This is not some dry, distant analysis without potential implications for the corrugated industry; this unexpected development may well take the edge off corrugated demand sufficiently to forestall the hitherto impending containerboard price rise later this summer. So what’s the background? The European Central Bank’s (ECB) quantitative easing (QE) programme was reduced from €60 billion a month to €30 billion a month at the end of 2017. Over the two years from 2016 to 2017 the ECB injected €2.2 trillion and racked up €4.7 trillion of cumulative QE by the end of March 2018. Despite a belief by the ECB that this initiative could be tapered, a slowdown seems to have happened within months of removing half of the monthly QE stimulus.
The strength of the euro is another complication. Once trading at €1.03 to the US dollar it rallied to over €1.25 and has settled at around 1.22. This exchange rate strength is acting as a brake on the economy because the Eurozone is so heavily dependent on trade (which represents over 80% of GDP). And as Europe imports over half of its energy requirements, 90% of its oil, 69% of its natural gas, 42% of its coal and 40% of its nuclear fuels, rising energy prices are a tax on the European economy.
The UK economy, despite an extreme weather-related lull in early March (which led to 1-2 days of lost production for many box plants), continues to generate somewhat more positive news:
- UK productivity has made its largest improvement since 2011, thanks to investment (in people and kit) prompted by a minimum wage that will have risen by 40% in the five years to 2020 and a tightening labour market heightened by a tail off in immigration from the EU, which has seen net migration fall by over 100,000 pa.
- There were 427,000 more people in work in the year to February and there were 815,000 vacancies in quarter one (a near record level that has been sustained for a good while now). Unemployment is at just 4.2% – around the same as the USA and half the level of the EU.
- The inactivity rate (the proportion of people aged from 16 to 64 years who were economically inactive) was 21.2%, lower than for a year earlier (21.6%) and the joint lowest since comparable records began in 1971.
- As the post-Brexit vote devaluation against the dollar abates (it’s currently $1.35 to the pound as opposed to $1.47 in May 2016 before the referendum), inflation is beginning to fall. In turn, we are seeing a return of real wage growth – which should help to sustain the domestic economy against the countervailing surprise slowdown in the Eurozone.
- With government borrowing finally below the widely acknowledged sustainable ceiling of 3% of GDP, wage restraint for the public sector is being eased. For example, NHS workers will receive an average 6.5% rise as the world’s fifth biggest employer seeks to fill over 100,000 vacancies.
Even with a potential plateau in prices, the containerboard market is dysfunctional; with the link between the cost base and the selling price temporarily broken. Whilst OCC prices have fallen precipitously (in light of some clunky Chinese policy making on imported waste products), no reductions in paper prices have been forthcoming – the improved margin has been openly pocketed by paper mills because they can get away with it.
As a result, one or two (but by no means all) integrated paper and packaging companies are perhaps understandably using the opportunity to tactically subsidise box or sheet feeder sales with a view to growing market share. This explains the gulf between some finished box prices in the market at the moment. When you’re buying waste at £55-70/tonne and selling boxes or board at £5-700/tonne, you have an awful lot of combined added value in your internal supply chain – more than enough even when you undercut what some consider to be an unsustainably high market price that may not last. It’s not terribly kind to the independent sector – but competitors are allowed to compete; even ones making record profits.
However, I’m struck by the ingenuity and enterprise of the independent sector in countering this development, who of course are perfectly entitled to compete too. I believe that these nascent pockets of admirable defiance will hit a critical mass, pop the bubble that is the current paper market and prompt a steep price correction at some point in the next year. Ultimately, whether the bubble will burst violently or only slowly deflate is in the hands of the paper mills.
Seemingly oblivious to this outlook, some paper makers are already talking up their next price rise. My advice to them would be not to do it – you’re pretty close to pushing some clients over the edge in terms of their willingness to forgive what they see as being treated in so high handed a way; why tip them over the edge? Be the guy who stayed his hand on a price rise and pocket the more valuable commodity that is loyalty. You’ll need it when we transition to a buyers’ market when 5.5+ million tonnes of new containerboard capacity are introduced to a European market currently producing circa 32 million tonnes. If a deflationary environment seems hard to countenance, try and note this observation by F. Scott Fitzgerald: “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”
IPC’s most recent offer to acquire Smurfit Kappa Group (SKG) equates to circa €38/share, which represents a significant premium to SKG’s pre-offer price of €28.62. This comes to circa 9.6x trailing EBITDA and ~8.7x and ~8.4x 2018E and 2019E EBITDA, respectively; which are pretty generous multiples for a containerboard acquisition.
IPC has identified a somewhat optimistic €450m run rate of cost synergies – to be realised in four years; it’s not clear how this squares with its other narrative that there is relatively little overlap between the two groups’ main markets? If there isn’t much overlap, how do you reach nearly half a billion in synergies?
Whilst acknowledging the potential for a good strategic fit between the two groups (i.e. IPC would buy a meaningful European footprint in one fell swoop and close off the need for Smurfit Kappa to continue growing its North American presence), market analysts consider some €250-300m of synergies as being more realistic, with the long timescale for fully realising these giving them additional pause for thought.
IPC has also indicated that there may be “significant revenue synergies that have not been quantified for reporting under the Irish Takeover Rules”. It seems reasonable for IPC to expect to be able to seal more global deals with the world’s biggest corrugated buyers with a significant presence in Europe, where 40% of box volume is with pan-European companies.
Having been repeatedly rebuffed thus far, IPC’s bid for SKG could go hostile. IPC has been courting major SKG shareholders and is exploring a London listing with a view to soothing concerns SKG institutional shareholders may have in accepting shares in the US company.
The received wisdom is that SKG shareholders are unlikely to support a revised bid if it’s less than €40 a share. Along the way, a successful tilt will require a valuation buffer that offsets downward pressure on International Paper’s own share price from so-called arbitrage funds that trade on the volatility surrounding large merger deals.
A revised offer of €40/share seems a distinct possibility…but paying top dollar at the peak of the paper price cycle, overly leveraging in the process, being unduly optimistic about potential synergies and going hostile against an excellent incumbent management team seems reckless.
Put it another way, it doesn’t seem a very shrewd allocation of capital for IPC – why not look for opportunities elsewhere to buy low and build value?
Raj Bhardwaj is Editor of the Know It All newsletter and also runs a software and consultancy business with a focus on the packaging sector. You can contact him via e-mail: email@example.com