The last quarter has been relatively sedate for the automation companies, ABB (ABB) included, as the companies recovered from their panic lows in February and March then hit a flatter patch as the major economies of the world aren't really in a state to support big corporate capex investments.
For ABB's part, the company continues to focus on what it can control - cutting costs and flattening the organization structure (taking out layers of middle management), expanding service offers, and trying to pivot toward higher-growth, tech-driven opportunities in areas like power and automation. I continue to believe that ABB looks undervalued, but that comes with the caution that ABB is heavily exposed to weak commodity verticals like minerals, metals, and energy and there is still substantial uncertainty as to what management will do with its Power Grids business and its M&A plans.
A Decent, But Far From Perfect, Second Quarter
ABB saw revenue slip another 2% in the second quarter (on an organic basis), which was a slight miss relative to expectations - expectations that have continued to get trimmed down as the year has rolled on. Power Grids was the one segment to post growth (up 1%), as this business rises from the depths of past underperformance. Process Automation was the weakest segment (down 6%), which isn't so surprising given the roughly 50% exposure to commodity markets/industries. Discrete Automation was down 3% and Electrification Products was down 1%.
The bright spot for the quarter was the company's progress with cost cutting in the face of significant slowdowns across multiple end-markets and geographies. Adjusted EBITA rose almost 5% for the quarter, beating expectations by 6%. Power Grids drove virtually all of the growth, with profits up 30% and margins improving by more than two points. Electrification was also positive (up 1%), and sported the highest segment margins at over 17%). Discrete Automation and Process Automation weren't bad relative to expectations (PA a bit above, DA more or less in line), with declines of 8% and 7%, respectively and both with margins in the double digits (14% and 12%, respectively).
Orders Don't Suggest A V-Shaped Recovery
Around the start of this year, my sweep of the automation sector turned up a lot of expectations for a strong second half recovery for companies like ABB, Emerson (EMR), Honeywell (HON), and so on. That doesn't seem to be in the cards, or at the very least, I don't see it in the order trends at ABB.
Orders were down 5% (organic) overall, which was about 4% weaker than expected after a 6% beat in the first quarter. Like the first quarter, base orders were flat, but large orders dove 41% after a 30% drop in the first quarter. On a base order basis, China was flat, the U.S. was down 4%, and Europe was up 7%, with 13% growth in Germany. ABB has been pushing to gain share on Siemens' (OTCPK:SIEGY) home turf, and it would seem that they're gaining some ground.
Organic base orders were actually up 7% for the Power Grids business, while Discrete Automation was flat. Electrification was down slightly, while Process Automation's organic base orders declined 8%.
I'm not all that surprised by these numbers. If you listen to what companies have been saying in recent months, they're spending where they have to stay in business (base orders), but few companies are making large-scale commitments to new expansion projects right now.
Interestingly, ABB management said that they're starting to see initial expressions of interest from oil and gas customers, and that may corroborate with what companies like Halliburton (HAL) have been saying about the U.S. energy sector bottoming out. Management also noted a solid tender pipeline in Power Grids, as well as strength in auto and food/beverage in the Discrete business.
A Quick Trip Around The Neighborhood
Honeywell reported 1% organic contraction in its Automation and Control Solutions segment, and a split of this business should give greater visibility in the coming quarters. As a reminder, Honeywell is much less exposed than ABB to upstream oil/gas and its focus on controls (relative to instrumentation) tends to lend more stability to results.
ABB talked about strength in its robotics business, and good results at Kuka would suggest good ongoing demand in the market, though Yasakawa's weak robotic results may be pointing to share issues and/or geographic differences (weaker Asian markets, for instance). I'm also wondering if mining and metals may be starting to bottom out - Metso's mining business margins have stopped contracting and Komatsu (OTCPK:KMTUY) announced its bid for Joy Global (JOY) just the other day.
What's Next For ABB?
As I said, I'm not looking for ABB to snap back to growth anytime soon. I do think ABB can post 2% growth in 2017, but utility spending on transmission/distribution projects is a substantial unknown and ABB still has to decide what it wants to do with its Power Grids business. That's a tough call.
ABB has a very good ultra-high voltage business, but General Electric (GE) and Siemens are going to be bundling more and more end-to-end solutions and ABB is looking at lower-cost competition coming from markets like China. On the other hand, there's still a big opportunity out there for connecting renewable energy products to the grid, extending utility coverage into rural areas in the developing world, and improved energy storage solutions.
On the automation side, I'm expecting ABB to pivot toward where the growth is. ABB should have a stronger presence in markets like food/beverage and pharmaceuticals, and it seems as though management is trying to develop solutions to better serve those markets. The company also recently announced a new head of Discrete Automation (Sami Atiya, formerly of Siemens), and his background may indicate more interest in moving more towards software and controls (a move I would like to see).
In the meantime, the company continues to build up its sales and service offerings, which is not a trivial detail considering that post-sale service and maintenance can represent a substantial opportunity in automation. I'd also note that there are pretty substantial chemical production capacity expansions on the books in the U.S. over the next five years or so, and ABB should stand to benefit from order growth there in the coming years.
Again, though, I'm not looking for near-term strength. The CEO refused to commit to guidance for positive organic growth in the back half of the year (despite easing comps) and that brings into question his former declaration that first quarter was the bottom, or at least it suggests that the company is going to "bump along the bottom" for a little while.
Looking at the model, the improved cost cutting leads me to bump up my margin assumptions for the next few years, while the general ugliness out there leads me to trim back my revenue expectations for this year. All told, I'm still looking for 3% long-term revenue growth and 6% to 7% long-term FCF growth. With those changes, my fair value actually ticks up about a dollar to $23.75.
The Bottom Line
With the recoveries in Rockwell and Honeywell, I think ABB is the better bargain in the automation space. I don't see the financials getting substantially better until mid-2017, but clarity on the Power Grids business and the potential for M&A could move the stock in the meantime. Should the U.S. and/or Western Europe slip into recession that would clearly be a negative for the sector (though ABB's less economically-sensitive utility exposure could offset that a bit). I continue to believe that this is a stock worth owning, but it is going to take some time for it to work.
