Description

Graphic Packaging Holding Company

Recommendation: Long

Current Price: $14.61

Important Disclosures:

Certain funds and accounts managed by us are currently long Graphic Packaging Holding Company.  We may buy and/or sell shares of Graphic Packaging Holding Company in the future for the funds and accounts managed by us without notice, and we are under no obligation or agreement to take, or not take, any action or restrict our actions in any manner.  This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation.  The information below is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below.

Summary of Long Thesis:

-          GPK is the leader in a niche packaging business, benefitting from stable end markets and relative consolidation

-          Valuation is undemanding: We estimate that the stock is currently trading at 12.7x fully-taxed 2016 free cash flow per share, using a fully-loaded capex number and 10.3x using management’s estimate of maintenance capex.  We estimate free cash flow per share can compound in the low double digits with very modest capital deployment assumptions.

-          GPK’s shrewd management team and conservatively levered balance sheet create an under-appreciated platform for highly-accretive acquisitions.  We believe management can generate close to $3 per share in value from tuck-in acquisitions, and the opportunity set is great.

Summary of Historical Financials

GPK was written up by quads1025 over a year ago, and I will refer you to his write-up for an excellent description of the fundamentals of this niche packaging business.  A brief summary of historical financials provides an illustration of the stability of this business.

Recent Business Developments

A number of business developments have taken place in the past year:

1)      Reduced leverage to 2.7x Net Debt / EBITDA at year end 2014 (from 6.0x in 2008) to the low end of their target range of 2.5-3.0x Net Debt / EBITDA

2)      Exited sub-scale and modestly profitable multi-wall bag business

3)      Announced the acquisition of the folding carton converting and paperboard mill assets of Cascades’ Norampac division

a.       Strategic Rationale: Grows integrated folding carton converting volumes and extends customer reach into Canada

4)      Announced the acquisition of the folding carton assets of Rose City Printing and Packaging in the Pacific Northwest

a.       Strategic Rationale: Enhances GPK’s West Coast footprint.  Allows for integration of GPK’s CRB mill in Santa Clara, CA and Sierra Pacifica Packaging converter with Rose City’s two folding carton plants in Portland, OR

5)      Announced $250 mm share repurchase authorization

It is important to call out these recent business developments, because they demonstrate how management thinks about capital deployment.  We believe this is an under-appreciated aspect of the GPK story.

“Tuck-Under” Acquisition Platform

Management has evidenced that they have clear intentions to make M&A a big part of their capital deployment plans.  This makes both strategic and financial sense.  GPK’s mill system has 150,000-200,000 tons of low cost, available pulp capacity.  This excess capacity is pulled through acquired folding carton facilities, which had previously sourced the inputs from third parties, resulting in significant and immediate synergies.

Excerpt from 1Q15 Earnings Call:

“Q: And Dave, just any general thoughts on what you’re seeing right now in terms of both flow and value expectations on assets that might be for sale?

A <CEO, Dave Scheible>: That’s a good question.  Mark, a lot of times it depends upon who owns those assets, right?  Certainly in the private equity, all the European assets that really Mike and Steve purchased, those things were all done from private equity and they were exit plans.  And the multiples on those things were on average, what, 6.5 or something like that.  They were accretive the day we bought them and with the synergies they are probably on average 3.5 times or 4 times…”

The data that I collated on GPK’s historical acquisitions generally support management’s claims:

And it sounds like they will be very opportunistic:

Excerpt from 1Q15 Earnings Call:

“A <CEO, Dave Scheible>: In Europe, yes and Mike said it last time that we’re probably looking at the second half of 2015 or early part of 2016 before we made another European assets.  But you’d also know timing is what it is.  If a great asset comes up that is in end-used space that we need to be in and we think that asset will fit then we’ll lean over our skis a little bit and we will ask Mr. Yost to buck it up and buy it and go do it…that’s really our DNA, that’s really what we do, and that’s kind of the expectation, if you’re going to be there.”

Potential Acquisition Math

Below I attempted to demonstrate how much firepower we believe the company has to do acquisitions and how that could potentially translate into increased earnings power if this hypothetical scenario plays out.

(Of course this is only one hypothetical scenario, and there are many potential outcomes with different or less favorable results)

The company has over $900 mm available under its domestic revolver at L+125-225.  Assuming the company uses one year’s worth of free cash flow and increases leverage from 2.7x to 3.2x, GPK would have over $750 mm of dry powder to deploy into acquisitions.

Following the math above, applying the current 13x earnings multiple to the estimated $0.23 of incremental earnings power would yield nearly $3/share of incremental value to equity holders.  It would also leave them at 2.5x net debt / ebitda pro forma for synergies.

Summary of Recent Results: Performing Well in Choppy Market

-          Despite FX becoming greater headwind, management maintained guidance for the full year.

-          Pricing fears are appear to be overdone.  Another excerpt from the 1Q15 call:

“<CEO, Dave Scheible> You got to remember…in our contracts with our end-used customers we don’t really move around on $10 a ton up or down.  Because it is just you would be changing invoice pricing forever on folding cartons.  And so there is a range at which it just has no impact on the carton side of the business and…we’re kind of comfortably in that range.”

-          GPK growing volumes in a tepid industry environment

o   681,000 paperboard tons sold in 1Q vs. 624,000 sold last year.

o   PKG and RKT both pre-announced negative CY1Q results, partially blaming bad weather.

-          Europe Opportunity sounds promising

o   The company believes SUS paperboard is gaining acceptance and increasing market share due to its better performance characteristics vs. competing substrates

o   150,000 tons to be delivered into this market this year, according to management on their 1Q15 call

o   Management sees a clear path to 200,000 tons over the next couple of years per 1Q15 call

-          Potential Natural gas tailwind in 2H15 and 2016

o   Energy is 12-13% of cost stack of paperboard production, according to their April 2012 Presentation

o   Per the 3Q14 earnings conference call, the Company had hedged most of its 2015 natural gas commitments at $4.00 per mm btu vs. current rates of $2.50.

o   We anticipate a modest tailwind as these hedges roll off, even if it is just on the company’s non-contracted business

Valuation

Management guides to 5-6% EBITDA growth long-term, which implies $750 mm and $785 mm of EBITDA in 2015 and 2016, respectively.  Based on our analysis of demand trends, input costs, the layering of synergies and benefits from productivity-enhancing capex (i.e. $30 mm co-gen energy project at the West Monroe mill), we believe these estimates are appropriately conservative.

Subtracting D&A of $280 mm, interest expense of $70 mm and applying a 33% tax rate (incl. foreign operations at lower tax jurisdictions) gets us to approximately $290 mm of fully-taxed Net Income.  If we assume $220 mm of total capex (probably conservative given management’s guide of $130 mm of maintenance capex), we get to a little over $350 mm of fully-taxed free cash flow, or $1.07 per share.  Side Note: intangible amortization is $40 mm per year.

The company also has approximately $340 mm of NOL DTAs, which are expected to be used over the next two-and-a-half years.

At the current price of $14.61, netting out $1 per share of NOL DTAs, the stock is trading at 12.7x our 2016 fully-taxed, free cash flow per share estimate.

Management believes that maintenance capex is closer to $130 mm, which would imply $1.34 in maintenance free cash flow per share.

Certain Risk Factors

The risks we have identitifed in connection with an investment in GPK include, among others:

-          Strengthening US Dollar: FX impact is both, translational and transactional

Due to the continued strengthening of the US dollar, GPK expects a $30-$35 mm headwind from FX in 2015, which had been increased from an expectation of $20 mm previously.  As the company ships 150,000 tons of paperboard into Europe, there is a transactional impact of the weakening Euro in addition to the usual translational impact.  GPK has exposure to the Euro, Pound and Yen.

-          US Cereal and Carbonated Beverage Demand Trends Worsen

US cereal and carbonated beverage consumption has been declining for several years.  GPK has managed to offset these declines by moving aggressively into craft beer and frozen pizza, but a significant acceleration of these negative trends will inhibit GPK’s ability to grow profits.

Catalyst

Potential Acquisitions, Share Repurchase