WestRock Company is a paper and corrugated products manufacturer. The company has aggressively expanded through M&A as a means of driving growth.
The stock's large dividend makes it a strong income play, and the 50% cash payout ratio means that the payout is well funded.
We don't like buying cyclical stocks during sector/economic uptrends. With the stock poised to finish 2019 at 52-week highs, shares are not attractive at this time.
Dividend growth investing is a popular and largely successful approach to generating wealth over long periods of time. We will be spotlighting numerous dividend up-and-comers to identify the best "dividend growth stocks of tomorrow." Today we look at the packaging industry through WestRock Company (WRK). The company is a large player in the paper and corrugated products sector. The stock offers strong dividend yield, and the company has utilized M&A to grow larger over time. However, there are some red flags to consider. The packaging sector is cyclical in nature, and the company has occasionally diluted shareholders by issuing equity to help fund M&A deals. While we like WestRock under the right circumstances, that time is not now. We will be waiting for a downturn in the sector before further considering WestRock Company.
WestRock manufactures and sells a variety of paper and corrugated packaging products across the world. The company is based in Atlanta, GA, but has more than 300 operations facilities. The end markets that WestRock sells into are almost endless. The company generates roughly two thirds of its $19 billion in annual sales from corrugated packaging. The other third is derived from sales of consumer packaging products.
WestRock Company has seen strong growth over much of the past 10 years. Revenues have grown at a CAGR of 20.59%, while EBITDA has grown at a 17.84% rate over the same time frame. This has largely been driven by M&A activity (which we will detail later on).
To better understand WestRock's operational strengths and weaknesses, we will look at a number of key metrics.
We review operating margins to make sure that WestRock Company is consistently profitable. We also want to invest in companies with strong cash flow streams, so we look at the conversion rate of revenue to free cash flow. Lastly, we want to see that management is effectively deploying the company's financial resources, so we review the cash rate of return on invested capital (CROCI). We will do all of these using three benchmarks:
We see a mixed picture when we look at operations. On one hand, the company fails to meet a number of our metric benchmarks. The company's operating margin has been volatile over the years. Additionally, it is only realizing 5.15% FCF conversion and a 4.46% return on invested capital. However, there is some needed context that adds some positive elements to the data. Capital expenditures have skyrocketed over time. The company is investing into a few key facilities including its Mahrt Mill, Porto Feliz plant, and Florence Mill. These investments total approximately $1 billion with this year having been the largest ($525 million invested). The investments will draw down moving forward and should generate $240 million in additional annual EBITDA.
This should lead to an improvement in FCF conversion, as well as CROCI where high CAPEX levels can influence the metric. We have also seen operating margin expand for the past couple of years (the company has been active in M&A, so we are looking for cost synergies). Overall, we will need to revisit these metrics periodically to make sure that operating metrics continue to improve.
In addition to operating metrics, it's important for any company to responsibly manage its balance sheet. A company that takes on too much debt can not only create a squeeze on cash flow streams, but also expose investors to risk should the company experience an unexpected downturn.
While we find the balance sheet to be lacking in cash (just $151 million against $10 billion in total debt), WestRock's leverage ratio of 2.4X EBITDA is manageable. We typically use a 2.5X ratio as a cautionary threshold. The debt load recently increased as a result of a large $4.9 billion merger with KapStone Paper and Packaging, so we expect management to pay down this debt in the coming years.
WestRock Company has established itself as a solid dividend growth stock, raising its payout each of the past 11 years. The company's streak means that the dividend managed to continue growing through the recession. The dividend today totals $1.86 per share and yields 4.35% on the current stock price. This is a strong yield compared to the 1.90% offered by 10-year US Treasuries.
What investors need to look out for with WestRock over the long term is how the company's (sometimes) volatile nature impacts its dividend growth. Not only does WestRock operate in a cyclical sector, but also the company is not shy about blockbuster M&A deals that can indirectly influence the dividend. At times the dividend will grow by leaps and bounds - sometimes, hardly at all. The most recent increase was a token penny increase for 2.2%. However, the company has grown its payout considerably over time. While the dividend may grow unevenly, the current payout ratio of just under 50% does leave enough room that investors should feel pretty good about the safety of the payout. We don't foresee a dividend cut happening without a somewhat apocalyptic scenario forming.
Investors need to also consider that management has a record of dipping into equity to help fund larger mergers. Shareholders have been diluted twice in the past decade, and buybacks really aren't a priority for management. The equity offerings have notably hampered EPS growth for investors.
WestRock Company's growth trajectory will slow down (you won't see multi-billion mergers every year), but there are both secular tailwinds and company specific levers that WestRock can utilize in the coming years. WestRock and its peers will continue to benefit from a general increase in demand for packaging. Not only are populations continually growing and economies in developing nations expanding, but also the continued growth of e-commerce has created increased need for shipping materials. In the US, the demand for packaging solutions is expected to grow at a CAGR of 4.1% through 2024. These macroeconomic tailwinds mean more need for food packaging, shipping boxes, and machines to increase the capacity that companies have to ship more products. In addition, paper-based products could have the opportunity to take share away from plastic products as political pressure grows for the reduction of plastic waste.
Specific to WestRock, the company continues to digest its merger with KapStone. The company will realize more than $200 million in synergies by 2021, and in a number of areas (see chart below). WestRock has an established record of pursuing M&A, and we expect this to continue over the long term. While not every deal will be a blockbuster, there are cost and market positioning benefits for a manufacturer to continue scaling larger. This alone will be motivation to consistently seek growth through M&A.
Volatility will be the major threat that investors need to remain aware of over a long holding period. The packaging industry is cyclical, and economically sensitive. The business will see operational pressure during a recession, and WestRock's tendency to pursue M&A will potentially expose investors to additional risk of dilution should management use equity to help pay for deals.
Shares of WestRock Company have come on strong to end the year. The current share price of almost $43 is at the high end of its 52-week range ($31-43).
Analysts are currently projecting full-year EPS at approximately $3.37. The resulting earnings multiple of 12.67X is a slight 6% premium to the stock's 10-year median PE ratio of 11.9X.
To gain additional perspective on valuation, we will look at the stock through a FCF based lens. The stock's current FCF yield of 8.54% is well off of multi-year highs, but still towards the higher end of its range. This is more impressive when you consider the recent surge in CAPEX, which suppresses FCF (and thus pushes FCF yield artificially lower).
Our main concern with WestRock Company's valuation is the fact that it's a cyclical stock in what is arguably the tail end of an economic uptrend. As the case with many cyclical stocks, we would avoid the stock until the sector turns over, and pressured operating metrics provide a better opportunity to acquire shares.
WestRock Company is a large player in the packaging sector - a "vanilla" space, but one that has growth properties via environmental agendas and increased shipping volumes. The stock is a great income play for investors, and the company's operating metrics should improve as KapStone synergies are realized. However, the company's cyclical properties mean that better opportunities to own the stock are likely to present themselves to patient investors. We recommend waiting for macroeconomic pressures to push the stock off of 52-week highs.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Post time: Jan-06-2020