Packaging Corp of America

Packaging Corp (PKG) is the fifth largest producer of containerboard and corrugated products (think cardboard boxes) in the United States with 2.5mil tons of annual production. PKG is primarily a virgin producer (meaning that they use trees to produce their containerboard) and will benefit from the long term secular rise in recycled containerboard costs (driven by Asian demand and fiber shortages to be discussed below). The company's competitive advantage is that they are the low cost producer in the industry with the strongest management team. Combining rising input prices for the recycled producers with a large energy project that will be completed this year will meaningfully shift current earnings beyond the consensus forecast. I think the business is worth $46 per share, or 60% higher than the current price of $28.80.

The Business:  PKG produces 2.5mil tons of containerboard at its four mills - Counce, Tennessee (1mt), Valdosta, Georgia (.5mt), Tomahawk, WI (.5mt), and Filer City, MI (.5mt). Eighty percent of the containerboard is consumed internally in the 67 box plants owned by the company, with 9% sold to non-company owned domestic box plants, and 11% in the export market. PKG is unique in that they consider both the containerboard mills and the box plants profit centers. As the majority of the containerboard is sold to the box plants, it is important to note that they are able to earn higher prices and margins in this segment because of their focus on smaller, local customers and not national accounts. A long term stated goal of the company's management is to increase the internal consumption of containerboard by either acquiring (they have announced 1 box plant acquisition this year) or building new box plants.

Whereas containerboard production is highly concentrated among five major players - IP, SSCC/RKT, GP, TIN, and PKG (top 5 are north of 70%), there are many small, independently owned box plants. The bottleneck in this industry is production of the containerboard sheet.

The following is a quick primer on containerboard:  Containerboard can be manufactured using either cut down trees (virgin containerboard), or old recycled containerboard (commonly referred to as OCC). Given the environmental regulations and capital costs, there has not been a new virgin containerboard plant built since the 1970s. That contrasts to OCC production where new capacity was built as recently as 2008.

It takes roughly 3.8tons of virgin trees to make 1ton of containerboard, whereas it takes 1.1ton of OCC to make 1ton of containerboard. Additionally, the virgin manufacturing process allows for the use of the black liquor in the tree to be used to produce fuel and power the facility. The OCC process requires outside purchases of fossil fuels to power the plants. There are some other differences that are not significant such as chemicals that also influence the costs. Taken the above together, and with OCC prices at $175/ton and Virgin prices at $25/ton, I estimate that today it costs on average $400/ton to make a ton of virgin containerboard whereas it costs $510 to produce a ton of OCC containerboard.

Finally, the quality differential of a virgin box compared to an OCC box is significant. The virgin box is stronger and more durable and is required for fresh produce and high end boxes.

Thesis: The three important points that drive long term earnings power for PKG are - 1. Rising prices of OCC driving rising prices of containerboard, 2. Major Energy Initiative and 3. Industry consolidation.

1. Rising OCC Prices: Only the United States and Scandinavia have the softwood needed to produce virgin containerboard. The rest of the world relies is short softwood and therefore relies on recycled containerboard as the main input. China is nearly 100% recycled containerboard producer and currently accounts for the 1/3 of global production, or 40mt - slightly more than the United States. As China continues to build containerboard manufacturing facilities - they are expected to grow 21% by CYE2012, the demand for OCC, particularly from the United States will cause recovered prices to rise significantly. As a reference point, OCC prices domestically have increased from $100/ton to $175/ton over the past three years. I further believe we will reach a tipping point this decade where the generation of OCC starts to fall and demand continues to rise (a box can only be recycled 4-5times before the fibers are too weak to recycle further). The recent proposed acquisition of Smurfit Stone by Rock-Tenn (which is 100% OCC before the acquisition and will be 45/55 post the acquisition) is evidence of the long term view on rising OCC prices.

What this means for the industry is that the price of containerboard going forward will be set by the price of OCC. As PKG has the lowest OCC usage (16%) among competitors, EPS should increase by $0.60/share for every $50 per ton increase in OCC.  For those interested, I highly recommend reviewing recent presentations and speaking with PKG or RKT to understand the supply dynamics going forward.

2. Major Energy Initiative: In late 2009 PKG initiated a $295mil capital investment in Valdosta and Counce which will result in the elimination of all fossil fuel purchases at these two plants, increase efficiencies and production, and potentially allow for the sale of electricity back to the grid. The company expects run-rate annual savings of $90mil per year and an after tax return of 25%. This project will be up and running in Q4 of this year and will add $0.55 of run-rate free cash flow which is not in the numbers currently. The project further enhances their low cost position and was done with cash and tax credits on hand.

Consolidation: In late 2007 IP bought Weyerhaeuser's containerboard assets and this year Rock-Tenn announced a purchase of Smurfit Stone. Together, the top 5 players have 75% of production and this has allowed for more disciplined pricing. Evidence of this can be seen during 2009 when in the midst of the largest drop in containerboard demand in decades -9% peak to trough, pricing fell from $635/ton to $510/ton, or above the previous peak. Current prices are $640/ton.

Prices are set using a survey conducted by RISI (the industry trade magazine) of customer prices and then based on those results the magazine publishes a price that is then used as the market price. This process is opaque and in August 2010 a third price hike of $60/ton to $700/ton was announced and then rescinded within three weeks by the magazine. This created a lot of confusion, surprise, and frustration among investors and producers as to what happened. My research indicates that it was primarily Smurfit Stone that did not go along with the price hike given their emergence from bankruptcy. Therefore, there is an expectation that once RKT completes the acquisition (RKT is known as excellent operators and a disciplined market participant) that the $60/ton increase will be implemented later this summer.

Financials:

The balance sheet is strong with $200m in cash, $659mil in debt and interest coverage of 9x. I use a multiple of 12x after tax free cash flow which is derived as follows:

2011 Earnings:                       $215mm

Depreciation:                          $150mm

Maintenance Capx:               ($100mm)

Energy Initiative:                     $55mm

Price Increase of $50:             $75mm

2012 FREE CASH FLOW:   $395MM

PER SHARE                             $3.87

At 12x after tax free cash flow PKG would trade at $46, or put another way at $28.80 you are paying 7.4x 2012 free cash flow - a 13.4% yield.

Final Comments:

-       I cannot speak highly enough about the management team at PKG given their record of consistently outperforming the industry on all relevant financial metrics. PKG has the highest margins in the industry, the lowest leverage, and has recently begun buying back shares and increasing dividend payments. After the completion of the energy project I expect them to meaningfully increase the dividend.

-       PKG was created in 1999 through the LBO of Tenneco and subsequent spin off of PKG in 2000. At the time of the acquisition the company was levered 6.0x compared to 1.2x forward EBITDA.

-       Late last year there was concern about the potential to convert old newspaper plants into containerboard facilities. The first company to announce a conversion - Abitibi canceled those plans citing the expense to convert the paper facility. The only new domestic supply would come from major capital investments which I do not foresee as likely but is a risk.

- The major risks are economic and a major economic slowdown such as seen in 2008/9 would severely hit demand for containerboard. There is also the "China risk" as the demand from Asia for OCC is driving pricing for containerboard. From an operational standpoint the energy project will be completed later this year (all the materials and the contract are procured at a fixed price).