Investors in Mondelez International (NASDAQ:MDLZ) had a great week. Shares have risen some 7% after the company released its first quarter results and announced its intentions to combine its coffee operations with D.E. Master Blenders 1753.
The Tie Up With D.E. Master Blenders
Mondelez will combine its coffee operations together with D.E in order to create a new coffee giant to be called Jacobs Douwe Egberts (JDE).
The new company will generate revenues of more than $7 billion on which it expect to generate EBITDA margins in the high teens. JDE will be based in the Netherlands and will operate in $81 billion global coffee market, still trailing Nestle's which is known from Nespresso and Nescafe, among others.
JDE will have numerous brands which should bode well for revenue synergies including the brands Jacobs, Carte Noire, Gevalia, Kenco, Tassimo, Millicano, Douwe Egberts, Pilao and Senseo, among others.
The coffee business of Mondelez generated revenues of $3.9 billion in 2013 while D.E. Master Blender's revenues came in at $3.4 billion. Following the deal Mondelez will receive $5 billion in cash and hold a 49% equity stake in the new company.
The remainder of the equity will be held by AHBV which currently owns D.E. Master. The deal is expected to close in 2015.
First Quarter Headlines
Besides announcing the details of the massive coffee tie-up, Mondelez reported its first quarter earnings.
Mondelez reported a 1.2% decline in revenues coming at $8.64 billion. Strict cost discipline resulted in operating income of $843 million, which is up by 1.1% compared to last year. Organic revenue growth was 2.8%, driven by strong pricing.
Net earnings took a plunge, falling from $542 million to just $150 million as interest expenses ballooned to $720 million. The jump in these expenses was related to losses being realized on the early retirement of some of the company's debt.
Margin Expansion Targets
Mondelez is accelerating its supply chain reinvention program and targets to reduce overhead costs. A $3.5 billion cost restructuring charge will cost the company $2.5 billion in cash, yet it should save the company an estimated $1.5 billion in costs by 2018.
As a result, adjusted operating income margins are seen at 15-16% by 2016, expected to expand further in the years following.
Mondelez ended the quarter with $2.4 billion in cash and equivalents while total debt approaches $19 billion. This results in a sizable net debt position of around $16.6 billion.
The $5 billion in cash to be received upon completion of the transaction could cut its net debt position significantly. On top of this comes the equity stake in JDE which could be worth billions as well, as outlined below.
For the year of 2013, Mondelez reported revenues of $35.3 billion on which it reported adjusted earnings of $2.3 billion. Excluding the coffee business, revenues are seen at little above $31 billion.
Assuming that adjusted operating margins could come in at 16% by 2016, this would result in adjusted operating earnings of around $5 billion. Applying interest rates of 5% on its debt and tax rates of 33%, net earnings could come in around $2.8 billion.
As the new combination reports revenues of $7.3 billion on a pro-forma basis, and reports EBITDA of 17.5%, the combination would create report EBITDA of $1.3 billion. Given the multiples paid for acquisitions of leading brands these days, a valuation of $10-$13 billion could be attainable. This would create another $5.0-$6.5 billion asset for Mondelez.
Takeaway For Investors
It has been a good news show for investors in Mondelez this week. The company appears to have made a great deal in the coffee business while the aggressive expense reduction targets allow for a jump in future operating earnings.
That being said, at $38 per share the company already commences a valuation of $65 billion. This values the company at 23 times GAAP earnings which are potentially attainable in 2016, while the net debt position will be quite low following the deal with D.E. Master.
Adding an additional $1.0 billion in GAAP earnings, after accounting for normal tax rates on $1.5 billion in cost savings, earnings of close to $4 billion by 2018 are within reach. This values equity in the business at 16 times today's valuation.
Therefore I remain very cautious and stay on the sidelines.