A number of corporate success stories emerged during the first Covid lockdown, but many proved to have unhappy endings. As we were puffing away on our Pelotons and dialling into Zoom meetings, company valuations were in some cases only temporarily elevated. It is tempting to view packaging company Macfarlane (MACF) through this lens. It benefited from the online spending boom, only for its share price to drop as physical shops reopened. However, Jupiter fund manager Matt Cable believes the company is worth a second look.
The UK packaging industry is dominated by three FTSE 100 companies: DS Smith (SMDS), Mondi (MNDI) and Smurfit Kappa (SKG). Macfarlane, with its market cap of £165mn, is small fry in comparison. This has important implications. Analysts often focus on the benefits of scale when it comes to packaging, and are drawn to companies with global footprints and resilient supply chains. However, it is worth keeping in mind that 90 per cent of Macfarlane’s sales come from distributing boxes, rather than making them.
“The particular part of the market that Macfarlane has gone after – over a very long period of time – is the bit it describes as value-added distribution,” explained Cable, who co-manages the Rights & Issues Investment Trust.
The UK packaging market is worth roughly £5bn a year, according to Cable, of which £4bn is a direct market. “This is the Smurfit Kappas and DS Smiths of the world selling boxes to the likes of Amazon. It’s all about the same bit of product. Everything’s generic and the lowest cost possible.”
However, about £1bn of the market goes through distributors. “Macfarlane supplies getting on for a quarter of that £1bn distributed market. So they really are the big players now, which means that they've got significant scale," said Cable. “They have national coverage. If you’re a big customer, they can supply you anywhere you need to be.”
Macfarlane focuses on the fiddly bits of the market where packaging is causing problems for its clients. The box might need to look beautiful, for example, or house awkwardly-shaped goods, or keep a multitude of components in the right place.
Attractive track record
Macfarlane clearly provides a useful service. Over the past decade, it has more than doubled its sales, while its operating profit has almost quadrupled as a result of organic progress and bolt-on acquisitions. Even against what the company called the “challenging” backdrop of 2022, it achieved organic sales growth and managed to increase its operating profit by 7 per cent.
That’s not to say it isn’t being affected by the ecommerce slowdown: retail accounted for just 26 per cent of distribution sales in 2022, compared with 30 per cent in 2021, and management flagged a “marked slowdown in spend from the ecommerce sector”. This is a concern, given that some of the group’s biggest relationships are with companies such as home furnishings retailer Dunelm (DNLM) and ready-meal delivery group Parsley Box, according to FactSet.
Near-term pressures remain intense, and management warned that 2023 will be “another challenging year with uncertainty over the impact of the increase in the cost of living on customer demand, rising operating costs… and increasing interest costs”. House broker Shore Capital added at the time of full-year results in February that it would “err on the side of caution” when forecasting for 2023. However, it still expects the group to achieve organic revenue growth of 3 per cent, and for adjusted profit before tax to creep up by the same amount. Macfarlane can always fall back on its bigger and more diverse industrials client base, which spans everything from aerospace and defence to science and medicine.
In the longer term, as the cost of living crunch eases, Shore Capital said ecommerce should be a “long-term growth market reflecting underlying secular trends”. This is supported by figures from the Office for National Statistics, which show that online shopping is still more popular than before the pandemic, despite recent declines.
Obstacles and opportunities
On top of concerns about demand for packaging comes the issue of cost increases. So far, though, the group’s margins have proved remarkably resilient. Cable stressed that – unlike the big cardboard and plastic manufacturers – Macfarlane’s distribution division “doesn’t take direct exposure to raw material inflation”, and its gross margin has held relatively firm at 32.1 per cent last year. Nevertheless, management is likely to be pleased that polymer and paper prices have finally started to soften this year.
Operating expenses are more of a worry for Macfarlane – particularly employee costs, which account for more than half of group overheads and represented 12.4 per cent of sales in 2022. However, operating margins were steady at 7.6 per cent last year, and remained significantly higher than the group’s pre-pandemic margin of 6.1 per cent.
This is testament to Macfarlane’s leadership team. “It is a very well-run business, with a very established management team,” said Cable. Chief executive Peter Atkinson has led the company for 20 years, while finance director Ivor Gray first joined the company in 1996, just six years out of university. “They run a very conservative balance sheet and have a very strong track record of delivering against strategy.”
Cost pressures could also usher in some opportunities. “If you think about a customer who’s using a lot of packaging, it’s only when you get the inflections in inflation that they start to really feel the pain,” said Cable. “And that’s where they might come to Macfarlane and say ‘we need to do something about the volume of material in the product’.” Macfarlane – with its innovation centre in Milton Keynes – is good at coming up with solutions.
Cable makes a similar argument about sustainability, which casts a long shadow over packaging companies (Macfarlane is split 70/30 towards paper relative to polymers, but Cable said the direction of travel is “only one way”).
“One of the biggest ways that you can improve the sustainability characteristics of a product is to make the whole supply chain more sustainable. Can you take physical product out of the packaging, make it lighter, pack it more densely so that you need fewer trucks? These are solutions they can apply.”
If customers start ordering lower volumes of cardboard or plastic, therefore, it doesn’t necessarily mean they will be spending less. Indeed, they may be willing to spend more on clever boxes in order to save money further down the line. This argument has been echoed elsewhere in the sector. DS Smith recently told analysts that “box profitability is higher versus five-10 years ago, with packaging no longer just a simple brown box, and customer relationships in many cases are changing to focus more on service levels, supply chain cost savings & innovation”.
The government’s new plastic packaging tax – which applies to companies manufacturing or importing more than 10 tonnes of plastic packaging a year and focuses on packaging containing less than 30 per cent recycled plastic – is likely to accelerate the transition to cardboard. However, given that Macfarlane is principally a distributor, it shouldn't be at the sharp end of this shift. “This is not about having to put big plants down and spend large amounts of capital,” said Cable.
Cash considerations
Indeed, Macfarlane is typically very good at generating free cash for its shareholders, and annual capital expenditure has averaged less than £2mn for the past six years (for context, DS Smith spent £431mn on capex in its 2022 financial year).
However, as economic conditions remain difficult, it is worth keeping an eye on how well Macfarlane is turning profit into actual money.
Cash generated from operations dropped in 2022 after the group tackled a sizeable lump of trade payables. Meanwhile, management warned that bad debt write-offs in 2022 increased from 2021, albeit from a low level, and said that current economic conditions increase the risk of more (at the end of 2022, the group retained an estimated credit loss allowance held against trade receivables of £795,000, compared with £731,000 in 2021).
“It's unfortunate, but it does come with the territory,” said Cable, noting the group’s exposure to some smaller ecommerce-only businesses.
Aged stock over six months old also increased in 2022 due to a slowdown in demand, and this has coincided with an increase in net debt and the company’s interest rates, which sat at 5.25 per cent in December 2022 and are expected to climb higher this year.
Such pressures will hopefully be offset by continued growth, however – particularly from Macfarlane’s lesser-known manufacturing arm. This is still a modest part of the business at the moment, but it is growing its profits quickly, and the group has just bought a Cambridgeshire-based manufacturing business to cement its presence. While small manufacturers face challenges around economies of scale, Macfarlane focuses on bespoke packaging solutions for which customers pay significantly more. Turbine blades for a jet engine, for example, require more than a standard cardboard box.
The group has also started a tentative move into Europe, making its first acquisition in Germany last year, which Cable hopes will provide a “nice growth runway”.
Far from petering out with the rest of the lockdown winners, therefore, Macfarlane looks to be in excellent health, and its forward price/earnings ratio of 8.9 suggests it’s cheaper than it has been for a while. Short-term demand is likely to be the big decider, but Macfarlane certainly ticks a lot of the right boxes.
