The company outsources the bulk of its material inputs in an effort to control costs but it really does not have much to show for it at the end of the day. This is my second take on ABB Ltd having covered the working results for the previous year ended too.
Power generation needs fine tuning
After observing the performance results of ABB Ltd, it would appear that being a player in the power segment in India is a mug's game or something. The brief financial data of its operations for the last five years that it has appended along with the annual report, gives the impression of a company which has as yet to get the better of the environment that it is operating in, either deliberately or otherwise. And, ABB has been a very long term player in India thank you. Both the top-line and the bottom-line over the five year period reveals a topsy turvy journey, with the company barely scraping through at the end of the day on a post tax basis.
ABB as the company proudly advertises, is one of the world's leading power and automation engineering companies with a portfolio ranging from light switches, to robots and electrical transformers, to control systems that manage power networks and factories. They also provide solutions for secure generation, transmission, and distribution of electricity. In India it produces 12 items ranging from motors, switchgears, transformers, robotics, electronic control systems, process control systems and yet others. But for accounting purposes the revenues are grouped under five heads of account. They are Power Systems, Power Products, Discrete Automation and Motion, Low voltage products, and Process Automation. It would sound like a lot of Greek to the layman. The biggest revenue generator is the Power Systems division, followed by the Power Products division. But the fact of the matter is that mainstay of their operations lies in the massive purchases of goods and services, as it calls it, and in the sales to group affiliates. Such group transactions have their own plus and minus points as we will see as we traverse along.
A humungous group operation
ABB has massive operations worldwide judging from the number of fellow subsidiaries that the India operations possesses - there are 130 fellow subsidiaries in all. Two of the fellow subsidiaries are India based ABB Global Industries and Services, and K-Tech Level Engineering Pvt. Ltd. It also has one wholly owned subsidiary; Baldor Electric India Pvt. Ltd. ABB India has during the year purchased the transformer, low voltage breakers, and the vacuum Interrupters division from ABB Global Industries and Services for a consideration for Rs 4 bn. One wonders what is left of this company post sale scenario wise, given the size of the purchase consideration. Besides, what benefits accrue from this purchase? The new wholly owned subsidiary Baldor Electric is a pipsqueak by all accounts. An equity capital base of Rs 100,000, a middling turnover of Rs 28 m, and a profit before tax of Rs 2.5 m. Possessing such teeny weeny siblings should be more of an embarrassment to ABB.
The list of the fellow subsidiaries of ABB India is a study in the diversity of ABB. Its reach extends to all continents barring the Arctic and the Antarctic it would appear. But within its area of operations it is placing far more emphasis on operations in some big ticket nations than yet others. For example, it has a gargantuan 21 companies operating out of China/Taiwan (all but one is located in China). The contribution of these companies to the group revenues is not known, but would appear substantial given that China is today one of the largest power equipment manufacturers in the world. By contrast, and as stated earlier, it has a mere four companies operating out of India. As a matter of fact there are also 11 ABB companies operating out of the Gulf region, the bulk of which are located in the UAE. Now, one can gauge the priorities of ABB the parent.
The Indian offshoot
ABB India generated revenues of Rs 73.7 bn during the financial year 2011. That is almost Rs 10 bn more than it recorded in the preceding year. It also toted up other income of Rs 949 m against Rs 855 m previously. Other income is a significant player in ABB's scheme of things. This income accounted for 35% of pre-tax profit in 2011 against a much larger 85% previously. It is not known how much the domestic manufacturing operations contributed to its overall sales - partly because the company has chosen to publish only the abridged statement of accounts for the year. ABB of Switzerland presently owns 75.2% of the outstanding equity of its Indian sibling and the management obviously believes that since it controls the majority stake by far, its interest are more than served by publishing only the bare minimum as required by law.
But even with such limitations one can still extrapolate and arrive at some conclusions. The point is that it earns its living using a very complicated mechanism. The revenue expenditure schedule shows that it purchased finished goods and services worth Rs 57 bn during the year. That in itself accounts for a slice over 77% of the sales value for the year. What then was the contribution of manufacture in this expenditure? The company boasts a net manufacturing block of Rs 11.6 bn. Besides, what value addition can a company generate if it outsources the bulk of its materials and services? In this material expenditure component, the purchase of raw materials, components, project items and traded goods from group companies amounted to Rs 15.5 bn. Thus the imports of materials amounted to 27% of all purchases. It is not known what percentage of trade creditors is attributable to group companies as ABB has not separately furnished details of trade creditors. But suffice to add that dues to group companies at year end amounted to Rs 5.5 bn. On a rough reckoning though, trade creditor dues at year end amounted to 35% of such purchases.
A lackey of the parent?
On the income side, sales and services to group companies toted up to Rs 6.1 bn or 8.3% of all sales. The trade debtor dues at year end amounted to Rs 2.4 bn or 41% of all such sales. This roughly corresponds with total trade debtor dues amounting to 42% of all sales for the year. Separately there is expenditure on royalty, trademarks, and technical know-how fees payable to several group companies which amounted to Rs 1.6 bn. The parent believes in bilking its sibling alright. There are several other expenses on revenue and capital account that it paid to its group affiliates. One such expenditure amounting to Rs 1.4 bn is in respect of payment on account of information technology, engineering and management services to group companies. Then it paid out Rs 106 m for technical know fees, and on account of other capital expenditure of Rs 111 m to group companies. The poor Indian company is not coming of age and does not appear to be contributing one penny bit to the intellectual capital base of any of the group companies it appears! There are no such receipts in its books. Is this deliberate or incidental? The company is also spending large sums on Information Technology access - Rs 895 m in 2011 against Rs 668 m previously. Is this spending having any spinoff benefits on the company? The bottom-line generation does not appear to show any such.
There are some unintended fallouts or otherwise of its dependence on group companies to generate overall revenues. Such as the play of exchange rate differences on foreign currency transactions which in this case are humungous. In 2010 the company lost a massive Rs 946 m on this count, while in 2011 it was on the right side of the draw gaining Rs 253 m. That works out to a cumulative turnaround of Rs 1.2 bn in 2011. Since the effect of such hedging cannot be decided in advance the company cannot even add such costs that it may have to incur onto the customer. These are not small sums by any yardstick. There are other related exigencies too which it has to take care on a regular basis. Such as the fact that the company has to give a long credit line for sales affected by it - trade debts on a rough basis account for 42% of all sales affected for the year. Further it has also provided for bad and doubtful debts of Rs 904 m, against Rs 431 m previously. Why should this be so given its clientele?
Questionable management of its finances
The company also gives the picture of bring totally debt free at year end. But that was not the situation during the year. The company decided that the cash flow that it generated was simply not enough to take care of its capital needs during the year. Hence you have the incongruous situation of zero debt at either year end and interest charges of Rs 307 m debited to P&L account during the year. The amount of interest that may have been paid out, capitalised, and added to fixed assets, is not known. The way the cash flow statement shows it, the company managed to generate a cash flow of Rs 1.2 bn from operations during the year, down from a much larger Rs 2.2 bn that it generated previously. But this cash generation was grossly inadequate to meet its capex requirements for the year, including the acquisition of the business of its fellow subsidiary. The company purchased fixed assets worth Rs 1.55 bn during the year and it may have been financed through borrowings. It also acquired businesses for which it paid out Rs 1.7 bn. But the notes to the accounts states that the businesses were acquired for an aggregate gross consideration of Rs 4 bn m on a slump sale basis. If it paid out only Rs 1.7 bn, how then was the balance consideration accounted for? Or am I missing out on something else here please? Compound this outflow with the acquisition of an India based company for Rs 340 m (and which became a wholly owned subsidiary in the process), and ABB then decided that it was deeply out of pocket. It was out of pocket to the tune of Rs 3.6 bn that is on a strict accounting basis.
So it resorted to borrowing big during the year - Rs 57.7 bn to be exact. Why exactly it sought to borrow such humungous sums beats me all ends up. This was far in excess of the funds that it required. Besides, it boasted cash reserves of Rs 5.8 bn at the beginning of the year. What's more, it had cash reserves of Rs 2.5 bn at year end. The borrowing of Rs 57.7 bn is classified as of the short term variety, and it was also repaid during the year. But it led to a cash interest outflow of Rs 307 bn - a needless expenditure in my humble opinion. This is indeed one heck of a way to manage the finances of a global corporation if one may use this term.
The future imperfect
Given the importance of adding to new power generating capacity ABB with its fine branding should have little difficulty in getting its act together in the future. The orders at year end and the order backlog at year end is more than that of the preceding year end. But at the same time it does not give the impression of a company that has got its head screwed correctly on its shoulders. The real plus point however is that the company may seek to delist from the Indian stock markets in none too distant future (it has already engineered one buyback) and any purchase of shares from the minority shareholders may well be at considerable premium to its market price. Or so one presumes, for the moment.
Disclosure: I do not hold any shares in this company, either directly, or under any non discretionary portfolio management scheme
This column Cool Hand Luke is written by Luke Verghese. Luke has been a business journalist, financial analyst and knowledge management head with a professional experience of more than 20 years. An avid watcher of the stock market, he has written extensively on stock market trends. His articles have featured in Business Standard, Financial Express and Fortune India amongst others. He has also been the Deputy Editor, Fortune India and the Financial Editor of The Business and Political Observer.