2023-05-21 05:29:48 ET
Summary
- UFP Industries' financials are solid with 10 year returns beating S&P 500, consistent earnings, decent RoE with low leverage.
- Competitive advantages from vertical value chain, product breadth, proximity of facilities to customers, and long-term supplier relations to name some.
- The short-term outlook based on leading economic indicators is starting to turn positive.
- I give mid-cap UFPI stock a long-term buy rating.
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UFP Industries, Inc. ( UFPI ) is a holding company with lumber-based retail, construction and packaging products. It is a constituent of the S&P mid-cap 400 index. It has good historical financials, and competitive advantages. In the short-term, the recession indicators have been looming large and in 2023, the company's own expectations are lower growth than 2021 and 2022. Like most of the basic materials sector, lumber companies are down-trending . However, in the long term, given the competitive advantages and track record of performance, there is long-term potential.
Financials are solid
In the last 10 years, UFPI's total return has beaten S&P 500 handsomely.
EBIT has been consistently up YoY, minus the economic downturn 2022-now. No erratic patterns here make this a predictable company.
RoE has been steadily increasing, minus the economic downturn 2022-now.
Leverage has not been overused to achieve this.
Such low levels of leverage & consistent returns are made possible by stable and growing OCF as shown in UFPI's latest IR presentation .
UFPI Investor Relations
Competitive Advantages
Restructuring to drive strategy and compensation to drive entrepreneurship
UFPI's 10-K shows they have restructured from their previous 64 years of regions based segments to 3 new segments - Retail, Construction and Packaging. This was to create deeper understanding of markets and more complete solutions and services. This helps UFPI to recognise and exploit market opportunities, enhance the efficiency of operations, and improve the deployment of capital. The business units are rewarded on operating profits to encourage strong entrepreneurial and sales culture. Managers are required to own the company stock. Such organisation and compensation structure will create long-term value and strong alignment to shareholders.
Vertical value chain, Geographical reach, and Product breadth
In their retail segment , UFPI manufactures, treats and distributes full line of commodity-based products on a national basis. Competition is mostly on individual products and on a regional basis - competitors mostly lack the full-chain value addition, product breadth and geographical reach. This creates an advantage in brand value and indeed creates scaling synergies that competition is unlikely to manifest.
In the packaging segment , the market is fragmented with numerous suppliers. Whilst UFPI has geographical reach advantage in this segment too, they plan to acquire companies that strategically enhance their product expertise and value add offering. With their current 10%-15% market share, UFPI has room for growth in this fragmented market.
Proximity to consumer
In their retail segment, customers are supplied from many locations. Treated wood is a heavy product and freight costs are a factor in competitive pricing of products to consumers. The strategic proximity of facilities to consumers means rapid turnaround times and competitive prices.
Similar dynamics exist in construction segment where UFPI provides timeliness of delivery due to the freight advantage from this strategy.
Product expertise, engineering and design
In their construction segment , for factory built sub-segment, UFPI enjoys a 45% market share of roof trusses. Such a massive share is down to product knowledge and brand name created over many years. For the site-built sub-segment, there is competition from regional and national building product dealers. UFPI's engineering, design and product quality gives it a 6% market share of all engineered wood components used in housing in US. The US population migration trends is benefitting UFPI given the states they operate in.
Long-term supplier relations
The depth of product value chain and breadth of products coupled with its growth over the years has made UFPI into one of the largest buyer of sawn softwood from lumber mills. This creates long-term supplier relations and better purchasing power for UFPI. This is not something a competitor can easily create as it is a product of multi-years of above successful strategies.
Intellectual property
UFPI boasts many existing and pending patents. However the company estimates loss of a patent will not be detrimental to their competitive position. They showcase how their innovation and new products have been able to keep up as % of their growing sales.
Short-term outlook
Sitting within the basic materials sector, UFPI faces cyclical pressures as normal. A key input into a lumber product company is - lumber prices. My thinking is that coming out of pandemic, saw pent-up demand for lumber and lagging capacity of lumber production which created for high lumber prices and much market volatility. UFPI has risk to lumber prices on products that have significant inventory levels and low turnover rates. Consider, for example, a drop in demand of end products paired with high prices of lumber. This will result in high cost spent on lumber but reduced product sales onwards - a hit on sales & margins. Over-time, lumber mills add capacity, there is over-production and prices drop. Although, UFPI aims to diversify products and reduce impact of lumber price driven market risk, there will always be some risk here. Margin pressure aside, higher prices will create a drop in consumer demand. Well, the good news is prices are showing signs of stabilising - I take this as an early indicator, all else equal, that demand will be back. Thus, I would see UFPI unit sales growth coming back up in 6 months - 1 year. Of course, a hard recession that kills all demand can prove me so very wrong.
Below graph shows how the unit sales growth has taken a hit across the board in 2022.
I would put inflation as a main factor for decrease in demand of the end products. FED rate hikes has started to show signs of containment - and below are what I would call the leading indicators for normalisation relevant to lumber products industry:
- US Housing starts is looking up
- US Retail sales which are an indicator of consumer spending show a surprise April rebound and month-on-month decreases are decreasing in magnitude.
I'd estimate a 1 - 2 year horizon for the sales and margins to catch up if the trend persists.
A theory for short-term fragmented market outlook
On the lines of "Survival of Fittest", I hypothesise UFPI's low leverage + strong OCF position as an advantage in the current macroeconomic environment. In addition to Macro factors laid out above, note that FED warns of "credit crunch risk from US Bank turmoil". As explained under the competitive advantages, some of the competitors of UFPI are local/regional, and may have exposure to regional banks. Some of these markets are fragmented. Prolonged economic stresses can potentially see some of the higher leveraged smaller players go out. My opinion is that a soft prolonged period of inflation with such credit crunches will likely see UFPI increasing its market share. This could translate translates to some rapid unit sales and sales growth over a 2 year - 3 year period.
Key Risks
In the long-term, competitors trying to copy some of the UFPI value chain strategies will be a company-specific (excluding macroeconomic) risk here. Decreasing market shares will be an early indication to exit.
Macro-economic concerns like hard or long recession, persisting inflation, supply chain disruptions could materially impact UFPI.
Concentration risk - Again company specific, two consumers Home Depot ( HD ) and Lowe's ( LOW ) make up 26% of sales of UFPI. A further material build up in this concentration would indicate risks like buyer's pricing power and transmission of specific weakness in those companies. At the time of this writing, both hold solid ratings:
HD:
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LOW:
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Valuation
I wanted to check on the future of wood industry in the long term before starting valuation. FAO's analysis on global consumption of wood products shows a 37% increase in Roundwood Equivalents, 102%for veneer/plywood and a 3% increase in sawnwood for construction by 2050. With consideration for natural resources and risk of any lumber substitutes, this was to test if wood products are going away permanently at all. That does not seem to be the case, and in line with the guidance here , I will use 2% (which is lower end for a mature company) terminal growth rate for UFPI.
Furthermore, I note that based on Q1 announcement excerpt , we need to think of the company in terms of pre-2021 financials.
Our outlook remains positive, albeit at a lower level than 2021 and 2022
- Chairman and CEO Matthew J. Missad
FCF based DCF
I used 2020 FCF, which is about 60% below 2022, as the starting FCF for 2023. This should act as a short-term shock and align with the forecast above.
Then I calculated weighted average cost of capital. Cost of equity was calculated using CAPM. For the risk free rate, I used peak 10 year treasury rate in last 1 year - 4.25%. The market returns of S&P 500 has been 10% over long term and is the market return I would use. Beta is assumed at 1.48 on a 5Y monthly basis. This results in a CAPM based cost of equity of 4.25 + 1.48*(10-4.25) = 12.76%.
Cost of debt is calculated by implying the pre-tax cost from interest expense and the after tax cost based on effective tax rate. The after tax cost of debt is then Pre-tax cost of debt * (1- tax rate).
Author's calculation based on SheetsFinance data
Next, I calculate the weighted average of both equity and debt costs in proportion of equity and debt, which is 94.8% and 5.1% respectively. WACC is thus calculated at 12.32%.
For appropriate growth rate to use in FCF, I again ignore 2021/2022 in line with Q1 earnings announcement guidance. The 3Y average CAGR, 5Y average CAGR for FCF are 36% and 31% respectively. Given the FCF shock of using 2020 FCF as starting point, I decided to have 2 cases - optimistic case of 30% initial growth and a low case of 20% initial growth. In both cases I will run the growth down to the terminal growth rate of 2%.
I used a linear decay of FCF growth rate to reach the terminal growth rate. Below is the FCF discounted cashflow model's output.
Above valuation creates a range of $79 to $114. There is balance of both 60% down-shocked FCF from 2020, to reflect economic uncertainty, and retention of company specific initial growth rates here.
UFPI has recently repurchased 451k shares recently at an average price of $78.27. Thinking of this price range as a good range signal from management, I'd read this with my valuation to see upto $90 as potential entry points. This is further supported by Wall Street analysts' consensus range of average $104 target. I'd keep $90 to $100 as a potential safety margin.
Overall, the ratings at the moment seem to be either buy or hold, perhaps slightly favoured towards buy.
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Conclusion
UFPI has good financials track record at low leverage. UFPI has competitive advantages in how it has positioned the vertical value chain, product mix, geographical facilities and organisational incentives. There is ongoing emphasis on innovation and focus on strategic acquisitions to enhance the competitive position. UFPI is not immune to macroeconomic pressures, but I view these as temporary and an opportunity for UFPI to increase market share in some fragmented/regional markets. Leading economic indicators of housing starts and consumer spending will favour UFPI if the trends persist. Valuation indicates modest upside in the short-term, but its more the long-term value that I see as the potential here. I will rate UFPI as buy for both long term investors and for short term modest opportunity seekers.
For further details see:
UFP Industries Is A Good Long-Term Addition