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A Crossroads for the Independent Converter

By AICC Staff

September 13, 2018

In 1980, 40 percent of the world’s containerboard capacity resided in North America. As did close to 40 percent of the world’s overall manufacturing, and the containerboard markets were very tight. Almost all of these mills that existed then are still operating. We currently export approximately 500,000 tons a month of paper from North America, which represents about one-sixth of our productive capacity. Supply and demand for containerboard in North America have been kept in equilibrium so far due to this export tonnage. However, there have been lots of major announcements of new containerboard initiatives in almost every market that is currently receiving North American containerboard.

Global demand for containerboard has been increasing, but at nowhere near the rate needed to support both existing containerboard manufacturing and all the new initiatives. The bottom line right now is that this export tonnage is not nearly as profitable as tonnage consumed domestically, due to the freight costs associated with exporting and the competitive nature of the foreign markets. While much of our paper is a desirable product in markets that do not have enough “fiber” in their systems, this dynamic will continue to erode over time, causing the export tonnage to be increasingly subject to competitive market pricing, and it will therefore likely be less profitable. If the need to export tons to keep our markets in equilibrium accelerates, and if this tonnage becomes less profitable, how will the domestic producers react? Will mills close? Will prices drop? Will they look for more domestic integration?

In 1980, the state-of-the-art corrugator was 87 inches wide and ran at about 500 lineal feet per minute. The state-of-the-art corrugator of 2018 is 130 inches wide and is capable of running close to 1,500 lineal feet per minute. In 1980, the state-of-the-art flexo folder gluer took 30 minutes to set up and ran 5,000 pieces per hour. Today, these machines can be set up in two minutes and run more than 20,000 pieces per hour. The quality of the print and the box are far superior today as well. Similar gains have been made in rotary die cutters, flatbed die cutters, specialty folder gluers, and almost every other kind of converting equipment. A good-sized corrugator plant in 1980 converted 50 to 60 million MSF per month, and a good-sized sheet plant converted 15 to 20 million MSF per month. The plants are now, on average, three times the size that they were then, so at the end of the day, there are far fewer plants needed to service the needs of our economy.

In 1980, the manufacturing sector accounted for approximately 20 percent of gross domestic product (GDP). It now accounts for a little more than 10 percent. The 400 percent-plus increase in converting speeds, as compared to the reduction (as a percentage of GDP) in manufacturing activities, has been a major driving force in the consolidation and elimination of corrugated converting operations. To be fair, there has been a dramatic increase in the distribution businesses that are also users of corrugated packaging that makes up for some of the manufacturing loss. However, what doesn’t show up in the statistics is an overall diminution of the quality of the customer. A manufacturer that is purchasing packaging to protect a relatively expensive product is willing to pay much more for packaging than a food manufacturer or a distributor, which is generally reshipping something that is already packaged. The bulk of the current growth in corrugated shipments can be attributed to food and distribution.

In 1980, flexographic printing became the “gold standard” methodology for printing on corrugated. Printing plates and ink were relatively cheap and accessible, and the image quality was high. Lithography was the standard for high-end labeling. Digital printing was expensive and not really ready for prime time. Things in the world of digital printing are changing rapidly, with a number of serious players developing this technology, and the quality and speeds of the machines are rather impressive. So is the cost to enter this market. Many industry veterans who thought that digital would never approach flexography or lithography in terms of speed and quality are now projecting that digital printing may replace flexography as the new gold standard for printing on corrugated in the not-too-distant future, and that the overall print quality offered by lithography may not be worth the price. The ability to print without the cost of plates and the ability to offer customers highly customized messages on the packaging may give it a decided advantage.

In 1980, the biggest issue for most converters was securing their supply of paper and board. While some independent converters still have concerns about securing supply, a big issue I hear about in my travels is finding qualified people, particularly at the plant level. According to the U.S. Bureau of Labor Statistics, the overall unemployment rate has gone from a high of 10 percent in October 2009 to 3.8 percent in May 2018. Those of us who follow manufacturing businesses know that it is very difficult to find factory workers who are motivated and hardworking, and who can pass a drug test. Productivity, quality, and safety are starting to suffer, and profits have been impacted because of the rise in labor costs.

Business cycles generally follow these five stages: expansion, peak, recession, trough, and recovery. From 1945 to 2009, the average expansion lasted 58 months. It is likely that if you were to ask 10 economists which key economic indicators are the best predictors of recession, you would likely get 10 different answers. However, I think that they would all tell you that no business expansion can last forever, and that based upon history, nine years is a very long time. Add to this the uncertainty associated with the recent unprecedented tariffs enacted in conjunction with the Federal Reserve’s continued policy of raising interest rates and the potential for a contraction in the U.S. economy in the near future.

The industry has been consolidating at all levels for many years. In 1980, there were more than 50 different companies that manufactured containerboard in North America. Today, five companies control almost 80 percent of all production, and there are only a handful of smaller producers left. Those of us who follow the industry know that the ranks of independent converters have been sorely depleted. Part of this is because of the speed gains in converting equipment, and part of it is because of unprecedented acquisitions of independent converters by integrated producers. The multiples paid for most of these independent converters is at an all-time high.

In 1980, interest rates were hovering at 20 percent, and unemployment and inflation were high. The economy was in recession, and the great loss of manufacturing in North America began to accelerate. Marginal tax rates were 70 percent for individuals and 46 percent for corporations. Today, interest rates are still historically low, and the maximum tax rates for individuals and corporations are 37 percent and 21 percent, respectively. Depreciation lives and rates were very unfavorable in 1980, so the effective cost of investment was taking into account the cost of capital, and the value of the associated tax deductions were astronomical. Today, equipment investments can be fully written off in the year of acquisition.

So, you may ask what all of this means to today’s independent. In my opinion, we are at a serious crossroads for many companies. Based upon the desire for integrated companies to become more integrated, the overall enterprise value for most converters is at an all-time high. Many have already sold, and many others are considering “cashing in their chips” before the landscape changes. This thinking is further exacerbated by the fear of a recession or the effects of an oversupply of containerboard that cannot be effectively managed with the current export strategy. In addition, the cost of investing in state-of-the-art converting equipment and new technologies can be downright scary. The cost of creating a state-of-the-art plant today is probably 10 times what it was in 1980.

And yet, the converting business continues to be lucrative. Most independent converters that I see in my travels are doing quite well right now. The traditional niches of the independent—fast turnaround, smaller order sizes, and a focus on quality and the customer’s overall needs—are still there. Despite heavy investments in state-of-the-art converting equipment and lots of talk, the large integrated producers are still motivated by the tonnage needed to keep their mills at high operating rates. There are fewer independent converters around to take care of the customers whose decisions are more quality- and service-oriented.

If you don’t have a good succession plan or are risk-averse, it’s time to consider selling. There is no guarantee that the current high multiples will last forever. If you are thinking about doing this, clean up your plant, straighten out your balance sheet, make sure you have good management in place, and market your company sooner rather later. If you do want to continue to operate, I think that the rewards may be even greater in the future due to the diminished ranks of the independent and the high cost of joining the game.

My advice is that now is the time to invest. There are no guarantees that the current interest rate and tax climates will last forever. The Federal Reserve wants rates to go up, and the political climate is fluid, so the tax landscape could change in two years. In addition, a recession will certainly make financing more difficult. You should all be making plans for how to deal with a recession, so that when it happens, you can calmly execute your plan.

The industry is at a crossroads from many perspectives. The past 40 years have shown us that the industry can change dramatically and that new ways of thinking and operating are required. The future will likely be very bright for those of you who decide to stay in the game, but you must plan for it now.


width=150Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or mitch@klinghernadler.com.