Getting Choked by Asbestos Liabilities

Companies require continuing cash flows from operations to breathe life into their businesses and to sustain their operations. Just as asbestos exposure can make it difficult for people to breathe or to live, asbestos liability can seriously impair a firm's cash flows and in some cases kill the company.

It has been many years since the asbestos-induced bankruptcy filings of the likes of Owens-Corning, WR Grace, and USG; but people are still getting ill from past asbestos exposure, and attorneys are eager to obtain settlement money from companies that bear some responsibility and have the ability to pay.

It's hard to imagine how packaging companies could be widely impacted by asbestos, a material widely used in the construction industry. But two packaging firms,  Owens-Illinois (OI) and  Sealed Air (SEE), have the asbestos albatross hanging around their necks. Here we provide investors with an in-depth analysis on how to quantify the asbestos risk for these two companies.

Owens-Illinois
Owens-Illinois, the world's largest manufacturer of glass containers, has been in business for over a century. For 10 of those years (1948-58) the firm produced and sold $40 million worth of pipe that contained asbestos insulation. Since that time, O-I has faced hundreds of thousands of claims and paid out over $3 billion. From 2000 to 2009, O-I on average has paid out more than $190 million each year on asbestos-related charges, and we believe that the cash impact for Owens-Illinois will continue to be meaningful. We think these large asbestos-related payments will continue for many years and should be accounted for when determining the fair value for the company's stock.

The good news for Owens-Illinois is that litigants must prove they were working with asbestos-laden pipe in the 1940s or 1950s; consequently, the average age of a claimant last year was in the upper 70s. Within the next two to three decades almost all of the people who were of working age during 1948-58 will have passed away, removing O-I's asbestos obligations.

In estimating Owens-Illinois' future asbestos-related liabilities, we conduct a scenario analysis incorporating three sets of assumptions: (1) the average cash cost per claim in a given year, (2) the number of claims in a given year, and (3) a discount rate to determine the present value of future asbestos claims.

Owens-Illinois: Average Cash Costs per Asbestos Claim
Since 1993 O-I has provided investors with statistics regarding how many total claims they have disposed of since the first claim, and the average indemnity per claim since then. We use this data set to calculate a rough estimate for what the average indemnity per year has been for Owens-Illinois and what it may be in the future.

The chart below shows that over the past 17 years the average cost per claim has been choppy but more or less increasing over time. We extrapolate this trend for our scenarios by growing the average claim by 2.5% per year for our bull case, 4.5% per year for our base case, and 5.5% per year for our bear case.

Owens-Illinois: Number of Claims Filed per Year
The number of claims filed each year has been volatile since the 1990s but has recently been on a downward trend. We note that health complications linked to asbestos may take years to surface, and the number of claims filed also depends on both the awareness that asbestos may have caused these health issues and the push for business from attorneys. We believe there is a wide variability in the range of possible suits filed against O-I in the coming years, but we also believe the quantity of annual claims will likely decay as the pool of potential litigants shrinks with time. Figure 2 depicts our range of possibilities for asbestos-related claims to be filed against Owens-Illinois.

Multiplying the cost of an average claim with the range of claims provides the investor with an estimate for the range of total cash payments related to future asbestos settlements. (Fig. 3)

We then discount these future cash flows to determine the present value of asbestos liabilities. When we discount our base-case scenario with our estimate for the firm's cost of capital (8.7%), we conclude the asbestos liabilities account for $1.35 billion, or almost $8 per share. However, the impact is far smaller in our bull case ($3 per share) and far larger in our bear case ($13 per share).

The variability in the quantity of lawsuits and size of each settlement for Owens-Illinois is quite high and difficult to reasonably estimate. Investors are advised against valuing O-I utilizing P/E multiples based on a peer average. Many other competitors in the packaging space do not have asbestos exposure; consequently, their earnings are much cleaner than O-I's earnings, which will likely include sizable asbestos-related charges for many years to come.

 

Sealed Air
Sealed Air, best known for its Bubble Wrap protective packaging, acquired its way into the flexible food packaging business and into the realm of asbestos-related obligations. In 1998, Sealed Air acquired its Cryovac assets from W.R. Grace & Company. Following Grace's 2001 asbestos-related bankruptcy filing, Sealed Air entered into an asbestos settlement agreement to fund an asbestos trust upon Grace's emergence from bankruptcy.

Sealed Air's asbestos agreement was reached in 2002 and resolves all current and future asbestos-related claims against the firm in exchange for $512.5 million of cash (which accrues 5.5% annual interest until the payment is made to the trust upon Grace's emergence from bankruptcy) and 18 million shares of stock (split adjusted). As of March 31, 2010, Sealed Air has carried a $757 million current liability on its balance sheet related to the pending cash payment. Offsetting this liability is over $600 million of cash and adequate borrowing capacity to fully cover this debt when it comes due.

Whereas O-I's asbestos exposure is challenging to quantify, Sealed Air's liability is a bit easier. There's a good chance Grace will come out bankruptcy in the next year; consequently, Sealed Air will give the trust over $750 million in cash and 16 million shares. Once the asbestos trust is funded, Sealed Air's interest expense will be reduced by more than $40 million per year, providing a boost the company's net income.

There is, however, a small risk that Sealed Air's settlement agreement may not become effective, in which case the firm would not have to provide the trust with its cash and stock contribution. However, this would not absolve Sealed Air from its asbestos-related liabilities. We believe there is only a minute chance of the settlement not occurring. In such an unlikely event, we'd want to run a scenario analysis on Sealed Air's asbestos liability similar to the one we conducted with Owens-Illinois.

Summary
Estimating the value of a share already hinges on a multitude of assumptions. Adding the uncertainty of legal payouts related to asbestos brings about yet another challenge. Companies such as Owens-Illinois that fight asbestos charges on a case-by-case basis are faced with a wide range of possible outcomes that will impact cash flow and share price. It's much easier to place a valuation on the asbestos impact for firms like Sealed Air, which have agreed to fund asbestos trusts in exchange for the resolution of all asbestos-related claims.

While we don't believe that asbestos will bankrupt either company, we do believe investors should be aware of the magnitude of asbestos-related liability and the impact on the companies' values.