In this episode of Market Foolery, Chris Hill talks with Mike Olsen from Income Investor about a few things that flew under the radar this year, and what he's keeping an eye out for in 2018.
Find out why the consumer retail-goods industry is skyrocketing this year, while most of the companies in it are churning out meager returns; a few places that consumer-goods giants might turn to in the future to dig up some new growth; why the box industry (especially in the U.S.) is so ripe for growth in 2018; a few of the most promising pure-play box manufacturers on the public market today; and more.
A full transcript follows the video.
This video was recorded on Dec. 27, 2017.
Chris Hill: It's Wednesday, December 27th. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio today, from Income Investor, Mike Olsen, in the house.
Mike Olsen: Hello, sir! How are you?
Hill: I'm well. It's good to see you!
Olsen: It's good to see you, too!
Hill: Thanks for being here. We're wrapping up the year, and I think it's fair to say that the biggest story of the year for investors, just in terms of oxygen taken up by the media, was bitcoin. And I think the second, third, and fourth biggest stories were related to bitcoin.
Olsen: I'm pretty sure about that.
Hill: Which leads to this question -- you look at a lot of different stocks, a lot of different industries. What's an investing story that really flew under the radar this year for you?
Olsen: I'm not sure this necessarily flew under the radar. It's the consumer-products companies. It's no secret that the historic sources of advantage for these companies, their brands, marketing might, advertising budgets, distribution, shelf space -- those have eroded.
Hill: And we're talking companies that are making products that pretty much everyone listening has in their house.
Olsen: Right, like Pepsi (PEP 0.79%), Coke (KO 0.35%), Nestle --
Hill: Procter & Gamble (PG 0.42%), Campbell Soup.
Olsen: Unilever, Kimberly Clark, toilet paper, diapers. These companies, what advantages they have somewhat declined with the emergence of e-commerce. And the theoretical barriers around shelf space, their ability to market on TV -- with the emergence of targeted advertising -- those advantages have declined. So this isn't new to anyone. But I think what is particularly interesting is the juxtaposition between the perceived erosion of advantage and the valuations. All of these companies, the consequence has been, their growth has flatlined, they've been slow to evolve their product portfolios, they don't have those advantages, they're very large. So each incremental dollar of sales can contribute less to growth. But if you look at Pepsi, Coca-Cola, Nestle, P&G, Unilever, Kimberly Clark, none of them have grown greater than, at maybe a mid-single-digit rate on operating profits for the last five years. Pretty meager. Some of these have not grown at all. A lot of them are toward the lower end of that spectrum. So now, what's interesting about that in context is, even as these companies face some of the strongest headwinds they have in some time, they're also trading at the highest valuations they have since the tech bubble. The S&P Consumer Staples index is trading at 23 times earnings. That's the highest since the tech bubble. Pepsi, Coke, Nestle, P&G, Unilever, they're all trading in and around 25 times earnings. Again, these are historic valuations. So you have to ask yourself why.
Hill: Yeah. I'm sitting here shaking my head, which obviously makes for great audio. But some of the names that you mentioned, particularly Campbell Soup, which has struggled mightily of late. So the idea that stocks in this category would still be trading at a premium is, to me, one of the reasons that people look at the market today and say, "This market is overvalued."
Olsen: Right. I think, my space, or my corner of the world is, the more staid end of the world, which is dividends. But dividends have become quite sexy over the course of the past five years, and it's sort of a function, or fixture, of the extended low-interest-rate environment that we've dealt in. So why is this happening now? People are going after yield. There are a lot of ETFs oriented toward dividend payers. Retail investors, the not-so-Foolish variety, they're hungry for it. And it's hard to find that. So each of these companies, they have to pay around 3% yields, and frequently, you hear about people talking about these companies' valuations relative to a bond index. That just doesn't make any sense. I don't care what a bond yields inasmuch as it relates to what I will pay for a given company. I'm thinking about the long-term value of cash flows from this company. So seeing these tremendous distortions in valuations, it's a consequence of them being these stalwart yield payers.
Hill: Do you think there's any reason to own bonds right now?
Olsen: No.
Hill: For the average investor?
Olsen: I mean, if you're looking for something that's a cash equivalent, where you might need money in the next two years or something like that, yeah, maybe there's a good enough reason. But even then, what you're getting in excess of cash in most cases is not sufficiently attractive that I would see a reason to do that.
Hill: Some of the companies that you're talking about, we've seen this over the past five or six years to some extent with Procter & Gamble, and I'm wondering if you think this approach is warranted with, in particular, Pepsi and Coca-Cola, and it's spinning off brands. Procter & Gamble, for as huge as it is, used to have more brands under the umbrella. And five or six years ago, they started the process of shedding a lot of them. It's still a massive company. But I'm wondering, if the CEO of Coca-Cola or the CEO of Pepsi comes to you and says, "We're thinking about spinning some of this stuff off." Do you think that makes sense?
Olsen: I think it makes a tremendous amount of sense in select cases. You don't want to kill your cash cows. But at the very same time, the products portfolios of many of these companies, Coca-Cola in particular, they are oriented toward products that have profound secular headwinds here. These are sugary, fizzy beverages.
Hill: Yeah, they are. [laughs]
Olsen: Delicious, but it's no secret that if you want to live longer and have better quality of life, don't own those things. If I'm Procter & Gamble, if I'm Coke, I'm something like that, I think of my business as if you're an incubator for smaller brands. If I'm Coke, I have the wherewithal to go ahead and, on a lark, buy a tiny coconut-water business, and you plug it into that distribution system and you can, of course, tremendously grow those product lines. And that's kind of what you need to do in order to evolve and respond to changing consumer tastes and preferences. They also need to go ahead and figure out the channel, because right now, it's not an enormous threat to Coke, or something like that, but all of these companies need to figure out how they can live in an e-commerce world.
Hill: OK. I want to get to your thoughts on 2018 in a second. 2018, in terms of industry, what are you watching in 2018?
Olsen: Boxes. [laughs] Yeah.
Hill: It's like the movie The Graduate. "Ben, I've got just one word for you: Boxes."
Olsen: The future is not plastic. It is, in fact, boxes.
Hill: So literally, cardboard boxes.
Olsen: Literally cardboard boxes. This is a really interesting story. This is an industry that went from a ragged bunch of miscreants maybe 20 years ago, didn't make money, did stupid things consistently, were their own worst enemy, to what appears to be a rational oligopoly, consistent cash cow, nice tailwind in e-commerce. Basically, they make good money day in and day out. As a consequence of that, a lot of people have questioned whether or not that discipline can persist. And the fact that they have made so much money for such a long time will indeed attract competition. I don't actually think that's the case, but it's going to be something that's really interesting to watch over the course of the next two or three years.
Hill: If you put a gun to my head, I couldn't name a single publicly traded -- for that matter, a private -- cardboard-box company. Are these just larger paper-goods companies that have a foot in this space? Or are there actually pure-play cardboard-box companies?
Olsen: There are, actually, pure-play cardboard box companies. Some of them, two of the larger companies, International Paper and Packaging Corporation of America, they have a small and declining paper businesses. But by and large, these businesses are exclusively focused on what they call containerboard. Right now, because I hearkened to the idea that the industry was not a particularly good one 20 years ago, it's an industry where there was a tremendous amount of consolidation. It went from, maybe, five players that held maybe some 40% capacity to now, five players owning 75%. The second largest one, and one that I'm particularly interested in, is WestRock (WRK +0.00%). This company is probably, about half of their business comes from containerboard, and the other half comes from consumer packaging. Think about the paper packaging in food, frozen food, cigarettes, beer, all of that -- it's basically a cash cow, GDP-esque business. It's going to go ahead and pay the bills. The interesting part about that business is in the containerboard side.
Hill: What's the ticker symbol for WestRock?
Olsen: WRK.
Hill: So in the tech industry, when people look at Apple and think to themselves, "Apple isn't making every single part of the iPhone, so I'm going to try to find out, what are the companies that are making the components inside the iPhone?" When it comes to the cardboard-box industry, I can't help but wonder, who's Amazon (AMZN +1.63%) working with? Does Amazon have just one supplier for all of their cardboard boxes? Because, between them and Wal-Mart, they have to be pretty high up the list of companies that are buying cardboard boxes.
Olsen: Yeah. Most of the companies are a little bit quiet about just how exposed they are to Amazon. What we do know, and this has been verified by a few sources, is that e-commerce is now about 10% of total box sales. Now, e-commerce as a percentage of retail sales is about 8%. I went ahead and ran the numbers on this a long time ago when I was looking at Amazon and the theoretical boundary in terms of putting hard goods that can be transacted vis-a-vis e-commerce, it's maybe 50%-60% of total retail. So is it conceivable to think that e-commerce can grow at, maybe, 15% annualized rates for a long time? Yeah. So for the box business, that could very easily add 1%-2% to that volume growth. Now, this sounds pretty unexciting. But understand, this is a 1% volume-growth business for maybe the past 10 years. So that incremental growth is pretty huge, and it's also huge within the context of WestRock's valuation. This is a stock that trades at 11 times free cash flow, so it's hardly a demanding price there.
Hill: Where are these businesses based? Are they all U.S. based? Or are there cheaper cardboard box makers overseas?
Olsen: They are all U.S. based, and I'm going to wonk out here, so interrupt me when it gets boring. Alright, we've already stopped out.
Hill: And we're out of time. [laughs] No.
Olsen: The U.S. has an interesting structural advantage when it comes to making boxes. There are two ways you can make boxes. You can use tree inputs -- they're called virgin fiber -- and you can used recycled inputs. The U.S. is one of the few countries which has enough softwood trees that they can go ahead and make boxes by using softwood inputs. That's a lot cheaper than recycled inputs. The rest of the world, they do not have enough softwood forests that they can go ahead and use that input price. So recycled boxes, they can only be used so many times. You have to consider that, in the context of increasing box demand, recycled fiber prices go up. So U.S. companies have a decided advantage. They will, more often than not, produce boxes here. When you go ahead and think about boxes, too, the other thing that's hard is, they don't travel well. This is a low value-to-weight product.
Hill: It's kind of ironic, isn't it?
Olsen: Right. You don't want to send a box 40, 50, 100, thousands of miles. All is equal, you'd rather go ahead and manufacture it relatively close to the actual destination.
Hill: What kind of pricing power does WestRock have to a behemoth like International Paper?
Olsen: WestRock is actually -- I think they're about 18% of total industry, whereas International Paper is about 25%. The pricing is, generally speaking, set -- I wouldn't say necessarily by collusion, but a wink and a nod, it is.
Hill: Allegedly.
Olsen: Right. There was an antitrust suit in 2011. The producers will go ahead and decide that they are going to go ahead and increase prices as if and when they say there's been sufficient raw materials cost pressures, etc. What we do know is, over the course of the past decade, there have been only two times when prices have gone down. In just the past year, they've taken two pretty measurable price bumps. And their customers have, by and large, swallowed it, just because the degree of consolidation has made it such that they can't do anything but. Now, that gets to the bigger question, which is, is it possible that there will be new supply? I don't think that's likely to be the case, just because, if you go ahead and look at the arc of how boxes are made, you have the mills, and they make the container board, the sheets of cardboard, and then you have to send it to a box plant. And the box plant is where they actually make them into boxes. When you look at the industry across history, maybe about 25% of box plants were independently held. These guys were sort of mercenaries, they were happy to go ahead and take excess supply. They didn't really care about the quality of product -- they just wanted to go ahead and make boxes, and ideally, cheaply. So right now, a lot of the container-board companies have acquired most of the smaller, independent box-plant manufacturers. So if you're thinking about adding capacity, it's very difficult to do, because there may not be a place to send your boxes. So that keeps the industry supply demand rational, and in turn, allows them to raise those prices.
Hill: Alright. I'm going to be watching boxes in 2018.
Olsen: Yeah.
Hill: Mike Olsen, thanks for being here!
Olsen: Thank you, sir!
Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!
