Introduction

In February of this year, ABB (ABB) management laid out their strategy for the Robotics and Discrete Automation (RA) business during an Investor Day presentation. Despite an expectation that RA results will "...decline by more than 30 percent year-on-year" in Q2 FY '20 due to economic effects from the Coronavirus, RA is still poised to benefit from secular industrial trends, including requirements around increased productive capacity, greater manufacturing flexibility, and an ability to produce short runs of highly customized products. These trends underpin managements estimate of a $75B addressable market growing at a 6% CAGR.

I am long ABB; but I perceive certain challenges with the companys plan for the segment. While these challenges do not (presently) change my long-term bet on ABB as a whole, I think that there is a better-than-average chance that management will miss the mid-term profitability targets set for the business. As I outline my concerns in this analysis, referencing the presentation and supplemental materials, I would point out that I present certain summarizations and inferences that are not stated directly; and thus they represent my interpretations of the data as presented.

It may not seem reasonable to evaluate a plan that was offered when the effects of the current pandemic were less understood than they are now. Yet, I would suggest the core elements of the strategy are likely unchanged in the face of COVID-19 and thus the analysis is still relevant.

In my view, ABB has attached 3 key goals to their RA business strategy:

1. Mid-term improvement of operating EBITA margin in the range of 13% - 17%: over the last 3 fiscal periods, operating EBITA margin for the unit has steadily declined, with performance of 16.0%, 14.6%, and 11.9% for FY 17, FY 18, and FY 19 respectively; and as a (somewhat imperfect) point of comparison, competitor FANUC (OTCPK:FANUY) realized operating margins of 28.5%, 31.6%, and 25.7% over its analogous fiscal periods.

2. Return to consistent revenue growth: segment revenue was down (8%) year-over-year in FY 19 at $3.3B, dragged by ...[challenges in] weak consumer demand for traditional automotive vehicles, a subdued consumer electronics market, and a tough machine builders market

3. Lessened reliance on the automotive sector: while ABB notes 60% of RA unit revenues today come from other industry segments, the business still remains highly sensitive to the automotive sector.

Distilling ABBs data, management basically positions 5 tactics to achieve its objectives. I offer my explanation of each as follows:

1. Leveraging existing expertise in new segments: While ABB has its roots firmly planted in industrial solutions, the RA business is increasingly looking toward consumer segments for growth and diversification. Such service robots, which find applications in a wide swath of industries including retail, restaurant, and healthcare are expected to see significant growth in coming years, with industry revenues growing at a 20% CAGR by ABBs estimate. Management seeks $1B in sales from Consumer Segments & Service Robotics (CSSR) by 2030 by roughly doubling the $250M of CSSR revenues today by 2025, and again by 2030.

2. Accelerating in existing segments: The automotive sector has been and still is the bread-and-butter of industrial robotics players, including RA. It is only logical to continue to seek growth opportunities within that industry, even as the overall RA business seeks a more varied sales structure to temper the effects when downturns in the sector occur. Management suggests it can grow automotive-related revenues at a 5% CAGR, against an overall industry CAGR of 3%, by capturing greater share of the fast-growing electric vehicle ("EV") manufacturing market and pushing into higher-value areas of the traditional market. The latter high-value areas include final assembly applications and robot cell solutions.

3. Driving new automation solutions: The current RA business emerged in FY 18 from ABBs Next Level restructuring strategy as one of four global P&L units, with a focus on discrete manufacturing. The carve-out of the unit, previously attached to ABBs Motion business, was bolstered by the companys acquisition of Bernecker + Rainer Industrie-Elektronik GmbH (B&R) in FY 17. ABB management sought B&Rs factory automation technologies to establish a competitive advantage with solutions composed of robotics and automation technologies. With software playing an increasingly larger role in automation, ABB has been quite vocal over the last few years stating their intent to be a leading player as manufacturers digitize their operations. Indeed, ABBs software application portfolio may offer both significant differentiation and a source of high-margin solutions. Management notes that the factory automation business has been growing at an 11% CAGR.

4. Continue to lead in key geographies: ABB management claims #1 status in both China and India.

5. Execution: ABB has been working to streamline its organizational structure for some time now, simplifying itself around 4 business units (inclusive of RA). ABB Groups restructuring efforts, meant to drive expense reductions across all business segments, were instantiated under the ABB-OS program. RA management is seeking intra-segment improvements in cost-control, quality, and sales execution to help it reach the profitability corridor mentioned earlier:

Figure 1: ABB RA Path to Margin Corridor

Source: ABB RA Investor Day Presentation FY20

Management notes a historical 11% sales CAGR for the overall RA business. It might be possible to carry this rate forward if factory automation roughly comprising 25% of total revenues today can maintain/grow its historical growth rate and if the balance of the business centered on robotics can continue pushing into higher growth areas, such as CSSR and EVs. Working off that top-line growth projection, the following table offers a set of operating EBITA forecasts:

Figure 2: ABB RA Operating EBITA Forecasts

Source: Yves Sukhu

Notes:

While I opted to show what operating EBITA numbers would look like if constant margin rates at the low, mid, and high points of management's range were carried through for the entire forecast period, we might expect a progressive improvement in operating EBITA margin as shown in the last row. For perspective, the progressive forecast would throw off a cumulative $4.4B in operating EBITA by FY '25, with ABB Group reporting approximately $3.9B in operating EBITA across all 4 P&L units in FY' 19:

Figure 3: ABB Business Segment Data

Source: Yves Sukhu

Investors might note in Figure 3 above that despite being the smallest of ABBs 4 P&L units by revenue, RA generated the highest revenue/employee in FY 19.

ABBs plan for RA is in a word sensible. As suggested in the Introduction, one would not necessarily expect the plans core elements to change in spite of the pandemic. But this would mean, of course, any weaknesses in the core remain; some of which may, in fact, be exacerbated under current conditions. I think that is indeed the case; and I suspect RA's historical sales growth rate, as well as management target corridor for profitability, will both be challenged.

Examining the strategy for RA, I basically question the units ability to:

1. Successful long-term development of RAs software portfolio, to establish and maintain significant competitive differentiation, may prove difficult and expensive. ABB is an engineering company, not a software company. Yet, industrial digitization means it has had no choice other than to push into software technologies, sometimes acquiring software assets to fill gaps in its offerings, as with B&R. ABB Ability, a portfolio of a couple hundred digital offerings positioned horizontally across all 4 ABB business segments, was touted in the Annual Report FY 17 as ...supporting [the companys] position as a leader in the Fourth Industrial Revolution...[with] an annual market opportunity of up to $20 billion. But bear in mind, ABB is hardly alone in its push toward digitization, and similar initiatives by other industrial players have struggled. In regard to the latter, I wrote a Seeking Alpha article in 2017 about General Electrics (GE) Digital business segment which was soaked in wildly bullish management forecasts, including the following:

[GE] noted in its FY 2015 Annual Report that GE can become a top 10 software company by 2020...

Suffice it to say, GE Digital is not a top 10 software company today. Developing a large software-centric business within an engineering-centric organization is no easy feat, and in a 100+ year-old company like ABB it is likely to be constrained by organizational and cultural idiosyncrasies. One possible approach to combat such constraints is to push development into each business unit; and indeed, this is the case with RA and its portfolio of simulation, factory automation, and other software technologies. It is questionable, however, if RAs historical R&D spend of ~5% of sales is sufficient given the companys software ambitions:

Figure 4: ABB RA R&D Investment FY 17 FY 19

Source: ABB RA Investor Day Presentation FY20

Consider that Microsoft (MSFT), an organization largely focused on software-centric research, spent more than 13% of sales in FY 19 on R&D. ABB RA, on the other hand, must spread its (much lower by percentage) R&D spend among research initiatives in software, robotic hardware, interface systems, automation technologies, and many other areas related to its product stack. One could easily imagine the segments software efforts being starved of the resources it needs to grow and thrive. Obviously, any significant increase in R&D to bolster software offerings is going to drag on already depressed margins. But, the alternative scenario could lead to a software portfolio that is non-competitive and perhaps offering limited marketplace differentiation.

2. ABB RA could struggle with its move into consumer segments. Since the 1970s, ABB RA now sits atop more than 400,000 robot installations throughout the world. But these are in large part manufacturing-centric applications and there is no guarantee that the companys success in industrial solutions will translate equally in the consumer space. Certainly, it is understandable why management is eager to target CSSR with the International Federation of Robotics 2018 Service Robots report estimating the cumulative sales volume for professional service robots at $46B for 2019 through 2021. Yet, that same report identified more than 700 service robot companies throughout the world, suggesting a fragmented and competitive market that is increasingly competitive given its position as a favorable and ...primary field for [robotics] start-ups. Thus, despite $250M in estimated CSSR revenue today, mainly in consumer goods and logistics applications, ABB RA might still be considered an emerging and unproven player. Although, to the companys credit, they appear to be picking their battles. For example, the companys acquisition of intrion in FY 18 further positioned RA to capitalize on the fast-growing logistics sub-segment of service robotics, which accounted for ...36 percent of the total sales (in value) of professional service robots [in FY 18]. Nonetheless, the number of market participants and lower barrier-to-entry for the CSSR space implies that ABB is likely to face pricing and margin pressure against a potential glut of competitive offerings. With a relatively small foot-hold today, it remains to be seen if the company can penetrate the CSSR market at scale.

3. Contrasting trends makes forecasting against the automotive sector a bit difficult. Softness was present in the automotive industry well before the appearance of COVID-19, as ABB itself noted in its Annual Report FY 19 that its sales result for RA was impacted by ...weakness in automotive-related sectors and weak book-and-bill business. Beyond ABB, a CNBC report noted that as consumers spent a record $462B on new cars in 2019, manufacturers produced fewer vehicles while the average price per vehicle increased. And in 2018, car sales were down 3% globally which included a 6% decline in China, the first such decline in 28 years. The causes behind the pre-pandemic slowdown were multi-faceted, but largely due to economic slowdowns in key markets including China, India, and Europe. Economic headwinds, worsened by Coronavirus, have devastated car manufacturers in 2020, and that trend may continue into 2021 with some manufacturers suggesting a shift to less expensive, less feature-rich vehicles is necessary. Obviously, none of the foregoing bodes well for industrial robotics. At the same time, however, the electric vehicle market, inclusive of associated infrastructure, continues to grow in markets around the world, off-setting downtrends in the traditional market. That would bolster the case for ABB managements forecast in its strategy presentation to increase the proportion of EV market revenues, growing at a robust 18% CAGR:

Figure 5: ABB EV Market Revenue CAGR Forecast

Source: ABB RA Investor Day Presentation FY20

So, there is bad news along with good news. And its not clear particularly in the darkness of the pandemic to see how these contrasting trends will add up. Accordingly, as ABB RA and all the industrial robotics providers remain sensitive to the automotive sector, sales and profit forecasts for these businesses are likely to be unreliable at best.

4. RA management should (of course) drive on-going improvements in execution, but investors should be somewhat wary before placing too much faith in such initiatives. ABB management routinely pushes improvements in execution as a strategic driver in all 4 of its P&L units. They particularly stress such initiatives as key to margin growth, as in Figure 2. Arguably, the "cost measures", "quality and execution", "mix & value" and "volume" drivers in Figure 2 are all execution-related with the latter two having a direct correlation to sales execution. Indeed, RA management has increased its spend nearly 14% between FY '17 and FY '19 to improve its sales operation, and plans to make further investments moving forward:

Figure 6: ABB RA Sales Operation Initiatives

Source: ABB RA Investor Day Presentation FY20

Certainly, these investments are necessary, particularly as RA's product stack has become more comprehensive and complex, as with the B&R acquisition. However, drawing upon my own experience selling enterprise software, sales improvement initiatives (unfortunately) have a tendency to fail to deliver a commensurate return relative to the corresponding investment. Far too often, companies mask problems with their product portfolio, suggesting instead that better execution is the recipe for higher sales volumes. That is to say, more simply, good products will sell in a given market, but companies rarely admit to a lousy product stack. I am not saying this is necessarily the situation at ABB. But, having seen the same "story" repeated elsewhere within ABB, one does wonder how reliable these investments will be in terms of driving material improvements in the business. Would RA be better off allocating less toward sales and more toward R&D? Time will tell.

Of the points above, it seems (particularly to me) that ABB RA needs to substantially increase its allocation toward R&D. But, in context of my other arguments, it is not clear that the unit will see sufficient growth to throw off enough cash such that R&D spend can be increased while maintaining, or, more necessarily, growing margins. COVID-19 notwithstanding, I think RA would struggle to maintain its historical sales CAGR and may have been challenged even reaching the low-end operating EBITA margin target. Coronavirus just makes the situation worse with management noting that Q1 FY '20 results "[reflected] continued deterioration in the automotive and related industries plus weakening in general industries...[and further] margin contraction." My take: expect a rocky road ahead.

As I mentioned in the Introduction, I have not changed my long position in ABB as a result of this analysis. As investors should know, the stock which closed at $24.00 as I wrote this report is up over 25% over the last 12 months.

In terms of what lies ahead for RA and the industry as a whole, I think it is fair to say that no one really knows. I would say, however, I dont think RA is a lost cause. I may have, for example, exaggerated the impact of the challenges discussed in the previous section. And some of the secular trends driving robotics - namely reducing the need for human labor - may, in fact, increase in intensity due to the current situation such that an explosion in the use of industrial robotics may be "just around the corner". Paradoxically then, COVID-19 may create massive tailwinds for the business.

Still, investors may wish to explore positions in other robotics players as something of a hedge against fundamental weakness in RA.

Perhaps the CEO of ABB competitor Teradynes (TER) said it best in a recent Barron's article, noting ...we believe the opportunities for automation will accelerate post pandemic as businesses see the resilience benefit of a more automated workflow.

Disclosure: I am/we are long ABB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Perceived Weakness In ABB Robotics And Discrete Automation - Seeking Alpha