British Polythene Industries (BPI): A Good Year

The portfolio is leading a blessed existence at the moment, with results coming in above expectations left right and centre and most of the shares performing well above the FTSE. A combination of  a smidgen of personal experience on variance and the long stretches luck can drag itself on for and a larger dollop of bemusement around why/how the shares are performing so strongly serves to keep any overconfidence in check, though. I am not feeling a particularly strong conviction on many of the shares in my portfolio at the moment - the only thing preventing a big sell-off is the dearth of new opportunities I've been coming up with. This has been noted by others on Twitter, though the exact combination of market factors (it is getting more expensive) and me becoming more picky is one I haven't really figured out yet!

The results

British Polythene Industries do exactly what you'd expect them to do - polythene and plastic products. They're a big player in the UK and European market, which appears to be a regional oligopoly with a few dominant players. The results were nothing groundbreaking - showing a decent improvement in operating profit alongside a small drop in revenue and volumes. The dividend is also up marginally. I suspect the main driver of the positive reception of the results was the outlook statement - almost unambiguously positive, with Cameron McLatchie, the chairman, noting that:

The prospects for 2013 look equally good, particularly for further improvement in our UK business. Current capital investment is targeting resilient and sustainable markets. We are confident that the prospects for growth in 2014 and beyond are now clear.

The UK issues are really the crux here. The UK business has been earning far worse returns than the mainland business for an extended period now - even with management's ongoing efforts to reorganise it. To put figures to it, Mainland Europe earnt £13.3m on £135.8m of revenue last year, using £58.6m of assets. UK earnt about 35% less operating profit on over double the revenue and almost 3 times the asset base. It is clearly a far less efficient and far less profitable story. To counteract this, management have been investing - restructuring , closing sites and spending on equipment.  They have been rewarded with an uptick - they are doing better, after all, but they're still leagues apart.

The valuation

Taking the business as a whole, it's grown revenues by more or less inflation over the last 9 years. Net profit is fairly volatile but has remained roughly flat for the last 3 years, with brokers penning next year as being about the same again. By my calculations, there are three things that can justify the current valuation. Two of these relate to the business; either some improvement in returns (via improved margins or asset efficiency) or a growth in revenues. The latter case seems unlikely (though certainly not impossible) given the past - it's not obvious where big growth would come from; BPI see demand firming, which might be good for prospects, but I usually find management predictions for the mid-term wayward at best. Perhaps we'll see an uptick next year. We might also see more in the future as, as they put it, 'capital investment is targeting resilient and sustainable markets'. These last two points are more or less the usual cut and thrust of business, though. Things are cyclical and businesses respond to changing markets by shifting capital allocation; capitalism at work.

The story for return on capital is essentially the same. Given I don't have any particular reason to believe BPI has a firm competitive advantage, or one in the making, as an investor the prudent thing to do would appear to be to take a cyclical average of returns and err on the side of caution with whatever pops out the other end. While there's clear potential for the business if they manage to improve UK returns to the EU level, given my own lack of knowledge with the industry and the specifics of the situation, I can't help but place equal weight to the possibility that the smaller mainland operations are the ones out of whack and more likely to see returns reverting.

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A more subtle and obvious driver of outperformance over the next few years, and the non-operational reason, could be the pension plan. I spoke a little about them in the comments section of my last post:

I’m guilty of fearing pension liabilities more than bank debt. Like everyone else, it’s probably the open-endedness that does it; though I wonder if now might be exactly the right time to flip that, since perhaps now is a turning point after market conditions colluded to make otherwise quite well-funded schemes look shaky.

British Polythene have a large pension deficit on their balance sheet - £64.6 million.  It was closed to future accruals towards the end of 2010, though still retains a PV of future liabilities of £256.3m. These are clearly large obligations for a company of this size. Since this is effectively debt, but debt whose 'value' is far more difficult to quantify than simple bank loans, the size means it could easily have a material impact on the valuation of the equity on the stock market. Again, I'm not an expert, but relatively small changes in pension scheme model variables could make large changes to the value of the equity here.

 Anyway, all in all I am - as you can probably tell - erring on the side of selling. The pension scheme aside, I don't have particular confidence in the valuation of the business at this level. Returns were higher this year than any of the last ten, which could be post-restructuring improvements. By my sums, the current valuation makes that an expectation and not a bonus, though, which puts me off slightly. It's had a nice run, but my current opinion is that it's an unexciting company now valued about fairly.