The Long Case for ABB Ltd.

One exciting investment opportunity identified through a fundamental/earnings quality screen that I run periodically is ABB Ltd. (ABB). ABB is a Swiss conglomerate that provides a wide range of products and services to the power and automation markets. A recent earnings warning from Siemens (SI), another European conglomerate that competes in similar markets, dragged the stock down in sympathy, and now trades at an earnings multiple slightly less than its long term growth rate. I felt the problems at Siemens were company specific, and the market reaction of ABB was unwarranted, creating an opportunity for long term investors to own a great business at a reasonable price.

The investment thesis on ABB is relatively straightforward. ABB has smartly positioned itself as an “energy efficiency” solution provider. Its products & services can be found at every node of the energy value spectrum, resource production, transportation, por generation, por transmission & distribution, and even consumption. Here is a sampling of the types of solutions that ABB offers:

• motors that efficiently por deep-sea drilling rigs
• marine propulsion systems that transport the oil
• substations, circuit breakers, capacitors used in electricity generation
• high, medium, low voltage transformers used to transmit and distribute energy across
• power grid automation, robotics, and variable speed drives/motors that drastically reduce industrial consumption

ABB is well positioned competitively to maintain its leadership status in most of the markets it serves. An enormous installed base, economies of scale, and a core competency in efficiency solutions provides the company with an enviable competitive moat. It's industry leading R&D budget that has generated a voluminous portfolio of intellectual property and innovative new products has galvanized this edge over the competition. Lastly its global footprint positions ABB favorably to benefit from rapidly growing emerging markets. Only 15% of revenues are generated in the US, and almost 40% from fast growing emerging markets. Interestingly, its leading market share in Asia is likely remain firm, as customers in that part of the world place greater emphasis on business relationships, and are more likely to award new contracts to their existing network of suppliers, a Chinese social custom known as Guanxi.

New Infrastructure needs to be built to support electricity demand in emerging markets-
As a provider of infrastructure & energy efficiency, ABB finds itself in a “perfect storm” of end-market demand. Emerging market electricity demand is expected to grow from 8B kilowatts per hour to 16B kw/h over the next 20 years. As population and GDP grows in these parts of the world, new infrastructure will be required to provide the energy to fuel that growth.

Existing Infrastructure in developed markets needs to be replaced -
Wall St. as ll as the entire northeastern US remember the summer of 2005 power outage in that left more than 20% of the US population in the dark for nearly 24 hours. A huge capital investment cycle in the 1960’s and 1970’s followed by a long period of neglect has left the US power grid in brittle condition, and as the head of the EIA describes, “one or two heat waves” away from crisis. The average US transformer is over 40 years old, ll beyond the average life expectancy for that type of equipment.


Energy Efficiency

– The low hanging fruit of the green movement. While less “sexy” than other green investment opportunities, efficiency improvements are the low hanging fruit of the energy problem. 65% of energy use and CO2 pollution can be attributed to motors and engines. ABB’s variable speed drives and motors can significantly lor energy consumption and pollutants, yet in the US are used marginally (only 5% penetration). For perspective, consider that the installed base of these drives/motors in Europe has reduced annual consumption of energy to a level equivalent to 32mm households (1/3 US households!) and reduced yearly CO2 tonnage by the amount that the entire country of Ireland emits on an annual basis. Throughout the energy value chain, ABB believes it can reduce waste by about 20%, generating low-risk, high return on investment opportunities that businesses and governments will find hard to walk away from.

Renewable Momentum

Remote energy sources (solar/wind) will require transmission

Renewables – Public and legislative momentum as economic parity with traditional coal, gas, and nuclear fired power plants is stimulating demand for renewable energy sources around the globe. While wind and solar power have become a meaningful part of the European power grid, the US still only generates about 2% of its electricity needs from such sources. Because renewable power sources are often great distances from the population centers that they serve (think Arizona!), infrastructure such as high voltage transformers must be used to effectively distribute the energy. ABB is the #1 player in this type of equipment.

Catalysts & Low Expectations

May drive upside surprise for investors

In addition to these growth drivers, ABB has a great balance sheet, which could be a catalyst for the stock. The company has paid off most of its debt and now boasts a net cash position of over $6B, which can be used as competitive ammunition, for strategic M&A, or simply can be returned to shareholders through dividend or share buybacks. Expectations are modest relative to recent results, and believe the 10% earnings growth that Wall St. is anticipating will be easily surpassed. A closer look at the company backlog reveals a visible stream of high margin revenue yet to be realized.

Fundamentals & Valuation very attractive – Price target of $43

Returns for the company have been strong. Margins have grown from 5% to almost 12%, and the company sees 18% margins down the road as internal goals are met. Return on invested capital is ll over 20% highlighting quality management and focus on creating shareholder value.

Valuation is reasonable

For a company growing earnings at a 20% rate over the long term, a P/E of 18 represents a fair value in our opinion. This is a 20% premium to the market, but would argue growth prospects and profitability deserve an even greater premium. I am also comforted by the free cash flow yield of just over 4%, and annual free cash flow generation of about $4B. Using relatively modest assumptions (about 10% long term growth) and a 8% discount rate, I arrived at an intrinsic value of about $43 for the shares.

In conclusion, I found it difficult to poke holes in this investment case. While the world adjusts to $130 oil, terrorism, and a rapidly growing population, ABB’s products and services address some very real problems. While we may not be able to find more energy, and it may take several years to find alternatives, ABB offers solutions to get much more out of what have, today.

Disclosure: None

Comments

[Tom B:]

Agreed. I bought a bunch in April. Looked at Siemans; picked ABB instead, Also added some GE-- should have waited on that!

2008 Jun 20 10:02 AM

[Gary Holdsw...:]

Goo point on the transmission build out for renewables. US utilities only spent about $2B per year on transmission early in this decade, they are now at $6B per year, going to $12B per year by 2010 and probably $20B soon thereafter if all of the wind/solar/geothermal projects that are in interconnection queues in CA, the Midwest, and TX all come to fruition. That means, lots of transformers, static VAR compensators, transmission towers, and power cable. Interested investors might also want to look at Quanta (PWR) as a premiere player in the installation of all of this T&D equipment.

2008 Jun 20 10:56 AM

[investor 101:]

I had ABB 2 years, sold 2 weeks ago, waiting to retreat to buy again. What do you think about Alsthom?

2008 Jun 20 11:50 AM

[skwestorange:]

Well researched commentary! I too have been following this one for a while and expecting a pullback to get in. I was in Alsthom for five years and got out early this year with a nice gain. It too is a similar story.

2008 Jun 20 01:33 PM

[Netpoppa:]

Don't wait too much for a pullback. I love this stock! Bought 12K shares at $6 a share in 2003. Sold 8K at $24 in 2006 and I'm still holding on to 4K shares.

2008 Jun 20 03:01 PM

[Le French:]

ABB was on my shopping list for a year but I always had one concern:
what would be the impact of a chinese economy slowdown on ABB stock?

2008 Jun 20 07:07 PM

[E Nuff Sed:]

Given a choice between GE and ABB - GE wins hands down. Even after stripping out its financial business GE is more profitable and diverse.
The value of GE's industrial business is over $30. You are basically getting one of the best run finance business for free. I'd like the author to do a comparison between GE and ABB.

2008 Jun 21 03:20 PM

[JNM:]

While I donʼt dispute your assessment of ABBʼs phenomenal market position with attractive exposure to the rapidly growing international markets, it seems that your valuation mark is a bit optimistic. To begin with, the consensus long-term growth rate of 20% is a bit toppy and sits at the top-end of managementʼs range of between 15% and 20%. A good chunk of ABBʼs easy growth has already been realized with comparisons growing tougher by the quarter. I have modeled 17.5% EPS CAGR on 11.0% REV CAGR through FY12E. Crediting ABB for its BRIC penetration, my DCF assumes TVG of 4%.. The balance sheet is roughly 80/20, equity dominated and bears a WACC of 11.6% based on current beta, UST rates, 12% dividend growth and 27% tax rate. I find it difficult to discount any companyʼs cash flows at just 8%. Under my assumptions, the DCF yields a value of just south of $30. If you look at PE/G, but substitute EV/EBITDA in the numerator, you will find ABB trades in-range with several of its peers (EMR, CBE, & SI). In pricing shares at 18x EPS, there does exist some modest upside, but incremental returns in ABB are more of an uphill battle from here on out. The stock is a story told now and management is CEO-less with a Board that is inclined to find a leader who will consummate a mongo M&A deal. Swallowing up Rockwell or comparable-sized firm will serve as a big distraction and will surely be dilutive for 12M if not longer based on deal terms usually in this space. Letʼs also not forget the BoE and ECBʼs hawkish tone in response to climbing inflation, which could mount headwinds for infrastructure players in quick time. To add to my current ABB position, I would require shares to revisit the mid-$20s, all else being equal.

Iʼm long ABB in several accounts.

2008 Jun 22 01:47 PM

[guliamo:]

I agree. This is also a great hedge for Americans as ABB income is mostly in Euro / Swiss francs..
I'cve owned these guys for years - great company with a bright future.

2008 Jun 25 05:14 AM