WestRock Company: 69% Upside But Poor Profitability Comps Vs. Peers (NYSE:WRK)

Intro

WestRock Company (NYSE:WRK) is a global provider of fiber-based paper and packaging solutions, operating across North America, South America, Europe, Asia, and Australia. The company operates through two main segments: Corrugated Packaging and Consumer Packaging.

The Corrugated Packaging segment produces a wide range of corrugated products, including containerboards, corrugated sheets, packaging materials, and automated packaging solutions. It also offers recycling services and lithographic laminated packaging products.

The Consumer Packaging segment focuses on manufacturing folding cartons used in various industries, including food, beverages, tobacco, and healthcare. Additionally, it produces inserts, labels, rigid packaging, and paperboard packaging for different applications, including pharmaceuticals and horticulture.

In our previous analysis of WRK in December, we issued a sell rating for the company. Since then, WRK’s stock has experienced a decline of 21.5%, while the broader S&P500 index has seen an 11.8% increase. Although we recommended selling the stock, we acknowledged WRK’s noteworthy growth in recent years. In this article, we will reevaluate the company’s performance in terms of growth and profitability, and assess how the valuation has changed given the significant stock decline of 21.5% since our previous coverage.

Growth Performance

Over the past decade, WRK has experienced significant growth in both revenue and free cash flow. Let’s examine these figures and discuss what’s been driving the company’s stellar growth.

Starting with revenue, WRK’s growth has been remarkable. In 2013, the company’s revenue stood at $9.54 billion. Since then, WRK has consistently increased its revenue year after year. By 2022, the revenue reached an impressive $21.2 billion, representing a total growth of 122.69%. This growth demonstrates WRK’s ability to expand its market presence, attract new customers, and effectively capitalize on business opportunities. With such consistent growth, WRK has clearly established itself as a strong player in its industry.

Moving on to free cash flow, WRK has also shown significant improvement over the last decade. In 2013, the company had a free cash flow of $634.30 million. This figure steadily increased over the years, reaching $1,187.70 million in 2022. The total growth in free cash flow stands at 87.25%, indicating WRK’s ability to generate cash and manage its finances efficiently. This growth is a testament to WRK’s financial stability and its ability to invest in future growth opportunities, research and development, and operational improvements.

Furthermore, it is worth noting the compounded annual growth rate (CAGR) of both revenue and free cash flow. The revenue CAGR stands at an impressive 8.34%, while the free cash flow CAGR is a solid 6.47%. These figures indicate that WRK has consistently achieved sustainable growth over the years, which is a positive indicator of its long-term success and profitability.

One of the main reasons behind WRK’s significant growth in recent years has been its strategic acquisitions. WRK has acquired several companies, such as MeadWestvaco in 2015 and Rock-Tenn in 2017. These acquisitions have played a crucial role in expanding WRK’s product offerings and geographic presence. This expansion has helped WRK generate more revenue and increase its profits.

In addition to MeadWestvaco and Rock-Tenn, WRK has made several other notable acquisitions. In 2015, they purchased SP Fiber Holdings, Inc. In 2016, they acquired Cenveo Packaging. In March 2017, WRK bought Star Pizza Box, a leading manufacturer and distributor of pizza boxes in the United States. In June 2017, they acquired Multi Packaging Solutions International (MPS). Furthermore, in 2018, WRK acquired Plymouth Packaging, Inc. and Kapstone, a pulp and paper company. Most recently WRK agreed to purchase the remaining ownership stake in Grupo Gondi for approximately $970 million, in addition to taking on their existing debt. This acquisition is expected to result in a total estimated enterprise value of around $1.763 billion for the transaction.

These acquisitions have been a smart move for WRK as they have allowed the company to expand its product range and reach new customers. By acquiring these companies, WRK has strengthened its position in the market and capitalized on new business opportunities.

Profitability Performance

One challenge faced by WRK is its inability to match the profitability of its industry peers like International Paper (IP), Packaging Corporation of America (PKG), and Graphic Packaging Holding Company (GPK). When compared to these competitors, WRK falls behind in various key margin indicators as well as measures of return on equity (ROE), return on assets (ROA), and return on invested capital (ROIC). See chart below for (TTM) profitability metrics comparison.

The profitability comparison results shed light on the most significant risk associated with investing in the WRK, which is the highly competitive nature of the paper packaging industry. The industry is characterized by its low barriers to entry, allowing for potential competition from new entrants. This can result in pricing pressures as companies strive to gain market share. Additionally, since WRK’s products are considered commodities, the company’s success heavily relies on effectively managing costs and maintaining efficiency.

It is essential for WRK to focus on cost optimization and operational excellence to remain competitive in the industry. Having better margins than the competition is crucial for a company’s success as it directly impacts profitability and financial performance. Higher margins enable a company to invest in research and development, expand operations, and withstand market fluctuations, giving them a competitive advantage and positioning them for long-term growth and sustainability. This is a competitive advantage WRK does not have at the moment.

Outlook

As WRK endeavors to improve its profitability, the company is confronted with a challenging outlook for the fiscal period ending in September 2023. According to estimates, WRK’s earnings per share (EPS) is projected to be $2.37, indicating a notable decline of 50.13% compared to the previous year. Additionally, WRK’s revenue is anticipated to reach approximately $20.58 billion, reflecting a year-over-year decline of 3.19% in growth.

These figures underscore the challenging road ahead for WRK as the company strives to reverse its profitability record and navigate the current economic landscape. Notably, WRK’s Corrugated Packaging and Global Paper segments continue to face the effects of lower demand, high inflation, and shifting consumer spending patterns. These factors contribute to the complex environment that WRK must navigate in order to improve its financial performance.

To right the ship, WRK’s management team has set ambitious goals to enhance the company’s financial performance by 2025. Their plan includes increasing EBITDA to surpass $4 billion, achieving EBITDA margins of over 19%, attaining a return on invested capital of over 10%, and generating a robust free cash flow per share exceeding $5.50. The journey towards these objectives began in 2021 when WRK’s EBITDA margins stood at 16%. To achieve their targets, WRK intends to optimize its product portfolio and boost sales of comprehensive solutions, aiming for a 100-150 basis points increase in EBITDA margins.

Furthermore, by developing innovative fiber-based solutions to reduce plastic consumption, WRK foresees an additional 50-100 basis points growth. The company also plans to invest in digital and automation tools to maximize asset utilization and optimize the supply chain network, which management believes will contribute an additional 200-300 basis points to EBITDA margins. Ultimately, WRK’s decision-making process will be guided by the goal of maximizing return on invested capital.

WRK has been performing well recently considering these ambitious goals. In the second quarter of 2023, WRK reported earnings per share (EPS) of $0.77, surpassing expectations by $0.27. This exceeded market projections and indicates a strong performance during the period. Additionally, WRK generated revenue of $5.28 billion, representing a slight year-over-year decline of 1.94%. However, the company’s revenue outperformed estimates by $33.93 million. During the company’s earnings call, CEO David Sewell shared his thoughts in regards to WRK’s initiatives in reducing plastic consumption and cost savings.

To invest in innovations that contribute to the circular economy and enable us to replace plastics, we are currently targeting $400 million in revenue from plastics replacements this year. To improve efficiency and drive margins through our cost savings initiatives, we are making significant progress and we continue to target $250 million in cost savings in fiscal 2023. And finally, to drive strong cash flows to invest in growth, optimize our footprint, and improve our return on invested capital, we are focused on returning leverage to our targeted range of 1.75 times to 2.25 times while investing in our assets and returning capital to our shareholders through our dividend. We are confident in our strategy and our optimization is a critical component.

Despite analysts’ expectations of a challenging full year in 2023, WRK is anticipated to rebound and regain growth momentum in 2024 and 2025. The company plans to continue working on its strategy to achieve their ambitious financial goals by increased focus on cost reduction, investments in new automation and digital tools, and a strategic shift towards encouraging consumers to embrace paper packaging products instead of plastic alternatives. By executing against these aggressive goals, WRK aims to position itself for a successful recovery.

Valuation

To evaluate WRK’s intrinsic value, we will utilize the discounted cash flow (DCF) analysis. By calculating the present value of anticipated future cash flows, we can determine the true worth of the company. Starting with WRK’s starting free cash flow of $1.19 billion, we will apply an initial growth rate of -50.13% for 2023, followed by growth rates of 6.71% for 2024 and 29.06% for 2025, based on analyst earnings estimates above.

For the subsequent period, we will use a growth rate of 7.40% for years 7-10, derived from the average compound annual growth rate of WRK’s revenue and free cash flow over the past decade. Employing a discount rate of 10%, based on the average return of the S&P 500 with dividends reinvested, and a conservative perpetual growth rate of 2.5%, we determine the intrinsic value of WRK to be $49.86. This suggests that WRK may be currently undervalued, presenting investors with a potential return of 69.35% compared to the company’s current market price.

Conclusion

While WRK has faced challenges and experienced a decline in its stock price, there are several factors to consider when deciding whether to hold or sell the stock. The company has demonstrated strong growth in both revenue and free cash flow over the past decade, indicating its ability to expand and generate cash. WRK’s strategic acquisitions have also strengthened its position in the market and opened up new opportunities for growth.

Although WRK lags behind its industry peers in terms of profitability, the management team has set ambitious goals to improve performance and increase profitability in the coming years. The company’s initiatives to reduce plastic consumption and optimize its operations through digital and automation tools are positive steps towards achieving these goals. Furthermore, WRK’s recent earnings report showed a strong performance, surpassing expectations.

Considering these factors, it may be prudent to hold the stock despite its current low valuation. The potential for WRK to execute on its ambitious goals and increase profitability presents an opportunity for future growth. However, we will continue to closely monitor WRK’s progress in achieving its targets and assess whether the company can effectively navigate the challenging industry landscape before issuing a buy rating.