Pact Group and a little about Amcor

I have put up a bit of research I have done on PGH.  This is posted on my blog at www.sharednews.com.au
The charts that are referred to in the valuation section can be found via the link on the blog article for PGH.  Maybe tomorrow if I get time I will go through how to upload images to HC.

This article is relevant to Amcor as a the two cost pressures evident for PGH will also be in play when Amcor reports.  Note that it will be less significant for Amcor as the rigid plastics section is only part of the business and the fall in the AUD has exacerbated the increase in the resin price for PGH.

Pact Group Holdings Analysis (PGH)

Pact Group is a manufacturer of rigid plastics items in Australia, New Zealand and Asia. Rigid plastics produced include many of the plastic containers used for food products as well as new acquisitions expanding into areas such as plastic coat hangers. Most of these plastics are Polyethylene based, the most common of which is Polyethylene Terepthalate (PET). Pact Group produces containers and packaging using two main inputs in their production process: the resin form of the plastic and energy. Both of these inputs have increased in price recently and this has had an impact (temporary) on Pact’s profitability and an even more dramatic impact on its share price. For the reasons discussed below, Pact Holdings may present an opportunity to build a position in a company of moderate quality, at an attractive price.

Industry drivers contributing to decreased profit margins in rigid packaging

Readers of articles presented on this blog will no doubt remember another packaging company is already held in the sample portfolio. Rather than rehash the information already presented in the Amcor article, a comparison of the two companies will be presented. Both companies operate in the rigid plastics, though rigid plastics makes up a vast majority of Pact’s business, in Amcor’s case flexible packaging makes up a larger part of the business. Amcor is also feeling pressure on margins in their rigid packaging division for the same reasons as Pact Group – specifically resin cost increases and to a lesser extent energy increases. In the case of Pact these two inputs have had a greater effect on profits. Resin which has been rising in USD terms, has had an even bigger increase in AUD terms. Increasing energy prices have been a worldwide phenomenon, however increases in Australia have been even greater. Both of these factors have contributed to Pact missing NPAT broker estimates by around 10 million AUD. It seems likely both of these inputs are temporary and the likely resultant price increases in the end product has yet to flow through to manufacturers such as Pact.

Overview of Pact Group

Pact Group was formed in 2002 by Raphael Geminder in a buyout of underperforming Visy assets. Between them, Visy and Pact account for most of the rigid plastic packaging production in Australia and Anthony Pratt, who happens to be the brother of Geminder’s wife, controls Visy. Possibly as a result, despite the commodity like nature of the products, we have not seen the extreme pricing competition witnessed in other industries of late in Australia (it should be noted Amcor does not have rigid plastic operations in Australia).

Business Quality assessment

Good Quality attributes
1. Defensive – in that there is consistent demand for its products throughout the cycle
2. Customers tend to be granular in nature, although some customers such as Wesfarmers and Woolworths would have some pricing power in their own brand products
3. Asset scale is important in this business and it would be hard for a competitor to enter the market without significant capital
4. Management that is invested in the outcome of the business with the Germinder family owning approximately 40% of the securities on issue
5. Reasonable return on capital of 10-12%

Poor Quality attributes
1. Product is commodity like with no brand or intellectual capital to differentiate from substitutes
2. Not a monopoly like asset or service and no intellectual capital/research costs to distinguish Pact Group from competitors.

In summary Pact Group is no CSL or REA, however, it is much better quality than many of the cyclical businesses listed on the ASX. Indeed due the nature of many businesses listed on the ASX (banks and miners) it could be argued Pact should enjoy a slight premium to market valuations. This is not currently the case.

Valuation

Pact Group announced the acquisition of TIC retail accessories for $122 million with the release of their annual report. The plastic garment hanger re-use business seems fair and has been acquired on a lower multiple than the group as a whole, at 6.5 times EV/EBITDA FY18. Though it should be noted that there is a $30 million earn out clause. This acquisition probably doesn’t affect the valuation of Pact Group overly and for simplicity will be not included in the multiples below.

Refer to link in this section of the blog at www.sharednews.com.au

Graph of EV/EBITDA 2014 – 2019 * Note 2019 is an estimate based off current share price and management forecasts

Pact Group EBITDA 2014 – 2019 est and UNPAT 2014-2018 in $millions

As the first graph demonstrate the price is at a historical low point. A large increase in 2019 forecast EBITDA is demonstrated above, but the effect on the EV/EBITDA multiple will be moderate as to fund the TIC acquisition the EV will increase by approximately $160 million. The decrease in UNPAT can be contributed to the two cost inputs discussed. Management estimates that NPAT falls by $1.5 million for every $100 AUD increase in resin costs per tonne. Over 2018 resin increased by around $400 AUD per a tonne and most of this was in the latter half. Management also estimates an approximately 3 month lag on the resin price increase so this will impact H1 19. Energy prices for Pact Group have increased by 40% over FY18 and this will have a similar impact in H1 19.
Debt servicing appears sound for Pact Group, with $33 million of interest to be paid in FY18 out of an EBIT of $164 million.

The good news for shareholders is that while the immediate future looks bleak, longer term should see some normalisation of these costs. Resin prices have been falling over the last month (https://www.plasticstoday.com/resin-pricing) and industrial energy prices in Australia are showing some price moderation after the increases of last year. Finally management has been able to claw back $3 million in costs through price increases in FY 18.


Summary

The Pact Group share price has fallen approximately 20% since the FY18 announcement, resulting in a forward EV/EBITDA of 7.5. This valuation appears attractive for a company that is of average quality and with earnings that are cyclically depressed. Revenue is growing, some of which is organic growth, and debt is easily serviced. It should be noted that the full effect of the two cost inputs discussed will not be felt until H1 19. Indeed earnings will be at a probable cyclical low in the next half and earnings depression should moderate as packaging prices increase and hopefully resin and energy prices continue to moderate. As investors know the market is forward looking and margin pressure appear to be priced in, making Pact Group an attractive risk/reward proposition for investors with a longer term holding period.