Paper & Packaging – A Few Ideas for 2016

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

January 19th, 2016

Paper & Packaging – A Few Ideas for 2016

  • The Paper & Packaging sector seems a potential defensive play for 2016 given its weighting towards consumer demand, which we see as having more resilience than industrial demand (Column E in Exhibit 1) – our view is informed by uninspiring PMI figures, generally positive employment data, and the expectation of oil being lower for longer
  • This group generally benefits from lower commodity prices and, outside of paper, product volumes are not subject to the volatile swings associated with commodities (Column B)
    • Input cost benefits are often contractually passed along in timely fashion, however:
    • Lower plastic resin prices should be an incremental boost for plastic packaging stocks
    • Paper demand remains in decline but imports have subsided in the wake of government imposed duties, which should relieve pressure on shipments in ’16
  • Several companies have taken advantage of the low interest rate environment to make large scale deals, so debt levels are elevated in certain instances but free cash flow in this sector is very healthy as well (Column A)
  • Containerboard is subject to competitive pressures from imports and many plastic packaging products are susceptible to commoditization (Column C)
    • Prefer local focused box converters (PKG) and participants in end markets with high barriers to entry such as healthcare/pharmaceuticals (ATR, though valuation looks full)
    • Industry consolidation is significant in metal/glass containers – with no category killers for the can makers, we prefer CCK to BLL on relative valuation and integration risk for BLL
  • Companies that have pending or recently completed acquisitions (OI, BLL, WRK) have enviable growth levers in a challenging market (Column D)
    • We additionally expect further M&A activity from UFS and PKG
  • Valuation is only really approaching a statistical extreme low on normal earnings for PKG and IP (the latter’s dividend yield is 4.8% at current prices) and OI is at a 10 year absolute and relative low
    • It is also hard to ignore Westrock (WRK) which is a standout on a FCF/EV basis
    • Estimates for the sector do not appear overly aggressive absent a recession

Exhibit 1

Source: Capital IQ and SSR Analysis

Valuation

In aggregate, the Paper & Packaging space shows one of the larger discounts to normal value in a currently inexpensive Industrials & Materials space. At the stock level, there are a handful of companies trading near absolute statistical or relative extremes on our normal earnings models (see the Appendix for individual company valuation histories and the return on capital trends that drive our estimates of normal earnings – we also include a simplified industry schematic).

While Exhibit 2 shows a much more reasonable valuation picture based on simple EV/EBITDA, we can see positive trends or reasons for optimism for all of the stocks trading below their 10 year average, excluding GEF which, in addition to company specific concerns about the ability to meet dividend payments, is the only stock in our Paper & Packaging index that is primarily driven by Industrial rather than Consumer demand.

In Exhibit 3 we look at a measure of free cash flow to total enterprise value and see a similar group at the top. OI slides here due to the high proportion of debt in its EV.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Favorites

UFS

Demand in the Paper & Packaging sector is relatively stable but consumer preferences can impact trends on the margin. There is little doubt that Paper shipments are in decline but even as the world rapidly digitizes there remains a baseline of demand based on consumer taste for page turning. The key question for the paper industry (and future research) is are we underestimating the pace with which we are becoming a digital facing world?

At any rate, it was not the direct performance of the Paper business that drove UFS to underperformance in 2015. The Personal Care segment grew steadily but slower than expected – Exhibit 4 – and we are still waiting for another acquisition in this space to provide the company with needed growth opportunities. There is a likely point of inflection at which UFS will begin to be recognized as a consumer products company with a commodity paper cash engine to fund the dividend and further expansion into personal care, but we are still a deal or two away at this point.

The stock is inexpensive and its dividend yield (4.8% currently) has provided consistent support over the past five years in the low $30s range, where UFS is currently trading.

On our 2016 framework from Exhibit 1, Domtar is not heavily indebted and its free cash flow is more than sufficient to meet dividend obligations. The company’s primary business, paper, remains a commodity, but fundamentals have improved incrementally with US government imposed duties on foreign imports (more on this later) and as the North American share leader UFS stands to gain back volumes. On the self-help front, margins in the Personal Care business should continue to benefit from the move to in-house manufacture, and we would not be surprised to see another acquisition in this segment in 2016. Demand in both the Personal Care and Paper business is largely consumer driven.

Exhibit 4

Source: Capital IQ and SSR Analysis

OI

For glass bottles the situation is similar to Paper but with a more robust baseline of demand – when we think about wine, spirits, beer, bottles of Pellegrino, it is possible to envision incremental shifts toward alternative packaging substrates but as long as there are people to drink there will be glass bottles to be filled.

OI ticks a number of boxes in our Exhibit 1 framework. The company is the world’s leading glass bottle producer, with dominant market positions on four continents. Significant Brazilian and European exposure has resulted in disappointing volume numbers and currency headwinds, and investors have left the stock for dead even as return on capital has steadily improved – Exhibit 5. There is a new CEO in place and while there should be some concern that the model he effectively employed in South America is location specific and not readily exportable, the potential for a strategy/sentiment shift at the company’s investor conference in March makes OI intriguing at current prices. We also like OI’s entrenched global scale, which provides a buffer from Chinese competition.

The acquisition of Vitro’s Food & Beverage business in Mexico, closed in September 2015, provides synergy opportunities and access to a growing market where OI previously had a limited presence. The deal also added debt to an already reasonably levered balance sheet – cash generation is still strong but will be focused on deleveraging in 2016.

Exhibit 5

Source: Capital IQ and SSR Analysis

PKG, IP, & WRK

Containerboard exports and prices have been impacted by the stronger dollar (and accordingly weaker Brazilian real). We prefer companies that are selling a finished product (the box) rather than the commodity input (containerboard) – PKG and IP, and WRK to a lesser extent. WRK consumes about 66% of its containerboard production at its box plants. The equivalent integration levels for IP and PKG are 80% and 90%, respectively.

Similar to UFS, we await further acquisitive moves from PKG and the company has yet to realize the full benefits of its converted paper machine at the Deridder, LA mill – PKG has the better case for growth and is more significantly inexpensive and at more of an extreme than IP.

Additionally, IP faces its most direct competitive threat to date in its Consumer Packaging segment from the combination of the former Rock-Tenn and MeadWestvaco, now known as WestRock (WRK). The combined entity supplants IP as the leading coated paperboard supplier in the US, with 30% of capacity compared to 25% for IP.

WRK itself has trended downward since inception. The stock looks only modestly inexpensive on our model, based on the combined entities, but is the best value in Paper & Packaging on a free cash flow basis. Synergy and growth opportunities here are considerable.

One of the major issues for these largely domestic companies has been the weakness in US consumer nondurable goods, for both manufacturing and shipments – Exhibit 6. We see a consumer recovery in 2016 as more likely than a major industrial rebound, given an improving employment picture and continued lows in crude pricing, and with shipments and production still off pre-recession peaks there is ample room for upside here.

Both IP and PKG get a modest negative check for their commodity white paper businesses that account for 20-25% of sales. Paper imports moderated throughout 2015 – Exhibit 7 – and with the implementation of government duties, 2016 is setting up as a year of relative stability.

Exhibit 6

Source: US Census Bureau, Federal Reserve, and SSR Analysis

Exhibit 7

Source: Bloomberg and SSR Analysis

BLL & CCK

Valuations in the metal packaging space are not overly attractive in their own right but the highly consolidated market structure and relative valuation between the two major competitors present an opportunity.

After Ball completes its acquisition of Rexam (expected sometime in 2H ’16) the metal can market will be an effective duopoly in North America, Europe, and Brazil. We see acquisition integration risk for BLL, where valuation is pricing in perfection, and relative upside for CCK which is likely to benefit from BLL’s acquisition both directly (via likely required asset sales) and indirectly (better industry structure from the resulting consolidation). The valuation divergence in the stocks is nearing a 25 year extreme – Exhibit 8.

Exhibit 8

Source: Capital IQ and SSR Analysis

Estimates Not Overly Aggressive

OI’s estimates reflect its acquisition of Vitro. The WRK figure is likely less relevant, as the 2015 base is a retrospectively reclassified figure (the merger closed mid-year) – at any rate the estimate for 2016 does not seem overly aggressive. The same can be said for UFS. Estimates for IP and PKG are more at risk if the US enters into a recession.

Exhibit 9

Source: Capital IQ and SSR Analysis

Appendix: Industry Flow Chart, Company ROC and Valuation Charts

Source: Capital IQ and SSR Analysis













Source: Capital IQ and SSR Analysis

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