Universal Power Group: Avoid Until Change In Corporate Governance

| About: Universal Power (UPGI)

Summary

This distributor of batteries looks interesting at a first glance. The stock is trading at a deep discount to NCAV while being profitable and having stable operations.

While this seems unreasonable, the management’s actions and incentives offset these attractive fundamentals. The company is controlled by a tight group of related insiders that don’t care about minority shareholders.

Most importantly they do not mind diluting everyone by issuing significant amount of restricted shares to top management. They also approve dubious investments which seem to burden the stagnant operations.

Due to this it is unlikely that there is clear catalyst that could unlock the value in the company, especially when management is likely to stay for the foreseeable future.

Therefore investors are better avoiding UPGI unless there is a significant change in corporate governance.

Company Introduction

Universal Power Group Inc. (OTCPK:UPGI) is a company focused on supplying and distributing specialty batteries in the US (such as deep cycle battery packs, etc.). They cater to a variety of markets and also offer additional value-add or supply chain management services. The company is originally a spin-off from Zunicom a holding company of sorts. UPGI went public in 2006.

They do not segment their revenue in any way as seen below.

They achieved 18.6% gross margin and a slim operating margin of 1.5% in the last fiscal year. They do not have an overly concentrated customer base as only one customer accounted for 12% of sales in FY2014. One customer is though accounted for around 19% of the account receivables in FY2015. On the supplier side, they are concentrated as they sourced the batteries mainly from three suppliers that accounted for 61% of the inventory purchases.

They used to be listed and filed with SEC until 2013 when they deregistered in order to shed operating costs. They now publish their results on their website. The financial statements are audited by BKD LLP a large auditing firm that operates around the US.

Investment thesis

One could think of UPGI as an undervalued gem. It trades at 40% of NCAV, it is profitable, have a relatively stable business and while most of the value is in its inventories these might not be such an issue. This though would be a misunderstanding of the situation as upon closer inspection one can see that there is more than enough red flags.

  • Most importantly it is the management which treats the company as if already private. A tight group of insiders who likely own more than 41% of the company has complete disregard to minority shareholders as the board recently approved the issuance of 1 million restricted shares (total of outstanding shares prior to this was 5 million) to the CEO and two other unnamed senior officers. The CEO is the son-in-law of the Chairman of the board and the secretary of UPGI is the wife of the CEO. These restricted shares then significantly diluted minority shareholders.
  • These also cast a doubt over a potential catalyst that would unlock the value because the family then is likely to wait and let the stock vest which means the company could face a significant amount of time (likely at least 10 years) under a management with dubious incentives.
  • While the business itself might be fundamentally sound and continue without much challenges in the future, the management is making sure that the company's fundamentals remain burdened. The latest example can be an acquisition of iTech for $12 million which resulted in $8 million of goodwill. One would think that this price should be supported by earnings of the acquired company, but it is already more than a year since the acquisition and the company's operations and profitability are left unchanged.

Due to these I believe that initiating a position in UPGI does not even constitute a speculative investment as there is a lack of catalyst and the value could only be unlocked should the management step away or sell the business. This might be possible but due to the vesting period of the restricted shares (10 years) it might be that they want to hold on to this company for a significant amount of time.

Operations

As mentioned the company fundamentals are not overly positive but are quite resilient and have been able to maintain profitability throughout the past.

This proved to hold in 2015 as well when Radioshack, one of UPGI's major customers, went bankrupt but the operations were not materially affected.

Moreover while the income is not significant, the operational cash flow is.

That being said it is most of the time consumed by the working capital cycle as the company uses heavily its credit line to fund the operations. Therefore the company creates only a small amount of cash that ends up on their balance sheet.

There are further challenges as the business seems to lack the ability to meaningfully increase profitability by increasing the scale (periods of 2006-2009) and it is unlikely that the market is going to grow substantially thus the future results are going to be similar.

On the other hand, it is unlikely that the company would face a disruption in the revenue stream anytime soon and thus these challenges are not posing a threat to the near future.

Valuation

While the operations are not overly exciting, they do not warrant the current valuation of the company as the stock is trading at only 40% of the NCAV as seen below.

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The inventories are relatively liquid as the cash flow suggests and UPGI also does not seem to increase the inventory levels.

Therefore I believe that there is not a significant need to aggressively discount the inventories.

What could be of additional interest though are the account receivables levels as they seem to increase in the past four years through one-off annual jumps which might be connected to customers not being able to repay in the same amount of time as in past.

The jump in 2015 though might be related to the acquisition of iTech or bankruptcy of Radioshack.

Management

Therefore it seems that the stock is trading at a such a discount due to the actions of the management which is completely understandable as mentioned in the thesis.

Zunicom, the parent company of UPGI, still owns at least 41% of the company (UPGI stopped disclosing ownership after going dark) which allows them to effectively control the voting. Zunicom is headed by Mr. William Tan, chairman of UPGI and Mr. Ian Edmonds, CEO of UPGI. Mr. Edmonds is also the son-in-law of Mr. Tan as Mimi Tan Edmonds, the secretary of UPGI, is the wife of Mr. Edmonds.

There seems to be a relatively cozy relationship between Mr. Tan and Mr. Edmonds who stepped in to become UPGI's interim CFO in 2008 when the previous CFO resigned and then went on to become interim CEO when in 2009 the previous CEO resigned. He was then appointed CEO in June of 2009. At that time Mr. Edmond was 37 years old which raises some questions regarding how the board decided to appoint Mr. Edmond.

This was also pointed out in Saj Karsan's Seeking Alpha article about UPGI after which the management responded to some of his concerns but did not provide much to quell the concerns.

On its own a control of the company and possible nepotism is not an issue. It becomes an issue when the management goes on to make dubious investments. The prime example of this is the acquisition of iTech in May of 2015 for $12 million. As the company does not hold a significant amount of cash on its books it meant that the company leveraged itself again on the back of stable but stagnant operations. This is not the only issue.

The company a paid a premium of $8 million to acquire the operations. This means that iTech should be highly profitable in order to justify such a price, but while iTech mentioned that it has been profitable in the past and that it is fully operational the impact on UPGI's results have been minimal.

As you can see below the revenue has registered a slight increase compared to the first six months of 2015 but the profitability remains virtually the same.

The company does not break down the operations enough to be sure what exact proportion is tied to iTech but most potential scenarios point to UPGI overpaying for that acquisition. iTech also does not seem to be promising significant new revenue streams as the company has been founded in 1991 and does not seem to work on their own product that they could grow.

Again the acquisition itself would not be such an issue as the valuation of UPGI remains enticing and the fundamentals are still stable. What makes the company almost uninvestable though is the recent action of the management.

They decided to issue a significant amount of restricted shares to top management which diluted other shareholders. The first batch of 500,000 shares was given to Mr. Edmonds, the CEO, and the other 500,000 shares were given to two other unnamed senior executive officers (one has to wonder whether Mimi Edmonds is one of them). The company does not specify the split of these shares and only state the aggregate amount.

This means that the share count went up from 5 million to 6 million, a 20% percent increase. This grant would not be so dubious if it was awarded for a clear reason but the company only stated the following;

'The shares were issued on May 4, 2016, in consideration of past and future services, have full dividend and voting rights, but remain subject to full forfeiture for 10 years from the anniversary date'

What exactly are the past services that have not been compensated by the salaries of the management? The stagnant operations, dubious investments and almost zero value returned to shareholders (they did a small special dividend in 2015)? The reasoning of the management is misguided and certainly shows what the management thinks of other shareholders.

This spurred legal action by one of the shareholders of UPGI, Mr. Ryan Schaper, who at that time owned roughly 12% of UPGI who called the management actions

...a mockery of the Texas Business Organizations Code and the entire concept of public companies," ... "I have brought this suit to force UPG, the board and the Tan family to comply with the law and behave like the public shareholder owned company that it is."

As seen in this article about the lawsuit.

I have not been able to track down what is the current situation of the lawsuit (I could not find the docket filings) but one deep value blogger who runs the Swedish blog 'Cheap Companies' mentioned that it is likely that the parties have settled the dispute out of court. If this is the case then the management will be able to get away with it and keep their control over the company.

Furthermore, this is not the first time they did a dubious corporate governance move. In 2011 they decided to reprice options of the management as the share price tanked due to probably lowered operational results. This would then mean that the management would still be able to profit should the price reverse without facing the same risks as common shareholders.

All this then shows that the management does not care what happens to other shareholders and it is likely that they are going to continue to run the business this way.

That being said there seems to be a group of shareholders that might be willing to take action. You can contact them here.

Conclusion

All in all, this is a similar net-net stock to Emerson Radio (NYSEMKT:MSN), whose management cares little about the minority shareholders. The difference here is that MSN has cash instead of inventories as its main value. Moreover, MSN's operations are probably going to become immaterial soon which strengthens the case for liquidation. UPGI is likely to continue to exist in the current state with management that was able to significantly dilute minority shareholders.

Final side note, if you do not see the situation in the same light, do not forget to look at the possibility of owning UPGI through Zunicom shares which are also traded OTC as there could be a way to own UPGI at a discount.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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