) higher. Milwaukee-based Rockwell, a supplier of industrial automation equipment, power controls, and information products, derives all of its sales from highly economically sensitive businesses. We at S&P recently upgraded the shares to 5 STARS (strong buy), our highest investment ranking.
Rockwell Automation started out as giant defense and industrial conglomerate Rockwell International. Following a series of divestitures and spin-offs that began in 1996, it now focuses on providing products and services to help businesses control and improve manufacturing processes. Its largest business unit, Control Systems, accounts for 78% of annual sales and produces a wide variety of input/output systems, drives, sensors, software, and more. Major users of the company's products include companies in consumer products, transportation, petrochemicals and mining, metals, and forest products.
Rockwell's other businesses include Power Systems (18%), which supplies power-transmission components. It also has a small presence in electronic commerce, providing systems and software to support companies' customer contact centers.
WAITING FOR RECOVERY. The U.S. is Rockwell's primary geographic market, from which it derived about 66% of total sales in 2002. Other key markets include Canada, several European countries, Mexico, China, Japan, Brazil, and Australia.
S&P views capital spending as critical to Rockwell's success. Unfortunately, current trends in this area from the manufacturing sector look uninspiring. This may be a result of aftereffects of the massive boom in capital spending throughout the late 1990s. S&P, therefore, anticipates Rockwell's top-line growth in the near-term to be flat to up only slightly, with most of the gains coming from recent acquisitions and a more favorable currency environment, given the dollar's recent decline.
However, once capital spending begins its eventual recovery from current depressed levels, Rockwell's recent cost-cutting initiatives and entrenched market positions bode well for its earnings leverage and upside earnings potential.
RISING MARGINS. Though we assume that revenue growth will be modest in the near term, S&P nevertheless expects Rockwell's operating profitability to continue to improve from its four-year low of 7% reported in fiscal 2001 (ended September), to approximately 8.5% to 9% in fiscal 2003. In fiscal 2004, we expect the ratio to rise to around 9.5% to 10%. Assuming capital spending picks up sooner than our current model anticipates, Rockwell's operating margins could rise to level of 14% to 16%.
Through management's focus on debt reduction in recent years, helped along by cost containment and cuts in the cash dividend (debt-to-total-capitalization has declined from a four-year high of 57% in fiscal 2001 to 48% in fiscal 2002), we expect annual interest expense to keep declining. In all, earnings excluding one-time items are projected to expand by approximately 21% in fiscal 2003, and by 17% in fiscal 2004.
Under Standard & Poor's Core Earnings methodology, we anticipate that earnings per share will grow approximately 18% in fiscal 2003, from 76 cents to 90 cents. Major adjustments include approximately 3 cents per share in stock-option expenses for both periods and the exclusion of an estimated 39 cents and 15 cents of pension and other post-retirement income in fiscal 2002 and 2003, respectively.
WARRANTED PREMIUM. S&P emphasizes
discounted cash-flow analysis in valuing the shares. We arrived at our valuation by adding the sum of free cash flow growing at a projected compounded annual growth rate of 4% to 5% over the next 10 years, and 3.5% thereafter. This analysis indicates to S&P that Rockwell's stock is worth $30 to $31 a share.
At their current quote of approximately $22.50, the shares trade at approximately 21 times our estimated earnings per share of $1.09 for fiscal 2003 and 18 times our $1.27 forecast for fiscal 2004. Although these multiples are at a modest premium to that of the S&P 500-stock index, S&P believes the a premium is warranted in light of Rockwell's strong balance sheet, enviable ability to generate surplus cash flow, and strong positioning in the markets it serves.
The potential risks in Rockwell Automation's meeting both our price and earnings projections include further deterioration among its customers and additional weakness in the global economic environment. Analyst Sanders follows capital goods stocks for Standard & Poor's