In early December of 2023 I recommended Hammond Power Solutions (OTCPK:HMDPF) to Seeking Alpha readers. Since then, shares are up almost 29%, vs. a 13% return for the S&P. At their peak of $117 last month, shares were up almost 100% from the price when I recommended them. I was feeling uncertain about my decision to not buy shares in my own portfolio. Last week, Hammond announced Q1 results and shares declined by 35%. While shares are still up since my initial recommendation, I believe the recent drop validates my initial trepidation. Below, I review my initial thesis and Q1 results, and accordingly downgrade Hammond from a BUY to a HOLD.
Initial Thesis
Hammond is a small (market cap around $1 billion) transformer manufacturer based in Canada. The company has been around for a century, and until 2023 was run by a member of the Hammond family. The family still owns a large number of shares. According to the company, it is the largest manufacturer of dry-type transformers in North America. Net margins had been very low (~1-3%) until the last few years, when the widely-discussed transformer shortage drove up prices, leading to a sharp increase in margins and the share price. Shares increased from around $5 at the start of the pandemic to over $100.
My initial thesis was that prices would stay elevated, sales would keep growing, and that this would drive share price appreciation. I wrote that:
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.
I also thought that this growth could inspire continued multiple expansion:
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.
My policy is to not include multiple expansion in my base case (because doing so amounts to speculating on market sentiment), so I estimated that the share price would increase only slightly faster than revenue growth.
I did not buy shares in my personal portfolio because the resulting expected return – 13.6% p.a. – was not high enough to justify what I saw as the significant risk that growing supply would drive down prices:
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.
Recent Results (Q4 ’23 and Q1 ’24)
As is often the case, Hammond’s share price has fluctuated much more extremely than the underlying value of its business. I was amazed by how much the share price surged in Q1 2024 after strong Q4 2023 results. Since another Seeking Alpha analyst reviewed those results here, I won’t go over them in detail. Instead, I’ll focus on the Q1 ’24 results, which have yet to be discussed on Seeking Alpha and, I believe, validate my initial concerns. Below, I outline them based on the earnings call.
In Q1, Hammond’s revenue was $190 million, crushing estimates by over $50 million. These results basically accorded with management guidance – they were “close to where we expected them to be” according to the call. But due to much higher stock-based compensation ($16.7 million, for a YOY increase of 270%) and other expenses, net earnings dropped by 50%. Profits temporarily exploded last year because there was a lag between rising profits and share prices and correspondingly higher compensation. That gap has now closed.
Meanwhile, revenue growth expectations have stopped increasing:
As we look out to 2025 and beyond, we continue to see strong demand from our emerging market segments, which include renewables, EV charging, data centers and semiconductors. To meet this demand, the Board has approved an additional $8 million of capacity investment. This incremental investment will help achieve our goal of reaching $1 billion of sales before the end of the decade.
Demand remains strong, but Hammond is sticking to its 2023 target of achieving $1 billion in sales by 2030. This would represent growth of 5.2% per year over the next seven years, hardly impressive given that the company is pushing through a 4% price increase in H2 2024 to compensate for higher material costs. This affirms my initial concern that revenue growth upside is limited because manufacturing capacity acts as a hard cap on sales growth.
There is also evidence that the transformer shortage is easing, leading prices to moderate. Declining prices would be very bad for Hammond’s profitability. Here is what management said about the question on the Q1 call:
Higher bookings versus Q4 2023 allowed us to utilize our additional capacity more fully. And as a result, bookings and shipments are now closely matched, meaning we are able to keep consistent delivery cycles to our customers even with higher order intake.
Hammond has now equalized their own “supply” and “demand” and the longer lead times (associated with shortage) are starting to moderate.
Throughout much of 2023, the company has benefited from operating at nearly full capacity, enabling us to maximize operating margins, a benefit that may change as we add more capacity in 2024
This will probably compress margins going forward.
The backlog remained relatively steady from the fourth quarter, experiencing a 1% decline.
The third – and most indicative – piece of evidence here is the backlog, which has stopped growing. That is strong evidence that current supply has now risen to the level of meeting future demand.
Bottom Line
Initial revenue growth expectations still appear reasonable, with Hammond beating estimates handily in Q1 and affirming guidance for $1 billion of revenue by 2030. But this is a forecast for very slow growth – almost no growth after inflation is considered. The second pillar of Hammond’s growth was price increases, which now appear to be slowing. The third was multiple expansion. I said that Hammond was trading at 60% of the valuation of its peers, implying a 66% upside and a price target of near $100. Shares hit that level at the end of March. But revenue growth is indeed going to be much slower from here on out, since the company’s plants can no longer increase their capacity utilization rates, and capacity increases are slow. And future margins are very uncertain, since they are determined by transformer prices over which Hammond appears to have little control. I think these concerns explain the dramatic recent drop in the share price, and justify it.
I don’t know the future of the transformer market in the US, and for that reason find it hard to say what will happen to Hammond’s share price. I remain convinced, however, that there is significant downside to shares at these prices if transformer prices start to drop.
Moral of the Story
Gold Panda recommended Hammond in late December, about three weeks after I did. They then downgraded the stock to hold a month ago, when shares were at $107 – near their peak. They should be congratulated on executing a very successful trade: shares were up nearly 70% in three months. Assuming that shares do not fall further before this piece is published, my readers would have only earned a return of 27% on their investment. But my personal investment plan is not to trade on a month-to-month basis. And for that reason, I’m happy to have not invested in Hammond. I was right to suspect that supply and demand would rebalance and to be concerned that Hammond’s share price would be highly sensitive to news about transformer prices, which remain beyond its control. It was tempting to buy in at a higher price, but in this case, it seems that it was better to leave some money on the table.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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