HMM.A (Hammond Manufacturing)
Intro
I recently stumbled upon Alluvial Capital’s Q3 letter, mentioning his investment in Hammond manufacturing. It sounded intriguing to say the least – a consistently growing company with its products experiencing huge growth in demand thanks to the boom in data centre construction trading at 5x run rate earnings. So, I decided to research the company a little bit deeper.
Company Description
The company is a family business with over a 100-year history, selling primarily electrical enclosures (metal cases for electrical equipment in buildings), rack mounting solutions (cabinets for electrical equipment) and transformers. The company’s market cap is 130mln CAD. It has no covering analysts and it doesn’t do earnings calls. “What a wonderful boring business that no one is interested in” – I immediately thought and continued investigating the financials.
Historical Financials
The company has grown EPS from 0.18 in 2010 to 1.66 CAD in 2023 (19% CAGR) and has grown revenues from 78mln to 238mln (9% CAGR). The majority of that margin expansion came from the increase in gross margin, which increased by 5.4 percentage points, from 28.3% in 2010 to 33.7% in 2023 if we exclude the effect of the exchange rate. Operating margin increased by 4.3 percentage points from 5% to 9.3% during this period, if we exclude the effect of the exchange rate. So operating margin expansion consists of gross margin expansion mitigated by a slight increase in operating expenses as a percentage of revenue. More than 85% of the gross margin expansion happened from Q4, 2022 until today.
Reasons for gross margin expansion
In the 2022 annual report, management that they increased prices in anticipation of annual labour cost increases and that the margins are going to decrease as labour costs increase in Q1 2023. However, in 2023 gross margin, adjusted for exchange rate effects decreased by only 0.3 percentage points from 34% in Q4 2022 to 33.7% in 2023. Management only said that they increased prices to offset cost increases from vendors in the 2023 annual report.
So an important question - is this a permanent change in the business economics or a temporary boost in margins?
There is an opinion that they have more pricing power than they realised, and as push came to shove vendors started increasing prices, they accidentally realised how much pricing power they have and are going to exercise it in the future.
There is an opinion within the company, that this was a one-off margin expansion and the margins will revert to historical levels.
My thoughts:
One possible explanation could be that the facility that they built, has led to an increase in margins, however, they didn't mention it and it's likely that the new facility wouldn't operate at full capacity at first and would lead to decreasing margins in the beginning on the contrary.
We could try to answer this question by looking at the business model. They sell a commoditised product, differentiated by the quality of customer support (support by large companies is typically worse, due to less personalised approach and higher number of calls). Consequently, they try to price the product in the middle of the price range (not the cheapest price, but good support). They sell through distributors - there will be a construction project, a manager responsible for electrical equipment, calls a distributor, a distributor would find several quotes from companies like Hammond and give them to the manager. Judging by these characteristics, I would guess that price is a very important factor in choosing the producer of casing and enclosures. So if for 10 years they had the same gross margins, I wouldn't think that without any visible catalyst, they would be able to charge higher margins in a price-sensitive industry, unless their product mix has rapidly changed towards higher margin products. But, they didn’t mention anything about it in the annual report.
Industry
The majority of sales are from electrical enclosures, transformers and power distribution solutions for buildings, which are tied to construction and are consequently cyclical, however, as we could see from 2008 results, less cyclical than housebuilders.
Capital Allocation
From 2010 to 2019 median ROE was 7.7%, median earnings yield was 16%, but the company was investing all of the cash back into the business at 7.7% ROE, instead of repurchasing shares to earn a 16% return. So it's possible to say that capital education leaves something to be desired, and the value is not likely to be maximised going forward.
Valuation
Currently, the company trades at 7 P/E, 9 P/E adjusted for exchange rate differences, and 1.3x book value, with a ROE = 19% this year, ROE = 15% if adjusted for exchange rate differences. Assuming the company can keep the current return on equity, you can buy a company growing revenue at a high single-digit rate and reinvesting profits at 15% ROE, for 9 P/E. However, if you think that margins are going to revert to historical levels (I will use 2022 gross margin), you are buying a company at 15 p/e, that reinvests its cash at 7.7% on average and historically traded at 6 p/e. I will try to find out what led to the margin expansion, but now I am leaning towards the second scenario and not going to buy the shares.