Description

Idea

Ball Corporation (“BLL”) is one of the largest producers of metal beverage packaging products in the United States and globally. On June 30, 2016, the company closed on the acquisition of its largest competitor Rexam (“REX”) in an industry transformative deal that has consolidated the market from three players to an effective duopoly. I believe Ball currently represents an opportunity to own a high quality consumer packaging business in a two player market at <12x PF earnings with further optionality to the upside.

Understated Earnings

Over the last few months, spotlight on regulatory approval and the size/buyer of the divestiture package has overshadowed several non-deal related earnings adjustments not currently present in the reported figures. While minor individually, I expect these factors will likely contribute up to ~$250mm of incremental EBIT over the next 12 to 24 months:

• Capacity Additions / Ramp-Up: Both BLL and REX currently have significant capacity expansion projects underway that are expected to generate meaningful incremental earnings over the next year. In total, the two companies have invested a combined $400mm in expansion projects that are currently in ramp-up or scheduled for completion in 2016. Based on BLL’s after-tax return targets, I estimate these projects will contribute additional EBIT of ~$40 – 50mm.
• Metal Premiums Normalization: Whereas aluminum premiums are typically passed through in North and South American contracts, EU contracts stipulate fixed values and force can producers to take on premium pricing risk. Consequently, skyrocketing EU aluminum premiums from ~$200 - 250 / ton in 2013 to over $450 / ton in early 2015 have been a major headwind for both BLL and REX earnings. Aluminum premiums have since dropped significantly from the peak to approximately $65 / ton today. From 2013 through Q1 ’16, BLL and REX combined have seen a ~$90mm cumulative headwind (net of premium benefits already booked in current earnings) that has already begun to reverse, with additional upside if premiums remain significantly below the historical average.
• Rexam Legacy Restructuring: Prior to the recent deal close, Rexam management had additionally announced a cost reduction initiative separate from BLL’s $300mm synergy estimate that targets structurally uncompetitive plants in Europe. The company has indicated it expects run-rate annual cost savings of ~$70mm to be achieved by 2017 and had already been in the process of shutting down disadvantaged facilities in Berlin.
• China: Despite double digit volume growth in the region, the beverage can market in China has suffered from significant over-capacity over the last several years. Notably, continued pricing pressure (and a consequent write-down in inventory) recently resulted in a $15 – 20mm impact on EBIT in Q1 ’16. Management has targeted $30mm of cost-out for its China business by year-end FY16. While the company has not quantified the level of losses from China, any improvement in market dynamics or strategic exit of the business would represent upside to the company’s current earnings.

Understated Synergies

BLL management initially guided towards a $300mm synergy target that was later revised to “in excess of $300mm” during early 2016. I believe based on a) management’s reputation for conservatism, and b) the set-up of the deal, that these “excess” synergies are likely meaningful in scale.

• Initial uncertainty surrounding the potential divestiture package likely resulted in an additional layer of conservatism in BLL’s synergy estimates. The company indicated post-announcement of the deal that the synergy target would be achieved independent of any asset sales mandated by regulators. This uncertainty, combined with antitrust hurdles that have prevented BLL from conducting a complete review of Rexam’s operations (prior to deal-close), have likely pushed management to build in a meaningful margin of error in their synergy estimates.
• While the synergy target appears to fall within range of recent deals in the industry, many of these deals have involved private companies that did not bear an additional layer of public company costs. Moreover, calls with industry insiders / formers suggest Rexam was a relatively inefficient operator with bloated corporate overhead (e.g. expensive office in London despite lack of any facilities in the region—Class A, downtown location ~500ft from Westminster Abbey) and should therefore have greater cost cutting opportunities than in previous transactions.
• UK Takeover laws incentivize companies to be conservative in their estimates, and apply significantly more onerous terms to synergy disclosures relative to the US.
• Given antitrust concerns over the deal, management had significant incentive to sandbag synergy targets in order to increase likelihood of regulatory approval (announcing massive synergies would raise an obvious red flag at the regulatory agencies).
• Ball management has publicly hinted in a past deal that its synergy guidance was partially derived by solving for the company’s required rate of return despite internal expectations for higher savings. Similar analysis for the Rexam deal suggests $300mm may have been a low-ball number put out by management to meet base-line return requirements.

Industry Consolidation

While I do not believe pricing power is likely to be immediately affected by further consolidation in the industry, the formation of an effective duopoly structure creates significant upside optionality not captured in my current valuation.

• In a regulatory update on April 25, 2016, BLL discussed additional revenue opportunities above and beyond the $300mm cost synergies.
• The relationship between Rexam and Ball has in the past been characterized by aggressive competition for major customers (e.g. Coca-Cola).
• Rexam has over the last 1 – 2 years commented on increased pricing pressure as a result of its consolidating customer base (pressure that will likely see relief from significantly greater scale post-deal).
• Net of the divestitures, BLL will have ~50% market share in North America, Brazil, and Europe.

Other

• Working Capital: During April 2016, BLL management additionally noted they believe there will opportunities to improve working capital efficiency at the acquired Rexam assets.
• Germany: Prior to the introduction of mandatory deposit systems in 2002, the German market was the largest beverage can market in the EU with ~7.2bn units consumed annually. Since these mandatory deposit systems heavily favored PET and glass packaging, however, major discount retailers began delisting metal canned beverages from shelves and can consumption dropped precipitously to 1.5 – 2bn units today. In late 2014, amended packaging legislation led to re-adoption of can-packaging at the retail level (two of the three major German dsicounters have reintroduced canned beverages in Q1 ’15). Though not included in my numbers, I believe there is meaningful upside optionality for Ball if the German metal can market sees a recovery as legislation changes.

Pro-Forma Financials

Management / Ball Organization

• The company has a long history of successfully executing on large acquisitions (four in the last two decades). Though difficult to measure directly, my impression based on management commentary / disclosed synergy numbers is that the company has generally exceeded initial targets on these deals.
• Management follows a strict economic value added (EVA) framework to capital allocation that requires a 9% after-tax hurdle rate on every dollar invested. ~70% of management compensation is performance based and tied directly to stock price appreciation, EVA dollar generation (NOPAT les Capital * 9% hurdle rate), and return on invested capital.
• 10% of the company is owned by employees. Employee compensation at all levels (not just management) is tied to factory-level and regional EVA to incentivize execution on cost-out initiatives.
• Ball has a demonstrated history of buying back shares. In the five years prior to deal close management has reduced share count by nearly 20%. I believe management will likely begin buying back shares by 2017 as leverage is reduced to management’s target of ~3x.

Catalyst

Discussed above.