Description

Macfarlane trades for 9.7x FCF, generates 25% a post-tax ROTC, has sustainable competitive advantages, almost no debt, and is run by an honest and competent management team. The opportunity exists because it is a boring small cap in the specialty packaging industry listed in the UK, trades £300k/day, and receives limited promotion from management or the sell-side. We see 85% upside over three years and a limited risk of permanent impairment of capital.

Situation Overview

Macfarlane provides specialty packaging in the UK. 75% of customers are industrial (auto, aero, medical, electronics) and 25% are retail (homeware, food & drinks, electronics). Customers include Thermo Fischer, Siemens, Honeywell, and Johnson & Johnson.

A typical customer may have a complex and fragile £5,000 aerospace part. Macfarlane will design packaging for that part, source corrugate, plastics and other materials from a network of suppliers, and store those materials on an ongoing basis while providing same-day supply when they are needed. Macfarlane’s solutions are typically under 10% of the value of the item being shipped and mean customers don’t have to spend as much on R&D, logistics, warehousing, operations, etc.

The company generates a 25% post-tax ROTC, £280mm of revenues, low to mid single-digit organic growth, 38% gross margins, 8% EBIT margins, and turns inventory over every 40 days. It is led by CEO Peter Atkinson and CFO Ivor Gray, both of whom are experienced and serious operators who under promise and over deliver. They have high integrity, a good customer focus, and track record of allocating capital well while carrying very little debt.

Atkinson joined in 2003 and has turned the company around by divesting wasteful acquisitions and loss-making expansions. He is focused on profits and has made around 20 bolt-on acquisitions at roughly 10x FCF. The stock has returned 15% p.a. over the last decade in a difficult period for UK small caps where the FTSE AIM All-Share index has returned 3% p.a. Macfarlane’s EBIT has also compounded at 15% p.a. over that period.

Atkinson’s compensation is reasonable at £650k p.a. over the last five years. His bonus is up to 100% of his base, with three-quarters payable on a profit before tax target. An LTIP of up to 100% of base vests on stock performance over three years and EPS growth. His stock ownership is relatively low like many UK executives at £1.3mm with another 1mm unvested performance shares, and the board lacks serious ownership. Nevertheless, we are encouraged given their track record and compensation targets.

Encouraging incentives extend throughout Macfarlane. The company is decentralized and split into 35 business units (largely depots). Each unit manager owns the P&L and is paid on the unit’s EBIT. The company has around 1,000 staff, of which over 100 are salespeople who earn a commission on gross profits above a target, not revenue. Hitting 95% of target means no bonus. Staff are additionally paid a bonus linked to the profit of their business unit or site.

This creates a culture of strong ownership, entrepreneurship, and profit focus. Former employees told us the main negative is that it can mean the culture is clinical and boring.

Economics

Over 60% of Macfarlane’s customers spend over £100k p.a. with the company. These customers speak to a sales rep, with only 5% of orders made entirely online. With 25% of customers pricing is linked off a paper index with time lags. With the other 75%, generally larger customers, it’s a negotiation.

70% of COGS are made up of corrugate (cardboard) and Macfarlane is able to use its size to negotiate better costs.

The fluctuating nature of input costs being passed on to clients means that gross profits are almost the real revenue line. High switching costs give Macfarlane pricing power over clients, and its scale gives it negotiating leverage with suppliers. When input costs spiked in 2021 the company was able to pass that on to clients, resulting in 26% revenue growth and 28% gross profit growth. Input costs and prices are declining now, but revenues were only down 3% in 2023 while gross profits were up 8%.

There is some risk that margins will shrink this year as customer sentiment may be weak, but overall we are confident in Macfarlane’s competitive strengths.

Competitive Advantages

The UK specialty packaging market is small subset of the overall packaging market; we estimate it generates about £1.2bn in revenues and £75mm in EBIT. The three largest players - Bunzl, Macfarlane, and Kite, have about half the revenues and the vast majority of the profits.

The market is orderly, with the big three players acting rationally. Pricing is disciplined.

Bunzl is a global conglomerate with £12bn in revenues. Their UK specialty packaging business is relatively small for the company and run by the broader packaging team. This team has found specialty packaging challenging as it is more consulting based with products specially designed to fit expensive products, unlike traditional packaging which involves buying and selling commodities. Bunzl has made three acquisitions in the last seven years and two of those management teams have left. The leader of one now works for Macfarlane and all three acquisitions were more difficult competitors before Bunzl bought them.

Kite Packaging is the other major player in the industry and was launched by ex Macfarlane executives after a botched acquisition under former management. Despite having 60% of Macfarlane's revenues Kite actually has 60% more EBIT and higher ROTC due to its higher margins and lower PP&E. Revenues per employee are £383k vs £290k for Macfarlane

While at first glance it appears Kite is better run, part of the reason the numbers look better is it focuses on customers buying less than £100k p.a. Half of these customers buy entirely online vs just 5% for Macfarlane. These customers do not require as bespoke a solution and Kite only has one distribution center. Still, Kite has done a good job. Macfarlane is relaunching its website in H2 2024 and expects it to be superior to Kite's.

Macfarlane has significant competitive advantages due to its scale and switching costs. This results in the company having pricing power, which it has not been afraid to use.

The company’s scale gives it bulk purchase discounts and better warehouse and vehicle utilization. That is important because customers expect same day delivery and Macfarlane is less than 1.5hrs away from most of the UK.

Macfarlane also benefits from significant switching costs. Customers told us that cutting out Macfarlane would involve hiring in-house expertise, going direct to numerous suppliers, building/leasing storage space and logistics, and investing in significant inventories given the lead times as they don't have Macfarlane's preferential treatment with suppliers. While going direct can often save a customer 10-15% in packaging cost, most customers believe this is not worth it given the relatively small cost of packaging against the product, the work this would involve, and the fact that capital would have to be invested to build out all the logistics.

The fact that Macfarlane supports the customer far beyond packaging itself ingrains it into the customer's operations and makes switching hard. Most of a customer’s packaging costs are 'hidden' (e.g. warehouse, customer returns, and utilization rather than just material costs), and Macfarlane is able to reduce those. As the CEO says, "when the major customers talk about pricing we just freeze pricing and say let’s talk about all these other areas we can help you".

As a result, Macfarlane face very low churn, with the customers over £100k churning at low single digits.

Customers told us that switching from Macfarlane to another competitor would involve several months work and face internal pushback. Nevertheless, customers do tend to have 1-3 suppliers to provide some competition and do shift their purchasing between the suppliers.

Use of Excess Cash 

Macfarlane’s main use of cash is in making bolt-on acquisitions. The company has made around 20 acquisitions over the last decade, mostly for 5-6x EBITDA pre-synergies which converts to 10x FCF. With limited organic growth that suggests a 10-20% IRR and corresponds with the company’s ROCE. Management only issued equity to fund acquisitions on three occasions, and each time issuance has been relatively small. Overall, we think management’s use of cash has been reasonable albeit not spectacular.

Macfarlane is considering a major expansion into Europe, which brings risks but if successful opens up a long runway for capital deployment.

The European strategy is driven by customers sourcing packaging on a pan-European basis and asking Macfarlane to expand. Pan-European means Germany, Benelux, and Scandinavia, the manufacturing hubs of Europe. The company has made several bolt-ons in Europe but is looking for a £50-100mm revenue acquisition to get to the scale necessary to serve European clients. The idea is to buy a large player with a quality management team that could then act as the platform to make Macfarlane's standard bolt-on acquisitions.

The base rate for companies replicating strong economics in new geographies is low and so we are skeptical this will create a lot of value. But at today’s stock price we view Europe as a free option.

Valuation

We estimate that run rate FCFE is £20.5mm. This is higher than reported net income as we added back the amortization of intangibles, pension contributions now that the pension is in surplus, FCF from the recent acquisition of Polyformes, and penalized for increasing UK corporate tax rates.

Assuming 3% organic growth implies FCF in three years is £22.5mm and that cash generation over the three years is £60mm after £5mm of working capital drag. We assume £20mm is paid in dividends and £40mm acquires £4mm of FCF. That implies total FCF of £26.5mm in three years. We value the company at 13x FCF, in line with historic averages, meaning £26.5mm FCF * 13x + £20mm dividends = £365mm or £2.3/shr for an 85% total return or 22% IRR.

We see significantly more upside in a Bull case where the European expansion works out, resulting in the company acquiring more FCF and likely gaining a much higher multiple.

However, what we like most about an investment in Macfarlane is actually the downside, where we see a limited risk of permanent impairment of capital. The company trades for 9.7x run rate FCF, has virtually no debt, and an honest and competent management team.

The biggest risk we see is that margins are higher today than they were pre-Covid. We believe this is sustainable. Margins have continuously improved since Atkinson became CEO, we believe reflect the company’s competitive advantages, and management is expecting further improvement.

Nevertheless, in our Bear case we assume EBITDA margins fall from 13% in 2023 to 7.5% at pre-Covid levels, and FCF falls to £12.5mm for a 40% decline. Then assuming no organic growth or acquisitions implies £40mm of cash generation. At a 10x FCF valuation that implies a value in three years of £12.5mm FCF * 10x + £40mm cash gen = £165mm or £1.03/shr, implying less than 20% downside in what we think is an aggressive scenario.

For these reasons we think an investment in Macfarlane allows an investor to sleep easily at night, which is welcome after the excitement from a day of reading about specialty packaging.

Catalyst

FCF growth and deployment.