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 parent’s 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.