Analysis of Investment Logic of Chinese Paper Producers
On May 12th, 2021, Paper Excellence and Domtar announced strategic agreement whereby Paper Excellence will acquire all the issued and outstanding shares of Domtar for $55.50 per share, in cash or about 3 billion US dollars.
According to Domtar's investor report in March 2021, Domtar currently owns:
· 2.1 million metric tons of market pulp capacity of which 0.8 million metric tons is dissolving pulp, mainly serving hygiene product applications.
· 1.2 million metric tons of NBKP (Northern Bleached Kraft Pulp) capacity primarily sold to tissue producers and specialty paper producers worldwide, 24% of which is sold into China market.
· 1.8 million metric tons of LBKP (Leaf Bleached Kraft Pulp) capacity of which 1.7 million metric tons is consumed internally for UFS production, and 100,000 metric tons is sold on the open market.
Domtar’s NBKP capacity which secures 1.2 million metric tons offers synergies with Sinar Mas, an ownership affiliated company of Paper Excellence. Additionally, the acquired NBKP could facilitate Sinar Mas further expansion in virgin fiber-based packaging grades that can be exported to growth markets in Asia. The Domtar acquisition delivers Sinar Mas with an operational cost advantage by integrating upstream raw materials such as NBKP and LBKP, with downstream operations comprising graphics grades and packaging grades.
SCOZ has analyzed this transaction and its investment logic to provide insight into the corresponding investment thesis of Chinese companies acquisitions of resource assets abroad.
1. China’s natural resource deficit is exacerbated by its finished product manufacturing dominance. China's voracious pulp consumption has resulted in its over reliance on imports of raw materials fiber.
Fiber deficits in China has worsened with the recent RCP ban further increasing China’s reliance on imports of wood pulp and recycled pulp. Tangentially, the RCP ban has increased demand for NBKP required to produce high-end containerboard product with high fiber strength requirement.
2. Lack of forest resources limits development of pulping industry in China
Compared to countries with vast forestry, the limited forestry resources in China lead to most Chinese pulp mills to import wood chips. Higher chip import cost coupled with high energy cost during production lessens the competitiveness of Chinese pulp producers when compared to its South and North American peers.
As shown below in the cost structure for some Chinese products, raw material accounts for 60% -75% of its total cost, and over 80% for other grades; figures are much lower for China’s South and North American peers.
High dependency in imported raw material limits Chinese paper producers’ ability control operating cost, and it raises operating risks from price fluctuation of global pulp market as reflected in the recent price inversion between finished tissue products and wood pulp price.
3. Increasing demand for wood pulp in China driven by announced new capacity thru 2023
New announced paper/tissue capacity by Chinese producers thru 2023 is expected to result in over 5 million incremental tons of demand for wood pulp in China market, so securing stable supply of wood fibers to support the annouced capacity is a question high on the minds of many Chinese paper producers.
CONCLUSION
China’s natural resource deficit exacerbated by its current dominance and projected future paper product manufacturing capacity continues to increase challenges to access sufficient wood pulp capacity to fiber product production in China. Challenges Chinese paper producers face in fibering its paper mills can be alleviated either by constructing greenfield pulp mills or from acquiring existing pulp producing assets overseas. Deficiency in forest resources in China coupled with related execution time and risks makes constructing greenfield pulp mills in China unlikely. M&A related to acquiring fiber to support existing and future paper capacity seems the most economically feasible solution for Chinse paper producers.
Acquisition of fiber resource assets abroad could secure raw material supply in domestic China market, reduce risk of paying price premium and thus reduce transaction cost. Furthermore, M&A as mentioned would debottleneck pulp supply that has long restricted the development of pulp and paper producers in China.
Due to the execution risks associate with cross boarder acquisitions, only a few Chinese companies have attempted it: Nine Dragon's acquisition of Catalyst Paper, Sun Paper's investment in Laos and the mentioned acquisition of Domtar by Paper Excellence are the most publicized ones.
Many Chinese firms shy away from cross boarder M&A because of their execution risks. Execution risks from language and cultural differences during transaction negotiation and post transaction integration can be mitigated by working with advisors resourced with members with sell side/buy side cultural and language expertise. The right advisors will ensure M&A targets are strategically aligned with the acquirer’s objectives, the target can be successfully integrated culturally, and the target is correctly valued to maximize its commercial return to the Chinese acquirer.
