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Moderating costs balance potential for slower growth in US packaging 07/03/2007. Source: Fitch Ratings.
 The abundant capital and easy credit of the past several years has spurred financial sponsor activity in the packaging sector and creditor protection built into high yield indentures and senior lending agreements has been easing with the upturn in the credit cycle since 2001, says Fitch. Private equity has been active in the industry, attracted by the relatively stable cash flows many packaging companies generate, as well as the opportunity in some cases to gain ownership in distressed situations.
Having endured an unusually difficult operating environment for the past 18 to 24 months stemming from volatile and increasing raw materials and energy prices, Fitch expects stable to improving credit quality in the North American packaging & containers industry in 2007. Raw materials and energy costs are likely to moderate on the whole during the year. Some materials may show increases, but should be less severe than in recent months. Still, energy costs will continue to pose a challenge to the industry in 2007.
Although domestic economic growth is expected to slow in 2007, higher international growth should offset lower domestic growth rates. Additionally, improved cost management and productivity gains will likely bolster performance for many firms. Volumes and individual market share will continue to be important, particularly if overall GDP growth slows.
Company specific credit issues, such as merger integration or issues with internal controls will continue to be important ratings factors. Strategic mergers, asset realignment, and financial sponsor activity are likely catalysts for credits in the sector during the coming year as consolidation in the industry continues and firms continue to cope with a higher, if less volatile, cost environment. Although the sector is largely considered defensive and non-cyclical, any macro-economic slowdown poses more serious risks to the most highly levered issuers.
Raw Materials, Energy Inflation
Raw materials pricing and volatility remain a primary concern impacting Fitch's outlook for the sector, but the picture will likely improve in 2007, at least for some commodities if not across the board. Prices are influenced by a variety of factors and are hard to predict. However, in Fitch's view, the balance of risk has shifted slightly toward energy costs, away from raw materials pricing, although the two are somewhat interconnected. The rationale behind this assessment is twofold:
First, packaging companies have been dealing with higher and more volatile raw materials pricing for two to three years and most (though not all) have demonstrated an ability to deal with these issues. Recalling the aftermath of the 2005 hurricane season gives reason to believe that many packaging companies can withstand moderately severe shocks.
The operating environment of the past few years has forced management discipline in many cases, and companies are improving their ability to cope with higher raw materials costs by increasing productivity, rationalizing operating costs, and negotiating price increases with customers. Most firms have demonstrated reasonable pricing power, given the extreme run up in prices. Fitch expects packagers will maintain or improve pricing in 2007.
Second, while supply for most raw materials remains tight, pricing is likely to improve for many materials (particularly some resins such as PET, PE, and PS with lower feedstock prices and additional capacity coming online) and volatility will likely moderate overall. Although demand should remain robust, the speculative frenzy that helped push aluminum and other commodities up dramatically in early 2006 has likely passed.
Contract pricing will be a key issue to watch for metals based packagers. Beverage can makers have benefited over the past year or so from contracts with price ceilings which limited the price they paid for aluminum rolled sheet from some of their suppliers. Meanwhile, suppliers such as Novelis were dramatically impacted, taking losses on product sold at prices well below their input cost of aluminum. As contracts are renegotiated, price ceilings will likely be eliminated for the most part, and beverage can makers such as Crown and Ball Corp., will be left more exposed to the supply chain squeeze. Although aluminum prices have retreated from their historic highs, prices are still above long-term averages and it remains to be seen if the packagers can pass on the higher costs to customers.
Higher energy costs and other inflation, although moderating in the latter half of 2006, still pose a significant challenge to many companies. Glass and metal based packagers are most exposed to higher energy prices, but plastic packaging firms are not immune. Higher energy costs have had a significant impact on glass container makers such as Owens-Illinois and Anchor Glass Container Corp. (Anchor filed for Chapter 11 protection in August 2005). The burden of higher energy costs will likely be a longer term issue for several packaging issuers. Most customer contracts allow for price adjustments based on raw materials indexes, not necessarily energy costs directly. Packaging firms must find other ways, beyond surcharges, to recoup these costs. Large manufacturers in some cases will need to modify product mix, facility footprint, and product lines to rationalize costs, remain competitive, and position their balance sheets to successfully meet an eventual economic down-turn.
Opportunities for Growth: Innovation, Emerging Markets
With much of the industry in maturity, packaging firms are looking for ways to differentiate themselves and generate higher returns. Plastic based manufacturers are experiencing higher growth than their metal, glass and paper counterparts as they have for the past several years due to conversion (substitution) trends wherein product packaging is moving out of heavier materials and into lighter weight plastics.
Fitch expects conversion to continue in 2007, particularly in the food industry. However, even certain plastic packaging products are becoming commoditized, and profitability is declining. Packaging companies across the spectrum are driving towards innovation. Highly engineered products, customized, solution-oriented packaging, and niche sectors are of high importance to companies in the sector. These products garner higher profit margins and will be the source of fierce competition going forward.
Another source of growth will come through capturing new volume in emerging markets, particularly in Asia and the Middle East. Multi-national packaging companies are pursuing opportunities to enter these markets through acquisition, greenfield expansion, or JV opportunities. These markets have seen robust growth in packaging demand (mid-teens to low twenties percentage growth in some cases), and will continue to be high growth for the foreseeable future. Larger firms that are able to leverage their global footprint to take advantage of these growth pockets will benefit. Those firms whose higher leverage leads to underinvestment or otherwise constrains capital deployment at opportune times may find it hard to capitalize on growth opportunities and remain competitive.
Mergers, Divestitures, and Financial Sponsors
M&A activity has also been a material factor impacting the credit outlook for several packaging companies and Fitch believes this trend will continue in 2007. In some cases (such as Crown Holdings), divestiture has strengthened balance sheets and lowered interest expense and capital expenditure. Strategic acquisitions have enhanced market position or improved results for some issuers (such as Graham Packaging and Berry Plastics), and have caused serious difficulty and credit deterioration for others (such as Solo Cup). Fitch believes strategic asset realignment within the industry will likely continue, particularly outside the U.S.
The abundant capital and easy credit of the past several years has spurred financial sponsor activity in the sector and creditor protection built into high yield indentures and senior lending agreements has been easing with the upturn in the credit cycle since 2001. Private equity has been active in the industry, attracted by the relatively stable cash flows many packaging companies generate, as well as the opportunity in some cases to gain ownership in distressed situations.
Financial sponsor involvement may be beneficial in some cases and detrimental in others. Although sponsors usually take a long-term investment approach, the packaging sector has not been immune to the recent trend in quicker dividend payouts and high advisory fees to private equity owners. Particularly in distressed situations, financial sponsors have been involved in lending at senior levels with high interest rates or taking equity stakes that result in change of control when a company becomes distressed.
In Fitch's view, creditors and potential investors should be mindful of anti-layering clauses, additional indebtedness provisions, and other creditor protection built into the covenant packages of leveraged packaging issuers, especially as the credit cycle may be peaking. Given the abundance of capital still available, and the current loose credit environment, Fitch believes the packaging sector remains a likely hunting ground for buyouts or other private investors looking to take ownership stakes.
Credit Fundamentals
Fitch analyzed roughly ten of the most prominent leveraged packaging issuers and found fundamental credit metrics deteriorating somewhat over the past year in particular, coinciding with the challenges outlined above. Total debt and leverage ratios have risen. Interest expense has risen with higher debt balances and interest rates. One trend of concern is the divergence of operating cash flows and EBITDA for the group as a whole. EBITDA has risen or remained flat over the past three years while cash flows have declined. However, as the effect of the second-half 2005 and first-half 2006 cost environment diminishes, Fitch believes credit metrics will improve through 2007. Some asset divestiture and repositioning is likely and modest debt reduction is possible for the industry as a whole if cash flows begin to improve.
Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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