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Summary

  • Deutsche Bank turns optimistic on KapStone Paper, adding to multi-year momentum.
  • The company has created value in an industry which traditionally has destroyed a lot of shareholder value.
  • I like the company and its track record, but won't buy at any price.
  • A $25 entry point, representing a 10 times earnings multiple during the good times in the economy cycle is my targeted entry point.

Investors in KapStone Paper and Packaging (NYSE:KS) enjoyed an upgrade from analysts at Deutsche Bank.

Analysts are not too worried about new capacity impacting prices a lot. I monitor the situation closely given the great operating leverage in the industry which works both ways of course.

That being said, I share long term optimism regarding the very strong track record of the company and management, being a buyer on significant dips.

Deutsche Bank Turns Bullish

Analyst Debbie Jones upgraded the rating on KapStone Paper from hold to buy, boosting the price target by ten dollars to $36 per share.

Jones notes that the stock has retreated from highs of around $34 per share set in June. The correction is driven by caution regarding new containerboard capacity coming on-line in North America, putting potential pressure on the health of the market and pricing.

Despite the lack of a pricing catalyst, the company does have the potential to drive earnings growth in the coming one to three years.

Investor And Analyst Day

Back in June, KapStone commented on its recent growth and the outlook for the future. The company which was founded as recent as 2005 has seen rapid growth ever since. Growth as been driven by the actions of its founders Kaplan and Stone which combined with their immediate family still hold a substantial stake in the business.

Since 2007 the company has made four substantial acquisitions. While the first three acquisitions being executed in 2007,2008 and 2011 cost a combined $1 billion, the large deal was of course the 2013 deal to buy Longview Fibre.

The $1.02 billion deal valued the acquired company at 6.1 times trailing EBITDA at the time, a ratio now adjusted to 4.3 times annualized EBITDA based on the improved performance since the acquisition. All of these past deals added scale, resources and a national footprint, each very important characteristics in this industry in which notably economies of scale are crucial. These deals and organic growth allowed the company to roughly ten-fold its operations in terms of revenues since 2007.

By now the company operates four paper mills with a total capacity of 2.7 million tons per annum. These supply 22 converting plants which are located throughout the country. The main product being produced by the company is the containerboard, of which it produced some 1.7 million tons. Kraft paper production totals about 600,000 tons being used for specifically designed and higher performance solutions.

Valuation

At the end of July, KapStone posted its second quarter results. The company reported having $49 million in cash and equivalents at the end of the quarter. Yet last year's deal has resulted in quite a bit of debt, with the total debt position of $1.20 billion resulting in a rather high net debt position.

On a trailing basis, KapStone has posted sales of $2.24 billion on which it has posted net earnings of $171 million. With 97.4 million shares outstanding and those shares currently exchanging hands at $31 per share, equity is valued at $3.0 billion.

This values equity in the business at roughly 1.3 times sales and 17-18 times annual earnings.

History Of Growth

In recent years shares have seen an incredible run-up. Shares traded at just $3 back in 2007, falling to levels below a buck during the crisis. Ever since shares have been on fire. In 2013, shares advanced from $10 towards $30 by the end of the year. Shares have traded in a $24-$34 trading range so far this year.

Underlying this is a tenfold in sales increasing from roughly $250 million in 2007 to $2.2 billion on a trailing basis. The company has been profitable in each year, posting solid earnings recently. Important to realize, investors have seen a bit of dilution, with the shareholder base increasing by roughly 50% since 2006.

The company has increased its leverage following least year's deal yet the operations have great cash flow characteristics. This allows for a rather quick pace of deleveraging if the company will not make huge capital expenditure commitments going forwards.

While leverage is high in relation to current earnings, it is not so high in terms of operational cash flows. The company's EBITDA to leverage ratio has fallen from 2.7 times at the moment. This is down from 3.8 times when the Longview deal was announced, partially driven by continued EBITDA improvements. The 2% cost of debt is very appealing as well, despite the reasonably leveraged position, making it a very cheap source of capital.

Final Recommendation

At the moment, the company is on fire as it reports earnings north of $50 million a quarter, or $200 million on an annualized rate. Excluding the contribution from Longview, sales were up by 7% for the legacy operations on an annual basis which are quite solid results.

More importantly the company recently raised Kraft paper prices which might add $30 million in operational earnings on an annualized basis going forwards. At the same time, the company still has to reap some benefits of the anticipated $20 million in annual synergies targeted by the end of 2015. With earnings having the potential to improve towards $250 million more appeal might be in the cards with shares trading at 12 times earnings.

Furthermore recently ideas surfaced suggesting that companies like KapStone could create master limited partnerships for their paper mill assets, much like the oil and gas industry in order to cut its tax bill and create shareholder value.

Little over a year ago I last had a look at the prospects for the company following the acquisition of Longview. At the time I understood why investors liked the deal very much, buying a profitable business at a discount to its own valuation with cheap debt. The all cash component furthermore implied that all of the $10 million in anticipated synergies would benefit shareholders in the own company.

Ever since, shares have rallied a lot further. Shares jumped from $15 to $20 following the deal. Shares have risen even further ever since after the company has doubled its synergy estimates, benefited from cheap cost of debt and displayed solid operational performance.

I remain positive given the developments as discussed above, yet I am not chasing the bandwagon given the cyclicality of the industry and the higher valuation at the moment based on long term historical average margins. A re-test of the $25 mark, which are the lows of 2014, could spark some imagination in my eyes. For now, I keep the shares on my watchlist.