We recently researched Orora (ASX:ORA) in The Dynamic Investor after the Company reported its financial results for the six months to 31 December 2022 (1H23). The results were ahead of consensus expectations, as the continued improvement in the performance of North American business saw EBIT margin improve. The market reaction following the interim results release was very positive, as the challenges in the North American business have weighed heavily on sentiment in recent years.
With the shares having retreated from its recent highs, we assess whether current levels present an opportunity.
Overview of Orora
Orora’s core businesses include the design and manufacture of packaging products such as glass bottles, beverage cans, corrugated boxes, and recycled paper in Australasia. They have 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 76% of group revenue and 51% of group EBIT, respectively.
Key Fundamental Drivers
Margin Recovery for North America Business Taking Shape
For the first time in a while, the North America business reported margin expansion across all businesses as the Company continues to focus on margin mix, the optimisation program, improving customer account profitability and cost recovery. There is scope for further EBIT margin improvement over the near term, as: i) The still-progressing optimisation program is likely to offset inflationary pressures on warehouse rents and labour and ii) The Company is targeting further improvement in product mix by continuing to target higher-value customers and exit (or replace) unprofitable customers.
One of the key factors underpinning earnings growth in 1H23 was a sequence of price rises implemented last financial year. This was offset by double-digit volume declines in manufacturing (which was in line with the broader industry). The potential for price realisation to continue to support revenue/EBIT growth in FY24 is lower than in 1H23 (where there was no volume growth and the profit growth principally came from price over cost spread) given the prospect for lower paper prices. However, the Company believes that it can continue to optimise margin across thousands of customers and SKU’s despite the backdrop of falling paper prices.
Planned Capacity Expansion to Support Earnings Growth for Australasia Business
The Australasia business is suffering from EBIT margin pressure, reflecting inflationary cost pressures related to freight, energy, and raw materials that are not being recovered through contractual pass-through mechanisms. In addition, there was a mix shift to lower-margin glass categories and lower wine and beer sales.
The Company has a number of expansion projects in the pipeline that are expected to underpin earnings growth for the Australasia business over the medium term. The majority of these relate to expanded capacity in can manufacturing – a segment that generated a double-digit increase in volume in 1H23. Cans continues to take category share with strong demand in craft beer, and the ready-to-drink and carbonated soft drink categories. There was also a positive mix shift towards higher-value slim and sleek can volumes
Balance Sheet Capacity Supports CAPEX Commitments
The balance sheet remains healthy, with gearing (on a net debt to EBITDA basis) of 1.9x as at 31 December 2022, which is slightly higher than the 1.8x reported 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.
Gearing is expected to move higher in FY23/24, as the Company is undertaking significant growth CAPEX directed towards an upgrade of manufacturing capacity projects at the Dandenong & Revesby plants, alongside the acquisition of long-lead items associated with the G3 furnace re-build at Gawler. While these growth projects are absorbing free cashflow and sending gearing higher, it is worth noting that the growth projects are expected to generate an attractive return on capital employed (ROCE) of ~15% (minimum) once fully utilised. The downside is that dividend franking is not expected until after FY24, due to ORA’s CAPEX program in Australia and instant asset write-off for Australian tax purposes.
Scope for Further Acquisitions
Notwithstanding the prospect of higher gearing, the balance sheet retains enough capacity to pursue further bolt-on acquisitions in North America, where declining asset values may present opportunities. Any further acquisitions have the potential to be accretive to EPS, given the likely opportunity for synergies to be extracted.
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, the earnings growth profile (~4.5% over FY22-25 on a CAGR basis) remains constrained by the elevated level of CAPEX being undertaken in the Australasian division, margin impact from cost inflation pressures in the Australasian division and the potential for lower price realisation in North America.
Further, 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 the OPS business is more volatile than the overall market.
ORA was in a downtrend between mid-2022 and February. Then the large week in mid-February has given us a clear reversal signal and this means that the downtrend in ORA is now over. At the moment it is easing back but this just looks like a short-term consolidation. The weakness back towards $3.20 now seems to be an opportunity for buyers.
Michael Gable is managing director of Fairmont Equities.
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