Diageo is taking steps ahead to complete its acquisition of a controlling interest in United Spirits. The last time I discussed this was in February 2013 when acquisition of shares based on a preferential issue to Diageo at Rs.1,440 per share put a value on the total equity of United Spirits at Rs.206 b.
Well, since that time much has taken place; some as envisaged, and some not as much. As of 31 March 2014, Diageo owns 41.83 m shares of United Spirits, and United Breweries Holdings owns 8.62 m shares.
Subsequently in April 2014, Diageo has come up with an open offer to acquire more (37.78 m) shares at Rs.3,030 per share, a significant premium to its original plan. With this offer Diageo considers that United Spirit's equity is more than Rs.440 b; its current market value is about Rs.415 b. Just for comparison in February 2013 it was Rs.247.86 b. This 67% increase in the market value is due to the expectations that Diageo would increase its offer price; and it did.
Now let's discuss whether United Spirits is worth that price.
Based on the provisional numbers supplied, its book value of debt as of 31 Dec 2013 was Rs.77.94 b and it had cash and investments of about Rs.4.5 b. Its expected revenues based on extrapolation for the full year are about Rs.108 b. Over the last five years, revenues have grown by 17.87% annualized; good stuff, there it ends though. Its operating margins have been falling since 2008 which currently stands at about 7%. Operating income in 2013 was not sufficient enough to cover finance costs of Rs.9.8 b; fortunately, its other income has been substantial due to interest on cash, income from IPL franchise and other items. I am not sure why United Spirits presents income from IPL franchise as part of its operating revenue. Its return on capital is less than 4%. Since its 2008 acquisition of Whyte & Mackay assets United Spirits book capital has increased significantly. With no corresponding increase in operating income the return on capital is affected adversely; Its 2013 operating income was lower than that of 2008. Now Diageo has to offload Whyte & Mackay assets back to the market at lower than its cost as per this report.
I am sure Diageo must have thought something about United Spirits; probably as its playground to increase market share, may be; Or it could be just one more expensive acquisition.
To justify Rs.415 b value for equity we have to do some reverse thinking to get the implied assumptions involved in valuation.
However, even with robust and optimistic assumptions I have found it a bit hard to come around and think like Diageo in justifying this acquisition at the price offered which is in fact higher than Rs.415 b.
I used a much higher operating margin of 15% which except for 2008 it hasn't reached at least in the last eight years I have looked at; and assumed a very low effective tax rate to begin with and expected it to reach the marginal tax rate on a gradual basis. With these assumptions I checked what combinations of return on capital and growth rates are required to get the current market value of Rs.2,853.95 per share. In all the scenarios United Spirits is expected to reach the stable growth period gradually, and accordingly demonstrate the characteristics of a stable growth firm; this means naturally there is a cap on the growth rate and return on capital until perpetuity.
Here's how it looked:
For instance, at 50% return on capital United Spirits should grow at about 35.75% in the next five years to justify the current market price; furthermore, the return on capital and growth rate should still have to be higher in the subsequent five years, although these should become lower gradually until the firm reaches the stable growth period. This means United Spirits should have to display extraordinary return on capital and growth rates in the next ten years in order to justify the current market price. Alternatively, at 25% return on capital (which is way higher than what it is currently) it has to grow at about 53.75% in the next five years.
I also looked at Diageo's operating margin and return on capital which stand at about 30% and 19% respectively. At these rates United Spirits will have to grow at 47% in the next five years.
An important aspect which is often forgotten in zest is that for a firm to grow it has to reinvest certain portion of its after-tax operating income; without this any firm can magically get to the desired value, albeit on paper.
In fact, as the return on capital becomes lower reinvestment required by United Spirits to get to the market price becomes higher. At 30% return on capital, reinvestment required exceeds 100% which means value generated during the first ten years becomes negative, and therefore the entire market price has to be powered by the terminal value.
Because of this reason, any higher operating margins at return on capital lower than 30% (and at the corresponding growth rate) would actually bring the value lower due to the burden on the terminal value, and it not being able to compensate for the initial ten years of negative values.
However, when return on capital is 40% (with the corresponding growth rate) or more, higher operating margins would be able to generate higher value.
It is also nice to check revenues at year five and year ten arrived at based on any growth rate assumptions, and ask whether these are achievable considering the available market, competition and market share. I checked, but then decided not to plot them on the graph...
If Diageo considers that any of these (or any other) combinations is possible, there is more power to this deal.
There is no fine on dreaming, is there? Nevertheless, if the dream is going to cost the shareholders there should be some fine...but how much?
Now let's discuss whether United Spirits is worth that price.
Based on the provisional numbers supplied, its book value of debt as of 31 Dec 2013 was Rs.77.94 b and it had cash and investments of about Rs.4.5 b. Its expected revenues based on extrapolation for the full year are about Rs.108 b. Over the last five years, revenues have grown by 17.87% annualized; good stuff, there it ends though. Its operating margins have been falling since 2008 which currently stands at about 7%. Operating income in 2013 was not sufficient enough to cover finance costs of Rs.9.8 b; fortunately, its other income has been substantial due to interest on cash, income from IPL franchise and other items. I am not sure why United Spirits presents income from IPL franchise as part of its operating revenue. Its return on capital is less than 4%. Since its 2008 acquisition of Whyte & Mackay assets United Spirits book capital has increased significantly. With no corresponding increase in operating income the return on capital is affected adversely; Its 2013 operating income was lower than that of 2008. Now Diageo has to offload Whyte & Mackay assets back to the market at lower than its cost as per this report.
I am sure Diageo must have thought something about United Spirits; probably as its playground to increase market share, may be; Or it could be just one more expensive acquisition.
To justify Rs.415 b value for equity we have to do some reverse thinking to get the implied assumptions involved in valuation.
However, even with robust and optimistic assumptions I have found it a bit hard to come around and think like Diageo in justifying this acquisition at the price offered which is in fact higher than Rs.415 b.
I used a much higher operating margin of 15% which except for 2008 it hasn't reached at least in the last eight years I have looked at; and assumed a very low effective tax rate to begin with and expected it to reach the marginal tax rate on a gradual basis. With these assumptions I checked what combinations of return on capital and growth rates are required to get the current market value of Rs.2,853.95 per share. In all the scenarios United Spirits is expected to reach the stable growth period gradually, and accordingly demonstrate the characteristics of a stable growth firm; this means naturally there is a cap on the growth rate and return on capital until perpetuity.
Here's how it looked:
I also looked at Diageo's operating margin and return on capital which stand at about 30% and 19% respectively. At these rates United Spirits will have to grow at 47% in the next five years.
An important aspect which is often forgotten in zest is that for a firm to grow it has to reinvest certain portion of its after-tax operating income; without this any firm can magically get to the desired value, albeit on paper.
In fact, as the return on capital becomes lower reinvestment required by United Spirits to get to the market price becomes higher. At 30% return on capital, reinvestment required exceeds 100% which means value generated during the first ten years becomes negative, and therefore the entire market price has to be powered by the terminal value.
Because of this reason, any higher operating margins at return on capital lower than 30% (and at the corresponding growth rate) would actually bring the value lower due to the burden on the terminal value, and it not being able to compensate for the initial ten years of negative values.
However, when return on capital is 40% (with the corresponding growth rate) or more, higher operating margins would be able to generate higher value.
It is also nice to check revenues at year five and year ten arrived at based on any growth rate assumptions, and ask whether these are achievable considering the available market, competition and market share. I checked, but then decided not to plot them on the graph...
If Diageo considers that any of these (or any other) combinations is possible, there is more power to this deal.
There is no fine on dreaming, is there? Nevertheless, if the dream is going to cost the shareholders there should be some fine...but how much?
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