Hashmeel Suka
Hudaco - Under the hood
Hudaco is a South African-based industrial and engineering supplies group, specialising in the sourcing, importing, and distribution of various electrical and mechanical products. Essentially, the company serves as a "middleman" between leading international manufacturers and local retailers (as well as end-users) of industrial materials and consumables. The group also manufactures a niche collection of equipment such as hydraulic and pneumatic systems.
The group has more than 30 distinct businesses throughout the country, and services more than 30 000 active customers across various sectors including mining, manufacturing, agriculture, construction, renewable energy, and the automotive industry. Products are sold through an extensive network of independent distributors and specialised stores.
A key feature of Hudaco's business model is the large and diverse catalogue of quality branded products, across which demand is relatively inelastic. The group also has a particular focus on efficient inventory management, ensuring that products are always available as required. In addition to this, the group supplements its product offering with after-sales services including expert advice, technical training, as well as maintenance and repair solutions.
Business Structures
The group is split into two main operating units, each composed of several different categories:
1). Engineering Consumables (~50.3% of revenue)
2). Consumer-related Products (~49.7% of revenue)
Macro considerations
Hudaco generates almost all of its revenue from the SA market, with most of its distribution hubs and retail stores based in Gauteng, Kwa-Zulu Natal, and the Western Cape. The group also has some sales exposure to the Namibian, Kenyan and Zambian markets (where products are supplied through third-party distributors), as well as operating exposure in the UK and the US.
Product imports are the main component of the group's activities. More than 75% of all items sold across the operating segments are sourced from outside of SoA borders. More specifically, within the Engineering Consumables vertical ~35% of all imports are from Europe, while in the Consumer-related Products vertical, ~64% of all imports are from Asia. The group therefore has significant supply-chain exposure and is also heavily exposed to the rand exchange rate - with a stronger rand being beneficial.
Sourcing products from all corners of the world presents a myriad of challenges (such as shipping delays and escalating logistics costs), but the group also faces another major obstacle - taking products from ports of entry and getting them onto shelves. Over the past 18 months or so, businesses in SA have been impacted by port congestion delays due to overwhelming cargo volumes and inadequate capacity (owing to underdeveloped and neglected rail infrastructure). To put things into perspective, the group saw a ~70bps contraction in the gross margin during FY23 as a direct result of these issues. More recently, we have seen an improvement in port and rail capacity and improvement in this space is a key priority for government.
In terms of its growth prospects, the group's Engineering Consumables vertical (geared toward the mining and manufacturing sectors) is highly dependent on fixed-capital formation in South Africa. The medium-term outlook in this regard looks a little better as we are currently still in the weaker end of the commodity cycle and have seen early signs of recovering manufacturing activity.
Growth of the Consumer-related Products vertical is highly dependent on durable goods consumption, which could improve near term as cost-of-living pressure (lower inflation and lower interest rates) and political uncertainty subsides, and infrastructure challenges are addressed.
Financial Review
Hudaco has performed relatively well over the past five years, with revenue and headline earnings per share (HEPS) growing ~7% and ~11%, respectively (on a compounded annual basis). Growth over this period has been underpinned by robust demand from both retail consumers and commercial customers across its diverse and defensive product portfolio. The group has also been able to firmly protect its margins, given a strong market share position coupled with substantial pricing power.
FY20 was an abnormally bad year for the group as Covid-19 brought the local economy to a standstill. Hudaco saw a significant slowdown in demand due to lockdown restrictions, which resulted in significantly lower mining, manufacturing, and retail activity, as well as severe infrastructure project delays. Consequently, revenue was down 7%, while HEPS dropped 21% during the period.
Despite persistent challenges (including severe supply-chain constraints as well as the devastating civil unrest), the group recovered strongly during FY21 (revenue: +16%, HEPS: +53%). This followed the reopening of various economic sectors, which was further complimented by a boom in residential construction and home improvement projects.
Hudaco has delivered healthy growth ever since, benefitting from notable improvements in certain businesses (such as batteries and renewable energy), strategic acquisitions (such as CADAC and Brigit Fire), as well as a sustained focus on efficient inventory management. These efforts have helped mitigate the impact of persistent macroeconomic headwinds overall, as well as deteriorating business conditions in SA.
The group displayed strong growth over FY23 (revenue: +9.1%, operating profit: +5.1%, HEPS: +7.6%), underpinned by healthy demand from the mining and manufacturing sectors; and despite the impact of higher operational expenditure and finance costs, cash generation was robust. Debt was significantly higher (due to business acquisitions, property purchases, share buybacks and increased working capital), but the balance sheet was still in good standing.
During a cyclically weaker 1H24, revenue decreased 6.3% y/y to R4 billion due to a substantial decline in the Consumer-related Products vertical (-15.7%) that was impacted by weaker demand across certain businesses. On a more positive note, the Engineering Consumables vertical (+3.9%) saw decent growth. Operating profit was down 11% y/y to R414 million, and the margin contracted ~50bps to 10.4%. HEPS dropped 15.3% y/y to R7.85, impacted by higher finance costs (+32% y/y). Despite weaker earnings, the interim dividend was maintained at R3.25 per share, representing a payout ratio of ~41%, near the lower end of management's long-term policy range. Net borrowings were stable at R1 billion, and the group has maintained a strong balance sheet (interest coverage: 7 times) with sufficient capacity to finance further growth opportunities.
Considering improving business conditions in SA, the mitigation of prior operational challenges, as well as the impact of a more favourable base, management guided for a much better performance in 2H24. The longer-term outlook is positive, with Hudaco well-positioned to benefit from a revival in the local economy.
Management Overview
Hudaco boasts a highly skilled and experienced management team, comprised of:
Non-executive members include Stephen Connelly (ACMA), Nonyameko Mandindi (BSc, Executive Masters), Mark Thompson (BCom, BAcc, CA(SA), LLB), and Bukelwa Bulo (BBusSci Hons, CA(SA), Harvard PLD).
Summary investment case
Risks
Valuation
We valued the company using a discounted cash flow (DCF) model on relatively conservative assumptions. Revenue has been forecast as a function of nominal GDP (gross fixed-capital formation as well as consumption of durable goods), while margins were kept fairly stable. This has filtered through into reasonable earnings and cash flow expectations:
Accordingly, we derive an estimated fair value on Hudaco of around R215 per share, offering good upside (~21%) from the current share price of R178.
