Good afternoon, everyone. My name is Jack Greenberg with the Southwest IDEAS Conference hosted by Three Part Advisors. Thank you all for making it. Our next session will begin with Hammond Power Solutions, traded on the TSX under the symbol HPS.A. Presenting on their behalf is Adrian Thomas, their Chief Executive Officer, and Richard Vollering, their Chief Financial Officer. With that, I'll hand it over to Adrian. Thank you.
Thank you. Good afternoon, everyone. As was mentioned, my name is Adrian Thomas. I'm the CEO of Hammond Power Solutions, and Richard Vollering, our CFO. I'll go through a quick presentation of our company, and feel free, if there's a question on a particular slide, feel free to stop me and I'll ask that. If it's not related to the slide, I just ask that we continue on, and if I don't address your question, I'll try and leave a few minutes towards the end so that we can answer those. Also, in the back, I'm joined by our IR firm, LodeRock. So Russ, if you have any interest to follow up with us after, please find Russ and he can help you coordinate that.
So, first, we started more than 100 years ago, so this may be the first time for some of you to learn about Hammond Power Solutions, but we've been in business for over 100 years. And actually, we started our firm as making consumer radios and shortly thereafter sort of transformed into a component manufacturer and started building more components for business-to-business use. And we've evolved to the company we are today, predominantly manufacturing electrical dry-type transformers and power quality equipment. And I'll talk a little bit more about that. We like to say that it's 100 years of saying yes to customers. What that refers to is we're very well known for custom products and finding ways to help customers find solutions to their needs.
We're located just outside of Toronto in a town called Guelph in Canada, yet we have a global reach and more than 22 locations now around the world, just cresting 2,000 employees. And I'll talk a little bit later about how we go to market, but one of the key strengths we have is our relationship with our distributors, which gives us a broad access to markets and geographies. And we have a network of close to 3,000 distributors. If I could do a little live Q&A here, if I could just ask, is anyone familiar with Hammond Power Solutions before today? Okay, great. Is anyone familiar with transformers before today? Yeah, a few of you. How about dry-type versus oil-filled? Okay, so great. So there's a couple of people in the room that are familiar, but for the rest of you, a quick Power 101.
So this is a simple representation of our electrical power system. Starting on your left with generation, power is generated, it goes through a transmission distribution system, and then it gets to the load or the end use where power is used. Now, when you're generating large facilities, you're generating at high capacity and high voltages. Though transformers used in those areas are large oil-filled or liquid-filled transformers, it's very efficient to transmit electricity at high voltage because you have less losses. So the transmission and the distribution network is also going to be at a high voltage. And then when you get to consumption, high voltage is not so easy to use, so it gets stepped down to lower, medium, and low voltage where we consume it.
We play in that demand side or load side of this equation, and predominantly in the commercial and in the industrial space. Residential does use transformers, but it's traditionally the cylindrical pole-top transformers, which goes through a different channel, typically utilities, and we're not focused in that area. So our focus is predominantly the commercial business, the industrial business, and on the renewables, and I'll talk a little bit about that. Renewables are generating at lower power outputs and medium voltage, and so we will participate in renewable generation, whether it's solar, wind, battery energy storage, and microgrid applications. So I talked a little bit about transformers. Our products convert voltage from higher or medium voltages to lower voltage, so it's easier to be used. We also have a variety of products in our portfolio called power quality products.
Power quality products help do exactly that, improve the quality of electricity in the system, reduce aging on equipment, and can protect equipment. We do have a number of products in our portfolio which do harmonic filtering, which cleans the power and makes energy more reliable and safer. Within that business, we have a very specific niche business called Mesta, and there we do induction heating, which is used in industries like silicon carbide manufacturing and fiber optic cable manufacturing. We are primarily a B2B business servicing a number of diverse markets. Industrial data centers and commercial construction are some of the larger sectors that we cover, having high demands for power consumption and electrical power consumption. We also participate in sort of the green transition with e-mobility, renewables, and microgrids. We do some specific niche products for utilities and for the semiconductor business.
This slide talking about where transformers and power quality components are used is also available on our website, so if you want to dive in, these are just nice pictorials of where you may find some of our products in different sectors and in different applications, so one of the major tailwinds driving our business is electrification. Electrification will be growing because of the need for power, the need for electric power, and the need for data. This projection shows a significant increase in electric needs, and regardless of what the shape looks like, we do believe that there are significant tailwinds which will grow the demand for electricity, and we know everywhere we have electricity, we need to convert, transmit, and reconvert that electricity, so we have a need for not just transformers, but also good power quality during that transition.
The market size of transformers can be split both from a geography perspective and a construction-type perspective, so we estimate the global market for transformers to be around $50 billion and growing. In North America, it's about just over $7 billion, and about 30% of that market in North America is dry-type transformers, so the sector that we play in within that market. Not just the overall electrification, but there are some key drivers in terms of demand for the products and the demand in the market space. I talked already a little bit about renewables. There's also been a lot of spending, particularly post-COVID, by governments in the U.S. and Canada, which is driving a lot of projects. We've all heard about many of the reshoring activities and new factories and facilities being produced domestically, as well as some of the high-growth markets, so things like data centers.
Aging infrastructure is another aspect where we have a lot of infrastructure in the U.S. that has been built out over the last 100 years. And a lot of that is being rebuilt or changed over or upgraded, which will also require upgrades to the electrical systems. In the energy sector, we play in a few different areas from electrical grid applications, predominantly around solar, in utility buildouts, predominantly in and around wind, and then in the electrification of transport. And here, we're predominantly, we provide a lot of equipment into transformers specifically designed for electric vehicle charging infrastructure. As a company, so that was a lot about the sector. As a company, where do we gain our strength? And I'll step through each of these, but we believe that our moat is comprised of four major items: our size and our scale.
The fact that we do customization, I'll talk a little bit more about that later. Diversification of our portfolio, so the diversification of the markets that we participate in. And then our access to market, and I'll start there. Our go-to-market is fairly straightforward. Most of the market in the electrical industry is accessed through electrical wholesale distributors. They, in turn, will then cover a wide swath of different sectors and predominantly selling to electrical contractors, sometimes developers, and sometimes end users. So we leverage that distribution network to give us access across North America. We do have a portion of our sales which goes to OEMs, so original equipment manufacturers. This could be mining equipment makers. This could be medium-voltage drive suppliers, people who are integrating our components into equipment of their own that they're selling into industries. And a bit of our business also goes into private label.
We'll talk a little bit about that more when I talk about market share. Private label is essentially designing, building, manufacturing on behalf of a different brand. From a scale standpoint, we've reached a unique position in terms of the size, particularly on the dry-type manufacturing, where we believe we're the largest or one of the largest dry-type manufacturers in North America. This gives us significant benefits in purchasing power, also purchasing resiliency. So if you're not large enough, you will funnel all your purchases through single vendors. As you grow, you still have the ability to purchase significant volumes where you get the discounts, but to spread those purchases across multiple suppliers and increase the resiliency of your supply chain. Manufacturing flexibility.
While each of our factories has a mandate for particular products, we can produce the same product in multiple facilities, giving us different ways to optimize our manufacturing footprint and flexibility based on product mix, and then with custom, it's very important when you're doing custom designs, you need the expertise and the engineers to do those designs and to do them well, and if you're going to do a lot of custom products, you need that depth of engineering, so not only do you need a number of engineers, but we've developed over time in-house software so we can model design effectively based on technical parameters, but also on cost optimization, and this slide is slightly out of date now. We're seeing roughly about 55% of our revenues are coming from custom products and the remaining coming from standard products.
When I talk about standard products, I'm really talking about products that are not adapted to the application. They're ordered by a catalog number, and they're frequently stocked. So we call it stock and flow business. Custom transformers based on the customer's needs will design that uniquely for the voltage level, for the performance, and also for the cost. From a geography standpoint, most of our business is here in North America, 95%. And a growing portion of that is in the U.S. and Mexico. So we started as a very Canadian-focused company back in around 2015, 2016. There was an energy efficiency changeover in the U.S., Department of Energy efficiency change. At that point, we tried to leverage that as a way to diversify and also enter into the U.S. market, particularly on the standard products that allowed us access to a number of U.S.
Distributors, and we continued to work to grow our market share in the U.S., and then India. India was an acquisition we made a number of years ago. We've been working in India to shift the focus. India is now focused on a number of key sectors, so we're working on export business to the Asia, Southeast Asia market space, focused on global OEMs, so supporting OEMs where we have relationships and to support them in their projects around the world, and we have a high focus on renewables in India, as well as we have a service group there which can do testing and rebuilds of oil-filled transformers in the local market. From an industry standpoint and the sectors that I mentioned earlier, since about two-thirds of our business runs through distribution, it's hard to understand precisely where each of your products goes, particularly the standard products.
They're purchased sort of on an ongoing basis, so you don't know necessarily what the application or end user is going to be. On the custom products, we have to design for the application so we get some sense of where the product is going. So traditional segments, oil and gas, mining, sort of if you think of the heavy industrials, have been sort of the traditional segments. And if you go back in our history prior to 2015, this is where a lot of our focus and a lot of our sales would have gone. Recently, emerging sectors, so renewables, EV charging, data centers in particular, have been a growing piece of our business based on the growth in those sectors over the last few years.
So I talked earlier a little bit about the market share and market size, but where do we fit sort of within that pie?
We're very uniquely positioned. On the left side of the market share, you'll see that there's a number of competitors listed there. Most of them are global platform players. Schneider, Eaton, ABB, Siemens, Hitachi. These are names if you're in the electrical space, you'll know quite well. Broad-form energy management companies. Although there's sort of an interesting difference. The first four are selling or producing standard dry-type transformers, but are not manufacturing custom medium-voltage dry-type. When I mentioned earlier about 10% of our sales to private label, these are the kind of customers that we will private label for. This is where our depth of expertise allows us to have that capacity to do the engineering work and to manufacture the products.
So we gain some market share access through them for projects where they're specified, and we still get to participate in that market by doing the private label. When you look at Hitachi, they're sort of the inverse. So Hitachi is well-known for their liquid-filled transformers. They also do a number of dry-type transformers, medium voltage and above, but are not producing standard dry-type transformers. And what's important about producing standard products is this is our daily relationship with the distributors. And having that daily relationship with the distributors gives us access to a wide variety of other projects, which then in turn brings us opportunity for custom. On the other side, we can look at the rest, and I would say it's a pretty long tail of other competitors in the North American market.
They may be a small regional player building standard design transformers, or it could be niche players doing custom, and they'll be doing custom in one segment or one type of product and just don't have the scale or the mass to do customization at scale, and so we fit nicely there, and we continue to work, particularly in North America, and particularly in the U.S., on continuing to develop our distribution channel and continuing to gain share with the standard products, as well as build out capacity, and we've announced a number of CapEx projects to build our capacity to produce more and more large custom.
In terms of our run rate over the last number of years, one of the things I mentioned is just before the graph here, 2016 is when the Department of Energy code changed, and that's where we started being more proactively focused on growing our U.S. business, and then post-COVID, you see there's some dramatic increases into our size and our scale, a lot of that coming from our ability to produce and to produce at scale, as well as a number of the projects and markets growing during that timeframe. From a financial standpoint, we generate quite a bit of cash, and we don't have any long-term debt, so that leaves our balance sheet open for us to look at things, not only investing in our own capacity, but also looking for target acquisitions moving forward in the future.
And we've also had a history of consistent and steady dividends. So just to reiterate from a CapEx or capital allocation, you've seen, if you've been watching us, a series of capacity expansions for us to meet the needs of the market, reduce our lead times, and remain competitive. We just announced an acquisition recently of a company called Micron Industries located in Sterling, Illinois. That will give us access to a set of customers, particularly some OEM customers. So it'll increase our access to a sector, as well as give us opportunity to sell some of our power quality portfolio into those customers. And as I mentioned, we've had a history of dividend growth. So I'll finish there, and happy to take a few questions if people have any.
Yes.
Maybe talk a little bit more about these two questions first, the DOE change, what that kind of did for going to the U.S. market, and then on slide 20, maybe just the different steps of how gross margins have expanded [audio distortion] .
Sure, so I will take the first question. I'll let Richard take the second question, so the first question was how Department of Energy change for efficiency changes helped us enter the market, so in 2016, when the Department of Energy changed the efficiency standard, it means all the standard products used in the industry had to meet a higher level of efficiency, which means most of the standard transformer products had to be redesigned, so that was ideal for us because as we entered the U.S. market, that takes a lot of time and energy for engineers to go and redesign and revalidate those designs, so every manufacturer was kind of going through that process, so we weren't sort of behind trying to develop something that was already in the market.
We were developing at the same time products which everyone else was developing concurrently. And I think one thing we did very well, and I think this goes back to our sort of mass customization, because we had that engineering depth, we were actually well prepared to build out new designs for the entire portfolio quickly and actually got ahead of some of our competitors at that point, which helped us gain share, so I'll let Richard take an answer on slide 20. If you could just repeat the question.
Yeah, just the gross margin expansion, just [audio distortion] .
You'll have to step up here.
Repeat the question into the microphone. So your question was, what is driving the margin increase over the course of the last three or four years? And the biggest single driver is operating leverage. I mean, we're a much larger company than we were before. Our factories have been, in many cases, working at full capacity. So we've been absorbing a lot of overhead and also levering a lot of the other SG&A functions. So that's the number one reason. There are a couple of other things that happened to our business in India. We've made some meaningful improvements there, both in terms of sales volumes, but also the margins. We've had some management team changes. We've pursued other markets that have higher margins.
A third reason is the acquisition of Mesta in 2021. And Mesta makes two key products. One are induction heating products, which are used in silicon carbide processing. And the other is something called an active harmonic filter, which is a part of our power quality portfolio. And both of those products have higher margins than our typical dry-type transformer products would have. So those are the three key reasons. Another sort of maybe broad market reason is just driven by all the changes that have happened in the electric industry over the last three to four years. So we've talked a lot about all the tailwinds that have been propelling growth. And a lot of our input costs had gone up dramatically, and we'd had to implement six price increases in the space of two years in order to respond to those price increases.
So the margins sort of you sort of saw them fall a little bit, but they've caught up again to where they should be. And of course, that is really just supported by overall industry constraints and general demand in the market.
So as [audio distortion ].
That's an interesting question because we're in brand new territory now. And so I mean, we're certainly in an environment where there's strong demand and lots of support for pricing. But at the same time, as I said, having great operating leverage is helpful to us. And as we continue to grow, that'll only get better. As we do more acquisitions in the future, that will hopefully be accretive as well. But certainly, there is some element of risk in terms of industry capacity and resulting price competition, so.
What's the life cycle of the work you do that has a custom element to it? Do things start out as a customer request because the standard solution doesn't work and they need something, and they know you can deliver it and you have a good reputation, and so they use you? And then three, four, five years later, that becomes kind of a standard product and it's no longer custom and special, and the competitors can produce that? Or is the life cycle for that custom period longer, or it doesn't really matter because there's only the new custom thing that needs to [audio distortion].
Yeah. So to repeat the question, and I'll summarize. So if I paraphrase the question, it's what is the life cycle of a custom product?
So, when does a product kind of go from a custom product, maybe move to a standard product, or do you constantly have to sort of reinvent the custom? Is that more or less the question?
[audio distortion ].
So on custom, we have a nice saying, which we say customization at scale. And there's a couple of reasons we say that. One, so as you might imagine, the smaller the product, the less costly the product, the higher the percentage of engineering effort becomes as a part of that product. So whether it's the engineering design firm or our own engineers trying to customize, and an example I might use, the most frequently used transformer in North America is 75 kVA transformer. That's the most widely produced, widely consumed.
If you have an application that is 70 kVA instead of 75 kVA, you're going to get a very small energy deduct, and it's going to take a lot of time, and you're producing so many of those, it costs too much to customize that, but you can imagine if you have a 7,500 kVA transformer and you only need 7,000 kVA, you can get immense first cost savings, and you can actually improve the performance of that 7,000 kVA transformer to give better life cycle costs to the customer, so certainly, as size increases, customization becomes more effective. Particularly in North America, the power system was built up over hundreds of years, so wherever you're connecting into the electrical system, it's going to have different characteristics.
So the first challenge is not to get too technical, but short circuit capacities, the voltage levels of supply, and the voltage levels of consumption are going to be different around the country. So that's one thing preventing you from standardizing on the larger size. We do have customers, and we certainly have industries. Mining industry is a good one where we produce transformers that go on large mining equipment, and we'll customize that product specifically and optimize it to make that equipment as reliable and robust and high performance as possible. But that manufacturer is building the same equipment over and over. So we sort of customize once and then continue to produce that. Now, when that equipment goes in through a new design, they're going to require a new transformer for that new design. So that would follow sort of the OEM life cycle.
Data centers is another good example where it's customization and then standardization. So wherever the data center is being put, there's going to be certain input parameters, and whatever web giant you work for is going to have their own configuration of how they do their data center process, the insides of it. So you'll design a transformer specifically for that scenario, but then they'll put in hundreds of those transformers in a campus. So you sort of design once, and then you produce 100 times. But the next site, a county over, will have different input parameters, and so you'll have to kind of design a different transformer.
I have another question [audio distortion] .
Go ahead.
I guess my other question is, my understanding is that you guys do a lot more direct work in Canada where you work directly with the end customer, or the products are custom work. You know exactly what the end customer is after. Whereas in the U.S., in Mexico, you're much more dependent on your distributor network. And so your customer is the distributor, but that's not really the end customer that's using the product. How do you deal with not knowing what the end customer really wants from you? How do you make contact [audio distortion].
Yeah. In that market. Yeah. So I think our connection with end users in Canada is a little bit more historical. And we also have a number of direct salespeople in Canada.
Both in Canada and the U.S., we use a lot of sales reps or sales agencies to help us promote our product to the 3,000 different distributors that we work with. What we've done to improve that connection is we have what we call a technical sales group, and they're really responsible for visiting and meeting with end users and design engineers, particularly trying to get involved early on in the project so that we can help optimize that transformer for the project early in the phase. The commercial path would still run through a developer, a contractor, a wholesale distributor, but we try and get ourselves specified early on and work, so the OEM work is primarily direct. We do have relationships with end users and engineering firms to help specify our product, but the bulk of the volume does go through wholesale distribution.
So we try and cover it from two different angles.
Thank you.
Yes,
And do you see any potential geopolitical risk on your parent company based in Canada with some of your key markets in India or potentially the U.S. and Mexico?
Yeah. So the question is, do we see any geopolitical risk both with the headquarters of our company in Canada, with operations in India, and production in Mexico? So yeah, I think it certainly makes life very complex. So maybe I'll start and say India is only 5% of our overall revenue. So there is probably some risk there, but it's pretty low. And we made a conscious decision not to focus India on importing into the U.S. So it's predominantly serving India and Southeast Asia.
So we believe that mitigates some of the risk in terms of sales and opportunities because they're sort of working in a geography. In North America, I don't see that there is a fundamental long-term risk of being a Canadian company operating in North America. I think there will be some bumps along the road. We produce most of our standard products in Mexico. We produce most of our custom in Canada. We do a little bit in the U.S. On the standard product market, the bulk of all manufacturers are producing standard product in Mexico. So I think everyone's sort of on a level playing field of whatever happens there. And I think fundamentally, as bad as it may get financially from tariffs or other things, I don't think fundamentally North America is going to break into three groups where you need maybe domestic production in every country.
So we've done a lot to mitigate material component risk and material component tariff risk. If the tariffs come to the product as a whole, that'll be a different challenge. But like I said, I think we're on an even playing field, and there's just not enough capacity in the U.S. to serve U.S. needs. So there will have to be imports. If we're on the topic of imports, a pro and a con of transformers is that they're big and they're really heavy. So it's not easy to build in one part of the world and ship it to another part of the world. So you do get some geographic moats. And so you can ship by water or you can ship by land. So by producing in North America for the North American market, logistics is straightforward.
It's not so easy to produce in Asia and ship it to North America. It can happen, but it's difficult. I'll go there first.
How are you anticipating the change in political situation since you don't manufacture that much in the U.S.? Is that going to be a problem for bringing things back into the U.S.?
Yeah, so I think so the question is not manufacturing in the U.S. and the political climate, whether that'll be a challenge for our business going forward. I'll sort of repeat a little bit my answer, so one, I don't think that there's going to be a restriction of imports. I think there might be financial tariffs, right? I don't think that I would find it an extreme probability to say that no imports are allowed into the U.S. from Canada or Mexico. There's a reasonable degree of probability that there may be tariffs.
And again, I think the market itself will pass those tariffs along to the end consumer just because there's not production of scale in the U.S. of transformers. Did I fully answer your question? Yeah. Okay. Thank you.
Maybe touch a bit on the CapEx increases, what exactly that's going into, and I assume that's for production, so maybe where the incremental volume is going, maybe how much, and then what end markets that's really being built for.
Sure. So we've announced since about 2022 around CAD 80 million of capital expenditures. There are sort of different categories of those capital expenditures. The first thing that I will say is that as the market demand was increasing, we saw that demand, we want to certainly increase our market share. So we have to increase our capacity to match that.
There was a number of investments early on where we're adding equipment to existing factories. So those CapEx improvements come relatively quickly. We're buying equipment. We're installing it into a facility we already know, hiring some people into a facility we already have. We train them and we produce. We're making some CapEx expenditures now on two new factories. So we announced so we opened a factory in June in Mexico, and we announced a second factory. The one that we opened in June was more focused on power quality and our smaller product lines. Part of that, there were some products which we were manufacturing overseas, and we were reshoring those. That is not 100% a capacity increase. It's a bit of a reshoring effort, but we built the factory to allow us to have more capacity.
The new factory that we just announced will be focused on custom power, where we still have some bottlenecks, and that will help us serve these emerging markets: data centers, renewables, and even some of the traditional legacy where we need custom. What we see is a lot of project work still being very active, and the project work requires custom. We're building that capacity to give us the ability to serve those custom project markets. Good. Was that the warning bell? Okay. Appreciate everyone. If you have any questions, let us know. Thanks.