Description

Hammond Power Solutions is a family-controlled, underfollowed Canadian manufacturer of dry transformers that sells products for industrial power applications.They don’t hold quarterly conference calls, there are only two analysts that cover the name, and the CEO, Bill Hammond (the founder’s grandson), owns 10% of the non-voting and all of the Class B voting stock of the company for a combined economic stake of 31%. HPS has been profitable every year since going public in 2005 and has been building transformers since the 1920s. In 2001, Hammond split off two companies, Hammond Manufacturing and Hammond Power Solutions, the former manufactures electrical components for low-power applications and is run by Bill’s brother, Rob. Hammond is a household brand in the transformer space, and even though it’s considered an older technology, it’s a necessary part of any electrification infrastructure build-out. 

Secular tailwinds from increasing preference for dry-type transformers should continue to support sales growth for HPS, which reports to have the biggest and broadest inventory of products and the largest market share of any dry-type, multi-purpose transformer company. Dry transformers rely on superior insulation and don’t require burning fossil fuels like oil-based transformers, so Hammond’s products are preferred when building any sort of green infrastructure project. Since dry transformers don’t have moving parts, they don’t require as much maintenance and can perform in more extreme conditions, like oil rigs or mining outfits which have historically been the primary end use markets for Hammonds products. More recently, though, dry transformers have benefited from increased demand in indoor applications like hospitals and data centers. Oil-based transformers are not a viable indoor solution. Currently, the majority of sales come from North America (60% US & Mexico, 35% Canada), and the company also sells through a joint venture in India, which accounts for the remaining 5% of sales. They broke into the India market in 2012 for C$16 million (or about 1x revenues)--sales peaked in 2017 at C$25.7 million. In 2021, sales in India were C$18.3 million, up 14% from 2019 levels. There may be some optionality here as there should be some extra tailwind from Covid reopening in 2022 vs 2021, but management hasn’t had a particularly strong record of expansion overseas, so I don’t put a lot of value on this segment. 

In 2021 growing demand and depressed comps resulted in sales increasing by 18% year-over-year, but because of raw material inflation and (you guessed it) supply chain issues, earnings only increased by 8%. There was also a subsidy (which reduced various expense line items for the company) from the Canadian Emergency Wage Services program (CEWS) that buoyed EPS in 2020 by C$0.47 and C$0.21 in 2021 (after tax), which goes away in 2022. The cost inflation has been largely sorted out though–in the first quarter, Hammond reported sales of C$128 million (+59% from 2021 Q1), gross margins were 28.5%, the highest on an ex-subsidy basis in at least a decade, and notably also reported that backlog was up 92% year-over-year and 32% quarter-over-quarter.

They reported C$0.72/share in EPS for the first quarter which is seasonally the weakest quarter over the past couple years. I expect the balance of the year to certainly exceed the C$1.02 that analysts are projecting, which puts HPS at less than 8.5x 2022 earnings. The business is pretty capital light–PP&E is around C$30 million with capex in the C$3-5 million range, which has been the case since 2017, and they’ve grown their annual revenue at a 7.5% CAGR during that time (without doing any major acquisitions). Longer term, ROIC is in the mid-teens, call it 15%, and even if 2022 is anomalous in terms of growth, I think the company will grow faster over the next five years than it did over the prior five. 

Leveraged to improved infrastructure and electrification, recent quarters have been incredibly successful and I expect the trend to continue for the foreseeable future as we upgrade the grid in North America to handle the growing electrical needs of consumers and businesses.Their market share and business longevity give the company a strong position – the “kleenex” of transformers is how management described it – especially in public infrastructure projects. The CEO told us an anecdote about a public infrastructure project in Florida whose design specced-in Hammond transformers–indicating the strength of the brand and that they were increasingly seeing their name specified on design contracts across the country. It’s a relatively simple business, and a mature one to be sure, but a business with operating leverage and secular momentum that trades at a cyclical multiple. The market has begun to catch on, the stock is up over 20% year-to-date with the S&P down over 15%. 

Risks

The company’s historical track record for international expansion and acquisitions isn’t pristine. Back in 2011, HPS ventured into Europe when they bought Italian dry transformer manufacturer Euroelettro for C$7.8 million (which was run-rating at about C$12 million of sales and a C$1mil operating loss). The decision to expand wasn’t a good one, and it finally flamed out in 2018, when sales dropped to C$8 million from C$17 million in the prior year with a loss from operations of C$4.5 million, so they shut down their Italian facility. 

Imminent recession would obviously slow the pace of industrial infrastructure build outs and impact sales growth. However, for a manufacturer of high ASP, long lived electrical components, sales have held up relatively well throughout business cycles. Peak to trough, in the Great Recession, sales were down just 16%, though and the company maintained its profitability.

Catalyst

Various insiders have been accumulating stock in the last 6-12 months

Growth in Mexico after recent buyout of partner operations

Strong cash-flow, should come in the next few quarters (Q1 is historically a low cash generation quarter)

Continued build out of electrical infrastructure in the US