UFPT: A Small Cap That Generates Giant Yields on Free Cash Flow

| About: UFP Technologies, (UFPT)

I absolutely love stable, growing companies that make simple products that are in demand and are likely to be needed for the foreseeable future. UFP Technologies (NASDAQ:UFPT) manufactures packaging for the healthcare, automotive, aerospace and computer industries, among others. UFPT has amazing fundamentals, a conservative balance sheet, and a management that is always seeking to maximize shareholder value while treating company money cautiously.

Management has made 3 excellent acquisitions lately, all amicably agreed upon in 2009 during the downturn. UFPT owns 350,000+ sqft of manufacturing space as well as its headquarters while leasing the rest of its needed space. Leases expire periodically through 2015 and many have options to renew. There does not seem to be a risk either due to long term lease contracts or due to increased pricing on renewal. Management compensation is another way shareholders have experienced an increase in equity and they can expect further savings in the future. CEO Jeff Bailey's current base salary is $330,000 (with a $300k minimum based on achieving various individual and company goals). He also receives a yearly stock bonus of 25,000 shares. At a stock price of $8 (which was standard for a period of time) this bonus was worth $200k. Due to the run up in share price to as high as $21.59, Mr. Bailey restructured his contract to pay him a minimum base salary of $350k while capping his stock bonus at $300k a year. This means that shareholders will be saving money each year if the stock price is above $14. At the current price of $17.50, Jeff Bailey's move will save shareholders approximately $100k a year. This among many others moves recently shows a predisposition of managing toward protecting and increasing shareholder value whenever possible.

The balance sheet is even more impressive. At the end of 2009, total cash stood at $15M while at the end of 2010 cash was $24.5M. We will see that this $9.5M increase was entirely due to the Free Cash Flow generated. Total current assets are $41.7M (counting receivables and inventory at 60% stated value) against total liabilities of $21.5M. Cash is nearly twice as large as current liabilities, which are just $12.5M. Shareholder equity stands at $34.1M if you exclude goodwill and intangibles. This is relative to a market cap of $110M and EV of $97M. The PPE is possibly stated on the low side if we look at the March 2009 acquisition of a 250k+ sqft manufacturing factory for $3.2M. This is a cost of $64 per square foot against what is a reasonable cost of $150 per square foot to build a new factory of similar size (not counting the cost of land). This alone represents a $4M unrealized profit that is not counted on the balance sheet.

PPE is $45.5M (and just $12.6M after depreciation) against 2010 net income of $9.3M. This is a yield of 20.4% on capital for operations. This is well above average returns, which is what Warren Buffett is always looking for. Considering one would expect 13% returns on capital we could expect competing businesses to require approximately $71.5M in capital to realize the same net income, thus implying the operating advantage UFPT holds. EPS has increased from $0.82 in 2008, to $1.37 in 2010, for a 63% increase. This increase occurred while revenue growth was just 9.3% over this same period. This disparity can be explained due to the competitive operating advantage mentioned earlier.

Just an 8.3% revenue growth in 2011 to $130M, assuming gross margins on revenue remain at approximately 75%, would increase gross profit $3M and probably require increased SGA of $1.5M. After taxes shareholders could expect to see $1.2M in additional net income for an EPS of $1.56 or growth of 13.9% yoy. Warren Buffett realized that outsized returns come from investing with a margin of safety in predictable stable businesses that have operating advantages. The cash flow for UFPT is even better as it generated $14M from operating activities (minus a one time income tax refund) against $3.3M in capital expenditures. FCF was thus $10.7M for 2010 compared with $4M in 2008. FCF growth seems to have come from normal inventory and accounts receivable cycles (though both inventories and receivables have remained relatively constant even with 20% revenue growth from 2009 to 2010). FCF is more impressive when considering that PPE yields 23.5%. Capital expenditures were nearly identical to depreciation, which leads me to believe that costs for maintaining the business are relatively flat.

UFPT made no significant expenditures such as share buybacks and has no dividend so nearly all of the FCF generated currently sits in cash. With 8.3% revenue growth in 2011, we could expect UFPT to generate $12M in FCF. Even if revenue growth is less than 8.3% we could expect FCF to remain at or above $10M moving forward. I used growth of 5% and a discount rate of 10% (twice the longest AAA corporate bond yields, which is the 20-year for 5.15%) to arrive at an estimated present value of $26.50 for a gain of 50%. I believe I have conservatively estimated UFPT at every opportunity and see $26.50 as a minimum value of estimated intrinsic value.

UFPT is not currently involved in any legal proceedings and there does not seem to be any risk of a substantial revenue decrease due to expiring contracts. The largest fear for current costumers is for automotive and defense contracts that total approximately 8% of total revenue. These contracts, if not renewed, would decrease over a period of 3 years. All mortgages, leases and other payables mature relatively smoothly through 2015 with no large bills due at any one time period.

Disclosure: I am long UFPT and would consider buying more around $15-16.