Value Investors Club / PACKAGING CORP OF AMERICA (PKG)

Description

Background

• Packaging Corp. was formed under that name in 1959 through the consolidation of 3 companies. They

were then taken public in 2000 by a private equity firm. They are headquartered in Illinois and have

15,500 employees.

• Market cap of $9.8 B, with broad analyst coverage.

• The CEO and chairman led the containerboard mill system for 12 years assuming those roles in 2016.

Executive’s annual incentive compensation is based on an EPS target, while long term incentive awards

are based on ROIC and total shareholder return measures.

How do they make money?

• Packaging Corp. is the third largest producer of container board and uncoated freesheet paper in North

America. Their paper operations expanded significantly with the acquisition of “Boise” in 2013.

• They operate 6 containerboard mills, 95 corrugated manufacturing plants, and 2 paper mills. Each

manufacturing plant serves a market radius of 150 miles. They lease cutting rights to 73,000 acres of

timberland, but mills can use both new wood fiber and recycled fiber.

• Three segments are reported, Packaging, Paper, and Corporate. Corporate results reflect timber lease

assets, and transportation assets. Corporate results are typically losses.

• Operations are some of the most integrated in the industry with ~95% of container board used for

manufacturing operations. Corrugated operations produce recyclable fibers, which are then used for

container board production and 2/3rds of a mill’s energy usage is generated from operations byproducts.

• Operations are flexible, but require costs and time to pivot. Opportunities are evaluated on an ROIC basis.

o In 2018, their Wallula paper mill was convert to produce linerboard. This switched its assets from

the paper segment to the packaging segment. This conversion took over two years.

Customers

In the packaging segment, they have 17,000 customers across 35,000 locations. However, 70% of customer are

regional and local accounts and the remaining 30% are national accounts with multiple locations that are supplied

by a number of plants. No customer makes up more than 10% of segment sales. Focusing on regional and local

accounts seems to provide Packaging Corp. with higher margins than peers who have higher national account

exposure.

End users of corrugated boxes operate in a number of industries and geographies, but food, beverage, and

agricultural products make up nearly half of the end market for corrugated boxes. E commerce, which has been

increasing as a percentage of box shipments still only makes up about 13% of demand.

The paper segment serves 100 customers in 400 locations, but the primary customer is Office Depot. Office Depot

makes up 50% of segment sales and 7% of total sales. Packaging Corp. has a supply agreement with Office Depot,

which runs through 2022. Office Depot does not have minimum volume commitments, but if the agreement is not

renewed then purchasing would phase down over a two year period beginning at the start of 2023.

Industry and Competition

On a national level competition comes primarily from other large producers, International Paper, WestRock, and

Georgia-Pacific, but they also compete with smaller independent operators in local markets. Packaging Corp.

competes with many of the same companies in both the paper and packaging segments.

On average, containerboard capacity has slightly exceeded consumption over the past 10 years. Capacity has

grown at 1.4% per year, while consumption (inventory change + production + net exports) has increased at 1.1%

per year, on average. This has led to reasonably stable operating utilization of 95%. However, in 2019, destocking

led to excess capacity, which in turn led manufacturers to increase downtime (partially for maintenance and or

upgrades) to balance supply. These actions led to utilization declining to 92% for the year.

Total U.S. containerboard capacity is about 40 million tons per year. Capacity that is set to come on line during

2020-2021 will add about 1.5-2 million tons or a 4-5% increase in capacity. This higher level of capacity increase

could out grow demand. The projects to increase capacity have been known for around 2 year and pricing has only

declined by 5% from the beginning of 2019 to today, suggesting demand may be more robust and able to absorb

the excess capacity. 40% of the new capacity will be brought on by current integrated suppliers which have

historically shown that they will increase/decrease production to fall in line with demand.

Some of the added capacity is coming from mill conversions. Declining demand in the commodity paper market is

causing manufacturers to convert mills to produce different types of paper goods such as packaging and pulp

products. This has led to some new entrants into the containerboard market. For example, in August 2020, Domtar

announced plans to enter the containerboard market by early 2023 through the conversion of paper producing

assets. Their conversion will increase total industry capacity by 1.5%.

Financial Strength

Solid financial strength and sufficient liquidity. Packaging Corp. has managed their leverage well over their history

by typically keeping it in a tight range. Other than one large acquisition in 2013, they have focused on bolt-on

acquisitions. In the most recent quarter management reiterated their capital allocation preference toward organic

investment, and small bolt-on acquisitions with no interest in looking to expand operations internationally.

• Rated BBB (Stable) by both Moody’s and S&P, which has not changed for many years.

o The primary risk noted by Moody’s is their lack of product and geographic diversity.

• Total debt of $2.5 B and cash of $0.9 B.

o No maturities until November of 2023.

o Lease liabilities of $270 M. The majority of buildings and land are owned.

o Undrawn revolver capacity of $330 M maturing in 2021.

• Leverage ratio and interest coverage covenants are tied to the revolver.

o Leverage ratio maximum of 3.5x

▪ Currently: 1.9x

▪ 10 Year Average: 2.1x

o Interest Coverage minimum of 3.5x

▪ Currently: 12.8x

▪ 10 Year Average: 14.9x

• Free cash flow has been positive each year for more than 10 years.

o 2010 and 2011 had only modestly positive FCF, but still positive.

Risks

• General commodity supply and demand.

o Continued declines in demand for paper without further permanent supply reductions.

o New capacity in the containerboard market exceeds demand. Demand increased during COVID

due to higher food staple sales as consumers ate more at home and ecommerce activity

increased, but demand could wane as the year goes on.

• Poor execution on organic investments such as conversions.

• Workforce issues as 45% of their total labor force is unionized. 9% of their workforce have collective

bargaining agreements expiring during 2020.

Why is it interesting?

• Capacity is being controled by a small number of large players. Producers continue to show rationality in matching production with demand.

• Solid balance sheet and financial strength which has been consistent for some time.

• Solid position on the industry cost curve.

• Track record of double digit ROIC and good capital allocation. Opportunities are evaluated on an ROIC

basis and managements longer term incentive compensation is tied to the same metric.

• Higher mix of small customers which provide margin advantages.

Valuation

A better opportunity could be presented to invest in Packaging Corp., as it is likely approaching fair value. However, news of someone looking to acquire them or a strategic move with their cash pile could lead to the price move beyond that level. This seems like a reasonable entry point to begin gradually building a position.

My valuation leads me to a 0.93 P/IV.

I am using an ROE based DDM to value the company. I use an ROE of 21% with a fade to 15%, payout ratio of 45%, terminal multiple of 12x and a discount rate of 9.5%. I use this model to reach a terminal value in both 10 and 25 years and take the average of these intrinsic values.

The ROE is lower than historical averages of 26% - 10Yr, 29% - 5Yr, and 30% -3Yr. However, bookvalue has growth signficantly in the past few years which will likely lead to lower ROEs unless a strategic decision is made with cash.

Using a lower ROE and a higher discount rate in the current interest rate environment may help to give some margin for error as this is a cyclical company who will experience a downturn at some point.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Recent $50 per ton containerboard price increase by International Paper is being accepted by other industry, showing continued rationality by large producers. Packaging Corp. has build cash up to near $1 B allowing for strategic flexibility. Packaging Corp. is the 3rd largest producer, but has the most attractive ROIC. With industry consolidation nearly completed, Packaging Corp. will be an attractive acquisition target for Westrock or International Paper.

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			2020	2021
Price:	107.65	EPS	5.40	0
Shares Out. (in M):	94	P/E	19.9	0
Market Cap (in $M):	10,136	P/FCF	0	0
Net Debt (in $M):	1,757	EBIT	927	0
TEV (in $M):	11,893	TEV/EBIT	12.8	0