Winner Final 8b9eeba93d

Rockwell Automation (ROK) Thomas F Harris CPA,CA Completed CFA L3

[email protected]

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Rockwell Automation is Mr. Buffetts next buy Rockwell Automation (ROK) is a great company at a fair price. Mr. Buffett would be

happy to own it for at least 10 years. It passes his tests with flying colors:

1. Circle of Competence

Simple ROK helps business customers to automate their manufacturing or production

processes. Automation lowers costs and improves quality.

The company primarily sells electric components, which are added on to the

customers production equipment.

Platforms are a comprehensive packaged solution of products. Software can be

used to program advanced applications.

Non tech ROK uses technology to enhance its product offerings, but it is not susceptible to

rapid change.

Scalable ROK has customers across all industries and all geographies. The products are

modular. They can be customized to nearly any business. Scalability is high.

2. Historical Moat

High ROE Past 10 years: Consistently high ROE of 34%. EPS growth of 12.3%, with only 1

year of decline (in 2009).

Low capex Past 10 years: R&D of 3.7% of sales. Capex of 2.3% of sales. Capex was only 21%

of CFO. The company is a FCF machine.

3. Future Moat

Network effect Internal network effect. Rockwells products are highly compatible with each

other. The products work together to perform functions which are crucial for the

customer. Often, platforms (comprehensive packages) are customized to specific

automation processes for a specific company in a specific industry.

Switching costs Switching costs are high. Customers become dependent on the automated

process. Removing it is like removing part of the human brain. Modularity makes

it easy to install, but network effects make it difficult to remove. Integration with

software and data systems further increases switching costs.

4. Management

Capital Allocation Management returned 72% of CFO to shareholders in past 5 years via dividends

and buybacks. Divested Power Systems division in 2007 at a cyclical peak.

Ownership mentality Long term oriented. Customer oriented. Consistently widening the moat by

improving quality and developing new products.

5. Margin of Safety

Fair price Price of $112.81 is fair compared to $129.71 DCF intrinsic value estimate.

Expected 10 year internal rate of return of 12-15% is excellent.

Charlie Munger Test

With $5 billion, could Mr. Munger create a hypothetical competitor from scratch? To create a true competitor to

ROK would require start investment in: R&D for >300,000 hardware and software products, sales, distribution,

manufacturing, industry experts, and switching costs. Running through his mental models and asking what could go

wrong, Mr. Munger would classify this as a wonderful company.

Rockwell Automation (ROK) Thomas F Harris CPA,CA

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1. Circle of Competence

You dont have to be an expert on every company, or even

many. You only have to be able to evaluate companies within

your circle of competence. The size of that circle is not very

important; knowing its boundaries, however, is vital. Warren

Buffett

There are a lot of things we pass on. We have three baskets: in,

out, and too tough...We have to have a special insight, or well

put it in the too tough basket. Charlie Munger

Simple

The first, and most basic test, is the too hard pile. If Mr. Buffett believes that the

company is too difficult to analyze, it is discarded. We will ask simple questions. If

the business is simple, we expect to quickly understand the nature of the

business.

What is the function of the business?

Rockwell Automation helps businesses to automate manufacturing and

production processes.

How do they accomplish this?

ROK primarily sells a wide range of electrical components which are added on to

existing machinery. Combined with software, the business is better able to

design, monitor, and control the process.

Why is this needed?

Automation addresses several business needs simultaneously. The initial benefits

of installation include:

Speeding up the process

Reducing errors

Improving quality

Increasing safety

Furthermore, there are second order benefits. The hardware components gather

data which was previously unavailable. This data allows employees to further

analyze the process and make incremental improvements and adaptations.

As such, automation provides a clear ROI. The investment is low risk, and offers

high upside as well. It is a small investment compared to the overall expenses of

these businesses.

The investment is easy to justify from both the bottom-up perspective of

employees (e.g. cost and efficiency metrics, ease of monitoring), and the top-

down perspective of management (e.g. data leads to transparency, quality

improvement versus competitors, makes company more consistent and

adaptable).

Operations

Revenues: How are revenues generated?

ROK sells hardware, software and services. Hardware consists of electrical

components which add-on to machinery. These components can be sold


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separately, but they are more often combined into packages and control

platforms. Platforms are combinations of various components and software.

Rockwell sells software which is used to help in process design, control of the

automation process, and integration of data. Services help the customer through

the entire product life cycle. Approximately 2/3 of sales is hardware.

Expenses: What are the costs?

Rockwells costs include manufacturing, sales, R&D, and service costs.

The company has low capital intensity, as both capex and R&D costs are low.

Input costs of manufacturing are commoditized raw materials. It seems that the

majority of Rockwells costs are related to employees: labor, service, R&D, SGA.

For capex, please note that depreciation is included in COGS. Thus, depreciation

is a good approximation for capex for ROK.

Customer base: Who is buying?

The customer base is highly diversified across size, geography and industry

vertical. The following industry vertical estimates are from Credit Suisse:

Generally, automation is categorized as either Process Automation or Factory

Automation (aka Discrete Automation). Process Automation is used on industrial

sites to control a continuous flow, such as water or oil. Products include DCS,

valves, and other flow products. Factory Automation is used to control

manufacturing facilities where component parts are assembled into a final

product. Products include drives, robots, PLCs.

Historically, Rockwell Automation focused on Factory automation. In recent years,

they have successfully expanded into Process Automation with a new product

called Logix, which allows for integration across all Automation types.

2.1%

4.4%

23.7%

54.0%

0% 10% 20% 30% 40% 50% 60%

Capex

R&D

Sales, General and Admin

Cost of Goods Sold

Expenses as a % Sales (2014)

source: company data

5%

8%

8%

12%

13%

23%

31%

0% 5% 10% 15% 20% 25% 30% 35%

Other

Metals

Mining

Transportation

Oil and Gas

Heavy industry

Consumer

End market revenue split


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Among Rockwells major industry verticals are those which can be considered

Hybrid industries: those with elements of both Process and Factory automation,

such as Life Sciences, Food and Beverage and Metals.

Rockwell is also diversified globally, with roughly 50% of sales coming outside of

the United States.

Sales and Distribution

70% of sales are made through independent distributors, who typically do not

carry competing products. Direct sales and service agreements tend to come

from customers in emerging markets, where the distribution channel is less

developed.

Technology

A key consideration is Mr. Buffetts low regard for technology companies.

Technology is based on change; and change is really the enemy

of the investor. Change is more rapid and unpredictable in

technology relative to the broader economy. To me, all

technology sectors look like 7-foot hurdles Warren Buffett

Although Rockwell Automation develops technology to improve its product

offering, the company is not a technology company at its core.

Rockwells software works very closely with the hardware components. It is the

interaction between Rockwells software, hardware, and the customers machinery

which adds value.

Therefore, the core of the business is not susceptible to rapid technological

change the way that Facebook and Samsung are. Rockwell Automation is similar

to Precision Castparts (held of Berkshire Hathaway) in its use of technology.

Favourable Business model

In assessing the boundaries of Mr. Buffetts circle of competence, it is helpful to

compare ROK to Mr. Buffetts past investments based on business model

characteristics.

Repetitive

Mr. Buffett is familiar with the repetitive business model of a Coca-Cola, Gillette,

or Wal-Mart.

8.3%

13.4%

20.0%

6.6%

51.7%

0% 10% 20% 30% 40% 50% 60%

Latin America

Asia Pacific

EMEA

Canada

United States

Geographic Revenue split (TTM)

source: Company data


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Rockwell claims an average product life of 20 years, so it is nowhere close to the

ideal repetitive business model. However, purchase is far more frequent than this

number suggests. Customers require a high volume of hardware components.

When changes are made to the manufacturing or production process, new

hardware is often required.

Furthermore, a key part of Mr. Buffetts interest in repetitive business models is

their habit forming nature. Although Rockwells customers purchase less

frequently, they actually use the products on a daily basis. This is particularly true

for Rockwells Automation software, which is used constantly by employees.

Scalable

Mr. Buffett is also familiar with businesses which are scalable. Coca-Cola has been

a terrific investment because the product can be consumed by every person on

Earth. Furthermore, the lack of an after-taste, and thirst quenching appeal in hot

climates, means that people can drink it multiple times per day without tiring of

it.

Rockwells offerings are similar in this regard. Since the products are modular,

they can be combined to form customized solutions for every type of

manufacturing and production business around the globe. Rockwells customer

base, fragmented across industry and geography, already reflects this universal

appeal.

Conclusion

Rockwell Automation is a simple and understandable business. Although the

company uses technology to add value, the core business is not susceptible to

rapid change like Facebook and Samsung. Rockwell Automation is clearly within

the boundaries of Mr. Buffetts circle of competence.


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2. Historical Moat

The number one idea is to view a stock as an ownership of the

business and to judge the staying quality of the business in terms

of its competitive advantage. Charlie Munger

Mr. Buffett and Mr. Munger refer simply to moat. I prefer to break the analysis

into two parts. The existence of a moat is examined in this section, focusing on

historical data. Once the existence of a moat has been established, we will go

deeper to determine how durable it will be in the future.

Profitability

Mr. Buffett requires consistent profits.

EPS consistency

Earnings consistency increases the probability that a moat exists. It also improves

predictability of future cash flows. Rockwell Automation has a consistent EPS

history. Over the past 10 years, ROK has increased EPS every year but one: 2009.

Furthermore, a 10 year EPS growth rate of 12.3% is excellent.

High ROE

With an ROE of 34% over the past 10 years, Rockwells efficiency is superb. Mr.

Buffett considers 20% to be an excellent mark, so Rockwells ROE is exceptional.

The consistently high ROE suggests that Rockwell has a strong moat. Only in

2009 did ROE fall below 28%.

1.85

2.77

3.49 3.53 3.90

1.53

3.06

4.80 5.14

5.37

5.92

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Diluted EPSsource: Company data

28%

38%

30%33%

13%

33%

48%

42% 41%

32%

0%

10%

20%

30%

40%

50%

60%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Return on Equity 10 yrsource: Company data,

my calculations


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To ensure that the company is achieving high Return on Equity without the aid of

excessive leverage, Mr. Buffett requires a high Return on Total Capital as well. The

company has averaged a ROTC of 25% over the past 10 years. This supports the

high ROE numbers. Calculation: (Net Income + Interest Expense) / (Equity + Debt

+ Employee Benefits)

Low debt

Beyond the distortion of ROE, Mr. Buffett does not like companies with high debt

levels because it increases business risk.

With 827m in 2014 Net income, Rockwell Automation could pay down the 1.4B

debt in less than two years.

Furthermore, the company holds 1.9B in Cash and ST securities, which offsets the

entire 1.4B debt.

Mr. Buffett would consider Rockwells balance sheet to be strong.

Capital Intensity

Mr. Buffett has stated repeatedly that a business with high capital intensity will

never be a wonderful business. Rockwell has low capital intensity in terms of both

capex and R&D.

Low capex requirements

Over the past 10 years, capex has averaged 2.3% of Sales. This equates to just

21.4% of Cash Flow from Operations (CFO).

Furthermore, depreciation is a good approximation of capex for the company.

This improves Mr. Buffetts ability to predict future cash flows.

21%24%

22%

26%

11%

21%

31%29% 30%

33%

0%

5%

10%

15%

20%

25%

30%

35%

1 2 3 4 5 6 7 8 9 10

Return on Total Capital 10 yrsource: Company data,

my calculations

Capex

Depreciation

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Capex vs Depreciationsource: Company data


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Low R&D requirements

R&D is considered to be a capital expenditure, because R&D is often compulsory

for the company to stay abreast of the competition.

According to the 2014 EU Industrial Scorecard, Rockwells recent spending of 4%

of Sales would be consistent with R&D expenses for the average Electronic and

Electrical equipment business. However, a large part of R&D for Rockwell is

more akin to Technology Hardware & Equipment, where the average is 8.0% or

Software & Computer services at 10.4%.

Considering Rockwells recent EPS growth and ROE, it appears that the company

is highly efficient with its R&D expenditures.

Cash Flow Generation

A company can use earnings manipulation to boost EPS and ROE. Since Mr.

Buffetts intrinsic value calculation depends on expected future cash flows, it is

wise to check that earnings are generating Free Cash Flow (FCF). FCF is calculated

as CFO less capex and business acquisitions.

The ratio of FCF / Net Income from continuing operations has been 88% over the

past 5 years. Given the growth in EPS, this is excellent FCF generation. Earnings

are quickly being converted into Cash.

Note: In 2007, FCF is abnormally high due to divestiture of the companys Power

Systems segment. 2008-2009 cash flow numbers are distorted by the companys

volatile working capital numbers during the financial crisis.

Industry profitability

As an industry, Automation is highly profitable. Rockwell has only a few

competitors which are as large and diversified. The comparisons are imperfect

because Rockwell is one of the few companies which generates 100% of its

2.8% 2.7%

3.3% 3.4%

3.9% 4.1%4.2%

4.0% 4.1%4.4%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

R&D / Sales

100%78%

319%

59%

184%

91%69% 77%

104% 98%

0%

50%

100%

150%

200%

250%

300%

350%

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

FCF / Net Income


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revenue from Automation. The point is that these companies are consistently

profitable, with high ROE. Furthermore, Automation tends to be one of the most

profitable segments.

10 yr ROE Auto % Rev Auto % EBIT Automation

EBIT margin

ABB 22% 42% 49% 12.6%

Emerson 23% 56% 64% 19.6%

Siemens 17% 13% 31% 13.2%

Rockwell 34% 100% 100% 17.8%

Automation is driving high returns across the industry. Each of these businesses is

able to maintain strong profit margins, so it seems that competitive rivalry is low

and the companies are not competing on price.

Furthermore, the consistently high ROE across the industry suggests that there

are strong barriers to entry.

Pricing power

The nature of the business gives Rockwell Automation a reasonable amount of

pricing power.

The input costs for hardware components are commodities such as copper, and

labor. Most of Rockwell Automations costs are related to employees, whose

wages are sticky.

Rockwell has increased gross margins for 5 years in a row, from 36% in 2009, to

41.6% in 2014. It is useful to note that R&D has been rising faster than Sales, and

Rockwell includes R&D in COGS. As such, the Gross margin numbers may be

understating Rockwells pricing power.

Conclusion

Rockwell Automation strong evidence of a moat over the past decade. The

company has consistently grown EPS, with a high ROE, and generated plenty of

cash flow. There appear to be industry level barriers to entry as well, which

increases our confidence in the existence of a moat.


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3. Future Moat (durability)

So we think in terms of that moat and the ability to keep its

width and its impossibility of being crossed as the primary

criterion of a great business. And we tell our managers we want

the moat widened every year. That doesnt necessarily mean the

profit will be more this year than it was last year because it

won't be sometimes. However, if the moat is widened every year,

the business will do very well. When we see a moat that's

tenuous in any way-it's just too risky. We dont know how to

evaluate that. And, therefore, we leave it alone. Warren Buffett

Rockwell Automation has a strong moat. However, Mr. Buffett will not invest

unless he is confident that this moat will not erode in the near future.

Nervous system

To get a deeper understanding of how Rockwells moat functions, an analogy is

helpful.

Think about how the brain functions in the human body. The brain allows the

body to function efficiently by automating processes. In fact, almost every

function is automated with the help of the nervous system.

Take driving for example. It probably took significant practice to learn how to

drive. At first each movement took conscious effort, but eventually the brain

automated nearly every process involved.

To make a right turn, you automatically turn your head to look for people, cars

and traffic signals. At the same time, your arms turn the steering wheel, and your

foot presses the gas pedal. These separate processes are further coordinated by a

higher layer automatic process which runs them at the correct time, in the correct

sequence.

Now, can you imagine removing even one of these processes? If your brain was

unable to automatically turn the steering wheel, you would have to consciously

focus on how much the wheel was turning as you were executing the turn. This

would take a significant amount of cognitive energy, and it would distract you

from every other part of driving. Your ability to drive might be severely impaired,

and at the very least it would be very slow.

Rockwell provides automation in a similar fashion. Rockwell sells hardware

components, which are similar to the nerve cells. Each product works with certain

types of machinery. Just as an optical nerve is differentiated to function in the

eye, a range of differentiated controllers and sensors can be customized to a

specific type of machines.

Furthermore, Rockwell software which helps to link each of these components to

the employees. This compares to the individual nerves linking back to the brain,

and then the interactions between different regions of the brain.


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Network Effects

To further the analogy, the communication between a group of Rockwells

components is like the communication between nerves. Simple parts send signals

back and forth to achieve an advanced function. Rockwells components work like

a network, whose value is greater than the sum of its parts.

Compatibility

Since communication between the components is important, the internal network

effect encourages the consistent use of one brand to ensure compatibility.

The higher the volume of components, and more complex the functions that they

perform, the greater the network effect. As the network size increases, so does

the incentive for the customer to stick with the Rockwell brand. Indeed, larger

customers tend to install entire control platforms of components from the same

brand.

Although weaker than the external network effects of a company like EBay,

Rockwells internal network effects strengthen the moat.

Distribution

As previously mentioned, 70% of Rockwells sales are through independent

distributors. These independent distributors tend to sell only Rockwells products.

This makes sense, because Rockwells customer base is highly fragmented across

both geography and industry.

This is important to the moat for two reasons. First, it lowers the buyer power,

which allows Rockwell to maintain high profit margins.

Second, it creates a barrier to entry. A new entrant would be unable to steal

market share without significant time and cost.

Switching Costs

Integration

One of Rockwells areas of focus has been integration.

Rockwell sells packages of its products called control platforms. The companys

diverse range of products can be highly customized to the customers business. A

platform means that the customer is using the same brand for an entire factory.

Even more integrated, Rockwells Logix controllers are information-enabled.

They collect data which can be programmed with software to perform more

advanced functions, which increases integration.

The ultimate level of integration is what Rockwell calls the Integrated Enterprise.

This is achieved when Rockwells Operations Technology (OT) is integrated with

the customers Information Technology (IT). This gives the customer the highest

degree of control over their manufacturing and production systems.

In the nervous system analogy, removing highly integrated, automated processes

would be like undergoing a lobotomy. This is an excruciating thought for the

customer. If an automation platform is running smoothly, there is little to gain by

switching to a competitor. Yet, there is much to lose by tampering with key

functions.


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High benefit to cost

Not only is switching a painful thought, the cost of each component is low

compared the overall production equipment. Unless a full overhaul is necessary,

it is unlikely that a customer would even think about switching.

Brand

Consistent

This has a bearing on a key attribute that Rockwell

must focus on: consistency. If the customer cannot

depend on each part functioning in the same way as

the previous part, it ruins their incentive to pay more

for the brand.

Evaluating Rockwell on this dimension, we see that the

company has done an excellent job in this regard.

Differentiation

Rockwell appears to be keenly aware of this consumer

behavior. Customers highly value the ability to take a

component and confidently add it to the network.

The company has focused on this customer need as a

way to widen their moat. In fact, it has become the

main point of differentiation from its competitors.

Rockwell has the most modular hardware and software.

The architecture is open source, which allows it the

flexibility to work with almost any production process.

Furthermore, Rockwells Logix controllers bridged the

gap between factory and process automation. In their

2014 annual report, they state:

Our integrated control and information

architecture, with Logix at its core, is an

important differentiator. We are the only

automation provider that can support discrete,

process, batch, safety, motion and power

control on the same hardware platform with

the same software programming environment.

Our integrated architecture is scalable with

standard open communications protocols

making it easier for customers to implement

more cost effectively.

By pushing the boundaries of modularity and

integration, Rockwell has improved its brand

perception. The Control Readers Choice Awards

(right) shows that Rockwell has increased their brand

perception in Process Automation from 2011 to 2015.

The Control Readers Choice Awards reveals Rockwells

improvement in Process Automation. This is based on a

survey of 1000 respondents:


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Future Growth

Rockwells next step in widening its moat is by further integrating Automation

with the rest of the company. Rockwells new marketing focuses on the

Connected Enterprise, which integrates Operational Technology (Rockwell) with

Information Technology. Cisco is partnering with Rockwell for this opportunity.

A major technological trend known as the Internet of Things has been the

subject of much hype and speculation. Per Gartner:

The Internet of Things (IoT) is the network of physical objects

that contain embedded technology to communicate and sense or

interact with their internal states or the external environment.

This sounds very similar to integrated systems that Rockwell has been promoting

in recent years. Rockwell seems to be well ahead of this curve. The trend should

fit neatly into the strategy that Rockwell is already pursuing, and make Rockwells

marketing efforts easier.

Mr. Buffett is generally skeptical of growth forecasts. In this case, the investment

thesis does not rely on optimistic growth. Investors have priced ~5% growth into

the stock. Rockwell is a wonderful company, regardless of the Internet of

Things.

Considering the Internet of Things as a threat, Rockwells strong moat is unlikely

to be eroded by this trend. Putting internet technology in a home lighting system

would clearly cause disruptive change in that market, because it is an untapped

market which is relatively homogenous.

But it is less dangerous to Rockwell. The company is already providing this level

of integration. To disrupt Rockwell, a competing technology would need to be

applicable to a range of highly fragment production and manufacturing

processes, in various industries.

Conclusion

Rockwells strong moat includes network effects, switching costs, and brand

loyalty. The diversified range of factors which create this moat translates into

lower risk of erosion. The company is making continuous efforts to widen its

moat.

Rockwell Automation appears to have a sustainable competitive advantage.


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4. Management

When we own portions of outstanding businesses with

outstanding managements, our favorite holding period is

forever. Warren Buffett

CEO

Keith Nosbusch has been CEO since 2004. Prior to this, he was president of

Rockwell Automation Control Systems, since 1998. He began his career with

subsidiary Allen-Bradley, in 1974.

This is a long tenure as CEO, which increases the likelihood that he is motivated

by long term goals for the company.

This is also a very long tenure as an employee of the company. Mr. Nosbusch has

an extensive amount of operating experience in the field of Automation. He also

played a key role in the development of the Logix controllers in the 1990s.

This should give Mr. Buffett confidence that the CEO has high capability as an

operator.

Management Incentives

Executive compensation is mostly based on metrics which align with

shareholders. However, these incentives are generally short term in nature:

2014 CEO

pay ($mm) Explanation

Salary 1.2 Base salary

Stock awards 2.2 75% Performance shares. Based on ROK stock price

performance compared to S&P500

25% RSUs. 3 year vesting period.

Option awards 2.3 Stock options. 1/3 vest in 1, 2, 3 years

Incentive plan 1.3 Incentives based on measurable goals. Goals include

Sales, EPS, ROIC, EBIT, FCF

Pension 1.4 Pension

Other 0.1 -

Total 8.5

The majority of compensation is based on 1 year of performance. It is only the

RSUs and 1/3 of the stock options which take 3 years to vest. This represents just

16% of total compensation.

It is a positive sign that ROIC and FCF are part of the Incentive plan. However,

their impact is only 6% of total compensation.

The best management incentive is the Stock Ownership policy, which an

executive must abide by within 5 years. The CEO must own Common shares

worth at least 5x base salary. Other executives must own at least 3x base salary.

To some degree, this offsets the short term nature of Rockwells executive

compensation.


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Capital Allocation

Rockwell is a Cash Flow machine, so capital allocation is crucial. Thankfully, the

Executives are excellent capital allocators.

A key indicator of good management is the consistently high EPS and ROE

numbers shown earlier. A ten year average ROE of 34% is far beyond what Mr.

Buffett considers to be excellent (15-20%).

Rockwell Automation would probably be a good business with only mediocre

management. Having excellent management is what accounts for the stellar

results.

Dividends and Buybacks

Management is eager to return capital to shareholders. They returned 72% of

CFO to shareholders in past 5 years via dividends (32% of CFO) and buybacks

(39% of CFO).

Mr. Buffett has said that his ideal company can both generate high returns on

capital, and employ large amounts of capital. Since invested capital is producing

30-40% returns, it is tempting to criticize management for not retaining more

capital.

There may be some merit to this, as Revenue has grown at 4.1% over the past 10

years. However, I believe that Mr. Buffett would be satisfied with a company that

is excessively efficient.

Acquisitions

In the past 5 years, Management has spent 5% of CFO on acquisitions. The

company clearly states its acquisition strategy in the 2014 Annual Report:

Acquisitions that serve as catalysts to organic growth by adding

complementary technology, expanding our served market,

enhancing our domain expertise or continuing our geographic

diversification

Capital Allocation Summary 2010 2011 2012 2013 2014 avg

Cash Flow from Operations 494,000 643,700 718,700 1,014,800 1,033,300

Allocated to:

Purchase of ST securities (4,100) - 350,000 22,200 257,900

% CFO -1% 0% 49% 2% 25% 15%

Capex 99,400 120,100 139,600 146,200 141,000

% CFO 20% 19% 19% 14% 14% 17%

Business acquisitions - 45,900 16,200 84,800 81,500

% CFO 0% 7% 2% 8% 8% 5%

Dividends Paid 173,600 211,000 247,400 276,300 320,500

% CFO 35% 33% 34% 27% 31% 32%

Debt repaid (Raised) - - (157,000) (22,000) (146,000)

% CFO 0% 0% -22% -2% -14% -8%

Equity bought back (Raised) 118,800 298,700 259,400 402,700 485,700

% CFO 24% 46% 36% 40% 47% 39%

Total 387,700 675,700 855,600 910,200 1,140,600

% CFO 78% 105% 119% 90% 110% 101%


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Recent acquisitions appear to fit with this acquisition strategy:

2014: Jacobs, US, a leader in intelligent tracking motion for OEMs.

2013: vMonitor, UAE, global technology solution for wireless in Oil and Gas.

2012: Harbin Jiuzhou Electric, China, a leading manufacturer of medium voltage drives,

direct current power supplies, switch gear and wind inverters.

2012: SoftSwitching Technologies Corporation, an industrial power quality detection and

protection systems provider in the United States.

These companies were not large enough to be acquired for the purpose of

empire building.

Divestiture of Power Systems business

Far from empire building, in 2007, management divested the Power Systems

segment. The Power Systems segment was smaller, and less profitable. In the

years prior to the sale, EBIT margin was much lower:

2001 2002 2003 2004 2005 2006

Control

Systems

12.7% 10.5% 12.0% 14.4% 18.4% 19.2%

Power

Systems

5.0% 7.2% 7.5% 9.0% 12.5% 16.1%

The segment was sold for 1.8B, or roughly 11.1 x EBIT. Considering how high

2006 EBIT was compared with prior years, this was probably an excellent price to

sell at. Regardless, the sale allowed management to focus on the more profitable

Automation segment.

Managements track record and stated strategy suggest that large, high risk

acquisitions are unlikely.

Ownership mentality

Management is long term oriented. They are consistently taking action to widen

the moat. The CEO seems to highly responsive to customer needs.

The company has focused on improving quality and using technology to create

new product offerings. Within the last 3 years, management has focused on

enhancing value for the customer by adding virtualization, remote asset

monitoring, and cloud based applications.

Management also saw the customer benefit to making their products as modular

and flexible as possible.

Trust

The CEO is quite candid. On earnings calls, he clearly states when he is

disappointed with results. He seems to respond frankly to all questions which he

is asked. The CFO is also straight forward.

Conclusion

Management is excellent. They are trustworthy, have an ownership mentality, are

excellent capital allocators, and aim to consistently widen the moat.


17 of 22

5. Margin of Safety

When we buy business, we try to look out and estimate the cash

it will generate and compare it to the purchase price. We have to

feel pretty good about our projections and then have a purchase

price that makes sense. Warren Buffett

Equity Bond

Mr. Buffett looks at the business as an Equity Bond. From this perspective, the

EPS that the business produces each year is like the coupon on a bond.

With 2014 EPS of 5.92, and price per share of 112.81, ROKs initial rate of return is

5.25% (5.92/112.81). Each year, this EPS coupon will grow larger.

We will now use two methods to calculate an internal rate of return for the Equity

bond.

1. ROE method

In the ROE method, we calculate the future value produced by assuming that the

recent level of ROE will hold over the next 10 years.

Taking the 5 year average ROE of 39% and multiplying by the retention ratio of

19%, we expect a Book Value growth rate of 8% (39% * 19%).

Compounding over 10 years, BV should be 39.34.

If BV is 39.34, if we multiply by ROE of 39%, in 10 years EPS will be 15.44.

Based on this EPS, we apply a P/E multiple to determine the stock price in 10

Book value per share 19.03

ROE (5 yr avg) 39%

Retention ratio (5 yr avg) 19%

Book value growth rate 8%

BV in 10 years 39.34

EPS in 10 years 15.44

5 year average P/E 16.87

Current P/E 19.06

Stock price in 10 years (avg PE) 260.45

Stock price in 10 years (current PE) 294.22

Total dividend pool 85.47

Total Value in 10 years (avg PE) 345.92

Total Value in 10 years (current PE) 379.69

Current stock price 112.81

IRR (avg PE) 11.9%

IRR (current PE) 12.9%


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years. For a low estimate, we use the 5 year average P/E of 16.87x. For a high

estimate, we use 19.06x.

Applying these multiples, the stock price should be between 260.45 and 294.22

To determine the total future value in 10 years, we need to add the total dividend

pool of 85.47. This leave us with the Total Value in 10 years.

Finally, we determine the rate of return necessary to grow from the stock price of

112.81 to the total future values of 345.92-379.69.

The result is an internal rate of return in the range of 11.9% to 12.9%.

2. EPS growth method

In the EPS growth method, the assumption is that EPS growth is maintained at

the historical rate for 10 years.

Starting with EPS of 5.92, we apply the 12.3% historical EPS growth rate for 10

years. This yields EPS in 10 years of 18.90.

To calculate the stock price in 10 years, we apply the 5 year average PE of 16.87x

for a low estimate, and the current PE of 19.06x for a high estimate. Therefore,

the stock price in 10 years will be 318.96 to 360.32

Adding the dividend pool of 95.69, the Total Value in 10 years is 414.65 to

456.01.Since the current stock price is 112.81, we can calculate the rate of return

necessary to grow to the future values.

The result is an internal rate of return in the range of 13.9% to 15.0%.

Conclusion

Using these 4 IRR estimates, Mr. Buffett would expect a return of 11.9% 15.0%

over the next 10 years. This is an excellent return considering the current 2.3%

return on long term bonds.

EPS growth rate - historical 10 yr 12.3%

Beginning EPS 5.92

Projected EPS 18.90

5 year average P/E 16.87

Current P/E 19.06

Stock price in 10 years (avg PE) 318.96

Stock price in 10 years (current PE) 360.32

Dividend pool 95.69

Total Value in 10 years (avg PE) 414.65

Total Value in 10 years (current PE) 456.01

Current stock price 112.81

low IRR 13.9%

high IRR 15.0%


19 of 22

Discounted Cash Flow model

I made the following assumptions: 9% discount rate, 5% revenue growth, 1%

increase in gross margin over 5 years, 4% terminal growth rate. My calculations

show an intrinsic value estimate of $129.70. At the current price of $112.81, this

represents a margin of safety of 13.0%, or potential gain of 15.0%.

Thus, $112.81 represents a fair price for Rockwell Automation.

2013 2014 2015E 2016E 2017E 2018E 2019E

Revenue 6,351,900 6,623,500 6,954,675 7,302,409 7,667,529 8,050,906 8,453,451

Growth %: 1.5% 4.3% 5.0% 5.0% 5.0% 5.0% 5.0%

Cost of sales 3,778,100 3,869,600 4,033,712 4,220,792 4,408,829 4,613,169 4,826,920

COGS % Revenue: 59.5% 58.4% 58.0% 57.8% 57.5% 57.3% 57.1%

Gross Profit 2,573,800 2,753,900 2,920,964 3,081,616 3,258,700 3,437,737 3,626,530

Gross margin 40.5% 41.6% 42.0% 42.2% 42.5% 42.7% 42.9%

Operating expenses:

Selling, General and Admin 1,537,700 1,570,100 1,669,122 1,752,578 1,840,207 1,932,217 2,028,828

EBIT - Operating income 1,036,100 1,183,800 1,251,842 1,329,038 1,418,493 1,505,519 1,597,702

Interest expense: Debt (60,900) (59,300) (52,559) (27,655) (17,875) (17,875) (17,875)

Other Income (expense) 5,700 9,700 2,000 2,000 2,000 2,000 2,000

Income before provision for income taxes 980,900 1,134,200 1,201,282 1,303,383 1,402,618 1,489,644 1,581,827

Tax rate 22.9% 27.1% 27.0% 27.0% 27.0% 27.0% 27.0%

Provision for income taxes 224,600 307,400 324,346 351,913 378,707 402,204 427,093

Net Income from continuing operations 756,300 826,800 876,936 951,470 1,023,911 1,087,440 1,154,734

Unlevered Free Cash Flow (FCFF) 831,256 854,428 895,247 897,073 952,536 1,006,369 1,064,437

Present Value of unlevered FCFs 821,327 755,049 735,532 712,937 691,811

Discount rate 9.0%

Terminal EBIT Multiple 12.00 x

Terminal Value Growth rate 4.0%

Terminal Value 22,140,289

Sum of present value of cash flows 3,716,656

PV of Terminal Value 14,389,669

Enterprise value (PV) 18,106,325

Terminal Value % EV 79%

BS adjustment (deducting debt) (484,702)

Implied Equity Value 17,621,623

Implied Price per share 129.71

Margin of safety 13.0%

Potential gain 15.0%

Diluted Equity Value (in thousands) 15,326,147

less cash (1,291,900)

less marketable securities (620,800)

less other Hidden assets / Redundant assets

plus debt 1,413,600

plus minority interest

plus preferred stock

plus pension 767,900

plus other liabilities 215,902

Enterprise Value 15,810,849


20 of 22

Charlie Munger Test

With respect to margin of safety, Charlie frequently suggests

that investors can benefit from following the Big Idea Model of

redundancy from engineering. Bridges are designed with backup

systems and extra capacity to prevent failures so too should

investing strategies Poor Charlies Almanack

Hypothetical competitor?

In Charlie Mungers 1996 talk Practical Thought About Practical Thought he

reinvents Coca-Cola from first principles. I think it is useful to ask an analogous

question. With a large sum of capital, $5 billion for instance, how difficult or easy

would it be to create a competing business?

A true competitor to ROK would require an investment in: R&D for >300,000

hardware and software products, sales, distribution, manufacturing, industry

experts, and switching costs.

These seem like extraordinary obstacles to overcome. The biggest problems are

the fragmented nature of both the product portfolio and the customer base. It

would not just take money, it would a great deal of time to enter this market.

What could go wrong?

Invert, always Invert Carl Jacobi (and repeated by Munger)

Mr. Munger uses his mental models to search for disconfirming evidence.

Inflation

As discussed earlier, it seems that Rockwell has some degree of pricing power.

The companys increasing Gross Margins give some comfort the Rockwell would

be able to pass on costs to the consumer.

Deflation / Economic downturn

Deflation would likely be a cause for concern. Deflation would likely hurt the

ability of Rockwells customers to pay for capex.

In 2009, organic sales fell 19%. However, the company took quick action to

manage inventories, receivables, and capex. This allowed the company to earn a

profit in 2009, despite the harsh environment.

Rockwells dependence on its customers capex is unavoidable, so the company

will be exposed declining sales during the next crisis. However, the companys

low capital intensity, high FCF generation, strong balance sheet, and high margins

will reduce the pain.

Foreign currency

The company receives revenue in foreign currency, but it also manufacturers

abroad. To some degree FX risk is mitigated this way. Furthermore, the company

does not have major exposure to any one country aside from the US.

Black or Grey swan in manufacturing

A black or grey swan in manufacturing would be a concern. What could possibly

destroy Rockwells moat?


21 of 22

Could artificial intelligence disrupt the need for employees? Imagine IBM had a

version of Watson which could manage a manufacturing process. Could IBM

disrupt Rockwell? This seems unlikely because of the fragmented and

heterogeneous nature of Rockwells customer base.

3D printing

Will 3D printing revolutionize the manufacturing process? Currently, 3D printing

is mostly used for custom parts (like a piece of an airplane) and prototypes. One

of the issues is that 3D printers are too slow for manufacturing. This may change

with time and changes in technology.

There are many other challenges for 3D printing to overcome. The materials used

for 3D printing can be expensive, and are limited in scope. It is unclear whether

3D printers can eventually become more economical than a machine automated

process.

In any event, 3D printers are unlikely to affect Rockwells business in the next

decade.

A change in the 1 or 2 key factors in the business

What is the most important factor for Rockwell? Perhaps it is the continued

integration of technology into product offerings. Rockwell seems to be the leader

in the industry in this regard.

Accounting issues

The accounting for Rockwell Automation is relatively transparent. The risk of

earnings manipulation is low because the company converts Revenue to FCF very

quickly.

Low capital intensity reduces the risk of asset impairment.

Acquisitions have been negligible, which means relatively low accounting

complexity, lower business risk, and reduced risk of Goodwill impairment.

Environmental

The company has contingent liabilities related to claims of personal injury from

exposure to asbestos. Asbestos was used in some components in the past. These

claims have existed for a long time. So far, they have not lead to significant

charges, nor does it appear that they will.

Are there hidden environmental issues? Food safety regulation is generally a

good thing for Rockwell. Could Rockwell be blamed for anything in their

products which is potentially toxic, like BPA in plastic? Even if these risks exist, the

likelihood that damages would be exorbitant are low.

Pension

Rockwell has a large pension. One of the biggest concerns is that the Expected

return on plan assets is 7.5%. If the Pension is unable to meet this return, the

funding shortfall will be a large unexpected cost.

Risk is mitigated to some degree by the companys strong balance sheet, and FCF

generation. However, there is pressure on the Pension to meet the return

expectations.


22 of 22

Competitors

Rockwells competitors are large and global. If competition increases, could a

price war start? For this to happen, the industry growth would have to disappear.

What could cause industry growth to slow that much? There are still many

opportunities for growth in emerging markets. Slowed growth is unlikely for at

the least the next few years.

Are there any large, resourceful companies who might be interested in entering

the market? Perhaps a technology company seeking to capitalize on the Internet

of Things. The fragmented nature of the products is a tough barrier to crack, even

for a large company.

Could Amazon compete with Rockwell? Amazon is a reseller. They may be able to

encourage some Chinese brands to sell online. However, Amazon is better at

replicating the model of brick and mortar resellers. If Rockwell outsourced and

resold their hardware, then perhaps Amazon would be able to compete. But it is

much harder for Amazon to compete in this market because they do not have

manufacturing abilities, or the industry expertise to sell the product.

Investor psychology

Is the stock hyped? Are optimistic growth assumptions priced in? No. The current

stock price implies a roughly 5% revenue growth rate.

Employee psychology

Are employees satisfied? Are they treated respectfully? Rockwell Automation has

a rating of 3.8 / 5.0 on Glassdoor.com from over 400 reviews. This is a good

score. The CEO gets a 90% approval rating.

Consumer psychology

What could change about consumer psychology? In a prolonged economic

downturn, would companies consider the purchase of lower quality,

commoditized versions of the Rockwells products from China? A prolonged

downturn would certainly hurt Rockwell, but it is not likely that customers would

quickly turn to low quality. Rockwells products integrate with key parts of the

customers value chain. Rockwell would probably be one of the last places that

the customer thinks of cutting costs.

Conclusion

After carefully considering what could go wrong with business, I think Mr.

Munger would be happy with Rockwell Automations risk profile.

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winner_r_cover.compressedwinner_r_inside.compressedwinner_r_thesis.compressedRockwell Automation is Mr. Buffetts next buy - Thomas F Harris1. Circle of Competence2. Historical Moat3. Future Moat (durability)4. Management5. Margin of SafetyCharlie Munger Test

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