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

So thanks, everyone, for being here. It's my pleasure to have up next Rockwell Automation. Blake Moret, Chairman and Chief Executive. Blake, has a couple of slides to go through first and then we'll do Q&A. So thank you, Blake.

Thanks, Julian. Well, thanks, Julian. Rockwell has been on a transformation journey since 2016 because we needed to move faster to meet market needs for information software, and high-value recurring services across the most attractive industry verticals. Acquisitions such as Plex, Fiix, ASEM and Kalypso have boosted our total annual growth to 9% between 2016 and 2023. However, our margins have been flattish during this period. To be sure, the shocks of pandemic and semiconductor shortages introduced inefficiencies and our margins have averaged a respectable 21% during this time, but it's clear we have a big opportunity to deliver consistent margin expansion. Also, we're not satisfied with our first quarter results, and we're taking actions to address the issues that led to the miss. This is how we're expanding margins while continuing to grow faster than the margin. On the heels of achieving our 2019 plan to $9 billion of profitable revenue, 1 to 2 years ahead of our original expectations, we introduced a new strategic framework for growth and performance last November at our Investor Day. Highlights of the new plan include 35% core earnings conversion on incremental revenue and 6% to 9% annual growth through the cycle. We also outlined the expected margin range for each business segment. We've already touched some of these ranges in the last year based on very high sales growth, but our intention is to tune these businesses so that this performance is consistent and not dependent on supercharged growth or big swings in incentive compensation. Importantly, we're focusing on getting the synergies and efficiencies from existing acquisitions versus making new acquisitions. The portfolio of capabilities that we built and bought is second to none. The acquisitions that we made between 2016 and 2023, will contribute $200 million of EBITDA this year, and that figure is expected to accelerate as we integrate technology and increase efficiency. We're well into actions and Lifecycle Services. I'm happy with the way we've started the year with 520 bps of year-over-year margin improvement on high single-digit organic growth, but we're just getting started. Key levers for full year margin expansion in this business segment are headcount reductions, spend and restructuring actions expected to account for about 3 points of year-over-year improvement. Sensia, which has swung to profitability and will contribute over 1 point of improvement and price and volume together, which improved margin by about 2 points. We're taking structural actions within intelligent devices, including the ramp to profitability of Clearpath Robotics, our most recent acquisition. Clearpath was originally expected to be $0.25 dilutive to fiscal year '24 EPS. Now we're expecting the loss in '24 to narrow to $0.20 based on purchasing efficiencies now that they're with Rockwell, hiring discipline and very strong orders growth. Other actions within Intelligent Devices target to return to operational excellence for this broad portfolio of products. Near term, we're building safety stock to smooth out volatility in the plants as we transition from shipments out of backlog to a shorter, more normal book-and-bill process. The headwinds from these inefficiencies will reduce in the second half of the year. We see opportunities to address the total number of SKUs in this portfolio while actually increasing customer service and expect this work to have a fiscal year '25 impact. In Software &, our recently announced leader, Matheus Bulho, is looking at the cost structures within the Plex and Fiix acquisitions. Both were already on a good ramp of increased profitability and double-digit ARR growth, but we're working on additional opportunities. Through the year, we will also see the increased impact in the market of factory talk design studio, a cloud-native Logix programming application that is industry-first technology we've been investing in for several years. We've made some organizational changes across Rockwell to support this focus, and that will continue. Company head count is also expected to reduce by 1% to 2% between the beginning of fiscal '24 and Q1 '25 as we execute our restructuring actions that began in Q4 of last year and that continued into this year. 80% of the increases in fiscal year '23 head count renew to acquisitions and manufacturing labor increases to support our growth. Across our total business, we see price cost of over 1 point this year, and I expect at least 1 point going forward. The ongoing innovation of drives and motion products of Intelligent Devices and Logix within software control will support continued price cost and share gains. Here are a few additional comments on Q1 results, Q2 and the full year guide. For Q1, we had previously indicated margins would be down year-over-year and sequentially, but we're not happy with the results. Primary causes of the year-over-year reduction were an investment spend comparable that is most significant year-over-year in Q1, followed by lower supply chain utilization, unfavorable mix and the recent Clearpath acquisition, which diluted margin by about 30 bps, a little better than expected. Orders grew double digits sequentially from the trough in Q4 of last year with the strongest growth in North America. That was very positive. As we said on our Q1 earnings call, we expect revenue dollars and EPS to be similar to Q1 in Q2. While operational issues are expected to subside through the quarter, we have less backlog entering Q2. So growing the amount of revenue is dependent on -- a growing amount of revenues dependent on orders received in the quarter, especially in Intelligent Devices. Orders are expected to increase sequentially again in Q2. For fiscal year '24, our primary dependency is the continued order ramp through the year. I am confident that the operational issues are being addressed. And if we have the orders, we'll hit the guide. Orders have started off well in the year, and they will have to continue to grow through Q2 and the second half. This slide gives additional transparency on our view of business segment margins and the ramp through the year. Software & Control margins will be down year-over-year and sequentially in Q2. In Q2 of last year, we had 42% growth in Software & Control. The Software & Control margin decline is expected to be offset by continued margin improvements in Lifecycle Services. Intelligent Devices margin is expected to be flat in Q2. Spend in Q2 for the company will be flat to Q1. Margin ramps through the year based on volume, ad spend and the benefits of lower incentive comp plus restructuring. I'm confident that our renewed focus on margin expansion through cost discipline, operational excellence and focus on organic growth will achieve the long-range target set out in the strategic framework introduced in November. Here's the outlook that we gave on January 31. And with that, I am happy to take your questions.

Thank you, Blake. Maybe first off, as you said, it's sort of flat earnings sequentially in Q2. The ramp in the second half to sort of first half, you have about $4 of EPS, second half is $8 to $9 roughly to get to that guide. So the sort of -- how much can we see that step up this year, second to third to fourth quarter? Is it sort of fairly steady? Is there a disproportionate amount locked into Q4? Or it just depends on kind of how the orders come in month to month?

Yes. Julian, increasingly, it's dependent on the order ramp as we have less product backlog. We continue to have a nice base of backlog in our longer cycle business, Lifecycle Services, configured order and so on. But as we talked about, we saw the trough in orders for products in Q4 of last year. So the quarter ended in September. We saw a double-digit sequential growth in Q1, and that was very positive. Order to date in Q2, we've seen orders support that ramp, and we expect orders to continue to ramp through the year. But that's contributing to the significant increase from Q1 to Q2 as the backlog of products subsides, and that more and more business is expected to be a more normal book and shift that we saw pre-COVID, and we expect to get back to by the end of the year.

That's helpful. And when you look at that book and ship portion, when you're sort of gauging customer demand, it seems that signals are quite mixed. The good thing is you order them up double digits sequentially. That's a big plus. When we listen to some of your peers in the industrial automation world, whether in Europe or Japan, they are more cautious, it seem. They talk about the stocking aspects in certain industries. Partly, I think they have a lot more exposure to China and electronics. So there are some mix hurting them. But yes, so how would you characterize that demand environment? Because it sounds worth if I listen to some of those Cs peers very good if I look at your own orders sequentially.

This is a good time to have North America and, in particular, the U.S. has the strongest market. I mean we have by far the largest share in the U.S. And China is probably at the bottom end of attractive spots right now in terms of growth. Europe is somewhere in the middle. That's where most of our competitors are. And so having the strongest base in the U.S. is playing out in the numbers and that we saw on this growth in Q1 in North America, and we expect that to continue. I think China continues to have a supply and demand problem. They have more supply than demand in terms of factory output, in terms of housing, real estate, in terms of people, employment, you see rising in unemployment. It's a fundamental issue of having more supply than is needed. And I think that's going to take a while to settle out. For reference, about 6% of our business is in China. A similar amount of COGS as well, and that's well below our major competitors.

Got it. So most of what you see in the U.S., very strong demand, at least, that picture hasn't changed?

It's just being the demand. I mean, a lot has been made of the EV delays. EVs are going to continue to become a larger part of the U.S. market. They were about 7.5% last year. They grew to over 10% of the U.S. market this year. But whether General Motors or Honda, whoever builds an EV or a hybrid or a gas guzzler, then we have good readiness to serve those applications. And then I do think that we see continued strong demand in process industries. That's probably the one that's already at a good level of growth year-over-year in particular, energy.

Perfect. And I think that there's a couple of things that help the sales back, if you like, recent months. One was the capacity constraints. And the second sort of related one that slightly separate was that shift in business mix from backlog to book and ship. So maybe just on that first point, capacity constraints, some inefficiencies there. Maybe flesh out is it any kind of particular product categories or end market verticals? And kind of where are we on resolving some of those issues from Q1.

Yes. We're well on the way to getting past the issues that led to the shipment miss in the first quarter. The biggest single issue for that was the transition from the period that we have been in for really over a year of shipping down a backlog where in any given quarter during fiscal year '23, it really didn't matter what the incoming orders were for the requirements in the quarter because we had such massive backlog. Q1 was the first quarter that we actually had a portion of our shipments depending on taking an order in the quarter and converting it in the same quarter. And what we didn't have in place adequately with safety stuff to cover that new demand. For reference, again, we had shipped over $2.5 billion in Q4. It was the highest quarter we've ever had, and we didn't have the additional capacity on top of that. While shipping out that record revenue, we grew, I think, 18% in the quarter. That was on 20% the year earlier in Q4 to, in addition to that, build the safety stock, that's largely complete and we're pretty much in a good place where we have the safety stock in place as we go through the second quarter. So that's not another question. You didn't ask it, but I get asked. It was that lost business in Q1. No, we get that business in Q2, so it's a part of the shipments we see in Q2.

Okay. And when you look at your -- some investors have mentioned where the inventory level in the balance sheet looks pretty high. That would suggest sufficient capacity. Is it more just like the type of inventory didn't exactly line up with the customer demand in the quarter?

Yes, there's a fair bit of raw and component inventory in the system. Last year, we saw after screening for semiconductors for a couple of years, they came in. And it was hard to tell a particular supplier where we need only these few, but don't ship us all the others that we have previously ordered, but that we've got plenty of now. And so there's a little bit of overage in components. And we'll see the finished goods inventory increase a bit as we complete that build the safety stock, but we do expect the inventory overall component to go down through the year, allowing us to get to that 100% free cash flow conversion. I really want us -- now that we're past this period of volatility to be boring again in terms of just printing 100% free cash flow conversion every quarter. That is absolutely our objective.

Perfect. And when I'm thinking about the sort of book and ship business, maybe just remind us kind of -- and it's a little bit tricky because there's been some portfolio additions. But for kind of base Rockwell, let's say, how much of your business to your revenue was book and ship pre-COVID? Kind of where are we today, how soon are we getting to the pre-COVID book?

Well over half of our business is product that moves through a distributor that is almost entirely book and ship, in that you get an order for it in the quarter, and then you ship it down in the same quarter. With the conversion rate of all orders converting it well over 80%, sometimes closer to 90% shipping in that same quarter. That was the pre-COVID paradigm, and we expect by the end of the fiscal year to be back to that paradigm for products. We'll have more dollar value of backlog because we're a much bigger company and because businesses like Lifecycle Services have grown, but not fundamentally has changed in the market expectations that when you enter an order for a Logix processor, either your distributor has it on the shelf or they've got it sitting in safety stock and to ship it out within a few days.

So that you feel pretty comfortable with what's happening on inventory and the safety stock. It's more a question of do those orders from the customers come in at the right pace, that continued?

That's right. The year started off well and it just needs to continue.

And when you think about that sort of customer conversations. Yes, there is some inventory out there with different businesses. Is your impression that they kind of -- they spent 18 months normalizing those inventories, they were too high. And so from here, it is largely an option to have the final demand, and that should need to order stream.

With distributors, we expect their inventory, some of their inventories because we've got good visibility into it. Some of their inventories have already reached that equilibrium point with underlying demand is now being reflected in the orders to us. In other words, they're not just absorbing that new demand by reducing their inventory and we expect most of the rest to be there by the end of Q2. Within the customers, if you want a place that customers have some higher inventories is in machine builders. So you have these customers making machines. They can't ship it out with having their products. They enter very large orders during 2022 when we had over $10 billion worth of orders. And in some cases, they're having to bleed that down. We think that, that happens roughly the same time as the distributor inventories normalized, although it's variable from OEM to OEM.

And so the point would be, I guess, the balance of this year, you're sort of book-to-bill close to 1-ish times. Is that in the second half? Is that sort of the assumption?

Yes. I don't know the precise figure of the book-to-bill, but we certainly see those conversion rates of orders received in the quarter continuing to ramp up through the year as we go through. So we really get back to a more normal kind of process where product orders come in, we ship them out and you care much less about order figures separate from shipment figures, right? We're talking about orders over the last few years because there's such a disconnect between the 2, but I think we get away from that as we go into fiscal '25. We'll continue to talk about book-to-bill ratios for Lifecycle Services because that's going to remain a longer lead time business with backlogs that remain meaningful.

That's helpful. And then as we see these sales sort of ramp back up in soft orders and the easy capacity constraints. I know you have that sort of 35% operating leverage your medium term. But I would assume that in this initial phase of the sales recovery, you'll get much higher leverage, is that fair? And kind of what's embedded in the guide in a way?

I mean the algorithm for the very good expansion of margin is certainly the volume. It's holding the investment spend flat sequentially through the quarters of this year. It is no new acquisitions get thrown on the heat, and it is lower incentive comp as well that helps this year. And then it's the growing impact of the more structural issues that we're doing to be able to get to those ranges of margins for the different business segments that aren't dependent on supercharged huge double-digit growth we're doing unusual things within some of the comp. So there's a current year set of priorities, but you're also putting in place longer-term actions to refocus the company on good old productivity and margin expansion now that we've assembled this portfolio of assets. And that's really the rallying cry for the next couple of years is to put these together. We've got the high growth, the better-than-market growth and now adding to that good market expansion and expansion of ROIC.

Yes, it's quite a big change. It sounds like sort of the next couple of years, you get a free cash conversion of around 100, not much new M&A, operating leverage probably over 35% because there's a big focus on extracting better margins from acquisitions and the base business.

If you heard that shift, then you heard it correctly.

On operating leverage, is it sort of what, it's like around the gross margin is what we should expect operating leverage for the near term?

I think we've got lots of pieces to work on. I think some of the refresh and products. We can come out with products at a lower cost base where some of that gets given back to the market and some of that goes into the margin. We've got SG&A opportunities. We've got manufacturing efficiency. There's a long list. Each business will have a slightly different area, the biggest pools of opportunity. Life cycle services is well into it, Intelligent Devices. And now we've got -- especially with some of the recent changes in software and controlled opportunities there as well. As well as on a company-wide basis, I mentioned before, slowing hiring, we've seen hiring to be down. Last year, we had a significant amount of hiring, but over 80% of that was through acquisitions and manufacturing labor. We do expect through this year to be down in terms of head count by 1% to 2%.

And I guess the point would be the demand is really good. It's just you want to sort of maximize what Rockwell itself is and shareholders are getting from that good demand.

Yes. I think our value -- I mean, we have great value to date. The opportunity to expand our value even more for shareowners is to take that growth and put it together with the margin expansion, 100% free cash flow conversion. The -- we're beating ROIC. I think those opportunities are there and now we're going to do it.

And when we think about kind of some of the ARR portion of the company of late, over 10% of total. Within that, software is a big part of it. For kind of hold it or not keep taking care in those businesses, you're confident you can do that even with more of a measured approach to hiring and the investment.

Absolutely. Absolutely. I mean those businesses, Plex, Fiix, capturing share each of them growing double digits, super high MDR, customer satisfaction. And so we just have to be strategic in the things that we add in terms of functionality with a real focus on knitting together those assets with other pieces. I've talked before about the recent Clearpath acquisition were mobile robots. Huge sales growth in that business, even greater opportunity as we take the data and land that in these software applications. So it's I think an opportunity we typically integrate all the pieces because that simplifies overall system. And when you simplify the automation system, you're going to grow faster because that's the single biggest impediment to growth in the market is just the complexity of automation. And we have an opportunity, I think, that's second to none that's simplifying the whole thing.

Perfect. So with that, I think we have to switch to the audience response survey questions, please. If you can bring up the first question around you're telling the stock and you can use those grade devices. So generally, no. So a lot of opportunity there. Number 2 would be around kind of general disposition towards the stock right now. Neutral to negative. The third question is around, I think, through cycle earnings growth for Rockwell versus the multi-industry kind of average. So generally in line with peers. Fourth question is around what to do with excess cash. So I'm not sure if there will be a lot of people saying large M&A in light of what's commented now, but let's see. So share buybacks, not surprised, half. And then number five, what multiple or PE multiple, let's say, should Rockwell trade at? Sort of around the market multiple. And the last question is kind of what's the biggest headwind or reason you don't own more shares of Rockwell. So mishmash, Capital One is definitely not one of them. But yes, it's fairly even on the other 3. So with that, thanks, everyone, and thank you so much, Blake.

Okay. Thanks, Julian.

Thank you.