In this analysis the Blue & White Investment Club will attempt to value Central European Distribution Company (CEDC) and its common stock.
CEDC, "The Company," is a Delaware corporation, started in 1997, which operates in the alcoholic beverages industry. CEDC is one of the largest producers of vodka worldwide and is Europe's largest integrated alcoholic beverage business by total volume. Operations involve the production and sale of their spirits and the importing of other brands to the European region. The majority of the operations are performed in Russia and Poland.
The company's common stock value has depreciated approximately $75 to $3 since July 2008. This is the result of internal and external events. Although alcohol has more negative income elasticity than most goods, the global recession in 2008 had an adverse effect. This external event exacerbated management's poor decision making.
CEDC purchased Whitehall Group, Russian Alcohol, and Parliament in recent years. These large acquisitions have a similar theme. Negotiations started before the recession hit, locking in CEDC as a buyer. As the economy fell, the firm's assumptions in valuing the acquisitions became overly optimistic. Goodwill from the acquisitions has since been impaired by approximately $1 billion in 2011.
Throughout the recent hard times, net sales (sales minus excise tax) have not performed badly. Net sales were $571 million and $877 million in 2008 and 2011, respectively. Profit, on the other hand, is another story. Due to the impairment charges and other administration costs, profit margin has been negative the past few years.
The decrease in profit margin introduced liquidity and solvency pressures. Recourse and non-recourse factoring have aided liquidity. In February 2011, Bank Handlowy and WBK waived covenants on the Company's interest coverage and net leverage ratios. Debt is approximately 80% of the capital structure (a mixed blessing given the writeoff of interest payments). Convertible Notes which mature in 2013 have been moved to 2016. The debt matures in 2016, providing the company with more outs.
In July 2012, the company concluded a strategic alliance with Russian Standard [RS] and affiliates. RS, which is owned by Rustam Tariko, should create large synergies in its high-end distribution business (Roust Trading) and banking division (Russian Standard Bank). Tariko currently owns a 28% stake in CEDC and intends to up his stake to a potential 43%, if approved by Polish regulators. He is currently a non-exec chairman on the board.
Since the RS deal, the company has had significant management changes. William Carey, CEO of CEDC has resigned and is receiving his golden parachute for approximately $5 million. He will remain as a consultant to the company until December 2012. The lead director, David Bailey, is serving as interim CEO.
To arrive at intrinsic value per share, we assigned an 80% probability that the company will continue as a going concern and a 20% probability of liquidation. The expected value [EV] representing the going concern and liquidation model comes out to $9.63. Since the current market price is approximately $3.00, significant alpha should be received.
Valuing CEDC as a going concern, we used a worst, base, and best case model. The difference between worst, base, best case models are the revenue and profit forecasts. These are the independent variables that are most sensitive and uncertain. We assigned equal weight of probability to worst, base, and best case models. This value was multiplied by 80%, which is the probability of a going concern.
The liquidation value is $0 due to the lack of assets against the firm's capital structure. Residual value is drowned by senior securities. Presumably, residual holders would be wiped out completely if this event occurs. Given this, we multiply the whole current share price of approximately $3.00 with the probability of liquidation of 20%.
The market is currently pricing shares with a liquidation probability higher than what is rational. In fact, if modeling for a 40% liquidation, shares should be approximately $3.50. We believe this is the product of market myopia, a common cognitive bias which overemphasizes the short term.
With much of the overpriced acquisitions already impaired (noncash), a new management pulse, and a beneficial strategic alliance, we propose going long. A catalyst to move the stock, such as a string of strong 10Q or 10K earnings, may take time as the company regroups. The optimal vehicle to utilize in this scenario is the underlying. Calls are thin and not trading at a long expiration date. For buying an out-of-favor stock, a margin of safety for time, not just share price, is preferred.
The goal of our approach was to be as conservative as possible for projecting revenue, and all other variables, over the excess growth period. Revenue was projected by functions of geographic and product categorical net sales. Geographically, we used Russia and Poland import and export sales in the sample size. We decided against including Hungary when cross referencing the categories due to its statistical and logical insignificance. Sales segments include an alcohol portfolio of domestic vodka, vodka export, imported beer, wine, and other spirits.
Poland's top line has decreased throughout the past few years. Poland's sales rebounded in 2011, we made the assumption of stagnation in our model.
Russia, as a geographic segment, has done very well for CEDC. We do not expect this trend to continue, for reasons that will be explained in the risks section of the analysis. Consequently, we have projected Russian sales decreasing 10% for 2012 in the geographic function. If viewing sales for product category, we have Russian vodka domestic sales decreasing 10%, vodka exports increasing 5%, ready to drink products increasing by 5%, and other spirits increasing by 5%.
To conclude, our estimates show CEDC sales for 2012 ranging from $815 million to $848 million. This is below 2011 sales of $877 million. In the two-period FCFF model that was used, which is explained in a later section, we used the $848 million revenue estimate for our best and base case scenarios.
Subsidiary and Affiliate Structure
There has been some discrepancies in analyst reports regarding the economic and voting rights of Whitehall Group. Page 29 of the 2011 10K and page 88 of the 2010 10K express a 100% ownership of both rights. (Russian Standard and affiliates are not inserted into the above image.)
Expected revenue for alcohol sales worldwide for 2012 is approximately $98 billion. Vodka has a 22% piece of the total market. Geographically, Europe has 41% of total consumption. Overall, industry profitability has declined due to economic conditions and an increase in raw material cost.
There is qualitative and quantitative industry information that is worth mentioning regarding CEDC. Industry profit margin is 15%. This is a benchmark that CEDC was once hitting. Keeping this in mind, the industry is in a mature life cycle with heavy regulation. We postulate that if the Company's worst days are passed, it is reasonable to expect industry profitability. We use a 13%, 10%, and 5% profitability rate for best, base, and worst cases respectively.
Key success factors of the industry provide an understanding to some of the Company's shortfalls in recent years. These are:
- Economies of Scope
- Control of distribution arrangements
- Effective product promotion
- Economies of Scale
- Export market
- Understanding market needs
Russian Standard Alliance
The Russian Standard alliance, which was finalized in July 2012, should improve the Company's results. RS has already provided a lifeline, using its subsidiary Roust Trading Limited to purchase $100 million in common stock and exchangeable notes to exhaust the Company's 2013 debt. The "New debt deal" between Roust and CEDC involves backstop and rollover notes due 2016.
The synergies created in the alliance between CEDC and RS should be significant. Roust is the largest distributor of premium products in Russia. RS's other affiliate, Russian Standard Bank, should help with short term financing and banking needs moving forward.
The owner of RS, Rustam Tariko, is a chairman of the board and will undoubtedly play a role in the firm's strategy. Tariko is an entrepreneurial genius, becoming a billionaire from nothing. In 1992 he started Roust, by 1994 it was Russia's largest importer of premium products. Tariko was doing business with Diagio, an alcoholic industry leader, until 2005 when Diagio terminated its contract with RS alcohol. Many have said that this act frustrated Tariko to a high degree. We believe that Tariko will have a strong positive impact on CEDC results.
For CEDC shareholders and prospective shareholders, this alliance could not get much better. Nothing more than an outright tender would provide more value in our view.
When CEDC began acquiring other companies such as Whitehall, Russian Alcohol, and Parliament Group, global markets were at the top of a positive feedback loop. This made management at CEDC optimistic about its future and the future of prospective buyouts. To provide the reader an understanding of the optimism by management, we would like to delve deeper into the value shareholders received by the Whitehall purchase.
The Whitehall purchase can be seen below. The entirety of the acquisition was performed over a couple years. The final purchase price was approximately $420 million.
There was also another payment, which was said to be for working capital (date not disclosed). This $7 million payment was a strange sign. It is illogical why Whitehall, which we will see shortly was valued optimistically, would need a few million for working capital. Unfortunately for shareholders, management's apparent overzealousness for the deal left them with few real options.
The value to shareholders of the acquisition is a function of not only the price paid, but what was received. Control of Whitehall has been a fragmented process. First, CEDC controlled 49% and 75% percent of voting and economic rights, respectfully. On February 24, 2009, the company received 375 Whitehall class B shares, increasing its economic rights from 75% to 80%. Lastly, on February 7, 2011, CEDC gained the remaining economic and voting rights, as well as the rights to the Kaufman vodka brand.
Determining the value of Whitehall is problematic since it was a part of WHC Holding Limited. CEDC used a discounted cash flow method to value Whitehall before its purchase. There are two pieces of information which can guide in valuing the acquisition. In 2010 CEDC received a $10.9 million dividend. If you simply use a breakeven analysis without the use of discounting, it would take CEDC approximately 39 years to recoup its investment. In fact, using the inputs of what was paid, a dividend readjusted for 100% rights to CEDC and a 12% discount rate (which CEDC uses for Russian operations) produces a growth rate of 8.9% in perpetuity. We are not sure if it was incompetence, hubris, or possibly an inexperienced overconfidence that played a role in management's decision making. Granted, hindsight is 20/20 and information at the time may have warranted such a large amount of goodwill.
We also found it strange that CEDC changed its accounting methods for the acquisition on several occasions. On Jan 1, 2010 the company changed its accounting method from consolidation to equity method. The 2010 10K stated that the purchase method of accounting was used in accordance with SFAS 141; a way to measure fair value of business combinations. On page 71 of the 2010 10K , liabilities of the acquisition were ambiguous. With strange accounting usage in mind, we refrained from doing an analysis of foul play due to the ex-post facto of the impairment charges of the past year (2011).
The large impairment charge of over $1 billion dollars in 2011 makes us believe that over optimism of Whitehall was not an isolated event. The Company paid $180 million cash and 22 million common A shares for Parliament Group in March 2008. We believe that with the guidance of Mr. Tariko and new management, events like these will not continue indefinitely.
The Company's ability to meet its maturity payments in 2016 is a sizeable function of share price. Conceptually, if the Company can create operating profit greater than or equal to the debt, then the Company will continue as a going concern. In this scenario, there is residual value to the shareholder. If the Company is unable to meet its debt payments, assets will be liquidated. There are other cases as well, such as the Company not hitting the mark, but still refinancing, or only selling off a division. In our worst, base, and best cases, CEDC will be able to create enough room to cover its debt by 2016.
In December 2009 the Russian government stated that it would like to reduce alcohol consumption by 70% by year 2020. This is quite bearish news for the company, but it is difficult to take at face value. All the marks of cutting alcohol consumption to this point have failed. In a BBC article, President Mcdevdev said he wanted to reduce consumption by 25% by 2012, which has not occurred. In Putins "national plan;" his first phase of cutting consumption by 15% per capita has not been achieved. In part two of Putin's plan, he desires to eliminate the illegal market, and reduce consumption by 55%. We are speculative about the intentions of the Russian government. Do they want to eliminate the illegal market as a way of bringing in more tax dollars or create a healthier environment? In reality, it is probably a combination of both. We believe the crack-down on black market sales will help counteract decrease in consumption.
There is currently a class action lawsuit due to CEDC overstating revenue by approximately $40 million in Russian Alcohol group. The June 1, 2012 8K states that, "as a result of the preliminary findings of that review, which is ongoing, senior company management determined that the company's reported net sales in the years ended December 31, 2010 and 2011 failed to reflect the timely reporting of the full amount of retroactive trade rebates provided to RAG's customers in Russia." It is improbable that the lawsuit will have a material effect on share price.
To value CEDC, we chose to use a free cash flow to the firm model [FCFF]. FCFF is simply the amount of cash flows a firm generates that are available to security holders. The equation we used is: FCFF = Net Income - Non-cash charges + After-tax interest expense - CAPEX - Change in Working Capital. We used a two-period model with a projected five year excess growth period and a long-term period which we will refer to as terminal value. We then discounted the projected cash flows back to present time using the weighted-average-cost-of-capital [WACC] and summed them. To arrive at a per share value, we added back current assets, then subtracted current and long-term liabilities from the sum of FCFF. Dividing this number by total shares outstanding provided a true value per share.
- Risk free rate: 6.49% for 10-year T-bond (rates are at historic lows so as a conservative measure we took the average from 2002-201; this will increase the discount rate)
- Risk Premium: 5.79% average over T-bond (this was taken from Damodarian)
- Tax rate: 21% blended rate taken from most recent 10Q (Q1 2012)
- Shares outstanding: 88,842,022 (accounted for the 10 million shares to be issued in accordance with the "Amended Securities Purchase Agreement")
- The 10 million shares that will be issued could keep the share price stagnant for a short period due to the increased float size
WACC is the cost of equity and debt weighted to the Company's capital structure. Cost of equity was estimated using CAPM. To calculate beta of equity, the percentage monthly returns for CEDC were regressed against the S&P 500 over the period of 2002 - 2012 to get a beta of 1.85. This date range was chosen because it matches the range used for the risk-free rate, accounts for periods of growth for CEDC, and also encompasses the recent downfall in share price. Therefore, the cost of equity came out to be 17.21%.
Since the Company's debt structure has changed significantly, the cost of debt was more difficult to determine. The "New Debt Deal", which was implemented on July 9, 2012, has been included into the calculations. First, we laid out the Company's debt, which is all due in 2016. Interest was assumed to be paid on an annual basis. Cost of debt was calculated as a function of face value [FV] weight rate to maturity, weighted rate to maturity, and weighted interest payments. This came out to 8.1% for 2012 and 6.42% after-tax for 2012.
D/V and E/V were calculated using market values [MV]. MV of debt was found by using weighted interest rates, interest payments, and maturity. MV of debt and equity for 2012 equal $1.17 billion and $266 million, respectively. Therefore, D/V and E/V equal 81% and 19%, respectively. WACC is 8.42% for the beginning of 2012. Since this model assumes a five-year excess growth period, all WACC and subsequent calculations were recalculated on a rolling year-over-year basis.
Interest Expense Forecast
CEDC has taken on significant amounts of new debt as a part of their ongoing overhaul of operations. They currently have six bonds outstanding due in 2016 which will be a burden when the principal payment is due. As a part of the deal with Roust Trading, large amounts of debt have either been issued or changed. The "New Debt Deal" matures in 2016 with interest to be paid in new shares of common stock through 2015. The "Rollover" and "Backstop" notes interest will also be paid in new issues of common stock through 2014 and 2013, respectively. The following table outlines all current debt on CEDC's books.
When forecasting future interest expense, we assume all payments are made on an annual basis. The years that interest will be paid in common stock do not affect total interest payments for the year, but are accounted for when that period has ended.
FCFF Model (Base Case)
There are many moving parts to the model that was used along with many forecasted values. It was our intention to make each of these values as conservative as possible for the base case model (and even best and worst case). Revenue forecasts have been explained in previous sections and those numbers feed directly into the model. Revenue is modeled to grow at 3.5% per year which we assume to be average GDP growth. Profit margin was difficult to forecast due to the relative inconsistency in the Company's performance throughout the past six years (see below). This has been mainly due to large write-downs of goodwill, growing interest expenses, or foreign exchange loss and benefits.
A profit margin of 10% was used for base case. This is a conservative number, which is lower than what CEDC have achieved in the past.
Non-cash charges [NCC] was taken as a percentage of sales. NCC as a percent of sales was calculated for the period of 2006 - 2012 and averaged together. For each year we took out all extraordinary items based on our judgment. These items include FX losses or gains and impairment charges. The percentages averaged together come out to 8%.
The Company states that capital expenditures [CAPEX] will be between 10 and 15 million per year through 2015. For the model we took the average of the two numbers to get 12.5 million CAPEX per year. We also made the assumption that this will be somewhat close to the amount of CAPEX in 2016 as well.
Working capital [WC] also varies with sales. Therefore, an average was taken from 2006 - 2012 and was determined to be 46% of sales. The FCFF model uses the change in WC in its calculation so each year's WC is equal to the current year minus the previous year's WC.
This model assumes a five year excess growth period because it projects cash flows for each year that all of their debt is still outstanding. These debt payments are going to be a big catalyst for growth at CEDC in the years to come and have previously been a large source of all of their problems. The "New Debt Deal" with Roust Trading mainly involved either adding on more debt, retiring old debt, or adjusting current debt. The five year growth period is the optimal length since it accounts for all interest to be paid.
The model is dynamic as it changes as time passes for CEDC. To make the most realistic model possible, we adjust CEDC's capital structure and other items as each year passes. We label this "Rolling Capital Structure" and can be seen in the image below.
MV of debt will change each year due to time left to maturity and differing interest payments. The differing interest payments were laid out in the previous section. MV of equity (the product of shares outstanding and share price which for each year is assumed to grow at the cost equity for each year) will also change because through 2015, additional shares will be issued to pay for interest in place of cash.
In calculating the cost of equity for each year, our thought process was that as time passes, CEDC's volatility will decrease. Therefore, we project beta of equity to decrease at 5% per year and level off for terminal value. WACC is recalculated each year using the updated inputs. FCFF for each year is discounted to PV using that year's WACC. Using the method outlined above, we arrive at an intrinsic value per share of $13.03 for the base case model.
Terminal value is what the business is projected to earn in perpetuity and accounts for the bulk of CEDC's intrinsic value per share. Terminal value is calculated as the last year's FCFF. In this case, it is 2016 divided by the WACC for that year. Numerically, the terminal value of $2.5 billion is discounted at 9.12%, and comes out to $1.77 billion.
FCFF Model (Best Case)
The FCFF model for the best case scenario uses similar assumptions as the base case (except for growth rate and profit margins). Profit margin is projected to be 13%, which we feel is still on the conservative side for a best case analysis. If we look at years past, from 2006 - 2007, CEDC has profit margins of 23% and 20%, respectively. Their margins have been very sensitive in the past to foreign currency translations and have been the cause of their wide swings. Therefore, we feel 13% is not an unrealistic number. For best case we also adjust growth upwards to 15.02% which is the expected five year growth rate for the consumer goods sector. This produces an intrinsic value per share of $20.00.
FCFF Model (Worst Case)
Worst case model scenario makes adjustments for profit margin. Profit margin is projected to be 5%. We keep the growth rate at 3.5%. Looking at CEDC's past, even in recent years where margins were negative, they still generated positive revenue growth. We see 3.5% as an attainable number even in a worst case scenario.
This model gives us an intrinsic value per share of $5.35.
Our expected value per share is a function of the base, best, and worst case scenarios. We assigned equal weights to each scenario to determine an EV for CEDC as a going concern and then we subtract from that what shareholders would lose in the event of liquidation. If liquidation were to occur, we believe shareholders would lose everything and the stock price would go to zero. To calculate a final EV per share, we assign an 80% probability for CEDC to continue as a going concern and subtract a 20% liquidation probability. This produces an EV per share of $9.63. This can all be seen in the image below.