We recently reviewed Amcor (ASX:AMC) after the Company upgraded FY20 underlying EPS growth guidance by 3% at the midpoint, to 11-12%. This was following a strong result for the 3rd quarter to 31 March 2020. With the share price not far off its all time high, what would be a good level to invest?
Amcor is a global packaging manufacturer which has two operating divisions: Flexibles and Rigid Plastics (Rigids). The Flexibles division has operations in North America and South America, Europe and the Asia Pacific region. Its key end market exposures are defensive sectors, namely food, healthcare, home & personal and tobacco. The Rigids division is mostly exposed to the beverage and personal care markets in North America and Latin America.
Implications from the Upgraded Guidance
The upgraded guidance is a positive from the viewpoint that it demonstrates the quality and defensiveness of AMC’s underlying businesses. This is despite COVID-19 uncertainty. In particular, over >90% of AMC’s consumer exposure is to food, beverage, healthcare, and speciality containers.
COVID-19 appears to have had minimal impact on the Company so far. All of AMC’s 250 plants globally have continued to operate since the start of the COVID-19 pandemic with minimal disruption. This highlights the “essential” nature of its business. Further, the global disruption from COVID-19 has highlighted the benefits of AMC’s geographic diversification.
Rigids Packaging Operations Remain Challenging
An expected return to profit growth in 2H20 has not materialised. This is despite the Rigids division now being a smaller contributor to group sales and EBIT following the Bemis acquisition. The division’s underperformance is disappointing given the much stronger performance of the Flexibles division. The latter is benefitting from lower raw material costs, synergies from the Bemis acquisition, and elevated food purchasing trends in the supermarket channel within developed markets (Western Europe and North America).
The key challenge facing the Rigids division beverage volumes in North America and Latin America have weakened significantly. Pricing mix remains unfavourable and a number of rigid plastics facilities are likely still not performing at targeted operating efficiency levels. As such, with both volume and cost pressures remaining, EBIT margin expansion over the next two years is unlikely.
Synergy Targets from Bemis Acquisition
AMC has maintained its targeted cost synergies of US$180m from the Bemis acquisition by the end of FY22. We consider that this target is likely to be conservative, given that synergies are being realised faster than expected. In addition, AMC has a strong track record of meeting or exceeding synergy targets and, in addition, potential revenue synergies have not been taken into account.
Input Prices Remain Supportive
Having faced cost pressures from rising raw material (input) costs in FY19, a stabilisation in raw material prices over the course of 1Q20 contributed to margin expansion in the Flexibles division for that period. This was despite a revenue decline of -2.6%.
Key raw material costs have continued to trend down. In particular, the fall in resin prices are positive for AMC. Notwithstanding that Asian resin prices have not recovered off their recent lows, they remain well below 2018 levels. Further, prices for titanium dioxide (a key input for AMC) have fallen as well. Lower input prices need to be sustained over a period of time, given that there is typically a 3-6 month lag for recovering lower raw material costs.
Strong Free Cash Generation Supports Lower Gearing Profile
Gearing (on a net debt to EBITDA basis) is currently 3.1x. This is above the upper end of the Company’s long-term target range of 2.25x-2.75x. However, we expect the gearing level to come back down towards 2.8x at the end of FY20. It may even fall even further in FY21 and FY22.
The key factors underpinning this assumption is that AMC’s business model is typically cash-generative. The Company reiterated guidance for FY20 free cashflow of US$1b and historically generating surplus cashflows of ~US$200-300m per year. In addition, the Company has substantial liquidity, with no material refinancing to complete over the next 12 months.
In combination, a lower gearing profile and strong free cashflow generation provides scope for further capital management once the current US$500m share buyback is completed.
The shares have re-rated since our recent review, to a P/E of ~16x FY21 EPS estimates. This is now in the middle of the range over the past five years. Accordingly, we consider that any weakness from current levels may present a more attractive entry point.
Despite continuing revenue challenges, the Company has demonstrated an ability to generate EBIT growth from a variety of sources (i.e. cost/volume/mix; Bemis synergies and raw material pass through benefits). The scope for further capital management once the current US$500m share buyback is completed is also likely provide share price support.
It is worth noting that a key uncertainty impacting market sentiment towards AMC at present is a possible change in US Corporate tax, from 21% to 28%. Such a move would likely impact EPS estimates for FY23 by around 2%-3%. In context, about 40% of Amcor’s revenue exposure is in the US.
Whilst Amcor’s share price has done well to edge higher in the last few months, it has recently displayed some signs of weakness. The last several weeks has seen it form a rising wedge, which can often be a topping pattern. The stock has fallen in the last few days on increasing volume, potentially breaking the underside of the wedge (circled). Unless AMC can quickly recover here, we are likely to see it fall back to the base of the wedge near $13.50. Investors can therefore keep an eye out for any support coming in near those levels. If so, that would provide a more attractive entry point.
Michael Gable is managing director of Fairmont Equities.
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