Here's My Top Stock to Buy in August

In the opening days of August, paper and packaging leader WestRock (WRK 0.88%) announced fiscal third-quarter 2018 results. The business delivered double-digit revenue and segment EBITDA growth compared to the prior year, beat Wall Street expectations for adjusted EPS, and generated $772 million in operating cash flow. And yet shares sank 3%.

Despite having some of the best tailwinds in over a decade, Wall Street thinks the American paper industry will suffer from the escalating trade spat between the United States and China. While the fear isn't entirely unfounded, investors who dig deeper into the business and industry could come to the conclusion that the reaction has been a bit overdone. In fact, increasing momentum and a big acquisition suggest that WestRock stock's 11% year-to-date slide could be a great opportunity for long-term investors. Here's why it's my top stock to buy in August.

Image source: Getty Images.

China is driving growth, not stopping it

Originally, Wall Street wasn't so concerned that China would place tariffs on American paper products -- comprising raw fibers, recycled fibers, and finished paper products. That's because China relies on recycled paper and recycled fiber imports for up to two-thirds of all inputs for its domestic paper industry. Since the planet doesn't have enough spare pulp capacity for the country to divert its supply chains, there simply isn't an alternative. 

Wall Street was instead worried that the trade war would have a secondary impact on the paper industry: Reduced shipments of, say, food products from the United States to China will reduce the need for paper packaging at the source. While that wasn't reflected in financial results from around the industry in the second quarter of 2018, on Aug. 6 China did the unthinkable and slapped tariffs on recycled pulp and finished cardboard products imported from the United States. However, it's difficult to imagine the country will be able to win the blinking contest with Uncle Sam on this one.

In 2017 China's central government dramatically reduced recycled material and scrap import volumes over concerns of smuggling and quality. The decision cut recycled fiber import volumes, forced the country's paper machine fleet to run well below nameplate capacity, and forced the country to import record volumes of corrugated packaging (read: finished cardboard products) from the United States. But considering there aren't alternative sources of supply for fiber, recycled paper, or finished cardboard, China's trade bans will probably inflict more harm on its own industry than that of North America.

Additionally, given the limited global supply -- and the fact that total global demand isn't changing -- it's possible that China's trade policies will keep prices for corrugated packaging at healthy levels. Consider the performance of WestRock's two main business segments through the nine months ended June 30:

Source: SEC filing.

When coupled with trends such as online shopping -- which was driving industry demand to new heights even before trade policy became a factor -- China's ban on imported recycled pulp sent prices and demand for corrugated packaging to record highs. Meanwhile, after a slow start to the year, the consumer packaging segment saw operating income margin recover in fiscal third-quarter 2018 to top 7%, the best performance of the fiscal year.

If the trade war between China and the United States is escalating, then it doesn't appear to be having an effect on WestRock. In fact, the long-term trends look pretty favorable, trade war or not.

Image source: Getty Images.

Overlooked long-term growth

WestRock has leaned on higher selling prices, improved product mix, and an upgraded manufacturing fleet to drive the growth of its business in the last year, and it doesn't seem Wall Street is giving credit where it's due.

Source: SEC filing.

While some of the year-over-year improvement in operating income can be attributed to restructuring and other one-time charges taken in fiscal 2017, WestRock appears to be firmly on the other side of the post-merger integration. In fact, the business achieved its goal of over $1 billion in annual synergies three months ahead of schedule. Considering nearly two-thirds of the synergy and performance improvements achieved have been derived from increased productivity and procurement advantages, the best could be yet to come for shareholders.

That's especially true considering WestRock pulled the trigger on another huge acquisition in January 2018, agreeing to gobble up KapStone, North America's fifth-largest containerboard (read: cardboard) producer, for a cool $4.9 billion. Management believes the acquisition price will fall under 7 times EBITDA after accounting for expected synergies, which would be below that of WestRock or peer International Paper (IP 0.31%).

Perhaps more important for investors is that the acquisition of KapStone will boost annual sales by $3.2 billion and shift the business toward the higher-margin corrugated packaging markets. The combined company will generate 63% of its nearly $20 billion in annual sales from corrugated packaging, compared to just 55% today. That's roughly in line with International Paper's 69% dependence on those markets.

While both paper stocks have suffered in 2018, there's a strong case to be made that the smaller peer is being overlooked by investors.

Source: Yahoo! Finance.

Smaller peer WestRock boasts advantages on a handful of key valuation metrics, and that's before the margin-boosting acquisition of KapStone takes effect. Plus, with management expecting to grow adjusted EBITDA from $2.9 billion in fiscal 2018 to more than $4 billion in 2022, the company clearly doesn't think recent operational strength is going to dissipate anytime soon.

Image source: Getty Images.

This paper stock is a long-term buy

Wall Street has sent shares of leading paper and packaging stocks lower in 2018 over concerns that the trade war between the United States and China will have a secondary impact on the industry. While that could still materialize down the road, results from the leading businesses to date sure don't hint that it's a major concern for shareholders.

In fact, other trade flows between the two countries appear to be having a more powerful effect on the industry, and WestRock specifically, driving high-margin business expansion. Considering the company has used size to its advantage (and just made another big acquisition) and remains well-positioned to capitalize on trends within the markets it serves, long-term investors should consider the sliding share price a great opportunity.