RO glass (NYSE:OI) is one of the leading glass container manufacturers in America and Europe, where it operates 68 manufacturing plants. The company’s share price came under pressure due to its balance sheet as OI had to focus on reducing its net debt. I believe the business is moving on and the ongoing free cash flow will now also be spent on further expansion as the European glass container market is still growing.
Focus on cash
OI Glass had a problem: its net debt was rather high and although free cash flow continued to flow, it was understandable that investors seeking exposure to glass containers were looking elsewhere for companies with more secure balance sheets. .
Although gross profit in 2021 was lower than the result in 2019, for example, OI’s pre-tax profit is improving thanks to higher earnings on equity and lower general and administrative expenses as well as a sharp reduction in its net interest expense from $311 million to $216 million in 2021. Although we are still feeling the impact of COVID in 2021, I think we can say it was a very decent for OI Glass.
Reported net income was approximately $149 million, but that includes an impairment charge of $118 million, so underlying, normalized net income would be higher than reported income. EPS of $0.90 from continuing operations is okay but nothing shocking.
In my previous article, published in September, I had already argued that investors should look at free cash flow rather than net income, because it is cash flow that will determine net debt and the pace of balance sheet improvement. .
This was confirmed again in 2021. Reported operating cash flow from continuing operations was $680 million and this includes a $13 million investment in working capital, but also includes an $84 million contribution dollars to the pension fund.
We still have to deduct the $16 in payments to non-controlling interests and thus end up with an underlying operating cash flow result of $677 million. And since capex was only $398 million, OI reported underlying free cash flow of $279 million. And that includes pension payments as well as a $71 million one-time tax payment related to a problem in Brazil. Additionally, the total capital bill was higher than the depreciation expense as OI catches up on maintenance but also invests in growth. So the underlying free cash flow of $279 million is likely still significantly lower than the underlying operating-level sustaining free cash flow. Excluding pension payments and Brazil tax payment, free cash flow – including growth investments – would likely have exceeded $425 million.
There’s clearly more than meets the eye here and while I agree that OI doesn’t look very interesting at first glance, it’s worth spending some time to figure out what it’s all about. acts.
I’m definitely not saying we should just “ignore” pension payments as it’s the right thing to do for all stakeholders, but I just wanted to show that OI Glass is showing very strong cash flow at an operational level . And the pension deficit will be solved as soon as possible. In just one year, the deficit went from $521 million to $284 million. This is due to the cash payment but also due to higher interest rates as this increases the discount rate used to determine the current deficit of the pension fund. The much smaller pension deficit will now allow OI to reduce its annual contributions and the company now expects cumulative cash deposits of $65 million to $100 million over the next three years. This means annual payments will drop to $22-33 million, creating additional wiggle room.
Balance sheet is improving, but OI’s growth investments this year will slow deleveraging
At the end of 2021, OI had approximately $725 million in cash (see below) and combined with the $72 million in short-term debt and $4.75 billion in longer-term debt, this means that OI Glass had approximately $4.1 billion in net debt. end of 2021. OI’s net debt is clearly heading in the right direction.
With an expected EBITDA of around $1.1-1.15 billion for this year, the net debt ratio is around 3.7, which is relatively high, but the debt is now manageable because OI has has now shown considerable progress towards reducing its debt and the continued decline in interest charges. will also contribute to free cash flow.
It also helps to have a definitive and binding solution for the Paddock problem. Paddock is now deconsolidated from OI’s balance sheet
As you can see above, Phase VIII includes the requirement for OI Glass to fund the Asbestos Trust. It will be a $610 million cash payment that will again temporarily weigh on OI’s net debt (which will likely increase to $4.6 billion by the end of this year), but OI reconfirmed its debt target for YE 2024 where it wants to achieve net debt of 3x EBITDA. Assuming EBITDA increases to $1.3 billion, this essentially means net debt will decrease again to less than $4 billion and this despite investing in growth and despite paying $610 million. for asbestos.
For 2022, OI expects to generate $125 million in reported free cash flow. That sounds disappointing, but it’s important to know that the company will be spending $225 million to expand capacity on top of the base investment of $375 million. Excluding these additional growth investments, the underlying free cash flow will actually be around $350 million.
With just under 156 million shares outstanding, the company is essentially targeting normalized free cash flow of $2.25/share. And while net debt will increase this year due to the one-time payment into the asbestos fund, there is now a clear path for OI and when the growth investments end, net debt will decline at a fairly rapid pace.
And as higher cost debt matures, I expect OI Glass to be able to refinance that debt at a significantly lower interest rate. A large 5.875% bond matures in 2023 and a steady decline of 100 basis points in the interest rate will save the company about $7 million a year in interest costs and increase the free cash flow of $5 million per year.
I am confident in the future of glass containers and glass packaging as demand continues to grow at a single digit rate. However, as its competitor Verallia mentioned during its financial market day, the demand for glass packaging in Europe to augment of around 2% per year and there does not seem to be any overcapacity since the confirmed capacity increase is only half a million tonnes (in a market of 21 million tonnes) in 2022 and 2023. So I don’t expect OI to have any issues when it comes to selling the products as competitor Verallia has mentioned that their ovens are running at full capacity but they cannot keep up with demand. The demand for glass containers and bottles is therefore there.
The main uncertainty right now is in energy prices, as natural gas prices have skyrocketed lately and natural gas accounted for 20-25% of total production costs. Fortunately, the average production cost of a container is only 15 to 25 cents, so even if natural gas prices triple, the total production cost will only increase by a few cents, which shouldn’t be a major hurdle for the end buyer as the cost increase is small enough to be fully passed on to the end consumer. This is also the main reason why I recently initiated a long position on Verallia in the ESCI portfolio.
I have started to initiate a long position in OI Glass and I will probably try to continue to expand my position by selling put options as I would like to take advantage of recent market volatility.