Plastic Packaging – A Range of Markets & Valuations, None Overly Attractive at the Moment

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 1st, 2014

Plastic Packaging – A Range of Markets & Valuations, None Overly Attractive at the Moment

  • After a decade of rising input costs and declining margins in the 2000s, plastic packaging companies have stemmed the tide and even made marginal improvements of varying success over the past few years. Currently, the most credit is being given to SEE and its turnaround story while ATR’s relative discount belies its best in industry margins and end markets (notably Pharma).
  • We believe SEE’s current valuation leaves little room for further upside – valuation and returns are in line but both well above trend. That said, there are several reasons investors have bought into the company’s transformation: quarterly EPS has come in above initial estimates in four of the five quarters since Jerome Peribere (a 25 year Dow Chemical man who led the integration of Rohm & Haas) took over as CEO, there are plenty of levers to pull (SG&A at 23% of sales is far and away the highest in the packaging space), and the final settlement of the WR Grace asbestos liability removes a considerable interest payment ($48 million in 2013) moving forward.
  • Bemis (BMS), following the recent divestiture of its Pressure Sensitive Materials segment (~10% of sales) is now primarily a plastic packaging pure play, supplying food industry customers mostly in the United States – 65% of sales are tied to food products and 69% of sales are in the US. There is something to be said for the company’s increased simplicity, having also shed its paper packaging unit earlier in 2014, but its current valuation, end markets, and margins provide little to be excited about on either the long or short side at the moment.
  • ATR is our preferred name in this space given its consistency of share repurchases and dividend increases, attractive end markets, industry leading margins/growth prospects, and spotless balance sheet. The stock is not cheap on an absolute basis – both our model and a simple EV/EBITDA multiple confirm this. However, the S&P relative forward P/E multiple is much more reasonable and within the plastic packaging group ATR looks like the best value – Exhibit 1 (these results also hold for the broader Packaging group).
  • We recently published our views on ethylene pricing in 2015; lower feedstock costs could help this group maintain earnings growth despite returns that are currently above historic ROC.

Exhibit 1 – Two and Five Year Relative Valuation Premiums

Source: Bloomberg, SSR Analysis

Overview

Over the past decade, margins in the plastic packaging space have trended downward as input costs (namely, plastic resin prices) have trended higher. BMS and SEE were most affected while ATR was somewhat more insulated due to the higher-growth value-added nature of its end markets and the relative pricing power the company enjoys as a result. In recent years, polyethylene prices have remained above those seen in the early to mid-2000s; in the face of this we have seen a steady but modest margin improvement at BMS, a stagnation at ATR, and a mixed recovery at SEE, as management works to integrate a $4 billion non-packaging acquisition. We recently published
our views on ethylene in 2015
, and while lower plastic prices would be a tailwind across the board for this subsector, company specific factors prevent us from being more bullish on the group as a whole. Though the correlation between polyethylene prices and margins shown in Exhibit 2 below has somewhat weakened over the past several years, if we do see the expected 10 cent per pound decline in ethylene it could be a source of incremental upside and positive revisions, given that BMS and SEE have stated they are factoring flat raw material costs into their forward guidance. ATR is also expecting resin costs to be “relatively flat” but given its greater European operations, lower US ethylene prices would be proportionately less beneficial for the company compared to its peers. These likely feedstock tailwinds suggest that despite these companies returning above their historic returns on capital, earnings growth could be maintained and downward earnings revisions may be less likely.

While margins and stock prices for these companies tend to move together broadly due to the comparability of key raw materials, the companies themselves are, by and large, not direct competitors in their end markets. We briefly highlight our views on each company below, before providing an
overview of industry metrics
, and concluding with deeper individual profiles. Click here to jump to a company:
ATR
,
BMS
, and
SEE
.

Exhibit 2

Source: Capital IQ, IHS, SSR Analysis

ATR is all about dispensers – think the pump on a bottle of hand lotion, the spray tops of those horrible Axe body sprays, the plastic ends of nasal pumps, the flip tops on the slimmer styled Gatorade or Smart Water bottles. Its pharmaceutical offerings are tied to both the prescription and OTC markets and the demographics of aging global populations and increased safety/regulatory mandates bode well for long term growth. These offerings are not only more specialized than most packaging products but require a good deal of design on the consumer side and regulatory know-how on the pharma side, and therefore have a high margin profile, giving the company the strongest and least volatile returns in the plastic packaging space. This is driven by the Pharma segment, which accounts for over half of the company’s income on less than 30% of net sales and has an operating margin that is consistently in the high 20% range. ATR’s over 50% sales exposure to Europe is a concern as is the potential for continued currency and inflation headwinds in Latin America, but the company annually repurchases a steady amount of shares, has consistently grown its dividend (19.4% CAGR since 2000) and has the lowest debt levels not only in the plastic group but in the packaging space in general, with a preference for smaller strategic bolt-on acquisitions. Like all the stocks in this space, valuation is not particularly attractive on an EV/EBITDA basis, which has come down year to date but remains one standard deviation above the 10 year average. Our own ROC driven model also shows ATR screening on the expensive side, but not significantly. Forward P/E looks more reasonable and relative to the group, ATR looks like the best value, as seen in Exhibit 1.

With the divestiture of its paper packaging operations in early 2014 and its pressure sensitive materials segment more recently, BMS is now more of a plastic packaging pure play, with broad exposure to a variety of end markets from the lower margin snacks and candies, to the relatively more attractive dairy & liquids and healthcare products. The company is actively seeking to drive sales in its higher margin segments, and to this end will modestly increase R&D spending in targeted growth markets over the next few years. Forward revenue growth is negative, however – volumes are expected to remain weak with consumer spending even though management sees potential for growth as the packaging mix in a variety of products shifts from rigid to flexible containers. The company still generates good cash flow and uses it to fund the highest dividend yield in this group. Valuation metrics are mixed, however, and give little reason to be excited on either the long or short side. The stock has been range-bound for the better part of the past two years, bouncing between $37.50 and $42.50, and at current trading levels around $38 a share, with a positive catalyst hard to see, we believe there is a greater likelihood of a breakdown than a move higher above this range – at least until the desired mix shift is reflected in margins or if lower resin prices in 2015 provide a meaningful tailwind.

SEE diversified from its packaging roots in 2011 with the $4 billion acquisition of Diversey, a provider of hygienic services and products – everything from institutional laundering to cleansers and sanitizers used in food service. This, the company hopes, is the key overlap, given that their packaging operations are tied heavily to the meat packing industry and the multitude of sanitary concerns therein. The Diversey acquisition proved to be dilutive in the immediate term, and Jerome Peribere, a 25 year Dow Chemical man, was brought on as CEO in March 2013, likely due to his experience leading the integration of the Rohm & Haas acquisition. Results had come in above the beginning estimate in each of his four quarters at the helm until a slight overestimate in the most recent report and revisions have been coming in positive while peers are seeing downward pressure on their estimates. The stock’s current valuation, while in line with returns, appears to be pricing in a continuation of the improvements seen under Peribere, and there is a risk that the low hanging fruit has already been picked. Management could continue to execute well as it appears there is ample room for cost cutting (SG&A at 23% of sales is far and away the highest in the packaging space) and valuation could follow returns higher – at current levels, however, we would prefer to see this demonstrated before it is priced in as fact. SEE looks expensive on our valuation model and its relative PE (Exhibit 3) and EV/EBITDA multiples are at all-time highs.

Exhibit 3

Source: Capital IQ, SSR Analysis


Plastic Packaging Metrics

Margins

The plastic packaging space is driven by end market and geographic exposure. The margin trends below follow similar patterns, as all these companies are manufacturing plastic packaging products of one kind or another, but the margin discrepancy is explained by the markets these products are sold into and the value proposition provided. ATR’s margins have held up better than its peers as the company’s products tend to have a higher degree of specialization. There is also a design and knowledge component of their offering that drives pricing power. BMS’ attempts to move into higher margin products is understandable given its lagging position. SEE is seeking to transform itself more towards ATR’s model, hoping to use the new set of (hopefully complementary) solutions provided by Diversey to bring a broader value proposition to its customers and developing a knowledge based business approach to this newly acquired segment.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: Capital IQ, SSR Analysis

Growth Expectations

Looking at the growth index exhibits on the following page, the obvious question is what is driving the net income growth at SEE? Clearly nothing on the top line. Some of this is a result of the February settlement of an asbestos related liability dating back to the acquisition of a WR Grace business. This had been a big overhang for the company and interest related to this liability totaled $48 million in 2013. Baked into this net income growth is also likely a strengthening of volumes in the Diversey segment, where operating leverage is significant.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Raw Material Exposures

“It [resin pricing], from our own internal perspective, hasn’t change since what we told some of you at last year’s investor’s conference. For the next couple of years, there are no new meaningful capacities coming online. So we still expect mid-single-digit type of increases across the portfolio. 2017, a lot of new capacity is coming online and that’s going to change the game. How it’s going to change the game will depend a lot on what supply and demand has done this year. The Asian and European demand has been fairly soft and actually kept in check potential increases that were on the table. So depending on how that demand curve looks forward, as well as what’s going to happen to the European chemical industry. That’s the big question mark. Right now, the European chemical industry is hurting. If those capacities stay, there’ll be ample, more capacity coming online in the period of ’17, ’18. But if that industry starts consolidating, then it’s going to drive a whole different dynamic.”

Sealed Air CFO Carol Lowe at Goldman Sachs Conference, May 2014

Plastic resins constitute a significant portion of the raw material inputs for these companies. For BMS, resins account for over 50% of cost of goods sold – of this, 50% is polyethylene and 50% are other specialty resins (nylon, polyester, polypropylene among them). SEE has a broader product portfolio post-Diversey and also purchases caustic soda, waxes, phosphates, surfactants, fragrances and paper and wood pulp products. ATR has some metal exposure, but not a significant amount.

Certain contractual mechanisms do allow for the pass through of price increases in raw materials, but these vary by region and duration, with the shortest having a 30 day lag and the longest up to 180.

Exhibit 10

Source: Capital IQ, SSR Analysis

Relative Valuation – SSR Valuation Models

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Revisions

Exhibit 14

Source: Capital IQ, SSR Analysis

Performance

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Exhibit 17

Source: Capital IQ, SSR Analysis

Dividend Yield

Exhibit 18

Source: Capital IQ, SSR Analysis

Sales Ratios

The plastic packagers are the closest you will find to a technology company in the Packaging space. ATR has historically maintained R&D spend around 3% of sales. BMS has indicated spending will rise modestly to 1% of sales over the next several years. These companies have relatively low input costs (specifically SEE and ATR, lowest in the group) but have elevated SG&A expenses (highest in the group). For ATR, personnel costs are elevated given the greater focus on the design aspect of the packaging product, relative to the can makers (BLL and CCK) to use the extreme example. For SEE it might be more a function of redundant costs – perhaps part of the impetus behind the decision to consolidate their three segment headquarters in a new facility in North Carolina.

Exhibit 19

Source: Capital IQ, SSR Analysis

Exhibit 20

Source: Capital IQ, SSR Analysis

Leverage

SEE is still paying down $4 billion of debt from the Diversey acquisition. BMS is unconcerning in the middle of the pack – the company’s last major acquisition was the 2010 purchase of 23 felxibile packaging faclitites from Rio Tinto, loacated in the US, Canada, Mexico, Brazil, Argentina and New Zealand. ATR has a very disciplined approach to M&A and prefers to take on smaller, well managed companies that can add valuable proprietary technology – recent comments from management indicate their belief that valuations are too full at the moment to feel good about pursuing a deal.

Exhibit 21

Source: Capital IQ, SSR Analysis

Revenue per Employee

Exhibit 22

Source: Capital IQ, SSR Analysis

Fixed Asset Productivity

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ, SSR Analysis

Exhibit 25

Source: Capital IQ, SSR Analysis

Debt Schedules

Exhibit 26

Source: Bloomberg, SSR Analysis

Exhibit 27

Source: Bloomberg, SSR Analysis

Exhibit 28


Source: Bloomberg, SSR Analysis

Short Interest

Exhibit 29


Source: Bloomberg, SSR Analysis

Exhibit 30

Source: Bloomberg, SSR Analysis

Exhibit 31

Source: Bloomberg, SSR Analysis

ATR

ATR is all about dispensers, the pump on your bottle of hand lotion, the spray tops of those horrible Axe body sprays, the plastic ends of nasal pumps, the flip tops on the slimmer styled Gatorade or Smart Water bottles. In Food + Beverage they make everything from the top down squeeze ketchup bottles that have replaced the traditional glass bottles to infant formula packages that are designed for ease of dosing and contamination prevention. In Beauty + Home, think of hand lotion pumps and the spray pumps on perfume bottles. The Pharma segment makes nasal sprays for example, as well as inhalers and other such medical devices for both the prescription and OTC markets.

Through the first half of 2014, operating income in the Beauty + Home segment has been flat as sales have grown 5% – currency headwinds and startup costs in Latin America and operational issues in North America have hindered operating leverage. The Pharma and Food + Beverage segments grew sales by 11% and 7% respectively, but segment income growth came in 2 percentage points below each of these figures, suggesting costs are weighing on margins. North America was highlighted in the Q2 earnings call as an area where the company admittedly “added costs that we didn’t need to add.” 75% of sales are derived outside of this region however, and ATR’s SG&A spend as a percentage of sales trails only SEE in the packaging space, so there are likely cost issues that could be addressed in operations elsewhere.

One of the dynamics that is often cited by ATR management is the competitive threat to branded products from store brands – this works to ATR’s benefit on both ends, as the store brands come to them to replicate the branded products, then the branded guys come to them to try and use packaging to re-differentiate themselves.

These customer relationships in part drive ATR’s competitive advantage. They approach the packaging solution from the product up, rather than trying to down-sell an existing product onto a customer. Understanding the product, the desired functionality, and the user experience is the first step and the packaging is then designed and manufactured to meet those specifications.

In the long run, this is a company with a strong track record of dividend increases and share repurchases, with a clean balance sheet, and exposure to high margin end markets and favorable demographic trends (notably the Pharma segment). The stock’s current valuation looks attractive relative to its peer group, but ATR is not cheap on an absolute basis and could continue to face currency and inflation headwinds in Latin America as well as lackluster consumer demand in the European markets which generate over 50% of net sales.

Return on Capital & Valuation

Exhibit 32

Source: Capital IQ, SSR Analysis

Exhibit 33

Source: Capital IQ, SSR Analysis

Exhibit 34

Source: Capital IQ, SSR Analysis

Exhibit 35

Source: Capital IQ, SSR Analysis

Exhibit 36

Source: Capital IQ, SSR Analysis

Exhibit 37

Source: Capital IQ, SSR Analysis

Segments

Exhibit 38

Source: Capital IQ, Company Filings, SSR Estimates

Aptar’s exposure to high margin end markets give the company the strongest and least volatile returns in the plastic packaging space. This is driven by the Pharma segment, which accounts for over half of the company’s income on less than 30% of net sales.

Currency translation in Latin America has been a major issue. In Q1 2014 for instance, core sales in the region grew by 14% but on a dollar reported basis actually declined 6% due to the devaluation of the Brazilian real. This is a factor not only on the revenue side, but on the cost side as well, as only about 50% of inputs are sourced locally, resulting in significant imports. This could be a source of incremental upside, as the company has indicated local procurement is an area of focus.

Since the company is not making a standardized product like a BLL or even the same basic product in different grades like a PKG, the costs are going to be higher almost necessarily since they are constantly innovating, even slightly (10% of every year’s sales coming from newly developed products). Their margins are higher because it’s not a straight commoditized type of product they are selling, but they still have to have an emphasis on cost control:

“I know a lot of times our products seem simple to the outside, but actually, as we upgrade the performance of them, we have to phase out the old product in terms of utilization of capital expense. And that’s what you find if you don’t keep a handle on that, you find yourself with a poor utilization of your capital, a poor utilization of your resources and your expenses go up.”

Patrick Doherty, President of Aptar Beauty + Home

This is the crux of their so called “affordable innovation” strategy – developing new technologies and solutions that drive pricing power but retain cost competitiveness.

Exhibit 39

Source: Capital IQ, SSR Analysis

Exhibit 40

Source: Capital IQ, SSR Analysis

Cash Flow, Dividends, & Share Repurchases

Dividend growth has been impressive and ATR annually repurchases a consistent amount of shares.

Exhibit 41

Source: Capital IQ, SSR Analysis

Exhibit 42

Source: Capital IQ, SSR Analysis

Exhibit 43

Source: Capital IQ, SSR Analysis

Estimate Analysis – Optimism

Exhibit 44

Source: Capital IQ, SSR Analysis

Exhibit 45

Source: Capital IQ, SSR Analysis


BMS

Over the past several years, Bemis has been focused integrating the 25 facilities acquired from Rio Tinto in 2009 in a $1.2 billion transaction. The company’s current task is generating organic growth. BMS seems to be a more low-margin oriented version of Sealed Air (minus the diversifying Diversey segment, which has actually somewhat closed the margin gap in recent years) with aspirations of being more of a value-added “technology” type of packaging provider in the style of ATR. The company is actively seeking to drive sales in its higher margin segments, and to this end will modestly increase R&D spending in targeted growth markets over the next few years, bringing the total to 1% of sales – still well behind ATR’s 3%. BMS management sees the potential for volume growth as the packaging mix in a variety of products shifts from rigid to flexible containers:

“Our customers don’t have to be selling say, for instance, more soup than they did in the past, but you’re going to see some of it in a standup pouch versus a can.”

-Henry Theisen, Executive Chairman

Return on Capital & Valuation

Exhibit 46

Source: Capital IQ, SSR Analysis

Exhibit 47

Source: Capital IQ, SSR Analysis

Exhibit 48

Source: Capital IQ, SSR Analysis

Exhibit 49

Source: Capital IQ, SSR Analysis

Exhibit 50

Exhibit 51

Segments Exhibit 52

Source: Capital IQ, Company Filings, SSR Estimates

Exhibit 53

Source: Capital IQ, SSR Analysis

Exhibit 54

Source: Capital IQ, SSR Analysis

Cash Flow, Dividends, & Share Repurchases

Exhibit 55

Source: Capital IQ, SSR Analysis

Exhibit 56

Source: Capital IQ, SSR Analysis

Exhibit 57

Source: Capital IQ, SSR Analysis

Estimate Analysis – Optimism

Exhibit 58


Source: Capital IQ, SSR Analysis

Exhibit 59

Source: Capital IQ, SSR Analysis

 

SEE

Jerome Peribere, a 25 year Dow Chemical man, was hired by SEE as President in August 2012 and ascended to the CEO role in March 2013. While at Dow, Peribere led the Rohm and Haas post-acquisition integration. It is likely that this experience appealed to SEE, given the integration issues seen with the $4 billion of dilutive Diversey assets that were acquired in 2011.

Exhibit 60

Source: Capital IQ, SSR Analysis

Sealed Air is highly levered to the meat packaging industry – nearly 50% of Food Are segment sales are tied to red meat or poultry. The company is trying to leverage the assets, products, and services acquired in the Diversey deal to provide a broader value proposition to its large industrial customers, selling Diversey’s hygienic solutions to existing packaging customers, for example, Tyson – meat packers are ideal and, on the surface, ripe for cross sell opportunities given the sanitary issues surrounding the handling of raw meat, but any factory or customer where there is a risk of food-related disease or contamination is an opportunity for the company to broaden its competitive offering. There are geographic opportunities as well, in developing markets, even though 78% of SEE’s 2013 sales came from the developed countries of the US, Europe, Australia, Japan, Canada and New Zealand:

“I’ve been in a Carrefour’s in Shanghai and they’re taking raw chicken and they’re throwing it over into a metal bin. It’s not even protected. So it’s helping that transition.”

Carol Lowe, CFO

On the whole, it seems that SEE is a company that is in the midst of a turnaround that investors are (literally) buying into. There is ample room for cost cutting (SG&A as a percentage of sales is far and away the highest in the packaging space), the asbestos liability overhang is now removed[1], and there is new management with all the attendant excitement – but also expectations.

The end market outlooks are mixed but management had a very positive tone on the Q2 earnings call. Across segments, particular attention is being paid to trimming the units of low-margin customers, or in the case of Product Care, “rationalization” of certain low-margin products. The Product Care segment is expected to make up for these losses with greater sales to e-commerce customers. The short to intermediate term outlook for global meat markets remains weak but management is confident that margin expansion within the Food Care segment can continue for the balance of 2014. Within the Diversey segment, margins are also expected to improve throughout the year due to cost cuts and rationalization of low-quality business, though this is a slower process here as the business is more contractually defined. Diversey as a segment has a much higher fixed cost structure than either packaging segment, which will translate to significant operating leverage as/if volumes pick up.

Return on Capital & Valuation

Exhibit 61

Source: Capital IQ, SSR Analysis

Exhibit 62

Source: Capital IQ, SSR Analysis

Exhibit 63

Source: Capital IQ, SSR Analysis

Exhibit 64

Source: Capital IQ, SSR Analysis

Exhibit 65

Source: Capital IQ, SSR Analysis

Exhibit 66

Source: Capital IQ, SSR Analysis

Segments

During the Q2 2014 conference call management discussed plans to consolidate the headquarters of the company’s three businesses (Food Care, Product Care, and Diversey Care, all currently dispersed and distinct), in an effort to create a “one company” culture. While these units have been operating as individual businesses to some extent, broadly speaking in the aftermath of the Diversey acquisition, there is the packaging side of SEE – Food and Product – and the hygiene side – Diversey. The move to consolidate the headquarters and R&D centers of their business segments, while likely a great source of cost savings, also reflects the broader strategy of driving synergy sales with existing Food Care and Diversey customers. SEE believes it can provide a “lowest total cost of ownership” service for their customers with a combined packaging-sanitation offering.

Exhibit 67

Source: Capital IQ, Company Filings

Cash Flow, Dividends, & Share Repurchases

Exhibit 68

Source: Capital IQ, SSR Analysis

Exhibit 69

Source: Capital IQ, SSR Analysis

Exhibit 70

Source: Capital IQ, SSR Analysis

Estimate Analysis – Optimism

Exhibit 71


Source: Capital IQ, SSR Analysis

Exhibit 72

Source: Capital IQ, SSR Analysis

  1. SEE was drawn into an asbestos-related litigation arising from the 1998 acquisition of Cryovac from WR Grace – when Grace entered bankruptcy in 2001, the legal liability fell to SEE. This issue was finally resolved in February, with SEE paying a $950 million cash settlement and placing 18 million shares of stock in a trust.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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