Summary
- Sales have done well on a dollar basis over the past year, and net income is up sharply from both 2021 and the pre-pandemic era.
- The problem is the capital structure. Debt is up significantly, with the result that interest payments are also up sharply. Sooner or later dividend increases will fade.
- The dividend yield is significantly lower than the risk-free rate. That makes no sense to me, given the many and varied risks present.
It's been a little over nine months since I announced to the world that I'm continuing to avoid Sonoco Products Company ( SON ) in an article with the highly original title "Continuing to Avoid Sonoco Products." In that time, the shares are up about 4% against a loss of 0.3% for the S&P 500. The company has just released financials, so I thought I'd review the name yet again to see if now is a good time to buy. I'll review those financials, and will look at the valuation to see if it makes sense to buy at the moment. I also like reviewing Sonoco because I think they, along with the railroad traffic stats among a few other variables, give us some interesting real-time insights into the health of the overall economy.
Welcome to the "thesis statement" portion of the article, where I give you the highlights of my thinking immediately, so you can get out before being exposed to too much Doyle mojo. Offering this is just one of the many ways that I try to make your reading experience as pleasant as possible. You're welcome. I think the financial results have been generally good, with revenue and net income up nicely over the past few years. If you're worried that the results to 2021 look too easy because of the pension adjustment that year, fret no further. Net income is much higher now than in the pre-pandemic era. The problem relates to the capital structure. Indebtedness has basically doubled over the year, and that translates to higher levels of risk. The stock is reasonably cheap, but it's not cheap enough in my view. This is because the dividend yield is lower than the risk-free rate by about 60 basis points. There are risks inherent in this business, ranging from acquisition risk, risks associated with the fact that industrial sales are down about 15% by volume, risks that higher interest payments will eventually crowd out dividend increases, etc. Given that, I see no reason to deploy capital and earn a lower return than I'd get on a risk-free investment. For that reason, I'm going to continue to avoid the shares. We're not seeking "returns." We're seeking "risk adjusted" returns, and the risk adjusted return potential here isn't favourable in my view.
Financial Snapshot
I'd characterise the financial results here as a "mixed bag." I really like what I saw on the income statement, and I am not really impressed by what I've seen on the balance sheet. In my view, added indebtedness means added risk, and interest payments crowd out dividends. I've no problem buying companies with increased debt levels, but I'd need to be compensated for taking on that risk by buying at a very reasonable valuation.
Specifically, net income spiked higher in 2022 because 2021 was a relatively easy comparison year. For instance, in 2021, the company took a $568.4 million non-operating pension cost expense. The income tax benefit of $67.4 million in 2021 wasn't enough to generate a profit that year. Given that, I want to compare the most recent period to the pre-pandemic era too, and on that basis, the income statement looks great. Specifically, compared to 2019, revenue and net income are up by 35% and 60% respectively. So, I think the company has done a great job growing revenue and earnings, and I think it's reasonable that shareholders have rewarded that.
As I suggested above, any positive feelings I have for the financials here quickly evaporate when I look at the capital structure. In my previous article, I complained about the deterioration of the capital structure as a result of the Ball Metalpack acquisition, and things have not improved. Over 2022, debt has basically doubled from (an already troublesome) $1.6 billion to $3.222 billion. This is perhaps one of the reasons why interest expenses have also risen dramatically in 2022, up 64% from $59.2 million to $97 million. This interest expense represents about 52% of the cash spent on dividends in 2022. Given this, I don't expect the dividend growth we've seen over the past several years will continue.
All that written, the payout ratio remains reasonably low at 41, so I'd be happy to buy this stock at the right price.
Finally, I'm compelled to write that the fact that industrial sales weakened by 8.9% on a dollar basis, and 15% on a volume basis, and the fact that the company sees weakness in the protective packaging for appliances and household goods business sends an unwelcome message about the health of the global economy in my view.
Sonoco Products Financials (Sonoco Products investor relations)
The Stock
If you read my stuff regularly, you know what time it is. It's the time when I turn into a bit of a financial "hall monitor," where I remind everyone that a company is distinct from its stock. The company sells packaging of various types at a profit. The stock, on the other hand, is a piece of paper that gets traded around in a public market and is influenced by a great many factors, many of which are only peripherally related to the underlying business. The stock price is definitely impacted by the crowd's ever-changing views about the company's future financial performance, the success of the RTS Packaging acquisition, and a host of other factors, for instance. Someone like me may fret, for instance, about the possibility of a slowing dividend because of higher interest payments. The stock price also is potentially impacted by the crowd's ever-changing perspectives on the relative merits of "stocks" as an asset class. When the market sours on stocks, people throw out financial babies with the indices bathwater. While this is tiresome, it's potentially profitable. If we can spot the discrepancies between the crowd's take on a given business, and the assumptions embedded in the price, we can earn a profit.
Finally, I should point out that I've found that cheaper stocks offer a higher risk-adjusted return, so I like to buy shares when I consider them to be cheap and eschew them when they get expensive. I consider something cheap if it's less expensive than the overall market and its own history. If you're one of my regular readers, you know that I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. In my previous missive on Sonoco, I characterized their valuation reasonably good, given the lower-than-average price to sales ratio, and higher dividend yield. My problem back in May of last year is that the shares didn't offer much prospect of a decent risk-adjusted return, because the 10-year Treasury Note was yielding about 3% at the time. Fast-forward nine months, and the yield on the 10-year Treasury is about 3.9% . In a world of limited capital, and a limited tolerance for risk, I think 3.9% is a "hurdle rate" for stocks. In my view, all stocks need to offer something much better than the risk-free 3.9% they'd get from Uncle Sam. There are risks with all stocks in a way that there isn't with the U.S. government, and thus, buying stocks must offer a return potential greater than 3.9% at the moment.
I'm very gratified that the shares are much cheaper on a price to sales basis than they were this time last year, but the dividend yield is currently about 57 basis points lower than it is on the risk-free rate. In the relativistic world of investing, that is troublesome, in my view.
My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to Sonoco stock at the moment suggests the market is assuming that this company will grow earnings at a rate of ~1% in perpetuity. I consider this to be a pretty pessimistic forecast.
While I'll admit that the shares are quite cheap, I can't get past the fact that the dividend yield is currently lower than the 10-year Treasury. I'm a pretty risk-averse person, so I don't see the point of taking on higher levels of risk to receive lower benefits. I think there's risk in packaging demand, I think there's risk in the capital structure, I think there's risk in acquisitions . I don't want to be paid less than the risk-free rate to take on these risks, and for that reason, I'm going to continue to eschew these shares.
For further details see:
Still Avoiding Sonoco Products