Smurfit Kappa should go for share buyback if market continues to box it in

It may be a jarring statistic for Irish nouveau riche sensibilities, but 44 per cent of all wine sold these days in supermarkets in France is in a bag contained in a box, according to the country’s own agriculture ministry.

It’s something for Smurfit Kappa shareholders to raise a glass to, as the cardboard box maker has built up a nice bag-in-box business over the past three decades with the help of a series of acquisitions.

Bag-in-box has also become the hottest areas of deal-making in the packaging industry in recent times, with the product used for everything from water to olive oil and liquid eggs for the catering industry. Crucially, according to Smurfit Kappa, it uses on average 75 per cent less plastic than rigid plastic packaging. The group says it is the biggest player in this field in Europe and number two globally.

Group chief executive Tony Smurfit was coy when asked by analysts on Wednesday, after the group reported full-year results, on the current size of the bag-in-box operation. But revenues are easily well into the hundreds of millions, according to analysts.

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He even hinted that the business may at some stage be sold to capture the high “multiples” of earnings that these types of businesses are currently changing hands for. “But that’s not for now,” he said. For now, Smurfit Kappa has ambitious further growth plans for the unit.

Goodbody Stockbrokers analyst David O’Brien’s not swayed by the comments. “Bag-in-box is one of the jewels in the crown and has been a great performer delivering consistently strong growth,” he said. “We expect it will remain a core part of the business.”

Tony, grandson to Jefferson, who started the enterprise by acquiring a small box-maker in Rathmines in south Dublin in 1938, rode on the crest of a wave as the already secular growth areas of ecommerce and sustainable packaging were turbocharged during the pandemic.

Smurfit Kappa’s shares soared 40 per cent from before Covid-19 struck to €48.36 each by the end of 2021, silencing shareholders who thought the chief executive should have sold the business in 2018 when US rival International Paper (IP) turned up as an unwanted suitor. IP’s cash-and-stock offer was worth about €38 before it got the message and walked away.

Shares in Smurfit Kappa subsequently sold off last year to fall to as low as €27.55 in early October, as investors fretted about inflation (the company’s energy bill rose by almost €600 million last year) and higher interest rates — and companies that make everything from breakfast cereals to TVs eased off on orders for packaging as they braced for consumers to pull back amid the cost-of-living crisis.

Smurfit Kappa saw the box sales volumes slump 6 per cent in the fourth quarter, with Germany, the Benelux countries and the UK standing out as particularly weak areas. This triggered further skittishness among investors, following a 40 per cent stock rally from its lows over the past four months.

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Still, for an industry in Europe that has notoriously been unable to stop pumping out cardboard that nobody wants at the wrong point of the cycle, it showed remarkable discipline last year. European mills took enough downtime in the second half of last year to avoid producing two million tonnes of containerboard. Smurfit Kappa accounted for 260,000 tonnes of this.

Prices of old corrugated containers that are recycled to make new boxes have tumbled in the past six months. Ordinarily, that would result in a drop in box prices, albeit with a lag — especially with the likes of Bank of America analyst Joffrey Bellicha Meller forecasting a further 5 per cent drop in box volumes in the first half of this year.

However, Smurfit Kappa managed to continue to increase box prices in 2022, including a 1 per cent hike at the end of the year — helping to lift its earnings before interest, tax, depreciation and amortisation (Ebitda) margin to 18.4 per cent from 16.8 per cent. And Bellicha Meller sees the company increasing box prices by a further 2 per cent by the end of June.

Smurfit Kappa has managed to extend the lag between falling paper and containerboard prices resulting in declining box prices. This is partly due to the company being more tied in these days with big customers these in terms of designing packaging that works best for them. It’s also down to the company’s vertically integrated model allowing it to meet customers’ demands when supply chains globally were thrown into disarray during the pandemic.

“SKG will be a relative winner in the fragmented EU containerboard and box market, with its scale, customer and end market mix advantages,” said Jefferies analyst Cole Hathorn in a note to clients on Thursday.

“Every 1 per cent box European price is worth €65 million-€70 million — or 3-4 per cent — to group Ebitda, thus if box prices prove more resilient despite lower containerboard (paper) prices, then so will Smurfit Kappa’s through the cycle earnings,” he said, adding that this should justify a “quality re-rating” of the stock.

Goodbody’s O’Brien agrees. “Given the successful capital deployment track record of management, which has seen returns [on capital employed] hit a record 22 per cent, in our view this is a stock that should trade much closer to 10 times enterprise value-to-Ebitda.” It is currently trading at less than seven times.

For now, the market is cautious. Shares in the company have fallen back by almost 8 per cent this week, even though it said it started the year off well, with volumes having picked up in most markets. While Germany — which makes up 14 per cent of sales — has yet to recover, the chief executive said he is confident that consumer sentiment is improving in that country. Easing energy prices should also help.

The group flagged in an investor presentation on Wednesday the possibility of a share buyback programme for the first time since it floated on the market in 2007. (A €40 million stock buyback launched in December doesn’t count, as it was merely to offset the issuing of stock under a management incentive plan.)

With its debt burden at a record low of 1.3 times Ebitda — less than half what it was a decade ago — Tony’s got plenty of scope if the market continues to treat the stock like middle-shelf plonk.