(note: this is marked ‘bonus’ given minimal underlying liquidity, and as such, will not go into the live ideas book)

Pact Group (Australia: PGH) – last price 81c – $275mm market cap, $685mm EV, $200-300k ADV

This is a very simple idea and, with limited liquidity, I will try to keep the write-up brief. Pact Group (PGH), an Australian packaging company, constitutes perhaps the most similar set-up/situation I have found to the Hunter Douglas majority/minority take-out situation from 4 years ago (see here). PGH saw an attempted take-out from its majority shareholder, Raphael Geinder in late 2023 (who owned 50% at the time of the bid), at zero premium to the extant stock price and with the stock down some 80% from its listing price (68c versus $3.80) – that is, after overseeing 15 years of massive shareholder value destruction. Despite raising the initial bid to 84c, the bid remained woefully insufficient on any fundamental grounds, but nevertheless shareholder apathy and board collusion (sound familiar?) ensured RG moved to 88% of the company by the time the (elongated) offer closed, in May 2024. Since the mandatory acquisition threshold in Australia kicks in at 90%, RG just missed out on the opportunity to compulsorily buy out the remaining minorities, and that is where we sit today.

I believe it is a matter of time before RG tries to buyout minorities again – much like in the Hunter Douglas situation – and, in fact, think fair value here is closer to $3 per share (yes, 4x the current price!). The register has consolidated into very few hands, such that the remaining holdouts are overwhelmingly much more value-conscious, and sophisticated, than the last names on the register who took the last deal. Crucially, there were huge errors in the way the ‘independent expert report’ was conducted – errors so gross that any future bid will either partially correct for them (at a minimum) or be summarily rejected by the remaining minorities – either way suggesting deep upside to the stock from current levels. Meanwhile, the core PGH business remains both highly cash generative, and somewhat financially levered – an interesting combination because it means time is the enemy of the avaricious majority owner here. The longer he waits, the more cash accumulates within the entity that, without full control, he cannot access. There remain a myriad of other benefits available to RG from taking PGH fully private – tax offsets with his other business interests; full possession of future franking benefits; ability to cut corporate overhead/listing costs; ability to refinance expensive debt; no requirement to file public accounts – that should motivate another take-private attempt as well.

There are other reasons, too, to motivate a near-term (2025) re-bid here – namely the forthcoming hearing of a $30mm earn-out dispute in the Victoria commercial courts, brought against Pact by vendors of one of Pact’s businesses, TIC – the same group who have now acquired a 6-7% blocking stake in PGH shares and therefore stand to get paid twice, potentially, from this situation. It is my belief that any solution to the earn-out dispute will likely be married to a further take-out of PGH minorities, because if PGH loses the earn-out case (for example), it will likely provide the last bit of bad news likely to dent shareholder willingness to wait it out for full value, allowing RG to anchor his next offer (as he did his last offer) to an arbitrarily low stock price totally divorced from fundamental value.

Let’s dig in. To get started I would recommend reading the Kroll independent expert report, from the October 2023 Target Statement (when the last take-out was launched) – the first 20-30 pages give all the necessary background on the business. The thesis here is really pretty simple, and can be boiled down to three points: 1) this is fundamentally a very stable, and cash-generative business; 2) the last offer was beyond opportunistic and monetized a woefully inadequate, and grossly erroneous, independent expert report; and 3) the shape of the register dictates a far, far better outcome in any likely future deal. I will briefly address each point in turn.

PGH: historically a stable, cash-generative business

If you read the business background in the Kroll report, you will see how tough a time of it PGH had during COVID; dealing with input cost inflation, supply shocks, declining Chinese business, etc; and how over the years they invested in various other ancillary businesses and yet the stock price kept going down. But then if you actually pull up the financial history of the company, you will see this:

PGH has three segments – Packaging & Sustainability, Materials Handling (since sold down by 50%); and Contract Manufacturing – but I have broken out the segment financials for the core Packaging segment, since it constitutes the vast bulk of revenues (~66%); EBITDA (69%); and EBIT (70%). I will touch on the other two segments, a little, but the kernel of the argument is that even though Contract Manufacturing experienced a large ‘boom then bust’ cycle during COVID, the core Packaging is not only not in decline, but that it is growing at a low-single-digit rate and earning more or less 8-9% EBIT margins as it grows. As you can imagine, this business – supporting basically a ton of GDP+ growing industries, as it does, is actually quite stable and cash generative. Given the size and nature of this business, it should be no surprise, then, that operating cash flows generated by the business have been substantial over time even if lumpy in recent years:

There are a fair few exceptional items, of course, and the interest (and lease principal) burden is high. But fundamentally this is a business that converts most of EBITDA to OCF; and even accounting for elevated capex in the last couple of years (FY24, not included above, was also an above-average capex year), converted 60-70% of EBITDA to unlevered FCF (that is, FCF before interest payments).

Intuitively, this should not really be a surprise: pure packaging companies (BERY, AMCR, Orora, etc) all tend to run with meaningful debt (and are habitually favored by private equity shops) because the stability and sustainability of their cashflow generation makes such debt burdens supportable. So it is not the business that is the problem here, but rather the size – or cost – of the debt burden (which was only 3-4x here but priced at 10% WACD, insanely high); and also the ‘diworsification’ into other, more volatile segments like Contract Manufacturing, at the wrong points in the cycle.

Keep in mind, too, that the last reported year in the above is FY23 (that is, June 23), and since then the company has both reported sequentially improved financial results (adjusted for partial asset sales as they sold half the Materials Handling business during FY24)…

…and a much improved balance sheet, given cash generation and asset disposals in period:

It is also worth noting that capex, historically averaging $90mm per annum over the last 8-9 years, has run at $116-130mm in the last couple of years as PGH built a new state-of-the-art facility for Contract Manufacturing (Horsley Park); and invested in other capacity to upgrade their facilities within Packaging & Sustainability. Once these programs complete – per the Kroll report, by the end of FY25, ie this June – there should be at least a $30mm tailwind to FCF as capex drops meaningfully below depreciation (around $100mm a year currently).

The last take-out offer: beyond opportunistic and riddled with procedural flaws

Before addressing the circumstances of the last bid, it is worth considering the high-level picture on valuation here. PGH generates ~$150mm EBIT (note I use EBIT not EBITDA given the complexity around lease accounting and its different treatment amongst comps) and, ref 81c, has a market cap of $278mm, with – as of June’24, a net debt position of $418mm, for a fully-diluted EV of $700mm and an EV/EBIT of 4.6x, and basically the cheapest packaging name I can find globally by a country mile. Any larger listed Australian or US/Canadian comps all trade a mid-double digit multiples of EBIT, for example Amcor (12.2x EV/EBIT); Berry (13.8x EV/EBIT); or Orora (14.4x EV/EBIT). On FCF generation, too, PGH valuation makes little fundamental sense: $150mm of EBIT, assuming even flat depreciation versus capex (ie no subsequent tailwind from capex falling below depreciation), with $40mm for cash interest expense and a normalized 28% cash tax rate (in line with historics) gives $78mm of FCF to the equity – versus our $278mm market cap, implying a 28% levered FCF yield, insane metrics for a stable business (even one that carries a bit of leverage).

With that as context, let’s address the deal process from a couple of years ago. As mentioned, the timeline here is important. The first bid, at 68c (nil premium!), was rejected by the Board, which hired the ‘independent’ Kroll to conclude that fair value on a control basis was, at that time $1.06-$1.52 a share; or, on the basis not of control (since RG already owned 50.7%), between 83c and $1.24 a share. As summarized in that report:

Seeing this ‘fair’ value of 83c-$1.24, RG promptly raised his bid to the bottom of the range – 84c – then threatened immediate delisting for all minorities who didn’t accept – in a fashion that was protested, to the Takeovers Panel, by a number of irate minority shareholders – and managed to harangue and scare enough minorities to get to 88% ownership before abandoning the pursuit of the rest of the minorities, in May 2024. An important point of the saga is that a large number of shares – at least 3-4% of the company, meaning a huge chunk of the minorities left – traded above the 84c last offer, purely to acquire shares to block that offer succeeding.

Now, the first time I looked at Kroll’s valuation work, it didn’t strike me as too egregious, as all I did was scan the introductory few pages. But digging through the detailed assumptions that went into Kroll’s compiling of the SOTP they use to justify the $1.06-$1.51 price range, I have concluded this piece of ‘analysis’ is perhaps the most blatantly erroneous, misleading, and frankly, borderline criminal valuation report I have seen (and I have read more than my fair share of these). Where to begin?

‘Adjusted’ net borrowings

In its SoTP, Kroll uses an ‘adjusted’ borrowings figure, $1025mm, to reduce EV to equity value, that is extremely different than reported net debt (including leases) as of the last balance sheet date (June’23), for reasons that seem entirely spurious. In this adjustment Kroll blindly assumes a ‘normalized’ level of borrowings of $769mm, apparently to equalize for the seasonality of working capital…

…even though reported gross debt as of balance sheet date (June’23) was only $664mm…

Importantly, there is zero historical evidence for the kind of working capital swings that Kroll added $104mm of arbitrary net debt to the equation to supposedly adjust for. If you look at mid-year/end-year working capital positions, over the last 5-6 years, you can see there is almost no seasonality in the net working capital position over this period. Yes, there is a slight draw-down in net receivables between December and June (increasing cash); but this is more than offset by decreases in Payables/accrued expenses (consuming cash); and, at the margin, increases in inventory (again, consuming cash):

This arbitrary $104mm of fictional ‘normalized’ debt decreases equity value, in the calcuation, by 30c a share, alone. I am shocked more was not made of this ‘adjustment’ at the time of the last report.

Calculation of ‘maintainable EBITDA’

Another glaring issue with the report is the methodology used to determine earnings power of each of the segments. Instead of taking, say, LTM EBITDA (or EBIT) and grossing it up at a comp or transaction multiple – as most all analysts would do – Kroll tries to derive something called ‘maintainable earnings’, derived from some rather arbitrary margin assumptions; then capitalizes this new number at a chosen multiple; and THEN deducts the present value of the assumed capex required to achieve this new, higher, maintanable EBITDA number. Here is what they give you for the main segment (P&S), for example:

To be clear, the new maintainable EBITDA number – $217mm – is higher than what the P&S segment reported in FY23 ($189mm). But conducting the ‘analysis’ in such a convoluted way allows Kroll to fudge the valuation in two further ways: by explaining away the arbitrarily low multiple selection (4.5-5x!) as a ‘minority discount’; and then by inserting a further discount via the capex negative value apparently needed to get to this fictional new EBITDA number.

Thus, instead of doing what any self-respecting analyst would have done, we have a situation where:

• Kroll has applied 4.5-5x EV/EBITDA to this business when no other packaging business in the very comp set they present traded below 7.5x EV/EBITDA on CY earnings (with median multiples way higher);
• no other transaction multiple in the universe of comparable transactions got below 5.9x EV/EBITDA (with median multiples way higher); and
• allowed Kroll to insert a further $128mm in negative value for ‘cost of implementation’.

If, instead, we simply used the LOWEST comp multiple of the entire set – 7.5x EV/EBITDA – on the LOWER EBITDA number the segment actually generated ($189mm), we would get a segment value of $1418mm. That is, a full $517mm higher than the mid-point of Kroll’s derived segment value – ie, a full $1.5/share.

Naturally, Kroll applied this same methodology across all three company segments, thereby compounding the error and size of the discount. I will not go through the relevant math for all those other segments, right now, but there is one further error worth discussing.

Sum-of-the-parts math includes a double discount

Part of the justification for Kroll’s absurd selection of well-below-market multiples is to capitalize the earnings of P&S (for example), is the idea that we need to account for the minority discount in the equity (since RG, at that time, already had control). This is simply erroneous thinking, since PGH – the listed entity – owns 100% of its various segments, and thus has full control over them. It is only at the PGH entity level (and not its constituent segments) that any theoretical non-control discount should be incorporated.

Kroll attempts to finesse this problem by including a ‘net synergies’ number in the SoTP – that is, to try to account for the value to a theoretical acquirer on the basis of achieving full corporate control. Hence this line in the table:

You can probably already identify the obvious complaint I have: the net synergy number is tiny and in no way compensates for the lost value that Kroll has deducted earlier by penalizing each segment for a theoretical lack of control. Said another way, if each segment got even a low comp multiple on its actual earnings power – but then zero synergies in the above chart to offset – the ultimate value to PGH shareholders from this now intellectually honest approach would still be wildly higher. As we just saw, the net value accretion through P&S of this methodology was $500mm+ alone…

What is the true value of PGH today?

This all begs the question, then, what is the true value of PGH today, both standalone and then as a controlled entity with zero premium payable for future control? Well, I would posit a very simple, conservative approach as follows – an approach totally divorced from the flawed Kroll process and simply grounded in reported numbers and common sense:

• look at LTM earnings (EBITDA or EBIT);
• capitalize at a very low comp multiple – implicitly taxing the valuation for the lack of control;
• adjust for balance sheet items and changes in the interim (cash generation from the business/asset sales/working capital swings, etc);
• and see where we land.

If we simply do this extremely simple analysis, and using 7x EV/EBITDA – actually below the low end of prior comp numbers even though comps have invariably richened since the last Kroll report was written – along with a few other basic assumption, I get a valuation of basically $3/share:

Given you could drive ten trucks through the distance between the last bid price and fair value here, I don’t think it is really too necessary to overthink it, but clearly you could drop the multiple further – all the way to 6x, the actual mid-point value used by Kroll in its last ‘analysis’ – and give NO credit for cash generated in the interim and you would still get close to $2 a share. But you get the picture.

Why now?

The one aspect we are yet to discuss, of course, is why now? Well, I alluded in the introduction to an ongoing commercial dispute – well covered in this article – regarding an earnout that TIC, one of the dissenting minority shareholders who own 6-7% of PGH, is arguing they are entitled to from Pact in the amount of $30mm – will go to court in April 2025. Obviously $30mm is a meaningful amount to PGH – even though I think it is basically less than 6months’ clean free cash flow – but given the overlap between the shareholder base and those pursuing the lawsuit, and the reality that every day RG waits to try to acquire the remaining shares is another day more equity value accrues to the minorities, I believe it would make most sense for him to try to settle both the lawsuit, and the minority ownership picture, in one go.

Given the obvious benefits of cleaning this up, before he is forced to pay $2-$3 in the future by some aggressive activist or group of activists, I imagine he will try to do this in the near-term – perhaps after the latest financials get reported (in late Feb) but before the Court hears the details of what is likely to be an acrimonious, and embarrassing, case.

A couple of other points to note on this before I put down my pen:

• as a listed company PGH is statutorily required to provide semi-annual audited accounts (but not quarterly updates). Custom dictated that the company, at its AGM (in November) would give a trading update to help inform the market – but last AGM they gave absolutely NO NEW INFORMATION on the performance of the business. I take that as a positive sign regarding progression of the business, as it is only to RG’s benefit to depress the stock as much as possible and hence any even potentially bad news would have been disclosed;
• mandatory acquisition can only begin at 90%, but I believe the register is already effectively blocked to this outcome as TIC owns 6-7%; another rich HNW who is vehemently opposed to a lowball bid is at 1.5%; and I know a few others, including myself, who collectively own 1.5%, so realistically there are only a few million shares unspoken for:
• delisting risk here – the key real risk before getting paid – I believe is largely a non-issue, mainly because of the specific history (RG was taken to the Takeover Panel once); and also because the ASX listing rules include provisions that clearly block a delisting attempt if it were being simply conducted to deprive minority shareholders of achieving fair value (see here). It would not be difficult to prove this, in the public domain, given all I have outlined above, should it come to that. And in any case the delisting period window is 3 months, allowing ample time to make the case to stay public if necessary.