Case Study on Gainesboro Machine Tools Corporation

TABLE OF CONTENT 1.0

Company Profile 1

2.0

Problem Statement

3 3.0

Analysis on Different Strategies 4

4.0

3.1

Zero Dividend Payout

4

3.2

Below 40% Dividend Payout

5

3.3

40% Dividend Payout

5

3.4

Residual - Dividend Payout

6

3.5

Corporate Rebranding

6

3.6

Share Buy Back

7

Recommendation 8

5.0

Appendices

1.0

Company Profile of Gainesboro Machine Tools Corporation James Gaines and David Scarboro founded Gainesboro Corporation in the year 1923 focusing their business on designing and manufacturing

machine

parts.

By 1975,

the

company had

developed a reputation as an innovative producer of industrial machinery and machine tools, which made Gainesboro stood out as an industry leader as press and mold companies were mostly small local or regional firms with limited clientele. In the early 1980s, Gainesboro ventured into a new field; computer-aided design and computer aided manufacturing (CAD/ CAM). Gainesboro worked with a small software company and developed manufacturing metal parts by responding to computer commands. Several years later, Gainesboro merged the software company into its operations and perfected the CAM equipment while developing a superior line of CAD software and equipment. In the CAD/ CAM industry, large firms like Autodesk, Inc., Cadence Design, and Synopsys, Inc. sets the standard for CAD/CAM. In the late 1990s and early 2000s, the technological advances and aggressive

venture

capitalism

fueled

the

entry

of

highly

specialized, cutting edge CAD/ CAM firms. From there, Gainesboro fell behind some of its competition in the development of userfriendly software and the integration of design and manufacturing. As a result, revenues slipped from a high of $911 million in 1998 to $757 million in 2004. Gainesboro took two separate approach to tackle the declination of revenues and to improve the weak margins: a) Devoted

a

greater

share

of

its

research

and

development budget to CAD/CAM in an effort to re-establish its leadership in the field b) The company also

went

for

two

massive

restructurings: i)

In

2002,

the

company

sold

two

unprofitable lines of business with revenues of $51 million, sold two plants, eliminated five

1

leased

facilities and reduced personnel. Restructuring cost totaled $65 million. ii) In 2004, the company took second round of

restructuring

by

altering

its

manufacturing

strategy, refocusing its sales and marketing approach and adopting administrative procedures that allowed for further reduction in staff and facilities. Total cost of the operational restructuring in 2004 was $89 million. iii)

These two restructuring produced losses

totalling $202 million in 2002 and 2004 but by 2005, the

restructurings and emphasis on CAD/ CAM

research which made the company leaner, and research also led to the development of a system that Gainesboro’s management believed would redefine the industry. Gainesboro introduced a new system known as the Artificial Workforce, an array of advanced control hardware, software, and applications that could distribute information throughout a plant. Applications of the products was developed for chemical industries and oil and gas industries in 2004 and in the next year, it had created applications for the trucking, automobile parts and airline industries. By October 2004, the first Artificial Workforce was shipped and Gainesboro orders was totaling $75 million. By year end, backlog was $100 million. Securities analysts were optimistic about the product’s impact on the company and viewed that the Artificial Workforce will enable Gainesboro to increase its share market (ignoring the periodic growth spurts) will expand to annual rate of 5% over the next several years and when production is in full swing, it will help restore margins. Gainesboro management expect domestic revenues from Artificial Workforce series to total $90 million in 2005 and $150

2

million in 2006. International sales through Gainesboro’s existing offices were expected to provide additional revenues of $150 million by early 2007. Currently, the international sales accounted for approximately 15% of total corporate revenues.

A number of corporate objectives had grown out of the restructurings

and

recent

technological

advances.

The

management wanted and expected the firms to grow at an average annual compound rate of 15 percent. Gainesboro’s Director of Investors Relations, Cathy Williams, concluded that investors misperceived the prospects of the firm and its current name was more consistent to its historical product mix and markets than those projected for the future. After conducting

surveys

in

financial

magazines,

a

program

of

corporate-image advertising targeting on guiding the opinions of institutional

and

individual

investors

was

recommended

to

enhance the firm’s visibility and image. A new name had been identified, Gainesboro Advance Systems International, Inc. with advertising campaign and name change costing to approximately $10 million. With the recent impact of Hurricane Katrina, causes untold destruction across the southeastern United States. After the storm, the stock market spiraled downward and Gainesboro’s stock had fallen 18 percent, to $22.15. 2.0

Problem Statement Some of the present challenges that the company faced is regarding its corporate goals and the growth of the company on how the company’s production should be structured, international expansion plans and planned acquisitions. Additional to the Hurricane Katrina causing Gainesboro’s stock to drop, the Chief Financial

Officer

Gainesboro

3

is

required

to

submit

a

recommendation to Gainesboro’s Board of Directors regarding the company’s dividend policy, a subject of an ongoing debate among the firm’s senior managers. Large number of companies had announced plans to buy back stock, while some want to signal confidence of their companies and the U.S. financial markets. Swenson has dividend-decision problem which compounded by the dilemma of whether the company should use company’s funds to pay shareholders dividends or to buy back stock. 3.0

Analysis of Different Strategies In this section, analysis of the strategies and its implication are discussed. Advantage and disadvantage of the strategies are presented together with the supportive calculations which are applicable. As for the dividend payout, we have calculated the Debt By Equity Ratios in Appendix 1.

Payout Ratio

2005

2006

2007

2008

2009

2010

2011

0%

34%

33%

30%

28%

25%

23%

21%

20%

36%

37%

36%

33%

30%

27%

25%

40%

37%

41%

43%

43%

41%

40%

36%

Table 1.0: Debt by Equity Ratio 3.1

Zero-Dividend Payout A zero-dividend payout will be financially favourable strategies for the company as no external funds need to be borrowed to payout dividends. Moreover, existing cash can be invested to fund new projects. However, the future growth of the company is uncertain and depends heavily on the market to react favourably. After a few years however, company still have to pay dividends to the shareholders and every year thereafter. In the circumstances if the company fail to get growth and income to company portfolio the shareholders or investor confidence will be jeopardized.

4

Advantages: 1. As per the company strategy 2. Coincides with high-growth and advance technology firms 3. No debt Disadvantages: 1. Board of director will not meet their commitment to the shareholder 2. Investor who are looking for stable investment will not be happy

3.2

Below 40% Dividend Payout i.e. 20% Dividend Payout This strategies will imply debt burden to the company but not as high as the 40% dividend payout. However this strategies would have better financial flexibility and reduce yearly liability of the company to the investors. Advantages:

1. Consistent with Gainesboro’s dividend payout policy 2. Board will continue to pay dividends 3. Uses debt capacity but still has flexibility Disadvantages: 1. Did not give good impression to the investor on the company’s future 2. Still higher that the other advanced technology companies 3.3

40% Dividend Payout This strategies will strain the cash of the company and also increases the debt on the balance sheet. From the Table 1.0 we can see that the debt by equity ratio is high. The result suggest that with fixed 40% dividend payout it will reduce flexibility of the company. Advantages:

1. Restores firm’s implied dividend payout 2. Payout ratio is in-line with electrical-industrial equipment manufactures 3. Strong impression to shareholders on company’s future 5

Disadvantages: 1. Exceed maximum debt capacity 2. No debt flexibility 3. Not reflective to the current business model

3.5

Residual-Dividend Payout From appendix 1, the calculations show that the company’s success of making a dividend payout depends on the ability to capitalise on the new technology being implemented which in turn will able to implement production in fully automated thus reducing the human capital and production cost. As it has already been mentioned that competitors are planning to introduce similar technologies, the growth estimated might have to be revisited. The growth projections taken optimistically therefore making a pay-out of 40 % which might not be the best strategies. However the pay-out ratio is inconsistent depending on the growth of the company and it might upset the investor. Advantages:

1. Fund receive to be utilize in projects and capitalise new technology while the excess funds is to build trust with investor. 2. Consistent with “Dividend Irrelevance Theory” which state that investor will obtain the same return even if company pay high dividends or reinvest the fund. 3. Debt will not be so high Disadvantages: 1. Does not in line with company growth strategy 2. Dividend payout ratio is not predictable 3. Negative influence on the stock’s prices during its implementations 3.6

Corporate Rebranding Corporate rebranding by changing their name from Gainesboro Machine Tools Corporation to “Gainesboro Advanced Systems International, Inc” will reflect that the company is embarking or 6

strategizing the business in technology locally and internationally which will attract more investor. With this objective, they can enhance the firm’s visibility and image as such stock prices will respond positively to the campaign and name changes.

Advantages: 1. Indication to shareholders that company commit to future growth and locally and international expansion strategy 2. Indication that company business will change from traditional machine tool to CAD/CAM Disadvantages: 1. The campaign is costly. Approximately 10 million 2. No empirical evidence show correlation between name changes and stock price 3.7

Share Buyback In this strategy, the company will determine whether or not to buy back share. Basically, shareholders would prefer a buyback because in this way they would rather see their share prices increase in value (if they didn’t sell) or they can enjoy the return coming from the positive difference in buying their shares cheap and selling high (Urry 2004). The decision on whether to buy back stock or not should be that, if the intrinsic value of Gainesboro is greater than its current share price, then the shares should be repurchased. But in the case, it does not provide the information needed to make free cash flow projections. So we only can assume the case, if the intrinsic value is higher than share price, the company should repurchase share. However, it will not resolve the company dividend/financing problem. By doing so (repurchase shares), it will would reduce the resources available for a dividend payout. Also, a stock buyback

7

may be inconsistent with the message that Gainesboro is trying to convey, which is that it is a growth company.

Advantages: 1. The management believes that repurchase share will estimate the stock to be undervalued. 2. By repurchase share will give decision to the investor. Disadvantages: 1. Increasing the debt to equity, makes debt riskier (Investor). 2. Loss for the company (EPS is lower). 3. Increasing the debt to equity (Higher risk)

4.0

Recommendation In reference to the above discussion on the dividend payout percentages and share repurchase, Gainesboro could declare the dividend payout however at a lower percentage than 40% due to outcome of company restructurings and recent technological advances in the industry.

The company is now having new

objectives and projection of sales growth at an average annual compound rate of 15%.

Based on the second-quarter financial

data, revenue of $870 million is projected in 2005 and consistently will achieve $2.0 billion of total sales and $160 million in net income. However, this dividend payout proposal is based on the positive projection sales growth of 15%. In view of the board put a commitment to pay the dividend in 2005, retracting its decision will give negative impression or negative signal to the shareholders on the company business operation status and this would jeopardize the company’s business strategy and initiatives as the outcome of the restructuring as follows:

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i.

Corporate

rebranding

-

reimaging

Gainesboro

with

a

campaign of corporate-image advertising and change of name to “Gainesboro Advanced Systems International, Inc” in order to improve perception in the market. ii.

To revitalize the operating divisions

iii.

New products to penetrate the market with positive feedback since the product would substitute the current products in the market.

iv.

Company A rating rated by Value Line

v.

Artificial workforce will increase and replace the existing workforce Hence, in meeting the Board commitment and shareholders

expectation, based on the projection dividend payout of 0%, 20% and 40%, it is suggested that a declaration of dividend payout of 20% to shareholders is recommended due to the following reasons: i.

This will maintain the board decision and commitment to pay dividend to the shareholders and gain trust from the shareholders since retracting its decision after the initial position that no dividend payout will give negative signal to the shareholders. It renders inconsistency of the management decision

and

signal

on

way

of

conducting

day-to-day

management. ii.

This will retain shareholders who want to receive dividends as well as who wants to see the company’s growth as a new business strategy as an outcome of restructuring by focusing its sales and marketing approach, manufacturing strategy and adopting

administrative

procedures

which

reduced

the

number of staffs and facilities and new product in line namely Artificial Workforce, a system of advanced control hardware, software and applications which by end of 2004 the backlog order was $100 million. iii. This will balance the financial needs of the company i.e. within the

maximum

debt

capacity

9

of

the

company

and

disbursement of free

cash

flow

projection from 2005 until 2011. compete

with

two

strong

towards achieving

the

The company needs to

competitors

who

developing

comparable products and would launch the products in 12 months. This would disrupt the sales growth projected should the company delay to meet the orders. iv. The debt to equity ratio is not more than 40% which normally gives comfort level to the lenders since the lender's’ interests are better protected in the event of business decline; since the Value Line rated A for the company. By proposing the dividend payout of 20% and with the positive projection of sales and net income throughout the years until 2011, Swenson may decline to consider the share repurchase since this will breach the company dividend payout commitment which had been declared to the shareholders.

Based on the

analysis above also it is also suggested that no major benefit will be earned by the company by doing share repurchase since the proposed dividend payout declaration of 20% couple with the strategic restructuring initiatives and new product in line will rebound the company financial performance. On top of this, the company will lose its debt capacity flexibility since the company is using its money to repurchase its own shares instead declaring dividend and invest in new investment in artificial workforce.

It

will also reduce its cash reserves or debt capacity and potentially affect its credit rating. In meantime, it is suggested that the company to undergo corporate rebranding - reimagining Gainesboro in the new era with the restructuring with a target to have an efficient cost of operation and new product in line namely Artificial Workforce will reflect company’s new image.

By changing its name from

Gainesboro Machine Tools Corporation to “Gainesboro Advanced Systems International, Inc” will reflect that the company is embarking

or

strategizing

the

business

in

new

advanced

technology locally with the business expansion internationally

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which would attract the investors’ attention to invest in the company anticipating positive growth over a period of 5 years. By having a dividend payout of 20% will help the company to retain and support the new image of CAD/CAM focus as a true industry leader in competition with others including Autodesk, Inc., Cadene Design, and Synopsys, Inc..

This is strategically in line with the

growing market and aggressive marketing strategy, efficient production in developing its new product in competing with its other two (2) alliance in the same industry.

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