Description

Libbey (“LBY”) is the largest glassware company in the Western Hemisphere and the second largest in the world.

In summary, LBY is a dominant niche business in the middle innings of a turnaround. The stock trades at 10x my estimate of current year earnings, reflecting a combination of underappreciated margin enhancements (via already achieved cost cuts) and lower interest costs (via a recently closed debt refinancing). I target fair value of $39, up 45%.

While the historical financials are uninspiring, I believe that the business is nearing an inflection point. Stephanie Streeter (appointed CEO in August of 2011) spent her first two years fixing the balance sheet and cutting costs, and is now turning her focus to growth. In addition, given the fixed cost nature of this business (60% of costs being fixed), future growth should be accompanied by healthy incremental margins.

LBY has many of the attributes of an attractive long:

- strong market share, recurring revenues, barriers to entry and increasing ROIC

- underfollowed by the Street (1 analyst at CJS)

- improving margins and competitive position as manufacturing is realigned and per-unit labor costs are reduced

- high pension costs that are working their way down (LBY fully funded its pension in 2012 and froze future benefits in 2013)  

- a highly accretive debt refinancing that recently closed

- a relatively new CEO who has brought bold decision making and good capital allocation

- longer-term opportunities for growth in emerging markets

LBY earned adjusted EBIT of $90m in FY13. As stated on the Q4 call, the company will benefit by $8m from its manufacturing re-alignment and $6m from lower pension costs. In addition, interest expense is set to decline from $32m in 2013 to $16.5m given new, much lower cost debt. Assuming no growth (which I view as unlikely), that gets me to EPS of $2.84.   

In addition, I like the fact that Streeter’s compensation package includes 240,829 stock appreciation rights that cliff vest in December of 2018 at $21.29. Despite the recent run-up (up 28% YTD), I still consider LBY an attractive risk/reward.

Business Overview

Libbey is one of the largest glass tableware producers in the world. Founded in 1818, the company has a long history. LBY has been public since 1993 when it was spun-off from Owens Illinois, and Stephanie Streeter (CEO) was hired in late 2011 to implement a turnaround. The company manufactures virtually all of its products through 6 fully owned plants around the world. LBY’s principal brands are Libbey, Crisa, World Tableware and Syracuse. It goes to market through three channels (foodservice, retail and B2B), 500 distributors and its own direct sales force. Libbey has dominant share in the Americas (58% in US foodservice, 43% in US retail and 55% in Mexico). Its Americas segment accounts for 91% of EBITDA.

Investment Thesis

1. Libbey is a tough business to “kill” with formidable barriers to entry and high recurring revenue streams.

• Libbey is the #1 glassmaker in the Western Hemisphere and #2 in the world behind Arc International.
• The company has dominant market share in the US and Mexico, pricing power (LBY has taken price increases in 39 of the last 43 years) and strong recurring revenues from its foodservice segment.
• While undisclosed, I estimate that Foodservice is approximately 50% of revenue but accounts for the lion’s share of profits. This segment is 90% recurring as it’s predominately replacement (think broken glasses at chains like DRI).
• Barriers to entry arise from the vast installed base, costly fixed assets, extensive distribution network and direct sales force.
• While asset intensive, LBY earns 10-11% ROICs and those should improve as its asset light sourcing business (dishes, silverware, etc) grows in importance.

2. Falling labor costs should drive a significant improvement in GMs as LBY re-positions its manufacturing footprint

• Salaries & wages are the largest component of Libbey’s COGS.
• Libbey currently produces 50% of its products in low cost countries and I expect this number to rise over the next several years.
• In particular, during 2013 Libbey expanded its facility in Monterrey, Mexico (now the largest in the Western Hemisphere) and subsequently announced layoffs at its plant in Shreveport, Louisiana. This is projected to benefit COGS by $7-$9m in FY14 as labor costs are, of course, much lower south of the border. The significance of the gross margin improvement, however, is not well understood by investors because of a furnace malfunction that hit FY13 gross margin by $8 million.
• FY13 gross margin of 22.9% was distorted by a furnace shutdown in Toledo ("it was a once in more than 4 decades occurrence"). Adjusting for this, FY13 gross margin was 24.2%. Pro forma for the Mexico benefit gross margins should be over 25% and, including the step down in pension costs, could be close to 26%.
• In addition, I would not be surprised if Libbey moved more of its production to its low-cost, duty free plant in Mexico. LBY has collective bargaining agreements expiring in the US on 12/14 (Louisiana) and 9/16 (Toledo).

3. Interest costs are set to drop ~50% and drive $0.49 in EPS accretion as LBY re-finances high cost senior notes

• Libbey announced in March 2014 that it was tendering for $360m of its $405m in 6.875% senior notes at 110. Virtually all of the holders consented. The remaining $45m will be called in May at 103. The new $440m in debt will be a term loan at a much lower L+300 rate with no leverage covenants and a 75bps Libor floor.
• This move represents the culmination of a 3 year process to fix the balance sheet. Pro forma interest should be $16.5m vs. $32m in FY13. This will drive $0.49 in fully taxed incremental EPS. To the best of my knowledge, the lone sell-side analyst has yet to publish a note.

4. Libbey’s laser focus on cost reductions should drive an improving competitive posture, especially in international markets

• Despite its leading share, LBY is not always the low cost player. Re-aligning its manufacturing should strengthen the company and lend to share gains. This is especially true in Central & South America where LBY should be able to leverage its relationship with growing WMT of Mexico where it has 70% of the shelf space.
• In addition, while the consumer outlook remains muted, sales in FY14 should improve for several reasons: (i) LBY announced a price increase of 4-5% for FY14 after no increase in FY13; (ii) 1-time furnace rebuilds/malfunctions hurt FY13 sales; (iii) 2/3’s of the FY13 decline was due to low-margin business that LBY walked away from (now a “clean comp”); (iv) the weak Mexican economy is now recovering nicely (Mexico accounts for 17% of sales); and (v) a slew of sales force additions during 2013 (grew US & Canada headcount 20% in 2H13; took China sales team from 17 to 53). 
• Finally, since coming on as CEO in August in 2011, Streeter has done an excellent job. The next phase of her plan: “transition to growth.”

Valuation

Assuming no growth, I believe that LBY can earn ~$2.80 in EPS given the cost reductions, lower interest expense and reduced pension burden. That said, over the past 22 years the company has grown sales at a 5% CAGR (2-3% organic) and has only witnessed declines 5x (2000, 2001, 2008, 2009 and 2013). Furthermore, the 2013 decline of -0.8% was largely due to LBY walking away from low margin retail business in conjunction with its manufacturing move. With Streeter now focused on growth, I think the odds are better than not that LBY will see improving top-line results.    

As already stated, LBY earned adjusted EBIT of $90m in FY13 and the company will benefit by $8m from its manufacturing re-alignment and $6m from lower pension costs. That results in adjusted EBITDA (using $44m in D&A) of $148m, or an 18% margin (which is in-line with Streeter’s goal of being at the high end of 16-18% by FY15). In reality, I think LBY will exceed this target and update its prior “goals” which were set in 2011. Assuming 2.5% sales growth this year and next, I think LBY could have sales in 2015 of $863m and EBITDA of $155m (using the 18% target). At $16.5m in interest, a 30% tax rate and 21.7m shares, that gets me to $3 in EPS or 8.9x the current price. 

For a business like LBY that grows LSD and earns ROICs of 10-11%, I value the equity at 13x EPS or $39. Comparables are tough to come by (Arc is private and EVRY is highly leveraged) and I view this as reasonable on an absolute basis.   

Free cash flow will be slightly higher than earnings given $95m in NOLs that reduce cash taxes to ~$12m vs. my estimate of GAAP taxes at ~$24m. I expect LBY to generate $50m in FCF in 2014 and $80m in 2015. Note that Capex is higher this year due to a 1-time technology investment of $17-$18m in Louisiana. Over time, D&A has approximated Capex.  

The current EV is $980m (pro forma for the new debt) and closer to $950m if you exclude the PV of the NOLs. Based on the latter figure, LBY currently trades at 6x forward EBITDA and 8.5x EBIT (assuming the 2.5% sales growth). My price target of $39 implies an EV of $1.2b or 10-11x forward EBIT or EBITDA-Capex (assuming no cash build or debt pay down). 

If there is another recession, LBY will get hurt as it did in prior downturns given its fixed cost base. However, the difference today is the capital structure. In 2008, EBIT declined 40% (before fully recovering in 2010). This was especially painful given high leverage and high cost debt (PIK notes at 16%). Not surprisingly, LBY was successfully written-up as a short by kejag700 in late 2006 with precisely this angle. In a scenario where EBIT declines 40% again, I project EPS of ~$1.50 ($60-$65m in EBIT) and downside in the low-to-mid teens. I would not consider this a “normalized” number nor do I expect EBIT to decline 40%. However, be warned: if you are forecasting another recession, LBY will not be a near-term winner.

In summary, to get to $3 in EPS does not require heroic assumptions. The majority of the step-up is driven by already announced reductions in COGS and a recently closed debt refinancing. At 13x EPS, I think LBY is worth close to $40 and additional upside could come from further cost cuts and/or execution on top-line growth.

Catalyst