CASE 1 DELTA BEVERAGE GROUP, INC.
GROUP 7 Dalia Abdelbaki Chesron Esseboom Wouter Hendriksen
1979329 1941143 2123258
The Delta Beverage Case discusses the financial difficulties that the Delta Beverage Group faced during 1989 till 1993, and the solutions that were brought in by the management. The Delta Beverage Group belongs to one of the top five independent bottlers of PepsiCo in the U.S, as it became a part of PepsiCo franchise in 1994. Delta Beverage Group has to buy its concentrate and syrup only from PepsiCo at established prices that would increase by the consumer price index. The other raw materials needed for the bottling process would include ingredients with non-fixed prices, for example; PET, fructose and aluminum. This proved to be challenging, considering the increase in the price of aluminum by 30 percent in the first half of 1994. This was accompanied by a significant rise in the prices of PET and fructose. John Bierbaum, chief financial officer of the Delta Beverage Group, is concerned about these increases and is not sure if the company could bear any more increases in raw material prices. The recapitalization plan in 1993 saved the company from bankruptcy by closing agreements with senior debt holders. Currently in 1994, debt holders are not willing to enter a new agreement to prevent the company from defaulting on its debt. John Bierbaum is considering the possibility of hedging aluminum by buying future contracts. This way aluminum prices are set and unfavorable fluctuations could not put the company in distress. To have a better insight of the situation at hand, and to be able to make a sound decision on whether the CFO should hedge aluminum by buying future contracts, we have to compute relevant financial ratios and determine the outcome of different possible scenarios. Along the way, we will make some assumptions. While the growth in soft drinks consumption of the South compared to the whole U.S. is relatively high, the U.S. industry shows clearly diminishing growth rates for soft drinks. From this we could assume that the Delta Beverage Group along with the whole soft drink industry is in its maturity phase. Regarding the debt-to-equity ratio and debt ratio of previous years as shown below in table 1, we could state that the Delta Beverage Group is highly leveraged. Based on this, we could assume that the company is not healthy and suffers from debt overhang. This would make investors reluctant to invest in the company due to default risk, which in that case leaves investors with nothing to collect after repaying the debt holders. The option of borrowing funds would be too expensive in addition to the limits of the covenants.
Table 1 Year Debt Equity Assets D/E ratio Debt ratio
1989 165,751 69,702 223,335 2.38 0.74
1990 162,310 57,052 210,069 2.84 0.77
1991 164,264 35,474 203,999 4.63 0.81
1992 172,185 7,372 210,438 23.36 0.82
1993 141,149 94,268 213,705 1.5 0.66
John Bierbaum, CFO of Delta Beverage Group, would like to consider the possibility of hedging aluminum prices by buying future contracts, which might secure the company in the long- term. However, defaulting on short- term obligations would be a financial disaster. This means assessing the current financial situation of the company implies the computation of the current and quick ratio. Those ratios measure the ability of paying short- term obligations and need to be at least 1 for the firm to be considered healthy. Table 2 below presents the ratios for year 1989 till 1993. In general the higher the ratio the greater the company’s liquidity.
Table 2 Year Inventory Current Assets Current Liabilities Quick ratio (Acid Test Ratio) Current ratio
1989 8,893 39,254 22,733
1990 6,726 33,196 19,233
1991 9,808 36,204 21,998
1992 10,607 41,349 27,291
1993 10,104 50,192 18,147
1,34 1,73
1,38 1,73
1,20 1,65
1,13 1,52
2,21 2,77
For the current ratio, we look at to which degree the current assets cover the payment of the current liabilities. While for the quick ratio, the inventory is considered to be illiquid in case of default and therefore is deducted from the total amount of current assets. Delta Beverage Group maintains a current and quick ratio of above the 1 for all stated years, which means that they are not likely to default on short- term obligations based on historical data. Now that the current financial situation of Delta Beverage Group is assessed, we can consider the possibility of hedging to secure the company from increasing aluminum prices. Hedging or not? As stated in the case an operational hedge is not recommendable because of the different market segments in which Delta is active. For fructose and PET financial hedging is not possible because there are no future contracts on the market. The expectation about the price of aluminum, that Mr. Bierbaum stated, is very risky since the volatility of the price is high and the company is on the edge of default. If the price of aluminum keeps rising Delta won’t be able to cover its interest payments, this will end in a default. In order to keep the interest coverage ratio above 2.0 in the upcoming years it’s advisable to consider the option of a financial hedge for aluminum. If the prices remain on the same level a financial hedge is 7-9% more expensive than buy aluminum with cash. The price can easily rise with more than this
percentage. Because the price of a 15m and 27m hedge are almost the same its advisable to hedge for 27 months. In the table below is shown what the effect of a financial hedge is on the interest coverage ratio of Delta. In the scenarios we described we first used the percentage increase of last year, which was 22.5%. Next to that we calculated the effect of a 17.5% and 12.5% increase in aluminum prices. These calculations are shown in the appendix of this paper. The interest coverage ratio only drops below 2 above an increase of 20%. Because of the minimum price difference between 15m and 27m futures we recommend Mr. Bierbaum to buy 27m future option on aluminum.
Price aluminium 22,50% 17,50% 12,50% Future 15M Future 27M
Table 3: Coverage ratio's 1993 1994 2,12 2,30 2,12 2,30 2,12 2,30 2,12 2,30 2,12 2,30
1995 1,84 2,05 2,26 2,52 2,42
1996 1,91 2,14 2,38 2,18 3,10
Conclusion & recommendations The CFO of Delta Beverage Group is considering the possibility of hedging aluminum prices by buying future contracts. This way the company can hedge the risk of fluctuating prices. Assessing the current financial situation shows that the debt-toequity ratio and debt ratios are high, which means that the company is highly leveraged causing an increased chance of default and debt overhang. Additionally, Delta Beverage Group is a maturing company operating in a diminishing growth industry. The net income and equity on return have increased, which could indicate that the company is recovering from its losses, although both are still negative. The current and quick ratios are above 1, which means that the company can meet its short- term obligations and is not likely to default. A further increase in raw material prices could lower net income, which could have negative effects on the firm. While hedging for PET and fructose is not possible, hedging for aluminum would eliminate some of the risk of price increases. Hedging would be the most recommendable option for Mr. Bierbaum to defend its company for rising aluminum prices. The high volatility of aluminum is a high risk if Mr. Bierbaum decides to don’t buy the futures.!
Appendix 1993 231207
1994 244926
1995 259458
1996 274853
138724 60114 32369
146955 63681 34290
155675 67459 36324
164912 71462 38479
Total revenues
231207
244926
259458
274853
Cans Bottles Contract sales total cogs
101269 37271 17479 156018
107277 39482 18516 165276
113643 41825 19615 175082
120386 44306 20779 185471
Gross profit
75189
79650
84376
89382
General expenses Selling expenses EBIT
20561 36791 17837
21907 39169 18574
23341 41701 19335
24868 44396 20118
7938
8256
Total revenues Sales mix Cans Bottles Contract sales
Tons of Aluminium
8256/1.04
Futures needed
318
Scenario 1: same Aluminium price increase as last year COGS-aluminium packaging Gross profit EBIT Depreciation&amortization EBITDA
1993 101269 75189 17837 10894 28731
Debt Interest expense
141149 13550
330
8812 9406 Average volume growth rate 6.3%
352
376
(1461/1193)1=22.5% 1994 1995 109448 119105 81261 78914 20185 13872 10083 9333 30269 23205
1996 126172 83596 14332 8638 22970
137149 13166
131149 12590
125149 12014
9,60%
Interest coverage ratio
2,12
2,30
1,84
1,91
COGS-aluminium packaging Gross profit EBIT Depreciation&amortization EBITDA
1993 101269 75189 17837 10894 28731
1994 109448 81261 20185 10083 30269
1995 116476 81542 16501 9333 25834
1996 123387 86380 17116 8638 25754
Debt Interest expense
141149 13550
137149 13166
131149 12590
125149 12014
2,12
2,30
2,05
2,14
COGS-aluminium packaging Gross profit EBIT Depreciation&amortization EBITDA
1993 101269 75189 17837 10894 28731
1994 109448 81261 20185 10083 30269
1995 113848 84170 19129 9333 28462
1996 120603 89164 19900 8638 28539
Debt Interest expense
141149 13550
137149 13166
131149 12590
125149 12014
2,12
2,30
2,26
2,38
Scenario 2: Aluminium price 17,5%
Interest coverage ratio Scenario 3: Aluminium price 12,5%
Interest coverage ratio
WITH FUTURES Total revenues Sales mix Cans Bottles Contract sales
1993 231207
1994 244926
1995 259458
1996 274853
138724 60114 32369
146955 63681 34290
155675 67459 36324
164912 71462 38479
Total revenues
231207
244926
259458
274853
Cans Bottles Contract sales total cogs
101269 37271 17479 156018
107277 39482 18516 165276
113643 41825 19615 175082
120386 44306 20779 185471
Gross profit
75189
79650
84376
89382
General expenses Selling expenses EBIT
20561 36791 17837
21907 39169 18574
23341 41701 19335
24868 44396 20118
7938
8256
Tons of Aluminium
8256/1.04
Futures needed
318
Scenario 1: Hedge with 15 month futures
330
8812 9406 Average volume growth rate 6.3%
352
376
(1,553/1,461)1=6,3% 1994 1995 109448 110589 81261 87429 20185 22388 10083 9333 30269 31721
16,80% 1996 122998 86770 17506 8638 26144
COGS-aluminium packaging Gross profit EBIT Depreciation&amortization EBITDA
1993 101269 75189 17837 10894 28731
Debt Interest expense
141149 13550
137149 13166
131149 12590
125149 12014
2,12
2,30
2,52
2,18
Interest coverage ratio
Scenario 2: Hedge with 27 month futures
(1,588/1,461)=8,7% 1994 1995 109448 111851 81261 86168 20185 21127 10083 9333 30269 30459
0% 1996 111851 97917 28653 8638 37291
COGS-aluminium packaging Gross profit EBIT Depreciation&amortization EBITDA
1993 101269 75189 17837 10894 28731
Debt Interest expense
141149 13550
137149 13166
131149 12590
125149 12014
2,12
2,30
2,42
3,10
Interest coverage ratio
