EMPRESAS POLAR vs. BAVARIA, S.A

ACQUISITION OF MINORITY BLOCKS OF BACKUS & JOHNSTON’S VOTING STOCK

A INTERNATIONAL CORPORATE GOVERNENCE CASE STUDY

CASE SUBMITTED TO: PROFESSOR LOPEZ DE SILANES

STUDENT DETAILS

NAME VINEETH VIJAYAN

COURSE MS FINANCE

TRACK CORPORATE FINANCE & BANKING

ROLL NUMBER 1303017 JANUARI 2014

• 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 ASSUMPTIONSKey Input Metric

COST OF EQUITY

METRIC VALUE REMARK

Risk free rate 4.7% Peruvian Brady Bonds corrected for country risk

Levered Beta 0.7 Based on Exhibit 22. Stock Market Synchronocity

Equity Risk Premium 9.01% Country base equity spread. http://pages.stern.nyu.edu/~adamodar/

Cost of Equity 11.0% Using the Classic CAPM Model for market

MACRO ECONOMIC INPUTS

METRIC VALUE

PERU LONG TERM GROWTH RATE

3.42% (Exhibit 18)

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

CAPITAL EXPENDITURE GROWTH RATE

7%

Based on industry standards accounting for firm’s 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)

Exhibit 19: Financial Results of Backus &

Johnston Company.

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

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%

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

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 southAmerican targets and compute theaverage P/Sales multiple. ( 2.12)

• We multiply average P/S multiplewith Company Sales (137.19) toarrive at market determined FirmValue ( 290.82 USD Mln)

• Dividing by number of open class Ashares(87.2 mln), we finally arriveat 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 southAmerican targets and compute theaverage EV/Ebitda multiple. ( 11.8)

• We multiply average EV/EBITDAmultiple with Company EBITDA(50.47) to arrive at marketdetermined Firm Value ( 596.81USD Mln)

• Dividing by number of open class Ashares(87.2 mln), we finally arriveat 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.

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.

FIRM VALUE VALUE OF SHARE

DCF 7,124 11.66

EV/EBITDA 596 06.84

PRICE/SALES 291 03.35

RELATIVE VALUATION- ANALYSIS

Company has a higher EV/EBITDA multiplecompared to peer group showing it to beundervalued. It also reflects in the value of sharecomputed on lower side (3.5 USD)

A lower EV/EBITDA multiple (< 10) shows amatured industry with concentrated playersevident in the company mix in major SouthAmerican markets( Exhibit 1-5)

Price/Sales method showing a lower value due tovastly different operating margins of peer groupand also nature of industry( stable income vis-à-visnegative profitability.

VALUATION- A FINAL WORD

Based on both intrinsic ( DCF) valuation & comparable study I arrive atthe conclusion that market is right now over valued.

As a method, I prefer DCF over relative valuation due to its strength inassessing the fundamental business model into estimation and hence abetter gauge for investment strategy than RV as stock market is not fullydeveloped in Peru.

I would advise my client to hold/sell their holding if seen from a tradingpoint of view with a 1-3 year horizon.

However for an activist investment option, I recommend a BUY due tothe 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 one-tenth the dividend and liquidation rightsof a Class A share

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

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

CLASS A MARKET PRICE –ANALYSIS

First we recomputed the shares per thevoting & dividend rights segmentation asmentioned in previous slide.

Based on recalculated the final shares(140 mn) we arrived at revised price pershare for the firm and subsequently forall classes of shares using case data.

I find Class A shares overvalued(30 SOL(market) vs 17.58(valuation) per myanalysis with marginal differences forClass I & Class B ( Exhibit 20)

In contrast to financial theories statingvalue 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 model’s 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 firm’s 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 theyalways have the controlling rights even though they might happen to lose out on equity. This results in aweak market for corporate control

Weak market for corporate control leads to inefficient stock markets stock prices do not reflect thefundamental 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 super-voting 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 percentpremiums for Backus shares respectively. The two transactions gave Bavaria andCisneros an aggregate 46 percent stake in the company and the right to nominate eightof the fourteen directors.

Due diligence and escrow Only Cisneros, not Bavaria, launched a due diligenceprocess and established an escrow account, following rule in this type of transactions.This indicates that because both companies "took control in collusive manner, only asingle due diligence process and escrow account was necessary."

Resignation of Directors Agreement to purchase Backus shares was conditioned onthe 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 withBavaria.

Common legal defense Bavaria and Cisneros launched a common legal defenseagainst the collusion complaints "to avoid any action that would have disturbed theirownership 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 themain 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 conferredadditional rights. In this sense, strategic shareholders can yield significantinfluence 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 shareholdersmeeting.

With 5% of the firm’s capital (Class A and Class B shares in the case of Backus), ashareholder 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, ashareholder 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 orspecial investigations about concrete items in the management of the firm withrespect 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 anyact that has been “impungando” (a decision taken by management without theapproval of the shareholder), and can request the compulsory distribution of up tohalf 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’ meetingfor three to five days.

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

In this case, Bavaria and Cisneros acquired in aggregate almost 46 percent which is more than40 percent which meant they could eliminate the pre-emptive rights given to other commonstockholders which certainly is not in favour of Polar.

Easterbrook and Fischel (1983) suggest that the premium of voting over nonvoting sharesrepresents 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 intheir prices. Megginson (1990) finds that low-vote shares are more actively traded than high-voteshares in his study of British dual-class firms and Zingales (1995) reports the volume in the high-vote 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 greaterpremium.

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, Backus’s revenues grew by 18.3% and net sales by 13.4% with projectionsin 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, betteredits 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 marketleader in Peru. Its size has made it a strategic takeover target for several large firms inthe region which see a chance to form a regional brewing group to counter the dominantposition of of AmBev After acquisition of Cervesur, Backus has become sole producerof 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 isexpected to further reduce taxes in future. This translates into not only higherprofitability but signals favorable government initiative in place, an important factorwhile 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 tocatch up with the developed nations with higher economic growth aiding more beersales. Expected increase in the figure 3x in medium to long term.

Favorable political climate with ousting of General Pinochet in late 1980s and moreconsumerist fervor in market.

One of the most brand loyalist consumer segment in South America aiding in stablegrowth and translating into higher dollar revenue per marketing expense spent.

Higher chance at creating societal & business synergies for better optimal control.

THANK YOU