Aptar's Niche Focus Delivers Profits

We found

The more important pharma segment turned in another solid quarter, with 6% year-over-year core sales growth and a 120-basis-point operating margin improvement to 27.5%. We were particularly pleased with the recovery in the injectables market following inventory destocking by customers in recent quarters. Now that GlaxoSmithKline's Flonase allergy treatment is being sold over the counter in the U.S., Aptar should benefit from higher volume because it supplies the product's delivery device.

We expect to see slight improvements in the beauty and home and food and beverage segments this year as a result of rising U.S. consumer sentiment, partially offset by adverse currency effects and volatile resin prices. We think there's a strong possibility that Aptar will look to acquire MeadWestvaco's plastic packaging operations once the latter firm merges with Rock-Tenn later this year. We believe this would be a good strategic fit, given the overlap of the companies' portfolios. MeadWestvaco's plastic packaging assets could be a good long-term investment if Aptar can acquire them for a good price.

Pharma Segment Is the Profit Star Aptar's focus on dispensing systems has provided it a very successful niche in the global packaging industry. The big profit machine at Aptar is its pharmaceutical division, which accounts for just 30% of group net sales, but nearly 60% of total operating profit. The key to its profitability lies in the intellectual property surrounding its delivery devices for both prescription and over-the-counter products. To stay ahead of the innovation curve, the pharmaceutical division invests approximately 5% of its sales in research and development, which we consider appropriate. Aptar 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 such as asthma and chronic obstructive pulmonary disease. We think the 2012 acquisition of Stelmi was a wise move as it increased the company's exposure to the rapidly growing injectables market and introduced the firm to new pharmaceutical end markets like vaccines, heparins, and veterinary.

In beauty and home, Aptar's dispensing systems can be found in popular products such as Coppertone's spray-on sunscreen, Axe body sprays, and Nivea skin creams. Beauty and home represents the bulk of Aptar's total net sales, but margins are thinner (typically 8%-10%), and though Aptar is a share leader in a number of beauty and home categories, it is a more fragmented market and subject to more intense competition. Significant growth opportunities remain, however, particularly in emerging markets where middle-class populations are growing and demanding more beauty and household products.

Food and beverage is Aptar's fastest-growing segment, and management expects long-term core sales growth of 10%-plus per year from this unit. Aptar dialed back its longer-term growth expectations (of 15%-plus) for this segment, which we think is appropriate, but there's still substantial growth potential as more consumers across geographic regions demand more convenience and cleanliness in their products. Aptar expects to see margins above 12% from this group, and we think that's a fair outlook.

Innovation, Regulatory Experience Set Aptar Apart Our narrow Morningstar Economic Moat Rating is derived from Aptar's clean-room manufacturing capacity, strong customer relationships, patented dispensing system technology, and experience with global health-care regulatory procedures. In fact, about 80% of Aptar's pharmaceutical output is processed through clean rooms, which we believe contributes to the segment's superior health-care packaging margins relative to competitors. Its pharmaceutical products also benefit from the barriers presented by the regulatory approval process for new treatments. A would-be competitor would need to have the requisite regulatory experience, clean-room manufacturing capacity, and quality standards to accompany demanding pharmaceutical companies through the approval processes, which represents a meaningful switching-cost advantage. The company also benefits from mild economies of scope by using existing dispensing technologies in new applications, such as pumps developed for health care in beauty products. Aptar historically has spent approximately 3% of group net sales on R&D to stay ahead of the innovation curve, which has resulted in many valuable patents and resources that potential competitors might struggle to match.

Though pharmaceutical companies may develop some of their delivery devices in-house, we believe they will continue to dedicate the bulk of their R&D budgets to developing new drugs and not on innovative delivery devices. This will benefit Aptar's pharmaceutical division, which spends roughly 5% of its net sales on R&D for delivery systems and should continue to provide reliable and innovative products to pharmaceutical companies. We think Aptar's pharmaceutical division may also benefit from a migration from traditional drug delivery systems such as pills and syringes, which can be difficult to administer to some patients, to metered-dose inhalers or nasal spray pumps. Finally, as branded drugs that use Aptar's dispensing solutions come off patent, generics often stick with Aptar's dispenser in order to be quick to market (competitors would require more time to get their dispensing devices approved) and maintain a consistent user experience. Aptar faces varying levels of competition across its business, but lacks a true competitor that serves all the same industries or product lines. We think Aptar could leverage this advantage to cross-sell its product line and expertise to larger conglomerates.

Increased Competition Is Biggest Risk We assign Aptar a medium fair value uncertainty rating primarily because of the competitive advantages of its pharmaceutical division and the company's solid financial health. The biggest risk to our thesis is increased competition in the pharmaceutical business. Competitors are surely taking notice of Aptar's 20%-plus operating margins here and may make bolder efforts to enter the ring sometime in the next few years. Additionally, pharmaceutical companies may find in-house development of delivery devices to be more attractive and cost-effective and thus provide less business to Aptar.

Input cost volatility is a common risk among packaging and container companies, but most of Aptar's contracts contain resin cost pass-through provisions, which can help Aptar stabilize profit margins over time. Resin prices can be quite volatile, and there can be a lag time in those pass-throughs, but normalized profitability should eventually be restored.

Aptar historically has had a disciplined acquisition strategy, primarily focusing on smaller bolt-on acquisitions that added geographic reach, manufacturing scale, or complementary technology. We expect Aptar to continue this strategy, mainly in emerging markets. With a relatively underleveraged balance sheet, the temptation to make a large-scale acquisition will certainly be present, and the Aptar team does not have a record of integrating larger acquisitions. We would be particularly skeptical of another significant acquisition in Europe because Aptar seems to have enough capacity there.

In recent years, we've seen many consumer products switch to more innovative dispensing solutions and we could be approaching the end of a broader innovation cycle within the industry. Also, new government regulation or a consumer scare regarding one of Aptar's key product components, such as aerosol, could force the company to make costly adjustments.

Stewardship Is Exemplary We believe Aptar management has consistently made good use of shareholder capital. The most recent example of prudent capital allocation is the increased investment in its pharmaceutical division--by far its most competitively advantaged business--by acquiring Stelmi and then earmarking 2014 capital expenditures to expand its capacity. Further, Aptar financed the Stelmi acquisition using internally generated cash rather than by issuing debt or equity. Finally, management's new approach of building production facilities closer to emerging-market customers is encouraging, as most competitors remain focused on domestic production that's later exported to emerging markets. As such, we think Aptar could benefit from a first-mover advantage in those important growth markets by building stronger relationships with local customers.

Executive incentive metrics, which include earnings per share growth and return on equity, are generally aligned with common stockholders' interests, though they could naturally lead the executive suite to favor buybacks and acquisitions. Management historically has used buybacks and acquisitions in a prudent manner, but those can be value-destructive if used improperly. With much financial firepower currently available to management, the temptation to buy back stock at overvalued prices or make aggressive acquisitions is certainly present. We were glad to see Aptar increase its dividend by 12% in 2014 and pay a higher percentage of earnings than in years past. We think the higher payout ratio, which is around 40%, will still allow Aptar to maintain a respectable buyback program that more than offsets share dilution, preserves adequate funding for its bolt-on acquisition strategy, and serves to reduce empire-building risk.