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Background
Last October, Hamilton Beach Brands (NYSE:HBB) spun off from NACCO Industries (NC). Hamilton Beach Brands consists of two companies: Hamilton Beach and Kitchen Collection. (Throughout this article when we refer to "HBB" we are talking about Hamilton Beach Brands Holding Co., and when we refer to "Hamilton Beach" we specifically mean the kitchen appliance designer of HBB).
Hamilton Beach is a leading global designer, marketer and distributor of branded small electric household and specialty housewares appliances, as well as commercial products for restaurants, bars and hotels. Hamilton Beach does not only carry its own brands, but also brings products to the market under the brands of Proctor Silex and Weston.
Kitchen Collection is a physical retailer that focuses on the retail of bakeware, cookware, small appliances, marble and ceramics, and other gadgets that simplify cooking.
We believe that HBB represents a very compelling investment for three reasons: misunderstood fundamentals, attractive spin-off dynamics and accretive taxation changes.
1. Misunderstood fundamentals
When looking at HBB, it becomes clear that Hamilton Beach and Kitchen Collection are very different businesses. Hamilton Beach represents top quality brands that are some of the highest selling in their respective categories. Hamilton Beach’s revenues account for around 81% of total revenues and profits 99.1% (FY2016) for HBB. Therefore, Kitchen Collection is negligible in terms of profits (Prospectus filing Sept. 2017).
Furthermore, Kitchen Collection has seen declining revenue and is facing unfavourable market trends currently associated with physical retail. A potential in that case could be that Hamilton Beach and Kitchen Collection have a lot of revenue crossover because a lot of Hamilton Beach's products are sold in Kitchen Collection stores. However, we do not see a problem here for three reasons. Firstly, the two largest customers - Walmart (WMT) and Amazon (AMZN) - constitute 42% of total sales. Secondly, the third-largest customer only has 5% of sales. Thirdly, Hamilton Beach has over 2500 customers, of which it only mentions its most prominent ones, and Kitchen Collection is not named. Therefore, we believe there to be hardly any revenue crossovers (Investor Presentation Sept. 2017).
In our opinion, HBB is predominantly a high-quality consumer goods designer/distributor with stable revenues and margin potential. However, it is currently partly perceived as a retailer when in fact regarding profits, Kitchen Collection is virtually irrelevant. The management has introduced a plan in which it will thoroughly optimise Kitchen Collection's store portfolio, focusing on stores in strong outlet malls and closing stores which do not generate acceptable profitability. As management optimizes Kitchen Collection, we believe that the underlying perception of HBB will improve and become seen as a strong consumer brand designer instead of a struggling retailer.
2. Spin-off
Spin-offs can be very positive for value creation because managing different businesses under the same organization can result in inefficiencies - specifically when there is very little overlap in the different businesses being run by the same organization. In the case of HBB, which was previously part of NACCO Industries, there clearly is hardly any overlap between the two businesses. This is because NACCO Industries was predominantly involved in the mining of coal.
The management has effectively said that it believes that HBB has been underperforming its potential. We can infer this because management has stated it believes that by spinning off HBB it will allow HBB to be more flexible in its access to debt and capital markets (prospectus filing 2017). In addition, management has signaled aggressive long-term operating margin targets of around 9-10%, given that the operating margins for 2015 and 2016 were 5.6% and 7.1%, respectively (investor presentation 2017). These forward-looking statements regarding margins are specifically in regards to only the Hamilton Beach division of HBB. If such goals would be realized, paired with the expected future revenue growth of the Hamilton Beach division, future outlook is very strong.
In addition, when looking at management and compensation, we find it encouraging to see that HBB has instituted a compensation plan for its management that is heavily made up of equity. This gives us confidence that management believes it will be able to extract value for the shareholders as it has made an explicit bet on that.
Finally, it appears that very senior management from NACCO Industries has decided to manage HBB. This shows that the senior management believes in the future of HBB. For example, Alfred Rankin, former Chief Executive Officer of NACCO Industries, has become CEO of the HBB holding company (prospectus filing 2017).
3. New US taxes as of January 1, 2018
President Donald Trump signed the new tax act into law as of December 22, 2017, and the new tax system will start as of January 1, 2018 (Tax Reform Statement, 2017). Under this new system, the corporate tax rate is 21%, a significant advantage for HBB, as it has been paying between 30% and 35% corporate tax for the last 2 years. The main reason why this is significant for HBB is that 84% of HBB sales are US-based, and we estimate the profits to be US-based for at least that same percentage. We estimate that this will result in around a 25% increase in net income, all else being equal.
Valuation and Conclusion
We have built a discounted residual income model in which we initialised the following assumptions:
22% tax rate
The largest percentage of taxes paid by HBB is in the United States, and for many other countries corporate taxes are around 20-25%. Considering this we decided to use a slightly higher tax rate than the current United States corporate rate in our model (21% as of 2018).
Flat revenue growth FY17 and 2% growth to perpetuity
Considering that management has said that it is targeting around $750-1000m in revenues from Hamilton Beach in the long term (which is 24% above last year's revenue), we consider it reasonable to consider 2% growth to perpetuity reasonable. This will bring revenues to around $750m in year 2028 and afterwards we have used a terminal growth rate of 2%. In our opinion, this is fair and conservative, because we believe Hamilton Beach sells products we believe will ultimately be inflationary in prices and correlated to growth in consumption.
Increasing operating margins for Hamilton Beach with terminal operating margins at 7.55%
We have calculated for Hamilton Beach margin growth until 2019-2020 and afterwards zero growth in these margins. This may be on the conservative side, but we find 9-10% operating margins a bit too optimistic, given this information is only backed up from inside HBB. This leaves for some additional upside in our valuation, but that depends on how effectively management can improve HBB after the spin-off.
Cost of Equity 7.63% with a beta of 1.1
Zero revenue and operating income contribution from Kitchen Collection after 2018
The main reason we have eliminated Kitchen Collection's revenues and profits from the model is because we believe Hamilton Beach is the value driver of HBB. In addition, KC contributes less than 1% of profits, and while we hope that management will be able to extract value from Kitchen Collection, we do not count upon it. We believe any small profits or losses on the side of KC over the years will cancel out.
Conclusion
We believe the fair value for HBB to be around $35-40. However, for this to be the case, it is important that HBB is able to steadily grow the Hamilton Beach revenues and improve margins. It is important to realize that a “fair value” is not an exact number and residual income models do not give exact values. However, we believe it gives us the ability to roughly estimate what something should be worth if a number of assumptions are met.
Any downward departure from the major assumptions used would result in a lower valuation. In addition, if HBB is able to outperform on revenue growth and operating margins, then there could also be a case for a higher valuation. We do concede that we may have been conservative on the revenue growth and terminal values. Moreover, if management would be able to significantly improve upon KC's situation, this may also be an additional source value and may result in higher valuation. Being conservative in our assumptions allows us to feel comfortable that our valuations are fair and are fairly likely to be met.
We will provide an updated article and valuation when we believe there is enough evidence to prove that our operating margin and revenue projections are too conservative.
