Paper & Packaging– Seasonality Strong, Expect Outperformance in December

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 8th, 2014

Paper & Packaging– Seasonality Strong, Expect Outperformance in December

  • Paper & Packaging stocks have historically outperformed in Q4, aided no doubt by the holiday season – December in particular has seen the most robust gains. 2014 is shaping up to be no different, with outsized gains for the group in October and November – Exhibit 1.
  • Our return on capital based valuation work shows a number of companies looking inexpensive (PKG, MWV, IP, UFS)however, absolute valuations are not notably cheap for the group as a whole on an EV/EBITDA basis relative to the broader Industrials & Materials group.
  • Implied growth analysis highlights some valuation anomalies – PKG and IP, for instance have significantly different levels of implied growth (11.5% for PKG, 8% for IP) yet are being afforded the same multiple (~8x EV/forward EBITDA), offering further support for our belief that PKG is relatively undervalued.
  • MLP conversion has been a major recent theme in the space and various management comments on the structure contributed to the outperformance in October and November. With an increasing sense of expectancy that the IRS will rule favorably being factored into valuations, we would favor UFS and PKG as relatively inexpensive names that would be less vulnerable to downside risk in the event the IRS denies these requests and would on the surface stand to benefit disproportionately from conversion.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

The Paper and Packaging sectors have traditionally been strong performers in Q4, benefiting from seasonality, and, as suggested by the step-up in these gains since 2000, expanding e-commerce. 2014 is aligning with the historical trend, and stocks have performed a bit better than average with MLP related gains contributing to this outperformance.

MLP has been the biggest topic within Paper & Packaging over the past two quarters, primarily focused on the containerboard names (RKT, IP, PKG and the more diversified MWV) but also extending to the pulp and paper play, UFS. During the fiscal Q4 conference call last month, RKT announced it had filed a private letter ruling with the IRS, and this drove the stock to the biggest gain within the group in November. In October, UFS was the beneficiary of an MLP related intraday spike (+10% on its earnings release day). IP and PKG have seen related gains as well. While MLPs are undeniably attractive structures for these highly cash flow generative businesses, it is no certainty that the IRS will rule favorably here. We do not claim to be experts on the topic, but as a primary qualification for MLP conversion is the use of natural resources, we wonder if containerboard is too far removed to legitimately qualify (timber pulp linerboard/medium). UFS, with a significant Pulp business, would seem to have a better claim to qualification. At any rate, we would be cautious about incorporating any premium into the names based solely on speculation. PKG again looks like the best bet here. As the company utilizes the highest percentage of wood among its competitors, a larger portion of its cash flows would figure to be eligible to be applied to the MLP. The relative valuation support for the stock should limit downside in the event the IRS denies these requests, and offer greater upside in the event they allow them.

For the group as a whole, while valuations are not cheap in the aggregate (Exhibit 4), we would expect the seasonality effect to dominate in December (five trading days in, the group has fared nearly 3% better than the S&P) – but history advises a quick sale in the new year.

Valuation

Exhibit 2

Source: Capital IQ, SSR Analysis

PKG and IP both screen as cheap in Exhibit 2 but we note that our models for these companies do not have a strong historical relationship between valuation and earnings (see the
Appendix
which compares current price with the normalized, mid-cycle price on our model, and the R2 which measures the extent to which valuation is explained by deviations from the return on capital trend). We continue to favor PKG in the containerboard space. UFS still has valuation support, offers a solid dividend (3.7%), and would on the surface be a more likely candidate for MLP conversion than containerboard producers (pulp operations are closer to the natural resource input, timber in this case, that is the primary qualification). These three stocks have the most reasonable EV/EBITDA multiples – Exhibit 3. Outside of the paper/containerboard space, multiples look much fuller. For the group as a whole the multiple is getting a bit elevated – Exhibit 4.

MWV is one of the cheapest stocks in the group on our framework, relative to its upward sloping ROC trend from 2002 (when the merger of Mead and Westvaco led to the current incarnation of the company). The stock has the interest of an activist investor, and the separation of the company’s Specialty Chemicals segment is seen as likely. If we think of the stock price pre-activist as the floor (around $40) and the upside as the mid-cycle valuation on our model (around $60, coincidentally also the midpoint of the activist’s targeted value) then the risk-reward sets up nicely as 3 to 1. MLP conversion represents an additional source of potential upside – the company earlier in the year mentioned they are considering the structure, not only for their wood based paperboard operations but also as a possibility for the Specialty Chem segment. It is also expected that there will be a leadership transition in the near future, which could be a catalyst for the change in sentiment that is likely needed to drive the stock higher, absent a resolution to the Chemicals question. MWV has seen the most positive revisions to 2015 EPS estimates over the course of the year, but the multiple is not low and the stock has been basing near its highs, suggesting the trade might be crowded as investors await further developments.

BLL and CCK still look expensive relative to their 30 year return on capital trends, and multiples are at a ten year peak. OI has been hurt by its optimism as the stock has tumbled on negative guidance in the past few months – valuation looks reasonable but not overly compelling and the specter of further downside surprises prevents us from taking a more constructive view on the name.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Implied Growth

We borrow a bit of analysis from our Consumer colleague Rob Campagnino (and Bloomberg) to look for valuation anomalies based on levels of implied growth (Bloomberg’s implied growth function compares the current share price to the theoretical DDM based share price).

This analysis further supports our positive stance on PKG, as despite a sizably higher expected growth rate than IP, the company is being afforded roughly the same multiple. UFS is also being viewed with a fair bit of skepticism by the market, which is giving a very low multiple to an asset that figures to grow faster than fellow paper maker IP. RKT looks interesting from an implied growth perspective, but the company has seen its 2015 EPS estimate cut by 22% year to date (second worst in the group) and while it’s multiple appears reasonable it is the only containerboard stock that screens expensive on our models.

Both axes in Exhibit 5 below are obviously open to interpretation – for instance, the implied growth for OI looks a bit high to us. CCK has a much greater emerging market exposure than BLL, and should have superior growth prospects in the long run.

SEE is the obvious outlier in the top right, and it seems that the Diversey business has disconnected the company from its former packaging peers. The company’s strategy is far more holistic in nature than any of the other companies in this space.

Exhibit 5

Source: Capital IQ and SSR Analysis

2015 EPS Estimates

Looking at how 2015 EPS estimates have changed over the year, we continue to see support for PKG. While competitors RKT and IP have seen some of the worst negative revisions over this time, PKG’s 2015 EPS estimate has been raised by 11%.

Exhibit 6

Source: Capital IQ and SSR Analysis


Appendix:

Note: The ROC based “normal price” is the value generated by our model from the company’s long term return on capital trend. The R2 measures the historical extent to which valuation has been explained by deviations from the ROC trend.

©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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