EUR 850.00 For Business Accounts Only

Morningstar | Dividend Cut and Likely Capital Raising to Shore Up Pact’s Stretched Balance Sheet; FVE Reduced 14%. See Updated Analyst Note from 20 Feb 2019

Soft Australian trading conditions and heightened capital requirements led narrow-moat Pact Group to suspend its dividend in first-half fiscal 2019 and makes an equity raising now look imminent. Lost volumes in its Australian rigids business led us to reduce our full-year expectations by 5%. We now forecast fiscal 2019 EBITDA of AUD 230 million, in line with the lower bound of Pact’s recently revised guidance range. We lower our fair value estimate by 14% to AUD 4.20 per share on account of reduced earnings estimates and an equity raise that will likely proceed at a price below fair value. Nonetheless, Pact shares continue to screen as undervalued and trade at a 40% discount to our revised valuation.

First-half EBITDA of AUD 110 million was unsurprising having been pre-announced, with Australian Packaging volumes negatively impacted by the Australian drought that softened demand from agricultural customers. However, we’re concerned that volumes from dairy, food, and beverage customers were also lost, leading us to lower our top-line forecast for this segment, reducing our EBIT projection by 15% to AUD 89 million. Offsetting this weakness, the Materials Handing and Pooling segment performed ahead of our expectations. We therefore update our EBIT forecast for the segment to AUD 39 million from a prior AUD 29 million. The Contract Manufacturing segment largely tracked our expectations.

Longer term, we continue to fully factor Pact’s targeted cost savings, with margins to recover to 10% at midcycle. Pact confirmed timing for its cost-out program with the remaining AUD 40 million in savings to be delivered by end of fiscal 2022, alongside program capital expenditures of AUD 175 million. We believe the market remains sceptical that cost savings can be delivered. A credibility issue has emerged for Pact, given two successive downgrades to guidance in fiscal 2019 thus far. This likely remains the major differentiator of our valuation versus the prevailing share price.

Pact has been awarded a long-term contract to provide returnable produce crate (RPC) pooling services to ALDI, the number three player in the Australian supermarket industry, for its fresh produce supply chain. The deal will leverage Pact’s existing crate washing facilities, and management expects the contract to hit Pact’s internal return targets in its first year of operation. While Pact neglected to provide forecast revenue or margins, we expect the deal to deliver AUD 27 million in by fiscal 2021, adding around one fifth in incremental revenue to the pooling business. EBIT margins are expected to be in line with existing RPC contracts of approximately 15%. Capital expenditure requirements of AUD 20 million have been earmarked by management.

Pact also announced a new resin supply strategy, intensifying the group’s working capital requirements. Pact is now sourcing all resins from Singapore, leveraging the Asian acquisition to improve the group’s negotiating position in resin procurement. But incremental investment in working capital is required in fiscal 2019 as inventory days for resins increase from two weeks to 12 weeks. We estimate that AUD 73 million in incremental investment in working capital is required in fiscal 2019.

We also anticipate an equity raising with the balance sheet looking stretched. At half-year end net debt/EBITDA of 3.3 times neared Pact’s debt covenant of 3.5 times. While the suspension of the first-half dividend aids leverage, incremental capital requirements of AUD 118 million would bring Pact face to face with its debt covenant in the absence of equity financing. While providing limited detail, Pact asserts it is assessing its options for capital to provide the flexibility for its capital expenditures program. We anticipate a raising in the vicinity of AUD 130 million, sufficient to bring leverage back to 2.9 times at fiscal 2019 year-end and thus in line with Pact’s target of below 3 times. While prudent, we note that the raise occurs at a time when the share price trades significantly below fair value and will be approximately 6% value destructive.