This Packaging Firm Makes a Canny Choice

After the sale of its plastic packaging businesses,  Rexam  is now fully focused on its metal beverage-can operations. We're pleased to see this, because beverage-can production has clearly been Rexam's most-advantaged business. Together, the world's three largest producers of metal beverage cans constitute nearly the entire share of the European, South American, and North American beverage-can markets and 60% of global supply. Thanks to the rational oligopolies that exist in most major markets, Rexam's beverage-can operations have largely been able to maintain steady operating margins as a result of its long-term contracts, most of which allow Rexam to pass through what are often volatile input costs (mainly aluminum and steel) to its customers. Contracts tend to be at least three years long and normally include annual supply targets. Its top customers include multinational beverage companies such as  PepsiCo (PEP) ,  Coca-Cola (KO),  Anheuser-Busch Inbev (BUD), and  Heineken (HEINY), which provide steady demand and help Rexam run its facilities at very high utilization rates.

Rexam has more than 60 beverage-can plants in 24 countries and holds a dominant share of the European and Brazilian markets. Transporting empty cans more than 300 miles is expensive, so having a plant near a customer's operations helps keep costs down and allows the can manufacturers to offer lower prices. Beverage-can manufacturers also benefit from ongoing customer demand for product differentiation on store shelves, such as higher-margin specialty cans (non-12-ounce/33-centiliter cans) and energy drink cans. Rexam is the sole manufacturer of cans for Red Bull energy drinks, for example, which grew from 1.9 billion cans sold in 2004 to 5.4 billion in 2013. Indeed, Rexam is increasing its specialty-can capacity in Europe primarily to serve this rapidly growing customer. Rexam's specialty-can mix is approximately one-third of production in Europe and about 25% in both North and South America. Over the next few years, we expect these figures to move closer to 40% as more than half of Rexam's planned capacity additions are for specialty cans.

Fair Value Estimate Is $44 per ADR Share
Our fair value estimate for Rexam's ADR share class is $44 per share. Each ADR represents five Rexam ordinary shares, which are listed on the London Stock Exchange, and we assumed an exchange rate of GBP 1 to $1.67. Our fair value estimate represents a 2014 price/earnings multiple around 15 times and an enterprise value/EBITDA multiple near 9 times. We assume an 8% weighted average cost of capital in our model.

Efficient Scale and Oligopolistic Markets Mean Narrow Moat
Rexam has a narrow moat derived primarily from its efficient manufacturing scale and the oligopolistic nature of its major markets. A potential competitor has little incentive to enter the North American, European, and South American markets because it would struggle to sustainably maintain sufficient market share and profitability against the likes of Rexam,  Crown Holdings (CCK), and  Ball (BLL). Plants must run at high utilization rates to be profitable, so steady demand from major customers is a key advantage to Rexam, as new entrants would likely struggle to obtain the large supply contracts necessary to maintain a profitable aluminum-can manufacturing business. This advantage is most secure in mature end markets such as Europe and North America, where growth and profit potential is less attractive than in emerging markets. As such, we expect market-share fights in developed economies to continue among the three established players. An upstart would thus face a number of obstacles, such as acquiring the large and long-term supply contracts necessary to profitably operate a greenfield plant. Finally, having plants located near its customers keeps freight costs low and allows Rexam to offer lower prices while maintaining an acceptable profit margin.

Rexam has a stable moat trend. Nearly all of its beverage can revenue is generated in oligopolistic markets that have rational pricing models. We expect the three major players in North America, Europe, and South America to keep prices at levels that also provide reasonable industry profitability. Beverage can competition is much stronger outside of North America, South America, and Europe, but Rexam currently derives very little revenue from those other areas. Rexam is particularly exposed to the secular decline in carbonated soft-drink (CSD) demand in developed markets, but we believe these negative effects are offset by strong demand for energy drinks--an area in which Rexam has a large market share--and that the secular decline in CSD demand is manageable. We expect that ongoing global packaging mix shifts should be a net positive for manufacturers of metal beverage cans, as metal should slowly take market share from glass packaging.

Management's Recent Actions Protect Shareholders' Interests
Graham Chipchase became CEO in early 2010. He joined Rexam in 2003 as finance director and board member and later became group director of plastic packaging. He played an instrumental role in Rexam's 2007 acquisition of  Owens-Illinois' (OI) plastics division, which in hindsight was not a great use of shareholder capital. As such, we're somewhat skeptical of management's ability to integrate large-scale acquisitions. That said, we give Chipchase credit for selling off the underperforming plastics businesses and not spending massive amounts of shareholder capital trying to fix them when there are better places for that capital in the beverage-can business.

We applaud the board's decision to increase the shareholding requirement for Rexam's chief executive and executive directors and think the move could better align management with shareholder interests. We also like the board's move in 2013 to require returns over cost of capital before long-term management incentives begin to vest. We think this will discourage management from pursuing a growth-at-any-cost strategy and will encourage management to stick to its core competency of metal beverage-can manufacturing. Executive incentive metrics, which include return on capital employed, free cash flow, and EPS growth, are appropriate, but these variable payments account for just half of expected annual compensation, and we would prefer to see variable compensation make up a larger percentage of expected compensation.