2023-09-18 05:16:12 ET
Summary
- Packaging Corporation of America's stock has stalled after a strong performance, prompting a review of its valuation.
- The company's earnings beat expectations despite a decline, thanks to better-than-expected performance during the downturn in demand for cardboard boxes.
- The trend of increased online retail sales and resilient consumer demand for goods is expected to support Packaging Corp.'s future performance.
- At a 16.5x P/E, the turn in the business is being priced in and shares have limited upside.
Shares of Packaging Corporation of America (PKG) have been a strong performer over the past year, but its stock has stalled out recently in the $150 area. Last October , I recommended investors buy PKG, but with shares up 33% since then, it is a good time to determine whether shares are now appropriately valued. I continue to view PKG as a well-run company with solid long-term fundamentals. However while it used to trade at a discounted valuation, it now appears fully valued and I view shares as merely a hold.
In the company’s second quarter , it earned $2.31 in adjusted EPS, which handily beat consensus of $1.92. Still, EPS was down from $3.23 last year. It may seem unusual for a stock to be near a 52-week high with earnings down over 25%, but there was significant concern about a decline in the demand for cardboard boxes, PKG’s primary business. While there has indeed been a decline, Packaging has weathered the downturn better than feared, helping to lift shares.
In the quarter, volumes were a $0.97 headwind with lower pricing a further $0.35 detractor Operating costs were $0.34 better, as uptime efficiency was running toward 99%. Indeed, this decline in operating costs is what the drove the quarterly beat as freight costs also have improved. Importantly, Management is seeing volumes improve in Q3 even as pricing remains soft. In July, bookings rose 15%
In recent quarters, customers have been working down inventories , which has weighed on volumes, but the trend is improving. As you can see below, in the wake of COVID, there was a surge in e-commerce’s retail sales penetration. With physical stores often closed, people shifted to ordering online. And of course, many of these online purchases are shipped in cardboard containers. With no one knowing how long this surge could last, there was a surge of orders for boxes as retailers added to their inventory, leading to a glut of boxes. With stores now open again, online penetration fell back from its COVID highs, though in recent months, it has started to tick back up.
This trend explains why we saw retailers focus on working down their inventory of boxes over the past year, reducing Packaging Corp’s earnings, but why that is now starting to abate. Structurally, it seems likely to me that online retail will continue to gain share over time. In fact, it is worth noting that on a dollar basis, e-commerce sales have continued to rise (note, though this is a nominal, not real series, so inflation is likely contributing to its ongoing rise).
One of the more remarkable things about our economy is how resilient consumer demand for goods has been. Goods demand surged in 2020 as consumers made home offices or did house projects, and a great rotation from goods to services was expected as the economy re-opened. Instead, goods demand has held steady at elevated levels, even after factoring in inflation.
With a resilient consumer and an inventory destocking cycle that is largely played out, the pressures that have been weighing on PKG's earnings should be peaking. Indeed, in Q3, management expects $1.88 in EPS as volumes broadly hold but it assumes that higher energy costs offset some of its operational cost improvement. Management tends to be conservative, and so I would expect earnings closer to $2.
It is also noteworthy that on September 12 , Smurfit Kappa (SMFTF) announced it would be acquiring WestRock (WRK), helping to consolidate the sector. I view this as a marginal positive for PKG and supportive of my view that results are bottoming. This is because Smurfit expects $400 million in synergies , partly from “portfolio optimization.” There is a good chance that cost-saving portfolio optimization is a PR-friendly way of guiding to plant closures and consolidation. Taking excess capacity out of the system will help to alleviate pricing pressures the industry has felt over the past year.
All in, this points to a business that has faced the worst of its headwinds. Alongside that, Packaging Corp has a fortress balance sheet. It has $580 million in cash and short-term investments, up $175 million this year. Against this, it carries a manageable $2.5 billion in debt. Having completed an upgrade cycle at its plants last year, cap-ex needs are much lower. After spending $824 million on cap-ex in 2022, it should run closer to $400 million this year and next. Lower cap-ex needs are supporting elevated free cash flow, which is $400 million year to date.
Shares also have a 3.32% dividend yield, which is very secure given the business’s strong cash flow and balance sheet. Finally, the share count is down over 4% over the past year due to share repurchases in H2 2022. While it has $478 million authorized, it has not made any purchases so far this year. This speaks to management’s conservative nature, which has served PKG well through economic cycles. With the business showing signs of troughing, I would expect buybacks to resume at a slow pace over the next year.
PKG is a premier operator in a business that enjoys secular tailwinds and is passing a cyclical downturn. It has managed through this well, taking out operating costs and building cash. This is why shares have been able to perform so well, even with earnings lower. With its $13.5 billion market cap, it has a 6% free cash flow yield. Assuming a stable pricing and volume environment at current levels, which I view as the base case, it should earn ~$9 in EPS for a forward P/E of 16.5x over the next year.
This is a fair valuation for a strong operator of what is fundamentally a commodity business. Given its management team and secular tailwinds, PKG is the type of company I have felt is quite suited for long-term investors. I do not see a catalyst or sufficient over-valuation to merit selling or shorting the stock. At the same time, with the cyclical turn fully priced in, the upside is limited to the dividend and modest share price appreciation.
That is why I rate Packaging Corp a hold from a buy previously. The upside has played out, and while there is no urgency to sell shares, I would look to invest new funds elsewhere. If shares were to move +/-10-15%, holding fundamentals constant, I would consider moving to a buy/sell, respectively. But for now, existing investors with a long-term horizon can continue to hold the stock, particularly if they have a large unrealized gain, and new investors should wait for a better opportunity.
For further details see:
Packaging Corporation of America: A Good Company At A Full Valuation