Unpacking the value in Pact Group

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Lex Hall: Hi I'm Lex Hall and welcome to the Morningstar Series "Ask the Expert". Today I am joined by Grant Slade, Morningstar Equity Analyst. He's here to talk about a little-known stock to some it's called Pact Group and it's Morningstar's most undervalued stock.

G'day, Grant.

Grant Slade: Hi Lex.

Hall: Now Pact Group is trading at a 33 per cent discount to your fair value estimate. Yet to most people it's probably not a household name. Tell us what do, they do? What are they known for?

Slade: Certainly, so Pact is the largest player in regent plastics packaging and processing in the Australian market. And they produce for large FMCG customers packaging…

Hall: Consumer goods.

Slade: That’s right. Long life products on the shelf like sauces and other household sort of categories like laundry detergent, skin care ranges and such.

Hall: So, stuff that we are dealing with every day, really.

Slade: Stuff that you use every day, every single day.

Hall: Why do you think you've got it at 33 per cent discount what do you think the market is, why do you think the market is undervaluing the company.

Slade: Certainly, Pact had a difficult fiscal 2018. Margins were hit essentially by a couple of things. First of a surge in oil price saw their raw materials costs move higher, faster than they could pass that on to their customers. They have lost some contracts with some customers and that's seen their operating margin compress to round about 9 per cent last fiscal year in fiscal '18 from around 11 per cent the year prior. So that's the first issue is some soft earnings. The second issue is a stretched balance sheet. So, Pact has come to its leadership position within the industry really by rolling up a very fragmented industry. So, Pact has completed around 50 acquisitions since it’s inception in 2002. And it completed a further acquisition in early fiscal '19. But unfortunately, at the same time capital requirements within the business have heightened as well.

So, Pact needs to reinvest in working capital and has also got a network rationalization program which is key to restoring margins. But does require capital investment as well. So those things coming together have made an equity raise now imminent. We expect Pact to imminently raise around $130 million in fresh equity capital. So that’s a second factor that’s overhanging the share price currently. But we do see the stock as around 40 per cent undervalued. So, it certainly does trade with margin of safety and we see significant upside here as that margin recovery comes through over the coming five years.

Hall: And I suppose another factor that spooked the market is leadership. Pact has gone through a bit of turbulence lately. Their CEO quit quite suddenly last year I believe. But now they’ve got a new CEO a guy who you like in particular a guy called Sanjay Dayal. Tell us why you like him?

Slade: So, look we are optimistic about his appointment as CEO of Pact. He's an engineer by background and we think that will really – his focus on like the technical aspects of manufacturing plastics will be helpful as they lead a turnaround which we'll focus on getting cost out of the manufacturing network, so that’s number one. Number two is that he has experience in turning around businesses, so he led a turnaround of Orica's Asia Pac business. The third factor is more recently he was CEO of BlueScope Steel's offshore steel building products business in Asia and in North America and was also Head of Strategy for the group.

Hall: And finally you think that we’ve spoken about some of the everyday things that business like Pact makes which some might think that makes it sort of "bullet proof" but nevertheless there are a few risks on the horizon what do you think they are.

Slade: Certainly. So, to your point I guess from a systematic or economic cycle basis the risks are benign. So, the top line is tied to household consumption which you know is not terribly volatile through the economic cycle. And then from a cost side of the business there is low operating leverage and there is high degree of variable cost in their cost structure. On loss of market share, certainly that's something that we have seen playout to an extent the Pact over the last 18 months and margins have deteriorated as they've lost some volumes from customers. We see it as fairly well managed however given Pact's position I guess on the industry's cost curve. So, because of their superior scale we see them as having a sustainable competitive advantage and then I guess touching on the sustainability issues of plastics. So, plastics obviously by no means a new technology but it is a remarkable material that has transformed the way that we consume household items. We see again those risks as fairly well managed and the reason for that is that it really comes back to the functional and cost properties that plastics have and that advantage that they have over alternatives. So, plastics are not going away anytime soon but solutions to the problems that they are causing in those externalities is what's going to now come forward.

Hall: OK, Grant thanks for your insights.

Slade: Thanks Lex.

Hall: Lex Hall from Morningstar. Thanks for watching.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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