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The following segment was excerpted from this fund letter.
UFP Technologies (NASDAQ:UFPT)
Company Overview
UFP Technologies engages in the design, development and manufacturing of custom-engineered components, devices and packaging primarily in the medical end market. Leveraging its access to and engineering expertise in specialty foams, plastics and composites, the company designs and manufactures parts and devices that are single use in nature. Representative products include surgical robotic drapes, vascular tools, wound therapy products and orthopedic devices.
In many ways, UFP serves as an outsourced R&D partner for clients by assisting during front-end product design and engineering. Through the development of customized machinery, manufacturing expertise and a network of FDA certified manufacturing facilties and clean rooms, UFP can oversee the transition from prototype to commercial production. The highly engineered nature of UFP’s products and the rigorous FDA approval process for both new product introductions and manufacturing techniques leads to deep and long-lasting customer relationships for the company. UFP counts 26 of the top 30 medical device companies as customers, which highlights the company’s design, engineering and manufacturing expertise in the medical market.
UFP’s revenues are highly visible as the medical end market has relatively stable demand given the critical nature of the products and most of UFP’s end products are consumable in nature in the form of single-use or single patient devices. Long-term contracts with high switching costs provide even greater revenue visibility for the company. The steady nature of UFP’s revenue allows the company to invest confidently in both R&D and capacity expansions that generate high returns on capital. As the company continues to focus more on product development alongside customers, it not only builds stronger customer relationships, but it will also result in higher margin revenue as these more innovative products come to market.
Business Transformation
UFP has completed a significant transformation from a commoditized packaging company serving cyclical end markets to a custom manufacturer of specially engineered components and devices for the highly regulated medical end market. In 2015, 41% of UFP’s revenue was generated from the medical end market and the majority of UFP’s other revenue came from commoditized packaging to cyclical end markets such as consumer, industrial and electronics. Today, 80% of UFP’s revenue is generated from the medical market, which is the result of a multiyear strategic plan to exit commoditized, low margin packaging businesses and instead focus on highly engineered medical components and devices that carry higher margins. The regulated nature of the medical end market creates high switching costs for UFP’s customers given the time and effort required to reach FDA approval. The high switching costs combined with long product life cycles provides UFP with an annuity-like revenue stream once a contract is won. A brief timeline of the key events in UFP’s transformation is shown below.
- Creating the Platform to Grow (2013-2016): UFP undertook a multi-year strategic repositioning of the portfolio to better position the company for future growth in the medical end market. The process involved facility consolidations, investments in new production capabilities, capacity expansions and an ERP system upgrade. During this period, the company was forced to requalify programs with existing customers, incurred restructuring charges and saw margin degradation as facilities were initially underutilized. However, this comprehensive portfolio overhaul created a platform that could better serve the medical end market.
- Investing in Medical Growth (2018): Acquisition of Dielectrics, which brought specialized manufacturing capabilities to UFP and deeper penetration into the medical device end markets. Following the acquisition of Dielectrics, medical sales accounted for 60% of revenue compared to 47% in the year prior to the transaction.
- Medical Market Expansion (2021): UFP completed 3 acquisitions in the medical end market in late 2021 and early 2022. The acquisitions enhanced manufacturing capabilities, added new customers and increased the company’s offshore manufacturing footprint. Historically, as products reach maturity, med device companies have sought to move manufacturing offshore to reduce costs. UFP’s customers encouraged UFP to expand their offshore manufacturing capabilities as they wanted UFP to retain the business given that the FDA had already certified UFP as the manufacturer. Prior to the offshore manufacturing capabilities, UFP lost this business, which resulted in annual churn that UFP had to offset through new contract wins. In addition to acquisitions, UFP also built its own manufacturing facility in Mexico, which is set to come online in 2H ’22. The expansion of the company’s offshore manufacturing expertise should allow the company to retain more programs as they reach maturity, which will reduce customer/product churn. Pro forma for these acquisitions and the divestiture below, medical sales now comprise 80% of UFP revenue.
- Portfolio Pruning (2022): At the beginning of Q3 ’22, UFP divested its low margin Molded Fiber packaging business. Proceeds were used to pay down debt associated with the three acquisitions above. Pro forma for the acquisitions and divestiture, leverage is <1.0x on a net debt/EBITDA basis.
This historical background illustrates that UFP is led by a management team with a long-term focus and a proven history of successful acquisitions and divestitures. Acquisitions that add manufacturing capabilities, materials expertise or geographic expansion all serve to make UFP a more valuable partner to its customers and, given the strong cash flow of the business, I expect M&A to continue. The successful transformation of UFP into a preferred R&D and manufacturing partner for the medical device industry gives me confidence that this management team is well suited to continue programmatic M&A. Insider ownership by the CEO (6% of the Company’s stock worth $40mm) aligns management with shareholders and provides further comfort that management will be good stewards of capital.
UFP still derives 20% of its revenue from the auto, aerospace and defense and industrial end markets. A&D has many of the same characteristics as the medical end market in the form of long duration contracts and highly engineered products. The industrial and auto markets are more commoditized and could be sold or exited in the future (similar to the recent sale of the molded fiber business), although the company continues to benefit from product innovations in these end markets that can also serve the medical market.
Financials
As described above, UFP’s transformation has been a long process, but is largely complete today. The culmination of the transformation into a medical device supplier with higher organic growth and margins has been masked by COVID disruptions which have impacted both top line and profitability. Consolidated organic growth for UFP averaged 2.6% from 2015-2019 but is likely to sustain at a significantly higher level now that the portfolio repositioning is largely complete. While the company targets organic revenue growth on a consolidated basis of 57%, I believe the company will grow faster than this target given that the medical end market for UFP has grown at a +6% organic CAGR since 2015 (+9% excluding COVID impacted 2020). Additionally, UFP’s medical end market growth is likely to accelerate as broader offshore capabilities reduce churn while an increased focus on product R&D should lead to more new product wins. The accelerating organic growth will be supplemented with a steady M&A program, resulting in top-line growth of 10-15%, depending on the pace of acquisitions.
From a margin perspective, UFP expects improvement in gross margins as supply chain pressures ease and manufacturing utilization increases. Management currently expects operating margins to improve from ~11% (LTM Q2 ’22) to 12-15%, supporting operating income growth well above revenue growth. As CAPEX normalizes following the recent capacity expansions, FCF should compound at a 15-20% CAGR for the next 5 years. The strong free cash flow and low leverage (<1.0x net debt/EBTIDA) provide the company with ample capacity for strategic M&A.
At a minimum, UFP should maintain its valuation multiple of 14x EBITDA. However, as the portfolio repositioning becomes more visible in 2023, growth rates accelerate and margins improve, the company could command a valuation premium in line with other specialty manufacturers in the 16-18x EBITDA range.
Investment Summary
UFP is a perfect example of the type of business that can tax efficiently compound for many years and is ideally suited for the HCM portfolio. UFP’s competitive advantages in the design and manufacturing of medical devices and components supports a platform that can execute on the long-term growth opportunities in this market. Recurring revenue from a growing medical end market combined with long-term customer contracts provides high visibility into future revenue growth. Improving margins will generate healthy free cash flow that can be deployed into strategic M&A that serves to deepen UFP’s value proposition to customers. An experienced management team with high insider ownership provides confidence that management will be disciplined allocators of capital.
The combination of all these factors supports an expectation that UFP can compound investor capital at a 15%+ CAGR over the next 5 years. Growing investor appreciation for the transformed UFP portfolio presents an opportunity for even higher share price gains as the market begins to appreciate the durability of UFP’s revenue and the improved return profile of this primarily medical portfolio.
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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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