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Owens-Illinois (OI) is the world's leading manufacturer of glass packaging, primarily for the beverage industry, including such major clients as InBev, Heinz, MillerCoors, and PepsiCo. The company has a large geographical footprint, with operations in North and South America, Europe, and the Asia/Pacific region including Australia and New Zealand. The company's current financial performance would suggest the company to be significantly undervalued, with a free cash flow yield of 10.3%, and strong indications that this performance will be maintained in future years.

As of the end of 2011, Owens-Illinois operates 37 glass manufacturing plants in Europe, 19 in North America, 13 in South America, and 12 in the Asia/Pacific region, as the low bulk/price ratio of glass makes it necessary to locate the factory near the customers. The company engages in significant research and development to ensure that it remains a leader in development of glass technology, both to enhance its own operating efficiency and to collect a little bit of licensing income, although this is not a major source of revenue. The company's products are normally sold through annual or multi-year supply contracts which allow for adjustments based on input costs. These arrangements provide confidence in the persistence of Owens-Illinois sales as well as the company's ability to pass on its cost increases over time.

In terms of sales mix, in fiscal year 2011 42% of Owens-Illinois' sales were in Europe, 26.5% in North America, 17.4% in South America, and 14.6% in the Asia/Pacific region. Owens-Illinois has been expanding its operations in South America in the last couple of years, mainly by way of a large acquisition in Brazil in 2010. As the South American region currently offers the highest operating margins of the company's four regions, the expansion makes sense.

Owens-Illinois Sales Mix by Region

 201120102009
Europe42%41.6%44.2%
North America26.5%28.5%31.4%
South America16.9%14.8%10.4%
Asia/Pacific14.6%15.1%14%

Owens-Illinois Operating Margin by Region

 201120102009
Europe10.6%11.8%11.4%
North America12.2%14.6%13.6%
South America20.4%23%21%
Asia/Pacific7.8%14.2%14.2%

The company attributes the decline in overall operating margins in 2011 to cost inflation as well as supply chain issues in North America and the impact of the Australian floods, with the bulk of the decline owing to cost inflation. Also the strong Australian dollar lowered the amount of wine bottled for export, while a decline in disposable income in Australia diminished the local demand for beer. However, these effects were partially offset by a 5% overall increase in shipment volumes and ongoing cost saving initiatives, and of course Owens-Illinois's supply contracts should allow the firm to pass on the cost inflation to its customers over time, as indeed occurred in the first quarter of 2012. I should, however, point out that in 2011 the major non-U.S. currencies that the company was exposed to--the Euro, the Brazilian Real, and the Australian dollar--strengthened in 2011, while in the case of the Euro and the Real the situation has reversed so far in 2012.

Turning to the financial statements, for the full year 2011 sales were $7.358 billion, operating profit as reported was $-103 million, but much of this was due to a substantial goodwill impairment pertaining to Australia, as well as other restructuring or nonrecurring expenses. Adding those back in, operating profit was $650 million. Furthermore, in this year depreciation charges exceeded capital expenditures by $165 million, which is a further source of free cash flow. This brings operating cash flow to $815 million. Cash interest expense in 2011 was $298 million, reflecting a reasonably safe interest coverage ratio of 2.73x. This leaves $517 million in pre-tax free cash flow, or $362 million in estimated after-tax cash flow based on a tax rate of 30%. After deducting $20 million for noncontrolling interests, this leaves $342 million in free cash flow to shareholders. Based on the current market cap of $3.32 billion, this represents a free cash flow yield of 10.3%, which is an impressively high figure for a company in such a strong competitive position and with some facility to pass on inflation costs to its customers.

Owens-Illinois Free Cash Flow

 201120102009
Sales735866336652
Operating Profit-103673437

Impairments & Restructuring

753-90-12
Excess Depreciation16545207
Operating Cash Flow815628632
Cash Interest Expense298239217
Pretax Free Cash Flow517389415
Est. After-tax Free Cash Flow (30% rate)362272291

Est. Free Cash Flow to Shareholders

(net of noncontrolling interests)

342235269

The first quarter of 2012, the most recent quarter for which we have data, continues these positive developments. Sales increased by 1% as compared to the prior year, but more significantly the company was better able to pass on costs to its customers while at the same time the cost-saving initiatives managed to lower the company's cost of goods sold despite the sales increase. And these results were perhaps lower than they might have been but for the furnace maintenance and rebuilds that took some of the capacity in South America offline. Overall sales volume increased slightly in every region except Asia/Pacific, which was lower owing to the continued strength of the Australian dollar as discussed above. The company was also able to lower its interest expenses owing to refinancing debt at a lower interest rate.

Owens-Illinois First Quarter Results

 1Q20121Q2011
Sales17391719
Operating Income234191
Excess Depreciation4041
Operating Cash Flow274232
Interest Expense6476
Pretax Free Cash Flow210156

Est. Free Cash Flow (30% tax rate,

net of noncontrolling interest)

143105

Unfortunately, Owens-Illinois does face some lingering asbestos claims; the firm reports in its latest 10-Q that it last engaged in the asbestos business in 1958 but nonetheless has settled nearly 400,000 claims over the years, with an additional 4,700 pending. As a result, the firm has added roughly $170 million a year for the last three years to its asbestos liability reserve. Even so, the above figures are calculated taking this reserve into account, and the number of new claims in 2011 was significantly below the number of claims resolved, so the level of asbestos charges may be expected to decline over time. There is also a net pension shortfall of roughly $750 million.

So, given the company's high free cash flow yield, its ability to pass on inflation in the cost of inputs, and the effectiveness of the cost savings initiatives, it appears that Owens-Illinois offers a substantial and sustainable cash flow yield, while its position as a leading manufacturer and its commitment to developing new glassmaking technologies is an additional source of confidence. As a result, I believe Owens-Illinois to be a very attractive candidate for portfolio inclusion.

Sources consulted: Owens Illinois 2011 10-K and first quarter 2012 10-Q.

Source: Owens-Illinois: A Leading Glass Company At A Very Good Price