Description

Owens-Illinois (OI)

Warning! The following recommendation contain certain elements (including commodity product exposure, euro/aud/brl currency risks, capital intensity, European subsidiaries, asbestos liabilities, an under-funded pension, moderate amounts of balance sheet leverage, and a somewhat distant government seizure of Venezuelan assets) which may not be suitable for some audiences.

Viewer discretion is advised.

Summary

The recent sell-off in Owens-Illinois stock has created an opportunity to get long shares at less than 10x 2015 earnings. OI has declined 20% in the past 7 weeks on the back of sputtering sales volumes in Europe and adverse foreign exchange movements in the Euro, Australian dollar, and Brazilian real which may (or may not) be transitory in nature. On the plus side the company is in the middle of a successful restructuring of its higher cost European plant operations and has demonstrated flexibility among its plants to respond to declining demand with minimal costs. OI produces ample cash flow ($300mm this year, and $350mm in 2015) and has been committed to good stewardship of capital: 90% of which is devoted to debt repayment and the remaining 10% to anti-dilutive share repurchases.

We estimate the company will earn between $3.00 to $3.25 a share in 2015 Trading at forward P/E multiple of about 8, we think the current valuation is pessimistic and the risk reward favors going long shares at these levels. If currency headwinds abate and volume trends in the European market stabilize, an undemanding bull case would have the company earning as much as $3.50 a share in 2016. At a 12x P/E the stock would be worth $42, or 60% above today's price.

Company Details

Owens-Illinois (OI) is the largest manufacturer of glass containers in the world with 77 manufacturing plants in 21 countries. The company produces glass containers for alcoholic beverages including beer, spirits, and wine. The company also makes glass packaging for a variety of food items, soft drinks, teas, juices and pharmaceuticals. OI's are the largest food and beverage manufacturers in the world, including Anheuser-Busch InBev, Brown Forman, Carlsberg, Coca-Cola, Constellation, Diageo, Heineken, Kirin, Miller Coors, Nestle, PepsiCo, Pernod Ricard, SABMiller, and Saxco International. No customer represents more than 10% of the Company’s consolidated net sales.

The company sells most of its glass container products directly to customers under annual or multi-year supply agreements. Multi-year contracts typically provide for price adjustments based on cost changes so there is minimal input commodity risk. The company also sells some of its products through distributors. Many customers provide the company with regular estimates of their product needs, which enables OI to adjust its glass container production to maintain reasonable levels of inventory. Due to the significance of transportation costs and the importance of timely delivery, glass container manufacturing facilities are generally closely located to customers. We think this is one of the company's main advantages and insures its strategic position in the industry.

OI's Markets

The Company’s main markets for glass container products are Europe, North America, South America and Asia Pacific.

Europe. The company has a leading share of the glass container market with 35 glass container manufacturing plants located in the Czech Republic, Estonia, France, Germany, Hungary, Italy, the Netherlands, Poland, Spain and the United Kingdom. OI is not in Russia.

North America. The company has 19 glass container manufacturing plants in the U.S. and Canada. OI has the leading share of the glass container segment of the U.S. rigid packaging market, based on sales revenue by domestic producers

South America. OI has 13 glass manufacturing plants in South America, located in Argentina, Brazil, Colombia, Ecuador and Peru. The company had operations in Venezuela that were seized by Chavez in 2010. In South America the company maintains a diversified portfolio serving several markets, including beer, non-alcoholic beverages, spirits, flavored malt beverages, wine, food and pharmaceuticals.

Asia Pacific. The company has 10 glass container manufacturing plants in the Asia Pacific region, located in Australia, China, Indonesia and New Zealand. It is also involved in joint venture operations in China, Malaysia and Vietnam. In Asia Pacific, OI primarily produces glass containers for the beer, wine, food and non-alcoholic beverage markets

International sales are about 75% of total revenue. Here's a historical breakdown of revenue by region.

Recent Performance

The company reported on its third quarter late last month and results were weak. Globally shipments were down approximately 3%. While South America delivered strong performance with double-digit volume growth (15% and margins close to 20%), mature European and North American results both experienced moderate volume and price declines.

North American sales declined mostly reduced demand from major beer brands, though that decline was partly stemmed by growth in craft beer sales. Europe appears a little more fundamentally challenged, although at this point it's clear that the market weakness extends beyond the beverages and the glass industry. Management observed in its last call the unease it sees among its European customers and that has continued into the fourth quarter. Asia Pacific also showed some weakness following OI's closure of Chinese plants due to poor demand. Australia was also down double digits in the quarter as it had weakness in its domestic beer and wine export markets.

Seeing how things were taking a turn for the worse, and exacerbated somewhat by the strengthening US dollar, in mid September management reduced guidance for Q3 significantly below consensus. This lead to much of the recent sell-off. With continued uncertainty in Europe and FX challenges, management was careful to temper bullish expectations for 2015 in last week's earning's call as well.

The impact of lower production volumes along with the various operational challenges, combined with the headwinds caused by the strong dollar, will more than offset the company's gains from structural cost reductions in the short run. Currently, investors are not particularly confident about the company's ability to grow earnings significantly next year. Going forward we think the company has a convincing plan that should keep full year earnings around $3.00 to $3.25 a share. In Europe the company has structurally reduced its production capacity to better align supply with demand. The asset optimization program OI has pursued has enabled improved productivity at many of the company's European plants and this should produce incremental cost savings in the coming year. In Asia OI is working to regain beer volume and has successfully negotiated a large contract which will begin filling in mid-2015 which should increase profitability in the region over the quarter and calendar year.

On balance we anticipate flat or slightly higher year-on-year profit for Europe in 2015 as more cost savings get realized.  In North America, we anticipate low single digit declines in sales volume but pricing to hold. South America should continue its positive earnings momentum.  Overall, we don't think the business is broken and all of the company's end markets will eventually recover. Fortunately, free cash flow generation for OI is more easily achievable than earnings and that  doesn't appear to have changed yet. While the timing of the strengthening of the US dollar is regrettable since the majority of the free cash flow is generated in the fourth quarter due to the seasonality of the glass business, the company expected to generate approximately $320mm for FY2014. (the strength of the US dollar is now expected to provide at least $30 million headwind). The majority of cash generated will be used to pay down debt. For 2015 we expect OI to generate approximately $350mm of free cash.

It's our view that the weakness in Europe and some adverse moves in FX have created an opportunity to buy the world's largest glass containers manufacturer at 8x 2015 earnings. The company has global cost reduction efforts that are on track and will blunt most of the financial impact of low single digit volume declines. The company's European asset optimization program in continue to generate financial and productivity improvements expected that will extend into the next year. If Europe goes into a longer recession, OI will be impacted and this investment won't work. But at the current multiple, you're already buying in at a high level of pessimism.

Catalyst

Stabilization in Europe
South American growth
Continued cost reductions
Debt paydown
Share buybacks