Coca-Cola takes plunge into coffee with 3.9 billion-pound Costa deal

On the 31st of August 2018, Coca-Cola (NYSE:KO) announced that it had reached a definitive agreement to acquire the U.K. Coffee-shop leader Costa for 3.9 billion pounds ($5.1 billion). This brave acquisition is a turning point for both companies.            


The Coca-Cola Company 

The buyer is The Coca-Cola Company, one of the biggest beverage company in the world. Its portfolio is extremely wide, including around 500 brands based in more than 200 countries.          
The firm was founded in 1892 in Atlanta, Georgia in the United States. The Coca Cola’s product was designed in 1886 by Dr John Stith Pemberton. A trade secret protects its recipe from the 20th century.    
The successful marketing campaigns are the major drivers of brand triumph. Indeed, they have a powerful impact on pop culture and society as a whole.

Coca Cola six-year financial performance        

74.1% of the turnover of Coca Cola is achieved at the international scale with more than 30 worldwide production sites. In the last quarter release of 2018, Coca Cola showed an increase of EBITDA Margin reflected by a reduction in Operating Costs. Despite a reduction in EBITDA by -2.94 % and Revenue by -7.64 %, EBITDA Margin in 2018 was 40.11 %, above the company average.

The beverage company expanded the range of its product by bringing other soft drinks such as Fanta or Sprite in its portfolio.   
Nowadays, Coca-Cola aims to reduce the amount of sugar and the environmental impact caused by traditional drinks. Therefore, Coca-Cola strives to achieve those goals through the acquisition of additional organic and artisanal beverage companies.        

As a result, the acquisition is a clear signal that it is diversifying away from the sugary and carbonated drinks on which it has built its name. It is the most significant acquisition of Coca-Cola in eight years, pushing it into direct competition with Starbucks, Nestlé and JAB Holdings in the international coffee market.


About Costa Limited        

The seller is Costa Coffee. It is a British private multinational coffee company established in 1971 by the Costa Family (Bruno and Sergio Costa) as a wholesale operation supplying roasted coffee to caterers and traditional Italian coffee shops.  The company is headquartered in Dunstable, Bedfordshire (UK).        
Costa Coffee is the largest coffeehouse in the UK, with a market share of 39%. It was initially acquired by Whitbread PLC, the UK largest hotels, restaurants and coffee shops operator for £19m in 1995 when it had only 39 shops.     
Nowadays, Costa Limited is running a coffee shop business internationally and specifically within the UK with around 2,400 retail outlets in the UK and over 1,400 stores in 31 global markets.

For several years, Whitbread was under pressure to spin off Costa from the rest of the business as an independent company but resisted the desire and waited for the right time. Indeed, Whitbread concluded that a straight sale would lead to a more profitable option. Associates emphasized the fact that the spin-off option would have led to smaller yields and might have taken around 2 years to produce comparable returns.

For Whitbread, the acquisition provokes a new period in its 276-year history that will be spearheaded by its Premier Inn hotels and complimentary restaurant brands such as Beefeater and Brewers Fayre. 

Costa Coffee five-year financial performance  


Costa’s revenue swelled at sturdy rate of 7.5% to £1,292m in 2017 (up from £1,202m in 2016). It also announced a hefty return on capital of 46.0%.

M&A in the coffee market heats up with entry of Coca-Cola        

The coffee industry has become a fast pace growing sector of the international beverage business. The worldwide coffee market is worth between $80 billion and $100 billion.
According to Statista, the US is the largest market on a global scale, with consumers spending $12.5 billion on coffee in 2017.

Numerous beverage companies have been acquiring companies to expose themselves to prospective markets.  
For instance, Nestle acted in the same way as Coca-Cola by acquiring smaller niche producers, Blue Bottle Coffee and Chameleon Cold Brew. The Swiss food company also paid $7.2 billion to establish an alliance with Starbucks with the aim of selling its coffee products outside the US company’s coffee shop, extending its Nescafé and Nespresso portfolio with Starbuck’s brand. Likewise, the U.K.-based food-and-coffee chain Prêt A Manger has been bought by JAB, Reimann family’s investment company for $2 billion earlier this year. Formerly, JAB had acquired high end coffee companies such as Peet’s Coffee & Tea in 2012 for an estimated £1 billion, Caribou Coffee in 2013 for $340 million, Nordic Coffee in 2015 for $300 million and Krispy Kreme in 2016 for $1.4 billion. The merger of Dr Pepper Snapple and Keurig Green Mountain for $18.7 billion also occurred previously this year. Therefore, Costa was the sole acceptable coffee chain available for a potential buyout in the market.

These decisions are explained by the desire of diversification, exploring new opportunities and penetrating new markets and businesses. Indeed, soft drink has always been a disintegrated sector without having strong positions in the coffee industry. 

The trend of “health-consciousness” has become the company’s priority. This move might lead to a reduction in the consumption of sugary and fizzy drinks.
The expansion towards Asia is another priority due to the fact that the coffee culture is growing at a fast pace. According to GlobalData, retail sales of hot drinks in China will hit $34.2bn by 2022. A few acquisitions are going along. Indeed, Costa itself acquired Yueda on October 2017, a Chinese coffee chain and Starbuck announced a deal with e-commerce giant Alibaba with the goal of extending its delivery services within the country in August 2018.

Buyer’s rationale of the deal

  • Coca-Cola buys Costa to fill in the final piece of the puzzle: Coffee Expertise

“Hot beverages are one of the few remaining segments of the total beverage landscape where Coca-Cola does not have a global brand. Costa gives us access to this market with a strong coffee platform” said Coca-Cola President and CEO James Quincey. Indeed, this big deal will help Coca Cola to further expand beyond soft drinks and move into the hot drinks sector. Costa provides new capabilities and expertise in coffee to Coca Cola.       
However, this coffee expertise might cause friction with Starbucks, which already forged strong ties with Coke. Indeed, this acquisition might spark a burden in the Starbucks marketplace.

Coca Cola will benefit the vast coffee vending business of Costa Coffee counting more than 8 000 Costa Express machines worldwide, located in convenience stores, cinemas, and offices. This business strategy will enable Coca Cola to expand its existing offerings. However, Coca-Cola does not have any experience in running a retail format. Therefore, it plans to let the existing management handle that part of the business. Moreover, this coffee expertise will also help Coca Cola’s customers.  In effect, the Coca-Cola president and CEO, James Quincey said “it’s the right thing to do to serve our consumers with more of the drinks they want, which in turn helps our customers”.
Overall, the acquisition of Costa Coffee will give Coca-Cola a competitive advantage through strong expertise across the coffee supply chain, including sourcing, vending and distribution.

  • Coca Cola’s long-run diversification scheme

Nowadays, the new generation is becoming health conscious, sugary drinks and junk foods are no longer part of the youth’s daily routine. Health organizations are raising awareness about the negative health effect of sugary beverages. Governments are also discouraging businesses by putting into practice severe measures such as “sugar taxes” to restrain their production.       
Overall, the consumption of sugary drink is dwindling swiftly at a global scale (estimated around 11% in 2018). Coca Cola and its competitors are facing this problem together and strive to shift their approach by reaching alternative beverage marketplaces. A previous M&A deal of $3.2 bn involving Pepsi and SodaStream is a typical example.    
Therefore, the world’s biggest producer of soft drinks is seeking for alternatives in the hot beverage segment in order to offset the unfavorable trends in consumer preferences who shifted from sugary drinks to healthier ones.

Despite the fact that Coca Cola has always been a flagship company, the firm lost its fizz over recent years. Coca Cola has made a lot of attempts such as expanding its fruit juice portfolio and striving to launch a naturally sweetened version of its flagship coke named “Coca-Cola Life”. However, all these attempts were not successful enough to regain momentum in the marketplace. This is reflected by a decrease in Coca-Cola’s sales since 2012. Therefore, one smart acquisition was the only way for the Atlanta-based company to help their revenues and margins revive.
This was the moment when the “Coca Cola and Costa Coffee deal of $5.1 bn” headline came up in the news. This move was designed to penetrate the profitable hot beverage marketplace as well as raising synergies by combining the Costa’s established coffee-selling platform with Coca-Cola’s astounding marketing expertise and global reach.

  • Synergies opportunities

Coca-Cola expected revenue synergies through the sale of the seller’s products added to its distribution network. Moreover, cost synergies could also be generated by centralizing ingredient purchasing and production reflected on a reduction in SG&A costs.


Seller’s rationale of the deal

·      Whitbread passes on Costa’s Chinese challenge to Coca-Cola

Although Costa has penetrated a lot of geographical markets, the company is interested in the Chinese market to guide its global expansion in order to compete with its US rival, Starbucks.  
China GDP projected to exceed $15 trillion by 2021 from $11 trillion in 2014, is a major driver for the company growth with a meaningful increase in its middle class.
Furthermore, the per capita coffee consumption in China is significantly higher than in the US which may lead to a revenue growth from the region.       

The intention of Costa Coffee is to augment the number of its store in the country from their current 449 to approximately 1,200 by 2022.
Coca-Cola will be essential for achieving this goal by using its financial power. Indeed, while there was little doubt behind Whitbread’s plans to expand Costa internationally it has delegated the enormous task of breaking into new markets against more established competition, to a more fitting owner, Coca Cola who has the resources needed to drive Costa to the lead of coffee on the international scale.

  • Costa Coffee is using Coca Cola’s well-established reputation to expand itself

The coffee shop chain is determined to realize its strong potential overseas. The combination of an international super-brand and the UK’s biggest coffee chain will ensure continued product development, greater market share and potentially enormous and rapid growth expansion overseas.        
The sale to Coke offers intriguing possibilities for the Costa name to appear in new formats, such as chilled variants, and reach a wider audience through Coca-Cola’s well-established distribution network. While Costa is “ubiquitous in the UK, the business has “plenty of opportunity to expand internationally, as Whitbread had been doing” says Patrick Mitchell-Fox, senior business analyst.                        
With operations in many markets, Coke would be well placed to facilitate international expansion further and take Costa Coffee to the next level.

  • Tremendous returns received by the shareholders

Whitbread shareholders will receive a majority of the proceeds of the £3.8 billion deal, taking into account the £100 million of costs. Also, Whitbread plans to lower its debt and address its pension deficit.       
It is worth mentioning that the net debt and the deficit were already shrinking. Indeed, Whitbread’s pension deficit was at £289 million at the beginning of March, £136million lower compared to last year. Net debt reached a pinnacle of £910 million in 2016 but fell to £833 million beginning of March. The Gearing is relatively low, with a ratio of Net Debt/ EBITDA equal to 1.

Deal structure        

According to Alison Britain, CEO of Whitbread said: “It’s been a very fast transaction, there was no auction process”.           

The sale was a cash and debt-free deal valuing Costa Limited Business at $4.15 billion (after transaction costs), with Whitbread’s financial debt and pension fund staying with Premier Inn (the hotel chain owned by Whitbread PLC).

During the 2018 fiscal year, (ending March 1, 2018) the revenue of the company is £1.3 billion and EBITDA of £238 million GBP. This is an equivalent of $1.7 billion in revenue and $312 million in EBITDA.        
This involves a 15.7x EBITDA multiple (or 16.4x if we take into account the total enterprise value of $5.1 billion). When Analysts compare the ratio EV /EBITDA of 16.4x to the 13.0x multiple that Nestlé paid for Starbucks’ market rights in mid-2018, they conclude that a hefty premium is paid by Coca-Cola.      

Nicholas Hyett, an equity analyst at Hargreaves Lansdown, commented: “£3.9 billion is an undeniably rich valuation and likely far better than Costa could achieve as an independently listed company, valuing its earnings higher than those of the robust Starbucks, and Coca-Cola is one of the few companies in the world that could justify the valuation”. Indeed, Coca Cola is paying up to 70% premium. Coca-Cola will acquire all issued and outstanding shares of Costa, the wholly owned subsidiary of Whitbread. This M&A deal is planned to be somewhat accretive the first year, which might however be impacted by the purchase accounting (not much in terms of cost synergies).

Two reasons can justify such a premium.

  • The first reason is the desire to circumvent a bidding war with a set of private equity firms that were informally initiating conversations with Whitbread.
  • The second reason is the potential operating synergies generated following the acquisition with Coca-Cola already using a lot of coffee and caffeine in its production chain and with Costa Limited providing the firm with exceptional experience in the field. Besides, Coca-Cola will have the opportunity to make the most of Costa’s retail chain to enhance its worldwide distribution of drinks.

Market Reaction     

The shares of Whitbread climbed to almost 20% following the deal announcement.
Alison Britain, CEO of Whitbread, mentioned that the acquisition reflected growth potential for the company. This has been reflected through an increase of the shares by almost 20% and closed at 14.3% higher following the news of the deal which analysts said was priced at 16.4 times Costa’s latest annual earnings.   
However, the share price of Coca-Cola has been impacted in a negative way. The share price decreased by 0.4% following the deal announcement. This small impact might be explained by two opposite reasons.

  • On the one hand, the acquisition is a good move and helped the company to diversify its product range and attract a new type of health-conscious customers.
  • On the other hand, investors are a skeptic to the fact that Coca Cola will not embrace the retail experience, crucial in the coffee business, which might result in a decrease in profitability. Starbuck, an expert in their approach of building customer relationship and delivering high-quality service, will be a burden for Coca-Cola who usually communicates information simply through advertising ads.

The consequences in the long-term

Whitbread managed to please their resentful shareholders that have been waiting patiently for it to segregate Costa, soothing them through the “substantial premium” received by the shareholders.   
The coffee chain owns the financial support required in order to operate on a worldwide scale and Coca-Cola acquires a brand that diversifies its portfolio, which possesses a platform essential for the company to raise global growth.            

Nevertheless, this acquisition may arise an issue. Indeed, the absence of Costa will make the Whitbread portfolio less diversified, which make Whitbread vulnerable compared to the large hotel players such as InterContinental Hotels Group, Marriott, Accor. Therefore, we may raise the following question:  Could Whitbread become a takeover target?


Advisors

Rothschild & Co was the unique financial adviser to the buyer the Coca-Cola Company. Coca Cola already had previous experience with the British-based elite boutique which advised the major deal of the 2015 merger of three major bottlers valued at $31 billion at the time. However, Whitbread decided to involve a few banks to advise the deal. Indeed,
Goldman Sachs, Morgan Stanley and Deutsche Bank were all sharing a piece of the pie. Clifford Chance was the legal counsel to The Coca-Cola Company, while Skadden, Arps, Slate, Meagher & Flom were its tax consultant. Slaughter and May acted as legal advisor to Whitbread.


Author : Charles Zeitoun

Bibliography

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