One of the most effective tenets of manufacturing is to increase capacity where demand is sustained, and to carefully contract production where demand has dimmed. This summer, Packaging Corp of America (NYSE:PKG) is living by this philosophy, completing a major conversion of the company's No. 3 machine at its Wallula, Washington mill. The machine will be converted from a paper outputting unit to a packaging beast, which CEO Mark Kowlzan describes as a "400,000 ton per year, high performance, 100% virgin kraft linerboard machine."

This conversion from paper to packaging, in the works since last year, comes as long-term demand for freesheet uncoated paper, the type of writing and office printing paper commonly sold in reams, remains sunk in a tepid demand environment in North America.

Packaging Corp's business is divided among these two major segments of paper and packaging, and the organization's most recent quarterly results illustrate the divide between the two business lines. During the first quarter of 2018, packaging revenue rose 11.6% over the prior year, to $1.4 billion, and operating income in the division improved by 22%. Management attributed the revenue gains to record volumes and improved pricing.

The varied uses of cardboard packaging have increased steadily in recent years, due to rising industrial packaging and product display demand, as well as food and beverage packaging expansion, and, of course, a leap in retail packaging spurred by e-commerce.

Packaging Corp's linerboard mills produce containerboard and corrugating medium -- the two primary components used in the manufacture of corrugated cardboard packaging. In this division, "PKG" is selling into a sweet spot.

Industrial roll of corrugated cardboard.

Image source: Getty Images.

The paper business, on the other hand, has suffered from an increase in digital communication in North America, which is somewhat offset by paper demand in developing nations. In the first quarter of 2018, Packaging Corp's paper sales increased less than 4% to $269.4 million, and operating income (adjusted for costs associated with the Wallula conversion) decreased 42%, to $16 million. Management attributed the weaker profit to lower prices and higher input costs, though these were offset slightly by higher volumes.

It's telling that in the paper division, which was formed by Packaging Corp.'s 2013 acquisition of Boise Paper, the company has a significant client concentration. Last year, Office Depot was responsible for 43% of the paper segment's revenue, and 7% of total company revenue.

Packaging Corp has an agreement in place with Office Depot that requires it to supply (and Office Depot to purchase) at least 50% of Office Depot's annual commodity office paper inventory. The agreement expires in December of this year, and we can assume that it's likely to be renewed, as the company hasn't mentioned any upcoming material changes in its paper segment within regulatory filings this year. Shareholders can expect management to speak to this agreement soon, perhaps in next quarter's earnings conference call.

While one can point to the advantages of maintaining a plum contract with a major office paper retailer, it's a sign of consolidation in the paper industry, as well as the relative decline in freesheet demand over the last decade, that Packaging Corp must hold such a concentration on its books in the first place. There doesn't appear to an obvious, overwhelming growth opportunity in this market.

As Packaging Corp diverts resources to a more promising business line, other paper and packaging companies are employing similar strategies. Last fall, paper and packaging giant International Paper (NYSE:IP) announced that it would convert its No. 17 machine at its Riverdale plant in Selma, Alabama, from uncoated freesheet production to linerboard and containerboard packaging. Scheduled for completion in mid-2019, the $300 million project will decrease the mill's annual uncoated freesheet capacity by 235,000 tons. Alternatively, it's projected to give International Paper an additional 450,000 tons of annual packaging capacity. 

A sensible investment

While Packaging Corp is taking the line of least resistance in switching manufacturing to a more vibrant revenue opportunity, the decision isn't quite as easy as it may seem on the surface. The conversion required $150 million in capital investment, in addition to severance, shutdown, and impairment charges associated with ending paper operations on the No. 3 machine. Thus, Packaging Corp executives had to essentially make an educated guess that the probability of a freesheet paper resurgence in the coming years was relatively low.

That's probably an accurate call. Unless the company decides to expand into paper markets in developing nations, management will likely seek to simply stabilize paper volume over the near term. Conversely, the global corrugated packaging market is expected to expand at a compounded annual growth rate, or CAGR, of 3.5% in the five-year period between 2017 and 2023. Continuing to lift corrugated sales several points above this rate should provide an attractive earnings base for Packaging Corp for the next several years.

Asit Sharma has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.