% from 90%. How should we think about that maybe into -- I mean, I guess, hard to say it in this environment on the inventory side, et cetera, into next year? Should we assume that we go back sort of like to above 85%? Or how do we think about this more?

No. We -- our guidance of 85% compared to how we started the year at 90%, working capital, primarily inventory, is the biggest piece of that. And it is a direct function of, I'll say, the volatility that we're seeing in supply chain and in some cases, holding inventory, waiting for 1 last or 2 components before we can ship it out, but also, in some cases, holding extra stock of inventory given some of the risk that we have. So I don't expect in fiscal year '23 a quick reversal of the inventory that we built in fiscal year '22 to come down immediately and benefit, nor do I expect this will become a new long term. This is the way it's always at. I just think it may be a more gradual move back to the normal types of working capital terms that we have. I think we want to see a little more stability before we're ready to say that we see that inventory level coming back down.

Got it. Okay. And if I think about sort of like some of these mitigation things that we discussed a minute ago around subassembly speed there, you just wait for a part. Is that still sort of like this, what we said in previous quarters, game of whack-a-mole, that it keeps changing?

It does unfortunately keep changing. This is the constraint this quarter and it's -- when you have some of the products we manufacture, it can vary on what it is.

Okay, okay. Great. Then on margins, again, sort of like given what you said on pricing and sort of volumes. Second half op margins, up significantly compared to the first half. How should we think about the sort of like quarter-by-quarter? Is there anything you can guide us Q3, Q4?

Yes. In the -- what I said on the second quarter earnings call is that sequentially, we expect our operating margin to move up between 300 and 400 basis points from Q2 to Q3. And that is being driven by flipping from our selling prices in second quarter, not keeping up with input cost inflation. In the third quarter, that flips to be about neutral between the 2, also with some higher volume versus what we saw in Q3 versus Q2. So those are the 2 biggest things driving up that 300 to 400 basis points in Q3. And then going to Q4, we set another 400 to 500 basis points of margin expansion. So -- and then that's at a point where we're now from a pricing standpoint flipping to the positive that our -- we expect our selling price growth to be exceeding our input cost inflation and benefiting our margin there, also from a volume perspective being benefited. So those are the 2 things that we expect to be driving the majority of that margin expansion.

Great. Okay. Before I move on with questions on the overall demand environment, I have one here from the audience on backlogs and the risk of cancellations in the backlog. As end markets potentially weaken here, the client states that some retailers, obviously, the different markets have started to talk about cancellations. How -- do you see any of that? Or is it still relatively resilient?

We've been monitoring cancellations. And for the first time on the last quarter's earnings call, we shared what our cancellation rates have been, and they've been 1% or less in each of the quarters. And so we continue to monitor it. If there were an economic downturn, could there be some cancellations? We certainly have some projections where there could be some. But given the magnitude of the backlog we have, we don't think it would become a material amount that would impact -- impacts our revenue in the near term from that. The backlog is large enough. We continue to -- we'll monitor that. For the vast majority of these orders, because we engage with our customers, there is real demand behind this. And it's often not being driven by the economic cycle for the reason they're investing. They are often investing because they want to be increasing their supply chain resiliency. So I'll say it's a little less discretionary for them that they're working on, on how to improve their operations, maybe based on some things they've seen in the last 2 years of vulnerabilities in their supply chain, and they're investing to improve that. There is some of the demand where we see it is related to capacity, that they want to increase their capacity. But there's also a lot of the backlog that we think are in industries that even if there's an economic downturn, they're likely going to keep investing. And so we will continue to monitor that and anticipate there could be some risk. I don't think it's material. And when the last 2 cycles that we've gone through of economic downturn, we, of course, did not have that magnitude of backlog that we have right now, but we did not see a significant uptick in cancellations in either of those 2 times.

Interesting. Okay. I want to double-click there a little bit because I think that thought is interesting that yes, you have obviously cycle-driven demand, and then you have this new resilience-driven demand, if you will, right, among your customers? And even if you look at the cycle-driven demand, at least what our data shows, and I'd love to hear your thoughts on this, is on the CapEx side, which I know is not driving all of your revenues, right? But on the CapEx side, we seem to have, particularly in North America and Europe, very, very strong and relatively broad-based cycle, if you compare it to the last time from '16, '17, '18, which at that time was more Asia driven, right, and now it seems more U.S. and more Europe driven, which is kind of interesting. So how do you think about the different, say, end markets in terms of discrete process hybrid? Where are the opportunities that you see maybe out of CapEx? And then regionally, sort of is that the image that we have that it's North America and it's Europe, particularly where the demand is on that cycle-driven part?

As I said in my earlier comments, a market like North America, we are seeing strong demand for our customers that possibly transcends, I'll say, cyclical factors that they are, in some cases, they're responding to high labor rates or the inability to hire enough people. And so that's spurring a need for demand for automation that previously they didn't feel they needed to automate or didn't have the capability to automate. So that's part of it. But also there is an aspect of -- sometimes I'm asked like what about reshoring or onshoring. We don't often -- I don't often see customers that are shutting down a part of their supply chain coming out of Asia and building a greenfield in North America. There's probably some instances. I think the more common is I have this supply chain in China. I also have some supply chain in North America. I need to make my North America one more viable, so I'm going to invest in more automation there so that I have multiple sources of supply, that resiliency and agility I talked about earlier. That's a more common thing. And that could have the ability to be an important thing for our customers even if there were an economic downturn that they still see...

They still have to shorten the...

And we need to be working on that resiliency of our supply chain.

Very interesting. Is there any sort of difference in, I think, the big buckets' discrete, hybrid process?

Yes. We probably go even more fine thinking of like industry itself. So an industry like electric vehicles, that, to us, seems like it's less about the cyclical part of the economy, more just a transformation going on in that industry. And so I'm sure there could be some economic impact on it, but much of the investment going on there is driven by this transformation going on in automotive. Similar in life science that there's changes going on in, for example, pharmaceuticals. And the solutions that our pharmaceutical customers are having to or wanting to provide this idea of the personalization of pharmaceuticals. And that creates ongoing or increased demand for automation to be able to provide that. And we think that may not have as much cyclical impact from it. And then in an industry like semiconductor, and I feel a little silly saying, semiconductor, maybe not, because I typically think of that as more cyclical. But given where that industry is right now, we think even if there is an economic downturn, there still could be a lot of committed capital going into semiconductor.

Got it. Okay. You touched on lots of the industries that I had here, one that I was...

Well, I'm sorry, Markus.

No, no, all good. One that I had here was obviously oil and gas and LNG is a major exposure there. I know some of your competitors are obviously focusing on that a lot. But how should we think about that part of your exposure?

Yes. Our process part of our industry segment grew 5%, and that was really led by oil and gas. And we are seeing some improvements in both upstream and midstream for oil and gas, so we feel that's a positive. One of our bigger components there is our Sensia joint venture that we have in place. Sales and demand really strong in that business. We're expected to grow double digits there. In terms of LNG, we have less exposure there. We do have a good pipeline going on in LNG, but I'd say we're positioned more outside of LNG and other places in oil and gas.

Okay. Great. Perfect. Time is running fast here. I want to make sure that we have some time left on the more strategic sort of like thinking and longer-term planning that you have in your mind. So maybe starting with sort of like a 30,000-foot view and say, okay, Rockwell as is today, like the strategic positioning, where do you see kind of white spaces? And how do you think about M&A on the one hand side and sort of what you mentioned earlier on partner networks, right? Like what do you sort of do through partnerships? What do you do sort of in-house? How do you broadly think about that?

Well, we think of -- manufacturing around the world is moving to a whole new level. Often it's being enabled by digital technologies that are coming available, and that's part of how -- why we have organized ourselves the way we are that the strong base we have around hardware intelligent devices on that factory floor, controlling a lot of what's happening on that on the factory floor and also generating a lot of that data. And that's partly why -- where we see this going with -- you've seen us layering on more software solutions of how that data is being used to try to optimize operations. And then the services that we provide to help our customers get the most out of where technology is from a hardware perspective, a software perspective, a data perspective, an analytics perspective, the consulting we do to bring that all together for the customer. So that's the strategy we've been playing and continue to play. We think it's a nicely growing market and we have a strategy that we think gives us the ability to grow share in a growing market. We don't think we can be everything. We don't have the aspiration that we will be and do everything. We think that becomes too dilutive to our ability to focus on solutions. And that's why we will partner with partners that we think have a core strength that complements what we can provide, play to their strength and our strength to bring to our customer an end solution that is more complete for them than if we were going just alone. So you've seen us adding partners across the spectrum to be providing those solutions. Some of the things you're seeing us also do is increasing our focus on what we're providing of industry-specific solutions. And we consider that an important part of where we're going that while we have all of these things in place, we have built up over time a lot of industry domain knowledge in order to provide to our customer solutions that make the most sense. And rather than them being generic and the customer has to figure it out, we're increasing our focus on how can they be more focused on particular industries that we're competing in. And so we've been doing that, and you're going to continue to see that grow in our go-to-market strategy. Many of our things we do and develop, we develop organically. But in some cases, we will look for inorganic to complement what we're doing. We've laid out under our framework that we expect 1% or more of our growth each year to come inorganically through M&A. It will be over 2% this year. primarily driven by our acquisition of Plex. And we've also laid out our focus areas of where we think that those M&A dollars will likely be going in the coming years. So that playbook for how we see that whole market evolving, needing more and more solutions, more and more on that whole digital thread going through the manufacturing operations and how Rockwell, we think, is -- has a unique position given that the fact we know the data. We're a big part of how that data is generated, which we think puts us in a position to be the best organization to be working with our customers for how to ultimately use that data.

Interesting. Maybe I can actually double click on that a bit because I think that's very interesting. You mentioned Plex. Obviously, you have the PTC relationship as maybe 2 examples now of partnership -- well, PTC is a partnership plus stake, but Plex, if I'm a Rockwell customer sort of -- and I sort of like get the solution from you, would I feel a difference between sort of like the Rockwell component, the new Plex component, PTC? How does that sort of like work in the end in terms of the overall solution?

Yes. I hope they're not finding a very different solution. We try to work with these partners in such a way that it is as integrated of a solution as possible. Part of what we provide is a fairly open approach to what we bring that our things can work with others, and we think work well, the solutions we provide work well with other solutions, and that we've thought through for our customers how the different things integrate. We feel it's part of our value offering that we've got through how things piece together versus providing solutions and letting the customer figure out how to piece them together.

Interesting. And I want to come back also to what you said around, obviously, your massive installed base. I mean if you think Allen-Bradley, right, it's probably every factory out there probably has at least some Allen-Bradley in there. So leveraging that in -- as you sell more and more of the digital software content, has that sale changed in the sense that sort of like historically may have gone to the shop floor and sort of like people said, "Oh, I was an Allen-Bradley engineer all my life. I'm going to buy, of course, Allen Bradley." Is that changing now with software being a bigger and bigger part that this becomes like a top-down sale? Or how do we think about the go-to-market?

There is an aspect of that change occurring. Of course, it's still important, the relationship we have with like the head of engineering, a plant manager, the head of operations. And that has been and continues to be an important relationship. But as we go to market, we also see the breadth of the solution we're providing that there's other players often with our customer base that are involved. So as an example, a Chief Information Officer becomes part of that process now. And that's been part of what we've been doing with our own go-to-market, increasing our capabilities there. It also brings to mind an acquisition we did a few years ago, Kalypso. A very successful acquisition that changes part of how we go to market there that this is a part of our organization that's very well situated and equipped to be having conversations with those types of offices in a company that are making decisions that often involve software. And so that's become part of our selling process as...

I guess the reason I asked is you often get the questions like, okay, so if software is this bigger and bigger part now, right, is there new players that enter sort of like top down? But I guess, you still have to think about, okay, how do I interpret all the data that comes out of your hardware, right? So I guess that's the interesting sweet spot that you might have and some of your competitors might have around kind of putting together the hardware and the software in one solution.

Often what we're putting together from a customer perspective requires their operations team as well as their IT team to be working together. So just likewise, we need to be there, ready to be able to work with both parts of that organization, not just one or the other.

Got it. Okay. And I know we're almost out of time here, but I want to go back to what you said at the very beginning around cybersecurity and it just struck me because, obviously, we hear a lot of necessity for that going forward. What's your role here? What's the offering? Just help us with a brief overview of that.

Yes. Just a brief overview. Like for many years, companies probably overfocused in their focus on cybersecurity to their personal computers, and Blake sometimes refers to it as the carpeted area of the operations. But meanwhile, on the factory floor, there's a number of nodes that have cybersecurity risk. And that's increasingly understood by many of our customers. And so part of the role we play is, first, from a consultative basis to help customers understand where their vulnerabilities are and what are some of the things that they can do to reduce their vulnerability from cybersecurity. And then as that's being implemented, we have other solutions that, on an ongoing monitoring basis, that we can be providing solutions to help them keep their operations protected. So it's a fast-growing part of our business. We started it several years ago, and it's, I think, an increasingly important part of the solution portfolio that we're providing for our customers. It also is an entree into customers where we've sometimes not had as much interaction. The fact that we have this gives us a new channel or a new reason to be talking with customers that we've traditionally had not as much hardware penetration into.

Perfect. Great. Thanks so much. We have 30 seconds left here. Anything that I forgot to mention that you wanted to highlight or any parting thoughts?

No. It's an exciting time for us. It's -- we're seeing a lot of changes going on, a strong demand for our products. And as we work through our supply chain constraints, we will continue to see some improvement there. And we're excited about what the future holds.

Great. Thank you very much, Nick. Really appreciate you coming. Thank you.