Sealed Air is a long as the company has a very attractive business (razor/razorblade model that we feel is underappreciated by the market) with a highly incentivized management team and a stock that has been hit due to fears over a large acquisition, a levered balance sheet and high European exposure.  We believe these fears are more than priced in at the current level.  The stock is down ~40% since the June 2011 announcement of the Diversey acquisition as most investors believed they overpaid for a non-strategic business.  Sealed Air’s largest shareholder, Davis Select Advisors, has reduced their shareholding from ~33% to ~5% since the acquisition was divulged.

However, synergy estimates drastically reduce the true multiple paid and we believe there is significant upside to those estimates as there should be a large opportunity to cross-sell the legacy SEE products with Diversey products.  The balance sheet worries some investors (currently ~4.2x ND/2012E EBITDA) but the company should be able to rapidly de-lever the balance sheet over the next couple of years as the company generates significant amounts of cash (management is highly incentivized to de-lever as discussed below). Sealed Air is in a great position to take advantage of the long-term trends toward global food safety/security and facility hygiene.   

Company Overview

Sealed Air provides food safety and security, facility hygiene, and product protection solutions worldwide.  Its Food Packaging segment provides shrink bags and vacuum packaging products.  The company’s Food Solutions segment offers case-ready packaging offerings, ready meals packaging technologies, foam and plastic trays, absorbent products for food packaging, and related packaging equipment, including vacuum chamber systems.  Its Protective Packaging segment provides air cellular packaging materials, shrink packaging equipment systems, polyurethane foam packaging systems, lightweight and tear-resistant mailers and bags, and inflatable packaging systems.  The company’s Diversey Segment offers kitchen cleaning products, food and beverage and manufacturing and processing products, floor care products and systems, restroom care and other housekeeping products, laundry products, and consulting services.  The company markets its products primarily under the Bubble Wrap, Cryovac, and Diversey brands.

Breakdown of geographic exposure by revenue:

~36% North America

~37% EMEA

~17% Asia

~10% LatAm

Breakdown of segment exposure by revenue:

~40% Cleaning and Sanitization

~25% Food Packaging

~13% Food Solutions

~17% Protective Packaging

~5% Other

Why the Opportunity Exists

The legacy Sealed Air business has been a solid business that generates a large amount of free cash flow.  There has been some short-term economic sensitivity, in terms of volumes, but margins have been relatively resilient with many of their contracts having cost pass-through provisions.  SEE seemed to be hitting its stride when they announced the Diversey acquisition last year (more details below).  Beyond the valuation paid for the business, this also significantly increased SEE’s European exposure.  There are clearly headwinds for their European exposure but we believe the actual economic sensitivity of this business is much less than most people assume.  We would categorize ~40% of their European business as economically sensitive (ie lodging and retail and part of building service).  The other segments (food service, food & beverage, and healthcare) are less sensitive as facility hygiene standards remain the same regardless of volume.  Even on the economically sensitive segments, we believe there will be a hit to volumes but margins should hold in there (in fact they will likely increase as cost pass-through provisions from last year’s commodity increase will finally kick in).  There will also be an FX translation hit (we estimate a 10% increase in DXY results in ~5% hit to earnings). 

Diversey Acquisition

Diversey was purchased by Sealed Air from private holders (including SC Johnson) in 2011 for cash and stock worth ~$4.3 billion.  Based on Diversey’s trailing twelve month EBITDA of ~$450mm, the acquisition looked expensive at 9.6x.  However, Sealed Air’s management has already arrived at a synergy target of $200mm ($130mm costs and $70mm revenue), which would reduce the multiple paid to 7.3x.  We believe the revenue synergy number is not even close to the potential for cross-selling legacy Sealed Air products along with Diversey products.  Sealed Air management is also targeting an additional 250 basis points of margin expansion during the next three years following its 350 basis point expansion in margins during 2008–2010. The key drivers of this margin improvement will be supply chain projects (150 basis points), portfolio optimization (50 basis points), and SG&A (50 basis points).

Diversey is a unique asset in a highly fragmented market. The company is the second largest player (7% share) after Ecolab in what we estimate is about a $40 billion global served institutional cleaning, sanitizing, and maintenance market. This market is served by another razor/razorblade business model in which the company sells cleaning solution dispensers at little cost and then sells the actual cleaning chemicals. This model has the benefit of high switching costs to the customer. Diversey’s business has a large opportunity to expand in emerging markets (revenue has recently been growing in the double-digits), and take share from smaller competitors (leveraging scale and cross-selling broader product portfolio – ie market is fragmented but there are only a couple of players that can provide national/international uniform service).

We think the market has unduly punished Sealed Air for the Diversey acquisition as many investors saw it as expensive (we believe that the pro-forma numbers will end up making the acquisition look cheap after true synergies) and believed that Diversey did not overlap well with the legacy Sealed Air business.  We believe that Diversey is highly complementary as they have many of the same customers and a similar business model to Sealed Air. 

WR Grace Liability

In 1998, Sealed Air purchased Cryovac from W.R. Grace.  In 2002 a settlement was reached between Sealed Air and asbestos litigants who claimed fraudulent conveyance related to the acquisition.  Under the terms of the settlement, Sealed Air has agreed to contribute 18 million shares of Sealed Air stock (already reflected in the diluted share count) plus a cash component (currently ~$810m) to a trust. However, the settlement is not triggered until W.R.Grace formally exits from bankruptcy.  Therefore, Sealed Air is currently incurring a ~$0.12 per share headwind owing to the difference of the lower interest rate on cash that Sealed Air is setting aside versus the 5.5% annual rate that the cash component of the liability accrues each year. Once the settlement is triggered, the ultimate value of the settlement (dependent on share price and cash contribution) will also create a net operating loss that Sealed Air will be able to apply against taxable income generated in the United States.  We currently estimate that this cash tax benefit should be in excess of $380mm (at today’s stock price).  This will also result in around $0.12/share in annual interest savings.   

In terms of timing, W.R. Grace’s bankruptcy plan was recently (January 2012) approved by the U.S. Bankruptcy Court for the District of Delaware but remains subject to appeals. However, W.R. Grace has announced that agreements have been made in principle to settle objections. When W.R. Grace exits bankruptcy (likely in the next 6-12 months), we believe the settlement payment from Sealed Air will remove a large overhang on SEE’s stock (the settlement will not only protect against future legacy asbestos claims but it will also reduce interest expense and help to de-lever the balance sheet with a ~$380mm cash tax benefit). 

Management

Management is completely aligned with other shareholders in that compensation is based on targets for EBITDA and Net Debt reduction.  The CEO, Bill Hickey, has agreed to lower his base salary to $100k (vs. $670,833 in 2010) in return for more performance-based comp.  An 8-K was released by the company in April detailing performance targets.  Essentially, the company must hit ~$1.2bn in EBITDA for 2012 for the CEO to hit the same comp level as in 2010.  The bar has been set high as the company has guided for a 2012 EBITDA range of $1.14bn to $1.233 (average of $1.187bn) and current street consensus is~ $1.12bn.  All of the targeted compensation would be given in the form of restricted stock.  

Obviously a big knock on management is the Diversey acquisition.  However, we believe they will eventually be vindicated in their view that it fits well with the legacy SEE business and that revenue synergies will massively surprise on the upside.  

Valuation

We are valuing Sealed Air on 2014 EBITDA as this should incorporate all announced synergies (we believe there is upside to the synergy target). 

Our “Downside” estimate utilizes very conservative growth rates in all business lines compared to historic growth rates (which have been GDP+) and also no revenue synergies and only $50mm of the $130mm cost synergy target; these conservative projections result in an EBITDA number that is in-line with street estimates. 

Our “Base” estimate of EBITDA incorporates $115mm of announced synergies and our estimate of $170mm of revenue synergies (we arrive at this number by assuming the European Diversey Food & Beverage division is able to cross-sell 25% into SEE products – this still assumes no cross-selling in the US). 

Our “High” estimate of EBITDA is based on full cost synergies and also 75% uptake in European Food & Beverage cross-selling (still no benefit to cross-selling in the US).  This estimate of $1.45bn of EBITDA in 2014 also happens to be management’s current forecast.  In our base case, we are valuing Sealed Air at 8x EBITDA, which is in-line with most of its consumer packaging peers, but at the low end its historic range of 8-9x and well below Ecolab (Diversey’s only real comp), which trades at over 10x.  Ultimately, we think there is upside to both our EBITDA (through further synergies) and multiple assumptions.    

Sealed Air trades on a 12+% Free Cash Flow yield in 2012; this yield should move closer to 22% in 2013.  After accounting for the impending WR Grace cash tax benefit, limited capex expenditures and a dividend that currently yields ~3.4%, the company should still be able to rapidly de-lever from the Diversey acquisition. 

Here are valuations under our different scenarios (all using 2014 EBITDA YE 2013 Net Debt of $4,180):

Base Case 2014 EBITDA:   $1,360

Multiple:  7x

Value/share:    $25.21 (~62% upside)

Downside Case 2014 EBITDA :  $1,200

Multiple:  6x

Value/Share: $14.35 (~8% downside)

Upside Case 2014 EBITDA  $1,450

Multiple:  8x

Value/Share: $35.14 (~125% upside)

Major Risks

The major risks to the thesis include problems with the Diversey integration, raw material cost increases (especially PET – although most contracts have pass-through provisions that adjust in a quarter or two – prices have actually been coming down), large exposure to Europe (~35% of revenue), and increased competition (this has been less of an issue with the legacy SEE business as switching costs can be high).