Description

RKT is an under-valued, leading manufacturer in an industry undergoing significant consolidation. By acquiring Smurfit-Stone (SSCC) soon after it emerged from bankruptcy, the company leapt up the ranks of a small group of containerboard producers, and by applying its expertise honed in past integrations, the company will be able to harvest impressive synergies and profit improvement opportunities which should lead to a doubling of EPS by 2014. As of the close on 12/15/11, an investor is able to participate in this upside for 8.6x FY2012 consensus EPS and 6.9x FY2013 EPS. On the basis of management’s guidance of $650-700mm free cash flow in 2014, when they expect to spend a normalized capex after their integration and profit improvement projects, the company is trading today at a 17-18% FCF yield. This is too cheap for a company which has significantly better prospects than it did in 2008/2009, a period in which it actually grew earnings, unlike the vast majority of industrial companies.

Company Description

RKT is an integrated packaging manufacturer, selling corrugated packaging (cardboard boxes), folding cartons in various grades, and merchandising displays. The company is also the largest paper recycler in North America. In terms of industry rankings, the company is the 2^nd-largest producer of both containerboard and coated recycled board (the latter being made into folding cartons).

Price: 54.75

Shares Out: 71.4mm

Market Cap: $3909mm

Net Debt: $3405mm

Enterprise Value: $7314mm

Investment and Industry Background

RKT closed the SSCC deal on 5/27/11, in a cash and stock deal (50/50) with a total consideration at announcement of approximately $5.0bn. This highly accretive deal promised $150mm of synergies within 24 months of close (now, by end of 2012), and the company has already captured a run-rate of $110mm by their FQ4’11 (September year-end). Since the closing of the deal, RKT has announced two specific projects which will drive $400mm additional EBIT, incremental to the current base and the announced synergies. In combination, the $550mm EBIT uplift by 2014 translates to $4.89 in additional EPS at a normalized tax rate (vs adjusted EPS in 2011/2010/2009 of $5.50/4.43/4.59).

The obvious question underlying this premise is whether or not the base earnings level the company is currently generating is sustainable. Secondarily, why should we have confidence in this management team’s ability to achieve its stated profit improvement plan?

Corrugated packaging has undergone substantial consolidation over the last decade, and if the IP-TIN deal gets completed as envisioned (in Q1’12), there will be 4 heavy-weights, each with a history of market discipline:

IP/TIN: 29+11% = 40%

RKT: 23%

GP: 12%

PKG: 6%

Other: 19%

More importantly, the domestic market is generally protected from imports, in particular due to the low value/weight ratio which requires large price differentials to justify freight costs. For example, Europe containerboard remains at a premium to the US traded price (it is actually a destination for US exports, which can range from 5-15% of output). Asian capacity is almost all OCC-based, which has a much higher cost than domestic virgin-based capacity. Beyond all this, the behavior of the leading players – taking market and maintenance-related downtime instead of competing on price for incremental volumes – has been displayed over a couple of years, even though box shipments in 2011 (estimated by IP/RISI to be 357BSF) are still below pre-recession levels (395BSF in 2006). Capacity has been removed in the industry, and it would appear that the top producers are more willing to close plants than accept lower margins.

The other key segment, Consumer Packaging, is much more consistent. The folding carton end market is highly defensive (67% food, 33% non-food which includes categories such as cosmetics and household goods) and demand is not overly volatile.

As for the second question, RKT has done two previous materially-sized acquisitions: Gulf States Paper Corp in 2005; and, Southern Container Corp in 2008. In both of these deals, management, which is highly respected in the industry, beat their synergy targets (by >50% and >100% respectively) and had smooth integration processes. While SSCC is a much more sizable entity, there is also (anecdotally) much more low-hanging fruit. The current capture rate and conversations with management suggest the remaining synergies will be relatively straightforward (and mostly involve the conversion and convergence of ERP systems, from SAP to JD Edwards).

For more specific background on the SSCC deal, please refer to the company’s presentation:

http://www.corporate-ir.net/Media_Files/IROL/91/91009/Acquisition_Investor_Presentation.pdf

While SSCC was considered to be an aggressive and sometimes undisciplined player in terms of pricing, and while there was a period of under-investment while it was in Chapter 11, the assets themselves are decent. They do need modernization (hence the profit improvement program), but the key mills are competitive in terms of size and market positioning. The converting/box system is being right-sized by RKT, and this is a source of some synergy ($25-30mm).

In terms of the $400mm profit improvement plan, management has not disclosed in detail the breakdown of the drivers, but a key input is the energy portion which entails displacing fuel oil with 5.4Bcf of natural gas (perhaps ~$70-100mm). There is also an addition of low-cost capacity (300-600kt), which will either be incremental or allow closure of higher-cost capacity ($60mm-$200mm extra EBIT from the additional volumes, using high/low capacity projections and an estimate of unit profitability).

Financial Overview

Per Bloomberg, there are no published estimates for 2014 (except for a solitary EBIT projection), and herein lies a key part of the opportunity.

In terms of major assumptions, this model assumes no corrugated price increases for 2012 and a slight decrease for 2013 (pricing is the key debate currently for the industry – monthly inventory statistics have been generally stable and the question from here will be overall demand, driven by the economy on the margin, as well as producer behavior). Raw materials (in particular natural gas and OCC) are flat with current prices through the forecast period, or in the case of nat gas, increasing. In addition, only partial credit for the profit improvement projects is given (i.e. full credit would be $400mm in 2014). The Street has generally yet to update projections for lower OCC prices this month (an open question whether or not prices rebound in early 2012), though this benefit might be offset by some slippage on price in the seasonally weaker winter months (i.e. discounts to list price, as opposed to a list price reduction).

Management has guided to $500mm capex in FY2012, and has implied $350-400mm for FY2013, with 2014 and beyond at $350mm. The prodigious FCF comes partly from the fact that D&A will be much higher than capex; it is likely to be at least $550mm (point guidance for 2012 – likely grows to more than $550mm with the extra capital spending through 2014).  

Comparables

The best comp group to look at should be GPK, MWV, PKG, IP, and SON (TIN shares, as described, have a takeover premium today). On 2012 consensus EPS, this group trades on average at 11.8x, while on EV/EBITDA, the multiple is 5.7x. These are materially above RKT’s current 2012 multiples (9.1x/4.9x), implying that  RKT is not only getting less credit for near-term results, but also getting no credit for the profit improvement projects described above. The option value of achieving this additional profit stream is thus arguably zero at today’s trading price – in our view, it should be significantly higher (assuming no multiple expansion, there would appear to be ~$30-45 of upside in the share price from this incremental EPS).

Risks

• Material decline in industrial production in North America, leading to a decline in corrugated packaging demand, potentially putting pressure on pricing (earnings decline would be partially mitigated by further decline in raw materials)
• Raw materials, in particular OCC and natural gas, are unpredictable and have a direct impact on margins
• SSCC legacy pension is under-funded, represents a cash drag over the immediate future, and is subject to changing discount rates. Management has identified cash contribution of $352mm in 2012 with a similar amount in 2013

Catalyst