Continental/Fintelco Jv Case Analysis Essay

1. Is entry into the Argentine market a good strategic move for Continental? Entering Argentine market in 1993-1994 was a good strategic decision for Continental as one of the TOP5 cable TV companies in the US despite certain risks for several reasons: 1. Changes in the US regulatory environment created additional challenges for Continental’s core business: 1992 Cable Act limited the cable TV companies’ ability to raise cable rates whereas costs at market prices reached up to $2000/subscriber. This inevitably led to constrained profit margins 2. US market began saturating: long-standing competition on the market coupled with growing demand and consumer selectivity has led to further squeezing margins and forced companies to seek for diversification of revenue streams –by entering non-traditional cable markets, capturing smaller niches, or expanding overseas. 3. Argentine cable TV marked lagged in behind US market by almost a decade: cable TV penetration barely re ached 50%, subscription growth rates approached 60-70% in selected areas. Also, the market was only beginning to consolidate around 4 major players – more than 50% of the market was controlled by a thousand of smaller operators. Although Buenos Aires was relatively more mature market, other regions and provinces presented lucrative opportunities. Telephone, satellite, and other adjacent markets had untapped future opportunities. So far, emerging Argentine promised much brighter prospects for cable TV companies than saturating US. 4. Argentine macroeconomic indicators exhibited positive dynamics despite high level of uncertainty: indeed, after a decade of political turmoil and military rule Argentine was finally building a democratic civilian government. During four years preceding the acquisition, Carlos Menem and Domingo Cavallo launched effective economic and political reforms, including deregulation and privatization in TMT and other major sectors. In particular, legislation became very favorable to foreign investors. However, Argentine was suffering from hyperinflation and chronic recessions during the previous decade. Moreover, political risks were becoming more and more tangible as presidential elections of 1995 approached. As a result, the beta for Argentine was two times as high as that for the US. Is Fintelco an appropriate venture partner? Fintelco possessed at least three characteristics of a good venture partner: a. Knowledge of local market including cultural, political, and regulatory background as well as customer programming tastes. Basically, buying a successful incumbent is one of the best potential moves while entering â€Å"terra incognita† b. Fintelco had strong presence in various regions and owned licenses in MDDS and satellite, which created solid base for revenue streams diversification and future growth. c. Fintelco was still owned and managed by its founder, a prominent serial entrepreneur with diversified assets. Liberman had a very hands-on approach in business, and thus secured complete alignment of incentives between the management and the owners. 2. What are the major opportunities and risks you see in the venture? Success factors and opportunities (excluding market opportunities mentioned above): a. Personal and professional â€Å"click† between Samuel Liberman and Amos Hotsetter indicated good potential for constructive and conflict-free partnership. b. Similar growth strategies and vision: both companies grew using clustering strategy and capturing operating efficiencies by consolidating subscribers geographically. c. Limited access to capital markets in Argentine: Continental had access to capital markets in the US which could significantly foster business development in a country with scarce financial resources. Risks&Concerns: a. Active involvement of Fintelco’s founder and owner in business operations has also created certain problems. For instance, it resulted in a sort of nepotism – many key positions were held by Liberman’s direct relatives. Thus, potential restructuring and changes in management would be complicated. Also, after an acquisition Liberman would have 50% ownership, which could decrease his involvement in this particular business and also led to incentives misalignment. Indeed, he had diversified businesses and could have been looking for a cash-out. Liberman’s full involvement and commitment were crucial for joint venture success. b. Fragmented regional market in Argentine commanded inorganic expansion trajectory for Fintelco, which in turn required capital commitment from both parties. A ceiling should have been established to limit uncontrollable capital pump and its inefficient allocation. c. Exchange rate risks: significant portion of revenue stream born currency exchange risk (peso vs. USD) regardless of geographical and product diversification. These risks were absolutely external and thus could have been hardly mitigated. 3. One could value Fintelco in either of the following ways: a. Peso cash flows discounted at peso rate and then value converted at the spot rate b. $US flows discounted at $US rate Which approach is more appropriate in this case? We analyzed assumptions required to adopt each of proposed approaches. Approach (b) – $US cash flow discounted at $US rate – assumes that: (1) Peso/$US rate would remain constant – despite stable projection of peso exchange rate till 1998, PPP implied exchange rate has a high range (0.999-1.436, 44%) and hence significant volatility. (2) $US discount rate reflects the risk of the project – As revenues of Fintelco are denominated in pesos while a significant portion of its liabilities, including interest expense and a portion of programming costs, would be denominated in $US, the project bears significant currency risk which is not reflected by US discount factor. Although the real currency of the industry in Argentina is in local currency Peso, we believe that finding a proper discount rate in Peso is quite tough and unreliable. Moreover discounting the Peso valuation with today’s exchange may be a biased approach. Hence what we prefer Ä ±s to conv ert the Peso cash flows to USD with the estimated USD/Peso rates for each period and then discount it with the US$ discount rate. 4. Is $80m for a 50% interest a fair value for Fintelco? Based on our valuation we believe that $80m for a 50% interest is a fair value for Fintelco. In our valuation we chose to be conservative with the assumptions as well as try to cover all possible risks and ran multiple iterations to obtain a good understanding of the value ranges. Our valuation is based on the following assumptions: (1) WACC of 15.35% calculated used 9.01% as Rd (BB rating), D/V ratio of 14.44% (current Balance sheet), Re of 17.07% (Lessard model) and tax rate of 40% (Exhibit 1). Beta was estimated using comparable companies (Exhibit 2). We recognize that D/V ratio as well as Return on Equity is subject to our judgment hence we assessed sensitivity of WACC to change in these assumptions. We estimated Re using 4 different models (Exhibit 3) and D/V at the level of comparable companies. WACC ranges between 10.77% and 17.19% (Exhibit 4). We believe that 15.35% is an adequate estimation of WACC reflecting both country and project risks. (2) Terminal growth of 4% based on our view of sustainability. We noticed that Fintelco’s projections imply 7% revenue growth however we do not believe that such high level of growth is sustainable in the long run, hence we suggest more conservative estimation. (3) Conversion to $US based on parity-implied exchange rates for 10yrs. We believe that due to difference in US/Argentina inflation rates over the long horizon only PPP-implied exchange rate reflects true value of money at any given point in time. We used it to convert annual peso free cash flows at the respective rate (Exhibit 5); We calculated terminal value using 2002 $US DCF value and Gordon Growth formula and arrived at Enterprise Value. We further subtracted net debt converted @1994 exchange rate to arrive to Equity Value in $US (Exhibit 6). We also calculated $US value based on spot rates (both official and PPP-implied) to assess sensitivity of the model (Exhibit 7) and concluded that our estimation is reasonably conservative and reflects country’s currency risk adequately. (4) 30% private penalty discount – as Fintelco is a private company, we discount its value further for 30% to account for lack of liquidity. Exhibit 8 contains the summary of our valuation under different scenarios. We concluded that though there are scenarios under which value of 50% share of Fintelco is below $80m, probability of these scenarios occurring is fairly low. Our base case scenario uses Lessard’s model for Return on Equity calculations, PPP-implied 10 years forecasted exchange rate and 30% private penalty discount (result highlighted). 5. In the course pack there is a reading (Estrada (2007)) about valuing offshore projects using techniques proposed by Lessard, Godfrey and Espinosa, Goldman Sachs and Salomon Smith Barney. What assumptions underlie each approach? The reading Estrada 2007 describes four models for evaluating investment opportunities in developing markets. Each model estimates a required return on equity by attempting to incorporate country and/or project-specific risk. Unlike the CAPM, none of these models has reached the level of standard-bearer in the finance community, and each rests on critical assumptions that must be considered before using them in a project assessment: The Lessard Approach: R = Rf + MRP*(ÃŽ ²p* ÃŽ ²c) * Assumes that the country beta is a good approximation of country-specific risks (political, sovereign, and expropriation) * Assumes that the risk of a project is not related to the risk of the country (e.g., ÃŽ ²p for oil industry may be low, but should be high for a country which has a history of expropriation) * Assumes that investors do not value the effect of global diversification that the project would bring the company The Godfrey and Espinosa Approach: R = (Rf + YSc) + MRP* [0.60*(ÏÆ'c/ ÏÆ'w)] * Assumes that the yield spread, which measures default risk, is an appropriate risk premium to capture sovereign risk associated with an offshore project * Applies a value (60%) that reflects the average risk reflected by the stock market but not the bond market across all developing markets, thus ignoring country-specific correlations * Assumes that the project’s risk is solely dependent on location. It does not factor project or industry-specific risk Goldman Sachs: R = (Rf + YSc) + MRP* [1- Ï SB * (ÏÆ'c/ ÏÆ'w)] * Assumes that the yield spread, which measures default risk, is an appropriate risk premium to capture sovereign risk associated with an offshore project * Assumes that the project’s risk is solely dependent on location. It does not factor project or industry-specific risk Salomon Smith Barney: R = Rf + MRP* ÃŽ ²p + [{Ï’1 + Ï’1 + Ï’3)/30]*YS * Assumes that three factors can be measures on a scale from 1 to 10 in a robust and consistent way: the company’s access to capital markets, susceptibility of project to political risk, and financial importance of project to the company) 6. Would you suggest any modifications to the structure of the deal? The structure of the transaction described in the case is to form a joint venture. Continental will: c. Purchase 50% of equity stake in Fintelco for USD 80 million. d. Commit to provide USD 70 million of capital for acquisitions and investments in technology upgrade at Fintelco. Samuel Liberman undertakes to provide another USD 70 million for the investments. e. Fintelco will bear a significant currency risk on its balance sheet, as its revenues are in peso, but liabilities, interest expense and programming costs are in US dollars. f. Continental will provide technical assistance to Fintelco on cost basis. g. The deal contained an exit agreement, the so called â€Å"shotgun deal†, whereby after four years the partners could sell to each other our trigger an outright sale to the third party. The terms of the transaction are in our opinion fair for both parties. When being a financial advisor of Continental, we would suggest: * That the commitment to invest USD 70 million in the target company is stated clearly, structured with limited recourse to the new shareholder to prevent undertaking a blanco commitment to invest capital. * Share purchase agreement between Continental and Samuel Liberman contains certain clauses about representations and warranties of both parties to mitigate the risk of financial loss in case of â€Å"window dressing† of the target company. * Shotgun clause to contain more substance over the price of the transaction in the future, giving a call and a put option to both contractual counterparties: * If one party will not wish to sell in the future at a certain price, it will undertake to purchase 50% shares in the target company from the other party at the price it declined to sell at.