Fear of Fine Makes Crown a Buy

Our fair value estimate assumes a $25.3 million fine following a review of European cartel laws, applicable fines, and Crown’s disclosures to date. The case includes an investigation into German, U.K., and French operations, limited in scope to food cans. Based on Crown’s disclosures, the company turned over evidence of wrongdoing by German employees within six months of the investigation in 2015, and the case cites a duration of “several years.” In our base- and bull-case scenarios, we assume that only 2013-15 German revenue is exposed to fines by the European Commission. We also expect that Crown’s early cooperation will qualify the company for a 25%-40% fine reduction under the European Commission’s cartel leniency policy. Before leniency, the assessed sales penalty rate is 7% in our base case and 5% in our bull case.

In our bear case, we assume a $429 million fine as Crown is fined on sales in the United Kingdom and France in addition to Germany. We also assume Crown underreported the wrongdoing and regulators assess an optional 15%-25% entry fee penalty--an additional tool to punish anticompetitive cartels. The penalty rate in this scenario rises to the maximum 10% of affected sales and leniency is considerably reduced.

Emerging-Market Exposure Should Boost Growth Crown is the world's second-largest producer of aluminum beverage cans and is a large producer of steel food cans. Used primarily for carbonated soft drinks and beer, beverage cans are a slow-growth industry, but one with favorable competitive dynamics for incumbents. The merger of the industry's former number-one and -two players, Rexam and Ball, has not materially altered the industry's competitive landscape.

Beverage sales make up the majority of Crown’s revenue and operating income. Of consolidated sales, they’re split 32% in North and South America, 17% in Europe, and an estimated 9% from Asia-Pacific beverages. We expect Crown’s exposure to emerging markets will lead to higher top-line growth in the long run, as discretionary income growth leads to higher consumption of beer and soft drinks. Crown maintains a leading market share in Vietnam, Cambodia, and Singapore and has strong competitive positions in Thailand, Indonesia, Mexico, and Brazil. We see negative consumption trends for soft drinks and mainstream beer in developed markets being overcome in the coming years by a mix shift from bottles to cans among craft beer brewers.

Food and aerosol containers make up the remaining 40% of sales. The majority of Crown’s food and aerosol operations are in Western and Central Europe, recently expanded through the acquisition of Mivisa’s high-margin assets on the Iberian Peninsula. We see almost no growth prospects in canned food or aerosols, as developed-market consumers are unlikely to increase their consumption of canned products. That said, with some of the most profitable assets in the industry, Crown’s food business should create plenty of cash flow to allocate to more attractive opportunities over time.

Can Industry Has Efficient Scale Crown has a narrow economic moat, in our view. High transportation costs, predictable demand, staggered long-term contracts, and high capital costs lead to an industry that benefits from efficient scale. In the majority of metro areas, food and beverage producers are typically served by only two or three can companies, and the entry of an additional competitor would impair the profitability of all facilities. As a consequence, incumbents are typically able to generate returns that exceed their cost of capital. Returns are capped by the prospect of beverage companies integrating upstream.

Once the lid and can are formed, they need to be shipped to the filling location. Beverage and food cans have a low value/volume ratio. Given that much of an empty can is air, shipping cans beyond 200-300 miles is unprofitable. As a result, starting a new plant is easier when demand changes within the shipping radius. Demand shifts for food and beverages depending on population growth, preferences, and increasing income. These shifts tend to take place over decades rather than years. Predictable changes in demand result in few opportunities to enter existing markets, as there are rarely material demand/supply mismatches. Attempts to fill capacity by competing for existing contracts would prove challenging, as staggered multiyear supply contracts reduce the volume of production open to competition in any given year. With the capital costs of a single production line in excess of $70 million and relatively slim per-can margins, facilities with low utilization rates cannot operate profitably.

Among existing market participants, competitive behavior has remained disciplined for decades. Even in mature markets such as North America or Europe, where growth has come to a relative standstill, Ball and Crown still find the relocation of assets more profitable than competing for existing contracts. For example, an underutilized beverage can facility could be relocated from Los Angeles to Malaysia. We believe that attractive consumption growth trajectories of emerging and frontier markets should inhibit contract competition in developed markets over the next decade.

Changing Competitive Dynamics Largest Risk We believe the largest risk to Crown and this industry is changing competitive dynamics. The Chinese market for food and beverage cans serves as a worst-case scenario. Economic returns elude most players in China, a fragmented market that includes three large state-owned enterprises. While we think there are economic barriers to entry in existing markets, the presence of one irrational player impairs profitability for everyone.

Crown and its peers face the constant threat of substitution. This could be substitution of packaging or the beverage or food itself. Cans have continued to take share from glass in the most markets, but this could change with consumer preferences. In the United States, a sustained decline in demand for mainstream beer in favor of craft brews could lead to an unfavorable shift away from cans and toward glass in the absence of a packaging mix shift. The threat of a soda or sugar tax could further erode the market for soft drink beverage cans.

Volume growth could be hampered by a recession in emerging-market countries. Developed countries possess per capita GDP well beyond the point at which demand for soft drinks and beer levels off. This is not so in emerging markets. As growth in emerging markets ebbs and flows, volume fluctuates.

There is tail risk associated with the use of bisphenol A, commonly known as BPA, dating back to the 1950s. Crown now has an added-cost option for clients that is BPA non-intent, a coating that contains no BPA but is dispersed through shared equipment. It remains unclear whether canning or beverage and food companies would bear the burden of a definitive link between BPA and health issues, as cans are made to client specifications.

The company also risks considerable fines for employee participation in a European food can cartel in 2015. Although the duration and scope of company involvement are challenging to estimate, we assume that the fine could range anywhere from roughly $20 million to $430 million.

As Crown doesn’t pay a dividend, it should be able to pay down its debt quickly and pursue further expansion in emerging markets in the coming years.