A LOT IS HAPPENING OVER A COFFEE..!!! (Case Study – Valuing IPO of Café Coffee Day)

~~
Beginning of the Case ~~
A LOT
IS HAPPENING OVER A COFFEE..!!!
(Case Study – Valuing
IPO of Café Coffee Day)
Swarup
prefers to spend his Sundays as dull as possible. The Sunday of October 11th
of 2015 was going to be different for him. On any other weekday he would’ve commenced
the day with getting a global market update from the Bloomberg app on his iPad.
Being an investment broker for several HNI investors of Equate Advisors, Swarup
is a much sought after relationship manager by his clients. His clients feel Swarup
is one such adviser, whose stock picks rarely go wrong. His boss at Equate
Advisors is generally happy with his performance in terms of delivering numbers
and maintaining satisfied customer relations, but, he feels Swarup sometimes
contradicts the stock advises of central research team. Swarup argues that’s
precisely the reason for his success. He does not blindly recommend a stock to
his clients, instead, with every such recommendation that comes to him from his
research team in Mumbai, he does his own valuation of the stock before he
arrives at his conclusion. He strongly believes this always works.
By
the time he woke up on this Sunday it was already 9.30 am. He stepped out of
his apartment after a short work-out module at the club-house. The
generally-residential area that it is, Sahakar Nagar in Bangalore, was
semi-urban in landscape. Less than 200 meters from his apartment complex was an
outlet of Café Coffee Day (popularly
called CCD), to which Swarup was a regular visitor. He had an emotional connect
with CCD, as most of his successful client meets happen in CCD outlets, thanks
to widespread presence across Bangalore; he spends most of his leisure and he
feels rejuvenated after every visit in CCD; and more than anything, it is in
this CCD that he proposed his girlfriend (and she accepted..!!). Truly a lot
happened to Swarup over Coffees in CCD…!!!

He
walked into the shop ordered his regular cappuccino with butter cookies and unlocked
his iPad

screen, while still being amused at the young crowd at the shop
already barged in. The moneycontrol.com
website that he had open yesterday was still on the first screen. As if it was
usual, Swarup reluctantly glanced through news stream, and he found a news item
– “Café
Coffee Day to go Public
”. He also recalled grapevine download from his
chitchat with his research team that Equate Advisors are going to recommend CCD
for a buy at IPO aggressively. His hot espresso was served and he could just
smile at the thought of how hot CCD’s IPO going to be. He decided to be better
prepared. And this Sunday was to become a working Sunday for him.

Swarup
believes valuing a stock means valuing a business. It’s important to understand
the fundamental business model of the company. He browsed through the red
herring prospectus (RHP) of the company and few websites to gather relevant
information and made notes as below, as he usually does:
i.              
Stakeholders: CCD’s parent company
Coffee Day Enterprises Limited (CDEL) is held by V G Siddarth-led promoter
group upto 93%, whereas private equity firm KKR, Infosys co-founder Nandan
Nilekani and Rakesh Jhunjhunwala’s Rare Enterprises make it to the list of
major shareholders with 3.43%, 1.77% and 0.24% equity stakes respectively.
ii.            
Businesses: CDEL classify
themselves into mainly food service market, as their primary business is into
coffee products. In addition to having the largest chain of cafés in India,
CDEL also operates in procuring, processing and roasting of coffee beans and
retailing coffee products across various formats. Their diversification into
non-coffee businesses include technology park development, logistics solutions,
financial services, Resorts & Hospitality and ownership stakes in IT-ITES
companies like MindTree.
iii.          
Environment: Their claims about
the growth in coffee vending business gets justified with the changing
consumption pattern of northern and western Indian tea drinking population also
preferring to coffee consumption. Added by strong economic and demographic
aggregates like increasing percapita income, rising urbanisation, discretionary
spending, out-of-home food consumption trends, corporatisation etc., coffee
outlets today are in demand more than ever.
Indian QSR (Quick Service
Restaurants) market is expected to grow exponentially in the coming years. The
same (in Rs. Billion) is shown in the below graph. (Source: Techopark, March 2015)

iv.          
Strengths: CDEL’s strengths are
strong home-grown brand, first-mover advantage, substantial market presence,
established network of franchises and dealers, multiple consumption points,
disorganised competition, scalability of the business, diversified businesses
focusing in India growth story and professional management.
v.            
Strategic
View
:
Currently, CDEL’s strategic outlook is to further deepen the existing chain of
cafés; increase café revenues by generating higher footfalls and driving
increased consumption; leverage brand equity of “Coffee Day” and “Café Coffee
Day”; constantly augur product range; and also develop non-coffee business.
vi.          
Financials: A simplified set of
consolidated financial statements for the previous five years were also
prepared like this:
Consolidated Multi-Step Income
Statement (Simplified
)
Rs. in
millions
Particulars
For the year ended
31st March
2011
2012
2013
2014
2015
Revenue from Operations
10244.04
15652.79
20995.60
22870.08
24793.55
Other Income
725.15
685.92
495.84
657.63
693.60
Total
Income
10969.19
16338.71
21491.44
23527.71
25487.15
Cost of Goods Sold
6727.64
7075.02
7205.34
7076.89
7751.94
Other Expenses
1994.49
2150.65
2355.52
2570.32
2983.10
EBITDA
2247.06
7113.04
11930.58
13880.50
14752.11
Depreciation
792.45
935.69
1208.55
1540.76
1579.54
EBIT
1454.61
6177.35
10722.03
12339.74
13172.57
Finance Costs
464.56
431.90
399.80
449.40
554.98
EBT
990.05
5745.45
10322.23
11890.34
12617.59
Tax Expenses
101.18
104.78
93.55
-1.37
44.46
EAT
888.87
5640.67
10228.68
11891.71
12573.13
Extracts of
Consolidated Balance Sheet
Rs. in
millions
Particulars
For the year ended
31st March
2011
2012
2013
2014
2015
Non-Current Assets
7384.3
9302.07
10700.71
11251.42
10794.61
Shareholders’ Funds
7566.96
7369.69
7344.04
7281.88
7693.05
Interest-bearing
Non-Current Borrowings
4355.66
4226.63
3713.46
3937.66
2844.03
Current Assets
7627.30
5860.35
4172.2
3984.27
4546.98
Current Liabilities
2735.78
3076.19
3146.95
3292.07
4092.01
Total
Assets
15011.60
15162.42
14872.19
15235.69
15341.59
Extracts of Cash
Flow Statement
Rs. in
millions
Particulars
For the year ended
31st March
2011
2012
2013
2014
2015
Cash Flows from Operating Activities
103.78
1520.04
1600.01
2304.60
3131.45
Cash Flows from Investing Activities
(2121.22)
(54.01)
(1078.10)
(1492.73)
(1147.97)
Cash
Flows from Financing Activities
2646.03
(611.97)
(852.16)
(803.87)
(1354.25)
Purchase of Fixed Assets
(2005.80)
(2689.87)
(2452.10)
(1650.63)
(1460.67)
vii.             
IPO: The current issue
was to raise Rs. 11500 million with a price band of Rs. 316 to Rs. 328 per
share using book building process. Currently, the number of shares held by
owners is 170,940,744 with a face value of Rs. 10
The issue proceeds are
planned to be utilised towards repaying of existing debt to the tune of Rs.
6328 million (in FY16); financing for expansion of coffee business to the tune
of Rs. 2875.10 million (in FY16 – Rs. 1241.08 million; in FY17 – Rs. 1634.02
million) and rest to be used for general corporate purposes (evenly in the
coming two years)
viii.           
Market
& Competition
:
Key players in the coffee outlets include Starbucks, Dunkin, CCD, Barista, Cost
Coffee and other minor operators. Their respective market shares are given in
the below table:
CDEL’s competitors include the
coffee outlets businesses as above; QSR operators such as McDonalds (WestLife),
Dominos (Jubiliant Foodworks) and KFC, Pizza Hut (YUM); food and grocery
businesses Nestle and HUL.
Swarup
uses Enterprise
DCF approach
to arrive at the valuation. He decided to use some
modifications in the process, as he normally does and calls it Midas Touch of Swarup..!!:
ü  He has decided to use
CAPM approach to compute cost of capital. Considering that this company do not
have historical data of prices, he wonders how to compute the beta. He has
anyways collected below information relating to industry players (those which
are listed):
Jubiliant Foodworks
Nestle India
HUL
Beta
0.14
0.62
0.11
Debt Equity Ratio
0
0.37
0
Risk-Free
Rate = 7.20% (RBI 10-year GOI yield)
Nifty
Monthly Returns annualised for the period 2011-2015 = 14.2%
ü  The marginal tax rate
for the corporate is 30%, and Swarup prefers to use this, instead of effective
tax rate, which is negative in many years for CDEL
ü  He also wants use a
growth rate estimate as below. These rates are based on his discussions with
few of his friends in the equity research industry and also few industry
experts he keeps interacting on social networking platforms: From 2016 to 2025 – 17% p.a; After 2025 – 3.50% p.a infinitely. He
consciously avoids using the sustainable growth rate as this is the case of
IPO, which is expected to be a turnaround event and company’s prospects will be
way different from its past.
ü  He wants to assign
weights to cash flows of last five years as below, for forecasting purposes, so
that he is giving higher importance to latest cash flows:
2011
2012
2013
2014
2015
Weights
0.10
0.10
0.20
0.30
0.30
ü  He decides to compute
FCFF first and then reduce the debt component to arrive at FCF for equity
shareholders.
ü  Swarup also wants to
conduct a sensitivity analysis using Monte-Carlo simulation for changes in
above growth rates.
Questions:
(1)  
Discuss
the possible valuation biases Swarup is exposed to in valuing CDEL.
(2)  
How
do you compute the beta for an unlisted company?
(3)  
Compute
the post-issue cost of capital for CDEL.
(4)  
Do
you agree with Swarup that sustainable growth rate of past cannot be applied in
the case of valuing an IPO?
(5)  
What
will be the projected FCFF for CDEL for the next 10 years and the terminal
FCFF?
(6)  
What
will be post-issue intrinsic value per share of CDEL?
(7)  
Conduct
a simulation using MS-Excel for varying rates of growth of next 10 years from
12% to 24% (changing interval of 1%) and terminal growth rate from 0% to 6%
(changing interval of 0.50%). What will be the expected post-issue intrinsic
value per share of CDEL
(8)  
Discuss
the areas of subjectivity involved in the entire CDEL valuation exercise of
Swarup and what other alternatives were skipped in the process.
~~ End of Case ~~
INSTRUCTOR REFERENCES:
       I.           
What courses are
intended to be using this case?
The case can be used
as part finance courses like Financial Management, Security Analysis, M&A,
Investment Banking, Corporate Valuation, Financial
Modeling/Analytics/Engineering
    II.           
What
concepts/models/theories can be explained through this case?
This case can be used
to demonstrate the below concepts/theories/models/applications:
i)             
Corporate
Objective – Shareholder Wealth maximisation to Intrinsic Value Maximisation
ii)           
Concept
of Intrinsic Value
iii)         
Valuation
biases, subjectivity and Challenges
iv)         
Accounting
Profit Vs. FCFF, FCFE
v)           
Cost
of Capital (WACC); CAPM; Cost of Equity for unlisted company
vi)         
IPO
Process
vii)       
Enterprise
DCF Technique
viii)     
Financial
Modelling using MS-Excel for corporate valuation
ix)         
Sensitivity
Analysis using Monte-Carlo Simulation using MS-Excel
 III.           
What main
issue/problem is addressed in the case?
The case addresses the
problem of valuing an unlisted company during its IPO that is already a
household name, and hence, has ample scope for pre-valuation bias
  IV.           
Teaching Notes:
1)     
The
anchor books for the above case would be,
ü 
Damodaran
on Valuation: Security Analysis for Investment and Corporate Finance, 2nd
Edition
” (Author: Aswath
Damodaran
) by Wiley Publishing
ü 
Corporate
Valuation and value Creation
(Author:
Prasanna Chandra) by McGraw Hill
ü 
Financial Management: A Step-by-Step
Approach
” (Author: N R Parasuraman)
by Cengage Learning
2)     
This
case can best be solved using MS-Excel.
Student should be comfortable in entering formulas, using functions and using
What-if Analysis feature in MS-Excel.
3)     
A
total for 4 sessions (approximately
5 hours of classroom discussion with demonstration is required). Ideal if the
students are grouped into groups of 3-4 members in each.
4)      Possible
Approaches for solving the key issues: (Explained Question-wise)
Question-(1)
: Discuss the possible valuation biases Swarup is exposed to in valuing CDEL
.
As Swarup is already having positive impression of
CCD (as a customer), he might be biased while using some inputs, like, the
growth rate, overlooking of past performance etc. (Input Bias); He may also revisit his assumptions after valuation if
his value differs from the Band Price of Rs. 316 to Rs. 328 (Post-Valuation Tinkering Bias); He may
also dedicate the distance between his value and the price band to qualitative
factors, like strategic consideration etc.(qualitative
factor bias
). (Refer Damodaran –
Chapter-1)
Question-(2)
: How do you compute the beta for an unlisted company?
Step-1: Compute the asset betas of listed
competitors – HUL, Nestle & JFW
Step-2: Compute the equity betas using the above
asset betas.
Step-3: Compute the average equity beta
Step-4: Compute the equity beta of CDEL using
proposed capital structure
(Refer Prasanna
Chandra – Chapter-3)
Question-(3)
Compute the post-issue cost of capital for CDEL
Compute WACC using post-issue weights
(Refer Prasanna
Chandra – Chapter-3)
Question-(4)
Do you agree with Swarup that sustainable growth rate of past cannot be

applied in the case of valuing an IPO?
Yes. CDEL has incurred losses in two out of last 4
years. The purpose of IPO is primarily to clear the debt. The financial performances
will turnaround once the debt is cleared and planned expansion take place. This
will not be reflected if we consider sustainable growth rate (ROE X Retention
Ratio) of past years.
(Refer Damodaran –
Chapter-3 & 4)
Question-(5) What will
be the projected FCFF for CDEL for the next 10 years and the

terminal FCFF?; Question-(6) What will
be post-issue intrinsic value per share of CDEL?
Step-1: Prepare
projected income statements for next 10 years, applying the growth rate given
in the case on the sales numbers. Using common size approach, project the other
numbers.
Step-2: Compute
projected FCFF for next 10 years
Step-3: Compute the
terminal cash flow using Gordon’s model and compute the present value
Step-4: Compute the
present value of all cash flows = FCFF or Value of the Firm
Step-5: Deduct the
debt component = FCFE or Value of Firm for Equity Shareholders
Step-6: Divide FCFE by
number of equity shares post-issue = Intrinsic Value per Share
(Refer
Damodaran – Chapters – 4,5 & 6; Prasanna Chandra – Chapter -2)
Question-(7) Conduct a
simulation using MS-Excel for varying rates of growth of next 10 years from 12%
to 24% (changing interval of 1%) and terminal growth rate from 0% to 6%
(changing interval of 0.50%). What will be the expected post-issue intrinsic
value per share of CDEL
Use
MS-Excel>>Data>>What-if Analysis>>Scenario Manager
Use
MS-Excel>>Data Analysis>>Random Number Generation>>Conduct
Simulation
(Refer
Parasuraman – Chapter-17)
Question-(8) Discuss
the areas of subjectivity involved in the entire CDEL valuation exercise of
Swarup and what other alternatives were skipped in the process
Areas
Swarup’s Action
Possible
Alternatives
Growth Rate
Expert Opinion
Regress with Economic Numbers
Sustainable Growth Rate (ROE X RR)
Competitors
HUL, Nestle, JFW
Other Hotel Stocks
Forecast Period
10 years
Can consider the Business Cycle and Decide
Risk-free rate
7.20%
Could’ve adjusted for long-term interest rate
expectation
Cost of equity
CAPM
Dividend Discount Model; Bon-Yield Plus Risk
Premium; APT; FF Five Factor Model
Tax Rate
Marginal Tax Rate
Effective Tax Rate
Capital Structure Weights
Current
Long-term Target Capital Structure

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