When I last wrote about Rotork (OTCPK:RTOXY) (ROR.L), I said that this British manufacturer of valve actuators and controls needed to accelerate product development and margin improvement efforts to support its valuation. Since then, the key oil & gas market has weakened dramatically and the shares have modestly underperformed the industrial sector. Weak organic growth remains a key concern, as although the company has made some progress on the product development front, it just hasn’t been significant enough to shift the company’s revenue mix all that much.
Rotork has good technology, and I expect electrical valve actuation technology is only going to become more valuable as 5G drives industrial IoT adoption and growth. On the other hand, I believe capex spending in the oil & gas vertical could be pressured for possibly five years, and that’s going to seriously challenge management’s capabilities. More positively, I do see Rotork as an increasingly attractive M&A target, though I’m not sure how much of a premium investors could reasonably expect to get.
Strong Where The Market Is Weak, Weak Where The Markets Are Strong
The biggest issue for Rotork today is simply its end-market mix. The company’s strongest brand position, market share, and margins are all in the oil & gas vertical, and particularly on the downstream side.
Orders in the oil & gas vertical are bad and getting worse, with Emerson (EMR) reporting a 30% yoy decline in August orders in the O&G vertical (within an 18% overall process automation order decline), and some industry participants warning that capex levels may not return to 2019 levels for four to five years. Rotork is actually doing okay on a relative basis, with a 13% yoy organic decline in first half O&G revenue, and management is bullish on opportunities in certain midstream and downstream sub-markets (pipelines and storage, namely), but it’s tough to make headway against that kind of pressure.
Rotork is likewise outperforming a weaker power gen market, with the company reporting good results in the first half, but I’m not too bullish on that trend continuing.
On the flip side, the stronger process markets like mining, food/beverage, and pharma are each only a few percentage points of Rotork’s revenue mix. The company has been working on repurposing and redeveloping technology for these markets, and there are attractive growth opportunities in each of these categories, but it takes time for companies to design new offerings into their projects, and particularly when those are components with high costs of failure – Rotork is a well-known name in oil & gas verticals, but that brand value doesn’t translate automatically to newer markets like food & beverages.
Industrial IoT Could Create Opportunities … Both Organic And Inorganic
Rotork’s core technology is in valve actuation – a $3 billion market for mechanisms that open and close valves. As process industries increasingly adopt automation, valve actuation is going to play a central role in systems, and that’s particularly true with electric valve actuation as industries move toward industrial IoT. With IIoT systems in place, process industries will be able to run their systems far more independently and precisely, with valves opening and closing in response to real-time sensing and control feedback.
Rotork has been investing in its own organic growth opportunities, repurposing technologies to new markets and developing complementary products in areas like instrumentation. With a clean balance sheet, Rotork has the opportunity to make some selective acquisitions to add more products and industry exposure, particularly in more attractive end-markets like water, food/bev, and pharma.
Emerson is one of Rotork’s biggest rivals in valve actuation, and they’ve made a few acquisitions in actuation and other parts of fluid control automation to build up their own automation offerings, and they’ve generally paid low-to-mid-teens forward multiples for those pieces.
By the same token, I could see Rotork becoming a target. With around 20% share, Rotork is a leader in actuation, but also enjoys strong share in areas like pneumatic and hydraulic actuation and related control devices. With companies like ABB (ABB), Rockwell (ROK), and Schneider (OTCPK:SBGSY), Siemens (OTCPK:SIEGY) all looking to build their process automation businesses and leverage opportunities to craft complete solutions, particularly in IIoT, Rotork could be viewed as a key enabling technology.
Now, it’s certainly true that many automation companies have been favoring software over hardware recently (certainly true for Rockwell, Schneider, and Siemens), but there are still growth opportunities in controls and instrumentation, and with the strong margins generated by actuation (Rotork has reliably generated 20%-plus adjusted margins), I could see Rotork as a possible target as there are few other players with scale in this key automation-enabling technology.
An ongoing shift toward electric actuation is good for margins, but the challenging conditions in oil & gas (which have gotten much worse over the last year) have mitigated any real progress on organic growth. As such, Rotork has found itself stuck as a slow-to-no growth industrial hardware company, albeit one with good margins. Looking out over the next few years, I’m concerned that ongoing weakness in oil & gas (which is still close to 50% of sales) is going to offset progress in markets like water, mining, food/beverages, and pharmaceuticals. A good targeted acquisition or two good certainly help that, and I would like to see Rotork direct its M&A spending toward growth markets like pharma.
I do believe oil & gas spending will recover at some point, and I’m looking for low-to-mid single-digit long-term revenue growth, but the next couple of years will likely be lean years for organic growth. Some recent cost restructuring efforts and an ongoing shift toward electric actuation should help boost long-term FCF margins toward the high teens (from the mid-teens), and I’m also looking for some margin uplift from mix (like higher-value IIoT products).
The shares don’t look undervalued on either a discounted cash flow or EV/EBITDA basis, and I believe there’s a M&A floor built into the share price. Even though I don’t believe potential acquirers are all that eager to buy large oil & gas exposure today, I think the opportunities to repurpose Rotork’s technology into other verticals and leverage its potential in IIoT are more compelling, and I can see a mid-teens forward EBITDA multiple still offering shareholders some upside (10%-15%) from here.
The Bottom Line
I rarely buy stocks on the assumption of M&A, and there are enough arguments against a Rotork buyout (hardware in a software-focused market, heavy oil & gas exposure, et al) that I won’t do it here. I do think Rotork is a quality company, and I do see M&A offering some downside protection, but I really need to see more energy devoted to repositioning Rotork toward longer-term, less cyclical markets before getting more excited about the shares.
Disclosure: I am/we are long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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