redburn capital goods, 'supply-side revolution

Important notice: See regulatory statement on page 278 of this report.

Capital GoodsThe supply-side revolution

8 March 2010

James Moore

Important Note:

Thesis: In spite of the worst demand drop in 50 years, the Capital Goods sector has demonstrated remarkable margin resilience. Our extensive supply-and demand-side analysis, a year in the making, suggests the 20-year trajectory of rising peak and trough margins will continue, based on sustained market concentration, emerging market and infrastructure demand growth, changing portfolio mix and further cost savings. While a Chinese slowdown is a risk, returns will be more resilient than feared given the sector’s barriers to entry and its increased proportion of low-cost manufacturing in emerging markets.

Capital GoodsThe supply-side revolution

www.redburn.com

Important Note: See Regulatory Statement on page 278 of this report.

8 March 2010

Companies:ABB BuyAlstom BuyAssa Abloy BuyAtlas Copco BuyElectrolux NeutralInvensys NeutralSandvik NeutralSchneider Electric NeutralSiemens BuySKF Neutral

James Moore Tel: +44 (0)20 7000 2135 Mob: +44 (0)7818 088 198 [email protected]

Our supply-side analysis examines 147 global competitors across 11 key industries for changes in industry concentrations, market shares, margins and pricing (globally and in China) over the past 15 years. Our demand analysis incorporates a 50-year study of fixed investment development across 226 countries and launches the Redburn ‘Global Capex Model’, which encompasses a 25-year history and five-year prospective analysis of over 800 global companies across 18 end markets. In assessing sector margin potential, we have deconstructed the 50-year history to identify structural vs cyclical changes.

Rising margins, disaggregated: we attribute the 20-year sector-wide upward margin trend to: (1) an improvement in pricing power, led by industry consolidation and increasing market shares; (2) the disenfranchisement of labour; (3) the variabilisation of the cost base; (4) increasing service and aftermarket content; and (5) portfolio optimisation across a number of companies.

Peak margins forecast in both 2011E… and 2012E: our margin forecasts are based on: (1) further pricing power improvements from continued consolidation; (2) structural improvements in portfolio mix; (3) further cost savings; and (4) demand growth recovery from emerging markets and infrastructure end markets.

Supply-side dynamics: margins are highly correlated with market shares and the degree of industry concentration. After a decade of consolidation, we see more to come. With strong balance sheets, we expect M&A to return in 2010.

Demand dynamics: following a 12% organic sales decline in 2009, we forecast +2% and +6% organic sales growth in 2010E and 2011E. The sector enjoys attractive exposure to both emerging markets (38% of sales) and infrastructure end markets (also 38% of sales) where we forecast higher long-term growth.

China: in the near term we expect continued growth from China. If China’s 32-year domestic investment boom slows, China’s exports could precipitate global pricing pressures. Our supply-side work shows the EU sector’s leading positions in China will be sustained by production relocation and technological, quality and standards advantages. We argue that concerns over the Sino-Western dynamic for the sector are exaggerated.

Valuation: upside to our five Buys ranges between 30% and 100% dependent upon scenario. Applying emerging market multiples (24x 2011E P/E) to the sector’s emerging market net income implies the West is in for free!

Stock selection: we rate five companies as Buy: ABB, Alstom, Assa Abloy, Atlas Copco and Siemens. There are no Sell recommendations, eloquent testimony to the power of the supply-side revolution.

Redburn Research Capital Goods 8 March 2010

4 Important Note: See Regulatory Statement on page 278 of this report.

Performance and summary data

Key company data for ABB, Alstom, Assa Abloy, Atlas Copco, Electrolux, Invensys, Sandvik and Schneider

ABB ABBN VX Equity Recommendation: Buy Alstom ALO FP Equity Recommendation: BuyPrice SFr22.2 Target Price SFr30.0 Price €48.6 Target Price €60.0Market Cap EV Market Cap EV

December Y/E, $ mn 2008 2009 2010E 2011E 2012E March Y/E, € mn 2008 2009 2010E 2011E 2012ERevenue 34,912 31,795 31,155 33,692 35,440 Revenue 16,908 18,739 19,562 22,323 23,613Adj. EBIT 5413 4228 4429 4912 5419 Adj. EBIT 1295 1536 1775 1812 2079Margin (%) 15.5% 13.3% 14.2% 14.6% 15.3% Margin (%) 7.7% 8.2% 9.1% 8.1% 8.8%PBT 4,518 4,120 3,993 5,000 5,549 PBT 1,152 1,464 1,667 1,687 1,885Net Income 3,118 2,901 2,688 3,418 3,812 Net Income 852 1,109 1,222 1,199 1,342EPS (FD) $1.36 $1.27 $1.17 $1.49 $1.66 EPS (FD) €2.95 €3.81 €4.19 €4.11 €4.60P/E 13.2x 12.4x 14.7x 13.7x 12.3x P/E 20.8x 13.6x 10.6x 11.2x 10.0xEV/EBIT 9.4x 8.2x 9.7x 8.7x 7.6x EV/EBIT 16.2x 12.0x 8.9x 9.9x 8.3xFCF to Equity 3,793 3,256 2,439 1,887 3,198 FCF to Equity 1,464 1,404 290 -300 1,914ROIC (post-tax) 45.5% 27.4% 26.9% 29.6% 29.3% ROIC (post-tax) 22.2% 27.7% 28.9% 19.2% 17.3%

Assa Abloy ASSAB SS Equity Recommendation: Buy Atlas Copco ATCOA SS Equity Recommendation: BuyPrice SKr139.3 Target Price SKr175.0 Price SKr103.6 Target Price SKr125.0Market Cap EV Market Cap EV

December Y/E, SKr mn 2008 2009 2010E 2011E 2012E December Y/E, SKr mn 2008 2009 2010E 2011E 2012ERevenue 34,919 35,026 35,910 38,027 39,902 Revenue 74,177 63,762 65,456 72,251 77,688Adj. EBIT 5508 5510 5945 6794 7344 Adj. EBIT 14084 9642 11198 13391 15048Margin (%) 15.8% 15.7% 16.6% 17.9% 18.4% Margin (%) 19.0% 15.1% 17.1% 18.5% 19.4%PBT 3,499 3,740 5,234 6,080 6,628 PBT 13,112 8,232 10,883 13,573 15,800Net Income 2,413 2,626 3,893 4,527 4,872 Net Income 10,157 6,205 8,019 10,009 11,183EPS (FD) SKr6.36 SKr6.97 SKr10.44 SKr12.14 SKr13.06 EPS (FD) SKr8.26 SKr5.04 SKr6.52 SKr8.14 SKr9.09P/E 9.9x 10.5x 12.7x 11.0x 10.2x P/E 10.1x 14.6x 15.9x 12.7x 11.4xEV/EBIT 8.8x 8.9x 10.0x 8.3x 7.2x EV/EBIT 9.3x 11.7x 11.6x 8.7x 6.7xFCF to Equity 4,169 3,897 3,919 4,774 5,065 FCF to Equity 6,736 14,353 9,898 10,376 11,721ROIC (post-tax) 8.8% 8.7% 12.2% 13.8% 14.7% ROIC (post-tax) 24.6% 16.2% 20.7% 23.9% 25.1%

Electrolux ELUXB SS Equity Recommendation: Neutral Invensys ISYS LN Equity Recommendation: NeutralPrice SKr154.8 Target Price SKr175.0 Price 328p Target Price 300pMarket Cap EV Market Cap EV

December Y/E, SKr mn 2008 2009 2010E 2011E 2012E March Y/E, £ mn 2008 2009 2010E 2011E 2012ERevenue 104,792 109,132 108,528 112,149 115,896 Revenue 2,281 2,284 2,192 2,239 2,356Adj. EBIT 1543 5322 6234 6924 7465 Adj. EBIT 261 244 244 272 306Margin (%) 1.5% 4.9% 5.7% 6.2% 6.4% Margin (%) 11.4% 10.7% 11.2% 12.1% 13.0%PBT 653 3,484 5,368 5,964 6,553 PBT 110 165 191 195 232Net Income 366 2,607 4,026 4,324 4,751 Net Income 239 130 164 159 183EPS (FD) SKr1.29 SKr9.18 SKr14.15 SKr15.20 SKr16.70 EPS (FD) 30.0p 16.2p 20.2p 19.6p 22.6pP/E 32.8x 8.1x 9.1x 8.3x 7.7x P/E 7.7x 8.9x 12.5x 13.9x 12.3xEV/EBIT 23.5x 7.5x 7.6x 6.7x 5.9x EV/EBIT 9.7x 7.3x 10.0x 10.4x 8.9xFCF to Equity 2,206 7,428 5,049 4,251 4,884 FCF to Equity 8 173 109 190 163ROIC (post-tax) 2.9% 9.5% 13.9% 13.9% 14.2% ROIC (post-tax) 31.9% 27.8% 27.9% 32.1% 34.3%

Sandvik SAND SS Equity Recommendation: Neutral Schneider Electric SU FP Equity Recommendation: NeutralPrice SKr79.3 Target Price SKr85.0 Price €80.7 Target Price €95.0Market Cap EV Market Cap EV

December Y/E, SKr mn 2008 2009 2010E 2011E 2012E December Y/E, € mn 2008 2009 2010E 2011E 2012ERevenue 92,655 71,937 74,836 82,112 86,633 Revenue 18,311 15,510 17,408 19,078 20,003Adj. EBIT 15075 1649 7226 11900 14172 Adj. EBIT 2912 1956 2609 3010 3268Margin (%) 16.3% 2.3% 9.7% 14.5% 16.4% Margin (%) 15.9% 12.6% 15.0% 15.8% 16.3%PBT 10,576 -3,472 4,461 10,479 12,548 PBT 2,278 1,187 1,777 2,272 2,650Net Income 7,472 -2,654 3,068 7,306 8,751 Net Income 1,682 852 1,283 1,631 1,885EPS (FD) SKr6.29 -SKr2.24 SKr2.58 SKr6.15 SKr7.37 EPS (FD) €7.00 €3.42 €5.20 €6.45 €7.38P/E 9.4x 125.2x 23.2x 13.5x 10.8x P/E 8.2x 12.4x 11.5x 10.1x 9.2xEV/EBIT 9.1x 67.4x 17.6x 10.6x 8.7x EV/EBIT 7.7x 10.0x 9.5x 8.2x 7.3xFCF to Equity 4,501 11,157 4,559 3,666 6,593 FCF to Equity 1,965 2,094 1,480 1,743 1,904ROIC (post-tax) 15.1% -0.4% 6.5% 11.5% 13.1% ROIC (post-tax) 10.8% 6.9% 9.2% 10.3% 11.0%

€19,932 mn €24,897 mn

£2,133 mn £2,433 mn

SKr127,429 mn SKr129,804 mn

€13,860 mn €16,865 mn

SKr44,038 mn SKr47,610 mn

SKr94,134 mn SKr127,028 mn

$46,752 mn $43,602 mn

SKr51,949 mn SKr59,323 mn

Source: Redburn Partners, companies



Important Note: See Regulatory Statement on page 278 of this report. 5


Key company data for Siemens and SKF

Siemens SIE GR Equity Recommendation: Buy SKF SKFB SS Equity Recommendation: NeutralPrice €65.9 Target Price €85.0 Price SKr116.8 Target Price SKr120.0Market Cap EV Market Cap EV

September Y/E, € mn 2008 2009 2010E 2011E 2012E December Y/E, SKr mn 2008 2009 2010E 2011E 2012ERevenue 77,328 76,651 71,386 75,741 79,459 Revenue 63,361 56,227 57,225 60,767 63,438Adj. EBIT 7782 7033 6352 8094 8899 Adj. EBIT 8049 4479 5804 6940 7568Margin (%) 10.1% 9.2% 8.9% 10.7% 11.2% Margin (%) 12.7% 8.0% 10.1% 11.4% 11.9%PBT 2,874 3,891 5,353 7,736 8,745 PBT 6,868 2,297 4,793 5,983 6,662Net Income 5,725 2,292 3,605 5,412 6,148 Net Income 4,616 1,642 3,290 3,999 4,457EPS (FD) €6.39 €2.63 €4.13 €6.19 €7.04 EPS (FD) SKr10.13 SKr3.61 SKr7.22 SKr8.78 SKr9.79P/E 10.8x 8.1x 13.0x 10.0x 9.0x P/E 8.6x 14.6x 14.8x 12.4x 11.2xEV/EBIT 9.3x 6.6x 9.7x 7.4x 6.5x EV/EBIT 7.4x 12.7x 11.1x 9.1x 8.2xFCF to Equity 11,114 5,763 2,963 4,374 5,018 FCF to Equity 2,733 4,222 3,725 3,399 3,996ROIC (post-tax) 8.6% 11.4% 9.9% 11.7% 12.0% ROIC (post-tax) 16.8% 7.7% 12.5% 14.0% 14.6%

€57,565 mn €62,055 mn SKr53,185 mn SKr64,444 mn

Source: Redburn Partners, companies

Sector sales by end market Sector sales by geography Sector sales by industry

38%

39%

23%

InfrastructureMacro-Dependent IndustrialConsumer Related

23%

39%

38%

N. AmericaW. EuropeRoW (inc E. Europe)

24%

16%

15%6%6%6%

4%

3%

15%2%

2% 1%

Automation T&D Power GenHealthcare Appliances RailMining Bearings CompressorsLocks Cutting Tools Other

Source: Redburn Partners, simple average data Source: Redburn Partners, simple average data Source: Redburn Partners, aggregate data

Redburn EPS vs consensus, 2010E and 2011E Ratings and upside/(downside) to target price

-30%-20%-10%

0%10%20%

Siem

ens

Assa

ABB

Atla

s

Sand

vik

Alst

om

Schn

eide

r

Elec

trolu

x

SKF

Inve

nsys

EPS Yr1 EPS Yr2

0%

10%

20%

30%

40%

ABB

Siem

ens

Assa

Alst

om

Atla

s

Schn

eide

r

Elec

trolu

x

Sand

vik SKF

Inve

nsysUp

side

to ta

rget

pric

e (%

)

Buy Neutral Sell

Source: Redburn Partners and Bloomberg Source: Redburn Partners

50 years of European Capital Goods sector average sales growth and EBIT margins

-20%

-10%

0%

10%

20%

30%

40%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011E

Sale

s Gr

owth

(%)

0%

5%

10%

15%

20%

25%

EBIT

Mar

gin

(%)

Sector Average Sales Growth Sector Average EBIT Margin

50 year margin trough

Source: ABB, Alstom, Assa Abloy, Atlas Copco, Electrolux, Invensys, Sandvik, Schneider Electric, Siemens and SKF

Report priced as at 3 March 2010.



Executive summary

“What was it then that touched off this recession? It would be accurate to speak of over-consumption, incited by governments that ran unduly expansive budgets and a banking system that helped to feed over-speculation in shares, real property and so on. The resulting sense of affluence and ample liquidity further encouraged excess consumption.”

This quote was taken from Sandvik’s 1990 annual report and points to a key conclusion from this study of the Capital Goods sector. Whilst demand cycles come and go, some issues resonate from cycle to cycle. As such, we argue the key determinant of returns in Capital Goods is more about the relentless and sustained supply-side changes than the severity of any single demand cycle. It is this point that explains, in part, how in 2009 the European Capital Goods sector enjoyed average margins in excess of the 2000 peak in spite of suffering the worst demand drop since World War II.

Understanding the history of this remarkable long-term industrial performance is critical to any realistic assessment of sector share price potential. Our analysis, 12 months in the making, provides a unique perspective on the supply-side dynamics of the sector, dissecting the evolution and prospects across each industry in significant detail.

We also disaggregate the specific drivers of sector demand, and note the premium levels of growth in both infrastructure and emerging markets. As regards China, we argue that the industry has learned from previous emerging market ‘challengers’, notably Japan (in the 1970/80s). By globalising production, we argue that the competitive risks are outweighed by the still remarkable Chinese opportunities.

Our conclusion is that, in spite of the sector’s strong relative outperformance since the March 2009 low and the rigours of a still challenging operating environment, the combination of the sector’s relentless supply-side improvement and sustained premium growth drivers give scope for 30-year sector-wide margin peaks in 2011… and 2012. In our view, the continuation of rising returns and earnings growth is not reflected fully in most share prices.

A comprehensive analysis of supply-side and demand drivers The European Capital Goods sector is a heterogeneous complex of products and exposures. To understand both the supply-side and demand dynamics of the sector we have mapped each company by industry, end market and geography. This exercise includes:

A 50-year financial history of the ten companies under our coverage;

A 15-year financial model for each of the 147 companies globally that compete with the European sector across the largest 11 industries, which comprise 85% of sector revenues (e.g. T&D, power generation, appliance, bearings, etc);

A 50-year analysis of fixed investment (or gross fixed capital formation) vs GDP data from the World Bank across 226 countries between 1960 and 2008, to identify the long-run development curve precedents as countries mature from agricultural to industrial to service economies;

Growth assumptions for each end market by region constituting 54 assumptions per year, for each of the 18 end markets across each of the three regions identified; and

Executive summary



Executive summary

The Redburn ‘Global Capex Model’, which incorporates a 25-year historic and five-year prospective forecast dataset for over 800 global companies in 18 end-market industries (e.g. automotive, electrical utilities, mining, etc). The dataset accurately reflects the global demand complex and sub-cycles of our sector’s customer base.

This analysis dispels various myths and received wisdoms, providing an evidence-based approach to assess sector share price potential.

Peak margins in both 2011 and 2012

Fig 1: EBIT margins have proven resilient in the face of intense organic sales decline

8.7%

7.1%

9.2%

10.5%9.5%

13.0%14.2%

13.6%

10.1%

8.8%

10.8%12.3%

10.9%12.1%

9.9%9.3%

8.8%

9.6%9.3%8.9%9.0%

5.6% 5.6%

8.3%

8.9%

13.2%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011E

Org

anic

Sal

es G

row

th (

%)

0%

2%

4%

6%

8%

10%

12%

14%

16%

Cle

an E

BIT

Mar

gin

(%)

Sector Average Organic Sales Growth (%) Sector Average Clean EBIT Margin (%)


Source: ABB, Alstom, Assa Abloy, Atlas Copco, Electrolux, Invensys, Sandvik, Schneider Electric, Siemens and SKF

Our analysis demonstrates that margin resilience in 2009 is in fact the continuation of a 20-year margin improvement story (from the trough of 1992) and that average sector peak and trough margins have increased across each of the past four cycles (since 1990). The detailed work undertaken ascribes this to improved pricing power, the disenfranchisement of labour, the variabilisation of the cost base, increasing aftermarket content, and portfolio mix improvements.

We forecast the sector to achieve new peak margins in 2011E and 2012E. Our confidence is underpinned by continued consolidation, the structural permanency of aftermarket and portfolio mix improvements, further 2010 cost savings, and emerging markets and infrastructure demand growth.

Based on our preferred valuation methodology, 2011E EV/IC vs ROIC/WACC, the sector is trading at a 21% discount to fair value, with a minimum average 25% and maximum 100% upside to our five Buy recommendations: ABB, Alstom, Assa Abloy, Atlas Copco and Siemens. Our top picks (ABB and Siemens) are summarised below (pages 16-17).

Of note is that we have no Sell recommendations. The corollary of the powerful forces driving growth and returns in the sector is that even the weakest franchises all enjoy some growth.



Executive summary

Supply-side dynamics

Improved consolidation and market shares

Fig 2: 2000-09 EBIT margins vs 2009 global market share

Sandvik (Tooling)

Assa Abloy (Locks)

Atlas Copco (Compressors)

SKF (Bearings)

Atlas Copco (M &C)Sandvik (M &C)

Invensys (Rail)

Siemens (Rail)Alstom (Rail) Electrolux (Appliances)

Siemens (Health)

Alstom (PG)

Siemens (PG)Schneider Electric (T&D)

ABB (T&D)

Alstom (T&D) Siemens (T&D)

Invensys (Automation)

ABB (Automation)

Schneider (Automation)

Siemens (Automat ion)

0%

5%

10%

15%

20%

25%

0% 5% 10% 15% 20% 25% 30%

2009 G lo ba l M a rke t Sha re (%)

2000

-200

9 A

vera

ge C

lean

EB

IT

Mar

gin

(%)

Outliers are Automation (where we see market definitional issues, which lower the market shares through aggregating the sub-industries) and Invensys Rail (which is actually a Signalling business where it has a #4 position with a 9% share, but we have included it in the wider Rail industry)

Line of best fit is for illustrative purposes only and is not calculated by regression Source: Redburn Partners

Our analysis demonstrates that company margins are highly correlated with market shares and that industry margins are highly correlated with industry concentration. This relationship holds across a diversified range of industries from washing machines to gas-fired power plants, suggesting that what you make matters less for returns than the degree to which you have cornered the market. In our ‘supply-side scorecard’ (see Fig 41), we have attempted to distil the findings of our nine supply-side chapters and their influence on margins into a single table: here Assa Abloy, ABB and Atlas Copco score the highest.

Further concentration expected Fig 3: Average ‘top five’ market share concentration across all 11 industries

Fig 4: Average sector global market share across all 11 industries

30%

35%

40%

45%

50%

55%

60%

1997 1999 2001 2003 2005 2007 2009 2011

Mar

ket s

hare

of T

op 5

by

Indu

stry

(a

cros

s al

l Ind

ustri

es)

6%

8%

10%

12%

14%

16%

1997 1999 2001 2003 2005 2007 2009 2011

Aver

age

Glob

al M

arke

t Sha

re o

f Eu

rope

an C

apita

l Goo

ds S

ecto

r

Average Global Market Share of European Capital Goods Sector (%)

Calculated as a simple average (unweighted) of all 11 industries’ annual concentration of top 5 market share Source: Redburn Partners

Calculated as a simple average (unweighted) of all 21 assets within the sector (whether group, division or sub-division) that participate in the 11 industries discussed in our supply-side analysis Source: Redburn Partners

Since 1997, the average market share of the largest five manufacturers across each of the 11 industries has lifted from 40.7% to 55.2%, and the average weighted market share of our sector has increased from 8.5% to 13.1%. Looking forward, there have been a number of significant consolidatory acquisitions by our companies and their competitors (Bucyrus/Terex, Black & Decker/Stanley Works, Schneider/Areva D, Iscar/ Tungaloy and Atlas Copco/Quincy Compressor) which will, in combination, by 2011, raise the average top five concentration (by a further 1.8%) to 57.0% and the sector’s average market share (by a further 70bp) to 13.8%.



Executive summary

Pricing power has been transformed Our analysis provides clear evidence that such industry consolidation and increased market shares have driven a significant improvement in pricing power across our sector’s 11 largest industries. This has improved the supply-side dynamics structurally and sustainably, as is shown in part by the increasing resilience of pricing during each of the last four downturns. We forecast net pricing (and therefore margins) to remain more robust throughout this downturn and recovery, than during any other downturn and recovery of the past 30 years. Furthermore, the sector’s pricing power should continue to improve as a consequence of ongoing consolidatory acquisitions.

Balance sheets are strong After a period of conservatism and noteworthy cash flow management during the downturn, sector balance sheets are strong, with the lowest sector adjusted net debt/ EBITDA for a decade. ABB, Invensys and Siemens stand out as having the strongest balance sheets. Subject to price the sector could afford to spend €50bn+ of cash on acquisitions, which should be materially accretive to earnings.

Cost savings continue in 2010 The European Capital Goods sector is in a period of intense restructuring. Our analysis highlights:

The bulk of heavy restructuring charges are behind us;

In this ‘SAP recession’ managements have been quick to act, and headcount reductions have been both responsive to and of similar magnitudes to revenue declines; and

After €4.1bn (or 3.5% of sales) of sector-wide savings in 2009 we expect a further €2.7bn (or 1.4% of sales) of savings in 2010E.

At a company level ABB, Sandvik, Schneider and Assa Abloy will benefit the most from 2010E savings.

Demand dynamics

We forecast organic sales growth to recover to +6% in 2011E Following an average 2009 organic sales growth decline of 11.5% for the European Capital Goods sector (the worst for 50 years), we forecast a recovery to c6% organic sales growth in 2011E. Over the past ten years our coverage universe (the ten Capital Goods companies covered by Redburn) has demonstrated an average +4.1% organic sales growth. At a company level ABB (+6.9%), Atlas Copco (+6.1%), Siemens (+5.0%) and Sandvik(+5.0%) have shown the highest ten-year average organic sales growth.

Organic sales growth in the European Capital Goods sector is driven by capex and, to a lesser degree, industrial production. With capacity utilisation at record lows in Europe and the US, managements in the sector are nervous that relatively empty factories will lead to a meaningful global capex holiday. History suggests such nervousness is overplayed and that while capex tends to lag industrial production into recovery, the lag is relatively short lived.



Executive summary

Emerging markets, a source of premium growth Fig 5: Ten-year average fixed investment growth by region

Fig 6: Sector revenues ranked by emerging market exposure (2009)

0%

5%10%

15%20%

25%30%

35%

Russ

ia

Indi

a

Chin

a

Braz

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Lata

m

Fran

ce UK US

Germ

any

Japa

n

Aver

age

Fixe

d In

vest

men

t Gro

wth

(%)

1999-2008 10 Year Average Fixed Investment Growth

Emerging

Western

56% 50% 50%39% 36% 36% 34% 33% 24% 23% 19%

32%31% 34%

34% 48% 42%31%

50% 60%44% 43%

12% 19% 16%27%

16% 21%35%

17% 15%33% 37%

0%

20%

40%

60%

80%

100%

ABB

Atla

sCo

pco

Sand

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Schn

eide

r

Alst

om

Siem

ens

Elec

trolu

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SKF

Legr

and

Inve

nsys

Assa

Ablo

y

2009

Sal

es E

xpos

ure

(by

Geog

raph

y) RoW (inc E. Europe) W. Europe N. America

Source: World Bank Source: Redburn Partners, company data

Over the medium term, we forecast the emerging markets to continue to grow faster than Europe and the US given the ongoing closure of the wealth gap and the compelling global demographics. Over the last ten years average emerging market fixed investment growth has run at triple European and US fixed investment growth. Our extensive fixed investment growth model (driven by World Bank data) highlights the development precedents for continued robust emerging market fixed investment growth.

ABB, Atlas Copco, Sandvik, Siemens and Schneider have the highest exposures outside of Western Europe and North America making them the most likely to see higher growth, ceteris paribus.

Infrastructure end markets have better structural drivers Fig 7: Ten-year historic organic sales growth by end market 2000-09E

Fig 8: 2009 end-market exposure clustered and ranked by infrastructure exposure

0%

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Min

ing

T&D

OGP

/Pr

oces

sPo

wer

Gene

ratio

n

Rail

Auto

mat

ion

Gene

ral

Indu

stria

l

Cons

truct

ion

Appl

ianc

es /

Auto

10 Y

ear A

vera

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rgan

ic S

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Gro

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(200

0-20

09E)

Infrastructure

Macro dependent

Consumer

0%

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100%

Alst

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ABB

Inve

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Siem

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Atla

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Assa

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Elec

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2009

Sal

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arke

t Mix

Infrastructure Macro-Dependent Consumer

We have bucketed 36 ‘pure-play’ divisions from the sector into the nine end-market buckets shown above and then taken the average ten-year organic sales growth. For instance Power Generation includes Siemens’ Fossil Power Generation division and Alstom’s Power division Source: Redburn Partners

Source: Redburn Partners, company data

Almost regardless of the longer-term level of general economic growth, we believe that those companies in the sector selling capital equipment into the infrastructure end markets (mining, rail, T&D, power, metals and oil & gas) will benefit from higher levels of growth than those selling into macro-dependent and consumer end markets. This is supported by the higher emerging market content and the significant Western replacement needs of the infrastructure end markets, and is underpinned by both our extensive historical end market growth analysis and our Redburn ‘Global Capex Model’.



Executive summary

Following decades of underinvestment in the West, the infrastructure end markets all enjoy attractive structural demand and supply imbalances, supported by environmental, technological and other factors.

Earlier cycle consumer spending and industrial production has already shown tentative green shoots of recovery. We forecast orders in the later-cycle capex markets to follow. As such, we argue that investors should invest in the more attractive infrastructure capex recovery plays such as Alstom, ABB, Siemens, and Atlas Copco.

Over the longer term (five years or more) we forecast infrastructure end markets to grow the fastest at between 6% and 7% pa. We expect the ‘macro dependant’ industrial markets to grow at 3-4% pa and the consumer end markets at 2-3% pa.

Mining highlights potential infrastructure capex recovery Of all the infrastructure end markets, the mining end market is showing the first signs of a recovering capex cycle. While organic sales growth for Sandvik and Atlas Copco’s respective mining businesses averaged -24% in 2009 (and -25% in 4Q09), the outlook is improving and we have already started to see industry capex upgrades. In October 2009, Rio Tinto raised its guidance for 2010 capex (from $5bn to up to $6bn) and Vale’s board approved a 29% increase in its capex for 2010 ($12.9bn vs the $10bn). More recently, in February 2010, BHP Billiton announced its intention to increase its capex to $15bn in 2011E (a 20% uplift compared to previous guidance), equating to 17% capex growth in 2010E and 21% in 2011E.

Redburn ‘Global Capex Model’, limited impediments to capexUsing historic and consensus forecast data for over 800 global companies, the Redburn ‘Global Capex Model’ argues for an optimistic stance on the potential for future capex growth. This optimism is based on the above-average margins (15% vs 12% average), and below-average indebtedness (1.7x net debt/EBITDA vs 1.9x average) across the entire end-market complex in 2010E, compared to the average of the past 12 years. From this we see scope for consensus capex upgrades.

Risks

China’s 30-year investment bubble poses risk to growth story

Fig 9: Sector sales to China ranked by exposure (2009)Fig 10: Chinese market share by company by industry 2008, ranked by share

12%9% 8% 7% 6% 6% 5% 4% 2% 2% 1%0%

2%4%

6%

8%

10%12%

14%

ABB

Atla

s Co

pco

Schn

eide

r

SKF

Siem

ens

Alst

om

Sand

vik

Inve

nsys

Legr

and

Assa

Abl

oy

Elec

trolu

x

2009

Sal

es E

xpos

ure

to C

hina

(%)

16%15%13%

11% 10%9%7% 6% 5% 4% 4% 3% 3% 2% 1%0.3%

0%

5%

10%

15%

20%

Sand

vik (T

ooling

)

Siemen

s (Health

)

ABB(T&

D)

Atlas (Com

pr.)

Siemen

s (PG)

Assa Ablo

y (Lock

s)

Siemen

s (T&D)

Alstom

(Rail)

Siemen

s (Rail

)

SKF (

Bearin

gs)

Alstom (P

G)

Atlas C

opco

(M&C)

Alstom (T

&D)

Sand

vik (M

&C)

Schn

eider

(T&D)

Electr

olux (App

liance

s)

Chin

ese

Mar

ket S

hare

(%) (

2008

)

Source: Redburn Partners, company data Source: Redburn Partners based on multiple company and industry sources



Executive summary

China represents 7% of direct sales for the European Capital Goods sector (but is a much more significant driver of indirect demand), and for those with the highest exposure (ABB and Atlas Copco), we see this as a valuable source of demand growth driven by attractive demographics, urbanisation and the rise of the middle classes.

Our 50-year fixed investment growth analysis (source: World Bank) highlights that China has experienced 32 straight years of fixed investment boom, more than any other country. Beyond the RMB4trn stimulus package, we see risks to growth and global pricing pressure from increased Chinese exports in those industries with low barriers to entry. We believe the European Capital Goods sector is perhaps better positioned than many fear with attractive barriers to entry across most industries.

Having learnt from the Japanese experience, the sector has repositioned its production costs to emerging markets and is now more competitively structured than in previous emerging market cycles. Furthermore, local Chinese manufacturers still lag behind Western manufacturers with respect to technology, manufacturing quality, and safety standards required to export their products into the West. Consequently, while China is not without risk, we argue the competitive risks are still outweighed by the opportunities.

2010 faces a risk that rising raw material costs impact margins

Fig 11: Synthetic cost inflation; 2010E vs 2009 based on spot prices and cost mix

-3%-1%

-2% -3%

-5%

-2% -2%-1% -2%

-8%

3%1%

3%1%

3%2% 2% 2% 2% 2%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

ABB Alstom AssaAlboy

AtlasCopco

Electrolux Legrand Sandvik Schneider Siemens SKF

Raw

Mat

eria

l C

ost

Infl

atio

n as

%

of S

ales

(ba

sed

on s

pot

mar

ket)

2009 2010

Our synthetic cost inflation data make the implied assumption that each company buys its raw materials at spot price and is entirely unhedged. Raw material exposures by company have been provided by companies where not disclosed Source: Redburn Partners

We see raw material reflation as a more pressing nearer-term risk relative to the more medium- and longer-term risk in China. While our forecasts are optimistic regarding net pricing and margins (given our supply-side analysis), our synthetic cost analysis highlights that, at current spot rates, 2010E will witness a return to raw material cost inflation of c2% of sales. If sector order volumes turn out to be lower than we currently forecast in 2010E and backlogs empty as a result, then there is a risk that prices may not show the resilience or the ability to pass on cost inflation that we expect. We have seen no clear evidence to suggest this is the case at this time.

The key conclusion for investors is that we expect further margin upside, supported by compelling supply-side dynamics and structural growth drivers in emerging markets and infrastructure end markets. As such, we forecast sector-wide earnings to beat consensus in 2010 and 2011. Although the sector has performed well since the March 2009 trough, we see further upside particularly in our five Buys: ABB, Siemens, Alstom, Atlas Copco and Assa Abloy. We summarise the valuation case below.



Executive summary

Valuation

Fig 12: The sector is trading on 12x 2011E P/E, and offers a 3.5% dividend yield and an 8% FCF yield

European Capital Goods Valuation Summary

TargetCompany Rating Price Price 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E

ABB Buy SFr22.2 SFr30.0 17.4 13.7 12.3 1.9% 2.3% 2.4% 5.2% 4.0% 6.8% 3.72 4.08 4.04Alstom* Buy €48.6 €60.0 11.6 10.8 9.7 3.0% 3.2% 3.6% -1.1% 9.6% 12.4% 3.20 2.60 2.62Electrolux Neutral Skr155 Skr175 10.9 10.2 9.3 3.3% 3.6% 5.2% 11.5% 9.7% 11.1% 1.97 1.95 1.96Invensys* Neutral 328p 330p 16.6 15.0 13.7 1.7% 1.8% 1.8% 6.7% 6.4% 7.1% 4.35 4.70 4.77Schneider Electric Neutral €80.7 €95.0 13.0 10.9 9.7 3.2% 4.1% 4.6% 7.4% 8.5% 9.2% 1.39 1.53 1.60Siemens* Buy €65.9 €85.0 12.3 9.7 8.9 2.6% 3.3% 4.3% 5.8% 7.9% 8.8% 1.53 1.72 1.72Electrical Sector (Median) 12.7 10.9 9.7 2.8% 3.3% 4.0% 6.2% 8.2% 9.0% 2.59 2.27 2.29

Assa Abloy Buy Skr139 Skr175 13.3 11.5 10.7 3.0% 3.5% 3.7% 7.5% 9.2% 9.7% 1.80 1.97 2.04Atlas Copco Buy Skr103.6 Skr125.0 15.9 12.7 11.4 2.8% 3.6% 4.0% 7.8% 8.1% 9.2% 2.87 3.30 3.46Sandvik Neutral Skr79.3 Skr85.0 30.7 13.5 10.8 1.8% 4.3% 5.2% 4.8% 3.9% 7.0% 1.04 1.82 2.06SKF Neutral Skr117 Skr120 16.2 13.3 11.9 3.1% 3.8% 4.2% 7.0% 6.4% 7.5% 1.85 2.06 2.12Engineering Sector (Median) 16.0 13.0 11.1 2.9% 3.7% 4.1% 7.3% 7.3% 8.4% 1.82 2.01 2.09

Overall Capital Goods (Median) 14.6 12.1 10.7 2.9% 3.5% 4.1% 6.9% 8.0% 9.0% 1.91 2.01 2.09

# Shares Mkt Cap EVCompany (FD, mn) € mn € mn 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E

ABB 2,291 27,982 26,153 1.4 1.3 1.2 8.5 7.6 6.7 9.7 8.7 7.6 3.96 3.45 2.98Alstom* 292 14,486 17,675 0.8 0.8 0.7 7.8 6.6 5.7 9.6 8.7 7.5 2.67 2.02 1.81Electrolux 284 3,408 4,040 0.4 0.4 0.4 5.0 4.5 4.1 7.6 6.7 5.9 1.43 1.33 1.21Invensys* 809 2,324 2,595 1.2 1.2 1.1 8.3 7.5 6.7 10.3 9.2 8.1 3.82 3.81 3.51Schneider Electric 247 15,075 19,526 1.4 1.3 1.2 8.3 7.1 6.5 9.5 8.2 7.3 1.20 1.13 1.08Siemens* 874 47,104 50,457 0.9 0.8 0.7 6.5 5.5 5.0 9.0 7.2 6.4 1.12 1.03 0.95Electrical Sector (Median) 114,728 126,358 1.0 1.0 0.9 8.0 6.9 6.1 9.6 8.4 7.4 2.05 1.68 1.51

Assa Abloy 373 4,032 4,955 1.7 1.5 1.3 8.5 7.1 6.3 10.0 8.3 7.2 1.63 1.52 1.44Atlas Copco 1,230 10,058 11,463 2.0 1.6 1.3 9.0 7.0 5.5 11.6 8.7 6.7 2.99 2.62 2.22Sandvik 1,187 7,814 11,289 1.7 1.5 1.4 11.1 7.8 6.7 17.6 10.6 8.7 1.67 1.62 1.52SKF 455 4,479 5,778 1.1 1.0 1.0 8.0 7.0 6.4 11.1 9.1 8.2 1.95 1.85 1.74Engineering Sector (Median) 26,383 33,484 1.7 1.5 1.3 8.7 7.1 6.4 11.3 8.9 7.7 1.81 1.74 1.63

Overall Capital Goods (Median) 141,110 159,843 1.3 1.2 1.1 8.3 7.1 6.4 9.9 8.7 7.4 1.81 1.74 1.63

P/E Div Yield

EV/Sales EV/EBITDA

FCF Yield to Equity

EV/EBITA EV/IC

ROIC/WACC

*Data has been calendarised to a December year end Source: Redburn Partners

25% upside to Buys on 2011E based on EV/IC vs ROIC/WACC Since the trough in March 2009 the European Capital Goods sector has seen an absolute average share price increase of 108%, outperforming the DJ Euro 600 Index by 49%. The sector is currently trading on 2011E EV/EBITA of 8.7x (at the median), which represents a 21% discount to the 20-year average of 11.0x. We see evidence of a systemic derating of the sector over time, implying the market is more cautious about profit growth beyond year two than it has been on average for the last 20 years.

Based on our core method of valuation, 2011E EV/IC vs ROIC/WACC, we calculate that the sector is trading at a 20% discount to fair value, with an average 30% upside to our five Buy recommendations. This valuation approach does not fully capture the variation of growth beyond 2011E. Based on our long run, DCF-style, dynamic economic profit valuation scenario, we see even more upside. If companies can sustain their ten-year average organic sales growth we see an average of 57% upside to the entire sector and an average of over 100% upside to our five Buys: ABB, Atlas Copco, Alstom, Siemens and Assa Abloy, which have averaged 5.4% organic sales growth over the last ten years, compared to the other five companies, which have averaged 3.1%.



Executive summary

Fig 13: Redburn EPS (based on Reported EPS) vs consensus (% difference)

-30%

-20%

-10%

0%

10%

20%

ABB Siemens AtlasCopco

AssaAbloy

Electrolux Schneider Sandvik Alstom Invensys SKF

EPS Yr1 EPS Yr2

Source: Redburn Partners and Bloomberg

On average our 2011E EPS forecasts are 11% ahead of consensus for our five Buy recommendations, led by ABB (18%) and Siemens (14%).

Western world for free! We have conducted a very simple, regional sum-of-the-parts, for the sector, valuing both the Western profit stream and the emerging market profit steam independently. If we apply the average emerging market multiple (of 24x 2011E P/E) for the sector’s direct competitors, to the sector’s 2011E emerging market net income then you get the entire Western side of the sector (58% of net income, on average) for free!

Our analysis in sum In the table overleaf (Fig 15) we have brought together the key factors behind our supply-side and demand analyses with our valuation and where our earnings forecasts are positioned against consensus. For each factor, we have ranked the companies and positioned them by quartile. Based on a weighted average of the various factors ABBand Siemens, our top picks, command the highest overall score. In the chart below (Fig 14) we have shown a summary of the overall scores. The order mirrors our investment preferences, which is reflected in our recommendation structure.

Fig 14: ABB and Siemens the clear winners from our ‘overall sector scorecard’ (Fig 15)

0

2

4

6

8

ABB Siemens AssaAbloy

AtlasCopco

Alstom Sandvik SchneiderElectric

Electrolux Invensys SKF

Ove

rall

Wei

ghte

d Sc

ore

from

Sec

tor

Scor

ecar

d

Source: Redburn Partners



Executive summary

Fig 15: ‘Overall sector scorecard’ of supply-side, demand, savings, valuation and Redburn EPS vs consensus

Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Score Rank Quartile

ABB 3.8 2 1st 6% 1 1st 57% 1 1st 65% 2 1st 0.85x 8 3rd 12% 2 1st 8.0 1 1st

Alstom 4.2 4 2nd 0% 10 4th 36% 5 2nd 100% 1 1st 0.78x 5 2nd 8% 5 2nd 6.1 5 2nd

Assa Abloy 2.2 1 1st 1% 4 2nd 19% 10 4th 0% 9 4th 0.77x 4 2nd 11% 3 1st 6.8 3 1st

Atlas Copco 3.8 3 1st 1% 8 3rd 50% 2 1st 39% 5 2nd 0.79x 6 3rd 10% 4 2nd 6.5 4 2nd

Electrolux 7.3 8 3rd 1% 7 3rd 34% 7 3rd 0% 9 4th 0.69x 2 1st -7% 8 3rd 4.3 8 3rd

Invensys 9.8 10 4th 1% 6 3rd 23% 9 4th 59% 3 1st 0.81x 7 3rd -14% 9 4th 3.1 9 4th

Sandvik 5.3 6 3rd 3% 2 1st 50% 3 1st 29% 6 3rd 0.89x 9 4th -1% 6 3rd 5.1 6 3rd

Schneider Electric 7.8 9 4th 1% 3 1st 37% 4 2nd 18% 8 3rd 0.74x 3 1st -1% 7 3rd 5.0 7 3rd

Siemens 6.3 7 3rd 1% 5 2nd 36% 6 3rd 51% 4 2nd 0.60x 1 1st 14% 1 1st 7.6 2 1st

SKF 4.9 5 2nd 1% 9 4th 33% 8 3rd 23% 7 3rd 0.90x 10 4th -16% 10 4th 2.6 10 4th

Scorecard Weighting

Revenue Growth FactorsMargin Factors Margin and Growth Factors

20%

Valuation 2011E EV/IC vs.

ROIC/WACC

30% 100%

Redburn EPS vs. Consensus

(Average of Yr 2 & 3)

Overall Weighted Score

10%20% 10%

Infrastructure as % of 2009 Sales

Supply Side Scorecard

1Q10 - 4Q10 Savings as % of

Sales

Emerging Market as % of 2009 Sales

10%




ABB: the investment case, Buy

Target Price: SFr30 Price: SFr21.3

Investment case: our Buy recommendation on ABB is rooted in the company’s high market shares, the consolidated nature of the T&D industry, and ABB’s exceptionally attractive demand mix of high emerging market and infrastructure exposures. Our above consensus estimates are supported by cost savings and demand recovery.

Supply-side analysis: ABB benefits from one of the most compelling competitive dynamics in the sector. ABB has successfully forged a dominant number one position in the global €56bn Transmission and Distribution (T&D) market. Despite continuous concerns regarding competitive threats, its 23% market share has lifted from 19% in 2002. The T&D industry has experienced an intense period of supply-side consolidation over the past 15 years, with the top five increasing their collective share by a substantial 21% since 1996 to 63% in 2010. T&D is now one of the most concentrated industries served by the sector.

Demand analysis: our demand analysis highlights that ABB enjoys the most attractive combined geographic and end-market revenue mix amongst our coverage, with 57% emerging market and 65% infrastructure end-market exposure. Our analysis demonstrates that this attractive mix is behind ABB’s sector-leading organic sales growth history and underpins our forecast that ABB will continue to generate sector-leading growth over the longer term.

China strength: at 12% of sales ABB has the highest exposure to China in the sector and, despite market concerns, our supply-side analysis suggests the company’s positioning is strong. Despite a decade of intense T&D competition, ABB has kept pace with the locals and retained its dominant 13% market share, twice that of XD Group, the number two. Importantly, with local margins above the group average this share has not been bought. While competitive threats in China are, as ever, omnipresent, and furthermore, the Chinese State Grid has signalled a 20% capex cut in 2010, we believe that the Chinese T&D industry remains an opportunity and not a threat for ABB given the longer term growth potential, ABB’s comparable local cost base and the company’s technological advantages.

Highest 2010E savings: our restructuring and cost-savings analysis highlights that Mr Hogan (CEO) has moved ABB up the savings leader board. We expect ABB to generate savings equating to 5.8% sales in 2010E, the highest in the sector and more than twice the second highest saver (Sandvik) and four times our coverage average. More importantly, near term we expect more than half of the 2010E savings to come in 1H10E.

Strong balance sheet: ABB is sitting on a $7bn net cash pile. ABB has the scope to finance a $20bn acquisition (or special dividend), which (at the right multiples) could be significantly accretive.

2011E EPS 18% above consensus: despite some near-term pricing challenges, which are fully embedded in our estimates, we still expect ABB to exceed consensus expectations. Our 2011E EPS of $1.49 is a meaningful 18% ahead of the $1.27 consensus.

Valuation: we find the valuation attractive and think 13.7x 2011 P/E is compelling for an emerging market company (which ABB is!) and the fastest growing company in the sector. Our SFr30 target price is driven by our returns based methodology.

ABB: the investment case, Buy



Siemens: the investment case, Buy

Target Price: €85 Price: €64.9

Investment case: the degree of change at Siemens is remarkable given its size. Over the last decade nearly half of the company has either been sold or JV’d. This dramatic portfolio optimisation has forged a much improved margin and return profile. Our supply-side analysis shows the streamlined business has leading market shares where margins have started to close the historic gap vs peers. We argue this margin gap can continue to narrow. Given the margin potential and the company’s attractive revenue mix we do not believe the discounted rating is deserved. We expect the company to raise its guidance at 2Q09 in April and for earnings expectations to lift towards our above consensus forecasts.

Supply-side analysis: our supply-side analysis highlights that Siemens has top three market positions in most of its industries and is relatively well positioned in China. Given these market-leading positions and the company’s high R&D spend, our benchmarking analysis identifies a potential c150bp upside to margins from a continued closure of the margin gap vs its peers.

Demand analysis: our demand analysis highlights that Siemens’ revenue mix is an attractive combination of a 36% exposure to emerging markets (in line with the sector) and an above sector average exposure to the infrastructure end markets (at 51%), dominated by power generation, T&D, oil & gas and rail. Over the last ten years, Siemens’ has outgrown the sector (+4%) with an average organic sales growth of +5%, putting it ahead of Alstom, SKF, Schneider, Legrand and Assa Abloy. While Siemens doesn’t have the revenue exposure of some, we believe that its relatively attractive growth mix is not reflected in its discounted rating.

Portfolio optimisation: our sector margin analysis highlights the degree to which profitability across Capital Goods has benefited from portfolio optimisation. Siemens has been the biggest beneficiary here. Its dramatic portfolio restructuring has addressed the company’s historic Achilles heel, margins. We calculate that 41% of 2001 revenues have either been exited or JV’d and that this has structurally lifted margins by c5%. Importantly, a mix adjusted analysis of Siemens’ current portfolio structure highlights that underlying margins have been far more resilient and much less cyclical over time than the actual reported margins.

Strong balance sheet: adjusting for both the €6bn pension and the €9bn of financial services debt, Siemens is significantly ungeared with €3bn of adjusted net debt (or 0.3x EBITDA). With further disposals in the pipe (such as Hearing Aids, which we expect to fetch c€1.5bn), the company is in good financial health and could easily resume its suspended share buyback programme or make c€10bn+ of acquisitions.

2011E EPS 14% above consensus: our estimates are predicated on a return to growth in 2011E, and a better pricing environment than the -2% guided by management. We expect Siemens to raise FY10 guidance (€6.0-6.5bn of ‘sector profit’ or PBT) by at least 10% at the 2Q09 results on 29 April 2010. We believe this guidance is too low and forecast €7.5bn in 2010E and €9.1bn in 2011E.

Valuation: our €85 price target is predicated on our returns based valuation methodology (EV/IC for 2011E is 1.03x, yet we forecast a 1.72x ROIC/WACC) and our above consensus estimates. Our price target is also supported by our detailed sum-of-the-parts analysis. Siemens is trading on 9.7x 2011E P/E (a 20% discount to the sector) and 7.2x 2011E EV/EBITA (a 17% discount to the sector).

Siemens: the investment case, Buy



Executive summary....................................................................................................................6

Margins

Margins (1): 2011E to exceed 2007 peak .................................................................................19

Margins (2): supply side – improved pricing power ...................................................................34

Margins (3): price and raw material cost inflation ......................................................................54

Margins (4): cost savings, 2010 tailwind ...................................................................................60

Supply side

Supply side (1): transmission & distribution (T&D) .....................................................................68

Supply side (2): power generation (PG).....................................................................................81

Supply side (3): appliances.......................................................................................................96

Supply side (4): rail equipment ............................................................................................... 107

Supply side (5): mining equipment.......................................................................................... 116

Supply side (6): bearings........................................................................................................ 124

Supply side (7): compressors ................................................................................................. 129

Supply side (8): locks ............................................................................................................. 135

Supply side (9): cutting tools .................................................................................................. 143

Demand

Demand (1): c6% organic sales growth in 2011E ................................................................... 148

Demand (2): macro outlook.................................................................................................... 152

Demand (3): geographical outlook.......................................................................................... 156

Demand (4): end-market outlook............................................................................................ 165

Demand (5): Redburn ‘Global Capex Model’ .......................................................................... 171

Demand (6): infrastructure end markets.................................................................................. 177

Demand (7): mining capex outlook ......................................................................................... 178

Demand (8): electrical utilities capex outlook........................................................................... 180

Demand (9): rail capex outlook............................................................................................... 183

Demand (10): oil and gas and process capex outlook ................................................................ 186

Valuation ................................................................................................................................. 187

Companies

ABB (ABBN VX, Buy, target SFr30) ........................................................................................ 200

Alstom (ALO FP, Buy, target €60) .......................................................................................... 208

Assa Abloy (ASSAB SS, Buy, target SKr175) ......................................................................... 218

Atlas Copco (ATCOA SS, Buy, target SKr125) ....................................................................... 226

Electrolux (ELUXB SS, Neutral, target SKr175) ....................................................................... 232

Invensys (ISYS LN, Neutral, target 330p) ................................................................................ 238

Sandvik (SAND SS, Neutral, target SKr85) ............................................................................. 244

Schneider Electric (SU FP, Neutral, target €95)....................................................................... 250

Siemens (SIE GR, Buy, target €85)......................................................................................... 258

SKF (SKFB SS, Neutral, target SKr120).................................................................................. 270

Table of contents



Margins (1): 2011E to exceed 2007 peak

Despite suffering the worst demand drop since World War II, the average sector 2009 EBIT margin will match the 2000 peak. Our analysis suggests this margin resilience is the continuation of a 20-year margin improvement story, which we believe is likely to continue. Average sector margins have increased across each of the past four cycles and we attribute this to: an improvement in pricing power (due to both industry consolidation and increasing market shares); the disenfranchisement of labour; the variabilisation of the cost base; increasing service and aftermarket content; and portfolio optimisation across a number of companies (e.g. Siemens).

Looking forward we see four factors underpinning our confidence that margins will reach new peaks: further pricing power improvements from continued consolidation; structural permanency of aftermarket and portfolio mix improvements (which drove half (1.3%) of the 2.7% increase in sector EBIT margins from the 2000 peak to the 2007 peak); 2010 cost savings from sector capacity reductions; and demand growth from emerging markets and infrastructure end markets.

Margin resilience has been staggering

Fig 16: Group clean EBIT margins, by company, 1995-2012E, peak margin highlighted

Company 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

ABB 6.7% 6.3% 3.6% 5.6% 4.6% 6.0% 2.8% 1.0% 1.4% 5.4% 8.7% 11.1% 13.9% 15.5% 13.3% 14.2% 14.6% 15.3%

Alstom 4.7% 5.5% 5.0% 5.9% 6.0% 5.9% 5.2% -1.0% 3.3% 3.4% 5.6% 6.7% 7.7% 8.2% 9.1% 8.1% 8.8% 9.1%

Assa Abloy 7.5% 10.4% 11.6% 12.8% 13.5% 14.6% 14.0% 14.4% 14.4% 14.4% 15.2% 15.5% 16.2% 15.8% 15.7% 16.6% 17.9% 18.4%

Atlas Copco 11.4% 15.9% 13.0% 14.1% 14.1% 15.0% 13.9% 11.7% 13.0% 14.7% 16.5% 18.4% 19.0% 19.0% 15.1% 17.1% 18.5% 19.4%

Electrolux 4.8% 4.3% 6.0% 4.5% 6.6% 6.3% 4.9% 6.3% 6.3% 5.7% 4.2% 4.4% 4.6% 1.5% 4.9% 5.7% 6.2% 6.4%

Invensys 6.9% 7.8% 9.4% 11.4% 10.7% 11.2% 12.1% 13.0% 13.6%

Sandvik 17.6% 14.0% 12.4% 10.6% 12.0% 13.5% 13.4% 12.3% 11.8% 14.0% 15.0% 16.7% 16.9% 16.3% 2.3% 9.7% 14.5% 16.4%

Schneider Electric 7.2% 7.5% 9.6% 13.3% 14.5% 15.2% 13.7% 14.8% 15.2% 12.8% 14.3% 15.5% 15.6% 15.9% 12.6% 15.0% 15.8% 16.3%

Siemens 3.8% 3.4% 3.5% 2.6% 2.3% 2.7% 4.2% 3.5% 3.1% 3.8% 4.3% 4.4% 8.8% 10.1% 9.2% 8.9% 10.7% 11.2%

SKF 11.1% 9.8% 8.1% 5.9% 5.9% 9.1% 8.5% 10.0% 9.6% 10.4% 11.4% 11.1% 13.3% 12.7% 8.0% 10.1% 11.4% 11.9%

Capital Goods Avg 9.0% 9.2% 8.9% 9.3% 9.6% 10.5% 9.5% 8.8% 9.3% 9.9% 10.9% 11.9% 13.2% 13.0% 10.8% 12.3% 13.6% 14.2%

Due to the dramatic historic changes of portfolio at Invensys we have only included data since 2004 Source: Redburn Partners

One of the striking features of this downturn has been the degree of margin resilience across the sector when compared to previous downturns (with the notable exceptions of Electrolux in 2008 and Sandvik in 2009). What has been so impressive is that this has been achieved in an operationally geared sector during its worst demand downturn since World War II (Fig 26). However, despite an average -11% organic sales decline (Fig 17), we expect the European Capital Goods sector to book a 10.8% clean EBIT margin in 2009.

Looking back before 1995 (i.e. prior to Fig 16) it is perhaps worth noting that, with the exceptions of Alstom in 2002 and SKF in 1992, our entire universe has remained in EBIT profit in each and every year since 1960.





Fig 17: EBIT margins have proven resilient in the face of intense organic sales decline

8.7%

7.1%

9.2%

10.5%9.5%

13.0%14.2%

13.6%

10.1%

8.8%

10.8%12.3%

10.9%12.1%

9.9%9.3%

8.8%

9.6%9.3%8.9%9.0%

5.6% 5.6%

8.3%

8.9%

13.2%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011E

Org

anic

Sal

es G

row

th (

%)

0%

2%

4%

6%

8%

10%

12%

14%

16%

Cle

an E

BIT

Mar

gin

(%)

Sector Average Organic Sales Growth (%) Sector Average Clean EBIT Margin (%)


Sector averages are calculated from our coverage universe (plus Legrand) Source: Redburn Partners

While our forecast for an EBIT margin decline of 2.2% in 2009 is the biggest single-year decline in sector EBIT margin since the 2.6% decline in 1976, when put into the context of the scale of organic sales collapse, it is actually relatively modest.

To understand the degree to which the European Capital Goods sector has improved its operational gearing compared to previous downturns, by distinct management action, we have contrasted 2009 with the only other three years during which the sector experienced an organic sales decline in the last two decades (1991, 1992 and 2002).

Fig 18: Operational gearing in years of sector organic sales decline

Recessionary years 1991 1992 2002 2009

Organic sales decline -4.0% -2.2% -1.3% -11.7%

EBIT margin decline (bp) -160 -64 -68 -221

EBIT margin decline per 1% of organic sales decline (bp) -40 -29 -53 -19


As shown in Fig 18, when taking into account the scale of organic sales growth decline in 2009, EBIT margins have been much more resilient this time. In fact, for every 1% of organic sales decline, sector EBIT margins (pre-restructuring) have only fallen 19bp compared to a range of 29-53bp in past organic downturns.

Much of this report is dedicated to understanding the drivers behind the steady uplift in sector margins of the past two decades and, more importantly, the sustainability of the upwards trajectory. From this analysis we see three factors behind the impressive margin resilience of 2009:

The increasingly variabilised cost base: as discussed in more detail below, wages (which, with depreciation, represent fixed costs) have dropped from 42.4% of sector sales in 1976 to 24.8% in 2008. Furthermore, as the sector has globalised, the proportion of sector costs in emerging markets (where labour unions have little or no presence) has risen from 16% in 1995 to 32% in 2009.

The speed of restructuring actions: in 2008 the sector expensed its largest restructuring provision for 20 years. More importantly, the speed of reaction to the demand drop in this ‘SAP recession’ has far exceeded previous downturns. Over the past 12 months the sector has seen a reduction in headcount of c10%, catching up the revenue drop after only four quarters of lag. Those with the most significant




headcount reductions are currently seeing quarterly savings of 4-5% of sales each quarter. This and more is covered in the restructuring chapter.

The significantly improved pricing power of the sector: core to our sector thesis is the view that our coverage universe has witnessed dramatically favourable changes in the supply-side dynamics of the industries it competes in. We support this view with the empirical evidence that: (1) market shares have increased across most of our companies; and (2) the sector’s key industries have predominantly experienced dramatic consolidation. This is discussed in detail below.

Impressive cash flow management, throughout the downturn

Fig 19: Free cash flow margins have been managed well throughout the downturn

10.7%

14.9%

10.9%

9.4%

11.4%11.9%11.3%

9.2%9.6%

12.2%13.7%

16.8%

0%2%4%6%8%

10%12%14%16%18%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Ope

rati

ng F

CF

as %

of

Sale

s

European Capital Goods, Coverage Average


Record margins during a downturn raise the question: has the sector been over-earning? A simple cash flow analysis suggests this was not the case and, if anything, the reverse has actually happened. As shown above, the sector’s average Operating Free Cash Flow margin (i.e. before cash interest and tax) actually rose in 2009 by 300bp from 11.9% in 2008 to 14.9%. We calculate Net Working Capital/Sales has improved from 21.7% in 2008 to 19.1%, driving a cash conversion of 113% (i.e. Op FCFC/EBIT) for 2009. Companies have not been building inventories to pump margins. They have shown the experience of many prior downturns, by de-stocking and sacrificing near-term margins, in order to generate cash. When investors worry about the sector being cyclical, they should look at this chart to see how well-managed these businesses really are.

Balance sheets are strong and ripe for acquisitions Fig 20: Sector balance sheet is at its strongest for ten years Fig 21: ABB, Invensys and Siemens, the strongest in 2009

0x

1x

2x

3x

4x

5x

6x

2000 2002 2004 2006 2008 2010E

Net D

ebt /

EBI

TDA

European Capital Goods, Coverage Average

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

ABB

Inve

nsys

Siem

ens

Elec

trolu

x

Atla

s Co

pco

Assa

Abl

oy SKF

Schn

eide

r

Alst

om

Sand

vik

2009

Net

Deb

t / E

BITD

A(F

ully

Adju

sted

)

Source: Redburn Partners Source: Redburn Partners




Even taking into account the lower EBITDA margins, the sector finished 2009 with the strongest adjusted net debt/EBITDA for a decade. Comparing this by company, ABB,Invensys and Siemens stand out as having the strongest balance sheets. Looking forward, given the sector balance sheet (and company comments regarding appetite), we believe 2010 will mark a meaningful return to acquisitions. This report discusses how sector margins have benefited from industry consolidation and improved market shares over time. We see acquisitions, in general, and if at the right price, as being value-creative and good for pricing power.

Sector could spend up to €55bn on acquisitions, subject to price

We do not actively forecast acquisitions in our company estimates. However, it is interesting to note that there is potential valuation upside (and downside for that matter) should the sector decide to deploy its balance sheet potential on M&A. We calculate that the sector could afford to spend at least €20bn on acquisitions, and up to €55bn dependent on the ROIC of any transactions.

Peak and trough margins have risen across the past four cycles

Fig 22: Sector average margins during periods of both cycle peak and cycle trough

0%

4%

8%

12%

16%

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Euro

pean

Cap

ital

Goo

ds

Cle

an E

BIT

Mar

gins

(%

)

-15%

-10%

-5%

0%

5%

10%

15%

20%

Sect

or A

vera

ge O

rgan

icSa

les

Gro

wth

(%

)

Trough EBIT Margins Peak EBIT Margins Organic Sales Growth (RHS)



We have shown the degree to which both peak and trough margins have risen across each of the past four economic cycles for the sector and the individual companies in Figs 22, 23 and 24. We have identified the drivers of this rising trend throughout this chapter.

Fig 23: Peak margins have been rising Fig 24: Trough margins have also been rising

0%

5%

10%

15%

20%

25%

ABB

Alst

om

Assa

Ablo

yAt

las

Copc

o

Elec

trolu

x

Sand

vik

Schn

eide

r

Siem

ens

SKF

Clea

n EB

IT M

argi

n (%

)

1988-90 Peak 1994-96 Peak 1999-01 Peak2007-09E Peak 2011E-13E Peak

-5%

0%

5%

10%

15%

20%

ABB

Alst

om

Assa

Ablo

yAt

las

Copc

o

Elec

trolu

x

Sand

vik

Schn

eide

r

Siem

ens

SKF

Clea

n EB

IT M

argi

n (%

)

1991-93 Trough 1996-98 Trough2001-03 Trough 2009E-10E Trough





As a consequence of both the margin resilience in the downturn and the longer-term trend of rising margins, we expect eight out of ten 2010E clean EBIT margins to exceed the ten-year average, the exceptions being SKF and Schneider.

Fig 25: Eight out of ten 2010E clean EBIT margins are forecast to exceed the ten-year average

-5%

0%

5%

10%

15%

20%

25%

Legrand AtlasCopco

Assa Abloy Schneider Sandvik SKF Invensys ABB Siemens Alstom Electrolux

2010

E EB

IT M

argi

ns v

s 10

Yea

r (H

igh,

Low

and

Ave

rage

)

10 Yr Minimum EBIT Margin 10 Yr Maximum EBIT Margin10 Average EBIT Margin 2010E EBIT Margin

We have included Legrand as an 11th stock for comparison purposes Source: Redburn Partners

Long-run margin trends highlight positives

Fig 26: 50 years of European Capital Goods sector average sales growth and EBIT margins

-20%

-10%

0%

10%

20%

30%

40%

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011E

Sale

s Gr

owth

(%)

0%

5%

10%

15%

20%

25%

EBIT

Mar

gin

(%)

Sector Average Sales Growth Sector Average EBIT Margin


European Capital Goods sector comprises our current universe of ABB, Alstom, Assa Abloy, Atlas Copco, Electrolux, Invensys, Sandvik, Schneider Electric, Siemens and SKF Source: Redburn Partners

For this report we have sifted through the historical archives to construct a 50-year retrospective of the European Capital Goods sector. We have compared the sector’s 50-year revenue growth against EBIT margin in Fig 26, and below we have focused on the margin side of the sector’s history, shown in Fig 27.




Fig 27: Annual EBIT margins 1960-2012E Fig 28: Ten-year rolling average EBIT margins 1969-2012E

0%

5%

10%

15%

20%

25%

1960 1970 1980 1990 2000 2010E

Clea

n EB

IT M

argi

n (%

)

Sector Average


0%

2%

4%

6%

8%

10%

12%

1971 1976 1981 1986 1991 1996 2001 2006 2011E

10 Y

r Rol

ling

Aver

age

EBIT

Mar

gin(

%)

Sector Average

1970s and 1980s saw sector margins deteriorate f rom rising energy costs, Japanese compet it ion, increasing interest rates and trade union power

1990-08 margins rise from industry consolidat ion, globalisat ion of demand, disenfranchisement of labour and variabilisat ion of cost base

1950s and 1960s - Keynsian growth f rom government st imulus

Source: Redburn Partners and company data Source: Redburn Partners and company data

In order to smooth out the cycle and annual volatility in EBIT margins we have looked at ten-year rolling average EBIT margins. This analysis is intended to represent a picture of ‘through-cycle’ or ‘sustainable’ margins, and is shown in Fig 28.

Sector analysts often claim that the European Capital Goods sector margin has been on a long-run rising trend and that the 2007 peak performance represented an all-time record. This is not the case, and while 2007 may have represented a 20-year EBIT margin peak at 13.2%, the sector achieved higher in the 1960s and 1970s, with peaks of 15.9% in 1974 and 19.1% in 1960

Does this suggest the ‘natural’ peak to margins is higher than the recent 2007 peak? Not necessarily, but based on our analysis in this report we believe margins will reach new peaks and, more importantly, that the 20-year improvement in sector margins is structural and sustainable until the China threat plays out (see below).

Why we believe sector margins will soon reach a new peak

As shown in our through-cycle analysis in Fig 28, we have identified a 40-year margin trend with three distinct periods of profitability. We have addressed each period in turn below.

1962 to 1974 – margin expansionThroughout the 1950s and 1960s, economic growth (and therefore sector margins) benefited from expansionary Keynesian policies where governments borrowed heavily to invest during downswings to stimulate their economies and prevent unemployment (not too dissimilar to today). From 1962 to the peak in 1974, sector EBIT margins lifted from 8.3% in 1962 to 15.9%. Revenue growth averaged a very high 15% throughout the same period.

1974 to 1992 – margin compressionThis 18-year period saw annual sector EBIT margins fall from a peak of 15.9% in 1974 to 5.6% in 1992 (the lowest margin in the past 50 years). We attribute this period of margin compression to the following factors:

1970s – energy price/general cost inflation: the excess liquidity and government spending of the 1950s and 1960s led to heavy inflation in energy-dependent industries such as steel, pulp & paper, mining, textiles and shipbuilding, which all saw profitability fall continually with oil prices rising exponentially until 1980.




1960s, 1970s and 1980s – labour unions strengthen: membership peaked across Europe in the late 1970s. This shift in power from management to the shop floor had a negative effect on sector margins throughout the 1970s and into the 1980s.

Fig 29: Trade union density (%) of selected OECD countries, 1960-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Trad

e un

ion

dens

ity

(%)

France Germany JapanSweden United Kingdom United States

Source: OECD

1970s and 1980s – Japanese competition: as the domestic Japanese growth story slowed, Japanese industry (especially shipbuilding, automotive and bearings) increased exports. Government subsidies, and the artificially undervalued yen, gave them a substantial c30% production cost advantage which they used to dump volume.

1980s – interest rate hikes: Reagan and Thatcher switched from Keynesian to Monetarist policies to combat inflation, which had overtaken unemployment as the perceived primary economic evil. Average Western rates of 10.1% in 1980s limited capex investment across most industries, driving lower growth for the European Capital Goods sector.

1989-92 – the end of the Cold War/the first Gulf War: the disruption of German re-unification coincided with the first Gulf War, which both contributed to the sharp downturn in demand in 1991 and 1992.

1992 to 2007 – margin expansion, rising peaks From the trough of 5.6% in 1992, annual sector EBIT margins lifted meaningfully over the following 15 years to 13.2% in 2007. A similar analysis of a comparable list of US Capital Goods companies over the same period confirms a similar picture, with EBIT margins lifting from 6.2% in 1992 to 11.5% in 2007. While we address each in turn, we identify five key factors behind this margin expansion:

1 A significant improvement in pricing power

2 The disenfranchisement of labour

3 The variabilisation and globalisation of the cost base

4 Increasing service and aftermarket content

5 Portfolio optimisation




(1) A significant improvement in pricing power (1990s and 2000s) Our supply-side analysis (which is detailed in a separate chapter) supports our belief that aggregate pricing power across the European Capital Goods sector has improved significantly over the last decade or so. Our core thesis is that through both industry consolidation and increased market shares, the sector has seen pricing power and margins improve across a number of industries served by the sector. Furthermore, given the sector constituents have improved their respective positions within these improving industries, we believe sector pricing power will remain robust throughout the current downturn and following recovery, and that through-cycle sector margins will continue their longer-term rising trend.

(2) The disenfranchisement of labour (1990s and 2000s)

Fig 30: 1965-2009 wages as a % of sales, from 42.4% in 1976 to 24.8% in 2008

0%

10%

20%

30%

40%

50%

60%

70%

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

E

Pers

onne

l Exp

ense

as

% o

f Sal

es

ABB Alstom Assa Abloy Atlas CopcoElectrolux Invensys Legrand SandvikSchneider Siemens SKF Sector Average

Source: Redburn Partners and company data

As shown in Fig 30, we calculate the European Capital Goods sector saw a staggering 1,759bp drop in personnel expense as a percentage of revenues from 42.4% in 1976 to 24.8% in 2008. This disenfranchisement of labour has undoubtedly helped longer-term ‘through-cycle margins’ but has also helped to variabilise the cost base of the sector.

In addition to lowering costs and improving margins, this transformation of the cost base over the last few decades has materially lowered the sector’s operational gearing and partly explains the relative resilience of margins in this recent downturn.

The move to low-cost countries has kept a lid on wage inflation

Throughout the last industrial boom (2002-08), sector margins have been massively supported by relatively benign wage inflation. Having calculated the average wage cost per employee for each company between 1991 and 2008, we can see this evaporation of wage inflation empirically in Fig 31.




Fig 31: Recent wage inflation per employee has been less than historically

-4%-2%0%2%4%6%8%

10%12%14%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009Aver

age

wag

e In

flatio

n pe

r Em

ploy

ee (%

)

Sector Average

Data is available for all companies except ABB post 1999 Source: Redburn Partners

We calculate that between 1991 and 2001 average annual wage inflation per employee was 5.0%. This same metric was only 0.6% between 2002 and 2008. This relative saving has largely dropped through and combines with improved pricing power and growth as a major contributor to improved sector margins.

Fig 32: Schneider, Atlas Copco, Assa and Electrolux have managed wage inflation best

2.3% 2.1%

1.5% 1.3%

0.3%

-0.1% -0.1%-0.7%

-1.1%-2%

-1%

0%

1%

2%

3%

Alstom SKF Siemens Sandvik Legrand Electrolux Assa Abloy AtlasCopco

Schneider

Wag

e in

flat

ion

(per

em

ploy

ee),

20

02-0

8 av

g.

Data is available for all companies except ABB Source: Companies

At the company level, all have done a good job in absolute terms, but there has been a range in relative performance.




(3) The variabilisation and globalisation of the cost base

Fig 33: Schneider and Assa shifted the manufacturing footprint most since 1995

0%5%

10%15%20%25%30%35%40%

AssaAbloy

Schneider ABB Legrand Sandvik AtlasCopco

Electrolux Siemens SKF Alstom Cha

nge

in %

of

Empl

oyee

s in

Em

ergi

ng M

arke

ts (

2008

vs.

19

95 a

nd 2

003)

2008 vs. 1995 2008 vs. 2003


This shifting of the manufacturing footprint to low cost, also referred to as globalisation, is shown in Fig 33. For the Swedes, globalisation is nothing new; for the rest of the world, true globalisation was spurred by the end of the cold war, technology and deregulation.

Fig 34: Share of sector revenues to emerging market lifted from 23% of in 1995 to40% in 2009

0%10%

20%30%

40%50%60%

70%80%

90%100%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009E

Sect

or S

ales

by

Geo

grap

hy o

fD

esti

nati

on (

%)

North America W. Europe E. Europe South America Asia RoW


Globalisation has changed the face of the European Capital Goods sector in a number of ways. From a demand perspective the share of sector revenues heading to emerging markets has lifted materially from 23% of total sector sales in 1995 to 40% in 2009, as shown in Fig 34.

But it’s the geographical shift in the cost base that’s helped margins

The cost base is so often ignored in equity analysis, but with respect to the dramatic globalisation story of the last decade it has not just been the shift in demand to emerging markets that has changed dramatically but also the cost base.




Fig 35: The manufacturing footprint has globalised as well as demand, the proportion of sector costs in emerging markets have risen from 16% in 1995 to 32% in 2009

0%10%

20%30%

40%50%60%

70%80%

90%100%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009ESect

or C

osts

by

Geo

grap

hy o

f O

rigi

n(%

)

North America W. Europe E. Europe South America Asia RoW


Fig 35 highlights the degree to which the sector has globalised its manufacturing footprint to low-cost countries, especially over the last decade, notably to Asia, Eastern Europe and Latin America. To put this in perspective, the proportion of sector costs in emerging markets has risen from 16% in 1995 to 32% in 2009. We see this as a crucial distinction.

Fig 36: The sector now exports less out of Europe

5.5%6.2%

7.4%7.1%6.7%

7.9%8.8%8.9%

9.6%

0%

4%

8%

12%

2000 2001 2002 2003 2004 2005 2006 2007 2008

Prop

orti

on o

f gr

oup

sale

s ex

port

ed o

ut o

f Eu

rope

(%

)

European Capital Goods Sector Average


Since 2000 the sector has managed to move the proportion of costs to low-cost countries even faster than revenues. While the sector is still a net exporter out of Europe (giving it a natural $/€ currency transaction exposure), as shown in Fig 36, the degree of export has been materially reduced from 10% of sector sales in 2000 to 6% in 2008. This shift is all the more impressive when considering the speed of emerging markets growth compared to the West.

This transference of the manufacturing footprint to low-cost countries has driven the twin benefits of reducing the natural currency exposure and lowering relative costs across most companies. In addition to being lower cost, emerging market labour is also materially more variable, with limited or no labour union presence. Consequently, globalisation has benefited both through-cycle margins and margin resilience in the downturn.




Fig 37: Global geographic sector map, comparing imports and exports

--- Western Europe --- --- North America --- -- Emerging markets --

2009

Salesby

destination

Salesby

origin

Import/export(+/-)

Salesby

destination

Salesby

origin

Import/export(+/-)

Salesby

destination

Salesby

origin

Import/export(+/-)

ABB 32% 43% -11% 12% 9% 3% 57% 49% 8%Alstom 48% 66% -18% 16% 15% 0% 36% 19% 18%

Assa Abloy 43% 33% 10% 38% 23% 15% 19% 44% -25%

Atlas Copco 31% 41% -10% 19% 14% 5% 50% 45% 5%

Electrolux 31% 38% -7% 37% 28% 9% 32% 34% -2%

Invensys 44% 42% 2% 33% 31% 2% 23% 27% -4%

Legrand 59% 58% 1% 16% 15% 1% 25% 27% -2%

Sandvik 34% 50% -15% 17% 13% 4% 48% 37% 12%

Schneider 34% 37% -2% 28% 24% 5% 38% 40% -2%

Siemens 40% 52% -11% 20% 21% -1% 39% 27% 12%

SKF 50% 58% -7% 17% 11% 7% 33% 32% 1%

Where available we have used sales by origin data, where unavailable we have used employees by geography as a proxy. We have removed Eastern European and Russian exposure from Europe into emerging markets Source: Redburn Partners and company data

In Fig 37 we have shown the current geographic status quo for the European Capital Goods sector by comparing the 2009 geographic demand footprint (sales by destination) with the 2009 geographic manufacturing footprint (sales by origin) for each company. This highlights that Alstom, Sandvik, Siemens, ABB and Atlas Copco all still face a double-digit percentage export out of Europe and therefore the highest natural transaction exposures, which some (e.g. Alstom) managed by sourcing in dollars and others hedge.

(4) Increasing service and aftermarket content We calculate aftermarket and service revenue will make up c46% of sector revenues in 2009. We estimate this has increased from 39% in 1999.

Fig 38: 1999 split of sector revenue by type Fig 39: 2009 split of sector revenue by type

Aftermarket, spares,

consumables, service, etc

39%

Equipment61%

Equipment54%

Aftermarket, spares,

consumables, service, etc

46%

Source: Companies Source: Companies

Aftermarket revenues tend to be more profitable and service revenues tend to have a higher ROIC than original equipment business.




Fig 40: 2009 split of revenues by aftermarket vs OEM, ranked by OEM

0%

20%

40%

60%

80%

100%

Inve

nsys

Schn

eide

r

Atla

sCo

pco

Alst

om

ABB SKF

Siem

ens

Sand

vik

Legr

and

Assa

Ablo

y

Elec

trolu

x2008

Sal

es E

xpos

ure

(by

Type

)

Aftermarket, Spares, Service, etc Original Equipment


Based on management comments (as aftermarket margins are often a closely guarded secret), we calculate aftermarket and service EBIT margins average c15% and OEM margins average c7%. From this, we calculate underlying EBIT margins have enjoyed a 0.6% increase between 1999 and 2009, solely due to the improved aftermarket vs OEM mix.

(5) Portfolio optimisation In addition to labour capacity reduction, globalisation, industry consolidation, market share gains and the increase in aftermarket mix, margins have also (in general) been improved by portfolio adjustments across the various companies from both acquisitions and disposals.

At one extreme lies Siemens, where we calculate 41% of 2001 group revenues have now either been exited or JV’d (mostly telecom- and technology-related businesses). Over the same period clean (pre-restructuring) EBIT margins lifted from 2.6% to 11.7%. We calculate 5% of the 9% margin improvement was down to portfolio mix alone.

At the other extreme lies Schneider and Assa Abloy, which have both been heavily acquisitive. Assa Abloy has lifted revenues tenfold from SKr3.5bn to SKr35bn since 1995 through 109 acquisitions, which make up c83% of current group revenues. This process has driven 7% of the 9.5% increase in clean EBIT margins from 7.5% in 1995 to c16% in 2009.

Schneider Electric, on the other hand, has made 42 (announced) acquisitions since 2003, excluding the recently announced acquisition of Areva D (€1.7bn sales). We calculate that collectively these acquisitions contributed c€9bn to 2009 revenues, which represented c44% of group revenues. Unlike Assa Abloy and Siemens, Schneider Electric has not meaningfully moved margins through its portfolio change, as these acquisitions had an aggregate EBIT margin of 11% (at the time of acquisition) which is similar to the group level. However, the effect of synergies has added c2% to the acquired businesses and c1% to the group.

Having analysed c400 acquisitions and disposals over the last decade across our universe of ten stocks, we crudely estimate margins have increased by 0.7% since 1999 purely as a result of M&A and portfolio mix changes. As such, when comparing margins over time, it is important to remember the comparison is not like-for-like.




2010-20E: the next chapter for margins So that’s the history. Looking to the all-important future, why do we forecast new peak margins (since 1974) in 2011E and 2012? Most of the arguments pertaining to future margin potential are covered in the following chapters, however, in sum, there are four factors underpinning our confidence that margins will reach new peaks.

(1) Further pricing power improvements from continued consolidation We believe the sector’s continued improvement, with respect to the supply-side dynamics of increasing industry consolidation and increasing market shares over the last decade (see supply-side chapters), is structural, sustainable and in several instances has more to play out.

From our nine industry chapters, we identify five recent M&A transactions, which collectively concentrate their respective industries by a significant 4-5% and, where conducted by sector constituents, will improve market shares.

Transmission & distribution industry to benefit from Schneider’s (5% global market share) imminent acquisition of Areva’s distribution business (4% global market share), which we expect to complete by the end of 1H10E.

Lock industry to benefit from the formation of a global number three lock manufacturer through the merger of Black & Decker (4% global market share) with Stanley Works (7% global market share) following completion expected in April 2010E.

Mining equipment industry to benefit from Bucyrus’ (7% global market share) recent move to acquire Terex Mining (7% global market share), which completed in February 2010, creating a new global top three manufacturer.

Metal cutting tools industry to benefit from Iscar-IMC’s (global number three with a 10% market share) recent acquisition (September 2008) of global number eight, Tungaloy (with a 3% market share), to move ahead of Kennametal as the world’s second largest player.

‘Positive displacement’ compressor industry to benefit from Atlas Copco’s (global number 1 with 31% market share) imminent acquisition of global number six, Quincy Compressor (with a 4% market share), expected March 2010.

We expect these acquisitions to further benefit the sector’s pricing power and margins in 2010 and 2011. Beyond this we expect further pricing power benefits from future acquisitions. As we have already indicated, we expect the pace of sector-based acquisition activity to increase in 2010.

(2) Structural permanency of aftermarket and portfolio mix improvements We calculate half (1.3%) of the 2.7% increase in sector EBIT margins from the 2000 peak to the 2007 peak came from both increased aftermarket mix and improved portfolio mix. This change is structural and flatters the optical improvement in sector margins, across the cycle, as the base of comparison is not like-for-like. As a result, however, investors should worry less about the sustainability of the sector’s higher margins. This is core to our belief that sector margins will reach a new peak in 2011E.




(3) 2010 cost savings from sector capacity reductions In 2009, the sector reduced its headcount by c10% (see restructuring and cost savings chapter). Wages are the most significant fixed cost in the sector, at six times the cost of depreciation and amortisation. We calculate these capacity reductions have yet to fully benefit the P&L of the sector, and we expect a further cost-savings benefit (of 1.5% of sales) in 2010E. We see evidence that managements have managed the downturn well and rebased the sector’s cost base. In the medium term margins will also benefit from this unprecedented capacity reduction (beyond the near-term savings) as management will largely re-fill manufacturing capacity (when needed) in emerging markets, furthering the globalisation and variabilisation of the cost base.

(4) Demand growth from emerging markets and infrastructure end markets In addition to pricing power, mix improvements and capacity reductions, our optimistic view on margins is also demand-related. Despite the other compelling arguments, without volume growth it is fair to say that sector margins will not reach new highs. We expect 1% organic sales growth in 2010E and 6% in 2011E. Our forecast recovery is driven by the sector’s exposure to emerging markets and infrastructure end markets (see demand chapters for detail).



Margins (2): supply side – improved pricing power

We have undertaken a thorough benchmarking of the competitive landscape of each of the largest 11 industries served by our sector. Our analysis suggests company margins are highly correlated with market shares and industry margins are highly correlated with industry concentration. We see clear evidence that sector pricing power has improved over time, with sector prices materially exceeding US and European producer prices during the downturn so far. In combination with the nimble restructuring actions of the last year or so, we attribute much of the current sector margin resilience to this improvement in pricing power.

Our core sector thesis is that both (1) industry consolidation and (2) increased market shares have driven this improvement in pricing power and that prices will remain more robust throughout this downturn than during any of the past 30 years. Consequently, we expect through-cycle sector margins to continue their long-term rising trend and achieve even higher peak margins (on average) during the next boom phase.

Fig 41: Supply-side scorecard (‘overall weighted score’ is a key factor of our ‘overall scorecard’ shown in Fig 15)

Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Data Rank Quartile Score Rank Quartile

ABB Automation, T&D 43% 7 3rd 14% 3 1st 15% 5 2nd 9% 2 1st 2% 2 1st 2.4 2 1st 3.7 2 1st

Alstom Power Gen, Rail 57% 2 1st 10% 6 3rd 10% 8 3rd 8% 6 3rd 4% 1 1st 1.6 4 2nd 4.2 4 2nd

Assa Abloy Locks 54% 4 2nd 29% 1 1st 24% 1 1st 13% 1 1st 2% 4 2nd 4.2 1 1st 2.2 1 1st

Atlas Copco

Compressor, Mining Eq. 58% 1 1st 14% 2 1st 22% 2 1st 9% 3 1st 1% 7 3rd 1.0 7 3rd 3.9 3 1st

Electrolux Appliances 54% 3 1st 7% 10 4th 13% 6 3rd 6% 7 3rd 0% 9 4th 0.0 10 4th 7.3 8 3rd

Invensys Automation, Rail 24% 10 4th 9% 8 3rd 5% 11 4th 5% 10 4th -1% 10 4th 0.3 9 4th 9.8 10 4th

Sandvik Cutting Tools, Mining Eq. 44% 6 3rd 13% 4 2nd 20% 3 1st 8% 5 2nd 2% 5 2nd 0.9 8 3rd 5.3 6 3rd

Schneider T&D, Automation 24% 9 4th 8% 9 4th 5% 10 4th 5% 9 4th 1% 8 3rd 2.0 3 1st 7.8 9 4th

SiemensAutomation, T&D, Power Gen, Health, Rail

39% 8 3rd 9% 7 3rd 13% 7 3rd 8% 4 2nd 2% 6 3rd 1.5 5 2nd 6.3 7 3rd

SKF Bearings 52% 5 2nd 10% 5 2nd 19% 4 2nd 5% 8 3rd 2% 3 1st 1.4 6 3rd 4.9 5 2nd

Scorecard Weighting 20% 20% 100%

2009 Global Average Market

Share (of measuredassets in measured

industries)

2000-2008 Average Industry Annual Price Increase

20%

2008 Global Market Concentration (% share of Top 5) of Average Industry

Industries included in

this report to calcuate average

industry data

Overall Weighted Score

China positioning (Share vs. Local

Top 3) adjusted for threat and

concentration

20%

2008 vs. 1997 Change in Global

Top 5 Concentration of Average Industry

1996-2008 Global Industry Average

EBIT Margin

10% 10%


A summary of our findings is shown in our supply-side scorecard in Fig 41 above. We have ranked our companies on six criteria and then attributed weightings of importance to various categories to drive an overall score. This highlights Assa Abloy, ABB, AtlasCopco and Alstom as being the best positioned in industries with strong pricing power.

Since 1997 the average market share of the largest five manufacturers across each of the 11 industries has lifted from 41.9% to 55.2%, and the average weighted market share of our sector has increased from 8.5% to 13.1%. Looking forward there have been a number of significant consolidatory acquisitions by our companies and their competitors (Bucyrus/Terex, Black & Decker/Stanley Works, Schneider/Areva D, Iscar/Tungaloy and Atlas Copco/Quincy Compressor) which will, in combination, by 2011 raise the average top five concentration





(by a further 1.8%) to 57.0% and the sector’s average market share (by a further 70bp) to 13.8%.

China threat Low-cost emerging market competition (predominantly from China) represents one of the most significant competitive threats to the sector’s (relatively attractively positioned) status quo of improved pricing power and margins. Our analysis suggests the threats differ widely by industry and by taking into account both market concentration and relative positioning of the Europeans compared to the locals, the Chinese healthcare, locks and T&D industries are the most favourably positioned (from the perspective of the Europeans) and the appliance, power generation and rail equipment industries are relatively unfavourably positioned.

Looking forward we believe industrial barriers to entry will determine the degree of future threats. In this regard cutting tools, locks, compressors, bearings, rail, T&D, and power generation face relatively limited threats compared to the appliances industry. We distinguish two types of threat: (1) the more immediate threat of losing exposure to Chinese growth, and (2) the longer-term threat of losing market share outside of China from Chinese exports (this has already happened in the appliance industry).

Benchmarking approach

Fig 42: Industry matrix; % of 2009 revenue by industry pillar

Automation T&D Power

gen Healthcare Appliances Rail Mining & constr. Bearings Compressors Locks

Cutting tools Other

ABB 48% 51% 1%

Alstom* 17% 59% 25%

Assa Abloy 100%

Atlas Copco 41% 53% 6%

Electrolux 100%

Invensys 33% 31% 35%

Legrand 100%

Sandvik 48% 27% 25%

Schneider* 31% 27% 43%

Siemens 27% 12% 22% 16% 6% 17%

SKF 100%

* Alstom and Schneider have been pro-rata’d as if T&D units were included from 1 January 2009 Source: Redburn Partners

Given the complexity of the European Capital Goods sector it is more time efficient to focus analysis on the demand side of the sector equation than the supply side. Consequently, the majority of sector research tends to centre on the demand drivers of end markets and geographic regions. While a demand-side approach is entirely valid (and we have done the same in the demand chapters of this report), demand is notoriously difficult to forecast and it only offers part of the equity story as it completely fails to capture the all-important dynamics of industry pricing power and associated margin resilience.

While some of this can be established through an analysis of the cost base (see the next chapter, ‘price and raw material cost inflation’), pricing power is best analysed using a thorough benchmarking of the competitive landscape. In some sectors (e.g. Automotive, Food Retail, Tobacco) this exercise is relatively straightforward, if all the sector constituents cross-compete, however (as shown in Fig 42), in the heterogeneous Capital Goods sector there are often only one or two sector constituents in a single industry. Despite being a hugely labour-intensive exercise, we have conducted a thorough competitive benchmarking of each industry.




Our proprietary analysis suggests that 11 industries represent 85% of the sector’s combined revenues (€181bn across our universe), other key industries in the remaining 15% of sales include low voltage wiring devices (Legrand), lighting (Siemens) and stainless steel seamless tubes (Sandvik).

Fig 43: €181bn sector revenue (2008) re-sorted by industry exposure and ranked by size

05,000

10,00015,00020,00025,00030,00035,00040,00045,000

Auto

mat

ion

T&D

Pow

er G

en

Heal

thca

re

Appl

ianc

es

Rail

Min

ing

&Co

nstr.

Bear

ings

Com

pres

sors

Lock

s

Cutti

ngTo

ols

Othe

r

Sect

or R

even

ues

by I

ndus

try

(€ m

n)

Source: Redburn Partners based on industry sources and company data

For each benchmarking exercise, we have analysed 15 years of orders, sales, organic order growth, organic sales growth, volumes, prices, clean EBIT margins, capex, depreciation, total assets and employee count (where available) for each of the key competitors in each industry.

Across our 11 industries, our benchmarking exercise has identified and analysed 147 companies (including the 11 in our universe). From this and other sources we have created annual market and market share data by industry for the same 15 years. From this we have been able to study industry concentration (measured as collective market share of the top five players) as well as volume growth, price, margins and other metrics. Perhaps more importantly, we have also been able to study how these metrics have changed over time.




Fig 44: Industry participants used in benchmarking, ranked by 2009 market share

Automation T&D Power generation Healthcare Appliances Rail Mining & Constr. Bearings Compressors Locks Cutting tools

Siemens (IA, DT and BT) ABB (PP & PS) GE (E) GE (H) Whirlpool Bombardier (T) Sandvik (SMC) SKF Atlas Copco (CT) Assa Abloy Sandvik (T)

ABB (AP & PA) Siemens (PT & PD) Siemens (FPG, O&G, R) Siemens (H) Electrolux Alstom (T) Atlas Copco (CMT) Schaeffler Dresser Rand Ingersoll Rand (ST) Kennametal (MSSG)

Johnson Controls (BE) Areva (T&D) Alstom (P) Philips (H) BSH Siemens (Rail) Metso (MCT) NSK GE (O&G’s C) Stanley Works (SS) Iscar-IMC

Honeywell (A&C) Alstom (T) MHI (PS) Roche (D) LG (DA) China South Joy Global Timken MAN Turbo Dorma MMC

Emerson (PM & IA) Schneider Electric (MV) Hitachi (PS) Abbott (D) Panasonic (HA) GE (T) Bucyrus NTN Gardner Denver Kaba Sumitomo Elec. (C)

Schneider (IC&A) GE Shanghai Elec. (PE) McKesson (T) Samsung (DA) China Northern Terex (MP&M) JTEKT Ingersoll Rand (AS) Black & Decker (H) Seco Tools

Rockwell Automation Toshiba BHEL Beckman Coulter GE (A) CJSR Transmashholding FLSmidth Siemens (DD) OSG

Yokogawa Mitsubishi Harbin Power Becton Dickinson Arçelik Trinity (R) Boart Longyear (DP) Kaeser Tungaloy (Pre-Iscar)

Regal Beloit China XD Group Donfang Elec. Varian (O) Indesit Patentes Talgo Furukawa (RD) Cameron (CS) Hunan Nonferrous (CC)

Fanuc (FA) TBEA Doosan Heavy (P&N) Cerner Miele Vosshloh Astec (A&M) Enpro (Quincy) Kyocera (CT)

Baldor Crompton Greaves Babcock & Wilcox (PG) bioMérieux Sharp (A) Ansaldo (S) Sullair (UTX HS I)

Yaskawa (MC) JAEPS (Hitachi) Solar Turbines (CAT) William Demant Fagor CAF Busch (V&P)

SEW Baoding Tianwei Foster Wheeler (PG) Sonova DeLonghi Thales (S) Bristol Compressors

Invensys (OP) SPX (Waukesha) Rolls Royce (E) Elekta Candy Hyundai Rotem Ariel

Converteam Guangdong Macro OJSC Power Machines GN ReSound Haier Invensys ® Edwards (V)

Hansen Henan Pinggao Eclipsys Stadler (TS)

XJ Electric TomoTherapy

EMCO Accuray

Shanghai Siyuan

Sanbian

If group data is not used then the initials of the division (or subdivision) used is shown in parentheses. Since the time of writing Alstom and Schendier have agreed to co-acquire Areva’s T&D assets, Black & Decker has agreed to merge with Stanley Works and Atlas Copco has agreed to acquire Quincy. However, as all of these will close in 2010 we have retained them in our analysis Source: Redburn Partners

The companies (or divisions/subdivisions) used in our benchmarking are shown in Fig 44 above, which highlights the complexity of remaining ‘on top’ of each industry contributing to capital goods.

Why bother? It’s all about understanding pricing power Anyone who has ever bridged an EBIT from one period to the next will know the importance of price. Unlike volume and other effects, price drops straight through to the bottom line and is a hugely powerful determinant of margins (both ways). Price and pricing power was ultimately what Michael E. Porter of Harvard was driving at when he identified those five infamous forces in his Industrial Organisation (IO) economic theory. Given its importance, we have dedicated much of this report to understanding the pricing power for each of the industries served by the European Capital Goods sector.

Pricing power is a subjective concept, driven by a number of factors such as brand, the competitive landscape, customer and supplier concentration and barriers to entry. For any particular industry, business line or product item the degree to which one factor may determine pricing power is difficult to predict, but there is one particular group of determining factors that consistently dominates, that of market concentration and market share. Ideally, one can take this further by looking at relative market concentration, which also takes into account the degree of consolidation of both suppliers and buyers. For instance, the ideal position would be a monopoly that buys off a heavily fragmented supplier base and sells to a heavily fragmented customer base.

Another way to consider pricing power is to look at historic returns and pricing. One might expect industries with super-normal pricing power to have high margins and demonstrate annual price increases even during periods of volume decline. By benchmarking margins and pricing data (in relation to volumes) these factors can be measured retrospectively.




Both (1) market concentration and (2) margins and achieved prices (relative to volumes) form the basis of industry-by-industry benchmarking work below. We have also analysed the degree of emerging market competition in each industry (predominantly a study on China).

Fig 45: Overview of industry by industry competitive landscape benchmarking analysis

Industry Company

2008sector

sales tothe

industry(€m)

2008global

marketsize

(€m)

2008 globalmarket

concentration(% shareof top 5)

2008 vs 1997change in

globaltop 5

concentration

1996-2008

globalindustryaverage

EBITmargin

Globalindustrymargin

progression(2004-08 EBIT

margin vs1996-2000)

2004-08global

industryaverage

incrementalmargin

2000-08averageannual

priceincrease

2009average

priceincrease

2000-08averagevolumegrowth

2009averagevolume

increaseAutomation Siemens,

ABB, Schneider,Invensys

41,506 223,000 27.9% +14.7% 10.1% +1.6% 21.3% -1.0% -1.0% +3.7% -11.4%

T&D ABB, Alstom, Siemens, Schneider

29,452 55,000 56.5% +12.3% 7.2% +3.1% 18.1% +5.3% -8.7% +7.3% +1.9%

Power gen Siemens, Alstom

27,355 100,000 60.8% +7.3% 9.1% +4.7% 8.9% +6.0% -2.4% +6.7% -20.4%

Healthcare Siemens 11,170 72,000 54.2% +9.0% 13.3% +3.8% 23.4% +0.2% -0.5% +6.3% -1.1%

Appliances Electrolux 10,872 89,225 54.5% +7.0% 5.9% -2.5% -20.3% -0.4% +2.6% +3.5% -10.8%

Rail Alstom, Siemens

9,949 50,000 46.7% +13.7% 4.0% +2.5% 17.9% -1.5% -1.0% +2.8% +9.0%

Mining & constr.

Sandvik,Atlas Copco

7,250 22,686 61.0% +20.5% 7.8% +5.5% 17.1% +2.0% +1.8% +12.6% -26.8%

Bearings SKF 5,184 28,873 63.9% +12.2% 6.5% +1.0% 13.6% +2.4% +4.2% +3.8% -23.9%

CompressorsAtlas Copco 3,670 14,281 62.6% +11.7% 10.5% -0.1% 46.3% +1.3% +1.0% +12.6% -28.3%

Locks Assa Abloy 3,601 15,000 53.6% +29.1% 12.6% +1.7% 17.1% +1.9% +1.2% +1.7% -12.2%

Cutting tools Sandvik 2,679 11,343 57.6% +14.3% 14.8% +2.2% 30.5% +3.0% +2.0% +3.4% -37.3%


Industry concentration

Fig 46: ‘Top five’ market share concentration for each of 11 industries

0%

10%

20%

30%

40%

50%

60%

70%

80%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Top

5 Co

ncen

tratio

n (M

arke

t Sha

re) Automation

T&D

Fossil Power Generation

Healthcare Equipment

Appliances

Rail Equipment

Mining & Construction Equipment

Bearings

Compressors

Locks

Cutting Tools


With the exception of the appliance industry, where the degree of emerging market competition has led to de-consolidation, all of the other key ten industry pillars in the European Capital Goods sector have seen industry consolidation of varying degrees over the last decade or so.




Fig 47: Average ‘top five’ market share concentration across all 11 industries

30%

35%

40%

45%

50%

55%

60%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Mar

ket s

hare

of T

op 5

by

Indu

stry

(a

cros

s al

l Ind

ustri

es)

Calculated as a simple average (unweighted) of all 11 industries’ annual concentration of top five market share Source: Redburn Partners

On average, the 11 industries in our analysis have seen the collective market share of their top five players consolidate by a further 13% over the last decade or so. In 1996, the average concentration of the largest five manufacturers in each industry was 41.9% and it has lifted to 55.2% as shown in Fig 47. Looking forward, the effect of the five current significant industry concentrating acquisitions (outlined in the previous chapter), will take this further to an attractive 57.0% in 2011 (assuming no further acquisitions, which we believe is conservative).

Fig 48: 2008 global market concentration (collective % market share of top five players by industry)

Fig 49: 1997 global market concentration (collective % market share of top five players by industry)

0%

10%20%

30%40%

50%60%

70%

Bear

ings

Com

pres

sors

Min

ing

&Co

nstr.

Pow

er G

enCu

tting

Tool

sT&

D

Appl

ianc

es

Heal

thca

re

Lock

s

Rail

Auto

mat

ion

2008

Glo

bal M

arke

t Con

cent

ratio

n(%

sha

re o

f Top

5)

0%10%20%30%40%50%60%70%80%

Min

ing

&Co

nstr.

Pow

er G

en

Appl

ianc

es

Bear

ings

Heal

thca

re

Com

pres

sors

Cutti

ngTo

ols

T&D

Rail

Lock

s

Auto

mat

ion

1997

Glo

bal M

arke

t Con

cent

ratio

n(%

sha

re o

f Top

5)

Source: Redburn Partners based on multiple company and industry sources Source: Redburn Partners based on multiple company and industry sources

While the bearing industry leads the pack with its top five players making up 64% of its market, 9 out of the 11 industries have a top five concentration of over 50%, with only automation appearing anything other than heavily consolidated.

Automation is a nebulous industry with a number of sub-industries and is quite difficult to define with wide ranging estimates from the companies and consultants (ARC (Automation Research Corporation), etc). As such, our concentration data for automation should probably be taken with some circumspection. The average size of our 11 industries is €62bn and automation is the biggest at €223bn (over twice the size of the second largest). In reality automation is a catch-all term for a number of markets that could easily be divided into three more specific categories: building automation (HVAC (Heating Ventilation and Air Conditioning) oriented), factory automation (PLC (Programmable Logic Controller) oriented) and process automation (DCS (Distributed Control Systems) oriented). Having said all this, automation remains one of the more fragmented industries and perhaps one of the more susceptible to pricing pressure.




Given its scale (i.e. nearly a quarter of sector revenues) automation remains a drag on the industry attractiveness of the sector and those participants (ABB, Invensys, Schneiderand Siemens).

Automation aside, it may surprise some just how consolidated the industries of the European Capital Goods sector are, and by logical extension just how much this embeds a high degree of pricing power into the sector. Evidence (shown in the last and next chapters) shows pricing and margin resilience in the sector have all improved over the past 20 or 30 years, we believe the degree of concentration throughout the sector’s industry pillars and perhaps more importantly the degree to which that concentration has improved further over the last decade are intrinsically key to the improved level of returns and pricing power in the sector.

Looking forward we have identified a number of significant, industry consolidating acquisitions (see previous chapter) that have either just been, or are about to be, completed, and that will improve aggregate sector pricing power beyond the current level to a new peak. This is an important pillar supporting our belief that sector margins will achieve new peaks in 2011E and 2012E. Beyond this, if consolidation continues, then margins (which are very driven by market share and industry consolidation) could continue to lift beyond 15%.

Fig 50: 2008 vs 1997 industry concentration change (increase/decrease in collective share of top five players by industry)

-5%0%5%

10%15%20%25%30%35%

Lock

s

Rail

Com

pres

sors

T&D

Cutti

ngTo

ols

Bear

ings

Heal

thca

re

Min

ing

&Co

nstr.

Auto

mat

ion

Pow

er G

en

Appl

ianc

es

Con

cent

rati

on c

hang

e: T

op 5

sha

re20

08 v

s. 1

997

by I

ndus

try

Source: Redburn Partners based on multiple company and industry sources

Top five concentration over the period varied significantly by industry. We have contrasted Fig 48 and Fig 49 to show the change by industry in Fig 50.

Understandably, the market often cites the bearing industry as a great example of industry consolidation. As shown in Fig 48, the bearing industry is still the most consolidated with 64% of the global market held by the top five. Furthermore, the bearing industry has continued its consolidation over the last decade, having increased its top five consolidation by a further 12%. However, given its starting point, the bearing industry has not been the biggest consolidation story of the last decade. Five industries (locks, rail equipment, compressors, T&D and cutting tools) have all seen a greater degree of consolidation, with four of the five (i.e. all except rail), having lifted their top five concentration to over 50%.




At the other end of the spectrum, the appliance industry has seen a de-consolidation through the advent of low-cost competition from Korea, China and Turkey (Samsung, LG, Haier and Arçelik). Power generation has also seen a lack of incremental global consolidation since 1997; while already one of the most consolidated industries a decade ago PG has actually seen a fair degree of further Western consolidation over the last decade (e.g. Westinghouse, AAP and Stewart & Stevenson), however, this has been offset by the astronomical growth of the local Chinese PG market and its incumbents (Shanghai Electric, Dongfang Electric and Harbin Power).

Industry margins; helped by market share concentration

Fig 51: Clean EBIT margins by Industry (1997-2008)

0%2%4%6%8%

10%12%14%16%18%20%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EBIT

Mar

gin

by In

dust

ry

Automation

T&D

Fossil Power Generation


Appliances

Rail Equipment

Mining & Construction Equipment

Bearings

Compressors

Locks

Cutting Tools


From our benchmarking analysis we have calculated average industry margins through time. The raw data is shown in Fig 51 (above) and various different perspectives on that below. While there is some commonality of cycle, there are also industries that appear to operate on entirely independent margin cycles, such as rail.

Fig 52: Average EBIT margin across all 11 industries has clearly lifted over time

0%

2%

4%

6%

8%

10%

12%

14%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Aver

age

EBIT

mar

gin

(acr

oss

all I

ndus

tries

)

Calculated as a simple average (unweighted) of all 11 industries’ annual EBIT margins Source: Redburn Partners

To simplify Fig 51, we have shown the simple average EBIT margin across all 11 industries in Fig 52. This highlights just how much margins have improved across the entire complex of 147 companies.




Fig 53: Through-cycle margins (1996-2008 average) Fig 54: Improvement in margins (2004-08 vs 1996-2000)

0%2%4%6%8%

10%12%14%16%

Cutti

ngTo

ols

Heal

thca

re

Lock

s

Com

pres

sors

Auto

mat

ion

Pow

er G

enM

inin

g &

Cons

tr. T&D

Bear

ings

Appl

ianc

es

Rail

1996

-200

8 Gl

obal

Indu

stry

Av

erag

e EB

IT M

argi

n

-4%

-2%

0%

2%

4%

6%

8%

Min

ing

&Co

nstr.

Pow

er G

en

Heal

thca

re

T&D

Rail

Cutti

ngTo

ols

Lock

s

Auto

mat

ion

Bear

ings

Com

pres

sors

Appl

ianc

es

Glob

al In

dust

ry M

argi

n pr

ogre

ssio

n (2

004-

08 E

BIT

Mar

gin

vs. 1

996-

2000

)


Over the last decade, cutting tools, healthcare and locks have witnessed the highest average EBIT margins, whereas rail and appliance have witnessed the lowest. In terms of change, we have compared two five-year averages (2004-08 against 1996-2000) to give an indication of how margins have improved (or declined) by industry. As shown in Fig 54, all industries bar two (compressors and appliances) saw an increase in margins, with mining & construction and power generation seeing the biggest improvements.

Margins are driven by industry concentration

Fig 55: Average EBIT margins vs industry concentration, high correlation

Cutting Tools

LocksCompressors

BearingsM ining & Constr.

Rail

Appliances

Healthcare

Power Gen

T&D

0%

2%

4%

6%

8%

10%

12%

14%

16%

40% 45% 50% 55% 60% 65% 70%

2008 Globa l M a rke t Concent ra t io n (% sha re o f Top 5)

1996

-200

8 G

loba

l In

dust

ry

Ave

rage

EB

IT M

argi

n

Source: Redburn Partners based on multiple company and industry sources, line of best fit added manually

The correlation between industry concentration and industry margins is not particularly high but there is some optical relationship. As discussed above, there are other factors that determine industry margins. The three highest margin industries – cutting tools,healthcare and locks – have factors supporting their high margins in addition to their relatively high concentration levels. Healthcare and locks benefit from the relatively fragmented nature of both their supplier and customer bases, and the cutting tools industry enjoys a uniquely compelling business model, with extraordinarily high replacement levels combined with technological barriers to entry.




Gross pricing not clearly linked to volumes or concentration

Fig 56: 2000-08 average price vs 2009 by industry Fig 57: 2000-08 average volume vs 2009 by industry

-10%-8%-6%-4%-2%0%2%4%6%8%

Pow

er G

en

T&D

Cutti

ngTo

ols

Bear

ings

Min

ing

&Co

nstr.

Lock

s

Com

pres

sors

Heal

thca

re

Appl

ianc

es

Auto

mat

ion

RailAv

erag

e An

nual

Pric

e In

crea

se

2000-2008 2009

-40%

-30%-20%

-10%

0%10%

20%

Com

pres

sors

Min

ing

&Co

nstr. T&

D

Pow

er G

en

Heal

thca

re

Bear

ings

Auto

mat

ion

Appl

ianc

es

Cutti

ngTo

ols

Rail

Lock

s

Aver

age

Annu

al V

olum

e In

crea

se2000-2008 2009


Price is driven by a variety of determining factors, such as relative market share, absolute market share, industry concentration, degree of low-cost competition, volumes, raw material cost inflation and many others.

Fig 58: 2000-08 industry pricing vs volume growth Fig 59: 2000-08 industry pricing vs concentration

Automation

T&D Power GenHealthcare

Appliances

Rail

M&C

Bearings

Compressors

Locks

Cutting Tools

0%

2%

4%

6%

8%

10%

12%

14%

-2% 0% 2% 4% 6% 8%2000-2008 Average Price effect to Sales (%)

2000

-200

8 Av

erag

e Vo

lum

e (%

)

Cutting Tools

Locks

Compressors BearingsM&C

Rail

Appliances HealthcarePower Gen

T&D

Automation

0%

10%

20%

30%

40%

50%

60%

70%

-2% 0% 2% 4% 6% 8%

2000-2008 Average Price effect to Sales (%)

2008

Top

5 G

loba

l Con

cent

ratio

n


Figs 58-61 highlights that gross prices are not particularly closely correlated to either volume growth or industry concentration.

Fig 60: 2009 industry pricing vs volume growth Fig 61: 2009 industry pricing vs 2008 concentration

Cutting Tools

Locks

CompressorsBearings

M&C

Rail

Appliances

Healthcare

Power Gen

T&D

Automation

-40%

-30%

-20%

-10%

0%

10%

-10% -5% 0% 5%2009 Average Price effect to Sales (%)

2009

Ave

rage

Vol

ume

Grow

th (%

)

Automation

T&D

Power Gen

Healthcare AppliancesRail

M&C BearingsCompr.

Locks Tools

0%

10%

20%

30%

40%

50%

60%

70%

-10% -5% 0% 5%

2009 Average Price effect to Sales (%)

2008

Top

5 G

loba

l Con

cent

ratio

n





We believe net price (a much better indicator of pricing power) would be more highly correlated to volume growth and industry concentration but sadly the data just is not available.

For instance, looking at the 2000-08 data would suggest power generation and T&D industries have great pricing power. However, if we look at how prices have developed in 2009 (we have used pricing in orders rather than revenues for both industries given their long lead-time nature), we can see how drastically pricing has reversed from being the most positive for a decade to the most negative in 2009.

In many ways, examining price action in a period of volume decline is a better test of pricing power; Fig 60 demonstrates this well, highlighting the ability of bearings, cuttingtools, compressors, mining & construction and appliances to maintain positive prices in the face of double-digit volume declines in 2009. No mean feat. While we would argue the lagging steel pass-through may be artificially propping up Bearing and Appliance pricing in 2009, and allowing for the myriad of other determining factors, there is still some evidence to support the idea that parts of the sector have genuine net pricing power. While we do not have the empirical data to prove it, we believe the degree of market concentration is important (there is some evidence of this in Fig 61). In general, the machinery industries tend to be more concentrated and exhibit greater price resilience than the electrical industries.

Market shares by company

Fig 62: Market share matrix (global market share by industry by company 2009)

Market shares (%) Automation T&D

Powergen Healthcare Appliances Rail

Mining &constr. Bearings Compressors Locks

Cuttingtools

ABB 6% 23%

Alstom* 6% 11% 11%

Assa Abloy 24%

Atlas Copco 15% 28%

Electrolux 13%

Invensys 0.4% 2%

Legrand

Sandvik 20% 21%

Schneider* 2% 8%

Siemens 10% 17% 15% 15% 9%

SKF 19%

*Alstom and Schneider have been pro-rata’d as if T&D units were included from 1 January 2009 Source: Redburn Partners

In addition to entire industries, we have looked at the attractiveness of individual company positioning within each industry. The positioning of our European Capital Goods coverage is summarised in Figs 62 (above) and 63 (below), which map and rank the respective global market shares of the companies’ exposures to each industry. These charts should be viewed in conjunction with Fig 42 at the start of this chapter, which shows the revenue exposure of each company by industry.




Fig 63: Market share of European Capital Goods by industry pillar (2009)

24% 23%

15% 15% 13%10% 9%

0%

19%20%

15%

6%

21%

2%2%6%

8%11%12%

17%

28%

0%

5%

10%

15%

20%

25%

30%

Atla

s (C

ompr

.)

Assa

(Loc

ks)

ABB

(T&D

)

Sand

vik (T

ool)

Sand

vik (M

&C)

SKF

(Bea

rings

)

Siem

ens

(T&D

)

Siem

ens

(Med

)

Atla

s C.

(M&C

)

Siem

ens

(PG)

Elec

trolu

x (A

p.)

Alst

om (P

G)

Alst

om (R

ail)

Siem

ens

(Aut

.)

Siem

ens

(Rai

l)

Schn

eide

r (T&

D)

Alst

om (T

&D)

ABB

(Aut

.)

Schn

eide

r (Au

t.)

Inve

nsys

(Rai

l)

Inve

nsys

(Aut

.)2009

Glo

bal M

arke

t Sha

re (%

)


Fig 63 ranks the sector’s exposures to each industry pillar by market share, and highlights that Atlas Copco, Assa Abloy, ABB and Sandvik have some of the highest market shares. In general, the machinery names have the strongest positions compared to the electrical names.

Fig 64: Increase/(decrease) in global market share (2009 vs 1997)

10%

5% 4% 4%

0% 0%1%2%2%

3%3%3%3%6%6%6%8%

16%18%

-2%-2%-5%

0%

5%

10%

15%

20%

Assa

(Loc

ks)

Sand

vik (M

&C)

Atla

s (C

ompr

.)

Atla

s C.

(M&C

)

Siem

ens

(Aut

.)

Siem

ens

(T&D

)

Sand

vik (T

ool)

ABB

(T&D

)

Alst

om (P

G)

Siem

ens

(PG)

SKF

(Bea

rings

)

Schn

eide

r (T&

D)

Siem

ens

(Rai

l)

ABB

(Aut

.)

Siem

ens

(Med

)

Alst

om (R

ail)

Schn

eide

r (Au

t.)

Inve

nsys

(Rai

l)

Inve

nsys

(Aut

.)

Alst

om (T

&D)

Elec

trolu

x (A

p.)

Chan

ge in

Glo

bal M

arke

t Sha

re20

09 v

s. 1

997

Alstom and Schneider have been pro-rata’d as if T&D units were included from 1 January 2009 Source: Redburn Partners

In terms of change, we calculate that Assa Abloy, Sandvik’s mining and construction equipment business and Atlas Copco’s compressor and mining and construction equipment businesses have seen the largest increases in market share over the past decade. Given market share is a significant determinant of margins (see below), where improvements in market share have been achieved, improvements in through-cycle margins should not be ruled out even when margins are already at high levels (e.g. Assa Abloy).

Analysts (including this one) so often contain their margin estimates within the previously achieved across-cycle range, however, given the evidence supporting the concept that margins are determined by market share (see below), it follows that those companies (or divisions) that have seen a significant increase (or decrease) in market share may also see a step change in achieved margins. In part this has already happened and can be seen in the improved cross-complex margins shown in Fig 52. So perhaps it makes sense to examine the more recent market share changes that may not have yet played out fully.




Fig 65: Increase/(decrease) in global market share (2009 vs 2007)

2%

-2%-1%-1%0%0%0%0%0%0%0%1%1%1%

2%2%2%2%2%

6%

3%

-2%-1%0%1%2%3%4%5%6%7%

Alst

om (T

&D)

Schn

eide

r (T&

D)

Atla

s (C

ompr

.)

SKF

(Bea

rings

)

Siem

ens

(T&D

)

Sand

vik (M

&C)

Atla

s C.

(M&C

)

Elec

trolu

x (A

p.)

ABB

(T&D

)

Siem

ens

(Med

)

ABB

(Aut

.)

Siem

ens

(Rai

l)

Inve

nsys

(Aut

.)

Alst

om (R

ail)

Schn

eide

r (Au

t.)

Siem

ens

(Aut

.)

Inve

nsys

(Rai

l)

Assa

(Loc

ks)

Siem

ens

(PG)

Sand

vik (T

ool)

Alst

om (P

G)Chan

ge in

Glo

bal M

arke

t Sha

re20

09 v

s. 2

007


In Fig 65 we have shown the increase or decrease in market shares between 2009 and 2007. We have included both Alstom and Schneider’s T&D acquisitions from Areva from 1 January 2010.

Improvements (or deteriorations) in through-cycle margins are rarely spotted by the market and therefore rarely priced in. Herein lies the opportunity. Identifying potential increases (or decreases) in through-cycle margins based on existing evidence of changes in market share is one of the primary objectives of this report.

Does market share drive margins? Yes!

Fig 66: 2000-09 EBIT margins vs 2009 global market share

Sandvik (Tooling)

Assa Abloy (Locks)

At las Copco (Compressors)

SKF (Bearings)

At las Copco (M &C)Sandvik (M &C)

Invensys (Rail)

Siemens (Rail)Alstom (Rail) Electrolux (Appliances)

Siemens (Health)

Alstom (PG)

Siemens (PG)Schneider Electric (T&D)

ABB (T&D)

Alstom (T&D) Siemens (T&D)

Invensys (Automation)

ABB (Automation)

Schneider (Automation)

Siemens (Automat ion)

0%

5%

10%

15%

20%

25%

0% 5% 10% 15% 20% 25% 30%

2009 G loba l M a rke t Sha re (%)

2000

-200

9 A

vera

ge C

lean

EB

IT

Mar

gin

(%)

Outliers are Automation (where we see market definitional issues, which lower the market shares through aggregating the sub-industries) and Invensys Rail (which is actually a Signalling business where it has a #4 position with a 9% share, but we have included it in the wider Rail industry)

Line of best fit is for illustrative purposes only and is not calculated by regression Source: Redburn Partners

Given the myriad of determining factors behind margins, we are more excited about Fig 66 than we are about most charts in this report. While there are outliers, and the relationship is far from perfect, there is, nonetheless, a clear and measurable relationship between margins and market share. The fact this relationship holds across such a diversified range of industries, from washing machines to gas-fired power plants, is, in our opinion, remarkable. To a degree this chart says: it doesn’t really matter what you make as long as you have cornered the market.




What is most interesting is to see just how much this relationship holds across such a heterogeneous complex as the European Capital Goods sector.

Importantly for our analysis, Fig 66 provides the empirical evidence to confirm this relationship. This in turn underpins why we have focused so much of this report on the individual market share dynamics of each industry, how they have changed over time, how they stack up on a cross-industry comparison, and emphasis the importance of future consolidation.

Fig 67: Improvement in margin vs improvement in market share

Sandvik (Tooling)

Assa Abloy (Locks)At las Copco (Compressors)

SKF (Bearings)

At las Copco (M &C)

Sandvik (M &C)

Siemens (Rail)

Alstom (Rail)

Electrolux(Appliances)

Siemens (Health)

Alstom (PG)

Siemens (PG)

Schneider Electric (T&D)

ABB (T&D)

Alstom (T&D)

Siemens (T&D)ABB (Automation)

Schneider (Automat ion)

Siemens(Automat ion)

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

-5% 0% 5% 10% 15% 20%

2009 vs. 1997 change in G loba l M a rke t Sha re

Mar

gin

prog

ress

ion

(200

5-09

EB

IT M

argi

n vs

. 19

97-2

001)

Line of best fit drawn by hand as an indication of the relationship we would expect Source: Redburn Partners based on multiple company and industry sources

Fig 67 attempts to show there is a relationship between market share gain (loss) and margin improvement (loss) over the past decade. Looking at the outliers, where this relationship has not occurred, is of interest. Sandvik’s M&C, Assa Abloy and Atlas Copco’s Compressors have all seen greater than 10% increases in market share over this period, and while margins have improved they have not been to the degree one might have expected. Fig 66 supports this finding, but also shows all three businesses were already generating some of the highest margins in the sector, limiting the scope for upside.

Conversely, Siemens’ health, rail and power generation and ABB’s automation businesses have all seen meaningful margin increases without a commensurate market share improvement. As we have said, market share is by no means the only determinant of margin, so it should come as no surprise that there are breakdowns in the relationships and, in these instances, internal restructuring and cycle-specific issues have lifted margins.




Market shares in the sector have increased over the last decade

Fig 68: Market shares by industry of European Capital Goods sector constituents (Redburn coverage)

0%

5%

10%

15%

20%

25%

30%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Glo

bal

Mar

ket

Shar

e (%

)

Siemens (Automation)Schneider (Automation)ABB (Automation)Invensys (Automation)Siemens (T&D)Alstom (T&D)ABB (T&D)Schneider (T&D)Siemens (PG)Alstom (PG)Siemens (Health)Electrolux (Appliances)Alstom (Rail)Siemens (Rail)Invensys (Rail)Sandvik (M&C)Atlas Copco (M&C)SKF (Bearings)Atlas Copco (Compressors)Assa Abloy (Locks)Sandvik (Tooling)


Electrolux (Group) and Alstom T&D have both seen their market shares decline over the period. For Electrolux this is a genuine share loss to the emerging market players. However, for Alstom this can be explained by the disposal of its T&D assets to Areva, replaced by the buyback of only the T business (Areva transmission is c65% of Areva T&D) from Areva (which we have included for 12 months in our 2009 market share).

On the other side, Sandvik mining, Atlas Copco compressor and Assa Abloy (Group) have all seen dramatic double-digit market share increases over the period.

Fig 69: Average sector global market share will lift further on pending deals

6%7%8%9%

10%11%12%13%14%15%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Aver

age

Glob

al M

arke

t Sha

re o

f Eu

rope

an C

apita

l Goo

ds S

ecto

r

Average Global Market Share of European Capital Goods Sector (%)

Schneider's acquisition of Areva D and Atlas Copco's acquisition of Qunicy will lift average share through 2010E and 2011E, but further acquisitions (which we expect) could take it further.

Calculated as a simple average (unweighted) of all 21 assets within the sector (whether group, division or sub-division) that participate in the 11 industries discussed in our supply-side analysis Source: Redburn Partners

While Fig 68 is difficult to dissect and digest clearly, taken in the round (Fig 69), it does at least highlight, the onward and upward increase in market shares over the last decade or so. Taking a simple average of the 21 entities, the average market share has increased by 4.6% from 8.5% in 1997 to 13.1% in 2009. We expect the average sector market share to lift another 70bp to 13.8% by 2011, purely based on the announced but not completed deals of Areva D (by Schneider) and Quincy (by Atlas Copco). Further acquisitions in the sector (which we expect) could take this higher.




China: scale of industry threat in China, and abroad

Fig 70: Overview of Chinese market size, shares and concentration (local manufacturers vs sector) by industry

Industry Companies

2008 sectorsales to

the Chineseindustry

(€m)

2008Chinese

market size(€m)

2008global

market size(€m)

2008 Chinesemarket

concentration(% shareof top 5)

2008 collectiveChinese market

share ofEuropean sector

constituents

2008 averageChinese market

share ofEuropean

sectorconstituents

2008 averageChinese market

share of top 3domestic

Chineseplayers

Automation Siemens, ABB, Schneider, Invensys N/A N/A 223,000 N/A N/A N/A N/AT&D ABB, Alstom, Siemens, Schneider 4,450 18,618 55,000 37.9% 23.9% 8.0% 5.4%Fossil power generation Siemens, Alstom 0 13,804 100,000 64.5% 0.0% 0.0% 21.5%Healthcare equipment Siemens 975 6,500 72,000 58.0% 15.0% 15.0% 0.2%Appliances Electrolux 83 25,198 89,225 45.3% 0.3% 0.3% 12.4%Rail equipment Alstom, Siemens 926 8,556 50,000 82.2% 10.8% 5.4% 33.3%Mining & construction eq Sandvik, Atlas Copco N/A N/A 22,686 N/A N/A N/A N/ABearings SKF 425 10,061 28,873 13.0% 4.2% 4.2% 3.0%Compressors Atlas Copco 330 3,000 14,281 51.0% 11.0% 11.0% 11.3%Locks Assa Abloy 312 8,000 15,000 7.1% 3.9% 3.9% 0.9%Cutting tools Sandvik 112 697 11,343 72.0% 15.0% 15.0% 17.3%


We consider the competitive threat from low-cost emerging market competition (predominantly China) to be the single greatest threat to the sector’s (relatively attractively positioned) status quo. On average China represents c20% of the global market across the eight industry pillars where we have the data. Our analysis suggests the global T&D and bearings industries have the most significant Chinese presence at c34% of their respective global markets. At the other end of the spectrum, the Chinese cutting tool and healthcare equipment markets only represent 6% and 9% of their global markets, respectively.

Fig 71: 2008 Chinese market size (€m) by industry, ranked by size

05,000

10,00015,00020,00025,00030,000

Appl

ianc

es

T&D

Foss

il Po

wer

Gene

ratio

n

Bear

ings

Rail

Equi

pmen

t

Lock

s

Heal

thca

reEq

uipm

ent

Com

pres

sors

Cutti

ngTo

ols

Chi

nese

Mar

ket

Size

(€

mn)


By examining the market size, share and concentration of each industry, comparing the position of the European companies to their local Chinese competitors, we have tried to measure the relative competitive threat faced by each industry (and company) to attempt to identify where China may be a headwind or tailwind to earnings, over time.




Fig 72: 2008 Chinese market concentration (by industry) vs average share of local top three

Cutting Tools

Locks

Compressors

Bearings

Rail Equipment

Appliances


Power Generation

T&D

0%

5%

10%

15%

20%

25%

30%

35%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

2008 Ch ine se M a rke t Co ncen t ra t io n (% sha re o f Top 5)

2008

Ave

rage

Chi

nese

M

arke

t Sh

are

of T

op 3

D

omes

tic

Chi

nese

Pla

yers


By taking into account Chinese market concentration (high concentration being more attractive) and the relative positioning of the locals compared to the Europeans, our analysis suggests the Chinese healthcare, cutting tool, compressor and T&D industries are currently more favourably positioned (i.e. in the bottom right of the chart). On the same basis (see Fig 72) the appliance, bearing, power generation and rail equipment industries appear relatively less favourably positioned (i.e. towards the top left).

However, while we can measure and objectively rank to some degree the current attractiveness of the various Chinese industries served by the European Capital Goods sector (acknowledging that no one metric can ever fully capture the picture), understanding the future attractiveness and how the current picture will change is more subjective, depending, as it does, on industry-by-industry barriers to entry.

Each industry faces a differing degree of threat and potential change to its current attractiveness. For instance, the global appliance industry has already seen market share and margin erosion at the hands of the Chinese (and Koreans and Turks for that matter) and, while the industry is currently relatively unattractively positioned (for the Europeans), perhaps much of the pain is behind them. On the other hand, the Chinese T&D industry currently remains attractively positioned for the Europeans but going forward the industry faces a bigger threat than most given the local Chinese manufacturers have partially closed the technology gap, upped the pace of Chinese industry consolidation and materially increased the degree of export over the past few years.

In general, future threats are determined by the industry barriers to entry. In this regard cutting tools, locks, compressors and bearings (i.e. the machinery industries) face relatively limited threats compared to the electricals (rail, T&D, power generationand appliances).

In general, we consider the future threats in two distinct camps:

Loss of exposure to China growth: we see this as the more immediate threat. We believe China is likely to continue (for at least the next two years) to be one of the key drivers of growth in the sector. If the local Chinese manufacturers in a specific industry take material market share from the Europeans, this leg of growth will be absent.




Impact on global growth from increased Chinese export: in those industries where the local Chinese manufacturers reach the necessary standards to compete globally and export their products, the Europeans, and not just Chinese, may see global growth pressure (this has already happened in the appliance industry). We see this as a longer-term issue and potentially a significant risk if the Chinese domestic growth story ever stalls and the locals are increasingly forced to look overseas for growth.

China: competitive risks still outweighed by the remarkable opportunities Investors have witnessed the pain of emerging market competition across a number of industries (e.g. appliances, solar cells, telecom equipment) and have understandably extrapolated the risks to all manufacturing industries. Across most of its industries, we believe the European Capital Goods sector is perhaps better positioned than many fear and has learned from previous emerging markets challengers, notably Japan. By doubling its manufacturing footprint in emerging markets (from 16% in 1995 to 32% in 2009), the sector competes on a level playing field in emerging markets.

Most in the sector now manufacture at a Chinese address, with Chinese management, across the street from their local Chinese competitors (and similarly in India). Despite a decade of vast Chinese growth, the sector has successfully defended its position across most industries (with the notable exception of appliances). When the sector was decimated by Japanese dumping throughout the 1980s it was competing with a Westernised cost base, not so now.

Furthermore, local Chinese are still well behind Western manufacturers with respect to the technology, manufacturing quality, and safety standards required to export their products into the West. These barriers to entry are more prevalent in Capital Goods (where failure can have catastrophic consequences) than they are in the global consumer durables or semiconductor markets, say. In this regard the Japanese example is not comparable. The Japanese were far more economically and technically developed relative to the West in 1970s than China is today. China just doesn’t enjoy the institutional memory of the European Capital Goods sector.

Consequently, while China is not without risk, we believe the competitive risks are still outweighed by the remarkable opportunities.

Fig 73: Concentration of Chinese markets by industry Fig 74: Relative China position European vs locals

16% 13%

68%

91% 82% 72%

45% 38%51%

4%9%15% 11%0%

24%11%2%

20%

0%20%40%60%80%

100%

PG Rail

Toolin

g

Health

care

Compre

ssors

Applia

nces T&

DLo

cks

Bearin

gs

Mar

ket S

hare

(%)

2008 Chinese Market Concentration (% share of Top 5)2008 Collective Chinese Market Share of European Sector Constituents

30%

12%

1% 0%

15%20%

11% 9% 8% 5% 4%3%11%

0%

17%

2% 5%

38%

0%10%20%30%40%50%

Health

care

Toolin

g

Compre

ssors

Lock

sT&

DRail

Bearin

gs PG

Applia

nces

Mar

ket S

hare

(%)

2008 Average Chinese Market Share of European Sector Constituents2008 Average Chinese Market Share of Top 3 Domestic Chinese Players


In Figs 73 and 74 we compare Chinese industries in terms of concentration and market share of the European compared to the locals.




Company positioning in China

Fig 75: Market share matrix (Chinese market share by industry by company 2008)

China market shares (%) Automation T&D Power Gen Healthcare Appliances Rail

Mining &Constr. Bearings Compressors Locks

Cuttingtools

ABB N/A 13%

Alstom* 3% 4% 6%

Assa Abloy* 9%

Atlas Copco 3% 11%

Electrolux 0.3%

Invensys N/A N/A

Legrand

Sandvik 2% 16%

Schneider* N/A 1%

Siemens N/A 7% 10% 15% 5%

SKF 4%

* For Assa Abloy we have pro-rata’d the Pan Pan acquisition. For Alstom and Schneider we have pro-rata'd Areva T&D from 1 January 2009 Source: Redburn Partners

Shifting from industry to company positioning highlights the significant range of Chinese market shares across the sector: from Electrolux, with only 0.3% of the significant €25bn Chinese appliance markets to Sandvik Tooling’s 16% share of a much smaller €700m Chinese cutting tool market.

Fig 76: Chinese market share by industry by company 2008, ranked by share

16% 15%13%

11% 10% 9%7%

6% 5% 4% 4% 3% 3% 2% 1% 0.3%0%

5%

10%

15%

20%

Sand

vik (T

ooling

)

Siemen

s (Hea

lth)

ABB (T

&D)

Atlas C

opco

(Compre

ssors)

Siemen

s (PG)

Assa Ablo

y (Lo

cks)

Siemen

s (T&

D)

Alstom

(Rail)

Siemen

s (Rail)

SKF (

Bearin

gs)

Alstom (P

G)

Atlas C

opco

(M&C)

Alstom

(T&D)

Sand

vik (M

&C)

Schn

eider

(T&D)

Electr

olux (App

liance

s)

Chi

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Mar

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Shar

e (%

) (2

008)


We have ranked these market shares in Fig 76 above and plotted them against the average market share of the top three Chinese players in Fig 77 below.

In general, the European Capital Goods sector still enjoys relatively attractive market positions in China. With the notable exceptions of Electrolux, the sector has relatively successfully defended its positions in the face of a decade of unprecedented Chinese growth.




Fig 77: Chinese market share of European sector constituents vs average market share of the top three local manufacturers in their respective industries

Sandvik (Tooling)

Assa Abloy (Locks)

Atlas Copco (Compressors)

SKF (Bearings)

Siemens (Rail) Alstom (Rail)

Electrolux (Appliances)

Siemens (Health)

Alstom (PG) Siemens (PG)

Schneider (T&D) ABB (T&D)Alstom (T&D)

Siemens (T&D)

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Well positioned today

Poorly positioned today


If we assume having a high market share in a market where the local Chinese manufacturers have a very low market share represents the optimal situation, then ABB’s T&D and Siemens’ healthcare businesses are well positioned today. The high concentration of the power generation and rail industries, combined with the high market shares of the local Chinese, suggest Siemens rail, Alstom rail and Alstom power generation are poorly positioned in China today, not so much from a market share perspective (where they have reasonable positions) but from the potential risk of future competitive threat.

The analysis contained within this chapter is based on a detailed study of each of the 11 global industries addressed. In the supply-side section of this report there is a standalone chapter devoted to each industry (excluding the automation and healthcare industries, which we hope to address in more detail in future reports).



Margins (3): price and raw material cost inflation

Despite the massive demand correction in 2009, with sector-wide volumes down -14%, sector-wide pricing remained remarkably resilient at +2%. The evidence from the US and European PPI data highlights that other manufacturing industries did not enjoy such pricing resilience, and had to handle price declines of -2%. To us this is evidence of relative pricing power in the sector.

One note of caution stems from our synthetic cost analysis, which highlights the risks in 2010E. Based on spot prices, the sector’s raw material blend (as a percentage of sales) fell -3% in 2009 and, at current spot prices, is heading for a reversal to +2% in 2010E. If this upcoming period of commodity price reflation is more ‘cost push’ than ‘demand pull’, then the sector faces a potentially damaging period for ‘net’ prices where lower volumes and emptier backlogs could lead to a period of lower gross prices.

Sector pricing (gross) has improved and exceeded US and European PPI In the previous chapter we addressed the more intangible issue of supply-side dynamics. In this chapter, we focus on the more factual picture of how sector pricing has behaved over time and how that has moved in relation to raw material cost inflation.

Fig 78: Sector pricing has remained very resilient in the face of sharp volume decline

-20%-15%-10%

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Q1 94 Q1 96 Q1 98 Q1 00 Q1 02 Q1 04 Q1 06 Q1 08 Q1 10E

Pric

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Sector Average Price Effect on Sales (%) Sector Average Volume Effect on Sales (%)

Forecasts

Quarterly price effect is based on the simple average of available data, we have only used price data from companies within our universe that disclose or discuss quarterly price effect (currently Assa Abloy, Atlas Copco, Electrolux, Sandvik, Schneider Electric and SKF). Quarterly volume effect is calculated by subtracting the price effect from quarterly organic sales growth Source: Redburn Partners and company data

Fig 78 shows quarterly average sector organic sales growth separated into volume and achieved price for the historic and forecast periods of 1994-2011E. This shows that, while average sector volumes fell -16% at the nadir of the current downturn (2Q09E), average pricing remained remarkably resilient at +2.4%.

Looking forward we expect pricing to remain resilient and positive at +0.5% in 2010E and rise to +1.3% in 2011E. Our forecast trough price of +0.4% in 2Q10E exceeds the last trough (post tech downturn) of +0.1% in 4Q03, which in turn exceeded the prior trough (post Asian crisis) of -0.8% in 2Q98. We believe these rising troughs (and peaks) are indicative of improved pricing power in the sector. In past downturns, prices have sometimes troughed before volumes and sometimes after. From this we see no clear pattern to draw from as to how future prices will behave following the recent trough in volumes (2Q09).





Fig 79: Sector price has remained more resilient than European and US producer prices

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Source: Eurostat and US Bureau of Labour Statistics

While strong pricing in the face of sharp volume decline has been a feature for a number of sectors during the recent downturn, comparing the sector’s price effect in Fig 78 with the YoY growth of both the European and US Producer Price Indices (PPI – shown in Fig 79) it is clear the sector’s 2009 YTD price effect of c+2% compares favourably to the European factory price average of c-2% and the US factory price average of -2.4%.

This suggests that while the complete universe of public and private industries throughout Europe and the US make up the PPI (including a wide range of industries from food manufacturers to industrial but excluding energy and construction) have been suffering a -2% or more price decline, the European Capital Goods sector has outperformed on pricing by a massive +4%. As discussed throughout, we believe this to be a function of the strong market positions of the companies in the sector combined with the attractive consolidation and concentration of the industries they serve.

Rail example of how consolidation has dramatically improved pricing

To give a bottom-up example, Siemens’ and Alstom’s rail pricing stories of the past 20 years are great illustrations of improved pricing power through industry consolidation and capacity reduction. The rail equipment industry saw a massive M&A consolidation phase during the 1980s and 1990s in which c100 companies consolidated into the ‘big three’ (Alstom, Bombardier and Siemens), this concentration was then followed by a decade of capacity reduction (both significant industry headcount reduction and plant closures across the industry).

Between 1990 and 2004 (the consolidation phase) prices across almost all rail car segments dropped by c25% (or c1.5% a year). This was an improvement on the pricing in both the 1970s and 1980s, which often saw annual like-for-like price declines of 2-3%. Following the end of consolidation, the Rail equipment industry then experienced a period of significant capacity reduction (via restructuring) in 2004. As a direct consequence of this restructuring and the consolidation phase before, the light rail, urban transit, tram and high speed train segments have all seen relatively stable pricing since. The commuter and regional trains segments, on the other hand, have continued to see some price declines (c0.2-0.5% per year) as these are the segments where competition remains more intense, has not consolidated, and local manufacturers – such as Talgo, Vossloh, CAF, Hyundai Rotem and Stadler – compete.

While we have used rail as an example, this supply-side phenomenon has occurred across most of the industries served by the sector. It is these supply-side changes of consolidations and market share increases that are behind the improvements in pricing power and margin dynamic.




Price drops through 100% and is nectar to margins

Manufacturers have two weapons with which to protect margins and tackle cost inflation: price increases and cost savings (whether productivity gains, restructuring or other). Price is very valuable to margins, as unlike extra volume, which has a drop through of c30%, extra price has a drop-through of c100% to the EBIT line. In general, managements look for pricing to cover raw material cost inflation; if they can also pass on labour cost inflation even better and if they can exceed both then there is a real chance of a meaningful positive margin surprise. Consequently, we have devoted much of this report to trying to tackle the relative strengths of pricing power.

However, gross price and net price are not the same

In reality margins are driven by net prices (which GE refers to as the ‘value gap’) and not just gross prices. Sadly, with the exception of Schneider Electric, none of the companies in the sector disclose this all-important line and most have historically been reluctant to discuss. However, as this is a particularly pertinent issue currently and because, in this SAP age, companies increasingly have the information themselves, we have noticed an increasing disclosure and propensity to discuss net price, led by the American Capital Goods companies.

Cost base, raw materials and the risk of ‘cost push’ inflation

Fig 80: 2008 sales by cost type and EBIT Fig 81: Raw material averages 13% across sector

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In Fig 80, we have disaggregated the sector’s revenue by cost type (and profit) by company. On average in 2008 wages represented c25%, raw materials c13% and components c21% of sector revenues. We see a company’s pricing power as its ability to pass on inflation across each of these three cost categories.

As we have already discussed (see Fig 31), the European Capital Goods sector lowered its wage inflation to 0.6% between 2002 and 2008 by shifting to emerging markets. This lowering of the wage inflation proportion of total cost inflation has probably been a driver of improved net pricing and therefore margins over time. The challenge will be whether the companies can continue to limit wage inflation per employee going forward, we have assumed they will from a continued shift to low-cost.

With respect to raw material costs, we have shown the exposure by company in Fig 81. This highlights the proportion of raw material costs varies in the sector from SKF with 27% of 2008 sales to Alstom at 7%.




Fig 82: Raw material costs represent 13% of sector revenues and roughly half of that is steel

2008 raw materials as % of sales ABB Alstom Assa Abloy Atlas Copco Electrolux Legrand Sandvik Schneider Siemens SKF Average

Steel 4.5% 2.3% 4.6% 6.8% 10.5% 3.2% 2.7% 1.4% 2.9% 19.7% 5.9%Copper 3.7% 1.5% 0.5% 1.3% 2.1% 2.3% 1.8% 1.3%Nickel 0.3%

Aluminium 1.9% 0.9% 1.1% 0.5% 1.3% 0.3% 1.1% 0.7%Lead 0.3% 0.0%Zinc 1.1% 0.3% 0.1%Brass 3.4% 0.3%Other metals 1.1% 1.2% 0.3% 4.0% 0.7% 10.8% 0.7% 1.4% 3.4% 2.4%of which Oil & Plastics 1.5% 0.7% 0.3% 1.9% 4.8% 3.7% 1.1% 1.4% 0.9% 4.1% 2.0%Other raw materials 2.2% 1.8% 0.4% 0.9% 0.5%Total raw materials 15.0% 6.5% 10.7% 9.7% 21.9% 11.5% 15.0% 7.1% 9.1% 27.3% 13.4%


While some companies provide good disclosure on their cost base, many don’t. As such, the data in Fig 82 contain a number of estimates based on conversations with management and IR. Nonetheless it provides an indication of the key exposures by raw material. On average raw material costs represent 13% of revenues, and steel is the most significant raw material for the sector at an average of 6% of revenues, with SKFand Electrolux having the biggest exposure at 20% and 11%, respectively. This table can be used as a guide to the relative likely impacts for when specific raw materials (such as copper today, which the electricals are more exposed to) see a significant move.

Looking at the spot price data for the various key commodities in Fig 83 highlights just how much the underlying raw material cost base has started to re-inflate. In general sector pricing is linked to raw material costs, as such this may signal a more optimistic environment going forward (in which case the sector really has ridden this downturn remarkably unscathed).

Fig 83: Lead, copper and oil have recovered the fastest, steel and aluminium less so

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Oil Copper Lead Nickel

Zinc Steel (CR) Aluminium

Source: Bloomberg

Inflation is the source of more disagreement in economics than almost any other economic variable. Some like it, some don’t. Most agree, however, that there are two kinds: demand pull and cost push. In general, the commodity price inflation experienced between 2005 and 2008 was largely the more attractive kind – demand pull. If we are now entering a period of cost push inflation then the sector faces a potentially damaging period for ‘net’ prices.




Consequently, while we are optimistic on the net pricing environment, we may be wrong. As a hedge, we believe it is sensible to avoid companies with poor pricing power. We have examined the relative degrees of pricing power in our ‘supply-side’ analysis in the next chapter. However, before that, we have run a synthetic cost analysis for each company using both the exposures in Fig 82 and the relative raw material price movements in Fig 83.

Synthetic cost analysis and ‘net’ pricing

Fig 84: Commodity spot prices are volatile Fig 85: Two-year rolling spot prices more linked to price

-6%-4%-2%0%2%4%6%8%

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Risk point in 2010E

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Our synthetic cost inflation data makes the simplified assumption that each company buys its raw materials at spot price and is entirely un-hedged Source: Redburn Partners


Given the raw material cost mix for each company (shown in Fig 82) and the moves in raw material spot prices (shown in Fig 83), we have created a synthetic cost inflation index for each company and compared the YoY changes to the YoY changes in gross prices for the last decade or so. Given the lack of space, we have just shown the aggregate data (see Fig 84 for the entire sector and Fig 86 for the individual companies). This shows that spot price movements are more volatile than achieved gross pricing.

This should not come as a great surprise given that companies rarely purchase raw materials at spot prices, as they tend to purchase on contract. Contract prices move much more slowly and smoothly than spot prices but ultimately the two are intrinsically linked. We have tried to eliminate this volatility by running our company cost inflation data on a 24-month rolling basis. The aggregate for the sector is shown in Fig 85, which shows a relatively highly correlated link between raw material cost inflation and gross selling prices (the individual company data is touched upon in Fig 86).

From all of this we can see that 2009 has been a period of raw material spot price deflation during which gross prices remained attractively positive (as seen at the company level with the Schneider example above). However, looking forward the picture reverses and herein lies one of the key sector risks for 2010E. At current spot rates, our data suggests that 2010E will witness a return to raw material cost inflation of c2%. If lower volumes and emptier backlogs lead to a period of lower gross pricing, then there is a risk that the net price environment deteriorates in 2010E.




Fig 86: Synthetic cost inflation; 2010E vs 2009 based on spot prices and cost mix

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This picture can be seen at the company level in Fig 86, where we have used our synthetic cost analysis to highlight the raw material cost inflation impact for 2010 vs 2009. Under the assumption each company buys its raw materials at spot price and is entirely un-hedged (neither of which is true, as they all tend buy on contract and hedge heavily) then the picture is universal. On this basis, 2010E would represent a period of cost inflation for all companies, compared to 2009 which was a period of cost deflation. Furthermore, those that buy the greater proportion of raw materials, such as SKF and Electrolux, would face the bigger headwind. While SKF has relatively average pricing power (see the overall weighted score in the final column of Fig 41 in the next chapter), Electrolux’s pricing power is at the bottom end of the spectrum. This suggests a potential 2010E or 2011E (given the lag effect of hedging and contract pricing) raw material driven net price headwind for Electrolux.

While we remain optimistic on net pricing and margins (given our supply-side analysis in the next chapter), our synthetic cost analysis highlights the risks going forward and that it is possible that, in addition to restructuring, cost savings (discussed in a separate chapter below), sector margins in 2009 (which were remarkably resilient) may have benefited from a favourable, but temporary, net pricing equation.



The European Capital Goods sector is in a period of intense restructuring. Our analysis highlights the following: (1) the bulk of heavy restructuring charges are behind us; (2) in this ‘SAP recession’ managements have been quick to act and headcount reductions have been both responsive to, and of similar magnitudes to, revenue declines; and (3) the sector saw €4.1bn (or 3.5% of sales) of combined cost savings in 2009, and while it has already reached the period of maximum savings benefit (2Q09 and 3Q09), we still expect a further €2.7bn (or 1.4% of sales) of savings in 2010E. On a company basis ABB, Sandvik, Schneider and Assa Abloy still have meaningful savings yet to come.

A caveat to those relying on cost savings as an earnings driver is to be aware of those that have used ‘Kurzarbeit’ (short-time working). While shifting workers from five-day weeks to four-day weeks had the benefit of protecting both margins and skilled labour and reducing costs quickly during the downturn, it may limit the operational gearing into the upturn. Both SKF and Sandvik have roughly a third of their current employees in short-time working compared to the sector average at c10% and the likes of Assa Abloy and Electrolux at close to 0%. For SKF and Sandvik, this will limit the operation gearing into recovery compared to last cycle when short-time working was not used.

Fig 87: Sector restructuring charge as a % of sales (1992-2009)

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Source: Redburn Partners based on reported company data

The European Capital Goods sector is no stranger to restructuring in times of economic weakness and the current downturn is no exception. The sector is currently in the midst of one of the most intense periods of restructuring of the past 50 years, even more intensive than the transformational restructuring of the early 1990s. As shown in Fig 87, in 2008, the sector expensed a restructuring charge of c1.6% of sales, twice that of the previous few years.

Margins (4): cost savings, 2010 tailwind




Fig 88: Average 3Q08-4Q09 restructuring charge as a % of sales

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

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Without exception, all those under our coverage have booked some form of restructuring charge over the past year and a half (we have used a six-quarter time frame to capture the earliest downturn-related charges in 3Q08). These charges have been predominantly directed at reducing headcount but in some instances they have also included manufacturing facility closures (for instance Assa Abloy, Electrolux, Sandvik and SKFhave all announced plant closures). Those adopting a big bath provision approach (Siemens with 7.4% of group sales in 3Q08 (fiscal 4Q08), Assa Abloy with 9.8% of group sales in 4Q08 and 10.6% in 4Q09, and Sandvik with 7.9% of group sales in 2Q09) are all at the upper end of the spectrum with respect to the size of restructuring charges. However, as we can see below in Fig 92, these three are not forecast to generate the biggest savings. While Sandvik and Assa Abloy are first and fourth on the 2009-10E collective savings list, Siemens is only eighth and, despite their relatively small restructuring charges, Legrand and ABB are expected to be the second and third highest 2009-10E savers.

Headcount reduction lagged revenue decline initially

Fig 89: Sector headcount reduction has now caught up with revenue decline

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Whoever coined the phrase ‘The SAP recession’ certainty captured the essence of this downturn. Previously, notably in the early 1990s, companies in the sector took between two and four quarters to adjust headcount downwards following demand collapses. In this downturn, improved real time management systems (such as SAP) have permitted companies to act quickly, booking provisions and planning redundancies faster than in previous cycles. This can be seen in Fig 89, where employee reduction has largely




followed revenue decline. The decline in headcount will never be perfectly aligned with revenues given the various labour law requirements. After the initial legal lag, the gap has largely closed with employees leaving at a greater pace in 2Q09 and 3Q09. By 4Q09 we saw the annual headcount decline of -9.4% exceed the organic sales decline of -8.8%.

Fig 90: Atlas Copco and Legrand have achieved the biggest headcount reductions

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Legrand Sandvik Assa Abloy B SKF Electrolux Siemens

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At the company level, despite their relatively small restructuring provisions, both AtlasCopco and Legrand have achieved the highest proportional headcount reductions in the sector, at 14% and 12%, respectively, between 3Q08 and 4Q09.

Sector already in the sweet spot for cost savings Where does all this leave the sector in terms of savings achieved and savings to come?

Fig 91: 1Q05-4Q11E sector average savings as a % of sales and EBIT

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Sector averages are calculated based on the simple average of nine companies (ABB, Atlas Copco, Assa Abloy, Electrolux, Legrand, Sandvik, Schneider, Siemens and SKF). We have not included Alstom and Invensys Source: Redburn Partners

Looking at Figs 91 and 92 highlights the sector is c60% through the bulk of the cost savings and has already reached the period of maximum benefit (3Q09). We calculate our universe generated €4.1bn (3.5% of sales) of cost savings in 2009 and we forecast a further €2.7bn (1.4% of sales) over 2010. This compares to a long run ‘normal’ cost savings average (prior to the downturn) of only 0.2% of sales per year. We expect the sector’s cost savings to return to 'usual business’ (i.e. c0.2% of sales) by 4Q11E. As such, while 2009 savings represented a blow-out 18x ‘normal’ savings, 2010E still represents a considerable 7x ‘normal’ savings.




At the peak (3Q09) savings equated to a meaningful 4.2% of sales and was an important counter-balance to the negative impact of operational gearing. Looking at it another way, we calculate that savings represented over 20% of EBIT in 2Q09 and 3Q09. Looking forward, we calculate that savings in 1H10E will represent 2.0% of sales and in 2H10E 0.9% of sales. All our savings forecasts are based purely on announced plans (summarised in Fig 94 below) and do not include further potential unannounced savings.

Fig 92: 1Q08-4Q10E sector average savings as a % of sales, by company

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ABB Assa Abloy Atlas Copco ElectroluxLegrand Sandvik Schneider Electric SiemensSKF Alstom


At the company level there are material differences in the scale and timing of cost savings. For 2009 and 2010E combined, we forecast the biggest recipients of cost savings to be: ABB (5.8% of group sales), Sandvik (2.6% of group sales), Assa Abloy(1.4% of group sales) and Schneider Electric (1.4% of group sales). In Fig 93 we have split the two-year period into 2009 and 2010, to identify those companies that have already achieved the majority of cost savings and those that have yet to see their maximum savings tailwind.

Fig 93: Last four quarters vs next four quarters savings impact (as % of sales) by company

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Source: Redburn Partners forecasts and companies historically

This highlights for instance that Legrand (where management reacted impressively quickly and have truly outperformed) has already seen the majority of its savings boost, whereas Sandvik, ABB, Schneider and Assa Abloy have meaningful savings yet to come.




Fig 94: Restructuring and savings overview for European Capital Goods sector

Savings Charge Employees

ABB $3bn of savings $1bn in 2009 and $1bn in 2010. Savings are 50% from sourcing, 20% operational, 20% footprint and 10% G&A

$1.1bn to be charged – $677m booked 4Q08-4Q09

Majority of plan is not redundancy-related. We estimate 20% of savings relate to people (G&A and Footprint plans), 3,000 people left in 1Q09

Alstom Alstom has not declared any formal plan but we expect €100m of savings from the 2,000 people out in 2009 (Fiscal 1H10)

Alstom has slightly raised its restructuring running rate from €40m per year to €50-100m guidance (we expect €70m for FY2010, March Y/E)

Alstom lower the headcount from 81,500 at the end of 2009 (March Y/E) by 2,000 to 79,500 by the end of 1H10 (30 September)

Assa Abloy MFP2 plan beating SKr600m target by 2011 (we expect SKr720m), Capacity reduction savings of SKr1.3bn by 1Q10, latest MFP3 plan to save SKr250m by mi-2012

SKr2.2bn booked between 3Q08 and 4Q09 1,800 people to leave from MFP2 plan, a further 1,900 people from Capacity Reductions and 1,100 from MFP3

Atlas Copco ‘Capacity and Cost Adaptation’ plan to save SKr2bn (has exceeded by 10-20%)

SKr824m charged between 4Q08 and 4Q09 Original plan for 5,000 people but lifted to c6,500

Electrolux Looking for SKr1bn of savings by 2Q10 from ‘Cost Reduction’ in addition to SKr500m savings over next year from ongoing SKr3bn savings plan

SKr1,045 charged in 4Q08 for ‘Cost Reduction Measures’ in addition to SKr900m of factory closure charges between 2Q08 and 1Q09

Downturn plan saw major step change in 2Q09 when c3,000 people left, but there were no real changes in either 1Q09 or 3Q09

Legrand Legrand achieved €180m of cost savings in 1H09 and is aiming to achieve €300m for FY09

Having averaged €5m per quarter for five years the restructuring charge lifted to €60m (i.e. €20m per quarter on average) between 4Q08 and 2Q09

Headcount fell 14% from 34,454 at the end of 1H08 to 29,593 at the end of 1H09 and is expected to fall further by Y/E

Sandvik Now expect to marginally SKr8bn annualised savings run rate by end of 2009 (i.e. SKr2bn in 4Q09); cSKr6bn actual savings in 2009 so therefore a further SKr2bn in 2010

SKr2.8bn of charges booked between 4Q08 and 4Q09. Further SKr1.4bn expected in 2010.

At the end of 3Q09 8,000 had left (incl. 2,000 temps) and furthermore the number of employees on short-time working had lifted from 0 to 15,000 (i.e. 1/3 of group employees)

Schneider Electric €1bn of base cost savings by 2011 and up to €600m of productivity savings dependent on demand, c€500m in 2009

Restructuring lifted from 4. €50m to c€100m per half for 4 or 5 halves

Not disclosed but temporary workers (which lifted from 1% of sales in 2004 to 10% in 2008) will be disproportionately effected

Siemens (1) 2008 SG&A savings plan for €1.2bn of savings by 2010, (2) unspecified 2009 procurement savings plan (we estimate €2.0bn), and (3) headcount reduction to adjust to demand drop

€1.6bn of charge taken in 4Q08 for SG&A programme plus €200-300m of other ad-hoc costs

Headcount fell 10% from 440k in 3Q08 to 400k in 4Q09. Despite still representing 31% of the workforce German headcount only fell by 7% over the same time frame

SKF Savings plan is for annualised savings of cSKr800m from mid-2010

SKr1.6bn of charges booked between 4Q08 and 4Q09

Between 3Q08 and 3Q09 4,400 people left SKF, furthermore the number of employees on short-time working had lifted from 0 to 14,000 (i.e. 1/3 of group employees)


Permanency of costs saving – the ‘Kurzarbeit’ syndrome One concern surrounding the next recovery is the degree to which cost savings have been achieved by the use of the short working week. Once the preserve of Austria and Germany, the use of ‘Kurzarbeit’, which literally means ‘short work’, has proliferated across almost all major European economies during the recent downturn. Employees accept a reduction in working hours of between 10% and 90% for up to 6-18 months. The terms vary by country of employment. The model allows employers to reduce labour costs in an economic downturn while at the same time ensuring that they need not lay off their experienced workforce which will remain on hand when the economy recovers. Employees in turn keep their jobs and most of their spending power, helping to stimulate economic recovery.

While we would argue the use of ‘Kurzarbeit’ was good management on the downside, it has perhaps left less investor equity upside in recovery. With margins having remained relatively resilient, should we expect less progress towards the next peak? Where companies have been aggressive users of ‘Kurzarbeit’, we expect the increased variabilisation of costs during the downturn to limit the operational gearing effect into the upturn, compared with previous recoveries.




Fig 95: Actual (and estimated) 3Q09 short-time working employees as proportion of total workforce, by company, and equivalent hires needed to effectively return the short-time employees to full-time (for the biggest three users)

2009 averageheadcount

3Q09short-time

working

% of total onshort-time

working

Utilisation ofshort-timeemployees

Equivalent hiresneeded to

return to fulltime

Equivalent hiresneeded to

return to fulltime

(as % ofworkforce)

Additional wagecost to return

all to full-timeworking

Margin impactvs historic

operationalgearing upliftinto recovery

ABB 110,563 3,000 2.7% 1% 25 0.1%

Alstom 82,992 830 1.0% 0% 11 0.1%

Assa Abloy B 29,448 100 0.3% 0% 1 0.0%

Atlas Copco AB 29,700 3,000 10.1% 65% 1,050 4% 42 0.7%

Electrolux 55,209 50 0.1% 0% 0 0.0%

Invensys 21,729 500 2.3% 1% 4 0.2%

Legrand 28,745 2,000 7.0% 2% 17 0.5%

Sandvik 49,658 15,000 30.2% 80% 3,000 6% 136 2.0%

Schneider Electric 108,924 0% 0 0.0%

Siemens 416,000 11,500 2.8% 1% 168 0.2%

SKF 41,592 14,000 33.7% 79% 3,000 7% 112 2.1%


There are three companies (SKF, Sandvik and Atlas Copco) where short-time working is employed to a significant degree. Other companies such as Assa Abloy andElectrolux have made the pro-active decision to make permanent structural redundancies. However, taking into account the fact that those on short-time working tend to be operating around a four-day week, the effective proportion of total man hours (or equivalent hires needed to return to full time as a percentage of the total workforce) is about 2% on average and 6-7% at the biggest two users SKF and Sandvik. Using group average wage costs, the average margin protection to the sector in 3Q09 was c0.5% and c2% for SKF and Sandvik.

However, putting this into context of a volume drop of about 40% for SKF and Sandvik, once volumes starts to pick up neither company should initially need to take back people as the initial volume increases should be manageable without increased working hours. The nearer they get to full capacity utilisation, the more of the short-time workers will need to return to full working hours.

One possible risk in this is that if volumes continue on a low level, SKF, Sandvik and Atlas Copco will need to re-negotiate agreements. If the unions do not accept then permanent redundancy action might be needed.

In conclusion, we do not see the operational gearing headwind as a significant headwind to margin recovery for the sector as a whole (maybe 0.5% off EBIT margins at the most). At SKF and Sandvik, where the impact is most material, we expect c2% off the degree to which group EBIT margins would have recovered should the companies not have used short-time working (or made other compensatory redundancies). This is more meaningful at SKF where through-cycle margins are lower and have fallen less, compared to Sandvik where through-cycle margins are higher, have fallen more and have a significant up-lift to come in recovery.




Fig 96: Restructuring, headcount and savings progression by company (1Q08-4Q10E), with averages

1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10E 2Q10E 3Q10E 4Q10E2009Avg

2010EAvg

2009-10E Avg

Restructuring charge as a % of sales

ABB 0.0% 0.1% 0.0% 1.5% 0.0% 1.4% 1.1% 3.9% 1.8% 1.6% 1.6% 1.4% 1.6% 1.6% 1.6%

Alstom 0.2% 0.1% 0.1% 0.4% 0.3% 0.3% 0.3% 0.5% 0.4% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3%

Assa Abloy 0.0% 0.0% 2.8% 9.8% 1.2% 0.0% 0.0% 10.6% 0.5% 0.5% 0.5% 0.5% 2.9% 0.5% 1.7%

Atlas Copco 0.1% 0.2% 0.0% 1.3% 1.4% 1.6% 0.0% 0.5% 0.0% 0.0% 0.0% 0.0% 0.9% 0.0% 0.4%

Electrolux 1.5% 0.0% 0.0% 3.6% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Invensys 1.4% 1.1% 1.1% 3.0% 3.0% 2.0% 2.0% 1.5% 1.5% 1.4% 1.4% 1.4% 2.1% 1.4% 1.8%

Legrand 0.3% 1.1% 0.2% 3.0% 0.9% 2.3% 1.6% 1.0% 1.3% 1.3% 1.4% 1.3% 1.5% 1.3% 1.4%

Sandvik 0.0% 0.0% 0.0% 1.0% 0.8% 7.9% 2.3% 3.3% 1.4% 1.3% 1.4% 1.2% 3.6% 1.3% 2.5%

Schneider Electric 0.6% 0.6% 1.2% 1.2% 1.5% 1.4% 1.4% 1.3% 1.3% 1.2% 1.1% 1.0% 1.4% 1.2% 1.3%

Siemens 5.6% 0.2% 7.4% 0.2% 0.3% 0.6% 2.0% 0.1% 0.6% 0.0% 0.0% 0.0% 0.7% 0.1% 0.4%

SKF 0.0% 0.0% 0.0% 2.1% 1.2% 3.5% 1.5% 2.8% 0.0% 0.0% 0.0% 2.0% 2.3% 0.5% 1.4%

Sector (simple average) 0.9% 0.3% 1.2% 2.5% 1.0% 1.9% 1.1% 2.3% 0.8% 0.7% 0.7% 0.8% 1.6% 0.8% 1.2%

Sequential (QoQ) headcount reduction ABB 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Alstom 0.0% 0.0% 0.0% 0.0% 0.0% -2.0% -2.8% -1.5% -1.6%

Assa Abloy -1.8% 0.2% 0.0% -4.0% -3.7% -4.3% -0.7% -1.3% -2.5%

Atlas Copco 2.9% 2.3% 2.3% -0.6% -4.5% -5.3% -3.3% -1.3% -3.6%

Electrolux -3.5% -1.0% 1.7% -3.8% -0.7% -7.7% 0.7% 2.4% -1.3%

Invensys 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Legrand 2.5% 1.2% -1.5% -4.2% -3.8% -3.2% -4.3% -1.5% -3.2%

Sandvik 2.7% 3.1% 2.3% -0.1% -3.1% -3.7% -3.0% -2.3% -3.0%

Schneider Electric 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Siemens -4.0% 1.2% -0.8% -1.7% -1.4% -1.9% -1.3% -0.9% -1.4%

SKF 0.6% 0.3% 2.4% 1.9% -1.5% -2.1% -2.2% -2.1% -2.0%

Sector (simple average) -0.1% 1.0% 0.9%-1.8%-2.7%-3.8%-2.1%-1.0% -2.4%

Cost savings as a % of sales ABB 0.0% 0.0% 0.0% 0.0% 2.2% 4.6% 6.4% 5.4% 7.0% 6.5% 5.2% 4.6% 4.6% 5.8% 5.2%

Alstom 0.0% 0.0% 0.0% 0.0% 0.0% 0.3% 0.3% 0.5% 0.5% 0.2% 0.2% 0.0% 0.3% 0.2% 0.2%

Assa Abloy 0.7% 0.6% 0.5% 0.7% 4.2% 4.1% 5.5% 4.1% 2.8% 1.3% 0.8% 0.7% 4.5% 1.4% 3.0%

Atlas Copco 0.0% 0.0% 0.0% 0.4% 1.9% 2.8% 3.4% 2.7% 1.4% 0.5% 0.2% 0.2% 2.7% 0.6% 1.6%

Electrolux 0.5% 0.3% 0.2% 0.5% 0.8% 1.1% 1.5% 1.2% 1.1% 0.7% 0.4% 0.3% 1.1% 0.6% 0.9%

Invensys 0.5% 0.3% 0.3% 0.3% 0.3% 1.0% 1.0% 1.1% 1.1% 0.8% 0.8% 0.6% 0.8% 0.8% 0.8%

Legrand 0.2% 0.2% 0.2% 3.8% 7.7% 12.4% 10.2% 5.9% 2.5% 0.0% 0.0% 0.8% 9.0% 0.8% 4.9%

Sandvik 0.1% 0.0% 0.0% 0.0% 4.5% 8.1% 11.6% 11.4% 6.6% 3.4% 0.8% 0.0% 8.9% 2.7% 5.8%

Schneider Electric 0.0% 0.0% 0.0% 0.0% 4.1% 3.9% 1.9% 1.8% 1.8% 1.7% 1.1% 1.0% 2.9% 1.4% 2.2%

Siemens 0.3% 0.3% 0.2% 1.4% 1.5% 1.5% 1.4% 1.4% 1.4% 1.4% 1.2% 0.4% 1.5% 1.1% 1.3%

SKF 0.2% 0.2% 0.2% 0.3% 1.1% 2.6% 2.6% 2.3% 1.4% 0.4% 0.2% 0.1% 2.1% 0.5% 1.3%

Sector (simple average) 0.2% 0.2% 0.1% 0.7% 2.6% 3.8% 4.2% 3.4% 2.5% 1.6% 1.0% 0.8% 3.5% 1.5% 2.5%

Source: Redburn Partners and based on companies

Fig 96 above shows a summary of our detailed quarterly restructuring, headcount and savings model. This shows that in most instances the sector has already witnessed the bulk of restructuring charges. It also shows that 2Q09 saw the sharpest period of sequential employee headcount decline (we do not forecast employee headcount going forward). Finally, Fig 96 highlights the savings picture and (as mentioned above) how the sector has already experienced the savings benefit sweet spot (in 2Q09 and 3Q09).




The following nine chapters expand our supply-side analysis on an industry-by-industry basis. Industries and end markets differ in their perimeter and so the percentage to each may vary (for example ABB has 51% of sales to the T&D industry but only 31% of sales to the T&D end market, i.e. ABB sells some T&D equipment to other industries).

In the next section we devote a chapter to each of the 11 global industries (that make up 85% of the revenues of our coverage), excluding the automation and healthcare industries, where information is less available.

We have adopted a common framework for each chapter, measuring the following seven factors and (most importantly) how they have evolved over the past 15 years:

Market description

Degree of industry consolidation

Concentration of the largest five manufacturers (the ‘top five’)

Industry margins

Industry volumes

Industry pricing

The degree of threat from new, low-cost entrants



Supply side (1): transmission & distribution (T&D)

ABB: 51% of group sales exposure to the T&D industry

Schneider: 27% of group sales exposure to the T&D industry (post Areva D)

Alstom: 17% of group sales exposure to the T&D industry (post Areva T)

Siemens: 12% of group sales exposure to the T&D industry

The T&D industry has seen significant consolidation over the past few decades as national champions developed and then integrated to create international market leaders. Currently the industry is engaged in a bout of de-consolidation with Areva (the global number three) disposing of its T&D business to Alstom and Schneider, converting the ‘big three’ into ‘big four’. However, even accounting for this, by the end of 2010 the top five manufacturers will hold 61% of the global T&D market compared to 44% in 1997.

We believe this consolidation has led to some improvement in T&D pricing and margins but that much of the improvement has come from a sustained period of strong volume growth. Despite concerns surrounding pricing and emerging market competition, we find the long-term T&D investment case of attractive emerging market growth, coupled with replacement of an ageing Western grid in a consolidated industry, compelling.

Fig 97: T&D product types, arranged by contrasting transmission vs distribution products

HV Transmission Switchgear

HV (Transmission) Circuit Breaker

Distribution Transformer

MV Distribution Switchgear

Power (Transmission) Transformer

HV (Transmission) Substation

LV Miniature Circuit Breakers

Distribution Substation

Source: ABB, Siemens, TBEA, SPX Waukesha, Schneider

China now represents over a quarter of the global T&D market and is served 70% by domestic manufacturers. Collectively, the local Chinese players have seen 29% average revenue growth over the last decade and have increased their level of export from zero to 10%. In general, the Western players have largely maintained shares and kept pace in China which is remarkable given the intensity of competition and a testament to their competitive advantage. Having said this there are mix shifts and in general the Western players have lost share in the standard voltages but have won share in the high voltage (HV) and rapidly growing ultra-high voltage (UHV) segments due to their superior technology at the high end.





Going forward, the Chinese plan to expand UHV lines from 640km at the end of 2008 to 11,000km by the end of 2012. Provided the technology gap does not erode too fast, UHV growth should protect ABB, Siemens and Areva’s Chinese T&D revenues in the medium term. In the longer term we see threats from the creation of a national T&D champion (‘a Chinese ABB’) and the increasing level of export-led competition out of China. In the nearer term we also see threats from the announced 20% cut in capex from the China State Grid (which represents c66% of Chinese T&D capex and is probably the biggest T&D buyer in the world).

Transmission & distribution (T&D)

Fig 98: T&D industry: consolidation of major players between 1982-2010, with supplementary key historical dates

'28 '69 '70 '73 '76 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10

Elin EBG (Austria)VA Tech (T&D) (Austria)Rolls Royce T&D (UK)Northern Engineering (Reyrolle) (UK)Siemens (Ger)

AEG (Transformatoren U) (Ger)Trench Electric (Neth)

EJF (Czech)Elta (Poland)CCC Group (Spain)Westinghouse (T&D) (USA)Ansaldo (Italtrafo / IEL / OEL / OTE)National Industri (Norway)Strömberg AB (Finland)Asea (Swed)ABB (Swiss)Brown Boveri (Swiss)

Calor Emag (Germany)ITE / Gould (USA)Zwar (Poland)Kuhlman Electric (USA)Comem SpA (Italy)

AEG T&D (Germany)Schlumberger Industrie (France)Sprecher and Schuh (Swiss)Compagnie Electro-Mécanique (CEM) (Fra)Thomson-Houston (Fra)SACM (Fra)Alsthom (Cegelec) (Fra)General Electric Corporation (GEC) (UK)English Electric (UK)Allied Electric Industries (AEI) (UK)Alstom (Fra)

WALTEC (Brazil)Nokian Capacitors Ltd (Finland)VEI Power Distribution (Italy / Malaysia)Passoni & Villi (Italy)RITZ Group (USA)Areva T&D (France)

Nu-Lec (Australia)Bardin (France)France Transfo (France)Merlin Gerin (France)Square D (USA)Schneider Electric (France)

Emerging marketnew entrants

Transmission

Distribution

Source: Constructed by Redburn Partners based on company report and accounts, press releases, and other company historical archives

The global transmission & distribution (T&D) complex spans a multitude of technologies. We calculate that the global T&D market represented €55bn in 2008. Within this, products represent c60% of revenues, and systems, automation and service represent c40% of revenues. Within products, we calculate that transformers represent c40% of




the market, switchgear c20% and the balance comprises circuit breakers, capacitors, surge arrestors, contactors, bushings, switches and interrupters.

Degree of industry consolidation The global T&D industry has seen material consolidation over the past 25 years. Currently the industry is engaged in a bout of de-consolidation with Areva (the current global number three) disposing of its T&D business to Alstom and Schneider, in order to fund the huge cash demands of its growing core nuclear business. This transaction will convert the ‘big three’ into a ‘big four’. Both the market leader (ABB) and Areva T&D saw their most meaningful T&D consolidations in 1980s.

Fig 99: 1996-2010E global T&D market shares

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1996 1998 2000 2002 2004 2006 2008 2010

Mar

ket

Shar

e (%

)

Others

EMCO

Crompton Greaves

Chinese Manufacturers

SPX (Waukesha)

Schneider Electric (MV)

ABB (PP & PS)

Alstom (T)

Areva (T&D)

Siemens (PT and PD)

Source: Redburn Partners based on company data

In addition to the original deals that formed the industry, the T&D majors have continued to experience meaningful consolidation over the past 10-15 years. As shown in Figs 99-101, we calculate that the top four global T&D companies have collectively increased their share of the global T&D market by a meaningful 17%, from 40% in 1996 to 57% in 2010 (we forecast).

Fig 100: T&D, 1996 global market share (€33bn) Fig 101: T&D, 2010 global market share (€48bn)

Crompton Greaves

1%

JAEPS (Hitachi)

1%

ABB (PP & PS)

20%

Siemens (PT and PD)

9%Alstom (T)

5%


4%

China XD Group0%

Mitsubishi2%

TBEA0%

Toshiba2%

GE3%

Others53%

Others27%

Toshiba2%

Mitsubishi2%

China XD Group3%

Crompton Greaves

3%TBEA4%

GE3%

Alstom (T)5%


9%

Siemens (PT and PD)

17%

ABB (PP & PS)

24%

JAEPS (Hitachi)

1%

Source: Redburn Partners based on company data Source: Redburn Partners based on company data

In addition, our analysis reveals the extent to which emerging market new entrants (notably from China and India) have arrived on the T&D scene. Collectively, the 11 Chinese and Indian T&D companies covered by our industry analysis (predominantly




transformer makers) have increased their share of the global T&D industry from 2% in 1996 to 17% in 2010 (we forecast).

Fig 102: Global T&D market share ‘big three’ vs emerging market players

0%

10%

20%

30%

40%

50%

60%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Glo

bal

T&D

Mar

ket

Shar

e (%

)

Combined share of "Big 3" Combined share of Emerging Market


The T&D industry is polarised between the majors in the West, which have continued to consolidate over the past decade, and the increasingly important emerging market players.

Industry margin behaviour

Fig 103: T&D EBIT margins of the ‘big three’, 1996-2010E

-4%

-2%0%

2%4%

6%

8%10%

12%14%

16%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EBIT

Mar

gins

(%)

Siemens (PT and PD) Areva / Alstom (T&D) ABB (PP & PS)


Looking through the cycle, the evidence suggests that clean EBIT margins for the three largest players (ABB, Siemens and Areva) have improved over the past 15 years. Over the past five years, the T&D industry has enjoyed a structural boom, supported by infrastructure growth in the emerging markets. While this volume demand has undoubtedly helped margins, what is less clear is whether T&D margins have also been helped by strong net pricing, driven by the industry consolidation story. We know that gross prices (achieved selling prices) were high but this was partly a function of the increase in raw material costs. The key question for future T&D returns is the degree to which net pricing will remain resilient through any downturn, and to understand that it is helpful to try to get a feel for how well net pricing held up in the good years. We pick up this question later.




Fig 104: T&D margins 1996-2010E, total dataset Fig 105: T&D margins 1996-2010E, grouped

-20%

-10%

0%

10%

20%

30%

40%

1996 1999 2002 2005 2008

EBIT

Mar

gins

(%)

Siemens (PT and PD)Areva (T&D)Alstom (T)ABB (PP & PS)Schneider Electric (M V)SPX (Waukesha)TBEABaoding TianweiSanbianChina XD GroupXJ ElectricGuangdong M acroShanghai SiyuanHenan PinggaoCrompton GreavesEM CO

0%

5%

10%

15%

20%

1996 1998 2000 2002 2004 2006 2008 2010

EBIT

Mar

gins

(%)

Emerging Market Average Big 3 Average


Before that it is interesting to consider the impact of the emerging market competition on T&D pricing and margins. In order to introduce the profitability of the emerging market players into our narrative, we have attempted to compare the T&D margins of our entire dataset in a single chart (see Fig 104). However, as this is largely illegible, we have grouped and compared the average margin of the ‘big three’ against the average margin of all 11 emerging market players in Fig 105. This shows an interesting picture and suggests that with increased scale the margins of the Chinese and Indian players have now eroded towards the level of the ‘big three’.

The real question is: will this competitive pressure drive margins even lower? The answer is we don’t know, but we take comfort from the fact that emerging market T&D margins have now stabilised for four years, and looking forward (based on Bloomberg consensus data), margins are still expected to do so by the analyst community (not that that is any guarantee!). Nonetheless, while we remain hopeful, we will monitor this issue quarter by quarter and report back if the picture changes.

T&D volumes

Fig 106: T&D industry volumes enjoyed five good years Fig 107: ‘Big three’ organic sales growth compared

-10%-5%0%

5%10%15%20%

25%30%

2003 2004 2005 2006 2007 2008 2009

Orga

nic

Sale

s Gr

owth

(%)

"Big 3" Average Organic Order Growth"Big 3" Average Organic Sales Growth

-20%

-10%

0%

10%

20%

30%

2003 2004 2005 2006 2007 2008 2009

Orga

nic

Sale

s Gr

owth

(%)

Siemens (PT and PD)Areva (T&D)ABB (PP & PS)


Over the five years from 2004 to 2008, the T&D sector witnessed some of the highest growth in the wider Capital Goods sector, with annual organic order growth averaging 18% and annual organic sales growth averaging 13% for the ‘big three’ (and higher if we include the Chinese, which grew at 28% over the same period).

As ever, the key with revenue growth is the company’s (or industry’s) ability to convert the additional revenue into additional profit. Performing an incremental margin analysis of the T&D sector shows that this conversion has been relatively low. In itself this is not




necessarily a bad thing (for instance, Atlas Copco has low incremental margins but some of the highest margins and ROIC in the sector). However, it does indicate that margins are likely to be slow to move in relation to volumes and that costs are relatively variable. This is indeed the case with T&D.

To put numbers on the operational gearing of T&D, over the same 2004-08 period, revenues increased by €14.5bn from €15bn to €29.5bn for the ‘big three’ companies (ABB, Areva/Alstom/Schneider and Siemens) and EBIT increased by €2.7bn from €1bn to €3.7bn. This represents a reported drop-through of only 19%, not a terrible number but not particularly high either and certainly lower than the 31% enjoyed by the European Capital Goods sector (in aggregate) over the same period.

So, with evidence that T&D margins are not hugely sensitive to volume changes, we should not expect much in the way of operational gearing in the future. Perhaps more importantly the next step is to understand the all-important pricing power equation for T&D.

Industry pricing behaviour While T&D industry margins have benefited from rising volumes over recent years, it is less clear as to what degree they have also benefited from net pricing. However, with ABB gross margins at c30%, it is tempting to say that the industry drop-through of 19% during the growth years should have been higher than it was and should have been closer to the gross margins. The syllogism of this is that there was some kind of negative headwind or cost mismanagement throughout the period; was this then negative net pricing and an inability to pass on the raw material headwind fully even in the good years? If so it will be disastrous in the bad years.

Fig 108: T&D specific raw material index, YoY growth Fig 109: Transformer input prices, YoY growth (%)

-100%

-50%

0%

50%

100%

150%

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

YoY

Chan

ge (%

)

Copper Electro-Steel OilPaper Hot Steel

-20%

-10%

0%

10%

20%

30%

40%


YoY

Chan

ge (%

)

Redburn Transformer Cost Index (as % of sales) YoY Growth (%)

Source: Monthly Data from COTREL (now called T&D Europe following the CAPIEL HV and COTREL merger) based on data from Areva, ABB, Schneider (France Transfo), Siemens, Pauwels, SGB, Transfix, Oasa Transformadores, Alkago, Cotradis, IMEFY and INCOESA

Source: Redburn Index is calculated using data shown in Fig 108 and the following mix: 24% Grain Oriented Electrical Steel, 12% Insulation (Transformer Oil), 12% Insulation (Paper), 43% Windings (Copper or Aluminium) and 10% Tank & Cover (Construction Steel). Raw materials represent 40% of transformer cost (vs 20% components and 40% labour)

Sadly, company disclosure from ABB, Areva and Siemens regarding pricing in their respective T&D operations is virtually non-existent. However, COTREL, the European Association of the Electricity Transmission and Distribution Equipment, provides monthly indexed data on the costs of various raw materials used in the T&D manufacturing process, which affords us some insight. Raw materials such as oil impregnated paper, transformer oil and grain-oriented electrical steel are not standard spot market commodities and price data are not freely available. However, COTREL compiles good quality data from the front line by surveying all the major European transformer manufacturers. This data is shown in Fig 108 and from this we have created a Redburn Transformer cost index (see Fig 109). Transformers represent 40-50% of the revenues in the T&D industry and are the biggest product category so they act as a good proxy for the industry as a whole. Our cost index is shown as a proportion of revenues to make




more comparable with output prices. The data show that costs increased considerably between 2005 and 2007.

In combination, these two charts give some idea of the volatility of raw material costs for the T&D sector. The data certainly seem to match the anecdotal picture as we know it.

Fig 110: US transformer prices recovering Fig 111: Transformer output prices, YoY growth (%)

0

50

100

150

200

250

Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09

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e In

dex

Power and distribution transformers PPI

-15%-10%-5%0%5%

10%15%20%25%30%


YoY

Chan

ge (%

)

Power and distribution transformers PPI Growth (%)

Source: US Bureau of Labor Statistics Source: US Bureau of Labor Statistics

Moving to output prices, the US Bureau of Labor Statistics, which compiles the US Producer Price Indices (PPI), provides data at a pleasingly granular level. Its index for the US domestic output price of power and distribution transformers follows a similar (but not identical) path to the COTREL data of input prices. As with input costs, output prices have fallen over the last year but are now stabilising against easier comps.

Comparing the average monthly input cost inflation (as a percentage of sales) against the average achieved monthly output price inflation between March 2001 and December 2009 suggests a positive and improving story. The evidence suggests that the ability of the transformer makers to pass on raw material cost inflation has improved with time. The data suggest that net price was negative (-1% per year) between 2001 and 2004 and positive (+5%) between 2005 and 2009. This analysis is enormously crude and far from definitive. Firstly, we are comparing US data with European data, secondly we have not allowed for component price or labour cost inflation, and finally we have made a number of assumptions about the proportion of costs that relate to raw materials and the mix of raw materials. However, while crude, it’s all we have.

This raises the possibility that pricing power has perhaps improved through consolidation, better management and the strong demand environment. However, this also raises the risk that transformer net pricing is highly demand elastic and may fall in an environment of falling volumes.

We interviewed the European head of one of the major global transformer manufacturers, and with respect to this exact issue, the response was:

“Over the last 15 years, the transformer manufacturers have become better at managing costs. In the early 1990s, the actual cost of the average transformer used to vary significantly to the cost in the tender design but these days the two are very similar. I would say we achieve roughly an 80% hit rate these days vs 20% in the early 1990s. Just look how many European transformer factories closed over the period when raw material costs lifted and smaller players failed to manage this issue.”




Pricing in order backlogs is negative

While both the COTREL input cost and US transformer PPI output price data above may not be a perfect representation of the company financials, they do at least give an accurate picture of the current cost and invoicing price environment across the industry. What they do not provide, however, is the all-important outlook for future pricing. With order backlogs of roughly one year at ABB and Siemens, the manufacturers are the only ones positioned to have a clear picture of this by tracking order pricing for future deliveries, rather than current invoicing prices. It is here that the manufacturers are painting a cautious picture.

At the 3Q09 results ABB indicated that its Power Products division (where transformers are 40-50% of revenue) had seen -4% pricing on new orders with distribution transformers worse than power transformers. The 2Q09 picture was also similar at -4-5%. ABB was keen to highlight that these numbers were gross pricing and that because of the fall in costs, the all-important net pricing was closer to zero but still negative.

So what does this say about T&D pricing power?

With the T&D industry enjoying some of the higher price increases of the industrial boom between 2004 and 2008, it is tempting to say, given the consolidation period, that the industry has relatively attractive pricing power. Indeed, this conclusion would support the crude data regarding the improvements in net price. However, the low level of incremental margins (see above) suggests otherwise. As one equipment buyer at a major utility put it: “The T&D equipment makers have been stiffing us all on price for so long that the utilities have been quick and universal in their demand for price cuts.”

The evidence suggests that underlying raw material costs and output prices in the T&D industry are relatively volatile and highly sensitive to end demand levels. Our net price data (which is relatively low quality) hints at an improving ability to pass on raw material cost inflation. What is less clear is whether this was a function of better pricing power or just strong demand. It also fails to explain why the industry level of incremental margins (or drop-through) was so low during the boom years.

It also leaves unanswered the degree to which costs can be passed through in a downturn. Our view is that falling prices in the order book will meet rising cost inflation in 2010E and lead to some margin erosion in the near term.

Low-cost entrants?

Fig 112: China €20bn T&D market, 2009 Fig 113: India €5bn T&D market, 2009

Others51%

Sanbian Sci-Tech1% NARI

Technology1%

ABB13%

Japan-Korea4%

Guangdong Macro

1%

Tianwei2%

XJ Electric1%

Areva4%

Siemens7%

TBEA6%

XD Group7%

Henan PingGao

1%

Shanghai Siyuan

1%

Areva India19%

Siemens India15%

Crompton Greaves

7%

BHEL6%

Others25%

Emco Transformers

1%

L&T2%

ABB India25%





The degree of new entrants and low-cost competition in the global T&D industry is some of the more intense across all industry pillars of the European Capital Goods sector. The explosion of domestic emerging market manufacturing capability has been exponential and predominantly a Chinese phenomenon. While India has undoubtedly witnessed some impressive growth from its domestic T&D manufacturers, notably Crompton Greaves (which owns Pauwels in Europe) and BHEL, the ‘big three’ still control over half of the Indian T&D market and remain comfortably dominant.

In China, however, the picture is different. While ABB still holds the number one position in China, the local players make up the vast majority of the market at c70%. The positions of the ‘big three’ Western players in China have been predominantly developed through a number of JVs with local manufacturers. ABB has 14 JVs in China in its T&D operations, the largest of which is its Chongqing Transformer JV. Siemens (which is fourth in China’s T&D market) is dominated by its Shanghai HV Switch and Xuji Power Transmission JVs. Areva (which is fifth) has its Suzhou (Jiangsu) JV, which makes HV and MV gas insulated switchgear (GIS) products, and its Xiamen JV, which makes vacuum interrupters.

Fig 114: 1996-2010E group revenues of leading Chinese T&D manufacturers

0

10,00020,000

30,00040,000

50,00060,000

70,00080,000

90,000

1996 1998 2000 2002 2004 2006 2008 2010

Sale

s (R

MB

mn)

Sanbian Sci-Tech

NARI Technology

Shanghai Siyuan

Henan PingGao

Guangdong Macro

XJ Electric

Tianwei

TBEA

XD Group

ABB Power China

Source: Redburn Partners, excludes Siemens, the Japanese and the Koreans, given the lack of disclosure

As highlighted in Fig 114, Chinese demand for T&D equipment has increased exponentially over the past decade. To be more precise, T&D revenues of the ten companies included above saw an average annual growth of 29% between 1997 and 2008, putting T&D growth well above China’s national growth in fixed investment (which was 18% over the same period) and making Chinese T&D one of the fastest growing large-scale industries in the world over the period.

China: loss of market share for Western players

Fig 115: Share of SGCC total transformer procurement, 2006–1H09

24% 19% 15% 12%0%

10%20%30%40%50%60%70%80%90%

100%

2006 2007 2008 1H09

Mar

ket

shar

e of

Sta

te G

rid

Tran

sfor

mer

Pro

curm

ent

(%)

Other

Baoding Tianwei Baobian Electric

China XD Group

Changzhou Toshiba Transformer

Tebian Electric Apparatus Stock (TBEA)

ABB

Source: State Grid of China Corporation




In the early part of this decade when T&D growth first ballooned in China, ABB, Siemens and Areva all stole material market share gains on the local manufacturers based on their technological expertise and advantage. However, as local capability has improved, this position has reversed.

Our analysis in Fig 114 and the State Grid of China procurement data in Fig 115 support the argument that ABB has been losing market share in the Chinese T&D market to local players (and anecdotally we hear this is also the case for Siemens and Areva, although we don’t have the data to confirm this).

HV and ultra-high voltage (UHV), continued advantage to the ‘big three’, for now?

The ‘big three’ continue to be protected at the more complex end of the technology spectrum of high (HV) and ultra-high voltage (UHV). Thankfully for the Western manufacturers there continue to be attractive structural trends that will drive significant growth in the UHV end of the technology spectrum in China for a number of years to come.

The Western players have the technological edge in UHV equipment, which to date has protected their Chinese market share. As pointed out by Magnus Strom, the head of ABB Chongqing Transformer Co (ABB’s biggest asset in China), ABB, Siemens and Areva have seen aggressive competition and share loss in the standard voltage levels in China (as discussed above) but remain very strong in the UHV arena (750-1,000kV for AC and 660-800kV for DC).

Fig 116: Share of SGCC HV (500-750kV) transformer procurement 2006-08

23%23%

28%

0%

20%

40%

60%

80%

100%

2006 2007 2008

Shar

e of

SG

CC

Tra

nsfo

rmer

Pr

ocur

men

t 50

0-75

0 kV

(%

)

Other

Changzhou Toshiba Transformer

Chongqing ABB

China XD Group

Baoding Tianwei Baobian Electric

Tebian Electric Apparatus Stock (TBEA)

Source: State Grid of China Corporation

Fig 116 above supports Mr Strom’s argument: to date in the upper voltages ABB has been holding its share (and even increased it in 2008). Note that we have not been able to locate any UHV market share data for China as it is a nascent market.

UHV growth expected to take off

The vast majority of China’s power generation takes place in the western and northern provinces (76% of China’s coal reserves are in the West and the North and 80% of the hydro capacity is in the West), but 75% of power demand is driven by the central and eastern parts (used in large cities like Shanghai and Guangzhou in the east). Given the degree of energy losses from transmitting electricity over long distances, China has decided to implement new ultra-high voltage (UHV) equipment.

According to the State Grid of China Corporation the transmission efficiency of one 1,000kV UHV line is 4-5x greater than a 500kV line. Under normal operating conditions, UHV lines are able to extend regular transmission distances by 3x, and wasted energy run-off is only 25-40% of regular 500kV lines. Furthermore, using 1,000kV lines instead of 500kV lines generates real estate savings of c50%.




Fig 117: UHV grid development plan

Timeframe Project Length

(km)Transmission capacity

(100m kW)New investments

(Rmb100m)

End-2008 Jindongan-Jingmen trial line 640 0.02 60

End-2012 2 vertical, 2 horizontal 11,000 0.5 1,055

End-2020 2 vertical, 6 horizontal 50,000 3 6,000

Source: Bank of China International

By the end of 2008 China had installed 640km of UHV lines but (as shown in Fig 117) intends to have 11,000km of lines by 2012 and 50,000km by 2020. This exponential growth in UHV should continue to provide protection to the Western manufacturers against the local threat.

China state grid announces 20% capex cut in 2010

Fig 118: 2009 market share of €170bn Chinese electrical grid utilities market (the buyers)

China State Grid66%

China Southern Power Grid16%

Other18%


Moving back to the total Chinese T&D market on 18 January 2010, the Chinese State Grid announced a planned 20% cut in capex for 2010E to RMB227bn. As China’s largest electrical utility, controlling roughly two thirds of the Chinese grid, the State Grid is by far and away the biggest buyer of T&D equipment in China and one of the, if not the biggest in the world. Given the already deteriorating outlook for global T&D demand in 2010E, the evaporation of the Chinese growth machine will put a strain on the market. We believe this to be a short-term setback, within a longer-term growth story, but nonetheless it will have effect. The state grid has at least confirmed that its UHV projects are expected to remain relatively unaffected.

The longer-term threats from China

We see two core threats to the global T&D industry and the Western ‘big three’ from the Chinese T&D market:

The development of a Chinese national T&D champion (the Chinese ABB): the State Grid of China’s recent acquisition of XJ Electric and Pinggao Electric marks the beginning of the State Grid’s efforts to vertically integrate its existing utility business into the T&D equipment market. The State Grid has signalled its desire to create a world-class T&D player. Although the domestic players still lag behind on technology, the State Grid has a unique overview of Western technology (as China’s biggest buyer) and it may not be long before it assimilates the technology and experience accumulated in domestic grid construction (particularly in UHV/DC projects) into its own T&D offering. Consequently, there is a real risk that a Chinese ‘ABB’ may emerge over the next five years with a globally competitive technology offering and a low-cost advantage.




Increased export of equipment from China into other emerging markets and even Europe and the US: over the last half decade the local Chinese T&D manufacturers have developed an increasing level of export – a contrast to their beginnings as almost entirely domestic-only companies. Over the past three years the local Chinese T&D players have seen exports increase to c10% of industry revenues, led by Guangdong Macro, TBEA, XD Group, XJ Electric and Tienwei. If the technology gap continues to narrow and if China’s economic growth story fades, there will be a significant level of Chinese domestic manufacturing capacity looking to chase global T&D demand, and export-led competition from China will almost certainly increase. Given the 2010E cut in capex from the state grid, this pressure may emerge sooner than feared.

Fig 119: Degree of domestic revenues 2008 (ranked) Fig 120: Average domestic share (across local Chinese)

100% 100% 100% 95% 91% 88% 85% 81% 79%

0%

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Hena

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ngGa

oNA

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roup

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acro

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2003 2004 2005 2006 2007 2008

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Chi

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Chinese T&D domestic manufacturers (Average)


The European head (of the major global transformer manufacturer) that we interviewed, was relatively relaxed about the Chinese competing in Europe and for the avoidance of paraphrasing here is how the conversation went:

Redburn Capital Goods question: “How much are you seeing the Chinese in Europe?”

Europe T&D head answer: “We are not seeing any massive competitive changes currently. Having said that they [the Chinese] are starting to show an interest in Europe… in the tendering process. However, as far as I can see, the European utilities are not that interested in buying Chinese. A lot of it comes down to local health and safety regulations. From a legal perspective the utilities are bound by that legislation and there has to be confidence about the ability for a manufacturer to (1) supply, (2) deliver and (3) install while meeting all of the standards. The Chinese have no history, experience, reference or track record in any of this, so why buy from them?”

Redburn Capital Goods question: “But why not just buy Chinese kit and hire a third-party player to install, deliver and service?”

Europe T&D head answer: “But then there is no continuity of warranty so should something happen on site after the third-party has left, who takes responsibility, the Chinese have no one on the ground and does the third-party installer have any idea how to repair and service? I don’t think that breeds confidence.”




Redburn Capital Goods question: “OK then but what about technology, what are the real barriers to entry for a Chinese trying to move up into HV and UHV? I have been to a transformer plant and to be honest it looks like how I imagine a 1920s textile factory to look, everything is handmade with lots of ladies wrapping the copper by hand with brown insulating paper, nothing is automated and so presumably the technology is very old and easy to copy.”

Europe T&D head answer: “Ha, well you are right that technology has not changed a lot over the last 50 years, in design terms at any rate. However, the barrier to entry, which is, I suppose, what you are getting at comes around the design tools, ability to test and the knowledge of local specification and safety standards which differ for each product category in each market (which is why manufacturers often never move across product category except through acquisition unless they have big R&D centres like the majors. The cost of breaking out into new technology bands is very high, take UHV only a handle of us could have taken that move.”



Supply side (2): power generation (PG)

Alstom: 59% of group sales exposure to the power generation industry

Siemens: 22% of group sales exposure to the power generation industry

The power generation industry is relatively mature following a century of consolidation. Over the past 20 years national champions have merged to create international champions. While the ‘big four’ continue to enjoy attractive concentration (with 55% of combined global market share), collectively they have lost 5% of market share to emerging market new entrants over the past five years. While we remain confident their share in the developed market is protected, given their differences in product quality, we expect increasing competition for new emerging market business, which is where the growth is.

Given the consolidation of the past 20 years, we see evidence that margins and pricing power have improved in the power generation industry, particularly since the Siemens/Westinghouse and Alstom/ABB mergers of 1998 and 2000. Margins showed real resilience in the 2002-03 downturn (compared to the past) and the industry is likely to face another test in the next two years as the recent order declines feed through into invoicing. We are optimistic on industry margins given the industry consolidation story and lack of competition in the West, but also because margins are driven by the service and spare parts consumed by the sizeable installed base.

The key area of risk is pricing. Power plants have seen an average annual price rise of 7% since 2000 due to passing through costs. Looking forward, we expect downward pressure on prices as falling costs work their way through the supply chain. Managing this pricing dynamic is a key challenge for the sector, if it is to protect margins in 2010E and 2011E.

Power generation Fig 121: Key generating technologies with (i) share of global 4,000GW installed based and (ii) share of 2008 global gross capacity additions (127GW) excluding China (64GW)

Nuclear (9% & 1%)

Gas (17% & 33%) Steam (Coal) (49% & 22%)

Wind (2% & 19%) Hydro (19% & 11%)

Source: Market share data from Platt’s UDI World Electric Power Plants Base (WEPP), Google images

The global power generation complex spans multiple technologies and fuel types as well as a number of regional differences. We estimate the total 2008 global EPC (Engineering, Procurement and Construction) market for power generation was €100bn, based on 190GW of gross additional capacity.





Fig 122: 1950-2008 global GW additions incl. China Fig 123: 1950-2008 global GW additions excl. China

0

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1950 1960 1970 1980 1990 2000

Glob

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Other Wind Nuclear Hydro Gas Coal (Steam)

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Source: Platt’s UDI World Electric Power Plants Database (WEPP) Source: Platt’s UDI World Electric Power Plants Database (WEPP)

Since the trough in 1990, the global power generation market has seen an annual CAGR of 6.3%. Our CAGR is calculated using gigawatts (GW) so it represents volume rather than value, which would be higher. Looking at the regional variations shows that China has been the clear winner, having grown by 10.3% CAGR over the same period (having increased sixfold from 11GW in 1990 to 64GW in 2008). In 2008, China represented an impressive 32% of total global generating equipment deliveries (in GW).

Excluding China, global deliveries have seen a 5.1% CAGR since 1990. However, 2008 was a relatively good year and, stripping out the global industrial boom effect of 2007-08 and the US gas bubble (2001-04), the growth curve has been relatively stable, measuring a 3.0% CAGR between 1990 and 2006. It’s hard to make any other conclusion than this industry (in the West) is relatively mature. However, given the relatively high value and low volume nature of the market, it does display a certain lumpiness, and any one year can be an aberration either way, particularly at the company level.

In the nearer term, demand is likely to suffer from the financial crisis but longer-term demand is supported by a compelling replacement story (see Fig 287). Power plants take a long time to build and backlogs are long; as such the delivery cycle is relatively long and late. Orders (which tend to drive share prices more than revenues) are perhaps more closely aligned with the general GDP cycle but even orders are lagged.

Technology changes

Fig 124: Additions to the global fleet by fuel type, 1990-2008 CAGR

22%

8% 1%

-9%

23%

7% 9% 4%

-9%

4%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Wind Gas Hydro Coal (Steam) Nuclear

Glo

bal

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alle

d C

apac

ity

(Gro

ss A

ddit

ions

(G

W))

1990

-200

8 C

AG

R (

ex C

hina

)

Excl. China Incl. China

Source: Platt’s UDI World Electric Power Plants Database (WEPP)




While the overall Western power generation market is relatively mature, there has been significant growth variation between the different fuel/technology markets. A key theme of the past 50 years, often determining the winners and losers amongst the power generation manufacturers, has been technology change. The traditional technologies of steam and hydro, which dominated in the 1950s and 1960s (steam turbines tend to be coal-based), have witnessed three meaningful competing technologies over the past half decade: nuclear, gas and wind.

Nuclear: rise and fall, then rise again? Following Hiroshima and Nagasaki, the US channelled its atomic knowledge into nuclear power generation. For a while the world bought into the dream of stepping towards free energy, and nuclear power generation tore a strip off steam with huge market share gains throughout the 1970s and 1980s. At its peak in 1985 (see Figs 122 and 123), nuclear power generation reached 35% of global power generating capacity additions (as measured in GWs). However, the dream was not long-lived and following the Three Mile Island accident in the US in March 1979 and Chernobyl in April 1986, global demand collapsed. To put it into context, there hasn’t been a single nuclear power plant order in the US since 1977 (interestingly 100 miles southwest of Houston, construction on the first fully licensed nuclear plant to be built in the US for 30 years is scheduled to begin soon by NRG Energy). In Europe, only 18 of the 183 operating plants that operate today have been built since 1985.

As a result, while 399 reactors were built between 1970 and 1990, installed capacity rose by only 14% between 1990 and 2008, leading to a -9% CAGR for new additions. Despite this, nuclear power generation revenues grew by 1-2% per year on average between 1990 and 2008, largely due to servicing and improving productivity at existing reactors.

Despite the risks, nuclear is back on the discussion table. With environmental and political pressures to address greenhouse gases, concerns regarding the security of fossil fuel supply and CO2 emissions costs rising, a number of governments are now contemplating nuclear again.

At the end of 2008, 44 reactors were under construction around the globe, compared with 35 at the end of 2007; 105 reactors were either on order or planned, compared with 91 at the end of 2007 and 62 at the end of 2006. Europe and the CIS overtook the US some while ago and now have about 45% of the world’s installed nuclear capacity; North America has 29%.

Most of the medium-term growth, though, is likely to come from Asia (Japan, South Korea and now China) and, to a lesser extent, the CIS. Alstom is well positioned in this market with its 44% share of the conventional island steam turbine market (mostly though its Dongfang JV).

Nuclear has a number of advantages:

It’s very clean with zero CO2 emissions.

Economics are attractive in that the cost of fuel is usually only 5-10% of the total cost.

The average nuclear plant lasts for 50 years or more.

Uranium is widely available and there is limited supply risk.

Nuclear can operate as a base load as an alternative to steam (rather than peaking power, which gas is more suited to). To understand the difference between base and peak, it may help to think of gas plants as light switches (they are very quick to turn




off and on) and coal and nuclear plants as kettles (they take a longer time to warm up and cool down).

However, there are also clear disadvantages: nuclear plants have very high up-front capital costs (€3-4bn) and take a long time to plan, approve and install (10-15 years). More important, though, is the safety risk as it is impossible to remove human error completely. Do governments really want to risk the 100-fold increase in thyroid cancer and nationwide farmland contamination witnessed by Belarus post Chernobyl? Furthermore, critics fear more nuclear plants in the US could encourage more plants abroad, leaving the door open to weapons proliferation. Equally, Greenpeace points to a 1980s-era report from the US government’s own Argonne National Labs, removed from government websites after September 11, saying a direct hit by an airliner on a nuclear power plant could lead to a meltdown.

Gas: compelling technology and a potential US shale gas boom?

Fig 125: 2009 global heavy duty gas turbine shares Fig 126: ‘Big four’ gas unit deliveries (excl. Alstom)

Other6%

Alstom11%

Siemens29%

GE46%

Mitsubishi Heavy (MHI)

8%

96 11460 35 45 55 61 70

350 323

175

122 127 134170 188

3510

21 24

355

106

0

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500

2001 2002 2003 2004 2005 2006 2007 2008Heav

y Du

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as T

urbi

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(Uni

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Siemens GE MHI

Source: MHI Alstom does not provide data on unit deliveries Source: Redburn Partners, company data

Historically, gas turbines were seen as relatively inefficient compared to other power sources. In the 1950s, the electrical efficiency of gas turbines was as low as 15%, capped by temperature limitations. As blade metallurgies and cooling methods advanced, temperatures have been successfully lifted, taking electrical efficiency past the 35% achieved by steam turbines to 45%+ in single cycle and over 60% in ‘combined-cycle’ (where the hot exhaust is recycled to power a second steam turbine).

Ever since then, gas has stolen a march over steam in the West. While steam turbines (which use coal) still represent roughly half of the world’s installed base, their dominance has diminished. In 2008 gas represented 33% of new additions (outside of China) ahead of steam at 22%. As shown in Fig 124, gas has enjoyed a CAGR of 8% since 1990 compared to steam at only 1% (excluding China).

China has no gas fleet

If we include China (which is religiously loyal to its sizeable coal reserves and has almost no gas turbine fleet whatsoever) then the picture reverses. Given China’s sheer pace of growth, the PRC has single-handedly returned steam to the global number one position. However, as China is a relatively closed shop, we believe the Western power generation manufacturers are unlikely to enjoy the growth of this enormous steam. As such, excluding China from global data (as we have in Fig 123 above) makes sense, in order to more closely reflect the true addressable market for the Western manufacturers.




Gas thrives under de-regulation In addition to the technology arguments, the market share gains of gas turbines in the West have been driven by de-regulation. As the energy markets opened, the characteristics of the gas turbine suited private investment capital more than steam.

Gas-fuelled power plants have lower capital construction costs and a faster time-to-market than steam. In addition, gas-fired power generation is flexible (i.e. quick to switch on and off), making it ideal for peak-load requirements (vs coal-fired and nuclear, which are predominantly used for base-load as they are slower to turn on and off). Gas is also scalable, making it more suited to serve the increasingly de-centralised power model.

Gas supported by wind

Furthermore, as the wind markets develop, demand for gas turbines is also likely to be supported. Wind is volatile and a parallel flexible power source is often needed as back-up, which neither steam nor nuclear can address efficiently.

Gas is the highest margin technology from a manufacturer standpoint

From the manufacturers’ perspective, selling more gas turbines than steam is highly desirable. Gas is more profitable than steam as it has a shorter life (and therefore faster replacement cycle) and gas turbines consume more spare parts. In the world of power generation, the real money is often made from servicing and replacing spare parts for the installed base. While wind may have growth today, once it matures, it may suffer from the lack of this important revenue stream, as unlike gas turbines, which are heavy consumers of spare blades, wind turbines last a relatively long time with the spare revenue focused more on the gear-box, which is often outsourced to other sub-suppliers (e.g. Hansen).

The US shale gas story

In June 2009 the Potential Gas Committee (PGC) released its biennial assessment of the US’ natural gas resources. The report estimated the total US gas resource base at 1,836 trillion cubic feet (Tcf). Not only was this the highest ever resource evaluation in the Committee’s 44-year history, but the 2008 assessment represented a rather surprising 39% increase on the 2006 assessment of 1,321 Tcf. So why the step change? Most of the increase from the previous assessment arose from a re-evaluation of the US shale gas reserves in the Appalachian basin and in the Mid-Continent, Gulf Coast and Rocky Mountain areas.

Fig 127: Published estimates of US recoverable shale gas resource (Tcf)

Year 2003 2007 2008 2009

Published estimates of US recoverable shale gas resource (Tcf) 35 125 385 616

Source NPC EIA ICF PGC

Source: NPC, EIA, ICF and PGC

Due to advances in horizontal drilling and hydraulic fracturing, previously unidentified and unreachable gas reserves can now be accessed. As shown Fig 127, estimates of the US shale gas resource have lifted 20-fold over the past six years, from about 4% of the total US gas resource to 33%. The Obama administration has picked up on this and signalled a national imperative to replace coal with natural gas in electricity generation to reduce CO2 emissions. Dr Joseph Romm of the influential Centre for American Progress has already declared shale gas a ‘game-changer’.




Fig 128: 1992-2010E global GW net additions by region

020406080

100120140160180

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Net I

nsta

lled

Capa

city

Add

ition

s (G

W)

N. America W. Europe E. Europe (inc Rus) China Other Asia RoW

This geographical data is from a different source to the Platt’s data in Fig 122 (which is by fuel type) and is also calculated net of retirements Source: The International Energy Outlook prepared by the Energy Information Administration (EIA)

Does shale gas represent a potential second US gas bubble (the last being 2001-04 as shown in Fig 128 above)? If so, GE and Siemens, the undisputed leaders in heavy duty gas turbines, would enjoy another bout of earning surprise. However, a second gas bubble is by no means guaranteed. Some suggest the US gas power generation capacity remains relatively under-utilised post the mass installation five or so years ago, and we have not found good evidence to refute this. Furthermore, ‘fracking’ costs are rising sharply and the decline rates of production in years 2, 3, 4 and 5 for the few longstanding shale gas facilities are disturbing. The estimated costs of developing the US shale resource are over $100bn and the main shale gas players are delivering poor margins off heavily geared balance sheets. Given the combination of low gas prices and increased supply of ‘tight’ gas from the Rockies and LNG, the viability of the US shale story is yet to be proven.

Nonetheless, in the relatively mature world of US Capital Goods, demand for the US shale gas resource presents an interesting growth potential.

Wind: the current rock star

Fig 129: 2008 global wind market shares by MW

GE Wind15%

Gamesa14%

Vestas21%

Others4%

Alstom2%

Siemens6%

Goldwind4%

Acciona4%

MHI3%

Sinovel3%

Nordex3%

Suzlon9%

Enercon12%

Source: BTM Consult

While gas has challenged steam for market share outside of China, wind is seeing the fastest growth. In 2008 wind accounted for 19% of global gross additions (excluding China) at 24GW – a 20-fold increase over the past decade from an initial 1-2%. Expectations of future growth in wind vary, but BTM Consult (the most widely respected Wind consultant) expects c20% growth per year over the next decade. We do not intend to go into the wind markets in any great detail (we will leave that to our renewables team)




and as such have excluded the standalone wind turbine manufacturers (Vestas, Gamesa, Enercon, Nordex, Suzlon, etc) in our company analysis below.

However, it is interesting to note that each of the traditional power generation majors, the ‘big four’ of GE, Siemens, Alstom and MHI, have built a wind power position of some description, with GE in the number two position, Siemens at six and both MHI and Alstom with smaller positions.

Power generation mix differences To add a layer of complexity, as well as the five fuel types discussed above, the power generation industry can also be analysed in terms of the type of equipment or service sold. For instance, any revenues in relation to a coal plant would come under steam in the discussion above; however, in reality steam revenues could come from a wide array of products and services (e.g. heavy duty steam turbines, industrial steam turbines, boilers, environmental emission reduction systems, automation controls, turnkey engineering, heat exchangers, spare parts or services).

Fig 130: Power generation heat map (including 2008 market share and ranking position, where available)

Hydro

Wind

Solar

GE (Energy)46% (# 1)

14% (# 4)

(# 1)17% (# 2)

19.9%

Siemens (FPG, O&G, Renewable)29% (# 2)

20% (# 2)

(# 2)12% (# 4)

7%(# 6)

14% (# 3)

14.3%

Alstom (Power Systems & Service)11% (# 3)

18% (# 3)

14% (# 2)

26% (# 1)

2%(# 11)

44% (# 1)

13.1%

Mitsubishi Heavy (Power Systems)8%

(# 4)6%

(# 5)4%

(# 7)3%

(# 8)14% (# 3)

7.9%

Hitachi (Power Systems)25% (# 1)

22% (# 1)

1%(# 9)

3% (#5)

5.5%

Shanghai Electric (Power Equipment)3% (#5)

3.3%

BHEL (Power)2%

(# 8)1%

(# 7)3.3%

Harbin Power (Group)6%

(# 5)20% (# 2)

2.9%

Donfang Electric (Group)16% (# 3)

2.7%

Doosan Heavy (Power & Nuclear)11% (# 3)

17% (# 2)

2.5%

Babcock & Wilcox (Power Gen.)8%

(# 6)1.7%

Solar Turbines (CAT) (# 3) 1.4%

Foster Wheeler (Power Group)7%

(# 4)1.2%

Rolls Royce (Energy) 1.0%

OJSC Power Machines (Group)5%

(# 6)4% (#4)

0.8%

Energy M

anagement

Environmental

Control Systems

Heat Exchanger

Small Gas &

Steam

Turbines

Instrumentation

& Controls

Renewable

Nuclear Conventional

Island

Company

Total Power Generation

Market Share

Large Gas Turbine

Original Equipment Aftermarket

Heat Recovery Steam

Generator

Generators

Boilers

Large Steam

Turbine

Plant / Turnkey

We have not included the nuclear reactor segment where Areva, Toshiba (Westinghouse), GE/Hitachi, FAAE (Russia), AECL (Canada) and MHI participate, as there are no sector participants Source: Redburn Partners, Alstom, GE, Mitsubishi Heavy, Siemens, Hitachi, McCoy Power Reports, Platt’s and other company sources

To attempt to cut through this complex maze, in Fig 130 we show how each player is positioned in each product and service segment. This is the same universe that we use in our ‘power generation’ analysis below (i.e. we have omitted the pure-play wind turbine manufacturers such as Vestas and the nuclear reactor equipment makers such as Areva).




Degree of industry consolidationFig 131: Power generation industry: consolidation of ‘big four’ between 1994-2009, with supplementary key historical dates

'28 '35 '62 '64 '67 '69 '70 '89 '94 '96 '98 '00 '02 '04 '06 '08Harbin JV (GE-HEPC ES)Enron Wind (US)Bently Nevada (US)Smallworld (US)Stewart and Stevenson (US)General Electric (US)Nuovo Pignone (Italy)Alstom AGT (Fr / Ger)Kvaerner (Norway)KVB-Enertec (US)Kvaerner Hangfa JV (China)

Solel Solar (Isr)Power Machines (25% JV) (Rus)Wheelabrator Air Pollution (US)Bonus Energy (Den)Alstom Industrial Turbines (Fra)Demag Delaval (Ger)Parsons (Rolls Royce) (UK)Siemens (Ger)AEG (merger creates KWU) (Ger)Shanghai Electric PE (40% JV)Westinghouse Electric (US)

NPCIL-BHEL (Nuclear JV)Ecotechnia (Wind) (Spain)Wuhan Boilers (China)Asea (Swed)

ABBBrown Boveri (Swis)Oerlikon (Swiz)Alstom (Fra)Thomson-Houston (Fra)SACM (Fra)Alsthom (CGE) (Fra)

General Electric Corporation (GEC) (UK)English Electric (UK)Allied Electric Industries (AEI) (UK)DongFang (Guangdong Nuclear) JV

Takasago Machinery Works (Jap)Mitsubishi (Jap)Yokohama Machinery Works (Jap)Nagasaki Machinery Works (Jap)DongFang (Guangzhou; Gas) JV

AAP JV

Emerging market new entrants


The power generation industry is relatively mature following a century of consolidation. Initially this consolidation was predominantly conducted to create national champions but over the past 20 years the focus has shifted to international combinations. We have tried above to illustrate the key transactions behind the current industry structure of the ‘big four’.

Siemens: having rebuilt its shattered manufacturing footprint after WWII Siemens merged with AEG in 1969 to create KWU, the bedrock of Siemens’ power generation offering today. In 1998, Siemens increased the size of its fossil power generation business by 50% with the major acquisition of Westinghouse’s non-nuclear fossil-fired power plants business from CBS for $1.3bn. More recently, Siemens moved into the wind market through the acquisition of Bonus (2004) and into the increasingly important




oil & gas market through the acquisitions of Demag Delaval (2001) and Alstom’s Industrial Turbines (2003).

Alstom: originally created by the 1928 merger of SACM and Thomson-Houston, Alstom has seen two transformational acquisitions over the past 20 years. In 1989, Alsthom (as it was then spelt) merged with the UK’s GEC and in 2000 it fully acquired ABB’s power generation business.

GE: as with Siemens, GE’s more recent acquisitions have been focused on oil and gas industrial turbines and compressors (led by the Nuovo Pignone acquisition in 1994) as well as the renewables market (buying Enron’s wind arm in 2002). In the more traditional steam and gas power generation markets, GE has made three transactions of note over the past decade: Stewart and Stevenson’s gas turbine division in 1997, Alstom’s heavy gas turbine business in 1999 (Alstom knew it was getting ABB’s heavy gas business at the time) and Kvaerner’s gas turbine division in 2000: all three deals consolidating its already strong position in gas.

Mitsubishi Heavy: MHI’s current power generation business was formed in 1962-64, when Mitsubishi added both Yokohama Machinery Works (boilers and steam turbines) and Nagasaki Machinery Works (boilers and steam turbines) to its core base of Takasago Machinery Works (gas and steam turbines). Disclosure regarding acquisitions is much less transparent in Japan, so while it appears MHI has not seen any major external acquisitions for 45 years, that may not be the full picture.

Market shares The power generation consolidation of the past 50 years has left the industry with a high degree of concentration at the top end of the market. In 2008, we calculate that the ‘big four’ made up 55% of the €100bn global market.

Fig 132: €100bn 2008 global power generation market by share

GE20%

Siemens14%

Alstom13%MHI

8%Hitachi

6%Shanghai

3%

BHEL3%

Harbin3%

Donfang3%

Doosan2%

B&W2%

Solar Turbines1%

Foster W.1%

Rolls R.1%

Power M.1%

Other19%

Source: Constructed by Redburn Partners based on company report and accounts

By grouping and contrasting the ‘big four’ in the developed world (GE, Siemens, Alstom, MHI and Panasonic) against the key emerging market new entrants (Shanghai Electric, Dongfang Electric, Harbin Power, BHEL, Doosan and Power Machines) and studying the data in time series (see below) yields a similar picture to the appliance industry.




Fig 133: 1998-2008 global power generation market shares

0%

10%

20%

30%

40%

50%

60%

70%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glo

bal

Mar

ket

Shar

e (%

)

Big 4 (GE, Siemens, Alstom, MHI)Emerging Market Players (Shanghai, Dongfang, Harbin, BHEL, Doosan and PM)

The data include the Chinese market (c€40bn) but exclude standalone wind turbine manufacturers (c€40bn) Source: Redburn Partners

Western consolidation continued throughout the 1960s, 1970s, 1980s and 1990s and at their peak in 2003 (see Fig 133) the ‘big four’ controlled two thirds of the market. The final 10% increase in concentration came from two significant transactions at the end of the 1990s, Siemens/Westinghouse and Alstom/ABB.

However, as with the Appliance industry, over the past five years the power generation industry has seen meaningful expansion amongst the low-cost competitors from China and India. To put this in context, despite increasing their collective revenues by 57% between 2003 and 2008, the ‘big four’ actually lost 5% of global market share over the same period (as the ‘emerging market players’ increased their revenues by a materially greater 480%). However, unlike the appliance industry, and as discussed below, the low-cost players have remained largely domestic and have not materially looked to compete in the Western markets.

Encouragingly, the ‘big four’ regained some market share in 2008.

Fig 134: 1998-2008 global power generation revenues of leading manufacturers

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Sale

s (€

mn)

Doosan

Foster W.

B&W

Rolls R.

BHEL

Harbin

Donfang

Shanghai

Hitachi

MHI

GE

Alstom

Siemens

Not all revenues are based on group data. The entities used are as follows: Siemens (FPG, O&G and Renewable divisions in aggregate), Alstom (Power Systems & Service divisions in aggregate), GE (Energy), Mitsubishi Heavy (Power Systems), Hitachi (Power Systems within P&I division), Shanghai Electric (Power Equipment), Dongfang Electric (Group), Harbin Power (Group), BHEL (Power), Rolls Royce (Energy), Babcock & Wilcox (power generation division of McDermott), Foster Wheeler (Power Group), and Doosan Heavy (Power & Nuclear divisions in aggregate)Source: Company reports

Fig 134 highlights both the cyclical nature of power generation and also the increasing importance of the three Chinese manufacturers (Shanghai Electric, Dongfang Electric and Harbin Power).





Fig 135: Global power generation industry EBIT margins 1995-2008, by company

-20%

-10%

0%

10%

20%

30%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EBIT

Mar

gins

(%)

Siemens (F,R & O) Alstom (Power) GE (Energy) MHI (Power Sys.)Hitachi Shanghai Electric Donfang Electric Harbin PowerBHEL (Power) Rolls Royce Babcock & Wilcox Foster WheelerDoosan Heavy

Not all margins are based on group data. The entities used are as follows: Siemens (FPG, O&G and Renewable divisions in aggregate), Alstom (Power Systems & Service divisions in aggregate), GE (Energy), Mitsubishi Heavy (Power Systems), Hitachi (Power Systems within P&I division), Shanghai Electric (Power Equipment), Dongfang Electric (Group), Harbin Power (Group), BHEL (Power), Rolls Royce (Energy), Babcock & Wilcox (power generation division of McDermott), Foster Wheeler (Power Group), and Doosan Heavy (Power & Nuclear divisions in aggregate)Source: Company reports

Between 1995 and 2008 EBIT margins across the power generation complex varied materially between manufacturers. However, since the Siemens/Westinghouse and Alstom/ABB mergers in 1998 and 2000, we believe there has been a step change for the better in both industry profitability and the quality of profitability.

Fig 136: Global power generation EBIT margins 1995-2008 in aggregate vs big four

0%

2%

4%

6%

8%

10%

12%

14%

16%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EBIT

Mar

gins

(%)

"Big 4" Average Power Generation Aggregate

Source: Redburn Partners, various company financials

By taking an industry average, we can see this conclusion more clearly. Industry margins averaged 7% from 1995 to 2000 and 11% since 2001. However, the real margin test is likely to come in the next two years as revenue volumes decline (based on recent order declines).

It seems a little disappointing that the ‘big four’ have not been able to capitalise on their scale and exceed average industry margins – ultimately there should be an opportunity here.




Fig 137: Global installed base drives margins

23%

8%

29%

4%

24%

43%

24%20%19%

25%20%

23%

15%15%

6%5%

6%

21%

37%32%

0%5%

10%15%20%25%30%35%40%45%

Gas Turbines (724 GW) Steam Turbines (2285GW)

Nuclear Steam Turbines(424 GW)

Total Generating Capacity(4578 GW)

Mar

ket S

hare

s (%

) of 2

008

Glob

alGe

nera

ting

Capa

city

by

Type

GE Siemens Alstom MHI Other

Source: Siemens

Margins in the power generation industry are driven by the installed base and from the service and spare parts and components that the installed base drives. In a rare moment of sub-divisional financial disclosure, Siemens provided some insight into this important margin mix five years ago in its May 2003 CMD presentation, where it indicated that new equipment (and associated EPC) margins were c5%, service margins were c14% and spare parts margins were c24%. This heavy skew in profitability makes the installed base count.

It is for this reason, as GE has the lion’s share of the higher margin higher replacement gas market, that GE has the highest margins. Siemens is more balanced and Alstom more steam-focused with its dominant position in nuclear steam turbines. Given that Alstom has a strong position in the lower margin turnkey market; it has done well to lift margins up towards Siemens over the last decade. This raises the question: why were Siemens PG margins so static between 2003 and 2008, and how have Alstom managed to catch them up, given Siemens’ higher margin mix?

Power generation volumes

Fig 138: Power generation industry volumes in Western Europe and the US

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Pow

er G

ener

atio

n In

dust

ry in

Agg

rega

te

Orga

nic

Grow

th (%

)

Organic Sales Growth Organic Order Growth

Source: Redburn Partners, various company financials (Siemens, Alstom, GE, MHI and Shanghai)

The power plant market is cyclical and sales growth lags orders. Demand is driven by economics, energy prices, liberalisation, retirements, regional trends, plant type mix, environmental considerations, industrial manufacturing capacity, decentralisation and a number of other factors. Following the order declines of 2009, we expect a decline in invoicing volumes in 2010.




Industry pricing behaviourSadly, investors are afforded no pricing transparency in the power generation industry as none of the companies provide any form of pricing disclosure.

Fig 139: Power plant construction costs have more than doubled since 2000

-10%-5%0%5%

10%15%20%25%30%35%

1Q01 3Q01 1Q02 3Q02 1Q03 3Q03 1Q04 3Q04 1Q05 3Q05 1Q06 3Q06 1Q07 3Q07 1Q08 3Q08 1Q09

YoY

Cha

nge

to t

he P

ower

C

apit

al C

osts

Ind

ex (

PCC

I)

PCCI PCCI, without Nuclear

Source: IHS Cambridge Energy Research Associates (CERA)

As a replacement for the lack of company pricing data, we have used IHS CERA numbers, which are widely used by the electric utility companies. Their Power Capital Costs Index (PCCI) tracks the costs of building coal, gas, wind and nuclear power plants. Looking at YoY changes to the PCCI (shown in Fig 139 above) highlights just how much price inflation the power generation industry has experienced over recent times. We calculate that excluding nuclear, the industry has seen an average annual price rise of 7% since 2000.

Most of the increase has been to pass through construction steel, wire, cable, concrete, asphalt, transport and labour costs to the customers. What is harder to gauge is how underlying prices (net of cost inflation) have developed.

Even when orders were growing in 2008, these cost pressures were a major strategic issue, but with orders down 25% in 2009 the pressure on the manufacturers for price declines will be mounting. We would expect downward pressure to continue as falling costs work their way through the supply chain.

The future risk from low-cost entrants?

Fig 140: Emerging market power generation

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

2001 2002 2003 2004 2005 2006 2007 2008

Sale

s (€

mn)

Shanghai Electric Harbin Power Dongfang Electric BHEL Doosan Power Machines





In the power generation markets there has been substantial growth amongst the emerging market players in recent years. As shown in Fig 140, the selected six emerging market players increased their aggregate power generation revenues from €3.6bn in 2003 to €15.5bn in 2008.

Fig 141: Development of Chinese market, 1950-2008: new additions to the fleet (GW)

0102030405060708090

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Chin

a In

stal

led

Capa

city

(Gro

ss A

dditi

ons,

GW

)


Source: Platt’s UDI World Electric Power Plants Base (WEPP)

This can also be seen at the GW level. Of all emerging markets, China has led the growth story in recent years. However, as the Chinese market is so heavily skewed towards steam (59% of 2008 additions) and hydro (35% of 2008 additions), there is no meaningful threat to the Western gas turbine players.

Fig 142: 2008 geographic split of power generation revenues for emerging market players

0%

20%

40%

60%

80%

100%

Shanghai Electric Harbin Power DongfangElectric

BHEL Doosan Power MachinesSplit

of

PG R

even

ues

(%)

Domestic Overseas


Even in the steam markets where all six emerging market players have a credible offering, there has been little or no threat in the Western market to date. Unlike some other industries (e.g. the appliance industry) where the emerging market players have actively targeted the Western markets, the emerging market players in the power generation industry have remained rather inward looking. In fact, all six companies had over 90% of revenues in their respective domestic markets in 2008 (see Fig 142).




Fig 143: 2008 €10bn Chinese power generation market Fig 144: 2008 €6bn Indian power generation market

Shanghai Electric24%

Harbin Power21%

Dongfang Electric19%

Siemens10%

GE6%

Alstom4%

Other16%

BHEL55%

Other8%

CMEC1%

Dongfang6%

Shanghai Elec.6%

L&T4%

Alstom5%

Power Mach. & Doosan

7%

Voith-Siemens & VA Tech

5%

Fuji3%

Source: Redburn Partners based on company data and Platt’s Source: Indian Business Standard

While the West remains largely free of competition from emerging market players, there has been some competition across emerging markets. China has remained largely unaffected, dominated by its three incumbents (see Fig 143). However, India’s incumbent leader, BHEL, has lost c10% of its market share to the Chinese (Shanghai Electric and Dongfang Electric) over the past few years. Until 2005, BHEL consistently held about 65% of the Indian market but it has struggled to head off the impact of lowly priced Chinese imports over the past few years and that share has lowered to 55%.

So with pressure in other markets, what is keeping the Chinese out of the West if they are prepared to take on India?

First of all, it should be noted that the Chinese were invited by the Indian government to aid its ‘mega’ infrastructure roll-out plan. So the market share taken by the Chinese in India did not fully reflect free market competition but was more of a free pass.

Furthermore, there are a number of clear reasons why the Chinese lack any competitive presence in Europe or the US, and they largely relate to technology. The Chinese are behind on size, electrical efficiency and cleanliness, which are all-important factors for success in the more developed power markets. The largest Chinese steam turbine offering to date is up to c600MW compared to the big four at up to c1,000MW. This lack of size is linked to China’s lack of electrical efficiency; Alstom offers c45% electrical efficiency vs the Chinese at c38%. Also, the Chinese have no credible environmental control systems offering, which is now necessary to compete in Western coal plants. Finally, the ability to service the installed base is an important factor. Here the Chinese have nowhere near the embedded installed base of the Western players in Europe and the US. In addition, utilities rely on delivery, installation and maintenance, all of which needs to be done in according with local safety regulations – here the Chinese just don’t have the knowledge or experience and the utilities are reluctant to let third parties manage the process.



Supply side (3): appliances

Electrolux: 100% of group sales exposure to the appliance industry

The global appliance industry is not for the fainthearted and may even be for the foolhardy. In general it suffers low margins and is highly competitive. Nonetheless, after three decades of intense consolidation from 1970 to 2000, pricing power and margins exited the last century at ‘relatively’ attractive levels compared to the past. However, since then the picture has darkened and industry peak margins have halved following the entrance of the emerging market manufacturers into Europe and the US.

The initial reaction by the incumbents to this low-cost competition was slow. However, by 2004, an aggressive period of cost-cutting had begun through capacity reduction (employee cuts and plant closures) and capacity transfer (the redeployment of costs from high cost to low-cost regions). Over this period, the appliance industry has transferred roughly a quarter of its costs to low-cost countries (from c25% to c50%) and plans to do more. Furthermore, in the last year alone, the appliance industry has seen a 10-20% reduction in headcount. As such, the incumbents have, to some extent, closed the competitive disadvantage gap compared to the low-cost competitors.

Although this relatively attractive recent capacity reduction/shift to low-cost (combined with the residual benefit of the 1970-2000 consolidation phase) augurs well, we have mixed feelings about calling a positive turn for the appliance industry. While this improvement in supply-side dynamics (particularly in Europe) will help pricing and margins to a degree, the absence of any credible and resilient barriers to entry in the white goods market, combined with the continued fragmented nature of the market (especially in Europe), makes it hard to get too bullish.

Appliances

Fig 145: Predominant appliance categories with a share of global €90bn market

Laundry (21%) Cold (28%)Hot (22%)

Floorcare (8%) Dishcare (7%)

Source: Electrolux, Whirlpool

Degree of industry consolidationFrom 1970 to 2000 the global white goods (or appliance) industry saw a staggering degree of industry consolidation. To put this into context, according to Indesit (the ninth-largest appliance company in the world in 2008), the global industry consolidated from c400 players controlling 65% of the market in 1970, to c150 players in 1980, c15 in 1990 and c6 in 2000.





Fig 146: Appliance industry: consolidation of Western manufacturers between 1980-2008

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08Email (Australia)Refripar (Braz)White Consolidated (US)Zanker (Ger)Zanussi (It)Electrolux (Swed)Vølund and Nyborg (Den)Thorn-Emi Dom. Appl. (UK)Corbero (E)Buderus / Juno (Ger)Lehel (H)AEG (Ger)

Amana Appliances (US)GS Blodgett (US)Hoover (Chicago Pacific) (US)Maytag (US)

Bauknecht (Ger)Philips White Goods (NL)Whirlpool (US)KitchenAid (Hobart) (US)Emerson Electric (US)Roper (US)Polar (Poland)

General Electric (US)GEC (UK)Hotpoint (UK)T-I Creda (UK)

Thermador (US)PEG Profolio (Tr)Bosch-Siemens (Ger)NEFF (Ger)Balay (E)Safel (E)Gaggenau (Ger)Continental (Br) Emerging market

new entrants


Fig 146 highlights the key consolidations throughout the period. Looking at this (and the wider list of transactions), it is clear just how much the pace of consolidation has slowed amongst the Western manufacturers over the past decade – the notable exception being Whirlpool’s 2006 $2.6bn acquisition of Maytag (0.53x EV/sales for a business in EBIT loss). In some segments there has even been a reversal of late, with a number of ‘bolt-off’ disposals being made across the complex.

The one transaction that might have taken consolidation further appears to have been abandoned. In May 2008 Mr Jeff Immelt (GE’s CEO) announced plans to sell or spin-off its Louisville-based appliance unit. Despite slipping from fourth position in 1997 to seventh in 2008, GE Appliance has the highest ten-year (1999-08) average EBIT margins. Given its track record in profitability, it was interesting that GE was prepared to sell a century-old business from a position of weakness (margins slipped from 12.5% in 2006 to a record low of 4.7% in 2008) without waiting for recovery. Was this just bad management, or did GE have a good reason to doubt recovery would ever come?

Even more interestingly, despite having lined up five possible bidders in the data room (China’s Haier, South Korea’s LG Electronics, Sweden’s Electrolux, Mexico’s Controladora Mabe and Turkey’s Arcelik), press reports suggest no-one made an offer, and Haier walked away at the eleventh hour. GE publicly pulled the deal in December 2008 and announced plans to restructure the unit. For those tempted to invest in the




appliance industry, the complete absence of M&A demand for a major player (albeit one with a heavy US revenue mix) at the bottom of the cycle should presumably act as a salutary warning.

Market shares

Fig 147: 1997-2008 global appliance market shares (company order shown as in legend)

0%

20%

40%

60%

80%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Sale

s (€

mn)

OtherFagor (Group)Maytag (Group)Candy (Group)DeLonghi (Group)Sharp (Appliance)Miele (Group)Indesit (Group)GE (Appliances)Panasonic (Home Appliances)BSH (Group)Electrolux (Group, excl. Husq)Whirlpool (Group)Samsung (Digital Appliance)LG (Digital Appliance)Arçelik (Group)Haier (Group)


With Western consolidation having ground to a much slower pace than the industry expected, a new era has emerged with low-cost competition coming to the fore (see the lower four players in Fig 147 above).

However, prior to this, pricing and margins saw a material benefit from a phase of consolidation between 1970 and 2000, with industry margins reaching a new 25-year margin peak in 1999 (at 8.4%). This is a common phenomenon, and is the reason why we have conducted such an exhaustive analysis of the various changes in industry concentration throughout our sector.

Since then (as we will discuss below), peak margins have halved and industry pricing has suffered given the new era of low-cost competition.

The degree to which the appliance industry consolidation of the past 30 years has slowed over the past decade is shown in Figs 148 and 149. In fact, the industry has only seen the combined market share to the top five manufactures increase from 52% in 1997 to 55% in 2008.

It should be noted that while the top end of the industry has a fair degree of consolidation, the bottom end remains hugely fragmented with a vast array of small and mid-sized appliance manufacturers chomping at the market share of the principals. As such, solely focusing on the concentration of the top five players fails to capture the fragmented and highly competitive nature of the appliance industry.




Fig 148: Appliances – 1997 global market share Fig 149: Appliances – 2008 global market share

Other39.1%Haier

0.6%DeLonghi0.7%

Maytag3.6%

Miele2.6%

Sharp1.8%

Indesit1.7%

Samsung1.6%

Electrolux13.0%

BSH5.8%

GE6.0%

Whirlpool9.0%

Panasonic10.1%

LG1.3%

Arçelik1.0%

Fagor1.2%

Candy1.0%

Other13.5%

DeLonghi1.7%

Sharp1.7%

Fagor1.7%

Miele3.1%

Electrolux12.2%

BSH9.8%

LG9.1%

Panasonic9.0%

Whirlpool14.4%

Indesit3.6%

Arçelik4.0%

Haier4.1%

GE4.9%

Samsung6.0%

Candy1.2%


Looking at 1997 and 2008 in snapshot also fails to reveal the degree of competition that the industry has faced from the emerging market players. By grouping and contrasting the principal players in the developed world (Electrolux, Whirlpool, GE and Panasonic) against the key emerging market new entrants (Arçelik, Haier, Samsung and LG) and studying the data in time series (see below), the challenges and dynamics of the past decade become clearer.

Fig 150: 1997-2008 global appliance market shares

0%

10%

20%

30%

40%

50%

60%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glob

al M

arke

t Sha

re (%

)

Electrolux, Whirlpool (incl. Maytag), GE and Panasonic Arçelik, Haier, Samsung and LG

End of Western consolidation phase

Entrance of low cost competition


Fig 150 shows that our selected group of principal incumbents lost a significant 12% of global market share in just seven years between 2001 and 2008, and during the same period our selection of low-cost entrants lifted their collective share by 10%. This is almost unheard of in mature manufacturing industries, where market shares tend to move by basis points and not tens of percents.

This appliance case study raises broader questions for the wider European Capital Goods sector and highlights the generic risks of new low-cost competition entrants (and why we have analysed that threat across various industries). An important question to consider is why has the lower margin white goods industry attracted so much more low-cost competition than the higher margin compressor, cutting tool and bearing industries (to name a few). Economic theory suggests that industries with superior returns should naturally face higher competition, so why haven’t they?




In our view, the degree of competitive threat in an industry boils down to the relative strengths of its barriers to entry. Across the European Capital Goods sector, the intensity and type of barriers to entry differ by industry and include (to name a few): technology, economies of scale, degree of industry consolidation, routes to market, regulation, safety standards, brand and security of supply barriers.

Sadly for the white goods industry there is an absence of credible and resilient barriers to entry. For instance:

The market is relatively fragmented at the tail and faces meaningful low-cost competition.

Products are technologically easy to make (when compared, say, to the tribology challenges of making large size bearings to under five microns of accuracy, or, multi-sequence vacuum sintering at about 1450°C to make cemented carbide cutting tools).

Both the routes to market and the availability of supply are highly competitive and unprotected.

There is a real absence of margin security from regulatory or safety standards.

With the possible exception of brand, where good managements have devoted much time and energy (Electrolux historically lagged but has made good strides over the past decade), the appliance industry has a distinct paucity of meaningful bulwarks against new entrants, much to the chagrin of long-term appliance investors.


Fig 151: Global appliance industry EBIT margins 1990-2008, by company

-5%

0%

5%

10%

15%

20%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

EBIT

Mar

gins

(%)

Electrolux (Group, excl. Husq) Haier (Group) GE (Appliances)Indesit (Group) BSH (Group) Whirlpool (Group)LG (Digital Appliance) Arçelik (Group) Sharp (Appliance)DeLonghi (Group) Panasonic (Home Appliances) Samsung (Digital Appliance)Maytag (Group)


Between 1990 and 2008, EBIT margins across the white goods complex have varied materially between manufacturers (see Fig 151), with some making a loss at the same time as others making double-digit returns.




Fig 152: Global appliance industry EBIT margins 1990-2008, in aggregate vs Electrolux

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

EBIT

Mar

gins

(%)

Appliance Sector Average Electrolux (Group, excl. Husq)

End of Western consolidation phaseEntrance of low cost competition


Looking at the industry average, shown in Fig 152, we see two distinct phases for margins. Industry margins appear to have been driven by the final period of Western consolidation (1970-2000), which peaked at a 25-year record margin of 8.4% in 1999; and the period of low-cost competition from new emerging market entrants (2001-08). Outside of the appliance sector, the period 2003-08 was generally very strong for macroeconomic growth and profitability, with most industries exceeding prior margin peaks between 2006 and 2008. Consequently, to see margins in the appliance industry roughly halve from 1999 to an average of 4.8% between 2006 and 2008 highlights just how much pressure the low-cost competition phase exerted on everyone.

Appliance volumes

Fig 153: Appliance industry volumes in Western Europe and the US

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Q1 00 Q1 01 Q1 02 Q1 03 Q1 04 Q1 05 Q1 06 Q1 07 Q1 08 Q1 09

Mar

ket G

row

th (%

)

Western European Appliance Market Volume Growth North American Appliance Market Volume Growth

Source: Electrolux based on AHAM and GFK data

More than in many industries, margins in white goods are driven by a variety of moving parts (restructuring, savings, raw material costs, pricing and mix being the key drivers). As such, the volatility of margins in the industry is high, which is exacerbated by the relatively low level of profitability (a normally minor 2% swing in margins means a lot to a white goods company). Consequently, while volumes are important, they are by no means the only factor behind returns. Nonetheless, it is worth bearing in mind that volumes in the white goods industry have seen a more sustained downturn than in most industries. To put this into context, US industry volumes turned negative in 3Q06 (12-24 months before the industrial world) and remain negative 13 quarters later. Consequently, some of the recent margin weakness has also potentially been driven by poor market development.




Industry pricing behaviour

Fig 154: Appliance industry pricing has improved (Electrolux price 1Q02–3Q09)

-3%

-2%

-1%

0%

1%

2%

3%

4%

Q1 02 Q1 03 Q1 04 Q1 05 Q1 06 Q1 07 Q1 08 Q1 09LfL

Pric

e ef

fect

(ex

cl.

Mix

) on

Elec

trol

ux S

ales

Gro

wth

(%

)

Price Effect on Group Sales Growth

Source: Redburn Partners, Electrolux LFL price effect as a proxy for the industry, data sourced form conference calls

During the low-cost competition phase of the past eight years or so, the appliance industry has suffered a period of price deflation. To us this highlights the lack of pricing power in white goods. Even including the recent return to price increases, cumulatively, global appliance prices have fallen by 1% between 1Q02 (when the macro picture returned to growth) and 3Q09. By way of contrast, over the same period, compressor prices at Atlas Copco rose by 15%. In tandem, the appliance industry has also had to bear a massive increase in raw material costs (we calculate that the increase in the steel price alone over the same period has led to a cost increase in the magnitude of c8% of current industry sales). So while gross pricing has been poor, net pricing has been dire. Without being able to pass on any of this massive headwind, the industry has had to find cost savings to avoid margin obliteration.

The future risk from low-cost entrants? While most industries in the wider European Capital Goods sector have yet to see any credible competitive threat from emerging markets (and the question we are trying to ask elsewhere in this report is whether or not they will over the medium term), for the appliance industry this is an old story. In effect, white goods was the lowest hanging fruit, and we expect other industries where the barriers to entry are lowest to suffer the same fate.

As discussed above, pricing power in the appliance industry, has suffered significantly from the influx of low-cost competition. The important question, however, is whether the pressure will persist or abate going forward.

Fig 155: 2008 €16bn US appliances market shares Fig 156: 2008 US appliance customers by share

Whirlpool46%

GE23%

Electrolux22%

Other9% Sears

33%

Lowe's17%

Home Depot13%

Best Buy7%

Others30%





In many senses the pressure has been worst in Europe, which is more fragmented (see Fig 157) than the US. As shown above, in the US the top three appliance manufacturers make up 90% of the market (vs 45% in Europe) and the top four customers make up 70% of the distribution market (vs 20% in Europe).

Fig 157: The €23bn European appliance market is more fragmented than the US

0%

5%

10%

15%

20%

25%

30%

BSH Indesit E'lux W'pool Arcelik Fagor Candy Gorenje Miele Samsung LG Other2008

Eur

ope

Mar

ket

Shar

e by

Volu

me

(exc

l. O

EMs)

Volume Value


Looking back to the start of this decade, the initial reaction by the incumbent principals to this low-cost competition was slow (especially at Electrolux), and consequently margins suffered. However, more recently the incumbents have made great strides to lower costs and close the competitive disadvantage gap compared to the low- cost competitors, especially in Europe. This has been achieved, to a degree, through a combination of closures, redundancies and relocations to low-cost countries.

Fig 158: Prices have been worse in Europe but have even lifted here recently

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

1Q02

1Q03

1Q04

1Q05

1Q06

1Q07

1Q08

1Q09

Pric

e /

Mix

Eff

ect

(%)

European Appliance Sector Average North American Appliance Sector Average


In this regard, 2009 was an interesting year. Despite major volume declines, 2009 saw positive net price retention. Prices rose despite raw material costs falling for the first time in six years. Although the price increases are, to a degree, flattered by currency devaluation recovery in UK, Russia and Poland, the underlying picture is still much more favourable.

Listening to the principals and observing the 2009 price increases (particularly given that they were achieved during a period of negative volumes and falling raw material costs), it is tempting to call an end to the threat of low-cost competition and signal a period of improved pricing and margins in the white goods industry.




While the lack of barriers to entry (discussed above) and the continued fragmented nature of the European market leave us cautious over the longer term, the evidence of capacity adjustment is compelling. We see this capacity adjustment in two camps:

Industry capacity reductions: evidence suggests that capacity has been reduced in the white goods industry to a greater degree than in many other industries, with a meaningful number of plant closures over the past five years and headcount dropping by 10-20% in the last year alone. As shown in the restructuring section of this report, our headcount analysis suggests Electrolux has lowered its headcount by c12% over the last year, putting its reduction at the upper end of the sector. Furthermore, since 2005, Electrolux has closed (or announced plans to close) 11 manufacturing facilities in high cost countries (vs 42 plants globally at the end of 2008). Elsewhere, over the last year, Indesit has seen an average decline in its cost of labour of 20.3%. Throughout 2008 Whirlpool saw a trebling of its restructuring charges, which have also led to a ‘meaningful headcount reduction’, but sadly no hard numbers are available for Whirlpool.

Fig 159: Electrolux has consistently lifted its LCC share of production and purchases

0%

10%

20%

30%40%

50%

60%

70%

80%

2003 2004 2005 2006 2007 2008 2009E 2010E

Elec

trol

ux s

hare

of

Purc

hase

san

d Pr

oduc

tion

in

LCC

Share of Purchases from LCC Share of Production in LCC


Geographic capacity mix improvement: taking into account the above closures and various downsizings in the West, compared to new plant builds and incremental investments in emerging markets, the mix of capacity in the industry has seen a dramatic and favourable shift in geography, with costs (employees, factories and sourcing) being redeployed to low-cost countries. Since 2003 Electrolux has lifted both its share of production and its share of purchases in low-cost countries from 25% and 20%, respectively, to c50% for both in 2008; and targets 60% and 70%, respectively, for 2010 (see Fig 159).

Elsewhere, the picture has been similar, with Whirlpool relocating to Poland and LG opening in Poland and Russia. Indesit has perhaps made the biggest strides, having relocated its cost base from 30% direct labour cost hours in low-cost countries in 2004 to 65% by the end of 2009. The slowest mover, in our view, has been Bosch-Siemens Hausgeräte (BSH), which has not meaningfully restructured its heavy German manufacturing footprint (no surprises there for Siemens). However, despite this, BSH continued to post some of the highest margins in the industry. As shown below, this margin protection stems from BSH’s higher-than-average price point, but it will be interesting to see if the company can hold on to its high profitability as others moving their cost base so materially.




Fig 160: 2008 European ASPs (excluding OEM appliances)

0

50

100

150

200

250

300

Miele BSH LG Electrolux Samsung Fagor Arcelik Gorenje Indesit Whirlpool

2008

Eur

opea

n A

vera

ge S

ellin

g Pr

ice

(€)

(exc

l. O

EMs)


Chinese appliance market

Fig 161: €25bn domestic Chinese appliance market 2008 by market share

Other53%

Electrolux0.3% TCL Corp

1%

HisenseElectric

1%

Samsung2%

BSH2%

Sichuan Changhong2%

LG Electronics6%

Guangdong Midea Electric Appliances

8%

Haier Group25%


Around a third of the world’s household electrical appliances are made in China, of which c20% are exported. We estimate the total domestic market for Chinese appliances is €25bn (28% of the world’s total appliance market). Between 2002 and 2008, the Chinese market saw an average annual growth rate of 9.8% (supported by construction volumes) and an average annual price reduction of 0.3%.

Competition is fierce and margins are tight. Margins have fallen hard over time with Haier Group (the market leader) seeing EBIT margins in its appliance arm (led by its subsidiary Qingdao) fall almost every year from 12.4% in 1994 to 3.3% in 2008. Recently the ‘Rural Appliance Rebate Scheme’, which gives rural residents a 13% rebate on selected white goods and consumer electronics, has given maturing volumes a significant boost (retail figures for the 2009 Chinese New Year showed a 17.8% YoY increase, i.e. above the recent 10% trend in a tough year).

While the top three manufacturers control 39% of the Chinese market, the remaining market is hugely fragmented. Furthermore the appliance retailers are highly fragmented with market leaders Gome, Suning and Jiangsu Five Star collectively holding less than 20% of the market (by way of comparison, in the US and UK, the leaders Sears and Dixons hold over 30%). This fragmentation is behind the fierce competition, worsened margins and annual price declines.




Electrolux decides to exit China

While there is consolidation among the manufacturers and the retailers, the process is slow and competition remains tough. CHEAA (the China Household Electrical Appliances Association) indicates that the number of Chinese white goods makers fell from 204 in 2004 to 192 in 2007.

Electrolux’s experience has been so challenging and so heavily loss-making that it has decided to exit China for good. In 2004, Electrolux saw cSKr3bn of sales in China, and this was ramped down to cSKr1bn in 2008 and is heading for a 50% fall to cSKr500m in 2009.

There are few markets in our sector where we have seen a wholesale organic exit in a particular region (especially in the high growth Chinese market). This says something about the level of unattractiveness of the Chinese white goods markets and the highly competitive nature of emerging market appliances.

BSH (Bosch-Siemens Hausgeräte) has found the experience less painful and has been growing its operations in China. The difference is that BSH has aimed for the high quality end of the pricing spectrum where it has taken share.



Supply side (4): rail equipment

Invensys: 31% of group sales exposure to the rail industry

Alstom: 25% of group sales exposure to the rail industry

Siemens: 6% of group sales exposure to the rail industry

A supply-side analysis of the global rail equipment market highlights that rail experienced an intense M&A consolidation phase during the 1980s and 1990s in which c100 companies consolidated into the ‘big three’. Although M&A consolidation almost completely dried up following the 2001 Adtranz acquisition, it was effectively replaced by a decade of capacity consolidation marked by significant industry headcount reduction and plant closures.

While rail remains a difficult industry, with respect to margins and pricing, we believe the industry has, to some degree, witnessed a structural improvement due to the M&A and capacity consolidation phases of the past 30 years.

We expect industry margins to benefit from some growth as rail is enjoying something of a renaissance, with high speed trains offering an environmentally attractive alternative to short-haul flight, and trams, metros and other light transit offering a space-efficient and environmentally attractive solution to urban congestion. Similar to the power markets, there is a compelling infrastructure replacement story in Rail from aging rail networks and rolling stock fleets. Furthermore, rail is seeing both significant growth in emerging markets and signs of resilience in the West despite the economic downturn. This resilience stems from the positive structural trends discussed above and the fact that rail is highly dependent on government spending and well exposed to the various stimulus packages.

What of the Chinese threat to the Western rail markets? Given the compelling supply and demand imbalance of the Chinese railways and the publicly announced plans to continue increasing domestic investment in rail infrastructure, we believe the two Chinese manufacturers (CNR and CSR) will be kept sufficiently busy, satisfying their domestic market that the risk of their dumping cheaply priced product into the global markets, diluting global market share concentration and eroding margins of the ‘big three’ is, for now, minimal.


Fig 162: Global rail equipment – 2008 market shares Fig 163: Global rail equipment – 1997 market shares

Others23%

China South7%

Bombardier13% Alstom

11%

Siemens9%

GE7%China

Northern6%

Vosshloh2% Talgo

3%Trinity

3%CJSR5%

Ansaldo2%

Hyundai Rotem

2%Thales2% CAF

2%

Invensys2%

Stadler1%

Adtranz9% Stadler

0%Invensys

1%

CAF1%

Thales1%

Hyundai Rotem

1%

Ansaldo2%

CJSR1%

Trinity2%

Talgo2%

Vosshloh2%

China Northern

2%

GE4%

Siemens6%

Alstom8%

Bombardier3%

China South2%

Others52%






The €50bn global rail equipment market has seen a meaningful degree of industry consolidation over the past decade, with the largest five manufacturers increasing their collective market share from 33% in 1997 to 47% in 2008. However, despite this, rail remains one of the more fragmented of the 11 industries analysed in this report.

Fig 164: Rail equipment industry: consolidation of ‘big three’ between 1980 and 2009 80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08

Fiat Ferroviaria (IT)De Dietrich Ferroviare (France)Wessex Traincare (UK)Sasib (Italy)Mirrlees Blackstone (UK)Konstal (Poland)CMW Equipamentos (Brazil)Linke-Hofmann-Busch (Germany)Ateinsa (Spain)Meinfasa (Spain)ACEC (Belgium)GEC (UK)CIMT (France)Franco-Belge (France)Brissonneau et Lotz (France)Alstom (France)Carel Fouché (France)Jeumont-Schneider (France)Metropolitan Cammell (UK)Geo Railmex (MEX)GEO Alstom Faur Transport (RD)AMF Industries (Canada)GTRM (CIMCo) (UK)Amerail (Hornell) (US)

Von Roll (Swiss)LEW (Germany)MAN Gutehoffnungshuette AG/MBB (Germany)Westinghouse (US)AEG (via Diamler Benz in 1985) (Germany)ABB Daimler Benz Transportation (Adtranz)ML Engineering (UK)Sorefame (P)Comeng (Australia)Hagglund (Sweden)BREL (UK)Sura Traction (Sweden)Kalmar Verkstad (Sweden)Ageve (Sweden)Asea (Swed)ABB (Swiss)Brown Boveri (Swiss)British Wheelset (UK)Scandia-Randers A/S (DK)L.M.E. (Sweden)Thyssen-Henschel (Germany)Waggon Union (Germany)IVV (Germany)Inter Logic Engineering (UK)

Vevey (CH)Ceska Lopez (CZ)Deutsche Waggonbau (Germany)UTDC (Canada)Procor Engineering (UK)Budd and Pullman (US)MLW Worthington (Canada)BombardierAlco Power (US)BN Constructions Ferroviaires et Métalliques (Belg)ANF-Industry (France)Universal Mobility (US)Concarril (Mexico)Waggonfabrik Talbot (Germany)

Signalling JV (CH)Railcare (UK)Integra (CH)SGP (Austria)WSSB (Germany)Krauss Maffei (Germany)Duwag (Germany)SiemensHRH (CH)Friedmann (A)SAEL (Germany)Krupp (Germany)Matra Transport (France)


Until the 1980s a globalised rolling stock manufacturing industry didn’t really exist. Until then, it was an amalgam of individual domestic markets living solely off their connection to nationalised rail networks (with some exports based on government policy). This structure started to change in the 1980s and accelerated in the early 1990s around the time of EU market integration and the restructuring of the national railways. In parallel




with this restructuring, the industry went through a consolidation wave in North America and Europe, creating international rail equipment champions led by Bombardier, Alstom and Siemens. At the same time, the consolidating Rolling Stock manufacturers took on the role of systems integrator (aka turnkey engineering), creating the industry structure that exists today.

Our analysis suggests that close to 100 companies were consolidated into three between 1980 and 2001. However, since then, as highlighted in Fig 164 above, the ‘big three’ (Bombardier, Alstom and Siemens) have made no further acquisitions of note. In effect, the rapid industry consolidation of the 1980s and 1990s hit a brick wall after Alstom’s acquisition of Fiat Ferroviaria in 2000 and Bombardier’s acquisition of Adtranz in 2001.

Headcount and plant consolidation replaces M&A consolidation

However, to the benefit of the industry, the improvement in supply-side dynamics and capacity reduction didn’t end with Adtranz. Our industry analysis highlights the fact that the M&A consolidation phase of the 1980s and 1990s was effectively replaced by a decade of industry headcount restructuring and plant closures from 2000. We calculate that since 2000, the ‘big three’ (which make up c33% of the global market) saw collective revenues expand by 61% from €10.3bn to €16.6bn. However, over the same period the collective employee headcount of the ‘big three’ actually fell by 3% from 78,000 to 76,000. These considerable productivity gains are very much behind the improved margin conditions in the rail equipment industry, in our view.

Rail equipment market is a complex of various segments

Fig 165: Global rail equipment market positioning by segment (2008 share and position where available)

Frieght Locom

otives

Passenger Locom

otives

Trams

Metros / Light

Rail

Regional / Com

muter

High speed / Intercity

Very High Speed

Freight Cars

Bogies

Bombardier # 1 # 1 # 1 # 1 4% (# 7) 13.2%

Alstom 11% 3%27%

(=# 2)22% (# 2)

22% (# 3)

25% (# 1)

45% (# 1)

13% (# 2) 11.4%

Siemens27%

(=# 2)6%

(# 3)28% (# 2)

17% (# 2)

19% (# 1) 14% (# 1) 8.5%

China South 6.8%

GE 6% (# 6) 6.8%

China Northern 6.3%

CJSC Transmashholding

5.2%

Trinity 3.5%

Patentes Talgo 2.8%

Vossloh 2.4%

Ansaldo 12% (# 2) 2.2%

CAF 2.0%

Invensys 9% (# 5) 1.7%

Hyundai Rotem 1.6%

Thales 9% (# 4) 1.6%

Stadler 1.4%

Company Turnkey / Service SignallingTotal Rail

Equipment MarketShare

Rolling Stock

11% (# 2)

10% (# 2)

# 3# 1

Source: Redburn Partners based on various sources




Rolling stock is the largest product segment for the rail equipment industry. In Fig 165, we have divided rolling stock into the individual product markets to demonstrate how the ‘big three’ are positioned against each other and how the Tier 2 competitors fit into the market. In addition to rolling stock the rail equipment market includes: (i) the relatively standalone rail signalling market, which has higher margins (12-13% in 2008) than rolling stock and is more concentrated (with the top five representing 57% of the global market), and (ii) the service/turnkey market, where margins are lower than rolling stock as the work is low value-added contracting work.

Fig 166: 1995-2008 global rail equipment market shares ‘big three’ vs collective top five

0%

10%

20%

30%

40%

50%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glo

bal

Mar

ket

Shar

e (%

)

Bombardier (Transport) Alstom (Transport) Siemens (Rail) Top 5 Concentration


Fig 166 highlights the market share concentration of the ‘big three’ and each constituent manufacturer over time. This supports the above argument and shows how consolidation effectively hit a brick wall following the Adtranz acquisition in 2001.


Fig 167: Rail equipment industry EBIT margins 1995-2008

-2%

0%

2%

4%

6%

8%

10%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EBIT

Mar

gins

(%)

Rail Average Big 3 Average


Operational gearing in the rail industry is relatively low and, as such, margins tend to be driven by mix, restructuring cost savings, pricing and productivity gains/losses as much as by volumes. We believe the steady improvement in margins since 2001 is a function of the 1980s and 1990s consolidation phase, the internal capacity reductions of the last decade and the volume and price improvements of the past four years.

Interestingly, the average margins of the ‘big three’ are lower than the industry average margins. This appears to go against the thesis that margins are correlated with market share.




Fig 168: Selected manufacturer margins to contrast the ‘big three’ with better performers

-20%-15%-10%-5%0%5%

10%15%20%25%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

EBIT

Mar

gins

(%)

Siemens (Rail) Alstom (Transport) Bombardier (Transport)GE (Transport) Invensys (Rail)


However, it should be noted that a number of the constituents of our rail industry average (such as GE and Invensys, as shown in Fig 168) operate in specific, higher margin niches. For instance, Invensys (like Thales) is well positioned in the higher margin signalling market, and GE operates almost exclusively in the US market where it has an extremely high market share (especially in the locomotive market). As such, there are a variety of mix differences not wholly captured in a simple industry average.

Growth supported by government stimuli, high speed/urban transit and Asia

Fig 169: Rail has been enjoying something of a renaissance of late

-15%

-10%

-5%

0%

5%

10%

15%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Orga

nic

Sale

s Gr

owth

(%)

Big 3 Average


Rail is a highly mature market with relatively low growth. Growth has returned in recent years with a structural story led by high speed trains offering an environmentally attractive alternative to short haul flight, and trams, metros and other light transit offering a space efficient and environmentally attractive solution to urban congestion.

As with the power markets, there is a compelling infrastructure replacement story in rail from aging rail networks and rolling stock fleets. Furthermore, rail is seeing significant growth in emerging markets (especially Asia) and signs of resilience in the West despite the economic downturn. This resilience stems from the positive structural trends discussed above and the fact that rail is highly dependent on government spending and well exposed to the various stimulus packages.




Rail pricing: an ongoing challenge but no more price war

Trains are not catalogue items: they are large and expensive and each has a different specification. Given the limited unit volume and significant mix effects, clean like-for-like price data is not disclosed by any of the key manufacturers. However, anecdotally, achieved pricing and pricing power is poor in rail but better than it was.

According to some manufacturers in Europe, Bombardier was quite aggressive in its rail pricing strategy following the industry restructuring phase of 2003-04, which led to a bit of a pricing war in 2004 (see margin erosion in 2004 in Fig 167 above). By all accounts, the pricing environment has been better since then but it remains far from an attractive expansionary pricing environment. Pricing (and margins) are better in very high speed trains (where the ‘big three’ have a technology advantage) and trams (where there has been a fair degree of international standardisation; Siemens Combino would have done as well as Alstom Citadis in trams as it was also a standardised programme, however, it suffered cracking problems and had to be recalled, leading to c€500m of provisions in total). Pricing (and margins) are perhaps worse in the metro and regional train markets where international standardisation has not occurred and the markets have remained regionalised. In this regional environment, the metro and regional train markets have been better competed at the local level by the domestic Tier 2 players such as CAF, Talgo, Vossloh and Stadler.

Going forward, there is scope for better rail pricing given the improved industry concentration (post 1980s and 1990s consolidation) and capacity reductions of the 2004 and 2009 restructuring phases. These positive factors will, to some degree, be offset by the competitive pressures from Tier 2 players.

Low-cost entrants?

Fig 170: Chinese €8.6bn (RMB82bn) rail equipment market 2009

CSR (China South)40%

CNR (China Northern)32%

Bombardier5%

Siemens5%

Other12%

Alstom6%


The €9bn Chinese rail equipment market is dominated by the two domestic manufacturers China South and China Northern (now China CNR post the December 2009 IPO), which collectively control three quarters of the market. In 2002, China National Railways Locomotive and Rolling Stock Industrial Corporation (LORIC) was given independent status and carved into these two companies with an ambitious programme of restructuring and modernising China’s then 50,000-mile railroad network. At the same time, the Chinese Ministry of Railways (MOR) opened its doors to international alliances and joint ventures in order to gain access to Western technology. Since then, through such alliances, the ‘big three’ have increased their revenues in China and taken some share from the locals, such that they now hold 16% of the market.




Chinese locals have increased share of global market through domestic growth

Fig 171: Global market share of the Chinese vs the ‘big three’

0%

5%

10%

15%

20%

25%

30%

35%

40%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glo

bal

Mar

ket

Shar

e (%

)

Big 3 (Bombardier, Alstom and Siemens) Chinese (CSR and CNR)

Source: Redburn Partners, Annual Reports

Despite having deliberately ceded some of their domestic share (in order to benefit from technology transfer), the Chinese still managed to nearly triple their global market share over the past decade. Our analysis suggests this has come more from the sheer pace of growth in the domestic Chinese market than any dramatic increase in ex-Chinese global market share (i.e. exports).

Fig 172: Proportion of revenue’s exported by the Chinese rail manufacturers

0%

2%

4%

6%

8%

10%

12%

14%

2004 2005 2006 2007 2008Leve

l of

Exp

ort

as %

of

Sale

s

CSR (China South) CNR (China Northern)

Source: CNR IPO Prospectus (2006-08); China Northern Annual Reports (2004–05); CSR Annual Reports (2005-08)

Based on the level of exports from China South and China Northern, there is no evidence of a meaningful uplift in Chinese exports. In fact, during the period of their greatest global market share (2004-08), both China South and China CNR saw their proportion of export revenues decline given the pace of domestic growth.

Having said this, there is some evidence that the Chinese are taking share in the non-Chinese emerging markets. For instance, in April 2009 China CNR signed a contract to export 455 metro cars and 160 double-deck coaches valued at €360m to the Middle East.




Fig 173: Chinese manufacturer margins have lifted alongside those of the ‘big three’

-2%-1%0%1%2%3%4%5%6%7%8%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EBIT

Mar

gins

(%)

Chinese Average Big 3 Average

Source: Redburn Partners, Annual Reports

EBIT margins at the domestic Chinese manufacturers have largely tracked the recovering margins of the ‘big three’ over the past five years. However, given the growth differential, it appears the ‘big three’ have done a better job at expanding their margins. Between 2004 and 2008, the ‘big three’s collective revenues grew at just 2% compared to China’s 29% on average. Between 2008 and 2010, this growth differential is expected to continue, with the ‘big three’ growing at 5% and the Chinese at 36% on average.

Fig 174: Chinese domestic rail equipment market 1996-2010E by market share

02,0004,0006,0008,000

10,00012,00014,00016,00018,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Rev

enue

s (€

mn)

CSR (China South) CNR (China Northern) Alstom Siemens Bombardier Other

Source: Redburn Partners, 2009-10 estimates for CSR and CNR from Bloomberg consensus (the rest are Redburn estimates)

China exports a minimal threat given domestic growth story

China’s demand for rail transportation and rapid transit rail equipment sector is expected to continue at a fast pace as economic growth continues and urbanisation becomes increasingly widespread.

China’s railway network by aggregate length is the third-longest in the world. However, China possesses a much lower length of railway per capita compared to countries such as the US, Russia, Germany, France, Japan and Brazil. Despite the operation of its railway transportation system at close to full capacity, China’s railway transportation capacity currently accommodates only approximately 35% of public demand, resulting in transportation bottlenecks and an attractive supply/demand imbalance, as shown below.




Fig 175: Passenger density of railway transportation (km/100 people)

0

2

4

6

8

10

US France Germany UK Japan China

Pass

enge

r de

nsit

y (k

m/1

00 p

eopl

e)

Source: China Railway Yearbook 2007

The Chinese government invested $90bn in rail infrastructure in 2009; given the stimulus package this was a substantial increase compared to $50bn of investment in 2008. The extra investment is part of a plan to extend the country’s railway network from 78,000km at the end of 2008 to 110,000km by 2012, and includes construction of five new high speed lines.

Given the compelling supply and demand imbalance of the Chinese railways and the publicly announced plans to continue increasing domestic investment in rail infrastructure, we believe the two Chinese manufacturers (CNR and CSR) will be sufficiently busy satisfying their domestic market that the risk of their dumping cheaply priced product into the global markets, diluting global market share concentration and eroding margins of the ‘big three’ is, for now, minimal.



Supply side (5): mining equipment

Sandvik: 48% of group sales exposure to the mining equipment industry

Atlas Copco: 41% of group sales exposure to the mining equipment industry

In our opinion, and despite the current downturn, the supply-side dynamics of the global mining equipment industry are well positioned. The industry has witnessed meaningful consolidation over the past 20 years with the combined market share of the ‘top five’ global manufacturers increasing from 41% in 1997 to 61% in 2008.

We see clear evidence that this consolidation has led to improved pricing power and higher through-cycle margins. Our analysis suggests that the mining equipment industry, in aggregate, will achieve a trough EBIT margin of c11% in 2009-10, which is actually above the prior peak of c9% in 1996 despite 2009 seeing the worst volume declines for 20 years.

Furthermore, despite the proliferation of new entrants in the Chinese mining equipment industry, we see limited threat to the dominant position of the Western manufacturers based on the low reliability, deficient after-sale service and inability to achieve international standards by the local manufacturers. In addition, the mounting volume of patent cases from the Chinese having allegedly copied Western designs may limit expansion for the locals.

Mining equipment

Fig 176: Mining and construction equipment types

Surface Crawler Drill Rig (DTH)

Loader (Underground)

Hauler (Underground)

Exploration UndergroundDrill Rig (Boomer)

Raiseboring DrillCrushing and Screening

(Mobile)Concentration and

Seperation (Filtration Unit)

Refining(Anode Furnaces)

Rock Drill Bits Hydraulic Rock Drill

Underground drill rig (top-hammer long hole)

Source: Sandvik and Sumitomo

For the purposes of the European Capital Goods sector where Sandvik and Atlas Copco(of our coverage) participate, the mining equipment industry is often referred to as the mining and construction equipment industry as 30-50% of upstream mining equipment products are also used in the construction markets. However, there is also a standalone pure construction equipment market (bigger than the mining equipment market) with segments such as dump trucks, skid steers loaders, dozers, backhoe loaders, excavators, etc, made by the likes of Volvo, Caterpillar, Liebherr, CNH and JCB, etc. We have not included this pure construction equipment market in our analysis below.





In general, the mining equipment business model is more final assembly than manufacturing. What do we mean by this? Both Atlas Copco and Sandvik, the market leaders (and sector constituents), buy in the majority of their components (such as wheels, tyres, engines, vehicle bodies, axles, seats, etc) as finished products from sub-contractors and do not make them in-house. This business model has the effect of raising the degree of variable costs and lowering the operational gearing, minimising margin variability through-cycle.

Despite buying in a large degree of content, Atlas Copco and Sandvik still have a high degree of value added and competitive advantage. They rely on technological barriers to entry surrounding their rock drill competence (both the effectiveness of the hydraulic mechanism and the wear resistance of the drill bits). In addition, these two also rely on their scale and breadth of service, knowledge management and distribution.

Fig 177: Mining equipment suppliers, segment positioning upstream to downstream

Exploration Development

Exploration for mineral resources

•Remote sensing•Geophysical / geochemical tests•Samples

Feasibility studies

Drilling and modelling of theore body

Selection of appropriatemining technique

Capital investment in mine infrastructure

Mining of the ore body

Rock breaking

Surface mining

Underground mining

Mined minerals transported to processing site

Use of loaders, trucks, trains, at the face mining systems and conveyors

Materials are crushed and ground to achieve finer particles

Particles sized for optimum recovery of minerals specie

Flotation, leaching, sedimentation and filtration are used to increase the mineral content to an economic level

Refining to increase concentration of minerals further

Key techniques:

•Pyro-metallurgy•Electro-winning

Extraction Materials Handling

Crushing, Grinding &

Sizing Concentration Refining

Sandvik

Atlas Copco

Furakawa

Terex

FLSmidth Minerals

Bateman

Metso Minerals

Outotec

Boart Longyear

Astec

Komatsu

Bucyrus

Joy Global

CAT (Elphinstone)

Source: Redburn Partners, adapted from FLSmidth Minerals chart

As shown by Fig 177, the mining equipment industry spreads across a number of segments from upstream (exploration, development, extraction) through to downstream (crushing, screening, concentration and refining). Through its various acquisitions in both the crushing & screening and exploration segments, Sandvik has vertically integrated in both directions over the past few years.




Fig 178: Mining equipment market 2008 revenues and EBIT margins, ranked by size

18.0%

14.0%15.4% 15.3%

13.0% 11.8%

19.2%

10.6%9.9%9.9%

13.9%

0500

1,0001,5002,0002,5003,0003,5004,0004,500

Sand

vik(S

MC)

Atla

sCo

pco

(CM

T)M

etso

(MCT

)

Joy

Glob

al(G

roup

)

Bucy

rus

(Gro

up)

Tere

x(M

P&M

)

FLSm

idth

(Gro

up)

Outo

tec

(Gro

up)

Boar

tLo

ngye

ar(D

rillin

gFu

ruka

wa

(Roc

k Dr

ills)

Aste

c(A

ggre

gate

and

Min

ing)

2008

Sal

es (€

mn)

0%

5%

10%

15%

20%

25%

2008

Cle

an E

BIT

Mar

gin

(%)

Sales Clean EBIT Margin


In general, and as shown in Fig 178, margins at the pure-play upstream end of the equipment spectrum (Atlas Copco and Boart Longyear) tend to exceed those at the downstream end (Outotec).


Fig 179: €23bn global mining equipment market, 2008 Fig 180: €10bn global mining equipment market, 1997

Metso11%

Joy Global10%

Other19%

Atlas Copco14%

Sandvik17%

Bucyrus7%

Furukawa1%

Boart Longyear

2%

Outotec5%

FLSmidth6% Terex

7%

Astec1%

Other47%

Atlas Copco8%

Sandvik5%

Bucyrus3%

Furukawa2%

Boart Longyear

3%Outotec

3%

FLSmidth2%

Terex7%

Astec1%

Metso5%

Joy Global14%


The €23bn global mining equipment market was relatively concentrated in 2008, with the top five manufacturers making up 61% of the market. If we include Bucyrus’ recent game-changing acquisition of Terex Mining, this concentration increases even further to 68%. The industry was not always so concentrated but it has benefited from a huge degree of consolidation over the last decade or so. In 1997, the top five manufacturers only controlled 41% of the market. With the exception of the lock industry, the mining equipment industry has seen the most significant degree of consolidation of the 11 industries addressed in this report.




Fig 181: Selected major transactions (>$100m sales) in the mining and construction industry 1989-2008

Target Acquirer Date % acquired or sold Country Sales ($m) Employees Price (€m) EBIT ($m)

Nordberg Inc Metso Jun-89 100% US 200 1,000

Dobson Park Joy Global Jun-96 100% US 422 3,800 330 27

Tamrock (Tampella OY) Sandvik Nov-97 100% Sweden 990 5,058 855 79

O&K Mining Terex Jun-98 100% Germany 250

Cedarapids Terex Jun-99 100% US 200 170

Powerscreen Terex Jun-99 100% Northern Ireland 362 294

Svedala Industri Sandvik Sep-01 100% from Metso Sweden 169 900 14

Svedala Metso Sep-01 100% Sweden 550

Ingersoll-Rand Drilling Solutions Atlas Copco Jun-04 100% US 226 950 198 17

Stamler Joy Global Apr-06 100% US 150 117

SDS Corporation Sandvik Jun-06 100% Australia 109 500 81 14

DBT Bucyrus Dec-06 100% Germany 1,000 3,200 731 90

Extec Screens sand Crushers Sandvik Jun-07 100% from 3i UK 271 450 281 43

Dynapac Atlas Copco Jun-07 100% from Altor Sweden 646 2,100 843 52

GL&V (Process Division) FLSmidth Aug-07 100% Canada 551 1,000 919 66

Continental Global Group Joy Global Feb-08 100% US 340 270

Terex (Mining Division) Bucyrus Feb-10 100% US 1,000 2,150 1,300 120


We have analysed c80 acquisitions over the past 20 years and selected the largest 17 (i.e. those with revenues over $100m at the time of acquisition) to construct Fig 181 above.

Fig 182: 1996-2008 global mining equipment market shares and concentration of top five

0%10%20%30%40%50%60%70%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glob

al M

arke

t Sha

re (%

)

Sandvik (SMC) Atlas Copco (CMT) Top 5


Looking at the collective market share of the top five manufacturers through time highlights three distinct period of consolidation (as shown in Fig 182):

Sandvik’s acquisition of Tamrock in November 1997: this was a watershed moment for the industry with Sandvik and Atlas Copco parting their longstanding alliance. Historically, Sandvik made the drill bits and Atlas Copco made the equipment and hydraulic drills and the two worked in alliance. Following Atlas Copco’s vertical integration into drill bits through the 1988 acquisition of Secoroc (a competitor of Sandvik), Sandvik made the decision to stop selling product via Atlas Copco and to vertically integrate into hydraulic drills and equipment through the acquisition of Atlas Copco’s competitor Tamrock. Around the same time Terex also made some sizeable mining equipment related acquisitions (O&K Mining, Cedarapids and Powerscreen).

Svedala acquired by both Metso and Sandvik: in September 2001 Metso acquired Svedala and was forced to spin-off its crushing and screening assets (to Sandvik) due to anti-trust. This continued Sandvik’s vertical integration away from its drill bit roots and took them into a market not offered by competitor Atlas Copco.




2006-08 bull market acquisition wave: with the industry averaging 20% organic sales growth between 2004 and 2008, increased margins and cash flows led to a wave of further consolidation between 2006 and 2008; including DBT by Bucyrus, Extec by Sandvik, Dynapac by Atlas Copco (more road building than mining), GL&V’s Process Division by FLSmidth and Continental Global Group by Joy Global.

Industry margin behaviour, current trough exceeds past peaks!

Fig 183: Mining Equipment industry EBIT margins 1993–2010E

0%

4%

8%

12%

16%

20%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EBIT

Mar

gins

(%)

Mining (and Construction) Equipment Sector Average Sandvik (SMC) Atlas Copco (CMT)


Ignoring Sandvik (which organically increased capacity more than most during the bull years, exacerbating its current margin compression) margins in the mining equipment industry have remained enormously resilient throughout the current downturn. In fact, our analysis suggests that the mining equipment industry, in aggregate, will achieve a trough EBIT margin of c11% in 2009-10, which is actually above the prior peak of c9% in 1996. This remarkable achievement of meaningfully lifting through-cycle margins is a great example of the benefit of industry consolidation.

Fig 184: Volumes in the mining equipment industry enjoyed a strong five years from 2003-08

-30%

-20%

-10%

0%

10%

20%

30%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

YoY

Volu

mes

(%)

Sandvik and Atlas Average

Source: Redburn Partners, Sandvik and Atlas Copco data is used as a proxy for the industry given the absence of data elsewhere

To a degree margins have also benefited from the strong volume story of the past five years, however, as discussed above, the operational gearing is relatively low in the mining equipment industry. Greater proof of our argument that consolidation has lifted margins can be seen in the 2009 example where volumes were at their worst for 20 years, yet despite this, margins (as shown in Fig 183 and discussed above) were very resilient.




Fig 185: Pricing in the mining equipment market has remained resilient in the crisis

0%

1%

2%

3%

4%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

YoY

Pric

e (%

)

Sandvik and Atlas Average

Source: Redburn Partners, Sandvik and Atlas Copco data is used as a proxy for the industry given the absence of data elsewhere. Atlas Copco price data are disclosed publicly but Sandvik pricing data are taken from conference call commentaries and are not disclosed in the quarterly reports

The price data over the last decade or so shows just how much the industry has experienced an improvement in pricing power. Interestingly, despite the huge volume decline of 2009, prices remain positive. While there remains a risk that manufacturers attempt to buy volume through aggressive pricing into the recovery, the evidence of price discipline and improved pricing power to date is compelling.

Low-cost entrants?

Fig 186: Chinese RMB107bn (€10bn) mining equipment market, 2008 by market share

Other36%

Zhejiang Kaishan1%

Metso2%

Terex1%

Lonking Holdings1%

Taiyuan Heavy Machinery

2%

Shanghai Jianshe Luqiao Machinery

1%

Shandong Mining Machinery

1%

Shanxi Pingyang Industry Machinery

1%

Bucyrus International0%

Sandvik3%

Guangxi Liugong Machinery

3%

Atlas Copco3%

Joy Global3%

Tiandi Science & Technology

3%

International Mining Machinery

3%

Zhengzhou Coal Mining3%

China Coal Energy4%

Caterpillar4%

Northern Heavy Industries

6%Xuzhou Construction

Machinery7%

Source: Redburn Partners based on company data and Freedonia ‘Mining Equipment In China To 2013’ report, December 2009

The Chinese mining equipment industry consists of over 1,000 companies, as the size and complexity of the industry allow numerous small firms to compete in selected niches. The top five players only control 24% of the market making it extremely fragmented and therefore competitive. Although acquisition and merger activity among mining equipment has been minimal to date in China, we would expect it to increase to combat the intense competitive pressures and share the costs of government efforts to improve the product quality of the local manufacturers.




The market breaks into larger scale equipment, where the likes of Caterpillar and Joy Global compete, and the smaller scale market, where Sandvik and Atlas Copco compete with their drill rig-led product offering.

The Chinese have a long history of mining equipment dating back 3,000 years. However, despite this proud history, post reform, the large-scale Chinese mining companies began importing Western drill rigs as their drilling precision and efficiency was so much better than local equipment. At the time, Western imports led to a gradual phasing out of traditional techniques and equipment, which in turn virtually wiped out local manufacturers.

Since then, and up until recently, the Western drill rig manufacturers, led by Sandvik and Atlas Copco, dominated the Chinese drill rig market (with higher Chinese drill rig market shares than they have in the wider Chinese mining equipment market, as shown in Fig 186 above). However, more recently, a legion of local manufacturers have re-emerged, having developed domestic drill rigs based on Western designs.

Despite this, Sandvik and Atlas Copco remain unphased and continue to invest heavily in China. Sandvik Mining and Construction has just opened its biggest Chinese production plant to date, a 120,000m2 factory in Shanghai, manufacturing most products in the range, from drilling rigs to crushers and loaders. Furthermore, Atlas Copco has relocated the global management of its Construction and Mining Technique business from Stockholm to Shanghai.

Fig 187: RMB107bn (€10bn) 2008 Chinese mining equipment market, by type

Coal Mining44%

Metals Mining33%

Minerals Mining23%

Source: Freedonia data used for mix and Sandvik data used for market size

According to Freedonia, 44% of the Chinese mining equipment market is coal-related where demand is inextricably linked to power generation and T&D demand, given the dominance of coal in China. Demand for metals and minerals mining equipment is more linked to steel, construction, agriculture and chemicals.

The China risk

We believe that, despite the volume of new entrants in the Chinese mining equipment market, there is limited threat to the Chinese market share for the Western players, let alone threat of meaningful competitive export out of China.

Sadly there is a lack of empirical data available and the majority of Chinese players are private companies. As such, our view is predicated on a number of anecdotal comments from the major Western manufacturers, who all remain relatively relaxed about the domestic manufacturer threat. This view is underpinned by a recent report from the China Mining Association on the state of the domestic drill rig capability.




The China Mining Association identifies four issues preventing the domestic drill rig manufacturers from successfully exporting product:

Chinese products are not sufficiently reliable,

Price fixing and cartels have resulted in disorderly competition and deficient after-sale service amongst the local manufacturers,

Chinese manufacturers have come up against intellectual property rights hurdles with the volume of tortuous patent cases increasing,

Achieving the certification of international general standards has presented a challenge to the domestic manufacturers.

From our experience, Chinese associations are, more often than not, relatively upbeat about their domestic capabilities. As such, these negative comments are particularly interesting and supportive of the argument that the global mining equipment market faces limited immediate threat from Chinese competition.



Supply side (6): bearings

SKF: 100% of group sales exposure to the Bearing industry

Despite the dramatic fall in 2009 margins, we believe margins in the global bearing industry are structurally improved compared to history. We believe pricing power in the bearings industry has improved markedly over the past 20 years as a consequence of meaningful industry consolidation. We believe that when volumes stabilise, the favourable supply-side dynamics of the industry will support a return to the rising trend in industry margins. However, in the medium term, we expect a very anaemic recovery for automotive volumes in Europe and the US, which, we believe, will hamper industry margin development in the next few years. Currently China and the emerging markets represent the more attractive driver of growth for the industry.

Longer term, however, China poses a potential new entrant risk. Over the last decade there has been a proliferation of new low end domestic bearing manufacturers in China (and other emerging markets). Should the Chinese investment bubble burst and volumes reverse then the Chinese domestic manufacturers could look to replace lost volumes with exports. When the Japanese manufacturers dumped product into the West after its own growth miracle faltered in the late 1980s and early 1990s, margins in the global bearing industry suffered heavily. With the Chinese stimulus package likely to last until 2011 and government spending relatively assured, this remains a longer-term issue.

Bearings

Fig 188: Bearing types

Source: SKF 2008 Annual Report

The bearing industry story is one of the more widely understood and compelling industry consolidation stories across the capital goods universe. It serves as an example of how materially an industry’s pricing and margins can benefit from a step change in concentration.






Fig 189: 1997-2008 global bearing market shares

0%

20%

40%

60%

80%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Glo

bal

Bea

ring

Mar

ket

Shar

e (%

)

SKF Schaeffler FAG NSK Timken Torrington NTN JTEKT Other


The bearing industry has seen material consolidation over the last decade. As shown in Figs 189, 190 and 191, we calculate that the top five global bearing companies had 52% of collective global market share in 1997 and that this increased a meaningful 12% to 64% in 2008.

Fig 190: Bearings, 1997 global market share Fig 191: Bearings, 2008 global market share

SKF16%

Other31%

NSK14%

Torrington5%

Schaeffler7%

NTN8%

FAG7%

JTEKT5% Timken

7%

SKF20%

Schaeffler17%

NTN8%

NSK15%Timken

10%

Other23%

JTEKT7%


This consolidation was predominantly driven by a number of major acquisitions:

INA/FAG: in September 2001, privately held INA-Holding Schaeffler KG (the then global number three in the bearing market) launched a surprise €673m takeover bid for FAG Kugelfischer (the then global number four in the bearing market) valuing FAG at 6.9x 2001 EV/EBIT and only 30% 2001 EV/Sales (€2.2bn of 2001 revenues). The bid was successful and INA merged with FAG (renaming itself Schaeffler), becoming the world’s second-largest bearing manufacturer behind SKF.

Timken/Torrington: in February 2003, Timken (the then global number five in the bearing market) acquired Ingersoll-Rand’s Torrington bearing subsidiary (the then global number seven in the bearing market) for $820m, valuing Torrington at 8.2x 2002 EV/EBIT and 68% 2002 EV/Sales ($1.2bn of 2002 revenues).

Koyo Seiko/Toyoda Machine Works: at the end of 2006, Koyo Seiko (the then global number five in the bearing market) and Toyoda Machine Works merged to form JTEKT. Toyoda added c3% or so to Koyo’s market share. Toyota Motor Corporation owned c23% of Koyo Seiko and c24% of Toyoda Machine Works at the time of the deal and largely controls current management.




NTN/SNR: in April 2007, over a year after the original announcement, Japan’s NTN increased its stake in SNR (Societe Nouvelle de Roulements) the French auto bearing business previously owned by Renault, to over 51%. SNR had c€550m of revenues in 2006.

There have also been a number of other ongoing smaller transactions such as SKF’s August 2006 acquisition of SNFA, the French-based Aerospace and Machine Tool bearings maker.


Fig 192: Bearing industry EBIT margins 1990-2009

-5%

0%

5%

10%

15%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

EBIT

Mar

gins

(%)

SKF (Group) Schaeffler (Group) Timken (Group)NTN Group FAG Kugelfischer Torrington (Ingersoll Rand)NSK (Group) JTEKT (Group)


In 2009, our SKF forecasts and consensus forecasts for the other manufacturers suggest that margins in the global bearings industry will fall to historically low levels of c1% on average. On the face of it, and to the bearing bears out there, this margin collapse serves to confirm that bearings are the same old highly cyclical industry with aggressive competition and a difficult margin profile. We are more optimistic and believe that margins will ultimately rebound to attractive levels and the long-term rising trend as highlighted by the black arrow in Fig 192.

We believe that despite the massive drop in 2009, margins have actually performed relatively well compared to history. When taking into account the sheer scale of the recent volume drop, margins have held up remarkably well, which we believe is a function of improved industry supply-side dynamics of better pricing power and industry consolidation.

Fig 193: Bearing industry volumes suffer record downturn (SKF volumes 1Q92–3Q09)

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Q1 92 Q1 94 Q1 96 Q1 98 Q1 00 Q1 02 Q1 04 Q1 06 Q1 08

SKF

Gro

up V

olum

e ef

fect

on

Sale

s (%

)

Source: Redburn Partners, SKF volume data used as a proxy for the industry




When one considers just how bad this downturn has been in volume terms (c-30%), when compared to previous downturns (between -5% and -10%), as shown in Fig 193, then actually the 2009 industry margin performance was relatively well managed. Looking at an incremental margin analysis of 2009 compared to the 1991 and 1992 downturn puts this into context. Taking the top five bearings companies (or the top five that disclose sales and EBIT), we forecast 2009 sales to decline by €3.2bn in aggregate and EBIT to decline by €1.2bn, a 38% decremental margin. Contrastingly, over the two years of 1991 and 1992, top five sales fell by €700m and EBIT also by €700m, a decremental margin of c100%. Had the bearing industry seen a 100% decremental margin in 2009 then it would be heading for a c-8% EBIT margin loss instead of the current c+1% forecast. As such there is no comparison between the handling of this downturn and the last, the improvement is unequivocal.

Industry pricing behaviour While industry margins have also benefited from an ongoing fixed cost reduction as seen by the sector as a whole (although it should be noted that SKF has lagged the sector on wage inflation reduction (see Fig 32) as it has been slower to move its manufacturing footprint to lower cost countries), we believe that, inter alia, the longer-term improvement in margins (and incremental margins) has been driven predominantly by both improved pricing power in the bearing industry and improved pricing behaviour amongst the key players (i.e. through bitter experience we no longer see the aggressive price wars in bearings).

Fig 194: Bearing industry pricing has improved (SKF price/mix 1Q92-3Q09)

-6%-4%-2%0%2%4%6%8%

10%

Q1 9

2Q3

92

Q1 9

3Q3

93

Q1 9

4Q3

94

Q1 9

5Q3

95

Q1 9

6Q3

96

Q1 9

7Q3

97

Q1 9

8Q3

98

Q1 9

9Q3

99

Q1 0

0Q3

00

Q1 0

1Q3

01

Q1 0

2Q3

02

Q1 0

3Q3

03

Q1 0

4Q3

04

Q1 0

5Q3

05

Q1 0

6Q3

06

Q1 0

7Q3

07

Q1 0

8Q3

08

Q1 0

9Q3

09

SKF

Gro

up P

rice

/ M

ix e

ffec

t on

Sale

s (%

)

Source: Redburn Partners, SKF Price/Mix data used as a proxy for the industry

This can be seen clearly in Fig 194, which looks at quarterly price/mix data over the last 18 years (we have used SKF data as a proxy for the industry). Ideally, we would look to analyse net price (i.e. the difference between incoming raw material cost inflation and outgoing sales price inflation) but sadly almost every company under the sun guards this information very tightly. Nonetheless there is a clear upwards trend in the level of gross Price/Mix achieved, which we believe to be indicative of improved pricing power as a function of better industry dynamics post industry consolidation.

Low-cost entrants? According to SKF, China has been the fastest growing emerging bearing market and has increased from being 10% of the global market in 2003 to over 15% in 2008 (c€5bn). According to the CBIA (China Bearing Industry Association), the Chinese market is even bigger at c€10bn but this is because they tend to include balls, cages, rings and components, which are double counted as they are also in the bearings. However, regardless of definition one thing is for certain; the Chinese bearing market has seen ferocious growth. Chinese state statistics suggest that bearing exports from local manufacturers have lifted from $490m in 2001 to $4bn in 2008 and that the number of Chinese bearing companies has increased from c500 to c1,700 over the same time period.




SKF claims a number one market position in China (which represented c7% of 2008 sales). On their own definition of market size, we calculate that SKF has a c9% market share of the Chinese market.

However, despite the rapid increase, the Chinese local bearing manufacturers remain low quality and highly fragmented. Technologically, the domestic manufacturers have almost no high precision, high tech or large size bearing capability. Only 3% of 2007 Chinese volume was represented by large size bearings (the high end, high margin, high growth products, which are used by the wind, cement, mining, power and other heavy industries). Furthermore, the Chinese market remains heavily unconsolidated with the top ten domestic manufacturers only accounting for 22% of market share (according to CBIA). In Europe, the US and Japan the top five account for over 60%.

Despite the fragmented and highly competitive nature of the Chinese bearing market, prices have remained remarkably resilient due to the high volumes. According to CBIA, the average bearing price in China increased to 13% in 2008 and 8% in 2007.

Fig 195: SKF’s presence in China

Source: Company data

The China risk

Nonetheless, while China has currently represented a force for good for SKF and a key driver of growth, should the Chinese investment bubble burst and volumes reverse, Chinese domestic manufacturers could look to export more in order to find volumes. In some senses, we have already seen the case study for this. When Japan’s domestic economic growth miracle finally faltered in the 1990s, the global bearing industry suffered a period of intense price competition as the Japanese bearing manufacturers tried to replace lost volumes by dumping cheaply priced exports. Ultimately this was heavily destructive for everyone’s margins and the Japanese retrenched. While the future remains to be written, should Chinese domestic bearing growth evaporate then the attractive global industry dynamics post consolidation could possibly revert to more difficult times, particularly if the Chinese have moved further up the technology curve by then. This remains, in our view, a key longer-term risk to the attractive margin story in the bearing industry.



Supply side (7): compressors

Atlas Copco: 53% of group sales exposure to the Compressor industry

The ‘turbo’ compressor market (led by GE, Dresser, Rand, MAN and Siemens) has seen a dramatic consolidation from 15 to 7 global players over the past 20 years. Evidence shows that this increased concentration has improved pricing and doubled through-cycle margins from a relatively low base.

In the higher returning ‘positive displacement’ compressor markets (led by Atlas Copco, Gardner Denver and Ingersoll Rand) margins have also been lifted by industry consolidation. We believe this consolidation has further strengthened pricing power in the ‘positive displacement’ markets and would highlight that prices have been very resilient (+1%) during the recent 20%+ volume downturn.

We see no current evidence of pricing pressure emanating from the low-cost players of the emerging markets where Atlas Copco already has attractive market shares.

Compressors

Fig 196: Compressor types

Centrifugal AxialScrew

Reciprocating PortablePiston

Source: GE and Atlas Copco

The compressor industry is relatively complex with a number of differing technologies and power ranges. While definitions vary, we calculate the global compressor market measured roughly €14bn in 2008. Within this, Atlas Copco dominated the €9bn positive displacement market with a 31% market share and GE led the €5bn dynamic (turbo) compressor market with a 20% market share.





Fig 197: Compressor types, organised by family tree

Dynamic (Turbo)

Source: Improving Compressed Air System Performance: A Sourcebook for Industry; US Department of Energy

Compressed air is used widely throughout industry and is often referred to as the ‘fourth utility’. Almost every industrial plant, from a small machine shop to a vast pulp and paper mill, has some type of compressed air system. In many cases, the compressed air system is so vital that the facility cannot operate without it. Plant air compressor systems can vary in size from a small unit of 1KW to huge systems with 70,000KW.

The compressor business model is to sell more efficient new equipment to replace out-moded equipment on the basis of energy cost savings, and then following that to make the high margins on selling spare parts and services to the installed base. In many industrial facilities air compressors use more electricity than any other type of equipment. Inefficiencies in compressed air systems can therefore be significant. Energy savings from system improvements can range from 20-50% or more of electricity consumption. As with the cutting tool model (discussed later) there is an attractive productivity argument for the sale of new compressors.

Degree of industry consolidationFig 198: 2008 global €9bn positive displacement compressor market (reciprocating and rotary)

Fig 199: 2008 global €5bn turbo compressors market and market shares

Enpro (Quincy)4%

GE4%

Sullair3%

Cameron2%

Ariel2%

Atlas Copco31%

Gardner Denver12%Ingersoll

Rand11%

Bristol2%

Busch3%

Edwards1%

Dresser Rand4%

Kaeser6%

Other15%

Dresser Rand16%

Atlas Copco7%

Other23%

Siemens16%

MAN Turbo18%

GE20%


Over the past 20 years, the turbo compressor industry (see Fig 199) has consolidated materially from more than 15 players to 7. Dresser Industries and Ingersoll Rand’s turbo business merged in 1986 to create Dresser Rand, GE acquired Nuovo Pignone in 1994, Rolls Royce acquired Cooper Cameron in 1999, MAN Turbo was formed out of the merger of MAN BORSIG and Sulzer Turbo in 2000, and Siemens acquired Demag Delaval in 2001. This has led to a highly concentrated market in which the top five




players control 77% of the market. Atlas Copco also participates in this market (with its gas & process business, which represents c10% of CT sales). Atlas only participates at the smaller end with its 200-2,000KW products in contrast with the larger scale products (15,000-70,000KW) offered by the oil & gas division of GE, Dresser Rand, Siemens and MAN AG.

While the ‘positive displacement’ market has also seen meaningful consolidation over the last two decades it has perhaps not seen the same degree of M&A as the turbo-compressor market. Having said this, the market is now relatively concentrated with the top five players accounting for 64%.

The ‘positive displacement’ market (Fig 198) includes both the ‘reciprocating’ and ‘rotary’ compressor markets. Like most players in this space, Atlas Copco competes in both markets but dominates in one, the rotary market, where its lower powered (1-150KW) screw compressors (which represent c60% of CT sales) dominate the market. At this lower power end of the spectrum Atlas Copco competes against Gardner Denver, Ingersoll Rand, Kaeser, Quincy and Sullair, whereas at the higher power end, the likes of Dresser Rand, GE and Ariel compete with 1,000-4,000KW products. In reciprocating compressors Atlas Copco has a strong position market in piston compressors.


Fig 200: Industry consolidation has benefited turbo margins more

0%

2%

4%

6%

8%

10%

12%

14%

16%

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

EBIT

Mar

gins

(%)

Dynamic (Turbo) Compressor Average Positive Displacement Compressor Average


Two observations spring to mind from looking at EBIT margins across the compressor complex (Fig 200). Firstly, the positive displacement market is more profitable than the turbo compressor market. Secondly, turbo compressors have closed the margin gap compared to positive displacement. We see this near-doubling of turbo margins (peak to peak) as evidence that turbo margins have benefited from industry consolidation, good news for Siemens and MAN.




Fig 201: Compressor industry EBIT margins 1990-2009, remarkable Atlas Copco resilience

0%

5%

10%

15%

20%

25%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

EBIT

Mar

gins

(%)

Atlas Copco (CT) MAN Turbo Gardner Denver (Group)

Sullair (UTX HS Industrial) Kaeser (Group) Ingersoll Rand (Air Solutions)

Siemens (Demag Delaval) GE (Oil & Gas Compressors) Cameron (CS)

Dresser Rand (Group) Bristol Compressors Enpro (Quincy)

Source: Redburn Partners. Limited data available for other manufacturers

Atlas Copco has been the star performer

Looking at individual company performances (Fig 201), highlights just how much star quality Atlas Copco has and how impressively it has managed its compressor margins over the past 20 years. Not only does Atlas Copco generate materially higher margins than everyone else in the industry but is has also shown remarkable margin resilience throughout the cycle, notably during periods of volume decline, such as 2002, when others saw material margin dips. We see five factors behind Atlas Copco’s industry busting margins:

Pricing: as shown below in Fig 203, pricing has been largely positive and increasingly resilient.

Scale: Atlas Copco has a material ‘economies of scale’ advantage. With 31% of the positive displacement compressor market, Atlas Copco is nearly three times larger than Gardner Denver, the next largest player.

Consolidation: Atlas Copco has made its own contribution to industry consolidation, having made 35 acquisitions in its compressor division over the last decade. We estimate that c30% of its 2008 Compressor Technique revenues came from these acquisitions.

Standardisation: except where there is a compelling business case (e.g. Gas & Process), Atlas Copco has a relatively strict strategy of only participating in the smaller scale compressor markets where a high level standardisation is achievable. As with a number of equipment markets (e.g. power transformers vs distribution transformers) the larger end of the equipment spectrum tends to involve a higher degree of customisation, which in turn introduces fixed costs, mix issues and higher operational gearing. Avoiding overly engineered bespoke products and focusing purely on highly standardised products gives Atlas a higher proportion of variable costs than most.

Higher aftermarket content: Atlas Copco’s compressor division has c30% of its sales (depending on point in the new equipment cycle) exposed to the aftermarket. We estimate that this spares and service work makes c26% EBIT margins (vs OEM at c8%), leading to the aftermarket making up c50% of CT’s EBIT. We believe this is a higher proportion of aftermarket than seen at the other manufacturers.




Fig 202: Positive displacement compressor volumes (Atlas Copco volume 1Q94–3Q09)

-25%-20%-15%-10%-5%0%5%

10%15%20%25%

Q1 94 Q1 96 Q1 98 Q1 00 Q1 02 Q1 04 Q1 06 Q1 08Atl

as C

opco

Com

pres

sor

Tech

niqu

eVo

lum

e ef

fect

on

Sale

s (%

)

Source: Redburn Partners, Atlas Copco volume data used as a proxy for the industry

When one considers that Atlas Copco’s compressor volumes have dropped some 20%+ this downturn, when compared to previous downturns (between -5% and -15%), as shown in Fig 202, then actually the 2009 margin performance (-230bp) is extremely impressive.

Industry pricing behaviour

Fig 203: Positive displacement compressor pricing (Atlas Copco Price 1Q94–3Q09)

-3%

-2%

-1%

0%

1%

2%

3%

4%

Q1 94 Q1 96 Q1 98 Q1 00 Q1 02 Q1 04 Q1 06 Q1 08Atl

as C

opco

Com

pres

sor

Tech

niqu

ePr

ice

effe

ct o

n Sa

les

(%)

Source: Redburn Partners, Atlas Copco price data used as a proxy for the industry

Fig 203, which looks at quarterly price data over the past 15 years (we have used Atlas Copco data as a proxy for the industry), shows just how resilient compressor pricing has been (+1%) despite the recent 20%+ volume downturn.

Low-cost entrants?

Fig 204: China compressor market 2008 (€3,000m) Fig 205: India compressor market 2008 (€500m)

Others45%

Kaishan15%

Shenyang Gas7%Liuzhou

6%

Fusheng4%

Wuxi (Atlas Copco)11%

Shanghai Compressor

12% Atlas Copco40%

Elgi Equipments

25%

Ingersoll Rand14%

Kirloskar Pneumatic

7%

Others14%

Source: Redburn Partners, Kaishan Source: Redburn Partners, Elgi




According to our calculations, at €3bn, China has now overtaken the US as the world’s largest compressor market. According to ‘ResearchInChina’, the number of registered compressor manufacturers with more than €0.5m in annual revenues has proliferated reaching 355 in 2008. Despite the long tail of new entrants there are a number of established players in China. We calculate that the top six manufacturers represent 55% of the market (although the data are not comprehensive).

Looking to the India market there is less low-cost competition. In the 1960s, a number of Swedish companies were given the first licenses by the Indian government to establish a manufacturing presence in Pune. As a consequence, the Swedish manufacturers have strong market positions across a number of industrial markets. Compressors are no exception and Atlas Copco leads the €500m Indian compressor market with a substantial 40% market share ahead of domestic player, Elgi Equipments.



Supply side (8): locks

Assa Abloy: 100% of group sales exposure to the global locks industry

The global lock industry has seen intense consolidation over the last decade with the top five global lock companies lifting their collective market share from 23% in 1997 to 57% in 2010E. We believe we can demonstrate evidence that this increased concentration has led to markedly improved pricing power and margins. We are relatively relaxed about the risks of low-cost competition from China and other low-cost countries as we believe the worst of the low-cost storm has passed and been weathered well.

Locks

Fig 206: Examples of lock products (also known as architectural hardware or access control)

Window Locks

Deadlocks Door Closers

Padlocks

MorticeLocks

Electric MorticeLocks

Access Control

Keypads

Electric Door

Operators

Cylinder Locks

Safes

Chain Locks

Window Locks

Deadlocks Door Closers

Padlocks

MorticeLocks

Electric MorticeLocks

Access Control

Keypads

Electric Door

Operators

Cylinder Locks

Safes

Chain Locks

Source: Redburn Partners, assembled from Assa Abloy materials

Over the last decade, the global lock industry has been transformed from a fragmented structure to a relatively concentrated structure. On any metric Assa Abloy (the market leader) has led this process of consolidation, having made c100 acquisitions since the original merger of Securitas (Assa) of Sweden and Metra (Abloy) of Finland in 1994. To put the scale of its acquisitiveness in context, we calculate that Assa has lifted its revenues from SKr4bn in 1995 to SKr33bn in 2008. To put it another way, while Assa witnessed an impressive average annual organic sales growth of +5% over the period, it saw more than three times as much growth (+16%) from its average annual acquisition impact to revenues.


Fig 207: 1997-2008 global lock market shares

0%

20%

40%

60%

80%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Glo

bal

Lock

Mar

ket

Shar

e (%

)

Assa Abloy (Group) Black & Decker (Hardware)Kaba (Group) Dorma (Group)Ingersoll Rand (Security Technologies) Stanley Works (Security Solutions)Other






The lock industry has seen material consolidation over the last decade. As shown in Figs 207-210, we calculate that the top five global lock companies had 23% of collective global market share in 1997, which increased (by 31%) to 54% in 2008. Assuming a successful merger of Black & Decker (the global number six) and Stanley Works (the global number three), we calculate that the top five concentration will increase yet further to 57% in 2010.

Fig 208: 1997 global locks shares Fig 209: 2008 global locks shares Fig 210: 2010E global locks shares

Other76%

Kaba1%

Assa Abloy5%

Black & Decker

(H)5%

Dorma3%

Stanley Works

(SS)4%

Ingersoll Rand

(ST)6%

Other43%

Assa Abloy24%

Dorma6%

Kaba5%

Stanley Works

(SS)7%

Ingersoll Rand

(ST)11%

Black & Decker

(H)4%

Other42%

Ingersoll Rand

(ST)13%

Stanley Black & Decker

(S)12%

Kaba5%

Dorma6%

Assa Abloy22%

Source: Redburn Partners based on company data Source: Redburn Partners based on company data Source: Redburn Partners based on company data

For all players, this consolidation was predominantly driven by a very large number of bolt-on acquisitions. There have been a number of larger deals, such as:

Assa/Essex: in January 1996, Assa Abloy paid SKr1.6bn (€188m) to acquire Essex of the US for 1.0x EV/Sales and 14.0x EV/EBIT.

Assa/Vachette: in May 1997, Assa Abloy paid SKr1.4bn (€168m) to acquire Vachette of France for 1.0x EV/Sales and 18.9x EV/EBIT.

Assa/Yale: in August 2000, Assa Abloy paid SKr8.6bn (€995m) to acquire Yale at 1.3x EV/Sales and 10.9x EV/EBIT.

Assa/HID: in January 2001, Assa Abloy paid SKr2.4bn (€264m) to acquire HID, the US-based leader in access control (contactless cards and readers), for 2.5x EV/Sales and 13.9x EV/EBIT. HID represented Assa’s move into electronic access control, a strategy followed by Ingersoll Rand and others.

Stanley Works/Best Lock Corporation: in November 2002 Stanley Works paid $316m (€279m) to acquire mechanical and electronic lock company Best Lock at 1.3x EV/Sales.

Black & Decker/Masco: in October 2003, Black & Decker spent $275m (€243m) on acquiring Baldwin Hardware Corporation and Weiser Lock Corporation from Masco at 1.1x EV/Sales.

Ingersoll; Rand/CISA: in January 2005, Ingersoll completed its $571m (€458m) acquisition of CISA, the Italian security products maker, for 2.6x EV/Sales.

Stanley Works/Black & Decker: in November 2009, Stanley Works and Black & Decker jointly announced their agreed intention to merge, creating Stanley Black & Decker. Of the combined €5.7bn revenue entity (2009), the new ‘Security’ division is likely to represent c28% of group sales (€1.6bn), taking SB&D Security to within sniffing distance of Ingersoll Rand’s number two position.




Away from the key lock consolidators above, the mechanical and electrical lock industry is relatively fragmented.

In many ways the Stanley Works and Black & Decker merger breaks new ground for the locks industry. Hitherto, industry acquisitions have predominantly been ‘bolt-ons’ and as such this recent merger announcement represents an exception in that it brings together two major players (the world’s third and sixth largest lock manufacturers) and constitutes the largest industry consolidation to date. Speaking to those in the industry, two comments stand out:

“Ingersoll Rand may see a tougher match in the DIY space but Assa isn’t really in DIY”

“In general the merger is most likely good for the pricing of the industry”

The locks industry is not naturally an easy industry to consolidate. There are no common global lock standards, quite the opposite, as the industry is highly localised with differing standards in most countries (and often within countries). However while these localised standards act as a barrier to new global entrants, for the patient and the very dominant (such as Assa Abloy, Ingersoll Rand and Stanley Black & Decker) it presents unique opportunities for economies of scale, pricing power and margin potential.

Despite the localised nature of the market, Assa Abloy (under CEO, Johan Molin) has been quite creative in finding both economies of scale (notably in the centralised manufacturing of cylinders and locks cases) and outsourcing synergies (notably the outsourcing of basic machining and stamping) to integrate its once fragmented portfolio of acquisitions into to a vastly reduced number of manufacturing sites.

The wider security market has also concentrated Those who know the industry well will know that there have also been a number of industry acquisitions not mentioned above. These were not in the lock markets as such but in the wider arena of security, which has been a hotbed of M&A activity over the last decade.

Fig 211: €200bn global security market, mechanicals and electronic locks a small part

Doors & Windows40%

Security Guards27%

Mechanical Locks10%

Electronic Access Control5%

Intrusion Protection & Detection

3% IT Security4%

Alarm Centres9%

Fire Alarms2%

Source: Assa Abloy

We would highlight acquisitions such as UTC’s 2003 purchases of Chubb’s Fire Alarms and Security Personnel business (Assa acquired the locks arm from Williams) and Kidde (fire protection); Schneider’s acquisition of Andover Controls (building automation and security systems); Honywell’s Novar (building automation); Cisco’s SyPixx Networks (surveillance); GE’s joint venture with Smith’s Detection; Tyco’s Simplex (fire alarms) and Sensormatic (RFID); as being the key transactions within the wider security markets.




This consolidation within the wider security markets has been driven by the larger industrial multinational conglomerates all looking to increase their level of product content compared to their legacy, low margin, service heavy, building facility management activities. Should Assa Abloy’s principal shareholders (Investment AB Latour, SäkI AB and Melker Schörling AB, with c41.5% of the votes) ever wish for an exit route then there is arguably a long line of industrial conglomerate buyers out there.

Fig 212: €54bn global electronic security market Fig 213: €20bn global fire safety market

Others67%

Brinks1%

Securitas1%

Secom5%

Honeywell4%

Tyco10%

UTC (FS)3% Alsok

2% Niscayah2%

Stanley1%

Assa Abloy1%

Siemens2%

G4S1%

Others37%

Nohmi2% Oshkosh

2%

Hochiki1%

Viking1%

Minimax3%

GE5%

Siemens8%

Tyco19%

UTC (FS)13%

Honeywell9%


From a sector perspective, the consolidation in the wider (non-lock) security markets (shown in both Figs 212 and 213 above) has undoubtedly been of some benefit to Siemens, which participates here through its Building Technologies division


Fig 214: Lock industry EBIT margins 1995-2009, by company

0%

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10%

15%

20%

25%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

EBIT

Mar

gins

(%)

Assa Abloy (Group) Black & Decker (Hardware)Kaba (Group) Dorma (Group)Ingersoll Rand (Security Technologies) Stanley Works (Security Solutions)


Returning, to the more specific niche of mechanical and electronic locks, Fig 214 highlights the margin progression of the key players over the past 14 years, which we have averaged in Fig 215 and compared against our sector participant Assa Abloy.




Fig 215: Lock industry EBIT margins 1995-2010E, Assa vs industry average

0%2%4%6%8%

10%12%14%16%18%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EBIT

Mar

gins

(%)

Assa Abloy (Group) Lock Sector Average


Industry margins have doubled from c7% in 1995 to c14% in 2009 with a large proportion of this increase achieved in the 1990s. Assa Abloy has, in general, led this industry trend, with notable success in recent years under CEO Johan Molin and the company’s structural restructuring of its manufacturing footprint.

Fig 216: Lock industry volumes are less volatile than other Capital Goods industries

2.3%

-3.5%

2.3%4.1%1.5% 1.8% 1.3% 1.6%

-12.2%

-14%-12%-10%-8%-6%-4%-2%0%2%4%6%

2001 2002 2003 2004 2005 2006 2007 2008 2009

Volu

me

effe

ct o

n Sa

les

(%)

Lock Sector Average

Source: Redburn Partners, industry volume data is calculated from the three companies that provide volume and price data (Assa, IR and Stanley)

Compared to other industries in the Capital Goods sector, demand in the lock industry is relatively defensive, which can be explained by the following three structural factors:

Durable not Capital Goods: locks are Durable Goods and not Capital Goods. As capital goods are used in the production of other goods they tend to be more cyclical.

High replacement content: although locks have a relatively long product life, roughly two thirds of lock demand is driven by upgrades and replacements compared to new installations, which only account for a third of demand.

Consumer, commercial and government demand drivers: locks have a natural spread of end demand and are sold into both the residential and non-residential construction markets. This gives the lock industry an exposure to consumer, commercial and government demand cycles, which in combination act as a natural hedge.

However, despite its relative defensiveness, lock industry volumes are not entirely immune to economic events. As shown in Fig 216, we expect industry average volumes to decline by c12% in 2009, the sharpest fall during the period of available data (i.e. since the mid-1990s). However, despite this record volume decline margins have been




remarkably bulletproof and relatively resilient. As shown in Fig 215, we forecast average industry margins to actually increase by 10bp to 13.6% in 2009.

We attribute this margin resilience to three factors: (1) low incremental margins in the lock industry (Assa Abloy’s organic incremental margins only averaged 15% between 1Q05 and 3Q09); (2) restructuring cost savings; and (3) improved pricing power compared to previous downturns.

Industry pricing behaviour While margins in the lock industry have undoubtedly benefited from the containment of wage inflation and the move to low-cost countries (Assa has led the sector in this regard as shown in Figs 32 and 33), there has also been an improvement in pricing, which we believe is a function of industry consolidation.

These improvements in pricing built off the already, naturally, strong pricing power in the industry. The cost of a lock is relatively small within the overall cost of a building (much of which is labour), equally the cost of a lock in the context of safety and security is often seen as relatively small. As such, locks have a long track record of positive pricing.

Fig 217: Lock industry pricing has improved and remained positive in 2009

0.8% 0.7%

1.3%

2.2%1.9% 2.0%

3.3% 3.3%

1.2%

0%

1%

2%

3%

4%

2001 2002 2003 2004 2005 2006 2007 2008 2009

Pric

e ef

fect

on

Sale

s (%

)

Lock Sector Average

Source: Redburn Partners, industry price data is calculated from the three companies that provide volume and price data (Assa, IR and Stanley)

Fig 217 graphs the industry’s annual average achieved price since 2001 and shows a clear upward trend from 2002 to 2008. We see this upwards trend (during a period of more normalised economic conditions) as evidence of improved industry pricing power.

While 2009 will see a reversal of that trend, taking into account both the massive (indeed record) volume decline and the fact that industry raw material costs are expected to decline, we actually see 2009 as an industry pricing success. For net price retention (i.e. after raw material cost inflation) to remain largely unchanged, despite the volume declines, is a pretty clear example of pricing power in the locks industry, in our opinion. Had the industry seen such a record volume decline in tandem with a raw material cost decline in the early 1990s then prices would have dropped meaningfully, in our view. Indeed, in its 1992 10-K Stanley Works talked about price declines in locks during a period of mild volume decline.

As such, pricing power has come a long way in the locks industry and this has been driven, in our view, by industry consolidation.




Low-cost entrants? The Asian lock market is highly fragmented, particularly in China. In 2008, China produced c3 billion mechanical door locks of which more than half were exported. According to Wove Consulting, in 2003 China had 1,500 registered lock companies and by 2004 this had increased to 2,200. The Chinese National Hardware Association indicates that this figure reached c4,000 in 2008.

Based on a combination of sources (Wove Consulting, Research & Markets, Assa Abloy and China National Hardware Association), we estimate that the Chinese lock market was worth c€2.9bn in 2008, of which Assa had a 4% market share. After the recent acquisition of Pan Pan we expect Assa to cement the number one position in the Chinese market with a 9% market share of a €3.5bn market in 2010.

Fig 218: 2010E €3.5bn Chinese mechanical lock and security door market

Others81.5%

Double Hill0.3%

Jin Feng0.3%

Doormax (USA)0.2%Hafele (Germany)

0.11%

Stanley Works (USA)0.11%

Assa Abloy9.0%

Stoutness Group (Wuzhou)

2.8%

Yantai Tri-circle2.4%

Ingersoll Rand (USA)0.3%

Tenyale0.4%

Baodeli0.6%

Zhong Shan Huafeng0.9%

Dongfeng GMT1.1%

Source: Redburn Partners, Wove Consulting, Research & Markets, Assa Abloy and China National Hardware Association

The Chinese lock industry is classified by the state as a sub-segment of the hardware industry. Given that hardware is not deemed a ‘pillar industry’ (e.g. telco, media, steel, power, health care, railways, etc), it remains relatively uncontrolled by the state and highly fragmented with only 10-15 companies with over $10m of revenues. In general the domestic industry is characterised by price sensitivity, low quality, imitation products and unstructured distribution.

Broadly, China’s lock industry has three regional centres of excellence: (1) traditionally padlocks in the north, predominantly in Shandong (notably Tri-circle, Double Hill and Jin Feng); (2) higher end cylinder locks, mortice locks, electronic locks and biometrics in the south, largely in Guangdong Province, the ‘hardware capital’ of China (including Assa’s Guli and Zhong Shan Huafeng); and (3) more latterly (post-Deng reform in the 1980s) a proliferation of low-cost, low quality players in Wenzhou in the Zhejiang Province, more recently this low end region has been pursuing an aggressive upgrade strategy (amongst which the Stoutness Group has broken away and lifted standards towards international level).

There is a lack of R&D capability or high knowledge base within the industry, with most manufacturers spending less than 1% of sales on R&D. In general buyers are unaware of the quality differences leading to excessive price sensitivity with consumers more interested in the design rather than the security of a lock. There is a higher end market, which is the focus of the foreign players who are putting more focus on developing brand awareness. A big drive for Assa Abloy is to use its influence in the China National Hardware Association to lift standards, forcing the lower end to either exit or compete at the higher end.




Assa Abloy’s development in China

Fig 219: Assa Abloy, annual China revenues 1995-2010E, with associated acquisitions

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010EAss

a A

bloy

's R

even

ues

in C

hina

(S

kr m

n)

China Revenue

Nov '09 Pan Pan

Sep '00 Guli

Jun '05 Wangli

Oct '07 Baodean

Jul '08 BJTM

Jan '09 ShenFei

Source: Redburn Partners, Assa Abloy

We forecast Assa Abloy to have c€300m of revenues (c9% of group) in China in 2010, making it one of the leading players. While Assa has been in China since its inception in 1994, its first major foothold came through the acquisition of Guli in September 2000 (as part of the Yale acquisition). Yale had set up the Yale-Guli JV, with China’s state-owned lock maker, Guangdong Guli Locks in 1996. Then in February 2001, Assa bought out the Chinese government’s 40% stake for €26m, giving it majority control, a leading position in the market and a seat in the Chinese National Hardware Association, which has allowed Assa the all-important influence in driving Chinese lock standards.

Since 2004 Assa has made six acquisitions in China, including WangLi in 2005 (€25m sales), which added security doors and nearly doubled revenues, Baodean in 2007, which added high security locks (€48m sales), and most recently Pan Pan Security (€113m sales) in November 2009, which will double revenues again with its six sites and strong position in high security doors (2.4 million per year). Assa already had a strong distribution presence in China but the acquisition of Pan Pan (which has an extensive network) gives Assa Abloy the strongest distribution footprint in China.

Fig 220: Assa’s presence in China

Source: Assa Abloy

The China/low-cost entrant risk

We are relatively relaxed about the China/low-cost entrant risks in the global lock industry and believe the worst of the low-cost storm has passed and been weathered well. The foreign players (especially Assa) have already shown great success in China even during periods of intense low-cost competition. Over the last few years, the gradual raising of lock standards and increased sophistication of buyers has lessened the threat and is set to continue to improve going forward.



Supply side (9): cutting tools

Sandvik: 27% of group sales exposure to the global cutting tools industry

The supply-side dynamics of the global cutting tool market are very attractive, in our view. The top five manufacturers control 61% of the market and we see no meaningful threat from Chinese competition. On the less positive front, the industry has a high degree of fixed costs and margins suffer some of the most extreme operational gearing in the sector. Given the recent volume collapse, margins are currently at historic lows. Looking forward we expect margins to rebound sharply and note that historically margins have always returned to attractive (above sector average) levels during periods of economic stability. Our confidence is based on the industry’s strong pricing power, as evidenced recently with prices remaining positive (at between +1% and +2%) despite the aggressive 40%+ volume declines.

Furthermore, we are confident that the global cutting tool market is unlikely to feel any disruptive competitive pressure from China. Firstly, domestic product quality remains relatively poor in China given the paucity of R&D and secondly, the industry is heavily concentrated with HNC now holding c45% of the market following the acquisition of the second-largest player (Zigong).

Cutting tools

Fig 221: Cutting tool types

Tool Blanks

Drilling TurningMilling

ThreadingSolid

Carbide Tools

Cutting Inserts

Source: Sandvik and Sumitomo

Metal cutting tools represent a small cost in the total cost of cutting metal. On a global basis, the total annual cost of metal cutting process is estimated to be c€300bn, whereas the cost of the cutting tools is only c€11bn. While cutting tools only represent c4% of the total cost of the metal cutting process, the performance of cutting tools is the dominant factor in the productivity of the process. This unique leverage allows for a relatively attractive business model with inelastic demand and strong pricing dynamics.





Degree of industry consolidationFig 222: Cutting tools, 2007 global market share (PRE Iscar’s acquisition of Tungaloy)

Fig 223: Cutting tools, 2008 global market share (POST Iscar’s acquisition of Tungaloy)

Other22%

Seco Tools6%

Sumitomo Elec.6%

Tungaloy3%

Hunan Non-Ferrous

3%

Kyocera2%

OSG6%

Sandvik24%

Kennametal11%

Iscar-IMC10%

MMC7%

MMC7%

Kennametal11%

Iscar-IMC13%

Sandvik24%

OSG6%

Other22%Kyocera

2%Hunan Non-

Ferrous3%

Sumitomo Elec.6%

Seco Tools6%


The global metal cutting tool market is relatively concentrated. We calculate that at the end of 2008, the top five players accounted for 61% of the €11bn market. In September 2008, Iscar-IMC (the global number three) acquired Tungaloy (the global number eight) to move into second position, ahead of Kennametal. This latest round of consolidation concentrated the share of the top five manufacturers by a further 3%, from 58% to 61% (as shown in Figs 222 and 223).

Fig 224: 1993-2008 global cutting tool market shares

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Sandvik (Tooling)Kennametal (MSSG)Combined Market Share of Sandvik, Kennametal, Seco, Tungaloy and OSG

We have only been able to show a selected picture of market share development. We have not been able to secure a long history of financial data for all players as Iscar is private and MMC and Sumitomo are buried within divisions of large industrial conglomerates. As such we have been unable to cleanly track the share of the top five over the past 15 years and have, instead, shown the combined market share of five largest companies where we have the data Source: Redburn Partners based on company data

Fig 224 shows our ‘selected’ top five (Sandvik, Kennametal, Seco, Tungaloy and OSG) players have collectively lifted their market share from 30% to 50% over the past 15 years. As such, the global metal cutting tool industry has experienced a period of considerable consolidation.




Fig 225: Selected major transactions in the cutting tool industry, 1993-2008

Acquirer Target Date % Acquired Sales (€m) EBIT (€m) Employees Price (€m)

Sandvik CTT Tools Jan-93 100% from SKF 208 8 3,313 264

KMT Hertel AG Jun-93 100% 172 n/a n/a 84

Sandvik Precision Twist Drill Co Sep-97 100% 116 9 1,600 122

Kyocera Tycom Jan-01 100% 89 n/a n/a n/a

Sandvik Walter AG Feb-02 100% 287 17 2,000 n/a

KMT Widia Group May-02 100% from Milacron 254 n/a 3,400 180

Sandvik Valentine Oct-02 100% from Milacron 175 -21 1,300 195

Berkshire Hathaway Iscar (IMC Group) Jun-06 80% 1,060 n/a 6,518 3,982

Sandvik Diamond Innovation Inc Mar-07 100% from Private Equity 135 23 600 210

Iscar (IMC Group) Tungaloy Sep-08 100% 361 54 2,618 677

Source: Redburn Partners, company data. Some data are taken from conversation where there is no available direct source

Unlike the lock industry consolidation (discussed above), which was more bolt-on driven, this cutting tool industry consolidation has been predominantly driven by larger sized acquisitions (in the region of €100-400m of revenues). We calculate that over two thirds of the 20% increase in market share concentration between 1993 and 2008 was driven by the nine larger sized industry transactions (highlighted in Fig 225, above). It should be noted that, unlike the other nine deals, Warren Buffet’s 2006 acquisition of Iscar only constituted a change of ownership and not industry consolidation.


Fig 226: Cutting tools industry EBIT margins, 1993-2009

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Cutting Tool Sector Average Sandvik (Tooling)


Given the industry’s high degree of fixed costs, margins have suffered some of the most extreme operational gearing in the sector. Due to the recent intense collapse in volumes (see below), margins are currently at historic lows. Furthermore, despite the industry consolidation, cutting tool margins have not seen an obvious improvement over the past 15 years.

However, it should be noted that, on a through-cycle basis, cutting tool margins were already some of the highest in the sector. Looking forward we expect margins to rebound sharply, supported by industry concentration and associated strong pricing power (see below). Our confidence is underpinned by the fact that historically, margins have always returned to attractive (above sector average) levels during periods of economic stability.




Fig 227: Volumes in the cutting tool market have collapsed

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Source: Redburn Partners, Sandvik data is used as a proxy for the industry given the absence of data elsewhere

In periods of more normalised economic growth, volumes in the tooling industry tend to grow at 5-7%, supported by the productivity model discussed above. However, in 2009 volumes were decimated. This deterioration has been predominantly driven by a decline in end-market demand but has also been exacerbated by a significant degree of distributor destocking. It is this collapse in volumes combined with a further 10-20% underproduction at some manufacturer’s (themselves looking to destock) that has led to such substantial fixed cost under-absorption and the aggressive margin collapses highlighted above.

Fig 228: Pricing in the cutting tool market has remained resilient throughout the crisis

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

Q105

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Source: Redburn Partners, Sandvik data is used as a proxy for the industry given the absence of data elsewhere. Sandvik pricing data are taken fromconference call commentaries and are not disclosed in the quarterly reports

However, despite these truly brutal volume declines it is interesting to note that industry pricing has remained extremely robust. So while we can see no obvious improvement in industry margins from consolidation, given the industry already runs at favourable levels of profitability, we believe that the fact that prices have remained positive in the face of such massive 40%+ volume declines speaks volumes about the attractive level of pricing power in the metal cutting industry and the potential to return to previous margin levels.




Low-cost entrants? Tungsten’s uniquely high melting point, high density, good corrosion resistance, and thermal conductivity make it excellent for cutting metal. It should be no great surprise therefore that over half of the world’s tungsten is used to make cement carbide cutting tools.

In 2008, China produced 75% of the world’s 55,000 tonnes of tungsten and currently has over half of the world’s known reserves. Consequently, China is a natural participant in the manufacturing of hard alloys and should not really be considered as a new entrant in cemented carbide cutting tools.

Fig 229: Chinese €700m cutting tool market (2008)

Zigong (Hunan HNC)17%

Xiamen Jinlu7%

Others28%

Kennametal (Pudong)5%

Sandvik (Langfan)15%

Zhuzhou (Hunan HNC)28%


In fact China’s cemented carbide industry was formed over 50 years ago with Zhuzhou’s first hard alloy plant opening in the early 1950s. Since the beginning Zhuzhou has remained the market leader and we estimate they enjoyed c31% of the 2008 Chinese cutting tool market. As with the global market, the Chinese market has seen a meaningful level of consolidation in recent times. In 2005, Hunan Non-Ferrous Metals Corporation (HNC) took full control of Zhuzhou and then merged it with the Chinese number two player Zigong in 2006. Since the merger, HNC now controls c45% of the Chinese market with Sandvik stepping into second place.

The Chinese market is heavily interlinked with JVs and alliances that have to a degree limited the extent of local standalone competition. As a result, investment has not been a primary focus and R&D levels are relatively low among the domestic players. Consequently, local Chinese product remains lower quality than foreign product.

The great positive for the Chinese market has been (and is likely to continue to be for now) the degree of growth in the market. Organically, HNC has seen 25% average sales growth since 2004. Much of this was volume but a fair degree (c10%) was price. While industrial demand has been important, another primary driver has been the Automotive market (what a contrast to the West). Looking forward, as Chinese automotive penetration per capita continues we would expect growth to remain relatively underpinned. Redburn’s Automotive analyst (Mr Charles Winston) expects Chinese automotive demand to grow at 25% in 2009 and 13% in 2010.

The China risk

Given the concentrated nature of the Chinese cutting tool market and the relatively poor quality of the domestic competing product, we remain very relaxed that the global cutting tool market is unlikely to feel any materially disruptive competitive pressure from China.



Demand (1): c6% organic sales growth in 2011E

Following an average 2009 organic sales growth decline of -11.4% for the European Capital Goods sector (the worst since World War II), we forecast a growth recovery to c6% organic sales growth in 2011E. We expect early cycle consumer spending and industrial production to recover first and lead the sector out of recession and we expect orders in later cycle industries to follow shortly after. As such, we believe investors should look ahead and invest in the more attractive capex recovery plays, such as Alstom, ABB and Siemens.

Over the medium term, we expect the emerging markets to continue to grow faster than Europe and the US given the ongoing closure of the wealth gap and the compelling global demographics. In terms of end markets, we believe those companies selling capital equipment into the infrastructure end markets (mining, rail, T&D, power, metals and oil & gas) will benefit from higher levels of growth than those selling into macro-dependent and consumer end markets.

Our confidence of a future capex recovery is underpinned by our ‘Global Capex Model’, which suggests the sector’s end markets face no obvious impediments to spending capex. Consensus expectations are for the end-market complex (weighted for the sector’s geographic and end-market mix), in other words, the sector’s customer base, to see above-average (near peak) margins and below-average indebtedness across all end markets in 2010E.

Growth history Fig 230: European Capital Goods saw 7.8% sales growth (excluding currency) over the past 20 years, of which 4.2% was organic and 3.6% from acquisitions

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1989 1992 1995 1998 2001 2004 2007 2010E

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European Capital Goods Sector Revenues (€ mn)Organic Sales Growth (%)Sales Growth from Acquisitions (%)


Between 1986 and 2009 the European Capital Goods sector has shown an average organic sales growth of 4.2% and sales growth from acquisitions of 3.6%.





Fig 231: Group annual organic sales growth, by company, 1998-2012E

Company 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

Ten-year2000-09average

ABB 2.5% 3.1% 3.0% 6.4% -4.6% -3.2% 9.8% 15.3% 10.2% 20.0% 17.5% -5.0% -2.9% 8.1% 5.2% 6.9%

Alstom 2.3% 5.8% 4.3% 0.0% 1.0% -10.0% -4.0% 8.0% 14.0% 19.0% 10.0% 5.3% -2.8% 5.8% 4.9% 4.8%

Assa Abloy 5.9% 5.0% 5.0% 3.0% 2.0% 0.0% 4.8% 5.5% 9.3% 7.0% 0.5% -12.4% 0.6% 5.3% 4.9% 2.5%

Atlas Copco 3.8% -1.8% 11.9% -0.3% -3.2% 3.1% 11.4% 12.6% 17.7% 18.5% 11.7% -22.5% 5.2% 10.1% 7.5% 6.1%

Electrolux 4.0% 4.0% 3.7% -2.4% 3.9% 3.3% 2.8% 5.9% 3.3% 4.0% -0.6% -4.9% 2.8% 3.3% 3.3% 1.9%

Invensys 2.5% 5.0% 8.8% 3.9% -0.3% -9.2% 2.1% 5.2% 4.1% 1.8%

Sandvik 1.0% -8.0% 12.0% 3.0% -7.0% 5.0% 15.0% 14.0% 13.8% 17.9% 5.7% -29.6% 6.5% 9.7% 5.5% 5.0%

Schneider Electric 5.1% 1.0% 8.3% 2.9% -5.2% 1.4% 8.4% 8.0% 10.7% 13.9% 6.7% -17.3% 4.1% 4.5% 4.8% 3.8%

Siemens 10.0% 6.0% 15.0% 6.0% 0.0% -4.0% 3.0% 3.0% 8.0% 10.0% 9.0% 0.0% -4.8% 5.6% 4.9% 5.0%

SKF 1.5% -4.5% 6.7% -0.3% 1.3% 4.9% 10.7% 8.5% 8.1% 9.7% 5.9% -19.3% 4.9% 6.2% 4.4% 3.6%

Capital Goods average 4.0% 1.2% 7.8% 2.0% -1.3% 0.1% 6.4% 8.6% 10.4% 12.4% 6.6%-11.5% 1.6% 6.4% 5.0% 4.1%

Source: Redburn Partners, data for Alstom and Invensys is March Y/E but lagged one year, data for Siemens is September Y/E

Looking at the average of our coverage universe, as shown in Fig 231, we forecast that after -11.5% in 2009, the sector will see an organic sales growth of +1.6% and +6.4% in 2010E and 2011E.

Fig 232: Group annual organic sales growth, by company, 1998-2012E

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1998 2000 2002 2004 2006 2008 2010E 2012E

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ABB Alstom Assa Abloy Atlas CopcoElectrolux Invensys Legrand SandvikSchneider Electric Siemens SKF Eu. Cap Goods Avg


Representing these growth rates graphically, Fig 232 highlights the shape of the sector’s organic sales growth cycle and shows the degree to which companies face a similar growth trajectory. While there is a common trajectory, there are also the more defensive companies (e.g. Assa Abloy and Legrand with high replacement business), the more cyclical companies (e.g. Sandvik and Atlas Copco), the early cycle companies (e.g. Electrolux) and the late-cycle companies (i.e. Alstom)




Fig 233: Group average organic sales growth (15, 13, 11 and 9-year average), by company

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ABB AtlasCopco

Siemens Sandvik Alstom SchneiderElectric

SKF Assa Abloy Electrolux Legrand Invensys Eu. CapGoods Avg

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1998-2012E 2000-2012E 2002-2012E 2004-2012E


If we look at average organic sales growth through the cycle (using a number of different time periods), we can see there is a range of longer-term growth rates with ABB and Atlas Copco at the top of the spectrum, regardless of time period, and Electrolux,Legrand and Invensys at the bottom end of the spectrum, regardless of time period. As discussed later, we see this as largely being a function of end-market mix.

Fig 234: 2010E organic sales growth vs ten-year average, minimum and maximum

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ABB AtlasCopco

Sandvik Alstom SKF Schneider Siemens Electrolux Assa Abloy Invensys Legrand

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We have compared 2010E organic sales growth against the ten-year historical average and range in Fig 234.




Quarterly organic sales growth appears to have now bottomed

Fig 235: Sector organic sales and margins troughed in 1H09

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Looking at the higher frequency quarterly data, the organic sales decline lifted from -13.6% in 2Q09 to -9.2% in 4Q09 and we expect a return to positive organic sales growth (albeit a minimal +0.6%) in 2Q10E as the comparables ease. In absolute euro terms (or SKr, $ or £), excluding Siemens and Alstom, the other eight companies in our coverage saw a sequential increase in 4Q09 revenues (vs 3Q09), with a sector average sequential increase of +7%. While we are on the topic of quarterly financial performance, quarterly clean EBIT margins have also lifted from the trough of 9.8% in 2Q09 to 11.1% in 4Q09.



Demand (2): macro outlook

Organic sales growth in the European Capital Goods sector is driven by capex and, to a lesser degree, industrial production. With capacity utilisation at record lows in Europe and the US, managements in the sector are nervous that relatively empty factories will lead to a meaningful global capex holiday. History suggests such nervousness is overplayed and that while capex tends to lag industrial production into recovery, the lag is relatively short-lived.

We have already seen consumer spending and industrial production start to recover but not capex. We expect this to come next. As such we believe investors should look ahead and invest in the more attractive capex recovery plays. This supports our Buy theses for Alstom, ABB and Siemens.

The capex cycle The European Capital Goods sector comprises a wide variety of industries producing machinery, tools, consumables and services for a vast array of end markets. Given heterogeneity, some generalisation may be of value, so please forgive a moment of macro observation. As shown in Fig 236, demand for the sector (as measured by sector average organic sales growth) is not particularly driven by GDP growth (although the direction is normally aligned), rather it is more highly correlated with fixed investment growth, and to a lesser degree industrial production growth, both of which tend to be more cyclical than GDP growth.

Fig 236: Sector organic sales growth vs global macro Fig 237: Sector organic sales growth vs Europe macro

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Our global macro data is a weighted blend of European (40%), US (30%) and Chinese (30%) GDP, Fixed Investment and Industrial Production data. We have used China as a proxy for emerging markets Source: Redburn Partners

Sector OSG (Organic Sales Growth) is based on the simple average of our coverage Source: Redburn Partners

The capex cycle tends to have a higher beta than the GDP cycle, as fixed investment (or capex) is a relatively discretionary item for managements (and governments). As a variable cash cost, capex is often one of the first and easiest items to cut in tougher times and vice versa in the better years.





Capacity utilisation currently at record lows in Europe and the US

Fig 238: US capacity utilisation at historic lows

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Source: Federal Reserve

From conversations with those on the ground making capital equipment across a number of industries, one overriding and consistent concern that is repeated time and again: ‘Why will capex return when there are so many relatively empty factories across the complex?’ Indeed, capacity utilisation, the great barometer of fullness or emptiness, has only recently been at all-time record lows in both the US and Europe (US records began in 1961). With factories emptier now than at any other time over the past 50 years (see Figs 238, 239 and 240), it is hard to envisage CEOs queuing up, en masse, to ask their respective boards for permission to materially lift capex.

Fig 239: European capacity utilisation 1996-2009

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Germany Capacity Utilisation France Capacity Utilisation Italy Capacity UtilisationUK Capacity Utilisation Sweden Capacity Utilisation Spain Capacity UtilisationPoland Capacity Utilisation Czech Capacity Utilisation European Capacity Utilisation

Source: Eurostat




History suggests capex is concurrent with industrial production While intuitively this rationale (that capex will lag a demand pickup until factories are full again) may seem eminently logical, historically the data suggest otherwise.

Since 1962 and prior to the current downturn, the US economy witnessed five clearly definable periods of declining industrial production. Interestingly, even in the three worst periods of capacity utilisation, 1975 (72%), 1982 (69%) and 2002 (72%) (i.e. a time of relatively empty factories), fixed investment growth recovered in the same or following quarter to the recovery in industrial production. Furthermore, in four of the five recoveries (the exception being 2002), fixed investment growth outstripped industrial production growth during the first four quarters of recovery. So much for empty factories drying up the capex well! In fact, looking at the capacity utilisation data above shows that in the US and in Europe utilisation has started to recover concurrently with industrial production and capex.

Fig 240: US capacity utilisation, fixed investment and industrial production 1961-2009

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Source: Bureau of Economic Analysis and Federal Reserve

Looking at the current situation, US capacity utilisation bottomed at 65.4% in 2Q09 (and recovered to 68.0% in 4Q09). In 4Q09, industrial production growth bounced to -4.6% (from -12.9% in 2Q09), whereas fixed investment growth recovered less to -16.6% (vs -21.5% in 2Q09). If history repeats itself and US industrial production continues to recover (a big ‘if’), then US fixed investment should follow suit.

Fig 241: European capacity utilisation, fixed investment and industrial production 1991-2009

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European Industrial Production Growth % European Nominal Fixed Investment Growth %European Capacity Utilisation

Source: Eurostat




While European historical data are less available, there is some concurrency between the timing and scale of recovery in 2002 between fixed investment and industrial production growth, as shown in Fig 241. Clearly, the current downturn has been of a much greater scale, and there is no available comfort as to what effect the extra level of emptiness across European factories will bring, which clearly remains a risk to recovery. Furthermore, there have been exceptions to the axiom that capex always recovers with industrial production. Following the 1991 and 1992 recession (which was worse in Europe than in the US given German re-unification) the fixed investment recovery in Sweden, Germany and the UK came over a year after the trough in GDP and industrial production.

Looking forward, while the historically low levels of capacity utilisation in Europe and the US pose a risk to the potential pace of capex recovery, we are more optimistic. Our optimism is far from universal and there are capex end markets where we are more or less bullish (see our assumptions). However, given the outperformance of the consumer exposed and industrial exposed names in the sector, we believe investors should look ahead and invest selectively in the more attractively positioned and attractively priced capex recovery plays.

It is important to be selective regarding geographies and end markets. While some companies and industries (e.g. automotive) are likely to take meaningful capex holidays, we believe that others, in the right industries (e.g. mining, T&D, oil and gas, power and rail), are likely to surprise and return to capex expansion faster than expected.

For instance, take the mining sector. While current organic sales growth from those exposed to mining like Sandvik and Atlas Copco’s respective mining and construction equipment businesses is running at -26% in 3Q09, the outlook is improving and we have already started to see industry capex upgrades. On 30 October 2009 Rio Tinto raised its guidance for 2010 capex from $5bn to up to $6bn. Furthermore, on 20 October 2009 Vale’s board approved a 29% increase in capex for 2010 ($12.9bn vs the $10bn target for 2009). More recently, on 10 February, BHP Billiton announced its intention to increase capex to $15bn in 2011E (a 20% uplift in guidance), equating to 17% capex growth in 2010E and 21% in 2011E.

The following chapters address more specific geographic and end-market issues.



Demand (3): geographical outlook

Over the medium term, we expect the emerging markets to continue to grow faster than Europe and the US. The ongoing closure of the wealth gap and the compelling global demographic equation is the basic driver of premium growth in emerging markets compared to the developed world and one of the most bankable sources of growth. Furthermore, in the near term we expect the emerging markets to lead the US and Europe out of recession (as already evidenced in the organic sales growth trends of the Capital Goods sector in 2Q09, 3Q09 and 4Q09). With respect to the West we expect Europe to lag the US into recovery by 6-12 months.

In the longer run, we are nervous about the sustainability of China’s 30-year plus investment bubble, and see a substantial risk that it could burst at any stage after the Chinese stimulus package starts to fade in 2011.

Europe typically lags the US

Fig 242: European capex cycle tends to lag the US capex cycle

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History suggests that Europe lags the US and, as shown in Fig 242, this cycle has been no different. US nominal fixed investment growth peaked in 1Q 2005 at 13.2% and Europe peaked two years later in 1Q07 at 12.1%. Looking forward, our estimates are predicated on Europe lagging the US by 6-12 months into recovery, however, we note that in 2H09 the recovery so far has been relatively concurrent across the Atlantic.

Emerging markets: a reliable source of growth

Fig 243: 10- and 20-year average fixed investment growth by region

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Over almost any time period you care to choose, emerging markets have outgrown the West, with respect to capital investment. For instance, average emerging market fixed investment growth has run at double European and US fixed investment growth over the past 20 years and nearly triple over the past ten years (see Fig 243).

Fig 244: Emerging markets vs developed world; 2008 population and GDP per capita

18%

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2008 Global Population(6.746 bn)

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Source: OECD (Organisation for Economic Co-Operation and Development)

While there are always near-term risks (usually surrounding default risk), the emerging markets are likely to continue to have a very favourable demographic advantage over the West and a more compelling growth story. According to the World Bank, the world’s population reached 6.746 billion in 2008; amazingly only 1.2 billion of those (or 18%) live in developed nations. A staggering 5.6 billion people (or 82%) still remain classified as living in emerging markets.

Those living in emerging markets generated a GDP/Capita of $6,192, some 23% of that generated by those living in the developed word (at $26,777).

Fig 245: Emerging market GDP/capita closes the gap vs developed world (2000-23E)

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Over the past ten years this wealth gap has closed meaningfully and is expected to continue to do so by the OECD over the next 15 years. As shown in Fig 245, the ratio lifted from 17% in 2000 to 23% in 2008 and is expected to rise to 32% by 2023E. It is this ongoing closure of the wealth gap that is the basic driver of premium growth in emerging markets vs the developed world.




Given the paucity of growth in general and the permanent uncertainty in trying to identify the next ‘growth story’, we believe the demographics of the emerging markets, their improvement in living standards and their ongoing closure of the wealth gap is one of the most bankable sources of growth.

Emerging markets showing the first green shoots of recovery

Fig 246: European Capital Goods sector average quarterly organic sales growth, by region

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European Organic Sales Growth North American Organic Sales GrowthAsia Pacific Organic Sales Growth RoW Organic Sales Growth

Geographic averages taken only from those with geographic disclosure (six companies: ABB, Assa Abloy, Electrolux, Legrand, Sandvik and Schneider Electric Source: Redburn Partners

An analysis of the sector’s average quarterly organic sales growth by region (see Fig 246) shows that not only have the emerging markets (Asia-Pac and RoW) grown faster than the US and Europe, but they also appear to be leading the West into recovery. Consequently, inter alia, we see emerging market exposure as a positive going forward.

Sector geographic exposure

Fig 247: Sector revenues ranked by emerging market exposure (2009)

56% 50% 49%39% 39% 36% 33% 33% 25% 23% 19%

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ABB, Atlas Copco, Sandvik, Siemens and Schneider have the highest exposures outside of Western Europe and North America, making them the most likely to see higher growth, ceteris paribus.




To try to capture how the sector’s regional revenue mix has changed, we have shown the increase in proportion of group sales exposed to emerging markets over the past ten years in Fig 248.

Fig 248: Ten-year increase in emerging market sales exposure (2009 vs 1999)

30% 27%23% 20%

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Interestingly, four out of the top five emerging market exposed companies mentioned above (see Fig 247) appear to have secured that status through change. Atlas Copco,ABB, Sandvik and Schneider have all seen a materially more sizeable increase in emerging market exposure than the rest of the sector.

Atlas Copco has seen the biggest increase with emerging market exposure lifting 30% from 20.8% to 50.4%. This increase was predominantly a function of Atlas Copco’sdisposal of its rental business (a domestic US operation). ABB has seen its increase from higher organic sales growth in emerging market (in both its power and automation businesses). Sandvik has also seen a big change with its Tooling division losing US auto revenue and growing in Emerging Markets and its mining and construction division seeing a major shift in revenues from the West to Asia and Africa (partly acquisition-led). Schneider has been the most acquisitive stock in the sector, acquiring roughly half of its current revenues over the last decade, making some argue that its mix shift has been acquired. However, only 23% of the acquired sales were in the emerging markets (taking the 65-odd acquisitions in aggregate), suggesting Schneider’s impressive regional mix shift has been organic. Indeed it has, with Schneider seeing an average organic sales growth of 1% over the last decade in Europe and North America and +13% in Asia-Pac and RoW.

China: will the investment bubble burst? Fixed Investment (also referred to at times as Gross Fixed Capital Formation) typically rises as a percentage of GDP as economies industrialise from agricultural economies into emerging economies and then declines as those economies mature and consumer spending becomes the predominant driver of economic development.




Fig 249: Progression of GFCF/GDP from agricultural through emerging to mature economy

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Phase 3 - fully mature economy

Phase 1 - from agricultural to industrial economy the emerging phase

Phase 2 - maturingindustrial economy

Source: Redburn Partners, World Bank database

Based on our analysis of fixed investment data from the World Bank (our dataset comprises 226 countries between 1960 and 2008), we have identified three phases through the development of economies. The median development curve (shown in Fig 249) is derived using data from 46 of the 226 countries (those countries that we have identified as having passed their peak). The curve is based on the following observations: economies tend to exit their agricultural economy with a GFCF/GDP of c10%, the first phase of development last roughly 25 years, the average peak GFCF/GDP ratio is 34.5%, and phase 2 has an average duration of c20 years.

For very mature economies the dataset does not have a sufficient history to show phase 1 or phase 2 as these economies are in a final third phase of total maturity and have been since 1960, as such these economies are also excluded from the analysis. Both the US and UK fit this description well, with GFCF/GDP ratios having remained largely unchanged for 50 years at or around 19%.

Fig 250: Phase 1 – GFCF/GDP rising as developing Fig 251: Phase 2 – GFCF/GDP falling as maturing

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Source: Redburn Partners, World Bank database Source: Redburn Partners, World Bank database

We have shown both the developing (phase 1) and maturing (phase 2) phases of the GFCF/GDP development curve in Figs 250 and 251. Fig 251 shows two economies (Japan and Germany) throughout the second phase. Japan saw GFCF/GDP peak in 1970 at 40% and has seen this ratio slow to 24% in 2008. Fig 250, on the other hand, shows China and India in the first phase with both economies still currently at or close to historical highs of 43% and 39%, respectively.




Given the importance of China for the European Capital Goods sector (see Fig 252), we see two important questions when assessing the longer-term outlook: ‘Has the GFCF/ GDP ratio in China peaked?’ and ‘What is the likely the pace of maturity?’ We have tried to apply our development curve analysis to consider a possible route map for China going forward.

Fig 252: Sector sales to China ranked by exposure (2009)

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ABB and Atlas Copco lead the sector with respect to Chinese revenue exposure with 12% and 9%, respectively, in 2009. While China represents 7% of direct sales for the European Capital Goods sector we believe its overall impact is greater when considering the indirect impact. For instance, what proportion of the sector’s revenues from Germany is ultimately exported to China? On discussing this issue with a number of companies there has been a range of answers, with one CEO commenting that virtually all of the sector growth between 2003 and 2008 was ultimately driven by China. Another replied that “at the peak of demand in 2007 we believe that as much as two thirds of our German demand was being driven by exports to emerging markets.”

China’s investment boom is stretched Our analysis of the World Bank dataset shows that the 46 countries with an identifiable peak saw an average peak GFCF/GDP ratio of 34.5% over the past 50 years.

Taking this into account China’s peak GFCF/GDP ratio of 45% in 2006 (see Fig 250) is clearly well above average. This is well above the highest GFCF/GDP ratio any Asian country reached in their mid-1990s booms (Malaysia hit 44% in 1995 and is now 22%; Thailand hit 42% in 1995 and is now 28%). Japan saw GFCF/GDP peak in 1970 at 40% and has seen this ratio slow to 24% in 2008. South Korea peaked at 40% in 1991 and is now 31%.

Given the behaviour of other developing nations, some understandably worry that China’s current fixed investment growth is unsustainable. Interestingly, on the subject of duration, we have only identified four economies (with over $100bn of GDP) that have exceeded ten years or more of an above 34% GFCF/GDP ratio. Singapore sustained 28 years of GFCF/GDP in excess of 34%, Greece 17 years (1960-76), Japan 14 years (1961-74) and Thailand ten years (1988-97).




Fig 253: Efficiency of Chinese investment is deteriorating (higher ICOR % is less efficient)

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According to IMF data, China’s marginal returns on investment are deteriorating (a higher ICOR is a worse performance), which can be seen by the rising Incremental Capital Output Ratios (ICORs) for China in Fig 253 above. China, in its third decade of investment boom (defined by us as GFCF/GDP in excess of 34%), is no longer achieving the levels of growth per percentage of GFCF/GDP that it saw in the 1980s and 1990s. Indeed, China’s ICOR in 2009 also compared poorly to other leading economies during their respective investment booms.

China currently being protected by massive stimulus injection

With China (a $4.3trn economy) now having sustained 32 years of GFCF/GDP above 34%, it seems fair to question the longevity and sustainability of China’s investment boom. Yet despite this, amazingly, China’s ratio of GFCF to GDP is expected by some economists to exceed 50% in 2009, driven by the massive RMB4trn stimulus package announced by premier Wen Jiabao.

Fig 254: China’s economic stimulus plan

RMBbn US$bn

Public infrastructure (railway, road, irrigation and airport construction) 1,500 220

Sichuan earthquake reconstruction (low-cost housing, welfare projects) 1,000 147

General housing 400 59

Rural development (public amenities, drinking water) 370 54

Technology advancement (high-end industrial production) 370 54

Sustainable development (energy saving, gas emissions) 210 31

Education and healthcare 150 22Total 4,000 586

Source: PRC National Development and Reform Commission (NDRC), 6 March 2009

We have segmented the infrastructure stimulus by spending category in Fig 254, but perhaps of more interest is Fig 255 below, which shows just how effective the Chinese pump priming has been.




Fig 255: Chinese M2 money supply growth has ballooned

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The speed of Chinese government reaction to the difficult 4Q08 post ‘Lehman’ was phenomenal. To double the national level of M2 money supply within six months highlights the significant degree of policy control that China has as a command economy.

What happens to Chinese fixed investment post stimulus injection?

While our working hypothesis is predicated on a continued strong Chinese investment demand picture (supported for the next year by the back end of the stimulus plan), we are acutely conscious that the Chinese goose (or should that be duck) may not lay golden eggs forever. China remains a downside risk to monitor in the years to come.

The China bull case hinges on the GDP per capita argument

Fig 256: GFCF/GDP vs GDP per capita for selected economies

United Kingdom

GermanyFrance

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South Korea

JapanEuro area

ChinaIndiaRussiaBrazil

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Source: Redburn Partners, World Bank database

The more bullish argument for China’s fixed investment outlook is shown in Fig 256, above. According to the World Bank, China’s GDP per capita was $2,940 in 2008. While this was nearly three times that of India, it remains only 7% of US GDP per capital ($45k) and 8% of both Europe ($36k) and Japan ($39k). On the basis of Japan and South Korea, which have both shown the path for Asia’s developing nations as to how to move from phase 1 into phases 2 and 3 of our development curve, China has a long way to go before closing the gap on the developed world.

The bull hypothesis makes the point that investment growth will continue as long as China continues to close the gap on the developed world. However, while we believe Chinese GDP growth has a strong outlook for some time to come, we are less optimistic on long-term Chinese investment growth.




As shown in Fig 257, we calculate that if China’s GFCF/GDP ratio were to fall by 1.5% a year from 45% in 2009 to 19.5% in 2026 while Chinese Nominal GDP grew at 10% per year until 2026, then the average growth in Fixed Investment during 2010-26 would be just under 5%, compared to the past ten years at over 18% and the past 50-year average of 15%.

Fig 257: China history and outlook based on 10% GDP growth and fade to 20% GFCF/GDP

1960-69 1970-79 1980-89 1990-99 2000-09 2010-26

GDP growth (%) 3.5% 9.0% 7.2% 12.5% 16.1% 10.0%

GFCF growth (%) 5.3% 16.6% 7.8% 12.5% 18.4% 4.7%

GFCF/GDP 19.2% 30.4% 35.9% 38.9% 41.3% 31.5%

Source: Redburn Partners, World Bank

This suggests that when the impact of the Chinese stimulus package starts to fade in 2011 there is a meaningful risk that at some stage the Chinese investment growth story will slow. On a 20-year view (does anyone out there care about the 20-year view) there would seem some merit in playing Chinese consumption growth as the smarter long-term play than fixed investment (GFCF) growth.



Demand (4): end-market outlook

Almost regardless of the longer-term level of general economic growth, we believe those companies in the sector selling capital equipment into the infrastructure end markets (mining, rail, T&D, power, metals, and oil and gas) will benefit from higher levels of growth than those selling into macro-dependent and consumer end markets. The infrastructure end markets have greater emerging market focus and compelling supply-side factors driving their need for investment. They have all seen decades of underinvestment, all enjoy attractive structural demand and supply imbalances, and will largely be forced by environmental or other factors to invest in changing technologies.

Over the longer term, we forecast infrastructure end markets to grow the fastest at between 6% and 7%. We expect the ‘macro-dependent’ industrial markets to growth at 3-4% and the consumer end markets at 2-3%.

Fig 258: Sector revenue exposure by end market (2009)

Other (incl. Medical)9%

Metals and Mining6%

Oil & Process10%

Power Generation16%T&D

8%

Rail9%

Transport (Excl. Rail)3%

Industrial Production1%

Industrial Capex11%

Non-Res Construction13%

Housing3%

Auto3% Other Consumer

8%

Macro-dependent Industrial

28%

Consumer15%

Infrastructure48%


The European Capital Goods sector sells to a wide variety of end customers across a number of end markets. Given the complexity of product portfolios within the sector (from locks at Assa Abloy, to bearings at SKF, to trains and power plant equipment at Alstom) we believe geographic and end-market analysis offer a simpler and unified framework for distinguishing and ranking demand potential between companies. We have covered geographic issues above and hope to address end-market issues below.

As shown in Fig 258, roughly half of the sector’s €173bn 2009 revenues are demanded by the infrastructure end markets of power: T&D, oil, rail, metals and mining. 28% are destined for what we have entitled the ‘macro-dependent’ industrial end markets of non-residential construction, other transport (excluding rail and auto) and general industrial markets (such as machine tools, pulp & paper, capital goods, etc) and 14% head for consumer end markets such as autos and appliances.





Fig 259: 2009 detailed end-market matrix of revenue exposure by company

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Mining 6% 26% 18% 5% 2% 3%Steel 4% 5% 2% 3%Oil & gas 10% 15% 5% 10% 6%Other process 9% 13% 6% 11% 4% 2% 4%Power generation (elec utilities) 6% 59% 14% 10% 14%T&D (elec utilities) 30% 6% 9% 8% 8%Rail 4% 41% 24% 10% 6% 10%Infrastructure 69% 100% 0% 39% 0% 51% 0% 29% 18% 51% 22% 48%

Aerospace 9% 2% 11% 2%Marine 7% 1%Agritech 6% 0%Trucks 1% 4% 1%Industrial production 14% 28% 1%General capex 9% 28% 17% 23% 14% 6% 11%Non-residential 5% 80% 22% 7% 2% 58% 16% 27% 12% 13%Macro-dependent industrial 20% 0% 80% 50% 7% 19% 58% 39% 50% 28% 54% 28%

Residential 1% 20% 7% 42% 10% 2% 4%Auto capex 2% 4% 3% 2% 1%Auto production 14% 20% 1%Internet & networks 19% 2%Other consumer 93% 18% 9% 1% 3% 6%Consumer related 3% 0% 20% 4% 93% 25% 42% 23% 32% 5% 23% 14%

Other (incl. medical) 8% 7% 5% 9% 16% 9%Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%


Our end-market matrix of revenue exposure by company (Fig 259 above) highlights the myriad of differing demand drivers faced by the European Capital Goods sector and the detail for each company.

End-market growth variations Trying to second guess future GDP demand is a relatively fruitless exercise. We believe an alternative to picking demand is to understand the structural differences between the various end markets of the sector and rank their relative attractiveness. Each end market has different dynamics, structural drivers and supply-side issues. We believe that understanding these issues can help rank which end markets are likely to grow the fastest, regardless of the economic climate. As such, while we have forecast the absolute level of growth in each end market (by region) (see Fig 266) and calculated the weighted average growth rate by company (see Figs 263 and 264) we first address the relative growth outlooks between the various end markets.

Do all end markets exhibit the same level of growth over time? The answer is no, and we have analysed the history to show the variations in growth by end market.

There are 56 divisions across our ten companies. However, we have only analysed those divisions that are unambiguously identifiable as selling predominantly to a single end market (we consider this to be 36 out of the 56 divisions). We have arranged the 36 divisions into their respective end-market groupings and derived the following average growth rates (see Fig 260).




Fig 260: Ten-year historic organic sales growth by end market, 2000-09E

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We have bucketed 36 divisions into the nine end-market buckets shown above and then taken the average ten-year organic sales growth. For instance power generation includes Siemens’ Fossil power generation division and Alstom’s power division Source: Redburn Partners

Notwithstanding the fact that the last decade was undoubtedly infrastructure-driven, we still believe the evidence contained in the chart above is compelling. It shows clearly that the infrastructure oriented end markets have been the key driver of sector growth with between 5% and 11% organic sales growth over the last decade. In contrast, the macro-dependent end markets have grown at a steadier c4% and the consumer end markets of appliances and cars have in general been a drag on sector growth, averaging only 0.5%.

Inter alia, this premium growth of the infrastructure industries (mining, rail, T&D, power, metals and oil & gas) can be explained by a number of factors, notably their greater emerging market exposure and compelling supply-side factors. With respect to the supply-side arguments, each of these industries faces a structurally compelling need for investment. They have all seen decades of underinvestment in the 1970s, 1980s and 1990s and now face material replacement needs, all enjoy attractive structural demand and supply imbalances, and all will be largely forced by environmental or other factors to invest in changing technologies. Consequently, almost regardless of the longer-term level of general economic growth, we believe that those companies in the sector selling capital equipment into these infrastructure end markets (see Fig 261 below) will benefit from higher levels of growth than those selling into macro-dependent and consumer end markets. We have examined each infrastructure end market and their respective supply-side issues in greater detail later on in this report.

Sector end-market exposure

Fig 261: 2009 end-market exposure clustered and ranked by infrastructure exposure

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Alstom (rail and power), ABB (T&D, oil & gas, power, mining, steel and rail), Invensys(rail and oil & gas) and Siemens (power, oil & gas, rail, T&D and steel) all stand out as having a relatively attractive mix compared to the rest of the sector with over half of group sales exposed to infrastructure. Invensys, however, faces the drag of its consumer facing controls business.

Redburn end-market and geographical assumption model We have constructed an end-market and geographical assumption model, which carries both historic and forecast growth rates for each end market by each region (Europe, North America and Emerging Markets). We have used these assumptions (see Fig 266) as the basis of our organic sales growth forecasts for each company. The reason for applying this approach, and the benefit of doing so, is to apply a systematic consistency across each organic sales growth forecast for the 50 divisions, and the ten companies, in our universe.

Does the model work?

Fig 262: Redburn end-market and geographical assumption model works

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Implied Sector Organic Sales from Redburn End Market Assumption Model Sector Organic Sales Growth

Based on each companies’ end-market revenue mix (shown in Fig 202), their geographic revenue mix (shown in Fig 190), and our Redburn end-market and geographical assumption model (which carries data from 2005 to 2011E and is shown in Fig 266), we have constructed annual implied organic sales growths for each company (assuming that they grow exactly in line with the end-market assumptions). We have then taken the simple average of this to create the above implied sector average. In reality, our actual company estimates for organic sales growth also allow for market share gains and losses, aftermarket and service mix issues (for instance we forecast Assa Abloy to exceed underlying construction trends on the basis of replacement demand), distributor re-stocking and other stock-specific considerations Source: Redburn Partners

We are pleased to note, see Fig 262, just how much historic correlation there is between the actual organic sales growth of the sector and the implied growth of our end-market and geographical capex growth model. This gives us confidence of its use as a tool to base our forecast on. Clearly, the output will only be as good as our end-market inputs, and herein lies the risk, but at least by making them explicit we hope to help investors understand the drivers better.




Fig 263: 2010E forecasts vs implied from model Fig 264: 2011E forecasts vs implied from model

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In Figs 263 and 264 we have shown our forecasts for organic sales growth, by company, in both 2010E and 2011E plotted against the implied output from our end-market and geographical capex growth model.

Infrastructure to lag into recovery but grow faster over the longer term Over the longer term we forecast infrastructure end markets to grow the fastest at between 6% and 7%. We expect the ‘macro-dependent’ industrial markets to growth at 3-4% and the consumer end markets at 2-3%. By 2011 we expect (with the exception of power generation, where we expect demand growth to lag by more, and rail, where we see some public spending challenges) infrastructure growth to have re-overtaken both consumer and macro-dependent growth.

Fig 265: Summary of global end-market growth assumptions

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Fig 266: Redburn end-market and geographical assumption model – detailed inputs

W. Europe 2005 2006 2007 2008 2009 2010E 2011E Long RunMining 10% 15% 25% 15% -30% 5% 15% 5%Steel 6% 15% 25% 15% -35% 0% 10% 3%Oil & Gas 5% 5% 25% 20% -10% -10% 8% 6%Other Process 10% 10% 30% 15% -7% -5% 7% 6%Power Generation (Elec Utilities) 10% 15% 30% 25% 5% -10% 2% 6%T&D (Elec Utilities) 5% 10% 25% 10% -5% -10% 5% 5%Rail 0% 5% 10% 3% 7% 3% 4% 4%Infrastructure 6% 11% 24% 16% -4% -6% 5% 5%Aerospace 8% 30% 2% 5% -6% 0% 4% 3%Marine 3% -10% 0% -22% -13% -20% 5% 2%Agritech 15% 15% 20% 5% -35% 3% 5% 3%Trucks 24% 11% 0% 24% -24% 5% 5% 3%General Industrial Production 1% 4% 3% 2% -15% 5% 4% 3%General Industrial Capex 1% 2% 5% 2% -25% 4% 3% 3%Non-Residential Construction -1% 1% 4% 2% -8% 1% 3% 3%Macro-Dependent Industrial 1% 3% 4% 2% -18% 2% 3% 3%Residential Construction -5% -12% -7% -25% -25% -2% 2% 2%Automotive Capex 10% 1% 6% 5% -16% 0% 3% 0%Automotive Production 1% 1% 1% -8% 5% -10% 1% 1%Technology (Electronics, Telecom, Internet, etc) 2% 20% 7% 7% -14% 5% 3% 2%Other Consumer 3% 4% 4% 2% -20% 3% 1% 1%Consumer Related 2% 1% 1% -4% -18% 1% 2% 1%Total 4% 6% 14% 8% -11% -2% 4% 4%

North America 2005 2006 2007 2008 2009 2010E 2011E Long RunMining 30% 15% 0% 10% -30% 5% 15% 5%Steel 40% 25% 18% 5% -40% 3% 10% 3%Oil & Gas 35% 20% 20% 7% -30% -5% 10% 6%Other Process 35% 20% 20% 6% -30% -10% 8% 6%Power Generation (Elec Utilities) 15% 15% 10% 5% -5% -15% 2% 6%T&D (Elec Utilities) 5% 10% 10% 5% -15% -15% 7% 5%Rail 15% 5% 5% 5% -5% -5% 3% 4%Infrastructure 20% 14% 11% 6% -16% -9% 6% 5%Aerospace 15% 10% 0% -1% -4% 3% 4% 3%Marine 10% -5% -10% -15% -35% -5% 5% 2%Agritech 20% 25% 20% 10% -30% 5% 5% 3%Trucks 25% 10% 25% 5% -30% 10% 6% 3%General Industrial Production 3% 4% 2% 1% -20% 6% 5% 3%General Industrial Capex 5% 2% -2% -10% -30% 5% 5% 3%Non-Residential Construction 5% 7% 19% 5% -10% -5% 5% 3%Macro-Dependent Industrial 6% 4% 6% -4% -22% 1% 5% 3%Residential Construction 30% -15% -45% -55% -40% 9% 3% 2%Automotive Capex 6% -2% -5% -10% -20% -5% 1% 0%Automotive Production 1% -2% -3% -19% -10% 0% 2% 1%Technology (Electronics, Telecom, Internet, etc) 30% 21% 0% -2% -15% 2% 4% 2%Other Consumer 5% 5% 4% 1% -30% 2% 1% 1%Consumer Related 14% 1% -10% -15% -28% 3% 2% 1%Total 14% 8% 6% -1% -20% -4% 5% 4%

Emerging Markets 2005 2006 2007 2008 2009 2010E 2011E Long RunMining 15% 25% 20% 15% -25% 8% 25% 9%Steel 20% 25% 25% 30% -10% 7% 15% 6%Oil & Gas 10% 20% 25% 25% 30% 0% 10% 9%Other Process 10% 15% 10% 10% 0% -5% 9% 8%Power Generation (Elec Utilities) 10% 15% 20% 20% 5% 0% 8% 10%T&D (Elec Utilities) 10% 15% 20% 20% 5% 5% 15% 10%Rail 7% 10% 10% 10% 7% 7% 7% 5%Infrastructure 10% 16% 18% 18% 6% 3% 11% 8%Aerospace 15% 10% 15% 5% -10% 8% 5% 4%Marine -8% 4% 32% 7% -26% -5% -20% 4%Agritech 10% 10% 20% 20% -10% -5% 8% 5%Trucks 10% 10% 20% 20% -10% -5% 8% 3%General Industrial Production 10% 10% 15% 13% -10% 10% 7% 4%General Industrial Capex 7% 5% 10% 8% -15% 10% 6% 5%Non-Residential Construction 25% 25% 10% 20% -5% 5% 10% 4%Macro-Dependent Industrial 13% 12% 11% 13% -11% 8% 7% 4%Residential Construction 10% 20% 5% 5% 5% 5% 1% 4%Automotive Capex 20% -8% 2% 10% -9% 1% 4% 5%Automotive Production 20% 30% 22% 7% 30% 15% 6% 5%Technology (Electronics, Telecom, Internet, etc) 35% 25% 15% -9% -17% 5% 7% 5%Other Consumer 0% 10% 20% 20% -30% 10% 4% 4%Consumer Related 10% 14% 14% 11% -13% 8% 4% 4%Total 11% 14% 15% 15% -3% 5% 8% 6%




Demand (5): Redburn ‘Global Capex Model’

Using historic and consensus forecast data for over 800 global companies that reflect the customers of our sector, we have built an end-market financial and capex model that incorporates a 25-year historic and five-year prospective period across 18 industries. This supports our assumptions in the previous chapter.

Our Redburn ‘Global Capex Model’ highlights that consensus expects only 0% and 2% capex growth in 2010E and 2011E, respectively, despite the 11% fall in 2009. We are more optimistic, given the (1) above-average margins, and (2) below-average indebtedness across all end markets in 2010E, and see scope for capex upgrades.

Redburn ‘Global Capex Model’: the approachUsing GICS, the global industry classification codes, we have identified 18 industry groups (or sub-industries) that represent a meaningful proxy for the salient end markets of the European Capital Goods sector. In each of the 18 industries we have identified 45 companies, the largest 15 quoted companies (by market capitalisation) in Europe, North America and the emerging markets. For each of the five industry metrics below, we have calculated the annual average for each region. To create the global data we have weighted the three regions based on the European Capital Goods sector geographic revenue mix (39% Europe, 21% North America and 40% Emerging Markets).

The data has been converted into euros, adjusted for year ends and cleaned for non-meaningful items. The forecast data is solely based on consensus forecast data and is not to be confused with our Redburn European Capital Goods end-market growth assumptions, which are based on our opinion (and in some instances differ significantly). Our ‘Global Capex Model’ focuses on five metrics for each global sector, our findings are summarised below:

Sales growth: the global consensus for revenue growth in 2010E and 2011E is for 8% and 9%, respectively. This is below the 12-year average revenue growth of 11% but is still positive.

Capex growth: global capex (weighted by sector end market and geographic mix) is forecast to fall by 11% in 2009, remain unchanged in 2010E and show minimal 2% growth in 2011E. Evidence suggests capex estimates are relatively inaccurate, relative to revenues and EPS. While we are very interested in future capex growth (the core driver of our sector’s organic sales), we look to other consensus metrics such as industry profitability and indebtedness (from the ‘global capex model’) and our proprietary work on the capex cycle of each end market to construct our own forecasts for global and regional capex growth (see Fig 266).

Capex/depreciation: global capex/depreciation is forecast to fall to 1.8x in 2010E, just below the mid point of the 12-year range of 1.5-2.2x. While this ratio has corrected from the 2.0x+ levels of the last few years, leaving scope for upside, it is not low enough to be an unambiguously bullish signal.

EBIT margin: despite the downturn, consensus 2010E-12E margins in all industries except housing are forecast to exceed the historic average of the past 12 years. This is a pretty bullish signal as industries generating premium (or even) record levels of returns are more likely to spend capex than loss-making industries.

Net debt/EBITDA: the global average consensus for 2010E indebtedness is 1.7x net debt/EBITDA. This is below the 12-year average of 1.9x. We see this as bullish and supportive of future capex growth. There are four industry exceptions (water utilities, housing, construction and healthcare) where the picture is less favourable.





Sales growth

Fig 267: ‘Global Capex Model’ 1998-2011E sales growth (consensus data for estimates)

Global sales growth 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Capital goods 10% 19% 26% 4% 3% 1% 9% 18% 12% 13% 11% -2% 6% 8%

Heavy equipment 11% 14% 30% 9% 6% 6% 20% 17% 20% 21% 15% -6% 5% 8%

Construction 3% 12% 27% 13% 4% -3% 7% 15% 20% 12% 15% 1% 4% 6%

Electrical utilities 1% 10% 25% 7% 1% 0% 2% 15% 14% 11% 16% 2% 5% 6%

Automotive 0% 22% 22% 8% 3% 2% 5% 10% 3% 7% 2% -6% 9% 9%

Mining 9% 4% 21% 8% 6% 8% 24% 25% 33% 11% 18% -7% 20% 14%

Steel 1% 1% 37% -4% 7% 10% 34% 18% 17% 18% 18% -32% 21% 14%

Upstream oil & gas -7% 23% 54% 5% 8% 9% 14% 39% 20% 12% 18% -21% 25% 16%

Downstream oil & gas -2% 26% 39% 8% 3% 5% 15% 28% 16% 9% 22% -27% 18% 12%

Truck haulage 11% 24% 24% 5% 2% -7% 1% 13% 10% 11% 1% 0% 7% 7%

Aerospace & defence 18% 19% 30% 16% 5% -3% 8% 16% 16% 12% 12% 9% 5% 7%

Marine 2% 5% 32% 7% -4% 7% 10% 14% 8% 17% 18% -27% 6% 7%

Rail 5% 18% 17% 4% 0% 2% 1% 11% 9% -1% 2% -6% 3% 6%

Housing 18% 30% 28% 11% 14% 0% 18% 27% 23% 7% -7% 0% 16% 17%

Healthcare 16% 18% 28% 11% 12% 7% 17% 21% 25% 17% 11% 8% 10% 8%

Water utilities 4% 5% 12% 7% 8% -2% 3% 14% 8% 9% 4% 9% 5% 9%

Farm products -11% 17% 6% 14% 11% 1% 5% 10% 21% 21% 15% -1% 12% 7%

IT, internet, electronics 12% 31% 36% 3% 8% 2% 17% 18% 21% 17% 10% 1% 12% 10%

End-market weighted average 5% 15% 29% 8% 5% 3% 11% 18% 17% 12% 13% -4% 8% 9%Our ‘Global Capex Model’ incorporates historic and consensus data for c800 companies. We have identified 45 companies for each of the 18 industries above (which we believe represent the key end markets for the European Capital Goods sector). The 45 companies for each industry comprise the largest 15 companies by market capitalisation for each of Europe, North America and emerging markets. Having cleaned the data, we have created regional simple averages for each historic and prospective year for Europe, North America and emerging markets. Our global averages (shown above) are calculated as a weighted average, using the sector split of geographic sales (39% Europe, 21% North America and 40% emerging markets) for the weighting. Overall global average is weighted using the sector split of end-market sales Source: Redburn Partners ‘Global Capex Model’

Ultimately, the degree and direction of any industry’s capex growth is predominantly a function of its through-cycle demand growth. Between 1998 and 2009, the average revenue growth across the 18 selected global end-market industries (weighted for the sector’s end-market mix) was 11%. Interestingly, though, average capex growth for the same industries over the same time frame was only 3.7%.

Fig 268: Industry sales growth ranked by historic 12-year average (data shown)

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Capex growth

Fig 269: ‘Global Capex Model’ 1998-2011E capex growth (consensus data for estimates)

Global capex growth 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Capital goods 9% 7% 13% 1% -18% -16% 14% 12% 10% 12% 22% -17% 3% 4%Heavy equipment -4% 2% 17% 12% -9% -2% -1% 17% 14% 21% 14% -23% -2% 8%

Construction -21% 13% 13% 2% -3% -18% 12% 18% 24% 9% 1% -10% -3% -3%

Electrical utilities -6% 7% 11% 4% 4% -18% -5% 18% 19% 20% 25% 2% 4% -1%

Automotive -14% 8% 4% 1% -15% -3% 9% 12% -3% 1% 8% -10% 3% 5%

Mining -10% 12% 19% -4% -1% 5% 11% 26% 23% 21% 29% -9% -14% -1%

Steel -4% -16% -7% -4% -16% -5% 19% 22% 23% 27% 23% -26% 3% 2%

Upstream oil & gas 15% -38% 15% 10% -14% -6% 29% 25% 23% 22% 21% 3% 2% 5%

Downstream oil & gas 37% -22% -24% 19% 8% 0% 3% 7% 18% 1% 9% -8% -4% -9%

Truck haulage 2% -15% 2% -8% -4% -6% -7% 12% 6% -9% -9% -15% 3% 2%

Aerospace & defence 17% -4% 9% 0% 3% -14% 1% 15% 12% 6% 4% -8% 4% -1%

Marine -15% -44% 17% 7% -20% -7% 1% 6% -5% 11% -11% -22% -3% 9%

Rail -6% 19% -14% -3% -10% 0% 0% 4% 0% -3% 3% -16% -2% 5%

Housing 8% 10% 12% -15% -6% -6% -18% 8% -1% -11% -20% -13% 4% -1%

Healthcare -18% -9% 4% 14% -9% 5% 5% 23% 14% 3% -7% -17% -3% 2%

Water utilities 9% -1% -1% 14% -11% -5% -13% 4% 9% -2% 4% -21% 2% 4%

Farm products -29% 13% 8% 8% -11% -13% 11% 1% 13% 2% 2% -11% -1% -11%

IT, internet, electronics 7% 15% 26% 5% -26% -5% 26% 21% 22% 8% -1% -15% 12% 4%End-market weighted average -4% 2% 8% 5% -6% -8% 4% 16.0% 15% 12% 11% -11% 0% 2%Our ‘Global Capex Model’ incorporates historic and consensus data for c800 companies. We have identified 45 companies for each of the 18 industries above (which we believe represent the key end markets for the European Capital Goods sector). The 45 companies for each industry comprise the largest 15 companies by market capitalisation for each of Europe, North America and emerging markets. Having cleaned the data, we have created regional simple averages for each historic and prospective year for Europe, North America and emerging markets. Our global averages (shown above) are calculated as a weighted average, using the sector split of geographic sales (39% Europe, 21% North America and 40% emerging markets) for the weighting. Overall global average is weighted using the sector split of end-market sales Source: Redburn Partners ‘Global Capex Model’

According to consensus data for the 800+ companies in our 18 selected global industries, capex is forecast to fall by 11% in 2009 (when weighted by sector end-market mix), remain largely unchanged in 2010 and show minimal 2% growth in 2011. As indicated above, we are more optimistic on 2011 levels. Interestingly, average capex growth (weighted by sector end-market mix) for the past 12 years was 3.7% (compared to an average sector organic sales growth of 3.8%). Having mapped the historic sector weighted average capex growth from our ‘Global Capex Model’ with the actual sector organic sales growth there is a high correlation, giving confidence in the model.

Fig 270: Industry capex growth ranked by historic 12-year average (data shown)

10% 8% 7% 7% 5% 4% 4% 3% 3% 3% 1% 0% -1% -1% -2% -7%-5%-4%

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Capex/Depreciation

Fig 271: ‘Global Capex Model’ 1998-2011E capex/depreciation (consensus data for estimates)

Global capex/depreciation 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Capital goods 1.6 1.2 1.3 1.4 1.4 1.2 1.3 1.6 1.6 1.8 2.0 1.5 1.4 1.1

Heavy equipment 1.5 1.5 1.6 1.5 1.8 1.8 1.9 1.9 1.9 2.5 2.5 1.4 1.4 1.3

Construction 1.7 1.5 1.5 1.3 1.2 1.5 1.4 1.7 2.0 2.5 2.0 1.7 1.4 1.3

Electrical utilities 1.5 1.4 1.3 1.4 1.4 1.2 1.3 1.6 1.8 2.2 2.4 2.6 2.6 2.5

Automotive 2.0 1.4 1.3 1.4 1.5 1.4 1.6 1.7 1.7 1.6 1.5 1.3 1.2 1.1

Mining 1.9 2.0 2.3 2.0 1.7 2.1 2.3 2.4 2.6 2.9 3.4 3.0 2.2 1.9

Steel 1.9 1.7 1.2 1.4 1.1 1.2 1.2 1.5 1.7 2.1 2.6 1.6 1.8 1.9

Upstream oil & gas 2.8 1.5 2.1 2.3 1.6 1.5 1.7 2.2 2.1 2.6 2.9 2.7 2.5 2.1

Downstream oil & gas 3.0 2.5 1.0 1.4 1.1 1.2 1.5 1.8 2.3 2.1 2.3 2.3 2.3 1.5

Truck haulage 1.8 1.4 1.5 1.5 1.6 1.5 1.5 1.7 1.5 1.6 1.3 1.5 0.9 0.9

Aerospace & defence 2.3 1.2 1.5 1.7 1.6 1.1 1.2 1.3 1.7 1.5 1.5 1.2 1.5 1.0

Marine 1.6 1.5 1.7 1.6 1.8 1.6 2.2 3.0 2.9 3.6 3.5 2.7 2.2 1.7

Rail 3.2 1.8 1.7 2.0 1.6 1.6 1.6 1.7 1.8 1.8 1.5 1.4 1.3 1.3

Housing 2.4 1.9 1.1 1.0 0.9 1.7 1.3 1.6 1.6 1.5 1.1 1.4 1.5 1.2

Healthcare 2.9 1.2 1.6 2.2 1.6 1.4 2.1 2.3 2.6 2.5 2.1 1.8 1.8 1.5

Water utilities 2.0 1.6 1.9 2.3 1.9 2.1 1.9 1.8 1.9 2.1 1.7 2.3 1.9 2.0

Farm products 1.4 1.6 1.4 1.4 1.7 1.5 1.7 1.7 1.9 2.1 2.4 2.4 2.4 1.8

IT, internet, electronics 1.4 1.5 1.6 1.7 1.2 1.4 1.6 1.5 1.4 1.3 1.3 1.1 1.2 1.3

End-market weighted average 2.0 1.5 1.5 1.6 1.5 1.5 1.6 1.8 1.9 2.2 2.2 2.0 1.8 1.7Our ‘Global Capex Model’ incorporates historic and consensus data for c800 companies. We have identified 45 companies for each of the 18 industries above (which we believe represent the key end markets for the European Capital Goods sector). The 45 companies for each industry comprise the largest 15 companies by market capitalisation for each of Europe, North America and emerging markets. Having cleaned the data, we have created regional simple averages for each historic and prospective year for Europe, North America and emerging markets. Our global averages (shown above) are calculated as a weighted average, using the sector split of geographic sales (39% Europe, 21% North America and 40% emerging markets) for the weighting. Overall global average is weighted using the sector split of end-market sales Source: Redburn Partners ‘Global Capex Model’

Global capex/depreciation is forecast to fall to 1.8x in 2010E, just below the mid-point of the 12-year range of 1.5-2.2x. While this ratio has corrected from the 2.0x+ levels of the last few years, leaving scope for upside, it is not low enough to be an unambiguously bullish signal. Capex/Depreciation is an asset replacement ratio that provides some indication of how expansionary or contractionary capex levels are. To be of real value this metric needs to be considered in conjunction with future growth. In the round, the lower the ratio the more bullish the signal for future capex growth.

Fig 272: Industry capex/depreciation ranked by historic 12-year average

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EBIT margin

Fig 273: ‘Global Capex Model’ 1998-2011E EBIT Margin (consensus data for estimates)

Global EBIT margin 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Capital goods 10% 9% 10% 9% 9% 8% 10% 10% 11% 12% 11% 10% 11% 11%

Heavy equipment 9% 8% 8% 7% 7% 7% 8% 8% 10% 11% 9% 6% 8% 9%

Construction 5% 6% 6% 6% 7% 6% 5% 6% 7% 7% 7% 7% 8% 8%

Electrical utilities 18% 16% 15% 16% 14% 15% 17% 18% 16% 17% 14% 18% 19% 20%

Automotive 7% 7% 6% 5% 7% 7% 7% 7% 7% 7% 4% 3% 6% 7%

Mining 16% 19% 17% 22% 22% 19% 23% 25% 28% 27% 27% 26% 31% 33%

Steel 7% 11% 11% 5% 10% 12% 18% 17% 17% 17% 15% 5% 13% 16%

Upstream oil & gas 7% 27% 31% 32% 28% 30% 28% 29% 32% 30% 27% 30% 35% 36%

Downstream oil & gas 4% 3% 5% 5% 5% 5% 6% 5% 5% 4% 0% 4% 5% 4%

Truck haulage 10% 10% 7% 7% 7% 9% 11% 8% 9% 8% 5% 9% 10% 11%

Aerospace & defence 11% 12% 12% 13% 12% 10% 11% 12% 12% 12% 12% 12% 12% 12%

Marine 4% 10% 13% 10% 9% 14% 18% 19% 16% 16% 14% 16% 17% 17%

Rail 13% 7% 7% 6% 6% 12% 10% 13% 10% 15% 13% 17% 19% 19%

Housing 11% 12% 12% 12% 12% 13% 16% 17% 16% 12% 6% 6% 10% 12%

Healthcare 12% 12% 10% 11% 12% 9% 10% 11% 11% 10% 10% 11% 12% 13%

Water utilities 23% 21% 24% 28% 26% 27% 27% 25% 25% 25% 23% 29% 31% 29%

Farm products 13% 13% 11% 10% 14% 9% 11% 12% 12% 11% 12% 14% 15% 15%

IT, internet, electronics 11% 14% 16% 10% 14% 16% 19% 18% 18% 18% 17% 18% 21% 24%

End-market weighted average 11% 11% 12% 11% 11% 12% 13% 14% 13% 14% 12% 13% 15% 16%Our ‘Global Capex Model’ incorporates historic and consensus data for c800 companies. We have identified 45 companies for each of the 18 industries above (which we believe represent the key end markets for the European Capital Goods sector). The 45 companies for each industry comprise the largest 15 companies by market capitalisation for each of Europe, North America and emerging markets. Having cleaned the data, we have created regional simple averages for each historic and prospective year for Europe, North America and emerging markets. Our global averages (shown above) are calculated as a weighted average, using the sector split of geographic sales (39% Europe, 21% North America and 40% emerging markets) for the weighting. Overall Global Average is weighted using the sector split of end-market sales Source: Redburn Partners ‘Global Capex Model’

In most industries, despite the downturn, margins over the next three years (2010E-12E) are forecast to exceed the historic average of the past 12 years. In isolation this is a relatively bullish signal for capex. In particular those industries at the highest end of the profitability spectrum (such as upstream oil and gas, water utilities, mining, electrical utilities, and to a degree rail), in other words the infrastructure end markets continue to have the highest capacity for incremental investment.

Fig 274: Industry EBIT margin ranked by historic 12-year average

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Fig 275: ‘Global Capex Model’ 1998-2011E net debt/EBITDA (consensus data for estimates)

Global net debt/EBITDA 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E

Capital goods 2.6 2.1 1.6 2.4 2.0 1.5 1.3 1.4 0.8 0.8 1.2 1.3 0.3 0.2

Heavy equipment 2.6 2.5 2.0 2.7 2.6 1.6 0.9 0.9 0.9 1.0 1.5 0.6 1.0 0.5

Construction 0.4 1.0 1.5 1.3 1.6 1.1 0.8 0.8 0.9 1.2 1.8 1.8 1.5 1.1

Electrical utilities 2.6 3.2 2.9 3.1 3.4 3.1 3.1 2.6 2.7 2.6 2.7 3.0 2.8 2.7

Automotive 2.0 1.6 1.6 1.7 1.4 1.2 1.1 1.1 1.7 1.4 2.4 1.8 1.6 1.0

Mining 0.9 0.2 1.2 1.5 0.9 1.3 0.8 0.4 0.0 0.2 0.3 0.4 0.1 -0.1

Steel 2.1 2.4 2.1 2.9 2.6 2.0 0.9 0.5 0.8 0.8 1.7 1.7 1.3 1.0

Upstream oil & gas 1.6 2.3 1.6 1.2 0.8 -0.5 0.3 0.6 0.3 0.1 0.1 0.6 0.5 0.5

Downstream oil & gas 2.0 2.4 1.3 1.5 2.3 1.9 1.0 1.4 1.1 1.8 1.7 2.6 2.1 1.6

Truck haulage 1.0 0.9 1.0 1.6 1.1 0.9 1.0 1.6 1.1 1.4 2.0 1.0 0.7 0.7

Aerospace & defence 0.0 0.8 1.0 0.8 0.7 0.3 0.5 0.3 0.3 0.1 0.2 0.2 0.1 -0.1

Marine 3.7 4.0 2.4 2.6 3.4 2.1 1.7 1.5 2.0 1.3 1.9 1.8 2.7 1.9

Rail 3.7 3.6 3.4 3.3 2.9 2.5 1.9 2.9 2.9 2.9 3.2 2.5 2.3 2.2

Housing 2.1 1.5 1.8 1.3 1.0 1.0 0.6 0.7 0.6 0.5 1.1 1.2 2.3 1.7

Healthcare 2.1 3.4 2.7 2.3 1.6 1.9 1.9 2.4 2.2 3.4 3.9 3.2 2.7 2.6

Water utilities 0.9 1.0 1.3 2.2 2.4 2.5 3.0 2.5 2.3 2.1 2.4 3.2 3.3 3.2

Farm products 1.6 1.8 1.5 1.5 1.7 1.3 1.0 1.3 1.3 1.4 1.7 1.2 0.8 0.5

IT, internet, electronics 0.4 -0.1 -0.9 -0.1 -0.6 -1.3 -1.1 -1.3 -1.0 -0.7 -0.6 -0.6 -1.0 -1.2

End-market weighted average 2.1 2.4 2.1 2.3 2.2 1.8 1.5 1.5 1.5 1.6 1.9 1.8 1.7 1.4Our ‘Global Capex Model’ incorporates historic and consensus data for c800 companies. We have identified 45 companies for each of the 18 industries above (which we believe represent the key end markets for the European Capital Goods sector). The 45 companies for each industry comprise the largest 15 companies by market capitalisation for each of Europe, North America and emerging markets. Having cleaned the data, we have created regional simple averages for each historic and prospective year for Europe, North America and emerging markets. Our global averages (shown above) are calculated as a weighted average, using the sector split of geographic sales (39% Europe, 21% North America and 40% emerging markets) for the weighting. Overall Global Average is weighted using the sector split of end-market sales Source: Redburn Partners ‘Global Capex Model’

Unlike consumers, governments, financial sectors and non-quoted corporates, the global quoted corporate sector has ridden the credit crunch with historically comfortable levels of gearing. With four exceptions (water utilities, housing, construction and healthcare), industry gearing levels over the next three years (as measured by net debt/EBITDA) are forecast by consensus to be lower than the historical 12-year average. We see this as a bullish signal, supportive of future capex growth. We would caution that those industries at the upper end of the indebtedness spectrum are the most likely to face pressure to conserve cash and limit capex.

Fig 276: Industry net debt/EBITDA ranked by historic 12-year average

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As shown in Fig 260, above, the infrastructure end markets have shown the fastest growth over the last decade, averaging 7-8% organic sales growth. Given Western replacement needs combined with emerging market demographics (Infrastructure is more emerging exposed), we believe the infrastructure complex will continue to provide the premium source of end-market growth to the European Capital Goods sector.

Fig 277: Breakdown of 2009 sector infrastructure sales (€84bn in aggregate)

Rail18%

T&D17%

Power Generation32%

Oil & Process21%

Metals and Mining12%


Infrastructure end markets represent 48% of our coverage’s revenue in aggregate and are dominated by the energy-driven end markets. NB: the simple average revenue exposure across our coverage to infrastructure is only 39%; the difference stems from the fact that the larger companies in the sector (e.g. Siemens, ABB and Alstom) are more infrastructure exposed, which creates a bias in the aggregated numbers.

While we see some challenges in infrastructure in 2010E, T&D pricing and sluggish rail demand given public budget deficits, we also believe the later cycle infrastructure markets are likely to demonstrate order recovery in 1H10.

We note that GE has taken a similar view, with CEO Jeff Immelt saying: “Infrastructure is the real sweet spot compared to the rest of the group and that’s where the new capital will go,” and also “This is not just a one-off, we are now seeing real global growth return in the infrastructure area” at the 4Q09 results. While GE’s infrastructure side (power generation, oil and gas equipment, jet engines, healthcare imaging equipment and trains) saw YoY orders down 3% at 4Q09, QoQ sequential orders compared to 3Q09 were up $3.7bn (or 24%), with strength in service orders and healthcare orders across all geographies and important sequential improvements in energy and oil & gas.

We have addressed each infrastructure market in a separate chapter below (we have not gone through each consumer or macro-dependent end market in such detail at this stage).

Demand (6): infrastructure end markets



Demand (7): mining capex outlook

Atlas Copco: 26% of group sales exposure to mining

Sandvik: 18% of group sales exposure to mining

ABB: 6% of group sales exposure to mining

Schneider: 5% of group sales exposure to mining

SKF: 2% of group sales exposure to mining

Mining is our favourite end market within the favourable infrastructure complex. While we expect mining capex to fall in 2009 (-28%), we expect it to return to attractive growth (+6%) in 2010E and extremely strong growth (19%) in 2011E. This puts our assumptions on a more optimistic footing for 2011 than global consensus forecasts shown in Figs 271 and 269 above and in Fig 278 below. Our reasoning is fivefold: (1) mining returns are at record levels; (2) the mining sector is largely ungeared; (3) the 1980s and 1990s saw underinvestment in mining; (4) commodity prices have recovered to above incentive prices; and (5) perhaps most importantly, the mining majors have started to signal meaningful upgrades to capex guidance.

Fig 278: 2000-14E global mining growth vs investment Fig 279: 2000-14 global mining gearing and margins

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The data for forecast years are solely consensus based and differ to our capex estimates Source: Redburn Partners and Bloomberg


While capex/depreciation in the global mining sector undoubtedly reached dramatic highs of c3x in 2008 (which would suggest a level of overinvestment and might be a pre-cursor to a cautious mining capex outlook), we are more optimistic that when the near-term financing headwinds dissolve the industry will return to heavy investment.

Firstly, returns in the mining industry remain sufficiently high and unchanged that continued investment is likely to continue to be attracted. As shown in Fig 279, the global mining majors are forecast by consensus to ride the downturn with margins remaining at close to historical highs and beyond that to improve to new highs.

Secondly, the mining sector is forecast to reach a 0.1x net debt/EBITDA in 2010 and as such is largely ungeared and unlikely to face major pressure to constrain cash outflows.

Thirdly, it is worth considering that in the 1980s and 1990s the global mining industry saw a relatively low level of investment and was largely underinvested in. To a degree the last decade of expansionary capex was partly catch-up investment.

Fourthly, after a period of mine closures and disruptions, prices for most commodities have now rebounded to above incentive prices (the levels where incremental investment in new mines is attractive) again.





While we have forecast a return to capex growth ahead of the curve in 2011 it is interesting to note that some companies are already moving back to sharp capex growth. In October 2009, Vale’s board approved $12.9bn of capex for its next fiscal year, a 29% increase over the $10bn invested in the year to June 2009. Furthermore in February 2010E, BHP Billiton announced its intention to increase capex to $15bn in 2011E. This included an uplift in guidance from $9.5bn in 2010E (i.e. -10%) to $12.4bn (i.e. +17%). After growing capex by 18% in 2008 and 14% in 2009, the company is now guiding to a further 17% growth in 2010E and, perhaps more excitingly, 21% growth in 2011E.

Fig 280: Metal prices, cumulative price performance since 1 January 2000

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Source: Redburn Partners, Bloomberg

Anecdotally, a year ago the global mining industry experienced an unprecedented level of idle drill rigs (Atlas Copco and Sandvik are the world leaders in manufacturing drill rigs for hard and soft rock mining). Consequently, demand for new rigs collapsed. Furthermore, the economic downturn has seen many old drill rigs that had been sitting idle being stripped naked as mining companies cannibalised spare parts and components to save cash by tearing equipment off idle drilling rigs to repair those in operation.

However, it looks as if the drilling industry may be seeing the beginnings of a recovery. Swick Mining Services (one of Australia’s largest mineral drilling contractors) indicated that utilisation of its drilling rigs had risen from a low of 35% in January to 59% in May, 71% by July and 80%+ by the 2009 year end. With spare parts heavily cannibalised, any recovery in the utilisation in mining equipment is likely to feed through to capex growth.

Sector plays in mining

In Europe, Atlas Copco (26% of group sales), Sandvik (18% of group sales), Metso (40% of group sales), FLSmidth (41% of group sales) and Outotec (100% of group sales) are the primary mining plays. However, as the majority of the recent capex uplifts from the majors relate to the upstream extraction process, where Atlas Copco and Sandvik deliver product, we believe they are better positioned over the downstream players (such as Metso, FLSmidth and Outotec, which are more exposed to crushing, concentration, refining, etc). Atlas Copco has more exposure than Sandvik (26% vs 18%) and is also more metal-based than Sandvik. Atlas Copco has only 10% of its mining equipment sales to the coal industry compared to Sandvik at 25%. We believe coal mining is likely to be later cycle as it is linked to the later-cycle power generation industry. We prefer the iron ore and copper markets where the return to excitement today is more Asian-linked.



Demand (8): electrical utilities capex outlook

Alstom: 59% of group sales exposure to power generation (59%) and T&D (0%)

ABB: 37% of group sales exposure to power generation (6%) and T&D (31%)

Siemens: 22% of group sales exposure to power generation (14%) and T&D (8%)

SKF: 10% of group sales exposure to power generation (10%) and T&D (0%)

Schneider: 9% of group sales exposure to power generation (0%) and T&D (9%)

Invensys: 6% of group sales exposure to power generation (0%) and T&D (6%)

After four years of double-digit growth (at an average of c15%), global capex for T&D turned down in 2009 (-3%) but remained positive for power generation (+3%). Looking forward we expect capex to decline in 2010 (-7% for power generation and -5% for T&D) and then to recover in 2011 to +9% for T&D and to +4% for power generation.

Fig 281: 1999-2013E global electrical utility sector data Fig 282: 1999-2013E global electrical utility sector data

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Electrical utility capex for T&D equipment is relatively aligned with the economic cycle, whereas capex for power generation is generally later cycle, given the 3-15 year planning cycle for new power plants (from gas to nuclear).

Fig 283: 18% use 53% of electricity Fig 284: Emerging to drive growth Fig 285: Electricity driven by GDP

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Source: IEA Analysis Source: IEA Analysis Source: IEA Analysis





When considering the capex outlook we note four positive factors: (1) both the power generation and T&D equipment markets face a compelling replacement cycle in Europe and the US (given the age of turbine fleets and the grid); (2) in emerging markets, we see an attractive long-term demand story driven by GDP growth and rising electricity consumption per capita towards Western levels; (3) consensus expectations are for EBIT margins of the global electrical utility sector to remain relatively resilient through the next few years, suggesting that cash is at least available for capex; and (4) the oil price, which tends to lead electricity prices, has rallied from the low.

Fig 286: Electricity prices are linked to oil, coal and gas prices

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Source: Redburn Partners, NY Mercantile Exchange, Bloomberg, ICAP US, BB OTC Composite

Negatives: economic downturn, recent premium capex and high indebtedness

However, despite these positives we expect the recent economic downturn to drive capex spending into decline. Expectations for future electricity demand and the need for investment (reflected by reserve margins in the electrical utility industry) have all pushed out to the right. Consequently, the immediate and bourgeoning need to invest in new capacity has materially declined.

As shown in Fig 281, global capex/depreciation for the electrical utilities is forecast to reach 3.0x in 2009. Despite coming after decades of underinvestment in the grid (T&D) and in power generation, recent capex has been at a ten-year historical high suggesting some short-term overinvestment risk.

Furthermore, as shown in Fig 282, the utility industry is relatively geared at 3.0x net debt/EBITDA. While the visibility of its regulatory framework affords the electrical utility industry the ability to take on a higher than average level of debt (the credit rating agencies allow the sector up to 3.2x net debt/EBITDA to retain an A- credit rating), there is limited room to spend unnecessary cash.

Longer-term positives: emerging markets and replacement needs

Ultimately the need for power generation and transmission & distribution (T&D) equipment is driven by the demand for electricity. Empirically, global electricity demand is highly correlated with real GDP growth. Longer term, with 18% of the world’s population consuming 53% of the world’s electricity, future demand for electricity is likely to come from the emerging markets where electricity consumption per capita is as low as 10% of that of the West.




In addition to the long-term drivers of electricity demand, power generation and T&D equipment demand is also driven by the replacement cycles of the electrical utilities. Here there is a relatively attractive structural story. Due to the age pyramid of the world’s installed capacity there is a significant proportion of global installed capacity that is due for retirement. Steam turbines past c50 years and gas turbines c25 years, and both markets saw dramatic increase in volumes 50 and 25 years ago, respectively. As such, the power markets are on the cusp of a compelling replacement cycle that should provide some support to the pace of any ultimate capex recovery.

Fig 287: 2007 global installed power generating capacity by age (segmented both by technology and geography)

Age pyramid of world installed capacity

EuropeRussia & CISMiddle East/AfricaNorth AmericaLatin AmericaAsia & OceaniaIndiaChina

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Source: Alstom based on UDI data



Demand (9): rail capex outlook

Alstom: 41% of group sales exposure to rail

Invensys: 24% of group sales exposure to rail

Siemens: 10% of group sales exposure to rail

SKF: 6% of group sales exposure to rail

ABB: 4% of group sales exposure to rail

We expect rail to be one of the more resilient end markets for the European Capital Goods sector throughout the current downturn, supported by: (1) structural trends in high speed rail, urban transit, and signalling; (2) government stimulus plans; and (3) strong three-year order backlogs (at Alstom and Siemens). Beyond that, however, we expect less of a strong recovery; firstly, as the end market did not fall particularly hard, and secondly, as we see risks to growth from European government budget deficits, as rail is the most public spending oriented end market within the sector complex. We expect capex to grow at 3% in 2010 and 5% in 2011 (vs consensus of -2% and +5%).

Fig 288: 1999-2013E global rail sector data Fig 289: 1999-2013E global rail sector data

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The railway sector is relatively ungeared (sub 0.5x net debt/EBITDA) and has seen and is forecast to see record levels of EBIT margins.

The railway sector matured many decades ago in Europe and the US and has been one of the lowest growth end markets for the last decade. According to our Global Capex Model, the global railway industry has seen an average 2% decline in annual capex over the past 12 years. Despite this, rail is enjoying something of a renaissance, with high speed trains offering an environmentally attractive alternative to short haul flights, and trams, metros and other light transit offering a space-efficient and environmentally attractive solution to urban congestion.

As with the power markets, there is also a compelling infrastructure replacement story in rail from aging rail networks and rolling stock fleets. Furthermore, rail is seeing both significant growth in emerging markets and signs of resilience in the West despite the economic downturn. This resilience stems from the positive structural trends above and the fact that rail, which is highly dependent on government spending, has been a significant beneficiary of the various stimulus packages.





Fig 290: Passenger rolling stock traffic data (1950-2007) Fig 291: Freight rolling stock traffic data (1950-2007)

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Figs 290 and 291, based on UIC data, highlight just how mature European rail growth is and just how fast Asian rail growth is. That passenger traffic has increased by 5.0% in Asia and 0.8% in Europe since 2000, and that Freight traffic has increased by 7.2% in Asia and by 0.4% in Europe in the same period, highlights the different regional trends. We expect continued lacklustre growth in Europe, with the exceptions of rail signalling (driven by EMTS), high speed rail and urban rail, where there is some growth.

Rail revenues are highly European-oriented

Sadly, for those with exposure, rail revenues in the sector have very limited emerging market exposure with the Asian markets predominantly served by local players (Hyundai Rotem, China Northern, China Southern, etc). For instance, the revenues of both Siemens Mobility and Alstom Transportation (the respective rail divisions) are c80% exposed to the West and only c20% to emerging markets (of which nearly half is China). Furthermore, within that, Europe makes up 70% of revenues. As such, this is an end market that is highly dependent on European growth and cannot look overtly to the emerging markets to replace weak Western growth.

The key risk for rail capex is its dependence on government spending

Fig 292: Rail capex is very government-linked (estimated drivers of rail capex)

Private Spending Related

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Throughout Europe, whether under the privatised UK model or the state-owned continental model, ultimately, rail spend, whether rolling stock, electrification or signalling equipment, is government-financed. With government budget deficits having widened globally (especially in Europe), there has to be a degree of pressure on the medium-term growth outlook for rail spending in Europe.




This pressure is counter balanced by an attractive replacement story with respect to an aging European fleet and also, to a degree, EU legislation. For instance, by 1 January 2020 every train in the EU must provide a certain level disabled access, with only 60% of the trains in the UK currently meeting this, the UK, which tends to adhere to EU legislation, is likely to enforce either refurbishment or replacement in its upcoming round of franchise tenders. The degree to which governments’ rail spend will be cut or not, in the face of well documented need, is unclear and comes down to political choices. Nonetheless, investors should be conscious of this risk to growth going forward.

Fig 293: Rail orders have already declined (LFL) in the sector in 2009

Rail Divisional Average (Alstom Transport, Siemens Mobility, Invensys Rail Systems)

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Demand (10): oil and gas and process capex outlook

Invensys: 21% of group sales exposure to oil and gas (15%) and process (6%)

ABB: 19% of group sales exposure to oil and gas (10%) and process (9%)

Siemens: 14% of group sales exposure to oil and gas (10%) and process (4%)

Atlas Copco: 13% of group sales exposure to oil and gas and process

Sandvik: 11% of group sales exposure to oil and gas and process

Schneider: 5% of group sales exposure to oil and gas and process

SKF: 2% of group sales exposure to oil and gas and process

Fig 294: 2000-12E global downstream oil and gas data Fig 295: 2000-12E global downstream oil and gas data

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(%)




We expect capex from the downstream Oil & Gas and Process end markets to be quite slow to recover and to face a difficult 2010. We expect a -5-6% decline in 2010E and a recovery to +8-9% in 2011E, supported by the recent increases in the Oil price. We expect upstream oil extraction capex to recover faster than downstream refinery capex. Siemens’ oil and gas division and Atlas Copco both have more exposure to upstream through their compressor activities, which are used to help extract oil. Looking at the pure-play divisions of Siemens, ABB and Invensys (Fig 296) we can see just how much organic orders have fallen in 2009. This is behind our 2010 caution.

Fig 296: Oil and gas and process orders fell 15% in 2009, this is behind our 2010 caution

Oil & Gas / Process Divisional Average (ABB Process Automation, Siemens Oil & Gas and Invensys Process Systems)

-50%-40%-30%-20%-10%

0%10%20%30%40%50%

Q1 06 Q1 07 Q1 08 Q1 09 Q1 10E Q1 11E

Quar

terly

Org

anic

Gro

wth

OGP / Process Organic Sales Growth OGP / Process Organic Order Growth


Demand (10): oil and gas and process capex outlook



Valuation

The European Capital Goods sector is currently trading on 2011E EV/EBITA of 8.7x (at the median), which represents a 21% discount to the 20-year average of 11.0x. We see evidence of a systemic de-rating of the sector over time, implying the market is more cautious about profit growth beyond 2011E than it has been on average for the past 20 years.

From the findings of this report, we are more optimistic. We believe the sector’s margins are structurally underpinned by high market shares, consolidated industries and improved manufacturing footprints, and can continue to reach new highs beyond 2011E, driven by a compelling emerging market and global infrastructure growth story. As such, we see the sector’s current low multiples as discounting an overly cautious outlook that we do not share. This is the basis of our optimistic view and our belief that the sector is undervalued and has the potential to re-rate looking forward.

Based on our core method of valuation, 2011E EV/IC vs ROIC/WACC, we calculate that the sector is trading at a 20% discount to fair value, with an average 30% upside to our five Buy recommendations.

This valuation approach does not fully capture the variation of growth beyond 2011E. While our target prices and recommendations are predominantly based on our core year two EV/IC vs ROIC/WACC methodology, we have also a growth factor to try to capture the potential upside from growth variation. Based on a long-run, DCF-style, dynamic economic profit valuation model, we see even more upside (of c100% to our fives buys), if companies can sustain their average ten-year historic organic sales growth into the future. Furthermore, if we apply the average multiple of the sector’s emerging market competitors to the sector’s emerging market net income (42% of global sector net income), we get the entire Western world for free!

Fig 297: Current sector market capitalisation compared to 2007 peak

-36% -34%

-46%

-26% -28%

-20% -23%

-12%

-33%

-23%-43%

0

20,000

40,000

60,000

80,000

100,000

120,000

Siemens ABB Schneider Alstom Sandvik AtlasCopco

SKF Legrand Assa Abloy Electrolux Invensys

Mar

ket C

apita

lisat

ion

(€ m

n)

-50%

-40%

-30%

-20%

-10%

0%Va

riatio

n be

twee

n 20

07 P

eak

and

Curre

nt M

arke

t Cap

(%)

2007 Peak Market Cap (€ mn) Current Market Cap (€ mn) Variation (%)


The current market cap of the universe shown in Fig 297 is c€177bn, which is down some 36% from the 2007 peak of c€275bn. Sandvik, Siemens, ABB and Alstomremain the furthest from past peaks and Electrolux is only 12% away.

Valuation



Valuation

From 2007 to 1Q10, a wide dispersion of performance

Fig 298: Consumer facing and early cycle plays have rallied faster than capex plays

-63%-67%-67%

-57%-72%

-63%-64%-60%

-64%-72%-72%

55%79%80%

96%96%

101%104%107%110%

162%193%

-100% -50% 0% 50% 100% 150% 200% 250%

AlstomABB

SiemensAssa Abloy

SandvikSchneider

SKFLegrand

Atlas CopcoInvensys

Electrolux

Sha re Pr ice Pe rf o rm ance (%)

2007 Peak to 2009 Trough 2009 Trough to Current Price


One observation of note is the degree to which performance in the downturn was relatively homogenous but performance in the rally has been more heterogeneous. This is shown in Fig 298, with stocks falling between 57% and 72% peak-to-trough but rallying between 54% and 187% from the trough to today.

Electrolux has seen its share price virtually treble since the low and Invensys has more than doubled. In general, the consumer-exposed (Electrolux and Legrand) and short lead-time companies (aka early cycle companies SKF, Sandvik and Atlas Copco) have rallied faster than the construction-exposed stocks (Assa Abloy and Schneider) and the capex plays (ABB, Siemens, Alstom), each of which we like for the longer term, have underperformed.



Valuation

Fig 299: The sector is trading on 11x 2011E P/E, c4% dividend yield and over 8% FCF yield

European Capital Goods Valuation Summary

TargetCompany Rating Price Price 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E

ABB Buy SFr22.2 SFr30.0 17.4 13.7 12.3 1.9% 2.3% 2.4% 5.2% 4.0% 6.8% 3.72 4.08 4.04Alstom* Buy €48.6 €60.0 11.6 10.8 9.7 3.0% 3.2% 3.6% -1.1% 9.6% 12.4% 3.20 2.60 2.62Electrolux Neutral Skr155 Skr175 10.9 10.2 9.3 3.3% 3.6% 5.2% 11.5% 9.7% 11.1% 1.97 1.95 1.96Invensys* Neutral 328p 330p 16.6 15.0 13.7 1.7% 1.8% 1.8% 6.7% 6.4% 7.1% 4.35 4.70 4.77Schneider Electric Neutral €80.7 €95.0 13.0 10.9 9.7 3.2% 4.1% 4.6% 7.4% 8.5% 9.2% 1.39 1.53 1.60Siemens* Buy €65.9 €85.0 12.3 9.7 8.9 2.6% 3.3% 4.3% 5.8% 7.9% 8.8% 1.53 1.72 1.72Electrical Sector (Median) 12.7 10.9 9.7 2.8% 3.3% 4.0% 6.2% 8.2% 9.0% 2.59 2.27 2.29

Assa Abloy Buy Skr139 Skr175 13.3 11.5 10.7 3.0% 3.5% 3.7% 7.5% 9.2% 9.7% 1.80 1.97 2.04Atlas Copco Buy Skr103.6 Skr125.0 15.9 12.7 11.4 2.8% 3.6% 4.0% 7.8% 8.1% 9.2% 2.87 3.30 3.46Sandvik Neutral Skr79.3 Skr85.0 30.7 13.5 10.8 1.8% 4.3% 5.2% 4.8% 3.9% 7.0% 1.04 1.82 2.06SKF Neutral Skr117 Skr120 16.2 13.3 11.9 3.1% 3.8% 4.2% 7.0% 6.4% 7.5% 1.85 2.06 2.12Engineering Sector (Median) 16.0 13.0 11.1 2.9% 3.7% 4.1% 7.3% 7.3% 8.4% 1.82 2.01 2.09

Overall Capital Goods (Median) 14.6 12.1 10.7 2.9% 3.5% 4.1% 6.9% 8.0% 9.0% 1.91 2.01 2.09

# Shares Mkt Cap EVCompany (FD, mn) € mn € mn 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E

ABB 2,291 27,982 26,153 1.4 1.3 1.2 8.5 7.6 6.7 9.7 8.7 7.6 3.96 3.45 2.98Alstom* 292 14,486 17,675 0.8 0.8 0.7 7.8 6.6 5.7 9.6 8.7 7.5 2.67 2.02 1.81Electrolux 284 3,408 4,040 0.4 0.4 0.4 5.0 4.5 4.1 7.6 6.7 5.9 1.43 1.33 1.21Invensys* 809 2,324 2,595 1.2 1.2 1.1 8.3 7.5 6.7 10.3 9.2 8.1 3.82 3.81 3.51Schneider Electric 247 15,075 19,526 1.4 1.3 1.2 8.3 7.1 6.5 9.5 8.2 7.3 1.20 1.13 1.08Siemens* 874 47,104 50,457 0.9 0.8 0.7 6.5 5.5 5.0 9.0 7.2 6.4 1.12 1.03 0.95Electrical Sector (Median) 114,728 126,358 1.0 1.0 0.9 8.0 6.9 6.1 9.6 8.4 7.4 2.05 1.68 1.51

Assa Abloy 373 4,032 4,955 1.7 1.5 1.3 8.5 7.1 6.3 10.0 8.3 7.2 1.63 1.52 1.44Atlas Copco 1,230 10,058 11,463 2.0 1.6 1.3 9.0 7.0 5.5 11.6 8.7 6.7 2.99 2.62 2.22Sandvik 1,187 7,814 11,289 1.7 1.5 1.4 11.1 7.8 6.7 17.6 10.6 8.7 1.67 1.62 1.52SKF 455 4,479 5,778 1.1 1.0 1.0 8.0 7.0 6.4 11.1 9.1 8.2 1.95 1.85 1.74Engineering Sector (Median) 26,383 33,484 1.7 1.5 1.3 8.7 7.1 6.4 11.3 8.9 7.7 1.81 1.74 1.63

Overall Capital Goods (Median) 141,110 159,843 1.3 1.2 1.1 8.3 7.1 6.4 9.9 8.7 7.4 1.81 1.74 1.63

P/E Div Yield

EV/Sales EV/EBITDA

FCF Yield to Equity

EV/EBITA EV/IC

ROIC/WACC


20-year historical spot multiple analysis Fig 300: Sector EV/Sales ratio has lifted with sector margin uplift

Fig 301: Sector EV/EBIT is currently at the lower end of the range

Fig 302: Sector P/E is also currently at the lower end of the range

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1990 1994 1998 2002 2006 2010

EV/S

ales

Sector Median

0

2

4

6

8

10

12

14

16

1990 1994 1998 2002 2006 2010

EV/E

BIT

Sector Median

0

5

10

15

20

25

30

35

1990 1994 1998 2002 2006 2010

P/E

Sector Median 10 Yr Eurobond

Source: Redburn Partners Source: Redburn Partners Source: Redburn Partners



Valuation

We have conducted a 20-year historical valuation analysis of our coverage universe using three traditional spot multiples: EV/Sales, EV/EBIT and P/E. From this we have calculated a 20-year high, low and average multiple for each metric, for each stock, and for the sector as a whole (both on average and at the median). We have then compared the 2011E multiples against this 20-year average and range in order to establish empirically whether the sector has been re-rated or de-rated over time, and more importantly, where current valuations sit in this historical perspective.

EV/Sales

Fig 303: Sector is trading on a 22% premium to 20-year EV/Sales history

0%

50%

100%

150%

200%

250%

300%

ABB Alstom Assa Abloy Atlas Copco Electrolux Invensys Sandvik Schneider Siemens SKF SectorMedian

2011

E EV

/Sal

esvs

20

Year

Ran

ge a

nd A

vera

ge

20 Yr Min 20 Yr Max 20 Yr Avg. 2011

Source: Redburn Partners based on company data and Bloomberg

At the median, the European Capital Goods sector is trading on 1.2x 2011E EV/Sales which is 22% above the 20-year average of 1.0x. This comes as no great surprise given the sector’s continued improvement of through-cycle margins across each of the past four cycles (see Fig 311). Given that we now appear to be heading out of a downturn, EV/Sales is perhaps less of a valuable tool currently. We see EV/Sales as more of a valuable tool for identifying floor valuations, when heading into a downturn. However, EV/Sales is still a useful measure of what margins the market is expecting.

Fig 304: 2011E EV/Sales vs EBIT margin

ABB

Alstom

Assa AbloyAtlas Copco

Electrolux

Invensys SandvikSchneider

SiemensSKF

0%

5%

10%

15%

20%

0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200%

2011E EV/Sales

2011

E EB

IT M

argi

n


Fig 304 highlights the strong correlation between margin and EV/Sales. Sandvik is discounting the highest EBIT growth currently, which is appropriate given the stock’s collapse in margin. Currently the market is expecting the least margin expansion (or most margin contraction) beyond 2011E at Siemens, Electrolux, Assa and Schneider as they are the furthest from the 45 degree line.



Valuation

EV/EBIT

Fig 305: Sector is trading on a 24% discount to 20-year EV/EBIT history

0x

5x

10x

15x

20x

25x


2011

E EV

/EBI

Tvs

20

Year

Ran

ge a

nd A

vera

ge



While EV/Sales multiples have expanded over the past 20 years, the expansion has not kept pace with the sectors’ margin expansion over the same period. We can see this from the fact that unlike EV/Sales multiples which have expanded, profit multiples for the sector have contracted over the same period.

The sector is currently trading on 2011E EV/EBIT of 8.7x (at the median), which represents a 21% discount to the 20-year average of 11.0x. At a company level, every single stock in our coverage universe is also trading below its 20-year EV/EBIT average, with ABB, Assa Abloy and Siemens at the biggest discounts, of over 50%.

In absolute terms, Electrolux is trading on the lowest current EV/EBIT multiple, of 6.7x 2011E. However, as we believe that our 2011E margins at Electrolux are less sustainable than across the rest of our coverage (given the poor supply-side characteristics of the appliance industry competitive landscape) and we argue that Electrolux is lower growth, we are not tempted to be sucked into optically cheap multiples, in this instance.

P/E

Fig 306: Sector is trading on a 20% discount to 20-year P/E history

0x5x

10x15x20x

25x30x

35x40x


2011

E P/

Evs

20

Year

Ran

ge a

nd A

vera

ge



As with EV/EBIT multiples for the sector, a similar picture can be observed on P/E, where our coverage is trading on 11.7x 2011E earnings. This represents a substantial 18% discount to the 20-year average of 14.2x.



Valuation

The de-rating has even occurred while government bond yields fell

As shown in Fig 302, the sector has de-rated over time with the market being prepared to pay less per unit of future profit today than in the past. Both P/E and EV/EBIT multiples are predominantly driven by future profit growth prospects (whether top-line or margin) beyond the year in question (2011E).

Overlaying some complexity, we might also expect the risk-free rate to also have some impact on equity multiples. To highlight the degree to which this has not been the case, and how much the reverse of what the text books would have predicted, has actually occurred, we have plotted the P/E of the ten-year Eurobond (the P/E being the inverse of the yield) against the 20-year sector P/E in Fig 302. Over a period when the yield on risk free assets has fallen from 7.6% to 3.2%, the sector has de-rated, with its earnings yield (the inverse of the P/E) increasing from 5.8% to 9.6%. The sector is now returning three times that of risk-free assets, a 20-year record.

So what is this de-rating telling us?

This de-rating indicates the market is more cautious about profit growth beyond 2011E, than it has been on average for the past 20 years. Looking into the annual data, the market is more cautious today regarding the sustainability (or potential future growth) of 2011E than its was for any other year in the past 20 years, except 1995 and 2008 where multiples fell lower. The picture is the same for EV/EBIT.

Current sector multiple is saying that 2011 is a year of peak margins

Interestingly, both 1995 and 2008 were years when the markets saw expectations for future growth and margins fall significantly. Comparably, fears exist today in the market that the global growth equation is precariously balanced and that stretched government budgets will lead to public spending cuts that cannot be fully replaced by expansion from the private sector. In a nutshell, we are more optimistic given the premise of this report, i.e. that margins are underpinned by supply-side factors and will reach new peaks and that growth will continue to benefit from emerging markets and global infrastructure needs. As such, we believe the sector is undervalued and has the potential to re-rate looking forward.

We have shown our historic multiples detail in full in Fig 307.



Valuation

Fig 307: 1990-2012E EV/Sales, EV/EBIT and P/E multiples

EV/Sales 1990 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E20 Yr Min

20 Yr Max

20 Yr Avg

2011 vsAvg

ABB 0.7 0.7 2.1 1.7 0.9 0.6 0.8 0.8 1.4 1.9 1.5 1.1 1.4 1.3 1.2 0.4 2.1 1.1 19%

Alstom 0.8 0.7 0.6 0.5 0.5 0.7 1.0 1.3 1.1 0.9 0.8 0.8 0.7 0.5 1.3 0.9 -9%

Assa Abloy 0.7 4.6 3.0 2.2 1.7 1.8 1.8 2.0 2.0 1.4 1.4 1.7 1.5 1.3 0.7 6.4 2.3 -36%

Atlas Copco 0.7 0.9 1.4 1.3 1.2 1.2 1.3 2.1 2.2 2.5 1.8 1.8 2.0 1.6 1.3 0.7 2.5 1.4 16%

Electrolux 0.3 0.4 0.3 0.3 0.3 0.3 0.4 0.4 0.5 0.3 0.4 0.4 0.4 0.4 0.3 0.5 0.4 8%

Invensys 0.9 0.9 0.9 1.1 0.9 1.0 1.2 1.2 1.1 0.9 1.2 1.0 21%

Sandvik 0.8 1.1 1.4 1.4 1.4 1.4 1.5 1.6 1.7 2.1 1.5 1.5 1.7 1.5 1.4 0.8 2.1 1.4 8%

Schneider 1.2 1.5 1.5 1.4 1.3 1.3 1.5 1.6 1.7 1.3 1.3 1.4 1.3 1.2 0.7 1.7 1.3 -1%

Siemens 0.5 0.4 1.0 0.7 0.6 0.5 0.7 0.8 1.0 1.1 0.9 0.7 0.9 0.8 0.7 0.4 1.1 0.7 19%

SKF 0.8 0.7 0.7 0.6 0.8 0.8 0.8 0.9 1.1 1.2 0.9 1.0 1.1 1.0 1.0 0.6 1.2 0.9 22%

Sector Median 0.7 0.7 1.4 1.3 0.9 0.8 0.8 0.9 1.2 1.5 1.2 1.1 1.3 1.2 1.1 0.7 1.5 1.0 22%Sector Average 0.7 0.7 1.6 1.2 1.0 0.9 1.0 1.1 1.3 1.5 1.2 1.1 1.3 1.1 1.0 0.7 1.8 1.1 7%

EV/EBIT 1990 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E20 Yr Min

20 Yr Max

20 Yr Avg

2011 vsAvg

ABB 10.9 10.0 35.5 59.6 92.0 40.6 13.9 9.3 11.9 13.7 9.6 8.2 9.7 8.7 7.6 6.9 92.0 22.1 -61%

Alstom 10.5 10.1 36.4 18.1 13.3 13.4 14.5 15.9 12.9 9.6 9.6 8.7 7.5 9.6 36.4 14.8 -41%

Assa Abloy 9.0 31.2 21.5 15.6 11.9 12.6 12.0 13.0 12.2 8.8 8.9 10.0 8.3 7.2 8.8 47.3 16.7 -50%

Atlas Copco 7.9 7.5 9.3 9.2 10.6 9.3 9.1 12.8 12.2 13.2 9.3 11.7 11.6 8.7 6.7 6.4 13.2 10.1 -14%

Electrolux 6.1 6.6 6.3 4.6 4.3 6.1 9.6 9.4 11.1 23.5 7.5 7.6 6.7 5.9 4.3 23.5 8.5 -21%

Invensys 12.9 11.6 10.1 9.7 8.0 9.3 10.3 9.2 8.1 8.0 12.9 10.3 -10%

Sandvik 6.4 6.3 10.7 10.3 11.8 11.8 10.4 10.5 10.2 12.6 9.1 67.4 17.6 10.6 8.7 6.3 67.4 14.1 -25%

Schneider 16.5 9.9 11.2 9.2 8.3 10.4 10.4 10.4 10.9 7.9 10.0 9.5 8.2 7.3 7.7 15.8 10.0 -19%

Siemens 21.2 11.0 31.7 17.6 16.2 15.1 16.8 17.7 18.0 11.8 8.6 7.3 9.0 7.2 6.4 7.3 32.5 16.6 -57%

SKF 11.9 6.2 7.4 6.7 7.8 8.8 7.3 7.5 9.6 9.2 7.4 12.7 11.1 9.1 8.2 0.0 23.8 9.6 -5%

Sector Median 10.9 8.2 10.5 10.3 11.8 11.8 11.5 11.1 11.2 12.0 8.9 9.4 9.9 8.7 7.4 8.2 14.2 11.0 -21%Sector Average 11.6 9.1 17.0 16.9 22.7 14.2 11.3 11.5 11.9 12.0 10.5 15.2 10.6 8.5 7.4 9.0 22.6 13.6 -37%

P/E 1990 1995 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E20 Yr

Min20 YrMax

20 YrAvg

2011 vsAvg

ABB 43.6 24.1 54.1 20.9 25.4 16.3 14.3 13.5 15.9 14.9 13.3 13.5 106.1 37.3 -60%

Alstom 8.5 8.5 75.8 18.9 20.5 16.3 10.2 11.0 10.3 9.3 8.5 75.8 20.4 -49%

Assa Abloy 11.7 44.0 27.0 19.0 12.4 15.2 14.6 15.3 16.5 9.9 10.5 12.7 11.0 10.2 9.9 77.9 22.4 -51%

Atlas Copco 13.3 8.5 12.0 11.2 13.2 12.0 12.3 19.5 9.1 18.5 10.1 14.6 15.9 12.7 11.4 7.5 19.5 13.2 -3%

Electrolux 9.1 4.2 6.6 6.8 5.4 5.3 4.8 5.8 8.0 12.9 32.8 8.1 9.1 8.3 7.7 4.2 32.8 9.7 -15%

Invensys 13.1 10.0 5.8 7.8 8.3 10.6 13.6 12.6 11.6 5.8 13.6 9.9 28%

Sandvik 6.7 9.6 15.5 13.5 15.2 15.1 12.9 13.1 13.1 15.7 9.4 125.2 23.2 13.5 10.8 6.7 125.2 20.3 -33%

Schneider 27.6 11.3 11.1 12.3 8.6 9.6 14.0 13.0 13.2 12.9 8.5 12.4 11.5 10.1 9.2 8.0 39.4 16.0 -37%

Siemens 20.1 11.5 46.3 19.7 21.2 18.4 17.3 19.9 19.0 14.7 9.6 9.1 12.1 9.7 8.9 9.1 48.3 19.2 -49%

SKF 17.4 7.4 9.5 8.6 9.7 10.2 10.0 9.3 12.2 12.7 8.6 14.6 14.8 12.4 11.2 7.4 23.2 11.8 5%

Sector Median 17.4 10.4 12.0 11.7 13.2 12.0 13.0 13.8 13.1 15.2 9.7 11.5 13.2 11.7 10.5 9.7 21.8 14.2 -18%Sector Average 19.7 11.0 23.1 13.4 13.2 11.9 12.4 20.2 14.0 14.9 12.8 22.9 14.0 11.6 10.4 10.9 29.7 18.1 -36%

Data are calculated using historic average annual share prices and current prices for perspective years. We have excluded non-meaningful data historically (e.g. when companies have gone into loss or have very small absolute levels of profit, lifting the multiple heavily). Due to space constraints we have removed eight years from the 1990s but the 20-year maximum, minimum and average data has been calculated using the full 20-year dataset Source: Redburn Partners

EV/IC vs ROIC/WACC, our core framework Our primary valuation methodology and the basis of our target price framework is an EVA (Economic Value Added) based approach. We believe a ROIC-based analysis in a capital intensive sector such as European Capital Goods is more appropriate than a DCF-based approach, which is more heavily dependent on terminal values and future growth assumptions.



Valuation

We believe valuations should ultimately be driven by the productivity of the capital put to work (here defined by ROIC). Economic theory suggests that the valuation of the invested capital (EV/IC) should be directly proportionate to the real economic returns (ROIC/WACC) an enterprise generates. So if a company is expected to exceed its WACC by 50% in every year to perpetuity, then it should trade at 1.5x its invested capital.

Fig 308: 20-year historic back-test shows EV/IC has strong correlation with ROIC/WACC

R2 = 0.9484

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x 4.0x 4.5x

1990-2009 ROIC/WACC

1990

-200

9 EV

/IC

Relative Undervaluation

Relative Overvaluation

45° lineEV/IC = ROIC/WACC

1990-2009 EV/IC vs ROIC/WACC for our coverage universe. 200 data points for 10 companies over 20 years Source: Redburn Partners

In Fig 308, we have plotted a 20-year history of EV/IC vs ROIC/WACC for all ten of our companies. A simple, ordinary least squares, regression analysis exhibits a compelling R-squared of 0.95x across the 200 data points, suggesting there is a very high correlation between the year one valuations of invested capital (EV/IC) and the economic returns (ROIC/WACC) generated by our coverage universe over the past 20 years. In short, EV/IC vs ROIC/WACC works.

Interestingly, the relationship is not entirely linear and the evidence suggests that those companies generating top quintile returns trade on a slight EV/IC premium (and more so when the high return is sustained for longer periods of time) and those generating bottom quintile returns also trade on a slight premium (supported by the option value that returns will improve), suggesting a slight overall 45 degree U-shaped relationship.

By solving the equation, EV/IC = ROIC/WACC for EV, we can derive an implied equity value by deducting/(adding) the adjusted net debt/(cash).

Out target prices are driven by two factors: (1) our year two estimates (2011E), and (2) our DCF-style, long-run ‘Dynamic Economic Profit’ scenario.



Valuation

Fig 309: Year two (2011E) EV/IC vs ROIC/WACC, our valuation cornerstone

ABB

Alstom

Assa Abloy

Atlas Copco

Electrolux

Sandvik

SchneiderSiemens

SKF

y = 0.8658x - 0.1874R2 = 0.971

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x 4.0x 4.5x

2011E ROIC/WACC

2011

E EV

/IC

Relative Undervaluation

Relative Overvaluation

45° lineEV/IC = ROIC/WACC


Using this economic profit based approach we have shown the calculation of our target prices in Fig 310. We have broken out the workings for our year two component (based on the data shown in Fig 309, above); the approach is identical for our five-year through cycle component.

Fig 310: 2011E fair values based on EV/IC = ROIC/WACC

Company Currency

2011Einvested

capital(IC)

2011EROIC

2011EWACC

Implied EV

Adjusted netdebt/(cash)

Equity fairvalue

Shares inissue

(FD, m)

2011E fairvalue per

share

ABB $ and SFr 12,468 29.6% 7.2% 50,919 -3,150 54,068 2,291 SFr25.7

Alstom € 8,901 17.7% 6.8% 23,131 4,187 18,944 292 €65.0

Assa Abloy SKr 36,794 13.8% 7.0% 72,481 7,374 65,107 373 SKr174.6

Atlas Copco SKr 44,502 23.9% 7.2% 146,906 2,375 144,532 1,230 SKr117.5

Electrolux SKr 34,686 13.9% 7.2% 67,514 3,572 63,942 284 SKr224.8

Invensys £ and p 721 33.7% 7.2% 3,387 203 3,184 809 394p

Sandvik SKr 77,710 11.5% 6.3% 141,471 32,894 108,577 1,187 SKr91.5

Schneider Electric € 21,659 10.3% 6.7% 33,183 4,965 28,218 253 €111.6

Siemens € 58,406 11.8% 6.9% 100,184 4,105 96,080 874 €110.0

SKF SKr 34,116 14.0% 6.8% 70,148 11,259 58,889 455 SKr129.3




Valuation

Fig 311: 2000-12E Return on Invested Capital (ROIC) detail, by company

ROIC 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

ABB 9.2% 2.7% 0.3% 6.8% 8.3% 16.9% 29.7% 40.2% 45.5% 27.4% 26.9% 29.6% 29.3%

Alstom 10.4% 19.5% 13.1% -2.7% -3.7% 1.6% 9.6% 15.0% 22.2% 27.7% 28.9% 19.2% 17.3%

Assa Abloy 10.2% 8.8% 8.9% 3.6% 9.9% 10.3% 7.2% 12.6% 8.8% 8.7% 12.2% 13.8% 14.7%

Atlas Copco 9.5% 9.3% 10.1% 11.7% 15.5% 11.7% 21.3% 30.1% 24.6% 16.2% 20.7% 23.9% 25.1%

Electrolux 8.7% 3.3% 7.9% 14.5% 10.0% 1.5% 9.1% 12.1% 2.9% 9.5% 13.9% 13.9% 14.2%

Invensys 12.9% 22.5% 27.3% 31.9% 27.8% 27.9% 32.1% 34.3%

Legrand 14.7% 12.1% 9.2% 7.6% 6.2% 7.1% 10.5% 10.7% 10.8% 8.3% 8.0% 8.7% 9.2%

Sandvik 11.3% 10.8% 10.5% 8.9% 13.3% 14.7% 16.7% 17.6% 15.1% -0.4% 6.5% 11.5% 13.1%

Schneider 13.9% 10.3% 14.6% 11.7% 8.7% 9.6% 11.2% 12.0% 10.8% 6.9% 9.2% 10.3% 11.0%

Siemens -1.8% 7.9% 5.4% 5.0% 6.2% 6.5% 4.7% 10.1% 8.6% 11.4% 9.9% 11.7% 12.0%

SKF 9.8% 10.7% 12.0% 10.3% 14.5% 15.2% 14.3% 19.0% 16.8% 7.7% 12.5% 14.0% 14.6%

Sector median 10.0% 9.8% 9.7% 8.2% 9.3% 10.3% 11.2% 15.0% 15.1% 9.5% 12.5% 13.9% 14.6%


We have tabled the individual annual ROICs for each company between 2000 and 2012E in Fig 311 above and graphed the ROIC/WACC ratios for the same period in Fig 312 below. We have used a constant Beta of 1.0x and an ERP (Equity Risk Premium) of 4.0% across all stocks, and as such the differences between WACCs are purely gearing driven. We have also used our forecast company tax rates and not constant tax rates to calculate our ROICs.

Fig 312: 2000-12E ROIC vs WACC, by company

-1

0

1

2

3

4

5

6

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

ROIC

/ W

ACC

ABB Alstom Assa Abloy Atlas Copco Electrolux

Invensys Sandvik Schneider Siemens SKF




Valuation

DCF-style, long-run ‘Dynamic Economic Profit’ scenario

Fig 313: 2011E P/E vs 10 Year Average Organic Sales Growth (%)

SKF

SiemensSchneider

SandvikInvensys

Electrolux

Atlas CopcoAssa Abloy Alstom

ABB

4x

6x

8x

10x

12x

14x

16x

0% 1% 2% 3% 4% 5% 6% 7% 8%

10 Year Average Organic Sales Growth

2011

E P/

E


The advantage of using year two spot multiples is the relative accuracy vs the more subjective longer-term dynamic valuations (such as DCF) that rely heavily on long-term growth assumptions. However, while using 2011 EV/IC vs ROIC/WACC captures variations in growth from now until 2011E, its snapshot nature fails to capture growth variations thereafter. This can mean that year two multiples trade with a relatively tight range despite significant variations thereafter. This is shown by Fig 313, where we have plotted 2011E P/E (ranging by 43% from 9.7x to 13.9x) against the sector’s ten-year average organic sales growth (ranging by 383% from 1.8% to 6.9%). This chart also highlights why we are buyers of ABB, Siemens, Atlas Copco and Alstom. Our Buy on Assa Abloy is based on our supply-side margin story.

To resolve this we have introduced an element of growth into our target prices. We have constructed a long-run (50-year) dynamic economic profit based valuation scenario, akin to a DCF, for each of the ten stocks under our coverage to try to capture the value of the sector’s significant variance in growth between companies. However, instead of estimating long run growth rates subjectively, we have deferred that role to history and used the ten-year average organic sales growths of each company. Our margin assumptions are based on the five-year average clean EBIT margins between 2008 and 2012E. Our assumptions are shown in the table (Fig 314) below.

Fig 314: Assumptions for our dynamic economic profit valuation approach

2008-12E average clean EBIT margin Ten-year average organic sales growth (2000-09)

ABB 14.6% 6.9%

Alstom 8.7% 4.8%

Assa Abloy 16.9% 4.2%

Atlas Copco 17.8% 6.1%

Electrolux 5.1% 1.9%

Invensys 12.1% 2.2%

Legrand 17.9% 2.2%

Sandvik 11.8% 5.0%

Schneider 15.1% 3.8%

Siemens 10.0% 5.0%

SKF 10.8% 3.6%


From these assumptions, we have calculated the economic profit ((ROIC-WACC)* Invested Capital) for each company for each year for 50 years. Then, using the WACC,



Valuation

we have discounted back all future years to provide an equity NPV per share for each company. The resulting upsides/(downsides) to the current share price are shown in the chart (Fig 315) below.

Fig 315: Upside/(downside) to current share price from dynamic Economic profit analysis

126% 110%93%

52%

-33% -38%-28% -30%-23%

205%

-100%

-50%

0%

50%

100%

150%

200%

250%

ABB AtlasCopco

Alstom Siemens AssaAbloy

Electrolux Schneider Sandvik SKF Invensys


This exercise serves to highlight the value of growth and how little it is captured in the relatively tight multiple range for 2011E. If each company were to fulfil our assumptions for 50 years, then on average, with perfect hindsight the sector is currently trading 43% below its fair value. On this basis, our five Buys (ABB, Siemens, Atlas Copco, Alstom and Assa Abloy) would have an average 117% upside to their current share prices.

This long-run scenario is designed to show the potential longer-term upside, the call option value, if you like, for the higher growth companies in the sector (which in general we prefer). However, by fixing both margins and capital intensity, this scenario analysis makes a number of crude assumptions, which collectively assume some companies will be able to generate premium returns (over their WACC) for the next 50 years. While the textbooks would argue against this, we note that premium returns have been achieved by many of our companies for the last 50 years. Furthermore, given the replacement cost of capital is arguably so much higher than the accounting-based invested capital, perhaps the potential returns for new entrants are not as high as they are for the long-established fully depreciated incumbents. As such, we believe that the incentive for new entrants to enter the market and compete away premium returns is perhaps less than the headline ROIC/WACC spreads may suggest.

Western world for free One of the core axioms of our sector view is that demand growth will continue to be underpinned by both emerging market and infrastructure growth. However, based on the sector’s multiples compared to its emerging market peers, we also believe that when investors look at European quoted Capital Goods names, they are blinded by the location of quotation. The valuation suggests they only see European companies with European cost bases and European demand drivers. The reality is very different, with most companies operating local emerging market operations competing across the street from the locals.

We have conducted a very simple regional sum-of-the-parts, for the sector, valuing both the Western profit stream and the emerging market profit steam independently. If we apply the average emerging market multiple (of 24x 2011E P/E) for the sector’s direct competitors to the sector’s 2011E emerging market net income, then we get the entire Western side of the sector (58% of net income, on average) for free!



Valuation

From our supply-side competitive analysis, we have identified 30 quoted emerging market companies from China, India and Korea that compete directly with our coverage in one or more of the sector’s ten largest industry pillars. We have included a broad spectrum of industries, including Haier, China’s leading appliance maker (which, despite being one of the tougher industries, is still trading on 19x 2011E P/E) as well as the sector’s quoted Indian subsidiaries: ABB India, Alstom AAP Project India and Siemens India (which are trading on 25x 2011E P/E on average).

Based on Bloomberg consensus data we have constructed a 2011E P/E for each. Taking a simple average of the lot, we calculate that emerging markets are trading on 24x 2011E P/E.

Fig 316: Emerging market peers trading on 24x

0

10

20

30

40

50

Guod

ian

Zeng

zhou

Data

ngAB

B In

dia

Nari

Sanb

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angh

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ompt

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Xiam

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arat

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TBEA

Guan

gdon

gSu

ntec

h

Qing

dao

Alst

om In

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Huan

eng

Doos

an

Dong

fang

Guan

gxi

Shan

ghai

Chin

a Co

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2011

E P/

E R

atio

Emerging Market quoted Capital Goods peers are trading on an average of 24x

Source: Bloomberg

On average our coverage universe has 38% of group revenues exposed to emerging markets. While we do not know the exact emerging market share of sector EBIT, because of lack of disclosure, we have estimated that it is 42%. Our assumption is based on the average differential between Western and emerging market margins for the five companies that provide regional margin disclosure and where emerging markets are marginally more profitable. We have assumed the split of net income is also 42%, however, we believe this may underestimate the true level of emerging market net income on the basis that most tax regimes in emerging markets are less onerous.

Fig 317: Implied valuation for sector’s Western net income

2011E

Sector net income (€m) 14,068

Proportion of sector net income in emerging markets 42%

Sector emerging market net income (€m) 5,909

Average emerging market peer 2011E P/E multiple 24.0x

Implied value of sector's emerging market net income (€m) 141,807

Current sector market cap (€m) 140,892

Implied value of sector's Western net income stream (€m) -915


Applying the 24x 2011E emerging market multiple to the sector’s 2011E net income gives an implied value of €142bn, just above the current €141bn combined market cap of our sector. Even the most sceptical investor must surely struggle to argue that the sector’s European and US exposure warrants a negative valuation.



ABB (ABBN VX, Buy, target SFr30)

Compared to the leading local Chinese T&D manufacturers, which are trading on 25x 2011E P/E, ABB (the global and Chinese number one T&D manufacturer), is trading on 13.7x 2011 P/E. We think this is a cheap multiple for an emerging market company (and ABB is that) and one of the fastest growing large cap industrials in the world. We like ABB’s supply-side positioning and attractive demand exposures and rate the stock a Buy, with a SFr30 target price.

Fig 318: 2009 ABB group revenues split by division, geography of destination and end market

Europe40%

Americas20%

Asia/ Australia

28%

Africa/ Middle East

12%

Marine7%

Oil & Gas10%

Rail4%Other

Process19%

Industrial18%

Construction6%

Power /T&D36%

Robotics3% Power

products32%

Power systems

19%

Automationproducts

25%

Process automation

21%


There are five main arguments to our Buy case:

Compelling supply-side dynamics: despite continuous concerns regarding competitive threats, its dominant 23% market share has lifted from 19% in 2002. In addition, the T&D industry has experienced an attractive period of supply-side consolidation, with the top five increasing their collective share by a substantial 21% since 1996 to 63% in 2010;

Strong growth mix: ABB has the best combined geographic (56% emerging) and end-market (69% infrastructure) mix of our coverage, which is why it has demonstrated the highest organic sales growth in our coverage over almost any period, and why we expect it to continue to generate premium growth over the longer term;

Strong balance sheet: ABB is sitting on a $7bn net cash pile, so we believe ABB could finance a $20bn acquisition (or special dividend), which (at 10x EV/EBITDA) would be 44% earnings accretive and would lower the P/E to c9x in 2011E;

Highest cost savings: due to Mr Hogan’s over-delivery of savings, ABB has moved dramatically up the savings leader board and will generate the highest cost savings in 2010E, at 5.8% sales, more than twice the second highest saver (Sandvik) and four times our coverage average; and

2011E EPS above consensus by 18%: despite our forecast for the already very challenging 2009 price environment (-3.5% net) to deteriorate in 2010E (to -4.2% net).

ABB is not without its risks, notably the current price environment and increased T&D competition (especially in emerging markets, particularly China). However, we believe the China concerns are overplayed, as evidenced by ABB’s ability to retain its 13% local Chinese market share (twice that of XD Group, the number two) in the face of a decade of intense T&D competition. Importantly, with Chinese margins above the group average, this market share has not been bought.





High growth revenue mix

Over the last decade ABB has enjoyed the highest organic sales growth (+7.1%) of all the companies under our coverage. This can be explained by the company’s very favourable exposure to both emerging markets and infrastructure end markets. In 2009 ABB had the highest exposure to emerging markets of our coverage, with a whopping 57% of its global revenues generated outside of the West (including 9% in Eastern Europe and Russia, 12% in China, 6% in India and 2% in Brazil). Furthermore, at 69% of its 2009 sales, ABB also has one of the highest exposures to the infrastructure end markets in our coverage (at 65%), predominantly T&D, power, rail, oil & gas, steel and mining (as shown above).

We believe that, because of the compelling combination of both its geographic and end-market mix, ABB will continue to experience some of the highest organic sales growth in the sector. We do not believe this premium growth is fully reflected in the company’s 13x 2011 P/E rating.

Fig 319: ABB ten-year OSG of 7.1%, top of coverage universe Fig 320: Portfolio mix has changed dramatically

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

1990 1993 1996 1999 2002 2005 2008 2011E

Orga

nic

Sale

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owth

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Sector Average ABB

0%2%4%6%8%

10%12%14%16%18%

1990 1993 1996 1999 2002 2005 2008 2011E

Clea

n EB

IT M

argi

n (%

)

Sector Average ABB


ABB (+16% OSG) has outgrown the sector (+10% OSG) in emerging markets

Over the past seven years (i.e. the extent of ABB’s regional organic disclosure), ABB’s emerging market operations have averaged +16% organic sales growth a year, compared to our coverage universe, which has averaged an attractive, but materially lower, +10% over the same period. While ABB’s Western operations (which have averaged +4% over the same period) have marginally outgrown the sector in the West (our coverage has averaged +2.5% over the same period), its premium growth has been driven, not only by its very high (56%) share of revenues to emerging markets, but also by the fact that ABB has outgrown our coverage in emerging markets. Based on long-term Chinese, Indian and other emerging market government investment plans, we believe that emerging market electrical grid infrastructure will continue to be a premium source of growth even within the relatively attractive emerging market growth universe.




Fig 321: ABB’s annual organic sales growth by region

-20%-10%

0%10%20%30%40%50%60%

2003 2004 2005 2006 2007 2008 2009

Sale

s Gr

owth

in L

ocal

FX

(%)

Europe Americas Asia/ Australia Africa/ Middle East


T&D growth has outstripped automation

Disaggregating ABB’s global organic sales growth from a divisional perspective highlights that the T&D side of ABB (which we classify as being an infrastructure end market) has materially outgrown the automation side of ABB (which we classify as facing macro-dependent end markets). Over the same seven-year period, ABB’s two T&D-based businesses (power products (PP) and power systems (PS)) have seen 12% organic sales growth compared to the three automation-based businesses (automation products (AP), process automation (PA) and robotics), which have seen 7% organic sales growth.

Supply-side analysis: ABB is well positioned but competitive pressures increasing

ABB scores relatively well in our supply-side analysis (see scorecard in Fig 41). This is partly because of its leading 23% market share in the relatively concentrated global €55bn transmission & distribution (T&D) industry.

The T&D industry has experienced significant consolidation over the past few decades as national champions developed and then integrated to create international market leaders. The industry has experienced a wave of emerging market new entrants (predominantly from China), which have increased competitive pressure and damaged pricing power in the recent downturn.

Pricing remains a risk

After favourable pricing between 2003 and 2008, helped by both the industry consolidation of the 1970s, 1980s and 1990s (see T&D chapter), falling prices in current order books will meet rising cost inflation in 2010E, we have factored this in to our estimates).

China, a growth engine with competitive threats

China now represents a third of the global T&D market and ABB has kept pace with the locals, which have grown c30% over the past ten years. Competitive pressures are an issue but we believe ABB’s ability to retain share over the last decade, combined with its dominant and cost effective local presence will protect its 13% market share. We have discussed this in a lot more detail in our T&D chapter.

Automation faces tough 2010E

All three automation businesses saw a heavy order decline in 2009 (c-21% organically). We expect the shorter cycle low voltage (LV) and discrete automation (DAM) businesses to see recovery earlier and for process automation (PA) to remain an order and revenue growth drag in 2010.




New CEO has been far more decisive than initial concerns suggested

It is now a year and half since ABB’s board, chaired by Hubertus von Grünberg, replaced Fred Kindle with Joe Hogan as CEO in July 2008. Despite some initial concerns (surrounding the seemingly unplanned nature of the leadership change), Mr Hogan has tackled a tough volume and price environment with some of the most aggressive cost-cutting action in the European Capital Goods sector. So far so good.

ABB to achieve the highest 2010E cost savings of our coverage, 2x the next best

At 4Q09 ABB raised its current cost-cutting programme, from $2bn of savings by 2010E by 50% to $3bn by 2010E. We forecast ABB to exceed this by $300m and to achieve $3.3bn. Using our estimates, this represents the second largest cost-savings programme in the sector at an average of 5.2% of sales between 1Q09 and 4Q10, just below Sandvik at 5.6%. In fact, excluding the 2009 savings (i.e. those already achieved), ABB’s outstanding 2010E saving of $1.8bn (at 5.8% of 2010E Sales), is by far the biggest relative savings programme in the sector for 2010E, at over twice that of the second largest, Sandvik (at 2.6%), and four times that of our coverage average (1.4%).

2009 cost savings needed to battle worryingly high organic drop-through

ABB’s incremental margins in 2009 were poor. We can see this from our bridging analysis of ABB’s 2009 sales and EBIT, below.

Fig 322: ABB 2009 sales bridge Fig 323: ABB 2009 EBIT bridge

34,912

31,795270

-1,639

-1,749

30,000

31,000

32,000

33,000

34,000

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2008 Sales OrganicSales

Growth

FX Impact StructureImpact

2009 SalesAB

B 2

009

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ridg

e ($

mn)

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4,2281,500 90

-106-2,6702,0002,5003,0003,5004,0004,5005,0005,5006,000

2008EBIT

OrganicEBIT

Growth

FXImpact

CostSavings

StructureImpact

2009EBIT

AB

B 2

009

EBIT

Bri

dge

($ m

n)


In 2009 ABB experienced a -5% (or $1.75bn) organic sales decline, excluding the c5% currency hit and c1% boost from acquisitions. Under normal circumstances we would expect ABB to see roughly 50% of this $1.75bn decline drop through to EBIT (operational gearing is usually worse in organic sales decline). If this had been the case in 2009, then organic EBIT would have fallen by only c$900m. However, looking at Fig 323, we can see that, allowing for the company’s $1.5bn of savings (and some small currency and acquisition impacts), the actual degree of organic EBIT drop-through was close to a much higher $2.7bn, which represents a massive 153% organic drop-through on the decline in organic sales.

Poor 2009 decremental margin explained by aggressive net price erosion

This excessive decremental margin is a worry and shows just how much the savings were needed.




Fig 324: ABB 2009 EBIT bridge (company detail) Fig 325: Our 2010E forecast for ABB EBIT bridge

-2.0%

13.3%15.5% 4.5%

-3.5%

-1.0%

-0.6%

6%

8%

10%

12%

14%

16%

2008 Volume Price Mix Savings Other 2009

AB

B 2

009

EBIT

Bri

dge

($ m

n)

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5.8%13.3% 14.2%

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12%

14%

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2009 Volume Price Mix Savings Other 2010E

AB

B 2

010E

EB

IT B

ridg

e ($

mn)

Source: ABB Source: Redburn Partners

ABB’s helpful bridge analysis (replicated in Fig 322 above) explains how EBIT fell so much (excluding the savings). Examining the (normally undisclosed) components of organic EBIT change (i.e. the volume, price and mix effects), we can see that -2% margin impact (or c$600m of EBIT decline) was due to volume (a 40% decremental margin, more in line with the level we would normally have expected) and a very substantial (and concerning) -3.5% margin impact, or c$1.1bn, was due to ‘gross’ price (before the impact of raw material cost).

We expect this gross price headwind to worsen in 2010E to -4.2% (see our bridge forecast for 2010E in Fig 323 above) and given the sharp increase in copper towards the end of 2009 this poses some margin risk. However, we believe this issue is well known and understood by the market and is captured in our forecasts.

Strong balance sheet

As mentioned above, ABB finished 2009 with a company-defined net cash of $7bn, equating to c1.5x EBITDA. Given this, we would argue that ABB could afford to spend up to $20bn on acquisitions (c2.5x net debt/EBITDA). Assuming ABB could acquire a 10x EV/EBITDA with all $20bn, such a deal would be 44% earnings accretive and would put ABB on c9x 2011E P/E.

We can also see a similar upside in valuation just from returning the cash to shareholders. Running a cash-adjusted P/E, assuming a $20bn special dividend (cSFr9.5 per share) and $800m of extra interest expense, ABB could lower its 2011E P/E from c13x to c10x.

Valuation

In terms of valuation, ABB is trading on 13.7x 2011E P/E (a 13% premium to the sector), a 2.3% 2011E dividend yield, and 8.7x 2011E EV/EBIT (in line with the sector). Given the company’s high emerging market exposure and forecast longer-term growth profile, we see this as an attractive entry point.




Fig 326: ABB vs sector EV/Sales Fig 327: ABB vs sector EV/EBIT Fig 328: ABB vs sector P/E

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Current earnings Issues

We forecast a -3% organic sales decline in 2010E, recovering to +7% in 2011E. In terms of profitability, we expect $1.8bn of 2010E cost savings to exceed another significant (-4.2%) net price headwind, leading to a 90bp increase in clean EBIT margins from 13.3% to 14.2%. This leads to our 2010E reported EPS (fully diluted) of €1.17, some 11% ahead of consensus ($1.06). Given our more optimistic top line in 2011E, our 2011E EPS (FD) of $1.49 is 18% ahead of consensus.

Fig 329: Our 2011E EPS for ABB of $1.49 is 18% ahead of consensus ($1.27)

A B B R edburn EPS vs. Consensus

11%

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Fig 330: ABB P&L with divisional detail, 2004-12E

ABB P&L (US$, December Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012EGroup Orders 21,185 22,364 27,048 34,348 38,282 30,969 28,843 31,110 32,732

Group Organic Order Growth 27% 16% 22% 21% 8% -16% -8% 8% 5%Group Book to Bill 1.05x 1.07x 1.16x 1.18x 1.10x 0.97x 0.93x 0.92x 0.92x

Power Products 5,622 6,185 7,275 9,777 11,890 11,239 10,732 11,700 12,402Power Systems 3,745 4,085 4,544 5,832 6,912 6,549 7,007 7,379 7,674Discrete Automation and Motion 3,769 4,138 4,460 5,414 6,588 5,410 5,549 5,921 6,158Process Automation 4,829 5,301 5,714 6,936 8,397 7,838 7,063 7,626 7,967Low-Voltage Products 2,872 3,153 3,398 4,125 4,747 4,070 4,045 4,306 4,478Non-core activities 1,668 415 382 424 0 0 0 0 0Corporate -2,355 -2,313 -2,493 -3,321 -3,597 -3,240 -3,240 -3,240 -3,240Group Sales 20,149 20,964 23,281 29,187 34,912 31,795 31,155 33,692 35,440

Power Products 16% 28% 17% -2% -5% 9% 6%Power Systems 10% 20% 16% 1% 6% 5% 4%Discrete Automation and Motion 16% 18% 13% -15% 2% 7% 4%Process Automation 8% 9% 17% 0% -10% 8% 4%Low-Voltage Products -25% 11% 11% -12% -1% 6% 4%Group Organic Sales Growth 10% 15% 10% 20% 17% -5% -3% 8% 5%

Group Structure effect on Sales (%) -15% -7% 0% -2% -1% 1% 0% 0% 0%Group Currency effect on Sales (%) 6% 1% 0% 8% 4% -5% 1% 0% 0%

Group Clean EBIT (Excl. NRIs) 1,091 1,834 3,090 4,057 5,413 4,228 4,429 4,912 5,419Group Clean EBIT margin (Excl. NRIs) 5.4% 8.7% 13.3% 13.9% 15.5% 13.3% 14.2% 14.6% 15.3%

Total Non-Recurring Items (NRIs) 0 -123 -38 -34 -861 -102 -500 0 0of which Restructuring 0 -123 -38 -23 -149 -537 -500 0 0of which Other 0 0 0 -11 -712 435 0 0 0

Power Products 514 600 939 1,596 2,100 1,969 1,873 2,152 2,398Power Systems 119 187 279 489 592 388 491 572 631Discrete Automation and Motion 382 490 780 836 1,066 555 632 921 1,004Process Automation 323 414 660 707 958 643 707 825 893Low-Voltage Products 318 408 650 696 819 521 607 822 874Non-core activities -26 14 65 9 -3 0 0 0 0Corporate -540 -401 -321 -310 -980 50 -380 -380 -380Group EBIT (Reported) 1,091 1,711 3,052 4,023 4,552 4,126 3,929 4,912 5,419

Power Products 9.1% 9.7% 12.9% 16.3% 17.7% 17.5% 17.4% 18.4% 19.3%Power Systems 3.2% 4.6% 6.1% 8.4% 8.6% 5.9% 7.0% 7.7% 8.2%Discrete Automation and Motion 10.1% 11.8% 17.5% 15.4% 16.2% 10.3% 11.4% 15.6% 16.3%Process Automation 6.7% 7.8% 11.5% 10.2% 11.4% 8.2% 10.0% 10.8% 11.2%Low-Voltage Products 11.1% 12.9% 19.1% 16.9% 17.3% 12.8% 15.0% 19.1% 19.5%Group Reported EBIT Margin (%) 5.4% 8.2% 13.1% 13.8% 13.0% 13.0% 12.6% 14.6% 15.3%

Financial income and expenses, net -209 -254 -160 -13 -34 -6 64 88 130Reported PBT 882 1,457 2,892 4,010 4,518 4,120 3,993 5,000 5,549Total tax -331 -464 -686 -595 -1,119 -1,001 -1,058 -1,325 -1,471

% Tax 37.5% 31.8% 23.7% 14.8% 24.8% 24.3% 26.5% 26.5% 26.5%Minorities -102 -126 -179 -244 -260 -235 -247 -257 -267Discontinued Income (Loss) -452 -127 -142 586 -21 17 0 0 0Other Non Recurring impact to Net Income 0 -5 0 0 0 0 0 0 0Reported Net Income -3 735 1,885 3,757 3,118 2,901 2,688 3,418 3,812Average number of (FD) shares (mn) 2,029 2,138 2,248 2,308 2,301 2,293 2,291 2,291 2,291Diluted EPS (US$) 0.00 0.34 0.84 1.63 1.36 1.27 1.17 1.49 1.66DPS (US$) 0.00 0.09 0.19 0.48 0.42 0.50 0.46 0.54 0.57

Diluted EPS (CHF) 0.00 0.43 1.05 1.95 1.47 1.37 1.23 1.56 1.74DPS (CHF) 0.00 0.12 0.24 0.48 0.48 0.51 0.48 0.57 0.60





Fig 331: ABB financial forecasts, performance metrics and valuation

ABB (December Y/E; US$ mn) ABBN VX Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth 8.4% -15.6% -8.1% 7.9% 5.2%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 17.5% -5.0% -2.9% 8.1% 5.2%

Orders 38,282 30,969 28,843 31,110 32,732 Sales growth 19.6% -8.9% -2.0% 8.1% 5.2%Revenue 34,912 31,795 31,155 33,692 35,440 Adj. EBITDA growth 30.4% -19.6% 5.4% 10.2% 9.7%

Gross profit 10,940 9,325 9,218 10,628 11,432 Adj. EBIT growth 33.4% -21.9% 4.8% 10.9% 10.3%EBIT (post-NRIs) 4,552 4,126 3,929 4,912 5,419 Adj. PBT growth 33.0% -21.5% 6.4% 11.3% 11.0%

Reported EBIT Margin (%) 13.0% 13.0% 12.6% 14.6% 15.3% Adj. EPS growth 5.0% -23.5% 5.2% 7.2% 11.5%

Net financial expense -34 -6 64 88 130 DPS growth -12.6% 20.2% -8.0% 18.4% 5.7%PBT 4,518 4,120 3,993 5,000 5,549Total tax -1,119 -1,001 -1,058 -1,325 -1,471 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 3,399 3,119 2,935 3,675 4,079 Gross profit margin 31.3% 29.3% 29.6% 31.5% 32.3%Minorities -260 -235 -247 -257 -267 Adj. EBITDA margin 17.4% 15.4% 16.5% 16.8% 17.6%Other (discont., prefs and other) -21 17 0 0 0 Adj. EBIT margin 15.5% 13.3% 14.2% 14.6% 15.3%Net income (all in) 3,118 2,901 2,688 3,418 3,812 Adj. PBT margin 15.4% 13.3% 14.4% 14.8% 15.7%

Adj. Net income margin 11.4% 9.5% 10.2% 10.1% 10.8%EPS (FD) 1.36 1.27 1.17 1.49 1.66DPS 0.42 0.50 0.46 0.54 0.57 Personnel costs / sales 25.3% 0.0% na na naWeighted avg shares (FD, mn) 2301 2293 2291 2291 2291 Depreciation and amort. / sales 1.9% 2.1% 2.3% 2.3% 2.3%

R&D / sales 2.9% 2.9% 2.9% 2.9% 2.9%Redburn (pre-restructuring) 2008 2009 2010E 2011E 2012E Effective tax rate 24.8% 24.3% 26.5% 26.5% 26.5%

Adj. EBITDA 6,074 4,883 5,146 5,671 6,223Adj. EBIT 5,413 4,228 4,429 4,912 5,419 Other items 2008 2009 2010E 2011E 2012E

Adj. vs. reported EBIT 861 102 500 0 0 Employees (average) 120,000 109,286 107,087 115,808 121,816Adj. PBT 5,379 4,222 4,493 5,000 5,549 Book to bill (orders / sales) 1.10 0.97 0.93 0.92 0.92Adj. Net income 3,979 3,033 3,188 3,418 3,812 Cash conversion (FCF / NI) 99.0% 130.4% 90.7% 55.2% 83.9%Adj. EPS 1.73 1.32 1.39 1.49 1.66 WC / sales 19.5% 22.1% 24.2% 26.7% 27.0%Adj. EPS (post-restructuring) 1.66 1.09 1.17 1.49 1.66 Inventory / sales 15.2% 14.3% 14.9% 15.6% 15.6%

Receivables / sales 26.5% 29.7% 30.4% 31.0% 31.1%Cash flow 2008 2009 2010E 2011E 2012E Payables / sales 16.4% 16.3% 15.7% 14.8% 14.6%

EBITDA 6,074 4,883 5,146 5,671 6,223 Capex / depreciation (inc intang) -1.77 -1.48 -1.37 -1.42 -1.41Provisions 720 -269 -38 -42 -43 Net debt (EV) / EBITDA -0.11 -0.51 -0.61 -0.66 -0.86Interest paid -34 -6 64 88 130Tax paid -1,119 -1,001 -1,058 -1,325 -1,471 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) -4,036 -4,786 -5,389 -6,034 -7,795Other 0 0 0 0 0 Mkt secs, leases and converts -1,407 -2,433 -2,433 -2,433 -2,433Operating cash flow pre-WC 5,641 3,607 4,114 4,392 4,840 Pension deficit (net of tax) 998 1,067 1,029 987 944Change in working capital -771 580 -725 -1,466 -548 Adjusted net debt -4,445 -6,152 -6,794 -7,480 -9,284Operating cash flow 4,870 4,187 3,389 2,925 4,292 Mins, assocs, advances, other 3,783 3,686 3,644 3,760 3,932Capex (PP&E and intangibles) -1,077 -931 -950 -1,038 -1,094 Net debt (EV) -662 -2,466 -3,150 -3,720 -5,352Acquisitions and disposals -608 -193 0 0 0Other -3,506 -4,934 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -5,191 -6,058 -950 -1,038 -1,094 Average / current share price 24.80 17.89 22.18 22.18 22.18

Dividends paid -1,212 -1,220 -1,337 -1,246 -1,439 Market capitalisation 52,509 37,732 46,752 46,752 46,752Other (incl. share capital) -569 97 0 0 0 Group EV 51,846 35,266 43,602 43,031 41,400Financing cash flow -1,781 -1,123 -1,337 -1,246 -1,439 P/E (pre-restructuring) 13.20 12.44 14.66 13.68 12.26

FX and other -204 214 0 0 0 P/E (post-restructuring) 13.71 15.12 17.39 13.68 12.26Reconciliation to basic net debt 4,366 3,530 -498 2 2 EV/Sales 1.49 1.11 1.40 1.28 1.17Net cash flow 2,060 750 603 644 1,761 EV/EBITDA 8.54 7.22 8.47 7.59 6.65

EV/EBIT (pre restructuring) 9.44 8.22 9.72 8.66 7.56FCF to the firm (post-tax) 3,827 3,262 2,374 1,799 3,068 EV/EBIT (post restructuring) 9.70 9.40 10.94 8.66 7.56FCF to equity (post-tax) 3,793 3,256 2,439 1,887 3,198 EV/IC 5.63 3.50 3.96 3.45 2.98

FCF yield (geared vs. M.Cap) 7.2% 8.6% 5.2% 4.0% 6.8%Balance sheet 2008 2009 2010E 2011E 2012E FCF yield (ungeared vs. EV) 7.4% 9.2% 5.4% 4.2% 7.4%Current assets 24,347 25,229 25,944 28,185 30,779Non-current assets 8,834 9,499 9,768 10,087 10,418 Economic profit 2008 2009 2010E 2011E 2012ETotal assets 33,181 34,728 35,712 38,272 41,197 Invested capital (average) 9,217 10,067 11,003 12,468 13,879

Current liabilities 16,004 14,579 14,165 14,296 14,581 NOPLAT 4,196 2,756 2,961 3,687 4,065Non-current liabilities 5,407 5,676 5,476 5,476 5,476 ROIC (post-tax) 45.5% 27.4% 26.9% 29.6% 29.3%Shareholders equity 11,158 13,790 15,141 17,314 19,687 WACC 8.0% 7.3% 7.2% 7.2% 7.2%Minorities and prefs 612 683 930 1,186 1,453 ROIC/WACC 5.70 3.77 3.72 4.08 4.04Total liabilities and equity 33,181 34,728 35,712 38,272 41,197 Implied equity value (per share) 23.2 17.7 19.2 23.8 26.8




Alstom (ALO FP, Buy, target €60)

We rate Alstom as a Buy, with a €60 target price. In particular, we like the company’s longer-term growth profile based on its 100% infrastructure exposure, and see the current valuation of 9.7x 2012E P/E (calendarised to December Y/E) as an attractive entry point. We believe Thermal orders have bottomed and that the Power division will benefit from its higher emerging market exposure. We are more cautious on the Transport division, where Alstom is c70% European exposed. Rail capex is almost entirely driven by government spending, and with most European countries currently facing stretched budget deficits, we are not optimistic for public spending based rail orders. In the longer term, we are more optimistic for rail as we see significant replacement needs and structural drivers behind high speed rail and urban transit.

Our Alstom estimates for FY12E are c12% ahead of consensus, based on our assumption of a return to revenue growth in 2012E, where we forecast 6% organic sales growth. These estimates have factored in a negative margin mix in 2011E,with Thermal Service (Alstom’s highest margin business) declining the most. We have also factored in a conservative €900m of working capital outflow in 2010E and €1.5bn in 2011E, driven heavily by customer advances as the advances are absorbed into work in progress in the weaker order environment. Unlike some, we are not overly concerned about Alstom’s customer advances as (1) Alstom has much less advances compared to last cycle; (2) marine is no longer at Alstom; (3) the group balance sheet was healthier going into this downturn; and (4) we already strip advances out of our EV calculation, taking the conservative approach.

Fig 332: 2011E Alstom group revenues split by division, geography of destination and end market (incl. Areva T)

Europe50%

RoW (ME / Afr. / Other)

9%

North America

18%

South America

5%

Asia Pacific18%

Rail28%

T&D (Elec Utilities)

14%

Power Generation

(Elec Utilities)58%

Power Transmission

14%

Transport28%

Renewables8%

Thermal Services

17%

Thermal Systems & Products

33%

Sales by Division Sales by Geography Sales by End Market


Long-term growth underpinned by replacement in the West and emerging markets

As a manufacturer of trains and power plants, Alstom enjoys the relatively attractive revenue mix of 100% infrastructure end markets. The company has 36% of its sales exposed to emerging markets (c40% in Power and c20% in rail), which is similar to the sector average of 38%. Over the longer term demand in the West will be driven by a compelling replacement story and the significant need to replace an over-aged fleet of steam turbines, gas turbines and rolling stock in both Europe and the US. Above that, the emerging markets should continue to boost growth from ongoing development.





Fig 333: Ten-year OSG of 4.7% ahead of 4.0% for coverage Fig 334: Margins have reverted to historic gap vs sector

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Orders have dropped 54% organically over the past four quarters

After a period of exceptional order growth (Power averaged 19% organic order growth between 2004 and 2008 and Transport averaged 15% organic order growth between 2005 and 2009, March Y/E), organic orders have been in decline for a year. Power has now seen five quarters of decline and has averaged -61% organic order decline over the last four quarters. Transport’s organic order decline has averaged -41% over the same period.

Fig 335: Orders, especially in Power, have taken a beating over the last year or so

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Forecasts

Source: Alstom, we have used a 12-month moving average as orders are extremely volatile on a quarterly basis

Backlogs are still robust at 2.2x revenues

However, despite the recent collapse in orders, and an average book-to-bill of 0.74x over the last four quarters, the backlog remains compellingly long at 2.2x revenues at 1H10 (Power 1.8 years and rail 3.4 years).

A key risk to our forecasts is rail’s exposure to budget deficits

Rail is the most public spending-oriented sector in the European Capital Goods complex. Alstom estimates that c90% of all rail spend is ultimately linked to government spending, even if indirectly. The market has increasing concerns that stretched government budget deficits (especially in Europe) may lead to a sustained period of poor rail orders for Alstom.




We share these concerns to a degree, however, we still expect a return to growth (albeit muted growth) in rail capex, as we see this risk offset by a number of positive factors: the Western replacement story; the renewed structural growth in high speed rail and urban transit; the positive boost from the various global governmental stimulus plans; and the various legislations that make rolling stock replacement (or at least refurbishment) mandatory.

We expect Power orders to improve going forward

We see evidence that Thermal Energy orders have now seen a trough globally, with Alstom, GE and Siemens each experiencing a sequential improvement in the latest quarter. Given the significant collapse in orders over the last year or so, and the longer-term structural needs, we expect the rate of order growth to improve going forward. This is supported by Alstom’s indication at the recent 3Q10 results that tendering activity in Power remains strong.

However, the risk to this view surrounds the Electrical Utilities, and the fact that they do not need to invest immediately. With reserve margins (the degree of spare generating capacity in power plants) having widened recently, global power generation capacity is not currently as stretched as it was. However, given the future needs and the significant time delay between order and delivery, we believe it won’t take too much of an uplift in confidence and GDP before Utility CEOs seek to re-join the equipment order queue.

Supply side strong in Power and much improved in rail

Alstom scores relatively well in our supply-side analysis (see scorecard in Fig 41). This is partly due to the highly concentrated nature of the global €100bn power generation industry (where Alstom has a 13% market share and a number three position) in which the top five players control c61% of the market. In the €50bn global rail equipment industry, where Alstom has a number two position and an 11% share, the market is less concentrated, with the top five controlling 47% of the market. Both industries have also experienced a further c10% increase in top five concentration over the last decade or so.

We believe the net pricing power in power generation is relatively attractive, and in rail it is more neutral. It should be noted that this is actually a meaningful improvement in rail, as historically pricing was very difficult, with annual net price declines of 1-2% not uncommon. However, following industry consolidation in the 1980s and 1990s (culminating in Bombardier’s acquisition of Adtranz) and two significant rounds of industry restructuring and capacity reduction in 2003-04 and 2008-09, we believe pricing has improved in the high speed train and tram segments (where there are technological barriers to entry and has been international standardisation, respectively), if not in the metro and regional train markets where there is local Tier 2 competition, such as CAF, Talgo, Vossloh and Stadler.

Areva T acquisition in our numbers from 1 April

In November 2009 Alstom announced it was acquiring the transmission arm (c€3.5bn of revenues, 21,000 employees and 65 sites) of Areva’s T&D division for €2.6bn (9x 2009 EV/EBIT, including pension and minority adjustments), with Schneider acquiring the smaller €1.7bn distribution arm. Alstom was forced by the French government to sell the entire T&D business to Areva in January 2004 in exchange for its financial bail-out. Subject to anti-trust (a formality, in our view, as this home-coming has no overlap), we would expect the deal to close in spring and have consolidated the acquisition in our numbers from the start of fiscal 2011E.




Areva T margins to deteriorate initially

Fig 336: Areva transmission sales and margins (adjusted to Alstom’s March Y/E)

10.1% 10.3% 10.1% 9.7%8.6%

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Transmission Revenue Tranmission EBIT Margin (%)

Source: Redburn Partners based on Areva disclosure 2004-09 and Alstom disclosure prior to 2004. Based on the 2006, 2007 and 2008 revenue data, we have assumed that transmission was a constant 66% of T&D revenues prior to 2006 and historic margins have been based on the T&D data with the assumption that transmission was 0.5-1.5% higher margin than Distribution. The data acts as a guide only and is not based on audited data but Redburn Partners estimates

Areva transmission peaked in 2008 (Alstom’s 2009 March Y/E) with EBIT margins of 11-12%. Areva is due to report its FY2009 results (December Y/E) in early March but, based on its 1H09 results, we expect transmission margins to have fallen to c8%, given volume declines. Looking into Alstom’s FY2011E (its inaugural year for the acquisition), we expect margins to fall further due to three factors: (1) price pressure in transformers; (2) under-absorption of fixed costs in the new unloaded factories – Areva recently inaugurated 11 new factories in India and China (out of 65 in total) which, given the crisis, will take two to three years to fully load; and (3) minor integration costs from the acquisition. As such, we expect 2011E EBIT margins of 6.2%, which we forecast to partially recover in 2012E to 7.3%.

Areva T, value neutral initially

In terms of margins, Areva T will be similar (if slightly below) Alstom’s group performance. However, we expect Areva T to generate a 6.8% post-tax ROIC in 2011E, just under Alstom’s WACC of 7.0%. While value neutral to shareholders, the deal is dilutive to returns, taking Alstom’s group ROIC down from 28% in 2010E to 19% in 2011E.

Thermal Service not immune

People often perceive service business as being less cyclical and more defensive. We do not believe this is the case at Alstom and expect the Thermal Service division to see a similar revenue decline in the next fiscal year (March 2011E) to the Thermal Systems business. The Service business is driven by: (1) operation and maintenance (O&M) contracts, long-term agreements often associated with new equipment orders; (2) retrofit business, €50-150m sized contracts to refit existing coal and gas plants; and (3) ‘classical’ Service and Spares activities. Going forward, we expect all three business lines to suffer, given the lower utilisation rates of most power plants. Service margins are the highest in the group by some way so any meaningful change in the share of revenue from the Service division can significantly affect the group margin.

Potential margin target downgrade or abandonment

Alstom is due to report its FY10 numbers on 4 May 2010. We expect Alstom to meet its FY10 targets at the results and for market attention to turn to Alstom’s next targets. As shown in Fig 337, the company tends to set group margin targets, for two or three years in advance at its FY results.




Fig 337: Alstom has a conservative seven-year history of setting longer-term targets that it largely hits

Outlook in Annual Report (March Y/E) 2003 2004 2005 2006 2007 2008 2009 2010FY2010 Targets Target Target Target ForecastGroup Margin Target 8% 9% 9% 9.1%Power Margin Target 9-10% 10-11% 10-11% 10.3%Transport Margin Target 7-8% 7-8% 7-8% 8.0%

FY2008 Targets Target Target Target ActualGroup Organic Sales Growth Target >10% +24%Group Margin Target 7-8% 7% 7% 7.7%Power Margin Target 8% 8% 8.9%Transport Margin Target 7% 7% 7.2%

FY2006 Targets Target Target Target ActualGroup Organic Sales Growth Target €15 bn €15 bn €15 bn €15.3 bnGroup Margin Target 6% 6% 6% 5.6%Power Systems Target 3% 3% 2.0%Power Service Target >15% >15% 15.5%Transport Margin Target 7% 7% 6.3%

Source: Redburn Partners, company

Given our forecast for margins to fall in 2011E and not to recover until 2013E, Alstom may struggle to repeat the current FY10E targets in either FY11E or FY12E. Alstom has a conservative seven-year history of setting and meeting longer-term targets (with the exception of its 2006 margin target, which it missed due to challenges in the Power Systems business). This raises the possibility of either a downgrade in margin target or even an abandonment of the target altogether. Conversely, if Alstom were to set new targets above the FY10E targets, then that would constitute a material upside surprise, and would have a meaningfully positive impact on the share price.

Valuation

In terms of valuation (we have calendarised the data to a December Y/E), Alstom is trading on a 10.8x 2011E P/E (a 10% discount to the sector), a 3.3% 2011E dividend yield, and 8.5x 2011E EV/EBIT (a 1% premium to the sector). Given the company’s infrastructure exposure, we see this as an attractive entry point, despite the nearer-term P&L risks of being a later cycle play. We strip customer advances out of our EV for Alstom, which makes a significant difference at c€4bn.

Fig 338: Alstom vs sector EV/Sales Fig 339: Alstom vs sector EV/EBIT Fig 340: Alstom vs sector P/E

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Current earnings issues

We do not trust consensus expectations for Alstom given the mixed sets of estimates, some of which include Areva T and some of which don’t. We estimate Alstom’s acquisition of Areva T is c5% earnings accretive, which goes some way to explaining our 2012E upside compared to consensus. We also expect an organic sales growth recovery in 2012E (based on a return to revenue growth in the Power business), whereas consensus expects a second year of decline.

Fig 341: Our 2012E EPS for Alstom of €4.60 is 14% ahead of consensus (€4.02)

A lst om R edburn EPS vs. Consensus

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Cash flow likely to suffer as customer advances are absorbed

Alstom has an unusual business model in that it operates with negative net working capital. Most companies are financed by either debt or equity. Alstom is heavily financed by its customers: it takes customer advances when orders are placed and at various milestones through the contract’s life. The advance sits in Cash & Equivalents on the asset side of the balance sheet and in Customer Advances on the liability side. During a period of order decline, these cash deposits are absorbed into working capital, which can lead to heavy cash outflows.

We expect €900m of working capital outflow in 2010E and €1.5bn in 2011E due to this effect. Some are worried about customer advances, and understandably so given the degree to which this very issue nearly brought Alstom into bankruptcy in the last downturn. However, while we expect a cash outflow from customer advances, which is reflected in the valuation, we do not believe that the issue is as significant as before for four reasons:

Less advances this time around: customer advances peaked at €10.0bn last cycle, but only reached €4.4bn in 2009, i.e. less than half despite reaching a similar level of orders. If we look at customer advances as a proportion of revenues, the reduction has been even more stark. Through much of the 1990s Alstom (then GEC Alstom) operated 60-90% advances/sales, compared to only 23% in 2009.




Fig 342: Customer advances have not built up like last time

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No more Marine: as anyone who followed Alstom at the time can confirm, much of the historic customer advances problem was related to the old Marine business (Chantiers de l’Atlantique), which was sold to Aker Yards in April 2006, now part of STX Shipbuilding. As such, this aspect of the historic advances risk no longer exists. The advances profile of cruise ships was very different to that of turbines. Cruise ships tends to command very large single customer advance payments upfront whilst Power and Transport tend to operate a series of milestones limiting the amount of surplus advances cash. Thus the absence of Marine not only reduces the amount of advances but also improves the mix.

Balance sheet healthier into this downturn: at the point of peak margins in 2000, Alstom was running 1.5x net debt/EBITDA and €10bn of advances. As business slowed, EBITDA fell and the advances were absorbed, falling to €3.5bn in 2003. This led to €5.5bn of debt, and a series of refinancing actions that obliterated existing shareholder value but saved the company, lifting the share count 28-fold from 0.2 billion to 5.5 billion through new issuance. This time, Alstom is entering the downturn with €1.2bn of net cash (0.6x Net Cash/EBITDA), with less advances (as a percentage of sales) and a better mix (no Marine).

We adjust for advances in our EV: having experienced the last Alstom crisis, we believe it is appropriate to adjust for customer advances in any debt or EV calculations (we do this for all companies, where applicable, but Alstom is the most significant). Advances are not the shareholders’ cash, rather, deposits needed to buy raw materials and components. By stripping all €5bn out of the current EV, we have implicitly valued Alstom (conservatively one might argue) on the basis that all advances are absorbed (although if that were to happen in practice, Alstom would face liquidity issues).

Sadly, just as we head into the downturn, when advances become a more pertinent issue, Alstom decided at 1H10 to stop disclosing customer advances in the notes to the accounts. In the era of transparency and open disclosure, we see this as a management mistake (or at least oversight). Lack of information will do nothing to allay fear. However, as outlined above, we are not overly concerned about advances but would like to be able to track their balance sheet development.

Estimates

We forecast EBIT margins to fall 1% in 2011E on 3% organic sales decline.

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Fig 343: Alstom divisional P&L data, 2004-13E (we have included 2013E as Alstom is a March Y/E)

Alstom P&L (€ mn, March Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013EThermal Systems & Products 5,107 5,180 6,076 9,535 11,569 8,828 4,678 5,919 7,399 7,706Thermal Services 3,343 3,228 3,491 4,058 4,401 5,156 3,745 3,941 4,957 5,105Renewables 2,482 1,460 1,901 2,471 2,670

Power 8,450 8,408 9,567 13,593 15,970 16,466 9,883 11,761 14,827 15,481Transport 4,709 5,490 5,184 5,388 7,467 8,114 4,829 5,936 6,232 6,451Power Transmission 2,665 579 398 3,300 3,535 3,721Group Orders Received 16,500 14,737 15,290 19,029 23,472 24,580 14,712 20,996 24,594 25,652

Power 14% 4% 14% 47% 17% -12% -40% 19% 26% 4%Transport -22% 17% -2% 8% 40% 11% -39% 23% 5% 4%Power Transmission 7% 5%Group Organic Orders Received (%) 1% 15% 8% 34% 24% 6% -39% 20% 17% 4%

Power 1.05 1.18 1.21 1.53 1.40 1.26 0.73 0.91 1.08 1.07Transport 0.97 1.07 1.01 1.02 1.36 1.43 0.81 0.97 0.97 0.97Power Transmission 1.04 1.07 1.52 1.00 1.00 1.00Group Book to Bill 0.99 1.08 1.14 1.34 1.39 1.31 0.75 0.94 1.04 1.04

Thermal Systems & Products 5,059 4,256 5,079 5,673 7,768 7,028 7,601 7,191 7,576 7,893Thermal Services 2,957 2,844 2,853 3,198 3,602 4,230 4,148 3,823 3,964 4,083Renewables 1,796 1,861 1,902 2,143 2,456

Power 8,016 7,100 7,932 8,871 11,370 13,054 13,610 12,916 13,683 14,431Transport 4,862 5,134 5,128 5,288 5,509 5,685 5,952 6,107 6,395 6,617Power Transmission 2,572 539 261 3,300 3,535 3,721Group Sales 16,688 13,662 13,413 14,208 16,908 18,739 19,562 22,323 23,613 24,768

Power -9% -7% 10% 18% 26% -3% 5% -5% 6% 5%Transport -1% 6% 4% 7% 5% 5% 6% 3% 5% 3%Power Transmission 7% 5%Group Organic Sales Growth (%) -10% -4% 8% 14% 19% 10% 5% -3% 6% 5%

Power 178 305 543 711 1007 1248 1403 1206 1370 1483Transport 64 218 324 350 397 408 476 513 556 589Power Transmission 136 30 16 0 0 0 0 198 257 285Corporate & Others -59 -82 -137 -104 -109 -120 -104 -104 -104 -104Group Operating Profit (pre Other Inc/Exp) 300 471 746 957 1,295 1,536 1,775 1,812 2,079 2,252

Power 2.2% 4.3% 6.8% 8.0% 8.9% 9.6% 10.3% 9.3% 10.0% 10.3%Transport 1.3% 4.2% 6.3% 6.6% 7.2% 7.2% 8.0% 8.4% 8.7% 8.9%Power Transmission 5.3% 5.6% 6.1% 0.0% 0.0% 0.0% 0.0% 6.0% 7.3% 7.6%Group Operating Profit Margin (%) 1.8% 3.4% 5.6% 6.7% 7.7% 8.2% 9.1% 8.1% 8.8% 9.1%

Group Other Income and Expenses (Other Inc/Exp) -1,171 -522 -19 -131 -74 -93 -91 -63 -69 -67of which Restructuring -655 -350 -80 -68 -35 -46 -72 -63 -69 -67

Group Reported EBIT (post Other Inc/Exp) -871 -51 727 826 1,221 1,443 1,684 1,749 2,010 2,185Group Reported EBIT Margin (%) -5.2% -0.4% 5.4% 5.8% 7.2% 7.7% 8.6% 7.8% 8.5% 8.8%

Financial income (expenses), net -460 -381 -222 -111 -69 21 -17 -63 -124 -87Reported PBT -1,331 -432 505 715 1,152 1,464 1,667 1,687 1,885 2,098Total Tax -251 -163 -125 -145 -291 -373 -432 -472 -528 -588Share of profit/(loss) of associates 0 0 -1 0 1 27 2 2 2 2Minorities 2 -1 -3 9 -10 -9 -15 -17 -18 -19Goodwill Amortisation -256 0 0 0 0 0 0 0 0 0Net profit/loss from Discontinued Operations 0 -32 -198 -32 0 0 0 0 0 0Reported Net Income -1,836 -628 178 547 852 1,109 1,222 1,199 1,342 1,494Average # Shares (Reported Basic) 82 275 281 281 282 287 289 289 289 289Reported EPS (Basic) -22.45 -2.28 0.63 1.95 3.02 3.87 4.24 4.16 4.65 5.18Average # Shares (FD, incl treasury) 82 275 284 287 289 291 292 292 292 292Reported EPS (FD) -22.45 -2.28 0.63 1.90 2.95 3.81 4.19 4.11 4.60 5.12DPS (€) 0.00 0.00 0.00 0.80 1.60 1.12 1.30 1.50 1.60 1.80





Fig 344: Alstom financial forecasts, performance metrics and valuation

Alstom (March Y/E; € mn) ALO FP Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth 24.0% 6.0% -39.5% 20.2% 17.1%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 19.0% 10.0% 5.3% -2.8% 5.8%

Orders 23,472 24,580 14,712 20,996 24,594 Sales growth 19.0% 10.8% 4.4% 14.1% 5.8%Revenue 16,908 18,739 19,562 22,323 23,613 Adj. EBITDA growth 25.5% 17.4% 14.2% 9.8% 17.9%

Gross profit 3,147 3,514 3,734 4,101 4,487 Adj. EBIT growth 35.3% 18.6% 15.6% 2.1% 14.7%EBIT (post-NRIs) 1,221 1,443 1,684 1,749 2,010 Adj. PBT growth 45.0% 29.1% 11.1% -0.5% 11.7%

Reported EBIT Margin (%) 7.2% 7.7% 8.6% 7.8% 8.5% Adj. EPS growth 36.0% 28.5% 9.2% -3.9% 11.8%

Net financial expense -69 21 -17 -63 -124 DPS growth 100.0% -30.0% 16.1% 15.4% 6.7%PBT 1,152 1,464 1,667 1,687 1,885Total tax -291 -373 -432 -472 -528 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 861 1,091 1,235 1,214 1,358 Gross profit margin 18.6% 18.8% 19.1% 18.4% 19.0%Minorities -10 -9 -15 -17 -18 Adj. EBITDA margin 9.7% 10.2% 11.2% 10.8% 12.0%Other (discont., prefs and other) 1 27 2 2 2 Adj. EBIT margin 7.7% 8.2% 9.1% 8.1% 8.8%Net income (all in) 852 1,109 1,222 1,199 1,342 Adj. PBT margin 7.3% 8.5% 9.0% 7.8% 8.3%




Adj. vs. reported EBIT 0 0 0 0 0 Employees (average) 77,063 82,992 86,639 98,864 104,579Adj. PBT 1,227 1,584 1,760 1,752 1,957 Book to bill (orders / sales) 1.39 1.31 0.75 0.94 1.04Adj. Net income 926 1,202 1,313 1,262 1,411 Cash conversion (FCF / NI) 164.3% 121.5% 23.4% -25.0% 142.7%Adj. EPS 3.21 4.12 4.50 4.33 4.84 WC / sales -3.4% -7.9% -3.3% 9.8% 12.4%Adj. EPS (post-restructuring) 3.09 3.97 4.26 4.11 4.60 Inventory / sales 13.7% 15.3% 17.7% 22.8% 25.4%


EBITDA 1,636 1,920 2,193 2,408 2,838 Capex / depreciation (inc intang) -1.46 -1.75 -1.59 -1.33 -1.09Provisions -414 -247 -66 0 209 Net debt (EV) / EBITDA 2.31 1.95 1.37 1.90 1.28Interest paid -58 22 24 63 124Tax paid -140 -192 -330 -472 -528 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 3 0 0 0 Basic (ST + LT debt - cash) -875 -2,172 -2,045 1,016 58Other 0 0 0 0 0 Mkt secs, leases and converts 517 570 545 545 545Operating cash flow pre-WC 1,024 1,506 1,821 1,999 2,643 Pension deficit (net of tax) 818 970 983 983 983Change in working capital 897 555 -890 -1,530 69 Adjusted net debt 460 -632 -517 2,544 1,586Operating cash flow 1,921 2,061 931 468 2,712 Mins, assocs, advances, other 3,319 4,370 3,522 2,037 2,042Capex (PP&E and intangibles) -457 -657 -641 -768 -798 Net debt (EV) 3,779 3,738 3,005 4,581 3,628Acquisitions and disposals -477 -4 -20 -2,200 0Other 38 4 9 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -896 -657 -652 -2,968 -798 Average / current share price 66.62 56.16 47.54 48.55 48.55

Dividends paid -117 -233 -329 -373 -430 Market capitalisation 19,221 16,367 13,860 14,153 14,153Other (incl. share capital) 100 29 12 0 0 Group EV 23,000 20,105 16,865 18,734 17,781Financing cash flow -17 -204 -317 -373 -430 P/E (pre-restructuring) 20.76 13.62 10.56 11.21 10.03

FX and other -31 -34 57 0 0 P/E (post-restructuring) 21.57 14.16 11.17 11.80 10.55Reconciliation to basic net debt -2 131 -146 -188 -526 EV/Sales 1.36 1.07 0.86 0.84 0.75Net cash flow 975 1,297 -127 -3,061 958 EV/EBITDA 14.06 10.47 7.69 7.78 6.27

EV/EBIT (pre restructuring) 16.23 11.96 8.86 9.86 8.30FCF to the firm (post-tax) 1,522 1,382 266 -363 1,790 EV/EBIT (post restructuring) 16.64 12.30 9.20 10.20 8.58FCF to equity (post-tax) 1,464 1,404 290 -300 1,914 EV/IC 4.71 4.34 3.37 2.52 1.89

FCF yield (geared vs. M.Cap) 7.6% 8.6% 2.1% -2.1% 13.5%Balance sheet 2008 2009 2010E 2011E 2012E FCF yield (ungeared vs. EV) 6.6% 6.9% 1.6% -1.9% 10.1%Current assets 12,988 15,619 15,891 16,168 18,273Non-current assets 8,357 8,625 8,688 11,062 11,103 Economic profit 2008 2009 2010E 2011E 2012ETotal assets 21,345 24,244 24,579 27,230 29,376 Invested capital (average) 4,886 4,630 5,011 7,447 9,385

Current liabilities 16,468 19,268 18,243 20,051 21,267 NOPLAT 1,086 1,283 1,449 1,431 1,620Non-current liabilities 2,632 2,092 2,572 2,572 2,572 ROIC (post-tax) 22.2% 27.7% 28.9% 19.2% 17.3%Shareholders equity 2,210 2,852 3,724 4,550 5,462 WACC 7.8% 7.3% 7.0% 6.7% 6.9%Minorities and prefs 35 32 40 57 75 ROIC/WACC 2.85 3.80 4.14 2.88 2.51Total liabilities and equity 21,345 24,244 24,579 27,230 29,376 Implied equity value (per share) 35.1 47.5 60.9 57.8 68.4




Assa Abloy (ASSAB SS, Buy, target SKr175)

Despite Assa Abloy’s relatively lacklustre demand mix (being 100% construction-related), we are initiating with a Buy rating and a SKr175 target price. We see Assa’s management as best in class, having implemented three structural manufacturing footprint capacity reduction and optimisation programmes, and overlaid these with a significant cyclical downturn, based redundancy programme. We believe investors should invest in Assa management and the company’s supply-side dynamics for outperformance in an uncertain global demand environment.

Assa Abloy scores highest on our supply-side scorecard analysis (see Fig 41); from this we take great confidence in the company’s ability to continue to surprise positively on price/raw material and margin management. The €15bn global lock industry and Assa’s positioning within it is as close to a textbook example of optimal supply-side dynamics as you could get. Firstly, the industry is highly consolidated with the top five manufacturers lifting their collective market share enormously over the last decade from 23% in 1997 to 57% in 2010 (allowing for the latest increase in concentration, the Black & Decker and Stanley Works merger). Secondly, Assa has a dominant 23% market share, which is almost twice the size of the global number two, Ingersoll Rand. Finally, Assa has undertaken an unprecedented degree of capacity reduction, having taken out 37% of group employees since Mr Johan Molin arrived as CEO in late 2005 (c11,000 excluding M&A, compared to a 4Q05 headcount of c30,400).

We forecast a record clean EBIT margin of 17.9% in 2011E vs a previous high of 16.3% in 2007. As such our 2011E EPS for Assa Abloy of SKr12.14 is 11% above consensus of (SKr10.96).

Fig 345: 2009 Assa Abloy group revenues split by division, geography of destination and end market

Europe46%


5%

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37%

South America

2%

Asia Pacific10%

Residential Construction

20%

Non Residential

Construction (Public)30%

Non Residential

Construction (Private)

50%

Entrance Systems

11%

EMEA37%

Americas28%

Asia Pacific11%

Global Technologies

13%



Lacklustre growth mix

With an average of only 2.5% organic sales growth over the past ten years, Assa Abloy has grown materially below our coverage average of 4.0%, but above Invensys at 1.5%, Electrolux at 1.9% and Legrand at 2.2%. This track record, which is related to Assa Abloy’s relatively lacklustre end market and geographical growth mix of 100% construction-linked demand and only 19% of sales exposed to emerging market demand (vs coverage average of 38%), acts as a perennial drag on the equity investment case. With the notable exception of 2009, Assa Abloy tends to demonstrate a relative degree of defensive growth profile, growing less in the bull years and holding up more in the bear years, supported by its significant aftermarket replacement exposure (roughly two thirds).





Fig 346: Growth has been lacklustre Fig 347: Margins have outstripped coverage universe

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1990 1993 1996 1999 2002 2005 2008 2011E

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EMEA showing sequential recovery surprise

Management has put in place a number of actions to lift this growth profile going forward, such as an ongoing consolidation of brands towards a single Assa Abloy brand, a re-organisation of the sales force along more segmented and specialised lines and an increase in the degree of new product launches. We see evidence of these actions having some effect in Europe (EMEA) in 4Q09, with the rate of organic sales decline recovering faster than lock peers.

Extremely attractive supply-side score

Assa Abloy is the highest scoring company under our coverage on our supply-side analysis (see scorecard in Fig 41). This manifests itself in the company’s very strong pricing track record and consistently high (and continually improving) margins. Assa Abloy enjoys a dominant market share of 23% in the €15bn global lock industry, which is almost twice the size of the global number two, Ingersoll Rand. Furthermore, after a decade of aggressive industry consolidation, the global lock industry has seen its top five manufacturers lift their collective market share from 23% to 57%, including the recent Black & Decker and Stanley Works merger (which has created a new global number three player).

We believe Assa’s dominant share, in combination with the degree of industry concentration, will continue to underpin Assa’s pricing power and the company’s ability not only to raise prices but also exceed raw material cost inflation and continue to drive margins forward. This is Assa’s positive offset to the company’s lacklustre revenue mix, unlike Electrolux, say, which has a lacklustre growth mix AND limited pricing power.

Excellent management execution

Perhaps more than the revenue growth and margin issues, the first point that springs to mind when trying to capture the essence of Assa Abloy is just what a good job management has done. Johan Molin arrived at Assa Abloy with great fanfare in late 2005 to replace Bo Dankis. Unlike most scenarios of high expectations, where disappointment is inevitable, we believe high expectations in this case have been exceeded. Mr Dankis, in our view, failed utterly in his mandate to integrate the array of acquisitions that created Assa Abloy and make the transition to an organic phase. In our view, Mr Molin (with CFO Tomas Eliasson) has made a meaningful and measurable difference in three areas:

Integration and optimisation of the manufacturing footprint: Assa Abloy comprises c110 individual acquisitions, made since the original Securitas/Metra merger in late 1994. When Mr Molin joined in 2005, the company had c90 plants with




c300 production lines. There was no coherent manufacturing strategy. The operation ran c90 P&Ls and the HQ reported the consolidated numbers.

Through two separate structural optimisation plans (know as Manufacturing Footprint Plan One (MFP1) and Manufacturing Footprint Plan Two (MFP2), Mr Molin has reduced the number of plants by 36, a relatively unheard of 40% plant reduction in four years. Furthermore, he has outsourced the low-end machining and stamping work to low-cost countries, created centres of excellence for manufacturing core common parts in China, Romania, Slovakia and the Czech Republic, and consolidated over 100 brands to the Assa Abloy brand (and six multi brands). Looking forward, Mr Molin has recently launched MFP3, which will lead to a further 11 plant closures.

When complete (see phasing in Fig 349 below), the three MFP plans will lead to c6,300 employee reductions and SKr1.7bn of savings. These are huge capacity-altering reductions that equate to 21% of the 4Q05 headcount (i.e. when Mr Molin started) and savings of 4.9% of 2009 group revenues.

Fig 348: Assa Abloy has managed the headcount well Fig 349: Further headcount reduction to come

-30%-25%-20%-15%-10%-5%0%5%

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Cyclical downturn restructuring: unlike Siemens, where we have argued that Mr Löscher has failed to crystallise the upside of his structural SG&A and Supply Chain Management plans by not following up with any substantial cyclical downturn-based capacity reductions, Assa has not failed. Far from it. In addition to the three MFP plans discussed above, Assa Abloy has reduced its headcount by a further 4,576 employees (organically) since 4Q07 when the cycle first broke on the downside. These cycle-based actions have saved a further SKr1.2bn (3.4% of 2009 group revenues).

Added to the three structural MFP plans, this amounts to SKr3bn of savings (8.3% of 2009 group revenues) and 11,000 employees (or 37% of the headcount when Mr Molin joined). This explains how Assa Abloy managed to maintain flat clean EBIT margins of 15.8% in 2009 when volumes were down a record 13%; without these actions margins would have been at 7.5%. If that’s not value-added management, what is?

Furthermore, this significant reduction in fixed asset capacity (47 plants closed in total) has reduced, and will continue to reduce, the level of PP&E on the balance sheet. Perhaps less understood is that the commensurate reduction in depreciation is lagging and has yet to come through to the P&L. We estimate this upside to be a further SKr200-250m per year, lifting margins by c0.5-1.0% over the next three years.




Price vs raw material management: like Legrand, Assa Abloy has a long history of stable and positive price rises. In fact, we believe that since 1996 Assa Abloy’s achieved price increase has not fallen below 1% (arguably better than Legrand’s 17-year track record of not falling below 0%). Despite the long-term track record, price management has improved even further since Mr Molin arrived in 2005. In his first two years, Mr Molin achieved an average price increase of +3.0% compared to the prior historical average of +1.5%. Even in 2009, which saw a -13% volume decline, Assa Abloy achieved +1.0% price.

Having tracked both Assa Abloy’s price development but also its raw material cost development quarterly for the past six years, we believe that not only has Assa Abloy improved the degree of gross price increases, it has also improved the degree of net price increases (net prices being gross price inflation minus raw material cost inflation). We calculate that Assa Abloy has grown its net price increases to an average of c1% over the past three years from closer to neutral under Mr Dankis. In our view, this is not accidental, but due to active, strong management by Mr Molin, exploiting Assa Abloy’s naturally favourable supply-side dynamics and dominant position in an attractively consolidated industry.

Valuation

In terms of valuation, Alstom is trading on 11.5x 2011E P/E (a 5% discount to the sector), a 3.5% 2011E dividend yield, and 8.3x 2011E EV/EBIT (a 5% discount to the sector). Given the company’s pricing power and management execution, we see this as an attractive entry point.

Fig 350: Assa vs sector EV/Sales Fig 351: Assa vs sector EV/EBIT Fig 352: Assa vs sector P/E

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Current earnings issues Assa Abloy is targeting 0% organic sales growth in 2010E, with the Americas down mid-single digits and EMEA up mid-single digits. While we expect the new building exposed aspects of Assa Abloy (roughly one third of sales) in Europe to deteriorate further (in line with our end-market assumptions of +1% in Europe and -5% in North America, as shown in Fig 266), we expect the two thirds of Assa Abloy’s revenues exposed to the replacement aftermarket to be more resilient. As such, our 2010E organic sales growth estimate of 0% is in line with Assa’s guidance. However, given the pace of sequential improvement in EMEA in 4Q09 (and even more so within the months of 4Q09, e.g. December with 0% organic sales growth vs -3% for the quarter), we believe there is some scope for EMEA upside.




In terms of EBIT, we expect a further cSKr500m of cost savings in 2010E, from the outstanding MFP1, MFP2 and cyclical restructuring based cost savings and some ramp-up of the MFP3 savings. We also expect a cSKr200m currency headwind (which is entirely translation so no real negative margin impact, in fact we expect some slight transaction positive in Asia Pacific from the Australian and New Zealand dollar vs the Chinese yuan). Finally, we expect some slight acquisition dilution, notably from the acquisition of China-based Pan Pan.

Assa appears to have been under-earning with conservative tax policy

We also expect tax to run at c25% going forward, which is lower than previous guidance. Assa has a track record of successful tax planning and low achieved tax rates. However, we have noticed that cash tax has moved away from P&L recently with Assa paying less cash tax than it has charged to the P&L for two years (based on a 12-month moving average to iron out the volatility of cash tax).

Fig 353: Tax analysis suggests that Assa has been over-providing for tax

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As such we believe Assa Abloy’s earnings are high quality and the company is potentially over-providing for tax in the P&L, therefore under-earning. This gives us confidence in our lower tax rates for 2010 and 2011E, which are a part of our better than consensus earnings.

Fig 354: Our 2011E EPS for Assa Abloy of SKr12.14 is 11% above consensus of (SKr10.96)

A ssa A b lo y R edburn EPS vs. C onsensus

8%11%

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0.002.004.006.008.00

10.0012.0014.0016.00

2007 2008 2009E 2010E 2011E 2012E



Based on Bloomberg consensus, we believe our estimates for Assa Abloy are above the top end of the range and some 13% ahead of consensus for 2010E. Our estimates are shown below.




Fig 355: Assa Abloy divisional P&L data, 2004-12E

Assa Abloy P&L (December Y/E, Skr mn) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012EEMEA 11031 11649 12509 13477 13988 13645 13871 14426 15003Americas 8270 8806 10142 10218 10467 9888 8900 9442 9820Asia Pacific 1847 2209 2309 2780 3321 3789 5133 5641 6093Global Technologies 4911 3387 4220 4923 4884 4780 4458 4794 5081Entrance Systems 2373 2716 2987 3173 3733 4350 4524 4705Other / Elimination -533 -622 -761 -836 -916 -807 -802 -800 -800Group Sales (Skr mn) 25,526 27,802 31,137 33,551 34,919 35,026 35,910 38,027 39,902

EMEA 3.3% 3.2% 8.2% 6.5% -2.3% -11.7% 4.5% 4.0% 4.0%Americas 5.7% 5.2% 10.1% 5.2% 3.6% -18.9% -6.1% 6.1% 4.0%Asia Pacific 6.8% 2.4% 3.6% 9.8% 0.6% -0.9% 6.9% 6.0% 8.0%Global Technologies 5.5% 11.8% 12.2% 10.5% 0.3% -11.6% -2.3% 7.5% 6.0%Entrance Systems 0.0% 10.2% 6.4% 3.3% -3.3% 1.6% 4.0% 4.0%Group Organic Sales Growth Rates % 4.8% 5.5% 9.3% 7.0% 0.5% -12.4% 0.6% 5.3% 4.9%

Price driven Sales Growth 1.7% 1.7% 3.0% 3.0% 2.0% 1.0% 1.0% 1.8% 2.0%Volume driven Sales Growth 3.0% 3.8% 6.2% 4.0% -1.5% -13.4% -0.4% 3.6% 2.9%

Group Reported EBITDA 4,588 4,959 4,194 6,366 5,189 5,497 6,845 7,687 8,202

EMEA 1,583 1,759 2,017 2,294 2,290 2,165 2,457 2,777 2,921Americas 1,456 1,629 1,945 1,995 2,101 1,925 1,763 1,959 2,054Asia Pacific 278 277 217 322 357 459 694 809 978Global Technologies 637 498 617 754 729 766 733 882 978Entrance Systems 335 368 433 453 588 631 701 746Other / Elimination -279 -276 -347 -349 -422 -393 -334 -334 -334Group Clean EBIT (Pre NRIs) 3,675 4,222 4,817 5,449 5,508 5,510 5,945 6,794 7,344

EMEA 14.4% 15.1% 16.1% 17.0% 16.4% 15.9% 17.7% 19.2% 19.5%Americas 17.6% 18.5% 19.2% 19.5% 20.1% 19.5% 19.8% 20.7% 20.9%Asia Pacific 15.1% 12.5% 9.4% 11.6% 10.7% 12.1% 13.5% 14.3% 16.1%Global Technologies 13.0% 14.7% 14.6% 15.3% 14.9% 16.0% 16.4% 18.4% 19.2%Entrance Systems 14.1% 13.5% 14.5% 14.3% 15.8% 14.5% 15.5% 15.9%Group Clean EBIT Margin (%) 14.4% 15.2% 15.5% 16.2% 15.8% 15.7% 16.6% 17.9% 18.4%

Associates (in Reported EBIT) 8 8 8 9 18 13 14 14 14Non-Recurring Items (NRIs) 0 -152 -1,529 0 -1,257 -1,148 -184 -194 -204

EMEA 1,583 1,707 913 2,294 1,427 1,376 2,387 2,704 2,846Americas 1,456 1,615 1,776 1,995 2,024 1,925 1,719 1,912 2,005Asia Pacific 278 245 119 322 293 457 669 781 948Global Technologies 637 476 460 754 580 599 710 858 953Entrance Systems 335 367 433 350 507 610 678 723Other / Elimination -271 -300 -339 -340 -405 -489 -320 -320 -320Group Reported EBIT 3,683 4,078 3,296 5,458 4,269 4,375 5,775 6,614 7,154

#######EMEA 14.4% 14.7% 7.3% 17.0% 10.2% 10.1% 17.2% 18.7% 19.0%Americas 17.6% 18.3% 17.5% 19.5% 19.3% 19.5% 19.3% 20.2% 20.4%Asia Pacific 15.1% 11.1% 5.2% 11.6% 8.8% 12.1% 13.0% 13.8% 15.6%Global Technologies 13.0% 14.1% 10.9% 15.3% 11.9% 12.5% 15.9% 17.9% 18.7%Entrance Systems 14.1% 13.5% 14.5% 11.0% 13.6% 14.0% 15.0% 15.4%Group Reported EBIT Margin (%) 14.4% 14.7% 10.6% 16.3% 12.2% 12.5% 16.1% 17.4% 17.9%

Financial Income and Expenses, net -484 -522 -671 -849 -770 -635 -541 -534 -526Reported PBT 3,199 3,556 2,625 4,609 3,499 3,740 5,234 6,080 6,628Tax -843 -943 -871 -1,240 -1,061 -1,081 -1,309 -1,520 -1,723

Tax as % of Reported PBT 26% 27% 33% 27% 30% 29% 25% 25% 26%Minority Interests -7 -5 -9 -10 -25 -33 -33 -33 -33Reported Net Income 2,349 2,608 1,745 3,359 2,413 2,626 3,893 4,527 4,872Average number of (FD) Shares (mn) 374.8 378.7 379.0 378.9 379.6 376.8 372.9 372.9 372.9Reported Diluted EPS (EUR) 6.27 6.89 4.60 8.87 6.36 6.97 10.44 12.14 13.06DPS 2.60 3.25 3.25 3.50 3.60 3.60 4.20 4.90 5.20





Fig 356: Assa Abloy financial forecasts, performance metrics and valuation

Assa Abloy (December Y/E; Skr mn) ASSAB SS Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth na na na na naIncome statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 0.5% -12.4% 0.6% 5.3% 4.9%

Orders na na na na na Sales growth 4.1% 0.3% 2.5% 5.9% 4.9%Revenue 34,919 35,026 35,910 38,027 39,902 Adj. EBITDA growth 1.1% 1.5% 7.5% 12.2% 6.7%

Gross profit 13,387 13,398 14,799 15,638 16,178 Adj. EBIT growth 1.1% 0.0% 7.9% 14.3% 8.1%EBIT (post-NRIs) 4,269 4,375 5,775 6,614 7,154 Adj. PBT growth 3.2% 2.8% 10.8% 15.8% 8.9%

Reported EBIT Margin (%) 12.2% 12.5% 16.1% 17.4% 17.9% Adj. EPS growth 9.0% 3.6% 9.1% 15.8% 7.5%

Net financial expense -770 -635 -541 -534 -526 DPS growth 2.9% 0.0% 16.7% 16.7% 6.1%PBT 3,499 3,740 5,234 6,080 6,628Total tax -1,061 -1,081 -1,309 -1,520 -1,723 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 2,438 2,659 3,926 4,560 4,905 Gross profit margin 38.3% 38.3% 41.2% 41.1% 40.5%Minorities -25 -33 -33 -33 -33 Adj. EBITDA margin 18.4% 18.6% 19.5% 20.7% 21.0%Other (discont., prefs and other) 0 0 0 0 0 Adj. EBIT margin 15.8% 15.7% 16.6% 17.9% 18.4%Net income (all in) 2,413 2,626 3,893 4,527 4,872 Adj. PBT margin 13.6% 14.0% 15.1% 16.5% 17.1%




Adj. vs. reported EBIT 1,239 1,026 170 181 190 Employees (average) 32,723 29,375 28,157 33,392 40,817Adj. PBT 4,756 4,888 5,418 6,274 6,832 Book to bill (orders / sales) na na na na naAdj. Net income 3,670 3,774 4,076 4,721 5,075 Cash conversion (FCF / NI) 167.2% 148.4% 100.7% 105.5% 104.0%Adj. EPS 9.67 10.02 10.93 12.66 13.61 WC / sales 25.3% 21.4% 21.4% 20.1% 19.0%Adj. EPS (post-restructuring) 6.57 6.97 10.44 12.14 13.06 Inventory / sales 15.4% 12.4% 12.2% 12.1% 12.1%


EBITDA 6,428 6,523 7,015 7,867 8,392 Capex / depreciation (inc intang) -1.11 -0.85 -0.99 -1.05 -1.10Provisions -486 -676 -400 0 0 Net debt (EV) / EBITDA 1.87 1.39 1.05 0.52 0.10Interest paid -719 -507 -541 -534 -526Tax paid -176 -907 -1,309 -1,520 -1,723 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) 10,717 7,803 6,088 2,837 -448Other -49 127 0 0 0 Mkt secs, leases and converts -58 -58 -58 -58 -58Operating cash flow pre-WC 4,998 4,560 4,766 5,813 6,143 Pension deficit (net of tax) 1,182 1,118 1,118 1,118 1,118Change in working capital 0 0 1 -137 -130 Adjusted net debt 11,841 8,863 7,148 3,897 612Operating cash flow 4,998 4,560 4,766 5,677 6,013 Mins, assocs, advances, other 162 226 226 226 226Capex (PP&E and intangibles) -829 -663 -848 -903 -948 Net debt (EV) 12,003 9,089 7,374 4,123 838Acquisitions and disposals -1,819 -1,171 -900 0 0Other 0 0 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -2,648 -1,834 -1,748 -903 -948 Average / current share price 95.54 105.33 139.30 139.30 139.30

Dividends paid -1,281 -1,317 -1,317 -1,537 -1,793 Market capitalisation 36,271 39,692 51,949 51,949 51,949Other (incl. share capital) 0 0 0 0 0 Group EV 48,274 48,781 59,323 56,072 52,787Financing cash flow -1,281 -1,317 -1,317 -1,537 -1,793 P/E (pre-restructuring) 9.88 10.52 12.74 11.00 10.24

FX and other 1,465 -192 0 0 0 P/E (post-restructuring) 14.55 15.12 13.35 11.48 10.66Reconciliation to basic net debt -3,526 1,697 14 14 14 EV/Sales 1.38 1.39 1.65 1.47 1.32Net cash flow -992 2,914 1,715 3,251 3,285 EV/EBITDA 7.51 7.48 8.46 7.13 6.29







Atlas Copco (ATCOA SS, Buy, target SKr125)

Atlas Copco has grown 50% faster than the sector average over the last decade given its emerging markets and mining exposure. We expect this leading growth to continue over the longer run and forecast Atlas Copco to experience the highest organic sales growth of our coverage in 2011E at +11%. In addition to the top-line story, we also believe that Atlas Copco offers an attractive price and margin potential. Atlas Copco scores very well on our supply-side scorecard, due to its leading positions and high market shares in two industries that have seen some of the most significant consolidation over the last decade (in particular, the mining equipment industry, which has seen the top five players lift their collective market share from 35% to 66% since 1997 (including Bucyrus/Terex)).

We believe investors should look beyond the fact that Atlas Copco’s valuation multiples are at a c10% premium to the sector, and ascribe a premium to the company’s higher longer-run growth mix. We rate Atlas Copco as a Buy, with a target price of SKr125.

Fig 357: 2009 Atlas Copco group revenues split by division, geography of destination and end market


11%

Europe39%

North America

19%

South America

8%

Asia Pacific23%

Non-Residential

Construction22%

Automotive Capex

4%

Other7%

General Industrial

Capex27%

Other Process14%

Mining26%

Compressor Technique

(CT)52%

Construction and Mining Technique

(CMT)40%

Industrial Technique (IT)

8%



Sector-leading regional growth mix to emerging markets and China

Atlas Copco enjoys the second highest exposure in the sector to both the emerging markets and China (behind ABB). Revenues to emerging markets are 50% (including 9% from Eastern Europe and Russia) compared to the sector average of 38%. Within this Atlas Copco has 9% of sales exposure to China. Not by chance, and entirely down to this regional mix, in our view, Atlas Copco has also logged the second highest organic sales growth average over the last decade (behind ABB) at 6%, compared to the sector average of 4%.

Atlas Copco has the highest mining exposure in the sector

While Atlas Copco’s revenue exposure to the infrastructure end markets of 39% is in line with the sector average, we believe the mix of that exposure is very attractive as Atlas Copco has the highest exposure to the mining end market in the sector at 26%.

Of all the attractive infrastructure end markets, we like mining the most. Mining capex has fallen the hardest and is the most likely to recover fastest, has the highest historic growth track record, is driven by the emerging market demographic story and is supported by an ungeared mining industry delivering ten-year record 25-30% EBIT margins (across the top 45 global mining companies – see ‘mining capex outlook’ chapter).





We would expect orders in CMT (the Construction and Mining Technique division) to show strong double-digit recovery over the next few quarters, leading the revenue recovery cycle. We expect Atlas Copco’s CMT to grow marginally faster than SMC (Sandvik’s mining and construction division) into recovery given its lower exposure to coal of 10% compared to Sandvik’s 26%; coal’s link to the power generation cycle is likely to make it later recovery than metals mining, in our view.

Fig 358: Atlas Copco has outgrown coverage Fig 359: Margins have outstripped coverage universe

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Sector Average Atlas Copco

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Pricing helped by increasingly consolidated industries

Atlas Copco operates in two of the most consolidated industry pillars served by the sector: compressors (where the top five players control 63% of the market) and mining equipment (where the top five players control 61% of the market, and will control 68% following the completion of Bucyrus’ acquisition of Terex Mining). Both industries, but especially the mining equipment industry, have seen meaningful industry consolidation over the last decade with mining equipment having seen the top five players increase concentration by 28% (including Bucyrus/Terex).

Pricing also helped by strong positions within these consolidated industries

Furthermore, Atlas Copco has a strong position within both of these markets. In the Mining Equipment market (where mining-derived products are also used to serve the construction industry), Atlas Copco enjoys a 15% market share and a number two position behind Sandvik (although this position will be closely challenged by Bucyrus/Terex). In the €9bn global positive displacement compressor market (reciprocating and rotary compressors), Atlas Copco dominates with 31% market share. We believe both supply-side dynamics of strong market shares and increasingly consolidated industries will support Atlas Copco’s achieved and net pricing going forward. The longer-term risk is China, where there is an army of developing mining equipment manufacturers attempting to copy Western designs. Currently they are poor on quality, but they may not be in ten years’ time.




Fig 360: We expect price to remain resilient at Atlas Copco given supply-side dynamics

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Source: Atlas Copco

Valuation the least supportive factor

Atlas Copco is not a deep value stock – far from it. The equity case surrounds the company’s favourable positioning in both its revenue mix and supply-side competitive positioning, which we believe underpins the company’s revenue growth, pricing and margin outlook. In terms of valuation, Atlas Copco is trading on 12.7x 2011E P/E (a 5% premium to the sector), a 3.7% 2011E dividend yield, and 8.7x 2011E EV/EBIT (a 1% premium to the sector).

Fig 361: Atlas vs sector EV/Sales Fig 362: Atlas vs sector EV/EBIT Fig 363: Atlas vs sector P/E

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Our 2011E EPS for Atlas Copco of SKr8.32 is 14% ahead of consensus (SKr7.32, according to Bloomberg). This is based on both a stronger revenue growth and margin recovery than consensus, in 2011E in particular. We forecast just 1% organic sales growth in 2010E (vs -14% in 2009), however, we expect this to accelerate sharply to 11% in 2011E, driven in particular by 14% organic sales growth in CMT. In terms of margins, we expect reported EBIT margins of 17.1% and 18.6% in 2010E and 2011E (vs 15.1% in 2009).

In 2010E, we expect cSKr600m of charges to drop out, cSKr400m of cost savings (down from cSKr1,700m in 2009), a cSKr400m currency headwind and cSKr1.3bn of organic drop-through (at a 55% incremental margin). 2011E is a relatively clean year in which the only driver of EBIT change in our number is cSKr2.7bn of organic drop-through (at a 38% incremental margin); of this we expect cSKr1.6bn in CMT (at a 43% incremental margin).




Fig 364: Our 2011E EPS for Atlas Copco of SKr8.14 is 11% ahead of consensus (SKr7.32)

A t la s Copco R edburn EPS vs. Consensus

7%11%

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2007 2008 2009 2010E 2011E 2012E



Potential uplift to outlook

Atlas Copco’s current outlook is cautious: “The current economic situation makes the outlook very uncertain but demand is expected to remain very weak in most industries and regions.” This is the sixth sequential quarter of relatively neutral or negative outlook from Atlas Copco. However, we would expect this to change over the coming quarters as the order environment starts to improve.




Fig 365: Atlas Copco divisional P&L data, 2004-12E

Atlas Copco P&L (Skr mn) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012ECompressor Technique (CT) 18,337 21,770 28,491 35,005 36,511 29,680 32,547 37,908 40,182Construction and Mining Technique (CMT) 11,177 16,581 20,563 27,447 30,129 23,500 28,637 32,741 36,015Rental Service 10,402 709Industrial Technique (IT) 10,681 6,086 6,533 7,043 7,407 5,366 5,377 5,592 5,816Eliminations -437 10,135 5,531 -436 -475 -95 -63 -63 -63Reported Group Orders 50,160 55,281 61,118 69,059 73,572 58,451 66,498 76,177 81,950

Compressor Technique (CT) 17,787 20,672 24,907 31,900 35,587 32,524 33,903 36,689 38,890Construction and Mining Technique (CMT) 10,454 15,154 18,914 25,140 31,660 25,909 26,375 30,174 33,191Rental Service 10,402 709Industrial Technique (IT) 10,508 6,064 6,440 6,871 7,450 5,392 5,241 5,451 5,669Eliminations** -497 -394 -506 -556 -520 -63 -63 -63 -63Reported Group Sales 48,654 42,205 50,512 63,355 74,177 63,762 65,456 72,251 77,688

Compressor Technique (CT) 13.2% 11.3% 17.2% 18.1% 8.9% -17.3% 5.5% 7.7% 6.0%Construction and Mining Technique (CMT) 15.5% 22.2% 24.1% 23.2% 16.9% -25.0% 5.6% 14.4% 10.0%Rental Service 12.2% 12.4% 14.6%Industrial Technique (IT) 4.4% 4.9% 3.4% 6.7% 4.4% -34.8% 1.3% 4.0% 4.0%Group Organic Sales Growth (%) 11.4% 12.6% 17.7% 18.5% 11.7% -22.5% 5.2% 10.1% 7.5%

EBITDA 10,016 10,556 12,190 14,347 16,490 12,284 14,499 16,669 18,306

Compressor Technique (CT) 3,322 4,032 5,154 6,634 7,365 5,986 6,568 7,388 8,030Construction and Mining Technique (CMT) 1,173 2,096 3,010 4,384 5,712 3,613 4,194 5,503 6,453Rental Service 1,732 206 0 0 0 0 0 0 0Industrial Technique (IT) 751 1,200 1,346 1,584 1,430 440 799 862 928Eliminations and Common Group Functions -464 -557 -493 -559 -423 -397 -363 -362 -363Group EBIT (Excl. NRIs) (Skr mn) 7,167 6,977 9,269 12,043 14,084 9,642 11,198 13,391 15,048

Compressor Technique (CT) 18.7% 19.5% 20.7% 20.8% 20.7% 18.4% 19.4% 20.1% 20.6%Construction and Mining Technique (CMT) 11.2% 13.8% 15.9% 17.4% 18.0% 13.9% 15.9% 18.2% 19.4%Rental Service 16.7% 29.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Industrial Technique (IT) 7.1% 19.8% 20.9% 23.1% 19.2% 8.2% 15.3% 15.8% 16.4%Group EBIT Margin (Excl. NRIs) (%) 14.7% 16.5% 18.4% 19.0% 19.0% 15.1% 17.1% 18.5% 19.4%

Associates (in Reported EBIT) 3 4 17 3 14 14 14 14 14Non Recurring Items (NRIs) -58 -43 -83 20 -292 -566 0 0 0

Compressor Technique (CT) 3,322 4,032 5,071 6,749 7,291 5,752 6,568 7,388 8,030Construction and Mining Technique (CMT) 1,115 2,073 3,010 4,384 5,602 3,470 4,194 5,503 6,453Rental Service 1,732 186Industrial Technique (IT) 1,404 1,200 1,346 1,539 1,328 253 799 862 928Eliminations and Common Group Functions -461 -553 -476 -606 -415 -385 -349 -348 -349Reported Group EBIT 7,112 6,938 9,203 12,066 13,806 9,090 11,212 13,405 15,062

Compressor Technique (CT) 18.7% 19.5% 20.4% 21.2% 20.5% 17.7% 19.4% 20.1% 20.6%Construction and Mining Technique (CMT) 10.7% 13.7% 15.9% 17.4% 17.7% 13.4% 15.9% 18.2% 19.4%Rental Service 16.7% 26.2%Industrial Technique (IT) 13.4% 19.8% 20.9% 22.4% 17.8% 4.7% 15.3% 15.8% 16.4%Reported Margin 14.6% 16.4% 18.2% 19.0% 18.6% 14.3% 17.1% 18.6% 19.4%

Financial Income and Expenses -328 -103 -709 -1,532 -694 -819 -329 168 738Reported PBT 6,784 6,835 8,494 10,534 13,112 8,271 10,883 13,573 15,800Tax -2,113 -2,896 -3,004 -3,118 -3,106 -1,995 -2,830 -3,529 -4,582Discontinued 0 217 8,047 53 184 0 0 0 0Minority Interest -14 -21 -24 -29 -33 -32 -34 -35 -35Reported Net Income (to Shareholders) 4,657 4,135 13,513 7,440 10,157 6,244 8,019 10,009 11,183Average number of (FD) Shares (mn) 1,258 1,258 1,258 1,221 1,229 1,230 1,230 1,230 1,230Reported Diluted EPS (Skr) 3.49 3.29 10.75 6.71 8.26 5.08 6.52 8.14 9.09DPS (Skr) 1.50 2.13 2.38 3.00 3.00 3.00 2.90 3.70 4.10





Fig 366: Atlas Copco financial forecasts, performance metrics and valuation

Atlas Copco (December Y/E; Skr mn) ATCOA SS Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth 1.4% -28.1% 16.1% 14.3% 7.6%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 11.7% -22.5% 5.2% 10.1% 7.5%

Orders 73,572 58,451 66,498 76,177 81,950 Sales growth 17.1% -14.0% 2.7% 10.4% 7.5%Revenue 74,177 63,762 65,456 72,251 77,688 Adj. EBITDA growth 17.1% -23.4% 12.8% 15.0% 9.8%



Net financial expense -694 -858 -329 168 738 DPS growth 0.0% 0.0% -3.3% 27.6% 10.8%PBT 13,112 8,232 10,883 13,573 15,800Total tax -3,106 -1,995 -2,830 -3,529 -4,582 Profit and cost margins 2008 2009 2010E 2011E 2012E





Adj. vs. reported EBIT 278 552 -14 -14 -14 Employees (average) 34,274 30,559 31,363 34,620 37,224Adj. PBT 13,404 8,798 10,883 13,573 15,800 Book to bill (orders / sales) 0.99 0.92 1.02 1.05 1.05Adj. Net income 10,449 6,771 8,019 10,009 11,183 Cash conversion (FCF / NI) 66.4% 231.3% 123.4% 103.7% 104.8%Adj. EPS 8.50 5.50 6.52 8.14 9.09 WC / sales 26.5% 20.2% 19.9% 19.8% 19.8%Adj. EPS (post-restructuring) 8.25 5.04 6.52 8.14 9.09 Inventory / sales 23.1% 17.8% 17.6% 17.5% 17.5%


EBITDA 16,768 12,836 14,485 16,655 18,292 Capex / depreciation (inc intang) -1.32 -0.75 -0.68 -0.81 -0.84Provisions 0 0 0 0 0 Net debt (EV) / EBITDA 1.50 1.08 0.16 -0.65 -1.44Interest paid 44 -1,575 -329 168 738Tax paid -3,975 -1,759 -2,830 -3,529 -4,582 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) 23,027 11,802 333 -12,890 -28,442Other -81 -126 -32 -13 -10 Mkt secs, leases and converts 0 0 0 0 0Operating cash flow pre-WC 12,756 9,376 11,295 13,281 14,437 Pension deficit (net of tax) 1,922 1,768 1,768 1,768 1,768Change in working capital -2,991 6,715 -170 -1,291 -1,045 Adjusted net debt 24,949 13,570 2,101 -11,122 -26,674Operating cash flow 9,765 16,091 11,124 11,990 13,393 Mins, assocs, advances, other 264 256 274 278 278Capex (PP&E and intangibles) -3,029 -1,738 -1,227 -1,614 -1,672 Net debt (EV) 25,213 13,826 2,375 -10,845 -26,396Acquisitions and disposals -278 -171 -1,400 0 0Other -1,086 683 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -4,393 -1,226 -2,627 -1,614 -1,672 Average / current share price 86.06 80.51 103.60 103.60 103.60

Dividends paid -3,667 -3,652 3,689 3,566 4,550 Market capitalisation 105,766 99,028 127,429 127,429 127,429Other (incl. share capital) -453 0 0 0 0 Group EV 130,979 112,854 129,804 116,584 101,034Financing cash flow -4,120 -3,652 3,689 3,566 4,550 P/E (pre-restructuring) 10.12 14.63 15.89 12.73 11.40

FX and other 198 -76 0 0 0 P/E (post-restructuring) 10.43 15.96 15.89 12.73 11.40Reconciliation to basic net debt -5,281 88 -717 -719 -719 EV/Sales 1.77 1.77 1.98 1.61 1.30Net cash flow -3,831 11,225 11,469 13,223 15,551 EV/EBITDA 7.81 8.79 8.96 7.00 5.52







Electrolux (ELUXB SS, Neutral, target SKr175)

We rate Electrolux as Neutral. While there is an attractive 13% upside to our SKr175 target price, supported by a relatively compelling valuation argument, we see limited upside to consensus numbers and a number of risks that prevent us being buyers. As a low margin company, Electrolux faces a higher degree of earnings risk, both ways. While 2009 was an exceptional year with price, mix, raw material cost and savings all helping to drive a significant earnings surprise (especially in 2H09), we expect 2010E and 2011E to see much less in the way of earnings growth. Furthermore, we see risks on the degree of volume recovery, which is needed to offset the raw material and branding cost headwinds. We are also concerned about the price and raw material cost environment given the industry dynamics (discussed in the appliance chapter).

Fig 367: 2009 Electrolux group revenues split by division, product and end market

Floorcare8%

Fridge / Freezer

28%

Other7%

Hot (Cooking)22%

Dishwasher7%

Professional Indoor

7%

Laundry21%

Consumer93%

Professional Food Service

7%

Professional Products

7%

Europe39%

North America

33%

Latin America12%

Asia Pacific9%

Sales by Division Sales by Product Sales by End Market


Lacklustre growth mix

Electrolux is almost entirely dependent on consumer demand. Over the longer term, we believe this exposure to be a slight handicap. Our end market analysis suggests that consumer demand is relatively low growth compared to the infrastructure end markets enjoyed elsewhere in the sector. On a geographical basis, Electrolux benefits from having 32% of group sales exposed to emerging markets (including 10% from Eastern Europe and Russia, and 1% from the professional products business). However, this is below the sector average of 38%, suggesting a lower growth mix relative to the wider European Capital Goods sector. Over the past ten years Electrolux has seen a 2% average organic sales growth against the sector average of 4%.

Fig 368: Growth has been at the low end of the sector Fig 369: Margins have consistently underperformed

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Average cost savings

Like others, Electrolux has restructured, reducing its headcount by 6% between 4Q08 and 4Q09. However, its 2010E savings are less than average as a proportion of revenues (and in line as a proportion of EBIT).

Difficult industry but impressive management actions

On our supply-side criteria, Electrolux scores below average. The global appliance industry is highly competitive and has relatively low margins. After three decades of attractive consolidation, industry peak margins have halved following the entrance of emerging market manufacturers. However, although slow to react at first, Electrolux responded with impressive management actions (often the case with Wallenberg-owned companies). Since 2004, Electrolux has lifted its share of purchases and production in low-cost countries from c25% to just over 50% and has also increased its proportion of revenues under the Electrolux brand from 16% in 2002 to c55% in 2009. This has helped to mitigate the effects of low-cost competition but not eliminate them.

Strategy has paid off but 2009 was an exceptional year, 2010E is less exciting

While Electrolux is right to focus on the areas it can control – notably improving mix through product launches, defending prices and lowering costs through restructuring and procurement savings – we believe 2009 was an exceptional period for all three items, with a combined tailwind of cSKr3.5bn. Looking at 2010E, we see less of a tailwind of cSKr700m from these items. Consequently, the earnings growth experienced in 2009 will slow meaningfully in 2010E and 2011E.

Our 2011E EPS is 6% below consensus

Fig 370: We see some upside to consensus earnings

E le ct ro lux R edburn EPS vs. C onsensus

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We see some scope for consensus earnings downgrades as our 2011E EPS forecast of SKr15.2 is 6% below consensus. However, looking into the detail, our revenues are largely in line, but our margin forecast is below consensus. This is driven by our supply-side work, which highlights the pricing pressure and poor competitive dynamics of thee global appliance industry.

Valuation is a supporting factor; Electrolux is still cheap on our numbers

In terms of valuation, Electrolux is trading below its historic averages and on 2011E EV/IC vs ROIC/WACC, it looks attractively priced. We would caution that optically attractively near term multiples may flatter the picture for Electrolux given its relatively poor growth potential beyond 2011 vs the rest of the sector.




Fig 371: Electrolux vs sector EV/Sales Fig 372: Electrolux vs sector EV/EBIT Fig 373: Electrolux vs sector P/E

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We expect group EBIT margins (Pre Items Affecting Comparability) to lift from 4.9% in 2009 to 5.7% in 2010E and 6.2% in 2011E. Electrolux enjoyed the sweet spot of cost savings, positive pricing and falling raw material costs in 2H09. Looking forward, though, we would expect the recent price/raw material tailwind to reverse into a headwind in 2010E and 2011E. However, we expect this headwind to be more than offset by a volume recovery, continued favourable mix effects and a currency tailwind.

2010E tailwinds: in 2010E we expect Electrolux EBIT to benefit from a return to volume growth (+2.6% vs -8.3% in 2009) from a US recovery (less so in Europe). We also expect continued emerging market growth leading to cSKr700m of extra EBIT, continued mix gains (cSKr350m) with increasing share in the higher margin built-in segment in Europe and further Frigidaire and Electrolux launch benefits in the US, further restructuring costs savings of cSKr650m, a positive cSKr600 mn of currency benefit (mostly in 1H10E) and a reduction of pension deficit amortisation costs (+cSKr200m) mostly in the US.

2010E headwinds: in 2010E we expect Electrolux EBIT to experience a SKr900m headwind from increasing raw material costs (mostly steel and plastics), a SKr250m headwind from price (we expect -0.2% for FY10, below Electrolux guidance for flat to positive) and a SKr500m headwind from the uplift in branding costs from 1.5% of revenue back 2.0%.

Beyond 2010E our uplift in margins is predominantly driven by volumes (we expect +3% in 2011). Our estimates are shown below.




Fig 374: Electrolux Divisional P&L Detail, 2004-12E

Electrolux Annual P&L (Skr mn, Dec Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012EConsumer Durables, Europe 42,703 43,755 44,233 45,472 44,342 42,300 41,278 42,517 43,792Consumer Durables, North America 30,767 35,134 36,171 33,728 32,801 35,726 35,221 36,278 37,366Consumer Durables, Latin America 4,340 5,819 7,766 9,243 10,970 14,165 14,751 15,488 16,263Consumer Durables, Asia Pacific 9,139 9,276 8,636 9,167 9,196 9,806 10,449 10,867 11,302Professional Products 6,440 6,686 6,941 7,102 7,427 7,129 6,822 6,993 7,168Group Costs 60 31 101 20 56 6 6 6 6Group Sales 120,651 100,701 103,848 104,732 104,792 109,132 108,528 112,149 115,896

Consumer Durables, Europe -1.0% 0.8% 1.2% 2.9% -5.2% -10.6% 0.8% 3.0% 3.0%Consumer Durables, North America 4.3% 12.2% 2.8% 1.4% -0.4% -5.3% 4.0% 3.0% 3.0%Consumer Durables, Latin America 17.4% 31.7% 25.7% 18.7% 16.0% 22.7% 7.0% 5.0% 5.0%Consumer Durables, Asia Pacific 7.0% -0.4% -1.8% 8.1% 1.4% -3.0% 3.8% 4.0% 4.0%Professional Products 0.0% 2.2% 4.2% 3.7% 2.2% -11.2% -1.5% 2.5% 2.5%Group Organic Sales Growth Rates (%) 2.8% 5.9% 3.3% 4.0% -0.6% -4.9% 2.8% 3.3% 3.3%

Group Acquisition Impact on Sales (%) -2.0% -0.2% -0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Group Currency Impact on Sales (%) -3.6% 3.2% 0.2% -3.1% 0.7% 9.0% -3.3% 0.0% 0.0%

Consumer Durables, Europe 3,130 2,602 2,678 2,067 -22 2,188 2,006 2,253 2,380Consumer Durables, North America 1,116 1,444 1,462 1,711 222 1,476 2,025 2,219 2,371Consumer Durables, Latin America 135 123 339 514 715 878 1,199 1,391 1,564Consumer Durables, Asia Pacific -289 13 163 330 369 619 893 990 1,078Professional Products 445 463 535 584 774 668 619 578 578Group Costs -898 -581 -602 -369 -515 -507 -507 -507 -507Group EBIT (Pre IAC) 6,767 4,064 4,575 4,837 1,543 5,322 6,234 6,924 7,465Items affecting comparability (IAC) -1,960 -3,023 -542 -362 -355 -1,561 -825 -980 -980

of which: Restructuring -1,760 -2,636 -490 -362 -487 -1,617 -825 -980 -980of which: Other -200 32 60 0 132 56 0 0 0of which: Capital gains and losses 0 -419 -112 0 0 0 0 0 0

Group Reported EBIT 4,807 1,041 4,033 4,475 1,188 3,761 5,409 5,944 6,485

Consumer Durables, Europe 7.3% 5.9% 6.1% 4.5% 0.0% 5.2% 4.9% 5.3% 5.4%Consumer Durables, North America 3.6% 4.1% 4.0% 5.1% 0.7% 4.1% 5.7% 6.1% 6.3%Consumer Durables, Latin America 3.1% 2.1% 4.4% 5.6% 6.5% 6.2% 8.1% 9.0% 9.6%Consumer Durables, Asia Pacific -3.2% 0.1% 1.9% 3.6% 4.0% 6.3% 8.5% 9.1% 9.5%Professional Products 6.9% 6.9% 7.7% 8.2% 10.4% 9.4% 9.1% 8.3% 8.1%Group EBIT margin (Pre IAC) (%) 5.6% 4.0% 4.4% 4.6% 1.5% 4.9% 5.7% 6.2% 6.4%

Group Reported EBIT Margin (%) 4.0% 1.0% 3.9% 4.3% 1.1% 3.4% 5.0% 5.3% 5.6%

Net Financial Expense -355 -550 -208 -440 -535 -277 -40 20 69Reported PBT 4,452 491 3,825 4,035 653 3,484 5,368 5,964 6,553Tax -1,193 -636 -1,177 -1,110 -287 -877 -1,342 -1,640 -1,802

Tax Rate as % of Reported PBT 26.8% 129.7% 30.8% 27.5% 44.0% 25.2% 25.0% 27.5% 27.5%Minority Interests -1 0 0 0 0 0 0 0 0Discontinued operations 0 1,905 1,199 0 0 0 0 0 0Reported Net Income 3,258 1,760 3,847 2,925 366 2,607 4,026 4,324 4,751Average # Shares (FD) 298.6 293.2 289.8 283.3 283.2 284.1 284.5 284.5 284.5Reported Diluted EPS (Skr) 10.92 6.04 13.32 10.41 1.29 9.18 14.16 15.20 16.71DPS (Skr) 7.00 7.50 4.00 4.25 0.00 4.00 5.12 5.59 8.06

For 2004, divisional Sales and EBIT do not add up, this is due to the absence of the Outdoor business from our P&L. We have hidden the Outdoor business for the sake of tidiness, as it was carved out to form the independently quoted Husqvarna in early 2005 Source: Redburn Partners, company




Fig 375: Electrolux financial forecasts, performance metrics and valuation

Electrolux (December Y/E; Skr mn) ELUXB SS Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth na na na na naIncome statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth -0.6% -4.9% 2.8% 3.3% 3.3%

Orders na na na na na Sales growth 0.1% 4.1% -0.6% 3.3% 3.3%Revenue 104,792 109,132 108,528 112,149 115,896 Adj. EBITDA growth -39.9% 92.5% 9.3% 7.1% 5.7%

Gross profit 17,997 22,152 22,626 23,828 24,931 Adj. EBIT growth -68.1% 244.9% 17.1% 11.1% 7.8%EBIT (post-NRIs) 1,188 3,761 5,409 5,944 6,485 Adj. PBT growth -77.1% 400.5% 22.8% 12.1% 8.5%

Reported EBIT Margin (%) 1.1% 3.4% 5.0% 5.3% 5.6% Adj. EPS growth -78.1% 476.3% 16.2% 9.3% 8.1%

Net financial expense -535 -277 -40 20 69 DPS growth -100.0% #DIV/0! 27.9% 9.3% 44.1%PBT 653 3,484 5,368 5,964 6,553Total tax -287 -877 -1,342 -1,640 -1,802 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 366 2,607 4,026 4,324 4,751 Gross profit margin 17.2% 20.3% 20.8% 21.2% 21.5%Minorities 0 0 0 0 0 Adj. EBITDA margin 4.3% 8.0% 8.8% 9.2% 9.4%Other (discont., prefs and other) 0 0 0 0 0 Adj. EBIT margin 1.5% 4.9% 5.7% 6.2% 6.4%Net income (all in) 366 2,607 4,026 4,324 4,751 Adj. PBT margin 1.0% 4.6% 5.7% 6.2% 6.5%




Adj. vs. reported EBIT 0 0 0 0 0 Employees (average) 55,177 55,209 55,240 55,272 55,304Adj. PBT 1,008 5,045 6,193 6,944 7,533 Book to bill (orders / sales) na na na na naAdj. Net income 721 4,168 4,851 5,304 5,731 Cash conversion (FCF / NI) 942.7% 291.2% 125.4% 98.3% 102.8%Adj. EPS 2.55 14.67 17.05 18.64 20.15 WC / sales 16.9% 13.0% 13.0% 13.0% 13.0%Adj. EPS (post-restructuring) 0.83 8.98 14.15 15.20 16.70 Inventory / sales 12.1% 9.2% 9.2% 9.2% 9.2%


EBITDA 4,553 8,764 9,582 10,265 10,848 Capex / depreciation (inc intang) -1.23 -0.75 -0.91 -1.06 -1.08Provisions 1,738 -3,501 -225 -272 19 Net debt (EV) / EBITDA 2.78 0.71 0.37 0.22 0.03Interest paid -729 -185 -40 20 69Tax paid -918 -929 -1,342 -1,640 -1,802 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) 5,826 4,068 1,423 65 -1,786Other -239 18 0 0 0 Mkt secs, leases and converts 0 0 0 0 0Operating cash flow pre-WC 4,405 4,167 7,974 8,373 9,134 Pension deficit (net of tax) 6,864 2,168 2,168 2,168 2,168Change in working capital 1,503 5,854 122 -574 -595 Adjusted net debt 12,690 6,236 3,591 2,233 382Operating cash flow 5,908 10,021 8,096 7,799 8,539 Mins, assocs, advances, other -27 -19 -19 -19 -19Capex (PP&E and intangibles) -3,702 -2,593 -3,047 -3,548 -3,654 Net debt (EV) 12,663 6,217 3,572 2,214 363Acquisitions and disposals -34 4 0 0 0Other -19 -378 -441 -458 -462 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -3,755 -2,967 -3,488 -4,006 -4,116 Average / current share price 83.50 118.14 154.80 154.80 154.80

Dividends paid -1,204 0 -1,138 -1,455 -1,591 Market capitalisation 23,647 33,558 44,038 44,038 44,038Other (incl. share capital) 17 69 0 0 0 Group EV 36,310 39,775 47,610 46,252 44,401Financing cash flow -1,187 69 -1,138 -1,455 -1,591 P/E (pre-restructuring) 32.80 8.05 9.08 8.30 7.68

FX and other 212 99 0 0 0 P/E (post-restructuring) 101.05 13.15 10.94 10.18 9.27Reconciliation to basic net debt -1,962 -5,464 -825 -980 -980 EV/Sales 0.35 0.36 0.44 0.41 0.38Net cash flow -784 1,758 2,645 1,358 1,851 EV/EBITDA 7.97 4.54 4.97 4.51 4.09







Invensys (ISYS LN, Neutral, target 330p)

We rate Invensys as a Neutral, with a target price of 330p. We expect Controls to show a positive recovery surprise over the next year and lift margins from 4.5% in FY09 to 11.0% in FY11. We are more cautious on IOM, where we expect oil, gas and process capex to remain sluggish for the next 12 months. We forecast 22.6p of EPS in 2012E, which is 13% below consensus of 26.0p.

Despite its relatively attractive infrastructure end market exposure of 59%, Invensys has delivered materially below sector average organic sales growth over time. This is partly due to its low emerging market content but also, we believe, due to historic market share losses. Rail is arguably Invensys’ ‘jewel in the crown’ but margins have lifted 650bp from 14.5% in 2007 to 22.0% in 2010E, and we see no further upside. As such, there is not enough at Invensys to get excited about at the current valuation.

Fig 376: 2009 Invensys group revenues split by division, geography of destination and end market


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The lowest organic sales growth of our coverage over the past six years

Over the past six years (we limit our financial history for Invensys given the portfolio changes), Invensys has only averaged +1.7% organic sales growth a year, making it the lowest growth company in our coverage, and well below the sector average of +5.3% over the same period. We attribute this partly to historic disruption, but also the company’s relatively low exposure to emerging markets (at 23%). However, even allowing for both issues, the number is low, particularly as the company has an attractive 59% of revenues exposed to infrastructure end markets (notably the historically higher than coverage average growth oil & gas and rail (signalling) markets).

Fig 377: Growth has been below coverage Fig 378: Margins have recovered to coverage average

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Margin resilience throughout the downturn

Invensys outperformed in 2009 (+78% from 166p to 299p) with the growing realisation that the company, under CEO Ulf Henriksson, could navigate a c-10% organic sales downturn while maintaining relatively resilient margins. Having virtually gone bust in the previous downturn, the stigma of Invensys’ ugly past has dragged on the company going into the downturn, despite having long outlasted the reality.

Invensys’ three businesses have no real synergy and there is little logic to their combination: they only exist together under Invensys PLC given the company’s eclectic past. However, as they each operate in relatively independent cycles, their combination provides an element of good old-fashioned conglomerate portfolio protection.

Both Controls and IOM (Invensys Operations Management – the old Process division) are cyclical businesses, whereas rail, one could argue, is more of a structural business. Controls faces earlier cycle consumer exposure and therefore saw the downturn first in 1H09 (March Y/E). A year later, Controls has started to see its rate of organic order decline improve in 1H10, just as IOM has started its later cycle, oil and gas exposed capex downturn. Throughout, rail has surprised positively by delivering an increase in margins from 16% in FY08 to 22% in FY10E, despite ongoing management guidance to cool rail expectations. In combination, Invensys margins have remained remarkably resilient.

Fig 379: We forecast 22.6p of EPS in 2012E vs consensus of 26.1p

Invensys R edburn EPS vs. Consensus

8% -14%-13%

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10.0015.0020.0025.0030.0035.0040.00

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Rail margins likely to drift downwards going forward

Rail is well positioned with leading market shares in the UK, Spain and US signalling markets, and 20%+ EBIT margins and negative working capital.

Looking forward, we believe rail margins have hit a structural peak and we expect them to drift down towards 19.8% in FY12E. Rail aims to book 17-18% margins on its orders, but allows for 3-6% of contingency (higher if overseas). Over the last year or so, Invensys has executed its rail signalling business more successfully than in the past, and, therefore, has not needed its contingencies. This explains the rail margin uplift.

However, looking forward, while we optimistically expect continued good execution, we see some margin headwind from an increase in international business. Rail has historically centred nearly all of its business in the UK, Spain and US. However, following a number of overseas contract wins, including Brazil, Singapore, New Zealand and Turkey, we expect a greater degree of execution risk.




IOM to see a difficult year

In 1H10, IOM saw a 23% decline in orders (at CER). We have seen a similar decline in ABB’s process automation business and in Siemens’ oil and gas division. Evidence suggests that capex out of the oil and gas end market may remain difficult for a while before recovering. The potential near-term upside for IOM stems from Triconex, which makes nuclear safety equipment. Having booked a $250m contract in China in January 2008 for four nuclear reactors, Triconex may be well positioned to win the outstanding contracts for the next eight reactors, currently being tendered. IOM is also currently bidding for greenfield work in the Middle East.

Controls to recover

Controls sells electronic control devices to the appliance industry, and both Electrolux and whirlpool expect modest volume recovery in 2010. We believe the combination of a return to revenue growth and the full-year effect of the recent cost savings will make Controls the positive earnings surprise of FY11. We expect OpBIT margins to lift from 4.5% in FY09 to 7.8% in FY10 and then 11.0% in FY11.

Valuation

In terms of valuation (we have calendarised the data to a December Y/E), Invensys is trading on 15.0x 2011E P/E (a 24% premium to the sector), a 1.8% 2011E dividend yield, and 9.2x 2011E EV/EBIT (a 7% premium to the sector). We would argue that these multiples are stretched for a company with one of the lower growth profiles amongst our coverage. This concern is mitigated to a degree by the company’s scope to win material nuclear and process orders through its IOM division.

Fig 380: Invensys vs sector EV/Sales Fig 381: Invensys vs sector EV/EBIT Fig 382: Invensys vs sector P/E

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Fig 383: Invensys P&L with divisional detail (2005-13E)

Invensys P&L (£ mn, March Y/E) 2005 2006 2007 2008 2009 2010E 2011E 2012E 2013EOperations Management 729 798 845 870 1,333 946 957 995 1,035Rail Systems 454 504 549 466 968 855 780 819 860Controls 900 797 741 641 505 532 559 584 602APV 390 419 448 97Eurotherm 122 119 111 119Group Orders 2,595 2,637 2,694 2,193 2,806 2,332 2,295 2,398 2,496

Operations Management 9.0% 4.9% 35.6% -34.7% 1.0% 4.0% 4.0%Rail Systems 10.1% -12.9% 108.9% -15.4% -8.8% 5.0% 5.0%Controls 1.1% -10.0% -33.1% -0.3% 5.0% 4.5% 3.0%Group Organic Order Growth 6.3% -4.6% 27.6% -21.9% -1.7% 4.5% 4.1%

Operations Management 1.03 1.10 1.08 1.05 1.25 0.96 1.00 0.99 0.99Rail Systems 1.10 1.15 1.06 0.79 1.52 1.25 1.07 1.06 1.06Controls 0.98 1.01 1.01 0.99 0.87 1.01 1.01 1.01 1.01Group Book to Bill 1.03 1.07 1.05 0.96 1.23 1.06 1.02 1.02 1.02

Operations Management 709 725 779 828 1,069 984 957 1,004 1,045Rail Systems 412 438 516 588 636 682 730 774 812Controls 921 788 737 649 579 526 553 578 595APV 360 388 421 101Eurotherm 122 118 109 115Group Sales 2,524 2,457 2,562 2,281 2,284 2,192 2,239 2,356 2,452

Operations Management 0.5% -1.3% 10.5% 8.1% 11.2% -13.5% -3.0% 5.0% 4.0%Rail Systems -4.3% 4.6% 19.4% 16.9% 7.7% 3.2% 7.0% 6.0% 5.0%Controls 8.5% 11.4% 2.4% -8.3% -22.5% -15.0% 5.0% 4.5% 3.0%Group Organic Sales Growth 2.5% 5.0% 8.8% 3.9% -0.3% -9.2% 2.1% 5.2% 4.1%

Operations Management 43 81 104 117 119 89 95 115 129Rail Systems 61 65 80 95 134 150 152 154 157Controls 94 64 65 71 26 41 61 73 83APV 5 0 16 3Eurotherm 17 16 13 9Corporate -46 -35 -37 -34 -35 -36 -36 -36 -36OpBIT (Pre NRIs) 174 191 241 261 244 244 272 306 333

Operations Management 6.1% 11.2% 13.4% 14.1% 11.1% 9.1% 9.9% 11.4% 12.3%Rail Systems 14.8% 14.8% 15.5% 16.2% 21.1% 22.0% 20.9% 19.9% 19.3%Controls 10.2% 8.1% 8.8% 10.9% 4.5% 7.8% 11.0% 12.7% 13.9%Group OpBIT margin (%) 6.9% 7.8% 9.4% 11.4% 10.7% 11.2% 12.1% 13.0% 13.6%

Non Recurring Items (NRIs) -161 -60 -34 -34 -66 -8 -32 -34 -35of which: Restructuring -50 -41 -23 -30 -48 -38 -32 -34 -35of which: Other exceptional items -111 -19 -11 -4 -18 30 0 0 0

Group Reported EBIT 13 131 207 227 178 237 240 273 298Group EBIT Margin 0.5% 5.3% 8.1% 10.0% 7.8% 10.8% 10.7% 11.6% 12.2%

Financial Income and Expenses, net -136 -157 -108 -117 -13 -46 -45 -40 -36Reported PBT -123 -26 99 110 165 191 195 232 262Tax 17 -12 -23 -30 -23 -24 -33 -46 -62

Group Tax as % of Reported PBT 13.8% -46.2% 23.2% 27.3% 13.9% 12.8% 17.0% 20.0% 23.7%Net income from Discontinued Items 36 60 133 159 -9 0 0 0 0Minority Interests 11 -3 -2 0 -3 -3 -3 -3 -3Reported Net Income (Pre Non-Recurring Items -59 19 207 239 130 164 159 183 197Average # Shares (FD) 608.7 608.7 702.3 795.5 800.5 807.5 809.0 809.0 809.0Reported Diluted EPS (p) -9.69 3.12 29.48 30.04 16.24 20.25 19.62 22.60 24.34DPS 0.00 0.00 0.00 0.00 1.50 3.00 6.00 6.00 6.00





Fig 384: Invensys financial forecasts, performance metrics and valuation

Invensys (March Y/E; £ mn) ISYS LN Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth -4.6% 27.6% -21.9% -1.7% 4.5%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 3.9% -0.3% -9.2% 2.1% 5.2%

Orders 2,193 2,806 2,332 2,295 2,398 Sales growth -11.0% 0.1% -4.0% 2.2% 5.2%Revenue 2,281 2,284 2,192 2,239 2,356 Adj. EBITDA growth 6.5% -4.6% -0.5% 8.5% 10.7%

Gross profit 654 695 688 725 783 Adj. EBIT growth 8.3% -6.5% 0.2% 11.2% 12.6%EBIT (post-NRIs) 227 178 237 240 273 Adj. PBT growth -10.0% 28.9% -14.5% 14.3% 17.2%

Reported EBIT Margin (%) 10.0% 7.8% 10.8% 10.7% 11.6% Adj. EPS growth -11.4% -36.6% -13.9% 11.4% 13.4%

Net financial expense -117 -13 -46 -45 -40 DPS growth na na 100.0% 100.0% 0.0%PBT 110 165 191 195 232Total tax -30 -23 -24 -33 -46 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 80 142 167 162 186 Gross profit margin 28.7% 30.4% 31.4% 32.4% 33.2%Minorities 0 -3 -3 -3 -3 Adj. EBITDA margin 14.3% 13.7% 14.2% 15.0% 15.8%Other (discont., prefs and other) 159 -9 0 0 0 Adj. EBIT margin 11.4% 10.7% 11.2% 12.1% 13.0%Net income (all in) 239 130 164 159 183 Adj. PBT margin 7.9% 10.2% 9.1% 10.1% 11.3%

Adj. Net income margin 13.5% 8.6% 7.8% 8.5% 9.2%EPS (FD) 30.04 16.24 20.25 19.62 22.60DPS 0.00 1.50 3.00 6.00 6.00 Personnel costs / sales na na na na naWeighted avg shares (FD, mn) 796 801 808 809 809 Depreciation and amort. / sales 2.9% 3.0% 3.0% 2.9% 2.8%


Adj. EBITDA 327 312 310 337 373Adj. EBIT 261 244 244 272 306 Other items 2008 2009 2010E 2011E 2012E

Adj. vs. reported EBIT 0 0 0 0 0 Employees (average) 26,002 21,729 19,922 19,626 20,429Adj. PBT 180 232 198 227 266 Book to bill (orders / sales) 0.96 1.23 1.06 1.02 1.02Adj. Net income 309 197 171 191 216 Cash conversion (FCF / NI) 2.9% 116.1% 81.8% 119.8% 89.4%Adj. EPS 38.84 24.61 21.18 23.59 26.75 WC / sales 13.7% 7.8% 6.6% 7.5% 9.6%Adj. EPS (post-restructuring) 35.07 18.61 16.53 19.62 22.60 Inventory / sales 6.3% 7.2% 6.7% 6.7% 6.7%


EBITDA 327 312 310 337 373 Capex / depreciation (inc intang) -0.88 -0.82 -0.95 -1.15 -1.18Provisions -131 -89 -94 -10 -25 Net debt (EV) / EBITDA 0.44 0.15 0.97 0.51 0.18Interest paid -57 1 -8 -7 -2Tax paid -37 -34 -31 -33 -46 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) -73 -286 -346 -513 -653Other 8 12 6 0 0 Mkt secs, leases and converts 0 0 0 0 0Operating cash flow pre-WC 110 202 183 287 299 Pension deficit (net of tax) 218 308 622 660 698Change in working capital -45 24 -13 -22 -58 Adjusted net debt 145 22 276 147 45Operating cash flow 65 226 171 265 242 Mins, assocs, advances, other 0 24 24 24 24Capex (PP&E and intangibles) -57 -53 -62 -75 -78 Net debt (EV) 145 46 300 171 69Acquisitions and disposals 181 28 -63 0 0Other 0 0 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow 124 -25 -125 -75 -78 Avg / current share price (p) 300.24 217.97 264.09 327.90 327.90

Dividends paid -1 -1 -21 -32 -48 Market capitalisation 2,388 1,745 2,133 2,653 2,653Other (incl. share capital) -25 -9 -4 0 0 Group EV 2,533 1,791 2,433 2,823 2,722Financing cash flow -26 -10 -25 -32 -48 P/E (pre-restructuring) 7.73 8.86 12.47 13.90 12.26

FX and other 34 30 -5 0 0 P/E (post-restructuring) 8.56 11.71 15.97 16.72 14.51Reconciliation to basic net debt 42 -8 44 10 25 EV/Sales 1.11 0.78 1.11 1.26 1.16Net cash flow 239 213 60 168 140 EV/EBITDA 7.75 5.74 7.84 8.38 7.30

EV/EBIT (pre restructuring) 9.71 7.34 9.95 10.38 8.89FCF to the firm (post-tax) 65 172 117 197 166 EV/EBIT (post restructuring) 10.97 9.14 11.76 11.77 9.98FCF to equity (post-tax) 8 173 109 190 163 EV/IC 3.89 2.51 3.34 3.99 3.75

FCF yield (geared vs. M.Cap) 0.3% 9.9% 5.1% 7.2% 6.2%Balance sheet 2008 2009 2010E 2011E 2012E FCF yield (ungeared vs. EV) 2.6% 9.6% 4.8% 7.0% 6.1%Current assets 1,184 1,250 1,247 1,427 1,600Non-current assets 639 788 741 750 762 Economic profit 2008 2009 2010E 2011E 2012ETotal assets 1,823 2,038 1,987 2,177 2,362 Invested capital (average) 652 714 728 708 726

Current liabilities 828 877 798 789 764 NOPLAT 208 198 203 227 249Non-current liabilities 549 521 840 910 981 ROIC (post-tax) 31.9% 27.8% 27.9% 32.1% 34.3%Shareholders equity 377 553 322 449 584 WACC 8.0% 7.7% 7.1% 7.1% 7.2%Minorities and prefs 69 87 78 81 84 ROIC/WACC 3.98 3.59 3.92 4.50 4.76Total liabilities and equity 1,823 2,038 2,038 2,228 2,413 Implied equity value (per share) 3.1 3.1 3.2 3.7 4.2




Sandvik (SAND SS, Neutral, target SKr85)

Sandvik has some of the highest operational gearing in the sector. While the sector saw an organic incremental margin of c30% in 2009, Sandvik saw 74%. With cSKr2bn of further 2010E savings largely known, limited 2010E and 2011E currency and structural impacts, and relatively attractive pricing power (which we believe will enable Sandvik to offset any raw material cost inflation going forward), we believe that Sandvik’s capacity to beat or miss consensus expectations is entirely volume dependent.

Given its operational gearing, small volume surprises will lead to significant EBIT surprises. As such, we believe that Sandvik is more of a bet on demand levels than almost any other stock in the sector. Given our numbers (excluding restructuring) are in line with consensus and also given the two-way risk of forecasting future demand compared to other factors such as price, savings and cost inflation (where we believe analysis can offer more certainty), we rate Sandvik as a Neutral, with a target price of SKr85.

Fig 385: 2009 Sandvik group revenues split by division, geography of destination and end market

Europe39%


10%

North America

17%

South America

6%

Asia Pacific28%

Consumer9% General

Engineering14%

Materials Handling

4%

Other5%

Aerospace9%

Autos14%

Construction16%

Mining18%

Energy / Process

11%Tooling27%

Mining & Construction

(SMC)45%

Materials Technology

(SMT)21%

Seco Tools7%



Demand driven by high emerging market exposure

Sandvik has delivered an average of 5% organic sales growth over the last decade compared to the sector average of 4%. In general this can be explained by its attractive regional mix. In 2009 Sandvik had 50% of its revenues in emerging markets (including 6% in Eastern Europe and Russia) compared to the sector average of 38%. End-market exposure is more balanced with attractive exposures to mining, energy (including nuclear) and less attractive exposures to auto, consumer and construction.

Fastest earnings growth in the sector given the 2009 margin collapse

We expect Sandvik’s clean EBIT (which fell 90% in 2009) to more than quadruple in 2010E and to nearly double in 2011E. Given the degree of margin collapse in 2009 (1390bp, from clean EBIT margins of 16.3% to 2.4%, vs the sector average margin drop of 220bp), Sandvik will see the highest earnings growth of our coverage in both 2010E and 2011E.

The collapse was partly due to Sandvik’s naturally high operational gearing (as a value-added manufacturer rather than an assembler) and management’s decision to under-produce in the downturn (to run down inventories and preserve cash). However, it could also be argued that management action into the downturn was overly optimistic.





In early 2007, Sandvik CEO Lars Pettersson lifted the group’s organic sales growth target from 6% to 8% saying: “I believe we are at the beginning of the beginning” and “Sandvik is no longer a cyclical company.” With this optimism behind the strategy, Sandvik increased its headcount more than any other company in the sector between 2006 and 2008, making it ‘right-sized’ for a level of revenue in excess of the peak. Arguably this management of the cost base was also behind the degree of decline.

Looking forward, management reaction to the downturn has been aggressive and swift in both restructuring and WC management. Consequently, 2010E earnings will benefit from some of the biggest relative cost savings in the sector.

Fig 386: 5% ten-year OSG average vs coverage at 4% Fig 387: Margins have generally exceeded coverage

-40%

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-10%

0%

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1990 1993 1996 1999 2002 2005 2008 2011E

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Sector Average Sandvik

0%

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1990 1993 1996 1999 2002 2005 2008 2011E

Clea

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)

Sector Average Sandvik


Strong pricing power driven by attractive competitive market positions

Despite the 31% group volume decline in 2009, pricing remained positive at Sandvik at +1.5%, and above 0% in all divisions. Based on our supply-side analysis, we believe Sandvik will continue to see attractive pricing in 2010E given its strong market shares in relatively consolidated industries. Sandvik is the number one in the €11bn global metal cutting tool market with a 24% market share (over twice the size of Kennametal, the number two), the number one in the global €23bn mining equipment market with a 17% market share and the number one in the global seamless stainless steel tube market with a 35% market share. Sandvik has a long history of successful pricing in Tooling (it saw positive prices in the 1992 downturn) but the positive surprise driven by industry consolidation has been the improved pricing discipline in SMC (Sandvik Mining and Construction). SMT (Sandvik Material Technology) is the weaker leg of the group when it comes to pricing power with the more commoditised ‘standard products’ side of the division (i.e. the non-seamless tubes business) likely to see price declines in 2010E, in our view.




Our 2011E EPS is in line but we are below in 2010E due to restructuring

Fig 388: Near-term earnings risk

Sandvik R edburn EPS vs. Consensus

-24%

0%-8%

(4.00)

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

2007 2008 2009 2010E 2011E 2012E



We believe consensus expectations are largely achievable. Looking at the details, we are in line with consensus on 2011E Sales, EBIT and EPS. In fact we are also in line with consensus for underlying 2010E numbers, however, due to a SKr1bn further restructuring charge we are 20% and 24% below on EBIT and EPS, respectively. The market should look through this.

As we discuss below, Sandvik’s 2010E and 2011E forecasts are more volume dependent than most companies. Looking back to previous periods of recovery, in 2003 (after one year of -7% organic sales decline) and 1993 (after three years of -5% average organic sales decline), organic sales growth in the recovery year was +5% in 2003 and +16% in 1993. We expect +7% in 2010E compared to -30% organic sales growth in 2009. It is here that the numbers will be made or broken and sadly the history offers no clear guidance either way.

Valuation

In terms of valuation, due to the company’s collapse in margins, Sandvik is currently trading well above its historic multiple ranges and at a 20-30% premium to the sector (for 2011E). On our numbers, by 2012E the premium has largely eroded and Sandvik is trading more closely to its sector peers. In terms of valuation, Sandvik is trading on 10.8x 2012E P/E (in line with the sector), a 4.3% 2012E dividend yield (on our DPS assumption), and 8.7x 2012E EV/EBIT (an 18% premium to the sector).

Fig 389: Sandvik vs sector EV/Sales Fig 390: Sandvik vs sector EV/EBIT Fig 391: Sandvik vs sector P/E

0.0

0.5

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1.5

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2.5

1990 1994 1998 2002 2006 2010

EV/S

ales

Sector Median Sandvik

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EV/E

BIT


010203040

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Current earnings issues We expect reported group EBIT margins (i.e. post non-recurring items) to lift from -2.0% in 2009 to 8.4% in 2010E and 14.9% in 2011E. More so than for any other stock in the sector, Sandvik’s earnings are heavily volume-dependent as we believe that most other factors in the EBIT bridge are either known or minimal. We expect further savings of cSKr2bn in 2010E and that prices will cover raw material cost inflation. As such, with no meaningful currency or acquisition effects expected going forward, the numbers will be heavily dependent on volumes, particularly given the huge degree of operational gearing at Sandvik. In this regard, CEO Lars Pettersson’s optimistic comments on volume recovery at the 4Q09 results may have set expectations on this all-important metric at a high level.

2010E tailwinds: in 2010E, we expect Sandvik EBIT to benefit from a return to organic sales growth (+7% vs -30% in 2009), led by Tooling and Seco, supported by a degree of customer re-stocking and some underlying end-market growth (driven by emerging markets) leading to cSKr5.7bn of extra EBIT. We also expect further restructuring cost savings of cSKr2bn and the dropping out of cSKr3.1bn of charges.

2010E headwinds: in 2010E we expect Sandvik to book a further SKr1bn of restructuring charges. Some of the gearing on the upside will be limited by the reversal of short-time working. In fact there is a risk that if Sandvik cannot extend the short-time agreements, further restructuring will have to occur.

Beyond 2010E our uplift in margins is predominantly driven by volumes (we expect +10% organic sales growth in 2011).

Stretched balance sheet As measured by net debt/EBITDA, Sandvik is the most geared company in the sector measure in either 2009, 2010E, 2011E or 2012E. This is partially due to the margin collapse and also due to the entering the downturn with the highest degree of net debt. As a result Sandvik is the least likely to augment its P&L through acquisitions in the coming years. However, this also means Sandvik’s P&L is more financially geared than most. Given Sandvik also has the highest operational gearing in the sector, this adds to the company’s volume sensitivity, both ways.




Fig 392: All divisions to recover sharply in 2010E; 2004-12E Sandvik P&L with divisional detail

Sandvik Annual P&L (Skr mn, Dec Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012ETooling 19,584 21,084 22,730 25,135 25,797 18,962 20,168 22,319 23,758Mining & Construction (SMC) 17,162 22,394 28,431 37,986 38,634 30,914 36,228 39,666 41,650Materials Technology (SMT) 15,391 17,712 20,977 22,734 21,581 16,479 16,007 17,072 17,926Seco Tools (60% capital, 89% of voting rights) 4,344 4,966 5,540 6,175 6,594 4,926 5,264 5,828 6,205Other 0 30 30 28 3 4 0 0 0Group Order Intake 56,481 66,186 77,708 92,058 92,609 71,285 77,667 84,885 89,538

Tooling 19,227 20,848 22,477 24,732 25,975 19,078 20,268 22,435 23,886Mining & Construction (SMC) 16,617 20,560 25,000 33,074 38,651 32,621 33,335 36,812 38,653Materials Technology (SMT) 14,423 17,003 19,337 22,487 21,480 15,328 16,028 17,103 17,958Seco Tools (60% capital, 89% of voting rights) 4,312 4,924 5,436 6,011 6,512 4,871 5,204 5,762 6,135Other 31 36 40 34 37 39 0 0 0Group Sales 54,610 63,371 72,290 86,338 92,655 71,937 74,836 82,112 86,633

Tooling 11.0% 8.0% 8.5% 9.0% 3.3% -35.4% 8.8% 10.7% 6.5%Mining & Construction (SMC) 20.0% 18.0% 18.6% 26.5% 15.0% -23.4% 3.6% 10.4% 5.0%Materials Technology (SMT) 23.0% 16.0% 15.2% 19.8% -4.9% -34.0% 8.3% 6.7% 5.0%Seco Tools (60% capital, 89% of voting rights) 11.0% 13.0% 10.8% 12.9% 5.3% -29.6% 10.8% 10.7% 6.5%Group Organic Sales Growth (%) 15.0% 14.0% 13.8% 17.9% 5.7% -29.6% 6.5% 9.7% 5.5%

Tooling 3,711 4,420 5,258 5,854 5,720 433 2,463 4,080 4,951Mining & Construction (SMC) 1,829 2,653 3,672 4,979 5,361 1,665 2,900 4,938 5,859Materials Technology (SMT) 1,354 1,769 2,349 2,869 2,798 -246 1,561 2,190 2,446Seco Tools (60% capital, 89% of voting rights) 840 1,100 1,310 1,490 1,421 363 788 1,178 1,402Group Activities and Other -431 -459 -522 -617 -225 -566 -486 -486 -486Group Clean EBIT (Pre-NRIs) 7,303 9,483 12,067 14,575 15,075 1,649 7,226 11,900 14,172

Tooling 19.3% 21.2% 23.4% 23.7% 22.0% 2.3% 12.2% 18.2% 20.7%Mining & Construction (SMC) 11.0% 12.9% 14.7% 15.1% 13.9% 5.1% 8.7% 13.4% 15.2%Materials Technology (SMT) 9.4% 10.4% 12.1% 12.8% 13.0% -1.6% 9.7% 12.8% 13.6%Seco Tools (60% capital, 89% of voting rights) 19.5% 22.3% 24.1% 24.8% 21.8% 7.5% 15.1% 20.4% 22.8%Group Clean EBIT margin 13.4% 15.0% 16.7% 16.9% 16.3% 2.3% 9.7% 14.5% 16.4%

Associates (in Reported EBIT) 122 89 136 119 46 46 46 46 46Group Non-Recurring Items (NRIs) 153 -40 -136 -300 -2,327 -3,106 -998 274 0

of which: Restructuring 0 -40 -268 0 -240 -2,565 -1,000 0 0of which: Other Non-Recurring Items 153 0 132 -300 -2,087 -541 2 274 0

Tooling 3,864 4,420 5,190 5,989 5,460 -527 2,263 4,080 4,951Mining & Construction (SMC) 1,829 2,653 3,672 4,979 4,996 465 2,300 4,938 5,859Materials Technology (SMT) 1,354 1,729 2,324 2,434 1,186 -1,137 1,364 2,464 2,446Seco Tools (60% capital, 89% of voting rights) 840 1,100 1,267 1,490 1,331 308 788 1,178 1,402Group Activities and Other -309 -370 -386 -498 -179 -520 -440 -440 -440Group Reported EBIT 7,578 9,532 12,067 14,394 12,794 -1,411 6,274 12,220 14,218

Tooling 20.1% 21.2% 23.1% 24.2% 21.0% -2.8% 11.2% 18.2% 20.7%Mining & Construction (SMC) 11.0% 12.9% 14.7% 15.1% 12.9% 1.4% 6.9% 13.4% 15.2%Materials Technology (SMT) 9.4% 10.2% 12.0% 10.8% 5.5% -7.4% 8.5% 14.4% 13.6%Seco Tools (60% capital, 89% of voting rights) 19.5% 22.3% 23.3% 24.8% 20.4% 6.3% 15.1% 20.4% 22.8%Group Reported EBIT margin 13.9% 15.0% 16.7% 16.7% 13.8% -2.0% 8.4% 14.9% 16.4%

Financial income and expenses, net -701 -713 -954 -1437 -2218 -2061 -1813 -1741 -1669Reported PBT 6,877 8,819 11,113 12,957 10,576 -3,472 4,461 10,479 12,548Total tax -1,766 -2,427 -3,007 -3,404 -2,740 875 -1,160 -2,829 -3,388

% of reported pre-tax 25.7% 27.5% 27.1% 26.3% 25.9% 25.2% 26.0% 27.0% 27.0%Minority Interests -265 -371 -406 -478 -364 -57 -233 -344 -409Reported Net Income 4,846 6,021 7,700 9,075 7,472 -2,654 3,068 7,306 8,751Avererage of FD Shares in Issue (mn) 1,268 1,228 1,191 1,190 1,188 1,187 1,187 1,187 1,187Reported EPS (FD) (Skr) 3.82 4.90 6.47 7.63 6.29 -2.24 2.58 6.15 7.37DPS (Skr) 2.30 2.70 3.25 4.00 3.15 1.00 1.40 3.40 4.10





Fig 393: Sandvik financial forecasts, performance metrics and valuation

Sandvik (December Y/E; Skr mn) SAND SS Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth -1.0% -29.8% 11.2% 9.3% 5.5%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 5.7% -29.6% 6.5% 9.7% 5.5%

Orders 92,609 71,285 77,667 84,885 89,538 Sales growth 7.3% -22.4% 4.0% 9.7% 5.5%Revenue 92,655 71,937 74,836 82,112 86,633 Adj. EBITDA growth 5.1% -66.6% 85.1% 40.3% 14.7%

Gross profit 31,093 17,067 24,751 30,697 32,695 Adj. EBIT growth 3.4% -89.1% 338.2% 64.7% 19.1%EBIT (post-NRIs) 12,794 -1,411 6,274 12,220 14,218 Adj. PBT growth -2.7% -102.8% n/a 86.9% 23.0%

Reported EBIT Margin (%) 13.8% -2.0% 8.4% 14.9% 16.4% Adj. EPS growth 10.3% -94.1% 561.8% 70.9% 25.9%

Net financial expense -2,218 -2,061 -1,813 -1,741 -1,669 DPS growth -21.3% -68.3% 40.0% 142.9% 20.6%PBT 10,576 -3,472 4,461 10,479 12,548Total tax -2,740 875 -1,160 -2,829 -3,388 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 7,836 -2,597 3,301 7,650 9,160 Gross profit margin 33.6% 23.7% 33.1% 37.4% 37.7%Minorities -364 -57 -233 -344 -409 Adj. EBITDA margin 20.0% 8.6% 15.3% 19.6% 21.3%Other (discont., prefs and other) 0 0 0 0 0 Adj. EBIT margin 16.3% 2.3% 9.7% 14.5% 16.4%Net income (all in) 7,472 -2,654 3,068 7,306 8,751 Adj. PBT margin 13.9% -0.5% 7.3% 12.4% 14.5%

Adj. Net income margin 11.3% 0.9% 5.4% 8.5% 10.1%EPS (FD) 6.29 -2.24 2.58 6.15 7.37DPS 3.15 1.00 1.40 3.40 4.10 Personnel costs / sales 25.0% 32.2% na na naWeighted avg shares (FD, mn) 1188 1187 1187 1187 1187 Depreciation and amort. / sales 3.8% 6.3% 5.7% 5.1% 4.9%



Adj. vs. reported EBIT 2,281 3,060 952 -320 -46 Employees (average) 48,576 47,192 47,051 51,768 55,133Adj. PBT 12,903 -366 5,459 10,205 12,548 Book to bill (orders / sales) 1.00 0.99 1.04 1.03 1.03Adj. Net income 10,425 614 4,065 6,949 8,751 Cash conversion (FCF / NI) 44.2% -571.9% 148.7% 52.7% 75.3%Adj. EPS 8.78 0.52 3.42 5.85 7.37 WC / sales 38.1% 30.2% 29.9% 32.0% 33.1%Adj. EPS (post-restructuring) 8.58 -1.64 2.58 5.85 7.37 Inventory / sales 30.9% 27.6% 26.9% 27.0% 27.0%


EBITDA 18,557 6,190 11,459 16,080 18,450 Capex / depreciation (inc intang) -2.06 -1.02 -0.87 -1.16 -1.20Provisions -663 0 0 0 0 Net debt (EV) / EBITDA 2.14 5.53 2.87 1.96 1.59Interest paid -2,218 -2,061 -1,813 -1,741 -1,669Tax paid -2,897 -870 -1,160 -2,829 -3,388 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) 32,130 30,415 27,686 25,361 22,755Other -142 481 0 0 0 Mkt secs, leases and converts 0 0 0 0 0Operating cash flow pre-WC 12,637 3,740 8,486 11,509 13,392 Pension deficit (net of tax) 2,735 1,460 1,460 1,460 1,460Change in working capital -1,348 11,632 -553 -3,324 -2,034 Adjusted net debt 34,865 31,875 29,146 26,821 24,215Operating cash flow 11,289 15,372 7,933 8,185 11,359 Mins, assocs, advances, other 4,795 2,339 3,748 4,634 5,157Capex (PP&E and intangibles) -6,788 -4,215 -3,375 -4,519 -4,766 Net debt (EV) 39,660 34,214 32,894 31,455 29,373Acquisitions and disposals -843 -1,980 309 0 0Other 0 0 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -7,631 -6,195 -3,066 -4,519 -4,766 Average / current share price 82.31 64.81 79.30 79.30 79.30

Dividends paid -5,111 -3,926 -1,186 -1,661 -4,033 Market capitalisation 97,764 76,934 94,134 94,134 94,134Other (incl. share capital) -44 0 0 0 0 Group EV 137,424 111,148 127,028 125,588 123,506Financing cash flow -5,155 -3,926 -1,186 -1,661 -4,033 P/E (pre-restructuring) 9.38 125.24 23.16 13.55 10.76

FX and other 228 38 0 0 0 P/E (post-restructuring) 9.60 -39.44 30.71 13.55 10.76Reconciliation to basic net debt -4,021 -3,574 -952 320 46 EV/Sales 1.48 1.55 1.70 1.53 1.43Net cash flow -5,290 1,715 2,729 2,325 2,605 EV/EBITDA 7.41 17.96 11.09 7.81 6.69

EV/EBIT (pre restructuring) 9.12 67.40 17.58 10.55 8.72FCF to the firm (post-tax) 6,719 13,218 6,372 5,407 8,262 EV/EBIT (post restructuring) 9.26 -121.34 20.40 10.55 8.72FCF to equity (post-tax) 4,501 11,157 4,559 3,666 6,593 EV/IC 1.73 1.37 1.67 1.62 1.52


Current liabilities 35,269 24,304 24,304 24,304 24,304 NOPLAT 12,002 -307 4,948 8,931 10,669Non-current liabilities 31,233 37,314 37,433 38,004 38,353 ROIC (post-tax) 15.1% -0.4% 6.5% 11.5% 13.1%Shareholders equity 35,588 28,987 30,869 36,514 41,232 WACC 6.5% 6.2% 6.3% 6.3% 6.4%Minorities and prefs 1,137 970 1,203 1,547 1,956 ROIC/WACC 2.34 -0.06 1.04 1.82 2.06Total liabilities and equity 103,227 91,575 93,809 100,369 105,845 Implied equity value (per share) 122.7 -33.0 38.7 92.7 116.0




Schneider Electric (SU FP, Neutral, target €95)

Schneider is a well-managed business. We like CEO, Mr Jean-Pascal Tricoire, and his second structural cost-cutting programme (One Company). We also like Schneider’s decision to acquire Areva D, which we find surprisingly value accretive for a large acquisition (at 10.9% post tax ROIC in 2012E), helped by the significant synergy potential from a neat industrial fit. We see Schneider’s 2010E margin guidance as cautious, because it only targets a 1% increase to 14% clean EBIT margins (excluding Areva D), whereas we forecast 15.4%). We believe it has set the growth expectation bar relatively high again by guiding to ‘mid-single digit organic sales growth’. The valuation case at Schneider is attractive but there is limited upside to consensus earnings since the growth guidance was set at FY09. We prefer the more cautious guidance of Siemens, for example, which is guiding to -5% organic sales growth and margin decline, where we can see real scope for upgrades. We rate Schneider Electric as a Neutral, with a €95 target price.

Fig 394: 2009 Schneider Electric group revenues split by division, geography of destination and end market

Europe41%

North America

27%

Asia-Pacific21%

Rest of the World11%

Energy & Infrastructure

18%

Data Centres & Networks

19%

Industrial26%

Residential Construction

10%

Non-Residential

Construction27%

Industrial Control &

Automation29%

Electrical Distribution

57%

Critical Power14%



Schneider’s growth profile similar to coverage average

While Schneider’s organic sales growth is acceptable, from an investment angle it does not stand out. Over the last decade Schneider has shown an average organic sales growth of 3.9%, very much in line with our coverage average of 4.0%. Looking at Fig 395 and the quarterly data (not shown), we can see that, of the stocks under our coverage, Schneider’s organic sales growth profile is the closest fit to our coverage average. It is neither late nor early cycle, neither defensive nor ultra cyclical, and neither higher nor lower growth but average in almost every way.

Fig 395: Schneider’s OSG profile matches sector avg. Fig 396: Margins have fallen to a ten-year low in 2009

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This assessment is supported by an analysis of its geographic exposure, where 39% of 2009 revenues came from emerging markets (which is in line with our coverage average of 38%). The one area of divergence from the sector mean is Schneider’s under-exposure to infrastructure end markets (at 18%) and its greater dependence on construction-related end markets. Given its under-exposure to the higher growth infrastructure markets, Schneider has done well to keep pace with the sector average growth rate. We attribute this to the structural growth in energy-efficiency products that Schneider specialises in.

One of the most acquisitive companies over the past seven years

Since 2003, Schneider has made c50 acquisitions, culminating in APC and Areva D, spending c€12bn, at c14x EBIT. These acquisitions (including Areva D) account for c60% of Schneider’s current revenues and have changed the shape of Schneider’s profile quite considerably. Effectively, Schneider has transformed from a low voltage power and automation control company to a multi-pillared company with interests in critical power, ultra-low installation, power monitoring, sensors, building automation and medium voltage, providing what Schneider likes to call “energy management solutions.”

Areva D to boost revenues

We calculate that, since 2003, Schneider has boosted its organic sales growth by an average of 5.5% a year from acquisitions. Looking ahead to 2010E and 2011E, we expect a similar +5.4% boost to revenue growth from Schneider’s acquisition of Areva’s Distribution business.

Schneider is paying c€1.3bn (or 14.9x 2010E EV/EBIT) for €1.7bn of 2009 revenues at c7% EBIT margin (down from a 10% margin in 2008, and heading to 5% margin in 2010E in our model). However, while this looks fully priced, if we factor in top-line recovery and therefore margin recovery (we expect 8% margins pre-synergies in 2012E) and combine that with Schneider’s targeted €120m of synergies (from merging Areva D with Schneider’s own €2.5bn of Medium Voltage sales), then the EV/EBIT drops to a very attractive 6.5x in 2012E (see below).

Fig 397: Schneider’s acquisition multiples are very attractive post recovery and synergies

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We calculate that adding Areva D equates to a very value accretive 10.9% post-tax ROIC in 2012E, making it an attractively priced acquisition (unlike some of Schneider’s historical deals). We see the industrial logic of this transaction as very sound, and are inclined to believe that the aggressive synergies (of 5% of Areva D’s revenues, 2% of combined MV revenues) are achievable. We have fully consolidated Areva D into our numbers from 1 July – this is three months after our assumption of Alstom’s consolidation of Areva T, given Schneider has anti-trust hurdles to jump.




‘One Company’ savings plan ahead of track

In early 2009 Schneider laid out a structural savings plan branded ‘One Company’ to save €600m of SG&A by 2011E (of which €200m in 2009) and €600-800m of COGS by 2011 (dependent on volumes). In April, at 1Q09, Schneider increased the overall 2011E SG&A savings target from €600m to €1bn, raising its FY2009 target to €450m. Having beaten expectations and achieved €310m of SG&A savings in 1H09, and no COGS savings due to volume decline, the company lifted its 2009 SG&A savings target for a second time to €540m. In reality, Schneider actually achieved €541m of SG&A savings in FY09. Looking forward, Schneider now targets €400-500m of further savings in 2010E.

‘NEW2’ addressed manufacturing footprint

‘One Company’ is actually Schneider’s second major restructuring programme under Jean-Pascal Tricoire (he structured the first as COO, and then became CEO partly because of his strong execution). The first, ‘NEW2’, launched in early 2005 was predominantly focused on the company’s expensive manufacturing footprint, which was very westernised. In 2004, Schneider was exporting 15-20% of its revenues (see Fig 37 and associated discussion) from high-cost Europe (mostly France) to low-cost emerging markets (largely China). Despite the faster growth of emerging markets, under Mr Tricoire, Schneider more than rebalanced this, taking its manufacturing costs from 39% in emerging markets in 2004 to 58% in 2008 (and mitigating the company’s currency transaction risk at the same time).

‘One’ to address purchasing efficiency

Unlike ‘NEW2’, which addressed the manufacturing footprint, Schneider’s ‘One Company’ plan is much more focused on squeezing suppliers and integrating a relatively complex, multi-layered, local company into ‘One’ simple company that would appear less ‘disjointed’ to customers and would rationalise both buying and selling strategies. Under the plan, Schneider is aiming to: (1) reduce its number of SKUs (stock keeping units) by a third from 1,200,000 at the end of 2007 to 400,000 by 2011E (it had already lowered this to 466,000 by the end of 2009); (2) lower its brands from 100 to 10; (3) reduce operating sites from 1,400 to 1,000; (4) reduce reporting entities from 560 to 350; and, perhaps most importantly of all (5) halve is number of suppliers from 20,000 to 10,000 while increasing its proportion of group purchases with ‘selected’ suppliers (c1,000 suppliers) from 39% in 2008 to 70% in 2011E.

Net price at risk in 2010

Fig 398: Price vs raw material

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Schneider Price Equation





With raw material prices increasing (especially copper which is 32% of Schneider’s annual €1.3bn raw material bill) Schneider is likely to face a raw material headwind in 2010E. Given Schneider forced through price increases of c1% in 2009 when raw material prices fell, we believe the company may find it hard to offset the 2010E raw material headwind with further price rises. As such we expect the three-year track record of improving net price to reverse in 2010.

FY2010 outlook?

Schneider has set a 2010E guidance of ‘mid-single digit’ organic sales growth and a clean EBIT margin of 14% compared to 13.2% in 2009 (excluding Areva D). The top-line growth is more ambitious than most, but because distributors account for more than 50% of Schneider’s group sales, the guidance is understandable given the potential re-uplift. Nonetheless, we believe that such guidance (compared to say Siemens guidance -5% organic sales growth and margin decline) only serves to push expectations upwards early. We now expect organic sales growth of +4% in 2010E and a clean EBIT margin of 15.4% (excluding Areva which is dilutive to margins).

We expect Schneider’s 2010E EBIT to lift from volume, savings, acquisitions and currency with the twin headwinds of mix (higher margin Europe growing slower and some product mix) and raw material costs. Our bridge can be seen below (using Schneider’s longstanding template).

Fig 399: Schneider bridge analysis history and our forecasts

Schneider EBIT Bridge Analysis 2004 2005 2006 2007 2008 2009 2010E 2011E

EBITA Prior Year (Schneider Headline) 1,007 1,286 1,565 2,019 2,562 2,937 2,044 2,609Currency effect -102 -8 1 -103 -159 -88 55 0Structural effect 152 67 103 289 45 -3 61 56

Volume 512 620 244 -1,305 379 160Mix -88 -191 -145 -244 -150 0Price 92 141 307 375 152 28 150

Volume, Price & Mix 314 320 565 736 474 -1,397 257 311Base Costs (SGA & R&D) -164 -212 -231 -354 -199 461 63 -106

Purchasing 133 130 97 124 165 152Lean Manufacturing 65 61 50 55 50 42Rebalancing 29 66 84 72 65 57Other / Fixed Manufacturing Costs 3 47 76 44 51 -146

Gross Industrial Productivity 230 304 307 295 331 105 265 286Raw Material Costs -50 -118 -227 -199 -149 144 -118 -110Production Labour / Payroll -75 -64 -64 -83 -106 -50 -19 -35

Net Industrial productivity (COGS) 105 122 16 13 76 199 127 141Other -26 -10 -1 -38 -26 -65 0 0EBITA Current Year (Schneider Headline) 1,286 1,565 2,019 2,562 2,773 2,044 2,609 3,010


From this our 2010E EPS of €5.20 is some 6% ahead of the €4.90 consensus.




Fig 400: Our 2011E EPS forecast of €6.45 is 2% above the consensus of €6.33

Schne ide r R edburn EPS vs. C onsensus

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Valuation

Schneider Electric is trading on 10.9x 2011E P/E (a 10% discount to the sector), a 4.1% 2011E dividend yield, and 8.2x 2011E EV/EBIT (a 6% discount to the sector).

Fig 401: EV/Sales vs sector Fig 402: EV/EBIT vs sector Fig 403: Schneider vs sector P/E

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Fig 404: Schneider Electric P&L with divisional detail, 2004-12E

Schneider Electric P&L (€ mn, December Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012EEurope 5,274 5,642 6,403 7,846 8,100 6,434 6,967 7,625 7,930North America 2,515 3,047 3,698 4,770 5,053 4,368 4,453 4,647 4,833Asia-Pacific 1,819 2,032 2,514 3,234 3,395 3,040 3,830 4,294 4,551Rest of the World 742 958 1,115 1,459 1,763 1,668 2,158 2,513 2,689Group Sales (€ mn) 10,349 11,679 13,730 17,309 18,311 15,510 17,408 19,078 20,003

Europe 4.6% 5.2% 9.6% 12.0% 6.0% -19.3% 1.5% 3.3% 4.0%North America 6.2% 8.1% 7.3% 13.1% 1.9% -21.3% 3.5% 3.8% 4.0%Asia-Pacific 20.1% 9.3% 15.7% 16.0% 9.7% -14.7% 7.3% 6.0% 6.0%Rest of the World 20.5% 23.5% 17.4% 23.3% 19.2% -1.9% 10.4% 7.0% 7.0%Group Organic Sales Growth (%) 8.4% 8.0% 10.7% 13.9% 6.7% -17.3% 4.1% 4.5% 4.8%

Europe 1,525 967 1,157 1,308 1,399North America 835 564 681 773 828Asia-Pacific 566 526 722 840 917Rest of the World 291 284 406 483 536Corporate & Holding Costs -280 -297 -358 -394 -413EBITAR (Pre Restructuring) 1,374 1,662 2,099 2,660 2,937 2,044 2,609 3,010 3,268

Europe 18.8% 15.0% 16.6% 17.2% 17.6%North America 16.5% 12.9% 15.3% 16.6% 17.1%Asia-Pacific 16.7% 17.3% 18.9% 19.6% 20.1%Rest of the World 16.5% 17.0% 18.8% 19.2% 19.9%EBITAR (Pre Restructuring) Margin 13.3% 14.2% 15.3% 15.4% 16.0% 13.2% 15.0% 15.8% 16.3%

Europe -102 -191 -80 -61 -44North America -14 31 -51 -36 -27Asia-Pacific -27 -26 -44 -33 -25Rest of the World 0 -11 -25 -20 -15Corporate & Holding Costs -21 -24 0 0 0Restructuring Provision -88 -97 -81 -98 -164 -221 -200 -150 -110

Europe 725 762 1,137 1,349 1,423 776 1,077 1,247 1,356North America 298 406 561 787 821 595 630 736 802Asia-Pacific 199 263 352 440 539 500 678 806 892Rest of the World 50 134 190 232 291 273 381 464 521Corporate & Holding Costs 0 0 -221 -246 -301 -321 -358 -394 -413Group Reported EBITA (€ mn) 1,286 1,565 2,019 2,562 2,773 1,823 2,409 2,860 3,158

Europe 13.7% 13.5% 17.8% 17.2% 17.6% 12.1% 15.5% 16.4% 17.1%North America 11.8% 13.3% 15.2% 16.5% 16.2% 13.6% 14.2% 15.8% 16.6%Asia-Pacific 11.0% 12.9% 14.0% 13.6% 15.9% 16.4% 17.7% 18.8% 19.6%Rest of the World 6.7% 14.0% 17.0% 15.9% 16.5% 16.4% 17.7% 18.5% 19.4%Group EBITA margin (%) 12.4% 13.4% 14.7% 14.8% 15.1% 11.8% 13.8% 15.0% 15.8%

Amortisation of Acquisition related Intangibles -18 -79 -174 -231 -246 -246 -246Reported EBIT 1,286 1,565 2,001 2,483 2,599 1,592 2,163 2,614 2,912Financial income and expenses, net -59 -105 -121 -266 -333 -384 -364 -321 -241Associate income (from equity inv) -4 -4 2 4 12 -21 -21 -21 -21Reported PBT 1,224 1,457 1,882 2,222 2,278 1,187 1,777 2,272 2,650Total Tax -365 -428 -535 -600 -555 -293 -444 -591 -716

Tax (%) -29.9% -29.3% -28.4% -27.0% -24.4% -24.7% -25.0% -26.0% -27.0%Exceptionals 0 0 0 0 0 0 0 0 0Amortisation of goodwill 0 0 0 0 0 0 0 0 0Minority Interests -34 -35 -37 -38 -41 -42 -50 -50 -50Reported Net Income 824 994 1,309 1,583 1,682 852 1,283 1,631 1,885Diluted number of shares (Avg.) 221 219 222 236 240 249 247 253 255Reported EPS Diluted (€) 3.72 4.54 5.90 6.70 7.00 3.42 5.20 6.45 7.38DPS (€) 1.80 2.25 3.00 3.30 3.45 2.05 2.60 3.30 3.70





Fig 405: Schneider Electric financial forecasts, performance metrics and valuation

Schneider Electric (December Y/E; € mn) SU FP Equity Growth (%) 2008 2009 2010E 2011E 2012E


Orders na na na na na Sales growth 5.8% -15.3% 12.2% 9.6% 4.8%Revenue 18,311 15,510 17,408 19,078 20,003 Adj. EBITDA growth 5.4% -29.4% 29.2% 14.8% 7.5%



Net financial expense -321 -405 -385 -342 -262 DPS growth 4.5% -40.6% 26.8% 26.9% 12.1%PBT 2,278 1,187 1,777 2,272 2,650Total tax -555 -293 -444 -591 -716 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 1,723 894 1,333 1,681 1,935 Gross profit margin 40.5% 38.3% 41.9% 42.7% 43.3%Minorities -41 -42 -50 -50 -50 Adj. EBITDA margin 17.9% 15.0% 17.2% 18.0% 18.5%Other (discont., prefs and other) 0 0 0 0 0 Adj. EBIT margin 15.9% 12.6% 15.0% 15.8% 16.3%Net income (all in) 1,682 852 1,283 1,631 1,885 Adj. PBT margin 14.1% 10.0% 12.8% 14.0% 15.0%




Adj. vs. reported EBIT 149 143 246 246 246 Employees (average) 126,481 107,133 120,244 131,782 138,167Adj. PBT 2,591 1,551 2,223 2,668 3,006 Book to bill (orders / sales) na na na na naAdj. Net income 1,995 1,216 1,729 2,027 2,241 Cash conversion (FCF / NI) 107.3% 210.5% 96.8% 92.9% 89.4%Adj. EPS 8.31 4.89 7.00 8.02 8.77 WC / sales 20.8% 19.6% 18.2% 17.4% 17.4%Adj. EPS (post-restructuring) 7.62 4.00 6.19 7.42 8.34 Inventory / sales 14.1% 14.0% 13.0% 12.4% 12.4%


EBITDA 3,286 2,321 2,998 3,442 3,702 Capex / depreciation (inc intang) -1.91 -1.66 -1.76 -1.74 -1.81Provisions 121 131 0 0 0 Net debt (EV) / EBITDA 1.85 1.92 1.66 1.20 0.89Interest paid -246 -297 -321 -278 -198Tax paid -567 -411 -444 -591 -716 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates -12 21 21 21 21 Basic (ST + LT debt - cash) 4,553 2,812 3,241 2,399 1,541Other 148 92 0 0 0 Mkt secs, leases and converts 0 0 0 0 0Operating cash flow pre-WC 2,730 1,857 2,254 2,594 2,810 Pension deficit (net of tax) 1,463 1,378 1,378 1,378 1,378Change in working capital -72 813 -127 -142 -162 Adjusted net debt 6,016 4,190 4,619 3,777 2,919Operating cash flow 2,658 2,670 2,126 2,452 2,647 Mins, assocs, advances, other 47 261 346 367 388Capex (PP&E and intangibles) -693 -576 -646 -709 -743 Net debt (EV) 6,063 4,451 4,965 4,144 3,307Acquisitions and disposals -598 -63 -1,114 0 0Other -17 -40 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -1,308 -679 -1,760 -709 -743 Average / current share price 68.34 60.58 80.74 80.74 80.74

Dividends paid -832 -351 -530 -688 -872 Market capitalisation 16,414 15,075 19,932 20,417 20,619Other (incl. share capital) 74 180 0 0 0 Group EV 22,477 19,526 24,897 24,561 23,925Financing cash flow -758 -171 -530 -688 -872 P/E (pre-restructuring) 8.23 12.40 11.53 10.07 9.20

FX and other -83 61 0 0 0 P/E (post-restructuring) 8.96 15.15 13.04 10.88 9.68Reconciliation to basic net debt -144 -140 -264 -214 -174 EV/Sales 1.23 1.26 1.43 1.29 1.20Net cash flow 365 1,741 -429 841 858 EV/EBITDA 6.84 8.41 8.30 7.14 6.46







Siemens (SIE GR, Buy, target €85)

We like Siemens’ revenue mix, both in terms of its 36% exposure to emerging markets and its above sector average exposure of 51% to the infrastructure end markets (notably the power generation, T&D, oil & gas, metals, mining and rail markets). We remind investors that Siemens has outgrown the European Capital Goods sector over the last decade and that its challenge has historically been margins. Here we note that the company’s dramatic portfolio restructuring (41% of 2001 revenues exited or JV’d today) has structurally lifted margins by c5% and that underlying margins on the current group structure have been more resilient and less cyclical than reported. Furthermore, our benchmarking analysis suggests that Siemens’ margins are still 1-2% below peer despite the company’s scale advantage.

We expect the company to beat expectations, and believe that management conservatism (helped by the unusually and pleasingly cautious CFO, Mr Kaeser) has set the bar attractively low, particularly in the risk areas (such as below the ‘sector’ line).

We are slightly concerned by management inaction. After a bright start, and two structural cost-cutting programmes (both SG&A and Supply Chain Management), we believe CEO Peter Löscher has lost momentum and been overtaken by others, by failing to follow up with a meaningful cyclical-based restructuring and capacity reduction, and losing some of the company’s hard earned savings to the downturn.

Our €85 price target is predicated on our EV/IC vs ROIC/WACC valuation methodology and our 20% above consensus estimates. Our price target is also supported by our sum-of-the-parts analysis. Our estimates are predicated on a return to growth in 2011E, and better than guided pricing. We expect Siemens to raise FY10 guidance in April.

Fig 406: 2009 Siemens group revenues split by division, geography of destination and end market

Europe50%


11%

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Asia Pacific12%

Consumer1%Healthcare

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Wind3% Transport

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Rail7%

Power Gen.13%

Oil & Gas10%

Manufacturing10%

Machinery3%

Auto1%

Industry46%

Energy33%

Healthcare16%

Other5%



We expect Siemens to raise guidance in April

At its 4Q09 results in December 2009, Siemens’ management set guidance to €6.0-6.5bn of ‘Sector profit’ (PBT) for 2010E (September Y/E). We believe this is too low and forecast €7.4bn in 2010E and €9.1bn in 2011E. We expect Siemens to raise its FY09 guidance by at least 10% at the 2Q09 results on 29 April 2010.





We are 20% ahead of consensus

We believe consensus expectations for Siemens are too low. Our 2011E EPS forecast of €6.59 is 20% ahead of €5.44 consensus, based on better revenue and margin assumptions. Our forecasts are predicated on a return to growth and a better pricing environment than the -2% guided by management.

Fig 407: Our 2011E EPS forecast of €6.59 is 20% ahead of €5.44 consensus

Siem ens R edburn EPS vs. Consensus

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Return to organic sales growth in 2011E

After a -5% organic sales decline in 2010E, we expect a return to growth with +6% organic sales growth in 2011E. Our ‘return-to-growth’ scenario is supported by our general sector analysis on end-market and geographic demand trends (elsewhere in this report), Siemens’ current order backlog of €83bn (1.2x 2010E ‘sector’ revenue) and recent order trends. Quarterly orders bottomed in 3Q09 and have lifted 11% sequentially since. Furthermore, the book-to-bill returned to above 1x in the last quarter.

GE has already signalled the ‘Infrastructure’ recovery

This picture has also been seen elsewhere, with GE’s CEO saying: “Infrastructure is the real sweet spot compared to the rest of the group and that’s where the group’s incremental capital [spend] will go,” and: “This is not just a one-off, we are now seeing real global growth return in infrastructure” at the 4Q09 results, which saw 24% QoQ sequential increase in ‘Infrastructure’ orders compared to 3Q09. GE Infrastructure is the directly comparable part of GE to Siemens, comprising healthcare, transportation (rail), energy (thermal and wind) and oil and gas.

We expect better pricing resilience than guided

Siemens has predicated its 2010E guidance on a -2% price decline. The company is currently experiencing good pricing discipline in its short cycle businesses (IA, DT and Osram), Healthcare, offshore renewables and fossil power generation, while pricing in Industry Solutions orders is “very bad” (especially in metal) and tough in both Onshore Renewables and T&D.

Despite the areas of pricing difficulty, we believe this guidance is cautious and, as with the sector, the company has resilient pricing power given its attractively positioned portfolio. Our benchmarking analysis of Siemens’ market positioning highlights that the company enjoys a median market position of third across its 15 operating divisions and that, furthermore, it has an average market share of 13% (similar to the European Capital Goods sector as a whole). While Siemens is no better positioned on pricing than the sector as a whole, that’s enough, in our opinion, to lead to upside surprise compared to company guidance.




Siemens has outgrown the sector over time

How many investors are aware that Siemens has outgrown its peers over time? Given the company’s discounted rating, we would argue not many. Siemens has delivered an average 5% organic sales growth over the last decade compared to the sector average of 4%, putting its ten-year average organic sales growth ahead of Alstom, SKF, Schneider, Legrand and Assa Abloy. In general, this can be explained by the combination of its in line exposure to emerging markets (36% including 8% in Eastern Europe and Russia) and its greater-than-sector exposure to infrastructure end markets (51% of revenues vs the sector average of 39%). Infrastructure exposure is dominated by Siemens’ high exposure to the energy (power generation and T&D), oil & gas and rail markets, as well as other exposures to the metals, mining and process markets.

Fig 408: Growth has exceed sector average Fig 409: Margins have closed the gap vs coverage

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Dramatically improved portfolio mix

Siemens’ biggest weakness historically has been its consistent under-delivery on margins. Siemens has a long history of underperforming its peers and continuous ‘one-off’ charges. With respect to both, we believe that the company’s portfolio changes have lowered the risks by exiting most of the culprits behind the historic charges and underlying operating losses.

Fig 410: Siemens revenue mix by division 1997-2008, current vs exited (or JV’d) portfolio

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Fig 410 puts these changes into context. We calculate that Siemens has either exited (or JV’d) 41% of group revenues since 2001 (mostly the telecom and technology-related businesses). This process has continued recently, with the clean-up of ‘Other Operations’ and the sale of its 50% stake in Fujitsu Siemens. Going forward, risks remain from the joint ventures, notably NSN (Nokia Siemens Networks) and SEC (Siemens Enterprise Communications).

Fig 411: Margins with current portfolio mix have been more resilient

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This portfolio re-organisation has had a significant impact on margins. Since 2001 Siemens has lifted its clean (pre-restructuring) EBIT margins from 2.6% to 10.1%. As shown in Fig 411, we calculate that 5% of the 7.5% margin uplift was entirely down to the portfolio mix changes. This also highlights the relative quality of the remaining portfolio, as shown by the greater margin resilience of the current portfolio throughout the last cycle.

Benchmarking exercise suggests 1-2% margin upside

Another weakness historically has been management’s failure to deliver margins consistent with its peers. Given its high R&D spend, economies of scale and market-leading positions, margins should be higher still, in our view. Our analysis (see Fig 412) suggests that Siemens’ margins are c150bp below the peer average across its 15 operating divisions (including SIS).




Fig 412: Siemens’ margins still slightly below peers despite its scale advantage

SIS# 16, 1%

Diagnostics, # 2, 13%

W&S# 3, 21%

Healthcare IT# 4, 5%

Imaging# 2, 25%

Power Transmission

& Distribution# 2, 16% Renewable Energy

# 6, 6%

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# 2, 19%

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# 3

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# 1, 8%

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OSRAM (General)# 2, 19%

BT (LV)# 5, 4%

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DT# 1, 17% IA

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Worse margins than peers

Bubble size represents Siemens’ revenue, and both market position and market share data are provided in the bubble titles. Industry sector divisions in grey; energy sector divisions in dark yellow; healthcare sector divisions in light yellow and cross sector divisions in black (we have only included SIS and have not included SFS, SRE and the joint ventures in our analysis) Source: Redburn Partners

While we have not baked any uplift from this into our estimates, this highlights the scope to improve margins in T&D, BT, Mobility and the troubled SIS.

Strong balance sheet

Adjusting for both the €6bn pension and the €9bn of financial services debt, Siemens is significantly ungeared with €3bn of adjusted net debt (or 0.3x EBITDA). With further disposals in the pipe (such as Hearing Aids, which we expect to fetch c€1.5bn), the company is in good financial health and could easily resume its suspended share buyback programme or make c€10bn+ of acquisitions.

Fig 413: Siemens is relatively ungeared

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Risks to Siemens’ attractive solvency position stem from three areas, in our view:

The JV line: we already expect a further €500m of NSN restructuring in 2010E, however, the formal amount has yet to be announced and could involve greater cash costs;




Working capital: as Siemens works through a period of lower orders, the company will draw on cash from the ‘billings in excess of costs’ line of the balance sheet – the outstanding net liability for this was €3.9bn at the end of 1Q10 and we expect c€1bn of cash outflow in 2010E, but it could be greater; and

Provision utilisation: Siemens had €7.1bn of provisions at the end of 1Q10, the company has not been clear on the degree of utilisation in 2010E and we expect €700m cash outflow but this could be greater.

Concerns: management failure to retain cost-cutting leadership

CEO Peter Löscher started brightly, launching a controversial structural cost-cutting programme to lower SG&A costs early in his tenure. In fact, Mr Löscher kicked off this programme before the downturn started and followed it up, shortly after, with the procurement cost-savings programme, spearheaded by hiring Barbara Kux, the Chief Procurement Officer of Philips (Siemens’ first female board member) as the Head of Supply Chain Management. However, since his luminous start, Mr Löscher has arguably failed to capitalise on his early momentum. Specifically, it appears he has failed to follow up his structural capacity reduction plans with any meaningful cyclical restructuring actions in reaction to the recent downturn. As a result, Siemens has undoubtedly lost the lead in the capacity reductions stakes and its cost-savings achievements have now been comfortably overtaken by others.

Fig 414: Siemens has lost its leadership in the cost-savings stakes

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In fact, we calculate that, with Siemens’ 2009-10E cost-savings measuring 1.3% of 2009-10E revenues, the company ranks seventh out of our ten stocks under coverage, and is saving well below the 2.3% sector average. We believe Siemens’ recent announcement to cut a further 2,000 employees in Germany (only 0.5% of group headcount) as a response to the downturn is a clear signal that Siemens is not going to bite the shareholder-friendly bullet and slash capacity in response to the cyclical downturn. This seems a major opportunity wasted, and a step backwards from a good start.

However, as this information is known and in numbers, there can be only upside if management action returns.

Further risks at the ‘below sector’ level

We expect Siemens’ ‘Other’ line (i.e. below the ‘Sector profit’ line where the JV associate profits, SIS, SFS, SRE, Other Operations (now Centrally Managed Portfolio Activities or CMPA) and Corporate Items sit) to cost a further €2.1bn in 2010E and €1.4bn in 2011E. We expect further losses at NSN, increased interest charges in the pension line, a worse profit at SIS in relation to the ‘carve out’, an increase in the Corporate Items from an




uplift in marketing spend and a worse loss in the CMPA line due to challenges in the Electronic Assembly business. Whilst we expect all of this, we see this section of the P&L as very low P/E (i.e. low quality) and believe the risk of disappointment lies here more than in the sector businesses.

Compelling valuation case

Siemens has some of the cheapest spot multiples in the sector. On our estimates, the company is trading on 9.7x 2011E P/E (a 20% discount to the sector), a 3.3% 2011E dividend yield, and 7.2x 2011E EV/EBIT (a 17% discount to the sector). Furthermore, its EV/IC for 2011E is 1.03x, yet we forecast a 1.72x ROIC/WACC, suggesting even higher potential upside than the pure P&L multiples.

Fig 415: Siemens vs sector EV/Sales Fig 416: Siemens vs sector EV/EBIT Fig 417: Siemens vs sector P/E

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Siemens is trading at 2011E EV/EBIT and P/E multiples that are 50% and 57% below their 20-year historical average, respectively.

Sum-of-the-parts (SOTP) highlights where the value lies

Siemens is a complex company and in many ways lends itself to a sum-of-the-parts analysis. While our €85 target price is based on our EV/IC vs ROIC/WACC, based methodology, it is encouraging that this is supported by similar SOTP-based valuations. Our SOTP analysis runs two valuations: one based on Sales and peer group EV/Sales multiples and one based on EBIT and peer group EV/EBIT multiples.




Fig 418: Our €85 target price is also supported by our sum-of-the-parts

Siemens SoTP (€ mn unless stat ed) Peers for Benchmarking Multiples2010ESales

PeerEV/Sales EV (1)

2010E CleanEBIT

2010EMargin

PeerEV/EBIT EV (2)

Discrete Manufaturing Rockwell , Yokogawa, Sch neider 3,779 100% 3,762 454 12.0% 11.1x 5,032Process Honeywell , Emerson, ABB 1,947 138% 2,684 127 6.5% 11.2x 1,414

Industry Automation 5,726 113% 6,446 930 16.2% 6.9x 6,447Motors and Drives Regal Beloit, Baldor, Emerson, ABB 4,509 141% 6,374 492 10.9% 11.0x 5,417Motio n Control, CNC Fan uc, Yaskawa, ABB 1,932 104% 2,016 275 14.3% 10.5x 2,895

Dri ve Techn ology 6,441 130% 8,390 768 11.9% 10.8x 8,312Bui ldin g Automation (Security, Fire, Comfort) Joh nson Controls, T yco, Hon eywel l, UTC 4,227 103% 4,374 68 1.6% 10.3x 699LV Installation Leg rand, E aton , Sch neider 1,899 151% 2,858 95 5.0% 11.7x 1,110

Bui ldin g T echnologies 6,126 118% 7,233 163 2.7% 11.1x 1,809Gen eral Lamps & Au tomotive Lighting Phil ips 3,049 86% 2,636 249 8.2% 10.9x 2,708Luminaires & Ball asts Zumtob el 536 73% 391 21 4.0% 13.2x 283Opto-Semicon ductors & LEDs Nich ia 536 57% 304 43 8.0% 11.2x 480

OSRAM 4,120 81% 3,331 313 7.6% 11.1x 3,471Metal P lants Danieli 3 ,052 6% 188 168 5.5% 2.6x 433Water Techn ologies Veolia, Nalco 1,276 120% 1,535 96 7.5% 12.9x 1,237Other (Minin g, Pulp & Paper, Cement, Marine) Metso, FLSmidth 1,221 73% 893 -10 -0.8% 10.7x -105

Industry Solutions 5,548 47% 2,616 254 4.6% 6.2x 1,564Roll ing Stock / Turnkey Vossloh , CAF 3,467 90% 3,123 342 9.9% 8.9x 3,049Sign alli ng Ansaldo 1,400 101% 1,416 140 10.0% 9.1x 1,280Airp ort Baggage & Cargo Handling Dai fuku 533 59% 314 24 4.5% 10.0x 240Posta l Automation Pitney Bowes 600 160% 959 27 4.5% 9.9x 268ITS (Road Safety Systems) T elvent, Quixote 667 126% 840 30 4.5% 11.8x 353

Mobili ty 6,667 100% 6,653 563 8.4% 9.2x 5,190

Industry Sector 32,218 108% 34,667 2,995 9.3% 8.9x 26,793Fossil Power Generation Alstom, GE, MHI 9,515 63% 5,960 1,306 13.7% 7.6x 9,951Renewable Energy Vestas, Gamesa 2,847 90% 2,569 277 9.7% 10.9x 3,016Oil & Gas Dresser Rand 4,016 125% 5,035 444 11.0% 9.8x 4,361Power Transmission ABB, Areva 5,577 143% 7,972 553 9.9% 26.6x 14,714Power Distribution ABB, Areva, Sch neider 3,010 141% 4,258 373 12.4% 21.5x 7,998

Energy Sector 24,364 106% 25,793 2,951 12.1% 13.6x 40,040Imaging E quipment Phil ips 5,736 86% 4,959 1,001 17.4% 12.4x 12,376Heal thcare IT Cerner, Eclip sys 1,175 247% 2,898 205 17.4% 16.2x 3,319

Imaging & IT 6,911 114% 7,857 1,206 17.4% 13.0x 15,694Hearing Aid s W illi am Demant, Sonova 588 421% 2,475 47 8.0% 17.8x 837Cancer Care Equip men t Varian, Elekta 441 222% 979 4 1.0% 12.1x 53Special (Mammography, Urology, C-Arm) Holog ic 441 320% 1,408 75 17.1% 12.2x 915

Workflow & Solutions 1,469 331% 4,862 127 8.6% 14.3x 1,805Diagnostics Roche, Abbott, Beckman Coul ter, bioMérieux 3,469 246% 8,549 593 17.1% 11.6x 6,895

Healthcare Sector 11,635 183% 21,268 1,921 16.5% 12.7x 24,394Siemens Sector EV 68,217 120% 81,729 7,867 11.5% 11.6x 91,227

50% in BSH Bosch & Siemens Hausgeräte E lectrolux, Whi rpool, Indesit 8,300 46% 1,907 651 7.8% 8.3x 2,69550% in NSN Noki a S iemens Networks Alcatel-Lucent, Eri csson, Cisco 13,300 88% 5,870 -700 -5.3% 9.2x Zero49% in SEN Siemen s Enterpri se Communications Nortel, Avaya, Cisco, IBM 3,000 226% 3,320 -200 -6.7% 9.6x Zero34% Areva NP Areva 3,214 226% 2,468 -300 -9.3% 42.7x Zero35% Voith Siemens Hydro Andri tz, Vo ith 800 46% 128 19 2.4% 9.7x 65

Equity Investments (SE I) 13,695 2,760Siemens IT Solutions & Servi ces (SIS ) Accenture, CSC, IBM 4,050 117% 4,739 -29 -0.7% 8.5x -248Siemens Finan cial Services (SFS) 1.5x E quity g iven 26% RoE 794 1,865 274 34.6% 1,865Othe r Operation s 30% Sales, 5x EBIT 571 30% 171 -321 -56.2% 5.0x -1,605Siemens Real Estate (SRE) 2x Eq uity gi ven 39% RoE 1,768 6,978 129 7.3% 6,978Corp ora te items & pension s 10x EBIT (mostly Corporate Items) -10,544 -1,054 10.0x -10,544Eliminations, Corporate Treasu ry and other 10x EBIT (mostly Corporate Items) -1,400 -140 10.0x -1,400

Siemens Group EV 71,386 138% 98,632 6,538 9.2% 13.8x 90,433LT Deb t ( incl. Oblig ations un der Finance Leases) -18,776 -18,776ST Debt ( incl . Obl igations under Finan ce Leases) -423 -423Cash and equi valents 9,130 9,130

Basic Net Debt -10,069 -10,069Less: Availab le-for-sale finan cial assets 178 178Plu s: Pension an d other related benefits -6,155 -6,155Plu s: Market Value of Minori ti es (@ 8x P/E) -1,858 -1,858Plu s: Cu stomer Advances -1,851 -1,851Less: SFS Debt excl . in ternal ly p urchased recei vab les 9,100 9,100Plu s: Cred it g uarantees -300 -300

Fully Adjusted N et Debt -10,955 -10,955Implied Market Capitalsiat ion (€ mn) 87,677 79,478

Fully Diluted Number of Shares (mn) 874 874

Implied Value Per Share (€) 100.4 91.0Con glomerate Discoun t (15% ) -15.1 -13.6

Implied Value Per Share (€) 85.3 77.3

Source: Multiples are based on Bloomberg data, no assumptions have been made, except where indicated (e.g. minorities). Where we have provided sub-divisional Sales and EBIT detail (e.g. LV in Building Technologies), we have used Redburn Partners estimates, largely based on company comments or other proprietary sources (such as press reports, interviews, industry magazines and company presentations). Source: Redburn Partners




Using a 15% conglomerate discount for both methods, our EV/Sales-based SOTP returns a value of €85.3 per share and our EV/EBIT-based approach returns a value of €77.3 per share. These are supportive of our €85 target price.

One area of significant discrepancy between the two methods is the ‘Other’ line. In particular, the JV line. While the JVs have no revenue as such, we have calculated Siemens’ pro-rata’d share of the underlying entities’ revenues to provide a valuation for the EV/Sales-based SOTP. On an EV/Sales-based approach the JVs would be worth c€13bn at peer group multiples but on our EV/EBIT-based approach we only come to a €3bn value for the JVs as three (NSN, SEN and Areva NP) are in heavy loss. As such, we have pencilled in a ‘zero’ value for them.

Current earnings issues Looking at our FY2010E ‘Sector’ profit bridge, we expect c€800m of clean EBIT decline from the drop-through effect of a 4% organic sales decline, +c€800m of cost savings, -€320m of currency headwind and +c€350m from the charges dropping out (we expect €445m of ‘Sector’ charges vs €776m in 2009). As such, we forecast Siemens to deliver €7,479m of ‘Sector’ PBT, which is relatively flat on the €7,466m in 2009, and well above the €6.0-6.5bn of guidance.

Our divisional detail is summarised below.




Fig 419: Siemens divisional detail

Siemens Divisional Detail (December Y/E, € mn) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

Sales (Total Revenue)Industry Sector 25,916 28,139 33,658 36,059 37,653 35,043 32,218 34,578 35,954

Industry Automation 6,391 7,545 8,699 5,763 5,726 6,192 6,440Drive Technology 6,428 7,793 8,434 7,526 6,441 6,988 7,267Building Technologies 4,247 4,415 5,728 6,038 5,984 7,007 6,126 6,062 6,183OSRAM 4,240 4,300 4,563 4,690 4,624 4,036 4,120 4,390 4,522Industry Solutions 4,290 5,390 6,465 6,601 7,106 6,804 5,548 6,131 6,437Mobility 4,310 4,190 6,404 6,160 5,841 6,442 6,667 7,226 7,515

Energy Sector 11,138 12,311 16,947 20,309 22,577 25,793 24,364 25,745 27,559Fossil Power Generation 6,764 8,129 8,171 9,802 9,515 9,622 10,342Renewable Energy 894 1,365 2,092 2,935 2,847 3,268 3,594Oil & Gas 2,973 3,363 4,038 4,276 4,016 4,203 4,472Power Transmission 4,222 4,901 5,497 6,172 5,577 6,038 6,396Power Distribution 2,425 2,851 3,211 3,284 3,010 3,214 3,357

Healthcare Sector 7,072 7,626 8,227 9,851 11,170 11,927 11,635 12,184 12,629Imaging & IT 6,974 7,066 6,811 7,152 6,911 7,226 7,443Workflow & Solutions 1,387 1,494 1,490 1,515 1,469 1,510 1,556Diagnostics 67 1,553 3,185 3,490 3,469 3,662 3,845

Total Sectors Sales (Total Revenue) 44,126 48,076 58,832 66,219 71,401 72,763 68,217 72,507 76,143Siemens IT Solutions & Services (SIS) 4,716 5,373 5,693 5,360 5,325 4,686 4,050 4,116 4,198Siemens Financial Services (SFS) 562 542 645 720 756 777 794 794 794Other Operations 31,525 27,345 3,944 2,884 2,902 836 571 571 571Siemens Real Estate (SRE) 1,584 1,621 1,705 1,686 1,665 1,763 1,768 1,768 1,768Corporate items & pensions 0 0 99 180 148 140 220 220 220Eliminations, Corporate Treasury and other -7,346 -7,512 -4,431 -4,601 -4,869 -4,314 -4,235 -4,235 -4,235

Siemens Group Sales (Total Revenue) 75,167 75,445 66,487 72,448 77,328 76,651 71,386 75,741 79,459

Reported "Profit" (PBT) (€ mn)Industry Sector 1,291 2,040 2,618 3,521 3,947 2,701 2,837 3,789 4,137

Industry Automation 964 1,102 1,606 681 814 1,033 1,118Drive Technology 559 913 1,279 836 726 1,033 1,105Building Technologies 108 181 275 429 466 340 127 172 205OSRAM 445 465 456 492 401 89 314 480 543Industry Solutions 95 139 221 312 439 360 256 385 447Mobility -434 45 144 274 -230 390 595 686 719

Energy Sector 1,199 1,163 1,084 1,818 1,434 3,315 2,978 3,380 3,753Fossil Power Generation 584 792 -89 1,275 1,292 1,360 1,528Renewable Energy 44 134 242 382 280 386 443Oil & Gas 112 241 351 499 444 533 583Power Transmission 138 371 565 725 592 687 756Power Distribution 177 279 369 435 370 414 443

Healthcare Sector 1,046 976 988 1,323 1,225 1,450 1,663 1,960 2,052Imaging & IT 841 1,052 899 1,161 1,209 1,327 1,374Workflow & Solutions 180 163 66 -53 130 145 155Diagnostics -2 95 248 338 325 488 523

Total Sectors Reported "Profit" (PBT) (€ mn) 3,536 4,179 4,690 6,662 6,606 7,466 7,479 9,129 9,942Equity Investments (SEI) 234 -96 95 -1,851 -235 89 169Siemens IT Solutions & Services (SIS) 40 -690 -731 252 144 90 -57 55 97Siemens Financial Services (SFS) 250 319 306 329 286 304 274 297 287Other Operations 1,422 1,198 -346 -232 -453 -372 -368 -318 -318Siemens Real Estate (SRE) 108 144 115 228 356 341 129 130 130Corporate items & pensions -1,207 -1,072 -507 -1,684 -3,853 -1,714 -1,442 -1,370 -1,377Eliminations, Corporate Treasury and Other 83 107 -343 -358 -307 -373 -427 -277 -184Siemens Group Reported "Profit" (PBT) (€ mn) 4,232 4,185 3,418 5,101 2,874 3,891 5,353 7,736 8,745





Fig 420: Siemens financial forecasts, performance metrics and valuation

Siemens (September Y/E; € mn) SIE GR Equity Growth (%) 2008 2009 2010E 2011E 2012E

Organic order growth 13.0% -14.0% -8.5% 4.4% 4.9%Income statement (reported) 2008 2009 2010E 2011E 2012E Organic sales growth 9.0% 0.0% -4.8% 5.6% 4.9%

Orders 93,495 78,991 70,685 74,188 77,818 Sales growth 6.7% -0.9% -6.9% 6.1% 4.9%Revenue 77,328 76,651 71,386 75,741 79,459 Adj. EBITDA growth 20.2% -8.9% -8.2% 17.9% 6.6%

Gross profit 21,044 20,710 19,816 22,727 24,313 Adj. EBIT growth 22.3% -9.6% -9.7% 27.4% 10.0%EBIT (post-NRIs) 2,492 6,347 5,897 7,810 8,659 Adj. PBT growth 22.4% -18.7% -11.3% 29.9% 10.8%

Reported EBIT Margin (%) 3.2% 8.3% 8.3% 10.3% 10.9% Adj. EPS growth 31.4% -18.7% -18.4% 29.9% 10.9%

Net financial expense 382 -2,456 -545 -74 86 DPS growth 0.0% 0.0% 0.0% 25.0% 40.0%PBT 2,874 3,891 5,353 7,736 8,745Total tax -1,015 -1,434 -1,521 -2,089 -2,361 Profit and cost margins 2008 2009 2010E 2011E 2012E

Net income (continuing) 1,859 2,457 3,832 5,647 6,384 Gross profit margin 27.2% 27.0% 27.8% 30.0% 30.6%Minorities -161 -205 -232 -236 -236 Adj. EBITDA margin 14.1% 12.9% 12.7% 14.2% 14.4%Other (discont., prefs and other) 4,027 40 5 0 0 Adj. EBIT margin 10.1% 9.2% 8.9% 10.7% 11.2%Net income (all in) 5,725 2,292 3,605 5,412 6,148 Adj. PBT margin 11.3% 9.2% 8.8% 10.8% 11.4%




Adj. vs. reported EBIT 5,290 686 455 284 240 Employees (average) 412,500 416,000 404,225 415,934 438,208Adj. PBT 8,715 7,088 6,287 8,170 9,055 Book to bill (orders / sales) 1.21 1.03 0.99 0.98 0.98Adj. Net income 6,853 5,417 4,435 5,760 6,386 Cash conversion (FCF / NI) 288.7% 119.2% 68.7% 75.9% 78.6%Adj. EPS 7.65 6.22 5.08 6.59 7.31 WC / sales 27.7% 27.4% 29.8% 29.8% 29.8%Adj. EPS (post-restructuring) 4.30 5.55 4.93 6.59 7.31 Inventory / sales 18.8% 18.4% 19.8% 19.8% 19.8%


EBITDA 10,875 9,905 9,093 10,726 11,429 Capex / depreciation (inc intang) -1.20 -1.02 -0.85 -0.99 -1.09Provisions 1,414 -669 -667 0 0 Net debt (EV) / EBITDA -0.08 0.30 0.49 0.27 0.07Interest paid 46 10 -826 -964 -797Tax paid -1,564 -1,536 -1,082 -2,089 -2,361 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 337 441 334 334 334 Basic (ST + LT debt - cash) 9,186 9,479 10,069 8,167 5,723Other 583 190 0 0 0 Mkt secs, leases and converts -152 -170 -178 -178 -178Operating cash flow pre-WC 11,691 8,341 6,852 8,007 8,605 Pension deficit (net of tax) 4,361 5,938 6,155 6,155 6,155Change in working capital 2,584 -533 -2,190 -1,722 -1,532 Adjusted net debt 13,395 15,247 16,046 14,144 11,700Operating cash flow 14,275 7,808 4,662 6,285 7,073 Mins, assocs, advances, other -14,234 -12,274 -11,557 -11,195 -10,856Capex (PP&E and intangibles) -3,161 -2,045 -1,700 -1,911 -2,055 Net debt (EV) -839 2,974 4,490 2,949 845Acquisitions and disposals 5,074 -442 -368 0 0Other -2,320 -1,138 44 -97 -119 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -407 -3,625 -2,024 -2,009 -2,173 Average / current share price 82.29 50.08 65.90 65.90 65.90

Dividends paid -1,600 -1,541 -1,665 -1,698 -2,065 Market capitalisation 73,727 43,617 57,565 57,572 57,572Other (incl. share capital) -4,102 134 0 0 0 Group EV 72,889 46,591 62,055 60,521 58,417Financing cash flow -5,702 -1,407 -1,665 -1,698 -2,065 P/E (pre-restructuring) 10.76 8.05 12.98 9.99 9.02

FX and other 872 6 127 0 0 P/E (post-restructuring) 19.15 9.02 13.36 9.99 9.02Reconciliation to basic net debt -6,732 -3,075 -1,691 -675 -391 EV/Sales 0.94 0.61 0.87 0.80 0.74Net cash flow 2,306 -293 -590 1,903 2,443 EV/EBITDA 6.70 4.70 6.82 5.64 5.11







SKF (SKFB SS, Neutral, target SKr120)

SKF faces two challenges in 2010: (1) steel-based raw material cost inflation and (2) difficult 2H10 automotive volumes. Due to our caution on both factors, our 2010E and 2011E EPS estimates of SKr7.22 and SKr8.78 are 11% and 16% below consensus, respectively. With the 2009 cost-savings tailwind largely behind SKF, 2010E is heavily dependent on volumes and the degree of organic drop through. Here, SKF should do well, with volumes likely to benefit from a degree of industry re-stocking and the degree of organic drop-through likely to benefit as SKF transitions from a period of under-production to a period of over-production as it re-builds inventories for the return to growth. On our lower than consensus estimates and our EV/IC vs ROIC/WACC framework, the valuation upside is less than the sector average. We rate SKF as a Neutral, with a target price of SKr120.

Fig 421: 2009 SKF group revenues split by division, geography of destination and end market

Europe56%


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Automotive29%



We expect SKF to deliver 2010E EPS some 11% below consensus

We expect SKF to lift its clean EBIT margins (before SKr300m of restructuring) by 220bp from 7.9% in 2009 to 10.2% in 2010E. Our forecasts are predicated on 5% organic sales growth in 2010E (helped by restocking in Industry and Service but hindered by a 2H10E demand deterioration in Automotive) and a Price/Mix of +0.3% in 2010E. We expect minimal savings of cSKr300m to be offset by currency headwinds and for the real driver of EBIT growth to come from volume-based drop-through. We expect an organic drop-through of 50% in 2010, helped by the shift from under-production (negative for margins) to over-production (positive for margins). We have also allowed for a degree of scrap steel and finished steel based raw material cost inflation, which we do not expect SKF to fully pass on in 2010.





Fig 422: Our 2011E EPS forecast of SKr8.78 is 16% below the consensus of SKr10.44

SKF R edburn EPS vs. C onsensus

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Top-line growth to benefit from distributor restocking

As with our Sandvik numbers, SKF’s organic sales growth in 2010E and 2011E is at the top end of the sector spectrum. Based on SKF’s below sector average exposure to both emerging markets (33% vs sector at 38%) and infrastructure end markets (23% vs sector at 39%), we would expect SKF to generate lacklustre organic sales growth in 2010E and 2011E. However, given SKF’s high exposure to distributors (we calculate that SKF has 34% of group revenues sold via distributors, predominantly from the Service division), we have allowed for an element of restocking benefit to SKF’s top line (as we have with Sandvik’s Tooling division).

The bearing industry has experienced a significant degree of de-stocking over the last year or so (we estimate roughly c10% of SKF’s 24% volume decline was de-stocking related based on end-market analysis). In 2010E, we expect a third of this to reverse, adding 3% to SKF’s volume recovery. Some expect more but we would not expect to see this unless underlying volume demand was very strong.




Automotive set to deliver 2H10 headwind

Fig 425: Automotive volumes have rallied sharply Fig 426: Industrial volumes have passed the trough

-50%-40%-30%-20%-10%

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Source: SKF, ACEA and the US Bureau of Economic Analysis Source: SKF, Eurostat and the US Federal Reserve

SKF has already seen its Automotive growth improve dramatically in 2H09 from -31% average organic sales decline in 1H09 to -14% in 3Q09 and +9% in 4Q09. With global automotive volumes artificially stimulated around early to mid 2009 by various government-led incentive plans, we would expect the Auto division at SKF to continue to experience growth in 1Q10 and arguably 2Q10. However, after that, the outlook for Automotive volumes is decidedly difficult. Our Auto analyst (Mr Charles Winston) believes that c2.5 million car purchases were brought forward in Europe alone (four million globally). Given Europe is selling c13.5 million light vehicles annually, that amounts to a 19% stimulus between 2Q09 and 1Q10. We therefore expect continued anaemic demand for the Auto division at SKF and for Auto margins to remain around 2% for the next two years or so (well below SKF’s ongoing soft Automotive target of 6-7% EBIT margins).

Price/mix to slow in 1Q10 but recover thereafter

We expect gross prices to remain flat to positive given SKF’s list price increases (+3.8% in Service Europe (18% of group sales) in January 2010) and our belief that there are more list price increases to come. Based on our supply-side analysis, which highlights how much consolidation the global bearing industry has enjoyed over time, we believe these price increases have a good chance of sticking. As such, we expect a +0.3% Price/Mix in 2010, protecting SKF’s 45 quarter track record of positive price/mix.

Raw material cost headwinds in 2010

As shown in Fig 81 in our ‘Price and raw material cost inflation’ chapter, SKF’s raw material bill as a percentage of sales is the largest in the sector at 27% (the sector average is 13%). With scrap steel costs up some 20% since the end of 2009, driven by Asia, 2010E is going to be tough year for managing the net price effect of raw materials vs price. We expect this to be a headwind for SKF in 2010, which we believe is a factor behind our lower than consensus estimates.




Margins to benefit as SKF shifts from under- to over-production

Fig 427: Manufacturing vs invoicing levels, (over/(under)-production shown on graph)

2%5%5%5%

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Source: Redburn Partners based on SKF disclosed volumes and comments on manufacturing level for each quarter of 2009

In 4Q09, SKF returned to over-production after a period of under-production. Given the positive margin impact of over-producing (as fixed costs are over-absorbed), we believe the 4Q09 result is much more reflective of SKF’s cost base going into 2010, which we believe will be a period of meaningful 4-5% over-production.

For the EBIT bridge technicians out there, based on the level of organic drop-through in 4Q09, combined with the over-absorption impact, we have forecast high 60-70% organic incremental margins in the Industrial division (the manufacturing hub of SKF) when it returns to growth. As a result of this enhanced gearing effect, we expect SKF to deliver c50% organic drop-through in 2010E (i.e. an organic EBIT increase of cSKr1.4bn).

Savings tailwind to fall by 75% in 2010E from short-time working headwind

After the significant cSKr1.2bn of cost savings in 2009, we only forecast a further cSKr300m of savings in 2010E and cSKr100m in 2011E. In terms of cost savings, 2009 benefited from both cSKr710m of savings from the short-time working programme, cSKr410m from the 4Q08 cyclical slowdown related restructuring programme and a small SKr100m of savings from the remaining 4Q07 plan. While the cyclical slowdown related restructuring programme (which is targeting cSKr800m of annualised savings from 2Q10) is due to deliver a further cSKr340 of additional savings in 2010E, the short-time working plan will develop into a cost headwind as those 17,000 people in short-time working (working at 76% capacity) return towards full working hours.

We have analysed this short-time working effect across the sector in the Restructuring and Cost Savings chapter, the details of which are shown in Fig 95. From this, we conclude that SKF faces the most significant short-time working headwind into recovery and that we expect c2% off the degree to which group EBIT margins would have recovered should SKF not have used short-time working (or made other compensatory redundancies). This is rather academic and in reality, short-time working will only be reduced as volumes return.

Valuation: fully valued on most metrics

On our cautious estimates SKF is trading on a premium to the sector, at 13.3x 2011E P/E (a 10% premium to the sector), a 3.8% 2011E dividend yield, and 9.1x 2011E EV/EBIT (a 5% premium to the sector). Furthermore its EV/IC for 2011E is 1.85x, close to its 2.06x 2011E ROIC/WACC.




Fig 428: SKF vs sector EV/Sales Fig 429: SKF vs sector EV/EBIT Fig 430: SKF vs sector P/E

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Fig 431: SKF P&L with divisional detail, 2004-12E

SKF P&L (Skr mn, Dec Y/E) 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

External Sales (Net Sales)Industrial 12,527 14,750 17,176 19,693 22,862 19,301 19,530 21,581 22,660Service 14,216 16,115 17,984 19,339 21,907 19,832 20,688 22,343 23,460Automotive 15,972 17,423 17,869 19,449 17,886 16,051 15,965 15,801 16,275Other / Elimination 67 72 72 78 706 1,043 1,043 1,043 1,043Group Sales 44,826 49,285 53,101 58,559 63,361 56,227 57,225 60,767 63,438

Organic Sales Growth (%)Industrial 26.2% 10.8% 12.7% 9.4% 10.4% -23.8% 5.0% 10.5% 5.0%Service 11.0% 12.1% 12.0% 12.0% 10.9% -16.2% 6.9% 8.0% 5.0%Automotive 23.1% 7.7% 1.1% 7.7% -3.8% -18.2% 2.7% -1.0% 3.0%Group Organic Sales Growth (%) 10.7% 8.5% 8.1% 9.7% 5.9% -19.3% 4.9% 6.2% 4.4%

Price / Mix Sales Growth 2.3% 3.0% 2.3% 2.4% 5.7% 4.1% 0.3% 1.0% 2.0%Volume driven Sales Growth 8.3% 5.5% 6.1% 7.5% 0.1% -24.1% 4.6% 5.2% 2.4%

EBITDA (Reported) 6,117 7,079 8,541 9,315 9,659 5,374 7,456 8,493 9,091

Clean EBIT (Excl. NRIs)Industrial 1,859 2,390 3,252 3,464 4,133 1,866 2,346 3,040 3,354Service 1,714 2,112 2,397 2,860 3,326 2,645 3,039 3,483 3,702Automotive 894 955 1,111 1,368 996 106 705 653 770Other / Elimination 48 -220 -1,091 114 -406 -138 -285 -236 -258Group Clean EBIT (Excl. NRIs) 4,677 5,612 5,914 7,805 8,049 4,479 5,804 6,940 7,568

Clean EBIT margin (Excl. NRIs) (%)Industrial 9.0% 10.1% 12.2% 11.9% 12.3% 6.6% 8.2% 9.6% 10.1%Service 10.9% 12.0% 12.1% 13.5% 14.9% 13.1% 14.4% 15.3% 15.5%Automotive 4.6% 4.6% 5.1% 5.8% 4.6% 0.5% 3.7% 3.4% 3.9%Group Clean EBIT margin (Excl. NRIs) 10.4% 11.4% 11.1% 13.3% 12.7% 8.0% 10.1% 11.4% 11.9%

Associates (in Reported EBIT) -3 172 738 -3 1 -11 -8 -7 -7Non-Recurring Items (NRIs) -240 -457 55 -263 -340 -1,265 -300 -300 -300

Reported EBITIndustrial 1,807 2,354 3,027 3,434 4,043 1,551 2,296 2,990 3,304Service 1,701 2,072 2,362 2,860 3,326 2,610 2,989 3,433 3,652Automotive 797 560 946 1,135 746 -809 505 453 570Other / Elimination 45 2 -353 111 -405 -149 -294 -244 -266Group Reported EBIT 4,434 5,327 6,707 7,539 7,710 3,203 5,495 6,632 7,260

Reported EBIT margin (%)Industrial 8.8% 10.0% 11.3% 11.8% 12.0% 5.5% 8.0% 9.4% 9.9%Service 10.9% 11.7% 12.0% 13.5% 14.9% 12.9% 14.2% 15.1% 15.3%Automotive 4.1% 2.7% 4.3% 4.8% 3.4% -4.2% 2.6% 2.4% 2.9%Group Reported EBIT margin (%) 9.9% 10.8% 12.6% 12.9% 12.2% 5.7% 9.6% 10.9% 11.4%

Financial Items -347 -74 -320 -401 -842 -906 -702 -649 -599Reported PBT 4,087 5,253 6,387 7,138 6,868 2,297 4,793 5,983 6,662Tax -1111 -1646 -1955 -2371 -2127 -592 -1438 -1915 -2132Minority Interests -50 -86 -115 -172 -125 -63 -66 -70 -73Reported Net Income to Shareholders 2926 3521 4317 4595 4616 1642 3290 3999 4457Average # Shares (FD) 455.4 412.7 455.4 455.4 455.6 455.4 455.4 455.4 455.4Reported Diluted EPS (Skr) 6.43 8.53 9.48 10.09 10.13 3.61 7.22 8.78 9.79DPS (Skr) 3.00 4.00 4.50 5.00 3.50 3.50 3.60 4.40 4.90





Fig 432: SKF financial forecasts, performance metrics and valuation

SKF (December Y/E; Skr mn) SKFB SS Equity Growth (%) 2008 2009 2010E 2011E 2012E


Orders na na na na na Sales growth 8.2% -11.3% 1.8% 6.2% 4.4%Revenue 63,361 56,227 57,225 60,767 63,438 Adj. EBITDA growth 5.1% -32.2% 15.6% 12.7% 6.5%

Gross profit 16,286 11,203 13,276 14,370 14,991 Adj. EBIT growth 3.1% -44.4% 29.6% 19.6% 9.0%EBIT (post-NRIs) 7,710 3,203 5,495 6,632 7,260 Adj. PBT growth -0.3% -50.1% 38.3% 23.4% 10.8%


Net financial expense -842 -906 -702 -649 -599 DPS growth -30.0% 0.0% 2.9% 22.2% 11.4%PBT 6,868 2,297 4,793 5,983 6,662Total tax -2,127 -592 -1,438 -1,915 -2,132 Profit and cost margins 2008 2009 2010E 2011E 2012E





Adj. vs. reported EBIT 339 1,276 308 307 307 Employees (average) 43,201 42,986 42,379 44,835 47,100Adj. PBT 7,378 3,682 5,093 6,283 6,962 Book to bill (orders / sales) na na na na naAdj. Net income 5,126 3,027 3,590 4,299 4,757 Cash conversion (FCF / NI) 57.1% 239.6% 113.2% 85.0% 89.7%Adj. EPS 11.25 6.65 7.88 9.44 10.45 WC / sales 33.8% 29.5% 30.6% 30.5% 30.5%Adj. EPS (post-restructuring) 10.50 3.87 7.22 8.78 9.79 Inventory / sales 24.0% 20.9% 21.7% 21.7% 21.6%


EBITDA 10,255 6,949 8,035 9,057 9,650 Capex / depreciation (inc intang) -1.15 -0.92 -0.64 -1.00 -1.07Provisions 0 0 0 0 0 Net debt (EV) / EBITDA 1.52 1.84 1.40 1.11 0.90Interest paid 0 0 0 0 0Tax paid -2,783 -1,068 -1,438 -1,915 -2,132 Net debt to EV net debt 2008 2009 2010E 2011E 2012EDividends from associates 0 0 0 0 0 Basic (ST + LT debt - cash) 10,915 6,575 5,023 3,827 2,393Other -90 590 -702 -649 -599 Mkt secs, leases and converts -1,834 -1,310 -1,310 -1,310 -1,310Operating cash flow pre-WC 7,382 6,471 5,895 6,494 6,920 Pension deficit (net of tax) 5,539 7,020 7,020 7,020 7,020Change in working capital -2,208 0 -921 -1,058 -798 Adjusted net debt 14,620 12,285 10,733 9,537 8,103Operating cash flow 5,174 6,471 4,974 5,435 6,122 Mins, assocs, advances, other 1,000 504 526 558 583Capex (PP&E and intangibles) -2,441 -2,249 -1,250 -2,036 -2,125 Net debt (EV) 15,620 12,789 11,259 10,095 8,686Acquisitions and disposals -1,141 0 0 0 0Other 1,354 2,189 0 0 0 Valuation 2008 2009 2010E 2011E 2012EInvesting cash flow -2,228 -60 -1,250 -2,036 -2,125 Average / current share price 96.95 96.83 116.80 116.80 116.80

Dividends paid -4,615 -1,629 -1,594 -1,639 -2,004 Market capitalisation 44,173 44,095 53,185 53,185 53,185Other (incl. share capital) 94 -6 0 0 0 Group EV 59,793 56,884 64,444 63,280 61,871Financing cash flow -4,521 -1,635 -1,594 -1,639 -2,004 P/E (pre-restructuring) 8.62 14.57 14.82 12.37 11.18

FX and other 222 -62 0 0 0 P/E (post-restructuring) 9.23 25.03 16.17 13.30 11.93Reconciliation to basic net debt -4,397 -374 -579 -564 -560 EV/Sales 0.94 1.01 1.13 1.04 0.98Net cash flow -5,750 4,340 1,552 1,196 1,433 EV/EBITDA 5.83 8.19 8.02 6.99 6.41







RECOMMENDATIONS

Buy: Redburn Partners LLP believes the stock price will appreciate in absolute terms by at least 15% over one year.Sell: Redburn Partners LLP believes the stock price will depreciate in absolute terms by at least 10% over one year.Neutral: Redburn Partners LLP currently has no strong opinion on the likely movement of this stock.

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