We See Plenty of Upside in Bemis

After an extended period of underinvestment, a 2014 change in management focused on putting the business back on track. A divestiture of the low-margin pressure-sensitive label business and a renewed focus on high-barrier flexible packaging have improved operating margins. Bemis’ profitability primarily revolves around the specialized production of meat, cheese, and dairy films. While consumption growth in these categories is likely to remain slow in developed economies, a steeper growth runway remains as emerging-market diets include a growing portion of these items.

Although Bemis has consistently focused on keeping its high-profit meat and cheese operations running smoothly, some of its commoditized business lines had become uncompetitive. Reinvesting in these assets should improve throughput and reduce operating costs for domestic operations. We think this could open the door to sales Bemis had previously turned away and boost profit margins thanks to more efficient equipment.

Following the announcement of Amcor’s acquisition offer, Bemis stands to gain scale in its international markets. Similarly, Amcor will benefit from more efficient North American operations, due to overlap with Bemis’ much larger regional presence. Given the deal premium paid to Bemis and the likelihood of meaningful synergies between the two businesses, prospects look good for Bemis shareholders.

High-Value Packaging and Materials Expertise Are Advantages We believe Bemis is worthy of a narrow moat. The company's main competitive advantage lies in its intangible assets associated with the production of meat, cheese, and dairy packaging. The process to manufacture a candy wrapper or bread bag differs substantially from producing a flexible package for bacon or cheese. Most dry goods can be packaged using wide-application resins or films from Dow or DuPont, while meat and cheese typically have characteristics that require specialized packaging. Only a handful of companies, including Bemis, are set up to combine 15-20 resins into a number of layered films that address the variety of issues associated with these products. For example, some cheeses produce gases that need to be vented from the package without allowing oxygen in, and these applications often come with a variety of pH levels that require custom films that don't interact with the product. Bemis' value proposition is that producers receive far fewer returns due to spoilage thanks to longer shelf life. Manufacturing methods for these resins and films remain intentionally segmented so that few operational team members are aware of the production process from start to finish. In sum, these factors facilitate operating margins in excess of 20% for these products.

Bemis’ smaller healthcare packaging business (10% of sales) also benefits from switching costs. The company’s flexible healthcare solutions keep anything from surgical equipment to stents sterile until the time of use. This environment has a near-zero failure tolerance, making the benefits of switching minuscule compared with the risk of switching to a provider that may cut corners and expose a company to litigation.

Although these two business segments represent only around 40% of revenue at Bemis, we think they make up closer to two thirds of operating income. The remaining 60% of sales is composed of a variety of undifferentiated flexible packaging solutions. This constitutes films for everything from candy wrappers to bread bags. While we don’t think Bemis has any competitive advantage in this space, we view these products as largely cost-of-capital businesses, or moat-neutral.

Lower Meat and Cheese Consumption a Risk We believe Bemis' largest risk is a sustained decline in the per capita consumption of meats and cheeses in North America. In 2015, the World Health Organization classified processed meat as a Class I carcinogen, among asbestos and tobacco. The threat of falling consumption could incite higher levels of price competition between Bemis and Winpak, eroding historically attractive profitability.

Bemis’ long-term growth could be jeopardized if emerging-market consumption patterns fail to converge to developed-market standards. Developed-market consumption of food products is primarily limited to population growth, causing the majority of Bemis’ long-term growth to hinge on rising demand for processed food in emerging markets. If emerging markets exhibit dietary patterns that place little emphasis on meat and dairy products, long-term earnings growth would fall short of our expectations.

There remains execution risk in Bemis’ ongoing recapitalization program. After nearly a decade of underspending on capital improvements, the company has a long road ahead when it comes to replacing its aged equipment.

Bemis is in good financial health. Even with its recent acquisitions, net debt/adjusted EBITDA stood at 2.7 as of Dec. 31, 2017. We think this is manageable, given that the company typically enjoys stable cash flows and could easily redirect cash from share repurchases to pay down debt.

Bemis’ share-buyback approach is seemingly valuation-agnostic. The company has stated that it does not try to determine a fair price for its shares, potentially diluting shareholder value when the share price rises above our fair value estimate. In addition, repurchase authorizations are granted based on share counts rather than a dollar value of repurchases, which makes it less likely that the company will optimize the price it pays on a dollar-averaged basis.