Amcor, plain and simple

Boxes rest outside of our imagination, usually regarded as a mere vessel for your latest Amazon purchase or an annoyance that needs to be squished on recycling day. Amcor has made paper packaging for more than 100 years – indeed, when the company first started collecting used paper for recycling, it did so with a horse and cart. Packaging is a sturdy, boring business, and that's why we like it. 

There is, however, a darker side to Amcor – around 14% of sales are from tobacco-related products. The business's flexible packaging division supplies cartons to all major tobacco companies and it's the largest supplier of tobacco packaging worldwide. Amcor has a near monopoly in the US, with an 85% share of the market.

Ethical dilemmas aside, this does have its benefits. Tobacco isn't a cyclical industry, so sales are less exposed – though not totally immune – to the ebb and flow of economic conditions.

Tobacco also highlights Amcor's most important competitive advantage – economies of scale. Fixed costs, such as the company's manufacturing machinery and distribution network, mean the average cost per tobacco carton declines as the company sells more units. As Amcor is the largest operator in almost all its markets, it can be profitable at a price that leaves smaller competitors, with higher average costs, losing money.

While Amcor is the lowest-cost operator, it doesn't try to milk its position, which keeps customers happy – Philip Morris has been a customer for 30 years; British American Tobacco for 70 years. The company's position as the top player has only strengthened over time: since 2012, Amcor's sales volumes of tobacco packaging have grown at 6% a year in North America, despite the overall market declining at a rate of 3%.

Management doesn't separate out the financial specifics for tobacco, but overall profit margins for the division aren't great – high single digits at best. That does, however, hold competitors at bay and Amcor still earns a respectable return on capital of 21% overall.

The ugly truth

The trouble with tobacco is that governments like to fiddle with taxes and regulations to discourage people from smoking, such as the gradual rollout of plain packaging mandates worldwide.

Australia was the first country to insist on plain packaging in 2012, but many others are following suit and the trend is accelerating. In 2016, the UK ordered cigarette packages be decorated only in ‘Pantone 448C opaque couché' – the ‘world's ugliest colour', according to research. France and Ireland made the switch earlier this year, while New Zealand and Norway will move to plain packaging in 2018.  

In the short term, packaging colours don't make a lot of difference to Amcor – whether a carton is red, white, or sludge green is irrelevant from a cost perspective. What matters is the long-term effect on sales: evidence suggests that plain packaging discourages young people from smoking, and, curiously, smokers even feel the cigarettes taste worse.  

Countries using standardised packaging only account for around 5% of Amcor's tobacco-related sales – the US is the big domino yet to fall – so the impact has been minor so far. The switch to plain packaging does, however, tell of a wider trend – governments are hell-bent on reducing tobacco sales, so growing the tobacco packaging division will be an uphill battle.

Financial result

Thankfully, Amcor's other segments, which cover paper and plastic packaging for the food and healthcare industries, are plodding along nicely. Amcor's ongoing operations generated sales of US$9.1bn in the year to June, up 4% after removing the effect of currency fluctuations. Net profit rose 5% to US$701m, or 61 US cents per share. A combination of market growth and cost-cutting has led to decent organic growth in recent years, and acquisitions have boosted profits further. Over the long term, however, it's only reasonable to expect sales to increase in line with the general economy.

Amcor's size and entrenched distribution network give it some competitive advantages, and we're increasing our Buy price from $11 to $12, which translates to a forward price-earnings ratio of around 14 and a free cash flow yield of about 6.0%.

We'll keep the same $18 Sell price for the time being, but may increase it should management's cost-cutting and expansion plan continue to deliver (see Amcor: Buying big and getting better at it).

We think these numbers are pretty conservative, but it's important to be mindful of the company's shortcomings.

Debt burden

The first is Amcor's exposure to volatile commodity prices, such as paper and plastic resin. Hedging contracts protect it from price swings in the short term but increases in the cost of raw materials could still squeeze margins if Amcor is unable to pass the added expense onto customers (no easy feat when selling generic products like cardboard boxes).  

What's more, emerging markets account for roughly a third of Amcor's sales, and their volatile currencies and economies add risk and make profits lumpy. All of this, though, is manageable; profitability that comes in fits and starts isn't a deal breaker, it just requires tempered expectations.

Our main qualm is with the company's balance sheet. Net debt rose 6% this year to US$4.0bn, while the interest bill came to $190m – consuming nearly a fifth of operating profits. Although hedging contracts protect Amcor from rising interest rates – and a bit under half the company's borrowings are at a fixed rate, providing a level of certainty – rising interest rates could still crimp profit growth over the long term.

Management hasn't provided specific financial guidance for 2018, but expects ‘another strong year of growth' due to the ongoing cost-cutting program and an additional five months of earnings from the recently acquired plastic moulding operations of Sonoco.

The stock trades on a free cash flow yield of 4.5% and a price-earnings ratio of 18 based on consensus estimates for 2018 earnings. Assuming organic growth of 3–4% over the long term, total annual returns could come in around the high single digits.

Amcor isn't going to shoot the lights out, and the balance sheet is a risk, but it's still a decent company going for a fair price. We need a greater margin of safety before upgrading the stock, so, for now, we continue to recommend you HOLD.