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Taller. Stronger. Sharper. These three words are synonymous with the childhood of several Indians. Indeed, it’s the tagline of ‘Horlicks’, the health drink produced by GlaxoSmithKline (GSK) Consumer Healthcare. The company has several other impressive brands under their portfolio such as Boost, Viva, Maltova, Crocin, Sensodyne, Eno and Iodex. But that’s not the talk of the town. The talk of the town is the proposed, massive Rs. 31,000 Crore merger of Hindustan Unilever Limited, India’s largest FMCG player and GSK Consumer Healthcare. Who will benefit from this deal, Goliath or David?
GlaxoSmithKline is the leading health drinks maker in India with their flagship brand ‘Horlicks’, while also snagging the top three spot in the sports drink market via ‘Boost’. An array of other well-recognizable brands decorate their portfolio. There’s no doubt that they will reign supreme for a long time to come.
But in a surprising turn of events, the country’s largest FMCG player, Hindustan Unilever Limited, is all set to buy out GlaxoSmithKline Consumer Healthcare in a massive deal. This will enable HUL to foray into the consumer healthcare space, where it has no footprints. This, in addition to the pharma business of GSK-CH, is welcomed with open hands by the top management of HUL. However, the shareholders of GSK-CH are caught in a dilemma. Whom does the deal benefit? HUL or the shareholders of GSK-CH? Can HUL’s running the company create more value? And, is the price paid by them justified? These are the fundamental questions that needs answering. There is another, more subliminal question that also begs investigation.
Very little needs to be said about the opportunity size and growth potential in the broader FMCG sector in India. So, the industry in question here, the healthcare drinks industry, will also catch some of the action. In the recent past, the growth in Rural consumption has outpaced Urban consumption.
As expected, the company has no debt and flush with cash holdings. In fact, most FMCG companies, owing to their opportunity size, often have no reason to mess up their Balance Sheet with unwanted debt or investments in random places. They do invest very little by way of Fixed Assets, but pay most of the remaining cash out as Dividends. Case in point, GSK-CH has had a Dividend Payout Ratio of 40%-45% in the recent past. This good and bad. Good, in the sense that Corporate Finance deems it better to pay out Dividends in the absence of reinvestment opportunities (Which is the case with most FMCG and allied players in the country). Bad, in the sense that a higher Dividend Payout Ratios curtail Revenue Growth.
The Risk-free Rate has been taken from the ‘World Government Bonds’ site:
Company Beta and Index Returns have been calculated with the help of Yahoo Finance:
Industry-related data has been obtained from simple online searches (Primarily from sites like Economic Times and Screener):
Let’s move on to next part.
The Capital Conversions (Advertising and Promotion Expenses)
I usually Capitalize those spends which have been wrongly expended. Of course, Accounting rules allows for expending even long-lived spending, say for instance Advertisement or Research & Development. But the Accounting truth isn’t always reality.
A company like GlaxoSmithKline spends roughly 12-15% of all its Operational expenses on Advertisement. But by logic, since these expenses help the company for years to come (In the form of promotion or brand recall), they should have ideally been Capitalized and Amortized over a period of time. This is what I have done here:
Elsewhere, when I valued HDFC AMC
, I attempted to explain how this change will impact the cash flows of a company (Hint: Ideally, there should be little to no impact). It has more to do with being in line with reality than anything else.
To illustrate this with GSK-CH, let’s see how it has altered the TTM figures of the company:
The decrease in Operating Margin and the increase in Capital Turnover are both negative for Value, since they go to decrease the cash flows of GSK-CH. This is offset by the stark increase in Depreciation (Actually to be thorough, Amortization of the Capitalized Advertisement Expenditure on top of the existing Depreciation of Fixed Assets).
To justify this further, let’s look at the Fixed Assets of GSK-CH for the past 12 years:
The growth in Gross Fixed Assets of GSK-CH has been a meager 1.80% for the past 12 years, yet its Sales has growth at an amazing pace of 12%+ in comparison. In fact, you will end up with similar findings in the financials of most FMCG and allied players. Does this mean that FMCG is some sort of a magical sector that can grow without any sort of investment? The answer is no, of course. They don’t invest in Fixed Assets, sure, but they do ‘invest’ in Advertisement and Sales Promotion. It forms a major part of their Operational Expenditure. It only makes sense to Capitalize a portion of it, since they behave almost like Fixed Assets themselves.
Otherwise, GSK-CH holds no debt and has no outstanding Equity Options. They do pay a small amount of interest on their Accounts Payable, but I’m going to let it slide.
As I’ve claimed several times in the past, this is the heart of the Valuation exercise. I’m going to envision the future of GSK-CH as a company and then try to justify the assumptions.
High Growth Period
FMCG and allied players have among the largest Competitive Advantage Periods (CAP) in the world. This is due to the fact that they solve literally the largest requirement in any country – the consumers’ daily needs. So, allowing GSK-CH a 20-year High Growth Period is more than justified.
The 5-year Sales Growth average of GSK-CH is quite abysmal at 6.25% or so. But the rise in Rural spending power and demand will enable it to grow faster than it has in the recent past. I’m going to use the 10-year Sales Growth average (10.92%) and the 7-year Sales Growth average (7.26%) to replicate this. I’m also careful not to breach the Self Sustainable Growth Rate of GSK-CH, which happens to be in the 11%-12% range.
In the Terminal Period, I usually assume a Growth of around 4% (Half of the Risk-free Rate in India), but serving the consumer daily needs market will enable GSK-CH to grow a little more, at 5.21% (i.e. 1-and-a-half of the Risk-free Rate in India).
Here, it needs to be noted that Cash Flows and so, Value, are in the future. So, we have to account for every possible information that affects the future of a company. What’s in the future of GSK-CH? HUL, of course. I am starting with the long-term average OPM of GSK-CH (20.52%), then eventually assuming that HUL’s brand power will easily help GSK-CH achieve the Industry Margin levels of 32.18% in the long run (Industry Margin details obtained from Prof. Aswath Damodaran’s ‘Useful Data Sets’
). If you think this is unlikely, take a look at GSK-CH’s own past. They started with a 16% OPM in 2006 and managed to ramp it up to 23% in the last 12 months. But just to be conservative, I have started with a lower base and used a steady improvement.
The Corporate Tax Rate will converge towards the Global Average Tax Rate of 25%. However, since GSK-CH is already paying 34.20% by way of Corporate Tax when the country’s designated rate is only 30%, it makes sense to assume that the additional 4.20% will also be paid in the Terminal Period, making 29.20% the Terminal Period Tax Rate.
As mentioned earlier, FMCG companies invest very little. So, it shouldn’t come as a surprise when we see that they have very high Capital Turns. For GSK-CH at least, if you calculate the historical Capital Turnover figure (Sales / Capital Invested), you will end up with numbers north of 14-15 and sometimes even negative numbers (Meaning, GSK-CH can grow Sales even when they’re selling Fixed Assets). All of that is Accounting noise. Since I have capitalized Advertisement Expenditure, we get to see the real picture: the historical average Capital Turnover of GSK-CH is around 4-5 (4.10 being the precise figure), which is in line with reality.
I have assumed here that HUL’s distribution network will allow GSK-CH to be more productive. So, I have improved their Capital Turnover estimates (4.51, 4.96, 5.46) gradually.
GSK-CH’s historical Depreciation is in the range of 1.5%-2% or so. Then, why have I used the very high figure of 4.12% for my valuation? You guess it right! It’s because of the addition by way of the Amortization of the Capitalized Advertisement Expenditure. I have kept it stable throughout the entire Valuation period.
There are several Yellow Flags here. But all of them are already justified. Since there are no Red Flags, we should move on.
The Cash Flows
GlaxoSmithKline Consumer Healthcare’s Cash Flows are likely to evolve in the following manner:
Put another way, this is how I think GSK-CH’s Business Life Cycle will occur over time:
Here is how much I think GSK-CH is worth as of today:
I believe GSK-CH is fairly valued at Rs. 6498. Compared to the HUL-GSK deal Value
of Rs. 7,537 (Rs. 31,000 Crores split across roughly 4.21 Crore shares), it is a ~16% overvaluation. I’ve used only a 5% Margin of Safety, on account of GSK-CH’s historical performance being quite steady.
For those who love to get into the details, here’s how I view GSK-CH’s Value as several different components:
I usually proceed with a Monte Carlo Simulation after my Valuations. Let’s go ahead and do that, before discussing the possible implications of this Valuation.
The Sensitivity of Value
The ‘Sensitivity of Value’ tool shows the different Values for the company based of changing Cost of Capital and Terminal Growth levels.
However, one should not draw too many conclusions here. The simple takeaway here is that, since the Win-Loss Ratio is < 1.00 (i.e 0.75), it means that GSK-CH is more likely to be overvalued than not.
The Monte Carlo Simulation
A Monte Carlo Simulation is the preferred way of ‘stress-testing’ the assumption made earlier. Here’s how I will do it:
Simulated between the short term Self Sustainable Growth Rate (12.23%) and the long-term Growth Rate (10.84%). The Terminal Growth Rate is simulated between 3.90% (Half of the Risk-free Rate) and 5.21% (One-and-a-half of the Risk-free Rate).
Simulated between the short-term average OPM (21.38%) and the medium-term average OPM (19.61%).
Simulated between the short-term average (34.97%) to the long-term average (34.20%)
Simulated between the lowest ever Capital Turnover (2.36) to the highest ever Capital Turnover (5.86).
Simulated between the short-term average Depreciation (4.31%) to the long-term average Depreciation (4.79%).
The initial result of the simulation looks like this:
The interpretation of this Normal Graph is best done this way:
In essence, I think there’s an extremely minuscule chance that GSK-CH could be undervalued. But this isn’t far from my original observation, where I found it to be fairly valued at Rs. 6498. In fact, the simulation has yielded a slightly higher fair value at Rs. 6597 (i.e. Value at the 50% Confidence Interval).
As I always say, I could be wrong too. If you think my assumptions do not do my model justice, feel free to download it and change them as you see fit:
If your calculated Value differs substantially from mine, do let me know in the comments below. We can discuss our differences and come to a fruitful conclusion.
The Subliminal Question..
So, a couple of things have been answered here:
- GSK-CH’s shareholders are likely getting a minor bonus by taking the deal.
- HUL’s shareholders are likely losing out a bit by allowing HUL to make the purchase.
But these are only baseline observations. Remember how I said in the very beginning that there’s a more subliminal question that needs answering? Here’s it: Why should HUL, the largest FMCG player in the country, overpay for GSK-CH? Well, I can think of a few reasons:
- I am wrong with my assumptions. HUL thinks it can improve GSK-CH’s Topline and Bottomline much better than what I have assumed. But I did perform a Monte Carlo Simulation, the results of which was also along the same lines as the original conclusion (i.e. That GSK-CH is definitely overvalued).
- HUL’s Cost of Capital for acquiring is not 10.10%, but a little lower. Indeed, if you use a Cost of Capital of ~9.40%, the deal seems fairly valued. However, this is an unlikely explanation. HUL’s own Cost of Capital is around 10.50% (i.e. Higher than both 10.10% and ~9.40%), at which level the deal would be even less favorable for HUL.
- Out of everything from the top of my head, this seems to be the most likely explanation. The deal is all-stock. So, in addition to GSK-CH’s own Valuation, we will have to think about HUL’s Valuation as well.
Let’s take the most likely explanation, #3, and understand it further. MoneyChimp’s Intrinsic Value Calculator is something I use from time to time. I do not recommend using it as a click-of-a-button solution for all Valuations, but it serves its purpose well for approximations like this:
Therefore, HUL could be approximately fairly valued at Rs. 1,660 itself. At its CMP of Rs. 1,824, this is indicative of a ~10% overvaluation. To spell it out: HUL is possibly overpaying by ~16%, but since it’s using its ~10% overvalued Equity to fund the deal, it is more likely that HUL is only overpaying by about ~5%-6% or so.
In my eyes, neither Goliath nor David won. They fought each other to a stand-still and finally decided to call it a truce. What does this imply for the shareholders of HUL and GSK-CH? I think it doesn’t imply anything special. It’s business as usual.
it would be logical to assume that HUL, being the buyer, would incur additional costs by way of M&A charges and integration costs. It is indeed a known fact that the buying firm mostly
destroys value in a large M&A deal. Here’s a short article
on why this is the case. I personally think M&As are a coin toss between destroying value (By overpaying or over-spending on post-M&A costs) and creating value (Minimizing post-M&A costs and putting the synergy to use as quickly as possible). In fact, during my MBA, I remember reading a survey of CEOs (I forget which one exactly), which opined that accelerating the post-M&A activities and solving cultural integration issues is the key to creating Value in a merger.
If you are personally confused by this deal, you are not alone. In his 1990 Berkshire Hathaway Chairman’s Letter to the Shareholders, Warren Buffet named this type of behavior the ‘Institutional Imperative’. In an earlier letter, he described why funds are mis-allocated in an organization:
“..For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
—Warren Buffet, 1989 Berkshire Hathaway Chairman’s Letter to the Shareholders.
Is HUL bitten by the Institutional Imperative bug or will it be able to pull off a Value-accrective merger? We will just have to wait and see.