Packaging Corp. of America ("PKG") is the 4th largest manufacturer of containerboard and corrugated products (cardboard boxes) in North America. Basic stats: $7.3b market cap, $9.5b TEV, 10.5x 2014 EBITDA - Maint. Capex and 8% 2014 Maint. Free Cash Flow Yield.
Attractive industry - The containerboard industry has gone through significant consolidation in the last several years. The 4 largest players now control ~75% of the market. The industry is characterized by rising prices, stable (and cyclically depressed) volumes, and consistently high operating rates
Clear path to industry-leading earnings growth - We estimate 10%+ annual EBITDA growth from $1.1b in 2014 to $1.4b in 2016
PKG has a strong track record of taking market share
PKG acquired Boise in October 2013 for 4.3x EBITDA post-synergies. PKG expects "at least $175m" of synergies, most of which have not yet been realized
In October 2014, PKG converted an old newsprint machine ("D3") to produce containerboard; PKG spent $115m to generate $60m of incremental EBITDA -> 1.9x EBITDA (highly accretive)
Attractive absolute and relative valuation - PKG trades at 8% 2014 Maint. Free Cash Flow Yield, growing to 11% by 2016; it trades in-line with its publicly traded comps on both levered and unlevered multiples, despite superior earnings growth and higher margins
Industry actively exploring an MLP structure, and PKG is the best positioned - We believe the production of containerboard from virgin fiber qualifies for MLP treatment. PKG is the best positioned to take advantage of this structure given (1) highest exposure to virgin capacity, (2) superior organic growth profile. Due to low cost capital and importance of distribution growth, an MLP within the industry creates incentive for further industry consolidation
At 10x 2016 EBITDA - Capex, PKG is worth $102 / share, ~40% upside in ~1.25 years. If PKG creates an MLP structure, we estimate PKG is worth $122+, 67%+ upside.
Investment Thesis
Attractive industry
After several mergers, the industry is now highly consolidated with top 4 players controlling ~75% share
Current industry structure: International Paper 32%, Rock-Tenn 20%, Georgia-Pacific 11%, Packaging Corp. 10%, Kapstone 7%
In 2000, top 4 players controlled 49%
Significant recent mergers: IP acquired Temple-Inland (2012), Rock-Tenn acquired Smurfit-Stone (2011), IP acquired Weyerhaeuser (2008)
Industry behaves rationally
IP and Rock-Tenn take downtime to control supply / demand balance
Containerboard prices have steadily risen over time at a 6% CAGR since 2006
Industry generally runs at 92% - 100% capacity utilization; currently at ~98%
Industry volumes are currently ~360 billion SF, which is relatively flat since 2010, but cyclically depressed versus a long-term average of ~388 billion SF (pre-2008)
All of the major containerboard producers have significant exposure to virgin fiber capacity, which is cost-advantaged vs. recycled containerboard (“old corrugated container” or “OCC”)
It is prohibitively expensive to build a new virgin mill from an environmental permitting and cost perspective, so new capacity uses recycled fiber
In the short-term recycled fiber prices are volatile, but in the long-term recycled fiber costs should increase (fiber can only be recycled 7x) -> recycled capacity will continue to be the marginal high cost producer
PKG has a track record of taking market share
Since 1997, PKG has grown volumes 55% (40% organic); during the same period, industry box volumes declined 7%
We attribute market share gains to PKG's focus on local / regional customers, IP and Rock-Tenn controlling supply to maintain industry pricing, and superior execution
Synergies from Boise and D3 conversion expected to add at least $155m in EBITDA by 2016
In October 2013, PKG acquired Boise for $2b at 6.8x EBITDA (4.3x w/ $175m in synergies)
$175m of synergies likely conservative, as guidance has increased from $105m to “at least $175m”
~$80m expected to be realized in 2014 -> “at least” $95m in incremental synergies to be realized beyond 2014
In October 2014, PKG converted a Boise newsprint machines (“D3”) to containerboard. The economics are compelling: $115m investment to produce $60M of incremental EBITDA -> 1.9x EBITDA
We note that the Company has a strong record of pursuing and completing high ROIC capex projects (Counce / Valdosta energy projects in 2010/2011, for example)
Attractive absolute and relative valuation
Trades at 10.5x 2014 EBITDA - Maint Capex, and 8% Maint. FCF yield
Trades at 8.2x our 2016 EBITDA - Capex estimate
EBITDA to grow from $1.15b in 2014 to $1.4b in 2016 ($155m from Boise/D3 + $100m from organic growth)
Assumes $250m of maintenance capex
Implies $7.75 / share of FCF in 2016 (11% yield)
At 10x 2016 EBITDA - Capex, shares are worth $102, ~40% upside before any value from an MLP structure
Attractive relative valuation – Based on 2014 EBITDA - Maint Capex, PKG trades at 10.5x vs 10x for the comps (IP, Rock-Tenn, and Kapstone). PKG has highest growth profile and industry-leading margins
Industry is actively exploring an MLP structure, and PKG is the best positioned
A Master Limited Partnership (“MLP”) is a tax pass-through entity for income derived from the exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource. We believe the conversion of virgin fiber into containerboard qualifies for MLP status
The Company can be thought of as 2 different businesses
(1) Mills that convert virgin fiber into containerboard
(2) Box plants that convert containerboard into corrugated boxes
Business (1) could be structured as an MLP that sells containerboard to business (2)
All publicly traded comps have announced they are actively exploring a MLP structure. Rock-Tenn and Kapstone have filed private letter rulings (PLR) to the IRS, while IP and PKG are preparing to do so
PKG appears to be very interested in the structure
“We spend a lot of time on this and we have a good appreciation of its merits, both financially and strategically”
“Our ability to redeploy assets should resonate well with any potential MLP investors and this can create a lot of value for both the MLP investors and the PCA shareholders”
“We’ve engaged legal and financial assistance to provide the information that will allow us to submit a request to the IRS for a Private Letter Ruling”
“As Mark said, we’ve engaged auditors, legal and other advisers to look at what we would need to do for setting up the initial MLP IPO for carve-out audited financials”
We believe PKG is best positioned in the industry to take advantage of the MLP structure due to (1) highest exposure to virgin mill capacity, (2) industry-leading organic growth profile
PKG’s mill capacity is 74% virgin, whereas KS is 65%, IP is 63% and RKT is 55%
Due to low-cost capital and incentive to create accretion, we believe an MLP at either PKG or a competitor would create more incentive for further industry consolidation
The value creation from an MLP is dependent on many assumptions, but we estimate the MLP can add $20+ / share in value, 27%+ of today’s share price. This implies $122+ / share of total value, or 67%+ upside
In a reasonable end state of the MLP, we estimate PKG could allocate 60%+ of EBITDA into an MLP, employ 4.5x leverage, and trade at a 6.5% dividend yield
Based on extensive work and conversations with leading tax experts, we believe there are multiple strategies that can be used to minimize, defer, and potentially avoid tax leakage
However, our estimate use conservative tax leakage assumptions
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.
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