Description

Company Description:

AEP Industries (AEPI US) is a leading manufacturer of plastic packaging films operated in the US. The company manufactures and markets an extensive and diverse line of polyethylene, polyvinyl chloride and polypropylene flexible packaging products, with consumer, industrial and agricultural applications. Their plastic packaging films are used in the packaging, transportation, beverage, food, automotive, pharmaceutical, chemical, electronics, construction, agriculture and textile industries. AEPI manufactures plastic films, principally from resins blended with other raw materials, which they either sell or further process by metalizing, printing, laminating, slitting or converting. While AEPI is exposed to both industry segments that have been significantly impacted by the economy (such as the home apparel and appliances industry), AEPI is also exposed to economically resilient sectors such as food packaging.

Long Thesis:

1.       Restructuring / consolidation to result in an improvement in industry competitive dynamics

a.       The plastic packaging films industry has been significantly impacted by the economic recession, and a number of operators have been driven into bankruptcy.

b.       With industry restructuring, there has been a number of consolidation M&A deals: specifically, Pliant Corporation is being taken out of Chapter 11 by Berry Plastic's Covalence subsidiary, and AEPI has taken Atlantis Plastics out of Chapter 11 in Oct-08.

c.       Sigma Plastics, the third largest operator in the industry has also contributed to the consolidation by buying majority stakes in two companies this year (FlexSol Packaging Corp, and ISO Poly Films). Sigma also purchased the assets of Santa Fe Extruders from its creditors.

d.       Specifically, in stretch film, with these consolidation moves, three companies now have around 70% of industry capacity (from 5 previously). This should help moderate pricing competition in the business. Berry Plastics / Pliant now has 26% market share, AEPI has 25%, and Sigma Plastics has 16%. 

2.       Acquisition of Atlantis Plastics a game changer for AEPI

a.       AEPI acquired Atlantis Plastics out of Chapter 11 in October 2008, at the height of the financial crisis. Prior to the acquisition of Atlantis, AEPI had annual production capacity of 750m lbs. Post the acquisition of Atlantis (300m lbs), AEPI now has more than 1bn lbs of capacity.

b.       Similar to the rest of the industry, Atlantis faced very difficult demand conditions due to the economy. At the same time, resin prices were increasing through 2008 (resin costs are derivatives of natural gas and oil) despite the weakening economy. These two factors combined to tip Atlantis into Chapter 11 given its debt load from a leveraged recap a few years ago.

c.       While the headline price for the acquisition was $99m, this included $10m of cash and $43m of positive working capital. Net of these adjustments, AEPI paid $46m for a company that previously achieved between $20m and $22m of EBITDA, pre-synergies, or under 2x EBITDA. AEPI also recorded negative goodwill for the transaction given the purchase price.

d.       AEPI has guided to $20m of synergies from the acquisition, mostly on plant rationalizations. Including synergies, AEPI paid slightly in excess of 1.0x normalized EBITDA of between $40m and $42m for Atlantis.

e.       Including Atlantis, the cost synergies and core AEPI earnings, the combined entity should have normalized EBITDA power of at least $125m per year when the economy recovers (which compares to $85m for pre-acquisition AEPI).

f.        Given the strong cash flow generation of the combined entity, AEPI has paid off the debt associated with the acquisition of Atlantis by Jul-09, reducing net debt from $250m at Oct-08 to $176m at Jul-09 (which compares with $173m at Jul-08). Essentially, AEPI has increased its core earnings power by 50% from the Atlantis acquisition while keeping its balance sheet unchanged.   

3.       Management team is shareholder friendly and good at allocating capital

a.       Management has shown itself to be very shareholder friendly. From Oct-06 to Oct-09, AEPI bought back 21% of its shares outstanding from its organic cash flow generation. It is expected that AEPI will restart its share buyback program sometime in the future. Earlier in the year, AEPI also bought back $14m of bonds at $9m, or $0.62 or so.

b.       AEPI management has shown itself to be good at allocating capital with the acquisition of Atlantis. One reason why AEPI was able to purchase Atlantis for the price it did was because the acquisition was announced at the height of the financial crisis.

c.       It is likely that AEPI management will also continue to acquire extremely cheap assets going forward that will be significantly cash flow accretive.

d.       Management owns in excess of 23% of the company. Given that CEO is currently 69 years old, it is logical that he might look to sell the company at some point in time in the future.

4.       Valuation is very supportive

a.       AEPI is currently trading at 5.6x Oct-09E EBITDA, and 3.5x FY Oct-10E EBITDA; or 7.8x Oct-09E Free Cash Flow (FCF), and 4.5x FY Oct-10E FCF.

b.       This is despite the fact that AEPI's EBITDA is toughing in FY09, and should improve from here. Obviously, the scale of the improvement is dependent on the speed of the economic recovery.

c.       However, it is worth noting that for the quarter ending Jul-09, AEPI reported EBITDA of $23m (or annualized EBITDA of $92m) despites volumes being 20% below plan due to the recession.

d.       While the company could continue to delever, if the company decides to use half of its FCF generation for the next fiscal year for share buybacks (and half for de-levering), the company could boost its FCF per share by 10%.

Risks to Long Thesis:

1.       The economy continues to weaken - If the economy continues to weaken from here, it is likely that AEPI volumes could be weaker than is currently modeled.

2.       Volatility in input costs could hurt margins - Volatility in the price of resins could impact AEPI negatively. Violent movements up down in a short period of time makes it very difficult for the industry to pass on pricing increase / decreases.

Target Price:

On 6x EBITDA and 9x FCF, AEPI should be worth between $74 and $82 on a one-year view. Using those same multiples applied to FY11E, AEPI should be worth between $92 and $99. This compares with the current share price of $37.23, which suggests upside of between 100% and 120% on a one-year view and 150% and 160% on a two-year view.

To the extent that AEPI restarts its buyback program, there could be additional upside to these target prices.

Catalyst