SMFTF - Smurfit Kappa Structurally Better Than U.S. Peers

2023-04-14 12:02:44 ET

Summary

• European packaging markets are more fragmented in the US.
• While discretionary spending trends are already showing volume declines, prices are still alright and costs are coming down.
• Smurfit is investing pretty meaningfully in converting equipment, and this improves their optionality and margin given lowered prices for recycled inputs.
• Historically, Smurfit has been a top-tier allocator and has had the best industry discipline in terms of capacity investment, yet they trade at a discount to peers.
• Resilience has also been phenomenal to COVID-19 these last years, but historically high margins are unsustainable, and it remains a bet against economic currents.

We thought readers might be interested in Smurfit Kappa ( SMFTF ) which we regard as one of the top picks among the packaging companies. They have had excellent historical resilience, are among the more disciplined allocators that focus on ROIC, they are currently investing substantially in equipment that will help take advantage of lower recycled paper prices, and they have a decent dividend too. Growing cost of capital isn't nice for them, and discretionary spending trends are not optimistic, so for these reasons, we avoid them as earnings growth is not likely to continue. But despite this direction, they are relatively cheap considering their superior economics and a more fragmented packaging landscape in Europe where they have a large presence.

Salient Smurfit Points

Pros:

• Margins were solid throughout COVID-19 and declined only marginally despite the hits to input markets and consumer spending. Currently, margins are almost at historical highs again from just before COVID-19 thanks to some major input costs like energy and freight coming down.
• Historically, Smurfit has had some of the largest ROIC to WACC spreads in the industry, and has been great at allocating capital. They are currently allocating the equivalent of about 25% of their market cap in major organic CAPEX works, their specialty, that should increase their converting capacity and help them take advantage of lower recycled input prices , which has come down very meaningfully from huge COVID-19 peaks thanks to China's woes.
• Smurfit is vertically integrated, and therefore their EBITDA growth has been fantastic compared to peers that need to buy up expensive pulp, which have been driving the higher box prices. Volumes have proven flat , EBITDA growth was 38% for this FY.
• There was some weakness, especially in Germany as they turned savings mode on for what could have been a cold winter, but in many geographies besides Germany volumes and trends looked incrementally stronger into the beginning of 2023. Still, volumes are trending downwards, also because of destocking reversals.
• While it is technically a global industry, supply chains aren't that long in packaging, so geography matters. Europe is more fragmented, which is Smurfit's primary EBITDA source, and Smurfit Kappa is better positioned to win out against smaller and less efficient peers with already very low asset costs than US peers.
• Smurfit is buying capacity facing Latin America, a more promising geography.

Cons

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