1. Indian Institute of Management CalcuttaMerger of Sunil Agro Ltd and ITC Ltd Course: Business Valuation Prof. Kaustav SenHappy Saini Harshit Krishna LaboniMandal Santhosh T Shruti Srivastava0137/48 0143/48 0190/48 0321/48 4031/18Mamtesh Ashok Sugla 0201/48 MurtuzaZoeb Kothari 0218/48 NamrataPenta 0258/48 RakeshSurineni 4022/48 SiddharthMalviya 0352/18

2. Groups 3 & 11Merger of Sunil Agro Ltd and ITC LtdTable of Contents Comparison1Sunil Agro as an apt acquisition target1ITCs motives for acquiring Sunil Agro Ltd9Strategic Implications of Merger9Valuation of acquisition targetFinancing the Merger12Conclusion11112 3. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 111. Comparison ITC Ltd is a conglomerate of companies in different sectors while Sunil Agro Ltd is a specialised agribusiness firm. The former is one of the latters customers for agricultural productsSimilarities Agribusiness commands approximately 10% of ITCs y-o-y revenues and 5% of its annual capital expenditure. Sunil Agro Ltd is wholly in the agribusiness industry Correlation in earnings over past 5 years and even accounting for coming five years forecasts is 0.43 which indicating a positive but less than perfect correlation between their earnings and cash flows.Dissimilarities As a group company ITCs agribusiness arm contributes to their FMCG businesswhich manufactures several food and non-food items. At least 80% of ITCs business is in nonfood sectors Sunil Agro is a localised producer in south India while ITC is a major national player in at least 5 sectors2. Sunil Agro Ltd as an acquisition target Based on the model presented in paper titled Predicting Takeover Targets written by K.G. Palepu, following six parameters were analysed for Sunil Agro Limited and its peers: Inefficient management hypothesis measured by average excess return(AER) and accounting return on equity(ROE) Growth resources imbalance hypothesis measured by growth resources dummy (GRDUMMY) Industry disturbance hypothesis as measured by industry dummy (IDUMMY) Firm size hypothesis as measured by the size Asset undervaluation hypothesis measured by the market to book value(MTB) Price earnings magic hypothesis as measured by price earnings ratio (P/E)Inefficient Management Hypothesis As mentioned in the paper, we have used accounting profitability as a proxy for management performance where profitability is computed as the return on stockholders equity averaged over a period of four years. Following table shows the ROE calculated for Sunil Agro Foods and its peers.2 4. Merger of Sunil Agro Ltd and ITC Ltd Name ADF Foods AGRO DUTCH INDUSTRIES LTD Aries Agro BRITANNIA INDUSTRIES LTD CHAMAN LAL SETIA EXPORTS DCM SHRIRAM CONSOLIDATED FLEX FOODS LTD HERITAGE FOODS (INDIA) LTD ITC LTD JEYPORE SUGAR CO LTD JUBILANT FOODWORKS LTD KWALITY DAIRIES LOTUS CHOCOLATE CO LTD LT Foods MODERN DAIRIES LTD NESTLE INDIA LTD RAVALGAON SUGAR FARM LTD RUCHI SOYA INDUSTRIES LTD SAPTARISHI AGRO INDUSTRIES Sita Shree Foods TASTY BITE EATABLES LTD USHER AGRO VADILAL IND Venkys VIKAS GRANARIES LTD VISHNU SUGAR MILLS LTD WATERBASE LTD SUNIL AGRO FOODS LTDROE (average of last 4 years) 12.5% -10.1% 9.9% 29.8% 17.8% 2.6% 12.5% -8.2% 29.2% 1.5% 32.8% 34.0% -42.8% 11.7% -16.8% 99.2% 12.3% 1.0% -4.8% 2.1% 13.9% 21.2% 9.9% 19.7% 29.7% 3.1% -4.0% 5.7%Industry AverageGroups 3 & 1111.6%Conclusion: It can be seen that Sunil Agro Foods Average ROE over last four years is less than the industry average. As mentioned in the paper, this shows that is has an inefficient management and so is a likely target to get acquired.3 5. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Growth-Resource Mismatch Hypothesis We have found the value of variable GRDUMMY for Sunil Agro Foods Ltd based on three parameters: Growth- measured as the average sales growth of a firm, Liquidity- measured as the ratio of net liquid assets to total assets and Leverage- measured as the debt to equity ratio.NameLiquidity (Ratio of Liquid assets to total assets) 0.05 0.01 0.14 0.03 2.75 0.00 0.44 0.52 0.00 0.03 0.00 0.04 0.01 0.01 0.06 0.01 0.01 0.01 0.01 0.03 0.14 0.05 0.00 0.21 0.01 0.01 0.11 0.01LeverageADF Foods AGRO DUTCH INDUSTRIES LTD Aries Agro BRITANNIA INDUSTRIES LTD CHAMAN LAL SETIA EXPORTS DCM SHRIRAM CONSOLIDATED FLEX FOODS LTD HERITAGE FOODS (INDIA) LTD ITC LTD JEYPORE SUGAR CO LTD JUBILANT FOODWORKS LTD KWALITY DAIRIES LOTUS CHOCOLATE CO LTD LT Foods MODERN DAIRIES LTD NESTLE INDIA LTD RAVALGAON SUGAR FARM LTD RUCHI SOYA INDUSTRIES LTD SAPTARISHI AGRO INDUSTRIES Sita Shree Foods TASTY BITE EATABLES LTD USHER AGRO VADILAL IND Venkys VIKAS GRANARIES LTD VISHNU SUGAR MILLS LTD WATERBASE LTD SUNIL AGRO FOODS LTDGrowth (Average Sales growth over last 4 years) 5.5% -20.9% 15.6% 17.0% 13.0% 13.6% 5.4% 23.4% 18.8% 4.5% 48.5% 69.5% 17.8% 14.0% 4.4% 20.1% -17.5% 14.9% -21.5% 13.6% 24.1% 58.5% 21.4% 20.3% 118.1% 5.8% 11.4% 11.2%Industry Average18.9%0.171.6440.13 4.3 0.9 0.05 1.36 1.3 0.23 2.234 4.83 4.67 3.43 0.76 1.05 1.62 0.45 0.83 1.37 3.36 0.6 1.54 1.12 0.46 1.13 6. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Conclusion: As can be seen from the table, growth, liquidity and leverage of Sunil Agro Foods are relatively lower than their respective industry averages which makes the GRDUMMY variable value as 0. And so there is no mismatch between the growth and financial resources which indicates that it is not a favourable target for acquisition.Industry Disturbance Hypothesis As suggested by the economic disturbance theory, we have looked at the recent history of acquisitions in its industry, which could act as a factor that signals the acquisition likelihood of a firm. The industry dummy (IDUMMY) is assigned a value one if at least one acquisition has occurred in the firms 4 digit SIC industry during the year prior to the year of observation. Presented below are some of the food industry facts with respect to acquisitions: Large foreign and local companies, too, are interested in getting a bite of the high-growth Indian food market through acquisitions Small- and mid-size companies have become favourable acquisition targets for large national and international companies looking to expand their operations in India In June 2011, the US-based spice and seasonings company McCormick and Co. Inc. bought an 85% stake in Delhi-based Kohinoor Foods Ltd for Rs. 520 croreits third acquisition in the country In the past, German food company Dr.Oetker International and Norwegian foods-to-metals group Orkla ASA entered India through acquisitions of regional food companies Chennai-based CavinkarePvt. Ltd, originally a maker of shampoos, bought Mumbais Garden NamkeensPvt. Ltd in 2009 to enter Indias expanding snacks and foods market NATUREX, world leader in specialty plant-based ingredients, announced the acquisition of VALENTINE, an Indian company specialised in the production of fruit and vegetable powders and natural colours for the food industry in March, 2012 Conclusion: As could be seen through the industry reports and news articles, there have been quite a few number of acquisitions in the food industry and the landscape looks quite favourable for acquisitions in the future. Based on this data, the IDUMMY parameter has been assigned a value of one and thus making Sunil Agro Foods Ltd. a favourable target for acquisition.5 7. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Size Hypothesis The size of the firm was calculated using net book assets for Sunil Agro Foods and its peersName ADF Foods AGRO DUTCH INDUSTRIES LTD Aries Agro BRITANNIA INDUSTRIES LTD CHAMAN LAL SETIA EXPORTS DCM SHRIRAM CONSOLIDATED FLEX FOODS LTD HERITAGE FOODS (INDIA) LTD ITC LTD JEYPORE SUGAR CO LTD JUBILANT FOODWORKS LTD KWALITY DAIRIES LOTUS CHOCOLATE CO LTD LT Foods MODERN DAIRIES LTD NESTLE INDIA LTD RAVALGAON SUGAR FARM LTD RUCHI SOYA INDUSTRIES LTD SAPTARISHI AGRO INDUSTRIES Sita Shree Foods TASTY BITE EATABLES LTD USHER AGRO VADILAL IND Venkys VIKAS GRANARIES LTD VISHNU SUGAR MILLS LTD WATERBASE LTD SUNIL AGRO FOODS LTD Industry AverageNet Book Assets (in INR Cr) 147 560 215.6 548 83 2855 60 272 18870 382 299 515.84 22.1 937 121 2244.83 69.1 5623 11 69.07 44 557.93 185 504 205 101 69 18.13 1271.02Conclusion: As can be seen from the table that Sunil Agro Foods is much smaller in terms of assets in comparison to its peers in the industry and so likelihood of acquisition is high for Sunil Agro Foods according to this parameter.6 8. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Market-to-book Hypothesis The market to book value ratio market value of common equity divided by its book value - was calculated for Sunil Agro Foods and its peers in the industry. Name ADF Foods AGRO DUTCH INDUSTRIES LTD Aries Agro BRITANNIA INDUSTRIES LTD CHAMAN LAL SETIA EXPORTS DCM SHRIRAM CONSOLIDATED FLEX FOODS LTD HERITAGE FOODS (INDIA) LTD ITC LTD JEYPORE SUGAR CO LTD JUBILANT FOODWORKS LTD KWALITY DAIRIES LOTUS CHOCOLATE CO LTD LT Foods MODERN DAIRIES LTD NESTLE INDIA LTD RAVALGAON SUGAR FARM LTD RUCHI SOYA INDUSTRIES LTD SAPTARISHI AGRO INDUSTRIES Sita Shree Foods TASTY BITE EATABLES LTD USHER AGRO VADILAL IND Venkys VIKAS GRANARIES LTD VISHNU SUGAR MILLS LTD WATERBASE LTD SUNIL AGRO FOODS LTD Industry AverageMarket-to-Book Ratio 0.8644 0.35 0.57 13.65 0.91 0.71 0.78 2.64 10.38 0.63 25.54 7.24 0.59 33.53 1.2 1.25 3.7 0.27 1.22 1.02 2.13 1.6 0.57 0.6363 0.64 0.55 4.35Conclusion: The market to book ratio for Sunil Agro Foods is much smaller as compared to its peers in the industry. This shows that it is a likely acquisition target.7 9. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Price-Earnings Hypothesis P/E ratio for Sunil Agro Foods and its peers is shown in the below table: NameP/E RatioADF Foods AGRO DUTCH INDUSTRIES LTD Aries Agro BRITANNIA INDUSTRIES LTD CHAMAN LAL SETIA EXPORTS DCM SHRIRAM CONSOLIDATED FLEX FOODS LTD HERITAGE FOODS (INDIA) LTD ITC LTD JEYPORE SUGAR CO LTD JUBILANT FOODWORKS LTD KWALITY DAIRIES LOTUS CHOCOLATE CO LTD LT Foods MODERN DAIRIES LTD NESTLE INDIA LTD RAVALGAON SUGAR FARM LTD RUCHI SOYA INDUSTRIES LTD SAPTARISHI AGRO INDUSTRIES Sita Shree Foods TASTY BITE EATABLES LTD USHER AGRO VADILAL IND Venkys VIKAS GRANARIES LTD VISHNU SUGAR MILLS LTD WATERBASE LTD SUNIL AGRO FOODS LTD Industry Average15.7 4.36 28 4.23 78.56 8.8 13.35 32.1 72.95 7.22 14.77 37.86 27.88 0 13 18.09 5.55 9.1 9.93 9.49 50.46 6.26 6.96 20.64Conclusion: Firmswith low P/E ratios are likely acquisition targets. As can be seen from the table, with low P/E ratio, Sunil Agro Foods is likely to be an acquisition target.Thus, 5/6 factors indicate that Sunil Agro Foods is a likely acquisition target.8 10. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 113. ITCs motives for acquiring Sunil Agro Ltd Sunil Agro Ltd displays inefficient management in the form of consistently lower than industry average ROE and hence average excess returns over past 4 years. It is possible that by executing this acquisition ITC may be able to change their debt ratio, ROC, reinvestment rate and reduce the cost of capital. The firm is relatively much smaller than ITC. The ratio of its assets to ITCs year end cash balance for the most recent financial year is 0.18%, that to ITCs assets is 0.083% and that to ITCs debt capacity for the most recent year is 1.01%. Yet Sunil Agro is an agricultural produce supplier to ITC and other large MNCs and is a dominant B2B player in southern states of India. Hence the motive of vertical integration itself is quite compelling. Two marginal reasons are a) Tax benefits that will accrue to ITC due to Sunil Agros negative EBT, b) any written up assets causing increased depreciation expenses and decreased tax liability Operating and Financial Synergies; factors that create positive synergiesare likely to increase intrinsic value of the new combined firm over the sum of individual intrinsic values. The four proximate determinants of intrinsic value are o Higher cash flows from existing assets (increased efficiency and Economies of Scale) o Increased expected growth rates (from market power, higher growth potential, new markets) o Increased length of growth period (from increased competitive advantages, new products) o Reduced cost of capital (from higher debt capacity) Finally there are some reasons which warrant not acquiring Sunil Agro for ITC. a) Sunil Agro is overvalued and FCFF valuation gives a SELL recommendation, b) both the earnings and cash flows of the two companies are positively correlated and as such variability in income is liable to increase and c) Sunil Agro is not only loss making but it doesnt give ITC any additional new geographical or market access apart from its expertise as a B2B agricultural supplier4. Strategic Implications of Merger Value of control From the adjoining calculations it can be seen that for ITC Ltd the implied growth rate by combining retention ratio and return on capital decreases slightly post-merger (from 4.04% to 4.03%). Although this growth rate is higher than that for pre-merger Sunil Agro Ltd, in the absence of any clear gains from management change value of control will relatively reduce present values of ITCs FCFF. The group has avoided any such assumptions like improved operating margins, improved reinvestment rate and a more optimal debt to equity ratio. A sensitivity analysis using an improved COGS to Sales ratio (15% reduction) in the terminal year for Sunil Agro yields 910mn in additional intrinsic value as per eVal.9 11. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 11Operating synergies Vertical integration: ITC is diversifying into FMCG business especially the snacks business for which it will need suppliers. Acquisition of Sunil Agro will give them a reliable supply base. The main benefit is greater control over the supply chain and assurance of supply of raw materials because of vertical integration. Greater Pricing Power: Greater pricing power will be gained by Sunil Agro once it is merged with ITC. This can help it to reduce its cost of raw material purchased. As such, Sunil Agro Ltd. is not a competitor for ITC ltd. and hence no change in the pricing power of ITC. Combination of different functional strengths: Sunil Agro caters to B2B market segment. The firm is currently undervalued in the stock market. After acquisition by ITC ltd., certain improvements in the management of the company are expected leading to an improvement in operations and hence valuation of Sunil Agro Ltd. Higher growth in new or existing markets: There is no diversification into new markets with this acquisition. Sunil Agro operates at a different level in the supply chain of the same market. Acquisition of Sunil Agro doesnt lead to any change in the market share of ITC. Benefits of vertical integration can be in the form of increase in operating margin due to reduced cost of raw material acquisition.Financial synergies Risk diversification: Both firms are publicly traded and investors in each can diversify on their own. Moreover a merger for diversification wont have any impact on the value and as such since these companies have positively correlated earnings as they are similar in their operations and industries, they are not expected to reduce earnings risk by diversification much. Cash Slack: As per phase 1 valuation of Sunil Agro Ltd, there dont seem to be any high value projects in near future for Sunil Agro Ltd that ITC could benefit from by investing its cash reserves. Tax Benefits:Unless asset write-ups are assumed for Sunil Agro leading to higher depreciation expense post-merger, there are no tax benefits accruing from this acquisition besides that from its negative EBT. This results in a tax benefit of 3.08mn for ITC. Debt Capacity: Free cash flows to firm and net earnings of ITC and Sunil Agro are less than perfectly correlated; therefore their total variability of the combined firms is likely to be lower than their individual earnings variability. This can result in increase in debt capacity post-merger and a lower cost of capital. Further Sunil Agro has a standard deviation on its stock returns of 4.077% while that of ITC as a percentage of mean is 18.39%. This merger may slightly reduce earnings variability for ITC Reduced cost of capital: Cost of capital declines from 12.35% to 11.96% as per adjoining calculations. This can potentially result in a huge increase in value (8.5bn) if the growth rate of the post-merger entity is same or higher. But as observed the growth rate actually declines and hence this increase in value would be reduced.10 12. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 115. Valuation of acquisition target Fair price of Sunil Agro Ltd (Status Quo valuation) As per Discounted FCFF valuation, the status quo fair value of Sunil Agro Ltd is INR 0.85bn or INR 85 crore. This is different from ReOI valuation done below which yields a value of INR 52 core as it values only the operations of the firm and not all cash flows to investorsSurplus value for acquisition (synergies and control) Financial synergy from reduced cost of capital post-merger amounts to INR 2.13bnPresence of other bidders It has been assumed that no other bidders are currently competing for this acquisition and hence the value is based on the above two factors.Price range As such ITC should pay the fair value for Sunil Agro Ltd given the benefit to this loss making firm are high from this acquisition. But theoretically the upper price limit will include the benefits to ITC from the acquisition which are worth almost INR 3bn.ReOI Valuation Sunil Agros operations were valued using residual earning on Operating Income model. The value obtained was Rs. 52.2 crore. Deducting total liabilities of 13.3 Crore it will still be a great deal at its current Market Capitalization of approximately 4.7 crore. Thus, it makes great sense to buy out complete equity of Sunil Agro at its current value. This undervaluation is primarily due to ineffective management & unprofitable leverage. (Its EBIT is positive, while its Net Income is projected to remain negative throughout). ITC has huge reserves of cash which it can utilize for financing this purchase & thus increase its returns on ideal cash too. Abridged table: Year 2011 2012 2013 2014 2015 EBIT 3,012.94 4,501.64 6,177.54 8,045.75 10,109.38 Operating Income after tax 2,018.67 3,016.10 4,138.96 5,390.65 6,773.29 Net Operating Assets 1,18,049.74 1,23,026.50 1,27,703.12 1,32,021.15 1,35,922.68 ReOI -12,572.28 3,016.10 4,138.96 5,390.65 6,773.29 DiscountedReOI -11,189.28 3,016.10 4,138.96 5,390.65 6,773.29 PV of ReOI 4,36,422.16 Current CSE 85,128.00 Value of Operations 521550.16 Figures are in 000. Discount rate used is ITCs cost of capital.11 13. Merger of Sunil Agro Ltd and ITC LtdGroups 3 & 116. Financing the merger Cash versus Equity ITC Ltd has an ending cash balance of INR 43.96 billion for FY2010. The net worth of Sunil Agro is only 0.19% of ITCs latest year end cash balance. This indicates sufficient surplus cash availability to make the purchase outright. ITCs stock is currently considered undervalued while Sunil Agro Ltd is currently overvalued as per Phase 1 analysis. Hence it does not make sense to use equity or equity swaps to buy Sunil Agro.Debt versus Equity Debt capacity is considerable for ITC with its Debt-Equity ratio for past 5 years at 0.01 being considerably lower than its peer companies (peer average~0.19) and Interest Coverage ratio for the same period at 194.66 being higher than most competitors (peer average~120). If ITC was to scale up its debt obligations such that its interest coverage ratio increases to its peer average, it can buy out Sunil Agro with only 1.01% of that new debt. Hence ITC can also use Debt for this acquisition. Recommendation: We recommend using cash to finance the acquisition as it is a strategic expansion for ITC and as such idle cash has an opportunity cost and will be given out to shareholders in all probability.7. Conclusion (Value Added or Destroyed) The acquisition adds value if ITC can derive the said operational and financial synergies and can improve the management of the target firm. While for the individual stock of Sunil Agro a SELL ratingwas recommended, at the same time we are recommending that ITC should acquire Sunil Agro. This contradiction is on account of the fact that Sunil Agros operating business is inherently profitable, however due to incorrect financial structure & inefficient management the company has been reporting losses for the past few years. An individual shareholder can do nothing to resolve these issues; however, an acquirer (acquiring majority stake) has the power to reform the financial structure of the firm & constitute new management. Hence, we recommend that while a retail investor shouldnt invest in Sunil Agro, it makes great sense for ITC to buy Sunil Agro out.12