Letter number 113 of May 2018
- QUESTIONS & COMMENTS
In 1974 the founding family of L’Oréal allowed Nestlé to take a 49% stake in the holding company which controlled 53% of the cosmetic group. Both companies were looking for a diversification, essentially financial, because the synergies between the two groups are virtually non-existent. Over time, a joint subsidiary, Galderma, was created in the skincare sector and another one, Innéov, specialising in food supplements with a cosmetic objective, whose activity was ended in 2015.
In 2004, L’Oréal absorbed its controlling holding company, resulting in the founding family and Nestle respectively holding direct stakes in the capital of 27.5% and 26.4%.
Given the substantial and growing generation of free cash flows by L’Oréal, which is far from fully absorbed by dividends, and a capital structure with no net financial debt, share buybacks were initiated in 2004 and by end 2013 had amounted to €5.6bn.
In 2014, Nestlé which then had a 29.4% stake in L’Oréal, sold the latter 8% of its capital, reducing its stake to 23.3%. The L’Oréal founding family’s stake rose correlatively and mechanically from 30.6% to 33.3%. This €6bn purchase was financed using €3.4bn in cash and 50% of the share capital of the jointly-owned Galderma, over which Nestlé thus took full control.
Between 2015 and late 2017, L’Oréal bought back €1bn worth of shares. On 31 December 2017, L’Oréal had €1.6bn in cash net of all bank and financial debts. This was not counting a 9.4% stake in Sanofi, a legacy of the 1973 acquisition of the Synthélabo laboratory, which merged with Sanofi in 1998. This remaining stake is now worth around €7.8bn. There are currently more or less the same synergies between L’Oréal and Nestlé as there are between L’Oréal and Sanofi, i.e. zero.
In 2017, L’Oréal registered an EBITDA of €5.9bn, received €350m in dividends from Sanofi and published net earnings, group share, of €3,825m.
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As Nestlé has announced a CHF 20bn share buyback programme, under pressure from Daniel Loeb’s activist fund Third Point which is pushing it to sell its stake in L’Oréal, and as a new CEO has been chosen from outside the group for the first time in Nestlé’s history, it is not unreasonable to assume that the group could soon be selling its shares in L’Oréal, finishing off what it started in 2014.
If Nestlé were to offer L’Oréal its stake – or a large chunk thereof let’s say 20% out of the 23.2% it currently holds – would it be reasonable for L’Oréal to go ahead with the purchase? In this article we look at the financial aspects of such a transaction, setting aside the accounting, legal or stock market dimensions.
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On the basis of L’Oréal’s current market capitalisation of €107bn, 20% would work out at €21.4bn. Of this amount €7,8bn could be financed by the sale of the Sanofi shares at a negligible tax cost give the tax regime that would apply. So €13.6bn would still have to be found, which would bring pro forma net bank and financial debt on 31 December 2017 to €12bn. Which is 2x 2017 EBITDA.
L’Oréal could find this amount without difficulty on the banking market and then on the bond market, given that the low volatility of its free cash flows means that is has a formidable capacity to repay debt. Sanofi has just raised €8bn in bonds with several tranches and an average maturity of 9 years and an interest rate of around 0.9%. And L’Oréal is not exposed to the risk of scientific research and the end of its patents like Sanofi is for it drugs.
In 2017, L’Oréal’s free cash flow after capex which exceeded depreciation and amortisation by 25%, was €3.7bn. By deducting €105m in additional financial expense net of taxes, the €350m in Sanofi dividends that would not be received (since the shares had been sold), and the 2017 dividends less 20% (Nestlé’s shares bought back), we arrive at a net cash flow of €1.75bn, which means that 15% of the debt can be paid off in the first year. In other words, even if we assume constant cash flows, which has never been the case (L’Oréal is a company that is growing as evidenced by its 2017 P/E ratio of 28x), the debt would be fully paid off in 7 years.
Earnings per share would be diluted by around 10%, equity per share would be diluted from €44 to €7.6 and return on equity would leap over 100%. But as our readers will know, this only has a very distant relationship with the creation or the destruction of value, and no attention should be paid to it.
Although this transaction does not call into question L’Oréal’s solvency or its ability to pay off its debts promptly, is it likely to restrict the external growth capacities of the cosmetic group?
It doesn’t seem so, for two reasons: firstly, the group has never carried out external growth operations worth more than €1.2bn (Yves Saint Laurent Beauté in 2008 for €1.15bn and IT Cosmetics for €1.1bn in 2016). This doesn’t seem to be its culture. Its culture is to buy small- or medium-sized companies, often national or regional, and to make them worldwide champions like Lancôme, La Roche-Posay or Maybelline. Furthermore, a large scale acquisition could raise anti-trust issues, given the number of leading positions L’Oréal occupies on the different beauty segments.
That being said, a €2-3bn acquisition even coming very quickly after a possible buyback of the Nestlé shares, would only bring its debt to 2.5 x EBITDA. Not much to write home about.
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Would a buyback operation of this size create value for L’Oréal’s shareholders?
In the Vernimmen, we explain that share buybacks are likely to create value if, and only if:
1/The shares are bought at a lower price than their value. In this case that case one can have doubts it could happen. It would be most presumptuous to claim that the L’Oréal share was overvalued or undervalued. L’Oréal is the 13th largest European market capitalisation with a free float of nearly €50bn and is permanently followed by dozens of analysts in a sector that is not hard to understand.
2/The increase in the amount of debt leads to better performance on the part of managers given the constraints of debt repayment. Perhaps, but with an after-tax return on capital employed of 22.6%, it can’t be said that L’Oréal is obviously underperforming!
3/The funds returned to shareholders had a marginal return in the company lower than its cost of capital. Very unlikely given the ROCE achieved!
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Well then, why do this deal if it is not very likely to create value for shareholders?
We can think of three reasons, and one condition.
1/When a large minority shareholder wishes to sell its stake, and unless an investor can be found to acquire it, it will have to make a placement on the market which will drag down the share price, and/or sell all or part of its shares to the company as part of its share buyback programme. The latter technique was used, for example for the exit of Dentsu from the capital of Publicis, Lagardère from that of Airbus, Danone from Yakult and Carlo Tassara from ArcelorMittal. So this is nothing out of the ordinary when the company’s capital structure makes it possible.
Given the size of Nestlé’s block (€21.4bn), financial investors able to acquire it without flinching can be counted on one hand. As for an industrial player, it is hard to see the interest of a minority stake in an era when diversifications have become a rarity. And a purchase of Nestlé shares with a view to taking control of L’Oréal at a later stage seems to be just as hypothetical for anti-trust reasons and because L’Oréal is performing so well that it would take an exceptionally talented team to do even better.
In other words, a share buyback when the company’s capital structure makes this possible (and we saw earlier on that this is the case), could prevent what is known as an overhang, i.e. a fall in the share price in anticipation of a transaction that it likely to occur, but the exact date of which is uncertain; and then a drop in the share price as a result of the sudden increase in the size of the free float, by more than half in this case.
2/For dealing with the 9.4% stake in Sanofi, which is doing about as much good on L’Oréal’s balance sheet (no synergies between the two groups) as L’Oréal’s shares on Nestlé’s balance sheet. It is obvious to the outside observers that we are, that L’Oréal has held onto this stake so as to enable it to buy up the Nestlé stake when the time is right. We note that from a financial point of view, if L’Oréal had sold its Sanofi shares a few years ago, its stock market performance would have improved since its Total Shareholder Return (TSR) was higher than that of Sanofi.
3/Given the legendary professionalism of L’Oréal’s management, there is no doubt that they’ve spent a lot of time on this matter. Once their decision is made, the exit of Nestlé from L’Oréal’s capital by buying up most of the block will be completed within a few hours and they’ll be able to focus solely on beauty, which is what they do best. The best results are always achieved when each one focuses on what he or she is trained to do.
As for the condition, it is that Nestlé’s L’Oréal shares be acquired at a price that does not exceed the market price and there is no reason for thinking, in this case, that this price does not currently reflect the intrinsic value of the world leader in the beauty sector.
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We note that at the AGM which was held a few days ago, shareholders approved by 99.3% and 99.8% the resolutions that would allow L’Oréal to buyback and cancel its shares, should Nestlé wish to sell them.
The average corporation tax rate in the world in 2017 is 24%, showing stability since 2013:
Corporate income tax rates are down in countries where they were high such France, Japan, USA, Belgium.
These rates are useful to compute corporate income taxes to be paid on pre-tax profits, to compute free cash flows or cost of capital or produce business plans. But they cannot be compared from one country to the other one to appreciate the tax burden borne by companies. Indeed, in some countries some local taxes are not levied on the pre-tax result but on added value, turnover or the renting value of buildings. And they are in addition to those computed on the pre-tax result and shown in this table.
With Simon Gueguen, Senior Lecturer at the University of Cergy-Pontoise
The study of the capital structure of firms often focuses on the choice between equity and debt, a fundamental question in corporate finance. Another feature of the financing of the company also deserves attention: the structure of debt and in particular, its maturity. Three researchers carried out an empirical study, on the consequences of debt maturity on its cost. They collected data on bank loans taken out by US firms between 1990 and 2014. They show that the maturity of bank loans is an essential determinant of the spreads paid on this debt.
There are two underlying theoretical hypotheses to this study that explain the links between maturity and spreads. Firstly, the rollover hypothesis. If the loans market is not perfectly liquid and is experiencing periods of tension, it may be difficult to roll over debt that has reached maturity even though the financial situation of the company has not deteriorated. The result is a refinancing cost that is borne by shareholders. The consequence is that shareholders will prefer to default on the debt more quickly, as bankruptcy costs are borne by creditors. This hypothesis assumes that a loan with a shorter maturity has a higher refinancing cost, and thus a higher risk of bankruptcy. The empirical study confirms this hypothesis: an increase in standard deviation of the short-term debt to total assets ratio results in an increase of around 11 basis points of the banking margin (compared with an average margin of 202 basis points). In the sample studied, this represents an average of $600,000 per year.
Secondly, the asset substitution hypothesis. After debt is issued, it may be in the interest of the shareholders of a company to replace the company’s assets with more risky assets. This phenomenon is linked to the limited liability of the shareholder: a share can be considered to be an option held on the company’s capital employed. The increase in risk results in a transfer of creditors’ wealth to shareholders. If creditors are rational, they anticipate this problem by charging the company a higher margin at the time of issue. The problem is particularly acute in companies experiencing strong growth, whose asset risk is easier to modify.
In this case, shorter maturity has a virtuous effect: since debt is rolled over on a frequent basis, the risk of assets can be revalued by creditors and shareholders are less inclined to increase this risk. The empirical study shows that the effect of maturity on the cost of debt is less in companies experiencing strong growth. For such companies, the effects of the asset substitution hypothesis (favourable for short maturities) partly offset the effects of the rollover hypothesis (unfavourable for short maturities).
This study thus confirms that debt structure is taken into account by banks when negotiating margins. For companies that depend on bank loans, the consequences can be significant.
 C.W. WANG, W.C.CHIU and T.H. DOLLY KING, “Debt maturity and the cost of bank loans”, Journal of Banking and Finance, publication pending.
 Spreads in this article mean all-in-drawn-spreads, which include, in addition to the difference between the price paid and the benchmark money market rate, commissions paid to the lender.
In our view, financial synergies are like Jupiter and Danaë: a lovely story but there’s nothing real about it.
Let’s first take a look at what they’re supposed to be.
If your cost of capital is 10% and you acquire a company in another sector that has a cost of capital of 8% (to make things simple let’s say it is of a similar size), the overall cost of capital of the new group will not be lower than 9% (average of 10% and 8%) because shareholders do not remunerate a reduction of the specific risk. They can, in fact, eliminate it by diversifying their portfolio, at no cost to themselves. Lenders, for their part, prefer conglomerates or highly diversified companies that reduce their risk of not being reimbursed. We see that generally, they are prepared to lend to them at a slightly lower interest rate. But this saving, which his often miniscule, is very soon wiped out and more by the appearance of a conglomerate discount, supervision costs and the complexity that is specific to such organisations.
Here’s another example. If your cost of debt is 2% and you buy a company with a cost of debt of 7% because it is very risky/indebted, the cost of debt of your group after this acquisition is unlikely to remain 2% because lenders will realise that you are now a bit more risky than before this acquisition. Obviously, if this is a very small acquisition compared to the size of your company, lenders won’t notice it and you’ll be able to carry on with a cost of debt of 2% and replace debt at 7% with debt at 2%. You’ll make savings of 5% on the interest, but because the size of this acquisition is small compared to your group, the savings will be negligible for you, and not worth talking about.
When sizes are not all that dissimilar, for example 10 and 3 – and not 10 and 0.5 – there are those who believe that shareholders or lenders won’t notice and that the cost of your debt can stay at 2%. Perhaps for a few weeks or a few months. Over a longer period, this would be betting against the collective intelligence of market players, the type of bet that is very difficult to win and most often lost.
Our experience in M&A has taught us that financial synergies are the latest gimmick used by advisers to justify the interest of an acquisition when the value of operational synergies is insufficient to justify the type of control premium necessary for carrying out such a transaction (and of course payment of success fees, not to mention the advisors’ bonuses a few months later).
It’s not always easy to judge, a few hours after the announcement of an M&A agreement, whether the deal will result in the creation or the destruction of value. But one thing is certain: if the press release mentions financial synergies, then you should consider that the brains behind this deal think that it is going to destroy value. They were unable to find enough real operating synergies to justify the price paid and had to resort to the fancy of financial synergies. And if insiders think that it’s going to destroy value, then it is highly unlikely that any value will be created through this merger.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest. Here are some of the comments published over the last month.
An IRR of 14.4% over 113 years!
“Fillette à la corbeille fleurie” is a painting by Picasso (blue period, but announcing the pink period) that he, penniless and refusing to exhibit in salons, sold in 1905 to American collectors living in Paris Léo and Gertrude Stein for 150 francs of the time. Acquired in 1968 by Peggy and David Rockefeller, it was recently sold for $115m, showing an IRR of 14.4% per annum, over the period of 113 years.
Power of compound interests over a long period. Even if this painting was not bought for financial reasons, it is rewarding to see its IRR way above the one achieved by the best investors.
Ironically, it was sold by Christie's in the Rockefeller Center in New York, which the family had built in the late 1920s and 1930s for a total of $250m at the time. approximately twice the current face price of this painting.
David Rockefeller (who died at the age of 101 in 2017), who was the president of Chase Manhattan Bank in the 1970s. The reading of his memoirs is extremely interesting.