ABB Undervalued As The Next Phase Of Its Evolution Begins (NYSE:ABB)


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For a company that was perpetually restructuring over the last two decades, what CEO Bjorn Rosengren has accomplished in two years at ABB (ABB) impresses me. The company has embraced decentralization with gusto and starting moving more definitively in terms of rearranging the portfolio (selling Dodge, looking to IPO the charging business, spin-off turbocharging, and so on). With that, margins have improved and the company’s credibility on the Street is substantially higher.

Now comes the next phase – growing off of this improved base, and this offers a different set of challenges and risks than the prior phase. I like ABB’s leverage to electrification and automation, two of what I believe will be the dominant trends over the next decade, but there will still be challenges to navigate, including the ongoing question of whether ABB has invested enough in software capabilities.

ABB has been a modest underperformer since my last update, but not by a wide margin. I still see core revenue growth potential of around 4% long term, as well as high single-digit to low double-digit FCF growth, and with that I think ABB is priced for a high single-digit long-term annualized return; good enough to keep it at a buy in my book.

Fourth Quarter Earnings Were Okay, But Sentiment Is Different This Cycle

On balance, I can’t really complain about ABB’s fourth quarter results – revenue and orders were ahead of expectations, as was EBITA, though margin was a little weak. That was very typical for what industrials have reported, and it’s a little strange – in past cycles, industrials that beat on revenue and missed on margins would have been punished. Yes, this cycle is different, and it’s also true that some air has come out of industrial sector valuations, but it’s a difference worth monitoring as a sentiment risk for the time being.

Revenue rose 8%, beating by 2%. Gross margin improved almost two points year over year, but declined about a point sequentially. EBITA rose 22% as reported, beating by 1% (though one reporting source indicated a higher average estimate, where ABB would have missed by about 2%-3%), though the 160bp margin improvement to 13.1% was about 20bp short of expectation (or 60bp by that other source).

On A Relative Basis, ABB’s Growth Comes Up Short

The Electrification business posted 4% organic revenue growth, beating by about 2%. By comparison, Eaton (ETN) posted 5% growth in its Electrical Americas business and 15% growth in its Electrical Global business, while Schneider (OTCPK:SBGSY) has not yet reported and Siemens (OTCPK:SIEGY) posted 6% growth in its Smart Infrastructure segment. Hubbell (HUBB), a smaller rival, reported 16% overall growth. Segment profits fell 1%, beating by 1%, with margin declining 80bp to 14.8%. Orders rose 20%.

Motion revenue rose 9%, beating by 2%. This segment is a little harder to benchmark, though Siemens did report 11% growth in Digital Industries and Rockwell (ROK) reported 26% growth in Intelligent Devices. Segment profit declined 1%, beating by 2%, with margin down 70bp to 16.1%.

Process Automation revenue rose a strong 19%, beating by more than 3%. Honeywell’s (HON) Process Solutions was down 2%, and again Siemens’ Digital Industries (which is about 20% exposed to similar markets) grew 11%, while Emerson (EMR) was up about 5%. While Rockwell pointed to 20% growth in its discrete automation business, process automation growth was tagged at 30%. Profits rose almost 150%, beating by 2%, with margin up almost seven points to 13.7%. Orders were up 20% adjusted for large orders in the year-ago period.

In the Robotics and Discrete Automation business revenue declined 1%, beating by 1%. Again, this can be a somewhat challenging business to benchmark, but ABB definitely lagged the reported results from Fanuc (OTCPK:FANUY) and Yaskawa (OTCPK:YASKY), something I’d attribute in part to quarter-to-quarter order habits of large auto OEM customers. Segment profits rose 10%, missing by more than 12%, with margin up 80bp to 8.1%, and orders were up 59%

ABB was undoubtedly hit hard by supply shortages in the quarter, and I think that explains at least some of the differences in revenue growth with its comparables. Along those lines, the 21% order growth and 21% backlog growth weren’t bad – the order growth in RDA was strong compared to Fanuc and Yaskawa. Likewise with the 20%-plus growth in the other businesses.

Time For The Next Chapter In The ABB Story

With ABB’s business stabilized and margins on a better path, the next challenge will be ABB’s transition to growth.

I’ll start with some negatives first. Management’s guidance for 4% to 7% growth at the December Capital Markets Day was an upgrade (from 3% to 5%), but not all that remarkable next to what we’ve seen/heard from the likes of Rockwell, Schneider, Siemens, and so on. Second, while CEO Rosengren has solid credentials where margins and business management are concerned, his ability to position businesses for growth is more questionable – it was an issue with both Sandvik (OTCPK:SDVKY) and Wartsila (OTCPK:WRTBY). Last and not least, while software is widely seen as a key enabling technology for this next leg of factory automation, ABB only generates about 3% of its revenue from software; rivals like Emerson, Honeywell, Rockwell, Schneider, and Siemens have all been more aggressive in building their software capabilities.

On a more positive note, ABB has excellent positioning in what I believe will be significant growth markets, including electrification (building and factory electrification, vehicle charging), factory automation (drives, controls, robotics), and process automation (full solutions for plant automation and electrification). Second, management has made it clear that they’re open for business where M&A is concerned, though with fairly rigorous price and fit criteria – ABB seemed to suggest that they passed on Aspen (AZPN) before the Emerson deal due to a lack of fit.

As far as software goes, management has gone to lengths to point to the number of engineers they have committed to software development and the R&D resources they’re spending there. This is a longstanding issue of mine with ABB and one I won’t belabor further, but I think this is an area that will remain controversial.

The Outlook

I’m still looking for long-term revenue growth of around 4% from ABB, and I think the company has excellent leverage to electrification and automation, which should serve as a strong tailwind across the next decade. I also see further margin improvement potential, with long-term FCF margins in the low-to-mid teens driving a nearly double-digit FCF growth rate. I also see an improving outlook for margins and ROIC beyond 2022, where supply chain risks are still significant, and this can support a higher forward multiple.

The Bottom Line

I do think that ABB is priced for a strong high single-digit long-term annualized return, and that’s enough to make it an attractive stock in my book. That said, the valuation at Siemens is still interesting and Schneider’s isn’t bad (I’ll get to Eaton another time). I do think investors should “shop around” as there are multiple plays on the key electrification and automation themes; I can’t and won’t call ABB my best idea in the space, but considering quality, risk, self-improvement potential, the possibility for outperformance, and so on, I still believe it’s a good option.

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