Interactive Investor

Confident DS Smith is boxing clever

3rd December 2015 12:55

Harriet Mann from interactive investor

Packaging group DS Smith has recovered from last year's de-rating and is building decent momentum despite stiff headwinds. Consolidation is an ongoing theme in the industry, and acquisitions have played a major role in the 75% rally since September 2015. A 425p resistance levels seems to be made of stronger stuff, however, as the papermaker shies away from the level for the second time in five months.

Churning out 6 billion corrugated boxes, 2.2 million tonnes of corrugated paper and 5.4 million tonnes of recycled fibre each year, Smith is one of the largest packaging firms in Europe.

Ahead of target, corrugated box volumes rose 3.1% in the first half, pushing group revenue up 6% at constant currency to £1.95 billion. As nearly two-thirds of profit is made in euros, turning this back into sterling - plus a £48 million write-down and restructuring charge - caused pre-tax profit to slump 20% to £91 million.

However, adjusted operating profit did rise 12% to £184 million. And the group is getting better at turning revenue into profit, with return on sales jumping by 50 basis points to 9.4%. In line with its other key targets, Smith's return on capital employed rose by 110 basis points to 15% and its ratio of net debt to earnings before interest, tax, depreciation and amortisation (EBITDA) reached 1.9 times.

Spending more on capital investments lowered reported free cash flow by 5% to £143 million, although this was partially offset by a 39% higher working capital inflow. With its adjusted earnings per share (EPS) up 13% to 13.5p, management has increased the interim dividend by 8% to 4p.

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"These financial results are a consequence of our focus on building a high quality, pan-European business that demonstrates the benefits of packaging solutions that improve our customers' sales and reduce their supply chain costs wherever they are in Europe," said the company Thursday.

M&A pipeline is key

Smith sold its StePac business for $31 million (£20 million) in May, and has spent £500 million on strengthening its position in Southeast Europe and Iberia, buying Duropack, Lantero and Cartonpack. It's also splurged on Turkish corrugated packaging and displays producer Milas Ambalaj since the period end.

It's this M&A pipeline which is key, says Jefferies equity analyst Justin Jordan.

"In three years to 2015, DS Smith's operating profit increased by 33% compound annual growth rate (CAGR), from £142 million in 2012 to £335 million in 2015. £194 million of this operating profit growth was derived from accretive M&A and synergies.

"With c.14% European corrugated market share in a highly fragmented EU market, further successful M&A remains crucial to future SMDS profit growth, in our view."

After losing over a third of its value in 2014's de-rating, an upbeat first half and promising M&A pipeline helped Smith break sharply out of its downward channel a year ago (see chart). The shares had hardly paused for breath since.

But Smith has fallen 2% to 407p in response to these interims, tracking away from its 425p resistance, after testing it for the second time since August. It puts them on a forward price/earnings (PE) multiple of 15 times, which doesn't look too demanding, and JP Morgan thinks the shares are worth 460p.

Although the group faces its fair set of hurdles - namely the economic backdrop and foreign exchange headwinds - chief executive Miles Roberts is confident:

"Our outlook remains positive as the business continues to grow, despite the ongoing challenging economic environment in some markets. The progress we have made over the period, combined with the opportunities available for further growth, gives the board confidence in the prospects for the business, in line with the group's medium-term financial targets."

Confident that higher operating margins will offset these foreign exchange headwinds, JP Morgan has maintained its £376 million operating profit and 26.6p EPS guidance for the full-year.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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