I'm not sure who's reading this blog regularly, but no matter who you are I'm sure you're not here for stock advice. But that's what you're going to get today... I'm wading into the world of stock promotion. I'm not working in the equity analysis industry right now but I'd still like to keep my skills in this area sharp. So you faithful readers might start seeing monthly stock recommendations here on this blog. Feel free to act (or not act) on them as you see fit... and if any of my faithful readers actually DO act on my advice, I would seriously question your sanity. After all, who am I? Just some dude on the internet talking about stocks. Is that whose advice you're going to take when investing your money? Really?
Well anyway, without further ado, here's my stock pick for June.
A friend of mine recently asked me for a stock recommendation in the basic materials (raw materials) sector. I did some searching for him and came up with one company that looks attractive. I didn't do any macroeconomic analysis as to why this stock (or the raw materials sector) is a solid buy, so you'll have to do that yourselves. But what I did find was a stock with some great fundamentals; a stock that appears poised for some solid growth -- KapStone Paper and Packaging Corp. (NYSE: KS).
I will get into the full analysis of the stock below, but I'll say up front that I think it's a very attractive stock at a very attractive price (currently trading at $15.05 as of this writing). Here are two disclaimers before I get into the full analysis of KapStone.
1.) I don't have the resources that paid analysts at other companies do. This means I don't have the ability to call up the company, announce I'm covering them and then fly down to their headquarters and manufacturing plants to be sure that they're actually a real, honest-to-goodness company making real honest-to-goodness products. KapStone, for all I know, could be a complete and total fraud. However, I do believe that if a company was a complete fraud, there would still be something odd or weird I would see in their completely fictional financial statements that I would see. Keep in mind I'm not talking about Enron or WorldCom type fraud--that type I could see. I'm talking about absolute fraud whereby the company has absolutely nothing going on and no headquarters, manufacturing plants or employees.
2.) I don't own any stock in KapStone whatsoever, so I'm not "talking my book" here. However, I made the recommendation to buy KapStone to my family and friends yesterday, before deciding to also post the recommendation here. As far as I know, only one person close to me chose to act on my recommendation and they bought 150 shares ($2,200).
Now that that's out of the way, let's get started with the analysis:
Firstly it's basically a paper company and lord knows there isn't a whole lot of room for exponential growth in the paper industry (especially with newspapers going out of business and people using more electronic forms of communication). But KapStone makes products like dogfood bags, grocery bags and retail shopping bags, and the product mix for their signature KraftPak line is very large. Their other two main product lines are Kraft Paper and Linerboard.
According to the American Paper and Forest Association (an independent outfit) the market for two of KapStone's main product lines (kraft paper and linerboard) are below:
US KRAFT PAPER MARKET SIZE:
2008 - 1.6 Tons
2009 - 1.3 Tons
2010 - 1.3 Tons
US LINERBOARD MARKET SIZE
2008 - 21 Tons
2009 - 20 Tons
2010 - 21 Tons
There is no defined or reported market size for the KraftPak line (but KraftPak does account for a large portion of KapStone's sales). As far as overall sales, KapStone has pulled back from the Kraft Paper market in the last few years and increased their presence in the linerboard market. Kraft Paper sales were 43% of total sales in 2008 and have fallen to 21% in 2010. The linerboard sales accounted for only 32% of total sales in 2008 and have jumped up to 51% today.
So clearly KapStone is focusing on the larger market -- which, from an investor standpoint, is a good thing. However, they don't provide any indication of the margins or profitability in these markets. Which is a bit bothersome to me, since we can't tell which product mix would be most profitable and whether or not they're focusing on the most profitable line, rather than simply focusing on the largest line. However, further clues in the financial statement reveal that KapStone sold off a part of their business in dunnage bags back in 2008-09 mostly because it was too low margin. This indicates that someone at the company understands margins and wouldn't be pushing the company to invest in growing their shares of the linerboard market if it were, ultimately, less profitable (again, there's no guarantee of this).
The percentage of sales of the KraftPak line has also been growing, and as a trademarked line I would hope it's go the best margin. The competition in the kraft paper line includes Georgia-Pacific, Longview Fibre and Delta Natura. In the linerboard market the competition is International Paper, Smurfit-Stone and Georgia-Pacific and in their signature KraftPak line the competition is Rock-Tenn, Carustar and Graphic Packaging. So we can see that their competition is of the 'little-known' variety in the KraftPak market.
Now for the interesting stuff. KapStone was formed by a bunch of investors (former paper industry guys) who wanted to buy some paper manufacturing plants and launch a paper company. They started by purchasing two kraft paper lines from International Paper in 2007 and another one from MeadWestvaco in 2008. They received approximately 400 customers from those two purchases but have managed to internally develop another 100 customers in the last three years, which is impressive. Furthermore, they've paid off virtually all of the debt involved with the first purchase, a good chunk of the debt used for the second purchase and in 2010 they finished their last earn-out payment to International Paper for the original purchase.
So the company has shed debt and shed other liabilities that are like debt and their revenues have been growing steadily even in the teeth of a massive recession. They have a much higher return on equity than most of the companies in their industry. For you noobs, ROE is defined as net income divided by total equity... it's a quick and dirty method for determining earnings that are available for equity holders (stock holders) after all investments in the company, debt payments and other liabilities have been paid. For stock analysis, ROE can be broken down into a number of component parts that lets you see how a company is achieving their ROE.
One of the ways to break down ROE is to use the component parts of ROE that are Return on Assets (ROA) multiplied by Leverage (Total Assets divided by Total Equity). If a company is 'goosing' its ROE through leverage, this would be unsustainable and that fact would show up in these ratios.
KapStone is, matter-of-factly, not using debt or leverage to goose up their earnings. Their leverage ratio has fallen consistently over the last three years as their ROA has grown... which shows that the company's management is what is driving profitability through higher sales and through management of costs and by growing the business organically. There are also low levels of accruals in the statements (so they're not using accounting tricks to goose earnings). Let's take a look at their ratios.
2008 - 16.6%
2009 - 22.1%
2010 - 16.1%
2008 - 4.1%
2009 - 11.5%
2010 - 9.4%
2008 - 4.0
2009 - 1.9
2010 - 1.7
So, you can see that ROE has been steady while leverage has been falling (I'll get into the 2009 bumps in ROE and ROA in a little bit), but first I want to further break down ROA to see how the company's achieving that.
ROA can be broken into two components - Asset Turnover and Net Profit Margin. Asset turnover is a measure of how much revenue the assets of the company generate and Net Profit Margin is a measure of how much a company makes from its revenue after all expenses and taxes and interest payments have been made.
2008 - 1.10
2009 - 0.91
2010 - 1.13
Net Profit Margin
2008 - 3.7%
2009 - 11.5%
2010 - 9.3%
KapStone has solid numbers in both Asset Turnover and Net Profit Margin but the uneven growth in both sections requires further inspection.
What happened in 2009 was that the company liquidated their dunnage bag line (the line that I said was low margin) and a lot of the bump in profits comes just from that sale. Once that sale is removed the profit margin and asset turnover ratio both fall back into line with the steady growth the company's been showing. The fall in the profit margin in 2010 is due to the company losing an alternative energy tax credit in the fuel mixture it uses to create its products. That tax credit expired but there is potentially another one on the horizon for them. But I didn't want to forecast that the company would receive that credit in the future.
Looking through the financials, I also found that the company raised prices for 2010 and that contributed a lot to the bottom line. The price hike increased revenues by $60 million in 2010, which is no small number. And that's an unsustainable number -- because a company can't continue to raise prices on customers that much every year unless they're Comcast. So I have to project that the revenues will grow more slowly than they did between 2009-2010. But there is still good underlying growth with the stock and the lower potential growth in 2011 prices will be partially offset by the $50 million payment that KapStone made in 2010 to liberate itself from the last of the earn-out payments it made to IP. Basically, there won't be any more of those in the future.
I'm sure I'm not writing this as well as I should be and it might be confusing, but that's the bulk of my analysis and I'll do my best to summarize it all:
KapStone used debt and equity financing in 2007 to purchase some paper mills. They bought another one in 2008. These paper mills -- KapStone's core business -- have been successful enough that the company has managed to liberate itself from any large debts and to pay back all the earn out payments it still owed for the original purchases. The company is growing organically (and growing rather rapidly for a paper industry company) and it's got very strong revenue growth, healthy profit margins and cash flows and there aren't any red flags that come up in the financial statements (their pension plan is close to being completely funded as well). The stock is, by my analysis, undervalued and should appreciate a lot in the medium term (the next year or two).
That being said, what are the major concerns with investing in KapStone? There are obviously macroeconomic factors to take into consideration, but like I said, I haven't performed a macro-demand analysis. The paper market might implode tomorrow or their might be a substitute on the horizon that I haven't seen.
The other concern is that the company doesn't release numbers in their financial statements that show profit margins by product line, so we're left to assume that management knows what they're doing and is reinvesting the excess cash flows into the higher margin business lines.
The final concern, and in my opinion biggest risk, is the overall health of the US economy. Any large drop in equities in the US will be experienced by KapStone as well (though one hopes, to not such a large degree). I can't see the US economy turning a major corner and growing substantially again until perhaps the end of 2012 or early 2013. Therefore equities should remain somewhat flat through the next year at least. With that being said, I certainly expect KapStone to outperform the market over that time frame.
The final concern for any of my readers who choose to invest in the stock is that I might not post follow-ups here on the stock (I might not monitor to ensure that the company is still healthy and on track). So, in that respect, buyer beware.
But I would highly recommend KapStone to any of my readers who happen to be active stock speculators.