Recent M&A deals may look expensive, but long term gains could well justify the extra cost

by Jim Kenny

The right move at the right time

It doesn't seem all that long since PPI confidently stated that there was more merger and acquisition activity set to take place across the pulp and paper industry. But the last few weeks have been extraordinary by anyone's standards.

Take a look at just some of the big names that have recently got a lot bigger - Stora Enso/Consolidated, UPM-Kymmene/Champion, Smurfit-Stone/St Laurent, Norske Skog/Klabin, Portucel/Papeis Inapa, Abitibi-Consolidated/Donohue, and Lecta/Torraspapel. But no matter who the individual company may be, practically every single group is chasing the same set of goals - strategic positioning, synergy gains and, most important of all, improved profitability. But just getting the deal done and past the various board approvals and regulatory hurdles is one thing. The really tricky part comes when the CEO of each group tackles that last goal - improved profitability.

So far, there is very little evidence to suggest a direct relationship between market scale and profitability. Indeed, small and medium-sized companies are among some of the most profitable in the sector. But that need not halt the progress being made and indeed, this particular round of consolidation looks like being something different in any case.

Basically, it's a race for pole position as the top dogs fight it out for supremacy on a truly global scale. And not only that, but it looks like there are a lot more deals to come.

Gain and pain

Given the financial sums involved in many of these deals, it is no surprise that it is taking a while for the full impact of the changes to be digested. Almost universally though, the consolidation has been welcomed by analysts across the sector who see the moves as essential for the longer term prosperity of the pulp and paper industry. But as expected, the prices being paid to stitch together these transatlantic deals are proving somewhat rich for some, especially European investors.

As we have noted in previous editions of PPI, the valuation gap between North American companies has proved difficult and expensive to bridge for the Europeans. For example, on a single day a couple of weeks ago after the M&A announcements were made, Stora Enso's price/earnings (P/E) ratio was slightly under 10 and UPM-Kymmene was trading at just over 7. At the same time, Consolidated's P/E ratio stood at 47 (admittedly boosted by the announcement of the deal) and Champion was trading at 19.

One analyst, Kathryn McAuley of Brown Brothers Harriman, went so far as to suggest that these differentials had the potential to cripple the deals on the table. Indeed, Stora Enso's share price took a hit of about 15% when its deal was announced, while UPM-Kymmene was similarly battered by a 10% drop. And a cursory glance at the figures certainly appears to suggest that European shareholders are feeling the pain, while the North American shareholders gain.

But in the long run it may not matter, assuming the transatlantic deals do squeeze through. Getting a 'global' stock price could do enough to pump up European valuations and make the price premium worth paying. After all, the valuations have been poor for some time and actually getting the deals done should at least provide the perception that pulp and paper companies are taking their shareholders' interests seriously. Many would agree with Morgan Stanley Dean Witter’s analysis of the situation when the group called the investors' bale-out short sighted.

Looking ahead

These are exciting times for the forest products sector and the big companies will simply have to move quickly to take advantage of the long term opportunities on offer.

Sensibly, if expensively, UPM-Kymmene and Stora Enso have chosen to move because they realize that the industry is entering a phase of rapid change and they want to play a leading part in that process. The imperatives of e-commerce and a fast-changing industrial landscape mean that there is potentially much more to lose than to gain. And as any player will tell you, "If you're not playing, you can't win.

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