Private equity investors specializing in the middle market (buyout transactions of $ 25 million to $ 1 billion according to PitchBook Data, Inc.) often find themselves with the opportunity to acquire plastics processors. While some private equity companies have had many years and many transactions worth of experience in the plastics space it is quite common for private equity companies that specialize in middle market industrial companies in general to find themselves presented with a plastics processing company opportunity for the first time.
Though all potential acquisitions require many of the same skill sets when it comes to due diligence and to maximizing eventual ROI following a purchase, plastics processing companies do come with their own, sometimes unique, sets of risks and opportunities.
It is no secret that EBITDA multiples have been high for some time and that financial buyers can be challenged by the willingness of strategic buyers to drive up multiples based on their anticipated synergies with the target following acquisition. Among plastics processors the richest multiples are normally reserved for companies with heavy exposure to the packaging and medical markets, as is the case in many industries, but not all plastics packaging and medical markets are the same when it comes to plastics processors.
There is a big difference between a plastics processor that manufactures syringes or housings for medical imaging equipment and one that produces bed pans, shower curtains for hospitals or plastic trays for holding meals. The regulatory requirements and barriers to entry for producing syringes are substantially higher than for a number of the products that do not directly come into contact with a patient or are components of multi-million dollar diagnostic equipment than the requirements for items, that while technically “medical”, are often just consumer disposables being used in a medical environment.
Improperly vetting a plastics processor in the medical market means risking paying a high, medical industry EBITDA multiple for what may actually be more of a general purpose plastics processor that just happens to sell its products in the medical market.
But with proper due diligence there can be opportunities in not only lowering the EBITDA multiple paid for such a “medical” plastics processor, but also in increasing sustainable EBITDA after the acquisition.
Plastics experts performing due diligence are first and foremost interested in the plastics and other raw materials going into a finished product, including whether the plastics being used are the correct ones, or if there are lower cost or better performing alternative plastics that can be used to produce the product. But some plastics processors will over specify the attributes of a plastic, higher impact than necessary for example, or they might never use lower cost recycled plastic in a medical application because of concerns about contamination. Both of these concerns may be valid, but there are often products that can be made less expensively without sacrificing safety if the right questions are asked before and after the acquisition.
Another thing to watch out for, and not just with medical products, is whether customer-specified or internally specified plastics are specified for good reason. Ask for and check the dates on “spec sheets”. If they are decades old it is worth asking why they have been in force that long and whether there are any approved alternative raw materials. Buying a plastics processor with a substantial portion of its products specified with one plastic product, or even worse with only one supplier, can be very risky, especially if the sole supplier has only one manufacturing plant and it is later affected by a fire, hurricane or other disaster.
It is also common for what would otherwise be considered a commodity plastic to be specified in the name of a specific supplier or without the specific supplier’s name but using the exact attribute values from a specific supplier’s product data sheets. For example, specifying Company ABC’s Grade 123 plastic when half a dozen other companies make essentially the same product as Company A is a recipe for higher than necessary costs—a risk and an opportunity in an industry where plastics raw materials costs are typically in the range of forty to sixty percent of Cost of Goods Sold (COGS).
Plastics producers that specify the exact attribute values from a specific plastics product data sheet are worth identifying, as well. As no two snowflakes are identical, the values of attributes measured by individual plastics suppliers also differ. Some of the differences are due to measurement bias introduced by differing laboratory equipment or different materials testing labs. In addition, many attributes are presented as a mean value or as a mean value within a standard range.
Even though values may vary between plastics suppliers there are often ways to increase the number of potential suppliers. For example, if the melt index of a particular plastic is listed by a specified supplier as 10 +/-2 and it is 9 +/-3 at a second, non-specified supplier it is possible to work with the second supplier to only provide raw materials within the same range of the specified supplier and have a second, qualified supplier available for negotiating leverage.
When reviewing raw materials with management of the candidate plastics processor it can be particularly useful to know if the company specifies raw materials primarily at the request of the customer(s) or if raw materials are normally specified internally by the plastics processor’s employees.
If plastics are normally specified by the customer, ask if the customer must be notified of any raw materials changes, if the customer must test the finished product following any raw materials change and if the raw materials change must be approved by the customer, and what percent of the savings, if any, must be passed along to the customer.
If plastics are normally specified internally by the processor’s employees, ask to speak with someone who can answer “why?” Don’t be surprised if the answer is “because that’s how we’ve done it for as long as I can remember,” or “that was done before my time”. If either of these is the answer, make a note to have a plastics expert work with management to find alternatives post-acquisition.
Acquisition candidates representing their business to be largely in plastics packaging, another high EBITDA multiple market, also deserve special scrutiny during due diligence. It is important to remember that there is no commonly accepted definition of what is included in the packaging category and plastics processors have considerable leeway in what they consider to be packaging. One of the more creative definitions we have seen was a company that classified the plastic burial vault liners it produced as packaging.
Food packaging is another broad area that deserves a closer look. Many food and beverage packaging products have seen substantial reductions in weight, with the classic example being plastics water bottles which now weigh, on average, fifty percent or more less than when they were first introduced. And recycled plastics content has increased substantially for many products. Since many of these changes have been driven by large consumer packaged goods companies and by big box retailers such as WalMart it is important to know how many of these projects the acquisition candidate has in the works and if they will eventually improve or cause deterioration in gross margins.
Part of determining the potential impact on gross margins is understanding how the acquisition passes along price increases or decreases in plastics raw materials. What percentage of their business is on a contract basis and what percentage of that is linked to changes in a plastics resin price index? But don’t stop there. Try to understand if there are opportunities to substitute lower cost recycled plastics to reduce costs without having to pass savings along to the customer. But don’t assume that all recycled plastics are less expensive than virgin plastics. Some recycled plastics, particularly post-consumer recycled plastics with FDA approval for food contact can be more expensive.
Don’t use assumptions in a cost model that say a company with 100% of its business under contract with the ability to pass along 100% of any plastics price increases will keep gross margins steady because that is not always the case. In addition to plastics resin increases there can be cost increases for additives such as colorants, for freight, for packaging, for utilities and for labor and it is rare for plastics processors to have these items included in any cost price pass-through provisions in their customer contracts.
These are just a few of the things that are worth paying attention to when considering acquiring a middle market plastics processor. Please feel to contact us if you should ever have any questions regarding due diligence of a plastics company.