Stock Talk Podcast Episode 263 Show Notes

KeyStone’s Stock Talk Show Episode 263.

Great to chat with you again – I will start with a brief review of the Q2 numbers released late last week from a company that should be no stranger to our clients, Hammond Power Inc. (HPS.A:TSX), a stock which has been a BUY recommendation in our Canadian Small-Cap Coverage dating back decades now gaining over 19,000%. Hammond, which enables electrification through its broad range of dry-type transformers, power quality products and related magnetics, reported better-than-expected Q2 2024 numbers which boosted the stock. In our YSOT segment, Aaron begins by answering a viewer question on CrowdStrike Holdings, Inc. (CRWD:NASDAQ), a cybersecurity company that specializes in endpoint security which recently saw its share price drop after being identified as the culprit in the huge Microsoft outage. Aaron let’s you know if the drop is an opportunity. Brett answers a viewer question on MTY Food Group Symbol (MTY:TSX), a franchisor in the quick and casual dining industry. The viewer asks if MTY is a value trap as valuations have fallen since they bought it a few years ago – Brett will let you know. Finally, Brennan put together a segment on interest rates and how they affect bank stocks.

Let’s get to the show –my cohost, Mr. Aaron Dunn – and the killer B’s, Brett, and Brennan

Hammond Power Inc. (HPS.A:TSX)

What does Hammond Power do?

With a history that dates back over 100 years, today Hammond Power enables electrification through its broad range of dry-type transformers, power quality products and related magnetics. HPS’ standard and custom-designed products are essential and ubiquitous in electrical distribution networks through an extensive range of end-user applications. The Company has manufacturing plants in Canada, the United States (U.S.), Mexico and India and sells its products around the globe.

Q2 2024 numbers snapshot.

• Record sales of $197 million in the quarter, an increase of 14.4% from quarter 2, 2023 and $388 million year-to-date, a 12.9% increase versus 2023.
• Earnings from operations up 85%.
• EPS was up 77%.

STAY ON SLIDE.

Additionally:

• Strong gross margin of 32.8% for the quarter and 32.3% year-to-date.
• Adjusted EBITDA at 16.5% of sales in the quarter. Year-to-date Adjusted EBITDA at 16.4% of sales. AND….Year-to-date Adjusted EBITDA increased by 16.7% year-over-year after a weaker Q1.

Q2 Highlights:

Official opening of a new factory in Mexico and achieving record all-time shipments once again.

The U.S. market experienced its strongest growth in the distributor channel as Hammond continued to grow both the number of new distributors, as well as sales within existing distributors.

The Original Equipment Manufacturer (OEM) channel, while higher on a year-to-date basis, decreased in the quarter.

Backlog: Despite reaching record shipment levels, the company’s backlog increased 1.0% from Q1 2024 (sequentially).

Valuations:

PE TTM: 26.9.

EV/EBITDA: 13.6

PE (2024e): 19.93

Given the 1,000+ percent gains we have seen in the last 5-years, these number are not overly inflated but one has to factor in that historically the company is looking for growth rates in the 10-12% range.

Conclusion:

First some colour:

Over the past 20 months, Hammond has been adding equipment to existing factories – coupling this with strong demand and the company has been consistently increasing shipping volumes. This cumulative added capacity produced sales growth of 14% year over year. The bulk of announced capital expenditures will be spent during this year and completed by early next year. Construction and equipment installations have been running smoothly, which enabled us to open the Monterrey 3 facility in Mexico on time and on budget.

Bookings were strong in the second quarter, and Hammond achieved its second-highest month of new orders ever in April. New orders reverted to more normal levels in June as standard product sales cooled in the United States (“U.S.”) offset somewhat by increased sales activities at new and existing distributors. The company expects the standard product market to remain stable for the remainder of the year, however management noted that they also expect to see continued strong activity in custom equipment as project activity remains elevated.”

In terms of the cooling in June, it appears to be in the company’s standard transformer products which are used in commercial construction projects and tend to be weighted towards general economic conditions – so the softening in construction due to higher rates is impacting part of the business which should be expected.

Since our original recommendation, Hammond Power has gained over 19,000%. 

Q2 results bested expectations.

Stock trades closer to fair value in the near-term.

Clients will be updated this week.

MTY Food Group YSOT

1)

MTY Food Group Symbol MTY on the TSX is a franchisor in the quick and casual dining industry. The company operates under the brands a wide variety of brands including, Papa Murphy’s, Dagwoods, Cold Stone Creamery, Sushi Shop, South Street Burger, Van Houtte, Thai Express, Ben and Florentine and Mucho Burrito, Wetzel’s Pretzels, Jugo Juice among others. All together the company has 7,107 locations in operation of which 6,885 are franchised locations.

The viewer asks if MTY is a value trap as valuations have fallen since they bought it a few years ago.

2)

The stock is trading at $45.40 after falling 18% year-to-date, with a market cap of $1.09 billion and a dividend yield of 2.5%.

3)

Let’s look at the last quarter, fiscal Q2 2024 ending May 31st.

System sales were slightly down 1%, to 1.46 billion with a slight decrease related to a weaker Canadian market.  Locations were materially the same at 7,107 compared to 7,124 in the prior year.

As locations and system sales were effectively flat we can generally expect relatively flat financials. Revenue came in at $304 million compared to $305 million. Normalized adjusted EBITDA came in at $74 million down from $75 million. Net income fell to $27.3 million from $30.4 million with the change largely being due to a foreign exchange loss of 3.4 million compared to a gain of $0.3 in the prior year. EPS came in at $1.13 compared to $1.24. Cash flow before working capital changes came in at $73 million compared to $75 million.

So overall, effectively flat year over year across the board.

4)

Shifting to the balance sheet, as the company is a brand acquirer and in the restaurant industry it is no surprise that it is in a net debt position.

The company holds $52 million in cash, $733 million in debt, and $512 million in leases, resulting in a net debt position of $1.193 billion. This puts the leverage ratio at 4.5 times when including leases, or 2.5 times without leases.

Given that the leases primary relate to the corporate stores it is expected to have a large lease balance impacting leverage, so while its not low by any means it’s not an outlandish level of leverage.

However, the company is sensitive to interest rates since the long-term debt is floating as well as leases are renewed the company would be subject to higher rates. However, now that we have seen the Canadian policy rates drop and the American rates expected to fall, the company will benefit from the lower rates going forward.

5)

Flipping to the dividend

The company currently pays a quarterly dividend of $0.28 or $$1.12 annualized, resulting in a yield of 2.5% at this time. The company has been a consistent dividend grower barring the suspension of the dividend during COVID.

The current dividend payout ratio as a percentage of free cash flow after leases is roughly 21%, which is maintainable and has room to continue to grow. However, the company is at its core an M&A company so I would not expect a massive yield to ever occur at a market price but with its growth of it, your effective yield could build nicely over time.

6)

Now onto valuation,
The valuation has dropped over time and is at an EV/EBITDA of 9 times and a P/E of 11 times trailing. Both ratios are quite cheap and I would attribute this to the lack of growth over the past year, whereas the company was previously priced to grow. I have a chart of EV/EBITDA overtime on the screen and you can see it generally ranges in the low to single double digits over the past decade except for the valuation during COVID as financials plummeted, which we will ignore for this. So compared to historic valuations, it is relatively cheap.

7)

Wrapping up,

The company does have some headwinds as consumer demand is weak in Canada and not the same level of strength we saw a couple of years ago in the States.

As well the company has been negatively impacted by interest rates, which if they do fall and the economies don’t fall apart could be a catalyst for the company to get a revaluation back to its historic level as interest expense wouldn’t weigh on growth as much.

But to get a true revaluation back to the mid-teens the company needs to return to growth driven by the top line whether organic or through acquisitions.

So answering the question of whether MTY is a value trap I would say it’s not but there is risks related to growth, but it is still profitable and has largely suffered due to macroeconomic factors.

Interest Rates & Banks (July 2024)

Slide #1

We got a question last Wednesday in our Canadian Income stock chat with clients, and the individual asked – “As interest rates continue to fall, what impact will this have on bank earnings?”

And considering the 25 basis point decrease in the Bank of Canada’s policy interest rate to 4.5%, I thought that it would be a good topic to cover on the podcast.

But first I must say, effects of interest rate changes on bank profits vary significantly by institution and time. So I am going to go over some general themes, but it all comes down to how each institution is structured, so keep this in mind.

Slide #2

So looking at when interest rates rise, generally this increases profitability across the banking sector due to:
– Rising interest rates will increase a bank’s Net Interest Margin, as they take advantage of the greater spread between the interest they pay to their customers and the profits that they earn by investing. As the bank’s cost of doing business are generally unaffected.
– And, higher interest rates are normally a sign of a booming economy. Meaning demand for loans to businesses & consumers should be high…. BUT – it’s somewhat of a double-edged sword as if rates go too high this could discourage borrowers (decreasing growth) and lead to larger credit losses.

I placed in an example of TD Bank’s NIM over the past 11 quarters. The Bank of Canada began increasing its policy rate in March 2022, and as such we saw the TD’s NIM expand from 1.57% as at January 31, 2022, to 1.82% by January 31, 2023 when rates were around 4.25%.

Slide #3

When interest rates decline, generally this decreases profitability across the banking sector as:
– As the U.S. Fed and Bank of Canada lower interest rates, they encourage consumers to borrow more money to spur the economy (which is good for growth). But declining interest rates will decrease a bank’s Net Interest Margin, as they earn less on short-term loans and the bank’s cost of doing business are generally unaffected.
– And, lower cost of funding can lead to increased competition for deposits among customers looking for greater returns from their cash holdings.
– And as you can see here, this is a direct quote from TD’s Q2 2024 conference call, where they say “As we look forward to Q3, while many factors can impact margins, we expect lower NIM from downward pressure due to competitive market dynamics”.

Slide #4

Another thing to keep an eye on is that the yield curve has been inverted for quite some time, meaning that interest earned on short term bonds is higher than long term bonds.

And as an example, we have a bank under coverage that is experiencing some NIM pressure given the inverted yield curve as loans are longer term at lower rates & deposits are shorter term at higher rates, but as the yield curve normalizes, NIM should experience a lift.

Slide #5

– Overall, results indicate that changes in interest rates have a strong influence on banking profitability, but their precise impact is complex. Just look back at TD’s quote in their Q2 2024 results, indicating that “MANY FACTORS CAN IMPACT MARGINS”.

– Generally though, Rising interest rates will in theory increase NIM, but elevated rates can lead to less growth and lead to larger credit losses.

– Falling interest rates will in theory decline NIM, but may encourage more borrowing (propelling growth), and lead to lower credit losses. And lower cost of funding may also lead to more competition for high interest deposits which will also decline a bank’s NIM.

Looking at how a specific bank will be impacted really comes down to analyzing their operations including its loan portfolio, deposits, and how they are invested into capital markets, as lower interest rates may decrease their NIM but these lower rates are generally positive for a bank’s capital markets division.

The bottom line though is that studies consistently demonstrate that lower rates result in narrower NIMs; however, their negative effects are offset by increased fee revenue and decreased loss provisions. So how much that offset is really depends on the institution itself.