EMPRESAS POLAR vs. BAVARIA, S.

A
ACQUISITION OF MINORITY BLOCKS OF BACKUS & JOHNSTONS VOTING STOCK

A INTERNATIONAL CORPORATE GOVERNENCE CASE STUDY

CASE SUBMITTED TO:

PROFESSOR LOPEZ DE SILANES

STUDENT DETAILS
NAME VINEETH VIJAYAN

COURSE
TRACK

MS FINANCE
CORPORATE FINANCE & BANKING

17 JANUARI 2014

ROLL NUMBER 13030

DO A DCF OF BACKUS.

SPELL OUT YOUR ASSUMPTIONS ABOUT THE COMPANY, THE INDUSTRY AND PERU. IN ADDITION TO ASSUMPTIONS ABOUT THE GROWTH OF BEER DEMAND IN PERU, YOU WILL NEED TO USE INFORMATION ABOUT PRICE AND INCOME ELASTICITY'S TO MAKE YOUR PROJECTIONS.

DCF MODEL ASSUMPTIONS

Key Input Metric

COST OF EQUITY

METRIC Risk free rate Levered Beta Equity Risk Premium Cost of Equity

VALUE 4.7% 0.7 9.01% 11.0%

REMARK
Peruvian Brady Bonds corrected for country risk Based on Exhibit 22. Stock Market Synchronocity Country base equity spread. http://pages.stern.nyu.edu/~adamodar/ Using the Classic CAPM Model for market

MACRO ECONOMIC INPUTS

METRIC PERU LONG TERM GROWTH RATE VALUE 3.42% (Exhibit 18)
Exhibit 19: Financial Results of Backus & Johnston Company.

Average Analyst Projections for the year 2002-2003 normalized over long term growth

CAPITAL EXPENDITURE GROWTH RATE

7%

Based on industry standards accounting for firms present capex spread over a 10 year window

Inflation Rate

2.5%

Projected Consumer Price Index used as proxy spread over 10 year period

Depreciation Rate

10%

Based on Net fixed Assets projected on historical data NET WORKING CAPITAL: a function of EBITDA( 40%) ( Based on Industry Average and Analyst reports)

CASH FLOW GROWTH RATE

Cash flow growth taken as function of both fast growing macro economic factors + company specific performance

Macro Economic Factors

Beer growth in local Peru market taken at 3% growth p.a ( Exhibit 1-5) GDP Growth rate of 3.42% (Average Analyst Projections for the year 2002-2003 normalized over long term growth)

Per capita beer consumption of Peru assumed to triple over 10 year time and matching global standards of 72 litres by terminal year
Income elasticity (0.498) incorporated into model as a lever of GDP Growth ( proxy for beer growth potential) This is multiplied with assumed increase of 3x in per capita beer intake to arrive at a macro economic proxy of 7.49% We subtract the given value with CPI Index ( inflation metric) factoring in assumed 5% price growth in beer * Negetive Price Elasticity( -1.676) arriving at net macro economic proxy= 6.89%

CASH FLOW GROWTH RATE-II

Cash flow growth taken as function of both fast growing macro economic factors + company specific performance

Company Specific Growth Rate

Historic EBITDA growth rate given in case =52.4% ( 50.4 mn USD(02) 31.69 mn USD(01)
The rate is normalized and reduced gradually with power of 5% decrease to arrive at terminal value growth rate of 2.39% ( To account for rising estimated competition locally and South American Brewery industry and unfavourable govt policy) Terminal Value Growth Rate = Function of long term Peru growth rate* Industry Beta Cash flow growth rate arrived for first 10 years 6.89%( Macro-economic proxy)+ 21.6% ( Company specific revenue growth) The arrived growth rate is accounted for a inflation of 2.5% assumed. Final cash flow growth rate used in DCF Model= 25.5%

DISCOUNTED CASH FLOW MODEL

( All figures in USD Mln)

QUESTION 1(b)
Can you think of an alternative way to value Backus based on the information of the case? Explain how you would do it, what the value would be and how it would differ from the DCF results.

RELATIVE VALUATION -I
( Data Source-Exhibit 16)- All figures in USD Mln
Approach-1 > Price/Sales Method

First we get the comparable south American targets and compute the average P/Sales multiple. ( 2.12) We multiply average P/S multiple with Company Sales (137.19) to arrive at market determined Firm Value ( 290.82 USD Mln) Dividing by number of open class A shares(87.2 mln), we finally arrive at a Share price of 3.35 USD

RELATIVE VALUATION-II
( Data Source-Exhibit 16) All figures in USD Mln
Approach-2 > EV/EBITDA Method First we get the comparable south American targets and compute the average EV/Ebitda multiple. ( 11.8)

We multiply average EV/EBITDA multiple with Company EBITDA (50.47) to arrive at market determined Firm Value ( 596.81 USD Mln) Dividing by number of open class A shares(87.2 mln), we finally arrive at a Share price of 6.84 USD

RELATIVE VALUATION- A RECAP

We find our classic RV approach using (EV/EBITDA) & (P/S) Method returning a firm value less than that of DCF Method.
FIRM VALUE DCF EV/EBITDA PRICE/SALES 7,124 596 291 VALUE OF SHARE 11.66 06.84 03.35

Class A shares used for computation of shares outstanding for RV method while sum of Class A+ Class I shares used to compute intrinsic value of stock Due to markets with less than 100% liquidity & synchronisation ( Exhibit 22-23) and less developed stock exchanges, shares are competitively under priced. stock prices do not reflect the fundamental and intrinsic value due to presence of different class of shares.

RELATIVE VALUATION- ANALYSIS

Company has a higher EV/EBITDA multiple compared to peer group showing it to be undervalued. It also reflects in the value of share computed on lower side (3.5 USD) A lower EV/EBITDA multiple (< 10) shows a matured industry with concentrated players evident in the company mix in major South American markets( Exhibit 1-5)

Price/Sales method showing a lower value due to vastly different operating margins of peer group and also nature of industry( stable income vis--vis negative profitability.

VALUATION- A FINAL WORD

Based on both intrinsic ( DCF) valuation & comparable study I arrive at the conclusion that market is right now over valued. As a method, I prefer DCF over relative valuation due to its strength in assessing the fundamental business model into estimation and hence a better gauge for investment strategy than RV as stock market is not fully developed in Peru. I would advise my client to hold/sell their holding if seen from a trading point of view with a 1-3 year horizon. However for an activist investment option, I recommend a BUY due to the vast synergies and operational improvement prospects.

QUESTION 2
Based on your valuations, can you make sense of the market price of Class A shares? Is that price the right one? How could you make sense of that price compared to price of your valuation?

CLASS A MARKET PRICE A RECAP

Only Class A shares have voting rights
Each Class I share is entitled to only onetenth the dividend and liquidation rights of a Class A share

Class A and Class I shares make up the common stock of the company

Class B shares constitute the preferred shares of the company and carry 1.1 times the dividend rights

CLASS A MARKET PRICE ANALYSIS

First we recomputed the shares per the voting & dividend rights segmentation as mentioned in previous slide.

Based on recalculated the final shares (140 mn) we arrived at revised price per share for the firm and subsequently for all classes of shares using case data. I find Class A shares overvalued(30 SOL (market) vs 17.58(valuation) per my analysis with marginal differences for Class I & Class B ( Exhibit 20) In contrast to financial theories stating value firms to be undervalued in market.

Exchange Rate: Peruvian Sol/USD= 3.53 Exhibit 17: Jan 03 forecast

CLASS-A MARKET PRICE CONCLUSION

Is the market price ( 30 SOL) correct? Though my study finds it overvalued but I do believe its in right direction. Class A market price is higher than normal firm market price owing to higher power with regards to voting and dividend rights on shares. Based on my valuation factoring in intrinsic factors, I believe the market is incorrect in valuing stocks due to inefficiency of emerging market, non optimal stock synchronisation and short term speculation in market throwing the value off the fundamental level. My models value ( 17.58) represents class-A voting equivalent share intrinsic value which contains Class I( 1/10th) and Class B( minimal amount after accounting for treasury stocks). If we take their effect away, the price will be slightly higher bringing closer to market price. I believe this is a market timing error and will revert back to the fundamental value of 17.58 in near future( As of 2002)

QUESTION 3
THE VALUE OF CLASS A SHARES AND CLASS I SHARES DIFFERS. HOW WOULD YOU EXPLAIN THIS DIFFERENCE? PROVIDE CORPORATE GOVERNANCE REASONS AND ALSO CONSIDER IMPACT OF LEVEL OF EFFICIENCY OF STOCK MARKETS IN EMERGING COUNTRIES.

DIFFERENCE BETWEEN SHARE CLASSES

CASE STRUCTURE
Only Class A shareholders have voting rights. Also, each Class I share is entitled to only one-tenth the dividend and liquidation rights of a Class A share. Class B shares constitute the preferred shares of the company and carry 1.1 times the dividend rights

FEATURES
Cash flow rights and voting rights altered in a multiple class shareholder structure. Superior shares i.e. in this case Class A shares trade at a premium over subordinated shares i.e. Class I shares, reflecting greater degree of control over strategic decisions of firm. Greater dividend to Class A shareholders stronger Cash flow rights for Class A shares The discount at which limited-voting shares (Class I) usually sell is attributed to firm fundamentals, as shareholders with limited voting rights are expected to appropriate a lower proportion of the firms future cash flows (Zingales, 1994 and 1995; Hauser and Lauterbach, 2004). This would cause a voting premium to emerge Extra Value of Class A shares can be attributed to private benefits of control Scope for opportunistic behavior increases leading to self dealing transactions, tunneling etc

DIFFERENCE BETWEEN SHARE CLASSES-II

INDUSTY NORMS
Companies that choose to have multiple classes issue two classes, Class A and Class B shares Common objective include provide its founders, executives or other large stakeholders with a different class of common stock that carries multiple votes for each single share of stock Commonly, the "super voting" multiple is about 10 votes per higher class share, although occasionally companies choose to make them much higher purpose of the super voting shares is to give key company insiders greater control over the company's voting rights, and thus its board and corporate actions existence of super voting shares can also be an effective defense against hostile takeovers, since key insiders can maintain majority voting control of their company without actually owning more than half of the outstanding shares Pvt benefits of control. In US 5% but in Peru say 25% but actually it is 75% as markets are not efficient Effect of liquidity - Edmans, Fang & Zur

Source: Investopedia

DIFFERENCE BETWEEN SHARE CLASSES-III

Corporate Governance Reasons + Impact in Emerging Markets
Dual class share structure enables the family controlling the business to prevent hostile takeovers as they always have the controlling rights even though they might happen to lose out on equity. This results in a weak market for corporate control Weak market for corporate control leads to inefficient stock markets stock prices do not reflect the fundamental and intrinsic value Existence of dual class shares would only be a problem if an investor believed the disproportionate voting rights were allowing inferior management to remain in place in spite of the best interests of shareholders. Families and senior managers can entrench themselves into the operations of the company, regardless of their abilities and performance. Finally, dual-class structures may allow management to make bad decisions with few consequences.

EXAMPLES
Ford's dual-class stock structure, allows the Ford family to control 40% of shareholder voting power with only about 4% of the total equity. Berkshire Hathaway Inc., which has Warren Buffet as a majority shareholder, offers a B share with 1/30th the interest of its A-class shares, but 1/200th of the voting power. Echostar Communications CEO Charlie Ergen has about 5% of the company's stock, but his supervoting class-A shares give him a whopping 90% of the vote.

Source: Investopedia

THE REPORT COMMISSIONED BY POLAR ARGUES THAT PREMIUMS OF 30%-50% ARE TYPICALLY PAID FOR CONTROL OF A COMPANY AND SUBSTANTIALLY SMALLER PREMIUMS ARE PAID FOR ACQUISITIONS OF MINORITY BLOCKS. IN YOUR OPINION, IS THE PREMIUM ON CLASS A SHARES PAID BY BAVARIA AND CISNEROS A PREMIUM FOR CONTROL THAT REFLECTS AN ACT OF COLLUSION ON THE PART OF THESE TWO FIRMS, AS THE REPORT SEEMS TO SUGGEST? ARE THERE ANY CORPORATE GOVERNANCE REASONS THAT COULD JUSTIFY THIS PREMIUM IF IT IS NOT A PREMIUM FOR CONTROL OF THE FIRM?

PREMIUM FOR CONTROL- A CASE

Bavaria (Columbia) and Cisneros (Venezuela) paid 111 percent and 62 percent premiums for Backus shares respectively. The two transactions gave Bavaria and Cisneros an aggregate 46 percent stake in the company and the right to nominate eight of the fourteen directors. Due diligence and escrow Only Cisneros, not Bavaria, launched a due diligence process and established an escrow account, following rule in this type of transactions. This indicates that because both companies "took control in collusive manner, only a single due diligence process and escrow account was necessary." Resignation of Directors Agreement to purchase Backus shares was conditioned on the resignation of all the directors and high officials of Backus and its subsidiaries. Cisneros could have only secured this condition had it been acting in collusion with Bavaria. Common legal defense Bavaria and Cisneros launched a common legal defense against the collusion complaints "to avoid any action that would have disturbed their ownership and right as shareholders.

PREMIUM FOR CONTROL- A CASE-II

Timing of transactions It is highly uncommon that negotiations for complex transactions would have taken place in such a short period of time (6 weeks) in the case of Bavaria's initial purchase and one week in the case of Cisneros
Similar selling price Once deductions are made for tax payments, both Cisneros and Bavaria paid the same price for the shares, which the "buyers as well as Backus have explicitly affirmed. confirming a case of share intelligence by competing firms.

Economic logic dictates that rational investor would not pay premiums of the magnitude paid by Bavaria and Cisneros for passive minority investment, but potentially would pay such premiums for investment that would provides control over target company because when their stake is taken in aggregate, they would have power to control 50% +of seats on Backus' board (up to eight of 14 seats if Cisneros completes its intended acquisition of shares)
Premium for control upto 50% makes economic rationale and if control not the main motive, then turning the company around and realizing its true potential. Eg. Internal audit to resolve execessive payment to suppliers etc to get operational control.

CORPORATE GOVERNENCE REASONS FOR PREMIUM PAYMENT

Under Peruvian law and Backus bye-laws, higher levels of ownership conferred additional rights. In this sense, strategic shareholders can yield significant influence over the decisions of the firm even if they do not control a majority stake. The rights of strategic shareholders include the following: With 5% of Class A shares, a shareholder gains the right to call a shareholders meeting. With 5% of the firms capital (Class A and Class B shares in the case of Backus), a shareholder gains the right to request certain information outside of the shareholders meetings. With each block of 7.14% of Class A shares that have effective voting rights, a shareholder gains the right to elect one person to the Board of Directors. With 10% of Class A shares, a shareholder gains the right to request revisions or special investigations about concrete items in the management of the firm with respect to matters related to the financial statements for the previous fiscal year. With 20% of Class A shares, a shareholder can request a court order to suspend any act that has been impungando (a decision taken by management without the approval of the shareholder), and can request the compulsory distribution of up to half of the profits in the form of dividends.

Source: Case Literature

CORPORATE GOVERNENCE REASONS FOR PREMIUM PAYMENT-II

With 25% of Class A shares, a shareholder obtains the right to postpone the shareholders meeting for three to five days.

Finally, with 40% of Class A shares, and this percent constitutes a majority of the votes at the shareholders meeting, a shareholder can request the elimination of the pre-emptive rights given to common stockholders.

In this case, Bavaria and Cisneros acquired in aggregate almost 46 percent which is more than 40 percent which meant they could eliminate the pre-emptive rights given to other common stockholders which certainly is not in favour of Polar.

Easterbrook and Fischel (1983) suggest that the premium of voting over nonvoting shares represents the opportunity of those with votes to improve the performance of the corporation. The liquidity risk affects shareholders willingness to invest in stocks and should be reflected in their prices. Megginson (1990) finds that low-vote shares are more actively traded than high-vote shares in his study of British dual-class firms and Zingales (1995) reports the volume in the highvote stock is less than half the volume of the low-vote stock on average. Therefore, due to illiquidity and reduced diversification greater risk and thus greater premium.

BESIDES THE CORPORATE GOVERNANCE REASONS THAT YOU HAVE THOUGHT OF IN QUESTIONS 3 AND 4, WHAT OTHER REASONS COULD BAVARIA OR CISNEROS HAVE FOR PAYING SUCH A HIGH PREMIUM?

BLOCK ACQUISITON MANDATE

STRATEGIC BUSINESS REASONS

High preference and brand loyalty for Backus. Extensive value chain strength of target. During 2002, Backuss revenues grew by 18.3% and net sales by 13.4% with projections in future tended at continuing double digit growth.

Improvements of gross margin (65.0%), operating margin (32.4%) and EBITDA (30.8%)
During 2002, Backus increased production capacity by buying new equipment, bettered its distribution channels and its storage capacity in certain plants by north of 80%. Backus has taken over smaller firms in the region to consolidate its position as a market leader in Peru. Its size has made it a strategic takeover target for several large firms in the region which see a chance to form a regional brewing group to counter the dominant position of of AmBev After acquisition of Cervesur, Backus has become sole producer of beer in Peru

Diversification of business bottom line with ready access to a growing economy.

BLOCK ACQUISITON MANDATE-II

STRATEGIC MACRO-ECONOMIC REASONS

The Peruvian government reduced the beer consumption tax from 65% to 54% and is expected to further reduce taxes in future. This translates into not only higher profitability but signals favorable government initiative in place, an important factor while dealing in a consumer intensive sector like brewery.
Potential growth in Peruvian beer market Recovery of consumer purchasing power Per capita beer consumption in Peru is one of the lowest (24 liters) and is expected to catch up with the developed nations with higher economic growth aiding more beer sales. Expected increase in the figure 3x in medium to long term. Favorable political climate with ousting of General Pinochet in late 1980s and more consumerist fervor in market. One of the most brand loyalist consumer segment in South America aiding in stable growth and translating into higher dollar revenue per marketing expense spent. Higher chance at creating societal & business synergies for better optimal control.

THANK YOU