DS Smith shares are undervalued

DS Smith (LSE: SMDS) shares have taken a pounding over the past year, but this performance seems unwarranted.

Demand for packaging is rising as the e-commerce sector grows and the firm stands primed and ready to supply the growing market.

The market opportunity for DS Smith shares

The FTSE 100 member started life as a family box-making operation in 1940. Today, it is a leading provider of innovative fibre-based packaging across Europe and the US, supported by recycling and paper-making operations.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The company’s packaging is fully sustainable and made from largely recycled or recyclable material. In 2021-2022, the packaging division sold about 9.3 billion square metres of corrugated board (which is more durable than cardboard). That’s nearly four million average-sized Amazon delivery boxes.

As investment platform AJ Bell notes, “Over the past decade, online shopping made the tired old packaging sector relevant and interesting again – including names like DS Smith. The need for boxes to transport goods to people’s doorsteps supported these businesses’ growth, with their strong commitment to recycling also helping to earn them helpful ESG credentials.”

In the pandemic, stuck-at-home consumers spent heavily online generating windfall profits for e-commerce retailers and other businesses with exposure to online retail, including DS Smith.

As profits boomed, DS Smith shares surged. However, since reaching the lofty height of 461p in September 2021, the stock has slumped by more than 40% partly due to concerns that a recession will hit packaging volumes.

But these concerns seem overblown. Indeed, DS Smith has just issued a trading update for the period since 1 May 2022, saying that “trading continues to be very good... Revenue growth has been very strong which, together with effective cost mitigation, has driven improved profitability, despite slightly lower like-for-like corrugated box volumes.”

The company had previously said that while virtually all input expenses, including energy, have increased “significantly”, it had largely hedged its natural gas costs.

“We now expect adjusted operating profit for the half-year to 31 October 2022 of at least £400m, with strong cash generation.” That means the firm is now on track to beat its previous targets.

The stock looks cheap with growth potential

While other companies are struggling with rising energy costs and economic uncertainty, CEO Miles Roberts is looking “forward to the remainder of the year with confidence” as DS Smith pushes ahead.

The CEO can afford to be confident. Not only has the company hedged its energy costs, but it also has a strong balance sheet with debts of £1.5bn at the end of April 2022, down from £1.8bn the previous year. Moreover, the interest bill on this borrowing is well covered by profits.

The FTSE 100 company is also set to benefit from the falling value of the pound. With more than 85% of sales booked outside of the UK, the falling value of sterling against other currencies means these revenues will be worth more than they were a year ago when covered back to the group’s home currency.

DS Smith’s shares are trading at a forward price/earnings ratio of 7.7 for the year to 30 April 2023 and 7.5 for the following year, according to average analysts’ forecasts.

What’s more, these forecasts are likely to be upgraded in light of the latest trading update.

Despite falling volumes, DS Smith has shown “genuine pricing power”, says AJ Bell. The prospective dividend yield is a healthy 6%. Such a high-quality stock deserves a far higher valuation – this could soon drive the stock price up sharply.