Hammond Power Solutions: An Investment Thesis

Summary

• Well-run and tightly held corporation with attractive financials.
• Stock is currently beaten up after last year’s selloff.
• Reasons for the selloff are likely cyclical not structural, thus presenting would-be investors with a potential opportunity.
• Low liquidity may be a significant risk or impediment to owning this stock.

Introduction:

This little-known company’s primary listing is on the Toronto Stock Exchange. It trades under the symbol HPS.A, and is headquartered in Ontario. Hammond Power Solutions (OTC:HMDPF) manufactures a variety of transformers and magnetic products. They are the largest manufacturer of dry-type transformers in North America and enjoy a variety of technological, process, and scale advantages over peers. While some competitors are large multinationals, the market is fragmented and many are small scale operators generating less than $20 million in annual revenue. Hammond Power has manufacturing operations in Canada, the US, and Mexico, as well as in the fast-growing Indian economy and, until recently, Italy.

The primary end users for their products are electrical utilities, local power companies, and commercial, industrial, and residential power consumers. The equipment alters the voltage of electrical current and is integral to distributing electricity. Their products essentially change the voltage from large power lines so it can be sent to individual power users. Other end markets include connecting mining outfits, oil & gas operations, renewable energy companies, and utilities to the grid.

Unlike most companies which will be written about here on Seeking Alpha or in our quarterly newsletter, Hammond Power Solutions is not held in a Contra the Heard portfolio. This is because the average daily volumes are too low. This volume issue aside, HPS.A has many of the characteristics we look for in a potential investment. The company has been on a watch list for years, and I now own it personally. My average cost base is roughly $5.75 and it was purchased in December 2018.

Corporate Characteristics Underpinning the Investment Thesis:

Hammond Power’s financials are strong. On the balance sheet, the enterprise has a good current ratio, low intangibles, and manageable debt. Not only does it have strong working capital, but the current assets handily exceed all its liabilities. Over time the organization has maintained a flat share count and the retained earnings line is impressive, implying healthy profitability. In each of the past 11 years, the company has generated a net income which has covered its dividends since distributions were first started in 2010. Since 2008, revenues have grown from $226 million to $309 million, cash flow from operations has been positive, and free cash has generally exceeded capex.

The management and board are also interesting and have ample skin in the game. The current Chief Executive Officer, William Hammond, is the grandson of the enterprise’s founder. He has been working with the Chief Financial Officer for years and they took the company public in the early 2000s. William owns all of the Class B stock and around 9% of the Class A stock which gives him effective control over the company’s voting shares. Though this means HPS.A will be impervious to shareholder activism or discontent if investors are unhappy, Hammond and his management team are shareholder-focused, as exemplified by the company’s financial position, dividend policy, and lack of dilution.

The transformer industry in North America is mature, growing slowly, and well established, yet there are two potential growth drivers for Hammond. The first is expansion in India where the power infrastructure is less developed. The second is in the automotive market where conversion from internal combustion engines to electric vehicles is gaining speed. The thesis for owning Hammond does not rest on these developments going well, if success in these fields occurs it will be a cherry on top.

Right now, the shares are beaten up and have fallen from over $10.00 in early 2018 to around $6.00 today. This puts the ticker near decade lows. As a result, the dividend yield is now over 3.5% and the company appears cheap. EV/EBITDA is around 5.5 and it is trading at 0.6 times book. The price to book ratio has matched its 2016 trough and the price to sales ratio is at its lowest point in over a decade. Investing in companies making money and trading under book is often a good mix. While the price to earnings and cash flow ratios appear high, I think this issue will correct itself as outlined below. After watching this one for years, I thought it was a good time to invest and did so in December 2018.

Why are the shares beaten up?

Given the downdraft, one has to ask (and try to answer) why the stock is so beaten up. Though the market selloff, fears of trade wars, and an economic slowdown may be partly responsible, the bigger answer is likely its European operations. Hammond entered this market right before the first wave of the European Financial Crisis and has never been able to find its footing. Competition is tougher in Europe, labour laws are problematic versus here in North America, and recently a competitor came out of bankruptcy and poached many of their Italian staff. After taking a variety of restructuring charges over the last two years, management called it quits in December and is shuttering the operation. The event will result in a one-time charge of $14 million to $16 million, of which $5 million will be a cash cost. Management anticipates the closure will add $3.5 million to $4.0 million in annual EBITDA. This translates into increasing EBITDA by roughly a quarter to a third versus the trailing twelve-month number.

In addition to the European problems, 2018 was a tough year to pass along price increases to customers. This was problematic as prices ballooned due to tariffs and deteriorating international trade conditions. Commodity price volatility in steel, aluminum, and copper markets added to the pressure and culminated in a net loss during the second quarter of 2018. The loss puts the trailing twelve-month dividend payout ratio over 100%.

The combination of poor European performance and difficulty pushing price increases onto customers has hurt the net profit margins, pulling the bottom line to its lowest level in a decade. This profitability problem is likely the major reason for the share price pressure. With USMCA close to the finish line, the world adapting to trade tensions, and the European operations shuttered, the assumption here is that these pressures are cyclical not structural. Going forward the thought is that earnings per share and cash flow per share will improve. If this happens it will improve the organization's price to cash flow and earnings metrics, provide better dividend payout ratio coverage, and hopefully lift the stock price too.

Liquidity Constraints:

A wrinkle here is a lack of liquidity. As mentioned above, the company is tightly held by the CEO, other insiders, and a small handful of investors. It is also a micro-cap with a market capitalization under $100 million and has a small buyback in place. As a result, the float and average daily volumes are low. Therefore, if things do turn south or this thesis is wrong, there may be little chance of escape at a desirable price, especially if one buys in significant quantities. This lack of liquidity is the reason why HPS.A did not make it into the Vice-President’s Portfolio at Contra the Heard.

Conclusion:

Hammond Power Solutions appears to be a well-run company with attractive economics, a strong financial position, and decent valuations. It has many of the marks of what makes a good investment here at Contra the Heard Investment Newsletter. Moreover, the current headwinds appear temporary which could present investors with a potential opportunity. Unfortunately, its volumes are too low for consideration in one of the two portfolios at Contra the Heard and this illiquidity may discourage others from owning the name. As a result, I have bought the company in personal accounts instead. Potential investors and interested onlookers wondering if the thesis holds water may wish to keep an eye out for Hammond’s upcoming year-end results, which should be released in March.

Disclaimers:

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor.

All amounts are in CAD unless otherwise stated.

Analyst’s Disclosure: I am/we are long HMDPF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.