SIEGY - ABB: Clear Evidence Of Weaker Short-Cycle But Valuation Makes This A Name To Monitor

2023-10-19 14:26:44 ET

Summary

• ABB's results highlight that short-cycle industrial demand has slowed, raising concerns about a potential recession and the timeline for global macro improvement.
• Process industries like chemicals and oil/gas remain strong, while longer-term drivers like electrification and automation are still in place.
• ABB's third-quarter results were mixed, with positive results as the company delivered on backlogs, but orders point to a meaningful slowdown in multiple end-markets.
• ABB is a borderline buy now; the valuation supports owning the shares, but sentiment could lead to a longer pullback cycle.

It seems increasingly clear that the question of whether short-cycle industrial demand has slowed is settled – it has – but valid questions remain as to whether the U.S. economy will actually slip into recession and how long it will take for the global macro picture to improve. In the meantime, process industries (like chemicals, oil/gas) remain strong, and longer-term drivers like electrification, renewable energy, automation, and digitalization remain firmly in place.

I saw more short-cycle risk in ABB ( ABBNY ) when I last wrote about this Swiss industrial conglomerate , and the results since then have been mixed. It’s taken longer for the short-cycle weakness to emerge and ABB had a good run through the summer, but the shares have performed only slighter better than the average industrial since my last article (with a sizable post-earnings decline), and names like Rockwell ( ROK ), Schneider ( SBGSY ), and Siemens ( SIEGY ) have fared even worse, while Eaton ( ETN ) (which has more leverage to aerospace and less to short-cycle automation/motion) and Emerson ( EMR ) (which has more process leverage) have fared better.

At this point I think ABB is an okay stock and a borderline buy/hold call. I do have concerns that motion and discrete automation will have a few more weak quarters and that process will start to slow some. On the other hand, management has been doing a good job restructuring this business and I like the long-term leverage to automation, electrification, and so on.

Something For Bulls And Bears Alike

Third quarter results were quite mixed, with some unexpectedly positive developments right alongside some more concerning developments. On balance, it reflects what I expected to see in the second half of 2023 – real evidence that multiple shorter-cycle end-markets are slowing, construction is weakening, and process remains an area of strength.

Revenue rose 11% in organic terms, missing by 2%, but I think the 7% volume growth took a lot of investors by surprise, particularly in a quarter where there are widespread expectations for slowing volumes on short-cycle destocking. Gross margin improved 120bp yoy to 34.7%, but did slip 70bp qoq. Adjusted EBITA rose 11%, missing by 1%, with margin up 80bp to 17.4%.

Looking at the segments, Electrification revenue rose 6% and profits rose 14%, with margin up almost two points to 20.8%. Sales and profits both missed by 4%; ABB cited weakness in construction (especially residential), which certainly tracks macro data, offset by ongoing strength in utility spending and other medium-voltage products. I do think the miss could be due in part to incorrect guidance after disposals in the business.

Motion revenue rose 11% and profits jumped 25%, with margin up two points to 19.8%. Revenue matched expectations and earnings were slightly better. I’m honestly surprised this business held up as well as it did, though some of that came from delivering on backlogs in areas like HVAC.

Process revenue rose 23%, but profits were flat and margins declined 70bp to 14.6%. Revenue missed by about 1% and profits by closer to 3%. Margins were hurt in part by the spin of Accelleron ( ACLLY ) as well as a mix shift away from lucrative business in the Marine category, but activity in areas like chemicals, oil/gas, pulp/paper, and mining (classic process industries) remains quite healthy.

Last and not least, Robotics and Discrete Automation (or RDA) saw 9% revenue growth on strong backlog delivery, with profits up 27% and margin up almost two points to 14.7%. Revenue beat by close to 3% and profits by about 1%, and while there wasn’t quite as much margin leverage as hoped for, management has still done a good job of boosting profits here.

Weaker Orders Chill The Bull Case

I don’t think some noisy numbers in margins, nor the guide for sequentially lower EBITA margin in Q4 (around 16% vs. 17.4%) mean all that much. After all, seasonal margin weakness in Q4’23 is not new.

I think the bigger issue was the order number, as orders rose just 2% yoy in organic terms and declined about 7% qoq in reported terms. Although this was only a 1% miss, results were boosted by a large order in Process (up 38%, beating by 12%). Electrification orders grew only 1%, Motion was down 7%, and RDA was down a bracing 27%.

Construction seems to be the main issue in Electrification, and given that I expect U.S. non-resi to start rolling over (which ABB described as “robust”), this could be softer in 2024. Eaton should fare relatively better given lower exposure to residential, but higher exposure to non-resi could be a threat if new-build and retrofit activity slows like I think it will. On the other hand, data center should be an area of strength; Schneider too has better data center leverage, but also more exposure to a weaker European market.

Weaker short-cycle demand in Motion is no surprise, with other companies noting weakening trends in HVAC, electronics, and food/beverage. Meanwhile, process industries continue to grow nicely. On balance this shouldn’t be good news for Rockwell, Honeywell ’s ( HON ) SPS business, or Siemens, and Regal Rexnord ( RRX ) could likewise see some challenges. I’ll also be very curious to see what the major HVAC companies ( Carrier ( CARR ), Daikin , and Trane ( TT )) have to say, and I could see some weakness at companies like Ametek ( AME ) and Dover ( DOV ) from this overall slowdown in short-cycle markets.

Process remains strong, and I’m not too concerned about this area. While there aren’t a lot of greenfield projects on the board for traditional chemicals, oil/gas activity remains strong and new energy (LNG, hydrogen, carbon capture) is strong, as is renewable energy. This should all be positive for Emerson, as well as Honeywell’s process business, and strength in mining and petrochemicals should be a positive for FLSmidth ( FLIDY ), ITT ( ITT ), and so on.

I’m not really surprised to see the weakness in RDA, particularly after Yaskawa ( YASKY ) reported a 25% decline in orders, including a 15% decline in robot orders. New factory automation projects are basically on hold for now, and while I still expect strong growth from automation retrofits and reshoring/near-shoring that includes significant automation content, the uncertainties about 2024 (including Congressional deadlocks and the elections) are likely to keep major capex paused. Still, given ABB’s better skew to the U.S. and Europe relative to China, they’re in better shape on the robots side than Yaskawa or Fanuc ( FANUY ).

The Outlook

With the Street apparently coming around to my view of a second-half slow-down in multiple short-cycle markets (and weakening construction), not a lot about ABB’s developments in 2023 have surprised me. Revenue has been stronger than I’d expected, with strong volumes in particular, but I think that has to do with strong process markets, ongoing strength in electrification (utilities), and more progress on improving the RDA business.

I’ve increased my FY’23 revenue estimate relative to my last write-up, but I’m still expecting FY’24 to be a soft year (I’m still expecting growth, but they may be too bullish), with a rebound coming in FY’25. Longer term, I’m still looking for 4% to 5% annualized revenue growth as ABB continues to leverage demand in automation, electrification, green energy production, and digitalization.

Margins have improved a little faster than I expected, which has the effect of pulling forward some parts of my model – I haven’t really changed my longer-term expectations, as I need more evidence of lasting structural improvement. With that, I’m still looking for long-term FCF margins in the low-to-mid teens, driving high single-digit core FCF growth.

Between my preferred valuation approaches I get mixed signals. On discounted cash flow ABB doesn’t look all that cheap, with a prospective return in the neighborhood of 8% - not bad for a quality company, but arguably a little light. On margin/return-driven EV/EBITDA I can argue for a fair value in the high $30’s, but with weaker orders and weaker growth prospects in 2024, it may take a little while for that to work.

The Bottom Line

I do think ABB is a name to consider on pullbacks, and the shares have already pulled back about 15%. I am concerned, though, that there’s still more to come here as the market incorporates lower expectations in 2024 estimates. If you don’t mind the risk of near-term losses, this may already be a good enough opportunity but it’s definitely a name I’d monitor as a name to grab on excessive pessimism about near-term trends.

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