2023-12-20 10:00:00 ET
Summary
- Sonoco Products' shares have underperformed compared to their peers, but they are now attractive given their valuation and lower inventories.
- The company's recent earnings report showed a decline in revenue but beat expectations for adjusted EPS as productivity gains took hold.
- With orders rising sequentially and price increases coming, the demand picture for Sonoco is getting more attractive.
Shares of Sonoco Products (SON) have been a poor performer over the past year, declining about 5%, which has materially lagged peers. Over the past year, Packaging Corp (PKG) is up by 28% while International Paper (IP) has rallied 8%. WestRock (WRK) has risen 23%, aided by Smurfit's announced acquisition of the company. While the company has been hit by falling prices and volumes as customers worked through inventory, shares do look attractive, and I would be a buyer.
In the company's third quarter , it earned $1.46 in adjusted EPS, beating estimates by $0.18 even as revenue fell by 10% to $1.71 billion. EPS was down 9% from last year. Alongside these results, management amended guidance. It is guiding to about $1.065 billion in EBITDA, translating to $5.25-5.40 in EPS and $600-$690 million in free cash flow. This implies a Q4 earnings level of $1.01-$1.16. It previously guided to $620-$720 million i n free cash flow. This was the second straight quarter management cut cash flow guidance, coming after it raised guidance in Q1 .
Guidance cuts are always disappointing to see, but to me, a warning sign is when we see a company go from raising guidance to cutting guidance in consecutive quarters. Unless there is a major unforeseen macro shock (ie COVID) that renders previous guidance moot, such an about-face speaks to a management team that is not fully grasping the business environment it is operating in. As a consequence, I think markets are likely to view guidance skeptically until it consistently delivers, which will constrain SON's multiple.
In the last quarter, consumer packaging revenue fell 9% to $938 million with segment EBITDA down 9% to $144 million. Industrial paper packaging fell 12% to $580 million. Adjusted EBITDA was down a more modest 4% to $105 million as margins expanded to 18% from 16% last year as the company has reduced cost and seen improved productivity at its metal can facilities. Industrial volumes were down 7.5%. While consumer volumes fell by 8% from last year, they did rise sequentially, a tentatively encouraging sign. Overall, SON generated $280 million in adjusted EBITDA, a 16.4% margin, down from $288 million last year even as margins expanded by 120bp, given the revenue decline. Gross margins rose by 170bp to 21.1%.
The primary challenge for packaging manufacturers has been excess inventory-not only that they hold but also that their customers hold. This inventory has needed to be worked down before orders fully recover. Managed said that customer inventories are "more favorable." This is primarily true in paper packaging while there remains more weakness in metals, where product has a limitless shelf life, in practice. Ultimately, customers over-ordered in 2020 until early 2022, and are now working off that inventory. Because of its longer shelf life, this dynamic is especially true in metals.
The reason for this is straight-forward. As a retailer, the cost of packaging is relatively small, and no management team wants to be unable to fulfill orders because they lack packaging. As you can see below, real goods consumption surged shortly after COVID, rising well above trend (the red-line). With consumers unable to travel and with government stimulus funds, they bought goods en masse. No one knew how long this would go on, and companies ordered enough packaging materials to enable them to deliver if growth continued.
As you can see though, consumption from 2021 until today has essentially not budged. This chart only shows US consumption, but North America accounts for about 80% of revenue, making it most relevant to Sonoco's financials. Higher inflation and fading stimulus sapped consumers' buying powers causing them to pause. Travel came back, and consumers shifted spending there. Moreover, goods consumption simply likely got too far above trend to sustainably grow. As increased orders did not materialize, companies were left with plenty of extra cardboard boxes, which they have been gradually working down, reducing their need to buy new product from SON.
However, spending levels are now back within 1% of trend. Additionally, it is plausible that there has been a slight mix shift towards more good consumption post-COVID, allowing us to stay slightly above the previous trend. With consumers no longer meaningfully over-spending on goods vs capacity, we should see increased spending next year, which will increase demand for packaging. Combined with lower customer inventories, that should support higher orders and revenue for Sonoco.
Alongside this, one of the bullish long-term arguments for the packaging producers is that higher e-commerce penetration should support increased demand for cardboard. Similar to total goods consumption, e-commerce usage spiked in 2020, but then it ticked back down as regular stores reopened. Not only were consumers spending less, but they were buying fewer things online, a negative mix shift for companies like Sonoco. In recent months, we have seen e-commerce penetration begin to rise again. This is a favorable development for 2024.
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These macro factors are consistent with management's commentary that volumes have improved sequentially as customer inventories are more favorable. However, actions speak louder than words. This is why I was encouraged when on December 18 , Sonoco announced it would be raising containerboard prices by at least 6% beginning on February. Raising prices is the surest sign that demand is rising relative to supply, which should help Sonoco improve margins next year.
Importantly, customers are not the only ones who cut inventories this year. It has been painful to earnings, but Sonoco's own inventories are down 25% this year to $826 million. By reducing inventories, it has less pressure to quickly move product, helping to tighten the market and retain pricing power. This rightsizing leaves the company leaner and poised to benefit from a cyclical upswing.
Now, lower inventory is flattering free cash flow. It has generated $434 million in free cash flow so far this year, and working capital has been a $67 million tailwind. For the full year, Sonoco will enjoy $148 million of working capital benefits. If we exclude this, Sonoco's run-rate free cash flow is $450-$540 million this year. I would also note management does not expect further inventory reduction next year.
With that cash flow, management is " focused on increasing the dividend." SON pays a $0.51 dividend, giving shares a 3.6% yield. This dividend costs about $200 million, meaning it is amply covered by free cash flow. Sonoco also has a solid balance sheet with just $3.3 billion in debt with no maturities until 2025. This enables the company to focus its capital policy on shareholders rather than debt reduction. 75% of debt is fixed rate, so if the Federal Reserve cuts rates next year, interest expense could fall modestly.
Sonoco shares have been a poor performer this year as inventory destocking has been worse than management expected, denting their credibility. However, its own inventories are light, and with price increases being pushed, it does appear this destocking cycle is largely complete. Shares have a 9% free cash flow yield (excluding working capital), which I view as attractive for a business seeing a cyclical turn with a solid balance sheet, and secure dividend.
Assuming a 5% price increase and 3% volume growth, SON could generate $625 million in run-rate free cash flow next year. As noted above, I am hesitant to ascribe much multiple expansion until the company delivers on results, given botched guidance this year. But even holding the 9% free cash flow yield constant, share can rise by a 30% to $72. At its current price, there is so much negativity priced into SON that with an improving inventory backdrop, shares are a compelling buy with meaningful upside.
For further details see:
Sonoco Products Should Benefit From Lower Inventories In 2024