Description

Description/Thesis

Crown Holdings (CCK) is a mid-cap packaging company (mainly Beverage and Food cans) with a sustainable 15% Free Cash Flow yield (that’s Cash From Operations minus Capital Expenditures, over Public Equity). To us, any company offering a 10% FCF yield is simply dirt cheap and worth a look. Why is CCK so cheap? How does company with strong margins, huge barriers to entry, a steady profitable acyclical mix of business, and which is enjoying pricing benefits of an oligopoly get so cheap? Not without a significant amount of “hair”. Yes, CCK is as hairy as a mountain gorilla. Never-the-less, we believe significant value lies underneath all that fur. Allow us to begin shearing.

First, CCK’s 15% Free Cash Flow yield, prospectively, is extremely attractive and the factor that originally caught my eye. Since packaging is among the steadiest, most acyclical businesses in the market, we are strong believers in the sustainability of these cash flows. And because CCK is dedicated to reducing its debt, in a static valuation environment, CCK offers a capital structure arbitrage opportunity. If all $230 mm of minimum annual FCF were applied towards debt pay down, over time a 15% return from current levels can be achieved. We believe this a “worst case” return, ignoring the inevitable “pop” one would receive when the company returned to investment grade in about 3 years.

So, where do we begin? Should we start with the Asbestos exposure or the brush with Chapter 11 in 2003? Let’s go with Asbestos; I’m feeling alphabetical. The flare-up of asbestos filings in 2001 that claimed so many companies hit CCK as well (having had the bad luck of owning a cork company with asbestos liabilities for 90 days in 1963). Since then, CCK has endured severe negative asbestos exposure sentiment and paid out about $250 mm in claims ($600 mm total since 1985). Since nearly 2 years have passed with asbestos fully saturating every pore in the market and media, we strongly believe this risk is entirely “in” the stock. Further, our 15% Free Cash Flow yield includes projected, conservative asbestos–related payments for the foreseeable future. Further, we give no credit to but eagerly anticipate two very positive asbestos-related catalysts sitting on the horizon: (1) US Congressional legislation capping exposure (it’s on the Senate schedule for March ‘04) and (2) Ratification by the Pennsylvania Supreme Court (CCK is a PA company) of legislation, passed by the PA Legislature, capping asbestos-related exposure for a PA companies. So, financially, with a 15% FCF yield, CCK is attractive today even if the asbestos payments were to last forever. And we know that potential asbestos legislation has misfired all through 2003 in Congress. However, we strongly believe that given the sheer ugliness of the issue there is strong motivation on both sides of the legislative aisle to find a resolution prior to November 2004. In any case, resolution of asbestos-related issues is UPSIDE to the story, not the story. On to the skirt with bankruptcy!

CCK came as close to Chapter 11 (“Ch”!) as one can come in 2002 without calling in the mortician. Significant debt matured, asbestos payments soared, and even the pension fund needed to be shored up. But, with the help of their bankers, they got through it. While CCK still carries an enormous amount of debt (Debt/EBITDA is 4.7x; The duration which has been greatly extended eliminating refinancing risk for many years), the addition of an ample bank line support our view that liquidity is not an issue. Further, given the leverage and restructuring, we note that the debt markets have been MUCH more focused on CCK than the equity markets for the past 18 months. So, if you want a second opinion on CCK’s business (excluding mine and the sell-sides) take a look at the Bond Market: CCK’s bonds all trade well above par (115 and higher). It would be exaggerating to say that they trade at investment grade levels, but it’s very close. Considering the much higher degree of time and attention that the Bond Market received from Management recently, we feel this is a very bullish sign for the equity.

Next, fundamental Comparisons (“Co”!) with last year are easy. With 2003 being one of the wettest years on record (I didn’t get to the beach once), the impact on consumption of beverages (Beer & Soda) was noticeable in the US (ask Bud if you think I’m kidding). We believe a “normal” summer (if not a scorcher) presents modest upside to volume projections and earnings estimates.


Sticking with our alphabetical order, we move on to currency (“Cu”!). When is a sinking dollar to your enormous advantage? When 50% of sales come from Europe and your primary raw material is priced in US$! From a reporting perspective (translational exposure), CCK benefits enormously from the surging Euro/$ exchange rate on its P&L. From a transactional perspective, CCK also benefits, as aluminum (largest cost) is a US$ denominated product, globally, and the savings from purchasing this product with Euro’s are passed on to its European operations. Management’s comments on this development? None. Very tight lipped. Since they are being very guarded about projections (of all kinds) on the last conference call their only comment on currency was “USING A EURO OF 1.112” RESULTS WILL BE COMPARABLE. TODAY, THE EURO CLOSED AT 1.2637 AND LOOKS HEADED HIGHER. A HIDDEN POSITIVE CATALYST? ABSOLUTELY.

CCK’s $700mm in NOL’s (“N”!) are a great asset as well. For investors focused on cash flows (that’s all the members of VIC right?), these NOL’s are an unequivocal positive. As the market focuses on P/E however, the NOL’s are problematic. Why? An example: Suppose CCK earns $200 mm in Europe and $20 mm in the US (Europe is much more profitable than the US), it will pay $70 mm in taxes in Europe (a full 35% tax rate) and $0 mm in the US. Consolidated, they will report Pre-Tax income of $220 mm and pay $70 mm in taxes, for a 32% tax rate. In the same exercise, were the US operations to earn $80 mm, there would be no associated tax, and CCK would report a tax rate of 25%. That’s a 7% swing in Tax rate on a $60 mm increase in earnings. Again, not material to me, but in the Sarbanes-Oxley Era, it certainly is making management and sell-side analysts overly cautious about issuing public guidance and earnings estimates (and adding to the value opportunity, in our view).

Finally, there is the major fundamental catalyst, Pricing (“P”!). Significant industry consolidation, led by CCK early in the 90’s and strongly continued by Ball Corp. and Rexam more recently, has created an oligopoly (CCK, Ball, Rexam Plc) which, for the first time in a decade, produced positive low single digit pricing power in 2003! This may not sound like much but in an industry with huge operating leverage the impact is enormous. We believe strongly that this trend is continuing into 2004 and beyond. As further price increases are announced (some would say confirmed) we believe EBITDA and earnings projections will rise across the industry. Remember that CCK operates in many markets each with its own pricing dynamics, thus “price increase” is a little vague. To be clear, we are bullish on pricing for European Beverages & Food cans (where BLL recently rolled up the #3 player nicely) and US Food Can. These three markets represent approximately 45% of CCK’s sales. US beverage (20% of sales) is not expected to announce a price increase in 2004 – However, Rexam is renegotiating the ever-so-precious Coke contract right now. If a price increase emerges from those negotiations, it could easily spark industry wide pricing. Note that Rexam holds a strong position in this negotiation – no other packaging company has the capacity to absorb the contract! In short, the advent of pricing power across the industry is not yet fully reflected in all three company’s, but especially CCK.

Finally, and we do not expect this to materialize in 2004, sales (“S”!) of non-core businesses could raise additional capital and expedite the pay down of debt. Readily saleable and highly attractive businesses include (1) The Beauty business ($150 mm sales), maker of plastic packaging for lipsticks, mascara, etc. We believe 1.5x sales is very achievable in a sale for this profitable division. (2) Plastic closures ($150 mm sales), plastic caps for water and beer bottles, could also be sold for north of 1.0x sales, conservatively.

To finish off the alphabet, T is for Texas, which also passed a law capping asbestos legislation, U is for undervalued, V is for what the stock chart’s gonna look like in 12 months, W is for weather, which has to be better than it was in 2003, I’m skipping X, and Z is for Zed, the odds of losing $$ on this stock.

Valuation

We believe a 15%+ Free Cash Flow yield ($1.40/share), intrinsically, is extremely appealing. How has this yield gone unnoticed by the market? The myriad issues above (asbestos, leverage, Chp.11 scare, lack of sell side coverage) have taken CCK off many radar screens. Further, many investors use quantitative screens to help “winnow” the field, and CCK doesn’t screen well: the P/E is too high (there is no “E”!) and the Free Cash Yield is prospective (and isn’t pick up by backward-looking screens).

How will the market revalue these shares? In a worst case, we believe CCK offers a “capital structure arbitrage” opportunity. Since packaging is among the steadiest, most acyclical businesses in the market, we are strong believers in the sustainability of these cash flows. And CCK is dedicated to reducing its debt. If all $230 mm of minimum annual FCF were applied towards debt pay down, over time a 15% return from current levels can be achieved, simply by swapping debt for equity. Again, we believe this a “worst case” return, ignoring the inevitable “pop” one would receive when the company returned to investment grade in about 30 months.

We note that essential to buying in to our Free Cash Flow yield projection is understanding the significant ramp down in Capital Expenditures going forward. We believe management has historically over-invested (the industry as whole is guilty of this – hence a decade of negative price) and that current projections of about $100 mm/year incorporate much more restrained (less than 1%) capacity additions.

Finally, from a comparative perspective, CCK’s EV/EBITDA multiple of 6.8x (includes everything – Asbestos, Pension, etc.) does not look especially cheap compared to Ball’s 7.0x. On FCF basis, however, BLL also offers an attractive near 10% FCF yield; Yes, we think both stocks are cheap and industry-wide multiple expansion is warranted: We believe there’s more money to be made in CCK.

Catalyst

Catalysts
1. Great results, strong earnings, strong cash flow.
2. Industry wide price increases.
3. Increasing volumes from normal (warm) weather patterns.
4. Paying down debt.
5. Asbestos Legislation.