Industry Reports

Deutsche Bank Reports Summaries

070705 Deutsche Bank Report - Are Expectations Rising Too Fast for MWV?

Deutsche Bank - Equity Research

We recently spent time with MeadWestvaco's CFO, Mark Rajkowski, visiting investors in Boston.  We walked away more convinced that management has begun to embrace meaningful change.   In the near-term, the questions on the stock revolve around the pace and extent of change.  Despite a number of encouraging signs, we are concerned about a potential mismatch between the heightened expectations by some new investors and a more measured pace of change being pursued by management.

We agree with the bulls that the company is changing and that there remains significant value to be unlocked.  After a slow start, we think Rajkowski has found his “sea legs” and is emerging as more forceful CFO and an internal advocate for deeper change.     In our view, the recent addition of James Kilts to the Board can only help to accelerate change.  We share the belief that there remains meaningful value to be unlocked at MeadWestvaco.   For example, in early 2006, we underscored the potential value of MWV's Charleston- area landholdings in a note drawing parallels between Westvaco's South Carolina lands with St. Joe's (NYSE: JOE) Florida holdings.  Our current asset valuation – which we deem “cautious” - suggests $49/share in potential value.

Timing and execution are both issues.  In contrast to the sweeping & rapid restructuring pursued by Temple-Inland, MWV's repositioning seems tentative in scope and apt to stretch into a multi-year process.  Dramatic value recognition on the SC real estate will not occur until the land is entitled - a multi-year process in which delays are possible.  Finally, we still have many questions about execution on MWV's 7yr-old strategy of expanding in downstream, value-added packaging.   Concern about acquisition discipline remains, but the bigger issue is whether MWV has the management culture & compensation systems to continually develop innovative packaging and attract/retain the needed talent.  As Mark Rajkowski noted, ‘we need to do a better job developing and commercializing new products.'

MeadWestvaco is changing - - - that fact is clear.  The company shed its large coated paper operations 2 yrs ago and is currently monetizing 290K acres of timberland in Alabama, Georgia and West Virginia.  Based on recent conversations with the trade, we believe a sales announcement is close at hand and that values should be at least $1400-1500/acre – a good $200-300/acre above our published estimate.  Management has promised another $300-400MM of HBU land sales over the next few years.  In addition, we believe the company could eventually sell its Charleston, SC containerboard & kraft paper mill.   Over the next 12-24 months, we would not be surprised to see the sale of the struggling media packaging operations ($550MM/yr in sales).   Indeed, Rajkowski's comments (‘we need to ask about the future of this business') suggested to us that the only issue with packaging is “when”, not “if”.  They'd clearly like to implement some “fixes” before selling the business.  The real question here is how much any buyer will pay for this poorly performing and structurally-challenged business.  Finally, MWV has a number of "odds & ends" like small specialty paper mills which are apt to be sold at some point.

What's not for sale?  It does not appear that the firm's Brazilian operations (Rigesa - forestry, paperboard & higher-end corrugatedpackaging) or its specialty chemical business are on the table.  On the contrary, MWV continues to assess opportunities to expand paperboard production in Brazil.  For the moment, an aggressive expansion program by Klabin (the key competitor in BZ), is delaying any final decision by MWV.   Although we are a big fan of Rigesa, we remain skeptical about the long-term “fit” within MWV.   High-productivity timberland and a strong position in the Brazilian corrugated market would make Rigesa an extremely attractive acquisition candidate.   It's not hard to imagine someone paying a big price for Rigesa and its growth potential.  Domestically, aside from the Charleston mill, Rajkowski suggested that MWV was happy with its other US paperboard mill operations.  There is no evidence of a serious look at disposing of specialty chemicals.   However Rajkowski did leave the door open to a sale at the ‘right price.'  Finally, we don't believe that a sale of the Consumer & Office Products business is on the table in the near-term.  Mark Rajkowski argued that cashflow from COP is important in funding the dividend and pointed to potential tax leakage on an outright sale.   

Cost-cutting remains another focus.  Rajkowski noted that a benchmarking study of overhead costs had placed MWV in the fourth quartile.  A current cost reduction program will drive SG&A down to just 11% of sales.  Rajkowski suggested that the number should eventually drop to 10%. On a $7B sales base, the leverage from a 100- 150bps reduction in overhead is $70-105MM - - - equivalent to $0.38- 0.57/share on a pretax basis.  The CFO also suggested that there was still more work to be done in reducing mill-level costs at MWV. 

What to look for in the near-term?  We believe that a large proportion of the proceeds from the pending land sale will be returned to shareholders - - - probably, through a share repurchase.  Management is quite conscious of rising shareholder pressures and appears inclined to address some of concerns through a return of cash (both dividends & share repurchase).   The near-term earnings news isn't quite as encouraging.  While paperboard prices are rising, the media packaging business remains very weak and performance in specialty chemicals is dampened by weakness in the automotive sector.  Our own estimates for Q2 appear overly optimistic.  We are trimming our Q2 EPS estimate from $0.35/share to $0.20/share and our FY07 EPS estimate from $1.40/share to $1.10/share.  Our 2008 estimate is trimmed from $1.70 to $1.60.

What to do with the stock?  We are raising our target price from $35/share to $39/share and maintaining our Hold rating.  At $39/share, MWV is valued at 9.3X 2007 and 8.3X 2008 on an EV/EBTIDA basis.   These multiples are in-line with the current mean on our paper & paperboard universe for both 2007 and 2008 and slightly above the mean for mid-cap packaging companies in our coverage.  Given MWV's unique land-base with its high potential value, the premium to other packaging companies isn't hard to defend.  This target is $10/share below our estimated break-up value and reflects the uncertainty around timing and extent of restructuring moves.  The stock is currently trading near its highs.  We expect MWV to continue performing well in the near-term as speculation continues to build around the pending 290K acre land sale and as investors focus more attention on restructuring potential.  As we noted early on, the chief risk to the stock is a mismatch between the expectations of some new shareholders and those of management and the Board.