The company at the intersection of three megatrends

The US is currently in the midst of an extraordinary construction boom. This boom has been driven by three prominent trends which continue to pick up substantial pace – Artificial intelligence (AI), renewable energy and onshoring of US domestic manufacturing. These trends have played out quite clearly in equity markets in recent years, with many companies displaying rapid growth in their share prices. There is one company however, with significant exposure to all three megatrends and whose share price is yet to price in the substantial growth opportunity ahead of it.

Three Megatrends for the next decade

We first begin by summarising the three megatrends evident in the market today which are expected to persist through the second half of this decade:

1. The Continued adoption of AI: Due to its productivity benefits, the AI infrastructure roll-out is on track to take place over many years to come. During the industrial revolution, we replaced human muscle power with machines. At its core, the AI revolution aims to replace human thinking power with machines. Big Tech companies are finding better ways to improve the intelligence of machines to try and achieve an artificial general intelligence. AI has the potential to be one of the great platform technologies in history. The demand for accelerated computing power to support AI advancements is driving a parallel expansion in data centre construction, which is notably energy-intensive and necessitates robust electrical infrastructure for efficient operation.

2. The continued rollout of renewable energy sources: According to Climate Action Tracker, the world is a long way from achieving the goals set out in the Paris Agreement, with only one in 42 indicators on track to reach its 2030 target:

To completely decarbonise the grid by 2050, the US will require adding approximately 75 gigawatts (GW) of capacity every year for the next 30 years. Last year, the US added only 37 GW of renewable energy, far from the level required. This transition not only underscores the need for an increase in renewable energy sources like wind and solar but also highlights the importance of upgrading existing electrical infrastructures to support increased electrical loads from renewable sources.

3. Reshoring of manufacturing capacity across the world: The passage of the Inflation Reduction Act, alongside other significant legislation like the CHIPS Act and Infrastructure Investment and Jobs Act, has catalysed a boom in U.S. construction projects. Post-Covid, the rate of mega construction projects has surged, with over $933 billion in projects announced since January 2021. These projects are in various stages of planning and execution, with only a fraction having commenced construction. As the world order becomes increasingly bifurcated, governments are working to ensure they have access to supply chains of essential goods by building manufacturing capacity domestically. This is leading to a construction renaissance across the US.

These three megatrends are interconnected in various ways. For instance, the increasing adoption of AI requires a lot more energy to power the datacentres that support it. By some estimates, US data centre demand for electricity will increase from approximately 4.5% of total electricity demand in 2023 to around 9% by 2026. Data centre demand for electricity, alone, will increase the overall growth rate in the demand for power by 3 times the pre-Covid pace. If the US is to achieve its climate goals, then renewable energy will need to play a big role. AI is also driving plans to reshore chip-making manufacturing facilities back onto US shores.

There is, however, one impact each of these megatrends have in common. Each megatrend requires vastly more power infrastructure, transformers, switchgear and other electrical products to support it. Grid infrastructure is needed to support the growth of each megatrend.

Hammond Power Solutions

This brings us to Hammond Power Solutions (TSE: HPS-A), a manufacturer specialising in dry-type transformers designed for commercial applications. Transformers play a crucial role in transferring electrical energy between circuits and will play a vital role within each megatrend described above. When electricity is carried over large distances, it is done at a higher voltage to minimise power loss. But the voltage required to power a data centre or manufacturing facilities, or the voltage at which electricity is generated by a solar farm is lower than the voltage used in transmission. Transformers are needed to make the necessary adjustments.

Transformers aren’t easy to design or make, and there aren’t many large transformer manufacturers in the US. The largest dry-type transformer manufacturer in the US is owned by Canadian-listed company Hammond Power Solutions. We believe that the market has vastly underestimated the growth that’s in store for this business.

We have already witnessed signs of the three megatrends discussed having an increasingly large impact on Hammond’s earnings growth, as can be highlighted below:

In their third quarter earnings report, Hammond stated that “we continue to see strong demand across our portfolio, especially in custom power units that serve renewable and datacentre applications. Hammond is in a great position to capitalise on the growing demand for clean and efficient energy solutions.”

Hammond’s backlog of orders has been growing at around 40% year-over-year. The company noted that “as the backlog continues to be high, product lead times are extended and the timing of shipments in the backlog becomes more uncertain…Hammond remains cautiously optimistic given the many macro-economic trends favouring the electrical industry, including onshoring, public and private investment in renewable energy, infrastructure, datacentres, electrical vehicle charging, investment in mining, oil and gas production and semiconductor production – all of which the company participates in.” On the last quarterly earnings call, management noted that they were actively turning down business. The last company we came across that said that was SuperMicro Computer.

Our conviction lies in the fact that the proof has been in the pudding. On its last quarterly earnings update, management noted that they expect to increase the annualised run rate of revenues by 27% over the course of 2024. As new manufacturing facilities get slowly built, we expect earnings per share to continue to grow by around 30% per year for the forthcoming cycle. Significant amounts of supply in the form of greenfield manufacturing facilities take time to bring online. As demand from these megatrends continues to ramp, we expect the shortage of transformers to persist for the medium-term. The main judgment we’re required to make in this instance is how long the trend may last for. In our view, these megatrends will last for a long time because we’re well behind in the infrastructure build-out that’s required to meet the Paris Accord climate goals, the ramp-up in data centres is just beginning and because many of the onshoring projects are yet to reach production. If we’re wrong on our forecast of one megatrend, the other megatrends are likely to be strong enough to validate the truth-value of our conclusion. In this way, our conclusion isn’t particularly sensitive to variability in individual inputs. These are some of the reasons that give us great conviction in this investment thesis.

As at the time of writing, Hammond Power Solutions’ stock trades at about 10x our expected annualised earnings of the company by the end of 2024. Its peers in the industry (like Emerson Electric, Schneider Electric, Eaton PLC and General Electric), trade at an average equivalent multiple of around 31.5x. Despite being relatively cheaper, Hammond Power Solutions is experiencing faster revenue growth, faster earnings growth and a higher rate of return on equity. Given the expected pace of earnings growth, fuelled by the structural nature of the 3 megatrends of our time, we believe the trend has a long way to run and that the current valuation of Hammond doesn’t reflect the likely growth ahead.