Techtronic powers up

Techtronic Industries, headquartered in Hong Kong, is one of the largest manufacturers of branded power tools and floor care products in the world. The US is its main market, with 70% of sales arising from the region, where do-it-yourself (DIY) giant Home Depot is its largest customer. Europe accounts for 20% of revenues and China constitutes approximately 5%.

The company has a number of leading mass market brands such as Ryobi, Homelite, Hoover, and Dirt Devil, as well as some that are used mostly in the professional and commercial markets: Milwaukee, AEG, and VAX. Bunnings is Techtronic's largest Australian distributor and many of these brands are widely available in their stores. Other major distributors include Walmart in the US and B&Q in Europe.

Techtronic remains a growth story. From 2014 to 2017 sales are forecast to grow 15%-plus per annum and earnings are expected to lift 21% per annum. In spite of a strong share price rally since 2012, the stock only trades at 14-times 2014 earnings – a significant discount to its growth rate.

Leverage to US housing

The investment case for Techtronic is based on an ongoing recovery in the US DIY housing market, the company gaining market share with a new product initiative and a turnaround in its European denominated markets. On top of that, Techtronic's disruptive battery technology is rendering internal combustion and plug in devices obsolete.

There is no better way to get a sense of what's going on in the US DIY space than looking at the recent results and commentary of Home Depot, the largest home improvement retailer in the US. Home Depot reported second-quarterly earnings on August 19 and beat expectations on both earnings and revenues. More importantly, they guided earnings to be up by some 20% for 2014. Their view of the housing market is positive but a bit below consensus forecasts. They see housing turnover stable at 4% and house price appreciation up 5-6%. These are two of the main drivers for the DIY business.

Recent economic statistics for housing in the US are also positive, with single family starts up 8.3% in July, housing permits up 8%, and homebuilder confidence at a three-month high. The broader US economy is also improving – expanding at a 4% annualised rate – after a weather related slump in the first quarter of 2014. All this augers well for the home improvement market. A recent survey by the Joint Centre for Housing Studies predicted that consumer spending related to home improvement should surpass the 2006 peak of 145 billion (See chart below). Consumer confidence is also improving with the latest index reading of 92.5 finally surpassing pre-GFC October 2007 levels.

Techtronic reported first-half 2014 earnings on August 20 and achieved record sales of $US2,250 billion. Gross margins expanded 100 basis points to 35% on the back of further production and supply chain efficiencies. Higher marketing and R&D expenses pressured the net profit result somewhat (still up 15.9% year-on-year) but analysts believe this extra cost is preparation for strong order growth in the second half of 2014. That there was a rise in inventories (from 74 days to 83 days) also suggests a stronger second half because as a rule the company doesn't manufacture excess product unless there is real demand.

Innovative new products

In the analyst briefing following the results the company highlighted new products (which now comprise about 30% of sales and will sell at a higher margin) and also the success of its established brands. In the mass market outdoor segment Techtronic is gaining market share over gasoline powered and corded devices by offering powerful battery powered alternatives. A new cordless floor care product was launched recently that can vacuum an entire house without a recharge.

In the professional Milwaukee segment, the company has launched a new “Fuel” line which involves continuously running tools such as angle grinders (on drilling rigs) and impact drivers for construction. In a recent video presentation on Bloomberg TV, chief executive Joseph Galli remarked that construction activity driven by the shale boom was creating a new end market for these high-end Milwaukee products. Milwaukee sales have been growing at 20% and remains Techtronic's fastest growing brand. Existing power tool growth (up 10% year-on-year) is also being driven by the high power Ryobi 18V and 40V lines.

Floor care, which makes up roughly 30% of group sales and where Techtronic is the largest player globally, is not really understood or appreciated by the market and may provide some upside surprises in 2014/15.Historically this has not been a growth area but by moving production to China from Mexico, integrating Oreck (a recent acquisition), and launching a new product line with Hoover and Vax should see volume growth and margin improvement later this year and into 2015.

Techtronic should also get a stronger contribution from its Eurozone business which grew 15% over the last year. The company is positive on Europe because it is gaining share from Bosch, Makita, and Stanley Black and Decker – its main competitors – and the DIY market is tracking well despite an economy that is still far below trend.

Management

Group founder Horst Julius Pudwill was chief executive until 2008 and is now a “hands on” chairman with an active role in strategic planning and operations. Pudwill still owns 18% of the company. The chief executive reports directly to him.

Chief executive Joseph Galli, who has been in the position since 2008, is experienced and highly regarded. Previous US-based roles include 20 years with Black and Decker (a Techtronic competitor), chief executive of Amazon in 1999-2000 and chief executive of Newell Rubbermaid, a major US consumer products company, for four years.

Corporate governance

Techtronic's board comprises five group executive directors, which are the chairman, chief executive, chief financial officer, strategic planning head and operations director, as well as one non-executive director and five Independent non-executive directors – mirroring the US system.

Valuation

Techtronic is trading at 14 times 2014 and has a three-year forward earnings-per-share (EPS) compound annual growth rate (CAGR) of 20% (or a price-earnings growth ratio of .70 times). For a growth investor that's an attractive multiple; most growth companies trade in excess of one times the growth rate.

Using a discounted cash flow (DCF) derived valuation methodology* one can arrive at a share price of HK36, which is the equivalent of 19 times 2016 EPS – not unreasonable given Techtronic's 20%-plus growth rate.

* based on a weighted average cost of capital of 9%, beta of 1, risk premium of 6%, a risk-free rate of 4.2% (the Chinese government bond rate), and terminal growth of 3.0%.

Conclusion and recommendation

Techtronic is a BUY at current levels (low to mid $HK20s), with a potential upside of 50%.

Risks

The risks to my valuation are as follows:

• Production costs in China rise significantly pressuring margins
• U.S. housing recovery stalls
• New products don't gain traction in a competitive marketplace
• Europe disappoints

To see Techtronic Industries' forecasts and financial summary, click here.