Anyone who’s been in a session with me knows I live in beautiful Findlay, Ohio. Despite its relatively small size, population 40,000, Findlay is home to several public companies, including the Cooper Tire & Rubber Company. Earlier this year, India-based Apollo Tyre announced plans to acquire Cooper at a 40% premium.
Almost overnight, Apollo’s shares plummeted 25% on the Indian stock exchange. Why the negative reaction to an acquisition that would more than double Apollo’s sales and give it a strong presence in the US market and several others where it currently isn’t much of a player?
Apollo announced it would finance the deal by borrowing 2.5 billion, with Cooper being responsible for acquisition debt repayments. Cooper’s leaders stated that Cooper will have no problems repaying the debt. But leaders acquiring a company or receiving a 40% premium for their shares can be bullish. What story do the numbers tell?
Cooper’s current debt to equity ratio is 2.7-1. Adding an additional $2.5 billion of debt takes the ratio to 6-1, approaching the level where additional borrowing will be difficult and expensive. The additional debt will require annual interest payments between 150-200 million (depending on interest rates and how the debt is structured). No matter the interest rates, Cooper will need to generate cash flow to cover the payments. Does it have the cash to do that?
Analyzing Free Cash Flow (Operating Cash – Reinvestment) tells a different story than the one in the media. In 2010, Cooper had Free Cash Flow of $55 million. In 2011, Free Cash Flow dropped to a negative 30 million. In 2012, Free Cash Flow recovered to 267 million. An inconsistent trend to say the least, but if one just looks at 2012, it seems Cooper can easily pay the acquisition-related interest while continuing to reinvest in the business.
Investigating the trend requires asking additional questions. Given Cooper’s Net Income decreased by 33 million from 2011-2012 what drove the rebound in Free Cash Flow in 2012? In other words, what’s the source of the $267 million in cash?
The answer: suppliers. In 2010, Coopers Days Payable (how long the company takes to pay its suppliers) was 67 days. In other words, Cooper paid a supplier, on average, about nine weeks after receiving the invoice. In 2011, Days Payable decreased to 51 days, which “cost” Cooper 43 million of cash flow. In 2012, Cooper increased Days Payable to 63 days, enabling the company to generate $121 of cash. Does Cooper have the ability to do that again or will supplier pressure require it to reduce days to around 50?
If a company cannot generate additional cash by growing sales, improving margins/mix or through better management of its operating cycle (i.e. reducing inventory and receivables while increasing payables), it has four other potential sources of cash: 1) additional borrowing, 2) selling new shares, 3) cost cutting or 4) selling assets.
Given the acquisition debt will make number one difficult and shareholders will not be interested in being diluted, maybe the specter of choices three and four are the cause for the drop in Apollo’s share value. If the deal goes through – it’s currently under review by the Indian government — we’ll see over time whether the Indian markets have reacted correctly.