Graham Packaging (GRM)

Graham Packaging is a worldwide leader in the decidedly un-sexy business of rigid plastic packaging (that's primarily plastic bottles to you and me).  This write-up will be equally unsexy, as the gist of it is to argue that GRM is a decent, well-run, stable business with market dominance in niches that allows for superior returns, a solid management team focused on good returns to equity and smart owners behind them to maintain discipline, where public market equity holders can benefit from normal LBO dynamics with option of occasional accretive acquisitions. Cutting to the chase, I think you can get $20+ for the stock in 1-2 years through a combination of debt paydown and conversion to peer multiples as the market gains comfort with the story. Just don't expect explosive upside from operations.

A quick background: The company has been around since the early 1970s, and was LBO'd by Blackstone in 1997, with the Graham family retaining a 15% stake. The company grew organically and by acquisition, most notably the plastics business of Owens Illinois in 2004 which roughly doubled the size of the company.  Results were poor post merger and Blackstone changed the management team. Capital allocation has been good since the current management team were brought in during 2006 with increased focus on operations, cost-cutting, culling low-return products and customers and increasing ROIC. Graham was then taken public again in early 2010, selling 18.3mm shares at $10 a share, in an IPO that received a decidedly lukewarm reception (the initial attempt was to price $14-$16). Graham recently completed the purchase of Liquid Container, the leading North American manufacturer of plastic containers for the food industry for $568MM.

Even after the IPO, GRM is a very leveraged company (over 4.7x debt/EBITDA), a factor that would normally give us pause.  The rigid plastic packaging industry is not the most attractive one in general: the industry suffers from input price risk (oil) and often commoditized products (especially in the soft drink space). Graham stands out from its competitors in a few ways that make us feel that it is, if not a great business, at least a good one:

• Graham has exited and/or tried to stay out of the commoditized product segment and instead strives to operate in niches where its technology and design leadership can allow it to earn excess returns, focusing on value-added products. Graham's innovations in design and performance include complex shapes, light-weighting, custom labeling, flavor protection, hot-fill capability, multi-layering, oxygen barriers and unusual pouring features.
• Graham has located about a third of its plants on-site at its customers manufacturing sites. This reduces transportation and logistics costs, enhances product development collaboration and gives Graham a permanent cost advantage over competitors.
• Graham mitigates the risk of high financial leverage by entering long-term contracts with its customers (up to 10 years for on-site) and focusing on the consumer products market - Food & Beverage, Household, Personal Care and Automotive. These end markets tend to exhibit fairly steady demand for product (Automotive being the most economically sensitive) which gives a steady income stream to service the company's debt.
• Margins are protected from volatile resin prices with contractual price pass-throughs. In addition, the company has energy pass-through provisions with most of its customers.
• There is a tailwind plastic continues to take share from metal and glass on a price basis, with growth projected at ~6% per year for the near term.

Graham's growth opportunity comes from:

• overall market growth (tied to GDP),
• plastic taking share from glass and metal (especially in food and beverage)
• winning new customers
• Acquisitions.
• Expansion to new geographies (GRM is predominantly North America focused today, but has started to expand into emerging markets)

GRM is cheap relative to its packaging peers, trading at just over 6x EV/EBITDA based on our 2011 estimates including Liquid Container, but more importantly producing a free cash flow yield in the 14-16% range. We expect that cashflow to be used to rapidly de-lever the company and this is where we see the base-case value creation for equity holders.

Management alignment: While controlling shareholders Blackstone, MidOcean Capital and the Graham family have levered the company up very highly, they still own the majority of the equity (just under 75%) and are incented to see value accrue to equity.  Unlevered pre-tax returns on capital are mid-to-high teens. While not spectacular, these returns are relatively stable (as outlined above) and when levered, should produce excellent returns for the equity.

We see a couple of ways to win here. While deals such as the Liquid Container purchase keep the overall leverage high, the company has shown a focus on ROIC, and we think that their acquisitions and organic growth in new markets (particularly internationally) will compound equity value at a good rate. We also think that as investors become more familiar with the name and GRM de-levers through its cashflow, that the multiple should move closer to its peers. Packaging peers trade 6.5-8x EV/EBITDA, and have generally created shareholder value over the last few years despite low volume growth.  As GRM gains recognition, we expect multiple expansion, and at ~7.5x EV/EBITDA and 10x FCF we would see a price over $20 within 12-18 months, a good return from today's $12.60 price.

Risks:

• Resin/oil prices. Though these are mostly passed through, they can reduce the appeal of plastics vs alternative materials and cause customer switching.
• Leverage: Graham has high debt levels, though we expect to see those reduced over the next couple of years. The next major maturity is 2014. That exposes the company to rising interest rates and rollover risk for existing debt.
• Low float: Only about a quarter of the shares are in the public's hands and insiders don't seem inclined to sell at these prices. This may limit appeal for larger institutional investors for the near term.
• Overpaying for acquisitions: Liquid Container should be accretive given synergies and the low cost of debt used, but the risk of paying increased multiples is real (and the O-I deal was not a homerun , even if it was done under old management). New management with increased focus on operations and ROIC, plus the continued significant insider ownership should mitigate this risk.