Musings on Markets

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Winning at a Loser's Game? Control, Synergy and the ABInBev/SABMiller Merger! Posted: 23 Oct 2015 07:15 AM PDT I have been a long time investor in ABInBev, though I became one indirectly and accidentally, through a stake I took a long time ago in Brahma, a Brazilian beverage company . That company became Amber in 1999, which in turn was merged with Interbrew, the Belgian brewer, in 2004, and expanded to include Anheuser Busch, the US beer maker, in 2008 to become the largest beer manufacturer in the world.  I made the bulk of my money early in my holding life, but Amber has remained in my portfolio, a place holder that provides me exposure to both the beverage business and Latin America, while delivering mostly positive returns. It was thus with trepidation that I read the news report in mid-September that ABInBev (which owns 62% of Ambev) had approached SABMiller about a takeover at a still-to-be-specified premium over the the latter's market value. While it is entirely possible to create value from acquisitions, I have argued that creating growth through acquisitions is difficult to do, and doubly so when the acquisition is of a large public company. Since ABInBev's control rests with 3G Capital, a group that I respect for its investment acumen, it would be unfair to prejudge this deal without looking at the numbers. So, here we go! The Fog of Deal Making: Breaking down an acquisition The first casualty in deal making is good sense, as the fog of the deal, created by bankers, managers, consultants and journalists, clouds the numbers. Not only do you see "control" and "synergy", two words that I include in my weapons of mass distraction, thrown around casually to justify billions of dollars in premiums, but you also see them used interchangeably. When you acquire a company, there are three (and only three possible) motives that are consistent with intrinsic value.  Undervaluation: You buy a target company because you believe that the market is mispricing the company and that you can buy it for less than its "fair" value. In effect, you are behaving like any value investor would in the market and there is no need for you to either change the way the target company is run or look for synergy benefits.  Control: You buy a company that you believe is badly managed, with the intent of changing the way it is run. If you are right on the first count and can make the necessary changes, the value of the firm should increase under your management. If you can pay less than the "changed" value, you can claim the difference for yourself (and your stockholders).  Synergy: You buy a company that you believe, when combined with a business (or resource) that you already own, will be able to do things that you could not have done as separate entities. Broadly speaking, you can break synergy down into "offensive synergies" (where you are able to grow faster in existing or new markets than you would have as standalone businesses and/or charge higher prices for your products), "defensive synergies" (where you are able to reduce costs or slow down/prevent decline in your businesees) and "tax synergies" (where you directly take advantage of tax clauses or indirectly by being able to borrow more money).  The key distinction between synergy and control is that control does not require another entity or even a change in managers. It can be accomplished by the target company's management, if they put their minds to it and perhaps hire some help. Synergy requires two entities coming together and stems from the combined entity's capacity to do something that the individual entities would not have been able to deliver. Note that these motives can co-exist in the same acquisition and are not mutually exclusive.  To assess whether these motives apply (or make sense), there are four numbers that you need to track:  Acquisition Price: This is the price at which you can acquire the target company. If it is a private business, it will be negotiated and probably based on what others are paying for similar businesses. If it is a public company, it will be at a premium over the market price, with the premium a function of the state of the M&A market and whether you have other potential bidders.  Status Quo Value: This is the value of the target company, run by existing management and based on existing investing, financing and dividend policies.  Restructured Value: This is the value of the target company, with changes to investing, financing and dividend policies.  Synergy value: This can be estimated by valuing the combined company (with the synergy benefits built in) and subtracting out the value of the acquiring company, as a stand alone entity, and the restructured value of the target company.  Connecting these numbers to the motives, here are the conditions you would need for each motive to make sense (by itself). Motive Test Undervaluation Acquisition Price < Status Quo Value Control Acquisition Price < Restructured Value (Status Quo Value + Value of Control Synergy Acquisition Price < Restructured Value + (Value of Combined company with synergy - Value of Combined company without synergy) Which of these motives, if any, is driving ABInBev's acquisition of SABMiller, and whatever the motive or motives, is the premium being paid justified? To make that assessment, I will compute each of the four numbers for this deal. Setting up the ABInBev Deal The first news stories on ABInBev’s intent to buy SABMiller came out on September 15, 2015, though there may have been inklings among some who are more connected than I am. While no price was specified, the market’s initial reaction was positive, with both ABInBev and SABMiller’s stock prices increasing on the story. The picture below captures the key details of the deal, including both possible rationale and consequences: There were two key reasons provided to rationalize the potential deal. The first is geographic complementarity, since these two companies overlap in surprisingly few parts of the world, given their size. ABInBev is the largest player in Latin America, with Brazil at its center, and SABMiller is the biggest brewer in Africa. SABMiller’s Latin American operations are outside of Brazil, for the most part and while ABInBev has significant North American operations, SABMiller's North American exposure is entirely through its Coors Joint Venture. While no specifics are provided, the basis for synergy seems to be that after this deal, ABInBev will be able to expand sales in the fastest growing market in the world (Africa) and that SABMiller will be able to increase its revenues in the most profitable market in the world (Latin America). The second is consolidation, a vastly over used term that often means nothing, but  if it tied to specifics, relates to potential costs savings and economies of scale. While the absence of geographic overlap may reduce the potential for cost cutting, ABInBev can use the template that it has used so successfully on prior deals (especially the Grupo Modelo acquisition) to cut costs in this acquisition as well. There are also negative consequences that follow from this deal. The first is that when anti trust regulators in different parts of the world will be paying close attention to this deal, and it seems likely that SABMiller will be forced to sell its 58% stake in MillerCoors and that Molson Coors, the other JV partner, will be the beneficiary. The second, and this adds to the pressure, ABInBev has agreed to pay $3 billion to SABMiller if the deal falls through.  In summary, though, the challenge is a simple one. ABInBev is paying a $29 billion premium to acquire SABMiller. Is there enough value added to ABInBev's stockholders that they will be able to walk away as winners? The Players in the Deal To make a value judgment of this deal, we have to begin by looking at ABInBev and SABMiller, as stand alone companies, prior to this deal. In the picture below, I start with a snapshot of ABInBev: Capital Mix Operating Metrics Geographical Mix Interest-bearing Debt $51,504 Revenues $45,762 Latin America $18,849.00 42.03% Lease Debt $1,511 Operating Income (EBIT) $14,772 Africa $- 0.00% Market Capitalization $173,760 Operating Margin 32.28% Asia Pacific $5,040.00 11.24% Debt to Equity ratio 30.51% Effective tax rate 18.00% Europe $4,865.00 10.85% Debt to Capital ratio 23.38% After-tax return on capital 12.10% North America $16,093.00 35.88% Bond Rating A2 Reinvestment Rate = 50.99% Total $44,847.00 100.00% Looking past the numbers, it is worth noting that not only does ABInBev has a history of growing successfully through acquisitions but that its lead stockholder, 3G Capital, is considered a shrewd allocator and steward of capital. On the other other side of the deal stands SABMiller, and the picture below provides a sense of the company's standing at the time of the deal: Capital Mix Operating Metrics Geographical Mix Interest-bearing Debt $12,550 Revenues $22,130 Latin America $7,812 35.30% Lease Debt $368 Operating Income (EBIT) $4,420 Africa $6,853 30.97% Market Capitalization $75,116 Operating Margin 19.97% Asia Pacific $3,136 14.17% Debt to Equity ratio 17.20% Effective tax rate 26.40% Europe $4,186 18.92% Debt to Capital ratio 14.67% After-tax return on capital 10.32% North America $143 0.65% Bond Rating A3 Reinvestment Rate = 16.02% Total $22,130 100.00% This table, though, misses SAB's holdings in the MillerCoors JV and its other minority holdings in associates around the world, and the numbers for SAB's shares of these are summarized below: SAB Share of Other Associates Operating Metrics Geographical Mix Revenues $6,099.00 Latin America $- 0.00% Operating Income (EBIT) $654.00 Africa (mostly South Africa) $2,221 36.42% Operating Margin 10.72% Asia Pacific $2,203 36.12% Effective tax rate 25.00% Europe $1,675 27.46% After-tax return on capital 11.00% North America $- 0.00% Invested Capital $4,459 Total $6,099 100.00% SAB Share of MillerCoors JV Operating Metrics Geographical Mix Revenues $5,201.00 Latin America $- 0.00% Operating Income (EBIT) $800.00 Africa (mostly South Africa) $- 0.00% Operating Margin 15.38% Asia Pacific $- 0.00% Effective tax rate 25.00% Europe $- 0.00% After-tax return on capital 11.05% North America $5,201 100.00% Invested Capital $5,428 Total $5,201 100.00% The numbers reinforce my earlier point about geographic complementarity at least at the parent company level, with ABInBev getting a large percent of its Latin American sales in Brazil and SABMiller getting most of its Latin American sales from countries other than Brazil. Is SABMiller a bargain? The first step in this analysis to a valuation of SABMiller, as a stand alone company and with its existing management in place. Based on the numbers, this is a conservatively run company (both in terms of use of debt and reinvestment for growth) and the valuation reflects that: SAB Miller + 58% of Coors JV + Share of Associates SAB Miller Consolidated Revenues $22,130.00 $5,201.00 $6,099.00 Operating Margin 19.97% 15.38% 10.72% Operating Income (EBIT) $4,420.00 $800.00 $654.00 Invested Capital $31,526.00 $5,428.00 $4,459.00 Beta 0.7977 0.6872 0.6872 ERP 8.90% 6.00% 7.90% Cost of Equity = 9.10% 6.12% 7.43% After-tax cost of debt = 2.24% 2.08% 2.24% Debt to Capital Ratio 14.67% 0.00% 0.00% Cost of capital = 8.09% 6.12% 7.43% After-tax return on capital = 10.33% 11.05% 11.00% Reinvestment Rate = 16.02% 40.00% 40.00% Expected growth rate= 1.65% 4.42% 4.40% Number of years of growth 5 5 5 Value of firm PV of FCFF in high growth = $11,411.72 $1,715.25 $1,351.68 Terminal value = $47,711.04 $15,094.36 $9,354.28 Value of operating assets today = $43,747.24 $12,929.46 $7,889.56 $64,566.26 + Cash $1,027.00 - Debt $12,918.00 - Minority Interests $1,183.00 Value of equity $51,492.26  I am adding in my estimated values for SAB's share of the Coor's JV and other associates to arrive at the total value of the operating assets. In valuing each piece, I have estimated equity risk premiums that reflect where each one operates, using a 6% mature market premium for the Coors JV, since it generates most of its revenues in North America, and much higher premiums for the other two parts. At least based on my estimates, the value of equity is $51.5 billion, well below the market capitalization of $75 billion on September 15. (This may be cynical of me, but if used (wrongly in my view) a 6% equity risk premium for SABMiller, based on its UK incorporation, I get a value of $76 billion for its equity.) Bottom line: To me, SABMiller does not look like it is priced to be a bargain, even at the pre-deal price, and definitely not at the deal price. The Value of Control Is SABMiller ripe for a restructuring? It is tough to tell from the outside but one way to measure room for improvement is to compare the company on key corporate finance measures against both the acquirer (InBev) and the rest of the alcholic beverage sector: SABMiller ABInBev Global Alcoholic Beverage Sector Pre-tax Operating Margin 19.97% 32.28% 19.23% Effective Tax Rate 26.36% 18.00% 22.00% Pre-tax ROIC 14.02% 14.76% 17.16% ROIC 10.33% 12.10% 13.38% Reinvestment Rate 16.02% 50.99% 33.29% Debt to Capital 14.67% 23.38% 18.82% This comparison may be simplistic, but it looks like SABMiller lags the sector is in its reinvestment rate and return on capital, and that it earns a profit margin that match up to the sector. It also has a debt ratio that is not far off from the sector average. ABInBev has a much higher profit margin than the rest of the sector and pays a lower tax rate. I revalued SABMiller with the return on capital, debt ratio and reinvestment rate set equal to the industry average. (I considered using ABInBev's operating margin but much of that comes from Brazil and it is unlikely that SABMiller can match it in South Africa or the rest of Latin America. Status Quo Value Restructured Changes made Cost of Equity = 9.10% 9.37% Increases with debt ratio After-tax cost of debt = 2.24% 2.24% Left unchanged Debt to Capital Ratio 14.67% 18.82% Set to industry average Cost of capital = 8.09% 8.03% Due to debt ratio change Pre-tax return on capital 14.02% 17.16% Set to industry average After-tax return on capital = 10.33% 12.64% Result of pre-tax ROIC change Reinvestment Rate = 16.02% 33.29% Set to industry average Expected growth rate= 1.65% 4.21% Result of reinvestment/ROIC Value of firm PV of FCFF in high growth = $11,411.72 $9,757.08 Terminal value = $47,711.04 $56,935.06 Value of operating assets today = $43,747.24 $48,449.42 + Cash $1,027.00 $1,027.00 + Minority Holdings $20,819.02 $20,819.02 - Debt $12,918.00 $12,918.00 - Minority Interests $1,183.00 $1,183.00 Value of Control Value of equity $51,492.26 $56,194.44 $4,702.17 Bottom line: Changing the way SABMiller is run adds about $4.7 billion to the value, but even with that addition, the equity value of $56.2 billion is still far below what ABInBev paid on October 15. That suggests that control was not the primary rationale either. The Value of Synergy This leaves us with only one option, synergy, and to value synergy, I valued ABInBev as a standalone company and put it together with the restructured value of SABMiller to get a combined company value, with no synergy. I then assumed that the synergy (from geographic complementarity and consolidation) would manifest itself in a higher operating margin, higher reinvestment and a higher growth rate for the combined company: Inbev SABMiller Combined firm (no synergy) Combined firm (synergy) Actions Cost of Equity = 8.93% 9.37% 9.12% 9.12% After-tax cost of debt = 2.10% 2.24% 2.10% 2.10% Cost of capital = 7.33% 8.03% 7.51% 7.51% No changes expected Operating Margin 32.28% 19.97% 28.27% 30.00% Cost cutting & Economies of scale After-tax return on capital = 12.10% 12.64% 11.68% 12.00% Cost cutting also improves return on capital Reinvestment Rate = 50.99% 33.29% 43.58% 50.00% More aggressive reinvestment in shared markets Expected growth rate= 6.17% 4.21% 5.09% 6.00% Higher growth because of reinvestment Value of firm PV of FCFF in high growth = $28,732.57 $9,806.49 $38,539.06 $39,150.61 Terminal value = $260,981.86 $58,735.57 $319,717.43 $340,174.63 Value of Synergy Value of operating assets = $211,952.80 $50,065.35 $262,018.16 $276,609.92 $14,591.76 It is possible that I have been too pessimistic about the potential cost savings or growth possibilities, but given the history of synergy in big deals, I think that I am being optimistic. Based on my estimates at least, the value of synergy in this deal is $14.6 billion (and that is assuming it is delivered instantaneously). Bottom line: If synergy is the motive for this deal, a great deal has to go right for ABInBev to break even on this deal, let alone create value. The Disconnect The history of 3G Capital as successful value creators predisposed me to give them the benefit of the doubt, when I started assessing the deal. After looking at the numbers, though, I don't see the value in this deal that would justify the premium paid. It is possible, perhaps even likely, that there is some aspect of the deal, perhaps taxes or other benefits, that I am not grasping. If so, I would encourage you to use my template, change the numbers that you think need to be changed, make your own assessment and enter them in this shared Google spreadsheet. It is also possible that even the smartest investors in the world can sometimes let over confidence drive them to over react. Time will tell! YouTube version Data Attachments ABInBev Annual Report (2014) SABMiller Annual Report (2015) Spreadsheets SABMiller: Status Quo and Control Value Value of Synergy  Google Shared Spreadsheet for Deal Analysis

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Disney near deal to buy a stake in Vice Media
http://nypost.com/2015/10/23/disney-buys-stake-in-vice-media/

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Closing Market Summary: Stocks End Upbeat Week on Higher Note

The stock market ended the week on an upbeat note thanks to an opening spike that was extended during afternoon action. The S&P 500 jumped 1.1%, extending its weekly gain to 2.1%, while the Nasdaq surged 2.3% to end the week higher by 3.0%.

Quarterly earnings released last evening ensured a higher start for the major averages while a surprise rate cut from the People's Bank of China supercharged the opening move higher. Specifically, the central bank lowered its one-year lending rate by 25 basis points to 4.35% and cut its reserve requirement ratio by 50 basis points for qualifying institutions, representing the sixth rate cut since November. With most of the action taking place before the opening bell, stocks drifted near their highs into the afternoon, building on their gains during the final hour of action.

Last evening, Alphabet (GOOGL 719.33, +38.19), Amazon (AMZN 599.03, +35.12), and Microsoft (MSFT 53.03, +5.00) delivered better than expected quarterly earnings, setting the stage for today's rally.

Alphabet and Microsoft helped the technology sector (+3.1%) spend the day well ahead of its peers while Amazon's strength helped the discretionary sector (+0.4%) end the day in positive territory even as apparel retailers struggled across the board. Retailers slumped in sympathy with Skechers (SKX 31.65, -14.54) and V.F. Corp (VFC 63.75, -9.46) after both companies reported disappointing results. The two names posted respective losses of 31.5% and 12.9% while SPDR S&P Retail ETF (XRT 44.99, -0.63) fell 1.4%.

Similar to the discretionary sector, seven other groups ended the day behind the broader market while health care (+2.0%) outperformed thanks to a rebound in biotechnology as the iShares Nasdaq Biotechnology ETF (IBB 316.28, +10.17) spiked 3.3%.

Although the market ended well above its flat line, it is worth noting that only 59.0% of NYSE-listed issues posted gains, suggesting the presence of some softness beneath a seemingly strong surface. To that point, investors used today's strength to increase their hedges, evidenced by the CBOE Volatility Index (VIX 14.40, -0.05), which essentially held its ground.

On the downside, the energy sector (-0.2%) struggled as crude oil lost 1.8%, falling to $44.59/bbl. For the week, the energy sector surrendered 1.0% while WTI crude fell 5.7%.

Elsewhere, the utilities sector (-1.8%) ended at the bottom of the leaderboard as higher Treasury yields reduced the relative attractiveness of high-yielding utility names.

Speaking of Treasuries, the 10-yr note notched its low during morning action and hovered near its low into the close with the 10-yr yield rising six basis points to 2.09%.

On a related note, the Dollar Index (97.18, +0.80) spiked in reaction to the news from China, extending its advance into the close to end higher by 0.8%.

Investors did not receive any economic data today while Monday's data will be limited to the 10:00 ET release of the September New Home Sales report (consensus 550K).

• Nasdaq Composite +6.3% YTD
• S&P 500 +0.8% YTD
• Dow Jones Industrial Average -1.0% YTD
• Russell 2000 -3.2% YTD

Closing Market Summary: Stimulus Hopes Send Stocks Higher Despite Mixed Earnings

It was a running of the bulls on Thursday and "re-examine" was the trigger that sparked the charge. The S&P 500 soared 1.7%, overtaking its 100-day moving average (2,038) in the process. The benchmark index settled near its best level of the day, registering its first close above the 100-day average since August 17, as hopes for more stimulus overshadowed mixed corporate earnings.

The stock market was off to the races after equity futures revved higher an hour before the opening bell. The pre-market activity took place in response to comments from European Central Bank President Mario Draghi, who addressed the media following the latest ECB policy meeting. During his press conference, Mr. Draghi said that the central bank will "re-examine" its asset purchases at the December meeting. This was immediately interpreted as a harbinger of more monetary easing in the near future, sending the euro lower while European equities and U.S. futures spiked. Those moves accelerated after Mr. Draghi revealed that the governing council had discussed lowering the deposit facility rate at today's policy meeting. Markets in France, Germany, Spain, and Italy jumped between 2.0% and 2.5% while the euro slid throughout the session to 1.1110 against the dollar after trading just above 1.1300 prior to Mario Draghi's press conference. As a result, the Dollar Index (96.44, +1.37) spiked 1.4%, returning to levels last seen in late September.

Nine sectors ended the day with gains of 1.2% or more, masking the mixed nature of quarterly reports released between yesterday's closing bell and today's open. For instance, Caterpillar (CAT 70.88, +1.98) spiked 2.9% despite missing estimates and lowering its earnings guidance while 3M (MMM 156.00, +6.18) jumped 4.1% after missing revenue estimates, lowering its guidance, and announcing restructuring plans that will involve 1,500 layoffs worldwide. Meanwhile, American Express (AXP 72.50, -4.01) also delivered a disappointing report, but did not get lifted by the tide, falling 5.2%.

To be fair, a few companies delivered better than expected reports with McDonald's (MCD 110.87, +8.33) surging 8.1% to a fresh all-time high and Texas Instruments (TXN 58.09, +6.19) spiking 11.9% after both beat their respective estimates. Texas Instruments contributed to a 3.5% spike in the PHLX Semiconductor Index, which in turn, underpinned the technology sector (+2.3%). That being said, even the two standouts of the day fit an all-too-familiar theme of bottom-line beats combined with sluggish revenue growth.

Elsewhere, PulteGroup (PHM 18.16, -1.29) and Kinder Morgan (KMI 29.75, -1.67) posted respective losses of 6.6% and 5.3% in reaction to disappointing reports; however, their weakness was overshadowed by the broad market strength.

Similarly, Valeant Pharmaceuticals (VRX 109.87, -8.74) had another woeful showing, tumbling 7.4% to extend its two-day loss to 24.7% after Citron Research voiced concerns of potential accounting fraud at the biotech company. On a related note, the health care sector (-0.6%) spent the day in negative territory.

Treasuries bounced around their flat lines throughout the day with the 10-yr yield respecting a six-basis point range before ending unchanged at 2.03%.

Today's trading volume was well above average with more than a billion shares changing hands at the NYSE floor.

Economic data included Initial Claims, Existing Home Sales, Leading Indicators, and FHFA Housing Price Index:

• The weekly initial claims level increased to 259,000 for the week ending October 17 from an upwardly revised 256,000 (from 255,000) while the consensus expected an increase to 265,000
  • The four-week moving average fell to 263,250 from 265,250, representing the lowest level since December 1973
• Existing home sales increased 4.7% in September to 5.55 million from a downwardly revised 5.30 million (from 5.31 mln) while the consensus expected an increase to 5.39 million
  • Unfortunately, the growth in sales may not stable, considering much of the gain resulted from an increase in all-cash and investor demand
    • All-cash sales accounted for 24% of all sales in September, up from 22% in August. Individual investors purchased 13% of existing homes in September, up from 12% in August
• The Conference Board's Leading Economic Index declined 0.2% (consensus -0.1%) in September after a downward revision resulted in no change (from 0.1%) in August
• The FHFA Housing Price Index for August rose 0.3%, which followed an unrevised increase of 0.6% in July

There is no economic data on tomorrow's schedule.

• Nasdaq Composite +3.9% YTD
• S&P 500 -0.3% YTD
• Dow Jones Industrial Average -1.9% YTD
• Russell 2000 -4.1% YTD