Paper & Packaging –Packaging Corporation of America (PKG) & The Containerboard Market

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 12th, 2014

Paper & Packaging –Packaging Corporation of America (PKG) & The Containerboard Market

  • We like Packaging Corporation of America (PKG) on the basis of favorable long term economics and attractive relative valuation. A move to its historical average EV/EBITDA premium (the least divergent of the metrics in Exhibit 1) implies a price of $73-75, representing 11-13% upside, while PKG’s predominantly virgin fiber based containerboard capacity, particularly relative to its competitors, gives the company an advantaged status in an environment with rising OCC prices (old corrugated containers, i.e. recycled fiber)given that the bulk of world capacity (and nearly all of China’s) is tied to recycled fiber, consensus sees OCC prices trending higher with increased demand from developing economies.
  • There is a lot to like about PKG: the company’s containerboard mills are diverse in their production capabilities and efficient in their fuel and electricity use after the completion of several energy optimization projects; following the Boise acquisition the company is operating above a 90% integration level and quarterly results have consistently matched or exceeded expectations since 2012; revisions have stayed positive as those of its peers have turned negative; dividends and share repurchases are steadily on the rise; a focus on regional accounts drives above industry average margins; the conversion of a newsprint machine acquired in the Boise deal to containerboard production should ease capacity constraints (for the time being); and consensus sees the opportunity for continued growth, with healthy forward estimates on both the top and bottom line.
  • The stock has made quite a run up since 2012, benefitting from consolidation in the industry and getting credit for the factors noted above. Results will likely need to keep beating consensus to justify any major moves higher.

Exhibit 1

Source: Bloomberg

(Comparables: IP, RKT, MWV, KS, GPK)

  • Opportunities remain, from both domestic growth as well as the export market, which could be very profitable for North American virgin containerboard producers in a world with predominantly recycled fiber based capacity and dwindling OCC supplies. The suggestion that virgin containerboard producers could qualify as MLPs is also being explored by several of the company’s peers, but the process is convoluted, PKG has yet to publicly comment on the issue, and all is ultimately dependent on private letter rulings from the IRS, making any near term action unlikely.
  • Downside risks include the potential industry trend toward lightweight paper grades in the long term, difficulties or delays in the conversion of the Deridder newsprint machine in the near term, and slower than anticipated economic growth in the intermediate termin particular, with the bulk of containerboard and corrugated shipments driven by nondurable goods, any weakness in what our colleague Rob Campagnino sees as a stretched US consumer could impact PKG, which generates the bulk of its sales in the domestic market.

The Favorable Economics of the North American Containerboard Market

The terminology in the Paper & Packaging industry is fairly obtuse – lots of synonyms and terms that sound similar but have important distinctions. Containerboard is the most commonly produced type of paperboard (
see Appendix
for more detailed industry data) and is used intensively in corrugated packaging. Picture a standard cardboard box that UPS would deliver. Containerboard entails the inner and outer layers (called linerboard) of the box as well as the wavy (or “fluted” as it is said) cross sectional “corrugating medium” that holds the two layers together. Containerboard can be produced from either virgin (i.e. trees – softwood pulp) or recycled (old corrugated container – OCC) fibers. When produced from virgin fiber, containerboard is called kraftliner, kraft being the German word for “strength”; when recycled fibers are used the resulting paperboard is called testliner (or recycled liner). North American producers have the unique benefit of abundant softwood forests in northern Canada and the US Southeast. As such, domestic producers have a much larger percentage of capacity that utilizes virgin fiber relative to global producers, who are reliant on imports of paper and/or the recycled fiber to produce it.

Exhibit 2

Source: RISI

Given the regional dependence on recycled fibers in markets outside of North America (notably China where virtually all of the containerboard production uses recycled fibers), it has long been anticipated that demand growth will put a strain on OCC supplies and push pricing higher. These forecasts did not come to fruition in recent years as Europe has been weaker than likely was expected (until recently); Chinese growth ticked down a notch; and India and Latin America slowed even more. As Europe continues to recover and consumer driven economies gradually emerge in these massive emerging markets, containerboard demand should accelerate. Recent forecasts reflect the same optimism that the industry had previously in 2011, moved forward three years.

Exhibit 3

Source: RISI

The cost components of kraftliner (made from virgin fiber) and recycled linerboard (made from recycled OCC fiber), also borrowed industry data source RISI, are shown below through 2013. At the end of 2011, the spread between virgin and recycled fibers was at its recent peak, prompting the concerns that OCC supplies would continue to be tight and prices would trend higher. As noted, this did not occur and the price differential narrowed, disappearing briefly at the end of 2012 before opening up again throughout 2013. Over time we can expect this spread to widen further – this at least seems to be the general wisdom, based on broad demographic and economic trends in world economies. The other cost components are different for the respective processes but sum to about the same amount. Producing kraftliner entails a greater transport cost (intuitively it makes sense that transporting logs would be costlier than moving baled old cutup cardboard boxes), but is less energy intensive (the recycled materials must undergo a costly cleansing process to extract the fiber).

Exhibit 4

Source: RISI

Exhibit 5

Source: RISI

Exhibit 6

Source: RISI

Packaging Corporation of America (PKG)

In an environment with rising OCC prices, Packaging Corporation of America (PKG) stands out as an attractive investment due to its low reliance on recycled fiber, particularly relative to its peers:

Exhibit 7

Source: Company Reports

PKG is predominantly a domestic play on containerboard[1]. Though the bulk of its capacity is capable of using virgin fibers, its plants have the flexibility to switch this capacity to recycled fibers as prices shift. In addition, PKG derives two thirds of its sales from regional and local accounts, which typically offer higher margins than the national bulk buyers. This flexibility and focus has given PKG higher and less variable margins than other industry players:

Exhibit 8

Source: Bloomberg, SSR Analysis

Valuation is not as simple a story. Despite a very strong move higher from 2012 through the end of 2013 (during which time the company handily outpaced the S&P and its peers – see chart below), PKG is currently trading at varying levels of discount to a comp group composed of fellow paperboard producers IP, RKT, MWV, KS, and GPK. The EV/EBITDA multiples, the least deviant of the several metrics below, imply a share price of $73-75 on return to the historical average, 11-13% upside from current levels. The Price/Cash Flow ratios show the most potential upside; see Exhibit 10 below.

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Bloomberg

Optimism – Estimates and Revisions

In its Q4 2013 earnings release in February, PKG guided above consensus for 2014. Revisions have been only modestly negative since (with an improving trend, versus markedly negative with declining trends for key competitors RKT and IP), certainly not justifying PKG’s relative underperformance year to date – but suggesting that earnings will have to keep beating estimates to justify any moves higher after a strong run up. In recent history this has not been a problem for PKG. Since 2010 the company has beat its beginning year EPS estimate by over 10% on average. On a quarterly basis since 2012 PKG’s EPS has come in on average 10% higher than the beginning quarter estimate – compare this to RKT, which has had the opposite experience, and IP which has fared even worse.

Exhibit 11

Source: Capital IQ, SSR Analysis

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Exhibit 17

Source: Capital IQ, SSR Analysis

Exhibit 18


Source: Capital IQ, SSR Analysis

Cash Flow & Capital Allocation

PKG has a solid dividend yield and has consistently grown distributions per share over the past several years. The company also has a history of consistent share repurchases. When questioned about cash allocation in recent conference calls, management indicated that paying down $1 billion dollars in Boise-acquisition related debt over the next two years is a priority and that dividend increases would likely come before buybacks in the event of excess cash.

Exhibit 19

Source: Capital IQ, Standard & Poor’s, SSR Analysis

Exhibit 20

Source: Capital IQ, SSR Analysis

Exhibit 21

Source: Capital IQ, SSR Analysis

Exhibit 22

Source: Bloomberg

Expectations

Exhibit 23

Source: Capital IQ, SSR Analysis

Exhibit 24

Source: Capital IQ, SSR Analysis

The Export Market

As you know, we’ve had the position the world is going to eventually run out of recycled fiber and virgin fiber producers are going to be very advantaged, particularly in the export market. And so we’re keeping our place in the export market. It may prove 5 years from now to be a very good place to be doing business”

-Mark Kowlzan, CEO of Packaging Corporation of America, Q1 2014 Conference Call

Exhibit 25

Source: Company Reports

The MLP Opportunity

A recent report that suggested virgin containerboard mills could qualify as MLPs triggered a short lived spike in related tickers. IP, up 8% at one point during that session, approached $52 a share, a level not seen since January of 2000. RKT was up 10% at its high. PKG also saw a jump, but of much smaller magnitude, perhaps because it was not mentioned as one of the companies the hypothesizer had established a position in.

Senior executives at IP, RKT, and MWV have all since made public comments indicating their companies are exploring the process; the consensus from top management is it is fraught with complexity, but the upside is indeed intriguing. The IRS must ultimately grant the tax-favored status.


The Paper Business

Along with the containerboard and corrugating medium mills, PKG acquired the legacy “white paper” business in the Boise transaction, making the company the third largest producer of uncoated free sheet in the U.S. behind Domtar (UFS) and International Paper (IP). These companies have seen their margins in this market deteriorate significantly over the past three years.

Exhibit 26

Source: Bloomberg, SSR Analysis

The modest improvement for UFS since mid 2013 in part reflects the shifting mix toward specialty and packaging papers (now accounting for 15% of paper shipments). This is nevertheless not a great business to be in –increasing trends towards digitization has the traditional white paper business in “secular decline” to quote the oft-used term. In September 2013 IP announced the closure of a large capacity facility, effectively trimming 8% of North American capacity, as the industry attempts to balance supply with steadily declining demand.

Legacy contracts oblige PKG to provide Office Depot (now inclusive of the former Office Max) with at least 80% of their paper supplies through 2017. This could work in either direction – in some sense, they are guaranteed a buyer but on the other hand the concentration of sales (38% of the Papers segment) leaves the company vulnerable if they do not divest the business by the time the contracts terminate.

The company’s options for the Paper business would seemingly include:

  • Convert the machines to support the core containerboard operations
  • Harvest cash flow
  • Sell the assets

Conversion seems unlikely (in the near to intermediate term) given management’s commitment to paying down $1b in debt over the next two years.

A sale might make sense, given that part of the premium multiple PKG has traditionally been afforded relative to peers likely derives from the company’s simplicity and focus compared to the IP’s and RKT’s of the world. Given management’s comments in the M&A call in 2013, this option would only come into play if the company fails to satisfactorily optimize the business within a reasonable timeframe.

Exhibit 27

Source: Capital IQ, SSR Analysis

Facilities and Fuel Consumption

PKG embarked on a number of energy optimization initiatives starting in 2010, and these were largely completed by the end of 2011. The results are evident – see exhibits below. The company did not report electricity consumption figures in its 2013 10-K, and the shift back towards wood waste & coal from natural gas seen in the 2013 purchased fuel figures reflect the addition of the Boise facilities. It remains to be seen whether PKG will undertake similar energy projects at these newly acquired mills.

Exhibit 28

Source: Company Reports

Exhibit 29

Source: Company Reports, SSR Analysis

Risks

Stretched Stock Price

While the fundamentals of the business appear solid, the Boise acquisition has been successfully integrated without any major hiccups thus far, and valuation relative to peers looks attractive, PKG’s stock may need more time to digest a sharp move up before taking another leg higher.

Exhibit 30

Source: Capital IQ, SSR Analysis

Some of this run up can be attributed to industry consolidation – the exhibit below shows that the stock only really began to take off as the containerboard industry put the final touches on a decade’s worth of deals. The higher concentration stabilized the supply and demand balance and improved pricing, while at the company level PKG completed not only a major acquisition of its own, but also several energy optimization projects – couple these with a relentlessly rising market and the series of quarterly earnings beats noted above and the run up is fairly well accounted for.

Exhibit 31

Source: Capital IQ, RISI, SSR Analysis

Interesting to note – for three consecutive trading days starting on April 28, PKG hit a session low of $65 but never broke this level. The stock approached the $65 mark again on July 22, the day after reporting Q2 earnings, touched it for a session low, but again held that level (see exhibit below). We do not subscribe to the school of technical analysis but there clearly seems to be some interest in keeping PKG trading above this level. A break below such a heavily fortified area could be sharp, but we believe it would only offer up a better entry point into a stock that is attractively valued relative to its peers.

Exhibit 32

Source: www.freestockcharts.com, SSR Analysis

Transportation Difficulties

Management noted in its Q3 conference call that the rail and trucking industries are experiencing delays due to railcar and driver shortages, respectively, slower rail speeds year to date, as well as new regulations on the amount of consecutive hours truckers can log. The current low interest rate environment makes it more logical to hold higher inventories at box plants rather than incur higher transportation costs. The company will have to continue to show good execution on this front. Couple this with “planned boiler and line film repairs” at the Deridder mill “which will increase purchased energy and chemical costs during the third quarter” and it is looking like a tough comp for PKG (though it will be the first Q3 with full Boise results).

Deridder Conversion Delays

The Boise acquisition included a newsprint machine at the Deridder, Lousiana facility – PKG announced in April that it would exit the newsprint business and convert the machine to containerboard production. PKG expects the refitted Deridder newsprint machine to be up and running and producing “lightweight linerboard and medium” by mid-Q4 of this year. The conversion will further integrate PKG’s operations – the 355,000 tons of containerboard capacity from the conversion turns what would have been a deficit of around 250,000 tons (purchased on the open market) in 2015 into a surplus.

Inability to Meet (Rather Healthy) Expectations

This would appear to be less of a concern given PKG’s recent track record of matching and usually exceeding quarterly estimates. That being said, as highlighted above, the company faces some healthy growth expectations.

Trend toward Lightweights (Long Term)

Lightweights are much more in use in Europe (where packages have shorter distances to travel and strength is not of paramount importance) – advances in strength and the benefits of lower cost and material efficiency could give lightweights an opportunity in North America in the years to come.

Appendix

  1. Were 100% containerboard prior to the 2013 Boise acquisition – they now also have an uncoated free sheet business that they are calling “white paper” – see section titled “
    The Paper Business
    ”.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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