PKG – All About Those Boxes

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 20th, 2015

PKG – All About Those Boxes

  • With our recent focus on insulation from Chinese export trends, we revisit our positive view on PKG
    • Simply put, China lacks the softwood trees needed to make higher quality, higher strength virgin containerboard – Chinese capacity is almost entirely based on recycled paper inputs
    • Substitution by end users is not likely, as short supplies of recycled inputs drive a cost differential in favor of wood based producers
  • This is currently the cheapest stock in Paper & Packaging and one of the 10 cheapest in our entire universe of 120+ names
    • Even after the move higher on strong Q2 earnings, valuation is near an all-time low on our models, on both a normalized value framework and on a relative P/E basis – this could be a $90 stock and still look inexpensive
  • The company remains an impressive cash generator
    • Forward free cash flow yield of ~8% is among the best in the Paper & Packaging space
  • PKG has a highly integrated business model and consumes the bulk of its containerboard production at its box manufacturing plants
    • The company’s high ratio of box plants to containerboard mills relative to peers reflects its focus on specialized box production – for an equivalent amount of containerboard capacity, PKG has many more facilities to turn those sheets into boxes
    • Maximizing revenue on these specialized boxes has yielded a higher margin profile than its more cost-focused competitors
    • This is likely to continue to drive growth in excess of the industry as packaging is increasingly used as a differentiator – for instance, shelf-ready-packaging has a much lower penetration in the US vs. Europe
  • For those with a longer investment horizon, we reiterate that our original thesis remains intact and has yet to play out
    • The outcome and timing depend on your assumptions for Chinese consumer driven demand growth – for perspective, Ali Baba ended 2014 with more active annual buyers than there are people in the United States
    • MLP conversion was never a big part of our thesis

Exhibit 1

Source: Company Filings, SSR Analysis

Overview

PKG was one of the top performing Industrials/Materials names of 2014, but has not fared as well in ’15 year to date. Operational difficulties plagued the company in Q1, as a machine conversion at the Deridder, LA plant did not go as smoothly as hoped. These challenges, along with significant price/mix headwinds in the smaller Paper business and the failed materialization of increased nondurable consumer spending post-crude collapse have deflated the stock’s value such that it now screens among the cheapest in our universe of 120+ names.

Such headwinds have obscured the fact that the core story that initially drove PKG from $20 to $80 is very much alive – PKG’s box shipments have continued to outpace the industry, a function of the company’s focus on specialized box production. The trends in the market (packaging as differentiator) and PKG’s status as a still-small player should result in continued box shipment growth in excess of a flattish industry.

Additionally, PKG fits very favorably in our “most-insulated” bucket in the context of our work on Chinese export dominance of commodity and, potentially, downstream derivative markets. Geographical factors (China doesn’t have the trees!) and cost differentials (virgin wood is advantaged versus recycled inputs) provide PKG a buffer from this theme. In fact we expect to see PKG’s export business actually grow in size and profitability in the years to come.

Box Focus a Proven Success Story

PKG makes its money by selling boxes, specifically, hard to make boxes, evidenced by its high box plant to mill ratio relative to peers which suggests that for the equivalent amount of containerboard capacity PKG has many more plants to turn that containerboard into a box versus its integrated competitors.

Exhibit 2

Source: Company Filings, SSR Analysis

Management is fond of saying that containerboard is a commodity but a box is not. By focusing on that hard to make box, PKG maximizes revenue and does not create significantly higher costs – margins are a step above competitors’ (Exhibit 4).

Exhibit 3

Source: Capital IQ, SSR Analysis

About Those Lower Gas Prices…

Domestically there is still leverage to a rebound in non-durable goods shipments, which have somewhat counterintuitively declined concurrent with the collapse in crude – Exhibit 5. Similarly, the US recovery has seen industrial production of non-durables trail that of durables by a wide margin, though the gap appears to have closed slightly over the past several months – Exhibit 6. Any improvements here would have a material impact – more than 60% of US corrugated demand comes from the food/beverage/ag products and retail/wholesale trade markets.

Exhibit 4

Source: US Census Bureau, SSR Analysis

Exhibit 5

Source: US Federal Reserve, SSR Analysis

Long Term Export Thesis Intact and Yet to Play Out – Alibaba Sales as Proxy for Corrugated Consumption

Currency has impacted containerboard exports recently, but the long term trend continues to favor domestic virgin producers, as relatively abundant softwood trees in North America will offer a pronounced input cost advantage versus recycled fiber, of which supplies are limited and for which demand growth is strong.

When exactly this happens is still a China question – the government there is clearly trying to stimulate consumer consumption, which would help.

On the matter of Chinese corrugated consumption: with some very conservative assumptions, we can see growth in Alibaba alone accounting for a 5% increase in corrugated demand over the next two years off of base levels.

  • Annual buyers at Alibaba have been growing by 10% a quarter since Q4 ’13 – we tick this down to 8%
  • We assume orders per buyer do not grow from 2013 levels (49 was the figure cited in Form F-1)
  • We assume there is only one box per order and that the average size is 16” by 16”
  • Converting to square meters, the incremental demand growth off a base demand level of 45 billion square feet is 5% cumulatively over 2015-2016
  • Not huge, but again a conservative figure, and 5% growth on the largest absolute consumption figure in the world, in a market with limited capacity to increase supplies
  • For perspective, Ali-baba ended Q4 with more active annual buyers than there are people in the United States of America
  • Again, however, this is likely a longer term (3-5 year) dynamic, but there is clearly plenty of runway for growth in corrugated consumption in China – Exhibit 7

Exhibit 6

Source: International Corrugated Case Association, RSA Inc.

Valuation

From a free cash flow perspective, PKG has among the better yields within the Paper & Packaging group – Exhibit 8. The company’s long term ROC trend indicates we should see a move off the trough in the coming quarters (the data in Exhibit 9 uses forward 12 month net income figures). Based on the current trend, PKG is at its all-time valuation low, trading at a level of discount not seen since the first year it went public – Exhibit 10. The stock’s relative PE based on our normalized framework is also at an extreme – Exhibit 11. The near term headwinds the company has faced would appear to be transitory in nature, and it does not otherwise appear that this is a fundamentally different story than it was six months or a year ago. PKG could trade up in the $90-100 per share range and still look relatively undervalued.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

©2015, 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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