Packaging Corp of America: Investing in Cardboard Boxes

Co-written by Patrick Kirts

At Portfolio Asset Management, we love a good fire sale. However, we don’t want to get stuck holding the bag for an industry that is going broke. Remember, you can’t live under a worthless stock certificate. Last week on CNBC we were asked about the casual dining sector. Our response was that the only thing on the dollar menu was the price of the stocks, some of which will go bankrupt. The same thing has already happened with the paper sector. On Friday the 13th, the American Forest & Paper Association showed an unprecedented decline of 25.3 percent in January 2009 from a year ago. Smurfit-Stone went belly up last month and others are on their way. International Paper (IP) and Domtar Corp (UFS) have been favorites of some deep value hedge fund players. Packaging Corp of America (PKG) is interesting because it doesn’t seem to be going broke this week and pays a decent dividend. The same was said about IP, but now the dividend looks like it will be bust before year-end. Our goal is to see if there is any paper stock worth investing in, or if we should avoid this car crash until next year.

What happened to the paper packaging industry in 2008? The first half of the year saw steady inflation for input costs, particularly in materials, shipping, and chemicals. Energy prices were a major input and killed them. These added costs did not decrease in the second half, and the problems were compounded by a heavy fall in demand for paper products and downward price action on pulp due, it seems, to high inventories. Remember that if China doesn’t ship to Wal-Mart (WMT), there is no need to order cardboard boxes from PKG. If companies are not doing business, there is no need for printer paper for UFS. Lastly, no new homes equals no need for timber in the case of IP. These negative developments have lead to increased downtime in the plants of PKG, IP and UFS, and each has responded differently to the challenges.

All three companies have ample liquidity and cash on hand, and the balance sheets of UFS and PKG are quite good, with debt to equity (D/E) well below 1 for both, and current ratios around 2. IP has a similar current ratio, but it D/E, which was below 1 in 2007, is now above 2. Total long-term debt almost doubled in the second and third quarters, and shareholder equity decreased by about a third. This comes on top of a Q4 loss of $1.07 per share, which management claims is due to high special charges related to restructuring, impairments, and write-downs. UFS's management, discussing its $1.31 quarterly loss (it will have a slight loss for 2008, IP a small profit), makes similar claims. Given its similar performance, the large amount of new debt taken on by IP is troubling; what did UFS do differently?

UFS, despite its losses, seems to be doing a better job adjusting to the troubled economic climate. It has new leadership (the President and CEO is new this quarter), and it closed two plants in the fourth quarter rather than take on new debt to boost cash flows, as IP has done. In fact, it plans to use its cash to reduce reliance on its revolving credit line, with the rest sitting on its balance sheet to weather the storm. UFS also made an excessive contribution to its pension plan, which will reduce future expenses. Other firms should consider this smart long-term move. A significant area of concern for this company, mentioned by management in their most recent conference call, is a sudden erosion of Asian demand (their customer base is about 60-40 export-domestic), which they say could impact them more than other paper and pulp businesses.

Only PKG is reporting positive earnings for Q4, and 2008 EPS of $1.31. The company has managed this profitability mostly because of improved cost-cutting techniques and some effective price action implemented in October, before the demand declines began in earnest. For instance, instead of contracting some of their plant maintenance in the coming year, they will be performing it in-house, with slightly longer schedules, reducing the costs and, it stands to reason, taking advantage of the increase in downtime by using employees rather than contractors. The real explanation for PKG's relative success in 2008 seems to be something intangible: good management.

Each of these stocks has fallen precipitously in recent months; UFS and IP more than PKG. We believe that IP's debt, and UFS's potential Asian losses, make these companies very unattractive bets. We are in a time in which value investors need to be looking for the firms that will survive the downturn, and be able to turn it to their advantage. PKG may very well be such a firm. So far, its stock price has only been cut in half in the past few months. We went long, and will be ready to buy the Street's pessimism.

Disclosure: Long PKG.

Comments

[donzelion:]

Contemplating a timber play like IP dying during this recession is pretty sobering. Taking on more debt in a recession strikes me as a fair strategy IF inflation looms around the corner (the debt will be comparably less painful), or IF a turn-around comes when it is expected (in 2010) rather than 5-7 years away.

Still, I'd expect IP and some other timber plays to get the "bailout assistance." IP's stewardship is several notches better than many of the cheap paper mills outside the States (companies that no one has ever heard of, but which rape the forests from Indonesia through Africa). Responsible timber management is expensive - and that means jobs - so a "pro-environmental" candidate wouldn't hesitate all that much to start sending some stimulus assistance to IP and others (although they would hesitate to send it to box makers in China, I should think).

Feb 19 06:31 AM

[Lee Eugene ...:]

donzelion,

I agree about the potential of IP. Portfolio Asset Management had originally looked at IP and even traded it late last year. PKG made more sense in the end, but if I could buy IP cheap enough it might change my mind.

I appreciate the well thought out comment compared to those that don't even reference the article. Keep them coming!!

Lee Munson


On Feb 19 06:31 AM donzelion wrote:

> Contemplating a timber play like IP dying during this recession is
> pretty sobering. Taking on more debt in a recession strikes me as
> a fair strategy IF inflation looms around the corner (the debt will
> be comparably less painful), or IF a turn-around comes when it is
> expected (in 2010) rather than 5-7 years away.
>
> Still, I'd expect IP and some other timber plays to get the "bailout
> assistance." IP's stewardship is several notches better than many
> of the cheap paper mills outside the States (companies that no one
> has ever heard of, but which rape the forests from Indonesia through
> Africa). Responsible timber management is expensive - and that means
> jobs - so a "pro-environmental" candidate wouldn't hesitate all that
> much to start sending some stimulus assistance to IP and others (although
> they would hesitate to send it to box makers in China, I should think).

Feb 25 02:27 PM

[Packaging:]

When some of the big players go and the up turn comes there will be a lot of money to be made in packaging. Less competition will mean the profit margins will increase.

Apr 07 09:25 AM