We've long been advocates of the view that the packaging sector in Europe is ripe for consolidation, but it's sometimes possible to stretch the narrative. RPC Group (RPC) provides a case in point. In December, the packaging group bought ESE World BV for €263m (£223m), following on from earlier deals that brought France's Global Closure Systems and British Polythene Industries within the fold for €650m and £261m, respectively. Earlier this month, the group changed tack. A foray across the Atlantic ended with a $640m (£511m) deal to acquire US plastics manufacturer Letica Group.
Investors might be justified in wondering whether RPC is guilty of over-reach, at least in terms of its ability to integrate the string of acquisitions, but that misses the point, particularly as the group has established a successful track record in this regard.
Management at RPC was quick to recognise that the relative fragmentation of Europe's plastic and paper board segments presented a strategic opportunity to achieve earnings growth simply through upscaling (the plastics market is more highly fragmented across all markets in both Europe and the US). Although deal activity has stepped up over the past four years, that opportunity still exists; research from advisory group Capitalmind shows that the three leading producers in Europe account for just over a third of the regional market, whereas the four largest players in the US control three-quarters of that market. US multinationals such as International Paper Co (NYSE:IP) have an established presence in Europe, although it's surprising that we haven't seen more transatlantic activity on the M&A front. The point is that there is a clear disparity in the concentration of ownership in the US and European markets.
Demographics and the Asia Pacific dynamic
The packaging market may be fragmented, but it is still exhibiting solid growth, due in part to the expansion of e-commerce, which we'll come to later. The industry has been growing at an annualised rate of 5 per cent over the past five years and the global packaging industry is now estimated to be worth in the region of $700bn, just under a third of which is generated in Europe. Paper and board packaging remains the largest segment, whereas plastic packaging has the strongest growth prospects.
Evidence shows that growth is accelerating due to demand from emerging markets, particularly in the Asia Pacific region; a reflection of rising median wages and disposable incomes. Growing urbanisation, the development of retail chains and the burgeoning healthcare and cosmetics industries are driving packaging demand. The emergence of a consumer class in China and other locales across the Orient is generating significant growth in all aspects of packaging from wholesale storage, transport and through to retail. Demographics aside, there are other dynamics at play.
Point-of-sale and e-commerce driving volumes and innovation
Until recently, the growth in demand has been linked to standard packaging, but interest in innovative products is growing strongly - for producers this means enhanced margins. So, the step-up in European M&A isn't solely driven by companies in search of scale benefits, but also by those looking to broaden their range of production capabilities. DS Smith (SMDS), for instance, has not only acquired several subsidiaries, including London-based Creo Retail Marketing and Deku-Pack in Denmark, but has also opened a €50m facility in Erlensee (outside Frankfurt), as part of a strategy to tap into the fast-growing point-of-sale (PoS) packaging market. In the UK alone, PoS packaging is estimated to be worth £6.6bn. Its increased use in advertising campaigns, exhibitions and presentations reflects the structural shift away from mass marketing of fast-moving consumer goods (FMCG), as ever more shoppers are making last-minute retail decisions in-store. Promotional and directional advertising, whether in the form of freestanding or shelf displays, are becoming indispensable tools in influencing buyer behaviour.
Packagers are tailoring their product lines in response to the marketing demands of PoS, but they're also driving their value-added proposition because of the steady expansion of e-commerce. More than half of e-commerce expenditure goes on physical goods, all of which require packaging. The e-commerce market is also very fragmented. Even the largest player, Amazon, has less than 10 per cent market share, meaning there is demand from both smaller and larger players across the manufacturing spectrum each with specific packaging demands.
The move to "rightsized" packaging
DS Smith estimates that e-commerce accounts for a fifth of the growth in the European corrugated market. Together, these two market segments now account for a fifth of DS Smith's revenues and are growing at 10 per cent per year. With competition intensifying online, it's little wonder that goods manufacturers are turning away from plain corrugated boxes in favour of "rightsized" packaging that cuts distribution costs and reinforces brand perception - consider the efficiency of an egg carton. Analysts at Peel Hunt make the point that the average package is currently delivered 55 per cent void and represents 20 per cent of the cost structure of each shipment; ergo there is an estimated €4bn savings opportunity for western European e-commerce businesses.
Europe struggles with feedstock costs
As well as opportunities, there are challenges. Heavy investment by China in paperboard capacity has put cost pressure on European producers, as has the US shale boom, which indirectly resulted in lower feedstock costs for plastic packagers across the Atlantic, although that has been offset to an extent by sterling's devaluation since last year's EU referendum. The fall in WTI prices gave US petrochemical producers a massive cost advantage over European and Asian rivals in an industry where feedstock and energy consumption account for as much as 75 per cent of total operating costs. It is vital for packaging businesses to manage the stability of their feedstock costs and pass through as much of the raw material price inflation as possible to customers, although this has become a trickier proposition given the squeeze on high-street grocers.
The regulatory challenge
There are other potential Brexit effects to take on board. The British Plastics Federation (BPF) recently submitted written evidence for an inquiry into 'The Future of Chemicals Regulation after the EU Referendum'. The BPF is examining how the regulatory landscape could look post-Brexit as well as how it could be administered - key considerations for the packaging industry. All of this at a time when plastic packaging producers are coming under increased pressure from regulators, as only just over a third of plastic packaging is recycled in Europe, against three-quarters of paper and board packaging.
| Price (p) | Max (p) (1-yr) | Min (p) (1-yr) | % change (1-yr) | % change (3-yr) | PE | Div. Yield (%) | Market-cap (£m) | |
|---|---|---|---|---|---|---|---|---|
| Mondi | 1,859 | 1,859 | 1,259 | 41.4 | 81.7 | 15.5 | 3.1 | 6,827 |
| RPC | 913 | 1,007 | 660 | 36.9 | 94.5 | 18.5 | 2.1 | 3,785 |
| Smith (DS) | 456 | 456 | 356 | 19.1 | 29.0 | 15.0 | 2.9 | 4,315 |
| Smurfit Kappa | 2,237 | 2,237 | 1,584 | 27.9 | 37.5 | 14.3 | 3.0 | 5,287 |
IC VIEW:
The packaging sector continues to attract interest from investors from outside the industry, most notably private equity inflows. The industry has delivered consistent growth, yet is viewed as lower risk and less cyclical than other sectors of the economy. That's partly because it is often driven by FMCG in the food, beverage and personal care industries, so cash flows tend to be more predictable and consequently more suitable to a private equity capital structure.
The four largest constituents now trade at or near 12-month highs, but at an average multiple of 12 times forecast earnings - and there are modest income streams into the bargain. This relatively undemanding rating belies that there are also strong growth levers in the PoS and e-commerce markets. Around 4.2bn items bought online were shipped in Europe in 2015, a number that should approach the 5.0bn mark by 2018. Increasingly, packaging is seen as integral to product perception and what marketers characterise as the modern 'retail experience' and is now seen as an effective adjunct for highly targeted marketing campaigns.
Packaging's resistance to cyclical trends could conceivably dissipate as the balance of product lines swings from FMCG to e-commerce lines, but the earnings streams will remain relatively predictable and the industry is well positioned to profit from the structural changes unfolding in consumer markets.
