Rating Methodology May 2006 Contact
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Global Packaging Manufacturers: Metals, Glass, and Plastic Containers
Summary This rating methodology explains Moody’s approach to assigning ratings to packaging companies, which manufacture metals (steel and aluminum), glass, and plastics containers and films used in packaging food, beverages, medical, industrial, and consumer products. The goal is to provide a clear understanding of how we arrive at company-specific ratings in the sector and to help constituents gauge a company’s likely enterprise rating within two rating notches while explaining how key quantitative and qualitative risk factors are weighed and mapped to specific rating outcomes. The three fundamental rating factors, individually and in combination, that are central to the assignment of ratings for the global packaging manufacturers are: 1. Financial Leverage and Coverage of Interest Expense 2. Operating Profile 3. Competitive Position Each of these rating factors is explained in detail along with a total of nine measurements (or sub-factors) used for the three factors. An important emphasis is given to how company-specific results map to Moody’s rating categories. Highlights of this report include: • Characterization of the industry and substrate-specific trends • An overview of risks and market factors for the packaging manufacturers • A description of Moody’s rating methodology using the three key factors and their nine measurements • Tables showing Moody’s actual application of the rating framework • A summary discussion of our results
About the Rated Universe Globally, Moody’s rates 31 packaging companies. Three companies are excluded from the sample as they do not file reports with the Securities and Exchange Commission (“SEC”). In addition, companies using paper as the primary manufacturing substrate are excluded from this methodology.
Enterprise Ratings of Packaging Manufacturers 20 18
18 16 14 12 10 8
5
5
6
3
4 2
0
0
0
Aaa
Aa
A
0
0 Baa
Ba
B
Caa
Ca
There are 28 companies included in the sample for which Moody’s rates approximately $36 billion in bonds and committed credit facilities. Five manufacturers have investment grade ratings and 23 have speculative grade ratings. Of the five investment-grade ratings, three companies are domiciled in the United States, one in the United Kingdom, and one in Australia. In aggregate, the financial profile of rated companies in the sector tends to be moderate to weak. The vast majority of the companies in this methodology have speculative-grade ratings with credit metrics consistent with a single B rating or lower. They are characterized by high financial leverage and high capital investment requirements, and therefore generate little free cash flow. Approximately 50% of the companies included in the sample have publicly traded equity and the remainder are privately held by investor groups led by private equity firms or families. Moody’s uses its fundamental ratings — the senior unsecured rating for an investment-grade issuer and the corporate family rating for speculative-grade issuers — as the benchmark for comparison. The methodology sample includes 14 companies that primarily manufacture plastic containers and plastic products such as films used in food packaging, shrink wrap, and protective packaging. In general, those can be divided into manufacturers of rigid plastic containers and manufacturers of flexible plastic containers. There are seven companies that principally manufacture metal containers and five whose operations focus on glass containers. Two packaging manufacturers, Australia’s Amcor Limited and UK’s Rexam PLC, are highly diversified and produce products made from each of the three substrates included in this methodology.
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Sample Companies* Company
Rating
Outlook
Domicile
Total Debt*
Sector
North America Bemis Company, Inc. Pactiv Corporation Sealed Air Corp. Ball Corporation Silgan Holdings Inc. Crown Holdings, Inc. AEP Industries, Inc. BWAY Corporation Berry Plastics Corporation Solo Cup Company Atlantis Plastics, Inc. Graham Packaging Company, L.P. Owens-Illinois Inc. Vitro Envases Norteamerica S.A. Vitro, S.A. De C.V. Plastipak Holdings, Inc. Consolidated Container Company L Constar International, Inc. United States Can Company Portola Packaging, Inc. Radnor Holdings Corporation Tekni-Plex, Inc.
Baa1 Baa2 Baa3 Ba1 Ba3 Ba3 B1 B1 B1 B2 B2 B2 B2 B2 B2 B2 B3 B3 B3 Caa1 Caa1 Caa1
Stable Stable Stable Stable Positive Stable Stable Stable Stable Negative Stable Stable Stable Stable Stable Stable Stable Negative Stable Negative Negative Negative
US US US US US US US US US US US US US Mexico Mexico US US US US US US US
839,199 1,313,000 2,080,000 1,589,700 970,700 3,705,000 192,576 395,300 1,165,128 1,062,254 207,300 2,548,258 5,201,900 613,717 1,497,066 396,249 587,330 398,322 554,820 204,080 323,967 800,517
Flexible Plastics Flexible Plastics Flexible Plastics Metal Metal Metal Flexible Plastics Metal Rigid Plastics Rigid Plastics Flexible Plastics Rigid Plastics Glass Glass Glass Rigid Plastics Metal Rigid Plastics Metal Rigid Plastics Flexible Plastics Rigid Plastics
Australia/Europe Amcor Limited Rexam PLC Ardagh Glass Group PLC Klockner-Pentaplast S.A. Gerresheimer Holdings GmbH Impress Holding B.V.
Baa1 Baa3 B2 Ba3 B2 B1
Negative Stable Negative Stable Stable Sable
Australia Britain Ireland Luxembourg Germany Germany
2,451,000 2,244,590 442,066 837,742 553,946 795,445
Diversified Diversified Glass Flexible Plastics Glass Metal
* Total reported debt in US$ (thousands) for the twelve month reporting period ended nearest to September 30, 2005 for the North American companies. All other figures are as of the fiscal years ended 2004.
Except where noted in the methodology, financial information is publicly available and is presented in U.S. dollars for the 12-months period ended September 30, 2005. For those companies which do not use a December fiscal year end, we use the 12-months period ended as close as possible to September 30, 2005. Financial data are adjusted according to Moody’s standard financial adjustments1.
Industry Overview General defining characteristics of the metals, glass, and plastics packaging industry include the following: • Mature and relatively low growth industry • Sales made through distributors or directly to wholesale or retail customers • Unit volume tied to stable and defensive end markets • Raw materials accounting for the majority of operating costs • Volatile raw material prices with immediacy of the pass through to customers a critical success factor • Push-pull between packaging design and consumer needs, acceptance and demands • Pressure on free cash flow due to sizable reinvestment needs to support capacity demands
1.
Refer to the following Rating Methodologies: Moody’s Approach to Global Standard Adjustments in the Analysis of Financial Statements for Non-Financial Corporations — Part I (issuers in the U.S. and Canada) and Part II (issuers reporting under International Financial Reporting Standards). Also, refer to the following Special Comment: Guideline Rent Expense Multiples for Use with Moody’s Global Standard Adjustment to Capitalize Operating Leases
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• Fragmentation in both rigid and flexible plastics sectors • Limited acquisition opportunities in metals and glass in North America and Europe • Less developed markets represent areas for potential growth The packaging industry competes on the basis of price, product quality, technological and design innovation, as well as capacity, regardless of the substrate being manufactured. Being first to market is a critical success factor, especially because technology transfer leads to rapid commoditization of a once-proprietary process. Strong and non-cyclical demand and the “must have” nature of the manufactured containers afford generally good stability of unit volume. Core assets consisting of equipment and physical plant used in the manufacturing process are predominantly owned rather than leased. However, distribution and warehouse facilities, which are considered core to operations, tend to be leased. On average, free cash flow is modest to zero because of the substantial need for capital reinvestment and meaningful working capital requirements. Free cash flow throughout the sector is further constrained by cash funding of pension plans and other retirement benefits, litigation-related expenditures, earn-out payments from prior acquisitions, dividends, and share repurchases. The packaging manufacturing industry is global, most notably because companies, regardless of revenue size, have off-shore operations and customers with increasing international demands. Consequently, there are no material industry differences across geographies. General risk factors for the industry include the following:
Rapid product commoditization Many packaging containers and manufacturing processes quickly migrate from high, value-added products and services, when first introduced to, “off-the-shelf technology”, which is commoditized. Being first to market with an innovation is a critical success factor. In general, the packaging industry does not have a substantial number of patent protected products, although patented processes are more common.
Management of raw material costs The impact of rising raw material costs for the packaging manufacturers and the related lag time to pass those on to customers affect both profit margins and working capital requirements, and therefore are principal rating considerations. The amount and rapidity by which costs increase can serve to depress margins because there is often a lag between the time when the manufacturer’s costs rise and the time when the manufacturer can raise prices. The primary raw materials for plastics manufactures are resins and monomers (such as polyethylene, polyethylene terephthalate — known as PET, polyvinyl carbonate, polypropylene, and many more), the cost of which is linked to oil and natural gas prices. Tinplate steel and aluminum are the essential raw materials for the metal container manufacturers, and soda ash is the principal commodity for glass manufacturers. The freight cost of hauling materials to and from the packaging manufacturers and the usage of natural gas, which is very significant for the furnaces used to make glass products, compound margin pressure when oil and natural gas costs rise.
Sourcing of raw materials Diverse sources of supply are essential for the packaging manufacturers since raw materials are priced as commodities and are subject to supply disruption based on weather or geo-political related events. The tightening of plastics resin supply from the chemical companies and the placement of some packaging manufacturers on allocation due to the effects of hurricanes Katrina and Rita during the fall of 2005 are examples of why supply chain management is a critical risk element.
Rising energy costs Exposure to energy cost increases affects not only the cost of those materials linked to oil and natural gas prices, but also affects utility bills and freight costs — both of which are significant to the manufacturing processes for metals, glass, and plastics containers and films. Long term hedging for a company’s complete requirements of energy or raw materials is not common in the industry given the related expense and complications.
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Moody’s Rating Methodology
KEY RATING ISSUES GOING INTO THE NEXT DECADE Conversion of containers made from one substrate to another During the next decade, Moody’s expects a continuation of changes among packaging substrates used for containers in response to the growing needs and complexities of the end users. Those opportunities for conversion (e.g. from a metal container for household paint to a plastic container) are more abundant in food and medical products and, to a lesser extent, within the quick service restaurants, dairy, and different types of products requiring aseptic filling. The end user’s desire for convenience and portability, or a consumer products company’s desire for improvement in the shelf life of its product, requires complex packaging solutions. The necessary advanced chemistry needed for product viability (e.g. protection from ultra violet light, multi-step sterilization requirements, prohibition of or need for oxygen permeation, increased durability or flexibility, etc.) also fuels innovation, which improves revenue. The result is a “push-pull” among the packaging manufacturer, its customers, and the end users. This often results in movement away from one type of packaging material toward another. When the end users’ demand is strong and their needs are clearly identified and articulated, there is little price sensitivity by the customer of the packaging company. Positive rating consideration is given to those packaging companies having multiple manufacturing capabilities across diverse substrates, thereby mitigating the potential dilution from a customer’s decision to launch (or relaunch) a product in a different packaging material.
Consolidations: Among customers and the resulting effects Packaging companies typically sell to large branded multinational consumer products, food and beverage companies. Doing business with such well-established clientele has distinct advantages when it comes to the level of unit volume and visibility into future throughput, and thus earnings. Offsetting this benefit is the fact that large branded customers have substantial negotiating leverage driven, in part, by their continuing desire to have more than one supplier of their products. Packaging companies are also exposed to consolidation of their customer base. Customer consolidation may result not only in lost volume for the packaging company, but can also result in a stronger more powerful client who may be able to extract both service concessions and discounted prices for extended periods.
Consolidations: LBOs, strategic acquisitions, asset purchases and joint ventures Acquisitions and joint ventures are likely to continue throughout the packaging industry during the next decade. Supporting this is the packaging manufacturer’s need to gain greater negotiating power vis-à-vis its suppliers and customers, to improve capacity, and to increase geographic penetration. Ratings could be negatively affected by the increased financial and business risk associated with potential acquisitions of competitors and asset purchases, as debt financing is expected to be a large portion of any acquisition (strategic or private equity sponsored).
In This Methodology Moody’s approach to rating the metals, glass, and plastics packaging manufacturers, as outlined in this global rating methodology, incorporates the following three steps:
1. Identification of Key Rating Factors Independent of country of domicile, there are three broad rating factors on which Moody’s rating committees focus for the metals, glass, and plastics packaging manufacturers. These key factors are: 1. Financial Leverage and Coverage of Interest Expense 2. Operating Profile 3. Competitive Position Measurements of the three key rating factors are quantified and compared across discrete industry sub-sectors and geographies.
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2. Measurement of Key Rating Factors We present a set of metrics used to quantify each of the three key factors. Our measurements comprise both financial statement metrics as well as other metrics that cannot be derived directly from financial statement analysis but which can be approximated with additional research. These “metrics” are quantitative where we can define an appropriate measure. However, for some factors, qualitative judgment or empirical observation is necessary to determine the appropriate category. In total, the rating methodology incorporates nine metrics, of which six are quantitative and three are qualitative. For each of the nine metrics, we assign a weight based on relative importance: • the six quantitative factors taken together are assigned a weight of 70%, with size having twice the weight of the others, and • the remaining 30% is allocated equally over the three qualitative factors. This results in: • Factor 1 (Financial Leverage and Coverage of Interest Expense) accounting for 30% of the overall rating • Factor 2 (Operating Profile) accounting for 20% • Factor 3 (Competitive Position) for 50%
3. Mapping to the Rating Categories The first step in determining an overall rating is to score each company by rating level on each of the nine metrics. We explain in this methodology how performance on each of the metrics cited maps to Moody’s rating categories, before taking into account any offsetting factors. For each of the nine metrics, we have determined what we consider appropriate ranges for broad rating categories (i.e. A, Baa, Ba, B, Caa and Ca). These ranges represent our expectations on average for each rating category. We recognize that any given company may perform higher or lower on a specific metric than its actual rating level. We highlight those companies whose indicated rating on any particular factor is two or more rating categories higher (positive outlier) or lower (negative outlier) than its existing rating and offer a discussion of the general reasons for outliers within a given metric.
4. Applying the Rating Methodology / Outlier Discussion To determine an overall rating, we convert each of the nine assigned metric ratings into a numeric value based on the following scale: A
Baa
Ba
B
Caa
Ca
1
2
3
4
5
6
We multiply each metric’s numeric value by an assigned weight (refer to the Appendix for weights), and then do a summation. The total is then mapped to the table below, and an overall rating is assigned based on where the score falls in the range. A Baa Ba B Caa Ca
< 1.50 1.50 - 2.49 2.50 - 3.49 3.50 - 4.49 4.50 - 5.49 > 5.50
Moody’s recognizes there are instances in which consolidated financial information may not capture a complete picture of credit risk. This can occur for many reasons, the most common of which relates to restricted group financing arrangements, recently completed or pending mergers that are not yet reflected in reported historical data, reorganization activity, and the prospective nature of a given rating. These instances are identified and explained as part of the overall rating mapping process and assessment.
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Moody’s Rating Methodology
The Three Key Rating Factors FACTOR 1: FINANCIAL LEVERAGE AND COVERAGE OF INTEREST EXPENSE Why it Matters For the packaging manufacturers, financial leverage and interest coverage have the strongest correlation of the nine sub-factors to the ratings, with interest coverage at 77%. We view this factor as the foundation of our ratings analysis, and therefore assign a weighting of 30% — the highest weighting of all the financial metrics used in our methodology. Given the highly capital intensive needs of packaging manufacturers and the modest levels of sustainable free cash flow, financial leverage and coverage of interest expense have proven to be highly predictive measures of default risk and therefore are essential to the quantitative analysis of packaging manufacturers. In general, companies’ sizable fixed assets, combined with significant amounts of revenue under long term contracts, increase the leveragability of these businesses. This factor reflects the cumulative effects of the company’s strategic and fiscal policies. The measurements for financial leverage and coverage of interest expense reflect historical performance and the chosen funding structure. However, the mapping to the ratings category includes an essential forward-looking view that incorporates the company’s need and willingness to increase debt to accommodate extraordinary capital spending or acquisitions, for example, while simultaneously taking a view toward its ability to rapidly return to pre-transaction metrics. However, even a strong management team and a sound business strategy can be offset by financial risk when financial leverage is at the maximum tolerance point and there is insufficient cash flow to get out from under such a burden during the near to intermediate term. The low corporate family ratings of Radnor Holdings, Constar International, and Tekni-Plex reflect situations involving such extreme financial leverage.
Measurement Criteria • • •
Free Cash Flow / Debt Debt / EBITDA EBIT / Interest Expense
Factor Mapping The criteria for each rating category for this factor are as follows:
Factor 1: Financial Leverage and Interest Coverage FCF / Debt Debt / EBITDA EBIT / Interest Expense
A
Baa
Ba
B
Caa
Ca
18%+ 5.50
Moody’s Rating Methodology
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