I guess assessing the state of the global economy today is a bit like taking a Rorschach test - where companies like Emerson (EMR) and Illinois Tool Works (ITW) see ogres and dragons, ABB (ABB) management seems to see butterflies and bunnies. Although that's obviously an exaggeration, ABB's call for a more resilient Europe, a strong U.S., and a more resilient China is definitely out of the mainstream and could represent an "all clear" for investors waiting to buy this undervalued and underperforming industrial conglomerate.
Second Quarter Results Better Than A Low Bar
To call ABB's second quarter good or strong is to really only do so in reference to expectations. It wasn't a terrible quarter, but the company has to do better than this for the stock to work.
Revenue rose 6% on an organic basis, but still missed analyst expectations by a couple of percentage points. Power was mostly weak, as flat power products and 1% power systems revenue were weaker than expected. Low voltage product sales rose 23% (better than expected), while process automation rose 3% and discrete automation fell 2%.
On the margin side, overall performance wasn't great. Operating EBITDA fell 5% (down 9% organic), with margins contracting about 80bp. Likewise, EBIT was down 9% (ex-charges). Nevertheless, these results were slightly better than expected, and all of the individual units beat expectations.
A Curious Outlook That May Reflect Business Mix And Policy
Far and away the most interesting (and strangest) takeaway from the ABB earnings was management's optimistic outlook on near-term business trends. Order growth of 9% (organic) certainly helped, with big gains in power systems and low voltage and only discrete automation lower. Curiously, though management was quite positive about the outlook for the U.S., believes China is already turning around, and that Europe is hanging in there. Suffice it to say, that's not a widely held belief, not among other European companies like Siemens (SI) or Alstom, nor North American peers.
Or is it?
Honeywell (HON) surprised a lot of investors with its relative optimism on China and seeing ABB echo that, I have a theory. My theory is that China is directing stimulus spending towards particular areas like refineries, airports, and other infrastructure components and that disproportionately benefits companies like Honeywell and ABB.
Moreover, there is some corroboration for the North American optimism. Although Emerson has seen weakness in Europe and industrial automation orders have been weak, process automation orders have remained strong. Rockwell Automation (ROK), too, has echoed the idea that automation demand in North America is holding on.
Improvement Can Come From Within
Although ABB has done a great job of cost-cutting, management isn't through yet. I'm a little worried that they may cut too deep, but I don't think we're at that point yet. It would also seem that pricing has bottomed - ABB management reported some small sequential improvement, suggesting rivals like Alstom have stopped under-bidding to win business. Last and not least, while a lot of the talk around ABB seems to revolve around M&A, don't forget that the company has internal R&D goals like expansion into high-power semiconductors that could stimulate growth and better margins.
The Bottom Line
I've liked ABB for some time and I was actually thinking that I'd be able to buy the shares a little cheaper after the second quarter earnings cycle. So, while I do regret not buying in before the big post-earnings jump, I have too many grey hairs in my beard to still believe that I can ever bottom-tick a stock.
If you trust ABB management (and/or believe that the global economy is not sliding toward a cliff), this could be a good time to add shares. At the same time, due diligence demands that you at least give a cursory look to names like Alstom, Prysmian, Siemens, and Schneider as well, not to mention a broader range of European industrials that would include Atlas Copco (OTCPK:ATLKY).
As it stands with ABB, I expect a meaningful stretch of growth and free cash flow margin improvement. While my expected free cash flow growth rate of nearly 10% may well seem too aggressive, some of that is a product of the unusually low figure for 2011 that sets a low starting point and inflates the growth rate. Adjust that out, and my growth target is between 5% and 6%, which works out to a fair value in the mid-to-high $20's today.