Techtronic Industries: Powering On

Hong Kong-listed Techtronic Industries (“TTI”) was founded in 1985 by German Mr. Horst Pudwill and Hong Konger Mr. Roy Chung Chi-ping (鍾志平) specifically to use Lithium-ion (“Li-ion”) batteries to design and manufacture safer, quieter and more compact cordless power tools. After success as a contract manufacturer for brands like Sears’ Craftsman, TTI moved upstream in the early 2000s by acquiring a stable of its own brands, including DIY-brand Ryobi in 2000 and Pro-brand Milwaukee in 2005. By focusing on these two clearly segmented brands, TTI lets consumers find precisely the right tool for their price and performance requirements. Over the last twenty years, it has grown revenue at an 11% p.a. CAGR and earned an average return on equity of 16%.

The United States is TTI’s largest market, comprising ~70% of its overall sales. TTI has taken substantial market share over the years from competitors like Stanley Black & Decker (“SBD”) and Makita thanks to its superior products and highly successful partnership with Home Depot, America’s largest home improvement retailer. Home Depot is, in fact, TTI’s largest customer and TTI’s sales to it have risen from 49% of its North American revenue in 2008 to 62% in 2022. Seen another way, TTI’s sales to Home Depot have risen from 3% of the latter’s cost of goods sold in 2008 to 6% in 2022 as it has grown and taken share.

TTI’s stock soared during the COVID years as it benefited from the stay-at-home boom in home improvement. But it has corrected materially since as expectations came back to earth and concern grew of a cyclical slowdown in the US housing market. TTI was also the subject recently of a short report, which led its stock to fall nearly 20% in a single session. While I believe the short report’s allegations are specious, the company is nonetheless going into a downturn with inventory at record highs and a stretched balance sheet (more on this below).

Over the longer term, there is a case to be made that TTI continues to take share from its peers; that as battery energy density improves, it continues growing in new categories like outdoor power equipment (“OPE”) and light equipment; and that Home Depot itself continues to take market share from smaller retailers and wholesalers, broadening the market for TTI products, particularly in the Pro category where higher-margin Milwaukee products are growing faster than TTI’s overall average. TTI also has room to keep growing its profitable after-sales battery line; into adjacencies like storage and personal protective equipment; and in Europe and other markets outside North America.

THE BEAUTIFUL BUSINESS OF LI-ION BATTERIES

Power tools were traditionally powered by compressed air, hydraulics, gasoline-powered mechanical engines, or electricity-powered brushed DC motors. Each solution tried to maximise its power-to-weight ratio but came with trade-offs. For example, gasoline motors create excessive heat, noise, and vibration. They are inefficient, prone to break and expensive to maintain. Their fumes are noxious, especially in confined spaces. And their emissions are terrible for the environment, as investment firm Harding Loevner recently wrote with reference to OPE:

Simply put, lawn care is an environmental disaster. Most consumer-grade leaf blowers, lawnmowers, and other OPE are powered by two-stroke engines—monumental polluters that burn gasoline and oil together. Gardening crews and homeowners using this equipment inhale noxious fumes containing benzene, formaldehyde, and particulates, all of which are linked to cancer, heart disease, and asthma. In California, blowers and other gas-powered equipment together produce more air pollution than the state’s 18 million automobiles. There, as elsewhere, lawnmowers contribute majorly to the damage: cutting the US’s 40 million acres of lawn consumes 600 million gallons of gasoline and emits 16 billion pounds of carbon dioxide each year; 17 million gallons of gas are thought to be spilled by refilling mowers.

The advent of efficient brushless DC motors in the 1960s and Li-ion batteries in the 1980s gave cordless tools an attractive enough power-to-weight ratio to become viable. These were clearly superior products: they are highly efficient, offer high speed (rpm), nearly instantaneous control of speed and torque, and do not require much maintenance. Batteries do away with the risk of tripping over cords and the need for diesel- or gasoline-fuelled on-site generators.

Even more so than doing good, what makes Li-ion power tools a beautiful business is its virtuous cycle: as the market grows, suppliers can justify larger-scale investments and R&D. These lower costs and improve performance, allowing manufacturers to offer consumers superior products at lower prices, further growing the market.

Akin to what Moore’s Law has done for consumer electronics, for almost two decades, this year’s power tools have almost always been better than last year’s. For example, ProTools Reviews cites that TTI’s Milwaukee Red Lithium battery series launched in 2010 offers up to 40% more run-time, 20% more speed and 20% more torque than its predecessors while running 20% cooler. It’s a great dynamic for keeping customers engaged and buying more.

BATTERY SYSTEM SWITCHING COSTS

TTI’s Ryobi and Milwaukee tools use common battery systems: the Ryobi ONE+ 18V system, and the Milwaukee M12 12V, M18 18V and MX Fuel 72V systems. These allow the same battery that powers your cordless drill to power your circular saw, impact driver, multi-tool, LED light, and hundreds of other tools. This convenience is especially valuable in the Pro category, where workers bring multiple batteries to a site to avoid expensive downtime waiting to recharge.

Common battery systems have created switching costs between power tool brands where none existed before. Why would you buy another brand’s tool when it won’t work with the batteries you already have?

Perhaps the most important display in TTI’s Hong Kong showroom is a cabinet showcasing each generation of Ryobi battery packs from 1996 to 2021. While the batteries inside the packs have made significant advancements over those twenty-five years, the packs’ form has remained the same. This commitment to forwards- and backwards-compatibility is the key to customer loyalty.

In comparison, SBD’s DeWALT 20V FLEXVOLT and 20V MAX systems offer limited interchangeability between different voltage systems, requiring users to invest in multiple batteries and chargers for similar tools. And Makita all but orphaned its 36V dual-battery system when it launched its new XGT 36V single-battery system in 2020.

The downside is that tool companies must keep adding tools to their line-up to discourage customers from leaving their systems. This results in a long tail of SKUs which do not sell as well as common tools like drills and saws.

The rise of Hong Kong-listed Chinese power tool manufacturer Chervon also speaks to an innovator’s dilemma. When designing its new Ego brand OPE, Chervon could use bigger, more powerful batteries because it did not have to ensure compatibility with a legacy battery system. These were far more suitable for the demanding needs of lawnmowers, ride-on mowers and other such products.

A similar dilemma may arise with the advent of superior battery technologies unless TTI can package them into its existing battery packs. For example, CAT has launched a range of graphene-battery power tools which claim four times longer life, three times faster charging time and less heat than Li-ion.

TTI’S FLYWHEEL & THE COMPETITION

To understand what makes TTI different and how it has taken so much share, it helps to consider the history of the power tool market.

My understanding is that many tool companies were founded at the advent of pneumatic, hydraulic, mechanical, and electrical technology in the 19th and early 20th centuries. Many of the brands which emerged would still be recognised today. But the market remained highly fragmented because most tools have niche applications; most brands struggled to grow out of their original verticals and geographies; and big box retailers like Home Depot did not yet exist to offer a channel with massive scale.

Growth plateaued after the initial wave of adoption and as early technologies matured. Industrial conglomerates emerged to grow instead through acquisition and cost-cutting, and probably to bulk up against increasingly dominant channel partners. This wave culminated in the merger of erstwhile competitors Stanley Works and Black & Decker in 2009 to form the largest company in the power tools industry.

Why bring this up? Because the strategy of inorganic growth in general – and this merger in particular – did not work. Successive management teams at SBD have failed to unite the collection of brands and technologies they stitched together. Instead, the company has reported restructuring charges every single year since its merger, totalling USD 3.3 billion as of 2022. And SBD has yet to cut, sell or buy its way to growth and success. Expert calls I’ve read are a litany of the death of once-great products and brands as R&D budgets were repeatedly slashed to meet quarterly earnings targets.

TTI initially pursued the same strategy, acquiring a string of brands in the early 2000s. But at some point, it changed tack. It leaned instead into developing its two leading brands – Ryobi and Milwaukee – and heavily re-investing into R&D to catalyse the virtuous cycle I described above: more powerful cordless tools, in more categories. We can enumerate TTI and SBD’s diverging strategies: since 2010, SBD has spent USD2.8bn on R&D and USD9.8bn on acquisitions; while TTI has spent USD5.3bn on R&D and USD0.2bn on acquisitions.

TTI’s playbook is quite simple: a) take share in existing categories with a superior product; and b) take the technology behind that superior product and introduce it to new categories. TTI CEO Joe Galli confidently spelt this out on an earnings call in April 2009 at the depth of the US housing collapse, and it’s worth quoting him in full:

We actually have two major drivers in our new product system that you should know about. The first is we believe the future of power tools is cordless. And TTI is rapidly becoming the global leader in cordless power tools. Last year, 2008, our cordless power tool business was up 34% worldwide. Our lithium cordless business doubled last year. We have jumped ahead of our competitors and we believe we are now in the vanguard of cordless technology of new product introduction.
The one part of the power tool market that's growing is cordless. Why? Because people are switching from corded to cordless. Why? Because lithium gives you more power, more capability in the same cordless tool than you could get with traditional nickel cadmium. So we are absolutely focused on winning in cordless. And you'll see a lot of highlights, a lot of new products we're bringing to market this year in our cordless program.
Then the second part of our new product flow is all about new businesses. People keep saying I don't understand how you could be growing, how can you outperform the market like you are? And the answer is, we're taking our core competence and we're moving in to near neighbour categories, business areas that we've never been in at TTI. And we're rolling out not one product, but whole programs, six, eight foot sections of new product that moves TTI into new categories that leverage our manufacturing and engineering capability that allow us to take market share from whole new sets of competitors.

I see no reason why TTI cannot continue executing on this same playbook to grow the market and take share from weak competitors.

It is doing particularly well in the Pro segment, thanks to Milwaukee’s superior products and its win-win partnership with Home Depot, which has been steadily taking share in that category from wholesalers thanks to its responsive service, low prices, expansive store footprint, well-stocked inventory and loyalty programme.

Milwaukee tools have higher gross margins than TTI’s other brands, and their growing revenue share has lifted the company’s overall gross margin. If Milwaukee comprised c. 50% of TTI’s sales in 2021, then why can’t it be 75% in 2031?

TTI has re-invested the gains into its flywheel to widen the gap with its competitors. This is evident in a chart of the company’s profitability: gross margins have increased while net margins have consistently hovered around eight per cent.

There are many other elements to TTI’s success:

Its Leadership Development Programme, through which it recruits college graduates and requires them to spend their first year selling products in-store.
Its expansive sales coverage.
The autonomy it gives each brand to manage its own sales plans.
Its in-house battery design team.
Supplier exclusivity gives more scale and lower costs.
Its early move into Vietnam to diversify its manufacturing footprint and lower costs.

But I will expand on these some other time.

ASSESSING THE SHORT REPORT

Jehoshaphat Research published a short report on TTI on February 22 this year, which I recommend you read if you are interested in TTI. The author went straight for the jugular: TTI’s curiously consistent gross margin improvements.

Short reports play into the psychology of loss aversion: we experience the pain of losses more viscerally than the joy of gains. You can ignore another sell-side report recommending you to buy a security. But it takes willpower to stay rational when a short report comes out, and others sell first and ask questions later.

In this case, it was clear that the author didn’t understand the dynamic I described above: Milwaukee is growing faster than TTI overall, and its higher gross margins are lifting the company’s overall gross margins. It was straightforward to dismiss this accusation. In their formal response, the company also disclosed for the first time that margins are receiving another boost from a growing share of after-market battery sales. These totalled almost USD1bn in 2021, up more than four times since 2016.

Jehoshaphat Research also challenged the probity of TTI’s R&D expense capitalisation and accounts receivable ageing. Were they cooking the books? These were difficult allegations for an outsider to disprove. In this case, I judged TTI unlikely to be a fraud because the extent of subjective judgements in its accounts did not seem material. The report compared TTI to frauds like Enron and Tyco for dramatic effect. But TTI does not rely on off-balance sheet entities like the former or inorganic growth like the latter. Moreover, while TTI has higher gross margins, its net margin is comparable to peers’; it simply has a different model, re-investing its gross profits into R&D.

Jehoshaphat published their report at an advantageous time when management could not respond due to black-out rules before their 2H22 earnings release. I, therefore, give much credit to the analysts at brokerage CLSA for their diligence during the days which followed (disclosure: I used to work there). Their team boasts a Chartered Accountant who drilled into TTI’s accounts details and gave them a clean bill of health. Their work helped me keep a level head, for which I am very grateful.

COMING BACK TO EARTH AFTER COVID

One criticism in the short report can’t be denied: TTI enjoyed explosive growth during the first phase of COVID by leveraging up its balance sheet to ensure it held enough raw materials and inventory to meet demand. But with the US housing cycle turning, and channel partners and competitors destocking, 2022 was a challenging year and 2023 looks set to be the same. TTI must now navigate the difficult part of the cycle with a stretched balance sheet and inventory days outstanding at record levels.

Was it worth stretching the balance sheet like this? I think so. As you can see in the table below, TTI was rewarded with substantial market share gains, which will persist thanks to the switching costs of its battery systems. (Note: that SBD’s 2022 revenue was boosted by its USD 1.6bn acquisition of the remaining 80% interest it did not already own in gasoline-powered OPE manufacturer MTD Holdings). What should also stand out to you is that TTI kept its gross margin stable despite its competitors destocking as the market slowed. This underscores Milwaukee’s ongoing strength and the profitability of fast-growing after-market battery sales.

Management has indicated they will prioritise reducing debt and inventory in the coming year. But they also stressed that high inventory is a strategic choice and that we should not expect it to return to previously low levels. I’ll quote their exact words:

A fundamental element to our strategy is to keep re-investing in our systems to enhance the overall value of the network using a “long tail” approach. As we add more niche products to the system, the gross margin of the product is higher, while the sales volume is lower. This strategy inherently increases the inventory days outstanding as lower volume, high margin SKUs have lower inventory turns than high volume SKUs with lower gross margins. This long-tail approach, coupled with our philosophy of maintaining service levels to our customers at above 98%, has resulted in the gradual increase in our Finished Goods on hand days.

Higher inventory must also be a cost of doing more business with Home Depot, one of the most capital-efficient businesses in America. It is also necessary to serve the Pro market, where busy contractors want a long tail of products immediately available.

THE US HOUSING CYCLE

Given the predominance of its sales to Home Depot, the US Housing market is likely the most important of TTI’s fifteen industry verticals. There are two ways to segment the US Housing market: New Home Construction and Home Improvement.

There seems little doubt that New Home Construction has peaked. In an excellent, in-depth piece, blogger The 10th Man concluded:

Despite a sizeable housing deficit that likely exists today, I think industry completions are at-or-near peak levels. Barring an immediate reduction in mortgage rates (which I don’t think is likely), affordability headwinds are likely to result in fewer completions and lower ASPs for this industry in 2023/2024. Beyond that, I think there is some support for new housing, but run-rate completions are probably 25% lower than 2022 if natural population growth continues to decline and net migration doesn’t change materially. Once the deficit gets worked off, this industry probably produces fewer run-rate units than it has been over the last few years.

Demand in the Home Improvement market is cyclical, too, but less so. And it is supported by longer-term trends like housing stock ageing and energy efficiency. Harvard University’s Joint Center for Housing Studies summarised the tension between short-term cyclical weakness and long-term secular growth in a recent survey:

After several years of double-digit gains, the pandemic boom in home improvement and repair is expected to slow in 2023 from its breakneck pace. The residential remodeling market faces many headwinds that may worsen over the near term, including high inflation, rising interest rates, slowing house price appreciation, and declining home sales. With uncertainty in the housing and labor markets, homeowners may scale back or defer high-cost discretionary projects, such as major kitchen and bath remodels and room additions. And remodeling firms continue to be challenged by disruptions in the building material supply chain and a skilled labor shortage.
Despite these concerns, many factors point to a promising outlook for the home remodeling market in the long term. The aging housing stock is in growing need of core replacements, such as roofing, windows, and HVAC systems, as well as increased spending for routine maintenance. Rising numbers of older homeowners will need to modify homes for improved accessibility and safety, and members of the huge millennial generation will move through prime ages for first-time homebuying and consequent remodeling. The recent Infrastructure Investment and Jobs Act and Inflation Reduction Act provide incentives and assistance to households seeking to retrofit homes for energy efficiency or resilience to the effects of climate change. Combined with the ongoing transformation of home uses and activities brought on by the pandemic, these factors are expected to support longer-term gains in home improvement and repair spending.

We can think about the Home Improvement market more granularly. At its 2022 Investor Day, Home Depot’s smaller competitor Lowe’s shared its estimate that Home Improvement has a total addressable market of ~USD1.0tn, of which two-thirds is spent on non-discretionary projects. They believe it will therefore prove less cyclical than feared.

Using data from the US Department of Housing and Urban Development, the Harvard Joint Center similarly estimates discretionary spending comprised 30% of Home Improvement spending in 2021, down from 42% in 2007 at the previous cyclical peak. The underlying figures are interesting, too: 28% of survey respondents reported undertaking discretionary work versus 84% who undertook replacement work (note: some respondents did both). The average ticket size for discretionary work was USD 14,520 and USD 7,669 for non-discretionary work. More people undertaking smaller ticket replacement work also seems more resilient to a potential recession. I would like to know whether more expensive discretionary work uses disproportionately more tools, but I don’t have the data.

Lowe’s also segments the Home Improvement market into DIY and Pro, with each taking an equal share. By all accounts, the DIY market has cooled since its peak in late 2020 and early 2021. I do not expect this to be a meaningful growth driver in the near-to-medium term, and it may continue to be a headwind as tool companies digest inventory (DIY products age faster). Nonetheless, it’s worth remembering this data from the Harvard Joint Center again, which suggests that DIY spending during COVID as a percentage of total expenditure was below previous peaks. Some of 2021’s surge may therefore have been catch-up growth from a low base.

The Pro market has proven more resilient to date thanks to the substantial backlog of housing construction currently underway and the backlog of home improvement work not yet complete. The latter is relatively easy to understand: homeowners are flush thanks to substantial home price appreciation and refinancing at record-low interest rates. Meanwhile, labour shortages mean work progresses slowly.

Both Home Depot and Lowe’s have guided that they expect the home improvement backlog to stay strong through 2023; in fact, they are counting on this and further market share gains to support their revenue this year. The companies’ stock prices, however, suggest scepticism.

TTI estimates that housing comprises ~7% of Milwaukee’s total revenue and 4% of the company overall. That feels low to me, intuitively, and I suspect their definition is narrower than I would like. But it is a reminder that there is more to the US construction market than just housing. Equipment rental company Ashtead reported that the >USD500m “mega-project” category is booming thanks to Federal government spending on infrastructure and semiconductors. Data from the US Census Bureau for February also shows that non-residential construction was up 17% y-o-y. TTI’s margins will also enjoy a cushion: non-residential sales skew to the Pro segment and the higher-margin Milwaukee brand.

VALUATION:

TTI’s valuation troughed in 2008 at ~2x forward earnings during the collapse of the US housing market. Unfortunately, the odds are extremely low that we will see those levels again. Back then, the stock was less liquid, and the company was much more leveraged and had not yet proven itself capable of leadership. More recently, valuations peaked at 36x forward earnings in early 2021 as investors extrapolated cyclically high growth rates forever. The stock now trades at 17x, up from the low of 14x it hit immediately after the short report. Its ten-year mean valuation is 20x.

WRAPPING IT UP:

Many good companies did well during COVID and are now being penalised for coming back to earth. TTI is one of them. While the next twelve to eighteen months will be choppy, there are plenty of reasons to be optimistic as it works its way through the cycle. FCF will improve as working capital normalises, though it’s important to acknowledge that TTI will never be a See’s Candies. It must continuously re-invest in R&D and working capital, albeit at attractive rates of return.

I haven’t touched much on management in this post because I think their achievements speak for themselves. Horst Pudwill still controls the company, and his son Stephan will succeed CEO Joseph Galli whenever the latter retires. Galli is sixty-four years old, and I expect him to have at least five more years in the seat. This is a point of uncertainty to bear in mind in the future.

As I wrote this, one thought that came to mind was the trade-off in investing between certainty and optionality. TTI is a known quantity which I expect to keep doing well by following the same playbook. There is an opportunity to potentially earn superior returns at this point, thanks to concerns about the cycle. Less established companies like TTI’s up-and-coming competitor Chervon may perform better thanks to their optionality, but that comes with uncertainty.

I naturally gravitate to companies I can understand and reasonably predict. But this begs the question, though: am I overvaluing certainty and undervaluing optionality? Likewise, how can minority investors in public equity systematically and successfully invest in optionality without becoming speculators? And how can one conduct sufficient due diligence to manage uncertainty while maintaining a high return on time? I would love to hear from anyone who has considered these questions.

My research also shows that TTI is one part of a very profitable value chain. Hopefully, growth will allow it to remain a blue ocean for everyone. In the future, I plan to read more into Home Depot and Lowe’s and battery manufacturers like Samsung SDI. It’s a habit to ask myself continuously, is this the best place for my money?

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.