To many consumers the packaging sector could seem dull. At best a bottle might have a trendy design and label; at worst it results in unsightly litter. In the case of plastic, it is damaging because it does not always degrade. However, few old-world industries offer a mix of fashion, product efficiency, volatile commodity prices and the opportunity to pioneer environmentally sustainable production quite like packaging does.

While paper packaging companies have to deal with the constantly changing needs of food manufacturers, those in the plastics industry have to contend with the unpredictable price of the key ingredient – oil.

Polymer, processed from oil or natural gas, often accounts for over half of the input costs of a plastic container. While the oil price is subject to supply and demand, the geopolitics of most oil-producing regions mean prices of this raw material can be high during a period of subdued demand or visa versa. An international nuclear energy agreement with, for example Iran, could affect a small Benoni packager or listed rival on the JSE Main Board.

In SA, throw one of the world’s most volatile currencies into the mix and you have enough moving parts to spur even the most ambitious executives. Relatively small changes in the import price of oil (or the rand) can dramatically change a packager’s plastics division into a profit or loss.

Paper packager Mpact, which spun off from global timber processor Mondi in 2011, said the weaker rand reduced annual underlying operating profit in its smaller plastics division in the year to December 2013. This was despite a healthy uptick in volume sales into the challenging consumer market, one that almost all local companies complain about.

An ‘inability to predict future market movements in raw material prices and lags in pricing recovery’ is one of the key risks facing the plastics business

While oil prices have been relatively stable since April 2011 compared to previous steep increases, polymer price increases were in line with the depreciation in the currency in 2013, Mpact said.

In 2013, the rand declined from R8.47 to R10.49 to the US dollar. This tough consumer market makes it difficult for plastics packagers to pull off price increases.

‘Average selling price increases achieved during the year were insufficient to fully offset polymer price increases of more than 20%,’ Mpact said. ‘Consequently, underlying operating profit declined by 9.3% to R105.8 million’, in plastics while the underlying operating profit margin shrunk to 5% from 6.6%.

In fact, Mpact identifies an ‘inability to predict future market movements in raw material prices and lags in pricing recovery’ as one of the key, specific risks facing the plastics business. Since the December 2013 result, the rand has continued to weaken, trading at R10.76 to the dollar in the beginning of June.

Despite these challenges, Mpact still sees strong potential in this category as the market share of rigid plastic consumer goods containers continues to grow at the expense of glass and metal packaging.

Meanwhile Astrapak, the only listed company in the sector to experience a decline in market value over the last five years, focuses on plastic packaging precisely because of what it sees as a global trend. The company is restructuring to focus on its core businesses.

To lead the execution of this strategy the company poached new CEO Robin Moore from the sector’s only relatively big cap firm, Nampak, in 2013. Astrapak describes Moore as a leader with an ‘established industry reputation as a turn-around specialist at previously under-performing operations’.

Astrapak suffered a devastating fire at its East Rand Plastics factory in January 2013, as it began the expensive process of attempting to kick-start profitability. The fire and restructuring related costs were a combined R78 million, resulting in a dramatic swing to an attributable loss of R96 million in the year to February 2014. A year earlier the profit had been R286 million. But Astrapak was still able to invest R209 million in capital and even pay down debt, reducing gearing (debt to equity percentage) to about 30% from approximately 42%.

In June Astrapak announced, in terms of JSE listing requirement, that value investor Regarding Capital Management’s (RECM) stake in the firm had risen to just under 17%. As relatively recently as February 2013, Astrapak did not list RECM as a top six shareholder in its annual report.

Nampak, which in late 2013 hired Andre de Ruyter as its new CEO from big polymer supplier Sasol, has similarly reported a shift in the drinks market towards plastic bottles. Nampak said that metal can sales also increased. Both gains have been at the expense of glass.

Even so, the company has invested R458 million in a third glass furnace, arguing that there is demand from food and beverage manufacturers for a second big competitor to the unlisted Consol. Nampak has increased its share of the glass market, even if the jury is still out on the long-term returns this SA investment will bring.

‘Packaging companies are the “ham in the sandwich”. They get squeezed on both sides by powerful suppliers’

MERYL PICK, EQUITY ANALYST, OLD MUTUAL EQUITIES

Some of the biggest market share battles over raw material preferences take place in the drinks industry, with ingredient costs usually in US dollars. Competition exists over the hard commodity ingredients such as oil, tin, aluminium and silica (for glass) that are used to make containers.

‘Packaging companies are the “ham in the sandwich”,’ says Meryl Pick, equity analyst at Old Mutual Equities. ‘They get squeezed on both sides by powerful suppliers, for example Sasol, and powerful customers, for example South African Breweries. They are selling a commodity whereas FMCG companies are selling unique brands, so they have little pricing power.’

Referring specifically to polymer processors, Pick says that ‘plastics plants, especially flexible film plastics, are relatively inexpensive to set up and that leads to oversupply, competition and low prices. FMCG companies can use more than one supplier and play them off against each other. A declining rand/oil price is what’s needed to restore margins’, she says.

Plastic’s attraction is due to the category’s market growth.

Notwithstanding the domestic glass outlay by Nampak, the group’s investment focus lies north of the Limpopo River. In February 2014, Nampak announced that its biggest investment of the last five years would be the R3.3 billion purchase of Alucan Packaging in Nigeria. The group added that Alucan had been ‘profitable from day one’, which showed that converting African economic growth into profits is not just MBA classroom theory.

Nampak’s strategy to ‘accelerate Africa and optimise South Africa’ could be a mantra for many of the country’s consumer goods firms, though curiously it hasn’t been for other packagers. The company has borrowed heavily to execute this Africa plan, quadrupling net debt-to-equity to 80% at the end of the first half of 2014.

Nampak will need to continue its pattern of increasing headline earnings – as it has for the last five consecutive years – to vindicate the investment. The company’s attraction to Africa is clear. Its trading margins of 17.3% in the rest of Africa were double the 8.5% in SA in the six months to March 2014. The rest of Africa contributed 24% to trading profit, or R261 million out of a total of R1.08 billion. Sales are also growing faster on the rest of the continent, and the group predicts this will be accompanied by a rising profit contribution.

Overall Nampak group revenue was up 12% to R9.8 billion, while attributable profit, including non-recurring items, fell by 6% to R729 million.

Mpact has had a more cautious approach to African expansion than Nampak. The former makes most of its money from manufacturing packaging from its own paper mills. The company was able to maintain profit growth, even as it faced industry-wide challenges in its plastics uni

Listed SA packagers still have a relatively small presence on the rest of the continent

Group profit attributable to shareholders was up 32% to R402 million in the year to December 2013, helped by lower finance costs and a diminished tax rate, Mpact said.

The company faces less pressure to expand north than its rivals that produce packaging from hard commodities, as the rest of African sales only accounted for 10% of revenue in March 2014. Mpact chief executive Bruce Strong told CNBC Africa: ‘No doubt there are good growth prospects in many African countries and the scale to support good packaging businesses. The key is to exploit them in a profitable way.

‘Our approach now is quite a conservative one, to look for the right opportunities and to deliver long-term value to our shareholders,’ Strong said.

Meanwhile, Pick says that paper packaging is an expensive business to get into, resulting in higher margins than plastic. ‘The big paper packaging producers have their own paper mills, which require far more investment. This provides a barrier to entry and more margin protection,’ she says.

In March 2014 Mpact announced that its Felixton paper mill in KwaZulu-Natal (one of three in the group) was being upgraded to make paper exclusively from recycled material. While the R765 million investment will enhance Mpact’s environmental reputation, it aims to exceed the firm’s return on capital employed target of 15%.

The upgrade is also a proactive move to ward off a long-term potential rise in input costs (the mill will no longer use bagasse – crushed sugar cane stalks – as part of the process). ‘The sugar industry is well advanced in the planning of projects that may see energy generated using bagasse as fuel, which will render bagasse less economical as a raw material for the paper manufacturing industry,’ Mpact said.

Plastic, on the other hand, has lower rates of recycling than paper. It is generally not biodegradable and it is more complex to recycle. Transpaco markets its plastic recycling division as one that is ready to take advantage of any government regulations that encourage increased recycling.

‘As the largest recycler in the country of polyethylene post-consumer plastic waste, Transpaco is a leader in eco-conscious business practices,’ said the firm. It sported group sales of R1.12 billion in the financial year ending 2013.

Transpaco recycles 24 000 tons of plastic waste a year out of a total 1.37 million tons of all varieties. The company says that the use of virgin plastics in SA continues to grow, underlining the environmental challenge facing the sub-sector.

Small-cap, specialised plastic packager Bowler Metcalf puts a more positive spin on the impact of the weaker rand on its fortunes. The company argues that it makes rival importers more expensive but admits there is a lag before this takes effect. ‘The effect of the weakening SA currency, while lamentable, is a boon to those companies involved in both plastic packaging and downstream filling,’ said the company.

Given that packaging sales in the rest of Africa are US-dollar denominated – negating the risk of a declining rand – listed SA packagers still have a relatively small presence on the rest of the continent. Of those that process hard commodities, only Nampak has a large presence.

They don’t have the same cushion as Mpact, which buys its timber-based raw material domestically. Time will tell whether or not the tough SA consumer economy will prod them to take the increased political and logistical risk of venturing over the Limpopo River where there is still little competition – for now.

By Tom Robbins
Image: Fredrik Broden/reneerhyner.com