Description

Lets start by keeping this one very simple:
- 9-10% free cash flow yield this year
- Strong catalyst indicating substantially higher future earning power in the future
- Best company in its industry
- Excellent management
- Industry has better economics than you’d think
- No “hair on it”
- An industrial product that is immune to China
- Institutionally appropriate market cap and liquidity

I know of very few, if any, domestic stocks that meet those criteria after this big run-up in the market. We were finding them in March, but not now.


Ball Corporation is the domestic leader in beverage cans (soda, beer). They also are one of three players in the domestic food can market and last year acquired their way into a large share of the European can market.

I’ll structure this in three parts – Cash, Cans, Catalyst. And then I want to tell you what I know about Ball’s management and why I consider this company without question the best in their business and a very underrated industrial company.

CASH
Management is guiding to free cash flow (ex a clearly one-time $130 million tax liability associated with their recent European acquisition) of “more than $250 million”, meaning a 9%+ yield at the current market cap. (That is how Ball guides – they never give points or ranges. Ball’s CEO just loves to drive sell-side analysts nuts.) Anybody watching Ball for the last few years will not find that number at all aggressive – this company pours out cash – they’ve been in the $200 million + range of free cash flow for the last 5 years, and that history would not include their 2002 European acquisition. One more point – whatever their capital expenditure forecast is after the first or second quarter, it seems like they never spend that much.

Cash flow is very seasonal – they build inventory into the summer (summer peak beverage demand) and then the cash comes in in the second half of the year.

CANS
At first glance, and even second and third in my case going back five years – I’m pretty slow when I get my mind closed on an industry – the can industry looks like just another commodity business.

Let me propose a few things that make this different from your loser commodity business, and then I am going to go into some history of what changed in the industry two years ago.
1. The can industry is a stable oligopoly. There are three beverage players and three food players.
2. You can’t import cans from China because a) cans are so big relative to their value that they are uneconomical to ship very far (a pallet of empty cans is mostly air – it’s worth about $450, but it’s the size of an SUV); and b) there is very little labor content. Don’t underestimate this point. Real quick, name three manufacturing businesses where you never need to worry about China? Tic, tic, tic…did you think of even one? Beverage cans would not be the first thing to come to mind, but once you know that one, name me two others real quick. I can’t think of too many. Even Boeing I would consider under threat from China within 10 years. But the physical characteristic of a can makes it immune to foreign competition.
3. Demand is very steady (Coke, beer, soup, etc.)
4. One of my favorite indicators of barriers to entry is simply asking the question has there been entry? There hasn’t in decades. The current players have consolidated the business, but the history of this industry has been lots of exit, but no entry.
5. There is some real know-how involved here. A barrier to entry is regional economies of scale, but much more significant is the learning curve on cost. If you’ve ever seen a can plant you know that you don’t just decide you’re going to build a can plant and make money. Margins are not large even for the best operators. Next time you are drinking a Coke or a beer take a good long look at the can, study it, and think about how you would make 10 billion of those for 5 cents a piece to Coke’s specs. 5 cents. Including printing the graphics on the can, which is just an amazing operation to witness. Including the aluminum (aluminum costs are a pass-through). I can think of easier ways to make a buck than that, especially since I would have to compete with players who have been doing this for decades. If Owens-Illinois or some Pepsi or Coke funded startup threatened to build a new can plant I think Ball would say, “yeah – go try!”. Coors recently threw in the towel and teamed up with Ball and Budweiser is still vertically integrated but let me just say my understanding is that this is not where Budweiser makes their money – it wouldn’t surprise me to see Bud hand the keys to Ball at some point. The last ten years have been nothing but exit in this business from formerly vertically integrated beverage and food producers. New entry would be a real secular event and I see no signs of it coming. Of course if the price of cans goes up enough it will happen eventually, but I don’t think we’re close to that price yet.
6. Substitution is an issue here. Glass bottles and PET plastic. Clearly PET has gained share over the years, but cans aren’t going away – they just haven’t grown with the beverage market. What could eventually cap can price increases would be switching to alternative packaging. The current high prices for glass and PET inputs (natural gas, petroleum) gives me some comfort (can-making isn’t particularly energy-intensive).

What Changed Two Years Ago?
What hurt this business for the last decade (until 2002) was overcapacity and poor pricing discipline. The can industry itself is every bit as oligopolistic as its customers. There are three players in the beverage can business and there are three players in the food can business domestically. Two of these players overlap.

Something big changed in late 2001 when this oligopoly learned how to count. Crown Cork, faced with near-term insolvency if something didn’t change, got religion and turned on a dime from being “the dumb competitor” who would do anything for more market share, to being the price leader. That was a huge change, and it was a big surprise. In August of 2001 Crown raised prices on cans $5 per thousand (10% price increase) for the first price increase in nearly a decade. At last, excess capacity had disappeared, so the usual drill for the customer didn’t work. Coke would call Rexam and say “Hey, guess what Ball wants to do. Ha ha ha! You want to take some market share?” For the first time all three beverage can suppliers were tight on capacity and smart and held tough. For the 2001 pricing negotiations (for the year 2002), the players cooperated, because without excess capacity there is no incentive to cut prices to grab share and the price increase was a complete success.

Over the next twelve months Ball stock, which had ALREADY doubled off really stupid March 2000 prices (remember those?) BEFORE anybody was thinking price increase, proceeded to outperform 99% of companies in the S&P 500 from that “already up” stock price. That was nice, but you would have been even better off owning Crown Cork, which went from 2 to 12 and was one of the best stocks you could have owned for that period.

I refer to that price increase (which was met with skepticism by Wall Street at first) as the mother of all catalysts. When you own a company that produces 35 billion of something and prices go up, that’s interesting.


CATALYST
Deja vous all over again…

Can prices are going to go up again in 2004 in both domestic beverage and food cans. I’d guess something like 5-10%. [Before you run that through BLL numbers (units x price, drops straight to the bottom line) recognize that beer and beverage are two different markets. Beer is not going up yet – that could be the next catalyst, and another huge one – but the other half of Ball’s business say it goes up 5-10%. You want to spread that over three years. Food cans is probably going up too.]

If you want to hear the catalyst firsthand listen to the last half of CCK’s 2Q conference call when the CEO talks about pricing while practically foaming at the mouth, and then listen to the last 20 minutes of Ball’s conference call when somebody asks about pricing.

In terms of industry structure, there are three can market segments to think about. Here are the players and the most recent information on competitive dynamics in each.
1) Domestic beverage. Ball is #1. Competitors are Crown and Rexam with Budweiser the only vertically integrated player in the market. [Crown and Rexam are signaling a price increase for 2004 just like they did two years ago. No doubt Ball follows. There is very little excess capacity.] Note that beer and soda are two separate markets – for now I think the price increase would not be for beer.
2) European beverage. Ball just acquired a large share of this market. Competitors are Crown and Rexam and Pechiney. I don’t know the European market, but things look stable for Ball despite a regulatory issue in Germany. [With Ball’s acquisition, the main players in Europe are now the same three as in the U.S., which makes me optimistic about competitive dynamics in the future.]
3) Domestic food. Silgan is #1 with half the market, Ball and Crown split the rest with just 10% of the market still vertically integrated. [Crown is fervent about raising prices in this segment (listen to their last conference call). No doubt Ball will follow – they basically said so on their conference call. I’ve spoken with Silgan recently and they have no incentive to screw this up as they have very little excess capacity.]

Cans are typically sold under long-term contracts. That is most true for Silgan (contracts up to 12 years but with a lot of passthroughs so their returns are very stable), least true for Crown (so Crown gets the biggest immediate pop out of a price increase – Crown is a pretty attractive stock and I own that one too, but there you have asbestos to worry about). One might also consider that Crown is more soda/less beer, ball more beer/less soda and it is soda prices that are going up for now. Ball would probably spread a price increase over three years as contracts expire as they did the last time prices went up.


A FIRST-CLASS COMPANY
No doubt in my mind that Ball is the best company in the industry – I’ve owned this stock and watched it very closely for over three years - they are just first class in everything they do from investor relations to manufacturing. I have a neighbor who is a salesman for a competitor who has the utmost respect for Ball (and of course is also a nice source of info on pricing dynamics in the industry). Listen to their conference calls and you’ll get a feel for how CEO David Hoover, communicates with his shareholders. He’s good, and he refuses to play Wall Street’s little games.

I visited one of their factories in May and spent some time with their plant manager – [I've never met top management but you get to know them after three years of listening to conference calls], and in that meeting I identified a VERY strong culture - something I'd always suspected, but I didn't know for sure until I spent some time with Ball people. They are very smart financially, but their core culture is manufacturing - they are incredibly disciplined on the factory floor and they take great pride in that. Though the machinery is far from gold-plated – the factory I visited is Ball’s oldest - this was probably the cleanest, most disciplined factory I've ever toured. You could eat off the floor.

An extremely proud company where people spend their whole careers.

I didn’t go into their aerospace business because its not germane to the investment decision, but this company built the Hubble telescope including the scientific instruments.

I recently interviewed a salesman for a can-making equipment supplier (talk about an awful business…) who described Ball as "fanatical". [I like that word and its kind of what I saw at the factory I visited – this company has a culture right out of Jim Collins’ books Built to Last and Good to Great]. This supplier told me Ball gets more output out of a piece of equipment than anybody in the industry. They are very good at sharing best practices between plants to eke out. that extra little bit of efficiency which makes all the difference when your product sells for a nickel a piece. That bodes well for their European acquisition.

Summary
To summarize this, let me just go back to where I started it. In this market, find me another $2.8 billion market cap, leader in its industry with good management trading at a 9% free cash flow yield where the wind is at your back. Really – I’d love to buy that one too.

Catalyst

Can prices are going up in 2004.