Packaging Corp Shows The Risk Of Underestimating Good Companies

By Stephen D. Simpson, CFA | October 17, 2012 AAA

It's well worth remembering that good companies have a way of surpassing expectations and delivering strong results. I should have remembered that lesson last quarter when it came to Packaging Corp of America (NYSE:PKG).

While I have long liked Packaging Corp (aka "PCA") as one of the best-run paper/packaging companies in the country, I didn't see much slack left in the valuation. Yet, not only has the company continued to see good expense leverage, but it has continued to gain share in the market, while enjoying strong industry-wide pricing. That propelled the stock up more than 20% over the past three months.

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A Very Modest Miss on Margins
It looks like PCA's third quarter results are a good news/bad news situation. On a straight reported basis, the company did miss the average estimate for the quarter (reporting 55 cents against a Street average of 56 cents). Keep in mind, though, that estimates kept moving up throughout the quarter (about 20% from the start of the quarter). Consequently, I think it's equally fair to say that analysts got ahead of themselves as it is to say that the company disappointed.

PCA saw revenue rise almost 8% this quarter, with production up about 3% and per-day shipments up nearly 6% (with half of that from acquisitions). Gross margin was solid, up about two points from last year and 30 basis points from the prior quarter. Operating income rose 29%, but the company did post a slight miss relative to sell-side margin expectations.

SEE: Understanding The Income Statement

Industry Pricing Staying Strong
I realize most investors don't pay much attention to the containerboard market; PCA and Rock-Tenn (NYSE:RKT) are relatively small companies and International Paper (NYSE:IP) is usually ignored as just another commodity company. That's unfortunate, because this industry has operated pretty effectively of late.

Many other types of paper are seeing sluggish (at best) pricing, and costs in containerboard have generally been under control. In spite of that, and ongoing efforts from food and beverage companies such as Kellogg (NYSE:K) and PepsiCo (NYSE:PEP) to control costs, the industry has done a good job of hiking prices and making those hikes stick - including a $50-per-ton hike in September.

Although PCA seems to have less per-share leverage to price hikes than IP or Rock-Tenn, it still benefits. What's more, PCA has a superior cost mix and a focus on specialty products and regional accounts. That local focus seems to be paying dividends, as the company continues to increase its shipments faster than the broader industry.

Valuation Vs. Momentum
Given that PCA's stock did so well over the past quarter, despite looking pretty fully valued in July, I'm reticent to say that the stock won't go higher. After all, that September price hike didn't make any real impact on September results and likely won't even be fully in place for the December quarter either. On the other hand, the restart of a Smurfit Kappa mill will increase supply, and I have to wonder if the industry really can maintain the discipline that has served it so well over the past year or two.

I still think PCA has the best margin structure in the industry and arguably the best prospects for growth (both organic and through small acquisitions). Rock-Tenn probably has more leverage to further price hikes (should they materialize) and Boise (NYSE:BZ) could have more to gain from improved execution and margins.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
The question, then, is whether the industry can push through additional price hikes and/or whether investors will transition away from cycle-average EBITDA multiples towards peak multiples. If Packaging Corp does see EBITDA multiple expansion, fair value could lie in the $40s, while mid-cycle multiples would point to a more modest target in the high $30s.

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

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