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DS Smith - volumes up, margins steady

Sophie Lund-Yates, Equity Analyst | 4 March 2020 | A A A
DS Smith - volumes up, margins steady

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Smith (DS) Ordinary 10p

Sell: 281.70 | Buy: 281.90 | Change -9.30 (-3.20%)
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DS Smith's third quarter trading update confirmed business is progressing well despite economic uncertainty, with volume growth increasing in the second half of the year.

The group said it hasn't seen any material impact from coronavirus to date.

The shares rose 2.5% following the announcement.

View the latest DS Smith share price and how to deal

Our view

As almost everything we order online comes in a cardboard box, and as hostility towards plastic packaging grows, we expect demand for DS Smith's products to rise going forwards.

DS Smith's environmental efforts go further however. It's Europe's largest cardboard and paper recycler which could make the share's popular with ESG focussed investors.

However there are some things to keep in mind. Packaging is traditionally cyclical - when the economy booms people want more, but demand falls in recessions. Lower demand means both lower volumes and lower prices. Revenues can go up in smoke as a result, a problem compounded by a largely fixed cost base.

This makes concern over coronavirus a potential worry, but DS Smith hasn't seen an impact yet, and we think the group has two big advantages to help it cope with volatility.

The first is a large exposure to consumer goods and food, for which demand tends to hold up rather well when the economy turns. They make up around 70% of DS Smith's sales, offering some shelter compared to competitors more exposed to industrials.

Secondly, DS Smith only makes about 80% of the paper it needs in-house, and wants to cut that even further to around 60%. This means DS Smith gets its raw materials cheaper when paper prices fall in tough times. However, when the industry is booming and paper is more expensive the group's margins get squeezed. The overall effect is, in theory, to make the group less cyclical.

DS Smith is currently chewing through the acquisition of Europac - a French, Spanish and Portuguese packaging group. The deal means there's more debt on the balance sheet than we - and management - would like. The recent sale of the plastics division will add around £400m to the balance sheet, but there's still work to do.

While the group's committed to a "progressive dividend", the need to trim debt could see growth slow in the years ahead - although with a prospective dividend yield of 5.3%, that shouldn't be a deal breaker. Remember yields are variable and not guaranteed. Nonetheless the increased level of debt and possible cyclical headwinds mean the shares trade on a price-to-earnings (P/E) ratio of 9.4, some way below the ten year average.

Overall we think DS Smith is a more defensive option with exposure to attractive end markets. Online sales and plastic substitution are structural tailwinds, but we can't rule out further ups and downs in the short term.

Third quarter trading update

Like-for-like corrugated box volumes showed a good second half performance in Iberia, Eastern Europe and the UK. The group's e-commerce and consumer goods businesses grew strongly over Christmas, although countries with exposure to export led markets, including Germany, remained subdued.

In the North American business DS Smith is "very pleased" with initial customer reactions and operational progress at the new box plant in Indiana. However, lower demand from China has reduced paper prices. The group said the new packaging capacity will reduce exposure to the Chinese market.

The group has sold its plastics division to Olympus Partners for approximately £400m. These proceeds will be used to reduce debt, in line with the medium term target of having a net debt to cash profit (EBITDA) ratio at or below 2 times.

DS Smith expects to deliver a full year margin "in line with that achieved in the first half."

Find out more about DS Smith shares, including how to invest

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.

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