The packaging sector has long been a favourite for private equity buyers due to its defensive revenue and strong cash generation. While investors often find it all too easy to overlook what is perceived as a dull industry, a recovery in packaging prices ahead of an important reporting period means this sector's charms may soon prove impossible to ignore. The sector's prospects are also being stoked by recent consolidation, which is delivering cost savings and boosting shareholder returns. So while the fragile European economy is a risk, strong structural growth drivers, healthy cash flows and enticing dividends means packaging shares can be expected to pack a punch in investors' portfolios.
There are solid grounds for optimism about the near-term prospects for the packaging sector. Despite a tough first half which saw falling prices and volumes, the outlook for packaging prices has improved and analysts are now forecasting a nascent recovery which, if it holds, will support forecast upgrades and potentially a share price rally. "We continue to emphasise the strong, and in our view under-appreciated, fundamentals in the packaging segment," said Lars Kjellberg, Credit Suisse analyst.
Difficult conditions at the start of the year resulted in paper mills shutting down and smaller players closing their doors. This reduction in industry capacity has stabilised packaging prices and analysts believe the sector has turned a corner. The latest FOEX indices - the Reuters for packaging prices - shows a strong recovery in Kraftliner - an essential raw material for packaging (see chart below). David Hathorn, chief executive of South Africa-based packaging giant Mondi, echoes these views: "Demand is still fairly soft but pricing is being driven by supply side contraction and that is where our price increases have come from."
Positive pricing recovery in Kraftliner
Price increases are all well and good but making them stick with customers is key. All eyes are now on next week's trading updates from European names including Stora Enso and US major International Paper. If they confirm packaging prices are holding up, then analyst upgrades will follow. Despite the weakening European economy the sector as a whole has been on a strong run this year, easily outperforming the FTSE All-Share: Smurfit Kappa is up 72 per cent, Mondi up 46 per cent and API shares up 65 per cent.
Packing a profit for your portfolio
| Company Name | TIDM | Market Cap | Price | Forecast PE | Forecast EPS Growth | DY | Net debt/cash profit | Earnings release date |
|---|---|---|---|---|---|---|---|---|
| Stora Enso Oyj (HLSE:STERV) | HLSE:STERV | €3.9bn | 479c | 11 | -42% | 6.4% | 3.3 | 23-Oct |
| Powerflute Oyj (AIM:POWR) | AIM:POWR | £67m | 24p | 12 | -17% | 4.7% | 0.0 | |
| RPC Group plc (LSE:RPC) | LSE:RPC | £704m | 425p | 11 | 6.6% | 3.4% | 1.3 | 29-Nov |
| Mondi plc (LSE:MNDI) | LSE:MNDI | £3.2bn | 655p | 12 | -8.1% | 3.3% | 1.6 | 31-Oct |
| Rexam plc (LSE:REX) | LSE:REX | £3.9bn | 450p | 12 | 3.9% | 3.3% | 2.0 | 15-Nov |
| British Polythene Industries plc (LSE:BPI) | LSE:BPI | £103m | 403p | 7.9 | 8.1% | 3.2% | 0.7 | |
| DS Smith Plc (LSE:SMDS) | LSE:SMDS | £1.9bn | 202p | 13 | 27% | 2.9% | 0.0 | 06-Nov |
| International Paper Company (NYSE:IP) | NYSE:IP | $17bn | 3,818c | 12 | -17% | 2.9% | 3.4 | 25-Oct |
| Smurfit Kappa Group plc (ISE:SK3) | ISE:SK3 | €1.9bn | 837c | 7.5 | -6.2% | 1.9% | 3.0 | 07-Nov |
| API Group plc (AIM:API) | AIM:API | £52m | 70p | 7.9 | 39% | 0.0% | 0.4 | 02-Dec |
Source: S&P Capital IQ
Long-term structural growth
There are strong structural reasons for the rise of packaging, including the inexorable growth in e-commerce. Each individual book or gift bought online arrives encased in branded packaging to ensure it arrives in one piece. This change in the way retailers do business is a solid prop against a fragile European market. But it is not just technology that is driving the pace of change, there are other more human reasons.
It is a symptom of important demographic changes such as rising populations, changing diets and shrinking family sizes. As the world population rises it will place ever greater stress on the world food supply. Transporting food long distances and keeping it fresh on shelves for longer will result in more and more plastic and boxes in our stores. In the west, as butchers and greengrocers disappear, meat and veg will increasingly come in presentation cases. These trends are well advanced in more mature western economies. The real growth comes from these trends spreading to eastern Europe. They will also be replicated in the emerging markets as China develops its domestic economy and supermarkets increase their penetration.
Packaging will also benefit from rising populations and shrinking households in the west as more people live in one- and two-bedroom flats and families have fewer children. The Office for National Statistics in the UK showed that the oft-quoted number of 2.4 children only really applied to the generation born in 1937; it has since shrunk to 1.9 children. The amount of packaging required for smaller more frequent purchases of ready meals and individual items will far exceed the packaging involved when a family bulk-buys the weekly shop. This societal shift of falling birth rates and smaller households is clearly being replicated in the developing markets as populations migrate to urban city dwelling en masse.
Efficiency improvements
Packaging is also no longer simply a cardboard box used to transport goods from the warehouse to the stockroom; it has become a cost-cutting and marketing device. Both DS Smith and Mondi now provide display boxes that go directly on to supermarket shelves, reducing shelf-stacking time. These individually branded boxes provide higher margins for packaging producers and the fast-moving consumer goods (FMCG) industry is more defensive through a recession. The boxes are also collected by DS Smith before being turned back into new boxes, this 'closed-loop recycling' is a growing market for the industry.
Another catalyst for earnings upgrades in the packaging sector is cost savings arising from acquisitions. Richard Sanders, partner at Catalyst Corporate Finance, said in a packaging sector review: "I am struck by how unconsolidated the European market is compared with its US equivalent. I am sure this will not continue for much longer."
DS Smith proved Mr Sanders right and demonstrated the savings on offer when it recently provided the market a 100-day update on its £1.3bn takeover of Swedish rival SCA. Cost savings, initially expected at €75m (£60m), were increased to €100m, and cash savings from working capital and capital expenditure efficiency, which it previously expected at €40m over three years, were increased to €130m. The enlarged group will also enjoy a lower cost of debt. This prompted broker Panmure Gordon to upgrade current-year adjusted pre-tax profit forecasts from £187m to £195.6m, giving EPS of 16.07p, rising to 20.3p the year after.
While scale benefits cardboard-based packaging, big isn't always beautiful. Niche operators that specialise in moulded plastics such as RP, or plastic wrapping such as British Polythene Industries have been forging ahead. Unilever has publicly pledged to reduce the weight of its packaging by a third by 2020. The solution it has turned to is lightweight plastic packaging. This combined with demand for innovative new products such as disposable coffee capsules is helping offset weakness in southern Europe for RPC.
IC VIEW
Cost-cutting since 2008 has left the sector profitable and generating healthy cash flow, and a recovery in prices could boost prospects further. The sector has also reduced its debts and through acquisition and growth has increased exposure to the more defensive FMCG market, which is supported by strong structural growth fundamentals. If signs of a continued recovery in pricing are delivered in trading updates next week it will be a catalyst for earnings upgrades.
