Income investors searching for high dividend yields have to dig a little deeper today. The Federal Reserve recently signaled it will suspend its recent interest rate increases. As a result, yields on bonds and other fixed-income securities are unlikely to rise over the next year. In addition, due to the stock market’s nearly decade-long bull market, the average stock in the S&P 500 Index yields just 2% right now.
Investors willing to purchase individual stocks should take a closer look at WestRock Co. (WRK, Financial), a high dividend stock with a yield of nearly 5%. Shares have declined 39% over the last 12 months, significantly underperforming the broader market in that time.
However, WestRock is proceeding through a lengthy turnaround and the company’s long-term growth prospects remain intact. In the meantime, investors can buy this high-yield stock at a big discount.
Business overview and recent events
WestRock was formed in July 2015 through the merger of Rock-Tenn and MeadWestvaco. Today, it is a leading provider of paper and packaging solutions. It operates two major segments: corrugated packaging (64% of revenue) and consumer packaging (36% of revenue). WestRock has a market capitalization of $10 billion.
In late April, WestRock reported fiscal 2019 second-quarter results. Revenue of $4.6 billion increased 15% from the prior-year quarter. Adjusted earnings per share, however, declined 3.6% for the quarter as revenue growth from acquisitions, price increases and a favorable product mix were more than offset by cost inflation, lower containerboard volumes and economic downtime. Revenue was also negatively impacted by the winding down of land and development segment sales.
Rising costs have put pressure on WestRock’s profit margins and, consequently, its earnings per share over the past year. However, the company has a significant growth catalyst up its sleeve that should allow it to return to positive earnings growth in the near future.
Future growth outlook
WestRock will pursue future growth both organically and through acquisitions. The company completed the acquisition of KapStone Paper and Packaging Corp. in 2018 for $4.9 billion and has already integrated it into existing operations. The acquisition boosted corrugated packaging segment sales by $776 million last quarter.
In addition, the acquisition of KapStone enhanced WestRock’s product offerings and geographical reach. However, it also saddled the company with higher debt. The deal increased WestRock’s net-debt-to-Ebitda ratio to 3.9. The company has set a goal to reduce the leverage ratio to a range of 2.25 to 2.50 this year. Now that interest rates are unlikely to climb in the months ahead, shareholders of leveraged companies like WestRock can breathe a little easier. Rising interest rates make debt costlier to service and roll over, so the Federal Reserve pressing pause on its interest rate hikes is a favorable development for WestRock.
Debt reduction will help improve WestRock’s dividend safety, and cost cuts will help achieve deleveraging. The company achieved $70 million of run-rate synergies last quarter and expects to produce a total of $200 million in annual synergies by the end of fiscal 2021. Assuming the company achieves its debt reduction goal, the dividend appears secure. WestRock has an expected dividend payout ratio of 45% for fiscal 2019. This should provide enough room for modest dividend increases to continue in the years ahead.
WestRock’s strong dividend payout and steady profits are the result of competitive advantages. The main competitive advantage for the company is its industry-leading position. That said, the industry is highly competitive. In addition, WestRock is not a recession-resistant business. Packaging is an economically-sensitive industry. If the economy enters a downturn, consumers and businesses would spend less and send fewer packages. However, we would expect WestRock to remain profitable during a recession as it has the flexibility to cut costs. Fortunately, the U.S. economy continues to grow at a solid pace, meaning a recession is not on the horizon at this time. Therefore, WestRock has a long runway of growth up ahead.
Low valuation plus high dividend yield equals buy
We have lowered our estimate of WestRock’s full-year earnings to $4.05 per share for 2019, based, in part, on the disappointing first-half performance. Still, the stock trades for a price-earnings ratio of just 9.1. Since the 2015 merger, WestRock shares have held an average price-earnings ratio of 16.8; given the recent earnings per share declines, a lower multiple may be justified. This price-earnings target is a reasonable estimate based on the company’s elevated debt and challenged near-term earnings growth. Still, a price-earnings ratio of 12.5 would represent a significant tailwind for shareholders. If the price-earnings ratio expands from 9.1 to 12.5, the associated rise in the share price would fuel a 6.6% boost to annual returns.
In addition, WestRock is expected to report 4% annual earnings growth through 2024, which will add positively to shareholder returns, as will the company’s impressive dividend payout. The company has a current annual dividend payout of $1.82 per share, good for a nearly 5% yield based on the recent share price. Through a combination of price-earnings expansion, future earnings per share growth and dividend payments, we expect annual returns in excess of 15% per year for WestRock over the next five years.
WestRock is a beaten-down dividend stock. While cost inflation and slowing global economic growth could reduce the company’s future earnings per share growth, it does not necessarily have to generate high growth to still be a worthwhile investment. The stock is priced at a significant discount to fair value and with a nearly 5% dividend yield, WestRock is a compelling buy for value and income investors.
Disclosure: No positions in any stock mentioned.
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