SMURFIT KAPPA: TONY SMURFIT'S GROWTH ILLUSION
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30th August 2021
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Share price: €48.90
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Dividend yield: 2.36%
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Historic P/E: 21.5 (based on earnings per share for the year ended 31st December 2020 of €2.279)
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Prospective P/E: 20.5 (based on forecast earnings per share of €2.39 for 2021 per the 'Simply Wall Street website)
Smurfit Kappa was one of three Irish stocks that were highlighted in our recent technical analysis of that market (along with CRH and Grafton Group), as having very bullish charts.
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However, a close examination of the fundamentals for Smurfit Kappa indicates that the image being projected by management on announcing results every year, of being a strong growth stock, is somewhat illusory.
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I reviewed the recent interim results for the six months ended 30th June 2021, and I also reviewed the annual reports every year from 2020 back to 2015.
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I noticed the following items which give some cause for concern:-
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(i) There were 'exceptional' costs in four of the last five years.
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The accounting standards allow a company to classify a cost as 'extraordinary' if it is outside the course of its normal business, and unlikely to recur. An extraordinary item is excluded in the calculation of earnings per share, so that investors can get a true picture of the underlying earnings growth.
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That is all fair enough, but there is a tendency amongst many large companies that are under pressure from investors to show continued earnings growth, to classify some costs as 'extraordinary', and thereby boost their earnings per share figure.
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That practice is normally resisted by the auditors, and so it should be. But the accounting manoeuvre that the company will often use, in that case, is to classify certain costs as 'exceptional' (as distinct from 'extraordinary').
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Exceptional costs are defined by the accounting standards, as costs which arise from the normal course of business, but are not expected to recur.
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The accounting standards compel companies to include exceptional costs in the calculation of earnings per share. However, what the company then does is report two earnings per share figures. One is called 'basic' earnings per share, and this includes the deduction of exceptional costs. The second is called 'adjusted' earnings per share, and this excludes any deduction for exceptional costs. The latter of course is usually a much higher figure.
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There is then some waffle in the annual report about the adjusted earnings per share being a much better measure of the company's underlying earnings, and that measure of earnings (usually higher) is the one that is prominently highlighted in the results and in the annual report.
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Does Smurfit Kappa use this accounting manoeuvre? You betcha it does!
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In 2015, 2017, 2018, 2019 & 2020, Smurfit Kappa classified certain costs as being exceptional, and sometimes these were quite substantial.
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It does not inspire confidence that a company has real earnings growth, when it reports exceptional costs in four out of the last five years.
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Ask yourself this question.
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How often would you expect a company to have exceptional costs?
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About once every 10 to 20 years, in my opinion.
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(ii) The misleading presentation of 'basic' and 'adjusted' earnings per share figures.
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Consider a hypothetical situation, where a company has lower than expected earnings, but wants to present those figures in the most favourable light.
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The Chief Financial Officer (CFO) then decides to classify a chunk of the current year's costs as being 'exceptional' so that the 'adjusted' earnings per share figure (which excludes these costs) is given a major boost.
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The CFO has now engineered a situation where this year's adjusted earnings per share figure is substantially higher than last year's adjusted earnings per share figure.
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But what about next year I hear you say?
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If the adjusted earnings per share figure is inflated for this year, then when next year comes around - it will be very difficult for the company to show an even higher adjusted earnings per share figure for that year compared to the previous year.
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What will happen next year, I can assure you, is that the basic earnings per share figure will then be compared to the lower basic earnings per share figure for the previous year!
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There will be no mention in next year's results and annual report that the adjusted earnings per share figure is a better indicator of the underlying earnings growth etc,etc.
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Suddenly the CFO seems to have changed his mind, and has decided that the basic earnings per share is a much better indicator of earnings growth after all (because this year's adjusted earnings per share, is much lower than than last year's artificially inflated adjusted earnings per share figure).
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Surely the Smurfit Kappa gang at Beech Hill, Clonskeagh, D4 would not engage in such cowboy-like behaviour, one would think?
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Think again!
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That is exactly what the Beech Hill Gang did in the 2020 annual report and results.
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The 2020 basic earnings per share was up 13%, compared to the 2019 basic earnings per share figure.
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But the 2020 adjusted earnings per share was down 14%, compared to the 2019 adjusted per share figure.
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No prizes for guessing which earnings per share figure was emphasised in reporting results, and in the subsequent annual report....the basic earnings per share, of course!
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But in 2018, when the basic earnings per share was much lower than the corresponding 2017 figure...and the adjusted earnings per share figure was higher than the corresponding 2017 figure, which set of figures did Smurfit Kappa emphasis in reporting results, and in the subsequent annual report?
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The more favourable looking adjusted earnings per share figures, of course!
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Does a company which is experiencing genuine earnings growth, need to engage in such accounting contortions?
Probably not.
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(iii) Smurfit Kappa has not produced any earnings growth in the past five years.
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Let's forget all this nonsense about adjusted earnings per share for a moment.
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The true measure, is basic earnings per share (with the so called 'exceptional costs' all deducted, thereby lowering the figure).
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The basic earnings per share for Smurfit Kappa for 2015 was 172.6 cent.
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The basic earnings per share for Smurfit Kappa for 2019 was 201.6 cent (I have taken the 2019 figures rather than the 2020 figures, as the latter were affected by the Covid crisis).
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That equates to a compound annual growth rate of only 4%.
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But Smurfit Kappa has a high level of debt, and interest rates have fallen even further since the low levels of 2015. Therefore the 4% growth per annum, was largely generated by the increased saving every year from lower interest rates - the real earnings growth rate is near zero.
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(iv) The Chairman and Chief Executive Officer continually highlight meaningless figures in reporting results and in the annual report.
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Almost every year the above two gentlemen tell us that Smurfit Kappa has, yet again, reported record EBITDA (Earnings Before Interest Tax Depreciation and Amortisation of Goodwill).
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A company like Smurfit Kappa, which makes acquisitions every year, will of course report higher EBITDA every year - just by virtue of being a larger company, after these acquisitions.
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These acquisitions must be paid for, either by borrowing more money (thereby increasing the interest paid on debt) and/or issuing more shares (thereby diluting the value of the existing shares).
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Neither of the above costs are taken into account in the EBITDA figures.
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The true measure of how well the company is doing, is the basic earnings per share figure.
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The increased interest charge arising from the higher debt level required to finance these acquisitions, and/or the increased number of shares in issue (thereby diluting the percentage ownership of the existing shareholders), are both taken into account in calculating this figure for basic earnings per share.
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And as regards meaningless figures, the two boys above were boasting recently that Smurfit Kappa's debt level had fallen. The implication seemed to be, that the level of cash flow being generated annually was so good, it was causing the debt level to fall.
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The real reason why the debt level fell, was because Smurfit Kappa had raised funds by means of a share placing. So when this cash was sitting on the balance sheet, it was deducted from the total debt, in calculating the net debt figure!
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Well done lads, you certainly deserve the near €10 million you're getting every year for that stunning achievement!
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Conclusion:
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Smooth talking CEO, Tony Smurfit, is talking a good game these days.
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'Our paper and packaging is good for the environment, and the plastic produced by our competitors is on the way out'...says he.
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'The move away from the high street and into on-line retailing is good for us, as we make the boxes that are used by the on-line giants'...says he.
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Overseas investors are piling in, based on the above themes. But these thematic concepts don't seem to be generating any real earnings per share growth thus far..
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The shares have had a very good ride upwards, the chart looks good, and there is some takeover speculation.
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But in terms of fundamentals, I think it's time to say:-
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'Tony, boy! You ain't fooling us no more!'