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Morningstar | Strong Fiscal 2018 for No-Moat Orora; Outlook Unchanged

No-moat Orora reported a solid fiscal 2018 result with revenue growing at 5.2% to AUD 4.24 billion, ahead of our expectations of 3.4%. Improved EBIT margins of 7.6% saw operating income grow ahead of revenue, up 7.0% to AUD 323 million from a year earlier. Nonetheless, our long-term expectations are largely unchanged following the result. We’ve adjusted our forecast to reflect forward expectations for a lower USD/AUD exchange rate, which leads to a 6% increase in our fair value estimate to AUD 2.75 per share, but Orora shares still look expensive, trading at 1.3 times our new fair value estimate.

The Australasian segment, contributing roughly two thirds of group earnings, benefited from increased organic volumes in both the fibre and beverage packaging business units. Increased volumes accounted for 4.2% of the total 5.2% segment revenue uplift to AUD 2.1 billion and compared favourably with our expectations for 3.3%. The remaining 1.0% in sales growth relates to the impact of passing on of aluminium price volatility downstream. While growth was pleasing and clearly resulted from market share gains, we see a moderation in revenue growth in fiscal 2019 toward our long-term forecast of for 3.5%, which reflects the confluence of population growth and inflation.

North American revenue also benefited from organic volume growth and the pass-through of raw material price volatility. While distribution revenue was strong, increasing by 5.4%, the exit of some short-term opportunistic volumes in manufacturing moderated the segment’s overall growth. Taken together, segment revenue grew 3.2% in U.S. dollar terms, reaching USD 1.66 billion. Segment margins remained relatively flat at 5.6% in fiscal 2018.

Looking forward into fiscal 2019 and beyond, Orora expects little in the way of market growth for both its Australian and North American businesses, largely aligning with our expectations for growth. We see this at 3.5% per year over the coming decade.

In Australasia, improved fibre packaging capacity utilisation and continued focus on production efficiency aided EBIT margins, which widened 30 basis points to 11.0%. As such, Australasian operating income grew ahead of revenue at 8.8% to AUD 232 million. We commend Orora on margin improvement, which was ahead of our expectations for 10.7% in fiscal 2018 and represents the fourth consecutive year of margin accretion in the Australasian business. We have a positive view of Orora’s continued efforts in finding manufacturing efficiencies in an effort to drive EBIT growth, which include both cost-reduction programs and reinvestment in the manufacturing asset base, notably in fibre packaging and glass, with a rebuild of the G2 glass furnace scheduled for early calendar 2020. However, we're of the view that margin expansion will be hard to come by, with price competition and powerful customers keeping a lid on margins. Under our base case, we anticipate segment margins to remain relatively steady and average 10.6% over the coming decade. We acknowledge the possibility of Orora holding onto the benefit of gains in productivity in our bull case, where margins will improve slightly to 11.4% over the coming decade.

In North America, segment operating income grew 5.9% in U.S. dollar terms, but a stronger Australian dollar in fiscal 2018 provided a headwind, with operating earnings growing 3.0% upon translation. We expect an approximate 5% depreciation in the Australian dollar in fiscal 2019, which will provide a tailwind should it come to fruition. Continued reinvestment into the existing North American business will see margins continue to improve, in our view, to 7.5% by fiscal 2021.

Reflecting the continued focus on reinvesting in organic growth for both segments, capital expenditure increased 20% year on year, climbing to AUD 189 million. At 152% of depreciation, the reinvestment in the existing business is evident and management continues to guide for similar levels looking forward. We view this as appropriate and necessary to both defend Orora’s position in its markets and to strip out costs to drive earnings growth in the face of mature packaging markets.

The balance sheet strengthened, with net debt/EBITDA falling to 1.5 times at fiscal year-end, down from 1.59 times in fiscal 2017. The balance sheet position provides Orora with optionality, either to pursue value-accretive acquisition or to return capital to shareholders.