Thursday, March 1st, 2018
Over the last six months Amcor has been the third-worst stock (before dividends) in the ASX 50, falling by some 14 per cent. This makes the stock interesting given most large companies mean-revert as their cycles turn and their capable management teams solve problems. We like Amcor for its attractive total shareholder returns of 13.7 per cent per annum over the last 10 years and 14.9 per cent over the last five years, and became increasingly interested as the stock trended lower from its $16.78 peak in June last year. This month the shares fell to levels of three years ago at $13.71.
Amcor appeals to us below $14.00. The attractions are the range of growth avenues available to the company, the skilled management, its ability to offset cost pressures and the 10 per cent discount at $14.00 to our $15.70 valuation. We think most of the risk is now out of the stock and the undervaluation compensates investors for the remaining downside risks, which centre on the earnings outlook in emerging markets.
Global leadership in rigid and flexible packaging is a solid business model for conservative long-term investors and Amcor’s current management has delivered on its potential. Organic revenue growth is slower than GDP but earnings volatility is low because the fast-moving consumer goods, food and healthcare products sold in the company’s packages are not particularly sensitive to economic cycles. The fragmented industry landscape in most countries presents options for growth by acquisition and the synergies with existing plants become an annual source of earnings growth. The supply of very large volumes to major consumer brands creates the pricing power to pass on raw material cost increases, admittedly with a lag. The company’s large size means cost savings can be found elsewhere in the group to help offset raw material price rises. Most years should see higher dividends.
In the recent interim result Amcor downgraded its full-year guidance for Rigids and Flexibles. The share price anticipated this. There are three problems: the first temporary, another manageable and the third a question mark. In North American rigids, Amcor maintained share and the category grew at normal rates but a major customer, PepsiCo, lost share and destocked, which weighed on Amcor’s volumes. Pepsi faces the decline of carbonated sugary drinks (CSDs) but can also improve its execution in innovation and marketing of CSDs and non-sugar alternatives. Better brand support of CSDs, for example at this year’s Super Bowl, and the launch of a new label in the fast-growing sparkling water segment are encouraging signs of a turnaround.
The manageable problem is raw material input cost inflation in developed markets as the price of resin, a synthetic polymer used to make flexible plastic packaging, rises with the price of oil, an input to the manufacture of resin. This detracted US$20 million from Amcor’s US$330 million interim result. CEO Ron Delia said industry price recovery mechanisms in developed markets are working as they should and expressed confidence Amcor will recover the full extent of raw material price rises, admittedly with a lag. We expect the oil price will trend slowly higher with strengthening world economic growth but also think the US resin sector will respond to higher prices by lifting output, which should then restrain prices. The return of production from plants compromised by Hurricane Harvey should add to this effect.
The question mark is Amcor’s emerging markets exposure, which contributes around 30 per cent of earnings but is underperforming despite the longer-term appeal of faster economic growth than developed markets. In the Asia-Pacific countries where Amcor makes flexible packaging, raw material price recovery mechanisms are weaker than in developed markets and Amcor as the industry leader will have to work harder to encourage the industry to pass on cost increases. In Latin America, rigids earnings were flat due to mixed economic conditions though volumes seem to have bottomed for the moment. Overall the last two years have been difficult for Amcor in emerging markets and the key risk is this extends.
Amcor’s earnings are defensive, so the stock falls out of favour when bond yields rise and the market wants reflationary, growth-oriented stories like resources and industrial cyclicals. These periods tend to coincide with the cost headwind of rising oil prices. Given we are now in such a period, the returns on an investment in Amcor should be adequate for the risk assumed, but longer-dated.