Description

Long Owens Illinois (OI)   $17.20

Owens Illinois is the largest manufacturer of glass bottles in the world. It has 80 manufacturing plants in 23 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).

Supply/demand dynamics by region:

NORTH AMERICA (34% of sales, 38% of EBIT*) : Growth in premium products (wine) and high end beer offset decline in mega-beer Well balanced supply and demand  

EUROPE (36% of sales, 29% of EBIT): Stable industry demand; Solid export trends; Less intense price dynamics

LATIN AMERICA (20% of sales, 27% of EBIT)  Attractive growth trends in Mexico .  General economic slowdown in Brazil.  Higher growth in one-way glass in Brazil.  Brazil seems to be stabilising as of q3

ASIA PACIFIC (10% of sales, 6% of EBIT) Stabilizing demand in Oceania  Profitable growth in emerging markets

OI’s major customers are the large blue chip food and beverage manufacturers - Anheuser-Busch InBev, Brown Forman, Carlsberg, Diageo, Heineken, Kirin, MillerCoors, Nestle, PepsiCo, Pernod Ricard, SABMiller and Saxco International. No customer represents more than 10% of the Company’s consolidated net sales, although the top 30 accounts are 50% of revenue.

Glass Manufacturing Industry Summary: See rrackam836 analysis for state of the glass manufacturing industry as not much has changed since then.  I have summarized the key points below.

1) “The manufacturing process involves converting sand, soda ash, limestone, recycled glass, energy and labor into glass containers. Raw material costs accounts for 40–50% of revenue, labor for 25% and energy costs around 5-15% percent. The company manages volatility in energy prices by including cost pass-through provisions in its fixed price contracts (1-3 years with annual inflation adjusters) and hedges.

2) Despite cheaper alternatives like aluminum and plastic, customers continue to use glass for brand identity and consumer preference.  Glass also has unique properties that make it an effective and attractive packaging alternative  It preserves the quality of food and beverages for extended periods of time. It can be recycled endlessly, remade into various forms and is hard to tamper with.its contents. It can be used to make containers of different shapes and sizes.

3) Global glass container shipments are forecasted to grow 1% per annum through 2018. Wine and spirits are growing as are craft beers while mega beer declines.  Glass has a 30% share of beverage containers by material in Western Europe. By share of rigid packaging (plastics, metal, etc.), glass’s share is as follows: South America (30%), Europe (>26%), Asia-Pacific (>26%) and North America (> 10%).

4) High Barriers to entry:  Glass manufacturing is capital intensive and is subject to various environmental regulations at federal, state, and local levels so getting approvals to build new plants is difficult and costly.

5) “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. 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. Because reliability is so important, large manufacturers compete on price and production capacity, but also leverage relationship marketing and loyalty to generate sales.”

7) Capacity has been rationalized over the years (number of glass plants down from 121 in 1983 to 50+ today) and through M&A, the industry has been consolidated with more rational pricing practices.

Estimated Market Shares for glass manufacturing are:

Europe:

Owens Illinois-36%

Ardagh Glass -19%

Verallia  -21%

Vidrala -7%

Others -17%

US:

Owens Illinois -36%

Saint Gobain -28%

Ardagh Glass -19%

Others -17%

 Deleveraging will accrete to equity at attractive rate

After selling the plastics business in 2007 and reducing its debt from $5.5 billion to $3.7 billion, OI re-levered to fund the Vitro Food & Beverage acquisition.  Management has clearly stated that it will use the bulk of its FCF to reduce debt. It is targeting a net Debt to EBITDA ratio of 3x in 2018 down from 5x currently. In the past 10 years OI has consistently generated anywhere from $1.1 to 1.4b in EBITDA as well as significant free cash flow after asbestos and pension payments as seen below for the most recent three years.

CFFO           Capx FCF per share

2015 612 (402) 210 $1.30

2014 698 (369) 329 $2.03

2013 700 (361) 339 $2.09

FCF in 2016 is expected to be $300M (includes one time VAT refund of $135mm)

2016 FCF of   165 (ex VAT refund)

+10 Vitro

+25 Inventory reduction

+50-70 business growth and some recoup from fx effects

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2017 FCFe **$250mm, $1.54/share

FCF in 2018 is expected to be >$300m from incremental inventory management, Vitro synergies and organic growth

Proceeds from potential asset sales (plants, JV etc) would also contribute to faster deleveraging

$200mm of debt reduction annually accretes $1.20/share to shareholders for 7% a annual return

Despite high leverage, financial risk is low

• No significant maturities until 2020 : $250mm due in 2018

• Negotiated more flexible leverage ratio covenant in light of volatile FX environment

• EBITDA coverage at >4x interest

Cheap valuation for stable cash flowing business primed to recover:

Management has guided to an adjusted EPS of $2.25-2.35 in 2016. At today’s price, investors are buying OI for a current year P/E of 7.4x (assuming a $2.30 EPS) and 9x 2017e FCF/share. If OI hits its goals the stock should re-rate higher. For first time in a while, new management’s financial assumptions (outlined below) to hit these numbers seem conservative.  A conservative 11x P/E (median over 10 yrs) implies a return of 50%.  

Assumptions:

1) Rev Growth of  1%

Europe :                    1% growth expected to be in line with market

North America: 0-1% Higher sales to CBI; ongoing mega-beer decline, growth in craft

        beer, food, spirits, wine and NAB

Latin America: 2% Growth expected across entire region

Asia Pacific: 0-1% Growth expected to be in line with market

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Total O-I:   1%   (approx 50bps greater than mkt)

2) 40 bps ($27mm of incremental operating profit) of margin improvement over 2016

From the latest analyst day  ”On track to deliver incremental segment operating profit of $50-70mm”  from the following initiatives

Improved year-on-year manufacturing efficiencies at two-thirds of plants

Reduced working capital at plant level

Reduced unscheduled downtime

Created new global supply chain lead and global network

Launched Key Account Management

-Vitro F&B acquisition-$30mm of synergies by year 3….exceeding expectations with 3-4% rev growth and 20% EBIT margins

-Currency effects have hit margins and likely to reverse at some point

-30% hit y/y to FCF in 2016, costing $.16-.20 eps/yr

-Overly penalized discount to peer packaging group

Assuming 6.0x EBITDA and $200mm of debt reduction over the next year implies a $21 target.  6x is not unreasonable given a mean of 9x for the group;  M&A multiples have been done generally higher over the last few years.  Ardagh Glass purchased Saint Gobain US assets for 6.5x EBITDA in 2013,  Apollo bought Verallia glass for 7.4x EBITDA in 2015

Downside scenario:  revenue comes in flat to down and only ½ the margin improvement accomplished; risk is more likely dead money as stock would still be at 7.5x EPS on flat numbers

Cheap on replacement value; Glass container plants are estimated to cost around $150 million. Today, OI has 80 plants worldwide, implying a value of $12.0 billion or $39/share for the equity. Management’s estimate of the replacement value is even higher..

Earnings upside from JV’s in out years

-6 JV’s, 5 of which are glass manufacturing and 1 strategic 25% stake in a soda ash supplier

                                                                                                                    2015 2014  2013

Equity in earnings:

Non-U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23   23   27

U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 41 40

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 64 67

OI is investing $250 mil for 4 new furnaces with the Constellation JV in 2015 - 2018 and the furnaces ramp up steadily from 2015 - 2018 (one per year).  This will likely remain a drag on returns until the investments start contributing more fully in 2018.  Thus far, that JV is tracking as OI had expected  I estimate upside of $.05-.10 in the out years with decent demand in Mexico..

Share repurchases still a lever to pull for EPS growth

$280mm share repurchase authorization remaining

Sell-side mostly bearish on the name

Most analysts overlook the value in the name given lower growth and the asbestos liability so they apply a severe multiple discount to peers as seen in the above table.  Interestingly, more favored names like BERY,  SEE or SON are only projected to grow revenue by 1-3% over the next few years and they sport premium multiples.

Asbestos will continue to weigh on cash flow but in a decelerating way

Owens Illinois is a defendant in numerous lawsuits regarding asbestos health issues going back to its exit from the business in 1958. Tort reform has made it harder for plaintiffs to bring frivolous cases against OI. As a result and given the average age of claimant is now >80 yrs old, the number of cases pending/filed and cash payments are steadily decreasing as seen in the table below.

    Filed     Pending Cash payments

2015         1,280 2,080 $138

2014 1,470 2,220           $148

2013 1,710 2,620 $158

2012         2,360 2,610 $165

2011         3.200 4,600 $170

2010         3,200 5,900 $180

2009         6,000 6,900 $180

Pension drag on earnings declining

OI had an underfunded pension liability of about $198 million YE 2015.  The pension liability as disclosed in the 10-k  is an estimate and is very sensitive to interest rates. Because of the current low interest rate environment, the liability has increased. Pension cash contributions were $17 million in 2015, $28mm in 2014 and $96mm in 2013 after a larger voluntary payment in 2012 to decrease the liability. Going forward, OI need not contribute to their US pensions significantly and they need only make the required contributions for their international plans (which are expected to be about $20 million through 2018).   Pension expense will likely come in around $35-40mm in 2017, or $.16-.18/share after tax down from as high as $.50 in previous years.

Gross pension benefit obligation at year-end 2015 was down more than 25% since 2012.   Actions already taken to reduce liability include:

• $200mm contribution in 2012

• U.S./Canada salary plan freeze

• U.S. hourly plan annuitization

• Netherlands plan annuitization

If interest rates rise in the future, this will have a positive impact on their bottom line by reducing pension expense

-Insider buying by executives and directors

-prices ranging from $14-20

Risks:

Currency can increase volatility of  EPS

-Estimated translation impact on annual EPS from 10% FX change:

Euro $0.10 , Mexican peso $0.07, Brazilian real $0.05 ,Colombian peso $0.03

Australian dollar $0.05

Higher interest rates

-46% of debt is variable rate

Cost inflation creep could crimp margins more than expected

Sources: Company reports, bloomberg.

*  6 mths ended june2016

**Ongoing capx projected at $450mm

Catalyst

Hitting targets

Asset sales