Hubbell

Hubbell reported second-quarter sales growth of 15% year over year, but 50 basis points of operating margin compression amounted to 12% adjusted earnings per share growth.

Why it matters: Red-hot demand for Hubbell's electrical components is being driven by maintained grid modernization and commercial construction. Hubbell's utility solutions segment grew 6% organically while its electrical solutions segment grew 18% organically. The firm also showcased its acquisitive nature with its $3 billion purchase of NSI Industries. We like NSI's complementary niche electrical connectors that are sold into commercial end markets.

Bottom line: We expect to raise wide-moat Hubbell's fair value estimate by a low-single-digit percentage as we underestimated the magnitude of its involvement in commercial construction. Hubbell's valuation currently sits above its historical average. We think valuation hinges on how long it can maintain this level of top-line growth. We view grid modernization as a multidecade trend, but we're less certain about data center spending. Nevertheless, we believe commercial construction should remain strong over a multiyear timeframe amid reshoring and bipartisan infrastructure spending in the US. Hence, a premium to Hubbell's historical valuation is justified, in our view.

We raise our fair value estimate to $502 per share, up from $479 to reflect our more bullish outlook on the firm's near-term growth potential. We value the firm at around 25 times our 2026 adjusted earnings estimate. The value of Hubbell is underpinned by its wide economic moat through which we believe the company can outearn its cost of capital over the next 20 years.

Hubbell should be a beneficiary of secular trends such as the energy transition spurring the connection of alternative and renewable energy systems to the grid, rising regulations driving the need for safer and more efficient electrical systems, and the automation of manual tasks resulting in the implementation of smart grid technologies and advanced meters. We also expect Hubbell’s growth to be supplemented by shorter-term trends like the reshoring of supply chains and the unprecedented spending on replacing and modernizing decrepit infrastructure in the US. We think the combination of these trends can propel Hubbell toward mid-single-digit top-line growth through the cycle. With efficiency gains, an improving revenue mix, and share buybacks at opportune times, Hubbell can compound earnings per share in the high single digits, in our view.

Hubbell has generated returns on invested capital in excess of its cost of capital for the vast majority of its history as a public company. We expect the same in the future, barring a large-scale economic downturn.

We assign Hubbell a wide moat rating. On average, the company has generated midteens returns on invested capital, inclusive of goodwill, over the past two decades, and its margin profile rivals those of closest peers Eaton, Siemens, Schneider Electric, and ABB. Notably, Hubbell's returns remained above its cost of capital during the past two global crises in 2009 and 2020. We believe the firm is more robust today, giving us confidence that it can outearn its cost of capital over the next 20 years.

Hubbell organizes its business into two segments: Hubbell Utility Solutions and Hubbell Electrical Solutions. We assign HUS a wide rating based on switching costs and intangible assets. On average, the segment generates returns inclusive of goodwill in the high teens, and it holds a leading share of the utility electrical components market. HUS offers over 85% of the components found on electric power T&D lines and has a strong presence on electrical substations and other utility metering infrastructure. Its T&D portfolio includes arresters, dampeners, anchors, enclosures, connectors, and fuses.

HUS has demonstrated pricing power by consistently passing inflation on to its customers throughout its history. The decision to purchase a Hubbell component tends to be made by local engineers or electrical contractors, with whom Hubbell works closely to develop components with varying clearance and voltage specifications. Land, labor, and other material costs represent over 95% of the total expenses to build a power line, meaning Hubbell’s components represent less than 5% of the bill. Regulators rarely push back on component costs because they are such a small part of utilities’ overall costs and, thus, a small part of utility customers' bills.

Moreover, HUS components are engineered to withstand harsh conditions, are critical for the safe and continuous distribution of electricity, and tend to have multidecade useful lives. The failure of a T&D component (for example, an arrester, designed to divert lightning strikes from live power lines) can result in power outages, fires, and even the loss of human life. We therefore suspect the price of a Hubbell component is not a priority on which customers negotiate. Instead, we think the primary factors include durability, defect rate, and performance.

We think Hubbell’s components benefit from high switching costs. Money saved by changing suppliers would have to exceed the sum of the upfront capital expense plus the costs of downtime, operational redesign, and regulatory reapprovals. Hubbell’s components tend to be replaced on a like-for-like basis to avoid the risk of an electrical fault from switching suppliers. Hence, the firm has sticky customers and generates lucrative aftermarket revenue in the form of maintenance, replacement, and overhaul sales, which represent around half of HUS sales.

HUS customers are risk-averse when selecting suppliers; we think they value Hubbell’s time-tested brands and product performance. The HUS segment owns a number of esteemed brands with rich histories and lengthy customer relationships. To illustrate these intangible assets, take Hubbell’s Ohio Brass, Chance, and Fargo subsidiaries.

Ohio Brass was founded in 1888, and in the early 1900s it pioneered the development of bushings and insulators to safely move electricity through the US’ newfound electric grid. Its components have been installed in electrical grids around the globe for over a century, and today its portfolio consists of over 3,600 types of insulators and arresters used to protect T&D lines and substations.

Chance and Fargo share similarly storied pasts, incorporated in 1907 and 1914, respectively. Chance manufactures around 13,000 different utility line switches, foundations, fuse links, bolts, and brackets. It was a pioneer in telephony hardware, and today its pole anchors are installed in every country around the world. Fargo manufactures over 1,900 types of bespoke fittings and connectors found on T&D lines, which have been developed with customer input throughout the 20th century.

Each of Hubbell’s over 75 individual brands has built a base of customers over the course of its history, and by operating under the Hubbell umbrella, the brands are able to pool inventory and cross-sell their products. Hubbell has one of the broadest portfolios of electrical equipment, an aspect that customers value as it minimizes supply chain complexities.

We assign Hubbell’s second segment, Hubbell Electrical Solutions, a wide moat rating based on switching costs and intangible assets. HES has generated returns averaging in the midteens over the past few decades, in line with Hubbell’s wide-moat peers. HES houses Hubbell’s commercial and industrial portfolio of electrical components, spanning from connectors and lugs to hazardous lighting and sockets. Here, Hubbell sells products in data center, healthcare, energy, manufacturing, and residential structures.

Like HUS, HES components are selected based on intangible assets and benefit from switching costs once installed in a building. The same factors are at play: HES components meet strict performance standards, are critical for the safe and continuous distribution of electricity, and represent a small percentage of an electrical system’s bill of materials. We estimate HES generates around 40% of its sales from MRO as customers replace these components on a like-for-like basis to avoid electrical faults.

Electrical contractors form brand preferences based on familiarity of installation, durability, and manufacturer reputation. The potential consequences of selecting a cheaper brand tend to dwarf savings. The Anderson, Bell, and Killark subsidiaries within HES have abundant heritages much like their HUS peers. Bell sells weatherproof outdoor electrical covers, and “Bell box” has become a generic term used by US electricians that represents time-tested quality and safety.

Demand for Hubbell’s components is set to outgrow GDP with the replacement and expansion needs of US infrastructure.

Hubbell’s components are a small but critical portion of customer spending, giving rise to substantial pricing power.

The firm uses its formidable scale to negotiate better prices from suppliers and simplify supply chains for customers.

Hubbell’s customer base is concentrated, and the spending patterns of utility companies can have a significant impact on its results.

The firm’s executive compensation plan lacks a return on invested capital component, meaning, management could be incentivized to increase profits at any cost.

Most of Hubbell’s sales are through distributors, which adds a layer between it and the customer that could make it difficult to develop products based directly on customer feedback.