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Due Diligences

Due Diligences in Pulp, Paper, Tissue and Packaging Industries

M&A transaction volumes in the industry are steadily increasing. The sector is attracting attention as returns in many segments have been very attractive for many years now. Despite some large-scale M&A activity in the US, the sector can still be considered rather fragmented, which drives interest and opportunity to consolidate. However, as in any transaction the opportunity and the fit need to be carefully assessed to make the right investment decision. A properly carried out due diligence details and assesses all opportunities, risks and red flags and forms the foundation for the right decision, be it for or against the transaction.

For acquisitions to be successful, careful planning, precise analysis, impartial decision-making and dedication in integration are required. Effective, efficient and thorough due diligences are a prerequisite for all stakeholders. StepChange has extensive due diligences experience from supporting strategic investors and stakeholders in target identification, due diligence and PMI with deal values ranging from $50m to $4bn.

Recent developments

In recent years, M&A activity across the globe has increased. Short and long-term interest rates have remained low, especially in the EU. With average returns on capital of 6-17% and the low cost of capital it is not surprising that M&A activity is increasing.

Major deals have taken place, reshaping and consolidating the industry landscape. Especially the packaging segment has been much sought after with respect to strategic acquisitions, while in the graphic and publishing sector M&A activity has focused on consolidation and reduction of capacity. Overall, the industry can still be considered fragmented, only North America has now reached a high level of consolidation in the containerboard and boxboard markets and the associated converting segments. In Europe, some consolidation has taken place and large multi-segment corporates are aiming to strengthen their portfolios strategically. Overall, the big players are now more focused on the core segments they want to operate in.

Even though M&A activity in the industry has been high in recent years, the markets are still fragmented and further consolidation can be expected. In pulp, capacity increases may lead to lower utilization rates and eventually may be a driver for further market consolidation. The HerfindahlHirschman Index (HHI), a measure of market concentration (0 = fragmentation; 1 = monopoly) is <0,07 for the hard-wood segment (including Eucalyptus), whereas the softwood segment has a value of <0,05 symbolizing a high level of competition and fragmentation.In graphic papers, declining demand and overcapacity can be expected to be a driver for further consolidation or divestments.

Demand for packaging is continuously growing, especially in flexible packaging, where the CAGR is expected to reach 5% until 2022. While the packaging sector is quite concentrated in North America, on a global scale the HHI is rather low (<0,02), signaling a high rate of competition and a large likelihood for further M&A activity.

Similar to many other segments, the tissue segment can also be considered rather fragmented from a global perspective even though markets are driven by global players. Globally the HHI is <0,04 and in North America it is <0,14.

Tailor-fit due diligence - the StepChange Experience

Due diligences must not be considered a simple "check-the-box" exercise. A tailored industry-based approach is needed to master the challenges of a due diligence and come to a credible valuation. As an industry-specialized management consultancy StepChange is ideally positioned to support companies along the entire M&A process. Step-Change has helped many industry players, debt and equity investors and stakeholders in target identification, due diligence and PMI with deal values ranging from $50m to $4bn.

StepChange provides strategic, operational and technical industry expertise and best practice support for clients planning to engage in M&A transactions. The foundation for this capability is based on:

By employing this in-depth expertise from across all segments of the pulp, paper, packaging and tissue industry, StepChange can conduct a credible and realistic due diligence to reduce the risk of an acquisition and detail the relevant opportunities to maximize and secure investment return.

The value of a diligent M&A process

For M&A deals to be successful, several critical elements need to be considered:

Due diligence - Make it or break it

The due diligence is the most significant aspect of the whole M&A process. A due diligence can only be considered successful in retrospect, meaning the evaluation of the target is proven to be true at a later stage - even if the target was not acquired.

A thorough due diligence is crucial because it lends comfort to the decision-making process of management, stakeholders and shareholders. It is in every stakeholder's interest to ensure that a rigorous due diligence process is carried out, which provides relative assurance to the decision-making. The process needs to ensure that potential risks have been identified beforehand.

The due diligence process paves the way for a go or no-go decision. In many ways, a strong due diligence capability is one that more often will come to a negative than a positive conclusion. It can be observed frequently that M&A teams and stakeholders are involuntarily too often on the "buy" track. An independent investment review team should be nominated to avoid biased decision-making.

Before undertaking a due diligence, it is important to target those opportunities and risks that are likely to have the most impact on the value. Therefore, the due diligence should be tailored to the type and rationale of the transaction. The due diligence should also address the plans for the target once acquired. The process should further uncover post-merger impacts on existing operations and identify resource capabilities and constraints to be addressed after the acquisition.

To obtain a thorough picture of the risks and opportunities, the due diligence process focuses on many different functions such as Finance, Tax, IT, HR, Legal & tax, R&D, Environment, Operations and Markets. Market and operational due diligences are, however, the key determinants from a forward-looking opportunity and synergy perspective. To conduct such due diligences properly, a thorough understanding of the industry is required.

StepChange has extensive experience performing both, market as well as operational due diligences in the forestry, pulp, paper, packaging and tissue industries.

Market Due Diligence

The target of a market due diligence is to assess the current and future market positioning of a company. The main questions covered are:

1. What is the current market position of the target?

2. How attractive is the current and potential future product & customer portfolio and geographic reach?

3. What are the growth perspectives and market opportunities and risks?

Operational Due Diligence

The operational due diligence will yield:

1. Assessment of the asset conditions and future capital requirements

2. Operational efficiency / performance and potentials for improvement

3. Current and future cost competitiveness

In capital-intensive industries, such as pulp and paper, return on capital KPIs such as ROIC and ROCE are critical for the investment decision. Therefore, it is also essential to understand capital expenditure requirements (CAPEX) already during the due diligence. Thus, the condition of assets (such as production and converting machinery, stock/fiber preparation, energy production, auxiliary and water treatment assets), their cost efficiency, and potential risks (e.g. age, condition) need to be assessed. The findings of this assessment serve as a basis to project future investment or maintenance requirements and to assess the long-term competitiveness of the assets. Future CAPEX requirements may vary significantly, depending on the target's adherence to maintenance plans and the overall maintenance philosophy and capability. It is important to critically review existing CAPEX and investment plans while also reviewing past CAPEX to identify maintenance backlogs and capital requirements. A development strategy will have a significant impact on future capital requirements whereas a stay-in-business strategy usually requires lower CAPEX.

In addition to the future capital requirements, the condition of the assets will also influence the current operational performance. Assessing operational (excellence) capabilities by analyzing the Overall Equipment Effectiveness (OEE) helps to better understand production performance in general and provides details about time, speed and material efficiency. This can be benchmarked against other comparable assets providing a view on competitive ranking and potential improvement opportunities. Apart from the efficiency of assets, the operational capabilities of the target need to be evaluated. Site visits allow to assess the quality of management and staff, review operating and management procedures, process adherence and the improvement culture on the shop floor.

In addition to the condition of assets and production efficiency, the overall cost competitiveness is crucial. Understanding and benchmarking specific consumption levels and prices of the main cost drivers is essential. This includes raw materials, chemicals, auxiliary materials, energy, labor, distribution, and overhead costs.

As raw materials are a main cost driver in the paper industry, they impact competitiveness significantly. Assessment of operational consumption drivers, yield factors, material efficiencies and a review of the sourcing strategy and procurement operations will highlight potentials for improvement.

Improvement in supply chain management immediately drives costs of goods down, and increases the On-Time In-Full (OTIF) delivery. Thus, logistics operations and costs, such as transport costs, truck utilization rates, and warehouse flows, need to be examined and benchmarked. Finally, labor costs are a major component of the cost structure. The organizational efficiency will be analyzed. Benchmarking blue and white collar staffing levels will help identify potentials for organizational streamlining.

Summarizing findings from the operational due diligence will provide a holistic view on strengths, weaknesses, opportunities and threats. The main interest of any acquisition is to generate returns on the capital divested or invested and increase shareholder value. By evaluating the core of the business, through a proper market and operational due diligence and combining the findings with the other due diligence areas a holistic picture will be created. This picture will then be the foundation for the go/no-go decision, dodging the likelihood of failure and creating a winning acquisition strategy with a tailor-fit due diligence.