2023-05-15 11:04:05 ET
Summary
- WestRock's total return to shareholders has been very disappointing ever since the company's formation in 2015 following the merger of MeadWestvaco and Rock Tenn.
- WestRock has pitched a transformation story to investors under the leadership of David B. Sewell, the former CEO of Sherwin-Williams.
- Given the excellent performance of one of WestRock's industry peers over the last decade, the turnaround story has no justification to fail.
- WestRock's strong free cash flow and newly found focus on improving the return on invested capital are a solid foundation for attractive shareholder returns in the decade ahead.
Boring And Predictable
One of the hot topics over the last few months has been ChatGPT, and if we go back to the immediate post-pandemic, the overarching idea that is believed to be the foundation upon which the future is going to be built is the exponential growth of technology and, more specifically, AI. All I can say given my level of expertise - very little - is that that's probably true. However, this same level of expertise does not allow me to predict who the winners of this race will be, nor how I can capitalize on the trend, at least in the immediate future. So, I turn to something I can predict: regardless of where AI is taking us, physical stuff will be around and pretty much all that physical stuff comes in some sort of cardboard packaging or box. And because a good fraction of these goods' demand is not all that cyclical, AI will not threaten these containerboard businesses. The question is: can we find one of these businesses cheap enough to guarantee an above-market return over the long run? The major players in this space are WestRock (WRK), International Paper (IP), and Packaging Corporation of America (PKG). I own PKG, but the underperformance of WRK year-to-date made me wonder if I should bet a few more chips on this industry.
Down 22% Year-To-Date - What Gives?
We should keep in mind that the stock price is the market's guess on a company's value based on what investors are willing to pay. Since PKG is up 2.6% since January, the market sentiment is clearly very unfavorable for WRK in particular (Figure 1). Investors seem to have an equally high degree of skepticism about IP, down about 10%. Although there might be short-term reasons for such contrasting performance, if we zoom out 10 years, we can see that one out of these three companies stands out, and that is PKG with a respectable 165% price return (Figure 2). Therefore, rather than trying to explain short-term performance, which I think is rarely relevant, we should look for underlying structural reasons that have kept WRK from returning value to shareholders.
The Housewife Indicator
A former Portuguese Minister of the Treasury and later financial commentator used to say he would rather have a housewife in charge of the treasury than the officially elected politician. I think that likely applies to companies' management. The point is, certain things are simple and obvious enough for any sensible person to understand. If a company pays 10% for capital and only generates 8% from its investments, at some point the proverbial shit will hit the fan. I think of Return On Invested Capital ((ROIC)) as the housewife indicator. It is one of the metrics I first look up when considering an investment. I believe ROIC has been one of the pitfalls for WRK. Over the last five years, the company's ROIC has been consistently below its Weighted Average Cost of Capital ((WACC)). WestRock has been destroying value, essentially eating itself as it continued doing business. One could suspect this might be due to industry-related factors, but that is not the case since PKG has consistently returned 4 to 10% above its cost of capital (Figure 3). We should keep in mind that PKG's sales are less than half those of WRK's. No wonder the market has raised its eyebrow at WRK while rewarding PKG. The market can often misprice equities temporarily, but over the long run, it does effectively identify the good and bad performers with accuracy. WestRock's negative total return of 47% over the last five years is no accident.
Growth - Muscle or Fat?
I believe we can see a hint of less-than-optimal capital allocation in WRK's acquisitions. Since the formation of WestRock in 2015, following the merger of MeadWestvaco and Rock Tenn, the company has spent about $4.8 Billion in acquisitions. Although this has led to revenue growth of about 5.9% per year, Free Cash Flow ((FCF)) has only grown at a rate of about 3.8%. How should we interpret these numbers? Well, in the same period, PKG has made $987 Million worth of acquisitions, grown revenue at a comparable 5.3% and FCF at 5.9%, while keeping debt under 2x EBITDA. With acquisitions one-fourth the value of those made by WRK, PKG definitely got more bang for the buck while keeping a healthier leverage level.
To add a bit more color to WRK's acquisitions, with the Q2 2023 earnings, we have learned that WRK wrote down about $1.9 Billion in goodwill, roughly 40% of the $4.8 Billion spent in the acquisitions I just mentioned. This adds to $1.3 Billion in 2020, bringing the impairment to 66% of the acquisitions' cost. This is sort of an admission that the company paid more than it should have. While this clean-up is positive and welcome, it does add more context to the stock's poor performance over the last 5 years. Hopefully, they are now committing to burning the fat and working up the muscle. And there is indeed some muscle! Free cash flow in the last five years has been a cool $1.1 Billion/year on average, or a yield of around 10%, which is not that easy to find in the market (Figure 4). If WRK is able to improve ROIC to levels similar to those of PKG, I believe there is serious potential in the stock.
The Box Is Filling Up
Should investors believe WRK can perform better going forward? Someone who invested in the company 10 years ago will reasonably be reluctant to believe so, but I think there is a ray of hope, and my case rests on the housewife indicator. The company seems to now be aware of it and make it a priority. Yes, that means ROIC was either an unknown thing before, or somehow purposefully ignored. We all know that investor presentations are the dressed-up pitch to investors, but even with that in mind, it is interesting to know that ROIC did not make its appearance in the investor presentations before Q4 2021. What changed? To start with, the CEO did. David B. Sewell, the former CEO of Sherwin-Williams (SHW) became the new head of the company. In his own words, from the recent earnings conference call, this is how he worded WRK's priorities:
"And finally, to drive strong cash flows to invest in growth, optimize our footprint, and improve our return on invested capital , we are focused on returning leverage to our targeted range of 1.75 times to 2.25 times..."
And knowing where the new CEO is coming from, we can have a glimpse of how Sherwin-Williams performed under his leadership. Sherwin-Williams' total returns since 2014, the year David Sewell became CEO, are 330% compared to WRK's -22% (Figure 5).
Can or will he walk the talk with WRK? He seems to be doing so already. In the recent earnings conference call, he highlighted:
- Focus on markets/segments with the most growth potential and exit those that do not meet WRK's return threshold
- Closing inefficient plants
- Targeting promising markets and geographies with the acquisition of the remaining stake in Grupo Gondi in Mexico
- Reduction of exposure to external paper sales to improve vertical integration and reduce earnings volatility
- Cost-cutting on SG&A
Combined, WRK expects all these initiatives to lead to $1 Billion in savings by 2025. If they hit this target, an impact on the company's performance should be felt.
The ingredients for success are there. Revenue? They are the market leader in essentially an oligopoly. All the players in the sector should be able to perform somewhat similar in terms of revenue growth. Free cash flow? It has always been there but it can definitely grow. With a 10-year average FCF margin of 6.4%, if efficiency improves and they achieve a margin comparable to PKG at 8.3%, the value returned to shareholders should see a boost. Leverage? It's under 3x EBITDA already and the target is 1.75 to 2.25 times, therefore also on the right track. Shareholder dilution? No. No strong buybacks either, and the priority should not be there anyway until everything else improves. If the company's performance improves, and if the market does not recognize it, then, share repurchases should happen. To sum it up, the box is half full with the right stuff but the remaining half is basically hope at this point.
Haggling With The Market
Benjamin Graham's Mr. Market is always pitching deals to investors. Is the current deal on WRK a good one? Although this is the question each investor should answer on their own, my take on it is a cautious yes, and here are the conservative assumptions I made to reach that conclusion. I started with the low end of analysts' revenue estimates for 2023, $20.2 Billion. I assume 2% growth in the first 5 years, followed by 4% in the second half of my forecast period to 2031. This results in a revenue CAGR of about 3.11% over the entire period, which is below the current risk-free rate (Figure 6). I am essentially assuming the company is growing at the perpetual growth rate already. Mature, boring, just chugging along company, buy-and-forget type deal. Because I have no crystal ball and I am not a professional analyst, my approach is usually rather conservative where I try to minimize the potential downside. If the math still works out, it can only get better from there.
I arrive at my FCF estimates by applying a 15% EBITDA margin and a FCF to EBITDA conversion ratio of 45%, well within the 85% confidence interval calculated for the period between 2015 and the most recent quarter. Given the bad performance of WRK we have discussed above, I would hope this conversion ratio to be higher. If anything, consistent FCF is one of the things WRK has always had going for them. PKG's average EBITDA margin is 19%, so my assumption is not unrealistic. In fact, that's where it currently sits at, so I assume no improvement. I do apply a correction to FCF in years 2025 and 2028 based on the historical FCF standard deviation because I don't like perfect mathematical models. Life is not one. But because of the consistent nature of WRK's FCF, this correction is barely noticeable in Figure 6 above. To estimate the terminal value of the company, I use a hybrid approach where I average a perpetual growth model calculation with that of an exit FCF multiple (10.3 x). For the perpetual growth model, I assume a perpetual growth rate of 3% and a Return on Equity ((ROE)) of 8%, a slight improvement over the 6.61% five-year average. My terminal value represents 46.7% of the total value of the company 10 years from now. Under these assumptions, buying WRK stock at the current price will come with an internal rate of return of 9.4%. At this point, some will point out that this return is just "meh...", and I agree with that if those are indeed the numbers we see in the next 10 years. However, because I consider this forecast perhaps a little overly conservative, I can see the justification to start a position at this price.
As a full disclosure, to make the deal a bit sweeter for me, I have sold a put with a strike price of $25 and an expiration date of September 15, which will give me an entry point of $23.95/share. At this price, the IRR based on the same assumptions discussed above will grow from 9.4% to 10.2%. That is enough for me to make a small bet on WRK's transformation story. If the story finds a happy ending, I believe the return will be well above my estimate.
The Verdict
I believe WestRock's transformation story has legs to run. The right ingredients are all there. However, the ingredients have always been there and the stock's performance has been extremely disappointing nonetheless. For this reason, a healthy level of caution is more than justified. The new CEO and the company's newly found interest in highlighting the importance of ROIC is a ray of hope for those looking at the company with a fresh pair of eyes. As a PKG shareholder, I believe I have ownership of the best company in the industry and for that reason, I am in no rush to buy WRK. For those wanting a boring, predictable, and potentially well-run business yielding a healthy 10% on a FCF basis, I think the potential downside is more than digestible at this price point.
For further details see:
WestRock Company: A Transformation Story Worth Looking At