There's a saying out there (from Warren Buffett, I believe) that goes something like "whenever a great management team and a lousy industry come together, it's the industry that maintains its reputation." That warning would seem to apply to Rock-Tenn (NYSE:RKT) these days as although the company's stock has done reasonably well, management continues to struggle to deliver on the potential synergies and operational improvements at the former Smurfit-Stone assets.

The crux of the Rock-Tenn argument is pretty simple. If Rock-Tenn can do with Smurfit-Stone's corrugated packaging assets what it did previously with its own paperboard/containerboard assets, this will be a large and profitable company. If Rock-Tenn cannot lift up those Smurfit-Stone assets, then the company will languish from a value-destroying deal that levered the balance sheet and saddled it with lesser assets.

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Recent Results Show a Lot of Volatility
Rock-Tenn has become an "interesting" stock around earnings time, as investors have run hot and cold on the company's ability to drive better results. In fact, there's been a good quarter/bad quarter pattern ever since the deal for Smurfit-Stone closed that has seen the company swing between beats and misses with little warning.

The issue has been, is and continues to be whether the company can realize the multi-hundred million dollars of potential synergies and cost/margin improvements at Smurfit-Stone. So far, the progress has been disappointing and Rock-Tenn has responded with sweeping management changes at several plants (in addition to ongoing plant closures/consolidations and infrastructure improvements).

This is no trivial question. Not only did Rock-Tenn pay about $3.5 billion for these assets, but corrugated materials now make up about two-thirds of the company's revenue base - making the company's former containerboard operations (which were very well-run) a secondary operation.

SEE: Biggest Merger and Acquisition Disasters

Industry Dynamics Favorable ... for Now
By and large, paper packaging companies are looking at what should be favorable operating conditions. Price hikes in containerboard and cartonboard seem to have stuck, and while fiber prices seem to be moving up a bit, the scale of the increase hasn't been bad. What's more, energy prices are pretty benign, and Rock-Tenn certainly benefits if natural gas prices stay low.

Demand should also be stable to up. Most packaged food companies are seeing volumes stabilize and are allocating more resources to promotional activities. That should help Rock-Tenn's carton and point-of-purchase display business, as well as the corrugated operations. That said, paper packaging producers like International Paper (NYSE:IP), Rock-Tenn and Packaging Corp (NYSE:PKG) generally see their demand tied to economic activity, so there isn't likely to be a huge tailwind for demand. Likewise, Rock-Tenn isn't as leveraged to new product introductions as a smaller company like Graphic Packaging (NYSE:GPK).

I don't think investors can afford to rest completely easy, though. The industry as benefited from a lot of consolidation and capacity curtailment. While the big players have been uncommonly responsible about not bringing mothballed capacity back up at the first sign of better conditions, there is a risk that better industry operating conditions will become a "self-correcting" phenomenon.

SEE: The Industry Handbook

The Bottom Line
An investment in Rock-Tenn comes down to this - do you believe that Rock-Tenn's high-quality management can turn around those Smurfit-Stone assets and make this a much larger very well-run company, or are those Smurfit-Stone assets/operations of a quality such that they cannot be fixed or run well by even a good management team? While I don't mean to give short shrift to matters like input costs, underlying volume growth and so on, I do believe the company's ability to deliver real synergies and margin leverage from Smurfit-Stone is the key question.

Right now I believe that the company will be mostly successful in that regard, but that the Smurfit-Stone assets will never be fully as good as the company's prior containerboard operations. To that end, I see mid-single digit revenue growth and gradual free cash flow margin improvement from the low/mid-single digits into the high single digits over time. That works out to an eye-popping growth rate in the 20% range (off of a low base), but a fair value after debt in the low $80s - making Rock-Tenn a good hold and a potential watch list candidate, but not a very compelling buy today.

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

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