Description

Capital-intensive industries like glass beverage manufacturers have problems with labour unions, raw materials, fuel costs for melting glass, which requires increasing average sales price to offset cost inflation— prospects are unpredictable. Charlie Munger once said, “If you want to ruin your life, spend it trying to change your spouse.” 

Here’s my disclaimer— owning shares of OI glass is still somewhat hopeful thinking for now. While I’m not betting the house on OI glass, they have passed an inflection point (our spouse is half converted)— they have fully resolved their asbestos liabilities by forming a trust called Paddock. 40% of OI glass’ cash flow was consumed by asbestos payments over the last decade alone.

Charlie’s partner also mentioned— “when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” 

Turnarounds seldom turn, but OI glass is trying to bring better business economics with the introduction of new MAGMA technology plants/lines and has already moved 35% of OI’s revenue concentrated North America beer capacity to high margin categories such as spirits, whisky, gin, food, and non-alcoholic beverages.

Affordable luxuries play out well during recessionary periods. Management is capitalizing on this opportunity— whether it finally materializes, improves free cash flow, and lower debt is yet to be seen.

Changes for the better

1. Resolution of pension liabilities

OI’s has resolved their pension and asbestos issues by creating a trust. OI reduced their unfunded pension liability by 325M in 2020.

2. Asbestos liabilities moved to the Paddock Trust

With a total one off 610M funding the Paddock Trust, OI dramatically improved their balance sheet, future cash flow, and reduced their risk by bankrupting the subsidiary and settling with the plaintiffs.

3. Previous expansion bearing fruit

Since 2015, a substantial investment to build out the Americas network (acquisition of OI Mexico and Nueva Fanal as well as JV expansion in IBC and Comegua), brings North and South American up to 35 glass container plants.

4. Shift to higher margin categories such as spirits, whisky, gin and less focus on beer

65-70% of OI’s total revenue comes from the glass packaging of alcoholic beverages. 25-33% is attributable to food packaging and non-alcoholic beverages. Globally, mainstream beer is now already only 3-4% of OI’s sales.

5. MAGMA transition from traditional furnaces

MAGMA (modular factories for premium niche brands to cater to spirits and hard liquor) allows for customization and downtime. Glass factories require a period for “cold maintenance”. Sand, soda ash, and limestone is melted in a furnace at temperatures of nearly 3000F (1650C) which tends to wear out the linings and becomes a maintenance capital expenditure. New MAGMA technology will lower capex— a typical furnace must be replaced every 10 or 15 years, while a MAGMA unit doesn't have a real end-of-life.

6. Selling off non-core businesses to build new capacity and shutting down underperforming furnaces

OI’s management plans to sell of 1.5B worth of assets, and to have two-thirds sold off before 2023. 1.3B of assets have been sold to date. With these proceeds, OI can allocate capital to effective projects. New business opportunities pipeline for OI currently adds up to 1.7 million tons.

Assets sold off includes the Colombia tableware sale and signing a sales/leaseback transaction, which is set to close in the second quarter. Management was also smart enough to sell off Asia Pacific (New Zealand and Australia) in 2020 for 677M and unnecessary divisions to focus on its core business. 85% of business in Asia was sold to Visy which comprises of Australia and New Zealand.

7. Director Hardie Gordon has been purchasing shares as noted in Form 4 on May 12, 2023

Risks

1. Long Term Debt

With current liabilities at 2.1B (1.3B in payables), total debt at 5B with long term debt at 4.6B, bringing long term debt to equity to 223% in 2023, June. While this is still a considerable amount of leverage, OI is heading towards a conservative trend if you consider long term debt to equity was once 1316% in 2020.

Furthermore, the balance sheet is now around 4x Debt/EBITDA, O-I has reconfirmed its debt target for year end 2024 where it wants to reach a net debt of 3 times EBITDA (EBITDA is overly optimistic compared to actual FCF). Assuming cashflow is conservatively around 200M, even if net debt decreases to 3B despite making the 610M asbestos payment, debt to actual cashflow is quite high.

ROE was 54% in 2020 and 33% in 2023, but ROIC, which considers leverage into the equation, paints a more accurate and bleaker picture of 3-5% ROIC in 2020 and 5-7% in 2023.

2. Cost inflation and decrease in volume

Aggregate volume decreased by 8-10% despite revenue increase due to price. Price adjustment formulas have worked 6 out of the 7 years before, but there’s no absolute guarantee in the future. Inflation is about 7-9%. Cost inflation now flushes through raw materials, SG&A, labour, and interest expense is increasing. Natural gas in Europe averaged EUR 120 per megawatt hour at its peak last year.

3. Contract Terms and Pricing

OI’s gross price realization each year, depends on the price increases negotiated. 55% of OI’s business is under long-term contracts, with annual price adjustment formulas at the start of the year. The price adjustment formulas exclude energy, which is either a monthly or quarterly pass-through— in North America, OI can pass through energy cost variations on a quick basis. For Latin America, this applies to both power and gas.

4. Cheap exports due to over production in certain countries

Certain countries produce more than the local demand (domestic market overcapacity), particularly when foreign exchange rates or when transportation costs change. These domestic producers then flood other countries with cheap exports.

5. Following Form 4, Andres Alberto Lopez, President and CEO, on June 06, 2023, sold 135,306 shares in O-I Glass for $3,018,886

History

OI Glass came into existence in 1929 following a merger between the Owens Bottle Machine Corporation and the Illinois Glass Company. OI is currently the largest glass manufacturer in the world, producing more than half of all glass containers used today with approximately 69 manufacturing plants in 20 countries for more than 6000 customers. OI has glass containers are not only used for alcoholic beverages, but for food items, soft drinks, and pharmaceuticals. Key markets for O-I include Italy, France, North America, Andean States, and Brazil.

Paddock Bankruptcy Agreement and Paddock Trust for Asbestos

OI intends to de-risk legacy liabilities by completing their Paddock Chapter 11 process with a reorganization where O-I will support Paddock’s funding of a 524(g) trust. Latham and Watkins, OI’s legal advisor, has the affirmation by the Delaware District Court that the trust is effective.

A total consideration of 610M was funded and the agreement provides a channelling injunction protecting Paddock, O-I and their affiliates from current and future liability (asbestos personal injury claims). The Paddock reorganization will improve OI’s cash flow and balance sheet.

How markets for glass beverages have changed— Global Capacity/Supply and Demand

OI’s sales mix use to be predominantly beer companies. Mainstream beer was 40% of sales and has been really a pressure point for OI in demand influencing growth and performance.

The beer purchasing index below shows a declining trend of domestic beer. 50 is the breakeven point and the index fluctuates between 40 to 55. January 2023 hit a low point of 38.

About NBWA’s Beer Purchasers’ Index: BPI is the only forward-looking indicator for distributors to measure expected beer demand. The index surveys beer distributors’ purchases across different segments and compares them to previous years. A reading greater than 50 indicates the segment is expanding, while a reading below 50 indicates the segment is contracting.

OI saw the writing on the wall, so they diversified to not be at mercy of beer companies when renegotiating contracts. Beer is now only 4% of OI’s global sales and 14% of North America, which reduces OI’s risk. Despite domestic beer slowing down, OI will keep some legacy furnaces catering to higher volume production for growing international brands.

Total addressable market

The beverage packaging market is currently (2023) worth around 150-160B (production volume of 700-800B units) and will reach 189B (925B units) by 2026. 150-220Mtons of glass is generated annually. The last 3 years of Covid has demonstrated that the glass packaging industry is very resilient—should there be a recession, it is expected that at-home glass consumption is going to go up.

For beverages today, there's 20x as many brands on the store shelf as there was a decade ago, with more differentiation and brands around themes of health, wellness, sustainability, premium quality. The MAGMA upgrade for OI further targets this fragmentation and differentiation.

Competitors

Ardagh, Toyo Seikan, AptarGroup, and Verallia are 5 glass packaging competitors close to the same scale as OI in terms of production. 5 out of the top 10 glass packaging companies in the world are based in Europe, and the remaining companies are based in North America and Asia.

Collectively, the top 10 glass packaging companies generated revenue of about 35-45B, where Ardagh and OI are among the highest with revenues around 6-10B, followed by Toyo Seikan at around 5-6B.

The future of glass containers and glass packaging as the demand continues to increase by a low single digit pace (2-5%). Despite slow growth, the demand is stable and consistent for glass containers and bottles. OI should not run into any issues when it comes to selling the products. Competitor Verallia mentioned its furnaces are running at full capacity, yet they cannot keep up with demand.

Pricing and Long-term Contracts Renegotiated

45-60% of OI’s business across the globe is covered under some form of long-term agreement that lasts from 3 to 10 years. In North and South America, OI has approximately 55-80% of their business in long-term contracts. With Europe, it is about 30%.

55% of those agreements have price adjustment formulas which are renegotiated on an annual basis. The formula is tied to a variant of PPI (producer price index) or actual realized costs that OI has (measures the average change over time in selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller). PPI takes into account wholesale inflation, while the Consumer Price Index measures the prices paid by consumers. The other 45% of OI’s business is usually either annual agreements with smaller customers, like wineries or orders with on-the-spot purchases. The agreements vary significantly by geography.

Despite most renewal of contracts having an increase in average sales price, OI’s total sales volume has dropped in 2023 by 9% relative to 2022.

Europe

The demand for glass packaging in Europe grows by 2-3% per year. 40% of what OI produces in Europe gets exported out into other markets, such as China or into the Americas, etc. Europe is an important region for OI, as it is the market with the most pricing power. The European market is a 23-24million ton market, or 83-85 billion bottles and jars. Growth is about 500,000 tons per year or two. OI has a capacity in Europe of more than 1 million tons which creates conditions in which securing supply is critical. In several key O-I markets imports adds up to more than 2.5 million tons.

OI was previously slightly oversold in Europe by about 5%. A large volume of glass historically imported from Russia and Ukraine is no longer available due to the recent conflict, driving up demand for locally produced glass.

In Europe, 70% of OI’s business in Europe is renegotiated on an annual basis, with the remaining 30% under long-term (3 to 5 year) agreements. Due to COIVD, OI has had a couple of price increases to cover cost inflation especially in raw materials.

There has been margin improvement in Europe since 2016. Mineral water, champagne and Bordeaux wine in France, Prosecco, Italian wine has recovered after the pandemic with substantial volume in Europe. Demand in beer from France, UK and Italy is critical for OI with high single-digit growth. Scotland will serve as a growing segment of high-end spirits.

In 2020, the operating margin for Europe was 9-11% (sales in Europe were 1.13B, while operating profit was 103M), while the operating margin for Europe in 2022 was 17-23% (sales in Europe were 1.47B, operating profit was 488M), in June 2023, OI’s operating margin increased.

Latin America

Significant growth taking place in Latin America— OI has been importing to sustain South American markets as it is difficult to keep up with the demand and pace. Once there’s capacity, it gets consumed as beverages and goods are going into one-way containers down in Latin America with more premium categories. In Latin America, OI is double digit oversold due to brands getting localized and customers are increasingly favouring premium products.

Demand in Latin America comes from the central region and Mexico. Brazil continues to be very strong for glass and imports come primarily from players like Ambev, Heineken, Kirin. Glass now holds 50% market share in the Brazil beer category and is gaining shares through returnable glass gain. Consumer affordability and sustainability are prompting greater use of glass returnable bottles.

In the Americas, OI had about 15 million or higher of operating costs associated with the combination of planned maintenance activity, primarily in Brazil— OI had a big furnace rebuild plus new capacity additions as well as unplanned downtime. 15 million was partially offset by about 5 million of margin expansion initiatives, changing in the operating costs.

North America

In North America, OI has transitioned about 35% of their beer capacity to other higher margin categories over the last several years of spirits to wines, to food categories. In the United States, imports go up to 1.6 million tons annually. The new capacity in Canada supports localization of global brands is sufficient in terms of volume. Over the last several years, OI has averaged 50 to 75M in their margin expansion initiatives. OI is up to 100M this year because of their added focus in North America that covers a wide range of elements.

Strategic Joint Ventures & Distribution

OI has about 4 or 5 strategic JVs spread across the globe. OI has 2 important ones— one in Europe catering to the higher-end categories, and one over in Mexico.

OI acquired a distribution channel and organization with Vitro, which was renamed to OIPS for a transaction valued at approximately 2.15B. Vitro is the largest supplier of glass containers in Mexico and manufactures glass containers across multiple uses including food, soft drinks, beer, wine, and spirits. Vitro/OIPS complements MAGMA as it brings access to the premium market. Vitro has added an estimated 2.3 million tons for imports.

The transaction includes Vitro’s five food and beverage glass container plants in Mexico, a plant in Bolivia and the food and beverage business of Vitro Packaging, its North American distribution business based in Plano, Texas, which together employ nearly 6,000 people.

Kentucky’s first MAGMA line is going to be serving OIPS premium market and spirits.

MAGMA – A change in upgrading plans from generation 1 to 3 to be more realistic and conservative

John A. Haudrich, OI’s CFO, has been explaining in earnings calls how the MAGMA project will upgrade from a typical “heritage” furnace to a modular, flexible, portable industrial warehouse which saves shipping costs by moving on site with important customers.

A typical glass facility, like OI’s existing heritage furnace, must be replaced every 10 to 15 years. The previous furnace was basically smokestack factory the size of a gymnasium which was limited to a 250 to 300-mile radius within the main facility. If one major part missing or delayed— the whole project is halted by a bottleneck. MAGMA has less complexity due to its smaller scale and allows OI to address the niche glass customers in spirits and hard liquor.

The new MAGMA system will bring flexibility, changing OI’s 50-50 fixed and variable cost to 2/3 variable, and 1/3 fixed. It allows OI to bridge 50-75% of their operating costs from the current glass model. Management claims OI will see 20%+ returns on these types of projects. Historically, on a greenfield glass factory, you could only expect 12-13% returns.

OI laid out a plan for supporting about 600,000 tons of growth, which would be 5- 6% growth over the next 3-year period, substantially supported by long-term customer agreements. The estimated capital for the 11 MAGMA plants is about 630-650 million, but OI may not go for all 11 lines.

The original intention was to use 11 different lines with Gen 1 technology in various markets. With supply chain challenges from covid and inflation and limited labour availability, management now believes MAGMA should be upgraded by a contingent-situation analysis, instead of going all in, since—

1. MAGMA has delayed certain customer’s shipments. Supply chain issues occurred, and the development cycle got impacted by 6 to 12 months. OI had firm customer contracts to honour which would otherwise incur penalties.

2.  Even with MAGMA, “Heritage” facilities are most suitable for beer clients, as volume and low cost is their priority. Down the road MAGMA will still represent 50% to 75% OI’s production, but Heritage will remain for large beer runs as it’s still the most suitable system.

With the new plan, there are less MAGMA lines, but an accelerated schedule— The first greenfield MAGMA factory will be in Bowling Green, Kentucky, conveniently located near the bourbon trail, which is close to customers, is on track for initial commercialization of Gen 2 by mid-2024 and will eventually be upgraded to Gen 3 by mid-2025. The remaining will use traditional technology with a consideration to cost when upgrading, since Gen1 will only have 5% less capital intensity than a heritage furnace with a large factory structure, whereas Gen 3 is approximately 40% lower. For MAGMA Gen 1 and Gen 2, there will be an elevated 60M in R&D.

Gen 2 focuses more on melting, with a new smaller glass melting batch system which is 1/10 of the legacy size including an on-off switch which saves energy by halting unnecessary production with a pilot forming machine, while Gen 3 is more about automation and optimizing bottles to be 30% lighter than previous iterations.

Once Gen 3 and ULTRA are commercialized, expenses start to decrease. For Gen 3, Kentucky will take the small batch system from Streator and a commercial grade melter Holzminden in Germany to have an integrated system with the MAGMA melter, the hot end forms the glass with a modularizing cold end, which allows for a smaller scale facility. OI now has a melter over in Holzminden in Germany, with a small batch system in Streator, Illinois.

Inflation for Raw Supplies and Fuel (natural gas and other sources)

Corporate expenses for OI have increased 50M in 2023 to a total of 220M due to—

1. management incentive fees up to 30M for a good year and
2. 20M for cost inflation, in particular, insurance costs.

Natural gas accounts for 15-25% of OI’s total production costs.

To mitigate the risk, there are 3 factors—

1. Flex Capacity

20% of OI’s production is now flex capacity and is going on to 50% for capabilities for both gas and oil. Fuel oil is more expensive, but not nearly as expensive as spot markets of natural gas are today. If OI did incur a higher cost, they would be looking to pass that on to the marketplace. 1/3 of OI’s electricity is supplied from renewable sources.

2. OI has hedged for energy procurement/contracts

OI has established long-term energy contracts prior to the run-up in the cost in the last few years extending well beyond the current year.TTF futures within a multiyear dynamic creates an enduring competitive advantage with considering milder winters and pricing. OI has paid approximately 40M and received approximately 38M related to hedge activity for the six months ended June 30, 2023 and June 30, 2022, respectively.

Energy in Europe previously peaked at EUR 120 per megawatt hour. Despite declining, it is still 2-3x higher than on a pre-pandemic basis at around EUR 60 per megawatt hour compared to EUR 20 per megawatt hour. The cost curve has gone up dramatically for all players in the glass industry, especially on long-duration energy in Europe and the ability to fix a reasonable price.

3. Product price increase

Fortunately, the average production cost of a container is around 15-30 cents, so even if the natural gas prices triple, the total production cost would still increase by just a few cents as this is small enough to fully pass on to the end consumer.

Financials/Capital Structure- Reduction of debt and refinancing

O-I has 650-750M in cash, and 850-950M of receivables on the balance sheet, but about 5B in debt, resulting in a net debt position of about 4.2-4.7B. With 155M shares outstanding, OI is aiming for a normalized free cash flow of 2-2.5 dollars a share, but as of now, FCF is about 1 dollar or less per share.  

Operating activities:

The attributable operating cash flow for 2023 (98-142M) in June 2023 was lower than the attributable net income (550-650M) because the income statement contained offset by the non-recurrence of the gains on the divestment of a business and sale leaseback (181M for facilities for Vernon, California) in the same period in 2022.

Operating cashflow was approximately 120-130M for June 30, 2022. The decrease in cash from operations was due to a higher use of cash from working capital

A decent chunk of FCF was previously attributable to non-controlling interests. Cash proceeds from the disposal of other businesses, asset sales and sale leasebacks approximated 3M in the first six months of 2023 compared to 286M received in the same period in 2022, which included proceeds on the sale and the one-time, non-recurring gain of the land and building of the OI’s plant in Brampton, Ontario, Canada, and its glass tableware business Cristar in Colombia.

Financing activities:

Cash provided by financing activities was 132M for the six months ending June 30, 2023, compared to  243M utilized in the six months ended June 30, 2022. The increase in cash from financing was primarily due to a 429M increase in net borrowings.

During each of the six-month periods ended June 30, 2023 and 2022, OI paid approximately 20M in finance fees related to debt issuances and to debt repaid before maturity.

O-I was able to refinance by issuing 725M of new debt at 3.125% due 2024.

OI Glass financing activities in 2023 include:

• May 23, 2023 to redeem all outstanding 250M of its 5.875% Senior Notes due 2023.
• Two days later, on May 25, 2023, OI completed a private offering of 690M of its 7.250% Senior Notes due 2031.
• On June 30, 2023, OI went into a credit agreement which includes a 300M revolving credit facility, a 950M multicurrency revolving credit facility and 1.45B term loan A that ends in 2027, to pay off the remaining 600M of the Paddock asbestos trust through a delayed draw (1.43 billion outstanding balance on June 30, 2023, net of debt issuance costs).

OI had unused credit of 1.24 billion available under the Credit Agreement. The weighted average interest rate on borrowings outstanding was 6.62%. This comes with a restrictive financial maintenance covenant with a Secured Leverage Ratio that requires the Company not to exceed a ratio of 2.50x calculated by dividing consolidated Net Indebtedness that is then secured by Liens on property and certain of its subsidiaries by Consolidated EBITDA.

The maturity dates of OI’s existing debt (excluding the term loan) are staggered, and OI should be able to refinance or pay off existing debt without hassle.

Working Capital and Inventories:

In addition, due to expansion and a change in payables, OI will see a dramatic decrease in debt once the working capital gets converted into cash. While leverage peaked at around 5.5x in 2020 to resolve legacy liabilities, OI remains on track to reduce total leverage to 3-4x debt relative to operating cashflow (I don’t like EBITDA assumptions, they’re overly optimistic).

In 2020, working capital was 399M, in 2021 it was 673M in 2022 it was around 228-236M. Working capital is probably 50M swing factor through accounts receivable and inventory through the balance of the year. Working capital was a use of cash of 570-700M in the first six months of 2023, compared to a use of cash of 250-270M in the same period in 2022. The use of cash from working capital was higher in the first six months of 2023 primarily due to higher inventories compared to the same period in 2022.

OI’s use of accounts receivable factoring programs resulted in an increase in cash provided by operating activities of approximately 21M for the six months ended June 30, 2023 and a decrease in cash provided by operating activities of approximately 28M for the six months ended June 30, 2022.

The cash conversion cycle as of June 2023 has increased by 8 to 15 days due to receivables being delayed from 37-38 days to near 50 days and, while payables to suppliers increased by 3-5 days.

*Excluding the impact of accounts receivable factoring

Investing activities:

Over a period of 3 years, OI’s capital expenditures will most likely amount to 1.1-1.4 billion— with 400-500M for maintenance CapEx and approximately 630-700M for expansion— mainly for the 11 new lines will be built, with a focus on the 2 main projects in Canada and Columbia to bring production capacity up to 600kT (5-6% profitable growth and hopes of an average IRR of around 20%).

In 2022, 190-220M of capital expenditures were mainly for expansion, with 600-725M for 2023, and the remaining 150-250M for 2024. With the lower CapEx in 2024, free cashflow should improve.

O-I Glass has completed a €40 million reconstruction of one of its melting furnaces at its Nové Sedlo, Czech Republic, manufacturing facility. The facility also renewed several related equipment in the plant, including two production lines, during the two-month reconstruction period.

Valuation/Prospects

3 year planning system

IBP, as mentioned in earning calls is Integrated Business Planning which is a 3-year running planning system, allows for management to plan for the long term instead of responding to monthly fluctuations of a cyclical industry.

Trading at just 6-7x earnings, O-I Glass doesn't appear to be expensive. The net debt of 4.8B is high but should be coming down relatively fast after funding the asbestos trust. OI Glass is not paying a dividend, which should help improve the debt ratio also. OI doesn't expect to be hit by cost inflation due to their ability to raise prices and hedges for fuel. I’m taking a small position and will take a much bigger chunk when FCF improves, since expansion and maintenance expenditures elevated Capex from 630 to 725M. For 2022 and 2023, OI glass repurchased 20M of shares of their common stock, let’s hope management buys more once things loosen up.

Catalyst

- Lower more sustainable debt, improvement in debt ratios

- MAGMA project succeeds and FCF improves dramatically

- shut down of underpeforming furnances

- Asbestos liabilities are gone

- Glass demand and volume recovers instead of just price increases to increase revenue

- Shift to higher margin hard liquor categories pays off