|Shares Out. (in M):||5||P/E||6.0x||4.7x|
|Market Cap (in $M):||11||P/FCF||5.3x||4.2x|
|Net Debt (in $M):||14||EBIT||3||4|
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One of the most difficult challenges in any investment analysis is assessing the quality of management. We think their competency is best demonstrated during challenging business conditions. Good managements use an industry crisis to take advantage of their competition and emerge as stronger entities. Over the past year Universal Power Group’s (UPG) management has been challenged with extremely difficult supply conditions in China. We have been impressed with their performance during this period and their ability to better strategically position the Company. Fortunately for us, “Mr. Market” has failed to take note of the Company’s performance and improved prospects, providing us with an enticing investment opportunity.
UPG is in the battery business. They are a leading supplier and distributor of batteries, power accessories and security accessories. In addition, they also have a third-party logistics services business, specializing in supply chain management and value-added services.
UPG distributes and markets batteries, related power accessories, renewable power products and security accessories under various brands and under its own proprietary brand. They are one of the leading US distributors of sealed lead-acid batteries (SLA batteries). SLA batteries cater to a wide range of markets including automotive, trailer, security, marine, medical mobility, hunting and solar. UPG also distributes a broad range of UPG-branded and private-label batteries of most chemistries, including nickel cadmium, lithium, lithium polymer, nickel metal hydride, alkaline and carbon-zinc batteries. These are used primarily in consumer electronic products. In addition they distribute jump starters, solar power generators and security system components.
In its logistics business the Company provides supply chain management for customers. Supply chain management services include inventory sourcing, procurement, warehousing and fulfillment. Value-added services include custom kitting, private labeling, product development and engineering, graphic design and sales and marketing. The Company believes that the demand for third-party logistics and supply chain management solutions is growing, particularly with globalization.
The Company services a broad spectrum of customers. Customers include OEMs, contract electronics manufacturers, distributors, retailers and electronics manufacturing service providers that serve a broad range of industries including: automotive, marine, power sports and recreation, medical mobility and other medical equipment, security and surveillance, consumer goods and electronics, telecommunications and solar. UPG’s largest customer is ADT Security Services for whom UPG functions as a supply chain manager throughout North America. In 2011, ADT accounted for 16% of net sales: the only customer that accounted for more than 10%. (ADT accounted for 9% of net sales for the first six months of 2012.)
The Battery Business?
We recognize that the battery business is very competitive but it has attributes that make it very attractive. Batteries serve as an energy storage solution for a wide range of consumer and commercial products including computers, smart phones, electronic devices, motorcycles, medical scooters and equipment, boats, solar panels and security systems. Technology and consumer preferences change rapidly and unpredictably but the demand for batteries will only grow because whether one has the latest iPad or an old-fashioned scooter he still needs a battery. More importantly, the battery business is not very cyclical as even during a recession batteries wear out and must be replaced. We like this business because it’s a “soap business” in a world that is getting dirtier every day.
The Supply Issue
Historically, UPG has had significant long-term relationships with manufacturers located in Asia, principally China, which gave the Company favorable pricing and delivery schedules. However, in May 2011, the government of China implemented a broad-based inspection program for manufacturing facilities dealing with hazardous materials, including lead. As a result of these inspections, the Chinese government closed a significant number of plants because of safety and environmental concerns. These factories accounted for more than 70% of China’s sealed lead acid battery production. These closures caused production and delivery delays across the entire industry. One of the factories closed by the Chinese government was UPG’s principal supplier of sealed lead acid batteries, the Company’s largest product line. Given the widespread impact of the Chinese government’s action, UPG was unable to immediately find alternative suppliers for SLA batteries to satisfy all of its customers’ needs.
UPG was forced to draw down inventory stocks to the lowest levels in years. The Company worked diligently to expeditiously identify and secure new and reliable sources of supply that would not only meet volume requirements but UPG’s standards of quality and pricing. By the end of 2011, the Company was working with new suppliers located in Taiwan, Malaysia and Vietnam. Through this crisis the Company was able to materially transform and improve its supply base. It went from a supply base dependent on several manufacturers in one country to one with a breadth of suppliers across many countries. By the second quarter of 2012, financial results were still affected by the supply disruptions but the company had substantially rebuilt its inventory.
Consider the Company’s results during the supply disruption period: (Dollars in Millions)
Q2 12 Q1 12 Q4 11 Q3 11 Q2 11 Q1 11
Sales 23.5 26.4 21.0 25.2 21.5 21.6
Income .76 .51 (.60) .33 .62 .77
The critical points are that the Company managed through a highly challenging environment, satisfied customer demand, cut expenses, experienced only one quarterly operating loss, and more importantly emerged as a much stronger competitor,
Recent Operating Results
Market conditions during the second quarter (June 2012 quarter) had not yet returned to normal, but the Company experienced improved performance of its supply chain. Increased deliveries from Chinese suppliers enabled the Company to satisfy customer demand and rebuild depleted inventories. Gross margins continued to be hurt by higher product costs from the supply disruption and the Company’s determination to honor customer price commitments.
During the second quarter sales increased by 9% and operating expenses decreased by 10% relative to last year’s second quarter. The Company had net income of $.08 per share during the quarter, excluding the loss from discontinued operations.
During the second half of the year, as UPG works through the margin issues, it fully expects to realize improving sales and margins. As a result of the crisis the Company added new customers and now gets 20% of its product sourcing outside China. In addition, the Company expects to maintain its lower expense levels.
Over the five year period before 2011, the Company averaged annual EPS of $.33 share. We fully expect the Company to generate annual earnings in the range of about $.35 to $.45 per share as the supply issues fade away over the next several months.
As deep value investors, we take great interest in the financial condition of our companies and their ability to easily withstand challenging business conditions. UPG has no long term debt and employs a line of credit to fund up to 80% of its receivables and inventory. The Company’s inventory of $38.8 million accounts for the bulk of its $58.6 million in assets. The inventory is up $14.6 million from the end of the March quarter as the Company was able to stock up with improving supply conditions. The good news is that the quality of the inventory is excellent since it was recently purchased and is in high demand.
The Company has a tangible book value of $3.57 per share and net current assets (fully diluted) of $3.47 per share. Wait, isn’t the stock selling for $2.10 per share? Yes, this implies that the shares are selling for about 61% of liquidation value! Mr. Market clearly thinks that the Company is on the precipice of bankruptcy and is worth significantly more dead than alive! No one told him that conditions in China have improved and the UPG has completely recovered.
Valuation is always a controversial topic with analysts. Do we use discounted cash flow analysis, break-up value or franchise value? What is the fair value of Facebook? We certainly have no clue. As for UPG, we can state with a high degree of confidence that its value is materially more than the $2.10 current share price. We have a profitable Company that has effectively managed through difficult industry conditions and emerged much stronger. Earnings over the next year can reasonably be expected to be about $.40 per share, giving the Company a price earnings ratio of 5. In addition, UPG sells for about 60% of liquidation value, with the bulk of this value composed of fresh, liquid and highly marketable inventory. It requires minimal analysis to argue convincingly for a value above $3 per share. We will leave the exact number to you.
Like almost every situation, we do have some items that concern us:
1) UPG is a micro-cap company with a market capitalization of about $11 million. Thus, liquidity of the shares is limited.
2) Management controls almost 50% of the shares and may not act in the best interest of outside shareholders.
3) Considering the small size of the Company, we find the CEO’s total compensation of $466,000 in 2011 and $716,000 in 2010 high.
4) To outside investors’ chagrin the Company does not break-out its revenues by product line or business. This obviously leaves outside shareholders in the dark about the relative importance and performance of each product.
To offset some of these concerns about management, we should note that they do hold quarterly conference calls during which they do effectively address shareholder questions.
1) The Company’s expected performance over the coming year.
2) Mr. Market simply wakes up one day.
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