Cash Flow Model: Kloeckner Pentaplast's High Leverage Under Base Case Mitigated by Sufficient Liquidity Under All Scenarios, No Near-Term Triggers; Ability to Manage Raw Material Costs Underpins Constructive View of Capital Structure Relative to Previous Periods of Inflation

Relevant Items:
Kloeckner Pentaplast Forward Model
Q1 Presentation
Q1 Report

Kloeckner Pentaplast’s second-quarter results are expected to show significant improvements by management to pass through raw material costs during the German plastics packaging group’s previous two quarters.KP’s €300 million senior unsecured notes due 2026 have rallied on the back of management reiterating guidance for full-year EBITDA (on a constant currency basis) and free cash flow. The guidance has also quelled some concerns that KP is highly susceptible to margin contraction because of raw material cost increases, which were partly the reason behind the selloff of its €395 million Holdco PIK notes (refinanced in February) to the 40s in 2018.
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Our cash flow model implies a 77% and 67% loan to value under our low and base cases, but we note that the unsecured notes remain fully covered under all scenarios, with the equity value estimated at €569 million and €960 million under our low and base case. We used a 10.5x exit multiple under our base case, flexed by 1x under the low and high cases, reflecting robust trading comparables, supplemented by KP’s above market cash generation and relatively stronger commitments to ESG factors than peers, as well as median transaction multiples at around 11x EBITDA.

KP’s confidence in managing raw material costs, as well as several actions taken since 2018, support our constructive view of the credit. While net leverage under our base case remains high by full-year 2024 at 5.6x, this is mitigated by our expectation that liquidity will be adequate throughout the forecast period, with the RCF staying undrawn across our low, base and high cases in the cash flow model. Additionally, following the refinancing in February, KP now has few near-term triggers.

Our base case is below:
 

Cash Flow Model

We expect the group’s second quarter top line to be impacted by relatively high customer inventories, particularly in the pharma, health and durables (PHD) segment. We expect customer inventory destocking will slow volume growth, which will be offset partially by improvements in pricing. Management noted that it has reduced the passthrough lag to 30 to 45 days on contracts on non-escalator agreements (representing 65% of revenue), which we expect will support pricing. For the second quarter, we expect a 1.1% year-over-year decline in total revenue to €473 million, driven by a 2.5% decline in PHD revenue, while food revenue is expected to increase by a modest 0.5% year over year.

Lower volumes are partially offset by KP’s pricing strategy, with passthrough beginning to support top-line performance and sequential gross margin expansion in the second quarter. KP has three types of contracts with customers:
 

• Escalator pricing - prices are adjusted automatically, every three months based on changes in raw material costs;

• Volatile resin clauses - these are combined with escalator pricing, which allow for an adjustment of prices, effective immediately or as of the end of the then-current month if raw material prices change beyond a certain value; and

• Price negotiation - price levels are negotiated and fixed for a certain period, before renegotiation for the following period.

As of Sept. 30, 2020, 35% of new sales volumes were covered by escalator pricing, with the remainder negotiated on an ongoing basis with a focus on price-cost spread. We note that KP is focused on not giving away the benefits to its margins following raw material normalization and we expect that the company may benefit longer term by locking in contracts at higher prices following the raw material spike.

KP’s ability to manage the raw material price spike remains the key issue for the company, as many familiar with the credit liken the current raw material environment to the 2018/2019 period, where raw material price pressure resulted in significant gross margin contraction. However, the current business, headed by new CEO Scott Tracey, has so far dealt with the raw material inflation, with the company maintaining current adjusted EBITDA and free cash flow guidance for 2021 of around €300 million and €85 million, respectively. However, we note that this is on a constant currency basis, and FX-adjusted EBITDA is set to be impacted by a stronger euro, which, as of May, is up 11% year over year at €1.2146/dollar, which will lead to moderate currency headwinds in the group’s PHD segment, which typically generates higher margins.

Upon joining the group, Tracey noted that the margin contraction was largely self-inflicted, and under the new management, KP’s commercial team has demonstrated a stronger ability to maintain pricing and reduce the time taken to pass through costs on non-escalator agreements to 30 to 45 days, which we expect will support margins. This compares with the group revising down guidance in the third quarter of 2018 due to raw material price increases, as well as productivity challenges relating to the group’s North American division, which were subsequently addressed.

Management’s ability to lower the days taken to pass through raw material cost increases underpins our view that the group’s sensitivity to raw material inflation is much lower than it was in 2018 and 2019, and supports our view of the company’s valuation.

From 2018 to 2020, KP made €88 million of capacity investments, which supported an expansion of its pharma coating capacity in Switzerland, Brazil and the U.S. (adding 14 kilotonnes of capacity), an expansion of its secure card foil capacity in Virginia, and an expansion of post consumer recycling (PCR) and polyethylene terephthalate (PET) capacity in North America to accelerate growth in the U.S. Further initiatives on growth projects through 2023 relate to the expansion of PCR and PET capacity for medical devices and consumer health packaging in North America, investments in beverage labels in North America, and the expansion of capacity for Pharma products and labels to accelerate growth in the APAC region. Our forecast for gross margin in the longer-term is premised on a normalized raw material cost environment, which sees gross margins moderately decline over the forecast period.
 
As shown below, PVC Polymers and PET prices have risen substantially from September 2020 to May this year, although KP’s management was confident that the raw material price increases should begin to subside in the second half of the year, albeit stabilizing at higher levels. The increase in prices was largely driven by supply bottlenecks, with many suppliers operating under force majeure conditions with resin allocations, creating a temporary supply shock. Additionally, the winter storm Uri disrupted supply of PVC, which is expected to continue into the second quarter as petrochemical refinery capacity output increases in the coming months, according to the International Energy Agency. Additionally, according to ICIS, a record amount of Ethylene capacity, a key building block chemical for the manufacturing of packaging materials, is set to be added in 2021 and 2022, driven by capacity increases in Northeast Asia. According to ICIS, Chinese ethylene capacity is forecast to double between 2019 and 2025, which will support a longer-term normalization of resin prices.

Changes in core resin prices are below:
 
KP’s other operating cost line items remain broadly unchanged, with selling expenditure largely constant as a percentage of revenue, while general and administrative costs are forecast to rise by 2% per annum under all cases. Further, over time we expect one-off adjustments to EBITDA to decline. For 2021, we expect KP to add back about €15 million of restructuring costs, as well as one-off costs related to bonus payments to employees. Additionally, we incorporate expected run-rate cost savings related to the consolidation of the group’s manufacturing plant in Ohio with its manufacturing plant in Virginia, as well as other logistics-based savings.

We expect KP will incur about €45 million per year of growth capex, with maintenance capex of around €30 million. The growth capex primarily relates to planned capacity increases at the Suzhou manufacturing plant in China to improve APAC PHD capacity. Further, our working capital forecasts assume management continues to demonstrate success in managing inventories throughout the financial year. The group plans to reduce scrap waste by 30% in its PHD segment and 43% in its food packaging (FP) segment by 2023 and optimize inventories by 5% and 3% in PHD and FP, respectively.

Valuation

According to some sources, KP’s €300 million senior unsecured notes are being shorted with the view that raw material price inflation will substantially eat into gross margins, with the unsecured notes viewed as the security within the capital structure where the value breaks. For those familiar with the credit, this was substantially the same thesis as in 2018 and 2019, when the group’s €395 million Holdco PIK-toggle notes fell as low as 40 following gross margin deterioration and headwinds in the food and consumer products segment.

KP reported that pricing lags also meant that the recovery in margins would be drawn out. Applying the same thesis to the KP of today though discounts both improvements that the current CEO and CFO have made to the business with respect to commercial contracts, as well as various investments made since 2018 to support the group’s capacity. As a result of the aforementioned initiatives, the appropriate valuation multiple in our view remains 9.5x to 10.5x, which is at the low end of publicly-traded peer comparable multiples, in spite of KP’s superior cash flow yield and stronger ESG metrics relative to plastics peers. Applying these multiples to KP based on our discounted cash flow analysis results in a full recovery under all cases. While the equity cushion is substantial, the group’s loan-to-value remains high, although we expect that this should ease in the near-term following normalization of raw material price increases. Further, following the group’s refinancing undertaken in February, there remain few near-term triggers and liquidity is sufficient under all cases to avoid a drawdown of the group’s RCF.

The group’s valuation under our low, base, and high cases are below:
 

Below is a sensitivity analysis of the base case, and the implied terminal free cash flow growth rates given the model output and our assumptions of EBITDA multiples and WACC.
 

Reorg’s calculation of KP’s WACC is below:
 
Our base case exit multiple is 10.5x, with this flexed by 1x in our low and high cases. Our base case discounted cash flow assessment values the group at €2.899 billion, or 10.3x LTM adjusted EBITDA. In the low case, which lowers the terminal multiple to 9.5x, this falls to 8.9x LTM adjusted EBITDA with an implied LTV of 77.3%.

Under our base case, we expect that following continued raw material pressures in the second quarter, the group’s pricing strategies will help offset inflation through pricing strategies. Meanwhile, a strong second quarter of 2020 results in a tough comparable for revenue growth, particularly in the PHD segment, in which pricing gains will be limited by the division's exposure to the euro, which has continued to strengthen year over year. As Covid-19 related demand pull-forward of PHD and FP packaging normalizes, thereby clearing existing customer inventories, we expect Kloeckner to grow revenue at about 2% per annum, with the PHD segment leading the growth ahead of the FP segment. While acknowledging raw material impacts on EBITDA, we expect that KP’s moderate capital intensity and strong commercial pricing agreements will support deleveraging towards 5.6x under our base case.
 
Although we expect leverage to remain elevated under our base case at 5.6x, relative to our base-case terminal multiple of 10.5x, our core scenario has the unsecured notes fully covered. Under our low-case, reflecting lower sales growth, more prolonged gross margin pressure from raw materials and a 9.5x EV multiple, KP has €569 million of equity value cushioning the unsecured notes. Crucially, with leverage expected to remain high, KP does have sufficient liquidity under our three scenarios, as well as no specific near-term triggers, with no debt maturities until 2026.

KP’s capital structure is below:
 
The exit multiple remains a topic of debate among those following the company, with the bond sell off throughout 2018 as a result of “clumsy” pricing, M&A integration issues and two downward EBITDA revisions supporting some investors' view that the company should be valued at a significant discount to plastics packaging peers, or similar to Berry Global at about 8x LTM EBITDA. However, we expect KP’s exit multiple to be in line with peer averages and comparable transactions. This is underpinned by both the group’s better cash generation relative to peers and stronger ESG metrics, although the valuation is partially constrained by persistently high leverage. Additionally, we believe that a multiple in line with Berry at about 8x discounts the steps taken by the current management to address the group’s issues that partially led to the steep bond selloff in 2018.

In 2017 and 2018, management cited clumsy pricing actions, as well as cost-related issues due to the acquisition of Linpac, which had a higher SG&A footprint. Subsequently, in the second quarter of 2018, KP noted that progress in addressing these issues was not progressing as fast as hoped for. It also noted the continued impact from a higher euro, which saw adjusted EBITDA decline 11% year over year. According to statements made by management on the second quarter call, KP was wary of repeating pricing mistakes from 2017 to retain customers. As a result, in light of these FX and raw material headwinds, KP subsequently revised down its full year 2018 EBITDA guidance twice to between €215 million to €220 million from €260 million to €280 million. Pricing for KP’s Holdco notes is below:
 

With respect to exit-multiples, as highlighted above, Kloeckner’s equity cushion remained a key topic of conversation during the refinancing roadshow. SVPGlobal pointed towards Aptar as a publicly-listed peer comparable, which is currently trading at 17.8x EBITDA, or a 2.4% EBITDA minus capex yield, as well as recent transaction multiples, which valued the targets at around 14x. We note that there has been a consistent step up in transaction multiples for the plastics packaging sector, with current transactions in 2021 at an average 14.5x, while the average in Reorg’s select transaction comps point to a 11.3x average EV multiple, or 2.1x revenue.
 
ESG considerations also remain a key determinant of exit multiples, and KP has above-market commitments to increase the amount of PCR materials within its packaging products, which it intends to increase to 30% by 2025, while certain peers have set goals of only 10% PCR usage by 2025. Additionally, KP’s term-loan B and RCF are subject to an ESG-linked margin ratchet based on Scope 1 and Scope 2 GHG emissions. To this point, KP has a 2023 target of a 38% reduction in Scope 1 and 2 emissions compared with Berry Global, which has outlined a target to reduce Scope 1 and 2 GHG emissions intensity by 25% compared to its 2016 baseline. Additionally, Berry has a goal to increase PCR content to 10% by 2025, which compares with 30% at KP. Also, Aptar has a planned minimum PCR content of 10% in its dispensing solutions by 2025. In turn, we expect that the group’s valuation relative to peers will not be hindered by relative ESG considerations.

Recent M&A transactions have largely been financial transactions, with the latest large-scale M&A transaction relating to the Ontario Teachers Pension Plan Board acquiring the Carlyle Group’s majority stake in Portuguese rigid plastic packaging company Logoplaste. The transaction was said to value the company at an estimated €1.4 billion, with expected EBITDA for 2021 of €120 million, valuing the group at 10x to 12x forward EBITDA.

Select M&A transaction multiples for peers are below:
 
Trading comparables for plastics packaging companies exhibit a fairly broad range, with Aptar trading at 17.8x EBITDA and Amcor and Berry Global trading at 12.1x and 8x respectively. Meanwhile, diversified packaging comparables trade at 9.5x EBITDA, while metals and glass packaging comps trade at 12.3x EBITDA. While plastics-focused peers Aptar, Amcor and Berry Global have reported 5.3%, 8.6% and 9% year-over-year EBITDA growth in the period ended March 31, Kloeckner reported a 12% fall in EBITDA in the first quarter. The relative underperformance is driven by peers having relatively favorable exposure to pandemic-related end-demand, while the impact of Covid-19 on KPs business was neutral/slightly negative according to comments made by management during the first quarter call. Additionally, peers benefitted from a weaker dollar, which by contrast impacted KP’s EBITDA by €4 million, and its top-line by €24 million.
 

Valuing KP on peer EBITDA multiples and EBITDA minus capex yield highlights KP’s above-market cash flow generation, even during a period where it was impacted by FX movements relative to peers and peers benefitted from relatively higher pandemic-related tailwinds. Based on implied EBITDA minus capex yields on an LTM basis, compared to both plastics packaging peers and broader packaging peers, KP’s implied EV is €3.956 billion and €3.011 billion, compared to €2.85 billion under our base case, highlighting our relatively conservative valuation.
 
KP’s above-average cash conversion is offset by the group’s high net leverage relative to peers. Under our base case, net leverage converges to packaging peer averages, reflecting deleveraging through higher EBITDA and levered free cash generation. Additionally, as noted above, KP has sufficient cash headroom under all cases to avoid a drawdown of its RCF.

Other Considerations

As highlighted in our primary analysis of KP’s refinancing in February, Bloomberg reported that SVPGlobal, which has owned KP since 2012 when it took over the business as part of a restructuring, may consider a sale or IPO of the business following the refinancing. On Sept. 30 LTM pro forma EBITDA, portability was largely achievable, with net leverage under IAS 17 at 6.21x as of Sept. 30, with portability set at 6.2x. While net leverage on adjusted EBITDA has risen since to 6.9x on an IFRS-16 basis, inclusive of local secured credit lines, our covenant analysis highlighted that calculation flexibilities could allow portability even if the actual net leverage test level is higher than 6.2x on the actual consummation of a change in control. Click HERE for our covenant analysis of the deal.