The longer you invest in the stock market, the more familiar you become with a lot of the concepts that are used to define and justify the various investing methods that drive them. Years ago, as I began to incorporate technical analysis and shorter-term trading strategies into my system, one of those basic principles was the idea that “the market is always right.” This is an idea that a lot of technicians also like to refer to as “efficient market theory.”
Efficient market theory holds that asset prices fully reflect all available information at any given point in time – in other words, that no matter what is driving a stock’s price right now, it is a perfect reflection of all of the information available about that stock. The strength of the theory that I found helpful in my own investing was the way it helped me begin to disconnect the natural desire we all have to believe a stock “should” move in one direction or another. Instead, it taught me to simply use a stock’s current information – technical or fundamental – to evaluate the direction and type of investment that I thought best fit those current conditions.
The idea that Mr. Market is always right is a bit at odds, in my opinion with other, longer-term investing strategies like value investing. That isn’t because a value-oriented investor is given license to operate on a less objective basis, but rather because a core principle behind value analysis isn’t just about what a stock’s price is right now, or what direction it could move in the near term, but also about what whether that price represents a bargain right now. The idea a stock could be cheap automatically infers an opinion about what a stock’s price should be versus where it is now, and that is where I think the disconnect between efficient market theory and value analysis is found.
Westrock Company (WRK) is an interesting case in point. The stock is at the low end of a long-term downward trend that began in January 2018 and has seen the stock decline from a peak at around $71 to a recent low at around $32. Such an extended decline is something that any technical trader will look at and decide that there is zero basis for any kind of a bullish trade to be made. A value investor, on the other hand will look at that same trend, and should automatically wonder if there is something that could make the stock interesting as a good value opportunity. The truth is that there are some holes in this stock’s fundamental profile that, if you don’t dive a little deeper than what the metric reflects, you’ll be tempted to simply that Mr. Market is right, and this is a stock to stay away from. I think that there are a few interesting reasons, however that could make WRK worth paying attention to at its current price for a patient investor with a long-term, value-based perspective.
Fundamental and Value Profile
WestRock Company, incorporated on March 6, 2015, is a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. The Company also develops real estate in the Charleston, South Carolina region. The Company’s segments include Corrugated Packaging, Consumer Packaging, and Land and Development. The Corrugated Packaging segment consists of its containerboard mill and corrugated packaging operations, as well as its recycling operations. The Consumer Packaging segment consists of consumer mills, folding carton, beverage, merchandising displays, and partition operations. The Land and Development segment is engaged in the development and sale of real estate primarily in Charleston, South Carolina. WRK has a current market cap of $9.4 billion.
Earnings and Sales Growth: Over the past year, earnings declined -3.6%, while sales improved about 15%. In the last quarter, earnings declined by the same amount as the last twelve months, -3.6%, while sales grew by 6.76%. That’s not a great pattern to see, and the warning flag should be raised a little higher when you factor WRK’s margin profile as well. The company operates with a very narrow margin profile right now; over the last twelve months, Net Income was 4.89% of Revenues, and narrowed to about 3.5% in the last quarter. This is an extension of a pattern of deterioration in Net Income since late 2018 that should raise eyebrows. Why the extended decline that has seen Net Income versus Revenues decrease from 11.7% just a handful of months ago to its current level? In November 2018, WRK completed a $4.8 billion acquisition of KapStone Paper & Packaging, using debt to finance a large portion of the acquisition. That, perhaps more than any other factor, seems to be the driving force behind the declining numbers. Management, and most analysts however are saying the acquisition will be accretive to both earnings per share and cash flow, meaning that these numbers should all begin to see significant improvement in the months ahead.
Free Cash Flow: WRK’s Free Cash Flow is healthy, at $1.265 billion, and which translates to an attractive Free Cash Flow Yield of 13.7%.
Debt to Equity: WRK has a debt/equity ratio of .80, which is pretty conservative but has declined since November 2018 from just .49. The company doesn’t have great liquidity, with cash and liquid assets of a little over $154 million in the last quarter versus long-term debt of more than $9.3 billion; it is worth noting that the increase in debt, which also corresponds to a significant decline in cash, is primarily tied to the KapStone acquisition.
Dividend: WRK pays an annual dividend of $1.82 per share, which at its current price translates to a very attractive dividend yield of about 5.08%. The passive income the stock’s fat dividend offers could be a compelling factor to consider for holding the stock and letting the price work through whatever market conditions do to the stock in the long term.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for WRK is $45.34 per share. At the stock’s current price, that translates to a Price/Book Ratio of .80. The stock’s historical Price/Book ratio by comparison is 1.34 and puts the top end of the stock’s long-term price target at almost $61 per share. The stock’s Price/Cash Flow ratio provides an even more optimistic view, since the stock is currently trading more than 76% below its historical average. Together, both elements put the stock’s long-term target price between $61 to $75 per share – which is pretty compelling right now. Value trap? In the short-term, maybe; the truth is that the stock could decline even further than it has over the last eighteen months. There are some industry and economic headwinds that are working against WRK’s business right now, including (no surprise) trade and tariffs, but in the long-term, the KapStone acquisition should help to give the stock an opportunity to expand its profitability significantly, which would give the market a reason to start paying much closer attention.
Technical Profile
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: WRK’s downward trend since late January is easy to see. That trend may have found a bottom at around $32, as the stock has rallied from that point and appears to be setting up a new consolidation pattern a little above $35; but the same could have been said March before the stock broke down to set that multi-year $32 low. The truth is that the stock will need to test, and hold support for a more extended period of time than it has been able to manage to this point before the downward trend can be considered to be slowing enough to build any kind of new bullish opportunity. That perspective could change, however, if the stock can manage to push above pivot resistance between $38 and $39. I’ll put the required break price at $40; if that happens, the stock should be able to see good bullish momentum to test next resistance around $47 per share. If support around $32 is broken, the stock’s next support point is around $27 from its all-time low in early 2016.
Near-term Keys: A short-term bullish trade right is now is extremely speculative on this stock; you really shouldn’t begin to consider any kind of momentum-based bullish trade unless the stock does manage to rally to about $40. That could be an early signal to buy the stock or work with call options, with an eye on the stock’s November 2018 high around $47 as an exit target. The stock’s current momentum also makes a bearish trade hard to see, unless major support at $32 doesn’t hold. If the stock can set a new multiyear low, you could consider shorting the stock or working with put options with an eye on $27 as the exit target for that trade. From a value perspective, there are definitely some risks to taking on a long-term position in WRK right now. The truth is that I don’t expect to see this stock’s price rallying significantly in the foreseeable future; I think there are too many question marks. The stock’s deteriorating pattern of Net Income and increasing debt would need to show major signs of improvement in both cases, and there are some strong headwinds coming from industry and broader economic conditions right now that might make you want to stay away.