Will Pepsi Take a Future Hit to Sweeten Merger Deal?

If PepsiCo wants to deliver a tax-free deal to the shareholders of the two bottling companies it wants to acquire, then it will have to give up fut...
Marie LeoneApril 23, 2009

As details of the proposed merger between PepsiCo and its two largest bottling companies unfold over the next few months, the form of that deal, and its resulting tax consequences, will be of particular interest to shareholders.

“Although it may seem on the surface to be a matter of cosmetics, the ‘direction’ of the merger will go a long way towards determining the tax consequences that the target shareholders can expect from this transaction,” noted tax expert Robert Willens said in a client advisory.

By “direction,” Willens means that PepsiCo has a choice of merger types: a traditional forward merger, or a reverse triangular merger. The deal has to be structured as a forward merger to be deemed a tax-free transaction for the shareholders of the two bottling companies — The Pepsi Bottling Group, located in Somers, New York, and PepsiAmericas, based in Minneapolis. In this case, a forward merger means that the two bottling companies are merged into PepsiCo or one of its controlled subsidiaries.

But PepsiCo will have to decide whether sweetening the merger deal for bottling company shareholders by offering them the tax-free transaction is worth losing the future tax benefit that PepsiCo itself would get if it used a reverse merger. A forward merger benefits bottling company shareholders, Willens told CFO.com, but it will force PepsiCo to forfeit a “big advantage.”

That’s because a reverse merger would give PepsiCo a relatively high ‘basis position’ in the stock of the bottling companies. The basis position, which is essentially PepsiCo’s recorded cost of acquiring the bottling companies’ stock, comes into play if the beverage giant decides to sell the bottling companies down the road — which happened most recently in 1999 when it spun off Pepsi Bottling Group. The higher the basis position now, the less profit PepsiCo would record if and when it sold the stock in the future, which would mean less taxable income and lower capital gains taxes.

Securing a “much higher basis [through a reverse merger] in the targets’ stock would justify using the reverse merger format even though the use of that format renders the target shareholders taxable on their receipt of PepsiCo stock,” Willens explained.

The difference results from the different ways an acquirer’s basis position is calculated, depending on the form of the merger. A forward merger would give PepsiCo a “net asset” basis in the stock of the entity into which the bottlers were merged. A net asset basis is equal to each target company’s basis in its assets, minus any liabilities associated with those assets that a new merger subsidiary assumes. “It’s almost always a small number,” contends Willens. And that’s almost always a much lower basis than the “cost basis” a reverse merger would deliver.

A cost basis is equal to the cash plus the fair value of the stock being offered in the deal. In this case, a reverse triangular merger would involve having a controlled subsidiary of PepsiCo merge with the two bottling companies to create the surviving corporation.

So far, PepsiCo has only said that the deal hinges on “the completion of definitive merger agreements,” without specifying the merger structure. The deal basics were laid out in a press statement on Monday, which announced the PepsiCo proposal to acquire all of the outstanding shares of common stock that it does not already own in Pepsi Bottling Group and PepsiAmericas.

The 50/50 cash and stock offer included $29.50 per share for Pepsi Bottling, and $23.27 per share for PepsiAmericas, about a 17% premium over the closing share price for each company as of April 17, and more than a 30% premium as compared to the 30-day average closing prices. PepsiCo currently owns 33% and 43% of the outstanding shares of Pepsi Bottling and PepsiAmericas, respectively.

In a conference call held yesterday, Pepsi Bottling Group chairman and CEO Eric Foss told analysts that he and the other executives on the call, including CFO Alan Drewes, would not be able to say much about the proposed merger until after a special committee of independent directors evaluated the offer.

However, there doesn’t seem to be too much standing in the way of a union. The “probability of a deal being completed is rather high, albeit possibly on different terms,” wrote Gimme Credit analyst B. Craig Hutson in an analyst’s note. However, Hutson warned that while the likelihood of seeing a competing offer was slim, “there could be some suggestion [PepsiCo] is trying to buy its minority-owned bottlers on the cheap.”

As evidence, he cited a Feb. 13 comment made by PepsiCo chief executive Indra Nooyi who remarked that, “in our sector there aren’t that many deals that are cheap enough to create value.” At the time, shares of Pepsi Bottling were trading 24.3% lower than PepsiCo’s current offer price, while PepsiAmericas’ share price was 20.8% lower than the offer, according to Hutson.