From Life Support to Lean Machine

Swedish-Swiss company ABB has experienced its fair share of struggle and a certain degree of luck, coming back from near collapse seven years ago. It was reeling from a combination of internal disorder and huge liabilities to asbestosis victims, a consequence of ABB's acquisition of US firm Combustion Engineering Inc. Settling the claims cost $2 billion and the struggling company shed assets and 40,000 jobs. With companies bracing themselves in the face of global recession, ABB's story of survival provides a salutary lesson.

It was fortunate for ABB, says CFO Michel Demaré, that the radical restructuring of the company into the proverbial mean-machine, totally focused on its core competencies, took place on the threshold of a strong market up-turn in capital goods. Demaré believes that to maintain strong performance in uncertain times, companies need to make preparations during the good times.

‘We kept this in mind during recent years when the markets proved favourable towards us,’ he says. ‘We took the time to get our house in order, by reinvesting our earnings internally and improving the business and the balance sheet. If you fail to do that during the good times then it’s likely you will struggle when times are hard.’

Demaré marvels at people in the capital goods industry who proclaimed that their business was no longer cyclical.

‘When you lose that kind of perspective, you are really putting your company in danger. ABB faced a near-death experience and we still have a lot of people who were there at the time. Once you have been that close, you certainly don’t want to go back. It also taught us a lot of humility, so that we look at situations in a slightly different way.’

Shrewd business

ABB is currently sitting on a $5 billion cash pile. Demaré recalls that in 2007 he was accused at an investor meeting of being fiscally irresponsible because ABB had so much cash on its balance sheet.

‘Today,’ he says with a smile, ‘this is not considered such a crime.’ Business, he believes, is returning to more conservative balance sheet indicators. ‘People are coming to understand that while leverage has some benefits, for instance tax-wise, it also endangers a company when economic conditions change as drastically as they have in the last six months.’

ABB’s luck did not end with the strong margins that allowed it to build-up its solid reserve. It recently began a twoyear, $2 billion share buyback and doubled its dividend. Some $650 million was repaid along with a $1 billion dividend. Demaré says he neither regrets this liquidity reduction nor believes ABB has given back any acquisition buying power.

‘The buyback was part of a commitment to our shareholders from when we were in bad shape and had to make rights issues that were very risky for investors.’ Many of them had stuck with the company and it was time that they saw a payback. The $1.6 billion was half of the year’s profits and so the buyback did not involve any leveraging.

‘The strategy was that if the economy continued improving then we would progressively re-leverage the company through a combination of acquisitions and sending some money back to the shareholders. Obviously that was a very conservative and prudent approach, which I certainly do not regret today,’ he says.

Further share purchases will have to wait until more liquidity flows back in the financial system, but Demaré believes investors understand this. Even for a modern CFO, Demaré is considered unusually assiduous in his attention to investor relations. But has it paid dividends in the downturn?

‘Yes and no,’ he says. ‘Yes in the sense that we have rebuilt credibility and trust with analysts and investors by being transparent, explaining not just our growth targets but how we are going to reach them and being open about those challenges. On the other hand, after a few good years, everyone has turned bearish on the capital goods sector, saying it is over-valued. When that happens, investors and analysts basically throw everything out the window; the good with the bad. We were rejected like everyone else but I also trust that, because our credibility is still there, when the sector again turns bullish, we will be recognised for our confident management.’

For Demaré, part of that confidence comes from a continuing attack on fixed costs, such as a programme to cut a further $1 billion of costs, announced just before Christmas. ‘We are working on our production engineering and logistic costs, and our administrative efficiency,’ he notes. ‘But we are not making cuts in our technology investments or selling efforts. We need to continue being optimistic and invest for growth, notably in China and India but also North America, the Middle East and even South America. ‘While it is important that we adjust our cost structure, we don’t want to cut too much and find ourselves short of resources for when the markets recover. We are quite hopeful in our business because of all the incentive programmes that governments are coming up with to try to boost their economies. A lot of these are in infrastructure. I think, in the medium term, we have quite a rosy future. The short-term priority is to adjust the cost structure of the crisis but at the same time keep investing in the regions where there is the most potential.’

Fine balance

ABB’s healthy net cash position has partly come about because of its strong margins, hitting 16% in the second quarter of 2008. Demaré explains that recent market conditions enabled ABB to focus on pricing and drive more value from its products and services. Cutting the internal cost base has, in part, involved moving manufacturing and engineering as well as materials sourcing to lower-cost countries. Internal productivity is also being enhanced by simplified business processes and a standardised ERP structure, through an ambitious project named ‘One Simple ABB’.

‘We have also worked a lot on risk management,’ Demaré adds. ‘Half our business handles projects where, if we don’t manage the risk the right way, it can really turn sour. We have made a lot of improvements through hard work and risk reviews, meaning we have a much more robust project portfolio, resulting in better margins.’

The right choice

ABB is no longer driven by just the top line, one of the mistakes that steered it into trouble. Demaré believes merely booking as many projects as possible and hoping to make money from them destroys value. ‘If you look at a new business and it does not appear good at the time you assess it, it is unlikely it is going to get any better later,’ he says.

For ABB, being able to walk away from a project because of poor margins, or because the business conditions were wrong, or that it did not look like it could match customer expectations was important. But in a downturn, should businesses be prepared to sacrifice margins to keep market share and the company turning over?

‘There is always a fine line between margins and market share,’ says Demaré. ‘There are some markets that are growing so fast that you want to keep a solid market share, because by doing so you will create enough critical mass to allow you to deliver good profits. And then you need to work hard on your cost and sourcing base. However, always going for the top line is not good enough. You have to be selective in how you do this and have a different strategy for each of the markets.’

China, ABB’s biggest market, and India were entered in the days when management was top line-driven, but Demaré notes that far from generating margin pressure, they are actually among the company’s top performers. ‘We are fighting in these markets, with a focus more on technology than on price, especially in China. We try to offer greater innovation and a higher level of technical sophistication compared to those offered by local businesses. And obviously we try to get paid for that as well. So it is not penetration at any cost.’

The Middle East, he says, is more price sensitive, but because of the size of the projects, ABB can be a bit more aggressive. ‘You can build critical mass and if you have the right cost structure you can earn a decent living.’ North America, however, is where ABB remains under-represented, accounting for only 11% of the order book. But with major infrastructure programmes due as part of the the Obama recovery plan, along with electricity grid upgrades and renewable energy programmes driven by the US Energy Act, Demaré believes it is definitely a growth market.

Rating the raters

Demaré compares the long hours spent with ratings agency analysts as ABB worked its way back to an investor-grade assessment with the few days it took to give AAA ratings to sub-prime derivatives. ‘You wonder if the rules have been the same for corporate entities and derivative packages,’ he says, ‘I have lost faith in the ability of ratings agencies to really highlight the risks embedded in derivative solutions.’

While he admits the agencies do an in-depth job on corporate risk, he sees room for improvement. ‘They need to be more agile, more swifter,’ he says. ‘The rating process is slow and bureaucratic. Outside the assessment cycle it reacts only to events such as acquisitions or large losses. The ratings agencies need to be more dynamic, and anticipate changes in trends.’

Demaré muses that agencies should not be in the business of rating derivatives at all. ‘They should explain the difference between how they assess derivatives and what they do for companies.’ ABB has had four recent upgrades and holds an A- from Standard & Poor and A3 from Moody.

Cottoning on to the blessings of SOX

While Demaré applauds the internal rigour SOX has brought to ABB, he deplores the the high financial cost of compliance. Over two and a half years, ABB spent $80 million on the exercise. ‘More than half of that money was spent internally and was clearly a worthwhile investment in the construction of a robust internal control process,’ he says. ‘The other part that we had to pay to the auditors and consultants to help us with the process was a cost I would happily have avoided paying.’

Last summer, before the financial meltdown, US legislators were considering easing some of the obligations imposed on companies to comply with SOX legislation. In one respect Demaré agrees.

‘Trying to achieve a more robust control environment with SOX is good,’ he says. ‘But if you have to pay millions to consultants to help you follow the process that the legislator has put together – and in fact it was not so much the legislator, more the big four consultants that built the whole process – that is a heavy burden. It requires a lot of detail that cannot be applied universally to companies in different industries.

‘In my view, it would be more important to emphasise what we try to achieve with SOX compliance and the way it is achieved, because it can be very different from one company to another. From that perspective, I would favour lightening the process and just focusing on what needs to be achieved. That is clearly something that would help a lot and make people feel less negative toward SOX compliance.’