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Container shipping: More mergers, better mergers

Container shipping: More mergers, better mergers

A few precepts can help industry players better manage mergers and the integration process.

The container shipping industry is expected to continue to struggle with overcapacity and an inability to deliver value to shareholders. As container lines search for successful paths forward, they need to first determine what their strategy and potential role in the continuing industry consolidation will be. While mergers will continue, they do not need to be feared, just managed—and the guidelines in this article provide a starting point.
Bad times will persist, despite the value container shipping brings to the world

Container shipping brings significant value to the world, yet delivers little to its investors. It has driven the global economy for the past 25 years; without container shipping and the globalization of supply chains that it enables, worldwide GDP would be reduced by $15 trillion. Container shipping has enabled trade that has lifted hundreds of millions out of poverty. Despite these achievements, the industry continues to produce low rates of return, which destroys value for owners. We estimate it has destroyed over $100 billion in shareholder value over the last 20 years (Exhibit 1). Its profitability was particularly poor between 2011 and 2016, when the industry average return on invested capital (ROIC) was consistently lower than the weighted average cost of capital (WACC).

Overcapacity is the key reason for the poor performance, and, unfortunately, it is here to stay. The current supply of container capacity afloat is about 20 percent greater than demand. We understand the challenge that lines faced over the past decade (2007 to 2016): as competitors ordered new, more efficient tonnage, there seemed to be no choice but to do the same or fall behind.

Slowing growth exacerbates the situation. First, the economic malaise in many countries has hurt consumer spending. Second, global GDP growth is forecast at only 2 to 3 percent for 2017 to 2019, versus the 4 to 5 percent of the boom years. Last, and even worse, the industry’s GDP multiplier, which increased as supply chains globalized, is falling. At its peak, container trade grew at two to three times GDP. Now, the multiplier is about one. Many industry watchers are predicting the end of the destructive freight rate environment. Unfortunately, we are not so optimistic.

McKinsey’s projections of supply and demand show a continued large gap for several years, closing only early in the 2020s—even with conservative assumptions on new ordering. With overcapacity, container lines often accept any cargo, even if it barely covers marginal cost; after all, carrying something extra on today’s ship is usually better than carrying air.
Consolidation has accelerated but is not yet enough to turn the industry around

The industry is experiencing unprecedented consolidation as it responds to the negative environment. The combined fleet capacity of the top five players almost doubled from 2000 to 2017, rising from 35 percent to 67 percent. Ten of the top 20 carriers in 2013 will soon no longer exist as stand-alone companies. Six—APL, CSAV, CSCL, Hamburg Süd, Orient Overseas Container Line (OOCL), and United Arab Shipping Company (UASC)—have merged or will merge with larger peers. One, Hanjin, went bankrupt. The three Japanese carriers are forming a joint venture.

Consolidation typically helps performance. Mergers can provide sizable operational synergies and commercial opportunities by combining two complementary businesses. The synergies can save 3 to 6 percent of the combined cost base (Exhibit 2). For instance, Hamburg Süd and Maersk expect their merger to generate operational synergies of $350 million to $400 million annually over the first few years. Hapag-Lloyd and UASC expect to generate $435 million in cost synergies from 2019. COSCO Shipping and OOCL also expect significant cost synergies, while maintaining separate brands, in the coming years.

The synergies from mergers are one driver of the economies of scale in the industry. Looking across the cycle, higher operating margins correlate with larger fleets, and this outperformance appears sustainable (Exhibit 3).

However, container shipping’s current industry concentration—where the top three players control 47 percent as of July 2017—is still below the level typically correlated with higher returns (Exhibit 4).

Given the negative environment and likely continued value destruction by the industry, funding flows may be cut off. One example may be government support, which may include direct cash infusions. Host countries frequently treat carriers as strategic assets. Some analysts question the rationale for this support because lines do not directly employ many staff and the country would not be cut off from global trade if the lines failed. The government infusions also hamper consolidation that is critical for industry stabilization. It appears, however, that some governments may be beginning to lose patience; for example, UASC eventually merged, and the Korea Development Bank stopped supporting Hanjin, which went bankrupt.

Container lines can use mergers to succeed in this environment

Lines need to carefully consider their future strategies, which must include a view on mergers and consolidation. Although some liners will acquire other companies, it is highly unlikely that all of the top ten liners can be acquirers. This does not mean that those who are acquired will be any worse off; in many cases, selling delivers higher returns to shareholders than acquiring. Share-price data from the past 15 years shows that, on average, the acquired company’s stock increases by more than 10 percent in a merger while the acquirer’s loses 3 percent.1 In negotiations, the acquired company may also be able to win a more significant share of the combined entity or a higher acquisition price if it strategically positions its value. Given these findings, it may make more sense for some lines to focus on improving their company so they will maximize their sale price (as well as current performance).

Liners need not fear mergers, although they do need to approach them strategically and with an eye toward best practices. Over the past decade, many container lines have learned to tread carefully, based on previous visible, bad outcomes (Exhibit 5).

The rest of this article describes two sets of guidelines that container lines can use to help conduct successful mergers and integrations. These are based on extensive experience, benchmarking, and best practices across industries and within container shipping. The first five apply to the overall merger. The second five apply to the integration itself and how to ensure that it runs smoothly.
Guidelines for conducting a successful container M&A

Select the right target with a clear investment thesis

Container lines need to identify targets or acquirers based on potential synergies (for example, optimizing cost), strategic alliance (for example, fit with network, enhancing capabilities), political reasons (some targets are not accessible due to political barriers), and other factors (for example, to strengthen market position, fit with culture).

The key analysis estimates synergies. From our experience in container-line mergers, most of the synergies come from reducing vessel and overhead costs. Employing larger, more cost-effective ships and optimizing vessel deployment on more popular routes lowers vessel costs. Integrating overlapping back-office functions (such as HR, finance, and international sales locations) reduces overhead costs. In addition to these major items, joint procurement, as well as customer cross-sell, can also bring value to both companies.

Correctly estimating synergies is an essential element in selecting the right target. Companies can accomplish this either outside-in, or through access to a data room. (Exhibit 6 provides an example breakdown of a synergy estimate.) This would then be combined with the other factors mentioned earlier to identify potential targets or acquirers.

Conduct due diligence

Rigorous, well-performed due diligence is pivotal to a successful merger or acquisition. Three additional areas must be resolved early along with the technical due diligence:

-Does enough agreement exist on the market’s future direction and rates for both parties to agree on a valuation? In-depth models of industry supply and demand can help address this issue.

-How can the different networks shift to help capture the cost savings? Because more than 80 percent of the capacity afloat belongs to three large alliances, choosing new alliance partners early and, potentially, conducting exploratory discussions is critical.

-Do the HR situations and existing labor contracts present roadblocks? Are there any other barriers to implementing the synergies in overhead and sales, general, and administrative (SG&A) costs? These are crucial because a large share of the synergies reside in overhead and SG&A costs.

Structure the right deal

M&A in the container-liner industry takes different shapes and forms. Each line needs to decide which structure is right for its particular strategy and situation. It should consider the objectives of the deal, the availability of funding, and the preferences of shareholders.

We have observed various merger structures:

-Standard acquisition. For example, Maersk will acquire Hamburg Süd for €3.7 billion on a cash and debt-free basis. Maersk will finance the acquisition through a syndicated loan facility.2

-Merger. Hapag-Lloyd merged equity shareholdings with UASC.3 The previous shareholders of each line became common shareholders in the new Hapag-Lloyd.

-Joint ventures. The Japanese carriers are setting up a new joint venture by injecting their assets into it; NYK Line is contributing 38 percent, and K Line and MOL Liner are each contributing 31 percent).4

-Partial integrations. COSCO Shipping and Shanghai International Port Group made a preconditional voluntary general offer to Orient Overseas (International) Limited (OOIL) to acquire all of its issued shares. COSCO Shipping and OOCL (wholly owned by OOIL) will continue to operate under independent brands.

-Charter arrangements. Rather than acquiring China Shipping’s fleet and container assets, COSCO Shipping chartered them long term.5 It also left China Shipping’s original listed company to develop into a leasing and finance company.

Fight for your fair value

Valuation for the seller and for the buyer is a complex process, and it can be difficult to reach consensus between seller and buyer. This is not different from M&A in other industries, but in container shipping there are the following specific factors:

-Earnings before interest, taxes, depreciation, and amortization (EBITDA) is highly volatile, and valuations tend to be based on current performance. It can be easy in this sector to make superficial improvements and temporarily increase EBITDA. Both parties need to make sure any EBITDA improvements are structural rather than incidental.

-Assets’ book values reflect only their original purchase price and may differ quite substantially from their current market value. However, a full reevaluation to market value may lead to significant impairments and breach debt covenants.

-Different vessels have different performance characteristics, which often leads to disputes over the real value of the ships.

-It is hard to value the intangible benefits such as customer relationships, sales networks, and management processes of each company.

We find that a rigorous approach can help both sides reach agreement and may lead to a 5 to 10 percent improvement in valuation over the first offer price for the acquired company in the negotiations.

Think through your negotiation strategy

Both the acquirer and acquired company should always ask themselves, prior to the negotiation, “Besides a better price, what do I want to achieve from the negotiation?” They will, of course, have different answers. Acquirers desire a smoother acquisition and integration process so they can capture more synergies and strengthen the new company’s competitiveness as soon as possible. Best-practice acquirers regularly meet a range of potential targets to convey their value proposition. Acquirees worry about brands, their people, and their own positions in the merged organization.

Acquirees need to be very clear about what is essential and what is important but optional. Examples of the types of questions they should answer include the following: “Do I want my company to be fully integrated into the acquirer? Do I want to keep my brand separate from the acquirer’s? Do I want to keep my management team members—and, if so, which ones? What direction do I want the integrated company to take?”
Key actions that ensure a successful integration

Despite some visible failures in past integrations, container lines can successfully navigate them with proper planning and the application of a few proven practices. More recent integrations, for example, those between CSAV and Hapag-Lloyd, and between China Shipping and COSCO Group, have caused few ripples.

The key actions, which have been proved in multiple integrations across industries, are detailed in the rest of this section.

Integrate the companies and form a shared new vision

The synergies from integration are substantial, ranging from 3 to 6 percent of the combined cost base. Network integration (that is, fewer, larger ships) and SG&A consolidation (that is, merging international offices) usually offer the largest savings. Combining fleet management, technical management, and overhead increases economies of scale.

To capture these synergies, organizations need to move quickly to a common leadership team with key figures from each side. Combining the trade and revenue-management teams also ensures that the acquired company will not compete against its acquirer.

The combined company has strength to pursue further development. The new company needs to think early on its strategy and use the shared vision to align two organizations, ensure organizational stability, build excitement for growth, and stimulate synergy capture.

Act early to fully capture synergies by launching a clean team

In the period after the companies agree to the merger and before day one, they cannot share customer or supplier contract information. During this time, we advise them to set up a clean team that can analyze their customer and supplier overlap, prepare for tailored customer and supplier communication on day one, and work on other immediate actions postmerger.

A clean team is valuable for three reasons. First, it helps to speed up value capture. Taking action on day one requires preparation before deal closure but can create meaningful early synergies. In one shipping-merger case, two months saved in faster synergy capture was worth $20 million. Second, a clean team helps minimize value leakage. With access to customer lists, pricing, and contracts, a clean team can identify customer overlap and pricing differences, enabling the companies to develop customer mitigation plans for most at-risk customers, to be ready for handover on day one. Finally, it supports the deal closure. A clean team allows for the identification of risks and opportunities at a granular level prior to regulatory approval. Competition regulators well understand the concept of a clean team, and seeing one in place reassures them that the right processes are being followed.

From the commercial side, the clean team does the following things:

-analyzes the current top customers of both companies, including those that overlap and those that do not

-conducts a high-level analysis to generate sharable insights to guide current customer-management efforts

-prepares a customer-management strategy with immediate actions once customer information can be shared, potentially saving precious time and helping retain customers

-identifies the different categories of customers for tailored communication based on their relative importance to the two companies and the new entity (Exhibit 7)

-implements the communication efforts and ensures they are effectively coordinated within the organizations

On procurement, the clean team helps on a few fronts:

-analyzing not only the key synergetic items such as terminals, trucks, and rail but also, if resources allow, insurance, feeders, and depots

-comparing the contract terms on rate and rebates, as well as analyzing suppliers’ optimization plans

-defining the day-one action plan for joint negotiation

Once the synergies are identified, they should be broken down into different levers and recorded under the responsibilities of key business managers. Liner management should also make sure these targets are embedded into the budgeting process to ensure that they are monitored in ongoing performance-management reviews and that they are part of the managers’ incentives.

Pay attention to cultural differences, and use these insights to facilitate cultural integration and communication

McKinsey’s research shows that 95 percent of executives who have been through integrations respond that it is critical to prioritize cultural integration. This priority is especially important in container-line mergers because most of these cross national boundaries and have to integrate companies with very different cultures.

We synthesize seven pitfalls that often occur when trying to deal with cultural issues in integration and offer tips on how to handle them (Exhibit 8).

Underestimating the importance of communication could also become a critical reason for an integration to fail. While the communication is usually done with customers and suppliers, lack of transparency and timely updates on the company’s future strategic direction and the ongoing integration process could endanger employees’ stability and even trigger talent loss. Management should communicate with key talent and all employees in various formats, such as town-hall meetings and newsletters.

Go ‘big bang’ for the transaction while migrating services gradually

Some deals automatically happen in one day because of their nature, such as a standard acquisition. Other structures have more flexibility (for instance, when assets are transferred to a new company). Our experience suggests that financial and legal clearance for the companies to fully operate together must occur as quickly as possible. If it does not, customer information cannot be shared because the two lines are still competitors. However, the integration of the services (for example, sales offices, lines, routes, and ship management) can occur over time. This reduces integration risk and helps manage the process more smoothly. In some cases, the IT system migration will become the key milestone to enable the operations integration.

Another reason to progressively integrate is the potential to keep two brands in the market. This decision depends on the brands’ relative strengths and positioning. Some companies drop the acquired brand (for example, Hapag-Lloyd did not keep the CP Ships brand). Others use only the acquired brand (for example, NOL adopted the APL name for all container operations). Some create a portmanteau brand, at least for a while. In two recent large deals, it was decided to keep both brands active in the market because of their different strengths: CMA CGM with APL and COSCO Shipping with OOCL.

Where two brands live, companies need to decide how to manage them. Should they be instructed to focus on different customers, one brand focusing on larger shippers and the other on serving smaller customers? Should they cover different geographies, with one brand serving trans-Pacific and another focusing on Asia and Europe? Or, is there a product difference, with one brand mainly serving port-to-port customers while another delivers end-to-end services? In all cases, lines need to be careful on how they manage overlapping customers, and what commercial coordination, if any, is in place.

With dual brands, frontline sales are operating with separate commercial teams. This does not mean that liners should forgo the cost synergy potential. Operations integration, while retaining two front ends to the customers, is key.

Set up a value-added integration infrastructure and governance

Finally, centralized management is a critical part of a smooth integration. We recommend companies set up an integration management office (IMO).

The IMO owns the entire integration; it plans and tracks milestones, progress, and the achievement of estimated synergies. It also manages external and internal communication. And it provides guidance to the business-related value-creation teams (for instance, network integration and customer management) that are responsible for capturing the synergies from the merger.

It is very important to ensure the integration infrastructure is effective (Exhibit 9). Within the IMO, management should nominate people with significant organizational power to take overall responsibility; this is a full-time job. This person will lead the steering committee to review and evaluate the integration process. Different work streams could be set up to implement the synergy capture. Staff working in the IMO need a deep understanding of the business, enough empowerment to make decisions, and cross-cultural awareness.

In conclusion, the industry will likely see more mergers. Lines need to decide on their strategy as well as their potential role in the consolidation, and they must build on the experience of others to ensure successful integration while avoiding the mistakes of the past.
Source: McKinsey & Company