The recent successful Xero initial public offering (IPO) and the current BurgerFuel IPO have drawn comparisons to the 42 Below listing in 2003. The common characteristics of these 3 IPOs are that the companies involved all had minimal or negative earnings, valuations that implied significant growth and a global strategy. The products, markets and business models of the 3 companies are completely different. Commentators have cited the returns provided to investors in 42 Below, “Shareholders made a lot of money out of it” (at approximately 2 min 20 sec), as a guide to the potential returns available from growth companies. Valuecruncher has posted previously on both the Xero and BurgerFuel IPOs. Given the comparisons Valuecruncher has decided to review the return provided to investors in the 42 Below IPO.

42 Below undertook an IPO in September 2003 issuing 31 million shares at $0.50 raising $15.5 million (every 3 shares purchased in the IPO was accompanied by 1 warrant with an exercise price of $0.50 available for exercise during October 2005). The issue price of $0.50 implied a post-money valuation of $60.5 million. At the time of listing 42 Below had negative earnings.

Post the IPO 42 Below traded significantly below the IPO price of $0.50 and remained below $0.50 for the majority of the first year it was listed. In the year ending 31 March 2004 42 Below had operating revenues of $4.41 million and an operating deficit of $1.125 million. This is to be expected from a company such as 42 Below that is developing products, expanding into new markets and building a brand.

42 Below continued to grow sales and in the 2005 financial year had operating revenues of $12.58 million producing an operating deficit of $5.22 million. A key driver of revenue growth in the 2005 year was increased sales in the U.S.. During the 2005 calendar year 42 Below consistently traded above $0.50 and at times over $0.80. In 2005 42 Below engaged Macquarie to advise on strategic issues surrounding development of international opportunities, the Bacardi offer arose as a result of this process.

In the 2006 financial year 42 Below continued to exhibit strong revenue growth increasing operating revenue to $17.0 million and improving the operating deficit to $2.8 million. A key contributor to these improved results was a foreign exchange gain of approximately $1.2 million.

After being listed for 2 1/2 years and nearly 4 full years of financial reporting 42 Below had grown revenues to approximately $17 million, established a strong brand in the New Zealand market for premium spirits and had grown sales in the U.S. to over $6 million in 2006. Despite this 42 Below was still not profitable. Although 42 Below were growing revenues, these revenues were spread across geographical segments (primarily New Zealand and the United States). Based on management forecasts for the 2007 financial year 42 Below was expecting trading revenues to grow to $18.2 and EBIT of ($4.9) million [compared to ($3.7) million in 2006].

On 27 September 2006 Bacardi made a full takeover offer for 42 Below at a price of $0.77. The day prior to the offer 42 Below closed at $0.57 and had traded at a volume weighted average price of $0.55 in the 6 months prior to the offer. Valuecruncher has discussed the framework required to evaluate the Bacardi offer in a previous post.

The offer from Bacardi represents a 54% return for an investor in the IPO, this represents an annualised return of 15.5%. Based on the $0.57 price the day before the offer the gross return would have been 14% or 4.5% annualised. In Valuecruncher’s opinion the Bacardi offer represented an excellent opportunity for investors to realise value from a company that had done a great job building a brand and penetrating the tough U.S. market but was showing no signs of reaching profitability.

A professional early stage investor (i.e. a venture capitalist) targets a 10x return on investment over a period of 5-7 years. The 42 Below return for IPO investors (even with the sale to Bacardi) is well below this targeted level.

Although the 15.5% annualised return realised via the Bacardi offer was a significant improvement on the pre-offer price it can hardly be described as a “home run” return for investors in a startup IPO. Citing the 42 Below result as validation for investing in early stage growth companies on the NZX is misleading. Each investment should be considered on it’s merits. Companies such as Xero have the ability to develop into global players and have significant upside potential but investors should not be relying on a 42 Below style exit to realise their return. If these growth companies achieve a significant global presence investors should expect a return well in excess of 15% per annum (of course any return is a function of the price paid).

Note: This analysis focuses on the return to an investor in the 42 Below IPO who adopted a buy and hold strategy and does not incorporate potential returns from any warrants exercised. 

Premium for control – doesn’t exist

The term “premium for control” is one that is often heard around mergers and acquisitions.  It is used to describe the reason why an acquiring company has paid more than the most recent share price to acquire the target company.  The interpretation is that the acquirer has had to pay a premium for a “controlling stake (i.e. greater than 51%)” in the business.  Commentators and company executives make comments about at 10-25% premium for control.  I have seen valuation professionals complete a reasonable valuation and then add a notional premium for control (10-25%) to come to a final value.

This is one of the most misunderstood areas of valuation.  The sweeping “premium for control” catch-all statement is misleading and often wrong.  Here is my explanation for how to think about valuation in a mergers and acquisitions setting.

The starting point is the standalone value of the business.  The discounted cash flow valuation described in my earlier post – What is a share price?  This values the business based on the current management’s business plan – as a standalone entity.  Why the focus on a standalone valuation?  A lot of technology companies would sell more if they partnered or merged with Microsoft – unrealistic to value them on that basis.

Financial markets are a fantastic invention – and we discuss aspects in future posts.  One aspect is that they require people to back their views with money – and there isn’t currently a better indicator of future prospects than people investing money in something (represented by a share price).  There is a body of corporate finance called “efficient market hypothesis” that basically states (in different forms) that markets efficiently represent information about a stock in the price of an asset (i.e. share price).  Sometimes share prices are above or below the calculated standalone value of a business – because investors (backing their views with money) think that something is going to happen (or not).  Why this is important – you will see in the example below.

When an acquiring company looks to takeover a company – it will complete its own valuation exercise.  It will build what is called a “merger model” which shows the effect of combining the potential target business with the acquiring company.  A key part of this analysis is assessing the “synergies” between the two businesses.  Synergies are basically costs that can be removed from the combined business or ways that the combined entity can make more sales than as standalone entities.  There are a range of other reasons for acquisitions such as technology or skills transfers – buying technology or people.  These will be the business case for the takeover.

The merger model will be a combined entity forecast – and allow a valuation to be completed for the combined entity.  The only party that will know the results of this analysis will be the acquiring entity.  If the synergies are positive (a key part of this work is in being conservative with calculating synergies) then there will be a positive valuation implication for the merger – the extent of this will depend on a case-by-case basis.  Because of these synergies it will place a value on the target company higher than the standalone valuation.

Then the negotiations or bid strategy will start.  The acquirer will look to maximise returns by paying as little as possible for the target company and the representatives of the target company will attempt to obtain the best price possible for the company.  The acquiring company will often pay away some of the benefits of the merger synergies to ensure the deal gets done – the economics says that they should be prepared to pay away all but the last dollar of the synergies to make the acquisition.  This is where you see prices being paid above recent valuation levels.  It is not a “premium for control” but rather the result of specific negotiations (or a merger bid tactic) where an acquirer pays away some of the synergies (or advantages) of the merger to make the deal happen.  It very much depends on a case-by-case analysis.  Be very wary of people making blanket comments about “premiums for control”.

Example – 42 Below acquisition by Bacardi

Assumptions:

All of these assumptions are based on 42 Below as a standalone company.

42 Below had revenues (excluding interest) of $17.0 million at 31-March-06 – growth of 39% on reveues of $12.2 million at 31-March-05.  The March-05 revenues were 218% above the $5.6 million at 31-March-04.  Moving forward we have assumed growth of 30% in 2007, 20% in 2008 and 10% in 2009.  We think this is reasonable for a standalone company.

42 Below is currently not profitable at the EBIT or EBITDA levels.  Bacardi is privately held so there is no easily available comparator of what EBIT margins we would anticipate for 42 Below when they reach a stable level of positive earnings.  We examined the UK listed Diageo and US listed Fortune Brands – between 2002 and 2005 they had EBIT margins between 16% and 35%.  For 42 Below we used a 15% EBIT margin in 2007 increasing to 20% in 2008 and 25% in 2009.

We have made some conservative assumptions around CAPEX and depreciation to 2009.
All other inputs are from the 31-March-06 42 Below Annual Report.

Output:

Using these assumptions Valuecruncher produces a standalone per share valuation of $0.35 – well below the Bacardi offer.  This standalone valuation is also below the pre-offer share price of $0.58.  The $0.58 share price is what appears to be a good example of investors expecting a potential acquisition and assuming that into the price they would be prepared to pay for shares.  Alternatively investors may feel that my assumptions are too conservative – and that growth prospects for 42 Below are much stronger than what I forecast.

Bacardi will be valuing the company based on the sales of the 42 Below products in the Bacardi sales and distribution system (which is much larger and more developed than the 42 Below system) and then giving up some of this value in buying the company to ensure the success of the transaction.  Bacardi’s valuation of 42 Below products in their sales and distribution system will be a higher number than $0.77 per share – but to ensure the transaction succeeds some of the value is paid to shareholders.

Our analysis is that this is a great outcome for the company with a higher value owner than the current shareholders of the business taking over – at a price well ahead of the value of the business as a standalone entity.

View the 42 Below valuation