There's nothing sexy about paper and packaging solutions. Many investors breeze past these companies in search of the next great growth story or deep value opportunity. Even still, there are great investments in "unsexy" industries. Graphic Packaging Holding (GPK), through the years, has been a killer investment.
Shares are up nearly 1,400% over the last five years and already up 10% year to date after announcing stellar quarterly results. Even still, the stock is still appealing from a valuation perspective, including its growth angle -- which includes revamping the European packaging market.
Despite being a rather "unsexy" business, Graphic has taken a strategic approach to building its brand. This has helped it remain fairly resilient against the broader economy. The stock is up 40% over the past year and crushed earnings estimates by 70% for 4Q; volume and sales were up modestly year-over-year and margins were pretty well up across the board.
However, we're still in the early innings of a turnaround, where volume in Graphic's core markets have been challenged for a number of years. I'm still encouraged by the fact that management continues to find ways to grow the business, including gaining market share via acquisitions. And one of its most notable strategies is continuing to introduce new products and solutions that ultimately allow it the ability to differentiate their products.
Product innovation drives sales higher
Contrary to popular belief there is room for innovation in packaging. During 2013, Graphic's newly introduced products saw sales increase $100 million. A few of these include its new strength-package container for mandarin oranges and other fresh fruit. The positive here is that it also gives retailers and producers a stronger branding opportunity compared to traditional mesh bags.
Other new products include Tite-Pak, a proprietary beer bottle carton, which it launched for MillerCoors and ABI during 4Q. I'd look for the company to continue funneling money into research and development to help find new and efficient ways to package goods. A couple of areas ripe for new products and that are growing volumes include craft beer, pasta and dry foods.
Along the food and beverage lines, it's worth noting that the company serves major multinationals, such as Anheuser-Busch, MillerCoors, PepsiCo, Coca-Cola, Mondelez, General Mills, Nestlé, Kellogg, etc.
Margin improvements should continue into 2014
2013 was a solid year given the operating environment. This comes as Graphic saw impressive results in its margins. For the three years ended 2013, revenues only grew at a 3% CAGR. On down the income statement, operating income grew at a near 16% CAGR thanks to an operating margin that's up to 7.6%. That margin continues to expand, and is well on its way toward the long-term target of high-single digits.
There were about $25 million in performance improvements the company recognized during the fourth quarter, bringing the 2013 total to $100 million. Part of this comes as the company has been seeing marked progress in generating its own energy. During 4Q, its biomass boiler in Georgia was fully operational, marking the second quarter the company was able to generate its own energy for the mill located there in Macon, Georgia. On the European side, cost savings came from consolidating a U.K. converting plant, and integration of its acquisitions (A&R beverage packaging business and Contego Packaging).
Those gains should continue into 2014. Continued performance improvements, coupled with the productivity gains with European acquisition synergies, and the benefits should be around $80 million for 2014. Synergies from its 2013 European acquisitions should drive costs savings of $18 million alone.
Pricing is also working in Graphic's favor. During 4Q, the company generated positive pricing benefits of over $4 million. 2014 should be another strong year for pricing and volume turnaround. That has the potential to boost both the top and bottom lines. Earlier this month the company announced a $50 per ton price increase on kraft paper grades.
Some areas of weakness could use improvement
One headwind that I see is the lower sales of carbonated soft drinks. This is a trend that's likely to continue as consumers become more health conscious. Now there is good news to Graphic's exposure to the beverage market; it's not all soft drinks. The Can Manufacturing Institute notes that canned soft drink volumes were down 5.7% during 4Q, but alcoholic beverages were down only 0.4%. Alcoholic beverages should continue to be a steady and growing market for the company. As well, Graphic should see momentum in craft beer. This is an area in which Graphic continues to invest.
There is room for improvement in the core food market, which includes cereals, dry foods and frozen foods. All three of those areas saw volumes down in 4Q. These were impacted by continued high unemployment and the government's curtailment of the SNAP food program. This happened in early November, with benefits to families under the program being cut by 6%. However, I'd look for some volume boosts related to a strengthening economy in the U.S.
Europe is a springboard for revenue growth and expansion
Going forward, Europe provides a strong platform for further growth and margin improvement. Graphic is building up a larger presence in Europe, which is a big positive. The region currently only makes up about 10% of its sales. The other beauty of Europe is that it's less reliant on carbonated beverages, as Graphic's beverage business in Europe is almost exclusively beer-based. That's, in part, because there really isn't much paperboard used in soft drink packaging over there. However, beer continues to grow in Europe.
With its A&R acquisition last year, Graphic now has a solid position with Heineken. The company is less involved in the food packaging side, but is embarking on that side of the business in Europe. By focusing on the food packaging physical asset space, the company will be able to better cater to its global customers, such as Mondelez and General Mills. And unlike the U.S., the European paper packaging market is highly fragmented and fractionated -- ripe for a vertically integrated company.
Graphic can also drive its top line higher with tuck-in acquisitions
As mentioned, Graphic snatched up Contego Packaging and A&R beverage packing business in 2013, which should set the stage for not only growth in Europe, but growth across other markets via acquisitions. I look for Graphic to continue making waves in the converting business. Converting involves using paper to fabricate another paper product. This requires highly specialized machines. However, it's a form of vertical integration that gives Graphic more control over its business.
The company is heavily focused on developed markets for the time being, namely the U.S. and Western Europe. But as time goes by, there's no reason that won't change. Right now, I'd look for the company to remain focused on acquisitions in Europe. Longer-term, China and India should prove to be interesting markets, but Graphic has its hands full with Europe for the time being.
As far as the balance sheet to promote growth, Graphic's 2014 leverage ratio target is between 2.5x and 3.0x. Driving that should be the continued use of cash from divested non-core assets to pay down debt. 2013 was a good year for reducing debt. It sold its Illinois URB mill and its flexible retail plastics business. Neither the URB or plastics businesses were key for the company. I look for the company to focus on becoming more vertically integrated following the moves.
At the end of 2013, its leverage ratio was down to 3.3x. This is down from the 5x levels in previous years. It still has ample liquidity - nearly $700 million - and can also use its stock as currency to make high return acquisitions. On the other hand, should a promising acquisition present itself, Graphic is not opposed to running its leverage ratio above 3x.
Its history of outperforming the market should continue
The company's capital investment requirement is minimal. This has helped keep its free cash flow margins at impressive levels, where Graphic's current free cash flow yield is around 6.5% for the trailing twelve months. Free cash flow should come in around $350 million for 2014, putting its forward free cash flow yield at 10%. Driving this will be volume/price improvements, as well as lowered interest expense thanks to refinancings.
Graphic also remains very nicely hedged, with over 50% of its natural gas exposure hedged below $4/MMBtu for 2014. Coupled with continued margin improvement, thanks to synergies and pricing improvement, earnings could grow a bit faster than Mr. Market expects. This comes as Graphic's business model contains a high level of operating leverage, given its primary fixed cost structure.
With Graphic's high levels of free cash flow, the company has been shareholder friendly, even though it doesn't pay a dividend. For 2013, the company snatched up $200 million worth of shares, with the repurchase being 7% EPS accretive. Since 2012, total share repurchases have been upwards of $500 million, 18% accretive to EPS. Share buybacks should continue to be a large part of EPS growth, helping the company grow EPS at a near 25% CAGR over the next five years.
While many investors might not be thrilled to admit they own a packaging company, and many likely don't own one, it is worth noting there are great growth opportunities in the space. With operating margins remaining relatively stable in the high single-digits, I look for Graphic to continue growing free cash flow nicely. Assuming a long-term free cash flow growth rate of 3.5%, less than half its historical average, coupled with a 10% discount rate, and fair value is around $16. And using its historical price to earnings multiple of 20x, along with 2015 EPS projections of $0.73, the price target is close to $15. All in all, Graphic looks to be a great play on both a rebounding U.S. economy and the changing paper packaging market in Europe.