Some comments on the merger with Lyreco

This morning CE surprised most of us, if not all of us with the announcement of the proposed merger with Lyreco, a French private company. CE claims the merger has nothing to do with the offer from Staples, and would have also been announced without the offer from Staples. This may be true, but from the valuation of Lyreco, I do get the impression this was a defensive move to prevent the acquisition by Staples. Without the offer from Staples, CE most likely would have been able to negotiate a better deal. Having looked at the presentation from CE, I am not impressed with the advantages of this deal over the stand alone strategy. In the first 3 years, the net synergy, after integration costs only increases slowly, while CE will incur a substantial increase in financing costs, and a substantial increase of goodwill on the balance sheet.

Purchase price for Lyreco

The purchase price for Lyreco consists of 102.5 million shares, cash of EUR 560 million and a Vendor Loan Note of EUR 340 million. Thanks to the offer from Staples the shares are valued at EUR 8.11, making the value of the total consideration EUR 1,731 million, which is 9.6 times 2007 EBITDA. With EBITDA for CE in 2007 of EUR 298 million CE was valued at 5 times EBITDA. Before the offer from Staples, with a share price of EUR 5.50 this was only 3.4 times. This indicates that CE was willing to pay quite a lot for Lyreco. Maybe the fact that Mr. Eric Bigeard, the current CEO of Lyreco, becomes CEO of CE confirms their superior management capabilities. If this would not be the case, the conclusion must be that the threat of an acquisition by Staples has driven CE to pay a high price for Lyreco.

Post acquisition balance sheet

I think I am starting to understand the composition of the balance sheets of both companies, so it will be interesting to make an attempt to see what the post-acquisition balance sheet looks like. Following statements made by CE that the deal will close in Q4 this year, I simplified my assumptions and assume that the deal will close on December 31th. We have a balance sheet for CE for Q1-2008 and in the presentation by CE and Lyreco, a balance sheet for Lyreco for December 31th, 2007 was included. Based on the guidance given by CE and my own assumptions, the picture would look something like this:



I have made a calculation of the results for the full year 2008, and added the value to both equity and current assets. The exact way I have looked at results will follow later. This leads to balance sheets for both companies at the and 0f 2008. Following this calculation the transaction has to be executed. CE needs to pay the agreed consideration to Lyreco shareholders and will assume all assets and liabilities. The difference will go to goodwill.

And this part looks a bit scary to me. The equity value of Lyreco at the end of 2008 will be EUR 548 million. This means CE will pay a goodwill of close to EUR 1.2 billion for this acquisition. Taking into account the EUR 210 million already on the balance sheet of Lyreco as intangible assets, CE will have close to EUR 2.8 billion of intangible assets on its balance sheet, with an equity value of EUR 2.4 billion. No wonder the vendor note was issued at conditions that allows CE to qualify it as equity, and no wonder they intend to pay down debt and strengthen equity in the coming years!

Results until 2011

Guidance for 2011 is a revenue of at least EUR 9.5 billion for the combined company, with an EBITDA margin of 8% before synergy effects and 9% including synergy effects. Given that the CE guidance was 7% EBITDA in 2011, the amount of 8% for the combined company seems too high. The following table can illustrate this:



It seems very strange that Lyreco would be able to achieve an EBITDA percentage of 10.5% in 2011. This was also noticed by an analyst at the conference call today, who aksed the question to the CFO of CE. He did not have an answer and thought this margin to be unlikely, so I will assume this is just an error.

I will attempt to determine the results for CE and Lyreco on a stand alone basis for 2008 and 2011, based on the given guidance and historical information that can be found in the presentation. To be on the cautious side I took the more conservative guidance from CE as a starting point. To my surprise the conclusion is that the costs for financing this acquisition are so high, that it takes away a big chunk of the synergy effects. With a calculated net result for CE shareholders of EUR 1.10 per share in 2011, the combined company with Lyreco only leads to a net result per share of EUR 1.22. I could be completely wrong of course so let's go through the calculations:



I am not uncomfortable with an estimate of EUR 0.50 per share for CE in 2008, which is at the low end of the guidance given by CE. The net result for Lyreco is calculated with the EBITDA amount of EUR 201 million that can be found from the guidance by CE. From the presentation we can see that Lyreco has been investing in all 5 previous years, and I assumed an annual depreciation charge of EUR 22 million. With the assumption of some exceptional items this gives an operating result of EUR 175 million. Since debt is almost non-existent and the effective tax rate has been quite high for Lyreco, a net result of EUR 105 million follows. The available data showed some adjustments for minority interest in 2007, which I continued in 2008, leading to a net result of EUR 99 million as an estimate for 2008. The combined result of EUR 0.67 per share is obviously completely overstated, since it does not take into account the financing costs CE would have incurred to get the net result of Lyreco.

For 2011 the same logic has been applied, working towards the margin guidance from CE, corrected for what I believe is an overstatement of the Lyreco margin in 2011. For CE an effective tax rate of 25% has been assumed in 2011, and for the combined company the financing costs relating to the acquisition have been taken into account. To reduce these costs, I have assumed that CE will decrease debt by EUR 100 million a year until 2011.

With respect to the synergy effects and integration costs, I have assumed they are after tax effects and will take place in the years 2009-2011. This means that positive synergy effects are EUR 28 million, EUR 68 million and EUR 100 million in those years, while the integration costs are EUR 40 million in 2009, and EUR 20 million in 2010 and 2011 each.

So after all these assumptions a net result of EUR 1.15 follows for 2011, based on the low end of the guidance of CE. For 2009, a net result per share can be calculated of EUR 0.49 and for 2009 net result per share would be EUR 0.88. From 2012 onwards the full effect of the merger should be visible in the results.

Shareholders of CE are now confronted with three choices. The offer from Staples can be accepted, the merger can be approved, or both previous possibilities can be declined. These choices are not easy. I am very worried about the merger with Lyreco. I believe there is a lot of risk in the strategic plan, and the merger will not make things easier, although I have full confidence that Lyreco is a strong company. Again results are pushed further to the future, with 2012 probably being the first stable and fully integrated year.
Although I remarked half jokingly in another post that Staples should just bid for the combined company, I am not sure that this would be appealing for Staples after considering the above calculations.

With an offer of EUR 8.00 per share from Staples, there is a serious chance that shareholders will have a preference for the uncertainty of the merger with Lyreco, which means that Staples now has to ask themselves how badly they want CE. In the current situation, the best thing that could happen to CE shareholders is an increased offer from Staples, to a level that makes them realize the risk of the proposed merger by CE with Lyreco. It probably means that Staples has one more chance to convince CE shareholders, or should now just move on.