I often look for long-term themes. In the gold rush out in California, who made money? Those who went out mining for gold? Sure…a few people struck it rich. But who made the BIG money? People who sold blue jeans and shovels are the ones who made it rich from the gold rush. Shovels aren’t sexy, but everyone needs them to dig for gold. In that vein, I personally see the same thing going on with e-commerce today. Wal-Mart, Amazon, Wayfair, Target, local stores competing online, specialized vendors like Chewy, etc all need boxes.
Packaging Corporation of America (NYSE:PKG) is one of the best, large publicly traded companies in this industry. I found PKG through a stock screener, and I have previously looked into them before. However, I believe now is the opportune time to invest in PKG when their stock has sold off due to short-term headwinds and a negative outlook for the year with slightly declining volume.
PKG’s business is relatively simple. They make boxes and paper. PKG is the 3rd largest producer in this industry. PKG has a nice, diversified customer base, with ~18,000 customers in more than 36,000 locations and they service all kinds of industries from ecommerce to grocery stores. No customer accounts for more than 10% of sales. In their paper business, Office Depot (including OfficeMax with their merger) is ~50% of their business. The paper business is much smaller than the packaging business.
This business is profitable with about $7 billion in revenue and about $700 million in net income, giving PKG a net margin around 10%. For a capital intensive, manufacturing business, a 10% net margin is strong. In a lot of capital intensive businesses, sloppiness with costs can drive the net margin into the mid to low single digits (see table below). In 2018, the business had about $1.2 billion in cash flow from operations. Backing out the $629 million for capital expenditures, PKG has $551 million in free cash flow. One of the most attractive attributes about PKG is their consistent history of free cash flow, thus making this an easy business to model. PKG returns their money to shareholders well, with a 427% increase in their dividend since 2010. In 2010 total annual dividends per share were $0.60. As of their 2018 annual report, total dividends were $3.16/share. In terms of structure, all of these box manufacturers carry debt. PKG has a lot less debt than its competitors. PKG has about $2 billion in net debt while its large publicly traded competitors carry about $10 billion each.
PKG has 4 main competitors, two of which are public: International Paper (NYSE:IP), WestRock Company (NYSE:WRK), Georgia-Pacific (private), and Pratt Industries (private). The table below shows that IP and WRK do not look nearly as strong as PKG in terms of their debt load, FCF growth rate, or net margin.
|Ticker||Mkt Cap||EV||FCF Yld%||FCF Growth % (yr)||Net Margin|
The key to a manufacturing business lies in cost controls and in capital expenditures. A manufacturing business is naturally going to spend a lot of money every year to keep up on its Property, Plant, & Equipment (PP&E). In their annual report for 2018 (published in early 2019), the company stated they expected capital expenditures to be approximately $390 million to $410 million in 2019. PKG’s 3rd quarter 10-Q shows that from January 1, 2019 to September 30, 2019, the company has only spent $263.8 million on capital expenditures. This means that their free cash flow from the first 9 months of 2019 was $614.4 million vs. $430.2 million for the 1st 9 months of 2018. Recently on their conference call they stated they expected capex to be about $500 million in 2020.
PKG is nice because they are steady and produce free cash flow consistently. This makes them a nice candidate to do discounted cash flow (DCF) analysis. With free cash flow around $700 million and FCF growth of about 12% per year (half of the average FCF growth over the past 10 years), and a 10% discount rate, PKG could be 50% undervalued from current prices.