Smurfit-Stone: Chairman of the Board
Because of its focus on the economically sensitive and capital-intensive packaging industry, Smurfit-Stone Container (SSCC; recent price: $13.25) has a cyclical pattern of profits. We at Standard & Poor’s Equity Research believe the company is in the early stages of a strong upswing in earnings.
We expect demand to outstrip supply for at least the next year, as linerboard manufacturers have cut capacity. At the same time, inventories in recent months have fallen to very low levels, despite a seasonal dropoff in demand. A price increase in October is now fully in place, and another one is being implemented this month. We expect Smurfit-Stone to post a loss in the first quarter of 2006, but to regain profitability for the balance of 2006. In 2007, we anticipate profits of $1 per share.
In addition, the company has recently instituted a restructuring program aimed at revising its business model, which should lead to $600 million in cost reductions by 2008 and new revenue opportunities. Smurfit-Stone also is considering selling selected assets that could be used to reduce its still-sizable debt load. For these reasons, we have Standard & Poor’s highest investment recommendation of 5 STARS [strong buy] on the shares.
CUSTOMER BASE. Smurfit-Stone, formed via the 1998 merger of Jefferson Smurfit and Stone Container, is the world’s leading paper-based packaging company. Its containerboard and corrugated-containers segment primarily produces corrugated containers, containerboard [about 69% is used internally in its corrugated-container plants], kraft paper, solid bleached sulfate, and market pulp. Corrugated containers are used to ship a variety of products, including industrial machinery, home appliances, grocery products, and produce.
The company also produces and sells point-of-purchase displays and specialty-packaging products. Smurfit-Stone’s paper mills produce solid bleached sulfate, or SBS, which is used by producers of folding-carton and carded packaging. The consumer-packaging segment produces folding cartons, coated recycled boxboard; multiwall and consumer bags; laminated products; paper, foil, and heat transfer labels; and flexible packaging.
Customers for folding boxboard include producers of pharmaceuticals, packaged foods, beverages, fast food, detergents, paper, and cosmetics. The coated recycled boxboard produced by Smurfit-Stone is primarily used internally. Its multiwall bags are used to ship a variety of products, including industrial and commercial products. The company also owns 1 million acres of timberlands.
SUPPLY AND DEMAND. The corrugated-packaging industry is highly competitive, with about 1,400 box plants operated by 650 different companies located throughout the U.S. Most corrugated products are custom manufactured to customer specifications, and they generally sell within a 150-mile radius of where they are produced. With about a 17% share of total industry shipments, Smurfit-Stone is the largest U.S. producer of corrugated packaging. Because of the fragmented and commodity-oriented nature of the packaging industry, however, we believe the company has little control over the pricing or demand for its products.
We expect the containerboard market to strengthen significantly in 2006, as industry fundamentals appear to be improving. Box shipments in November, 2005, rose for the third consecutive month on a year-over-year basis. In October, shipments had risen to their highest per-day volume in more than five years, and — according to statistics from the Fibre Box Association, a corrugated-industry trade association — containerboard inventories at box plants fell 356,000 tons from the end of August through the end of October, and were at 2.8 weeks of supply at Nov. 30, the lowest level since 1994.
Much of the inventory improvement has been due to capacity reductions over the past several years, with Smurfit-Stone leading the way. In 2002, it closed a 180,000-ton linerboard machine in Montana. In 2003, it shut a corrugating-medium mill in Ontario and a recycled boxboard machine in Philadelphia. In 2005, it announced plans to permanently close three separate mills with total linerboard capacity of 700,000 tons. In total, nearly 1.4 million tons of containerboard capacity was closed in North America in 2005, accounting for about 3.5% of capacity.
Given this improved supply-demand situation, most major North American containerboard producers have announced price increases of about $40 per ton on linerboard and corrugating medium, to take effect in January, 2006. The second increase announced since October, 2005, this comes at a time when demand is seasonally slow. Our forecast is for the U.S. economy to remain healthy in 2006, and we project real gross domestic product growth of 3.5%. This should provide a boost to industrial production and the movement of manufactured goods, and we project that box shipments will rise 3% to 5% in 2006, while prices increase at least 10%.
COST-CUTTING MEASURES. In November, 2005, Smurfit-Stone outlined a broad restructuring program to reduce costs and boost sales. When fully implemented by 2008, the company expects to achieve annual costs savings of $600 million and an incremental sales increase of $650 million per year. As part of the program, Smurfit also may divest its consumer-packaging segment, which accounts for about 20% of sales.
Smurfit-Stone’s earnings performance historically has been quite weak relative to its paper- and forest-products peers, and this latest restructuring move is an attempt to be more consistently profitable. A strategic review that the company conducted with outside experts determined that its mill system was very cost-competitive, with about two-thirds of its plants in the top half of the cost profile. Management believes that its converting operations, however, have significant opportunity to reduce costs.
One strategy is to invest in high-speed corrugators in certain strategic geographic markets that are capable of producing large volumes of linerboard. This move will allow the company to eliminate 10 to 15 corrugated-container plants, and help focus its production on maximizing machine utilization.
Another tactic is to examine the costs at every container plant; the plants with the highest costs and the least potential for lowering them will be shut down. This should lead to the closing of an additional 10 to 15 facilities, according to the company. Meanwhile, it plans to adopt common business systems across its operations and to reduce the number of grades that it produces, in order to focus on those that generate the highest profits.
TARGET MARKETS. Smurfit-Stone also plans to change the way it views the market. The company acknowledges that it has had a rigid, expansive operating structure that has been an impediment to good operating results in the past. It has historically had a decentralized approach, with high volume as the goal and little accountability. Its planned restructuring should create a more centralized way of doing business with separate manufacturing and sales functions. Plant managers will be held to cost objectives, sales representatives will have more profit-oriented incentives, and teams will be aligned around target markets.
Smurfit-Stone intends to have a keener focus on customers’ needs by offering complete packaging services, more involvement in product design, and improved graphics. Some of these steps may require outside expertise. The company also seeks to target higher-growth and more-stable markets, such as pharmaceuticals, frozen foods, and produce. With a lower-cost system and more-focused approach, we think Smurfit-Stone will expand the revenue opportunities available to it.
In order to revamp its converting base, the company estimates that over the next two years it will require a total of $400 million in capital expenditures above its current run rate. If it decides to divest its consumer-packaging operations — and we think it will — Smurfit would generate $600 million to $700 million in proceeds, by our estimate. We expect these funds to be used primarily for debt reduction, but they also could be allocated for increased capital spending.
CASH-FLOW GAINS. Smurfit-Stone is a highly leveraged company. The merger in 1998 of Jefferson Smurfit and Stone Container saddled the surviving company with about $7 billion in debt. Smurfit-Stone has used its solid cash flows since that time to pare down its long-term obligations to about $4.5 billion currently.
As of Sept. 30, 2005, its ratio of long-term debt to total capitalization stood at 62%. While this is a substantial debt burden, it’s only modestly higher than that of its peer group, and we think the company’s expected earnings improvement and selected asset sales will allow it to reduce debt levels over the next two to three years.
We are projecting Standard & Poor’s Core Earnings of 2 cents per share for 2006, which includes an estimated impact of 25 cents per share, after tax, for anticipated restructuring charges. There are likely to be additional charges of this type and magnitude in 2007, in our opinion. We are also including an adjustment of about 8 cents to reflect gains in Smurfit-Stone’s pension plan.
We look for sharply accelerating free-cash-flow growth over the next two years, due primarily to a projected recovery in operating earnings. Our discounted cash-flow model shows intrinsic value of $15 per share, assuming significant cash-flow gains in 2006 and 2007, a weighted average cost of capital of 7.8%, and 3.6% growth in perpetuity. Using a peer-forward price-earnings multiple of 23 applied to our 2007 estimate of $1 per share shows a potential value of $23. Our 12-month price target of $20 is a weighted average of these two metrics.
POTENTIAL RISKS. In our opinion, Smurfit-Stone’s corporate-governance policies are generally well aligned with shareholders’ interests. The board of directors is controlled by a supermajority [more than 75%] of independent outsiders, the full board is elected every year, and no former CEO of the company serves on the board. We are also encouraged that all directors with more than one year of service own stock, and that directors receive all or a portion of their compensation in the form of equity.
We are concerned, however, that Smurfit has a poison pill in place, that it wasn’t approved by shareholders, and that the board may amend the company’s bylaws without shareholder approval.
Risks to our recommendation and target price, in our view, include a slower recovery in packaging prices and demand than we currently anticipate. With its high concentration in the packaging sector, Smurfit-Stone is very dependent on prices and demand for corrugated boxes. This sector appears to have favorable fundamentals right now, but an unexpected downturn in the economy likely would adversely affect the sector.
Additionally, we see greater-than-expected input costs as a potential risk. Energy prices have been very volatile over the past 18 months or so, and are currently well above the level of two years ago. While the company has taken steps to reduce its energy consumption, another unforeseen jump in oil and natural gas costs would likely have a negative effect on the stock.
FAVORABLE FUNDAMENTALS. We also believe that there’s a modest level of risk associated with Smurfit-Stone’s restructuring plan. If the company is unsuccessful in changing its marketing approach, it could face lower sales at a time when its capital expenditures are increasing. Unfavorable currency and interest-rate movements also pose a moderate risk, in our opinion.
Overall, we believe that the fundamentals of the containerboard industry are very favorable, and that an upturn in demand and prices is in the early stages. As the leading producer in the sector, we expect Smurfit-Stone to be a major beneficiary of the anticipated improvement. We are encouraged by the company’s restructuring plans, as we expect them to lead to lower costs and reduced debt over the next two years.