SIF Folio: Packaging looks cheap but will Macfarlane box up a profit?

Another week, another second chance. Last week Carr’s Group rejoined the SIF folio and I explained why I’m hoping for a better result this time.

This week, another stock has reappeared in my screening results. Packaging firm Macfarlane (LON:MACF) was a SIF stock from May – November 2016. It wasn’t an especially successful trade, closing with a 10% loss. But as I commented at the time, the company did deliver “a solid operating performance” during the period.

Macfarlane shares went on to double bag between November 2016 and June this year. But the firm’s share price has since fallen by 35% to 75p from this summer’s 52-week high of 114p.

At this level the shares look quite reasonably priced to me, so I’m keen to see if they qualify for a repeat investment.

How I selected this stock

I know that a number of you like to follow my screening results. So I’ll start with a quick word about how I selected Macfarlane, even though it’s not the highest-ranked new stock in my SIF screen results:

I’ve crossed out in red all of the companies that are already in the portfolio, or which duplicate those which are. That left two choices:

• FTSE 250 infrastructure investment company HICL Infrastructure (LON:HICL)

• Small-cap packaging group Macfarlane (LON:MACF)

I was tempted by HICL, as this is a stock I quite like from an income point of view. This group owns stakes in a wide range of infrastructure investments in developed markets around the world.

HICL doesn’t specifically invest in renewables. But it is run by the same investment manager (InfraRed Capital Partners) as portfolio holding The Renewables Infrastructure Group. I also felt that there was some potential overlap with Costain and Sirius Real Estate, both of which are already in the portfolio.

On balance, I decided that packaging firm Macfarlane might be a better choice in terms of diversification.

An under-appreciated business?

It’s not just Macfarlane that’s been falling recently in the packaging sector. I’ve noticed that peers of all sizes have taken a battering. FTSE 100 firms Mondi and DS Smith have also fallen heavily in recent months.

I guess these businesses do carry a certain cyclical risk. A downturn in consumer goods, industrial activity or any other major sector would have a knock-on effect on packaging demand.

Macfarlane appears to make about 95% of its profit from packaging distribution, rather than from its manufacturing business. It supplies a wide range of products including retail, e-commerce and industrial packaging, plus labels and tapes.

Growth seems to come from bolt-on acquisitions as well as organic gains. Like NWF and Carr’s, Macfarlane appears to be another company that’s acting as a consolidator, sweeping up small regional firms.

The group’s retail customers include ASOS, judging from the pictures on its website. This may not seem like good news following Monday’s profit warning from the retailer, but it’s worth remembering the internet firm’s UK volumes still rose by 19% in Q1. Only profits fell.

Overall, I think cyclical risk could threaten incremental growth but should not be an existential threat. So I won’t rule out Macfarlane based on its exposure to the UK economy.

Improving value

Stocko’s algorithms see Macfarlane as a Balanced, Contrarian stock. It’s not a Super Stock, but for value-minded investors with an eye on quality, it could be worth a closer look.

The ValueRank of 61 isn’t outstanding, but falling share price has improved this score. I don’t see anything too alarming here:

(You can see these component scores by going to the sector page for a stock and clicking on the relevant rank)

These ratios all seem fairly consistent with each other, and don’t suggest any major concerns to me. Cash generation appears to be fairly good, and net debt fell by £3.6m to £11.1m during the first half of the year. That’s just 1x forecast net profit for the current year — well below my screening limit of 4x profit.

The story here seems to revolve around growth. Let’s see if the stock’s quality score provides the kind of fundamental safety net I’m looking for.

Top quality

Macfarlane’s QualityRank of 91 is the highest of its three factor scores. The picture is quite attractive, in my view:

I’m particularly attracted by the firm’s long-term average return on capital employed (ROCE) of 14.9%. This looks impressive to me because it represents a very consistent track record of profitability.

In turn, this suggests the group’s acquisition policy works well. Overpaying or buying poor quality companies would be likely to result in a gradual decline in ROCE.

You may wonder why Macfarlane is able to generate attractive returns despite having low profit margins. I suspect this is a characteristic of the distribution business, which probably turns over stock quickly but at low margins.

The firm’s Stock Turnover ratio of 10.2 seems to support this view (the equivalent figures for manufacturing-led Mondi is 4.4).

The final element of Macfarlane’s quality score is a Piotroski F-Score of 7/9. This snapshot reassures me that profits and cash generation are moving in the right direction.

The F-Score also highlights a placing last year, when management raised £8m to help fund an acquisition. I don’t see this as a concern and institutional investors appear to have agreed. The placing was oversubscribed and took place at a discount of just 1.1%.

A turning point for momentum?

Patience is a necessary ingredient of investing, in my view, but trying to swim against the tide can be costly.

Macfarlane’s MomentumRank of 39 suggests the situation is borderline, at best:

However, there are a couple of highlights which enable the shares to pass my screening tests:

• 1y relative strength remains positive (just). This means the shares have outperformed their benchmark index over the last 12 months.

• Adjusted earnings per share are expected to rise by about 35% this year. The dividend is expected to gain around 9%.

The combined effect of these strong forecasts puts Macfarlane stock on a rolling forecast P/E of 9.5, with a rolling yield of 3.5%. That seems a reasonable entry point to me for a business that’s averaged a 15% ROCE over the last six years.

My decision: I intend to accept the cyclical risks of investing in packaging. I will add the shares to the SIF portfolio and to my own holdings this week, after this article has been published.

Disclosure: Roland owns shares of Carr’s, The Renewables Infrastructure Group, Costain and Sirius Real Estate.

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