One of the big surprises for me so far this reporting season has come from giant plastic packaging producer Amcor Limited (ASX: AMC).
At first glance the company's full year result was unexceptional; revenue dropped 3.4%, while profit before significant items was up 4.5%. Ho-hum.
But when we compare Net Profit After Tax (NPAT) of US$614m, to the equity shareholders have in the company we get a monster Return On Equity (ROE) of 69%!
Cut it anyway you like, it's a big number. In 2016, for example, the average ROE for the Packaging & Container industry in the U.S. was 15%. Specialist hearing device manufacturer Cochlear Limited (ASX: COH) by comparison has a ROE of around 42%.
So how does Amcor do it?
Breaking down return on equity
To see how Amcor makes its huge 69% ROE we can break it down into three components using the DuPont analysis:
- Net profit margin (Net Income ÷ Revenue) 0.067
- Asset Turnover (Revenue ÷ Assets) 1.01
- Equity Multiplier (Assets ÷ Shareholders' Equity) 10.18
- Return on equity = (0.067) x (1.01) x (10.18) = 68.8%
We can quickly see that Amcor is a low margin business and that the huge driver of returns is the aggressive use of debt to fund assets. Without this, if Amcor didn't leverage its assets with borrowed money, ROE would be a weeny 6.7%.
I usually advocate avoiding debt because it reduces operational flexibility if market conditions change. But Amcor shows how powerful debt is at scaling returns and adding value for equity investors when used effectively.
Amcor reported short and long term debt of US$4.6 billion at 30 June 2017. This seems like a lot, but the company could cover its interest obligations by nearly 5x which doesn't ring any alarm bells to me.
To get a more rounded view of Amcor's returns, say to compare to a competitor, we could instead look at Return On Invested Capital (ROIC) which factors in the use of debt as well as equity. Here Amcor returns clock in around 15%.
Is Amcor a buy today?
I like that Amcor is dominant enough and stable enough to use so much leverage. But there are several factors that would hold me back from buying today.
Revenue has been declining over the last three years and given the underlying profit margin is slim, at the current share price I don't think there is any real margin of safety if demand for packaging slows or input costs rise.
