Berry Global Stock: 31% IRR Likely Over Next Five Years (NYSE:BERY)

The following segment was excerpted from this fund letter.

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Berry Global Group, Inc. (NYSE:BERY)

Berry Global is the largest rigid and flexible plastic and nonwovens packaging firm serving home, health and personal care, and food and beverage customers located in the United States, Europe, and emerging markets. BERY is part of Bonhoeffer’s consolidation theme and has characteristics of a public LBO. BERY is the Rodney Dangerfield of plastic packaging firms in that they have reduced debt to peer levels and the valuation of 7.3x earnings has not rerated to peer levels of 13-14x earnings. Over time, as BERY repurchases shares, the rerating should accelerate.

BERY is consolidating the plastic and nonwoven packaging industry in the US, European, and emerging markets. BERY has historically been the low-cost producer of the packaging market. In 2019, BERY made its largest acquisition-RPC, a European-centered competitor whose focus was more on the custom portion of the packaging market-for $3.5 billion. BERY financed the acquisition with debt which increased BERY’s Debt/EBITDA to close to 5.3x. RPC increased BERY’s footprint in Europe, as well as in the emerging markets. BERY generates 50% of its revenue from the US and Canada, 35% from Europe, and 15% from emerging markets.

The plastic packaging market is still very fragmented. Currently, BERY has a global market share of 4% of the global rigid plastic packaging and flexible plastic packaging market. About 53% of BERY’s sales are from rigid packaging and 47% are from flexible packaging. The top four market participants have only 20% of the flexible packaging plastics market and 24% of the rigid packaging plastics market. BERY has historically realized 5% synergistic cost savings from its acquisitions. Historically, BERY’s leverage has been a restraint on acquisitions, but with the leverage levels below 3.8x, BERY now has the capacity to incur debt to finance acquisitions. However, higher recent interest rates will increase the IRR that any acquisition will have to exceed before it is viable. Thus, share repurchases given the modest valuation and dividends make sense in the absence of any accretive acquisition opportunities.

Given BERY’s large size, BERY receives a greater discount on its primary cost of goods sold supply- resin-than its competitors. Resin is about 50% of the final price by BERY’s cost of goods sold or about 42% of sales. About 70% by volume of BERY’s customer contracts have resin “pass through” pricing provisions.

Historically, BERY has operated with higher levels of debt than its competitors. When BERY was owned by Apollo, its debt level was as high as 7.0x EBITDA. The higher level of debt has led to BERY’s equity trading at a discount to its peers. BERY has reduced its debt by $3.0 billion since its acquisition of RPC in 2019, resulting in a debt/EBITDA to 3.8x by FYE 2022. With a debt level below 3.8x, BERY has begun returning cash flows to shareholders via buybacks (10% of shares outstanding in FY 2022), dividends, and further reducing debt.

BERY’s remaining debt stack includes $8.1 billion of fixed-rate or swapped-rate debt with a weighted average rate of 4.6% and $1.2 billion of floating rate debt at LIBOR+1.75%. Interest rate expense will increase by $3 million dollars for each 0.25% increase in LIBOR. So the sensitivity to rising rates is nominal.

Packaging is used in most consumer and health care/medical products. Packaging is typically 5-10% of total product costs. Packaging is designed into most products, so once an initial decision is made on a packaging provider, the retention rate is high for a given product. Given the stability and long-term growth of consumer and health care/medical products, cash flows from these customers are stable. Thus, a firm like BERY, with large exposure to food and beverage and medical/healthcare products customers (65% of sales), also has steady cash flows.

BERY’s customer base is very diverse, as the largest customer is less than 5% of sales and the top 10 represent 15% of revenues. Most customers are repeat customers, with 85% and higher customer renewal rates. This is due to:

1. the design-in of packaging in specific consumer/healthcare products, and ,
2. the multi-national nature of customers, where changing vendors can be expensive and time consuming due to the different regulations across countries.

The more custom vendors have more stickiness than low-cost vendors like BERY due to custom molds for packaging and the specialized services provided. Most customers like to have multiple vendors to reduce dependence upon one packaging vendor. Thus, when acquisitions occur, some customer volume is reduced to ensure vendor diversity. BERY’s largest customers include food and beverage (30%) and home, health, pharmaceutical, and personal care products (35%); specialties and distribution make up the remainder.

BERY’s capital allocation strategy includes:

1. reinvesting for organic growth (4-5% of sales),
2. pay down of debt to a 3.9x Debt/EBITDA level (which has already been achieved),
3. share repurchases (estimated to be 10% of shares outstanding next year),
4. dividends ($1.00 per share),
5. divestitures, and,
6. acquisition with IRRs well above BERY’s current WACC.

Historically, BERY has generated 3-4% per year organic growth, 2-3% per year in mergers and acquisitions, and recently 5% per year from repurchases, for a total growth rate of 15-17% assuming flat margins. For 2023, management expects 34% organic growth, 8-10% growth from common share repurchases, and 2% from dividends, for a total return of 13-16% assuming flat margins.

BERY missed FY 2022 EBITDA targets due to:

1. not being able to pass all of the inflationary costs through to their cost-conscious customers,
2. the strong US dollar, and,
3. the reduced demand for health care products post-COVID.

Inflation should subside, as well as the US dollar weakening over the next 12 months. These are temporary issues and should be resolved over the next year, in addition to paying back more debt and buying back more stock.

Despite these challenges, BERY was able to generate a return on equity in the mid 20%s. BERY has generated mid 20%s or higher returns on equity over the past five years and thus continues to be an interesting investment. In FY 2022, BERY was also able to increase sales by 10%, with an EPS increase of 7%.

Plastic and Nonwoven Packaging Business

Packaging represents between 5-10% of consumer product cost. According to Vision Research, the size of the global rigid plastic packaging market was estimated to be $182 million in 2021 and was predicted to grow to $275 million by 2030-a 5.5% CAGR. According to MarketsandMarkets, the size of the flexible global plastic packaging market was estimated to be $161 million in 2020 and was predicted to grow to $201 million by 2025-a 4.5% CAGR. BERY has about a 4% market share of both the rigid and flexible plastic packaging market.

There are five types of commercial packaging/containers: flexible plastic, rigid plastic, paper and board, glass, and metal. Plastics represents 37% of all packaging and is expected to represent 40% by 2025. Thus, the expected organic growth rates of flexible plastic packaging (4.7% per year) and rigid (3.1% per year) were higher than the expected growth rates for other materials such as paper and board (2.6% per year), glass (2.1% per year), or glass (1.4% per year).

The largest firms in the plastic packaging business include Amcor plc (AMCR, $13.9 billion revenue), BERY ($13.2 billion), AptarGroup (ATR, $3.2 million), Pactiv Evergreen (PTVE, $5.4 billion), Silgan (SLGN, $5.5 billion), Sealed Air (SEE, $5.3 billion), and Sonoco Products (SON, $5.5 billion). BERY is positioned as the low-cost competitor using standardized components to reduce costs versus shorter-run customized competitors like Amcor.

One ESG-related issue with plastics is the mistaken view that plastics are environmentally harmful versus other packaging options. Plastics use less energy than other packaging solutions and are one of the most environmentally friendly packaging options. Plastic recycling improves the friendliness of plastics, and this is being implemented by all of the plastic packaging companies, including BERY.

A large portion of BERY’s sales (35%) are in the faster-growing segments of the medical supplies and emerging markets. Emerging markets also can be less competitive. For example, BERY has a dominant position in Brazil, where they are one of two competitors that can provided packaging solutions to consumer products firms.

Downside Protection

BERY is a cash-flowing business, using the cash flows to repay debt and return cash flows to shareholders via share repurchases and dividends. BERY is levered, but it has repaid over $3 billion in debt over the past three years from cash flows. BERY has publicly traded debt, which yields 6.2%, and is rated BBB. The debt is primarily fixed rate or swapped into fixed rate, and thus the effects of higher short-term interest rates are nominal ($3 million increased interest expense for each 0.25% increase in LIBOR).

The biggest risk is a decline in cash flows from lower revenues. The effects of reduced post-COVID product demand are already reflected in FY 2022 results, and these should resume growth in FY 2023. Given BERY’s large exposure to Europe, foreign exchange has adversely affected FY 2022 results. This should reverse in FY 2023 if US interest rates decline or go up by less than last year.

The analyst’s projection for BERY is as follows:

9/30/16 A		9/30/17 A	9/30/18 A	9/30/19 A	9/30/20 A	9/30/21 A	9/30/22 A	9/30/23 E	9/30/24 E	9/30/25 E	9/30/26 E	9/30/27 E	CAGR
Revenue 6,489.00		7,095.00	7,869.00	8,878.00	11,709.00	13,850.00	14,495.00	13,840.04	14,175.95	13,902.82	14,045.00	16,183.00	2.23%
% Change YoY	32.90%	9.30%	10.90%	12.80%	31.90%	18.30%	4.70%	-4.50%	2.40%	-1.90%	1.00%	15.20%
EBITDA	1,223.00	1,327.00	1,380.00	1,530.00	2,157.00	2,224.00	2,101.00	2,093.46	2,183.98	2,217.68	2,285.00	2,541.00	3.88%
% Change YoY	49.10%	8.50%	4.00%	10.90%	41.00%	3.10%	-5.50%	-0.40%	4.30%	1.50%	3.00%	11.20%
% EBITDA Margins	18.80%	18.70%	17.50%	17.20%	18.40%	16.10%	14.50%	15.10%	15.40%	16.00%	16.30%	15.70%
Net Income Normalized	316.25	407.08	455.62	458.99	655.24	802.14	982.72	899.17	929.11	982.24	1,026.00	1181.359	3.75%
% Change YoY	112.60%	28.70%	11.90%	0.70%	42.80%	22.40%	22.50%	-8.50%	3.30%	5.70%	4.50%
% Net Income Margins	4.90%	5.70%	5.80%	5.20%	5.60%	5.80%	6.80%	6.50%	6.60%	7.10%	7.30%
EPS Normalized	2.48	3.07	3.37	3.41	4.85	5.8	7.4	7.52	8.31	9.09	9.08	10.45	7.05%
% Change YoY	105.80%	23.80%	9.80%	1.20%	42.20%	19.60%	27.60%	1.60%	10.50%	9.30%	-0.10%
Free Cash Flow	517	601	634	764	947	904		892.92	930.57	995.5	940
% Change YoY	13.10%	16.20%	5.50%	20.50%	24.00%	-4.50%			4.20%	7.00%	-5.60%
% Free Cash Flow Mar	8.00%	8.50%	8.10%	8.60%	8.10%	6.50%		6.50%	6.60%	7.20%	6.70%
Return on Equity (%)	302.56	66.19	40.61	26.47	30.13	15.22	29.64	28.19	26.45	29.4	18.21

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If these projections materialize, then management should be able to execute its business plan of debt paydown, share repurchases, and dividends.

Management and Incentives

Thomas Salmon, the CEO, has been in BERY’s management since 2003, heading various divisions of the company before becoming CEO in 2016. He was with BERY when it was privately owned by Apollo Global (APO) before BERY went public in 2012. He owns or has options on 1.8 million shares-or 1.5%-of the common stock. The CEO is required to own 5x his salary in BERY common stock and options, and his salary is 10% of his compensation. Other senior managers are required to own 3x their salary in BERY common stock or options, and their salaries are about 20% of total compensation.

BERY’s management incentives include short-term cash incentives 75% based upon adjusted EBITDA and 25% based upon FCF targets. The long-term stock-based incentives are based upon BERY’s relative total shareholder returns to peers and return on capital employed targets.

The major shareholders include a Canadian owner-operator investment manager, a high yield/distressed investor (Canyon Capital), and index funds.

Valuation

			Sensitivity Table
					Price	Upside
Current Adjusted Earnings	$7.40			$181.95	7.4
7-year Expected EPS Growth Rate	10%			0.0%	$ 54.17	0.0%
Historical EPS Growth Rate	30%			3.0%	$ 92.57	70.9%
Current AAA Bond Rate	5.1%		Growth Rate	5.0%	$ 118.11	118.0%
Implied Graham Multiplier*	24.59			7.0%	$ 143.65	165.2%
Implied Value	$181.95			10.0%	$ 181.95	235.9%
Current Price	$54.17			12.0%	$ 207.49	283.0%
* (2*Growth Rate + 8.5)*(4.4%/AAA bond rate)

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The key to the valuation of Berry is the expected growth rate. The current valuation implies no increase in earnings into perpetuity using the Graham formula ((8.5 + 2g)) with the conservative assumption that the AAA bond rate of 5.1% will continue over the long term. The historical 10-year earnings growth has been 30% per year including acquisitions and the current return on equity of 28%.

A bottom-up analysis based upon market growth rates of flexible and rigid plastic markets and a 50/50 split between rigid and flexible plastic results was used to estimate an organic growth rate of 4.0% to 5.0% for Berry. Over the past six years, BERY has grown sales by 14.3% per year, about 10% in excess of the market growth rate, primarily due to acquisitions.

Over the next five years, BERY has plans to increase share repurchases to about 8-10% per year, start a dividend of about 2% per year and using a realized organic growth of 1-2% per year resulting in a total return growth rate per year of 11-14% per year. This EPS growth rate (9-11%) is lower than the historical EPS growth rate of 30%, the 35% growth of operating margins with a doubling of revenues, and the current 28% return on equity with about an 85% customer retention rate. The resulting current multiple is 25x while BERY trades at an earnings multiple of 7.3x.

If we look at firms with similar growth prospects and debt levels, they have earnings multiples of 13 to 22x. If we apply 14x earnings to BERY’s FY 2022 earnings of $7.40, then we arrive at a value of $104 per share, which is a reasonable short-term target. If we use a 12% seven-year growth rate, then we arrive at a value of $207 per share. This results in a five-year IRR of 31%.

Growth Framework

Berry
				EPS Growth		9.3%
	2021	2022	2023	2024	2025	2026	2027	2028	2029		$ 54.15	4.37	5-yr fwd PE		7% growth PE
											14.6%	6.83	Earnings/FCF Yield		22.5
Revs	$13,850	$14,495	$13,827	$14,161	$13,945	$14,045	$16,183	$16,992	$17,842
		5%	-5%	2%	-2%	1%	5%	5%	5%			1-2% organic growth
												2% dividends
NI	$802	$983	$899	$929	$982	$1,026	$1,182	$1,241	$1,303			8-10% Repurchase		Inv Turn	$278.68
	5.8%	6.8%	6.5%	6.6%	7.0%	7.3%	7.3%	7.3%	7.3%			11-14% Total growth		IRR	39%
EPS	$5.94	$7.93	$7.98	$8.61	$9.49	$10.33	$12.39	$14.00	$15.88		$ –	130	$7,039.50
		33%	1%	8%	10%	9%	20%	13%	13%
Buyback														Debt Yield	5%
	135	124.0	112.7	107.9	103.5	99.4	95.4	88.7	82.1	##					9.6%
40%	5.83	11.34	4.79	4.37	4.13	3.91	6.76	6.62	6.52	##
	55	65	75	85	95	105	70	75	80	81

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Another way to look at growth and the valuation of companies is to estimate the future EPS of FCF/share five years into the future and see how much of today’s price incorporates this growth. In this framework, the assumption of 40% of net income will be used for share repurchases, and the remainder of the net income will be used for debt paydown and dividends.

Using the same revenue and operational leverage described above results in a 2027 EPS of $12.39, or 4.4x the current price. If we assume a steady-state growth rate from 2027 on of 7%, then this results in a fair value Graham multiple of 22.5x, or $279 per share higher than to the five-year forward valuation above of $207 per share.

Comparables

Below are the US and international firms engaged in the plastic packaging market.

Plastic Packaging Comps
					EBITA				Debt	Earnings –	Net Debt/	EBITDA
	Price	Book Value	Earnings	Inv Turns	Margin	RoE	P/E	P/BV	Interest Rate	Debt Yield	EBITDA	Int Coverage
Amcor	11.87	2.75	0.53	5.29	11.4%	19.3%	22.4	4.32	5.7%	-1.2%	2.8	12.95
Berry	54.17	25.73	7.4	6.54	10.6%	28.8%	7.3	2.11	6.2%	7.5%	3.8	7.36
Sealed Air	51.16	1.51	3.81	4.63	17.8%	252.3%	13.4	33.88	6.4%	1.0%	2.9	7.15
Silgan	51.71	15.36	3.61	6.65	14.2%	23.5%	14.3	3.37	6.0%	1.0%	3.9	7.54
Sonoco	60.47	19.78	4.41	7.23	11.9%	22.3%	13.7	3.06	5.6%	1.7%	2.7	12.29
Pactiv Evergreen	11.48	8.22	1.58	5.48	9.5%	19.2%	7.3	1.40	7.0%	6.8%	4.1	4.35

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Benchmarking

Compared to other plastic packaging firms, BERY has one of the highest inventory turns and lower margins, but higher returns on equity than most of the comparables. This is in line with BERY’s approach as the low-cost vendor. The low-cost position with higher throughput (inventory turns) allows BERY to generate one of the highest returns on equity amongst its peer group.

The EBITDA coverage ratio for BERY is in the midpoint of these comps and above more highly levered comparable Pactiv Evergreen. Despite the leverage more typical of the comps, BERY is valued like the more highly levered comparable Pactiv Evergreen and 7.3x earnings.

Potential Upside/Catalyst

The primary catalysts are:

• share repurchases of about 10% per year;
• paydown of debt;
• recovery in sales from COVID-induced decline;
• reversal or stabilization of US dollar exchange rate vs. Euro; and
• further consolidation of the global plastic packaging industry.

Timeline/Investment Horizon

The short-term target is $104 per share, which is 93% higher than today’s stock price. If BERY can generate a 7-10% growth rate over the next five years and the valuation of BERY rerates to reflect a longer-term growth rate of 7%, then a value of $207 per share could be realized. This is a 31% IRR over the next five years.

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Disclaimer This letter does not contain all the information that is material to a prospective investor in the Bonhoeffer Fund, LP (the “Fund”). Not an Offer: The information set forth in this letter is being made available to generally describe the philosophies of the Fund. The letter does not constitute an offer, solicitation, or recommendation to sell, or an offer to buy any securities, investment products, or investment advisory services. Such an offer may only be made to accredited investors by means of delivery of a confidential private placement memorandum, or other similar materials that contain a description of material terms relating to such investment. The information published and the opinions expressed herein are provided for informational purposes only. No Advice: Nothing contained herein constitutes financial, legal, tax, or other advice. The Fund makes no representation that the information and opinions expressed herein are accurate, complete, or current. The information contained herein is current as of the date hereof but may become outdated or change. Risks: An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the Fund, and this letter is qualified in its entirety by the more complete information contained therein and in the related subscription materials. No Recommendation: The mention of or reference to specific companies, strategies, or instruments in this letter should not be interpreted as a recommendation or opinion that you should make any purchase or sale or participate in any transaction.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.