Description

Rock-Tenn (RKT)

September 4, 2012

$66.

Target Price:  $85

Company Description

RockTenn is a leading integrated North American manufacturer of corrugated and consumer packaging and recycling solutions. RockTenn reports its results of operations in three industry segments: (1) Consumer Packaging (2) Corrugated Packaging and (3) Recycling and Waste Solutions. The Consumer Packaging segment consists of an integrated system of five coated 100 percent recycled paperboard mills and a bleached paperboard mill that produces paperboard for our folding cartons facilities and third parties.

Summary of investment thesis

The containerboard industry is an industry undergoing structural change driven by consolidation, where pricing, returns and industry metrics like operating rates and inventory turnover, will improve.  Given the opportunity for significant synergies due to the merger with Smurfit Stone, I believe that RKT is like to grow earnings from $4.50 in F2012 to $8.50 in F14.  Achieving this level of earnings power will require better execution on the net synergies delivered by the Smurfit Stone acquisition, and announced price increases to become realized, but no real acceleration in volume growth.  I believe that if the company merely holds its multiples from current levels (5x EBITDA. 10x forward earnings), the stock could be worth $85.  If it achieves any multiple expansion based on strong execution and shareholder-friendly uses of free cash flow, I think that the stock could be worth as much as $95 in 2-3 years.

Track record

The company has been a significant outperformer over time almost purely on the backs of two acquisitions - Southern container and Gulf States.  The company’s earnings went $0.49/share in F2005 to $2.17/share in F2007, as the company was able to confuse surprising investors by delivering synergies in excess of stated targets.  Over the last 10 years, RKT (+300%) has significantly outperformed IP (-8%), and the S&P 500 (+53%).  The 5 year track record has shown material outperformance as well.  It is important to understand that, during this period, there was no real sustained tailwind from the industry as a whole - the organic compounded growth rate of demand was -0.5%, mostly flat, as companies continued to send more manufacturing capacity offshore.  (This trend will reverse if we see continued instances of near-shoring).  Over the last three years, RKT has modestly outperformed the market, but has badly trailed IP, as their acquisition of Smurfit Stone has trailed expectations.  I believe that the company is poised for significant performance given the low expectations and valuation, and the opportunity for great growth in earnings and cash flow while the rest of the market is experiencing slowing growth.  

Points of contention

I believe that RKT trades at a discount to its own history, to the market and importantly a substantial discount to its intrinsic value for three important reasons:

(i)            Inconsistent performance and integration of the Smurfit Stone assets.  The G&A synergies are being achieved, but the performance of mill upgrades has been poor thus far and have required an increased level of capital spend relative to initial expectations.  The weaker than expected performance of the Hodge mill, their largest, is testimony to this.

(ii)           There are doubts as to whether additional pricing power can be achieved in this business.  If the industry fails to push across the most recent price increase – given the tailwinds of consolidation and low inventory – the market will rightly assume that sustained pricing power is not possible.

(iii)          Demand remains fragile.  The industry has struggled to consistently generate organic volume growth and the most recent data around industrial production and consumer spending show some slowing.

(iv)         Chinese supply is always a threat to enter the market en mass, potentially carrying with it, higher OCC costs. 

Investment thesis in detail

I believe that RKT is materially undervalued, and that the market has become distracted by short term issues (e.g. the Hodge mill) as opposed to the structural changes in the business.  I think that the low valuation (15% free cash flow yield and 5x EBITDA) isn’t warranted, given the opportunity for significant growth over the intermediate term. I think that the price appreciation potential calls for a 30% rise in the share price.  My thesis has four main components:

1. Industry pricing will rise.  Despite still sluggish demand, the industry is moving toward a scenario where pricing isn't a derivative of robust demand or rising raw material costs, but rather constrained supply in the hands of experienced returns-focused operators who are all focused on improving pricing. 

*The top 5 players now have more nearly 75% of the industry supply (15 years ago, the top 5 players had ~45% of industry capacity).  After the mergers of RKT/Smurfit Stone and IP/TIN – now the two largest companies with over 50% of the market - the industry has announced a $50/ton (~8%) price increase in August ’12.     

*Operating rates have recovered and have trended around the key 95% level for the last year.  While there is some volatility in this number, I believe that the most important aspect of the consolidation is that the industry has been able to flexibly take economic downtime when volumes have been weak and deprived the industry of any opportunity to experience lower prices or to build inventory.  The large companies have shown a willingness to forgo greater tonnage and earnings at lower prices in order to sustain a tight supply/demand curve and high operating rates.  This discipline will prove significant over time I believe.

*Inventory levels are currently at historically low levels having dropped ~30% since January 2000, and have dropped below 4 weeks of supply, a level considered to be very low.  It’s important to emphasize that this level of inventory has come from restricted supply and not accelerating demand.  If demand were to rise more rapidly than the current pace, the supply/demand curve would tighten further.

2.  Margins will improve significantly over the next three years

*Given how well RKT integrated their acquisitions, RKT had the highest industry margins from 2008-10.  Today they have the lowest.  The major reason is simply the mix effect of adding the lower margin Smurfit Stone assets, and the need to spend money on severance costs, etc to execute this merger.  That said, the company is poised to see margins float up by over 300bps over the next two years, while they realize the impact of the synergies that they are driving (e.g. closed box plants, procurement, administrative expenses, etc.).  Even then, the company will be short of their best ever margins in 2010, at a point where they will have had only $3B in revenue vs. $9B in F13.  I believe that there is significant runway for margin improvement over the next several years.

*The company has the opportunity to move 'down and to the left' of the industry cost curve as they continue to shift production to their lowest cost mills.  Currently, over 70% of RKT’s mills are below the industry average and getting to full production at Hodge, their lowest cost mill, will materially help drive a lower weighted average cost of production. 

*RKT’s raw material position is dramatically improved given the merger with Smurfit Stone.  Their fiber mix has moved from 20% virgin/80% recycled to 55% virgin/45% recycled allowing a ‘natural hedge’ given the volatility of OCC prices.  This higher level of virgin fiber allows them a strategic advantage vs. the industry, but particularly relative to Chinese supply, which is almost exclusively recycled and exposed to volatile OCC prices.  It’s also important to note that OCC prices have moved downward this year, off of their historically high levels, giving the industry some reprieve, if temporary.

3.  Free Cash flow is large, will rise dramatically, and is understated

*RKT free cash flow will rise rapidly just given the synergies discussed and the opportunity for pricing.  Their segment EBIT will nearly double from F12 to F14. 

*Their capital spend is temporary elevated give the mill improvements, and is likely to fall by over 30% from F12 to F14.

*The company has an advantaged tax position and will not be a federal tax payer through 2014. With the acquisition of Smurfit Stone, they inherited $165m in after tax NOLs.  They also have $69m in AMT credits and $146m in cellulosic tax credits at their disposal.  They are waiting on a ruling (expected sometime in 2013) on their application related to Black liquor tax credits, which would total another $225m in after-tax credits.

*Near term, some of the company's free cash flow will be dedicated toward delivering the balance sheet.  The currently level 2.8x debt/EBITDA will likely come down to the target level of 2x EBITDA sometime next year, freeing the company to do initiate a material share repurchase program, (The amount of the debt paydown that we’re likely to see would be equivalent to buying ~4% of the shares, annually), or to significantly raise their dividend yield of 1.2%.

4.  Valuation is low and could rise

*On traditional metrics, the stock trades at fairly low multiples - 10x F13 earnings, 6x EV/EBITDA, 4.8x OCF and an 11% fcf yield.  (on F14 free cash flow, the fcf yield is 15%).  These levels are low relative to its history (when margins were higher) and a material discount to the market.  I believe that the successful achievement of stated synergies combined with the price increases will drive the kind of margin improvement that the market will reward with multiple expansion. 

*In the event that the stock doesn’t merit any expansion in valuation, my sense is that the multiple is low enough that the stock will not de-rate much into the robust earnings growth that the company is likely to see in the intermediate term.  If it does, I think that the stock will be a home run.

*Though there has been some volatility in recent earnings forecasts, the industry is a mature, slow growth industry, with highly visible cash flow.  As a result, I think that a DCF model can be used with some confidence.  My base case results get me to a value range of $80-90.  I am using an intermediate-term revenue growth rate through 2017 of 3% (which is achievable based on a mixture of volume growth, pricing and tuck-in acquisitions) and a long-term growth rate of 1%.  I am giving the company credit for 400bps of EBITDA margin expansion over the next 5 years (which suggests that they will take 5 years to achieve their 2010 EBITDA margin levels.  I keep capital spend and working capital constant and use a 30% marginal tax rate.  I am using an 11% discount rate and have 71.7m shares. 

*I believe that these inputs are conservative because I am essentially modeling the company to be building cash.  I don’t believe I need to make aggressive assumptions on growth, margin expansion, multiple expansion, or use of cash to demonstrate that the stock is undervalued. 

Near term catalysts

*We will know in the next few weeks whether or not the August price increase is reflected in full or in part, or not at all, as the RISI data will be out mid-September. 

*The company has undergone some management changes in the areas of the mill system, box plant and preprint operations and corrugated supply chain.  These changes are designed to deliver the expected improvement in mill performance and net synergies.  Of particular interest is management’s statement that the Hodge mill will be running at full capacity by end of F2013.

-Going forward, more of the free cash flow will be directed toward shareholders as opposed to paying down debt.  We may hear some additional communication on this post the Board meeting in October.

Key Risks

*Investor sentiment is squarely focused on pricing right now.  If the RISI survey data doesn’t reflect the pricing increases in the September data, the stock will be negatively affected.

*The company has had surprisingly volatility in its earnings in the recent past.  Earnings have been impacted by economic downtown, volatility in export demand and commodity prices.  The long run history of their earnings surprises has been quite positive, but the company has not been able to forecast its earnings well in the last several quarters (both favorable and unfavorable).

*Cash flow could be impacted by achieving lower net synergies as well as requiring more capital spend in order to generate the stated mill improvements.

Catalyst

*We will know in the next few weeks whether or not the August price increase is reflected in full or in part, or not at all, as the RISI data will be out mid-September. 

*The company has undergone some management changes in the areas of the mill system, box plant and preprint operations and corrugated supply chain.  These changes are designed to deliver the expected improvement in mill performance and net synergies.  Of particular interest is management’s statement that the Hodge mill will be running at full capacity by end of F2013.

-Going forward, more of the free cash flow will be directed toward shareholders as opposed to paying down debt.  We may hear some additional communication on this post the Board meeting in October.