Richard Perry of Perry Capital LLC has generated some immediate buzz around a plan that he believes could spike the value of the entire container board industry by restructuring companies to take advantage of the fact that some of their most valuable assets process natural resources.
“Over the past few months, we have been conducting extensive due diligence on the paper and packaging industry,” Perry writes in the thesis recently obtained by Valuewalk. “This led us to identify an opportunity that could revalue upwards the entire containerboard industry by 50-100%. In short, we believe that containerboard management teams can pursue Master Limited Partnership treatment for each company’s domestic virgin containerboard mills.”
MLPs eliminate corporate taxes, but only for certain types of income
A Master Limited Partnership (MLP) is an investment vehicle that is taxed like other partnerships or LLCs but is also traded on public exchanges. The main incentive for switching to an MLP is that income is passed straight through to unit-holders on a tax-free basis instead of getting hit with corporate taxes, but only if the IRS determines that it has qualifying income.
“The IRS has defined qualifying income for MLPs to include income and capital gains from natural resource activities, including processing, refining and marketing of oil, gas, petroleum products, coal and timber,” Perry explains.
Not every part of big paper companies like International Paper are involved in processing natural resources, but that’s probably ok. The virgin containerboard mills process a mix of wood fiber (which counts) and recycled fiber (which doesn’t), but the split is 75/25 or even greater towards wood fiber. Perry thinks this will be good enough for the virgin containerboard mills to qualify, and when he contacted PricewaterhouseCoopers for a second opinion they agreed.
“Although the rulings do not specify the percentage of non-qualifying material included, we believe that the use of less than 25% recycled fiber (determined as a percentage of the weight of input materials) in the Hybrid Timber Papermaking Process should not change the Service’s view that the underlying activity is still the processing of a Natural Resource,” writes Brian A. Meighan of PwC.
So paper companies would split off their virgin containerboard mills as MLPs, and sell off perhaps a quarter for an immediate infusion of cash.
KapStone has up to 98% upside if it forms an MLP: Perry Capital
But investors also treat MLPs differently than they do run of the mill paper companies: Kapstone currently has one of the richest valuations in the industry at 7.3x EV/EBITDA, but Perry Capital argues that yield hungry investors are likely to set a higher multiple on its MLPs. The paper industry is already pretty consolidated with KapStone Paper and Packaging Corp. (NYSE:KS), International Paper Company (NYSE:IP), Rock-Tenn Company (NYSE:RKT), Packaging Corporation of America (NYSE:PKG), and Georgia-Pacific (a subsidiary of Koch Industries) accounting for 79% of containerboard production last year, up from 43% in 1995. But even if there isn’t room for M&A deals, at the very least management could return value to shareholders with buyback programs for the less expensive parent company stock.
Perry also argues that the value of the mills is unlikely to go down because they are already low on the international cost curve and can rely on the stable food and beverage market plus growing ecommerce (which drives demand for corrugated boxes for all the shipping) to support prices.
Assuming MLP terminal yields in the 7% – 8% range, Perry Capital sees the most upside for KapStone Paper and Packaging Corp. (NYSE:KS) shares, as much as 98% over current prices, but even his most conservative upside is 50% – 62% for International Paper Company (NYSE:IP). You can see the sum-of-the-parts valuations for KS, IP, and Rock-Tenn Company (NYSE:RKT) below for the full breakdown.