Description

I.                    Investment Thesis

UFP Technologies (“UFP” or the “Company”) is a high quality business with an operationally best-in-class management team and considerable strategic value. However, the Company has long been undervalued by the market due to corporate governance shortcomings, poor disclosure, and an inefficient capital structure. The company in the final innings of a restructuring plan/plant consolidation effort which has caused its recent financial results to be below its historical and potential earnings power; I estimate that normalized 2015 EBITDA could be ~$25.4 million, vs. just $18.3 million as-stated, implying a valuation of ~6.0x normalized EBITDA -- much too low for a business of this quality. Moreover, UFPT inexplicably owns amost 800k square feet of industrial real estate, which I calculate could be sold/leased back for an amount that would reduce the implied valuation to just 5.2x normalized EBITDA.

In addition, the recent addition of an activist investor (that has the ability to do PE) to the shareholder base, and a subsequent 8-k suggesting that at least one director will not stand for reelection this year, suggests that there is a smart investor working behind the scenes to improve corporate governance and capital allocation, and possibly initiate a sale of the business.

II.                  Key Investment considerations:

•     Attractive Financial profile:

o   Compelling valuation, as described elsewhere in this write-up

o   High margin (29.5% peak GMs, currently depressed at 27.0%), high ROIC (19.4% 10-year average) business model driven by short-run, somewhat highly engineered, made-to-order products

•       Stable, Growing Revenues

o   UFP products spec’d into OEM customers’ products: 90% - 95% recurring revenue vs. prior year before extensions/upgrades

o    Thousands of customers, largest of which is ~5% sales

o    mid-single digit organic revenue CAGR over last 12 years; mid-teens EBITDA CAGR (depending on adjustments); Book Value CAGR in the very high teens

• Durable Competitive Advantages

o    Largest player in fragmented mkt (est ~14% share, 1.4x RMS)

o    Cost advantages due to supply, scale economics

o    Pricing power due to robust engineering capabilities and ability to convert multiple materials; UFP is sole-sourced for existing products and often sole-source for exist. cust.’s new applications

•       Multiple Opportunities for Further Value Creation

o   Company overcapitalized with 19% of mkt cap in adj. net cash

o   796k ft2 of non-core owned real estate could yield after-tax proceeds of ~$36 million, offset by less than $3m of new rent

o   Oppty to reduce mfg O/H and expand GM% by at least 250 bps; over $2m of expected annual cost savings from plant consolidation yet to be realized.

o    UFP is largest player and obvious consolidator in a $2 - $3 billion, highly fragmented market (est. 200+ Mom & Pops)

o   Significant free cash flow generation supports return of capital

III.                Business Description

UFP Technologies (NSDQ:UFPT), a Delaware C-corp headquartered in Georgetown, MA, is North America’s largest custom converter of foams, plastics, and other natural materials into components and specialty packaging products for a diverse array of end markets including medical, automotive, aerospace & defense, electronics, industrial, and consumer.

UFP now reports in just one segment, but previously it reported in two segments, which I believe to be useful information:

Its Component Products segment (67% last mentioned sales; 63% last mentioned EBITDA) designs and manufactures custom engineered components that become subassemblies of customers’ products. UFP has expertise working with multiple raw materials including foams, plastics, molded fibers, fabrics, natural fibers, films, and adhesives, and its products are spec’d into products across thousands of applications in markets including Medical, Automotive, Aerospace & Defense, Electronics, Industrial, and Consumer.

UFP’s Specialty Packaging Segment (33% last mentioned Sales, 37% last mentioned EBITDA) designs custom packaging to present and protect customers’ products. These products are typically repurposed foam, plastics, or fiber, and also serve thousands of applications in the same end markets.

IV.    Capitalization

On the surface, UFP’s capitalization looks as follows:

V.      Real Estate/Margin of Safety

UFP owns 796,000 square feet of industrial real estate, despite the implied unlevered return on such capital being in the low single digits (as compared to LT average of ~20% for the remainder of the business). I did a property-by-property analysis and ran it by a senior industrials-focused CRE broker and came up with a conservative range of values of the land and buildings of $33.1 million to $47.6 million, against an est. tax basis of $28.6 million (based on gross land and building PPE). This suggests mid-point after-tax proceeds from a sale-leaseback of $36.2 million, against roughly $2.9 million of new rent (in other words, the company could sell its real estate for net proceeds of 12.5x EBITDA).

Although I do not believe that management intends to monetize this real estate any time soon (absent intervention by an activist), it should underpin the valuation of the stock and would be considered by any potential acquirer if a transaction were to occur.

VI.    Leading Market Position

UFP has an enviable market position that a buy-and-build oriented investor could get extremely excited about, as the Company is the largest player in an enormously fragmented market. UFP Management estimates that its current addressable market is $2 to $3 billion (of which ~$1 billion is for flexible foam-based technical products) and that each time it launches a new product offering or enters a new end market, its TAM expands. UFP is the second largest player in the custom conversion/technical products space, with 0.9x RMS as compared to FXI, the largest player (and UFP’s primary supplier), based on my analysis:

Whether public market shareholders benefit from this position by virtue of a more aggressive add-on policy with the company’s balance sheet, or because a private equity firm or other buyer pays for the implied platform value, remains to be seen.

VII.   Sustainable competitive advantages

UFP has a number of compelling competitive advantages that reinforce the narrative that it is a high quality business:

•       Spec’d into customer products

o   UFP products are sub assemblies that are spec’d into customers’ end products. UFP has thousands of customers with long-lived projects, so 90%+ of its sales are recurring (and not competitively bid) each year. UFP has significant pricing power when these projects are renewed as they are effectively a sole-source supplier once they win a contract.

o   When existing customers develop new products, UFP typically gets a first or only look at the RFP given its compelling value proposition relative to its mom & pop competitors. Even when a new project does go to a broad RFP, it is hard for competitors to beat UFP on high margin/custom products given UFP’s superior engineering capabilities and lower cost basis for technical products

• Ability to Offer Customers Any Material

o   UFP is unique amongst competitors in that it is material neutral/can design and convert almost any relevant material into a component or packaging product for its customers. Most competitors only have the ability to convert one type of material.

o   As previous UFPT write-ups have noted, UFP mgt likens the company to a car dealership that carries every car in existence, competing with dealerships that only carry Toyota (for example). UFP can thus ensure that it helps its customer find the right car, whereas competitors are focused on selling the Toyota, whether or not it is the best fit for the customer’s needs.

• Favorable Vendor Relationships

o   UFP is one of 25 approved purchasers of foam raw materials from Foamex (“FXI”), as well the exclusive US buyer for Zote foam, giving it significant procurement advantages over smaller competitors who have to purchase foam from second-step distributors.

o   UFP is likely the largest purchasers of cross-linked foam in the United States, giving it a supply/cost advantage even against other approved purchasers from FXI. UFP believes it achieves a 15% - 20% discount on raw materials vs. its average competitor.

• Significant Investment in Research &  Technology

o   UFP maintains multiple clean rooms (which cost in some cases millions of dollars to build), enabling it to manufacture products for the medical industry and other applications which require a clean room manufacturing process

o   UFP had 64 engineers on staff as of January 2012 (the last time it disclosed employees by segment), a significant investment in personnel that would be difficult for a smaller competitor to replicate. Moreover, these engineers have created multiple proprietary end products, any of which could become the “tail wagging the dog” of UFP’s financial results.

o   UFP currently possesses 22 active patents in addition to trademarks and significant proprietary “know-how.”

o   UFP has the ability to custom design machinery for its own factories that give it significant proprietary manufacturing capabilities

• Most obvious consolidator in Industry

o   UFP mgt estimates that it has ~200 mom & pop competitors, few of which have sales in excess of $20 million, representing a significant consolidation opportunity. Mgt believes many of these business owners are at or approaching retirement age.

o   When UFP does tuck-in acquisitions, it pays a small premium to NAV for the smallest companies, and 4-6x EBITDA for businesses with <$3 million of EBITDA, suggesting a compelling roll-up opportunity

VIII.             Underearning and Implied Valuation

Perhaps the crux of the thesis is that UFPT significantly under-earned in 2014 and 2015 relative to historical and potential results. The reasons for the underperformance are due to idiosyncratic roll-offs of high margin projects that were offset with lower margin projects (often government backed, which spending has been under pressure), compounded by the company’s multi-year real estate consolidation project, which has not only resulted in significant reduction in profits (not all of which is captured in restructuring costs), but has also likely distracted management from optimally managing the core business.

For 2015, I calculate adjusted EBITDA and PF EBITDA as follows:

Note that the only difference between FY15 and PF15 is that in PF15, I assume the company is able to achieve a mix of business which enables it to realize the 29.5% gross margins it achieved in FY13. I don’t have a specific timeline for a return to this margin level, but the 26.5% GM earned in 2014 and 27.0% in 2015 were idiosyncratically impaired by an unfortunate mix of business and manufacturing inefficiencies from the real estate consolidation. I have no reason to believe that UFP won’t return to a more normal GM, and believe there could be room for further GM expansion beyond in future years. In that sense, PF2015 is less “this is what the business really did in 2015,” and more, “this is how the business would perform in a normal year based on a similar sales level.”

IX.                 Implied valuation

If you assume that UFPT does a sale-leaseback as described above, the pro-forma TEV is reduced from $153m to $116.9. PF2015 EBITDA would be reduced by $2.9 million of rent, to ~$22.5 million, implying a PF EV/EBITDA of just 5.2x. This is way too cheap for a business of this quality and capital efficiency, whose peers trade at double digit multiples.

X.       Risks

UFPT has every corporate governance shortcoming in the book, including:

·       Classified board with 3 year term

·       Directors elected by plurality

·       90 day notice required to nominate directors

·       Shareholders can’t call special meetings

·       Shareholders can’t act by written consent

·       Flip-in poison pill enacted without shareholder approval; CEO and family are exempt

·       Board is authorized to adopt, amend, or repeal bylaws without shareholder approval

·       Blank check preferred stock

·       No cumulative voting

There is always the possibility that mgt could attempt a take under, though the last two years would have been an excellent time to do that, and they did not. Also, a committed investor could corral the existing shareholder base in a way that could prevent any such abuse

Other risks are described adequately in the 10-k.

XI.     Other

The business also has a few easter eggs in the form of finished, generally patented products that UFP markets and sell directly. Examples include wine packs for shipping, plantable packaging for botanists, beauty supplies, multi-purpose erasers, medical wipes, bioshells for shipping human tissue and organs, various products for clean rooms (insulation, fixture caps), beauty and spa supplies, etc. Although I have no great insight into the performance of these products, they all seem kind of interesting and there is always a chance that UFP’s in-house designs could end up driving significant profitability in the event of a hit product.

Catalyst

• Earnings normalize

• Potential board involvement by 13D filer and experienced small cap investor Mill Road Cap

• Potential M&A target for both strategics (FXI would be obvious) or more likely private equity (in that management are significant owners and would likely prefer a financial buyer)