by Michael D. Benson and David M. Evatz, SRR
Given the turbulent economic conditions over the last few years and the effect on the plastics industry, many processors are just glad to have survived. As conditions begin to improve, processors are looking to move beyond the survival tactics used over the last few years and are once again considering strategic moves that have been on hold. M&A activity has been significantly impacted since 2008 largely due to declining company operating performance, restricted financing markets and overall economic instability. Additionally, with the plastics industry in general experiencing far fewer bankruptcies and closures than expected, the seemingly never-ending state of over capacity still exists (especially for those on the more commodity/lower value-added end of the continuum). However, as business activity has improved over the last year, the proverbial rising tide has not lifted all boats equally – the leaders among various segments have seen a robust increase in business that has stretched capacity thin, while others are seeing little if any recovery and potentially even continued decline in business levels.
Improved economic conditions and increased availability of capital have combined to create a significant level of pent-up demand for many businesses to make major strategic moves. Both strategic and financial buyers are looking to expand and grow through acquisition and sellers are looking to monetize their ownership interests. This has resulted in a series of trends which promise to fuel significant M&A activity in the plastics processor sector over the next several years. Given these conditions, buyers, sellers and long term owners/operators should understand, and most importantly focus on, what drives the value of a plastics processor and what can be done to affect change.
As the impact of these consolidation-driving trends increasingly affect processors, a significant portion of industry participants, by choice or by circumstance, will be compelled to evaluate strategic alternatives in the near-term, including potential M&A transactions. Whether viewing the industry from a buyer’s, seller’s or long-term holder’s perspective, it is important to understand what drives value in a plastics processor and what considerations allow one company to command a higher value relative to another. In many instances, valuation levels for companies with similar asset bases and operating metrics can exhibit variances of as many as three times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). The following section discusses the attributes that determine which companies are valued at the high end versus the low end of the value range.
When determining what drives value in a business, one needs to understand the basics of how companies are valued. In the context of an M&A transaction, potential buyers commonly employ several valuation methodologies in an effort to “triangulate” the value of the target company. The most commonly utilized approaches include; discounted cash flow analysis (DCF), leveraged buyout analysis (LBO), market approach and underlying asset approach. Although the market approach, with its ease of calculation (i.e., 5 X EBITDA), gets used most frequently in casual conversation, the methodology most relevant for measuring the true underlying value of a business is the DCF approach. The reason for this lies in the fact that when a buyer acquires a business, what they are essentially buying is the right to the future stream of cash flows generated by the business (along with the assets which are in place to generate those cash flows). Furthermore, the overall attractiveness of the current and future “book of business” is the best predictor of the future cash flow streams and therefore will be instrumental in the determination of the value of the company. The DCF analysis is a two-stage process, the first of which takes the cash flows forecasted over the projection period and equates them to todays dollars by discounting them at a rate commensurate with the risk of those cash flows occurring. The quality of the projected cash flows (i.e. stability and predictability, etc.) will impact the discount rate and accordingly, the value. The second stage capitalizes all of the cash flows occurring beyond the projection period in perpetuity (the terminal value), which is commonly calculated using an expected long-term growth rate or a cash flow multiple. The sum of the present value of the cash flows occurring over the projection period plus the terminal value equals the value of the company in today’s dollars.
In the end, the buyer or current owner of the company is essentially interested in the right to the free cash flow generated by the company – to the extent that the company is better able to clearly articulate and predict the drivers of the future cash flows (e.g., ability to produce a clear and concise booked business schedule), the more credit they are likely to get in the form of a higher purchase price.
The chart on this page illustrates several factors which impact a company’s shareholder value, plotted based on the degree to which they impact value and degree to which management has direct control over the factor.
Higher Impact, Higher Control Factors
The items plotted in the upper right quadrant of the chart on this page are those with the most impact on value and also are where management has the highest degree of relative control, theoretically at least. Accordingly, these are the areas which should be the focus of both a buyer’s due diligence in a transaction scenario as well as management’s value-building initiatives. Among the most critical value drivers are:
- Book of business: One of the more important metrics in determining the value of a plastics processor, the existing and future book of business, provides a realistic view of the company’s near term revenue expectations and the sources of that revenue. In many ways the book of business is the culmination of many of the other company- specific factors. The more predictable, attractive and profitable the book of business, the more value a buyer would theoretically place on the company.
- Niche market leadership: The use of plastics to produce virtually any product has resulted in a highly competitive global industry with thousands of participants. It also resulted in an industry with little to no barrier to entry with many of the attributes of a commodity industry. Because of this environment, those processors that have historically been the most successful and that are likely to be successful in the future are those that are a market leader within a specific product or market niche, or better yet multiple niches. Leadership in a particular niche has significant benefits to the current owner of the business, including higher profit margins, less competition, more loyal customers etc. Furthermore, a company that commands leadership in a particular niche will be coveted by potential buyers, many of whom do not have a strong position in any aspect of their business and are looking to achieve this position through an acquisition.
- End market attractiveness: As mentioned previously, given the widespread use of plastics in product manufacturing, a processor can find itself in the supply chain of almost any end-user industry. Like companies themselves, no two industries are the same – each with its unique attributes including growth, competitiveness, maturity, use of and advancement of technology etc. Recently, end markets such as medical and packaging have experienced higher margins and valuation levels as these markets tend to be less cyclical and are generally tied to non-discretionary dollars as compared to automotive or appliance. The end market’s effect on the value of the company is significant given how strong the growth and financial results can be for those companies involved in an attractive industry. The opposite is true, of course, for those in an under-performing industry – as good as some of the companies may be, they will struggle over time to “swim against the current” of a struggling industry. As with M&A activity driven by the pursuit of a market niche, many acquisitions are undertaken with the specific goal of a company looking to break into an attractive industry.
- Customer concentration: While factors like the aforementioned niche market leadership and end-user industry typically drive value higher in an M&A setting, customer concentration, or lack thereof, generally detracts from the value of the company. This is driven mainly by the level of risk perceived by a potential buyer in having a significant amount of the company’s business with a relatively small number of customers. However, for those operators who are not considering a sale of the company and are comfortable with the level of risk, it may not be an issue. Diversification in and of itself may not be a good strategy – especially if the additional customers generate lower margins and result in the addition of incremental non-value-added overhead.
- Process/product technology: Proprietary and/or advanced technological capabilities are a larger factor in buyer considerations today than at any time in the past. Technology has become a key differentiator for companies as an overcrowded marketplace has commoditized many sectors in the plastics industry. Suppliers can add value from technology either by offering technologically-advanced proprietary products or by developing process technology which allows them to be more nimble, efficient and cost effective while providing better quality. Furthermore, the ability to differentiate based on high-value-added capabilities such as advanced design and engineering capabilities is critical.
- Geographic reach: The term globalization may feel over-utilized in today’s world, but a processor with a well- conceived and attractive geographic footprint will create added value and appeal to a wider array of potential buyers. Extension of geographic footprint and access to emerging markets are two of the primary goals of expansion via acquisition. As with customer diversification, geographic expansion not driven by a clear strategy may not be productive in the end; however, with customers’ increasing sensitivity to logistics time and cost, it may be difficult to find an attractive market sector that would not benefit from a vendor with a diverse geographic footprint.
- Balance sheet strength: By the very nature of business valuation, the strength of the balance sheet (mainly in terms of working capital and debt level) of the target company does not factor in to the enterprise value, or overall, value of the company. However, when it comes to determining the attractiveness from an acquisition perspective of one company compared to another, it in fact does matter. The reason is simple. An under-capitalized, over-leveraged company will, over time, tend to lag behind in terms of investing in the company to drive many of aforementioned value drivers.
- Strength of management team: Management teams with a proven track record are valuable in every industry, and the plastics industry is no exception. Buyers can derive significant value from management teams with the depth and capability to execute the company’s strategic plan into the future. Continuity of management can be a key factor in successful post-transaction integration.
Lower Impact, Higher Control Factors
Factors in the lower right quadrant of the chart on page 7, while within the control of management and important aspects of a business, do not have the same impact on value as the major value drivers in the upper right quadrant. These items, such as ERP systems, front-end infrastructure and value and condition of the M&E can have a detrimental impact on value if they have been neglected historically and will require an additional influx of capital from a buyer. In instances such as those, the seller will most likely be required to accept a discount equal to, or even greater than, the amount that is required to be invested in the business to make up for any historical deficiencies.
Lower Impact, Lower Control Factors
Items in the lower left quadrant of the chart on page 7 such as the health of the U.S. economy and capital markets as well as geopolitical issues, while critical to the health and performance of the industry as a whole, do not heavily impact the relative value of one company versus another as they tend to impact the entire industry in a similar manner.
Higher Impact, Lower Control Factors
Items in the upper left quadrant of the chart on page 7 are factors which can have a high impact on value, however are often out of the control of a company’s management team. While over time the company may be able to strategically move in or out of a particular customer or industry, the timing and the performance is well beyond the control of the company.
In order for the plastics processing industry to prosper, contraction and consolidation must occur, particularly for highly fragmented sectors such as injection molding. If overcapacity on a widespread basis persists, intense price competition and corresponding margin erosion will continue to make it difficult for processors, especially those on the commodity end of the continuum, to survive and thrive. The improving transaction environment can be viewed as an opportunity for those companies well-positioned to bolster capabilities to compete in the future, as well as those looking for an exit strategy. Regardless of a companys current strategy relative to the continuum of strategic alternatives, resources should be allocated toward those areas which management can control and that have the highest impact on value. From an overall industry perspective, however, value drivers and their affect on company performance are simply one piece of the puzzle.
SRR’s Investment Banking Group, with significant experience in the plastics industry, provides mergers and acquisitions (M&A) advice, private capital raising services and other financial advisory services to family-owned businesses, portfolio companies of private equity firms and divisions of large corporate parents. For more information, contact Michael D. Benson, Managing Director, Investment Banking at 248.432.1229 or mb[email protected], or contact David M. Evatz, Director, Investment Banking, at 312.752.3328 or [email protected].