Boring into Orora
Recommendation
- Orora isn't as bad as it appears
- Profits growth driven by efficiency gains
- Gains already priced in. Sell.
It's a business so boring that even Amcor got rid of it. As a manufacturer of boxes, folding cartons, sacks, glass and aluminium cans, the newly spun-off Orora Group is not about to set the world alight. There won't be queues to buy the latest line of boxes; celebrity managers won't make fibre sacks for a living; but for the dispassionate investor, this is the kind of business that can yield opportunity.
Yet Orora makes a poor first impression. The business demands copious amounts of capital yet revenues grow slowly and yield meager margins. Worst of all, it is hard to differentiate products, so there is little pricing power. Orora must continuously strive for efficiency or it will perish. Before spinning it out, however, Amcor addressed some of those concerns, restructuring the assets that constitute Orora and spending $1bn on new plant and equipment.
Entire business lines have been divested and marginal plants have been sold or closed. Orora no longer makes plastic bottles, aerosol cans or metal cans, for example, and 65 manufacturing plants have shrunk to 26. Amcor also left a new state-of-the-art $600m recycling plant in Botany. Said to be the lowest-cost plant in the Asia-Pacific, it is an extravagant farewell that will help deliver efficiency gains.
The new Orora will comprise only two divisions: Australasia and North America. Australasia will include a Fibre business, which manufactures and sells cardboard boxes and folding cartons, and a Beverage business that makes glass bottles and aluminium cans. The North American business will house a small US distribution business.
The Australasian business is the biggest, generating 65% of revenue and 70% of earnings before interest and tax (EBIT). Within Australasia, Fibre generates about two-thirds of revenue with Beverages chipping in the rest, although higher margins in Beverages mean that EBIT is split 50/50.
Most of the company's markets are mature and expected to generate negligible revenue growth. There is considerable scope, however, to increase profits by cutting costs.
Efficiency gains
Orora's business is one that depends on finding and implementing small operating efficiencies. As part of a $10bn Amcor where Orora represented less than 10% of profit, tedious efficiency gains were not a focus. Under independent management, they will be.
At the time of the demerger, management identified $93m of potential cost savings and we estimate that about half of that is still to be realised. For a business that operates on razor thin margins and produced EBIT of less than $200m last year, that's a lot.
If the savings are realised, Orora could be a far more profitable business in 2016 than it is today. As Table 1 suggests, Orora could make a net profit of more than $120m a year in 2016 compared to $104m last year. Dividends could rise, lifting the yield from 3.6% today to 4.1% by 2016.
2011 | 2012 | 2013 | 2014 | 2015E | 2016E | |
---|---|---|---|---|---|---|
Revenue ($m) | 2,774 | 2,823 | 2,895 | 3,176 | 3,239 | 3,304 |
EBITDA ($m) | 236 | 252 | 245 | 290 | 307 | 330 |
Cost improvement ($m) | 30 | 16 | ||||
Adj. EBITDA ($m) | 236 | 252 | 245 | 291 | 337 | 346 |
Adj. EBITDA margin (%) | 8.5 | 8.9 | 8.5 | 9.1 | 10.4 | 10.4 |
D&A ($m) | 91 | 98 | 95 | 98 | 110 | 110 |
EBIT ($m) | 145 | 154 | 150 | 191 | 208 | 219 |
Interest ($m) | 44 | 44 | 44 | 44 | 44 | 44 |
PBT ($m) | 101 | 110 | 106 | 147 | 164 | 175 |
Tax ($m) | 30 | 33 | 32 | 43 | 49 | 52 |
NPAT ($m) | 71 | 77 | 74 | 104 | 115 | 122 |
EPS ($) | 0.06 | 0.06 | 0.06 | 0.09 | 0.10 | 0.10 |
DPS ($) | 0.04 | 0.04 | 0.04 | 0.06 | 0.06 | 0.07 |
Dividend yield (%) | 2.4 | 2.4 | 2.4 | 3.6 | 3.6 | 4.1 |
PER (x) | 28 | 28 | 28 | 19 | 17 | 17 |
The business's cash flow could be even better. With a large capital expenditure program now complete, accounting depreciation would likely exceed capital expenditure, so free cash flow should increase significantly toward reported profits.
Dominated by duopolies
The biggest risk to this scenario is that instead of shareholders enjoying the fruits of these efficiency gains, competition may deliver them to customers in the form of lower prices.
Two producers – Visy and Orora – dominate the corrugated box market in Australia, with a 95% market share. Despite this high concentration, competition is fierce because both producers must run their mills at full capacity despite changes in demand. This makes for low, variable margins. Revenue has been falling slowly over recent years in response to the increasing number of substitutes for cardboard boxes; supermarkets, for example, increasingly use plastic crates. Although low, profits are stable and new competition is unlikely. A lower currency could also help as it would make exporting excess supply more profitable.
The folding carton market has been chaotic in recent years as a new competitor – New Zealand giant Carter Holt Harvey – tried to enter the local market. This resulted in a price war that devastated margins. Carter Holt Harvey has since left, selling its business to rival Colorpak. Collectively, Colorpak and Orora now control over 60% of the folding carton market and are increasing that share by taking over struggling smaller rivals. The business, recently bleeding, has now stabilised and a return to normal profitability is expected.
The glass market is a pure duopoly, controlled entirely by Orora and US-based Owens Illinois. Importing empty glass bottles is uneconomic and, although Owens has been cutting capacity in recent years, Orora's volumes have been growing. About 45% of revenue is contracted for at least three years and limited competition means steady pricing and stable profits for the two incumbents.
It's a similar story in aluminium cans, where just two producers – Visy and Orora – control the market. Orora manufactures two-thirds of all aluminium cans produced in Australia and 70% of its revenue is contracted for at least five years. This is Orora's best business: it boasts an 80% market share in soft drinks, 50% in beer, 70% of the fast-growing energy drinks market and 40% of the alcopops market. The two incumbents both enjoy high returns, and operating margins – estimated to be over 15% – are the highest in the company.
Too expensive
As either number one or two in all the businesses it operates and with a credible plan for profit growth, Orora is a more compelling opportunity than a casual glance might suggest. Unfortunately, as you might have already guessed given its position as this month's Sell recommendation, there is a catch.
The stock currently trades on a price-earnings ratio of 19, which should fall to about 17 next year if cost savings are achieved and competition within the company's key markets remains rational. Those are two big ifs, but the market appears to be taking them for granted, thereby allowing no margin of safety. This is an interesting business to follow in case an opportunity appears: at prices around $1.15 – book value for the business – we might consider upgrading to Buy. That's a long way from the current price, however, and at these lofty levels we recommend you SELL.