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I felt sheepish at my local café this week. Everybody who ordered a takeaway coffee had a re-useable cup and eco-friendly mindset. I asked for my long black in a double paper cup, then put a napkin around it for further insulation. And used a plastic spoon, once, to stir the coffee.
Later that day, I bought a bottle of water. My younger colleagues had re-usable water bottles and dutifully filled them at the office water fountain. That’s good for the environment, but not so good for packaging stocks that face threats – and opportunities – from sustainability trends.
Global consultancy McKinsey & Co recently wrote that smart bottles and edible boxes are the future of packaging. By 2030, a jam jar might have your name on it as part of a customised promotion (that’s already happening) or an ice-cream tub could have a scannable code that suggests other ingredients to make desserts, acting as a personalised digital menu assistant.
The box your hamburger comes in might be edible. According to McKinsey, you might reheat the vegetable-based packaging and use it in soup. Or if the burger doesn’t fill you up, eat a protein-based box that is safe for human consumption.
These trends must terrify veteran packaging executives who have spent a lifetime overseeing the manufacture of paper and plastics – and watched their companies benefit from overpackaged goods. A new generation of consumers wants goods to have less packaging and investors are using their power to mark down laggards that refuse to change to society expectations around sustainable packaging, particularly with plastics use.
The big change will come when distributors put the packaging onus on producers; for example, Woolworths or Coles in coming years requiring cereal makers to sell their goods in re-useable containers rather than oversized cardboard boxes. Or stop packaging so much fruit and vegetables in plastic bags, which boosts their margins but hurts the environment. That trend is evident in Germany and other European countries.
None of this should be new to packaging companies. Sustainability trends are well known and well entrenched. Longer term, I see the coming revolution in packaging as a transformational opportunity for packaging companies. The leaders will move up the value curve, turning packaging from a basic commodity to a higher-margin product, in some cases.
Some packaging companies might even start to look like technology companies if smart packaging takes off. But that is many years away and there could be a painful transition as big producers, such as beverage companies, move away from plastic packaging.
A fragile global economy is a more immediate concern. Slowing global growth, trade wars and weakening consumer sentiment are bad for packaging demand. But Australia’s top packaging stocks have shown they can grow in good and bad markets, as they find more cost savings and respond to changing consumer expectations on sustainable packaging.
Packaging stocks caught my attention earlier this year after heavy price falls. I wrote favourably about Orora (ORA) for The Switzer Report in May 2019 at around $3.15 a share. The stock rallied to $3.40 within a few months, then slumped to $2.61 after a disappointing FY19 result as oversupply in the company’s North American markets weighted on performance. Orora has recovered to $3.17 and now looks fairly valued after the downgrade.
I prefer Amcor and the much smaller Pact Group Holding at current prices.
Australia’s largest packaging company has been mostly range-bound in share price for the last three years, oscillating between $13 and $16. The three-year annualised total return (including dividends) is about 5%, Morningstar data shows. Over one year, Amcor is up almost 14%.
Shareholders will hope Amcor’s merger in 2018 with Bemis Company Inc in the United States, in a US$6.8-billion transaction, will be the catalyst to break Amcor out of its trading range. The deal boosts Amcor’s global footprint, particularly in emerging markets, and is expected to deliver annual cost synergies of US$180 million over three years.
So far, so good. Amcor’s recently released first-quarter results suggest synergies from the Bemis merger are on track. Amcor reiterated previous FY19 guidance – a good effort given challenging economic conditions.
Macquarie Group believes Amcor has been affected by sustainability concerns (as more companies move away from plastic packaging) and believes the threat is already substantially discounted in the share price. Macquarie has a 12-month share-price target of $16.87. If that view is correct, Amcor would deliver a 22% total return from the current price over one year.
Several other brokers have hold recommendations on Amcor and value it around $14. Macquarie notes that Amcor is trading at a 10% discount to the bank’s forecast PE for the ASX 100 in FY20 – the biggest discount in the stock since the 2008-09 Global Financial Crisis. An expected yield of about 4.5% is another attraction.
I rate Amcor on two fronts. First, it is delivering resilient performance in a weakening global economy. One economic indicator after another, notably the Purchasing Managers’ Index, turned lower in the first half, yet Amcor has kept its earnings-per-share guidance. I pay extra attention to companies that perform well in difficult markets, knowing they will pick up when conditions turn.
I expect global reflation in the next 12 months as the US-China trade war gets closer to resolution and as we pass a mid-cycle lull in the global economy. Don’t expect a large growth spurt, but macro conditions for Amcor should improve next year.
In the medium term, Amcor looks well placed to lead recyclable packaging solutions. It’s introducing more reusable products across its packaging range. Also, for all the talk, it’s hard to see manufacturers moving too quickly away from plastic packaging given its benefits in terms of weight, shelf life and convenience. More likely is a gradual transition away from plastic.
Amcor has fallen from a 52-week high of $16.74 in July to $14.38, principally on fears of a slowing global economy and sustainability issues. Both threats look overdone.
I’m not quite as bullish as Macquarie, but a double-digit return from Amcor over 12 months is likely, and attractive given the risk profile and valuation. The expected yield, unfranked, should appeal to investors who want a mix of income and growth – and exposure to a company that has much upside to come from the merger and the move to more innovative packaging.
I included Pact Group in a story on “five neglected small- and mid-cap stocks” for The Switzer Report in September at $2.26. The $860-million packaging stock is now $2.52 and had better momentum in the past month as a few research houses recommend it.
To recap, Pact rumbled from a 52-week high of $4.10 to as low as $2.08 as higher energy and raw-material costs crimped profit margins, market share fell and a stretched balance sheet that took Pact closer to breaching its debt covenants spooked the market. Investors feared a dilutive equity capital raising was on the cards.
I wrote at the time: “Operationally, Pact looks to be stabilising, but the valuation is not factoring in any turnaround … expect a recovery to unfold slowly in Pact as its profitability improves and market concerns about its debt levels ease, as debt is refinanced or an asset sale creates balance-sheet breathing space.”
My views still holds. Pact said in its FY19 result that its balance-sheet capacity has improved and that near-term refinancing risks have reduced. Debt is still too high, but Pact should be able to refinance its debt over 2022-23, avoiding a dilutive equity raise.
Morningstar this year included Pact Group on its “best Australian stock ideas list”. The research house says Pact can get its leverage to 2.5 times net debit/EBITDA (its debt covenant is 3.5 times) and that a significant asset sale could remove an overhang on Pact stock. Morningstar values Pact at $3.90 a share.
Clearly, Pact is a higher-risk turnaround play that suits experienced investors. The combination of soft earnings growth and a stretched balance sheet means the company is treading a fine line.
However, Pact’s valuation may be anticipating too much bad news: the stock is on a forecast Price Earnings (PE) ratio of about 10 times, on Morningstar numbers. Pact’s average PE ranged from 15 to 19 over FY15 to FY18. The stock has been significantly de-rated, and justifiably so.
Still, every stock has its price. If Pact continues to ease its balance-sheet pressures, a re-rating in the next 18 months is likely. Much depends on market conditions stabilising for Australia’s largest rigid plastics packaging business – and Pact continuing to grow its position in reusable plastics as demand for this type of packaging increases over the next few years.