Macfarlane ticks the right boxes

Having started out life as a commercial stationery company back in 1949, Macfarlane (MACF) has grown to become the UK’s leading protective packaging business. Largely operating in the business-to-business (B2B) market, the group serves a variety of customers – everyone from third-party logistics providers to aerospace and defence companies. While the UK currently accounts for the vast majority of revenue, Macfarlane also has a small but growing footprint in Continental Europe as it follows its customers into the region.

Readers of our Ideas Farm may have notices Macfarlane is a popular fund manager pick. Unicorn Asset Management is its seventh largest shareholder, and the Unicorn UK Growth Fund (GB0031217937) has Macfarlane as a top 10 holding.

"Macfarlane has grown its pre-tax profits in every one of the past 11 years, including 2020, delivering an impressive compound annual growth rate of 11 per cent,” says the fund’s co-manager Alex Game. “The outlook for the group remains strong as it is set to benefit from continued structural growth in e-commerce volumes and also cyclical recovery in the industrial, automotive and aerospace sectors."

Marlborough, meanwhile, is the group’s second largest shareholder, and holds Macfarlane in its UK Micro-Cap Growth (GB00B02TPH60) and Multi Cap Income (GB00B5L8VH15) funds. The manager of the latter, Sid Chand Lall, points to “an enviable client list that includes household names like Dunelm (DNLM) and Halfords (HFD) and larger global brands such as Johnson & Johnson (US:JNJ) and Thermo Fisher Scientific (US:TMO).”

Boxing clever

Almost 90 per cent of Macfarlane’s revenue and 97 per cent of its operating profit is generated by its packaging distribution business. The group leverages its scale to source protective packaging products at attractive prices from more than 1,000 global suppliers. It then adds value by advising on product choices and enabling customers to avoid ‘hidden costs’ such as those of damages and returns if their goods are not adequately shielded.  

The remainder of Macfarlane’s earnings come from its design and manufacturing operations, which provide bespoke packaging solutions to protect goods while in storage and transit, and also supply custom adhesive and resealable labels for ‘fast moving consumer goods’ (FMCG) customers. For example, Macfarlane makes the labels that appear on Carex soap bottles, as well as the resealable sticky labels on snack packets that allow you to close them back up and keep the food fresher for longer.

The design and manufacture division was squeezed in 2020 as higher demand for labels – particularly for hygiene products – was unable to offset weaker demand from aerospace and automotive customers. Revenue from the division dipped by just 1 per cent to £28m, but operating profit collapsed by almost two-thirds to £0.4m.

Over in the packaging distribution business, revenue ticked up by 3 per cent to £202m, as momentum in the more defensive e-commerce, household essentials and medical sectors offset pandemic pressures in automotive, aerospace and high street retail. The segment’s operating profit rose by 13 per cent to £14m.

A resilient pandemic performance saw Macfarlane as a whole post its 11th consecutive year of profit growth in 2020 and that streak looks set to continue. Headwinds for industrial clients should ease as the pandemic abates, and the group also benefits from structural growth drivers such as the accelerated shift towards online shopping.

Retail accounted for 28 per cent of Macfarlane’s packaging distribution sales in 2020 – up from 23 per cent a year earlier – and the majority of this was from e-commerce. Shore Capital analyst Robin Speakman says that e-commerce sales “went through a bit of a step-change last year and we don’t expect the same level of growth in 2021.” But he notes that this is a long-term trend and the relative immaturity of the internet retail market across the Channel “makes the European opportunity that much more attractive”.

Macfarlane is not in the Amazon (US:AMZN) end of the market where the focus is on bulk packaging, but the rise of e-commerce is likely to open up more business-to-consumer (B2C) facing opportunities for premium branded packaging. Macfarlane has been developing easy to open and visually appealing packaging to improve the ‘unboxing experience’ for customers, which Speakman views as “a significant differentiator”. He believes that “the box opening experience is becoming more and more important as part of the retail experience.”

Aside from e-commerce, rising regulation and an increased focus on climate change should also drive higher demand for sustainable packaging options. “ESG plays nicely to Macfarlane’s strengths, as the company is seen as a ‘solution’ by clients not a cost,” says Lall. “Over 80 per cent of its product families are recyclable and 70 per cent are made with some recycled content.”

Finding an edge

Packaging may not seem like an industry where you can develop a strong competitive edge, but Macfarlane does have some advantages over its rivals. With a market leading position and 25 distribution centres spread out across the UK, the group’s scale makes for more efficient operations than smaller competitors, and also means it can service national accounts.

Its custom design solutions also enable it to out manoeuvre more generalist distributors, and its product breadth and specialist knowledge have underpinned strong customer relationships. Operating as a single-source supplier, Macfarlane has amassed more than 20,000 clients in the UK, although it is not overly reliant on any of them – no single customer accounts for more than a tenth of its total revenue.

All goods require some form of protective packaging, so Macfarlane’s essential products and services enjoy recurring orders. This, along with a diverse customer base, should also help smooth out some of the cyclicality of its end markets.                      

Packaging is a fairly low-margin affair, although it does benefit from high volumes. Macfarlane’s gross margin expanded by 1.3 percentage points last year to 33.3 per cent thanks to lower raw materials prices and the shift towards higher margin e-commerce packaging. The operating margin increased by a more muted 0.2 percentage points to 6.2 per cent.

Raw material costs are expected to be higher this year which could prove a headwind, although some of this will eventually be passed through to customers. Macfarlane tries to limit the impact of cost increases on customers by redesigning and removing material from its products.

Still, the group’s margins have been steadily rising (see chart) and should continue to do so as it increases scale, ekes out more efficiencies from its supply and logistics network, and provides more value-added products to customers.

Acquisitions aplenty

The group finished 2020 with just £0.5m of net debt (excluding lease liabilities), down from £13m a year earlier. It also reduced its pension deficit by more than three-quarters to £1.5m, and annual scheme contributions through to April 2024 are set to fall from £3.1m to £1.3m. This should provide a further boost to cash flows, with cash generated from operations rising by 14 per cent last year to £26m.

The balance sheet should therefore enable Macfarlane to continue consolidating its fragmented markets through a disciplined ‘buy and build’ acquisitions strategy.

“Macfarlane’s M&A strategy is a carefully executed one, with a longstanding discipline of not overpaying,” says Lall. “The company selects small businesses with capabilities and clients that may be overlooked by larger peers such as Bunzl (BNZL).”

Macfarlane aims to make at least two “good quality” additions per year, and it has made 14 bolt-on acquisitions since 2014. This includes two recent purchases that have expanded its footprint in south west England. The group bought protecting packaging manufacturer GWP for a maximum consideration of £15m in March – a £10m upfront payment and a £5m earnout based on certain profit targets – while Cornwall-based Carters Packaging was acquired for a maximum consideration of £4.5m at the beginning of this month.

Macfarlane has used dilutive placings in the past to fund acquisitions – it raised just under £17m through three placings in 2014, 2016 and 2017, although these equity raises were conducted at higher prices each time (37.5p, 58p and 66p), at a modest discount to the prevailing share price, and were oversubscribed. At the last share sale in 2017, the group secured £8m via a placing at just a 1 per cent discount to its share price.

The GWP and Carters acquisitions were funded through a £30m debt facility which has been extended through to the end of 2025, and both purchases prompted analysts to nudge up their forecasts.

Brokers suspended their forecasts amid pandemic uncertainty last May (see chart) and introduced a lower set of numbers in August. But they have been getting more bullish on Macfarlane’s prospects, since increasing their expectations. More acquisitions are likely to come, and Speakman says that “the opportunity for continued upgrades is very strong”. The pandemic may well throw up M&A opportunities at more attractive valuations as smaller rivals come under pressure.

A potential bargain?

At 110p, Macfarlane’s shares have recovered to within touching distance of their pre-pandemic levels, hovering around a 52-week high. But they are not overly expensive, currently trading at just 12 times consensus 2022 earnings, cheaper than the forward P/E ratios of larger packaging peers DS Smith (SMDS), Mondi (MNDI) and Smurfit Kappa (SKG) (see table).

Although there is still uncertainty regarding the pandemic, Macfarlane nonetheless expects that 2021 will be “a year of progress” as it picks up more acquisitions, increases the penetration of new products and further improves its operational efficiency. Shore Capital has set a price target of 138p and Speakman is “very confident that it’s going to hit that target in due course and move forward way, way beyond that”.

Macfarlane has proved its resilience during tumultuous conditions, but beyond this crisis, it offers investors an attractive long-term growth story underpinned by structural tailwinds, the scope for margin improvement and further expansion opportunities.

Last IC View: Hold, 92p, 27 Aug 2020