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How would you like to buy a Amazon/e-commerce play at 6.2x 2Q TROUGH EBITDA with a 18% LFCF yield?  Wait - there is more! 

1. If the 1x pull-forward in e-commerce in 2Q holds while the rest of the US economy recovers, I suspect we could be tight on supply as early as this fall!
2. The industry is a structural oligopoly with highly stable operating margins and free cash flow
3. The stock I have in mind trades at 2-3x TEV/EBITDA discount to its peers who are STRUCTURALLY and CYCLICALLY inferior
4. There is a real chance that in the next 12-36 months that China starts to import product from the US and forces the construction of more virgin mills – which will only occur if margins lift to replacement levels.  If so, the stock is worth 3-5x more than today’s prices.

If you haven’t guessed by now, the stock I have in mind is WestRock.

WestRock is a domestic manufacturer of container-board (boxes) and consumer packing solutions (paper food boxes).  There are two ways to manufacture the product – with virgin fiber from trees or recycled fiber/boxes (old corrugated containers “OCC”).  WestRock’s portfolio is comprised of 55% virgin and 45% OCC.

Since I had two trolls rate my TROX write-up a 1.0 on quality, I will spend more time on a containerboard primer. 

Industry back-drop:  The industry has been growing at a low-single digit pace as e-commerce demand offsets light-weighting and a structurally slower GDP.  In stable times, demand is approximately a 1.0x Beta.  In periods of dislocation like the GFC, the industry destocks and Beta moves to 2.0x.  During the GFC, -8% GDP translated into 15%+ drop in demand.  The industry has matched the modest demand expansion by debottleneck and slowly converting uncoated freesheet and other mills into supply.  The industry is dominated by Packaging Corp of America (“PKG”), International Paper (“IP”) and WestRock (“WRK”).  On top of dominating domestic market share, the players have pocket of regional strength which enhances their ability to match supply/demand and hold margins.  Despite repeated handwringing by investors about new supply & slow-down fears, the industry has managed supply to match demand.  Margins have been extremely stable as a result.  WRK has generated >$1.0bn of FCF for the past 5+ years.  This will almost certainly repeat in 2020.  The cost-curve is skewed to feedstock price volatility.  Today, mills that used OCC feedstock are lower on the cost curve.  When China was ripping every idle ton of OCC out of the market, virgin plants were lower on the cost curve.

There are three items that could accelerate the market on its path toward tightness.

1. As I mentioned above, containerboard historically has a 2.0x Beta to GDP in periods of dislocation.  This would imply an incredible decline of 60% in 2Q as the entire economy closed except for e-commerce and the most essential services.  What happened to demand?  Demand was essentially flat as e-commerce demand offset an implosion in the rest of the economy.  AMZN’s stock price and most pundits would have you believe that this pulled forward the inevitable adoption of e-commerce permanently.  I tend to agree with the thought process and suspect we hold onto much of the 1.0x surge in demand.  What happens when demand from the rest of the economy recovers?  The US industry was running at 92-93% capacity utilization before this hit and held this during 2q.  95% is the theoretical sustained limit.  There is a real chance that the industry is caught off guard as demand overwhelms supply and the industry will need to ration supply via price.  To be balanced, the demand surge in e-commerce may have accompanied an inventory demand whip in that segment – offsetting the rest of the industry’s demand decline which was likely amplified by a destock.  Nonetheless, an economy that runs at 95% of 2019 levels may be short containerboard.  So far, this hasn’t shown up but the math is hard to reconcile.  Despite this, I am the one clown that senses this upside risk.  I could be wrong but I can’t see how.
2. Containerboard and paperboard is a green (recyclable) alternative to single-use / plastic.  WRK has been a leader in developing these packaging solutions on a customized basis for its customers.  WRK believes that this transition will drive 1% secular demand growth for the foreseeable future.  My suspicion is this may understate the opportunity.  Nonetheless, I would add 1% to your demand growth assumptions to reflect this.  While it may not sound like much, in 3-5 years this additional growth will consume a large amount of the potential Uncoated free sheet supply that can be converted into containerboard.
3. China structural shift.  The Chinese market is 3x the size of the US.  China has zero fiber basket – ex China Forestry.  As a result, most Chinese containerboard mills run on OCC.  Historically, they imported OCC with the US forming a huge component of the supply.  The process of cleaning dirty OCC and running it through plants is highly pollutive.  In an effort to curtail the pollution and remove high cost capacity, the Chinese government restricted the import of OCC to all but the cleanest grades of OCC.  As a result of these changes, OCC prices in China soared as domestic plants scoured the domestic sources for OCC.  The lack of exports from the US drove OCC prices much lower.  The net result was a large drop in production as Chinese producers couldn’t obtain OCC feedstock.  I suspect the supply reduction in Chinese was about 15-20%.  This 15-20% production decline went unnoticed in 2019 as the Chinese economy was reeling from the trade war and many industrials were destocking.  This destock had a double impact on containerboard demand.  1)  Industrials were destocking parts – which means they didn’t need as many boxes to store parts  2)  The containerboard/box supply chain destocked.  However, toward the end of 2019 containerboard prices started to move up appreciably.  I strongly suspect that if not for covid, China would have begun to import material amounts of containerboard as it didn’t have sufficient domestic raw materials to run the mills to supply its market. 

As a reminder, the Chinese market is roughly 3x the size of the US and suffered from a 15-20% decline in production.  TO PUT THIS IN CONTEXT – Chinese production possibly declined volumetrically by an amount that represents 45-60% of total US production!!!!  In late 4q, Europe was running at 95% capacity and the US was low 90s.  The global industry WAS NOT and IS NOT ready for this.  At the end of this year, the Chinese will expand further their OCC import ban to additional grades – further hampering internal efforts to supply their market.  During this 2 year trough, the fragmented and high cost Chinese containerboard industry has likely rationalized material amounts of production.  While many in Indonesia, Malaysia and other parts of the world are rushing to build plants that can upgrade OCC to a grade that the Chinese can import, the reduced production capacity might be insufficient should the Chinese economy eclipse 2019 levels.  As indicated above, these imports volumes could easily tighten the global market.  Much has been written of the eventual import of finished containerboard from the US into China and it has never come to fruition.  Maybe another change will occur that defers this moment.  However, if this were to occur, we would need to materially expand capacity fulfill this demand.  9 dragons has not been announcing price increase like late 4q-19 but this is something to watch.

Cost structure:  I was long this sector when Covid hit.  I sold as I anticipated a staggering hit to volumes.  I suspect that management came to the same conclusion.  In response, they announed a plan to reduce $1.0bn of cash costs.  Some of these efforts included converting cash comp to stock comp which isn't accretive to shareholders.  however, the additional effort to remove fat likely helped to drive the large beat reported yesterday.  If you include these efforts plus an on-going cost savings effort from synergies and other intiatives - WRK is far cheaper on 2q-20.  I suspect this could add at least 300mm to the run-rate in 2021 and protect if none of the above call options play out.

Why has this stock failed to recover?

Given the tremendous optionality from 1)  a potentially undersupplied US market  2)  Chinese imports , why has the stock failed to perform while PKG and IP have resumed their pre-Covid levels?

1. I have no bleeding idea why.  It boggles the mind.  IP and PKG have material exposure to structural and cyclical flawed grades of paper: uncoated freesheet (copy paper), other graphic paper and pulp.
2. This disparity is particularly acute as WRK has 45% of its exposure in recycled capacity which moved lower on the cost curve when China banned the import.  WRK is 100% high quality growth grades.

Putting the structural and cyclical inadequacies of PKG/IP aside, I believe the following rationale explains the weakness in WRK.  Much of which is petty b/s and backward looking.

1. For many years, WRK was a higher cost producer owing to its 45% balance of recycled capacity.  IP/PKG have far more exposure to virgin.  Despite the flip in the cost curve in favor of WRK, it takes a while for the humans to reprogram the computers to price stocks efficiently.
2. WRK modestly underperformed IP/PKG on volumes in 2Q.  IP/PKG were +VLSD and WRK was -VLSD
3. PKG management has developed a cult following.  WRK has been effective managers though.  This is not a case of good/bad management.
4. WRK is focused on reducing debt to 2.25-2.50x leverage limiting their capacity to buy back debt.  I believe this is misguided.  2.25-2.50x is a vestige of an epoch with higher rates.  At these borrowing costs and given the stability of FCF generation, WRK should term its debt out further, raise its leverage target and more efficiently allocate capital.
5. The decline in uncoated freesheet demand has left the Uncoated freesheet market acutely over-supplied.  Many of these mills that could convert to containerboard are in IP/PKG hands.  If converted, this would force investors to wring their hands about supply concerns.  My suspicion is that we will need this capacity.  Further, I am not sure why this should penalize WRK but not IP/PKG.
6. A Portuguese based containerboard producer announced that it would start a small mill in 2023.  Again:  1)  this is not a material addition that will likely be needed 2)  The additional suppliers are part of this oligopoly that have effectively managed this industry 3)  Why does this only penalize WRK?

In conclusion, the 1x pull forward in e-commerce adoption likely created a step-function up in demand which hasn’t been recognized yet due to the weakness in the rest of the economy.  As we re-open and resume normal activities (like building cars), this shortfall may surprise the market.  In addition, the company possesses a very powerful call option on the structural shift in Chinese for free.  All of this is encapsulated in a stock that is:  1)  intrinsically cheap on trough earnings power  2)  trading at an egregious discount to its inferior peers  3)  huge discount to replacement cost. Hope this helps!

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