Description

The 2022 writeup on HUBB provides a solid overview of the company and provides a different take on some of the key drivers of share price. It is worth reading in conjunction with this writeup, as it covers housing correlation dynamics, a possible utility spending slowdown and other potential downside drivers.

https://www.valueinvestorsclub.com/idea/HUBBELL_INC/5771761780

Their 2022 investor day presentation provides excellent background as well.

https://hubbell.gcs-web.com/events/event-details/hubbell-2022-investor-day

As a maker of electrical components that are not particularly customized nor high tech, other than arguably their Aclara (advanced metering) division and emerging segments, HUB has expanded margins in an extraordinary way from 2019 to 2023 from mid teens to the low 20s.

Particularly noteworthy was the massive jump in margins reported in Q1 2023.

Management isn’t hiding the ball here about the source of margin expansion. Per Q1 2023 call, they indicate it’s mostly due to price cost, with some productivity benefit as well. Because of the nature of the industry, they choose their products’ listing price ahead of time based on their best estimate of input costs. The margin they capture depends largely on where costs land due to their LIFO accounting, and their production efficiency. In recent quarters, it appears their pricing actions dramatically exceeded production costs, and customers did not push back.

Operationally, we achieved over 600 basis points of adjusted operating margin expansion in the quarter, driven by favorable price cost and productivity in addition to volume growth. 

…

Q: And I also believe you said that relative to February, the expectation is for a bigger price cost tailwind this year. And that comes despite metal reflation over the past couple of months. So just kind of curious for more color on that.

A: So maybe let's start with your price cost. Yes, so the pricing actions that we were taking at the end of the year that we didn't have insight into their stickiness when we shared our full year outlook at the end of January, it was a much better take-up than we expected and much better than historical average on price increase take-up. So the price side of that is quite a bit bigger. And then it really does dominate and overwhelm what will happen from the amount of inflation that we've seen in the new year on the materials side. And as, I think, Joe was asking beyond materials, we've got to do a really good job of working our suppliers and making sure that any lower material cost they got in '22 that we're -- that's getting passed through to us.

What isn’t clear from these comments is why price cost has been such a tailwind, when the cost side is meant to be a passthrough with some appropriate margin on top. Per their Q2 2023 call, they are clear that capacity constraints have resulted in a significant pricing premium detached from cost inflation:

Q: And then I wanted to ask on the deflation comment where you're seeing it in both raws and components, specifically on the components side. Is that a function of efforts that you are making and going to market and any supplier consolidation is translating to some of it? Or is it something that you're seeing broadly in the market on component deflation? And then related to that, I mean, historically, when you do see some of it, what would generally be the lag time before you would start to see that filter into the conversation around price?

A: And it's interesting how you're describing the relationship between material cost. And Dan had a page, I think, 2 quarters ago that did a nice job of showing our cost structure being about 50% driven by raws and material cost and the other half being labor and overhead and burden and other items. And usually, I would say our paradigm is to have price offset the material cost and our productivity initiatives to offset inflation in the nonmaterial areas. And so what you're asking usually, we would see -- if we were to see inflation in materials, if I'm going back 3 years ago and earlier, it would take a quarter or 2 for us to get the price kind of into the market to offset that. So that was kind of a lagged hedge, if you will. But I would say in the last 2 years, the pricing has been driven by lack of capacity rather than necessarily by cost and connecting back to Joe, to the first question, service is kind of a relative question, right? You're trying to outcompete somebody else. And it just feels to us like we're doing -- we're leaning in on the investment. I think we're finding this to be -- utility space to be really core part of Hubbell's identity and sort of leaning into that, maybe where maybe others might be a smaller division of a larger diversified company.

What do they mean by “lack of capacity”? As of mid-2022, HUBB noted the buildup of backlog in a business that is normally a book-to-burn business.

So you can kind of see -- before December of '20, you can see the illustration of a book-and-bill business, taking orders and we're shipping. Now you see the last 6 quarters, a pretty dramatic buildup of strong orders with strong billings growth, shipments growth, but the bottom depicts the creation of an ever-growing backlog.

We spent a lot of time fielding questions from you all about how sustainable the order pattern is, our customers ordering ahead, so I thought I would add maybe for some illustration purposes the orders on the bottom that are in gray are meant to be delivered 90 days from now. And I thought that would give you a sense of are customers expecting future price increases, are they expecting longer lead times, and therefore, do they need to put in orders that are longer dated than typical. And the answer to all of that is yes. And so I thought this would give you at least a little bit of insight into how our year is shaping up and how to the extent customers were to pull back in orders that we've got a substantial backlog to live off of for a while.

This buildup of constrained supply continued to grow into Q1 2023 to 2-3 quarters worth of backlog.

And what you can see is starting really at the beginning of 2021, a very significant and sustained increase in the backlog on the utility side of distribution and transmission components. It's obviously driven by the fact that the demand exceeded our ability to be able to make and ship a like amount of material.

And one of the reasons we wanted to show you the page is we feel that that level of demand is not the norm and would not be a sustainable level over the long time. Essentially, I think we see the order pattern was responding to longer lead times and the fact that we were in an increasing price environment, both of those phenomena, I think, caused people to put their orders in earlier than they otherwise might, and that's evidenced and supported by the fact that there's quite a bit of content in this backlog that's dated longer than 90 days.

And so what we expect is that as we start to get the supply chain normalized, get our lead times normalized and bring those factors down, we think we'll be enabling our customers to get their orders put in with the anticipation they will get the material much faster.

And so our anticipation is that the order rate can come down and we'll be reducing this backlog to get it back into balance and what we feel over the medium and long term is a mid-single-digit sustainable book-and-bill order and ship rate.

HUBB’s Utility segment is the higher growth, higher margin half of the business and also accounts for most of the profit improvement. The majority of backlog was built up in the Utility segment as well, which correlates well to the big jump in Utility margins along with a smaller jump in Electrical margins

Per prior investor day commentary, HUBB owns approx. 10% market share in the Utilities space, and historically has not demonstrated strong pricing power. Sales are primarily through distributors, of which the largest 10 make up 40% of their channel. Their distributor channel dependence exemplifies how mundane their products are vs. competitors which do a % of their business directly with utilities.

Because of their broad base of products, they compete against a variety of companies in the Utilities segment, notably Eaton, ABB, Hitachi, Alstom, Schneider on the larger corporate side. 

Notably, Eaton has a much higher quality business than HUBB and was already operating around 20s operating margin prior to COVID (vs. HUBB’s Utility in 17s and 18s), improving to 26% by their latest report (vs. HUBB also at 26%). ETN’s backlog also rose 3x+ between 2019 and 2023. ETN notes that many of their products are more specialized and directly sold into multi-year megaprojects, so a direct distributor comparison would be imperfect. ETN's backlog has continued to grow as of their last report, and they express strong though unspecific visibility into 2024-2025.

Comparatively, HUBB has provided fuzzy, relatively circumspect responses regarding demand normalization, channel inventory, and potential impacts on their business, preferring to fall back to backlog setting up a strong H2 2023. 

HUBB’s Q2 2023  commentary on backlog was not as encouraging:

As we've seen those lead times start to normalize, I would say, in 2 particular segments of the components area, we've really started to see customers adjust their order pattern to reflect the fact that they can work off of inventory and can moderate their order pattern until that inventory gets to the proper levels. So that's both the distribution side of Power Systems as well as the telecom end market.

Note Distribution is Utility’s largest subsegment, and management identified it as the key driver of backlog build:

And what you can see is starting really at the beginning of 2021, a very significant and sustained increase in the backlog on the utility side of distribution and transmission components. It's obviously driven by the fact that the demand exceeded our ability to be able to make and ship a like amount of material.

Just as margins improved dramatically on the back of the backlog build, it should reverse as the backlog disperse. Investors are aware of this risk and traded shares down post Q2 2023 earnings despite a beat-and-raise. 

Determining when backlog runs off and what the implications for margins is complex:

For starters, utility capex spending remains healthy. Whether the key capex areas are aligned with HUBB’s portfolio is hard to ascertain, but there seems to be some divergence between ETN’s optimism and HUBB’s reticence to speak past 2023. It is very likely that they do in fact lack visibility.

Secondly, the pace of normalization depends on the combined actions of all of their competitors and distributor stocks as well. In addition, as we have seen in many other industries, price reductions tend to happen more slowly than price increases due to the incentives of the intermediaries. On the other hand, we may see a reverse bullwhip destocking of some kind in the next few quarters.

HUBB is trading at 14x 2024 EBITDA and 19x P/E Wall Street consensus. Consensus has 2024 operating margin falling to 20% vs. 21% in 2023 even as revenues grow 5%. While this may or may not be the correct margin for 2024, it would be reasonable to believe margins have more downside from here than upside. The pace of any reversion will be difficult to forecast, but if we illustrate a simple reversion back to 2022 levels of ~17% (still several hundred bp above when they started building backlog, giving them 100 bp of credit for productivity over 2022 actuals), we’d still be looking at a 15% reduction in operating profit vs. forecast. Assuming some concurrent compression in multiple, it is possible to envision 20-40% downside. This downside likely needs to be probability adjusted for growth, timing of normalization and cash generation during that period, but these variables are impossible to determine with any degree of accuracy. 

The previous writeup posited that falling commodity inputs would be efficiently incorporated into pricing with a slight lag, slowing top line growth. The company’s own discussion in the past also supports this view. This has not proven to be the case recently as raw materials deflation has only helped price cost, likely due to elevated pricing power brought about by supply shortages. It’s hard to know how the future plays out, but if supply availability is normalizing, then I suspect input inflation would help normalize margins faster than input deflation as distributors would prefer to hold prices where they are and let costs catch up.

We haven’t spent much time on the Electric Solutions side, but note that organic growth was negative last quarter with both C&I and residential highlighted as soft. Delivery times are weeks now, not months. To the extent these markets continue to show volume declines, we would likely see price impacted.

Although HUBB will report very strong earnings the next two quarters, management has indicated they have now lapped the last price increases and will be riding from here. They further indicate their H2 guide assumes some price softening. If possible, they will comment further on 2024 on their next call, but they appear to have no visibility yet. While the post-pandemic environment has been anything but easy to forecast, I believe there is more downside risk than upside risk for HUBB from here now that markets have capitalized margins that are unlikely to be maintained into perpetuity.

Catalyst

Backlog burn

2024 guidance