Packaging Corp. of America (NYSE:PKG) is set to release third-quarter 2018 earnings on Oct. 24 after the close of trading. Shares of the packaging manufacturer have slumped 28% year to date as investors have fretted over the company's ability to sustain profit margins. Let's preview Packaging Corp.'s earnings report to understand why investors are concerned and to see if the upcoming filing can initiate a rebound in the company's stock.

Cardboard box top.

Image source: Getty Images.

Breaking down earnings catalysts and obstacles

Packaging Corp. doesn't provide a wealth of detailed forward guidance. With each earnings report, management usually simply provides the next quarter's diluted GAAP earnings per share (EPS) estimate. The company has advised investors that it's targeting diluted EPS of $2.16 for the third quarter of 2018. This number represents an improvement of approximately 29% over third-quarter 2017 EPS of $1.68 and a slight advance over the $2.08 earned in the second quarter of 2018 (both periods are adjusted for one-time costs). 

The revenue side of the earnings equation shouldn't be a problem. Packaging Corp.'s top line is quite healthy -- in the first two quarters of 2018, total revenue advanced nearly 11% to $3.5 billion. A more serious obstacle to meeting or exceeding the EPS goal is a slate of rising costs, many of them external and thus outside management's control.

To understand the dynamics facing the business, it's helpful to review the forces that shaped the last sequential quarter's (Q2 2018) EPS. Packaging Corp. often provides a helpful breakdown of the various factors comprising the year-over-year change in EPS within its earnings filings. I've taken this data from the second quarter of 2018 and created a table that traces the period's $0.56 improvement over prior-year earnings:

Q2 2018 Factors EPS Impact
Packaging segment price and mix $0.47
Packaging segment volume $0.26
Paper segment price and mix $0.05
Lower wood and recycled fiber costs $0.07
Favorable tax rate $0.16
Higher operating costs ($0.24)
Higher freight expense ($0.09)
Conversion costs: Wallula No. 3 machine ($0.04)
Higher converting costs ($0.02)
Higher annual outage expenses ($0.01)
Higher depreciation ($0.02)
Other costs ($0.03)
Total EPS Impact $0.56

Data source: Packaging Corp. of America.

The first three lines reveal that price, mix, and volume in the packaging segment together contributed the bulk of the organization's revenue advance last quarter, with a more muted revenue contribution from the uncoated freesheet paper segment (which primarily consists of office paper sales).

In June, I discussed management's logical strategy of selling into the path of least resistance, more specifically, attempting to fulfill the current rapacious market demand for packaging materials versus paper. Such thinking informed management's decision last year to convert its No. 3 machine at its Wallula, Washington, mill from paper to linerboard. Packaging Corp. successfully completed the first phase of this conversion in Q2 2018.

Management has stated that it's continuing to run its containerboard machines "all out" to meet market demand for packaging. Corrugated products hit a company record last quarter -- box shipments increased 6.6% per equivalent workday against the prior-year quarter. Thus, we can expect that revenue momentum in the third quarter will continue to reside in packaging.

Returning to the table, after additional benefits in the form of lower wood and recycled material costs and the advantage of a lower tax rate from last year's U.S. tax legislation, we can see the various weights on earnings per share.

Chiefly, a rise in operating costs marked the biggest drag on last quarter's earnings. The company attributed this $0.24 headwind to inflationary pressures spread across several categories, including labor and benefits, repair, materials, environmental costs, professional services, equipment-related costs, and building rental costs. 

Freight costs have also ascended this year due to tight capacity in the truck market. A moderately expanding U.S. economy, a current driver shortage, and the effect of Congress's electronic logging device (ELD) mandate to regulate truck drivers' hours have all combined to push up shipping rates, and the trend shows little sign of abating.

Of course, shareholders should watch what the organization can control, such as mill operating costs, which Packaging Corp. generally lowered last quarter versus the prior year. Costs to run Wallula No. 3 are expected to drop now that the initial implementation is completed (final implementation consists of a new press section and headbox installation during the month of October, which will allow the machine to run at full capacity). 

Still, those pesky external costs have investors on guard, and they may end up roiling this week's earnings report. Management has indicated that it anticipates inflationary pressures to remain vis-a-vis freight, as well as wages stemming from a tighter labor market. Higher recycled-fiber prices are also expected to have a slightly negative impact on earnings. In sum, while vibrant revenue will likely overcome rising expense, Packaging Corp. may need to outpace its own EPS estimate handily to jolt its stock out of its current malaise.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.