YASKY - ABB Has Rebuilt Belief In Its Execution But Macro Is Getting More Challenging

Summary

• ABB's third quarter results included above-average revenue and order growth, as well as the best margins seen in many years as ABB leverages past self-improvement efforts.
• Cracks are emerging in the macro outlook, with short-cycle demand likely to fall next year and a pause in automation capex looking more and more likely to me.
• The next 12-18 months will likely be more challenging for reported revenue and order growth, but ABB is attractively-leveraged to major growth opportunities (automation, decarbonization, electrification) and undervalued.

I’ve been pretty straightforward in my praise of ABB ’s ( ABB ) management team since Bjorn Rosengren joined the company, and they continue to deliver results with significant transformation (selling, divesting, and restructuring businesses) and restructuring, with the company now posting the best margins in many years despite ongoing input/supply chain inflation.

Valuation did get a little ahead of itself, though, and coupled with growing concerns about short-cycle and automation demand in 2023, the shares have underperformed of late. Since my last update , the shares have lost close to 20% of their value, underperforming the broader industrial sector by about 15%, as well as frequent comparables like Eaton ( ETN ), Rockwell ( ROK ), Schneider (SBGSY), and Siemens ( SIEGY ).

I do have some concerns about the macro outlook for 2023-2024, but my concern is more on market sentiment toward ABB than any meaningful alternation in the long-term outlook for major drivers like electrification and automation. Still, with a prospective long-term annualized return back in the high single-digits, this is a name worth at least a spot on a watchlist.

Exceptional Growth In The Third Quarter

ABB’s third quarter results were pretty good, but it does seem as though there are some signs of “fatigue” in the company’s end-markets. Moreover, expectations for ABB’s performance have been growing over the past 12-18 months, and that sets a higher bar for impressing analysts and institutional investors.

Revenue rose 18% in “comparable” terms in the third quarter, beating expectations by about 1%. Gross margin rose almost a point (up 90bp to 33.5%), and management did note some improvements in its supply chain situation. Reported EBIT declined 17%, beating by 13%, while company-reported operational EBITA rose 16%, beating by 8%, with margin up 150bp to 16.6%. I should note that ABB’s EBITA calculation includes some items that I wouldn’t normally recommend excluding, but most analysts do seem to go along with this calculation.

Orders rose 16% on a comparable basis, while backlog rose 35%, and that compares quite strongly to what many industrials are reporting and it does at least partly refute the concerns over a steep slowdown in 2023 earnings. This also marked the seventh straight quarter of a book-to-bill above 1.0.

Relative to the “average” industrial, ABB was well ahead of the roughly 11% organic growth seen in calendar third quarter results, with the 150bp improvement in operating margin (operational EBITA) likewise well above the sub-50bp average.

Breaking Down The Businesses

Looking at ABB’s segments, the trends were positive overall, but there were certainly a few soft spots worth monitoring. I also want to note that while I present comparables information, there are always challenges comparing two businesses, as they don’t structure/define their businesses identically. In other words, regard this as more like commentary on general trends.

Electrification

ABB’s Electrification business posted 22% organic revenue growth this quarter, beating by 1%. Segment EBITA rose 27% (beating by 4%), with margin up 210bp to 18%, and orders rose 20% (beating by 4%), while backlog rose 41%.

The business was strong across the board, though results in China were softer. Eaton reported revenue growth of almost 13% and 18% in its comparable businesses (with combined orders up around 27%), while Schneider’s revenue was up 12% and Hubbell ’s ( HUBB ) rose 20% (Utility up 28%, Electrical up 10%).

Motion

Motion segment revenue rose 23%, beating by 2%. Segment profits rose 5%, beating by 7%, with margin up 40bp to 17.8%. Orders rose 24%, beating by 4%, while backlog rose 42%.

Results were again strong across the board in terms of end-markets, though business in China was softer. Neither Rockwell nor Siemens have reported as of this writing, but I’d argue that Regal Rexnord ( RRX ) and Altra ( AIMC ) are somewhat useful comps, and sales here were up 8% and 2%, respectively, in the quarter.

Process Automation

ABB’s process automation business revenue grew 6% in the quarter, a 4% miss versus expectations. Segment EBITA rose 9%, beating by 5%, with margin up 160bp to 15.3%. Orders rose 3%, missing by 6%, while backlog rose 11%.

Honeywell ( HON ) reported 7% revenue growth in its comparable business this quarter, while Emerson ( EMR ) reported 13% revenue growth and 6% order growth, and Schneider reported 12% revenue growth in its automation business. ABB is seeing improving gas demand and stable power generation and pulp/paper demand, but is seeing early signs of a slowdown in the metals and mining end-market. Management talked about some “timing” impact on orders, but it’s worth mentioning that ABB isn’t as well-placed as some of its peers in areas like oil/gas and petrochemicals where demand could be firmer in 2023.

Robots & Discrete Automation

Revenue in this division rose 13%, missing by 2%. EBITA rose 16%, beating by 11%, with margin up 170bp to 12.8%. Orders rose 7%, missing by 9%, and backlog rose 87%.

Comparables are limited given the reporting cycle, but Schneider’s 12% growth in automation is still relevant (that business is roughly 50/50 discrete and process automation). Fanuc ( FANUY ) reported 6% order growth, with 38% growth in robotics, while Yaskawa ( YASKY ) reported 21% order growth and 34% growth in robotics. ABB is seeing strong food/beverage demand, but slowing trends with auto and general industrial customers.

The Outlook

I do expect ABB to see weaker orders from short-cycle customers across most industrial end-markets next year, though delivering on the backlog should support results in the first half. All told, the short-cycle correction could be more of a 2023-2024 event than just a 2023 slowdown given the likelihood of significant backlogs at the end of this year.

I do also expect a short-term decline in orders related to automation, as companies digest the investments made during and after the pandemic meant to de-bottleneck operations and address labor challenges. Longer term, though, I don’t see any signs of a slowdown in automation as a trend. Electrification demand is holding up well now, but I do have concerns about both residential and non-residential construction in 2023. Like automation, I except positive long-term trends in electrification driven by efficiency, automation, and de-carbonization.

As far as restructuring goes, ABB has taken most of the big swings already – spinning off Acceleron and preparing for an IPO of the E-mobility (vehicle charging) business when the market recovers. I don’t see a lot left to do, and I would expect more tuck-in acquisitions like the ones the company has made this year in areas like motors and power converters. Management continues to reiterate that they don’t need to make large acquisitions in software, and frankly there’s not that much left to acquire that would significantly alter the business (though select smaller deals could add attractive capabilities at appealing prices).

Relative to where I started the year with my model, my outlook for 2023 and 2024 is notably weaker on my expectations of a short-cycle slowdown and a pause in investments in automation. Longer term, I believe ABB is well-placed to harness long-term above-average demand in automation (factory, process, warehouse, et al), electrification, energy efficiency (more efficient motors, etc.), and clean energy/de-carbonization.

I believe those “mega-trends” can drive 4% long-term revenue growth, and I continue to believe that management’s margin-improvement efforts will drive FCF margins into the low-teens over time, pushing the FCF growth rate into the high single-digits.

The Bottom Line

With the underperformance in ABB shares since my last update, the prospective return has improved and I like the combination of a high single-digit prospective annualized return and strong market positions in markets with strong long-term secular growth drivers. I also believe the shares are about 10% undervalued in the near term on a margin/return-driven EV/EBITDA approach that includes a temporary step down in operating margin and ROIC relative to my longer-term expectations.

I wouldn’t say that ABB’s valuation is sufficient for a table-pounding “buy”, but with the combination of good expected returns, strong strategic/secular positioning, and moderating expectations, this is a name to consider.

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