The recent company results for Orora (ASX:ORA) for the 12 months to 30 June 2022 (FY22) reflected a strong performance in one division – North America. They also showed a poor result in the other – Australasia. This trend has been in place for a number of years now. EBIT for the North America division increased by 37% (+33% on a constant currency basis). This was due to ongoing improvement in customer account profitability, price management, and cost recoveries. In contrast, EBIT for the Australasian division was flat (in comparison to FY21) and in line with Company guidance. Modest volume growth in beverages were offset by a shift towards lower-margin sales as well as cost inflation.
With the group earnings growth profile becoming increasingly reliant on the North America division, the key question for investors is whether the performance from the latter is strong enough to offset the flat earnings growth outlook for the Australasian division and support a recovery in the shares.
Orora’s core businesses include the design and manufacture of packaging products such as glass bottles, beverage cans, corrugated boxes, and recycled paper. They have operations in Australasia, as well as three operating segments in North America: Orora Packaging Solutions (OPS), Corrugated board manufacturing and Orora Visual, which is the Point of Purchase (PoP) Display business that the Company first entered in March 2016.
Both the Australasian Beverages and North America packaging solutions & visual businesses are positioned in the top five of their respective market segments. The Company reports results across two divisions: North America and Australasia. The North America division accounts for 78% of group revenue and 47% of group EBIT in FY22.
Key Fundamental Drivers
Further Earnings Growth Expected in North America
The Company has guided to further EBIT growth in North America in FY23. This reflects the full year impact of price increases in FY22 and continued implementation of profit improvement initiatives. In the US, ORA implemented five price increases over the course of FY22, including two price increases in 2H22.
The guidance also implies further margin expansion in North America in FY23. The margin for OPS increased from 4.4% in FY21 to 5.2% in FY22. This reflected the impact of improving customer account profitability and managing supply cost inflation. Overall, the EBIT margin for OPS is expected to increase in FY23.
However, while the overall outlook for the North America division is strong, there is some weakness with the Orora Visual (OV) business. Margins in 2H22 appeared weaker, as a result of operating in a higher inflation environment. The Orora Visual segment has been challenged due to lockdowns in the US. This has seen a temporary closure of US retail stores. It is estimated that retail represents 30–40% of OV’s sales. In addition, the OV business has been impacted by the deferral of customer promotional activity and marketing campaigns, given wide-spread corporate cutbacks on discretionary expenditure.
Capacity Expansion to Underpin Earnings Growth For Australasia Division – But Not Until FY24
The Company has provided guidance for EBIT to remain flat in FY23, with 1H23 to be impacted by inflationary cost increases (i.e freight, soda ash) and supply chain pressures likely to offset volume and mix benefits in Can and Glass packaging. The Company expects customer price recovery to come into effect in 2H23 and to this end, the Company is managing its energy costs well. Around ~80% of electricity costs are covered by wind farm PPA’s / fixed retail contracts, and ~99% of gas contracted. In context, energy costs represent ~2% of ORA’s total group cost of sales and ~10% of Australasia’s cost of sales.
The Company is expanding capacity in its Australasian operations, which is expected to contribute to earnings growth in FY24. Importantly, the capacity expansions are supported by customer contracts and ORA are targeting an EBIT return of 15% from organic growth investments over a 3-4-year time horizon.
Balance Sheet Capacity to Pursue Further Acquisitions
ORA has a healthy balance sheet, with gearing (on a net debt to EBITDA basis) of 1.8x as at 30 June 2022. Except for the FY19 period, where the gearing level was elevated because of acquisitions, heightened capital investment and a build-up of working capital, gearing has typically remained below the Company target of 2.0-2.5x.
The gearing level is expected to increase towards the bottom end of the target gearing range by the end of FY23. This is because the Company is undertaking significant growth CAPEX directed towards an upgrade of manufacturing capacity projects. However, the gearing level is then expected to trend downwards again, as the earnings benefit from the capacity expansions begins to flow through.
Notwithstanding the expected increase in gearing levels, the Company still retains sufficient balance sheet capacity, which can be used to support Merger & Acquisition opportunities and still remain within the mid-point of its target gearing range.
To this end, ORA have commented that ‘an active assessment is underway’ for North America, with the Company working through a range of opportunities (although it is unclear whether any of these have progressed to the due diligence stage).
The defensive leverage to Australasian beverage packaging and the ongoing margin recovery story in the North America division are attractive aspects of the investment case for ORA. However, we consider that the increased reliance on the North America division to generate group earnings growth increases investment risk, in light of the cyclical nature of operations in North America (which are essentially distribution-based business); where volume and margin performance for both OPS and Orora Visual are still highly reliant on external macro conditions and as referred to above, the OPS business is more volatile than the overall market.
Further, while the Australasian division is expected to resume earnings growth in FY24, there is execution risk given the significant CAPEX program being undertaken.
Finally, it is worth noting that the current P/E multiple of ~15x is unappealing in the context of a relatively modes EPS growth profile of ~4.5% over FY22-25 on a CAGR basis.
Accordingly, we take a cautious view on the shares.
Since the May peak, Orora has been trending lower and it still remains in that downtrend. For us to start to be positive on the chart, the share price needs to move sideways for several weeks to build a base. However, at this current rate, ORA is likely to drift back to levels under $3.10 before we can reassess.
Michael Gable is managing director of Fairmont Equities.
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