Case 061Capital allocation and corporate actionsHard

Aurevik Foods buys Zestora Naturals, a direct to consumer brand, for 6x sales. Zestora's operating profit is small but growing 30% a year. How many years until the deal earns Aurevik's 12% cost of capital?

The situation

Aurevik Foods, a listed packaged foods company, agrees to buy Zestora Naturals, a direct to consumer brand of health snacks, for Rs 1,200 crore in cash. Zestora has sales of Rs 200 crore, so the price is 6x sales, and operating profit of Rs 20 crore, a 10% margin. Management's deck says operating profit will grow 30% a year.

Aurevik's cost of capital is 12% and its tax rate is 25%. Assume, generously, that Zestora needs no further capital to grow.

Your task

Work out the return Aurevik earns on the price each year, how long until it reaches 12%, and what has to be true for the deal to have been worth it.

Quick check

At 30% growth, roughly when does Zestora earn 12% after tax on the Rs 1,200 crore price?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

About 8.6 years: the deal earns 12% on its price only during year 9, and only if 30% growth holds the whole way. Aurevik needs Rs 144 crore a year of after-tax profit from Zestora; today it gets Rs 15 crore, a 1.25% return. Until year 9 every year falls short of the cost of capital, about Rs 687 crore in total. A high price buys years of value destruction first.

Step 1What does Aurevik actually earn on the price in year 1?

Buying a flat for Rs 1.2 crore that rents for Rs 15,000 a month gives you 1.5% a year, however fast rents in the area are rising. An acquisition is judged the same way: after-tax operating profit divided by the price paid, against the cost of the money. Zestora's Rs 20 crore of operating profit is Rs 15 crore after 25% tax, a 1.25% return on Rs 1,200 crore. Aurevik's money costs 12%, so the gap in year 1 is more than Rs 125 crore.

Step 2How long does 30% growth take to close the gap?

Aurevik needs 12% of Rs 1,200 crore, Rs 144 crore of after-tax profit. That is 9.6 times today's Rs 15 crore. At 30% a year, profit takes 8.6 years to grow 9.6 times, so the deal crosses its cost of capital during year 9. Every year before that, Aurevik's shareholders earn less on the Rs 1,200 crore than they would have demanded, a cumulative shortfall of about Rs 687 crore over the first eight years.

The relationship
n=ln⁡(144/15)ln⁡(1.30)=ln⁡9.6ln⁡1.30≈8.6 yearsn = \frac{\ln(144 / 15)}{\ln(1.30)} = \frac{\ln 9.6}{\ln 1.30} \approx 8.6\text{ years}
14412% of the Rs 1,200 crore price, the after-tax profit needed
15Zestora's after-tax operating profit today
1.30one year of 30% growth
What it says in wordsThe number of years of 30% growth needed to multiply profit 9.6 times.
Return on the price paid, by year, against a 12% cost of capital0%4%8%12%16%12% cost of capitalYr 0: 1.25%Yr 3: 2.75%Yr 6: 6.03%Crosses at 8.6 yearsEvery year in the shaded area destroys valueYr 0Yr 2Yr 4Yr 6Yr 8Yr 10Yr 12NOPAT of Rs 15 crore growing 30% a year, over a Rs 1,200 crore price
Aurevik's return on the Rs 1,200 crore price starts at 1.25% and, even with Zestora's profit growing 30% a year, reaches the 12% cost of capital only after 8.6 years, so every earlier year destroys value.
Step 3What has to be true for the price to have been right?

Turn the growth into a business. After nine years of 30% growth, operating profit is Rs 212 crore. At today's 10% margin that needs sales of about Rs 2,121 crore, ten times today's Rs 200 crore; even at a 15% margin it needs Rs 1,414 crore. The price assumes Zestora becomes a large mainstream brand, not a successful niche one. A discounted cash flow says the same in other words: at 12%, the stream is worth the Rs 1,200 crore price only if 30% growth lasts about 10 years before settling at 5%.

Years of value destruction before the deal earns 12%, by growth rateProfit grows 20% a year12.4 yearsProfit grows 25% a year10.1 yearsProfit grows 30% a year8.6 yearsProfit grows 35% a year7.5 yearsProfit grows 40% a year6.7 yearsThe deck's 30% case is the lime bar; a slower brand pushes breakeven past a decade
At 30% profit growth Zestora needs 8.6 years to earn 12% on its price; at 25% it needs 10.1 years and at 20% 12.4 years, so a small miss on growth adds years of value destruction.

State the generous assumption. Direct to consumer growth usually needs cash: marketing that is really investment, inventory and working capital. Every rupee Aurevik adds to fund growth raises the capital base and pushes the crossover further out. The right counter-case to raise is a synergy one: if Aurevik's distribution lifts Zestora's sales without extra spend, the curve steepens. Ask for that number in rupees before believing it.

Where candidates lose it

Candidates look at 30% growth and call the deal attractive without converting the price into a return. The interviewer wants to hear 1.25% against 12% in the first minute.

The second loss is using pre-tax profit, which makes the crossover look more than a year sooner. The cost of capital is an after-tax hurdle, so the profit set against it must be after tax too.

What the interviewer asks next

  • Aurevik could have bought back its own shares at a 5% earnings yield instead. How does that change your view?
  • What distribution synergy in rupees would bring the crossover to year 6?
  • How would you expect Aurevik's reported return on capital to look for the next five years, and how would you adjust for it?

Company names and figures are illustrative.