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Morningstar | Sealed Air Reports Soft Volumes in 1Q and APS Acquisition Inspires Skepticism; Lowering FVE to $47

Sealed Air's results in the first quarter were mildly disappointing versus our broader outlook for 2019. Volumes stagnated in the Food Care business, but the company was able to improve price/mix due to both price increases and resin price declines. Product Care results were more disappointing, with volumes off 4% versus the prior year on industrial weakness. The most concerning announcement was the purchase of Automated Packaging Systems, or APS, with almost no financial disclosures. We've updated our forecasts for 2019 and have added a negative enterprise value adjustment based on our expectations that the company overpaid for APS. We're only mildly reducing our fair value estimate to $47 per share from $48 and our narrow-moat rating is unchanged.

In our view, performance was mixed between Sealed Air's two segments. In the Food Care business, the company appeared to focus on price over volume, which worked well to lift adjusted EBITDA margins 1.7% to 21% in the quarter. Over the long term, we expect a boost to food care volumes via increasing grocery-sold food volumes in developing markets. In most cases, quality food packaging more than pays for itself by reducing spoilage and increasing shelf life to make transportation possible. For that reason, we think recent segment margins will generally be sustained going forward.

Our concerns lie in the Product Care segment. While industrial end-use has been a drag across the packaging space, we thought Sealed Air's volume decline would be less severe than it was. Volumes fell 4% in the quarter, due to lower industrial purchasing. We thought some of that softness would be offset by e-commerce customers switching to mailer solutions, but that wasn't the case. Over the long term, we're still optimistic on the segment's prospects. We see room for both margin improvement and revenue growth as packaging fulfillment increasingly turns to recyclable flexible solutions that consume less shipping space than boxes.

Investors appear to be especially sour on the announced $510 million deal to purchase APS. APS produces both equipment and consumables, which has historically focused on bag solutions more suitable to products like apparel. While we have no qualms with the strategic logic behind the purchase, we're concerned that management significantly overpaid unless they're able to realize substantial revenue and cost synergies. Management has only stated that the acquisition will be EBITDA accretive in 2019, which is a shockingly low hurdle to clear. APS will likely add around $300 million to sales on an annualized basis.

Based on management's unwillingness to comment further on the profit profile of APS, we fear that nearly all of the value is predicated on Sealed Air's ability to use APS' automation equipment to increase the viability of mailers in shipping applications. While we do think the acquisition will help Sealed Air to that end, we remain fearful that it bought a very low-profit business on high hopes that come with significant execution risk. It's hard to make concrete estimates around the valuation impact of the purchase with so little information disclosed, but we have docked enterprise value for 25% of the purchase price in our base case. We believe that not only are acquisitions generally value-dilutive by default, but when management is reluctant to disclose details, we grow even more skeptical. In our bear case, we assume fully half of the purchase price is lost on the deal, and in our bull case, we assume the deal is merely break-even for Sealed Air.