Description

Would have liked to get this idea out earlier but I think investing in this business at these prices still makes sense. This is a small cap idea with limited trading liquidity – having said that, Mario Gabelli was able to build up a 7% stake.

Executive Summary

I am positive on United Guardian (UG-US), a producer of gels and solutions for the personal care, medical, pharmaceutical and to a lesser extent industrial sectors. A quick review of historical financials will reveal UG to be a stable high margin, high ROE business with reasonable growth prospects and low capital requirements. Combined with a very strong balance sheet and a nicely aligned management, I don’t believe investors were offered a compelling enough valuation to invest in this business until the most recent earnings disappointment – where most of the issues should be transient. Further, a small portion of UG’s revenues have been obscured by production issues of Renacidin, possibly leading the market to underappreciate the dual catalysts of production returning to normal, and the pricing lift associated with the  pending FDA approval for a small dose format of the product. Bottom line, UG seems to be a high quality and niche business that is currently generating a depressed FCF/share run-rate of ~$1.10, with FCF/share potentially normalizing at $2+. Trading at $25 (or ~ $22 ex-cash), I see this as an opportunity to own a great business at a normalized double digit FCF yield (if one can look 3-5 years out).

Long-version of UG Write-Up

Frankly, this has been an uncomfortable idea for me to write up because: 1) I lack the technical expertise required to have a deep knowledge of the company’s products, 2) this is not a special situation where I can be comfortable non-fundamental factors are impacting the stock price (i.e. spin-off, index inclusion, forced seller, etc.), and 3) I’m venturing into the area of “great businesses at a good/fair price” – which requires some discussions on the business’s moat. Therefore, a lot of my discussion will end up sounding like “the proof is in the pudding” type arguments or relying on a bunch of check-list type items that should support my thesis. Fortunately or hopefully, as a small cap name with no sell-side coverage (other than by EVA Dimensions, with no price target), no market presentations and no quarterly conference calls, UG’s stock quote may just be inefficient from time to time (i.e. I think currently undervalued).

Brief History and Overview

UG dates back to the 1942 when it was founded by Dr. Alfred R. Globus. Its business in current form really started in the 1980’s and displayed its high margin and stable growth properties ever since. Almost 10 years ago, UG recognized its Eastern Chemical subsidiary was more of a mediocre business – serving as a distributor of chemicals, reagents, indicators, dyes and stains. Accordingly, UG sold its Eastern business at the end of 2007.

Practically speaking, UG sells two main products, Lubrajel and Renacidin, accounting for 91.4% and 2.9% of 2013 net sales respectively. From what I understand, Lubrajel is a gel that is mostly used as an ingredient in personal care products such as cosmetics and for medical purposes such as a general or catheter lubricant. Lubrajel seems to be enough of a differentiated and niche product that allows UG to continue to drive both volume and pricing growth (5 year CAGR of +7% and +3% respectively, see below)

Renacidin, on the other hand, is a pharmaceutical product (solution) used to prevent incrustations in catheters. Due to manufacturing issues at UG’s Renacidin supplier, revenues of this product are meaningfully lower than they would otherwise be (will be addressed later in the write-up).

Looking at UG’s historical financials, UG’s business performance has been very impressive. Over a 15 year period, UG’s EBIT $ and FCF per share grew at an 11% and 13% CAGR respectively, while its share count actually decreased at a -0.4% CAGR. Within the last 5 years, these metrics were even better, presumably due to UG’s decision to sell its mediocre Eastern subsidiary (see below).

Equally impressive, UG did not have to spend significant amounts of capex to generate these results, with capex/sales at 1.9% in 2013 and the 15 year average at 1.7%.

Poor 2Q Results Presents an Opportunity

After hitting an all-time high around mid-May following UG’s dividend increase announcement, UG began sliding and reacted violently to poor 2Q results. Surprising the market, 2Q14 EPS was $0.20, down 31% yr/yr (from $0.29). UG is attributing this primarily to:

1. Significant yr/yr declines in personal care segment sales, especially to Ashland Chemicals, its marketing partner. The decrease is roughly 22% yr/yr, which assuming 40% EBIT is ~ $0.05 EPS negative impact yr/yr. UG attributed this to higher than normal inventory building in 1Q14

2. Weaker Western European demand for Lubrajel

3. A medical product customer eliminated using Lubrajel as an ingredient for its product ($0.02 EPS impact on my rough estimate)

After doing some digging, I got some comfort that many of these issues should be transient. In particular:

1. Checks with Ashland does not suggest there are significant demand issues for Lubrajel (although they refused to provide much comment). In fact, UG suggests Ashland’s sales of UG products were +3% in 2Q14. After reviewing historical financial reports, this has happened to UG before. For instance, in 2006, UG talked about ISP (marketing partner for UG, before being bought out by Ashland) sales of UG products were actually +2.6% for the year. However, UG’s sales to ISP over the same period was down 4.4%. UG management at the time noted it was an inventory timing issue. In 2007, things did more than reverse, with UG sales to ISP +20.3% while ISP’s sales were only +5.3%.  (I noticed Ashland coincidentally was just written up on VIC – perhaps the author would be more qualified in discussing this issue)

2. As I am not a macro person, there is not much to comment on the Western European economic climate. The only thing I can add is UG’s sales are generally very resilient to economic conditions, with net sales +3.4% yr/yr in 2008, and +8.0% yr/yr in 2009.

3. Apparently, this consumer decided to substitute UG’s product for a generic less expensive ingredient. My understanding is that this is not related to any patent issues/expiry and is a normal part of business.

Finally, the violent reversal of UG’s positive share price momentum is understandable – UG just increased its mid-year dividend in May, only to report poor 2Q14 results, leading investors to question whether management knows what is going on. However, looking beyond the surface, I suspect UG’s board was probably aware of a weaker 2Q – since by mid-May, UG was through half of its 2Q14 and ought to be aware of declining yr/yr sales. Therefore, I think UG’s board, armed with this knowledge, still hiked the dividend speaks volumes to their confidence in a much stronger second half of 2014. In fact, in the 2Q14 MD&A, it explicitly expects the weakness in sales to Ashland to reverse:

“ASI is also projecting an increase in its sales of the Company’s products for the full year 2014 compared with 2013, and as a result expects that its inventory needs will reflect that increase as the year progresses.”

Discussion of Lubrajel’s “Moat”

By the numbers apparent in UG’s financials, Lubrajel implicitly has a huge moat given its high margins (EBIT margins in the 40% range), consistent revenue growth (+9% per year since 2008, from 7% volume growth and 3% price increases), ridiculously low advertising and capex spend ($16,000 (dollars!) in advertising for 2013 and < $300K in capex), and UG’s conservative accounting where all R&D is expensed under “operating expenses”.

Looking a layer deeper, it appears Lubrajel’s moat is built on: 1) the brand/trademark value given its strong reputation established over 15 years ago (in fact reading UG’s annual reports back in the 1990’s convey a similar message on Lubrajel as it does today), 2) its broad range of grades and products that no competitor has yet to match, and 3) the distribution network in place given its partnership with Ashland and the ability to leverage Ashland’s significant sales force (i.e. ISP prior to Ashland’s acquisition). Anecdotally, I also understand that UG will copy a competitor products if UG views that the competitor is encroaching on its Lubrajel product lines. As the incumbent, it seems this action is sufficient to deter competitors from entering UG’s market in a meaningful way. Finally, I suspect Lubrajel represents a small portion of overall costs in the cosmetic/personal care product area – implying more leeway in terms of pricing power. On the medical product side, I suspect the power of existing relationships and switching costs tend to give UG the upper hand.

Management’s Alignment with Shareholders

Upon reviewing the proxy material, it is fairly easy to conclude that management’s interests are likely strongly aligned with shareholders, as the CEO Ken Globus owns 30.5% of UG. In addition to a significant ownership stake, the compensation structure current involves no options, avoiding the pitfalls of hidden shareholder value dilution over time. Further, compensation in dollar terms does not appear egregious, even for the CEO (at ~$400K). When compared to the >$1.3 mln in annual dividends the CEO expects to receive, it is no wonder UG is laser focused on shareholder returns, with 5 year FCF/share CAGR growing at almost 13% while dividends grew at a similar 5 year CAGR of 12% (15 year FCF/share CAGR grew at 13% as well!). As well, UG is very open to paying special dividends in good years given the high margin and low capex nature of the business. In the past decade, UG declared special dividends in both 2006 and 2007 (good years) and also in 2012 given the uncertainty in the tax treatment of dividends going forward.

Again as another indication of shareholder friendliness, UG smartly converted its previously defined benefit pension plan into a defined contribution plan ~ 4 years ago. Finally, even as Ken Globus wanted to sell some of his shares (~300K shares), UG decided to use this opportunity to buyback and retire the shares at a discount to the prevailing stock quote (I believe UG paid $10.75 per share when the market quote was $11.95).

Renacidin, near-term catalyst and revenue opportunity

As previously mentioned, Renacidin is a solution used to prevent incrustations in catheters and help dissolve kidney stones in patients. Unfortunately, UG relied on a third-party to manufacture this product and the supplier ran into production problems in 2010. While lost profits were reimbursed under a settlement agreement, demand for the product certainly did not grow as it otherwise would if the product were widely available. The table below estimates what Renacidin revenues could have been, as implied by the settlement payments received by UG:

Interestingly, while Renacidin production from this supplier is expected to resume and continue until at least 2015, UG is working at receiving FDA approval to produce Renacidin in smaller 30 ml bottles (instead of the current 500 ml bottles). To be produced by another supplier, UG expects to charge 2.5-3.0x the price of 500 ml bottles on a per ml basis. Further, shipping costs are anticipated to be lower given lower expected breakage associated with 30 ml plastic bottles vs 500 ml glass bottles. Bottom line, the Renacidin revenue opportunity in the medium term, in theory, could reach $9 - $10 mln (UG’s total net sales were $15.4 mln in 2013 for reference).

Taking a step back, in assessing Renacidin’s revenue opportunity, it is critical to answer 2 questions:

1. Will customers really pay 2.5-3.0x in price per ml for a more convenient dosage of Renacidin?

2. Why won’t competitors copy Renacidin?

As UG does not provide information of Renacidin pricing and its customers, it is difficult to answer the first question. However, there is some comfort that Renacidin is somewhat of a niche product that represents a small percentage of the cost of managing a patient requiring a catheter or kidney stones removal/management. Therefore, a more conveniently sized bottle may not receive as much pushback to the implied price increase.

In response to the second question, there appears to be limited patents preventing competitors from copying Renacidin. The force protecting UG in this area is mainly the concept of first mover advantage, given the fairly small addressable market implied by current Renacidin revenues (< $3 mln). My understanding is that the cost associated with formulating a copy of Renacidin and obtaining an NDA from the FDA to copy the product is prohibitively high when compared to a measly $3 mln opportunity (or even $10 mln if they copied both formats). As such, this niche probably only has enough room for one player, UG, and naturally gives the incumbent a good measure of pricing power.

Financial Forecast

Given the near-term headwinds, I see 2014 FCF/share at ~ $1.15 and FCF/share reaching $2+ starting 2018+. On a normalized FCF yield basis, I find UG shares to be attractive at current levels.

When using a DCF approach, UG’s valuation fluctuates wildly depending on LT growth assumptions. Clearly, assuming a repeat of its 15 year revenue CAGR of 4% and 15 year FCF/share CAGR of 13% will generate seemingly unreasonable (high) valuation targets. If you force me to have a medium term target, I would say ~$35.

Potential for Capital Structure Optimization

Although I see UG as being generally shareholder friendly, UG’s capital structure remains clearly suboptimal due to the company’s ultra conservative stance on debt.

Given UG’s remarkably consistent FCF generation, assuming $2 mln of UG’s taxes can be shielded by 5% debt, there is likely excess capital of $50+mln that can be returned to shareholders, representing 40%+ of its current market capitalization.

Although it is both premature and speculation that investors would exert more pressure on UG, it is notable that the latest proxy voting results revealed a meaningful number of votes (~300,000 votes) were withheld for 3 directors Ken Globus (CEO), Robert Rubinger (CFO) and Lawrence Maietta (Audit Committee Advisor). The number of votes withheld coincidentally match the approximate shares held by Mario Gabelli’s funds, although UG suggests Mario Gabelli is a long-term investor that remains very supportive of the board and management.

Risks

Assessment that Lubrajel has a moat and can sustain its growth and margins is wrong.

Maintenance of marketing relationship with Ashland

Macroeconomic factors, especially in Europe.

Disclaimer: The write-up is only intended for VIC members and not for dissemination.

Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

Catalyst

• Lubrajel sales to Ashland improve as inventory timing issues get worked out

• 2H14 FDA Approval of smaller dose Renacidin

• Implied Renacidin price increases for the smaller bottle format

• UG gets pressure from shareholders to optimize capital structure and return excess capital