I used to be really into weightlifting when I was younger.
And there’s one saying from back then that I’ll never forget:
“Everybody wants to get big, but nobody wants to lift heavy weight.”
Well, a similar thing could be said about wealth:
Everybody wants to become rich, but nobody wants to to work hard, save, and invest.
Of course, you’re not a nobody.
That’s why you’re reading this article today.
And it led me to becoming financially independent and retired in my early 30s, as I lay out in my Early Retirement Blueprint.
The hard work and saving is up to you.
But I think I can help a bit with the investing aspect.
I’m going to reveal a high-quality dividend growth stock that appears to be undervalued.
This could be a huge long-term opportunity for you.
I’ve personally experienced a ton of success with the dividend growth investing strategy.
In fact, following this strategy allowed me to build the FIRE Fund.
That’s my real-money early retirement stock portfolio that generate the five-figure passive dividend income I live off of.
Dividend growth investing involves buying and holding stock in world-class enterprises that pay their shareholders rising cash dividend payments.
You can find more than 800 US-listed dividend growth stocks by checking out the Dividend Champions, Contenders, and Challengers list.
But you have to work hard, save your money, and buy the stock.
And it’s not just about buying high-quality dividend growth stocks.
It’s about buying high-quality dividend growth stocks when they’re undervalued.
Valuation at the time of investment can play a critical role in the long-term success of an investment.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
Putting the two together is a massive boon for your possible long-term rate of return.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
You want to limit your downside, while simultaneously maximizing your upside.
These dynamics are clearly favorable to the long-term investor.
Fortunately, they’re not that difficult to spot and take advantage of.
Fellow contributor Dave Van Knapp put together an excellent valuation tool for dividend growth stocks.
Check out Lesson 11: Valuation, which is part of an overarching series on dividend growth investing.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
WestRock Company (WRK)
WestRock Company (WRK) is a leading integrated manufacturer of various corrugated and consumer packaging materials.
The company was formed through the 2015 merger between Rock-Tenn and MeadWestvaco.
With more than 320 manufacturing facilities across the world, WestRock Company has become one of the world’s largest producers of corrugated medium and linerboard. They sell these products to more than 15,000 customers.
Producing various paper products such as containerboard, folding cartons, and displays, the company’s packaging solutions are an integral part of end markets ranging from foodservice to healthcare.
E-commerce is obviously a huge trend in the US, and globally.
More and more people increasingly shop online.
Well, those products have to be packaged, boxed, and shipped – and this is a long-term tailwind for companies that produce quality packaging materials.
That’s a tailwind that’s on top of the usual demand for these materials.
In addition to this, developed countries are starting to move away from plastics.
You see this in everything from straws to bags to packaging.
This could be another long-term tailwind for paper companies that are all too happy to step in with their own solutions. The growing popularity of paper straws is a great example of this.
WestRock reports in three segments: Corrugated Packaging, 55% of FY 2018 sales; and Consumer Packaging, 44%. The third segment, Land & Development, is immaterial and will cease to exist in FY 2019.
This isn’t the kind of company you think of when you go about your daily life.
You might not ever notice their logo.
But their products show up practically everywhere.
The box your tub of toothpaste came in. The cardboard your ice cream from the grocery store is housed in. The neat container that holds your french fries when you swing through a drive-thru for afternoon lunch.
Again, the products are all around us.
Dividend Growth, Growth Rate, Payout Ratio and Yield
This ubiquity screams one thing to me.
As it sits, the company has increased its dividend for 10 consecutive years.
That track record actually predates the aforementioned merger.
If you want to look at the post-merger record, WestRock’s first official dividend increase in its current iteration occurred in 2016.
Regardless, the company is clearly committed to a big and growing dividend.
The three-year dividend growth rate is a stout 11.7%.
Even the most recent increase came in at almost 6%.
That’s not bad at all when you consider the stock yields a monstrous 5.44%.
This yield, by the way, is more than 260 basis points higher than the stock’s own five-year average yield.
With a payout ratio of 56.5%, this dividend is easily covered and in a great position to continue growing.
Of course, that future dividend growth is what dividend growth investors should be most concerned about.
Revenue and Earnings Growth
We invest in where a company is going, not where it’s been.
In order to estimate what kind of dividend growth to expect, I’ll build out a forward-looking trajectory by first showing you what the company has historically done in terms of top-line and bottom-line growth.
And then I’ll compare that to a near-term professional forecast for WestRock’s profit growth.
The dividend is ultimately only able to grow as much as earnings will allow for.
So having a very good idea of what kind of earnings growth to expect will give us a very good idea of what kind of dividend growth to expect.
Now, I usually use a 10-year period for top-line and bottom-line growth.
I consider 10 years as a pretty good proxy for the long term.
However, because WestRock in its current form didn’t exist until 2015 (upon which time the aforementioned merger was completed), I don’t think the years prior to this are particularly relevant to the company as it stands today.
As such, I’m going to show you top-line and bottom-line growth between FY 2015 and FY 2018.
WestRock increased its revenue from $11.381 billion in FY 2015 to $16.285 billion in FY 2018.
That’s a compound annual growth rate of 12.69%.
I usually look for mid-single-digit revenue growth from a fairly mature company.
WestRock obviously did much better than this. It’s impressive.
However, it’s difficult to make too much of this since it’s such a short period of time. It’s skewed by this.
Meanwhile, earnings per share increased from $2.93 to $4.09 over this period, which is a CAGR of 11.21%.
(I used adjusted EPS for FY 2018 only because GAAP EPS for FY 2018 artificially jumped due to a significant one-time tax benefit.)
I wouldn’t expect WestRock to continue pumping out low-double-digit bottom-line growth from here.
But they don’t have to.
Even if the company’s EPS growth potential is closer to a mid-single-digit range, which I believe it is, that still allows for ~5% long-term dividend growth. And that’s plenty enough for most investors, with the starting yield being so high.
Looking forward, CFRA is predicting that WestRock will compound its EPS at an annual rate of 2% over the next three years.
CFRA seems to believe that WestRock is in a great position as a business, but the recent pressure on containerboard pricing has them concerned.
We have a forecast of 2% annual EPS growth here from CFRA.
And the company has produced something closer to 11% annual growth over the last few years.
A pretty wide divergence.
I think the truth lies somewhere in between.
One thing to keep in mind here, as it relates to future growth, is the surprising progress of a recent acquisition.
WestRock recently completed the $4.8 billion acquisition of KapStone Paper and Packaging Corporation, which strengthened WestRock Company’s US West Coast presence, added distribution capabilities, and also broadened the product portfolio.
The company expected this deal to quickly be accretive.
Part of that anticipation relates to realizing synergies of $200 million by the end of FY 2021.
Well, they’re actually ahead of pace on this.
The company’s Q3 FY 2019 quarterly report, which was released on August 1, noted that they’ve already achieved $80 million of run-rate synergies and performance improvements from the KapStone integration.
Moving over to the balance sheet, I think this is the one area of the business that could stand to be improved the most.
In particular, the KapStone acquisition really stretched the balance sheet.
The debt situation is, in my view, slightly concerning.
Well, management is fully aware of the need to reduce debt and clean things up.
That Q3 FY 2019 report showed notable improvement on this front – net debt declined $282 million compared to the Q2 FY 2019.
The long-term debt/equity ratio, as of Q3 FY 2019, is sitting at 0.83, while the interest coverage ratio is approximately 4.
Total cash is immaterial.
I’d like to see that interest coverage ratio get above 5 very soon. I see the number 5 as a kind of a “line in the sand” as it relates to a company’s ability to cover its ongoing interest expenses.
If the accretive nature of the KapStone acquisition holds true, the additional cash flow should give management the ammo they need to reduce debt while simultaneously modestly increasing the dividend.
Profitability is acceptable for the industry.
The company is producing some good numbers here, but it’s difficult to ascertain exactly what it’s going to look like after everything starts to smooth out.
The merger between Rock-Tenn and MeadWestvaco was completed in mid-2015.
And then the KapStone acquisition was completed in November 2018.
There are a lot of moving parts here.
But they’ve averaged annual net margin of 4.53% and annual return on equity of 6.80% between FY 2015 and FY 2018.
I think there’s some room for improvement here, too, but I see the balance sheet as a greater priority.
Overall, there’s a lot to like about the company.
It’s a boring business model that is looking at multiple long-term tailwinds.
However, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Also, any global economic slowdown would reduce demand for WestRock products across the board.
Furthermore, the KapStone acquisition was rather large relative to the size of WestRock. If there are any problems with the purchase, this could negatively affect results in a major way.
Interest rates are currently very low. This helps an indebted company like WestRock. But any rise in rates could impair their ability to pay debt and improve the balance sheet.
Lastly, this is largely a commodity business. They’re a price taker. Higher raw material costs are difficult to pass on with a lack of pricing power.
Stock Price Valuation
At the right valuation, though, this could be an outstanding long-term investment for dividend growth investors.
After a 40% drop in the stock’s price over the last year, the stock looks attractively valued…
The stock is trading hands for a P/E ratio of 10.43.
That’s about half that of the broader market’s earnings multiple.
The P/S ratio, at 0.7, is also less than half that of the stock’s own five-year P/S ratio of 1.6.
And the cash flow multiple, which is 3.2 right now, is way off of the stock’s three-year average P/CF ratio of 7.5.
Also, the yield, as noted earlier, is substantially higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 4%.
That long-term DGR is well below what the company has produced over the last decade.
It’s even lower than last year’s dividend raise.
The payout ratio remains modest, the company’s dividend commitment is evident, and the KapStone integration is ahead of schedule.
But I think the debt load needs continued attention (and cash flow).
And concerns relating to global economic slowing warrant a cautious expectation here.
WestRock seems unlikely to grow its dividend slower than this over the long run.
If anything, I think there’s room for the company to do better than this.
But I’d rather err on the side of caution right now.
The DDM analysis gives me a fair value of $47.32.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
My analysis wasn’t overly aggressive.
Yet the stock still looks very cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates WRK as a 4-star stock, with a fair value estimate of $55.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates WRK as a 4-star “BUY”, with a 12-month target price of $43.00.
I came out somewhere in the middle. Averaging out these three numbers gives us a final valuation of $48.44, which would indicate the stock is possibly 45% undervalued.
Bottom line: WestRock Company (WRK) is a packaging giant that offers a great way to play the e-commerce boom and the move away from plastics. With a 5.4% yield, a moderate payout ratio, 10 consecutive years of dividend raises, a long-term double-digit dividend growth rate, and the potential that shares are 45% undervalued, this dividend growth stock deserves a close look right now.
Note from DTA: How safe is WRK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 51. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, WRK’s dividend appears Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.
Silicon Valley Analyst: $5 Backdoor Apple Play [sponsor]
This little-known Apple project could be 10X bigger than the iPhone, MacBook, and iPad COMBINED. Here's the best way to play the opportunity. Click here for more details.