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Sonoco Downgraded to Underperform

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We have downgraded our recommendation on Sonoco Products Co. (SON - Free Report) from Neutral to Underperform, given the reduction in its 3Q12 EPS guidance, weak volumes, volatile raw material prices and uncertainty among its customers, given the slow recovery in the U.S and ongoing European weakness, and higher pension costs. Currently, the stock retains a Zacks #5 Rank, implying a short-term Strong Sell rating.

Looking at the second quarter numbers, Sonoco’s second-quarter 2012 adjusted earnings per share decreased 3% to 58 cents, but net sales increased 6.6% to $1.2 billion. While EPS was in line with the Zacks Consensus Estimate, revenue failed to beat the same. The improvement in sales was attributable to the acquisition of Tegrant Corp., partially offset by lower volume and currency translation effect. 
Sonoco has recently trimmed its third quarter EPS guidance on the back of operating problems in its North American papermaking operations, which led to unscheduled downtime, thereby resulting in excess costs. Compared with the prior-year third quarter earnings of 66 cents, Sonoco’s new guidance reflects an annual decline of 20% to 23%, down from the previous expectation of a decline 6% to 0%. 
Sonoco has experienced lower-than-expected volume in many of its consumer and industrial businesses. Region wise, Sonoco continues to experience weakness in Europe and slower-than-expected volume in South America and China. In China and Latin America, the company does not expect any meaningful recovery in volumes in the near future.
In the consumer business, weak composite can volumes as well as softness in certain thermoformed product lines will likely continue through the rest of 2012.
Furthermore, volatile raw material prices and uncertainty among its customers, given the slow recovery in the U.S and ongoing European weakness remain headwinds for the company in fiscal 2012. Considering that Europe contributes 17% of Sonoco’s sales and given the economic scenario in Europe, we believe volume growth in the region will remain muted for some time. 
Sonoco contributed $142 million toward pension contribution in 2011. The aggregate unfunded position of the company’s various defined benefit plans stood at $334 million at the end of 2011.  The company paid $59 million as pension contribution during the first half of 2012 and plans additional contributions of around $13 million during the second half, bringing total contributions made during 2012 to approximately $72 million.  
Furthermore, in 2012, pension expense is expected to be higher at around $14 million compared with the 2011 levels. Further changes in the discount rate or lower-than-expected returns could increase pension expense in the future and necessitate additional cash contributions.
Hartsville, South Carolina-based Sonoco is a global manufacturer of consumer and industrial packaging products. The company has around 340 operations in 34 countries throughout North and South America, Europe, Australia, and Asia. The company operates through four segments - Consumer Packaging, Paper and Industrial Converted Products, Packaging Services and Protective Packaging.

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