KapStone Paper is a leading manufacturer of specialty kraft papers and containerboard.  It was formed by two industry leaders Roger Stone (of Smurfit-Stone) and Matt Kaplan in 2005.   It currently has 2 mills capable of producing 1.3 million tons of product annually and has a distinct cost advantage to other manufacturers in its industry due to its reliance on wood fiber (as opposed to recycled fiber).   The company currently consists primarily of its two virgin kraft paper mills: the 425,000-ton Roanoke Rapids mill and the 882,000-ton Charleston Mill. These mills are equipped to make four major grades of paper: linerboard, Dura Sorb (a saturating kraft unbleached paper made for high-pressure laminate applications), kraft paper (which is made into bags and sacks, most often found at the grocery store), and kraft pack (which is used in folding carton applications).

KapStone Paper began as a special purpose acquisition company (SPAC), Stone Arcade Acquisition Corporation.  Almost 2 years later Kapstone became KapStone Paper and Packaging Corporation.  On  January 2, 2007, KapStone closed the deal to purchase IP's unbleached kraft Roanoke Rapids facility for $151mm.  On July 1, 2008, KapStone expanded its operations with the purchase of MeadWestvaco's Charleston Kraft Division for $475 million.  KapStone acquired the kraft paper mill in North Charleston, a lumber mill in Summerville, South Carolina, chip mills located in Elgin, Hampton, Andrews and Kinards South Carolina, as well as the cogeneration facility located at North Charleston. 

Management represents one of the intangibles that should factor into the valuation of Kapstone.  It was formed by experienced industry executives who have had experience successfully building and selling a company.  Management is also highly incented since they own about 20% of the company.

Roger Stone is the chief executive officer and chairman of the board at KapStone.  Kaplan is best known as one of the primary drivers behind consolidating the modern U.S. containerboard industry. In the late 1970s, Roger took over Stone Container as its CEO. During his 20-year tenure, Roger grew Stone Container through a series of acquisitions, until finally merging with Jefferson Smurfit in November 1998 to make what is now Smurfit Stone Container.  Smurfit Stone Container is now being acquired by Rock Tenn.

Matt Kaplan, the son in law of Roger Stone, is the president and a director of KapStone Paper and has been since the company's inception. He began his career at Stone Container in 1979 and led the North American Operations until the merger with Jefferson Smurfit in 1998.

 

KapStone has four major products, related to the containerboard industry: (1)  linerboard, (2) DuraSorb, (3) Kraftpak, and (4) Kraft Papers.  On a tonnage basis, about 50% of shipments were of linerboard, 25% of DuraSorb, 20% of Kraft Paper, and 5% Kraftpak.

Linerboard-The base for the containerboard market.

Linerboard is the paper that makes up the outsides of the wall of a brown box, like those seen shipped by Amazon.  Linerboard is used to make containerboard, and then the sheets of containerboard are cut to size and folded into finished boxes.  The containerboard market, and by extension linerboard, is extremely mature.  Containerboard is used to ship food, durable and non-durable goods.  In North America, the containerboard market is highly consolidated, with the top five players having 75% of the market.   The top players include International Paper (IP), RockTenn/Smurfit Stone(RKT/SSCC) , Temple Inland (TIN) and Georgia Pacific (Private).   Most of the larger players are vertically integrated owning both the linerboard mills and the plants which make the boxes.  KapStone does not own its own box plants.  For this reason, Kapstone sells into various box plants and also exports about half of its linerboard production.  The North American linerboard industry is operating at about 95% capacity.   Currently North America ships out about 12% of its linerboard production.  One of the important reasons why North America is at a competitive advantage worldwide is because of its wood fiber input costs.  While Europe and other parts of the world source about 70% of its input for linerboard from recycled fiber, North America's mills produce only about 30% from recycled fiber.  Recycled fiber (or OCC) costs are going up due to the finite life of recyclable fiber, costs of collecting recycled fiber are going up, and the growth in mills that only produce from recycled fiber.  KapStone is the only publically traded company in the container board industry with 100% virgin wood fiber input!

 

DuraSorb (Saturating Kraft)

The DuraSorb line, is a very high grade of kraft paper, similar to linerboard, but is designed to absorb resins and other materials. The product is used in a myriad of applications, including laminates for countertops, furniture, and floor as well as in industrial applications, such as printed circuit boards, concrete forms, and audio equipment.   Saturating Kraft is a consolidated niche market with only two othercmajor producers - IP in Savannah, GA and a former Stora Enso mill in Finland that was recently acquired by OpenGate Capital.

 

Kraft papers are most often seen in the grocery store, and comprise the paper bags into which groceries are put.   KapStone is the leader among a small group of unbleached kraft paper producers and has a market share of 19% in North America. As the paper bag market shrank during the 1980's and 1990's, many kraft paper producers exited the business. KapStone has an approximate capacity of 300K tpy, produced at the Roanoke Rapids mill. The kraft paper market can be broadly divided into three product categories (1) Multiwall paper - used to produce heavyduty bags for agricultural products, pet food, baking products, cement and chemicals, (2) Specialty Converting paper - used in tape & label backing, wrapping paper, wax paper packaging, coating & laminating, roll wrap and dunnage bags, (3) Bag & Sack paper -converted into retail shopping bags, grocery sacks and lawn and leaf refuse bags. KapStone's largest competitors include Longview Fibre, Georgia-Pacific and Smurfit-Stone. Demand for kraft paper is fairly stable and prices tend to shadow linerboard.

Kraftpak is heavy kraft paper  that has been converted into boxes and containers used to ship and display product. Examples include food packages, coffee cups, etc.  It is a niche business that retains the highest company margins.  Kraftpak is a low-density, virgin-fiber paperboard used in beverage carriers, gift boxes, takeout cartons, and retail food cartons.

 

Price Increases in Linerboard-The industry is due for a price increase that should happen on July 1 or August 1 which will drive earnings estimates higher.  The linerboard industry is very tight right now operating at 95% capacity with input costs rising.  Currently there are a number of scheduled and unscheduled mill downtime which should drive inventories lower.  There was a price increase which did not materialize in the fall of 2010 because of the disorganization of Smurfit Stone.  Now that RKT is in the process of acquiring RKT, the industry price increases should go through.  The industry wants to raise prices because it can, and also because their input costs are rising starting with recycled fiber.  Since KapStone has zero exposure to higher recycled fiber costs, an industry price increase drops to their bottom line as opposed to offsetting the higher costs.  KapStone produces 565,000 tons of linerboard annually.  A $60/ton increase would increase topline by another $34mm or 4% but drop mostly to the bottomline.  2012 EBITDA and FCF estimates could be another $20mm higher.  If this happens KS would trade at a mere 4.5X 2012 EBITDA and 17.5% 2012 FCF/EV yield.

Stock Dividend or Stock Buyback-Over the past 2 years the company has generated $350mm in cash flow from operations and has substantially delevered its balance sheet.  It will have a net cash position by the end of this year.  Management has acknowledged this and may look to institute a buy back or dividend.

 

 

It is important to note in the model that while KS accrues a full tax rate their cash taxes are very low to bio-fuel tax credits and net operating losses.  Their maintenance capex runs at about $25-30mm and they have various growth and efficiency capex which is small but holds a high ROI.  As you can see their discretionary cash flow models quite high over the next year or two.  It is also important to note that I am not incorporating any upcoming price increase in the containerboard market which could make these number too low

 

	2010		2011		2012
Revenues	782		855		875
Gross Profit	217		269		280
Freight & Dist.	73		73		75
SG&A	31		38		40
D&A	45		48		50
EBIT	68		110		115
Interest	5		2		1
PBT	63		108		114
Taxes	-2		37.8		39.9
Rate			35%		35%
NI	65		70.2		74.1
EPS	1.38		1.48		1.56
EBITDA	113		158		165
Margin	14.5%		18.5%		18.9%
Interest	3.2		2		1
Cash Taxes	-13		2		8
Maint Capex	25		26		28
Discretionary FCF	97.8		128		128

I believe the stock is conservatively worth $20/share which is 6.4X this year's EBITDA versus its peers like PKG at 7.1X.  KS should trade at a discount given its smaller size and less vertical integration.  At 20/share KS still trades at nearly a 13% FCF/EV yield.

Shares Outstanding		46.3
Price		16.32
Market Cap		756
Net Debt		85
EV		841
EV/2011 EBITDA		5.3
EV/2012 EBITDA		5.1
2011 FCF/EV		15.2%
2012 FCF/EV		15.2%