If you have been following my work lately, you can probably tell that I have been on a discounted cash flow analysis binge. It took me a long time to warm up to the idea of using so many estimates to calculate an intrinsic value for a company, but I feel like the advantages of trying outweigh the disadvantages of not having precise numbers. The danger in using estimates can, in part, be mitigated by being conservative, which I attempt to be. The DCF analysis takes a lot of emotion out of investing for me: if I use conservative projections and determine that a company I really like is sitting in my buy range based on the intrinsic value I determine through my required rates of return, I will buy. Doesn’t matter if that company is at all-time highs or is falling like a knife. Today, I want to conduct the analysis for Packaging Corp. of America (PKG), and see if where I bought it at will meet my target rate of return, and if I should buy even more.
The Analysis
Like I mentioned, DCF analysis requires making a lot of estimates. Without insider knowledge, thorough industry specific knowledge, or management guidance, the challenge of making accurate projections is even more pronounced. With PKG, I have none of the above mentioned things. Therefore, the only resource I have is past performance, coupled with my general outlook for the industry in which PKG competes. Given that they sell cardboard boxes for a variety of applications, to include e-commerce, I feel like the future growth potential is very good. They also have a brilliant history. Under those premises, let’s get into the specifics. Below is my reasoning for making the assumptions I did for each component of the DCF analysis:
Revenue: PKG has grown revenue by 11.81% per year in the past 10 years. That growth has accelerated in the last 5 years, coming in at just above 15%. Given that percent returns diminish with larger numbers, I don’t think PKG can maintain quite that growth rate in the next ten years. I am going to go with 9% growth in revenue each year for the next decade. This growth will come from GDP growth, growth in e-commerce specifically (which is set to outpace GDP), organic investments PKG makes, and acquisitions as the industry continues to consolidate.
Operating costs: PKG has done impressive work improving margins over the past decade. This has come in part from increased vertical integration. They are 95% vertically integrated, the highest in the industry. As they continue to invest in vertical integration and look at other ways to bring up margins, their operating costs will go down. Here are my margin projections:
| 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | |
| operating margin % | 14.8 | 15 | 15.25 | 15.5 | 15.75 | 16 | 16 | 16 | 16 |
Taxes: I used a 25% tax rate across the board, which is in line with what management has guided to in the 24-26% range for 2018.
Net Investment: This consists of what is spent on CAPEX minus non-cash depreciation. To get these numbers, I looked at how much CAPEX and depreciation there was, as a percent of revenue, in each of the last ten years. Then, I average those numbers and applied the result to each years revenue to get a projection for how much there will be each year for the next decade. My numbers for CAPEX was 6.9% of revenue and depreciation was 6.2% of revenue. While this lacks nuance, I feel that what has happened in the past 10 years is a decent indicator of what it takes, on average, to run the business, and that those numbers will remain relatively steady.
Change in Working Capital: My method here is similar to net investments. I look at how much working capital there was, as a percent of revenue, at each year end going back ten years. Averaging those values gives me a decent idea of how much working capital will exist at each year end for the next ten years, or how much working capital is needed to run the business as the business grows. Subtracting the year over year difference gives me the change in working capital.
After capturing each years free cash flow, I need a terminal value. I don’t anticipate PKG going away after ten years, so something has to account for their continued operation. For my terminal value, I assume 2% FCF growth in perpetuity.
I then discount each years free cash flow back to the present using two values that represent the range for my required rates of return. I am aiming for compound annual gains of 12-15% from my investments. Adding all the discounted free cash flows together, I then subtract the current debt outstanding of $2.4 billion. This number then gets divided by shares outstanding for my intrinsic value range of $93.50-$111.58. Anything between those values should return between 12-15% each year for the long haul. Given that I first bought PKG at ~$109 and shares are currently trading at ~$106, I feel confident about my entry point and will add if it continues to drop.
EPS Growth
The other model I like to use is projecting EPS into the future, applying a P/E ratio to that number to get a future stock price, and then discounting that value back to the present to determine an intrinsic value. The advantages to this method are two-fold: 1) It requires a lot less estimating (which hopefully means less likelihood for error) and 2) it takes into consideration market sentiment, through the multiple application, that DCF lacks.
PKG has grown EPS by more than 20% in the past decade. However, I highly doubt they will be able to maintain that in the next decade, if for no other reason than it is harder to compound larger numbers at high rates. So, to be conservative, I am going to say that they can grow EPS by 10% per year for the next decade. Like I mentioned with revenue above, this growth will come from GDP growth, growth in e-commerce specifically (which is set to outpace GDP), organic investments PKG makes (MUTF:CAPEX), and acquisitions as the industry continues to consolidate. Furthermore, any share-buyback activity will boost EPS as well. I think 10% is reasonable. Under these premises, in ten years EPS will be at $20.15. Applying the current 5-year P/E ratio average of 17.36, that would result in a stock price of $349.86. Discounted back to the present using my required rates of return gives me a price range of $86-$112. Shares are currently in that buy zone.
Conclusion
By both measures, I think PKG is going to return 12-15% from these levels in the long run. I am layering into a position currently, averaging down opportunistically. Shares are have been trading mostly sideways for a year, and given the good growth prospects, I don’t think a break-out is unlikely. They outperform their peers in terms of margins and ROIC, and are therefore better poised to take advantage of e-commerce trends in a disciplined and profitable manner.
Disclosure: I am/we are long PKG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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