This is an update to our long KapStone Paper and Packaging (KPPC) investment thesis, which we articulated on our investment idea website, on September 11, 2009. The stock was trading for $7.66 per share at the time.
We view the equity at $6.65 as an even better bargain than before. First, and most importantly, we believe fundamental downside risk is limited. The current $302 million market capitalization is a discount of approximately 19% and 12% below what we estimate book value and tangible book value, respectively, will be at the end of the current quarter. This valuation is far too low for a company with low cost of production assets, large market shares within high margin niche paper products, and the highest normalized margins in the industry. Further, management undoubtedly has created value through efficiency enhancements and capacity expansions since acquiring their facilities. Additionally, KapStone acquired both of their facilities at purchase prices below replacement cost. Therefore, the current market cap represents a meaningful discount to an already conservatively stated tangible book value, in our view.
Second, the key driver of KapStone’s business recovery – pricing – is currently in the process of improving. As a non-integrated producer, KapStone realizes the impact of changes in its product pricing immediately, which explains the rapid margin compression the company has endured over the last twelve months. However, the company’s margins will expand as its prices rise, just as quickly as they contracted when its prices fell. Importantly, KapStone’s pricing, in terms of average revenue per ton, bottomed in Q3 and is poised to improve, perhaps significantly so, during the next several months. Industry capacity closures are rapidly tightening the linerboard market, which has led to price increase announcements by producers for domestic and export linerboard across the board.
Presently, KapStone’s largest and lowest margin product line is linerboard, so imminent linerboard price increases are the single best cure for the company’s depressed margins. We estimate that every $50/ton price increase for linerboard will add an incremental $30-$36 million to annual run-rate EBITDA. We believe the current market price of KapStone shares implies no meaningful recovery in industry pricing, which we believe to be inconsistent with current developments.
Third, KapStone’s share price has declined by 19% since October 5th, which is the date the largest shareholder, Elm Ridge Capital Management, LLC, began selling. In contrast, the S&P 500 and two paper industry ETFs, WOOD and CUT, have appreciated by approximately 5%, 5% and 2%, respectively, over the same time period. With insiders holding approximately 40% of the company’s shares, Elm Ridge holding 9.99%, and many seemingly long-term value oriented institutions holding shares, we believe the effective float is limited. Consequently, a major holder like Elm Ridge who chooses to sell shares can create significant downside pressure on the stock price. This is a factor that is both temporary and non-fundamental. Many of our best investment opportunities present themselves when we can identify both a) a large mispricing and b) a specific non-fundamental reason why the mispricing exists. We believe this is one of those opportunities.
Two important recent capacity closures are:
- Linerboard - On October 22nd, International Paper (IP) announced the permanent closure of its containerboard mills at Albany, OR, Pineville, LA, and the previously idled No. 3 machine at its Valliant, OK mill, effective mid-December. IP’s closures will remove about 1.4 million tons of linerboard capacity. On October 28th, West Fraser announced the permanent closure of its Eurocan mill in B.C., which will remove about 330,000 tons of linerboard capacity, effective January 31st. Collectively between the two companies, over 1.7 million tons are being permanently closed, which represents almost 5% of North American capacity, which should push the industry operating rate into the mid-90% range – a level at which price increases historically have been successful.
- Kraft Papers - West Fraser’s Eurocan closure will also remove about 150,000 tons of kraft paper capacity, which will contribute to a tighter overall market, despite being a higher grade kraft than KapStone’s. Consequently, we believe KapStone’s previously announced $50/ton kraft paper price increase will be successfully pushed through either December 1st or in early 2010.This price increase should add about $15-$16 million to annual run rate EBITDA, in our view.
Additionally, more industry capacity closures are likely in 2010. Higher cost mills will no longer be economically motivated to run without the benefit of the Alternative Fuel Tax Credit (AFTC), which is set to expire at the end of this year. Further, many believe Smurfit-Stone Container (SSCC) is likely to announce significant permanent capacity closures in January when its Chapter 11 reorganization plan is due to be filed. Without naming names, CEO Roger Stone believes there could be another million tons of containerboard capacity that could close in the coming months, which would represent another near 3% of the North American market. The containerboard industry operating rate has the potential to reach the high-90% range in 2010, in our view.
Due to the lean inventory conditions, many companies have announced price increases in recent months. Some of them include:
- On Oct. 15th, Klabin (Brazil) announced a €40 price or $60/ton price increase on kraft linerboard in Europe, and $30/ton increase in Africa and Asia, effective this month. This is on top of the $60/ton, $40/ton, and $30/ton increase in Asia, Europe and Latin America, respectively, from earlier this year.
- On Nov. 5th, Smurfit-Stone Container announced a $50/ton containerboard price increase for Mexico, Central America and South America, effective Dec. 1st.
- On Nov. 9th, Pratt Industries announced a $50/ton containerboard price increase to Latin America, effective Dec. 7th.
- On Nov. 16th, Longview Fibre (LFB) announced a $50/ton price increase on linerboard and medium, effective Jan. 1st. Longview is the 12th largest North American containerboard producer with capacity of about 600,000 tons.
- On Nov. 20th, Europac (Spain) announced a €60/ton price increase on linerboard, effective Jan. 1, 2010. This is on top of the €60/ton price increase implemented in September. Europac cited a shortage of kraft linerboard production in Europe and declining imports from the U.S.
- On Nov. 23rd, Georgia-Pacific (G-P) announced a $50/ton and $70/ton increase on liner and medium for the East Coast and West Coast, respectively, also effective Jan. 1st. G-P is the 2nd largest North American containerboard producer with capacity of about 4.2 million tons.
- On Nov. 23rd, IP informed its Mexican customers of a $50/ton price increase for linerboard and medium, effective Dec. 15th. This price increase follows the company’s previously announced $50/ton price increase for Latin America.
- On Nov. 24th, Pratt Industries announced a $50/ton and $70/ton price increase on containerboard to East Coast and West Coast customers, respectively. Pratt is the 6th largest North American producer (1.15 million tons) and the third domestic producer to announce the increase.
Again, the expiration of the AFTC at year-end likely will lead to further capacity closures, which should cause further price increases. Interestingly, during the Q3 conference call, Roger Stone indicated his belief that overall pricing could approach year ago levels by the end of 2010. Importantly, Stone stated he is bearish on the macro economy and that the pricing gains he foresees are due entirely to paper industry specific capacity closures. Given his experience and credibility within the industry, this view should not be overlooked. Pricing alone had a negative $28.5 million year over year impact to Q3 EBITDA, which implies that the pricing recovery Stone sees will represent an incremental $114 million of annual run rate EBITDA by the end of 2010. Add that to Q3’s $35 million annual run-rate and KapStone would generate almost $150 million of EBITDA—without any improvement in mix. That level of EBITDA would result in a stock price in the mid-teen range, in our view.
As for mix, the company’s normalized revenue mix is about 30% linerboard, 32% kraft papers, 30% saturating kraft, and about 8% Kraftpak. Saturating kraft and Kraftpak are both higher margin products followed by kraft papers, followed by linerboard, of which export linerboard is the lowest margin. Over the past twelve months, as demand for its higher margin products declined with the economy, KapStone filled the hole with linerboard, including export linerboard. Consequently, the overall revenue mix has a higher percentage of lower margin product than is typical. This negative mix shift alone negatively impacted Q3 EBITDA by $11 million year over year, which implies an incremental $44 million of annual run rate EBITDA once normalized mix returns. While we have little insight into the timing of when this normalized mix will return, we are confident it is a matter of when and not if.
As for valuation, KapStoneis trading at about $348 per ton on an EV/ton basis, which is an enormous discount to its peers, some of whom trade over $1,000 per ton. This incredibly low valuation implies that current depressed EBITDA levels are certain to last in perpetuity, which is inconsistent with current pricing developments, in our view. If we add Q3’s $35million annual run-rate EBITDA to an incremental $15-$16million and $30-$36million for the $50/ton kraft paper and $50/ton linerboard price increases, respectively, we reach about $80-$87 million of annual run-rate EBITDA. We subtract $2 million of interest expense, $12million of taxes, and $22 million of maintenance capex, which leaves us with an estimated $44-$51million of levered free cash flow, which represents a 14%-16% current free cash flow yield. If the improvements stopped here, we would expect the shares to trade between $6.78 and $10.11, assuming 7x-9x free cash flow, which implies no fundamental downside from current levels. Importantly, though, we are becoming increasingly confident that improvements will continue. If Stone’s prediction on pricing ends up being accurate, we believe $150 million of EBITDA and about $90 million of free cash flow would be reasonable estimates in 2011. Based on 7x-9x free cash flow, those results would result in a $14-$18 per share stock price, in our view.
While we are not relying on Stone’s prediction in our investment thesis, we are instead relying on a $110-$150 million EBITDA range, which we consider to be an appropriate mid-cycle EBITDA range. While we make no attempt at precision, we view the array of potential outcomes as significantly skewed to the upside. Additionally, the Biomass Crop Assistance Program (BCAP), the cellulosic ethanol black liquor tax credit, and the potential permanent closure of Stora Enso’s Kotka Mill represent three free call options, each of which has potential to be material, although we assume no benefits.
To conclude, KapStone’s product pricing is clearly improving and more industry capacity is likely to close, which should lead to further price increases, yet KapStone shares are reflecting none of these improvements. In fact, KapStone shares are available in the market at a price 12% below tangible book value, despite efficiency enhancements, capacity expansions, and overhead cost reductions that have further lowered the company’s breakeven point. At the current level, we believe the odds are highly skewed in our favor, given what we view as an asymmetric outcome for KapStone shares. We believe this investment opportunity exists at this even better price due to Elm Ridge’s documented selling of shares, which as a temporary and non-fundamental reason, provides us with the opportunity to increase our position at even more favorable prices.
Disclosure: Long KPPC.