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Printer Friendly AEP INDUSTRIES INC(AEPI) - $35.50 on Jul 9,
2014 by zzz007
2014 2015
Price: $35.50 EarningsPerShare: $0.75 $4.50
Shares Outstanding (in M): 5 P/E: 47.0x 8.0x
Market Cap (in $M): 183 P/FCF: 47.0x 8.0x
Net Debt (in $M): 280 EBIT (in $M): $27 $60
TEV (in $M): 463 TEV/EBIT: 17.0x 8.0x
AEP Industries (AEP or the Company) is a manufacturer of plastic packaging films, primarily for the
North American market. Earnings are temporarily depressed due to a confluence of relatively weak
demand and high raw materials pricing, making the Company appear relatively expensive on current
run-rate numbers. However, with a more normalized demand environment, and with the benefit of
forthcoming significant raw material supply expansion (and associated price relief), I believe that AEP
can generate over $7/shr in earnings in the medium-term, and over $10/shr in earnings over the long-
term, putting shares somewhere in the range of 3-5x EPS. The business is well-managed, with
significant inside ownership, a history of aggressive share repurchase activity, an opportunistic M&A
mentality, and a business mix that has been moving slowly up the value chain over the last couple of
years.
AEP produces myriad products, the one common denominator being that virtually all can be categorized
as flexible films. Products range from the highly commoditized to the specialized, and are sold into a
broad range of verticals including packaging, transportation, food & beverage, automotive,
pharmaceutical, chemical, electronics, agriculture, and textiles. The Companys higher value-added
products require close coordination with customers to ensure that the films have specific chemical and
physical properties. In 2013, the top five product lines by sales (per Company categorization) were
stretch wrap (31%), custom films (30%), food contact (16%), can liners (11%), and PROformance
(specialized) films (6%). Gradually, over the last several years, management has been improving its
business mix, transitioning away from pure commodity products (like stretch/pallet wrap) to those that
are either more retail-oriented (freezer storage bags, sandwich bags) and therefore somewhat less
price-driven, or those that require customer-dictated customization. These moves have largely been
made through tuck-in M&A activity.
AEP has two national competitors, Berry Plastics (Berry, ticker: BERY) and Sigma Plastics (Sigma).
AEP and Berry each reportedly control over 30% of the national market for more commodity-oriented
films, with Sigma controlling roughly half that amount. Each of these firms has smaller market shares
for the higher-end specialty films. Berry is a PE-favorite, having passed through the hands of First
Atlantic, Goldman Sachs, JPMorgan, and Apollo over the past two decades. Berry reports LTM revenue
of roughly $1.4bn and $0.9bn in its Engineered Materials and Flexible Packaging segments,
respectively, subsegments of which are direct competitors with AEP. This compares with AEPs LTM
revenue of roughly $1.2bn.
The flexible film industry has been rationalizing capacity now for a number of years. A significant
portion of the commodity-oriented portion of U.S. flexible film capacity supported the housing
boom/bubble leading up to 2007, and when housing crashed so did demand for many of these

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products. These products included things like mattress film (the heavy translucent films used to wrap
mattresses for shipping), carpet wrap/film, and manufactured housing wrap. I dont have specific
housing-driven capacity detail, but AEP management has provided anecdotal detail of their exposure,
and their sizable market share should make them a decent proxy for the overall market. For instance,
in 2007, AEP had contracts to provide 35mm lbs of mattress film to three large national mattress
manufacturers (Sealy, Serta, and Simmons). The following year (2008), they only sold 10mm pounds, a
hit to their company-wide volume of over 3% on a single product. The combination of reduced housing-
oriented demand, as well as broader demand reductions driven by the Great Recession, drove many
flexible films manufacturers into financial distress. AEP and its two primary competitors, Berry and
Sigma, had the financial flexibility to profit from these dislocations. AEP purchased competitor Atlantis
Plastics out of bankruptcy in 2008, Berry purchased competitor Pliant out of bankruptcy in 2009, and
Sigma purchased majority stakes in both FlexSol and ISO Poly Films in 2009. In all, this put about of
total U.S. industry stretch film capacity into the hands of these three firms, down from five firms
controlling similar aggregate market share prior to the financial crisis. Moreover, both concurrent with
and subsequent to these purchases, numerous other industry players have continued to shut down
manufacturing capacity.
It would be disingenuous to classify the flexible film business as anything better than ordinary. Prior to
2007, AEP consistently generated ROICs in the high-single and low-double digits, with ROEs
significantly better due to reasonably aggressive use of financial leverage. Subsequent to 2007, ROICs
have range in the mid-to-high single digits, with commensurate declines in ROE (averaging in the mid-
high teens) from the pre-2007 period. Notwithstanding the uninspiring industry returns on capital, AEP
management has generally demonstrated good (and improving) capital allocation discipline over the
years, and has been moving the Company slowly up the value chain into activities with higher implicit
returns.
Prior to 2008, AEP had roughly 800mm lbs of annual (extrusion) capacity. The 2008 acquisition of
Atlantis significantly increased the Companys size, adding an additional 300mm lbs of capacity. AEP
purchased Atlantis for just $99mm. Net of $53mm of cash and net working capital, it paid just $46mm
for a business that had been doing north of $20mm in EBITDA prior to the financial crisis. In 2011, AEP
purchased Webster. Webster added an additional 120mm lbs of capacity, and moved AEP (for the first
time) into the retail segment (freezer bags, sandwich bags, conventional trash bags), a modestly less
commodity-oriented subsegment of the stretch film business. Webster was purchased for $25mm
cash, a discount to the $32mm in net assets received in the deal (which necessitated a bargain gain on
purchase adjustment). In late 2012, AEP acquired assets from Transco ($5.3mm purchase pricing + an
additional $5.6mm to move and install the equipment), which moved the business further up the value
chain by giving it the capability to customize commodity films through printing and other conversion
activities.
AEP is led by Chairman and CEO Brendan Barba. Barba co-founded the Company in 1970, and is 73
years old. He owns roughly 10% of the equity, with an additional 10% held by other members of
senior management. The Company returns cash aggressively to its various stakeholders. Over the
past eight years, it has retired 40% of its shares outstanding. These share repurchases are sporadic
and opportunistic. Most recently, in April of this year, the Company bought a block of 508k shrs (9% of
shares outstanding) from a large shareholder, the Crown Cork & Seal pension fund. AEP has also,
during times of market dislocation, been a purchaser of its own debt. There is a large long-time
outside shareholder, KSA Capital Management, that is run by a former packaging analyst. KSA owns
20% of the Company, and has made noises in the past about getting active, but is currently subject to
a standstill agreement with the Company.
AEP is levered. The Company carries about $280mm of net debt, vs. LTM EBITDA of $44mm. While this
may sound untenable, there are a few caveats to keep in mind. First, LTM EBITDA is significantly
depressed. The current trailing $44mm level is about half of what the Company was at just 12 mos
prior. Second, the Company (and its management team) has a long history of managing through
difficult cycles, and has a good relationship with its lenders. The closure of the Webster acquisition
during the height of the financial crisis in 2008 is instructive, as none of the other bidders were able to
put together financing for the deal (which drove the very attractive purchase price). Lastly, the
Company has something of a built-in safety valve, as its able to release significant cash from working
capital during periods of severe downturn. As an example, fiscal 2008 was a decent cash generation
year for the Company, despite being difficult from a P&L perspective.
AEP runs what is effectively a spread business. The Companys primary raw (and cost) input is resin,
and it processes that resin into flexible films, earning a spread over the raw resin cost in the process.
At the commodity end of the spectrum (pallet wrap) it is almost a pure spread business; at the higher
value-added end of the spectrum (printed labels, custom films, etc.) there is moderately less
(customer) price sensitivity and more associated opportunity to earn excess spread. Since fiscal 2008,
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the Company has generated gross profit per lb (spread) in the range of 15.5 to 18.5 (on a LIFO-adj
basis). Prior to that, profitability levels in excess of 20/lb occurred regularly. In addition to soft
demand over the last few years (resulting from depressed housing activity plus a generally tepid level
of economic recovery), flexible film manufacturers have faced an extremely tight resin market. AEP can,
over time, pass resin price increases through to customers. Unlike some of its competitors, it never
enters long-term, fixed price contracts. However, price increases are never easy to pass through, and
there is virtually always a lag. On a current trailing basis, this lag has had a major negative impact on
profitability as resin pricing has increased for 20 months in a row, a nearly unprecedented run. Looking
forward, this tight supply situation should ease over the medium-term. Due to the natural gas
bonanza in North America, significant new resin supply is under construction for the first time in quite a
while. Over the coming three years, 6-10 billion pounds of new resin capacity is slated to come on-line,
representing a rough increase of 6-10% in overall supply. This should supply a major tailwind for AEP.
It is difficult to model AEP financials precisely, as disclosure about the Companys productive capacity is
scant. Company filings used to disclose production capacity, however, have stopped doing so in recent
years. In large part, this is a result of business mix changes over the last few years. Prior to 2008,
the vast majority of the Companys business was in the commodity end of the product spectrum and,
as such, extrusion capacity was a relevant measure of the businesss manufacturing potential.
However, as the business has diversified (through the aforementioned M&A), this has become less
relevant since a printing operation, for example, might not be additive to overall capacity but merely
represent an additional step in the production process. That said, here is my math. We know that the
business had 800mm lbs of extrusion capacity in 2007. Atlantis added an additional 300mm lbs and
Webster added roughly 120mm pounds. This brings the total to 1.2bn pounds. Over the last 9 mos,
roughly 65mm pounds of additional capacity expansions have been announced (and in some cases,
implemented). So roughly speaking the business has (or will have) a total of 1.3bn of productive
capacity. At a utilization rate in the mid-high 80s, this would imply about 1.2bn lbs of sales. With a
combination of a return to a more normalized demand environment, relief on the resin cost side, and
benefit from the Companys initiatives to improve its product mix, I see gross margins trending back
towards 20/lb. This implies gross margin potential of $240mm. Assuming a 70/30 fixed/variable split
on operating expenses, the business should be able to support this with about $140mm in operating
expenses, yielding EBIT of $100mm (EBITDA of $135mm). A $20mm in interest expense, a 40% tax
rate, and 5.1mm shrs drops this down to $9.40/shr in EPS. I believe this could happen within the next
three fiscal years.
So, in summary, youve got a business with an improving return on capital profile, a good management
team, strong insider ownership, an aggressive capital return policy, and medium-term margin tailwinds
that trades at a cheap multiple of normalized earnings. Any sort of rebound in housing or
strengthening in the growth rate of the broader economy is gravy. Im not sure exactly when the turn
(in the stock) will come, but when it does it could potentially move. A year ago, this stock was at
$90/shr. It doesn't need to get back there to be a homerun.
I do not hold a position of employment, directorship, or consultancy with the
issuer.
I and/or others I advise hold a material investment in the issuer's securities.
Improved demand.
Additional U.S. resin capacity comes on-line, providing raw material price relief.
Improving product mix begins to flow through P&L.
# Author Date Subject
3 zzz007 07/14/14 02:47 PM
RE: RE: RE:
resin
capacity
Nails,

I agree with most of your comments.

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There are a couple of different forces at work w/respect to resin pricing. On
the one hand, as resin pricing rises the company gets to run lower cost resin
from inventory through the P&L. This helps optically. To minimize this impact,
mgmt focuses on LIFO-adj numbers. Countering this benefit from rising
prices, there is always customer push-back when the company tries to push
through higher resin pricing. This hurts the top-line, and therefore the P&L.
To further muddy the waters, the company may at the margin stockpile more
or less resin in inventory depending on which direction they think pricing is
going. Given these countervailing forces, predicting short-term margins
based on resin price movements is difficult without inside knowledge of
whether price increases (pushed through to customers) are sticking or not.

With the sort of persistent price increases that have occured over the past
two years, however, the price for the product ultimately rises, and at some
point demand gets impacted through substitution at the margin.

Management certainly believes (strongly) that the sort of persistent price
increases for resin they have experienced over the last couple of years have
had a material negative impact on their margin.

I agree with you that a reasonably stable resin price is probably the best
environment for the Company, as that gives them the ability to capture their
true value-add withouth constantly fighting with customers over pricing.
2 zzz007 07/14/14 09:52 AM
RE: resin
capacity
VI,

Thanks for the question. I mixed and matched data from a number of
sources, leading to an incomplete picture. My apologies. Here is some
clarification.

There was roughly 107bn pounds of resin produced in 2013. This included
both thermoset polymers (15bn pounds) and thermoplastics (92bn pounds).
The thermoplastics piece of this can be further subdivided into PVC, nylon,
polyethylene resins, and polypropylene resins.

Polyethylene resin is what AEP requires, and there is 29-30bn pounds of
capacity for this currently in the U.S. The 6-10bn pounds of new capacity
refers to this polyethylene resin, thereby representing a 20-33% increase in
overall capacity.

There has not been any new polyethylene resin capacity brough online in the
U.S. since 1990. Post-2009 significant (old and inefficient capacity) was shut-
in by both Equistar and Dow, contributing to the current supply-demand
imbalance.

zzz
1 zzz007 07/10/14 08:50 AM
Insider
purchase +
small
writeup
correction
Form 4 filed by board member Belsky. 2k shrs purchased, roughly $70k
purchase price. Not huge in absolute terms, but represents a doubling of
Belsky's current direct ownership stake.

Also, noticed that my writeup refers to the "closure of the Webster
acquisition during the height of the financial crisis"; this is incorrect - it should
have referenced closure of the Atlantis acquisition during this time period.

zzz
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