Why O-I Glass Will Thrive As The Market Improves (NYSE:OI)

Editor’s note: Seeking Alpha is proud to welcome Maze Insights as a new contributing analyst. You can become one too! Share your best investment idea by submitting your article for review to our editors. Get published, earn money, and unlock exclusive SA Premium access. Click here to find out more » Monty Rakusen/DigitalVision via Getty Images O-I Glass (NYSE:OI) is a great value stock and will thrive once market demand recovers for a few key reasons. Firstly, management has focused on strategic portfolio optimization and margin expansion efforts to make the company as lean as possible, to not only survive the current weak market but be more productive once the market recovers. Second, the current destocking and soft consumer demand trend is a temporary occurrence within the cyclical industry, and O-I will regain profits once the current trends subside. Third, O-I is investing in innovation to position itself for success with macro trends like environmental consciousness and premiumization. O-I Glass is the world’s largest glass container manufacturer, producing bottles for well-known brands including Budweiser, Jack Daniel’s, Coca-Cola, Modelo, and many more. With 68 glass manufacturing plants in 19 countries, they are a large company with a global presence. Two-thirds of the company’s portfolio comprises alcoholic beverages, including beer, wine, and spirits. During covid, when alcohol consumption skyrocketed, O-I’s revenue looked great. However, since 2023, it has struggled to remain profitable. Within its last earnings report that ended on March 31, 2024, O-I reported disappointing earnings. First quarter revenues dropped 13% YoY due to lower sales volume in their Americas and Europe segments. EPS came in at $0.45, below investor expectations and significantly below the $1.29 EPS in the first quarter of 2023. These numbers reflected softer market recovery than anticipated, as management projected greater improvements in sale quantity after a tough 2023 of destocking. Unfortunately, the market wasn’t so complying. Q1 marked a quarter of poor profit results, continuing the trend of decreasing volume from the past quarters. Operating profits dropped 41% YoY due to a 12.5% decline in glass container shipments and lower average selling prices across its Americas and Europe segments. This decrease is due to a slower-than-expected recovery of consumer demand and persistent destocking across its value chain. As a result, management revised their full-year 2024 guidance downward once again. O-I now projects sales volume to be flat to up in the low-single digits. Expected EPS was lowered to the range of $1.50-$2.00 per share, which is a 43% decline YoY. With the disappointing first quarter results, investors worried the soft demand market will continue to be drawn out in the foreseeable future, and O-I’s stock tanked 16%. At about $11.59 per share, the stock is now trading at 5-year lows. O-I Stock Price (Yahoo Finance) Higher Operating Costs Prolonged periods of destocking and soft consumer consumption recovery are driving poor profits. First, on soft consumer demand. During the COVID-19 pandemic, there was an increase in alcohol consumption that drove higher demand for the product, but demand softened beginning in 2022. With aggressive cost inflation outpacing wages growth, consumers are trading down to cheaper products. The change in consumer behavior regarding alcohol during the pandemic scrambled producers’ conventional predictive methods, resulting in higher expectations for future demands that didn’t manifest. Consumers also have unconsumed alcoholic beverages built up at home from the pandemic, and therefore, less likely to purchase more before they finish their current supply. In addition, there’s a change in alcohol consumption with millennials and GenZ towards health and wellness. Richard Halstead, IWSR COO of Consumer Research, states that there is a “trend for moderation, mindful drinking, and the rise of non-alcoholic products,” leading to lower consumption in some areas. Hard seltzers and beer have seen lower demand, while volumes of no- and low-alcohol products more than doubled in the US, with IWSR forecasting a 17% gain between 2022 and 2027 (‘IWSR’). A combination of factors has led to softer consumer demand for the products. Next, destocking also leads O-I to have lower sales. O-I’s customers, distributors, and retailers are engaging in destocking – where O-I’s customers, distributors, and retailers use existing inventory before placing new orders to adjust their inventory levels. During the early stages of the COVID-19 pandemic, limited supply due to supply chain issues led to significant increases in inventory as a buffer for uncertainty, switching to a “just-in-case” mentality within its supply chains. However, as supply chains recovered back to pre-pandemic conditions and interest rates continued to grow higher, extra inventory just drove higher operating costs. There is now an imbalance in supply and demand. Consumer demand has declined, but packaging companies have built up inventory, leading to destocking across the supply chains that we see now. To adjust to lower demands from O-I’s consumers, management temporarily curtailed production, leading to lower revenue and unabsorbed fixed costs given the high overhead costs associated with glass production. 2023 was a year of destocking from O-I’s customers. However, O-I reports that they believe “destocking activity is in the later stages for products with a short-cycle, like beer, non-alcoholic beverage, and food, while activity will likely continue for several more quarters for longer-cycle products, like spirits and wine” (O-I 10Q). With the management’s more cautious outlook on customer demand, there are still signs of a promising revenue recovery. In addition, the Russia-Ukraine conflict is driving costs higher. Even though 40% of O-I’s energy is under long-term contracts controlling for short-term price volatility, energy costs still impact profits. Cost inflation still ate into profits, as price adjustment formulas in their long-term agreements partially offset the impact. As a result, the 2024 profit guidance was revised downwards, and the expected EPS is 43% lower. What’s Next? The big question now is when destocking will end and consumer demand will recover. Although it’s impossible to know for sure, O-I is taking strategic steps to best prepare for that time and weathering through the current tough macroeconomic storms. Management’s margin expansion initiatives and portfolio optimization divestitures are keeping their balance sheet lean and improving operational efficiency. O-I is likely to retain its market share because its long-term staggered contracts with customers make it very challenging for another glass producer to poach its clients given the high overhead costs and staggered timeline. However, the current soft demand is a difficult period O-I to weather. O-I is down around 50% from its year-high of around $23.57. On the contrary, O-I’s decrease in stock price provides a great opportunity for investors to profit in the long run from this lean company. Although different industries are recovering from destocking at various paces, the fact that the industrial sector has begun seeing their destocking tides turn from the pandemic, with orders outpacing inventories, serves as a promising indicator that destocking within O-I’s supply chain may be phasing out soon too. Within this very cyclical industry, O-I has efficiently managed its resources and has strong potential for rebounding into profitability in the future. Addressing the Problem Destocking is a major concern that is the core of O-I’s struggles, and it is lasting for a longer period than previously anticipated. While O-I can’t control macroeconomic trends and consumer demand, management is “controlling the ‘controllables'” to mitigate the effects of this problem (1Q24-Earnings-Presentation). Management is continuing to engage in efforts to optimize their operating performances. During Q1, they achieved a $50M benefit from their margin expansion initiative, and since then, increased their annual target benefit from $150M to over $175M (O-I 10Q). The margin expansion initiatives have been critical in offsetting the impact of lower sales. Management has also engaged in portfolio optimization initiatives, divesting inefficient operations, and focusing on using the profits from the asset sales to continue advancing its operating strengths. In 2022, O-I sold Cristar Table Top, their glass tableware business in Colombia for a profit of $95 million to focus efforts on their products for the food and beverage container business. O-I also engaged in sale-leasebacks for two plants in the Americas in 2022 to trim its locations where demand is lower. Because glass is a fragile and heavy substrate, factories must be near customer demand to remain feasible and profitable. The leasebacks provide O-I with more room to reinvest in expanding capacity in locations with higher demand. In addition, management is investing in expanding capacity in select areas where they identified demand and strong room for growth. O-I is focusing on capacity expansion development projects in Brazil, Canada, Colombia, Peru, Scotland, and the U.S. (Kentucky) that management expects, once fully operational, will increase annual profit by around $120 million. For example, in early 2024, O-I upgraded one of its largest plants in Latin America in Zipaquira, Columbia, investing $120 million to modernize production and decrease CO2 emissions by 15%. Focusing on development in strategic locations with proven demand enables O-I to operate plants near full capacity and maintain lean production. Management is working on addressing the issue with rising energy prices and interest rates. Glass productions require significant energy use, making up 10-20% of their total manufacturing costs. However, O-I hedges against the risk of volatility in energy prices and inflation by entering into long-term arrangements that protect it from short-term prices. The rise in energy prices is especially present in Europe, where the conflict in Ukraine and Russia is causing a large increase in energy prices. O-I’s energy risk management reports that they have over 50% coverage in Europe within the medium term, and are pushing for renegotiations to increase coverage. Financials Now on earnings, O-I sales in the first quarter were $1.6 billion, a 13% decline YoY due to destocking, and EBIT fell 56.7% YoY. Although the numbers are rough, there is a slight trend indicating that consumer demand is very slowly improving. In the Americas and Europe segment, glass container shipments declined 12.5% in the first quarter, slightly better than the 16% decline in the fourth quarter of 2023, and April 2024 shipments were only down 10%. In the Americas, O-I was able to pass through cost inflation through preferential terms in their long-term contracts and therefore increased net sales by $6 million. Favorable foreign currency exchange rates, including the strengthening of the Colombian Peso, Mexican Peso, and Euro in relation to the US dollar, partially offset the decline in sales, but the long-term effects are likely to fluctuate. The margin expansion initiatives that O-I implements also partially offset the increased operating costs and lower production volumes. O-I change in consumer consumption of glass packaging (O-I 1Q24 Earnings Presentation) O-I’s cash flow in the first quarter was weak, at -$483 million, a decrease of $428 million. However, management expects demand to improve through 2024, projecting cash from operating activities to be about $750 million in 2024. With its divestitures and margin expansion initiatives, O-I ended the quarter with $395 million in cash, providing enough liquidity to weather through current demand uncertainties. O-I has also resolved its legacy asbestos liabilities that have been eating away at the company’s cash flows over the last decade with Paddock Enterprises. After the achievement of the settlement of 2022, they created a new deal that protects O-I from future liabilities related to their asbestos liabilities “giv[ing] the Company increased flexibility to incur secured debt in the future” to continue investing in their core initiatives (O-I 10K). O-I’s gross margin at 19.4% is around its 3-year average of 19% thanks to its cost-cutting mechanisms decreasing COGS by $72 million. However, down the line, O-I numbers are a little less optimistic. Its operating margin is 10.6%, down from 11.3% same time last year, due to a decrease in operating income by $163 million. This is mainly due to lower shipments and lower net prices along with higher operating costs from lower production volumes not absorbing overhead costs. As a result, its net margin dropped to -3.5%, significantly less than its last 3-year average of 4%. Due to lower demand, O-I’s asset turnover ratio is 0.73, reflecting that the company isn’t fully utilizing its resources to generate sales revenue, while glass production usually rests on high utilization because of the predictive factors of long-term contracts. However, O-I is balancing the lower demand levels with adequate capacity adjustments, maintaining an inventory turnover ratio at a healthy level of 5.2. As a result of the uncertain demand recovery, it has low revenue growth potential, where management predicts that sales “will be flat to up low single digits in the full year 2024 compared to 2023” due to destocking and slower customer recovery. Given all this, O-I is vastly undervalued for its current price and presents a great investment opportunity for investors. It has significant upside in the future with its low EV/EBITDA ratio of 5.7x and EV/Revenue ratio of 0.92. O-I is efficient with its finances given each dollar of shareholders’ equity, with its return on equity being 55% from the last three years compared to the industry average of 6%. Its low Price/Sales ratio of 0.26 and Price/Book of 1.07 indicate it is undervalued given its current earnings and $1.76 billion in assets. Given its positioning for growth when the market recovers and how undervalued it is, O-I is a solid investment when its price is below $22 with a price/book ratio below 0.5. Risk Factors Although I’m pretty bearish on O-I thriving as market conditions improve, there are a few key risk factors to keep in mind while looking at the company. Firstly, O-I has pretty significant debt. O-I currently has $4.7 billion in outstanding debt, with $850 million maturing in 2024. It has a debt-to-equity ratio of 2.3, which indicates that it has taken on high leverage, although it’s comparable to competitors like Silan Holdings with a 2.04 ratio. Although divestitures and margin expansion have freed up cash flow, the low customer demand is still eating away at earnings and could lead to challenges to finance leverage if low sales continue. Luckily, management is proactive with debt management. With over $900 million in cash and $1.5 billion in credit agreements, it has enough cash to pay off near-term debt. Management has historically been disciplined about paying off debt, having brought down net debt/adjusted EBITDA from its peak at 6.4x after acquiring Vitro’s food and beverage glass container in 2015 to 3x now. I would turn my bullish stance to neutral O-I isn’t able to maintain financial positioning to pay off debt, but so far, management seems to have had a good grasp on managing debt. O-I Glass Debt to Equity History (Simple Wall St) Another risk is the threat of substitutes replacing glass. Packaging for food and beverages will always be needed, but there are many alternatives to glass containers, like plastic, aluminum, and flexible pouches. Notably, there’s been a trend with large mass-marketed beers, one of O-I’s major products, towards aluminum with its lighter and cheaper transportation and eco-friendly nature, while small brewers are still relying more on glass bottles. Given the diverse markets and customer bases of O-I services, who are all looking at different “price, quality, service, and marketing and functional attributes of the container,” (O-I 10k) there are many variables that may determine what kind of substrate they choose. Even though O-I has built a solid moat around itself with its staggered long-term contracts, it’s still under the heel of the preferences of its customers. Future Growth No matter the short-term changes in consumer preferences on the type of substrate, O-I is positioning its capabilities to address long-term trends within the food and beverage packaging industry. The premiumization trend is driving the continued demand for glass containers. Glass serves as a medium that provides a feeling of sophistication within both the alcoholic industry (wines, beers, spirits, liqueurs, etc.) as well as a growing number of health-focused beverages (kombucha, cold-pressed juices, coffee, teas, etc.). Using glass containers differentiates brands trying to break into the market. O-I is innovating within its product offerings to serve a growing market of diverse customers. Its Catalyst Collection utilizes research on human emotions to empower its customers to customize their containers’ physical shape to stand out from their mass-produced competitors. In 2023, O-I entered the 400% YoY growth ready-to-drink (RTD) market by designing Drinktainer™, an RTD product with a wide-mouth container created to maintain the optimal drinking experience. The recent release of Coast Spirits Italian Ice is the first brand with the Drinktainer bottle and is the beginning of O-I’s penetration into the RTD market. O-I has also launched offerings geared towards the recent health and wellness trend with its “better for you” bottles for companies like the Wild Tonic brand with alcoholic Kombucha and Stone Brewing’s Buenavida Hard Seltzers. With rising demand for health-conscious and RTD beverages, O-I’s new offerings are crucial to the long-term success of O-I in high-growth industries. Another major trend driving O-I is positioning itself as a sustainable substrate within the packaging industry and continues to pursue its sustainability goals. As of 2023, 40% of O-I’s material is cullet (recycled glass or flawed containers), a 2% increase from 2020 and a step towards their goal of 50% cullet use by 2030 (2024-Sustainability-Report). O-I is also promoting local efforts to drive further glass recycling. O-I Glass partnered with Anheuser-Busch to launch the Denver Series to encourage residents to fill bins with glass bottles with the incentive of a free beer. In support of continued development within CO2 reduction technology in its plants, O-I has been awarded $125 million for the IRA’s US decarbonization project, to rebuild four furnaces across three US facilities which will reduce emissions and increase energy efficiency. O-I’s clear efforts to focus on developing environmentally is a critical asset in differentiating itself within the packing industry. When O-I is competing against substrates like plastic, which is cheaper but also worse environmentally, O-I is positioning itself as an excellent option for companies striving to achieve environmental goals and improve efficiency. Most exciting, O-I’s MAGMA initiative is a key driver for O-I to capitalize on the premiumization and optimization trends. O-I’s MAGMA technologies enable O-I to “reduce logistics cost” by being both “flexible” and “scalable,” while also designing production with sustainability at its core. The flexibility MAGMA provides O-I to serve the “fragmented premium market” mentioned above, which is increasingly becoming one of O-I’s core customers (Q1 2024 Earnings Call). With the improved mobility of operations, smaller production runs, and faster deployment, O-I can better adjust to changes in customer demand and take advantage of market opportunities. Within the MAGMA initiative, in addition to increasing sustainability in the productions, the ULTRA lines focus specifically on designing lighter and more eco-friendly packaging. Management reports that MAGMA and Ultra should expand OI’s total addressable market by over 30%, which sets O-I for strong growth and less susceptible to demand fluctuations in a few products (Q1 2024 Earnings Call). An exciting milestone with the O-I MAGMA initiative is the launch and upcoming commissioning of its first full-scale MAGMA Generation 3 MAGMA facility in Bowling Green, Kentucky. As O-I’s first facility built from scratch in almost two decades, this facility is a key step in O-I’s advancements to improve operational capacity, sustainability, and adjustability with quantity and location. Launched in Bowling Green to serve the premium distilleries in Bourbon, the MAGMA facility will allow O-I to deploy faster and enter new markets to address one of its key limitations. By 2026, we’ll see the full deployment of facilities incorporating Gen 3 technology to serve more flexibly and sustainably. Conclusion O-I has had a tough time as of late. Destocking within the industry and soft consumer demand have decimated profits, and the last quarter indicated that destocking will take longer than anticipated, worrying already skeptical investors. However, O-I is navigating the tough times by focusing on its core fundamentals, divesting inefficient plants, and using freed-up cash flow to expand capacity in strategic locations and continue its MAGMA initiative. The recent nosedive in price has created an optimal opportunity for value and growth, and for us as investors to take advantage of the market’s current pessimism. O-I may be facing tough sales as of late, but management has built a solid foundation, allowing its production to thrive once the market demand recovers. As the largest glass manufacturer, with existing long-term contracts with suppliers and customers, O-I is doing all the right things to succeed once the tides turn. Quarter 2 results are about to come out on July 30, 2024, and even if market recovery is slow, the company has solid fundamentals for long-term success.

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