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This article is part of our Rising Star Portfolios series.
When I purchased shares of Rock-Tenn (NYSE: RKT ) for my Rising Stars Portfolio last month, I saw a value trifecta: obscured earnings power at Smurfit Stone, recently emerged from bankruptcy; a market that wasn't giving proper due to recent consolidation among box-makers and according pricing strength; and potential synergies from Rock-Tenn's recent acquisition of Smurfit.
Cut to today: The shares are off 12%, amid the market's (justified) concerns over the state of the global economy.
To be clear, I don't take the risks of a Greek default lightly. Though recently passed austerity measures reduce the near-term risk, a Eurozone contagion could be outright disastrous. But my sense is that if the Europeans take some hard medicine and Greece proceeds with an orderly restructuring of its debt, the worst-case scenarios will be averted -- at least in the near-term.
Amid this, Rock-Tenn shares are trading at seven times my estimate of this year's cash flow. By my eye, that's stupid cheap, and equally important, affords some margin of safety against disruptions the macro-economy may lob our way. So I'm buying more, in an amount equal to 1.7% of my Rising Star Portfolio's first-year capital.
In the time since I first wrote, a few factors -- some obvious, and some not so much -- have come to light. For one, Greece is still in trouble (and the market is now really concerned, or was) and that could impact the economy. Also, International Paper (NYSE: IP ) wants to buy Temple-Inland (NYSE: TIN ) .
All of this economy talk is relevant because Rock-Tenn sells boxes. Because boxes are used to move consumer goods, Rock-Tenn is exposed to the economy at large. But the company's not as exposed to the economy as you'd think: The industry derives close to 60% of its sales from food, beverage, drugs, and household chemicals. Consumption of these goods is relatively inelastic. This, and today's price -- seven times cash flow, to reiterate -- makes the risk of a slowing seem a whole lot less dire.
That gets to the second matter related to the economy. Should it happen, a little bit of weakness, or concerns of surrounding it, might actually be good for Rock-Tenn. The containerboard industry's input costs are tied to commodities -- it produces boxes, after all. In the long run, I expect the industry's newfound pricing discipline to offset commodity cost pressures, but near-term, rising commodity costs will squeeze earnings.
The perception of economic weakness should culminate in lower commodity costs and higher earnings for Rock-Tenn. Absent a major dip to consumer sentiment, and consequential declines to product volumes, a tiny bit of fear is good news for near-term earnings. Yet again, that's a net positive for Rock-Tenn.
Now the last and most interesting element: International Paper's hostile bid for Temple-Inland. Temple duly, and quickly, rebuffed the offer. Though the deal would face antitrust hurdles, and Temple-Inland is likely to wage a mighty fight, the prospect of more consolidation bodes well for the industry. Fewer companies means more pricing power, and this deal would strengthen the industry's already strong hand. That's good news for Rock-Tenn.
Add it up
At seven times my estimate of this year's cash flow, Rock-Tenn shares are basically pricing a company in decline. Things may get ugly, but as it stands, the fundamental elements of my thesis remain unchanged. The shares have simply gotten cheaper. Join me on my discussion board to talk about it.