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DS Smith - continued recovery in Q2

Nicholas Hyett, Equity Analyst | 3 November 2020 | A A A
DS Smith - continued recovery in Q2

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Smith (DS) Ordinary 10p

Sell: 368.80 | Buy: 369.10 | Change -11.50 (-3.03%)
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In a brief pre-close trading statement DS Smith said performance has continued to improve since the beginning of September. As a result half year results are expected to be in line with previous guidance.

Overall volumes for the first half are expected to be 1.5% behind last year, as the second quarter saw continued growth from e-commerce and consumer good customers in Europe and the US. Coronavirus disruption in the first quarter means half year profits are expected to be lower than last year - although the board continues to expect to pay a half year dividend.

The shares rose 2.5% in early trading.

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Our view

DS Smith is a cyclical business, meaning its fortunes wax and wane with the wider economy. Despite that it's weathered the current crisis surprisingly well, and that's thanks to exposure to two key client groups.

The group is a key supplier to ecommerce groups - providing the carboard boxes that have become a familiar sight outside houses up and down the country as we shifted to online shopping during the lockdown. DS Smith also sells around 72% of its boxes to consumer goods and food groups. These include many of the "shelf-ready" cardboard boxes you'll find in the supermarket, and supermarkets have remained open and busy throughout the crisis.

Despite those tailwinds the group hasn't escaped the current crisis unscathed. Disruption to industrial customers has hit volumes, but extra costs are the real headache. As well as the cost of transitioning to new ways of working, disruption to supplies of recycled paper has pushed up the cost of this key input. Those headwinds have eased over the second quarter of the financial year, but could pick up again now large parts of the world are heading into a second lockdown.

Given the uncertainty ahead it's good to hear dividends remain on the table. It means management's confident the impacts from coronavirus aren't going to derail plans in the short term.

We continue to think the group's longer-term prospects are intact too. E-commerce and consumer goods exposure should remain long term positives. Consumer's growing dislike of plastic packaging should also increase demand over time.

We think DS Smith's business model is attractive too. 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.

The balance sheet is carrying a little more debt than is ideal, following the acquisition of Europac - a French, Spanish and Portuguese packaging group. But there's comfortable breathing room before the group's in danger of breaching the financial terms set by its lenders. Nonetheless we'll be looking at leverage more closely when half results are announced - if it's crept up that could hamper future dividend growth.

Overall we think DS Smith is built to be a more defensive option than some of its peers, with exposure to attractive end markets. With a price to earnings ratio that's slightly below its longer term average this could be an attractive entry point. However, with the full impact of COVID-19 yet to play out, patience is key while waiting for any recovery - and of course nothing is guaranteed.

DS Smith key facts

  • Price/Earnings ratio: 11.0
  • 10 year average Price/Earnings ratio: 11.7
  • Prospective dividend yield (next 12 months): 4.7%

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Full Year Results - 02/07/20

Full year revenue fell 2% to £6bn, ignoring the effect of exchange rates. This reflects weak paper pricing in Europe and North America, partially offset by improved corrugated box volumes in Europe. Despite this fall, cost control and the nine-month contribution from Europac after its acquistion, meant underlying operating profit rose 5% to £660m.

The direct impact from Covid-19 on operating profit was around £15m.

Despite lower corrugated box volumes in March and April l because of coronavirus disruption, for the year these rose 0.6%. The improvement was helped by the group's exposure to e-commerce and consumer goods, while industrial demand was weaker.

Revenues in Northern Europe fell 9% to £2.3bn, driven by lower paper prices and the knock on impact on box prices. The group also increased paper integration, which reduced external sales. The region reported lower-than-average corrugated box volumes for the year - there was stronger growth in the UK, but higher exposure to industrials in Germany weighed on performance. The lower paper prices meant underlying operating profit was down 16% to £219m.

Southern Europe however saw revenues rise 10%, reaching £2.2bn and this was primarily driven by the addition of Europac. Volumes for the year improved overall, but Covid-19 disruption meant these were challenged in the final two months of the year. Underlying operating profits were £314m compared to £186m last year. Revenue dipped 3% in Eastern Europe, to £892m although strong packaging price retention meant operating profit rose 17% to £88m.

North America was significantly affected by declines in the US export paper price, while corrugated packaging volumes were flat. Full ramp-up of the new packaging site in Indiana is on track to complete in the next two years. Revenue was down 9% to £604m, and weaker paper margins and costs associated with Indiana meant operating profit fell 65% to £39m.

The group achieved profit margins of 10.9%, which is within the target range and higher than last year's 10.2%.

Higher profitability helped free cash flow increase to £354m from £339m. Net debt reduced slightly to £2.1bn, thanks to the proceeds from the disposal of the plastics division. The group is well within the terms set by its lenders (covenants), with net debt lower than required as a proportion of cash profits.

In the short-term DS Smith expects Covid-19 to negatively affect industrial volumes and increase operating costs, especially those associated with recycled materials.

In response the group will lower spending in a number of areas this financial year. Capital expenditure will be lowered by 20%, non-essential spending deferred and headcount flexed.

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

The Author holds shares in DS Smith.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.