Description

Description: -

Owens Illinois is the largest manufacturer of glass packaging (ie containers) in the world (bottles, etc.). It has 77 manufacturing plants in 21 countries. The Company is the #1 or #2 manufacturer in all of the regions in which it competes (Europe, North America, Asia Pacific and South America).

The company sold off its plastics division in 2007 to Rexam PLC and started focusing only on glass manufacturing from that point on. It started its expansion into emerging markets starting 2010. Today, the company derives revenues from the following four segments (regions) -

Europe (40% Sales, 32%% EBIT, 35 manufacturing plants)

North America (29% Sales, 32% EBIT, 19 plants)

South America (17% Sales, 21% EBIT, 13 plants)

Asia Pacific (14% Sales, 14% EBIT, 10 plants)

The company can be viewed as a converter of sand, soda ash, limestone, recycled glass, energy and labor into glass containers. Raw material costs accounts for 40–50 percent of

revenue, labor for 25 percent, and energy costs around 5–15 percent. Energy costs include costs for both natural gas and electricity. The company controls for volatility in Energy prices by including cost pass-through provisions in its fixed price contracts and hedges. About 70% of its energy costs are typically secured in this way.

OI’s major customers are the large blue chip food and beverage manufacturers - Nestle, Coca-Cola, AB-InBev, Diageo, etc with whom they have long term contracts. In 2011, sales to Brewers represented approximately 58% of U.S. glass container shipments.

Glass itself has unique properties that make it the ideal packaging material. It is chemically inert and preserves that quality of food and beverages for extended periods of time. It also can be recycled endlessly and remade into various forms. Its impervious nature makes it hard to tamper with package contents. Easily malleable into various shapes, it can be used to make containers of different shapes and sizes - jars, bottles, etc. Over 75% of European (ref: - European packaging Survey, 2010) and 60% of US consumers (ref: - Glass Packaging Institute study) prefer glass over other packaging materials. Hence despite the existence of other packaging materials - like metal and plastic, glass is still the dominant packaging form for beer and spirits (for eg, in the US, representing more than 60% of U.S. glass container usage).

The glass packaging markets can be described as slow growth. Global glass container shipments are forecasted to grow at about 2% pa through 2016. Glass has a 30% share of beverage containers by material in Western Europe. By share of rigid packaging (plastics, metal, etc.) transactions, glass’s share is as follows - South America (30%), Europe (>26%), Asia-Pacific (> 26%) and North America (> 10%).

Glass Manufacturing Industry: -

Glass manufacture involves a high level of capital intensity. Manufacturers must build large plants capable of achieving economies of scale to gain significant market share, meaning capital is a significant sunk cost prior to any production. Moreover, much of the market is controlled by large manufacturers. There are thus significant barriers to entry for new players and this allows the global leaders to remain entrenched.

The glass industry has a concentrated market structure where a few key players control most of the market share, both in Europe and the US. The large glass-container manufacturers are multinational companies with steady to moderate competition. Due to the high transportation cost of glass products, these companies operate locally or regionally and have long-term contracts with their customers. Since the start-up cost in this industry is high, newcomers are at a disadvantage when competing for business with already established players, not only because of high startup costs but also because of the long-term nature of the relationships with customers. Companies grow by acquisition rather than organically.

The list of global leaders mirrors the list of U.S. leaders, reflecting an ongoing trend towards consolidation and globalization which began in the early 1980s and has magnified recently. Compagnie de Saint Gobain in particular has grown through a continuous stream of acquisitions beginning in the mid-1990s. Foreign companies, for example those from Europe and Japan, have made advances into the United States market through acquiring U.S. firms.

Distribution also remains a limiting factor for container glass; the weight and volume of empty glass containers makes transportation over long distances economically unfeasible. This limits imports. Usually, plants are located close to the facilities that consume the products for which the containers will be used.

Large glass manufacturers enforce processes and timelines in order to deliver large quantities of product meeting customer specifications on time. Because glass is fragile, companies have their own distribution channels which rely on specialized trucks and equipment to safely deliver shipments to their customers. For the players serving the food and beverage industries, it is critical to achieve economies of scale. Price can be a differentiator, but quality and reliability is just as important. Customers are on tight production schedules and depend on the glass manufacturers to meet government-mandated safety requirements. Because reliability is so important, large manufacturers compete on price and production capacity, but also leverage relationship marketing and loyalty to generate sales.

The glass industry is subject to myriad environmental regulations at federal, state, and local levels and getting approvals to build large new plants is not easy. This also serves as a significant barrier to entry for new competition.

Market shares (estimate) for glass manufacturing are as under: -

Europe: -

Owens Illinois- 36%

Ardagh Glass - 19%

Verallia (Saint Gobain) - 21%

Vidrala - 7%

Others - 17%

US: -

Owens Illinois - 36%

Saint Gobain - 28%

Ardagh Glass - 19%

Others - 17%

In the years prior to the 2000s, there was excess capacity and the three Majors (Owens Illinois, Ardagh and Saint Gobain) competed on price. Beginning with the 2000s, capacity has been rationalized (In 1983, there were approximately 121 glass container plants run by 23 companies. During the 1980s and 1990s, a series of mergers reduced the number of competitors. Today, there are only 47 glass container plants) and the industry has pursued a price over volume strategy to ensure more profitable returns.

Recently Ardagh Glass proposed to takeover Saint Gobain which would effectively create a duopoly. From the FTC’s complaint: -  

“Brewers and Distillers do not view other packaging materials as interchangeable for glass containers because of commercial constraints, such as consumer preferences and brand identity. The existence of other packaging materials has not prevented the Three Major from shifting cost increases to Brewers and Distillers and raising prices in recent years. Indeed, glass container prices have increased substantially more than plastic containers and aluminum cans.

Aluminum cans and plastic containers are already significantly less expensive than size equivalent glass containers, yet Brewers continue to purchase glass containers. Many Brewers sell beer in both aluminum cans and glass bottles, and view these two forms of packaging as complementary to each other, not as substitutes. Despite the presence of aluminum cans, Respondents forecast demand for glass bottles for beer as stable for the two largest Brewers and growing for craft Brewers”

Key Issues: -

1) Asbestos: - Owens Illinois is a defendant in numerous lawsuits regarding asbestos health issues, though it exited the business in 1958. The average age of the claimant is about 80 years old and today, tort reform has made it harder for plaintiffs to bring frivolous cases against OI. As a result of this, though OI is liable for past Asbestos issues, the number of cases pending/filed (and therefore payments) are steadily decreasing.

2) Pensions: - Owens Illinois has an underfunded pension liability of about $290 million.

A small note on Pensions. The pension liability disclosed is actually an estimate and is very sensitive to interest rates. A pension is an obligation to pay a certain benefit in the future. To calculate the current liability, OI discounts these projected (projected because OI needs to make certain assumptions like future projected salary increases, vesting, etc) future obligations to today using current interest rates.  The lower the interest rate, the higher the estimated liability and vice versa.

Because of the current low interest rate environment, their liability has increased. The Company made a discretionary pension contribution of $120 million in 2012 to significantly decrease the liability. Basically, now they are not required to contribute to their US pensions at all and the only required contributions are for their international plans (which are expected to be about $75 million through 2015). Interestingly, the pension hit to EPS was $0.16 in 2009 and is now $0.5.

As interest rates rise in the future, this should have a positive impact on their bottom line.

Financials and Valuation: -

The company has compounded Sales, EBIT, and Net Income at -1.33%, -3.56% and -6.54 % over the last 5 years. It appears to be a pretty recent business having generated an ROC (defined as unadjusted EBITDA-Capex/NWC+FA) of 27%. At a price of $25.82, OI trades at an EV of $6.43 billion, Market cap of $4.26 billion. Considering the nature of the industry (2-3 major players, nature of the product etc.), and high ROC, it looks like Owens Illinois has a nice moat around its business.

OI used the sale of the plastics business in 2007, to reduce its debt from $5.5 billion to $3.7 billion. At the time, the majority of revenue and EBIT was coming in from glass.  It took on some debt to fund growth in emerging markets (in 2010), but management has clearly stated that it will use 90% of its fcf to reduce debt and the remaining for share repurchases. It is targeting a net Debt to EBITDA ratio of 2x. In 2010, it was 3x and it is now about 2.6x. With Interest Expense/EBITDA about 20%, I am not worried about their debt serviceability. FY 2013 EBITDA (this is after asbestos and pension payments) was $1.192 billion and FY 2009 it was $1.32 billion. It would have to fall by a considerable amount for OI to have issues with its interest payments.

OI is in the midst of a cost rationalization program that plans to yield $75 million in savings by 2015. Specifically, their plan is to close down unprofitable furnaces in Europe and increase asset efficiency. As well they are being careful about not trading pricing for volume in their contractual agreements.

Note that Yahoo Finance EPS and EBIT numbers include charges for asbestos as well as restructuring. Asbestos should be a declining liability in the future, considering the declining nature of the claims (see note above).

OI did $2.72 in adjusted EPS in FY 2013. Management had guided to an adjusted EPS of $3.5 by 2015 in their Feb 2013 Investor day (adjusted EPS excludes restructuring charges as well as asbestos charges - I agree with excluding the asbestos charges because of their legacy nature as well as the fact that they are declining in value). In their Q3 2014 conference call however, management stated they will not be able to meet their $3.5 EPS goal due to macro issues (softer demand in Europe, Brazil and Australia), as well as an increase in their non-cash pension expense due to an increase in life expectancy (according to recent changes in projections by the Society of Actuaries, American men are living an additional 2 years and women, 2.4 years since the year 2000).

Longer term, I believe a $3.5 goal is pretty reasonable. The macro issues should subside over time. With respect to its pensions, OI generates a lot of cash flow and can make additional contributions to its plans (as they did back in 2012). $75 million in cost savings implies an EPS upside of $0.45.

At today’s price, we are buying OI for a P/E of 7.4x (assuming a $3.5 EPS). Even if we shave a further $0.5 from this EPS target, we are at a p/e of 8.6x. As OI gets closer to achieving this goal, the stock should re rate higher. A very conservative 10x p/e implies a return of 16%, a 12x implies a return of 40% (this is if they hit $3 in EPS).

OI’s Management is incentivized to reach these goals because 50% of their long-term compensation is keyed off of EPS. They have also stated that the replacement value of their assets is $13 billion. Glass container plants are expensive to build and cost around $150 million. Today, OI has 77 plants worldwide, implying a value of $11.55 billion. In other words, management’s estimate of the replacement value, though a bit higher seems reasonable. It appears to me that there is considerable margin of safety at these price levels and a return in 2-3 years of 50% seems definitely possible.

Note that I have not taken into account the potential for the pension liability to decrease in the future as interest rates decrease.

Risks: -

A global recession is definitely a risk. Europe is on the struggling, with Japan already in a recession. Also, the turmoil in South America is not positive near term. However, OI is a company that has been EBIT and FCF positive through the Great Recession. They generated an EBIT of $1billion and reported FCF (Operating Cash Flow - Capex) of $345 million in the last recession. A company that can do that is definitely a company that I wish to own.

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Sources:

OI filings, Conference Calls

FTC complaint against Ardagh Glass

“Industrial Sectors Market Characterization” Glass Industry Prepared for Pacific Gas & Electric and Southern California Edison

Vidrala Company Presentation (2013)

Catalyst

Management hitting their EPS goals.