Berry Plastics Group BERY US
December 20, 2016 - 7:35am EST by
wjv
2016 2017
Price: 51.00 EPS 3.99 4.46
Shares Out. (in M): 122 P/E 12.8 11.4
Market Cap (in M): 6,222 P/FCF 11.8 10.9
Net Debt (in M): 5,300 EBIT 790 867
TEV: 11,522 TEV/EBIT 14.6 13.3

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  • M&A
 

Description

 
Apologies for the weird formatting and for charts moving to random places in the write-up. I can't use Google Docs in the office...
 
Recommendation
 
Company
Berry Plastics is a global leader in plastic packaging and engineered plastic materials
 
80% of earnings come from ‘consumer staples like’ products: food containers, beverage cups, frozen
vegetable bags, nappies, bin liners, etc
20% of earnings come from more cyclical products: duct tape, sealing, anti-corrosion pipeline films, etc.
 
80% of revenues are generated in North America. The company reports results along 3 segments:
 
Consumer Packaging, 38% of EBITDA
 
Health, Hygiene & Specialties, 33% of EBITDA
 
Engineered Materials, 29% of EBITDA
 
 
 
 
 
 
Recommendation
Berry offerslow but stable organic top line growth. Coupled with decent margins and returns this translates
into high and stable FCF generation. Berry excels at redeploying this cash, mostly in the form of buying
smaller competitors at a substantial discount to Berry’s valuation post synergies. The biggest driver of
synergies are raw materials savings, with Berry having a substantial scale advantage in resin buying and resin
representing 50% of COGS. Berry typically pays 4-6x EV / EBITDA or roughly half its own valuation.
 
With conservative assumptions I get to a 15% EBITDA and FCF CAGR over the coming years. My model is
roughly 10% ahead of consensus 3 years out. The big delta is analysts not properly modelling future cash flow
deployments. Most analysts do model some debt pay downs and even share buybacks because the cash
builds up rapidly and they have to do something with it. But none model future acquisitions, which are more
accretive. My EPS is 66% ahead of consensus on the back of PPA amortisation adjustments.
 
Berry’s 12 month forward valuation multiples of 9x EV/EBITDA, 12.5x Adjusted P/E (adjusted for PPA
amortisation), 9% Equity FCF Yield and 6.5% EV FCF Yield look very reasonable for the steady compounding
profile of the company. Equally important, these multiples represent a 20% valuation gap with peers.
 
Berry delivers higher growth and generates higher margins and returns than peers. So the valuation gap is
driven by other things and a number of catalysts on that front might help narrow the discount over the coming
12 months
1) The net debt / EBITDA ratio will fall below 4x in FY17. This is an important hurdle for two reasons. It
will help investor sentiment as a leverage ratio starting with a 3 is deemed more acceptable by most
investors. And 4x is the upper limit of Berry’s long-term target range, which means investors can start
dreaming about alternative uses of FCF.
2) Organic top-line growth will turn positive in FY17 after years of negative growth. The change in
direction is driven by the end of management’s ‘portfolio pruning’ efforts (taking out less profitable
products and contracts) and the acquisition of Avintis, which adds substantial exposure to the higher
growth hygiene and health care markets.
3) Raw material prices are likely to provide a sizeable tailwind to margins. Headline price changes are
largely passed on to customers through automatic pass-throughs, but negotiated discounts to the
headline price are pocketed by Berry. And those discounts should increase in FY17 as Berrys’
purchasing power in polypropylene (half of resin, so 25% of COGS) expands by 85% on recent
acquisitions while polyethylene (the other half of resin) moves into oversupply on capacity additions.
Analysts are all expecting to see a benefit, but nobody has included anything in their model. And the
sensitivity is large with every $0.01 extra discount (on $0.70-1.00 prices) boosting EPS by 10%.
4) A few large brokers have recently initiated on the stock. This should help investors become more
familiar with a stock which has largely been below the radar since its 2012 IPO ($6bn mcap).
 
Assuming that half of the valuation gap with peers gets closed leads to target multiples of 10x EV/EBITDA,
15x P/E, 7.5% equity FCF yield and 6.7% EV FCF yield. Applying these to the model allows for 20% upside
on FY17 numbers ($60 TP), 40% on FY18 numbers ($70 TP) and 80% on FY19 numbers ($90 TP). And there
is plenty of cushion in my model.
 
 
Operations
 
What is the edge that we have over consensus?
 
Edge 1: Capital deployment continues to drive upward earnings revisions
 
Berry offers low but stable organic top line growth and sizeable margins, which translates in high FCF
generation. The company has excelled at redeploying that cash, mostly in the form of M&A. Berry has done
more than 40 acquisitions over the past 25 years and the runway for future deals remains large. Plastics is a
scattered industry, with Berry claiming to review 100 M&A options per year. They classify 40% of those as
‘serious options’ and execute on 1-2 deals per year on average.
 
Most acquisitions are done at a substantial discount to Berry’s own valuation. Management targets a 20% IRR
and typically pays 6-8 EBITDA pre-synergies and 4-6 post synergies. The biggest driver of synergies are raw
materials savings, with Berry having a substantial scale advantage in resin buying and resin representing 50%
of COGS.
 
 
 
 
Below are details on the last 2 acquisitions as they will impact FY17-18 results. Avintiv closed last year and is
currently being integrated. AEP is expected to close in February 2017.
 
Avintiv
Berry acquired Avintiv in Oct 2015. Avintiv specialises in nonwoven materials used in the hygiene and
healthcare markets. Product examples include absorbent components used in diapers and feminine
products, hospital gowns and masks, disinfectant wipes and air and water filters. 55% of Avintivs
revenues are generated outside North America (EMEA, Latam, Asia).
This is somewhat of a transformational deal because 1) the $2.25bn all-cash transaction represented half
of Berry’s market cap at the time, 2) it took Berry into health & hygiene, a new and higher growth product
category and 3) it provided geographical diversification as Berry was predominantly a North American
company.
Leaving aside the strategic importance this was a typical Berry acquisition in the sense that large
synergies significantly reduced the acquisition price. Also typical was Berry’s initial conservative guidance
on synergies and the frequent upward revisions.
The deal was valued at 8x EV/EBITDA pre synergies and the original synergy guidance was $50mn. That
target was revised over the past year to $65mn and $80mn with management saying there might be room
for further revisions. The historical synergy average of Berry is 5.7% of sales. Applying that to Avintis
suggests $120mn and a post synergy acquisition multiple of 5.8x EBITDA. I have modelled $100mn in
synergies by FY18.
 
AEP Industries
Berry announced the acquisition of AEP in Aug 2016 for $765mn in a 50% cash / 50% shares transaction.
AEP produces polyethylene-based flexible packaging, which will slot into the Engineered Materials
division of Berry. The deal has passed all regulatory hurdles and is scheduled to close in Feb 2017.
This is a typical Berry acquisition; a sizeable bolt-on with scope for large synergies on the back of Berry’s
purchasing power in raw materials. The initial guidance is for $50mn of synergies over 3 years or 4.5% of
revenues, but management has said to brokers that they believe they can achieve close to that amount in
year 1 alone because AEP was such a bad purchaser of raw materials. They didn’t even have a
purchasing department, the CEO negotiated the contracts himself.
Some brokers are dreaming of $100mn in synergies, but nobody is modelling anything close. I have
included $60mn in my model, or 5.4% of revenues. This would imply that the 7.4x pre-synergy EBITDA
multiple falls to 4.7x after synergies.
 
 
 
 
 
 
Edge 2: Higher raw material discounts could lead to meaningful margin expansion
 
50% of COGS are resin, roughly half polypropylene and half polyethylene. Polypropylene is mostly used in
consumer packaging and health; polyethylene is mostly used in engineered materials. 75% of resin costs are
contractually passed through with a lag of around 1 month. The other 25% is negotiated. For completeness
sake, 15% of COGS is other raw materials, 15% is labour and the remaining 20% includes freight, electricity
and overheads.
 
Automatic price pass-throughs and negotiations are based on headline resin prices. Any discount that can be
negotiated on those headline prices is pocketed by Berry. And Berry indeed is able to negotiate discounts as it
is the largest resin buyer in the world. The acquisition of AEP will increase its annual demand by 1bn pounds
to 4.5bn, more than double the volumes of the second largest buyer (Bemis) and triple the volumes of the third
largest buyer (Sealed Air). As discussed, the purchasing power in resins is a competitive advantage for Berry
and its largest source of acquisition synergies. Berry’s 18% EBITDA margin is 300bp higher than its large
competitors.
 
The negotiated discount of Berry’s resin price relative to the headline price is likely to go up next year, for two
reasons
The polyethylene market will turn into a buyers’ market as it moves into oversupply. Demand for
polyethylene typically grows at 2-5% per year and operating rates have risen from the mid 80s to the low
90s as the last capacity addition on the supply side dates back to 2010 (10%). That situation reverses
going forward with 10% extra capacity scheduled to come on-line in 2016 and an additional 15% in 2017.
A lot of that capacity is likely to be exported to China, which has a chronic shortage of polyethylene as
they have recently banned the recycling of plastics (chemical involved in the process were dumped in the
drinking water, so the government now burns plastic instead). However, even with rising exports, it should
be possible for Berry to negotiate a somewhat higher discount given the oversupply situation.
The polypropylene market should remain fairly balanced. But the AEP acquisition will expand Berry’s
polypropylene buying by 85%, which should give them a better negotiating position.
 
Berry offers the largest delta to the changing resin prices. It is the largest buyer, it has the biggest delta in
purchasing volumes next year, and resin is a larger part of COGS because Berry has more exposure to rigid
packaging and less to flexible packaging. The 50% of COGS of Berry compares to 35% at Bemis and 20% at
Sealed Air.
 
Analysts are all expecting an increase in the discount in FY17, yet nobody is including anything in their model
aside from the guided deal synergies. And the sensitivity is large with every $0.01 discount that Berry gets on
resin (polyethylene is priced at $1.00 and Polypropylene at $0.70) boosting EPS by 10%. I don’t really model
anything either as I already get to 80% upside without this. But it does give me confidence that there is plenty
of cushion in my model.