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Kapstone Paper (KPPC) is a microcap paper company specializing in the production of kraft paper, the strong brown paper used for packaging and paper laminating applications. Kraft paper is made into grocery bags, consumer packaging for flour/sugar/pet food etc., industrial packaging for fertilizers/cement/dry chemicals etc, wrapping papers (the kind found around a burger at a fast food restaurant), corrugated cartons, and dunnage bags (inflatable paper bags used to secure goods during freight). The US market for kraft paper has been in a long-term decline due to competition from plastics. Most supermarkets and grocery stores have by now switched to plastic bags, which cost 2 cents each, while paper bags cost 5 cents each. Alternative plastic materials are also threatening to replace multiwall paper sacks in many industrial and consumer packaging applications. Currently, the US kraft paper market is approximately 1.5 million tons, with around 40% used for grocery paper and sack, 40% used for multiwall packaging, and 20% used for wrapping and converting papers. Most analysts predict that the US kraft paper market will stop declining and stabilize in 2009, as almost all grocery stores now use plastic bags, and the remaining users of kraft paper are unlikely to switch. Kapstone’s two paper mills together produce some 1.2 million tons of kraft paper, with a dominant share of the domestic kraft paper market.

The long-term decline in the kraft paper market has led to the closing of many kraft paper mills by the major paper companies, and they are now eager to exit this market. Kapstone’s strategy is to acquire these kraft paper mills on the cheap and achieve the market power to increase product prices. Kapstone Paper was founded in 2006 by Roger Stone, a veteran of the paper industry, through the sale of 20 million units of one common stock plus two warrants, each warrant with a strike price of $5 and expiring in August 2009, for $6 a unit. Together with existing 5 million shares, this gives the new company a share base of 25 million and $120 million in cash. In Jan 2008, Kapstone paid International Paper $155 million for a kraft paper mill in Roanoke Rapids, North Carolina, and an inflatable dunnage bag plant in Arkansas, with two contingent payments of up to $60 million, payable 5 years after acquisition depending on earnings achieved. The Roanoke mill produced some 400k tons of kraft paper in 2007. In July 2008, Kapstone paid MeadWestvaco $485 million for a kraft paper mill located in Charleston, South Carolina. The Charleston mill produced some 800k tons of kraft paper in 2007.

What is the profitability of this market? For the year ending December 2007, Kapstone produced some 400k tons of kraft paper from its Roanoke mill with a net revenue of $228 million, and gross profits of $51.9 million, for a 22% gross margin. The dunnage bag business contributed an additional $6.3 million in gross profit, and with $13.9 million of SG&A expenses, EBITDA comes out to $44.3 million, or an impressive 29% pre-tax return on the $155 million investment. KPPC was similarly profitable for the first 2 quarters of 2008 ending in June, after which it bought the Charleston mill. In its Q2 2008 earnings call, Kapstone management mentioned strong backlogs in kraft paper as well as continuing price increases in kraft paper. With the new Charleston acquisition, Kapstone will now produce some 1.2 million tons of kraft paper annually, and and Kapstone is estimated to reach an annual revenues of $780 million, and an EBIDTA of $100-120 million.

Kapstone has several factors in its favor. Firstly, the kraft paper market may be poised to turn due to increasing environmental awareness. Unlike plastic bags, paper bags are carbon-neutral, and plastic bag bans have been instituted in a number of cities and nations. Secondly, kraft paper demand is also somewhat resistant to a recession. A large percentage of kraft paper sales is for food packaging and grocery bags, and this demand is unlikely to decline even in a recession. Thirdly, Kapstone has one of the lowest cost structure in the kraft paper market. Kraft paper manufacture is energy intensive, and the cost of kraft paper is highly sensitive to the price of pulp as well as energy. The Charleston mill comes with a coal co-generation plant, which gives Kapstone a huge savings in energy costs when oil prices are high. Domestic competition comes from International Paper, which has indicated that it is intending to exit this niche market. Limited competition also comes Canadian and Scandavinian paper mills, which enjoy a pulp cost advantage, but incurs a freight cost disadvantage compared to Kapstone. In general, the higher the energy costs, the greater the cost advantage enjoyed by Kapstone. Lastly, Kapstone has a high insider ownership, with recent heavy insider buying.

The risks involved in this investment mainly pertain to the leverage involved. KPPC has about $455 million in long-term debt, and a $100 million credit line, with some $56 million in cash-on-hand as of June 2008 (which has probably decreased to around $30 million due to the Charleston acquisition). Therefore, debt runs at about 4 to 5 times EBIDTA. Interest expense is pegged to the Bank of America prime rate, and interest expense plus mandatory principal payments are expected to be $30-40 million annually, which consumes some 30-40% of the $100 million EBIDTA. I estimate that to adequately cover its debt, annual revenues have to be at least $720 million. In the worst case scenario, if revenues drop by 15% to $660 million, KPPC will incur losses of $60 million annually, a burn rate which it can probably sustain for 2 years.

I was first attracted to this stock a few weeks ago due to its heavy insider purchases. At that time, I felt that despite the risk, there is considerable upside and minimal downside in KPPC, and bought a half-position at $6.30. Since then, the general economic outlook has darkened considerably, and the stock has sunk accordingly. A lot now depends on how well kraft paper demand holds up in a recession. However, I still think there is a decent chance that the company will emerge unscathed from the recession, and hence am still holding onto this stock. I will be paying attention to the next quarterly report by the company. Specifically, I am looking for quarterly revenues above $180 million (translating to my estimated breakeven point of $720 million annually), as well as management predictions about future kraft demand.