Rock-Tenn Capitalizes on Smurfit-Stone's Reorganization

Includes: IP, RFP, SSCC, WRK, WY
by: Violent Capitalist

Smurfit-Stone (NYSE:SSCC) recently emerged from bankruptcy and emerged a pretty healthy company at that. So healthy that I had told some friends that I believed that this company was almost 100% undervalued at a price of $25. I must've not been alone in this regard since another SA author picked up some other notable hedge funds in picking up huge tracts of shares in the sub $25 range.

The main knock on Smurfit was the fact that they were simply over-levered. Once the slowdown hit, they simply got crushed with the inability to handle their debt load. My how that scenario has changed as they are an extremely neat little company now! I'm not privy to exactly why the offer by Rock-Tenn (RKT) has been accepted, but it can possibly be because of the chance for prior debt-holders to quickly exit this investment in one swing. There were some worries about margins erosion in the past as well, but with the transformation this industry has undergone, I actually believe that corrugated-related packaging is one of the best places to be in the packaging industry relative to an expanding economy (even if it is a meager expansion). If you've ever been to an emerging markets country, it seems that they are generally focused on cardboard type of packaging as suppose to glass/plastic/metal - so it should bode well as these markets expand.

Back to Smurfit-Stone, I had a target for SSCC at $50. This was a function of their enterprise value at $50 would be $5.7 billion. With expected net income of $250 mil, $350 mil in D&A, and $200 mil in capex - I figure a free cash flow of $400 mil. I project that out at a growth rate of 3.5% for 5 years and hit $475 mil. At $50 a share, the enterprise value to free cash flow ratio would be 12x, which is in line with the industry.

However, since Rock-Tenn is buying the company today, I had to adjust my valuations a bit to factor in the fact that I won't be able to participate in Smurfit-Stone's growth. For some comparisons I thought what better company for some comparables than the acquirer itself? Using the common industry statistic of an ebitda multiple, Rock-Tenn has an approximate ebitda of $500 mil, against a current enterprise value of $3.7 bil, equating to a 7.5 multiple. Smurfit-Stone has about $700 mil in ebitda, multiplied by 7.5x, equates to a $5.2 bil valuation and $45 a share. Today's price for Smurfit is $37, suggesting about 20% being left on the table.

I'm not one to say the offer is inadequate but I will say that in these times of what seems to be a slightly frothy market, it's harder to find cheap companies. This is now the 3rd company that I follow that is a target for M&A activity (see here and here) and I generally only invest in companies that are 1) under-followed and sometimes harder to understand 2) have ample cash flow and 3) have a solid market opportunity and an ability to become more efficient. With the valuations becoming frothier, companies that are looking for deals are definitely increasingly looking at similar traits. Kudos to Rock-Tenn for making it happen, I'll probably hang on to their shares for a bit if my put options land in the money.

If you're looking at International Paper (NYSE:IP), Weyerhaeuser (NYSE:WY), Meadwestvaco (MWV), or AbitibiBowater (ABH) for a potential investment in this space, both Rock-Tenn and Smurfit-Stone warrant strong considerations. Smurfit-Stone on the short-term side for a potential sweetener and you can then follow that up by holding Rock-Tenn shares as I think they may be slightly undervalued as well and will reap some extras in terms of synergies.

Current Price (SSCC): $37
Conservative Fair Value Estimate: $45, or just over 20% today's price

Disclosure: I am long SSCC.

Additional disclosure: Specifically, I am short put options on SSCC.