ROK - ABB: A Counterintuitive Top Pick For 2023

Summary

• ABB shares are down ~(21%) YTD as FY ‘22 comes to a close, even lagging the Euro STOXX Industrials index which is down ~(16%) YTD.
• After a rough 1H, Q3 results were strong with strength in the Electrification and Motion businesses, which together contribute ~75% of ABB’s operating EBITDA.
• Management expects to exit Q4 with a strong cash position. And I argue that the business may offer investors countercyclical dynamics under threat of a 2023 recession.
• While shares rallied following Q3, I suggest they may still be undervalued when considering the value of ABB’s “parts”.
• I propose ABB as a top pick for 2023 considering the points above, the current ~2.9% dividend yield, and management's ongoing commitment to unlock shareholder value.

From Bloated to Buy

With a potential recession looming, industrial giant ABB Ltd. ( ABB ) might seem to be a stock best avoided. Counter-intuitively, I propose the exact opposite and suggest ABB as a top pick for long investors in 2023.

After struggling for years (arguably) with a bloated portfolio of businesses and depressed demand during the pandemic, a newly streamlined ABB saw its operating EBITDA margin recently hit a high of 16.6% in Q3 FY ‘22.

Granted this is merely one, isolated data point, but it’s worthwhile noting here in the introduction that it puts management on track to reach their long-term EBITDA profitability goal of 15%+ one year early.

And mentioning this fact helps set the stage in this report to argue that:

1. Management’s turnaround plan is working.

2. The firm’s product and geographic diversity, coupled with its positioning to tackle the megatrends of electrification, renewable energy, and automation, may prove resilient even under recessionary conditions.

3. Shares may be undervalued on a “sum of the parts” basis.

Against the Grain

To be clear, my pitch of ABB as a “buy” heading into the new year goes against the grain of some recent important analysis, including a late November downgrade issued by BNP Paribas to sell shares.

Investors also seem a bit skittish of what may lie ahead in 2023, despite the rally in shares following the announcement of Q3 results.

Notes:

• Data as of market close December 23, 2022.

These sentiments are to be expected given the overhang of a potential recession, even if I do not agree.

Signs of a Turnaround: Diving Into Q3 FY ‘22 Results and Looking Out to Q4

As readers know, 1H FY ‘22 was a turbulent period for ABB, with the firm battling supply-chain bottlenecks and strict COVID-19 lockdowns in China. Problems in China were felt across ABB’s 4 operating segments of Electrification (“EL”), Motion (“MO”), Process Automation (“PA”), and Robotics and Discrete Automation (“RA”); but they hit RA especially hard. However, with supply-chain shortages easing and China re-opening its economy, Q3 performance was generally excellent (with quotes below from ABB’s Earnings Release Q3 FY ‘22 ):

• Group revenue of $7.4B was up 18% year-over-year (“YoY”) on a comparable basis. Americas and Europe geographic regions “led the way”, growing 23% and 18% respectively on a comparable basis; with strong sequential growth in the United States, Spain, Italy, and the United Kingdom. Total sales of $21.6B for the 9 month period ending September 30 reflected comparable growth of 10%.

• Orders of $8.2B grew 16% on a comparable basis. EL and MO order growth outpaced PA and MO, growing 20% and 24% respectively on a comparable basis. “[PA] was hampered by a high [prior period] comparable and timing of [new orders]. [“RA”] saw protracted lead times in customers’ decision making.” Even so, PA and RA orders grew 3% and 7% respectively on a comparable basis. On the whole, management noted “...customer activity was robust for both the short-cycle flow business and the systems business.”

• Order backlog of $19.4B at the end of Q3 reflected 35% YoY growth on a comparable basis.

• Group book-to-bill ratio of 1.11. The firm’s book-to-bill ratio reflected the 7th straight quarter with the metric above 1 signaling continued, healthy market demand.

• Record 16.6% operating EBITDA margin. EL, MO, and PA drove the strong group operating EBITDA margin performance with 18.0%, 17.8%, and 15.3% segment margins respectively – the highest results seen in those segments in several years. Even RA, which, as mentioned, has struggled in FY ‘22, achieved double-digit operating margin during the quarter of 12.8%. Management noted operating EBITDA performance was driven by higher volumes, pricing execution, and other operational improvements which offset raw materials, labor, and freight cost inflation.

• As ABB’s 2 largest segments, both EL and MO saw comparable sales growth above 20% during the quarter. As evidenced by FY ‘21 and Q3 FY ‘22 data as two examples, EL and MO account for more than 2/3 of total sales and ~75% of operating EBITDA. Both segments posted a strong performance, with EL and MO sales jumping 22% and 23% YoY respectively on a comparable basis. MO saw strong growth in China – a particularly large market for the segment – and was the only operating segment to realize positive growth in China during Q3.

• Adjusted EPS of $0.36/share versus $0.33 in the prior period. GAAP EPS declined (41%) YoY to $0.19 during the quarter. However, net earnings were impacted by a ($325M) non-operating charge related to ABB’s settlement of bribery allegations related to the Kusile Power Station project in South Africa. Adding back the charge using ~1.9B shares outstanding, adjusted EPS was ~$0.36/share, as compared with $0.33 in the prior period.

Note: Comparable figures above account for portfolio changes and currency effects. Management noted the strong dollar introduced a (9%) to (10%) headwind during the quarter.

Figure 5 below summarizes Q3 performance across operating segments and for the group.

Notes:

• Consolidated group results for Q3 include intersegment eliminations.

Q3 performance, of course, only reflects a point in time. However, strong orders growth across the group, feeding into the nearly ~$20B backlog, signals the “leaner and meaner” ABB – which shed itself of its Power Grids , Dodge , and turbocharger businesses over the last handful of years – is progressing with its turnaround by doubling-down on electrification and automation technologies. Moreover, guidance indicates the company will exit Q4 FY ‘22 in a strong position with management anticipating:

• Low double-digit comparable revenue growth. Sales growth will come against a tough Q4 FY ‘21 comparison.

• Strongest quarter in terms of cash. ABB exited Q3 with ~$3.5B in cash and marketable securities. The firm’s cash position will be bolstered in Q4 by management’s decision at the end of Q3 to exit the company’s remaining 19.9% stake in Hitachi Energy for $1.4B. Additionally, management noted that the biggest tie-up in cash during 1H FY ‘22 was in inventory; however, CFO Timo Ihamuotila noted that inventory levels have normalized. Accordingly, investors can expect the business to finish FY ‘22 with a strong cash position.

• No additional provisions to be made relative to the Kusile Power Station project. CEO Bjorn Rosengren suggested during the Q3 FY ‘22 Earnings Call that the Kusile “matter” is effectively resolved. However, Mr. Ihamuotila seemed to hint that the settlement is not entirely finalized and that there could be future cash flow impacts. Perhaps a reasonable investor inference is that the bulk of a final settlement amount was recorded in Q3. Thus, any additional impacts in Q4 and/or 2023 may be limited.

• Sequentially lower operating EBITDA margin, but strong enough to support full-year target of 15%+. Management noted its historical business pattern sees lower profitability in the fourth quarter. Still, to reiterate, the group’s strong Q3 performance puts the business in a position to hit its full-year target of 15%+ operating EBITDA margin in FY ‘22 – one year ahead of plan (see Figure 2).

While ABB’s turnaround journey is far from over, Q3 results and the outlook for Q4 suggest the group is “on-the-right-track”, with Mr. Rosengren offering that he thinks “..[ABB has] taken a giant step…[and thinks the business is]...now coming up to the right levels [of financial performance].”

A Counter-Intuitive Play for 2023

Even if a recession hits next year, that doesn’t necessarily imply all industries will be equally affected, nor that all geographies will be equally affected. Indeed, ABB’s geographic diversity, along with its product diversity, may prove resilient even under recessionary conditions.

On this point, consider EL and MO. As mentioned in the last section, EL and MO make up the bulk of ABB’s operating EBITDA (see Figure 5). Both segments have significant exposure to the buildings and transportation/infrastructure end-markets; and each of these two end-markets is being driven by sticky trends in “greener” design, energy efficiency, electrification, etc. Progressive governments (technologically-speaking) in EL and MO’s largest geographies – namely Europe, the United States, and China – seem “dead-set” on re-architecting their infrastructures and transport systems, irrespective of economic conditions to a certain extent. For example, following a lackluster 2022, infrastructure spending in China may be set to grow significantly in 2023 with the Chinese government seemingly abandoning their long-standing zero-COVID policy. With the Russia-Ukraine war exposing the European Union’s (“EU”) weakness with respect to energy, EU governments are set to increase funding for strategic infrastructure projects to move the continent toward energy independence. And, of course, climate change concerns are driving increased electrification of not only automobiles, but heavy vehicles as well. It goes without saying that EL and MO are well-positioned to exploit these dynamics; and, obviously, a strong performance from both businesses in the new year will support the overall group.

It seems to me the outlook for PA and RA in 2023 is more uncertain, albeit perhaps with room for optimism. Management indicated they expect a better PA performance in Q4, although headwinds emerged in Q3 in the metals end-market due to high energy prices. Yet, with good demand in refining, mining, marine, and gas during the most recent quarter, PA may have more to look forward to in the new year, especially with respect to energy-related projects. RA, which cited lower order growth in Q3 in part due to longer sales cycles, could be set to rebound in Q4 and 2023 as customers pull the trigger on new orders, particularly with the easing of semiconductor and electronics component shortages. Moreover, management is anticipating a stronger RA margin performance in Q4, driven in part by strong development in the food and beverage (F&B) end-market. Logically, the massive F&B market is likely to continue pushing more into automation – even during less-than-ideal economic conditions – to counteract inflationary effects and drive efficiencies.

All in all, it is reasonable to think that ABB’s operating segments will offer investors certain countercyclical dynamics during a potential 2023 recession. That is not to say that the business will be immune to macroeconomic headwinds. But, I believe, using the argumentation above, that the group may prove far more resilient than some may think.

Room to Run

As discussed earlier, ABB shares rallied following Q3 results and closed at $30.30 on December 23, 2022.

I noted in my last article on ABB that activist investor Cevian Capital had suggested a while ago that shares should be trading closer to CHF 35; although that call came pre-pandemic, during very different market conditions than right now. In fact, if the analysts listed in Figure 3 are in the right ballpark, shares may be fairly valued right now based on the average of CHF 28.40, or $30.44 using a conversion rate of 1 CHF/$1.07 USD.

However, it does seem that the valuation the market places on the “whole” of ABB may not fairly reflect the sum of the parts – i.e. a scenario where each operating segment was trading as an independent company. For example, let’s consider a simple exercise where we assume that Schneider Electric S.A. ( OTCPK:SBGSY ), Rockwell Automation ( ROK ), Emerson ( EMR ), and Fanuc ( OTCPK:FANUY ) are proxies for ABB’s EL, MO, PA, and RA businesses respectively. Now, let’s take a guess at total FY ‘22 revenues for each ABB operating segment by:

• Starting with total FY ‘21 sales for each segment.

• Subtracting an equal amount from each segment to account for FY ‘21 intersegment eliminations.

• Assuming each segment will grow this year by the midpoint revenue growth target of 5.5%, implied by the company’s growth algorithm in Figure 2, to arrive at an estimate of total FY ‘22 revenue for each segment.

Next, let’s estimate the value of each operating segment as if it were an independently traded business using the forward P/S multiples for each proxy business mentioned above and ~1.9B shares outstanding. The model looks like this:

Notes

• “Proxy” forward P/S multiples applied to each segment as follows: SBGSY P/S of 2.19 applied to EL; ROK P/S of 3.49 applied to MO; EMR P/S of 3.76 applied to PA; FANUY P/S of 4.84 applied to RA.

• Forward P/S data for proxy companies from Seeking Alpha.

Now, I’m not saying ABB is worth ~$50/share as calculated by this simplistic model; and the proxy companies that I selected are far from perfect analogues for each of ABB’s operating segments. Rather, to reiterate, I’m simply saying – and trying to illustrate via Figure 8 – that it seems to me the market is undervaluing the conglomerate. Moreover, if ABB’s businesses do demonstrate countercyclical effects in 2023 against the drag of a downturn, perhaps shares do have more room to run despite what the analysts “say” in Figure 7. How far can they go? I can’t say for sure of course. But, Cevian Capital’s previous call for CHF 35, or ~$37.45/share, doesn’t seem unrealistic to me, especially given that shares were trading north of $38/share at the beginning of the year. Accordingly, it may not be unreasonable to think ABB shares could appreciate ~25% in the new year as they retrace ground lost in FY ‘22.

A Smarter Approach to Creating Shareholder Value

The “old” ABB model of buying businesses left and right, which led to the unwieldy mess that current management has been working to streamline, has fallen by the wayside. Mr. Rosengren has committed the firm to stability and profitability before growth. This is evidenced by management’s intelligent focus on small, bolt-on acquisitions, such as the recent purchase of energy management platform provider ASKI Energy , as opposed to large, high-risk acquisitions.

Moreover, investors can expect management to continue their efforts to unlock shareholder value, driven in part by activist shareholders like Cevian Capital mentioned earlier. Notably, management:

• Launched a new share buyback program of up to $3B at the start of Q2 FY ‘22.

• Remains committed to list the E-mobility division (electric vehicle charging).

• Believes the firm is already “right-sized” to weather any potential near-term downturns.

As I offered in the introduction, recent performance and the outlook for Q4 FY ‘22 suggest management’s turnaround strategy is working; and the group’s play on electrification and automation megatrends, combined with their product and geographic diversity, may prove resilient in the coming year, even under recessionary conditions. As I argued, shares seem undervalued when considering the potential value of the individual “parts” of the business.

Notes:

• Data as of market close December 23, 2022.

• Forward P/S, P/B, and GAAP P/E data from Seeking Alpha except ABB forward P/B.

I don't know exactly what to expect with 2023 around the corner. But, if the world falls apart, I think ABB shares may unexpectedly offer long investors sanctuary.

Editor's Note: This article was submitted as part of Seeking Alpha’s Top 2023 Pick competition, which runs through December 25. This competition is open to all users and contributors; click here to find out more and submit your article today!

For further details see: