Value Investors Club / Berry Plastics Group (BERY US)

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 Avintiv’s

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.

Edge 3: A number of catalysts / changes might help close the valuation gap with peers

Berry trades at attractive absolute valuation levels. Equally important, there is a 20% valuation gap with peers

despite Berry delivering higher growth and generating higher margins and returns compared to peers. So the

valuation gap is driven by other things than growth or returns and a number of catalysts on this front might

help narrow the discount over the coming 12 months.

The net debt / EBITDA ratio will fall below 4x in FY17

 Berry was a roll-up story held by private equity for 22 years before listing in 2012. Unsurprisingly the IPO

came with high leverage, 11x net debt / EBITDA

 Strong FCF generation, the accretive deployment of that FCF and 2 deal-related equity raises have

brought down the leverage to 4.5x and we are scheduled to dip below 4x in FY17. I model the net debt /

EBITDA ratio to fall to 3.9x in FY17, 3.4x in FY18 and 2.9x in FY19. And my model includes cash being

deployed for future acquisitions and a dividend, not just debt pay downs.

 Having the leverage ratio start with a 3 makes a difference as many investors’ psychological hurdle is 4x.

4x is also the upper limit of Berry’s long-term target range, which means investors can start dreaming

about FCF being used for other purposes than paying down debt. Analysts are indeed writing about the

increasing potential for M&A, share buybacks and even a dividend.

Organic top line growth turns positive in FY17

 Berry is not a top-line growth story, but a low single digit organic growth company. And the organic growth

has actually been negative over the past 5 years. Packaged food and restaurant sales trends have been

weak on an industry level. And Berry’s growth has been below the market on the back of management

actively pruning its contract and product base. This pruning has benefited margins and EBITDA growth,

but the lack of organic top line growth for a prolonged period has weighed on investor sentiment.

 Sentiment might pick up in FY17 as the company returns to positive organic growth. Industry trends aren’t

showing much signs of improvement, but management is signalling that we are reaching the end of the

pruning efforts. Also, the mix will improve as the Avintiv acquisition adds substantial exposure to the

higher growth hygiene and health care markets (3-5% organic growth). And Avintiv’s international

presence might help unlock new geographies for Berry’s legacy products. With 9 of Avintiv’s top 10

customers being substantial Berry customers it should be possible to unlock some opportunities.

 I model a modest turnaround to 1.5% organic growth over the coming years. The absolute level is unlikely

to make much of a difference to our intrinsic value, but the change in direction could improve sentiment

towards the stock.

Raw material changes

 The changing supply / demand dynamics in the polyethylene market and the potentially substantial

earnings uplift from higher raw material discounts are attracting a new investor base to Berry.

 Analysts are telling me that they are seeing a lot of interest from fundamental hedge funds, which typically

look for an edge and believe to have found one in the commodity story coupled with the conservative

company guidance and conservative analyst modelling.

New broker initiations

 Berry has largely stayed below the radar since its 2012 IPO, but that seems to be changing now. Five new

broker initiations in FY16 (JP Morgan, Citi, Jefferies, RBC, KeyBanc) should improve investor awareness.

The $6bn mcap and the opportunity for brokers to be involved in future M&A is no doubt a motivating

factor.

How fast does this company grow?

 Berry offers low but stable organic top line growth. I model 1.5% going forward.

 Coupled with decent margins and returns this does however translates into high and stable FCF

generation. Berry excels at redeploying this cash, mostly through highly accretive M&A. And therefore

with conservative assumptions I get to a 15% EBITDA and FCF CAGR over the coming 4 years.

What is the basis of the company’s competitive advantage? How do margins compare to history and

peers?

Berry produces commodity products, the competitive landscape is fragmented, and it doesn’t cost much to

build a new plant ($20-50mn). Yet Berry generates an 18% EBITDA margin and an 11% ROIC which I expect

will trend towards 16% over the coming years.

25 years of rolling up the industry has given Berry a substantial scale advantage in raw material buying. It

purchases 2x more resin than #2 Bemis and 3x more than #3 Sealed Air, with resin being 50% of COGS. This

explains the decent margins and returns in what is essentially a volume business.

Despite the low barriers to entry we’ve seen little in terms of new entrants in the industry. Private equity isn’t

interested in a GDP- growth industry where it will be difficult to compete and catch up with a handful of

players. And the fact that it’s not economical to ship plastic packaging over long distances has kept this a

regional business, so without much threat from China.

Berry’s margins have expanded by 2% since 2013 on the back of

 Price/mix improvements, with Berry pruning lower margin products / contracts and growing / purchasing

higher margin products

 The expanding scale, which leads to higher resin discounts

 An ongoing focus on cost reductions and efficiencies (consolidating plants)

 And a small tailwind from falling raw material prices. The decline is mostly passed on, but with a small lag.

Berry estimates that this represented a $10mn or 0.8% tailwind in FY16 and has included a reversal of

that trend in its FY17 guidance. This guidance is conservative as resin prices have continued to fall,

despite higher oil prices.

Margins are expected to be flat this year as Berry integrates the slightly lower margin AEP acquisition (Berry’s

tape business in engineered materials is exceptionally high margin). But they should trend up modestly

beyond that, I include a further 20bp increase in FY18 and 10bp in FY19. As discussed, margins might

increase substantially more on the back of higher resin discounts over the coming year.

The ROIC is expected to expand from 11% to 16% over the coming years. The two biggest drivers are 1) the

extraction of synergies from the sizeable Avintis and AEP deals in the near term and 2) a reduction of the tax

rate longer-term. Berry has substantial NOLs against its 32% tax rate but has to pass on 85% of those tax

savings to its former private equity owner Apolo. The Apolo agreement phases out in FY19, at which point

Berry will fully benefit from the Avintis NOLs to reduce its tax rate.

Do we have a materially different view on sales, earnings and/or free cash flow growth vs consensus?

With conservative assumptions, my revenues/EBITDA/FCF is 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 so 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 as I adjust for PPA amortisations. As discussed, both the analysts and

me do not really model the benefit of higher raw material discounts. Every $0.01 would add 10% to earnings.

Finance

Does the company manage its balance sheet effectively? What is the maturity profile of the company’s

debt? Is the company’s pension plan fully funded and are the assumptions sensible? Are there other

off-balance sheet liabilities? Is the tax rate sustainable?

Leverage

Berry’s net debt / EBITDA ratio should fall below 4x in FY17. That is an important hurdle for 2 reasons. Firstly

4 is the psychological barrier for most investors, with 3-something seen as more acceptable. Second 4x is the

upper limit of Berry’s target range, which means investors can start dreaming about alternative uses for the

FCF.

Aside from the psychological angle, the leverage is not an issue. Berry generates stable cash flows and has

gone through recessions with far more debt whilst being in private equity hands for 22 years. In absolute

terms the total net debt is $5.3bn with $1.3bn of term loans / bonds expiring in 2020, $0.8bn in 2021, $2.8bn in

2022 and $0.7bn in 2023. The company pays around 5% in interest.

Additionally Berry has 334mn of operating leases and 142mn of capital leases (included in my EV). 78mn of

that is due within a year.

Pension and health liabilities are not an issue as the total defined benefit projected obligations total less than

$200mn. The plans are roughly $50mn undervalued with a 7.25% expected return and 4% discount rate

Tax

Berry’s non-cash tax rate of 32% is high given the 80%+ exposure to North America. So Berry would benefit

from the rumoured Trump tax changes.

The cash tax rate is somewhat lower, I model 27.2%. Berry has a large NOL position, but only gets to keep

15% of the benefits as they pass on 85% to their last private equity owner Apollo. The remaining tax

receivable agreement (TRA) has come down to $114. Berry paid $60mn in FY16 and expects to make the last

payment in FY19, at which point they can use the $500mn NOL that came with the Avintis deal for their own

benefit. Berry aims to fully use that NOL within 2-3 years, which implies that the tax rate will fall to around 15%

by the end of the decade.

What is the outlook for free cash flow generation? Will cash flow be reinvested or returned to

shareholders?

Berry is guiding for $550mn in FCF in FY17 and made it very clear that this is a conservative estimate. I model

$565mn and expect that the FCF will double to $1.1bn over the coming 4 years.

 Management’s first priority is to pay down debt and bring the leverage ratio below 4x. I believe they will

reduce the debt level by $800mn over the coming 2 years, taking net-debt / EBITDA down to 3.9x in FY17

and 3.4x in FY18.

 The second priority is further acquisitions. I model the $765mn AEP deal in FY17 and a further $250mn in

FY18, $500mn in FY19 and $750mn in FY20.

 The third priority is capital returns. I model a token $30c dividend (0.5% yield), in-line with management

guidance for a token dividend (without specifying an amount).

The above capital spending on M&A, debt reduction, buybacks and a dividend still allows for the build-up of

$1bn of excess cash over the coming 5 years, and for the net debt / EBITDA ratio to fall to 2x. Therefore I

expect that we might see even more M&A than I modelled. The reason for not pushing the numbers further is

simply the fact that I already get to very meaningful upside with mycurrent assumptions.

Have management been good stewards of shareholder funds? How are management paid and are we

aligned with management as minority shareholders?

Management has done an excellent job for shareholders. The shares have more than tripled since the 2012

IPO and so has the economic profit (see chart below). Compensation is not excessive with the CEO taking

home $8mn ($1mn base, $1mn ST bonus and $6mn in LT options) and the rest of senior management $1.5-

2.0mn.

Current CEO Jonathan Rich is retiring to the Chairman position over the coming months. That is seen as a

neutral to good thing by investors as he is regarded as ‘the guy who was put in place by private equity ahead

of the IPO’ and somewhat promotional (once calling Berry the Apple of Packaging). More important is that his

replacement Tom Salmon is highly regarded. He is the current COO and has been president of both the

consumer packaging and the performance materials businesses throughout his long career at Berry.

Insiders hold 3% of the outstanding shares ($180mn)

How do we reach our fair value estimate? How does this valuation compare to the company’s history

and peers?

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, despite

Berry delivering higher growth and generating higher margins and returns.

As discussed, a number of catalysts might help close that gap over the coming year, such as the return to

organic growth, the leverage ratio falling below 4x, the commodity tailwind and investors becoming more

familiar with the stock on the back of recent broker initiations.

For my base case I assume that the stock’s multiples move up slightly to 10x EV/EBITDA, 15x P/E, 7.5%

equity FCF yield and 6.7% EV FCF yield. This remains below the peer group multiples of 11x EV/EBITDA, 18x

P/E and 5.9% Equity FCF yield.

Applying these multiples provides 20% upside on FY17 numbers ($60 TP, September year end so we are

already in FY17), 40% on FY18 numbers ($70 TP) and 80% on FY19 numbers ($90 TP).

I should stress that most of the upside is generated through growth in fundamentals rather than through

multiple expansion. Keeping the current 12 month forward multiples and simply rolling them forward provides

20% upside over 1 year ($60 TP by year-end when we apply the multiples to the next 12 months, so on FY18

numbers), 50% upside over 2 years ($75 TP) and 90% upside over 3 years ($95 TP).

Risks

Deal integration risk

 With Avintis and AEP, Berry is integrating 2 major deals (60% expansion of revenues).

 I’m not too worried about this given Berry’s excellent track record of integrating acquisitions. They have

done most of the heavy lifting ofthe transformational Avintis deal and theAEP integration should be

relatively smooth given that it’s more of a large bolt-on with most of the synergies coming from improved

purchasing.

Increasing hedge fund exposure

 Berry ticks a lot of the boxes of fundamental hedge funds, which typically look for an edge and can find

one here in the form of the recent deals, the commodity angle, the conservative guidance, the

conservative consensus modelling and the low valuation. This is a good thing as the increased interest

should help to close the valuation gap. But we should be aware that higher share price volatility typically

follows this investor base.

 So whilst I like Berry a longer-term investment, we should be aware that some ‘new investors’ might jump

ship if certain parts of the investment case take too long to materialise in the short-term. The commodity

angle is probably the least predictable factor.

AEP shareholders will own 5% of Berry shares on a fully diluted basis

 I don’t know what the intent is of those shareholders. If they want to sell we might see some pressure in

the months after the deal closes.

Downside

 Given the relatively short period as a listed company, I turn towards peers Bemis and Sealed Air to get

better insight in the downside. Similar to what I expect from Berry, their revenues and earnings were

relatively stable throughout the FY08-09 recession. So the swing factor is the multiple, with the

EV/EBITDA falling to 6x.

 Applying a 6x multiple to FY18 numbers gives a $26 TP (50% downside). This is an extreme scenario and

similar to peers in the great recession, I would expect Berry to outperform the MSCI World in that

scenario.

 Even with the extreme downside scenario and a conservative upside scenario, the risk / reward remains

an attractive 2:1.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

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