Ball (BLL): A Debt Laden, “Economic Value Added” Obsessed Organization with a Super Wide Moat
Write-up by Mister Compounder
The 3 most important variables to the Ball (BLL) investment thesis are:
- The industry structure and the symbiotic relationship with beverage companies, that naturally leads to “survival of the fattest”.
- The EVA approach that links interesting site economics to the creation of shareholder value.
- Credit risk (having the right level of debt).
Ball is one of the world’s leading suppliers of metal packaging to the beverage and food industry. The company has a long history and was founded in 1880. Through its entire history, Ball has been involved in close to fifty different segments. Today, the business is mainly based on delivering aluminum beverage containers to the beverage industry. The company’s business is about delivering aluminum cans to large consumer staple companies like: Coca Cola, Unilever and AB InBev.
This sounds like a really dull, capital intensive and boring business. So, why should it interest you?
Interesting Site Economics
The source of Ball´s competitive advantage is dependent on local scale and switching costs, resting on a highly consolidated industry among both producers and customers. The plants making the beverage container cans are huge. This is best illustrated by the size range of the production plants from about 100,000 square feet to around 700,000 square feet. The company’s largest site is the Findlay, Ohio plant (733,000 square feet) that produces both beverage cans containers and food containers.
To get an understanding of the underlying unit economics driving both revenue and profitability at Ball, it might be interesting to do some guesstimates on the profitability of the site locations.
In the North American segment, the beverage container industry represents about 110 billion units, where five companies dominate the market in the U.S, Canada and Mexico. For fiscal year of 2017, Ball produced 46 billion units, hitting a market share of 42%. This volume is served by 19 plants in the US, 1 in Canada and 2 in Mexico. They have also one joint venture production facility, but I have not included that one in this calculation. In total 22 plants, which means an average of 2.1 billion units per plant per year.
This means that – each year – the typical Ball plant should make:
- 1 billion units
- $190 million in revenues
- $37 million in gross profit at a 19.5% gross profit margin
- $25 million in operating profit at a 13% operating margin
- Which is: $624 of revenue per square foot in and $81 in profit per square foot
Ball typically generates 9 cents in revenues per beverage can and 1.2 cents in operating profit per can. This is what generates sales and earnings at Ball. In other words, these are huge operations. Just like with distributors, it will be difficult to compete with a fully functioning and operative production plant. Given this, it is highly unlikely that a competitor would add excess capacity near an existing plant. It leads naturally to local markets as it does not make sense to transport the products over long distances. Therefore, locally, the beverage container business should be oligopolistic at worst which should lead to interesting site economics. This gives the company a moat. The underlying economics of each production plant at Ball does not lead to fantastic returns, but good enough returns. Following this logic, given that the industry structure is not disrupted, and the site economics continues to generate good returns, the question is rather whether and how the interesting site economics of the company turn into good returns at business level. This becomes a question of capital allocation and is a fundamental part of the thesis in Ball.
The development of gross profit divided by net tangible assets may be indicative of the underlying profitability of the business. Going further down the income statement is much more influenced by capital allocation decisions made by management. A good example may be the acquisition of Rexam which made Ball add a lot of physical assets on the balance sheet but did not have the same immediate effect on the gross profits. Thus, Gross profit/NTA went from 56% in 2015 to 36% in 2016. However, the asset base Ball acquired can be leveraged operationally going forward, so Gross profit/NTA was back to 49% in 2017 and 56% in 2018. However, this acquisition should not affect the underlying profitability of an existing Ball plant. What makes Ball an attractive company to study is really that it combines attractive industry structure and local markets, which leads to interesting site economics of the plants. Additionally, and central to the thesis, Ball also has a management that is disciplined in its capital allocation policies.
Over to the business. Ball did about $11.6 billion in 2018. Ball have five different reportable segments based on product lines and geographical areas.
These are:
- Beverage Packaging, North and Central America with $4.6 billion in segment sales equaling 40% of total sales.
- Beverage Packaging, South America, with $1.7 billion in segment sales equaling around 15% of total sales.
- Beverage Packaging, Europe, with approximately $2.6 billion in segment sales, equaling 22% of total sales.
- Other with $1.5 billion in segment sales, equaling 13% of total sales.
- Aerospace with $1.2 billion in segment sales, equaling 10% of total sales.
The Aerospace segment is profitable and has stayed around 10% of the company for some time. It’s an interesting and profitable segment, but it doesn’t move the needle in the sense that it is not overly important to the business value of Ball. Historically, Ball has shown willingness to focus on the most important part of the business which also explains why the number of business segments have been reduced from 50 to 5. As long as Aerospace is growing and is profitable within their framework, I can see them continue to own it. But at the same time, the management seem quite agnostic about it, in the sense that they may be willing to sell it, or even spin it off in the future, if the situation change. It´s all about priorities made by following the EVA-framework. The management seems willing to focus on creating shareholder value. That´s what matters. This was also exemplified in December 2018, when Ball sold its beverage can facilities in China to a Chinese company for $225 million.
Once again, let’s review…
THE 3 MOST IMPORTANT VARIABLES TO AN INVESTMENT IN BALL
The three most important variables that make Ball an interesting long-term investment are:
- The industry structure and the symbiotic relationship with beverage companies
- The EVA approach
- Credit risk (having the right level of debt)
If all these are still valid, then it’s more a matter of price to make an investor able to protect and compound capital in this company.
A change in any of these variables should be a red flag in terms of risks in the stock and the durability of the thesis, from my perspective, really rests on these three variables. I´ll go into more details on these variables.
The Durability of the Industry
The durability of the business model relies heavily on the industry structure. In general, the business is dependent on soft drink bottlers and breweries´ general willingness to use aluminum beverage cans for carbonated drinks, beer, food and so forth. Ball is really dependent on having an industry structure that is dependent on customer segmentation, with supplying a few big customers. The site economics of each plant and thus also the economics of the business is heavily dependent on the consolidation of the industry on both supply side and demand side. This is an important part of the reason why this company is an interesting company long-term. So, it is a local business where you need to pair a really big customer (Coca Cola, Coors) with one producer in one location to get the economics to work long-term.
This is best illustrated by just summing up the four biggest customers of Ball, which may illustrate the kind of concentration there is in this industry:
- 14% Anheuser-Busch InBev
- 11% Coca Cola
- 9% U.S Government
- 7% Molson Coors
In other words, these four customers make up 40 per cent of their revenue. Losing any one of these customers is a major risk to the thesis, but it´s also necessary that the industry remain consolidated based on standardized packaging because Ball is dependent on volume and utilization to make each plant economically viable. If you invert the problem and look at it from the buyer’s perspective, there are really few competitors that really can meet the sheer volume of these customers. Therefore, there are few realistic alternatives that can meet this kind of production. As a consequence, there is also a risk for the big beverage companies to change suppliers and it would make little sense for competitors of Ball to start a nearby plant close to an already fully utilized Ball plant. The industry structure gives Ball a competitive advantage based on:
- Scale, resting on the pure volume needed to make it economically viable
- Switching costs for the customers
You also have strong concentration in the production part of the equation. According to publicly available information, the beverage can market in North America is around 110 billion units. According to Ball, five companies manufacture almost all of this volume. Of this, Ball produce 46 billion units, equaling 40% of the market. Ball’s competitor, Crown Holdings (CCK) did $2.9 billion in sales for fiscal year 2017 in their American Beverage segment. Crown’s production includes glass bottles, but it should indicate that they probably have no more than 30% market share, and no less than 15%. That means that the two largest players probably have something like 55% to 80% market share, and that Ball is substantially larger than its next competitor.
In the annual report of 2017, they mention that:
“In 2017, aluminum beverage cans were confirmed to be the most recycled beverage package in the world, with a global weighted average recycling rate for aluminum at 69 percent. In comparison, 43 percent of PET and 46 percent of glass bottles were collected for recycling, although not necessarily recycled. In some of Ball’s markets such as Brazil, China and several European countries, recycling rates for aluminum beverage cans are at or above 90 percent.”
Aluminum has this advantage over plastic solutions from a sustainability perspective and may also gain share from other types of packaging products over time. In this way, Ball´s products do not only compete against other aluminum companies, but also against other packaging alternatives as well, like plastic and glass. To judge Ball´s relative position towards other packaging solutions is more speculative but a shift from other packaging solutions towards aluminum would benefit Ball.
What can disrupt this? The biggest risk would be a very big trend against standardization and much more against specialization in packaging which would lead to economy of scale becoming less important. For a volume driven business-like Ball, this would be a big risk. There is probably a greater trend towards specialization today than it has been before, which is observed by studying the younger generations born in the 1970s, 1980s and onwards. This can be seen in the way craft brewers; specialty sodas and specialty water have been growing which make people feel these products are more tailored to the individual than single large brands. The trend towards specialization would also mean higher costs for the customer as it increases the unit cost of production because of increased fragmentation. So, a very strong trend towards specialization would be a major risk for Ball, as it could disrupt the economics of the industry. Ball sees itself as a technical advisor and has a price range, where more specialized containers gain more profit per serving than more standardized container. So, it is an economics incentive for customers to choose more specialized packaging solutions within Ball´s range, but in general there must be a certain volume and utilization rate at each plant to make it economically viable and sustain attractive returns on capital.
The Role of EVA
There is attractive site economics at each production plant of Ball. The question of the long-term value in the stock becomes one of capital allocation. Ball talks a lot about EVA, or economic value added, which is defined as net operating profit after tax, less capital charge on average invested capital, multiplied by Ball´s WACC, or hurdle rate, of 9 percent. If EVA is positive, then the company and the capital allocation decisions taken by management are value creating and are adding value for shareholders. If it is negative, they are destroying shareholder value. For shareholders it is a prerequisite for growth being value creating that return on invested capital (ROIC) exceeds the weighted average cost of capital (WACC).
This is a fundamental part of Ball and an important reason to why this is an interesting company, and potential interesting investment in the long run. This is what links the interesting site economics of each production plant into interesting business economics for business. It also the link to creating long-term shareholder value for investors. The interesting part of EVA at Ball is really that Ball´s incentive compensation is directly linked to EVA. This is disclosed in their proxy filings, and economic value added is the key driver for long-term stock appreciation.
The whole organization is built around EVA and the management want to increase EVA dollars over time. In this way they aim to maximize free cash flow generation and seeking to deliver comparable diluted earnings per share growth between 10 to 15 percent.
The cash generated by the business will be used to:
- Finance the company’s operations
- Fund strategic capital investments
- Service the company’s debt
- Return value through stock buybacks and dividends
I think Ball´s capital allocation should add value as long as the EVA-culture is embedded in the organization. It is really the combination of a static industry, with low competition and high barriers to entry for new competitors and a disciplined approach to capital allocation that makes this an interesting thesis. The discipline of only investing in projects that, with a combination of equity and leverage, can return 10% after tax return on the relevant project, can be explained by the stability of the industry. It’s is really the static industry structure combined with a disciplined execution of EVA by the management that makes this an interesting idea. Without industry stability, you won’t make your EVA-targets, as competition would reduce the ability for such long-term planning. Without managements approach to EVA, the interesting site economics are not necessary turned into long-term value creation for shareholders. This is important, as capital allocation is the necessary link that translates the good site economics of Ball’s production plant into solid long-term returns for the shareholders. It’s really this combination that makes it interesting. After the successful acquisition and integration of Rexam, Ball has now focused the capital allocation towards getting control over the debt levels and buying back its own stock and paying dividend.
Credit Risk
As an asset heavy business, Ball needs to use a certain amount of debt to achieve a good return on equity. This means Ball will continue to have meaningful amount of debt going forward. As of now, the company has $6 billion in net debt relative to an EBITDA of around $1.6 billion, which equals 3.75 times EBITDA and 6 times EBIT. This might worry some investors as this is quite a heavy debt load compared other companies. However, Ball can carry substantial debt, has shown the ability to do it, and they tend to spread out their maturities. They also keep a considerable amount of cash on hand, which at year end was more than $700 million.
It is interesting to just list up the maturities of the debt of $6.6 billion:
- $2.25 billion within 1-3 years
- $2.6 billion within 3-5 years
- $1.75 billion after 5 years:
A bigger risk would be if they shortened the type of financing and got more aggressive on borrowing short. This would reduce the risk of refinancing.
This is what is mentioned in Moody’s rating of Ball:
“Ball Corporation benefits from its stable profitability, consolidated industry structure with long-standing competitive equilibrium and scale. The company also benefits from its high percentage of long-term contracts with strong cost pass-through provisions, geographic diversification and a continued emphasis on innovation and product diversification.
Ball is constrained by its aggressive financial policy, primarily commoditized product line and concentration of sales. The company has demonstrated a willingness to undertake large, debt financed acquisitions that stretch credit metrics and significant share repurchase programs. The product line still includes a large percentage of commodity products. Ball also has a high concentration of sales by both customer and product line.”
Debt is important to the long-term value creation here, but contrary to many other asset heavy industries, the market for beverage can products is consolidated and stable. This is a major advantage and a big reason to why Ball can tackle quite substantial debt levels. As an investor you have to be comfortable with these kind of debt levels, as Ball will use debt going forward. But as long as the company spread things out, are keeping cash on hand and the current industry structure is not disrupted, the debt levels should not be a concern.
How to Value Ball?
In the valuation of Ball, I will focus on how much Ball can be expected to do in gross profit and how much of gross profit that it turns into free cash flow.
Ball generated more than $2.3 billion in gross profit for the fiscal year 2018, which is close to a normalized gross profit margin for the company. Ball has usually been able to convert close to 30% of gross profit into free cash flow. Thus, gross profit of $2.3 billion should result in $750 million free cash flow. Following this line of argument, an easy way to track the valuation of Ball is to say that Ball should trade at a ratio of EV divided by gross profit. Buying Ball at 6 times gross profit is the same as paying 20x free cash flow and getting a 5% free cash flow yield given a 30% conversion of gross profit into free cash flow.
The question then becomes one of growth and hurdle rate of the investor. The challenge is that the underlying volume growth in the markets they operate, like the US and Europe has been quite weak, as a consequence of reduced consumption of beer and carbonated soft drinks in the US and Europe. These are also Ball’s most important markets. It would be an aggressive assumption to assume volume growth of more than 1-2% in their most important markets. Before the acquisition of Rexam, Ball was doing around 64-65 billion cans. It was not until the acquisition of Rexam that production spiked up to around 100 billion cans a year. There might be upside in volume growth by conversion from other kinds of packaging, like glass and plastic, into aluminum as the recycling rate for aluminum might be better. This is potentially a big opportunity and it could definitely add some growth to the business over the coming years. But it’s speculative.
So, what will the business look like in 5 years?
I think it’s possible that volume might increase by 1-2% a year. Therefore, they should be able to do between 105 billion to 110 billion cans in 5 years. It seems like there has been some price pressure, but I think Ball can be able to do a companywide sales per can of 9 cents to 9.5 cents. Assuming this, Ball should be able to generate around $10 billion from the packaging segment, which is a conservative, but reasonable estimate given the slow growth in the end markets. In addition, they have income from the aerospace segment and other, which today is more than $1.7 billion. If we assume a 5% growth rate in this segment, it could be at $2.2 billion, bringing total sales to around more than 12$ billion. This might be a bit conservative, but it’s better to be conservative than too optimistic in these assumptions. Median gross margin has been 18% over the last 13 years. Gross profits have tended to increase more than sales and over the last couple of years, they have worked to make efficiency improvement in the business after the acquisition of Rexam. That should bring gross profits to assets / assets up to a more normalized return of 20%, up from to around 13% of 2017. Therefore, Ball should be able to do at least $2.5 billion in gross profits by the end of 2023.
Management also guides that they will do $2 billion in adjusted EBITDA and $1 billion in free cash flow in 2019. If we base that on gross profits of $2.4 billion that translates into a conversion from gross profits to free cash flow of more than 41%. Since 2006, Ball has only hit that kind of level in 2014 and in 2017, when it hit 40% and 48% respectively. However, it’s doable if capex come down by the guided $200 – $300 million or so, but it is more aggressive than what it has produced in its recent past. Still, it might be doable. Following this line of argument, the company could be making $1 billion to $1.2 billion in free cash flow based on gross profits of $2.8 billion 5 years down the road. I’m unsure if this will be a conservative way to think about it as both 1) gross profits must be in pace with its historical growth of more than 4% and 2) cash conversion must be higher than its long-term median. Based on a free cash flow multiple of 20x, this scenario would value the company at $24 billion.
What will be a conservative way to approach the valuation?
I think Ball, at least, and conservatively, is worth at least 6 times gross profits. At 6 times gross profits, you have a fair shot at 10% return in the stock, dependent on a 5% free cash flow yield and 1-2% volume growth, maybe some efficiencies at production plant level, which might get gross profits and EBITDA to increase somewhat faster than sales growth. On top of that you will get buybacks that should get shares outstanding to decline over time which should make free cash flow per share to rise faster than the 1-2% in volume growth and management guides on 10-15% EPS growth. This indicates a business value of $15 billion and Ball should conservatively at least be worth $15 billion. Divided by 334 million shares outstanding, we get a business value of around $45 per share, based on conservative assumptions. It might also be a relative bargain at 7.5 times gross profit, given the certainty of the business model and the history of capital allocation at the business. This indicates a business value of $19 billion. That equals a price of $56 per share, including leverage. So, paying 7.5 times gross profits quals paying around 25 times free cash flow. Is this an outrageous price? I think that might be an interesting relative idea at that price, given the historical performance, the stability of the business model and the proven track record of the management.
Conclusion
As an investor in Ball, which questions would I ask myself every year when they publish the annual report? What would be the key variables to watch going forward?
The biggest risk in my view, is whether we have seen the best part of standardization in packaging or not. As mentioned, this industry is dependent on pairing a very big producer (Coke, Coors) with a huge supplier (Ball) to make it work. An extreme trend towards specialization could be a problem for Ball. This is a soft factor that would be difficult to measure over time, but I would follow up on how management talks about standardization vs. specialization.
I would also watch how they think and talk about EVA, as this is the link between attractive site economics and good returns for you as a shareholder. Capital stewardship has been excellent at Ball and they have turned a capital-intensive business which require a lot of investments to grow to be a value creating business for shareholders in the long run.
Lastly, I would watch how they treat the debt structure and the financing of the company. Do they make sure to spread out the maturities and do they keep cash on hand? Debt will always be elevated at this company compared to other, but if they don’t get too aggressive they should not have problems refinancing the debt, as they operate in a stable and settled industry.
As a final remark, I would add that the number I would track to follow the attractiveness of Ball as an idea, would be EV/gross profits. If all the mentioned assumptions are still intact, like the industry structure, the role of EVA and credit risks, I think you make an interesting long-term bet if you can get this company at an EV/gross profit of 7.5 times gross profit.