|Shares Out. (in M):||259||P/E||11.6||12|
|Market Cap (in $M):||7,741||P/FCF||6.4||6.4|
|Net Debt (in $M):||9,800||EBIT||1,256||1,320|
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How would you like to buy a Amazon/e-commerce play at 6.2x 2Q TROUGH EBITDA with a 18% LFCF yield? Wait - there is more!
If you haven’t guessed by now, the stock I have in mind is WestRock.
WestRock is a domestic manufacturer of container-board (boxes) and consumer packing solutions (paper food boxes). There are two ways to manufacture the product – with virgin fiber from trees or recycled fiber/boxes (old corrugated containers “OCC”). WestRock’s portfolio is comprised of 55% virgin and 45% OCC.
Since I had two trolls rate my TROX write-up a 1.0 on quality, I will spend more time on a containerboard primer.
Industry back-drop: The industry has been growing at a low-single digit pace as e-commerce demand offsets light-weighting and a structurally slower GDP. In stable times, demand is approximately a 1.0x Beta. In periods of dislocation like the GFC, the industry destocks and Beta moves to 2.0x. During the GFC, -8% GDP translated into 15%+ drop in demand. The industry has matched the modest demand expansion by debottleneck and slowly converting uncoated freesheet and other mills into supply. The industry is dominated by Packaging Corp of America (“PKG”), International Paper (“IP”) and WestRock (“WRK”). On top of dominating domestic market share, the players have pocket of regional strength which enhances their ability to match supply/demand and hold margins. Despite repeated handwringing by investors about new supply & slow-down fears, the industry has managed supply to match demand. Margins have been extremely stable as a result. WRK has generated >$1.0bn of FCF for the past 5+ years. This will almost certainly repeat in 2020. The cost-curve is skewed to feedstock price volatility. Today, mills that used OCC feedstock are lower on the cost curve. When China was ripping every idle ton of OCC out of the market, virgin plants were lower on the cost curve.
There are three items that could accelerate the market on its path toward tightness.
As a reminder, the Chinese market is roughly 3x the size of the US and suffered from a 15-20% decline in production. TO PUT THIS IN CONTEXT – Chinese production possibly declined volumetrically by an amount that represents 45-60% of total US production!!!! In late 4q, Europe was running at 95% capacity and the US was low 90s. The global industry WAS NOT and IS NOT ready for this. At the end of this year, the Chinese will expand further their OCC import ban to additional grades – further hampering internal efforts to supply their market. During this 2 year trough, the fragmented and high cost Chinese containerboard industry has likely rationalized material amounts of production. While many in Indonesia, Malaysia and other parts of the world are rushing to build plants that can upgrade OCC to a grade that the Chinese can import, the reduced production capacity might be insufficient should the Chinese economy eclipse 2019 levels. As indicated above, these imports volumes could easily tighten the global market. Much has been written of the eventual import of finished containerboard from the US into China and it has never come to fruition. Maybe another change will occur that defers this moment. However, if this were to occur, we would need to materially expand capacity fulfill this demand. 9 dragons has not been announcing price increase like late 4q-19 but this is something to watch.
Cost structure: I was long this sector when Covid hit. I sold as I anticipated a staggering hit to volumes. I suspect that management came to the same conclusion. In response, they announed a plan to reduce $1.0bn of cash costs. Some of these efforts included converting cash comp to stock comp which isn't accretive to shareholders. however, the additional effort to remove fat likely helped to drive the large beat reported yesterday. If you include these efforts plus an on-going cost savings effort from synergies and other intiatives - WRK is far cheaper on 2q-20. I suspect this could add at least 300mm to the run-rate in 2021 and protect if none of the above call options play out.
Why has this stock failed to recover?
Given the tremendous optionality from 1) a potentially undersupplied US market 2) Chinese imports , why has the stock failed to perform while PKG and IP have resumed their pre-Covid levels?
Putting the structural and cyclical inadequacies of PKG/IP aside, I believe the following rationale explains the weakness in WRK. Much of which is petty b/s and backward looking.
In conclusion, the 1x pull forward in e-commerce adoption likely created a step-function up in demand which hasn’t been recognized yet due to the weakness in the rest of the economy. As we re-open and resume normal activities (like building cars), this shortfall may surprise the market. In addition, the company possesses a very powerful call option on the structural shift in Chinese for free. All of this is encapsulated in a stock that is: 1) intrinsically cheap on trough earnings power 2) trading at an egregious discount to its inferior peers 3) huge discount to replacement cost. Hope this helps!
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