CA - Buy Hammond Power Solutions To Profit From AI EVs And The Green Economy

2023-12-04 21:30:32 ET

Summary

• Hammond Power Solutions is a small company participating in the reshoring of U.S. manufacturing, the transition to electric vehicles, the green transition, and the AI boom.
• The company operates in a fragmented and growing industry with significant barriers to entry and solid growth prospects.
• Hammond's revenue is growing rapidly, driven by price increases and expanding scale, and the company is making investments to expand capacity and continue growth.

Looking for a way to profit from the reshoring of U.S. manufacturing? The transition to electrical vehicles? The broader ‘green transition’ in the economy? The boom in AI? Hammond Power Solutions (ticker [[HMDPF]], abbreviated HPS) is participating in all of these trends because they make the electrical transformers and other equipment required for these projects. But unlike Intel ( INTC ), Tesla ( TSLA ), and NVIDIA ( NVDA ), Hammond Power is a tiny company largely immune from the headline-grabbing competition within these growth industries. Since its industry is so dull and the company is so small, it remains reasonably priced. Below, I outline the case for buying Hammond and offer a three-year price target of $100.

Competitive Position

Hammond is a small, excellent company in a fragmented and growing industry

The market for electrical equipment is $50 billion in the US alone (IBISWorld) and is very fragmented. Of that, $7 billion is for transformers. While IBISWorld does not have a breakdown of market share in the transformer industry specifically, the market share concentration in the electrical equipment industry is moderate. The four largest players have 34.7% market share: Eaton ( ETN ) (12.2%), Johnson (JELCF) (9.2%), Schneider (SBGSY) (7.6%), and ABB (ABBNY) (5.7%). They are mostly multinational companies, founded over a century ago, with enterprise values and annual revenues about 100 times those of Hammond. In other words, Hammond is a significant but very small player in this larger market. I would estimate their share of the US transformer market at around 10% (~$700 million of 2022 revenue in a $7 billion industry).

Electrical equipment is an industry with significant barriers to entry and solid growth prospects. Power outages are expensive, and equipment malfunctions can be very expensive and even dangerous. Hospital power outages can be deadly. Data center power surges can destroy customer data. While it might be hyperbolic to call Hammond’s products “mission-critical,” they are certainly essential parts. Additionally, transformers are a crucial but secondary aspect of most construction projects, and I have heard that purchasing decisions are often made by contractors, who are incentivized to spend slightly more for more reliable products. Those contractors are also required to finish projects on tight schedules, meaning that having a large and well-run distribution network is essential for electrical equipment manufacturers to be able to deliver products quickly. For these reasons, I think, most of the major players in the industry have been around for many decades.

The industry is also primed to benefit from some of the major trends of the next two decades: the AI boom and the turn to green energy. Transformers are integral to the electrical infrastructure underpinning the electrification of the broader economy. For example, I think that Hammond won a large multi-year contract to supply transformers for Google’s ( GOOG ) Red Oak data center, south of Dallas (there was “a very large multi-year order for data centers in Texas” in Q2 [I cannot share links to the earnings call transcripts due to copyright restrictions, but recordings are available on the company website here ]). While IBISWorld only sees a CAGR of ~5% for the industry over the next five years, Morningstar predicts that growth could be significantly higher. According to Research Nester , the global market for dry-type transformers will grow from $6 billion in 2022 to $15 billion in 2035, at a CAGR of 9%. While there is some cyclicality in the industry, which is exposed to input material price fluctuations and the changes in infrastructure spending, the short-, medium-, and long-term trends all look very good. In earnings calls over the last year, Hammond management has repeatedly mentioned the following growth drivers: EV recharging, solar power, energy storage, data center expansion, oil and gas, mining, chip manufacturing, and public infrastructure (see link above).

Hammond produced numerous types of electrical transformers and related equipment for a variety of end markets, primarily in North America. The company was founded in 1917 and is still majority-owned by Bill Hammond, who retired as CEO earlier this year but remains chairman of the board. Their most important product offering is dry-type transformers. These devices are used to change electrical voltage and are thus ubiquitous in all modern societies. They are called “dry” because they are insulated and cooled using air, instead of oil or another liquid. This makes them more expensive and bulkier (from what I can tell), but also less prone to fire and easier to service. As a result, they are the product of choice for applications where fire is an unacceptable risk, such as in homes, hospitals, and data centers (see discussion here and here ). According to a 2010 Byron Capital report, Hammond became the largest producer of dry-type transformers in North America via a 2008 acquisition. According to the current CEO, who previously worked at Schneider and G.E., Hammond’s dry-type transformers are the "gold standard" ( press release ). Unfortunately, I have been unable to assess their pricing power or technological advantages in a more precise way. For now, I think that their advantage comes from a mixture of engineering and manufacturing expertise, brand power, distribution scale, and product diversity.

Management

Hammond is a family company managed for sustainable growth

Hammond’s management team is led by Bill Hammond, whose family founded the company a century ago. This family legacy (and his significant stake in the company) aligns his interests with those of other long-term shareholders. Hammond ran the company for decades before stepping down as CEO earlier this year. As he emphasized repeatedly in the Q4 2022 call, “I’m not retiring.” He remains actively involved in the company and controls decisions through his ownership of a B class of shares which give him a 2/3 voting stake. In each earnings call this year, Hammond and his successor, Adrien Thomas, emphasized their conservative approach to growth: they are actively thinking about a recession in 2024, and expanding primarily using existing cash flows and in response to strong market demand for their products (see link to recordings above).

Capital allocation has remained conservative despite growth. Interest coverage is over 50 times; the quick and current ratios are both over one, and Debt/Equity is only 0.16. Conscious investors will therefore be pleased to note that there has been only very minimal share dilution over the past decade, and management has consistently grown a small dividend (the yield was over 4% several years ago, but recent share appreciation has driven it down).

This excellent management is also reflected in employee reviews. Indeed reviews have been stable at 3.8/5 since 2020 (compare Indeed.com and link ), and Glassdoor reviews have increased from 3.4 in 2020 to 4.1 today. At Glassdoor, 93% of reviewers approve of Bill Hammond as CEO (the website has not updated to reflect the succession of Thomas earlier this year). I view this as strong evidence of good corporate culture at the firm.

Revenue and Margin Growth

Price increases and expanding scale have driven fast revenue growth and margin improvement

Hammond’s revenue is growing rapidly (see below) and accelerating. In recent earnings calls, management repeatedly mentions turning away business due to a lack of inventory. In discussing Q3 capex, the CEO mentioned "turning away [demand] due to capacity constraints. In Q2, the CFO discussed the "need to add capacity to meet demand." In Q1, they noted the need for additional capacity to pursue growth opportunities in the US and Mexico. The backlog continues to grow, up about 40% YOY in Q2 and Q3 (in quarterly reports available here ). Business is booming. Over the last year, revenue has shot up due to a combination of organic growth and higher prices. According to earnings calls, organic revenue growth has been around 10-13% this year. Due to supply chain disruptions, import tariffs, the Biden infrastructure bill, and other demand shocks, transformer prices have gone up notably since 2022. Management estimates that these higher prices have generated about 2/3 of the 47% revenue growth in the last 12 months.

(all data from Morningstar, calculated on 11/30/2023)

Looking forward, I think it is unlikely that revenue will continue to grow at the current rate. According to the earnings calls, price growth has already been slowing in the latter half of 2023. While it has been encouraging that Hammond has been able to raise prices on the order of 20-30% without losing business, they do not seem to think that prices will continue increasing. Given that this is a competitive industry with numerous other players, it seems likely to me that prices will come down as new supply comes online in the next year or two.

With that said, the conservative Hammond management team clearly thinks that growth will continue because they are making significant investments in expanding capacity. Revenue will probably be around $700 million in 2023, reflecting 85-90% utilization of $800 million in capacity. In Q4 2022, management announced a goal of hitting $1 billion in revenue by 2030. But last quarter, they announced plans to increase capacity to over $900 million by the end of 2025. It seems to me that the 2030 goal is thus very conservative. Over the next five years, I guess that prices hold steady. I have no insight into raw material costs, and it seems like the primary demand for their products will remain strong. I think we can probably organic revenue growth to be at least 10%.

One major driver of this above-average growth is international expansion. In 2019, North America was 96% of revenue . In the 2010s, Hammond entered the Italian market through an acquisition but was unsuccessful. More recently, they have been expanding into Latin America, beginning in Mexico, and into South and Southeast Asia, beginning in India. Five-year revenue targets for Mexico have come up significantly in the last year, from $30 million forecasted in Q4 2022 to $50 million in Q2 2023 (earnings calls). Growth has been very rapid. Their business in India was slow to get going c. 2014-2019 , but sales almost doubled in 2022 after a management change. Management forecasts continued strong growth in both regions, although the overall numbers remain small.

Given this history, I forecast 2024 revenue at around $800 million, 2025 revenue at around $850 million, and 2026 revenue at around $900 million. These are rough, conservative estimates. In the past, management has frequently under-promised and over-delivered.

Over the last year, price increases and (probably) economies of scale have finally led to margin expansion. The chart below shows Hammond’s profitability metrics as a percentage of the average of those of their competitors (Eaton, Schneider, and Abb) over the last decade. As you can see, gross margin improvement, especially in the last year, has driven a magnified improvement in net margins, from about 1/3 of their competitors, to about 75%. Concretely, the ~5% increase in gross margins (from around 25% to around 30%) has directly driven a ~5% increase in net margins (from ~3% to ~8%). This, more than anything else, is what has driven earnings and share price growth over the last two years.

What will happen to gross margins going forward? At the start of this year, management said that they thought long-term average gross margins would remain around 28-29%, and that the 2022 increases were temporary. But by Q3, the CFO was becoming more confident that margins of around 31% would be sustainable going forward. Given how sensitive margins are to transformer prices, and Hammond’s limited degree of pricing power in this competitive market, the fate of the broader industry will significantly shape Hammond’s profitability going forward.

Valuation Modelling

Despite higher profitability and growth, Hammond trades at a significant discount to its peers. While most of its larger competitors have barely grown over the last decade, Hammond has had a revenue CAGR of 8%. Their operating efficiency, as shown below, has been progressively increasing over time, and is now significantly better than that of its competitors. Growing prudently, Hammond has managed to make thoughtful and efficient use of their invested capital, leading to lower inventory, higher turnover, and improved returns on their investments in the business.

Despite these impressive improvements in Hammond’s operating efficiency, valuations are still at about 60% of their competitors. This can probably be attributed to the fact that Hammond is smaller and less well-established. Although multiples have come up about 2-3 times in the last two years, they are by no means unreasonable given the strength of the business. If anything, it appears that they have further room to expand.

Base Case

Based on the analysis above, I would therefore forecast 2026 revenue of around $825 million, with net margins of about 8%. If the earnings multiple stays around 16, this would give a three-year price target of $88, or about 47% above the current price, for an annualized return of 13.6%.

Bull Case

In a bull case, management continues to exceed their own conservative revenue growth expectations by expanding capacity more rapidly than they currently expect. As a result, revenue grows at the long-term expected rate of 13%, and 2026 revenue is $975 million. This impressive growth drives continued multiple expansion, and the P/E rises to 19, closer to the industry average. The growth comes with stable net margins of around 8%. In this case, the price target would rise to $124, 107% above the current price, for an annualized return of 27.4%.

The price target given at the beginning of this article is a compromise between these two scenarios.

Bear Case and Risks

Hammond has benefited from a perfect set of tailwinds over the last two years. Their local supply chain is better suited to the current era of tariffs and supply chain disruptions. EVs and AI are very hot. The Biden infrastructure bill has turbocharged infrastructure spending. All these trends have led to a transformer shortage, driving up prices. In my bear case, these three trends moderate, and transformer demand weakens. At the same time, other manufacturers increase capacity, further driving down prices. As a result, Hammond’s revenue growth stalls, and 2026 revenue is $700 million – about equal to 2023 revenue. Lower prices lead net margins to contract to 6% - still higher than before, but a significant drop from 9% in 2023. All of this drives the P/E back down to its ten-year average around 13.5. In this case, the shares would fall to $47, or 22% below current prices. If transformer prices were to fall further, shares would fall even more.

Bottom Line

Hammond is the leading manufacturer of dry-type transformers in North America, and there are several strong tailwinds driving their future revenue growth. They benefit from growth in EV charging, solar energy, new infrastructure, and data centers, as well as electrification in Latin America and Asia. Moreover, the company is a conservatively managed family business with an excellent balance sheet and a prudent approach to growth. If they continue to execute their strategy successfully (which seems probable to me), shares will rise ~20% per year over the next three years. But if these trends abate, or competition increases, margins could fall, and shares could give up much of their recent growth.

Potential investors should carefully follow company results in the coming quarters for further evidence that Hammond will be able to sustain higher prices, margins, and growth rates. They should also be aware that shares trade over the counter, and so liquidity is low. Prices of HMDPF track those of HPS.A, which trades on the Toronto Stock Exchange.

For further details see: