Description

Westrock was written up by Motherlode in August of 2020 and given recent events I think the stock is still attractive today. Since the time of the writeup two industry price increases have been announced with one being fully implemented and a second partially implemented. Furthermore, the CEO stepped down due to health reasons and a new CEO with a terrific pedigree has joined. At $50 I think the stock has 50%+ upside. My target price range is $70-90 per share.

Industry Dynamics

Motherlode provided a good overview of the industry in his report up through the summer of 2020. In the second half of last year, box shipment growth accelerated from 1.7% in the 1H to 5.4% in the 2H (4Q was a record 104bn sqft of boxes sold, or +6.9% y/y). For the full year shipments were +3.6% and through March shipments/workday were +6% according to WRK. Simply put, demand has accelerated due to e-commerce and the containerboard manufacturers can’t produce fast enough. While some of the demand is COVID related and due to lockdowns I believe much of it is simply a pull-forward of e-commerce growth and is permanent. In response to the sold out position producers implemented a $50/ton price increase in November and announced a second $60-70/ton increase of which $20-30 has been implemented. Furthermore, export prices have increased >$100/ton since the fall of 2020. While shipping costs and recovered paper prices have also increased the majority of the pricing should fall to the bottom line.

In addition to stronger pricing for containerboard we have also seen price increase announcements in paperboard. Volumes for virgin paperboard have been strong due to food and beverage consumption. SBS which is used to produce cups and other eat out consumption was weak in 2020 and is seeing a turn in demand combined with industry (notably WRK) capacity reductions. All told, $50/ton increases have been announced and are being implemented there as well.

Westrock Overview:

Westrock was formed through the merger of several of the largest containerboard producers throughout the year. The architect of much of those acquisition was CEO Steve Voorhees who recently stepped down. It started with 1 plant in the 1990s under Southern Container and grew through acquisitions, the most notable being Smurfit Stone out of bankruptcy in 2011, MeadwestVaco in 2015 and most recently Kapstone paper in 2018. Integrating and digesting the assets has taken a lot of management capacity and earnings have underperformed expectations as synergies have been offset by a weak industrial market in 2019 and early 2020.

Westrock has two segments – containerboard and consumer packaging. Within containerboard they produce 12mt globally, of which 10mm is in the US and the remaining 2mm are in Brazil and India. Of the domestic production, 60% is virgin and 40% is produced using recycled paper. Of the 10mm tons around 1mm tons is exported, 1mm tons is sold to independent converters and the remaining is consumed and sold as boxes internally. The importance of being vertically integrated can not be understated and WRK’s excess capacity that is sold to the independent converters will allow them to make small, bolt-on converting acquisitions and immediately see a 200-500bps improvement in margins. In fact, Packaging Corp who I believe to be the best operator in the industry has regularly had margins ahead of peers of 200-300bps due to their vertical integration (95%+).

The second segment is consumer packaging or paperboard which makes primary packaging used for food, beverages, cosmetics, etc.  The segment produces ~4mt per year of which 50% is sold to converters and the remaining is converted internally. The mix is 75% virgin and 25% recycled fiber.  

Turning to the financials – containerboard earnings are 75% of total company earnings and consumer packaging represents the balance. In 2020 the company reported segment income of $1.4bn and Adjusted EBITDA of $2.8bn. Looking ahead the company should benefit from several factors:

1.       Industry price increases in containerboard: The $50 and $30 price increases in North America should add $800m of incremental earnings. Every $10 increase adds $100m and should the remaining $30/ton be implemented that is another $300m.

2.       Price increases in paperboard adds another $100m based on announcements through April.

3.       The company has several projects underway including the ramp up of a new paper machine in Florence, South Carolina, expansion of the containerboard facility in Tres Barras, Brazil and continued synergy capture from Kapstone which adds $125m of EBITDA in ’21.

4.       Offsetting that will be raw material, shipping and personnel inflation. That runs ~$200-250m annually.

5.       Finally, capital expenditures are expected to be $800-900m in ’21 relative to D&A of $1.5bn.

Taken together, WRK should generate $3.3-$3.4bn of EBITDA and $2.4-2.5bn of operating free cash flow. Near term management has committed to delivering the balance sheet by paying down debt (I estimate $1bn per year).

Furthermore, while not shown (happy to discuss in Q&A) I have Westrock generating $5-6 of after tax free cash flow.

Valuation:

Containerboard ESG bona fides are well established. As CS writes in a note this week - "Corrugated board is a good example of a circular economy, in our view. Packaging is 100% recyclable, bio-based and biodegradable, and is widely recycled and reused as raw material to create new packaging. The virgin fiber raw material, wood, is renewable and for most, if not all, leading companies is sourced from certified forests." Aluminum can companies such as Ball and Ardagh who are benefiting from similar trends (consumer preference for recyclable materials) though in fairness are in tighter markets trade at 12-14x EBITDA. Comparatively, I believe an 8-9x EBITDA multiple for WRK is appropriate. At that valuation, WRK would trade between $70-90 per share or 50%+ above where it is currently trading. Since 2015 WRK has traded between 6x and 10x EBITDA and given the focus on deleveraging, strong industry tailwinds equity multiples should appreciate.

Furthermore, in early March of this year, David Sewell was appointed as the new CEO. David joins from Sherwin Williams where he most recently was the President and COO of the company. He joined Sherwin in 2011 and over his tenure, the company’s stock compounded at 27% per year. While we don’t yet know his strategy my intuition says it will be to get closer to the customer through furthering the vertical integration of the business possibly through M&A but also through organic investment in converting operations.

Risks:

The primary risk around containerboard is incremental investment in industry capacity. Motherlode had a good overview in his writeup. My personal point of view is that capacity should increase 1-2% per year (though 2021 will be ~4-5% due to capacity starts that were delayed in 2020) primarily through debottlenecking but also some greenfield in the recycled paper business. However, as vertical integration is key to sustaining margins and profitability the requirement for any new capacity is finding a home for it and those that do not have converting operations will struggle. Furthermore, the industry, led by Westrock, has been extremely disciplined about moderating production during slowdowns (2019 is an excellent proof point where the company took 460kt of economic downtime). My belief is that at the current valuation you are well compensated for those risks.

Catalyst

realization of industry price increases

strong volume growth from a combination of organic demand growth due to e-commerce and restocking

deleveraging