Switzerland's ABB (NYSE:ABB) is one of those large companies that most people never think about, but wouldn't want to live without the end results of what they facilitate. ABB's automation products allow factories, refineries, power plants, and steel mills to operate smoothly, safely, and efficiently, while its varied products and service in the power market are vital to power generation and transmission. If you believe that Europe's economy is set to turn around and that emerging markets like China will continue to invest in power generation and factory and plant modernization, ABB is a name to consider today.
Automation seems to be picking up
Two of ABB's rivals, Rockwell (NYSE:ROK) and Siemens (OTC:SIEGY), reported improving conditions in the automation market in their recent quarterly reports. Rockwell, which competes with ABB in areas like industrial motion and controls, robotics, and process automation in markets like oil and gas, saw 7% revenue growth in its most recent quarter, and management sounded generally upbeat about the prospect for improving orders in the coming year.
Siemens likewise seems to be on better footing. Siemens is a sizable head-to-head rival with ABB, competing in areas like motors, robotics, industrial motion, controls, and up and down the process automation industry (including markets like oil and gas, pulp and paper, chemicals, and metals and minerals). Siemens saw orders improve by 7% and likewise appears to be comfortable with the idea of improving orders in Europe and good growth prospects in China.
For ABB, the fourth quarter was a middling performance in automation, as discrete automation sales were up 8% as reported, but down about 2% on an organic basis, while process automation was up 3%. Much more encouraging was the 10% growth in discrete automation orders.
Power is a balancing act between potential and politics
Products and services for the power and utility market constitute a significant business for ABB. The company generates almost half of its revenue from the power products and power systems segments, including such products as transformers, switch gear, grid systems, and substations. It is also a business where ABB enjoys strong share competing with the likes of Siemens, Alstom, and Schneider.
Unfortunately, this has been a challenging business for ABB. It is sensitive to weather (witness the large $260 million charge in the fourth quarter due to storm-related delays in offshore wind power projects). It is sensitive to economic conditions, as utilities and businesses curtail spending in weak times. It is also political, as utilities and regulators wrangle over rate structures that give the utilities enough incentive to upgrade their infrastructure and as countries like China wish to see "national champions" emerge to compete with the likes of ABB.
I believe there is definite risk in the timing of power orders and revenue, but the potential is large. Western Europe and the U.S. need grid and transmission upgrades and countries like China, India, and Brazil need to add capacity. To that end, China's State Grid Corporation intends to spend 13% more in 2014, and much of that is likely to go to infrastructure products.
General Electric (NYSE:GE) also seems to provide some potential reason for optimism. GE saw a sizable increase in thermal and wind power orders in the fourth quarter, and while these companies do compete in some areas, an overall increase in generating capacity usually translates into more orders for equipment from ABB for other parts of the network.
GE and ABB have also made sizable bets on the future of renewable power, but at different points in the process. GE is a major player in wind turbines, while ABB has a large presence in substations, grid connections, and other components that basically patch the turbines into a network. Likewise in solar, where GE has some presence in inverters and ABB has a significant presence after its acquisition of Power-One.
Growth plus execution
ABB is looking to drive additional growth in automation by bulking up its offerings in areas like instrumentation and software. I believe ABB has ample room for improving its software offerings for applications like process automation, and this may be an area where the company looks to grow through acquisition – ABB has made a billion-dollar (or larger) deal for each of the last three years, and it has the capacity to do another sizable deal now. At the same time, I believe the company remains focused on cutting costs where it can, as prior efficiency drives have delivered good results.
I expect "predictable unpredictability" in ABB's revenues and orders, as its markets have long been cyclical and challenging to accurately forecast beyond the next year or two. That said, I'm looking for long-term-revenue growth of around 4%, with high-single-digit, free cash flow growth driven by better utilization on improving orders in Europe and growth in emerging markets.
The bottom line
Discounting those cash flows back, I arrive at a fair value of around $27 for ABB. Factoring in the dividend, I believe ABB can deliver annual expected returns of 10%-12%, well ahead of what you would normally expect from the broader stock market. With that in mind, and considering the prospects for better industrial orders in Europe and growing utility orders in China relatively soon, I still think ABB looks like an attractive stock to own today.