Narrow-Moat Aptar Has Exemplary Stewardship

 AptarGroup (ATR) might be a lesser-known name in the packaging industry, but it's one to get to know. Its dispensing niche has proved to be very profitable, and the firm has carved out a narrow economic moat by leveraging its clean-room manufacturing capacity and its intellectual property to successfully partner with pharmaceutical companies through the expensive and challenging drug-approval process. We have also awarded Aptar an Exemplary Stewardship Rating for its consistently wise use of shareholder capital. The stock is currently trading above our $60 fair value estimate, but given that only 71 companies in Morningstar's coverage universe possess the combination of a wide or narrow economic moat, an investment-grade balance sheet, and an Exemplary Stewardship Rating, we believe Aptar is worth keeping on your radar.

Most packaging products--such as cardboard boxes, metal cans, and glass bottles--are undifferentiated and compete mainly on price. The packaging companies that do possess economic moats primarily derive their advantages from favorable industry dynamics or low-cost production. Aptar's economic moat, on the other hand, is substantiated by its ability to produce innovative and useful dispensing products through a robust research and development budget, clean-room manufacturing capacity, and close relationships with customers.

Aptar's traditional organic growth strategy has served the company well, but we think the company will emphasize acquisitions more in the coming years. Its 2012 acquisition of French elastomer component company Stelmi was the largest in company history ($207 million) and has thus far been successful by just about any measure. It's also worth noting that the Stelmi acquisition was financed with available cash held in Europe. We believe Aptar paid a reasonable price for Stelmi based on prevailing multiples at the time, but the integration has exceeded our expectations, introduced the firm to new application fields such as vaccines and veterinary care, and given Aptar more exposure to the rapidly growing market for injectable drugs.

It's this type of smart asset allocation and disciplined approach to acquisitions that contributed to our upgraded Stewardship Rating to Exemplary earlier this year. We expect future acquisitions and growth investments to be well thought out and appropriately financed.

Aptar's Business Segments by Sales and Income

Source: Company filings, Morningstar estimates

While Aptar's food and beverage and beauty and home divisions are competitive, it's clear that its pharmaceutical division is the major differentiating factor between Aptar and its closest peers in the dispensing product business, which include Berry Plastics, MeadWestvaco's food and beverage and home, health, and beauty segments, and Rexam's former household packaging business, which was acquired by Sun Capital in 2012. Aptar's closest publicly traded competitors in the pharmaceutical business are Rexam's health-care packaging segment (currently for sale) and MeadWestvaco's health-care solutions (part of the home, health and beauty segment). 3M (MMM) also produces drug-delivery devices, but we estimate that accounts for about 9% of its overall health-care segment sales, making it difficult to ascertain the subsegment's margins. Still, we estimate that 3M's drug-delivery margins are relatively close to those of Aptar's pharmaceutical segment, in the 20%-30% range.

Intellectual Property Key to Pharma Division's Profitability
The key to the pharmaceutical segment's profitability lies in the intellectual property surrounding its delivery devices for prescription and over-the-counter products. To stay ahead of the innovation curve, Aptar invests approximately 5% of segment sales in R&D, which is well ahead of its closest pharmaceutical dispensing competitors. Aptar also has a majority share of the nasal spray pump and metered-dose inhaler markets and anticipates increased demand for these products, which help treat increasingly prevalent respiratory ailments like asthma and chronic obstructive pulmonary disease. We think demand from these markets will remain steady in the coming years.

In addition, approximately 80% of the segment's output is manufactured in clean-room facilities that limit exposure to pollutants that could compromise the product's integrity. Clean-room facilities aren't cheap to build and maintain, so we don't believe a would-be competitor could easily match Aptar's production scale to meet customer needs.

​

Between the two major end markets (prescription and consumer health care), profit margins are higher in the prescription end market, where Aptar works closely with its pharmaceutical customers throughout the expensive and rigorous drug-approval process. In recent years, the balance between sales to the two end markets has remained fairly stable--about 70%-75% for prescription and 25%-30% for consumer health care. Given the massive drug-discovery and regulatory costs on the line along with Aptar's experience partnering with drug companies through the regulatory process and delivering successful dispensing products, we think there are considerable switching costs for a drug company to consider when evaluating proposals by newer competitors.

More important, once a branded drug using Aptar's delivery system goes off-patent, the generic producers frequently use the same Aptar-made delivery system so customers have a similar experience as they had with the branded version. In addition, because the delivery systems also require regulatory approval, Aptar typically has a least a one-year head start on competitors, and generic producers that are looking to be first to market don't want to wait for a new delivery device to gain regulatory approval. All of this is good news for Aptar and supports the durability of its economic moat.

The company ventured away from its traditional pump and valve business when it acquired Stelmi in 2012, but given the growing demand for injectable drug delivery and Aptar's expertise in the dispensing niche, we think Aptar was smart to expand its portfolio. In 2014, it's expected that 7 of the 10 best-selling drugs will be delivered by injection, versus 1 of 10 in 2001, and the market is growing at twice the rate of the general pharmaceutical market.

The company's recent decision to expand Stelmi operations will increase production capacity 40% and should help Aptar achieve its 4%-7% core growth rate target for the pharmaceutical segment. Another positive coming out of the Stelmi acquisition was that it introduced Aptar to new application fields such as vaccines, heparins, and veterinary care. We think this will allow Aptar to leverage existing technologies for new end uses and will further support top-line growth.

Technology-Sharing Benefits the Entire Company
While we do not believe Aptar's beauty and home and food and beverage segments themselves possess durable competitive advantages, we do believe the company benefits from sharing dispensing technologies across sectors. To illustrate, Aptar's beauty customers were looking for ways to sell preservative-free lotions, but to do so, the package needed to keep out air and bacteria from contaminating the product. Using intellectual property developed in the pharmaceutical division, Aptar was able to deliver an innovative package that met its customers' needs and maintained the integrity of the preservative-free product. We believe this technology-sharing results in a mild economy-of-scope advantage since a competitor would probably spend more money researching and developing a dispensing product for a single end use while Aptar can spread the research benefits across multiple end markets.

Though food and beverage currently accounts for 13% and 12% of Aptar's sales and segment income, respectively, management expects core growth to be above 10%, which we think is appropriate. Most of the growth will continue to come from the beverage end market, driven by new dispensing technologies and geographic expansion. An example of this trend is the squeezable water enhancer market, which was nonexistent only a few years ago. Kraft's Mio brand was released in March 2011 and is now a $200 million-plus business; competitors have naturally taken notice of the category's dramatic growth and are demanding similar dispensing technology. This trend is a tailwind for Aptar, and we anticipate continued high rates of growth in the beverage market as a result of similar innovations that target on-the-go and millennial consumers.

Aptar's Food and Beverage Segment Sales by Market, 2010-Present

Source: Company filings, Morningstar estimates

We're also encouraged by Aptar's recent announcement that it will open a production facility in Colombia, as the firm has traditionally generated the majority of its revenue from North America and Western Europe and could benefit from more emerging-markets exposure. The Andean region currently accounts for about $30 million of Aptar's annual sales, and the company believes it is the first of its peers to have an on-the-ground facility there. We think the new facility will help Aptar better understand Latin American consumer needs and could serve as a blueprint for future capacity expansion in emerging markets.