Huhtamäki – A food packaging company

+ Large player in food packaging niche, riding on global tailwind of “on-the-go” food and drinks.

+ Good track-record of growth through acquisitions.

+ Exposed to emerging markets, where the competition is more fragmented and expectation is for significant growth.

+ Food packaging is a sensitive product in terms of food safety. This creates a moat for a companies like Huhtamäki compared to smaller competitors. This also explains why many of the worlds largest food producers is a customers to Huhtamäki.

– Currently trading at fairly high multiples. Valuation demands continued growth with at least stable profit margins.

– Capex heavy business, a lot of capital is needed to scale the business and keep a high growth rate.

– Pulp prices have been rising, at the same time consumer staples companies are facing headwinds. Short-term some questions around companies pricing power, might be squeezed in both ends.

– Some countries, like UK, are fighting back against the trend of increased usage of disposable food containers. Threatening to ban or put taxes on usage of for example disposable paper cups.

Background and history

Huhtamäki is a Finish global food packaging company. It started out in 1920 in Finland and has through organic growth and a long line of acquisitions grown into a global player. Some 5-6 years ago the decision was taken to focus on becoming the global leader in food packaging and consequently started to dispose of business units which were not in line with that agenda. The company has some 17 000 employees worldwide. It’s Indian unit (owned to 66%) Huhtamaki PPL is listed in India with a MCAP of about 300m EUR, compared to Huhtamäki’s 3.7bn EUR.

The business is today divided in the following segments:

Foodservice business operates across Europe, Asia and Oceania. Foodservice paper and plastic disposable tableware, such as cups, is supplied to foodservice operators, fast food restaurants and coffee shops. Other examples are plates and bowls, cutlery, and takeout packaging.

North America packaging for consumer products and foodservice. Examples of products are Chinet (No. 1 premium brand) disposable tableware, as well as ice cream containers and other consumer goods packaging products.

Flexible packaging used for a wide range of consumer products including food, pet food, hygiene and health care products. The segment serves global markets from production units in Europe, Middle East, Asia and South America.

Fiber packaging business protects fresh produce through the global food chain. Manufacture egg cartons and trays, fruit trays and cup carriers in Europe, Oceania, Africa, and South America.

Acquisition driven growth

Although some divestments have also been made over the years, much of Huhtamäki’s growth (about half) comes from acquisitions. The acquisitions have been funded by free cash flow and debt, where Net Debt to EBITDA moved up from around 1.6 in 2013 to 1.8 in 2017. The divestments have mostly been made to focus the business on the food packaging area. The largest sale was in 2014, when the Films business was sold for 141m EUR, which meant a drop of 187m EUR of annual net sales. The proceeds were used for a larger investment in India (Positive Packaging) for 284m EUR.

List of acquisitions

In later years the acquisition multiples have gone up, as stated by Huhtamäki themselves. This means less low hanging fruit where acquisitions made at low multiples give a direct positive effect for the Group. The company has therefor the last years focused more on organic growth, which can be seen in capital expenditure for 2016 and 2017.

Business Outlook discussion

Packaging products is a local business

An important factor to understand is that most types of food packaging products is a local business. Why is that? Basically because its a low margin product that takes up a lot volume, both on the sourcing side (pulp/plastics) and the final product. If we take the example of paper cups. Starbucks could have a supplier/producer of paper cups in China, which has a oversupply of paper cups. It still doesn’t make economical sense to ship those cups over to America, where they might have a deficit in supply vs demand. So when companies grow in different markets, they need to engage a local player to provide the paper cups we drink our coffee from. In my view this is one of the stronger reasons to buy Huhtamäki long-term. With its strong global position and already strong ties to many global players in their home markets, it’s easier to be a partner to these companies and grow with them as they enter new markets, as for example in India.

On-the-go and home delivery services

There are several global trends together creating a larger need for food and drink take-away and on-the-go services. One is the general urbanization, big city people tend to eat take-out to a larger degree. Another is the specialization of people. This is especially noticeable in Asia, where its common that highly educated people, barely know how to cook food. And even if you do, there is cheap easily available take-away options, that many use daily. A more recent trend is restaurants gaining sales through food delivery services. A lot of money has been poured into food delivery start-ups and their services seem to be building momentum. Although a bit out-dated (from 2016) Euromonitor shared their analysis of  home delivery services outlook (Food delivery race heats up)

TOTAL FOODSERVICE VALUE OF HOME DELIVERY: CURRENT MARKET SIZES VS FORECAST GROWTH

The sustainability trend

As part of the concerns for the global environment and sustainability, the pursuit of more environmental-friendly packaging is a strong trend. For larger companies it has become essential to show a willingness to “go green”, even though it even sometimes means inferior products for the customers. An example of that is Dunkin’ Donuts in the US, which I myself visited recently. Their Styrofoam cups are an excellent product, keeping cool although you have a very hot liquid inside. Nevertheless, foam cups is not perceived as sustainable and will be replaced with paper cups: Dunkin’ Donuts to have all paper coffee cups by 2020.  Another out-cry to more responsible use of packaging came from UK, where threats have been made for a ban on even paper based cups: MPs demand 25p tax on ‘disposable’ coffee cups and threaten a BAN if it doesn’t cut waste. As can be seen from Huhtamäki news, they are working hard on coming up with solutions to improve not just the products, but recycling solutions: Environment Minister launches pioneering Gosport paper cup recycling scheme (with Huhtamäki). From what I can gather Huhtamäki has come quite far in the field of sustainable solutions (another example: GreeNest egg packaging).

Although there are several providers of paper cups in USA, the kind of changes Dunkin’ Donut and many other companies are pursuing should be a tailwind for Huhtamäki’s sales. Since Huhtamäki’s product range is much more geared towards paper based “environmental friendly” solutions.

Emerging Markets – the source of growth

Although developed countries will probably keep a steady demand in food packaging products, the next frontier is really the Emerging Markets. Again as many of my other Asia inspired investment, this becomes a play on a rising middle-class that consumes all these packaged products. As an example, looking at the business plans of companies like Starbucks and Costa Coffe, they have major plans for growth in the EMs. Huhtamäki grows with it’s customers in the EM space is where the potential for double digit growth exist. In the case of India it’s more related to flexible food packaging growing with companies as Unilever as they expand in India (Doubling India business in 7-10 years no-brainer for Unilever).

Current business and segment analysis

Huhtamäki has a high reliance on the US market, which also means that a weakening USD vs the Euro creates a currency headwind (as has been the case lately). In the graph below it’s also easy to see which markets has produced the largest revenue growths historically. Germany sales dropped in 2014 due to the sale of the Films business.

Looking into the different segments it gives us the following breakdown of sales, EBIT and consequently EBIT margin.

Usually at this stage I would start to make projections of Sales for the coming years and even more importantly margin projections. Sales is somewhat easier, it’s to a large degree dependent on investments. That has for the last years been high, meaning we can expect some 4-6% sales growth. On top of that you can add either some tail or headwinds, which would bring the top-line figures in a bit better, or a bit worse. Regarding margins though, I have very much struggled to come up with information that has given me clear indications what the potential improvements or pitfalls would be for the different segments. Therefor I have ended up looking at competitors and what kind of margins they have been able to achieve.

Competitor Margins

Given these competitors and their margins, one could either draw the conclusion that Huhtamäki is a mis-managed company for not being able to reach the same type of margins. Or one could be up-beat that there is room for margin improvements rather than downside risk to the margins. Without a much deeper analysis its hard to draw conclusions from these type of comparisons. All these companies have a different range of products they supply, in different markets. Looking at Huhtamäki’s listed entity in India, the EBIT margins there are even lower at around 6%. Given that Huhtamäki has a larger proportion of sales in EM, compared to the competitors, this might explain partly the lower EBIT margins. On the flip-side this EM exposure means a greater potential for future growth.

Valuation

Free cash flow assumptions:

• WACC = 7%
• Tax rate= 21%
• Reinvestments = 55% of revenue growth
• Net Debt + Leasing obligations = 796m EUR

Revenue and Margin Assumptions

The companies own long-term ambitions are: Growth of 5-7% of Sales, this would be in-line with the Bull case. EBIT margin of 9-12%, which would be somewhere in-between the Base/Bull case.

I assign a 25% probability to the Bear and Bull cases, and a 50% probability to the Base case.

Bear Target: 16.7 EUR

Base Target: 34.2 EUR

Bull Target: 46.3 EUR

This gives me a probability weighted target price of 33 EUR per share, compared to the latest traded price of 34.87 EUR per share.

Two reason for the fairly large disparity in target prices is the companies debt level, as well as the large impact from changing profit margins.

Conclusions

One reason why this analysis has taken so long to finalize is that I have battled a bit with myself when I realized that the numbers a telling a different story than how I feel about this case. I think the company is in a really good niche, riding on the back of giants like Unilever, as they break new ground in Emerging Markets. Huhtamäki is in many cases there as a partner for them, creating their product packaging. At the same time the numbers are telling a story of a stock that is more or less fully valued. The major upside I could see is if Huhtamäki would be able to significantly increase its operating margins, but even then upside is barely good enough. I need to believe in my bull case, with significant growth, between 7-5% in the coming years and a lift in profit margins in line with competitors, then Huhtamäki would be strong buy. At this point I think that is possible, but not my base scenario, which leaves me more hesitant.

Huhtamäki is one of my largest holdings currently and this does not make sense when I see limited upside. I’m also not willing to sell my full holding, as I still see this as a strong case for the food packaging niche long term, especially in the Emerging Markets. I have decided to better at taking the long term view with my investments, so that Huhtamäki is close to my target price should not warrant a total sell. I’m fairly bearish on equity markets and the global economic cycle currently, Huhtamäki is not a cyclical company and I do see good tailwinds. It might not have massive upside, but my WACC of 7%, means I’m accumulating about 8% return on my investment, which is still decent. Therefor I just reduce my holding with 50% as of Friday close. I hope I could buy back those shares at a future pullback if such an opportunity would arise.

Much more can be said about the future for packaging in general, for the interested reader this report gave some insights: Future of packaging.