Ladies and gentlemen, good afternoon. Welcome to the ABB First Quarter 2012 Results Analyst and Investor Conference Call. I'm Stephanie, the call's operator. I would like to remind you that all participants will be listening on remote and the conference is being recorded. After the presentation, there will be a Q&A session. You can register for questions at any time by pressing star and one on your telephone. Should you need assistance, please press star and zero to call an operator. At this time, it's my pleasure to turn over to Mr. Joe Hogan , CEO of ABB, and Mr. Michel Demaré, CFO of ABB. Please go ahead, gentlemen.
Good afternoon and thanks for joining us to discuss our first quarter 2012 results. As always, my comments in this call refer to the presentation available on our website at abb.com. Please refer to chart two for our safe harbor statement covering any forward-looking statements we may make today. Let me start with a summary of our first quarter performance on chart three. The first highlight in the quarter is the strong performance we showed on the top line, despite the tougher market environment compared with a very strong Q1 a year ago. Orders are steady, up slightly in local currencies and flat year-on-year, excluding the Baldor acquisition, while revenues are 8% higher, up 6% on an organic basis. The Americas showed strong growth, especially North America, which helps us offset weaker demand in China and Southern Europe.
I'll come back to the regional picture in more detail in a moment. We've been working hard to grow the services business, and this quarter we saw some results as services outgrew the group on orders and revenues. As we guided after Q4, we saw continued price and mix pressures on operational earnings. We could mitigate some of these through the cost savings and positive volume effects, but with increases in selling and R&D investments this quarter, we saw a decline in operational EBITDA and margin. Cash flows were lower as we saw a seasonal increase in net working capital in the divisions, as well as some higher cash outflows from the corporate in areas such as hedging and pensions. Net income was higher than a year ago.
Last but not least, our recent bond issues were very well received in the market and we were able to secure long-term financing at attractive rates, which gives us additional financial flexibility going forward while maintaining our balance sheet at a solid A credit rating. Chart four gives you an overview of the key figures for the first quarter. Revenues were higher in local currencies and organically, supported by execution of the order backlog, which reached a new record of almost $30 billion. Our cost savings program generated savings of $260 million this quarter, and you'll see in the later chart this again more than offset the pricing pressure. Baldor continues its very strong performance and contributed more than $500 million of revenues this quarter and delivered operational EBITDA of more than $100 million. Moving to chart five, where you'll see an overview of results by division.
PAL Products turned in a good revenue performance with growth in all businesses. Discrete automation saw great growth, both including Baldor, but also organically with sales up 15% excluding Baldor. In addition, DM's operational EBITDA margin improved compared to Q4. The year-on-year margin decline is mainly a reflection of higher levels of investments and growth initiatives and mix weaknesses versus some quarter last year when demand was strong for higher margin products like low voltage drives. Nevertheless, it was an excellent quarter for DM, and the outlook for the rest of the year in this business remains very positive. Low voltage products also reported higher revenues, mainly due to the execution of the increasing level of systems projects in the order backlog. This also impacted LP's operational EBITDA margin, and I'll come back to that in more detail shortly.
Price pressure in PAL Products remained where it was in Q4 at about 4%- 5% on orders and 5%- 7% on revenues. It will take several more quarters to work our way through these declines. In the meantime, we continue to push hard on cost and productivity savings, as well as launching new products that open growth opportunities at margins that support our longer-term targets. As for PAL Systems, revenues were more or less stable versus a year ago, which is mainly a reflection of the mix of projects and the timing of their execution. As you know, this tends to be a very lumpy business on both the top and the bottom line, and we saw that again in division's Q1 operational EBITDA.
Let me take this opportunity to comment briefly on the many questions we received recently around the risk in the offshore wind business, which we serve from our PS division. As we said at Q4, this is a new field with new technologies and therefore an inherently higher level of risk. You can expect to see charges and provisions both up and down as we work our way through these large and complex orders. As of today, we haven't seen any material changes. Our expectation is that PAL Systems will come back to more typical longer-term margin levels as we progress through 2012. Finally, process automation continued to deliver steady revenue growth and profitability. This business has done a great job in refocusing its services offering, expanding its product portfolio, and executing well on project and risk management.
Its resilient end markets in areas like oil and gas and mining have also contributed to the overall stability of results. The outlook in these sectors for the rest of the year looks positive. In chart six, let's take a look at some regional developments. As you might expect, order growth was strongest in the Americas, led by North America, where we're seeing good economic growth. Even excluding Baldor, we saw local currency growth above 20% in the Americas, thanks mainly to continuing strength in the power businesses. Orders were lower in Europe, but here we see a clear two-track development between Northern and Southern Europe. I'll come back to that on the next slide. The Middle East was up slightly in the quarter as we took some new substation orders. As you know, we've been very selective in this large market in the face of strong price pressure.
Today, we're seeing stabilizing prices and even some increases, and that allows us to go after new business at acceptable margins. Asia orders were down 11% in a quarter because of lower orders in China. As you may recall, last year in the first quarter, we won some large transformer orders in China, in addition to recording strong order increases in most of our divisions. The comparison was always going to be a tough one. However, demand in key markets like construction and rail transportation remains low, and we see that in both the top and bottom lines. Let's drill down a little further on order growth geographically with chart seven. Here you can see the orders development in our largest country markets.
I just talked about China, where orders were down in both power divisions as well as low voltage products, but were higher in discrete automation and process automation. We'll do a deep dive on China in a moment. India improved mainly on strong growth in power. Americas did very well this quarter on all fronts, in line with the solid economic growth in the region. I also mentioned the Middle East improvements, and that's largely the result of substation orders in Saudi Arabia, which has become a key market for us with revenues in 2011 of more than $1 billion. As in Q4, Europe showed a mixed picture. Germany, Sweden, and the UK, for example, also decent growth in the first quarter, while our largest Mediterranean market, Italy, was again down strong double digits.
A recovery in demand in Italy will obviously depend on the improvement in the overall confidence in the weaker eurozone countries. In the meantime, we are making cost adjustments to mitigate these weaknesses and reduce the negative impact on margins going forward. Let's take a closer look at China on chart eight. As we saw in Q4, weak demand in China had some impacts on operational profits again in Q1. In fact, more than half of the total gap in operational EBITDA for ABB compared to Q1 last year comes from China. The bar charts show you some of the main reasons for this development. Demand in the construction sector, for example, was at a near historic peak at the beginning of 2011, but fell off sharply over the rest of the year.
Since some 10% of LP's revenues are related to the Chinese construction sector and high margin products like crankers and switches, this downturn had a significant impact. It is a similar picture in rail, where China is the largest market for our MV business. While some positive trend lines appear to be developing in these sectors, we are taking a cautious approach with short-term mitigation around cost savings and footprint adjustments, while at the same time accelerating the development of localized products for China that will allow us to increase revenues at more attractive margins. Turning to chart nine, here you can see the mix impact we are talking about in low voltage products. This has both a business and a geographical component.
The business mix is related to the share of revenues coming from the low voltage systems unit, which typically carries a significantly lower operational EBITDA margin than the other businesses. That share is up by 5 percentage points compared to a year ago. On the right side, you will see the geographic mix impact and how the share of revenues has declined in countries where margins are typically higher, either because of the type of products sold in the market or because of the pricing levels in these countries. We have flagged Italy and China, which are two large markets with typically higher margins for LP. Both saw significant revenue declines in LP this quarter. These two countries together normally comprised about 30% of LP's revenues, and you can see how they are now below 25%.
This development highlights the importance of our planned acquisition of T&B, the U.S. low voltage T&B will diversify our geographic scope and LP provide a natural hedge against the local fluctuations that are typical in this business. It will bring us new products to expand our low voltage portfolio both in North America, but also in the rest of the world. We remain on schedule to complete the acquisition in the second quarter, and we're looking forward to growing our portfolio in this key area. Let's turn to chart 10 and our quarterly operational EBITDA bridge. Working from left to right, you can see first of all that we have continued to see price pressure in the P&L, mainly the result of delivering lower priced products and projects out of the order backlog.
That had a negative impact of $250 million or just under 3% of revenues, which is a sequential improvement compared to the fourth quarter. This is mainly in the power division. We could offset this, however, through volume effects as we increased revenues and saw improved absorption of our fixed costs. Project margins were slightly negative this quarter, but we again saw strong execution on the cost and total savings of about $260 million. Growth in investments around sales and R&D were higher this quarter. These are at relatively low levels a year ago and started to ramp up more in the second quarter of 2011. We have the product and geographic mix effects I described in China and in LP. Finally, we have the other category, which is a mix of mainly currency translation effects, changes in G&A costs, and raw material costs.
Overall, we continue to more than offset pricing pressure through cost savings while maintaining our investments in future growth. Turning to chart 11, as I just explained, we again were able to take out significant costs in the first quarter, mainly through sourcing and productivity improvements. The power divisions have taken the most aggressive measures to mitigate the price and capacity issues they've been facing, but the automation divisions have also been successful. Savings in indirect sourcing, such as travel and contracted services, have also contributed some $26 million to the bottom line. As those of you who have followed us for some time now know, our Q1 is historically a weak quarter when it comes to cash flow, and I'm moving to chart 12, especially when we are growing revenues and ramping up working capital on our project businesses.
On chart 12, you can see a similar trend, and at the divisional level, we are actually $100 million lower versus Q1 last year as net working capital reached almost 16% of revenues. We have measures in place to improve our networking capital performance, and we see this trend normalizing over the year as we return to the 11%- 14% range that we've guided to over the long term. Additionally, this quarter we saw higher cash flows out of the corporate line in the form of cash payments related to hedging, as well as pension contributions. Chart 13 gives you a quick summary of our balance sheet at the end of Q1. We are still in a net cash position with growth gearing at a comfortable 26%.
We received an enthusiastic reception from the market to our bond issue this quarter, which allowed us to secure additional long-term funding at relatively low rates. We also put a $4 billion bridge loan in place to take us T&B transaction and to pay our normal dividend. The success of our bond activities means that we're able to reduce our commitments under this facility down to about $2 billion at the end of this month. Before wrapping up, I'd like to highlight a couple of other developments in the quarter. Chart 14 shows the growth in our services business in the quarter. As I mentioned at the beginning, we executed well on our service strategy, and we're seeing some early wins.
Services outgrew group orders and revenues with particularly strong growth in lifecycle services, which is the recurring maintenance and spare parts type of service that comes in above average margins. Here you can also see the impact of our refocusing efforts in full service to reduce the volume of projects in sectors with limited value added or margin from the total ABB perspective. That is all reflected in a decline in the service orders and process automation in the quarter. Everywhere else, we saw very good growth in both service orders and revenues.
We've also seen excellent progress with the special initiatives we've launched last year in a number of pilot countries, and we have rolled that out now into a larger group to capture this huge opportunity. There are some encouraging signs in this business, which is key to achieving our growth objectives, as well as bringing greater stability and reliability to earnings. On chart 15, I'd like to highlight our efforts in new product development. I've just picked two out of a dozen of new products launched in the first quarter to illustrate how our investments in R&D are helping us on both growth and cost. For example, if you visit the Hanover Trade Fair this week, you'll see our new GIS product that is 33% smaller than its predecessor, more energy efficient, and environmentally safer.
That not only opens up new growth opportunity in terms of meeting customers' needs, but also means we can tap our competitive advantages in design and economies of scale to produce this equipment more cost effectively. Our DM division has launched a new version of the synchronous reluctance motor, introduced at the Hanover Fair last year. This year, we have taken the development further to sell a complete high output package, including a drive and controlling software that gives customers the same performance in a much more compact size. That means, for example, lower costs for our OEM customers who are bundling our equipment into their products, as well as more cost-effective manufacturing for us. As I said at Capital Markets Day last year, managing for both cost and growth will be one of the main challenges going forward. R&D will be a key lever for achieving that balance.
Let me conclude on chart 15 with a recap of Q1 and our outlook for the rest of 2012. Again, we saw good top line growth in a challenging market environment, and especially considering a tough comparison to a great Q1 a year ago. Our market-leading technologies, broad geographical scope, and record order backlog all contributed to that performance. Discrete automation in motion and process automation performed well on operational EBITDA, while pricing pressure and power and cyclical mix issues in low voltage products continue to dampen margins as expected. We're taking measures to mitigate these impacts, whether it's through cost savings, new product development, or in strategic acquisitions like T & B in U.S. I just mentioned, we continue to work from one of the strongest balance sheets in the industry, which gives us confidence to build the business even during uncertain times.
On the outlook, not much has changed compared to what we told you at the end of Q4. A long-term view remains very attractive across the portfolio around the themes of industrial efficiency and productivity, energy savings, and grid improvements in all regions. In the short term, we still have a mixed European market with relatively resilient economic developments in Northern Europe, offset by weaknesses in the Mediterranean region. North America continues to look positive on both the power and the automation front, while China remains an open question as far as the timing of new investments in key sectors for ABB like construction.
For the rest of the year, we expect revenues in our early cycle businesses to remain near 2011 levels or to grow at low single-digit rates, while our mid to late cycle businesses will continue to grow as we've seen in recent quarters. We will continue to see price pressure in the P&L as we work through our backlog and as long as the mix issues we've seen in the past couple of quarters persist. Having said that, we also believe there are plenty of growth opportunities to support both revenues and operational earnings and margins over the rest of the year. We can, with confidence, confirm our growth and profitability targets. That concludes my formal remarks. I'd like to thank you for your attention and turn over any questions to Michel and me. Thank you.
We will now begin the question and answer session. Anyone who wishes to ask a question may press star and one on the touch tone telephone. You will return to confirm you have entered the queue. If you wish to remove yourself from the question queue, you may press star, then two. Participants are requested to use only hands at school asking a question. Anyone who has a question may press star and one at this time. First question from Daniela Costa from Goldman Sachs. Please go ahead.
Good afternoon, everyone. I have a few questions. The first one would be, can you just update us where are you on your CROI targets? So it's the return on capital. What gives you, what's the trend for this year and what gives you confidence that the target in 2015 is still achievable? The second question, when I look at the bridge this quarter versus last quarter and what you've said, it looks like the mix and the pricing impacts and cost savings were pretty much in line with what you had guided for. It looks like this other portion is the bigger differential versus at least what consensus had. What is the visibility there in terms of not having or having these costs as you go forward in the year? If you can, how much each of the FX, commodity, G&A, how much each portion is?
Finally, on cost savings, seem to be compensating for pricing. If negative mix persists, given the uncertainty around China, would you be able to step up the cost savings to compensate for that? Thank you very much.
Okay. Good. Starting with your first question on the cash return on invested capital, from the moment of view, we are far away from the 20% target that we have set, but I had also said that this is a target that we aim to reach when we have kind of absorbed the initial cost of making an acquisition. For the moment, the combination of digesting the Baldor acquisition and some of the others, plus the fact that it's a low margin quarter as we are used to in Q1, makes that our cash return on invested capital is close to 12% at this stage. We're still confident, you know, that we can work on these investments in time and get back to the kind of margin, to the kind of returns that we have had before because we were always above 20% before starting the acquisitions.
As you know, we have done a few good ones. I'm still quite confident there that by 2015, this can turn around. Here for the moment, we take the dual effect of taking the full capital charge for Baldor plus the fact that the overall level of margin is not that high. When we come down to the bridge, no, I would not say that order is the one that we had not foreseen. If you look into this order, it is clear that this quarter forex translation has been a bigger component than usual. If you look at the way the U.S. dollar has fluctuated versus other currency compared to the first quarter last year, we've seen a huge volatility. The U.S. dollar, for instance, has strengthened 11% against the Indian rupee, 6% against the Brazilian currency, about 4% against the euro.
On the other side, it has devalued against the Chinese currency. It has devalued against the Swiss francs. It was a little bit all over the board. It is clear that the forex revaluation of some of our costs that we read in India and Brazil, but also, for instance, the impact of the decline in profitability in China has been exacerbated by this currency impact. If you ask what surprised us compared to the guidance that you gave us, I would rather point out the weakness of the medium voltage business in China, for instance, and the fact that the low voltage business in China was even weaker than we had anticipated. Don't forget that most of the heads up we gave you was by analyzing our backlog. Medium voltage and low voltage are not backlog products. These are book-to-bill products that hit you right away.
Cost savings, Michel.
I can handle that. You asked about Daniela, about, you know, the moves aspect and how that will be compensated. I mean, obviously, we'll try to drive the cost aspect as hard as we can. We still, this mix piece, particularly within the low voltage business, will take actually more cost focus in that area. We can't respond, you know, right in accordance with what we've seen in the marketplace. Overall, we'll fight mix specifically in low voltage products, I think, for the rest of the year.
Okay. Thank you. Just one follow-up on your chat on the point in China. Just a few competitors have said they expected better second half in Asia. Why are you not confident at the moment to give similar statements? Is it because of your end market specifically?
Yeah. I think it's a different segmentation. I think we could say that about most of the industrial segments. The question that remains more is how long will it take before China lets the real estate market develop again? You know, they are really trying to contain the bubble at this stage. That is a specific one. I would say the same for the rail market, you know, rail transportation market where clearly there's a little bit of change of strategy. That one is more question marks to see how long it takes to come back. While the plain industrial activity, we expect, based on the Chinese official forecast of GDP at 8.5%, we expect indeed that that one will recover pretty fast.
Thank you very much.
Next question from Mr. Ben Uglow from Morgan Stanley. Please go ahead.
Afternoon.
Hey, Ben.
I had a couple of questions. One was just in terms of the cost savings. I see that the cost savings continue to be primarily from sourcing and operational excellence. What I was wondering was when you look at the landscape for 2012 and you look at the operating conditions, what sort of conditions would be necessary for you to entertain a proper adjustment in industrial footprint? Are we getting to the point where you need to focus more on your sort of existing capacity, or are you comfortable that you can continue to offset price with, you know, with sourcing and operational excellence? That was question number one. Question number two is a much more general one about the capacity situation in transformers.
It's very difficult for us to get any meaningful data really on this or even to understand what is happening to supply and demand in the industry. What I would say is when I look at the investments being made by Mitsubishi, by Hyundai Heavy, and also SPX, what's clear to me is that whilst demand is going up, so is supply. Are you, you know, either Michel or Joe, able to give me just a rough idea of what is happening to capacity in your factories? Is capacity utilization improving at all, or are we actually seeing just a low level of utilization continue to impact price?
You know, Ben, first on the cost savings side, and Michel, I can join in where you want to, sourcing versus OpEx. I think you have to understand that a lot of our footprint changes, we make continuously. We don't do large announcements in the sense because we've explained before how you work through unions, particularly in the European area. I could say what we constantly do and we do this year is adjust our footprint. Our biggest footprint adjustments have been in PP over the years. Underneath this, what you don't see is a lot of movement at times where we won't close the factory specifically down, but we'll move a lot of that production capacity from one region to another, with a certain amount of layoffs, obviously, in the old exporting region.
It wouldn't be necessarily an entire plant shutdown because we try to keep that capacity allocated to that local region. That would come off, honestly, not necessarily as a footprint, that would come off as OpEx from a productivity standpoint overall in those figures. There are some gray areas between those numbers that aren't as clear in the sense of what is footprint and what OpEx.
Yeah. I think as well, when we take footprint decisions, it takes much more time for these savings to start hitting the income statement too because it's a long process. You always try to optimize as much as you can. For instance, we have reduced some capacity in China, but we have not closed the factory. We have transformed it into a service workshop. In a way, you're not taking as much cost out, but you create a new opportunity to generate different types of revenues, more resilience, and more stable margins. That's why you don't always see these numbers coming very clearly out of the statistics that we publish here. It takes a little bit more time to come in, but there are some programs. We have made some closures. I think it's moving in the right direction and always ready to do more if needed.
Okay, thank you.
It's a big labor piece on that side. Remember, these facilities aren't real expensive facilities that we shut down at times, too. It's not like a chemical facility or anything like that. They're operating bases of $50 million- $90 million or so. On the transformer capacity piece, I share your frustration because when you try to get any kind of industry understanding of that, you get stuck because it's not real clear. You get stuck between what's a large power transformer to medium power transformer and how that works. I can tell you that our capacity utilization rates have improved or at least stabilized. What we do often is when you see a job like Northeast Agro that comes through, there's a number of high voltage, large transformers that are HVDC in that sense.
They'll take up a significant amount of capacity in Sweden and different parts of the world where we'll make those things. We have a kind of a different mix at times within those facilities based on how we pull these jobs geographically and then some of the uniqueness that we offer out there through our systems business because of HVDC in those areas. I would say right now what's affected the marketplace are a couple of things. One is the legislation in the U.S. with a dumping suit recently that's affected the Koreans pretty dramatically in the U.S. We've seen prices certainly stabilize there. That whole suit's moving on to Canada now. That changes the market to a certain extent.
Social, but they're still insignificant over capacity all day. That is quite clear. I think all the investment that you mentioned in the U.S., I think a lot of the pre-marketing of these factories has already been done. The worst in terms of price push has probably come through. I think that if medium voltage had held steady like it used to do in the past, we would have been able to show a better profile of our product portfolio this time than we were in the past. It is really the medium voltage now that offsets the slight improvement that we've seen in our transmission offering.
Okay. That's very helpful. Thank you.
Yeah, Ben.
Next question from Mr. Andreas Willi , JPMorgan . Please go ahead.
Good afternoon, gentlemen. My questions are the following. On China, where you have the pressure in some areas in terms of medium voltage rail construction link businesses, what have you seen in pricing in these markets, given I assume many of your competitors have a similar situation of having built up capacity over the last few years that's now materially underutilized? Have prices remained stable, or are you seeing price pressure in some of these products in China? The second question on your comment about kind of flattish early cycle, but still kind of better mid-later cycle business, would you normally expect the mid-later cycle business to show weakness six months after as some of the effects we're seeing now on the earlier cyclical businesses kind of when they spread further out in the economy?
Do you think the kind of the mid-late cycle business can pull through this dip we are seeing currently that's coming from the weaker economy? Thank you.
Andreas, on the China pricing, what I would say is, you know, we haven't seen material pricing differences in the upper-end markets that we participate with, like the breaker side of LP. It's just you've seen a collapse in the construction marketplace. It's been primarily a slowdown in demand, and that hasn't, from what we've seen so far, created a frenzy as far as pricing around those areas. I think we probably will see a little more pressure in that area, but that's fundamentally not the issue. The fundamental issue right now is just when does that construction market come back and at what level will it come back? On the medium voltage switchgear piece that Michel talked about with transportation, I'd say in that specific segment, it's not about competition. It's about the change in specifications.
The lower the speed of the trains moves it from gas-insulated switchgear to air-insulated switchgear. When you go to air-insulated switchgear, there's a lot more competition in that realm. Essentially, the rail market in China has been shut down for almost a year. We see it in traction transformers. We see it in medium voltage switchgear in those areas, and that's going to have to be revived in China as part of the political process. We'll see where it goes in that sense. In the meantime, I wouldn't say that market has materially changed in the sense of the competition piece, but certainly, we've seen some specification changes and there's a very weak demand pattern now out of China rail. The rest of the market in China, I'd tell you, there's no material difference than what we've seen before.
On the large power transformers, process automation, often in discrete automation in motion is actually pretty strong.
The robotics business is still doing well in China.
It is still doing well, yeah.
Very well in China.
Yeah, yeah, and that's good.
Thank you.
That gets a little bit to your second question about early cycle, later cycle. For sure, for the moment, we see our mid to late cycle still getting quite robust. Even power product from a top line perspective has now a few quarters of improving orders all the time. We see it even in transmission. Very soon, revenues in transmission will even turn positive as we look at the backlog. The process automation business, in segments like oil and gas, minerals, marine, is really still enjoying very good demand. In fact, discrete automation, which is not that further away on the cycle than low voltage products, is really showing a lot of robustness, including robotics, and not only in China. The business is really doing very well. Very strong demand in motors and generators too.
For the moment, it really looks like it is focused on this very short cycle and this very segmentation of construction, transport, and a couple of others like nuclear. Our feeling here is that it's not going to pull down the rest of the cycle. We may rather be a bit more optimistic and think that sooner or later this short cycle will correct the excesses that we have seen in the last two quarters.
You know, Andreas, if you took, I'd say the same thing, Michel. He took a market look, and I'd give you a geographic look and come up with the same answer. You say, what's going on in China is the Chinese had to attack the construction segment to obviously address the inflation piece. Our industrial markets there are very strong, and that longer cycle piece that's associated with industrial hangs in there. Move to the United States, we haven't seen an apparition in the sense of the growth of that marketplace. Short cycle and long cycle blend into the way you do a normal economic curve. I think in Southern Europe, we can say, yeah, we're worried about how that short cycle thing will work and also how the mid and long cycle comes in behind that. In Northern Europe, it's followed the cycle pretty much.
If you look at it geographically or by market, you can kind of pick this thing apart and see where the pressure is.
Thank you very much.
Next question from Mr. Fredric Stahl from UBS. Please go ahead.
Yeah, good afternoon, gentlemen. It's Frederic here at UBS. I had a question on discrete automation in motion. I noticed that your European business is doing very well in the quarter and double-digit order growth. I was wondering if you could provide some more color there, if you had any unusual order wins in the quarter, if we should expect good momentum in the coming quarters as well. That's the first question. The second question would be the tax rate. Should we expect it to creep up over the coming quarters as North America, which is a higher tax market, grows faster? You add T&B as well to your business.
Okay. On the first question on DM. In fact, the northern part of Europe has been an excellent market for DM and especially strong in terms of drives, motors, and generation. The southern market was not as bad as it was in low voltage products. That's why overall we have really seen a very good development of orders from that perspective. In terms of the tax rate, 29.5% is a bit high, but if you look in the past, in fact, the first quarter has always been a little bit higher. We're still guiding at this stage for a tax rate of 27%. I think even with Baldor, we believe that we can go there with good tax planning initiatives. We still have to reassess the situation once T&B is on board. We'll guide you more later on.
In the current state of affairs with the current portfolio, we stick to our guidance of 27%.
Thank you very much.
Next question from Mr. Mark Troman, Bank of America Merrill Lynch. Please go ahead.
Yeah, thank you. Hi, Joe. Hi, Michel. It's Mark from Merrills. Just a quick one on pricing. I guess we've talked a little bit about medium voltage, low voltage. Just on the power transformer side, you know, you talked briefly about, I guess, the anti-price dumping situation in the U.S. and the Koreans. Can you just provide a bit of color in the major hotspots? What's going on with power transformer pricing? Europe, the Middle East, China, you know, where is it getting worse, getting better, changing? Just the dynamics around that, please. Secondly, just so I understand this, in the bridge that you put on the presentation, how do you differ between price and mix? Is mix between products and services, or is it the reported divisions? You know, so if medium voltage is weaker, does that go into the price number, or does it go into the mix?
Thanks very much.
progressing relative to your expectations?
You want to hit the bridge, Michel, and hit the power transformers?
You hit the power transformers. Okay. No, listen, the bridge, indeed, if it is the same product that is sold cheaper, then it is a pricing impact. If, for instance, you have what we have now in China, where suddenly the market for medium voltage appliances has kind of come down, and we have to replace it by more basic switchgears, that is really a mix difference. If you look at low voltage, for instance, where most of our product sales are down, but our revenues from low voltage systems are up 46%, that is also a mix impact. This is not a pricing impact. It is basically a shift of revenues coming from a different nature of offerings.
Okay, thank you.
Okay.
On power transformers, Mark, I just go like this: United States, North America, better. Northern Europe, same. Middle East, pretty much the same. China, no material difference.
Okay. Brilliant. Thank you very much.
Next question from Mr. Martin Prozesky, Bernstein. Please go ahead.
Good afternoon, everyone. It's Martin from Bernstein. I want to dig a bit into the low voltage products unit. You've given us here a good explanation on the declines in China and Italy. Can you just give us an example of what solutions in this business look like and where the market, what solutions look like in low voltage products? Is it a lot of subcontracting margin in there that dilutes the margin? Why is the mix effect so large? The services you pointed out grew quite nicely. What exactly is services in low voltage products? Can you just give us a bit more color there, please?
Okay.
On the low voltage, we call them not solutions. We call it systems. I think it's a better way to kind of narrow it down.
Yeah, I don't know if you use Schneider.
Yeah. I think, yeah, Schneider has a different kind of place. Think about almost like panel building, you know, Martin, in the sense that you bring together breakers and switches and DIN rail connectors and those kinds of things. You actually use manual labor to put those things together into an overall system. These systems are often sometimes geared toward like a data center marketplace. They could be geared toward oil and gas. They can go in the middle of mining. All those have different specifications. ANSI is different than NEMA is different than IEC. We're set up to do that. In different parts of the world, systems become more important. When you're in Southeast Asia, a lot of our business for low voltage has been in systems for years because we've had different distribution channels and you needed to go to OEMs. OEMs don't necessarily buy parts.
They buy total systems in that sense, and we put those systems together. We like this business because it gives us access to markets and customers that we hadn't had before. We wouldn't have without that business. It pulls through a lot of high-margin product like breakers and DIN rails and controls. The labor component to it and the time component associated with it by nature just makes it a lower margin product than what the products themselves would be. I would say that, you know, Martin, this is old information. This would be 2010 and 2011 information. At the top of my head, I think the largest OEM segment for low voltage systems is oil and gas. Yeah, when you go around the world.
I think it's still the case.
Yeah, does that help?
Thanks. Yeah, it does. On T&B, is that more of a product business as a whole? It should help the margin.
Yes.
Going forward, it's primarily a products business.
Yeah, it's a planned product and distribution business.
Thank you.
Next question from Mr. Martin Wilkie, Deutsche Bank. Please go ahead.
Hi, good afternoon, Mr. Martin at Deutsche Bank. A couple of questions. Firstly, on power systems, you mentioned that the margin was hit very slightly because of the execution of lower margins and the backlog. I think you also said that you're confident that's going to rise as the year progresses. Given the numbers and what's happening at one of your big competitors in that business and their numbers today, I think there's still a general question out there about how much risk contractors are being asked to be taken on to build some of these large power contracts. I wonder if you could just generally comment about the environment for orders. Are you being asked to take on more risk? In the medium term, is that something that you're worried about, or do you think that it's something that is under control?
The second question was, just going back to low voltage and the Italian number, which I think you say is down 24%. If you could just talk a little bit about your exposure in Italy, is that primarily the buildings and construction market or primarily industrial? Thank you.
Okay. On the power system, I want to be very clear on this too because the margin is a bit disappointing this quarter in power system, but it has nothing to do with these large projects. Actually, just to make sure it's clear to everyone, we have taken on this project this quarter a charge of $20 million. You see, it's not very relevant or material for the whole group. I think these are obviously risky projects. I would think the risk profile in a way improves as we keep learning. We started first with these offshore wind connections. We lost quite a lot on the first projects last year. We are getting already much better at this one.
I think that each time we and our competitor really understand the risk involved, I believe we'll also finally come with a proposal and strive that reflects the risk that we are taking. In a way, I would say the risk profile is a bit better managed than it was before. I'm not saying there's no risk left now. There's still a very high risk into that. We will never tell you nothing will ever happen. I think we are getting a better grip at it and that we should see it's a huge market out there for the future too. We need to get better at it as well. Just to finish on that, the major deterioration of power systems this quarter is really more operational. It is really the backlog in substations. From there, indeed, from what we see in the backlog, we expect an improvement next quarter.
On Italy, I don't know the specific numbers and the IR team could dig down for you, but I think a lot of this has to do with industrial more than building. A lot of OEMs that we service there would be exporting machinery and those kinds of things that the products go through.
That's true.
Okay. Thank you.
Next question from Mr. William Mackie, Berenberg Bank. Please go ahead.
Hi. Good afternoon, guys. It's Will Mackie. A couple of quick, just staying with power systems, can you maybe run through what measures or contingencies you may have taken in the risk committees when you assess the prospects on your two offshore contracts with TenneT or in the German region? You mentioned, I think, today that there is a prospect of charges. Really, what sort of contingencies or risk you see given the evolving situation? Also, within power systems, I see that the order intake in Europe dropped somewhat. How do you feel about the tender outlook or the tender backlog within Europe? I noticed you've been quite promotional in the press in Germany to accelerate perhaps some order intake in that segment. Just sticking with Italy again, actually, you talked about 26% down in Italy and 24% in low voltage.
What's it like with regards to the power businesses in Italy in terms of the decline in order intake in Q1? Thank you.
You want to do the contingency piece, Michel?
I don't think that we have indicated that we would consider taking any additional charge. I just say, you know, we live with a certain risky business. From time to time, you have to adjust your margin expectation, but we are not making any specific charge other than the $20 million that I just mentioned, which is a slippage that can happen because of some technical difficulties. At this stage, as I say, we are just learning our lessons, adjusting our risk profile, making partnerships with experts, for instance, to build these gigantic platforms in the middle of the North Sea. We have now found better partners that can really help out. We have reduced the risk with the ship, also making a chartering agreement with a cable-laying ship. You try to vertically integrate a little bit through partnership to try to reduce the execution risk.
It's not about just asking more guarantees from the customer. We know it's a tough game there and that it's also not the end customer. We just have to understand the risk profile and price accordingly.
You know, going through on that piece too, we have learned a lot over the years in the sense of how to bid these jobs. We've made mistakes in the past. As we quote those jobs, we make sure that, like the cable-laying issue that I mentioned before, we are not held liable for those things or the terms and conditions reflect what we're responsible for and what the end user would be responsible for too. It's not just how we book this thing. It's also that the terms and conditions are extremely important on these jobs for us.
To your second question, the power businesses in Italy were down double digit as well.
Great. Can I just follow up with a couple of quick ones? The minorities were down 34%. How much of that was structural, and how much related to the performance of the JVs in China and other emerging markets?
I would say a big part is the performance in China, obviously, as we mentioned. The segments in which we got hit were also the ones where we have really pretty good margins in some of these products. The profits out of China were much lower this quarter. I think it accounted for a good part of this change.
You also asked about that PS order intake in Europe. It dropped. I don't think there's anything meaningful going on there in Northern Europe. When you said we're in the press and we're trying to accelerate things, I don't know what you're reading, but it could be the Hanover fair. I mean, this whole grid system that has to take place in Germany because of the shutting of the nukes and trying to get this power from the North Sea down to the southern part of Germany. What we've been basically positioning ourselves is to have the high voltage DC technology of a total system, not just point-to-point, but an actual DC grid. That's what we're promoting right now.
It's just to make sure that if that whole grid system is planned, HVDC in that kind of arrangement is not seen as a stumbling block by the authorities there, and we can actually facilitate that transition.
Super. Thank you.
Okay.
Next question from Mr. James Moore, Redburn Partners. Please go ahead.
James, we are worried about you because we didn't hear anything. Okay.
Don't worry. Hi, everyone. Just a couple of questions. I think my core questions have been mostly asked, but maybe I could get back to pricing on orders. I wondered if you could give us some numbers on how that looked for some of the key pieces in power products and maybe some of the other divisions. Secondly, I see in your outlook, you kind of leave it a bit open on the mix effects going forward. You obviously signaled at the last set of results that this quarter will be a tough quarter for mix. You've talked about it depends on China and Southern Europe and how that plays out. As it currently looks, are you able to help us a bit on what the margin looks like next quarter in the way that you did last quarter?
Good try, James. We did that in the first quarter, as I said, because we knew that we had some specific output from our backlog that we saw was better to warn you on. I also said that we are not going to get into a quarterly guidance exercise. No, we're not going to do this. You know, especially that here, the biggest question mark is China. As I said, your crystal ball is as good as ours here. We have to just see how long it will take to turn around. We really don't want to get into a quarterly guidance exercise from that perspective. As to your first question, a bit the same answer, I'm afraid. In terms of pricing on orders, we have only done that for PP. There I can tell you it's the same as last quarter, not really changed from that perspective.
We mentioned 5%- 6%. We have usually not done that for the other divisions. We won't do that here too because it changes too much from one quarter to another, depending on which kind of segment they are hitting. Sorry.
No, listen.
Maybe I can tell the answer.
Go ahead, James.
Maybe I could follow up with another question. I think there's a lot of confusion about what the medium to longer-term outlook is for margins in the T&D industry. Clearly, you don't have a crystal ball there, but the divergence in profitability between you and your principal competitor is at a record level. The industry has historically made high single-digit margins, and you're well above that in power products. Do you think that you have more visibility on that issue now than you did? Are you more concerned that you're over-earning and Siemens is pointing in the right direction, or are they under-earning and you're pointing in the right direction?
That's a good question, because I would say it's the latter. They're under-earning. Remember, the Siemens reports there is a total transmission and distribution plus the power products division. We don't get a clear look in the sense of how PP and how T&D is doing in that sense.
I look first, and then the one makes it also a bit difficult to read through.
Yeah. When you write up, you know, $500 million, €500 million, it's a tough comparison. I think, you know, if you go back even before the big write-off change, and I'm just trying to help here as much as I can, I think Siemens was very critical of their T&D margins and where they had gone. We worry about ours, you know, also, and we've been fighting that with the cost out and all the other things that we've done. I think Siemens is very vocal in the sense of their disappointment with those margin pieces. My expectation was that they would, you know, obviously, from a market standpoint, move to correct that.
Our guidance is what we have given in the capital markets. The EBITDA ranges that we give there, we don't see any reason at this stage to change anything to that. We'll still manage to keep within these ranges.
Thanks for the confidence. All right, thank you.
Thank you.
Next question from Mr. Olivier Esnou, ex-BNP Paribas Exane. Please go ahead.
Yes, hello. Good afternoon.
Olivier, bonjour.
The questions I have are the following. On the bridge, the piece which is sales and R&D reinvestment, I had written down somewhere that the plan was for $300- $400 million this year. If that was correct, you seem to be quite ahead of that. I was wondering if you could update us on that.
Yeah. It is because last year in the bridge, we reported acquisitions separately. Now we have integrated everything. In fact, if you out of these $144 million of increase in sales and R&D, I would say there's about $40 million that is inorganic. The same store kind of increase is really about $100 million, a bit more than $100 million, which then matches into the $400 million that you have taken note for.
Okay. We.
Which is still 1.2% of sales, 1.2% of margin that we sacrifice for those investments.
Okay. We are at the top end of that. Do you have a lot of room to maneuver? I mean, if things don't come back the way you want, how quickly can you adjust that level of reinvestment?
I would say we can because obviously, it's not a straight line. You know, you put an effort, let's say, if you talk of salespeople, for instance, you hire a certain number of salespeople, then you take a break. You see when it starts generating some additional revenue, then you go for the next wave. You can also just delay or stop the next wave if you think it may be too dangerous because the economy changes. It's a little bit the case in low voltage, for instance, where we have delayed some hiring phases to just get a little bit more of a flavor of what's going on in the market.
You're generally happy with the return you get because, you know, right now we see margins coming down and there's this reinvestment. It's difficult to assess if.
We see a return on the salesman. It takes a while before he's trained, before he's really introduced to the customers. If I take, for instance, the service segment where we have invested a lot in sales, I think that there we start seeing now that the service is really taking off. You know, holders are up 9%, revenue is 12%. In fact, if we dig down in some of the countries where we really invested in salespeople, we have solid double-digit growth. I really think we see the returns, yes.
I think what you, unfortunately, can't see and what we don't do is we don't break this thing out by division for you and BU and how we do it. If you look at what the big investments we've made in discrete automation and motion, we've seen massive payoffs on those. Like Michel said, in low voltage, we've actually cut back on that as we've seen the market tighten more. PP is actually flat year to year down in those areas. We really manage these things by BU and by component, depending on what we're seeing in the cycle.
Okay. Just a follow-on on the commodity piece in the bridge, which is also new to me. I mean, I've long waited to see some commodity impact in your bridge, and it has not happened. We know that commodity price had recovered very strongly over the last 18 months. Are we now just at the beginning of you having an impact on your bridge every quarter, or is that going to work?
That's another crystal ball I don't have. As you know, we are constantly hedging all our commodities. What we are doing with that is smoothing out the impact that it has on a specific quarter because the hedge kind of equalizes a little bit the changes. What we said here out of this $144 million is that the major component is Forex. Commodity is probably, I would say, between $20 million and $30 million, which again, for a $10 billion quarter is not hugely material. It can happen from time to time that you have this kind of deviation. We had that one time last quarter too. I still expect that overall the hedging policy helps to smooth this impact and that it's not extremely important.
Okay, thank you very much.
You're welcome.
Next question from Mr. Alfred Glaser from Kepler Cheuvreux. Please go ahead.
Yes, hi. Good afternoon.
Hello.
I just wondered on coming back on prices again. You mentioned before that the price pressure in the new order intake remained very much what it was in Q4. Could you give us some idea on how this could develop into sales and EBIT bridges going forward into the next few quarters? Should we expect a kind of run rate of $250 million price pressure per quarter going forward, or is this too much, or is this kind of a lucky quarter for Q1?
No. We have guided at the beginning of the year that we were looking at generating $1 billion of savings because we felt that the pricing pressure would be around $1 billion. I think after this first quarter, it appears like it's still in the same zone. At this stage, we kind of consider that as a run rate and run the company accordingly.
All right. So kind of a dominant situation going forward here.
Yeah.
All right. Second question on free cash flow, please. Could you give us some indications on what's your current outlook on the full-year free cash flow, either in absolute terms or compared to last year's performance?
Yeah. Let me maybe answer that one a little bit in detail because I think it's important that we understand a bit what's going on with the cash flow here. I'm the first to admit that this is not a great cash flow, but I also think that it's not as bad as it may read because there has been a big component here, a bit variation in corporate cash flow. If you look in terms of operating cash flow, you saw that, in fact, the divisions' operating cash flow are only down $30 million compared to last year. We have a delta of almost $200 million in corporate. Last year, corporate cash flow was $6 million positive. This time, it's $187 million negative.
I would say a normalized corporate cash flow, you know, which takes care of all the headquarter costs, the central research, real estate, and all that kind of thing, should always be in between negative $130 million and $140 million. You see what happened is that last year, we had pretty large one-off gains from a hedging contract that gave a kind of artificial positive corporate cash flow. This time, it was a small outflow instead of being this large inflow. We had as well some contributions to the pension funds in the U.S. and in Sweden. It was about $40 million. There's a big delta there that explains a little bit the difference in cash flow. Again, from the pure division cash flow, operating cash flow was down $30 million, and cash flow from operation, which includes interest and taxes, was at division level down $100 million.
Now we start the year, the first quarter, with a free cash flow, which is negative $250 million. We're still investing quite a lot in CapEx, you know, with some pretty big projects like the cable factory in Sweden and in the U.S. Some of these CapEx and redesign of some factories too is quite important. Over five years, we have said we will try to reach this average 90% net income to free cash flow conversion. I think it's still a year here where we might shoot a little bit below that, maybe 80%- 90%, but I'm still confident that over the five years, we can get there because we will not continue having every year's projects of $300 million, $400 million.
That's right.
All right, thanks. That makes it clear.
That was the last question for today.
Okay. Thanks. Thanks for joining the call and thanks for your interest. We'll report back to you on the progress of the company in the second quarter. Thanks again.
Thank you. Bye-bye.
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