Phase 1
Group 11, Section A
Overview of ITC
 ITC - India's foremost private sector companies with a market

capitalisation of over US $ 33 billion an...
Divisions of ITC

Business Valuation

3
Strength

Weaknesses

•
•
•
•

• No global exposure

Strong top management
Strong supply network (E-chaupal)
Vertically in...
Ratio Analysis

Business Valuation

5
Advanced DuPont Analysis
Financial Year

2008

2009

2010

2011

2012

2013

Net Operating Margin

0.224

0.216

0.226

0....
Advanced DuPont Analysis
1.6

1.4

Net Operating Margin

1.2

Net Operating Assets Turnover
1

Return on Net Operating Ass...
Cost of equity calculation
Assumptions
 CAPM was used to find the cost of equity
 Rm and Beta has been calculated using ...
Cost of capital parameters
Parameters

Values

Rf

7.66%

Rm

14.92%

Cost of equity

12.36%

Beta

0.55

Cost of debt

10...
Important forecasting assumptions
 Sales growth put at 4.5% given ITC’s potential and the long term

growth possibilities...
Valuation models used
Dividend discount model

Discounted cash flow
model

Residual earnings
valuation

• Steady payout ra...
Forecasted values
Parameter

Actual

DDM

Residual
earnings

Price

182

225

281

P/E
ratio

12.88

15.93

19.89

Forecas...
Sensitivity Analysis

Business Valuation

13
Sensitivity Analysis

Business Valuation

14
Accounting Flags
Horizontal Analysis
• RnD, SGA, COGS, Revenue rise inconsistently in FY 2011
• Huge jump in current liabi...
Conclusion
Market Price

Residual
Earnings Model

BUY

Business Valuation

16
Phase 1
Group 3, SectionA
Background
 Started in 1995 by B. Shantilal group
 B2B company based out of Karnataka
 Manufactures wheat products like...
Overview of Company operations
 Company being sustained by raising more debt
 Cash from operations and cash from investi...
Valuation models used
 Risk free rate calculations

Estimated from security zero rate curve as on 31 December 2010 for
ea...
Beta calculation
 Stock is highly illiquid; CAPM theory doesn’t reflect the true value of

the cost of equity for this st...
Estimated Beta
Levered Beta for Sunil Agro

Self (Bloomberg)

0.24

Indian Peers

1.08

Indian Select Peers
(Mkt Cap less ...
Cost of Debt calculation
 Reported book values of debt & interest expense from the annual

reports of 2006 - 2011 were us...
Salient Features of Valuation
 Valuation done as on 1st January 2011 for both 5 year and 10 year growth

scenarios
 Stab...
DCF Valuation - 10 year forecast
Case

Beta Value

Average Cost of
Equity *

Average Cost of
Capital *

Benchmark

N.A.

1...
DCF Valuation-5 year forecast
Case

Beta Value

Average Cost of
Equity *

Average Cost of
Capital *

Share Price
using FCF...
Residual Income Valuation - 10 year
forecast
Case

Beta Value

Average Cost of
Equity *

Average Cost of
Capital *

Share ...
Residual Income Valuation-5 year
forecast
Case

Beta Value

Average Cost of
Equity *

Average Cost of
Capital *

Share Pri...
Option Pricing Valuation
 Assuming the total assets of the firm as the underlying assets








having a strike pric...
Option Pricing Valuation
Year

2006

2007

2008

2009

2010

Total Assets

1,83,705

2,15,658

1,99,686

2,23,882

2,17,98...
Conclusion
 The company is not investing in its growth and is meeting the whole of

its cash flow requirements by raising...
Phase 2
Groups 3 and 11
K.G. Palepu’s parameters
Parameter

Sunil Agro Foods Industry Average

Inefficient Management
Hypothesis (Accounting ROE)
...
Comparison






Sunil Agro Foods Ltd: B2B agro produce supplier
Agribusiness at ITC: 10% of revenues, 5% capex
Earni...
Strategic Motives
 Vertical Integration with suppliers to FMCG business
 Intangible gains: experience in agri-business; ...
Points against acquisition
 Positively correlated earnings and cash flows
 Variability in earnings & cash flows will not...
Price of the Target Firm
Status Quo valuation:
As done in Phase 1 of analysis

Surplus Value:
As per value of control and ...
Valuing Synergies from Acquisition
 WACC reduced from 12.35% to 12.34%
 Value generated from reduced cost of capital: IN...
ReOI valuation
 Using ReOI valuation, the value of Sunil Agro’s operations: 5.21 crore
 Current Market Capitalization is...
Financing the Acquisition
Variables
Total assets of target and acquirer

0.08%

Net worth of target and acquirer

0.05%

T...
Merger valuation for itc and sunil agro
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Merger valuation for itc and sunil agro

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Merger valuation for itc and sunil agro

  1. 1. Phase 1 Group 11, Section A
  2. 2. Overview of ITC  ITC - India's foremost private sector companies with a market capitalisation of over US $ 33 billion and a turnover of US $ 7 billion  Diversified presence in FMCG, Hotels, Paperboards & Specialty Papers, Packaging, Agribusiness, and IT  Market leader in its traditional businesses of Cigarettes, Hotels, Paperboards, Packaging and Agri-Exports Business Valuation 2
  3. 3. Divisions of ITC Business Valuation 3
  4. 4. Strength Weaknesses • • • • • No global exposure Strong top management Strong supply network (E-chaupal) Vertically integrated supply chain High cash reserves and debt capacity SWOT Opportunities Threat • Economic Growth • ITC’s Brand Positioning • Leveraging IT • • • • Business Valuation Indian taxation policies Illegal tobacco trade Low consumption Import restrictions 4
  5. 5. Ratio Analysis Business Valuation 5
  6. 6. Advanced DuPont Analysis Financial Year 2008 2009 2010 2011 2012 2013 Net Operating Margin 0.224 0.216 0.226 0.244 0.247 0.246 Net Operating Asset Turnover 1.255 1.222 1.330 1.430 1.415 1.397 Return on Net Operating Assets 0.281 0.264 0.300 0.349 0.350 0.344 Net Borrowing Cost (NBC) 0.062 0.097 0.336 0.361 0.091 0.091 Spread (RNOA – NBC) 0.219 0.167 (0.036) (0.012) 0.259 0.253 Financial Leverage(LEV) 0.019 0.016 0.010 0.008 0.008 0.008 ROE = RNOA +LEV*Spread 0.285 0.266 0.300 0.349 0.352 0.346 Business Valuation 6
  7. 7. Advanced DuPont Analysis 1.6 1.4 Net Operating Margin 1.2 Net Operating Assets Turnover 1 Return on Net Operating Assets Net Borrowing Costs 0.8 Spread (RNOA-NBC) 0.6 Financial Leverage ROE 0.4 0.2 0 2008 2009 2010 2011 2012 2013 -0.2 Business Valuation 7
  8. 8. Cost of equity calculation Assumptions  CAPM was used to find the cost of equity  Rm and Beta has been calculated using S&P CNX 500 index for the period 2007-2011  5 years were taken to normalize the abnormal market movements due to economic downturn in 2008-09  Rf calculated on 10 year government bonds since horizon used is 10 years Business Valuation 8
  9. 9. Cost of capital parameters Parameters Values Rf 7.66% Rm 14.92% Cost of equity 12.36% Beta 0.55 Cost of debt 10.50% Cost of capital 12.36% Business Valuation 9
  10. 10. Important forecasting assumptions  Sales growth put at 4.5% given ITC’s potential and the long term growth possibilities in India  COGS has been approximated to the 5 year average for the terminal period considering the nature of the industry  R&D sales has been expected to stay up as per MD&A  Interest expense/ debt fluctuating but due to low D/E ratio left unchanged  Dividend payout ratio left constant at 40.2% as is been the trend Business Valuation 10
  11. 11. Valuation models used Dividend discount model Discounted cash flow model Residual earnings valuation • Steady payout ratio of 40% in last fours years • FCFE almost equal to FCFF • Uncertainty of earnings in the terminal period • Dividends are paid & rest is invested in operating assets & marketable securities • Model not recommended since ITC has substantial investment in marketable securities • Consistent & predictable dividend payout • Use of model is recommended • ITC is diversifying into other sectors; beta is 0.55 (less than 1) Business Valuation • Model is less sensitive to terminal value estimations • Model overvalued the stock as compared to dividend discount 11
  12. 12. Forecasted values Parameter Actual DDM Residual earnings Price 182 225 281 P/E ratio 12.88 15.93 19.89 Forecasts as on April 1st 2011 – using different models Business Valuation 12
  13. 13. Sensitivity Analysis Business Valuation 13
  14. 14. Sensitivity Analysis Business Valuation 14
  15. 15. Accounting Flags Horizontal Analysis • RnD, SGA, COGS, Revenue rise inconsistently in FY 2011 • Huge jump in current liability in FY 2010 Vertical Analysis • Operating Cash and Equivalents as share of Total Assets quadruple in FY 2009 Other factors • Inventory lying with 3rd parties not accounted for Positive Signals • Besides these, good corporate governance practices exist • Beneish M-score of -3.32 (<critical level -2.22) Business Valuation 15
  16. 16. Conclusion Market Price Residual Earnings Model BUY Business Valuation 16
  17. 17. Phase 1 Group 3, SectionA
  18. 18. Background  Started in 1995 by B. Shantilal group  B2B company based out of Karnataka  Manufactures wheat products like Maida, Sooji, Bran  Clients include Britannia Industries Limited, MTR Foods Limited, ITC Foods Limited Business Valuation 18
  19. 19. Overview of Company operations  Company being sustained by raising more debt  Cash from operations and cash from investing is negative over the years  Investments over the 5 years comparable to depreciation  Growth in account receivables much higher than growth in revenue  Highly volatile sales  Gross profit margin increased from 0.6% in 2007 to 2.7% in 2010 but net income remains negative  COGS decreasing over the past 5 years – only positive trend Business Valuation 19
  20. 20. Valuation models used  Risk free rate calculations Estimated from security zero rate curve as on 31 December 2010 for each period from year 1 to 30  Term structure used to calculate relevant market premium too  Market premium Calculation (Source - Sensex data) Market Premium used for 5 year & 10 year are as follows: Time Period Average return per month Market return (per annum) 5 years 13.06% 16.80% 10 years 10.47% 13.31% Business Valuation 20
  21. 21. Beta calculation  Stock is highly illiquid; CAPM theory doesn’t reflect the true value of the cost of equity for this stock  Beta estimate calculated by regressing with Sensex is too low  Hence, sensitivity analysis of valuation done for the following betas:  Using the past 3 year values (1 Jan 2008 to 31 Dec 2010) of sensex and stock prices of Sunil Agro Foods Ltd. we obtain the following values:  σ (sensex) = 1.109% , σ (stock) = 4.077%, ρ = 0.01548 , Beta = 0.057  The beta is too low to be true, and we attribute this to high illiquidity of this stock  To get a better estimate of cost of equity we also considered Bloomberg values of its peers in India & across the globe Business Valuation 21
  22. 22. Estimated Beta Levered Beta for Sunil Agro Self (Bloomberg) 0.24 Indian Peers 1.08 Indian Select Peers (Mkt Cap less than 50 Crore ) International Peers 1.62 Global Peers 1.36 Business Valuation 1.42 22
  23. 23. Cost of Debt calculation  Reported book values of debt & interest expense from the annual reports of 2006 - 2011 were used to find out the weighted average cost of debt  Weighted average cost of debt – 12.23% 2011 2010 2009 2008 2007 2006 Debt 9,61,76,079 9,88,95,539 7,73,91,639 8,03,98,942 9,20,68,090 7,93,87,559 Interest 1,07,46,218 1,05,22,949 1,07,20,475 1,21,47,749 1,05,26,375 94,72,087 Cost of debt 11.17% 10.64% 13.85% 15.11% 11.43% 11.93% Business Valuation 23
  24. 24. Salient Features of Valuation  Valuation done as on 1st January 2011 for both 5 year and 10 year growth scenarios  Stable growth rate was assumed to be equal to long term forecasted GDP growth rate of 6%  Debt/Equity = 1.13  High Leverage results in higher cost of equity resulting to a lower growth rate  COGS reduced from 99.80% to 97.30%, and we expect a further improvement of 250 basis points – 95% of sales as Terminal Value  A minor change in COGS can have a major impact in valuation of the company  Hence, it is important to focus on the efficiency of the firm in reducing COGS Business Valuation 24
  25. 25. DCF Valuation - 10 year forecast Case Beta Value Average Cost of Equity * Average Cost of Capital * Benchmark N.A. 12.23% 10.16 5.41 2.84 Benchmark +100 Bps N.A. 13.23% 10.16 3.21 2.85 Calculated 0.057 8.48% 8.21% 24.97 28.66 Bloomberg Value 0.24 9.41% 8.55% 17.06 21.24 Indian Peers 1.08 13.72% 10.09% 2.33 0.71 1.62 16.48% 11.08% -1.33 -6.73 1.42 15.46% 10.72% -0.09 -4.28 1.36 15.16% 10.61% 0.27 -3.48 Indian Select Peers (Mkt Cap less than 50 Crore) International Peers Global Peers Business Valuation Share Price using Share Price using FCFE (Rs.) FCFF (Rs.) 25
  26. 26. DCF Valuation-5 year forecast Case Beta Value Average Cost of Equity * Average Cost of Capital * Share Price using FCFE (Rs.) Share Price using FCFF (Rs.) Benchmark N.A. 12.23% 9.44% 17.28 11.83 N.A. 13.23% 9.63% 14.57 7.39 N.A. 12.9% 9.73% 15.38 8.76 Calculated 0.057 8.68% 8.28% 43.93 42.01 Bloomberg Value 0.24 10.25% 8.82% 26.61 24.78 Indian Peers 1.08 17.49% 11.30% 8.2 -4.66 1.62 22.14% 12.90% 4.96 -12.01 1.42 20.42% 12.31% 5.92 -9.7 Benchmark +100 Bps Benchmark + 67bps Indian Select Peers (Mkt Cap less than 50 Crore) International Peers Business Valuation 26
  27. 27. Residual Income Valuation - 10 year forecast Case Beta Value Average Cost of Equity * Average Cost of Capital * Share Price using FCFE (Rs.) Share Price using FCFF (Rs.) Benchmark N.A. 12.23% 10.16% 5.41 2.84 Benchmark +100 Bps N.A. 13.23% 10.16% 3.21 2.85 Calculated 0.057 8.47% 8.21% 19.31 28.59 Bloomberg Value 0.24 9.41% 8.55% 14.59 20.78 Indian Peers 1.08 13.72% 10.09% 2.28 -1.89 1.62 16.48% 11.08% -1.72 -10.8 1.42 15.46% 10.72% -0.45 -7.81 1.36 15.15% 10.61% -0.03 -6.85 Indian Select Peers (Mkt Cap less than 50 Crore) International Peers Global Peers Business Valuation 27
  28. 28. Residual Income Valuation-5 year forecast Case Beta Value Average Cost of Equity * Average Cost of Capital * Share Price using FCFE (Rs.) Share Price using FCFF (Rs.) Benchmark N.A. 12.23% 9.50% 17.17 16.41 Benchmark +100 Bps N.A. 13.23% 9.84% 14.57 11.88 Calculated 0.057 8.68% 8.28% 35.15 43.09 Bloomberg Value 0.24 10.25% 8.82% 24.95 28.50 Indian Peers 1.08 17.49% 11.30% 6.96 -1.20 1.62 22.14% 12.90% 2.56 -9.62 1.42 20.42% 12.31% 3.9 -6.94 1.36 19.9% 12.13% 4.36 -6.05 Indian Select Peers (Mkt Cap less than 50 Crore) International Peers Global Peers Business Valuation 28
  29. 29. Option Pricing Valuation  Assuming the total assets of the firm as the underlying assets     having a strike price equal to the debt, we calculated the value of equity as a call option However, in this method of valuation as the risk of the investment increases so does the value of the option In Sunil Agro’s case, the firm is sustaining by raising more debt and hence is on the verge of bankruptcy Due to this, the risk of failure is being shifted considerably on the debt holder which results in exaggeration of the value of holding equity We are thus of the opinion that the value derived by BlackScholes formula doesn’t truly reflect the fair value of the stock Business Valuation 29
  30. 30. Option Pricing Valuation Year 2006 2007 2008 2009 2010 Total Assets 1,83,705 2,15,658 1,99,686 2,23,882 2,17,981 Value of Debt 96,176 Returns 0.16 -0.08 0.11 -0.03 Horizon 90 days 6 months 1 year 5 yr Value of equity Price per share 10 yr 30 yr 1,23,450.78 1,25,061.90 1,28,440.02 1,52,574.99 1,74,723.34 2,10,516.45 41.11 41.65 42.77 Business Valuation 50.81 58.18 70.1 30
  31. 31. Conclusion  The company is not investing in its growth and is meeting the whole of its cash flow requirements by raising debt  Net income negative throughout due to high interest costs  Negative cash flows from operations and investments and they are expected to remain so for the foreseeable future, unless the debt is restructured or operations are made more efficient  The low beta values are mainly due to illiquidity and hence CAPM model is not suitable for valuation using calculated beta value  Stock is overvalued. Recommended rating - SELL Business Valuation 31
  32. 32. Phase 2 Groups 3 and 11
  33. 33. K.G. Palepu’s parameters Parameter Sunil Agro Foods Industry Average Inefficient Management Hypothesis (Accounting ROE) Growth resources imbalance hypothesis (GRDUMMY) Likelihood of Acquisition 10.20% Growth Liquidity Leverage Firm size hypothesis (Net Book Assets) Asset undervaluation hypothesis (MTB) Price Earnings magic hypothesis (P/E) 11.60% High 11.20% 0.01 1.13 18.10% 0.17 1.64 Low Rs. 21.8 crore Rs. 1271.02 crore High 0.55 4.35 High -3.94 20.64 High Industry disturbance hypothesis (IDUMMY): •Quite a few number of acquisitions in the food industry in the last year •The landscape looks quite favourable for acquisitions in the future •Thus making Sunil Agro Foods Ltd. a favourable target Business Valuation 33
  34. 34. Comparison      Sunil Agro Foods Ltd: B2B agro produce supplier Agribusiness at ITC: 10% of revenues, 5% capex Earnings correlation: 0.43, Cash Flow correlation: 0.51 ITC geographically and sector-wise diversified Target company dominant in south India alone Sunil Agro ITC Leverage High Low ROC 0.66% 6.20% ROA -5.37% 20.46% ROE -14.13% 34.88% — — — — Business Valuation 34
  35. 35. Strategic Motives  Vertical Integration with suppliers to FMCG business  Intangible gains: experience in agri-business; can use E- Chaupal to source raw material for them  (-ve) EBT of target despite (+ve) EBIT implies tax benefits  ITC debt free, can gain from increasing leverage  Sunil Agro’s COGS ≈ 97% while ITC’s COGS≈ 53%  Better management will improve target’s COGS and ROE Business Valuation 35
  36. 36. Points against acquisition  Positively correlated earnings and cash flows  Variability in earnings & cash flows will not go down  Risk diversification as a motive doesn’t hold ground  Target firm consistently loss making  Target cheaper than peer companies, yet overvalued by market  No new investment opportunities produced by merger Business Valuation 36
  37. 37. Price of the Target Firm Status Quo valuation: As done in Phase 1 of analysis Surplus Value: As per value of control and value of synergy Range of prices payable by ITC: (Status Quo) < x < (Status Quo + Surplus Value) Business Valuation 37
  38. 38. Valuing Synergies from Acquisition  WACC reduced from 12.35% to 12.34%  Value generated from reduced cost of capital: INR 206mn  ITC’s tax benefits from negative EBT of target : INR 3.08mn  Sunil Agro’s value increase from 15% COGS reduction = INR 910mn  ITC’s ROC marginally declined by 0.01% Business Valuation 38
  39. 39. ReOI valuation  Using ReOI valuation, the value of Sunil Agro’s operations: 5.21 crore  Current Market Capitalization is approximately 4.7 crore  Makes great sense to buy out complete equity of Sunil Agro at its current value  Undervaluation is primarily due to ineffective management & unprofitable leverage (its EBIT is positive, while its Net Income is projected to remain negative throughout)  ITC has huge reserves of cash which it can utilize for financing this purchase & thus increase its returns on ideal cash too Business Valuation 39
  40. 40. Financing the Acquisition Variables Total assets of target and acquirer 0.08% Net worth of target and acquirer 0.05% Target’s net worth to ITC’s cash balance 0.19% Target’s net worth to ITC’s debt capacity      Ratios 1.34% Debt and cash available to make the acquisition ITC undervalued, Sunil Agro overvalued by the market Sunil Agro’s operating assets are undervalued Using equity or equity swaps not in acquirer’s favor Cash the preferable means to finance the acquisition Business Valuation 40

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