WestRock: Take Advantage Of The Cyclicality And Potential Turnaround

Summary

• The paper industry is highly cyclical, and it's now experiencing a downturn.
• WestRock is one of the largest players in the industry, heavily dependent on the US market. Recent performance has been below expectations.
• Management still hasn't had enough time to prove they can improve, although there are promising signs.
• Very cash-generative business, they should still be able to deliver around $1B in FCF in a lousy year. The dividend is well covered.

Mehmet Hilmi Barcin/E+ via Getty Images

WestRock (NYSE:WRK) can, in my opinion, fill both categories from Peter Lynch's approach to stocks by being both a turnaround and a cyclical one. While I fear the timing could be on the early side, the company shows interesting possibilities of risk-adjusted returns for medium to long-term investors.

Recent overselling of its stock, change in management incentives to include ROIC metrics, paper packaging (mega?)trends, and the possibility of returns returning to the mean all contribute to my investment thesis.

Business

WestRock is part of the "boring", commodity-like, paper and paper packaging business. They provide a multitude of solutions to various known customers ranging from simple pizza boxes and yogurt holders to e-commerce boxes. They have an integrated value chain to provide mill operations, paper products, and distribution.

Westrock's Value Chain (Westrock Investor Presentation)

They are very strong in the US which also acts as a weakness since they're highly sensitive to the US economy and hinders the potential growth rate. The management seems to be addressing this through the Brazilian presence and, since late 2022, the large acquisition of Grupo Gondi's remaining assets to bolster its Mexican presence, ending the previous joint venture. The price paid was 8.81x EV/EBITDA, a more than 50% premium to what WestRock is valued at the moment even if we consider the next twelve months' EBITDA, perhaps bought at the peak. Management claims a very interesting $60M in annual synergies by year 3, but I'll need to wait and see it to trust it. I'm very fearful of EBITDA accretive, from year 1, acquisitions since they increase management's bonuses but don't clearly show returns above the cost of capital for the shareholders, and even despite some changes, EBITDA is still part of the short-term management objectives. These can indeed destroy value for the shareholders.

Data by YCharts

Paper Industry

For the paper industry, cost is king since there is very little differentiation between products and, besides scale and location, there are no "moats" to provide competitive advantages. Besides that, it's also a cyclical industry because consumption will vary in economic downturns, and consumers will buy fewer packaged goods and paper in general. Because it's a capital-intensive business with large fixed costs and high operating leverage, margins can fluctuate negatively in these depressed periods.

Since there is little differentiation, I would expect an half-competent management to close the gap with competitors, especially considering the size of WestRock and recent measures. After the recent transformation period undergone in the industry, returns should follow the mean around the cost of capital. WestRock should stop to underperform its peers or else risk failing completely.

Data by YCharts

PPI for Pulp, Paper, and Allied Products has been steadily increasing at a low rate. It exponentially increased during COVID-19 like most goods and is now experiencing a reversal. I would expect a similar development going forward with maybe some recovery in the short term, although overall inflation continues to be high.

PPI by Commodity: Pulp, Paper, and Allied Products: Packaging and Industrial Converting Paper (FRED Economic Data)

A positive point for the industry is the fact that paper packaging is seen as a "greener" replacement for plastics, and long-term trends are supporting the overall market. McKinsey calls it the "transformation change" era, with behavioral changes and environmental regulations to push demand.

Management

The team is relatively new to the office and has been through a very volatile period amid the pandemic, supply chain problems, and now inflation, so I would still give them the benefit of the doubt, although they should deliver soon to recover the equity premium this stock trades at the moment.

Some signs allow me to show an optimistic view; for example, the governance page on the annual report is very thorough, displaying important incentive metrics that move away from the simple EPS or (adjusted) EBITDA. EPS or EBITDA can inadvertently encourage leadership to pursue any buyout regardless of its returns on capital or the leverage used, and this seems to be the past example of WestRock. Other positive examples include the utilization of return on capital metrics and opportunistic buybacks instead of "blind" stock acquisitions.

Pay at Risk (Westrock 2022 Annual Report)

Despite the positives, I would like to see the compensation more in line with the industry and more insider ownership. The recent insider selling does not inspire much confidence in the business.

CEO Compensation (Simply Wallstreet)

Cyclicality Advantage

With the exemption of the fast-growing Graphic Packaging (GPK) in the example, paper companies tend to have frequent cycles, as the chart for the last 10 years shows:

Data by YCharts

This is an advantage for the patient investor that doesn't share the myopia problem with most investment firms, i.e. focused and evaluated by short-term results. Buying when there is "blood in the street" should turn out to be a rewarding option, hence an advantage here.

Valuation

Scenario 1 - Management Delivers on Target

On their investor presentation slides, the CFO, Alex Pease, defined clear and ambitious 2025 targets with EBITDA margins (19%), returns on capital (+10%), and free cash flow per share (+$5.50). The math is not very complicated to do; if indeed these goals are achievable, the returns will be exceptionally impressive. Considering a modest 10x EV/EBITDA for 2025 and the same $10B of debt, that leaves $30B of equity for the shareholders, meaning 3x to 4x the initial investment. Although a tad lower, the cash flow scenario is similarly sound.

There is also the possibility of multiple expansion beyond the 10x due to performance, market greed, or even a positive economic cycle, adding to the potential.

Data by YCharts

Scenario 2 - Subpar Performance Lingers

The current status and what markets are valuing, at the moment, is the continuation of the same past performance. Costly acquisitions and failing management are expected. If this is to be the case, I found the loss limited since this scenario, at the end of the day, should still be able to provide roughly $1B in FCF, perhaps more in a favorable macro environment.

So, I would say, in a negative scenario, wait for the favorable cycle to exit while being paid close to a 4% dividend yield for the opportunity cost. This business is unlikely to go bankrupt soon.

Value Proposition (Westrock Investor Presentation)

Bottom Line

I believe WestRock offers a good risk/reward proposition.

• Heads - management delivers on the promises, margin, and returns improvements which expands multiples;
• Tails - the downside risk is limited by the sustainable dividend and strong free cash flow capabilities while waiting for advantageous industry conditions.

Investment companies tend to focus too hard on short-term market noise and uncertainty, leaving smaller investors with good risk/return possibilities.

Analyst’s 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.