Amcor: buying big and getting better at it

Growth by acquisition can lead companies astray, but this packaging maker knows how to do it right.

Nothing boosts a company’s charm like the perception that it’s growing profits and cutting costs.

Take Dick Smith, for example, which forecast that operating earnings would triple in the year after its 2013 float due to various ‘efficiency programs’ and ‘growth initiatives’. When the company listed, the intoxicating combo led investors to pay five times the price at which Woolworths had sold the business just a year earlier. We saw through the smoke and mirrors and recommended members avoid the float – and thankfully sidestepped the company’s collapse in 2015.

But in a world of accounting shenanigans and dodgy marketers, Amcor is the real deal. The plastic containers and packaging maker has been genuinely cutting costs and improving its operating margin one percentage point at a time (see Chart 1).

Key Points

  • Scale reduces costs, boosts profits

  • Sonoco deal looks attractive

  • Cost cutting at acquisitions is improving

What’s more, the company seems to be getting better at it, as we’ll explain shortly, and that comes down to one thing: economies of scale.

Amcor has significant fixed costs, such as manufacturing equipment, sales staff and head office expenses. That means that as more boxes and bottles are churned out of its machines, the average cost per unit goes down.

Commodity types

Amcor is one of the largest packaging manufacturers in the world and is the market leader in many of its product categories, such as flexible plastic containers for the food industry or paper packaging for tobacco products.

Packaging is known as a ‘commodity type’ business because there’s little to distinguish one plastic bottle from another. This makes the industry especially competitive as price is about the only lever companies can use to make a sale.

Amcor’s size, however, ensures it can remain profitable at prices that would leave smaller competitors losing money, which is a significant barrier to newcomers trying to enter the market.

Extra bottles = extra profits

The company’s size also means it can push back on suppliers, which – together with its lower average fixed cost base – helps to explain a profit margin of 7%.

That’s nothing spectacular, to be sure, but still reasonable given the intensity of competition in this industry. For comparison, the second largest plastic packaging maker, Sealed Air Corp, has a margin of just 5%; the fourth largest, Coveris Holdings, hasn’t turned a profit in five years.

What’s more, packaging companies need to reinvest in capital equipment to maintain their factories. But with more packages being churned out of its machines, Amcor’s capital expenditure is spread across a higher volume of sales – capital expenditure came to 31% of operating cash flow over the past three years, compared to 40% for Sealed Air Corp.

The flipside of lower capital expenditure is that more of the net profit flows through as free cash flow: Amcor had US$750m of free cash flow in 2016, a margin of 8%. This may not be a great business, but there’s still plenty of free cash flow that can be returned to shareholders as dividends – or used for acquisitions.

Hey big spender

Given the benefits of being big in this industry, Amcor’s management rightly loves to acquire smaller competitors. In addition to the US$2.0bn mega-purchase of Alcan Packaging at the height of the global financial crisis, Amcor has spent a further US$1.6bn since then buying more than a dozen bite-sized companies.

Earlier this month, Amcor agreed to buy the rigid plastic moulding operations of Sonoco Products for US$280m. The Sonoco operations generate US$210m in sales and include seven production sites in North America.

The new facilities are a welcome addition as they beef up Amcor’s specialty food and personal care segments. When it comes to a commodity-type industry like plastic packaging, the more specialised the niche, the better, as it usually comes with hints of pricing power. Indeed, the Sonoco assets generate an earnings before interest, tax, depreciation and amortisation (EBITDA) margin of 17% compared to Amcor’s overall margin of 15%.

Amcor also expects to remove US$20m of costs following the purchase by cutting out duplicate expenses in the supply chain and, with the economies of scale mentioned earlier, we expect the company will have no trouble doing so.

But here’s the kicker: the purchase price of eight times EBITDA already looked quite reasonable – Amcor itself currently trades on a multiple of 12 – but the cost cuts reduce the price to just five times EBITDA.

Better than ever

More interesting still is that the Sonoco transaction suggests a budding trend: not only is Amcor cutting costs with each acquisition, it seems to be getting better at it.

Table 1: AMC result
Year to June 2016 2015 /–
(%)
Revenue (US$m) 9,421 9,612 (2)
EBIT (US$m) 1,055 1,053 0
U'lying NPAT (US$m) 671 680 (1)
U'lying EPS (US cents) 58.0 56.6 2
Final dividend 22.0 US cents, unfranked, (up 5%),
ex date 6 Sept

When Amcor bought Alcan Packaging in 2010, cost-cutting ‘synergies’ amounted to around 5% of Alcan’s sales. The purchase of Aperio in 2012, then Alusa earlier this year, both came with cost-cutting targets of 7% of sales. And now, with Sonoco, management expects synergies of around 10% of sales.

When you consider that these businesses typically come with profit margins in the single digits, the ability for Amcor to remove this much in duplicate costs is a huge deal. It’s conceivable that the Sonoco assets will make double the profits under the Amcor umbrella than with its previous owner.

Bad balance sheet

The global plastic packaging market is worth a good US$300bn, with hundreds of manufacturers. We expect many more opportunities for Amcor to make sensible purchases and add a few percentage points to its organic growth of around 3%.

Unfortunately, with net debt of US$3.8bn – and interest expense consuming nearly a fifth of operating earnings – Amcor already carries an uncomfortably large chunk of leverage. If the company tries to make any more large acquisitions, we expect it will need to tap shareholders for money. However, even after paying dividends, Amcor still has around US$280m of free cash flow, which is ample to make a few smaller bolt-on acquisitions each year.

Amcor isn’t a high-quality business but there’s still plenty to like at the right price. The stock has an underlying price-earnings ratio of 20 and unfranked dividend yield of 3.7%. That isn’t ridiculous, but nor is it enough to whet our appetite given that we only expect earnings to grow in the mid-single digits over the long term.

We’re increasing our recommended Buy price from $8.50 to $11 and the Sell price from $14 to $18 to reflect an improving outlook. For now, though, we’re sticking with HOLD.