This is a short sale recommendation for Libbey, Inc. (LBY).  LBY is an over-leveraged, low-growth consumer and institutional table top products company.  Its principal product line is glassware for restaurants, hotels, institutional dining rooms, and for retail sale (i.e. Bloomingdales, Wal-Mart, Kohl’s, etc.).  LBY is highly over-leveraged due to a recent financing done at punitive junk bond rates.  This, as well as a highly competitive market, low endogenous growth of the firm’s core businesses, and overly optimistic expectations, will make it difficult for LBY to generate any significant earnings until at least FY09.  Consequently it should prove increasingly difficult for LBY to justify its current share price, which is based on the promise of a significant turnaround.

 

While LBY is an industry leader in quantity and, perhaps more importantly, quality, it operates in a highly competitive and low-margin industry.  For these and other reasons, LBY has experienced somewhat of a glass ceiling.  Its balance sheet has deteriorated considerably, and LBY has registered a net loss over the last two years:

 

 

In response to this pressure, as well as rising labor and energy costs, by far the two biggest cost items, in June of 2006 LBY purchased the remaining 51 percent it did not own of Crisa, a glassware manufacturer in Mexico, and the largest of its kind in Latin America.  LBY had previously owned 49 percent of Crisa in a joint venture with Vitro, a Mexican holding company.  LBY’s aim in the acquisition was to streamline Crisa’s operations and integrate them fully with its own, providing important labor savings.  In order to finance the purchase, LBY used JPMorgan and Bear Stearns to refinance its bank lines with onerously expensive first and second lien facilities.  LBY’s high interest charges, combined with the substantial capital expenditures required for the proper integration of Crisa and a new facility in China, make it unlikely that LBY will generate free cash flow any time soon.

 

LBY and its bankers appear to have misjudged the market for its recent debt offering, in which it sought to raise $400 million at a rate between 8.5 and 9.5 percent.  The final issue was for $306 million of senior secured notes at LIBOR + 7 and $102 million of payment-in-kind notes at 16 percent, for an average rate of 13.26 percent on $408 million of debt, all due in 2011.  (LBY has since done a swap for $200 million of the first lien facility for a fixed-rate at 12.24 percent).  At these rates, LBY’s interest payments for these notes will be $53.89 million in 2007.  To give some perspective to this figure, Q3 EBITDA was $20.3 million and LBY projects EBITDA between $95 and $105 million for 2007.  The market for LBY common stock does not reflect the real capital expenditure cost of the Crisa acquisition and the interest burden of the refinancing.

 

From there, LBY’s financial picture does not look much brighter.  The interest from the recent offering is $53.89 million; in addition to that, LBY has $77 million in other debt and borrowings.  Even under the favorable assumption that interest on the additional debt is just over LIBOR, say 6 percent, that is $4.62 million in additional interest charges, for a total of $58.51 million (the true total is likely above $60 million). 

 

LBY’s second problem is capital expenditures.  LBY’s operations are capital intensive, requiring the company to maintain a large fixed cost base.  Capital expenditures for 2006 are expected to be $43 million, not including construction expenditures relating to the China facility.  Using non-China 2006 capital expenditures as a base, it appears that the 2007 figure will be at least $43 million.  After acquiring the remaining half of Crisa, LBY began consolidating Crisa’s two manufacturing facilities into a single larger facility in order to streamline operations.  If executed properly, such measures may well improve operating margins.  In the near term, this is a capital intensive endeavor; LBY expects to spend an additional $40 million over the next three years to further consolidate Crisa’s operations.  Taking such factors into account, and according to statements made by CEO John Meier at a recent conference, capital expenditures are estimated at $45 million for both 2007 and 2008.

 

For the time being, we can assume that LBY’s projection for 2007 EBITDA of $95 to $105 million is accurate.  Interest expense and capital expenditure together is estimated at $103.51 million ($58.51 + $45m).  This puts LBY’s estimated 2007 earnings/loss between ($8.51) million and $1.49 million.  LBY has 14.3 million shares outstanding and a market capitalization of $176.63 million (at $12.35 per share).  Clearly it does not take a huge nominal increase in earnings to dramatically improve EPS and justify the current multiple.  However, it remains a long shot that LBY will make even a very modest profit in 2007; more likely it will register yet another loss.  This earnings range translates into EPS between -$0.60 per share and $0.10 per share.  Despite conservative interest and cap ex projections, coupled with a generous EBITDA projection, the best case scenario for 2007 is EPS of $0.10.

 

Once much of the Crisa consolidation is complete and the China facility is running smoothly, LBY still needs strong growth to improve earnings, though its growth prospects are less than ideal.  In 2008 LBY will again be faced with the same debt burden, $58.51 million.  Likewise 2008 cap ex is equal to 2007 cap ex, $45 million.  If we allow for a 10 percent increase over LBY’s 2007 EBITDA forecast—which seems rather generous—we can expect 2008 EBITDA between $105 and $115 million.  Since interest costs and cap ex is again $103.51 million, using this EBITDA estimate results in an earnings range of $1.49 million to $11.49 million.  Again carrying forward previous losses, these earnings are unlikely to be taxable.  The resultant EPS estimate ranges from $0.10 per share to $0.80 per share.  At best this translates into shares trading at 15.4x forward EPS; if the median figure is met, shares would trade at 27.4x forward EPS. 

 

 

 

 

The free cash flow figures from 2005 and 2006 are negative due in large part to China related cap ex and, in 2006, to the Crisa acquisition.  Nevertheless, even without these charges, free cash flow would remain negative, albeit to a much lesser degree.  In 2007 free cash flow should be slightly positive, and likely around zero in 2008.  To qualify this estimate, several provisions should be noted.  First, in 2005 and 2006, non-China cap ex outpaced depreciation and amortization.  Being conservative, 2007 and 2008 cap ex are assumed to be equal to D and A.  It is assumed that there will be additional China cap ex in 2007—to date, $48.4 of the $52 million budgeted for the China facility has been spent.  Further, net income is estimated to be zero in 2007 and $10 million in 2008, both favorable estimates.  As noted above, free cash flow in 2008 suffers from the $19.5 million payment to Vitro.    

 

At the end of Q3 06, LBY had approximately $38 million in cash.  Accordingly, without a refinancing, there will be little room to address unforeseen problems requiring increased capital expenditures or to execute any advantageous acquisitions.  Should LBY fall at all short of its EBITDA projections or require additional cap ex, its cash squeeze could become a very serious issue, crippling the company in terms of operational flexibility.  If LBY further mortgages itself, at punitive rates, the added debt burden would detract from already marginal earnings and make it more difficult for LBY to operate strategically and efficiently. 

 

The debt issue brings into clear focus the real problem for LBY: it paid too much to control Crisa.  In controlling Crisa, LBY establishes a broader presence in Mexico and in Latin America.  Control of Crisa has allowed LBY to begin to consolidate Crisa’s operations and shift much of its own operations away from high-cost labor in the U.S. and into low-cost labor in Mexico; LBY does not expect to register appreciable growth in sales from the acquisition, but rather hopes to increase margins that will save the company $13 to $15 million annually.  On an annualized basis, Q3 2006 EBITDA is ~ $80 million.  LBY will be able to hit its 2007 EBITDA estimate of between $95 and $105 million through modest (3 to 5 percent) growth in EBITDA and labor costs savings.  If and when these labor changes are fully enacted, LBY will not realize further cost savings from the acquisition.  The net result is that a 10 percent increase in EBITDA from 2007 to 2008 is very generous. 

 

Another way of looking at this is what does controlling Crisa add directly to the bottom line?  By reorganizing operations, Crisa will save LBY $13 to $15 million in annual labor costs.  In the refinancing needed to buy Crisa, LBY took on an additional $35 of annual debt service, not to mention the one-time $19.5 million payment owed in January 2008.  In the simplest terms, LBY is paying $35 million a year to save $15 million.  By any standard, that is a bad deal. 

 

 

 

LBY uses natural gas as its primary fuel for glass production.  Any sharp increase in natural gas prices would severely squeeze already thin margins, and LBY has little in the way of protection against this.  With the exception of the Royal Leerdam operations, which account for a small fraction of production, the company does not have long-term contracts for natural gas.  In the event of a lasting spike in natural gas prices, LBY would exhaust much of its cash and its credit facility to keep operations running. 

 

LBY’s business is highly dependent on the travel, entertainment, retail and restaurant/bar industries.  In turn, these industries are highly dependent on macroeconomic health.  The U.S. economy has already begun to feel the effects of the housing bubble, and, if some of the more pessimistic forecasts are to be believed, could actually experience a formal recession at some point next year.  The slowdown in the housing market will directly affect the tableware sector, resulting in fewer sales, which correlate highly to new-home sales.  In the commercial sector, much of LBY’s U.S. tableware sales are replacements to chain restaurants, and less business means fewer or less frequent replacement orders.  There is little doubt that if these industries feel the effects of an economic slowdown or recession, LBY will feel them as well.

 

There is little upside potential to LBY.  LBY is unique in that it is a market leader in both quality and quantity, but has little to no profits (in fact, significant losses of late) to show for it.  For the past 6 years LBY has been named Best in Class for tabletop suppliers by a foodservice industry publication.  It was ranked the 27^th best supplier this year to Sysco, out of more than 2,000 eligible firms, and was ranked higher than any other company of its type.  Clearly LBY is unlikely to add revenue by improving quality—it is already the standard bearer.  Moreover, their recent expenditures are geared more towards cost savings than growth.  The Crisa acquisition will allow for cheaper labor on many of LBY’s core lines; the China facility will mainly serve to lower the cost of goods supplied to LBY’s current Asian customers.  Beyond that, without any free cash in the near term, LBY has slim prospects for expansion or any unexpected upside. 

 

All of this adds up to a company that does not stand to generate any significant earnings for the next two years and will have almost no free cash to address apparent or unforeseen problems in the near future.  LBY simply has little upside, and has little flexibility to deal with any problems.  If it does manage to return to real profitability in 2009, it will still be laden with onerous debt service and limited liquidity.  For these reasons LBY is highly overvalued and is an attractive candidate for a short sale. 

 

 

Catalysts:

-         Cap Ex estimates prove too low or Cap Ex takes longer than projected

-         Natural Gas price spike

-         Earnings miss

-         Slowdown in travel and entertainment expenditures