Street Capitalist: Event Driven Value Investments

Vertical integration appears to be a continuing trend in the business world, with Coca-Cola’s (NYSE:KO) decision to acquire Coca-Cola Enterprises (NYSE:CCE) being the latest example:

Coca-Cola Co. agreed Thursday to buy the bulk of its largest bottler in a deal valued at about $12.17 billion, including debt, to gain more control of manufacturing and distribution.

Under the terms of the deal, Coke would give up its 34% stake in Coca-Cola Enterprises Inc., worth $3.4 billion, and assume $8.88 billion in debt, and all North American assets and liabilities. CCE agreed in principle to buy Coca-Cola’s bottling operations in Norway and Sweden for $822 million, and acquire a 83% equity stake in its German bottling operations in the near future.

CCE’s shares surged 30% to $25 in premarket trading, while Coca-Cola fell 2.6% to $53.65.

With the transaction, Coca-Cola Chairman and Chief Executive Muhtar Kent said the company was converting “passive capital into active capital.” He added it would give Coca-Cola direct control over its investment in North America to accelerate growth.

CCE shareholders will get one share of a new Coca-Cola Enterprises company focused only on European bottling and will get a one-time $10-a-share payment. The company plans to issue debt to finance this payment and the European acquisition.

Coke will control about 90% of the bottling of its products in North America. It expects cost savings of $350 million over four years and that the acquisition will add to earnings per share by 2012. The transactions are expected to close in the fourth quarter.

Coca-Cola Strikes Deal With Bottler (WSJ)

Dana Cimilluca, Betsy McKay, and Jeffrey McCracken go on to note how this is a big reversal in strategy by Coke. We saw the first example of this earlier with Pepsi:

PepsiCo announced last April that it aimed to subsume Pepsi Bottling Group Inc. and PepsiAmericas Inc. Pepsi said the $7.8 billion deal will allow it to have greater control over development, distribution and marketing of new products with the acquisitions, which are expected to close Friday.

Owning its bottlers allows PepsiCo to negotiate alone with retailers, rather than sharing that task with representatives of separately publicly traded bottlers…

When PepsiCo Chairman and CEO Indra Nooyi launched that company’s similar move in April, she said owning the two bottlers would give it the flexibility to decide how its beverages should be distributed. As the industry moves from a heavy reliance on carbonated soft drinks into water, juice, teas and other noncarbonated drinks, some soft-drink bottlers don’t have the equipment to manufacture the noncarbonated drinks and many are sold in small volumes. “We can accelerate revenue growth and be more agile and flexible,” Ms. Nooyi said at the time.

PepsiCo has said it expects to save $400 million by 2012 from the deals. But Bill Pecoriello, chief executive of ConsumerEdge Research LLC, believes the company may actually reap more than $600 million.

These deals make sense for Pepsi and Coke as consumers shift away from soft drinks. With consumers becoming more health conscious, they are looking towards healthier drink options, think Vitamin Water or juices and teas. This is problematic for Pepsi and Coke because they didn’t have the power to bring such drinks to market. By shedding their bottling units in the 80′s, they were able to take assets off of their balance sheet and become more akin to marketing companies — thus boosting their ROIC. Now though, even if they generate good returns on invested cash, they still face the problem of lagging behind upstart competitors. Coke needs control over bottlers so they can push new investments in equipment and strategy, to bring non-carbonated beverages to market. The price of that lag can be staggering, Coke’s decision to acquire Vitamin Water for $4.1B is evidence of that.

The main problem stems from the fact that the bottling business is expensive and very capital intensive making it difficult to quickly deploy resources in trying new and untested beverage concepts. I would guess that Coca-Cola Enterprises is reluctant to do this, given the nature of their business, and would rather have Coke shoulder the risk. How does that shouldering of the risk occur? Coke sells Coca-Cola Enterprises its syrup at a certain price. Longer term fixed prices for syrups would have enabled the bottlers to raise prices and increase margins on their end, without having to resort to increasing the volume of their sales. But, it seems as if such an agreement was not possible, and Coke had to follow Pepsi’s lead in a bottler acquisition.

Still, there is some savvy dealmaking behind the transaction. Unlike Kraft’s decision to sell its Pizza business to Nestle in a poorly structured manner that incurred a high tax rate, this deal looks as if it may be a tax fee exchange in which their equity position in the bottler is swapped for operating assets. However, deal will undoubtedly dilute Coke’s return on invested capital. Coke’s ROIC appears to be at about 22% whereas the bottling unit CCE achieves a low 7%. But, this may make strategic sense in the longer term as Coke and Pepsi fight to expand beyond their carbonated offerings and continue their dominance as

Overall, this looks to be the continuation of an ongoing trend where companies are integrating vertically as their margins are pressured by shifts in the market and consumer demand. I loved Ben Worthen, Cari Tuna, and Justin Scheck’s piece in the Wall Street Journal on it:

…executives [are] reviving “vertical integration,” a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co.

The reasons vary. Arcelor, the world’s largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed.

“The pendulum has shifted from disintegration to integration,” says Harold Sirkin, global head of the Boston Consulting Group’s operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue — challenges exacerbated by the recession…

Such steps don’t necessarily portend a return to the early-20th-century vertical conglomerates of Andrew Carnegie and Henry Ford. Then, Carnegie Steel Co. and Ford Motor Co. each owned iron-ore mines, while controlling everything from manufacturing to sales.

“The historical view of vertical integration was that you had complete control of the supply chain and that you could manage it the best,” says Bain & Co. consultant Mark Gottfredson.

Today’s approach is more nuanced. Companies are buying key parts of their supply chains, but most don’t want end-to-end control.

Companies More Prone to Go ‘Vertical’ (WSJ)

If the trend continues, investors could go hunting for some of these key supply chain players that are publicly traded. If they are undervalued, an acquisition would undoubtedly be a catalyst for that value being unlocked. For investors in the acquirers, you can expect some of that ROIC being sacrificed.