Paper Gains
An initial appraisal of the Smurfit Kappa / WestRock merger situation.
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I’ve written before that public equities involved in transformative merger transactions can make for interesting value situations. Within this framework, a recently announced merger transaction in the paper and packaging industry caught my attention.
In September, Irish-headquartered Smurfit Kappa Group Plc (SK3 / SKG) and US-based WestRock Company (WRK) announced they were merging in a ~$11bn+ transaction to form the global industry leader with PF revenues of ~$34bn, making the combined company ~1.7x larger than nearest competitor International Paper (IP):
Source: Smurfit WestRock merger presentation, September 2023.
The timing of the transaction is interesting. The paper and packaging industry experienced a boom in the wake of the COVID pandemic, during which profits peaked thanks to spiking demand for corrugated cardboard boxes and packaging as online shopping surged during pandemic lockdowns. Since the second half of 2022 however, demand has weakened and prices for containerboard (the material used to make boxes and packaging) have declined as the pandemic boom has faded with inventory destocking and inflationary pressures casting a negative outlook over the industry. This outlook is reflected in both companies’ share price performance since then, with SK3’s stock declining -29% from its pandemic-era peak of ~€50/share to ~€35.84 just prior to the merger being announced, while WRK’s fell ~45% from its pandemic peak of almost ~$62/share to ~$34 share prior to the deal announcement:
Since the merger announcement on 12 September, SK3’s share price has appreciated ~1.6%, while WRK’s has appreciated ~25%, however both remain well below their previous COVID-era peaks (SK3 at -27% and WRK at -31% respectively).
Notably, on announcement of the merger, SK3’s stock price initially reacted negatively, falling ~10% at one point, reflecting investor concerns around the ~28% implied premium being paid for WRK stock under the transaction terms (discussed below) given WRK’s relatively high leverage (~2.7x net debt/EBITDA), a challenging industry/macro outlook and questions around the achievability of targeted synergies of ~$400m.
However, there has been evidence of improving fundamentals recently, with signs of demand recovery and price increases being implemented by WRK, IP and fellow US peer Packaging Corporation of America (PKG), while SK3 reported a positive Q3 trading update noting YoY volume growth in its Europe and Americas segments.
As such, the combination of SK3 and WRK is occurring at a potentially very opportune time, creating by a fair margin the global market leader in a consolidating packaging industry just as fundamentals may be recovering (particularly if the growing consensus view of a soft landing is proven correct over the next 12 months).
As an aside, both SK3 and WRK have played active roles in industry consolidation in recent years. SK3 was the subject of a rejected takeover bid by IP in 2018 at an indicative valuation of ~9.5x EBITDA. Prior to this, SK3 was formed via predecessor entity Jefferson Smurfit Group acquiring Dutch peer Kappa Packaging in 2005 to form the largest paper and packaging group in Europe. Similarly, WRK was formed in 2015 via the merger of two US packaging companies, MeadWestvaco and Rock Tenn Company, to form the #2 player in the US market (behind IP). More recently, WRK acquired smaller, US-listed peer KapStone Paper and Packaging in 2018 (at a ~10x valuation), putting it on a par with market leader IP in revenue terms.
While the SK3/WRK deal is being billed as a merger, it is essentially a takeover of WRK by SK3, with SK3 shareholders holding a (marginal) majority stake in the combined company post-completion (50.4%), and given that SK3 CEO Tony Smurfit will lead the new company. In addition, the new board will comprise 8 directors from SK3 and 6 from WRK.
While there is a clear strategic and commercial rationale for the merger (which I outline below), a key feature of the deal is that the combined company will obtain a new US listing post-merger. Currently, SK3 has a primary listing on the London Stock Exchange and a secondary listing on the Euronext Dublin (Irish Stock Exchange aka “ISEQ”), while WRK is listed on the NYSE. Post-merger, the combined company will move its primary listing to the NYSE and retain a secondary listing on the LSE, but de-list from the Euronext.
The move to a US listing effectively offers a multiple arbitrage play on both SK3 and WRK stock, in two respects. Firstly, it’s well reported that US stocks generally trade at a premium to European-listed names, and within the packaging industry US companies have historically traded at a premium to European listed peers:
Source: Value Situations analysis; Koyfin.
As such, a US listing on the NYSE should lead to a substantial re-rating of SK3’s equity (as part of the new combined company) as it is re-positioned as both the global market leader and a US-listed company with a deeper investor base, greater analyst coverage and more liquidity. Tony Smurfit, SK3 CEO and CEO-designate of the combined business articulated this view in his remarks on announcing the deal:
“We want to gravitate towards a market that has much more liquidity and higher ratings… And if we’re the best, which I think we will be, in time, then we will have a significantly higher rating than we currently have, which obviously will translate into significant value creation for our owners.”
Secondly, WRK has traded at a discount to US peers such as IP and PKG due to its higher debt load and weaker margins. This fact led to the announcement of a transformation plan last year with a target of delivering $1bn in cost and productivity savings by FY25. In combining with SK3, this transformation plan should be accelerated and WRK’s business should benefit from integration with SK3’s higher margin, higher ROIC operations and generate improved earnings over time. As such, WRK’s equity value should re-rate in line with peers as part of a stronger, combined company with SK3 post-merger.
As I outline below, the headline terms at the time of the deal announcement in September valued WRK at $43.51/share, based on the SK3 share price at the time plus a $5/share cash consideration component payable to WRK shareholders. This equated to a ~28% premium to WRK’s share price prior to the deal being announced and implied a valuation multiple of ~6.2x EBITDA for WRK at the time. Furthermore, the deal terms implied an overall PF valuation multiple of 6.3x for the combined business, well below US-listed peers (as per the chart above) and valuations indicated by precedent private market transaction multiples in the sector (~10x).
This multiple arbitrage value potential has been well illustrated recently in the case of another Irish headquartered large cap name that moved to a US listing, with CRH Plc re-rating from a sub-7.5x multiple to ~9x today, unlocking significant value for shareholders.
With that context, lets now examine the deal and potential value opportunity in more detail…