German industrial conglomerate Siemens (NYSE:SI) has gotten a great deal more serious about streamlining its operations around those businesses and markets where management believes they have a long-term edge and appealing growth potential. With that, Nokia Siemens Networks is gone, Osram is about to be spun off, and other businesses like water treatment, baggage handling, and low voltage could be on the way out.
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Siemens actually held pretty good share in these businesses, so the streamlining process doesn't really change the fact that Siemens is typically a leader in its chosen businesses. What still has to be proven is whether the company can significantly improve its execution and margins. Relative to many other global industrial conglomerates, Siemens has an unspectacular track record in margins, returns on capital, and free cash flow generation, and management needs to convince the Street that it can do better before the shares will garner a better multiple.
NSN And Osram On The Way Out, Is There More To Follow?
The question(s) of what Siemens would do about Nokia Siemens Networks and Osram have loomed over the company for some time, but investors have clarity on both now.
Osram, Siemens' lighting business, will list on July 8, with shareholders getting one Osram share for every 10 shares of Siemens that they own. Siemens will still hold a 17% stake, but Osram will otherwise be free to pursue its own path as the second-largest lighting company in the world behind Philips (NYSE:PHG).
Siemens and Nokia (NYSE:NOK) also recently announced that they'd reached an agreement whereby Siemens will sell its 50% stake in the Nokia Siemens Networks joint venture to Nokia for 1.7 billion euros. While it's hard to say that Siemens got full value for this asset, “full value” was always an ambitious goal anyway and this was likely the best option available that Nokia would also find acceptable.
With these two businesses gone, attention now turns to what Siemens management will do with its water treatment, postal automation, and baggage handling businesses – businesses which collectively contribute about 2.5 billion euros in annual revenue. I don't believe selling the water treatment business will be difficult, but Siemens may also be interested in getting rid of its Low Voltage operations.
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Siemens Has Good Share In Attractive Markets, But Execution Is Important
Just looking at what Siemens does, there's no reason to believe this business cannot be successful over the long-term. Along with General Electric (NYSE:GE), Siemens is a leader in both fossil fuel power (steam and gas turbines) and wind power. Siemens is also a significant player in automation alongside ABB (NYSE:ABB), Emerson (NYSE:EMR), and Honeywell (NYSE:HON), a leader in healthcare imaging and diagnostics, and a leader in markets like building environmental controls and intracity trains.
The question is whether Siemens can improve its execution and hit its goals for restructuring and cost improvements. Relative to the likes of ABB, Schneider (OTC:SBGSY), GE, and other peer conglomerates, Siemens has had higher labor/employee costs in recent years and unimpressive margins. To that end, I don't necessarily believe that transactions like the Osram spin-off will be “cure-alls”, and I think Siemens management is going to have to deliver actual reported margin improvement before the Street buys into the idea that better margins/returns/cash generation are attainable.
Is it possible? Yes, I believe so. ABB has significantly improved its cost base in recent years and I don't think the two companies are so different that Siemens investors shouldn't take encouragement from what ABB accomplished. That said, fixing European industrial businesses with cost issues is not easy (as Colfax (NYSE:CFX) is learning) and execution risk is significant.
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The Bottom Line
I'm not sure there's a better correlation in industrial stocks than that between stock price performance and margin improvement. If Siemens management can lift operating margins to the low-to-mid teens levels of peers like ABB, Emerson, and Schneider, these shares could do very well over the next couple of years. At the same time, though, the company will have to deal with strong competition from the likes of GE and ABB, as well as emerging Chinese rivals in several of the company's core markets.
As I'm only willing to give Siemens partial credit today, the shares don't appear to be a tremendous bargain. I'm looking for Siemens to grow its top line at a roughly 3% rate, lower than I project for both ABB and GE, and for free cash flow margin to improve to just under 10% over the next decade. With that, I see fair value at about $107. If I give Siemens the same sort of growth and free cash generation expectations as I do for ABB and GE, the target jumps into the high $130s, so there is definite upside here if Siemens gives cause for optimism on its ability to execute.
At the time of writing, Stephen D. Simpson owned shares of ABB.
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