Description

Long Rock-Tenn - $100

Investors have been flocking to shares of recently consolidating industries like airlines, car rentals, DRAM and broadcasters.   We think they are overlooking an old favorite in the containerboard industry that has fully integrated its transformative acquisition and de-levered the balance sheet.  Rock-Tenn has successfully integrated their 2011 acquisition of Smurfit-Stone, repaid debt to below target levels as of the most recent quarter, and is now in a position (and management is incented) to use its significant cash flow for dividends, buybacks and acquisitions.

Hao777 and gas394 have each nailed the integration/earnings power investment case in the past.  With that thesis having largely played out as predicted, we think it’s a good time to revisit the company as Rock-Tenn enters a new chapter of capital returns.  Both of the previous RKT reports are well worth reading for background/industry dynamics.

As brief background, Rock-Tenn became the second largest containerboard producer with the purchase of the larger Smurfit-Stone for $5 billion in 2011.   Although there were a few integration hiccups and a 2012 management change in one of the operating units, Rock-Tenn will have fully integrated Smurfit-Stone by mid-2014 when the box plant integration is completed, cut costs as expected (and will be running at $550 million in synergies/cost cutting in 1Q14) and as of their year-end in September already de-levered to below their target of 2x net debt/ebitda.  Management has already increased their share buyback authorization to 5 million shares from 1.8 million and increased the dividend to $1.40/year and we think there is much more to come.  Rock-Tenn will report results for 4 segments in 2013 with merchandising displays broken out from the consumer packaging segment for the first time.  The more cyclical corrugated segment produced 68.6% of sales last year while the more consistent packaging unit was responsible for 26.5% of sales, recycling accounted for the remaining 4.9% of revenue.

The containerboard industry began consolidating in 2008 with International Paper’s acquisition of Weyerhaueser’s packaging unit and since that time there has been a number of transactions amongst the leading players – as a result the top 4 producers now control 76% of the market as opposed to 47% in 2000.  International Paper and Rock-Tenn are the two largest players in the containerboard market with a 33% and 20% share, respectively.  Both companies are focused on returns and matching supply with demand, both have paid down debt and both will be returning their significant free cash flows to shareholders via dividends and buybacks.  Neither of the two companies are chasing volumes and RKT halted production of 60K tons in the most recent quarter to focus on matching supply with demand.  We like both stocks but think RKT is slightly cheaper and further along on debt reduction which will allow for larger buybacks and we think will result in multiple expansion.

Even with a weak economy the past few years, RKT and the industry have been running capacity in the mid 90's and have been able to push through two price increase in the past year.  With the wave of consolidation, significant capacity has been shut down, and new capacity additions and announcements have been moderate with announced additions approximately equal to expected increases in demand through 2015.  Historically a low to mid-90's utilization rate is associated with a balanced market so the metrics here have been strong.

The investment case for Rock-Tenn revolves around improved industry conditions and the significant free cash flow they will generate in the coming years.  We think shareholders will be rewarded in 2014 and 2015 as Rock-Tenn has hit their target leverage, has very little debt due in the next two years, has increased their buyback authorization from 1.8 million shares to 5 million shares and management is incentivized to increase free cash flow to equity to hit their 2013-2015 long-term incentive grants.

Management is guiding to $12.50-$13.50 a share in FCF for the current year; the metric they use is “Cash Generated for Net Debt Repayment, Dividends, Acquisitions/Investments and Pension Funding in Excess of Expense” which does not penalize them for the $200-$255 million/year pension cash expense through 2017 but it also does not give them any credit for growth CapEx (2014 CapEx of 537.5 at midpoint vs. MGMT’s $350 million maintenance figure) or share buybacks which we think will be close to 7% this year as they max out the authorization. 

Without a price increase in containerboard we think 2015 will look similar 2014 but slightly better cash generation due to continued cost reductions, lower CapEx and returns from prior CapEx investments offset by increased cash taxes.  Management believes that they have significant opportunities for 15-25% after-tax returns on internal CapEx.

Overall we think Rock-Tenn will have somewhere in the vicinity of $30/share to return to shareholders in the next two years.

The key question is what will they do with the cash?

We think management will take a - it’s true if you don’t use it you lose it attitude – and either make acquisitions or buyback significant amounts of stock in excess of what the street is modeling.  Management is paid an annual bonus, the majority of which is based on operating income, which leads one to think they will make acquisitions.  Management also has a three year (2013-2015) long-term incentive which is based on a cash flow to equity ratio: a big reduction in the denominator makes the high end of the bonus easier to hit and there is a big jump from the 2nd highest bonus level to the highest level.  It's also worth noting that management has a large stock component as part of their compensation so they are motivated to get the stock price up.  All incentives lead one to believe that management will be aggressive in deploying free cash flow over the next two years and won't continue to pay down additional debt or let the cash grow on the balance sheet after already hitting their target leverage ratios.

As always the proof is in the pudding and at the Bank of America conference on 12/10/13 management announced RKT had already purchased 560K shares in just over a month since the announcement.  

We think there will be some combination of acquisitions, buybacks and increased dividends throughout 2014 and 2015.  Rock-Tenn has historically grown through acquisition, and is a skilled integrator and cost-cutter.  The current CEO was the CFO from 2000 onwards and has overseen three large acquisitions in the past.  On the most recent call management seemed to indicate they would like to make a strategic acquisition to expand their reach in South/Central America or Mexico (RKT exports 1 million tons overseas, approx.. 2/3 of which goes to Central/South America).  Management has a strong track record with acquisitions and the market has been cheering on company's making acquisitions so we think buyback/acquisition is a win-win situation for shareholders.

In sum, we think management will be aggressive with the cash and not focus on debt repayment.  Rock-Tenn has run between 2-3x leverage since the Smurfit-Stone acquisition in 2011 and we don’t think they will use excess free cash to pay down reasonably priced debt when they are incented towards buybacks and acquisitions.

Valuation

In terms of estimates, we are more or less in-line with the street, maybe slightly more optimistic on continued cost cuts but the big difference comes in what Rock-Tenn will do with the excess cash they generate.  Giving RKT credit for price increases from the Spring containerboard and full credit for cost cuts we get to somewhere in the 1.65-1.7 billion EBITDA range for 2014.  On the capital allocation side we think RKT will generate enough free cash flow to buyback all 5 million shares, increase the dividend and complete a decent size tuck-in acquisition. 

Again, 2015 should at worst look very similar to 2014, with a free call option on increased containerboard prices.  We assume that the company will again use cash to buyback shares and/or make acquisitions.  Management has said buybacks will be the residual after acquisitions are made - given management competence, incentives and acquisition history we think any acquisition will be highly accretive and have an attractive IRR.   

We think that as Rock-Tenn and IP both show discipline and return cash to shareholders that multiples will increase to approx. 7x EV/EBITDA (the net of tax benefits and pension deficits adds $300-400 million to the EV).  Goldman had a recent piece where they showed packaging companies Ball, Crown Holdings and Siligan Holdings were rewarded with increased P-E multiples of approx. 20% when they began returning cash after a period of consolidation.  We think that is appropriate here as the business is better than it has ever been, integrations risks are off the table, and balance sheets are de-levered.

Over a two year holding period, we think that shares have a 60% total return without a containerboard price increase.  A containerboard price increase could lead to a virtuous loop where cash flows increase and are put to work in buybacks and accretive acquisitions while investors recognize the strength of the consolidated industry structure and are willing to pay a higher multiple. 

The company is cyclical but we think RKT's significant free cash flow generation and utilization provides some downside protection. 

Additional Upside Levers

-Further price increases for containerboard, we think likely if economy improves and/or utilization rates remain in the mid-90’s

-Increase in rates can lower pension cash contributions

Catalysts

-Continued industry discipline: as the two leading players in the industry focus on return on investment and capital allocation, earnings, as well as multiples, for the group should improve

-Use of cash in the form of significant buybacks and increased dividends

-Accretive acquisition in Central/South America, Mexico

-Improvement in US GDP

Risks

-Increased containerboard capacity announcements

-General economic malaise

-Input costs, primarily virgin fiber, recycled fiber, natural gas

-Litigation: Smurfit-Stone was one of nine companies charged with violating the Sherman Act for conspiring to fix containerboard prices - too early to tell what will come from this 

-Multi-Employer Pension Plans

Catalyst

-Continued industry discipline: as the two leading players in the industry focus on return on investment and capital allocation, earnings, as well as multiples, for the group should improve

-Use of cash in the form of significant buybacks and increased dividends

-Accretive acquisition in Central/South America, Mexico

-Improvement in US GDP