Containerboard Capacity Additions Unlikely To Affect Operating Rates – PKG Well Insulated

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

October 29th, 2014

Containerboard Capacity Additions Unlikely To Affect Operating Rates – PKG Well Insulated

  • We do not believe that containerboard capacity additions are going to have a negative impact on the US business in 2015. The American Forest & Paper Association (AF&PA) estimates YTD North American containerboard operating rates averaged 96.1%, implying production growth of more than 2% (after 1.1% growth in 2013).Capacity additions expected online in the balance of 2014 and in 2015 (including 300,000+ tons per year each from a converted newsprint machine at PKG’s Boise acquired Deridder, LA mill and a brand new machine at private producer Pratt’s greenfield project in Indiana) require roughly a 1.5% increase in 2015 production to maintain operating rates at this level.
  • However, domestic box shipments have been flat, indicating that production increases are making their way elsewhere. Year to date the AF&PA reports exports are up 4.6% versus 2013 – going forward there is a risk that the strengthened dollar keeps some of those volumes at home.
  • Inventories have risen in absolute terms, but as a percentage of sales they are not at an overly concerning level. Q3 reports will shed some more light here – PKG for instance had noted on the Q2 call that inventories rose as a result of transportation difficulties, but Q3 levels were slightly down even though the logistical problems persisted.
  • At the company level, our favored containerboard play, Packaging Corporation of America (PKG, where we still see as much as 15% upside) is operating at a very high level of integration and the company indicated on its Q3 earnings call that their constraint is not finding a home for their corrugated products but rather ramping up production at the newly converted Deridder mill so outside purchases of containerboard will not be necessary to meet box plant needs. We expect PKG to be fairly well insulated to the effects of the new capacity.

Exhibit 1

Source: American Forest & Paper Association, Numera Analytics, SSR Estimates

Capacity Additions – Not Yet Impacting Operating Rates

Nearly a million tons of capacity were added to the North American containerboard market in 2013, and further additions are on the way. The conversion of PKG’s Deridder, Louisiana mill from newsprint to containerboard was completed several weeks before schedule, as the company indicated in the Q3 earnings call. Pratt, in August, ordered a new machine for its greenfield project in Valparaiso, Indiana.

Exhibit 2

Source: American Forest & Paper Association, Press Releases, SSR Estimates

Through September, the American Forest & Paper Association reported an average 2014 operating rate of 96.1% – assuming 2013 capacity additions are fully online and excluding the upcoming addition from PKG, this projects out to a more than 2% production increase over 2013 levels (when production rose 1.1%). Moving into 2015, when Deridder should be fully online and assuming half a year’s worth of capacity from Pratt’s new mill (which is expected to start production in July), we would need to see production increase roughly 1.5% to maintain this operating rate.

Exhibit 3

Source: American Forest & Paper Association, Numera Analytics, SSR Estimates

Box Shipments – Flat Domestically, Exports Increasing

Box shipments have been flat year to date and Rock-Tenn highlighted the flattish box demand environment at a September conference. Given high operating rates, this suggests increased exports – for the first nine months of 2014, containerboard exports were up 4.6% versus the prior year. PKG cited better export pricing in Europe and increased demand from South America. Exports have been soaking up the tons not required in a flat North American box environment, but there is a risk that the strengthening dollar keeps some exports at home – this would test the continued high operating rates seen year to date.

Inventories – Trending Higher But Not Concerning Relative to Sales

PKG noted in its second quarter conference call that inventories had grown due to transportation difficulties. Inventories for the containerboard companies (PKG, RKT, KS, and GPK) remained elevated in Q2, but declined slightly from Q1 levels. The ratio of inventory to sales has a slight upward trend from 2011 but does not appear to be particularly elevated. PKG inventories were down in Q3 – the company did note it anticipates building some inventory in Q4 but more as a result of certain mill downtime scheduled for early 2015.

Exhibit 4

Source: Capital IQ, SSR Analysis

Stock View – PKG Well Insulated

When we first wrote about
PKG in August
, one of the company’s main competitive advantages appeared to be its regional focus. Driving two thirds of revenue from smaller local accounts with more specialized product requirements results in higher selling prices and margins and less dependence on a major national customers. For PKG the question has typically been “how much containerboard will we have to purchase from the spot market to meet our box plant needs”, rather than “will there be enough demand for our production.” The company operates at a high level of integration, meaning most of its containerboard is consumed internally at its box plants, and this has only increased with the Boise acquisition (PKG’s integration level was 92% in Q3 2014, up 4% quarter over quarter). As a still relatively small player (#4 North American containerboard producer) PKG has been able to enjoy high operating rates independent of broader industry demand lulls. Notably, the capacity additions that we have seen in the past few years and those yet to come are based on recycled-fiber – customers come to PKG in part as a result of the quality of their kraft products (kraft containerboard has higher strength and durability properties than recycled, and often a superior aesthetic appearance). So the company will likely be marginally less affected by increased recycled capacity, and should remain insulated to the effects of that capacity given its operational self-sufficiency.

The stock’s positive reaction during the Q3 earnings call shows there are multiple ways to win in the name – shares ripped higher when management announced they too were exploring an MLP structure for their containerboard mills. The original report that suggested virgin containerboard mills could be structured as MLPs did not mention PKG, but we noted in our prior work on the company that its capacity slants more toward virgin sources than any of its peers, and as a result the company would, on the surface, be a disproportionate beneficiary in this scenario. This is still a speculative story as the IRS has yet to lift its moratorium on the private letter rulings that grant the tax-favored status, and it is not a certainty that containerboard mills will even qualify as MLPs (wood is indeed a natural resource but containerboard is produced from pulp which is another step downstream from the timber itself).

A largely virgin-slanting capacity base is also the foundation of the broader long term thesis on the company. PKG management has on many occasions expressed the view that global supplies of recycled fiber (OCC) will become increasingly limited as demand from growing Asian economies (mainly China) will outstrip availability and drive prices higher. This would benefit the company, not only in the domestic market where virgin producers already enjoy a cost advantage relative to recycled producers (Exhibit 5), but also in the export market. PKG is currently a smaller player here, but their share of production allocated for exports would stand to increase, perhaps significantly and in a highly margin accretive manner, in a rising OCC price environment. We will explore this topic further in future research.

Exhibit 5

Source: IP Investor Presentation

Appendix: Methodology for Exhibit 1

  • 2012: The 2012 figures are actual, borrowed from the American Forest & Paper Association (AF&PA).
  • 2013: The additions came online in the second half of 2013 so only half of the annual capacities are included. 1.1% growth in production in 2013 sourced from the AF&PA. Implied operating rate is 94.7%.
  • 2014: Includes the other half of the annual capacities that came online in 2H 2013. PKG’s Deridder mill conversion which the company noted on the earnings call actually came on two weeks earlier than expected (so, mid-October as opposed to early November), was not included as we expect (and management said as much) that it is still ramping up. Estimates vary for the quantity and timing of the additions private player SP Fiber has made in 2014 – we have taken the higher estimates and the quicker timeframe and included 150,000 of the 200,000 tons/year SP Fiber is reported to be bringing on at its Newberg, OR mill. The operating rate is the AF&PA’s average estimate year to date, as of October 15, and we backed out what production would need to be to get to this rate.
  • 2015: Assumes PKG’s Deridder is in full operation. Also includes half of the annual capacity of a greenfield machine Pratt is expecting to come online in July and the remaining 50,000 tons from SP Fiber. 1.5% production growth is needed to maintain operating rate at 96.1%. We exclude the potential capacity additions from the Spanish company SAICA, which is reportedly looking to build a recycled containerboard mill in the US, and the Canadian producer Kruger, which is evaluating the conversion of a newsprint machine.

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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