ABB Attractive for Automation Exposure

ABB ABB/ABBN reported 2018 results that were about 2% lower than our forecasts for revenue and earnings. However, we are maintaining our wide economic moat rating and $25.40 and CHF 25 fair value estimates. The company also announced a partnership with Dassault Systemes, which increases its exposure to higher-value industrial automation software with an offering more in line with that of Siemens and Schneider Electric. In addition, management proposed new medium-term targets of 3%-6% comparable revenue growth and 13%-16% EBITA margins, with the latter suggesting moderate upside relative to our current forecasts.

Group revenue grew at 4% and orders at 8% on an organic basis. The robotics division came in with better growth than we expected, up 11% for the fourth quarter and 8% for the year, about 200 basis points above our 6% forecast. The electrification division (low voltage) also posted good growth. The industrial automation division (process automation) posted just 1% growth, about half of what we expected. However, given the long-term potential for process automation and the recent partnership with Dassault, we see upside potential from the current base of business in that division. We think the shares are attractive for investors looking for exposure to longer-term industrial automation expansion.

Positioned to Capture Market Share ABB's power grid and robotics and motion divisions are better positioned now to capture share in their markets than they have been in recent years. The power grid division, which contributes roughly 24% of group EBIT before intersegment eliminations, faces a changing market, requiring software and equipment that can manage dynamic power supply. Although ABB's product portfolio has led innovation in this area, its internal sales and structures were predicated on previous market dynamics. The division is retooling its salesforce toward representatives who can better address utility customers' needs with regard to dynamic power allocation. This has involved retraining some existing salespeople but also hiring new ones with consultant backgrounds.

In 2017, ABB acquired B&R, a top-five global supplier of critical discrete automation components, including programmable logic controllers, which were previously missing from ABB’s product portfolio. This deal enables ABB to offer a complete discrete automation offering, as the programmable logic controllers, which include microprocessors, control the equipment and are present in most discrete automation setups. Because ABB is also the number-two robotic arm supplier globally, we believe this deal puts it at a competitive advantage relative to suppliers such as Rockwell Automation and Siemens, which do not manufacture robotic arms.

Wide Moat Based on Switching Costs and Intangible Assets ABB is the number-one or -two supplier in all of its core markets, and its products are embedded in its customers' processes in each its four divisions: power grids, industrial automation, robotics and motion, and electrification products.

We consider the power grid division, which contributes around 24% of group EBIT before intersegment adjustments, to be a wide-moat business. It is one of the most dynamic of ABB’s segments, as the introduction of renewables into the grid has added a previously unknown degree of volatility in power supply. Two changes in equipment demand have emerged from this trend: First, utilities and other companies supplying transmission need to put in automation components, such as controllers and algorithm-driven software, to be able to predict changes in power supply from different sources--for example, renewables versus gas turbines--and must dynamically change sources to ensure consistent power supply. This is commonly called the smart grid. Service and software constitute 14% of this division. Second, substations are being pushed deeper into the grid, closer to the end user, or the microgrid, increasing demand for switchgears and transformers. Utilities and private users are building out substations to cope with the increased risk of outages.

The company’s power grid customers have high switching costs, as equipment can last 50 years or more, and so utilities need to have a very high degree of confidence in the supplier and its equipment. ABB and its key competitors in this segment have a long history of supplying to their customers. Roughly three fourths are utility customers, supplying a critical resource for communities and businesses. They are therefore highly risk-averse and are more reluctant to introduce new vendors (and, critically, new technologies) into their supply chain. Therefore, it is no small feat that utilities have introduced high-voltage direct-current systems into the grid. HVDC can transmit power over long distances with almost no loss of electricity, one of the great inefficiencies of traditional AC transmission systems. ABB was a pioneer in HVDC and is one of the few vendors utilities will use for the systems. HVDC now contributes about 15% of the power grid division’s revenue and is fast-growing. ABB’s reputation as a technological leader and a reliable partner contributed to this technology’s growing prevalence in the grid.

The origins of switching costs and intangible assets for the industrial automation and robotics and motion divisions, contributing a combined 50% of group EBIT before intersegment adjustments, is the same, and we also consider these to be wide-moat businesses. Both are integrated into their customers’ processes, with a high degree of technical skill. At their core, they both run machines and ensure efficiencies, as well as other operational performance metrics, through control systems. These involve a system of motors, sensors, and microprocessors that power equipment and simultaneously feed back key measurements into ABB’s control software. Measurements of temperature, vibration, power, and other elements enable the software to predict maintenance needs as well as changes needed to meet performance requirements. Service and software constitute 41% and 16% of revenue for industrial automation and robotics and motion, respectively.

Industrial automation deals with process automation for chemical plants, refineries, oil production, and food processing for items like yogurts. Oil and gas customers make up nearly one third of this segment and marine a similar amount. Both of these industries run processes 24/7 and in potentially dangerous environments and therefore tend to be very conservative when it comes to picking suppliers. In marine, ABB has a monopoly on electric propulsion systems. The most common product in this segment is the control system.

Robotics and motion deals with discrete automation, the control of objects. For ABB, this essentially means control of its robot fleet. ABB is the number-two industrial robotic arm supplier, behind Fanuc and ahead of Kuka and Yaskawa. Most of its robots are controlled by algorithm-based software and connected to its data centers. ABB continuously draws data from the robots across all customers, feeds the data into algorithms to extract performance improvements, and then distributes those updates to all of the robots online at its customer premises. This has three benefits to ABB: a regular revenue stream, greater customer dependence on its systems to meet performance targets, and an informational advantage over competitors. This division also sells motors and drives (which control the speed of the motors); ABB is the number-one supplier in both segments.

ABB supplies medium- and low-voltage products to utilities and within buildings through its electrification products division, which generates 35% of group EBIT before intersegment adjustments. We would argue that this is a strong narrow-moat segment, but we hesitate to assign it a wide moat because the life of some of the components is shorter than that of high-voltage equivalents, and for supply to buildings, customers may move premises within a 10- to 20-year time frame. This segment offers equipment for local substations as well as components for in-building electricity distribution. As with power grids, customers look to suppliers to ensure constant energy supply and tend to stick with known suppliers. For buildings, ensuring clean power supply is critical, as large pieces of equipment (like air-conditioning systems in the summer) can create distortions in in-building electrical transmission and disrupt supply. Many modern electrical components contain software, such as smart meters, and integrating all of a building’s components to guard against power supply disruptions requires a high level of design and engineering skill.

Acquisitions and Cybersecurity Are Main Risks Our uncertainty rating for ABB is medium. We see noncore acquisitions and cybersecurity as the two key risks to ABB's business. The company has a long history as a serial acquirer and at times has veered off road from its core business. However, we view the acquisitions of B&R and GE's low-voltage business as strategic and do not anticipate that the management team, in place since 2013, will make significant noncore acquisitions in the near term.

The company is moving more of its equipment on line, with customers looking to ABB to take live measurements to improve algorithms running equipment and predict maintenance needs. However, we believe this leaves the company open to increased risk of a major cyberattack and risk to its reputation as a reliable partner. The utilities segment is one customer segment that has not put its equipment on line for this very reason.

ABB’s balance sheet is conservatively managed, with net debt/EBITDA remaining below 1 for the past decade. The company generates about $3 billion annual in free cash flow, so in theory ABB could pay off its roughly $7 billion in gross debt in less than three years.