Company profile: Smurfit Kappa
Smurfit Kappa stock looks relatively cheap and, with a recovery in the packaging sector forecast, Proinsias O'Mahony suggests it might not be such a risky bet.
A year ago, plummeting earnings and grave debt worries meant that the market was doubting as to whether Smurfit Kappa might survive the global financial crisis, with shares falling all the way from above €20 to a low of €1.16. By January, however, shares in the Irish paper and packaging giant had risen sixfold and the recent earnings report was greeted enthusiastically by analysts, many of whom argue that the share price is once again heading back to double-digit territory.
Highly-leveraged business models were in fashion in 2007 when Smurfit refloated on the stock exchange. Not so in a severe credit crunch, especially when a €3.2bn debt pile and contracting earnings means that a firm is in danger of breaching its covenants. By March, Smurfit's debt was 3.7 times its earnings before interest, tax, depreciation and amortisation (EBITDA), within its banking covenant of 4.7. With covenants tightening every quarter and earnings continuing to fall, however, nervousness prevailed. When debt markets finally showed signs of life last summer, Smurfit was quick to act, relaxing its covenants and extending the maturity of key loans.
Another €1bn of bonds was successfully issued last November. With a long-term debt maturity profile of almost six years, no material sums to be repaid before December 2013, almost €650m in cash and €525m in unused credit lines, investors are now much more relaxed on the debt front.
Cost-cutting has delivered savings of €210m over the last two years, with another €90m earmarked for 2010, something that management says will improve long-term operating margins by 1.5%. Not that they're bad already - the current 12.2% EBITDA margin is approximately 4% above its main competitors. Smurfit is determined to protect those margins - every 1% increase in box prices adds €33m in EBITDA whereas a 1% volume increase adds less than half that. A series of industry-wide price hikes have been successfully implemented over the last six months. A 5% fall in box demand in 2008 was the first decline in over a decade while 2009 saw another 8% fall. European box volumes arrested the slide after rising in November and December, however, while Poyry, an independent consultancy, expects demand to grow by an average of 2% annually over the next five years, with the fastest growth being recorded in 2011 and 2012 as economies emerge from recession.
Smurfit will be hoping to do more than just share in the overall gains. It's top dog in the European corrugated box market with a 20% share, almost double that of Swedish rival SCA and over three times that of Spanish competitor SAICA. With operations in 21 countries, it possesses an obvious strategic advantage when dealing with pan-European customers.
Eastern Europe, where growth is expected to be greater in coming years, is an obvious target for expansion, as is Latin America. Latin American revenues have grown from €757m in 2003 to €1.46bn last year, a growth rate of 12% per annum. Despite accounting for 17% of group revenues, Latin America accounted for 26% of EBITDA courtesy of tasty profit margins (18.5% compared to an overall group rate of around 12%).
Smurfit is no longer "just a packaging company", as NCB put it recently but a "one-stop shop" for its customers who increasingly use packaging as a marketing support tool. With a database of over 3,000 designs, Smurfit offers "first-time right" packaging solutions to its customers, to use the official lingo, helping juice margins in the process. Note that 60% of boxes sold are ready for retail display ("shelf-ready") while 40% of boxes are sold as mere transport packaging. The former can cost up to three times that of the latter, with margins higher on the shelf-ready format. This trend, Davy's Barry Dixon notes, should lead to a "structural improvement" in margins over time. Trends in the highly cyclical packaging industry are clearly improving, both in terms of price and volumes, while medium-term structural improvements also bode well. But what of valuation? With such an enormous share-price rally, is it all baked into the cake? No. Valued at €1.375bn, Smurfit still looks cheap. Due to its indebted nature, price-earnings ratios are of little use in valuing a company like Smurfit. Instead, analysts tend to focus on its Enterprise Value/EBITDA. Smurfit is trading at a 2010 EV/EBITDA of 5.7, well below the median value of its peer group (7.5). With a string of upbeat statements from firms in the sector confirming that 2009 was likely the trough in earnings, most analysts have pencilled in large increases in earnings in coming years. For 2010, consensus earnings of €830m are forecast, up from €741m last year. Goodbody has EBITDA peaking at €1.18bn by 2014-15, adding that this is "just over €100m ahead of the 2007 peak", thereby implying that they are "still not giving full credit" for the €260m of costs taken out in recent years. It estimates over €900m in earnings by 2011, adding that a typical mid-cycle EV/EBITDA multiple to mid-cycle earnings would suggest a valuation of approximately €10.
At the very least, it says, Smurfit should be trading at its Net Asset Value of €7.60, given that this is the minimum the sector trades at through the economic cycle. Davy, meanwhile, envisages €1.1bn in EBITDA by the end of 2011. If the share price did not budge, Smurfit's EV/EBITDA would then be at an almighty low 3.6.
Like any heavily indebted stock, Smurfit remains a risky bet. Over €800m in debt is due by 2013 and a similar figure is due the following year. Demand for corrugated boxes historically correlates with GDP and industrial production and it's likely that the stock will be pressured in the event of economic hiccups. Certainly, the stock was slapped as investors fled risk in early February, suffering a prompt double-digit tumble as markets corrected.
Still, considering the overall market run has far outstripped any impending improvement in economic fundamentals, it's refreshing to find a stock as conservatively valued as Smurfit. Despite the huge share-price gains, valuation remains depressed. Assuming the recovery in the packaging sector is genuine, that should change.
