Description

KapStone Paper and Packaging Corporation (KPPC) shares are a compelling investment at current prices. I believe the shares are conservatively worth $11 - $15 per share, and that an investment in the shares at the current stock price of $7.66 offers a 30% - 49% margin of safety. The current market price does not reflect the magnitude and speed of the company's debt reduction efforts, which are being supercharged by a partial warrant conversion and large government tax credits, the significant improvement in underlying business conditions that began in mid June, and the ongoing industry capacity rationalization that has left inventories lean and pricing strong.

This investment opportunity exists for three primary reasons. First, outstanding warrants that had the potential to add 37 million shares to the prior 28 million share base created a technical overhang in the stock.  With the exercise of 17 million of these warrants and the expiration of the remainder on August 17^th, this technical overhang is diminishing. Second, liquidity fears created by acquisition-related leverage sent the market capitalization to as low as $30 MM earlier this year, far below investable levels for the vast majority of institutional investors. Third, the company has had limited exposure and investor interest due to its former microcap status, very limited and volatile trading history, and complex financial statements. For these reasons, I believe KapStone has been overlooked and underfollowed.

I am especially attracted to KPPC because these factors are largely related to temporary and technical market dynamics. For example, the recent warrant expiration has removed the enormous technical overhang on the stock.  I expect the stock to increasingly trade on fundamentals going forward.  As an added benefit, the partial warrant exercise created 17 million new shares, which along with the recent price appreciation, increased the Company's market capitalization from $140 million on August 17^th to today's more liquid and investable $348 million. Further, with a materially improved liquidity position, comparable year over year results that begin in the current quarter, and a more compelling fundamental story to tell, the company's investor exposure should increase going forward.

Fundamentally, KapStone is both the highest quality and cheapest paper and packaging company of which I am aware. This discrepancy cannot persist, in my view. KapStone is a low cost producer of various paper grades and has the highest EBITDA margins in the industry. Founder and CEO Roger Stone and son-in-law, Matt Kaplan, are an extraordinarily well respected, high quality and owner-oriented management team with decades of accumulated industry knowledge and experience. Insiders own 25% of the company, including 13% between Stone and Kaplan, who recently purchased another 100,000 shares on the open market. Management's five-year goal at inception was to create a $2 billion revenue company through intelligent acquisitions. Today, KapStone generates roughly $700 million of revenues and is soon to have an underleveraged balance sheet in what I believe will be an increasingly favorable environment for acquisitions.

Company Background

KapStone is a small-cap paper company formed by Stone and Kaplan as a SPAC in 2005. Stone-Arcade Acquisition Corp, as it was originally called, acquired International Paper's (IP) kraft papers business ("KPB") in early 2007 and later tripled the size of the company by acquiring MeadWestvaco's (MWV) Charleston, S.C. kraft division ("CKD") in 2008. KapStone took on significant leverage to make the latter acquisition, which in retrospect was ill-timed. The subsequent deterioration in economic conditions caused major liquidity and debt covenant concerns among investors, driving the stock to as low as $1.05 per share in February 2009.

The original acquisition, the KPB business, is an incredibly high margin business. It consists of an unbleached kraft paper facility in Roanoke Rapids, N.C. with 420,000 tons of high quality linerboard and kraft paper production capacity and an inflatable dunnage bag business, which was divested on March 31, 2009. Roanoke Rapids is a business that had a 22.3% EBITDA margin and 19.8% ROIC in 2007 and a 25.0% EBITDA margin during the first six months of 2008. These are the highest margins I am aware of in the paper industry. The facility is able to generate such high margins because it is a low cost producer due to its access to structurally lower wood fiber costs in the U.S. southeast, its favorable energy profile (energy usage is 60% self-generated and 25% from cheap coal), and its very well maintained and highly efficient operations. IP invested roughly $40 MM into upgrading the facility, including $17.5 million in high ROI capital projects, in the three years before selling it to KapStone. The capital investments from IP combined with present management's upgrades and optimizations have created a facility with sustainable, high margins, in my view.

The second acquisition, the CKD business, consists of an unbleached kraft paper mill and cogeneration facility in Charleston, S.C., a lumber mill in Summerville, S.C., and five chip mills located throughout S.C. The mill has three paper machines that have the capacity to produce 833,000 to 882,000 tons of saturating kraft, linerboard, and kraft papers in total. CKD had a 15.6% EBITDA margin and an estimated 8-9% ROIC in 2007. Since then, the facility has undergone numerous efficiency enhancements, which I expect to be evident in financial results next year.

The combined company would have had a 2007 pro forma EBITDA margin of 17.8% (18.1% including synergies) and an estimated ROIC in the low-teens. At the time of the CKD acquisition in April 2008, Stone stated that he would be disappointed if the company couldn't increase EBITDA margins for the combined entity to at least 20.0% after synergies, high return capital projects, and optimizing the machine schedules. While the world has changed since then and demand for many paper products is weaker than it had been, a 20% EBITDA margin on the $745 million of 2007 pro forma revenues would yield $149 million of EBITDA. I am convinced the Company can generate margins in this range in a stable macroeconomic environment. On the Q2 2009 call on July 30^th, Roger Stone expressed confidence that the company would return to that EBITDA level, but declined to predict when. If the Company were to earn $149 million of EBITDA, the stock would likely trade well north of $15 per share. This illustrates a bull-case scenario.  I am not relying on the Company achieving 20% EBITDA margins in my investment thesis.

Paper Industry Background

Paper making is a tough business. It is capital intensive, cyclical, and vulnerable to swings in raw material costs. The key to sustainable, long-term profitability is being a low cost producer. KapStone is exactly that due to its two highly efficient manufacturing facilities, its access to high quality, low cost southeast wood fiber, and its favorable energy profile with 60% self-generated power at Roanoke Rapids and an on-site 100 megawatt cogeneration facility at Charleston.

Notably, the industry currently has unprecedented pricing power. Many paper companies historically owned their own trees, which often led to high levels of production even during economic downturns because no significant cash outlay was required to obtain the wood. During the ensuing economic recoveries, pricing power was nonexistent due to the resultant bloated inventory levels. In recent years, many paper companies have divested their timberland assets, notably IP, and rationalized a significant amount of production capacity. This has led to much more responsible levels of production. After struggling with overcapacity for years, the industry has finally created a lean inventory environment, which has created pricing power throughout the industry.

Price Hikes

Due to the current lean inventory environment, the three largest U.S. producers of kraft papers, KapStone, Longview Fibre, and Georgia-Pacific, have each announced a $50 per ton price hike. According to management and industry trade publications, the price hike is likely to be successful. Management indicated the price hike would add $15 million to annual revenues and operating income beginning in Q4. Further, export linerboard pricing is starting to tick higher and domestic pricing could follow suit.

Saturating Kraft Market Developments

KapStone holds a 60% market share of the U.S. saturating kraft market and a 40% global market share. KapStone, IP, and Finland's Stora Enso collectively produce 75% of the world's needs. Interestingly, Stora recently announced restructuring plans due to its uncompetitive cost structure and plans to divest its Kotka mill and Malaysian facilities, which produce the company's saturating kraft paper, among other products. This is the second time Stora Enso has tried to sell these assets, and if unsuccessful again, I believe those facilities will be permanently closed. Importantly, Stora's unprofitability in this product is not an indictment of the product or of its demand, but of Stora's high wood cost environment. Finland itself has high wood fiber costs and Russian wood duties have reduced affordable imports, making Stora's production unprofitable - permanently so in Stora management's view.

Saturating kraft is an 885,000 ton worldwide market. While there are no published industry statistics for this niche specialty grade, it appears to be growing 2-3% per year. KapStone's 40% global share means the Company is responsible for about 350,000 of those tons; however, KapStone has swing capacity to produce up to 523,000 tons or 59% of global demand should the opportunity present itself. Should Stora Enso close its production, KapStone would be in an enviable competitive position to absorb the available market share in light of the tight supply environment. Charleston is also a major international shipping port, making it ideal for exporting saturating kraft. Given KapStone's small size and the magnitude of this market share opportunity, developments along these lines would be materially positive for KapStone. I am not relying on this scenario playing out in my investment thesis though, but instead view it as a free call option. Should it occur, there would be upside to my estimated intrinsic value range.

Alternative Fuel Tax Credits

KapStone is scheduled to receive about $175 million in total from the Alternative Fuel Tax Credits this year, of which $70 million has been received through the end of Q2. The tax credits were implemented as a tool to encourage companies that use diesel fuel to substitute some portion of alternative fuels into their production. Many paper companies have been using a natural by-product of their production called "black liquor" as a fuel for years, and realized they could qualify for the tax credits if they mixed in a small portion of diesel fuel into their production process. While legislators never intended for paper companies to qualify for and receive these tax credits, the paper companies have a duty to shareholders to take advantage of them. There had been some controversy in the Senate over whether the paper companies deserved these credits and whether they should be cancelled early, but the chatter appears to have died down in recent months. The Senate has much bigger issues to address, notably health care, so I expect the tax credits to expire as scheduled at year-end. Even if the tax credits are cancelled early on October 1, 2009 with the fiscal 2010 Obama budget, I do not believe I am paying for them at the current price anyway. In addition, there had been some uncertainty as to whether paper companies would owe income taxes on the tax credits received, but it now appears that they will be tax-free.

Importantly, I believe there is industry capacity that is likely to be permanently closed once these tax credits expire. The tax credits encourage otherwise unprofitable capacity to continue to produce paper in order to receive the credits. It is difficult to predict which companies, which machines, and which specific paper grades will see reduced capacity when the tax credits expire. Some machines have the ability to produce multiple products, and therefore any closures are likely to reduce the capacity for multiple paper grades. This can only benefit KapStone, which has profitable production without the tax credits and will not be closing capacity.

In light of this, I expect plenty of potentially interesting assets to be shown to KapStone management in the coming quarters. As self-proclaimed "value buyers" with a significant amount of skin in the game (13% ownership), Stone and Kaplan's extensive experience should allow them to opportunistically identify and acquire quality assets on the cheap that they could upgrade or optimize to maximize returns. Due to Roger Stone's lengthy industry experience, he has unique insight into the quality and value of much of the industry's paper production facilities and paper making machines, many of which may be acquisition opportunities. I view Stone and Kaplan's experience as an important competitive advantage. KapStone's balance sheet has transformed from a major weakness to a major strength at exactly the right time, in my view. 

Valuation

I believe KPPC shares currently are worth somewhere between $11 and $15 per share, primarily based on my conservative DCF and supported by various other metrics.

• Asset Value - KPPC is currently trading at about 0.8x of my estimated year-end book value. This is an attractive valuation for a low cost producer with the highest EBITDA margins in the industry. Given the partial warrant exercise, high visibility cash flow from the tax credits, and free cash flow from operations, year-end book value should approach or surpass $9.00 per share. Most industry peers currently are trading between 1.3x - 2.0x book value, which if applied to KPPC, would imply a fair value range of $11.70 - $18.00 per share by year-end.

In addition, applying 1.0x the tangible book value of the acquired property, plant, and equipment in 2006 and 2008, and deducting year-end net debt, I estimate tangible NAV to be $7.90 per share, which is higher than the current stock price. This is an incredibly conservative valuation metric, as it fails to give the company credit for any of the high ROI capital projects completed since the acquisitions were made, including capacity expansions, machine optimizations, and efficiency gains between the two facilities. This measure of tangible NAV is an overly conservative, rock bottom valuation floor that is very likely even lower than current liquidation value, in my view. In addition, management completed its annual impairment test in Q4, during the throes of the downturn, and concluded no impairment had occurred.

While new capacity buildouts would be a concern in some industries, I believe the industry is highly unlikely to build out material net new capacity. The industry has been plagued with overcapacity issues for years and has only recently closed the necessary capacity to enable a more balanced supply-demand environment. Consequently, it is unlikely that industry players would reverse course, invest substantial sums of capital and time into significant net new capacity, during a recession no less, that would crush the hard earned pricing power now finally being realized. In fact, as previously mentioned, I expect further industry capacity reductions, if anything, after the tax credits expire.

• EV/EBITDA -I view unlevered pre-tax operating cash flow (EBITDA) as a sub-optimal valuation method because it fails to account for companies' various maintenance capex requirements. Compared to peers, KapStone has relatively low maintenance capex requirements, an advantage which is masked in any EBITDA-based valuation. In addition, as an unlevered metric, EBITDA fails to give KapStone credit for its extraordinarily favorable credit agreement, which currently offers the Company financing at a 2.9% rate that is expected to fall to 1.9% by the fourth quarter. Further, due to acquisition-related accelerated depreciation for tax purposes, KapStone will not be paying cash taxes for at least the remainder of this year. EBITDA fails to give KapStone credit for all three of these advantages and therefore is poor metric with which to value the Company. [Note: KPPC is trading at 4.5x-5.4x my estimated EBITDA range and 4.5x 2010 consensus EBITDA versus the 6.0x-7.0x multiples of lower quality peers.]
• DCF - I believe it is most appropriate to value KapStone equity using levered after-tax free cash flow discounted at a reasonable rate of return. I prefer an 18-month DCF, given the high visibility into near-term cash flows much of which is from tax credits, and a wide terminal value range to avoid implying an unrealistic level of precision. For my terminal value, I use a long-term low and high end free cash flow assumption of $50 and $80 million, respectively, which implies a wide EBITDA margin range between 13% - 20%. For perspective, the consensus 2010 EBITDA margin is 17.6%. I assume $22 million of depreciation and amortization is offset by $22 million of maintenance capex on a long-term basis, which is conservative, given that current D&A is roughly $50 million. I conservatively use a 15% discount rate and a 2% long-term growth rate, which results in an equity valuation range of $10.69 to $15.00 per share, as can be seen in the table below.

Exhibit 1: KPPC Per Share Equity Valuation Sensitivity to Terminal Year FCF and Discount Rate

The per-share equity valuations above are calculated after deducting the present value of the maximum earn-out payments potentially due to International Paper in 2012.

• EV/Ton - KapStone currently is trading at $424 per ton of production capacity on an enterprise value basis. While there are no perfect comps, as no company has the same business mix and margin profile, a comp table I have put together in Exhibit 2 shows a group of 7 paper companies trading in a range of $517 to $1,434 per ton. Verso Paper (VRS) and Wausau Paper (WPP) are the two lower valued companies on the list at $517 and $583 per ton, respectively. Both of these companies are much lower quality companies than KapStone, in my judgment. Verso is an enormously leveraged company that has been burning cash for almost three years, while Wausau has been unprofitable in recent years. While consensus numbers should be taken with a grain of salt, I have included consensus 2010 EBITDA margins to highlight the quality gap between KapStone and its peers.

Exhibit 2:  Enterprise Value per Ton of Production Capacity Comp Table

I find it difficult to reconcile that KapStone is trading at just $424 per ton, an enormous discount to even the worst companies in the space, while simultaneously having the highest margins, the best balance sheet, and an enviable competitive position. Applying the $517 per ton implied by the valuation of Verso, a serial cash burner, to KapStone results in a $10.32 per share equity value.  In reality, I believe KapStone's production is much more valuable than that of Verso.  This exercise simply illustrates the attractiveness of KapStone's current market valuation.

• P/FCF - I expect an undiscounted $130 million of free cash flow to accrue to equity holders in Q3 and Q4 of this year and about $175 million in total over the next four quarters. That implies a forward free cash flow yield of 50% on the current $348 million market cap. Clearly, that level of free cash flow is not an ongoing number since the majority of it is due to the tax credits, which are scheduled to expire at year-end. However, I view the prospect of essentially recouping 50% of my initial investment within the first year as very compelling.

So Why Is It So Cheap?

• Small Market Cap - KPPC began trading March 1, 2007 and had a market capitalization that ranged between $200 and $300 million in 2007 and most of 2008. Soon after levering up to acquire CKD, the economic downturn negatively impacted end demand for KapStone's products, which ultimately created liquidity and debt covenant fears and sent KPPC's market capitalization to as low as just $30 million in February 2009. This market cap left the stock far removed from the investable universe for the vast majority of the investment community and left the already underfollowed company even more so.
• Warrant Overhang - Due to the company's SPAC origins, there had been 28 million shares and about 37 million warrants outstanding before August 18^th, 2009. This created a massive technical overhang on the stock at $5.00, despite significant positive fundamental developments. About 17 million of the 37 million warrants were exercised upon expiration, which provided the company with $85.2 million of cash and increased the share count to 45.4 million shares. I view the partial warrant exercise as the best possible outcome. It provided some cash to delever the balance sheet and avoided the majority of the potential dilution. With the warrant overhang recently lifted, I expect the shares to increasingly trade on the fundamentals.
• Rapid Deleveraging Underestimated - The market does not appreciate the rapid debt reduction currently underway, which should increase equity value materially. Kapstone's $479 million of debt at Q3 2008 has quickly turned into $250 million of debt as of August 18, 2009 and should approach $150 million by the end of this year. The $85.2 million of cash received from the partial warrant exercise and about $175 million ($70 million received through 6/30/09) from the tax credits, assuming they continue as scheduled through year-end, will likely be used for debt reduction. The liquidity concerns that decimated KPPC shares earlier this year are no longer an issue, in my view. I expect Stone and Kaplan to utilize the soon to be underleveraged balance sheet to opportunistically acquire additional manufacturing assets.
• Recent Operating Improvements Underappreciated - KapStone cut production in Q4 and Q1 to match output with demand, which brought the company's operating rate to the low 70% range. The industry-wide production cutbacks brought inventories to unsustainably low levels, which has created a restocking snapback and pricing power. Consequently, in mid-June, KapStone was able to bring all five paper machines back on-line (previously running four), increasing the company's operating rate to 100%. Typically, the company's operating rate is around 95%, so the current rate is not some big bubble that is materially higher than normal. Management noted its current backlogs are as high as they have ever been since acquiring CKD, which was acquired during good times. Due to the high fixed cost nature of the business, I believe the significant profit swing from running in the low 70%'s to running full is not appreciated by the market.
• Short History and Complex Financial Results - A number of factors create complexity in KapStone's financial statements and complicate the task of understanding the Company for potential investors. First, year-over-year comparisons have not been meaningful for several quarters due to the "game changing" acquisition of CKD last year. Second, recent sequential comparisons have not been relevant, because the dunnage bag business cannot be treated as a discontinued operation. Third, a number of one-time expenses, including acquisition-related overhead expenses, have negatively impacted recent results. Fourth, the timing of the income statement recognition of the tax credits is affected by the fact that the Company accounts for its inventory on a FIFO-basis. Finally, the mid-quarter partial warrant exercise has materially altered the capital structure and share count. KapStone is the epitome of a small and underfollowed company undergoing material change, which the market is often slow to recognize.

So Why Will the Discount to Intrinsic Value Close?

• Warrant Overhang Lifted and Liquidity Increased - The partial warrant exercise immediately increased the share count and float (insiders owned about 40% of the shares; now 25%) and increased the market cap from $140 million to the current $348 million over about three weeks. The increased liquidity and market cap should boost investor interest. Given management's growth through acquisition strategy and rising market cap, I expect additional sell side coverage in the coming quarters.
• Balance Sheet Weakness Now A Strength - As an increasing number investors do the work on KapStone, they are likely to realize the balance sheet has turned from a weakness into a strength.
• Inflection Point in Operations - A major inflection point in underlying business results occurred in late Q2. KapStone brought all 5 machines back online in mid-June, increasing its operating rate from roughly 70% to 100%. I believe the current market price is materially underestimating the magnitude of the profit swing from running at 70% to running at 100%. Paper making is a high fixed cost business, so the large improvement in the operating rate should have a material, positive impact on KapStone's margins. I expect the P&L impact will manifest itself with a lag of 3-5 months due to the fact that the Company accounts for its inventory on a FIFO-basis.

In addition, dramatically lower raw material costs for wood fiber, caustic soda and natural gas, none of which are hedged or bought forward, should benefit margins materially in Q3 and beyond. Gradually declining acquisition related overhead costs and the potential for the Q4 price hike should also boost margins.

Conclusion

I believe KPPC shares are a compelling and timely investment opportunity, trading at a 30-49% discount to my estimate of intrinsic value. Importantly, I believe this opportunity exists for non-fundamental reasons, which should allow the stock price to approach my $11 - $15 intrinsic value range over a reasonable time frame. I expect a virtuous cycle to develop between KapStone's market capitalization and the level of investor interest, which should serve as a catalyst to a revaluation of the Company's shares. Most importantly, I view an investment at the current price as a low risk, high reward proposition with an attractive margin of safety and an extremely low chance of permanent loss.

Disclosure: Long KPPC 

Appendix

Business Mix and Market Share

The company's business mix is currently about 40% linerboard, 26% kraft paper, 25% saturating kraft, about 8% unbleached folding cartonboard, known as KraftPak, and 1% lumber.

KapStone has just over 2% market share of the U.S. linerboard market, an estimated 20% of the U.S. unbleached kraft paper market, 60% of the U.S. saturating kraft market (40% global share), and 20% of the U.S. unbleached folding carton market ("KraftPak"). Saturating kraft and Kraftpak are higher margin products than kraft papers and linerboard, the latter which is more of a widely made commodity than the other products. 

Product End Uses

• Linerboard is primarily used to manufacture cardboard boxes.
• Kraft papers include multiwall kraft paper, specialty converting, and bag and sack.

• Multiwall is used for shipping sacks for pet food and litter, agricultural products, cement, lawn and garden fertilizer bags, grocery bags, and other specialty products.
• Converting products are used in wrapping paper, wax paper packaging, tape and label backing, and poly-coating and laminating applications.
• Bag and sack kraft papers are high quality and used in retail shopping bags, fast-food carry out bags, and grocery sacks.

• Saturating kraft is a specialty paper that provides impact resistance and thickness to the surfaces of high-pressure laminate products, such as laminated kitchen countertops, flooring, doors, furniture, vertical panels, shelving, circuit boards, roof and wall sheathing, siding, and audio equipment.
• KraftPak is used for beverage, gift boxes, take-out cartons, retail food, and quick serve cartons.

Roger Stone Bio

Roger W. Stone has been Chairman of the Board and Chief Executive Officer since the company's inception. Mr. Stone was Manager of Stone-Kaplan Investments, LLC, a private investment company, from July 2004 through December 2007. He was Chairman and Chief Executive Officer of Box USA Holdings, Inc., a corrugated box manufacturer, from July 2000 until the sale of that company in July 2004. Mr. Stone was Chairman, President and Chief Executive Officer of Stone Container Corporation, a multinational paper company primarily producing and selling pulp, paper and packaging products, from March 1987 to November 1998 when Stone Container Corporation merged with Jefferson Smurfit Corporation, at which time he became President and Chief Executive Officer of Smurfit-Stone Container Corporation until March 1999. Mr. Stone has served on the board of directors of McDonald's Corporation since 1989. Mr. Stone also serves on the board of directors of Stone Tan China Acquisition Corp., a blank check acquisition company. Mr. Stone received a B.S. in Economics from the Wharton School at the University of Pennsylvania. Mr. Stone is the father-in-law of Matthew Kaplan.

Catalyst

Warrant overhang lifted

Q3 and Q4 quarterly results with materially improved operating results

Continuation of the tax credits

Increasing investor exposure (a 9/9/09 conference presentation was management's first since last Fall)

An acquisition annoucement, likely next year