Friday, October 23, 2015

Winning at a Loser's Game? Control, Synergy and the ABInBev/SABMiller Merger!

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 Ambev 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
  1. 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. 
  2. 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). 
  3. 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: 
  1. 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. 
  2. Status Quo Value: This is the value of the target company, run by existing management and based on existing investing, financing and dividend policies. 
  3. Restructured Value: This is the value of the target company, with changes to investing, financing and dividend policies. 
  4. 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).

UndervaluationAcquisition Price < Status Quo Value
ControlAcquisition Price < Restructured Value (Status Quo Value + Value of Control
SynergyAcquisition 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 MixOperating MetricsGeographical Mix
Interest-bearing Debt$51,504Revenues$45,762Latin America$18,849.00 42.03%
Lease Debt$1,511Operating Income (EBIT)$14,772Africa$- 0.00%
Market Capitalization$173,760Operating Margin32.28%Asia Pacific$5,040.00 11.24%
Debt to Equity ratio30.51%Effective tax rate18.00%Europe$4,865.00 10.85%
Debt to Capital ratio23.38%After-tax return on capital12.10%North America$16,093.00 35.88%
Bond RatingA2Reinvestment 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 MixOperating MetricsGeographical Mix
Interest-bearing Debt$12,550Revenues$22,130Latin America$7,81235.30%
Lease Debt$368Operating Income (EBIT)$4,420Africa$6,85330.97%
Market Capitalization$75,116Operating Margin19.97%Asia Pacific$3,13614.17%
Debt to Equity ratio17.20%Effective tax rate26.40%Europe$4,18618.92%
Debt to Capital ratio14.67%After-tax return on capital10.32%North America$1430.65%
Bond RatingA3Reinvestment Rate =16.02%Total$22,130100.00%

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 MetricsGeographical Mix
Revenues$6,099.00Latin America$- 0.00%
Operating Income (EBIT)$654.00Africa (mostly South Africa)$2,221 36.42%
Operating Margin10.72%Asia Pacific$2,203 36.12%
Effective tax rate25.00%Europe$1,675 27.46%
After-tax return on capital11.00%North America$- 0.00%
Invested Capital$4,459Total$6,099100.00%
SAB Share of MillerCoors JV
Operating MetricsGeographical Mix
Revenues$5,201.00Latin America$- 0.00%
Operating Income (EBIT)$800.00Africa (mostly South Africa)$- 0.00%
Operating Margin15.38%Asia Pacific$- 0.00%
Effective tax rate25.00%Europe$- 0.00%
After-tax return on capital11.05%North America$5,201 100.00%
Invested Capital$5,428Total$5,201100.00%
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 AssociatesSAB Miller Consolidated
Operating Margin19.97%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
Cost of Equity =9.10%6.12%7.43%
After-tax cost of debt =2.24%2.08%2.24%
Debt to Capital Ratio14.67%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 growth555
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:
SABMillerABInBevGlobal Alcoholic Beverage Sector
Pre-tax Operating Margin19.97%32.28%19.23%
Effective Tax Rate26.36%18.00%22.00%
Pre-tax ROIC14.02%14.76%17.16%
Reinvestment Rate16.02%50.99%33.29%
Debt to Capital14.67%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 ValueRestructuredChanges 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 Ratio14.67%18.82%Set to industry average
Cost of capital =8.09%8.03%Due to debt ratio change
Pre-tax return on capital14.02%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$1,183.00Value 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:

InbevSABMillerCombined 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 Margin32.28%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$340,174.63Value 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
  1. ABInBev Annual Report (2014)
  2. SABMiller Annual Report (2015)

  1. SABMiller: Status Quo and Control Value
  2. Value of Synergy 
  3. Google Shared Spreadsheet for Deal Analysis


Travis Lundy said...

A question of procedure...
In a "fair value" SOTP estimate of SABMiller's value ($51.492bn?), why would one value the minority interest (which I assume to be the 42% of the Coors JV not held by SABMiller) at such a low level? Surely if the operating asset value of the 58% is $12.9bn, the value of the 42% minority interest should be higher than $1.2bn. To get that number "right" would require seeing the debt and cash inside the Coors JV to back out the implied market cap of the 42%. If that is not possible, one could take a stab at it using older numbers, pre-consolidation numbers, or a group average.

The main issue is that the minority interest is equity, which should be worth the same PBR as the equity of the 58%. It is, in the standard EV/EBITDA calculation treated as an "equity-linked" liability where the price of the equity has been over-ridden by the net equity per share. Surely Molson would not sell that 42% for 1x book.

Unknown said...

Great analysis as usual Professor - what about all the "soft" not immediate benefits that could materialize in better economics for AbInBev in the future - it is swallowing a potentially fierce competitor that could have jeopardized AbInBev position in some markets (with the resulting lower prices and profits on AbInBev end; e.g. In Brazil). As far as I am concerned, I believe that this is a key element in this deal.

Anonymous said...

You wrote off margin improvement very quickly despite what 3G was able to do at Budweiser. If you get the SAB margin closer to 30%, plus a lower tax rate and some marginal cost synergies, the deal makes sense.

Aswath Damodaran said...

If, by makes sense, you can get the deal to break even, I think that it illustrates my point. ABInBev has to make massive changes at SABMiller but SABMiller's current stockholders walk away with all or most of the upside. Does not sound like a great deal to me!

Anonymous said...

Hi Professor,

I personally think in order to understand this deal, we'll also need to factor in some of the dynamics of behavioral finance, and potential external factors driving this:

1. Dry powder: usually the public is no privy to such info...but generally when there's lot of un-invested capital, or "dry-powder" left...the private equity firms are under tremendous pressure to deploy it. Despite 3 G's reputation for good capital deployment...the pressure is always there because investors don't want to pay 1-2% fees per year for no action.
2. I don't ever recall a mega merger actually delivering what people expected at first. It must exist...but it is rare. People's egos sometime get in the way and want to control behemoths
3. I think we all know in real life bankers fiddle around with numbers until it works. Granted, 3G isn't an investment bank...and will need to return value to its limited partners...but once they set their mind to it...they will "find" it. I won't be surprised if this gets justified by some ridiculous growth strategy they think they can pull off (ie. raising prices, etc).

Aswath Damodaran said...

Actually, understanding why companies do big (even bad) deals is very easy. It can be empire building, egos, banking self interest and/or pressure from hedge fund clients but that is too me is the conclusion to arrive at after you have had a chance to see if you can justify it on economic or financial reasons.