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Out of the Box: How Lowly Cardboard Became an Attractive Business
The containerboard and corrugated business will always be somewhat cyclical, depending on the nature of the customer. However, recent sales and earnings among this group have been generally positive, despite an economy that has slowed down substantially. And profits should remain relatively healthy even if the national economy slips back into another recession.
What’s changed? Certainly increasing international trade has supported demand and pricing for cardboard. Too, paper-based packaging is often more environmentally acceptable than alternative containers, given the large recycled content these days. But even boxes for U.S. virgin fiber are experiencing growing demand, thanks to their high quality and better printing characteristics. And box makers in the United States have a cost advantage in virgin fiber. But the most important factor in creating a more stable industry has been the tremendous amount of consolidation and reduced production capacity.
Corrugated container demand started to fall off sharply in October of 2008, and many box makers, especially ones with highly leveraged balance sheets, began to run into financial trouble. Smurfit-Stone Container Corporation (SSCC), in fact, filed for Chapter 11 bankruptcy protection in January 2009 as its cash flow dried up. The company had a lot of debt with maturity dates approaching. Its product portfolio was also heavily weighted toward containerboard and corrugated packaging for consumer and industrial purposes. Smurfit-Stone lost $2.82 billion in 2008.
On the other hand, companies serving primarily consumer nondurables markets fared much better. Rock-Tenn (RKT) is a good example. Its share earnings for 2007 and the recession years of 2008 and 2009 were $2.14, $2.77, and $4.64, respectively, even as the share count continued to rise. For the same periods, Sonoco Products (SON) saw share net slip from $2.38, to $2.24, to $1.78. Sonoco’s customer base is roughly half consumer and half industrial, though it sells much more tube and core products than cardboard boxes.
Smurfit-Stone achieved a remarkable rebirth, however. Since 2006, it closed eight paper mills and 56 box plants and reduced its headcount by 43%, all while maintaining its number two market share position in containerboard, behind International Paper (IP). Smurfit-Stone cut its box conversion costs by 16% in 2010, while it earned $1.43 billion last year. Privately held Georgia Pacific is number three with a 12% share, and Packaging Corporation of America (PKG) pulls in at number four with 7%.
But Smurfit-Stone is not finished with its transformation just yet. Only seven months after emerging from bankruptcy it agreed to be bought out by Rock-Tenn, and the deal was completed in May. The first thing the company did was announce the closure of three former Smurfit-Stone corrugated container plants to be completed in the fourth quarter of this year. Still, corrugated packaging will represent 76% of combined company sales, versus just 26% for Rock-Tenn as a stand-alone supplier, making it more cyclical. Management expressed confidence, however, believing that market fundamentals are so much better these days. And Rock-Tenn knows a thing or two about acquisitions and successful integration. Both its purchase of Gulf States assets in 2005 and Southern Container in 2008 far exceeded synergy-savings targets and earnings expectations.
The industry has played right along, too. Weyerhaeuser (WY) sold its containerboard and packaging assets to International Paper in August of 2008. Sonoco and Greif (GEF) have also been on the acquisition trail, though the latter is more focused on rigid industrial containers (i.e., drums). It is interesting to note that Greif had the biggest earnings disappointment recently (its July fiscal quarter), as volumes of rigid products fell off. Sales in its Paper Packaging division were up year to year, though, indicating a favorable supply and demand balance. Since the fourth quarter of 2008, industry containerboard production capacity has been reduced by a 5.8%. The top five producers now have 74% of the market, compared to only 42% in 1997. The plant rationalization and consolidation have resulted in unprecedented industry pricing power.
In early September, International Paper entered into a definitive agreement to acquire Temple-Inland (TIN) for $4.3 billion, or $32 a share (raised from $30.60 a share). The deal is subject to shareholder and antitrust regulatory approvals. If successful, the merger would be very significant for the industry, as corrugated packaging accounts for 83% of Temple-Inland’s revenue, or $3.2 billion in 2010. The combined company would have a 38% market share in containerboard and 33% of the corrugated packaging market. Moreover, Temple-Inland was regarded as the second-least disciplined player in terms of pricing and supply, behind, interestingly, Smurfit-Stone. The acquisition, expected to be completed in the first quarter of 2012, should make for an even more-stable industry.
Investors should definitely give this industry more respect. The sector has outperformed the S&P 500 Index for the past three months. And the stocks of paper-based packaging companies have done better than those of glass, metal, and plastic container suppliers, represented by Ball Corporation (BLL), Crown Holdings (CCK), MeadWestvaco Corporation (MWV), and Owens-Illinois. IP has been one of the better performers, and WY one of the poorer. (Remember Weyerhaeuser sold its packaging assets to IP.) Still, excluding Temple-Inland, which was driven up due to the offer from International Paper, the group is trading near the low end of their historic valuation ranges, and further price erosion would make it quite attractive as an investment.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.