Delta Beverage Case Essay
Delta Beverage Case
Delta Beverage Group
Delta Beverage is a bottler company which is an important part of the franchise system of PepsiCo, Inc. Over the years Delta Beverage has also become an important manufacturer of cans, bottles, PET and other packaging for other several brands. The concentrate and syrup for the soft drinks are bought from PepsiCo, where the prices are establishing annually by PepsiCo. Delta processes all the other raw materials which are needed to produce these soft drinks.
One of the core raw materials which Delta uses to produce cans, is aluminum. The risen prices for aluminum over the last few years have made the management of Delta consider about the negotiations with the suppliers, the costs, the prices and the financial footing of the company.
The company has had a few critical financial leverage moments in the past. To prevent a new crisis in the firm, the management has decided to look for the possibilities which will reduce the risks of the company.
Before we start with an analysis of the risks, it is important to make an analysis of the current situation. The variables about the firm’s environment, the governance, the strategy, operations and the financial structure are important to understand the firm. But also a look into the market efficiency, cost of equity, debt and the capital structure is necessary to identify the situation.
In our review we will only examine a few financial variables and go further into the probabilities of the risks that could be occurring in the future. We will try to provide some insight in these probabilities.
After our study, we will give Mr. Bierbaum advice about the current financial review of the company, the possibility about an acquisition/buyout, the life cycle and financial hedging. Our advice will be focused on the actions that can be undertaken to have cost reductions on a long-term period.
Product life cycle
The product life cycle tells us within what phase(s) a company is and which strategic decisions should be taken. To have a good feeling of in what stage Delta is situated, we need to analyze the product life cycle. Since Delta is known as a leveraged company, the company is mostly financed by liabilities. Since the market shows a trend of less growth we could conclude that Delta is at the moment in the life cycle stage ‘Mature’ (see also matrix below). This will influence our view on several ratios we calculate and perhaps even if an acquisition or buyout is an option for Delta Beverage group.
We will calculate some ratio’s to understand the financial position of the company:
Current Ratio: is the ratio to measure whether the firm has enough resources to pay its debts over the next 12 months. We can see that the current ratio is increasing from 1989 till 1993.
Return on Equity: this ratio meassures the rate of return on the ownership interest.
Within Delta Beverage we see that the Return on Equity (ROE) is negative, but is increasing from 1989 till 1993. Especially between 1992 and 1993 there is an obvious improvement in the ROE. This has to do with the recapitalization plan. The recapitalization plan resulted in a reduction of total debt subsequently a reduction in the interest costs.
A high or a low ROE does not mean that owning a share results in immediate benefits. Simply because it’s profit might has been reinvested in the company, which would result in earnings on the long run. If a shareholder is interested in immediate benefit then he should involve the ratio of earnings per share.
Debt ratio: The debt ratio indicates the percentage of a company’s assets that are provided by debt. We can see that this ratio is varying in the period 1989 – 1992. But in 1993 there is a decrease. The reason for this is that Delta had a recapitalization plan in 1993. This recapitalization had a great (positive) impact for the debt ratio. In general, the debt ratio of Delta is too high. The higher the ratio, the greater risk will be associated with the firm’s operations. In addition, a high debt to assets ratio may indicate a low borrowing capacity of the firm, which in turn will lower the firm’s financial flexibility.
To make a good analysis of this situation, we would need to compare these ratio’s with other competing firms in the same industry, however it’s obvious that the ratio is very high even for a company in a mature lifecycle.
Net income: The net income of the company is increasing. To properly analyze this variable we need to consider other factors which would have an impact on the calculations. Over the years we see that the sales volume is increasing. The total operating earnings per case also show an increase. We also notice that the discounts and allowances do not change in percentage (±35 %). An explanation for the increase of the net income is that the selling expenses and the cost of sales did not grow in proportion with the profits. However in 1993 the interest costs are decreasing significantly, unfortunately it wasn’t enough to provide a positive net income.
A weak position in these ratio’s could become a crucial issue for the company. It could affect the continuity of the company. The management has to make some good and careful decisions at critical points to prevent a bankruptcy.
Debt/Equity Ratio: This ratio indicates the financial leverage of a company. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity. The debt/equity ratio of Delta isvery fluctuating over the years. Still we can conclude the majority of assets are financed by debt, because the ratio is all over the years above 1.
An acquisition is the purchase of one business or company by another company or other business entity. Consolidation occurs when two companies combine together to form a new enterprise altogether, and neither of the previous companies survives independently.
Being acquired by a strong firm can create value for the following reasons. The combination may result in valuable economies of scales, the combination may enhance product-market power, acquiring firm can solve operational troubles through superior management techniques and badly needed capital can be contributed by acquisition.
Besides these benefits there are also some important disadvantages of being acquired. A few disadvantages are higher unit costs because the business becomes too large, clashes of culture between different types of businesses can occur and may need to make some workers redundant.
A buyout (also often called a leveraged buyout, LBO)occurs when a group of individuals uses cash to purchase the shares of a firm and takes ownership and control of a firm. Generally, the buyers arrange debt or equity financing to facilitate the purchase. The literature emphasizes the following advantages/motives for a buyout: managerial incentives can increase because of the changed ownership structure, a takeover can be averted and there can be tax-benefits realised.
A buyout also has a couple of disadvantages like, the possibility of bankrupcy because of the rising level of debt after LBO, employees and suppliers could cause problems if the LBO fails and high interest rates on paying LBO debt can damage company’s credit rating.
Considering the product life cycle and the ratio’s of Delta which is in a mature stage and the D/E ratio is above 1 over the past 5 years we are inclined to advicea buyout Delta Beverage Group with a LBO. Besides these arguments there are also a few other benefits of a buyout such as tax-benefits, increasing managerial incentives etc.. With such an solution Delta Beverage can go on as company, but also get the needed financial support. However perhaps Hedging might be a solution.
Hedging is a method to decrease risk as it’s used to settle prices right now to buy products in the future, in this case it has been proposed to hedge the aluminum prices. This way Mr. Bierbaum is able to maintain a stability in prices, however before we start giving advice we will first calculate what part of the Cost of Goods Sold (CoGS) is the direct result of the usage of aluminum.
According to our calculations we approximate the share of aluminum in CoGS to 9.5%. The current price of aluminum has risen to 1461 $/tonne, which means an increase of 16.9% aka a reduction of net revenue of $1.6 mln should this price remain the same for the rest of the year. However since Delta is part of a buying co-op which negotiated prices for this year, Delta is safe from a price increase until the year end.
The firm is in a precarious situation; there is little room for loss of revenue, even worse there are strict conditions imposed on the company during a debt restructuring. These conditions involved a limit on the senior debt to cash flow ratio, a limit to the total debt to cash flow ratio, an interest coverage ratio and a debt service coverage ratio. These limits and the current ratio will be displayed below:
Seeing that some ratio’s have already exceeded tolerance in 1993 it’s essential that the profit margins are increased so that the free cash flow is able to reduce these ratings.
Now we return to one of the main questions. Is it wise to hedge the needed aluminum contracts for next year? First of all, the co-op in which Delta is participating negotiated for prices in January for the entire year. So Delta wouldn’t suffer from a price increase until next year of January. However, if prices increase significantly Delta would be suffering a significant price increase and a reduction of cash flow (assuming the net revenues translates directly into cash flow). Out calculation results in a net loss of $0.95 mln per 10% of aluminum price increase negotiated by the co-op. Though the other case could also be true, the aluminum prices could set for a drop again and thus cash flow could instead rise. Any futures bought now could negate that probable benefit.
Another thing that should be accounted for is the distress costs which the company will incur, should the company be unable to raise sufficient cash flow to apply to the debt conditions. Seeing that the Total Leverage Ratio and Debt Service ratio is not met there, it already is a problem. To solve this problem an Operating Cash Flow of $26.650K is needed (without increasing debt), which means an operating cash flow increase of approximately of $4 mln. is needed. Also the free cash flow needs to increase to $13.500K which results in an increase of free cash flow of approximately of $3 mln.
Should Mr. Bierbaum want to hedge (3 months) his aluminum prices he currently occurs an increase of aluminum costs by 22,3% ((1485-1214,42)/1214,42) which results in an increase of CoGs by $2.15 mln.
Therefore if Mr. Bierbaum is confident enough to increase net revenue (by negotiating better selling prices or increasing gross margin) by $6.15 mln. so it would meet the required cash flows. Then he definitely should hedge his aluminum costs, since the distress costs would be significantly higher than any lost benefit in a drop of aluminum prices. Should he feel unable to do this he should rather find someone to take over his company to avoid a loss in his company’s value. Conclusion
After analysing the situation we have reached the conclusion that this company can only continue on itself if Mr. Bierbaum manages to increase his ratio’s significantly by increasing his net revenue further. However the recent rise in aluminum prices might prove to be an added problem to this. Mr. Bierbaum proposed to mitigate this risk by hedging. Our analysis shows that he only should do this if he’s confident enough to raise net revenue by $6.15 mln. to compensate for the loss of increased Cost of Goods sold.
Should Mr. Bierbaum not be confident enough to raise net income by this rate we advise him to sell the company by a leveraged buy out. This could safeguard the future of the company and avoid costs which would encur if the company gets into distress. However the franchise and added benefits associated with it will discontinue as well, perhaps a Leveraged Buy Out by pepsico itself could be an option.
Should this not be an option as well then there only hopes for Mr. Bierbaum for the aluminum price to decrease, which seems unlikely according to Mr. Bierbaum himself.