Description

Idea: Short Veritiv Corp (“VRTV” or “the Company”), a company enjoying cyclically elevated earnings due to elevated goods demand & supply chain struggles which have produced a temporarily tight packaging market. Street coverage is limited, with one covering analyst, who views recent margin expansion as mostly permanent. We believe the packaging market began to loosen considerably in 3Q22 and expect Veritiv to experience declining revenue & margins in 2023. We are 33% below Street Adj. EBITDA estimates for 2023 and 46% below on 2024. We think the market is not pricing this in, as our base case calls for 44% downside (7x our fwd. Adj. EBITDA estimate). 

Company Overview / Recent History

Veritiv was formed via Reverse Morris Trust transaction, combining International Paper’s distribution business – Xpedx – with Unisource (PE owned) in June 2014. Both businesses focused on print and packaging distribution in North America, with a smaller “facility solutions” business which distributed other products necessary to upkeep large facilities (janitorial supplies, etc.). 

At combination, the combined company was split by revenue: Print (55%), Packaging (28%), and Facility Solutions (17%) with a total of 165 distribution centers in North America. Since then, Print Distribution has been in secular decline, to the tune of (-) HSD volumes per year – items like office print and copy paper which are being replaced by digitization. Packaging Distribution volumes have grown (+) LSD per year, around GDP, with the largest items being containerboard (boxes), plastic wrap & tape (warehouse / shipping), and other flexible/rigid solutions. Lastly, the Facility Solutions segment has been volatile, with average (-) LSD volumes per year – items like cleaning supplies, PPE, towels & tissues.  

On the whole, this has been a declining business with very low operating margins. While we only have combined Veritiv financials from 2010, we have Xpdex financials going back prior to that (through International Paper’s disclosure). As can be seen below, the unification of Xpedx and Unisource did nothing for the operating margins or trajectory of the business – from 2Q14 through 2Q20, operating margin bounced around between -1% and +2%. With the onset of COVID, demand accelerated for goods driving unusually elevated demand for packaging; this led to unprecedent price increases which benefitted Veritiv’s consolidated operating margins from 3Q20 through today:

Since 2019, Veritiv’s Print Solutions EBITDA has gone from $65mm to $115m in 2021, Packaging Distribution has gone from $244mm to $395mm, and Facility Solutions has increased from $33mm to $53mm; in total consolidated Adj. EBITDA has increased 120% between 2019 and 2021 after declining each year since 2016. Today, Packaging Distribution makes up ~70% of EBITDA, Print Solutions makes up 20% of EBITDA, and Facility Solutions drives the remaining 10%; given Packaging Distribution’s size it is the focus of the writeup. 

*after 2Q22 results, 2022 Street figures were changed to: Print ($212mm), Packaging ($434mm) and total ($494mm)

Consensus View

Veritiv is only covered by Bank of America, which has a buy rating on the stock and price target of $150 based on 7.5x their 2023 EBITDA estimate. BAML thinks “margins have staying power longer term.” They wrote in March of 2022, “while we see potential for margins in Print, and Publishing to a lesser extent, to ease as supply catches up with demand (this drives the decrease in our earnings forecast from 2022 to 2023), the company should be able to sustain margins at or near current levels supported by its improved ability to pass on price increases, continual process improvement, and productivity efforts and the natural shift in business mix towards Packaging.”  

Variant Perception

We believe the vast majority of the profitability improvement has come from transient supply/demand factors in the packaging market. Customers had to accept higher prices because containerboard and other packaging supplies were severely constrained nationwide over the past 18 months. Margin improvement came in the form of extracting value from customers in a tight market environment. BAML’s 2023 Adj. EBITDA forecast is 157% above 2019 Adj. EBITDA ($156mm), which translates to a low 20% ROIC; this business historically peaked at 8.4% ROIC in 2016. 

We have not uncovered a fundamental or structural reason why ROICs should not decline back to the long-term average of ~7%. In our base case we have Veritiv achieving a 9.5% ROIC (above prior peak) and estimate 2024 Adj. EBITDA 19% above 2019 levels in our base case (~50% below Street). 

Thesis:

1. Packaging distribution margins benefitted from a tight market environment, spurred by e-commerce / goods demand, which is now loosening fast.

2. Print distribution is a secularly declining business that is temporarily over-earning. 

Thesis Point 1) Packaging distribution margins benefitted from a tight market environment, spurred by e-commerce / goods demand, which is now loosening fast.

Veritiv is a “total solutions provider” in the packaging distribution space. They have relationships with the major packaging manufacturers – International Paper, Packaging Corp of America, Georgia Pacific, and Westrock – and a long list of customers, both regional and national accounts. Corrugated boxes are the single largest product category within Packaging distribution, making up 26% of the total. The “flexibles” category – which encompasses many resin-based products, including tape, plastic shrink wrap, bubble wrap, tapes, and mailers – contributes 44%. 14% is “ancillary packaging” which the Company defines as “labels, surface protection, adhesives.” Lastly 8% is other rigid packaging (non-corrugated/paper-based) and 8% is equipment (machines that bag/seal/wrap/etc.). 

Customers use a provider like Veritiv to manage their packaging needs in a way that lessens the need for warehousing and upfront cash payments for large orders of boxes, plastic wrap etc. Common customer archetypes are: a customer that has a need for 10k boxes a week but does not have warehousing capacity, a customer that wants to hit the minimum order quantity for custom prints but does not need to sit on months of inventory, or really anyone that needs access to an array of packaging SKUs that is of at least modest size. 

Veritiv is the largest total solutions provider in a fragmented space. The second largest, by a close margin, is Landsberg Orora, followed by Crown Packaging, and Victory Packaging (owned by WestRock). This is a very competitive space with many local / regional players. Veritiv estimates it makes up 8% of the market with the next largest 9 competitors making up 23% (long tail of 69%, Appendix 1).

Conditions which lead to better margins

While usually a very low margin and low return business, Veritiv’s Packaging Distribution business caught fire with the onset of COVID. According to the Pulp and Paper Products Council, North America containerboard demand increased 3% in 2020 y/y and another 8% in 2021 y/y, after declining 3% in 2019. This strong demand environment (along with cost inflation) enabled corrugated packaging manufacturers to push through four price increases since November 2020. This is an unprecedented level, according to Green Markets (a Bloomberg entity focused on fertilizers, packaging, among other markets): 

“Strong demand, supported by a pandemic-induced shift in consumer spending to goods from services, enabled corrugated-packaging peers to push through an unprecedented four price increases since November 2020. Box-shipment volume shot up 5.7% in 2020-21, the biggest two-year jump in 27 years.” – June 2022 Green Markets report

Below is the price index of corrugated paperboard (collected by the U.S gov); price increases started in earnest in 1Q21 and have continued to grow since: 

The paper/packaging producers were sold out of product and had long lead times. 

• International Paper on 3Q21: “July, we still had more containerboard shortages in different parts of the box system and we had a heavy order intake. And in some cases, we just couldn't take the orders.”

• International Paper on 4Q21: “We're experiencing very stretched supply chains and poor carrier reliability across just about every mode of transportation, which put significant strain on our shipments and cost pressure on our mills and box plants.”

• Westrock on 1Q22: “Demand remains strong for our distribution business and is outpacing our ability to supply customers due to labor and supply chain challenges.”

With the onset of COVID, e-commerce growth accelerated which created a step-function change in packaging demand. There was a “cardboard boom” and mills all operated beyond capacity, extending lead times. Prices went up and demand skyrocketed for distributors with good supply relationships, like Veritiv. We believe smaller, regional, distributors ceased their usual competitive bidding strategies as they were struggling to support existing customers. This means that customer attrition and price competitiveness decreased. 

This environment enabled distributors like Veritiv to capture excess margin. While not perfect, plotting the q/q growth in the paper container manufacturer pricing index against Veritiv’s packaging EBITDA margins, we see a close correlation between the rising price environment with excess margin capture: 

We think this does not line up exactly because availability is the key determining factor to excess spread capture for distribution (rather than pricing alone). To illustrate this, we can zoom out to the historical margin structure. EBITDA margins for Veritiv’s packaging segment never broke 8% historically and kept in a tight band around 7.0%; in the current environment they hit 11.1% in 4Q21 (10.7% LTM as of 2Q22), or a 370bps of increase from 2019. 

In each 10-Q of 2021 and YTD 22, the Company called out in its MD&A section for Packaging, “cost of products sold increasing at a slower rate than net sales” as a primary reason for the increased packaging Adj. EBITDA. 

In the 10-K for FY21, the following is stated in the MD&A:

“Adjusted EBITDA increased $93.5 million, or 31.2%, compared to 2020. The increase in Adjusted EBITDA was primarily attributable to cost of products sold increasing at a slower rate than net sales and higher net sales, partially offset by (i) a $23.8 million increase in selling and administrative expenses and (ii) a $20.7 million increase in distribution expenses.”

Our conversations with smaller competitors indicated they, too, were seeing all time high gross margins (~300bps higher than 2019) due to this excess price vs. cost movement. 

Clearly, Veritiv is benefitting primarily from capturing excess pricing in the current environment.

The issue going forward, for the Company, is 1) demand is now falling off peak levels and 2) suppliers have rapidly improving lead times. 

Demand is now falling for boxes

After a growth spurt beginning in 4Q20, North America containerboard demand started to comp flat in 1H22 – which is still LDD above 2019 levels. Demand declined significantly in 3Q22, down 11% y/y, brining growth to a slight negative comp to 2019 (-.5%): 

While demand is declining in real time, we do not need demand to decline for the thesis to work. Rather, we just need demand growth to settle down such that paper mills / containerboard producers can get caught up – reducing the “pull” on distributors.

RISI, the industry’s standard market data provider, recently updated OCC (old corrugated cardboard) prices which shows a drastic decline in recent months (really beginning in August of this year). This is both a real time indicator of true demand for boxes, but also a leading indicator to price declines (as OCC is a key raw material):  

“The trade publication Fastmarkets RISI has reported -- and we continue to hear -- that U.S. containerboard mills are turning away OCC tonnage because they already have too much of it. U.S. containerboard inventories ended 2Q well above historical averages (~20% higher than the 5- and 10-year averages), and box demand is getting worse rather than better from what we hear. And into this poor backdrop is coming nearly three million tons of additional N.A. containerboard capacity over the next 18 months, which equates to ~7% of 2021 U.S. containerboard production at a time when U.S. demand is falling” – Keybanc note from August 18th, 2022.

Lead times have improved dramatically

Finished-box lead times improved three business days month-over-month for July 2022, to 11 on average, with 61% of box plants able to turn an order around within 10 days. Lead times have shrunk 50% since February of 2022:

Source: Bloomberg Green Markets

To walk through this one step further – lead times really started to extend in 3Q21, when surveyed demand for boxes began to outstrip production growth. Again, using data from Green Markets which does a great job – they asked their network of plant sources in 4Q21 to estimate “how much they expected output to change in the coming months.” They then compared that to their demand survey. The gap between indicative demand and production is effectively the “call” on distributors (or excess demand vs. supply). This delta was 9% in 4Q21 (producers could have increased shipments by 9% if they had capacity to meet orders):  

This completely changed in 1Q22. 

“Demand sentiment plunged, narrowing the gap with actual production to 1.9%. The shrinking “surprise” may have stemmed from a drop in demand, better plant performance from having more employees or new equipment, or improved accuracy from producers after being surveyed about demand on a regular basis.” – Green Markets on May 26, 2022. 

Some commentary from distributors in Green Markets’ survey: 

• “Inventory is now overstocked.” 

• “General economic uncertainty.” 

• “Decrease in industrial demand.” 

• “Customers over-ordered before increases and now working through inventories.” 

• “Our backlogs have fallen more than 20%.”

•  “Our lead time is now about 10 days. It was about 12 weeks at its worst.”

Linerboard pricing has begun to fall

Key plastic product prices are starting to decline

From our conversations with competitors and formers at Veritiv, corrugated box availability was the largest issue over the past 18 months. Outside of corrugated, plastic stretch film was the next hardest hit. Stretch film is typically used to wrap products (or stacks of boxes) securely in place on a pallet. It looks like this:

Plastic stretch film availability was hit from diminished imports as well as weather impacts in 2021 on certain plastic manufacturing facilities in Louisiana / Texas. 

Stretch film is made using linear low-density polyethylene (LLDPE). Below one can see the spot prices of LLDPE rapidly rose in 2021. In 2Q22, prices peaked and  through 4Q22 have been declining significantly – now roughly in-line with 2018 levels: 

Why VRTV is specifically poorly positioned for this environment 

Even if we assume volumes and pricing at the manufacturer level do not fall (they are rapidly), we’d expect a large decline in Veritiv’s Packaging EBITDA as it gives back the excess pricing it took on customers. To illustrate this, we take the run-rate of 1Q22 Packaging revenue – $4bn of sales – and apply a 7% Adj. EBITDA margin (in-line with the 2014 to 2019 average). This results in $280mm of segment EBITDA, 29% below ’21 and >30%% below ’24 Street estimates (but still 15% above ’19 of $244mm). Our 2024 segment EBITDA estimate is slightly above this, at $301mm. Our 2024 estimates have Veritiv earning a 7.5% adj. EBITDA margin on top-line 16% above 2019 (we continue to grow volume and keep pricing elevated). This Adj. EBITDA margin is slightly above the five year pre-2020 average of 7.4% but gives credit to slightly higher spreads (on higher prices). 

Thesis Point 2) Print distribution is a secularly declining business that is temporarily over-earning. 

Paper and containerboard manufacturing are interconnected, as many of the largest producers make both with similar supply chains (and can even switch paper capacity to containerboard capacity, which we have seen happen in the past two years). In 2021 and 2022, raw pulp price increases, initial mill closings (COVID), and transport/labor issues strained the paper / containerboard supply chain while demand snapped back from COVID lows, creating a temporary disconnect.

“Yes, there is a paper shortage in 2022 for coated and uncoated papers. Manufacturers, wholesalers, marketing companies, and printers continue to experience difficulties securing materials and producing goods for a number of reasons. Industry experts agree that we’ve never seen a shortage this big before. COVID-19 lockdowns and global supply chain issues have had a significant impact on the availability of paper products. As we emerged from the lockdown period, demand for printing paper and direct mail services increased faster than supply was able to rebound. Now, demand for paper is actually greater than pre-pandemic 2019 levels.”

“Prior to the COVID pandemic, several large domestic paper mills planned to convert to packaging material production, and during the pandemic, some mills navigated the shortage by switching from paper to packaging, producing cardboard, kraft papers, and other materials to cater to increased online shopping demands.”

“We are hopeful that by the end of 2022 or early 2023, things may level out as lead times reduce and supply and demand approach equilibrium.”

Source: Phoenix Group (a paper & packaging provider)

Similar to trends we discussed in Packaging, Veritiv’s Paper Distribution business saw rapidly expanding margins. 

As can be seen above, Paper revenue had been declining at a fast clip until late 2021. This is predominantly due to annual HSD declines in volumes, mostly driven by the overall shift away from paper to digital solutions. Veritiv has never earned an EBITDA margin north of 3.0% in this business, let alone the 9.0%+ it is enjoying currently. This segment is now doing~$200mm of EBITDA vs. $65mm in 2019 (>$100mm of over-earning vs. 2019; less than Packaging due to the lower top-line base). 

Pathway to paper normalizing

We believe the paper market will normalize after packaging, given the dearth of inventory which was available in 1H22. Inventories have remained weak (comparing three-month avg. inventory to three-month avg. demand), which explains the current strong pricing & margin environment:

Given the pace of the end market decline, tight S/D should resolve itself even without capacity increases. If there are otherwise no changes to domestic production or net imports from here, it may take 4-5 months for the usual underlying demand decline to lead to operating rates again in the low 90s (if demand declines 5-6% per year, we would be at 93-94% operating rates by YE22 from the three-month avg 96.3% operating rate seen in June of 2022). 

“By 2023, availability of coated paper should normalize enough to limit outright shortages. Year-to-date demand remains robust compared to the prior year.  So, while capacity remains low, coated freesheet production is performing better than the end-of-year 2021” – Specialty Print 2Q22 Paper Market Commentary.  

Increasing imports could help bring up the time-frame here (as container rates decrease, it further incentivizes imported paper). Net Imports as a % of domestic demand have been increasing since 2020, though have leveled off around 10%:

We spoke with a large private paper distributor competitor. This conversation detailed how paper imports became temporarily higher cost than domestic supply due to the container price surges; import prices are now below domestic and import availability is great – which should start to pressure the market in coming months. Improved imports will lead to lower “pull” on domestic mills and better availability of paper; this will reduce paper prices and allow distributors to become competitive with each other again (collapsing Vertiv’s excess spread).

Longer term, we believe this is a secularly declining business (and there is good reason why EBITDA here should normalize even lower than 2019). The Company even agrees with this – see commentary on paper demand from their 1Q22 10-Q: 

“The Company believes that the historical decline in demand for paper and related products is due to the widespread use of electronic media and permanent product substitution, more e-commerce, less print advertising, fewer catalogs and a reduced volume of direct mail, among other factors. In the long term, this trend is expected to continue and will place continued pressure on the Company’s revenues and profit margins and make it more difficult to maintain or grow Adjusted EBITDA within the Print Solutions segment. In the short term, shortages in the supply chain and product cost inflation have resulted in higher paper and related product prices. The Company believes the shortage of supply is due to mill closures and conversions and international supply chain disruptions, which have been accelerated by the COVID-19 pandemic. Higher prices, if continued over the longer term, could further accelerate demand decline.”

We expect margins to revert back to historical levels. We give credit for 2.2% Adj. EBITDA margins here (the margin achieved in 2019) but assume ~35% lower top-line in 2024 vs. 2019 to account for continued volume declines. This results in $41mm of Adj. EBITDA in 2024 vs. $65mm in 2019 and $115mm in 2021. This still assumes spreads earned are higher than pre-2021 -- $1.26 of EBITDA / unit (index methodology) vs. a pretty consistent ~$1.00 per unit b/w 2016 and 2020:

Valuation

Putting together the aforementioned factors, below is how we see Veritiv’s overall revenue & EBITDA progression shaping up in FY24, compared with FY19 and FY21. We assume Adj. EBITDA will settle out high-teens above 2019 levels in our base case for 2024 (note: this includes EBITDA from the recently divested Canadian ops): 

Veritiv has usually traded between 6.0 and 8.0x fwd Adj. EBITDA:

As such, in our base case we value Veritiv using 7.0x 2023 Adj. EBITDA. With YE23 net debt (giving credit to cash gen through year end and the recently divested Canadian operations) and our 2024 Adj. EBITDA estimate, this results in a $72 price target (discounted back), or down 44%. 

For the bear case, we assume EBITDA per unit returns closer to 2019 levels (plus HSD for Print and plus LDD for Packaging, which seems conservative), resulting in Adj. EBITDA of $148mm in 2024 (12% below the base case, after accounting for the divested Canadian operations). At 6.0x fwd EBITDA this would be a $53 stock, or down 60%. For the bull case, we assume margins stay mostly elevated (4.8% consolidated EBITDA margin vs. 2.0% in 2019 and 5.0% in 2021). This results in adj. EBITDA of $305mm (post-Canadian divestiture); on 8.0 fwd Adj. EBITDA this translates to at $158 stock (23% upside). 

On a blended basis we see 37% downside to $80.3:

Risks

• Margin improvement is structural and not cyclical

  • This is inherently what we are betting against. Management attributes margin improvement to restructuring actions across the organization and pricing changes (dropping the lowest margin customers). 

  • SG&A: 

    • While is true that Veritiv cut its workforce over time, particularly in 2020, the employee count declined roughly in-line with total revenue. SG&A intensity has actually gone up over time, from a 10.2% average b/w 2016 and 2018 to 10.7% in 2021. 

    • While the Co does not break out Selling & Administrative expenses, it provides commentary in the MD&A. 2021 SG&A saw an overall increase of $12.3mm in personnel expenses and $4.8mm in professional fees offset by $7.8mm of lower bad debt expense. They provide that the increase in personnel expenses was primarily driven by higher wages, higher incentive comp expenses, increase in travel expenses “offset by a decrease in commission expenses due to change in the salesforce compensation plans.” This does not seem like its resulted in a significant overall shift. They cut headcount and adjusted comp plans, but SG&A still rose and intensity is in-line with 2019. 

    • What has levered is the SG&A as a % of gross profit. This is because gross margins are up. It seems like there has been no meaningful shift in SG&A intensity of the business despite the headcount cuts. 

    • 

  • Distribution:

    • Distribution expenses increased by $10mm y-y in 2021. They bridge this in the MD&A as follows: $11.7mm decrease in facility and equipment rent expense (driven by consolidation), $7.1mm multi-employer pension plan withdrawal charge that did not repeat in 2021, and a $6.4mm decrease in wages and temp employee expenses offset by a $17mm increase in freight and logistics expense. So, of this change, $12mm is perhaps permanent (facility consolidation). At a maximum ~18mm inclusive of lower wage expenses within distribution – or 0.26% of 2021 sales. 

    • Distribution expense intensity was 6.1% in 2021, down from 6.8% in 2020, 6.6% in 2019, and 6.3% in 2018. So, it seems reasonable to give them credit here for ~25bp or so worth of sales of sustainable cost cuts in distribution. 

  • Overall Adj. EBITDA margins

    • Overall, we are projecting Adj. EBITDA expansion from 2.0% in 2019 to 2.7% in 2024 in the base case. Within this, Print Solutions is roughly flat at 2.2%, Packaging expands 40bps from 7.1% in 2019 to 7.5% in 2024, and we have Facility Solutions going from 2.8% to 4.7% (2019 to 2024). We believe we are capturing any sustainable cost actions taken within this framing (no real SG&A leverage, as discussed, and ~30bps of distribution leverage). 

    • The largest source of EBITDA margin expansion has simply come from gross margin expansion. Consolidated gross margin was 19.0% in 2019. GM grew to 20.9% in 2021 and 22.5% in 2Q22. 2019 to 2021, gross margin expanded 194bps and Adj. EBITDA margin expanded 297bps. Of this delta, $47mm of Adj. EBITDA is explained by movements in the LIFO reserve (benefit of $43.6mm to EBITDA in 2021 and hit of $3.7mm in 2019). In total that delta is 69bps. Bridging 2019 to 2021, we can therefore see that only ~34bps is explained by cost cuts or general op leverage: 

      • 

• Company purses M&A which gets the market excited about projected synergies

Appendix 1

Appendix 2

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation. This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Earnings misses