Buy WestRock - Do Not Wait For 2022

Summary

• The final part of the bear case will crumble for WRK as valuation hits an all-time low.
• Tax selling is hitting its peak.
• I lay out the case for owning WRK and debunk the bear case.

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As we look through the rubble created by the relentless selling of value stocks since February, WestRock (NYSE:WRK) stands out as being particularly compelling. Not only because the valuation multiple has compressed to the lowest on record, despite lower leverage and better industry structure, but because the incessantly bearish narrative of the sell-side seems to be at stark odds with the recent sharply improved industry fundamentals. This is highlighted by the comments from leading industry consultant RISI this past week. After being bullish on WRK at $72 a few years ago, many of the sell-side analysts have been aggressively bearish on WRK over the last few years saying

1. Demand is going to slow

2. Financial leverage is too high

3. Management is not great and

4. There is too much supply coming on.

So far they have been dead wrong on

a. demand, as it has been stronger than they expected

b. the company, as it has reduced leverage significantly to a prudent level and

c. the management team, which has done a fine job generating a ton of cash in the process.

In addition, on point c, about management, the board recently hired a new CEO, a highly regarded senior executive from Sherwin-Williams (SHW) (a company that has always traded at a big premium valuation, currently at 40x EPS, not because there is much growth in paints but because it is so well run). Before joining WRK, the new CEO was the COO of SHW. It is worth noting that while at SHW, he oversaw the highly successful integration of SHW’s acquisition of Valspar, optimizing efficiency and reducing costs meaningfully. This quality demonstrated as a "hands-on" manager will come in quite handy at a company like WestRock that has done several large acquisitions over the last few years but has not fully integrated them.

In summary, despite three of the four legs to the bear case having fallen apart and the management point actually having become a positive, the multiple of WRK has gone from 7.5x EBITDA to 4.8x, its lowest on record. This valuation translates into a free cash flow yield north of 17%. Now to the last point of the bear case: supply additions. As the other arguments have fallen by the wayside, the sell-side has focused incessantly on this last argument, with a week rarely going by without one or more of them publishing reports pounding this argument. It goes like this, despite demand growing at mid-single digits over the last two years it is now supposed to grow at only 1.25% in 2022 and 2% in 2023 while supply will grow at 2.5% in 2022 and 2.5% in 2023. This implies that utilization will fall driving prices lower. I have pointed out in the past the issue with this argument is the following: Even if the bears are right regarding demand decelerating this much and supply coming on at the expected rate, pricing won’t fall because:

1. The industry has been running full out and above technically healthy levels for 2 years so plants will need more than normal catch-up maintenance thereby effectively reducing supply.
2. Even if the bears are right on supply/demand numbers, pricing won’t fall because utilization will drop to a trough at 93% which is still too high for prices to fall (historically for prices to fall utilization has to fall to the high 80%).
3. The industry is consolidated now and with the top four players controlling close to 80% of the industry, their proven oligopolistic behavior means they will cut runs to protect pricing if necessary.

Now, let’s ignore my three arguments for a moment and focus on what the industry consultant (RISI) said this week since the sell-side treats them as the authority on containerboard and the backbone of their last bearish point of more supply than demand.

The World According to "RISI"-

(My Detailed Notes from a Conference Call with multiple investors and the RISI Consultant - My commentary in italics)

1. US Industry utilization is likely to tighten in H1 of 2022 as supply is coming out of the market from three players offset the announced supply additions: (a.) Sonoco is converting one of its containerboard plants to a different packaging material. (b.) PCA has been running so hard they need to take extended maintenance and (c.) IP has had production problems at two plants so they are down. (I suspect because they have been running too hard.) It is interesting how this tightening of utilization has not been mentioned by a single sell-side analyst. Supply coming out is particularly damaging to the sell-side bear case because they have been saying that price weakness would come in H1 2022 as their argument is demand is facing high comps from H1 2021. While some of this supply will come back in h2 of 2022, so will demand as supply chain disruptions diminish (WRK said this was costing 2% of demand growth).
2. Inventories are back to normal BUT if you adjust for supply chain issues they are probably 20% to 25% below normal. (This is a problem for the sell-side that said that “bloated inventories” would put downward pressure on prices.)
3. Exports have been trending significantly below normal for the last 24 months as the US market has been so tight. A recovery to normalized levels of exports would add over 1% of growth to US production. This means that even if the bears are right that consumption in the US slows from mid-single-digit growth to 1.25% we will see another 1%+ of growth from the normalization of exports (particularly since the global market is expected to tighten more than the US market by RISI). This would mean 2.5% production growth in the US even with the lower level of domestic demand, or similar growth to supply so no drop in utilization.
4. Why is demand growing faster in Europe than in the US? This is because of ESG. While US investors seem very willing to play the ESG theme in other parts of the market, so far they seem to be ignoring it for containerboard, despite the secular tailwinds for paper-based packaging as they take share from single-use plastics. Interestingly European investors are not ignoring this with European containerboard stocks trading at a premium to US containerboard stocks. It is quite rare that US stocks trade at a discount to European stocks. While it is easy to conclude this is because European demand is expected to be higher than in the US, this is a weak argument as it just relates to timing. We have seen time and time again that when it comes to ESG, Europe leads and the US follows. We actually know this to be true when it comes to packaging by following what the FMCG companies are saying about packaging materials and recycling targets in the US. This means that the benefit that Europe is seeing from this structural tailwind from ESG will show up in the US with a short lag. The result will be higher demand for paper-based packaging globally. This is another reason why we think the US demand forecast is too low.
5. Another interesting point from the RISI call was the risk of supply from conversion of other packaging grades is diminishing. Most of the supply additions announced over the last few years have come from conversions from other paper products (fine paper and newsprint mainly). We have argued that there was a finite number of these machines that could economically be converted. RISI confirmed this when saying the potential conversions were now done.
6. While we have laid out the reasons why we think RISI’s domestic production growth forecast is too conservative, let’s assume their lower demand forecast is correct too. The issue is that even if this is the case, the sell-side’s logic that prices would fall still does not hold. Here is why: RISI project GLOBAL utilization to RISE every year for the next few years (their forecasting period). Somehow they still have US utilization FALLING. This does not make any sense at all. In the end, containerboard is a GLOBAL commodity. This means that even if they are right that US demand is lower than US supply by a percentage or two, the first thing that would happen is that US export goes back to trend, thereby bringing the US market back into balance. If for some reason that is not enough, they would export above trend (just as they exported below trend when the US utilization was higher than global utilization over the last two years). While temporary price differences can exist due to short-term dislocations, beyond the short term the law of economics will prevail.

In summary, despite being wrong on the first three points of their bear case, when it comes to the fourth point, they cannot have their cake and eat it too. They uniformly treat RISI as the ultimate authority on the containerboard industry. If RISI is saying GLOBAL utilization will rise, then domestic utilization is not likely to fall much at all, let alone fall to below 90% where prices would come under pressure. It seems to be that the fourth and last point of the bear case is falling apart just as the valuation has hit an all-time low. In addition, we will know much more about the plan of the new CEO which should combine more aggressively buying back stock (now that leverage is down to the target level) and increasing profits through further integration of WRK’s acquisitions. It is just fascinating how WRK has hit an all-time low valuation when the entire bear case is broken and instead of trading at a 40% discount to its own history it should trade at a premium (like its European peers) as the secular tailwinds from ESG accelerate. Anyway, with this type of valuation, the uniform bearishness on the stock (now double accentuated by the heavy recent tax selling) the odds are quite skewed to the upside, to put it mildly.

Disclosure: I/we have a beneficial long position in the shares of WRK either through stock ownership, options, or other derivatives. 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.