Case Delta Beverage Group, Inc. History The Delta Beverage Group is a bottling and canning company from the United States. Delta had some very strong brand names, like Pepsi and Mountain Dew, included in their franchises. Around 1988, a price war occurred and Delta suffered from compressed margins. About a year later situation became critical and a new management team from was hired. The new management stopped the fall in prices, the decline in market share and increased margins by changing the cost structure.
Delta also acquired some other bottling companies at the same time increasing their sales and operating cash flow. After a couple of years operating profits increased by almost 100% and net income made a solid upward progress. However, net income was still negative due to high interest expenses. Despite growing profits Delta had problems on making payments on their bank loan. They were unable to make the payments without violating an interest coverage or leverage ratio covenant. Violating a covenant meant that Delta was in technical default!
Restructuring To avoid defaulting on its debt, Delta restructured their debt. $30 million of existing senior notes were converted to subordinated notes, almost $90 million of senior notes and bank debt were retired at par using a new private placement debt issue of $105 million. The restructuring resulted in a lower total debt and an increase in the average maturity of the debt. The new debt issue came with five new covenants. Again a violating of a covenant meant technical default. Time period |Maintenance of senior leverage ratio (not in excess of) | |12/31/93 |5. 15 x | |1/1/94-12/31/96 |5. 00 x | |1/1/97-maturity |4. 50x | | |Maintenance of total leverage ratio (not in excess of) | |12/31/93 |6. 40x | |1/1/94-12/31/96 |6. 5x | |1/1/97-maturity |5. 75x | | |Interest coverage ratio (not less than) | |After 1/1/94 |2. 00x | | |Debt service coverage ratio (not less than) | |Third quarter 94-second |1. 5x | |quarter 95 | | Recent Events Because the price of aluminum increased by 30% during the first half of 1994 Delta was concerned about a further increase in the latter half of 1994. This raised the probability of a financial hedge on aluminum. Because there are no financial contracts available for PET or fructose we will not mention them again. Aluminum is subjected to an annual price volatility of 30. 4%.
The price of aluminum cans however had historically varied much less than the price of raw aluminum, in fact the cost of aluminum cans had fallen. Hedging procedure Bierbaum could hedge the increasing price of aluminum with a put option. Future contracts of aluminum are quite attractive for traders, these contracts can be bought and sold 24 hours a day, this possibility to trade constantly gave companies a level of flexibility. Traders on the LME can specify the delivery date themselves, as well traders can be confident about the quality of the aluminum because only metal of a purity of 99. % could be delivered to satisfy the LME contracts. Furthermore it is possible to buy and sell European option contracts, an option gave the holder the right to buy or sell the underlying futures contract at a predetermined price. He could take a put option to exercise a futures contract (against the price of aluminum at that moment), he would only do this if the prices won’t be as high as expected. If the prices behave like the expectations or even better, Bierbaum won’t have to exercise the put option.
The best opportunity is that the total of 8270 tonnes of aluminum could be hedged in future contracts, which will cover the expected case volume of 23. 55 million in aluminum cans. This investment should not harm the covenants in 1994 and the following years. Hedging With respect to the covenants, Bierbaum wants to look at a financial hedge. In order to quantify the magnitude of the hedge we have to calculate the aluminum cans expenses of Delta. We will make some assumptions on growth rates for the next years. Sales will grow with 4% in 1994, and we assume a growth of 3% in 1995.
The same rates we use for the growth of net revenues and growth of cost of sales. We want to know the amount aluminum cans account for in the cost of sales. According to the provided information cans account for 60% of net revenues. Net revenue in 1994 will be $231,207 * 1. 04 = $240,455. The cans contribute 0,60 * $240,455 = $144,273. With a gross margin on cans of 27% the cost of sales of aluminum cans for 1994 is (1-0. 27) * $144,273 = $105,319. Exhibit 9 shows that packaging is 49% of the cost of goods. So the amount paid in 1994 through the co-op for the aluminum cans only is 0. 9 * $105,319 = $51,606. One case of cans contains 0. 774 pound of aluminum. The total expected aluminum case volume over 1994 is 23. 55 million cases. Delta’s can production would use 8,270 tonnes of aluminum: 23. 55 * 0. 774 : 2204 lbs/tonne = 8,270 tonnes. Hedging this amount of aluminum would require 331 aluminum futures contract. The price of aluminum at January 1994 is $1,218. So raw aluminum accounts for 8,270 * $1,218 = $10,073 in the total amount of cost for aluminum cans. Dividing $10,073 through $51,606 shows use that raw aluminum accounts for 1/5th of the total amount of aluminum cans.
Now we can explain why the price volatility of aluminum cans historically seen varies much less than the price volatility of raw aluminum. When the price of raw aluminum changes with 10%, the price of aluminum cans changes with 2%, so it’s much less volatile than raw aluminum. The aluminum cans contract is signed in January of each year. So for 1994 the contract is already signed. So we want to hedge the contract which will be signed in January 1995. In the first half of 1994 the price of aluminum increased 30%. We assume a further growth of 10% for the latter half of 1994.
A 40% price increase in raw aluminum means a 8% price increase in the aluminum cans. So the price of the aluminum cans contract in 1995 will be $51,606 * 1. 08 = $55,734. We would recommend to hedge the extra cost of the aluminum cans contract for the year 1995, $55,734 – $51,606 = $4,128. The problem with the rising price of aluminum is that the operating cash flows will stop going forward. When that happens, Delta could get into trouble because of the probability of violating a covenant. In order to protect their profitability Delta could hedge with futures contracts.
We assumed that the price of aluminum would increase by another 10% during the second half of 1994. Price of aluminum will then be $1. 461 * 1. 10 = $1. 607. Aluminum has a volatility of 30. 4%. If we assume that the price of aluminum increases 20% during 1995, the price will be $1. 607 * 1. 20 = $1. 928. If we take a 15 months future price at June 1994 of $1. 588 the profits at expiration date could be around $1. 928 – $1. 588 = $0. 34. $0. 34 * the amount of futures contracts should be $4. 128. $4. 128 / $0. 34 = 12,142 futures, to hedge our expected price increase of aluminum.
When hedging only with futures, Delta protects itself to an increase in price of aluminum. But when the price of aluminum drops, they have a problem. Therefore, they could hedge again with put options on the futures. If the price of aluminum drops, they have to pay the price as agreed on the future and thereby suffering a loss because they have to pay the difference between the future price and the price of aluminum at expiration date. If they go long in a put option they can gain from a decreasing price. [pic]