By and large, it's hard to get excited about owning paper and paper packaging stocks for the long term. A few strong operational stories such as Rock-Tenn (NYSE:RKT) and Packaging Corp (NYSE:PKG) have outperformed, but by and large this is an industry with very modest revenue growth and highly variable input costs. All of that said, I think investors should take a closer look at Graphic Packaging (NYSE:GPK). Not only has the company made good progress with operating efficiencies, it is also a long-term deleveraging and diversification story.
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The Company, in Brief
When shoppers pick up a box of cereal, a frozen pizza or a case of beer, there's a decent chance that Graphic Packaging made the package they're picking up. Graphic Packaging holds about one-third of the market for folding cartons in the food/beverage category and boasts major customers such as PepsiCo (NYSE:PEP), Kellogg (NYSE:K) and General Mills (NYSE:GIS). The company also has fairly sizable share in multi-wall bags (again, largely for the food/beverage and consumer goods space).
While MeadWestvaco (NYSE:MWV) is another major producer of coated unbleached kraft (CUK) paperboard, the company holds less share of the folding carton market. Likewise, while Rock-Tenn is a major competitor in coated recycled board (CRB), the company is less focused on the folding carton market than Graphic Packaging.
Graphic Packaging needs a pretty hefty amount of old corrugated containers (OCC) to keep its mills running, and variable input costs are an industry-wide issue. This company has cost pass-through contracts on a sizable percentage of its cartons business, however, which transfers quite a bit of pricing risk on to its large multinational customers. That said, the company generates about 90% of its sales from North America, which means that it has very definite vulnerabilities to volume trends in food and beverage (and those trends haven't been great over the past year or two).
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What Can Change for the Better?
I see two primary avenues for Graphic Packaging to improve its revenue prospects. First, the company needs to expand beyond North America. Management seems to agree, as it has made two recent acquisitions of European carton businesses. While exposure to Europe may not seem like such a great thing today, the food and beverage business there still has respectable prospects.
I believe the company also needs to become more active in diversifying its business mix. The company has begun expanding into other product categories such as cartons for pasta and also recently won business from Kraft (Nasdaq:KRFT) for Capri-Sun multi-packs. Keep in mind, however, that companies such as Bemis (NYSE:BMS) and Aptar (NYSE:ATR) are also pushing in the other direction - trying to get customers to switch from cartons to films, pouches and other packaging alternatives.
Last and by no means least, Graphic Packaging can also be a multi-year deleveraging story. This company was basically built through a series of mergers and acquisitions (M&As), and the byproduct of the process has been a large slug of debt on the balance sheet. High debt levels are not exactly uncommon in this space, but with debt of about 146% of shareholder equity, using cash flow to reduce that debt burden could offer some upside to future earnings and free cash flow (FCF).
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The Bottom Line
While there's a sizable insider group holding Graphic Packaging shares, a recent secondary offering reduced their ownership from roughly two-thirds to one-half. I don't necessarily believe that these insiders are in any particular hurry to sell down their stake further, but I would not be surprised to see another secondary someday.
In the meantime, while overall industry volumes have been sluggish, Graphic Packaging has offset this with new product introductions. Over the long term, I believe Graphic Packaging could continue to outgrow the industry, but I will go with a more conservative long-term revenue growth estimate of about 2%. At the same time, the company has a better-than-average history with respect to free cash flow margins, and I believe it can continue that performance.
Accordingly, I believe Graphic Packaging could grow its free cash flow at a long-term rate of 3% to 6%. Assuming that the company can continue to work down its debt, that argues for a fair value around $7.50 to $8.50. That's not huge undervaluation relative to today's prices, but it's sufficient to at least make this a worthwhile stock to watch.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.