Silgan's Great, But The Price Isn't

The way I approach the markets, I want to find not only the right companies, but the right companies trading at the right price. I have no qualms at all that Silgan (SLGN) fits into the first bucket. I also don't dispute the idea that the company can, over time, grow its closures business and build its presence in emerging markets. The dent in the can today is valuation - I just cannot find a reasonable basis by which Silgan shares are cheap today.

Bad Packs Can't Last Forever … Right?

Silgan gets more than 60% of its revenue from metal food cans, holding about 50% share in the North America by virtue of buying the self-operated canning lines of Campbell Soup (CPB), Nestle (OTCPK:NSRGY), and Del Monte years ago. Apart from the incoming entry of Ardagh, the North American food can market has been pretty calm for quite a while, with Ball (BLL) and Crown Holdings (CCK) holding around 20% each.

Although there isn't typically much turnover in the major contracts in the space, Silgan still has some revenue drivers that are out of its control - namely the annual vegetable and fruit packs. Fresh pack is about one-quarter of U.S. volume, and weather issues this year led to a third straight disappointing pack. This situation was made worse by a disappointing peach pack in Greece. I'm inclined to think that the odds favor a better pack year in 2014, but I'm well aware that there was probably more than one analyst making that call over the past couple of years.

I'm also a little concerned about the long-term direction of the business. Overall soup volumes have been okay (at least according to Nielsen data), but Campbell's volumes have been weakening of late and the company seems to be losing some share again to General Mills (GIS). As Campbell Soup is a 10% customer of Silgan, that's not a trivial item. At the same time, while I think the slowdown in Europe will pass and the company will see better margins in the coming years, the company's presence in emerging markets is still underwhelming to me.

Added Scale In Closures Should Be A Plus

Silgan has long been a willing acquirer, and the company has been looking to increase its exposure to plastics and closures. In buying Portola Packaging for almost $270 million, Silgan is getting a little bit of both.

Portola sells plastic closures for a variety of beverages, bottled water, dairy, and food applications, and has a relatively larger exposure to Europe than Silgan's existing business. All told, Portola should grow Silgan's closures business by about 30%. Market research reports indicate that Berry Plastics (BERY) is the leader in the plastic food and beverage closure market in the U.S., but the market is essentially an oligopoly between Silgan, Berry, and CSI.

Silgan is also looking to operating synergies to drive value from this deal. Portola was bought out of a prepackaged bankruptcy back in 2008, and the owner (Wayzata Partners) has been busy in the interim repositioning the company around more profitable product lines with solid long-term growth potential. While I don't want to underrate Silgan's operating excellence, I do wonder how much fat there will be left to trim after Wayzata's ownership tenure. That said, Silgan brings operating synergies to the deal that Wayzata can't match so even if Portola is running at or near peak efficiency as a standalone, there are still likely to integration benefits that accrue to Silgan over time.

Steady As She Goes?

Silgan has posted very consistent gross and operating margins for some time, a testament in part to the benefit of long-term pass-through contracts that effectively minimize the margin risk from input costs. Even so, three straight years of bad packs and a weak European economy have taken a toll, as operating margin has weakened from just over 10% to just under 9% this year.

As I said, the North American food can market has been pretty close to static for some time, but now Ardagh is looking to change that. Traditionally a strong player in glass bottles, Ardagh is spending $250 million to build two new food can plants in the U.S., and the company has already taken a ConAgra (CAG) contract away from Ball. Trade journal reports suggest this was a decision based on technical factors (ConAgra wanting a 2-piece solution instead of a 3-piece) instead of price, but I wouldn't completely dismiss the threat that Ardagh's entrance will impact industry pricing. While Silgan's co-location at many of its key customers should make those relationships very sticky, Ardagh's entry isn't a positive for them.

Barring a big commitment to emerging markets like China, India, Brazil, and so on, I expect Silgan's future growth to look a lot like the past. There's some risk of ongoing substitution away from metal food cans, but the company has been investing in products like plastic pouches, and I think Silgan will see underlying revenue growth of around 3% (excluding M&A) and sufficient margin and cash conversion leverage to grow free cash flow by 4% to 5% a year.

The Bottom Line

The trouble with Silgan is the valuation. Running a discounted cash flow analysis on Silgan is tricky. Unless you're willing to just ignore the company's sizable net debt position or accept a very low rate of return, the suggested fair value today is in the $30's (against an average sell-side target of $48).

In cases where DCF provides squirrelly numbers, I like to turn to EV/EBITDA, but this doesn't help much in the case of Silgan. Historically Silgan has traded at a forward multiple of 7x EBITDA, but that again produces a target in the mid-$30s. Some sell-side analysts argue that Silgan deserves a premium for the quality and stability of its business. I agree, but even an 8x multiple (more than double the expected EBITDA growth rate over the next three years) just gets you to about $45 per share.

As I said in the open, I have no qualms or concerns about the quality of Silgan's business. The outsized debt load doesn't trouble me much given the stability and predictability of operating earnings, and I believe the company's core business is relatively secure. I just cannot find a way to evaluate the stock such that it looks cheap, and that leads me to stay on the sidelines with this name.

Source: Silgan's Great, But The Price Isn't

Disclosure: I 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. (More...)

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