Macfarlane – Ticking all the Boxes

_{Disclaimer: I have a material personal interest in Macfarlane shares. A portfolio I help to manage has a large weight in Macfarlane shares. Hence, I cannot help but be biased. Please do your own research – my projections are mine alone.}

Elevator Pitch

Macfarlane is a packaging distributor with 26 core sites around the UK. It stocks boxes, wraps, tape and plenty more, and sells to customers like Dunelm, Halfords and Honeywell, as well as a raft of smaller businesses.

Boring, sure – but boring is often resilient. Customers avoid managing their own warehouses full of various dimensions of packaging. Macfarlane’s scale gives it buying economies, while manufacturers avoid having to deal with hundreds of small customers. A well-run distribution business is hard to dislodge, because for every party involved, the alternative is a world with a lot more hassle. It can be mismanaged, though, as long-standing CEO Peter Atkinson found in 2003 when he took the reins of a packaging empire stretching from Guadalajara to Glasgow.

Within two years Atkinson had steadied the ship, and from that baseline in 2005, Macfarlane has grown normalised earnings from ~£1.5m to my estimate of over £17m in 2021. Accounting for dilution, that’s an EPS CAGR of 14.0%, while paying dividends along the way. A substantially above-market return.

Better yet, the return I’ve just described isn’t obvious. Non-cash accounting charges other companies would routinely adjust aren’t mentioned. Property provisions for rationalising the network – which other management teams would call ‘one-off restructuring expenses’ – aren’t broken out. That’s an opportunity, as economic earnings are more than 20% higher than reported.

But perhaps the most compelling element here is the timing: Macfarlane just announced their best H1 ever by an enormous margin. The business is firing on all cylinders as eCommerce packaging demand drives significant growth, and the recovery in the group’s core industrial business is beginning. Careful expansion into Europe provides further upside.

The market earnings multiple in the UK is around 17x. I think you’re getting Macfarlane at about 12x earnings – a big discount, particularly considering Macfarlane is a far superior business to most. It is better managed, more resilient, more predictable and its growth plans simply require ‘more of the same’. Investors are getting a winner for a discount price.

The Business

So, first things first: let’s dive into the exciting world of packaging distribution.

Macfarlane buys packaging from the big manufacturers – Smurfit Kappa, for example – and holds it in their 26 distribution centres.   Smurfit doesn’t want to deal with Macfarlane’s 20,000 customers. Tinkering with delivery route optimisation and holding custom stock for rapid delivery is not their game. Hence, distribution is a win-win; it aggregates demand and reduces cost-of-service for manufacturers.

Customers – like Argos, Dunelm or Glasses Direct – place orders with Macfarlane, typically for next day delivery. These guys don’t want warehouses stuffed with huge amounts of packaging. They won’t get the best price from manufacturers compared to Macfarlane, which buys in serious volume. Nor are they experts in packaging, an unloved and unsexy part of the world of commerce. Having a consultative partner is a big help.

Of course, some big customers do go direct, and some use a mix of distribution and manufacturer. Ikea uses Macfarlane for part of their needs.  But Amazon doesn’t need them at all – Amazon is big enough and complex enough to negotiate and manage their own packaging supply chain. Luckily for us, we don’t care about Amazon anyway – incessantly squeezed margins and a lopsided relationship is no way to run a business. Dunelm and Ikea are meaty customers, and even small businesses offer plenty of margin potential.

Peter Atkinson, CEO, likes to point out that the actual cost of packaging is not that material in the grand scheme of things. Think about part breakage and damages. Or the nightmare of dealing with your own packaging logistics – likely in a facility that doesn’t have the space or the layout to effectively store these materials. If you’re a growing retailer, do you want your warehouse to be stocking your £25 candles, or do you want to be stocking bulky pieces of cardboard – which you could receive as you need from Macfarlane? Like any good salesperson- Macfarlane’s pitch is to persuade the customer to see that the price is not the primary concern:

It’s important to note here that Macfarlane predominantly sells products for ‘moving goods around’ as opposed to for ‘marketing products’. Macfarlane does not stock Kellogg’s cornflakes boxes. They might be providing a big brown cardboard box in which 32 cornflake boxes are packed for shipment to a cash-and-carry. Or, better yet, they’ll sell a box and some void filling for a hydraulic pump part – because about two-thirds of Macfarlane’s business is exposed to industrial end-markets. This doesn’t mean it’s all completely standard; for most of their customers, they’ll source, procure & hold onto branded boxes, in a more consultative and value-add relationship. See this video of Lakeland, below, which highlights it nicely:

Packaging distribution has grown up as a local business. Partly this is because of the low-value, relatively high-volume nature of packaging; when you’re operating on thin margins, you can’t afford to ship halfway around the country to service far-flung customers. And those customers – whose whole operations will be disrupted without packaging – don’t want to take a risk on a supplier 200 miles away. Macfarlane spends about 3% of its revenue on logistics. For a business making 6-8% margins, that’s a material cost.

Peter has an interesting further theory as to the history of the industry, though, which I’ll loosely transcribe from this video. It’s worth watching if you want an introduction to the business:

“The reason the industry is fragmented is because these sorts of products aren’t very high profile for organisations; they’re very low on their priority list, so they often delegate to someone quite low down the food chain in terms of decision making. Their natural reaction is to use a local supplier – and because the sophistication of the way they plan and order these sort of things – like bubble wrap and boxes – isn’t very good, they want an insurance policy – and the best insurance policy is to have someone local. And hence, the industry has grown up as a series of local companies”

I find these sorts of ideas fascinating. Business structures often end up the way they do for silly, human-sounding reasons.

Anyway, the fragmented and local market is plain for all to see, and it’s a big boon for current investors, particularly if you get on board with a consolidator like Macfarlane. Packaging distribution is not a business where you want to open a greenfield site today. 6% EBIT margins are not causing competition to batter down the doors, and private equity is not fascinated by a total addressable market which probably has the potential for £75m of operating profit in the UK. It’ll take you years to acquire the customers to run an efficient distribution centre from scratch.

So you end up with sticky customers in a sleepy market without aggressive price competition and disruptive new entrants. Companies service their local areas and retain their customers unless they screw something up.

As to long term growth, there are both positives and negatives. Environmental concerns, on one hand, suggest that we should be using less packaging. Indeed, a drive to use less (for cost reasons and eco reasons) is a constant feature of the business. On the other, we are all sitting at home in an increasingly piecemeal and fragmented supply chain, buying boxes of vegetables to be delivered twice a week and mobile phone cases on Amazon. Industrial production is unlikely to get less specialised any time soon. I don’t know where this all pans out, but I am content with the assumption that Macfarlane’s end markets are flat to modestly growing.

All of this is the business school theory – the stuff they write case studies about. Luckily for us, we have actual data we can consider to get to the fundamental question we care about: is this a good business?

Financial History

Surprisingly, yes. I say ‘surprisingly’ because 30% gross margins are not software-like, by any stretch of the imagination. But when you are churning your inventory ten times a year, you are getting plenty of bites at the apple. And – more importantly – it’s highly predictable and incredibly reliable. Packaging is an unusually resilient industry because of its involvement in almost every sector of the economy. eCommerce is only exacerbating this trend. Macfarlane’s gross profit still rose in COVID-hit 2020.

Ponder that point for a second. Macfarlane faced headwinds, like all businesses. Many of their large customers are in the aerospace market, which was obviously battered in 2020. The overall level of GDP – which is typically the correlate for packaging consumption – fell by 10%. I can’t think of a better testament to the resilience and diversity of the business than the fact that profitability still improved last year.

Investors under-rate predictability, in my view. Predictability allows for effective cost management. Logistics costs, staffing costs, inventory levels and negotiations with suppliers are much, much easier when you know that demand will be there on the other side. It turns business into a game of continuous improvement – how to squeeze a little more cost out, how to negotiate slightly better prices, how to manage the network geographically. This is all much harder when you’re sweating about where tomorrow’s sales will come from.

And all of that means you get a long-term financial profile that looks like this:

The dark and dreary days of the GFC are barely noticeable; the distribution business still doubled profits from 2008 to 2012. You won’t find many small-cap businesses with smoother earnings profiles than this.

It’s been profitable growth, too: the group has deployed approximately £60m of incremental capital in the last 15 years to support group level EBIT growth of ~£12m. That’s an excellent return, and as I describe later, I think that meaningfully underestimates the value creation because of the group’s conservative accounting and because 2020 figures will shortly be blown out of the water.

Macfarlane isn’t unique in this sector, either. If I look at their competitor set – other large packaging distribution businesses in the UK (all private) – we see a similar story of stability and resilience. These businesses are consistently profitable, to a greater or lesser degree, with overall average annual margins of 5.5%. That’s not dissimilar from Macfarlane historically, and a little lower than their 8% target:

The outlier in that chart, by the way – the one with margins shooting into the stratosphere – is Kite Packaging, a company with roots entangled with Macfarlane. Indeed, its formation only came about when a botched acquisition Macfarlane completed under the old management team led to the departure of a number of key executives. Sure enough, they remain a thorn in the side twenty years later!

Still, it’s important not to read too much into charts like this – I have pulled the data from Companies House with no knowledge of the inner workings of these businesses. Do they have similar depreciation policies? The same property structure (leased vs. owned)? Management remuneration equivalent with respect dividends vs. salary? While we can’t know that, it should give some comfort that Macfarlane is neither unusually profitable nor operating in an industry with large variability. Everyone is making money.

My hope is that Macfarlane – which is now pushing on 25% market share in the UK, they reckon, about 2.5x their largest competitor – should be able to earn margins at the top end of that group. They target 8%. I suspect if they stopped acquiring, consolidated to the operating base they’d want to work with today and ran for maximising short-term outcomes, they could comfortably beat that.

Manufacturing

One thing I have neglected to mention in the entire write-up so far is Macfarlane’s manufacturing division. I don’t think it is hugely material to an analysis of the group. In the last full year, it made £381k of operating profit – against £14.0m for the distribution side.

Granted, that was an unusually low figure – substantially below where it should be in a business segment that has hovered around £1m in EBIT for the past decade. COVID hit manufacturing harder than distribution since it relies more heavily on aerospace and other industries more severely impacted than, say, home improvement retail.

Manufacturing has two sub-segments. Packaging Design & Manufacture, while not hugely relevant from a group financial perspective, can be seen as an important facilitator of group sales. This typically produces bespoke packaging for niche or high-value products – an industrial customer needing to transport a sensitive and expensive part, for instance. Around 15-20% of the division’s sales are to the packaging distribution business.

The Labels business, on the other hand, has less to do with the broader group. It produces labels for consumer products and sells to the likes of PZ Cussons and McBride. It appears to be an OK business, throwing out a little EBIT, but it has no obvious benefit to the core distribution segment.

In the half-year just passed, manufacturing profitability improved significantly, both organically and through the acquisition of GWP. Management restructured during the pain last year, so I expect they will carry this improvement in profitability through to the full year. None of this changes my story for the group as a whole. Manufacturing is an enabler that will hopefully throw off a little extra profit. It is not core to the investment story.

Framing the Opportunity

Everything I’ve said above reiterates Macfarlane as a steady, slow organic growth business. I think that’s a fair characterisation. The flip side of packaging’s stability is, well, its stability.

But management has squeezed more juice out of this market with a consistently executed acquisition strategy. Indeed, the inorganic front has been the only operational cash consumer in the last 15 years. Organic growth has been achieved with shrinkage in the group’s PP&E. Better management of suppliers means net working capital has shrunk, too.

By my estimates, Macfarlane has spent £60-70m in the last 15 years, predominantly with internally generated cash. That spend, combined with organic growth, has produced an EBIT increase from £1.5m to £17m in 2020. This figure – the return on incremental capital – is a more meaningful statistic, and a better guide to the future than group level, point-in-time calculations. You can calculate it however you want, but I won’t quibble if you get anywhere from 15-25% pre-tax. Any number you pick in that range is meaningfully better than the average UK company and indicative of a shrewd and disciplined capital allocator at the helm.

But before we get into recent figures and the future, let’s just wrap up our review of the past by consdering last year’s financials. I hope to explain why I think the group’s reported figures are meaningfully underestimating the free cash flow this business can produce.

As I mentioned right at the start of this post, Macfarlane’s potential isn’t handed to you on a plate. In the most recent set of results, management began adjusting for the most obvious ‘costs which aren’t costs’. In my view, though, even their adjusted numbers are more conservative than the unadjusted numbers many management teams produce. Looking at 2020, for instance:

• The group reported £10.2m of net profit. No adjustments were shown. Free cash flow, on the other hand, came in at £15.9m – an early hint that things are looking rosy
• I ignore the amortisation of acquired intangibles – an accounting treatment whereby you write-off some of the value of companies you purchased. Macfarlane’s acquisitions are not depreciating in value, so this non-cash cost is accounting fiction. And this is big, at £2.5m – or ~25% of reported net profit
• The group also increased its provisions across the board. Net inventory provisions increased by £576k, a material sum on £16m of fast-moving stock. Provisions on receivables were increased by £838k, despite an aging profile which looks a little better. Property provisions due in respect of dilapidation on leased premises were jacked up by £1,766k.

Prudent provisioning is a classic sign of management conservatism – but extreme prudence on the provisioning front cannot recur every year. You cannot continually put aside much more in inventory and receivable provisioning than you write off.

Likewise, dilapidations on the exit of leased properties are, of course, a real cost. But they relate to the exit from two long-term leases, reducing the group’s property costs in the future. Each instance relates to a separate, non-recurring and long-term beneficial decision to improve the efficiency of the group. These are the costs you like paying, and they are as much ‘investments’ as they are ‘costs’, notwithstanding the accounting.

I hope my point is clear: I don’t think Macfarlane created £10.2m in economic value last year; I think they certainly made ~£12.6m, ignoring that silly amortisation. And I think we can have a robust debate about how we view the provisioning and the recurring or non-recurring nature of property adjustment costs.

Current Momentum

If you’re with me so far, I hope you agree that the company is cautious and not prone to exaggerating its virtues. You might acknowledge that the sector and particularly Macfarlane itself is stable and favourable for long-term investors. And you probably agree that, with a long history of cash earnings exceeding accounting earnings, there’s more to Macfarlane than meets the eye.

Hence, one might conclude that 2021 would produce another solid but unspectacular performance, continuing a long history of not surprising investors.

You would be wrong; because H1 2021 was a brilliant six months for Macfarlane.

Operating profit doubled on revenues up 26.5%. Indeed, EBIT of £11.1m was approximately 72% of full-year forecasts prior to the release of this set of figures.

Brokers have raised forecasts – but H1’s profit is still 51.3% of that fresh figure. Even if the group had no seasonality, that would be a harsh assumption, I think. Macfarlane completed two acquisitions this year, and they came partway through the first half. The simple mechanical effect of a few more months of contribution from those will add a few hundred grand of profit.

But, more importantly, Macfarlane has historically displayed a pronounced H1/H2 split:

Now, there are some clear reasons for caution. Input prices have been increasingly aggressive, and Macfarlane will need to manage its customers carefully to effectively pass on these price rises. One other thing I haven’t quite figured out is how their two newly acquired businesses contributed £1.9m of EBIT in the few months they were owned. It’s much more than I was expecting. And the industrial recovery is yet to properly come through in the numbers, which is both a negative and a positive in that it leaves a little upside on the table for the next couple of years.

Perhaps this year will be the first in Atkinson’s tenure that H2 is weaker than H1, which will be necessary to meet market forecasts, despite the obvious signs of very strong trading. I don’t think it will be.

Tying it Together

The reasons I find Macfarlane so exciting today also make the business difficult to forecast.

We have never seen an H1 performance this strong before. That makes it hard to know whether it augurs an exceptionally strong H2, or if the existence of such an anomalous event should make us more cautious as to our predictions.

Likewise, conservative accounting means I am directionally comfortable with earnings figures, but it also makes things hard to predict. I never want to make blanket assumptions that management are overprovisioning, and start to adjust or assume that’s the case. That feels dangerous to me. So I would rather comfortably sit in the knowledge that profits are always likely to be cash-backed, and that the accounts are simply a prudent reflection of the truth.

Still, we have to try and put something on paper. Here is my current best guess for where FY 2021 will pan out:

I hope I’ve made my assumptions fairly clear in the table above. I will reiterate that these forecasts contain a wider band of uncertainty than usual: on the one hand, you might consider that assuming Macfarlane will have its first-ever H2 margin reduction is punitive. On the other, you might think that assuming 10% organic growth is aggressive given much stronger comparators than in H1. I look forward to any and all debate in the comments!

But let’s say you agree with me, and think they’ll earn ~£17m this year. This puts them, at the time of writing, on a P/E multiple of 12.4x for the year which will soon end.

What’s a fair multiple to pay for Macfarlane?

Well, multiples are simplifications of proper DCF analysis, and you can distil down to two things: how fast is a business growing, and how safe is the business? Safer – more ‘bond like’ operations, with smooth cashflows and little variability in results, deserve a higher multiple. Likewise, businesses with the opportunity to grow – either organically or acquisitively – also deserve higher multiples.

How does Macfarlane stack up?

Let’s take the latter first; the growth. Macfarlane is manifestly not in an explosive market. But – through consistent organic improvement and a repeatable and reliable acquisition strategy, they have grown at mid-teen rates for a long period of time. The ‘follow your customer’ program, moving cautiously into Europe alongside customers they know and trust, is an increasing focus of the group. And the pension deficit – which had been a millstone around the group’s neck for the last decade – is no longer an issue. I think Macfarlane can continue to do what they have been doing and continue to get a little larger and a little better every year.

And as to the first factor, stability, I don’t need to reiterate what I’ve said above. If market fundamentals don’t persuade you – crucially, packaging’s relevance to every sector of the economy – the financial track history of the business should. Investors recognise this in other packaging companies, which trade at full multiples.

The market multiple at the moment is somewhere between 16-18x. In my view, Macfarlane’s clear and executable growth strategy and the defensive nature of its business means it is certainly a more worthwhile investment than the average company. Hence, I think a 180-190p price target for the company is both realistic and achievable, likely after the market wakes up to how well they are trading.

That said, it’s not how I think about valuation. Every business I buy, I intend to hold for many years. Hence, I mostly think in terms of expected return, not point-estimates.

With the pension deficit issue behind it and a balance sheet with only a little net debt (which is being paid down rapidly), Macfarlane is set fair for the medium term. I wouldn’t be surprised if we see an EPS CAGR in the low-teens, combined with cash returns of 2-3% annually. That gives me an expected return in the mid-teens, with lower risk than the vast majority of other investment cases I see. Given the investment landscape today, that’s compelling.

It’s a long way from sex, drugs and oil & gas exploration, but I think Macfarlane makes a great bedrock to a portfolio.