Description

Executive Summary

Ball Corp is a manufacturing business in a low to no growth market (aluminum cans).  The end markets are beverage staples (beer and soda), but it is a commodity business with a consolidated set of customers.  Investors got excited about the stock beginning February of 2015 (+20% on announcement, back down to ~+10% since) when the company made an offer to acquire one of its competitors, Rexam.  Given a business that weathered the downturn nicely and the ability for the combined company to cut costs, investors piled into the ‘safe’ earnings/cash flow story with cost-cutting upside. 

Today, nearly a year and a half later, the deal has finally closed and the issues with the go-forward stock and company are multifaceted.  First, after doing the math on the ultimate regulatory divestitures, it appears they overpaid at least ~30%+ on face (~13x EBITDA vs headline deal at ~10x and not including the impact of the Brexit).  Second, the actual integration will be more challenging given both the scope of the divestitures and the assets which were sold vs retained.  Further, consensus estimates are fully-baked and the timing of synergy realizations is aggressive.  Finally, the company is trading at a large premium that embeds much of the potential synergy upside and the company is levered 2.0x above target levels.   Specifically, the risk/reward to the downside is favorable and the stock could trade somewhere in the mid/low $50’s (~25%+) even if management executes on their timetable as valuation normalizes.  Downside into the $40’s (30%+) is possible if a confluence of execution problems, industry headwinds, or market de-risking arises.

Thesis

1.       Elevated expectations / aggressive timeline:  Consensus is showing EBITDA margins of greater than 16% next year from the sub 14% the business has been operating at.  The street at ~$1.8bn EBITDA in 2017 represents nearly 100% of the synergies vs my model that gets to $1.6-1.7bn.  Overall, street numbers exceed $300mm in implied margin improvement, embed topline growth of 2% in outer years (above trend), and realize synergies almost immediately. 

2.       Unrealistic buyback / deleveraging:  The company will still have ~$7bn of net debt at the end of this year by generating ~$500mm FCF.  Even if normalized FCF approaches $1bn over time, there is a dollar for dollar investment in these cost savings and ultimately the company would not reach ~3.0x leverage until the end of 2018 in a blue sky scenario.  In this best case, they might begin buying back stock in late 2018 but not in a meaningful way, and realistically, there will be more than 170mm shares by the end of 2018.  Further, it would not be a great use of cash to be buying stock at these elevated multiples.

3.       Excessive valuation:  The company is trading for ~14x EBITDA.  Yes, there are pro-forma adjustments to make on synergies but they are not worth a 4.0x turn premium to the group.  A normalized multiple for the business today should be in the 9-11x range which still implies downside if you give them credit for $300mm of synergies.  Not only is the stock rich to packaging peers, but the group as a whole is rich in the context of the cycle.  The same goes for P/E (or FCF).  Even if they hit ~$1.8bn of EBITDA in 2017 (unlikely), that implies the stock would be trading for ~17.5x earnings (2-4x higher than the comp set).  It’s expensive any way you cut it.

4.       Execution risk:  At face it looks like BLL simply bought REX and kept half of it, adding $3bn of revenue to the existing BLL $8bn.  The reality is that they actually bought $6bn of revenue, are divesting ~$2bn of their own assets, and actually retaining nearly all of REX.  That means more integration work and associated risks to costs, timing, personnel, customers, processes, etc. The REX business could represent greater than 40% of the total pro forma business.  Not to mention any forward implications associated with Brexit, given REX is UK domiciled, and the EU at large.

5.       Limited topline growth:  Topline should grow below GDP if at all as demand in the US for aluminum cans is soft, China has oversupply issues, and Ball’s customers have consolidated making negotiations on renewals more challenging.  Moreover, there is a secular shift away from traditional cans to more specialty beverage packaging that could be challenging to fully-offset.

6.       Price paid for Rexam:  The headline number paid was >13.0x and the divested assets were sold for ~8x.  First, this demonstrates that management was not that disciplined in this deal and bodes negatively for future capital allocation.  Secondly, if the divested half of the business was worth $3.1bn, all aluminum cans being equal, simple math implies the full REX business be worth closer to $6.2bn (vs the ~$9bn BLL paid).    

7.       High leverage:  The company is highly levered at 4.7x EBITDA and it will take a full 2-3 years to bring that below 3.0x where the company can think about alternative uses of capital allocation.  In the interim, a hiccup in the integration execution and/or the market at large in conjunction with the embedded valuation premium to the group could be problematic for the equity.

Catalysts

The first catalyst will be earnings in August with potential updates on pro forma financials and integration progress.  The rubber meets the road when the street starts to tighten numbers for 2017 later this year that appear high and ultimately when management guides for FY2017 (potentially as late as January).    

Business Overview

Ball Corp (“BLL”, “Ball”, or the “Company”), per their 10K, is a is one of the world’s leading suppliers of metal packaging to the beverage, food, personal care and household products industries.  The majority of their business is 1) manufacturing beer and soda cans in North America, Europe, Brazil, and China with a smaller portion of the business in 2) household product containers like aerosols and to a lesser extent 3) for aerospace use.  In 2015 the Company generated ~$8bn in revenue ($5.9bn in beverage cans, $1.2bn in household products, $800mm in aerospace) and $1.1bn in EBITDA with the corporate-wide EBITDA margin of 13.6% (beverage can EBIT margins are ~12% and the household and aerospace EBIT margins are slightly lower at ~8-10%).  This translates into beverage cans representing the lion’s share of earnings at 80% in markets where they are substantial players (~32% share in North America in a 5-player market, 18% in China where the top 5 control 75% of the market, and 30% share in Europe where they are the 2^nd largest).  Their customer base is also very consolidated as they sell primarily to the beer manufacturers (Anheuser-Busch, MillerCoors) and to Coke and Pepsi.  Overall, the business has stable end markets and was largely stable through the last recession, but the beverage cans business is competitive, capital intensive, and commoditized.   Today, with demand for beverage cans in the US coming down on lower soda sales and supply issues in Asia from Chinese manufacturers, the business has little organic topline growth. 

Situation

The situation is that the Company just completed the acquisition of one of their largest competitors, Rexam.  The deal represented a combination of the 2^nd and 3^rd largest players in the industry behind Crown and finally closed on July 1^st this year after having been announced in February 2015.  Despite the fact that there has been substantial time for the market to digest and finance the merger, there’s still some ambiguity due to the large size of the divestitures required, what the actual pro forma business will generate, and the timing of synergies.  In summary, a company that had been generating ~$8bn in revenue, bought a competitor that generates ~$6bn in sales, but was forced to divest half of the gross acquired revenue for regulatory purposes. 

Was REX a good deal?

The first question is whether or not the deal was economically sound.  The headline purchase price was ~$6.6bn back at the time of the original announcement in early 2015.  The deal was structured as 32.3mm shares of stock (worth $2.3bn) and $4.3bn of cash.  Including the assumption of ~$2.4bn in net debt, the total transaction value was $9bn and so they were paying ~10x EBITDA at the time.  Comparable deals over the past 5 years have been in the 9-10x range so it looks like a reasonable deal at face. 

The complication is that the divestitures on an after-tax basis change the economics.  Specifically, adjusting for the $3bn of divestitures (half the business) for the receipt of ~$2.8bn after-tax dollars, it appears they actually paid $5.7bn for ~$413bn of EBITDA (~13.9% margin based on the 8K filing).  The result is an acquisition multiple of 13.7x.  It is only after adding $300mm of synergies where the deal ultimately looks attractive at 8.0x once they are fully-realized in 3-years, but it is important to keep in mind that every acquirer assumed healthy synergies and so this deal was rich.  Moreover, it appears the buyer of the divested assets (Ardagh) actually got a better deal at face (~$400mm of EBITDA @ ~8.0x).

Pro Forma Company

 Regardless of what management paid for a deal (despite larger strategic implications), arguably what you are getting as an investor today is more important.  To that end, the pro forma company was announced to generate ~$11bn in sales and expects synergies to be at least $300mm by the end of 2019 (3-years away).  A read of the financials pencils to circa ~$1.5bn of pro forma EBITDA this year which means you are paying ~13.9x EBITDA (4+ turns north of the comp set).  This translates to ~11x if you give the company full credit for the synergies today (still a bit rich to the comps).  The company has over $7bn of net debt which pencils to 4.7x leverage at this yearend.

Risks

The risk is that the two businesses get integrated seamlessly and faster than management has guided and that synergies (announced and realized) come in well above $300mm (consensus is already there).  Notwithstanding, in the event everything comes together for management over the next two years and the market as a whole moves sideways, the stock is still not worth more than ~$85 (which assumes 10x @ $2bn of EBITDA and includes $2bn of debt pay-down).  Even if they can get $1bn of FCF by 2018 as some of the bulls hope, they will be using the free cash to de-lever.  At the current share count, this implies a $75-85 stock (not much higher than today) at between a 6.5%-7.5% implied FCF yield.  There may be a perceived floor in the stock at some price given these businesses have held up well historically through a recession, but that floor should be closer to 8-10x EBITDA.

Catalyst

The first catalyst will be earnings in August with potential updates on pro forma financials and integration progress.  The rubber meets the road when the street starts to tighten numbers for 2017 later this year that appear high and ultimately when management guides for FY2017 (potentially as late as January).