Trade of the Day: Packaging Corp. of America (PKG)

Think outside the box with this packaging stock

   

Trade of the Day: Packaging Corp. of America (PKG)

The paper and packaging business has been in a state of flux for several years now. Unfortunately for the major stocks in this segment, a shift towards electronic records, e-commerce and lower protections from imports has all contributed to a decline of 17% in output from 2002 through 2012. Over the last year, industry experts estimate that the decline has leveled a little, but growth remains elusive.

Because of contraction in the industry, gains have mostly been made through improvements in efficiency and consolidation. For example, the top and bottom line numbers for Packaging Corp. of America (PKG) look good but only because they acquired their competitor, Boise, Inc. for $2 billion in 2013. So far, that merger seems to have accomplished its primary objectives, but organic growth is going to be much more difficult.

Consolidations (mergers, acquisitions, etc.) in a shrinking industry can be good and bad for stocks. In this case, we think the bad outweighs the good in the short term and should send PKG’s stock back down as the lack of growth dampens investor expectations for future performance. This stock looks cheap on the surface but in reality it is getting much more expensive.

Cash flow is king in a mature industry

Because packaging and paper is a very mature industry without a lot of growth potential, cash flow is the most important metric for investors. Growing free-cash-flow means greater returns to shareholders through dividends regardless of stagnant growth. This is where we hit a little bit of a snag with PKG. The company’s ratio of free-cash-flow to cash-flow-from-operations hit a multi-year high in 2012 but has now plateaued and begun to ease off.

Over the last few years, PKG has been able to successfully use efficiency and acquisitions to drive free-cash-flow and the stock has been rewarded with a 700% increase in price since 2009. However, if you compare price-performance with a 266% increase in the dividend, a 183% increase in EPS and a massive jump in interest expense (to fund the acquisition), then the gains seem disproportional.

Clearly, this isn’t a company that is going out of business or anything, but has the quest for yield over the last few years inflated the stock’s price? We think so and, if the technicals complete an emerging ‘double-top’ pattern, it could be an interesting short opportunity.

The move towards consolidation has been good for the companies doing the acquiring, but it has also exposed these firms to new risks. For example, prior to 2013, two of PKG’s largest customers were Office Depot (ODP) and OfficeMax. A concentrated customer base is always a risk but when your largest customers begin to merge with each other as well, that risk is compounded.

The obvious risk for PKG is that 9% of its sales comes from ODP – the unprofitable merged company with shrinking sales and rising debt (due to the acquisition). Investors also have to consider another one of “Porter’s 5-Forces” when evaluating growth prospects for stocks – the bargaining power of customers. A smaller customer base means that customers have a stronger bargaining position and that increases the risk to PKG’s future free-cash-flow.

Stop blaming the weather

In the short term PKG has joined the crowd by blaming their first quarter’s performance on “the weather”, however, we think they have made a tactical error by doing that. Investors will now be expecting the company to pick up its performance over the second quarter while the company has a significant portion of its production capacity down for maintenance and improvement.

Investor sentiment is a curious thing when it comes to stocks. On the one hand, everyone knows that PKG’s performance in the second quarter is probably going to look like the first quarter because production will be down for capital improvements. On the other hand, investors aren’t rational and sometimes the headline numbers take on a life of their own despite the underlying truth.

From a technical perspective, we don’t recommend immediate action on the stock. If our analysis is accurate then we would expect the price to drop below short term support at $65, which completes a slightly uneven double-top pattern. Volume levels have been dropping as the stock has consolidated, which adds more weight to that forecast. Our target is set at a point equal to 100% of the depth of the double-top below the breakout point at $55 per share. This is roughly equal to the bullish gap in September 2013 and a likely support level.

stocks PKG Trade of the Day: Packaging Corp. of America (PKG)

Conclusion

Our bearish stance on PKG is conditional on a breakout below $65 per share. We believe the breakout is likely due to flattened free-cash-flow growth, concentrated risk within their customer base and shifting investor sentiment. The stock appears to have run ahead of its justifiable valuation and is likely to correct despite recent improvements in the retail sector.

John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today.

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Article printed from InvestorPlace Media, http://investorplace.com/2014/07/trade-day-packaging-corp-america-pkg/.

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