Description

WestRock (WRK) has been written up four times on VIC in the past four years. I last submitted WestRock as my reactivation idea two years ago. The story has improved substantially while the valuation simultaneously has seen an extreme contraction. Thus, I believe it makes a great deal of sense to revisit this name, particularly since the sell-side has been so vocally negative recently right in front of WRK's earnings report next week. (See TRUIST report and the Jefferies downgrade yesterday.)

Investors and the Proverbial Forest for the Trees

If we ignored the performance of WestRock stock and just looked at the fundamental facts over the last decade, most people would draw a similar positive conclusion: this stock must have very done well, and you probably want to own it. However, investors’ and sell-side analyst memories of what used to be a volatile and cutthroat industry combined with the recently volatile input cost environment have led to the opposite result. In a world of ever-expanding valuation multiples, WestRock has seen its valuation fall from a historical average of 7.5x EBITDA and 9% FCF yield to a current 5.5x EBITDA and 16% FCF yield. Sometimes, we see the market being slow in recognizing structural improvements in an industry so the re-rating takes longer than we would expect, but to see valuations do the opposite, or de-rate during structural improvement, that is quite rare.  

WestRock is one of the leading manufactures of paper-based packaging with about 2/3 of its earnings derived from containerboard and 1/3 coming from consumer packing. While the consumer packaging grades that WestRock sells benefit from many of the same secular changes as containerboard, we’ll focus on containerboard as this is where the industry changes have been most dramatic. The containerboard industry used to suffer from three headwinds:
1. Low demand growth
2. Aggressive competitive behavior in a fight for market share
3. Accelerating recycling rates making recycled paper cheaper and increasingly available for recycled paper-based containerboard capacity additions. Going forward we believe all three of these are turning from headwinds to tailwinds for this industry, just as WRK valuation has hit a new trough.

1.       There has been much discussion in the media over the challenges caused by globalization, reflected in the ascension of nationalist political agendas around the world and accentuated by all the supply chain issues resulting from covid 19.  Plenty of articles and reports have been written about re-shoring and how supply chains are being brought closer to home as we move from just in time to just in case. The dislocation in the supply chain caused by covid will pass, but nations’ desire to be less reliant on foreign countries for their own supplies is likely permanent. Lost in this discussion is one of the sectors has been disproportionately harmed by globalization - containerboard. UBS published a report last week showing the dramatic impact of offshoring over the last 30 years, suggesting this has been one of if not the key driver for containerboard demand having been lower than consumption growth. This analysis states that every 1% of offshoring has reduced containerboard demand by 1.7%. This implies that simply the absence of further offshoring should cause containerboard demand to grow in line with consumption. If we go from offshoring to reshoring, we would see a double whammy driving demand significantly above consumption. 

2.       Pre-2011 the containerboard market was more fragmented and a lot more competitive, which meant that in periods of demand weakness or inventory adjustments, companies would aggressively fight for volume putting downward pressure on pricing. There were two manufactures that were well known in the industry for chasing volume while breaking price: Smurfit Stone and Temple-Inland. Their behavior would force the rest of the players to match their price cuts thereby taking the market price lower. In 2011 WestRock acquired Smurfit-Stone and in 2013 International Paper acquired Temple-Inland. Not only did these two transactions have the benefit of consolidating the industry but they also removed the two price disruptors. At the time we were hopeful that these two acquisitions would improve the pricing structure of the industry, and 10 years later we have plenty of evidence that they did. The economy has been nothing but stable in the last 8 years so we have had the chance to observe what happens when demand weakens relative to supply: the large industry players which now control close to 80% of supply cut production runs to match supply with demand to protect price. This is not openly coordinated as this would be anti-competitive, but this is an oligopoly at its best: each player cuts enough capacity to protect prices from falling, some more some less, depending on the period we look at. This can be seen in 2015/2016 (China / EM slowdown) and again in 2019/ 2020 (trade war / covid). Fortunately for investors, the two largest players (WestRock and International Paper) disclose “maintenance” downtime separate from “economic” downtime. It can be observed that maintenance downtime takes place with reasonable consistency as this is downtime driven by mechanical maintenance, while economic downtime only happens when the market price is at risk of weakening. This does not mean prices cannot go down at all. In fact, during these periods of stress, we have seen prices have small price moves ($10 per ton) before they move back up. This pales in comparison with the declines pre-2010 and with the $50 price increases we see when the industry gets tighter. Regardless of demand growth growing at 1% or 5%, it is remarkable that in a low-interest-rate environment where “stability” warrants a large premium for most stocks, containerboard stocks with almost a decade of proven rational pricing behavior, have not only not seen a valuation expansion, but a large valuation compression. With large parts of the government bond market still generating negative yields, it is hard to believe WRK stock generates an 18% FCF yield.

3.       Recycling rates have peaked and may decline from here.  There are two ways of making containerboard, using virgin fiber (from trees) or using recycled paper (using paper that was once manufactured using pulp, fiber, or already recycled paper).  Virgin fiber-based containerboard is preferable for most uses as it is stronger but recycled fiber-based containerboard is acceptable for most applications. As demand for containerboard has grown, supply has been largely based on recycled paper as it is virtually impossible to get a permit for a new virgin fiber mill in many parts of the world (like refineries). In addition to the unavailability of permits, many markets lack enough trees relative to the demand due to topography and climate (Asia, in China, in particular, are, significantly short).  However, over the last 15 years, the lack of fiber-based supply growth has been offset by growth in recycled paper-based supply as the percentage of paper-based products that are recycled has gone from the low 60% to the high 90%. Recently with the growth of e-commerce, recycling rates have fallen as individual consumers have a lower recycling rate than businesses, and the cost of collecting the used product increases when collecting from consumers. This has two important implications:
(a.) recycled paper is likely to become more expensive over time because it will be difficult to increase supply now that recycling rates are maxed out and
(b.) the containerboard manufacturers that have significant virgin fiber-based capacity will see that capacity become more valuable as incremental recycled paper-based capacity will drive prices higher to offset their higher cost. Additionally, the more times you recycle paper/board, the weaker it becomes, which means fiber-based containerboard should increase in value relative to the recycled-based board as box makers will need increased fiber mix to meet the required strength. 

Additional Topics to Discuss

While the reversal of the three adverse trends discussed above is amply sufficient to increase the value of the stock dramatically, there are additional topics that are worth discussing:

1.       E-commerce. In addition to being sensitive to the level of outsourcing/insourcing, containerboard growth is increasingly sensitive to changes in distribution channels, in particular the growth in e-commerce.  The reason behind this is that packaging intensity in e-commerce is significantly higher than the traditional brick-and-mortar channel. While e-commerce has been growing for many years it has not been until recently that e-commerce has become a big enough component of total containerboard shipment to have an impact on the total growth rate. Over the last 5 years, as a percentage of total containerboard shipments, e-commerce has gone from 5% to 15%, and at this level, it is now starting to matter for the overall growth rate. This impact was on full display during the pandemic.  While consistent with the communication from the large e-commerce companies we expect e-commerce growth to slow down as we anniversary the comps of the pandemic for the next few quarters before it re-accelerates to its higher underlying trend. Even at the current lower rate of 10%, at 15% of shipments, this piece alone generates 1.5% of growth. Even if the remaining 85% grows at the same as the average of the last 10 years (despite the headwind from outsourcing which should now subside or reverse), the total demand growth will be 2.8%. Every year that goes by e-commerce becomes a bigger piece and drives the blended growth rate higher. As mentioned earlier, the end of outsourcing and trend towards insourcing will potentially add significantly to this growth number

2.       China and its lack of trees.   A point completely ignored by the analyst community, the Chinese paper-based packaging market is likely to run into a significant shortage of containerboard over the next few years. This is because due to their lack of tree supply (this is not even a permitting issue) they need to import more recycled paper or recycled pulp to feed their own growing demand for containerboard. With their recent regulatory changes limiting imports of recycled paper, the supply of recycled pulp is nowhere near sufficient to meet demand. RISI, the US paper, and packaging consulting firm has indicated that China may therefore need to import finished containerboard instead, to the tune of 8 million tons per year.  To put this in context, the US containerboard market is just over 40 million tons. While the Chinese economy has been volatile as they move more of their economy towards consumption, this transition will certainly drive higher containerboard growth. We won’t even speculate on the impact on US containerboard prices if you see an incremental 25% demand from an industry that is operating at full capacity.

3.       The threat of more supply. For the last 6 years, the analyst community has talked about one thing and one thing only when it comes to the containerboard industry - that supply that is coming onstream and supposed to cause prices to decline precipitously. We never disagreed with the fact that this supply was going to come on. We were in a period of time when printing paper and newspaper demand was declining (and continues to) so most of the mills, if not all, that produced these grades that could be converted to containerboard mills did so. While the threat of further conversions makes great headlines for a sell-side community that is already very bearish, the reality is that after going through all the plants in the US with an industry expert, we don’t think there are many plants, if any, that can be converted. This is in part due to cost and in part due to logistics limitations. While anything can be justified if prices are high enough, the fact that so many mills have recently been shut down as opposed to converted despite healthy containerboard prices is quite telling. Despite the plants that could be converted having done so, they have not had the negative impact on pricing the bears were hoping for as demand has been healthy, some older capacity was shut down and the large concentrated players have temporarily cut some supply in periods of demand weakness. While there is still some growth in supply, it is rather modest at 1.4% in 2022 and 1.5% in 2023. These numbers do NOT assume any shutdown of older capacity. It was 2020 that was supposed to be the year that would cause the collapse in pricing as supply increased almost 5% that year, but it did not. In 2021 supply was supposed to grow at 2% but ended the year flat because 2% of older capacity was shut down. With demand accelerating while supply additions decelerate, if pricing has not been impacted so far, it is not likely to do so going forward. 

As we discussed before, even if for some reason demand were to slow down or supply were to increase, we suspect the industry competitive response would be the same as we saw in 2015/2016 and 2019/2020, thereby preventing prices to fall much if at all. In fact, industry sources are talking about containerboard prices potentially going HIGHER in Q1 2022. It has been a while since we have seen this magnitude of a disconnect between the industry view and the wall street view. 

Another potential flaw in the bears’ thinking is that pricing has to fall because supply will grow faster than demand according to their forecasts. They arrive at this conclusion by assuming demand slows significantly over the next few years despite all the arguments we have discussed to the contrary. Even if this were to be true, the industry is coming from running at maximum utilization, even to the point that some of the capacity needs catch-up maintenance.  This is important because for pricing to fall, it is not enough that utilization falls, it must fall below a critical level (even if industry players were for some reason NOT be managing supply the way they have since the industry consolidated). The bearish forecasts assume utilization falls to 92% from 94%. Even in competitive industries WITHOUT the highly favorable level of industry concentration, you would have to see utilization drop below 90% to see prices fall materially.  

Now finally, 2021 was a mixed year for containerboard earnings because despite demand being strong, this strength in demand translated into stronger pricing with a 9-to-12-month lag. Raw materials and energy, on the other hand, hit the income statement almost on a real-time basis.  This mismatch of timing cost the company $1.20 in cash EPS, so cash EPS would have been $6.75 without the timing mismatch in 2021, instead of $5.55. 2022 is seeing the benefit of the contract roll-throughs so cash EPS in 2022 is $7.65 even assuming raw materials stay this elevated. More recently raw materials prices have come down so if this continues 2022 cash EPS is likely to be even higher than that. Now, just to illustrate how much cushion there is in the valuation here, let’s assume that pricing does fall and they give up, not the 10% they have given up in prior dislocations or the cumulative $30 they gave up in the unprecedented trade war, but the full $50 that are rolling through the contracts going into next year. Let us also assume that raw materials go back up despite their recent falling trend. Even if these things were to happen (quite unlikely based on the data) then we are looking at an industry leader in a highly consolidated and rational industry with a secularly growing demand profile trading at an 11.50% free cash flow yield. Again this is unrealistically low because one of the main reasons raw materials (recycled paper) is high is because the economy has not fully re-opened. Once it does (consistent with the lower assumed e-commerce growth) then supply will increase bringing raw material prices lower. 

4.       ESG: One aspect that gets a lot of airtime is ESG, with chemicals and aluminum likely to lose out in favor of paper-based solutions. While this potentially has an even bigger positive impact on the company’s consumer packaging business, it is clearly a meaningful positive for the containerboard market as well. Containerboard companies in Europe are seeing multiple expansion due to this dynamic, not only because it will add to growth over time but also because more and more investors have ESG mandates so there is more demand for environmentally friendly stocks. Interestingly, the European containerboard stocks trade at a premium vs their US counterparts despite the fact that the US containerboard markets have better fundamentals due to their more concentrated competitive structure, higher e-commerce penetration, and a higher level of underlying economic growth. This stands in stark contrast due to European stocks’ usual DISCOUNT to its US-listed peers across most other sectors.

5.       CEO transition, self-help opportunities, and capital allocation. In March of 2021, longtime WestRock CEO retired for health reasons and the board hired David Sewell, COO of Sherwin Williams. At Sherwin, Sewell was intimately involved in the integration of the acquisition of Valspar as well as the company’s highly successful commercial efforts that have made Sherwin one of the strongest chemical franchises globally. There are more similarities between paints and containerboard than first meet the eye. Both industries are highly consolidated with highly rational pricing structures. Given some of the early indications, we suspect Mr. Sewell will focus on two areas.
(a.) Improve the integration of WestRock’s assets (between containerboard and consumer packaging) to take out costs.
(b.) Accelerate further the forward integration of WestRock to earlier hit the 90% box plant integration the company is targeting. The company is currently at 82% integration. Why is this important? Because given the level of forward integration of the big 4 containerboard producers, we are getting closer to the point where the independent box market is so small that it ceases to matter from a pricing standpoint. This means that any potential new competitor, in addition to the raw material disadvantage relative to the incumbents (the majority of their supply being virgin fiber-based, while new suppliers are all recycled fiber-based – WestRock is 2/3rds virgin fiber-based) they are also faced with an ever-shrinking set of potential customers. With the vast majority of the box plants being owned by the upstream containerboard players and this number increasing, it becomes increasingly difficult for new players to either take market share or have an impact on price. The new CEO has confirmed the company is not likely to make any large acquisitions which leaves the question of what to do with the enormous amount of cash the company generates. Even if raw materials stay at 2021’s high level, and even if pricing does not go higher as expected by the industry, the company going to generate a 16% free cash flow yield. After several years of deleveraging, the company’s net debt is now down to its low 2x target, which leaves the cash to increase the dividend and to buy back stock. Due to the extraordinarily low valuation, if the company were to use all the cash to buy back stock it could retire every single share without increasing financial leverage in just over 6 years. We are accustomed to seeing companies with good and improving fundamentals at high valuations as well as the opposite. What is truly rare is finding not only good but improving fundamentals at rock bottom valuations. We wish there were more situations like this one.

Earnings and Valuation

Given the highly favorable competitive structure, the likely accelerating growth from the end of outsourcing and e-commerce, and the tailwinds from environmentally driven demand, we believe the stock should trade at least at 16x cash EPS (in line with packaging comp Sealed Air).  If raw materials stay high AND there is no incremental Q1 2022 price increase as expected by industry participants, cash EPS would be $7.65, so the price target would be $122 per share, or 155% upside from here. If raw materials normalize as the economy recovers and we re-coup the $1.20 per share we lose in 2021, then cash EPS will be $8.85 and the target price moves to $142 per share or 200% higher than today’s price. Obviously, if the incremental price increase takes place, the upside would be even greater. 

Catalyst

Volumes improving as supply chain issues clear up into Q4 and then into 2022