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This article is part of our Rising Star Portfolios series.
Flowers may inevitably grow as spring comes -- but portfolios don't. That's why I keep a watchlist for my Rising Star portfolio. Today, I'm turning over the soil to examine two companies that appear to be putting up green shoots.
Smurfit-Stone (NYSE: SSCC )
After it recently accepted a buyout offer from packaging brethren Rock-Tenn (NYSE: RKT ) , why would I put this company on my watchlist? Frankly, I think that buyout offers a sweetheart deal. Rock-Tenn's bid ridiculously undervalues box manufacturer Smurfit-Stone's earnings power, which is somewhat obfuscated by a recent bankruptcy filing, cost savings that haven't yet flowed through to its income statement, and recently improved industry dynamics. Better yet, it's possible that shareholders could still get a better deal for their shares.
In recent years, the packaging industry has undergone significant consolidation, leaving 64% of market share in the hands of five players: Smurfit, International Paper (NYSE: IC ) , Georgia Pacific, Temple-Inland (NYSE: TIN ) , and Packaging Corporation of America (NYSE: PKG ) . Thanks to its dwindling number of competitors, the industry managed to pass two price increases last year. Even though a third attempted increase failed, I think these companies should be able to sustainably shift higher prices onto customers in the future.
By my estimates, Smurfit's run-rate cash generation (based on fourth-quarter earnings and anticipated cost savings) is $357 million. That makes the takeout price just 10 times cash flow, a price which essentially assumes Smurfit never grows.
With a buyout pending, how can shareholders possibly get a better valuation? A wickedly smart activist investor group, including Third Point and JANA, collectively owns about 14.5% of the shares, and it's making the case for a higher selling price. The transaction was expected to close in the second quarter, and Smurfit CEO Patrick Moore's employment contract was slated to end March 31. But the board recently extended his contract indefinitely, which leads me to speculate that it may be seeking renegotiations with its suitor.
If the transaction goes through as is, we'll get paid somewhere around today's price, give or take a little. The technical bits related to the deal's completion seem pretty safe: It recently passed antitrust muster, and the bond market's content to offer financing to just about any monkey in a suit these days.
But if Third Point and JANA successfully push for a higher price, my quick and dirty valuation work pegs the upside as high as $60. And if the transaction fails, and the shares plummet? Fools, back up the truck!
KAR Auction Services
Every so often, a terrific business gets inexplicably cheap. While KAR Auction Services (NYSE: KAR ) is cresting recent highs, it still looks like a bargain. KAR lets us buy a duopoly in its respective business lines for a mere 10 times my estimate of free cash flow.
The lion's share of KAR's business involves whole car auction services, which resell off-lease, repossessed, or commercial fleet cars, and salvaging, which scavenges the parts of those older cars for additional sales. Both of these businesses are mouth-wateringly good, possessing huge barriers to entry and sizable network effects.
As the owner of a 22% share of the auction market, KAR enjoys a sweet model. It's capital-light, and the value and efficiency of auction markets increases as the number of participants grows. Because two players, Manheim and KAR, dominate the market, KAR has been able to consistently post high margins and maintain stable market share.
Salvage is similar in nature: The more parts you sell, the more valuable the service becomes to prospective buyers such as insurers and junkyards. Scale players in the salvage market can employ information technology to remarkable advantage, buying parts (and cars) at the right price in light of industry conditions, matching parts to insurers' needs, and passing some of the savings on to customers. Consequently, market share remains fairly stable. Here, again, KAR possesses only one significant competitor, Copart (NYSE: CPRT ) : KAR owns 35% of the market, and collectively, the two own almost three-quarters of the market.
Only a lack of car sales has kept KAR cheap.The fall-off in domestic car sales, a vestige of the great recession, has resulted in lower wholesale car volumes as prospective new car buyers hold onto their vehicles. That trend just can't last forever. As the population grows and people replace older vehicles, auction volumes should pick up. KAR's profits should follow, since its business carries very little in the way of incremental costs. Longer-term, I'd expect growth in KAR's business volumes to roughly approximate the rate of growth in new car sales.
Right now, the market holds no such expectations. That's why I'm so interested.
Add Smurfit-Stone and KAR to your Fool watchlist, and keep your eyes peeled. One of these stocks just might end up in my Rising Star portfolio. Come talk to me about it on my discussion board.