The e-commerce market is booming, and packaging providers like DS Smith (LSE: SMDS) are riding high on the coattails of the industry.
The company is Britain’s biggest box maker, although UK sales now account for just 10% of group revenue. It has diversified outside of the UK in recent years with two substantial acquisitions recently. Europac in Europe earlier this year, and Interstate in 2017. This deal thrust the group into the US.
Buying and building
Over the last few years, it has proven itself to be extremely capable of buying and integrating competitors. I’m always a bit dubious of companies that spend billions on acquisitions because more often than not, these deals end up eroding value for shareholders.
However, it looks to me as if DS Smith has avoided this trap. For example, earlier this year the company revised upwards its anticipated cost synergies associated with Europac from €50m to €70m, owing to “head office cost reductions and paper optimisation.“
Following these acquisitions and cost optimisation efforts, City analysts expect the company’s earnings per share to grow by around 26% this year. And based on current estimates, the stock is trading at a forward P/E of just 10.1.
In my opinion, this is far too cheap. Over the past six years, the firm has gone from strength to strength, and earnings have grown at an average compound annual rate of 14%. The only year in recent history when earnings have contracted was fiscal 2019 when earnings per share declined 14% linked to the acquisition of Europac.
Management has a laser focus on improving profits. This year the company is targeting a return on sales from between 10% to 12% (revised upwards from 8% to 10%) with a combination of organic growth and price rises.
Balancing margins so returns are within this bracket is not easy. Earlier this year the company had to quickly react to market changes when input costs spiked as consumers rushed to ditch plastic in favour of paper-based packaging. It managed to push £174m of higher costs to customers, as well as increasing box volumes by £27m. These efforts offset lower volumes in other areas and increased input costs, which together totalled £115m.
The fact that DS Smith was able to push these higher costs onto customers tells me that the group has a degree of pricing power, which is a positive sign.
Companies with pricing power don’t have to worry about rising input costs eating into margins, because they can pass costs to customers. This makes the business more predictable as margins can be kept constant. DS Smith’s margins have only grown since 2014. The firm’s operating margin has increased from 5.4% in 2014 to 6.7% for 2019 as operational synergies and economies of scale from acquisitions have flowed through to the bottom line.
The bottom line
So overall, I think this is a high-quality business that has a good track record of growing through sensible, value-creating acquisitions. However, despite this track record, the stock is currently trading at a depressed and evaluation of just 10 times forward earnings, and it supports a dividend yield of 4.75%.
Considering the fact that the stock has changed hands for as much as 20 times earnings in the past, I think it looks undervalued at current levels and has the potential to double your money.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended DS Smith. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.