Chapter 18

Trying Your Hand at Investment Banking with a Case Study

IN THIS CHAPTER

check Understanding why firms buy versus build

check Seeing how firms can afford to pay a premium over market value

check Discovering how goodwill is created on the balance sheet

check Finding out how pro forma financial statements are constructed

check Seeing how deals are constructed

Congratulations! You’re an investment banker. Well, at least you will be one in this chapter. After you read this chapter, you’ll know how to piece together the complex framework of a merger or acquisition deal. You’ll need to use your cunning, and things you’ve discovered in other chapters, to forge a mishmash of financial data into a cogent plan for a company looking to buy another one.

Investment bankers advise companies on ways to increase their value and ultimately the value of stock held by the owners of the firm. There are many different ways that companies can transform themselves and add value for stockholders. One of the most popular methods is to grow via acquisition.

This chapter walks you through a hypothetical case involving a company growing via acquisition of another firm and illustrates some of the quantitative and qualitative factors that investment bankers and company managements consider when making these transformative decisions.

Setting the Scene

In order to solve an M&A problem, you need a good grasp on who’s doing the buying, who’s doing the selling, and what the parties are hoping you, the investment banker, can help them accomplish.

The acquirer

Performance Ade is one of the leading firms in the sports energy drink industry. It has been in existence for ten years and has grown from a small venture capital–financed company into an international company with a globally recognized brand name. It’s a stock market darling — it commands a high earnings multiple in the financial markets — and it’s considered a growth company in the mature beverage industry. Although Performance Ade is very successful in the sports energy drink niche, company management and the board of directors want to expand into other segments of the beverage industry, particularly the soft drink segment. They’re seeking to diversify in order to reduce their dependence upon the sports energy drink market and to capitalize on the existing Performance Ade brand and distribution channels.

Performance Ade produces a product that is viewed by the market as a high-quality product. The company has a high degree of marketing savvy and has positioned the Performance Ade drink as a premium product that captures a large portion of the high end of the market.

Performance Ade management is working with its investment bankers to determine how best to break into the more established (and much larger) soft drink industry. In consultation, company management and their investment bankers have determined that Performance Ade can either grow organically by developing its own products in the soft drink industry or acquire another soft drink manufacturer to jumpstart this growth. Management is open to either alternative and is looking for counsel on which path to take.

The target

The company’s investment bankers did a thorough industry analysis and came to the conclusion that the most likely company for potential acquisition was Yankee Beverages, a regional soft drink manufacturer in the Northeast. Yankee has been producing a product line of soft drinks that sell under both the Yankee name and various other private-label brands in stores throughout the region.

Yankee has been in business for nearly 95 years and, although the stock is publicly traded in the over-the-counter market, the company is still managed by members of the Gilmour family, who founded it. In fact, much of the stock is still held by members of the Gilmour family, and the family controls the majority of seats on the board of directors. The stock held outside the Gilmour family is thinly traded (there is not an active market for it) and is currently selling at a substantial discount to the typical firm in the industry (as measured by a price/earnings multiple).

Remember The P/E ratio tells investment bankers how much investors are willing to pay for a claim to a dollar of a company’s earnings. The higher the P/E ratio, the more richly valued a company and its stock are. For more on P/E ratios, see Chapter 8.

The revenues of Yankee Beverages have been fairly stable in recent years; unit sales have been flat and total revenues have been expanding at roughly the rate of inflation. The company hasn’t actively been looking for ways to grow its product line, and in recent years, the free cash flow produced by the company has been used to virtually eliminate long-term debt and to provide robust dividend payments to the shareholders. The company has an extreme aversion to debt, because it barely survived the Great Depression, and debt financing is inconsistent with the very conservative philosophy of the Gilmour family. What little long-term debt there is left on the balance sheet is from a program from a few years ago in which Yankee modernized its plants, installing new state-of-the-art equipment.

The Gilmour family is in a transition phase with respect to involvement with Yankee. The grandchildren of the founder are all in their seventies, and their children and grandchildren show little interest in active involvement with the family business and are pursuing other interests.

Considering the Options

Performance Ade’s management team may know a great deal about mixing and marketing tasty beverages to tempt consumers. But when it comes to lining up money, running financial calculations, and thinking through a make-or-break deal, that’s where you come in as the investment banker. Having to weigh all the options may seem overwhelming, but it’s a job you can easily handle if you break it into steps.

Identifying the options

Performance Ade wants to grow and diversify its revenue stream and can basically take one of two paths: It can develop its own products and brands or it can acquire another existing firm (or firms). Both alternatives have their advantages and disadvantages.

Growing organically — that is, building its own product line — is advantageous because management can build the firm in its own image. Building or buying a firm is analogous to the decision to build or buy a home. When deciding to build a home, you can build it exactly to your own specifications — you get the floor plan, the kitchen countertops, and the exact lighting fixtures that you want. When you buy a home, you oftentimes must compromise by accepting limitations such as outdated bathrooms or kitchens that are smaller than you would like.

The flip side is that when you’re buying an existing home, you can generally occupy that home sooner than is possible in the typical construction scenario. In addition, you can often buy an existing home for less than it would cost you to build one. The same is true in the corporate world — some firms are selling for less than they’re “worth” to someone who can do the investment banking equivalent of painting walls, replacing countertops, and landscaping.

The buy or build decision has many factors, but it often comes down to a matter of both price and time to market (how long it takes for the company to have products ready to sell). Many companies lean toward the acquisition route for growth because they’re looking for immediate gratification. And why wouldn’t they? Most investors are very impatient and want to see growth in earnings and share value.

Looking at financing

Though it’s enormously successful, Performance Ade doesn’t have a great deal of free cash flow (the amount of cash flow from operations [CFO] remaining after paying for any needed capital expenditures; see Chapter 12). It’s a growing company and it has been using its prodigious cash flow to invest in more assets — particularly property, plant, and equipment — to support its robust sales growth. The firm does not pay a dividend to shareholders and has attracted an investor base that is growth oriented and not income oriented.

Tip Companies typically have a particular dividend policy and stick to it. This is what is known as the clientele effect. That is, investors often choose to invest in companies that have dividend payout policies consistent with their own goals and objectives. For instance, because retired individuals often need to supplement their income, they often have portfolios comprised of companies that pay out a large portion of earnings as dividends. Individuals who aren’t looking to supplement current income, and are looking to minimize taxation, tend to invest in companies that don’t pay dividends or may pay minimal dividends. Firms generally adopt a certain dividend strategy — either a high-payout or low-payout strategy — and stick to it. They don’t want to alienate their dividend clientele.

Performance Ade, however, is in the unenviable position of needing to satisfy investors’ ever-increasing growth expectations. The company has been able to grow largely through increasing its share of existing domestic markets and by expanding globally. However, it’s becoming increasingly more difficult to capture market share because Performance Ade is already an industry leader in the niche market of sports energy drinks.

Performance Ade isn’t saddled with a great deal of debt, because the firm was financed in its venture capital stage largely through convertible bonds that, as a result of the success of the company, have been converted into equity at the option of the original bondholders. This provides Performance Ade with a great deal of unused borrowing capacity, which is a terrific option for a firm to have. This is akin to an individual being virtually debt-free when seeking a mortgage loan, car loan, or money to fund a child’s education. The less debt on an individual’s balance sheet — or on a firm’s balance sheet — the more willing lenders are to provide them with loans because the lenders have a large margin of safety.

Creating the Analysis

Stories are nice, but in the investment banking world, decisions come down to whether the numbers work out for both parties. That’s why investment bankers sharpen their pencils — or, more accurately, fire up their laptops — and design financial models that allow both the acquired and target firms to win. These models are often iterative in nature and are constantly tweaked to provide each party with a winning hand. Remember: The goal should be to increase shareholder value — for the shareholders of both parties.

An analysis of the financial statements

We’ve talked about our two companies. Now let’s take a look at their financial statements, and see if we can make a deal!

Note: These financial statements are being presented in terms of thousands of dollars. There is simply no reason to get bogged down with a bunch of extraneous zeros. Doing the analysis is easier with fewer zeros, and the implications are the same. So, other than any per-share information, all the numbers are presented in thousands of dollars.

Income statements

The income statements for the most recent year for Performance Ade and Yankee are presented in Table 18-1.

TABLE 18-1 Income Statements

Performance Ade

Yankee

Sales

$1,651,667

$710,000

Less: Cost of goods sold

$566,667

$359,000

Gross profit

$1,085,000

$351,000

Less: Selling, general, and administrative expenses

$600,000

$200,000

Operating income (EBIT)

$485,000

$151,000

Less: Interest expense

$50,000

$6,000

Earnings before taxes

$435,000

$145,000

Less: Taxes (30%)

$130,500

$45,000

Net income

$304,500

$100,000

As you can see, Performance Ade has over 2.3 times the sales volume that Yankee has, and over 3 times the net income. The key cost categories to compare are cost of goods sold and general, selling, and administrative expenses. For a beverage company, the largest elements of the cost of goods sold will be the ingredients such as sugar, labor costs, and depreciation on the machines used to produce the product. For a beverage company, the largest selling, general, and administrative expenses are those related to marketing and promotion.

Common size analysis is a tool used by investment bankers to compare two companies who may differ dramatically in size or structure. Investment bankers doing this analysis divide every category on the income statement by sales for that firm and allow you to see how the firms stack up in comparison to one another. (See Chapter 7 for a discussion of common size analysis.)

If you were to perform a common size analysis, you would find that Performance Ade has much larger general, selling, and administrative expenses than Yankee does, while Yankee has much larger cost of goods sold as a percentage of sales than Performance Ade does. This is consistent with the fact that Power Ade is a premium product, while Yankee doesn’t produce premium products, operating on a more regional basis in the store brand or plain-label space. So Performance Ade spends a greater percentage of revenues on advertising and promotion, while Yankee spends a higher percentage on the actual production of the product.

Balance sheets

The balance sheets for the most recent year for Performance Ade and Yankee are presented in Table 18-2.

TABLE 18-2 Balance Sheets

Assets

Performance Ade

Yankee

Cash

$550,560

$200,200

Accounts receivable

$275,280

$205,000

Inventory

$206,460

$150,000

Property, plant, and equipment

$1,926,960

$757,000

Total assets

$2,959,260

$1,312,200

Liabilities and Equity

Accounts payable

$344,100

$212,200

Short-term debt

$619,380

$200,000

Long-term debt

$516,150

$110,000

Other liabilities

$344,100

$90,000

Equity

$1,135,530

$700,000

Total liabilities and equity

$2,959,260

$1,312,200

Akin to the common size analysis of the income statement, the analyst can perform a common size analysis of the balance sheet. However, instead of dividing all balance sheet amounts by sales or revenues, the analyst will divide them by total assets (or total liabilities and equity). Doing this shows that the asset bases of both firms are heavily weighted toward property, plant, and equipment. In the case of Performance Ade, this isn’t surprising — it’s a growing firm, and it has been reinvesting all its earnings in expanding the business. In the case of a more established company like Yankee, it’s a little surprising — however, remember that a few years ago Yankee renovated its plants and purchased state-of-the-art manufacturing equipment.

Tip The accounts on the balance sheet are book values and may not have a close relationship to the actual value of the assets. Generally, cash, accounts receivable, and, to a lesser extent, inventory are carried on the balance sheet at values that are very close to actual market values. However, property, plant, and equipment may have a book value that is markedly different from the actual market value. For instance, a firm like Yankee may have real estate that is carried on the books at the acquisition value from over 95 years ago! Likewise, plant and equipment may have been written down from its purchase value due to depreciation deductions, but it may have a market value that is dramatically higher than the value on the books. Investment bankers need to assess market values in acquisition situations and not simply use book values as a proxy for market values.

Structuring a Deal

Buying a whole company isn’t like walking into a store and buying a gallon of milk or a dozen donuts. In that case, you simply pay the price listed and you’re the proud owner of breakfast. Firms looking to acquire other firms typically must pay a premium over the current stock price to be able to purchase enough shares to control the company. The amount over the current market price of the shares is called a control premium and is oftentimes over 20 percent of the current market value of the equity.

To illustrate, Table 18-3 contains some additional financial information concerning Performance Ade and Yankee.

As you can see, total market value of the equity of Yankee is $1,050,000, which is computed as the total number of shares outstanding of Yankee multiplied by the current price per share of $84. The first point of note is that the market value of equity of Yankee is higher than the book value of equity ($1,050,000 versus $700,000). This is fairly common, because the average market value–to–book value ratio for companies in the S&P 500 was near 3.6 at the time of the writing of this book. Performance Ade is currently selling at 4.5 times book value, largely reflecting the high growth expectations of investors and the strength of the Performance Ade brand.

TABLE 18-3 Additional Data

Performance Ade

Yankee

Stock price

$51

$84

Total shares

100,000

12,500

Earnings per share

$3.045

$8.00

Market value of equity

$5,100,000

$1,050,000

P/E ratio

16.7

10.5

Net income

$304,500

$100,000

To acquire Yankee, Performance Ade simply can’t write a check for $1,050,000. Upon consultation with its investment bankers, Performance Ade management believes it can acquire Yankee for a 25 percent premium over market value. Thus, the cost to acquire Yankee is estimated to be $1,312,500.

Remember Why would Performance Ade be willing to pay a 25 percent premium over the market value of Yankee’s shares? After all, the shares are publicly traded and the market has determined that, in total, the shares are worth $1,050,000. The reason is that Performance Ade believes that there are some synergies that would result from a combination of the two companies — specifically, it believes that cost savings of $150,000 per year can be achieved from combining the two firms and reducing redundant costs. This is an immediate benefit. In addition, Performance Ade management believes it can take the Yankee brand, transform it, and achieve growth well in excess of the growth that Yankee has been able to accomplish on its own.

Remember One of the biggest reasons to acquire another firm is that the acquiring firm can make more productive use of the assets and create more value than is currently being realized. Much like a baseball team that is a third baseman or shortstop away from being a contending firm, some companies are in a position to maximize the use of assets, while others are not.

Form of acquisition

Given the lack of debt in the capital structure of both Performance Ade and Yankee, issuing debt to purchase Yankee makes the most sense. Performance Ade has tremendous unused debt capacity and has a very steady revenue stream. The consistent and growing revenue stream and operating income provides creditors with the margin of safety they need in order to feel comfortable loaning Performance Ade the money at reasonable terms. In fact, with the help of their investment bankers, Performance Ade management has been able to secure bank financing at the rate of 8 percent in order to do the deal.

The shareholders of Yankee would also likely not be very interested in receiving stock of Performance Ade in lieu of cash. Remember: Yankee currently has a high dividend payout. Its shareholders would likely not want to receive stock of Performance Ade, a company that currently doesn’t pay a dividend. So Yankee shareholders would likely value the flexibility to reinvest their cash proceeds in a company with a high dividend payout. Now, these shareholders will incur tax consequences and be responsible for paying capital gains on their holdings, but the premium above market price will likely placate them.

Creating pro forma statements

What will the reorganized Performance Ade firm look like following the acquisition of Yankee? Investment bankers put together pro forma statements in order to model the new structure. The pro forma balance sheet is shown in Table 18-4.

TABLE 18-4 Performance Ade’s Pro Forma Balance Sheet

Assets

Amount

Cash

$750,760

Accounts receivable

$480,280

Inventory

$356,460

Property, plant, and equipment

$2,683,960

Goodwill

$612,500

Total assets

$4,883,960

Liabilities and Equity

Accounts payable

$556,300

Short-term debt

$819,380

Long-term debt

$1,928,650

Other liabilities

$444,100

Equity

$1,135,530

Total liabilities and equity

$4,883,960

Notice that there is a new account on the balance sheet called goodwill. One way that goodwill comes into existence is when a company buys another company for more than the aggregate current value of that company’s specifically identifiable assets (see Chapter 7). The accounting treatment for goodwill can become somewhat complicated, but the essence is in the case of Performance Ade purchasing Yankee, the total cost was $1,312,500. Performance Ade is buying the entire Yankee company with the book value of equity of $700,000. Typically, the company must determine how much the assets listed on the balance sheet are currently worth, but let’s assume here that the current book value of these assets approximates each of their market values. The difference between the purchase price and the net book value of equity of $612,500 is listed on the balance sheet as goodwill. As you can see, unlike inventories or property, plant, and equipment, goodwill is not a tangible asset. A company can’t raise cash by selling its goodwill.

Most investors are less concerned with what the balance sheet will look like than the earning power of the reconstituted company. The pro forma income statement is shown in Table 18-5.

TABLE 18-5 Performance Ade’s Pro Forma Income Statement

Income Statement Line Item

Amount

Sales

$2,361,667

Less: Cost of goods sold

$925,667

Gross profit

$1,436,000

Less: Selling, general, and administrative expenses

$650,000

Operating income (EBIT)

$786,000

Less: Interest expense

$161,000

Earnings before taxes

$625,000

Less: Taxes (30%)

$187,500

Net income

$437,500

As you can see, the newly constituted Performance Ade is more profitable and more highly leveraged than it was before it acquired Yankee. It’s more profitable because its return on equity has gone from 26.1 percent ($304,500 ÷ $1,135,530) to a robust 38.5 percent ($437,500 ÷ $1,135,530). It’s more highly leveraged because its total debt–to–total equity ratio has gone from 1.30 ($1,479,630 ÷ $1,135,530) to 2.81 ($3,192,130 ÷ $1,135,530). What this means is that the firm has been able to increase its profitability because it’s earning more on its borrowed funds than those funds cost the firm.

But Performance Ade hasn’t leveraged itself to a dangerous level. The pro forma times interest earned ratio (computed by dividing operating income by interest expense) is still a healthy 4.88 times. That gives lenders a fairly large margin of safety, especially given the stable revenues of the firm. It appears that the firm even has more unused debt capacity.

The new Performance Ade would also have higher earnings per share of $4.375 ($437,500 ÷ 100,000) than it did before the acquisition of $3.045 ($304,500 ÷ 100,000). This will generally be very well received by investors, because one of the most common valuation methods is to multiply earnings per share by a price/earnings multiple to obtain an estimate of firm value.

Warning Before you assume the market will simply apply the same P/E multiple of 17 to the new Performance Ade that existed before the acquisition, a word of caution is in order. The financial markets are populated by some very sophisticated and knowledgeable investors and analysts. They’ll recognize that the increase in earnings is the result of acquiring a lower-growth soft drink business by the higher-growth sports energy drink business. The P/E multiple applied by the market will likely be somewhere between the 10.5 applied to Yankee and the 17 applied to Performance Ade. The key will be how that market assesses the chances that Performance Ade will be able to successfully grow the revenues of Yankee beyond that under the current management.

Success or Failure

Like many things in business, the success or failure of any merger or acquisition often can’t be determined immediately. Although the acquisition of Yankee by Performance Ade has made the shareholders of both companies better off in the short run, only time will tell if Performance Ade will be able to integrate the operations of Yankee into one smooth operation and build long-term value. What can’t often be predicted is the inability of different company cultures to integrate because, after all, companies are not simply comprised of inventories, buildings, and equipment — they involve people and personalities. Often, you can’t determine if an acquisition was a good idea until many months or years after the event was announced. It’s at that time when you can compare the pro forma financial statements prepared by investment bankers to the actual financial statements of the combined operation and determine if your investment bankers were more like fortune tellers or charlatans.

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