March 05, 2010 - 11:37am EST by
2010 2011
Price: 25.92 EPS $1.60 $1.75
Shares Out. (in M): 492 P/E 16.2x 14.8x
Market Cap (in $M): 12,743 P/FCF 14.8x 15.9x
Net Debt (in $M): 7,731 EBIT 1,595 1,714
TEV (in $M): 20,474 TEV/EBIT 12.8x 11.9x

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     Just before PEP closed the acquisition of its domestic bottlers (PBG & PAS) on 3/1/10, KO announced a friendly deal on 2/25/10 to buy out the North American division of CCE via a split-off and exchange offer.  KO presently owns 34% of CCE, which operates two segments, North America and Europe.  North America accounted for $15.1bn or 70% of '09A sales and $1.5bn EBITDA (10% margin). Europe accounted for the remaining 30% of sales ($6.5bn) and just shy of $1.1bn of EBITDA (16.5% margin). The deal will create the European bottling operation with no debt, $1bn of cash and whatever monies the combined CCE biz generates between now and the close of the transaction early in 4Q10.  The unlevered CCE stub will immediately borrow $2bn, pay a $10 special dividend and spend $822mm (8.3x '09A EBITDA of $99mm on $741mm of sales) to buy KO's bottling operations in Sweden and Norway.

     I would buy CCE today and toward year end (1) collect a $10 special dividend and (2) exchange CCE for shares in the newly formed CCE Europe.  CCE Europe trades on 6.7x '09PF EBITDA and a 10% free cash yield.  Its peers trade on 9x '09A, 8x '10E and 5%-7% free cash yields.  If EBITDA does not grow and we put CCE Europe on 8x '10E, the upside is 26% and the downside is 26% (@ 5.5x).  On 9.0x '09A the upside is 47% and the downside remains the same. As an alternative to buying shares, one can purchase Jan 2011 $25/$30 call spreads for $2.05, which would return $5.00 (+144% if the shares rise to $30, or -100% below $25/shr).

     18-36 months after the close of the exchange offer the CCE stub will also negotiate the purchase of 83% of KO's German bottling operation for "fair value." Both KO and CCE have been tight lipped about the potential price for the German asset, but given that the transaction is better than two years away, I set it aside for the purposes of this analysis. Note that KO will not receive the special $10/share dividend on its CCE holdings.

     CCE Europe's closest peer (Britvic) trades on 9.0x '09A and 8.0x '10E. Roughly 40% of CCE Europe sales come from the UK, and Britvic operates exclusively in the UK. Comparable international bottlers (FEMSA, Hellenic, Amatil, Icecek, Arca, Britvic and Andina) also trade on an average of 9x '09A and 8x '10E.  Britvic's markets are mature, similar to CCE Europe (see for a geographic breakdown and pro-forma financials).  By subtracting the $10 special dividend from the $26.00 share price, we get an implied stub price of $16.00/share. So, 9.0x '09PF EBITDA of $1.179bn less $2.25bn of PF Net Debt over 355mm fully diluted shares (debt and share count are per management guidance and are each treated later in more detail) = 9.0 x $1.179bn = TEV $10.611bn - $2.25bn Net Debt = $8.361bn Equity Value / 355mm shares = $23.55 for the CCE stub. $23.55/$16-1 = 47.0% upside. Even if we hold EBITDA constant and put the biz on a forward multiple of 8x we still get $20.23/$16-1=26% upside.  On the downside, if the deal does not go through, or closes while the broader market tanks, the CCE stub could trade down to a historically low multiple of 5.5x, or $11.82/$16-1= -26.1%. Before the deal announcement combined CCE traded on 6.7x '09A, or $19.18, so if market conditions hold and the deal breaks, $19/$26-1= -27% downside. So, call it 26% downside and 26-47% upside.

     As sanity check, I estimate the stub throws off about $560mm of free cash, $16.00 x 355mm s/o = $5.68bn equity value would imply a free cash yield of about 10%.  After the close of the deal CCE will initiate a $1bn share repurchase and a 50c/share dividend, so we'll actually realize that yield. To get to $560mm I multiply $847mm of '09PF EBIT x the 30% tax rate guidance for CCE Europe, add D&A and subtract CAPX. Again all these inputs can be found at $847mm (1-30%) + $332mm D&A - $363mm CAPX (@ 5% '09PF sales per mgmt guidance) = $562mm. Net working capital (ex cash and st debt) has run at about 2% of sales at CCE - but the annual change in net working capital is small and highly variable - so for the sake of simplicity I did not adjust FCF for working cap.

     CCE is still awaiting final word from the IRS, but currently expects the special dividend to qualify as a tax free return of capital. To be conservative one could assume that only $5 gets tax free treatment and the other $5 gets taxed at 15%, thereby knocking 75c off the value of the special dividend. As an aside, CCE pays 9c/qtr so holders will also get 36c, 30c after tax assuming a December close. See slide 29 of 30 for a list of regulatory approvals related to the transaction The main idea here is that because regulators allowed Pepsi to buy its North American bottling network, they will let Coke do the same.

Transaction Multiple:

     KO will not exchange its 169mm shares (34%) of CCE stock for shares of CCE Europe.  KO's abstention from the exchange offer will effectively convey $3.4bn of equity value (169mm shares @ 30 day avg of $20.13) to CCE Europe holders, who will then own 100% of the pro-forma entity. In addition to the $3.4bn equity contribution, KO will assume all $8.88bn of CCE's outstanding debt and $580mm of pension obligations.  At YE09A total ABO for all plans was $3.4bn and FV of plan assets was $2.964bn, so by assuming $580mm of pension obligations KO will leave CCE Europe with a $147mm pension accounting surplus ($2.964bn-$3.4bn+$580mm=$147mm). So, ex-the assumption of pension obligations, total consideration paid to CCE holders comes to roughly $3.4bn Equity + $8.88bn Debt = $12.2bn TEV, $12.2bn / $1,496 of Adj. '09 North American segment EBITDA = 8.15x. The PBG deal was done at 7.6x LTM.  For our purposes, as long as KO does not feel the need to back out of the transaction (i.e. if they had paid say 12x for some reason and later came to regret the decision) we are happy.

Net Debt:

     CCE had $1bn of cash at year end '09A and CCE Europe will get to keep all of it, plus whatever cash CCE generates up until the close of the deal in 4Q10. Last year CFO - CAPX was $860, and management guided to $800mm of FCF for the full year '10E. Free cash is reasonably stable ($717mm '05A, $666mm '06A, $721mm '07A and $637mm '08A), and was somewhat elevated in '09A because of a one time working capital benefit (the Accounts Payable and Accrued Expenses line item on the cash flow statement was up $100mm y/y on accrued comp, fx and a one day increase in days payable). $860mm of FCF in '09A less the $100mm one time benefit would be $760mm; $800mm '10E - $760mm would imply $40mm of FCF growth in the '10E guidance. CCE pays a 9c dividend per share, as mentioned earlier, and will pay a year of dividends before the deal closes 9c x 4 x 492mm S/O = $177mm. So, $1bn of cash on hand, plus $800mm generated through year end, less $177mm paid in dividends equals $1.6bn of cash at the time the deal closes. CCE Europe plans to borrow $2bn, bringing total cash on hand at the end of 2010 to $3.6bn, before the payment of the special dividend and the purchase of Sweden and Norway.  Remember this $3.6bn figure; it will come up again in just a moment.

     CCE listed 492mm shares outstanding on the front of its 10-K, filed on 2/12/10.  The cancellation of KO's shares will leave CCE with (492mm - 169mm) = 323mm shares.  Although not all vested options will be exercised, CCE includes in the money options their fully diluted pro-forma guidance range of 350mm-360mm shares.

     Above $25/share, 91% of 26.6mm vested options are exercisable, and those 26.6mm options generate 19mm shares of dilution via the treasury method. CCE has an additional 11.5mm restricted shares, RSUs and Performance share units that have vested (2mm more will vest if the CCE share price rises above $27.19). So, 323mm basic shares + 19mm options + 11.5mm RSUs/Restricted shares = 353.5mm. 7mm outstanding options remain to be vested over time, and on average CCE grants about 3mm new options a year. So, I add in another 1.5mm shares to the 353.5mm total to get 355mm (midpoint of the guidance range).  Even if there are no grants, another 2.1mm options are vested in the $25-$28 range with a weighted average price of $26.24, so share price appreciation from here would create a bit more dilution, independent of the baseline rate at which pre-existing unvested in-the money options vest during the year.

     At year end '09, 26.7mm of 33.7mm options were vested and those vested options had a weighted average strike price of $20.92. 14.5mm of the 26.7mm vested options (54.5%) were struck between $21 and $25, so the deal announcement which drove the stock from $19.18 to $26 was a boon to CCE employees and shareholders alike. Those insiders who do not exercise options will have their contracts adjusted for the special dividend and tied to the appropriate new entity. Employees will exercise some options ahead of the deal close, but because the min strike price in the CCE option pool is $9.00 and the special div is $10, proceeds from options exercised will, on balance, handily exceed the incremental cash cost associated with the increase in the number of shares eligible to receive the special dividend.  The net cost of the special dividend will at most be 323mm shares x $10/share = $3.23bn. $3.23bn plus the $822mm purchase of Sweden and Norway comes to a $4.05bn use of cash by the end of 2010. So, how much cash will be left over from the options exercise?

     CCE employees exercised 3.5mm options in '09A, 0.9mm in '08A, 6.5mm in '07A. Given that 54.5% of vested options just came into the money, options execution should exceed past levels during 2010. Management guided to 1.7x Net Debt/EBITDA on the deal conference call, which implies a net debt balance of around $2bn. Given that we have narrowed the cash balance at year end to $3.6bn, and the uses of cash to $4.05bn, that leaves $450mm that must come from options exercises - in order to leave a $2bn net debt balance consistent with guidance.  At an average price of $20.92 that would imply 21.5mm options, or 80% of the vested balance and over 90% of the vested, in-the money, options would need to be exercised. That seems a tad aggressive to me, so I assume about 13mm options (double the '07A number of 6.5mm and 49% of the vested balance at YE09A) are exercised for proceeds of $270mm. Then I subtract $10 for the special dividend associated with each newly created share, for net proceeds of $270mm - $10 x 13mm = $140mm.

     So, the year end cash balance of $3.6bn we calculated above, less the $4.05bn CCE Europe will use during the year, means that this newly formed company will need $450mm, less $140mm from net options exercises, leaving $310mm still to borrow. The cash balance at YE09A is actually $1.057bn. So $310 - the $57mm we have been rounding away = $253mm. Add $253mm of new borrowing to the $2bn of debt CCE will borrow immediately after the exchange offer, and we get the net debt balance of $2.25bn from the first page.  In the deal related slide presentation (link provided earlier) CCE indicates a range of 3.0x Total Debt to EBITDA, which could mean $1.179bn x 3.0 = $3.537bn total debt, less $1.057 cash = $2.480bn Net Debt. But, on the deal call CCE targeted 1.7x Net Debt/EBITDA. If they really do wind up with $2bn of net debt and not $2.25bn we get $250mm/355 shrs = 70c/share more upside (or 70c/share less upside on $2.48bn of net debt).  I spoke with both companies this week and reached the conclusion that not even CCE could be entirely sure which level to forecast at this stage. The mid range, $2.25bn, seems reasonable given what we know about the heavy option vesting this year.

Call Spread:

     As mentioned earlier, one could buy the Jan 2011 $25/$30 call spread for $2.05. The OCC will adjust the strike price for the $10 special div, making it a $15/$20 call spread. Earlier we calculated that 8.0x no growth '09A EBITDA gets us to $20.23, just into the money on the short $20 call, and $5 into the money on the long $15 call. So, here we can put up $2.05 to make $5.00, or $5.00/2.05-1= 144%. One could invest a smaller amount of capital in this more levered structure, and if it goes to zero wind up with the same loss, in absolute dollar terms, as being down say 26% on a large long position in the stock.  Time horizon matters here, since the option structure will force the realization of a loss upon option expiration in Jan 2011- whereas with the stock one could hold an unrealized loss.

     One year, 26-47% up and 26% down in the stock, or 144% up and 100% down in the Jan $25/$30 call spread. Have a Coke and smile.



1. Filing of SEC proxy statement, and notice that the proxy is effective

2. CCE shareholder vote (no vote required by KO shareholders, and KO will not vote the 34% of CCE shares it controls).

3. News of approval from anti-trust regulators in the US, Canada and Europe

4. Exchange offer and payment of the special dividend (expected in 4Q10 commensurate with deal close).

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