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Enjoy the difference

The difference is in the degree to which private equity funds are loaded up with fire power. From that, two questions arise – will that compromise their judgement; and if so, will it puncture their investment returns? As if to further demonstrate the readiness of that fire power and how it might benefit investors, just as this magazine was publishing last week’s cover feature about the way private equity sizes up a company, one such fund lighted upon a holding in the Bearbull Income Fund, thus providing a generous little pay-day.

The company in question is European spirits distributor Stock Spirits (STCK), whose directors recommend shareholders accept a 377p a share bid, which values their company at £767m. At a 41 per cent premium to the closing share price the day before, ordinarily this offer would be plenty.

But these aren’t ordinary times. As we wrote last week, the private equity industry has maybe $2.5 trillion to invest worldwide; of that, approaching $1 trillion is in the hands of conventional buyout funds. One such is Stock Spirits’ suitor, CVC, a big hitter in the game which has companies in its portfolio worth $115bn (about £85bn) and – tellingly – $165bn of dry powder to invest.

Small wonder then that investors can’t quite make up their collective mind whether a competing bid will emerge. If they were convinced CVC had secured its prey, the shares would trade slightly below the bid price to allow for the time value of money. As it is, they trade at 383p, a price which implies that a higher offer just might emerge although it would be a stretch to justify. After all, CVC might even be pushed to justify the price it has put on the table; or, at least, it would if it were a conventional investor buying just a slug of the shares.

To discuss that, let’s start with Table 1, which compares Stock Spirits with similar companies. Actually, finding acceptable comparators is tricky. The most obvious is Diageo (DGE) since Stock Spirits is often caricatured as a European ‘mini-me’ of the Johnnie Walker-to-Smirnoff drinks group. Yet Diageo, whose annual sales, at approaching £13bn, are 42 times those of Stock Spirits, has a global reach that the smaller company can’t match even if the market power and economies of scale of the biggest consumer-goods producers are constrained by local tastes and the logistics of distribution. Thus, as Table 1 shows, Diageo makes returns consistently superior to Stock Spirits’ and its shares have a commensurately higher rating. Much the same applies to the two other global drinks conglomerates shown, Pernod Ricard (FR:RI) of France, whose global brands include Jameson Irish Whiskey and Jacob’s Creek wines, and Constellation Brands (US:STZ), which is little known outside the USA.

Table 1 : Stock Spirits compared
 Stock SpiritsDiageoPernod RicardConstellation BrandsNicholsAG Barr
Share price†3833,6361862141,405581
Mkt cap (£m)76084,83741,23029,254519646
Price/sales2.66.76.14.74.12.8
Price/book1.4na2.63.04.22.4
Price/est'd earnings20.227.827.319.726.821.2
EV/ebitda7.122.617.517.528.610.8
Profit margin (%)*16.530.326.832.420.315.9
Return on assets (%)*3.78.54.08.316.611.0
Cash flow return (%)*11.116.47.111.421.622.2
Net debt/ebitda0.32.9na3.1net cashnet cash
†Share prices in local currencies; *Five-year average figures. Source: FactSet

Alternative comparators might be similar-sized companies in similar industries; thus the choice of UK-listed soft-drinks distributors Nichols (NICL), of Vimto fame, and AG Barr (BAG), producer of Scotland’s favourite fizzy drink, Irn-Bru – just the thing to wash down a deep-fried Mars bar. Here, too, Stock Spirits’ financial performance does not quite measure up, although its five-year average profit margin is slightly better than Barr’s, and its share rating similarly lags behind.

Ratios such as those might tell a conventional investor that Stock Spirits' shares are cheap; or, at least, they could be if our notional investor simultaneously thought that the spirits distributor, which does over 80 per cent of its business in Poland and the Czech Republic, was likely to bring its financial performance up to the average.

It is debatable, however, whether logic such as that would mean much to a private equity operator looking to buy 100 per cent of a company. That said, it is debatable whether there is any logic that makes Stock Spirits’ shares look good value at the 377p CVC is offering. After all, when last I crunched valuation figures for the group (see Bearbull, 28 May 2021) the share price stood at 278p and I reckoned that was about right for a company whose equity looked to have a fair value somewhere between 240p and 290p. Nothing much has happened since then, so what has persuaded CVC to bid so much?

It can’t be anything to do with synergies – none are available. The best CVC can offer is a convenience-store chain in Poland, which it bought in 2017, and some experience via a brewer in the Czech Republic, which it has sold. However, there may be some clues in Table 2, which looks at growth rates in key measures from Stock Spirits’ income and cash-flow statements. Most interesting – at least from the view point of boosting a company’s value – are the five-year growth rates for cash flow. Cash generated from the group’s operations, which are unaffected by lump-sum amounts from investing and financing activities, grew by almost 11 per cent a year; meanwhile, free cash flow, which is basically operating cash flow minus capital spending, grew by 12.5 per cent.

Table 2: Stock Spirits growth rates
 Latest full year (€m)Compound growth (% pa)
  10 years5 years
Sales3411.25.4
Operating profit59.51.26.2
Pre-tax profit30.015.5-0.9
EPS (euro cents)18.216.710.9
Operating cash flow69.86.510.8
Free cash flow62.17.912.5
Source: FactSet   

These are lively growth rates and, from the perspective of a private equity investor, they may be sufficient to justify the significant amounts of fixed-rate debt in the financing mix that help to lever up returns for the comparatively small amount of equity left in an acquired business. Typically, a private equity buyout deal will target a return of about 15 per cent. As it stands, Stock Spirits produces nothing like that. Expressing the net profit in its income statement as a percentage of equity (with deferred tax liabilities added to shareholders’ funds, since it is only an accounting nicety that separates the two in the first place), then its return on equity has averaged 5.6 per cent for the past five years.

That’s nowhere near enough, but growth and leverage can solve that. A crude – almost simplistic – way to show this is in Table 3. Stock Spirits shows its accounts in euros but, for easy understanding, the table shows amounts in pence per share and in the year to September 2020 the group generated almost 26p per share of free cash (25.8p, to be precise).

Table 3: Valuing growth
Free cash flow (p/share)25.8
Target return15%
Assumed growth rate10%
Therefore, value =25.8p/(0.15 - 0.10)
=25.8p/0.05
=516p
Source: Investors' Chronicle

The question is, how much value can that 26p generate if it is thought of as annuity? If the annuity remains static at 26p then – assuming that target return of 15 per cent – its capitalised value would be just 173p, less than half of what CVC is offering. However, add growth into the mix and the value of the 26p annuity can be transformed. Use something like the five-year growth rates for Stock Spirits’ cash flow shown in Table 2 then it might be fair to assume the cash-flow annuity grows by 10 per cent a year. In that case just five percentage points of the 15 per cent target would need to be extracted from the cash annuity; the remainder would come from internally-generated growth in value while the un-needed cash was left in the business to do more good work. Arithmetically, therefore, the value of Stock Spirits’ 26p annuity is capitalised at just 5 per cent rather than 15 per cent. The result is a transformation. The equity’s value soars to 516p, almost 40 per cent more than CVC is offering.

Many readers will recognise all we have done here is apply a constant-growth version of the basic dividend-discount model. As such, it is bordering on the naïve; for example, no annuity will grow by 10 per cent a year in perpetuity. However, the exercise helps illustrate the simple proposition that where there is growth there is the possibility of transforming value and we can be certain that somewhere in their workings CVC’s analysts are factoring in growth from Stock Spirits.

Despite that, the private equity manager might still be overpaying for Stock Spirits. I could say, ‘what do I care?’ Assuming the offer completes, then the Bearbull fund is looking at a 71 per cent total return on its investment of a year ago and, without CVC’s 377p per share offer, I couldn’t see Stock Spirits shares reaching anything like that level any time soon.

Yet it is not as if there are clear signs that all this investable fire power is corrupting private equity’s judgement. For example, shortly before CVC launched its bid, the private equity arm of Carlyle (US:CG) in effect walked away from its offer for drugs-delivery specialist Vectura (VEC), unwilling to match the amount that Philip Morris International (US:PM) had tabled. Still the guys who run private equity firms, smart though most of them are, would be less than human if a little of this powder didn’t ignite in the pockets of their Leonard Logsdail suits. Which means that this time it may be, well, a little different and investors should enjoy the boost it gives the listed share prices while it lasts.