Vidrala: Message in the bottle (II)

Part 2: Vidrala Investment Case

Welcome to the Staying Rational newsletter, where I analyze companies that are from the “old” economy and without much hype. To my eyes, these companies are interesting either because they are too cheap to ignore — such as Ibersol — or because the market doesn’t seem to fully appreciate their quality as long-term investments, like Vidrala. Please note that this letter is not investment advice and I may or may not own shares of Vidrala (but I definitely do).

In this first part, I wrote a few months ago, you can find a primer on the European Glass Packaging business, its corporate history, and why I find this industry attractive. I highly recommend you read that first. In this second part, I will cover:

1. Vidrala (VID) investment merits

2. Peer comparison

3. Main risks and negative aspects

4. Premortem (what would need to happen to change my mind about the investment case)

1. VID Investment Case

“Our strategy is not based on higher top-line but on being competitive.”

- Vidrala CFO, Raúl Gomez, during the 1H23 earnings conference call

The key reasons I like Vidrala as an investment are:

• VID is a low-cost producer in Western Europe, focused on competitiveness, standard products and long runs. Apart from the manufacturing of glass containers, VID has been recently developing its logistic solutions and filling services in the UK, internalizing a wider service offer that some clients are outsourcing. The recent GBP 30m The Park acquisition allows VID to expand its vertical integration into filling services and to secure multi-year sales contracts. Importantly, by doing this, VID diminishes clients ability to switch between suppliers.

• Significative barriers to entry due to local consumption and the need for high utilization rates to be profitable.

• Capital allocation has been exceptional, with VID being good at both expanding capacity organically and inorganically. Return On Invested Capital (ROIC) has been quite good: hovering at 9-16% through the full economic cycle.

• Conservative capital structure: Net debt-to-EBITDA currently stands below 1x, or at ~1.5x if we consider the pending €300m Vidroporto acquisition (Brazil)

• Multi-family controlled: long-term capital base ensures long-term focus, with the family Delclaux being the main reference shareholder. Chairman Carlos Delclaux himself has a reported 7.7% direct stake in Vidrala. Top management is typically selected internally and has a low turnover.

• Undemanding price multiples: Vidrala has guided for an EPS of at least €7 and they are typically very conservative when providing guidance. At the current price of €83, it means we are paying a PER of ~11x for a high-quality company (for reference: that’s a significant discount to last 10y PER average for VID of 17x). Some concerns might explain the current valuation: Industry volumes are all but certain to decline in 2023 (they were already 6% down in 2Q23) as clients work through their high level of inventory built as a buffer to supply-chain issues during the pandemic and there is the ever-looming recession in the horizon. VID guided for flat volumes in 2023 but acknowledged that they might decline, but if it does, VID is still confident in its guidance.

2. Peer comparison

"To finish first, you must first finish."

- Juan Manuel Fangio, Argentine racing car driver. He dominated the first decade of F1 racing, winning the World Drivers' Championship 5 times

Source: Staying Rational using companies’ reported figures, own estimates and TiKR

As you can see in the table above, VID trades at higher multiples than its peers:

• The premium vs. OI is easy to explain: OI is 5x bigger than VID (sales) while it trades at a similar market cap, but it is significantly less profitable, has lower returns on capital, is more leveraged, and has been underinvesting. OI’s last 4 years capex (average of 6% of sales per year) is significantly below that of the remaining companies invested (10-11% of sales). However, given its low starting valuation, I can see a scenario where OI significantly outperforms VID: If everything goes well for a few years, OI might generate enough cash flow to be able to both deleverage and improve its industrial park. In case there is a recession or too much capacity entering the market, OI is likely to be much more impacted than Vidrala.

Source: Staying Rational using companies’ data

• VID premium over Verallia (VER) is harder to justify as both are well managed and VER has had better operational performance recently. But there are important differences: VER’s management is more institutionalized, more focused on growth, and much more promotional. VER’s financials have significantly more adjustments so the comparison with VID is not entirely apples-to-apples. It wouldn’t surprise me that VER is taken private by a Private Equity firm (again) so that it is leveraged up and IPOed as it was done in the past so it might even have higher short-term potential. However, I’d prefer to own VID due to its more stable shareholder base, very long-term focus, and longer track record of value creation.

3. Main negative and threats

• VID operates in a high capital-intensive business: To grow volumes it typically needs to spend capex. It even needs to spend capex just to stay at the same level of production due to periodical replacements and technological development demanding constant adaptation. The best businesses in the world grow without much further capital requirements (think big-tech back in the heydays or restaurant royalty brands) — a container glass producer is not it.

• Largely mono-product company with limited organic growth sales potential (glass container volumes should increase ~1-2% per year in Europe).

• Turkish Ciner Glass entering Europe with two plants: One of which will be in the UK, in Wales, and have an annual production of 300kt/year, ~15% of the UK market. It’s expected to come on stream by 2026. Ciner is also planning a new greenfield plant of 500kt/year in Belgium (Lommel) to supply glass bottles to the beer and wine markets with an annual production of 500kt/year and cost €400m to build. Given its distance to VID’s sites, Ciner’s Belgium plant is unlikely to materially affect it. The UK plant, on the other hand, is likely to increase price competition in the region. As a mitigant, VID is very competitive in the UK, where it produces >700kt/year and has the biggest furnace in the world.

4. Premortem

We all suffer from our own biases and the endowment bias (tendency to like things that belong to us) is one I am particularly aware that I suffer from. But as stocks don’t like you back, it might be worth creating strategies to mitigate this. One such strategy would be to imagine a scenario in which the investment is not successful. This is called a premortem (as opposed to a postmortem which is the typical analysis that happens after bad investments are made). A premortem has the benefit of forcing you to think about what might go wrong. Vidrala’s investment can go sour if there is:

• Significant excess capacity built in VID’s markets: So far glass container producers have been very disciplined and Ciner is the only newcomer in an industry that has had decades of consolidation and improving returns. But if more players decide to enter Europe and existing producers significantly expand their capacity, we might see a long period of lower returns.

• Structural change of customer preferences away from glass (which again would lead to excess capacity). This one is possible although it seems unlikely. In fact we seem to be going in the opposite direction.

• Significant top management turnover; I’d be especially disappointed to see its Chairman and main shareholder Carlos Delclaux go as would likely represent a strategy shift.

• Suboptimal capital allocation. In particular, I am concerned with VID expansion into Brazil, a market which is growing at high rates. At first glance, high growth might seem like an opportunity but if one thinks about it, high growth allows for new capacity to come in and that might make old plants obsolete. It also creates room for newcomers to enter and be aggressive. Moreover, Brazil is a unique market in terms of legal structure, currency, and capital flows which add an additional layer of complexity. However, VID’s initial commitment to Brazil seems to be limited to ~€300m — easily digestible even if it goes wrong.

The only limit to this list is my imagination as some threats are not yet visible, or if they are, I might be completely unaware of them.

But, as I wrote in my previous report: “the glass packaging industry is interesting to me for the reason it is also boring: it’s stable and predictable”, and Vidrala might be the most boring company in this boring industry.