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Morningstar | Weak Volumes Affect Narrow-Moat Amcor in Fiscal 2018; FVE Reduced to AUD 14.60

Weak volumes led to a softer-than-expected result for narrow-moat Amcor in fiscal 2018. Operating income of about USD 1 billion was 11% below our expectations, owing largely to the North American beverage business unit, which was hurt by soft demand due to a wet start to the North American summer. Beverage volumes were accordingly 5% lower than the prior year. While we expect volume growth to resume in fiscal 2019, we reduce our fair estimate by 6% to AUD 14.60, reflecting weaker North American beverage volumes and softer expectations for emerging-market volume growth following a transfer of analyst.

Rigid segment sales fell 3.1% to USD 2.8 billion, primarily due to lower North America beverage volumes. Volumes compared unfavourably with our expectations for modest volume growth of 1.6% in fiscal 2018. Unfavourable mix shift accompanied the falling volumes, with higher-margin Hot-Fill PET volumes falling 9% year-on-year and outpacing the total decline in segment volumes. We do not expect this to repeat in fiscal 2019, with the wet conditions prevailing in the 2018 North American summer unlikely to recur and drag on segment results. We expect segment volume growth to revert to 1.6%, with segment sales growing 5.7%, largely reflecting the passing on of raw material cost inflation.

Flexibles segment sales climbed 4.9% to USD 6.5 billion in fiscal 2018, in line with our expectations. Currency translation delivered all of the benefit, however, with sales falling 0.1% on a constant-currency basis. As such, our expectations for volume growth of 2.7% in fiscal 2018 did not come to fruition. Segment EBIT margins were 12.8%, down slightly on the prior year but still ahead of our expectations for 12.5%. For fiscal 2019, we expect a resumption of flexibles volume growth to 2.6% in fiscal 2019. Together with resin price inflation of 4.1%, which we expect to be fully passed on in fiscal 2019, we anticipate sales growth of 6.2%.

Rigids segment operating leverage unwound off the back of the lower volumes, but the effect was exacerbated by the pronounced seasonality of the North American beverage business and resulted in segment EBIT falling 9% to USD 312.0 million. With significant skew in beverage sales towards the second half of Amcor’s fiscal year, which corresponds with the North American summer months, the 3% fall in second-half volumes has an outsize impact on operating leverage. As a result, EBIT margins fell to 11.2% from 11.9% a year earlier. However, we expect segment margins to improve and average 11.6% over the forecast period, with organic volume growth once again improving operating leverage alongside a further USD 20 million in cost savings, a combination of synergies still to be realised from the Sonoco acquisition in fiscal 2017 and a restructuring program aimed at eliminating approximately USD 10 million annually from the rigids manufacturing cost base.

Meanwhile, the relatively stable operating margins of 12.8% in the flexibles segment, just 10 basis points lower than fiscal 2017, were largely the result of swings and roundabouts. Resin price volatility resulted in USD 43 million in raw material cost inflation that wasn’t effectively passed on to customers, largely the consequence of surging and volatile oil prices. While this should have crimped margins, incremental benefits from the segment restructuring program of USD 36 million provided an offset. Management expect to deliver the final USD 10 million in segment restructuring cost savings in fiscal 2019. Segment EBIT growth will be limited to 1.5% in fiscal 2019, however, owing to our expectations for falling tobacco folding carton sales. We still expect sales to fall 2% a year over the forecast period as smoking rates fall further, limiting margin gains from operating leverage.

Amcor’s balance sheet strengthened slightly in fiscal 2018, with net debt/EBITDA falling to 2.8 times, down from 3.0 times a year earlier, but remains stretched relative to its through the cycle target of 2.25 to 2.75 times. The Bemis transaction, should it receive shareholder approval and proceed, will not result in a marked increase in leverage, with net debt/EBITDA expected to increase to circa 2.9 times upon completion.