A mispriced manufacturer? $SXP (Supremex)

I do not own shares in SXP (Supremex) and i am not a financial advisor.

Intro

Supremex Inc. manufactures and markets envelopes, paper packaging solutions and speciality products to corporations, resellers, government entities, SMEs, and solutions providers in Canada and the Northeastern and midwestern United States. The company offers a range of stock and custom envelopes in various styles, shapes, and colours; corrugated boxes, folding carton and e-Commerce fulfilment packaging solutions; polyethylene bags for courier applications and bubble mailers. It serves a variety of industries, including food, pharmaceuticals, cosmetics, and personal care products. The company was founded in 1977 and is based in LaSalle, Canada.

Supremex’s position as the dominant market leader for envelopes in Canada (85% share) allows it to generate a ton of free cash flow that it can then use to self-fund its entrance into the packaging and specialty products market. Management has overseen the pivot over the last 5 years and has thus far done a terrific job at turning the cash flows from their dying envelope business into promising growth opportunities in the packaging segment, which is no easy feat. Supremex has a vast network of manufacturing facilities and distribution centres which allows it to enter a secular growth market with both a ton of management expertise, and the infrastructure in place to make a real dent in the market. All-in-all, Supremex can reach 70% of the US market within 800km for the US envelope business, and there is no reason to believe they can’t say the same for packaging.

History

Supremex has undergone a significant transformation since its initial public offering in 2007. Initially focused solely on the Canadian envelope market, the company has since branched out. What might seem like a declining industry on the surface now houses a growing segment in niche packaging, which currently contributes a substantial part of Supremex's revenue, in addition to expanding into the U.S. envelope market. The company started in 1977 as a relatively minor entity in the envelope industry. By 1991, Supremex had risen to become the third largest envelope manufacturer in Canada (now at the top spot). After several transactions, it was eventually acquired by Cenveo (previously known as Mail-Well Holdings Inc.). In 2007, Supremex was spun off from Cenveo as a strategy for Cenveo to reduce its debt, leading to the Supremex we know today.

Strategy

In 2014 the company was worried about their sole business line of Canadian envelopes being in a structural decline. They had a few ways to remedy this: 1) Consolidate envelope manufactuers in Canada and selectively in the northeastern U.S. to gain some form of economies of scale and pricing power, and 2) Use cash flow to grow a packaging & specialty products business while paying dividends and buying back shares. Supremex’s have been extremely active in the M&A space, and their acquisition list is extensive and split between packaging and envelope see graphs shown below. They have successfully acquired the majority of their competitors in Canada and are now producing around 90% of Canadian envelopes.

The 2022 acquisition of Royal Envelope solidified themselves as a monopoly in Canada with there being no more competitors left to acquire. Although mail volumes have been in a structural decline, Supremex have impressively been able to offset the impacts of volume decline by additional cost cutting, price increases, and acquisitions.

The envelope segment is broken down into ‘Stock’ Envelopes (generic envelopes for everyday use; Birthdays, greetings cards etc) and ‘Custom’ envelopes which are manufactured to set specifics (e.g. Banks when they mail you a debit card)

Packaging on the other hand is a mix of folding carton (differentiated, used for pharmaceuticals & consumer packaged goods) and E-Commerce.

The envelope market has been in secular decline for over 10 years. The Canadian market which has declined by 6.5% per year in which Supremex has a 90% capture of. Conversely, the U.S. envelope market is around 20x larger than the Canadian market and is declining at a slower rate of 3.4% over the past several years. Although Supremex only having a small fraction of the US market, they have the capability and facilities to cover up to 80%. Again, they have consolidated envelope operations and seem to be doing the right thing to maintain the business as best as they can.

Packaging on the other hand continues to grow. Over the last 10 years the Canadian market has averaged 11% ( Similar growth seen in the US) . The goal it seems based on managements outlook is to stabilize the envelope segment and build up the packaging capabilities and equal out revenue split between the two products (Packaging currently at 30% Revenue split:

When looking at 2023 numbers, it shows they’ve continued to pass through costs and have grown packaging through acquisitions while managing debt carefully. However, it’s important to note the significant volume decline in 2023 in confluence with not being able to maintain margins, which is worrying. However, It was emphasized in the Q4 earnings call that 2022 was an anomaly year that should not be used as a comparable due to supply constraints that caused increased demand and that although 2023 faced headwinds it was more organic than 2022. This may be a factor linking to the decline and potential misprice if 2022 is used as a benchmark at face value.

It was also mentioned on the Q4 call that the 2023 volume decline was felt across the industry and is somewhat due to Macro struggles:

“CPG focused packaging businesses have been experiencing virtually the same volume related challenges that Supremex packaging has been facing. I believe I use the analogy last quarter that for many right now, as weekly grocery bills significantly outpace wage gains, that bounce dryer sheets are a luxury item that many are foregoing as budgets get pinched and consequently the box manufacturers getting squeezed as well.”

And this repeats itself across a number of verticals, including health and beauty, vitamins and e-commerce purchases. It is fair to say that sales and volume growth was bumpier than anticipated, and it's been and it has been for longer than anticipated time. However, like the Envelope segment, the Packaging segment also appears to be slowly coming out of a long slumber, and with significantly improved operations and a revamped sales team, weare wellpositioned to capitalize.

We had a lot on our plate for 2023 with acquisitions to integrate and plans to relocate. In Q1 and Q2, we were completing the move and commissioning of our flagship folding carton location in machine and had much more cost overhang and inefficiencies than we would have liked.”

The dynamics of envelopes and packaging are very different, but Supremex has demonstrated pricing power in both, albeit with packaging having recent challenges. Supremex continues to harvest free cash flows to fund the transitional goal of a 50-50 split between envelope and packaging. At first glance, it is potentially easy to write off Supremex as an envelope monopoly destined for despair going forward, and whilst envelope revenue is 71% of the total, that number is down from 80% in 2016 and should continue to shrink.

Valuation

Let's start with the balance sheet. Supremex’s balance sheet looks good despite recent cash acquisitions. Serial acquirers have the tendency to take on a lot of debt and lever up their balance sheet to support inorganic growth at massive future costs. In this respect, Supremex has done a good job of managing debt and keeping cash levels high enough that there is no real fear of short-term liquidity crunches (Current ratio sitting at 2.3). While there appears to be some red flags (growing inventories, high portion of assets as goodwill/intangibles) this seems in level with a company acquiring as much as Supremex.

Hidden real estate value? A shareholder proposal by Mr. George Christopoulos at April 2022 (71.4% voted against) – The proposal reads as follows: Supremex Inc. immediately sell and lease back 2 owned real estate properties located at 400 Humberline Drive, Torono and 7213 Rue Cordner, Monstreal and surface very significant hidden value of approximately $62 million or about $2.30 per share ~ Something interesting to note maybe

Buybacks. Supremex values rewarding their shareholders through share buybacks, which they have done consistently for years and continue to do so due to their belief that they’re vastly undervalued by the market – an encouraging sign of things to come, and management's view of potential growth opportunities. Furthermore, insiders are heavily invested themselves, with insider ownership in Supremex at over 35%. Pairing that with the decrease in share count over the last decade, along with the continued buying of shares by insiders makes for a very encouraging future for the company.

DCF. In the model, you will see a breakdown of Supremex in which I have purposely created the scenario of a negative outlook along with relatively negative assumptions to show the upside while in a low growth scenario). I have assumed the continuation of -10% annual decline in envelope revenues with a 10% annual gain in Packaging & Specialty products revenue.

I have assumed a -5% annual decline in revenue, a 4% net income margin , a Capex/Depreciation of 0.3 and a Capex/Sales of 2% for the 2027-2034 Period. Bloomberg gave me a 7.8% WACC, so I went with 10% along with the pessimistic trend and a 2% terminal growth rate. All of this brought me to an implied fair value of $6.55 CAD per share, a 71% upside from todays prices all whilst with relatively pessimistic assumptions.

This is impressive outright and has the potential for this number to be even higher in the bull scenario which considers a multitude of factors such as; a strong talented management team being able to successfully integrate prior acquisitions, source further accretive acquisitions, emergence of new e-commerce markets expected to bring significant growth to the packaging market and provide organic growth along with an uptick in volume.

Risks & Bear case

One thing that stuck out to me and seemed extremely attractive was the downside protection in the Bear Case. Let me break down the risks and scenario. Some of the major risks include failed acquisitions, poor synergies or goodwill impairments derived from overpaying for targets. As a result, impairments could lower the book value and lead to share price declines. Furthermore, a failed acquisition may alter sentiment and look sour to investors if it becomes hard to convince them of confidence in management's ability to select and acquire targets successfully. It is worth mentioning inflation has a key impact here, if inflation remains high or there’s another wave discretionary spending could be dampened further, volumes might not rebound/decline further and will affect key products (Packaging specifically) . My Bear case price target sits at around $3, roughly 20% downside from today's prices.

Conclusion

Finally, on a relative basis, the company looks cheap, and the market is pricing in little-to-no growth as the most likely outcome for Supremex. Supremex is currently trading at a discount to peers as seen below via Bloomberg.

The company is also at a discount to its historical averages, while maintaining a high FCF yield (See Ratios Tab)

Based purely on financial metrics, ignoring the qualitative aspects of the business, this company boasts a strong balance sheet, a history of successful acquisitions, impressive returns on investment, and significant growth in revenue over the past 5 to 10 years. It also returns value to shareholders through buybacks when it finds limited opportunities for effective cash allocation. From a standpoint of generating cash, Supremex is well-positioned for future growth and likely to see its valuation adjust upwards as the market begins to recognize its potential. Even in bear scenario, the balance sheet and ability to generate cash provides a high margin of safety. I anticipate that the company will continue to generate robust free cash flow in the next five years, which will support additional acquisitions and drive growth. With its undervalued shares, minimal risk, high margin of safety, excellent capital returns, and an aligned management team committed to shareholder value, Supremex represents a compelling, low-cost investment opportunity with significant upside and minimal downside.

Feel free to reach out or leave any comments if you have a question. I hope you enjoyed! :)