September 15, 2017 - 8:00pm EST by
2017 2018
Price: 115.00 EPS 0 0
Shares Out. (in M): 94 P/E 0 0
Market Cap (in $M): 10,846 P/FCF 0 0
Net Debt (in $M): 2,314 EBIT 0 0
TEV ($): 13,160 TEV/EBIT 0 0

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  • Compounder
  • secular tailwinds
  • High ROIC
  • High ROE


PKG a best in class competitor in an industry undergoing two significant secular shifts that could lead
to accelerating profits for many years to come. Despite being perceived as expensive by the sell side,
PKG’s GAAP earnings understate the true economic earnings of the business and its premium
valuation compared to its competitors does not appropriately reflect the degree of its superior
economics and competitive position.
PKG is the fourth largest containerboard producer in the US (85% of EBITDA) and the third largest
white papers producer (15% of EBITDA) in North America. Our main focus is on the containerboard
side of the business. PKG’s white paper business is largely a no-growth cash cow. The white paper
business has relatively modern equipment, requires modest CapEx and produces good cash flow.
Before we dig into PKG’s corrugated business specifically, I am going to describe the industry
The Corrugated Packaging Industry
Corrugated packaging (cardboard boxes) are responsible for transporting 80% of all consumer goods
at some point in the distribution chain. There are currently no economically rational substitutes for
cardboard boxes. Over 90% of cardboard boxes are recyled. A cardboard box can be recycled up to
eight times before its structural integrity completely breaks down. Fiber is very important because it
is the largest variable input cost for boxes. North America is the largest source of virgin (non-recycled)
fiber which is the precursor necessary to make first run boxes which can later be recycled. About one
third of all recycled fiber or “OCC” in the US is exported to feed the world’s recycled plants. Only a
little more than one quarter of the world’s container board is made with virgin fiber.
Prior to the downturn, the corrugated box business was not very attractive, despite the US’s
competitive access to virgin fiber. Many producers were vertically integrated with timber assets, and
often the businesses were managed to get returns on timber at the cost of box margins. The market
was very fragmented with the top five producers only representing 44% of total production. Integrated
producers would slash prices to gain share and keep operating rates high. As a result, there was a race
to the bottom and no one consistently made any money. Following the financial crisis, the industry
consolidated and major corrugated producers divested themselves of their timber assets. After this
string of M&A, the top five corrugated producers went from 44% of the market to 81%, with the top
two processors controlling 55%. Many cyclical industries often experience dramatic increases in
returns on capital following a significant consolidation wave.
From 2011-2015 box shipments grew at 0.8% CAGR, however since October 2016, monthly box
shipment growth has accelerated to 3.3%. So, what is driving this growth? It is likely that e-commerce
has hit an inflection point where continued growth is dramatically effecting the consumption of boxes.
E-commerce sales have doubled in the last ten years, and is growing 15% annually, representing 9%
of total retail sales. If E-commerce accounts for 10% of volumes and grows at 15% annually, while
the remaining volume grows at the same 0.8% historic rate, total volume growth for boxes would be
2%, more than double historic growth rates.
E-commerce uses corrugated boxes in a much less efficient fashion than when products shipped to
traditional retail. Below, Jack Sanders, CEO of Sonoco, which has some exposure to recycled
corrugated boxes, discusses the effect of the internet on box demand and OCC,during the company’s
first quarter call.
M. Jack Sanders, CEO of Sonoco:
…. the way I look at it, e-commerce is adding one box, one corrugated box to every product purchased…
because I bought 2 pairs of shoes this week. If I'd have gone to a shoe store, I'd have walked out with 2
shoeboxes. But I got them delivered to my house, so the 2 shoeboxes came in a corrugated box. So that's
happening every day, everywhere, not only in the U.S. but also in Asia, China specifically… The negative side
of that is that if that box -- if the master box that carried shoes went to the shoe store, it would then be collected,
put in the back of the store, we would have picked it up from our recycling business. Today, I now have the
box, so I don't have curbside recycling here in Florence, so I'mgoing to throw it in the garbage can, and it'll
wind up in the landfill. So, it's a dual impact that in those areas where you don't have recycling, it's winding
up in the landfill, which is taking it out of the recycling stream. And then, of course, the extra box that is
created by e-commerce.
As a result, containerboard operating rates are very tight with plants running at 99% of capacity since
May. Increased demand for boxes, along with recycled container board capacity additions from 2014
and 2015, has led to a spike in OCC prices from about $90 per ton last year to $150 per ton today.
Recently, the Chinese have placed restrictions on OCC imports which has caused domestic OCC to
fall from a peak of about $175 per ton to $150 but most industry experts believe that the strain on
Chinese box costs should force the ban to be lifted or relaxed early next year to prevent too much
distruption to the Chinese supply chain.
It is possible the increased demand for e-commerce is pushing OCC into a very inflationary environment. Today, the global recycle rate for boxes is 85%. All new containerboard capacity in the rest of the world utilizes recycled OCC which must ultimately have a virgin source. With global virgin containerboard capacity remaining flat, and OCC containerboard capacity growing each year, eventually OCC prices will get squeezed higher. This is important because the largest source of
potential increased containerboard capacity in the US is paper machine conversions to make OCC derived containerboard. At current OCC prices, despite the increase in box prices, the economics of OCC containerboard mills are not very attractive.
Virgin fiber is generated from wood scrap which is typically created as a result of increased new home
construction. For the last several years virgin prices have been flat to declining. In an environment
with rising OCC prices, stable virgin fiber prices, and improved pricing for corrugated packaging,
containerboard manufacturers with higher virgin fiber content should enjoy significant margin
expansion. Despite this, it is unlikely for additional containerboard capacity utilizing virgin fiber to
come online in the near future as new containerboard plants with the ability to use virgin fiber as an
input cost nearly $1 billion and take nearly 5 years to construct. There are only a few white paper
plants that con be converted to add additional virgin capacity and PKG has already announced
convierion of one that will add about 1% to US capacity. The remaining conversions will not likely be
sufficent to keep up with domestic demand growth and prices will likely contintue to rise.
Packaging Corporation’s Place in the Corrugated Industry
Degree of Box Plant Integration
As we did more work on the space, we eventually decided to add PKG to the portfolio. PKG’s
Corrugated Products Group has a unique set of strengths in the industry. Unlike most of its
competitors, PKG’s customer base is skewed to small local accounts which represent about three
quarters of its business by revenue. The remaining quarter of its customers are its top 30 national
accounts, however, most of the products PKG produces for national account customers are higher
margin value-added products customized to the specifications of the customer. PKG has a rich
product mix, from traditional brown boxes to high-end graphics and displays. Most corrugated
products made by PKG are manufactured to the customer’s specifications. For small local accounts,
corrugated producers generally sell on a just-in-time basis within a 150-mile radius of their plants and
compete with other corrugated producers in their local region. Because PKG focuses on smaller
regional customers and more specialized packaging with smaller runs, PKG is able to charge a greater
premium than its competitors. This leads to higher revenue and operating margins per ton than those
enjoyed by its large, less integrated rivals.
PKG also has the highest percentage of box plant integration relative to its other major competitors. This allows PKG to capture a larger percentage of the margins associated with specialty boxes where more value is added. Because of these advantages PKG is the best in class among its competitors. You can see from the chart below that PKG has historically run circles around the competition in terms of returns and profitable growth.
In the current environment of rising OCC prices, PKG also has the lowest exposure to OCC which
could lead to multiple price increases and a rerating of the entire industry. As a result, PKG will capture
the improvement in box pricing but will not suffer anywhere near the drag its competitors will face
from rising OCC input costs.
Based on our analysis of virgin exposure and sensitivity to price increases, it seems likely that the sell
side is underestimating PKG’s earning potential. The chart below illustrates the net effect of higher
OCC prices and the announced containerboard hikes for 2018. The sell-side appears to be giving
more credit in earnings estimates than just the containerboard price hikes announced so far for every
company except PKG. In addition to the estimated increases below, PKG has two large box plant
acquisitions which should add around $0.25 to $0.40 of incremental EPS, and an expansion at its
DeRidder plant in 2018 that should add $0.15 to $0.20 per share in EPS. On August 21 of this year,
PKG announced the acquisition of Sacramento Container Corporation for $265MM at approximately
5X EBITDFA after synergies. This should result $0.20 to $0.25 per share of EPS for 2018. With these
four items, plus the declared price increase, PKG should be able to produce $7.65 to $7.90 in 2018
EPS. Earlier this month Georgia Pacific the third largest corrugated producer announced a $60 price
increase for container board and Kapstone Paper followed. Assuming the rest of the industry follows