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DS Smith hits the big time

SHARE TIP: DS Smith (SMDS)
February 23, 2012

DS Smith has never had a problem finding businesses to buy. A string of acquisitions since the 1980s has turned the former cartons maker into a force in recycled packaging. None, however, can match the latest deal, which will not only transform Smith's fortunes but, quite likely, the wealth of its shareholders, too.

IC TIP: Buy at 167p
Tip style
Growth
Risk rating
High
Timescale
Long Term
Bull points
  • Benefits of SCA integration to come
  • Targets are too conservative
  • Potential for re-rating
  • Less cyclical as paper assets sold
Bear points
  • Integration risk
  • High raw material costs

The Berkshire-based company is paying €1.6bn (£1.4bn) for Swedish rival SCA Packaging, funded by debt and a £466m rights issue. Landmark deals like this don't come cheap, but it still looks a fair price – and it has the scale to propel Smith into the big league. With SCA, Smith becomes Europe's second-largest producer of corrugated sheet, more than doubling production and tripling collection capacity of recycled paper. It will also double group revenues to £4bn.

The deal won't be completed until June, but shareholders have backed it via the rights issue, and it's easy to see why. Management estimates annual cost savings from buying and operational efficiencies of €75m (£63m) within three years, plus €40m of working capital benefits. Too conservative, say City analysts, and they're probably right.

When Smith bought French corrugated packaging company Otor in 2010, it pencilled in savings of €9.3m a year by April 2014. Management now thinks it can find €13m by 2013. Admittedly, Otor was much smaller than SCA at just €247m, but it was good experience and, if management has undercooked forecasts again, earnings upgrades could follow over the next 12 to 18 months.

Analysts at investment bank Morgan Stanley have already increased their earnings estimates for the first full year of ownership (ie, 2013-14) by 28 per cent to 20.3p and by 42 per cent to 23.9p for 2014-15. They believe the outlook for profit margins is "overly pessimistic" as well. They think the share price discounts an operating margin of just 5.7 per cent, which looks stingy, given that the company is targeting margins of 7-9 per cent – a level that analysts think Smith can hit by 2014. And, if Smith can replicate its success with Otor at SCA, then a share price target of 273p is "not unrealistic". If the share price gets there, a place in the FTSE 100 index beckons.

DS SMITH (SMDS)

ORD PRICE:167pMARKET VALUE:£1.55bn
TOUCH:166-167p12-MONTH HIGH/LOW:196p112p
DIVIDEND YIELD:3.8%PE RATIO:11
NET ASSET VALUE:See textNET DEBT:See text

Year to 30 AprTurnover (£bn)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
20092.1117-2.13.0
20102.07556.73.2
20112.4710211.44.5
2012*2.0211812.85.8
2013*3.9119014.86.4
% change+94+61+16+10

Normal market size: 10,000

Matched bargain trading

Beta: 1.5

*Morgan Stanley forecasts (profits and earnings are not comparable with historic figures)

Reducing the company's exposure to cyclical products has also been key. Around 70 per cent of Smith's sales now come from supplying recycled corrugated packaging to makers of fast-moving consumer goods, for which demand is resilient. "People don't stop eating and drinking," explains chief executive Miles Roberts. And there's plenty of scope for increasing the contribution from food and drinks packaging at SCA, which currently stands at just 50 per cent of sales. Meanwhile, profits from paper making have fallen from 40 per cent of the total to less than 10 per cent in three years.

SCA will also introduce Smith to new markets, bringing access to Germany, Italy and the Netherlands, and high-growth markets in eastern Europe. This should please important customers such as Tesco, Reckitt Benckiser and Procter & Gamble – being within 150km of customers keeps transport costs low. That will trim the UK's proportion of sales from 51 per cent to 30 per cent, with most of the rest from continental Europe. SCA already has an 8 per cent share of a highly fragmented market, and Smith's bosses clearly think it can win share from competitors big and small.

Of course, there are risks. Passing on any further increase in raw material prices to customers is essential and, while regulatory approval of the SCA deal should be a formality, the task of integrating such a large acquisition won't be straightforward. Still, management has done it before and is savvy enough to make it work – it's worth noting that packaging industry analysts have just voted Mr Roberts their European chief executive of the year 2012.