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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Thank you for joining the Silgan Holdings Fourth Quarter and Full Year 2017 Earnings Results Call. Today's call is being recorded. At this time, I'd like to turn the conference over to Kim Ulmer, Vice President, Finance and Treasurer. Please go ahead.
Thank you. Joining me from the company today I have Tony Allott, President and CEO; Bob Lewis, EVP and CFO; and Adam Greenlee, EVP and COO.
Before we begin the call today, we would like to make it clear that certain statements made today on this conference call may be forward-looking statements. These forward-looking statements are made based upon management's expectations and beliefs concerning future events impacting the company, and, therefore involve a number of uncertainties and risks, including but not limited to those described in the company's Annual Report on Form 10-K for 2016 and other filings with the SEC. Therefore, the actual results of operations or financial condition of the company could differ materially from those expressed or implied in the forward-looking statements.
With that, I'll turn it over to Tony.
Thanks, Kim. Welcome everyone to our 2017 year-end earnings conference call. I want to start by making a few comments about the highlights of 2017 and then provide a brief update regarding 2018 outlook. Bob will then review the financial performance for the full year and fourth quarter and provide more details around the 2018 outlook. Afterwards, Bob, Adam and I will be pleased to take any questions.
As covered in our press release, 2017 was a very good year for the company with record fourth quarter and full year results, both on a reported and an adjusted basis and leaving us well positioned to continue to grow and create shareholder value. Among the milestones for the year we delivered, we recorded net income per share of $2.42. Delivered record adjusted net income per share of $1.65. Generated free cash flow of $224.1 million or $2.01 per share. Enhanced the scope and growth opportunities of the company with the acquisition of Dispensing Systems. Exceeded our targeted improvement in the plastic container business. Initiated construction on two new manufacturing facilities to support customer growth.
Recognized $110.9 million net reduction in future cash tax obligations primarily due to the recently enacted U.S. Tax Cut and Jobs Act. Refinanced our debt portfolio to extend maturities, increase flexibility and increase long-term fixed rate debt at attractive interest rate. Completed our third two for one stock split and increased the cash dividend by approximately 6%. As a result of these strategic initiatives and the contributions of Silgan's employees around the globe, our adjusted earnings per share were up 33% in the fourth quarter, 20% for the full year and free cash flow was up 25% versus 2016.
Each of our operating businesses improved solidly over the prior year for the quarter and the full year. Perhaps more importantly we have increased the growth opportunities for the company, both organically and through potential future acquisitions with the significantly increased product capabilities in our closure business as well as through successfully lowering the cost position and service performance of our plastics business.
The new tax act furthers this opportunity by increasing the anticipated cash generation from a majority of our businesses which had historically been operating with a comparatively high cash tax burden versus many of our competitors. As a result of these factors, we are providing 2018 guidance for adjusted earnings per diluted share in the range of $2.03 to $2.13, which represents another 23% to 29% year on year improvement in adjusted earnings per share.
In addition, we expect free cash flow in 2018 to improve by up to 34% to approximately $300 million. With that I will turn it over to Bob.
Thank you, Tony. Good morning, everyone. As Tony highlighted 2017 benefitted from the successful completion of several strategic initiatives, some of which were initiated in early 2016. These initiatives were designed to eliminate excess manufacturing and logistical cost, exit high cost production facilities and allows us to better serve our customers for the longer term.
We also benefitted from a strategic acquisition during the year and are positioned to eliminate a competitive disadvantage as a result of the recent enactment of the U.S. Tax Cuts and Jobs Act, which will fundamentally improve our future free cash flow of our business. As a result, in 2017 we delivered adjusted earnings per diluted share of $1.65 and we delivered free cash flow of $224.1 million. On a consolidated basis, net sales for the year were $4 billion, an increase of $477 million or 13.2% over the prior year. This increase was primarily attributable to the inclusion of the Dispensing Systems acquisition and higher net sales in our legacy businesses.
We converted these sales to net income for the year of $269.7 million or $2.42 per diluted share as compared to 2016 net income of $153.4 million or $1.27 per diluted share. Adjustments decreasing earnings per share in 2017 totaled $0.77 including $1 per share in net tax adjustments reflecting reduced future cash tax obligations under the newly enacted tax reform.
In 2016, adjusted earnings per share benefitted by adjustments that increased earnings per share by $0.11. As a result, adjusted net income per diluted share was $1.65 in '17 versus $1.38 in '16. Interest expense before loss on early extinguishment of debt increased $42.4 million to $110.2 million, primarily due to the higher average outstanding borrowings, principally as a result of the additional borrowings to fund the Dispensing Systems acquisition in April and higher weighted average interest rates including the impact from increasing long-term fixed rate debt through the February 2017 issuance of the 4 3/4% senior notes due 2025, and the 3 1/4% senior notes also due 2025, and rising short term interest rate.
In addition, we incurred a loss on early extinguishment of debt of $7.1 million as a result of the prepayment of outstanding U.S. and Euro term loans under the previous senior secured credit facility in conjunction with the issuance of the new senior notes and the April 2017 partial redemption of the 5% senior notes due in 2020. Our 2017 effective tax rate was a negative 12.5% as compared to the 2016 rates of 33.9%. The 2017 rate was favorably impacted by the benefit from the effective tax rate adjustments totaling $110.9 million or $1 per share.
These adjustments are primarily the result of the reevaluation of net deferred tax liabilities to reflect lower future cash tax obligations as a result of the reduction in the U.S. corporate tax rates under the recently enacted U.S. Tax Cuts and Jobs Act of 2017. The effective tax rate, exclusive of these effective tax rates adjustments would have been 33.8%, generally in line with the prior year. Full year capital expenditures totaled $174.5 million in 2017 which includes additional capital investments for the newly acquired Dispensing Systems operation.
Capital investments in 2016 totaled $191.9 million, which included cost associated with the new plant expansions and investments to support our footprint optimization plans. Additionally, we paid a quarterly dividend of $0.09 per share in December, the total cash cost of that dividend was $10.1 million and for the full year we returned $40.5 million to shareholders in the form of dividends. As outlined in table C, we generated free cash flow of $224.1 million or $2.01 per share versus $179.9 million or $1.49 per share in the prior year.
I will now provide some specifics regarding the financial performance of each of our three business franchises. The metal container business recorded net sales of $2.28 billion, up $6.2 million versus the prior year. This increase was primarily due to the pass-through of higher raw material cost and the impact of favorable foreign currency translation of $5.2 million, partially offset by lower unit volumes of approximately 2% attributable to lower soup volumes and a less favorable fruit and tomato pack on the west coast of the U.S.
Income from operations in the metal container business was $230.2 million, an increase of $15.5 million versus the prior year. This increase was primarily due to lower manufacturing cost, lower rationalization charges and the favorable impact from an increase in inventories in the current year as compared to a decrease in inventories in the prior year. These benefits were partially offset by the impact of lower unit volumes, the unfavorable impact from the contractual pass through to customers of indexed deflation, an increase in depreciation expense, the unfavorable impact from the resolution of a past non-commercial legal dispute, and foreign currency losses in the current year period as compared to foreign currency gains in the prior year period.
Net sales in the closures business increased $449.6 million to $1.25 billion in 2017, primarily due to the inclusion of the Dispensing Systems operations, the pass through of higher raw material cost, and the impact of favorable foreign currency translation of $6.7 million. These benefits were partially offset by approximately 3% lower volumes in the legacy closures operation as compared to record volumes in the prior year period. Unit volume declines were attributable to the decline in single serve beverages due to colder weather conditions in major markets served.
Income from operations in the closures business for 2017 increased $42.2 million to $142 million, primarily due to the inclusion of the Dispensing Systems operations and lower manufacturing costs, partially offset by the impact from lower volumes in the legacy closures operations. We also recorded a onetime write-up of inventory for purchase accounting totaling $11.9 million in the second quarter of 2017 which negatively impacted operating margin for the year.
Net sales in the plastic container business increased $21.1 million to $565.1 million in 2017, principally due to the pass through of higher raw material costs, higher volumes of approximately 2%, and the impact of favorable foreign currency translation of $1.2 million, partially offset by a less favorable mix of products sold. Operating income increased $22.6 million to $27.8 million for the year, largely attributable to lower manufacturing cost, higher volumes and lower rationalization charges, partially offset by higher depreciation expense and the unfavorable impact from the lagged pass through of increases in resin cost.
For the fourth quarter we reported earnings per diluted share of $1.31, as compared to $0.20 in the prior year quarter. We recorded adjustments reducing earnings by $0.99 per diluted share in 2017, largely a result of the net tax adjustments reducing future tax obligations. We recorded adjustments increasing income of $0.04 per share in 2016 and as a result we delivered adjusted earnings per diluted share of $0.32 in the fourth quarter of '17 versus $0.24 per diluted share in the same quarter of last year.
Net sales for the quarter increased $189.8 million versus the prior year, driven primarily by the inclusion of the Dispensing Systems operation, the pass through of higher raw material cost, the impact of favorable foreign currency translation and an increase in volumes of approximately 4% in the plastic container business. These benefits were partially offset by a decrease in unit volumes in the legacy closures operation and the metal container business of approximately 4% and 1% respectively.
Income from operations for the fourth quarter of 2017 increased by $34.2 million to $86.4 million, primarily as a result of the inclusion of the Dispensing Systems operations, manufacturing efficiencies and lower cost in each of our businesses, the favorable impact in the metal container business of an increase in inventories in the fourth quarter of 2017, as compared to an inventory decline in the prior year period. Lower rationalization charges and higher unit volumes in the plastic container business also benefitted the quarter. These benefits were partially offset by lower unit volumes in the legacy closure operations and the metal container business and the unfavorable impact from the contractual pass-through to customers of indexed deflation in the metal container business.
The tax rate for the fourth quarter of 2017 was a negative 159.2% versus 32.4% in the prior year quarter. The fourth quarter 2017 tax rate benefitted due to the impact of the recently enacted U.S. Tax Cuts and Jobs Act. During the quarter we recorded effective tax rate adjustments of $110.9 million, primarily to revalue the net deferred tax liability to reflect the lower future cash tax obligations. Exclusive of this adjustment, the fourth quarter rate would have been 37.6% which is somewhat higher than anticipated due to the settlement of certain outstanding tax disputes, partly offset by higher income in more favorable tax jurisdictions.
Turning now to our outlook for 2018. Our current estimate of adjusted earnings per diluted share for 2018 is a range of $2.03 to $2.13. Reflected in our estimate for 2018 are the following. Operating income in the metal container business is forecasted to benefit from continued manufacturing efficiencies and the lagged contractual pass through to customers of indexed inflation which are expected to be largely offset by the unfavorable impact from significant reductions in inventory which we expect to be approximately $60 million over the course of 2018. Not all of this improvement will benefit free cash flow in the current year due to the timing of the inventory reductions and our corresponding payment terms with our vendors.
The closures business is expected to benefit from the full year of the Dispensing Systems operations including synergies, the options of the purchase accounting inventory write-up reported in the second quarter of 2017, continued benefits of manufacturing efficiencies and higher unit volumes. We are expecting the plastic container business to benefit from continued manufacturing efficiencies and volume growth. These benefits will be partially offset by costs associated with the startup of the new Fort Smith, Arkansas facility.
In addition, we expect interest expense to increase versus 2017, largely as a result of higher average short-term interest rates and higher average outstanding as a result of a fully year of borrowings to fund the Dispensing Systems acquisition, partially offset by the benefit from the portion of 2017 free cash flow used to pay down debt. We currently expect our tax rate to be approximately 24% but it is subject to adjustments as more guidance is provided around the recently enacted Job Cuts Act. Also we expect capital expenditures in 2018 to be approximately $200 million as we have chosen to utilize a portion of our cash tax savings to fund additional high return projects, including the two new facilities announced to support customer growth largely impact [free] [ph].
We are also providing a first quarter 2018 estimate of adjusted earnings in the range of $0.32 to $0.36 per share, excluding rationalization charges, loss on early extinguishment of debt and cost attributable to announced acquisitions. This compares to $0.31 in the first quarter of 2017. This increase is primarily a result of the inclusion of the Dispensing Systems operation and the benefit of the lower effective tax rate, partly offset by higher interest expense, lower operating profit in the metal container business due to the unfavorable impact of the inventory reduction program and a very strong product mix in the first quarter of 2017. And the unfavorable impact from the pass through of increases in resin cost.
Based on our current outlook for 2018, we expect free cash flow to be approximately $300 million, a 34% increase versus free cash flow of $224.1 million in 2017. This increase is expected to be driven by improved operating income in each of our businesses including the benefit from a full year of the dispensing systems operation, net improvement in working capital as a result of the significant reduction in inventories in the metal container business, and lower cash taxes.
These benefits will be partially offset by an increase in interest payments and higher capital expenditures. That concludes our prepared remarks. I will turn it over to David and he can provide directions for the Q&A session.
[Operator Instructions] We will take our first question from Mark Wilde with BMO Capital Markets.
I wondered if it's possible for you to just parse out in maybe a little more detail those swing elements in the free cash flow guidance. You have given some of it already. You have given us like the CapEx numbers are going to be up $25 million. I just wondered if you can help us a little more on some of the other pieces.
Yes, sure. So if you are bridging that, basically you have got roughly $40 million coming from the dispensing systems operation, which includes the synergy. It also offsets the acquisition cost that we had in 2017 and then basically you have got the interest hit there of roughly $10 million and some capital. And then you have got some legacy business improvement in the EBITDA of, call it somewhere between $15 million and $25 million. And then you have got the working capital benefit that we talked about and that’s offset by incremental CapEx and higher interest and that is a bit of a cash tax benefit. So those are the primary pieces.
Okay. And, Bob, is it possible to give a little bit more color on the two projects that you have announced with the release of the Allentown project and the Fort Smith project.
Sure. It's Tony. I think what we in the release is mostly what we have for you. We have seen growth opportunities for both of those businesses. On the Allentown side it's a relative small two piece can plant, just supporting growth for a key customer in that region. I think maybe more importantly and slightly more -- and that, by the way, the cost of that at this stage is some $15 million. So just to scale the size for you. I think the Fort Smith one is perhaps a bit more interesting. That is a plastic thermoform business. As I think you know we have acquired the Rexam business several years ago and have been very happy with the free cash generation of that business and have been seeing some growth as it sort of filled up its capacity in a single plant. And really our hope all along is that it would be able to grow out into a second plant. And essentially what's happened here is that it has had that opportunity with some really interesting growth opportunities coming forward that we are now building a second plant. That will be in $30 millionish range of cost.
Okay. All right, that’s helpful. Then finally, Tony, I wondered if you could just give us some sense of how you see the path forward this year on the turnaround in the plastics business. I know now you are starting to focus more on selling new volume and trying to kind of increase the load on those plants. So if we could maybe get some sense on how that’s going and how you think the cadence looks as we move through the year.
Sure. We are obviously very pleased with the progress the business made on its cost side this year. Which was our key focus. We needed to get the cost -- again, recall this all started with an effort for us to get the competitive cost position of that business in a better spot. That took a little longer than we thought. It was a bit more challenging as we went through it and I would say that we have now come through that process. Feel very good about the cost position of the business. As you know we have called out sales through that process of business that was less attractive to us. And so you are right that we now believe we are at a spot where we can begin to get back to growth. You already saw it for the year, up 2%. Quarter up 4%. I wouldn’t read too much into that discrepancy by the way, that’s kind of just the lumpiness of growth if you will.
I would think that we will be -- our expectation is something like 2% growth continues. Obviously, that’s not enough to get us all the way where we want to go but a, it takes a lot of the growth in that business. You got to get capacity in place, get tooling, ramp up for customers. So we look for modest top line growth but increased backlog as we go and continued cost reduction and work on the cost side. So that would be a big part of the EBIT improvement. But as Bob said, our expectation is for improvement. Not on the scale that you saw in 2017 of course but meaningful nonetheless.
And next we will go to Chip Dillon with Vertical Research.
You mentioned in your press -- I am sorry, in your comments and press release about the volume for food cans this year and there could be some potential declines in other can markets. I thought maybe, perhaps you are talking about soup, but maybe you could give us a little more clarity on that.
Sure. I think exactly we said, we are not trying to signal anything there other than what we kind of generally say about the can business, which is that we see it as being probably flattish over time and that’s because there are some markets that are growing and we list some of those. And then there are some that have had certain trend line where it has been a little more challenging, soup being a clear example of that. I would not read that as saying we think that’s a permanent answer for soup by just saying that it's a much longer question of whether consumer preference, an interest in the product and the package can change over time. But that’s all that’s really implying is that we see growth in some markets. We see a little bit of recovery in the west coast, vegetable pack. And we offset that with some markets may well see a little bit of trended declines.
Okay. And speaking of volumes, when you look at Dispensing Systems, I guess the acquisition of, the kind of the lapse in the second quarter. And so what kind of volumes would you be looking for since then and it will be all organic at that point. What kind of range should we expect for the rest of the year there and perhaps in the '19?
Sure. Good question. Probably won't surprise [them] on the call but we have been very pleased with the Dispensing Systems business thus far. Not only as it achieved integration and synergy target but they have hit their numbers along the way and there was some growth in the current year. Even though current being 2017, even though we had seen some declines on the home and garden side. We are obviously expecting the home and garden to be better season in 2018 and some of those other markets that have been growing through '17, we expect to continue in 2018. So the number I would put out there for you, something in that 3% to 4% range.
And next we will go to Anthony Pettinari with Citi.
Just following up on metal container volumes. I think in 4Q the industry was up 2% and you were down 1% and you talked about soup and then a less favorable west coast harvest. I was wondering if it is possible to parse out how much of that was soup versus the weaker harvest. And then you have a customer that announced a plant closure in Canada. Is that something that’s impactful for you going forward or is that just kind of part of some of the long-term pressures you talked about.
Sure. And just to clarify, your question is really on the volume in the quarter, right?
Yes. Yes.
Yes. Okay. So I would say the impact on the volume in the quarter for us where we were down about 1%, as you said. Europe was down a little bit and then, as you point out, soup was down. And I would say soup there were, recall there were a couple of things going on in there. One, you had a customer was moving a fill site and so that had some impact that would have carried in the quarter, we believe. Then you had another customer who was in negotiations with their end customer. So that had some impact on it. So those were kind of the two things that were going on in soup. Not really a lot else there. There have been, as we have talked about in Q2 or Q3, there has been a fairly small competitive loss that we had incurred. So there was a little bit more of that in Q3 as well.
So that kind of what happened. If you compared that to the rest of the market which did have a little more growth, I would remind you that I think it was made clear in Q3 that some of the vegetable pack in the Midwest, I think particularly southern Midwest, had shifted a bit from Q3 to Q4. That’s a market we are underrepresented in. So it makes perfect sense to us that the rest of the market got some of that pack business in Q4 that we were not expecting to get, as a difference there. It is true that one of our customers has announced shutting of a fill plant. That really had zero impact on us. We were importing cans to them from a plant in the U.S. and we will continue to do that. Now too they are moving basically that fill to another one of their plants in the U.S. and they had really more changes as and of where we ship the cans to.
Okay. That’s extremely helpful. And then just a follow up on Allentown and Fort Smith. It sounds like Allentown is serving and existing customer. In terms of Fort Smith, are you -- is that being built to serve a large customer or multiple customers and do you have committed volumes as you ramp that plant.
Yes. So on Fort Smith, the plant is not just to do any one thing. It is primarily being supported right now by growth of one existing customer. And, yes, that particular customer we have long-term contract with.
All right. And next we will go to Chris Manuel from Wells Fargo.
This is actually [Gabe] [ph] sitting in for Chris. One question that’s probably a little bit higher level for you, Bob. Just thinking about the change in tax rates. Does that in anyway alter sort of the hurdle rate for you guys with respect to both kind of internal investment as well as M&A and maybe open up the pipeline of investments that you otherwise might not have thought about or considered allocating capital towards, with a more favorable tax environment. And I ask that question sort of in the context of having some of your food can asset sort of co-located with customers and stuff like that and/or appreciating that some of them are somewhat older.
Yes. Look, there is no question that with the lower cash tax rate, your after tax returns look better. So I think it's incumbent upon us to make sure that we don’t open that gap to too much so that we are taking on projects that we actually aren't earning the kind of return that we would be accustomed to. But I think on the margins, there is opportunity for us to put some good value creating projects on the list that benefit from the lower tax rate as well. So I think it does help the investment thesis over time but the point is to not let the air out of that too quickly.
And Gabe, just a thought on this, at the very end you mentioned the assets, somewhat older, I think I couldn’t help but react to that a little bit. I think while it's true, we would not look at our can assets and say that we see a whole lot of inefficiencies sitting on our system that these are much slower etcetera, lines. So I wouldn’t want to leave you with a wrong impression of that. We have invested where it makes sense as long as we have been in the business. Yes, the hurdle changes here a little bit but it's not as if we are sitting with a huge amount of un-invested opportunity. That’s not how we view it.
Okay. If I were to try to frame up the number and I think about legacy Silgan, sort of standalone CapEx of 135, 140 plus 15 from the acquired Dispensing Systems business. Could that maybe migrate closer to kind of the 175 range for some period of time or is that just putting to fine of a point on it.
Yes. The 175 is kind of where we would have targeted this year, right. 2017. And I think we are moving that up a little bit which does include the two new plants. And some of that is, as we are taking on some new projects because of the tax benefit, freeing up some cash. So I would probably put the number on an ongoing basis, probably somewhere between that 175 and 200 as being pretty normal on a go forward basis. Obviously the 200 is a little bit to the high side but I think we will find out opportunities to invest with customers and the like. So that’s kind of the norm including Dispensing Systems. And that’s similar to what we said in the acquisition call as well.
Understood. One last quick one, hopefully, and I apologize if I missed it. Did you guys talk about timing of the Newport or Fort Smith online and servicing customers as more of a 2019 event.
Yes. It's probably a '19 event by the time you see any benefits. So the plant will be under construction for most of the first half of the year into Q3. We will probably go through some qualification in Q4 and have commercial volume being sold in '19. So that is a net drag of a bit on 2018 earnings as well.
And next we will go to Scott Gaffner with Barclays.
Just want to -- first question is really a follow up. When you look at some of these high return projects, what exactly is the return hurdle or return threshold that you are looking for to take on these projects today.
Well, typically we have said that we look at whether it's a CapEx project or an acquisition, or a restructuring. We look at all of them from a cash in, cash out basis. Typically we have looked at a pre-tax return from an IRR standpoint that’s been -- from an acquisition it's probably been in the low teens. When we are putting new capital into the business, we are looking certainly above that and that’s kind of helped us maintain our average returns in the mid to higher teens. So on a pretax basis, I am not sure that return changes much but obviously you get a benefit on the tax side. So overtime I think it will open up some opportunities for us to spread the edges just a bit.
Okay. And Tony, I think in your prepared remarks or maybe within the press release, you talked about being previously disadvantaged from having a high cash tax relative to your competitors. Can you sort of parse out that comment, what sort of competitors you were focusing on in that commentary in your plastic business?
Well, no. It could be across the board. I mean we have lots of our competitors are and more heavily on the international side on tax that we compete with. So it could be in plastic, certainly in the can side it's true too, that we have a higher tax rate. I think even if you want to talk about who our [indiscernible] competes with, I think across the board we have been kind of comparatively at relatively higher tax rate. In other way I think that Silgan is a poster child for a company that benefits from this tax change. We have been a highly profitable, high tax payer for a long period of time. Heavily in the U.S. Competing with a lot of companies that are in the different jurisdictions to get the benefit of global tax structures, treaties that we didn’t have. So, again, I think it give us an advantage against that entire population versus where we were before.
Yes. Scott, I think one of the important things not to miss is that this tax change does permanently improve the free cash flow generation of this business. And that’s comparative to the competitive landscape.
Right. No, that’s fair. I guess on the working capital benefit though, I mean, Bob, you mentioned a $60 million -- I think you mentioned a $60 million negative impact to segment operating profit. Is that right and if so--?
No, no. The $60 million is the inventory that we plan to take out. Now that will be impacted to some degree by inflation that we will experience on a year over year basis. But that $60 million of inventory will come out and that will yield -- it won't yield free cash flow in 2018 because of the timing of some of those reductions against the payment terms that we have with our corresponding vendors. So of that we are expecting that we will get some $25 million or $30 million of cash benefit on a year over year basis. And that probably has somewhere in the $10 million to $15 million drag on earnings over the course of the year. And that will be split between Q1 and Q4 as we take the inventory out on the shoulder periods of the slower season.
All right. That’s really helpful. Last one for me is just on transportation cost. Can you talk about -- I think you don’t use very much rail other then on the way in for steel. But can you talk about rail versus truck and any sort of inflationary pressure you are feeling there and just your ability to pass that through. Is it mostly through the contracts or how should we think about that?
Sure. That’s a good question by the way. So transportation has been a bit of a challenge since the hurricanes of the fall. There is definitely a very tight supply for trucks primarily. So you are right that that rail for would be more inbound and as a rule it's truck outbound. And so there absolutely has been inflation. It's in our numbers. Currently we are assuming there will be inflation as we go forward and it varies across our business. As a general rule a lot of it gets past through but not all of it. And of course, by the way, some of the moving things between our plants too and that’s generally our problem. So it's a headwind for us and one that we are managing.
And next we will go to Ghansham Panjabi with Baird.
First off, just as a clarification, is the Allentown for metal food sort of part of your longer term footprint optimization. As the end markets themselves are changing, growth in pet food, declines elsewhere. And if that is the case, should we expect the capacity cut elsewhere in your production footprint as an offset over time.
No, that site is totally fueling growth in a geographic region that suits the customer.
And can you size the incremental business for us?
Yes. $15 million capital investment. So I think that’s kind of the site..
So I mean mostly there were public announcements about the site, we wanted to be sure everybody understood what was ongoing on. So we don’t typically talk specifically about a single $15 million investment.
Okay. And then just in terms of the like for like volumes for the acquired Dispensing Assets. I am sorry if I missed it but can break that up for us. And also why is legacy Silgan closure still down on the heels of a pretty large decline in 3Q as well. Is this customer specific, end market specific and how does that break down between metal and plastics.
Hey, Ghansham, it's Adam. I will start with the last question first, on the legacy closures. Again, as we had talked about in Q3, really the cooler weather and wet conditions in the U.S. market really did effect our single serve beverage business. And at the time that we were talking about that in Q3, we expected Q4 volumes to be down versus prior year as well. Remembering that 2016 was a record year in volumes for our single serve business. So it was a tough comp anyway but I would say our volumes were roughly in line with what we expected and as we look at the business we feel great about where legacy closures business is. And it's well positioned for growth in 2018 and won't be back to the record levels of 2017 or at least we don’t expect it to be at this point. But we are well positioned for growth in that business.
For the most part it was on the plastic side of our metal plastic distribution because it was the single serve beverages. Again, sports drinks, [indiscernible] tea, those types of products. Like for like Dispensing Systems business, unit volumes were up slightly. The business has performed well. As Tony said, we had a market that was challenged in 2017 in the home and garden market. That was really offset by growth in a variety of other markets, probably led by fragrance and healthcare and again well positioned for growth, well positioned for recovery in home and garden in 2018. So across the board in our closures business, I think we are feeling really good about the prospects of 2018.
And next we will go to Tom Narayan with RBC Capital Markets.
Actually my first question is a follow up on Mark's question, and thanks a lot for providing that bridge to the free cash flow guide. When I do the math on the numbers you gave, I am getting a $50 million source of cash on working cap. I know you guys said $25 million to $30 million was from inventory take out. Just curious what was causing the rest of that. And also the $20 million on the EBITDA benefit, what was behind that expectation? How does that compare to what you have gotten previously?
Yes. I think the working capital difference there is we had some benefit in 2017 from working capital improvement as well. So the 25 to 30 that I gave you is the net year over year benefit. So it depends upon from where you are starting bridge is.
Okay. And then the $20 million EBITDA expectation. What was behind that?
Yes. That’s just improvement across the businesses.
Okay. And on the 1Q guide, there were three components you called out in the release. The year-over-year seasonal inventory build lagged resin prices and higher interest. Could you maybe rank which is the biggest contributor and maybe what's really behind that first component.
I am not sure I got the first. But the big components on the Q1 comparison are, first and foremost is the inventory reduction that Bob has been talking about. Again, we are going to be looking to take $60 million of inventory out on a pre-inflated basis. And we will do that roughly one third in the first quarter and two thirds in the fourth quarter. And so you are going to have it, it's a $50 million overall overhead cost and for those that aren't tracking with us, basically you just add, allow the fixed cost of your business and let them into [trailing] [ph] in your balance sheet and lead those cost plus through your P&L. So you will get roughly one third of that in the first quarter of call it 5ish million in the quarter. The second part in the container, in the food can business is, if you look back at that quarter a year ago, we had a really good mix because we were getting a lot of the pet cans out early in that year and so we are comparing against that and that’s got some 3ish million of impact as well. So most sizable when you compare the total businesses, the bulk of this is going to sit in our metal food can business, which could be down than what I just gave you, some 9ish million dollars in total.
The rest of the inventory spread amongst our businesses, sorry, would be resin impact spread amongst our businesses. Although the bulk of that is probably going to be in closures given kind of which resins are doing well.
Okay. And then so the inventory adjustment, that’s the primary cause for the Q1.
That’s number one.
And next we will go to George Staphos with Bank of America Merrill Lynch.
Congratulations on the year and Tony good luck on Sunday as well. And also feel better, so like you are battling something there. So I want to go back to that question that Tom was teeing up earlier. So if we try to equate the $50 million effect to earnings to volume, or the $60 million working capital. I was very roughly and probably incorrectly coming up with maybe a 4% to 5% drop in production. Is that reasonably accurate for the year for the food can business?
Yes, it's reasonably accurate. But I think you are a little high.
Okay. Understood. Thank you for that. And I guess the one question, not that anyone is perfect, certainly we are not but if we ask the question what was it that caused you to have to take the working capital out. Recognizing it's a good thing in some ways, it will help fund your CapEx. What happened that you had to take this sort of one off adjustment in working capital in prior periods.
It's a great question, George and I kind of wish we could redo this call over again and say this to us is totally expected. Maybe we should have signaled it much sooner. But basically we went through a major footprint optimization of our can manufacturing assets. We improved the layout of those assets for our current needs etcetera. We had indicated that left us with excess capacity in three piece at this stage. We had indicated that that’s not one plant that goes out, that’s across lots of plants. And so the net of all that means that we have got better served asset as well and therefore less need to carry quite as much inventory. And that has been known to us for a long time but that’s some point you will do it.
Also as we went through this rather major process of rationalizing our footprint, we had to build inventory. We had to have inventory ready from the old assets for the new assets that came on. Then we had to run up the new assets and so over the course of the last three years, we have built inventory mostly at the beginning of the project. So that’s kind of what's happened. So to us this is kind of a natural extension of where we are now. That we work this inventory down. It's our intention that this is a more permanent level for the business going forward. It will not only produce cash for us this year but it will also reduce overall operating cost of the business going forward. Less packaging materials needed, less warehousing, more efficient in terms of moving items around. And so it's just the right thing to do for the business. Generate cash and by the way it has a non-cash P&L hit in the process of doing it.
Tony, that’s very clear. I appreciate that. One thing again. Everyone in Washington should be happy with what you are doing in terms of using the tax proceeds, some of it to invest for growth. The investment this year in plastics and also in metal, I didn’t hear if you call that if there is any kind of operating cost negative from those investments in this year. Would it be more of a '19 event after you are done with the capitalizing then you start running the equipment.
No. Bob did mention it but I can understand that and everything, you may not have heard it, but particularly in the plastics business, there is a couple of million dollars or so of cost associated with the plant. That’s embedded in our outlook for that business. And on the can side a little less so just because of the scale of it against the can business it's not really worth discussing.
Okay. Two last quick ones and I will turn it over and try to come back. So a $15 million food can plant, I don’t that I have ever heard of one that that is so byte sized now. Are you utilizing a pre-existing line or is that new equipment that’s going to the $15 million plant. And the plastics plant, is that aimed at a foot processing based customer or is the customer more in fresh products. Just curious on that. Thank you and I will turn it over.
Sure. So on the food can one, you are right about that. It's possible this plant will get bigger in time but certainly this plant relies upon the infrastructure of the entirety of our can business. So it's making a particular can, it needs any supply from somewhere else is better. So it's more about the geographic play that’s good for the customer and good for us. And it's a very discreet operating cell so it's reasonably efficient to do it in that manner. The plastic business, it will be for kind of anything that our thermoform business, barrier thermoform business tends to sell to, which are food based. Even for humans or pets, so that it is not -- if your question is that, is it personal care or anything else like that. No, it's human or pet food is the market that will be served.
Okay. It sounds more process on plastic and then on food can, it sounds like it was a new line.
That’s right.
Yes.
And next we will go to Debbie Jones with Deutsche Bank.
My question is actually looking to Europe, or focusing a lot more on U.S. because of tax reform, but I didn’t quite catch what your volume expectation is in Europe metal food. And then I just wanted to ask, what's the strategic direction of your business there? What's your capital spend? Is there an M&A pipeline or is everything really now just being directed towards plastics and other U.S. businesses?
So Europe food cans, good question. The expectation is for modest growth in that market. They had a reasonable year this year and so there is not any kind of major change there. Again, for history I will recall for everybody that when we acquired the business, the ideas was really to move heavy into eastern developing markets. Those markets in some cases are not as developing and interesting as they once were, so we kind of slowed that down a bit. Some of those markets that's less true, for instance in Russia we continue to grow and have an interesting operation. Although we are doing that kind of modestly and in a disciplined manner if you will. So we continue to like what the business is doing but are really assessing kind of where that growth goes. We are happy just leave it where it is and growing a little bit more organically, right now, and watching the overall market.
Okay. Thanks. That’s helpful. And my second question. Maybe too many steps I had here, but I have seen a number of consumer analysts taking down their margin assumptions for some companies including some of your customers and the idea being you know wage inflation, increased marketing spend. And in some cases, pricing moving down on a competitive level. Is there a risk and do you think about this as a risk that that kind of has a trickledown effect to your margins.
Well, there is certainly, there is a lot to that. I mean many of our businesses we have pass through of our inflation of labor. At least on an indexed base, can business as an example. So in that market it's actually been the deflation of last couple of years that’s been a problem for us, as we talked about. Because we weren't deflating what we paid our people or other costs etcetera. And so deflation pass through was more of a challenge for us in the past. If you get to inflation on an indexed basis, you pass that through and if you pay it to your employees then you are kind of, you are whole on that. Not all of our business does that of course. So in other cases, we do have wage inflation pressure on our business and we have, plastics as an example, that we absolutely have it. And we have been experiencing this for some period of time.
One of the things that made the footprint optimization plan so hard for us for so long was the challenge in hiring qualified people in the markets that we were adding capacity etcetera. So we are very familiar with the challenge to hire good people and the fact that we need to pay a strong wage for that. So, yes, there is absolutely going to be some inflation of wage in that. Our expectation is that we will keep trying to push that into the market and that we and our competitors need to get that. Again, if you say we are plastic, margins have been pushed down so low in that market, our believe is that over time that you are going to have the opportunity to get that back out to the price. Which can them move [indiscernible] of course to our consumer goods customers and which is what you are hearing from them and then the problems that they have, that can they get that through to the consumer.
[Operator Instructions] Next we will go to Brian Maguire with Goldman Sachs.
Tony, I think you have mentioned a competitive loss in the third quarter. Just was hoping to get a little bit more detail on anything you could provide, any inside into what happened there and how much of a one off that might be. And if you think you can kind of make it up with some competitive wins on other parts of the business.
Yes. Just again to review that this is something that we had talked about I think in the second quarter, if I am not mistaken. So this was a relatively small customer that had to had move suppliers. So we do view it as kind of an isolated item. But we have also said that you do have excess capacity in the market. You have got new lines that have been built and players are trying to fill those lines up. So I can't tell you it happened ever again for sure. We feel very good about the quality, value, that we bring to our customers. So we feel like we are in a really good spot as all of that, kind of competitive activity unfolds. But this is just one example where there is bound to be a little bit of give and take through that process. And we have scaled this. This is kind of a 1%ish to our business. So really I was just sharing it again today to help everyone bridge our volume move for the year.
Okay. Thanks for that reminder. And I was hoping to get some updated thoughts on the balance sheet now that you had the dispensing business for a couple of months generating some cash off of it, and it sounds like a pretty good free cash flow outlook for 2018. You know just wondering when we might get to the second stage of that acquisition which is maybe some of the platform for growth that it gives you from an external growth point of view and how close we might be getting to that point.
Sure. We are executing just as we would have expected. I think in previous calls, we kind of indicated that we thought would be from a leverage standpoint, down closure to 4 as we exit the year. We are kind of right there. And then with the free cash flow profile of next year, that’s roughly another half a turn of leverage coming off. So that would put us right back kind of in the range. Just kind of what we anticipated and what we communicated through the deal announcement. So I think we said that our preference was to demonstrate that free cash flow was there that we wanted to delever. We are certainly through step one of that with a very good path to step two.
I think through all that we are also at least endeavoring to be pretty clear that that didn’t mean by any sense in circumstance that we were not looking at the acquisition pipeline that we were going to stay active. That where we found strategic opportunities, we would pull the trigger for the right value creating one. So I think we are well positioned as we move into next year to continue into '18, to continue to look in where the right opportunity presents itself. We are happy to pull the trigger if the economics look right. And as you said, that’s a good opportunity set for us around dispensing systems business because of the quality of the team that we have on the ground there. The broader profile of closures generally is an area that we certainly would look to grow out. So, yes, I think by all intents and purposes, we are kind of there with step one. And obviously we got to move along the path of generating that free cash flow but feeling pretty comfortable that it's there and for the right opportunity would move forward.
And next we will go to Adam Josephson with KeyBanc.
Bob, just a couple of questions. Following up on Mark's on the free cash flow bridge. Just want to make sure I understand. So the working capital benefit I think is around 50 and then the year-over-year growth, or the year-over-year net benefit is about 25, 30, right. Is that what you were saying earlier, Bob?
That’s right, yes.
And then what's the cash tax benefit in '18 versus '17?
So there is some $25 million or so, maybe a little bit more than that in the year.
And that would be...
The [indiscernible] payment.
Yes. We have got timing of some tax payments that move between Q4 and Q1 between '17 and '18 will offset that a little bit. But the gross benefit is the tax change with the 25 so million.
Right. And then beyond '18, the 25 to 30 is what we should think about as the recurring benefit you would have from this tax cut. Right.
Yes. Actually if the business grows, it will get bigger, right. So it's the flat rate against the taxable income but, yes, that’s a permanent cash flow benefit that we will get on an ongoing basis.
Okay. And then just, Adam, on the dispensing business. Can you just help me with what the resin buy there is and then what your outlook is for polypropylene and other resins.
Sure. I think you identified the resin, primary resin material dispensing systems use is polypropylene around the world. Obviously as we sit here today, polypropylene is undergoing a significant increase here at the beginning of the year. Really since the hurricane season of 2017, polypropylene has increased and so we have been passing that through to our customers with our contractual mechanisms throughout the businesses. Where we don’t have contractual pass-throughs we have gone out with price increases etcetera to offset that resin cost increase. As we look to the full year of 2018, it will absolutely be a headwind in polypropylene for Q1 but we think that with the forecasts that are out there through [CDI] [ph] and other indices, that resin prices for polypropylene will fall towards the latter half of the year and ultimately we are expecting somewhat of a flat resin market for the entire year, even though we have got the headwind in Q1.
Got it. And then just what's the nature of the pass through. I know that you said not all that is pass through. But can you just help me with what percentage of sales are pass through and just give the average length of the pass through.
Sure. I think on the contractual business, what they say it's a broad majority of the pounds that are purchased for dispensing systems. So I am saying pounds versus the unit volume shipped because of the broad breadth of products that they have. The pass through mechanism for the majority of those pounds really looks a lot more like our plastics business. And you have kind of got a quarterly pass through mechanism that’s pretty standard in the plastics world. For the business that is not covered by a pass through mechanism, again much smaller volume, more unique parts. And those are negotiated on an annual basis with the ability to [impart] [ph] price increases if necessary. But again, the volume is so small on the pounds that we feel pretty good that we are covered from a total polypropylene perspective.
And next we will go to Tyler Langton with J.P. Morgan.
Just on the Dispensing Systems acquisition. Are you still targeting that $15 million of synergies and we sort of assume you kind of earned half in '17 and you will earn the remainder this year.
The number actually is going to probably better than that and we have got more of it in the current year, a little bit more. Certainly by the first quarter we have got most of it into the run rate of the business.
Okay. So you earned the majority of it in '17 and kind of after 1Q in '18...
No, no. The majority is in full run rate, so you have got something in the range of $10 million of it in '17, $5 million more or coming in '18 and that’s already in the run rate you will see in Q1.
Got it. Okay. Perfect. And then just, Bob, I know you guided to higher interest expense for the year. Can you just give kind of a range of what you are assuming and if you have any sensitivities of that expense to interest rates moving higher.
Sure. We would kind of guide towards something that looks like $124 million for the year, that’s probably a little bit higher than what we would have been expecting. And essentially what you have got versus the 110 that we had in 2017 and that 110 is excluding the loss on early extinguishment obviously. But the bridge between the 110 and the 124 is essentially you have got another quarter of Dispensing Systems which is roughly $10 million of that. And then the $4 million which is the piece that maybe is a bit higher than where we would have expected is largely driven by increases in short term rates. So on a year over year basis, looking at the forward curve, the expectation is that short term rates could be somewhere between 75 and 100 basis points. And so what we did do, however, is offset the incremental two months of the bonds that we issues and the negative arbitrage on the rate differential there is we used our free cash flow in 2017 to pay down a portion of our debt. So that’s kind of how you net to the 124.
Okay. No, that’s perfect.
I think the risk and the opportunity there is really just driven around what rates ultimately do. Right now we are basing it on the forward curve.
Got it. Okay. And then just a final question. I think you said sort of passing through inflation this year would be a benefit. Do you have kind of rough sense of what that could amount to?
Well, what I really said is that the deflation in the past is more of a headwind. So basically what happened is if we experience exactly what index inflation is, we pass that through whole on that. If we could be a little bit better than that than we gain. And so historically we manage to be a bit better but I am talking about fractions of percent difference between the inflation you pass through. I would scale that as a reasonably small number, a couple of million dollars in 2018.
And next we will go to George Staphos with Bank of America Merrill Lynch.
This is actually [Molly] [ph], George had to drop off for another call. But basically we are working on bridge analysis for revenue and basically we found that for just that price mix for the segments was up about 4% to 10%. Was there any of this margin created from pricing?
Yes. Sure. Price mix, depends on how you do your math. Absolutely the revenue line is going to have pricing in it. No one has asked in this call actually but we have meaningful inflation in our raw materials for next year. We talk resin but we didn’t talk -- steel is up double digit, kind of whatever region you want to look at. Aluminum is up. And so that all is being passed through in our top line as well.
And next we have a follow up from Chris Manuel of Wells Fargo.
Thanks for taking my follow up guys. Just one question maybe for Adam. You have mentioned 3% to 4% growth in the dispensing systems business. I just want to confirm that was in fact in the acquired business and does not include anything from legacy. And the, two, if you can comment at all, to the extent that anything has changed in the competitive landscape with one of the larger players changing hands here recently. Maybe it's too early.
As far as the 3% or 4% growth, that was specific to the dispensing systems business and, again, we feel good about that. That was not in relation to our overall closures business.
Okay. And the second part?
Can you repeat the second question, please?
Yes, just if you have seen anything in early days in competitive landscape in the closures business in general with one of the competitors changing hands.
Got it. No, at this point, no, we have not. Again, there is a broad array of markets that the business and dispensing systems serves and a broad geography as well. So lot of different competitive sets out there for the business as we go forward, but at this point no change in landscape or activity with that acquisition, specifically.
And I show that we have no further questions at this time. I will turn the call back over to the speakers today.
Great. Thanks, David. Thank you, everyone. We appreciate your time and we look forward to talking to you about the first quarter in late April.
And that does conclude today's conference. We thank you for your participation. You may now disconnect.