Description

Thesis:  Defensive high-margin excellent business with attractive FCF, aligned management and a catalyst in its pending sale/spin of large, non-core division called Diversey (important accounting change described below)

The company has very good disclosure, has had several investor days explaining the business in detail with full slide decks, etc. available on its IR site, so I’ll stick with the highlights and my summary viewpoint on the three segments (Food Care, Product Care, Diversey).

Food Care:

• Produces packaging for protein producers, which is actually far more interesting than it sounds; for example, the film you see in the supermarket covering a tray of ground beef is much more than a basic plastic cover, it’s actually a highly engineered multilayered material that is there to ensure product safety and increase shelf life.  

• Food Care business is a strategic $3.2 billion dollar global franchise with 20.5% EBITDA margins where Sealed Air has dominant market share with ~58% of the revenue coming from outside of North America.   It’s fair to say that if you were on the production floor of any major protein producer worldwide, you would likely find a Sealed Air machine at the end of each line.

• Employs a razor and blade model as the company sells both the equipment as well as the consumable feedstock creating a recurring revenue stream.  The real key to the product is food safety which is paramount to the customer as all packaging must be specified and also obtain regulatory approval.  This is important as it creates high barriers to entry and keeps out low cost foreign materials.  Additionally, unlike in other packaging businesses, the material here is a critical component of the value chain, but only a small portion of the customer’s cost structure, giving Sealed Air price power.  The long term secular trends are on their side as emerging market protein consumption grows, as does the need for a safe food chain.

Product Care:

• Best known for bubble wrap, but the majority of the business is largely targeted at B2B and ecommerce; the company has a variety of value-added solutions to protect high value supply chain items in transit (i.e. Instapak) as well as multiple ecommerce/3PL targeted solutions.

• This business has approximately $1.5 billion dollars of revenue and 21.8% EBITDA margins and also has a razor and blade model where the equipment is installed and the recurring consumables follow.

Diversey:

• Diversey is an industrial cleaning businesses which manufactures and sells chemicals worldwide into key endmarkets including food production, foodservice, lodging and building care.  They are the #2 global player (8% share) behind Ecolab (ECL) (17% share) and their product offering covers everything from food processing to beverage bottling to restaurants to hotel rooms to office buildings.  Diversey is the #1 player in Europe, Latin America and the Asia Pacific region.

• Large international business with more than $2.6 billion of revenue, 12.4% EBITDA margins with strongholds in Europe and the emerging markets and a relatively smaller business in the U.S (where ECL dominates); also has a razor and blade model where they sell the equipment and dispensers up front and the recurring chemical sales follow.

The quick history is that the former management team of SEE well overpaid for Diversey back in 2011, paying $4.3B for a company that was only midway through a private equity backed complex turnaround.  Furthermore, the company levered up to do the deal and the industrial logic combining Diversey and the packaging businesses never really made sense.  The company had a rough stretch culminating in a full management change when Jerome Peribere was brought in to run the company from DOW.  He was highly successful and has created a lot of value as the stock was in the teens when he joined and is now in the low $40s.  Not only did he cut costs/restructure and de-lever, but more importantly he (i) flexed the company’s inherent but underused price power (given its entrenched position/high share/switching cost) and (ii) reinvigorated / retargeted the R&D effort which is bearing fruit in the form of a robust new product pipeline.  The fact that he was so successful pushing price validates the strong position of the company; in both Food and Product, they have very large market share (and have not lost any share) and are the industry leaders across sub-segment.  They are also one of the few packaging businesses that does not simply “convert” raw materials (in their case, specialty and commodity resins) and charge a spread to their customers.  There are only a few very large customers that have contractual price adjustments based on raw material price changes and that is by design; SEE’s products are highly technical and mission critical and are thus priced for the value they add and are not a commodity.  

That brings us to today where after a great run the stock has stalled out after a large buyback and a temporary period of soft volumes that has been caused by:  (i) ceding some low margin volume, (ii) a soft beef market in Brazil and Australia and (iii) mostly due to the fact that the company is in the middle of a R&D cycle where the product sell in and commercialization is finally occurring on a large portfolio of new products in both the Food and Product divisions.   Also it is very important to note that FX has been a huge headwind which over the past 2 years has hit EBITDA by more than $160M or more than 8%.

Fundamentally, there are several real and sustainable tailwinds in place that will reinvigorate volume growth in the business.  This will never be a massive growth company but they should be able to get back to 3-5% in short order.

• Most importantly, is the North American beef cycle that drives that company’s biggest and best business in the Food segment.  The US beef herd size peaked in 2006, declined for 7+ years and finally began to rebound in 2014/2015.  The company has done very well in spite of this headwind and had been waiting for the turn in the cycle that is finally here and should supercharge the business.  According the head of the Food segment, this cycle is expected to last until at least 2020-2021 providing a 3%+ tailwind in volume per year in the core business alone and this is before adding in the new products.

• 40% of the Product segment is levered to ecommerce and 3PL megatrends and this has boosted the business (10-15% per year) vs. the other 60% which is more cyclical and levered to Global Industrial Production which has yet to get into full gear.

• The company has multiple new large products across both remaining divisions that collectively can be >$400M of revenue and come at higher margins.

• Much of this is likely to be discussed at upcoming investor day later this year in Charlotte.

That brings us to Diversey.  SEE first announced late last year that they were planning on spinning the business off but many thought at the time this made less sense than a sale as there are both strategic and financial buyers that in the past have been very interested in this asset.  Was hunch then that the spin was really a dual process and sale was preferred and that came to pass as the company recently confirmed that is was looking to sell the company rather than spin it.  The company has not publicly stated the tax basis as that would give too much info to prospective buyer but they have publicly stated that their internal tax planning should mitigate most of the potential leakage.

Ecolab is by far the most logical buyer and reportedly was interested in the past when it was private equity owned.  This makes a ton of sense as Ecolab has historically had a very tough go getting their European business fixed and this has been a 5+ year restructuring process.  There would likely be no HSR risk as the geographic overlap is limited in the US and the European market is more fragmented and lower margin.  Ecolab trades at a huge EBITDA multiple premium partly due to its much better margins and they unquestionably can run Diversey better and extract large synergies.  Furthermore, ECL has done large M&A in the last several years in the Energy space which has brought more volatility to a historically incredibly run and stable business.  Diversey is a perfect fit.  The second rumored strategic is the large German company Henkel who used to be in this business but sold its assets to Ecolab and likely regrets doing so.  Finally there is reportedly heavy private equity interest as this is a high FCF and capital light business.

VERY IMPORTANTLY on this point, Diversey’s standalone capex is only $15-$20M however one must note that Diversey GAAP accounts for its dispensing equipment much differently than ECL, it expenses it through the P&L while ECL capitalizes it.  Per SEE management, if they were to account the same was as ECL, reported EBITDA would be 150bps higher or $40M+ more (i.e. the spending would shift form the P&L to the cash flow statement in capex).  In the upcoming Form 10 for the spin, the company will likely account for Diversey the same way as the leading comparable ECL (i.e., headline EBITDA for Diversey will show up ~$360M).  When comping the business vs. ECL, one must use this number to place a multiple on and I think this is one reason the street is way low on their estimated TEV for the business.

Misc. Numbers:

• As mentioned above, real comparable to Ecolab EBITDA is $360M, not $320M and one must put a multiple on this number to calculate the TEV

• D&A is much higher than capex due to intangible amortization from the original Diversey deal, some other SEE tuck-ins and from stock based comp

• FCF is well understated by the company as (i) they are building a new HQ for $120M and this is in capex and is now complete, (ii) they have been funding the last of their large restructuring programs and this too is done after a big spend this year with only a small $30M left in 2018 and no large restructuring plans to follow

• Company has loaded new SEE with all the overhead but they have identified savings to offset the stranded costs of ~$30M post deal

• The CEO has a target EBITDA margin of 25% over the medium-long term for the pro forma new SEE vs. 20-21% today, this is driven by mix, price, new products and operating leverage

Summary:

As shown in the numbers below, I believe that Diversey sale will go for a higher number than expected and one can create the new SEE, which is an excellent, non-cyclical, defensive, high margin FCF business at a discount.  The new story will also be free from five years of Diversey hair and distraction.  The company will have a ton ($12-%15+) of cash per share to use as it maintains a target 3.5-4x leverage ratio; the company will not do a big deal but rather small bolt-ons and has stated that will offset the dilution likely with a large Dutch or ASR plan (they can start buying back stock again once the ultimate Diversey transaction is announced).   Finally the CEO has hit all of his original (and aggressive) employment agreement stock price based targets and has gotten very rich with stock value of ~$100M.   He is not going to mess that up and this is likely his last CEO job before retirement; at some point, after he reinvigorates growth and marches toward the 25% EBITDA target, I think it is likely he puts the whole company up for sale in the medium term.

As shown in the numbers below, based on only modest top line growth and EBITDA improvements, and assuming a FCF yield in line with the packaging group (of which new SEE is arguably the highest quality company), one can get to a mid $50s stock or up 30% or so while maintaining optionality on better volume, higher EBITDA margins and an eventual sale of the company.   

Catalyst

Diversy sale, large buyback, product cycle drives volume and margins