SUMMARY

HMS Networks AB is a leader in niche industrial networking and communication products with a track record of strong execution, superior organic growth and rare but smart acquisitions. Forthcoming synergies from its recent acquisition, a cyclical rebound of end markets and a reasonable valuation offer a timely investment opportunity.

NICHE INDUSTRIAL NETWORKING AND COMMUNICATION PRODUCTS

On the factory floor, a communication network connects automation equipment with industrial computers for real-time process control, factory uptime and safety. A communication protocol is a set of rules that determine how information flows through the network. Developed since the 1970s and governed by the standards bodies, multiple protocols today fall into three families: legacy fieldbus, mainstream Ethernet and nascent wireless (Exhibit 1A).

To target a global market, a factory automation OEM needs to offer equipment compatible with most protocols. This is possible with an interface card, a turnkey hardware module embedded into a machinery unit. OEMs can either develop such cards in-house or buy them from external vendors. In-house products require a dedicated team, compliance with evolving protocols and certification with the standard bodies – a costly option only affordable for major companies. Smaller OEMs achieve the lowest cost of ownership with third-party cards. Once designed into an OEM’s equipment unit, a card yields recurring revenue over the design lifecycle of 8-10 years (Exhibit 1B). The interface card market amounts to over $2 bn (of which ~30% is “outsourced”) with an 8% annual growth rate.

Among other niche industrial communication products (Exhibit 1C) are gateways (a card’s significantly more expensive, standalone plug-and-play version), remote control modules (gateways for remote management and maintenance of equipment) and HMIs (human machine interfaces for factory monitoring and management) – the last two are larger (if defined broadly) and faster-growing markets at 10-15% per year. All markets are cyclical and correlate with global PMIs and machine tool orders.

The leading provider of niche industrial networking and communication products is Sweden’s HMS Networks AB.

OVERVIEW OF HMS NETWORKS AB

Founded in 1988 as Halmstad University’s student project, HMS Networks AB (“HMS” or the “Company”) pioneered interface cards with its flagship Anybus product which organically developed into a global leader (30% market share, followed by Softing, Hilscher and ProSoft). HMS complemented core organic growth with three sizable acquisitions of niche leaders and in 2023 reached $288 mn in revenue mainly from the embedded card and gateway (68%) and remote control (17%, through the 2016 acquisition of Ewon) products from Europe (60%), APAC (18%) and the U.S. (14%). HMS’s niche leadership and strong execution are evident in (i) consistent #1 industry rankings (Exhibit 2C), (ii) growth rate ahead of the automation market and peers (Exhibit 2F), (iii) high gross (65%) and operating (25%) margin and ROIC (44%) and (iv) track record of successful acquisitions (Exhibit 2D).

In 2020-23, HMS underwent a supercycle, as the initial order boom gave way to a subsequent bust (Exhibit 2E). In late 2023, in its largest-ever transaction, HMS acquired a major U.S peer Red Lion Controls (“RLC”) for $345 mn at 13x operating profit in order to (i) add the HMI product (47% of RLC’s and 15% of combined revenue, Exhibit 2B), (ii) expand the North American presence (to 39% of combined revenue) and (iii) achieve cost and revenue synergies (RLC is 4 ppt behind in operating margin; growth rate is only 4%) in the already accretive deal.

Co-founder and longstanding CEO Staffan Dahlström and the Swedish family office Investment AB Latour jointly own 38% of HMS. The Company’s stock trades in Stockholm since 2007.

LONG THESIS

We expect HMS to (1) deliver a material earnings appreciation in the medium term due to synergies from the RLC acquisition and cyclical demand recovery and (2) further solidify its leadership position in the niche industrial networking and communication products in the long run.

1. HMS’s earnings will double in 2024-28 due to (a) RLC synergies and (b) cyclical end market recovery

(a) We expect HMS to harvest significant cost and revenue synergies from the RLC acquisition. We believe that RLC, as already one of the better-performing assets in its seller’s portfolio, until now had little incentives for further improvements, and we also note turnover in its leadership since 2016. Specifically, the 4 ppt shortfall in operating margin relative to HMS results from less efficient manufacturing of products and sourcing of components which, in turn, are HMS’s strengths. Furthermore, RLC is known as a product- rather than sales-driven organization, which is visible in minimal price increases during the pandemic and lack of direct customer relationships. We thus believe that a concerted go-to-market effort with a unified sales team under  HMS’s high-performing U.S general manager together with overdue product price increases will improve RLC’s modest growth rate.

We project RLC’s operating margin to converge with HMS’s and top line growth to accelerate to high single digits over the next three years in a linear manner. In this scenario, we estimate the acquisition multiple of RLC at only 8x operating profit in 2028.

(b) Global PMIs and machine tools orders, a proxy for HMS’s end markets, troughed in late 2023 – early 2024 and are already rebounding (Exhibit 2E) in a typical cyclical manner. While the pace and magnitude of the next upturn are uncertain, we expect a sequential improvement in the combined order intake from 2H24 and new highs over the next three years, driven by greater order volumes but also HMS’s sticky ~20% ASP increases since 2021.

Overall, we expect RLC synergies and a cyclical recovery to result in the combined Company’s earnings power by 2028 nearly twice the 2024 trough and 1.5x higher than the previous peak in 2023. We also note that the five sell-side analysts’ projections (only published through 2026) assume the combined Company’s low organic growth and, implicitly, no improvement in RLC’s profitability from the current level.

2. HMS will further widen its niche market leadership in the long run

We are compelled by HMS’s aforementioned track record of niche product leadership and execution. We expect the Company to stay the course under Staffan Dahlström (and possibly an internal successor later) and continue outgrowing its markets with further accretive acquisitions, also in new niches like remote data analytics software. On a ten-year horizon, we see HMS as a larger and better recognized leader in its industry.

valuation

HMS is in many ways a unique company and is arguably best valued relative to its own historical levels, an approach we nevertheless cross-check against discretionarily selected European peers Mycronic, BE Semiconductor and ASM International.

We value HMS on an EBITDA basis, applying the FY1 EV/EBITDA multiple of 18x (below HMS’s 10-year average of 21x and the recent peer levels) to our 2028 EBITDA estimate of SEK1.8 bn for the 2027 target share price of SEK675, a 58% upside from the current price. Our bull and bear scenarios provide for share price targets of SEK979 and SEK341, with the latter assuming no improvements at RLC and a low valuation of HMS as a result.

RISKS

1. Integration of Red Lion Controls

While the acquisition of RLC presents an execution risk given its size, we note the transaction’s low valuation and the abundance of seemingly straightforward synergies without obvious major impediments to their extraction.

2. Networking protocol convergence

A world with a single networking protocol needs no converters, and even though over 20 protocols still exist, three major Ethernet protocols now account for ~50% of new installations. However, unification of protocols seems unlikely in the medium term, and a vast installed base of multiprotocol automation equipment still necessitates protocol conversion across new and older machinery units. Furthermore, the contribution of Anybus to HMS’s revenue has been declining (from 60% before RLC to 40% today) due to product portfolio expansion.