The U.S. packaging sector is facing a slump in credit quality these days, with a handful of downgrades and negative outlooks occurring over the past two years. Some of the negative rating actions followed acquisitions or generous shareholder-reward programs. Still others reflected weaker operating trends. The industry must also heed consumers' calls for greener and less wasteful products and keep up with environmental standards. Here S&P Global Ratings answers investors' frequently asked questions about the sector's credit quality.

Frequently Asked Questions

What's the rating outlook for the packaging sector?

Our ratings outlook of the U.S. packaging sector is slightly unfavorable due to an uptick in downgrades since 2018, reflecting deterioration in credit quality for a handful of companies. The upgrade to downgrade ratio was about 1:4 and about 30% are on negative outlook. Some of the downgrades reflected companies' aggressive financial policies related to acquisitions or shareholder rewards that resulted in higher debt leverage. Some examples of these are Berlin Packaging, TricorBraun, Trident TPI Holdings Inc., and Consolidated Container Corp. In other cases we lowered ratings because of weaker operating trends, including for Owens Illinois Inc., Transcendia Holdings Inc., Anchor Glass, Dunn Paper, and Ball Metalpack. While many of these downgrades resulted in stable outlooks at their respective lower ratings (Owens Illinois, Transcendia Holdings) we maintain negative outlooks on about a third of the sector. We currently have negative outlooks on Berry Plastics Global, Grief, Flex Acquisition, Viskase, and Fort Dearborn. Nonetheless, many companies are still operating with ample liquidity and have limited debt maturities through 2020 because they refinanced through favorable credit markets and covenant-lite deals.

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How does raw material price expectations and tariffs affect profitability?

We expect input prices to be fairly manageable over the next few years because of likely additional ethane capacity from fracking expected in the Appalachia and the Gulf Coast areas. We expect this will curb most short-term price spikes and support an overall favorable environment for converters. For paper companies, China's import restriction on recyclables has driven old corrugated containers (OCC) prices down and helped companies' margins. For the major metal packaging companies we rate, the tariffs on metals have not had a major direct impact on performance because they have been able to diversify supply sources and achieve pricing pass-throughs, despite that aluminum is roughly 60% of materials costs.

Has the increased consumer scrutiny for more environmentally friendly products affected demand for plastic packaging?

Growing consumer calls for more environmentally conscious packaging seems to have had minimal impact on demand for plastic products so far. We expect it will have a tangible impact in the future. Some beverage companies have opted away from plastic-based packaging, but the shift has generally been limited to smaller formats (i.e., 20 ounces or less), where there are established alternatives (i.e., paper liquid carton, beverage cans).

Over the longer term, the call for environmentally friendly packaging options continues to stem from rising consumer scrutiny and environmental laws around the use of plastics. However, for the time being plastics are still the most cost-effective and versatile substrate of choice for the lifestyles, features, and preferences of consumers. Nonetheless, most plastic packaging companies are looking ahead. They're using more recycled or recyclable content in production and redesigning packaging to use less plastic content. These secular trends away from plastic packaging in the next 5 to 10 years may have negative rating implications for the sector in the future as providers of more sustainable packaging materials (paper, glass, metal) benefit from the shift away from plastic.

How have recent M&A and sponsor-to-sponsor sales affected ratings, and will these trends persist into 2020?

M&A activity has been high, fueled by consolidation in the industry and favorable credit markets. Two major transactions occurred in 2019: Amcor's acquisition of Bemis ($5.3 billion) and Berry's acquisition of RPC Global ($6.5 billion). Smaller transactions include Olympus Partners selling Pregis LLC to Warburg Pincus and BWAY merging with Industrial Container Services. Most of the negative rating actions reflected M&A due to the debt-financed nature of the transactions and generally aggressive financial sponsor policies. These include Berlin Packaging, TricorBraun, Berry Global's acquisition of RPC Global, BWAY's acquisition of Mauser, WestRock's acquisition of KapStone, and Greif's acquisition of Caraustar. In other cases, companies have stabilized credit metrics and enhanced businesses through acquisitions resulting in an upgrade such as Crown after the Signode acquisition.

Is the sector positioned to withstand a potential turn in the credit cycle and slowing economic growth in 2020?

Most of the packaging converters have a strong presence (more than 60% of revenues) in the food and beverage, consumer product, personal care, and health care sectors, which we generally view as more resilient during a downturn. However, some are more exposed to industrial end markets such as Greif, International Paper, Sonoco Products, and BWAY Corp., which could exhibit more volatility in volumes and profitability during economic slowdowns. While some may have some exposure to industrial end markets, we believe they are more resilient if they are part of a larger diversified operation versus the more narrowly focused ones that could experience more material declines in operating performance.

What will happen to operating trends and credit quality if paperboard and container board capacity outpaces demand?

Several paper packaging companies have voluntarily taken down mill capacity to address slowing demand for containerboard products. For example, WestRock announced in September that it would reconfigure its North Charleston paper mill to eliminate 288,000 tons of linerboard capacity (roughly 3% of the company's annual capacity). In June Georgia-Pacific announced that it would shut down the bleached board, pulping, and extrusion operations at its Crossett, Ark., facility in 2019. These types of momentary production curtailments help stabilize pricing in the context of the potential for roughly 4 million tons of capacity (about 9% of industry production capability) coming online by 2022. Depending on trade-related tensions and the impact of a global macro slowdown, demand growth during this time may only be for 1 million tons. How the pace of the capacity additions will play out, and whether the new industry participants who are adding capacity will act rationally with regard to selling prices remains uncertain. We think credit quality for large well-capitalized containerboard companies will remain fairly stable during this transition, as International Paper, WestRock, and Packaging Corp. of America have balance sheets that are not aggressively leveraged, and should be able to withstand a near-term slowdown. They will likely also see cost savings from the enhanced efficiency of any new plants that they bring on.

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How has rising labor costs affected profitability?

Labor continues to be a headwind for most packaging companies. The strong U.S. labor market has caused an uptick in labor costs for many packaging manufacturers and we expect this trend to continue into 2020. In contrast, transportation costs seem to have stabilized if not somewhat improved from prior years. The general economic slowdown combined with modest cost pass-throughs (for example, freight) has moderated transportation cost pressures.

What changes are we seeing as a result of increasing e-commerce?

The ever growing e-commerce market has spurred increased demand for pallet- or parcel-ready packaging solutions. Pallet/parcel-ready packaging involves the use of automated, form-fitted packaging with protective cushioning materials already embedded into the shipping parcel. We expect this shift to improve the overall fulfillment process by reducing throughput time and increase automation, but we think it will also dampen demand for a la carte protective packaging, such as air cushions, bubble wrap, crumpled paper, and other void fill products.

What are the key challenges in glass?

We expect headwinds for glass packaging companies for the next few years for a few reasons. Mega beer consumption has been down, with glass down even further with a switch to aluminum. Access to cullet (recycled glass) in the U.S. is becoming scarcer due to a broken recycling system. Lastly, we believe premiumization of glass to some extent may result in more cyclicality in a downturn.

In 2012, beer consisted of 59% of all glass container volume shipped; as of 2018 that was down to 53%. Much of that volume is either entirely gone--with beer falling out of favor with younger would-be drinkers, and some converting to aluminum cans. That has led to the closure of OI and Anchor's plants in Georgia, and Ohio, respectively, which serviced beer and beverage end markets. We expect this trend to continue.

Anchor Glass.   We downgraded Anchor Glass twice since September 2018 because of weaker operating trends. In 2018, we lowered the rating on weaker-than-anticipated operating results in the first half of 2018 and our expectation for further weakening in the second half. This deterioration came on the back of volume decline amid shifting consumer preferences away from glass and products traditionally sold in glass as well as uncertainties regarding replacing volume from the loss of a significant product line of a major customer, Dr Pepper Snapple. The downgrade in September of 2019 reflected our belief that the company's capital structure had become unsustainable given continued negative free cash flow generation and elevated leverage, along with challenged growth prospects for glass packaging.

Owens Illinois.  October 2019 downgrade reflected lower cash flow guidance to $100 million from $260 million and incorporated our base case assumptions for an adjusted debt-to-EBITDA ratio in the mid-5x area by the end 2019 with slight improvement in 2020. We believe the lower guidance reflects deceleration in some end markets such as China and the U.S. offsetting organic growth elsewhere in the organization. We suspect the declining U.S. beer trend is particularly heightened for glass manufacturers as customers substitute aluminum cans for glass to save on costs.

What is the sustainability of glass for the next few years?

From an environmental, social, and governance (ESG) perspective, glass is infinitely recyclable and is inert, not imparting any contamination on the enclosed product. OI believes there is a premiumization with glass, and consumer products companies that want to differentiate themselves will be using glass. While ESG sensitivity may motivate some consumer product companies to avoid plastic, the cost of glass is high relative to aluminum and plastic. Unless sentiment in the U.S. grows away from plastic as it has in Europe, it is unlikely that this will be a tailwind for the industry, particularly at this point in the economic cycle. As such, we believe it may prove difficult to replace decreased volume in the food and beverage space as well.

In our view glass will continue to have a place on the shelves of American retailers but given the above trends along with the heavy capital spending and energy-intense nature of the business, it will likely be produced by a smaller and more nimble industry that can deal with a shifting landscape. OI could be better suited to survive this than other players given its Magma mobile-furnaces, which, if successful, could be moved around the country as demand and tastes shift.

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Related Criteria And Research

Related Research

• Owens-Illinois Inc. Downgraded To 'BB-' Due To Softness In Demand And Lower Projected Cash Flows; Outlook Stable, Oct. 29, 2019
• Anchor Glass Container Corp. Downgraded To 'CCC+' On Weak Credit Metrics, Macro Challenges; Outlook Negative, Sept. 5, 2019
• Ball Metalpack Finco LLC Downgraded To 'B-' From 'B'; Debt Ratings Lowered; Outlook Negative, Aug. 1, 2019
• Dunn Paper Holdings Inc. Downgraded To 'B-' From 'B' On Very Limited Covenant Headroom; Outlook Negative, June 13, 2019
• Berry Global Group Inc. 'BB+' Rating Affirmed, Off CreditWatch; New Debt Rated; Outlook Negative, May 7, 2019
• Greif Inc. 'BB' Rating Affirmed On Caraustar Acquisition; New Debt Rated 'BB-'; Outlook Negative, Jan. 28, 2019
• Transcendia Holdings Inc. Downgraded To 'B-' On Weaker-Than-Expected Operating Performance, High Leverage; Outlook Stable, Jan. 14, 2019
• WRKCo Inc. Ratings Removed From CreditWatch; Parent WestRock Co. Rated 'BBB'; Debt Rated; Outlook Negative, Nov. 27, 2018
• Anchor Glass Container Corp. Downgraded To 'B-' From 'B' On Weaker Performance; Debt Ratings Lowered; Outlook Negative, Sept. 28, 2018