Player Avatar notzia (64.31) Submitted: 3/27/2010 11:51:09 PM : Outperform Start Price: $21.64 RKT Score: +109.37

Although anticitrade provided the spark of interest in RKT, my decision to recommend was based on the following analysis. I am viewing this as a combination value and growth play. I’ll explain as I go. This analysis is based on a price of $42.44, the close on 2/24 when I looked at it for purchase. (which I did). I apologize for delaying my recommendation this long, but I had higher priorities.

Rock-Tenn Company (RKT) is a manufacturer of packaging products, recycled paperboard, containerboard, bleached paperboard and merchandising displays, operating in four segments. The Consumer Packaging segment consists of facilities that manufacture coated paperboard products and convert paperboard into folding cartons. The Corrugated Packaging segment consists of facilities that manufacture containerboard and produce corrugated packaging and sheet stock. The Merchandising Displays segment consists of facilities that produce displays. The Specialty Paperboard Products segment consists of facilities that manufacture specialty paperboard and convert paperboard into interior packaging, convert specialty paperboard into laminated paperboard products, and facilities that collect recovered paper.

Before I look at the valuations, I look at three indicators of financial safety. For this stock, two results were cautiously safe and one was quite good. The Altman Z is 3.9; below 1.8 is risky, above 3 is the safe range. The Piotroski F is 7; 2 or below indicates caution, while 8 or 9 indicates that the stock is expected to rise within the next year. The Sloan accrual is -6.6; 5 or higher is high risk, while -5 or lower is excellent.

The calculated estimates for the intrinsic value of a share of RKT ranged from $163 to $277. Three of the four estimates were based on Discounted Cash Flow (DCF) analysis. This method discounts estimates of future cash flows for a company to estimate the present net value. Although the typical discount used in such analyses is 10%, the following analyses were conducted with a 15% discount to be 50% more conservative in estimating the value of a company or its stock.

The most conservative estimate ($163) was based on a DCF using cash flow from operations minus depreciation and amortization as the measure of cash flow in the analysis. The most aggressive estimate ($277) was based on a calculation using a risk-adjusted cash flow (EVA – economic value added) in the DCF; this method identifies the extent to which capital used to generate future growth leads to an added return on that investment. There were two other estimates calculated. One was based on a DCF using a more traditional estimate of free cash flow (cash flow from operations plus capital expenditures) with a resulting estimate of $208. The other was based on Benjamin Graham’s formula and resulted in an estimate of $233. These initial estimates of valuation suggested a margin of safety between 74 and 85%; that the market value of the stock and company is substantially less than the true value.

The following is something I am trying to do for myself on a regular basis, but it does take a bit more effort because it is not programmed into my spreadsheet yet. This is drawn from reading Rob Crawford’s analyses (bert111).

The first step for refining the valuation is to consider the sensitivity of the valuations to differing cash-flow growth assumptions. The most conservative estimate drew upon the growth rate of the adjusted cash flows between 2000 and 2009, and when that rate exceeded 25%, the growth rate was set at 25%. The following table explores a range of cash-flow growth rates and what their effect would be on the compounded annual growth rate (CAGR) on the stock price. The cash-flow growth rates were defined as ranging from -10% to +30%. Over the short term, the stock market is largely driven by emotion. Without emotion, it would be difficult to find equities that are significantly undervalued. Over time, though, efficient market theory suggests that markets make efficient use of information, and that under (as well as over) valuations will eventually be corrected by the market. Typically, the market makes this move within 18 months, but it may take longer for the move to occur. It can be seen from this table that even with 0% growth in cash flows, the CAGR would still be almost 13% after three years which is in line with the stock market’s long-term average performance. The prospects are better than that because each of the other valuation estimates and every indicator of company growth were higher; so, even in a near worst-case scenario, the prospects exceed the market average.

Book value is a rough estimate of the net asset value of a company. For RKT, the TTM book value is $22.19. The price to book value is 1.91. This does not meet Graham’s ideal of 1.6 or less, but it is reasonably close. Nonetheless, net asset value is a very conservative measure of a company’s value because it is based on the tangible assets of a company valued at the purchase price. A more appropriate measure is the replication value of a company. The replication value is the estimated cost that a startup company would expend to duplicate RKT’s standing within the paper and paper products industry. Based on the adjustments to the weight given various balance-sheet items suggested by Bruce Greenwald, the estimated replication value of RKT is $28.44. The resulting price to replication ratio of 1.49 is substantially less than the suggested threshold of 2.50.

In the last four years, revenues have been growing faster than the cost of goods. Operating income has increased at a 31% annualized rate since 2000 and at an annualized 61% since 2004. Part of this growth has been fueled by acquisitions. The two major acquisitions occurred in June 2005, when Gulf State Paper Corp. was purchased for $552 million, and in March 2008, when Southern Container was bought for $1.06 billion. In both instances, operating income increased substantially following the acquisitions.

A discussion of capital expenditures (CapEx) by RKT’s James Rubright suggests the growth in free cash flow and cash from operations starting in 2005 may be a direct result of CapEx in the preceding years. According to Rubright, the capital expenditure (CapEx) process is dynamic involving the evaluation of market opportunities, customer needs, and opportunities to cut costs. Describing the trend, he said that RKT had a “very heavy investment in the first half of the decade in our businesses … and then after that a trend of reducing CapEx. I think the current environment has made us cautious about growth projects, which is the primary driver in the reduction of CapEx.” Rubright went on to suggest that while RKT was exercising caution, “a maintenance CapEx level, … would be significantly lower than the $85 million that we anticipate spending next year. … I think we could run the business on $40 million.”

Although it is difficult to parse out the impact of the two acquisitions from the organic growth of RKT, there is limited information available. For example, in the 2005 annual report, Gulf States Paper was reported as having contributed 30% ($38M of $125M) of RKT’s net income for the year despite contributing only about 23% ($487M of $2,082M) of the sales. Similarly, Southern Container was reported as having contributed 21% of the total earnings per share ($1.18 of $2.75) for 2009.

In sum, RKT looks to be a worthwhile investment from both the value and growth perspectives. It is clearly undervalued from a discounted cash flow perspective, and the fundamentals look to be sound. RKT has also made significant acquisitions that have more than doubled the company in relatively short period of time, while keeping debt at a manageable level. Based entirely on the results from discounted cash flow analysis, while maintaining a 50% margin of safety, RKT should be purchased at $81.73 or less. However, Buffett is reported to look for investments that have a 15% return from the onset. With a trailing-twelve months earnings per share of $6.38 and the dividend at $0.60 per share, a purchase price of $46.53 would ensure a starting return of at least 15%.

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