Libbey: A Company As Fragile As Its Products

Summary

• Libbey's share price decline and generous dividend attract attention from value-oriented investors.
• However, the company's business and financial condition has deteriorated significantly, placing the company in a poor position.
• We find that the company's shares are not materially undervalued, and the company's dividend may be at risk in the foreseeable future.

Libbey (NYSEMKT:LBY) is a manufacturer of glassware and related products for the business and retail markets. The company’s shares have fallen considerably since peaking two years ago, returning to prices last experienced during the last recession. The sharp increase in share price earlier this week – despite the company badly missing earning expectations – has done little to offset the long-term decline. The depressed valuation is cause for taking a closer look at the company's fundamentals to evaluate whether the decline represents an opportunity or reasonably reflects the company's underlying issues.

We review the company’s markets, operating performance, and other factors to develop a perspective on whether the company warrants further research and, ultimately, should be considered for investment. However, despite the depressed nature of the shares, our conclusion is that Libbey’s current share price reflects the ongoing challenges and risks of the business, and we don’t consider the company a compelling investment opportunity at this point.

Market

Libbey is a leading manufacturer in the glassware and tableware categories for both business and retail customers and maintains an international presence although the majority of revenues originate in North America. The market is mature and highly competitive thus limiting pricing power and the opportunities for significant organic growth.

The lack of growth opportunities and pricing power is reflected in the company's own commentary and results. Revenues and operating income have been essentially flat or declining for the last eight years - a period of consistent economic growth - as reflected in the following chart:

Source: Company Financial Data

Indeed, the company has shown little evidence of significant growth potential despite holding a leading market position in its product categories.

The company has acknowledged that the market is extremely competitive but at the same time has offered a variety of other explanations for the lackluster results, denoting such issues as a work stoppage at one of its plants last year and the impact of hurricanes and wildfires in other parts of the country. However, for the most part, these explanations are insufficient to explain the ongoing decline in the company’s revenues and operating income.

Instead, widespread destruction should have the opposite effect, at least eventually, but the reality is that natural disasters, even a hurricane impacting multiple states, are not sufficient in scale to impact the glassware and tableware market either positively or negatively for any significant period of time.

Moreover, the company's recent earnings commentary reinforced the lack of pricing power available to manufacturers in the market. The company projected forward price increases for the coming year of about 4% - similar to prior years - although the historical increase realized from price increases is closer to 2%. The company plans to focus on improving pricing realization while at the same time potentially shedding less profitable customers, but the prior results clearly reflect an inability to offset revenue declines due to product volume and mix factors through price increases or achieve pricing power meaningfully greater than basic inflation. The company's prior price increases have also failed to staunch the decline in revenues, gross margins, and operating margins, as discussed in more detail below, which only serves to emphasize the company's lack of pricing power in the marketplace despite the company's leading position. Indeed, the company's projection for forward year revenue growth in the low single digits suggests few expectations for gains in volume and mix and a near complete reliance on incremental price increases for revenue growth.

The company does deserve credit for accelerating the introduction of new products to attract business customers as well as new retail customers looking for different and modern looks versus the company’s legacy business lines. A growing proportion of revenues are generated from these new lines but, clearly, have not yet been sufficient to offset the decline in revenues from other products. It’s possible that the company will introduce a line of products that prove highly popular – and gains in the interim from higher revenues and margins – but the company is nonetheless limited by the nature of is industry.

Still, it’s also worth noting that in the company’s most recent conference call management stated that the company’s manufacturing plants are essentially running at capacity. The comment indicates that a significant increase in production which would be required to accommodate growth is not immediately possible and any significant growth in production would require significant capital expenditures, further limiting already thin free cash flows.

The bottom line from a market perspective is that the company’s markets are relatively unattractive, and there is little cause for optimism. However, this alone is insufficient justification for failing to consider the company’s merits as many highly profitable companies operating in mature industries. So, does Libbey make up for operating in a lackluster market through high operational performance?

Margins

The short answer is – no. The company has struggled with operations for the last several years, and in fact, a major factor in the company’s poor performance has been a consistent decline in both gross and operating margins. Gross and operating margins have, in fact, been declining since 2012 with those declines accelerating in the last three years, as reflected in the following chart:

Source: Company Financial Reports

In combination with declining gross margins, SG&A expense as a percentage of revenues has been on a consistent uptrend over the last several years, further pressuring the company’s operating margins. Indeed, if the company’s projections for the coming year are accurate, SG&A expense will rise further to around 17% of net revenues, offsetting at least part of the expected gains in revenues. The combination of declining margins and rising expenses has severely impacted net income and earnings per share, especially since net margin is only roughly 1% to 2% of revenues.

On the other hand, companies which operate on thin margins can show significant gains in net income and earnings per share on marginal improvements in gross and operating margins. Indeed, in the event the company were to achieve the peak gross margin recorded in 2012 (and corresponding SG&A ratio), the company’s earnings per share would likely exceed $1.60 on a clean income tax basis calculation.

A cyclical shift could provide the impetus for such improvements. However, we consider such a reversal in the near future unlikely for a few reasons. First, the declines in gross and operating margins (and corresponding increase in SG&A expense) have been consistent trends for several years during which the U.S. and global economies have been consistently growing. In addition, the company experienced lower gross and operating margins (and higher SG&A expense) in the current year than the prior year despite the prior year including a work stoppage at one of its manufacturing facilities. The most recent year was impacted by a large initial order that reportedly impacted gross margins due to sales discounts, but we don’t believe this was sufficient to make a material difference in the long term. Clearly, the competitive pressures have continued to erode the company’s profitability.

The company is therefore also not terribly compelling from an operating standpoint. We’d expect to see a stabilization, at least, before considering the company an interesting investment opportunity.

Net Income

The company’s deteriorating margins flow through to weakness in the company’s financial position. The company operated at a deficit in the last year, reflecting the decline in revenues and margins, and while the company anticipates improvement in the year ahead, the company’s own financial projections suggest ongoing pressures.

Libbey did not provide guidance for the year ahead with respect to net income or cash flows but did provide projections for net revenue growth, EBITDA, and capital expenditures. We’ve used these projections to develop free cash flow and net income estimates for the year ahead based on management’s projections in order to evaluate ongoing operating performance.

The company’s projection for growth in net revenues for the coming year was in the low single digits. In order to estimate annual revenues, we interpreted this statement as a range of +1% to +4% from the prior year results. We applied management’s projection of full year EBITDA margin in the range of 10% to 11% of net revenues to develop an projected EBITDA value and, using this value, calculated the corresponding net income (with a projection of annual depreciation and amortization, interest, and income tax expense) over a range with a low and high end estimate, as detailed below:

Source: Proprietary Calculations

The results are not terribly impressive. The company is clearly expecting a return to profitability, and on an earnings per share basis, the shares may appear attractively priced, but the net income margin remains extremely thin, and any adverse outcome could quickly shift the company into a loss. Indeed, a small shift in the projected interest expense and/or depreciation and amortization expense would result in a large change, as a percentage, in the projected net income.

It’s also worth noting that these are management’s projections, not ours, and it’s worth testing some of the implicit assumptions reflected in these figures. In order to do so, we developed a separate income statement for the company using management’s projection for SG&A expenses in the year ahead of 17% of net revenues in order to evaluate what the corresponding gross margin would need to be to match the above net income values. The results, of course, depend on the underlying assumptions, but the resulting gross margin necessary to achieve these results is in the range of 21.0-21.5%. A gross margin at this level would not be unprecedented for the company, but given the discussion of declining gross margins earlier in the article, such a shift would represent a major reversal of the decline over the last three years, a reversal which we consider highly optimistic. We therefore take management’s projections with a grain of salt and believe the odds are against the company – at this point – in achieving these results.

A Note on Income Taxes

The most difficult value to estimate for Libbey in the above projections is the applicable effective income tax rate. Libbey has a long history of adjustments to the applicable tax rate associated with permanent differences, unrecognized tax benefits, and valuation allowances that greatly complicate the estimate of a “clean” effective tax rate absent the collection of unusual tax items. The proportion of income associated with overseas operations can also vary significantly and impact the effective tax rate although to some degree this should be mitigated going forward due to the reduction in the U.S. statutory rate versus the applicable tax rates in overseas jurisdictions. Nonetheless, the company’s effective tax rate over the last several years has ranged from a benefit of -135.9% to rates higher than 63.7%. In many cases, the large swings have been associated with changes in the company’s valuation allowance for deferred tax assets, primarily net operating losses.

Our best estimate of a “clean” effective tax rate going forward is roughly in the range of 25%. We have used this effective tax rate in developing our projections realizing that interim results could be significantly impacted by future valuation allowance adjustments and other factors.

Cash Flows

We extended our analysis of the company’s year ahead financial projections by using the aforementioned values to project the company’s free cash flows for the coming year. The projection of free cash flows requires certain assumptions regarding changes in working capital accounts, such as inventory and receivables, which are inherently uncertain and should be recognized when evaluating cash flow estimates.

In reviewing the company’s financial statements, we did not identify any consistent working capital cash flow adjustments. In many cases, increases in one year were followed by decreases in subsequent years such that the net result was not material. The only consistently recurring cash flow items were depreciation and amortization and stock compensation expense, and we therefore elected to include only those items in our cash flow projection (on a low and high range basis):

Source: Proprietary Calculations

It’s possible to quibble with these estimates, but we believe they accurately reflect what would be considered an ongoing free cash flow calculation. The company may benefit from inventory reductions in one year, or receivables collections, but with projected growth in revenues, it’s more likely that in the year ahead, the company would experience growth in inventories and receivables for a marginal net reduction in cash. Regardless, it’s clear that significant contributions to cash flows from any of these categories are unlikely – and also transitory – so it’s questionable whether significant reliance should be placed on these factors for sources of cash.

The cash flow projection, in our view, only serves to emphasize the company’s relatively precarious financial position. The company is free cash flow positive, but significantly all of the company’s free cash flows (and possibly more than all) are consumed by the company’s highly generous dividend. In fact, there is little (if any) cash left for debt reduction, a use of cash that management rather oddly defined as a priority going forward in the last conference call.

The cash flow issue, especially with respect to dividends, would not necessarily be a significant factor in evaluating the company except for one issue – the company is highly indebted, is facing an upcoming refinancing window, and almost certainly won’t be able to refinance at terms as favorable as the current term loan. The addition of corporate income expense deductibility limits in the new tax law only serves to aggravate the situation. The result, in our view, is that cash flows are deficient, placing the dividend and, thus, the share price at risk going forward.

Debt

Libbey ended the prior year with long-term debt of about $384 million, not significantly different from long-term debt of $397 million in 2011. The majority of the company’s debt consists of a variable rate term loan which bears interest at 3% over LIBOR and matures in April 2021. The company has swapped the variable rate for a fixed rate of 4.85% on $220 million of the term loan, thus limiting the impact of rising interest rates, but this swap expires in January 2020.

The company’s debt is a significant challenge for the company for a few reasons notwithstanding the extended remaining time horizon the company has before maturity. First, in practical terms, since companies generally wish to avoid having such loans move into current liabilities, term loans are refinanced at least a year before the stated maturity date, so the likely refinancing time horizon moves up to the spring of 2020.

Second, the company will likely face significantly higher interest rates when the term loan is refinanced whether the refinancing occurs in the near future or in two years. The company’s current credit rating is roughly B (depending on the agency) and the current credit premium spread for debt in this category is around 3.5% per the Federal Reserve’s data. In addition, the 3.5% premium remains relatively low by historical standards, and should the company face a refinancing in a period of less certainly, it’s not improbably that the margin could move up closer to 4% or 5%. In addition, the company’s significant deterioration in performance over the last several years since the term loan was originated, combined with the introduction of the generous dividend which greatly restricts liquidity, suggests that the company would likely be subject to far stricter covenants in addition to a higher interest rate.

The result is that the company will likely face significantly higher interest expense in the near future which would further erode profitability and offset any potential improvements in revenues and/or margins. A refinancing interest rate in the range of 5.5-6.5% is probable, given ongoing incremental interest rate increases over the remaining term although, depending on financial conditions at the time it’s not unrealistic to foresee a refinancing rate upwards of 7.5-8.5%. Indeed, such a rate would still be lower than the 10% senior notes the company has outstanding only a few years ago. The company’s lack of free cash flows would prevent material debt paydown in the interim (the company’s debt reduction in the last year was entirely funded from cash on hand rather than free cash flows), suggesting interest expense could rise from the current $20 million to $25-32 million depending on the ultimate refinancing rate. The result could wipe out the company’s thin new income margin and add to the company’s financial challenges.

Interestingly, this would be a reversal of a trend that the company had used in the last few years to significantly boost its operating results. Recall, for a moment, that the company’s long-term debt (including the current portion) did not materially change over the last six years, dropping from $397 million to $384 million at the end of the most recent year. However, interest expense did drop significantly over that time from, from $43.4 million a year to $20.4 million in the most recent year, contributing about $0.70 per share to earnings. The savings were achieved through a series of refinancings at progressively lower rates, but this trend has since reversed and may place the company at greater risk going forward.

Moreover, the adoption of limitations on the deductibility of corporate interest expense tied to a percentage of EBITDA could aggravate the situation further and prevent the deduction of a portion of the increased interest expense, thus raising the company’s effective income tax rate. Indeed, per management’s projections, an increase in interest expense of a mere $4-5 million would push interest expense over the deductibility threshold, further impairing the company’s financial position:

Source: Proprietary Calculations

Unfortunately, the company, as detailed above, has at best marginal free cash flows – even eliminating the dividend – to significantly reduce the current debt load. We therefore consider the company’s high debt load and likely refinancing terms, in combination with thin free cash flows, to be a material risk to the shares.

The debt situation in combination with the company’s aggressive dividend presents an additional risk in that, barring a significant turnaround in the business, the company if left with few – if any – funds with which to reduce debt or absorb higher interest rates without cutting the generous dividend.

Conclusion

Libbey is a company as fragile as its products. The primary attraction is a low share price (relative to potential earnings) and a generous dividend, but both the dividend and the share price are at risk, given the company’s ongoing financial and market challenges. The company’s thin operating margins mean that any improvement in gross margin, operating margin, or SG&A expenses would significantly boost the bottom line, but short of unprecedented growth in the business, these marginal changes would not materially change the risks associated with minimal free cash flows, a heavy debt burden, and rising interest rates, combined with an approaching refinancing window.

Libbey may be able to make meaningful improvements in its operations, but there is little indication that the company is on the path to achieving such improvements. In fact, management’s own projections for the business in the year ahead are lackluster and reflect the difficult conditions.

In addition, the current price is meaningfully supported by the generous dividend, and any reduction in the dividend would likely have a large negative impact on the shares. Nonetheless, in light of the company’s debt load, it’s worth noting that even eliminating the dividend would provide only a sliver of free cash flow for debt reduction.

We don’t anticipate imminent bankruptcy unless the business turns very sour. However, we consider the shares neither overvalued nor undervalued but reasonably valued with a higher tilt towards additional downside risk. Libbey is, at best, a cyclical opportunity following the company’s historical boom and bust cycle, but the challenging will provide difficult to overcome. The best case may be that the company manages to muddle along through sluggish growth, marginal profitability, and a high and increasingly expensive debt burden, but this is hardly a rationale for investment and we would recommend avoiding the shares for better opportunities.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.