Description

Berry Plastics Group Inc. (BERY)

Conclusion:

The combination of 1) a stable, market-leading packaging business, 2) a levered balance sheet, and 3) +10% FCFE yield focused on reducing debt, should deliver a high-probability +20% IRR for the next several years.

Business description:

Berry Plastics is a leading manufacturer of plastic consumer packaging and engineered materials.  Approximately 55% of revenues are rigid packaging (drink cups, containers, bottles), 15% flexible packaging (personal care, films, coated & laminated packaging, etc.), and 30% engineered materials (tapes, food wrap, etc.).

The company holds #1 or #2 market positions in >75% of their sales.  The majority of sales are domestic, with +90% in North America.  The largest end market is food & beverage at ~40%, followed by industrial at ~20-25%, and the remainder being split between foodservice, personal care, healthcare, household and retail.  Customer concentration is low, with the largest customer being ~3% of sales.  The company’s largest raw materials are plastic resins and they have contractual pass-throughs on ~75% of their contracts.  The majority of these pass-throughs are monthly or bi-monthly, with the remainder being quarterly.  As such, the company’s margins have shown very low volatility relative to plastic resin prices.

The plastic packaging market is very fragmented, and BERY has been an active acquirer executing 34 acquisitions over the past 24 years.  The company’s revenue CAGR since 2000 has been 23% and management estimates that ~4-5% of that has been organic.  The company has a full-time M&A team and targets pre-tax returns in excess of 25%.  A good example of the company’s M&A prowess is their September 2011 acquisition of Rexam’s specialty and beverage closures business.  BERY paid 4.5x EBITDA post synergies and funded the entire acquisition via their revolving credit facility which carries a LIBOR +200 interest rate.

The business was acquired by financial sponsors Apollo and Graham Partners in September of 2006 and taken public in October 2012.  The financial sponsors still own ~45% of the equity.  Management owns ~15% of the equity.  The company is headquartered in Evansville, Indiana.

Why BERY is cheap / misunderstood

I believe that BERY was cheap at $20, and I think in recent days it has gotten even cheaper as the shares have declined due to a) a weak market, and b) the 4/18 secondary transaction.  Apart from the recent decline that has exaggerated the mispricing, I believe BERY is mispriced mainly because it is new to the public markets, and because it is levered.  While core packaging holdings like CCK and BLL have been delivering strong returns in the public markets for over a decade, BERY went public just last October.  In addition, the company is nearly 5x levered.  While “newly public & levered” admittedly does not sound like a very unique or compelling reason for a mispricing, I think we do not have to go far for precedent – packaging peer Graphic Packaging (ticker: GPK).  While GPK has been public for a while, I think it has been underfollowed due to, until recent secondaries, the limited float (TPG and Coors family ownership) – in that sense, I believe it has only recently begun to attract significant investor attention.  Like BERY, Graphic is also highly levered.  Also like BERY, the bull case on GPK has, and continues to be, a high levered FCF yield on a stable business, with that FCF focused on debt paydown.  The pushback on GPK’s valuation has for a while been along the lines of “yes it’s cheap on FCFE, but it’s levered so it deserves to be cheap on FCFE”.  Nevertheless, shares have outperformed the broader market nicely due to the stability of that FCF, and the focus on using it to transfer value from debt to equity holders.  I expect a similar dynamic to play out at BERY.  While Apollo is selling down their stake in the company at what looks to be cheap prices, I think it is worth noting two things: 1) BERY is apparently in an Apollo fund that they are actively trying to liquidate due to the vintage, and 2) management bought on the IPO only a few months ago at $16, only less than 10% below current prices (management also noted that they are not selling in the current secondary, but have the option to buy – I do not know whether they participated).

Earnings power:

I expect BERY to generate nearly ~$250m of levered FCF this year.  I estimate EBITDA to be ~$815m, capex of ~$230m, cash interest of $225m, ~$45m use from working capital, restructuring, etc., and $70m of cash taxes.  Sell-side estimates for cash interest are generally higher than my estimate because some are not updated for the company’s February refinancing of their term loan at LIBOR +250.  Regarding the company’s cash taxes it should be noted that while they have significant net operating losses, they entered into a tax receivable agreement with their financial sponsors whereby they pay them the majority (85%) of the tax benefits.  I expect revenues to grow low single digits, and for EBITDA margins to continue to expand, driving low-to-mid single digit EBITDA growth.

The core business should be a +GDP grower for two main reasons: 1) plastics have been taking share from other substrates such as metal and glass, and 2) BERY’s size should allow it to organically capture some increased share over time.  The company also has some promising new products that could drive significant growth, the main ones being VersaLite and NuSeal.  VersaLite is a polypropylene-based cup that is cost competitive with polystyrene and paper cups (~$0.10 per cup and ~0.03 per lid) and has advantages of being more durable, microwaveable, and having better graphic / decorating ability.  The market for this product in the U.S. is very large.  For example, McDonalds uses ~2b hot drink cups per year.  The company currently has one production cell in their Kentucky facility.  Every cell costs ~$15m and can produce ~300m cups at 25% margins or better.  These cups are being tested by customers now and the company expects to start getting traction towards the end of the year, begin installing new cells, and be capacity constrained for the foreseeable future.  The other significant new product opportunity is NuSeal, a dual seal lid that uses both rigid and flexible packaging to eliminate the waste of inner seals.  The company believes that the product can be produced at +25% margins, and that the cost is lower than current competitive products.

In addition to revenue growth, I expect EBITDA margins to expand.  The company has a long history of productivity improvements, driving several points of margin expansion (when looking at historical financials, note that a few points of margin expansion over the past few years have been a result of the new CEO exiting certain unprofitable contracts, and thus not recurring).  The company spends roughly $65m of capex per year to invest in these productivity improvements, and targets a +25% pre-tax return similar to their M&A strategy.  I also expect the company’s margins to benefit from lower natural gas prices driving down plastic resin costs over the next decade.  There have been significant petrochemical capacity addition announcements in the U.S. over the last several years, and as this new capacity comes online and drives down resin costs, I believe the result will be an environment where BERY has an easier time pricing for their value.

Valuation:

I expect an investment in BERY to deliver a +20% IRR over the next 3-5 years.  In my model I use the above FCF calculation, revenue growth, and EBITDA growth.  I assume that all of FCF goes towards debt paydown, despite management’s focus on M&A and the fact that M&A would likely be more accretive, and I use an 8x trailing EBITDA exit multiple.  BERY’s packaging peers currently trade at approximately 8.5x ’12 EBITDA and 8x ’13 EBITDA.

Balance sheet & liquidity:

BERY is nearly 5x levered, but the company has almost $450m of total liquidity, minimal near-term maturities, and no significant covenants.  Management’s target leverage is 2-4x, the CEO has a long history at levered companies, the CFO has been efficiently using leverage at BERY for decades, and I believe that in debt markets of the current nature, they are more likely to purposefully keep leverage towards the higher end of the range in order to drive equity returns.  Regarding the leverage, I think it’s also worth reiterating that this is not a particularly cyclical business, customer concentration is minimal, and the company has excellent raw material pass-throughs in their contracts.

Catalysts:

Debt paydown – every turn of leverage drives nearly $7/share in value, and the company is targeting approximately half a turn of leverage reduction per year.

M&A – the company has long track record of successful M&A and I believe additional M&A would be accretive to my forecasted returns.

New products – significant uptake of new products like VersaLite and NuSeal could drive growth above expectations.

Risks:

Leverage – the company is highly levered, however as I’ve stated I believe this is a key positive in the investment thesis.

Volume – volumes have been sluggish the last few years and were negative this past quarter.  I believe the past few years have simply been a result of a sluggish economy with inflated food & grain prices - a situation which I view as cyclical and not company-specific.  Volumes in the quarter were pressured by food & beverage – this quarter saw difficult weather versus very favorable weather in the prior year which drove an adverse comp in the fast food channel.

Financial sponsor ownership overhang – even after this recent secondary the financial sponsors still own ~45% of the stock, which limits the float and could cause short-term pressure around future secondaries.  I don’t see this as a problem for a long-term investor, and I think the recent dip in the stock reflects this risk and is part of the current opportunity.

Catalyst

Catalysts:

Debt paydown – every turn of leverage drives nearly $7/share in value, and the company is targeting approximately half a turn of leverage reduction per year.

M&A – the company has long track record of successful M&A and I believe additional M&A would be accretive to my forecasted returns.

New products – significant uptake of new products like VersaLite and NuSeal could drive growth above expectations.