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The Street has given a thumbs down to Apollo Tyres' debt-funded $2.5-billion acquisition of US-based Cooper Tire and Rubber Company, sending the Indian company's stock price crashing 25 per cent on Thursday. Given the enterprise value (EV) of $2.5 billion, which is nearly two times Apollo's current size and the fact that the acquisition is financed entirely through debt, it is over-leveraged, according to Ashvin Shetty, analyst at Ambit Capital.
The Street did not like the steep premium paid for the deal and the consequent doubling of net debt to equity to 1.35 times and net debt to earnings before interest, taxes, depreciation and amortisation (Ebitda) to 3.8 times at the consolidated level. Nirmal Bang's Gaurant Dadwal says the deal at EV/Ebitda of 4.8 times is on the higher side, because Cooper Tire traded at EV/Ebitda of 3.5 times of CY14 estimates as of Tuesday's closing price.
According to Kotak Institutional Equities, net debt/Ebitda for the consolidated operations would be close to 3.5 times and is aggressive, considering a benign raw material environment has buoyed Ebidta margins of tyre makers globally.
Credit Suisse analysts say the company's Dutch acquisition, Vredestein, has worked for it as it was bought from a bankrupt company at a very reasonable valuation. While admitting that there is strategic fit for the Cooper acquisition, the research firm says given the fair price paid for it, any upside would be based on the kind of synergies it can get.
Due to the uncertainty on the margins and execution fronts, most analysts have either an 'underperform' or a 'neutral' view on the stock.
Earnings accretive, but can margins be sustained?
The Apollo management has indicated that the deal would be earnings per share (EPS)-accretive in the first year itself, but analysts believe the soft input costs have helped boost Ebitda margins and that these margins, especially at Cooper, may be peaking out.
Jatin Chawla and Akshay Saxena of Credit Suisse say while the transaction is EPS-accretive on CY12 numbers, investors will question the sustainability of Ebitda at Cooper, given CY12 profits, to a large extent, were driven by a favourable raw material cycle.
Moreover, there are concerns over pricing stability in the US given increasing competition from Chinese and Japanese players. If Apollo has to make it count from day one, there is zero room for error.
Kotak analysts believe if annual interest costs of $225 million are taken into consideration and compared with CY12 net profit of $220 million, the deal would add to Apollo's earnings only if current margins at Cooper are sustained. Even a 100 basis points (bps) deterioration in margins can swing the situation from EPS-accretion to the other way round. Given that $2.1-billion of the total debt to be raised would be funded by Cooper and Vredestein, the overseas entities -- especially Cooper -- would need to maintain margins to be able to bear the higher interest outgo. Currently, Cooper has a net debt of about $100 million and is a working capital positive company.
Complementary, but execution worries remain
There is little doubt about the synergies between the two companies. Apollo has no presence in the US and China - Cooper's key markets. The deal means Apollo will put on hold its greenfield expansions in south-east Asia and eastern Europe given Cooper's presence in these geographies. The combined entity with revenues of $6.5 billion (Cooper: $4.2 billion) will be the world's seventh largest tyre company.
The Apollo management expects the combination benefits of Rs 465-700 crore ($80-120 million) per annum at the Ebitda level, on the back of operating scale, sourcing benefits, technology, product optimisation and manufacturing improvements. Given the nature of this global deal, implementation and integration of operations of the two entities will be critical to deriving the benefits envisaged by the Apollo management. Goldman Sach's Sandeep Pandya and Sumeet Jain say execution is key in order to generate stable margins, particularly amid a volatile demand and raw material environment, and reduce leverage over time.
