Berry Global - Stable Growth At A Discount

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About: Berry Global Group, Inc. (BERY)
by: Sam Weston
Summary

Berry is an equity with a proven acquisition growth strategy.

Overblown concerns surrounding high leverage have created a value investment.

Berry exhibits stability, which is desirable considering current economic conditions.

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Berry (BERY) offers an opportunity to invest in a company with strong growth potential at a discount. Berry is a plastic packaging manufacturer, operating worldwide but with a focus on North America. Over its lifetime the company has grown rapidly, primarily driven by successive acquisitions. Since going public in 2012 it has continued its proven growth strategy, notably acquiring companies such as AVINTIV, AEP and Clopay.

Investment Thesis

Berry has a history of strong growth and, within reasonable market conditions, this is likely to continue. Specifically, it has averaged annual growth of 24% in free cash flow over the last five years. Its EBITDA over the same period has had 12% annualized growth. By capitalizing on a low cost of debt, Berry has attained outperforming growth driven by a high leverage. Aside from this remarkable growth, it scores well on other metrics. P/E comes in at 15.8 and EV/EBITDA at 9.5, both indicating, in terms of value at the present, it is comparatively undervalued within its market.

This combination of competitive price and strong anticipated growth is highly desirable. A primary explanation for this undervaluation comes from debt related volatility fears. Berry has had a historically high debt/EBITDA ratio, currently at 4.4x. The Ba2 Moody's rating, assigned to Berry's last bond offering, reflects the negative perception of this leverage. I believe due to the structure of the industry and Berry's fundamentals, this fear is overblown. In conjunction with this, fears that environmental activism will damage the plastic packaging market are starting to impact share price growth. As Berry continues to engage and adapt, I believe it will overcome this negative market sentiment. The combination of unfounded caution around Berry and its market have resulted in an undervaluation of this stable growth stock.

Industry and the Macro View

The packaging industry, in which Berry operates, is well suited to its growth strategy. The 10 largest companies represent under 50% of the market; this high fragmentation provides a favorable environment for strategic acquisition. As Berry proceeds with its new RPC deal, it is set to become the second largest in its competitor group by revenue. In this position it holds advantages to scale, yet can continue to expand without the danger of cannibalization.

The plastic packaging market is within the bracket of consumer non-cyclicals. This means, in varying macro-economic climates, we would expect revenue stability. As many analysts see the current conditions resembling a late stage in the economic cycle, this stability becomes especially poignant. Since Berry was until recently a private equity, it is more reliable to analyze its competitors' data. For the sake of later debt evaluation, the most useful metric to consider is EBTIDA. As seen below, the last financial crash had minimal impact on EBITDA in this sector. With this stability in mind, it is time to evaluate Berry's debt.Sam Weston - data from Factset

Source: Created by author, data from FactSet

Debt - Risk and Management

A quick competitor analysis puts the company's debt ratio into perspective. This industry has a tendency towards higher debt ratios but on this metric alone, Berry sits behind much of the competition.

Source: Created by author, data from FactSet

It is important to note the company's debt burden is the byproduct of strategic expansion, not the result of systematic loses. Much of the financing for Berry's acquisitions comes from debt, for example, in order to fund its new RPC deal, it is loaning $6.5 billion. After establishing that high leverage is not the symptom of a deeper issue we need to consider if, in itself, the debt is problematic. In the near term this is an issue of solvency, and longer term, a question of Berry's ability to de-lever. Both are intertwined with the company's capability to generate free cash flow.

Past performance is a good starting place to anticipate future free cash flow. Berry has a mean growth of 24%, with a standard deviation of 25%. The standard deviation shows it is a fairly volatile metric; however, statistically we would estimate positive growth in 70% of future years. Since the IPO, Berry has had two years of negative FCF growth, the minimum being -9.6%. Debt related solvency concerns originate from interest expenses. For Berry, its interest coverage with respect to EBIT has grown steadily from under 1 prior to its IPO, to 3 times today. The growth here comes from a diminishing cost of debt, a relatively stable liabilities balance and improving cash flow. This indicates solvency concerns are diminishing and, combined with historic EBITDA stability, we can consider insolvency to be a marginal issue. In tandem with the inherent market stability I touched on earlier, Berry's diverse end market, no client exceeds 4% of sales, fortifies this security.

The importance of acquisitions for Berry means that taking on and reducing debt is integral to its present value. Taking its acquisition of AVINTIV as an example: Berry closed the deal at a 5.1x leverage ratio. In two years it brought this down to 3.9x, within its target range of <4x, a figure sighted as sustainable by researchers covering the stock.

This leverage range is typical for the company, with historical data showing common bounds of 3x to 5x. Looking into the future, the current guidance on the RPC deal states a debt/EBTIDA of >5x at deal closure. This is anticipated to reduce to <4x by 2021. Aside from the companies historic ability to meet its de-levering guidance, its capability can also be inferred directly from predicted FCF. With a conservative growth estimate of 4% (the company's historic organic growth) applied to Berry and RPC's combined EBTIDA, 2021 EBITDA will be $2600M. Contrasting this with post deal debt of 12.4B leaves 1.9B to pay down over two years. This rate is required in order for Berry to achieve its desired <4x debt ratio. With a combined FCF of approximately 1.2B, this appears to be a realistic assumption.

Growth Strategy

Regardless of debt stability, it is still a concern that current increases in liabilities will not be justified if future acquisitions don't return value. To address any concerns, let us take a more detailed look at the acquisition strategy that underpins this thesis. Since its inception Berry has made over 40 acquisitions. Over the past 15, it has achieved synergies of 5% of acquired revenue and, including this in the calculation, it has acquired at an average of 5x EV/EBITDA.

Breaking down this success, there are three main drivers of synergies. A primary driver comes from consolidation of market power. Looking at cost of goods, resin makes up 50%. In fact, a single resin, polyethylene, makes up 25% of all costs of goods on its own. Increasing the order size for these bulk contracts would improve negotiating power and drive better prices. Another deal-driven advantage comes from the client side. As Berry expands, it gains more bargaining power over its contracts. A tangible benefit from this is the pass through power it has over costs.

Volatility in costs of goods, ranging from resin prices to freight costs, can be written into contracts. This means Berry is able to mitigate long term losses by passing increases in costs onto clients. Through contract renegotiation Berry is able to streamline this pass through process, minimizing lag and reducing volatility in the bottom line. In addition to improving existing clauses, Berry is also able to add pass through conditions on new cost items, such as freight expenses. In their Q3 2018 earnings call, this renegotiation is something Berry specifically mentioned as an area for development.

On top of contract based synergies, the company has a history of integrating new technology. Berry is doing just this with its incorporation of Laddawn. Importing Laddawn's proven e-commerce business is anticipated to strengthened its small client growth. By importing a tested system and integrating it, Berry can drive down its own research and development costs. Berry expects to continue this trend with its RPC deal, using the company's technology to respond to environmental requirements.

As we can see, possibilities for strategic expansion exist and there remains tangible benefits. The best indicator that Berry will continue to capitalize on this comes from its history of success and its accredited management. The majority of its senior team have worked for Berry for over 19 years, including Tom Salmon, the CEO, and Brett Bauer, strategist and head of acquisitions. Both of the aforementioned worked in the packaging industry before joining Berry. The theme of long tenure assures experience but also justifies a continuation of past success.

The outlook for Berry is equally positive as the company continues its strategic acquisition strategy. The current driver for change is the recently closed acquisition of RPC. This deal should add 50% to current revenues and management hopes to achieve its historic 5% synergies of acquired revenue.

Environmental - Risk

Environmental pressures on the packaging industry are very visible, especially in the EMEA market. Examples of pledges to combat environmental damage include: ALDI UK's commitment to 100% plastic free own brand products by 2022 or Walmart's (NYSE:WMT) pledge to have all its own brand packaging recyclable, reusable or industrially compostable by 2025. The Ellen MacArthur Foundation currently represents the biggest effort for change and thereby it is feasibly the most relevant threat to Berry. Signatories account for 20% of all plastic packaging produced globally. The focus is on reducing single use plastics and obtaining assurances of recyclability from producers.

Berry is addressing this impending issue in two main ways. First, it is engaging with the conversation through its partnership in the Alliance to End Plastic Waste. Alongside 27 other members, there has been a combined commitment of 1.5 billion dollars to end waste. The alliance includes many other plastic interested parties, such as oil majors and plastic producers. The goal is to tackle the end issue: plastic waste. The strategy is to educate, innovate and improve infrastructure. Simply put, to avoid damaging plastic products sales. This contribution to the global plastic waste conversation helps Berry avoid bad publicity and also gives it a way of steering the conversation and limiting damages to its own interests.

Second, Berry is adapting its product offering to meet new demands. This can be broadly broken up into organic and non-organic growth. Within its own development, Berry is working to produce new products such as the Versalite cup. This fully recyclable cup meets the demands of initiatives like the ones set out by the Ellen MacArthur foundation. More than this, it beats alternatives like the common paper hot cup on most environmental metrics. In addition to organic growth, Berry is using its acquisitions to import other company's environmental strategies. RPC is a prime example of this, the company's use of recycled material in its products sets it ahead of the competition.

The bottom line is that Berry's products do not currently have viable alternatives. The biggest threat to conventional plastic packaging is from innovating current design and materials to reduce waste, a movement that Berry is at the forefront of.

Catalysts for Share Price Increases

Berry is representative of a stable class of stocks: consumer non-cyclicals. From a macro perspective, it is a safe option to hold in the late stage of an economic cycle. When a recession occurs, cash flows are likely to be unhindered and, consequently, the share price should rebound quickly. Further to this, a post recession climate is favorable for acquisition strategies: opportunities for takeovers at a favorable price are more plentiful.

The debt thesis for Berry doesn't leave much room for abrupt share price catalysts. As the leverage ratio remains high, the market will continue to undervalue the stock. There is, however, room for reevaluation given a change in the market conditions. In a post-recession market, the uncertainty over Berry's solvency would be lessened. In line with our thesis, such a market should reassess concerns around Berry's leverage and, resultantly, we should see a stock price appreciation. For a value investor, this lack of a precise date for appreciation should not be a deterrent. The knowledge that Berry, a strong growth stock with high stability, currently sells at a discount should be enough.

Conclusion

Berry has proven itself to be a growth stock and in reasonable market conditions, its fundamentals indicate that this is set to continue. I believe a combination of high leverage and exposure to increasingly hostile public sentiment around its product, exacerbated by the fears of market cycle volatility, has led to a significant discount.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.