Packaging isn’t the type of investment opportunity people usually talk about with their friends down the pub. Cardboard boxes and paper products aren’t very exciting or associated with bumper returns. They are, however, essential, unlikely to get replaced by other technology, and not as commoditised and susceptible to competition as you might think. From an investor standpoint, these are enviable traits.
Three companies in the FTSE 100 specialise in packaging. One of them, DS Smith, appears to have been overlooked of late. The company, founded in 1940 by two cousins in London, provides its customers, mainly big supermarkets, industrials and online shops in Europe and North America, with packaging solutions supported by recycling and papermaking operations.
The economic environment is spooking investors. When consumers tighten their purse strings, fewer goods are transported. And in the six months to October 31, DS Smith spent £779 million more than usual on energy, materials, labour and distribution. Those challenges haven’t yet put a dent in revenues and profits. In fact, DS Smith has grown both, mainly by raising prices. Proof that it has enough pricing power to cover its higher costs and then some would normally reassure investors. However, it’s falling volumes, a trend across the sector, that have been grabbing attention.
Weakening demand and cost inflation have left DS Smith with a rating of just under eight times forecast earnings, a much larger than normal discount to its higher-margin peers and a 37 per cent markdown on its own long-running average. That’s not a fair price tag and suggests investors are overlooking quite a few important things.
Firstly, DS Smith’s revenues are less cyclical than its peers and more defensive than people give them credit for. The bulk of DS Smith’s packaging is used to transport consumer staples such as foods, toiletries and cleaning products. This explains why its volumes have been falling less than others in the sector.
Earnings, meanwhile, should be boosted by easing costs. Management has hedged against unfavourable gas prices for the next few years and paper, which DS Smith doesn’t completely source in-house, is getting cheaper to buy. According to Jefferies, it typically takes three to six months for falling production costs to be passed on to customers.
The longer-term outlook is also encouraging. DS Smith is on top of the green agenda, recycling materials and developing various innovative alternatives to plastics. If all goes to plan, the upshot will be more blue-chip customers relying on it, wider profit margins – there’s more money in fancy boxes – and winning over the growing number of ESG-focused investors and associated funds.
These various profit and revenue drivers, coupled with the balance sheet being in its best shape for years, should support the dividend, which is one of the most attractive in the FTSE 100. At the end of April, net debt stood at 1.3 times cash profits, indicating there’s headroom to continue returning money to shareholders and gobble up more market share through acquisitions.
Given the fragmented nature of the packaging industry and increased demand for more sustainable solutions, there’s even a chance that DS Smith gets taken over itself. Mondi reached out in the past about matching its low-cost mills with DS Smith’s innovative new products loved by big customers such as Amazon but was swiftly rejected. At this discounted price, there are likely to be other suitors keen to add DS Smith’s differentiated offering to their arsenal.
ADVICE Buy
WHY An uncertain economic backdrop justifies caution but DS Smith has more going for it than investors give it credit for and pays a decent dividend
Hotel Chocolat
Hotel Chocolat Group is making a habit of disappointing investors. Last Thursday it warned that sales over Easter, which are vital for a chocolate company, were worse than expected, mainly because of a failure to get new, suitably priced products on shelves in time.
That means profits for its 2023 fiscal year are now forecasted to break even, rather than land in the £4 million to £7 million range we were promised just seven weeks ago, marking another major setback for a company that was already skating on very thin ice.
The direct-to-consumer brand, known for its quality chocolates with a high cocoa content, has been battling to preserve its reputation ever since it pulled the plug on its poorly executed overseas expansion. That experience served as a wake-up call, making it apparent that, following years of growth, Hotel Chocolat had lost its way a bit and done a lousy job of managing costs and maximising returns across all its operations.
The onus is now on getting the business back in tiptop shape. Better stock management and other efficiencies, together with the opening of new stores in the UK and a revamped product range, are expected to push Hotel Chocolat’s growth story back on track.
Its targets seem achievable and, judging by the positive reaction overseas to the brand, the prospect of one day making it abroad without losing money, the next important step, shouldn’t be entirely dismissed. Mistakes can be advantageous if learned from and management is saying all the right things.
Trust is a major issue, however. After a series of disappointments, it’s going to take plenty of positive headlines and kept promises to restore faith and reassure investors that the company is heading in the right direction. Not being permitted any hiccups during a period of economic uncertainty and dwindling disposable incomes might prove extremely challenging.
Hotel Chocolat is an interesting turnaround story that could really pay off. But there are hurdles to overcome and a forward price-to-earnings ratio of 20 times leaves little margin for error.
ADVICE Avoid
WHY A retailer that cannot afford any slip-ups
