Description
HUBB Short Memo
Summary
- HUBB has recently outperformed XLI by ~25% due to:
1. better relative growth vs. peers driven by price, as they have more metal costs vs. peers and better availability of their products as they were less impacted by supply chain issues.
2. Perception of better growth potential in their utilities segment
- However, things are about to inflect:
o Metal deflation and cyclical pressures are about to cause HUBB’s organic growth to revert to peer average or below (starting in Q4)
- Utility spend is slowing and HUBB’s utility segment is heavily driven by resi starts with a 1-year lag. This will cause a significant slowdown in growth in 2023.
- I see a relative underperformance of ~23% to a PT of $170
Overview
Hubbell is an electrical manufacturer that operates in 2 segments:
- Electrical Solutions (44% sales)
o The segment sells a combination of wiring, enclosures, connectors, bonding, tooling, industrial controls, and residential lighting products.
o The segment mainly serves the industrial, non-res, hash & hazardous, and residential markets
- Utility Solutions (56% sales)
o The segment is ~60% power systems (widgets for T&D), ~20% Aclara (Electric meters) and 10% gas connecters and distribution automation
o ~90% of power systems sales are tied to distribution of electricity
The Setup
- Hubbell has performed in-line with the XLI over the past ~5 years or so. With sporadic periods of underperformance and outperformance
- However, since March of this year, the stock has outperformed XLI by ~25%
- Outperformance has been driven by relatively strong Q1/Q2 earnings results, a bullish analyst day, and the company’s exposure to the electrification and grid hardening themes
o Q1 – The company had 12% price and 9% volume that drove ~15% EPS beat and a 2% upgrade to annual EPS guidance vs. the street
o Analyst Day – The company said they will earn $12 in EPS in 2025. Grow organic CAGR of 3-5% between 2023-2025. Have DD EPS CAGR. 17% margins in 2025. They also said they are tracking towards the high end of their range for 2022 ($9.00-$9.40)
o Q2 – The company had 14% price and 6% volume that drove ~16% EPS beat and a ~3% upgrade to annual EPS guidance vs. the street
Thesis
1. Relatively low-quality business vs. peers:
- HUBB’s EBITDA margins are ~300bps below electrical peers
- FCF margins are ~250bps below
- EBITDA 5yr CAGR below best in class peers (LR FP, SU FP)
- Conversations with industry participants also highlight that the portfolio is lower quality in nature and never attracted the interest of consolidators in the industry (ABB, SU FP and ETN)
2. Outperformance due to outsized growth. But peak relative growth driven by peak pricing is about to end:
- Supply chain issues have been negatively impacting the electrical space. Predominantly, driven by semiconductor and power electronic shortage. HUBB’s products are mainly bent metal with very little electronic components. Therefore, they have been able to meet demand (similar to NVT) and their growth metrics have stood out in recent quarters. However, volume and price have peaked and growth is about to inflect downwards.
- In Q1, HUBB had 21.2% organic growth out of which ~12% was price. In Q2, they had 19.6% organic growth out of which ~14% was price. NVT is also heavily exposed to steel as an input and its price was up ~11% in Q1 and ~12% in Q2. This is in contrast to the less commodity heavy manufactures such as LR FP who had price up ~7.8% in Q1 and 10.4% in Q2 and SU FP at ~7% in Q1 and ~6% in Q2.
- The outsized growth in the last couple of quarters has been a main driver of the re-rating along a “story” about unique growth drivers. However, steel, aluminum, and copper have been dropping. These commodities including components are north of 60% of COGs which are ~72% of sales. Therefore, we have hit peak pricing as commodities are now down for the year. Furthermore, volume demand drivers such as PMIs, IP and industry surveys suggest we are about to decelerate – which would imply we are at peak growth and that will lead to underperformance from here.
- During its recent analyst day. HUBB showed the slide below. While their intention was to show that eventually they catch up on price/cost – they also showed us that their pricing actually comes down following material deflation. This is in contrast to common belief that electrical products that go through distribution do not see price downs even in times of deflation.
o “You see the material prices go down, and you see our price to customers lag that. Yes, it comes down. But the area of the blue above the yellow represents margin that's dropping through for us.”
- HUBB’s Utility segment is perceived to have strong growth driven by grid modernization, renewables, smart grids etc’. As the only pure-play electrical utility segment, HUBB attracts interest from investors looking at the theme. The disconnect between perception is most of the investment has to do with Transmission vs. Distribution. HUBB does not have exposure to Transmission. However, Grid modernization is a distribution investment area.
o But HUBB is not exposed to the real “modernization” efforts but more to “components” on a pole. While grid modernization is predominantly an investment in software and automation vs. additional poles.
o Utility Capex plans are forecasted to barely grow in 2023 and then decline in 2024:
o Also, the increase in capex by utilities in the last couple of years has caused rates to rise for consumers. With the increase in commodities (Coal, Nat Gas) that are driving rates even further, there is an expectation that regulators are going to pause capex spending to provide rate relief to consumers.
o Lastly, to bring home the point on the Utility Solutions’ growth drivers – the segment growth rate has ~90% correlation to housing starts with a 1 year lag.
· Starts were up ~16% last year. Forecasted to be up ~4% this year (with risk to the downside) and down ~7% next year.
3. Underperformance ahead
- One of my favorites “themes” to short in industrials is when cyclical headwinds meet structural growth perceptions. HUBB is a cyclical, IP driven manufacturer that is about to see significant deceleration in growth and earnings. However, investors believe the “electrification” theme is going to provide tailwinds. Even if true, capex decisions in time of economic pain are going to be pushed to the right. Therefore, underperformance of the stock will be driven by:
A. Peak growth
B. Negative earnings revision (starting in ~FQ3)
C. Peak valuation (absolute and relative)
- Case studies – How does HUBB react in a “recession”?
a. Industrial recession (2015/2016) - When oil started selling off (Thanksgiving of 2014) – HUBB underperformed the XLI by ~20% for the following year (this after selling off prior to oil falling.
b. Covid – HUBB’s stock initially outperformed XLI by ~14% when the market sold off during Feb/March. But after peaking relatively in April, the stock gave back all the outperformance over the next several months. This situation resembles the current environment where HUBB has been outperforming during the current market selloff only to give up the outperformance in the upcoming months.
Risk:
o Metals strength – if metals reverse course and start rising, this can provide firepower to HUBB to push more price and artificially present their growth rate as higher than peers.
o Electrification/Grid Modernization themes can keep volumes elevated in a recessionary economic environment.
· My work suggests this is highly unlikely due to: 1) Low quality / exposed portfolio and 2) Capex decisions will be pushed to the right
· However, this can also be easily hedged by buying names that will do much better on the electrification theme such as ETN or SU FP.
- Valuation
· Hubb is currently the most expensive electrical products manufacturer both on P/E and FCF yield. Furthermore, it is currently trading at a massive premium vs. its historical average multiples (both on EV/EBITDA and 5yr and 10yr averages). This is in contrast to the group who is trading, for the most part, at discounts or small premiums).
· There is no fundamental reason for this premium as margins, or EBITDA CAGR haven’t been unique vs. the group. Also, expected EPS growth also doesn’t standout at ~10% which isn’t different from the rest of the group.
· Without assuming a 2023 recession (which is consistent with how the comps are modeled) I think, HUBB can generate ~$10 of EPS in 2023 and should trade at ~175x (alongside the comps). This should result in a PT of ~$170 or ~23% relative downside to the group.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.
Catalyst
1. Earnings
2. Continued commodity deflation
3. slowdown of the residential construction market
