Wednesday, January 18, 2012

UFP Technologies Shows Promise

UFP Technologies (UFPT) has been coming up on value screens lately. The designer and manufacturer of packaging solutions (e.g. the plastic or foam that surrounds your consumer electronic device when you buy it) has generated free cash flow approaching $10 million in each of the last two years, but trades for just $90 million despite a net cash position of $24 million!

There's a lot to like about this company. Returns on assets and equity have been strong since 2006, perhaps thanks to a strong management team. Management incentives also appear aligned with those of shareholders, as the company's CEO owns more than $10 million worth of stock (compared to pre-tax annual compensation of $1.5 million). As a result, you are probably less likely to see the company's cash load spent on acquisitions with poor returns for the purpose of increasing the company's size.

History bears this out, as the company appears to be a very shrewd acquirer. In 2009, the company bought three companies at what appears to be very favourable prices. The company spent $3.7 million and acquired net assets (including a good amount of cash, receivables and inventory) of $4.5 million.

But this is not a stock without some risk. For one thing, current profitability is abnormally high. Consider the company's margins over the last few full fiscal years:

Will current margins persist into the future? They might. If you believe the company has successfully transitioned away from commodity-like packaging towards higher-margin engineered packaging solutions, you might say these margins are sustainable. But you should make sure you know this to be true; otherwise, you could be buying into a company that is likely to see margins compress if/when business conditions in this industry return to normal.

It's not that clear that management believes the current high profits are sustainable. Midway through 2011, insiders (including the CEO) started selling shares, and they haven't bought any shares recently even though the price has fallen more than 20% since those sales.

Another thing potential shareholders should be wary of are the company's stock compensation practices. The company's free cash flow is overstated by about $1 million per year because that's how much stock compensation expense is added back to operating cash flow. While stock compensation is not a cash loss, it is a loss that is certainly felt by shareholders. The company's share count has been rising about 5% per year, and looks set to continue to rise as there are a great number of options remaining outstanding at much lower exercise prices than the current stock price. So although the company touts in its latest press release that its quarterly sales and income are up, these measures are actually both down on a per share basis!

If current earnings hold up, UFPT looks like a steal at the current price. Management appears intelligent with their acquisitions, and so even though the company doesn't buy back shares, there may not be a lot of risk to the company's cash. However, if current earnings are an aberration, shareholders could be left holding a disappointing stock with margins that decline to more normal levels.

Disclosure: No position

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