Smurfit exposed after share slump
Packaging giant has taken a €1.27bn hit in Venezuela and its share price is down by a quarter since it spurned International Paper’s bid, writes Dan White
THE turmoil in Venezuela has cost Smurfit Kappa dear with the Irish company being forced to write off €1.27bn and its share price is down 28pc on last year’s spurned International Paper offer. Smurfit Kappa reported a 35pc increase in operating (pre-interest) profits before exceptional items to €1.1bn last year. A refinancing of most of the company’s debts reduced its interest bill from €248m to €214m so its pre-tax profits before exceptionals soared by 56pc to €938m.
However, Smurfit Kappa’s sales grew by only 4.4pc to €8.94bn while its volumes, ie the number of cardboard boxes it actually produced, were up by just 2pc.
The sales and volume numbers demonstrate once again the cyclicality of Smurfit Kappa’s business where relatively small movements in prices and volumes can have a disproportionate impact on the bottom line.
Despite being headquartered in Ireland the vast bulk of Smurfit Kappa’s business is done overseas with just over 1pc (€119m) of its 2018 sales being to customers in this country.
Germany, with 2018 sales of €1.32bn (almost 15pc), is the company’s biggest market followed by France with sales of €1.05bn (almost 12pc) and then UK and Mexico both with sales of just under €800m (9pc each).
Venezuela was one of the many countries in which Smurfit Kappa did business having operated in the now-troubled South American country for 33 years. That is until it announced on August 29 that the Venezuelan government had “temporarily” seized control of Smurfit Kappa’s Venezuelan operations.
The full-year results contain a massive €1.27bn exceptional item related to the “deconsolidation” of the Venezuelan operations.
While the fact that Smurfit Kappa is pursuing an international arbitration claim against the Venezuelan government means that it has every incentive to portray the seizure of its assets in the very worst possible light, there is no doubt but that it has suffered a very significant loss at the hands of the Maduro regime.
And that isn’t the only exceptional item in the full-year results. Last June International Paper, the largest US paper and packaging producer, walked away from a proposed takeover after the Smurfit Kappa board refused to discuss the deal. Fending off the International Paper approach cost Smurfit Kappa €18m in professional fees.
When the various exceptional items, which between them amounted to €1.34bn, are taken into account Smurfit Kappa goes from an apparent pre-tax profit of €938m in 2018 to a loss of €404m. By the time the company’s €238m tax bill is added to the mix one is left with an after-tax loss of €639m.
As if to add insult to injury, even after climbing about 8pc to €27 last week following the results announcement, the Smurfit Kappa share price is still 28pc shy of the €37.54 that International Paper was offering to pay less than nine months ago.
Having declined to go hostile with its previous offer for Smurfit Kappa, International Paper is barred from making a new offer for a 12-month period which doesn’t expire until June.
So with the Smurfit Kappa share price languishing in the 20s, almost a tenner less than it was prepared to pay last year, will International Paper come back with a new offer then?
With the top five producers responsible for approximately 75pc of total output, the US paper packaging market is much more concentrated than its European counterpart, where the big five — of which Smurfit Kappa is the largest — control about a third of the market.
This means that US paper packaging companies are going to have to look outside North America for most of their future growth opportunities.
While the Smurfit Kappa share price is currently trading at less than three-quarters of what International Paper was prepared to pay last year, the American company has since been busy buying back its own shares.
Last October it announced plans to spend up to $2bn on a buyback. However, this is still only fraction of the €8.9bn it was prepared to pay to acquire Smurfit Kappa.
Even if International Paper does decide to target a European acquisition once again, Smurfit Kappa may not be the automatic choice.
While its share price is down more than 28pc since last summer, the share price of the second-largest European paper packaging producer DS Smith has fallen by 22pc over the same period. International Paper might not be short of choice.
“The overall sector will see further consolidation. The biggest players will look outside the US market”, says Investec analyst Thomas Rands.
While its 2018 results were blighted by the Venezuelan write-down, Smurfit Kappa recorded a solid operating performance last year. EBITDA (earnings before interest, taxation, depreciation and amortisation — generally reckoned to be the best gauge of a company’s ability to generate cash) rose by 24pc to €1.54bn and its free cash flow jumped by 61pc to €494m.
For most of this decade Smurfit Kappa’s annual EBITDA has hovered around €1bn-€1.1bn while free cash flow has been in the €280m-€390m range. Is last year’s performance an indication that there has been a step increase in the company’s cash-generating capacity?
Rands believes that there has been a structural improvement in Smurfit Kappa’s operating performance and that last year’s growth is sustainable. He points to the improvement in the group’s margins, a 17.3pc EBITDA margin in 2018 compared to just 14.5pc the previous year.
If he is to get his share price back up and deter International Paper from having another crack at the company, chief executive Tony Smurfit needs to demonstrate that this improvement is sustainable rather than being due to once-off factors.
In the first years after it returned to the Stock Exchange in 2007 Smurfit Kappa concentrated on paying doing its debt pile, which stood at almost €5bn, at the end of 2006.
That focus has shifted in recent years with its net debt increasing by €260m to €3.12bn in 2018 despite the jump in free cash flow. This was largely due to Smurfit Kappa spending €498m on acquisitions, all of which were paid for with cash, in 2018.
Even allowing for this increase in Smurfit Kappa’s borrowings, 2018 year-end net debt as a multiple of EBITDA fell to just 2.0 from 2.3 at
Relatively small movements in prices and volumes can have a disproportionate impact on bottom line
the end of 2017 and 5.5 at the time of the IPO. It is the EBITDA/net debt multiple that potential borrowers focus on rather than the absolute amount of the borrowings.
As a result, despite the increase in its borrowings, Smurfit Kappa was able to issue a €600m bond at a 2.875pc interest rate in June 2018. It followed this up last month by issuing a further €400m of these bonds at 0.75pc premium for a yield of just 2.756pc. In addition it also signed a five-year €1.35bn revolving credit facility with its banks. As a result of these refinancings the group’s average interest rate fell from 4.1pc at the end of 2017 to 3.7pc at the end of 2017 and the average maturity on its borrowings now stands at 4.6 years.
At the current share price of €27 Smurfit Kappa has a market capitalisation of just €6.4bn. Even when one throws in its borrowings that gives a total enterprise value of just over €9.5bn, the equivalent of just six times EBITDA and just 8.6 times pre-exceptional operating profits.
Throw in a full-year dividend of 97.6 cent a share and that’s not expensive for what is a well-managed company that is the market leader in its segment.
International Paper know this as well as anyone. Given how sharply the Smurfit Kappa share price fell following the rejection of its last offer, Tony Smurfit may find it harder to say no if it comes calling a second time.