ABB Keeping Power Grid Segment, Powerful Dividend

| About: ABB LTD. (ABB)


ABB recently successfully fought off an attempt from activist investor Cevian Capital to force the company to separate its Power Grids segment.

We're fans of ABB's dividend growth profile. Recurring-revenue service momentum is a key building block for profitable growth at ABB and will be a positive for future dividend growth potential.

ABB has solid targets for 2015-2020. It is targeting revenue growth of 4%-7%, which is higher than its total market expected growth of 3.5%-5%.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

ABB (NYSE:ABB) is the world's largest builder of electrical grids and looks set to experience some nice tailwinds in its operations in the coming years. The firm recently successfully fought off an attempt from activist investor Cevian Capital (~6.2% shareholder) to force the company to separate its Power Grids segment. Its largest shareholder, Investor AB, supported the firm's opposition to Cevian's plan. Management is betting on itself to be able to improve performance. While the separation may very well have created additional value for shareholders, income investors have little to complain about when it comes to ABB's dividend.

ABB boasts a healthy Dividend Cushion ratio (1.6) that is supported by the company's strong free cash flow generation and reasonable balance sheet. The firm's solid yield (~3.4%) adds appeal to its seemingly safe dividend, and it has raised its dividend for 5+ consecutive years. Average annual free cash flow generation of nearly $2.8 billion has been sufficient in covering annual run rate cash dividend obligations of ~$1.4 billion in 2015. Management has stated it has a high priority for maintaining a steadily rising, sustainable dividend.

Faults in ABB's dividend payout seem to be few and far between. In 2014, ABB authorized a share buyback program of up to $4 billion through 2016, which could impact the pace of dividend expansion moving forward as it increases the magnitude of a competing allocation of capital. In addition, the company plans to buy back $3 billion of its own shares from 2017-2019.

The only year ABB was not able to increase its payout in Swiss Francs since 2005 was during the Financial Crisis of 2008-2009. We wouldn't be surprised to see a similar scenario play out if its operations face pressure once again. It is important to note the firm's payout is in Swiss Francs, so US investors should expect volatility due to foreign exchange rates.

Otherwise, we feel ABB's dividend is on solid ground, but let's now dig into the remainder of its investment considerations. There's so much more to consider than its dividend!

Image source: Valuentum

Image source: Valuentum

ABB's Investment Considerations

Image source: Valuentum

Investment Highlights

• ABB is a market leader across its power products and systems portfolio and is among the top 3 global providers in discrete automation, low voltage products, and process automation. The company has folded Baldor (electrical motors) and Thomas & Betts (low-voltage market) into operations. It was founded in 1883.

• It's hard not to like ABB, and shareholders are taking notice. Cevian Capital has taken a stake of more than 5% in the firm, noting 'large value potential'. We like the company a lot on a fundamental basis.

• ABB has solid targets for 2015-2020. It is targeting revenue growth of 4%-7%, which is higher than its total market expected growth of 3.5%-5%. The main drivers of this growth are the strengthening of its competitiveness and increased organic growth momentum. Perhaps the best target is management's goal to convert more than 90% of net income to free cash flow.

• ABB is set to benefit from key growth areas, including power grid expansion, emerging country demand, energy efficiency initiatives, and automation business growth. The company is targeting revenue advancement at twice the pace of global GDP. Investors should also expect an ongoing focus on cost savings via Lean/Six Sigma and best-cost sourcing.

• Service momentum is a key building block for profitable growth at ABB. Service order share has advanced to ~20% in recent years from the mid-teens. We like this increasing recurring revenue stream.

Business Quality

Image source: Valuentum

Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. ABB's 3-year historical return on invested capital (without goodwill) is 19.7%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

Image source: Valuentum

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. ABB's free cash flow margin has averaged about 7.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At ABB, cash flow from operations increased about 3% from levels registered two years ago, while capital expenditures fell about 21% over the same time period.

Valuation Analysis

We think ABB is worth $19 per share with a fair value range of $15-$23.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 0.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.4%.

Our model reflects a 5-year projected average operating margin of 12.5%, which is above ABB's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.2% for the next 15 years and 3% in perpetuity. For ABB, we use a 10% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

Image source: Valuentum

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $19 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for ABB. We think the firm is attractive below $15 per share (the green line), but quite expensive above $23 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

Image source: Valuentum

We estimate ABB's fair value at this point in time to be about $19 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of ABB's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares 3 years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $24 per share in Year 3 represents our existing fair value per share of $19 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Tagged: , , , Industrial Electrical Equipment, Switzerland
Problem with this article? Please tell us. Disagree with this article? .