Description

Summary:  WRK is a rare find with such a severe dislocation that we wanted to present this case of uber-high conviction, that we believe we can buy in size and sleep well at night confident that we have calibrated the risk/reward correctly. As members here know, value stocks have been completely out of favor for a good part of the past decade.  However, the divergence is so extreme that, in a few cases, even if the economy were to go into recession, we believe these names would emerge as new leadership stocks. And, if the economy remains fair to strong, a few companies, such as WRK stand to see enormous upside. In the worst-case scenario, we believe we will enjoy an outsized and very safe dividend, and the FCF yield on WRK gives us a lot of enthusiasm. While many investors are experiencing anxiety due to macro topics ranging from China, interest rates and indexes hitting new highs, to the inevitable conclusion for the longest bull market in history, we feel confident that we stand to make very outsized returns owning great businesses such as WRK at bargain-basement valuations.

WestRock (WRK) is a packaging company with a long history, but the current structure was formed in early 2015 from the merger of Rock-Tenn and MeadWestvaco. The company manufactures paper-based corrugated boxes and consumer-packaging products. Their products serve food, beverage, produce, protein, industrial, various consumer and e-commerce markets. If you have ordered something from Amazon.com, received pizza delivery, purchased a box of cereal, or consumed coffee in a paper cup, then you have personally touched products from WRK. The company is part of a capital-intensive oligopoly, in which participants have historically exhibited pricing rationality rather than aggressively seeking to grow market share through discounting. WRK is generally lumped into a group of comps, including IP and PKG, but today, it is by far the cheapest and most compelling. In late August, the stock hit a multi-year low ($32) and has been cut in half from its late January 2018 high in the low $70s when the valuation already seemed reasonable if not compelling. After being decimated last year, WRK has continued to trade in a fairly tight range between the low and upper $30s with little change to fundamentals due to misplaced pricing and capacity fears along with multiple contraction. WRK is among the most compelling value ideas we have seen in years. WRK’s decline and lackluster performance through last year occurred despite street estimates increasing on the accretion from the recently completed acquisition of KapStone Paper and Packaging (KS), as well as the constrained North America supply/demand balance that placed sustained upward pressure on containerboard prices through 2018.

Despite bouncing 20% in January of this year with the year-end market rebound, the stock has since traded sideways for most of this year and has bounced off of the low $30s and pulled back on every mini-rally with a slew of sell-side downgrades and negative notes about fears around industry containerboard pricing and recently lackluster demand due to one-off factors such as Midwest weather and a delayed ag season in California. Despite insistence from top industry players like International Paper (NYSE: IP) and WRK that discounting is not apparent in their business, industry consultant RISI lowered their benchmark containerboard price over the summer by a small $30/ton (~4%) for the ~10% of the market they survey. However, due to the aforementioned oligopolistic industry structure and producer discipline, we believe fears of further price erosion are unfounded. If anything, the industry setup resembles early 2016 when producer discipline held after a small price cut, inventories normalized, and pricing resumed higher later that year. It is also important to note the scale of the industry consolidation that has occurred since the early 2000s - back then, the top 4 containerboard producers were only ~36% of the North American market vs. ~80% today. This is all while the industry has trended away from commoditization due to customer requirements and innovation across the packaging business.

We believe WRK is poised to finally break-out of the $30s trading range when they report on Thursday morning November 7, 2019.  We already have heard stable commentary and reports from IP, PKH and SKG ID (Smurfit Kappa Group PLC), and significant outperformance by WRK competitors. Inventories have already started to rapidly normalize, and as export market destocking comes to an end (already noted by a large European player) and domestic demand returns to more normal levels, the current narrative will change quickly. Despite this, most sell-side estimates for forward earnings include further price declines, underestimate synergy capture from the KS deal, give WRK no credit for incremental growth/efficiency projects (an area where the company has historically over-delivered), and include no significant benefit from lower key input costs (more on this below).

Importantly, recent actions by Chinese authorities have created huge distortions in the global containerboard market. For now, China's ban on imports of recovered fiber has led to a collapse in prices for OCC (old corrugated containers), a key feedstock for WRK. Prices last year were over $100/ton and now sit at $22/ton, and every $10/ton reduction is roughly a $60m EBITDA benefit to WRK. These lower OCC prices are also not being fully accounted for by current street forecasts. That said, ultimately something must give - either China relaxes the ban on imports of recovered fiber or domestic Chinese packaging companies must import vast amounts of finished containerboard. This demand would likely be served by virgin board from the US or, if tariffs made this un-economical, imports would be sourced from Europe or elsewhere. Regardless, the net impact would tighten the global containerboard market significantly, with WRK poised to benefit. For scope, RISI forecasts that Chinese imports of containerboard will increase from 2.6m tonnes in 2018 to ~8m in 2023, with a ~1m tonne increase in 2020 alone. This significant and incremental demand is more than all of the combined expected capacity additions in North America over the period and is not widely appreciated.  Add to this the fact that WRK announced in mid-September that a reconfiguration of its South Carolina paper mill would add $40mm in annual EBITDA starting in January of 2020. Moreover, as part of the reconfiguration, WRK will permanently shut down one of the mill’s three paper machines eliminating approximately 28K tons of linerboard capacity. Reconfigured, the mill’s production capacity will total ~605K tones annually in three grades.

We have seen the capitulation and believe the bottom is in for WRK.  We believe the price range thus far in 2019 is unsustainable, and investors will not be able to ignore the valuation and attractiveness for long.  We believe with the price disparity and performance divergence with WRK vs. other players in the industry will likely generate a lot of investor interest in the WRK report on Thursday morning. The dividend yield is now just under 5%, compared to recently priced WRK bonds which saw very strong demand for a 3.9% yield on a 2028 maturity. Given the consolidated market structure and exposure to stable consumer end-markets, WRK should trade at a ~15x cash multiple and is thus likely to triple from current depressed levels.

The core WRK business lines tend to be so steady as to be boring. Out of the WRK box volumes, more than 60% of box volumes relate to food shipments, and industry volumes have grown at a very predictable and consistent rate of 2% annually for more than the past five years. During the 2008-2009 global financial crisis, volumes declined by a mere 8% and the declines were closer to 5% in prior recessions. It is noteworthy that this was prior to the industry consolidation and boxes used for e-commerce shipments were not a meaningful contributor to overall volumes (like they are today).

Despite these defensive characteristics, after the recent decline in the share price this year, WRK equity is priced at just 6x  cash flow (fiscal 2021 free cash flow measured by operating cash flow less maintenance capital expenditures. The FCF multiple including growth capex is still a healthy 6.5x.) In other words, over the next three years WRK will generate over 50% of its equity market value in cash profits. Investors receive a portion of this cash generation via a ~5% dividend yield and we are anticipating a more meaningful portion of the balance will be returned in the form of share buybacks. Current management is not only a good allocator of capital historically but also investor friendly. WRK has returned over $2 billion to shareholders over the past three years.

The primary concern from investors seems to center on conversions of paper production mills/machines currently focused on secularly declining markets like printing paper or newsprint. The fear is that these potential conversions will expand the supply of raw containerboard too much. Many investors believe that excess supply from such conversions will occur, resulting in falling prices sometime in the next decade. This would reduce the profitability of companies like WRK.

However, what is lost in the analyst negativity and apathy is any thoughtful analysis of how long it takes to convert machines (equipment lead times alone are close to two years), and not all conversions are created equal. Most importantly, the consolidated industry is running above effective capacity. As a result, announced conversions would simply meet future demand increases versus creating dangerous excess supply in an industry that already lacks any spare capacity. (Current capacity utilization is 93%. In general paper mills cannot be run flat out for extended periods.)

As we model out the potential timeline of new supply on a mill-by-mill basis, we think the risk of oversupply is quite low. The capacity additions are mainly being driven by vertically integrated suppliers who need these additions to meet customer demand. In addition, four players control ~80% of industry volumes today.

We believe that the market is also not considering important empirical evidence related to how these oligopolistic players behaved during the last periods of capacity additions and one period of demand weakness on the back of a produce reducing drought in California. In each of these three periods since 2010, market participants behaved rationally, and idled machines for brief periods of time to balance supply, demand and pricing (resulting in little to no negative impact to profitability per ton of output volume).

What were the multiples these stocks traded at in 2016 when they capitulated?

(Please note that the market itself is nearly ~60% higher than February of 2016, and higher rates should favor names companies such as WRK and hurt the market. Thus, we believe this is a massive disconnect.)

WRK bottomed at $30 in 2016, but EPS estimates were $3.00 whereas now the stock is approaching $40 and the estimates are $3.94.

Regardless of how one views the industry or the market backdrop, the comps as well as WRK – 2019 marks the lowest valuation at which they have ever traded. As part of an oligopoly, the group is not nearly as cyclical as some would believe. A big portion of WRK’s business is food-related, and even in a recession, food consumption is not going to decline significantly. As an early-cycle name, even if we see a recession imminently, WRK will be among the first to recover. Looking at past recessions, the beaten-to-death value names start to recover well before the recession is done. We believe companies such as WRK are already factoring in a worst possible recession scenario.  It is exceptional to find quality companies such as WRK at a ~5% dividend yield if markets were purely rational. A recession will certainly come (at some point), but we believe companies such as WRK already largely reflect it. Obviously, the stock can see lower levels, but, then we will have a bigger yield and we are confident in our analysis in claiming that the dividend is safe. The companies remaining in the space are highly unlikely to price irrationally to try and gain share. We believe we have been experiencing the worst downcycle for value in history. Positioning remains at an all-time low for value and cyclicals. Thus, we believe the upside from here is similarly extreme.

Catalyst

• Quarterly Earnings on Thursday morning where expectations are de minimis, but numbers for next year are likely to go up, and concerns and any bear thesis likely to be dispelled by conference call.  This call we believe will prompt many investors to recognize the value in WRK, and see many new buyers coming into the name.
  
  
• Some analysis and recognition by the sell-side that WRK is trading below historic trough multiples and the consequential sponsorship that the stock is currently missing.
• Recognition that the tariffs and “trade war” will have minimal impact on WRK, and if a deal with China is consummated, then concerns on tariffs will have no impact on WRK
• Containerboard price increases
• Recognition that even in the event that tariffs or something unforeseen ultimately lead to a recession, that WRK is ridiculously cheap and as part of an oligopoly with heavy exposure to the food industry, will not see substantial decline in revenue or earnings