DS Smith contends with softening box volumes

It could be argued that the packaging sector acts as a lagging indicator for the economy. And it could also be argued that investors will get a better steer on the economy due to the growing preponderance of online retail. If true, half-year figures from DS Smith (SMDS) point to a deteriorating macro-economic environment with like-for-like box volumes down by 4.7 per cent.

Softening volumes were most noticeable in Northern Europe, where revenues were down by 17 per cent, although underlying profit benefitted from an increase in packaging pricing relative to input costs. This market segment accounts for 38 per cent of group revenue and has a greater weighting to industrial and e-commerce customers, so the general slowdown in the European economy has had a more pronounced impact on volumes. Management notes some positive signs on this score, most likely due to cessation of destocking in its customer base, although comparisons with the prior year interim report still come up short.

It was a mixed bag segmentally. Although packaging prices have proved more resilient than expected, a partial consequence of entrenched client relationships, aggregate packaging prices were down by around 9 per cent, “reflecting lower external paper, recyclate and energy sales”. However, the aggregate decline in pricing was offset by a reduction in raw material costs and improved efficiencies. It is not difficult to appreciate the impact of faltering demand along the supply chain – nobody is immune.

The packaging group had foreshadowed a fall-away in free cashflow due to one-off items, margin calls, and a net outflow of £79mn brought about by the reversal of prior cash collateralisation of energy hedges. DS Smith won’t be the last company to record an outflow on this basis given the likelihood of further volatile energy prices and heightened counterparty risk.

Jefferies expects EPS of 32.52p, falling to 30.42p in FY25.

In a sluggish market, return on average capital employed (ROACE) reduced by 40 basis points to 12.8 per cent against the previous half year. The general malaise is apparent as the group now trades well below its five-year average on a price-to-book basis. Yet, the structural drivers of the industry – “plastic replacement and changing retail formats” – remain in place. Realistically, investors will require patience as the consumer and/or industrial backdrop won’t improve markedly through 2024, but an expected recovery in corrugated volumes and an end to the destocking phase provide near-term encouragement. Buy on weakness.  

Last IC view: Buy, 321p, 08 Dec 2022