Amcor thinking outside the box

Boring businesses can sometimes make the best investments, but is good management enough to offset a bad balance sheet?

There's no getting around it, making boxes is dull. Aside from the occasional innovation in materials – such as the invention of biodegradeable plastics in the late 1980s – flexible packaging and box manufacturing has barely changed in decades. It also has a straightforward business model: make box, sell box. But while these things are unlikely to wow the guests at your next dinner party, we see them as admirable qualities.

At the centre of this industry is Amcor, one of the largest packaging companies in the world and the clear number one in many of its product categories, such as paper packaging for tobacco products or PET bottles used in the beverage industry. You almost certainly have an Amcor product in your fridge.  

Key Points

  • Simple business; strong market position

  • Raw materials, debt and emerging market risk

  • Fair value; Hold

The company’s flexible packaging division, which supplies cartons, plastic containers and films to food, healthcare and tobacco customers, accounts for two-thirds of revenue and is the leading player globally, with a market share of 25–30% – including 85% of the US tobacco packaging market.

Management value

When buying a stock, you aren’t purchasing a ticker symbol, you’re buying a slice of a real business. You become a business owner. The trouble – or perhaps benefit – is that as a minority shareholder someone else will be running this business for you. Assessing management’s integrity and capability is extremely important, as shareholders of Unilife recently learned the hard way.

We follow this creed religiously at Intelligent Investor and avoid businesses where management gives us the heebie-jeebies – even when the stock appears undervalued on financial measures.

Thankfully, everything about Amcor’s management suggests it’s working for the benefit of shareholders. Chief executive Ron Delia doesn’t sugar coat bad news during presentations and speaks matter of factly about opportunities and risks facing the company.

Management also has a good track record on capital allocation. In 2011, Amcor bought back $150m worth of stock at an average price of $7.10. Then, in 2015, the company bought back $667m worth of stock at an average price of $13.70. Both transactions have created significant value for shareholders.

As we explained in Amcor: buying big and getting better at it, there are several things to like about Amcor. It benefits from economies of scale, it has a good track record of cutting costs from new acquisitions, and it has far better margins than its competitors. Nonetheless, the company still has its share of risks.

Not without risk

The first is the company’s exposure to volatile commodity prices, such as paper, resin and aluminium. Hedging contracts protect Amcor from volatility in the short term but, ultimately, any increase in the price of raw materials needs to be passed onto the customer – and when you’re selling basic products like boxes where price is the main differentiator, that isn’t always easy.

What’s more, emerging markets represent around 32% of Amcor’s sales. Their more volatile currencies add another layer of risk.

As the company found in Venezuela last year, a plunging economy and hyper-inflation made the importation of raw materials next to impossible. Amcor's factories came to a standstill. It wrote off US$350m in 2016 and net profit is expected to take a further US$20m hit in 2017.

What Amcor does have is a lack of exposure to cyclical industries. Around 95% of its sales are to food and beverage, healthcare, and tobacco companies, which are less exposed – though not totally immune – to the ebb and flow of economic conditions.

Still, between commodity prices, currencies, and emerging markets exposure, Amcor’s profits are prone to boom and bust. With that in mind, the company’s net debt of US$4.3bn is a major turn-off.

Interest expense consumes a fifth of operating profits, so Amcor is exposed to rising interest rates – particularly in the US – though the company has hedged its exposure in the short term. However, a one percentage point rise in interest expense would shave around 11% from net profit once the hedging contracts roll off.

Valuation

Amcor generated sales of US$4.5bn in the six months to December. Net profit came in at US$306m, or 26 US cents per share, which was up 5% after removing the effect of currency fluctuations.

Excluding acquisitions, organic growth has been reasonable at around 4% in recent years and we expect sales to keep increasing in line with the general economy.

Consensus estimates are for 60 US cents per share in the 2017 financial year, putting the stock on a forward price-earnings ratio of around 19 at the current AUD-USD exchange rate of 0.75.

Assuming long-term organic growth of 3–4%, with room for sensible acquisitions to add to that, total annual returns could come in around the high single digits. On the face of it, that's a pretty decent return. However, after taking into account the operating risks and debt, we'd need a wider margin of safety before we'd consider an upgrade and we continue to recommend you HOLD.