Containerboard and corrugated packaging is admittedly not the most exciting of market sectors, and it is most definitely a commodity market. But not all commodities are quite the same, and Packaging Corp (NYSE:PKG) has built a solid defensible niche by running low-cost mills and focusing on specialty products and regional customers that companies like International Paper (NYSE:IP) and Rock-Tenn (NYSE:RKT) do not. While Packaging Corp (aka "PCA") is rightly well-respected within the industry for its patient, conservative approach, it's worth wondering if there's enough growth here to really appeal to investors.

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Surprisingly Strong Second Quarter Results
At least by the standards of the paper and packaging sector, PCA had a surprisingly solid second quarter. While industry shipment trends have been pretty much flat, PCA reported a nearly 7% increase in shipments atop 5% production growth. Coupled with solid pricing, PCA saw revenue growth of over 7%, with organic growth in excess of 3%.

Margins were also quite solid. Gross margin improved more than a full point, helped by lower energy costs as well as lower prices for chemicals and recycled fibers. Management also kept a firm hand on expenses, resulting in operating income growth of about 23%.

SEE: Understanding The Income Statement

Good Times Never Last...but Neither Do Bad Times
It may be reasonable to argue that the present environment is not one where PCA really shines. Relative to IP, Rock-Tenn, KapStone (NYSE:KS) and the like, PCA runs very cost-efficient mills. So while low natural gas prices and lower chemical prices are a help, the benefits arguably don't show as strongly.

Pricing is always a key talking point here as well. While the company's focus on higher-margin specialty projects shelters it somewhat, industry pricing trends still matter a great deal. To that end, it will be interesting to see if a recent price hike from KapStone sticks and/or whether a Smurfit Kappa plant closure impacts export pricing.

Play the Hand or Risk Shuffling the Deck?
One of the problems with a stock like PCA for long-term investors is that there is just not that much underlying growth in the market. PCA is a pretty small player (so far, at least) on the global market, and the U.S. market for food/beverage packaging is not really a high-growth opportunity.

With IP and Rock-Tenn together holding over 50% of the market, maybe there's a deal to be done between PCA and Koch brothers' Georgia-Pacific. Honestly, I don't see much point in it. Management under Koch Industries has brought a lot of expense reduction and efficiency to GP, and while GP may well want to free up resources to dive deeper into building products ahead of a sector rebound, I don't see that PCA has enough to gain to balance out the debt and risk involved.

The trouble with running a differentiated niche business with low-cost plants is that large mergers don't necessarily bring much benefit to the table. I suspect that if PCA does anything, it will be to focus on buying up small operators that either lack scale to compete effectively or can bring in worthwhile accounts and/or product types.

SEE: Earning Forecasts: A Primer

The Bottom Line
I expect Packaging Corp's free cash flow to improve significantly now that major capex investments have been made, and for the free cash flow margin to return to the high single-digits (and perhaps very low double-digits in a few years). Unfortunately, even with these improvements there's not all that much value left in the shares. Both an EV/EBITDA model and a discounted cash flow analysis suggest fair value of between $30 and $34 - so while the company offers a good dividend and a well-run business, I don't see a real money-making opportunity in the stock over the short-term.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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