KapStone: Better Positioned Than Other Cyclical Names

| About: KapStone Paper (KS)


The environment may be getting difficult for cyclical names, but KapStone might be able to hold its own.

Besides superior execution that was covered in my previous note, the business should benefit from product price increases, recent acquisitions and fewer outages.

The stock continues to trade at a discount to peers, especially based on next year’s numbers.

Since my previous note, KapStone Paper and Packaging (KS) stock has performed well, mostly due to improving paper industry dynamics and superior execution, which is positioning the company to monetize consolidation, stable pricing and financial discipline visible across the industry. Now that the changing macroeconomic environment, including potential interest rate hikes, is leading to increased scrutiny for all cyclical names, KapStone seems like a name that should be able to withstand the pressure and continue to create value for the shareholders.

Image source: Xerium Tech (NYSE:XRM)

Even though some of the major issues for the industry, like inventory and imports, do not seem to be posing the kind of risk they did just a while back, a sudden economic downturn, competition, strong U.S. dollar or any type of panic reaction to capacity mismatches, including aggressively priced acquisitions, do have the power to derail the story and are worth monitoring closely. All in all, the core nature of the business continues to be cyclical and carries the risks associated with it. For KapStone, besides the macro industry-related issues, the biggest risk is any kind of let-up in the pace of operational improvements, be it managing outages, product mix, integration of acquired assets or prioritizing profitability over top-line growth. Mostly because the financial impact of a let-up can raise the risk profile of the business and derail the Long thesis, given net debt/EBITDA is still close to 4 that needs to go down to create long-term sustainable value for the shareholders. Even with these risks, the story right now seems to be on a stable footing.

Industry that respects responsible pricing

For an industry that has suffered long from lack of pricing power, the recent reports, including some on Seeking Alpha, of price increases of almost $50/ton by containerboard producers should come as a major boost. The case is no different for KapStone, which, as the chart below shows, suffered from negative pricing and mix issues during the previous quarter, overshadowing the improving execution.

Image source: Earnings presentation

Besides the near-term help to the top-line growth, the development holds significance at various levels. If the price increase sticks, it will be a positive vote for the consolidation underway in the space, easing worries over oversupply, and may lead to price increases for kraft paper as well. Indeed, as the independent producers shrink and prices improve, there is a chance that the bigger players move away from their reliance on the index-driven prices and move towards negotiated deals, which may completely re-rate the sector.

Of course, KapStone that derives almost 60-65% of the revenue from containerboard products stands to benefit, but other players like Packaging Corp. (NYSE:PKG), which derives a majority of its EBITDA from containerboard products, WestRock (NYSE:WRK) and International Paper (NYSE:IP) will also benefit.

Operational improvements that may add to the favorable macro backdrop

For KapStone, the stable macro environment can help establish the improvements that were already visible over the past few quarters, and discussed in my previous note.

Going forward, new Greenfield box capacity from the first of the two plants is expected to start by the end of this year, which combined with Victory and integration of recently acquired Central Florida Box should help on the top line.

Operationally, the business, over the coming months, should benefit from reduced planned outages that was one of the biggest reasons for lower production last quarter, synergies from the Victory acquisition, integration of Central Florida Box acquisition, and lower mill costs, with help from lower energy costs and reduced headcount.

In the meantime, integration of Victory Packaging's purchase is moving as planned, the company is growing faster than the market in box products and fiber costs, the rise of which was one of the biggest causes for poor profitability per ton over last two years, have eased.

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.

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