OFLX - Omega Flex: More Engineering Expenses And Undervalued

Summary

• Omega focuses on the production and distribution of flexible metal hoses that are mainly used for the transport of gases and other liquids that require high-security transport systems.
• Omega’s revenue is well diversified. According to the annual report, the company currently estimates that it has around 10k active clients internationally.
• Investments in development and technological innovations will likely lead to new improvements of Omega products, in their quality and cost.

Omega Flex, Inc. ( OFLX ) reports a large number of clients from very different industries. I detected a recent increase in engineering expenses , which could bring further technological innovations and product generation. Besides, if sales, general and administrative expenses continue to decrease as we saw in a recent quarter, I would be expecting even better FCF margins. Even considering potential supply chain risks or issues due to the political tensions in the United Kingdom, in my view, the company appears very undervalued.

Omega Flex: Massive Number Of Clients And Operating For Many Different Industries

Omega focuses on the production and distribution of flexible metal hoses that are mainly used for the transport of gases and other liquids that require high-security transport systems.

The company's products are intended for various industries, such as automotive, aerospace, commercial, institutional and residential construction, and general industrial plants.

Despite having a single segment for all its production lines, the development of each of the products is intended for different functions for the needs of its different consumers. Among the company's products I should highlight the Meditrac, developed for the medical industry and used in hospitals, ambulances, and veterinarians, the TracPipe Counter Strike, leader in sales with regard to gas distribution networks in the United States, and the Double Track, an oil transmission tube aimed at reducing environmental damage.

Around 13% or 14% of the company's sales are concentrated in a single client since 2019, which does not look ideal. With that, I believe that the number of clients is enough to say that Omega's revenue is well diversified. According to the annual report , the company currently estimates that it has around 10k active clients internationally.

Its sales channels are direct and through distributors or retailers as well as through its website and that of other online retail businesses. Sales are generated from purchase operations, which are short-term, meaning that once the order is active, Omega distributes the product.

Solid Balance Sheet

As of September 2022, assets included cash worth $30.569 million, accounts receivable of $19.043 million, and inventories of $21.827 million. The other current assets were $4.615 million with total current assets of $76.054 million. The current assets/current liabilities ratio was 3.8x, so I am not concerned about the company's liquidity.

The right of use of assets operating stood at $3.095 million together with property and equipment of $8.558 million, goodwill worth $3.526 million, and other long term assets of $1.584 million. Finally, total assets stood at $93.023 million.

The company also reported accounts payable worth $2.576 million accompanied by an accrued compensation of $2.897 million and accrued commissions and sales incentives of $4.765 million. Dividends payable were equal to $3.230 million.

Besides, other liabilities stood at $7.079 million with lease liabilities of $2.668 million, deferred taxes of $13 million, and long term tax payable of $427 million. In sum, total liabilities stood at $25 million, and the asset/liability ratio was 3.7x, so I would say that the company stands in a good financial position.

Further Increase In Engineering Expenses And More Decreases In Sales, General And Administrative Expenses Could Lead To FCF Growth

Investments in development and technological innovations will likely lead to new improvements of Omega products, in their quality and cost. I also expect new successful products considering the successful stories of Meditrac and TracPipe. In this regard, let's keep in mind that in the nine months ended September 30, 2022, engineering expenses increased as compared to the same period in 2021. I believe that more engineering expenses could lead to more product developments and technological innovations.

Engineering expenses consist of development expenses associated with the development of new products and enhancements to existing products, and manufacturing engineering costs. Source: 10-Q

I would also be expecting improvements in the company's FCF/Sales ratio thanks to further reduction in stock-based compensation expenses and less sales, general and administrative expenses. In the last quarterly report, the company reported a significant decrease in sales, general and administrative expenses.

Higher items include product liability reserves and expenses, associated primarily with one pending case, which the Company continues to vigorously defend, and staffing related expenses. As a percentage of sales, general and administrative expenses decreased to 15.0% for the three months ended September 30, 2022 from 18.0% for the three months ended September 30, 2021.

There also was a reduction in stock-based compensation expense which moves in relation to the Company's stock price, as detailed in Note 6, Stock-Based Compensation Plans, to the Condensed Consolidated Financial Statements included in this report. Source: 10-Q

My Cash Flow Statement Model

I studied very carefully the company's cash flow statement in order to run my DCF model. 2021 net income stood at $26.256 million with depreciation and amortization of $1.020 million, changes in inventories of $4.185 million, and accrued compensation of $1.582 million.

Changes in accrued commissions and sales incentives were equal to $2.835 million with lease liabilities of $0.335 million together with other liabilities of $2.992 million. In sum, 2021 net cash provided by operating activities was close to $25.149 million.

We know that the FCF was $14 million in 2019, $18 million in 2020, and $24 million in 2021. In my view, financial advisors will likely appreciate that cash flows are stable.

My financial model includes 2031 net income of $35.876 million along with non cash compensation expenses of $0.691 million, depreciation and amortization of $1.394 million, accounts receivable of $0.391 million, provision for inventory adjustments of $0.138 million, changes in accounts receivable of -$1.288 million, and changes in inventories of -$5.718 million.

I also estimated that changes in the right of use assets would stand at close to $0.448 million combined with other assets of -$0.695 million, changes in accrued compensation of $2.162 million, and changes in accrued commissions of $3.874 million. In sum, I obtained a CFO of $34.363 million.

If we also assume capex close to -$1 million, 2031 free cash flow would be $35.363 million. Besides, with a WACC of 6.70%, the NPV of future FCF would be $198.17 million.

For January 2021, the EV / free cash flow stood at close to 100x. Later it decreased to 60x. Again in January 2023 it stood at close to 74.38x. I believe that assuming an EV/FCF ratio close to 79x-80x makes a lot of sense.

My results would include a terminal value of $2.829 billion and a NPV of $1.57 billion in addition to an enterprise value of $1.776 billion, equity of $1.806 billion, and a fair price of $179 per share. I do believe that Omega Flex, Inc. could be trading at more than its current valuation.

Competitors And Risks

The competitors of Omega Flex are Ward Manufacturing, Hose Master, Titeflex Corporation, Penflex, and a number of smaller operating and commercial companies. None of these companies participates in more than two distribution lines. For this reason, I believe that Omega is better positioned in terms of market breadth than its competitors.

Among the existing risks for Omega, in my view, the most relevant is the dependence on its sales agents in terms of commercial operations. Supply chain issues and the fact that the company's revenue comes mainly from the sale of TracPipe and CounterStrike are also relevant risks.

Most of the Company's sales are derived from the sale of TracPipe and CounterStrike flexible gas piping systems, including Autoflare and AutoSnap fittings and a variety of accessories. Sales of our flexible metal hose for other applications represent a small portion of our overall sales and income. Any event or circumstance that adversely affects our TracPipe or CounterStrike flexible gas piping could have a greater impact on our business and financial results than if our business were more evenly distributed across several different product lines. Source: 10-k

It is also worth considering that the new political situation created by Brexit could increase border and customs controls, which may increase the company's exporting costs. As a result, I believe that the company's free cash flow margin could diminish, which would lead to lower stock valuation. Management provided a lot of information in this regard in a recent annual report.

The Company's main operating subsidiary, Omega Flex Limited, is headquartered in Banbury, England in the U.K. The result of the referendum held by the U.K. to withdraw from the European Union had created a level of uncertainty regarding the final terms of that withdrawal for a number of years, until an agreement was reached on December 24, 2020, by the U.K. and the European Union. While an agreement was reached, uncertainty still exists, and adherence to the new rules regarding border and customs controls could increase costs on materials imported into the U.K. and finished goods exported from the U.K. Source: 10-k

Conclusion

Omega Flex reports a massive number of clients, and works for very different industries, which will, in my view, likely make the company's revenue stable. The recent increase in engineering expenses is also worth noting, which may bring further technological innovations and perhaps new products. Besides, if sales, general and administrative expenses as well as stock-based compensation expenses continue to decrease, I would expect further FCF/Sales ratio increases. In sum, even taking into account risks from failed commercialization of new products, Brexit, or potential supply chain disruptions, I believe that Omega Flex is significantly undervalued.

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