Interactive Investor

Stockwatch: what would a US takeover mean for this FTSE 100 firm?

Analyst Edmond Jackson considers a FTSE 100 firm that has seen its share price soar amid takeover talks.

2nd April 2024 12:51

by Edmond Jackson from interactive investor

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In June 2023, I made a “buy” case for FTSE 100-listed DS Smith (LSE:SMDS), a British multinational packaging group. It was a classic investment value situation: at 270p, representing a price/earnings (PE) multiple below eight times and an apparently sound yield near 7%, twice covered by earnings.

Packaging was out of favour amid concerns about a recession after interest rate rises. In addition, delivery giant FedEx Corp (NYSE:FDX) had cited quarterly revenue down 10% and given tepid guidance for its May 2024 financial year. Smith has derived a modest 8% of revenue from the US, its majority 92% being Europe-wide. Subsequently the US economy has surprised on the upside, lending more confidence there.

While Smith shares ended the year over 300p, the price fell back to 270p as of early last June. Yet confirmation of how the market has undervalued this business is underlined by recent merger talks with Mondi (LSE:MNDI) now attempted but blown out the water by a possible offer equivalent to around 400p a share by International Paper Co (NYSE:IP). This is a $13.6 billion (£10.8 billion) global producer of sustainable packaging, pulp and other fibre-based products.

At the start of this week, Smith share are trading very close to 400p, as if the market senses a strong chance of this latest approach consummating.

All-equity merger terms with Mondi implied a value of 373p per Smith share – expressed as a 33% premium to the 281p share price as of 7 February. This is broadly “mid” Smith’s share trading range over the past 10 years, having breached 500p in mid-2018. You could say, given that it is based on an equity exchange, that shareholders retain exposure to upside potential; yet for a decent business a premium paid for control is normally also paid. So, the Mondi proposal was quite an invitation to rivals to take interest.

An obvious chance for a highly rated US company to step in

On 26 March, Smith confirmed media speculation that it was in discussion with International Paper on another all-share possible offer, implicitly around 400p per Smith share, which would be a circa 7% improvement on Mondi.

Relatively higher US equity ratings versus the UK bestow an inherent advantage. Where an acquirer is exchanging more highly rated paper, it can boost earnings per share (EPS) simply through buying a company trading on a lower PE, irrespective of any benefits from integrating operations.

At $39, International trades on 45x trailing earnings, yet even after Smith has jumped to 395p in the market, its historic PE is 10x and if consensus is fair then the forward multiple is 12x and the yield 4.6%. International Paper’s yield is more like 2%. You get the sense of value differential.

Having also identified economic synergies, International Paper probably senses potential to achieve a double whammy here, which raises the odds that the possible offer terms are an opening proposal and could get sweetened. They might need to be too, to tilt UK shareholders in favour of accepting US equity.

DS Smith - financial summary
Year-end 30 Apr 

Turnover (£ million)4,7815,5186,1716,0435,9767,2418,221
Operating margin (%)
Operating profit (£m)316317412448304443733
Net profit (£m)209259274527194280503
Reported EPS (p)20.421.119.721.013.220.335.5
Normalised EPS (p)26.432.728.227.118.423.136.8
Earnings per share growth (%)3.823.6-13.6-4.0-31.925.159
Return on total capital (%)
Operating cashflow/share (p)51.238.839.946.254.566.662.5
Capex/share (p)23.929.222.727.324.031.239.3
Free cashflow/share (p)27.39.617.218.930.535.523.2
Dividend per share (p)14.114.416.
Covered by earnings (x)
Cash (£m)139297382595813819472
Net debt (£m)1,1401,7052,3722,1481,8121,5291,672
Net assets/share (p)132183227244257308297

Source: historic company REFS and company accounts.

The mood music sounds encouraging

Smith’s board responded in an accommodative manner, versus “significantly undervalued” rebuttals that we have seen lately elsewhere – to the wave of takeover approaches for London-listed companies.

 It “acknowledged the strategic merits and potential for value creation”, hence accordingly is progressing discussions.

International Paper contends that the combination would have “compelling strategic and financial rationale” creating “a truly global leader”. A detailed list of synergistic benefits is presented.

It altogether conveys more serious intent on both sides than approaches for Currys (LSE:CURY) and Direct Line Insurance Group (LSE:DLG) – where rebuttals of “seriously undervalued” were made, and suitors retreated.

Mind how International Paper has no long-term growth chart

Despite their high rating, the shares have achieved very little by way of capital growth. They are trading where they did in the early 1990s, with various jagged swings – down to $5 in the 2008 crisis and up to $60 in March 2021 when Covid lockdowns boosted home deliveries and share trading alike.

A sizeable acquisition could be transformative for International Paper if executed well. On current possible offer terms, it would be buying Smith for around £5.5 billion, about half its own market value. Similarly, in its last financial year, Smith achieved £8.2 billion revenue versus around £15 billion equivalent for International Paper.

With revenue expected more like £7.2 billion in the near term, however, it makes the timing of approaches astute. Smith shareholders may feel the stand-alone prospect unexciting despite a near 5% yield at the current share price of 395p.

Showing why UK equities are preferable to US, for income

It is not just the near 5% versus 2% yield differential here; the overall risk/reward profile on US equities concerns me.

Yes, they have for a long time been rated higher than the UK, however, as I explained in my last macro piece, the Federal Reserve is in a real dilemma after its mixed messaging fuelled one side of the economy, hence inflation creeping up again, while bearing down on another with high interest rates.

If there is any kind of upset, say inflation advances or the delayed effects of high rates cause a slowdown – then US equities are liable to turn jittery.

It is a snapshot but US unemployment has ticked up from 3.7% to 3.9% albeit below the long-term average of 5.7%.

The likes of International Paper probably would not get hit like highly valued technology shares, but this is still a cyclical packaging company on a big “growth” PE. I do not see a robust prop versus much change in market sentiment.

Mind the aspect of 30% US withholding tax on dividends

While this “buy” idea is worked out well by way of industry affirming underlying value in Smith, things could get tricky for many UK individuals. It is not simply a matter of opening an international share dealing account just for one holding.

There is the aspect of 30% US withholding tax, where a UK agreement with the US on double-taxation means you can reclaim 15% back via HMRC – obtaining a tax document from your stockbroker, declaring US dividends on your tax form and getting a credit against tax paid. Assuming that it all works out.

Some UK shareholders appear to have run into complications hoping an ISA or SIPP would shield them from withholding tax, but the US apparently does not recognise such wrappers.

It is a matter on which I am not qualified reliably to comment, but I can draw it to your attention for vital investigation, should a US equity offer for Smith materialise.

While I therefore conclude on valuation criteria that near 400p Smith currently rates a “hold”, shareholders might prefer to exit than hold International Paper.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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