Description

Bet:

UL Solutions (“ULS”) is a newly listed great business that investors should come to appreciate as a compounder over time. We are paying a multiple that is just above TIC peers which we believe means we are getting a cheap look at various potential options:

1) that ULS deserves a premium multiple due to its market position and brand strength relative to peers,

2) that ULS garners a further premium as the only US-listed testing, inspection and certification  (“TIC”) player,

3) that revenue growth is understated due to latent pricing power in its business, and

4) that earnings growth is understated due to the aforementioned revenue growth plus operating leverage that may arise due to investments in new initiatives that occurred in the previous three years.

 This IPO is highly unusual in that it’s a for-profit company being carved out of a not-for-profit organization.

Business Overview:

ULS provides independent TIC services and related software and advisory (“S&A”) offerings to customers worldwide. The company’s history dates back to its founding in 1894 as part of the nonprofit Underwriters Electrical Bureau, a predecessor to UL Research Institutes, UL Standards & Engagement and UL Solutions. ULS is the largest TIC services provider headquartered in North America (by revenue) with a global network of laboratories. The company served more than 80,000 customers across over 110 countries in 2023. Furthermore, ULS offers over 450 independent third-party conformity assessment services around the world and are capable of testing and certifying against over 4,000 global standards. ULS is the owner of the iconic UL-in-a-circle certification mark (“UL Mark”) that appears on billions of products around the world (you will likely find 100s of products around your home or office carrying the UL mark, which generates recurring revenue for the company over the life of the product). ULS offers its customers global market access services that help them ensure the safety and quality of their products while also supporting their efforts to manage the broader risks they face throughout their product lifecycle processes. The company is well positioned to benefit from secular tailwinds such as energy transition, sustainability and supply chain complexity.

Key attributes of ULS include: low price/high value service, strong regulatory tailwinds, premiere brand recognition (UL Mark, etc), long standing customer relationships, scale advantages and recurring (nearly 50% of the business is contractually recurring) and re-occurring revenue.

These characteristics culminate in both pricing and volume tailwinds that feed into a financial model with strong incremental margins and robust free cash flow generation. The company has also demonstrated its ability to successfully pull on inorganic growth levers with more than $1 billion deployed in M&A since 2010. Additionally, ULS operates in a favorable industry structure that exhibits both rational pricing dynamics yet significant fragmentation for continued tuck-in acquisitions.

In our opinion, the most important sentence in the S-1 is: “…we believe that although our services are of high value to our customers, they make up a relatively small proportion of their total product development and selling costs, and that our customers largely choose their outsourced TIC partners based on measures of quality and service over price.”

We believe the real gem here is the industrial business. We think there is significant pricing power in the industrial segment (particularly in the energy and automation markets) due to our conversations with management, customers, and formers. ULS customers convey their product quality via the UL Mark and there is a very high cost of failure.

The Bet: Details:

Given the quality of the business and growth profile, we believe ULS should trade higher than the peer group’s 20-23x 2024e EPS (Intertek, Bureau Veritas, SGS and Eurofins). We would note the potential, over time, for the market to reward ULS with a higher multiple given the scarcity value of an established TIC player listed in the US markets. Furthermore, a better compset might be US-listed compounders, many of which trade 25-35+x 2024e EPS.

We note that ULS’s historical revenue growth and margin profile is in-line with peers (mid-single digit growth; low-20%s EBITDA margin) despite its stronger position to push price and recent investments through both the P&L and cash flow statement that are yet to generate meaningful contributions. Given its pricing power, recent investments, and strong balance sheet, we believe there is potential upside to growth and earnings expectations over the coming years. We question if ULS’s previous corporate structure, being owned by a non-profit, limited its previous ability to maximize pricing and margin potential.

Based on our interactions and diligence to date, we have been extremely impressed with the management team of ULS. CEO Scanlon and CFO Robinson have demonstrated their deep understanding of ULS, industry drivers and shareholder value creation. CEO Scanlon’s track record as a public company CEO speaks for itself, as USG’s total shareholder return meaningfully outperformed the S&P500 under Scanlon’s leadership. It is also worth noting, she led USG through a sale to a large strategic, receiving support from USG’s largest shareholder Berkshire Hathaway. We believe the management team is appropriately aligned with shareholders given the 2.5 million options that were awarded as part of the IPO as well as the large equity awards that are currently outstanding.

In sum, we believe paying a small premium to peers creates a compelling risk/reward: if we are wrong, ULS is similar to other companies and likely trades at an in-line multiple; but if we are right, there could be significant multiple expansion.

Financials:

The company’s financial targets are:

- Revenue: Based upon their historical revenue CAGR (~5-6% organic, 6-7% total), we believe there is upside to their organic growth estimate due to their recent opex/capex investments nearing completion and the fact that their Industrial segment is becoming a larger piece of the whole. The mix shift should lead to incremental growth tailwinds (industrial segment, which is roughly half of the business today is growing faster than the consumer segment and should continue given industrial-specific tailwinds). Additionally, the market itself is projected to grow at a ~5-6% CAGR through 2026 (source: S-1) and ULS appears best positioned to take share due its best-in-class brand recognition.

- EBITDA Margin: There was pushback on EBITDA margin expansion during the IPO roadshow. We disagree. The Industrial segment has meaningfully higher EBITDA margins (30-33%) vs Consumer (14-15%) and is growing faster. This mix shift alone should drive margin expansion. Further, elevated investment in opex should fall away as recent projects are completed. The company is also focused on internal process improvement to drive additional margin expansion (recently rolled out a single instance of Salesforce and pricing/quoting software, real estate planning, centralizing corporate overhead functions, etc). Additionally, Software and Advisory is a growing business that should have high incremental margins as it scales. It is our understanding that the S&A segment is a collection of ~20 acquisitions that had not been properly integrated. ULS recently hired an experienced software leader to run the S&A segment whereas it was previously not run internally as a separate software business. Lastly, none of this assumes the margin from taking more price than they did historically.

- OpEx and CapEx have grown in recent years as ULS invests in new EV/battery testing labs including in China and Auburn Hills, Michigan. Many of these projects are at or near completion.

- There is also balance sheet optionality at only ~1x leverage which strikes us as low given the recurring and resilient nature of the business.

Risks:

- Pricing power does not materialize as we hypothesize it could

- Recent investments in new initiatives end up not generating sufficient returns

- Poor M&A/capital allocation

Catalysts:

- Increased time in the public markets, allowing the quality of the company and management team to season amongst investors

- Increased float as the parent sells down its stake over time

** The thesis expressed above contains forward-looking statements and is intended for informational purposes consistent with the nature of this forum; it is not a recommendation to buy, sell, hold, or otherwise trade the securities of the referenced issuer.  The authors/their affiliates do not hold a position with the issuer such as employment, directorship, or consultancy.  The authors/their affiliates currently own a position in the referenced issuer's securities; however, that position may change at any time and without notice.

Catalyst

- Increased time in the public markets, allowing the quality of the company and management team to season amongst investors

- Increased float as the parent sells down its stake over time