1- Briefly describe the companies. Do the SWOT analysis for both bidder and target. Explain rationale behind the deal. Why does it make sense for these two companies to merge?
Kellogg Company is a food producing American multinational that offers its brand in more than 180 countries and has a history of more than 100 years. Its global headquarters are located in Battle Creek, Michigan and it has around 30,600 employees. The company produces breakfast and snack foods, cereal, beverages, crackers, cookies, toaster pastries and waffles, pancakes and syrups.
Kellogg generated revenue of $ 13198 million during the financial year ended on December 2011 (FY2011), an increase of 6.46% compared to FY2010. The operating income of the company was $1,978 million in FY2011, a decrease of 0.7% compared to FY2010. The net income was $1,231 million in FY2011, a decrease of 1.28% over FY2010 (Kellogg Annual Reports, 2012).
DR. Pepper Snapple (DPS):
DR. Pepper Snapple is America’s number one flavored carbonated soft drink company and a leading innovator and marketer of functional/non-carbonated beverages. The company has a history of more than 300 years even though it has recently registered on New York Stock Exchange. It has more than 50 brands, 200 plus distribution centers and approximately 19,000 employees. The company produces Sunkist Soda, 7UP, A&W, Canada Dry, Crush, Mott's, Squirt, Hawaiian Punch, Peñafiel, Clamato, Schweppes, Venom Energy, Rose's and Mr & Mrs T mixers.
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DPS generated revenue of $5903 million during the financial year ended on December 2011 (FY2011), an increase of 4.74% compared to FY2010. The operating income of the company was $1,024 million in FY2011, a decrease of 0.1% compared to FY2010. The net income was $606 million in FY2011, an increase 14.77 over FY2010 (Dr Pepper Snapple Annual Reports, 2012).
Dr Pepper Snapple might be a good acquisition target for Kellogg because it can benefit from the vast distribution network of the acquirer. Dr Pepper is currently operating in a much smaller scale. Its operations are limited only to the United States and South America. On the other hand, Kellogg is global company with widespread operations in many international territories. The implication is that Kellogg can help Dr Pepper grow in many new territories. Moreover, the larger scale of operations might enable Dr Pepper to increase its profit margins, moving in synchronization with its competitors like Coca Cola. Similarly, Kellogg’ products might be able to benefit from the acquisition through a boost is sales. Such a boost in sales can be achieved by strategically placing the drinks with the company’s snack foods. Snack foods and non-alcoholic drinks might make a good combination.
2- Do due diligence.
All merger transaction within the United States have to be approved by the FTC and Department of Justice under the Hart-Scott-Rodino Antitrust Improvement Act of 1976 (Horizontal Merger Guidelines, 2010). Since both the companies are based in the US, they will have to gain the approval of the aforementioned federal departments before the merger can be implemented. The US government primary concern during a merger transaction is to ensure that the merger does not significantly increase the firm size to negatively affect competition. Since both the companies operate in the food and beverages industry, there might be a risk that the merger might increase the concentration of the industry. Regulators often use the Herfindahl-Hirschman Index (HHI) to measure the concentration of the industry. If the merger is estimated to cause a significant increase in HHI, regulators might not approve the merger. However, the food and beverage industry is dominated by much larger companies like Coca Cola and international food chains. Therefore, it is unlikely that the HHI will be significantly affected by this merger transaction.
The accounting issues relating to both the companies are expected to be limited. Kellogg is a global company that operates in many international locations. Therefore, it is familiar with the both the US GAAP and IAS methods of presenting financial statements. On the other hand, Dr Snapple operates in Americas (North and South) and predominantly reports its performance in accordance with US GAAP. However, it is believed that Kellogg has significant accounting expertise and will be able to integrate the reporting requirements of Dr Snapple within the consolidated entity.
On the other hand, the financial position of both the companies may be a little risky from the viewpoint of leverage. Both companies currently have a significant amount of debt in its operations. Moreover, the debt of Dr Pepper is not particularly highly rated. This may be because the company has a high degree of competition and low profit margins relative to its competitors. Therefore, lenders might assign a higher risk premium to Dr Pepper. The financial position of the merged company may not be optimum because Kellogg will have to pay a higher interest cost on the existing debt of Dr Pepper. The ideal solution would be for Kellogg to retire the existing debt of Dr Pepper and replace it with new, high-rated debt. However, Kellogg also has a significant amount of debt on its balance sheet and may not find it easy to issue new debt.
3- Determine value ranges for bidder and target by using several valuation methods.
Valuing a company is a complex process and is based on a number of potentially unrealistic assumptions. An acquisition transaction involves further uncertainty because the amount of synergies resulting from the merger cannot be determined with certainty. Therefore, it is important to support the company valuation through multiple approaches. We will be valuing Kellogg and Dr Pepper through two different valuation approaches and we will contrast these values with the market values of the company. In an ideal situation, the intrinsic value of the company that is derived from the valuation models should be close to the market value of the company. However, market imperfections, transactions costs, heterogeneous expectations, and asymmetric information often lead the intrinsic value to differ from the market value. Using the results of the valuation models and the current market value of the companies, we will construct a range of possible values for the company. We will then use some external and qualitative information to provide a best estimate of the value of the companies.
We will be using the discounted cash flow and the multiples approach to value Kellogg and Dr Pepper. For the discounted cash flow approach, the dividend discount model is deemed to be the most appropriate model. Both the companies are well established and have been paying a consistent level of dividend over a long period of time. This also makes it easy to forecast the dividends into the future. Moreover, the forecasted earnings and dividend per share are readily available for the next four years. The terminal values of both the companies are estimated by employing the Gordon-growth model. The long-term growth rate for the Gordon-growth model is determined by multiplying the companies’ respective retention ratio with their long-term projected return on equity. The companies have been paying a consistent level of the earning as dividends. Hence their average retention ratios are fairly stable over time. On the other hand, the long-term return of equity (ROE) of the companies is subject to much higher level of uncertainty. The current level of return on equity is very high for both the companies. Theoretically, the ROE is expected to converge toward the cost of capital of the company. Using this assertion, we assume that the long-term ROE for the companies will be between 200 to 300 basis points above the cost of capital for the companies. At this point, the profit margins will not attract further competition and equity return will stabilize.
The cost of equity for the companies is calculated using the weighted average cost of capital. The cost of equity is calculated using the capital asset pricing model. The stocks of both the companies are defensive in nature where the current betas are significantly less than one. However, it has been observed that betas tend to move towards one with the passage of time. Therefore, we have taken a conservative approach and adjusted the betas upwards to reflect this trend. We have assigned a weight of two-third to the current betas of the company and a weight of one-third to the mean-reverting level of one. This treatment is consistent with the popular market convention. The cost of debt is estimated by adding a risk premium to the risk-free rate. The risk premium is consistent with the historical risk premiums (Fernandez and Baonza, 2010) for corporate bonds. The effective tax rate is assumed to be equal to the statutory tax rate. The targeted market values weights of debt and equity are obtained to calculate the weighted average cost of capital (WACC). The WACC can be used to discount the cash flows in the dividend discount model to calculate the value of the companies under the discounted cash flow approach.
Multiples, based of comparable company information, have also been used to estimate the intrinsic value of the company. We have used four different multiples to estimate the value of the company: price to earnings, price to sales, price to cash flow, and enterprise value to EBITDA. These multiples have estimated for a group of peer companies and their average values are used to project the comparable value of Kellogg and Dr Pepper. The multiples approach tells us the value of a company relative to the value of its competitors. In our case, the valuation derived from the four multiples is particularly appealing because the values are very close to each other. This is in sharp contrast to the value derived from the discounted cash flow (DCF) approach, which is largely dependent on the terminal value estimated through the Gordon-growth model.
The Gordon-growth model is highly sensitive to its inputs. In our case, the long-term growth rate is of particular concern because it has been estimated using a fairly theoretical assumption about the long-term return on equity (ROE). Therefore, it is reasonable to do a sensitivity analysis, based on different values for long-term ROE. The sensitivity analysis reveals that the value based on DCF approach is highly dependent on the assumption about the long-term level of ROE. A 2% increase or decrease in the ROE leads to drastic change of the value estimated by the DCF model. On the other hand, the range of values estimated by the multiples relatively stable. The stock prices for the companies have also not shown considerable variation over the past three years. Moreover, the value estimated by the DCF method is considerable higher than the current market values of the companies, while the value based on multiples is between the two extremes. Therefore, the value derived from the multiples approach should be assigned a higher weight-age when calculating the expected intrinsic values of the companies. The following diagrams present the range of values using different valuation methods:
Figure 1: Range of Values for Kellogg
Figure 2: Range of Values for Dr Pepper
4- Assume a share-for-share exchange where any synergies will be distributed proportionally to the values of the companies. What is the minimum and maximum exchange ratios based on your value ranges obtained from point 3?
If the synergies from the merger are expected to be distributed among the companies in proportion to their intrinsic values, the exchange ratio is just the ratio of the intrinsic values of the companies. This makes sense since the exchange ratio denotes the number of shares that the shareholders of Dr Pepper will receive in the merged company. Under the worst-case scenario, the stock price for Kellogg will be $53, and the stock price for Dr Pepper will be around $35. In such a case, the shareholders of Dr Pepper will receive 0.39 shares for each share held by the shareholders of Kellogg. Therefore, 0.39 is the exchange ratio. This exchange ratio increases to 0.47 under the best-case scenario where the stock prices for Kellogg and Dr Pepper are expected to be around $83 and $67. In reality, the exchange ratio can be expected to lie between 0.39 and 0.47. To logic check our calculations; the attached spreadsheet also details the post-merger value attributable to the shareholders of both companies. It should be noticed that the post-merger values of both companies increase by 10% - the percentage amount of synergies assumed to be realized from the merger.
5- Based on the average premium observed in the relevant industry sector (or in the market as whole if information on the industry sector is not available), estimate the purchase price for the target.
It is hard to estimate the transaction premium for a possible acquisition of Dr Pepper. Ideally, premiums should be based on the intrinsic value of a company. However, investors perceptions about the intrinsic values differ. Therefore, transaction premium are often reported over the market price of public companies. Since acquirers tend to buy undervalued companies, it can be implied that the actual transactions premiums are much lower than the reported premiums because the intrinsic value of most acquirees is higher than the traded market price. We have been unable to find a specific industry transaction premium for mergers in the food and beverage industry. Therefore, we will be using the average market premium in the US stock market. The estimates for the transaction premiums differ across different studies. There are usually estimated to be between 38% (Laamanen, 2007) and 50% (Porrini, 2006) over the traded market price of the acquired company.
Since the intrinsic value of the company is expected to be significantly above the current market price of Dr Pepper, we assume that the premium will be closer to the higher end of the range. This leads to an implied transaction premium of about 20% over the calculated intrinsic value of the company. Therefore, it is estimated that each share of Dr Pepper will be sold at a price of about $58.
6- Assume that the market value of the bidder and target are equal to their triangulated values. Assume that the only synergies generated by the deal are the tax shields resulting from additional debt in case of a cash payment financed with new debt (i.e. no synergies in case of stock financing).
Determine (1) dilution/accretion of the share price of the combined company under 100% equity, 100% debt, and 50% equity and 50% debt financing options; (2) under a 100% debt financing what is the maximum price that can be paid by the bidder to avoid stock price dilution?
If the purchase of the target company is financed through a 100% of equity, there will be no synergies. It has already been determined that Kellogg is expected to pay a 20% premium over the intrinsic value of the target company. Therefore, the shareholders of Kellogg would end up paying extra for Dr Pepper without realizing any additional return from synergies. Under such a scenario, the post-merger value of the company will drop by the amount of the acquisition premium and the justified (intrinsic) stock price of Kellogg will experience a decline of 8.7%.
On the other hand, Kellogg can use issue debt to finance the purchase of the target company. Under such a situation, the tax shield from the issuance of additional debt will also serve as a source of synergy. For the purposes of calculating the value of this tax shield, it is assumed that the additional debt will be issued for a long period (equivalent to perpetuity) and its riskiness can be captured by its interest cost. Under these simplistic assumptions, the present value of the tax shield from the additional debt is equal to the amount of debt multiplied by the effective tax rate (40%). The implication is that a higher level of debt will lead to a higher level of synergies arising from the tax shield. Theoretically, the optimal scenario will be where all of the purchase price is financed through debt. Under such a case, the post-merger price of can be expected to increase by as much as 12%. In such a situation, the amount of synergies will be maximized, and Kellogg can afford to pay upto $72 for each share of Dr Pepper without incurring a fall in its share price.
7- Based on market conditions and the profile of the two companies, which payment method and financing option would you recommend?
In reality, there will be distress costs associated with issuing such a high level of debt and the cost of debt (required interest rate) may increase with increasing levels of debt. Therefore, the actual levels of synergies may be much lower than expected, under a 100% debt financing. In fact, issuing such a large amount of debt may even lead the company into a dangerous solvency position. In contrast, the prospects of 50% equity financing and 50% debt financing are much more appealing. Under such a scenario, the company will not incur a dilution in its stock price even if it fails to realize any additional synergies. Clearly, any additional synergies will lead to an increase in the post-merger price of Kellogg. If Kellogg decides to offer stock-based compensation to the shareholders of Dr Pepper, it will have to share the resulting synergies with the shareholders of the target company. This is because the shareholders of Dr Pepper will also hold a considerable stake in the merged company. On the other hand, if no synergies are realized from the transaction, the shareholders of target company will also suffer and Kellogg will not have to pay an acquisition premium out of its own resources.
Cash payment has historically been the predominant form of mechanism in a merger transaction (Mergerstat Review, 2006). We believe that it is highly likely that Kellogg will be able to realize considerable synergies from the transaction. Moreover, the proposed transaction premium payable to the target company is offset by the synergies realized by the debt tax shield in case of a partial debt financing. Therefore, Kellogg should endeavor to maximize its upside potential from the deal and pay cash to the shareholders of Dr Pepper.
8- Summarize the key risks in the deal and how you intend to reduce them.
Perhaps the most significant risk is that the expected synergies from the transaction may not be realized. Although it appears that the companies can adequately complement each other, complications can arise in real-life situations. The management philosophies of the two companies may not agree, which might lead to differences in the proposed future direction of the merged company. Similarly, the larger scale of the company may lead to inefficiency due to diseconomies of scale. Similarly, the employees of the company may not be in favor of the merger and may not feel comfortable in the changing landscape of the company. In short, there is a significant operating risk inherent in the merger. To mitigate this risk, we need to ensure that operating climate of the two companies are checked for compatibility. It is important to take the different stakeholders of the companies on board and address their concerns. It might serve well to forecast the impact of the merger on the sales of different products and on different operating procedures and expenses.
Dr Pepper Snapple Annual Reports (2012) '2011 Annual Report'. Available at: http://investor.drpeppersnapple.com/annuals.cfm (Accessed: 15 April 2012).
Fernandez, P and Baonza, J (2010) ‘Market Risk Premium Used in 2010 by Analysts and Companies: A Survey with 2,400 Answers’, Working Paper
Horizontal Merger Guidelines (2010). Available at: http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf (Accessed: 18 April 2012).
Kellogg Annual Reports (2012) '2011 Annual Report'. Available at: http://investor.kelloggs.com/annuals.cfm (Accessed: 14 April 2012).
Laamanen, T (2007) ‘On the role of acquisition premium in acquisition research’, Strategic Management Journal, 28(13), pp. 59–1369
Mergerstat Review (2006). Available at: http://www.mergerstat.com/ (Accessed: 19 April 2012).
Porrini, P (2006) ‘Are investment bankers good for acquisition premiums?’, Journal of Business Research, 59(1), pp. 90-99
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