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WestRock to Gain From Favorable Demand, Higher Costs Ail

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On Jul 5, we issued an updated research report on WestRock Company (WRK - Free Report) . Favorable demand price and mix trends across paper and packaging businesses will drive the company’s fiscal 2018 results. Execution of its capital allocation strategy and the acquisition of KapStone Paper and Packaging Corporation , once complete, will drive growth. However, increased debts to fund the deal along with inflationary costs of raw materials remain headwinds.
Gearing Up for a Sound Q3 & Fiscal 2018 Despite Inflated Costs
WestRock’s second-quarter fiscal 2018 adjusted earnings per share surged 54% on a year-over-year basis to 83 cents. Adjusted earnings per share in third-quarter fiscal 2018 are expected to improve further from the second quarter. Lower recycled fiber costs are anticipated to positively impact margins. Further, sales price increases, seasonally higher volumes, favorable mix and continued productivity gains will lead to sequential rise of $98 million to $118 million in adjusted EBITDA.
However, higher transportation and certain chemical costs are likely to dent margins in the quarter. Further, maintenance downtime is likely to increase 83,000 tons sequentially across the company’s mill system in the third quarter, which will have an estimated $20 million cost impact quarter over quarter. Further, higher expected tax rate, higher depreciation and amortization and higher interest expense will impact adjusted earnings per share by 8-10 cents.
The Zacks Consensus Estimate for the third quarter is currently pegged at $1.05, reflecting year-over-year growth of 42%.
WestRock is benefiting from favorable demand, price and mix trends across its paper and packaging businesses. The company projects generating revenues of more than $16.4 billion and adjusted segment EBITDA to come in above $2.9 billion in fiscal 2018. Adjusted EBITDA margins are likely to increase by more than 250 basis points year over year to approximately 18%. WestRock maintained full-year adjusted operating cash flow guidance of greater than $2.45 billion.
The Zacks Consensus Estimate for fiscal 2018 is $4.04 (54% year-over-year growth) on the back of revenues of $16.3 billion (10% year-over-year growth).
Productivity Improvements Will Aid Results
WestRock was formed by the merger of MeadWestvaco and Rock-Tenn in July 2015. The company is realizing the strategic benefits of the merger. In second-quarter fiscal 2018, WestRock achieved $64 million in year-over-year productivity improvements, and a run rate of $975 million of synergy and performance improvements. The company anticipates achieving its $1 billion target in the next two months. This will be achieved by the productivity and performance improvement programs across its manufacturing footprint, as well as cost savings from capital investments. Further, manufacturing optimization and reductions from the elimination of duplicate corporate costs and support functions will support results.
KapStone Buyout Will Enhance Presence, Product Portfolio
WestRock previously announced that it will acquire all the outstanding shares of rival KapStone at $35 per share. On conclusion of the deal, it is anticipated to be accretive immediately to WestRock's adjusted earnings as well as cash flow and lead to around $200 million of annual cost synergies and performance improvements, with half to be realized within first 12 months. Notably, the deal is anticipated to be concluded by the end of the September quarter or during the December quarter.
KapStone’s corrugated packaging operations will enhance WestRock’s North American corrugated packaging business. It will help strengthen presence in western United States and to compete better in the growing agricultural markets in the region. The company will also be able to broaden portfolio of paper grades, allowing it to capitalize on the kraft bag market with the inclusion of KapStone's complementary specialty kraft paper offerings.
Higher Debt to Fund Deal 
WestRock plans to fund the cash portion of the KapStone deal through new debt and plans to refinance KapStone's assumed debts at the close of the deal. The company’s current debt-to-capitalization ratio is at 33%. Higher interest expenses will affect margins.
WestRock has underperformed the industry with respect to price performance over the past year. The stock has dipped 1%, while the industry has recorded growth of 10%.
Zacks Rank & Stocks to Consider
WestRock currently has a Zacks Rank #3 (Hold) and an impressive VGM Score of A. Here V stands for Value, G for Growth and M for Momentum. The score is a weighted combination of these three scores (Value - B, Growth - A, Momentum - B). Such a score allows you to eliminate the negative aspects of stocks and select winners. The VGM Score of A, along with some other key metrics, makes the company a solid choice for investors.
Some better-ranked stocks in the sector include KMG Chemicals, Inc. and Domtar Corporation (UFS - Free Report) . Both the stocks sport a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
KMG Chemicals has expected long-term growth rate of 28.5%. Its shares have appreciated 56% over the past year.
Domtar has expected long-term growth rate of 5%. Its shares have gained 22% over the past year.
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