AEP Industries (AEPI) manufactures and sells plastic packaging films in North America and Europe and has a market cap of about $205 million and $218 million of net debt on its latest balance sheet (1/31/08) for an enterprise value of about $423 million. AEP is trading at 50% of LTM revenues, 4.9x LTM adjusted EBITDA of $86 million, 6x LTM free cash flow of $5 per share,  and 7x LTM adjusted EPS of over $4 per share.  (We calculate our adjusted numbers by adding back the non cash LIFO changes as discussed below).  AEP’s shares are near a 52-week low at $30 versus a high of $56.  AEP’s LTM ROIC is solid at 25%+.  We think AEP is a strong business trading at a very cheap price.  AEP just reported results for Q1 ended 1/31/08 which were relatively solid despite current economic headwinds and this reinforces our belief that AEP’s competitive position and food-related customer base will allow it to continue to perform well in recessionary conditions.

Furthermore, AEP has had a major share repurchase program, indicating management’s confidence level in the business.   Over the past 18 months AEP has bought back about 22% of shares outstanding (1.98 million shares) at an average price of about $43 per share (most of them from Third Point).  The result of this buyback has been to reduce the share count to 6.85 million and provide very significant upside in potential share price appreciation once the market recognizes AEP’s true value.  It is not difficult for us to see a share price here well into the $50’s within the next 12 months, as compared to $30 today.

AEP’s packaging films include a range of polyethylene, polyvinyl chloride, and polypropylene flexible packaging products, with consumer, industrial, and agricultural applications.  AEP’s plastic packaging films are used in the packaging, transportation, beverage, food, automotive, pharmaceutical, chemical, electronics, construction, agriculture and textile industries.  The company manufactures plastic films, primarily from resins blended with other raw materials, which is sold or further processed by metalizing, printing, laminating, slitting, or converting.  AEP’s processing technologies allow it to create value-added products designed to customer specifications.  AEP has a network of eight plants located in North America and one plant in Europe.  AEP manufactures both industrial grade products to general industry specifications and specialty products, which are manufactured under more exacting standards.  Specialty products sell at higher margins than industrial grade products.  AEP has a leading market share in each of its segments and seeks to be the low cost provides and provide reliable service to customers.  AEP’s flexible packaging and film products are thin, ductile bags, sacks, labels, and films used for food and non-food consumer, agricultural, and industrial items.  Importantly, the relatively recession resistant food industry represents the largest part of AEP’s customer base. 

You can look at the company’s various product lines at AEP’s website, which is www.aepinc.com. 

For FY2007, total sales of $786 million were divided into custom films ($365 million), stretch (pallet) wrap ($246 million), polyvinyl chloride wrap ($128 million), printed and converted films ($22 million), and other specialty ($26 million).  Most of the custom films, which include up to 20,000 separate products, are designed to meet specific customer needs.  Small manufacturers represent about two-thirds of industry custom sales.  Stretch wrap is used for wrapping palletized products for shipping and this segment continues to experience overcapacity.  Polyvinyl chloride wrap is used for food wrap in the supermarket, consumer, institutional, and industrial markets.  The printed and converted films segment provides roll-stock to the food and beverage industries while the other specialty film segment provides film for use in battery labels and credit card laminates.

The European flexible division in the Netherlands manufactures custom film and converted film used in the food processing and pharmaceutical industries and also makes stretch film for wrapping pallet loads.  The company is currently in the process of trying to sell its Netherlands operation.  Over the past few years AEP has sold off almost all of its foreign operations to focus on its core North American manufacturing operations.

We think one key to understanding AEP is to recognize and adjust for two factors:  1) its primary raw material input (about 73% of COGS) is resin and 2) it primarily uses LIFO accounting.  Resin pricing is very much tied to oil prices and a weaker U.S. dollar and thus resin prices have been steadily rising since early 2007.  Under LIFO accounting the result has been to understate GAAP earnings relative to cash earnings for EBITDA, EBIT, and EPS.  (Management saves significant cash taxes in using LIFO).  Management instead focuses on Adjusted EBTIDA as its most important measurement of financial performance.  We have also focused on Adjusted EBIT and Adjusted EPS numbers as well.  We believe based on these adjusted numbers, which give a more accurate indication of cash earnings, AEP is significantly undervalued at today’s prices.   Because the price trends of resin can distort financial results, as discussed above, AEP management tends to manage and evaluate its business on a per pound basis, including adjusted gross profit per pound, operating expenses per pound, and net profit per pound.   Management has been able to keep operating expenses per pound relatively stable in recent years and we expect this to continue.  With stable operating expenses, the keys to AEP’s performance are the total number of pounds shipped and the adjusted gross profit achieved per pound.  (The gross profit is adjusted for any LIFO changes).

AEP management is very focused on profitably growing its market share which it measures in pounds.  During FY07 AEP sold 766 million pounds of plastic film product which was a 5.2% increase as compared to FY2006.  During Q1 FY2008 the company sold 182 million pounds, which was an increase of 4% compared to prior year, while management estimates that industry sales in pounds were about flat.  Thus, AEP management believes it is continuing to take market share from weaker competitors. 

The key to AEP’s business model is the ability to quickly pass resin price changes onto its customers since, when resin prices are increasing, any delay negatively impacts the company’s adjusted gross margin.  It is important to note that AEP’s management is strongly focused on passing on resin price increases to its customer base and does not want to grow its total pounds sold by adding additional unprofitable business.   Since the beginning of 2007 there have been six resin price increases and AEP management has been fairly prompt about passing these increases on to its customers.  However, there have been some instances (e.g., in Q4 of FY2002) where industry and competitive conditions made it impossible for AEP to pass on price increases and this impacted the company’s gross margin for a while.  Because most of AEP’s key competitors are significantly leveraged, and some are in financial difficulties, we do not believe they are likely to delay increasing prices to their customers and thus impact industry profitability and cash flows.  However, this risk does have to be considered in evaluating this investment.

 

 

AEP management runs its business based on total pounds sold which gives the best indication of whether the company is growing and taking market share.  The trend in total pounds sold for AEP shows how management has grown the business over the last 7 years:

2000                       668 million pounds          +0.3%

2001                       639 million pounds          -4.3%

2002                       686 million pounds          +7.4%

2003                       694 million pounds          +1.1%

2004                       730 million pounds          +5.2%

2005                       756 million pounds          +3.6%

2006                       728 million pounds          -3.7%

2007                       766 million pounds          + 5.2%

 

We believe these financial results on a per pound basis show that: 1) management controls operating expenses fairly well (usually about 13 cent per pound); 2) adjusted gross profit per pound has generally averaged 20 to 22 cents per pound and was 21 cents per pound even in a difficult climate for FY2008 Q1; and 3) AEP has, over time, steadily increased the size and value of the business (and its market share) by growing pounds sold per year from 686 million in FY2002 to 786 million in FY2007.  We believe that over time AEP can continue to grow its annual pounds per year and maintain or improve its adjusted profit margin per pound, consistent with the results of the last several years.

AEP’s attractive business model allows the company to earn good returns on invested capital and generate significant free cash flow.  AEP’s ROIC (EBIT to the sum of working capital, excluding excess cash, plus net PPE) was over 25%. 

The result of AEP’s strong business model has been significant generation of free cash flow.  We look at AEP’s free cash flow as net income (adjusted for non cash LIFO changes) plus depreciation and amortization less capital expenditures.  We do not include working capital because this can fluctuate for various reasons.  In fact, we believe AEP has some significant excess working capital assets on its 1/31/08 balance sheet.  Three examples are as follows:  1) during FY2008 Q1 AEP significantly increased resin inventories by almost $25 million as its purchased ahead of likely near-term price increases; 2) AEP’s level of accounts payable is less that industry because mgmt takes advantage of discounts for paying within 10 days; and 3) due to the current LIFO layer, the market value of AEP’s inventories is $26 million higher than book value.  Based on our definition above, FCF for FY2007 was $34 million or about $5 per share. (This does not include a tax loss asset which will allow AEP to pay limited cash taxes thru FY2008).  We think AEP can sustainably generate $35 million to $40 million of annual free cash flow at current levels of operation, or $5 per share or more.  We think this potential level of annual free cash flow, which represents a 20%+ FCF yield on the current market cap and a 10% FCF yield on the enterprise value, as compared to a ten-year treasury rate below 4%, compensates us for the risks involved here.  We note that AEP is modestly leveraged compared to other packaging companies and especially some of its direct competitors.

AEP financial results in its recently released FY2008 Q1 were solid:  the company grew total pounds by 5% in a flat industry market and Adjusted EBITDA was about $19 million versus $20 million prior year.

AEP is the second largest manufacturer of plastic film in the U.S.  The company doesn’t really compete against the larger packaging players such as Bemis but primarily against smaller, less well-capitalized player such as Atlantic Plastics, Pliant, Intertape, and Covalance.  These players generally have weaker balance sheets than AEP and management uses its stronger balance sheet position as a selling point in winning new business and protecting market share.  There are significant transportation costs involved with plastic film so it becomes fairly critical for plastic film customers to be supplied by a plant within 500 miles of their operations.  Customers generally have a handful of plastic film suppliers and, according to AEP management, they can have concerns about the financial strength and stability of those companies which are supplying them.  Furthermore, some of AEP’s less well-capitalized competitors do not have the financial capacity to invest in the type of highly customized equipment required to meet some of these customer’s specific needs.   Along these lines, AEP has invested substantial capital expenditures over the past few years to selectively increase its production capacity in certain high-return product categories, particularly specialty films which have higher profit margins, and it does not appear that AEP is fully using this additional capacity as of yet.  We believe all of these factors have helped AEP increase its annual pounds shipped over the past few years.  We also believe these factors will help AEP report reasonably decent results even in a tough economic climate through the rest of 2008.

Recent financial information for AEP is presented below:

 

** Adjusted to add back non cash changes in LIFO reserve and, for adjusted P/E, deduct taxes.

*** FCF is net income (adjusted for LIFO changes) plus D&A minus capital expenditures.

 

 

 

 

** Adjusted for changes in LIFO reserve.  These changes are non cash items.

 

 

Disclaimer:  We own shares of AEPI.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

 

Strong niche competitive position through low cost position, customer relationships, plant positions, and stronger balance sheet than its direct competitors

Attractive valuation on relative and absolute basis; small share count and continued solid performance could eventually drive a much higher share price

Potential for additional share repurchases

Strong balance sheet for packaging industry and relative to its direct competitors

Attractive good ROIC business

Could be a potential acquisition for a larger strategic player or even a financial buyer if the LBO markets ever come back

Management owns a significant stake and has consistently taken actions to enhance shareholder value

 

 

 

Severe economic downturn could impact AEP’s results

Irrational competitor pricing actions could impact industry gross margins for some time

Relatively modest trading volume