Packaging Corp Navigates Challenging Operating Environment Amid Lower Index Prices

Equity Analyst

Spencer Liberman

Packaging Corp of America manufactures packaging products and uncoated freesheet, or UFS, paper. It accounts for roughly 10% of the North American containerboard market and is the third-largest producer. The majority of the company's containerboard is used internally to produce corrugated packaging, with the remainder sold to external customers. A decade of consolidation in the corrugated packaging industry allowed Packaging Corp to raise prices aggressively, but increased competitive intensity from legacy paper producers has limited pricing power in recent years.

In Packaging Corp’s largest segment, packaging, the company manufactures containerboard and corrugated packaging products. A majority of the company’s containerboard production is sent to Packaging Corp’s box plants where it's converted into corrugated packaging. The remainder is sold on the open market to local or regional box manufactures. The company's corrugated packaging products are used in a variety of end markets, including food and beverage, e-commerce, paper products, and other goods. Corrugated boxes provide a strong yet lightweight packaging option that is cost-effective. This dynamic has made corrugated boxes a favorite in the packaging industry and is used in many different end markets.

The company’s paper segment produces UFS paper and is one of the largest manufacturers in North America. Packaging Corp was a small paper producer prior to its 2013 acquisition of Boise Inc. that also included additional containerboard capacity. The firm now produces commodity paper and specialty paper, which can include custom features (that is, coatings, colors, and brightness). Packaging Corp sells its paper through retailers and directly to customers, with its partnership with ODP Corporation (previously Office Depot) accounting for 61% of segment sales in 2023 (5% of consolidated sales).

Business Strategy & Outlook

We do not think Packaging Corp of America benefits from an economic moat, despite being one of the largest containerboard manufacturers in North America. A majority of Packaging Corp’s business (91% of 2023 revenue) involves manufacturing containerboard, which is mainly used in corrugated packaging products. Over the last two decades, consolidation has shifted a once fragmented industry into four major players and a handful of smaller firms due to the high capital costs required to efficiently produce containerboard. Almost all of Packaging Corp’s packaging segment sales are in North America, where the company accounts for approximately 10% of industry supply. While there are some traces of efficient scale and cost advantage moat sources, we do not think they are substantial enough to award Packaging Corp an economic moat.

Packaging Corp is one of the largest producers of containerboard and corrugated packaging in North America. The containerboard industry has gone through a period of consolidation, with four players now controlling approximately 70% of supply. Many incumbents have deep roots in traditional paper but have since pivoted to containerboard as demand for paper declined and corrugated packaging rose. Packaging Corp still operates a paper business, but its production volume and sales have declined for years as paper assets have been converted to containerboard production. Machines used to make paper can be converted to produce containerboard, making it an attractive opportunity for legacy paper producers looking to capitalize on growing demand. Additionally, e-commerce growth has increased regional and global shipping, with many opting to ship with corrugated packaging for its low cost and durability. This dynamic provided a strong incentive for paper companies to convert their aging paper mills to containerboard mills. During the period of consolidation, corrugated packaging companies enjoyed widening margins as prices were increased aggressively. Following this, incumbents and new entrants were quick to increase supply, mainly by converting aging paper mills to containerboard, putting pressure on containerboard prices. While e-commerce provided a tailwind, declining paper consumption and a flat volume outlook for food and beverage (two significant containerboard end markets) diminished upside. Today, the corrugated packaging industry shows elements of a rational oligopoly but continues to face pressure from converted paper mills and threats of substitutes from plastic packaging.

We continue to see little contribution from the efficient scale phenomenon toward Packaging Corp’s economic moat. The consolidated nature of the North American containerboard market, where four companies account for about 70% of supply, combined with the commoditized nature of containerboard make for an industry that could enjoy an efficient scale moat source. That said, the conversion of paper assets has increased capacity and limited containerboard price growth. Lower price growth has constrained margins and hindered Packaging Corp's ability to earn strong returns on its invested capital. While high capital costs usually inhibit new entrants from entering a market with efficient scale, smaller paper producers can join the market with relative ease by converting their paper assets to containerboard production.

As one of the largest containerboard producers in North America, Packaging Corp could benefit from a cost advantage moat source, but we see little evidence that would suggest the firm enjoys this competitive advantage. Packaging Corp operates eight packaging and paper mills that are located across the United States. Once the raw materials are processed at its mills, they are transported to one of its 90 converting and packaging plants. Packaging Corp's plants are dispersed throughout North America to minimize the distance between the plants and customers due to the low value/weight ratio of corrugated board. Packaging Corp’s competitors have comparable mill and plant footprints as they source raw materials in similar areas and require a dense plant network to service customers efficiently. While Packaging Corp is one of the largest producers of containerboard and could benefit from scale, its production is spread across a handful of mills and numerous plants that each have their own fixed cost structures, preventing it from capitalizing on any operating leverage advantage.

For commodity producers, their position on the cost curve is significant. Operating as low-cost producer can lead to years of strong economic profits and provide a durable competitive advantage. That said, the low value-to-weight ratio of containerboard forces producers to operate with a regional and even local presence, with each location having its own cost curve and rendering the industrywide cost curve largely irrelevant. Packaging Corp’s substantial size within the containerboard industry does little to lower its operating and input costs, forcing the firm to compete on price. Without a cost advantage or presence of the efficient scale phenomenon, we do not think that Packaging Corp, being a commodity producer, possesses an economic moat.

Packaging Corp’s paper business produces uncoated fresh sheet, or UFS, paper that is sold to a variety of customers in North America under its Boise Paper brand. UFS paper is primarily used in businesses and schools for printing, writing, and publishing. A majority of the UFS paper produced by Packaging Corp is commoditized and produced in line with industry standards for size, weight, and color. Its commoditized paper competes mainly on price, limiting returns the firm can earn on its paper business. Demand for UFS paper has declined for years as consumers and businesses shifted from printed materials to electronic alternatives. This incentivized Packaging Corp and its competitors to move away from paper, and many opted to convert their paper assets for containerboard production. While the segment has struggled to consistently earn a in profit recent years, we expect slow growth and limited operating profits for Packaging Corp’s paper business over our forecast. That said, the paper business is not large enough to represent a material impact on our opinion of Packaging Corp.

None

Economic Moat

Packaging Corp of America

Packaging Corporation of America engages in the production of container products. It operates through the following segments: Packaging, Paper, and Corporate and Other. The Packaging segment offers a variety of corrugated packaging products, such as conventional shipping containers. The Paper segment manufactures and sells a range of papers, including communication-based papers, and pressure sensitive papers. The Corporate and Other segment focuses on transportation assets, such as rail cars, and trucks. The company was founded in 1959 and is headquartered in Lake Forest, IL.

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