Current Share Price approx. $16
Cash & Similar Per Share Outstanding= $2.28
Last Dividend= $0.44
Payout Ratio (
ttm) = 34%
Payout Ratio (4*
mrq) = 37%
Market Cap = $38 B
LT Liabilities & Debt (net of Cash) = -$2.7 B
Enterprise Value = $41B
Revenues (
ttm) = $34 B
Gross Margin (year ago) = 32.7%
Gross Margin (
mrq) = 30.7%
Operating Cash Flow (
ttm) = $3.4 B
Operating Cash Flow (
mrq) = $1.0 B
Enterprise Value/
EBITDA (
ttm as of 23.July) = 6x
Current Ratio (year ago) = 1.52
Current Ratio (
mrq) =1.63
Background:
ABB released the 30.June numbers today. The 2Q results are consistent with
Gudovac's 26.June analysis. Therefore,
ABB remains a buy at $5 per share on the NYSE.
ABB's leadership decided many years ago to shift into businesses with
higher knowledge and service content as a theme for the future.
ABB exited the
Rail and Large Power Generation business a decade ago. This long term strategic decision which may be turn out to be very successful someday. However, the strategy isn't successful today.
ABB's competes as a highest quality equipment supplier. Customer's describe ABB as expensive, but worth it. ABB can command price premiums of close to 30% in some sectors simply because of ABB's quality reputation.
Owner's should realize that
ABB is the enterprise that
Percy Barnevik successfully built out of the wreckage of
Asea and Brown
Boveri.
ABB was considered one of a handful of truly superior enterprises when Percy
Barenvik was at the helm. Owners should also realize that a one is partnering alongside (or perhaps in competition with)
Investor and the Wallenbergs. The
Wallenbergs are the premiere value investors in the world - full stop.
Finally, Owners should recognize timing expressed in years when examining an enterprise such as ABB. ABB's development and cycle times are are long. ABB's customers require years of preparation to embark on a major project. A decision to buy ABB does not require instant action. Events take months to gestate.
The decision to own ABB requires the patience of hunter - observe, stalk quietly, wait, wait some more, and then strike.
As the 2Q results indicate, it is difficult to make spectacular profits in
higher knowledge industrial capital goods when capacity utilization in the US is
68% and EU industrial production is down
17% year over year. It is even more difficult to sell
ABB's clever Gird solutions when
OCED power consumption is dropping for the first time since 1945.
The difficulties ABB's managers have is expressed in the right hand slide from ABB's quarterly presentation. New Orders are down nearly 30%. This decline can be expected to continue until industrial utilization expands significantly. It is unlikely that industrial utilization will expand in the next 2-5 years.
Owners can also expect margins will come under pressure as managers accept lower quality orders. ABB indicated in its statements today that customer are getting the benefits of lower commodity prices on ABB orders. In lean times, Customers will naturally bargain harder for price concessions which is straightforward to manage. (ie Do we accept this order at this margin or not ?)
What is more difficult to manage is that Customers will also tend to increase performance specifications on orders. Tough performance criteria which ABB might have been able to negotiate away in the boom times will be reluctantly accepted. These risks are impossible to quantity at the time of order acceptance. What is the risk that a $100 million ABB automation order will miss a increased productivity standard by 1% costing ABB a 20% performance penalty ? ABB managers are first rate Engineers with a solid track record of meeting performance specs, but in lean times everyone accepts tough spec. orders which may have been refused in a boom times.
The next slide indicates the full impact of under utilized industrial capacity on ABB's focus on energy efficiency, automation, and grid expansion. Orders are down in the US and Europe as one would expect.
But,
ABB's orders for China are down 20% y.o.y. In stark contrast to
ABB, both
GE and
Alstom's Chinese order intake rose in the same time frame.
ABB's drop in order intake for China should be followed closely by Owners. If this is a consistent pattern over the next few quarters, then Owners should discount
ABB's price accordingly.
The next operating slide came as a surprise to Gudovac.
Coil Winding and Assembly tend to be labor intensive operations sometime consuming 30% of the labor for equipment in ABB's size range. The operating initiatives listed in the slide may have been worth celebrating 15 years ago. One would expect that productivity efforts at a cost center representing 30% of labor content would have been exhaustively addressed a long time ago.
It is shocking that relatively prosaic
Kaizen initiatives (Preventive Action, Key Performance Indicators, and Parallel Processes) are so new at
ABB to warrant inclusion in a CEO report. Conspicuously absent from the slide is any quantitative information on results. Enterprises with advanced manufacturing cultures would have presented the slide with quantitative information such as "30% reduction in cycle time" or "25% reduction in scrap". Instead, the CEO only is able to state that by June 30
th, 2009, the initiatives were
completed.
A cynical observer might imagine the completion occurred at 11:59pm on June 30th after some forceful messages to line managers came from on high.
Management projects significant cost savings over the next 18 months.
They present they have achieved 1/4 of their $2 Billion 2010 target. Three-quarters of the cost savings which has been achieved to date is via optimized global sourcing. This us likely to mean substituting Chinese and Indian for ABB's current German and Swiss suppliers.
Gudovac has directed first hand the promise, success, and eventual agony of such efforts. ABB's enterprise depends on remaining the highest quality supplier - with supreme confidence. The unforeseen effects of changing suppliers in the capital goods business are nearly impossible to manage. Capital goods supply chains are best changed at a glacial pace. ABB's dramatic efforts may be successful over the long term. Owner's should watch carefully warranty costs 2-5 quarter's from now. The slightest upward tick in warranty costs should be cause for very close scrutiny.
Gudovac is disappointed that management has set such a low goal for improving operational efficiency and quality. Opportunities must abound at ABB for efficiency improvements base upon the Winding Shop situation. Management would do well to focus on creating a modern operational culture at ABB to fit hand in glove with ABB's superior engineering culture. ABB would be unstoppable.
Finally, Owners should recognize that the easiest cost efforts are completed first. The last $500 Million of the $2 Billion target will be difficult indeed to achieve.
Financial Analysis:
The slide on the right underlies ABB's situation.
The 2 mature Power divisions experienced the smallest drop in EBIT margins and new order volume. The 2 higher knowledge Automation divisions saw EBIT percentage drops from 19% to 15% and 12% to 9% respectively. Owners can expect margins to continue to drop. This is evidenced by the 19% and 43% drop in new orders booked by the 2 automation divisions.
After more than 10 years of being the second leg on which ABB's strategy rested - Service is a mere 15% of revenues. Service revenue is flat year over year. Little or no mention is made of service by ABB management. Owner's need to understand if ABB still considers high margin service to be part of ABB's core strategy.
ABB's management has worked hard at reducing fixed costs. S , G, & A has been reduced by nearly as much as the drop in revenues as the summary spreadsheet indicates below. Owners can expect the pace of fixed cost reductions to increase as bookings drop. However, owners can not expect fixed costs to drop more than revenues. Capital equipment companies simply can not reduce fixed costs that quickly.
ABB's management has performed a journeyman's job of cleaning up the appalling balance sheet from the 2002 - 2005 period.
Trade Working Capital has remained steady over the last 6 months. Owners can expect the W/C DSO ratios to deteriorate over the next few quarters as customers stretch A/R and delay accepting finished orders.
ABB management has the benefit of being in a sector with large progress payments. Progress payments has remained steady at over $2 billion. This will decrease with the decline in ABB's backlog. The net cash position (including all long term liabilities such as pensions) is a acceptable $2.7 Billion. Owners should watch carefully changes in this position. In the last 6 months the net cash position has worsened by $300 million.
Gudovac calculates ABB as having a Owners book value of slightly less than $10 Billion. This is significantly lower than the accounting book value of $13 billion. Owners book of $10 Billion works out to some $4.32 per share.
ABB's Cash Flows appear to have suffered earlier than one would expect in such a long cycle business. Free Cash Flow is down 86% on a six month basis 1H 08 versus 09 and a down a staggering 94% on a 2Q 08 to 2Q 09 basis. Lumpy cash flows is typical of ABB's sector. Owner's should
not immediately conclude that the sky is falling at ABB just because of a wide quarterly swing in Free Cash Flow. Owner's should examine the root cause. Gudovac notes that operating cash flows have not decreased. The greatest year over year change in Free Cash Flows is due to the proceeds of the sale of securities which netted $2.8 Billion in 1H 2008. Therefore, one may conclude the operating enterprise is reasonably stable at this stage of the cycle.
Price to Buy:
What price would be reasonable to buy ABB ?
ABB is a high quality capital goods OEM with a strong Balance Sheet facing a devastating macro-economic climate.
Owners need to model what will ABB look like financially once the fat 2007 orders have long been shipped and forgotten.
What will ABB look like when the backlog is composed solely of lean 2009 & 2010 orders ?
Gudovac generated a back-of-the-envelope-model which depicts the likely range of possibilities for ABB as the bad orders flow through the factories (see below). Gudovac projects the ABB service business will remain flat at $5 million. New equipment revenues are likely to drop between 15 and 25% from 2007 levels. This is consistent with current booking activity.
Gudovac ascribes a range of Gross Profit with 'lean orders' of between 12% - 10%. The 12% Gross Profit is not far off from 2Q 09 result of 13.2%. The 10% Gross Profit level represents a 3 point drop in margin (nearly 30%). A 3 point margin drop is possible if ABB's competitors engage in price cutting to add volume. Destructive Price competiton of this sort happened in the mid 1980's and in the early 1990's. It could happen again.
Owners should note that ABB's EBIT was 11% as recently as 2006
Management can be expected to cut S, G, & A. Gudovac suggests management will have to reduce S, G, & A between 63% and 50% of 2Q run rate. This exceeds Management's Cost cutting goals - aka Target 2010. Gudovac believes that Management will be forced to push cost cutting onto S, G, & A as the full impact of Margin destruction becomes clear.
Therefore, ABB is likely even with successful cost cutting measures to end up with annual EBIT of positive $1,000 to negative $400 million. Adding the $600 million of annual D&A to the EBIT and one arrives at a EBITDA range of $1,600 to $200 million.
What should owners expect to pay for an Enterprise which generates these levels of EBITDA ? Owners can use EBITDA as a proxy for Free Cash Flow. Working Capital productivity eventually ends and should be excluded. ABB's weighted average cost of capital is in the 9% range. Owner's can expect ABB's long term growth rate to slightly exceed worldwide growth in GDP at 2.7%. Application of the
Gordon Growth Model. One arrives at a
wide range of values for 'lean order' ABB between $25 B and $3 B.
Readers should note this wide range of outcomes would horrify green eye shade analysts on the sell side. These are the type of analysts who want their 'customers' to believe they can predict net income per share to-the-penny 18 months from now. Gudovac does not have the level of wisdom nor insight that these brilliant sell side wage slaves posses.
The best that Gudovac can do is think like a mere owner and split the difference between $25B and $3B for a midpoint of value of $14 B. Subtracting the Net Cash Position (don't forget Pension liabilities), divide by the number of shares:
One arrives at a $5.04 share value.
Note, $5 per share is still a healthy margin over Owner's Book value of $4.32 per share. Owners of ABB would be able to generate modest returns over the long term at $5 per share.
Don't Get Massacred !
Gudovac1941@gmail.com
