Description

We’re long WestRock, a leading manufacturer of corrugated and consumer packaging in the U.S. and Latin America.  Shares in WRK trade near decade lows due to cyclical and idiosyncratic issues, but competitors PKG and IP last week signaled that we are nearing the end of a destocking period and WRK’s relatively new CEO and management team are doing the integration work that the prior management team didn’t effectuate during a decade of large-scale M+A.

Under prior CEO Steve Voorhees, MeadWestvaco and RockTenn merged and then later acquired KapStone.  The industry consolidated, and today 4 companies control roughly 70% of the North American containerboard market, up from 36% in 1995.  The combined WestRock holds a #1 or #2 market position in all 4 of the major paper-based packaging grades in North America, and further holds leadership positions in body & shower spray pumps and Brazilian containerboard.  It is the second largest producer of containerboard in North America, and a significant producer of paperboard (e.g., it is the largest North American producer of solid bleached sulfate, kraft paper and uncoated unbleached kraft).

WestRock has struggled operationally as acquired assets have not been well integrated.  In the past three years WRK has cut the dividend in half, pulled annual guidance and recorded significant ($1.9 billion total) noncash write-offs in both business units.  On top of the company specific issues, you have a post-COVID goods hangover, recession fears and concerns regarding new supply coming to market in 2023 and 2024.

Some of the industry issues have been well captured with ZeroHedge getting in on the fearmongering yesterday Tweeting / X’eeting out

Big Drop In Cardboard Box Sales Scream Recession

Earlier this month, Packaging Corp. of America reported that cardboard box sales fell 9.8% in the second quarter. That ranks as one of the biggest slumps on record when you combine it with the 12.7% drop in Q1.

According to a report by FreightWaves Research, the combined six-month decline ranks as the biggest plunge since early 2009.

And the BOA chart showing box demand at the weakest levels since the Great Financial crisis has been making the rounds.

 With many of the cyclical concerns well discussed, and a competent management team incentivized properly, we think shares are interesting at current levels.  With net leverage targets nearly achieved, we expect management to begin increasing the dividend and buying back shares.  The stock yields nearly 3.5% while we wait for the market to turn and management to optimize the portfolio.

An investor day in May of 2022 gives an overview of the business and the broad set of industries WRK sells into.  The meeting was met with a tepid reaction, as the 2025 targets were not exciting given the company was operating at a cyclical peak at the time.  As is frequently the case with cyclicals, now that the end market has turned down, investors think the once easily achievable targets will never be met and shares are trudging along near lows.

 Management focus moving forward is on integrating the decade plus of large-scale M+A into a system of mills, instead of operating as individual assets.  Goals are to keep as much production as possible in-house and reduce external paper sales while shutting down higher-cost mills to improve ROIC.  Management sees a net savings of $1 billion in costs over the 2022-2025 period after reinvesting other savings back into the network.

WestRock is also an ESG beneficiary as a leader in plastic replacements.  Management expects sales to nearly double to $700 million in 2025, which seems reasonable based on current trends and a $50 billion TAM. 

Since the investor day WRK acquired the remaining 2/3 stake in Grupo Gandi for total consideration of $1.76 billion.  Expects EBITDA of $200-2110 million and synergies of $60 million in three years.  The transaction positions WRK nicely in Mexico with an existing legacy portfolio in Brazil and Latin America.  The company expects the LatAm market to grow 2x North America moving forward and the acquisition deepens WRK’s integration with multinational customers.

The acquisition bumped WRK slightly above the 1.75-2.25x leverage target, but the company should be in-range shortly.  The dividend was slashed 57% in May of 2020 and has only crept up since then.  The stock still pays a $1.10 annual dividend good for a 3.4% yield, and we expect dividend increases as part of the go-forward capital allocation plan.

 New Management Team and Compensation Changes

In March of 2021 CEO Steve Voorhees stepped down due to health issues, and David Sewell was announced as his replacement.  Mr. Sewell had a 14 year career at Sherwin-Williams and was involved in the successful integration of the Sherwin-Williams / Valspar merger.  Sewell brought in a new CFO and other members of the senior management team.  We think Sewell is the right person for the job, and are still doing some diligence on the CFO (who had been at the helm as CFO for a few months before the, lets call it aggressive, CommScope / ARRIS merger).

Historically, management compensation had been heavily skewed towards EBITDA, which worked out well for the prior team given the industry went through a debt fueled consolidation period.

The new compensation plan (particularly the long-term plan) aligns management compensation with their ability to rationalize the WestRock network and produce returns for shareholders.

 2022 Short-Term Incentive Plan

At the beginning of fiscal 2022, the Compensation Committee established STIP performance metrics and goals. In addition to EBITDA, which had been the sole STIP financial metric in fiscal 2021, the Compensation Committee concluded it was appropriate to add Revenue and Free Cash Flow Per Share metrics for fiscal 2022.

50% EBITDA, 25% Revenue and 25% FCF / share

2022 Long-term Incentive Plan

Paid on FCF / share, ROIC added for the first time and TSR 

Awarded Feb 7, 2022

For the portion of the award allocated to the Free Cash Flow Per Share metric, the Compensation Committee set the target goal following consideration of expectations over the performance period related to volume, pricing, capacity, raw material and other cost inflation, expected higher tax rates, and the macroeconomic environment. This resulted in a target that was 7.6% higher than the target level used for 2021 grants. The actual number of shares that will vest pursuant to the grants will be a percentage of the respective allocated target awards based on the three-year Free Cash Flow Per Share performance as follows:

$4.95 FCF/share is 100% payout

$5.95 is 200%

Under $4.50 is nothing

ROIC was added as a compensation metric for the first time as well.

The Compensation Committee included ROIC as a performance metric in fiscal 2022 to focus on the effective and disciplined use of capital and the return generated for stockholders.

Operational Changes 

Following the compensation changes, management has begun optimizing the operating footprint put together via a series of acquisitions, shutting down high-cost mills and divesting non-core, lower margin business units.

WestRock announced the closure of a Tacoma, Washington paper mill yesterday, continuing the mill rationalization.  Continued industry plant closures, increased maintenance times and project delays to new plants should help offset the planned industry capacity additions.

Valuation

For nearly a decade WestRock has produced FCF / share in excess of $1 billion.  In a subpar year they’ll do $4 / share, and in better times they’ll do closer to $6.  Management thinks they can take out another $750 million in costs over the following two years, which would be another $2 / share.  End markets still need to fully destock, and the industry will have to get through the supply additions, but the stock trades cheap on current earnings and the business should look better in the near future. 

Moving forward WRK is run by a competent CEO with plenty of levers to pull to increase free cash flow.  The company should benefit from onshoring, e-commerce and the move away from plastic packaging.  While not the most exciting business in the world we think the company will be higher quality with better returns on capital in the future, and there are a lot of ways to map out a three-year double from today’s cyclical low levels.

Risks

Recession

Oversupply – expansion projects come online on schedule, lack of mill closures

Overpaying for / doing large M+A that increases leverage

Catalyst

End of customer destocking

Continued pruning of high cost mill operations

Management comes anywhere close to $1 billion inn three year cumulative cost savings

Increase to quarterly dividend payments