Pro Pac Packaging announced its quarterly results last week 

 Since my last post on this Company more than 2 years ago, the share price has performed poorly with a more than 90% decline in value. Like other Companies in this sector (Pact Group, Orora) the sector is suffering from negative investor sentiment. Pact Group was delisted earlier this year after a takeover bid by their largest shareholder- Kin Group, owned by Raphael Geminder. Pro Pac has not helped its cause either. The last few annual reports have blamed volatile resin prices, high shipping costs, disruptions in the labour market, Covid and poor consumer sentiment for the declining profit. Most tellingly, sentiment has been influenced by high debt levels incurred during a period of aggressive expansion under Chairman Ahmed Fahour in 2017/2018. With higher interest rates, management has had to take decisive action to shed debt. This has included capital raising through a share entitlement offer, closure of some manufacturing sites and divestment of what was initially a plastics distribution business. They have also consolidated debt using a syndicated debt facility. Borrowings have reduced from over $100M four years ago to $23M today. 

 The Company has had its share of misfortune too. The Middle East war has incurred lost revenue of $30M from a major customer- Israel. 

 Notwithstanding, I think there are a lot of positives which have been overlooked by the market. These include:

 1.   The Company continues to gain market share in a growing segment of the plastics market- flexible packaging. Flexible packaging supplies everything from bags, pouches, liners and wraps to rollstock. It has rapidly replaced glass, rigid plastic and cardboard because it is lighter, makes the items easy to pack and transport, preserves the freshness of the product and requires less raw material to produce. This lowers manufacturing cost and waste. It’s transparent, can be labelled and branded and can be engineered to suit the client’s requirements. Laser Perforation creates high precision holes in the packaging which allow the produce to breathe. In Agriculture and Horticulture, bales and fodder have UV properties that protects bales and fodder from extreme weather conditions and preserve a viable product. 

2.   The Company remains committed to its vision of becoming a leading flexible plastics manufacturer, distributor and recycler. Flexible plastic manufacturing in Australia is a fragmented industry. Pro Pac presently has about 15% of the flexible plastics manufacturing market in Australia, a market a with CAGR of 4%.

3.   The Company is leading soft plastics recycling in its industry. Integrated Recycling is an entity of Pro Pac and is building a plant in Albury to recycle 15,000 tonnes annually of stretch film, shrink products, bulk plastic like sileage and pallet wrap into polytensilate. This substrate will be used to recycle 50% of plastic content into the Company’s products. This is above the 30% component established by the 2025 National Packaging Targets and gives The Company the credentials to promote itself to clients as environmentally focussed and intent on participating in the circular plastics economy. The recycling plant was part subsidised by a $13.9M government grant.

4.   In addition, the Company presently down-cycles hard plastics into useful products like railway sleepers (Duratrack), plastic furniture, decking and boardwalks. 

 My feeling is that plastics, or some form of plastic-like packaging, will continue to be with us for the foreseeable future. Biodegrable plastic has received a lot of hype but has failed to live up to expectations. For the time being, the focus is on increasing recycled content through technological improvements in manufacturing, more selective packaging, improved waste collection and sorting and specialised recycling. As I discussed in my previous article, dumping our plastic waste on Asia or tucking it into landfills is no longer a viable option. Asian countries don’t want it and landfill is becoming too expensive. It is also unsustainable to the planet. 

 Companies like Pro Pac should be enjoying better consumer and investor sentiment. I think they could do a better job in marketing themselves to ethical investing funds and to the general investing public. Investors Mutual has been selling down their share on the open market which has weighed on the share price. The Company has a market cap of $17M at today’s price and an enterprise value of $41M, despite a tangible asset value of $100M.

 In conclusion, Pro Pac is heading in the right direction in steering itself towards flexible packaging. Flexible packaging is fundamental in enabling the trend towards fast moving consumer goods and is integral in the Agriculture and the Food industry. It is ahead of its peers in becoming an integrated manufacturer and recycler. It is leading the way in recycled content which will give it a marketing advantage in negotiating new contracts with companies like Woolworths, Arnotts or Coca Cola who are keen to show their sustainability ethos to consumers. It needs to have a disciplined focus on reducing debt, keeping costs down and maintaining working capital. If it gets through this period, it will emerge stronger. Its value will be realised when sentiment turns back towards the sector. I am concerned that a forced takeover by its largest shareholder may occur at current prices and I am keeping a nervouse eye on things until the share price recovers.

Disc: I hold shares on SM and in RL 

Pro-Pac Packaging reported its first-half earnings on Friday. As flagged by the Company, there was no meaningful profit. The Company has pivoted towards the higher growth flexibles market and this division has been hit hard by the dramatic rise in resin costs and the difficulties obtaining supplies because of port congestion, limited ship space and the high demand for shipping containers. Plastic manufacturers are forced to turn to the spot markets where the price is higher. These input costs are being passed on to consumers but there is a lag during which manufacturers have to weather the costs. This increase in plastics PPI is a phenomenon globally and will eventually flow through to the CPI. Printing and laminating capacity has been increased and the Company is well placed to benefit from the increased demand for flexible packaging. For the moment, however, Flexibles is detracting from the Company's performance. PBT from flexibles fell to 44% compared with 70% in 1H21.

To deal with these challenges, the Company has increased working capital to $103M from $81M and gearing has increased to 3.3X (from 1.5X). Labour costs and site disruptions have further impaired performance and inventories have increased with a reduced sales turnover.

On the plus side, PBT in the industrial business (which is traditionally low margin) increased 100%. This was not really impactful to the Company's overall profit.

Pro-Pac is positioning itself well in the Flexibles sector and is trying to do the right thing in regards to plastic recycling. I still think the Company is more of a follower than a leader in this space.

The Company's rhetoric is full of trite and cliched phrases like 'Centres of Excellence', 'unrelenting focus on profitable revenue growth', 'we are committed to a circular economy', ESG committee' and 'sustainability charter'. I don't know who dreams up this drivel and sometimes I feel it is a real turnoff for investors. Hopefully, they are managing their business better than their public relations. On the other hand, I think they are showing financial constraint and managing their capital conservatively. Eventually, when the headwinds subside, profit will accelerate. I remain concerned about the long-term future of plastics and I have written about this previously. Whether the industry flourishes or dies a slow death depends on how they manage their own future.

I have faith that Pro-Pac will exceed expectations in the medium term (2-3 years). I think that the business is undervalued and I have been buying shares for both my SM and private portfolios.

Pro-pac further refined its guidance for 1H22 by reducing profit estimate by another $3Mil. I have already alluded to the factors in my previous post (18Nov). The same factors remain at play: labour shortages, shipping delays and input costs.

I remain of the same opinion, namely that these factors will affect all manufacturers and are not a reflection on the Company per se. I am encouraged by the increase in orders, even though some of them were placed before the price increases. Long term, my evaluation of the Company remains the same.

I have bought more shares

Today's profit guidance can be read here

Pro-pac AGM 23Nov21.pdf

Dear Members, following on from my recent straw on The Environmental Group (ASX:EGL), I wish to introduce you to another of my core holdings: Pro-Pac Packaging (ASX:PPG).

PPG manufactures and distributes commercial and industrial packaging in Australia and New Zealand. The Company purchased Integrated Packaging in 2017 and pivoted from an industrial distribution company to a leading manufacturer of flexible packaging. Flexible packaging is the second largest packaging material in Australia. It is lightweight and made from plastic film and small additional strips of lightweight material such as metal. Technological improvement has created packaging which is fit-for-function and versatile for products in the food, pharmaceutical, electronics and medical industries. A flexible package is any package whose shape can be readily changed. Examples include stand-up and gusseted pouches, sachets, shrink film, MAP-packaged products, ‘heat and eat’ food containers, bubble wrap, tubes and sleeves. Flexible packaging has a lower carbon footprint than conventional packaging, is lighter and easier to transport, keeps food fresh for longer, is re-usable and convenient, and is more versatile in terms of its branding and aesthetic capabilities.  A recent survey by the Flexible Packaging Association (FPA) found that 83% of brand owners had switched to flexible-type packaging and most were looking for ways to reduce their use of rigid packaging in the future. The global flexible packaging market is expected to grow at a CAGR of 6% in the next 10 years, with some products like Bi-axially orientated polypropylene (BOPP) predicted to grow at 10%. In Australia, the flexible packaging market is $1.8B. Amcor is the largest player. PPG has 14% share of this market. There is a long tail of small independent operators who will eventually be acquired by one of the larger participants.

With this in mind, there is clearly a realisation within PPG’s management that flexibles is the target market to drive growth and profitability for the Company. To this end, they have been focused on bedding down their acquisitions (Integrated Packaging and Supreme Packaging), rationalising their manufacturing facilities (closing down the plant at Chester Hill), driving efficiencies within the organisation through enterprise resource planning, and by investing in best-in-class technology at their Integrated Packaging site. They have been paying down some debt and they carry a lower debt/equity ratio (77%) than competitors Pact Group (244%) and Amcor (112%). They have been able to maintain their working capital ($81M) despite carrying additional inventory to cope with Covid supply disruptions. This puts them in an opportunistic position for making more acquisitions to grow their flexibles business. PPG has historically lagged the performance of its peers in profitability and in ROE. I think this is because it is a business in transition which is re-aligning and consolidating itself towards the more profitable side of the packaging business.  PPG has a small market capitalisation ($178M) compared to the big competitors that it is trying to measure up against (Pact: $1.3B; Amcor: $13.6B). Its enterprise value-EBITDA-ratio is 5.8X vs 8.6X (Pact) and 10.48X (Amcor) suggesting it is relatively undervalued.

The biggest risk facing PPG in my opinion is the growing sentiment which is pushing back against the use of single use plastics and the use of plastic packaging in general. There is a lot of rhetoric about improving the circular economy for these materials but we don’t have the technology or the infrastructure to do this. Australia generates 2.5M tonnes of plastic waste each year and it recycles less than 20% of it, of which about half is recycled locally. About 130,000 tonnes of plastic waste leaks into the environment annually. To avert the risk of government legislation, participants in the industry have subscribed to the Australian Packaging Covenant Organisation (APCO) which has set voluntary targets for the industry. The 2025 targets include 70% of plastic packaging being recycled or composted and 50% average recycled content in packaging (30% in plastic products). If they don’t meet these targets, Government will likely intervene. Under the NSW Waste and Sustainable Materials Strategy, Stage 1: 2021-2027, NSW has adopted several targets including the phase out of single use plastics -like straws, stirrers, cutlery and plastic cotton bud sticks-, reducing plastic litter items by 30% by 2025 and tripling the plastic recycling rate by 2030. What this means for PPG is difficult to predict. There is always the risk that EPR legislation will place the cost of collection, sorting and recycling (Stewardship) of plastics onto the manufacturer. There is also the risk that the use of plastics will be restricted or that a tax will be placed on items that use only virgin resins. How this impacts PPG will depend on whether they seek to take a pro-active and leadership position in driving this necessary change, or they wait for others to lead the way. I spoke with CEO Tim Welsh and he wasn’t forthcoming on this, but I believe there are initiatives underway within the Company to increase the recycling of its products.

Consumers have grown dependant on the convenience of flexible packaged products. Manufacturers can see the economic, aesthetic, and product marketing advantages.  The industry is primed for growth and PPG can participate in this but they will also have to be part of the environmental solution in the future.