MeadWestvaco: Breaking Up Is Hard to Do

Over the past three- and five-year periods,  MeadWestvaco shares have underperformed the U.S. packaging peer group. Unlike most of its competitors, which have shed legacy land holdings and noncore businesses to focus on packaging, MeadWestvaco still owns more than 600,000 acres of land, actively engages in property development, and runs a specialty chemical business that is largely unrelated to the core packaging business.

We consider the specialty chemical and real estate operations to be a distraction from the core business and believe they are a key reason that the packaging business has struggled in recent years. We think MeadWestvaco shareholders would be best served by an outright sale of the specialty chemical business and a tax-free real estate investment trust spin-off of the land and property management business.

A quick summary of the company's five reporting segments follows:

• Food and beverage. This is the largest segment by sales and consists of beverage, tobacco, and food paperboard packaging and converting. Margins are fairly steady, as MeadWestvaco has strong relationships with some of the world's largest consumer packaged goods companies, which provide steady demand.
• Home, health, and beauty. In recent years, this segment's operating margins have lagged those of food and beverage packaging. Approximately three fourths of annual revenue comes from North America and Europe, and demand is more sensitive to consumer sentiment than in F&B.
• Industrial. Primarily consists of MeadWestvaco's Brazilian corrugated packaging business, as well as Ruby Macons, the India-based corrugated packaging business acquired in late 2012.
• Specialty chemicals. Using sawdust and other byproducts from the papermaking process, this group produces marketable chemicals used across the globe in emission control systems, printing inks, asphalt paving and adhesives, and various purification systems. EBIT margins have averaged an impressive 23% since 2010.
• Community development and land management. This group manages more than 600,000 acres of land assets. CDLM was formed in 2007 as a way to better monetize the valuable real estate holdings that include land designated for master planned communities, industrial properties, and rural lands spread across the Southeastern United States.

Of these five businesses, we believe MeadWestvaco would be best served by selling its specialty chemical group and spinning off its CDLM businesses as a REIT in order to focus on the remaining packaging segments. Here's why we think that's a smart move.

Left Wanting More
The packaging and container sector has materially outperformed the S&P 500 Index over the past 10 years, and while MeadWestvaco partially participated in this outperformance, it has also underperformed the peer average.

10-Year MeadWestvaco Stock Performance vs. Packaging Peers and S&P 500, Indexed

Peer group = ATR, BLL, BMS, CCK, GPK, IP, OI, PKG, RKT, SLGN, SON (equal weighted)
Source: Morningstar Direct

In February, Nelson Peltz's Trian Fund Management announced it had made a small investment in the company; shares surged 10% on the day the investment was revealed. We believe the investment community was encouraged by Peltz's record of taking an active role in unlocking shareholder value via selling off noncore assets and possibly doing the same at MeadWestvaco.

Just one quarter later, however, filings showed that Peltz had sold Trian's stake in MeadWestvaco, and the firm's performance subsequently lagged its packaging peer average. We think the market's reaction to Trian's entry and exit reveals that the investment community is eager for a shift in MeadWestvaco's strategy.

Specialty Chemicals
MeadWestvaco's specialty chemical division has performed extremely well in the past three years, with EBIT margins averaging more than 23%, and has helped offset weakness in the packaging division in recent quarters.

Though MeadWestvaco has certainly benefited from its specialty chemical business, we nevertheless think the company would be wise to sell it to a chemical firm looking to augment its own downstream offerings. MeadWestvaco probably accrues some benefit from internally supplying the papermaking byproducts used in pine chemicals, but we think a potential suitor could come to agreeable supply terms with MeadWestvaco. Based on its stable and attractive 20%-plus EBITDA margins and current peer valuations, we see no reason the segment couldn't fetch an acquisition multiple of at least 11 times EBITDA to yield $2.8 billion-$3.0 billion in proceeds.

With its approximately $3 billion in proceeds from the sale of the specialty chemical business, we think MeadWestvaco would be wise to make strategic acquisitions to augment its health-care packaging business--particularly higher-margin spray and pump dispensers used in prescription drugs and consumer health products.

Community Development and Land Management
As of March, MeadWestvaco owned 643,000 acres of land in the Southeastern U.S. This figure includes the company's master planned communities in South Carolina at East Edisto (72,000 acres) and Nexton (4,500 acres). MeadWestvaco's landholdings are primarily a legacy from the premerger days (Mead and Westvaco merged in 2002), when vertical integration was common in the North American paper industry. Most of MeadWestvaco's packaging peers, however, have parted with their legacy land holdings over the past decade, preferring to focus on their core business and allowing other companies to manage the real estate.

Most packaging firms parted with their land by choice, while others were compelled to deleverage. International Paper (IP), for example, monetized its immense land holdings in 2006 and used most of the proceeds to smartly consolidate the North American containerboard industry, while Packaging Corporation of America (PKG) sold almost all of its legacy timberland holdings in 2000 to reduce a heavy debt burden. Though MeadWestvaco has sold parcels of land on an as-needed basis in recent years, it continues to actively manage community development projects like East Edisto and vertically integrated mills like Covington, Va.

We think MeadWestvaco's unwillingness to divest the real estate holdings has contributed to its underperformance relative to peers. Investors today have the means to cheaply add real estate portfolio exposure through REITs and exchange-traded funds, which contributes to a conglomerate discount for MeadWestvaco that is largely absent in its peer group. (We'll illustrate the conglomerate discount later.) Further, consider that Brookfield Asset Management acquired the vertically integrated Longview Fibre in 2007 and split it into separate packaging and timberland operations, selling each separately at attractive multiples in June 2013. We similarly think a separation of MeadWestvaco's land and packaging operations would be a value-enhancing move for shareholders.

MeadWestvaco's Land Holdings by Type as of March 2013

Source: Company filings

The vast majority of MeadWestvaco's land holdings was acquired decades ago and has a low tax basis, putting an outright sale of the land out of the question because of a potentially massive capital gains tax bill. As such, we think the company should separate these assets as a tax-free REIT spin-off. In recent months, such spin-offs have been favorably received by the market, and the REIT structure is a more tax-advantaged method of managing real estate.

MeadWestvaco's income proposition has been underwhelming relative to peers, with stagnant dividend growth and just $92 million spent on buybacks since 2007. A REIT structure, therefore, could be particularly appealing to MeadWestvaco's income-minded investors.

We believe now is a good time for MeadWestvaco to spin off the CDLM business. When asked at an investor meeting in June 2011 about alternative ownership structures for the real estate holdings, CEO John Luke said, "Real estate market conditions ... need to improve materially" before an alternative structure would be seriously considered. Since that meeting, Charleston-area single-family home values have increased 7% (according to Zillow) and timberland investment performance has materially improved since the end of 2008.

Aside from an improving real estate picture, with interest rates recently on the rise there could be increasing headwinds for REIT valuations in the next year or two. MeadWestvaco should seize the opportunity to spin off its real estate holdings while rates remain below historical averages.

Bottom Line
Based on our sum-of-the-parts valuation, we believe MeadWestvaco is trading with a 20% conglomerate discount. By selling the specialty chemical business and spinning off the CDLM business, the company would unlock substantial value for its shareholders, in our opinion.

Base-Case SOTP Valuation

Source: Morningstar

Given MeadWestvaco's reluctance to divest its specialty chemical and CDLM divisions, we will continue to value the business with a conglomerate discount and are maintaining our fair value estimate of $32 per share. If management takes the necessary steps to divest these two noncore businesses, we would probably increase our fair value estimate closer to our sum-of-the-parts estimate of $43 per share.