2023-08-02 11:01:31 ET
Summary
- Sonoco Products has experienced minimal movement in its valuation despite a nearly twofold increase in earnings over the past two years.
- The company has a strong track record in capital allocation, reinvesting back into their businesses, and engaging in share repurchases and dividends.
- The stock appears undervalued by around 50% based on a standard P/E ratio, but this is largely due to current higher-than-normal margins.
Introduction
Despite a nearly twofold increase in earnings over the past two years, Sonoco Products ( SON ) has experienced minimal movement in its valuation. This comes as a surprise considering the low earnings multiple that the stock is assigned, despite management's consistent reassurance that current margins are stable and poised to improve in the upcoming period. If their projections hold true, I think it is highly probable that the stock's price will see a notable surge in the near future.
Sonoco Products, along with its subsidiaries, is involved in the design, development, manufacturing, and sale of a diverse range of engineered and sustainable packaging products across North and South America, Europe, Australia, and Asia. The company operates through two main segments: Consumer Packaging and Industrial Paper Packaging.
In the Consumer Packaging segment, Sonoco offers a variety of packaging solutions, which include round and shaped rigid paper, steel, and plastic containers. Additionally, this segment provides thermoformed plastic trays and enclosures, along with high-barrier flexible packaging products.
On the other hand, the Industrial Paper Packaging segment is dedicated to serving specific industrial packaging needs, focusing on paperboard tubes, cones, and cores.
Q2 2023 Earnings
In Q2 2023 , Sonoco experienced a setback in both revenue and profit due to ongoing customer destocking and the persistent inflationary pressures. As a result, the bottom line fell short at $1.38, missing expectations by $0.08. Similarly, revenues were below forecasts by $150 million, amounting to $1.71 billion.
Despite these challenges, Sonoco's management expressed overall contentment with the results. They were pleased with how well the businesses, especially the profit margins, held up during this difficult period.
Though we are not satisfied with these results, our excellent cash flow and EBITDA margins reinforce the durability of our underlying profitability and the integrity of our strategy.
- CEO, Howard Coker
Although the results did not meet analysts' expectations, I believe management has valid reasons to be content with them. The outcomes closely align with the historical trend of the company's fundamentals.
The revenue exhibits remarkable consistency, with acquisitions being the main source of volatility. In 2022, the acquisition of Ball Metalpack for $1.35 billion contributed significantly to the revenue increase. Historically, the average revenue growth has remained in the mid-single-digits, and it is unlikely to escalate further due to the growing challenge of finding suitable acquisitions that significantly impact the company's performance.
As depicted in the graph below, Sonoco's profit margin has consistently exhibited remarkable stability, a testament to the strength of its businesses. However, there is a concern that with the easing of lockdowns, a potential return to average profitability at a slightly lower profit margin might be at risk. The recent earnings report, which disappointed analysts, could be an early indicator of this possibility.
Thanks to the stable profit margin, the company has consistently generated a steady amount of net income. The only exception was in Q2 2021, when a pension settlement charge of $406.5 million was incurred due to the resolution of outstanding pension liabilities .
Capital Allocation
Over the past two decades, Sonos has demonstrated a strong track record in capital allocation in my view. Their diverse strategy includes reinvesting back into their businesses, engaging in share repurchases, and paying dividends. Typically, the dividend is funded by approximately 50% of the earnings, while a majority of the remaining earnings are reinvested.
Consistently maintaining a high rate of reinvestment, Sonos has achieved an average return on equity of around 13% from 2010 to 2021. This level of performance should have contributed to approximately 6.5% annual growth in earnings per share. However, in reality, the EPS growth has been slightly lower due to some of the remaining ~50% of earnings being used for share buybacks. While share buybacks have also contributed to EPS growth, their impact has been somewhat less significant than that of the reinvestments, primarily due to the valuation at which the repurchases were executed.
Therefore, it is reasonable to anticipate an EPS growth rate ranging from 3.8% to 6.5%. The lower estimate assumes that share buybacks will continue near its average P/E ratio, while the higher estimate assumes that all earnings, after dividends, will be reinvested.
Valuation
As depicted in the graph below, Sonos has shown remarkable EPS growth over the past two decades, with an average of 6.68%. However, when excluding the current fiscal year, which boasts higher margins compared to historical levels, the growth rate drops to 4.71%. Assuming the company can maintain a similar pace of reinvestment while keeping the dividend payout at approximately 50% and engaging in minor share buybacks, one can reasonably expect mid-single-digit annual EPS growth. Additionally, the current dividend yield stands at 3.47%, bringing total annual capital gains to the high-single-digit.
The next crucial question is determining a fair valuation for Sonos. I believe the answer is close to a standard 15 P/E, which aligns closely with its historical average P/E of 16. With a P/E of 15-16, the company would appear undervalued by ~50%. However, it's important to note that this is largely due to the current higher-than-normal margins. If margins were to return to historical levels, the stock would only offer a small margin of safety, as it would then trade slightly above its average P/E.
During the Q1 2023 call, management emphasized the sustainability of the strong margins, with COO Rodger Fuller expressing their expectation of continued increases in profitability this year. This sentiment was further echoed by a representative from the earnings call, who had the following to say:
We're in the early stages of leveraging our operating model to expand margins, our operating model is solid and sound.
Considering the compelling guidance provided by management, if they successfully maintain or even increase current profit margins, the stock indeed seems to be significantly undervalued.
Stock Chart
Quick disclaimer: A technical analysis in itself is not a good enough reason to buy a stock, but combined with the company's fundamentals, it can greatly narrow your price target range when investing.
Like many consistently profitable and growing stocks, the 50-month moving average has historically served as a reliable indicator of intrinsic valuation for this company. Over the years, the stock has occasionally dipped slightly below the moving average, only to recover and remain above it. Presently, the stock is at the moving average, and given the positive long-term earnings outlook indicating a margin of safety, it appears probable that the share price will rise back above the moving average.
The 200-month moving average has also been a valuable indicator of severe undervaluation in the past. However, I don't anticipate a drop to such low prices unless there's a broader market crash or a significant deterioration of fundamentals. As neither of these scenarios seems likely in the short term, it would be more sensible to prioritize focus on the 50-month moving average for assessing the stock's valuation and potential trajectory.
Final Thoughts
If one places trust in management's projections of maintaining or even improving current profit margins going forward, there exists a substantial margin of safety at present. In such a scenario, expecting the share price to double seems reasonable, as a P/E ratio of 9.71 for a profitable and growing company is not sustainable in the long run.
However, if management fails to meet their expectations, and profit margins readjust to pre-COVID-19 levels, only a small margin of safety would remain, with the stock trading slightly above its average P/E.
Regardless of the outcome, both scenarios provide a margin of safety, and even with a modest margin of safety, the conservatively estimated annual EPS growth rate in the mid-single-digit, coupled with the dividend yield of 3.47%, would still make the investment a lucrative prospect for the long term.
For further details see:
Sonoco Products: Packaging Powerhouse With Promising Prospects