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Kapstone Paper and Packaging (KPPC) is a manufacturer of kraft paper, linerboard and dunnage bags in the U.S. I find the company to be an excellent cash flow and balance sheet play with strong earnings numbers and at a reasonable, even cheap, valuation.

Kapstone just announced their fourth quarter numbers earning .23/share, up 46% over last year. For the year they earned a solid .75/share against a 6.55 share price at the close yesterday giving them a PE of a modest 8.5. Its EV/EBITDA is under 3. Not only is it reasonably priced from an earnings perspective, but the company generated enormous free cash flow over the last year of roughly 1.10/share, which means it's trading at about 6 times free cash flow.

The balance sheet is excellent with their cash and receivables of 86 million exceeding all balance sheet liabilities. Book value is roughly 4.00 per diluted share.

Prospects:
There are reasons for optimism for the company's prospects going forward. First there was a major capacity contraction in the kraft paper business in recent years. This has pushed up the price of kraft paper and in fact is still pushing up prices. The company recently announced another price increase of $40 a ton which will partially benefit Q1 results and will fully benefit Q2 results. There is expected to be an increase in linerboard prices also. Increases in prices naturally flow straight to the company's bottom line.

Recent consolidation in the industry should help also. International Paper (IP) recently purchased Weyerhaeuser's (WY) containerboard business, which is expected to have a positive impact on the industry due to an expected reduction of capacity, according to Claudia Hueston at JP Morgan. The company stated on its conference call that it expects this to be a positive for the industry as well.

Finally I will engage in a bit of pure speculation here on another positive for the market for Kapstone's products. Kraft paper, which is a large share of its business, finds its heaviest use in paper grocery bags. This business was shattered over the last 20 years as paper was largely replaced by plastic. I suspect that trend may reverse. There is a strong environmental movement to restrict or ban the use of thin plastic grocery bags. The bags were banned in San Francisco last year and in January China banned them as well. Ireland in effect taxed them into oblivion back in 2002. The economics here seem interesting as a plastic bag costs about 2 cents. A paper bag costs about 5 cents and various plastic substitute bags are in the range of fifteen cents. I expect this environmental movement to pick up steam and I expect the net result to be that grocers will be using more paper bags at checkout. Indeed that is what has happened in San Francisco. The economics of the grocery industry with their razor-thin margins just don't allow ultra-expensive alternatives.

Insider buys:
If that isn't a reason for optimism, then insider activity may be. Insiders over the past 6 months have made net purchases of almost 250,000 shares at prices up to 7.26 well above current price levels.

The negatives:
There is not much growth baked into the cake here that does not involve price increases. The company has stated it is interested in acquisitions, and it certainly has the balance sheet to pull them off, but growth should be rather modest, based on existing business.

The company is also sensitive to changes in the costs of its inputs. Energy costs, transportation, wood chips, chemicals etc. all have an effect on margins. The company has stated that the prices on wood chips remains stable however they have obviously seen an increase in energy costs, and chemical costs have also increased. The company's pricing power should more than compensate for these factors, but it is important to keep them in mind.

Source: Kapstone Is Poised for Growth in the Paper Market