Our interaction with ABB India management at the recent investor meet reconfirms our view that the company's In Country, For Country and By Country strategy could have further legs to improve gross margins. This, in addition to the parent company's strategy to use India as a low-cost exporting destination, could drive a strong earnings growth recovery. Even after assuming demand uptick from H2CY15, we forecast (CY14e/CY15e EPS up 6%/5%, respectively) a 59% EPS CAGR over CY13-CY16e (estimates). We maintain Buy on the stock with a DCF (discounted cash flow)-based 12-month target price of R785/share.
Gross margins could improve by 200-300 bps: ABB India management reiterated that (i) its In Country, For Country, By Country strategy looks at how to make products that are more suitable and cost effective for the market in India, and (ii) how to take advantage of the currency depreciation that has enabled the already competitive Indian facilities even more at the global level. With improving clarity on these two facets, we believe that the gross margin expansion headroom could have more legs (200-300bps).
Our medium-term estimates are significantly ahead of consensus: Our revised CY14e/15e estimates are 10%/42% ahead of Bloomberg Finance LP consensus, and we now expect RoE (return on equity) to improve to 19% by CY16e.
Valuations and risks: Our 12-month target price of R785/share is based on DCF (arrived using Deutsche Bank risk-free rate assumptions of 6.5%, risk premium of 7.6% and terminal growth of 4%). The DCF assumes a mid-cycle margin that is 500 bps below that of its parents margins and looks reasonable even after assuming higher royalty cost. Key risks: commodity price inflation and unclear election verdict. As per our model, a one-year delay in recovery to CY16e reduces our target price by 11%.
Takeaways from investor meet
Regulatory environment is uncertain: ABB management said the environment had been tough in the past, with fierce competition in the market and rising competition from the east. With the economic slowdown, a number of projects had stalled and power was the first to feel the impact, followed by industry. The company highlighted that over the past two years, the government had taken initiatives to improve the investment climate. However, the regulatory environment remains quite uncertain.
Initiatives for cost control: ABB had foreseen the problems, and taken a number of initiatives to counter them, such as:
* Right sizing the company.
* Focusing on cost reduction post-2009-10, cost levels are flattening.
* Localisation: On the supply side, ABB was a net importer. It concentrated on localisation of many products. It started producing in Indiaimplying arbitrage of labour. It then went for procurement of component and localisation of equipment. For India, specifications were changed to suit local conditions.
Focus on technology to protect margins: The management stated that the core part of its strategy is to use technology to protect margins. Customers prefer ABB because of the technology. As prices come down, ABB should find new solutions. It is continuously focusing on finding innovative ways to protect prices.
Liquidity concerns taking away benefit: The management stated that biggest dampener is the liquidity crunch. In 2011, the company did not resort to borrowings. In 2013, it had to borrow money (R3 bn). This has eaten away some of the benefits.
Competitive intensity: Compared with Chinese or Korean peers, ABB is very competitive. For instance, one of the east Asian peers quoted 10% more discount with payments after three years for an R1.8 bn contract in the past. Of late, these kind of bids are absent from the east Asian peers, and ABB is in a position to withstand pressures.
Capacity utilisation: On average, capacity utilisation is in the range of 80-90% on a single-shift basis. To that extent, management stated that its facilities are highly scalable and it would not lose on new orders.