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Morningstar | Resin and Energy Prices Hit Narrow-Moat Pact in Fiscal 2018; Cost-Out Measures Imperative. See Updated Analyst Note from 15 Aug 2018

Competitive pressures, powerful customers, and an adverse macroeconomic environment saw narrow-moat Pact deliver a soft fiscal 2018 result. Operating income in the Australian segment of AUD 103 million was 19% below our expectations for AUD 128 million, with resin price volatility, a 40% jump in energy costs in the second half, and lost rigids volumes acting together to arrive at the weak result. EBIT margins in the segment were 8.1%, down from 8.9% a year earlier. The international segment, with contributions from New Zealand and Asia, delivered EBIT of 60 million, largely in line with our expectations. We reduce our fair value estimate 8% to AUD 4.90 per share, reflecting the Australian segment’s loss of volume and the near-term cost headwinds.

Pact announced cost-reduction initiatives for the Australian rigids business, having identified AUD 50 million in annual cost savings. We view a continuous focus on cost reduction as imperative for Pact to maintain EBIT margins. Pact intends to optimise its overly complex rigid plastics manufacturing network, a symptom of the 50 acquisitions since inception in 2002 that have brought scale but also inefficiencies. Improved operations management, higher capacity utilisation and productivity, and lower freight and warehousing costs will combine to provide the targeted savings, but these come at a cost of some AUD 175 million.

Pact also announced the acquisition of TIC Retail Accessories, a closed-loop plastic garment hanger reuse business with AUD 95 million in annual revenue. The business supports leading apparel retailers in Australia, the U.S., and the U.K., and customers include Target, Kmart, Myer, Bonds, and Big W in Australia, and Tesco and Kohl’s in the U.K. and the U.S., respectively. At a purchase price of AUD 122 million, the deal was struck at an enterprise value/EBITDA ratio of 6.5. Pact will fund the purchase with AUD 62 million in cash and the remainder by issuing stock to the business' current owners.

The Australian segment consists of five disparate business lines, namely Pact’s rigids and contract manufacturing businesses; its materials handling business; the reusable crate pooling, or RPC, business launched in fiscal 2018; and a nominal contribution from the recently acquired ECP Industries. With the RPC and ECP businesses performing slightly ahead of our expectations, the core rigids, contract manufacturing, and materials handling businesses, which together represent 60% of companywide earnings, delivered EBIT circa AUD 32 million less than we had anticipated. While granular disclosure is not provided, management called out the rigids business as the major source of weakness. Several factors conspired together to yield the weak result relative to our expectations. Higher input costs accounted for AUD 10 million of the weakness, relating to unfavourable resin price movements and a 40% spike in energy costs in the second half of the fiscal year. While we expect the effect from resin price volatility to abate in fiscal 2019, the significant increase in energy costs will take Pact time to pass on to customers, with the firm having only managed 30% pass-through in fiscal 2018. With all rigids players facing the same manufacturing cost pressure, we anticipate gradual pass-through of costs, with an approximate four-year time frame before the full AUD 14 million in annualised headwind is passed on. In the near term, margins will suffer accordingly, and we now expect EBIT margins to average 8.4% over fiscal 2019-23, down from a prior 10.4%. However, we expect the announced cost-out initiatives to see margins again improve and average 11.0% over fiscal 2024-28.

Guidance for capital expenditure associated with the rigids cost-out program was sparse, with neither precise quantum nor timing of the expenditure provided. The program is still subject to financial and operational analysis. However, management is targeting a 3.5-year payback on the associated capital expenditure, and so we expect an incremental AUD 175 million in capital expenditure to effect the program. Management were also explicit that the initiatives will be incremental, and thus capital expenditure is also assumed to be incremental. We therefore provide for a five-year time frame for the program as our base case, with cost taken out at a rate of AUD 10 million per year, beginning fiscal 2020 with full realisation of savings in fiscal 2025 and resulting in EBIT margins of 10.6% in that year, up from 8.1% in fiscal 2018. Capital expenditure will precede cost savings, and thus the estimated AUD 175 million will proceed at an annual cost of AUD 35 million, beginning in fiscal 2019 and wrapping up in fiscal 2023.

The international segment, representing the group’s New Zealand business and the newly acquired Asian business, performed largely in line with our expectations, delivering EBIT of AUD 60 million, down 7% year on year. Operating margins eased to 15.5%, down from 19.5% in fiscal 2017, reflecting the contribution of lower-margin earnings from Asia following the CSI/Graham Packaging acquisition but in line with our expectations. While incremental volumes from Asia boosted segment earnings, these were wholly offset by lower volumes in New Zealand. Like the Australian segment, volatile resin prices and increased depreciation and currency translation headwinds provided a combined AUD 9 million drag on segment EBIT. We anticipate a significant improvement in segment EBIT in fiscal 2019 to AUD 80 million, reflecting a full year’s earnings contribution from the Asian acquisition. Accordingly, segment EBIT margins will ease to average 13.9% over the forecast period.

Pact’s balance sheet strengthened, owing to the equity raise associated with the Asian acquisition in the second half of fiscal 2018. Net/debt EBITDA fell to 2.8 from 2.9 in fiscal 2017. However, we see the metric increasing over the coming five years due to increased capital expenditure and softer EBITDA growth, peaking at 3.4 in fiscal 2023. As such, further acquisition activity will likely be equity-funded over the medium term.