Sunday, January 31, 2010

Merger Analysis: Pepsi's Acquisition of its bottlers

We are going to analyze the antitrust situation brewing in PepsiCo’s (PEP) acquisition of its two bottlers, Pepsi Bottling Group (PBG) and PepsiAmericas (PAS). In merger arbitrage transactions, regulatory approvals are critical. For the Pepsi deal, the HSR notification is under scrutiny with the FTC (recall that the Hart Scott Rodino Act governs the US antitrust filing process). For a little background, PEP made an unsolicited cash & stock offer for both companies on April 20, 2009, with bids worth $29.50/share and $23.27/share for PBG and PAS, respectively. The offers are cross-conditional based on the successful completion of both transactions. At the time of the announcement, PEP said it saw no issues in obtaining regulatory approvals. The offers were rejected by PBG and PAS’ boards, as all initial unsolicited proposals are. The spreads were negative, indicating that a higher offer was expected, and on August 4, definitive agreements were reached. The new offers were a cash or stock election worth $36.50/share for PBG and $28.50/share for PAS.

The antitrust review of a deal is paramount in risk arbitrage. It plays an important role in the timing of deal close and the ultimate successful completion of a deal. Deals with the most attractive spreads are likely to have complex antitrust issues, therefore it is essential to get a handle on this facet of deal analysis.

The first step in analyzing antitrust issues is to check right away whether there are any horizontal overlaps between the two companies. Horizontal overlaps are of great importance as these are the most likely to be challenged by the Antitrust Division of the Department of Justice (DoJ) or the Federal Trade Commission (FTC), if the merger results in a Small but Significant and Non-Transitory Increase in Price (SSNIP). We will discuss the meaning of SSNIP later. In the PEP/PBG/PAS merger, we can right away conclude that the merging companies do not have any significant overlaps.

In fact, the merger is a vertical merger. This is very good news, as historically, US antitrust authorities have had a fairly hard time challenging vertical mergers in a court setting. This gives us sufficient comfort to say that there is a very low probability that the merger would be challenged (blocked) by the antitrust authorities.

The next logical step is to look at the expected timing of the antitrust approval. The first thing we want to check is when the merging parties expect to file under HSR. We can usually find information related to the filing date in the Merger Agreement. Usually the parties commit to file either with the DoJ or the FTC in a fixed time period (usually 10 to 15 business days). So we check the PBG and PAS Merger Agreements (click here for the PBG and here for the PAS Merger Agreement). We are not that lucky here though: Section 8.01 of the Merger Agreement states that the parties will file under HSR “as promptly as practicable.” To remain on the conservative side we would pencil in one month for filing (early September 2009).

Next, we seek to estimate the length of the antitrust review period (here, we will not discuss the deals’ required European Union filings). We know that the initial waiting period under HSR is 30 calendar days for mergers. However, if there are substantial competition concerns the DoJ or the FTC could further extend the review period. This could substantially postpone the closing of the merger. In a Second Request, the parties would have to substantially comply with the DoJ’s or the FTC;s request for further information, for which there is no time limit. Once the parties have substantially complied, another 30 calendar day review period will start.

Does it follow from the fact that the PEP/PBG/PAS merger lacks any horizontal issues that the merger will result a quick antitrust resolution? No. There are two things to consider here. First, the FTC’s or DoJ’s track record in a given industry. Second, how complex the transaction is.

Complexity of the transaction is important because the FTC and the DoJ have scarce resources to look at a particular merger. Don’t forget that there are lots of mergers ongoing at the same time, and as a result, the DoJ and the FTC have to allocate resources (time and staff) efficiently. The antitrust authority has 30 days to decide whether a given merger deserves an in-depth investigation. What can be done in 30 days? Not much; the antitrust authority requests data on the companies’ products, the companies’ financial reports, name of the customers, suppliers and market share data. In the event of some overlaps or potential competition concerns, the antitrust authorities will contact major customers and suppliers, and if these do not complain, will allow the merger to proceed after the expiration of the 30 day HSR waiting period.

In the PEP/PBG/PAS merger, we are skeptical that the antitrust authorities will reach a quick resolutions on the deal. Why? The FTC has a track record of looking at bottling integrations very carefully. The FTC published an interesting booklet focusing on antitrust issues related to the US carbonated soft drink industry in November 1999 (prepared by staff members of the Bureau of Economics of the FTC). The FTC report analyzed bottlers in the U.S. carbonated soft drink industry and the effect of consolidation on carbonated soft drinks. Although the FTC’s study concluded that vertical issues were not of serious concern, we should conclude that the FTC will likely be concerned about the PEP/PBG/PAS merger. In this specific case, our best guess is that the FTC will be concerned because both PBG and PAS distribute products of PEP’s competitors (such as Dr Pepper). The FTC has historically been concerned that, as a result of consolidation, third parties’ products may be excluded, resulting in a price increase for consumers. Considering this, we pencil in a longer review period for the deal.

After a September 11th HSR filing, PEP announced on October 9th that it had withdrawn its HSR report forms from the FTC, and that it intends to re-file. A withdrawal of an HSR form can have various effects on a spread. If clearance is expected, then a withdrawal is negative, since it shows that there are still concerns to address. If a lengthy review is anticipated, then a withdrawal is largely a non-issue. It is positive is when the companies re-file the form, because it shows that they are confident that the material presented will be sufficient to gain clearance. When the form is re-filed, the clock is restarted, giving the FTC an additional 30 days to review the transactions. The withdrawal and re-filing process is done to prevent a formal extended review or Second Request (we will review Second Requests in more detail in a later post). On November 10, PEP announced that it once again withdrew its HSR forms. As of today, PEP has still not re-filed its application with the FTC. In PEP’s case, the market clearly expected a lengthy review and as a result the spread did not move too much.

On January 11, 2010, PEP disclosed that that it believes it can complete the deals by the end of the first quarter of 2010 and do so without a remedy that would constitute a material adverse effect.

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About the Authors

Hunter is the founder of the Distressed Debt Investing Blog and the Distressed Debt Investors Club. He has worked on the buy side for the past 7 years in high yield and distressed debt investing.

Edward has been a professional investor for four years, focusing mainly on the event-driven space. His investment philosophy is value-based, and he spends the majority of his time identifying near-term catalyst based opportunities.

Email

hunter [at] distressed-debt-investing [dot] com