MLPs: The Next Big Thing For Paper Stocks

Nothing could be more uninteresting than firms that make paper products. After all, toilet paper, cardboard boxes and fax paper aren’t something we really get excited about.

timber commodity stocksSeriously, when was the last time you “jumped for joy” when you bought a ream of fax paper? Exactly. And with that said, the shares of the various paper stocks aren’t very exciting either. They’re boring by nature — steadily churning out production from their mills and facilities.

However, the paper stocks may be getting a dash of high growth from using certain corporate tax structure typically found in the oil patch — master limited partnerships (MLPs).

Sector giant International Paper Co (NYSE:IP) has begun the first steps of formulizing plans to place some of their facilities inside an MLP. If successful, not only would it lead to some large tax-advantaged distributions, but some pretty hefty share gains as well.

For investors, the adoption of MLPs by the various paper stocks could be the growth element the boring sector needs to really get moving.

Paper Stocks: 100% Gains Possible

This isn’t the first time that the forestry sector has used “pass-through” corporate structures to enhance returns for investors. I’ve been a big long-term fan of the various timber real estate investment trusts (REITs) and there is one timber company — Pope Resources (NASDAQ:POPE) — that is structured as a MLP. However, this is the first time that paper producers have seriously toyed with the idea of placing various mills inside the tax structure.

The key for the paper stocks is just what kind of assets that can be placed inside the MLP.

According to consultants at PricewaterhouseCoopers LLP, the paper companies could adopt an MLP structure if the mills that produce containerboard use only virgin feedstock — trees or wood chips, or only use a maximum of 25% recycled fiber based on annual input weights to produce paper or cardboard.

Mills relying too heavily on recycled corrugated boxes aren’t eligible for the MLP structure. The reason is that the IRS clearly defines that in order to use an MLP, an operation must be processing or transporting natural resources.

We tend to think that only oil and natural gas-related commodities can be placed in a MLP. However, almost any commodity can. So there’s really no reason why the various paper stocks shouldn’t at least be considering using the tax structure for some of their assets.

And there are plenty of reasons why they should want to.

First, the use of an MLP would help boost cash flows and earnings at the paper stocks. The incentive distribution rights (IDRs) and tax-advantaged dividends would ultimately help drive the bottom lines at the cardboard producers. As such, the mills will be more highly valued inside a MLP rather than the current corporate structure.

That would also allow the sponsoring paper companies to sell additional at higher multiples for various corporate actions — namely big dividends for shareholders. Additionally, using POPE as an example, the paper stocks with timberland holdings could place some of those assets into the MLP as well.

All in all, the additional cash flows and earnings from using a MLPs could send shares of the boring old paper stocks higher by 50% to 100% and be the spark the sector needs to finally recapture investor’s attentions.

3 Paper Stocks That Go Hand-In-Hand With MLPs

Given that it takes a certain series of assets to actually even consider using an MLP, not all of the paper stocks will qualify. But the trio of IP, Rock-Tenn Company (NYSE:RKT) and KapStone Paper and Packaging Corp. (NYSE:KS) are perfect candidates.

As the largest paper and packing company in the U.S., it’s no wonder why International Paper is being the guinea pig and taking the MLP plunge first. IP has access to some of the largest and cheapest forestlands in North America — many of which were formerly owned by the firm. With that fact in tow, IP should be able to place enough mills into the MLP that generate roughly 60% of its earnings.

That will continue to boost cash flows, margins and ultimately dividends at the firm. IP recently raised its quarterly payout by 14% and now yields 3%.

Like IP, RKT should be able to place about 60% of its profit-generating mills into an MLP. However, that number could go up. Rock-Tenn has agreed to merge with rival MeadWestvaco Corp. (NYSE:MWV) in a $16 billion transaction. Before the announced merger, MWV was also evaluating what mills and facilities could placed inside the structure.

After kicking out MWV’s specialty chemicals division, the combined firm will be able to produce about $2.9 billion in earnings and create substantial cash flows — cash flows that will be enhanced by the addition of a MLP.

Finally, while KS isn’t as big as IP or the combined RKT/MWV, it could be one of the best paper stocks to buy in terms of MLP formation. That’s because KapStone should be able to place almost all of its mills inside the tax structure. That could be just the spark the struggling firm needs to move forward.

KS has struggled on the earnings front over the last few quarters. However, the kind of tax advantaged distributions that an MLP provides could help turn the tide at KS. Analysts seem to think so. If KS is able to use an MLP, it should see its share price almost double.

The Bottom Line

The boring paper stocks are about to become less boring. With many of them mulling the idea of using MLPs to their advantage, the sector could see another huge wave of growth in the future.

For investors, the trio of IP, KS and RKT are the best way to play the sectors shift into MLPs.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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