|Shares Out. (in M):||5||P/E||47.0x||8.0x|
|Market Cap (in $M):||183||P/FCF||47.0x||8.0x|
|Net Debt (in $M):||280||EBIT||27||60|
|TEV (in $M):||463||TEV/EBIT||17.0x||8.0x|
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AEP Industries (“AEP” or the “Company”) is a manufacturer of plastic packaging films, primarily for the North American market. Earnings are temporarily depressed due to a confluence of relatively weak demand and high raw materials pricing, making the Company appear relatively expensive on current run-rate numbers. However, with a more normalized demand environment, and with the benefit of forthcoming significant raw material supply expansion (and associated price relief), I believe that AEP can generate over $7/shr in earnings in the medium-term, and over $10/shr in earnings over the long-term, putting shares somewhere in the range of 3-5x EPS. The business is well-managed, with significant inside ownership, a history of aggressive share repurchase activity, an opportunistic M&A mentality, and a business mix that has been moving slowly up the value chain over the last couple of years.
AEP produces myriad products, the one common denominator being that virtually all can be categorized as flexible films. Products range from the highly commoditized to the specialized, and are sold into a broad range of verticals including packaging, transportation, food & beverage, automotive, pharmaceutical, chemical, electronics, agriculture, and textiles. The Company’s higher value-added products require close coordination with customers to ensure that the films have specific chemical and physical properties. In 2013, the top five product lines by sales (per Company categorization) were stretch wrap (31%), custom films (30%), food contact (16%), can liners (11%), and PROformance (specialized) films (6%). Gradually, over the last several years, management has been improving its business mix, transitioning away from pure commodity products (like stretch/pallet wrap) to those that are either more retail-oriented (freezer storage bags, sandwich bags) and therefore somewhat less price-driven, or those that require customer-dictated customization. These moves have largely been made through tuck-in M&A activity.
AEP has two national competitors, Berry Plastics (“Berry”, ticker: BERY) and Sigma Plastics (“Sigma”). AEP and Berry each reportedly control over 30% of the national market for more commodity-oriented films, with Sigma controlling roughly half that amount. Each of these firms has smaller market shares for the higher-end specialty films. Berry is a PE-favorite, having passed through the hands of First Atlantic, Goldman Sachs, JPMorgan, and Apollo over the past two decades. Berry reports LTM revenue of roughly $1.4bn and $0.9bn in its Engineered Materials and Flexible Packaging segments, respectively, subsegments of which are direct competitors with AEP. This compares with AEP’s LTM revenue of roughly $1.2bn.
The flexible film industry has been rationalizing capacity now for a number of years. A significant portion of the commodity-oriented portion of U.S. flexible film capacity supported the housing boom/bubble leading up to 2007, and when housing crashed so did demand for many of these products. These products included things like mattress film (the heavy translucent films used to wrap mattresses for shipping), carpet wrap/film, and manufactured housing wrap. I don’t have specific housing-driven capacity detail, but AEP management has provided anecdotal detail of their exposure, and their sizable market share should make them a decent proxy for the overall market. For instance, in 2007, AEP had contracts to provide 35mm lbs of mattress film to three large national mattress manufacturers (Sealy, Serta, and Simmons). The following year (2008), they only sold 10mm pounds, a hit to their company-wide volume of over 3% on a single product. The combination of reduced housing-oriented demand, as well as broader demand reductions driven by the Great Recession, drove many flexible films manufacturers into financial distress. AEP and its two primary competitors, Berry and Sigma, had the financial flexibility to profit from these dislocations. AEP purchased competitor Atlantis Plastics out of bankruptcy in 2008, Berry purchased competitor Pliant out of bankruptcy in 2009, and Sigma purchased majority stakes in both FlexSol and ISO Poly Films in 2009. In all, this put about ¾ of total U.S. industry stretch film capacity into the hands of these three firms, down from five firms controlling similar aggregate market share prior to the financial crisis. Moreover, both concurrent with and subsequent to these purchases, numerous other industry players have continued to shut down manufacturing capacity.
It would be disingenuous to classify the flexible film business as anything better than ordinary. Prior to 2007, AEP consistently generated ROICs in the high-single and low-double digits, with ROEs significantly better due to reasonably aggressive use of financial leverage. Subsequent to 2007, ROICs have range in the mid-to-high single digits, with commensurate declines in ROE (averaging in the mid-high teens) from the pre-2007 period. Notwithstanding the uninspiring industry returns on capital, AEP management has generally demonstrated good (and improving) capital allocation discipline over the years, and has been moving the Company slowly up the value chain into activities with higher implicit returns.
Prior to 2008, AEP had roughly 800mm lbs of annual (extrusion) capacity. The 2008 acquisition of Atlantis significantly increased the Company’s size, adding an additional 300mm lbs of capacity. AEP purchased Atlantis for just $99mm. Net of $53mm of cash and net working capital, it paid just $46mm for a business that had been doing north of $20mm in EBITDA prior to the financial crisis. In 2011, AEP purchased Webster. Webster added an additional 120mm lbs of capacity, and moved AEP (for the first time) into the retail segment (freezer bags, sandwich bags, conventional trash bags), a modestly less commodity-oriented subsegment of the stretch film business. Webster was purchased for $25mm cash, a discount to the $32mm in net assets received in the deal (which necessitated a bargain gain on purchase adjustment). In late 2012, AEP acquired assets from Transco ($5.3mm purchase pricing + an additional $5.6mm to move and install the equipment), which moved the business further up the value chain by giving it the capability to customize commodity films through printing and other conversion activities.
AEP is led by Chairman and CEO Brendan Barba. Barba co-founded the Company in 1970, and is 73 years old. He owns roughly 10% of the equity, with an additional 10% held by other members of senior management. The Company returns cash aggressively to its various stakeholders. Over the past eight years, it has retired 40% of its shares outstanding. These share repurchases are sporadic and opportunistic. Most recently, in April of this year, the Company bought a block of 508k shrs (9% of shares outstanding) from a large shareholder, the Crown Cork & Seal pension fund. AEP has also, during times of market dislocation, been a purchaser of its own debt. There is a large long-time outside shareholder, KSA Capital Management, that is run by a former packaging analyst. KSA owns 20% of the Company, and has made noises in the past about getting active, but is currently subject to a standstill agreement with the Company.
AEP is levered. The Company carries about $280mm of net debt, vs. LTM EBITDA of $44mm. While this may sound untenable, there are a few caveats to keep in mind. First, LTM EBITDA is significantly depressed. The current trailing $44mm level is about half of what the Company was at just 12 mos prior. Second, the Company (and its management team) has a long history of managing through difficult cycles, and has a good relationship with its lenders. The closure of the Webster acquisition during the height of the financial crisis in 2008 is instructive, as none of the other bidders were able to put together financing for the deal (which drove the very attractive purchase price). Lastly, the Company has something of a built-in safety valve, as it’s able to release significant cash from working capital during periods of severe downturn. As an example, fiscal 2008 was a decent cash generation year for the Company, despite being difficult from a P&L perspective.
AEP runs what is effectively a spread business. The Company’s primary raw (and cost) input is resin, and it processes that resin into flexible films, earning a spread over the raw resin cost in the process. At the commodity end of the spectrum (pallet wrap) it is almost a pure spread business; at the higher value-added end of the spectrum (printed labels, custom films, etc.) there is moderately less (customer) price sensitivity and more associated opportunity to earn excess spread. Since fiscal 2008, the Company has generated gross profit per lb (spread) in the range of 15.5¢ to 18.5¢ (on a LIFO-adj basis). Prior to that, profitability levels in excess of 20¢/lb occurred regularly. In addition to soft demand over the last few years (resulting from depressed housing activity plus a generally tepid level of economic recovery), flexible film manufacturers have faced an extremely tight resin market. AEP can, over time, pass resin price increases through to customers. Unlike some of its competitors, it never enters long-term, fixed price contracts. However, price increases are never easy to pass through, and there is virtually always a lag. On a current trailing basis, this lag has had a major negative impact on profitability as resin pricing has increased for 20 months in a row, a nearly unprecedented run. Looking forward, this tight supply situation should ease over the medium-term. Due to the natural gas bonanza in North America, significant new resin supply is under construction for the first time in quite a while. Over the coming three years, 6-10 billion pounds of new resin capacity is slated to come on-line, representing a rough increase of 6-10% in overall supply. This should supply a major tailwind for AEP.
It is difficult to model AEP financials precisely, as disclosure about the Company’s productive capacity is scant. Company filings used to disclose production capacity, however, have stopped doing so in recent years. In large part, this is a result of business mix changes over the last few years. Prior to 2008, the vast majority of the Company’s business was in the commodity end of the product spectrum and, as such, extrusion capacity was a relevant measure of the business’s manufacturing potential. However, as the business has diversified (through the aforementioned M&A), this has become less relevant since a printing operation, for example, might not be additive to overall capacity but merely represent an additional step in the production process. That said, here is my math. We know that the business had 800mm lbs of extrusion capacity in 2007. Atlantis added an additional 300mm lbs and Webster added roughly 120mm pounds. This brings the total to 1.2bn pounds. Over the last 9 mos, roughly 65mm pounds of additional capacity expansions have been announced (and in some cases, implemented). So roughly speaking the business has (or will have) a total of 1.3bn of productive capacity. At a utilization rate in the mid-high 80s, this would imply about 1.2bn lbs of sales. With a combination of a return to a more normalized demand environment, relief on the resin cost side, and benefit from the Company’s initiatives to improve its product mix, I see gross margins trending back towards 20¢/lb. This implies gross margin potential of $240mm. Assuming a 70/30 fixed/variable split on operating expenses, the business should be able to support this with about $140mm in operating expenses, yielding EBIT of $100mm (EBITDA of $135mm). A $20mm in interest expense, a 40% tax rate, and 5.1mm shrs drops this down to $9.40/shr in EPS. I believe this could happen within the next three fiscal years.
So, in summary, you’ve got a business with an improving return on capital profile, a good management team, strong insider ownership, an aggressive capital return policy, and medium-term margin tailwinds that trades at a cheap multiple of normalized earnings. Any sort of rebound in housing or strengthening in the growth rate of the broader economy is gravy. I’m not sure exactly when the turn (in the stock) will come, but when it does it could potentially move. A year ago, this stock was at $90/shr. It doesn't need to get back there to be a homerun.
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