This is a microcap idea and therefore is only suited for small accounts.

Synopsis:

Mod-Pac is a cardboard box company. It’s not that exciting, but the company has a clean balance sheet and is trading for about 3x 2011 EBITDA. It’s just emerging from a number of very tough years, and soon the earnings power should become apparent to investors. The company is buying back its own stock despite the illiquidity. Insiders own a third of the firm and are buying more stock. Unlevered free cash yield is more than 15%. The firm’s end markets are not very economically sensitive (food is the largest).

Business Overview:

The vast majority of MPAC’s business is making cardboard boxes. The boxes hold things like chocolates, cereal, candy, medical devices, and things of that nature. Covidien (COV) is actually the largest customer at about 17% of sales. Some of the competitors include Rock-Tenn and MeadWestVaco. The very small remainder of the business is making custom printed paper goods – things like napkins for weddings and family reunions. I suspect this segment is EBIT negative but overall it’s not at all material to the results.

In the box business, MPAC does not usually compete head to head with the big boys Rock and MWV. Instead of printing out a few million Cheerios boxes or Hershey boxes, they specialize in smaller production runs. These runs are not efficient for the typical RKT plant, as they entail much more setup/takedown time. As a result, these folks have actually been dropping some smaller accounts, and MPAC have been picking them up.

One example might be Hershey itself. While a RKT might print the stereotypical brown boxes for the common Hershey bar, MPAC is actually a Hershey supplier too, except that it makes boxes for a niche, limited run Hershey chocolate stick.

One of the biggest drivers of MPAC’s growth is private label. Private label, broadly defined, is probably 40% to 50% of the business today. When I visited the plant in Buffalo, I saw probably several hundred thousand private label cereal boxes. When you make private label boxes, you frequently have to make small alterations to the box depending on the retailer that’s the end customer. This limits the print runs, and therefore is not easily won by the huge companies in the space. For example, I saw a ton of “Froot Loops” type cereals, but some boxes may be “Country Inn Froot Loops” and some boxes may be “Auntie May’s Froot Loops”. All the boxes are being filled at the same cereal plant.

I wouldn’t say this is a great business deserving of Warren Buffet, but it’s not a bad one and deserves to trade for a higher multiple than it does today. For several years prior to this year, the company had been under stress and had changed itself quite a bit. I think this is currently causing the stock to trade the way it does.

History of the Company:

MPAC was actually a spin off from Astronics, a $400M aerospace company back in 2003. Astronics is run by MPAC’s current CEO’s father, who is currently MPAC’s chairman. At the time, MPAC was actually very fast growing. The biggest source of that growth was an outsourced printing relationship with Vistaprint, a $1 billion cap company founded by MPAC’s CEO’s brother. By 2005, Vistaprint grew to be 35% of revenues and was probably the most profitable part of the company.

In 2005, as VPRT was trying to go public, the company’s investment bankers essentially told them that it looks really bad to have outsourced this vital function, and to a closely related party to boot. So VPRT bought its way out with a $22 million settlement that year and took its printing in house.

Unfortunately for MPAC, even though it got $22 million dollars, a huge chunk of its business disappeared. It had invested a lot of money in the immediate preceding years in new equipment to accommodate the growth of VPRT. That equipment was essentially idled. The company worked on growing the other parts of the biz, especially the custom folding cartons, to fill capacity. The box business did grow fairly rapidly, but it was not able to overcome the loss of VPRT. Plus, back then, the company had a struggling commercial printing business and personalized printing (custom napkins, which doesn’t make money) was larger. As a result, the company struggled with losses. The only silver lining is that capex has been below depreciation as they have been trying to fill this capacity with new business.

Of course a few years later, when they haven’t fully recovered, the recession hit. The commercial printing business was hit hard. In 2009, this entire business line was shut down and the firm is now nearly a pure play box maker. This had a visibly positive impact on the cost structure, and I think it freed up a lot of management time and sales force talent which paved the way for a strong recovery. At its peak, the company employed 490 employees. Earlier this year, they troughed at 340. This important because besides paperboard (maybe 40% of COGS), labor is a close second in the cost structure. They have actually started to add slowly to its workforce, and currently employ about 360 people. If you look at the sales numbers and compare to their workforce, you can see that labor productivity has improved quite a bit in recent years.

I should emphasize, throughout this time period, the growth of the custom box business has actually been substantial. In 2005, boxes did $23 million revenues. 2011 is shaping up to be more like $43 million. This is a very good rate of growth for a mature industry. Management talks a good game about providing better service levels to customers and such. I tend to usually discount such talk, but in this case they had clearly been successful in winning market share.

In either case, the company entered profitability in 2010 after four years of losses largely on the strength of box growth. Profitability should improve greatly in 2011 as boxes grew 20%.

Financial Exhibits:

As you can see here, MPAC has been able to earn pretty decent incremental margins, and is on track for low teens EBITDA in 2011.

Looking Forward:

I think the private label story is compelling, and should drive growth faster than the industry average. However, the years of 20% growth are certainly behind the company. Furthermore, the company has picked much of the lower hanging fruit in utilizing the idled equipment, and the factory is running 3 shifts a day, 5 days a week. I’d expect capex intensity to pick up a bit in future years.

The firm has a huge 500K sqft facility in Buffalo. About half of this space is currently not utilized (it’s rented out as warehouse space). There is plenty of room to incrementally add capacity and de-bottleneck to accommodate growing volumes if need be.

Here are my financial projections for the next two years. I do not believe any of these assumptions are at all heroic.

If we assume DD&A equal to capex going forward, the business will be generating somewhere around $3 million in free cash per year, equating to 15% FCF/EV. The company has been trying to buy shares, and recently was able to buy several good blocks totaling 185K in a quarter, but with the liquidity the way it is, I doubt they’ll be able to deploy as much into share buybacks as they might want. MPAC has never been particularly acquisitive, and the management shows little inclination to veer in this direction. It would be a very good thing if they started paying a dividend, and the co at least seems receptive to the idea.

Management:

We have some good news, bad news here. On the good side, the business is reasonably well managed. They have dealt with some very unfortunate events and have managed to make out fairly well from it. From what limited evidence we have, the deployment of cash has been decent as well. CFO Dave Lupp seems to run a lot of the daily operations on top of the financials related duties (not like there’s a ton going on here on that front) and has a very deep knowledge of the business. He has been a huge part of MPAC’s turnaround since joining the company in 2006.

On the negative side, there is a dual share class with super voting rights in place. The CEO and his father own very substantial portions of both A and B class stock, which although aligns their interest, certainly takes away from the rights of minority shareholders. I think they are somewhat overpaid (no surprise) and there are some minor annoying governance things like the company paying club dues and other perks.

I will note though that the CEO’s father is in his late 70s. I’m wondering if when he retires, the current CEO will move up to Astronics, which would put MPAC in play. The facilities are very good, and I wouldn’t be surprised if a RKT or even a financial buyer would take a look at them.

Valuation:

I had been working inconsistently MPAC for several months now. And unfortunately the stock has appreciated over a buck during that timeframe. I finally got around to touring their facilities and spent a significant amount of time with all of the management team a few weeks ago, and decided to write it up for VIC.

This is obviously not going to make you rich. That said, in the 5’s, the stock was just stupidly cheap. Even in the 6’s, given the non-cyclicality of the end markets and lack of financial leverage, it’s hard to see a lot of downside. On the other hand, I can certainly visualize the stock in the $10-$12 range, which would imply a 10% or so FCF/EV, and a low-teens forward P/E, and 5-6x EBITDA. For a risk/reward play, I think MPAC is still compelling.