Bank of Nova Scotia acquires ING Direct Canada (2012)

Although this is not the deal of this week for this deal took place almost a year ago however this deal is certainly not as boring as the Blackberry sale likely to take place very soon (If I had been a Blackberry shareholder, that day would be my Christmas eve). Bank of Nova Scotia acquired ING Direct, ING's Canadian retail and commercial banking business, in 2012. The deal was announced on the 29th of August 2012 and was completed on the 15th of November 2012. The deal is interesting at least from three perspectives - How the deal took place, What is in it for Scotia, and How the banking industry is shaping up in Canada.

The Global Banking Industry

The banking industry across the globe has undergone a phenomenal shift aftermath of Lehman crisis and amidst the onslaught of Global Financial Crisis. Changing environment, both political and economic, has brought about changing demographics (including social and cultural behavior), changing customer needs and expectations, and changing reputation of the industry. These trends have forced the industry monitors across the globe to bring about regulatory changes and strict surveillance on the progress and this is one stage in the history of banking industry when the regulatory changes are jurisdiction specific and so international banks needed to take this in to consideration. The industry has undergone a largest ever consolidation in its history and today a few banks, in each of the dominant economies in the world, hold majority of the market share. For e.g. in the US, the top six banks hold about US$ 9.8 trillion of the ~ US$ 14 trillion assets and contribute to about 65% of the total banking activity in the country. Similarly in Canada, the top six banks account for 90% of the total banking operations and control more than 90% of the total ~ C$ 4.5 trillion assets. As a result of the financial crisis, the banking industry diversified from its traditional retail and commercial banking operations in to wealth and asset management. Aging population particularly in the western world has further increased the need for wealth management products. In addition, concentration of wealth in the hands of few individuals (particularly during the crisis, the rich get richer and the poor get poorer) has encouraged the banks across the globe in offering moderate risk and high reward wealth management products. We have also seen a huge reduction in the loan to deposit ratio and banks have become more conscious about proprietary trading activities, which typically require large amount of capital and is a high risk high reward game. Large banks have also intensified their Investment Banking operations as a result of M&A activities in many other sectors such as Telecommunications, Transportation, Information Technology, and Pharmaceuticals. Particularly in Canada, the banking system continues to support the M&A activity in the economy. It is estimated that the banking industry is likely to grow at a CAGR of 8% to reach ~ US$ 163 trillion by 2017 however it goes to see how the industry shapes itself to the changing environmental landscape.

ING Direct Canada

In 2008, after the financial crisis, ING group (Netherlands) together with all other major banks in Netherlands took capital injection from the Dutch government. The support increased ING's capital ratio above 8% however as a condition of Dutch state aid, EU demanded many structural changes. The Dutch government provided ING with Euro 10 billion and as against this aid, EU required ING to divest its Insurance and Investment management operations by end of 2013. In addition, the Dutch government also held securities and veto rights on major operational and investment operations that ING would carry out. This forced ING to divest its Insurance business in Latin America, Asia, Canada, Australia, and New Zealand. As a requirement, ING sold its ING Direct US business to Capital One for about US$ 600 million, ING Direct Canada to Bank of Nova Scotia for C$ 3.1 billion, and ING Direct UK to Barclays bank for about GBP 10 billion. In 2009, ING raised Euro 7.3 billion through shares and repurchased securities equivalent to half of the capital injection and in 2011, it repurchased securities equivalent to Euro 2 billion leaving the state aid to Euro 3 billion. So the sale of ING Direct US and Canada is just going to take care of repurchasing the remaining Euro 3 billion equivalent securities. 

ING Direct Canada was one of the most innovative banking concepts in Canada. It is aimed at those customers who want to save more and spend less on fees and other statutory engagements. So the Bank did not operate any physical branches rather had five ING Direct cafes and a few ATM machines. Customers were paid healthy interest rates (typically more than other banks) and all that customers needed to do was go online and complete transactions. ING Direct served customers via internet, contact centers, and mobile devices by offering savings, chequing, mortgages, and four mutual fund products. As of 2012, ING Direct Canada was the 8th largest bank in Canada and had 1.8 million customers with C$ 30 billion in deposits and C$ 40 billion in assets. The bank had a healthy mortgage portfolio with 59% of its mortgage insured and the average loan to value ratio on uninsured mortgages was 53%. 

Bank of Nova Scotia

Bank of Nova Scotia is the most international bank in Canada with operations in 55 countries. The bank had 81000 employees and had 70% of its income coming from traditional personal and commercial banking activities and the remaining 30% from wholesale operations. Scotia bank operates in four major categories namely - Canadian retail banking, International retail banking, Global wealth management, and Global markets. In 2012, the bank reported a revenue of C$ 19.7 billion with an operating income of C$ 9.3 billion. Between 2008 and 2012, revenue growth averaged 13.6% per year however growth rate in operating income during this period averaged 20% thus indicating that the bank improved its efficiency ratio (Operating expenses to sales), one of the key measures of a bank. Between 2008 and 2012, Net income increased by 106% at an average of 19.9% per year to reach C$ 6.5 billion in 2012. The difference between the operating profit margin growth and net profit margin growth indicates that the statutory losses such as provision for credit loss was very minimal. As of 2012, Scotia bank managed total assets worth C$ 668 billion and was the third largest bank in Canada behind RBC (Royal Bank of Canada) and TD Bank (Toronto Dominion Bank) in terms of assets under management. The bank reported a ROA of 1.4% in 2012 and has remained the same all through 2008 to 2012. In 2012, Scotia bank reported a ROE of 16%, which was marginally lesser than the 17% it reported in 2008 and 18% it reported in 2010. Part of this decline was because of the dilution by issue of more common shares in 2011 and 2012. Assets to Shareholder equity (Asset to capital multiple), another important measure post the Basel III regulations declined from 23.5 in 2008 to 16.9 in 2012 mainly because of the growth in the asset base relative to growth in equity. However since the risk bearing assets in Scotia were not as significant, the bank was able to improve its Tier I capital ratio (capital to risk bearing asset ratio) from 9.3% in 2008 to 13.6% in 2012 and thus was well above the Basel III threshold of 7.5%. Finally the loan to deposit ratio, that in a way guides the credit rating agencies in rating the banks, declined from 87% in 2008 to 76% in 2012. Part of the reason for this decline could also be softening housing prices and saturation in the retail lending space because of very high debt to disposable income within the Canadian population (164.6%). In fact in January 2013, Moody's cut credit ratings of TD Bank, Scotia Bank, Bank of Montreal, CIBC, and National Bank of Canada by one level citing concerns over consumer debt and housing prices.

Scotia bank expanded internationally particularly in the Latin America after it acquired 51% stake in Columbia's fifth largest bank. This expansion gave the bank access to Latin American markets including Brazil, Mexico, and Chile and It is expected that the Latin American countries are likely to experience significant grow rates relative to the US and Canada. The growth in the wealth management and global markets space was something to observe between 2008 and 2012. Between this period, income from Canadian retail banking declined from 42.6% to 31% and income from International retail banking operations declined from 29.3% to 25% thus indicating the growth in the wealth management and global markets space. The global wealth management operations grew from 0% in 2008 to 18.3% in 2012 and the global banking and markets operations grew from 19.5% in 2008 to 24% in 2012. 

Even though Scotia bank was able to grow internationally, it's policy of seeking 50% income from Canada and the remaining 50% internationally was not getting satisfied for reasons such as limited domestic growth opportunities and profitability of domestic banking business. Since the big six banks in Canada were well capitalized with high levels of liquidity and readily accessible funding in the Canadian capital markets (In 2012, Scotia bank issued C$ 4 billion of common shares at two times the book value to fund acquisitions) at extremely low rates as compared to global standards, the Canadian banks were able to diversify through acquisitions within Canada so as to increase their market share and Internationally in to high growth economies such as Latin America and Africa. As a result, Scotia bank acquired Dundee wealth for US$ 3.2 billion in 2011 and the acquisition of ING Direct in Canada would have helped it to overtake CIBC as the third largest bank in terms of deposits. So the ING Direct deal was critical not just for Scotia bank but also for other banks operating in the Canadian market for it gave market share in addition to the innovative business model that ING Direct had in the country.

How the deal happened

Having understood the rational behind why ING wanted to sell ING Direct in Canada and why Scotia and other banks wanted to buy ING Direct, let us examine how this process was conducted. It is important to understand that whenever a company is forced in to selling its business, it will sell the best business it has. So without any doubts, ING Direct Canada was ING's cherry. The sale process was a 2 stage auction where in the first stage, bidders were invited to submit their bids and the bids would undergo screening by the Investment bank appointed by ING and the successful bids will go to the second and final stage. Considering the competition to secure this deal, it was not surprising that 28 banks bid for ING Direct. Only three banks made it to the second stage where intense discussions and negotiations led to ING selecting Scotia bank to takeover ING Direct in Canada. It was made to understand that the bank that would take over ING Direct was not just offering the best price (in fact there were banks in the first round that offered better price than what Scotia bank was offering) but also had sound management to manage the target. 

This is one of a kind of process of deal making and is very interesting because this process is particularly applicable when you are selling one of your most important and strategic business units and the target company has an upper hand right from the announcement of the auction.

Deal structure

Scotia bank agreed to pay ING C$ 3.1 billion in cash and will also clear C$ 320.5 million of subordinated debt that ING Direct held with the state. This meant that the net investment that Scotia bank will be making on this deal was C$ 1.9 billion after netting of the capital that ING Direct carried on its balance sheet. To support the deal, Scotia bank issued common shares of 29 million (4.35 million additional shares can be issued in case of over subscription) at a price of C$ 52 per share. The proceeds of this issue was carried out by Scotia Capital Inc. This meant that the gross proceeds raised under the share offering would be about C$ 1.73 billion. 

After the deal

At the end of the deal, Scotia bank became the third largest bank in terms of deposits overtaking CIBC and just behind RBC and TD Bank. This also improved its deposits by 9.1% (YTD 2013) to reach C$ 506 billion by third quarter of 2013. ING Direct still continues to operate as a wholly owned subsidiary and Scotia bank had promised that it will not cross sell any of its products to ING Direct customers. However this deal helped Scotia bank enter the much needed internet banking space, which is not very efficient within the big bank circle. In addition, Scotia bank was allowed to retain the ING logo and brand name for a period of 18 months from the conclusion of the deal so in six months from now, Scotia bank will have to re-brand ING Direct and this could be a challenge for the Scotia bank management. We are likely to see a lot of customer poaching activity during this period particularly from TD Bank, which has good internet banking facilities within the country. At the end of third quarter of 2013, Scotia bank reported revenues of C$ 15.9 billion with an operating income of C$ 7.3 billion and a net income of C$ 5 billion. With one more quarter for year end closing and lots of activities to be carried out by Scotia bank to merge ING Direct completely in to itself, it will be an interesting time in the banking space particularly with respect to product offerings and channels of customer engagements. 

Journey of AT Kearney through the 90s and 2000s

This week was fabulous for two reasons - one that we spoke about an acquisition in the banking space (probably the most confusing and most interesting for it offers varied dimensions with respect to regulations, market share, etc) and another we got to understand how AT Kearney steered through the Mid 90s and then through all of the 21st century till 2011. Let me start with a brief on AT Kearney and will discuss about the Nova Scotia acquisition in my next post.

For all of those who did not know, AT Kearney was acquired by GM's outsourcing arm EDS in 1996 (at least I did not know this). EDS (Electronic Data Systems) was a company setup by GM (General Motors) as an IT outsourcing arm. It was when GM realized that it's core business is in making and selling cars, that it spun off Hughes and EDS in 1996. In later half of 1995, that was when EDS aspired to become a consulting and outsourcing company (Aka Accenture in today's world) and so it started on a shopping spree and acquired 39 small consulting firms. Finally it reached to partners of AT Kearney and offered $300 million in cash and $300 million in EDS shares to buy the consulting firm in December 1995. In addition, AT Kearney was promised complete autonomy and also a task to integrate and manage the 39 consulting firms that EDS acquired. As a result, AT Kearney became double its size after integrating the consulting firms within itself. Between 1996 and 1998, after EDS was spun off, the share price of EDS rose from $42.06 to $78. This made the AT Kearney partners even more happy as they were holding shares of EDS. It was those very happy times when the EDS and AT Kearney combination struck a $5.3 billion deal with Rolls Royce in order to make it the number one in the Aero Engine space (pushing GE to number two). However a series of mismanagement and the dot com bubble sank the EDS share price to $8. This made the partners really worried as they were dreaming of a healthy and wealthy retirement. The decline forced the then CEO out and the company got in a new CEO. The CEO had different plans - he was amused by the fact that the AT Kearney folks were getting special treatment (as usual as a consulting firm) and the consulting firm had different management structures (independent CEO and senior leadership) and policies. Much to his amusement, the new CEO decided to bring commonality across the organization (EDS + AT Kearney). As usual, this evoked the partners of AT Kearney and they started to revolt and as a result approached the CEO seeking a buyout option and the proposal was rejected by the CEO. Given with a task of getting the company back to glory, the new CEO was on a road show promising sun and moon. This got the share price back to $42.06 and the CEO sold all his shares at that healthy price. EDS board got to understand this and they fired the CEO. In addition, the CEO was trialed for insider trading. This news sank the share prices to historical low. Finally EDS got a sensible guy, a partner in McKinsey. He understood the operations of a consulting firm and felt that it had to stay autonomous. Realizing this, the partners in AT Kearney approached the new CEO (the McKinsey guy) for a buy out. The CEO and the board of EDS was fine with this. Immediately, the partners put together a buy out package and asked the CEO of the consulting firm (very unusual to have a CEO in a consulting firm however it had one) to reach out to EDS board to present the case. The then CEO of the consulting firm traveled all the way to Texas to present the case. While on the journey to EDS headquarters, he felt he might be crowned as a hero if he were to buy back the consulting firm cheap and as a result cut the offer price by 40%. After his presentation, the CEO of EDS just threw him out of HQ for faulty valuation of the consulting firm (Mind you the new CEO of EDS was from McKinsey) and AT Kearney was put on auction (it is a process where the target firm is put on sale by the parent company). Monitor approached EDS to buy AT Kearney but offered such a low price that it forced the CEO of EDS to give AT Kearney one final chance to put together a business case for MBO. Four senior partners of AT Kearney got together in preparing the business case (just over a weekend). It was one of those innovative packages that involved - Equity, Debt, and PIK (Payment in Kind). AT Kearney was supported by Morgan Stanley and EDS was supported by Goldman Sachs. Since it was a high profile and tense buyout, both parties intended to have investment bankers on their side. Despite push from Morgan Stanley to price up the deal, as their fee is tied to the acquisition value (very strange how these IB firms work - their job is to get you the lowest price in case of a MBO where in they were trying to push the price up), AT Kearney put together a package for $200 million that involved $40 million in equity, $100 million in Debt, and $60 million in PIK (Payment in Kind - this means that the consulting firm is available to offer services at free of cost to EDS for a certain period). The buyout package was accepted by EDS board as the CEO and board expressed their appreciation for PIK. This way AT Kearney became an independent consulting firm again. The partners were able to pay back the debt within 6 months and Morgan Stanley walked away with $7 million in fees. Today the total revenues of AT Kearney is little less than a billion dollars (I guess about $850 million).

This is a story told by my professor who was a witness through the entire process and was one of the four partners who finally bailed out AT Kearney from EDS. Today the consulting firm is at the bottom of the "Industry smile curve" (a tool that graphs firms based on market share and profit margins - this tool is very helpful to understand who will be the next target and how the industry is likely to consolidate) and could be a target again for M&A. The leading players in the consulting industry today - PWC, Deloitte, E&Y, and McKinsey have revenues more than $5 billion (Deloitte is the market leader with $18 billion, followed by PWC with about $13 billion, E&Y with about $11 billion, and McKinsey with about $6 billion). Already we have seen Monitor acquired by Deloitte and as we would experience more consolidation in this industry, the probable targets could be AT Kearney, Booz, and Bain.

My professor has now left AT Kearney (a year ago after serving the firm for 26 years) and is a senior partner with E&Y in their transaction advisory.

Largest deal in the Canadian Retail Industry this year

There is an interesting deal taking place in the Canadian retail space - Loblaw Companies Limited (will be referred to as Loblaw) has announced that it will be acquiring Shoppers Drug Mart Corporation (will be referred to as Shoppers) for C$ 12.4 billion. The deal was announced on the 15th of July 2013 and is likely to be executed by end of this year. According to analysts, this deal is likely to be the largest deal this year. It is an interesting deal for at least three reasons - the strategy behind the deal, structuring of the deal, and the proposed synergies out of the deal. 

Canadian Food retail industry

With a GDP of US $1.8 trillion (almost equivalent to India), Canada has a population of 34.9 billion. Between 2000 and 2012, the population of the country has grown by 13.4% at an average of 1.1% per year. As of 2012, more than 35% of the population is aged more than 50 years and about 5.5% of the population is aged less than 4 years. It is estimated that by 2036, the country would have about 25% of the population represented by people above 65 years of age and currently people above 65 years of age account for 45% of the government healthcare spending thus indicating that as the country grows old, the healthcare spending is going to rise. As per the report published by the government, in 2012, the total retail sales in Canada was about C$ 470 billion, a 3% increase over 2011. Food retail sales represented 19% of this total retail space thus contributing about C$ 87 billion. The industry is expected to grow at a CAGR of 2% between now and 2016 and it was also expected that much of this growth will happen through expansion in the selling space (measured in Square feet) but not much increase in the number of stores. Grocery retail in Canada is a matured and highly developed industry and as a result of slower population growth, the overall growth rate in the industry is slowly declining (3.9% in 2009, 2.6% in 2010, and 1.2% in 2011). By the end of 2012, the industry was dominated by domestic retail players such as Loblaw Companies Limited, which had a market share of 20% by value, Sobeys Inc, which had a market share of 12% by value, and Metro Inc, which had a market share of 9% by value. However with the arrival of US retail giants such as Walmart and Target, the scenario is fast changing. Walmart arrived in to Canada in 1994 and as on 2012, the retail giant reported a revenue of US$ 22.3 billion and occupied the third position in the retail space. Despite slow growth in the retail sector (owing to various reasons such as the consumer debt to GDP is at all time high in the economy and consumers have been conscious of their spending patterns), Target entered the market in 2013 after acquiring a series of retail chains. So the industry as a whole is moving towards consolidation. The arrival of deep pocket US retail giants is not just changing the dynamics of the industry but also creating a sense of nervousness among the existing players. As a result of this, Sobeys, earlier this year, announced a C$ 5.8 billion acquisition of 200 Safe way stores (Drug stores). This is now being followed by Loblaw that has announced acquisition of Shoppers for C$ 12.4 billion. It is also anticipated that Metro and Jean Coutu, a drug store chain, may join to form one company. So over next few years, it is highly likely for us to see a few big retail chains dominating the industry. 

Loblaw Companies Limited

Loblaw is the largest food and grocery retailer in Canada and is listed on the Toronto Stock Exchange. The company is the leading provider of drug store, general merchandise, and financial products & services. The company is a subsidiary of George Weston Limited, which owns 63% of Loblaw. As of 2013, Loblaw operated more than 1000 corporate and franchisee stores. For the year ending 2012, Loblaw reported an operating revenue of C$ 31.6 billion with an operating income of C$ 1.19 billion. Between 2008 and 2012, the revenues of the company grew by 2.6% at an average of 0.6% per year. Loblaw has two major operations - Retail and Financial services (credit cards and other financial products). This end to end everything under the sun business model helped the company maintain huge customer loyalty. Between 2010 and 2012, the operating revenue from Financial products and services increased by 23.6% to reach C$ 644 million in 2012 and the operating revenue from retail increased by 2.1% to reach C$ 30.96 billion. The gross profit margin, between this period, was relatively stable at about 23.5% thus indicating that the company although was able to increase sales but was not really able to increase its marginal revenue. This could partly be because Loblaw operated in a very highly competitive and a matured market that hardly showed signs of inflation. However during this period, Operating income grew by 13.68% at an annual growth rate of 3.9%. This indicates that the company was better able to streamline its operations between 2008 and 2012. The operating profit margin for the company was 3.8% in 2012 as against 3.4% in 2008 although it is worthwhile to note that the operating profit margin did reach 4.4% in 2010 and 2011 before slipping to 3.8%. Another indication of the market being matured was - the same store sales (in retail, same store sales is used to compare sales of stores that have been in operation at least one year) for Loblaw declined 1.1% in 2009, 0.6% in 2010, and 0.2% in 2012. From an investor point of view, this is important because - although it is evident that the company has been growing year on year however much of the growth has come from the stores that have less than a year of operational experience (new stores) and the growth from existing stores have been saturating. In addition, retail chains are always measured by growth in sales. So combining both the growth in sales over the last five years and the growth in same store sales, it looks like Loblaw has reached the maturity stage in the business life cycle despite the company attempting to grow organically (Loblaw opened 26 new stores between 2010 and 2012). As a result of this, the company sought to grow inorganically as the strategy would not just bring growth to its otherwise declining top line growth but also safeguard the company from mammoths such as Walmart and Target. In addition, realizing the significance of its retail space, the company launched a REIT fund in 2013. With interest rates looming uncertainty, the REITs are actually operating at relatively low P/E ratios (compared to their historical average) particularly in the US (however there is a scare of real estate bubble in the Canadian economy). Once there is some news on the US likely tapering off the monetary easing, the markets will settle down and as a result REIT fund strategy of Loblaw might benefit the company. 

Shoppers Drug Mart Corporation

Shoppers is a licencor of full service retail drug stores and is listed on the Toronto Stock Exchange. The company operates 1242 Shoppers drug mart and Pharmaprix (called in Quebec). In addition, the company also operates 57 medical clinic Pharmacies, 6 luxury beauty destinations, and 62 Shopper home health care stores. Shoppers is the leader and number one provider of pharmacy products and services in Canada. For the year ending 2012, the company reported a total revenue of C$ 10.78 billion with an operating profit of C$ 881 million. Shoppers Pharmacy segment contributed 47.3% to this revenue pie and the Front store (that sells OTC medication, health & beauty aids, Cosmetics & fragrances, Seasonal products, and Everyday household essentials) contributed the remaining. Between 2008 and 2012, the revenue from Pharmacy operations has increased by 13.7% at an annual rate of 3.3% to reach C$ 5.1 billion in 2012. During the same period, the revenue from front store operations has increased by 15% at an annual rate of 3.6% to reach C$ 5.68 billion in 2012. Although the number of prescriptions dispensed in 2012 was more than 100 million, 5.4% increase over 2011, Pharmacy sales increased only 2% in 2012. Part of the reason was generic penetration and government's control over increasing healthcare costs. As we look in to the future, generic penetration is likely to increase more as the government would want to control increasing healthcare cost so although we are likely to see increase in the volume of prescriptions and as a result increase in the volume of sales but the value of sales is less likely to grow at the same pace. Between 2008 and 2012, the operating revenue of the company increased by 14.4% at an annual rate of 3.4%. The gross margin of the company averaged 38.1% and in fact bettered from 37.4% in 2008 to 38.7% in 2012, thus indicating that the marginal revenue of the products sold by the company improved over this period. The operating profit of the company however remained pretty much stable during this period and grew by just 1.6% to reach C$ 881 million in 2012. EBITDA (Earnings before interest, tax, depreciation, and amortization) though increased by 11.4% to reach C$ 1.12 billion in 2012 thus indicating that the expansion plans of the company that were put in to effect during this period drove away some of the potential operating profits in the form of depreciation and amortization. As a result of this, ROA of the company declined from 8.7% in 2008 to 8.1% in 2012. In addition, between 2008 and 2012, the selling expenses of the company increased from 26% of revenue to 27.5% of revenue. However in 2010, the company delivered a ROE of 14.4% and with a retention ratio of 70%, theoretically Shoppers should have grown at 10% in 2011 but the actual growth rate was 2.6%. Similarly, the sustainable growth rate was 9.7% for the year 2012 but the actual growth rate was 3.1%. This is the case even when the total debt of the company remained largely same between 2010 and 2012 (C$ 1.294 billion in 2010 and C$ 1.138 billion in 2012). So it is hard to predict if the company will grow at a theoretical growth rate of 9.2% in 2013 as arrived after using the ROE and retention ratio of 2012. Growing concerns on healthcare costs is putting increasing pressure on hospitals and pharmaceutical companies to reduce the total cost of care and this might affect Shoppers going forward. On the positive side, as the primary care is experiencing shortage of physicians, pharmacists have become the second line of care and the state of Ontario and other provinces are looking at possibilities of licencing pharmacists to provide basic primary care to the patients. So the Medication Therapy Management (MTM) that includes clinical services by pharmacists provided to the patients could generate some revenue for the company. Looking at the past growth, future challenges, and the growth prospects for the industry, Shoppers should grow at a minimum rate of 2.5 to 3% per year for the next five years and there after, it will be safe to assume that the company will grow at a rate of 2% year on year perennially for the Canadian economy should be growing at a real rate of 2%. 

Valuation of Shoppers

With a systematic risk (Beta) of 0.39 (as reported by FT and Reuters), the weighted average cost of capital for Shoppers is 5%. For the year 2013, Shoppers management is investing C$ 275 million in capital expenditure. It is assumed that for the next five years, the management will further continue to make investments equivalent to C$ 250 million year on year. After the fifth year, the investments have been reduced to C$ 200 million per year perennially. In addition, it is also assumed that the changes in working capital are likely to grow at the same rate as the overall growth rate. This is theoretically a correct assumption for the changes in working capital (if not improved upon) should grow at the same pace as the changes in sales. Finally it is assumed that the company will not go for any additional debt for there is evidence for the same - between 2010 and 2012, long term debt of Shoppers decreased from C$ 943.4 million to C$ 247 million although the total debt remained pretty much the same. So based on this assumption, the interest expense has been assumed to remain constant year on year. 

Based on the above assumptions and future growth rate of the company (2.5% for the next five years till 2017 and 2% there after), the present value of Shoppers operating assets is C$ 15.135 billion. Adjusting for the total debt and cash components, the value of Shoppers equity is C$ 13.89 billion. 

Loblaw offer to Shoppers

Loblaw has announced on the 15th of July 2013, that it would be acquiring Shoppers for C$ 12.4 billion. The deal is structured in such a way that Loblaw would pay C$ 61.54 per Shoppers share using cash and its own stock. Each Shoppers shareholder will receive a cash of C$ 33.18 per share and 0.5965 of Loblaw share for each Shoppers share. The transactions in cash amount to C$ 6.7 billion and the stock transfers amount to C$ 5.7 billion. In addition, Shoppers shareholders can avail capital gains tax deferral out of this transaction which means they will not need to pay any tax in receipt of the cash and Loblaw shares as against the Shoppers shares they are holding currently. 

What this means to the Shoppers shareholder - 

• Between 17th July 2003, when the company actually got listed on the stock exchange, and 12th July 2013, the day before the announcement of the deal, the Shoppers stock gained 9.64%. During the same period, the S&P/ TSX Composite index delivered a return of 7.48%. So the Shoppers stock did reasonably better than the market.
• On 12th of July 2013, the Shoppers stock was trading at C$ 48.4 and on 15th July 2013, the announcement meant that Shoppers stock holders will be richer by 27%. In addition, they will become shareholders of Loblaw once the deal materializes
• It was interesting to note that the price paid by Loblaw is at least C$ 1.5 billion lower than the proposed valuation of Shoppers Drug Mart Corporation. This indicates that Shoppers shareholders should have received C$ 69.4 for each share as against the proposed C$ 61.54. However if we analyze the returns delivered by the Shoppers stock in the last five years (period before the announcement of the deal), the stock just delivered 1.77%. So it could be that the shareholders are happy that finally they are seeing some value in holding the stock.

What this means to the Loblaw shareholder - 

• After the announcement of the deal, George Weston Limited, which once held 63% of Loblaw Companies Limited, will now hold only 46%. This means the parent company losses its majority shareholder status. Shoppers shareholders through the stock transfer will hold 29% of Loblaw shares. The institutional and retail investors of Loblaw, who once held 37% of the total outstanding shares will now hold only 25% of the total outstanding shares. So because of this deal, the Loblaw institutional and retail shareholders have got their stake in the company diluted by 48%.

From the financial point of view, Loblaw benefited from the deal where in it got Shoppers relatively cheaper than the proposed valuation and from the shareholder point of view, Shoppers shareholders benefited for they got results for holding on to a stock that was under performing for quite sometime now. However an interesting point to be noted is that - the parent company, George Weston Limited, was happy to give away its majority shareholder status thus indicating something around the interest of the parent company in this business.

Proposed Synergies and applicable logic

It is often said that "You buy growth in M&A". In this case, however we are seeing two mature companies coming together to form a big company. Both Loblaw and Shoppers span coast to coast and have significant presence in each of the provinces in Canada. On one hand, this new company will deter competition for sometime till Walmart and Target gear up. However it also showcases the nervousness of Loblaw to do something particularly after we know that Sobeys Inc acquired 200 Safeway stores earlier this year. On a broader scenario, we have to understand that Loblaw is fighting against the financial muscles of retail world - Walmart and Target. If they see an opportunity in the market, they have all the financial and operational resources to tap in to the opportunity and it will all be game over for Loblaw. 

Through this deal, Loblaw proposes that it will gain synergies equivalent to C$ 300 million over the next three years. 40% of this synergy is likely to yield from operational expenses - SG&A, Supply Chain, IT, and Shared infrastructure. 45% of the synergy is likely to yield from COGS (procurement) and the remaining 15% from loyalty and Financial services. On the Hindsight, it must be noted that Loblaw is a food retailer and Shoppers is a drug store. So I am puzzled as to what synergistic benefits the combined company could earn through procurement, which is likely to deliver 45% of this proposed synergy. Also when you have two different companies, which have varied business operations, I am not sure how marketing activities can be combined. Finally distribution channels and warehousing can barely be shared when Loblaw sells food and grocery and Shoppers sells high end merchandise and Pharmaceutical products. However since both the companies are relatively strong in their private label brands, this M&A could mean that there could be some synergies out of cross selling and reaching out to a wider population. Besides Shoppers is very strong in convenience store format in urban areas and with this acquisition, Loblaw can tap in to these stores though the scope of synergy is limited. In addition, Shoppers loyalty program is regarded one of the best in the country. So Loblaw could benefit by expanding the program to its stores as well. So overall, I am a bit skeptical about this C$ 300 million synergy that has been proposed by Loblaw management  although there are a few foreseeable benefits though this deal clearly showcases some eagerness from the company to make some news. However it is not a bad news considering that Shoppers has some reasonably better growth prospects than that of Loblaw. 

Yuan likely to be the gold standard currency!

China is ramping up gold like as if everybody in China will only consume gold from tomorrow! Its crazy but this did not strike me for a long time until we had a one hour discussion in the class today (I have to give credit to my Professor who had influenced me to write this post) that finally led to a conclusion that there is a likely possibility that China could gold standard its currency and already there are talks in the government circles. What this means is that the so called "Gold standard" currency - US dollar - will be replaced by Yuan as the global reference currency and much of the trade will happen in Yuan. Already China has surpassed USA in terms of the volume and value of trade and it has started discussions with the Middle East, Russia, and Australia about using Yuan as the medium of currency for trade. In addition, Gold is being sold in Yuan (no longer in dollar per Oz) and it is not very far that Petrol will also be sold in Yuan for by 2017, China is likely to be the world's largest consumer of Oil. If Yuan is backed up by gold, then it will be easy for China to just dump the trillions dollars of T-bills (i guess about $ 1.32 trillion). TRILLION DOLLARS OF T-BILLS!!!! Just imagine what would happen to US currency. China knows that US will not pay back that debt and neither they can for it will raise a huge cry in the US political circles. Till date, they could not dump dollar for Yuan is pegged to dollar and if it gets an alternate currency (a more stable one such as Gold - If you track gold: the spot rate of gold has remained stable for a long long time, its only because of rollovers, we have seen negative yields in gold), it is high time they would want to dump the T-bill paper. If dumped, there will be mad rush in the bond market creating prices to drop and yields to go up and as a result "Margin Calls" from other countries including Europe and Canada. Then as Prof Barrows mentioned, US will have to sell Manhattan or the entire Wall street to get its currency back on to track!

On the other hand, people around the world (including Bernanke and other central bank heads) thought that the gold prices were declining (dropped from $1800 end of September 2012 to about $1315 as on date) because of improved performance in the US and Europe. The answer to this is a partial YES but a big exclamation because who is buying all that gold that is being sold in want of US dollar (for dollar started appreciating in the recent past) - CHINA. India is a big player in the Gold market (second big player) but the form of gold that India buys is majorly in Jewelry not gold bars as is done in China. Furthermore now with the duty levied on gold imports, the imports have relatively cooled.

Lets start with Europe - Europe has a long way to go before it can even showcase the world that it is improving. Yes, the European economy as a whole improved by about 0.7% however it was mainly due to Germany, and France. German elections (due next Monday) are considered to be a critical point for a turnaround in the European growth story however it is very clear that Angela Merkel will come to power as the Chancellor of Germany but it needs to see if it will be a grand coalition with the Socialist opposition, which is highly likely to be. In which case, she will have relatively less vigor to showcase her sympathy for the failing states. There is a new party that is contesting this year that is fighting for Germany to be out of Euro! Already the sentiments in Germany is showing up in the form of aversion towards the Greeks, who are seeking another bailout package. So I am not sure if the German elections are going to make a big impact however it will in the announcements to be made by European Central Bank. The banks in the European economy are yet to build up their balance sheet to meet the Basel III regulatory requirements (minimum capital requirements) and as a result, credit market is weak (banks don't want to lend anymore and shrink their equity capital base) and thus resulting in low growth in consumer spending. The big banks are planning to raise capital from the equity market however the consumer confidence in these big banks is so low that it will be hard to expect any surprises further supported by relatively poor ROE reported by these banks. In addition, the bond market in Europe has done so well in this year (more than 14% increase in this year relative to 2011 - Thanks to the relatively low lending by the commercial banks. Europe is a market where bank financing was a major part of the borrowings for a long time) that I am not sure if the investors have the appetite. There was a chance a few months ago when the equity market were trading at relatively low P/E compared to historical average (even now it is the case) but now I am not sure. Finally the unemployment rate of about 12% is a huge issue in the region. Although the unemployment rate is showing signs of improvement but most of the jobs that are being created are for the new job seekers. Employment rate for people who have been out of jobs for more than a year has hardly shown any positivism (this is a concern even in the US). So the European growth story can barely be a factor.

US on the other hand for quite some time has been contending that it is going to taper off the monetary easing that it has been carrying out for the last five years. This speculation has caused havoc in the emerging markets except China (Yuan was the only currency that was performing well even when the US dollar depreciated). Yes, China experienced relatively low growth rate but I am again taken back to Prof Barrows class where he mentioned that as the base increases, it is relatively hard to grow at double digits. China's GDP as of 2012 is about $8.6 trillion and still expecting to grow at 7.5% per year. Actually speaking, US is the only country that has recovered very quickly from the Lehman crisis (i wrote about this in my previous blog so I am not going to reiterate) however there are certain factors that are still pinching the economy. One that, US probably no longer holds the same say in the G-20 as it used to once. The recently held G-20 (in Russia) is a classic example of this where only 50% of the nations voted for President Obama when he proposed a air strike on Syria and even out of those 10 countries that voted, only France agreed to ally with the US. Even within the home, people are not really happy with the governance for unemployment rate is still a concern. Although the government statistics show that the unemployment rate has been declining, much of the new jobs are either part time or contract jobs and even those full time jobs that are being created, they are being taken up by fresh graduates or new job seekers. Furthermore there is quite a percentage of people who have been dropping from job seeking list relative. So the 7.3% unemployment rate may not be a representative of normal rate of unemployment in the economy. The business environment seemed to be somewhat going with President's voice and now even that is going to be deterred with the "Affordable Care Act" or popularly called the "Obama Care". "Obama Care" requires all citizens of US to be insured either by a private insurance or by government insurance schemes (It is a complicated process so I am not going to dwell in to the process in this post). In addition, it also mandates employers with more than 50 employees to offer insurance to its employees or pay a fine. However it includes another clause that the employees should be full time working with the employer. This means employers particularly the retail chains and the fast food chains are going to cut down the number of hours their employees need to work and employ them as part time. In the case where there is no choice but for the employer to pay for the insurance, it will reflect in reduced salaries for the employees. So I am a bit critical if these new regulations are going to benefit the people and if it is going to improve the unemployment rate any further. In fact it might result in slow growth in employment and reduced wages and salaries. In addition, Obama Care is going to cost the government tonnes of dollars. Finally productivity is yet to return to pre-crisis levels adding to further concern. So although there might have been hints of US recovery playing a role however not as major as China buying all the Gold.

So coming back to the point, the emerging economies have become equally vulnerable to the recent recession. The world has seen two recessions following two bubbles in the last 15 years and developed markets have played a big role in both of them and as a result the developed markets were badly hit although the emerging markets survived partially. So for a while it also made the emerging markets such as India and China feel that they were "de-coupled" however they did not realize that they have actually become even more serious part of the global trade than they were before. This to some extent makes up the story that the reliance on US dollar being the global currency is slowly declining not just within the allies of US but also across the globe with over reliance on trade with emerging markets and China is trying to cash on it.

Need for Health care reforms in India

In 2012, India spent 4.1% of its GDP on Healthcare. This is equal to $75.4 billion marginally higher than some of the poorest Sub-Saharan African countries. China on the other hand spent about 5.1% of its GDP on healthcare (mind you China's GDP is 4.6 times higher than India). Between 1990 and 2013, Indian population increased by 42% with an annualized growth rate of about 7.3% to reach 1.24 billion in 2012. On the other hand, China's population grew by 19% during this period at an annualized growth rate of about 3.5% to reach 1.35 billion in 2012. As in 2012, per capita spend by India government on healthcare was $39 as against $203 in China. I am not even going to bring in statistics from US and other developed nations for the health coverage in those countries are far better (though concerns remain and i will speak about those in my future posts) than what it is in emerging economies. Many economists and so did i believe that this relatively low spending has vastly resulted in poor healthcare facilities in the country. However as i say this, in his paper - "It's broken: Health Policy in India" - Jishnu Das points out there there is virtually no correlation between Public spending on healthcare and health status of the population. In addition, he also points out that availability of nearby government healthcare facilities has no bearing on the health status of the population. In addition to his findings, It seems that the average primary healthcare providers per 10,000 people (2011) across the globe is 14 however the case in Kerala was 2.4 and in Tamil Nadu was 3.1 and in Gujarat was 4.8. These three states have health statistics on par with some of the developed nations. So if additional public spending is going to improve health status, these three states should be spending more on healthcare to bring the ratio closer to the Nation's average of about 12 healthcare providers for 10,000 people. These are interesting findings particularly when the Prime Minister last year announced the Universal Health Coverage (UHC) program indicating access to healthcare for all. In fact soon after Prime Minister's announcement, a series of ministerial meetings lead to announcement of two ambitious programmes - National Urban Health Mission (NUHM) and Free Essential Medicines. When implemented, the programmes would cost the government Rs 22,000 crore and Rs 28,560 crore respectively. The combined cost is equal to about $8.5 billion per year at an exchange rate of RS 60 per USD. 

So what is the missing link?

There are a few issues broadly and i am going to cover only a few key ones in this post - the composition of the providers is one of the important aspects. 59% of the healthcare providers in India have no formal training and 44% of this 59% have just an high school education and another 44% of this 59% have little more than high school education and the remaining 12% of this 59% have barely been to school. 26% of the healthcare providers in the country are Privately trained physicians and only 10% is being offered by the public healthcare providers. This means that if the government is aiming at providing universal healthcare in the country, it has to take over 10 times the market it currently serves! Just moving on this subject - does supply and demand ratio really provide any solution. I mean does it make any sense to talk in terms of ratios (health status to public spending, etc). Professor Jeff Hammer (Princeton University) in his profound speech provided statistics that the ratio of public healthcare spending to health status is not relevant at all so he concluded that the supply and demand analysis does not work in this case and in particular the Healthcare sector. Another scaring detail is that the average amount of time the primary care physician spends in the health center is just 39 minutes per day (Thankfully in Tanzania, it is 29 min). This is a larger level corruption than the so called 2G or Common wealth games - If a doctor is paid a salary for at least 40 hours per week of service and the practitioner spends on an average 6 hours per week. Finally most of these physicians have low capability and make very little effort to bond and create a trust with the people. So much of it boils down to trust and bonding that the people have to set with the physician. It is in fact striking that 80% of the people in India first make a visit to a private practitioner. So this broadly concludes that even if government were to increase spending on healthcare, the results may not be cor-relational. However this evidence still does not help us conclude if spending in general will not help improve health status.

So what is lacking in India - unlike many developed and developing economies which have social welfare organizations that cater to basic amenities such as water and sanitation, India has few besides a few NGOs that work on this ground (India has about 8 lakh ASHA (Accredited Social Health Activists) in the villages with very poor training and knowledge). India suffers from basic sanitation facilities so much so that about 30% of the population that lives in cities have sewage water seeping in to their homes at some point in time in a year. So first of all, Indian cities are still not ready to the so called urbanization. Second, as per the Economist magazine, nearly half of India's small (under five) children are malnourished and this is one of the highest rates of underweight children in the world and in fact higher than most of the countries in the Sub-Saharan African continent. About 48% of Indian Children under 5 are stunted (under height for their age) and about 43.5% of Indian children are under weight. Third, right from 1946 till 2012, we have been talking about universal healthcare however we failed to understand that if we can take care of primary healthcare (essential healthcare), more than half of the bottleneck at the secondary and tertiary healthcare is resolved. As against this, we want to step in everywhere. Part of this illusion is also stems back to low capability of the physicians in the public health particularly in the villages. If a person in a village goes to a primary care physician in a village complaining about heart burns, without any diagnosis or questions, the individual is directed to undertake tests for a probably heart attack. As a result the public claims with respect to healthcare has increased from Rs 750 to Rs 1100 - 1200. So probably the government is mislead on this front that it has to tackle at all levels of healthcare and if we improve the quality of primary care, this misconception could be alleviated. The above are just a few infrastructural issues facing the country besides grueling issues such as increasing maternal mortality rates, growing infant mortality rates (in comparison to developed economies), shortage of doctors because we have so many constraints if one wants to start a medical school, regulatory dimensions towards other healthcare specialists such as Nurses providing primary care, and out of pocket personal healthcare spending as against government spending in India (ratio is 3:1). 

The RSBY (Rashtriya Swasthya Bheema Yojan) has as on date enrolled about 120 million people and the government is wanting to expand the horizon to cover the entire population not just the poor people. If this has to be achieved, then the per capita expenditure is likely to reach Rs 1500 and I am not sure if we have enough money to fund this expansion. In addition, an average cost of operating a primary healthcare center in a village in India is about Rs 3 crore as against Rs 12 lakhs for many of the private health care centers in the same region. Besides in the year 2012, India spent Rs 21000 crore on essential medicines but at least 25 to 30% of the drugs and equipment that government procures as part of the free essential medicine program is wasted because of lack of adequate storage capacities. So even if we want expansion plans provisioned, implementation of the strategy is largely at stake besides poor infrastructure.

So what can the country do now - 

• Move away from the combined healthcare provision to concentrating on the primary healthcare as this will alleviate burden on secondary and tertiary care which are largely managed by private healthcare set ups. In fact much of the government's proposed spending should be in this area while improving the quality of care with better infrastructure, qualified professionals who can bond with the local population, and adequate monitoring systems to ensure value for care.
• Providing adequate drinking water (non availability of adequate drinking water results in 200 million cases every year in the secondary healthcare centers) and sanitation as this can lessen the burden on primary healthcare centers
• Remove regulatory constraints towards other medical specialists such as nurses from providing primary care. This to a large extent will alleviate the shortage of doctors concern.
• Finally move towards privatization of the healthcare (government can just fund the initiative through the insurance schemes and pay for performance schemes but give the onus to private healthcare providers who can manage the health centers - In fact this could bring in a revolution in the Indian Medical educational system), and improve the standard of the social health activists as it will not just bring in more education and awareness in to the system but also will improve the care provided by the 59% of the healthcare providers - non-trained segment. 

However as i write, there has been very little progress (the two ambitious programmes have been shelved for almost two years now) that has happened on implementing any of these healthcare programs partly because as a country, politically we are yet to move to a stage where healthcare is on the agenda to buy votes. We are yet to see advocacy groups persuade governments to include specific healthcare programs as part of their political agenda. But it is not very far that we will see this change and the government will have to redefine the UHC (Universal Health Care) program.

Two Important events this week (week of 8th September 2013)

This week marks two important events. One - an unfortunate anniversary celebration of the collapse of the Lehman Brothers - and another - mark of a new progress in the eventual attack on Syria. 

Starting with the World today in five years from the Lehman Collapse - Have we come a long way from the collapse of the Lehman Brothers even though we know that many other countries particularly the emerging markets and the Europe have yet to recover from the collapse. It somehow seems like baring the US, none of the major economies have really performed as one would expect. This could also be because US was the most affected as a result of GFC. The US though seems to have done good during the last five years - household debt ratio has gone down by more than half and has almost reached the stage what it was in the early stages of the last decade, S&P 500 has performed better than most of the other indexes across the globe and Investors have earned close to 7.7% per year after inflation. This is better than the long run average which is about 6.5 to 7%. Unemployment rate has gone down to reach ~ 7.3% and average labor wages have gone up thus prospering more spending. Europe however has still been behind although there are some signs of progress - banks are not yet capitalized as the talks on Basel III regulations are on the table, countries such as Greece, and Spain are yet to be out of their bankruptcy situation, the debt problem is yet to be solved and most important is the unemployment rate (~ 12.1%). Emerging markets baring China, have crawled growth during this period. So overall it will be difficult to conclude that we have come a long way from the collapse!

This week saw President Barack Obama addressing the American population on the possibility of an attack on Syria. However he started his speech by saying that there are many wrong things happen in the world and we cannot right all wrongs. This was contrary to his stand that US is the messiah of the world. When we retrospect, this is no surprise speech for he had already given away the initiative that he had when John Kerry said in the media that the only way the strike could be evaded is when Syria admits possession of chemical weapons, discloses their location, and destroys them. The Russians immediately cashed on this proposing Syria to disclose the chemical weapons and destroy them. In fact President Obama had lost the initiative even before when he went to Congress seeking its vote so that he can launch a strike on Syria. This to a large extent showcased that he did not want Congress to turn around later. Now everything lies with Syria in frankly declaring the chemical weapons which ideally would be the best possible scenario that could happen as it would avoid any attack on Syria although the chances of this happening is very weak. One that it is very complex to carry out a detailed inspection of the locations and identify the chemical weapons and destroy them when the country is experiencing a civil war. Second that Bashar Assad should support this initiative which the world believes that he might not out-rightly as was the case in Iraq during the Saddam Hussein's regime. However the good way this Russian plan (asking Syria to disclose the Chemical weapons and then destroying them) could succeed will be if Congress votes in favor of the strike stating that US could strike Syria should diplomacy fail. This will keep pressure on both the Russians and as a result on Assad to quickly move on this front.

Verizon buys 45% of Vodafone stake in Verizon Wireless - a critical review

The US wireless telecommunications industry is worth more than $150 billion and the industry as such employs about 3.8 million individuals directly or indirectly. There are four major players in the wireless telecommunications industry - AT&T, Verizon Communications, Sprint Corporation, and T-Mobile US. AT&T is by far the largest of them in terms of market capitalization and firm value. As of 13th September 2013, AT&T has a market capitalization of $180.41 billion and an enterprise value of $248.8 billion. The company is also largest in terms of revenue generation with revenues of about $127.5 billion for the financial year ending 2012. However in terms of number of customers, Verizon leads the race with 108.7 million customers followed by AT&T with 103 million. Sprint caters to 55 million customers and T-Mobile caters to 33.73 million customers. The industry once dominated by AT&T has come a long way as today internet connectivity is built into appliances, utility grids, electronic equipment, and buildings. As a result new technology solutions are emerging in sectors such as Healthcare, Energy, Transportation, Education, and e-commerce. This has opened up quite a few avenues for the wireless telecommunications industry. Today the global internet network connects the major cities in the US with business hubs in the Europe and Asia with networks that can deliver speeds up to 100 Gbps (Gigabytes per sec). The industry has moved a long way from the traditional copper network, speed and bandwidth constraints to LTE (Long Term Evolution) network. Verizon as of the second quarter of 2013 has covered the entire US population with 4G LTE and has span the entire 3G footprint, the previous generation spectrum. As of the year 2012, the smart phone penetration in the US has been close to 58% and Verizon has about 40 4G LTE enabled smart phones, tablets, and internet devices. 

Between 2000 and 2013, US population has grown by 11.2% reaching 314 million in 2012. But the year on year population growth rate averaged only about 0.9%. 20% of the population is below 18 years old, 67% of the population lies in the age group of 18 to 64, and about 13% of the population is above 64 years old. This demographics one hand offers challenges to the telecommunications industry that the growing population will lead to reduction in demand however on the other hand, older population also will result in demand for other services to which wireless and wire-line telecommunications cater to such as the Healthcare. In addition, Increasing age of the population also brings increased care and thus increasing cost. So sectors such as Healthcare are looking for ways in which they can offer quality care at a reasonable cost.

Today, an average US household has at least seven devices and so bandwidth and speed have become the call of the day. As of 2011, average price per minute in the US costed about $0.049 as against $0.167 in the Europe. With increasing demand, there has also been pressure on the cost of service. As a result, although the revenue per customer has remained pretty much stable, the cost of maintaining and providing value added services to retain the customer is being challenged. For the year ending 2012, the revenue per customer for AT&T was $1237, $1064 for Verizon, and $644 for Sprint. However the operating income per customer varied across these players - AT&T had an operating income per customer of $126, followed by $151 for Verizon, and Sprint actually reporting operating losses. To counter these imbalances, organizations such as Verizon have been diversifying in new growth avenues and improving on the operating margins. In spite of recession and increasing cost pressures, between 2009 and 2012, Verizon was able to increase its revenue per wireless connection by 6.5% and reduce the cost of serving the customer by about 17.3%. In addition, the company has engaged in partnerships with nation's major cable companies to deliver video solutions on a national scale across 4G LTE wireless and cable networks. The company identifies that digital healthcare and mobile health platforms is one of the future growth potentials and is investing in R&D while partnering with entrepreneurs and other computing technology firms in areas such as cloud computing. 

Earlier this month, Verizon announced that it would be buying the 45% stake that Vodafone has in the Verizon Wireless for $130 billion. This is the third largest deal in the corporate history. Start of this year, Verizon offered $100 billion for the 45% stake and Vodafone board felt that the wireless division was valued much beyond this. The deal was announced on the 6th of September 2013 and on the 9th of September, a Verizon shareholder sued the company stating that the price it is paying is too high. If Verizon was wanting to pay $100 billion at the start of this year, then it must have valued the business unit (Verizon Wireless) at $222 billion. So what makes Verizon change its stand and pay Vodafone a whooping $130 billion resulting in a value of $289 billion for Verizon Wireless.

• Verizon communications Inc is a wireless and wire-line communications company incorporated in the US. The company is listed on the New York Stock Exchange and has a market capitalization of $135.5 billion. For the year ending 2012, Verizon reported an operating revenue of $115.65 billion with an operating profit of $20.7 billion (excluding non recurring items). As of 2012, Verizon is the largest telecommunications player in the US in terms of number of customers. Between 2008 and 2012, the company has grown its revenue by 23.5% despite recession. Between this period, year on year revenue growth averaged 5.4%. During this period, the company also invested in both tangible and intangible assets and as a result, the fixed assets of the company increased by 23% to reach $196.5 billion. For the year 2012, Verizon registered a ROA of 4.42% and a ROE of 13.99%, much above its competition (AT&T reported a ROA of 2.82% and a ROE of 7.98%, Sprint reported a ROA of 0.99% and negative returns to equity, and T-Mobile reported a ROA of 2.3% and negative returns to equity). This just goes to show that Verizon has sound financials relative to the industry.
• However the composition of the revenue and operating income of the company brings new dimension and to a large extent substantiates reasons for why Verizon is eager to buy back the 45% share held by Vodafone. Verizon Communications Inc constitutes two separate business units - the traditional wire-line division and the wireless division (Verizon Wireless) that was formed in June 2000 as a merger of Verizon (55%) and Vodafone (45%). Between 2008 and 2012, the contribution from Verizon wireless to the total revenue of the company (Verizon Communications) increased from 52.6% to 65.6% to reach $75.9 billion. During this period, operating income from wireless segment increased by 55.9% to reach $21.7 billion (excluding extraordinary items) where as operating income from wire-line segment decreased by 98% to reach $60 million (excluding extraordinary items). 
• The wireless segment constitutes of pre-paid and post-paid connections. The post-paid connections as a percentage of total wireless customers is about 94% (remained stable between 2009 and 2012). As of 2012, the total number of retail connections reached 98 million (crossed 100 million in the second quarter of 2013). Between 2008 and 2012, The number of retail connections has grown by 40% to reach 98.2 million as against 53.9% increase in revenue thus indicating that the company was probably able to charge a price premium for this segment. 
• On the other hand the wire-line segment constitutes voice connections, broadband connections, fiber optic internet and video subscribers. The fiber optic internet and video subscribers contribute to about 60% of the total revenue generated by this segment although they only constitute 25% of the total customer base in this segment. As a result, there is a huge cost to benefit disparity in this segment. Between 2008 and 2012, the number of fiber optic internet and video subscribers increased 1.4 times to reach 10.2 million and the revenues increased by 47.7% to reach $23.1 billion in 2012. On the contrary the voice and broadband has been doing very bad. These services include voice service over long distance, broadband video and data, IP network services, network access, etc. Revenue from these services has actually fallen by 37% between 2008 and 2012. Part of the reason could be that there has been migration happening between wire-line and wireless segment and so there must be a few customers who must have moved from wire-line to tap in to the wireless services. 

As a result of above performance, Verizon has realized that its growth potential lies in wireless and fiber optics although they cannot do away with the voice and broadband. However with the joint venture with Vodafone (which states that Verizon will pay Vodafone 45% of the net income generated from the wireless segment excluding all the extraordinary items), the Net income that went towards non controlling stake (income that needs to be paid to Vodafone) increased from 58% in 2009 to 92% (of the company net income that includes both wireless and wire-line combined) reaching $9.7 billion in 2012. As a result, the operating cash flow that would otherwise be available for Verizon to expand was being challenged by this agreement. The above growth story in the wireless segment and dwindling incomes from the wire-line segment explains why Verizon is more keen today than it was earlier in getting this deal done. So this largely answers one part of the story as to why Verizon is so keen in pushing this deal through although the price it paid increased from $100 billion at the start of this year to $130 billion when it closed the deal this month (September). However it is also important to know if Verizon paid the right price. This post though will not answer the question as to whether Verizon paid the right price however it will give you some insight in to how long it is likely to take for Verizon to break even on this deal. It is then left to the audience to decide whether this is an appropriate deal or not!

• The $130 billion that Verizon needs to pay Vodafone is being funded by $58.9 billion in cash, $60.2 billion in Verizon stock, and $5 billion in loan notes and other considerations. As on 2012, Verizon has a long term debt of $51.2 billion and approximately, it pays an interest on this debt at a pre-tax rate of 5% per year. In addition, for this current deal, Verizon has tapped the credit markets to raise an additional $49 billion. This makes the total long term debt equivalent to $100 billion. Besides, Verizon is likely to go for bridge financing up to $11 billion, which will be paid from smaller transactions resulting from a deal that is likely to close by first quarter of next year. Since the deal does not include any exchange of equity, the market capitalization of the company will not be impacted. The deal just ensures that Verizon no longer has an obligation to service the joint venture. So this means that the present value of future cash flows (resulting from this 45% of the net income generated by the Wireless segment) should be greater than $130 billion. In order to understand this scenario, we calculated the WACC for the company. As the market capitalization is unlikely to change but the total debt position has for sure changed as on date (13 Sept 2013), we used this updated numbers to arrive at the cost of equity and cost of debt. The price of risk (Beta) was calculated using multiple linear regression however after adjusting to the stock splits that have taken place in the interim. The weighted average cost of capital (WACC) for Verizon was 4.73%. This is not unusual for a large company with such a large debt component and equivalently proportional equity.
• As per the market statistics, Verizon covers about 36% of the US population followed by AT&T with 34%. US population has been increasing at a rate of 0.89% year on year between 2000 and 2012. In addition, on an average between 2007 and 2012, there were about 1 million legal immigrants residing in the US. So besides migrating customers from one segment to another segment, taping into new generation of advanced electronics and medical devices with LTE connectivity, and Fiber optics, Verizon could tap in to the new immigrants who arrive in to the country and also increasing its offerings in the space of fiber optics and wireless communications. Based on the past performance (average revenue growth year on year between 2008 and 2012 was about 5%), competition (Qualcomm is another serious player in the mobile health platforms besides AT&T, and Verizon), adaptability of these rising sectors to the technologies offered by the wireless telecommunications industry, we feel that Verizon will grow by 5% year on year for the next five years, then the company would have grown too large to grow at the same pace so the growth rate is likely to be around 3% till 2023 and then on the company will grow at the same rate as GDP of the economy so we have considered that to be about 2.5%. We do understand that in any discounted cash flow, growth rates do make a huge difference in valuation however for a company as large as Verizon, we feel the growth rate projection will hardly deviate by a few basis point as against our prediction.

Based on the WACC, growth rate, and the free cash flow calculated using the growth rate, the present value of cash flows generated between 2014 and 2033 is $131.3 billion. This indicates that it is likely to take 20 years for Verizon to break even on this deal. However the free cash flows considered while arriving at this present value constitute - the wire-line segment, the 55% stake that Verizon Communications holds in Verizon Wireless, and the 45% stake that Vodafone holds in Verizon Wireless. In order to truly understand the value of this deal, the free cash flows have to be derived just from the 45% that Verizon is currently buying from Vodafone. Due to limitations of information availability, we many not be able to arrive at a present value number however we can confidently conclude that it is going to take Verizon more than 20 years to break even on this deal and the conclusion is based on the present value number that was arrived at using the company wide free cash flow projection. So it seems like the concern raised by the shareholder to some extent remains valid. However from Verizon point of view, it does give the company a lot more freedom in terms of cash flow available for exploring new avenues, investing in R&D, and fostering growth. We now leave it to the audience to decide whether you are fine with a break even in 20 + years. While making your judgement, please bear in mind that we are not looking at a small or a mid cap company. Here is a company with a market capitalization of about $133 billion and a revenue base of about $115 billion and covers more than a third of US population!

Amgen acquires Onyx for USD 10.4 billion - A good buy ?

On 25th August 2013, Amgen announced that the acquisition price of USD 125 per share has been approved by the board of Onyx and as a result Amgen will be paying USD 10.4 billion to acquire the mid size Oncology drug development company. Onyx is a California based bio-pharmaceutical company specializing in Oncology drug development. The company was incorporated in 1996 and is listed on the Nasdaq stock exchange since then. The company reported revenues of USD 362 million for the year ending 2012 with an operating loss of USD 271 million. 

Stock performance of Onyx

Between May 1996 (when Onyx actually got listed) and September 2013, the annualized return from the stock was 8.95% with a standard deviation of 35.1% where as S&P 500 during this period gave a return of 7.35% with a standard deviation of 18.5%. However in the last five years, Onyx still delivered a annualized return of 8.05% with a standard deviation of 24.5% but S&P 500 slipped to deliver a return of just 1.78% with a standard deviation of 11.5%. One may argue that Onyx is a mid cap company and why am I comparing its returns with S&P 500. So a better comparison would be to S&P healthcare index. In the last five years, S&P health care Index (constituting of 52 companies) delivered an annualized return of 9.38%. So we can broadly conclude that from an investor perspective, Onyx has not done anything remarkable which is typically expected of a growing company although it has benefited a few short term investors. 

Onyx started generating revenues from 2008 and since then in the last five years, the company has reported profits only twice - 2009 and 2011, when it earned royalties for licensing one of its products to Bayer (Germany) to commercialize the product outside USA. Since the earnings for the company are negative (in 2012), its Price to Earnings ratio is reported in negative however for any growing company such as Onyx, Sales makes more sense than earnings as much of the income would be invested in R&D and SG&A. The Price to Sales ratio for Onyx was about 17 (as of year ending 2012). This is way high even if it is a growing company. I say this because, the average Price to Sales ratio for the healthcare stocks listed on S&P 500 as of 2012 was 2.9. In addition, the Price to Earnings ratio for the companies listed on S&P 400 is 25 thus indicating that the Price to Sales ratio should be far less (should not be more than 6 considering the net profit margin for a mid cap company is optimistically about 25%). This clearly tells me that the stock is way too over valued however we cannot conclude without estimating the growth potential for the company. 

Although not much relevant for a growing company, but still the Price to Cash ratio for Onyx for the year ending 2012 was about 12.4 and the average Price to Cash ratio for the healthcare stocks listed on S&P 500 for the year ending 2012 was about 12.1. Generally one would expect the price multiples for mid cap stocks to be higher than large cap but in this case, the Price to Cash ratio is almost same. This is not surprising for the investors have placed not much emphasis on the cash generation potential of Onyx as they realize that Onyx will be investing majority of its income in to R&D and SG&A. 

Why such a high P/S ratio

Onyx concentrates on two varied platforms - Protease inhibitor and Kynase inhibitor. Without getting in to the technicalities of the targets (platforms), the efforts of the company has resulted in three commercialized drugs (Nexavar for treatment of Kidney and Liver cancer, Kyprolis for treatment of Multiple Myeloma, and Stivarga for treatment of Colorectal cancer and Gastrointestinal cancer). In addition, the three drugs are being evaluated (currently in varied phases of clinical trials) for other forms of cancer. The company has a partnership with MMRF (Multiple Myeloma Research Foundation) for development of drugs for treatment of Multiple Myeloma. Besides the efforts of the company in evaluating the existing commercialized drugs for other forms of cancer, Onyx has two more drug candidates (one being Oprozomib for treatment of blood cancer) undergoing Phase II and Phase III clinical trials respectively. This indicates that there is considerable growth potential for the company particularly with the relationship with Kathy Giusti lead MMRF, which managed to get four drugs approved by FDA in just six years. The positive news i guess for Onyx is that its equity investors realize this potential and so the high Price to Sales ratio.

Company performance

In the last five years (2008 - 2012), Onyx reported an average revenue growth rate of 19.3%. The company, with an employee base of about 750, outsources much of its production and as a result, the gross margin for the year ending 2012 was about 98%. But Onyx invests heavily in R&D and SG&A. In the year 2011 and 2012, the R&D to sales ratio was 59.9% and 89.8% respectively. Much of this investment went towards conducting clinical trials and seeking commercialization approval for the drugs. Considering that the company reported operating losses for the year 2012, its interest coverage ratio, ROE, and ROA were negative. However the asset turnover for the the year ending 2012 was 0.27, which was way low relative to its competition. Analysts estimate that Kyprolis that was fast tracked and approved by FDA in 2012, when it generated a revenue of USD 64 million, has potential to generate a peak sales of USD 3 billion by 2025. In addition, Oprozomib (currently undergoing Phase III trials) along with Kyprolis could generate combined sales of about USD 4 billion. Between 2011 and 2012, the sales of Nexavar increased in USA (USD 288.4 million in 2012) where Onyx has retained commercialization rights. Although the analysts predictions look positive, considering the pipeline and research initiatives of the company, it is very hard to predict when Onyx will start reporting consistent profits for it is likely to face huge pricing pressures (even though the company develops life saving drugs) and generic competition (both large and small molecules) as time progresses.

Cost of Capital

The levered beta for the company, calculated using linear regression, was 1.05 (however Financial times reported a beta of 1.33 and Yahoo finance reported a beta of 2.01). Considering the recent treasury bill rate and equity premium for US stocks (on S&P 500), the cost of equity for Onyx was 9.3% (considering regression beta as it is a very pessimistic estimate relative to FT and Yahoo Finance). The post tax cost of debt for Onyx was 8.13%. When most of the companies in the US could borrow at low interest rates (average post tax cost of debt for US companies ranges between 4% and 6%), 8.13% for Onyx is not very surprising because the company had reported positive earnings only twice in the last five years and lenders, unlike equity investors, do not look at future potential of the company but past performance of the company. 

With a debt to equity ratio of 1.91%, the weighted average cost of capital (WACC) for Onyx came out to be about 9.31% (if we had taken the FT beta, WACC would have been 10.93% and if we had taken the Yahoo Finance beta, WACC would have been 14.93%). So this is the minimum return the company has to return to any investor including potential acquiring companies.

Amgen acquisition of Onyx

Amgen is paying USD 10.4 billion to acquire Onyx. This equals to USD 125 per share when the share was trading at USD 117. The acquisition value is at a control premium of 21% when the average control premium for acquisitions carried out in the last two years is about 40%. So this is good news for Amgen that it is able to buy a high profile research and development company at a reasonable price. However on the contrary, the present value of USD 10.4 billion means that the target company (Onyx in this case) has to deliver a free cash flow of USD 1.41 billion per year for the next 13 years (considering a WACC of 9.31%). This means the Net Operating Profit After Tax (NOPAT) should be close to USD 1.6 billion (calculated at present Working capital requirements and depreciation). This means the operating profit (EBIT) that Onyx has to deliver year on year for the next 13 years should be close to USD 2.45 billion. A company that barely reported positive earnings in the last five years needs to deliver a consistent operating earnings of at least USD 2.45 billion year on year for the next 13 years to make the investment appealing for the Amgen shareholders. Even after considering the peak sales potential of the drugs that Onyx currently commercializes and those in pipeline, I have my doubts if this target could be achieved. Yes, with the acquisition, Amgen will consolidate the R&D and SG&A spend in addition to diversification of its portfolio but still I am not sure if the Amgen has secured Onyx at a right price. Even Amgen, after 33 years of its existence, is able to generate a sales of about USD 17 billion (in 2012) with a operating profit of about USD 5.6 billion so it will be challenging to expect a nascent drug development company to generate USD 2.45 billion. 

One may argue that why consider 13 years for no acquiring company takes control over a target company just for a minimum period of time (for any company has to be valued as a going concern). My contention here would be that the efforts put forth by Onyx till date resulted in three drugs and a few in approaching registration and approval (as they are undergoing phase III trials or Phase IV safety trials) and any valuation effort needs to look at the future growth potential of the target company considering the assets it posses as on the date of valuation or acquisition. Any future expansion or investments will not be carried out by the target company (Onyx) rather by the acquisition company (Amgen in this case) once it acquires the target company. So from this point of view, I believe that the assets (drugs and R&D efforts) that Onyx posses can only long 13 years (highly optimistic - actually it should be about 10 to 12 years). However to the benefit of my audience, If I consider that the assets possessed by Onyx will yield perennial income (hypothetical situation), still Onyx has to deliver a free cash flow of USD 968 million, which means the operating profit has to be at least close to USD 1.2 billion if not more.

Conclusion

I am ready to give credit to Onyx management (very promising one with very respectable credentials) and its potential to take the company on a linear growth path however I might want to conclude that Onyx shareholders won a jackpot here with Amgen paying a higher price for a company that might be extremely challenged to deliver a return on the price paid by Amgen to acquire Onyx.  

One of my colleagues inquired about synergies so I thought i should update this post with my thoughts on the same. Agreed that there will be synergies and for a highly efficient company like Amgen, getting synergistic benefits out of any acquisition will not be a big deal. In fact i have mentioned in this post that Synergy will be there with respect to sales and marketing, R&D efforts, operations, and human capital. However said that the maximum synergistic benefits a company can attain in a technology acquisition (Amgen is acquiring a drug development firm) is in the range of 15 to 20% (thumb rule based on past acquisitions) if managed well. Since this is a mid cap acquisition, we can increase this percentage to say 25 or 30% (being highly optimistic). Even considering the synergies, we are talking about going from negative operating earnings to at least USD 970 million year on year perennially at a WACC of 9.31%. For the first two quarters in 2013, Onyx reported revenues of USD 298.5 million with an operating loss of USD 87 million. Besides these figures, Onyx flagship product - Kyprolis - is yet to pick up pace. This year I can estimate that the product will earn about USD 250 to 300 million in revenue. So even if the synergies were to be achieved, i have my doubts if the investment can make the NPV positive in 10 to 13 years (I have explained earlier in this post as to why i want to consider 13 years). 

Having said this, most of the Oncology companies are trading at very high P/E ratios. This is because FDA is fast pacing many of the Oncology drugs since they are life saving however we still do not know if different countries (across the globe - because after acquisition, the bandwidth for products such as Kyprolis, Stivarga, and yet to be launched Oprozomib will increase) including US (thanks to the Sequestration program) will put pricing pressures on these drugs (Nordic countries have already started efforts on this front). Amgen is very strong in Oncology as they have recently reported trial results for nine of their drugs in the portfolio and they want to strengthen their portfolio with this buy. They are buying Onyx for the products they have in market (3) and pipeline (2). So from a relative (Oncology related companies) standpoint, Amgen got Onyx at a good price (21% control premium) but from a broader acquisition standpoint, I am not sure if this is adding value to Amgen shareholders. 

Should Amgen have waited some more time. I am not sure because I don't see the prices falling for these Oncology drug development firms for the regulations are becoming more amicable to them and will become even more as time progresses.