2007 Mid-Year Economic Report

June 28, 2007

US markets tighten as others feel strength continue

Positive business feedback from narrow web converters rose through 2006 and early 2007. "Best April on record" and "best first quarter we ever had" were among comments registered by label printers. That continues for some, perhaps most. But the economic picture in one influential part of the globe, the United States, is shifting. It is a general tightening whose main contributors are rising interest rates, lower consumer spending, declining real estate prices, and difficulty in generating organic growth.

The label industry, according to observers, will undergo considerable contraction in North America and to a lesser degree in Europe starting later this year. This has been long predicted and is expected.

As in our previous mid-year economic updates, we have invited both converters and suppliers to give their views on a specific range of topics: How their company is performing, what changes they have experienced, what pressures or challenges their customers are experiencing, how they plan to invest this year, what they see as the great marketplace challenges, and what thoughts they have about the near future in our industry. This year we are pleased to offer contributions from John Hickey of Smyth Companies (also TLMI chairman), Richard Spencer of Label World USA, Klaus Bachstein of Gallus Group, and Vic Stalam of Kodak Graphic Communications Group.

To begin, we invited Elisha Tropper, an industry consultant and former label company owner, to give an overview of the economic picture that our readers face today.

Elisha Tropper, president, T3 Associates, Harrison, NY, USA

The American economy is consumer driven, and the American consumer is maintaining consistent pressure on the accelerator. Strong performance of both private and public equities along with a surprisingly resilient housing market have, for consumer spending, alleviated the traditionally curbing impact of rising interest rates and a weakened US dollar.

But the economy is not a rising tide that raises all industries. Overall GDP growth and near-record low unemployment notwithstanding, the American manufacturing sector is under attack. Consumerism, in the form of demanding shoppers and even more demanding shareholders, continues to pressure retailers to pursue lower costs, better products, and additional services from their vendors, who, in turn insist on similar contributions from their own supply chains. As a result, a great deal of high volume manufacturing, along with its packaging requirements, has departed for lower cost shores, never to return. The effect on the narrow web industry has been a continued reduction in the overall market of products requiring domestically printed labels.

It would be tempting to point to the positive impact of the Lean Manufacturing movement within the label industry as the key to retaining and even growing the domestic label production market. Certainly, companies have gotten leaner and the results have been to maintain profitability against a backdrop of challenges. However, while label manufacturing for domestically produced products will probably not be outsourced anytime soon, the reality is that the North American market for labels is shrinking as the products that require labels are outsourced to lower cost nations. What Lean Manufacturing has accomplished is to effectively offset the squeeze felt by converters between rising raw material costs and the ultra-competitive pricing in the marketplace due to intense competition to fill overcapacity. Despite the very best efforts of the industry, which include advances in process, product and application, the label market as a whole is barely growing, and whatever growth that exists is at considerably lower margins than just a few years ago.

Today's label printing industry is characterized by price wars, rising print standards and a tightening labor market for skilled press operators. Industry-wide, organic growth has become more and more difficult to achieve, stalling top line growth, making consolidation inevitable. This is precisely what we have been witnessing over the past several years, particularly at the large company level, where acquisitions have spearheaded the growth initiative of industry notables Multi-Color, WS Packaging, Fort Dearborn, York Label, among others. Even at the smaller and midsize company levels, the industry has seen a flurry of ownership turnover, including acquisitions by companies in related industries such as packaging equipment, folding cartons, cans, and bottles.

Looking ahead, the industry will certainly be impacted by its customers' green packaging initiatives. Organic substrates and a stress on recycling waste will bring both costs and opportunities to the industry. In addition, pressured by Wal-Mart's scorecard, consumer products companies will strive to reduce packaging, which could potentially open up new markets for label converters. In particular, prime labels could find opportunities to replace folding cartons if they can satisfy the multifunction requirements, including branding, brand security, regulatory verbiage, etc. This could potentially portend a rise in demand for expanded content labels, a higher margin specialty product that only a small percentage of label manufacturers are capable of converting.

Digital printing will continue to make inroads, in three specific arenas:

-    The pharmaceutical industry (and other industries), where print accuracy, particularly in the smallest fonts, is of paramount importance;
-    The short to medium runs that are characteristic in the private label consumer products, food, beverage, and personal care products industries; and
-    Brand protection, through rapidly advancing piracy-countering technologies.
Companies with strong digital printing capabilities and customer bases will become acquisition targets for larger organizations seeking to quickly gain market presence and identity as pioneers of the industry's most rapidly growing production technology.

In the USA, as we look towards the next six months, we will find ourselves entering a presidential election year, which brings with it the potential for dramatic changes to the economy. The attractive long term capital gains tax rate of 15 percent could be in jeopardy, especially if the Democrats assume control of both the White House and Congress, but this probably wouldn't occur until 2010. However, the looming threat of this possibility will offer even greater incentive for divestiture, particularly for owners of private companies. And since the stock markets generally perform well in election years, the pressure on businesses to achieve substantial returns for shareholders will continue to challenge every label manufacturer, large or small.

John Hickey, president, Smyth Companies, St. Paul, MN, USA

Performance: As it relates to narrow web we have seen some challenges in holding margins for many accounts based on pricing pressure in our markets. We expect this to continue.

Changes: We have continued to push "Lean" to the extreme in all areas of personnel, systems and manufacturing to abate these trends. The heat in the kitchen is intense but you need to keep baking to eat or you must leave the kitchen. The best recipe for success is world class employees.

Customers: I believe every American manufacturer is concerned about overseas pressure. This is reflected in the number of mergers of what used to be considered very large independent corporations.

I think customers need a good supplier more now than ever. Despite the pricing pressure our customers have less people to supervise our performance and their expectations of world class service are implied when they select you. For them to make a mistake in this selection process would be very costly. Their jobs are riding on it and they need to know you have what it takes to service all their needs for performance and product innovation.

Investment: We do plan to invest in the business in production equipment, personnel and facilities.

Challenges: The biggest challenge is deciding on the reinvestment areas of the business. There is much to study in this area and the margin for error is slim.

Future: Mergers provide both pending threats and opportunities for us. Many of us are leery of when a major customer is acquired, but if you can prove that we are worthy of the business to the new entity we have leveraged properly. I see this game of chicken played over and over again and the chicken better be in good shape for each bout. As usual, excellence is a factor. This hasn't changed.

Richard Spencer, president, Label World USA, Rochester, NY

Performance: We have a strong sales pipeline and have experienced very strong growth in our label business in 2007 driven by a combination of an acquisition and double digit organic growth. Through May we are ahead of budgeted sales and profits as a result of our associates driving a series of important performance improvement initiatives across the business.

Changes: We continue to invest energy and capital to improve our business processes and deliver world class quality and customer service to our customers located all over North America. Superior service is, and always has been, at the heart of our success and the reason for our growth. In our last two customer satisfaction surveys, 100 percent of respondents said they would refer us to another company for their pressure sensitive label needs, 85 percent strongly so in our June 2007 survey.

We have overhauled our sales and marketing infrastructure and invested selectively in equipment to add important new capabilities such as digital roll-to-roll label printing. We continue to drive an aggressive continuous improvement agenda to improve quality, operational efficiency and eliminate waste — all foundations of building a world class business that delights its customers every day.

Customers: Customers are becoming more demanding. Today's markets are complicated and increasingly competitive. Pressure on costs is incessant and manufacturers are all searching for ways to improve supply chain efficiency and reduce manufacturing costs. Products are proliferating — putting further pressure on costs and margins — as manufacturers compete for their buyers' attention. Increasingly, exploding product choices can overwhelm and confuse harried buyers. How do you cut through all this marketing clutter and operational inefficiency and make your product or service stand out and sell at a profit?

Label World is a company that succeeds by providing some of the solutions to these challenges that our industrial and consumer packaged goods customers face in spades. We are seeing an increasing demand for, and receptivity to, a range of value added services and solutions targeted at helping solve our customers' most important product branding, identification, security and tracking challenges. We work hard to help customers both improve their supply chain efficiency and make their products "pop" at the point of sale. By focusing on how we can help our customers succeed we are able to add significant value over and above 'simply printing labels', which becomes a win-win for converter and customer. In a recent PodCaster News interview (see links below, part 1 and 2) I discussed a variety of labeling technologies and solutions that we use to help our customers win. Topics covered included:

-    Print-on-demand solutions
-    Just-in-time delivery
-    Kitting & fulfillment services
-    Automatic label application
-    E-commerce and ordering practices
-    Artwork redesign & rebranding services
-    Regional brands, versions
-    Test marketing & digital prototyping
-    Digital printing, reduced inventories, obsolescence management
-    Personalization, variable data printing, one-to-one marketing
-    Special print effects: foils, metallics, fluorescents, holograms, lenticular, and domed labels
-    Smart labels: time-temperature indication, extended content labels, RFID
-    Brand security, anti-tamper, anti-counterfeit packaging features

Investment: We are currently evaluating several equipment investments, mostly in the finishing area, that will extend capabilities and/or improve productivity and throughput. As our business grows we will continue to add talented new associates in sales, customer service and operations.

Challenges: Change. Our industry has become tougher and customers more demanding. Technology continues to evolve. Printing labels is no longer a "local" business — today's technology allows us to supply and delight customers all over North America and even the world. Some of our largest customers today are nowhere near our plant. In this context we are likely to see continued consolidation as many smaller converters find it tougher and tougher to compete and either sell or go out of business. Only the strongest are going to survive.

Future: As converters become more efficient and sophisticated, technology more complex and expensive and market growth slows from the heady days of the 1980s and '90s, there will be too much capacity in our industry and continued rationalization is bound to occur. We are already seeing a raft of business closures, mergers and acquisitions as many family owned converters see the writing on the wall and are opting to sell their hard earned interests. We are going to see this trend continue.

Klaus Bachstein, CEO, Gallus Group, St. Gallen, Switzerland

Performance: In the first months of 2007, Gallus has been enjoying development similar to 2006. We have seen good improvement in the overall marketplace, and in our specific markets in the years 2003, 2004, 2005, and 2006, leading to the best year in our history in 2006. As such, we are satisfied with the current situation, since it reflects a rather strong industry.

Changes: As described above, we enjoyed several good years in a row, and used this period to further improve our organization. We have implemented some major improvement and investment programs, like the opening of a new state of the art facility for our screen printing plate business at a new location in Switzerland to allow next levels of innovation in the screen printing plate business. Further, the upgrading and expansion of our plants in Germany and Switzerland, combined with major investments and improvements in processes, allow us further growth steps and increase productivity. Important is the continuous improvement of our sales and service organizations around the world.

Above all, we keep investing significant amounts of funds in innovation, both for products as well as for continued improvements in products, people and processes.

Customers: We see a direct correlation of the business sentiment of our customers, the label printers, to their economic environments. Today in the US, after many years of strong consumer spending and strong business, we now experience flatter rates of growth in consumer spending. On the other hand, Europe and the emerging parts of the world are going strong. However, it is our aim to give our customers tools to lower their costs per print/label. As such, we believe that new investments in press equipment will be made irrespective of end consumer spending as long as such new equipment contributes to the business success of the label printers.

Investment: As described above, we have had several years of strong investment into capacity expansion, process and technology improvements, and new equipment investments, in addition to strong investment in people, processes and innovation. We will continue our commitment into continuous people, process and innovative programs, and we will keep our investment programs in line with business development.

Challenges: Our industry is undergoing continued and rapid change. As such, the question stays for every company the same: Do you want to be at the forefront of change, or do you want to be a follower? And I strongly believe that every business leader has to answer this question: What is your company's uniqueness? Gallus has answered it in its current positioning, "Success and security for the label printer", by:

-    Contributing to the business success of our customers;
-     Giving our customers the security to be the right partner, the partner of choice; and
-    Giving our customers the security to get from Gallus all relevant printing and processing technologies and corresponding services.

We will continue to follow this path.

Future: The label printing industry has a proven track record of continuous innovation and customer responsiveness. It will continue to do so. Any underlying trends for this industry are still positive, even in so-called mature markets. In my view, there is no question that we will see continued globalization and concentration in market segments where end customers globalize and concentrate.

On the other hand, this allows for niches where specialized offerings in products/services will create unique solutions. Important is to decide where somebody would like to play and then to shape the company accordingly.

Vic Stalam, VP of packaging products, Kodak Graphic Communications Group, Norwalk, CT, USA

Performance: Kodak's Graphic Communications Group had a good year in 2006 as the economy was strong in most parts of the world and customers were growing their businesses. So far in 2007 we've increased our solutions to the packaging market, including the label and narrow web market. Earlier this year, Kodak launched a digital flexographic plate, giving it a complete portfolio including workflow software, digital color proofing systems, thermal computer to plate (CTP) devices and thermal and flexographic printing plates.

Changes: Kodak is transitioning toward a segment-focused organization to better serve our customers. In the packaging segment, we now have a dedicated sales team in the United States and Canada and other parts of the world. The overall effect of this focus is we're positioned to understand our customer's business at a deeper level and develop solutions to meet their specific needs.

Customers: Our narrow web customers are facing increased pressure from the demand side by end users looking to maximize their purchasing power and squeeze margins. In order to remain competitive, many label converters are looking to invest in solutions that maximize productivity and quality. According to a recent TLMI survey, 97 percent of respondents expect to make investments in new technology and solutions. The same survey shows that most narrow web printers expect growth around 2 percent in 2007.

Investment: Kodak will continue to invest in research and development and manufacturing to address our customers' migration to digital. Look for new product news from Kodak at Graph Expo in September.

Another area that Kodak is investing in is anti-counterfeiting technology. One of the biggest threats to the packaging industry is brand theft, which costs the industry worldwide an estimated $450 billion a year through product counterfeiting and grey market diversion. To assist brand owners in defining, developing and implementing solutions to answer these challenges, Kodak offers digital watermarking, MICR and micro printing along with the recently launched Kodak Security Solutions. At the highest level of protection is the Kodak TRACELESS System, a forensically invisible authentication technology that deploys a combination of proprietary markers and handheld readers.

The TRACELESS System marker materials can be mixed with inks, dry inks, varnishes and other items for analog and digital printing, as well as paper pulp, plastics, powders, pigments, liquids, and textiles.

Challenges: Today's narrow web converter faces increasing pressure from consumer product companies to match brand colors across substrates and printing locations against increasingly condensed cycle times. There is a clear need for integrated solutions and digital workflows to improve productivity and enable new capabilities. Kodak brings process control to the prepress area with a complete digital portfolio from capture to final converted label.

Future: Mergers and acquisitions within consumer product companies will continue to place pressure on converters. To exceed growing customer expectations, narrow web converters will seek to produce consistent, stable, repeatable print that delivers high impact results on the store shelf. Kodak recognizes that issues such as a reliable digital file supply, consistent color quality and matching, and workflow efficiency are issues common to printers in the packaging environment and has assembled a breadth of solutions unmatched in the industry to address these challenges.
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