Delta

Group 5

Beverage
Group, Inc.
In this report we will give insight in the current financial situation of Delta Beverage
Group, Inc. Furthermore, we will advise you regarding the problems and short
comings of the company. Firstly, we will be pointing out the key problems by
analyzing the business and financial risk of Delta Beverage in the soft drinks
industry. Next we will discuss a hedging program using aluminum futures contracts,
this will be done by a scenario analysis. In the end we will give the Mr. Bierbaum an
advice on whether he should hedge aluminum using futures contract or not.

Delta Beverage is a large bottling company and a part of the PepsiCo franchise.
Looking at the sales we see that Delta Beverage is a large company. We see that the
sales volume has increased the past few years, especially due to the taken number
of acquisitions. Competition became a problem in 1989 when CCE succeeded in
buying some of the competing brand franchises in the same areas. A new
management team had been hired which succeeded in stopping the fall in prices
and the dwindling market share and also increased the margins by attacking the
cost structure.

Despite the positive impact of the recapitalization plan in 1993, net income is still
negative due to the high interest expenses, although it increased by almost 100
percent. It’s important to still focus on the cost structure, so that the company will
be able to make profits. As told before Delta Beverage is a franchise of PepsiCo. One
of the obligations of being a franchise is that Delta Beverage has to buy its
concentrates and syrups from PepsiCo only. This means Delta Beverage is not able
to influence the given price, so it should focus on the cost structure of the bottles
and cans. Further, the price of aluminium, which is a core raw material, had risen 30
percent on the London Metal Exchange during the first half of 1994. As a result of
this there is a high chance the price of aluminium cans rises. This will have a high
impact on the cost of goods sold because these aluminium cans are a key cost
component. This situation will again lead to continuing losses. To hedge against this
risk, we will consider a hedging program using aluminium futures

To give a good view on the several calculated ratios it’s important to know in which
phase of the product life cycle soft drinks are situated. Delta Beverage operates in
the soft drinks industry, which shows diminishing growth in the US industry.
Remarkable is the relatively high consumption of soft drinks in the South areas of
the US. Considering the diminishing growth of the whole US soft drinks industry and
the high leverage of Delta Beverage (see exhibit 1), we conclude that the company
is in the maturity phase of the product life cycle, which mostly indicates a high
leverage level.

Exhibit 1 shows the long term financing risk Delta Beverage has to deal with. The
debt to equity ratio increased extremely during the period of 1989-1992. The 1993
recapitalization plan has caused a sharp decrease, but the ratio is still excessive.
The debt ratio also shows the high leverage of Delta Beverage. For a company
which is in the maturity phase of the product life cycle it’s normal to have a higher
debt, but the debt ratio is still extreme in this case. Although the 1993
recapitalization plan lowered the debt level, it still shows a high financing risk which
make it less attractive for shareholders to invest in the company. In case of
bankruptcy shareholders will lose all their money because the debtholders will be
paid first. Also this high long term financing risk leads to a situation where the
company can’t get any additional borrowing funds and has to deal with less
financial flexibility. So maintaining the 2.00 interest coverage ratio is key since
attracting new additional long term debt is hard.

Exhibit 1: Long term

financing risk
1989 1990 1991 1992 1993
18848 18154 18626 20675 16657
Debt 4 3 2 2 2
Equity 34851 28526 17737 3686 47134
1050 5609
Debt to equity ratio 541% 636% % % 353%
22333 21006 20399 21043 21370
Total assets 5 9 9 8 6
Debt ratio 84% 86% 91% 98% 78%

Exhibit 2 shows the short term financing risk over the past few years. The working
capital ratio and the quick ratio gives an indication whether delta beverage is able
to meet its short term obligations. It’s important to have a working capital ratio and
quick ratio of 1 (or higher). We see that the working capital ratio had decreased
during the period 1989-1992. Due to the 1993 recapitalization plan the working
capital ratio increased by 82.3 percent. A ratio of 2.77 indicates that the company is
able to meet its short term obligations. The same applies to the quick ratio, which
gives almost the same insight as the working capital ratio but it deducts inventories
from the current assets.

Based on exhibit 2 we conclude that the short term financing risk of delta beverage
is low, which indicates a strong liquid position where Delta Beverage is able to meet
its short term obligations.

Exhibit 2: Short term

financing risk
1989 1990 1991 1992 1993
Current assets 39254 33196 36204 41349 50192
Current liabilities 22733 19233 21998 27291 18147
Net working capital 16521 13963 14206 14058 32045
Working capital ratio 1,73 1,73 1,65 1,52 2,77
Inventories 8893 6726 9808 10607 10104
Quick ratio 1,34 1,38 1,20 1,13 2,21
The debt of the company is restructured with the 1993 Recapitalization Plan. With
these new senior notes, the company has to meet new loan covenants. These
covenants include to maintain a certain senior leverage ratio, a total leverage ratio
and an interest coverage ratio.

The biggest concern of the company should be the aluminium prices. Aluminium
packaging is 49% of the costs for a can, while these cans also contribute for 60% of
the sales. The can manufacturers are suffering from higher aluminium prices,
however it isn’t clear how this will affect the company. We expect that it can have a
big impact due to the high weight of aluminium packaging in the cost of goods sold.
By hedging this risk can be mitigated. Since an operational hedge is not an option, a
financial hedge should be considered by using futures for the aluminium prices
since there are no futures available for fructose concentrate and other raw
materials.

We calculated the required rates for the covenants from 1993-1996 in different
scenarios to predict the expected impact of the price. A summary of these situation
and the impact on the required ratios can be found in Exhibit 3, a more detailed
view are on Exhibit 4 and 5 at the end of the report. For the calculations a couple of
assumptions have been made. We expected a 4% growth. First we calculated two
scenarios where no hedging takes place and the prices increase by 22.5% and 15%.
You can immediately observe that a price change of 22.5% will affect the ratios
heavily, bringing it to a level below the required levels of the covenants. In the
scenario with a price increase of 15% everything seems fine, however it is still a
risky scenario. Next we created two scenarios with fully hedging, both seem to
satisfy the covenants significantly. We hedged for the years 1995 and 1996 since in
1994 the prices were fixed due to the co op. However by hedging fully we excluded
possibly situations where the prices will drop below the expected levels with
hedging. This way we might miss on some opportunities that come with a price
drop. That is why we created one last scenario where we decided to hedge partially.
By hedging for 46% and a price increase of 22.5% the interest coverage ratio will be
breakeven, while satisfying the other covenants. However this still might be a bit
risky in case the price increases even higher than 22.5% due to the high volatile
market. So our advice to Mr.Bierbaum is to hedge partially. Between 50-60% seems
reasonable and will leave a significant amount open for possible price drops that
might affect the firm advantageously.

Exhibit 3: covenant
requirements
Scenario: Ratio 1993 1994 1995 1996
Required levels Interest Coverage 2,00 2,00 2,00 2,00
 >
Total Leverage < 6,40 6,25 6,25 5,75
Senior Leverage < 5,15 5,00 5,00 4,50
22.5% Price increase Interest Coverage 2,12 2,49 1,62 1,80
Total Leverage 5,70 4,86 7,45 6,73
Senior Leverage 4,24 3,58 5,40 4,78
15% Price increase Interest Coverage 2,12 2,49 2,00 2,20
Total Leverage 5,70 4,86 6,06 5,49
Senior Leverage 4,24 3,58 4,39 3,91
Hedging 15M Interest Coverage 2,12 2,49 2,43 2,67
Total Leverage 5,70 4,86 4,99 4,53
Senior Leverage 4,24 3,58 3,61 3,22
Hedging 27M Interest Coverage 2,12 2,49 2,31 2,54
Total Leverage 5,70 4,86 5,24 4,76
Senior Leverage 4,24 3,58 3,80 3,38
Partial 46% Hedging Interest Coverage 2,12 2,49 2,00 2,20
Total Leverage 5,70 4,86 6,06 5,49
Senior Leverage 4,24 3,58 4,39 3,91
Mr.Bierbraum has a difficult decision to make, so we provided him different
scenarios. By taking a quick look we can see that a 15M hedge seems to offer the
best result. However if we look closely to the cash and future price differences we
notice a 6-8% difference. Futures being higher. That is why we recommend
Mr.Bierbraum to not hedge fully. In our calculations we have made it clear that by
hedging for 46% and increase of prices by 22.5% the interest coverage ratio will be
exactly 2.00 which satisfies the required level of the covenant. Due to volatile
aluminium prices it would be better to hedge a larger part of the prices. Our advise
is between 50-60% so a slightly higher price increase than 22.5% wouldn’t exceed
the interest coverage covenant. Although we have mentioned the volatile prices
mostly as a negative risk it might be a positive risk as well. The high volatility of the
aluminium prices can cause the prices to drop under the futures level which might
be more advantageous then a fully hedged scenario. So by hedging partially
Mr.Bierbraum can mitigate the impact of the volatile aluminium prices on his
business, but still have opportunity to take advantage of the same volatile prices.