Brewing a monopoly

Beer is named the 3^rd most popular drink in the world, just behind water and tea. Sri Lanka ranks at 49^th place out of a 50 country list in terms of per capita beer consumption. In 2013, Sri Lanka’s beer production was 120.2 million litres. (well! That sounds a lot of beer for 15.3 million 15+ Sri Lankans). However, in global terms it is just drop in the bucket. In Asian region Sri Lanka’s production is just a mere 0.2% or slightly lower. What was most interesting about the beer production in Sri Lanka is that the production has increased at a 21% CAGR over the five years from 2009 through 2013. This is exactly the period where Sri Lanka has been in peace after a 30 year old conflict and the period Sri Lanka saw the highest growth in tourist arrivals to the country. The graphs below showclearly that peace and resultant tourist arrivals have enabled the Lankan beer industry to achieve a fast growth rate. (of course, needless to say peace helps any industry to thrive not just the beverage industry) 

Similarly, the number of new licenses issued has also grown at a momentous pace. 

As of CY2013, Sri Lanka had 24 licensed liquor manufacturers. Of them only three players were beer manufacturers. Amongst the three manufacturers LBL dominates the market with a 75% market share based on the beer manufacture (a drop from 83% in 2009). The balance is shared between APBL and MBL with 14% and 11% market share respectively. 

Market Share 

Total beer market of Sri Lanka can be estimated at around LKR34.4 billion.

The Players

Asia Pacific Brewery (Lanka) Ltd

APBL is 60% owned by Singapore-based Asia Pacific Breweries Ltd. The rest of the holding is held in partnership with Sri Lankan-based Anandappa family group and MBL Offshore Limited, wholly-owned subsidiary of Phoenix Beverages Limited, which is a leading beverage group from Mauritius.

APBL offers the Anchor, ABC Stout, Baron's Strong Brew and local beer brand Bison Super Strong in Sri Lanka.They also offer Heineken brands in Sri Lanka as well. 

Millers Brewery Ltd

MBL came under Sri Lankan conglomerate Cargills (Ceylon) PLC with the acquisition of the renownedMcCallum Brewery Limited through fullyowned subsidiary Millers Brewery Limited.MBL offers the famous brands ‘Three Coins’, ‘Irish Dark’, ‘Sando’ and ‘Grand Blonde’ etc.

Lion Brewery (Ceylon) PLC

LBL is a subsidiary of Ceylon Beverage Holding PLC which is part of diversified group called CarsonsCumberbatch PLC. Both LBL and its parent companies are listed on the Colombo Stock Exchange (CSE). The group structure of the company is given below. 

Acquisition of competition

In a recent acquisition of MBL by LBL, the industry was consolidated by LBL by effectively regaining the lost market share.As per the public announcement; the purchase consideration paid by LBL was LKR 5.15 billion (without debt). 

Post-acquisition price movement

The public announcement of the proposed acquisition was made on the 20 June 2014. With the announcement, the price of LBL went up significantly with the investors factoring in the impact of the acquisition. Interestingly, not only did LBL move up; so did the parent company and the ultimate parent Bukit Darah PLC.  

The total market capitalization of LBL pre-acquisition was LKR 34.4 billion (on 18 June 2014) and at the close of business on 20 June 2014 it was at LKR 35.512 billion, just up by LKR 1.112 billion. The increase was just 22% of the acquisition price paid (or suggested). However, the momentum continued and by 14 July 2014, LBL was valued in the market at LKR 54.736 billion adding a staggering LKR 20.336 billion to the pre-acquisition market cap (which is almost 4 times as much as the price paid!). As of my writing, the company is valued at LKR48.6 billion, at a share price of LKR 607.60. Had the market factored the exact value the Company paid to buy MBL, the market cap would have been at LKR 39.55 billion with a per share value of LKR 494.38.

Was it value accretive or dilutive?

Well, that depends. Not that every acquisition is necessarily value accretive or vice versa. For instance, there are enough examples of disastrous acquisitions done by some very well-known companies. If you could remember, HP’s acquisition of Autonomy for $11 billion and subsequent write off of $8.8 billion is a classic recent example of a dreadful acquisition. In the beer industry, one noticeable recent acquisition was Heineken’s $24 bn acquisition of Asia Pacific Breweries completed in 2012.

In the case of acquisition of MBL by LBL, lack of public information (given that MBL is a private entity) makes it difficult to suitably look at the accretive/dilutive impact on the acquirer. The acquiring firm also did not mention the exact motives behind the acquisition, though it was only clear that it’s an effort to gain market share by eliminating the 3^rd largest player in the market. The chairman, however in his discussion, mentioned in the Annual report that they look to enhance volumes and profitability via the acquisition. As per available numbers, this acquisition would potentially lead the beer industry in Sri Lanka to a Herfindahl-Herschman Index (HHI) number of 8,117 from current 5,942, signifying even more industry concentration. (yet more concentrated than the 2009 index of 7,094; note that an index number closer to zero signifies perfect competition while 10,000 is indicative of a monopoly). Interestingly, Sri Lanka does not have anti-trust law that would prohibit LBL from creating a beer monopoly in the future and that this acquisition, in my opinion, has laid the foundation for the creation of a beer monopoly in Sri Lanka. That is good news for the shareholders.

Whether there was an intention to cut costs, enter attractive new markets, etc is not known yet. Even if the intention was not there, if they were not able to achieve these synergies; post-acquisition there is massive potential for this acquisition to be value destroying. Without an idea on the cost structures and margins at MBL, I’m unable to gauge the impact of the acquisition on LBL’s earnings. I would only assume that LBL will be able to maintain the same operating performance at MBL level post-merger as well. In that light, I believe that the acquisition of MBL would generate them return on capital in excess of the cost of debt for the deal. (My belief is that the acquisition was funded by LBL with debt as evidenced by the increased borrowings on the balance sheet, see tables below of the debt position and cash position) Over the last five years, LBL has on average generated return on equity of c.21.4% which is in excess of cost of debt for LBL which is currently rated AA- by FitchRatings. 

Moreover, I believe that post-merger; LBL will enjoy a market share of c.86% (or more) which should enable them to be more profitable. 

Pricing the deal

Cargills (Ceylon) PLC interim financials for the period ended 31 March 2014 reveals that the beverage segment was not contributing towards the profitability of the Group. Hence, I assume that there is no meaning in looking at the trailing PE to evaluate the deal pricing. However, looking at the market share data I tried to approximate the topline of MBL. Based on data I estimate their revenues to be c. LKR3.859 billion. At an acquisition price of LKR 5.15 billion the deal is priced at 1.3 times a Price to Sales multiple. This was exactly equivalent to the P/S multiple LBL was trading at on 18th June 2014.  (based on trailing revenue of LBL).

Also based on the available data, the deal is valued at P/B of 2.56x. Comparably, LBL was trading at 4.96x price to book at 18^th June 2014.

I also deconstructed the purchase consideration as follows.

Since, LBL bought a private entity the pricing seems to be not as high as it would have been for a public company acquisition, in which case normally the buyers have to pay a premium over the market price. Further, the market prices would also move up before the acquisition due to market rumors and that might lead to potential over-payment in a market transaction. My belief is that the above approximate pricing metrics also suggests this verity.  

Value of the combined entity

I have also done a valuation of the combined entity in order to see its valuation based on the DCF method.

Bottomline

Overall I believe that market has so far over reacted to the acquisition and based on my valuation LBL is currently over-priced by around 17%. In terms of the acquisition, it makes sense for them to acquire competition which should allow them to be cost efficient, grow faster, compete stronger, etc. Moreover, the acquisition has been made at the right time when the industry is growing fast. However, regulatory risks, operational risks at MBL level would be significant risks to watch for.