The Fuqua School of Business at Duke University

Cencosud: Without limits to dream TEACHING NOTE Identification of risks and mitigation strategies

The acquisition of Colombia will help Cencosud continue its expansion plans in the Colombia market. However, it brings several risks that need to be identified and contained.

1. Carrefour’s Colombian operations represent a large asset that would require Cencosud to undertake extremely high levels of debt. The company came from pursuing a steady acquisition campaign in that led Cencosud to spend over $2 billion. Certainly, the company did not have any cash to conduct the acquisition and should undertake debt.

Mitigation strategy: Although the acquisition was financed through a $2.5 bn bridge loan by JP Morgan, a capital increase, to lower the debt levels, was committed before the acquisition.

2. Currency exposure should also be addressed for two reasons. First, Cencosud would have to conduct the transaction in euros, while acquiring debt in us dollars. As the company would borrow the exact amount Carrefour Colombia was worth, any fluctuation in the euro currency during the days of the transaction would have resulted in a nightmare for Cencosud, which did not have any extra cash to provide. Second, the company would acquire its debt in US dollars, but all its operations were conducted in . Devaluation of local currencies would jeopardize Cencosud’s ability to repay its debt.

Mitigation strategies: Conduct the operation in US dollar. Refinance its debt and put a 10% cap in the amount of debt in US dollars.

3. In order to beat Wal-Mart and Falabella, Cencosud had to act fast and come up with a valorization of Carrefour’s operations in a short period of time. If the company makes a mistake and the valorization is flawed, Cencosud would have to perform an impairment over time, which would cost significant loses for the company. At the same time, competitor’s pressure was forcing Cencosud to skip some steps of the due diligence process and in doing so, the firm could fail to consider important contingencies.

Mitigation strategy: Propose to sign a contingency contract. If Carrefour did not have any hidden issue, they would not have any problem with it and Cencosud would reduce uncertainty.

The Fuqua School of Business at Duke University 4. Cencosud could not continue operating under the Carrefour brand. The firm would have to convert all Carrefour supermarkets to and Maxi stores. As these brands were unknown for the Colombia consumers, Cencosud risked losing market share in doing the transition.

Mitigation strategy: Invest in a massive marketing campaign to make sure the transition is as smooth as possible.

Valuation

For the valuation of Carrefour Colombia, we have to split it into two:

The value of the real state assets and land bank: witch we only have Cencosud’s estimation of that value of ~$1 Bn. This valuation was ratified by the Chilean pension funds on November of 20121.

Free cash flow estimation:

After we calculated the 2011 free cash flow, we projected the upcoming years assuming that Cencosud will maintain Carrefour’s current market share (18%) and revenue growth will come from the growth of the industry2. Additionally we are assuming that Cencosud is able to improve Carrefour’s margins to the average level of their supermarket operations (8%) over a period of 3 years, starting on 2014. We assumed that 2013 would be transition period and any synergies would be effective from 2014 onwards. For the CapEx, we calculated the average expenditure of Carrefour in the past 2 years as a percentage of total depreciation expense and used that number to project the upcoming years. For the 2013-2015 period we increased our estimation by ~60% (from 1.3x depreciation to 2.0x), in order to incorporate the additional CapEx resulting of the overhaul of the stores and changing the brand from Carrefour to Jumbo. For working capital estimations, we projected based on Carrefour’s 2011 levels. Perpetuity: The last cash flow estimation was 2018, for the upcoming periods we calculated a perpetuity based on 2018 cash flows, by assuming that the company only grew at the same pace as the GDP (4.5%3), thus no incurring in any “expansion CapEx “ (making depreciation equal to CapEx).

1 https://www.df.cl/cencosud-se-reune-con-afp-y-calcula-activos-inmobiliarios-de-carrefour-colombia-en-us-1-000- millones/prontus_df/2012-10-23/212530.html 2 Based on Marketline’s Colombian Food proyections 3 IMF’s long term Colombian GDP growth forecast The Fuqua School of Business at Duke University Discount rate: For the discount rate, we used Harvey’s ICCRC model to determine the cost of equity: Colombia’s risk factor, and we adjusted by applying a beta of 1.054, then for the cost of debt we used the average “junk bond” spread as of June 20125. For the tax rate, we used Carrefour’s effective tax rate of 29.7% and finally for the debt to equity ratio we used Cencosud’s leverage at the time. The reason why we used junk bond spread for the cost of debt and the leverage ratio of an investment grade corporation (Cencosud) was because Cencosud’s investment grade category was due to many other several factors in addition to their indebtedness. The resulting is a discount rate of 10.9%. The result of the valuation is a total value of assets of $ 2,035 million, which compared to the $2,614 million, paid by Cencosud represents a premium of 31%.

What Happened?

On October 18, 2012 Carrefour announces the signing of an agreement with Cencosud for the sale of its operations in Colombia for a value of € 2.0 billion. Cencosud shares tumbled 6.26 percent as analysts and investors questioned if the high-priced purchase would effectively add value to the company. As Cencosud’s debt soared (debt relative to earnings is about 5.5 times ) with the acquisition, Fitch Ratings placed Cencosud’s BBB- ranking, on negative watch7.

Given that the acquisition was in euros, they took forward agreements to mitigate the exchange rate risk. JPMorgan provided $2.5billion in bridge financing which was eventually syndicated to six banks (BBVA, Itau, BNP, JPMorgan, Santander and Bank of Tokyo). In order to repay this debt Cencosud did the following8: 1. Issue 10-year bonds for around $1.0billion 2. Capital increase of $1.5billion

4 Damodaran Retail (Grocery & Food) Beta as of 2012 5 Ibbotson data 6 Reuters. “'s Cencosud shares tumble as it funds acquisition”. http://www.reuters.com/article/2012/10/19/us- chile-cencosud-colombia-idUSBRE89I0YI20121019 7 Bloomberg Business. “Billionaire Paulmann’s Purchase Hits Cencosud Debt: Andes Credit”. http://www.bloomberg.com/news/articles/2012-11-29/billionaire-paulmann-s-purchase-hits-cencosud-debt-andes- credit 8 Cencosud. ”Adquisición Carrefour Colombia”. http://www.cencosud.com/wp- content/files_mf/9.espadquisicioncarrefourcolombia.pdf The Fuqua School of Business at Duke University WACC assumptions and calculation:

Risk Premium Calculation Inputs Output Category 4.28 U.S. risk free in % 3.20 U.S. risk premium in % 89.40 Current U.S. Credit Rating 64.60 Institutional Investor country credit rating (0-100) 13.23 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)

5.75 Country Risk Premium

Industry Adjustment 1.05 Beta (Industry) 0.16 Sector adjustment

Project Cost of Capital 13.39

Source Cost of equity 13.4% ICCRC model Cost of debt 8.1% Junk bond spread June '12 (Ibbotson) Tax rate 29.7% Carrefour's efective tax rate D/E ratio 32.7% Based on Cencosud's ratios

Wacc 10.9%