Swiss automation and power technologies conglomerate ABB (NYSE:ABB) managed to avoid another major quarterly sell-off, but I think the reaction to this earnings report owes a lot to lower expectations and stronger orders. Looking through the line-items, ABB still has a lot of work to do in its Power Systems business and underwhelming margin performance across the board is a concern. ABB is a rare stock within the industry space in that it trades below my estimate of fair value, but that undervaluation comes with the intangible cost of significant execution risk and downside revision potential.
More "Less Bad" Than Better
The second quarter was a better one for ABB, but how much can you celebrate when the company's operating EBITDA miss shrank from 14% (relative to sell-side estimates) to 10%? A double-digit miss on profits is a pretty significant miss in my book and I'm concerned that it was not due entirely to the weak high voltage business (particularly Power Systems), as most of the other units were a little shy of expectations as well.
Revenue fell 1% on an organic basis, with Power Products down 3% and Power Systems down7%. The automation and low voltage operations fared better, with 3% growth in Discrete Automation, 3% growth in Low Voltage and "only" a 2% decline in Process Automation.
As mentioned, the company's profit performance was pretty poor. Operational EBITDA declined 15% (and missed expectations by 10%), while clean operating income declined 20% and missed expectations by 12% as margins declined about two and a half points. Ongoing charges related to offshore wind projects are pummeling the profits in the Power Systems business, but ABB's other units came in a little light as well.
Orders A Bright Spot
ABB reported 13% organic growth in orders, with 7% organic base order growth and a 70% rebound in large orders. While this reported figure is about 8% ahead of published estimates, it was closer to a 4% beat on a "like for like" basis given an earlier Canadian HVDC order. Low Voltage was the only business not to see organic order growth, with Discrete Automation up 7% and Process Automation up 16% as strong oil & gas and general industry demand offsets ongoing weakness in mining.
Power Still Dim
ABB's troubles in its power business force investors to choose between focusing on near-term challenges that the company has little power to alter (and stretch back for years) and the future profitability of the business. Both Siemens (OTC:SEIGY) and ABB have seen major issues (including penalties and charges) with offshore wind power projects in the North Sea; of $6.6 billion in industry orders, there have been about $2 billion in charges recognized so far. While ABB is not entirely free and clear yet, the end is in sight and management claimed that the losses should end this year.
This isn't the only issue with the Power Systems business. The company entered the PV inverter business at almost the perfectly wrong time and despite strong share behind SMA, the company hasn't been able to make headway as European solar installations fell 40% in 2013 and haven't really rebounded yet.
Seeing General Electric (NYSE:GE) win Alstom over Siemens isn't going to help, as it creates three large players in the offshore wind connection business and creates a stronger player in high voltage, network management, and power generation. While management has said it is launching an in-depth strategic review of the business, I'm not optimistic that it will sell this business - management has indicated in the past that it does not want to be an automation-focused business. I disagree - while I do agree that a turned around Power Systems business has potential and emerging market growth could be significant in the coming years, I'd rather see ABB sell or spin this business (perhaps combining it with Siemen's operations?) and focus on adjacent markets in automation (PLCs, valves) and building products (lighting, building controls, etc).
Good Opportunities In The Core
I continue to believe that ABB is well-placed to take advantage of ongoing growth in industrial automation demand. ABB is a top player in most markets within automation, leading Siemens in LV drives and trailing just slightly in motors, including robotics and electronics. The company is likewise a leader in process automation ahead of companies like Siemens and Honeywell (NYSE:HON), but weakness in the mining sector is a headwind (though strength in oil/gas offsets that to some extent). Low voltage is also a recovery opportunity, but one predicated on better non-residential construction.
Good Opportunities, Not-So-Good Risk
I think pressure is building on management heading into the September analyst day. More and more, I think investors expect management to "do something" - a strategic disposal of Power Systems would likely meet with the best near-term response, but I'm not sure selling Power Systems and keeping Power Products will work and I don't think management (or the board) is willing to quit yet. All of that said, this could be posturing - employees and rivals watch these earnings reports too and management gains nothing by telegraphing its intentions to bail on Power. In any case, given how expensive M&A is starting to look, the best move from management could be to announce a share buyback to tide investors over while the work on repairing the Power operations.
I'm continuing to look for mid-single digit revenue growth from ABB over the long term, with FCF growth in the low double digits on the basis of better operating leverage and asset efficiency. Discounting those cash flows back, my fair value estimate is basically unchanged at $25.50 to $26.
The Bottom Line
Relative to other industrials that address some of the same markets, including Honeywell, Eaton, Emerson, and General Electric, ABB is clearly failing to execute at a high level. The compensation for that execution deficit is one of the few industrial conglomerate stocks that appears to trade below fair value, though it can fairly be argued that ABB's execution problems mean my estimates and fair value are too high. I remain guardedly bullish on ABB; I might consider selling if a better idea emerges and/or management underwhelms at its analyst day, but I think today's results don't fully reflect the long-term potential from the business.
Disclosure: The author is long ABB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.