This Just In: Sealed Air Stock Upgraded

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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A funny thing happened to Sealed Air (NYSE: SEE) stock investors last month -- and by "funny," I mean "horrible."

On Aug. 8, the maker of Bubble Wrap box filler and Cryovac food packaging released Q2 earnings numbers that (barely) missed Wall Street's target for profits, but beat targets for sales (also barely). Adding clarity to where the company is heading, Sealed Air then proceeded to raise its guidance for the rest of 2017. Problem was, it didn't raise guidance enough; the midpoint of company's new range for expected adjusted earnings -- $1.75 to $1.80 per share -- fell a bit short of Wall Street's expectations of $1.79 per share, and Sealed Air's sales target likewise fell short of expectations.

Result: Sealed Air stock plunged, and was recently sighted more than 7% below pre-earnings highs.

But that's just the bad news. Now here's the good news.

Merrill Lynch delivers an upgrade

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Sealed Air sprung a leak last month, there's no doubt about that. But according to one Wall Street banker, it's also delivering investors an opportunity to buy the stock at a good price. This morning, StreetInsider.com (requires subscription) spotted Bank of America's Merrill Lynch brokerage unit releasing an upgrade for Sealed Air stock.

Announcing a new buy rating and a $48 price target, Merrill muses that Sealed Air shares are now "down [by a] double digit percent relative to the S&P 500 since mid-August," writes StreetInsider. (The stock has also lost 10% of its value over the past year, versus a 15% gain on the S&P 500 -- a 25% divergence in fortunes.) That all sounds bad, but in Merrill's view, it gives investors "a better entry point" into the stock than they've had in some time.

Finding the leak at Sealed Air

That Sealed Air stock is cheaper now than then is obvious, but before clicking "buy," it behooves investors to ask, "Why?" Last quarter, Sealed Air reported a modest 3% growth rate in its overall sales, but with resin prices rising, the company admitted that its cost of sales grew nearly twice as fast -- 5.4%. This higher costs of goods sold depressed margins and reduced Sealed Air's operating profits for the quarter.

As Merrill Lynch explains in a note covered by TheFly.com, however, things may soon turn around for Sealed Air. Profit margins and profits should bounce back nicely as resin prices moderate. Plus, the company just finished selling its Diversey institutional cleaning and hygiene products division to Bain Capital in a deal that yielded $3.2 billion -- money that can be applied to paying down Sealed Air's debt and buying back shares.

What comes next?

In fact, Sealed Air plans to do exactly that with its $3.2 billion. In announcing the deal to sell Diversey to Bain back in March, Sealed Air committed to using "the proceeds" of the sale "to repay debt ... repurchase shares to minimize earnings dilution, and fund core growth initiatives, including potential complementary acquisitions to its Food Care and Product Care divisions." Roughly half the company's take from the now-completed sale will be used to "increase of the share repurchase program by an additional $1.5 billion of Sealed Air common stock," with the balance going to paying down debt and complementary acquisitions.

The upshot for investors

And now Merrill Lynch is endorsing Sealed Air's approach, and advising investors to follow suit. Is that the right call?

Let's crunch the numbers.

With an $8.1 billion market capitalization and $4.2 billion in net debt, Sealed Air as a whole carries an enterprise value of $12.3 billion. Against that number, the company reported earnings of $379 million over the past year, and free cash flow of $606 million (according to data from S&P Global Market Intelligence).

That values all of Sealed Air stock at roughly 32.5 times earnings and 20.3 times free cash flow. At first glance these numbers look pretty expensive, given that most analysts who follow the stock expect Sealed Air to grow earnings at less than 14% annually over the next five years. But what about at second glance?

Now that Sealed Air has sold Diversey to Bain, the numbers are going to shift a bit. Enterprise value will come down as debt gets paid down. Earnings growth (per share, at least) will spike as shares get bought back, concentrating profits among fewer shares outstanding. On the other hand, though, with Diversey no longer in the mix, overall profits will probably shrink. Indeed, in its Q2 earnings report, Sealed Air warned that free cash flow at the company will probably fall by more than a third this year, from 2016's $631 million to "approximately $400 million" in 2017.

So what's the upshot? If Sealed Air's enterprise value post-divestiture were to decline by the entire value of the Diversey transaction (hint: it won't), the new enterprise value would be $9.1 billion. But that would still leave the company valued at about 22.8 times free cash flow based on the latest 2017 projections -- more expensive than the stock was before it sold its second-biggest business division. Given this, I have to take issue with Merrill Lynch's decision to upgrade the stock today.

Post-divestiture, I think Sealed Air looks like a worse investment than before -- not a better one.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.