EUR 850.00 For Business Accounts Only

Morningstar | Pact’s Push Into Asia: Growth but Not Without Its Challenges

We reduce our fair value estimate for Pact by 11% to AUD 5.30 per share from AUD 5.90, following a transfer of analyst and a revision to our top-line growth assumptions. We now expect a 10-year sales CAGR of 4.6%, down from prior forecasts of 9.4%. While updated top-line growth figures incorporate a significant uplift in sales in fiscal 2018 and 2019 from the CSI/Graham packaging acquisition, we neglect to include any of the prior assumed revenue growth from value-accretive M&A activity, with acquisition activity in Asia suggesting a change of tack on this front.

We upgrade Pact's moat rating, assigning it a narrow moat in acknowledgement of its resin procurement cost advantages relative to nonscale players in its home domiciles of Australian and New Zealand. We believe Pact enjoys somewhere from 10% to 15% better purchasing terms from the petrochemical industry relative to nonscale players. We think this is sustainable, given its leading market share in the Australian and New Zealand rigids markets, which are characterised by mature, inelastic demand derived from household consumption patterns.

The appeal of the acquisition of the CSI/Graham Asian packaging assets by Pact in February 2018 is understandable, given mature organic growth and a lack of M&A opportunities in the Australian and New Zealand plastic packaging markets. We expect economic development and faster population growth in the region to drive market volume growth averaging 3.7% over the coming decade, comparing favourably with average 1.3% volume growth in Australia and New Zealand. Pact has spent AUD 133.9 million (excluding acquired cash) to acquire the businesses, equating to an enterprise multiple of 6.8 times presynergies. With EBIT margins of 8.3% for the acquired businesses in 2017, we see the deal as shareholder-friendly, provided margins remain above 7%. We see margins likely reverting from this level over the forecast period , however, and thus aren’t entirely optimistic about the deal.

The CSI closures business produces highly commoditised bottle caps and is thus subject to significant price competition. Furthermore, these plastics transport rather well, which nullifies the protective efficient scale effect from which blow-moulded plastics benefit. Thus, regional competition in Asia in closures is likely to remain intense, and we see the potential for a threat to margins. We further note the prior owner's commentary on the loss of sales volumes and lower pricing due to competitive pressures in calendar 2017.

Meanwhile, the Graham blow-moulding beverage and bottle assets acquired in China will also face margin pressure, in our view. Rigid categories in China are likely to be highly contested, with price competition the name of the game. Further, we note a significant drop in revenue in Asia reported by the seller in calendar 2017. With resin prices in the region having rallied in 2017, and U.S. dollar strength not explaining this softness, we view the 2017 result as indicative of the realities of doing business in competitive Asian markets.

Taken together, we see downside risk to margins in Pact’s new Asian businesses. We give the benefit of the doubt and forecast margins contracting modestly to 7% from current margins of 8.3%, which would make the deal value-neutral for shareholders. However, we reiterate that any deterioration in margins below this level effectively destroys value for Pact shareholders, in our opinion, and thus could represent capital misallocation.