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Thinking Outside The Cardboard Box

On Jan. 1, Los Angeles became the largest city in the U.S. to ban plastic shopping bags in grocery stores and other large retail venues that sell perishable foods.

Now a bill in the state legislature wants to make a plastic-bag ban statewide.

Other cities in California and elsewhere already have bans, or are considering them.

The war on plastic bags, petroleum-based products that foes say fill landfills and collect in oceans, may benefit a leading alternative: good old biodegradable paper bags.

Even without a legal mandate, a growing number of merchants have been rolling out the welcome mat for paper, Whole Foods (WFM) and Trader Joe's among them. McDonald's (MCD) is switching to paper cups from polystyrene for hot coffee in its thousands of U.S. units.

Does this mean old-school paper products are making a comeback

"It's not a dying industry," said Cathy Foley, vice president of the American Forest & Paper Association, or AF&PA. "We're growing. We're innovating. We're putting sustainable products into the marketplace.

Newsprint may be fading in the digital age. But contrary to popular opinion, the Web has not only failed to kill off the paper and paperboard industry, it is, in places, creating demand.

"Amazon (AMZN) might destroy the need for brick-and-mortar retail, but it doesn't destroy demand for boxes," said Stephen Chercover, a paper packaging analyst with D.A. Davidson & Co. "It might enhance demand for boxes.

Most companies that make boxes and packaging products are found in IBD's paper and paper products group. The group's 21 stocks collectively climbed 10% year-to date through Thursday, logging a 42% gain over the past 12 months. That puts the group at No. 23 among 197 industry groups.

Its companies range from the century-old giant International Paper Co. (IP), with nearly $30 billion in annual revenue, to the $2 billion in revenue Kapstone Paper and Packaging Corp. (KS), formed in 2005.

Kapstone specializes in unbleached heavy kraft wrapping and packaging paper and corrugated packaging.

Other top performers in the 21-member group include Packaging Corp. of America (PKG) and Graphic Packaging Holdings (GPK).

Game Changers

The U.S. paper business was long its own worst enemy, chasing boom-bust cycles that crippled profits. Over the past decade, consolidation and inventory management have been game changers.

"It was a fragmented industry that would compete away strong returns," Chercover said. "Now that you've got a much more consolidated industry, there's no hurry to ruin the party by adding capacity. Demand has not been exceptional, but supply has been matching demand and that has led to stable pricing with an upward bias.

Less excess inventory has meant firmer prices, Chercover says, which translate to better profits and less cyclicality.

Containerboard Conversion

In another piece of industry strategy, several newsprint plants have converted to containerboard production. They've had varying degrees of success, Chercover says.

"One of the things people fear is that desperate newsprint producers will convert and spoil the party," he said. But conversions haven't yet had much of an impact on the consolidating paper industry, he added.

That could change. Capacity increases due in part to newsprint conversions may be a factor in holding back containerboard price increases this year, analyst Adam Josephson of KeyBanc Capital wrote in a recent research note.

Almost all the major players have been acquisitive in recent years.

In 2011, Georgia-based Rock-Tenn (RKT) acquired Chicago's Smurfit-Stone Container in a $3.5 billion takeover. The combined company became the No. 2 North American producer of containerboard and the No. 2 producer of coated recycled board.

(International Paper is the top containerboard maker. Graphic Packaging leads coated recycled board segment.) Rock-Tenn is still on the move, announcing on March 3 it would buy the Simpson Tacoma Kraft Paper Mill in Tacoma, Wash.

In 2012, Tennessee-based International Paper bought corrugated packaging and building products company Temple-Inland in a deal valued at $4.5 billion.

That same year, Georgia-based Graphic Packaging, which provides packaging to food, beverage and consumer-product companies, bought two European carton operations.

Packaging Corp. of America acquired Boise in October, making it the fourth-largest producer of containerboard and corrugated products in the U.S.

The deals have often come with immediate benefits.

In July, Kapstone paid $1 billion for Longview, Wash.-based Longview Fibre Paper and Packaging, which makes containerboard, specialty kraft papers and corrugated products. Longview added $440 million in revenue and $160 million in adjusted EBITDA in the five and a half months it was part of Kapstone in 2013.

"Clearly the Longview acquisition was the key driver of our improved results," Chief Financial Officer Andrea Tarbox said in the Q4 conference call. "Longview has been highly accretive from day one.

Sunsetting 'Black Liquor' Credits

Kapstone's earnings in the quarter spiked 221% from the earlier year to 45 cents a share.

Profit-fueling acquisitions are especially welcome now that federal regulators are winding down the "black liquor" energy tax credits. The subsidy boosted profits among paper makers beginning in 2007, allowing tax credits for producers that used pulp-wood processing byproduct as fuel to generate in-house electricity.

Kapstone's federal cash tax rate for 2013 was only 2%. But as Tarbox said in the call, "I'm afraid, though, that those days are behind us.

Acquisitions have played a big part in building cash flow, which in turn is helping to pay off debt and return cash to shareholders or buy back shares.

Packaging Corp., which reported a 60% surge in Q4 earnings, said strong cash flow has allowed it to pay down $150 million in debt since it acquired Boise five months ago. Synergies from the merger were stronger than expected and realized sooner than forecast.

Meanwhile, producers haven't been averse to taking downtime to keep supply and demand in balance. In its December ending quarter, Rock-Tenn came in below views as weaker demand led to downtime at containerboard mills.

But prices rose by $9 per ton from the prior quarter and $65 from a year earlier, noted KeyBanc's Josephson.

By the second half of December, demand had improved. Management said in its late January report on the quarter that demand was firming across its markets. Its stock shot up nearly 6% on Jan. 29 despite the miss.

But it is Kapstone that is KeyBanc's "favorite idea" within the containerboard sector. That's because the well-managed firm, wrote Josephson, won't likely have to take much, if any, downtime, unlike significant downtime taken by some of its larger peers in 2013, International Paper included.

Also, noted Josephson, Kapstone will likely de-lever quickly from its Longview investment, possibly allowing it by the end of 2014 to be in shape again to make another "highly accretive acquisition.

Market Demand

Paper and paper packaging is hardly an explosive growth industry. Demand tends to grow at about half the rate of gross domestic product, Chercover says. After all, not everything comes in boxes.

Worldwide demand for paper and paperboard is growing a little more than 2% on average, according to AF&PA.

That's spurred in part by rising incomes in developing nations, which in turn increase demand for consumer products. Think tissue paper and a multitude of other goods that come in cardboard containers, such as milk, cereal, pharmaceuticals and personal-care products.

"Think of all those things in a paper package. And all those things are shipped in corrugated boxes," AF&PA's Foley said.

The U.S. exported about 20% of the paper and paperboard it produced in 2013, according to AF&PA.

Tissue-paper production rose 3.7% in 2013, followed by containerboard at 1.2%, the trade group said.

Containerboard is used to make the big cardboard and corrugated boxes that carry big-ticket consumer goods such as washing machines and refrigerators.

"We think demand (for containerboard) will improve as manufacturing comes back to these shores and the housing recovery moves forward," said Chercover.

Not surprisingly, output of newsprint and writing paper has been down.

Boxboard production used for smaller boxes for such things as cereals and cosmetics has been relatively flat the past few years. But it was up 0.5% in 2013.

"Containerboard and tissues are the best grades to be in. They don't have secular challenges from iPads, iPods and computers," Chercover said. "An iPad destroys demand for newsprint, but it doesn't destroy demand for tissues.

Boxboard demand is seen improving a little this year.

"A lot of people look at box shipments as one barometer of how the economy and manufacturing are doing," Foley said, noting that big brown shipping boxes hold everything from food to appliances.

In his recent research note, Josephson said KeyBanc doesn't expect "much more" than 1% box-shipment growth this year. But a 1% pickup, he wrote, would be "meaningful" and likely alleviate the need for producers to take downtime.