Sealed Air's Protective Cushions
By Stewart Scharf
Best known for its Bubble Wrap and Cryovac products, Sealed Air (SEE ) was recently upgraded by Standard & Poor's from 4 STARS (accumulate) to 5 STARS (buy). We raised the rating based on Sealed Air's global reach, new product introductions, strength in food packaging, and improving market trends, which we believe should benefit the protective- and specialty-packaging segment.
Sealed Air is a leader in protective- and specialty-packaging products, as well as food-packaging products. The company expanded its global presence in food packaging when it merged with W.R. Grace's Cryovac business in 1998. Through mid-2003, 61% of its net sales were from food packaging, with the remaining 39% coming from protective and specialty packaging. In 2002, no customer or affiliated group of customers accounted for 10% or more of the company's consolidated net sales.
Sealed Air has a significant presence outside the U.S. Europe accounted for 26% of total net sales in 2002, while nearly 10% of sales came from Asia Pacific, 7% from Latin America, and 3% from Canada. An increasing proportion of sales are expected to come from outside the U.S. in future years.
IN THE BAG?
Food-packaging products -- including shrink bags, shrink films, and laminated films -- are sold mainly under the Cryovac name. The segment also makes polystyrene foam trays, rigid packaging and absorbent pads. Surface protection and other cushioning products include the ubiquitous Bubble Wrap -- plastic sheets containing encapsulated air bubbles that protect products from damage through shock or vibration during shipment.
Sealed Air's engineered products include Instapak foam-in-place packaging systems for things like computer, electronic, and communications equipment; and Jiffy protective mailers and other durable mailers and bags.
The demand for innovative packaging products has picked up steam in recent years, and we believe Sealed Air has done well in developing new products and improving its existing products and processes. From time to time, the company also acquires new packaging designs or techniques developed by others and commercializes them. The company has joint research and development projects combining the technical capabilities of its three divisions. It incurred R&D-related expenses of $59.3 million in 2002, up from $55.8 million in 2001, and $54.3 million in 2000.
One segment of the food-packaging business that has already shown significant potential for growth, in our view, is case-ready packaging -- the trays, pads, and films sold to meat and poultry processors to package their products prior to shipment to the supermarket. Sealed Air's management believes this could be a $200 million-plus business for the company over the next few years.
We expect Sealed Air to continue to focus on generating cash flow and reducing leverage on its balance sheet, although long-term debt should increase due to the recent issuance of senior notes. In July, 2003, the company used $1.3 billion from the note issuance to redeem its Series A convertible preferred stock at $51 a share.
We anticipate that this transaction will contribute to cash flow, as the net after-tax interest expense on the new debt is less than the preferred dividends that would have been paid. This should add 3 cents to 2003 earnings per share. Also, EPS will no longer be diluted by the potential conversion of the preferred stock. The deal should have another positive effect for Sealed Air: lower borrowing costs and extended maturities on its debt. The company will take an estimated net charge to equity of 27 cents a share on the redemption in the 2003 third quarter.
LOOKING TO HIGHER MARGINS.
Sealed Air's reported 2003 second-quarter EPS of 56 cents, vs. 61 cents a year earlier, was in line with S&P's estimate. Net sales increased 10% (with 6% coming from the positive foreign-exchange effect of a strong euro), reflecting 13% growth in food packaging and a 6% increase in the protective- and specialty-packaging segment.
Excluding foreign currencies, its food packaging sales rose 6% and protective- and specialty-packaging edged up 1%. Overall, net sales benefited from higher prices and as higher-margin items made up a larger proportion of sales. A boost in unit volume for certain products in the food packaging segment also helped.
For 2003, we project that sales (excluding acquisitions and foreign exchange) will rise at a percentage rate in the mid-single digits, reflecting our view of further growth in food packaging, as Sealed Air focuses on higher-margin products, such as case-ready meat packaging. We expect improvement in protective and specialty sales in successive quarters as the global economy begins to recover.
As for gross margins, S&P expects them to widen sequentially from the second-quarter's 31.1% (33.1% a year ago), on pricing initiatives and stabilizing raw material costs -- especially if natural gas prices head lower. We expect EBITDA (earnings before interest, taxes, depreciation and amortization) margins to exceed 20%, as $23 million in annual cost savings from restructuring efforts cuts selling, general, and administrative (SG&A) expenses to a projected 16.5% of sales. That should outweigh the effects of higher insurance and health-care costs. By Stewart Scharf
Despite higher expected interest expense, with a lower effective tax rate of 36.5%, we project 2003 EPS at $2.43 (before a 24-cent net charge related to the preferred stock redemption), with a 15% gain expected in 2004, to $2.80.
On a per share basis, we project Standard & Poor's Core Earnings for 2003 to be virtually the same as our operating EPS estimate, given no stock-option expense and a 1 cent per share impact from pension adjustments. The same holds true for 2004, as we expect S&P Core EPS to match our $2.80 operating EPS projection.
We base our valuation on p-e-to-growth (PEG), average historical multiples, and discounted cash flow analysis. Although the stock recently traded at 17 times our 2004 EPS estimate, a modest premium to the projected p-e of the S&P 500 for the comparable year, this was well below its average historical p-e of 23-to-24 times earnings. Based on a PEG of 1.1, well below its peers, and a projected five-year earnings growth rate of 13%, above the growth rate seen for other packaging companies, we see significant upside potential.
On a discounted cash flow basis, our model indicates that the shares trade at a 19% discount to estimated intrinsic value. We have a 12-month target price of $56, or 20 times our 2004 EPS estimate.
PROMISE AND RISKS.
Additionally, we see sound earnings quality in Sealed Air, with the company having virtually no stock option or pension expense. Although it has reached a settlement regarding its asbestos litigation related to W.R. Grace, a pending law for a private trust fund could lift the stock, in our estimation, as the company could be relieved of all or part of its payments of $512 million in cash and $321 million for 9 million common shares. After at least $125 million of projected capital expenditures, we anticipate 2003 free cash flow generation of $250 million to be used for possible debt reduction and acquisitions of companies in niche markets.
There are risks to our earnings growth assumptions and target price. These include: a potential rise in resin costs, especially low-density polyethylene, triggered by higher natural-gas prices, which were recently selling at twice historical averages; a deflationary economic environment or a slower-than-expected recovery; and a substantial weakening of foreign currencies, primarily the euro.
Analyst Scharf follows packaging stocks for Standard & Poor's