Automation Firms Build Their Moats Through Integration
Reaping the rewards of investment, Rockwell is our favorite.
With its strong growth and investment, automation has been one of the more robust industrial segments during the past decade, and we think it can support narrow economic moats. Rockwell Automation (ROK) remains our favorite pick in the industry, while Siemens (SI) appears to be the most likely acquirer.
Automation vendors tend to be broken down by the types of processes that their software handles. Discrete automation focuses on defined motion processes on countable items--what we typically see in a sorting line or a packing function. Several individual actions performed in succession are the forte of this branch. Equipment is typically bought from multiple vendors. As a result, software compatibility with the production equipment is critical. Manufacturers typically have a resident engineer to program the software, making ease of use also important. While there are some custom applications and solutions, these products typically are sold through distribution, though with back-end support. Rockwell Automation, ABB (ABB), and Siemens all have established roots in these markets.
On the other end of the spectrum is process automation, which entails larger batch jobs (mostly involving a liquid, gas, or mineral) and much more complex systems. End markets typically include refineries and mining. Since the cost of failure is quite high at a refinery, for example, automation providers may use uninterruptible power supply sources or slack capacity to ensure that the batch is completed. The higher complexity of these jobs requires higher levels of input/output support by the automation provider. These solutions are more customized in nature, requiring high levels of domain expertise by automation sales staff and engineers. Their counterparts at the refinery also have detailed knowledge and specific requirements for the project. This integration between the vendor and the customer makes the relationship fairly sticky and somewhat cumbersome to alter after a project has begun. Honeywell (HON), Emerson (EMR), Yokogawa, and ABB have typically dominated these markets.
Hybrid automation features a mix of discrete and process functions. This market was historically served by multiple vendors. In a brewery, for example, Emerson may have served the batch processes while Rockwell would have handled the bottling aspects. In the early 2000s, Rockwell invested heavily in its Logix platform of multidiscipline controls, allowing for a single terminal to control both the batch and discrete processes. This investment spawned the first legitimate threat to the traditional process players. Until a couple of years ago, process firms were content to let Rockwell pick up the smaller pieces, but all indications are that Rockwell is interested in pushing deeper into process automation.
New Opportunities Ahead
Many automation vendors have been preaching the value of variable-speed drives over traditional drives. Many motors in a plant simply have an on/off switch, either operating at full speed or not at all. Attaching a variable-speed drive allows a motor to be run continuously at an optimal speed, reducing wear and tear and energy costs. The push for variable-speed drives is relevant for process and discrete manufacturers since both use motors extensively.
We have also seen a fair amount of internal investment and new products in energy monitoring. Instead of taking plant-level energy consumption readings, a number of firms are focusing specifically on machine-level consumption. Schneider (SU) and ABB have been strong players on the energy side, given their natural linkage with power components. Rockwell is emerging as a leading innovator here as well. Since Rockwell's forte is in integrating disparate parts of the plant, its core strength should help clients successfully push into energy monitoring.
Longer term, we remain optimistic about the industry, despite its inherent cyclicality. Technology investment is the principal means of driving productivity growth. This applies for all economies, even after considering labor cost disparities. Automation firms have made material investments in emerging markets that have helped to offset sluggish growth in developed economies. Interestingly, many companies have reported that the labor cost disparity has started to shrink globally, giving manufacturers a decision node that ultimately plays into the hands of the automation firms, in our opinion. A manufacturer must build new facilities, chase lower labor costs, or remain in the same location and become more productive. Automation firms will have a shot at new revenue opportunities in any case.
We think the automation industry supports narrow economic moats, given high customer switching costs and the relative value added versus the incremental cost to the customer. Installing a new automation platform involves a manufacturer's critical production assets, so firms typically would prefer not to tinker with them, even if a supposedly better solution is available. This makes being an incumbent a very powerful position and also helps moderate the innovation cycle by participants. For example, a number of automation firms have only recently started adapting to Ethernet/IP protocol and have been rather sluggish, in our opinion, in adapting to wireless communication. While the technology exists and is out in the field, customers haven't necessarily demanded it and vendors are comfortable maintaining the existing base.
Industry Consolidation Unlikely
Aside from cyclical swings, automation firms tend to generate respectable cash flow, particularly considering the modest level of investment needed to sustain operations. Still, there has not been a significant amount of acquisition in the last cycle. Since most firms have reasonable internal growth opportunities, there isn't an overriding need to grow externally. Broadly speaking, software firms continue to be more attractive and justifiable as targets. As the need for smarter, more integrated components grows, it becomes critical to create a central brain that ties the pieces together. Other firms may pursue this path, much as Rockwell did with its development of Logix.
Industry consolidation is an unlikely route. There is little potential for economic value creation, with value destruction the more likely outcome, in our opinion. Once an incumbent firm acquires a rival, it has to decide whether to support the target's existing automation software. If the acquirer elects to support the existing automation software and to continue investing in the platform, everything continues as before. However, key synergy opportunities will most likely not be met since the back-office support and related costs will have to remain in place. At best, this is value neutral. If the firm elects to stop supporting the target's existing automation infrastructure, it sends the signal to customers that they are now able to find a new vendor, since the automation vendor will soon stop supporting their infrastructure. Putting the whole customer list up for bid is a risky proposition, and one that we generally think will end up in an erosion of value across the industry. For this reason, the notion that Rockwell will get bought by some major firm is largely overdone, in our opinion. Either a newcomer to the industry will pay a hefty premium for the business and let Rockwell run itself, or the other majors will coexist with the status quo.
While most people would point to Emerson as a potential acquirer, we think Siemens is in a better financial and strategic position. Emerson's recent acquisitions in the unrelated network power business have soaked up available capital and management attention, in our opinion, and limit the opportunity for another major purchase in the near term. Siemens, on the other hand, has largely stayed out of the acquisition mix this past cycle, instead cleaning up its own house. The firm already has solid discrete applications and sells directly into some process markets, namely water. If Siemens can integrate its pieces (through Logix or some other integrated architecture), it may have a much stronger value proposition for customers. We think this may be the one marriage that does not destroy significant value in the industry.
Uncertainty in the global atmosphere caused stocks to pull back materially last summer, creating some opportunities for investors focused on the longer term. While the threat of a global recession and a pullback in capital spending could create headwinds in 2012, we think the underlying need to maintain factory technology and improve productivity will drive longer-term growth for automation players. All six of the companies we cover that have a respectable presence in automation are currently rated 4 or 5 stars, with European firms ABB, Schneider, and Siemens trading at steeper discounts than their American peers.
Rockwell Automation remains our favorite pick. The company has made the requisite investments and is currently enjoying the harvest of many years' of hard work.
While heavy investments may stunt operating margin growth, they pave the way for growth in upcoming cycles, in our opinion.
As a whole, we view process automation as a narrow-moat industry, making Rockwell's success here all the more intriguing. As a pure-play in discrete automation, the firm was able to make significant and risky investments in technology, which paid off handsomely. Incumbent process players have been somewhat clumsy in responding to Rockwell's entry, with most resigned to letting Rockwell live off of the smaller projects that may not be as meaningful to the incumbent. We think that as Rockwell gains more experience and a larger process portfolio, it could emerge as a formidable competitor.
ABB joins Rockwell as one of the few firms that can play in the discrete, hybrid, and process markets. The same growth fundamentals that apply to Rockwell also bear significance for ABB. Additionally, ABB has strong relationships in the energy and power consumption fields, giving it a bit more gravitas there. The firm also has the capital to invest as it sees fit. While we are bullish on the longer-term fundamentals of ABB's portfolio, automation and controls make up just slightly more than half of the company's consolidated revenue.
Daniel Holland does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.