Counting Boxes

I continue to plow through earnings season and will hopefully finish in the next week or two. At that time I’ll put together a summary of what I’m seeing within my 300-name opportunity set. Although my review isn’t complete, I’m noticing a few interesting trends.

As the Federal Reserve and bond market remain fixated on statistics suggesting disinflation, signs of rising costs (including labor) and pricing power are appearing in Q2 earnings reports. I thought Sonoco Products Company’s (SON) second quarter results and management commentary were particularly interesting.

Founded in 1899, Sonoco is a leading manufacturer of industrial and consumer packaging. It’s a relatively simple business with a long operating history and respectable track record. Selling at 18x 2017E earnings, Sonoco‘s valuation isn’t cheap, but it’s less expensive than most of the high-quality equities on my possible buy list. In my opinion, Sonoco’s relatively subdued valuation is a result of slow earnings growth. For the year Sonoco expects EPS of $2.73 to $2.80 versus $2.72 in 2016.

During the second quarter, Sonoco’s gross margin was under pressure due to declining volumes and rising costs. SG&A was also higher, partially due to wage inflation. In an attempt to offset higher costs, Sonoco is raising prices. In fact, higher prices contributed 4% to sales growth in Q2, while volume and mix subtracted 1.9% (total sales growth was 3%).

Commenting on sales and volumes, management said, “One of our toughest challenges right now is dealing with generally weak demand from many of our Consumer Packaging customers. This isn’t new. Consumer Packaging volumes have been flat to down since the end of 2014 as consumers’ preference for packaged food is clearly being impacted by changing taste for more fresh and natural products.”

Sonoco is in a tough spot with declining volumes and rising costs. The rising cost of OCC (old corrugated cartons – used in recycling) has been particularly noticeable. According to management, OCC pricing in the Southeast averaged $165 per ton versus $87 in the same quarter last year. On their Q2 conference call management commented, “As most of you know, Sonoco is a significant recycler and consumer of OCC. The cost of OCC reached historic levels in March, then declined in April and May but has now pushed back to record levels of $185 a ton in the Southeast.”

What is causing the spike in OCC prices? Management believes e-commerce may be a possible contributor. Specifically, the OCC supply from retailers, or as management calls it, “what’s available behind the stores,” may be in decline. As e-commerce grows, the number of boxes carrying merchandise directly to homes is increasing, which reduces the number of boxes sent to retailers. Considering the collection process of OCC from stores is more efficient than from homes, it’s reasonable to assume less OCC is finding its way into the recycling supply chain.

Management explains, “One of the things that is still confusing me, and I must say this, is e-commerce isn’t new. It’s been here for some time. What’s so unique about this particular year? I think that we really need to get our hands around that. We’re working internally to better understand it. AF&PA [American Forest and Paper Association] is also working to understand how you improve recycling rates through the home — through homes versus behind the stores.”

As the industry determines how to recycle OCC from homes more efficiently, Sonoco isn’t sitting still and is responding with higher prices. Management believes they are early in the process and are “going to go for recovery.” Sonoco isn’t alone. Management states, “These are real increases, every one of our competitors. No one’s not receiving these cost increases. So I remain fairly confident that our competition understands the magnitude of the increase that’s hitting them, and we’ll react accordingly.”

I find all of this very interesting. While the structural shift in retail may be having an impact on OCC prices, what about shifts in store inventory and consumer demand? When I started as a buyside analyst, I remember retail analysts would visit shopping centers and count cars in parking lots as a way to measure consumer traffic and demand. Today, instead of counting cars, maybe it would be more useful to go behind stores and count the stacks of empty boxes waiting to be recycled! Based on OCC pricing, I wouldn’t be surprised if they found fewer boxes than a year ago.

Despite all of the attention deflation and disinflation have been receiving, there are clear examples of rising costs and pricing power in recent earnings reports. As a patient absolute return investor, I view inflation as one of the many potential catalysts for future opportunity. Put simply, what happens to central bank asset purchases and the Fed put once inflation reaches a level similar to Sonoco’s pricing power (4%)? They vanish along with the belief profit and market cycles are a thing of the past.