DS Smith PLC
LSE:SMDS
Earnings Call Analysis
Q4-2023 Analysis
DS Smith PLC
Within the company's European operations, margin variability corresponds with regional paper capacities and market conditions. Eastern Europe often outperforms during periods of high paper prices due to its reliance on open market purchases, while Southern Europe benefits from its kraftliner capacity, a segment that enhances margins. In contrast, Northern Europe, with significant recycled capacity, is positioned differently. These dynamics invert when paper prices fall. North America operates distinctively, reflecting its unique market environment. As for paper capacity investment, only modest increases have been noted, with a focus on replacing old capacity and facilitating smaller increments in production. The company exercises prudence in managing paper capacity expansions, considering market accessibility and the strategic importance of regions like Italy, where securing supplies is more complex due to import dependence.
The company's strategy to replace plastic has resulted in approximately 300 million new packaging units, translating into revenues exceeding £100 million. This movement represents both a commitment to sustainability and a lucrative margin opportunity within the larger context of their roughly £5-6 billion annual packaging turnover. Revenue fluctuates with paper price variations, but the underlying trend of growing its eco-friendly packaging solutions is clear and appears to be a growing contributor to the company's financial health.
The company is mitigating cost pressures such as a £100 million headwind from energy costs with efficiency measures across various facets, including labor, where low to mid-single-digit inflation rates are expected. Inflation recovery efforts include offsetting non-paper inflation through strategic paper price adjustments. The industry trend indicates that while capacity increases are widely announced, capacity reductions often occur unannounced. The company's own capacity management, like the recent reduction of its Bulgarian mill, suggests a careful balance between adapting to market demands and maintaining industry leadership. Paper prices are currently near low points, and future moves will be reactive to industry conditions.
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Good morning, everybody, and a warm welcome to the presentation of our financial results to June 2023. I'm Miles Roberts, the group's Chief Executive. And I'm joined by Adrian Marsh, our CFO, for what is his final presentation before his retirement. But I'm delighted to be also joined by Richard Pike, who will be taking over from Adrian. We have a short presentation followed by a Q&A session, and also, we'll be happy to answer any questions you may have.
We're pleased with our performance; especially given the volatile trading environment we've been operating through. This performance is really a result of years of focusing on a consistent business model and strategy, working with the world's leading FMCG brands. Our most packaging volumes and end consumer demand was more challenging than we originally expected. Our ability to support our customers and thereby increase the value added of our products and services was especially evident. And this is clearly reflected in our pricing, which, when combined with our relentless cost focus, has delivered an excellent financial performance with our profits up 35% over last year.
And it's resulted in us achieving our medium-term financial targets, and I'm pleased to see our return on capital getting towards the top of our medium-term range. And our sustainability performance has also been strong, and we'll talk a lot more about that later. And of course, we've continued to invest in our business. We focus not only delivering the short term but also in the medium term as we have strong fundamentals and really great ongoing opportunities to improve efficiency and reduce our carbon footprint whilst at the same time making attractive financial returns. And whilst it remains a challenging trading environment, we started the current year well with trading in line with our expectations. Adrian?
Thank you, Miles, and good morning, everyone. By way of my normal reminder, I'll describe the performance of the business on a constant currency basis. Here are our financial highlights. Revenue was up 11% despite a reduction in box volumes, reflecting higher sales prices across the whole business, which themselves reflect the rising input costs and inflation we've seen over the last two years. Price increases in the year more than offset significant cost increases of nearly £900 million compared with last year, with operating profit up 35%. Return on sales increased 190 basis points, which is a very strong performance within a highly inflationary environment.
As I described at the half year, in addition to selling packaging, we also buy and sell a large amount of paper, OCC and energy, the prices of which increased over the year, albeit that was more first half weighted. This increases both revenue and costs on a gross basis with limited impact on profit, hence, is diluted to reported margin. As usual, I'll give the breakdowns to calculate underlying margin absent these gross-ups.
Profit growth has flowed strongly through to EPS and cash, and I'll talk more about our continued leverage reduction shortly. Our earnings growth has allowed a significant increase in the dividend for the year. Our key financial metric of ROACE, which does not have the same nuance from inflation as for margins, has increased by 310 basis points to near the top of our 12% to 15% target range.
I'll now go through the main moving parts with the usual bridges. As before, we have broken out the packaging revenue from the totals and also the price mix to help you understand the impact of the pass-through of external sales of paper, recyclate and energy on underlying margin. The worse-than-expected box volumes decline had a negative impact on revenues with half two being worse than half one. Other volumes as a mix have reduced other packaging and less external paper sales as we produced less and used a greater proportion internally.
The major increase is clearly the sales price increase, just over £1 billion of the £1.2 billion is packaging pricing, representing average prices of around 18% higher versus the comparative period, reflecting the multiyear inflationary cost recovery. The balance made up of positive year-on-year external paper and energy and lower recyclate sales pricing.
Turning to EBITDA. As with revenue, there is a negative contribution from the volume decline and a similar story for other volumes with less external paper being sold, although there's a corresponding benefit on the cost side as less is being purchased. Sales price mix dropped straight through to profit.
As Miles will talk more about, the fact that we've been able to offset the inflationary cost increases over several years is testament to the ability and quality of our customer offering as well as our ability to manage our cost base through our proactive risk management and procurement processes whilst ensuring security supply at all times for ourselves and, as importantly, our customers.
On the cost side, the largest contributing factors were raw materials with external paper purchasing and raw materials such as starch more than offsetting lower fiber costs, particularly in half two. Together, raw materials make up roughly half with other costs such as labor distribution, together with energy, making up the other half. In respect of energy, half two was better than we expected, mainly because we used less energy due to lower volumes in packaging but, also, more importantly, with downtime taken in paper production.
Overall, group margin has increased significantly, albeit, as I noted before, this is despite the inflationary environment. As I've discussed previously, regionally, there will always be short-term variations depending on the total of our own paper production, although clearly, we think of our supply on a global basis.
Northern Europe profits were up over 50% despite weaker volumes. Germany is more exposed to the industrial sector, and the U.K. has generally been a tough economy. Paper performed well and the drop-through to packaging was also positive. Also, of note, there's a circa £20 million cost in relation to the closure of our U.K. recycling depots.
Eastern Europe also had a similar number for closing of our Trakia mill. Otherwise, profits would have been up significantly more as volumes were down less than the group average, and cost control and pass-through to packaging were good. Southern Europe has delivered an exceptional performance with profits up over 50%, The Europac assets continued to deliver very strong returns both within packaging and paper, particularly in our Portuguese kraftliner mill.
North America remains a high-margin business despite the overall U.S. packaging market being difficult, in particular in half two. We continued to make good progress with our multinational packaging customers as we replicate the offering they receive in Europe, but there was an impact from export paper prices declining in half two.
Turning to cash flow. Returns and profitability have also converted well into cash despite the increased investment into the business. Within working capital, as I highlighted at the half year, paper and energy prices declining towards the end of the year has had a negative impact on our working capital. And this more than offset the positive £69 million net inflow from risk management of our energy hedges. By way of note, absent further risk management actions during the year, then we expect our net inflow from energy margin cause a circa £180 million will have fully unwound in full year 2024.
Pension payments and other is the add back of the two restructuring elements within EBITDA, as I described earlier. CapEx has increased as we continue to see attractive returns from investing in the business, and we make progress against our carbon targets. For information, invoice discounting has reduced to £360 million despite the significant increased selling prices, meaning on a volume basis, it is lower still. So overall, a continued strong free cash flow.
Moving to the cash flow bridge. Net debt has increased slightly over the year, principally due to both increase in the absolute amount and also the timing of dividend payments and the increase in CapEx as described earlier, an FX impact of around £90 million and increased renewals of IFRS 16 leases. Clearly, one of the highlights of the results is that net debt over EBITDA is now significantly below our target ratio of 2 times.
This is my last set of results at DS Smith, and I've been extremely proud to work with Miles and all my colleagues over the last 10 years. I've very much appreciated all the support I've personally received from our shareholders and the occasional challenges, and I hope you'll agree, we're in a strong financial position and the business we've built is delivering against the ambitions we've consistently set out.
I'm now delighted to hand over to Richard, who will share some initial first thoughts on the business, capital allocation as well as providing our usual technical guidance.
Thank you, Adrian, and good morning, everyone. I've been in the business for just under three months now. And as Adrian has been around during that time, I've had the opportunity to spend most of my time out in our European operations, meeting the regional teams and visiting sites across our larger markets.
My initial observations about the strong customer centricity that Miles describes really is prevalent throughout all areas of our business. And that, together with a real down-to-earth, can do, and solutions-orientated mindset, really shapes the culture that exists across the organization. And whilst the business is obviously in good shape, as demonstrated by the financials that Adrian has just talked to, I see plenty of opportunity to drive further operational efficiency, innovation, and growth.
As a result, I see my key focus areas, certainly over the next couple of years, will be working with Miles and the team to build on the strong platform that we've built over the last decade, to ensure that we're driving optimal performance from our existing assets with a clear drumbeat to our operational efficiency programs and ensuring we're lean and fit for purpose in all areas, and prioritizing the areas of investment that make most difference and soonest with attractive returns on investment.
Specifically, in terms of capital allocation and driving return on average capital employed, I see lots of attractive organic investment opportunities available to us. We'll pursue these within a consistent capital allocation framework, remaining within the parameters that will retain our investment-grade credit rating as well as enabling us to maintain a progressive dividend policy.
We won't rule out M&A where compelling. And if, after prioritizing the above, we have surplus capital, we'll look at returning capital to shareholders. At the moment, however, my view is that the returns from organic investment opportunities available to us are compelling and compare favorably when we benchmark them against share buybacks.
Turning now to the technical guidance on Slide 11. I'm just going to focus on a few of these areas. Firstly, in terms of interest cost, you'll see that we're expecting higher interest charge in the current year as a result of us having higher borrowings at higher rates. Again, we've actually got good coverage in terms of energy hedging with over 70% of our book covered for the current year.
Moving to the cash flow side of the business. We will see further working capital deterioration this year. £180 million of that relates to the unwind of the collateralized energy hedging. We will again see CapEx around the £500 million mark as we invest in the areas that I mentioned earlier, and we also have the final Interstate put option amounting to around £110 million.
I'll now hand back to Miles.
Thank you, Richard. The economic backdrop to last year was one of the volatile rapidly changing environments, but we saw our large FMCG sector was quite resilient with volumes down only a few percent whilst our smaller industrial sector was weaker, where volumes were down a double-digit percentage. And geographically, Germany along with the U.K. were our weakest regions, but there was a lot more resilience, particularly in the East and South of Europe. And on a time, basis, volumes during H2 were, on a like-for-like basis, worse than those in H1. But that was primarily due to destocking, which accounted for roughly half the decline in H2.
And whilst our overall market share improved during the year, this was offset by the poor economic backdrop and did result in volumes being lower than we originally expected. However, the volumes at the end of the year were showing an improvement over January and February, and this improvement has continued into the current year as destocking reduces, but the end consumer demand is still fragile. But ultimately, we think this volume weakness is short-term as the corrugated packaging market shows good ongoing fundamentals and we continue to take market share.
The rapidly changing market allowed us to work even more closely with our customers, offering us the opportunity to add more value through the introduction of new product and services. All of these supported by our ongoing outstanding levels of customer service, product quality, our responsiveness, our digital capabilities, and investment program. And as well as improving the value add, the profitability, this close relationship with our customers can clearly be seen in the results of our regular customer surveys as well as the results of our own brand survey. Both of these are showing good further improvements on what were already high scores and has resulted in our performance being at an all-time high.
And to further satisfy our customers' demand for new product and service innovation, during the year we opened a new dedicated group innovation center and recruited an additional 40 innovation specialists. And this has led to a higher rate of new product launches than in previous years, and these launches attract a much higher level of value add. And one specific element of innovation remains plastic replacement, where we've seen a good acceleration in the take-up of our products from customers who remain committed to eliminating the use of plastic packaging wherever possible.
Part of delivering a high-returning business remains our relentless focus on cost -- on cost reduction, for labor, for energy, for materials, for distribution, but also in capital. And these reduction programs, these improvement programs are based on our lean manufacturing and investment programs, ongoing implementation of best practice, where we find it throughout the group, supported by a global procurement function, where we seek to maximize the benefits from our flexible supply chain, where our short paper not only gives us a cost advantage at the moment, but also allows flexibility in terms of utilizing our own paper production.
And for the medium term, we continue to invest to reduce our cost base through increased automation as well as energy efficiency. And we've taken action to reduce our exposure to mature low-returning assets, such that through the disposal of De Hoop or the closure of the Trakia paper mill as well as some of our U.K. recycling depots. And we've continued to invest, driving returns through our investment program. Richard has already commented on this, but we think about investment both over the short and the medium term to meet our customers' expectations, to reduce our costs, but also to improve our environmental impact as well as the financial performance of the group.
Some recent examples of our investment are into new products and services. New products include new barrier technology, new enhanced grades of lighter, higher-performance paper that utilize new manufacturing techniques. And in services, new services in digital automation of processes where we connect with our customers and to support our customers in their own in-house manufacturing processes to improve their efficiency and cost base. And for us to invest to improve our efficiency, to reduce our costs as well as enhance our capacity in faster-growing regions.
We've seen in the new box plants we've recently opened that continue to deliver to our plans, have efficiencies far in excess of what we've been able to achieve historically. For example, the new plants have a labor efficiency that's about 75% ahead of the comparable size older plant. And we've also been investing to reduce our carbon footprint, where we've often shared the capital costs by investing alongside third parties such as in the creation, the construction of a new waste-to-heat plant in Aschaffenburg in Germany. And all these investments have attractive returns, with that return on capital between 15% and 20%, exactly as we've spoken about previously.
And leading the way in sustainability is about having the right product, a fiber-based packaging product. We don't have plastic anywhere in our portfolio. And about producing it in the right way, having a 1.5-degree science-based institute target. And to -- and the performance last year, we've seen our CO2 emissions reduced by 10% over the previous year, on track to deliver our leading ambitions and targets by 2030 and net zero by 2050.
And we've launched biodiversity programs at 13 of our paper mills. We've updated our next sustainability strategy that's currently being launched, not only with enhanced targets for environmental performance, but also targets to improve the understanding of the importance of the environment and our performance in the communities in which we operate. And of course, we're delighted to see the ongoing recognition of our performance by many external agencies.
And of course, all the progress the group has made over many years comes from really everybody who works in DS Smith, all of our 30,000 colleagues right across the organization, wherever they are. And we continue to invest in developing our people, providing ourselves and them with the skills that we need, not just for today but for the future, and in creating a safe environment.
We've again delivered another year of improvement in our health and safety scores, our 15th consecutive year of improvement, and working with our European Works Council to deliver on the commitments enshrined in our employee charter. And of course, we're also pleased with the progress. There is more to do. There's always more to do here, But the progress on our diversity and our inclusion as well as our employee engagement and engagement with our communities has moved forward over the last year.
And turning to the outlook. Well, the trading environment continues to be volatile, Consumer and demand remains fragile, but we do expect to see an improving trend in volumes. We continue to focus on adding value to our customers, and this is supporting our pricing. And of course, we remain utterly focused on driving efficiency, reducing our cost base throughout the business, supported by our investment program where returns are attractive. So, we're pleased with the start of the new year, where trading has been in line with expectations.
And I'll leave you with our last slide of a summary about how differentiated, about why we feel confident about our business model and the future. Thank you. Myself, Adrian, and Richard are now happy to take any questions you may have.
[Operator Instructions]. The first question comes from Charlie Muir-Sands from BNP Paribas Exane. Please go ahead. Your line is open.
Good morning, gentlemen. Thank you, very much for taking my question. I've got several, but I'll limit myself to three. Firstly, in order to -- I appreciate it's early in the year, but it's encouraging you're giving that message around meeting expectations, which I understand is consistent with consensus as well. Can you talk about what kind of improvement you would need to see in volume through the year to get there? Obviously, recognizing that's not the only potential moving part.
The second question relates to working capital. You've obviously given us the quantum of the likely energy hedge unwind. But can you give us any steer on the potential quantum of the other remaining underlying working capital outflow you might see?
And then the final question relates to those 297 million items you've replaced with fiber-based packaging in the last year. Could you just help us quantify that financially, what kind of percentage of your packaging sales would that represent? Thank you.
Thank you very much, Charlie. I'll take the volume and talk about the plastics. And Richard, are you happy to take in the working capital? Look, on the volumes, as I said, we've started to see there's some very early signs that the destocking is certainly starting to improve, and we are expecting to see a -- that sort of trend -- that trend continues. We're not expecting anything heroic on the volumes during the year. As I said, the end consumer remains weak. But we are expecting the -- that sort of rate of decline certainty to be improving during the coming year.
And that sort of leads into the issue on the plastics, the £300 million. The revenue from those is over £100 million. But the -- as I said in my earlier presentation, the actual -- the value-add on those is actually very -- is very good. It's better than the group average. Richard, on working capital?
Yes. And on the working capital, Charlie, it's -- I mean basically around about £100 million is sort of what we expect to see in terms of further decline in working capital over and above the energy hedge collateralization unwind. And that's -- I mean that obviously depends on where paper prices go so that, that could move if we see paper prices improving in the second half. But as we sit today, we think with sort of paper prices declining and energy price declining, that's the sort of order of magnitude we're expecting.
We'll now move to our next question from Lars Kjellberg from Crédit Suisse. Please go ahead. Your line is now open.
Thank you. I just want to stay a bit with volume component. Of course, you're getting into a very easy compass with transition into H2. It looks like you were down 8%, and 9% in H2. So, do you expect that to be year-on-year positive? And really, how do you see sort of incremental volumes transitioning through the year, not in statistical comparison but in absolute terms?
And other question is, of course, relating to box prices. Maybe I didn't catch it, but I don't know if you made any reference to box prices, how they transitioned in the final two quarters of the year, and what you're seeing in the near term.
And then the final question that I have, relating to the energy hedges and how you can make us understand what sort of impact this has on your energy cost for the current year in relation to where spot prices are which, of course, have come down quite materially. Thank you.
Thank you, Lars. Again, if I take the volume and box price, and Richard, are you happy on the energy?
Sure.
So, you're absolutely right. In the volume in the second half was worse than the first half, but about half of the volume declined in the second half, we think -- our analysis shows us it's around about half of that second half decline. So, the underlying position for the second half, first half was very broadly the same. And we started to see the destocking coming to an end. And in fact, the -- on a like-for-like basis, the rate of decline is certainly improving when we look at sort of second half of March into April, and actually that's continued into June as well.
You're absolutely right. The comparators, particularly in the second half of the year, will be very favorable. But nevertheless, we are looking for that rate of decline to carry on improving. And it'd be second half weighted, but we should start to see, hopefully, the volumes get back to, just on an absolute basis on to a position that we've seen in previous years during the second half of the year. As I said, there's quite a bit of uncertainty there.
We haven't built our forecast on any heroic assumptions on volume. We've got a number of new contract wins coming in. We have -- looking quite positive, we're very focused, as you see, on the FMCG sector. There are some signs that that's improving a bit. But we do remain a little cautious.
Interesting on the box prices. If we go to last year, Q2 was -- our Q2 pricing was better than Q1. Q3, as it takes us into this current calendar year, was better than Q2. But Q4 did show a modest -- a very modest initial decline. Now since then, we've obviously seen a reduction in the paper price. That does trigger a number of the indices. I remind everybody, we still have a lot of non-paper inflationary indices in our mechanisms.
And obviously, the index is for half of our business, the other half are fully negotiated. Now clearly, we expect box prices to fall the first quarter of this year compared to the Q4 of last year. But at the moment, the declines are coming through, but they are modest. We are not -- they are modest for reasons that I've said. Richard, on energy?
Commenting on energy hedges, Lars. I mean, as you know, we have a sort of rolling three-year hedging program. So, as you can imagine from that because the impact of that is that it did sort of smooth the impact of energy movements on the business. You wouldn't expect to see a marked difference in terms of the price of energy per se. However, as you know, we took capacity down during FY '23 and therefore utilize less energy in our paper mills during the current year, as Miles has talked about, as we expect volumes to start moving in the right direction.
We're expecting our mills to operate at close to capacity, and therefore, we'll be buying more energy. So, it's more of a volume impact rather than a price impact. We'd expect to be around about, again, £100 million of year-on-year negative impact in terms of energy cost in our P&L.
We will now move to our next question from Cole Hathorn from Jefferies. Please go ahead. Your line is open.
Good morning, Miles, Richard, and Adrian. I'd just like to focus on the free cash flow of the business into next year and then into '25 and '26 as you see it develop there. I mean maybe if we start off on the CapEx number, I mean it's still an elevated CapEx spend. Maybe I'd just like to hear your thoughts around that CapEx spending. Is this more efficiency, ultimate goal, improving the relative position of all your assets into the future? Just wondering how that's split versus kind of expansion versus efficiency CapEx.
And then coming back to the working capital, are you saying that there's going to be £180 million outflow for the energy and then a further £100 million outflow for the working capital? Or will there be an underlying item you can do to improve that working capital inflow and protect your free cash flow through '24 and '25?
Why don't I take both of those, Cole? I mean in terms of the first thing on the CapEx, as you know, I mean that depreciation is sort of north of £300 million. So just spending to maintain our assets in good shape, you'd expect our CapEx to be around that level. And hence, although we're looking at a number of £500 million, you're talking about £180 million to £200 million of sort of incremental CapEx.
As we touched on, we see opportunities in lots of areas with attractive returns, and we think that those, as a result, are worth pursuing. There will be a weighting towards efficiency. Miles has given you some examples of the things where not only have we got some degree of capacity expansion, but we're actually operating much more efficiently on the back of those investments. And when you look at some of the areas where we actually have assets coming at the end of life, we're not just replacing those assets but we're investing in further improvement in efficiency or capacity, which actually enhances the returns from those investments.
So -- and I think in overall terms, you'd expect us to be looking to ensure that we're deploying our monies most effectively in the areas that will return most quickly, but also to enhance our underlying operational capability. And even if the market continues to be difficult in the near term, those efficiency investments will stand us in good stead as we go forward.
On the working capital, as you described it, it's just that. It's the £180 million in relation to the energy hedges plus a further £100 million of underlying outflow based on, as we see things today, where paper and energy prices are in particular. To your point about can we improve on that, we'll obviously be looking at that.
There may be upside if actually paper prices and energy prices recover because I'm sure you're aware, energy prices sort of bottomed -- well, bottomed so far at the start of June, have recovered since then, but we'll have to see how the year plays out. And we'll be looking in the same as with our capital, how can we ensure that we're deploying our capital employed most efficiently across the piece.
We'll now move to our next question from Justin Jordan from Davy. Please go ahead.
Thank you, good morning everyone. I've got two questions, I suppose, on capital allocation, really looking at your four circles on Slide 10, as it were. Firstly, can you talk us through the last circle, the surplus cash return to shareholders? I'm just trying to understand in the Board's thinking where would buybacks potentially ramp currently given your confidence on your medium-term capital generation -- sorry, cash generation versus de-rated valuation.
And then secondly, on, I suppose, the £500 million CapEx for the current year and beyond, we've had recent announcements from Valmet of two orders to supply a new recovery boiler to DS Smith for your Viana mill in Portugal, and a new -- I think it's 450,000-tonne kraftliner mill to your Lucca mill in Italy. Can you just explain your confidence in CapEx and daily CapEx in excess of growth -- sorry, in excess of depreciation given the sort of volume outlook that you're talking about?
So, on the return of capital, Justin, I think as I tried to describe [indiscernible] through, we see attractive returns in terms of organic investment. We absolutely want to maintain the progressive dividend policy. There are obviously continuous bolt-on acquisition opportunities, but that's not where our primary focus is right now. If we generate surplus capital, then we will look at returns of capital to shareholders. But in the near term, I believe that actually, we -- the attractive returns from investments will be where we're deploying our capital.
On the -- where are we spending our money? The replacement boiler in Viana is our kraft mill in Northern Portugal. That's an end-of-life asset where the investment that we're making actually will make us even more efficient on the back of the replacement. And Lucca isn't a kraft mill, it's actually a testliner facility where, again, one of our lines is end of life. But the new line there basically runs at 3 times the speed of the old facility. So that both produces additional capacity, but it's much, much more efficient than the old things.
So, as I was saying, when we're looking at end-of-life assets, we're looking at ways in which we can improve our underlying efficiency as well as actually being more sustainable because the actual CO2 emissions from these sort of investments are much lower as well.
We will now move to our next question from Kevin Fogarty from Numis. Please go ahead.
Two questions, if I could, please. Firstly, in terms of margins. So obviously, kind of well done in terms of the margin delivery during the second half of the year. With the business now sort of delivering close to the midpoint of your margin target at an EBITDA level, I just wondered -- I appreciate there's a lot of moving parts as we go through the current year. But just in terms of the kind of level of commitment to either kind of maintaining or at least remaining within those -- that sort of target range this year, is there anything we should think about in terms of cost initiatives to help you to do that? So maybe sort of a point on that, please?
And just secondly, in terms of inventory destocking, I just wondered if you could sort of help us -- what sort of gives you the level of confidence that destocking has come to an end? And I think there about perhaps kind of level of inventory typically held by customers or perhaps what that looks like now, if you could help to put that into context, that would be useful. Thanks.
So, if I take the sort of cost reduction efforts, Kevin, and hand over to Miles. As you'd expect for international manufacturing business, cost efficiency is top of mind all the time. And particularly given the inflationary environment we've been in and continue to face into, that continues to be something that is very important to us. Now will those cost reduction efforts more than offset the inflationary factors? I would say, kind of bear in mind the levels of inflation, that will be a pretty chunky ask.
But we are looking at all areas in terms of what we can do in that regard. We have now relatively well-established continuous improvement program, The DS Smith Way. That's four or five years into its evolution so far, and therefore, the drumbeat of our continuous improvement efforts are ongoing. Miles mentioned the -- basically the value the procurement is bringing to our business, again, to offset those inflationary pressures. And quite a bit of our capital investment is again focused on those areas.
So, we've got very established programs to drive cost efficiency. But just bear in mind that we are -- that, in large part, is offsetting the underlying inflation that we're facing into.
And on the destocking, so the first, in our second half volumes, if you start to look at it on a monthly basis, we could see in the second half of December and then into January, we saw that our customers were taking extended downtime in their facilities. And they talked to us about how they've built a lot of stock during the COVID years to maintain their service levels really into the retailers and the final consumer given all the supply chain challenges there have been.
And I've explained that now the environment looks different as we've come out of COVID. They, therefore, don't need to hold the level of stock in their own finished goods that they have in the -- that they had for the previous two years. So, we -- they can't take it all out in the first sort of month. They start to take it out with reducing over time and extend it sort of lower production.
We've also seen the end consumer has been weak as well. So, therefore, the volumes came down to take out the additional stock they're holding and then to adjust to the new end consumer demand.
Now we would expect this to take a number of months to come out. And indeed, when we started to get into March and April, we could see our underlying level of demand into our customers start to improve, and that's continued into June. When we also look where -- we have substantial positions -- supply positions with our main customers. And when we look at their own sales in volume of their product and match it to our sales of their business where we know that we can have the whole category, 100% of the category, et cetera, we can see the mismatch. So, everything tells us that there should be a relatively short lift. In fact, that's what's happened.
But we say again, but we are working in a volatile environment and the end consumer does remain challenged. Our market share has certainly been improving, I think, and we've got new contract wins, which gives us some real -- some confidence about future demand. But it is based on that -- partly on that destocking context, but it does seem to be happening. And that's what our customers tell us as well. But at the end of the day, we don't know exactly because we don't know their final stock position.
We will now move to our next question from Brian Logan Morgan from Morgan Stanley. Please go ahead. Your line is open.
Hi, guys. Thanks very much. Can I just ask on tactical approach to updating your own paper machines at the moment? Would you be running your paper mills at full at the moment and then buying less paper on the open market at the moment?
I mean we have a -- our paper capacity is less than our packaging capacity. And the reason we have this position is because some markets, principally the German paper market, is very oversupplied in paper and, indeed, even more capacity since that has recently come on in and around the German market. So, there's an abundance of supply. And indeed, the financial returns from holding those assets in and around Germany in paper mills, in testliner have historically and continued to be extremely challenging.
But as we said in the presentation, having that short position also allows us to use the paper that's right for the customer and not just the paper we produce. And it also gives us flexibility when volumes move that we don't have to adjust our own production to the same degree as if we were more integrated in that we just are able to flex the supplies we've taken from our third parties. So, during at last year, we have taken some downtime. But that downtime, I think, is much less than you've seen across the industry because we've had that flexibility.
And in fact, there's been one reason why our financial performance has been so strong in what has been a -- in a challenging market. So, it does give us that flexibility and it works very well for us. More importantly, I think it works very well for our customers.
We will now take our next question from James Twyman from Prescient. Please go ahead. Your line is open.
Thank you. I've got two questions, if I may. The first one is there's quite a big range in margins between your three European regions. Could you go through the key reasons for that given they do seem to be quite long lasting? And then there was another question earlier about this 297 million units that you replaced, which is obviously pretty valuable stuff. Could you translate that into something that we can understand in terms of either tonnes or percentage of sales? That would be very helpful. And then if I may, just very quickly, what is the net capacity impact of these investments that you're doing in terms of whether it increases your net purchases or reduces your net [indiscernible] relative to market...
Adrian, going to take first one?
Yes, exactly. Come in for this. In terms of the different regions, I think we -- over the years, we've tried our best to describe this. It largely depends on where our paper capacity sits. In Northern Europe, we have a significant amount of our recycled capacity. In Eastern Europe, we have less and it's much more based on pure open market purchases. And in Southern Europe, we have our -- is where the Europac acquisition was, where we've got our kraftliner capacity, which is a very, very margin-enhancing business. And we also have some testliner capacity as well.
So that generally describes a spread. So, when paper prices are high, Eastern Europe generally does better than Northern Europe. Southern Europe still does well. And when paper prices start reducing, you'll see the flip of that. And in North America, as North America is a very separate business in terms of the environment in the States is very different from the rest of Europe. So, it is largely around where paper capacity is.
Look, on the plastic replacement, you said it's just under 300 million new units. I mean the revenue on that is over £100 million. And the gross margin is very attractive. And that relates to a total packaging turnover of about £5 billion, yes. Just on sort of an average basis, it can go up and down depending on the price of paper, but that's sort of the -- sort of the 5 -- last year, it was put about £5.5 billion to £6 billion, is that sort of percentage.
Then on the last question around capacity, if I understood the correct -- question correctly in terms of what amount of our CapEx is being deployed in increased paper capacity, not much of it is the reality. So, as I mentioned, the Viana investment is mainly around replacement of the boiler. It does give us an incremental level of capacity improvement, but it's very modest. And the Lucca investment, which is a several-year investment, does increase our capacity, but actually it replaces some degree of old capacity as that machine is coming to the end of its life.
So, the vast majority of our incremental CapEx over and above our license to operate spend is around efficiency improvement, energy efficiency improvement, labor productivity improvement as well as box capacity increases. But I think your question was about how much are we increasing paper capacity, Brian. It's very modest.
It's a limited -- there's no increase in the short term. Over time, there is. And we said consistently, we will invest in paper capacity where it's difficult for us to get access on the open market. So, for us, as Richard was saying, Italy is again where it's much harder, it's either paper tends to be imported in from either overseas or by road from Northern Europe. So, there are times where our security supply will be tighter there.
So, investing in Lucca makes sense for that. And as Rich said, it's part of our CO2 program as well. And then Viana is an absolutely essential asset for us now. It was the reason -- or the large reason behind the Europac acquisition, gives us kraftliner capacity in Europe, which is very tight. So, any increase in capacity there over time, again, would be beneficial to us from a group perspective.
We will now move to our next question from Andrew Jones from UBS. Please go ahead. Your line is open.
Just a couple. One is just on the bridge for next year, and then we've talked about energy and the £100 million headwind there. Can you just give us an idea for maybe some of the other cost elements? Labor and -- I mean we can work out the OCC ourselves. Just give us a bit of a bridge on some of the other less visible cost items, if that's okay.
And then secondly, just on the state of the industry, I mean, obviously, we're seeing you take out some capacity in Bulgaria. I mean it's relatively small in the grand scheme effect. We've seen some capacity being taken out by store including Europe now. Is there any -- I mean as a leader in the industry, do you feel responsibility to potentially exit more in the near future given the sort of expected capacity additions and, obviously, relatively soft demand? Is that -- could we see more sort of capacity from yourselves? And do you expect to see much more come for in the coming months in the industry?
Yes. So, I'll take both, actually. In terms of the first question on the cost basis, the bridges, obviously, the first part of call will be to pass -- would be to assume normalized inflation or normalized inflation is where it's currently running at across Europe. So, don't get too focused on the U.K. on that. It's predominantly for us, there'll be the labor, inflation rates going through. And again, one should think about low mid-single digits there.
And then you've got to think about the -- as we will be planning all the time on what efficiency measures are we taking to mitigate against those. So, there are a number of the normal inflationary cost pressures coming through. The options we have on that, and Richard talked quite extensive about it, is the efficiency measures, Miles has described it in terms of some of the capital programs. And against that -- and we've been -- we've done that every year, to be fair. And then against that, you've also got how we're recovering our inflation -- our non-paper inflation through paper price rises.
In terms of your other question on paper capacity, yes, look, it's no great surprise. You always hear sort of large announcements over time of when new capacity is coming down. You hear it about a day before it's announced when it's taken out. So, we have seen an announcement last week in terms of the Netherlands. You would have seen -- we took a decision in Bulgaria with our Trakia mill. Would I imagine others would take similar activities at the moment? Yes, it wouldn't surprise me at all, but you never know until the day before it happens.
It feels like paper -- I mean who knows? It feels like paper prices sort of bumping along the bottom at the moment. But obviously, we don't know. But it certainly feels that.
Charlie Muir-Sands, BNP Paribas. Please go ahead.
I had one more question which is also in a way about the cost bridge. So, in the year's finished, you flagged £19 million across -- from the restructuring of Trakia and £17 million to shut down the U.K. recycling, which I think both are costs that you incurred in underlying profits. Just wondered, as you look here today, are they kind of similar quantum of cost you might expect in other parts of the business? Or is that a sort of £35-odd million just as we look at your overhead?
Look, I mean, there's nothing that's planned at the moment. We manage these things on a case-by-case basis. We look at the economics at any point in time. So, there's nothing that I can think of. Richard is obviously owning the numbers going forward. There's nothing that I'm aware of that's been planned for at the moment.
Yes, nothing to flag at the moment, Charlie.
Great. Well, thank you very much, and that concludes all the questions. Thank you very much, everybody, for your time. As I said when we started, we're pleased with the progress that we've made in what's been a very volatile environment, and our trading in the year to date is in line with our expectations. Thank you very much, everybody.
Thank you.