Citywire Selector

With the prospects of steady and rising demand for glass, falling energy prices and growing green credentials, the outlook for Spanish glass company Vidrala (ES:VID) appears promising. However, its valuation looks low, which has encouraged some of the world's best portfolio managers to make significant bets on the stock.

Citywire Elite Companies AA-rated Vidrala started business back in 1965 and is now the third biggest glass container maker in Western Europe and the leader in Spain and Portugal. It also has a logistics business in the UK which transports packaged food products and offers beverage filling services.

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The company has suffered from the fallout from Covid-19 and soaring energy costs but now looks to be experiencing better times.

Significant investment in new assets is making the business more efficient. It is allowing the company to produce more environmentally friendly glass containers as the world tries to wean itself off plastic.

Vidrala shares are widely held by Digital Stars funds managed by Citywire elite portfolio managers Julien Bernier and Aymar de Léotoing at Chahine Capital, the quant specialist.

Sources: Citywire / Morningstar, latest holdings data.

The two managers explain that they split the European equity market and each stock within it into the fundamental styles of growth, value and quality/visibility and then add momentum as a behavioural factor.

‘While Vidrala's value and visibility current scores are rather in line with the overall European equity markets and its sector peers, its growth score is absolutely outstanding (96%) with no chink in the armour,’ say Bernier and Léotoing.

‘Markets are obviously buying this since Vidrala's 12-month and six-month momentum scores are 99% versus 56% for its sector. Likewise its 12-month Sharpe ratio score, which is also 99%, is exhibiting a very attractive risk-return profile for the past 12 months. Hence, Vidrala can currently be seen as a momentum stock.’

Source: FactSet. Price-to-earnings ratio, EPS growth and dividend yield based on 12-month forecast earnings. EPS = earnings per share; CAGR = compound annual growth rate; Ebit = earnings before interest and tax

Source: FactSet, adjusted earnings figures, data as of 26 Jan 2023. DPS = dividend per share.

The bulk of Vidrala's revenues come from the sales of glass jars and containers to customers in Iberia, the UK and Ireland.

These containers are used by over 1,600 customers to sell products such as beers, wines, spirits, oils, juices, vinegars and preserved foods. Vidrala's customers include some of the world's biggest consumer staples brands. Around two thirds of sales are for beer and wine products.

The glass business operates from eight sites in Europe with 19 furnaces. In total, they make more than eight billion containers a year. Recycled glass makes up to 49% of its products with the potential to increase.

The business is very capital and energy intensive. Glass manufacturing plants are operating 24 hours a day and 365 days a year. The plants have high replacement investment requirements as assets wear out and the company needs to constantly adapt to changes in glass technology.

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Electricity and natural gas costs are immense as the furnaces need to be heated to very high temperatures to make glass. Vidrala tends to hedge a proportion of these costs in order to protect its profits.

Given significant labour costs, Vidrala's business has a very high level of fixed overheads. This ‘operational gearing’ means that its profits are very sensitive to changes in revenues.

Fortunately, the demand for glass has been historically very stable – it tends to track changes in GDP – but when demand fell as it did with Covid's enforced closure of pubs and bars, or energy costs soar as they have in recent years, profits can fall significantly.

Vidrala's sites and furnaces need to be kept busy with orders in order for the company to make decent profits.

Price increases with customers are agreed through contractual pass-through formulas or direct renegotiations. These usually come with a time lag so when costs rise, profits fall before higher selling prices allow them to recover.

The glass container business is competitive, but the industry has consolidated into bigger players over the last few decades. In Western Europe, Vidrala's biggest competitors are O-I Glass and Veralia. Closeness to the customer and service quality are the keys to winning and retaining business.

There is widespread agreement that the world is using too much plastic, especially when it comes to selling food and drink to consumers. Glass is seen as a good solution to this problem, providing its production can become less energy intensive and eliminate its heavy carbon footprint.

The key attraction of glass is that the product is 100% recyclable. It can be reshaped over and over again without losing any of its properties. It also protects and preserves the food and drink within it, as a hygienic and healthy type of packaging.

Big consumer brand companies also like the versatility of glass as it can be used to signal product quality and premiumisation and therefore a way of differentiating products.

Vidrala is making significant investments in its business in order to make it more energy efficient. If successful, its profits should be able to grow as it intends to become one of the leading manufacturers of carbon neutral or net zero glass products.

It is worth noting that Vidrala's investment record is already fairly good. Its return on invested capital (ROIC) is respectable and more than covers its cost of capital - the minimum return investors demand to invest in its business.

Vidrala is spending money to electrify its manufacturing plants to reduce their reliance on natural gas and cut carbon dioxide emissions. The spending is focused on renewable solar energy and an increase in energy self-sufficiency.

There is also ongoing investment in green hydrogen with the building of a hydrogen furnace at Elton in Surrey, England. This will result in the first scale production of net zero glass bottles by 2027.

CO2 emissions are expected to be reduced in this plant by 90% due to the use of green energy and hydrogen, with carbon capture taking out the remainder.

By 2030, it is expected that the facility will produce 200 million net zero bottles for drinks giant Diageo for the use in brands such as Smirnoff vodka and Tanqueray gin.

Vidrala's recent £30m acquisition of logistics and beverage filling facilities in Bristol is backed by a long-term supply agreement with Accolade Wines which uses 100% renewable energy.

As well as improving its efficiency and green credentials, Vidrala is investing in extra production capacity as well as expanding into new markets by taking a 29.4% stake in Brazilian company, Vidroporto.

Vidrala intends to eventually buy Vidroporto outright. While giving it a new market to earn money from, it also helps to cement existing relationships with the big drinks companies.

Vidrala's earnings before interest and tax had not seen much growth between 2017 and 2022. Covid-19 resulted in a hit to profits, as did soaring energy costs in 2022. This year is looking much better as cost savings and price increases kick in.

While sales volumes are not expected to increase much due to weak economic growth, selling prices have risen. According to the company, this should feed through to double-digit gains in revenues and earnings per share (EPS) growth of 40% to more than €7.

Looking at current analyst estimates, EPS is likely to be nearer €8 following a series of forecast upgrades in recent months.

At the moment EPS is expected to fall back slightly in 2024 and 2025. The key uncertainty here is energy costs which have been falling in recent months.

Vidrala has hedged 65% of its costs for 2023 but only 25% for 2024. Falling energy prices will have to be passed back to customers in lower prices but if glass volumes hold up or increase modestly, there could be grounds for further forecast upgrades.

Despite this, Vidrala shares look as cheap as they have been in the last decade based on estimates of its earnings over the next 12 months. At less than 12 times earnings, they do not look expensive in absolute terms either.

That said, shares of the world's biggest glass producer, Citywire Elite Companies A-rated O-I Glass (US:OI) trade on less than seven times forecast earnings. Some of the difference with Vidrala can be explained by O-I's much higher debt levels and much lower levels of interest cover.

A combination of high financial and operational gearing can be a lethal mix if revenues fall. Vidrala's lower debts make a less risky play in this respect.

Taking into account the impact of debt using enterprise valuations, the difference between Vidrala and O-I is not as big. Vidrala trades on a forecast EV/Ebit of 10.1 times compared to 7.7 times for O-I.

Vidrala shares have slightly underperformed the Spanish IBEX 35 index this year (11.8% versus 14.8%) but could see their valuation rerate if forecasts are upgraded and its investments in its green credentials improve its competitive position.