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Pinched Profits

A Perfect Storm of Macro Economic Events Lead to Price Spikes in Finishing Supplies

by Thomas Franklin

What do a volatile oil market, hurricanes, natural gas price spikes, ethylene capacity crunches, a Chinese construction boom, and plasma TVs have in common? All have conspired to raise the price of laminates and related finishing materials for the graphics industry to what vendors are nearly unanimous in describing as unprecedented levels.

"Over the last 18 months prices have gone up dramatically," says Angie Mohni, director of marketing, Neschen Americas. "We’ve seen 18 to 30 percent increases in the costs of our materials since December 2005. It’s the worst I’ve seen."

Some suppliers have been forced to raise prices two or three times in a single year, others as rapidly as every 60 days. These increases have sunk their teeth into what can generally be a healthy profit center for many printing businesses—finishing.

"Over the last two years we’ve seen an unprecedented increase in substrate costs," says

Gideon Schlessinger, VP of Marketing, GBC. Among the hardest hit, he says, are thermal laminates and heat-activated films.

Though there are a number of forces pushing costs up, the main culprits are the steep climb in natural gas and oil prices.

"Natural gas is the feedstock for the petrochemicals which are the building blocks of adhesives and laminates," states Howard Rappaport, global business director, plastics, at the Houston-based Chemical Markets Association, Inc. (CMAI) research firm.

One of the major chemical components used in laminates and films is ethylene and in the U.S., 60 to 70 percent of all ethylene is derived from natural gas, the remainder is produced from Naphtha, a form of refined petroleum, Rappaport says. As prices for both resources headed north, they lifted prices for all products associated with them.

The price of natural gas has nearly doubled since 2001, according to the Energy Information Administration (EIA). The wholesale price of natural gas hovered around $2 per thousand cubic feet (Mcf) during the 1990s. Since 2000, however, prices have ballooned. In 2005, they rose to an average of $9 Mcf, according to the EIA. The spike in oil prices has been similarly severe, from an inflation-adjusted average of $20 per barrel—in 2006 dollars—throughout most of the 20th century, to over $60 in 2005 and as high as $78 in July 2006.

These increases have cascaded throughout the industry not just in the form of more expensive raw materials but in the more predictable spike in transportation and energy costs.

"I would argue that the shipping costs have hurt the most," says David Cowart, director of sales, Remington Laminations, Inc. Remington has had to alter its free freight policies as a result. "We keep getting hit with fuel service charges and so we have to change the rules for free shipping." Cowart adds that the company has had to pass on higher than normal increases, from a typical average of two to three percent, to five and six percent hikes due to the higher oil prices.

"There are two components driving higher materials costs, polyester and ethylene," states Al Boese, director of the Post Print Manufacturers Association (PPMA). On the polyester side, an enormous demand for polyester-based films used in plasma TVs has manufacturers chasing supply. "There aren’t shortages, but a strong demand is raising prices," Boese observes. "No one predicted how fast flat panels would take off."

On the ethylene front, not just high natural gas prices but a lack of manufacturing capacity has driven prices skyward, Boese adds. A significant chunk of U.S. petrochemical production occurs in the Gulf Coast, in a corridor spanning from Louisiana to Texas, the same area devastated by Hurricanes Katrina and Rita. While chemical manufacturers have largely restored pre-storm capacity, no new plants—called crackers—are planned in the U.S. for the remainder of the decade, according to Chemical and Engineering News. Indeed, demand is so strong and capacity so tight that chemical producers look to enjoy substantial profits in the coming year. Which in itself presents a strong disincentive to increase capacity.

Even if producers wanted to add capacity, it’s not so easy. "It takes three years and costs $1 billion to build an ethylene plant," Rappaport says.The rise of China as an economic and industrial powerhouse is yet another contributor to price increases. China is now the world’s second largest importer of oil and its surging demand is ensuring the global market remains tight.

"China is sucking up raw materials," states industry consultant Joe Webb, Ph.D. Not only that, but China consumes those raw materials inefficiently, using heating oil to run electric plants, Dr. Webb adds.

"Increasing demand for raw materials from China has contributed to higher prices for PVC films," concurs David Grant, VP of marketing, Oracal USA.

A Chinese construction boom is contributing to the country’s voracious resource appetite, Schlessinger says.

It’s not a one-to-one relationship between raw materials and end-user costs, cautions Grant. "Price increases that we pass on to our distributors are typically reflected in higher costs to end-users, although not always immediately, nor necessarily in direct proportion. Other factors such as competitive products, market conditions, and existing inventory levels play a role in determining final product pricing to consumers."What to Do

In a fiercely competitive marketplace, no one relishes the thought of passing on higher prices to their customers. According to a survey conducted by the National Federation of Independent Business earlier in the year, less than a one-third of business owners surveyed reported raising prices over the previous three months, despite increased inflationary pressure.

It may be easier to stall, but there is only so much a business can absorb before profits are completely whittled away.

Some customers have reacted by seeking out lower cost alternatives, either within a company’s existing product line or through overseas suppliers, says Jerry Hill, VP of sales and marketing, Drytac Corporation. His company has responded to the price crunch by offering an economy line of products and an internal effort to maximize efficiencies to minimize the impact of higher material costs.

"There is a danger that people simply won’t laminate," Mohnie adds. PPMA’s Boese notes that the costs of laminates were low enough, versus the value they add, that businesses would continue to promote the value of finishing despite inflationary pressures.

So what to do? A business faces three general options in the face of rising material costs: do nothing, eat the increases, and hope that the profitability squeeze is temporary; keep prices steady and attempt to offset the margin erosion by increasing sales volume; and lastly, to keep sales volume steady but raise prices to ensure profitability.

No path is without pitfalls and it is likely that a combination of approaches will yield optimal results. The first option, however, presents the most risks as it assumes that the squeeze is temporary, when in fact many vendors and analysts believe it is not.

The second path makes assumptions as well—primarily that additional sales are there for the taking. It also places extra burdens on equipment and personnel to cope with the increased work load. A firm may be able to ramp up sales while keeping prices steady, but they will be working equipment and personnel harder for the same profit margin. That extra sales volume comes at a cost, even if it’s not realized immediately.

The third route, passing the price increase onto the customer, offers a path to retaining profitability without putting added wear and tear on machines and more work on existing personnel. Raising prices, however, is not without its own risks, which is why many businesses are loath to do so.

That needs to change, says Jason Bartusick, CEO of Media One Digital Imaging Solutions LLC, a CA-based distributor. "Businesses need to pass on these price increases."

Many print buyers have never experienced an inflationary market, Schlessinger states. "Some of them entered this business in the last ten years, when there were no price increases—when there were even price cuts—and so they’re not conditioned to regular increases" that are common in inflationary times. That leaves print sellers in an awkward position, he adds. "Our customers are trying to manage this."

Mohni notes that the cascade of price hikes has begun to trickle through to print sellers. "Eventually they can’t hold back," she says.

There are reams of studies and reports analyzing just how a firm should set prices for their products or services. Many business gurus tend to advise that pricing not be set on a cost-plus basis—cost of materials and labor plus a desired profit margin—but by the value a certain product brings to its customers. This criteria, while more subjective and elastic, leaves the door open to setting a higher price for products than a simple cost-plus approach.

"Anyone producing things on a cost-plus basis or on contract is in trouble, especially in this market," Dr. Webb adds.

All that’s required is the marketing moxie to convince print buyers that your services are providing a value beyond the costs of materials and labor.

Communication is the key to successfully passing along price increases, vendors agree. A familiarity with the market forces driving cost increases can help a business explain why costs are up.

One innovative approach to offsetting oil-induced price hikes was pursued by Media One. According to Bartusick, after raising prices in 2005, the company began buying oil futures to hedge against further price increases. As oil prices rose, the profits from the sale of the futures offset the price increases Media One was receiving from its suppliers. By turning rising oil prices to the company’s advantage, Media One was able to hold the line against further increases.

"We won’t raise prices this year, even though we’ve had about 30 price increases from our suppliers," Bartusick concludes. What’s to Come

The bad news is that in the near term—12 to 18 months—few vendors or analysts see signs of relief. Many of the factors pushing oil prices higher, like demand from China and turmoil in the Middle East, are long term issues with no resolution in sight.

Natural gas prices have eased of late and may ease further, but sufficient volatility remains to keep prices above average. Commodities traders are also pushing prices higher irrespective of the realities of supply and demand, Rappaport observes.

Regular price increases, in other words, may be here to stay. Most manufacturers are reluctant to predict a return to pre-inflationary price stability. "We’re in for a fairly long cycle of these price increases," Boese predicts. "I would say 24 months minimum."

For his part, Dr. Webb expresses optimism that oil prices will come down. He adds, "When you adjust oil prices for inflation, this is not the worst we’ve seen. People were spooked because they rose so quickly."

"We do see some moderating in price, though it’s more than likely temporary," Rappaport says. Raw materials prices will remain high in 2007, he adds.

Other businesses, such as Federal Express, have passed along fuel-induced price increases without suffering unduly, so it can be done, Dr. Webb concludes. "You manage your labor costs, reduce waste, use good equipment, and cope."

Look for a full feature article on Rising Laminate Costs in the January 2007 issue of Digital Output.

Dec2006, Digital Output

 
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