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Thursday, August 14, 2008

 

Future of manufacturing in the packaging industry



As e-commerce changes the underlying economics of business, is the old business model — based on scale — under serious threat?

In my consulting work, some of the packaging companies that I like to track are AEP Industries; Avery Dennison; Ball; Bemis; Crown, Cork & Seal; Owens-Illinois and Sealed Air. These companies supply a wide variety of packaging materials, and looking at them I can get a fairly good indication of the overall industry trends.

However, by looking at their performance in the past 52 weeks, I am disappointed. Other than AEP Industries and Bemis, the rest have not been profitable investments.

Market share as a driver
What concerns me is that when the economy is so good, the packaging sector continues to perform rather disappointingly. What would happen if the economy slows down? My discussions indicate that only the top management in the packaging industry is concerned about the performance of the stock; the middle-level management is still driven by market share.

I am surprised to see that companies continue to add infrastructure to produce more and eventually gain market share. I am a firm believer of profitability over market share, but most middle-level executives do not seem to believe in that because nine times out of 10 their compensation is determined by sales and not earnings, and rarely the stock price.

I am starting to believe that the old business model based on scale is under serious threat. E-commerce is changing the underlying economics of business. In the past, large infrastructure resulted in high market share, which eventually meant excellent cash flow and future growth. This is no longer the case. Vertical integration (as traditionally understood) is starting to become a meaningless business model because it is now possible to outsource practically everything that someone else can do “better, cheaper or faster.”

Traditionally, companies relied on leveraging their infrastructure to bring down the cost of manufacturing to either drive down the overall market price or to increase their margins. Now this is no longer the prerogative of companies with the biggest infrastructure. A small organization can put together a virtual team of providers where each focuses on what it does best — be it manufacturing, technology, product development or marketing. This is a serious threat to a typical company that tries to do everything, since margins on its core competence can be eroded by inefficiencies in everything else that it does.

Is manufacturing no longer attractive?
As I said in one of my previous columns, if you are not the absolute best at manufacturing a product, stop manufacturing it and focus on what you do best. On the other hand, if you are the best, focus on maintaining that position. Somebody in the future will definitely figure out a way to beat you, and you should be prepared to react immediately.

What about those companies that already have a large base of assets? My recommendation is this: retain what you do best and get rid of the rest. I know this is a rather radical recommendation, but the alternative is even worse. I make this recommendation based on my past experiences.

I lived in Japan from 1992 to 1997. During this period, I saw a revolution taking place there. The bubble had essentially burst, and signs of recession were setting in. During the bubble economy, the wages had reached such high levels that the cost of manufacturing went through the roof. However, during the recession when demand dropped, such high cost of manufacturing made the Japanese uncompetitive in the market.

The Japanese companies reacted fast and started cutting down their Japanese manufacturing base. They established plants in several parts of the world and kept only the value-added operations in Japan. Japanese companies realized that they should focus on what they do best, that is, product design and marketing. Manufacturing could be accomplished by building skill set and infrastructure overseas.

As a final thought, do what General Electric does. Every couple of years, it reinvents itself. The company looks hard at what it needs to do to thrive till the next opportunity to reinvent arises.

The hard reality of business is that while you may invest enormous resources in developing internal capabilities and strengths, sometimes the environment changes faster than you can anticipate. This is exactly what is happening now. Don’t try to beat the marketplace. Instead, adapt your business model to the marketplace.

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