Turnaround plays can test the patience of investors. The problems that led a company to be a turnaround candidate usually can't be solved overnight, and investors have to contend with seeing their stock underperform for long periods of time while they wait for both an improvement in operations and Wall Street's acknowledgement of that fact.
Swiss power and automation giant ABB
ABB operates essentially two large businesses -- automation systems and power equipment. The automation business sells a variety of process and manufacturing automation systems including things such as valves and sensors and robotic systems. The power business sells transmission and distribution equipment for electrical power and other utilities systems.
ABB is No. 1 or No. 2 in nearly all of the business lines in which it competes. What's more, there is reason to believe that there should be strong demand in the future. Although automation sales into developed economies is more of an upgrade/replacement business (in other words, slow growth), countries such as Turkey, India, and China are only beginning to emerge as customers.
What's more, the power business could benefit across the globe. While countries such as India and China scramble to add more electrical utility capacity, the U.S. should be facing a major replacement cycle. The average age of power equipment in the U.S. is about 40 years -- in other words, a large percentage of our country's electrical infrastructure was put into place when Elvis and the Beatles were topping the charts.
Results for the fourth quarter suggest that business is in fact improving, albeit slowly. Sales were up 5% in local currency, and the backlog of business climbed 7%. Margins improved significantly, and the company managed to generate more than $500 million in free cash flow for all of 2004.
Of course, risks still abound. The company is facing a significant asbestos liability, and no one really knows the dollar amount involved until the court battles are over. Secondly, no one should expect powerful revenue growth, meaning that ongoing margin improvements will be a key component of future improvements in profitability.
Valuation on ABB shares is mostly about the future. The trailing P/E is about 60, and the trailing EV-to-FCF is around 30. Looking ahead, though, if the company is able to hit its revenue and margin improvement targets, those valuations improve considerably (for instance, the stock trades at only about 15 times next year's estimates). Accordingly, ABB shares might be interesting for patient Fools with a long-term orientation and the ability to handle some risk in their portfolio, but this stock is definitely not for those investors who blanch at the sight of a bad quarter or two.
Fool contributor Stephen Simpson, CFA, has no ownership interest in any stocks mentioned.