They say the market does not offer any free lunches and for the most part this is true. However market inefficiencies are more common than the academics care to admit and while this Special Report update is not about a free lunch, I hope to show that there is at least a free bottle of Coke to be had in the acquisition of the North American operations of bottling company Coca-Cola Enterprises (CCE) by The Coca-Cola Company (KO). This is one of the most interesting and complex mergers I have come across since we started the Merger Arbitrage service in March. To clarify CCE is the bottling and distribution company that takes concentrate from KO, converts it into the various brands of fizzy drinks we are familiar with and sends them to retailers and other channels for sale. KO is the company that owns the brands like Coca-Cola, Fanta, Sprite, etc and sells concentrate to bottling companies like CCE.
How would you like to own a company that retires a significant portion of its outstanding stock (like a large stock buyback), increases its regular dividend by 39% (bumping the yield to approximately 3.08%), sends you $10 per share in cash and to top it all has another company take over all its debt and pension liabilities while retaining all the cash on the balance sheet? In return the company has to give up all its North American operations, retain its European operations and acquire additional European operations in Norway and Sweden. If such a company sounds interesting, then CCE should definitely be on your radar.
Why now?
This deal was announced on February 25, so why would I want to consider the deal now after all these months?
1. I saw a SEC form 4 filing after market close on Monday that indicated CCE’s Chairman and CEO acquired 7,000 shares on the open market last week. This is a vote of confidence and the timing is interesting because CCE is presenting at the Deutsche Bank Global Consumer Conference on Wednesday.
2. The CFO of KO reaffirmed on Monday that the deal is on track to close in the fourth quarter of this year. We are already near the end of the second quarter and hence the amount of time capital will stay tied in this deal is at most 6 months.
3. I recently read that CCE has become a favorite play amongst hedge funds. Despite this interest, the stock has dropped along with the rest of the market from a high of $28.80 in mid-April to its current price of $26.25.
Based on these catalysts, I figured it was time to elaborate on the deal for Special Reports subscribers and start a position in CCE. Given below are highlights of the deal and a short discussion about the valuation of the new company (new CCE) once the deal is completed.
Deal Highlights:
1. KO will acquire all the North American operations of CCE, while CCE will continue to retain its European operations. CCE will in principle acquire the Norway and Sweden bottling operations from KO for ~$822 million in cash. CCE also has the option to acquire KO’s German bottling operations within 18 to 36 months at fair value.
2. Upon completion of the deal, current CCE shareholders will receive $10 per share in cash and a share of the new CCE for every share of CCE they hold.
3. KO will assume $8.88 billion of CCE debt. KO will also assume $580 million of CCE’s North American pension liabilities. Essentially all of CCE’s current debt and most of their liabilities will be acquired by KO.
4. New CCE will retain all CCE cash, cash equivalents, marketable securities, and certain idle assets.
5. KO will retire its 34% stake in CCE (168.96 million shares) and new CCE will be 100% owned by common shareholders.
6. New CCE will launch a $1 billion stock buyback program following the completion of the deal.
7. Dividend for the new CCE will jump to 50 cents per share when compared to the 36 cents the old CCE is currently paying. The dividend yield will work out to 3.08% provided your purchase price is around $26.25 and you receive the $10 in cash after the merger completes.
8. EBITDA margins for new CCE are expected to jump to 16.1% from the current 12%.
Debt After Deal Completion:
Total Debt/EBITDA post merger is expected to be 2.9x. Since the new CCE is expected to generate $1.2 billion of EBITDA in 2009, new CCE should have $3.48 billion in debt when compared to the $8.78 billion in debt the old CCE held on its balance sheet as of December 2009. This new debt will be used to fund the Norway and Sweden acquisitions and to fund a $1 billion share repurchase program.
Calculating the Enterprise Value Post Merger:
CCE currently has 500.43 million total shares outstanding. Removing KO’s 168.96 million shares that they plan to retire, we should have 331.47 million shares left. Assuming the stock drops by $10 following the merger due to the $10 cash returned to stockholders, the stock price would be $16.25 based on Monday’s closing price of $26.25.
Multiplying $16.25 by 331.47 million shares gives us a market cap of $5.39 billion for the new CCE. Adding the $3.48 billion in new debt and subtracting the $1.036 billion in cash CCE already has gives us an enterprise value of $7.834 billion. I am not taking the $1 billion share buyback into account and if you were to include that, the EV would drop further.
Valuation:
If new CCE generates $1.2 billion in 2009 EBITDA as expected, the EV/EBITDA works out to 6.53. Compare this with the current CCE, which trades at an EV/EBITDA of 7.7 but has lower margins. While the Coca-Cola (KO) business is very different at this time, it should be noted that KO’s EV/EBITDA is currently 12.06 and Pepsico (PEP), which has already integrated its North American bottling operations has an EV/EBITDA of 12.72.
Overall I see this as a compelling merger and will start a position in my personal portfolio after this update is published.
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