A Tale Of Paper Cuts And Profit

Investor's Business Daily

Paper cuts come in all sizes.

On an industrial scale, paper-products manufacturers have cut, spliced and suffered over the past decade to consolidate and streamline. The process netted a leaner, meaner, more competitive industry. And it concentrated the majority of production in what had been a vastly fragmented North American market within a handful of companies in each paper and board segment.

"After this wave of consolidation, paper and packaging manufacturers have been better able to match supply with demand, which provides them with a better bargaining position with customers," said Morningstar analyst Todd Wenning. "They certainly have a stronger foothold than in the past.

A more disciplined market points to more stability and higher profitability for an industry that's struggled against poor returns and over-capacity, adds Vertical Research Partners analyst Chip Dillon.

Packaging Corp. of America (PKG) is the fourth-largest producer of containerboard and corrugated box products in the U.S. Analysts say the Lake Forest, Ill.-based operation has been a leading beneficiary of the consolidation and of a more competitive market. In the third quarter, it saw earnings jump 28%, its second straight quarter of double-digit profit growth and an acceleration from the prior quarter.

Analysts see that growth accelerating to 55% in the fourth quarter, although sales growth is seen holding to low-single digits.

The industry began to flex its newfound muscle in the fall, when top players passed through a hefty hike in containerboard prices — their first price increase in 2-1/2 years.

Graphic Packaging Holding (GPK), a top producer of folding cartons, has also benefited. Its earnings rose by 22% in the second and third quarters. Analyst consensus projects a fourfold earnings gain in the fourth quarter.

Investors' response to those and other gains have, during much of the fourth quarter, held the Paper & Paper Products group in the top 50 rankings among 197 tracked by IBD. The group ranked No. 58 on Friday.

The industry is not a treasure trove of leading stocks. Packaging Corp. and Graphic Packaging, among its top performers, hold 2013 sales growth forecasts of 7% and 2%, respectively.

But the group is a sensitive indicator of economic activity, and a turnaround story that appears set to exit the recent economic recession stronger than when it went in.

That story, and Packaging Corp.'s consensus earnings growth forecast of 35% this year, are drawing in both growth and value investors, with Vinik Asset Management, Columbia Mid-Cap Value Fund and Blackrock Master Large Cap Core Portfolio among the funds to establish or add to holdings in recent quarters.

BusinessPackaging Corp. produces corrugated boxes — everything from the basic boxes used in moving and shipping to custom-printed containers and retail displays.

It's the industry's only pure play in the containerboard segment, says Wenning. Its position as a North American producer gives it direct access to virgin fiber — from the tree to the box, so to speak. That keeps its costs pretty steady, Wenning adds.

In addition, says Jefferies analyst Philip Ng, the company has squeezed a lot of costs, like energy consumption, out of its operations. That is part of what has helped boost earnings this year.

It's a very well run company, says Ng, and it has executed "flawlessly.

Wenning expects benefits from the fall price increase to begin feeding through in fourth-quarter results. It reports on Jan. 22. Thus, analysts polled by Thomson Reuters see earnings rising 55% in Q4, and 48% in Q1.

Graphic Packaging, headquartered in Marietta, Ga., makes paperboard packaging products for the food, beverage and household products industries. Products include cereal boxes, paperboard packaging for beer, soft drinks and other beverages. Major long-term customers include Kraft Foods (KRFT), Anheuser-Busch (BUD) and General Mills (GIS).

Graphic Packaging benefits from the market's built-in demand, mainly from the food and beverage companies. Also, the company has been growing market share, executing well, and taking costs out of its system, says Ng.

"It consistently generates a lot of cash flow," he said.

Graphic Packaging's cash flow-to-earnings was 263% in 2011, vs. Packaging Corp.'s 105%.

In another segment of the industry, Schweitzer-Mauduit International (SWM) is the world's largest producer of the fine paper used in making cigarettes.

The company held an estimated 2.9% of the tobacco paper product manufacturing market in 2012 based on its U.S. production, says a report by Caitlin Moldvay, a senior analyst at market research firm IBISWorld.

But, as in many industries, "declining demand in the U.S. has hampered the company's growth," she said. "However, demand is relatively strong in emerging economies." This has led to an increase in international operations and a decline in its share of sales in the U.S. market, which now accounts for an estimated 28.2% of revenue.

The company has increased earnings by at least 22% for six straight quarters. Sales began declining in the second quarter, and analysts see earnings down 25% on a 1% slip in sales for Q4.

ClimateU.S. containerboard producers — including No. 1 International Paper (IP), No. 2 RockTenn (RKT), Packaging Corp. and others — pushed through a price increase of $50 a ton. They also passed through most of an announced 8% increase on finished corrugated boxes, says Will Mies, editorial director at RISI, the leading information provider for the global forest products industry. It was the segment's first price increase in 2-1/2 years.

What changed to allow them to push through the increase? Containerboard supply has been tight due to mill maintenance and project outages, unexpected operational problems at major mills and some market downtime, says Mies. At the same time, containerboard inventory levels at box plants and mills have been at multidecade lows. U.S. containerboard mills have been running nearly flat out, with capacity utilization rates year-to-date at around 95%, he says.

"We think the recent price increase from containerboard producers was a catch-up price increase from the prior two years," adds Wenning, who sees potential for the industry to raise prices again in 2013.

"It could be a sign that the industry is getting more bargaining power because there are fewer producers and supplies are tighter than in the past.

Certain areas of the paper industry are doing quite well, including containerboard for boxes, says Wenning.

MarketThere's not a lot of innovation going on in the paper market, says Wenning.

It's all about making sure plants are running efficiently, and not over- or underproducing.

"It seems like the industry has done a better job of matching supply with demand, particularly in North America," Wenning said.

Food, beverage and agricultural products account for about 50% of the end-use markets for containerboard. Year-to-date box shipments as of Dec. 18 were essentially flat vs. the prior year, says Wenning.

Over the five years to 2012, revenue for the cardboard box and container manufacturing industry rose at an annualized rate of 0.6% to an estimated $56.8 billion, tallies Moldvay.

Demand for cardboard packaging began to turn the corner in 2010, and has continued to rise through 2012, she says. Steady demand from food and beverage manufacturers has kept the industry afloat over the five-year period. In addition, auto manufacturing has increased since the recession.

Over the three years to 2012, consumer spending is estimated to have risen an average of 2.1% annually, which has positively influenced retail sales and, in turn, increased manufacturing activity in the U.S., Moldvay says. An increase in activity from these downstream industries has benefited demand for cardboard packaging during the industry's recovery. She estimates industry revenue rose 4% in 2012 vs. the prior year. In 2013, revenue is expected to rise 4.2% to $59.1 billion from $56.8 billion.

OutlookWhen it comes to assessing the climate for the industry, much depends on the sustainability of the economic recovery.

The industry, says Wenning , has done a better job of managing supply and getting it closer to demand.

"Going forward it becomes a question of demand," he said. "They've cut costs, and reduced capacity where necessary, and they've taken steps to better match supply with demand. There's only so far they can cut. Demand will have to improve for there to be outsized growth in the industry again.

Most watchers are cautious about the outlook for the stock performance of companies in the space.

Dillon says he's upbeat about the year's prospects for Graphic Packaging and Packaging Corp.

He calls 2012 a "transition" year. Still, he says, a lot of investors don't appreciate how much these companies have improved.

Wenning concurs he's seen improvement in the industry.

"But we think the market has also noticed it, and the share prices reflect most of the improvements we see," he adds.

Ng is generally "upbeat" on the companies he follows. He has a buy rating on Graphic Packaging and a hold on Packaging Corp.

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