Earnings Are Surging At Packaging Corporation Of America

| About: Packaging Corporation (PKG)

Summary

Economic growth and other favorable underlying trends have the bottom line on a sharp ascent.

A recent acquisition further elevates the long-term growth profile.

A prolific cash-flow stream should allow a rapid de-leveraging of the balance sheet.

The subject of this recommendation is Packaging Corporation of America (NYSE: PKG), the fourth largest producer of containerboard and corrugated packaging products in the United States and the third largest producer of uncoated free sheet paper in North America. Boxes and paper certainly don't offer investors the glamour and excitement of Tesla or Twitter, or even GoPro - Wall Street's latest darling - but there's actually a very interesting story unfolding at the large packaging concern, and one that offers both substantial tangible earnings and the opportunity for solid total returns over the next several years.

Online superstore Amazon, another long-time Wall Street favorite, may not generate much in the way of profits shipping gazillions of merchandise all over the country, but Packaging Corporation of America certainly does since all of those goods are being transported in protective boxes produced by the company and its peers. Indeed, the Illinois-based concern has been solidly profitable every year since it went public some 15 years ago, even including the three recessionary years that America experienced during that period. That's not all, an improving economy has the bottom line moving in a sharp northeast trajectory, with share net well into record territory the last two years. And if that weren't enough, the accretive acquisition of Boise, Inc. late last year has further elevated the growth profile. Earnings per share were $2.06 in 2012 and $3.28 in 2013. They'll probably approximate $4.65 this year and $5.40 next year. Looking further out, the huge "free cash flow" stream that the combined company should generate will afford management myriad ways to further boost shareholder value. The initial focus will be on debt reduction, with the company already on record saying that it will pay off about $1 billion over the next three or four years. Beyond that, share repurchases could pick up in earnest. Acquisitions are another possibility, as is the continuation of dividend hikes, which have occurred regularly of late.

Packing Corporation's impressive bottom-line performance certainly hasn't gone unnoticed by Wall Street, with the stock price up some 170% in the past three years, after essentially marking time for about six years - when the sharp plunge during the financial crisis of 2008/2009 is smoothed out. Even with those gains, however, PKG shares still look attractive, trading at 14.1- and 12.1-times our earnings estimates for this year and next, respectively. Valuations reflect a nearly 20% discount to the market multiple, which seems unreasonable given the company's growth prospects. From the current level, we think the equity will out-distance most others over the next three to five years. We would also note that our earnings and share-price projections conservatively assume far less stock and/or debt repurchases than could be the case. Factoring in the decent (and growing) dividend, PKG offers very attractive long-term total returns potential.

The Company

Packaging Corporation of America - PCA - is the fourth largest producer of containerboard in the United States and the third largest producer of white papers in North America, as measured by production capacity. The Lake Forest, Illinois-headquartered company operates eight mills - consisting of five containerboard and three paper mills - and 100 corrugated products manufacturing plants. The manufacturing plants make a wide variety of corrugated packaging products. They include conventional shipping containers that are used to protect and transport manufactured goods. They also include honeycomb protective packaging, as well as multi-color boxes and visually appealing displays, which help merchandise the packaged product in retail locations. Additionally, PCA offers packaging for meat, fresh fruit and vegetables, processed food, beverages, and other industrial and consumer products. The company was incorporated on January 25, 1999 and conducted its initial public offering almost exactly a year later, but its origins go all the way back to 1867 when Henry Weis founded the North Star Mill in Quincy, Illinois, making paper from wild grasses and eventually straw. It current composition reflects multiple mergers and acquisitions, including last year's transformative purchase of Boise Inc., which is discussed in greater detail below.

Packaging Corporation of America's manufacturing plants are spread out over 32 states, reflecting the need to be close to customers. The company also has facilities abroad - three in Europe, two in Mexico, and one in Canada - but foreign operations are not material to its financial position or bottom-line results. Indeed, sales to customers outside the continental U.S. totaled only $162.4 million in 2013 (or about 4.4% of aggregate revenues) and the carrying value of long-loved foreign assets was a mere $14.0 million. Corrugated products are sold to more than 15,000 customers in over 25,000 locations. About two-thirds of those sales are to regional and local accounts, which are broadly diversified across industries and geographic locations. The remaining third are primarily to national accounts that have multiple locations and are served by a number of PCA plants. No single customer exceeds 10% of packaging segment sales. The primary end-use markets in the United States for corrugated products are: food, beverages, and agricultural products, 42% (as of 2012); paper products, 21%; general, retail, and wholesale trade, 18%; petroleum, plastic, synthetic, and rubber products, 8%; and miscellaneous manufacturing, 6%. At December 31, 2013, the company had around 13,600 employees, approximately 50% of them covered by collective bargaining agreements. (Note: The business description of Packaging Corporation of America contained in this article is derived directly from company filings with the Securities and Exchange Commission. So, too, are the historical statistical data presented throughout the article. All forward-looking statements, expectations, and projections, on the other hand, are ours, unless specifically attributed to other sources.)

PCA historically manufactured and sold packaging products and reported results in one reportable segment. The acquisition of Boise last October put it in the paper business, too, as the third largest producer of white papers in North America. Since the addition, the company has been managing its business in three reportable segments: Packaging; Paper; and Corporate and Other.

Boise Acquisition

On October 25, 2013, PCA paid $1.2 billion (net of cash acquired) for Boise Inc., a large manufacturer of packaging and paper products. Factoring in some $830 million in debt assumed, the company entered into $2.35 billion of new borrowings, which supported both the funding of the acquisition and refinancing of existing debt. The combination provides myriad advantages. First, the addition of Boise significantly increases the company's containerboard capacity, allowing for continued growth in the packaging industry; containerboard capacity increased from 2.6 million tons to 3.4 million tons. Second, Boise's substantial presence on the west coast greatly complements PCA's operations, which are clustered in the eastern half of the country, expanding the combined company's geographic reach and offerings. Third, it affords a large entry in the white paper business, as the third largest producer of white papers in North America. And perhaps most important, the transaction was immediately accretive to both earnings and cash flow, with the opportunity of substantial additional benefits in the years ahead. Synergies of about $105 million were expected to be generated over three years but this could prove conservative.

Boise is included in PCA's results as of October 25, 2013, adding $448.0 million to revenues and $3.5 million to income to 2013 results. Excluding special items, income from operations increased $165.6 million during the first six months of 2014, compared with the same period in 2013. The increase in earnings was driven by a full six months of Boise operations, which contributed $135.2 million, and a $30.4 million improvement in PCA's historical earnings. A large increase in free cash flow, meantime, should allow a rapid pay-down of debt; management expects to pay off $1 billion in three to four years.

Packaging Segment (93.6% of 2013 sales, 77.4% of first half, 2014)

The Packaging segment manufactures and sells a wide variety of corrugated packaging products, including conventional shipping containers and multi-color boxes and displays that help retailers display their merchandise to prospective costumers. In addition, it is a large producer of packaging for meat, fresh fruit and vegetables, processed food, beverages, and other industrial and consumer products. Following the acquisition of Boise, the company is also a low-volume producer of newsprint. In 2013, the segment produced 2.7 million tons of containerboard at its mills and sold about 38.4 billion square feet (NASDAQ:BSF) of corrugated products. Net sales to third parties totaled almost $3.7 billion.

Corrugated products plants tend to be located in close proximity to customers to minimize freight costs. The U.S. corrugated products industry consists of approximately 570 companies and 1,240 plants. As detailed in some of the company's publications, each of PCA's plants serves a market radius of around 150 miles. The close proximity of the various facilities enables the company to offer additional services and converting capabilities such as small volume and quick turnaround items. As of December 31, 2013, PCA was the fourth largest producer of containerboard and corrugated products in the United States, according to industry sources and management's own estimates. Competition tends to be regional, with the primary basis for competition including quality, service, price, product design, and innovation. Most corrugated products are manufactured to the customer's specifications. The company also faces competition from large competitors with significant national account presence. On a national level, the main rivals are International Paper Company, Rock-Tenn Company, and Georgia-Pacific LLC.

Energy at the packaging mills, a major cost item, is obtained through purchased or self-generated fuels and electricity. Fuel sources include natural gas, by-products of the containerboard manufacturing and pulping process, including black liquor and wood waste, and purchased wood waste, coal, and oil. Each of the company's mills self-generates process steam requirements from by-products (black liquor and wood waste), as well as from the various purchased fuels. The process steam is used throughout the production process and also to generate electricity. Of all the energy consumed last year, about 64% was from mill-generated by-products, and 36% was from purchased fuels. Of the 36% in purchased fuels, 39% was from purchased wood waste, 33% was from natural gas, and 20% was from coal.

Packaging segment sales rose $687.2 million (or 44.2%, year over year) in the first half of 2014, reaching $2,242.6 million. New contributions from Boise added $553.6 million to the top line, while the balance derived from improves sales price and mix ($61.6 million) and higher volumes ($72.0 million) in PCA's historical operations. Corrugated products shipments increased 30%. Excluding Boise volume, corrugated products shipments for 2014's initial half were up 3.6% from last year's comparable tally. The company's containerboard mills produced 1,667,000 tons, or 1,300,000 tons excluding Boise, compared with 1,275,000 tons in 2013. Segment income, meanwhile, increased $96.9 million (40.3%), to $337.1 million. Excluding various special or nonrecurring items, the segment's income increased $115.3 million. The increase related to a full period of Boise operations ($83.2 million, excluding special items) and increased income in PCA's pre-acquisition operations, which were bolstered by higher sales price and mix, higher sales volumes, and lower fringe benefits.

Paper Segment (5.9%; 20.8%)

By virtue of the Boise acquisition, Packaging Corporation of America manufactures and sells a range of white papers, including communication papers, and pressure sensitive papers, and market pulp; the trade name for the segment is Boise Paper. The company's white papers are manufactured as either commodity papers or as specialty papers with specialized or custom features, such as colors, coatings, high brightness, or recycled content. Shipments to customers are made both directly from the mills and through distribution centers.

The Paper segment has 600 customers, including paper merchants, commercial and financial printers, paper converters such as envelope and form manufacturers, and customers who use the company's pressure-sensitive paper for specialty applications such as consumer and commercial product labels. OfficeMax is the largest customer. In November 2013, OfficeMax merged with its competitor, Office Depot. Boise Paper has an agreement with OfficeMax which calls for it to supply at least 80% of OfficeMax's requirements for commodity office papers through December 2017. For the period of October 25 through December 31, 2013, which represents the time in which Boise was part of PCA last year, sales to Office Depot (including OfficeMax) accounted for 38% of Paper segment sales. Sales to the large provider of office supplies represented 9% of total company sales for both the three and six months ended June 30, 2014, and 45% and 43% of Paper segment sales for those periods, respectively.

The paper markets are large and highly competitive. Commodity grades of white paper are globally traded, with numerous worldwide manufacturers, and competition is based primarily on price. All of PCA's paper manufacturing facilities are located in the United States. The level of competition varies depending on domestic and foreign demand and foreign currency exchange rates. In general, paper production does not rely on proprietary processes or formulas, except in highly specialized or custom grades. The largest competitors include Domtar Corporation, International Paper Company, and Georgia-Pacific LLC. Significantly, too, electronic data transmission, e-readers, and electronic document storage alternatives have taken sales from white papers. Indeed, in response to a growing shift towards those alternatives, the company shut down two machines last fall.

As with the packaging segment, the white paper business consumes substantial amounts of energy, which is obtained through purchased or self-generated fuels and electricity. Fuel sources include natural gas, electricity, by-products of the manufacturing and pulping process, including black liquor and wood waste, and purchased wood waste. Each of the paper mills self-generates process steam requirements from by-products, as well as from the various purchased fuels. The process steam is used throughout the production process and also to generate electricity. Of the energy used last year, about 63% was from mill-generated by-products, and 37% was from purchased fuels. Of the 37% in purchased fuels, 73% was from natural gas and 27% from purchased wood waste.

Paper segment sales during the six months ended June 30, 2014, were $604.5 million. During this period, sales volumes of white paper were 560,000 tons. Segment income from operations was $61.3 million during the period, including $0.4 million of income from integration-related and other special items. Excluding special items, segment income was $60.9 million.

Corporate and Other (0.5% of 2013 sales; 1.8% in 2014's first half)

The small Corporate and Other segment includes corporate support services, related assets and liabilities, and foreign exchange gains and losses. This segment also includes transportation assets, such as rail cars and trucks, which are used to transport products from manufacturing sites and assets related to a 50%-owned variable interest entity, Louisiana Timber Procurement Company, L.L.C. (LTP), that was acquired in the Boise transaction. Sales in this segment relate primarily to LTP and the company's rail and truck business. PCA provides transportation services not only to its own facilities but also, on a limited basis, to third parties when geographic proximity and logistics are favorable. Rail cars and trucks are generally leased.

Good Long-Term Trends

Packaging Corporation of America turned in an impressive performance in 2012, posting year-to-year top- and bottom-line advances of 8.5% and 28.0% (to $2.06), respectively. A notable increase in demand for containerboard and corrugated products helped lift revenues, and those gains were magnified on per-share earnings by declines in energy costs. Year-over-year comparisons were solidly positive for both measures in each of the year's four quarters. The Illinois-based concern's showing was even better in 2013, with sales rising 28.9% to a record $3.7 billion and earnings-per-share, excluding $1.19 in nonrecurring gains, soaring 59.2% to $3.28. New contributions from Boise (two months and five days) certainly helped results, but most of last year's earnings improvement stemmed from increased pricing and higher demand, tempered modestly by increases in costs for labor, energy, fiber, freight, and interest expense. The operating margin expanded by more than 1.7 percentage points in each of the past two years, reflecting both the leverage inherent in the business and the benefits of pricing flexibility. As was the case in 2012, year-over-year matchups were strongly favorable in each quarter of 2013.

PCA's performance in 2012 and 2013 marked strong moves into record territory, following several years spent recovering from the Great Recession of 2008 and 2009. The ongoing improvement, albeit slow, in the U.S. economy certainly helped the company's financial results, considering the market for containerboard and corrugated products is generally subject to changes in macroeconomic activity; according to the Department of Commerce, the U.S. economy, as measured by GDP (Gross Domestic Product) increased by 2.8% in 2012 and 1.9% in 2013. That said, it should be noted that the packaging concern has been solidly profitable in each year since it went public. This includes the recessionary years of 2001, 2008, and 2009. The resilience over the past decade and a half is attributable, in part, to the transition among American shoppers from traditional retail stores to online shopping, which translates into merchandise being delivered to the home in cardboard boxes as opposed to shopping bags.

Momentum Has Accelerated in 2014

Packaging Corporation of America reported net income of $114 million, or $1.16 per share (excluding a $0.15 nonrecurring charge), for the June quarter of 2014. By comparison, net income totaled $71 million ($0.73) in last year's comparable period. The company's performance in the second was even better than in the first, when it earned $1.08 a share, which, in turn, was considerably above the $0.62 tallied in the year-earlier quarter. Excluding special items, earnings totaled $2.24 per diluted share during the first half of 2014, compared with $1.35 per diluted share in the first six months of 2013.

Sales increased by a whopping $1,344.3 million (or 86.4%) to $2,899.7 million in the first half of 2014. The sharp year-over-year increase in this year's initial six months is due largely to contributions from the Boise operations ($1,210.7 million), but it was also helped appreciably by higher sales in PCA's historical operations ($133.6 million), which benefited from both better sales price and mix and higher sales volumes.

Packaging segment sales increased $687.2 million (or 44.2%), to $2,242.6 million, compared with $1,555.4 million in the first half of 2013. A full period of Boise operations added $553.6 million and the balance of the increase derived from higher sales price and mix ($61.6 million), and higher sales volumes ($72.0 million) in PCA's historical operations. In the first half of 2014, shipments of corrugated products increased 30%. Excluding Boise contributions, shipments were up 3.6% over the comparable period last year. The company's containerboard mills produced 1,667,000 tons, or 1,300,000 tons excluding Boise, compared with 1,275,000 tons in 2013. Paper segment sales, meantime, which include sales from the white paper mills that were part of the Boise deal, were $604.5 million, with white paper sales volume of 560,000 tons.

Results in both the first three months and first half were positively affected by the Boise acquisition. The newcomer was meaningfully accretive to earnings, due to earnings generated by Boise as well as the synergies generated from the integration of its business. PCA has implemented several actions to improve productivity and reduce costs, including moving lightweight containerboard production from Counce, Tennessee and Valdosta, Georgia to the newly-acquired mill in DeRidder, Louisiana.

All in all, we think the company will earn $4.65 for all of 2014 and $5.40 in 2015. A steadily expanding domestic economy augurs well for continued increases in sales volume and further improvements in pricing. At the same time, actions take to enhance productivity and efficiency have positive implications for operating margins, as do the ongoing integration of Boise, which appears to be proceeding ahead of plan. Management's latest guidance is for share net of $1.25 in the current quarter, based, in part, on expectations of higher sales volume and lower operating costs, due to higher synergies from the Boise acquisition and less scheduled annual mill maintenance outage downtime.

Finances are Stronger than They Appear

Long-term debt tripled following the acquisition of Boise Inc., totaling $2.4 billion as of June 30, 2014. As of that date, shareholder equity was far smaller at $1.5 billion, meaning that debt constituted 61.5% of total capital. Reflecting the sharply higher indebtedness, net interest expense more than doubled in 2014's first half, rising from $14.8 million to $31.7 million. Significantly, though, the credit is relatively cheap, costing a blended rate of about 4.5%. Moreover, only about $832.5 million is due over the next five years. Even more important, the debt-servicing obligations are handily covered by PCA's cash flow. Net interest expense will probably reach roughly $85 million this year, compared with $58 million in 2013. Cash flow, on the other hand, should exceed $830 million in both 2014 and 2015, almost $300 million more than in 2013. Current spending plans also suggest that the packaging concern will have ample "free cash flow" (cash available after meeting capital expenditure and dividend requirements) to rapidly pay down the debt. Indeed, management has already indicated that it expects to pay off some $1 billion over the next three to four years. Debt reduction, meantime, will add incrementally to the bottom line.

Risk Factors

The state of the U.S. economy is probably the most important variable in terms of determining the direction and velocity of PCA's top and bottom lines, since volume demand, pricing, and supply dynamics will all be affected by aggregate business activity. Geopolitical developments also need to be monitored for their impact on not just consumer sentiment but also on energy prices as it represents a major cost item for mill operations and transportation. As well, it may be worth keeping an eye on Office Depot/Office Max, given both its importance on the paper business and the troubles that the office supplies sector has seen over the past decade or so.

The Final Word

The U.S. economy is growing but its durability and vigor remains suspect some five years since the last recession officially ended. American businesses are hiring again but the jobs being created aren't paying as well as those that disappeared last decade, and income for the average worker is below where it was some six years ago. Disconcerting, too, are the uncertainties and potential ramifications associated with the Federal Reserve's extended easy monetary policy, which, presumably, has to end at some point. And if that weren't enough, it's difficult to remember when the world seemed to be in as much turmoil as it is now, with challenging problems in Eastern Europe, the Middle East, and many part of Northern Africa, not to mention the moribund economies of the European Union. All that said, Packaging Corporation of America is almost exclusively a domestic concern, subject mostly to the business climate at home. And on this front, the company is operating on all cylinders, with its historical operations performing well and its latest acquisition further boosting results. Clearly, all of the aforementioned issues are potential headwinds, but that's true for almost all of Corporate America. Reasonable valuations, meantime, provide both support near current price levels and a springboard to potentially superior long-term capital appreciation. Also worth noting is a dividend yield that's at parity with the 10-year government note. All in all, we think these shares deserve consideration for the haul to late-decade.

Disclosure: The author is long PKG.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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