ABB Performing Well, But A Big Change Is Coming

By Stephen D. Simpson, CFA | May 13, 2013 AAA

This earnings season had been setting up quite well for ABB (NYSE:ABB). Though there was some consternation that the company had overpaid and bought unwelcome volatility with Power-One (Nasdaq:PWER), the company's earnings compared quite favorably to its peer group. With news now that CEO Joe Hogan is resigning, though, investors are right to question whether the company will be able to continue what has been a quite successful run under Hogan's leadership.

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Good Earnings In A Down Market
All in all, I think ABB has navigated this rough patch of the industrial cycle pretty well on both an absolute and relative basis. Revenue was about 3% better than expected for the first quarter, up 9% as reported, and up 3% in organic terms. That stacks up very well with Eaton (NYSE:ETN), General Electric (NYSE:GE), Honeywell (NYSE:HON), Rockwell Automation (NYSE:ROK), and even Emerson Electric (NYSE:EMR).

The power business was mixed, with Products flat on an organic basis and Systems up 15%. In automation, Discrete was up 4% (also organic), while process was up 1% on somewhat surprising strength in mining. Low voltage was flat for the quarter.E

Margins were a little mixed, but strong on balance. Group reported EBIT barely rose, and the company's margin fell versus last year and came in below expectation. On an adjusted basis, though, earnings were up almost 17% and the company exceeded Street estimates for the adjusted operating margin. Generally speaking, ABB saw better results in power and weaker performance in discrete automation and low voltage.

Last and not least, orders were up a reported 1%, but down 4% organic and about 5% shy of Street expectations. While the book-to-bill was positive (1.08), it was well below the norm for Q1s (1.2x over the past four years), short-cycle business conditions look weak. That makes me doubt the likelihood of a big second half recovery in the U.S. (something echoed by Emerson management last weak). On a positive note, China has come back strong (orders up 20%) and Europe seems to be stabilizing (orders down 1%).

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Powering Up, Or Buying Trouble?
Just prior to earnings, ABB announced the all-cash acquisition of Power-One (Nasdaq:PWER). Power-One has established itself as one of the leaders in solar inverters, holding the #4 global position behind SMA Solar, KACO, and Fronius and the #3 position in particular niches relative to SMA and Advanced Energy Industries (Nasdaq:AEIS).

While the premium ABB offered seems large (more than 50%), the price paid on an EV/EBITDA basis was consistent with past deals in the sector. ABB has been quietly building its solar business, learning valuable lessons along the way without risking major amounts of capital. Now the question is whether the solar business is going to be a perpetual cyclical boom/bust industry, or settle into a stable growth trajectory. The cost competitiveness of solar has definitely improved, and inverters are critical to the system, but analysts have soured on this market. Whether that makes ABB a bold contrarian with a good long-term vision or a fool parting with its money, time will tell.

Hogan Could Be A Real Loss
As an ABB shareholder, I was very disappointed to see the news Friday that CEO Joe Hogan is resigning after five years “for personal reasons”. This isn't a retirement, and it doesn't appear that health issues are involved, and the board saying that it “sincerely regrets” the decision is a bit ominous to me. ABB has a strong board and has squabbled with its CEOs in the past, so that leaves ample scope to speculate as to what happened.

Hogan's tenure was a fruitful one, at least in terms of reconfiguring ABB's cost structure. With considerable attention paid to discipline in manufacturing and distribution, Hogan has made ABB one of the more efficient companies in this sector. That said, he hasn't managed to completely dispell the skepticism that has often dogged this company – the stock's performance over Hogan's tenure doesn't actually stack up all that well against peers like Emerson, Eaton, Siemens, and so on.

In theory, the CEO of ABB should be a good job that attracts very qualified candidates. This is one of the best-positioned companies for energy efficiency products and one of the largest players in automation. That said, executives talk and if the ABB board is seen as unreasonably difficult to deal with, it likely will hurt the company in its recruiting efforts.

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The Bottom Line
As management is so key to determining the long-term winners and losers, it's harder to recommend ABB shares than it was before. That said, I do believe ABB has a very attractive growth profile. There are very few weak spots in the company's line up (largely process automation in oil / gas / petrochemicals and pumps/valves) and those can be patched up. Along similar lines, the company's geographical positioning is quite good, with very solid standing in major emerging markets like China and India.

If ABB can grow its revenue at around 5% a year long-term and continue to improve its free cash flow margin, I can see low double-digit free cash flow growth here – a level of growth usually only seen in real turnaround stories. If ABB can grow at that rate, though, fair value in the mid-$20s seems perfectly reasonable and ABB stands as one of the cheapest high-quality industrial names in the market right now.

At the time of writing, Stephen D. Simpson owned shares of ABB.

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