Description

PLEASE NOTE: This is an immediately actionable investment idea given that after the close today Graphic Packaging announced a $300 million secondary offering of stock to be priced tomorrow, February 12.  Initial price indication is $9.90-10.00/share (~2.5% discount to today’s close of $10.22).  The Company will not receive any proceeds from the offering.  Selling shareholders are private equity firms (they have held an interest in the Company for a while and are realizing their investment).  This is an excellent opportunity to pick up stock at a discount.

SUMMARY

Graphic Packaging Holding Company ("Graphic Packaging") is an attractive long investment opportunity.  Through a series of Company actions, including product pricing, productivity improvements, etc. which are described in detail below, the Company should deliver $380 million in what I will term “base FCF” during 2014, equating to an ~12% FCF yield.  The Company will also receive an additional $100 million in cash during 2014 through divestiture proceeds and government tax grants.  Accordingly, total cash flow to the equity will be $480 million, equating to a ~15% FCF yield.  In addition, the fundamentals for the Company are quite strong in that it holds the leading market position in its main lines of business, and it serves end markets which are defensive in nature and very stable.  Further, the stock is now “hitting the radar screens” for larger institutional investors because in November 2013 the Company completed a secondary offering of stock after which the average daily traded dollar volume effectively doubled from ~ $16 million/day (2.0 million shares/day at $8/share) to ~$30 million/day (3.0 million shares/day at $10/share).  With today’s announced secondary offering of stock, the free float and trading liquidity will increase even more.  Now that more institutional investors can buy the stock given the increased liquidity, there should be a large amount of new “marginal buyers” which should place upward pressure on the stock’s price.

In 2015, the Company should generate ~$1.20 in FCF/share.  Valued at a 9% FCF yield, that equates to a share price of $13.30, over 30% higher than current levels.

COMPANY DESCRIPTION

• Graphic Packaging is a provider of packaging solutions for a wide variety of products to food, beverage and other consumer product companies.  The Company is organized into two segments:
  • Paperboard Packaging (86% of 2013 Revenues) – supplies paperboard cartons and carriers designed to protect and contain certain products for the following end-use markets: (i) beverage - beer, soft drinks, energy drinks, water and juices, (ii) food - cereal, desserts, frozen, refrigerated and microwavable, (iii) prepared foods - snacks and quick-serve foods for restaurants and food service providers, (iv) household products - dishwasher and laundry detergent, health care and beauty aids, tissues and papers.
  • Flexible Packaging (14% of 2013 Revenues) – produces multi-wall bags, shingle wrap, plastic bags and film for building materials (such as ready-mix concrete), retort pouches (such as meals ready to go), medical text kits, batch insulation bags and film.  Key end markets include food and agriculture, building and industrial materials, chemicals, minerals, pet foods and pharmaceutical products.

INVESTMENT THESIS

• Sizeable, Near-Term Cash Flow to Equity – Not only should Graphic Packaging generate strong “base FCF” over the course of 2014 due to the factors listed below, but the Company will also receive additional cash from non-recurring times making total cash flow to equity particularly strong in 2014.  The following analysis details first an EBITDA bridge from 2013 to 2014, and then outlines the Company’s FCF from the 2014 EBITDA.  Of note, management articulated most, but not all, of the details below during their 4Q13 earnings call, so reading the transcript is an excellent reference.

EBITDA Bridge from 2013 to 2014:  The Company’s EBITDA should increase from $670 million in EBITDA in 2013 (see 4Q13 8-K filing for EBITDA calculation) to $715 million in 2014 due to the factors listed below:

• Pricing ($50 million addition to EBITDA) – For 2014 pricing for Graphic Packaging's products will turn positive as contracts reset predominantly for coated-recycled board ("CRB").  While management estimates that the contract price resets will add an incremental $30-40 million to revenues which will flow directly down to the Company's EBITDA, they indicated on the earnings call that it was likely to be on the “upper end” of the range and could even surpass $40 million.  In addition, during the week of February 3, 2014, both Graphic Packaging and KapStone Paper (KS) announced a $50/ton price increase for kraft paper, effective for all grades March 1, 2014.  Graphic Packaging has 200,000 tons of annual capacity, equating to ~$10 million in annual EBITDA improvement.
• Cost Savings and Productivity Initiatives ($80 million addition to EBITDA) – For 2014 management is projecting $70-90 million in cost savings and productivity initiatives ($80 million at the mid-point).  Part of these savings will result from synergies captured from integrating relatively recent acquisitions in Europe ($16-18 million) as well as the start-up of the Company’s new biomass boiler in Macon, GA which satisfies some of their energy needs at lower cost ($20 million in annual savings).  The remainder will come from Graphic Packaging’s efforts in implementing a series of significant initiatives designed to reduce costs, improve productivity and increase profitability.  Specifically, the Company is implementing a Six Sigma approach focused on reducing variable and fixed manufacturing and administrative costs (in both their manufacturing footprint as well as their supply chain).
• Cost Inflation ($65 million reduction to EBITDA) – For 2014 management is projecting $35-40 million in raw material input cost inflation.  This is comparable to what the Company experienced in 2013 and will be from increased fiber costs, energy costs, etc.  In addition, management is projecting $25-30 million in labor and benefit cost inflation.  These increases are $65 million in total at the mid-point.
• Divestitures ($20 million reduction to EBITDA) – On September 30, 2013, the Company completed the sale of certain assets related to its Flexible Plastics business as well as the sale of its uncoated-recycled board (“URB”) mill.  Then, on February 3, 2014, Graphic Packaging sold its Di-Na-Cal label business.  All together, these businesses generated about $20 million in annual EBITDA.

Of note, the projections above do not include any volume improvement in Graphic Packaging’s business.  Any improvement represents a source of additional upside.

EBITDA to “Base FCF” for 2014:  Starting with $715 million in EBITDA as calculated above, Graphic Packaging should generate $380 million in “base FCF” in 2014:

• Capital Expenditures ($195 million cash usage) – Management is guiding to a capex range of $185-205 million for 2014 ($195 million at the mid-point).  See 4Q13 earnings presentation, slide 15.
• Cash Pension Contributions ($50 million cash usage) – Management is guiding to a cash pension contribution range of $40-60 million for 2014 ($50 million at the mid-point).  See 4Q13 earnings presentation, slide 15.
• Cash Interest Expense ($90 million cash usage) – Management is guiding to a cash interest expense range of $90-100 million for 2014.  See 4Q13 earnings presentation, slide 15.  However, they noted in the “Business Outlook” section on pg. 37 of their 2013 10-K that this includes $5-10 million of non-cash interest expense associated with amortization of debt issuance costs.  So, figure $90 million in actual cash expense.

Additional, Non-Recurring Cash Items in 2014:  In addition to the $380 million in “base FCF” Graphic Packaging should generate in 2014, the Company should also receive an additional $100 million in cash during 2014 from the following non-recurring items:

• Divestiture Proceeds ($75 million cash inflow) – From the divestitures Graphic Packaging completed in late 2013/early 2014, the Company has guided to $150 million in total cash proceeds.  The Company received $75 million in cash proceeds during 2013 and is expected to receive the remainder in 2014.
• Tax Grants Related to the Macon, GA Biomass Boiler ($25 million cash inflow) – Graphic Packaging is expecting to receive a $25 million tax grant related to its Macon, GA (US government’s promotion of renewable energy).  The Company was supposed to receive this grant last year, but the government review process for the application was delayed.  Management now expects the Company will receive the grant in 3-to-5 months.

For reference, with only very modest top-line and cost growth in 2015, the Company’s “base FCF” should increase from $380 million in 2014 to $390 million in 2015, or to ~$1.20/share.  Over the next 6 months, the market should “roll” its valuation metrics forward and value the business on 2015 FCF.  At a 9% FCF yield, the stock should be worth $13.30, over 30% higher than current levels.  Of note, management has shown their willingness to repurchase stock (they bought $200 million worth in the Company’s November 2013 secondary offering).  If the Company repurchases stock during 2014, the $1.20 in FCF/share in 2015 could prove to be conservative.

FUNDAMENTAL ANALYSIS

• Paperboard Packaging– This business segment supplies paperboard cartons and carriers designed to protect and contain certain products for the following end-use markets: (i) beverage - beer, soft drinks, energy drinks, water and juices, (ii) food - cereal, desserts, frozen, refrigerated and microwavable, (iii) prepared foods - snacks and quick-serve foods for restaurants and food service providers, (iv) household products - dishwasher and laundry detergent, health care and beauty aids, tissues and papers.  The Company produces paperboard at its mills; prints, cuts and glues ("converts") the paperboard into folding cartons at its converting plants; and designs and manufactures specialized, proprietary packaging machines that package bottles and cans and, to a lesser extent, non-beverage consumer products.  The Company also installs its packaging machines at customer plants and provides support, service and advanced performance monitoring of the machines.  Graphic Packaging offers a variety of laminated, coated and printed packaging structures that are produced from its coated unbleached kraft ("CUK"), coated-recycled board ("CRB"), kraft paper and uncoated-recycled board ("URB"), as well as other grades of paperboard that are purchased from third-party suppliers.  Several characteristics of Graphic Packaging's business make it highly attractive from an investment perspective:
  • Market Leading Position - Graphic Packaging is the world's largest producer of CUK and holds an ~55% share of the North American market.  CUK is a specialized high-quality grade of coated paperboard with excellent wet and dry tear strength characteristics and printability for high resolution graphics that make it particularly well suited for a variety of packaging applications.  There are only two major CUK producers in theUnited States: MeadWestvaco Corporation (MWV) and Graphic Packaging.  Internationally, The Klabin Company inBrazil makes similar grades of paperboard.  In addition, Graphic Packaging is the largest domestic producer of CRB with an ~35% share of the North American market.  CRB is manufactured entirely from recycled fibers, primarily old corrugated containers ("OCC"), double-lined kraft cuttings from corrugated box plants ("DLK"), old newspapers ("ONP"), and box cuttings.  The recycled fibers are repulped, formed on paper machines and clay-coated to provide excellent printing surface for superior quality graphics and appearance characteristics.  Graphic Packaging's market leading position in these products provides the Company with a degree of pricing power over its customers and enables it to pass through raw material price increases.
  • Defensive End Markets - Graphic Packaging's paperboard products are predominantly sold for use in packaging food, beverages and a variety of consumer products.  Most of the end markets Graphic Packaging sells into are "consumer staple" in nature and have little cyclicality or variance with the movement in the broader economy.  Accordingly, Graphic Packaging's paperboard business is highly stable and defensive in nature.

Volume demand in Graphic Packaging's Paperboard Packaging segment is mainly driven by the general consumption of consumer staple products, which has typically increased at ~1.0-1.5% annually.  However, Graphic Packaging has been encountering weakness in beverages, specifically carbonated beverages, as consumers have been shifting to healthier alternatives.  To be conservative, the financial analysis of the Company detailed above does not include any volume growth for the business.

• Flexible Packaging – This business segment produces multi-wall bags, shingle wrap, plastic bags and film for building materials (such as ready-mix concrete), retort pouches (such as meals ready to go), medical text kits, batch insulation bags and film.  Key end markets include food and agriculture, building and industrial materials, chemicals, minerals, pet foods and pharmaceutical products.  This business segment's profitability has been suffering due to production issues which the Company is addressing.  Specifically, management of the segment has been replaced and the Company has installed new equipment and systems.  As a result of these changes, production in terms of tons per day has improved by ~9%.  With the increase in productivity, management has decided to close the segment's Brampton, Ontario plant which makes flexible films, in order to "right size" the segment's geographic footprint.  Management believes that the segment can eventually generate double-digit EBITDA margins, up from the 2.5% EBITDA margins the segment has been generating.  If management can achieve this goal, it would present even more earnings upside for the Company.
• Net Operating Loss Carryforwards - As of December 31, 2013 Graphic Packaging has $892 million of net operating loss carryforwards for US federal income tax purposes, which are being used to offset taxable income.  Graphic Packaging currently pays very minimal cash taxes, something which will continue for the next several years, making its FCF disproportionately higher than its EBITDA and Net Income.

NOVEMBER SECONDARY OFFERING

• On November 21, 2013 Graphic Packaging completed an underwritten, secondary public offering of 47.9mm shares of common stock held by certain of its existing stockholders.  The stock offering was the fifth such offering in the past twelve months and is part of a multi-year exit by Graphic Packaging's private equity shareholders, TPG Capital, the Coors Family, Clayton, Dubilier & Rice, and the Agnelli Family.  The Company did not sell any shares are receive any proceeds from the offering.  However, in conjunction with the secondary offering, Graphic Packaging repurchased from the underwriter $200 million worth of common shares being sold the selling stockholders.  Given the low cost of funding to finance the share repurchase, the buyback was accretive to Graphic Packaging's EPS.  In addition, the secondary offering increased the free float in the stock to 75% from 63%.  Prior to the secondary offering, the daily trading volume on Graphic Packaging's stock was ~2.0 million shares.  Since the offering, the daily trading volume is now ~3.0 million shares, a 50% increase.  The expansion in daily trading volume enables a greater number of investors to purchase Graphic Packaging stock and these new “marginal buyers” should place upward pressure on the stock’s price.

CATALYSTS

• 1Q14 Earnings – Estimated to be released April 25, 2014.
• Accretive Acquisitions - Graphic Packaging has a history of completing accretive acquisitions and management has stated that bolt-on acquisitions remain a priority for the Company.  On December 31, 2012 Graphic Packaging completed the acquisition of Contego Packaging Holdings, a leading food and consumer packaging company based in the United Kingdom for $128 million.  Contego operates four folding carton facilities that convert ~150,000 tons of paperboard annually.  Also on December 31, 2012 Graphic Packaging acquired A&R Carton Holding BV's Beer and Beverage packaging business in Europe for $27 million.  A&R includes two manufacturing facilities that convert ~30,000 tons of paperboard annually.  Both of these transactions have been accretive to Graphic Packaging's EPS.  The Company maintains a robust pipeline of acquisition opportunities.  Should the Company complete additional accretive transactions, it would increase Graphic Packaging's earnings per share even more.
• Relatively Near-Term Additional Share Repurchases or Dividend Increases - Internal analysis indicates that Graphic Packaging will reach its 3.0x Total Debt/EBITDA target by mid-2014.  Accordingly, the Company could be in a position at that time to deliver more cash to shareholders either through additional share repurchases or dividend increases.  Management has stated that their preferred use of cash is towards accretive, bolt-on acquisitions.  However, if these are not completed, excess cash will be returned to shareholders.

KEY RISK

• Raw Material Price Volatility - The biggest risk to Graphic Packaging is the Company's exposure to raw material price volatility.  The Company must purchase pulpwood, OCC and chemicals in order to produce CUK, CRB and URB.  Prices for these raw materials can fluctuate and may cause volatility in Graphic Packaging's earnings accordingly.  There is no real mitigant to this risk, although Graphic Packaging does have some pricing power over its customers and can pass along some raw material price increases to them albeit at a lag.

Catalyst

CATALYSTS

• 1Q14 Earnings – Estimated to be released April 25, 2014.
• Accretive Acquisitions - Graphic Packaging has a history of completing accretive acquisitions and management has stated that bolt-on acquisitions remain a priority for the Company.  On December 31, 2012 Graphic Packaging completed the acquisition of Contego Packaging Holdings, a leading food and consumer packaging company based in the United Kingdom for $128 million.  Contego operates four folding carton facilities that convert ~150,000 tons of paperboard annually.  Also on December 31, 2012 Graphic Packaging acquired A&R Carton Holding BV's Beer and Beverage packaging business in Europe for $27 million.  A&R includes two manufacturing facilities that convert ~30,000 tons of paperboard annually.  Both of these transactions have been accretive to Graphic Packaging's EPS.  The Company maintains a robust pipeline of acquisition opportunities.  Should the Company complete additional accretive transactions, it would increase Graphic Packaging's earnings per share even more.
• Relatively Near-Term Additional Share Repurchases or Dividend Increases - Internal analysis indicates that Graphic Packaging will reach its 3.0x Total Debt/EBITDA target by mid-2014.  Accordingly, the Company could be in a position at that time to deliver more cash to shareholders either through additional share repurchases or dividend increases.  Management has stated that their preferred use of cash is towards accretive, bolt-on acquisitions.  However, if these are not completed, excess cash will be returned to shareholders.