Description

Background

Graphic Packaging (Ticker: GPK) produces a variety of grades of cardboard packaging termed paperboard which is used predominantly in food (cereal boxes, takeout food) and beverage packaging (coffee cups). They are over 85% exposed to the North American markets, after the recent acquisition of AR Packaging.

The specifics of the different grades are less impactful to this thesis because of the substitutability of the production but this website provides some good background (https://paperbox.org/4-types-of-paperboard/). In general, pricing of each grade generally moves in tandem because of the ease of substituting production/supply to each grade.

Prior to COVID (2017 through 2019), GPK operated in a relatively weak industry structure because of the following:

1. Customers are concentrated among large consumer products and fast food providers (i.e., General Mills, Kellogg's, Starbucks, Dunkin Donuts)

2. The barriers of entry are relatively low, especially in light of a recent trend of printing paper machine conversions to paperboard

3. Product is easily importable into North America under normal circumstances, because of high value to weight ratios and ease of transport/storage.

The weakness of the industry structure is most evident in the pricing pass through mechanisms. Raw material prices flow through immediately while announced price increases take 6-12 months to be realized due to the contracts with customers. This creates large periodic dislocations of price-cost pressure, most recently in 2021, where the company realized $310m of raw material inflation (-3.8% headwind to margin) and was only able to gain $130m in price in 2021 (1.7% tailwind to margin). The chart below illustrates this. 

GPK has responded to inflation with price and they are projecting that they will gain $510m of price in 2022 which I believe is overly optimistic and assumes that imports remain at depressed levels or supply does not respond to the 30%+ increase in prices since 2020.

In addition to imports, barriers to entry are low and new entrants into the North American market have typically led to increased price competition or margin pressure or both. Sappi’s entrance into the market in 2018 is the most recent example, leading to price/ton decreases of about 2% (pro forma for the acquisition of International Paper’s packaging business) and margin compression of 150bps. 

Thesis 

GPK is over earning as a result of supply chain tightness and food takeout demand surging to a lesser extent. As a result of this tightness, GPK has been able to announce unprecedented price increases in the order of 30%+. Price increases of this nature have historically invited imports and more supply through machine conversions to paperboard.

I believe that more supply is likely in the next 6-18 months, initially through more imports as supply chains ease, followed by more machine conversions.

During COVID, imports as a percent of total consumption fell from a peak of ~20% to much less than 10%. As global supply chains normalize, I expect the import mix to return back to the 20%’s, adding pressure to price and/or margins. 

In addition to machine conversions, an underappreciated trend of higher secularly declining printing paper demand is prompting machine conversions from printing paper to paperboard. 

Billerudkorsnäs recently acquired Verso to convert their machines to paperboard, setting a precedent, while Suzano, the world’s top 2 producer of printing paper is slowly converting printing paper machines over to paperboard. 

From Suzano’s Investor Day in 2021, they estimated 2020 printing paper consumption to be about 63MTPA and paperboard consumption to be 53MTPA. Where printing paper is declining about 2-4% per year, excess supply can be converted to paperboard, implying 2.5-5% increases to paperboard supply every year just by natural attrition of printing paper.

As a result, I think these market forces could delay GPK’s Vision 2025 goals of 18-20% margins, which is 2%-4% above the last 5 year average. GPK’s Vision 2025 is predicated on realizing a premium on higher-value add products, like KeelClip, even though GPK has not been able to realize any such margin uplift in the last 4 years after significant similar product launches. 

Financials and Valuation

I expect GPK to give back some of the pricing they gained from inflation in 2021 as increased supply leads to pricing competition, which is likely to result in pricing back to the historical average of $1,650/ton (adjusted for the acquisition if Intl Paper’s paperboard business), vs the implied $1,750/ton in 2022. I also expect margins to decline to the historical 16.5% vs the expectations for 17-18% based on consensus. 

Given my expectations for 2023 EBITDA of $1,302, it implies a valuation pro forma for AR Packaging of 7.6x EV/EBITDA vs a historical range of 6.5-7.0x. With the historical trading range, I believe that GPK’s fair value is about $15/sh (20% downside).

Risks and Mitigants

There are several risks to the thesis worth addressing:

1. Timing of new supply is unpredictable, however, I believe that with 30%+ price increases announced since 2020, paperboard has gone from not making their cost-of-capital to making excess of 15% assuming a greenfield replacement cost of about $250 EBITDA/ton and over 20% on a brownfield conversion. As a result at current economics, I believe either price goes down to dissuade new supply or conversions are a matter of when, not if.

    

2. GPK is projected to generate >10% FCF yield in 2022 and 2023 but it’s primarily because they are under-spending on capital after over spending in 2020 and 2021. Furthermore, their tax shelter ends in 2023 and they will become a substantial cash taxpayer in 2024, which brings down their FCF yield by ~4%.

    

3. As part of GPK’s Vision 2025 plan, they are expecting to boost their margins based on a higher integration rate (i.e., make more paperboard that feeds into a premium product), except GPK’s integration rate has gone from the 50%’s in 2015 to the 60%’s after the acquisition if International Paper’s paperboard business and sits at 70% today, yet there has not been a commensurate increase in margins, making me skeptical that integration rate truly helps the margin

    

4. Sustainability and ESG was a driver of premium valuation in GPK in the past but much of that premium has faded because of GPK’s inability to commercialize on the plastics-to-paper sustainability trend. Despite innovations such as KeelClip launched since 2019, there has been some adoption but insufficient to grow significantly over their 1-2% organic growth target.

Catalyst

1) 4Q21 earnings is the most immediate catalyst but the thesis is more longer-term, will provide guidance on 2022, should underperform consensus expectations of $1.47bn

2) Additional capacity announcements, or machine conversions, particularly by Suzano or other printing paper companies

3) Increasing imports as supply chains normalize.