Fast & furious $6 billion

The weather here is better than India’s summer,” smiles Neeraj Kanwar on being asked why he is in London. Certainly, almost anywhere will be an improvement over sweltering Delhi and neighbouring Gurgaon but it needs no saying that heat and humidity are way down on the priority list of the 41-year-old vice-chairman and managing director of Apollo Tyres. What’s more to the point is that Gurgaon, where the company is headquartered, isn’t really the best place to be when you want to keep one eye on the West and the other on the East. And right now, that is what is high on Neeraj’s agenda.

He settles in a chair, looks straight into the video conferencing monitor, and gives a more serious explanation for this extended London stay. “I am meeting many investors in the UK and the US. I am taking them through what the combination has to offer.” The “combination” is the result of a recent shopping spree, where Apollo Tyres snapped up the Findlay, Ohio-based Cooper Tire & Rubber for a staggering $2.5 billion. It’s the largest deal in India’s automotive and tyre industry, the largest M&A between the US and India and even bigger than the $2.3-billon Tata-JLR deal of 2008. 

The $2.5-billion tag is nearly three times what Apollo is worth and will be paid entirely by debt, raised on Cooper’s profitability prospects. In mergers and acquisitions (M&A) parlance, such shopping is called leveraged buyout (LBO). Paras Chowdhary, former managing director of Ceat, says, “It’s an ambitious deal…they have paid a very heavy price in this all-cash deal. If they can pull it off, it will be good for them.” But LBOs aren’t common in India, and jittery investors promptly voted on the deal with their feet. Nearly a third of Apollo’s market capitalisation was wiped out in just two days following the announcement. 

Neeraj’s father, the 70-year-old group chairman Onkar Kanwar, is unfazed by the development. In 2011, the then-$2 billion Apollo had set a target of becoming a $6-billion company by 2016. The Apollo-Cooper combine has achieved that: total revenues of around $6.6 billion and operations covering practically the entire world, something that Kanwar Senior can’t stop exulting about (see: Combustible combination?). “With a stroke of a pen, we have not only put Apollo on the world map, but also created a place in history,” he exclaims. Name one truly global company from India, he challenges us, and brushes aside suggestions of Tata and Bharti Airtel. “Well, Airtel could have been, had they bought Vodafone. And I respect the Tatas, but JLR is only a segment,” Onkar counters. “Now, Antarctica will be the only continent where we won’t be selling tyres. That’s because there’s no market out there — and even there, we could sell winter tyres in future,” he laughs. What’s worrying the market is that the entire Apollo-Cooper deal has been built on just such a flight of fancy. 

Trophy buyout

A quick peek at Apollo’s history with Cooper is enough to raise doubts that this deal has all the markings of a trophy acquisition. For Onkar, Cooper has long been the tyre company to emulate, the benchmark against which he measured his budding company back in the 1980s. Indeed, in 1989, he approached the company about a possible relationship. “But it didn’t happen then,” points out Onkar. 

He didn’t give up the connection, though, and a serious dialogue on how both companies could work together started rolling again about seven years ago. Apollo’s acquisition of Dunlop Tyres’ South African operations in 2006 brought the two companies together and Apollo became the distributor for Cooper Tire in the country. Various other possible associations were discussed over the years but nothing materialised. “We then went ahead and bought Vredestein Banden [of the Netherlands] in 2009,” reveals Neeraj. The way Onkar tells it, in late 2011, Cooper’s management suggested buying out Apollo. “Instead, I said, ‘I am interested in buying you’,” he recalls.

The conversation was followed by a formal proposal that was rejected by Cooper but the second offer was one Cooper couldn’t refuse — at $35 a share, it is a 40% premium to Cooper’s shareholders in an all-cash deal. As it turns out, while Indian shareholders were sceptical about the high debt levels, the Cooper board wasn’t.

In an interview to an American trade journal, Roy Armes, chairman, CEO and president, Cooper Tire, points out, “We needed to make sure that with the leverage they were going into, this deal could be done with the financing arrangements that Apollo had.” Incidentally, the deal has made Armes, who has been at the helm since 2007, a very rich man: his stake in the company is now worth almost $24 million.

Was the 40% premium a little too much? Certainly not, defends Neeraj. “If you see M&A transactions in the tyre industry in the past five or six years, the multiple has been averaging four to eight times. We have paid 4.4 times. We are really inside the mean,” he says. Analysts don’t disagree. Before the acquisition, Cooper was trading at a 40-50% discount to its peers and Vishal Bhargava, president of equities research firm Achelous Advantage, explains the undervaluation. “If you have to invest in an ancillary industry stock, like tyres, you pick the top players, not the third or fourth largest. That is why even after the buyout and consequent upswing, Cooper Tire’s PE is lower than its peers.”

It’s also a good price if you consider what all was thrown into the deal, Bhargava adds, pointing out the exorbitant cost of setting up plants in the US or China. “In February, Michelin launched a 12 million tyres per annum facility in China, investing $1.5 billion. In comparison, Cooper’s plant in China has a capacity of 15 million tyres annually. Apollo paid $2.5 billion for that and all other Cooper facilities.” The American company has three plants in the US, two in China and one each in Serbia, Mexico and the UK, with an overall capacity of 54 million tyres. 

But, as analysts and investors point out, the problem isn’t with the price Apollo is paying but where it’s getting the cash from. 

Debt blues

Simply put, the biggest worry is that the buyout is actually an overleveraged one. “We find the acquisition to be aggressive as it is nearly thrice Apollo’s current size, and overleveraged, given that 100% of the financing of the acquisition is through debt,” says Ashvin Shetty, analyst at Ambit Capital. 

Ambit isn’t the only one voicing concerns over the deal. Jatin Chawla of Credit Suisse, too, believes the accompanying debt is cause for worry and has pegged the combined entity’s consolidated net-debt to Ebitda ratio at 3.71 times. Neeraj, though, calls the Cooper LBO a standard one, saying there are much larger buyouts happening in the US. “I have met many investors in this part of the world. They say both the financial plan and strategic rationale are excellent,” he adds. Certainly, Apollo chief financial officer Sunam Sarkar terms this “by far the largest and most complex deal because of scale and cross-border regulations”.

The deal involves taking debt at two levels — $450 million on the books of Apollo’s Mauritius-based subsidiary and $2.1 billion between Cooper ($1.9 billion, from the US bond market) and Vredestein ($200 million, an asset-backed loan). There will be no principal payment on the Cooper loan for seven to eight years after which a bullet payment is to be made. Meanwhile, annual interest payments at 6.75-9.5% have to be made. The loan on Apollo’s books will be reduced by some $40 million realised by selling one of its factories in South Africa to Sumitomo Rubber Industries. The remaining $410 million, from Standard Chartered Bank, will be serviced at around 10-11% and repaid out of Indian cash flows. 

Incidentally, Apollo India already has existing debt of $354 million. “Our annual interest liability on $2.1 billion at 8% a year is expected to be $200 million a year. Cooper’s Ebitda for CY12 was $525 million and Vredestein’s Ebitda for FY13 was $100 million, a total of $625 million. Now, even if you subtract $100 million each as depreciation and taxes, we are still left with $425 million to cover interest outgo,” explains Sarkar. In addition, he plans to set aside money every year to repay the principal after seven years. The risk here is obvious. Apollo’s financial plan relies a little too much on Cooper’s sustained profitability. Cooper is currently enjoying high margins because of low rubber prices (more on that in a bit) (see: Too good to last).

The American company has also benefited significantly from anti-dumping duty imposed by the US on Chinese tyres (see: Dragon rising). But that cess lapsed in September 2012 and, as Chawla of Credit Suisse points out, “While the transaction is EPS-accretive on CY12 numbers, we believe investors will question the sustainability of Ebitda at Cooper given that CY12 profits to a large extent were driven by a favourable raw material cycle. Moreover, there are concerns over pricing stability in the US given increasing competition from Chinese and Japanese players.” 

It doesn’t help that most studies have very pessimistic outlooks on the success of M&As — globally, three of every five buyouts don’t yield the desired results, says one, while another concludes that mergers for size are counterproductive since they send the signal that organic growth opportunities have been exhausted.

Neeraj rubbishes all such observations. “People shouldn’t generalise,” he says, pointing to the success of Tata-JLR and Mahindra-Ssangyong. He also offers up Apollo’s own experience with the Vredestein as a case in point. Chawla of Credit Suisse, though, points out that the company was acquired from Russia’s bankrupt largest tyre manufacturer, Amtel-Vredestein NV, at a very reasonable valuation, and has since been turned around. The Dunlop buyout for ₹290 crore, on the other hand, has had mixed results and recently, there was also the South African plant sale. Not surprisingly, Neeraj has a defence ready. “When we entered South Africa in 2006, the level of Chinese imports was 10-15%. Today, it is 55% and the size of the market has shrunk equally for the four largest players,” he says. 

No growth market?

If there’s trouble in South Africa, the US market isn’t free of worries, either, and some observers feel Apollo may have done better seeking an acquisition in emerging, high growth markets. Cooper is a true blue American company with 70% of its revenues in 2012 coming from the North American market and 30% from international operations (mainly Europe and China). The bulk of its income comes from the replacement market: 47% from passenger vehicles and 23% from light trucks. But North America is a mature market and growth has remained flat over the past decade, especially in light vehicles, which is Cooper’s area of strength, averaging around 210 million tyres a year (see: Flat feeling). 

The good news for the US replacement market, in which Cooper holds 5% and 6% share in the passenger and light truck tyre segments (see: How they stack up), is that owners are holding on to their vehicles much longer . The average age of light-duty vehicles on American roads today stands at a record 10.8 years: for passenger cars it’s 11.1 years and for light trucks it’s 10.4 years. But at the time, for the eighth year in a row, vehicle miles travelled is down on a per-capita basis.

Further accentuating the situation is that bigger players such as Continental, Bridgestone, Michelin and Yokohama are ramping up car and light truck tyre capacity in the US. In addition, Pirelli recently opened a consumer tyre plant in Mexico, while Hankook Tire declared its intention to build a consumer tyre plant. At the same time, Chinese players such as Aeolus Tyre and Double Coin Holdings are for the first time looking to sell their own branded passenger and light truck tyres in the US. “Indian companies are quite competitive but fighting China in international markets is tough,” points out Chowdhary.

The folks at Apollo don’t see this as a problem. Neeraj points out that pre-acquisition, Apollo was catering to a $500 million “potential profit pool [comprising Indian, South African and European markets]”, which has now nearly tripled to $1.4 billion. The company will also see a rejig of revenues as a result of the deal, with 43% coming from North America, 12% from Europe, 22% from India, 18% from China and 5% from the rest of the world (compared with 65% from India till now), which means 40% revenues will come from low-cost, high-growth markets. Besides, points out Neeraj, “The US is the largest tyre market in the world and Apollo cannot be a world-class player if we don’t operate there.”

It does help that Cooper has a presence in China. The American company entered China in 2006 through joint ventures. “Cooper was among the early entrants into China. Bridgestone and Michelin have set up manufacturing facilities there only recently, so it may have some advantage,” concedes Bhargava. 

Certainly, the Chinese tyre market has been growing at 24% a year since 2007, which is perhaps why Neeraj refers to the market as the “big fish” for Apollo. Still, it’s not too fresh right now — in Q4CY12 and Q1CY13, Cooper’s sales volumes in Asia decreased by 2%, driven by reduced passenger tyre exports. Declaring the company’s results for the quarter ended March 2013, Cooper’s Armes said, “Looking ahead to the second quarter, we continue to be cautious about volumes as the weak global economy and sluggish tyre demand look to continue.”

In the same release, Cooper admitted that current profitability for overall operations has been driven partly by the low price of rubber. “In addition to other profit contributors, the company’s first quarter operating profit was positively impacted versus the same period a year ago by $90 million in lower raw material costs.” Left unsaid is what will happen if and when rubber prices go up again.

Rubber-made

Rubber as a raw material constitutes 55% of the production costs of tyres. Not only is its price very volatile, it is also more expensive in India, at ₹192 a kg compared with the rest of the world (₹152). “Prices have doubled in the past five years. And, at times, it is difficult to pass on prices for tyre companies due to competition,” says Rajiv Budhiraja, president, Association of Tyre Manufacturers of India (Atma). 

Agrees Chowdhary. “Availability of rubber is a key issue. Two years ago the situation was still better, but now the shortage is increasing every year.” Globally, rubber is a very tightly-controlled commodity, both in terms of prices and supply, with just three countries (Malaysia, Thailand and Indonesia) accounting for 70% of global output. And where tyre makers in the US and Europe almost entirely depend on rubber imports, Apollo’s India operations mostly uses rubber from Kerala.

Two years ago, the company announced it was leasing 10,000 hectares in Laos for a captive rubber plantation that would ensure 10-15% of its raw material supply. “But that is still some time away. Leasing land, planting trees and maturing of plants will take seven to eight years,” points out Bhargava. 

Volatility in input costs, then, is a very real worry, both for Apollo and for Cooper. Deepak Jain, analyst, Phillip Capital, lays out the risk in black and white. “The key point to note is that the Ebitda margins in CY12 represented a peak of the past seven years. In case the Ebitda margins decline to 8.3% (the average of the last seven years), the acquisition will be earnings decretive.”

For his part, Neeraj says such risks have been incorporated into the business plan. “With $625 million Ebitda from Cooper-Vredestein and annual interest liability of $200 million, I am covered more than 3 times. In the worst case, if my margins deplete, the cover can come down to 2.5 times. But it is still manageable,” he says. Also, the $1.9-billion debt taken on Cooper’s books is covenant-light, which means no riders or targets regarding quarterly P&L or Ebitda margins attached. “This allows some room to deal with volatility,” Neeraj adds. There’s certainly plenty of that in the domestic market, even leaving aside input prices.

The bulk of the Indian tyre market comprises replacements, while OEM sales account for just 15-20% of the market. “OEM margins are wafer-thin. Tyre makers operate there only to get visibility and value,” explains Budhiraja. For its part, Apollo is the market leader in truck tyres or, as Onkar likes to put it, it is the “Coca-Cola of truck tyres”. Of late, the market’s taste seems to have changed — the tyre industry as a whole and commercial vehicles in particular have taken a 30% negative hit in the past one year, according to Atma. It’s a double whammy, since much capacity creation happened post the recovery from the 2008 slowdown. “There is a dual impact now,” agrees Budhiraja.“New capacity was created at high cost. So, that burden is still there as the capacity is lying idle. The industry is currently operating at 70-75% of capacity.”

That is something that has rankled analysts as well, who believe that even before Apollo Tyres could capitalise on its just completed greenfield expansion for truck and bus radials in Chennai for over ₹2,300 crore, it went ahead and spread itself thin with Cooper. “The market was eager to see Apollo consolidate on its expansion and bring down the debt,” points out Credit Suisse’s Chawla.

However, the management at Apollo points out that a lacklustre demand back home was one reason why the company was keen on reducing dependence on any one market. The acquisition, then, will help Apollo reach out to new geographies and markets and derisk the combined entity as well. And, it is banking quite heavily on synergies between the two companies to make this deal a success. 

Seeking synergy

Neeraj says the Apollo-Cooper combination is a fit from all angles — strategy, branding, product portfolio and geographies. On the face of it, there are certainly several complementarities. The deal increases Apollo’s capacity from 26 million to 80 million a year. It will now have a presence in all markets, with Cooper for the Americas and China, Vredestein for Europe, Apollo and Regal in Africa and Apollo in India (see: At the end of it all). While Cooper is strong in passenger vehicles, Vredestein is known for winter tyres and Apollo, for truck tyres. Going forward, Apollo plans to introduce its truck tyres in the US market using Cooper’s dealership network and also sell Cooper tyres in the Indian replacement market. 

In the next three years, then, Apollo expects to gain $80-120 million per year on manufacturing, branding and procurement, human resources synergies. “Apollo has a strong track record of synergy realisation. Post acquisition of Apollo Europe, we increased Ebitda margin from 11% to 18% between 2008 and 2012,” says Neeraj. The current deal may not reap benefits as quickly and analysts fear the first two or three years may be exceptionally tough when the synergies won’t have kicked in but interest payments would have. “It will be a major operational challenge. And realising huge synergies will be essential to make sense of the premium Apollo is paying to acquire Cooper,” says Ambit’s Shetty. 

The trouble is, the larger the organisation, the more unwieldy it is, making integration that much more difficult. Cooper has over 14,000 employees across the world and Onkar clarifies that there is no intention of retrenching staff at the American company. That means the combined strength of Apollo-Cooper will be 30,000. 

Next year, Onkar will be travelling to Ohio to join in Cooper’s centenary celebrations. “It will be held under Apollo’s flag,” he says decisively. In the meantime though, several issues relating to cultural integration remain to be sorted out. To begin with, trivial decisions such as extending Cooper’s endorsement of baseball games has been taken but Apollo is yet to take a call on whether it will send any representatives to be based out of Findlay.

Raja Lahiri, partner, transaction advisory services, Grant Thornton India and a cross-border M&A specialist, points out that, “In any large acquisition, synergies will only work if there is integration at the level of operations, people and culture. After a deal, if you don’t communicate well to market, dealers, customers and employees, the impact will be seen on the books later. It will also hurt your earnings and sales.” However, for now the management is not taking any hard decisions and is leaving the management and workforce untouched.

In fact, Armes was quoted as saying that the deal will give Cooper’s customers access to new products such as off-road and farm tires, which could eventually be made at one of the company’s North American plants. “It won’t make sense to import everything from India,” Armes said, adding that Apollo has made a “pretty strong commitment” not to shut down the Cooper Tire plants in Tupelo, in Findlay in northwest Ohio, and Texarkana, Arkansas. Sarkar, too, pointed to analysts in a conference call that “as we work together on a full integration of the companies. I would like to make it very clear that we have no plans to close any existing facilities. We would rather grow them to meet the expanded needs of the joint entity.”

Retaining a workforce in developed markets also means higher manpower costs. However, Sarkar points out that the company looks at the ‘total cost of ownership’ rather than just manpower costs. Right now, total cost of ownership for Apollo Europe is four times as high at 20% of sales compared with Apollo India where  total cost of ownership is just 5% of sales. Sarkar isn’t concerned, though: “Ebitda in Europe is higher than in India.”  

Bumpy ride

Concerns, whether about financials or integration, these have got investors worried. A newspaper report last fortnight said Apollo’s institutional investors have urged a rethink on the deal, arguing that the company is overpaying for synergies that will be difficult to achieve. Sarkar, however, denies the report categorically. “We have not been approached to rethink the deal,” he declares.

That is not to say investors aren’t voicing their objections. Amit Tandon is managing director of Institutional Investor Advisory Services, an independent investor advisory firm. He is openly critical of the Apollo Tyres deal, saying shareholders have been taken for a ride. “When an investor invested in the company, he believed it to be an Indian company with a different debt profile. Overnight, things have changed for him,” he points out. As an all-cash deal, the Cooper acquisition did not need voting from shareholders but, had it required voting, no prizes for guessing what Tandon’s advice would have been. “I would have taken a hard look and advised to vote against the deal. There is absolutely no safety margin in this,” he says. 

For its part, Apollo has tried to ringfence the Indian operations by taking most of the debt on Cooper’s books. But that may not be enough going forward. “They have already taken $450 million on Apollo’s books. If tomorrow, they need $100 million more, will they walk away from it?” says Tandon. 

With investors in India not buying into the Apollo-Cooper success story, Neeraj is now scouting for investors with a global worldview — hence, the current London sojourn. But, as it happens, even Cooper’s investors don’t seem too enthused by the deal, the 40% premium notwithstanding. The acquisition has been reportedly challenged in a US court by Booth Public Trust, an investor in the company. Its grouse: the $35 payout is too low. In the US, even one investor challenging a deal in the US can have a domino effect, so is this a threat to the deal? Cooper’s shareholding is very widely held, mostly by financial institutions, and the shareholder vote for approval of the transaction is expected only in early September.

Sarkar says he hasn’t heard specifically about the Booth Public Trust case but doesn’t anticipate any problems going ahead. “Such cases happen regularly in any public company transaction in the US, but the Cooper board of directors has followed a publicly documented process to discharge their fiduciary responsibility to the fullest, and in a manner beneficial to all shareholders.” Even Achelous’ Bhargava agrees that, at best, shareholders can only delay the deal. “Such litigation happened during the Tata-Corus and Arcelor-Mittal deals as well. But, if the promoters agree, these deals go through,” he points out.

Onkar Kanwar is confident that the Apollo-Cooper buyout is a done deal. If there are problems ahead, he’s certainly not seeing them as insurmountable. “One can’t reach the next level without taking some risk,” he says with a smile. “There are 33 million gods in this country. They will help us.” Ask investors in Apollo Tyres and they echo that sentiment — God help the Cooper deal.