NIBE the Swedish heat pump giant

The first issue of Tail Investing is on NIBE, a company that has minted a handful of billionaires from its success. Since its IPO in 1997, the stock has compounded at 31% annually and the company has grown from a small firm making tubular elements, heat pumps, and wood stoves into an internationally established heating firm with profits growing from 46 M SEK to 2868 M SEK between 1997-2020.

In 1989, NIBE was acquired from the founding family by management and two outside investors and then taken public in 1997. Current and former board members hold 46.1% of the shares and the CEO has been with NIBE since 1989.

In this case study, I first give a brief introduction to NIBE’s business and strategy. I then discuss the heat pump market development and NIBE’s business development. I divided this section into three parts: proof of concept, domestic replication, and international replication. After that, I discuss the ways in which NIBE stands out among competition and counterfactuals. Last, I discuss how the stock has traded over these periods, when an investor could have underwritten the company, and what the bear cases have been. 

NIBE's Business Description

NIBE develops, manufactures, and sells energy solutions for cooling and heating used in real estate, industry, and infrastructure. Example products include water heating, heat pumps, fireplaces, and different components used by OEMs (Original Equipment Manufacturers) such as pipe elements. The business is divided into three segments: Climate Solutions, Elements, and Stoves.

Climate Solutions is NIBE’s largest segment and encompasses their heat pumps, and is the focus of this case study. But the core technologies used in heat pumps - compressors, heat exchangers, expansion valves and steering equipment - are also core to NIBE’s element segment. In the early days of the heat pump industry, heat pumps depended on an alternative source during peak load (winter months). A common alternative was wood-fired stoves, which is NIBE’s third segment. Thus, all three of NIBE’s segments are interconnected.

Strategy

Since the Swedish real estate crisis in the early 1990s, NIBE has had three major financial targets: operating margin over 10%, maintaining ROE over 20%, and growing revenue by 20% yearly on average over a business cycle. They target revenue growth of 50% from organic sources and 50% through acquisitions. Between 2004 and 2020, revenue grew at a CAGR of 15% with an operating margin on average above 10% and an average return on capital excluding goodwill of 25%. NIBE achieves its organic growth target by GDP growth, increased market share, and establishing new markets.

NIBE’s internationalization strategy has been through acquisitions of small to medium-sized companies that fulfill five requirements:

• supplying NIBE with a new technology, market, or market share

• possessing a strong brand

• possessing competent management

• profitable or on a clear path of becoming profitable

• fosters development opportunities inline with NIBE’s strategies.

NIBE works with a decentralized structure and only achieves scale benefits through raw material purchases and productivity improvements in production. They otherwise keep operations independent.

Development of the Heat Pump Industry

In this section, I will discuss the early formation of heat pumps in Sweden, the replication period, and the international expansion of Swedish heat pump firms.  

Industry formation - Proof of concept

Heat pumps were first invented in the mid-1800s but did not become commercialized until the 1970s in Sweden. Increased interest in alternative heating solutions formed when the Swedish energy system got caught between the 1973 oil crisis and increased mobilization against nuclear power. This launched the early formation of the heat pump industry in 1975 despite policymakers' indifference to the technology. After a deep economic recession in the late 1970s, a second oil crisis in 1979, and a heated nuclear power debate, interest in heat pumps skyrocketed.

In the first half of the 1980s, there was a gold rush into the Swedish heat pump market and over 80 companies entered. NIBE entered the heat pump industry in 1981 by offering exhaust-air heat pumps in a package aimed at the construction sector. Market leaders in exhaust-air heat pumps in the 1980s were Elektro Standard, followed by NIBE and CTC. The largest producers of small heat pumps were Thermia, followed by IVT.

The incumbent oil boiler manufacturers mostly supported the transition towards heat pumps.CTC had major success selling oil boilers during the 1970s, but rising oil prices forced them to change their product range. CTC launched an exhaust-air heat pump in 1982, which became a gigantic success. The primary competition was from electrical heaters. Their low capital investment and technological simplicity made it an attractive alternative to heat pumps. Thus, despite heat pumps’ higher energy efficiency and lower environmental footprint, 75% of all new single-family houses built in Sweden in the late 1970s used electrical heating. But these houses usually lacked a chimney which had created a natural draft in the past. The lack of a natural draft led to moisture and mold, which pushed new building regulations to be developed. The new regulation mandated that new houses have ventilation and heat recovery of at least 50%. This gave home builders two options, install an exhaust-air heat pump, which NIBE produces, or use an efficient FTX heat exchanger, a ventilation system that recycles heat in a building. The exhaust-air heat pump was the most economical option and this regulatory change was a considerable factor in the exhaust-air heat pump market growth during the early 1980.

The mid-1980s saw oil prices drop significantly, which coincided with lifted subsidies on heat pumps which almost killed the entire industry. Lower oil prices, reduce the cost of heating with an oil boiler, and hence, reduce the economic benefit of investing in a heat pump. Demand for heat pumps - other than exhaust-air - dropped over 50% (some sub-categories dropped as much as 90%) forcing leading manufacturers, IVT and Thermia among many others, into reconstruction. The subsidy removal likely played a larger role in reduced demand, since increased taxes on oil kept the electricity-to-oil ratio stable.

Relatively unscathed were NIBE and the other exhaust-air manufacturers. This was because of the regulatory requirement for ventilation mentioned earlier, combined with a building boom in the overheated economy. But this came to an abrupt end in 1992 with a real estate crisis and skyrocketing interest rates. Between 1985 and 1995 the rest of the industry underwent a 10-year long dark winter with low sales for small heat pumps, and the large heat pump segment died out entirely. Companies left as fast as they had entered and in the end, less than 30 companies remained, as seen in the figure below.

The quick expansion in the early 1980s tainted the industry with a reputation of poor reliability. Many products during this time were subpar or not functioning at all. Part of the problem was that the market was growing so fast that the installers had inadequate time to educate themselves on the new heating technology. Some imported air-air heat pumps from the US but never adapted them to the Swedish climate, tainting the industry's reputation further.

To solve heat pumps’ poor reputation, the large manufacturers, such as IVT and Thermia, had integrated vertically and built specialized retail and installer networks. NIBE made the strategic choice of not integrating and stuck with its wholesaler strategy. Thus, at the end of the dark winter, the supply chain resembled the figure below, with Thermia School and IVT University working as education centers for their exclusive retailers and installers and technical universities and government agencies in some forms supporting the entire industry.

Domestic Replication Phase: 1995-2005

Several factors played a role in turning the heat pump market around in the mid-1990s. Key among them was a large housing stock in need of renovation, uncertain energy prices with oil prices increasing in 1995, and increasing electricity prices after the 2000s. Increased environmental awareness also drove demand. The Swedish government had decided on a five-year program to increase energy efficiency in 1991. This resulted in NUTEK launching a competition for heat pump manufacturers in 1993. The criteria for the competition was to develop a 30% cheaper and 30% more effective heat pump than what was currently available. The competition helped increase awareness about heat pumps and helped repair heat pumps’ bad reputation.

During the dark winter period, the heat pump industry matured and a standardized design emerged in the 1990s. The period also washed out more than half of the competition with Thermia, IVT, NIBE, CTC, and Elektro Standard as leading manufacturers in 1995.

The consolidation led to increased horizontal integration and competition between heat pump segments. IVT and Thermia both entered the exhaust-air heat pump segment, IVT in 1998 and Thermia a few years later. In retaliation for IVT, NIBE entered the ground-source heat pump segment. CTC also expanded to ground-source heat pumps in 1998.

IVT entered the exhaust-air market through an acquisition of Elektro Standard while Thermia chose the organic path. The exhaust-air heat pump market was reliant on new construction, and thus required relationships with home builders. IVT gained this from their acquisition while Thermia - whose product was similar on a technical level - lacked access to the right networks to make their heat pump a success. 

Despite Thermia’s failed entrance to the exhaust-air market, an investment in any of these companies after the consolidation would have made for an excellent investment. Between 1995 and 2006, heat pump unit sales grew from six thousand to 72 thousand (CAGR of 25%). Between 1996-2008, NIBE grew its revenue at a CAGR of 21% (617M SEK to 5810M SEK). IVT grew its revenues at a CAGR of 22% (131M SEK to 1 410M SEK) during the same period. Thermia grew its revenues from 120M SEK to 658M SEK between 1996 and 2008, a 15% CAGR.

Since 1995, the value network of heat pumps in Sweden has been stable and the only way for an international competition to get a foothold in Sweden has been through acquisitions.

According to the Swedish Competition Authority in 2015, NIBE had a market share of 40-50% for heat pumps sold in Sweden. IVT and Thermia each had an estimated market share of 20-30%. All other large international heat pump manufacturers had a share of less than 5%. A study showed that the most common heat pumps in 2003 were NIBE, Thermia, and IVT, thus a sign that the market structure has remained stable.

International Replication Phase: 2005 and beyond

The Swedish heat pump manufacturers had had an international presence since the 1990s, but when the Swedish heat pump market showed signs of saturation in the mid-2000s, the focus shifted towards internationalization. Between 2003 and 2008, Swedish exports of heat pumps increased from 172 MSEK to 1200 MSEK.

IVT, Thermia, and NIBE adopted two strategies when they expanded internationally. NIBE expanded by acquiring small to medium-sized companies in other markets, starting with Poland in 1995, then Finland and Sweden. Acquisitions then followed in Denmark and Norway, central and southern Europe, and later Russia and USA as well. IVT and Thermia were instead acquired by large international companies with their own distribution channels, Bosch and Danfoss, respectably.

Since both IVT and Thermia are part of large diversified companies, it’s hard to break out their success compared to NIBE. However, judging from their parents’ financials, growth seems to have slowed down while NIBE has continued its growth trajectory.

This phase is still ongoing and heat pumps represented ~3% of the global heating market in 2018. NIBE’s heat pump revenue of ~18 BSEK (2020) and self-reported TAM of ~500 BSEK suggest that NIBE’s growth can continue for the foreseeable future.

Below, I will try to highlight the contrasts between NIBE and its competitors to decode NIBE’s success over its peers both locally and internationally.

Counterfactuals

I think all the market leaders that survived the dark winter would have been excellent investments during the domestic replication period. However, NIBE still stands out among them. In this section, I will try to highlight what differentiated NIBE from its competitors.

Strategic Focus on Exhaust-Air Heat Pumps

NIBE entered the heat pump industry in 1981, early in the gold rush era. IVT and Thermia were already market leaders yet NIBE managed to gain market leadership. A large part of this could be due to NIBE’s strategic focus on exhaust-air heat pumps marketed towards the construction sector. These heat pumps did not suffer to the same extent in the downturn after 1985 because of the boom in construction along with the regulatory change that made exhaust-air heat pumps the most economical option. This left NIBE financially strong while IVT and Thermia were forced into reconstruction. Thus, I think this strategic focus helped position NIBE well for the eventual boom that was to occur in 1995 and forward.

The reconstruction likely hurt Thermia’s and IVT’s company morale and affected their respective specialized retail network and installers. For example, Thermia had fired over 90% of its workforce by 1992, compared to before the crisis.

NIBE was not the only exhaust-air provider but was one of the few offering only exhaust-air heat pumps. For example, CTC was a leader in the exhaust-air pumps but also provided other types of heat pumps with their launch of an air-water heat pump right before the market downturn in 1985. Thus, NIBE should have been among the least affected by the downturn.

Ownership structures

During the dark winter between 1985 and 1995, the surviving heat pump manufacturers went through several ownership changes. Thermia was first sold in 1984 and then again in 1986. The owners between 1984 and 1986 did not value the company strongly enough and more or less gave away the company. In 1986, the new owners started selling the company’s facilities and then hired two consultants to implement just-in-time production. The new owners eventually invited the consultants to take over leadership at Thermia, along with a new CEO. However, an internal strife between the new owners and distrust among Thermia’s retailers resulted in poor performance for the company. In 1992, Thermia entered bankruptcy and the new CEO eventually sold the company. Thermia remained under this ownership until 2005, when they sold it to Danfoss.

IVT went through six ownership changes between 1985 and 1989. First, at its peak, the founders sold it to Frico who sold it back to the founders in 1987 after the market had collapsed. Then it was sold and merged with Triator to become IVT-Triator. This new entity was later sold to an investment company that planned to IPO IVT-Triator along with other industrial companies in 1989 but the launch was fraught with problems and the investment company sold IVT-Triator to a private investor who owned the company until 2005 when he sold it to Bosch. After the 1989 ownership change, IVT focused on air-air heat pumps which still were not properly adapted to the Swedish climate and fraught with reliability issues.

CTC also went through multiple ownership changes and was at one point part of the same group as Thermia. Later Thermia and CTC were separated and CTC ended up in SAAB-Scania’s ownership where they merged CTC with two other companies to create CTC/Entertech. There were some inter-group-related conflicts and in 1988 SAAB sold CTC/Entertech to the Trelleborg group and concentrated on HVAC-oriented production. In 1993, Trelleborg sold CTC/Entertech to Wolseley. In 2016, NIBE acquired CTC/Entertech.

In 1989, NIBE underwent one ownership change when management, along with two outside investors, bought the company from the founding family.

Wholesale

Early in the heat pump industry formation, reliability was poor. Besides air-air heat pumps not being adjusted for the Swedish climate, a large part of the reliability issue was in faulty installations. To solve this issue, most of the large manufacturers integrated vertically into the supply chain and started their own networks of dedicated installers and retailers, thus taking responsibility for the installations.

NIBE, who entered the ground-source heat pump market at a later date, chose to never integrate and continued using wholesalers. Here, NIBE benefitted from the improved industry reputation without the cost of training retailers and installers. Selling to wholesalers is one of NIBE’s primary advantages in Sweden because it does not compete directly with customers nor limit its offering to a select portion of retailers and installers.

This strategy has worked better in Sweden - where competence is high among installers - than in other countries where heat pumps are still a new technology. For instance, there have been cases where homeowners have thrown out their NIBE heat pump and gone back to gas-fired heating. In one case, the issue according to NIBE, was that the house lacked proper insulation, an issue a competent installer would have noticed in advance and informed the homeowner about.

After IVT was acquired by Bosch and Thermia by Danfoss in 2005, both companies have reverted to wholesalers, something that caused a stir in their dedicated retailers and installers network who had to buy the branded products at a higher price than competing retailers who bought the same product under the Bosch or Danfoss brand name at a much lower price. Thus, it’s possible to argue that NIBE has gained from a strong and competent leadership team while the competition has mismanaged their assets, possibly helping NIBE take market share from both IVT and Thermia.

International expansion

The Swedish heat pump industry is seen as world-leading. The early development of the Swedish heat pump industry has given them a first-mover advantage and IVT/Bosch, Thermia/Danfoss and NIBE have been among the largest heat pump manufacturers in Europe as of 2015.

When expanding, NIBE used an acquisition strategy of small to medium-sized companies while Thermia and IVT sold themselves to larger companies, believing an international distribution network would be a better fit for expansion.

NIBE’s strategy seems to have worked better and this could be for the same reason that IVT’s expansion into exhaust-air heat pumps worked better. If there is a rigid supply chain in place in the new market, NIBE can pay for distribution access through acquisitions - as IVT did for exhaust-air heat pumps - while the large distribution networks cannot penetrate the right networks. This is also similar to how Bosch and Danfoss entered the Swedish market.

With the benefit of hindsight, it is interesting that IVT thought it was better to use a large distributor for expansion, given their success with Elektro Standard. It should have been clear in 2005 that the entry barriers are potentially very high, making it hard even for large companies such as Bosch to penetrate the European market. Potentially affecting the decision was that IVT had tried acquiring a Swiss company, which turned out to be unsuccessful.

Alpha Generation

NIBE’s business development can be constructed into three parts: proof of concept, domestic replication, and international replication. But from a stock perspective, there were two periods when the stock significantly outperformed the general market. The first one corresponds with the domestic replication period and is between mid-2000 and mid-2007. The second one starts 6 years later in mid-2013, which coincides with increased sales of heat pumps across Europe in 2014.

NIBE’s business has performed well during the entire period of 1995-2020. Most of the volatility in NIBE’s business was during two periods, 2005-2006 with a slowdown in domestic sales of heat pumps, and around the 2008 financial crisis. During the former, NIBE saw a sharp drop in gross margins of 600bps (from 33% to 27%) but quickly stabilized again around 30% in 2006. In the latter, NIBE’s growth slowed down between 2007-2009 (around 8% in 2007, 2008, and -1% in 2009) but then quickly increased again. Gross margins remained stable at around 30% and operating margin dipped to around 8% from 10%.

Since 2010, gross margins have been remarkably stable around 35%, and before that slightly more volatile around 30%. Operating margins have followed gross margins and stabilized around 10%.

Return on capital, excluding goodwill, has been on a high level and has increased slightly in recent years, while ROE has been trending downward because of goodwill.

Despite superb and profitable growth, NIBE's stock never experienced multiple expansion besides a short period at the end of the domestic replication period and after 2019. The median P/E and EV/EBIT multiple have been 20x and 16x, respectively.

The first alpha creation period was supported by strong heat pump growth domestically and the stock followed the business fundamentals. Between 1995 and 2006, unit sales grew at 25% CAGR while NIBE grew revenue at a ~21% CAGR. As I’ve stated earlier, all the leading manufacturers would most likely have made an excellent investment at the beginning of this period.

After the financial crisis, NIBE’s business and stock price decoupled slightly. The business progressed adequately, with NIBE growing faster than the heat pump market while the stock largely followed the market. Not until mid-2013 does the second alpha creation period start, which coincides with increased sales of heat pumps across Europe in 2014.

Key Decisions & Feedback Loops

There were two alpha creation periods for NIBE. I think an informed investor could have figured out that NIBE would have been an excellent investment at either, but that there were more uncertainties in the first period compared to the second.

In the first period, mid-2000 to mid-2007, an informed investor could have known that:

• the market had matured with a standardized design, increased consolidation and a maturing supply chain

• there was an acute interest in reducing carbon emissions and that heat pumps were a suitable solution

• there was evidence of high barriers to entry given Thermia’s failed attempt at entering the exhaust-air pump market.

• Sweden was ahead with its heat pump transition and that the world would likely follow, thus both a first-mover advantage and a large TAM.

Therefore, an investor could have known that the heat pump industry was a good industry to invest in. Less known was if NIBE, Thermia, or IVT were the right company to bet on. Here, NIBE was the only publically available company.

I’m not sure an investor would have had enough information to assess their ability to expand internationally yet, even if the heat pump manufacturers had done so. Obviously, NIBE’s international expansion helped EPS growth during this period, but a large majority of their sales were in the Nordics. Thus, I don’t think NIBE would have turned into a poor investment even if expansion was unsuccessful, rather NIBE would have stagnated after 2008.

The real bear case for the heat pump manufacturers was a repeat of the dark winter period between 1985-1995. Especially given that NIBE had expanded into more heat pumps segments and was not solely dependent on the construction sector anymore.

Cyclicalities in the heat pump sector was to be expected and should have been a known unknown to investors. The big difference after 1995 is that the market had consolidated and high barriers to entry existed compared to the previous period. Heat pumps also had a tailwind behind them as oil and gas boilers were being phased out and replaced by heat pumps, even if policymakers created a whiplash effect on demand with the introduction and removal of subsidies throughout the early 2000s. The limited supply and growing demand should have reduced the risk of a new dark winter.

The financial crisis tested the heat pump manufacturers' resilience. Macro-economic uncertainties and low oil prices weighed on the heat pump sector and demand remained subdued all the way till 2014. During this period, NIBE had an 80% drawdown.

Despite the low demand for heat pumps during 2008-2014, it never seriously materialized in NIBE’s financials, besides in 2009 when sales decreased by 1%. Otherwise, NIBE grew between 7-25% and kept its operating margin around 10%. Investors should have lost all fear of a new dark winter after the worst of the financial crisis was over.

Between 2008-2014 I think NIBE should have been quite obvious as an investment despite the macro-economic uncertainties. The tailwinds remained and heat pumps gained traction in Europe. NIBE was growing profitably and was trading around a P/E of 15x. Investors were clearly not factoring in the economy turning at some point, nor the tailwinds for heat pumps or that NIBE would be its beneficiaries. I’d like to highlight that an investor did not have to buy NIBE at the height of uncertainty but could have waited even as late as 2015-2018 as NIBE’s returns have mainly come from EPS growth rather than multiple expansion. Stated differently, investors had a buying opportunity for a 10 year period.

The Swedish heat pump market had shown signs of saturation around 2006 and for NIBE to keep growing, it had to expand internationally. The bear case after the financial crisis was NIBE’s ability to expand internationally, especially given that the value chains were less developed and NIBE’s strategy to sell to wholesalers had led to problems in the past. Thus, there was a risk of NIBE reliving the experience of the mid-1980s, where faulty installations led to a poor reputation and slowed down the transition towards heat pumps. This could also have resulted in competition winning the local market.

Even if this was a genuine risk, I think an investor would have to weigh it against the first mover advantage of NIBE, and other Swedish manufacturers, with over ~25 years of heat pumps experience and NIBE’s ~15 years of experience operating internationally. There were also no signs in the financial statements to support this bear case.

The first-mover advantage, in this case, is immense. Production of heat pumps has clustered around certain areas of Sweden where NIBE, Thermia, IVT, et cetera had their production. Manufacturing that was once outsourced to low-cost labor countries has moved back to Sweden again, upon the realization that there is enormous value in having production and development closely located.

Takeaways

During the industry formation period, there was incredible business volatility, and it was probably impossible to know which of the companies would be successful. But after market consolidation and the emergence of a standardized design, business volatility decreased significantly. I think business volatility is almost synonymous with the randomness of competition. Thus, I think the high barriers to entry are the primary contributor to the reduced business volatility.

This case study has also given me some perspective on patience and long-term thinking. It took 25 years for the heat pump sector to reach the replication phase where it would make for an excellent investment. After NIBE reached the replication phase, an investor could have invested any time during the entire period and still outperformed the market over the long-term. There is thus no need to rush into quality companies if you are a long-term investor.

In the replication phase, I think stock volatility was a lot higher than business volatility and should have thus been exploited by investors. Looking at the figure below, this becomes clear. In the financial crisis, the stock had almost an 80% drawdown while NIBE’s EPS remained fairly stable. As long as the replication thesis holds, the right strategy is to average down in each correction.

Yen Liow has been a big inspiration for me to launch a case study-based newsletter. Thus, I thought I should include some characteristics he had found to be true for companies he calls horses. These are companies that compound for a long time and are characterized by:

• a niche they dominate and a large TAM to grow for the next 5-10 years.

• an ability to translate that into EPS growth at 2-3x the market rate

• a quality management that is also ethical, highly capable, hungry and aligned with shareholders

• additive, and not detrimental, balance sheets

• fair valuation

• being in the replication phase of their lifecycle.

Given this checklist, and that management owns 46% of the company and that the equity ratio has never been below 30%, I think NIBE had all the signs of what Yen calls a horse.

Yen has also found that the output of a company with a strong moat has the following characteristics:

• high competitive win rate

• high and stable gross margin

• high incremental return on capital

For an investor, it could be hard to judge if these factors were at play during the first period between mid-2000 to mid-2007, but at the second alpha creation stage, after 2014, it should have been obvious.

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For readers interested in learning more about the history of heat pumps in Sweden, I highly recommend reading Petter Johansson's doctorial thesis A Silent Revolution: The Swedish Transition towards Heat Pumps, 1970-2015. It has been instrumental to this case study.