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Investing in paper in a paperless world

With the paper industry in transition, containerboard companies have made improvements.

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One of the big developments in the U.S. materials sector in the past year has been a cumulative price increase of roughly 15% for containerboard, a material most people would recognize as the cardboard used for corrugated boxes. After holding steady at around $640 per ton for almost two years, the benchmark price jumped to $740 per ton through two separate increases within eight months of each other (see the chart below, right). Earnings growth and market returns for the paper and forest products industry have been strong as a result.

The price increases are remarkable. Because containerboard is more like a commodity good than a specialty product, producers have typically been price takers. Successful price hikes for commodity products usually occur only when demand rises faster than supply, when the cost of production has sustainably risen, or both. For containerboard, neither condition exists to a meaningful extent.

Paper industry transformation

U.S. demand for paper products overall peaked in 1999.1 What had been the cyclical ebb and flow of paper production (mostly tied to economic growth), underpinned by a long-term trend of gradual increase, began to show the signs of secular decline. The industry did not respond at first, perhaps interpreting the inflection in demand as a temporary effect of weak economic conditions. Instead of bracing for shrinking revenues by cutting capacity and reducing costs, by and large the industry continued with business as usual.

As a result, the overall paper industry produced relatively low returns on equity for much of the decade following 1999. The commodity-like nature of the products and the cyclicality of the industry had probably been major factors, but other disadvantages were likely also at play. Paper production was a fragmented industry where many players competed mainly on price, making it difficult to establish sustainable benchmark prices in the face of diminished demand.

Moreover, large diversified companies may have contributed to the problem. Often enough, paper mills were smaller operating segments of larger companies that owned timber resources on large land holdings, and these companies used paper production partially as an outlet for otherwise unusable wood. These conditions were unsupportive of a rational and profitable industry.

To its credit, the U.S. paper industry seems to have evolved over the past six years or so. Consolidation is the most obvious change, and the recent pace of it has been noticeable. For example, the top three producers of containerboard in North America held 29% of market share in 1995; that number grew to 64% of market share in 2012.2 With a consolidated industry, large paper producers may be better able to find cost efficiencies and improve service levels, and the industry overall may be more likely to maintain pricing discipline.

Additionally, some of the largest diversified companies have been divesting other businesses (e.g., timber and land, chemicals, distribution), which may allow their paper-milling divisions to apply greater focus on growing returns.

Outlook for containerboard producers

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Now that the industry has consolidated somewhat and the recent price increases have held, containerboard producers’ margins may very well continue to grow, thanks to other industry tailwinds. Energy costs for both production and freight affect margins, so cheaper U.S. energy may have a sustainable beneficial effect, particularly as paper mills gradually switch over to using plentiful natural gas. Moreover, lower domestic energy costs may aid in a resurgence of industrial production more generally, which may in turn increase the demand for boxes in which to ship manufactured goods.

With some of the largest acquisitions having occurred just in the past few years, we are likely to see continued cost benefits to the acquirers as they optimize supply chain efficiency. The usual structure is to have several paper mills in various locations; each mill produces large rolls of containerboard, which are then shipped to a network of box plants in the area. The plants fashion boxes out of the containerboard, then distribute the boxes to nearby customers. This “hub and spoke” structure often provides substantial opportunities for acquirers to reduce their downstream supply chain costs, by optimizing production across mills, closing redundant box plants, and using a wider network of box plants to reduce freight costs.

One quirk of North American containerboard mills is that a significant number of them use “virgin” fiber—fiber from trees rather than from recycled boxes. For many years, this was a disadvantage, because newer plants using recycled boxes enjoyed much lower fiber costs. However, because all containerboard made in China is produced from recycled fiber, mill output there over recent years has raised the demand for fiber and narrowed the price differential, with the cost of recycled fiber sometimes even exceeding that of virgin fiber.3 If demand trends continue, North American producers with processing capacity for virgin fiber may end up consistently on the low end of the cost curve in the years to come. In addition, because containerboard made from virgin fiber can be manufactured to be stronger, it is the shipping material of choice worldwide for many delicate products, creating the potential for North American containerboard exports to grow.

Export demand growth would be a nice windfall for the industry, because domestic demand growth for containerboard overall will likely be slow, if positive at all. Advances in packaging efficiency and the trade imbalance for manufactured goods with China have been a drag on containerboard demand in the U.S. for many years, and those trends will likely continue. Compound annual growth rates for U.S. box shipments that were above 2% for decades leading up to 2000 (and growth rates as high as 5% from 1976 to 1979) turned into declines of roughly 1% per year from 2004 to 2008, further challenging profits for containerboard companies.4 Going forward, the expansion of e-commerce and a swelling U.S. manufacturing sector may help to counter the declining trend, but strong growth in domestic demand would be an unexpected (and welcome) surprise for producers.

Still, with disciplined pricing in place, a sustained bid for exports of virgin-fiber products, and a more rationally structured industry, U.S. containerboard companies may likely benefit. In particular, companies that have further opportunities to optimize operations and cut costs, and have mill capacity for virgin as well as recycled fiber, may be well positioned to lead the transformation of the paper industry.

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1. Source: American Forest & Paper Association (AF&PA), Haver Analytics, as of 7/15/2013.
2. Source: Company filings, Fidelity Investments.
3. Source: Timber Mart–South, The Frank W. Norris Foundation, Athens, Georgia; company filings; Fidelity Investments, as of 7/18/2013.
4. Source: Fibre Box Association, as of 7/18/2013.
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