WEGZY - ABB Could Be Caught Between Long-Term Trends And Near-Term Macro Headwinds

2023-03-07 10:30:00 ET

Summary

• ABB's fourth quarter results were mixed relative to expectations, with good revenue growth but some ongoing challenges in margins and free cash flow.
• Short-cycle exposure could hit ABB a little harder than some of its peers, particularly with a greater exposure to capex machinery versus subscription-based software.
• ABB offers good long-term exposure to automation and electrification, but there is work to do to optimize the portfolio, with an eye toward maximizing the revenue, margin, and FCF opportunities.
• A fair value in the mid-$30's doesn't offer abundant upside at today's price, and while the long-term growth opportunities are attractive, there are higher near-term macro risks.

Not unlike Eaton ( ETN ), Schneider ( SBGSY ), or Siemens ( SIEGY ), ABB ( ABB ) is leveraged to strong tailwinds across automation and electrification, including building, factory, and process automation, grid modernization and vehicle electrification, and robotics. Relative to those companies, though, I still see ABB as a comparative underperformer in terms of execution, particularly free cash flow, and I believe management cannot afford to call “job done” on the progress already made.

I do expect further improvement in the operations, which perhaps is a structurally bullish position, though one I believe is supported by the actions taken already under the CEO’s tenure. I also expect very healthy underlying growth in the core addressed markets, though ABB is more exposed to short-cycle trends and is still more exposed to more commoditized parts of its markets (“more machines, less software” is simplistic, but not wholly inaccurate). Valuation here is a little more favorable than for some of its peers, but adjusting for quality, I’d say the basic argument is the same – ABB shares aren’t exactly cheap today, but still leveraged to attractive long-term markets.

Earnings, Then And Now

ABB’s fourth quarter results were mixed, with modestly better than expected revenue, a little weakness in adjusted operating margins, and a modest shortfall in orders, including a book-to-bill ratio that fell below 1.0 for the first time since mid-2020.

Overall organic revenue growth of 16% was strong compared to the typical industrial this quarter (up around 10%), while 180bp EBITA margin improvement (to 14.9%) and 16% EBITA growth were still pretty good even if the latter was a little short of expectations.

In the Electrification business, 16% revenue growth was pretty much in line with the peer group, including Eaton and Siemens at 15% and Schneider at 17.5%. Motion revenue grew 20%, better than 15% at Siemens and 19% at WEG ( WEGZY ). Process revenue rose 6%, on par with Emerson ( EMR ), but around half the growth seen at Honeywell ( HON ) and Siemens. Finally, Robotics and Discrete Automation grew 23%, outperforming Fanuc ( FANUY ), Rockwell ( ROK ), and Siemens, and just barely lagging Yaskawa ( YASKY ).

I will also note that these comparisons are, at best, a broad brush. These companies don’t compete in the exact same markets or product categories and don’t present their results in identical ways. Consequently, the takeaways are more of the “general trends” variety, but I would argue that outside of process automation, ABB is performing at or above peer levels. Process could be explained by a relative lack of software leverage and the company’s particular end-market exposures.

Looking ahead, analysts expect a significant slowdown in the business in the first quarter, with revenue growth in the 3% to 4% range.

Machine automation, perhaps the most short-cycle of all of ABB’s businesses, was quite weak in the fourth quarter and I’ll be very curious to see how this business performs as a “tell” on the broader market for short-cycle industrial capex in 2023. Likewise with Motion, as multiple companies did report slowing trends in the fourth quarter.

Electrification and process automation should hold up better. Electrification does have some near-term exposure to weaker residential and non-residential new-build activity, but building retrofit demand has stayed strong, and demand in areas like vehicle charging and utilities continues to be healthy. With process, ABB is less leveraged to oil/gas, but marine, mining, and renewable energy should remain healthy. I would also expect to see a pick up in the China business unless the company is losing share to rivals like Supcon at a faster rate than I believe to be the case.

Progress Made… But Work Left To Do

Management hit its 15% EBITA target about a year ahead of schedule, but this would be a poor time for the company to rest on its laurels. First among issues is the company’s relatively recent poor track record of free cash flow conversion. There are plenty of ways to polish non-GAAP metrics like EBITA, but while free cash flow isn’t exactly immune to tinkering, it tends to be a harder number to inflate for extended periods of time. To that end I’d note that recent results (FCF margin) have been pretty poor, with a trailing four years of 2.2%, 8.7%, 3.8%, and 5.6%.

I do expect FCF margin to improve from here, I’m expecting close to 10% in FY’23 and a little over 12% in FY’27, but this is definitely an area where ABB lags relative to its peer group. Again, some of this can be explained by business composition, but that is also a management choice – Eaton, Emerson, Honeywell, Schneider, and Siemens have all been active in remaking their business mix in recent years, repositioning the businesses toward growth opportunities, while ABB has arguably been making more defensive decisions, shedding lower-margin or lower-growth businesses (like high-voltage power), but also shedding some higher-margin businesses to improve liquidity.

I also see more room for operational improvements. Margins in the robotics business need to be better and I’d like to see the company take another step or two forward in terms of leadership in emerging areas like cobots. I’m also going to beat a dead horse here – I believe ABB has made some questionable strategic decisions where software and digitization are concerned, and while there is going to be a market for motors for years to come (and it’s a good, high-margin business leveraged to automation and electrification), I’d have liked to have seen more on the software side, as well as in control systems for commercial buildings, process automation, utilities, et al, and in industrial IoT.

The Outlook

ABB is well-leveraged to the long-term growth of automation and electrification around the world. Companies are going to continue to turn to automation to drive improved manufacturing efficiency, while other end-markets like utilities will need increased automation simply to maintain operational reliability. Automation will, in turn, drive demand for electrification, as will a move toward more sustainable, cleaner energy sources (electricity over on-site fossil fuels and grid-scale renewables), more vehicle electrification, and so on.

I’m looking for long-term revenue growth from ABB in the 4%-5% range, or a little below that of Eaton. While ABB has more leverage to automation, they also have a lot of competition and a lot of portfolio exposure that is at risk of becoming more commoditized in the coming years. On the margin side, I’m expecting ongoing improvement toward mid-teens FCF margins, but this is an area where I think ABB still has something left to prove to the Street.

Discounting the cash flows back, I believe ABB is priced for a high single-digit return that is a little better than what I expect from Eaton, but I also consider Eaton a better-run company with a better overall mix of businesses (albeit not without challenges, like its conventional auto/truck components). A 14x forward EBITDA multiple gives me a $35 fair value, and while that is a premium to what underlying margin/ROIC would support, it’s not as robust of a premium as for names like Eaton and Honeywell.

The Bottom Line

I’ve held ABB in part due to what I believe the company can become; there are excellent world-class businesses under this umbrella, including highly competitive segments within Electrification, Motion, Process Automation, and Robotics & Discrete Automation. I’m encouraged by the progress management has made in unlocking some of that potential, and I think there is room for more improvement. At this valuation, though, and with short-cycle markets weakening, I do see a more modest risk/reward trade-off.

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