Ratings were resilient in 2021 through challenging market dynamics.   Over the last year, packaging companies have demonstrated considerable rating resiliency, with only a handful of downgrades. Stability within the industry can be attributed to (1) generally diversified end markets; (2) strong demand as pandemic effects in certain industries such as foodservice were offset in other areas such as household goods, grocers, and e-commerce; and (3) contractual cost pass-through mechanisms to absorb some of the inflationary pressures on the industry.

Despite the ratings stability, 2021 was not without its challenges. The run-up in costs of raw materials, labor, freight, logistics, and energy pressured many packaging issuers' ability to keep pace with pricing. Add to that global supply chain issues and winter storms in the United States that further disrupted supplies, resulting in tight inventories and at times limited product availability. The frequent and constant cost increases and broad inflationary pressures made achieving sufficient pricing to offset cost more difficult than in previous years, and certain issuers fared better than others. The lag time for contractual cost pass-throughs can range from one month to five months or longer, and packaging companies on the lengthier end of the spectrum have seen more significant margin compression as pricing could not keep up with rising input costs. Many issuers responded by increasing the frequency of contract openers as raw material indices moved higher and adding other non-raw material costs into the pricing discussions. Other packagers with strong technical expertise and leading market positions in their niche categories have better negotiating power with customers and have been quicker to pass-through additional costs.

We expect less volatility in raw material prices in 2022, which should help to boost margins and cash flows as pricing catches up with inflated costs. However, raw material cost movement will still vary by substrate. Aluminum prices should continue to increase this year, as well as certain plastics substrates such as polyethylene terephthalate (PET) and recycled PET, owing to such factors as elevated demand, higher logistics costs, and higher energy costs, albeit likely at a slower pace and smaller degree. Other resin substrates such as polyethylene and polypropylene should see some pricing stability or even moderate declines as additional supply comes to market. Paper-based packaging is still in high demand, allowing major corrugated, containerboard, and boxboard manufacturers to increase prices across the various grades early this year after multiple rapid price increases in 2021. The pandemic accelerated the secular shift toward e-commerce as consumers became accustomed to purchasing goods online, and we expect it to grow even as the pandemic effects subside. Though we believe raw material prices will remain elevated for many packaging issuers, stabilizing costs should be sufficient for them to regain some lost margins from the last year. The conflict in Ukraine will likely have far-reaching effects on the global supply chain and could keep costs higher, particularly over the near term.

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Negative rating actions occurred primarily on the lower end of the rating spectrum and/or as a result of debt-financed acquisitions.   Of the 49 North American packaging issuers we rate, we downgraded nine in 2020 and four in 2021. Of the 2020 negative rating actions, seven stemmed primarily from COVID-19-related weakness and the ratings continue to remain at a lower level, including Hoffmaster Group Inc. (currently 'CCC+' from 'B'), Liqui-Box Holdings Inc. ('CCC' from 'B'), Mauser Packaging Solutions Holding Co. ('B-' from 'B'), O-I Glass Inc. ('B+' from 'BB-'), Pregis TopCo Corp. ('B-' from 'B'), Transcendia Holdings Inc. ('CCC+' from 'B-'), and Zinc-Polymer Parent Holdings LLC. The downgrade of Ring Container Technologies Group LLC has subsequently reversed back to the original rating. We downgraded Sonoco Products Co., the lone investment-grade issuer, one notch to 'BBB' from elevated leverage stemming from previous acquisitions. Lastly, we downgraded Intelligent Packaging Sub L.P. ('B-' from 'B') because of a debt-financed distribution.

Three downgrades in 2021 were on the lower end of the ratings spectrum: LABL Inc. ('B-' from 'B') due to the debt-financed acquisition of Fort Dearborn Holding Co. Inc.; Poseidon Investment Intermediate L.P. ('B-' from 'B') due to its debt-financed acquisition of Alpha Packaging; and Dunn Paper Holdings Inc. ('CCC+' from 'B-'), which had upcoming debt maturities that were difficult to refinance under the operating environment. In addition, we downgraded Greif Inc. to 'BB-' in early 2021 due to sustained elevated leverage following the acquisition of Caraustar Industries Inc., but subsequently upgraded it back to 'BB' this year on its strong performance and debt repayments.

Rated packaging companies include several high-speculative-grade issuers at the 'BB+' rating level, such as Ball Corp., Berry Global Inc., Crown Holdings Inc., Graphic Packaging Corp., Sealed Air Corp., and Silgan Holdings Inc. While we view these businesses as having potential for investment-grade ratings, particularly the first three, financial policy continues to be a limiting factor with these issuers. With access to cheap debt, these issuers have prioritized growth investments, acquisitions, and shareholder returns. Given the interest rate environment, we believe these companies enjoy the financial flexibility of a spec-grade rating and will continue to manage leverage accordingly for the foreseeable future.

Another dynamic over the past year was the shift in capital structures to secured debt from unsecured, which came because of favorable secured debt pricing for stronger spec-grade issuers. Issuers include Graphic Packaging, Silgan, Sealed Air, and Berry Global, and in the case of Graphic Packaging and Silgan, resulted in lower recovery ratings and issue-level ratings for unsecured debt due to the addition of the secured higher priority debt. If there continues to be a large dislocation between secured debt and unsecured debt pricing, we expect other issuers could follow suit and lead to further impairment of recovery prospects for unsecured debtholders.

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We are maintaining a stable ratings outlook for 2022, despite persistent challenges.   As the world continues to re-emerge from pandemic-induced restrictions, we expect end markets that were directly affected, such as foodservice, industrial, and personal care, to see an uptick in demand. This pickup has already been seen during the second half of 2021 and we expect the momentum to continue into 2022. Issuers like Greif Inc. and Mauser Packaging Solutions, and niche players such as Hoffmaster and Liqui-box, should all be direct beneficiaries. E-commerce remains a long-term growth market for packaging issuers as consumers continue to shift their purchases online, a trend further accelerated by the pandemic. In contrast, end markets tied to at-home consumption and cleaning, such as food and beverage and homecare, should experience a modest pullback in 2022 seen in the second half of 2021. Companies such as Graham Packaging and Plastipak could be affected by these trends.

We believe labor shortages and supply chain bottlenecks to remain issues through the year, which will continue to lend unpredictability to the operating environment. Beyond absenteeism from COVID-19, changing dynamics in the labor market, particularly at the manufacturing floor level, has seen many exit the workforce or pursue more lucrative opportunities. These factors have attributed to ongoing labor constraints, requiring companies to increase wages to attract talent or increase overtime, which come at higher costs and do not guarantee enough capacity to keep manufacturing lines open. Several packagers have noted giving up volume in 2021 due to labor constraints, and we believe this dynamic could persist over the next 12 months.

Supply chain issues have also added to costs and may continue to do so this year. Strong demand for products has required packagers to think creatively to maintain supply for their customers, which often adds additional costs to their process. Supply issues not only add variability at the plant level, but for customers as well. Though demand remains strong, many packagers have reported customers halting orders as they are unable to access enough materials or labor to finish their products. Such issues create inefficiencies, which ultimately impair earnings and cash flows.

We expect capital investments to remain elevated for many packagers as they pursue organic expansion to meet robust demand, which will lower cash flows this year. Aluminum beverage can manufacturers such as Ball Corp. and Crown Holdings have reported enormous growth in capital spending to keep up with customer demand. Similarly, within paper packaging, Graphic Packaging is nearing completion of its Kalamazoo, Mich., facility, and Packaging Corp. of America is investing in changing its Jackson, Ala., mill paper machines to produce corrugated to meet higher demand. We expect O-I Glass to have higher capital spending as it expands its new Modular Advanced Glass Manufacturing Asset (MAGMA) technology.

Manufacturing automation has been a focus area for many packagers and we expect investments in this area to accelerate in 2022 and beyond in light of current labor dynamics. While we view this as a step in the right direction to address what is likely to be persistent labor constraints, we believe companies are in the early stages of what is likely a multiyear initiative and do not expect to see meaningful earnings contribution in 2022.

The sector has been active on acquisitions for both platform investments and bolt-on opportunities, and we see this year as no exception. Packaging remains an attractive area for financial sponsors due to the predictable demand profile and moderate capital requirements that support steady cash flows sufficient to support highly leveraged debt capital structures. Recent financial-sponsor transactions include Novolex (Apollo), Paragon Films (Rhone Group), and BW Holding (Genstar Capital). Bolt-on opportunities also remain an important part of many issuers' long-term growth strategy as a means of expanding into higher-growth end markets and product categories and improving vertical integration (for example, paper converters) and overall operating leverage. Acquisitions in higher-growth end markets and product categories, such as pharmaceutical, nutraceuticals, and dispensers continue to command premium multiples (greater than 10x pre-synergies) while smaller, tuck-in opportunities remain in the 6x-8x range. Active acquirers in the space include Graphic Packaging and Silgan Holdings and financial sponsor-owned issuers such as Berlin Packaging, TricorBraun Holdings, and ProAmpac. Capital markets remain highly receptive to more-aggressive capital structures, with total debt leverage consistently above 7x (on an S&P Global Ratings-adjusted basis) for sponsor-backed transactions.

Environmental issues are coming into greater scrutiny.   We view waste and pollution as a considerable issue in packaging, and we have seen these concerns manifest themselves within the industry. This has been elevated since China enacted its "National Sword" policy in 2018, banning the import of most plastics and other materials into the country. This act revealed the lack of domestic infrastructure to deal with the increasing amount of postconsumer waste. We have seen some regulatory actions at the state level, such as the banning single-use plastics, including straws, cutlery, and plastic bags, and we believe some substitution risk will continue to exist for similarly replicable products. However, the availability of other substrates, costs, quality, and standards are still large factors in determining the scope and pace of such substitution. We assigned an E-3 environmental indicator to over 40% of packaging issuers, typically on plastic packaging companies, which indicates our view of a moderately negative consideration in our ratings analysis.

Packagers have been making investments in tackling waste issues, and we believe continued investments will be needed to keep pace with customer and consumer sentiment, as well as potential further regulatory and governmental risks. We see the primary focus areas over the near term include continued focus on reducing the amount of packaging through light-weighting of packaging materials (flexible packaging has seen strong growth compared to rigid packaging in this regard), increasing product recyclability (e.g., transitioning from multilayer substrate packaging to single substrate or single-polymer packaging materials to allow for more simplified recycling), and using postconsumer materials in the product (e.g., upgrading production assets to be able to use renewable inputs). However, one of the primary drawbacks continues to be the insufficient infrastructure to support large-scale recycling and broader closed-looped systems, though the magnitude varies widely by substrate. Plastic packaging has one of the largest hurdles in this regard, with U.S. recycling rates at about 9%, and is worse outside of the PET and high-density polyethylene substrates. Additionally, plastic resins are typically downcycled, meaning that the recycled material is of lower quality and cannot be remade into the same product, which limits the prospects for a true closed-loop system. In contrast, in the U.S. over 90% of corrugated boxes are recycled, and about 50% of metal beverage cans are recycled and can be infinitely recycled, which led to a strong demand for beverage cans prior to and through the pandemic and resulted in meaningful growth opportunities for manufacturers such as Ball and Crown.

We believe there will be a continued emphasis on reducing packaging waste, both from consumers and regulatory authorities. Extended producer responsibility laws were enacted in Maine and Oregon and are being considered in other states, which could shift some of the cost burden for recycling and disposal on to producers. There is a potential for such costs to decrease packaging company earnings, and we continue to monitor how they incorporate these industry changes into their operations. Still, with increasing product proliferation and shifting consumer habits, there remains tremendous growth opportunities for all packaging substrates, and we believe ratings impacts with respect to environmental factors will be relatively limited in the near term.