Consumer packaging firms--the makers of bottles, cans, plastic wrap, and everything associated--have expanded around the globe during the last few decades, sourcing plants near customers. The global economic downturn has affected their financial results, as demand for consumer packaging has declined alongside demand for consumer goods. If people are buying less beer, they are de facto buying fewer bottles and cans.
Often, firms will decrease pricing to spur volume, in an effort to keep their high-cost production lines at higher capacity. However, the strengthening U.S. dollar has affected these firms' revenues far more than a drop-off in volumes or any declines in pricing. Meanwhile, near-term profits have benefited from this currency move and, in many cases, from lower raw-material costs. During the downturn, the industry has been forced to protect profits, leading to the permanent closing of many manufacturing facilities. Although relative currency values and raw-material costs will always be volatile, the industry should benefit in the long term from the ongoing restructuring.
For U.S.-based firms with global operations, a strengthening U.S. dollar has the effect of lowering reported revenues and costs of goods sold. Most of the consumer packaging goods companies have global businesses: it makes no economic sense to make a bottle in the U.S., pay the freight costs of it to be shipped to Europe, and fill it with a beverage. For the most part, consumer goods firms want their packagers to be nearby, as this facilitates communication and helps with inventory control.
The economic downturn led to a drop in unit volume demand for packaging, but what can get lost amid the anxiety of a recession is that other factors can lead to reported revenue declines. Consider that in the second quarter, Crown Holdings reported a year-over-year decline in reported revenue of $141 million, a 6.4% decline. One might conclude that volumes had declined and the firm was suffering amid the economic downturn. That conclusion would be wrong. Currency translation caused a $205 million decline in reported revenue. In fact, the firm actually experienced an increase in volume production as sales grew in developing countries and were flat in the U.S. Another firm, Bemis, did have lower volumes in the second quarter, which lowered sales in its flexible packaging business by 3.3%; that business had a reported revenue decline of 9.9%, meaning that 6.6% of the overall decline came from currency translation. This is important, because as we reach the one-year anniversary of the strengthening U.S. dollar (and perhaps even a weakening U.S. dollar), the comparisons get easier and many of these firms could begin reporting sales growth even if volumes taper off.
Another effect of currency movements is reflected in costs. A strengthening dollar is one reason for the higher gross margins that have been reported across the industry. After all, if the strong dollar translates foreign currencies into less revenue, it will have the same effect on translated costs. So, to use Crown again as an example, in the second quarter cost of goods sold was $166 million lower due solely to currency translation, but reported costs of goods sold was only $113 million lower as the benefit from currency was partially offset by an increase in the cost of steel. As the dollar's strength anniversaries or as the dollar weakens, look for gross profit margins to come down across the industry.
To see what could happen to U.S.-based firms in the coming year, it may be beneficial to consider the case of Rexam during the last year. Rexam has been on the other side of the currency movement as it is based in England. A stronger dollar benefits revenue and harms margins. So, in the first half of 2009, Rexam reported revenue growth of 20%, solely due to currency translation. Otherwise, sales would have declined 6%. Furthermore, reported operating profit was stable, but without currency translation it would have fallen 20%. This could be the scenario that plays out for U.S.-based firms in 2010.
Another issue over the past several months for the entire industry has been declining costs for raw materials. Aluminum prices have fallen, as have resin costs. For instance, the price of polystyrene averaged only $0.53 per pound in the second quarter compared with nearly $0.84 per pound in the year-ago period. Most consumer packagers pass along raw-material price increases and decreases to the consumer goods manufacturers. But this pass-through of costs has a bit of a lag, due to the timing of contracts. Thus, whereas the price decline has helped the overall decline in cost of goods sold, this tail wind will go away in coming quarters as the customer reaps the benefit. So the tail wind could become a head wind. It's another moving part that needs to be considered in the industry's financial performance.
The best scenario for U.S.-based packaging firms, then, is that the dollar stabilises or weakens so that currency translation boosts revenues enough to offset both any increase in raw-material costs and the translation effect on costs. If prognosticators' forecasts for the U.S. dollar are correct, given the country's ever-expanding debt burden, these firms could enjoy many years of revenue growth from currency translation effects alone.
The value of currencies and raw materials will always fluctuate--the laws of supply and demand will ensure that. However, during this downturn the entire industry has been restructuring its operations. Global expansion often leads to inefficient production for any industry, as new plants don't reach planned capacity utilisation. Furthermore, many production lines are equipped with outdated machinery. So in an economic downturn, it's natural for firms to adjust their operations to preserve profits and cash, with the lasting effect of a leaner operating structure. Since the fourth quarter of 2007, Ball has closed or announced plans to close eight manufacturing plants in North America. Silgan has closed facilities in Minnesota, Alabama, and Virginia. Rexam has shuttered plants around the globe, including six plastic packaging plants, reducing 12-ounce can-making capacity in North America by 15% and beverage can production in Europe by 7%.
The upshot is that, whatever happens to the strength of the dollar or the cost of raw materials, the entire industry is poised to become more efficient and, hence, more profitable as unit volume growth returns in an economic recovery.
Mike Taggart, CFA, is a senior equity analyst with Morningstar, based in the United States.
