The Full Package?

Good things may come in small packages, but a slowing economy is no small thing to U.S. packaging companies.

While these companies are widely regarded as being recession resistant - with demand coming largely from food, beverage, personal care and household cleaning products - plenty of packaging concerns have exposure to less stable industries like industrial and protective packaging applications.

“Demand growth for protective and industrial packaging is tied to industrial activity and GDP growth rates, which makes demand susceptible to economic cycles,” said Standard & Poor’s analyst Liley Mehta. “Moreover, the films market that many of these companies participate in is highly fragmented and plagued with overcapacity, particularly the stretch film and other industrial film segments.”
 
For those companies involved in the more cyclical side of the business, the recent economic readings can’t be of much comfort. Third-quarter GDP was a scant 1.6 percent (in part due to a slowing housing market), well below the 2.6 percent growth in the second quarter. At S&P, economists are projecting fourth-quarter GDP of 2.7 percent, and just 2.1 percent for all of next year.

The manufacturing industry as a whole has experienced a noticeable slowdown of late as measured by the Institute for Supply Management’s manufacturing index. While that barometer remains above levels that indicate manufacturing activity is still growing, it’s well off the pace of earlier in the year.

“For packaging companies with exposure to the industrial economy and housing market, these trends are troublesome,” Mehta said. “The slump in the housing market has already begun to impact sales of certain products for Atlantis Plastics Inc., Covalence Specialty Materials Corp., and Intertape Polymer Group Inc.”

Of course, the broader economic slowdown is coming at a time when manufacturers of all shapes and sizes are grappling with higher raw materials costs. Mehta noted that resins including polyethylene, polypropylene and polyvinyl chloride (PVC) are key raw materials for plastics packaging companies, and the costs of these has rise sharply in the past two years. (Prices have come down in the past few months in tandem with the pullback in oil and natural gas.)

“Most of these companies do not have contracts with customers that allow for pass- through of raw material price fluctuations, unlike the contractual pass-through arrangements widely prevalent in the rigid plastic packaging and metal and glass packaging segments,” Mehta noted.

For many companies, the analyst said, that means operating margins have been squeezed to about 10 percent.

To offset some of that pressure, companies are continuing to cut costs through various initiatives, including improving operating efficiency, sourcing raw materials from overseas locations at lower costs, and rationalizing their manufacturing capacity. S&P also noted that some companies, such as AEP Industries, have restructured through the sale of underperforming businesses, while bigger players, liked Sealed Air, are focused on optimizing their supply chain and reconfiguring their global footprint.

Companies the size of Sealed Air and AEP can offset some of the expected economic weakness through their product and geographic diversity, their excess cash and their leadership positions in the areas in which they operate. And the companies that are investing in new technology to improve productivity and efficiency should weather the storm should the economy slow significantly. But the rest of this year and 2007 could prove trying for many protective and industrial packaging companies.