Pact Packages A Weak Earnings Outlook

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Packaging provider Pact Group has disappointed brokers, reducing earnings guidance for FY19 on the back of higher costs.

-Earnings skewed to the second half, with full six-month benefit from acquisition
-Resin cost pressures easing, providing potential for margin recovery
-Is there a case for the chairman taking the company private?
 

By Eva Brocklehurst

Pact Group ((PGH)) provided a disappointing trading update as raw material prices continued to put pressure on earnings. The company now expects FY19 operating earnings (EBITDA) of around $245m versus prior guidance of $270-285m. This represents a -12% downgrade at the mid point.

Earnings for the first half are expected be weaker, adversely affected by delays in recovering higher resin costs amid higher costs for contract manufacturing. More efficiency benefits should be recognised in the second half as well as a full six-month contribution from TIC Retail Accessories.

Macquarie observes this was a big change in outlook in the short space of time since the August results, but also points to uncertainty stemming from the departure of the CEO in September. The broker acknowledges ongoing Australian drought is also a negative factor.

The headwinds from resin costs appear to have lingered longer than expected but higher costs for contract manufacturing present a new issue and were the largest cause of the latest downgrade. This relates to surfactants & caustic soda used in the company's Jalco business, which makes detergents and shampoos for Aldi, exacerbated by a weaker Australian dollar.

Deutsche Bank believes guidance is extremely conservative, as it no longer assumes any recovery in raw material costs. The broker believes such an outcome is unlikely because resin prices are stabilising or beginning to decline.

Moreover, around 60% of rigid plastics volumes are contracted with a three-month lag rise & fall clause, as is around 30% of contract manufacturing volumes. Despite the downgrade, the broker maintains a Buy rating.

CEO Uncertainty

Macquarie points out that as rise & fall recovery for contract manufacturing is less than that for resins, there is greater exposure to volatility. The uncertainty regarding a new CEO, yet to be appointed, keeps the broker on a Neutral footing, despite a reasonable return from the stock.

Morgans was surprised by the magnitude of the downgrade, given prior guidance was only delivered three months ago. A recent easing of the oil price and the stabilisation of the AUD/USD should help with some flattening in resin prices. However, there is further downside risk if oil prices and FX resume unfavourable trajectories.

On top of this, the company is implementing efficiency programs, integrating acquisitions and seeking a new CEO. Despite a reasonably attractive valuation, the broker considers the operating environment difficult, with further risks possible in relation to raw material costs.

Credit Suisse still expects investors can achieve a 25% total return over the next 12 months, highlighting that the stock is trading on a 6% dividend yield on 10% FY20 free cash flow yield.

The broker acknowledges the trading update reflects a more conservative outlook for profits but believes prior guidance was aggressive. New guidance assumes raw material costs will not change and there is no further recovery in output prices. Yet, Credit Suisse now envisages resin costs are no longer threatening and if this remains the case there is some potential for margin recovery.

Ord Minnett considers the stock price depressed and, while there is fundamental valuation support, the poor track record of organic growth warrants caution about the outlook and earnings prospects.

Case For Going Private?

Credit Suisse reflects on whether the chairman, who owns around 38% of the company, may consider privatising the business, given the present situation. The broker points out, the rationale for going public was the vision of a much larger business. Now, five years later, the logic for remaining public is being tested.

The broker points out that scrip is valued at a lower multiple and, therefore, costly to issue, and neither sellers of potential bolt-on businesses nor passive shareholders would appreciate being issued additional scrip, given the track record and risk. Moreover, the stock market is valuing the stock cheaper than when the company was listed. All up, Credit Suisse believes Pact Group is at a point where investors face little downside.

FNArena's database shows two Buy ratings and three Hold. The consensus target is $4.02, suggesting 28.1% upside to the last share price. This compares with $4.64 ahead of the update. Targets range from $3.24 (Morgans) to $5.50 (Deutsche Bank). The dividend yield on FY19 and FY20 forecasts is 6.1% and 6.4% respectively.

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