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This article is part of our Rising Star Portfolios series.
My brilliant, young self spent a great many hours pretending a very large box was a spaceship with my younger sisters. And make no mistake, that large box was actually a spaceship to us, despite outward appearances indicating otherwise. As the spaceship box, in the stock market, looks can be deceiving.
Just consider Rock-Tenn (NYSE: RKT ) , the second-largest box manufacturer in the U.S. Obscured earnings power at just-acquired Smurfit Stone, recently improved industry dynamics, and potentially lucrative acquisition synergies create an impressively cheap investment that any quick run of the numbers might lead you to pass up. To avoid making that mistake, I'm buying a position worth 4.5% of my Rising Star Portfolio's first-year capital.
Boxes (not bags) of money
Rock-Tenn makes its dollars manufacturing and selling boxes. At about $10 billion in annual sales, Rock-Tenn's cobbled together a box empire through a disciplined strategy of acquiring, integrating, and improving.
Boxes haven't always been great business. In 1997, the top five players owned 42% of capacity, and industry returns on equity languished in the high single digits. In the years since, industry participants undertook a disciplined, economically minded strategy: consolidating, removing excess capacity, and pricing to earn reasonable returns on equity.
Today, the top five players -- International Paper (NYSE: IP ) , Rock-Tenn, Georgia Pacific, Temple-Inland (NYSE: TIN ) , and Packaging Corporation of America (NYSE: PKG ) -- own 73% of domestic capacity and trailing-12-month returns on equity sit above 20%. This industry has gotten religion, as consolidation has permitted industry participants to pass price increases on to customers.
Boxes, a staple of -- well, just about any consumer good -- enjoy stable, ho-hum demand. Just over half of the containerboard industry's sales come from food and beverage companies, and historically, volumes have grown just about in line with GDP. Looking forward, I expect volumes to grow a touch slower than GDP, as U.S. manufacturing business moves abroad and U.S. consumption of imported goods grows.
Despite the containerboard business's seemingly improved fortunes, Rock-Tenn shares come cheap. By my measure, the market's missing three things:
- Improvements at Smurfit: Smurfit Stone, recently acquired by Rock-Tenn, sought Chapter 11 bankruptcy protection in 2009, and emerged in 2010. Prior to its bankruptcy and restructuring, Smurfit Stone was a bloated mess. The company was bleeding cash and strapped with debt, with facility costs exceeding industry averages. Smurfit used the bankruptcy process to reduce the number of facilities, cut costs, and slim down its debt profile.
The company emerged a much more profitable entity, but amid the vagaries of bankruptcy accounting and lack of financials for the newly leaner company, the market never gave its potential fair due. Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), as reported in the 10-K, clocked in at $592 million for the year ended Dec. 31, 2010. A quick glance at that figure belies the operational improvements undertaken during bankruptcy. On a conservative basis, I estimate that Smurfit can earn at least $800 million in EBITDA, and likely more.
Better yet, with Rock-Tenn's acquisition, the market continues to undervalue the potential in Smurfit's assets.
- A new box: As detailed above, the containerboard industry's undergone a dramatic transformation in recent years. After a string of price increases, selling prices are 10% higher than they were a year ago. The market continues to discount this potential, valuing Rock-Tenn at just 5.5 times my estimate of EV/EBITDA.
That figure effectively assumes that Rock-Tenn's cash flows will continuously decline. In my opinion, its recently improved industry dynamic, and growth prospects, warrant a much-higher valuation.
- Acquisition synergies: Though Smurfit's a big pill to swallow, Rock-Tenn is no stranger to the acquisition game. In Gulf States and Southern Container acquisitions, the company delivered synergies in excess of original expectations: $35 million vs. $23 million expected, and $26 million vs. 10 million expected.
With the Smurfit acquisition, management is targeting $150 million in synergies. My valuation gives little credit to this prospect, because I'm typically skeptical of these proclamations, and Smurfit's a large deal for Rock-Tenn. But if management's track record holds up, it should be able to deliver some fraction of the anticipated savings, if not more.
I estimate that Rock-Tenn can grow its top line at about 4.5%, with 3.5% from price increases and 1% volume growth. Recent industry consolidation, relatively inelastic demand for food and beverage products, and a modest recovery to the U.S. economy should help the company achieve that mark. I expect operating margins to reach 9%, which factors in price increases and $40 million in synergies from the Smurfit deal. By this measure, I peg the shares at $115 a stub.
The risks are fairly straightforward. First, manufacturing capacity may leave the U.S. at a higher-than-expected rate, slowing volume growth and creating slack capacity. I believe the shares' valuation adequately accounts for this risk, but it bears watching.
Second, beware Rock-Tenn management's proclivity for acquisitions. The management team has displayed a savvy eye for previous purchases integrations, but across a long enough time horizon, growing solely through acquisition is a loser's game. I'll be watching this, too.
The bottom line
A newly improved industry dynamic and understated earnings potential in the Smurfit acquisition create an investment that's more than meets the eye. I'll be investing 4.5% of my portfolio's first-year capital in Rock-Tenn, and I encourage you to join me on my discussion board to talk about it.