By Todd Wenning
The stock prices of major containerboard producers such as International Paper (NYSE:IP), Rock-Tenn (RKT), and Packaging Corporation of America (NYSE:PKG) have surged over the past nine months, dramatically outperforming the S&P 500 Index. The cause is largely due to a seemingly improved outlook for industry profitability following a wave of consolidation that reduced capacity and led to a more favorable pricing environment. The industry is attempting to pass through its second price increase for containerboard and boxes in the past nine months, and, based on consensus forecasts for the three companies, we believe the market is assuming continued price increases in the coming years. Though we think the industry is in a better position than it was five years ago, we do not think the changes have contributed to a narrow economic moat for the participants. Consequently, we see a limit to the industry's pricing power in the medium term and consider the shares to be moderately overvalued today.
Industry Consolidation Results in Renaissance
For most of its history, the containerboard industry was highly fragmented and generally lacked the ability to raise prices on customers without support from higher demand or input prices. This allowed independent converting plants to acquire supply from multiple sources and play containerboard suppliers off one another to obtain the best prices.
The containerboard consolidation trend began in earnest in 2008 when IP acquired Weyerhaeuser's (NYSE:WY) packaging business for $6 billion. This deal was part of IP's immense transformation plan in which it shed legacy forest product businesses and its timberland assets.
Two major recessions since 2000 and subdued North American box demand over the period also served to shake out higher-cost containerboard producers, the most important being the 2009 bankruptcy of Smurfit-Stone Container. At the time, the company was the second-largest producer of containerboard and corrugated containers in North America, behind the recently transformed IP.
Soon after it emerged from bankruptcy, Smurfit-Stone was acquired in 2011 by Rock-Tenn, which catapulted from a fringe player in the industry to one of the two largest players. Just weeks after that deal, IP announced its intent to acquire Temple-Inland and extend its position as the market leader. As a result of these acquisitions, the playing field has dramatically changed in the industry, with the top four containerboard producers now accounting for about 70% of North American capacity compared with 47% in 2000.
The consolidation has allowed the industry to better match supply with demand. Despite tepid box demand, containerboard operating rates have averaged 95.8% on a rolling-three-month basis since the Rock-Tenn/Smurfit-Stone merger was completed in May 2011. Historically, the containerboard industry has exhibited pricing power when operating rates have been over 95%, indicating a very fertile period for price increases today.
Containerboard Operating Rate and Box Shipments
Containerboard prices had been unchanged for more than two years when in July 2012, KapStone -- the seventh-largest producer -- announced a $50 per ton price increase on unbleached linerboard and medium (the two components of containerboard). Within a few weeks, other major producers followed suit and announced similar price increases.
Even though the containerboard producers were benefiting from lower input costs at the time of last year's price increase, there was relatively little pushback from customers as tight industry supply gave them little choice. In fact, some independent box converters supported the move as it gave them an opportunity to raise their own prices on customers.
The second price increase came in February 2013, when Georgia-Pacific said it would increase containerboard prices by an additional $50/ton beginning March 1. Once again, other most North American producers quickly followed with their own increases.
We considered the first hike to be a catch-up on prices following two years without an increase, but this second move is a clear indication that the industry is looking to flex its muscle and capitalize on current industry dynamics. The second round of price increases is a departure from historical trends in which the containerboard producers would generally lag input cost changes and inflation. This departure -- and the expectation of further decoupling -- has contributed to the market's positive re-evaluation of the industry since mid-2012.
Containerboard Versus Softwood Pulp Prices, Indexed
To Infinity and Beyond? Not So Fast
The outperformance from this group raises the question: At what point might containerboard price increases stop? After all, the Department of Justice in its complaint against the original IP/Temple-Inland merger proposal found a lack of "reasonable substitute" for corrugated boxes, noting that competing products like returnable plastic containers are "typically too expensive or lack the required performance characteristics to serve as a commercially viable alternative." With inelastic demand and reduced supply, at first glance there seems to be very little stopping the containerboard industry from increasing prices at will.
Since the industry's pricing power is predicated on its ability to manage U.S. containerboard supply relative to demand, however, it requires rational behavior from industry participants in order to be sustainable. We do not consider the industry to be a rational oligopoly and believe that this recent aggressive price hike will encourage additional supply in the market, thus reducing the industry's pricing power in the medium term.
If the containerboard producers were indeed digging an economic moat, it would most likely be supported by the efficient scale phenomenon, in which a market of limited size is effectively served by one or a handful of companies. New competitors are discouraged from entering such a market because doing so would lead to price competition that would depress returns for all players.
The benefits from efficient scale are enhanced when new entrants are required to sink substantial amounts of capital to gain sufficient market share. In the containerboard industry, however, participants do not require a considerable market share in order to generate suitable returns. Packaging Corporation of America, for example, has consistently posted some of the strongest margins in the industry despite holding a single-digit market share for more than a decade. Indeed, PCA largely avoided participation in the recent wave of consolidation, even though it had plenty of capital to do so, precisely because it saw a great deal of value in focusing on its existing mill system.
Moreover, the cost to participate in the containerboard industry, and do so profitably, is not insurmountable -- particularly if the company already possesses most of the equipment, facilities, environmental permits, distribution system, and experience in the paper industry required to be an effective competitor. For this reason, we believe there is strong potential for other companies in the paper industry to convert idle capacity to containerboard fairly quickly and at a reasonable cost.
According to industry researcher RISI, some 3.5 million tons of North America paper capacity has been permanently shut, net of restarted capacity, since the beginning of 2011; roughly two thirds of these closures have come from graphic paper grades and 20% from newsprint. Just because a mill closure has been called permanent, however, doesn't mean that the mill is destroyed. Indeed, a number of once-closed paper mills have reopened to produce different goods; for example, IP's Franklin, Va., mill that once produced white office paper was reopened as a fluff mill in 2012. A number of newsprint mill conversions to containerboard have already commenced, and more have been rumored in recent months.
The largest near-term impact on domestic containerboard capacity will come from Norampac's new 540,000 ton-per-year recycled linerboard mill in Niagara Falls, N.Y., which is scheduled to launch in July. Though the Greenpac mill took two years to build after four years of planning and negotiating with the local government, we consider it to be an indication that paper companies are willing to undertake large projects in the containerboard market. Perhaps more telling is that Norampac's decision to build the mill came well before current market conditions made containerboard more attractive. As such, we think it's likely that more companies will entertain similarly large brownfield projects that could have a material impact on containerboard capacity in the medium term.
What's more, most of the new containerboard capacity that's coming on line through conversions and new mills will be lightweight grades that appeal more to e-commerce companies and megaretailers looking to reduce packaging costs. Most of the installed containerboard capacity from the major integrated players is heavyweight grades, and with billions of dollars tied up in these machines, we think it unlikely that the larger companies will be eager to switch to lightweight grades in the near future. Consequently, we forecast that the new lightweight capacity being added to the system will have steady demand from both converters and end users.
Lack of Moat Will Result in Reduced Pricing Power
Because the containerboard industry lacks sufficient barriers to entry and because industry participants have not exhibited rational pricing discipline, we do not think that the wave of consolidation in recent years has created an economic moat around current participants. As a result, we expect an increasing number of idle paper mill conversions and potentially additional brownfield mills like Greenpac to come on line in the coming years and reduce the industry's pricing power.
Risks to our thesis include further industry consolidation, capacity reductions, and rising recycled fiber costs. Rumors persist that the containerboard industry could undergo another round of consolidation, ranging from deals as large as Georgia-Pacific and PCA combining containerboard assets to small deals among fringe participants. We think the Justice Department's close scrutiny of the IP/Temple-Inland merger and its requirement for IP to shed three containerboard mills to gain approval indicate that regulatory hurdles are now considerably higher and are a deterrent to large deals that would leave a meaningful amount of domestic containerboard supply in fewer hands. Given the important role corrugated products play in the domestic market and the cascade effect that substantially higher containerboard prices could have on consumer spending, we think regulators will be skeptical of further consolidation.
The vast majority of new containerboard capacity that we expect to come on line over the next five years will be from recycled fiber mills rather than virgin fiber mills since they are far less capital-intensive. Increased domestic demand for old corrugated containers would probably drive recycled fiber costs higher and could discourage higher-cost machine operators from converting idle paper machines to containerboard. However, since we also expect the new capacity to focus on lightweight grades, they will be less sensitive to OCC price changes than mills that produce heavyweight grades.
Todd Wenning is an equity analyst for Morningstar.Elizabeth Collins, CFA, is a director of equity research with Morningstar.