Investment Thesis:

We believe VET represents a good value investment for the following:

• Discounted after tax free cash flow indicates an intrinsic value 35% higher than current market price (assumptions:  3yr average after tax cash flow, 10% discount rate, and conservative growth rates)
• Financial metrics also support cheap value:  next year EV/T12m EBIT = 7.23x versus around 10x historic and low double digit for similar industrials(2011 EV/EBIT=7.22, 2012 EV/EBIT=6.73).  P/B = 1.23x, price/replacement value = 0.60x and steady increase in margins
• Market is too pessimistic on growth rates in Eastern and Central Europe
• Market is misinterpreting FX translations for poor performance
• Higher barriers to entry, few competitors
• Capital intensive industry.  Vetropack 5yr average ROE = 15.34%, ROA = 9.31%
• Strong balance sheet (no net debt).  Conservative use of debt
• Family run business, aligned with shareholders

Company Description:

Vetropack designs and manufactures glass bottles and containers.  The Company produces beverage bottles, jars, and other glass containers for the food, chemical, and pharmaceutical industries.  Vetropack also offers production plant engineering, glass packaging design, and recycling services.  Vetropack was started in 1911 and has operated continually since.  The founding family (Cornaz) owns directly and indirectly 50% of the stock and 80% of the vote.

Vetropack operates in six markets and three product segments.  Vetropack is the largest producer in Austria, Czech Republic and Croatia and second in the remaining markets.  The domestic markets make up 86.2% of sales with 13.2% being exported.

Markets

Product Segments

Background

Glass design and manufacturing presents some sizeable barriers to entry.  The industry is essentially a local business that requires high volumes and ample supply of local resources.  Typically factories supply customers within a 300km radius.  Glass does not travel well and imports (i.e. China) cost 2-3x more due to transportation costs.  The business is also run on a made to order/just in time basis so imports are not considered realistic.  The market is generally made up of a larger producer with several smaller scale producers acting as secondary suppliers to the customer. 

Distance is the biggest local competitive factor.  Outside of direct competition alternative products (PET, Aluminium) pose the next best threat.  Almost 20 years ago, glass products were being replaced by plastic (PET) type products.  Back then the biggest differentiator was cost but today this gap no longer exits.  Through the decline in glass raw materials and re-cycling, product costs for PET, glass and Aluminium are essentially the same.  Additionally raw material prices for glass (quartz and soda being the largest) are stable versus inputs for PET (petroleum) and aluminium. 

For VET close to 50% of the raw materials come from the recovered market.  Re-cycling at this level not only lowers the raw material cost by about 10% but also lowers VET's energy component by about 3%.

Glass production is a 24/7 operation.  The furnaces run all day everyday at 1500C and can only be turned off for major production declines or refurbishments.  Shuttering a furnace for any period of time is a costly process.  This makes the industry very inflexible to production.  Breakeven rates vary depending the age of furnace, VET claims to have a 60-70% capacity B/E which is declining as they replace aging furnaces.  The furnace replacement rate for VET is 10 years with a three year pay-back (depending on the type of furnace).  A typical greenfield site producing 500 tonnes/day is estimated to cost Eur100mm with an 8yr payback period. 

The cost structure is made up of approximately 50% variable and 50% fixed.  The high fixed costs give the business good operating leverage (which also works against them in slow times) making profitability very dependent on loading.  The variable costs are (labour is included in raw materials, factories are highly automated):

The raw materials are typically purchased on a yearly basis; the main energy input is natural gas.

Customer contracts are also done on a yearly basis (because of the lead time to produce), giving the company about 12 months visibility.  The industry cycles around the harvest, peak times are:  March-August for beer, May-June for wine and September-November for food.

Pricing is somewhat inflexible and often done at last year's levels (with adjustments).  That said input costs are also agreed a year in advance.  The company has been able to pass on higher input costs to the customer on almost a 1:1 basis.  Technological advances do flow through to the bottom line.

Company Financials - Summary

Balance Sheet

Income Statement

Cash Flows

Investment Details

The company's value took a significant hit after H1 2010 results mainly due to an FX translation loss.  The company reports in CHF and due to its strong appreciation (mainly against the Eur:  EUR/CHF -11%), translated earnings outside of Switzerland declined.  The company recorded the FX translation on the income statement of about Chf15mm as a conservative accounting measure (Swiss GAAP FER has certain criteria before inter-company FX translation can be booked against equity).  IFRS would likely have this booked to equity.  Regardless of the accounting entry a hit of this size is likely to be a one-time paper loss as the company does not make transfers or hedge.  Should the Chf decline or auditors decide to move the effect to equity, this would be reversed.

Our view is there is more upside than downside now with the Chf at the strongest levels in decades.  Plus actual volume and local profits are higher yoy for almost all entities.

Currently the markets are pricing in very low levels of growth for Central and Eastern Europe, 0-4% over the next three years, then returning to high single growth thereafter.  According to the company Eastern European growth is back to full capacity with Central and Western Europe still struggling.  Again, with the market pricing in very low expectations we see limited downside and a good chance of surprises.  The company has indicated that Eastern Europe would continue to be their preferred expansion area.

The company made significant investments and refurbishments during the boom and therefore have very low cash outflows for the next two years and average cap ex spending in 2013 and 2014 (company estimates the average around 10% of sales).  This should not only produce low double digit FCF yields for the next few years but also add to an already strong balance sheet.  VET's balance sheet has been a competitive edge during the crisis and market share has been gained from smaller producers that were not able to finance daily operations.

The excess cash built in the next few years could be used for further expansion, debt repayment or further share buybacks - management is open to all three avenues at this point.

VET is a well run "family" business, with high barriers to entry that has a good track record or looking after shareholders.  Although it's a capital intensive business, management has made consistently good returns on owner's capital.  They are not stock promoters but focus on the business and always take the most conservative approach to accounting.  The expansion plans, if executed properly, should provide growth well above normal GDP.

• economic recovery
• share buybacks
• further expansion