Shares of various paper and packaging companies tumbled on Monday following a slew of analyst downgrades driven by concerns over pricing. International Paper (NYSE:IP) was down about 10% shortly before the market closed on Monday, while smaller players Graphic Packaging Holding Co. (NYSE:GPK) and Packaging Corp of America (NYSE:PKG) were down 9.6% and 12.3% respectively. Earlier in the day, Graphic Packaging was down as much as 10.7%, while Packaging Corp of America bottomed out at a 13.1% loss.
What's going on?
International Paper and Packaging Corp of America were hit with downgrades, along with other companies in the same sector. Citi cut its rating for both companies to neutral, and its price target for International Paper stock dropped to $38, down from $45. Macquarie downgraded KapStone Paper & Packaging, while Bank of America cut its rating of WestRock. Both of those stocks also suffered heavy losses on Monday. Graphic Packaging didn't catch a major downgrade, but the stock slumped along with the rest of the sector.
The main concern cited by Citi relates to pricing. In January, kraftliner prices declined by 2.4% to $15 per ton, while corrugated medium prices fell 3.7% to $20 per ton, according to Citi. Given that these products are largely commodities, falling prices could signal that the sector is getting more competitive, which could lead to further price declines going forward.
This downgrade from Citi comes a little more than one month after the firm listed International Paper as a top value stock for 2016. International Paper's revenue has been essentially flat for the past decade, but the company has been generating substantial free cash flow over the past few years. In 2014, the company reported $1.7 billion of free cash flow, up from just $856 million in 2010. The company's operating margin over the past 12 months was 13.3%, well above the 3.3% operating margin the company managed in 2010.
Packaging Corp of America is also coming off of some highly profitable years, with an operating margin of 12% in 2014, compared with 7.6% in 2010. Over the past 12 months, Graphic Packaging has managed an operating margin of 10%, well above its 5.4% operating margin in 2010.
Citi pointed out that during previous periods of price declines, list prices fell in a "disorganized fashion" for months. With profitability for all three companies at high levels, falling prices could lead to margin erosion in the coming months.
Shares of International Paper, Packaging Corp of America, a Graphic Packaging have all slumped over the past year, even before the declines on Monday. For all three stocks, this decline was preceded by substantial multiyear gains, coinciding with increasing profitability.
When considering companies in cyclical, commodity industries, it's always important to understand that profitability can fluctuate from year to year. All three stocks look inexpensive based on forward earnings estimates, but those estimates will likely decline given the current pricing environment. Buying shares of a company based on peak earnings is a recipe for overpaying for the stock.
Predicting where paper and packaging prices will go in the coming months is next to impossible. Further price declines are possible, which could cause margins at all three companies to contract. The most optimistic scenario is that these price declines are a one-off, with prices stabilizing and margins remaining high.
While analyst upgrades and downgrades should always be taken with a grain of salt, the concerns that Citi and other firms have about International Paper, Packaging Corp of America, and the rest of the sector should not be ignored by investors looking for bargains.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.