“It is not inequality which is the real misfortune, it is dependence.” – Voltaire “The strength of criticism lies in the weakness of the thing criticised.” – Henry Wadsworth Longfellow, American poet and educator “The only thing we know about the future is that it will be different.” – Peter Drucker “Instead of working for years to build a new product, indefinite optimists rearrange already-invented ones. Bankers make money by rearranging the capital structures of already existing companies. Lawyers resolve disputes over old things or help other people structure their affairs. And private equity investors and management consultants don’t start new businesses; they squeeze extra efficiency from old ones with incessant procedural optimizations. It’s no surprise these fields attract disproportionate numbers of high-achieving Ivy League optionality chasers; what could be more appropriate reward for two decades of résumé-building than a seemingly elite, process-oriented career that promises to ‘keep options open’?” – Excerpt from Zero to One by Peter Thiel and Blake Masters

The Fractal Geometry of Nature by Franco-American mathematician Benoit Mandelbrot is a mathematics book that behind all the Greek symbols holds within it explanations of the elegant shapes, sequences and patterns that repeatedly occur within nature. In this book Mandelbrot outlines a theory called the Lindy Effect – a theory he developed but that was named after a New York diner where stand-up comedians used to gather – that advances the idea that the longer a technology or concept has survived, the longer it is likely to survive. More specifically, the future life expectancy of non-perishable items such as a technology or concept is proportional to their current age, such that each incremental period of survival implies an increasing remaining life expectancy.

Consumer packaged goods (CPG) companies, relatively speaking, have been around a long-time.

CPG companies have had a great run for well over five decades. During that time the well-established CPG companies – like The Kraft Heinz Company, Kimberley Clark, Procter & Gamble, Unilever, and PepsiCo to name but a few – have each created their very own ecosystems. These ecosystems are comprised of retailers, advertising and public relations agencies, media companies, trucking and warehousing solutions providers, container and packaging producers, and many other ancillary businesses that are almost entirely focused on servicing the dominant CPG company within the ecosystem they exist.

As CPG companies have thrived over the decades so too have the businesses that are focused on servicing them. And the larger the CPG companies have grown, the more dependent these businesses have become on them.

These dominant companies are now under threat. The threat comes from multiple angles including changing consumer tastes and shopping patterns, demographics, technological disruption, rising commodity prices, and more responsive niche competitors. The CPG companies have responded to these threats by becoming increasingly inward looking. That may appear to be a strange way to describe their behaviour but as we read through transcript after transcript of these companies’ earnings conference calls we find one common theme across all of them: cost savings. Some companies have hired strategy consultants like McKinsey & Co. to help identify areas of inefficiency and procedural optimisation, while others have launched clumsily named cost cutting initiatives such as “FORCE”, “SPORT”, and “Agility”. Many of the companies in face of investor scepticism are going out of their way to trump up their research and development capabilities and their focus on innovation; for the most part, however, the supposed innovations appear to us to be a doubling down on what has worked in the past or playing catch-up with niche brands that have blazed a trail in new market segments. Based on airtime given during the conference calls cost saving not innovation is obviously the key area of focus for most, if not all, of the major CPG companies today.

The focus on cost saving and efficiency is not surprising. The management teams at the leading CPG companies are comprised primarily of, in Peter Thiel’s words, “indefinite optimists”. And the consultants they hire too are likely to be indefinite optimists. These indefinite optimists, as Thiel describes them, are far more like to alter and try to improve that which already exists than to create new products that will deliver meaningful revenue growth. Take for instance PepsiCo CEO Indra Nooyi’s response when asked about the company’s conservative expectations relating to their innovations in 2018 (emphasis ours):

“Internally, we’d like to do more, but we want to be very, very cognizant of the headwinds around us, some of which we don’t even understand at times because the consumer is not consistent.”

And The Kraft Heinz Company’s Chief Operating Officer Georges El-Zoghbi’s response when asked about the importance of brands to consumers in food and the investments they are making into brands (emphasis ours):

“Brands matter most because the investment behind advertising, the investment behind promotions, the investments behind new products that come to market not only helps the brand, but stimulates overall category demands for everybody who is operating in those categories. So in an environment where there is changing consumer needs and changing go-to-market model, brands become a lot more important. However, brands need nurturing and nurturing means investment and staying relevant with what consumers’ needs are and what consumer wants to buy. So for us, an investment in the brand has always been important. Now we’re even accelerating that to deal with an environment where consumers changing what they buy and where to buy it from. And we are accelerating the investments to deal with that. So we see now increasingly important to have stronger brands in those categories for everybody.”

In an environment where LaCroix has become the leading carbonated water brand in the US without advertising, we see the above comments from PepsiCo and the Kraft Heinz Company as being symptomatic for management teams that are still coming to terms with the scale of the challenges they face in growing their revenue.

As the CPG companies’ face up to the challenges on the revenue side, we think their focus on cost savings and efficiency will only increase further. And this is bad news for businesses that exist almost entirely to serve these companies. As a case in point consider Procter & Gamble’s comment on rationalising costs relating to media spend (emphasis ours):

“Looking ahead, we see further cost reduction opportunity through more private market placed deals with media companies and precision media buying, fueled by data and digital technology. We continue to reinvent our agency relationships consolidating and upgrading P&G’s agency capabilities to deliver the best brand building creativity. We’ve already reduced the number of agencies nearly 60% from 6,000 to 2,500, saved $750 million in agency and production costs, and improved cash flow by over $400 million additional through 75 day payment terms.”

Investment Perspective

Businesses providing undifferentiated, commoditised products with increasing production capacities are the most at risk of being hit by the cost saving drives being undertaken by CPG companies. Containers and packaging companies are, in our opinion, amongst the most vulnerable.

By containers and packaging companies we are referring to the likes of Ball Corporation, Crown Holdings, Bemis Company, Silgan Holdings, Sealed Air Corporation and Tredegar Corporation. These companies manufacture products such as flexible and rigid plastic packaging, metal packaging and steel cans for the consumer packaged goods industry.

The table below provides the share of revenue coming from major CPG companies for a number of the containers and packaging companies

Company Major CPG Companies’ Share of Revenue Ball Corporation 27.9% Crown Holdings 17.1% Silgan Holdings 48.9% Bemis Company 42.3% Sealed Air Corporation 7.2% Tredegar Corporation 12.0%

Note: Based on Bloomberg data as at 1 March 2018, revenue shares are calculated based on sales to The Coca Cola Company, PepsiCo, Unilever, Procter & Gamble, Nestle SA, Conagra Brands, Johnson & Johnson, Reckitt Benckiser, Dr Pepper Snapple, Campbell Soup, The Kraft Heinz Company, General Mills, Hormel Foods, TreeHouse Foods, Dean Foods, Mondelez International, Kimberly-Clarks, Kellog Company, and Tyson Foods

Most of the containers and packaging companies highlighted above sell largely commoditised products and are operating in highly competitive market segments, giving them little power when dealing with customers that in and of themselves possess a significant amount of marketpower. Moreover, the containers and packaging companies’ largest markets – namely developed economies – are characterised by excess capacity while their growth markets – emerging economies in Asia and South America – are witnessing deliveries of increased production capacities. Despite this a number of the companies continue to expand production capacities both in developed and emerging markets. It is then no surprise that return on invested capital for most of these companies is declining sharply.

Annual Return on Invested Capital (%)

Source: Bloomberg

At the same time, in terms of trailing price-to-earnings ratios in a historical context, these companies appear to be richly valued with most trading at one to two standard deviations above their historical trailing price-to-earnings ratios.

Ball Corp Trailing Price-to-Earnings Ratio

Source: Bloomberg

Silgan Holdings Trailing Price-to-Earnings Ratio

Source: Bloomberg

Bemis Co Trailing Price-to-Earnings Ratio

Source: Bloomberg

Tredegear Corp Trailing Price-to-Earnings Ratio

Source: Bloomberg

If one is to invest in the containers and packaging segment, we think manufacturers catering to highly regulated markets or delivering highly complex solutions is where to look. Manufacturers catering to the pharmaceutical segment, for example, would be those operating in highly regulated markets. Suppliers to the pharmaceutical market have to meet very high regulatory standards and their production facilities have to go through rigorous testing and audits to be validated for production. Customers of such manufacturers are unlikely to switch suppliers quickly or easily and are more likely to see validated suppliers as trusted partners whom they are likely to work closely with in developing new and innovative solutions.

The stocks of the more commoditised containers and packaging producers, in our opinion, are clearly ones to avoid and amongst them might even lie some very compelling short opportunities. While stocks of companies – such as AptarGroup $ATR – operating in more regulated segments of the containers and packaging sector or those delivering highly complex solutions may offer relatively more compelling investment opportunities.

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable