Description

Summary

Crown Holdings is a worldwide leader in food and beverage packaging, mainly cans (global #1 in food, #3 in beverages).

The company has specialised in packaging since 1892 and invented the crown cork

The concentrated industry structure and defensive nature of the product have limited the downside of the stock in market

corrections, while the decent growth has allowed the stock to more or less keep up with rising global markets. This combination

has led to substantial outperformance for Crown through the cycle, and I expect this trend to continue going forward.

Positives

EM growth

• 70% of Crown’s business is mature and consists of developed market food & beverage cans growing more or less

in line with GDP.

• 30% of sales come from the faster growing emerging markets, where demand for cans benefits from 1) the expanding

middle class consuming more food and beverages, and 2) cans gaining market share as packaging material versus glass, paper and

plastic. The latter allows for more sustainable EM growth compared to the Unilievers of this world and the opportunity going forward

remains substantial. Cans currently have a market share of <5% in China, compared to 50% in the US. Even Brazil has grown to

around 40% now, so it’s probably not a stretch to believe that the Chinese can market will double over the coming years to 10%

market share. The popularity of cans as a packaging material worldwide is driven by the fact that they are the easiest to handle (transport,

stack, refrigerate), offer the best preserve qualities (long shelf-life, air and light tight, and therefore no preservatives necessary),

are the cheapest to produce, and offer the best environmental credentials.

• Crown has been an early mover in EM, which is now paying off. Decades of experience, seasoned local managements, and the

ability to rapidly expand capacity thanks to the in-house manufacturing of equipment, have all contributed to Crown having the

largest EM exposure amongst developed food & beverage packaging companies and therefore the largest growth rate. Competitors

are also ramping up capacity in EM, but Crown continues to take market share, helped by the fact that it is the lowest cost producer in

most countries. Over the past 3 years, Crown’s market share has grown from 17% to 27% in China and from 19% to 26% in Brazil.

• EM sales have grown at a CAGR of 11% over the past 13 years and 12.5% over the past 3 years, from $800mn in ’00 to $2.1bn

in ’10 and $3bn expected in ’13. In Q3, Asia Pacific volumes were up 19% yoy, Brazil +10%, Colombia +7.5% and Mexico +6.5%.

Attractive industry structure / company positioning

• The top 3 beverage can manufacturers (Ball, Rexam and Crown) have a 67% global market share. The top 3 food can players

have a 79% market share in Europe, while the top 4 have a 91% market share in the US. Crown is the global market and price leader in

food cans and the #3 in beverage cans (#1 in Asia & the Middle East).

• This concentrated industry structure provides stability, especially in the mature developed markets. When North American beverage

can shipments declined 3.7% between ’07 and ’10, the industry reduced its capacity by 7.4% allowing for stable operating margins.

Similarly, the US food can market has seen a gradual 1% per year decline in volumes without this leading to price competition and margin

pressure. The defensive nature of Crown’s end product adds an additional layer of stability.

• The barriers to entry for can manufacturing are high. It’s a capital intensive industry due to the need for a manufacturing presence

close to the client (Crown has 149 plants across 41 countries). It is also more technologically advanced than one would think, with substantial

R&D going into innovative design and the reduction of raw material consumption.

• And finally, we already discussed Crown’s advantage of being an early mover in EM, its ability to produce equipment in-house (allowing

for faster capacity expansion in growth markets), and the fact that it is the low cost producer in most of its end markets, including the

emerging markets.

FCF expansion, capital returns

• Revenues should around GDP.
• A gradual recovery in OP margins, from 10.5% last year to 11.7% in ’15, turns 3% revenue growth into roughly 6% OP growth.
• Mid-single-digit share buybacks turn the OP growth in double-digit earnings growth longer-term. Shorter-term, the share buybacks

will be suspended for 18-24 months to fund the Mivisa acquisition (see further down). But given that the acquisition should be up to 20%

earnings and cash flow accretive, it would be worth giving up 10% capital returns.

• Crown has consistently generated positive FCFs, even during the recession ($263mn in ’08, $694mn in ’09). FCF generation has

been lower in recent years on the back of 1) a rapid capacity expansion program in emerging markets, 2) restructuring efforts in developed

markets, and 3) some exceptional costs related to the Thai floods. With most of the above behind us and a renewed focus on working capital,

FCF generation is expected to grow to $500mn in ’13 and $580mn in ’15 (10% FCF yield). The projected increase in FCF is easing market

worries about the balance sheet and pension funding, and increases investor confidence in the guidance for $300mn annual share buybacks

a year longer-term.

Long-term compounder

• This is a very stable industry / business, with a management who communicates well, covered by analysts who have followed

the sector for years. So I struggle to model numbers substantially ahead of current consensus expectations.

• Instead, the investment case for Crown is based around the fact that the concentrated industry structure and defensive nature

of the product have limited the downside of the stock in market corrections, while the decent growth has allowed the stock to more or

less keep up with rising global markets. This combination has led to substantial outperformance for Crown through the cycle, and I

expect this trend to continue going forward. Crown declined 19% in the ’08-’09 correction (MSCI World -59%), has rising 106% since

Mar ’09 (MSCI World +124%), which adds up to a 71% performance since Nov ’07 (MSCI World -7%) and 440% since the IPO in ’03

(MSCI World +97%).

• I will come back to valuation in more detail, but I believe we have reached an attractive entry point. Earnings downgrades on

the back of temporary European food / EM weakness have led to underperformance in the stock in recent months. With the FY1 P/E

ratio falling to 11.5x as we move into ’14, at the lower end of the historical trading range and the peer group, we are approaching a

level where I see 30-50% upside, while downside should be limited to 10-20%.

• Also, I believe Crown stands out versus other defensives (consumer staples) because of 1) its reasonable valuation and 2)

its ability to grow in EM on the back of can penetration even if consumption slows down.

Management are good stewards of shareholder funds

• Management focuses on returns and cash flow generation. The working capital comments during Q3 are another illustration

of this and the CFROI track record is very stable. The CEO owns $60mn worth of shares.

• The stock also ticks the social responsible box. Metals retain their original properties regardless of how many times they are

recycled, and therefore cans are an environmentally friendly packaging alternative to plastic/paper/glass. Aluminium is 100% recyclable

and 75% of the aluminium used over the past 150 years is still in use today.

Catalysts for change

Mivisa Envases Acquisition

• Crown announced 2 weeks ago that it is acquiring Mivisa Envases, the #3 food can manufacturer in Europe (most of this note was

written before the announcement, which is why I write about it separately).

• They paid €1,2bn to Blackstone, who bought the company originally for €900mn a few years ago. Mivisa generated €555mn in sales

and €133mn in EBITDA over the fiscal year ending in June, implying a price of 9x EBITDA excluding synergies and 7.5x including synergies.

That is a fair price compared to Crown’s EV/EBITDA of 8.3x, and taking into account that Mivisa generates an OP margin that is more than

double the OP margin of Crown in European Food, and twice Crown’s overall OP margin. The acquisition takes Crown’s market share in

European food cans to 40-45%.

• I see the deal as positive because 1) it increases the chance of a turnaround in Crown’s European Food segment, which had been a

source of disappointment in recent years, and 2) the deal could be 20% accretive on a FCF basis (see calculations below, depending on full

regulatory approval).

• The downside of the acquisition is that Crown will have to suspend buying back shares for a while. Based on my calculations, they can

bring the net-debt / EBITDA ratio back to current levels in 2 years. Netting it all out, you give up 10% growth from buybacks in return for

roughly 20% growth from the acquisition.

• The market also saw the deal as a positive, driving the stock up 7.4% ($3) on the day of the announcement. Taking the potential

earnings accretion of $0.58 and putting the FY1 multiple of 12.3x on it implies that the deal should add $7 in value, excluding additional

synergies or a turnaround in Crown’s European food business on the back of the deal. So there is still some upside from the deal on the table.

The calculations above are speculative because we don't know yet if the European Union will allow Crown to keep all plants, and the

company has not profived details on things like D&A. I've built in some conservatism by using historical Mivisa numbers instead of

forward looking, by setting a high D&A number, and there should be upside to synergy targets.

End of the earnings downgrades

• The earnings revision chart is not a pretty one. In Crown’s defense, the chart looks the same for every US food and beverage

packager. The 11/12 decline in earnings estimates was largely driven by the falling Euro, and to a lesser extent weakness in the European

food market. The more recent decline has been driven by a combination of ongoing weakness in European food, margin pressure in Asia,

and the decision to lower Q4 production in order to flush out excess inventory. I discuss all of these factors in more detail below.

• Q3 pre-announcement / results

-          Crown lowered its Q3 guidance from $1.15-1.25 to $1.05-1.10 at the end of September, quoting weakness in European

food and to a lesser extent margin pressure in SE Asia.

-          Actual earnings came in at $1.13 (excluding restructuring charges), or 13% yoy growth. Sales were up 4% on strong

beverage can demand globally and a 1% FX tailwind, partially offset by the pass-through of lower raw material costs. EBIT grew 8%

on lower depreciation expenses, and EPS grew 13% after share buybacks.

-          European Food was indeed the weak spot (sales -0.7% yoy, OP -1.6%), with general economic weakness leading to

both lower volume growth and a mix shift from larger to less profitable smaller cans. Additionally, there was an element of

weather-related harvest delays.

-          SE Asia margins of 10.7% versus 14.6% last year were the other disappointment. Management breaks down the 400bp

drop as 1) a 200bp headwind from new plants coming on-line (start-up costs, lower utilisation rates), 100bp from acquiring the

lower margin Vietnamese beverage can producer Superior Multi-Packaging, and 100bp from volume disruptions in Cambodia on

the back of social unrest following the elections.

• Q4 guidance downgrade

-          Crown guided for a $0.46-0.51 EPS in Q4, versus consensus expectations of $0.57. The lower EPS is driven by a temporary

production cut to flush out some excess inventory (mainly European food) in order to maximise cash flows and hit the $500mn FY

FCF target.

• Is this the end of the downgrades

-          I’ve questioned a number of sell-side analysts on the Q4 production cut and they all seem very relaxed about this.

Management has a track record of focusing on cash flow generation rather than earnings and has done this before. Also, inventories

aren’t high at the moment, so the production cut should be limited to Q4.

-          The acquisition of Mivisa is a game changer for European Food, and could turn the business from a serial disappointer into

a source of earnings surprises on the back of better synergies.

-          Expectations for European beverages and the Americas businesses seem reasonable compared to current trends.

-          Which leaves the SE Asian business as my only real worry. Some analysts assume a 4% rebound in margins within 2 years,

while I model 2%. I accept the strong position of Crown in non-China part of South-East Asia (good growth, consolidated market,

Crown is market leader) and I can see margins recover as the new plants fill up and the peace returns in Cambodia. But I am less

positive on the Chinese business (50% of SE Asia), which is more scattered (including government-run competition), with growth

slowing down as new competitive capacity is coming on-line. So I expect that some of the recent 4% margin loss will be more

permanent. The good news is that the ’14 consensus expectations seem reasonable, it’s ’15 and beyond that I’m worried about.

-          It will probably take around 6 months to get regulatory approval for the Mivisa deal, so we might see some further disappointing

European food numbers in the meantime. But absent further economic/FX weakness, I believe we have seen the worst in terms of

earnings downgrades. And once the deal comes through, downgrades should turn into upgrades.

Risks

EM overcapacity

• The industry has shown great capacity discipline in developed markets. But emerging markets are less concentrated and especially

China has some small competitors and government enterprises.

• We haven’t seen a period of real oversupply yet. Crown was quick to pull some line extensions in ’12 when growth slowed down

and kept its OP margin at 14%. But total sales growth was still 14% in ’12, so it hardly qualifies as a very challenging year.

• It remains a question mark what will happen if EM goes into oversupply, and something to watch closely.

US overcapacity

• Ball has lost a big contract (Conagra) to Ardagh earlier in the year. Ardagh is a smaller player and needs to build a new plant

in order to fulfil the contract. As a result, the US food can market will have 4% overcapacity.

• This is not a big issue, but we need to keep an eye on Ardagh’s future plans. If they would start bidding aggressively for other

contracts, it might lead to some disruption in the industry. Silgan has the biggest contract up for renewal next year.

Consolidated client base

• Some of Crown’s clients are huge – Coca Cola, Peposico, Ambev, P&G, Heinz, Nestle, etc. Concentrated client bases come with

the risk of big contract losses and the potential for margin pressure.

• With no company accounting for more than 10% of sales, and the top 10 combined only driving 28% of sales, the risk seems

manageable. Contract losses have never been disruptive before for Crown, and margins have been very stable over time. Although

you can see the impact of the client base when comparing the margins of the more concentrated beverage business (13.9% in the

Americas, 14.5% in Europe) with North American Food (17%).

Balance sheet

• Management has done a good job bringing down leverage over the past decade. The current net-debt / EBITDA level of 3x is

not the most conservative, but it is manageable given the stability of the business and decent FCF generation, and a big improvement

from the 6x ratio in 2001.

• Crown plans to bring down debt further over the coming years, which I welcome given that there is also a $773mn pension

deficit (see below) and $2bn of goodwill on the balance sheet. The increase in FCF generation over the coming years should allow the

company to take down debt, close the pension deficit and still leave room for capital returns.

Pension fund

• Crown has a $5bn defined pension obligation, which was $773mn underfunded at the end of ’12.
• The company has a plan in place to close the gap through annual contributions. There was an exceptional cash injection of $400mn

in ’11 when the company lowered the expected rate of return. And management is guiding for contributions of $85mn, $85mn,

$134mn, $120mn and $145mn over the coming 5 years.

• The current expected returns are 8% in the US and 6.4% internationally (down from 8.75%/7% pre-’11). Every 0.25% change

to the expected return / discount rate would change the ’13 expense by $11mn / $4mn.

• The pension deficit is definitely a problem, as it adds to an already demanding debt load. But it’s not a life or death situation

given the reduced leverage, the stability of the business and the projected FCF generation.

FX

• 72% of sales are generated abroad. Europe is the biggest foreign exposure (36%) and the stock has lagged somewhat every

time Europe’s economic and sovereign debt worries hit the headlines.

• A 0.10 move in the Eur/USD rate (7-8%) impacts the net income by $11mn (2%).

Weather

• Food is vulnerable to crop conditions. Poor weather has historically led to harvests moving into different quarters, or being

much smaller. This lowers the demand for cans, as does food inflation which can be triggered by smaller harvests.

• The consumption of beverages is influenced by spring/summer weather.

Raw materials

• Crown’s main commodities are aluminium (38% of COGS), steel (26%) and to a lesser extent tin. Changing commodity

prices can lead to short-term volatility in margins. However, the concentrated industry structure has allowed Crown to pass on

price increase historically. And similar to what we see with tobacco companies, Crown has used any historical price increase to slightly expand margins.

• Therefore raw materials are near the bottom of my list of risks. Moreover, none of these commodities are expected to rally any time soon.

Alternative technologies

• Cans are not the prettiest from a marketing point-of-view, and we have seen some very gradual market share loss over

the past decade in food to (re-sealable) plastics. However, the crucial word here is gradual, there have been no disruptive shifts.

• In EM, cans should continue to gain market share because they are the easiest for of packaging to handle (transport, stack,

refrigerate), offer the best preserve qualities (long shelf-life, air and light tight, and therefore no preservatives necessary), are the

cheapest to produce, and offers the best environmental credentials.

Valuation

Crown is trading on 13.1x consensus '13 EPS, 11.5x '14

• That is below historical average levels, reasonable for the expected double-digit earnings growth and cash flow generation,

and cheap versus most consumer staples.

• Relative to its packaging peers, Crown trades on a slight discount while offering better growth prospects and having a

history of trading in-line.

Target price

P/E

The Mivisa acquisition should allow for around 10% upside on the numbers mentioned below (20% accretion, -10% from

the share buyback suspension)

• Base case 13x consensus ’15 EPS of $3.90 gives a target price of $51 (19% upside from today’s $43)
• Bull case 14x ’16 EPS of $4.52 gives a target price of $63 (47% upside)
• Bear case of 11x ’14 EPS of $3.29 (7% EPS growth next year instead of consensus’ 13% and a multiple at the low

end of the historical range) gives a target price of $36 (16% downside)

• Black sky scenario of $10x ’14 EPS of $3.1 (flat sales and margins from ’13 onwards, similar to the last recession)

gives a target price of $31 (28% downside).

EV/EBITDA

• Using the historical average EV/EBITDA multiple of 8x (chart below) on ’15 Crown numbers and ’13 Mivisa numbers

gets me to a TP of $53 (23% upside).

• A more bullish scenario using today’s EV/EBITDA of 9.3x and assuming 5% annual growth for Mivisa and slightly

higher synergies leads to a TP of $68 (58% upside)

DCF

• I get to a fair value of $55.8 through a DCF (30% upside, excludes the acquisition).

Upside

• I comfortably get to 30% upside as a base case triangulating 3 different valuation methods.
• More bullish scenarios allow for 55% upside.
• And equally important, downside should be limited

Disclaimers

Past performance is no guide to future performance and the value of investments and income from them can fall as well as rise.

Data is for illustrative purposes only. This information does not constitute an offer, solicitation or recommendation for the purchase

 or sale of securities or other financial instruments, nor does the information constitute advice or an expression of my view as to

whether a particular security or financial instrument is appropriate.

I, my employer and/or others we advise hold a material investment in the issuer's securities.

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