Smurfit Kappa Group (SKG.I) – Think Inside The Box

(This is the seventeenth installment in my series of case studies on the shares that make up my portfolio. To see the other sixteen articles, on Bank of Ireland, AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish Life & Permanent, Datalex, Trinity Mirror and Datong, click on the company names. I remain an investor in all of the above stocks, save for Glanbia, which I sold earlier this year)

 

Smurfit Kappa Group (SKG) is one of the leading integrated producers of paper-based packaging in the world. It is the largest European containerboard (paper specially manufactured for the production of corrugated board) and corrugated (two outer layers of paper with an intermediate layer of fluting) producer, with a circa 17% share of capacity. In Latin America, which accounted for 18% of revenues in 2011, SKG is ranked #1 for corrugated and #2 for containerboard across the 9 countries it has a presence in. The group, which generated revenue and EBITDA of €7.4bn and €1.0bn respectively in 2011, has 331 operating facilities across 30 countries, employing 38,000 people.

 

In this piece I look at its business model, performance since its 2007 IPO and outline why I believe its shares offer great value at current levels.

 

SKG’s business model has a number of attractive qualities. Firstly, as an integrated producer, this provides a competitive advantage due to its control of supply of a critical input — Smurfit is the world’s second-largest recovered paper user. This is particularly valuable given that rising Chinese demand in recent years (in 2010 some 13% of recovered paper collected in Europe was exported to China) has impacted the availability and pricing of this commodity. A second big advantage for SKG is its scale — given that 60% of its customers are in the fast-moving consumer goods segment, the group has the capability to support some of the biggest firms in this area due to its wide geographic coverage. On this point, 18% of SKG’s customers by volume are described as ‘Pan European’, with a further 16% classified as multinational. In addition, SKG has a considerable breadth of product offering, which allows it to meet a wide variety of customer needs.

 

The group had its IPO in March 2007, just before the economic storm hit. The shares, which were initially priced at €16.50 apiece, soon came under severe pressure due to a combination of wider economic concerns and the firm’s level indebtedness at the time. At the end of fiscal year 2007, SKG had net debt of €3.40 billion, or 3.2x that year’s Ebitda (€1.06 billion).

 

The firm’s response to these pressures has been impressive. The group focused on maximising cash flow by reducing working capital, suspending dividends, implementing significant cost takeout measures and minimizing capex (the ratio of capex to depreciation fell from 98% in fiscal year 2007 to 67% in 2009). These efforts helped offset the pressures on profitability, and net debt, which fell to €2.75 billion by the end of 2011 (a 19% reduction in four years), represented only 2.7x that year’s Ebitda. This has been done without any recourse to shareholders (the number of shares in issue has increased by only 8.4% in the five and a quarter years since the IPO).

 

In terms of recent milestones, since the start of 2012 the group has announced a successful extension of its debt maturities, which pushed the weighted average debt maturity out to over five years and left the group with no significant maturities until 2015. This gives the group greatly enhanced financial flexibility.

 

In March, one of the private equity vehicles that had retained an investment in Smurfit post its IPO had placed nearly €150 million worth of stock. While this applied downward pressure to SKG in the short-term, in the longer-term SKG will benefit from the improvement in the free-float (the placing increased SKG’s free-float from 65.4% to 75.1%). Clearly, the potential for further placings cannot be ruled out, but for reasons set out below I believe that this is more than factored into the current share price.

 

SKG’s Q1 results, released in May, surprised on the upside, with Ebitda of €246 million coming in comfortably ahead of the top of the range of sell-side estimates (€181-233 million). At the time, management said it expects: “to deliver an Ebitda performance broadly similar to that achieved in 2011” (i.e. €1 billion) this year.

 

Since then, we have seen further turmoil in the euro zone, coupled with some pressure on containerboard prices, which may put this guidance under threat. Against that, SKG does have a lot of levers on the cost side that it can use to counter these developments. The firm’s next set of quarterly results, due on August 1, will presumably provide more clarity on this.

 

Tying it all together, in terms of the investment case for Smurfit, the company represents a very attractive way of playing the European packaging sector, given: (i) its competitive advantage on the input side; (ii) its breadth (both geographic and product); (iii) its relentless focus on cash flow generation; and (iv) its cheap valuation. On the final point, based on last night’s closing price (€5.40), SKG is capitalized at €1.20 billion. Considering that the group is presently guiding Ebitda of €1 billion for this year, I see potential for a significant re-rating as debt is paid down. On this note, SKG exited 2011 with net debt of €2.75 billion and an employee benefits liability of €0.65 billion. Keeping things simple, its EV (based on the last audited figures and the current market cap, along with taking the pension into account) is €4.60 billion. By the end of 2012, net debt will have reduced further given the impressive cash generation of the business (over the past 4 years SKG has reduced net debt by an average of €163 million per annum). In my model I forecast that net debt will fall to €2.5 billion by year-end. This puts the group on a prospective EV/Ebitda of 4.2x, while the shares yield 4.2% at these levels. This is cheap both in absolute terms and also relative to its sector peers.

 

There are, of course, some threats to the company, such as the challenging economic conditions across much of Europe and the possibility of further placings. However, given the low multiple of what are far from peak earnings (SKG’s Ebitda margin of 13.9% in fiscal year 2011 is 70bps below 2007 levels, despite the significant cost takeout measures undertaken since then) the company trades on I would contend that this is priced in. Furthermore, I note that the current share price is roughly 25% below where the recent placing occurred.

 

In all, I view SKG as a story of industry leader + significant operating leverage from an eventual recovery in the European economy + attractive emerging economy assets + a de-risked balance sheet (given the recent refinancing deal) + cheap rating + debt paydown driving a significant re-rating over time. I like this stock a lot, hence I hold it in my own portfolio.

 

Note: This is an edited version of an article that I wrote for Marketwatch yesterday