It proved necessary to compute the weighted average cost of capital of a company based in Pakistan in order to calculate the present value of the losses suffered. Nichols plc, an AIM company, markets the Vimto brand of soft drinks and other soft drink brands. Gul Bottlers (Pvt) Limited is a bottler and distributor of soft drinks, based in Pakistan.
There was an agreement reached that Nichols would supply Gul with Vimto concentrate for sale in the Pakistan market. Vimto was already extremely popular in the Middle East and North Africa, marketed in those territories by a very large distributor. There were powerful reasons to believe that the drink could also succeed in Pakistan. The Middle East distributor had no agency in Pakistan but some sales of the cordial were already being made there.
As a result of pressure from the Middle East distributor the agreement reached between Nichols and Gul was terminated before it became fully operational.
The litigation
The nature of the agreement was disputed between the parties as some of the documentation contained drafting errors. The finding of the judge was, “Nichols' case, prior to this concession was an opportunistic case based on a mistake made by its lawyer in drafting the amendment letter, unnoticed by anyone at the time.”
A letter was sent after the contract was breached, offering Gul the various rights which were in the original contract. However, the letter also stated that Nichols was fully prepared to engage in litigation and that, in such circumstances, it would vigorously defend its position and pursue its counter-claim.
The judge’s findings with regard to this letter were uncomfortably direct. “The letter was therefore maintaining a dishonest stance in the sense that Nichols knew full well that its defence to Gul’s claim was untenable and wholly unjustified. Nichols knew what had been agreed and was putting forward a contrived defence on the basis of mistakes in the agreement and letter of amendment.”
The judge found generally against Nichols and expressed his findings in the starkest terms. “The treatment meted out to Gul by Nichols was disgraceful.”
The market
It was recognised by the parties that Vimto was a premium brand, which could be offered to a growing middle class in Pakistan at a price significantly above that of certain other brands in the cordial market.
The penetration of Vimto in other markets provided telling evidence of its potential in Pakistan: it represented 42% of the liquid concentrate market in Saudi Arabia and 40% in the United Arab Emirates. Cable television channels from the Middle East, like Al Jazeera frequently show adverts for Vimto as a status drink. There were already existing sales being made in Pakistan by “grey” imports of bottles from these countries.
The expert for Gul had undertaken research into the Pakistan drinks market and had computed the sales and profits which might have been generated had Gul been able to buy the concentrate and then to bottle and sell Vimto in that market. He prepared long-term forecasts which showed an initial market penetration of 2.7% of the Pakistan cordial market, increasing to 13.8% in year 10.
The blend
Any valuation expert appearing for Nichols against the background of the judge’s findings was likely to face an uphill task. This was the case, as the judge generally preferred the evidence of the Gul expert.
The two experts agreed that the correct approach was to compute the present value of the likely future cash flows deriving from the sale of Vimto products in Pakistan. There was also agreement that the discount rate should be the weighted average cost of capital of Gul. This therefore required use of the Capital Asset Pricing Model. The expert for Gul looked at guideline companies and arrived at a relatively low beta of 0.44.
The expert for Nichols considered that the beta should be 1 or more, 79 guideline public companies had been reviewed in order to determine the beta. The Nichols’ expert considered that a beta of 0.44 made no sense as this suggested a close comparison to Coca Cola, whereas Gul would be more volatile than the entire world market. The expert for Gul dissected the question of risk involved in the project – as this was the sale of an established product into a market in which the product was already being sold. He considered the risks to be relatively modest.
The expert for Nichols considered that two further adjustments were needed. The first was a size premium taken from the Ibbotson SBBI yearbook which included a decile analysis of the market in the USA. He used the 10z data (the smallest 25% of the tenth decile) and derived an increase to the discount rate of 11.65%. He also added a further discount of 5%, specific to Gul, to allow for the fact that it maintained two sets of accounting records so as to reduce its tax liabilities. It was therefore riskier due to this corrupt practice.
Final verdict
The net results of the above differences were two materially different discount rates. The expert for Gul had used a discount rate of 15.65%. It seems that the equity component had been built up on the basis of a risk free rate, an equity risk premium moderated by a beta of 0.44, and a country risk adjustment.
The expert for Nichols advocated a discount rate of 33% on the basis that it should be increased by both the small stock premium and the premium specific to Gul.
The judge was impressed by the statement from the expert for Gul that the weighted average cost of capital of the companies on the Karachi stock exchange were in the range from 12% to 17% and that none were above 20%.
As noted above, any valuer appearing for Nichols was likely to be faced with an uphill task in view of the earlier findings by the judge in respect of the conduct of Nichols and Gul. The judge showed a preference for the calculations of the Gul expert and awarded 1,359,978,570 Pakistani Rupees, which is equivalent to some £8m to Gul. Costs were also awarded against Nichols.
There is no mention in the written decision of any opportunity cost adjustment that is the likely alternative returns from the capital underlying the weighted average cost of capital.
A bitter aftertaste?
It appears that Nichols is unrepentant. It has stated in a press release on the day of the decision that it fundamentally disagrees with the quantum of the award by the High Court and is considering options for an appeal. The directors had provided some £2m for the costs relating to the litigation in the financial statements for the year ended 31 December 2013. They have now recognised an exceptional cost of just under £8m in the half-yearly statement to 30 June 2014.
Andrew Strickland, Corporate Partner, Scrutton Bland
Valuation Group, December 2014