Supremex Is Pushing The Envelope Into Packaging (OTCMKTS:SUMXF)

It has been a while since I took a look at Supremex (TSX:SXP) (OTCPK:SUMXF), a small Canadian company I have been holding for a while in my portfolio. The objective of this exercise is to assess if I should hold, sell, or add to my position.

Source

Supremex Inc. is a small-cap manufacturer of envelopes, which is a declining industry and is now pivoting into the labeling and packaging industry. It is using its dominant position in the declining Canadian envelope market to push both into the much larger US market for envelopes as well as into the adjacent business of packaging and labeling.

I had bought it because it was cheap and for its dividend. Following the coronavirus crisis, the company has now cut its dividend to zero (as a precautionary measure and in order to deleverage) and has gotten a lot cheaper, which frequently happens to deep value stock.

The company describes itself as follows:

Supremex is the only national envelope manufacturer in Canada, with 12 facilities across seven provinces as well as three facilities in the United States, employing approximately 830 people. Supremex’ growing footprint allows it to efficiently manufacture and distribute paper and packaging solutions designed to the specifications of major national and multinational corporations, resellers, government entities, SMEs and solutions providers.

Source: Company Investor Presentation

It has a long history of consolidating the envelope manufacturing industry which is in secular decline, with acquisitions and is now expanding into the packaging as well as the US market. While envelopes make up <50% of total revenue, the company recently made another opportunistic acquisition in the envelope space last quarter (Royal Envelope Limited, the #2 envelope manufacturer in Canada).

Source: Company Investor Presentation

While the stock price has fallen by over 75% in the last 5 years, operating cash flow and free cash flow are up, after a period of consolidation.

Operating Cash Flow

Looking at the operating cash flow chart over the last 5 years, I observe the following. The company took a large asset impairment charge in 2018, resulting in a loss when it wrote down assets. However, the company has been free cash flow positive throughout this period. It is currently generating about CAD $20 million a year in free cash flow, quite extraordinary when you consider the market cap is only ~CAD $33 million. A price to free cash flow ratio of less than two.

Source: Author with data from Gurufocus.com

The company had levered up in the last few years, but debt, as compared to EBITDA, remains comfortable. As mentioned previously, the company has now discontinued its dividend in order to deleverage and should survive the current recession.

Source: Author with data from Gurufocus.com

The following diagram depicts its balance sheet. Equity to asset ratio is 0.37.

The debt-to-equity ratio is 1.33, debt-to-EBITDA ratio is 3.83, and interest coverage is 4.33. All debt ratios are in a reasonable range. Working capital is about CAD $30 million.

Source: Simplywall.st

Valuation

In the following sections, I have valued the company using a couple of methods.

Discounted Free Cash Flow Method

Here I have assumed a cost of capital of 9% and a total company life of 20 years. I have assumed that the company will be able to maintain flat free cash flow per share for the first 10 years and for the next 10 years growing at about 2%, in line with GDP. I came up with a value of CAD $6.58 vs. the current stock price of CAD $1.15.

Source: Gurufocus.com

Historical Price Ratios

This method values the company based on median price to earnings, price to sales, and price to book ratios. The method indicates that the company’s median justified price should be at least CAD $2.54, which is more than double from where it is right now.

Summing Up

Supremex is extraordinarily cheap, and it has been like that for a while. It’s either a deep value or a value trap, and both perspectives have merit. I lean towards the former. As a deep value investor, the stock price is an interesting reality, but it’s the underlying earnings power and assets that count.

Supremex is underfollowed and, now that it cut its dividend, very much unloved. While the stock price has fallen precipitously, cash flows remain steady showing that the company’s strategy of pivoting from envelopes to packaging is working. The suspension of dividends is disappointing but understandable given the gravity and depth of the crisis we are in. The market was not valuing the company based on this large dividend and there now might be better ways to use those funds today such as buying back shares or purchasing distressed assets on the cheap. The company’s leverage is on the higher side but now that it cut its dividend, it should be able to reduce debt. It generates a lot of cash for its size.

Return on invested capital is about 25% and return on equity is about 13%, both very good numbers. The risk of permanent loss of capital is low, in my opinion. The market has basically thrown the company into the garbage bin. It’s an easy hold for me, and I may even add to it (not yet fully decided) if I see clear evidence of economic recovery both in Canada and the U.S. and how the company handles the next couple of quarters.

Disclosure: I am/we are long SUMXF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note currency is Canadian dollar. The primary listing is on the Toronto Stock Exchange (TSX) where there is good liquidity for the stock.

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