Hubbell's Astute Acquisition of Systems Control Offsets Negative Macroeconomic Headwinds

Senior Equity Analyst

Joshua Aguilar

Associate Equity Analyst

Yuyang Zhang

We view Hubbell as an intelligent play on industrial infrastructure spending, particularly from improvements made to the U.S. power grid. Over 90% of Hubbell’s consolidated sales are made in the United States. Hubbell has one of the most complete offerings across the entire electrical supply chain, from power generation to the end user. In our view, it has wisely chosen to competitively position itself in the highly differentiated approximately $58 billion electrical components market, avoiding larger-scale global players that focus on the apparatus markets as well as highly fragmented, commoditized portions of the market that sell easily replicable products, such as wires and cables. 

We think the company is smart to overweight its stronger utility solutions segment, whose returns on invested capital have consistently averaged in the 20s. Most of the utility segment serves the middle portion of the supply chain in transmission and distribution. We believe growth drivers here include the transition away from fossil fuel generation to renewables, hardening of the grid, and technology adoption of smart meters. A significant portion of T&D components are aging, and we believe the market will continue transitioning toward capital investment and away from maintenance and overhaul.

Around two thirds of Hubbell’s sales flow through distributors, of which one third are made to most of the 10 largest distributors like Grainger and Wesco. Hubbell differentiates itself in a competitive market with strong brands, its wide array of products, and its ability to lower a customer’s total cost of ownership while managing a high degree of SKU complexity. Large product lines help distributors eliminate the back-office cost of dealing with multiple suppliers. Hubbell’s large suite of products allows it to generate ample volumes that lead to cost efficiencies in key portions of its supply chain. Cost-efficient customer service allows Hubbell to receive superior pricing when it negotiates with distributors. Direct sales to utility customers at about 25% of sales are sticky and benefit from the risk-averse nature of the utilities industry.

Business Strategy & Outlook

We assign Hubbell a narrow economic moat rating, based primarily on switching costs and intangible assets. We see switching costs related to (1) the mission-critical nature of its highly engineered products found in infrastructure that possess an inherent high cost of failure, (2) the company’s ability to lower a customer’s total cost of ownership, (3) the need for customers to comply with increasing building, health, and safety regulations amid less available skilled labor and pricing pressures, and (4) the risk-averse nature of its customers. We view intangible assets based on (1) well-regarded brands associated with quality and reliability, (2) valuable customer relationships, including with distributors, utilities, contractors, and homebuilders, and (3) multiyear contracts that feature built-in price escalators.

To a lesser extent, we also see cost advantage at play in the form of economies of scope with Hubbell’s broad portfolio of products, which enables cost-efficient customer service and secures favorable pricing with its customers. Even so, we hesitate to award a wide moat rating given customer insistence on competition (no duopolies exist in the markets Hubbell competes in), Hubbell’s contracts are shorter relative to other industrials (longer-term contracts come from the high-voltage business, for instance) as well as some of the pricing pressures in the lighting industry, which has prompted divestitures from other competitors. Despite the fragmented nature of the industry, however, we still see a moat given that there are few large players in the highly differentiated $45 billion North American electrical components market, including Hubbell.

We believe the firm’s utility solutions segment is its comparably stronger business, which we also assign with a narrow economic moat. Management has explicitly stated its preference for allocating capital to this segment. We estimate that power’s ROICs, including goodwill, have averaged in the mid-20s over the past 10 years, a trend we expect to resume at our midcycle projection. Hubbell claims number-one market share with the industry’s large installed base in a predominantly high-margin maintenance, repair, and overhaul business. We traditionally associate the MRO business with switching costs when analyzing industrial firms. About two thirds of Hubbell’s total volume flows through its distribution network, of which one third of that figure goes through the top 10 largest distributors. The installed base was built on the strength of Hubbell’s powerful brands, record of success, and customer relationships.

Over 90% of Hubbell’s utility solutions sales are made in the United States. According to the U.S. Department of Energy, forces affecting the electricity sector include the growing use of renewables and natural gas for power generation, the retirement of coal generation, uncertainty regarding the long-term role of nuclear generation, severe weather, cybersecurity and terrorist threats, evolution of load types, and jurisdictional interactions at the federal, state, and local levels. We think Hubbell and its competitors will continue to play a critical role in ensuring that electricity infrastructure is reliable and secure. The largest component of the business mainly serves the electric transmission and distribution, or T&D, market, which makes up about 75% of utility solutions (or about 35%-40% of the total company).

The U.S. T&D network is a massive grid of interconnected generation facilities, high-voltage transmission lines, substations, and low-voltage distribution lines. Power transmission lines, for instance, facilitate the bulk transfer of electricity from a generating station to a local distribution network. These networks are designed to transport energy over long distances. Power plants are generally distant from a demand center. At a constant power output, electricity can’t be transmitted over sizable distances without meeting significant resistance and power loss. Power transmission lines, along with other portions of the supply chain that Hubbell also serves, including step-up transformers, minimize power loss by boosting voltages at specific junctures along the electric supply chain. 

The United States’ bulk electric system, according to the North American Electric Reliability Corp., consists of more than 360,000 miles of transmission lines, including 180,000 miles of high-voltage lines, connecting to about 7,000 power plants, and serving hundreds of million customers. Components of transmission lines include structural frames, conductor lines, cables, transformers, circuit breakers, switches, and substations. Transmission represents about 25% of the utility solutions segment. By contrast, the power distribution system is the final stage in the delivery of electric power, carrying electricity out of the transmission system to individual customers. Distribution systems can either link directly into high-voltage transmission networks or use step-down transformers to reduce voltages and route power to commercial and residential customers. Components in a distribution network, which Hubbell manufactures, include arresters (which safely redirect power surges from lightning), switches, circuit breakers, and voltage regulators (which help route high-voltage connections where the distributions lines connect to the step-down transformer). Distribution represents about 50% of the utility solutions segment.

We believe U.S. utilities will continue making considerable investments to replace, upgrade, and expand new and existing T&D infrastructure driven primarily by the need to improve the reliability and capacity of the grid as well as long-term regulatory requirements and incentives. Spending on electricity distribution system rose 54% over the past two decades, which mirrors transmission investment over the same period. Over the past decade alone, investment in overhead poles, wires, devices, sensors, relays, and circuits has risen 69%, and spending on substation transformers has increased by 35%. In the past, these increases have largely been driven by increases in capital investment (as opposed to operations and maintenance). 

Even so, we think this prolonged investment cycle is still in its early stages, which gives us confidence in our 10-year forecast period of Hubbell’s excess returns. According to a 2015 U.S. Department of Energy report, 70% of power transformers are 25 years of age or older, 60% of circuit breakers are 30 years or older, and 70% of transmission lines are 25 or older. Industry research adds that the significant level of investment to replace, upgrade, and expand T&D infrastructure over the next two decades is nearly a threefold increase over the prior two decades.

Other opportunities for Hubbell’s continued runway, in our view, include hardening of the grid, which refers to increasing the durability of grid assets, such as burying transmission and distribution lines (which is cost-prohibitive), or modifying design elements through Hubbell’s metal component offerings that are more resilient to adverse weather. We think Hubbell’s industry-leading breadth of product offering gives it an edge over its smaller competitors in the form of economies of scope, which typically have a much smaller product line except for Cooper (now a part of Eaton) and Thomas & Bett (now owned by ABB). Hubbell’s product offering can provide more than 85% of the content on a typical distribution pole as well as 90% of the content found on a transmission steel tower. Hubbell’s large suite of products enables it to generate sufficient volumes for scale efficiencies, particularly in its supply chain through activities like automation as in the firm’s Missouri operation, which automates pick and pack as well as welding operations.

Large product lines help distributors like Anixter or Wesco eliminate the back-office cost of dealing with many suppliers, which leads to Hubbell receiving superior pricing with these key distributors. We think this is a key aspect of Hubbell’s ability to deliver customer cost-efficient customer service, since most electrical contractors make purchases from electrical distributors, according to a consulting study prepared for Electrical Contractor magazine. From a utility customer’s standpoint, Hubbell also ensures that it can deliver its products in a way that lowers that customer’s total cost of ownership, which is important given utility pressures to recover costs in their rate base.

Reducing a customer’s total cost of ownership is a delicate balance with stock-keeping unit complexity, given that very little standardization exists in the electric T&D market. SKU complexity is itself a barrier to low-cost entrants. While Hubbell’s products are a small cost of a utility’s bill of materials and represent about 5% of its total purchases, Hubbell represents more than half of the SKUs needed to maintain and extend the grid, which consumes significant customer time and monetary resources. Utility customers are a risk-averse cohort, and eliminating both logistical and supply chain complexities in a reliable way, including reduced lead times, makes these customers loath to switch. Switching costs are also reinforced with the training Hubbell provides for its products, which is critical given less available skilled labor in the utilities industry. During a prior investor presentation, Hubbell reported securing three- to five-year contracts whereby utilities agreed to have Hubbell service 65% to 80% of their T&D needs in about 20% of Hubbell’s North American business, which we think also evidences switching costs.

Hubbell’s power offerings also serve mission-critical functions with a high cost of failure. We point to its content in transformers as proof. Transformers serve a critical function in the grid in delivering electricity to customers. The loss of a transformer in a substation raises significant energy security concerns due to an inventory shortage in the supply chain. These are highly specific to the systems they serve in terms of both design and application, which limit interchangeability. Moreover, the implementation timeline of a large power transformer takes around two years. As a result, the failure of even a single unit could result in a temporary service interruption to customers. Hubbell sells market-leading bushings (manufactured by its PCORE brand) that are the insulation devices that allow for the safe connection of transmission wires into the tank enclosure of the transformer. These are manufactured according to a litany of industry specifications. 

According to trade publication T&D World, substation transformer bushings contribute 17% of the total failure rate of transformers and more than half of these are catastrophic. Hubbell’s PCORE bushings can save electric utilities thousands of dollars in field service because their quick-link design allows the transformer to be shipped with the bushing connection in place. During a short circuit, moreover, the design can carry up to 25 times the rated current. The engineering design further eliminates the need for an internal rod that other competitors rely on that can cause overheating or loosening that ultimately lead to bushing failures. Hubbell also completed a bolt-on acquisition in the first quarter of 2018 that measures current in bushing transformers and can serve as a predictive maintenance tool before a bushing fails. 

The acquisition of Aclara (completed in 2018), which provides smart meter and communication solutions, only reinforces these switching costs, in our view. Aclara, which brought with it $500 million in sales, competes with companies like Itron, Landis, as well as Elster, owned by Honeywell (meters) and Sensus (water only) that have more limited offerings. The acquisition brings Hubbell a large installed base of recurring revenue, and 30% of its revenue is MRO sales. Like the core of Hubbell, Aclara has a broader portfolio than its cohorts in terms of meters, communication, software, and installation services. Moreover, its products also serve the electric, gas, and water utility markets. Metering systems measure and record the location and amount of power transmitted through transmission and distribution lines and offer increased grid efficiency and reliability through real-time data. The data is then used as a predictive maintenance tool designed to reduce utilities’ O&M expenses before they occur at a higher cost. According to the U.S. Department of Energy, the kind of technology offerings Aclara provides have been introduced at an unprecedented rate relative to the history of the industry, a trend that we expect to continue. Ultimately, we believe it is more likely than not that power systems can safely continue to outearn its cost of capital over the next 10 years.

We assign Hubbell’s electrical segment a narrow moat rating. This segment benefits from similar dynamics as the power segment, including strong brands with a long pedigree (intangible assets) and product portfolio breadth that leads to economies of scope (cost advantage). In contrast to the power segment, electrical has more diverse end-market exposure, including residential, commercial and industrial, oil and gas, among others. Over the past 10 years, we estimate that the electrical segment’s ROICs, including goodwill, have averaged in the upper teens, which we expect should improve by our midcycle projection. At over 35% of segment sales, electrical’s largest subsegment exposure is lighting, 75% of which is nonresidential, which we consider a positive. 

We view the residential portion of lighting as commoditized and price-competitive, given the rise of Chinese competitors willing to undercut more established competitors. Stock and flow is difficult, given that most residential customers only have lighting because they need it. In some ways, the advent of LED lighting has exacerbated these issues and removed the razor/blade dynamic (that some malign as a razor bump model currently). While alternatives last six months to two years, depending on the type of bulb, the estimated life span of an LED light is about 34 years with no maintenance cycles. LED growth has simply not offset the revenue decline from traditional products.

By contrast, the nonresidential portion of lighting still has strong moaty characteristics. Most of the available dollars in the marketplace are found in national account sales that are sticky and place a premium on high-value, quality offerings that innovate outside of mundane white lighting. Big names like Hubbell, Acuity, Cree Lighting (sold to Ideal Industries), Philips Lighting (which was spun out from the rest of Philips), Eaton (lighting will be divested), and GE (Current and Lighting International have been sold) are always on the short list for bids. Commercial lighting manufacturers like Hubbell, moreover, still retain strong pricing power of LED suppliers. 

Differentiated offerings from Hubbell including horticultural lighting, color tuning technology, and power over Ethernet products that use enterprise software and cloud analytics and are highly valued by the commercial and industrial markets. Network lighting control systems, for instance, can lower customers’ total cost of ownership by cutting lighting-related energy demand by 75%-88%, according to industry trade publications. Other areas of the market highly valued include harsh and hazardous lighting that is seen in the oil and gas industry, for instance. These solutions use advanced materials to exceed regulatory requirements for corrosion, vibration, or explosive atmospheres.

According to Electrical Contractor, a variety of codes specifically regulate emergency lighting, and we think the need to comply with these codes evidences switching costs. The two most prominent codes are NFPA 70, the National Electrical Code, and NFPA 101, the Life Safety Code. Other codes regulating emergency lighting, transfer switches, and standby power systems may apply. In the event of a power loss, these emergency lighting solutions must be able to automatically override any control setting and establish the appropriate illumination level in the event of a power failure. This requires that the entire lighting system and related equipment be tested to comply with code, including switches, sensors, dimmers, and energy management and bypass equipment. 

Other opportunities for differentiation in the form of switching costs involve reducing a commercial customer’s cost of ownership. Commercial and industrial solutions constitute another 34% of segment sales. According to the U.S. Department of Energy, plug and process loads account for one third of commercial building energy consumption. Plug loads draw power from standard alternating-current receptacles and often operate all the time (computers and printers typically remain continuously plugged in, for example), which waste considerable energy. Plug load controls turn off plug loads when they’re not in use, and sales are driven by recent code updates. These controls can provide 15%-50% energy savings, with the opportunity to save more if controlled by Hubbell’s occupancy sensors. The shortage of skilled labor also reinforces switching costs in this segment. Hubbell helps this dilemma by designing solutions with ease of installation. One solution would be SnapConnect, an outlet that allows a contractor to snap it in a switch with a USB without a complicated install that would have to be performed by a trained electrician.

With energy code compliance, energy costs, financial incentives, and the adoption of new technologies continuing to be key drivers that play to Hubbell’s electrical segment’s strengths, we believe it is more likely than not that the segment can continue to safely outearn its cost of capital over the next 10 years.

Narrow

Economic Moat

Hubbell

Hubbell, Inc. engages in the designing, manufacturing, and sale of electrical and electronic products for non-residential and residential construction, industrial, and utility applications. It operates through the following segments: Electrical and Utility Solutions. The Electrical segment manufactures and sells wiring and electrical, lighting fixtures, and controls for indoor and outdoor applications as well as specialty lighting and communications products. The Utility Solutions segment consists of operations that design, manufacture, and sell a range of electrical distribution, transmission, substation, and telecommunications products. The company was founded by Harvey Hubbell II in 1888 and is headquartered in Shelton, CT.

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Hubbell, Inc. engages in the designing, manufacturing, and sale of electrical and electronic products for non-residential and residential construction, industrial, and utility applications. It operates through the Electrical Solutions and Utility Solutions segments. The Electrical Solutions segment manufactures and sells wiring and electrical, lighting fixtures, and controls for indoor and outdoor applications as well as specialty lighting and communications products. The Utility Solutions segment is involved in the design, manufacture, and sale of electrical distribution, transmission, substation, and telecommunications products. The company was founded by Harvey Hubbell II in 1888 and is headquartered in Shelton, CT.

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