We have been long-time admirers of the business models of the leading electrical product manufacturers including: Cooper Industries, Thomas and Betts, Hubbell Incorporated and Acuity Brands, Inc.  The stocks are not widely followed, but they have compelling business models from a financial perspective.  All four of these companies have traditionally generated free cash flow in excess of net income and delivered a return on equity of 15%+.  Over the past decade each of these companies has increased its market share in the end-markets they serve through organic growth and acquisitions.  Electrical equipment manufacturers are highly levered to construction activity, industrial production and utility CAPEX, all of which have declined sharply in the past 12-months.  Despite these significant fundamental headwinds, the publicly traded companies in this space have delievered operating margin performance in 2009 that is 400-500 bps higher than those witnessed in the 2001/2002 economic downturn. In short, the operating environment has not been favorable, but the financial results have been.

Historically, the shares of the four leading electrical component manufacturers have been highly correlated despite their slight differences in end-market exposure and product-lines.  In the past 6-12 months, shares of Acuity Brands have underperformed the peer group by more than 50%, which represents the widest gap since the company has been public.  We think shares are now poised to outperform the peer group and those of Hubbell Inc. in particular based on the following:

1. Mean reversion in relative stock price performance appears imminent.  We attribute the unprecedented outperformance of HUBB shares relative to those of AYI to investor perception that HUBB’s end markets will improve more rapidly than those of AYI.  While there are merits to that thesis, we think there is increasing fundamental evidence that volume trends in lighting could improve over the next 3-6 months, which we think could spark outperformance for AYI shares relative to those of HUBB. 
2. Proprietary survey results suggest consensus revenue expectations for AYI for FY10 could be too low.  We recently conducted a survey of lighting designers and lighting agents/distributors.  The results suggest that consensus revenue expectations for the current quarter and into 2010 could be too low.  Additionally, AYI and other lighting equipment manufacturers should benefit from strong demand related to retrofit/rennovation projects and the secular growth in LED products. 
3. We think there is greater upside to consensus estimates for AYI compared to HUBB based on operating margin cross-currents and relatively modest street expectations.  If we assume a 15-20% organic decline in lighting product volume in 2010, it still appears that consensus EPS expectations for AYI remain too low given the favorable operating margin tailwinds from streamlining efforts, lower commodity costs, and reduced incentive compensation.

Overall we are targeting a 25% return for this pair trade.  In a scenario in which investors grow comfortable with stabilization of lighting volume trends we think AYI shares could trade as high as $40-$45/share, while we see incremental upside to HUBB to the $50-$55 level.

A Brief Overview of the North American Lighting Market

Both AYI and HUBB operate in the $10B North American lighting market.  The lighting products industry includes traditional lighting fixtures, outdoor lighting produts, emergency lighting fixtures and energy management and architectual lighting control systems. Commercial real estate remains the largest end-market for lighting products, followed by outdoor products, and residential real estate.  In the chart below we outline the five major end-markets for lighting products in North America.

Philips Is the Market Leader in the North American Lighting Products Industry

Even though there has been a great deal of consolidation among lighting products manufacturers over the past decade, the market still remains highly fragmented.  The top four players (Philips, Acuity Brands, Cooper and Hubbell), have just over 50% market share.  We expect consolidation to continue particularly among manufaturers of LED/solid state lighting components and lighting solutions/controls providers.  Philips is the clear leader in the marketplace from both a market share and technology perspective. In the chart below we outline the market share of the top four industry players.

From Components to Solutions – LED Is a Huge Secular Growth Driver

Historically demand trends for lighting have been highly correlated to construction spending.  While these trends remain in place, there has been a shift in the growth trajectory for the industry caused by an increased focus on energy efficient lighting solutions and LED/solid state lighting products.  Although the annual amount of lighting products sold in North America approaches $10B, the installed base of lighting products exceeds $100B.  Even though the economic downturn has hampered demand for traditional lighting products, sales growth for LED products and lighting controls continues to eclipse 20% based on comments from industry executives, lighting distirbutors, and lighting designers.  Demand for retrofit and rennovation projecst remains strong due to an increased focus on energy efficency among consumers and corporations alike.  We expect this trend to accelerate over the next 10-15 years.

The industry is increasingly evolving from component to solutions based products. We expect each of the industry leaders to benefit from the transition from lower priced commodity type lighting components to higher ASP LED and lighting solutions systems.  At this stage, it appears Philips has the strongest suite of LED solutions and lighting contol solutions, but we expect the other industry leaders to expand their offerings in the next 12-24 months through a combination of new product introduction and acquisitions.

A Snapshot of Acuity Brands

 Acuity Brands is the second largest manufacturer of lighting products in North America.  The company was spun-out of National Services Industries, Inc. in 2001 and currently operates 14 manufacturing plants in North America and 2 in Europe.  Overall products manufactured in the US accounted for 29% of sales, those produced in Mexico 46% of sales and the vast majority of the remainder were produced by third parties.  AYI’s principal customers are electrical distributors, home improvement retailers, electric utilities and lighting showrooms.  Even though the company has a manuacturing presence in Europe, only 3% of the company’s sales come from outside North America.  In the table below we provide a brief financial snapshot of AYI:

Source: Company reports, Yahoo finance, PAA Research

One of the issues that AYI has faced over the past 12-18 months from a fundamental and investor perception perspective is the company’s fairly large exposure to spending levels on new construction.  Overall, revenues related to products sold for new construction accounted for 78% of sales in FY09, down from 83% in FY08.  We anticipate revenues related to retrofit and rennovation projects could increase as a percentage of total companywide revenues for the next 12-18 months due to secular growth in the replacement of incandescent bulbs for energy efficient products and weakness in new construction activity. 

 

AYI  Continues to Expand its Product and Solutions Portfolio Through Acquisition

In the past 12-months AYI completed acquisitions of two smaller companies that had strong product and solutions portfolios in the broader controls market.  In December of 2008, AYI acquired Lighting Control and Design, Inc. for approximately $31 million. The company offers a suite of lighting controls products and digital thermostats.  The company had annual sales of $18 million in 2008.  In April of 2009 AYI acquired Sensor Switch, Inc., which significantly enhanced the company’s energy management systems offerings.  The purchase price of $205 million represented a multiple of 5.5x revenue, which appears fairly aggressive on the surface.  However, Sensor Switch is experiencing rapid growth and has margins that are much higher than the AYI corporate average.  We expect the Sensor Switch acquisition to be accretive to earnings in FY10. 

We anticipate AYI will pursue further acquisitions in the next 3-6 months. This week the company completed a $400 million bond offering, which was used to refinance $200 million of existing senior notes due in 2010 and promissory notes owed to the management team of Sensor Switch.  Through the offering AYI raised an additional $170 million beyond what the company needed to refinance its existing debt.  We expect the company to generate more than $130 million in free cash flow this year and the company’s total debt levels pro-forma for the bond offering remain modest. This suggests to us that the most likely use of the incremental proceeds from the bond offering will be additional strategic acquisitions.

A Snapshot of Hubbell Inc.

 Hubbell is a leading global manufacturer of electrical and electronic products for residential and non-residential construction, industrial and utility applications.  The following table is a brief financial snapshot of the company:

The company now is organized along two major operating divisions: electrical and power.  The company’s electrical division includes: wiring products (cables, connectors, switches), electrical products (high voltage test equipment), commercial products (steel outlet boxes and panels), industrial controls (radio control products), and lighting products.  Based on our estimates this division will account for 70% of revenues and 53% of operating income in 2009.

Hubbell’s power segment manufactures transmission and distribution products for the utility industry.  Some of the companies products manufactured through the power segment are sold to end-users in the construction and transportation industries.  The power segment will account for approximately 30% of revenue and 47% of operating income in 2009 based on our estimates.

From an end-market perspective HUBB is more diversified than AYI.  The company’s revenue growth prospects are not as tied to new construction as are those of AYI.  Only 40% of HUBB’s revenues are generated from products sold to customers in the non-residential construction industry.  Although, HUBB’s revenue growth has been highly correlated to construction, the company does have the benefit of servicing utility clients whose CAPEX cycle does not have the same amplitude as those in the non-residential sector.  For the time being, investors have taken the approach that demand for electrical equipment in the end-markets that HUBB serves will recover more quickly than those for AYI.  In the chart  below, we outline the percentage of revenue the company generates from each broad end-market:

Similar to AYI, HUBB has made a number of acqusitions over the past 12-18 months to enhance its market position and product portfolio for the end-markets the company serves.  The company recently completed the acquisition of Burndy for $360 million. The acquisition will add roughly $225 million to HUBB’s top-line in the company’s electrical products division.  During 2008, HUBB completed two acquisitions to enhance the company’s product offerings in its lighting business (Varon and Kurt Versen) and two for the power segment.  Given HUBB’s strong free cash flow generation prospects we anticipate the company could continue to pursue “tuck-in” acquisitions over the course of 2010, although we do not expect the company to pursue a deal as large as Burndy.

Recent Outperformance of HUBB Shares Appears Ripe for Mean Reversion

AYI shares have been highly correlated to those of the other leading electrical product manufacturers over the past 10-years.  From the date of AYI’s spin-out from National Service Industries in 2001, the stock has had a 0.778, 0.850, and 0.936 correlation with the shares of HUBB, TNB, and CBE, respectively.  However, in 2009 the stock price correlation has broken down.  In the past 3-months, AYI shares have demonstrated almost no correlation to those of HUBB, TNB, and CBE.  This is unusual.

Source: Yahoo finance, PAA Research

Looking at the recent performance of AYI shares another way: this is the greatest level of underperformance of AYI shares relative to those of HUBB, TNB, and CBE since the company went public in 2001. Over the past year, HUBB, TNB, and CBE have outperformed AYI by 52%, 63%, and 68%, respectively.  The chart below compares the stock price returns of HUBB to those of AYI on a 1-month, 3-month, 6-month, and 1-year basis going back to 2001.  As you can see this is the greatest level of outperformance HUBB shares have generated this decade. It also should be clear that periods of outperformance by HUBB or AYI typically do not last long.  In almost every case, mean reversion to the longer term trend of stock price correlation normally takes 3-6 months.  We expect this latest period of outperformance to be no diffferent. 

Source: Yahoo finance, PAA Research

Proprietary Survey Of Lighting Designers and Lighting Agents Suggests Street Revenue Expectations Are Too Conservative – Other Key Observations

 We recently conducted a survey of approximately 15-20 lighting agents and 15-20 lighting designers to gain a better understanding of the state of inventory in the channel, project activity, and the prospects for 2010.  Although Home Depot is the single largest customer for both HUBB and AYI, both companies rely heavily on the lighting agent (agent can be viewed as synonymous with “distributor”) channel for its sales.  Lighting design historically has been viewed as a sub-speciality within architecture.  With the proliferation of LED products and comprehensive control systems, lighting designers have broken out from the shadows of the architecture industry.  Similar to what insights architects provide for future project activity in construction, we think lighting designers can offer unique perspective on demand for lighting products over the next 6-12 months.

Key Observations from the Agent Channel – Revenues Appear to Be Stabilizing and Inventory De-stocking Is Complete, Some Pricing Pressure

Here are some of our key conclusions from the feedback we received from our lighting agent survey respondents:

•  Revenue declines for distributors/agents in calendar 2009 are similar to those witnessed by AYI and HUBB.  Overall approximately 50% of respondents indicated that they had witnessed a YOY decline in revenues on a YTD basis of at least 15%.  We were surprised to learn that more than 20% of respondents have generated positive YOY sales growth in 2010.

Source: PAA Research

•  On a YOY basis the rate of revenue decline has slowed substantially in the fourth quarter – revenues appear to be stabilizing.  Approximately 50% of respondents indicated that revenues were flat or down as little as 10% on a YOY basis thus far in the fourth quarter.  On a  sequential basis, 67% of lighting agents indicated that revenues had changed in a range of -5% to +5% thus far in the fourth quarter compared to the third quarter.  The level of improvement has not been dramatic and there are number of agents that are still witnessing double digit revenue declines on a YOY basis, but there are clear signs of stabilization.

• Inventory levels at most distributors are flat to down on a YOY basis.  Most distributors/agents are comfortable with current inventory levels based on their outlook for revenues over the next 6-12 months.  40% of agents have lower inventories at this point in the year compared to a year ago. The remaining respondents indicated that inventories were flat on a YOY basis.  Overall 67% characterized inventory levels as “adequate”, while another 13% characterized them as too low. Based on this feedback, it appears that inventory de-stocking has reached an endpoint, or is close to complete.

• Sales of LED products remain robust despite the economic downturn.  All respondents indicated that sales of LED products have increased on a YOY basis by an average amount of 15-20%.  For both HUBB and AYI, sales of LED products represent less than 5% of total lighting products revenues. Through acquisition and organic growth we expect sales of LED products to become a sizeable driver of growth within the next 2-3 years.

• At this stage, Philips has the best suite of LED products according to the lighting agents we surveyed.  56% of respondents indicated that they thought Philips had the strongest suite of LED products.  Acuity and Hubbell were a distant second and third with 22% and 11% of respondents indicating that they had the best suite of products.
• Pricing pressure has increased considerably as a result of the economic downturn.  More than 60% of respondents indicated that prices on comparable products have declined this year compared to a year ago.  This is not a total surprsie given the tepid amount of demand and sharp decline in input costs.  However, the majority of lighting agents indicated they had experience a significant amount of pricing pressure on at least some products.  We think lighting products manufacturers such as AYI and HUBB should witness a sizeable margin tailwind from lower commodity costs.  We will keep a watchful eye on pricing trends in the channel to see if this tailwind is sustainable.

• Lighting agents expect relatively flat or a decline in sales in 2010. Almost all of our respondents indicated they expected sales to decline as much as 10% or increase up to 10%.  This adds further credence to our view that sales trends have started to stabilize.  Sales for retrofit and rennovation projects should remain strong and help to offset what most lighting agents expect to be a continued decline in product sales related to new construction.  100% of respondents expect sales related to retrofit and rennovation projects to increase in 2010, while 56% expect sales related to new construction activity to decline.

Feedback from Lighting Designers Corroborates that from Light Agents – Revenues are Stabilizing, Retrofit/Rennovation Projects Continue to Increase, 2010 Could be a Flat Revenue Year

As we mentioned earlier, we view feedback from lighting designers as a leading indicator of demand for lighting products.  Here are some of the key findings from our survey:

• Similar to the trends witnessed by lighting agents, billings in the fourth quarter for a good portion of lighting agents have stabilized, if not increased on a YOY basis.  More than 50% of respondents have witnessed flat or an increase in billings on a YOY basis thus far in the fourth quarter.

• A majority of lighting designers expect billings to increase in 2010.  65% of lighting designers expect an increase in billings in 2010.  Similar to lighting agents, the lighting designers we surveyed that anticipate an increase in billings activity expect retrofit and rennovation projects to be a primary source of growth, while work related to new construction could remain a drag on revenues in 2010.

• According to the lighting designers we surveyed, demand for LED products increased 15-20% on average thus far in 2009.  The lighting designers we sureveyed also indicated that Philips offers the best suite of LED solutions followed by Cooper and Acuity Brands.  Hubbell was not mentioned.

Consensus Revenue Expectations for 4Q09 and 2010 Appear Too Low In Light of Our Survey Feedback

Current consensus FY10 revenue expectations for AYI imply a 7.7% YOY decline in revenues.  Based on the feedback from our surveys of lighting agents and designers it appears that revenues related to new construction could decline as much as 10-15%, while those related to retrofit and rennovation projects could increase as much as 10-15% YOY.  Including the contribution from the Sensor Switch and LC&D acquisitions which should add 1-2% to revenue growth in FY10, it appears that AYI’s YOY revenue decline could be closer to 5%.  In the table below we have outlined a simple revenue analysis based on the the company’s exposure to rennovation and retrofit business and to new construction.  The revenue analysis does not include the benefit of currency or acquisitions.  In our bull case scenario, AYI revenues only decline 5% EXCLUDING any contribution from Sensor Switch and LC&D or favorable impact from currency.  We think acquisitions and currency could add 3-4% to top-line growth for AYI in 2010.

Despite Economic Headwinds, AYI Has a Number of EPS Tailwinds That Have Not Yet Been Factored Into Consensus Estimates

Overall we think there is considerable more upside to consensus EPS expectations for AYI relative to those of HUBB.  We estimate HUBB could earn as much as $3.20-$3.25 in 2010 compared to consensus of $3.15, while for AYI we think the company can generate EPS of $2.30-$2.40 relative to consensus of $2.05.  Our optimism for AYI’s earnings prospects is not entirely predicated on our expectation that the company could exceed consensus revene forecasts.  AYI has a number of favorable earnings tailwinds in FY10 that should more than offest the negative leverage from lower manufaturing utilization and a strengthening peso (46% of AYI’s product is manufactured in Mexico).  In the table below we have outlined a rough sketch of the company’s earnings drivers in FY10 in a scenario in which total revenues decline 17% on an organic basis (ex-currency, ex-acquisitions).  Our analysis suggests that EPS could still increase by as much as $0.35 from FY09 levels in that scenario based on the company’s lower commodity costs, benefits  from FY09 streamlining efforts, and lower incentive compensation.

It is important to note that the analysis above does not include the benefit of additional acquisitions.  Between the $130 million in free cash flow we expect AYI to generate in FY10 and the $170 million in incremental proceeds raised in the bond offering AYI now has an enormous amount of “dry-powder” the company can now use to pursue additional acquisitions.

Current consensus EPS expectations imply flat YOY EPS for AYI from 2009 to 2010, which we think is too conservative. As a result of our analysis we see more meaningful upside to AYI earnings in FY10 relative to that of HUBB and subsequently more upside in the stock.  We think AYI shares could trade as high as 18-20x FY10 EPS as investors become increasingly comfortable that revenue trends for lighting products have stabilized. HUBB shares have outperformed in large part this year based on the view that the end-markets the company serves will witness a recovery in revenues sooner than those for AYI.  Our survey results suggest that demand trends in the lighting market are similar to those of other electrical products.  Additionally  we would argue that HUBB shares have also outperformed based on the view that the company is poised to benefit from major investment in the electricity grid as well as the secular growth in energy efficient lighting products.  At this point it is not clear whether HUBB’s end-markets will offer superior growth over-time, particularly in light of the fact that AYI  as a pure play lighting company has a more robust LED product and lighting solutions offering. 

We expect investors to rotate into AYI shares over the next 3-6 months given the relative underperformance to the company’s peer group and the increasing likelihood that the company is positioned to beat consensus EPS expectations.  We are targeting a 25% return for a pair trade long AYI/short HUBB.

As always, please act accordingly…