I’ve been a pretty big bull on electrification as a secular growth story, but even then I underestimated just how much strength Hubbell (NYSE:HUBB) was going to see (particularly in its transmission and distribution, or T&D, business) and how eagerly the Street would bid up the shares in response. Even with a recent correction, the shares are up over 70% since my last update, handily beating the double-digit gains of the broader industrial sector and other electrification players like ABB (OTCPK:ABBNY), Eaton (ETN), nVent (NVT), and Schneider (OTCPK:SBGSY).
This is a tough time to evaluate the short-term potential of the stock. I like the business and I believe electrification players are set up for mid-single-digit organic growth for at least a few years. On the other hand, Hubbell has gotten a big boost from supply constraints across the industry that have started to ease and ordering patterns are starting to normalize. While I could make a case for a double-digit return on the basis of what the Street has been willing to pay for “theme stocks” in the past, I’d be careful given that the shares seem richly priced on likely long-term free cash flows.
Another Beat And Raise, But Less Robust Than Recent Results
Hubbell has enjoyed a good run of beat-and-raise quarters, with better results and guidance driven by strength on the top line, strong orders, and good cost leverage. While strong margin leverage was once again present in the second quarter, top-line momentum is slowing against a higher bar.
Revenue rose 9% as reported or about 6% in organic terms, coming in just below expectations. The Electrical business saw further erosion in sales momentum, with sales down 4% on a high single-digit decline in volumes (though sales were up 6% sequentially), while the Utilities business posted 13% revenue growth on 3% volume growth, with balanced growth in T&D (up 13%) and Communications and Controls (up 16%), with the latter aided by improving chip availability. By segment, Electrical missed by about 1%, while Utility was slightly better than expected.
Adjusted segment profits rose 47%, beating by 10%, with margin up almost eight points to over 22%. Electrical profits rose 12%, beating by 11%, with margin up 160bp to 17.3%, and Utility profits rose 70%, beating by 9%, with margin up 840bp to 25.6%.
Momentum Is Slowing, But Underlying Trends Are Still Broadly Favorable
Hubbell has been a big beneficiary of an overall shortage in lower-voltage components and T&D-oriented gear as companies have navigated a challenging supply environment by prioritizing higher-value components further up the food chain. That scarcity trend is starting to reverse, and with it Hubbell saw a sub-1.0 book-to-bill ratio in the quarter and management reported that lead-times are starting to normalize – in recent quarters the company had a two to three quarter backlog in a business that typically had lead-times of less than 90 days.
In the Electrical business, I don’t think it will surprise readers to hear that residential remains quite weak (down about 20%), as construction and remodeling activity has dropped in response to higher rates. Industrial demand remains quite healthy, though, with the company continuing to benefit from increased on-shoring/near-shoring and healthy activity in areas like oil/gas. Non-residential is more mixed, as sector indicators have definitely turned more negative but retrofit activity offsets some of this weakness. Data centers also remain an area of relative strength.
Turning to the Utility business, apart from the normalization of ordering patterns, I don’t see anything particularly wrong here. Utilities continue to invest in grid modernization and grid hardening, and I believe underlying T&D demand will remain healthy for some time, helped by investments into renewable generation and charging infrastructure. I also expect some “catch-up spending” in communications and controls as semiconductor supply issues reverse.
Underlying Trends Remain Attractive
While I generally favor the product/market exposures of ABB, Eaton, and Schneider to Hubbell (more high-value products, particularly in medium-voltage), I still see Hubbell as a significant long-term beneficiary of a multiyear electrification growth trend.
Companies continue to bring more manufacturing back to the U.S. or nearby countries (like Mexico), and this manufacturing capex is typically rich in electrical content these days. I also like the ongoing opportunities in data centers – while may be getting a lot of hype now, the reality is that generative AI data centers have much higher power consumption, which means more demand for Hubbell’s products. Grid modernization/strengthening should remain a multiyear trend, spurred in part by government funding, and I see ongoing growth in renewable generation and micro-grids. Last and not least, I expect significant ongoing investment in EV charging infrastructure.
One outstanding question is the extent to which prices and margins will normalize. Hubbell was previously a mid-teens EBITDA margin type of business, but will likely see 2023 and 2024 EBITDA margins in the 22%-23% range. I think the risk of immediate (or at least short-term) price competition is relatively limited, as there are barriers to entry based upon certification standards, but I do see further margin expansion from these elevated levels as a big challenge.
I expect Hubbell to generate long-term revenue growth in the mid-single-digits on the back of this multiyear secular growth opportunity in electrification (across industrial capex, data centers, retrofits, grid spending, and so on). I also expect ongoing reinvestment into M&A, though valuation multiples have been heading higher.
With stronger margins and a good competitive position, I believe Hubbell can see its FCF margins climb from an historical average in the 10% to 11% range into the mid-teens, driving around 10% annualized long-term FCF growth. Even factoring in M&A, though, that’s not enough to drive an attractive value on discounted cash flow, and the prospective annualized return of 6% to 7% is pretty consistent with what I’ve seen in the past for popular theme-driven industrials.
Looking at margins and EV/EBITDA, if operating margins in the low-20%’s can be sustained, it’s not hard to support a forward multiple close to 15x, and that gets me to a fair value around $320 today. If Hubbell goes back to a “theme stock” EBTIDA multiple (something in the 16x-19x range), that fair value gets to almost $390.
The Bottom Line
I wouldn’t buy Hubbell thinking that $390 is a done deal. The Street loves momentum with stocks and with slowing top-line growth, a book-to-bill below 1.0 in Utility and signs of normalization, that momentum story may be ending. I think Hubbell is a fine company with a strong multiyear outlook, but the process of wringing out theme stock enthusiasm can be painful – look at the trading activity of stocks like Carrier (CARR), Danaher (DHR) and Roper (ROP) over the last few years to see what I mean. Carrier and Roper have since rebounded, but it can be painful to hold these stocks in the interim.
If Hubbell were to continue to derate lower it’s a name I’d come back to more bullishly. As is for today, I don’t see the appeal from a GARP investment perspective.