KapStone - A Safe Short

| About: KapStone Paper (KS)

Summary

KapStone is only good for short positions or short legs of industry pair trades.

KapStone's stock price broke from the fundamentals in 2010, running well ahead of its intrinsic value.

The company is paying out all its cash as dividends and is essentially a bubble waiting to burst.

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Source: Stock photo.

When you short a stock, you are generally looking for an overvalued company. The expectation is that, while the stock market tends to rise, overvalued stocks will still fall. But now that we are in a more volatile market in which both traders and investors have the word "bear market" on their lips, shorting overvalued stocks seems more akin to buying undervalued stocks in a possible bull market.

That said, short trades can go drastically wrong. Anyone who's been on the wrong side of a short trade knows this. Realize that a short position puts you at unlimited risk before you run any short trade.

But short positions do not have to be scary. If you can identify the vehicles that facilitate a company's stock movement, short positions can be just as safe - and sometimes safer - than long positions. Often, a company has clear financial troubles and is on a downward spiral to being delisted.

I believe I've identified such a company. KapStone Paper and Packaging (NYSE:KS) has performed poorly over the past year, and with reason. Looking at the year-long chart, it would have been nice to short KS a year ago, but only can we see the true trouble KS is in and safely short the stock:

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Perusing Seeking Alpha's articles on this company, I notice mostly long theses. For an example, read "KapStone: Looks Good on Paper." Most articles have stated that KS is growing, citing reasons such as the acquisition of Victory, a distribution company that works in sync with KS's paper and packaging production business. In addition, they cite high yields and high free cash flows as reasons for expecting a potential comeback.

As I will show later, KS is not in such good shape. But for now, recognize the fact that KS is in a commodity market. In such a market, you want to avoid companies that are not making profits on the commodities they sell (common sense) but you also want to avoid companies that make their customers overpay the market price, as the case is for KS.

Think of it from a client perspective: You need what KS sells. But with KS selling paper and boxing in US dollars, why overpay? Right now, the US dollar is at a high, and other markets are struggling. If I were such a company, I would simply pay the extra shipping to get my boxes and paper from China, Japan, or any other economy where my dollar goes further; I've usually mentally equated $1 with 100 JPY through my decade of travel and living here, but today my $1 gets me $120 JPY - If I can get 20% more paper at a better quality (let's be honest here, Japanese companies such as Daio (TYO:3380) care more about quality than even publicly listed American companies) for the same dollar, why bother continuing business with KS? (As a side note, Daio is doing well despite market pressures, up 2% for the year in a declining commodities market, making it a possible long part of a pair trade with KS, assuming you're willing to invest in the Tokyo Stock Exchange.)

Of course, this is just the logic - what about the actual company? As I'm about to show, if we put the market together with logic and the following analysis of KS fundamentals, we have a safe and profitable short position.

KS Is Cheap for a Reason

As stated previously, a look at Seeking Alpha's articles on KS shows mainly long positions. In fact, after having read through every article on KS, I found no article advising a short position. With sentiment being bullish, readers will be misled to believe that it is selling at a discount.

Yes, KS is cheap. Yes, their yield is growing. But both of these facts are due to falling stock prices, not because of misvaluations or dividend increases. Anyone who had followed the advice offered by the articles on KS on Seeking Alpha will be in the hole today, counting dividend earnings.

Several definitions of investing permeate investor communities, but only one definition is objectively true: Investing is a game of arbitrage. The investor's expectation, whether it be in a long position or short position, is that the stock he owns today will be worth more (less in a short position) in the future than it is today. The exception is dividend investors, which can still profit from a sideways trending stock.

But in the end, KS is not going to trend upward because its price is attached to its fundamentals, as I'll show later. In addition, even if KS trends sideways, it cannot sustain its dividend, as I'll show later. Overall, KS is not cheap for what it is.

The Definition of Cheap

Many investors use P/E to evaluate whether a stock is cheap. In this regard, KS indeed looks cheap. It trades at 10.6 P/E, which, when compared to the 56.5 P/E of the paper industry, makes it over 80% cheaper than other paper stocks. However, the danger in using P/E to value stocks is that it ignores debt. KS currently has a debt of 1.59 M. This debt leads to a debt-to-total assets ratio of roughly 50%.

In such a case, a better measurement of value is EV to EBITDA, as this ratio accounts for debt. I calculated this ratio for the past eight years for KS, and -- oddly enough -- KS was "fairly priced" until 2010, when the stock got ahead of this ratio. The table follows:

Date

EV to EBITDA

2008-03-20

4.729282

2009-03-21

6.281437

2010-03-05

3.250257

2011-02-16

6.794271

2012-02-17

5.695160

2013-02-16

6.932194

2014-04-24

5.544561

2015-03-09

5.271249

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According to this table, KS should have trended sideways, taking debt into account. Its fair value has always been at around $5. Yet the stock has managed to escape to nearly $35 at one point.

This is good news (but not conclusive) for those of us willing to short stock. As KS is currently at roughly $15, much lower than its $35 high, it is still ripe for shorting, as its fair value is around $5 per share as per this ratio. But what we should really learn from this ratio is that KS should be treated as a dividend stock that trends sideways.

With KS paying $0.10 per share per quarter, this would give KS investors that invest at the fair $5 value a nice 8% dividend. Unfortunately, speculators and investors who believe KS to be "cheap" have brought the price of KS up while KS cannot raise its dividend. The result is a low yield on a falling stock.

If you're a smart investor, you probably read what I just wrote thinking, "How does the author know that the stock truly has a lower fair value and how does he know that the dividend cannot be raised?" The answers follow.

Valuing KS

One of the strangest things about KS stock is how its stock kept rising despite earnings having trailed off. Earnings were rising since 2007, all the way into 2012. From there, KS earnings were flat:

It's as if the stock lagged behind this data, investors only discovering, years after 2012, that KS had grown its earnings. The chart above shows KS to be a stable company in terms of earnings. Why were more people investing? Mere sentiment inflated this stock, making it one of those rare targets for a safe short position.

Looking at earnings per share, we see that most investors missed the boat. EPS was growing until 2013, where it fell precipitously. The stock, however, lagged behind these fundamentals:

Again, this is the pattern of a "discovery stock," a stock that investors only learn of through sentiment, not through fundamental research. Indeed, looking at the growth of the stock compared to the financials, we should have invested from 2008 to 2011. Yet a Google Trends and news search only shows investors getting hot about this stock well after the fundamentals for supporting the investment had fallen off.

My discounted cash flow model can give a decent valuation for a stock. In this model, we look at both the growth rate of the stock and the free cash flow. Even though this valuation is better than EV to EBITDA in my opinion in that it tends to follow stock price more closely, this model still shows KS to be overvalued and declining.

For my discounted cash flow model, I use 5-year averages to smooth the data. This also gives us a better idea of cash on hand instead of looking at pure free cash flow (which can be negative for a given year but misleading if a company has much cash on hand). Unfortunately, both the free cash flow and growth of KS are down.

My numbers show an insignificant growth (1.31%) in KS and a reduction in free cash (13%). This leads to a discounted cash flow valuation of $12.04 for KS. Though this value is not much lower than the actual stock price, the downward trend implies lower valuations in the future.

Another way to value a company is to determine what its shareholders will gain if the company liquidates. In this valuation, the shareholder equity is important, as it determines how much of the equity will be distributed to shareholders in the event of liquidation. KS's shareholder equity ratio has fallen since 2007 and has remained below 40% since 2014:

Currently, if KS were to liquidate, all shareholders would get $8.10 per share. This is nearly half the current value of the stock. Liquidation is a rare event, but assuming the event allows for a fair valuation of the stock, which in this case is overpriced.

My excess returns model valuation is also popular with Seeking Alpha readers. Though it usually applies to bank and insurance stocks, I often get requests to run it "just for fun" on non-bank stocks. The results are often striking, with the numbers often leading true stock prices.

For the sake of checking how KS fares with this model, I again ran it "for fun," producing a fair value of $6.99. The point here is that every valuation I've looked at points to KS being overpriced: PE, discounted cash flow, liquidation value, and excess return valuations all show KS to be the opposite of cheap.

Dare I say we are seeing a bubble in this stock? I quote Wikipedia: "A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices deviate from their fundamental values in relation to some system of stock valuation. The market has changed structurally and entered a completely new regime, which is entirely driven by market sentiment and no longer reflects any real underlying value." Here, the fundamentals and stock price clearly don't match.

Overall, all three valuation methods give numbers below the active trading price of the stock. The likely conclusion is that the stock is overpriced.

KS: A Dividend Stock?

So let's go back to my idea that KS should be a dividend stock. Clearly, KS is not a growth stock and has struggled to maintain its free cash flow. Will it also struggle to maintain a dividend?

The story of KS's dividend is a short one. In 2013, they paid out a special $2 dividend per share, equating to a 10.1% yield. In late 2014, KS initiated a quarterly dividend of $0.1 per share. This dividend has held through 2015 with no raise.

In 2015, stockholders were getting a yield of 1.2% with this dividend, which is certainly not attractive. But the problem isn't the dividend - it's the price. The price has been so inflated that the yield has shrunk far below acceptable levels.

Yet even though the yield is at low levels, the company should have a problem paying said dividend. The outstanding shares have increased with time, implying that dividend payouts will become more expensive if this trend moves forward:

As a percentage of the net income, the dividend payout is actually quite within manageable levels:

This implies that holding outstanding shares at the current level shouldn't be a problem. In other words, a buyback program isn't needed at this time. But should KS continue to dilute shares, they hurt not only the shareholders but themselves through increasing the dividend payout.

Assuming the $0.1 dividend holds, dividend payouts will only occupy 22.36% of KS's net income. Is this sustainable? To answer that, we need to compare free cash and the dividend payout. Using the 5-year running average of free cash flow (as quarterly data shows an oscillating pattern), I calculated the following numbers:

Date

Cash

Dividend Payout

2013-02-16

-86.58

95.00

2014-04-24

42.46

9.57

2015-03-09

36.86

38.44

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Currently, the company looks to be close to a situation of paying out all its cash as dividends. This might be good for the investor but not for the company, therefore ironically making it a bad situation for the investor as well.

KS: A Speculative Stock?

Now that we see that KS does not look to be a good choice for the dividend investor as well as a growth investor, the question is "Is there anything that can make KS a good buy?"

The paper and packaging industry are set for hard times ahead. January saw this industry drop its prices, hurting the companies within the industry. Several paper and packaging companies have been downgraded, including KS, which was downgraded to Underperform by Macquarie.

Could KS's recent drop in price be an overreaction to these factors? As I stated above, I believe KS is already overpriced, but humor me for a second. The paper and packaging industry is a cyclical one. Q1 and Q4 typically hurt the most because of the winter weather. Paper companies often reduce production because of the rising costs, selling excess inventory, and then starting up production again in Q2.

Let's look at KS's cyclical nature, which we can easily see in free cash flow charts:

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(Source: YCharts)

Indeed, KS might be one of those cyclical stocks that are better for market timing investments instead of buy-and-hold investments. I ran several backtests on such strategies for KS and found an interesting strategy.

Simply put, avoiding the month after Q4 earnings is an improvement over the buy-and-hold strategy. This avoids the post-earnings fall and allows you to buy at a relative low:

The strategy is less volatile than buy-and-hold with a lower average drawdown, a higher Sharpe ratio, lower volatility, and a higher Cagr. Most importantly, the return of this strategy is 26% higher than that of buy-and-hold.

However, even this strategy cannot save you from the recent downturn in KS:

Even avoiding the worst month puts you down 35% over the past two years. Thus, even a creative market timing strategy cannot save this stock. Seasonal speculators would be better off looking for another stock or industry.

KS: Random Thoughts

Though we've had a good look at the financials of KS and discussed briefly the macro environment within which it works, the financials are partly based on how the company is run by management. I don't particularly like the increase in the outstanding shares coupled with KS's focus on acquisitions instead of organic growth. Perhaps KS does not possess the assets to continue the growth it has once seen.

KS is fighting in the top 5 of the US paper industry. But for KS, this is likely a losing battle. Investors might continue holding KS, hoping for a surprise comeback, industry boom, or acquisition. I think all three hopes are foolish.

First, KS is limited in how much it can produce with its current assets; increasing production is possible but will reduce margins. Second, industry boom would be more likely to carry the industry's bigger players, such as International Paper (NYSE:IP) to higher levels than would KS, bringing KS a large opportunity cost. Third, hoping for an acquisition is not a sound investment strategy and is mere speculation, more akin to gambling.

So is there any safe way to invest in KS? As you've probably guessed, my answer is a resounding yes: Short KS.

Conclusion

All I see here is a safe short opportunity. KS is overpriced; paper buyers can find cheaper sources of paper; the KS dividend is being sustained with all its cash flow; growth is down; and even seasonal strategies on this cyclical stock cannot save it. The investment decision is simple: Short KS into the ground.

If you're uncomfortable with shorting, you can always run a pair trade. Find a paper company that is the opposite of everything KS is and buy it while shorting KS.

If you're not bullish for the paper industry and still don't want to risk the unlimited risk that comes with shorting stock, consider options. For KS, I recommend buying bear put spreads at strike prices around the current price every month. For example, for this month, buy:

  1. Buy 1 Feb 16 15 Puts
  2. Sell 1 Feb 16 12.5 Puts

In either case, with KS reporting its Q4 earnings on Feb. 9, now is the time to act. Pro subscribers get an early look at this article - so take this as insider information; all the other information out there is slanted toward bullish. Generally, when everyone in the market is bullish, it's a good time to take a bearish position.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.