Shares in Mpac (MPAC:125p), a small-cap niche packaging engineering business and a constituent of my 2018 Bargain Shares portfolio, slumped below my 156p entry level after the company warned on profits in the summer (‘Investors overreact to Mpac cost overrun’, 18 July 2018). The problems relate to cost over-runs on two technically challenging legacy contracts, one of which is a UK-based project to deliver a first-of-a-kind healthcare production device. The second is a Canada-based project which hit issues in the commissioning stage in relation to the robustness of the packaging line and product variability.
The good news is that the £1m hit to Mpac’s underlying operating profits which resulted in the company breaking even on sales of £28m in the first half has been contained. Moreover, following a detailed review of all other contracts in the order book, chief executive Tony Steels says that it is of “a higher quality and lower project complexity than previously as a result of the strategic objectives being put in place”.
He also points out that although order intake was down a fifth in the first half, reflecting some customers deferring investment decisions due to economic uncertainty, the closing order book was at the same level as a year ago. Analysts Paul Hill and Hannah Crowe at Equity Development believe that Mpac has 90 per cent cover to achieve their full-year revenue and operating profit estimates of £57m and £1.5m, respectively, helped in part by headcount reductions post the half year-end. Finance director Will Wilkins informed me that annualised costs of £1.2m have been taken out of the business. Analyst Sanjay Jha at broker Panmure Gordon has similar forecasts based on second half operating margins improving to 5 per cent on a similar level of first half sales. That outcome would still represent 15 per cent operating profit growth year on year.
Furthermore, Mr Steels revealed to me that a major contract his company has just been awarded will account for between a quarter and a third of next year’s revenue estimates of £60m, highlighting that the business is still winning new business and supporting the long-term growth story. Underlying growth drivers for the high-speed cutting-edge packaging machinery and equipment that Mpac supplies to customers operating in the pharmaceutical, healthcare, nutrition and beverage industries – these end markets are expanding at 5 per cent a year – include a trend towards urbanisation, convenience and health awareness. Mpac’s core clients include multinationals Nestlé, GlaxoSmithKline, AstraZeneca, Unilever, Diageo, and Ferrero.
I would flag up that although net funds on Mpac’s balance sheet contracted from £29.4m to £24.9m in the first half, around £2.4m of that decrease reflected increased inventory levels which should be largely reversed by the year-end. Based on 20.17m shares in issue, Mpac’s market value is fully backed by that cash pile and is less than half tangible net asset value of £51m, so effectively nil value is being attributed to what is still a profitable business. Analysts are maintaining forecasts for 2019 and with good reason. Mr Steels says the company’s order book for delivery next year now stretches out to the autumn of 2019 which is reassuring.
This suggests that operating profits could double to £3m on 2019 revenues of £60m based on a 5 per cent profit margin to produce adjusted EPS in the range 12.1p to 13.5p. Sentiment may have been hit hard after the summer warning, but if the company delivers on full-year expectations then I would expect the share price to recover all the paper losses and move back into positive territory as investors start to warm to the long-term growth story once again. A decision on a residential planning application for non-core land and investment property in Market Risborough, Buckinghamshire is expected early next year too, the potential investment upside from which is not in the price either.
I would point out that Mpac has a pension surplus of £35m on its UK scheme and a deficit of £5.8m on the US scheme, an improvement on last year which reflects higher bond yields on corporate AA rated debt. Mpac still makes annual payments of £1.9m to the employee pension schemes as the actuarial assumptions used in the triennial review are far more conservative (gilt yields of around 1.5 per cent are used whereas the aforementioned UK corporate bonds yield is 2.6 per cent and those in the US around 4 per cent). The combined assets of both schemes are around £426m so minor changes in bond yields have a major impact on the pension surplus or deficit. I have taken this factor into account when making my buy recommendation. Offering 80 per cent upside to my 12-month target price of 225p, I rate Mpac’s shares a buy.
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