Value Investors Club / PACKAGING CORP OF AMERICA (PKG)

Description

PKG a best in class competitor in an industry undergoing two significant secular shifts that could lead

to accelerating profits for many years to come. Despite being perceived as expensive by the sell side,

PKG’s GAAP earnings understate the true economic earnings of the business and its premium

valuation compared to its competitors does not appropriately reflect the degree of its superior

economics and competitive position.

PKG is the fourth largest containerboard producer in the US (85% of EBITDA) and the third largest

white papers producer (15% of EBITDA) in North America. Our main focus is on the containerboard

side of the business. PKG’s white paper business is largely a no-growth cash cow. The white paper

business has relatively modern equipment, requires modest CapEx and produces good cash flow.

Before we dig into PKG’s corrugated business specifically, I am going to describe the industry

backdrop.

The Corrugated Packaging Industry

Corrugated packaging (cardboard boxes) are responsible for transporting 80% of all consumer goods

at some point in the distribution chain. There are currently no economically rational substitutes for

cardboard boxes. Over 90% of cardboard boxes are recyled. A cardboard box can be recycled up to

eight times before its structural integrity completely breaks down. Fiber is very important because it

is the largest variable input cost for boxes. North America is the largest source of virgin (non-recycled)

fiber which is the precursor necessary to make first run boxes which can later be recycled. About one

third of all recycled fiber or “OCC” in the US is exported to feed the world’s recycled plants. Only a

little more than one quarter of the world’s container board is made with virgin fiber.

Prior to the downturn, the corrugated box business was not very attractive, despite the US’s

competitive access to virgin fiber. Many producers were vertically integrated with timber assets, and

often the businesses were managed to get returns on timber at the cost of box margins. The market

was very fragmented with the top five producers only representing 44% of total production. Integrated

producers would slash prices to gain share and keep operating rates high. As a result, there was a race

to the bottom and no one consistently made any money. Following the financial crisis, the industry

consolidated and major corrugated producers divested themselves of their timber assets. After this

string of M&A, the top five corrugated producers went from 44% of the market to 81%, with the top

two processors controlling 55%. Many cyclical industries often experience dramatic increases in

returns on capital following a significant consolidation wave.

From 2011-2015 box shipments grew at 0.8% CAGR, however since October 2016, monthly box

shipment growth has accelerated to 3.3%. So, what is driving this growth? It is likely that e-commerce

has hit an inflection point where continued growth is dramatically effecting the consumption of boxes.

E-commerce sales have doubled in the last ten years, and is growing 15% annually, representing 9%

of total retail sales. If E-commerce accounts for 10% of volumes and grows at 15% annually, while

the remaining volume grows at the same 0.8% historic rate, total volume growth for boxes would be

2%, more than double historic growth rates.

E-commerce uses corrugated boxes in a much less efficient fashion than when products shipped to

traditional retail. Below, Jack Sanders, CEO of Sonoco, which has some exposure to recycled

corrugated boxes, discusses the effect of the internet on box demand and OCC,during the company’s

first quarter call.

M. Jack Sanders, CEO of Sonoco:

…. the way I look at it, e-commerce is adding one box, one corrugated box to every product purchased…

because I bought 2 pairs of shoes this week. If I'd have gone to a shoe store, I'd have walked out with 2

shoeboxes. But I got them delivered to my house, so the 2 shoeboxes came in a corrugated box. So that's

happening every day, everywhere, not only in the U.S. but also in Asia, China specifically… The negative side

of that is that if that box -- if the master box that carried shoes went to the shoe store, it would then be collected,

put in the back of the store, we would have picked it up from our recycling business. Today, I now have the

box, so I don't have curbside recycling here in Florence, so I'mgoing to throw it in the garbage can, and it'll

wind up in the landfill. So, it's a dual impact that in those areas where you don't have recycling, it's winding

up in the landfill, which is taking it out of the recycling stream. And then, of course, the extra box that is

created by e-commerce.

As a result, containerboard operating rates are very tight with plants running at 99% of capacity since

May. Increased demand for boxes, along with recycled container board capacity additions from 2014

and 2015, has led to a spike in OCC prices from about $90 per ton last year to $150 per ton today.

Recently, the Chinese have placed restrictions on OCC imports which has caused domestic OCC to

fall from a peak of about $175 per ton to $150 but most industry experts believe that the strain on

Chinese box costs should force the ban to be lifted or relaxed early next year to prevent too much

distruption to the Chinese supply chain.

It is possible the increased demand for e-commerce is pushing OCC into a very inflationary environment. Today, the global recycle rate for boxes is 85%. All new containerboard capacity in the rest of the world utilizes recycled OCC which must ultimately have a virgin source. With global virgin containerboard capacity remaining flat, and OCC containerboard capacity growing each year, eventually OCC prices will get squeezed higher. This is important because the largest source of

potential increased containerboard capacity in the US is paper machine conversions to make OCC derived containerboard. At current OCC prices, despite the increase in box prices, the economics of OCC containerboard mills are not very attractive.

Virgin fiber is generated from wood scrap which is typically created as a result of increased new home

construction. For the last several years virgin prices have been flat to declining. In an environment

with rising OCC prices, stable virgin fiber prices, and improved pricing for corrugated packaging,

containerboard manufacturers with higher virgin fiber content should enjoy significant margin

expansion. Despite this, it is unlikely for additional containerboard capacity utilizing virgin fiber to

come online in the near future as new containerboard plants with the ability to use virgin fiber as an

input cost nearly $1 billion and take nearly 5 years to construct. There are only a few white paper

plants that con be converted to add additional virgin capacity and PKG has already announced

convierion of one that will add about 1% to US capacity. The remaining conversions will not likely be

sufficent to keep up with domestic demand growth and prices will likely contintue to rise.

Packaging Corporation’s Place in the Corrugated Industry

Degree of Box Plant Integration

As we did more work on the space, we eventually decided to add PKG to the portfolio. PKG’s

Corrugated Products Group has a unique set of strengths in the industry. Unlike most of its

competitors, PKG’s customer base is skewed to small local accounts which represent about three

quarters of its business by revenue. The remaining quarter of its customers are its top 30 national

accounts, however, most of the products PKG produces for national account customers are higher

margin value-added products customized to the specifications of the customer. PKG has a rich

product mix, from traditional brown boxes to high-end graphics and displays. Most corrugated

products made by PKG are manufactured to the customer’s specifications. For small local accounts,

corrugated producers generally sell on a just-in-time basis within a 150-mile radius of their plants and

compete with other corrugated producers in their local region. Because PKG focuses on smaller

regional customers and more specialized packaging with smaller runs, PKG is able to charge a greater

premium than its competitors. This leads to higher revenue and operating margins per ton than those

enjoyed by its large, less integrated rivals.

PKG also has the highest percentage of box plant integration relative to its other major competitors. This allows PKG to capture a larger percentage of the margins associated with specialty boxes where more value is added. Because of these advantages PKG is the best in class among its competitors. You can see from the chart below that PKG has historically run circles around the competition in terms of returns and profitable growth.

In the current environment of rising OCC prices, PKG also has the lowest exposure to OCC which

could lead to multiple price increases and a rerating of the entire industry. As a result, PKG will capture

the improvement in box pricing but will not suffer anywhere near the drag its competitors will face

from rising OCC input costs.

Based on our analysis of virgin exposure and sensitivity to price increases, it seems likely that the sell

side is underestimating PKG’s earning potential. The chart below illustrates the net effect of higher

OCC prices and the announced containerboard hikes for 2018. The sell-side appears to be giving

more credit in earnings estimates than just the containerboard price hikes announced so far for every

company except PKG. In addition to the estimated increases below, PKG has two large box plant

acquisitions which should add around $0.25 to $0.40 of incremental EPS, and an expansion at its

DeRidder plant in 2018 that should add $0.15 to $0.20 per share in EPS. On August 21 of this year,

PKG announced the acquisition of Sacramento Container Corporation for $265MM at approximately

5X EBITDFA after synergies. This should result $0.20 to $0.25 per share of EPS for 2018. With these

four items, plus the declared price increase, PKG should be able to produce $7.65 to $7.90 in 2018

EPS. Earlier this month Georgia Pacific the third largest corrugated producer announced a $60 price

increase for container board and Kapstone Paper followed. Assuming the rest of the industry follows

and pas through a $50 price increase for container board, we can add another $1.41 in EPS for PKG,

bringing the total to around $9.20 a share. We don’t think that consensus numbers accurately capture

these benefits.

In addition to these acquisitions, PKG has also announced that it will discontinue production of

uncoated freesheet and coated one-side grades at its Wallula, Washington mill in the second quarter

of 2018 to begin the conversion of its 200,000 ton-per-year No. 3 paper machine to a 400,000 ton-

per-year high-performance 100% virgin kraft linerboard machine.

The conversion of the No. 3 paper machine at the Wallula Mill is planned for the second quarter of

2018 with an initial production rate of approximately 60 percent of capacity. Ultimately, production

will increase to 1,150 tons per day once a new headbox, forming section, and shoe press are added in

the fourth quarter of 2018. The capital cost of the conversion is expected to be approximately $150

million. Discontinuing paper operations at the Wallula Mill will result in pre-tax cash severance and

other shutdown charges of approximately $20 - 25 million charges.

The Wallula conversion will represent about an 11% increase in PCA’s containerboard production

when it is on line in late 2018. There are only about four or five different paper plants in the US that

have adequate to the right virgin fiver to support a similar conversion. Current revenue estimates for

PKG are flat from 2018 to 2019 and do not include the impact of this conversion. For the purpose

of my earnings analysis, I also don’t include the conversion but it could result in significant increases

in both earnings and revenue.

Regardless of these factors, we don’t believe current estimates accurately reflect the price increases

that have already been adopted by the market. See the chart below.

One other important consideration regarding PKG is that there is a significant difference between

maintenance capital expenditures and depreciation expense. This has the effect of depressing reported

earnings compared to the company’s true economic earnings. Packaging Corp reports roughly $170M

of maintenance cap ex vs. depreciation of $356M. This delta, if corrected for, would add an

incremental $1.29 to cash EPS. Based on 2018 numbers, PKG would generate about $9.20 in

economic earnings. Given the quality of the company, and its ability to consistently generate returns

in excess of its cost of capital, I think fair value is about $147 per share, or 16X economic earnings or

about 28% from its $115 clsoing price. In an upside scenario, if the anounced containerboard price

increase sticks the stock probably deserves to trade north of 20X the $10.61 per share the company

would produce, or about $212 per share. This higher multiple would incoproarte the secular change

that is taking place in the box market as a result of the infleciton point in ecommerce.

I believe PKG may be in front of a major secular trend driven by the improving container board

market and a global tightening of OCC supply. Without this trend, PKG would still be a desirable

continuous compounder given its competitive position in a consolidated industry.

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

Catalyst

Rising containerboard prices

Earnings

Capital Projects not incorporated into sell side projections

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			2017	2018
Price:	115.00	EPS	0	0
Shares Out. (in M):	94	P/E	0	0
Market Cap (in $M):	10,846	P/FCF	0	0
Net Debt (in $M):	2,314	EBIT	0	0
TEV (in $M):	13,160	TEV/EBIT	0	0