Rexam 18 Mar 10

Packaging King Recovers

The use of packaging may be a constant annoyance for environmentalists but it is also a necessity for many goods. Rexam is a leader in the packaging field with products most of us use on a regular basis. The group is in fact the world's second largest consumer packaging business and also a leading global beverage can maker. With a recent fundraising and a new CEO the group looks to be on the recovery path and we therefore recommend it as a buy.

Packaging businesses are generally fairly resilient to economic downturns as whatever goods are bought still need to be packaged. Thus although the sector suffers from volume drops it escapes to some extent the trading down among goods. The industry has also moved to reduce volumes and cut costs, which means that, when sales growth returns, profits and return on capital should rebound in the future.

As a manufacturing industry it should be noted that input costs including energy can have a major effect on profits. This is especially the case as long-term contracts often provide little pass-through flexibility. Packaging makers are also often dependent on the success of the businesses they supply relative to other firms.

Rexam's two divisions are beverage cans and plastic packaging. Beverage cans provided £310m of operating profits in 2009 while plastic packaging managed £130m. Unfortunately plastic packaging has been more affected than the global downturn that the group anticipated.

Looking at Rexam's recent history and the group has had to change course from its prior focus on growth and acquisitions. In typical "management speak" it is now looking to prioritise the "three C's" which are: costs, cash flow and return on capital. Such a change of direction might appear like a sketch from a Dilbert cartoon (a cartoon that mocks management dictums) but it is positive that a focus on these areas should lead to fast results.

Turning firstly to the balance sheet at the start of 2009 debt stood at £2.6bn. The grade of the debt was around BBB, which is only one grade short of junk status. Furthermore, first quarter de-stocking in Q1 2009 was followed by lower consumer demand in the next two quarters. Thus poor trading and a stretched debt position prompted the group to take action. If debt had been downgraded significantly then refinancing could of become prohibitively expensive.

Rexam's rights issue in August 2009 raised approximately £334m (the take-up was 95%) which was used to pay down debt. This has meant that combined with strong cash flow that debt has fallen from £2.6bn a the start of 2009 to £1.8bn which is a fall of £0.8bn. This is an impressive debt reduction but it should be noted that working capital needs in the next six months may see debt increase again.

Going forward sales look set to stabilise and the focus on costs and reducing debt should provide an earnings rebound when conditions improve. However, debt levels do remain high and as such clearly Rexam isn't a stock for the faint-hearted. However, cost cutting and a cash flow improvements should see the situation stabilise overtime.

Taking a look at the long term chart of Rexam we can see that the stock had been in a long term downward channel since 2007. The stock found a bottom in 2009 and has since managed to form an intermediate term uptrend which has broken the upper bound of the channel.

Looking more closely at the daily chart of REX we can see that the stock is still in an uptrend but is currently consolidating between 305p and 270p. The stock looks to be forming an ascending triangle which we expect to break to the upside.

Turning to full-year 2009 results and sales rose 5% while profits fell 4% on 2008 at £446m. This might appear to be a reasonable performance, however, the result was principally due to foreign exchange as the dollar and the euro strengthened against sterling.

Organic changes are quite different with this approach adjusting for acquisitions/disposals and the currency impact. Stripping out these external factors sales were actually down 7% and operating profits were down 17%. This is used just for illustrative purposes to see how the business performed with other factors held constant.

Moving towards the bottom line, finance costs rose to £162m from £139m with the net result being that profit before tax fell to £285m from £328m from a year before. EPS thus fell from 31.5p in 2008 (adjusted for the rights issue) to 25.4p in 2009. The pain for shareholders was felt with a dividend cut from 18.7p in 2008 to 8p for 2009.

The new CEO appointed in January is internal candidate Graham Chipchase. Mr Chipchase joined the group in February 2003 as Finance Director and therefore is very much a known quantity and hopefully a safe pair of hands. As well as financial experience at Rexam Mr Chipchase also served as Group Director of the Plastic Packaging division from October 2005.

Mr Chipchase is currently 47 and so could potentially serve the group as CEO for sometime to come. His corporate experience prior to Rexam came at the BOC Group where he became Group Controller in 1999 and Director of Planning and Financial Control the following year. He also served as finance director of the Aerospace Services business of GKN which he joined in 2001.

Encouragingly there are been some large director purchases of late with Mr Chipchase purchasing £140k of stock earlier this week. The finance director also bought £127k worth of shares at the same time. Mr Chipchase originally trained as an accountant and so hopefully he can bring his expertise to boost investment returns for the group.

Achieving higher returns on capital must be a strong focus for Rexam as the figures achieved have fallen from 15.6% in 2006 to just 9.5% in 2009. Clearly the current level is simply too low and unsustainable in the long-term as this isn't a sufficient return to attract capital. However, low returns for the industry might also be seen as a positive for the near future as it will encourage capacity to be reduced.

Rexam is playing its part with a major drive on efficiencies while also closing existing plants in Europe and North America where demand is weak. Efficiency savings in 2009 have been £42m with a variety of approaches achieving the savings including thinner cans and reduced scrap.

South America has been a relatively strong area for the group and business from emerging markets in general now accounts for 25% of total business. Thus plants are being closed in North America but opened in Latin America with some machinery even being taken between the two geographies. Performance in Russia has been weak and the group's move into that market looks poorly timed at best.

Looking forward the forthcoming world cup should see beverage cans sold at a rapid rate. Rexam recognises, though, that forward visibility will be weak and expects 2010 to remain a challenging year. However, our view is that Rexam is a strong recovery play with earnings and dividends set to increase from hereon in. The P/E for 2010 is about 11X and the yield is 4.1%.

Accordingly, we rate Rexam a buy to all members at 294p.


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