Do you follow any particular guidelines on selling?
FP: We’ll speak later about Rochester Medical, whose shares we’ve owned off and on in recent years. The last time we sold it was in early 2007, when the stock had clearly gone from being unloved and neglected to a momentum play. It went from trading 5,000 shares per day to 1 million per day, and even made one of those Investor’s Business Daily “hot” lists where the higher and faster a stock has risen the better it ranks on the list. We always look to sell into that kind of momentum. In fact, at that point we even went short even though we loved the company.
In general, we’re not in the business of holding securities that are fully priced. If in our judgment the company’s valuation is appropriate for its growth prospects, we should be selling and buying things that are bargains.
We also don’t automatically sell if a stock is down a certain percentage, assuming the market knows something we don’t and getting out to be prudent. Superior Essex went 40% against us before the buyout offer came in. My threshold for pain is high as long as I believe I’m still right. Historically, we’ve made a lot more money on the long side when what we thought we were buying cheap went down another 30% before finally going up – we always buy more if our thesis hasn’t changed.
That’s probably a good lead-in to discuss your holding in Libbey [LBY], the glassware maker.
FP: We started buying Libbey earlier this year at an average cost of $12 and the stock went below $7 earlier this month, so we have suffered. There are several things pressuring the stock, but the two biggest are the fact that people are eating out less in restaurants, lowering demand from that sector, while energy costs for making glass have gone up significantly, which has hurt gross margins. Making glass requires melting sand, which is quite energy intensive – the company spent $60 million last year on natural gas and that may go up as much as 50% this year.
What we like here longer term is the company’s competitive position. It was founded in 1818 and is now the second-largest maker of drinking glasses in the world, behind a privately owned French company called Arc International. Roughly three-quarters of Libbey’s sales are in the U.S., where its food-service market share is around 55%, but it also exports to more than 90 countries. Half of the business is selling to the food-service trade and half is selling at retail.
Say you have a small restaurant that uses 40 wine glasses. After 200 uses, three things on average will have happened to those wine glasses: they will be chipped, broken or stolen. It doesn’t happen all at once, so after a month or two you may have to replace 10 of the glasses. Not surprisingly, you’re going to want to buy exactly the same glass. As a result of that nice competitive moat, 90% of Libbey’s food-service revenue comes from repeat business.
Is the business overall threatened by Chinese or other lower-cost competition?
FP: Libbey is actually a low-cost producer itself. Two years ago it bought out Vitrocrisa, the largest glass tableware manufacturer in Latin America, which has large production facilities very near the U.S. border in Mexico. Not only are the average hourly labor rates in Mexico maybe 15% of the rates Libbey pays in the U.S., but because of NAFTA, glasses come into the U.S. duty-free, vs. a 20% duty on glasses coming from elsewhere. The company also has a new low-cost facility in China, which started producing last year.
Does Libbey’s market position translate into pricing power?
FP: In the food-service business, the company has successfully passed on cost increases in 30 of the past 32 years, with the only two exceptions being during the start of both Gulf wars, when people were more likely to be watching CNN than going to restaurants. Raising prices to the retail trade, where they deal with big retailers like Wal-Mart and Target, has been much tougher. That’s why you’re seeing gross margins decline when costs of good sold have been increasing as they have.
The company’s stock chart wouldn’t appear to be a testament to efficient markets, going from $25 in early 2005, to $6 in mid-2006, to $25 again in mid-2007, to just below $9 today. Have actual business prospects changed that dramatically?
FP: There’s clearly cyclicality to the business, but not as much as that volatility would imply. People eat out less when the economy is tough, so fewer glasses get broken. That won’t last forever. The volatility in natural-gas prices has been an issue, but absent much larger increases, that shouldn’t be an insurmountable long-term problem. One more technical factor contributing to the share-price volatility is the fact that Libbey in May 2007 was added to the Russell 2000 and S&P 600 indexes, which increased demand for the stock. As the share price fell it was taken out of those indexes earlier this year, which added to the price pressure on the way down.
In fact, the biggest long-term change in the company’s prospects over that time, the acquisition in 2006 in Mexico, was a positive one that has had a dramatic impact on labor-cost competitiveness.
How are you looking at valuation?
FP: The company earned 90 cents per share last year, excluding a non-recurring, non-cash tax allowance. The unanswered question this year is how successful they will be in passing on price increases. They just announced an 8% price increase. If they get 6%, that would translate into $50 million in incremental revenue, which would allow them to cover most of their increased costs. To be conservative, let’s say some combination of unit sales declines and cost increases make them earn only 75 cents per share this year.
On top of that, management is optimistic that they will be able to reduce the interest cost on $500 million of high-cost debt by three percentage points, which would save $15 million per year. After tax, that would add another 70 cents per share in earnings. So you’ve got $1.45 or so per share of earnings power even in a business downturn, which at the current share price results in an earnings multiple of around 6x.
The company’s goal is to reach $1 billion in sales, with average EBITDA margins of 15-18%. If they can hit that sales goal, which is reasonable, and earn at the midpoint of their margin goal, that would translate into $165 million in EBITDA. Today’s enterprise value of around $650 million is less than 4x that EBITDA level. In my view, these multiples are a steal for a company with this type of market position and competitive moat.
What do you see as the biggest risks?
FP: If natural-gas prices go through the roof, that would be a problem. It would also be a problem if trouble in the credit markets doesn’t allow the company to refinance its debt to save interest costs. I’m not an expert on that, but management here usually doesn’t commit to something they can’t deliver.
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