Over the weekend a friend told me he wanted to invest in Nvidia. My first thought was do you really want to pay $80 for $1 of free cash flow.*

*(Nvidia currently trades with a market cap. of $2.2tn, we subtract the ~$26bn cash/short term investments on the balance sheet and divide by ~$27bn in free cash flow in 2023 to get $80 figure).

The question got me thinking, how much should we be willing to spend for $1 of annual free cash flow? After all the entire goal of value investing is to spend money now to buy a business that will continue to deliver cash in the future, with the aim that the cash returned will reward the investor with a healthy return.

Buying a $1 business

If we take a basic example, how much should we pay for a business that generates $1 in annual free cash flow. The common back-of-the-envelope method is to apply a multiple of say 10x or 20x, depending on how other comparable businesses are valued. Paying $10-20 for our $1 business, we would get our money back in a 10-20 year period.

But spending $20 so you can get the same back in 20 years isn’t a great investment; $20 is worth around $11 after 20 years with a modest 3% inflation rate. What makes businesses so attractive as investments is that they not only generate cash, but a good business will grow its revenue and will re-invest the cash back into the business to deliver future earnings growth. So in our imaginary $1 business, how do growth projections change the picture? If the business were to increase its free cash flows by 15% every year we recover our investment after 7 years if we paid $10, and after 10 years if we paid $20. By the end of 10 years we receive $3.52 in free cash flow per year and the business is now valued at $35-70 (depending on our multiple).

Instead of asking "how much should I pay for a business" we can flip the question around and ask "by how much does the company need to grow to justify the current market price?"

We can see that the price we pay for a business has a built in growth requirement if we expect to get our money back in a reasonable time period. We can ask the question “What growth rates are necessary just to recover my investment”. Here we have calculated the number of years required to recover the price paid for the business for different valuations ($10 = 10x free cash flow, $80 = 80x free cash flow etc.). Then along the top we track the free cash flow growth rate and the table provides the number of years we need to wait to get our money back.

Price is everything when buying a business. When paying $10 for our $1 business, we can still get our initial investment back in 10 years even if free cash flow declines by -1% per year. $20 requires a slightly steeper 12% growth, and paying $80 (looking at you Nvidia) requires a sustained 40% free cash flow growth every year for 10 years just to get our money back.

Achieving Investment Returns

So far this is just to recover the initial investment we made in the company but as investors we’d like to make a healthy return on our money. We can also assume that at the end of the period we can re-sell the business, so the value is not just the cash we receive but also the resale value at the end.

To account for inflation and our desired investment return we update our model to apply a discount rate of 12% so that cash is devalued by 12% every year into the future. At the end of the 10 year period we calculate the terminal value as the discounted cash flow at year 10, times by 20x multiple.

Now the picture changes, buying the business for 10-20x free cash flow, we can always get our desired return from the cash flow and by simply re-selling the business. Paying 30-50x requires a sustained growth rate of 12-20%, and paying 80x requires 25%+ growth to hit our return goals.

So if you are buying Nvidia today, you are implicitly signing up to the expectation that it will grow its free cash flow by 20-25% per year every year for 10-15 years. Is this a fair assumption? Our model assumes that 20x is a fair multiple and if you pay more for the business it will revert to this fair multiple in the due course of time. Many Nvidia investors may assume the high multiple will continue for years to come, but the market is under no obligation to do so.

Looking at the past 10 years, Nvidia has had an impressive track record, growing at a 55.6% CAGR since 2015, and an average of 30% (25% CAGR) between 2015-2022 if we exclude the 2023 bumper year.

Can the growth be sustained? The market clearly thinks so. Nvidia has certainly ridden the recent waves of Crypto and AI to stellar success. Whether these trends will continue to power 25% growth remains to be seen, we don’t think competitors like Intel or AMD are going to stand by and let Nvidia take all the action. Apple has also entered the game with their combined CPU/GPU M* series chips, which may not match Nvidia in performance but do exceed in terms of efficiency and power use; ideally suited to their mobile and personal devices.

Discounted Cash Flow Modelling

Putting Nvidia aside, the process we went through goes to the core of Discounted Cash Flow Modelling, an essential tool for investors to assess the value of a business:

• Predict the future cashflows for the business from now to n years into the future.

• Discount the future cashflows at an appropriate rate - as cash now is more valuable than cash in the future.

• Sum the future discounted cashflows to give the total cash the investor will get from the business over a period of n years.

• Finally, if the investor wishes to eventually sell the business, calculate the terminal value of the business n years in the future at which point the investor will see the business - usually by valuing the business as an appropriate multiple of the free cashflow in that year.

• The present value of the business can then be calculated as: the sum of the discounted cash flows + the terminal value of the business + any cash or short term investments currently held by the business.

At phron.io we simplify this process by adding a Discounted Cash Flow model that automatically projects cash flows into the future and determine if the business is overvalued or undervalued based on the projections.

By tweaking the model parameters we can determine what is the implicit growth required to justify the fair valuation of the current market capitalization of the business.

There are multiple ways to forecast future cash flow, here we just assume a fixed growth rate going forward. You can also use a linear regression model to project cash flows into the future based on the past trend, or even manually enter if you want plot the future cash flows yourself.

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Fever-Tree Drinks was founded in 2004 by Charles Rolls and Tim Warrillow on the simple principle that if you are going to treat yourself to alcoholic drink, with some expensive top-shelf liquor, it matters what you are going to mix the other three-quarters of the drink with. While the liquor side of the drinks market had been exploding with a new range of artisan gins, tequilas and whiskeys, established players in the mixer market (like Schweppes) had left the goal open for disruption.

Fever-Tree’s first product was launched in 2005. The premium Indian Tonic Water quickly became the market leader in the United Kingdom and remains the dominant brand today in its home market. An initial investment after the IPO in November 2014 would have rewarded the investor with a 2200% return at the peak in 2018. Revenues have grown at 27% CAGR since 2013.

Part of the success in the UK was the on-premise exposure. Every drink served with the accompanying Fever-Tree bottle was a free marketing opportunity that helped cement the brand and drive off-trade (supermarket, store) sales. Such a go-to-market strategy was key to early the success, but observers were skeptical the same mechanism could be applied to larger markets like the US where soda streams are more established in bars and restaurants.

The company was hit by multiple headwinds, the COVID pandemic and the lockdowns naturally hit On-Trade sales (bars, restaurants, venues etc.) but Off-Trade (supermarket, stores etc.) held strong. The consequent inflationary energy crisis in Europe in 2021-22 significantly impacted the glass bottling costs with Operating Expenses substantially eating into Net Income.

Since the peak in 2018, the market euphoria has abated and the shares have declined some 73% from the all time high. Long-term shareholders are naturally disappointed that the company has failed to maintain momentum. Famed UK investor Nick Train described Fever-Tree as his “biggest embarrassment” in 2023.

Margin Squeeze

Looking at margins, we only need to compare 2019 and 2022. Fever-Tree went from generating $85m on $341.6m in revenue (a 25% free cash flow/revenue), to less than $1.7m in 2022 despite growing revenue to $416m (0.4% fcf/revenue!) in 2022.

Before the pandemic all eyes were on cracking the US market to power growth and dethrone the soda stream. On this score the business appears to have succeeded with the United States overtaking the UK to be the largest market in 2023 with an average annual growth rate of ~27% since 2018. But margin challenges have long since eclipsed US growth as the primary goal for the company, and revenue growth alone will no longer save the company.

Looking at revenue growth since 2018, the most mature market of the UK has languished but the remaining markets of the US, Europe and Rest of the World have held strong resulting in a respectable 9% overall annual growth rate since 2018:

Despite impressive growth numbers outside the UK, the growth decline in the UK raises concerns about the total addressable market for its products and the impact of competitors. If it can’t achieve steady growth in its most mature market, coming out of a pandemic, then we should be concerned about a ceiling for revenue in other markets too.

Management emphasize margin improvements will be driven by new glass contracts with fully hedged energy pricing, lower Trans-Atlantic freight rates, supply chain optimisations and cost savings. While all this will help, a company of its scale and reach should not be so dependent on the fluctuations of bottling and transit costs. Rumour swirl about problems bringing online their US bottling plants; on-shoring production clearly has not provided the boost needed to transition away from sea shipments.

Outlook

Did Fever-Tree just enjoy first mover advantage coupled with the tailwind trend of premium spirits gaining market share over wine and beer, or is there some lasting value here? Despite the recent doom and gloom, there are still reasons to be optimistic about Fever-Tree.

Firstly, the management is sensible and seasoned, with many directors hired with long term experience in the soft drinks industry (the US CEO is the former President and CEO of Belvedere Vodka; a number of directors with substantial experience, soft drinks and supply chains for the likes of PepsiCo). Management still has a good level of insider ownership, estimated to be around 10% of outstanding shares. The company model is asset-light and outsourced. With only 300 employees Fever-Tree has launched into a global brand with a range of popular products.

Competition is hotting up in the mixer market with new entrants like Q-Mixers and established players like Schweppes developing their own premium brands. A host of regional and national mixers such as Fentimans and Mil 976 will eat into market share. It is curious that these companies have produced an almost identical product line-up and strategy, a testament to what Warren Buffett describes as an iron law of Capitalism: unless you have a wide moat others are going to do their level best to storm your castle and seize the prize.

Despite this, it’s hard to see how these products can catch-up to the premium brand, scale and distribution model of Fever-Tree. Once customers find a mixer they like there will be little incentive to risk disappointment by switching and smaller players will struggle to win major contracts with large scale distributors, airlines, hotels and other venues.

Q-Mixers is a substantially smaller privately owned company still in growth mode, clearly lacking the same scale and brand quality or awareness as Fever-Tree. Schweppes is a brand that is licensed by 5 different companies across different regions and suffers from a lower quality perception with customers. This fragmentation made it harder for Schweppes to respond with a counter-attack worldwide, but not impossible. In Spain, where gin and tonic is huge, Fever-Tree struggled to gain market share because Schweppes had so much to lose. They responded fast with a premium tonic and held onto their market position.

Fever-Tree is replicating its go-to-market strategy in the US by deepening relationships with Walmart, Wholefoods, Target, Marriott, Four Seasons and Hyatt. It also partners with national distributors like Southern Glazer’s in the United States (with a 35% market share in wine and spirits distribution) and Asahi in Japan for improved go-to market; whereas competitors rely more on direct sales teams for distribution. Of all the mixer companies Fever-Tree also has the longest and deepest partnerships with alcohol companies like Diageo, Pernod Ricard and Beam Suntory that helps it both develop new products and pair with liquors at both on and off-trade points of sale.

The company has a number of wonderful products well loved by customers. They have a track record of quality drinks and innovative products that fill a gap in the market where fewer others operate. They clearly take pride in the ingredients and sources for their drinks, boasting 3 different types of ginger for their ginger beer and ingredients sourced from all over the world. The brand is established and increasingly well known worldwide for quality and customers trust. If you are going to treat yourself to a drink why would you ruin it with a substandard mixer, or risk disappointment by saving a few dollars.

More than anything we are optimistic about the return of On-Trade sales. Fever-Tree is already a favourite among bartenders and the increasing penetration into hotels and bars serve as another avenue of marketing and brand awareness. Each drink served in a bar or restaurant, with the accompanying Fever-Tree bottle is an opportunity for free marketing and organically growing off-trade sales.

Product Line up

Leadership within the company emphasize innovation as the path of forward, and on this front they have demonstrated that they can expand beyond just tonics into markets like the US where G&T is not as popular. The Ginger Beer range and Sparkling Pink Grapefruit have been instrumental in driving in growth in the US and other markets where whiskey, tequila and other liquors are more popular than gin. The expectation in the alcohol industry is that spirits will continue to gain market share over wine and beer, and so expand the market for mixers and long drinks.

Coming to market soon are ready made cocktail mixers such as Fever-Tree Margherita, Mojito, Espresso Martini and Bloody Mary Mixer. Going on sale now in the UK are adult soft drinks, partly a tacit acceptance that their drinks are enjoyed both as a mixer and also standalone. We think Fever-Tree has both the brand and reach to make a success of each of these new product lines.

What will make Fever-Tree successful is its brand, dependability, customer loyalty and ability to command a premium price above competition. After all, go to Safeway of Wholefoods and you will see a range of existing mixers, cocktail mixers and adult soft drinks; there is no shortage of competition so the differentiator will be it’s brand and go-to-market strategy and most importantly a sustainable strategy to control its bottom line compared smaller competitors.

Conclusion

We trimmed our holdings of Fever-Tree in 2023 as part of an end of year tax harvesting strategy. Despite optimism, we think Fever-Tree is still on the “too hard” pile for now as revenue growth has slowed to 6% in 2023 and margins are still recovering. We give Fever-Tree a HOLD status and await margin improvements before re-evaluating. A wonderful brand is not enough if a business can’t control its margins and profits can be buffeted so substantially by external forces.

Management has reiterated their guidance of 10% revenue growth and 15% EBITDA margin for 2024, but really for a premium drinks company with a great brand and customer loyalty we should be seeing EBITDA and Net Income Margins at historical levels of up to 30% or more. At such margins the current market capitalisation of $1.2bn will look substantially cheap at only around 10 times free cash flow, but for now we believe it is fairly priced.

A great business going through a difficult - if transitory - times should pique the interest of any value investor, so will continue to monitor Fever-Tree and eagerly await substantial improvements in the business’s bottom-line.

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UFP Industries Inc.

Firstly, welcome to our Substack and our first post! Our goal is to provide detailed analysis of hidden gems in the small to mid-cap range. In our first post we analyse UFPI: Universal Forest Products Industries. We first invested in this diversified company in the lows of 2023 - when the market cap hovered around $4.7bn-$4.9bn. At the time we considered it undervalued to intrinsic value and since the market has reevaluated its valuation upward by about 48%. At the time of writing the market cap is touching $7bn.

The Summary:

• A diversified business with multiple business segments and geographies.

• Quality, experienced management focused on balanced capital allocation and acquisitions to power growth.

• Healthy and growing cash flows, balanced Capital Allocation program to fuel future growth and return value to shareholders.

• Seasoned management is committed to moving up the value chain in all segments.

Let’s dive in.

1. The Business

UFPI is a holding company based out of Grand Rapids, MI founded in 1955 as a lumber supplier to the manufactured housing industry. The company boasts it has been profitable every year since inception in 1955; going public in 1993. It has 3 main business segments, Retail, Packaging and Construction and a smaller International segment. It is geographically diverse, with 221 facilities worldwide spread across US (197), India (9), Australia (5), Mexico (4), Canada (2), the UAE (2), the UK (1), Spain (1), and China (1).

Retail Solutions

Retail is the largest segment (~41%) providing products like decking and railings through the business units: ProWood and Sunbelt, Deckorators and UFP-Edge.

ProWood and Sunbelt sell pressured-treated, fire retardant lumber products such as fencing, lattice and decking for outdoor environments. Deckorators supplies composite decking and decking accessories based on its patented mineral based composite decking and wood plastic composite. UFP-Edge manufactures and sells exterior sliding, pattern and facia products using traditional, engineered and modified wood.

The retail segment faces competition from mostly regional players on an individual product basis, but there are no known competitor that currently manufacture, treat and distribute the range of products on a national basis in the same way as UFPI.

As the two largest customers, Home Depot and Lowes, account for 15% and 11% respectively of sales in this segment in 2022, changed from 16% and 10% in 2021, and 24% and 4% in 2020 suggesting that it has diversified away from Home Depot in recent years towards Lowes and other customers.

The company occupies a sizable market share, estimating that they produce approximately 28% of all residential treated wood in the USA, 5-6% of all composite decking and accessories, and 9% of all wood and vinyl fencing.

A key differentiator in this segment is the rapid turnaround it can achieve delivering mixed truckloads of products delivered from regional facilities in short time from receipt of an order. The “low maintenance” decking is considered to be a favorite choice amongst contractors.

Construction

The construction is the next largest segment (~30%) features the business units: Factory-Built Housing, Site-Built Construction, Commercial Construction, and Concrete Forming.

Factory-Built Housing designs and manufactures custom roof trusses for manufactured housing. The company estimates it produces 45% of all roof trusses for factory-built housing in the USA. Again it’s differentiator in this field is the regional facilities, but increasingly it also provides design and engineering support services.

Site-Built Construction designs and manufactures roof and floor trusses and other lumber packages to frame residential and light commercial projects. They estimate they provide approximately 6% of all engineered wood components used in housing in the USA.

Commercial Construction designs, manufactures and installs highly customized interior fixtures and casework primarily through the operations of idX Holdings.

Concrete Forming unit designs and manufactures wood forms used to form concrete for structures such as large parking garages, stadiums, bridges and other infrastructure projects.

Packaging

Packaging accounts for about 25% of the business and delivers various packaging solutions through the units: Structural Packaging, PalletOne and Protective Packaging Solutions.

Structural Packaging designs, engineers and manufactures custom packaging products made of wood. The products are custom and designed according to customer specifications and serves a variety of regional, national and global customers.

PalletOne designs and manufactures wood and heat-treated wood pallets in variety of sizes and compositions used by customers for shipping a wide assortment of consumer and industrial products.

Protective Packaging Solutions features a wide variety of products and solutions and are sold primarily as additional offerings to structural and pallet packing products to provide a more complete solution for customers.

As with retail, competition in packaging is fragmented. They currently believe they provide 15% of all US domestic customized structural packaging with a 10% market share of wood pallets.

Purchasing & Suppliers

Given the size and scale of the business it is one of the largest domestic buyers of softwood lumber from lumber mills in the USA, purchasing approximately 7% of softwood production in North America. This has allowed it to maintain long-term relationships with many suppliers leading to better management of raw material inventory, lowering costs and mitigating the volatility of lumber prices.

2. The Management

Reading through the annual report and quarterly earning transcripts the management come across as experienced (many with long tenure at the company - averaging 23 years at the company), sensible and optimistic about their company. The company struggled during the downturn after the financial crisis of 2008 but the subsequent restructuring during this time paved the way for future growth.

“Today we are a more efficient organization than we were three years ago. And then to be honest with you we are a more efficient organization today than we were last week” - UFPI Q4/2009 Earnings Call Transcript

All plants are profit centres and bonuses are calculated based on return on investment. The firm fosters an operator mentality in management requiring managers to own stock in the company. We like the level of insider ownership and levels of tenure amount senior leaders and managers.

The company has a dedicated sales team and management have set targets regarding gross margins to achieve. If deals don’t meet the gross margins hurdles they are comfortable walking away instead chasing down every deal.

3. Financials

Looking at the financials, revenue grew a 16% CAGR from $2.5bn in 2013 to $9.6bn in 2022. During the same time period Gross Profit grew at ~23% CAGR from $280.6m to $1.8bn, Net Income at ~36% CAGR from $43.1m to $692.7m, and Free Cash Flow at a stunning 54% CAGR from $13.2m to $657.4m. The number speak for themselves, but the operational improvements have driven improved profit and free cash margins over this time on top of the revenue growth.

Q4/2023 numbers have yet to be announced, but it looks like revenue will decline overall in 2023 compared to 2022. Q3/2023 net sales were down -16% compared to 2022 driven by reduced lumber prices and reduced volume due to a decline in housing starts.

Despite a depressed year in 2023, we still expect UFPI to generate healthy cash flows, to continue its Capital Allocation program. It ends 2023 with ~$957m in cash or cash equivalents on the balance sheet, $2.5bn in Current Assets vs. $604m in Current Liabilities and low long term debt levels of ~$273.m demonstrating a very health balance sheet.

4. Capital Allocation

Management has set a balanced model for capital allocation of cash flow, spreading across acquisitions, Capex, “opportunistic” share buybacks and dividends. We believe the share buybacks program at current low price levels will reward shareholders in the long run.

A key aspect of its growth strategy is through acquisitions with a team dedicated to identifying acquisition targets. In a fractured and regional field, we believe UFPI stands as a unique national and international player with potential to establish dominance through targeted acquisitions.

Management has stated their goal to move up the value chain by providing higher value services in design, engineering and support; we believe their acquisition pipeline will help support this goal and move the company beyond raw manufacteuring.

The low levels of Capex required to fund growth is a feature we look for in all investment opportunities and UFPI has a solid record, in recent years dedicating 20-30% of Net Income for Capital Expenditure.

5. Valuation

Performing a quick Discounted Cash Flow Model on UFPI, it’s hard to conclude it is anything other than undervalued:

In this model we assume a 10% Free Cash Flow growth going forward - using the average of the last 4 years of FCF to smooth out the bumper years in 2021 and 2022. A 12% discount rate, 30% margin of safety and a terminal market price of around 10x Free Cash Flow. Even with such conservative assumptions the Net Present Value comes somewhere between $5.9bn-$8.5bn vs. the ~$7bn current Market Capitalization.

6. Risks

UFPI isn’t without risks. Despite being well diversified and robust, it is still heavily subject to price fluctuations in lumber prices. It is heavily impacted by crashes in housing starts and homebuilding which has clearly impacted sales in 2023.

It should also be noted that 2021 and 2022 were particularly stellar years for the company as high lumber prices fueled record profits. The high interest environment will certainly reign in profits.

Another aspect often mentioned during the quarterly earning calls is the challenge they face hiring quality employees and training the next generation of managers and leaders within the company. The current management is seasoned and stable, but they will not be around forever. Fortunately they are aware of these challenges and regularly enhance their internal training programs to foster talent and grow the next generation.

7. Summary

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” - Warren Buffett, Berkshire Hathaway (Source: 1992 Shareholder Letter)

The gold standard of value investing are quality businesses that generate healthy free cash flow and sensibly allocate that cash at high rates of return for future growth.

In an era when investors look for quick returns in the next Nvidia, sometimes the unsexy quality businesses can be overlooked and we believe this has been the case for UFPI. While the market currently prices UFPI as a raw materials manufacturer we believe there is scope and potential for the company to move up the value chain through acquisitions and investment.

UFPI passes our criteria for a high quality business in many regards: seasoned management, diversified business segments, healthy and growing free cash flows, robust balance sheet and financial statements, reinvesting for future growth and expansion while also rewarding shareholders through dividends and buy backs.

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