Investment Banking Department Analysis Handbook
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Investment Banking Department Analysis Handbook CONFIDENTIAL | 2006
Table of Contents Introduction
11
Comparable Companies Analysis
15
1.
Overview 1.1. Definition of Compco Analysis 1.2. Where Does Compco Analysis Fit into Overall Valuation Analysis? 1.3. Key Concepts for Compco Analysis 1.3.1. Consistency 1.3.2. Full Range of Multiples 1.3.3. Forward Looking Nature of Compco 1.3.4. Uniformity 1.3.5. Correlation 1.3.6. Relevance of Multiple 1.4. Selection of Comparable Companies 1.5. Specific Sector Multiples 1.6. Frequency of Updates 1.7. Formatting 1.7.1. Overall Formatting of Output 1.7.2. Pages and Tables 1.7.3. Names 1.7.4. Notes and Sources
15 15 15 17 17 17 18 19 19 20 20 20 22 23 23 23 23 23
2.
How to Complete a Compco Analysis 2.1. Sourcing Data – Market Cap 2.1.1. Share Price 2.1.2. Number of Shares 2.1.3. Foreign Exchange Translation (P&L versus Balance Sheet Translation) 2.2. Sourcing Data - Financial Statements and Financial Projections 2.2.1. P&L and Cash Flow Statement 2.2.2. Consensus Forecasts 2.2.3. Balance Sheet 2.2.4. Accounting Standards and Related Issues 2.2.5. Calendarisation of Statements 2.2.6. LTM Financials 2.2.7. Adjustments to Financial Projections 2.2.8. Credit Ratings Reports 2.3. Mechanics of Compco Analysis 2.3.1. Market Cap and Fully Diluted Equity Value 2.3.2. Calculation of Enterprise Value 2.3.3. Special Dividends 2.3.4. Other Adjustments 2.4. Core Multiples – Approach to Calculating Multiples of Core Business
25 25 25 25 26 26 26 27 27 27 29 29 30 37 37 37 39 40 42 43
3.
Common Pitfalls
44
4.
How to Interpret Comparable Analysis Results
45
5.
Case Studies 5.1. Basic Comparable Calculation – BSkyB 5.1.1. Valuation and Leverage Multiples 5.1.2. Business Statistics 5.2. Advanced Comparable Calculation – Vodafone 5.2.1. Calculation of Vodafone Core Mobile Multiples
45 45 48 48 49 50
Comparable Acquisitions Analysis 1.
Overview 1.1. What is a Compacq and What is it Used For? 1.1.1. Applications 1.1.2. Advantages 1.1.3. Disadvantages 1.1.4. Overall Comments 1.2. Identification of Relevant Precedent Transactions 1.3. Information Required to Complete a Compacq Analysis
55 55 55 55 55 55 55 56 57
3
1.4.
1.3.1. Sources of Deal Specific Information 1.3.2. US Filing Codes Sample Output Sheet 1.4.1. Example: Logistics Sector
2.
How to Complete a Compacq Analysis 2.1. Filling in the Qualitative Columns 2.2. Target Financial Performance 2.2.1. Selecting which Target Financial Statements to Use 2.2.2. Calculating LTM Income Statement 2.2.3. Extraordinary / Non-recurring Items 2.2.4. Acquisitions / Divestitures 2.2.5. Announced Synergies 2.2.6. Cyclicality 2.3. Consideration Paid and Assumed Liabilities 2.3.1. Transaction Structure 2.3.2. Consideration Levered or Unlevered? 2.3.3. Shares Outstanding 2.3.4. Preferred Stock and Convertible Debt 2.3.5. Options and Warrants 2.3.6. Assumption of Debt 2.3.7. Minority Interests 2.3.8. Investments in Associated Companies 2.3.9. Marketable Securities 2.3.10. Capital / Financial Leases 2.3.11. Operating Leases 2.3.12. Pension Liabilities 2.3.13. Financial Fixed Assets 2.3.14. Contingent Liabilities 2.4. Special Situations 2.4.1. Dividend Distributions to Selling Shareholders 2.4.2. Earn-Outs 2.4.3. Tax Basis Step-up
59 59 59 59 59 59 60 60 60 61 61 61 61 61 62 63 63 63 64 64 64 65 65 66 66 66 66 67
3.
Compacq Analysis Output 3.1. Cross Checking the Results 3.2. Standard Output 3.3. Sector Specific Multiples
67 67 67 67
4.
Common Pitfalls
68
5.
Example 5.1. Step 1: Information Gathering 5.2. Step 2: Filling in the Qualitative Columns 5.3. Step 3: Prepare LTM Income Statement 5.4. Step 4: Calculate Consideration Paid and Assumed Liabilities 5.4.1. Calculation of Equity Consideration 5.4.2. Calculation of Enterprise Value 5.5. Step 5: Calculate Industry Specific Multiples 5.5.1. Calculate Adjusted Enterprise Value 5.5.2. Calculate EBITDAR 5.5.3. Resulting Multiples
68 68 68 69 69 70 71 71 71 71 72
Valuation Matrix
4
57 57 58 58
75
1.
Overview 1.1. Objectives 1.2. What Is a Valuation Matrix? 1.3. What Is a Valuation Matrix Used For? 1.4. What Is Needed to Complete a Valuation Matrix? 1.5. What Does a Valuation Matrix Look Like?
75 75 75 75 75 75
2.
How to Complete a Valuation Matrix 2.1. Getting Started 2.1.1. Select Appropriate Sources of Information 2.1.2. Setting Up a Valuation Matrix 2.2. Common Inputs and Outputs 2.2.1. Range of Offering Prices / Company Values 2.2.2. Time Periods
78 78 78 78 78 78 78
2.3.
2.2.3. Multiples General Valuation Matrix Steps
78 78
3.
Common Pitfalls
80
4.
Case Studies 4.1. Merger Application 4.2. IPO Application
82 82 85
Merger Consequences Analysis 1.
93
Overview 1.1. What is the Analysis? 1.1.1. Description of the Analysis 1.1.2. Why is it Used? 1.2. What Information is Needed to Complete the Analysis? 1.2.1. Form of Consideration (Cash, Stock, Mix) 1.2.2. Stock Prices / Transaction Value 1.2.3. Buyer / Target’s P&L / Balance Sheet / Cash Flow Historical and Projected Statements 1.2.4. Buyer’s and Target’s Fully Diluted Number of Shares 1.2.5. Post Transaction Capital Structure 1.3. What does a Merger Consequences Analysis Look Like?
93 93 93 93 93 94 94
How to Complete a Merger Consequences Analysis 2.1. Key Aspects of the Analysis 2.1.1. Merger vs. Stock vs. Asset Purchase 2.1.2. Considerations on Accounting Treatment – IFRS Regime – and Tax Implications 2.1.3. EPS Accretion / Dilution 2.1.4. Adjustments in the Merger Plans 2.1.5. Advanced Themes 2.2. What are the Inputs / Where Do I Find the Information? 2.3. Mechanics of the Analysis 2.3.1. Steps of Merger Model Mechanics
96 96 96 97 98 98 101 105 105 105
3.
Common Pitfalls 3.1. Calendarisation 3.2. Currency 3.3. Goodwill Impairment Treatment / Deductibility 3.4. Financing Costs and Expenses 3.5. Options and Other Dilutive Securities 3.6. Dividend Policy 3.7. Synergies 3.8. Lack of Footnotes 3.9. Sanity Check of the Outputs
106 106 106 106 106 107 107 107 107 107
4.
Examples 4.1. 100% Cash Transaction 4.2. 100% Stock Transaction 4.3. 50% Stock / 50% Cash Transaction 4.4. Acquisition of Minority Stake in a Consolidated Company
107 109 110 111 112
5.
Case Studies 5.1. Pro Forma EPS With Different Forms Of Consideration 5.1.1. Assumptions 5.1.2. Required Analysis 5.1.3. Transaction Prices 5.1.4. Scenarios 5.2. EPS and Balance Sheet Impact 5.2.1. Assumptions 5.2.2. Required Analysis
114 114 114 114 114 114 115 115 116
2.
Contribution Analysis 1.
Overview 1.1. Definition of Contribution Analysis 1.2. Why is it Used? 1.3. What Information is Needed to Complete a Contribution Analysis? 1.4. What Does a Contribution Analysis Look Like?
95 95 95 95
121 121 121 121 121 122
5
2.
How to Complete a Contribution Analysis 2.1. Key Aspects of the Analysis 2.2. What are the Inputs? 2.3. Mechanics of the Analysis
122 122 123 123
3.
Common Pitfalls
124
4.
Case Study 4.1. Case Study Inputs 4.2. Answer These Questions
124 125 125
Discounted Cash Flow Analysis 1.
Overview 1.1. What Is The DCF Analysis? 1.2. Why Is It Used? 1.3. What Information is Needed to Complete the Analysis? 1.4. What Does a DCF Look Like?
129 129 129 129 129
2.
How to Complete a DCF Analysis 2.1. Key Steps of a DCF Analysis 2.1.1. Forecasts 2.1.2. Terminal Value 2.1.3. Discounting / Present Value 2.1.4. Enterprise Value vs. Equity Value 2.1.5. DCF Matrix 2.1.6. Sensitivity Analyses 2.2. What Are the Inputs / Where Do I Find the Information? 2.3. What is the Output? 2.4. Mechanics of the Analysis – Best Practices 2.4.1. Time Effects in Discounting 2.4.2. Terminal Value 2.4.3. WACC 2.5. Selected Special Valuation Issues / Enterprise Value Adjustments 2.5.1. Non-Operating Assets / Cash Flows 2.5.2. Minority Interest 2.5.3. Preferred Equity 2.5.4. Under-Funded Pension And Other Post-Retirement Liabilities 2.5.5. Provisions 2.5.6. Employee Stock Options 2.5.7. Operating Leases 2.5.8. Deferred Taxes 2.5.9. Bank Valuation – Equity Cash Flow / Dividend Discount Model 2.5.10. Valuation Across Currency Borders – Special Considerations 2.6. How to Interpret the Results
131 131 131 134 135 135 136 136 137 137 138 138 140 145 151 151 152 152 152 153 154 154 155 155 156 157
3.
Helpful Hints 3.1. Sense-Checking Results 3.2. Surviving the MDR/DIR/VP “Grilling”
157 157 158
4.
Example
159
Leveraged Buy-Out Analysis
6
129
169
1.
Overview 1.1. What is a Leveraged Buy-Out (“LBO”)? 1.2. What Is A Financial Sponsor? 1.3. Value Creation in LBOs
169 169 169 172
2.
How to Complete a LBO Analysis 2.1. Main Characteristics of a Suitable LBO Target 2.2. Simplified Acquisition Structure Overview 2.3. Sources & Uses of Funds / Capital Structure 2.4. How To Assess Maximum Leverage 2.5. Exit Strategy 2.6. LBO Model Inputs & Outputs
173 173 174 174 176 177 177
3.
How To Use and Interpret a LBO Analysis 3.1. Exit Multiples 3.2. Investment / Exit Horizon
178 178 178
3.3. 3.4.
Choice and Use Of Projections Interpretation of IRRs
178 178
4.
Common Pitfalls
179
5.
Example 5.1. The Amadeus Global Travel Transaction Example 5.1.1. Company Presentation 5.1.2. Key Transaction Considerations 5.1.3. Financial Projections 5.1.4. Equity Returns
180 180 180 180 183 183
6.
Case Study
184
Credit and Debt Capacity Analysis
187
1.
Overview of Credit Analysis 1.1. Introduction to Credit Analysis 1.2. Key Tenets for Analysing Credits and Debt Capacity 1.3. Structuring Considerations, Security, Covenants and Tenor 1.3.1. Overview 1.3.2. Security and Ranking 1.3.3. Covenants 1.4. Key Products 1.4.1. Overview for Non-Investment Grade Debt 1.4.2. Overview of Investment Grade Debt 1.4.3. Other Products 1.5. Credit Related Analyses 1.5.1. Overview of Debt Comparable Company Analysis 1.5.2. Key Credit Ratios and Metrics 1.5.3. Sources and Uses 1.5.4. Capitalisation Table 1.6. Issues to Consider 1.6.1. Key Aspects of the Analysis 1.6.2. Sources of Information 1.7. Common Pitfalls 1.8. Credit Comparables and Term Sheet Examples 1.8.1. Credit Comparables Example 1.8.2. Summary Term Sheet Examples
187 187 187 188 188 188 190 191 191 192 193 193 193 194 194 195 196 196 196 196 197 197 198
2.
Overview of Ratings Analysis 2.1. Overview 2.1.1. The Role of the Rating Agencies in the Financial Markets 2.1.2. The Rating Scale 2.1.3. Ratings Definitions 2.2. Rating Methodology 2.2.1. Fundamentals of Credit Analysis for Ratings 2.2.2. Financial Analysis: Key Credit Ratios 2.2.3. Interpretation of Key Ratios 2.2.4. Information Requirements for Ratings Analysis 2.2.5. Suggested Outline of a Ratings Presentation 2.3. Distinguishing Ratings of Issuers and Issues 2.3.1. Notching Guidelines for Debt Ratings 2.3.2. Bank Loan Rating Methodology 2.4. Equity Credit: What It is and How an Issuer Gains It 2.4.1. What is Equity Credit? 2.4.2. Equity-Like Features of Hybrid Securities 2.5. Common Pitfalls 2.5.1. Operating Lease Analytics 2.5.2. PIK Instruments 2.5.3. Post-Retirement Obligations
201 201 201 201 202 202 202 204 206 206 207 207 207 208 209 209 209 209 209 210 211
7
Introduction
9
Introduction The Investment Banking Department Analysis Handbook is a practical guide on valuation techniques for analysts and associates at Credit Suisse. It introduces approaches and Credit Suisse preferred methodology for financial analysis. The handbook assumes little or no experience conducting the analyses covered and can be used as a step-by-step guide when preparing analyses for the first time. This is the first edition of the Investment Banking Department Analysis Handbook and feedback from the Firm’s analysts and associates is essential to make it a success and become an integral part of both the fulltime and summer analyst and associate programmes. Please provide feedback to the Analyst and Associate Programme Manager. The Investment Banking Department Analysis Handbook could not have been completed without the hard work and commitment of the following Credit Suisse employees: Ronan Agnew, Giuseppe Baldelli, Gemma Barclay, Alastair Blackman, Jane Brean, Stephen Carter, Bruno Delmas El-Mabsout, Didier Denat, Gabor Illes, James Janoskey, Ishan Kaul, Daniel Lawrence, Pierrick Morier, Jeff Murphy, Edouard Muuls, Guy Noujaim, Antonio Occhionero, Gianluca Ricci, Anastasia Sakellariou, Martin Schmidt, Piotr Skoczylas, Nishan Srinivasan, Flavio Stellini, Cathy Topping, Marc-Oliver Thurner, Alexander Voronyuk, Matthew Wallace, Jens Welter and Klaus Wuelfing. Their dedication to the book and the training and development of analysts and associates has been invaluable.
Christopher Horne Chief Operating Officer, IBD Europe
11
Comparable Companies Analysis
13
Comparable Companies Analysis 1.
Overview
This chapter addresses the following: „ What is the purpose of a Comparable Companies (“Compco”) analysis? What it is used for? „ How should companies be selected for Compco analysis? „ What are the common ratios used in Compco analysis? How are they calculated? „ Which accounting and tax issues affect Compco analysis? „ What are the current best practices for Compco analysis? „ When should pro forma Compco analysis be prepared? How should the pro forma adjustments for various events be made? „ What are the tricks for completing an error-free Compco analysis? „ What are the common pitfalls of Compco analysis? How can they be avoided? „ How should the results of Compco analysis be interpreted?
1.1.
Definition of Compco Analysis
Compco analysis involves comparing and/or applying multiples or yields of publicly traded companies. These multiples or yields are ratios of valuation metrics such as Enterprise Value or Market Capitalisation (“Market Cap”) and comparable profitability metrics such as EBITDA or Net Income, respectively. The main purposes of such comparisons are to perform relative valuations of public companies or to generate benchmarks for the valuation of private businesses. Compco analysis is commonly used in the following situations: „ To determine how a public company is valued compared with its public peers (i.e. if it is over- or undervalued by the market in comparison with similar, listed companies) „ To value a private / limited liquidity company (where market valuations are often distorted) or an unlisted subsidiary of a company „ As a potential sub-set of the above, to perform a sum-of-the-parts valuation of a company (i.e. where the business divisions that make up the company are diverse in business profile, and revenue model, and, therefore, require different types of comparison) Compco analysis can also be used to assess how relatively cheap or expensive a particular sector is in comparison with others.
1.2.
Where Does Compco Analysis Fit into Overall Valuation Analysis?
It is not only vital to understand the Compco analysis itself but also how it fits into the overall valuation exercise. To avoid inappropriate conclusions, which could arise from simply using market data, it is important to apply other valuation techniques in conjunction with Compco analysis. When considering Compco analysis it is important to bear in mind the following: Overall Market Context: Compco analysis provides a market-based valuation. Therefore, to the extent that the market is over- or under-valuing an asset, the Compco analysis will reflect this and will mirror these market biases (e.g. take-over speculation). For example, during the “tech boom” of 2000, the market often valued technology stocks at extremely high multiples (see the following chart) and often higher than their fundamental Discounted Cash Flow (“DCF”) valuation. Today, given the benefit of hindsight, “tech boom” multiples, though market determined, were irrationally high.
15
Comparison of Forward Multiples Over Time Historical Valuations – 1 Year Forward Enterprise Value / Revenue March 2000
3.1%
3.3%
3.1%
5.5%
5.6x
3.4x
1.3x
3.6x
Lycos Europe
Lastminute.com
32.7% 17.6%
Tiscali
As % of March 2000 multiple 104.3x
Terra Lycos
107.0x
March 2002
65.4x 54.1x 42.0x
eBay
Lastminute.com
Lycos Europe
Tiscali
Terra Lycos
Yahoo!
eBay
13.7x
US Source:
9.5x
Yahoo!
41.9x
Europe
Factset
Relative Valuations of Sectors: As highlighted above, Compco analysis is often used to benchmark sectors against each other in order to analyse their relative valuations. However, comparability can be significantly impaired by structural differences between sectors in a range of areas including inter alia, risk and growth profile, cyclicality, seasonality, different accounting treatments, fiscal rules, technology life cycle and cash conversion. Later in this chapter, key adjustments, and their respective rationales, will be discussed and highlighted in detail. Comparability of Comparables or Peers: A Compco valuation is only as good as its set of comparable companies. To obtain an accurate valuation of a target company (the company for which the multiples are being calculated) it is critical to identify a set of listed peers that are truly comparable. Not only should the comparable companies typically be in the same sector, ideally they should also be comparable in terms of market position, size, growth rates and margins. Whilst perfect comparables never exist, benchmarking can identify the closest comparables that, with appropriate judgement, can be used in valuation analysis. Availability of Information: In many situations, insufficient information is available to generate the long-term forecasts required for a DCF valuation. The Compco analysis requires less forecast data. Minority Valuation: The Compco-based valuation provides a minority valuation of a company, since it is based on traded shares where control is not being transferred. This makes it particularly suitable for valuations in IPOs, secondary offerings, minority buy-outs and other transactions which do not involve transfer of control of the company. Both DCF and comparable acquisitions of majority stakes analysis include a control premium embedded in their valuation.
16
Key Pros and Cons of the Compco Valuation Methodology Pros
Cons
p
q
p p p
Based on market benchmarks and, therefore, less dependent on subjective assumptions Commonly used and easily understood by most investors and boards Ideal for minority stake trading valuation (including IPO analysis) Can be used as a quick, “back of the envelope” valuation tool to support a detailed company specific approach (e.g. DCF)
q q q q
1.3.
Key Concepts for Compco Analysis
1.3.1.
Consistency
Affected by short-term market forces (e.g. bid speculation) Difficulty in selecting best comparables Availability of good quality short-term financial forecasts Inaccurate, unless adjustments are made (illustrated in this chapter) Unless placed in the context, does not always accurately account for the long-term business performance (i.e. growth beyond initial years)
It is important to consider that some valuation measures apply only to equity holders (for example, Market Cap), while others apply to all stakeholders (debt holders, minorities and equity holders). At different stages of the life cycle of a business (e.g. start-up, growth, maturity and decline) different metrics gain in relative importance when assessing value. For start-up businesses, with negative or very low EBITDA / earnings, the standard multiples are less relevant. On the other hand, for mature businesses with less growth, but greater EBITDA / earnings, and lower capital expenditure, cash flow multiples are more relevant. „ Enterprise Value based multiples: metrics such as Revenue, EBITDA and EBITA apply to all investors and, therefore, should be used with Enterprise Value „ Market Value based multiples: metrics such as Profit before Tax, Profit after Tax and Net Income (post minorities) are calculated once the cost of debt has been taken into account. Therefore, when used for the purpose of calculating multiples, they should be used with a valuation which only applies to equity holders, namely Market Cap „ Yields: when appropriate financial metrics are divided by Market Cap, the ratios are known as yields (i.e. a summary measure of cash flows that equity holders expect in any given year relative to current market equity value of the company). Unlike multiples, these are commonly presented as percentages. Examples of yields are Dividend Yield and Free Cash Flow (“FCF”) Yield. (See the Discounted Cash Flow Analysis chapter for a discussion on levered and unlevered FCF)
1.3.2.
Full Range of Multiples
Where possible, it is important to analyse a number of different multiples, as a given company may look relatively cheap or expensive depending on which multiple is considered. For example, a company might look cheap based on a comparison of EBITDA multiples, but expensive based on a comparison of Price / Earnings (“P/E”) multiples, purely as a result of higher investment in fixed assets (and corresponding higher levels of depreciation), higher net interest and/or higher tax rate. P/E multiples account for differences in capital structure, tax base and asset base. Other multiples focus more narrowly on operating items. The EBITDA multiple, for example, excludes all non-operating differences (e.g. depreciation). Similarly, cash flow metrics such as EV / (EBITDA – Capital Expenditure (“Capex”)) or Market Cap / FCF, reveal how comparatively cheap or expensive a company is, in terms of its ability to generate cash-flow (important for companies that have heavy capital expenditure requirements, which are not adequately captured by Profit and Loss (“P&L”) metrics). In the following example, Mobinil appears cheap or in-line with peers on an EBITDA basis, but expensive on an (EBITDA – Capex) basis.
17
VOD
TEM
MOBINIL
COS
2006
5.9x
7.6x
4.9x
8.9x
6.8x
2007
5.6x
6.8x
5.0x
8.3x
6.4x
Mobinil trades on lower EBITDA multiples than the average
Average
EV / EBITDA
On a EV / (EBITDA – Capex) basis, it trades at higher multiples
EV / (EBITDA – Capex) 2006
9.0x
11.3x
28.7x
20.5x
17.4x
2007
8.3x
9.4x
25.7x
14.4x
14.5x
1.3.3.
Forward Looking Nature of Compco
Companies are valued by the market on the basis of expected future growth. For example, in order to value a company today, investors (as of the date of publication in August 2006) would look at EV / 2006 Expected EBITDA or EV / 2007 Expected EBITDA. While less important from a valuation point of view, Compcos are often analysed on a LTM basis – ratio of Market Cap or Enterprise Value to the previous 12 month’s operating metric (e.g. EV / LTM EBITDA). Commonly Used Multiples and Key Pros / Cons Multiple / Yield
Pros
Cons
EV / Revenue
p
q
Does not account for profitability, cash flow generation, etc.
q
Fails to fully capture ability of business to generate cash, especially important in businesses with heavy fixed asset investments Does not capture tax differentials
p p
EV / EBITDA
p p p
p
EV / EBITA
p
Easily obtainable information Not subject to many accounting differences Not influenced by capital structure Generally easily obtainable information Proxy for cash-flow generation Avoids distortion due to accounting rules relating to non-cash items such as D&A Relates value to profitability Potentially a closer cash-flow proxy, as depreciation is a proxy for capex
q
q q q
P/E
p p p
Effective for companies in the same sector and same country Easily obtainable information Captures all operating variations between companies (including tax)
q
q
q
EV / (EBITDA – Capex)
p p
Relates value to ability to generate cash Not affected by capital structure
q
q
Dividend / Market Cap (commonly known as Dividend Yield)
p
FCF / Market Cap (commonly know as Free Cash Flow Yield)
p
18
p
p
Relates value to cash distribution to shareholders Useful for analysing dividend policy (e.g. IPO situation) Relates value to ulitimate cash generation ability Accounts for tax related and working capital charges in addition to Capex
q
q q q q
Capex and depreciation can differ materially Can be impacted by differing depreciation policies Does not capture tax differentials Comparability might be limited due to different accounting rules, especially in cross-border situations Need to adjust for one time / nonrecurring items, which can distort earnings Affected by capital structure Comparability may be limited by the fixed asset roll-out strategy / cyclicality Ignores tax and working capital differentials Entirely dependent on distribution policies and entirely ignores buy backs Less relevant for growth stocks Impacted by one-off items Affected by capital structure Normally requires greater number of adjustments to be calculated
Exercise: Consider the following multiples and determine if they are consistent and why. If they are not consistent, suggest correct alternatives. Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set. „ Dividend / Market Cap (Dividend Yield) „ FCF / Enterprise Value „ Market Cap / (EBITDA – Capex) „ Market Cap / EBITDA „ Enterprise Value / Dividend
1.3.4.
Uniformity
It is important to apply a consistent multiple definition across the set of peers to ensure proper comparability. For example, if pension liabilities were included in the Enterprise Value for only some of the comparables, it would be impossible to accurately compare and derive valuation benchmarks from them. In this case, comparables excluding pension liabilities should be adjusted accordingly. Similarly, it is important to use the same definition of the P&L item (e.g. EBITDA). For example, TV broadcasting companies have different accounting approaches to the treatment of the costs / expenses of Programming Rights. The same is true of the way some consumer companies treat brand and marketing expenditure (e.g. beer mats and umbrellas for beer companies). Some companies treat these expenditures as an operating cost, whilst others capitalise the rights as part of their assets (intangibles) and amortise them over time. In the latter case, EBITDA would be artificially high when compared to the former. On a multiple comparison basis, all other things being equal, the latter case would make the company look cheaper than the former. To make the approach truly uniform, for example, programming rights amortisation / brand expenditure should be added back to operating costs (as a proxy for the operating costs) for all peers (and reduce EBITDA).
1.3.5.
Correlation
Relative valuation is theoretically correlated to the growth prospects of a company. Therefore, all other things being equal, if the target company has growth comparable to the high end of the comparables set, it should logically enjoy a valuation towards the high end of the comparables set. A regression analysis of the 2 year forecast EBITDA Compound Annual Growth Rate (“CAGR”) versus 2 valuation multiple would typically show a strong correlation (high R ). This is because, investors are usually willing to pay more for companies with higher growth prospects. However, it is important to bear in mind that growth will not always be the most important driver. The other critical factor to consider for an investor is the risk attached to actually achieving the expected / forecast growth. Therefore, conceptually, multiples can be considered as 1/(i – g), where i = risk of the stock and g = expected future growth. Other things remaining constant (including relative growth forecasts between the companies), the multiple for a higher risk stock will be lower and for a lower risk stock the multiple will be higher. Inherent risk is, therefore, one of the critical reasons why stocks with similar growth profiles trade differently. Other factors that could affect valuation are as follows: „ Low liquidity of stock (without a free and regular trade of a stock, valuations can become distorted) „ Operating factors, such as number, and strength, of competitors and barriers to entry „ Rights attached to shares (all other things being equal, a class of share with greater voting rights attached to it should trade at a premium to a class of share with less voting rights) „ In some sectors, valuation is strongly correlated to scale or other factors
19
Regression Analysis: EV / Sales ‘06E vs. Sales CAGR (‘06E - ’08E) 4.0x
EV / Sales ('06E)
3.5x
R2 = 98.3%
3.0x 2.5x 2.0x 1.5x 1.0x 0.5x 0.0x 0%
2%
4%
6%
8%
10%
12%
Sales Growth ('06E-'08E) Note:
1.3.6.
Dummy numbers
Relevance of Multiple
Aside from assuming basic uniformity and consistency in the application of numbers, it is important to ensure that any multiple being used as a valuation benchmark is relevant to the target company – judgement and common sense is required for this. For example, companies that have only recently been established may have negative or slightly positive EBITDA, which would be likely to make this metric meaningless from a Compco perspective.
1.4.
Selection of Comparable Companies
The following sources are available to assist in the selection of the comparable companies set: „ Equity research reports usually contain a Compco analysis showing the comparables used by the analyst. Equity research can be obtained from: § Research & Analytics (http://research-and-analytics.csfb.com) § Thomson Financial § Multex „ Bloomberg lists the key competitors in each sector which could form a basis for a set of comparables „ Colleagues – those that have been involved in precedent work in the sector and especially those that have sector experience „ Annual reports – companies often benchmark relative share price performance
1.5.
Specific Sector Multiples
Compco analysis should be conditioned to the particular sector. As mentioned previously, due to the various operating and financing structures observed in different sectors, the same operating parameters cannot necessarily be applied across all companies / sectors for a multiples based valuation. For example, in businesses where capital expenditure is lumpy (such as for lottery companies which typically sign long-term contracts with governments to provide services – capital expenditure occurs when these long-term contracts begin) it may be preferable to use EBITA, as depreciation smoothes out the Capex spend over the period of the contract, whereas with a cash-conversion multiple such as EBITDA – Capex, may be affected by the lumpy nature of Capex spend (absent any normalisation adjustment). The following table illustrates selected industry specific multiples. Consult industry bankers for the appropriate metrics when preparing Compco analysis.
20
Selected Industry-Specific Multiples Multiple
Sector
Comments
EV / Revenue
Various
„ Early stage companies
EV / Subscriber
Various
„ Subscriber based businesses, such as Cable and Direct
EV / EBITDA
Various
„ Many Industrial and Consumer industries, but not
To Home (DTH) Banks, Insurance, Oil & Gas and Real Estate EV / EBITA
Various
„ Commonly used in several Media industry sub-sectors,
Gaming, Chemicals and Bus & Rail industries „ Used when EBITDA multiples are less relevant due to
significant differences in asset financing (e.g. mix of leases, rentals, ownership) EV / EBITDAX
Oil & Gas
„ Excludes exploration expenses
EV / EBITDAR
Retail, Airlines
„ Used when there are significant rental and lease
expenses incurred by business operations EV / Reserves
Oil & Gas
„ Used when looking at Oil & Gas fields and companies
heavily involved in upstream „ Gives an indication of how much the field is worth on a
per barrel basis Oil & Gas
„ For producing fields, gives value on a barrel per day
Ports
„ For container ports, gives value per tonne of cargo
Airports
„ For airports, gives value per passenger through airports
EV / Capacity
Oil & Gas
„ For refiners, gives a value metric in terms of barrel per
Market Cap / Book Value (“P/BV”)
Technology / Banks / Insurance
„ Used for Semiconductor industry
EV / Production
production basis handled
day of refining capacity „ Book value of equity is used since there can be
significant earnings fluctuation in this sector „ Bank’s shareholders equity is important because it is
looked at as a buffer / protection for depositors EV / FFO(1)
Real Estate
„ Principally used in the US
P/E
Various
„ Often using normalised cash earnings, excluding both
exceptional items and goodwill amortisation (2)
PEG ratio
High Tech, High Growth
„ Big differences in growth across companies
(EV/EBITDA)/EBITDA CAGR(3)
High Growth
„ Used in Specialty Retail industry and when valuing
emerging markets IPO candidates „ Big differences in growth across companies
(1) Where FFO represents Funds From Operations (2) Where the PEG Ratio represents (P/E) / Earnings Growth Rate (3) Where CAGR represents Compound Annual Growth Rate
21
1.6.
Frequency of Updates
The table below provides a guide as to when the various components of the data in a Compco should be updated. Compco Item
Source(s)
Frequency
Share Price
Factset, Bloomberg
Daily
# of Shares Outstanding
Company accounts / website, RNS announcements (UK companies only), Bloomberg, Equity Research
Quarterly or as appropriate
Options Outstanding
Company accounts obtainable from website or Thomson Financial
Annual
Balance Sheet Data
Company accounts obtainable from website or Thomson Financial
Quarterly
Book Value of Minorities
Balance Sheet
Quarterly
Market Value of Minorities
Factset or Bloomberg if publicly traded, brokers’ Sum-of-the-Parts if unlisted
Fortnightly or as appropriate
Income Statement Data (Actual)
Company accounts obtainable from website or Thomson Financial
Quarterly
Income Statement Data (Forecasts)
Forecasts obtainable from equity research reports (accessible from Thomson Financial or Multex)
Fortnightly
Cash Flow Statement Data (Actual)
Company accounts obtainable from website or Thomson Financial
Quarterly
Cash Flow Statement Data (Forecasts)
Forecasts obtainable from equity research reports (accessible from Thomson Financial or Multex)
Fortnightly
Debt Rating
SDC, S&P or Moody’s Reports, Bloomberg
Quarterly
M&A
Company Press Releases, As appropriate Mergermarket, Equity Research, SDC Note: Company accounts will be referred to as 10-K for annual report and 10-Q for quarterly reports in U.S. filings
22
1.7.
Formatting
1.7.1.
Overall Formatting of Output
As the Compco output will be used by others, it is important that the output sheet contains all information and is formatted in a user-friendly way.
1.7.2.
Pages and Tables
Both output and input pages of the Compco file should be formatted to print. Typically, pages should be set up using font size no smaller than 8. In terms of tables, one year of historical multiples (representing LTM period) and at least two years of forward multiples should be shown. Also included on the output sheet should be the following: „ Relevant growth rates and CAGRs (for forecast years) „ Margins „ Share price „ Share price as % of 52 week high „ Market Cap „ Net Debt and other adjustments
1
„ Enterprise Value
1.7.3.
Names
The Compco analysis should always be neatly labelled, including the following: „ Name of sector / sub-sector „ Names of the companies § The comparables should be segregated according to any sub-categories (e.g. small cap vs. large cap or emerging market vs. mature markets) or alphabetically, depending on the circumstance and personal preference
1.7.4.
Notes and Sources
The output page should always include the sources used in completing the Compco analysis. The broker and the date of the report used should always be noted. Whenever any adjustment is made, it is essential that this be noted on the output page. Again, include the source used for making the adjustment and the reason for the adjustment.
1
For example: Minorities
23
Illustrative Compco Output Comparable Company Multiples – Mature Incumbents Industry (€ in millions, except per share amounts – calendarised for 31 Dec YE) Belgacom Country
Belgium
Deutsche Telekom
Eircom
France Telecom
UK
Germany
Ireland
France
BT Group
KPN
OTE
Netherlands
Greece
Portugal Telecom
Swisscom
Portugal
Switzerland
Telecom Italia
Telefonica
Telekom Austria
Telenor TeliaSonera
Italy
Spain
Austria
Norway
Sweden 46.20
Median
Stock Price (Local currency)
26.00
2.15
13.82
2.14
18.63
9.33
19.16
9.91
410.00
2.28
12.85
19.75
80.25
Local currency
EUR
GBP
EUR
EUR
EUR
EUR
EUR
EUR
CHF
EUR
EUR
EUR
NOK
SEK
(15.8%)
(9.2%)
(16.2%)
(12.7%)
(27.9%)
(5.8%)
(0.8%)
(5.1%)
(5.5%)
(18.2%)
(9.3%)
(4.7%)
(2.1%)
(9.0%)
(9.2%)
4.0%
9.5%
8.0%
43.4%
5.9%
47.6%
39.4%
35.2%
5.7%
2.7%
5.7%
34.7%
64.1%
30.1%
9.5%
8,957
26,470
57,991
2,300
49,118
19,592
9,415
11,187
14,906
42,374
61,713
9,505
17,475
21,369
Stock price to 52 week high Stock price to 52 week low (1)
Market Value - Actual + Financial Debt
(1)
-
16,001
44,647
2,588
53,225
9,981
3,440
7,584
1,476
39,351
55,332
3,344
3,995
2,375
(534)
(4,161)
(6,008)
(495)
(5,211)
(1,041)
(1,512)
(3,912)
(656)
-
-
(139)
-
(2,002)
(1)
8,423
38,310
96,630
4,393
97,132
28,532
11,343
14,859
15,726
81,725
117,045
12,709
21,469
21,742
(1)
8,423
38,310
96,630
4,393
97,132
28,532
11,343
14,859
15,726
81,725
117,045
12,709
21,469
21,742
508
844
3,774
578
2,519
1,034
694
1,912
840
-
-
95
225
171
1,664
-
4,795
-
11,543
257
3,556
2,141
1,888
381
8,015
21
2,873
3,561
- Cash and Cash equivalents
(1)
Enterprise Value - Actual
Enterprise Value - Actual
+ Unfunded Pension Liability + MV of Minorities - MV of Uncons.Associates
-
(393)
(1,300)
-
(876)
-
(368)
(1,022)
-
(3,266)
(2,264)
(5)
(3,338)
(6,006)
10,595
38,761
103,899
4,972
110,318
29,823
15,224
17,889
18,454
78,840
122,796
12,820
21,229
19,468
2006
5.0x
4.8x
5.1x
7.9x
5.8x
6.4x
7.1x
7.6x
7.1x
5.9x
6.2x
6.5x
5.6x
5.5x
5.9x
2007
5.2x
5.0x
5.0x
7.3x
5.7x
6.4x
6.4x
7.3x
7.2x
5.7x
6.0x
6.5x
5.3x
5.3x
5.7x
2008
5.3x
5.3x
4.9x
7.2x
5.6x
6.5x
6.0x
7.1x
7.3x
5.6x
5.8x
6.4x
5.2x
5.4x
5.6x
2006
6.9x
10.5x
9.4x
13.6x
9.1x
10.3x
16.5x
12.2x
10.3x
9.1x
9.9x
9.6x
17.3x
9.1x
9.9x
2007
7.0x
11.7x
8.9x
12.1x
9.1x
10.3x
11.5x
10.7x
10.6x
8.3x
9.2x
9.3x
12.6x
8.3x
9.3x
2007
7.1x
11.9x
8.6x
11.7x
8.8x
10.2x
9.9x
10.3x
10.9x
8.0x
8.7x
9.1x
11.3x
8.3x
9.1x
2006
10.8x
10.9x
13.2x
17.0x
10.4x
15.5x
24.3x
21.0x
13.2x
14.1x
11.7x
18.4x
16.0x
11.9x
13.2x
2007
11.5x
11.9x
13.7x
11.7x
9.7x
14.9x
15.1x
16.7x
13.6x
12.7x
11.4x
15.5x
14.8x
11.6x
12.7x
2008
11.7x
12.9x
14.0x
10.5x
9.0x
14.9x
12.6x
15.1x
13.9x
11.6x
10.3x
13.6x
15.0x
11.9x
12.6x
2006
10.7%
7.5%
10.8%
9.2%
13.9%
11.1%
5.4%
6.2%
7.2%
10.7%
11.9%
10.7%
1.7%
7.7%
10.7%
2007
10.6%
6.3%
11.2%
11.4%
13.9%
10.6%
10.2%
8.2%
7.3%
12.3%
12.9%
11.2%
2.9%
8.7%
10.6%
2008
10.7%
5.9%
11.6%
12.2%
14.4%
10.5%
12.3%
8.7%
6.9%
12.5%
14.1%
11.6%
4.0%
9.0%
11.6%
Adjusted Enterprise Value Adjusted Enterprise Value / EBITDA
Adjusted Enterprise Value / (EBITDA - Capex)
Price / Earnings
Equity FCF Yield
Methodology (1) Actual Market Value, Financial Debt, Cash and Cash equivalents and Enterprise Value are based on information from latest available financial statements adjusted for any further transactions taken into account in the forecasts. Market Value reflects fully diluted shares outstanding on a treasury method basis. Financial Net Debt reflects consolidated group net debt and is calculated as short- and long-term interest bearing liabilities less cash and equivalents. Convertible securities are included in Debt until actually converted (i.e. excluded for calculation of fully diluted shares outstanding).
2.
How to Complete a Compco Analysis
2.1.
Sourcing Data – Market Cap
2.1.1.
Share Price
„ The share price is obtained from Factset. CS excel is linked to Factset directly and will download share price information automatically, provided the correct share ticker is linked „ Other sources for share price information, which could be used as crosschecks, are Bloomberg or Datastream, with the Financial Times also a potential source „ Certain companies have multiple classes of shares. To determine the Market Cap of these companies, the share price for shares in each class must be determined. Company Annual Reports disclose (usually in a note to the financial statement called Share Capital) the various share classes „ Share prices used should all be from the same date Example: Telecom Italia – Ordinary Shares and Savings Shares (€ in millions, unless specified)
Telecom Italia Stock price for ordinary shares Fully diluted ordinary shares outstanding (m)
€2.22 13,618
Savings shares current stock price
€1.98
Fully diluted savings shares outstanding
5,902
Market Cap
41,935
„ Certain companies have unlisted shares. While these shares might not be priced on a public market, they do form part of the total equity of the firm and should be included in the Market Cap. The share price of listed shares can serve as a proxy for the share price of unlisted shares. However, it is important to keep in mind that, in reality, there are usually differences in the voting rights assigned and dividend payout policies to various classes of shareholder, which might lead shares of different classes to trade differently
2.1.2.
Number of Shares
Shares outstanding is available from the latest financial statements of a company. The starting point for research should always be the company’s own official data, but if this information is not available in the interim statement and if the Annual Report is out of date, then press releases, equity research reports or Bloomberg can be used. For UK companies, RNS announcements are also a useful source of information. Shares outstanding can be shown in the following two ways: „ Basic: options, warrants and convertibles are not included; or „ Fully Diluted: assumes all exercisable in-the-money options, warrants and convertibles are exercised § Outstanding versus Exercisable Options: It should be noted that not all outstanding options are exercisable. It is common for companies to issue options with a vesting period (a minimum period of time during which they remain un-exercisable). Therefore, even if these options are technically inthe-money they can not be exercised if the vesting period has not expired. Since these options can not be exercised (even when technically in-the-money) they should not form part of the share capital of the company. Therefore, when calculating shares outstanding, only the exercisable options should be used in the fully diluted calculation. For valuation purposes, the fully diluted number of shares outstanding is almost always used. Shares resulting from exercisable options or convertibles that are in-the-money should be added to shares outstanding. Options are in-the-money if the strike price of these instruments is less than the current market price. This means that a holder of these securities would rationally exercise the option to realise a gain by selling in the market, as underlying shares are available at less than market price. Usually the notes to the financial statements in the Annual Report will illustrate the various tranches of options and 25
warrants, describing average strike price per tranche. Equivalent information will also be disclosed for convertible instruments. Weighted average shares outstanding is a measure of the average shares that were outstanding during a particular year. As with shares outstanding this can be basic weighted average shares or fully diluted weighted average shares (the latter assumes that all in-the-money options were exercised). During the course of the financial year, the company will typically have exercised options and/or convertible instruments, undertaken share buy-backs, rights issues, etc. It will rarely be the case that the number of shares outstanding will be the same for a company over the course of the year. Valuation occurs at a point in time rather than over a period of time (e.g. Market Cap refers to a point in time not a period). Therefore, shares outstanding and not weighted average shares should always be used for valuation purposes. Please note that it is convention to use price at close of the trading day to avoid any intra-day price fluctuations.
2.1.3.
Foreign Exchange Translation (P&L versus Balance Sheet Translation)
The CS Compco shell will automatically convert the financial statements of the various comparables to Euros (or any other currency needed), as long the correct exchange rate ticker is included. The CS template automatically downloads this information from Factset. P&L items (recorded over the financial year) should be translated at the average exchange rate for the financial year. Balance Sheet items should be translated at the exchange rate at the point that the Balance Sheet was recorded.
2.2.
Sourcing Data - Financial Statements and Financial Projections
2.2.1.
P&L and Cash Flow Statement
Historical information should be obtained from the company’s previous year-end Financial Statements. Financial Statements can be obtained from the company’s website or the Thomson Financial database. Forecasts are obtained from broker reports. It is advisable to use CS research, if CS covers that particular company. If CS research does not cover the company, another major broker can be used unless a smaller broker has particular insight into the company (e.g. if the smaller broker is also the company’s corporate broker for UK companies). Ideally, if not CS research, it is preferable to use a common broker for as many of the comparables as possible. In any event it is essential to benchmark the selected broker forecast (including CS) against consensus forecasts, such as I/B/E/S. For the purpose of the Compco analysis it is crucial that the forecasts used are representative of the market view. Therefore, even when a particular broker has detailed financial forecasts, these should not be used for the analysis if they are outliers compared with consensus forecasts. To obtain a CS research model the procedure is as follows: For European Companies The front page of each CS research report carries the name of the analyst covering that particular stock. „ The current process is set out below but please always check for changes in policy which may be put in place from time to time § Permission (via e-mail) must be requested from Richard Kersley, David Mathers or Debra Batey, before contacting the research analyst to obtain models § Once permission has been granted, the same e-mail (i.e. with the permission) should be forwarded to the research analyst requesting the model For US Companies „ US Equity research models may be downloaded (http://spider.app.csfb.net/nirvana.asp?Direct=Y)
26
via
the
Model
Repository
in
Spider
„ At times, European research analysts cover US listed companies (companies that operate in Europe but are listed in the US) and these may not be available on Spider „ For US listed models, analysts must be contacted via a LCD chaperone and not directly „ Paul Barry, Anna Marie Mottram or Katrina Glover from LCD should be requested to act as chaperones in the same email sent to Richard Kersley, David Mathers or Debra Batey requesting permission to obtain US models
2.2.2.
Consensus Forecasts
Rather than using an individual broker, for more detailed analysis it would normally be preferable to use consensus estimates. Factset can download consensus estimates from I/B/E/S directly onto the CS excel sheet. In addition to I/B/E/S, Multex also provide consensus forecasts for headline metrics. Note that consensus metrics from these sources include estimates of all brokers and, therefore, are affected by outliers. Build up consensus forecasts by using all available research notes and creating averages for each financial item (e.g. Revenues and EBITDA). Judgement should be exercised when creating a consensus from scratch to avoid distortions, which can arise from including outliers (e.g. bullish or bearish estimates). Judgement also needs to be exercised when compiling consensus numbers for outer years as, typically, there will be fewer brokers forecasting outer years – thus changing the basis of the consensus.
Pros
Individual Analyst Forecast
Consensus Estimates
p
p
p p
Cons (1) (2)
q
If using the same analyst for all companies, ensures consistency of underlying assumptions(1) Ensures transparency with respect to definition of key line items (e.g. EPS) Ability to select reputable brokers Selection may be an outlier
p
q
Broadest possible view, not affected by view of just one analyst Easily explained / justified
Includes effect of outliers unless manually computed(2)
For example, in the case of upstream oil and gas companies, the commodity price assumption This is particularly true of mean consensus. Consider using median instead
2.2.3.
Balance Sheet
Balance Sheet information should always be obtained from the latest financial statements issued by the company. Presentations to analysts and the press release that accompany interim statements may also provide supplementary information. Some companies may not disclose sufficient information to calculate Net Debt, neither in their interims nor disclosed separately. In this case, the numbers used by brokers should be applied and noted accordingly.
2.2.4.
Accounting Standards and Related Issues
Companies’ financials are not always comparable due to differing accounting rules under the different Generally Accepted Accounting Principles (“GAAP”). The following table highlights the main differences between IFRS and US GAAP. Some companies / brokers might show both local GAAP and IFRS restatement. In this case, it is preferable to use IFRS to facilitate comparability.
27
Key Differences Between IFRS and US GAAP Subject
IFRS
US GAAP
Extraordinary items
The use of the term extraordinary items is prohibited. IFRS otherwise allows flexibility in the presentation of line items - certain items may be separately identified
Defined as being both infrequent and unusual. Negative goodwill is presented as an extraordinary item
Cash flow statements – definition of cash and cash equivalents
Cash includes cash equivalents with short-term maturities (typically less than three months) and subject to insignificant risk of changes in value. May include cash overdrafts
Similar to IFRS, except that bank overdrafts are excluded
Revenue recognition
Based on several criteria, which require the recognition of revenue when risks and rewards have been transferred, revenue can be measured reliably, the selling entity no longer has control over the goods sold and it is probable that economic benefits from the transaction will flow to the selling entity. When delivering a service, which is not completed at the balance sheet date, the entity also needs to be able to measure the stage of completion of the transaction at the balance sheet date
Similar to IFRS in principle, based on four key criteria. Extensive detailed guidance exists for specific types of transactions
Employee benefits: pension costs – defined benefit plans
Projected unit credit method is used to determine benefit obligation and record plan assets at fair value. If the entity takes the corridor approach, actuarial gains and losses (which are less than 10% of the pensions’ assets or liabilities) can be deferred. Many UK companies take the option to recognize all actuarial gains and losses through equity as they arise. Plan assets value is market / fair value
Similar to IFRS but with several areas of differences in the detailed application
Acquired intangible assets
Capitalised if recognition criteria are met; amortised over useful life. The criteria for recognition are that it is probable that the expected future economic benefits of the asset will flow to the entity, and that the cost can be measured reliably. Intangibles assigned an indefinite useful life are not amortised, but reviewed at least annually for impairment. Revaluations are permitted in rare circumstances
Similar to IFRS, except revaluations are not permitted at all
Internally generated intangible assets
Research costs are expensed as incurred. Development cost is capitalised and amortised only when specific criteria are met
Research and development costs are expensed as incurred. Some software and website development costs are capitalised
Convertible debt
Convertible debt (fixed number of shares for a fixed amount of cash) accounted for on a split basis, with proceeds allocated between equity and debt. The fair value of the liability component is calculated first and the equity component is a residual
Conventional convertible debt is usually recognised entirely as a liability, unless there is a beneficial conversion feature
Note:
28
There are other differences – please refer to an accounting manual for a full list
2.2.5.
Calendarisation of Statements
Different companies have different financial year-ends. For example, many UK companies have a March year-end. For Compco analysis, the financials of all companies should be calendarised to a common year-end (typically December). In most situations, calendarisation is usually aligned with the year-end of the target company. It is important to note that forecast estimates may also require calendarisation. Remember to check the basis on which they are presented when completing the Compco analysis. In the example below, the company has a March year-end. To obtain December year end financials for 2006, 3 months from the financial year 2006 financials (or ¼) and 9 months from the financial year 2007 financials / forecasts (or ¾) are taken. As a formula, this would be: EBITDADec’06 = ¼ * EBITDAMar’06 + ¾* EBITDAMar’07 Calendarisation to December YE of a Company with YE March FY 2006 for a March YE company
FY 2007 for a March YE company
1/4 of FY 2006
Mar 2005
Dec 2005
3/4 of FY 2007
Mar 2006
Dec 2006 Mar 2007
FY 2006 for a December YE company
2.2.6.
LTM Financials
In certain cases (e.g. where forecast financials are unavailable for a publicly traded company) it is useful to consider the actual performance of the company over the last 12 months. To obtain LTM financials for a company that has released its 9-month results, the computation would be as follows: 2
EBITDALTM = EBITDA9m’05 + (EBITDA2004 – EBITDA9m’04) Similarly, to obtain LTM financials for a company that has released its 6-month results, the computation would be as follows: 3
EBITDALTM = EBITDA6m’05 + (EBITDA2004 – EBITDA6m’04)
2 3
to 30 September 2005 to 30 June 2005
29
2.2.7.
Adjustments to Financial Projections
Normalisation Since the objective of the Compco analysis is to arrive at the underlying value of a company, any effects that are temporary or one-off in nature should be stripped out, in order to prevent the generation of an inaccurate multiple. This is known as normalising financials. Typical normalisation items include: „ Restructuring charges „ Tax holidays „ M&A related annualisation „ Write-offs „ Redundancy payments „ Exceptional income / expenses, for example: § Impairment of goodwill § Gains or losses from asset sales § Pension gains § Unrealised gains or losses from hedging activities § Litigation or insurance settlements „ Discontinued operations „ Accounting changes
30
Example: Non-recurring Income / Charges (Exceptionals) The example below demonstrates a step-by-step approach to eliminating exceptional items from the Compco analysis to derive a normalised Compco: Step 1 – Identify the Exceptional Items (€ in millions, unless otherwise specified)
Note
2006
2007
2008
(11)
3,000
2,150
3,308
D&A
(200)
(210)
(221)
EBIT Net Interest expense
2,800 (75)
1,940 (79)
3,087 (83)
EBITDA
PBT
2,825
1,861
3,004
Tax expense
(1,090)
(745)
(1,202)
Tax rate
40.0%
40.0%
40.0%
1,635
1,117
1,803
Net income
Check notes for any exceptional items
Step 2 – Determine if the Exceptional Item Needs to be Tax Adjusted Note (11) Exceptional item included in EBITDA
2006
2007
2008
0
(1,000)
0
Exceptional cost included in EBITDA
Step 3 – Tax Affecting the Exceptional Item, if Required
Exceptional
2006
2007
2008
0
(1,000)
0
Tax rate
40.0%
Tax shield
(400)
Tax adjusted exceptional item
(600)
Pre-tax exceptional item will need to be tax affected before adjustment is made to net income Value of tax shield that will be lost Net adjustment at Net Income level
Step 4 – Adjust for Tax Affected Exceptional 2006
2007
2008
EBITDA
3,000
2,150
3,308
Adj. EBITDA
3,000
3,150
3,308
Reported Net Income
1,635
1,117
1,803
Adj. Net Income (without tax treatment)
1,635
2,117
1,803
Adj. Net Income (with tax treatment)
1,635
1,717
1,803
2008
No tax adjustment required at EBITDA level
Step 5 – Calculate the Multiple Market Cap
25,000
Enterprise Value
30,000
Multiples
2006
2007
EV / EBITDA (unadj.)
10.0x
14.0x
9.1x
EV / EBITDA (adj.)
10.0x
9.5x
9.1x
P/E (unadj.)
15.3x
22.4x
13.9x
P/E (adj. without tax treatment)
15.3x
11.8x
13.9x
P/E (adj. with tax treatment)
15.3x
14.6x
13.9x
Not adjusting overstates, while incorrectly adjusting (w ithout tax treatment) understates the multiple
31
Example: Mergers and Acquisitions Adjustments An acquisition or disposal by a company distorts the reported growth profile of a company’s financial results – it may also impact Net Debt. For this reason, it is important to make a pro forma adjustment to the company’s financials so that they can be analysed on a like-for-like basis. The best sources for information to enable accurate pro forma adjustment are the company’s website (investor relations) and equity research. Annualisation is an important concept, especially in the context of an M&A pro forma. Companies consolidate acquired business financials in their financial statements from the time of completion of the transaction. Therefore, if a transaction completes in, say June 2005, the target will only be consolidated from June onwards (assuming acquirer’s year ends in December). If no pro forma adjustment is made, on a Compco basis the EV would consolidate the entire equity value of the target (for a 100% acquisition), but the EBITDA would only include the target’s performance for 6 months, making the multiple artificially high. The multiple should be adjusted by annualising 2005 EBITDA. For example, if the 6 month EBITDA is €500m, the annualised 12 month EBITDA in the following manner, €500m/(6/12) = €1,000m. Obviously, if available, it is better to use the target’s actual 2005 EBITDA rather than to annualise on a straight-line basis. In the example below, Company A acquires Company B – because of the high multiple paid for the acquisition (15.0x one year forward EBITDA) the pro forma multiple rises by nearly half a turn. Step 1: Annualise for Acquisition at end June 2006 (€ in millions, unless specified)
Dec YE EBITDA from target EBITDA for target
2006
2007
2008
500
1,750
3,063
1,000
1,750
3,063
Only 6 months of EBITDA consolidated in 2006
EBITDA annualised for 12 months (e.g. 6 months multiplied by tw o)
Step 2: Pro Forma the Acquiror’s EBITDA (€ in millions, unless specified)
Dec YE EBITDA (acquiror) EBITDA (target) Acquiror's pro forma EBITDA
2006
2007
2008
10,750
12,000
13,250
1,000
1,750
3,063
11,750
13,750
16,313
Step 3: Pro Forma the Acquiror’s Capital Structure M&A Valuation(1) Multiple 15.0x
Valuation 15,000
Price Shares outstanding Market Cap Existing Net Debt Adjustments Adj EV
85 705 59,925 125 21,608 81,658
Acquisition finance
15,000
Pro forma adj EV
96,658
(1)
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Assume all cash acquisition of 100% equity of Company B
Assumes no synergies
Step 4: Calculate Multiples EBITDA Multiples
2006
2007
2008
Standalone
7.6x
6.8x
6.2x
Pro forma (not annualised)
8.6x
7.0x
5.9x
Pro forma (annualised)
8.2x
7.0x
5.9x
Non-annualised multiple is artificially inflated
In addition, the following factors should be considered: „ Synergies from combination: any assumptions on synergies from an acquisition should be duly noted and sourced in the file. Synergies could materially alter the multiples „ Acquisition of minority stake: minority stakes should not be pro forma adjusted as they are excluded from the Compco analysis (consolidated analysis) in any case (see below) Minority Interests and Income from Associates Typically a company will have subsidiaries and associates as part of its group structure. General accounting rules for subsidiaries and associates are as follows: „ Subsidiaries A subsidiary is a company over which the holding company exercises significant control – typically 51% or more ownership. In such a case, the subsidiary company will be fully consolidated. A parent recognises 100% of the assets and liabilities of its subsidiaries on a line-by-line basis. Minority interest is recognised at the bottom of the balance sheet as a separate part of equity. Similarly, in the income statement, 100% of the subsidiaries’ income is recognised on a line-by-line basis, but minority interests are separately identified (and deducted) at the bottom of the statement. The target company may exercise control though owning less than 50% of the equity (e.g. through contractual agreements). In such a case it will be consolidated as a subsidiary. „ Associates An associate is a company where control is not held (i.e. typically owns less than 50% and typically more than 20%) by the holding company. An entity is treated as an associate when the parent has significant influence over it (i.e. it can influence but not control the financial and operating policies of the entity). This may arise through share ownership, or other means (e.g. appointment of directors or contractual arrangements). From an accounting perspective, these assets are included using the Equity Method. Under the Equity Method the parent recognises, in one line, its share of the assets and liabilities of the associate – including any goodwill that arises on the acquisition. The parent will recognise its share of the associate’s net income on one line of the income statement. Proportionate consolidation is not permitted under IFRS for associates. „ Joint Ventures A joint venture arises where there is joint control between the parties. The economic shareholding does not have to be split on a 50:50 basis; rather it is the ability of each party to prevent the other venturer/s from exercising control alone that results in a joint venture. A joint venture can be accounted for under the equity method or on a proportionate consolidation basis. Whichever method is chosen should be applied to all joint venture interests of the relevant group. Efficient Market Theory The Efficient Market Theory is centred on the concept that prices of securities are the result of perfect and efficient information. In other words, markets see through the accounting rules that give companies greater credit (in their financials via full consolidation) for subsidiaries than their ownership would strictly warrant (when the subsidiary is not 100% owned). In theory, the market price of equity only credits companies up to their level of ownership in the subsidiaries. This means that multiples may look distorted by inconsistencies between the numerator and denominator, in the absence of any further adjustments. Consider the EV / EBITDA multiple – the numerator “EV” consists of Net Debt (determined by the accounting rules described above) and Market Cap (based on the efficient market theory). The denominator consists of EBITDA (determined by the accounting rules as described above). Thus, while accounting rules give the company full credit in the financials even when
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subsidiaries are not fully owned, or no credit when there is a less than controlling interest in an associate, the market sees through this and rewards exactly to the extent of ownership. Consolidated Versus Proportionate Multiples Where a company has a subsidiary of which it owns 51% it will often account for 100% of the EBITDA and Net Debt of this subsidiary, while the market only values the owned stake (i.e. 51%). There are two principal ways to calculate Compco multiples in this context: „ Proportionate Multiples Some companies report proportionate financials as well as consolidated financials and brokers will provide forecasts on the same basis. If this is not available, the latest results, website or equity research (last resort) will contain the corporate structure of the group and the ownership level in each asset. EBITDA (or any other metric forecasts) per asset should be obtained and the proportionate EBITDA can be calculated by the summing of EBITDA of each asset weighted by the relevant ownership level. Proportionate Net Debt can be obtained in exactly the same manner. Market Cap by its very definition (assuming Efficient Market Theory) is proportionate. Thus an internally consistent multiple can now be obtained. „ Consolidated Multiples The EV should be adjusted such that it corresponds to financial accounting rules. Therefore, (estimated) market values of the un-owned stakes in consolidated subsidiaries should be added to Enterprise Value, whilst (estimated) market values of unconsolidated minority stakes should be deducted, as they do not relate to consolidated metrics. Most Compcos are calculated on a consolidated basis, this is the standard Credit Suisse method. However, the choice between calculating a consolidated and a proportionate multiple is ultimately determined by the specific structure of the company, as discussed below. Valuing the Subsidiaries And Associates „ If the subsidiary in question is listed, then the market value of the company should be used „ If the asset (subsidiary or associate) has been recently acquired, the acquisition price should be used to calculate the asset value „ If the subsidiary or associate is not listed nor been recently acquired, the estimated market value of the particular asset should be applied from equity research § This is typically found in brokers’ analysis „ When none of the above are available, the book value of the asset (from the balance sheet of the parent company) should be used as a proxy. However, it should be noted that this is often quite different than the current market value of the asset Compco analysis is normally conducted on a consolidated basis mainly because it is generally easier to obtain the information required for this calculation. However, if a company has a large stake in a large unlisted company, it may be advisable to undertake a proportionate Compco, as the consolidated Compco may be too dependent on one equity research valuation of the subsidiary / minority stake. Consider the following example: „ Vodafone has a 45% minority stake in Verizon Wireless (VZW) of the US § VZW is unlisted and has ~50m subscribers § It is estimated by various brokers to be worth between US$60-100bn The Vodafone multiple is highly sensitive to brokers’ valuations of VZW, if the consolidated approach is used. The following illustration highlights the differences in methodology, as well as the differences in output between the consolidated and proportionate approaches.
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Example: Multiples on Consolidated and Proportionate Basis The following example illustrates the method for calculating multiples on both a consolidated and proportionate basis. Step1: Determine Consolidation Parameters The first step would be to determine the consolidation basis from the annual accounts of the parent company. It is necessary to identify the firm’s economic stake in each of its subsidiaries and associates and how it consolidates them. (€ in millions, unless specified)
Status Subsidiary Associate Associate
UK US Italy
Ownership 65% 45% 30%
Consolidation 100% 50% –
Difference 35% 5% (30%)
Step 2: Determine Forecasts per Asset and Valuation of Each Asset Determine proportionate forecasts and valuation of each asset. Financial Data by Asset (€ in millions)
2006 10,000 1,500 5,000
UK US Italy (1)
EBITDA 2007 11,000 2,000 5,250
2008 12,000 2,500 5,500
Valuation(1) Multiple EV 9.0x 90,000 5.0x 7,500 7.0x 35,000
Current Net Debt 100 50 900
Assumed 1 year forward EBITDA multiples
Step 3: Obtain Consolidated / Proportionate Financials Consolidated Financials
Proportionate Financials
(€ in millions)
UK US Italy Consolidated
(€ in millions)
2006 10,000 750 0 10,750
EBITDA 2007 11,000 1,000 0 12,000
2008 12,000 1,250 0 13,250
Current Net Debt 100 25 0 125
UK US Italy Proportional
2006 6,500 675 1,500 8,675
EBITDA 2007 7,150 900 1,575 9,625
2008 7,800 1,125 1,650 10,575
Current Net Debt 65 23 270 350
„ For subsidiaries: add the un-owned equity value to the parent company’s EV § In this example, the parent company owns 65% of the UK subsidiary, which has an EV of €90,000m § Obtain the equity value of the UK subsidiary by subtracting from the EV its Net Debt of €100m. The equity value is, therefore, equal to €89,900m § Add 35% of this (€31,465m) to the EV of the parent „ For associates: subtract the owned equity value from the parent company’s EV § In this example subtract 30% of the Italian assets equity value (calculated as above) from the parent’s EV Step 4 – Calculate EV Consolidated Price NOSH Market Cap Net Debt EV
85 705 59,925 125 60,050
Proportionate Price NOSH Market Cap Net Debt EV
85 705 59,925 358 60,283
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Step 5 – Minority Adjustments Minority Adjustment (Consolidated EV) UK US Italy Total Adj. EV
31,465 373 (10,230) 21,608 81,658
„ Adjustments need to be made whenever a company consolidates a different proportion of an asset’s financials than it owns § Note, however, that P/E multiples will be the same under both methodologies when Net Income post minorities is used „ The resultant multiples are as follows: Consolidated Multiples
EV / EBITDA P/E
Proportionate Multiples 2006 7.6x 15.0x
2007 6.8x 14.3x
2008 6.2x 13.2x
EV / EBITDA P/E
2006 6.9x 15.0x
2007 6.3x 14.3x
2008 5.7x 13.2x
Pension Liabilities Related Costs / Income Defined benefit liabilities are often seen as debt as they reflect financing provided by employees to fund the operations of the company. They result in a financial obligation that a company needs to fulfil in the future. According to International Accounting Standards 19 (“IAS 19”) the balance sheet treatment of pension related liabilities is as follows: The amount recognised as a defined benefit liability shall be the net total of the following amounts: „ The present value of the defined benefit obligation at the balance sheet date „ Plus any actuarial gains (less any actuarial losses) not recognised because of the treatment set out in the detailed rules „ Minus any past service cost not yet recognised „ Minus the fair value at the balance sheet date of plan assets (if any) out of which the obligations are to be settled directly The P&L treatment according to IAS 19 is as follows: An entity shall recognise the net total of the following amounts in the P&L, except to the extent that another standard requires or permits their inclusion in the cost of an asset: „ Current service cost „ Interest cost „ The expected return on any plan assets and on any reimbursement rights „ Actuarial gains and losses, as required in accordance with the entity's accounting policy „ Past service cost, and/or „ The effect of any curtailments or settlements The actuarial gains and losses on pension assets and liabilities (e.g. deviation of expected returns and liabilities from actual experience) can either be deferred using the corridor approach (for actuarial gains and losses less than 10% of plan assets or liabilities) or taken direct to equity through the Statement of Recognised Income and Expense (“SoRIE”) as they occur. Defined benefit liabilities are increasingly being recognised as part of the company’s financial debt and added to Market Cap to arrive at Enterprise Value by the market. The notes to the financial statements disclose the Net Present Value (“NPV”) of the defined benefit obligations as well as the market value of
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assets set against these. The difference between the two is the defined benefit net liabilities. This unfunded portion arguably represents a source of financing for the company (liability to be redeemed in the future – used to finance production in the present) and, therefore, should be added to the debt of the company. If the unfunded portion of the pension liability is added to debt, then the corresponding interest cost from this liability should flow through the net financing costs in the P&L rather than in operating costs (where it is commonly reported by companies). In spite of the above theory, equity analysts do not always adjust for pension liabilities and the market has yet to develop a consistent approach. The implication of this is that the market may have a different view of a particular company’s valuation than the analysis (adjusted for pension liabilities) may suggest. As a general rule, adjust for pensions if the target company meets two criteria: „ Companies in the industry / sector typically have significant under-funded pension obligations „ The industry team usually adopt the adjustment approach The example below illustrates how multiples change when adjusted for unfunded pension liabilities. Pension Related Adjustment (€ in millions, unless specified)
2006 10,750 100 10,850
Consolidated EBITDA add back: Pension Interest Adj EBITDA
Price
85
NOSH
705
Market Cap
59,925
Net Debt Adjustments Adj EV (1)
2008 13,250 110 13,360
Pension Adjustment NPV of PBO
5,000
Market value of funded portion
(500)
21,608
Unfunded portion of pension liabilities
4,500
81,658
Pension adj EV
125 (1)
2007 12,000 105 12,105
86,158
Adjustments for minorities and associates
EBITDA Multiples Pre-pension adj Post-pension adj.
2.2.8.
2006 7.6x 7.9x
2007 6.8x 7.1x
2008 6.2x 6.4x
Credit Ratings Reports
Credit Ratings Reports from any of the major rating houses (e.g. Standards & Poor’s, Moody’s, Fitch) can be useful sources of information for a Compco analysis. Aside from the in-depth information about the financial strength of companies (usually measured by metrics such as Net Debt/EBITDA and Net Interest Expense/EBITDA) they also contain details about interest expense and interest income of the company.
2.3.
Mechanics of Compco Analysis
2.3.1.
Market Cap and Fully Diluted Equity Value
Primary / Ordinary Share Price American Depository Receipt (“ADR”) / American Depository Share (“ADS”) ADRs provide additional liquidity and are listed on a US exchange. ADRs / ADSs are usually based on the listed ordinary shares. For example 1 ADR is often equal to 5 ordinary shares. If 80% of the ordinary shares are part of the ADR programme, then 80% ownership of the company is in the hands of ADR holders and 20% in the hands of holders of ordinary shares. To calculate market capitalisation, it is common practice to use the price of the more liquid of the two.
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ADRs and ordinary shares usually trade differently (i.e simply converting the ADR into local currency using the spot FX rate will not normally equal the ordinary share price). These differences arise due to a number of factors, such as: „ Type of investor demand (retail vs. institutional) „ Different information flows and timing of information flow „ Possible FX arbitrage Outstanding Shares for Market Cap and Fully Diluted Equity Value Treasury Shares Treasury shares are not considered part of the company’s share capital and should be deducted from shares issued and outstanding to arrive at the number of shares outstanding used for Compco analysis. Preferred Shares, Convertible Debt, Convertible Preferred Shares and Share Options & Warrants „ Preferred shares are a class of share which have very limited or no voting rights and a pre-determined, fixed dividend amount. In the event of liquidation, holders of preferred shares are considered senior to holders of common equity. These can be treated as debt or as equity, depending on particular features and this needs to be established on a case by case basis. If preference shares pay a fixed dividend, are redeemable at the issuer’s discretion, non-convertible to equity and carry no votes, they are treated as debt (for example, some UK preference shares). On the other hand, if they are convertible, nonredeemable and carry a non-guaranteed dividend, they are treated as equity (for example, Italian savings shares). „ In order to decide on the appropriate treatment for convertibles, options or warrants, assess whether they are in-the-money or out-of-the-money. To do this use the rules below: § Strike price > Market price = Out-of-the-money § Strike price < Market price = In-the-money „ Convertible Debt is a hybrid instrument that is debt for a certain period of time (vesting period). Once the vesting period is over, the debt is convertible into equity shares of the company at a pre-determined price. Out-of-the-money convertibles are treated as debt. Generally, in-the-money convertible debt is treated as part of equity. This is applied in the following manner: § If the convertible bonds are in-the-money, assume they are exercised § Deduct the face / book value from Net Debt § Add the number of shares from conversion to shares outstanding to calculate Market Cap „ Convertible Preferred shares are considered equity or debt, depending on whether they are in- or outof-the-money and also depending on the exact features of the underlying preferred shares „ Options and warrants are as previously described in section 2.1.2 (warrants adjustments work in exactly the same way as option adjustments) and are considered part of the Market Cap of the firm depending on whether they are in-the-money or out-of-the-money Treasury Method of Calculating Shares Outstanding – Convertibles, Options and Warrants The treasury method (which is the preferred Credit Suisse method) assumes that the company buys back its own shares (at market price) in the open market using these proceeds rather than reducing Net Debt. Given that the market price is higher than the strike price (condition for the instrument being in-themoney), the company is able to buy back fewer shares than it issues. If the instrument is in-the-money, assume it is exercised and, therefore, included in the number of fully diluted shares outstanding. „ Depending on the instrument, this effectively means that a certain number of new shares will be issued and that the company will receive proceeds from the sale of these new shares. For options / warrants the calculation is as follows: § Proceeds from exercising options / warrants = # of options x strike price „ If convertible debt is in-the-money it is assumed it converts to equity at the strike price. The number of new shares can be calculated as follows: § # New shares issued = Face value of debt / Strike price
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Fully Diluted Method of Calculating Shares Outstanding Under the fully diluted method assume that all exercisable in-the-money instruments are exercised. The proceeds are used to reduce Net Debt and the shares outstanding changes by the full amount of the new issuance. The steps involved in this computation are outlined in the following example. Example: Calculations using Treasury and Fully Diluted Methods Step 1: Determine How Many Options / Warrants are In-The-Money A company has 700m shares outstanding and 210m options in 3 tranches. The exercise price is €90, €86 and €80 per share for each of the 3 tranches respectively and the market price today is €85 per share, implying that only tranche C options (85m) are in-the-money. Current share price (€) Shares outstading (m)
85 900
Amount (m) 50 75 85
Options Tranche A Tranche B Tranche C Total
Exercise Price (€) 90 86 80
In The Money? No No Yes
Options Exercised 0 0 85 85
Proceeds (€m) 0 0 6,800 6,800
Step 2: Determine the Number of Shares Bought Using Proceeds from Exercise of Options Using the treasury method, it is assumed that the firm issues 85m new shares at €80 each, raising €6,800m. With these proceeds it buys back shares at the market price of €85, i.e. it buys back 80m shares. Therefore, net addition to share capital is 5m shares, meaning the new number of shares is 705m. Net Debt is not adjusted. Shares Outstanding for Compco
Treasury Method Total shares Options exercised Shares bought back Total shares
700 85 (80) 705
Fully Diluted Method Total shares Options exercised
700 85
Total shares
785
Using the fully diluted method, the same example as above, 85m new shares would be included and Net Debt would be reduced by €6,800m.
2.3.2.
Calculation of Enterprise Value
Gross Debt Gross debt comprises all interest-bearing liabilities of the company. Typically, companies will separately disclose both long- and short-term debt. Theoretically, market value of debt should be used, though in practice this is often the same as book value of debt (this will, however, not be the case if companies do not mark to market). The main exception to this are hybrid debt securities, where market and book values can differ. Gross debt would normally include the following: „ Long-term debt „ Short-term debt „ Preferred stock „ Out-of-the-money convertible debt In addition, it may include the following: „ Finance leases - there are two kinds of finance lease: § Finance leases: these are typically short term and renewed annually if required § Capital leases: these are typically longer term 39
Of these, only the latter are capitalised in the company’s Balance Sheet. However, if a company has use of most of its assets via lease arrangements it may be appropriate to capitalise operating leases as well. Typically this decision depends on a number of factors such as the length of time the lease is valid versus the useful economic life of the asset, responsibilities of the lessee versus those of the lessor towards maintenance and upgrade of the asset and value of lease versus fair value of underlying asset. The most common situation is in the airline industry, where the airplanes are recorded as operating leases but the airline captures the full benefit of owning the asset for its economic life, so the operating leases are commonly capitalised (conventionally, using a specific capitalisation multiple). If operating leases are deemed to be debt, the multiples should consistently reflect this in the numerator and in the denominator, EBIT and EBITDA should, therefore, be adjusted by adding back the interest component of the lease charge (e.g EBITDAR) „ Pension related liabilities (as discussed above) „ Contingent liabilities: most companies disclose the litigation they are involved in and the maximum financial damage that can be suffered. Usually, these are not included in the debt of a company. But may result in a future cash outlay „ Future earn-outs: are incentive schemes which align the interests of the management with those of shareholders. These are also used in M&A situations where the acquisition price is dependent on achievement of certain pre-agreed performance standards. In situations where consideration is contingent on future business performance (earn-outs), the consideration should theoretically assume the level of the consideration anticipated at the time of announcement. Often it is difficult to determine the expected level, but earn-outs are often based at zero if the business meets its projections; in such cases, the anticipated value of the earn-out should be assumed to be zero. Adding a comment in the commentary section with the adjusted multiple(s) including the earn-out at full value should be considered Note that rating agencies often view debt differently from equity research analysts. For valuation purposes, it would be prudent to examine the broker approach and use that as guidance, but to also consult team members on the treatment of more complex company-specific hybrid instruments. Cash and Cash Equivalents A clear definition of what is included in Cash and Cash Equivalents is essential for consistency. It may include the following: „ Cash as per the company’s latest balance sheet „ Cash equivalents consist of many short-term cash items with varying levels of liquidity. It is important to read the notes to the financial statements and exclude from the cash line anything that is not sufficiently liquid, such as time deposits or restricted cash Furthermore, cash equivalents often comprise marketable securities. It is critical to note that market value (as opposed to book value) should be taken, as values can change significantly in a short space of time.
2.3.3.
Special Dividends
Special dividends are normally funded through either asset sales or increased leverage. In the case of large special dividends, the Compco analysis will need to be appropriately adjusted. In the case of asset disposals, the amount of special dividend should be subtracted from the Market Cap in the period between the announcement of the dividend and the actual payment of the dividend. In the case of increased leverage, the net effect on the Enterprise Value is zero as the deduction of the amount of the special dividend is matched by the increased leverage. There might, however, be an effect on P/E multiples and FCF yields from the additional interest expense arising from the increased leverage.
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Mechanics of a Compco Analysis Associated Inputs % of 52 week High
Stock Price = 52 – Week High
Equity Market Cap
=
Diluted (or Basic) Shares Outstanding x Stock Price
=
Equity Market Cap + Net Debt Where, Net Debt = STD + Current portion of LTD + LTD + Capitalised Leases + Minority Interest + Convert. Preferred (if not converted) + Preferred Stock – Cash – Cash Equivalents and Marketable Securities
Enterprise Value / Levered Market Cap
P/E Ratios
Stock Price = EPS
Estimated EPS Growth
Next Year EPS –Current Year EPS = Current Year EPS
P/E to Est. 5-Year Growth
P/E Ratio = 5 Year Average Annual EPS Growth
Revenue Multiples
Enterprise Value = Revenues
Dividend Yield
Annual Dividend = Stock Price
EBIT Multiples
Enterprise Value = EBIT
EBITDA Multiples
Enterprise Value = EBITDA
Debt to Total Cap
„ 52 Week High „ Current Stock Price „ Diluted or Basic Shares Outstanding „ Current Stock Price
„ Preferred Stock
„ Short Term and Long-Term Debt
„ Convertible Securities
„ Diluted or Basic Shares Outstanding
„ Minority Interest „ Cash
„ Current Stock Price „ Trailing (LTM) or Projected Earnings Per Share „ Current Diluted Earnings Per Share „ Projected Diluted Earnings Per Share „ P/E Ratio (based on diluted EPS) „ Estimated 5 Year Growth Rate (IBES via Bloomberg) „ Enterprise Value „ Trailing or Projected Revenues „ Annual Dividend „ Current Stock Price „ Enterprise Value „ Trailing (LTM) and Projected EBITDA „ Enterprise Value „ Trailing (LTM) and Projected EBITDA „ Short Term Debt
„ Minority Interest
„ Long Term Debt
„ Preferred Stock
Short Term Debt + Long Term Debt + Total Preferred Stock + Minority Interest + Shareholders’ Equity
„ Shareholders’ Equity
„ Convertible Securities
Total Debt
„ Current Stock Price
„ Short Term Debt
„ Long Term Debt
„ Convertible Securities
Total Debt (including Preferred Stock, excluding Minority Interest) =
Debt to Market Cap
„ Current Stock Price
= Equity Market Cap
„ Diluted Shares Outstanding
2.3.4.
Other Adjustments
Notwithstanding the adjustments described above, there are still further adjustments that theoretically can be made. It is important to note that the adjustments below are made on a case-by-case basis, so judgement is required to determine if they are relevant in the calculation for the particular set of circumstances of industry or company being analysed: „ Capital Increases: be aware of capital increases / rights issues, which change the number of shares outstanding „ Seasonality: Certain industries are seasonal in nature (e.g. due to the way clients are billed or revenue is received over the course of the year, or because of working capital swings). As a result of this, balance sheet items such as Net Debt can be higher or lower at certain times in the year, every year In such a situation, rather than using Net Debt at a particular point in the year, it may be advisable to use the average Net Debt over the most recent quarters „ Share Splits: companies usually undertake share splits to ensure that the share price remains at an absolute value that does not optically discourage investors (especially retail investors) from investing. Theoretically, this should not affect Market Cap „ Factoring of receivables: Many companies provide services in advance of receiving payment, thus creating receivables on the balance sheet. These receivables can often be sold in return for cash that can then be used for operations. This process of selling or factoring receivables can unlock cash for the company. This source of financing will not appear as part of net financial debt (it will appear on the balance sheet as receivables). To the extent that factoring of receivables is an important source of financing, one should adjust for this
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2.4.
Core Multiples – Approach to Calculating Multiples of Core Business
For companies that have many different lines of business, it is common practice to strip out non-core businesses to arrive at the valuation of the core business. For example, typically telecommunications incumbents operate a mobile business, a fixed line business and often a directories business. If the telecom operations are to be valued on a multiples basis, the non-telecom businesses should be stripped out. Consider the case of telecom incumbents (example may apply to any operationally diversified business): „ Identify non-core business(es) § In the following example the directories business is classified as non-core „ Value the non-core business(es) § The non-core directories business, assumed not to be publicly listed, is valued by applying the sector multiple (e.g. 10.0x 2006 EBITDA) to the relevant metric (2006 EBITDA of €50m) to arrive at an EV of €500m „ Exclude value of non-core business from target’s EV § Removing the directories’ EV of €500m from the target’s EV of €1,125m identifies the pure telecom EV of €625m „ Exclude non-core business(es) from underlying financial forecasts § Removing directories’ 2006 EBITDA of €50m from firm’s EBITDA of €150m identifies the pure telecom EBITDA of €100m § This will need to be carried out for each of the forecast years „ Calculate multiple § The pure telecom multiple is 6.25x 2006 EBITDA versus the whole company multiple of 7.5x Core Multiple €1,125m
€500m
€625m
€625m
€150m €50m €100m Firm EBITDA
€100m Firm EV
Telco EBITDA Core Telco
Firm EV / EBITDA = 7.5x
Telco EV
Directories
‘Core’ Telco EV / EBITDA = 6.25x
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3.
Common Pitfalls
The list of the most common pitfalls in the preparation of the Compco analysis are: „ Not using all share classes (especially those not listed) § The Market Cap of a company consists of all the share capital times the relevant share price. Shares from all share classes, including those not listed, should be included „ Not normalising for unusual / non-recurring items such as restructuring charges and tax holidays § The purpose of the Compco analysis is to generate valuation benchmarks. Therefore, it is essential to remove the effects of one-off items that impact the financials of a company for only a short period of time. Compco analysis requires normalised financials so that short-term / one-off effects, such as restructuring charges and tax holidays, are excluded (these can be valued separately) „ Not annualising financials appropriately in pro forma adjustments for M&A § Typically when a company makes an acquisition, this is not consolidated for all 12 months of the first year (i.e. acquisition is made during the course of the year). To generate correct multiples for that year it is necessary to annualise the financials of the M&A target such that multiples are calculated on a like-for-like basis „ Not including market values for minorities and investments § When adjusting for minorities and associates it is critical to use market value. Market values can be obtained from Factset for listed companies or estimated using Broker’ Sum-of-the-Parts analysis „ Not adjusting for treasury shares § For valuation purposes they should be excluded from Market Cap „ Not adjusting for the impact of Share Buy Backs or stock split or changes in ADR / ADS ratio § Adjust the number of shares outstanding for stock splits or share buybacks. If using the ADR / ADS price, the ratio to common shares should be checked and updated as appropriate „ Special dividends § Special dividends not yet paid need to be adjusted for „ Not reviewing multiples on the output page § Multiples on the output page should be regularly and carefully checked. If a multiple is out of line, this should be checked again and the reason for divergence understood „ Not checking all rows / columns are included in the average / median calculation § It is essential that the averages / median multiples on the output page include all companies. Often companies that have been added later are inadvertently left out of the calculation of the averages „ Hardcoded cells § Hardcoded cells should be avoided in nearly every circumstance in the output sheet. At times, hardcoded numbers are used in the output sheet (most likely for negative multiples). However, the hardcode is often no longer relevant because of a change in the underlying fundamentals of the company. Therefore, it is extremely important to check for hardcoded numbers each time the Compco sheet is updated „ Not footnoting assumptions § All assumptions should be clearly footnoted and sourced. It is important to leave an audit trail so that others can follow this easily „ Not spotting / understanding basic errors or ‘red lights’ § Current share price not between 52 week high/ low § Multiples not reducing going forward § Margins not steadily improving § Enterprise value is greater than equity value
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„ Not spotting and examining differences when comparing to brokers reports § Some brokers use forward looking net debt § As sanity check it is useful to check calculated multiples vs. brokers for material differences § If there are differences, one should assume that one is wrong, but it may well be due to different approaches § Differences should “raise a flag” and suggest extra care
4.
How to Interpret Comparable Analysis Results
Compco analysis is a crucial component of most valuation exercises. It provides valuation data points based on current trading of stocks and, therefore, provides an important, independent benchmark of value. At the same time the value of such an analysis is crucially dependent on a) the market – whether the market is systematically undervaluing / overvaluing assets and b) the selection of appropriate comparables. Compco analysis is also useful in determining which stocks within a peer group are under / over valued. While the most common reason for a stock to attract premium valuation with respect to peers is the growth profile of the company’s financial projections in the near term, there may be other important factors. Always ensure that Compcos are internally consistent in terms of the metric in the denominator and the valuation measure in the numerator. A fundamental adjustment that must be performed is the difference between the consolidated results of companies and valuation, as captured by the market price (the perfect market theory) – the scope of the two is often different. Equally important is to pro forma for various corporate developments, such as: „ M&A „ Options and warrants „ Special dividends „ Completed share buy back programmes „ Stock splits „ Capital increases A crucial component to Compco analysis is the necessity of using particular multiple(s) for particular industries. This way, specific value drivers for specific industries can be identified and the relevance of these to the market value of equity of the companies can be more readily understood.
5.
Case Studies
The following case studies focus on the mechanics of Compco analysis, including are a basic example of a Compco calculation and a slightly more complex exercise. Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set.
5.1.
Basic Comparable Calculation – BSkyB
British Sky Broadcasting Group plc (“BSkyB”) and its subsidiaries operate the leading pay television broadcast service in the UK and Ireland under the Sky brand. The main business is based on the broadcaster of proprietary and non-proprietary channels (e.g. Sky News and Sky Sports). BSkyB also retails some of its channels, together with channels broadcast by third parties, to a limited number of cable and Digital Subscriber Line (“DSL”) subscribers. BSkyB also makes three of its channels available free-to-air via the UK Digital Terrestrial Television(“DTT”) platform, which markets itself under the brand Freeview.
45
The following information is required to complete this case study: Basic Information (In £m, unless specified)
Share Price Net Debt Associates Basic Shares Outstanding
5.30 667 (352) 1,808.62
Exercisable Option Schedule Tranche A Tranche B Tranche C Tranche D Tranche E Tranche F Tranche G Tranche H Tranche I Tranche J Tranche K Tranche L Source:
46
Filings
# of Options 0.00 0.01 0.01 4.97 3.28 6.22 0.02 6.27 0.02 0.15 0.15 0.04
Strike Price 0.00 3.63 4.38 5.16 6.39 7.84 8.36 9.87 10.53 11.40 12.80 13.97
Broker’s Model (In £m, unless specified)
YE June
2006A
2007E
2008E
2009E
Profit & Loss Revenues Growth
4,414
4,746 7.5%
5,084 7.1%
5,375 5.7%
982 22.2%
1,058 22.3% 7.8%
1,195 23.5% 12.9%
1,328 24.7% 11.1%
EBITDA Margins Growth Depreciation Amortisation EBIT Margin
(126) 0 856 19.4%
Interest Expense Other
(132) 0 926 19.5%
(82) 19
PBT Tax Expense PAT
(127) 0 1,068 21.0%
(66) 26
(50) 32
1,183 22.0% (23) 44
793
886
(246)
(275)
(326)
(373)
547
612
725
830
Minorities
0
1,050
(145) 0
0
1,204
0
0
Net Income Margin Growth
547 12.4%
612 12.9% 11.8%
725 14.3% 18.5%
830 15.4% 14.6%
Cash Net Income Margin Growth
547 12.4%
612 12.9% 11.8%
725 14.3% 18.5%
830 15.4% 14.6%
FD WASO
1,915
1,825
1,766
1,768
EPS (p) Cash EPS (p)
28.6 28.6
33.5 33.5
41.0 41.0
47.0 47.0
Cash Flow EBITDA Interest Expense Tax Expense
982 (82) (246)
1,058 (66) (275)
1,195 (50) (326)
1,328 (23) (373)
(200) 4.5%
(200) 4.2%
(108) 2.1%
(120) 2.2%
Capex as % of sales Ch. In NWC
67
100
94
75
521
617 18.6%
806 30.5%
887 10.0%
10 191.5
11 200.8
33 579.2
38 663.7
35.0%
32.8%
79.9%
79.9%
EFCF Growth DPS Dividend Payout Ratio Source:
Filings, Equity Research
„ Step 1 – Determine Market Cap Calculate the Market Cap / Equity Value (fully diluted using Treasury Method) of BSkyB. Determine the Adjusted Enterprise Value Calculate the Enterprise Value, adjusting for the value (book or market depending on the information available) of minorities and investments in associates, if applicable. If applicable, include adjustments for unfunded pension liabilities. „ Step 2 – Financial Estimates Calculate BSkyB’s financial estimates based on the model / broker reports provided above. Include in the following: § P&L (from revenues to net income) § Equity FCF § Dividend estimates § Fully diluted weighted average outstanding shares § Capex 47
Notes: Include also calculation of 2 and 3 year CAGR Where if applicable, adjust for pension costs (only if it has been possible to adjust Enterprise Value for unfunded pension liabilities). „ Calculation of Cash Earnings Calculate the value of Cash Earnings and Cash EPS (note the EPS should be calculated on a fully diluted basis as is Equity Value). „ Step 3 – Calculate multiples and ratios Include in the list of multiples and ratios as per the list reported below. Note that it will be necessary to calculate each metric for the financial year and also for the calendar year (i.e. calendarisation of the projections in Step 3 is required).
5.1.1.
Valuation and Leverage Multiples
„ EV / Revenues „ EV / EBITDA „ EV / EBITA „ EV / EBITDA – Capex (EV / Operating FCF) „ P / E (Cash) „ FCF Yield „ Dividend Yield „ Net Debt / Market Value „ Net Debt / Capital „ Net Debt / EBITDA „ EBITDA / Interest Expense (Interest cover)
5.1.2.
Business Statistics
„ Revenue growth „ EBITDA margins „ EBITDA growth „ Net income margin „ Net income growth „ Cash net income growth „ Dividend growth „ Dividend payout
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5.2.
Advanced Comparable Calculation – Vodafone
Vodafone is one of the world’s largest providers of mobile telecommunication services. It is regarded as the benchmark stock for the European mobile sector. Vodafone operates in 27 countries and has varying stakes in each of its operating companies. The bulk of Vodafone’s revenues are generated in Europe where it occupies #2 or #3 positions in most major markets. Vodafone owns a 45% stake in Verizon Wireless (“VZW”) in the US. VZW is one of the largest mobile telephony providers in the US with c.30m subscribers. VZW is unlisted and Vodafone’s stake is worth approximately US$45bn (though this figure varies significantly by source). Vodafone accounts for VZW using the equity method. Because of this minority stake, in addition to preparing the consolidated accounts, which are a statutory requirement, Vodafone also provides key metrics such as subscribers, revenues, EBITDA and Capex on a proportionate basis. The following information is required to complete this case study: Consolidated Financials – Vodafone (£ in millions, unless specified)
YE March
2005A
2006A
2007E
2008E
2009E
Revenue
34,073
36,561
38,827
40,121
41,597
7.3%
6.2%
3.3%
3.7%
12,715
13,307
13,456
13,800
14,338
37.3%
36.4%
34.7%
34.4%
34.5%
4.7%
1.1%
2.6%
3.9%
6,365
6,515
6,001
6,192
6,624
(4,910)
(5,163)
(5,662)
(5,357)
(5,908)
14.4%
14.1%
14.6%
13.4%
14.2%
YE March
2005A
2006A
2007E
2008E
2009E
Revenue
1,108
Growth EBITDA Margin Growth Net Income Capex As % of sales Source:
CS Equity Research 28/02/2006
Consolidated Financials – Arcor (£ in millions, unless specified)
1,363
1,499
1,612
1,692
23.0%
10.0%
7.5%
5.0%
158
204
225
242
254
14.3%
15.0%
15.0%
15.0%
15.0%
29.4%
10.0%
7.5%
5.0%
(160)
(160)
(160)
(160)
(160)
14.4%
11.7%
10.7%
9.9%
9.4%
Growth EBITDA Margin Growth Capex As % of sales Source:
CS Equity Research 28/02/2006
Consolidated Financials – Verizon Wireless ($ in millions, unless specified)
YE Dec
2005A
2006A
2007E
2008E
2009E
Revenue
32,301
36,090
39,604
42,302
44,243
11.7%
9.7%
6.8%
4.6%
12,140
13,895
15,248
16,286
17,033
37.6%
38.5%
38.5%
38.5%
38.5%
14.5%
9.7%
6.8%
4.6%
5,501
6,250
6,795
7,151
Growth EBITDA Margin Growth Net Income Capex As % of sales Source:
4,451 6,460
7,218
7,921
8,460
8,849
20.0%
20.0%
20.0%
20.0%
20.0%
CS Equity Research 28/02/2006
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Share Price (£) Basic Shares Outstanding (m) USD / GBP Exchange Rate Source:
1.24 60,135 1.45
Factset, Company website
Options and Warrants Number (millions) 64 40 27
Tranche A Tranche B Tranche C
Exercise Price (£) 1.6 2.8 0.9
(£ in millions, unless otherwise specified)
Consolidated Net Debt Verizon Source:
Net Debt 14,093 8,722
Company Website as of 30 Sep, 2005
Additionally here is some further information that will be required to arrive at the correct multiple: „ Arcor EV based on CS equity research (28/2/2006) is £2,044m „ Acquisition of a minority stake in Bharti, an Indian mobile operator for £820m „ Divestiture of the Japanese business for £6,800 (net debt of £800m at the asset) „ Special dividend of £6,000m from the proceeds of the above sale The CS research report is pro forma for all the above events that occurred after the balance sheet date of 30 September 2005 but before 28 February 2006, when the research report was published. Details for the share buy back programme post the balance sheet date are as follows: „ From 1 October 2005 to 14 November 2005 SBB programme returned £648m to share holders „ NOSH at 15 November 2005 was 62,541m „ NOSH at 27April 2006 was 60,135m „ Volume weighted average price (VWAP) from 15 November 2005 to 27 April 2006 was £1.24 per share
5.2.1.
Calculation of Vodafone Core Mobile Multiples
Though the majority of Vodafone’s stake comprises of mobile telephony assets, it also owns Arcor, an unlisted fixed line asset. In the following exercise, strip out Arcor financials from the Vodafone proportionate financials (and remove Arcor EV based on CS Equity research SOTP analysis from Vodafone proportionate EV). Removing Arcor generates approximate core mobile financials for Vodafone. „ Step 1 – Determine financials for core mobile business Strip out Arcor financials from Vodafone consolidated financials „ Step 2 – Obtain proportionate financials for the core business Adjust for the 45% stake in Verizon Wireless, as per above discussion „ Step 3 – Determine Market Cap Calculate the Market Cap (fully diluted) of Vodafone „ Step 4 – Calculate the proportionate Net Debt Adjust for the 45% stake in Verizon Wireless, as per above discussion
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„ Step 5 - Pro forma for the following: § Acquisitions in various emerging markets § Divestiture of Japanese business § Share buy back § Special dividend On the basis of the above calculate EV / EBITDA for 2006, 2007 and 2008 on a consolidated and proportionate basis – calendarised to December.
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Comparable Acquisitions Analysis
53
Comparable Acquisitions Analysis 1.
Overview
1.1.
What is a Compacq and What is it Used For?
Comparable Acquisitions (“Compacq”) analysis is used to derive multiples from relevant precedent transactions. It is based on selected precedent transactions in the same industry as the target company to establish valuation benchmarks in a change of control scenario.
1.1.1.
Applications
„ Determining sector valuation benchmarks „ Valuing a business in a change-of-control situation through identifying multiples paid in similar transactions „ Determining the market demand for different types of assets (i.e. frequency of transactions and multiples paid) „ Identifying acquisitive companies in sector and historic valuation approaches (i.e. “bottom fishers” vs. “paying a full price”) „ Providing statistics on particular transactions as basis for discussion of industry trends and cycles
1.1.2.
Advantages
„ Based on public information „ Realistic in the sense that past transactions were successfully completed at derived multiples. The analysis, therefore, indicates a range of plausibility for offered multiples or premia to unaffected stock prices „ May show trends within industry segments such as rapid consolidation of certain sub-segments, foreign purchasers and financial purchasers „ Provides guidance to assess likely interlopers and their willingness to pay
1.1.3.
Disadvantages
„ Public data on past transactions can be limited and misleading „ Precedent transactions are rarely directly comparable „ Not all aspects of a transaction can be captured in multiple valuation (e.g. commercial agreements, governance issues, specific findings from due diligence, synergistic benefits) „ Values obtained often vary over a wide range and, therefore, can be of limited use „ Market conditions at the time of a transaction can have substantial influence on valuation (e.g. business or industry cycle considerations, competitive environment at the time of the transaction, scarcity of the asset at the time of the transaction)
1.1.4.
Overall Comments
The usefulness of the Compacq analysis depends upon the thoughtfulness, judgment and analytical rigor of the preparer. Often clients are familiar with the transactions being presented and will ask questions about the rationale for the inclusion/exclusion of certain deals or why a multiple does not match the multiples they have seen previously for that deal. The key to preparation and analysis of Compacqs is to know why (e.g. why a different valuation from peer transactions, why different multiple than other industries and why multiples based on a particular metric in the specific industry). The Compacq is an extremely useful piece of analysis that frequently attracts the focused attention of clients. Preparers should, therefore, invest the time and effort to ensure the quality and completeness of
55
the data presented and should also consider which of the comparable acquisitions they believe to be most relevant to the situation in hand.
1.2.
Identification of Relevant Precedent Transactions
In a valuation context, it is advisable to identify a small subset of the broadly comparable transactions and study these most comparable transactions in more detail to get a better understanding of the circumstances leading to the specific valuation levels. The quality of comparables is far more important than the quantity of comparables. Check for comparability of the business and operations in terms of product mix, revenue / operating income split, size and geographic coverage. The quality of a Compacq analysis is materially influenced by the selection of the most applicable precedent transactions. Any announced transaction that provides an indication of valuation in the relevant sector should be shown on the Compacq, including: „ Acquisitions of public companies „ Acquisitions of private companies „ Acquisitions of divisions and subsidiaries „ Withdrawn and pending deals (be aware that withdrawn transactions may not be relevant comparables) „ Minority stake investments (be aware that the consideration may not reflect a control premium) „ Mergers of Equals (be aware that the consideration may not reflect a control premium) It is advisable to begin with a complete list of deals and to eliminate transactions that do not match the following criteria: „ Industry: target company's business and financial characteristics should be comparable „ Size of the deal: transactions that are close in size to the company that is being evaluated are more relevant „ Timing: the more recent the data, the more relevant the benchmark „ Circumstances of sale: forced sale vs. truly competitive auction „ Stake sold: minority vs. majority There is a wide variety of information sources that help in selecting the most relevant list of transactions for a Compacq analysis: „ Colleagues Always make sure that the analysis has not been performed already (ask people in the relevant industry team, check for previous presentations in the sector). In theory, transaction multiples need to be prepared only once. However, it is the preparer’s responsibility that the multiples used are correct, so all multiples used must be rigorously checked. „ SDC (Thomson Securities Data Company) Always ask the library for an SDC run. The best option for a first scan is “all detail excel download” and upon elimination of the clearly irrelevant transactions, get an “all detail pdf download” which is more user-friendly. SDC is a comprehensive source, but its sector classification is unreliable so each target business profile should be double checked (e.g. website or press release of the acquiror, pretransaction annual report and pre-transaction research report). „ Discussions with the client In general, the client most probably has a good sense of pertinent precedent transactions in the industry.
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„ Mergermarket A mergermarket search may provide additional information, mainly on European M&A transactions (not covered by traditional news searches). „ Research reports Look for larger industry pieces, in most cases Initiation of Coverage of a stock in the sector will have a useful industry section. Use credible brokers and make sure it is clear how the research analyst defines metrics (EBITDA, EBIT, Net debt, Enterprise Value, etc.). Multiples derived by equity research must be used as cross-check only. „ Annual Report/10K: may list recent transactions in the discussion of the competitive environment „ Industry and trade publications
1.3.
Information Required to Complete a Compacq Analysis
Once the relevant precedent transactions have been identified, there are several sources of information that will facilitate a thorough understanding of the relevant transactions. SDC is a useful source for summary transaction information and to identify precedent transactions, but cannot be relied upon as a reliable company or transaction specific data source. All information sourced from SDC should be checked against other data sources to verify the accuracy of the information.
1.3.1.
Sources of Deal Specific Information
„ Target/parent and acquiror annual and interim reports (post-announcement and post-closing reports often contain descriptive information; e.g. Cash Flow statement may show cash disbursed / received due to acquisitions / divestitures) „ Press releases and analyst presentations at the time of the transaction „ Offering circular, in case of public take-over „ Pre- and post-announcement equity research reports on the target/parent and the acquiror „ News run from 6 months prior to announcement to 1 month after closing (it is often very difficult to obtain information on private deals; news articles may be the only available source) „ SDC full detail report „ Check whether Credit Suisse advised on the transaction. If so, the transaction team should have the best insight into the multiple paid
1.3.2.
US Filing Codes
In case either the acquiror or the target is a US listed entity, the following US filing codes may be useful in sourcing information. „ 8K: must be filed to detail any material event; a large company that divests or acquires a small division of assets may not file an 8K „ S4: filed by acquirors who issue securities in connection with business combinations - so will only be available for some proportion of stock deals „ 14D1: tender offer document filed by the acquiror (sometimes referred to as "Offer to Purchase") „ 14D9: recommendation statements filed in connection with tender offers, whether friendly or hostile „ Merger Proxy: this document is filed in connection with transactions that require shareholder approval (i.e. stock-for-stock mergers involving at least one public company)
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1.4.
Sample Output Sheet
1.4.1.
Example: Logistics Sector
Logistics Sector (Transactions by Sub-Sector) Date of Announcement
Target
Stake Acquired
Bidder
(US$ in millions) MV AMV
Sales
AMV / LTM EBITDA
EBIT
Contract Logistics 17-Oct-2005
ACR Logistics (France)
Kuehne & Nagel (Switzerland)
100%
565
629
0.4x
3.9x
7.5x
19-Sep-2005
Exel (UK)
Deutsche Post (Germany)
100%
6,666
7,258
0.6x
13.3x
29.0x
30-Jul-2004
Etinera (Italy)
Logista (Spain)
96%
473
174
1.1x
5.4x
NA
15-Jun-2004
Tibbett & Britten (UK)
Exel (UK)
100%
594
688
0.2x
6.7x
16.8x
09-Dec-2002
P&O TransEuropean (UK)
Wincanton (UK)
100%
239
239
0.2x
5.1x
10.3x
10-May-2001
USCO Logistics (US)
Kuehne & Nagel (Switzerland)
100%
300
300
NA
9.6x
NA
01-Jan-2001
GATX Logistics (US)
APL Logistics (Singapore)
100%
210
210
0.6x
10.8x
28.2x
04-Sep-2000
CTI Logistix (US)
TPG (Netherlands)
100%
650
650
1.3x
14.1x
19.1x
30-Aug-2000
Livingston (Canada)
UPS (US)
100%
NA
NA
0.7x
8.3x
NA
20-Feb-2000
NFC (UK)
Ocean Group (UK)
100%
2,218
2,080
0.9x
10.3x
15.8x
High
100%
6,666
7,258
1.3x
14.1x
29.0x
Low
96%
210
174
0.2x
3.9x
7.5x
100%
565
629
0.6x
8.9x
16.8x
Median Freight Forwarding 16-Nov-2005
BAX Global (US)
Deutsche Bahn (Germany)
100%
1,120
1,120
0.4x
9.5x
14.3x
15-Jul-2005
GeoLogistics (US)
PWC Logistics (Kuwait)
100%
394
454
0.3x
16.2x
24.0x
11-Oct-2004
Kuehne & Nagel (Switzerland)
Kuehne & Nagel (Switzerland)
20%
3,902
3,649
0.4x
9.9x
14.6x
05-Oct-2004
Menlo Worldwide Forwarding (US) UPS (US)
100%
150
260
0.1x
8.1x
NM
11-Jun-2004
Wilson Logistics (Sweden)
TPG (Netherlands)
100%
308
308
0.4x
9.8x
17.4x
03-Jul-2002
Stinnes (Germany)
Deutsche Bahn (Germany)
65%
2,491
3,364
0.3x
5.8x
10.3x
10-Jan-2001
Fritz Companies (US)
UPS (US)
100%
450
530
0.3x
8.6x
15.9x
02-Jul-2000
Circle Int. (US)
EGL Inc (US)
100%
543
545
1.6x
11.7x
18.4x
14-Nov-1999
Air Express Int. (US)
Deutsche Post - Danzas (Germany) 100%
1,100
1,116
0.7x
13.7x
18.5x
26-Jul-1999
Mark VII (US)
Ocean Group (UK)
100%
226
226
0.3x
11.1x
12.4x
09-Dec-1998
Danzas (Switzerland)
Deutsche Post (Germany)
100%
1,100
907
0.3x
8.8x
19.9x
100%
3,902
3,649
1.6x
16.2x
24.0x
20%
150
226
0.1
5.8x
10.3x
100%
543
545
0.3
9.8x
16.6x
High Low Median
Given the business profile of the target and particularly its primary focus on contract logistics activities, Wincanton’s acquisition of P&O TransEuropean (2002) and Exel’s acquisition of Tibbett & Britten (2004) represent the most relevant comparable transactions. Enterprise Value / EBITDA multiples are used as primary valuation benchmarks in the contract logistics industry. Adding the announced run-rate cost synergies to the targets’ EBITDAs would result in adjusted AMV / EBITDA multiples of 4.8x and 4.9x for the Wincanton / POTE and Exel / T&B transactions respectively. Whereas Wincanton / POTE was a privately negotiated transaction, Exel acquired T&B through a public takeover (all-cash), at a 36% premium over the pre-rumour share price.
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2.
How to Complete a Compacq Analysis
2.1.
Filling in the Qualitative Columns
Column
Comments
Announcement Date
„ The announcement date is the date that the acquiror and the seller
declared their definitive intentions (i.e. when the transaction terms have been finalised). Standard analysis is performed on the announcement date, not on the closing date. Acquiror
„ List full name of ultimate acquiring company. Do not use an acquiring
Target
„ List full name of the target. When a company is selling a division,
subsidiary name subsidiary, or assets, list the business being sold followed by the parent's name Business Description of the Target (optional, not part of the standard template)
„ Use full sentences „ Begin with the company name (can abbreviate) followed by a verb „ Include a breakdown of sales if the company operates in multiple
business segments that could potentially be represented on different Compacqs „ For asset deals, begin with ‘Assets acquired comprise...’ or ‘Assets
acquired include...’ or ’Assets acquired consist of...’ or some variant thereof „ Example: ’Exel is the world’s largest integrated contract logistics (58% of
sales) and freight forwarding (42%) services provider’
2.2.
Target Financial Performance
2.2.1.
Selecting which Target Financial Statements to Use
Compacqs are primarily based on the latest available historic information (even if standalone financial projections are available for the target company) to ensure comparability of public and private transactions shown (projections are not available for private targets). The objective of the Compacq is to evaluate the offer in relation to the information being used by the acquiror at the time it values the business, so the preparer should use the financials that represent the best proxy for this information. As a general guideline, if a transaction is announced less than one month prior to the end of the target's fiscal quarter, assume the acquiror has the financials for that quarter. Therefore, the target's next financials should be used as the basis for LTM multiples. In situations where an acquiror makes multiple bids or changes the economic terms of the transaction, the announcement date should be the final bid date and the LTM period should be based on that date. Example: Acquiror announces the acquisition of Target on 15 March 2006. Target's last published financials were for quarter ended 31 December 2005. Target LTM financials used in calculation of multiples should be for year to 31 March 2006, because the acquiror likely has financials up to early March when determining the valuation of the target.
2.2.2.
Calculating LTM Income Statement
Please refer to section 2.2.6 of the Comparable Companies Analysis chapter.
2.2.3.
Extraordinary / Non-recurring Items
Extraordinary items, abnormal items and restructuring charges are generally considered to be one-off charges and should be excluded from the financial statements (subject to a check of the footnotes and verification of the item's one-off nature). The acquiror is purchasing the Target based on its ongoing (“normalised”) business performance, so any financial results that do not relate to that future performance should be excluded. The preparer should ensure that these charges are appropriately tax-affected at different points on the income statement. Pre-tax charges should be shown at the EBIT line and post-tax charges at the Net Income line. The pre-tax and post-tax charges are generally disclosed in the financial statement footnotes, but in the absence of this information use the overall statutory tax rate relevant for the business.
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Example: Restructuring Charge Target Income Statement Sales
€150,000
Operating Costs Restructuring Charge EBIT
124,600 4,800 20,600
Net Interest Expense
1,500
Taxes (32% rate)
6,112
Net Income Note:
€12,988
Adjusted EBIT = 20,600 + 4,800= €25,400 Adjusted Net Income = 12,988 + 4,800*(1-0.32) = €16,252
2.2.4.
Acquisitions / Divestitures
Target financial statements should be pro forma for any material acquisitions or divestitures that occurred within the LTM period (the effect is included in the balance sheet but not fully in the income statement). The Compacq preparer should carefully check the financial statements to ensure that these are not ignored. „ Acquisition The acquiror will receive the full benefit of owning the combined entity. Financial statements should be adjusted to reflect the combined financial statements assuming the two entities had been combined for the full LTM period, including any synergies announced, to the extent such synergies are clearly disclosed and identified. „ Divestiture The acquiror is not receiving the benefit of the discontinued operations, so the LTM financial statements should exclude these operations. If these operations are not separately accounted for on the income statement, they should be backed out using information in the footnotes and other sources in relation to the given past transaction. Example: Target acquisition of Subsidiary: If the Subsidiary’s income statement is available, it should be added to the Target’s LTM income statement. If the Target only provides pro forma sales, the full pro forma income statement should be derived assuming the Subsidiary has the same margins as Target. Any such assumption made must be clearly footnoted on the output sheet.
2.2.5.
Announced Synergies
Synergies may represent a significant driver of the valuation an acquiror is able to pay for a target. Although multiples shown in the Compacq output sheet should not be adjusted for synergies (as synergies can never be compared on a like-for-like basis), Compacqs may track this information and refer to it in the commentary. When quoting announced synergies, the preparer should ensure they are quoted consistently (i.e. top line versus bottom line, timing of realisation). The recommended approach is to quote Full EBITDA synergies (which refers to the level of synergies at full realisation adjusted to the EBITDA level). It is often useful to mention synergy-adjusted multiples in the commentary to the analysis (see previous Logistics sector example). Example: Full EBITDA Synergies Calculation Acquiror includes the following statement in its press release: ‘This business combination is expected to yield incremental sales of €100 in 2005, €150 in 2006 and €250 in 2007 and beyond.’ Full EBITDA Synergies = €250 * 12% = €30 (Assuming Target EBITDA margin of 12%).
2.2.6.
Cyclicality
In the case of the industry sector having significantly cyclical characteristics (e.g. container shipping), acquisition multiples will likely reflect the status of the cycle which, therefore, should always be highlighted in the commentary to the analysis.
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2.3.
Consideration Paid and Assumed Liabilities
2.3.1.
Transaction Structure
Understanding the transaction structure is key to calculating the equity and enterprise considerations. The transaction structure is determined by four factors: „ Is the acquiror purchasing assets or equity? „ What percentage of the target is being purchased? „ How is the transaction being effected? „ What is the target ownership structure? The following table summarises the differences between the major transaction forms. Purchase Of
% of Target Purchased
Transaction Mechanism
Target Ownership
Public Tender Offer
Equity
< or =100%
Public tender / exchange offer
Public owned entity
Private Transfer of Equity Interest
Equity
< or =100%
Private negotiation
Public / private
Merger
Equity
100%
Shareholder vote
Public / private
Asset Purchase
Assets
100% of assets in question
Private negotiation
Privately owned division or assets
2.3.2.
Consideration Levered or Unlevered?
If a transaction description is not explicit as to whether the consideration is levered or unlevered and debt exists on the target's books, all efforts should be made to determine whether the debt is assumed on top of the purchase price. If no information can be gathered, assume the consideration is levered for asset purchases and unlevered for equity purchases (including most purchases of divisions and private companies). In a public deal, the information to assess this should nearly always be available.
2.3.3.
Shares Outstanding
Number of shares outstanding has a substantial effect on the consideration of a transaction in public transactions, so care should be taken in determining the number of shares in issue at closing. The most common source for shares outstanding is the most recent annual / interim report (10K/Q for US companies), but this may not be the most recent source. The number of shares in issue quoted in offer documents are likely to be more recent and relevant. External market sources, such as Bloomberg, FactSet and research reports, should always be double checked from several sources (these sources should also be checked for updated option information). In theory, the share count and balance sheet would both be on the same date and as recently as possible before the transaction closes. In practice, use the most recent information available for both and be mindful of any major share issuances or buybacks that could affect the balance sheet. Options are also an important consideration in this regard and are discussed below.
2.3.4.
Preferred Stock and Convertible Debt
Preferred Stock and Convertible Debt should be classified as either equity or debt, depending on the redemption and conversion characteristics of the instrument and on the nature of the transaction. The following table provides basic guidelines, but the redemption and conversion details of the securities should be closely examined to determine the appropriate treatment.
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Convertible Into Common Equity At Holder's Option
Mandatory Redeemable
Converts Into Common Upon Change Of Control
Not Convertible Into Common Equity
„ Treat as equity if
„ Treat as debt unless
Change of Control Transaction
„ Treat as debt. The
security is in-themoney based on offer price. The holder of the security can convert to equity and capture the benefit of the acquiror's offer
convertible at holder's option. If mandatory redeemable the issuer can prevent holder capturing deal premium
„ Treat as equity. The
security will convert into equity upon change of control
security is not convertible, thus should be treated as a debt instrument
Minority Stake Transaction „ Treat as debt. The
security does not convert into equity as no change of control occurs
Example: Convertible Debt (Assumes a Change of Control Transaction) Target Balance Sheet (Selected Items) Assets Cash
€1,000
Marketable Securities
100
Other Assets
8,300
Total Assets
€9,400
Liabilities Short Term Debt(1)
€1,800
Long Term Debt
4,400
Capitalized Lease Obligations Total Liabilities Minority Interest Convertible Preferred Stocks
50 €6,250 €150
(2)
Common Equity (100 shares)
1,000 2,000
Total Equity
€3,000
Total Liabilities and Equity
€9,400
(1) (2) (3)
Notes to financial statements reveal that long term debt includes €3,000 of notes which are convertible into common equity at €15 per share at the holder's option. Convertible at the holder's option at €20 per share. The offer was made at €25 per share.
Note: Adjusted Net Debt = 1,800 + (4,400 - 3,000) + 150 + 50 - 1,000 - 100 = €2,300 Adjusted Shares Outstanding = 100 + (€3,000/€15) + (€1,000/€20) = 350 shares
2.3.5.
Options and Warrants
Options and warrants have a dilutive effect on share count if their exercise price is below the per-share transaction consideration. As with the Compco analysis, best practice is to use the Treasury Method to calculate the number of common shares that would need to be issued to retire the outstanding options. The Treasury Method assumes all in-the-money options are liquidated and the holder receives common stock equivalent to the premium of the transaction price over the option exercise price. Example: Treasury Method Calculation If no breakdown of the tranches is available, simply use weighted average strike price and options outstanding. Example: Offer Price = €70; Options outstanding: 25; Average exercise price: €58 Dilution = ((70-58) * 25) / 70 = 4.3 shares
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If tranches are disclosed, perform treasury method calculation on each tranche. For example, Acquiror offers €50 per target share. Target has 100 shares outstanding plus the following options: Option Tranche
Avg. Exercise price
# Outstanding
Dilution
€25 - €35
€29
10
4.20
€35 - €45
€41
12
2.16
€45 - €55
€52
13
0.00
Diluted Share Count = Basic Shares Outstanding + Share Equivalent of Other Instruments Cash required to liquidate options = (€50-€29)*10 + (€50-€41)*12 = €318 Shares required to liquidate options = €318/€50 = 6.36 Diluted Share Count = 100 + 6.36 = 106.36 Note: The calculation is based on the tranches with average exercise prices below the offer price and is based on options outstanding (not options exercisable). The €45-€55 tranche has no dilutive effect because the average exercise price of the tranche is greater than the offer price.
2.3.6.
Assumption of Debt
Often a news article, research report or acquiror filing will quote a figure for debt assumed in connection with a transaction. This debt assumed figure will usually not exactly match that reflected on the target’s balance sheet. The question of whether the acquiror is assuming all of the target's debt requires some judgment but a few rules can simplify the decision: „ Is the target public? If so, the acquiror must assume all of the target's debt „ Is the deal an asset acquisition? If so, the acquiror often assumes some or no debt „ Is the assumed debt materially different from the balance sheet debt? This question ultimately determines the judgment call
2.3.7.
Minority Interests
Minority interests are generally created when target owns at least 50% but less than 100% of a subsidiary, and effectively controls the subsidiary. Under IFRS and US GAAP, 100% of the subsidiary's income statement is consolidated into the target's income statement, so the transaction consideration must be adjusted to reflect the presumption that the acquiror is paying for 100% of the target's subsidiary (EBITDA, EBIT etc include 100% of that subsidiary’s results). In some rare circumstances, a company may actually control a subsidiary (e.g. super voting rights) despite less than 50% ownership and may consequently consolidate the subsidiary under US GAAP. Minority interests can be treated by including the minority interest from the balance sheet in Net Debt. This is equivalent to the target buying out the other owners of the subsidiary at book value. If the subsidiary is publicly traded the minority interest should, where practical, be capitalised in Net Debt at market value rather than book value (because market value better represents the liability to the subsidiary's other owners).
2.3.8.
Investments in Associated Companies
Investments in associated companies generally occur when the target owns less than 50% of a subsidiary, and does not exhibit control over the subsidiary. In this case the income from affiliates should be included in Operating Income (the capital employed to achieve these returns is reflected on the balance sheet). Income from equity affiliates is generally recorded as post-tax (check the notes to the financial statements) in which case it should be grossed up to a pre-tax income and added to EBIT. However, income from equity affiliates is sometimes reported pre-tax as a separate line item in Operating Income. Be aware of how the investment is treated when determining what adjustments to make to Operating Income, EBIT, and Net Income.
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Example: Target Owns 25% of Subsidiary: Target Income Statement Sales
€150,000
Cash Operating Costs
104,200
Depreciation and Amortisation
20,400
EBIT
25,400
Net Interest Expense
1,500
Taxes (32% rate)
7,648
Income from Affiliates
3,200
Net Income
€10,848
Note: Adjusted EBIT = 25,400 + 3,200/(1-0.32) = €30,106 Adjusted EBITDA = 30,106 + 20,400 = €50,506
The basic treatment of investments in associated companies assumes the subsidiary is strategically related and should therefore be included in the valuation metrics. If the subsidiary is unrelated, similarly to the treatment of Financial Fixed Assets (see section 2.3.13), it should be excluded from both the income statement (i.e. Net Income pre Income from Associates) and balance sheet (i.e. deducted from Enterprise Value at book value, or at market value if listed).
2.3.9.
Marketable Securities
Marketable securities and other short-term liquid investments should be treated as cash in the calculation of Net Debt unless the investments represent operating activities of the target. In most cases these investments do not represent operating activities, and income from this capital is recorded in Other Income below the EBIT line on the income statement. Therefore, consistent treatment of the income statement and balance sheet requires marketable securities, like cash, to be offset against Net Debt. Please note that some businesses or industries need to maintain a minimum level of cash for working capital purposes. Therefore, please use judgment and be consistent throughout all transactions included in the Compacq when calculating Net Debt if 100% of cash is not offset against Net Debt.
2.3.10.
Capital / Financial Leases
Capital lease obligations (where the company acquires all of the economic benefits and risks of ownership) should be included in the calculation of long-term debt because the lease is a form of borrowing for the company. Under a capital lease, a long-term asset is acquired and a long-term liability is incurred in exchange for lease payments. These lease payments are treated partially as interest payments and partially as reductions in the liability. This structure mirrors the financial impact of buying the assets using debt, where the costs would be recorded partially as interest payment and partially as depreciation of the asset.
2.3.11.
Operating Leases
Unlike with Financial Leases, when an asset is “procured” on an operating lease, the asset does not appear on the balance sheet (e.g. “off balance sheet” financing) and consequently, no liability is incurred on the company’s books. The lease payments therefore mirror the characteristics of simple rental payments and are accounted for within the operating costs above the EBITDA line in the income statement. Certain special situations require operating leases to be capitalised. Typical examples are the airline industry (e.g. leased airplanes) and the retail industry (e.g. leased real estate), where assets are recorded as operating leases but the operators capture the full benefit of owning the assets for their economic life. These operating leases are commonly capitalised, using conventional methodologies specific to the assets/sectors in question (e.g. capitalisation multiples for airplanes; assumed alternative usage yield for real estate, etc). If operating leases are deemed to be debt, the multiples should consistently reflect this in the numerator and in the denominator. EBIT and EBITDA should, therefore, be adjusted by adding back the interest component of the lease charge (e.g. EBITDAR).
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Example: Airline Sector Compacq Date Mar-05 Dec-04 Nov-03 Sep-03 Nov-02 Aug-02 May-02 Mar-02 May-01 Mar-01 Jan-01 May-00 Apr-00 Apr-00 Dec-99 Dec-99 Nov-99
Target Acquiror SN Brussels Lufthansa SN Brussels Virgin Express Spanair SAS KLM Air France Spanair SAS British Midland Lufthansa Go easyJet Virgin Blue Patrick Braathens SAS British Regional Airlines British Airways Trans World Airlines AmericanAirlines US Airways United Airlines Air New Zealand Singapore Airlines Sabena SAirGroup Iberia British Airways Virgin Atlantic Singapore Airlines British Midland Lufthansa
Stake Value Stake (US$ in millions) 100.0% 1,437.0
Status Pending
100.0%
NA
Completed
NA
NA
41.0%
723.7
Completed
12.8x
NA
100.0%
940.8
Completed
8.8x
8.8x
49.0%
846.1
Completed
15.8x
NA
10.0%
67.5
Completed
10.7x
NA
100.0%
531.1
Completed
10.5x
NA
50.0%
140.0
Completed
46.0x
5.5x
100.0%
121.5
Terminated
5.6x
5.7x
100.0%
110.2
Completed
7.9x
6.8x
100.0%
500.0
Completed
19.8x
NA
100.0%
4,300.0
Terminated
14.0x
11.3x
16.7%
136.4
Completed
8.2x
7.4x
35.0%
120.8
Terminated
8.2x
NA
9.0%
248.0
Completed
6.4x
8.6x
49.0%
960.0
Completed
8.0x
NA
20.0%
148.2
Completed
11.1x
9.7x
12.4x 9.7x 46.0x 3.9x
8.0x 8.0x 11.3x 5.5x
Mean Median High Low
2.3.12.
Adj. AMV / EBITDAR Historic Forecast 3.9x NA
Pension Liabilities
Please refer to section 2.2.7 in the Comparable Companies Analysis chapter.
2.3.13.
Financial Fixed Assets
Financial fixed assets are long-term investments, typically unrelated to the business. Any income (i.e. interest or dividend) from these assets would come under the EBIT line in the income statement and, therefore, the value of the assets needs to be excluded from the Enterprise Value (at book value, or at market value in case of listed securities) for the purpose of calculating EBITDA or EBIT multiples. It is a fair assumption, that the purchaser has valued these assets separately from the core business.
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Example: Acquisition of a Company with Significant Financial Fixed Assets Target Income Statement Equity purchase price
€1,000
Net debt
€1,200
Financial fixed assets
€600
EBITDA
€275
Note: Enterprise Value: 1,000 + 1,200 = €2,200 Adjusted EV (i.e. value of operational / “EBITDA generating” business) = 1,000 + 1,200 - 600 = €1,600 Adj. EV / EBITDA = 1,600 / 275 = 5.8x
2.3.14.
Contingent Liabilities
Occasionally a target has material contingent liabilities (e.g. environmental or asbestos liabilities) that are not reflected as debt on the balance sheet, but will result in a future cash outflow. These liabilities result in reduced equity consideration (an acquiror will pay less for a business that has large future cash liabilities), and the balance sheet and income statement may need to be adjusted to ensure consistency. Great care should be taken to: „ Classify the liability appropriately as operating or non-operating „ Treat the balance sheet and income statement consistently If the liability is deemed to be operating (i.e. a normal part of the business, affects both debt and equity holders), there are two possible ways to make consistent adjustments: „ The Present Value of the liability (often estimated by US companies in the 10K filings) should be added to the Equity and Enterprise Values (i.e. how much the acquiror would have paid if there had not been a contingent liability) and no adjustment should be made to the P&L „ An annual expense should be incorporated on the income statement above EBIT and the effect of this expense should flow through to Net Income. The annual expense should approximate the Present Value of the liability multiplied by the business WACC. The result is reduced EBIT and Net Income to match the actual enterprise and equity consideration (which reflect the acquiror’s awareness of the contingent liability) If the liability is deemed to be non-operating (i.e. a cash flow to debt holders only), an interest-like expense should be incorporated on the income statement, thereby affecting Net Income, but not EBIT. The annual expense should approximate the Present Value (often estimated by US companies in the 10K filings) of the liability multiplied by the cost of debt. The Present Value of the liability should also be included as debt on the balance sheet.
2.4.
Special Situations
2.4.1.
Dividend Distributions to Selling Shareholders
If a special dividend is issued in connection with an acquisition it should be included in the transaction consideration, but the treatment depends on which party pays the dividend „ Acquiror pays dividend - include in Equity Consideration „ Target pays dividend - include in Net Debt
2.4.2.
Earn-Outs
In situations where consideration is contingent on future business performance (earn-outs) the consideration should theoretically assume the level of the consideration anticipated at the time of announcement. Often it is difficult to determine the expected level, but earn-outs are often based at zero if the business meets its projections; in such cases, the anticipated value of the earn-out should be assumed to be zero. Adding a comment in the commentary section with the adjusted multiple(s) including the earn-out at full value should be considered by the preparer.
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2.4.3.
Tax Basis Step-up
Transactions where the acquiror receives a tax basis step-up for the assets being acquired will require or allow the acquiror to pay a higher price, and this information should be captured in the Compacq analysis. A tax basis step-up will only occur in certain circumstances, mainly in asset transactions.
3.
Compacq Analysis Output
3.1.
Cross Checking the Results
„ Equity research reports (specific reports on the target / acquiror and/or sector notes) „ Press releases / press articles „ Old presentations „ Industry team
3.2.
Standard Output
Example: Bus Sector LTM EV/ EBITDA
LTM P/E
Stake
EV(1) ($m)
Spain
100%
807
9.3x
NA
Australia
100%
78
~9x(2)
NA
Connex
US
100%
93
5.1x
NA
3i
France
53%
683
4.7x
15.6x(3) 18.9
Date
Target
Acquiror
Country
Oct-05
Alsa
National Express
Aug-05
National Express Australia
JV incl. ComfortDelGro
Jul-05
ATC (National Express)
May-04
Keolis
Jun-03
Citybus
Delta Pearl Limited
Hong Kong
100%
290
6.9x
Jul-02
Stagecoach Portugal
Vimeca Transp. Viacao
Portugal
100%
21
7.1x
NA
Oct-99
Swebus
Concordia
Sweden
100%
261
5.9x
25.0x
Jul-99
Ryder Public Transp Svcs
FirstGroup
US
100%
940
9.7x
NA
Jun-99
Coach USA
Stagecoach
US
100%
1,836
11.7x
24.0x
Dec-98
Citybus Group
Stagecoach
Hong Kong
100%
450
12.4x
17.4x
Oct-98
Greyhound Lines
Laidlaw
US
100%
604
7.5x
22.2x
Sep-98
VSN North
Arriva
Netherlands
100%
79
3.3x
24.3x
Aug-98
Yellow Bus
Stagecoach
New Zealand
100%
57
8.2x
15.9x
Dec-97
Linjebuss
GCEC Transport
Sweden
67%
309
6.2x
25.4x
Median
300
7.3x
22.2x
Mean
645
7.6x
21.0x
(1) (2) (3)
CS Assessed Relevance
üüü ü üü üüü üü üü üüü ü ü üü ü üüü ü üüü
Enterprise value as per 100% Depreciation estimated at 5% of sales Keolis earnings based on CS estimates
3.3.
Sector Specific Multiples
Similar to the Compco analysis, most industry sectors have specific valuation metrics that need to be reflected in the input and output for a Compacq analysis. Examples are set out in the Comparable Companies Analysis chapter. Consult industry group bankers to identify which multiples to use in a particular situation.
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4.
Common Pitfalls
In addition to those noted under the corresponding section in Comparable Companies Analysis: „ Completing the analysis despite lack of appropriate information (show “NA”, rather than a wrong result) „ Getting the enterprise and equity considerations wrong (levered vs. unlevered consideration) „ Not commenting on status of industry cycle (in case of cyclical industries) at time of the transaction „ Not checking database numbers for accuracy „ Not footnoting assumptions or unusual data items. It is important to create an audit trail which will allow others to follow the methodology used „ Using the multiples on projected, not historic results
5.
Example
The task is to perform a Compacq analysis on the acquisition of Debenhams plc (“Debenhams”), a UK mid-market department store chain, by a private equity consortium consisting of CVC Capital Partners, Texas Pacific Group and Merrill Lynch Private Equity (the “Sponsors”) in September 2003.
5.1.
Step 1: Information Gathering
As Debenhams was a public company prior to the transaction, a key source of information is the offering circular which was filed as part of the public takeover process. Note: It is important to source the right offering circular, i.e. the one that includes the parameters for the completed transaction. In the case of the Debenhams transaction, there were a number of public offers before the shareholders accepted the offer at 470p per share from the Sponsors. Therefore, the date of the offering circular should be checked against other data sources (i.e. a detailed mergermarket report lists the chain of events in the context of the transaction). Besides the offering circular, the following data sources should be compiled in order to develop a thorough understanding of the transaction: „ Mergermarket and SDC full detail report on the completed transaction „ Debenhams latest available annual and interim reports prior to or around the date of the transaction „ News run 6 months prior to announcement to 1 month after completion, i.e. February 2003 to January 2004 „ Pre- and post-announcement equity research reports on Debenhams
5.2.
Step 2: Filling in the Qualitative Columns
Acquiror and Target Data
Target Name
Debenhams plc
Target Country
UK
Business Description
UK mid-market department store chain
Acquiror Name
CVC Capital / Texas Pacific Group / Merril Lynch Private Equity
Acquiror Country
UK
Note: It is important to list the full name of the target and the acquiror. In case of this transaction, the private equity groups formed a new entity called Baroness Retail Ltd. as bid vehicle, however the name of this entity is an irrelevant technicality from the perspective of the Compacq analysis.
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Transaction Data
Comment
Announced Date
23/10/2003
„ Use announcement date of the final successful offer
LTM Date
31/08/2003
„ Latest available historic information which were used for Compacq
Last Fiscal Year
31/08/2003
„ Date of latest fiscal year
The objective of the Compacq is to evaluate the offer for Debenhams plc in relation to the information being used by the Sponsors at the time they valued the company. The offering circular and the annual report 2003 include the consolidated financials for the financial year ended 30 August 2003, which is closest to the announcement date and, therefore, the relevant LTM date for our analysis.
5.3.
Step 3: Prepare LTM Income Statement
Since the full year financials for the relevant LTM date are published in the offering circular/annual report 2003, we do not have to calculate the LTM financials for this transaction (for a description on how to prepare LTM income statements, please refer to section 2.2.6 of the Comparable Companies Analysis chapter). The key P&L data used for the Compacq valuation are summarised below. Target Financials (100%, £ in millions)
1,810.2
Sales EBITDA
258.5
% Margin
14.3%
EBIT
175.8
% Margin
9.7%
Net Interest
(7.4)
Taxation
(43.7)
Net Income
124.7
The financials in the offering circular / annual report 2003 have already been normalised for exceptional costs of £17.4m consisting of advisory fees of £13.6m and £3.8m cost related to increased costs of share schemes due to the takeover situation. An analysis of the notes further reveals that the above financials include a profit from disposal of fixed assets of £1.6m, which needs to be excluded from the relevant items of the income statement. Adjusted EBITDA: = 258.5 - 1.6 = £256.9m Adjusted EBIT: 175.8 - 1.6 = £174.2m Adjusted Net Income (UK corporate tax @ 30%): 124.7 - 1.6*(1-0.3) = £123.6m It is important to ensure that any income statement adjustments are appropriately tax-adjusted at different points on the income statement.
5.4.
Step 4: Calculate Consideration Paid and Assumed Liabilities
The next step in order to calculate the correct equity and enterprise considerations, is to analyse the structure of the transaction. The four factors that determine the transaction structure and the relevant answers are as follows: „ Is the acquiror purchasing assets or equity? Answer: Equity „ What percentage of the target is being purchased? Answer: 100% „ How is the transaction being effected? Answer: Public tender offer „ What is the target ownership structure? Answer: Public owned entity
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5.4.1.
Calculation of Equity Consideration
To calculate the equity consideration, source the offer price and the number of shares in issue from the offering circular. The notes of the annual report 2003 provide the necessary details to calculate the fully diluted share count under the treasury method. No. Options (m) 2.60 2.80 0.10 0.50 0.30 0.60 0.60 1.40 0.30 0.70 0.70 0.60 4.50 2.50 0.40 0.10 2.20 0.80 1.10 4.10 26.90
Description Long-term Incentive Plan ESOP
All Employees Share Option Scheme Sharesave Scheme
Exercise Price No. Options (p) Exercised – 2.60 388.50 2.80 394.00 0.10 329.50 0.50 465.50 0.30 300.00 0.60 181.00 0.60 207.00 1.40 447.25 0.30 386.50 0.70 396.00 0.70 284.25 0.60 257.00 4.50 400.00 2.50 311.00 0.40 294.00 0.10 145.00 2.20 358.00 0.80 311.00 1.10 247.00 4.10 26.90
Converted Options Shares Buy-Back from Options (7,133 / 470p) Net Options
Proceeds – 1,087.80 39.40 164.80 139.70 180.00 108.60 289.80 134.20 270.60 277.20 170.60 1,156.50 1,000.00 124.40 29.40 319.00 286.40 342.10 1,012.70 7133.20
26.9 (15.2) 11.7
The resulting calculation of the equity consideration is summarised below. Consideration Data
Comment
Stake Acquired
100.0%
Consideration Payable in
Cash
Inputs in Currency
GBP
Offer Price (p)
470.0
„ As per Offering Circular
#Total Shares Outstanding (m)
366.4
„ As per Offering Circular
Net Options (m)
11.7
„ As per Annual Report 2003
Equity Consideration (£m)
1,777.3
70
5.4.2.
Calculation of Enterprise Value
As this transaction was effected through a public tender, the acquiror had to assume all of the target’s debts and other liabilities. The offering circular and annual report include the relevant balance sheet items to calculate the total enterprise value. Besides the assumed debt for the transaction, also thoroughly read the notes in the offering circular and annual report to account for any other financial items that would affect the enterprise value (e.g. minority interest, investments in associated companies, leases, contingent liabilities). Total Equity Consideration (100%, £ in millions)
1,777.3
Short-Term Debt
86.6
Long-Term Debt
59.4
Convertibles
–
Preferred Stock
–
Total Debt
146.0
Cash
(18.2)
Marketable Securities Total Cash & Equivalents Total Enterprise Value
– (18.2) 1,905.1
Note: Always use the comments function in excel to footnote the exact source of each item (i.e. stating the page number of the annual report where the information can be found) to ensure that the transaction multiples can be audited and used easily by colleagues.
5.5.
Step 5: Calculate Industry Specific Multiples
Adj. EV/EBITDAR multiples are commonly referred to in the retail industry and the Compacq output includes such multiples for other transactions. Note: Retailers can either own, rent or lease the properties they operate (retail stores, distribution warehouses etc). As real estate is core to their business, the ownership status of the real estate portfolio is mainly a financing decision (i.e. P&L impact is either in the form of depreciation or in the form of lease/rent charges). Retailers’ ability therefore to generate EBITDAR (i.e. “pre-financing operating income”) is seen by many market observers as more relevant to compare than EBITDA or EBIT. Consequently, Adj. EV (i.e. EV + market value of leased/rented properties) / EBITDAR multiples may better highlight differences in ratings. To estimate the “market value” of the leased/rented properties (i.e. capitalised leases/rentals) a weighted average “opportunity cost” (i.e. yield) is usually assumed for the property portfolio. Sources for this assumption could be various depending on the information disclosure and the circumstances of the transaction.
5.5.1.
Calculate Adjusted Enterprise Value
The notes to the annual report reveal that Debenhams had an operating lease charge of £59.5m in FY2003. No information has been disclosed by Debenhams in relation to the market value of its leased/rented properties. However, the average yield of commercial real estate in the UK was estimated to be at around 7% at the time of the transaction. Lease Capitalisation Adjustment: 59.5/0.07 = £850.0m Adjusted Enterprise Value: £2,755.1m
5.5.2.
Calculate EBITDAR
EBITDA + Operating lease rental charge: 256.9 + 59.5 = £316.4m
71
5.5.3.
Resulting Multiples
The resulting transaction multiples of the Compacq analysis is shown below below. (in £ millions except stated otherwise)
Date
Acquiror
Target
Business of Target
Announced 23-10-2003
CVC Capital /Texas Pacific Group/ Merrill Lynch Private Equity
Debenhams
UK mid-market department store chain
17-06-2003
Baugur Group
Hamleys
UK-based toy retailer
12-05-2003
Wittington Investments
Selfridges
19-12-2002
Scarlett Retail (Minerva)
18-09-2002
Broadgain (Dickson Poon)
10-09-2002
08-03-2002
Ent.
Value
Value
Adj. Ent. (1)
Value
Adj. EV / EBITDAR
(1)
EV / EBITDA
P/E
1,777
1,905
2,755
8.7x
7.4x
14.4x
59
67
67
8.2x
8.2x
17.4x
Upmarket UK department store chain
598
628
631
10.7x
10.7x
21.1x
Allders
UK department and homeware store chain
135
162
546
10.0x
5.8x
11.5x
Harvey Nichols
Upmarket UK department store chain
69
143
216
9.7x
8.3x
16.1x
Taveta (Philip Green)
Arcadia
UK clothing retailer comprising Topshop, Topman, Evans, Burton, Dorothy Perkins, Wallis and Miss Selfridge
850
847
3,487
9.2x
4.4x
13.1x
JJB Sports PLC
TJ Hughes
Liverpool-based discount department store operator
42
46
49
5.8x
5.6x
12.5x
High
10.7x
10.66x
21.1x
Average
8.9x
7.18x
15.1x
(1) Each target based in the UK. Property leases capitalised assuming a 7% yield.
72
Equity
Median
9.2x
7.42x
14.4x
Low
5.8x
4.36x
11.5x
Valuation Matrix
73
Valuation Matrix 1.
Overview
1.1.
Objectives
This chapter aims to answer the following key questions: „ What is the purpose of a Valuation Matrix? „ What are the common ratios used in a Valuation Matrix? How are they calculated?
1.2.
What Is a Valuation Matrix?
„ The Valuation Matrix is a financial analysis that shows the implied multiples across a range of values for a company. It is pure calculation with no inherent analytical content and allows the reader to compare valuation parameters and implications in real time with no calculations necessary (e.g. a net income multiple of X implies an EBIT multiple of Y) „ The Valuation Matrix provides a sensitivity analysis to the company’s valuation parameters. It presents key multiples at different valuations
1.3.
What Is a Valuation Matrix Used For?
„ The Valuation Matrix helps determine a company's equity value and offer price per share for an Initial Public Offering and/or its value for acquisition or divestiture. It can also be useful in formulating a bidding strategy or assessing the relative price considered for a target acquisition „ The Valuation Matrix, while simple in its construction, is one of the most useful tools that investment bankers use on a day-to-day basis. A Valuation Matrix should be completed for each and every valuation analysis
1.4.
What Is Needed to Complete a Valuation Matrix?
Only two items of data are required to complete a Valuation Matrix: „ Key items of historical and projected financial data (e.g. Sales, EBITDA, Net Income) „ A preliminary opinion as to a valuation range for the company being examined
1.5.
What Does a Valuation Matrix Look Like?
The following illustrations display two different examples of a generic Valuation Matrix. The second of the two variations shown is more useful in an M&A situation when more details need to be shown.
75
Valuation Matrix – Variation A (€ in millions)
Equity Value (1,2) per share Enterprise Value (3)
1,000.0 25.0 1,200.0
1,100.0 27.5 1,300.0
1,200.0 30.0 1,400.0
1,300.0 32.5 1,500.0
Metric LTM FY 2006E FY 2007E
1,300.0 1,400.0 1,550.0
0.9x 0.9x 0.8x
1.0x 0.9x 0.8x
1.1x 1.0x 0.9x
1.2x 1.1x 1.0x
LTM FY 2006E FY 2007E
225.0 240.0 260.0
5.3x 5.0x 4.6x
5.8x 5.4x 5.0x
6.2x 5.8x 5.4x
6.7x 6.3x 5.8x
Enterprise Value / EBIT (4)
LTM FY 2006E FY 2007E
160.0 180.0 190.0
7.5x 6.7x 6.3x
8.1x 7.2x 6.8x
8.8x 7.8x 7.4x
9.4x 8.3x 7.9x
Equity Value / Net Income (4)
LTM FY 2006E FY 2007E
105.0 120.0 126.0
9.5x 8.3x 7.9x
10.5x 9.2x 8.7x
11.4x 10.0x 9.5x
12.4x 10.8x 10.3x
Enterprise Value / Sales (4)
Enterprise Value / EBITDA
Sources: (1) (2) (3) (4)
(4)
Company information; I/B/E/S consensus estimates; CS IB analysis Assumes 40.0 million basic shares outstanding as of 31 December 2005 Assumes there are no exercisable options outstanding Assumes Net Debt of €200.0 million as of 31 December 2005 I/B/E/S consensus estimates (median) as of 1 August 2006
Comparable multiples of selected companies can be shown graphically (i.e. as shading) to help bracket the selected value range. Additional Variations The Valuation Matrix is a very flexible analytical tool that easily allows customisation and has the ability to show a significant amount of information for deal decision-making. „ Implied stock price premiums can be added for publicity listed companies to allow benchmarks against precedent sector or market deals „ “Discount to DCF-derived equity value” can be added to illustrate whether or not the selected range represents a standard trading discount to DCF for companies primarily valued on DCF
76
Valuation Matrix – Variation B (€ in millions)
€ per share
Equity Value
EV
(in €m)(1)
(in €m)(2)
23.75
950
1,150
25.00
1,000
26.25 27.50
Premium to Stand-Alone Value Low
High
EV / Sales
EV / EBITDA
EV / EBIT
P/E
LTM
2006E
2007E
LTM
2006E
2007E
LTM
2006E
2007E
LTM
2006E
2007E
(11.5%) (20.7%) (28.1%)
0.9x
0.8x
0.7x
5.1x
4.8x
4.4x
7.2x
6.4x
6.1x
9.0x
7.9x
7.5x
1,200
(7.7%)
(17.2%) (25.0%)
0.9x
0.9x
0.8x
5.3x
5.0x
4.6x
7.5x
6.7x
6.3x
9.5x
8.3x
7.9x
1,050
1,250
(3.8%)
(13.8%) (21.9%)
1.0x
0.9x
0.8x
5.6x
5.2x
4.8x
7.8x
6.9x
6.6x
10.0x
8.8x
8.3x
1,100
1,300
0.0%
(10.3%) (18.8%)
1.0x
0.9x
0.8x
5.8x
5.4x
5.0x
8.1x
7.2x
6.8x
10.5x
9.2x
8.7x
Medium
28.75
1,150
1,350
3.8%
(6.9%)
(15.6%)
1.0x
1.0x
0.9x
6.0x
5.6x
5.2x
8.4x
7.5x
7.1x
11.0x
9.6x
9.1x
30.00
1,200
1,400
7.7%
(3.4%)
(12.5%)
1.1x
1.0x
0.9x
6.2x
5.8x
5.4x
8.8x
7.8x
7.4x
11.4x
10.0x
9.5x
31.25
1,250
1,450
11.5%
0.0%
(9.4%)
1.1x
1.0x
0.9x
6.4x
6.0x
5.6x
9.1x
8.1x
7.6x
11.9x
10.4x
9.9x
32.50
1,300
1,500
15.4%
3.4%
(6.3%)
1.2x
1.1x
1.0x
6.7x
6.3x
5.8x
9.4x
8.3x
7.9x
12.4x
10.8x
10.3x
33.75
1,350
1,550
19.2%
6.9%
(3.1%)
1.2x
1.1x
1.0x
6.9x
6.5x
6.0x
9.7x
8.6x
8.2x
12.9x
11.3x
10.7x
35.00
1,400
1,600
23.1%
10.3%
0.0%
1.2x
1.1x
1.0x
7.1x
6.7x
6.2x
10.0x
8.9x
8.4x
13.3x
11.7x
11.1x
36.25
1,450
1,650
26.9%
13.8%
3.1%
1.3x
1.2x
1.1x
7.3x
6.9x
6.3x
10.3x
9.2x
8.7x
13.8x
12.1x
11.5x
37.50
1,500
1,700
30.8%
17.2%
6.3%
1.3x
1.2x
1.1x
7.6x
7.1x
6.5x
10.6x
9.4x
8.9x
14.3x
12.5x
11.9x
38.75
1,550
1,750
34.6%
20.7%
9.4%
1.3x
1.3x
1.1x
7.8x
7.3x
6.7x
10.9x
9.7x
9.2x
14.8x
12.9x
12.3x
40.00
1,600
1,800
38.5%
24.1%
12.5%
1.4x
1.3x
1.2x
8.0x
7.5x
6.9x
11.3x
10.0x
9.5x
15.2x
13.3x
12.7x
41.25
1,650
1,850
42.3%
27.6%
15.6%
1.4x
1.3x
1.2x
8.2x
7.7x
7.1x
11.6x
10.3x
9.7x
15.7x
13.8x
13.1x
42.50
1,700
1,900
46.2%
31.0%
18.8%
1.5x
1.4x
1.2x
8.4x
7.9x
7.3x
11.9x
10.6x
10.0x
16.2x
14.2x
13.5x
Metric
1,300
1,450
1,600
1,300
1,400
1,550
225
240
260
160
180
190
105
120
126
Source: (1) (2)
Company information; I/B/E/S consensus estimates (median) as of 1 August 2006; CS IB analysis Based on 40.0 million basic shares outstanding as of 31 December 2005; asumes there are no exercisable options outstanding Assumes Net Debt of €200m as of 31 December 2005
The valuation matrix summarises critical information such as multiples at different prices and the implied share price of offer values. A shaded row highlights the suggested mid-point of a valuation range and the table allows a quick overview of the valuation parameters.
2.
How to Complete a Valuation Matrix
2.1.
Getting Started
2.1.1.
Select Appropriate Sources of Information
„ The Valuation Matrix is a model (in some cases circular) that can be developed in many different ways depending on what information is available
2.1.2.
Setting Up a Valuation Matrix
„ The Valuation Matrix is a grid that allows an easy translation between transaction prices, multiples and company data. For example, Compco analysis may imply a range of public market P/E multiples of 10.0x–12.5x for 2006 estimated (consensus) net income. The user can refer to the Valuation Matrix and, from the previous example, read an equity consideration of €1,200 million to €1,500 million „ Alternatively, the client may refer to valuation levels (equity) of around €1.4 billion and infer that this corresponds to an EV/EBITDA 2006E multiple of 6.7x. Referring to the Valuation Matrix grid, the team may conclude that the implied multiples for an equity value of €1,550 million or €38.75 per share (1.1x next year's revenue, 6.7x next year's EBITDA, 12.3x next year's earnings) seems high
2.2.
Common Inputs and Outputs
2.2.1.
Range of Offering Prices / Company Values
„ The only essential choices which need to be made when constructing a Valuation Matrix are determining the midpoint of the valuation range and determining the boundaries (i.e. the highest possible number and the lowest possible number around the mid-point). A Compco that has already been completed for the company's industry can help develop a first-guess valuation around which to build a range. Check with senior team members for the first estimate of an appropriate range
2.2.2.
Time Periods
„ The time periods included in the analysis will be trailing (usually last reported or LTM), projected, or a combination of the two. Consult with team members about the appropriate time periods to include in the analysis, however, as a general rule, the more data in the Valuation Matrix, the more useful the analysis will be
2.2.3.
Multiples
„ The multiples that are included in the analysis will depend on the industry in which the company operates. Multiples can include, but are not limited to Revenues, EBITDA, EBIT and Net Income. Credit Suisse industry or product groups often use standard sets of multiples with which to value clients in certain industries. Check with team members, industry experts in the investment banking department, published research reports and/or published research models. Similar to the Compco analysis, most industry sectors have specific valuation metrics that need to be reflected in the Valuation Matrix. Examples are set out in the Comparable Companies Analysis chapter. Consult with industry group bankers to identify which multiples to use in a particular situation „ However, keep in mind that any communication with CS Research needs to be in compliance with the firm's policies and procedures, which requires, among other things, pre-clearance with Compliance and/or Compliance chaperoning. If in doubt, please contact the Legal and Compliance Department (LCD) or a senior team member
2.3.
General Valuation Matrix Steps
„ Select the types of multiples (e.g. EV/EBITDA, P/E) and which time periods to include in the Valuation Matrix „ Determine a reasonable range of IPO offering prices / company values „ Calculate Net Debt (where appropriate if examining as multiples of Enterprise Value)
78
„ Calculate multiples „ Interpret model and answer questions Merger Case Application Steps „ Enter price range for Valuation Matrix grid § Consult with team leader for the appropriate range „ Enter the company's financials § Enter the financials for the multiples to be calculated. Typical items include Sales, EBITDA, EBIT, Net Income and Tangible Book Value „ Calculate multiples for each point in the range § Calculate multiples for relevant company financials. Ensure that the multiples for financial data before interest expense (e.g. Sales, Gross Profit, EBITDA and EBIT) use levered consideration (Enterprise Value). Also make sure that the multiples for financial data after interest expense (e.g. Net Income) use equity consideration. „ Interpret the model and answer questions Initial Public Offering Application Steps „ Calculate pro forma earnings Calculating pro forma Net Income examines the company's valuation relative to its earnings after taking into consideration what the company will do with the proceeds from the offering. Remember that proceeds usage will generally drive incremental interest or interest savings, either of which will impact Net Income. Net Income, in turn, may drive proceeds for P/E-valued companies. Hence there is a circularity that must be factored into the model „ Make first guess at post-offering equity value range As a first guess, build a range around this number in increments of €50 million (for medium-sized companies). Get input from team members, team leader, or ECM as needed „ Calculate multiples for each point in range Verify that a reasonable post-offering equity value range has been chosen. Do the multiples shown on the Valuation Matrix represent an appropriate range in relation to where comparable companies are trading? „ Calculate what percentage of the company must be sold to raise X million (e.g. Euros). Complete the following calculation for each column in the model: Amount Being Raised
% of Company sold =
Post-Offering Equity Value
%
„ Calculate how many shares must be sold. Complete the following calculation for each column in the model:
# of Shares sold = Shares Outstanding x
(
% of Company Sold 1-% of Company Sold
)
„ Calculate diluted per share value. Complete the following calculation for each column in the model:
Per Share Value Fully Distributed =
Post-Offering Equity Value Post-Offering Shares Outstanding
„ Interpret the Valuation Matrix and answer questions from team members and the client
79
Key Outputs and Associated Inputs Key Output
Basic Calculation
Associated Inputs
Diluted Shares Outstanding x Offer Price
Pre-Offering Equity Market Cap = Post-Offering Equity Size =
Pre-Offering Equity Size + Equity Offering Size
Post-Offering Net Debt =
Pre-Offering Net Debt – Proceeds Applied to Debt
„ Offer Price „ Diluted Shares Outstanding „ Pre-Offering Equity Size „ Equity Offering Size „ Short-Term Debt
„ Cash
„ Long-Term Debt
„ Use of Proceeds
„ Leases „ Offer Price
Equity Market Cap + Net Debt
Levered Consideration =
„ Diluted Shares Outstanding „ Post-Offering Net Debt
Levered Consideration
Revenue Multiples =
„ Trailing or Projected Revenues
Revenues Levered Consideration
EBIT Multiples =
Levered Consideration
3.
„ Levered Consideration „ Trailing or Projected EBITDA
EBITDA
„ Equity Consideration
Equity Consideration
Net Income Multiples =
„ Levered Consideration „ Trailing or Projected EBIT
EBIT
EBITDA Multiples =
„ Levered Consideration
„ Trailing or Projected Net Income
Net Income
Common Pitfalls
Getting the valuation range wrong is probably the most common pitfall. A good approach is to start with a “football field” graph (also called floating bars) where the multiple ranges of comparable companies as well as comparable acquisition analysis will provide an indication how a suitable range should be framed. Also refer to the Comparable Companies Analysis chapter for additional common pitfalls that may also apply to the Valuation Matrix. Illustrative Football Field / Floating Bars – Variation A (€ in millions) 35.0 34.0
34.0
33.0
33.0 32.5
30.0
32.5
30.0
30.0
30.0
Selected Range
Analyst Price Targets
28.5 28.0
26.0 Trading Range
DCF
Comparable Company Analysis
Comparable Acquisition Analysis
Equity Value
1,120m - 1,320m
1,200m - 1,360m
1,040m - 1,300m
1,200m - 1,400m
1,140m - 1,320m
1,200m - 1,300m
1,200m - 1,360m
Enterprise Value
1,320m - 1,520m
1,400m - 1,560m
1,240m - 1,500m
1,400m - 1,600m
1,340m - 1,520m
1,400m - 1,500m
1,400m - 1,560m
EV/Sales 2006E
0.94x - 1.09x
1.00x - 1.11x
0.89x - 1.07x
1.00x - 1.14x
0.96x - 1.09x
1.00x - 1.07x
1.00x - 1.11x
EV/EBITDA 2006E
5.50x - 6.33x
5.83x - 6.50x
5.17x - 6.25x
5.83x - 6.67x
5.58x - 6.33x
5.83x - 6.25x
5.83x - 6.50x
EV/EBIT 2006E
7.33x - 8.44x
7.78x - 8.67x
6.89x - 8.33x
7.78x - 8.89x
7.44x - 8.44x
7.78x - 8.33x
7.78x - 8.67x
9.3x - 11.0x
10.0x - 11.3x
8.7x - 10.8x
10.0x - 11.7x
9.5x - 11.0x
10.0x - 10.8x
10.0x - 11.3x
P/E 2006E
80
LBO Analysis
Illustrative Football Field / Floating Bars – Variation B (In € per share) EV / Sales 2006E
EV / EBITDA 2006E
EV / EBIT 2006E
P/E 2006E
Trading Range
0.94x - 1.09x
5.50x - 6.33x
7.33x - 8.44x
9.3x - 11.0x
DCF
1.00x - 1.11x
5.83x - 6.50x
7.78x - 8.67x
10.0x - 11.3x
Comparable Companies Analysis
0.89x - 1.07x
5.17x - 6.25x
6.89x - 8.33x
8.7x - 10.8x
Comparable Acquisition Analysis
1.00x - 1.14x
5.83x - 6.67x
7.78x - 8.89x
10.0x - 11.7x
LBO Analysis
0.96x - 1.09x
5.58x - 6.33x
7.44x - 8.44x
9.5x - 11.0x
Selected Range
1.00x - 1.07x
5.83x - 6.25x
7.78x - 8.33x
10.0x - 10.8x
30.0
Analyst Price Targets
1.00x - 1.11x
5.83x - 6.50x
7.78x - 8.67x
10.0x - 11.3x
30.0
28.0
33.0
30.0
26.0
34.0
32.5
30.0
28.5
35.0
33.0
32.5
34.0
81
4.
Case Studies
The following case studies demonstrate the mechanics and uses of the Valuation Matrix. Each case is presented and provides worksheets to assist in performing the calculations. Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set.
4.1.
Merger Application
„ The owners of Premium Cars AG would like to compare potential IPO valuations against outright sale valuations. Using the assumptions about Premium Cars AG, create a Valuation Matrix and determine the following: § What is the approximate price range implied from the multiples from other valuation models (Compco, DCF Analysis and Compacq)? § What are the implied multiples from various price ranges? Merger Application Assume that a private company, Premium Cars AG, wishes to compare potential IPO valuations with outright sale valuations. Merger Application Inputs (€ in millions)
Total Debt Cash Net Debt 2006E Sales
500.0 (200.0) 300.0 1,400.0
2006E EBITDA
240.0
2007E EBITDA
260.0
LTM Net Income
105.0
2006E Net Income
120.0
2007E Net Income
126.0
Corporate Tax Rate (%)
82
30.0
Merger Application Worksheet Directions: Now that the information is available, the Valuation Matrix is ready to be calculated. In order to simplify things, the Valuation Matrix format has already been set up. It is now necessary to input the information for Premium Cars AG into the Valuation Matrix. Perform the relevant calculations to complete the Valuation Matrix output. (€ in millions)
Equity Consideration (€ m) Net Debt Levered Consideration (€ m) Multiple of Revenue (Leveraged) (x) 2006E Multiple of EBITDA (Leveraged) (x) 2006E 2007E Multiple of Net Income (x) LTM 2006E 2007E
Metric
1) Enter the Price Range for the Valuation Matrix Grid Consult the team leader to get an appropriate range for the Valuation Matrix. The user should try to have the relevant valuation range and multiples print within the Valuation Matrix grid. In this case, use a equity consideration range of €1,200 to €1,650 million. 2) Enter the Company’s Financials Enter the financials for the accounts for which the multiples are to be calculated. Typical financial items include Sales, EBITDA, EBIT, Net Income and Tangible Book Value. 3) Calculate The Multiples For Each Point In The Range Calculate the multiples for relevant company financials. Ensure that the multiples for financial data before interest expense (e.g. Sales, Gross Profit, EBITDA and EBIT) use levered consideration (Enterprise Value). Also make sure that the multiples for financial data after interest expense (e.g. Net Income) use equity consideration. Range Of Levered Market Cap (€ in millions)
Metric
1,500
1,550
1,600
1,650
1,700
1,750
1,800
1,850
1,900
1,950
1,250
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
Revenue 2006E EBITDA 2006E 2007E
Range Of Equity Value Metric
1,200
Net Income LTM 2006E 2007E
Verify that a reasonable equity value range has been chosen. Do the multiples represent an appropriate range, given where comparable companies are trading? Interpreting the Results „ What is the approximate price range implied from the multiples from other valuation models (Compco, DCF Analysis and Compacq)? „ What are the implied multiples from various price ranges?
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4.2.
IPO Application
„ The owners of Premium Cars AG wish to analyse potential IPO valuations for its privately-owned niche automotive company. Using the assumptions about Premium Cars AG, create a Valuation Matrix and determine the following: § What is the post-offering Market Cap of the company? § What percentage of the company must be sold to raise €400 million? § How many shares must be sold? § What is the approximate price per share at which the company can go public? IPO Application: Premium Cars AG Premium Cars AG, a private company, wants to raise approximately €400 million by issuing primary shares (i.e. new shares. A secondary offering represents sales of shares by an existing shareholder to a new shareholder and has no impact on the company’s financial statements or common stock). It will use the proceeds to pay down debt that has an interest rate of 5%. There are currently 40 million ordinary shares outstanding to the current owners. IPO Application Inputs (€ in millions)
Pre-Offering Net Debt
500.0
Proceeds from the IPO
(400.0)
Post-Offering Net Debt
100.0
2006E Sales
1,400.0
2006E EBITDA
240.0
2007E EBITDA
260.0
LTM Net Income
105.0
2006E Net Income
120.0
2007E Net Income
126.0
Corporate Tax Rate (%)
30.0
Shares Outstanding (m)
40.0
„ Also assume the following: § A Compco prepared by a team member showed that the median P/E ratio at which comparable companies are trading is 9.5x 2006E P/E and 10.0x 2007E P/E § Proceeds from the sale will be used to pay down debt (and, therefore, will have no impact on sales or EBITDA) Answer These Questions „ Upon completion of this example it should be possible to answer the following questions: § What is the post-offering Market Cap of the company? § What percentage of the company must be sold to raise €400 million? How many shares must be sold? § What is the approximate price per share at which the company can go public?
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IPO Application Worksheet: Premium Cars AG Directions: Now that the information is available, the Valuation Matrix is ready to be calculated. In order to simplify things, the Valuation Matrix format has already been set up. It is now necessary to input the information for Premium Cars AG into the Valuation Matrix. Perform the relevant calculations to complete the Valuation Matrix output. IPO Application Worksheet (€ in millions, except per share amounts)
Per Share Value – Fully Distributed
Metric
Pre-Offering Equity Value Equity Offering Size Post-Offering Equity Value Post-Offering Net Debt Levered Market Capitalization Levered Multiple of Revenues 2006E Levered Multiple of EBITDA 2006E 2007E Multiple of Pro Forma Net Income LTM 2006E 2007E Pre-Offering Shares Outstanding (m) # of Shares Issued Post-Offering Shares Outstanding (m) % of Company Sold The fully distributed price is the expected price at which shares would trade in the market, before any IPO discount.
1)
Pro Forma Earnings Pro Forma 2006E Sales Pro Forma 2006E EBITDA Pro Forma 2007E EBITDA LTM Net Income 2006E Net Income 2007E Net Income IPO Proceeds Interest Rate Corporate Tax Rate Savings from Debt Pay Down
=
x
Pro Forma LTM Net Income
=
+
Pro Forma 2006E Net Income
=
+
Pro Forma 2007E Net Income
=
+
x
(1- ____%)
Calculating pro forma Net Income examines the company's valuation relative to its earnings after taking into consideration what the company will do with the proceeds from the offering. In this case, assume they will use the proceeds to pay down debt with an interest rate of 5%. 2)
Make First Guess at Post-Offering Equity Value Range
Post-Offering Net Debt Pro Forma 2007E Net Income 2007E P/E Multiple Post-Offering Equity Market Cap
=
x
Post-Offering Levered Market Cap
=
+
Post-Offering Equity Value Range
to
Hint:
3)
in € 50 million increments
As a first guess, build a range around this number in increments of €50 million. Input from team members can be helpful when determining the range. Multiples for Each Point in the Range
Pro Forma 2006E Sales Pro Forma 2006E EBITDA Pro Forma 2007E EBITDA Pro Forma LTM Net Income Pro Forma 2006E Net Income Pro Forma 2007E Net Income
Range Of Post-Offering Levered Market Cap (€ in millions)
Metric
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
1,700
1,750
Revenue 2006E EBITDA 2006E 2007E
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Range Of Post-Offering Equity Value (€ in millions)
Metric
1,200
1,250
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
Net Income (Pro Forma) LTM 2006E 2007E
Verify that a reasonable post-offering equity value range has been chosen. Do the multiples represent an appropriate range, given where comparable companies are trading? 4)
Percentage of the Company Sold
Complete the following calculation for each column in the model: Amount to Raise % of Company sold =
Post-Offering Equity Value
%
Range Of Post-Offering Equity Value 1,200
1,250
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
% of Sold
Example:
5)
For a post-offering equity value of €1.4 billion, 28.57% of the company will have been sold (€400 million ÷ €1.4 billion).
Number of Shares Sold
The number of shares outstanding before the offering, and the percentage of the company to be sold, has been determined. It is now possible to calculate the number of shares which need to be sold to the public in order to raise €400 million. Complete the following calculation for each column in the model:
# of Shares sold = Shares Outstanding x
% of Company Sold
(
1-% of Company Sold
)
Shares Outstanding: _____________________ Range Of Post-Offering Equity Value 1,200
1,250
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
% of Sold # Shares
Example:
6)
If Post-Offering Equity Value = €1.4 billion, then 28.57% (or €400 million / €1.4 billion) of the company needs to be sold in order to raise €400 million. If 40 million shares are outstanding before the offering, 16.0 million shares will need to be sold [40 x (0. 2857 / (1 - 0. 2857))].
Per Share Value – Fully Distributed
Complete the following calculation for each column in the model: Post-Offering Equity Value Per Share Value Fully Distributed = Post-Offering Shares Outstanding
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Range Of Post-Offering Equity Value 1,200
1,250
1,300
1,350
1,400
1,450
1,500
1,550
1,600
1,650
% of Sold # Shares Value / Share
Example:
If Post-Offering Equity Value = €1.4 billion, then 28.57% (or 16.0 million shares) of the company needs to be sold in order to raise €400 million. If the post-offering shares outstanding is 56.0 million, then the per share value fully distributed is €25.00.
Interpreting the Results Example: If the company can go public at 10.0x 2007E Net Income, it will have a Market Cap of €1.4 billion, and an IPO price of €25.00 per share. The public will own 28.57% of the stock after the offering. Answer the following questions: „ What is the post-offering Market Cap of the company? „ What percentage of the company must be sold to raise €400 million? How many shares must be sold? „ What is the approximate price per share at which the company can go public?
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Merger Consequences Analysis
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Merger Consequences Analysis 1.
Overview
1.1.
What is the Analysis?
1.1.1.
Description of the Analysis
The Merger Consequence Analysis analyses the impact of a transaction on the financial statements of the potential buyer at various transaction prices and forms of consideration (cash, stock or mix of cash and stock). Frequently analysed financial statement metrics include: „ Income statement / earnings impact (Revenue growth, EBITDA growth and margin, EBIT growth and margin, Net Income growth and margin, Earnings per share) „ Balance sheet / credit impact (Gross Debt / EBITDA, Net Debt / EBITDA, EBITDA / Interest, Net Debt / Total Cap) „ Cash Flow / Cash Flow Impact (FCF per share) Merger Consequence Analyses are important tools in supporting views on the potential market reaction to a transaction. Given the importance of P/E multiples for investors and the straight mathematical relationship between P/E multiples and the EPS impact of a transaction, the primary focus of the analysis relates mainly to EPS accretion / dilution. However, the impact of a transaction on Revenue and EBITDA / EBIT growth (or other metrics’ growth depending on the industry) may be equally important when considering potential market reactions. It must be noted that the analysis of EPS impact is only one of the parameters used by investors to assess the merits of a transaction which is also generally judged on the basis of strategic rationale, potential synergies, economic returns (when does return on investment exceed WACC?) and quality of earnings (in particular with reference to execution risks and overall risk profile of the combined entity).
1.1.2.
Why is it Used?
„ Sell-Side Application § Select best buyer § Buyer’s financial capacity / rating constraints § Accretion / dilution analysis at a given price / consideration mix / growth rates § Synergies required for EPS neutrality „ Buy-Side Application § Buyer’s financial capacity / rating constraints § Accretion / dilution analysis at a given price / consideration mix / growth rates § Synergies required for EPS neutrality § Interloper analysis
1.2.
What Information is Needed to Complete the Analysis?
Completion of a Merger Consequences Analysis requires certain key financial information (see following sub-paragraphs). Moreover, key process / structuring information is also needed: „ Transaction involving the whole or part of share capital of the target § The analysis is generally performed on transactions involving 100% of share capital of the target; however, acquisitions of stakes may also be considered „ Assumed closing date § The analysis is generally performed on a pro forma basis and thus carried out – as a simplifying assumption - as if the closing took place on the first day of the financial year
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1.2.1.
Form of Consideration (Cash, Stock, Mix)
Companies can finance the acquisition through cash (debt), stock, other types of securities or a mix of these. It is typically useful to be able to vary the forms of financing in models. „ Cash / Debt § Cash may come from either the buyer’s balance sheet or be borrowed from a third party § Adjustment is required for interest paid on the debt raised (or interest foregone on an existing cash balance) „ Stock § The value of each share issued is equal to the buyer’s stock price at the time of issue
– An important element of analysis for both buyer and target is represented by the analysis of the fair value of the stock issued, in order to understand real value transfer associated with the execution of the transaction § Adjustment is required for the issuance of shares as it dilutes pro forma EPS § For modelling purposes, it does not matter whether shares are issued to the vendor as consideration or if they are issued to the market to raise funds for a cash deal „ Other § Additional securities that can be issued as acquisition currency include:
– Bonds – standard, convertible or exchangeable – Warrants – Preferred stock – Vendor notes § The calculation of total consideration paid also needs to factor in potential deferred payments (e.g. in the form of earn-outs) „ Mix § A combination of cash / stock and other securities can be used
1.2.2.
Stock Prices / Transaction Value
„ Target For public companies, the current share price should be used (sourced from Factset, Bloomberg or Datastream). If the current share price is not representative (e.g. low stock liquidity, market vs. fundamental value discrepancy, market speculations), a “fair” (based on fundamental valuation) or “unaffected” (prior to start of market speculation) price should also be calculated and assumed as a reference for the analysis. A range of premia may then be considered to be applied to the share price of the target. Such range generally reflects premia paid in relevant recent transactions (i.e. comparable transactions with regard to industry, country, transaction structure and consideration mix) but may also incorporate fundamental value considerations (i.e. valuation gap between market and fair value). The range should be consistent with the valuation. For private companies, the price determination is mainly based on fundamental analysis or the buyer’s or target’s indications / expectations. „ Buyer In the case of stock consideration, the current share price of the buyer should be used unless (i) such share price is not representative (see above) in which case a fair or unaffected price should be used as the basis of the analysis, or (ii) the terms of the deal are specifically based on a different share price (e.g. 30 day average). If modelling an equity issue to raise funds, a placing discount may need to be included. Valuations of target and buyer stock are ultimately subject to negotiations between the parties.
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1.2.3.
Buyer / Target’s P&L / Balance Sheet / Cash Flow Historical and Projected Statements
Historical financial information should be extracted from primary sources (annual report, interim report and other company filings). For public companies, projections can either be based on single / multiple broker reports (available online on Thomson Research) or on Reuters / IBES consensus estimates. Usually Reuters / IBES consensus estimates include the most recent estimates and are more objective (e.g. in a public deal they can be quoted as third party official database) but contain fewer details and do not allow for an understanding of underlying assumptions. It would, therefore, be advisable to create projections on the basis of a consensus of brokers reports obtained by selecting reports which are recent (at least published after the issuance of the latest financial statements or profit updates or in any way reflecting material events disclosed to the market) and issued by primary brokerage houses. As an important check, such consensus would need to be compared to Reuters / IBES consensus estimates. For private companies, projections will generally be provided by the client or will come from information provided during the due diligence process.
1.2.4.
Buyer’s and Target’s Fully Diluted Number of Shares
The buyer’s and the target’s fully diluted number of shares is based on the companies’ current number of shares outstanding (as disclosed in latest financials, press releases, etc.) adjusted for potentially dilutive securities such as options, warrants and convertible bonds.
1.2.5.
Post Transaction Capital Structure
The Merger Consequences Analysis examines the capital structure of the new company pro forma for the transaction. The pro forma capital structure is impacted by the level of buyer and target leverage before the transaction, as well as by the amount of leverage resulting from the completion of the transaction. Special attention should be paid to the optimisation of the capital structure of the buyer post-transaction, especially in view of any relevant leverage and/or credit rating targets.
1.3.
What does a Merger Consequences Analysis Look Like?
Assumptions „ Company A merges with / acquires Company B for shares § Company A current share price: $7 § Company A fully diluted shares: 100 million § Company B current share price: $5 § Company B fully diluted shares: 100 million „ Key Assumptions § Company A Net Income:
$650 million
§ Company B Net Income:
$300 million
§ Pre-tax synergies:
$20 million
§ Debt consideration:
50% of total consideration
§ Cost of new debt
6%
§ Effective tax rate
30%
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The following example shows the EPS accretion / dilution on the combined entity. (In USD millions, unless otherwise stated)
Company A Share Price (in $) Company B Share Price (in $)
0% $7.00 $5.00
Premium to Company B Shareholders 10% 20% 30% 40% $7.00 $7.00 $7.00 $7.00 $5.50 $6.00 $6.50 $7.00
Transaction Value
500.0
550.0
600.0
650.0
700.0
Debt Issued Company A Shares Issued (in m)
250.0 35.7
275.0 39.3
300.0 42.9
325.0 46.4
350.0 50.0
Company A Net Income Company B Net Income Post Tax Impact of Synergies Post Tax Impact of New Debt Pro Forma Net Income
650.0 300.0 14.0 (10.5) 953.5
650.0 300.0 14.0 (11.6) 952.5
650.0 300.0 14.0 (12.6) 951.4
650.0 300.0 14.0 (13.7) 950.4
650.0 300.0 14.0 (14.7) 949.3
Total post transaction Company A FD Shares (in m)
135.7
139.3
142.9
146.4
150.0
6.50 3.00 7.03
6.50 3.00 6.84
6.50 3.00 6.66
6.50 3.00 6.49
6.50 3.00 6.33
(0.2%)
(2.6%)
Company A EPS (in $) Company B EPS (in $) Pro Forma EPS (in $) Accretion / (Dilution)
8.1%
5.2%
2.5%
2.
How to Complete a Merger Consequences Analysis
2.1.
Key Aspects of the Analysis
2.1.1.
Merger vs. Stock vs. Asset Purchase
The transaction can be structured either as a Merger, as a Stock Purchase or as an Asset Purchase (although it should be noted that in some countries, such as the UK, it is not possible to merge companies from a legal perspective). The chosen structure has a limited impact on the modeling. „ Merger The two companies combine all existing assets and liabilities. One legal entity will survive, the other being incorporated in the former. „ Stock Purchase The buyer acquires the stock of the target thus achieving control and/or access to all existing assets and liabilities. „ Asset Purchase The buyer acquires explicit assets (listed separately) that form either part of the business or its totality. In this case, the buyer will only assume the assets and liabilities that have been specifically determined. The decision whether to structure a transaction as an asset purchase or share purchase depends on: „ Nature of liabilities: if there are potentially significant hidden liabilities (e.g. environmental), it may be preferable to acquire assets only „ Tax considerations: the buyer and/or the target will try to optimise taxes on the transaction. A conflict may arise between the two, as a share sale is often more beneficial for the target, in that any capital gain arising may be partly or wholly tax exempt. However, an asset acquisition may allow a step up in value for tax purposes (tax basis) of the assets acquired and allow for enhanced leverage of the acquisition by the buyer „ Complexity of the process: an asset purchase is generally more cumbersome compared to a stock purchase „ Structure of the target: are the assets sought only part of the target’s entity assets?
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2.1.2.
Considerations on Accounting Treatment – IFRS Regime – and Tax Implications
The accounting treatment of the transaction is regulated by IFRS 3 Business Combinations, which replaced IAS 22 in January 2005. As with US GAAP, IFRS now requires the application of the purchase method of accounting for all transactions and that consequent goodwill is not amortised but tested for impairment on, at a minimum, an annual basis. The Purchase Accounting Method The purchase accounting method allocates the difference between the amount paid on the date of the acquisition, and the book value of the net assets, to individual assets / liabilities. The acquired identifiable assets and liabilities are measured at their fair values as at the acquisition date. Any excess of the purchase price over the fair market value of the individual assets, less liabilities, is allocated to goodwill. Depreciation and amortisation of asset values will be calculated based on these fair values and included in the consolidated income statements in subsequent periods. Goodwill is not amortised. The goodwill is tested for impairment firstly at the end of the reporting period in which the business is acquired and then annually or more frequently if events or changes in circumstances indicate that it might be impaired. Usually, in a stock purchase deal, the incremental depreciation and amortisation charges, relating to the write-up of the assets or newly identified intangible assets, will not be tax deductible. In an asset purchase, the resulting incremental depreciation and amortisation for any asset write-up may be depreciated or amortised (for tax purposes) over a range of years and is generally tax deductible. Fiscal rules vary from jurisdiction to jurisdiction so it is important to verify the correct treatment of such items with a tax consultant. An intangible item acquired in a business combination, including an in-process research and development project, must be recognised as an asset separately from goodwill if it meets the requirements for recognising an intangible asset (it is controlled and provides economic benefits, it is either separable or arises from contractual or other legal rights, and its fair value can be measured reliably). Finally, a buyer must recognize contingent liabilities assumed in the business combination, if their fair value is reliably measurable. Goodwill Goodwill is the amount by which the purchase price exceeds the total value assigned to the assets acquired less the present value of the liabilities assumed. Theoretically, it represents the price paid for the unidentifiable intangible assets and the future earnings potential of the company. Practically, it represents the amount of the transaction price that exceeds the fair value assigned to the assets and liabilities acquired: Goodwill + Asset Write-Up (if any) = Purchase Price - Book Equity Goodwill is recognised by the buyer as an asset from the acquisition date. IFRS 3 prohibits the amortisation of goodwill. Instead, goodwill must be tested for impairment at least annually. In an asset purchase, goodwill will arise in the normal way where the acquisition is regarded as a purchase of a business rather than as the purchase of separate individual assets. In such a transaction the assets acquired are carried at fair value. If the transaction was not regarded as the purchase of a business, but rather the purchase of separate individual assets, then the assets acquired should be recorded at cost with no goodwill arising. Negative Goodwill If the buyer's interest in the net fair value of the acquired identifiable net assets exceeds the cost of the purchase price, the excess must be recognised immediately in the income statement as an extraordinary loss, typically in the period in which the transaction is completed. Before concluding that negative goodwill has arisen, however, IFRS 3 requires that the buyer reassesses the identification and measurement of the target’s identifiable assets, liabilities, and contingent liabilities and the measurement of the transaction price, as it presumes that in most circumstances negative goodwill will not genuinely arise.
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2.1.3.
EPS Accretion / Dilution
The Merger Consequence Analysis examines the impact of the transaction on the buyer’s projected EPS. The impact will either be: „ Dilutive – The buyer’s EPS decreases as a result of the transaction „ Accretive – The buyer’s EPS increases as a result of the transaction „ Neutral – The buyer’s EPS does not change Since many public companies trade on earnings (amongst other metrics), dilution to earnings may have a negative impact on the buyer’s stock price. As a result, the level of earnings accretion / dilution created by a transaction is a critical issue for public buyers. The level of dilution that a company is willing to accept from a merger depends on a number of factors, including in particular, the strategic value of the transaction. To measure whether the transaction is accretive / dilutive, the buyer’s current EPS is compared with the pro forma EPS (EPS of the combined entity). (Buyer NI(1) + Target NI(1) – Incremental D&A+ Post Tax Impact of Synergies – Post Tax Impact of New Debt) (Buyer’s Fully Diluted Shares Outstanding + Buyer’s Newly Issued Shares)
Pro Forma EPS = (1)
Represents Normalised Net Income
Although, the IFRS standard on EPS requires that EPS is shown based on total earnings for the period on the company’s filings, it is common practice in financial markets to focus on earnings that exclude significant one-off and non-trading items (net of tax impact) and show additional EPS measures based on these adjusted earnings. A discussion and examples of adjusting for significant one-off items can be found in section 2.2.7 of the Comparable Companies Analysis chapter. The Merger Consequence Analysis can also examine the impact of the transaction on the target’s projected EPS in the case of a 100% stock transaction. The target’s shareholders will remain investors in the combined entity, as such it is important to assess the EPS impact on them and their willingness to receive buyer’s stock as a consideration.
2.1.4.
Adjustments in the Merger Plans
Numerator Adjustments Synergies Synergies are defined as the economic / financial benefits achievable through the transaction from greater economies of scale or critical mass. Unless a detailed synergies analysis is available from the client, synergies are typically calculated by Credit Suisse as a percentage of target / combined entity sales, costs or EBITDA (based on comparable transactions) and not as a percentage of the combined Market Cap. Synergies are differentiated between cost synergies and revenue synergies. The latter are harder to measure and, therefore, are not usually included in the analysis. In the Merger Consequence Analysis, synergies to breakeven reflect the additional synergies, on a pretax basis, which must be generated to prevent the transaction from being dilutive to the buyer’s EPS. The formula to calculate the amount of pre-tax synergies to breakeven is: Pre-Tax Synergies to Break-Even =
(New EPS – Old EPS) x Fully Diluted Pro Forma Shares Outstanding (1 – Tax Rate)
Debt Financing „ Financing cost and capital structure As discussed previously, the form of the consideration impacts the pro forma earnings. The debt that is raised to finance the acquisition generates an increase in the interest charge. This leads to a decrease of pro forma earnings. This is counterbalanced by the implied tax shield from which the buyer benefits by financing the acquisition through debt.
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„ Cost of borrowing The cost of borrowing is dependant on the buyer’s current financing cost as well as the leverage / credit rating of the pro forma entity following the transaction. Some, if not all, of the acquisition consideration could also be financed through the buyer’s existing cash. In this case, the interest foregone on this cash represents the assumed cost of financing. „ Refinancing of existing debt Following the transaction, the buyer assumes the liabilities of the target, including debt. Given that the target’s debt may incorporate change of control provisions, the transaction may trigger the refinancing of the target’s existing debt. „ Minimum cash requirement If the form of the acquisition consists solely or partially of the buyer’s existing cash, the analysis needs to make sure that a minimum level of cash remains for operational reasons in the new company’s balance sheet. Depreciation of the Write-Ups and Newly Identified Intangible Assets The write-ups of the revalued assets (difference between fair value and book value), and the newly identified intangible assets, should be depreciated on the remaining useful life of the asset. This extra annual depreciation needs to be reflected in the adjustments to the consolidated pro forma earnings. Usually, in a stock purchase deal, the incremental depreciation and amortisation charges relating to the write-up of the assets or newly identified intangible assets will not be tax deductible. In an asset purchase, the resulting incremental depreciation and amortisation for any asset write-up may be depreciated or amortised (for tax purposes) over a range of years and is generally tax deductible. Fiscal rules vary from jurisdiction to jurisdiction, so it is important to verify the correct treatment of such items with a tax consultant. Goodwill „ Existing and new goodwill No adjustment for goodwill to EPS is required after the introduction of IFRS 3 Business Combinations. As with US GAAP, IFRS now requires that existing and new goodwill is not amortised but tested for impairment annually. The potential impairment is treated as a one-off significant item and as such added back to the EPS calculation. The existing goodwill on the target's balance sheet will disappear completely following the acquisition. It will be replaced by new goodwill arising on the acquisition. The existing goodwill on the buyer's balance sheet will be tested for impairment by allocation to the relevant cash generating units as set out in IAS 36. If the acquired business is merged into the existing operations then it may result in a cash generating unit that has both some existing goodwill and the acquired goodwill allocated to it and therefore tested together. Other existing goodwill allocated to other cash generating units will be tested separately. The extent to which acquired goodwill can be depreciated for tax purposes by the buyer varies between countries. For instance, in the UK, a share acquisition should not give rise to tax deductible goodwill as consolidation goodwill is not tax deductible. However, an asset acquisition may give rise to deductible goodwill. Taxation Synergies should be taxed at the tax rate of the jurisdiction where they arise geographically. Interest cost on incremental borrowings should be taxed at the marginal tax rate of the jurisdiction in which it is incurred. For example, in a cross-border transaction, any debt push down at the target level would require the incremental interest cost to be taxed at the target’s rate. Loss of interest income due to use of cash balances as part of the consideration should trigger a tax benefit calculated at the tax rate of the entity (buyer or target) which employs the cash balances. The structure of the transaction also has tax implications. As discussed above, in a stock purchase, generally neither the incremental D&A from the asset write-up nor newly identified intangible assets, nor the goodwill resulting from the transaction will be tax deductible for fiscal purposes. In an asset purchase deal, generally both can be deductible.
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Fiscal rules vary from jurisdiction to jurisdiction so it is important to verify the correct treatment of such items with a tax consultant. Denominator Adjustments Buyer’s Number of Shares The number of shares used in the denominator should be the latest available fully diluted shares outstanding. This number includes the equivalent number of shares of in-the-money exercisable stock options / warrants and other dilutive securities. A discussion and examples of calculating number of shares outstanding can be found in section 2.3.1 of the Comparable Companies Analysis chapter. „ Options / Warrants In-the-money exercisable options and warrants of the buyer should be treated as per the treasury method (proceeds from exercise of stock options used by the company to buy-back shares) or the fully diluted method (shares from exercise of stock options accounted for in the number of fully diluted shares outstanding, proceeds from exercise of stock options accounted for in the net financial position). „ Convertible debt Convertible securities allow the holder to convert the security into common voting shares or, less often, preferred stock or warrants. These are to be treated as stock if in-the-money, if not, they will be treated as debt. If treated as stock, P&L interest expenses should be adjusted to exclude interest expenses (net of taxation) related to the convertible. New Buyer’s Shares Issued The number of new shares issued will depend on the mix of consideration (cash vs. stock) and the exchange ratio, as well as the treatment of the target’s dilutive securities. When a transaction involves some share consideration, the exchange ratio will be defined as the number of buyer shares to be offered per each target share. To determine the total amount of new shares to be issued by the buyer, multiply the fully diluted shares outstanding by the exchange ratio, and the result by the percentage of the transaction paid in shares. All decisions regarding the treatment of outstanding dilutive securities depend on the objectives of the parties and the specific situation. Generally, for options: „ In-the-money options of the target should be treated as per (a) the treasury method or (b) the fully diluted method (as discussed above) „ For convertibles, if the holder cannot roll over the convertible, the holder will face an economic decision to either cash out as debt holder or accelerate the exercise and thus become an equity holder. When the security is trading in-the-money, the holder will typically convert the bond into the underlying stock of the target, thus receiving the same consideration and treatment as the target’s ordinary shareholders. If, however, the security is trading out-of-the-money, the bond will not be converted and the bond holder will receive the redemption value of the bond in cash. In this case, the bond should be treated as normal financial debt and included in the overall target company’s Net Debt and Enterprise Value For both options and convertibles, other treatments (which allow convertible or option holders not to forego any option value embedded in the convertibles / options) can also be considered. „ Roll over If all or a portion of the merger consideration is paid in buyer’s stock, holders of convertible securities of the target will often be allowed (and usually required) to roll over their convertible securities into similar convertible securities of the buyer (i.e. the surviving entity). In this case, the strike price of the convertible (i.e. the price at which the holder will be able to convert the bond into shares) would be adjusted so that the value of the stock into which the security is convertible is the same as before (i.e. target’s stock) and after (i.e. buyer’s stock) the transaction. Generally, convertible holders will also benefit from a change of control adjustment of the strike price in the form of additional shares receivable upon conversion. The principal amount and interest rate on the convertible security would generally remain unchanged. When target options are rolled over, the buyer issues new options on its stock in exchange for the old options on target stock. The number of shares issued upon exercise and the strike price of the new options are typically set such that the option holder remains in an economic position similar to that when holding the target’s original options.
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„ Liquidation When options are liquidated, the option holders receive cash from the acquiring company in return for extinguishing the securities. The value of the liquidated options is based on market value, if such options are listed, or mathematical formulas (e.g. Black-Scholes). In any event such value is ultimately subject to negotiations between the parties.
2.1.5.
Advanced Themes
Acquisition of a Stake Below 20% – Buyer has Neither Control nor Significant Influence „ In the case of an acquisition of a stake in the target below 20% of the voting stock, the acquisition will most often be accounted for as an investment „ When acquiring less than 20% of the voting stock, there is a presumption that the buyer will have neither significant influence nor control over the target „ “Significance influence” means ‘the power to participate in the financial and operating policy decisions of the investee but not in control or joint control over those policies’ (IAS 28) „ “Control”, in accounting terms, means ‘the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities’ (IAS 27) „ The presumption can be rebutted if the buyer has significant influence over the operations of the target through a means other than the voting stock – for example, through a right to appoint members to the board, or through other contractual arrangements „ IFRS requires the particular circumstances of each acquisition to be considered when deciding how much influence is with the buyer „ If the acquisition is accounted for as an investment, under IFRS it will be carried in the balance sheet at fair value, with gains and losses in fair value taken directly to equity (or through the income statement when the investment is linked to a trading activity) „ Upon acquisition, the cash on buyer’s balance will be reduced by the purchase price and investments increased by the fair value of the investment on acquisition „ The target’s dividends will be recorded as investment income in the buyer’s P&L below EBIT. Such dividends may be subject to taxation
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Example „ Buyer pays 50 for a 10% stake in Target „ Assuming 50 is fair value for 10% of Target, Buyer will recognize an investment in its balance sheet at 50 Opening B/S
Buyers 10% Stake In Target
Closing B/S
Buyer – Group Balance Sheet Investments Cash
50 50
(50)
50 0
Other Net Assets
100
100
Equity
150
150
Net Assets
500
500
Equity
500
500
Target
Acquisition of a Stake Above 20% and Below 50% – Buyer has Significant Influence, but not Control „ In the case of an acquisition of a stake in the target above 20% and below 50% of the voting stock, the acquisition will most often be accounted for as an associate „ When acquiring more than 20% of the voting stock there is a presumption that the buyer will have significant influence over the target, but will not be able to control the operation of the target – the target will therefore be an associate. Usually board representation is required to evidence significant influence „ As above, this presumption can be rebutted if the circumstances of the acquisition indicate that either the buyer is able to control the target or that the buyer is not able to exercise significant influence. In such cases, the accounting treatment would be consolidation or accounting as an investment respectively „ An associate is accounted for under the equity method, with the buyer’s share of the associate reflected as a one line entry in the income statement and the balance sheet of the group accounts „ The balance sheet includes an investment in associates in fixed assets which represents the percentage owned of fair value of the net assets of the associate plus the goodwill „ The income statement includes the group share of the associate net income (recorded before Group Operating Profit). It should be noted that the accounting treatment does not impact the tax treatment of dividends received, which may be subject to taxation
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Example „ Buyer takes 30% stake in Target for consideration of 250 „ Stake is recorded in one line in the Buyer’s group balance sheet Opening B/S
Buyers 30% Stake In Target
Closing B/S
Buyer – Group Balance Sheet Cash
250
Fixed Assets Investments Accounted for Using the Equity Method
(250) 250
0 250
Other Net Assets
100
100
Equity
350
350
Net Assets
500
500
Equity
500
500
Target
Acquisition of a Stake Above 50% and Below 100% – Buyer has Control „ In the case of an acquisition of a stake in the target above 50% and below 100% of the voting stock, the target is likely to be accounted for as a subsidiary „ It is presumed that a stake of 50% or more of the voting stock will give the buyer control of the target. The target will therefore become a subsidiary of the buyer „ The presumption can be rebutted in exceptional circumstances if it can be clearly demonstrated that such a stake does not give the buyer control „ Conversely, as noted above, a stake of less than 50% may give the buyer control over the target. This may be through, for example, the ability to appoint a majority to the board of the target, or the power to direct the operations of the target through agreement with the other investors „ All the assets and liabilities of a subsidiary are consolidated on a line by line basis in the group accounts of the buyer „ Minorities from Net Income (equal to the minority share of the target Net Income) and from the shareholder equity (equal to the minority share of the target shareholder equity) have to be stripped-out „ In the balance sheet, the minority interest account in the shareholders’ equity is used to capture the assets that have been consolidated and that are not actually owned by the holding company „ In the income statement, the minority interest is a deduction to the consolidated earning to reflect the deduction made for earnings not owned by the holding company „ Again, dividends received may be subject to taxation Example „ Buyer pays 600 for an 80% stake in Target and achieves control „ Buyer recognises all assets and liabilities of Target on a line by line basis in its group financial statements, at fair value (for convenience in the table below these are shown in one line as Other Net Assets) „ The fair value of the assets of Target is 550 – after recognizing 50 of intangible assets „ Buyer recognises Goodwill as the difference between the assets acquired and purchase price: 600 – (550 * 80%) = 160 „ Minority interest is recognized for the 20% of Target that Buyer does not own (550 * 20% = 110)
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Opening B/S
Buyers 80% Stake In Target
Closing B/S
Buyer – Group Balance Sheet Investments Goodwill Other Intangibles
160
160
50
50
Cash
600
(600)
Other Net Assets
100
500
Equity
700
Minority Interest
0 600 700
110
110
Target Net Assets
500
500
Equity
500
500
Treasury Stock „ In the case that buyer or target have treasury shares on their balance sheets, these should be assumed as cancelled for EPS analysis purposes. The accretion / dilution should therefore be carried out on the total number of shares outstanding net of any treasury shares Tax Losses / Assets „ The target’s tax losses or tax assets may be utilised to reduce the buyer’s tax costs (or vice-versa) subject to tax legislation. Fiscal treatment will depend upon jurisdiction and it is important to note that there are frequently restrictions on the ability to use such losses / assets after a change of control. In addition, historic tax losses may be trapped in the entity in which they arose and not able to be offset against profits in the acquiring group Contingent Liabilities „ Under IFRS, contingent liabilities of the target must be recognised in the balance sheet at fair value – if the fair value can be reliably determined. Recognition of contingent liabilities will increase the value of the purchase price attributed to goodwill Dividend Policy „ Differences in the dividend pay-out ratio between buyer and target should be considered when combining the businesses „ Usually dividend policy is aligned to the buyer. However, it is necessary to assess potential change due to, for example, a high leverage of the combined entity post-acquisition or specific features of the target’s shareholder base (e.g. interest in high dividends) „ Cash-flow of the combined entity should be adjusted to reflect the combined entity dividend policy
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2.2.
What are the Inputs / Where Do I Find the Information?
Merger Item
Source(s)
Historical Financial Data EBIT
Annual Report, Interim Report
EBITDA
Annual Report, Interim Report
Cash Flow (including Cap Ex)
Annual Report, Interim Report
Capital Structure
Annual Report, Interim Report
Number of Shares Outstanding
Annual Report, Interim Report
Equity Book Value
Annual Report, Interim Report
Dilutive Securities
Notes to financial statements
Projected Financial Data Financial Projections
Client management, due diligence, equity research reports
Transaction Data Borrowing Cost
Historical financials and discussion with DCM
Opportunity Cost of Cash for the Buyer
Historical financials and discussion with DCM
Synergies
Client, estimates based on precedent transactions
Tax Rate
In general, statutory tax rate
Asset Write-Up / Newly Identified Intangible Assets
Client, accountants or estimates
2.3.
Mechanics of the Analysis
2.3.1.
Steps of Merger Model Mechanics
„ Gather information „ Layout separate standalone financials for bidder and target „ Add the two income statements with necessary adjustments: § Synergies (after tax) § Depreciation of the write-ups / newly identified intangible assets including any tax impact § Interest from acquisition debt / other cash flow impacts (after tax) § Calendarisation § Foreign exchange „ Keep the existing facilities and adjust evolution of debt in the balance sheet / cash flow statement for the acquisition debt (if any) and other cash flow impacts including: § Synergies (net of taxes) – positive cash flow contribution § Interest from acquisition debt (after tax) – negative cash flow contribution § Difference in dividends (delta between the combined entity dividends and the sum of the buyer and target dividends) – if dividends of the combined entity are higher than the sum of the buyer and target dividends negative cash flow contribution „ Sometimes, especially in transformational transactions, the existing facilities may have to be refinanced in order to establish a new / optimal capital structure for the combined entity – in this case, the selected facilities will have to be modelled (including one or more facilities to finance the acquisition if there is a cash consideration) „ Adjust the total number of shares of the buyer for the newly issued shares (if any) § Total stock consideration value / value of buyer share „ For a quick analysis, all the adjustments listed above can be made directly at a per share level without the need of a working model
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§ EPS of buyer and target can be added together and adjusted as described above on a per share basis „ The results of the analysis should be analysed critically, considering the impact on the combined entity market perception of the following: § Strategic rationale – scale? market leadership? § Quality of earnings – growth? risk? § Fair vs. market valuation of standalone companies § Premium paid – appropriate? aggressive? § Value uplift from synergies – synergy deal? § Multiple re-rating – would the combined entity multiple expand? § Optimal capital structure – credit rating impact? § Dividend policy – in line with the buyer?
3.
Common Pitfalls
3.1.
Calendarisation
„ Both buyer and target financials should be on the same calendar year to be comparable and consequently consolidated on a like-for-like basis. The selected calendar year will, in most cases, be the one of the acquiring company
3.2.
Currency
„ Both buyer and target financials should be in the same currency to be comparable and consequently consolidated on a like-to-like basis. The selected currency will, in most cases, be the one of the acquiring company. Generally a spot exchange rate is used. However, for more precise analysis, the use of a forward rate for each forecast year is recommended
3.3.
Goodwill Impairment Treatment / Deductibility
„ Goodwill is calculated using the equity purchase price based on a fully diluted actual and not weighted average number of shares outstanding „ Goodwill is not amortised but tested for impairment at least on an annual basis „ Goodwill in a stock purchase is generally not tax deductible. However, it is recommended to check with a tax consultant as tax rules vary depending on jurisdiction „ The amount of goodwill is reduced by the write-up of assets or value of newly identified intangible assets which are subsequently depreciated
3.4.
Financing Costs and Expenses
„ Appropriate cost of new debt depends on creditworthiness of the new company „ Only need to reflect the incremental financing charge „ Need to check whether outstanding bonds and other debt and credit facilities of the target have change of control provisions „ Are interest assumptions reasonable? What is the credit rating of the surviving entity? „ Need to consider financing and advisory expenses for both buyer and target – if amortised and fully expensed in year of the transaction, exclused from EPS calculation as exceptional items
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3.5.
Options and Other Dilutive Securities
„ Need to be included in the equity purchase price „ Options generally handled using the treasury or fully diluted method „ Convertibles generally handled either as debt or equity „ Roll over / liquidation
3.6.
Dividend Policy
„ Dividend of the combined entity would not necessarily reflect the sum of the dividends of the standalone companies „ Usually dividend policy is aligned to buyer’s (e.g. buyer’s dividend per share). However, it is necessary to assess potential change due to, for example, a high leverage of the combined entity post-acquisition or specific features of the target’s shareholder base (e.g. interest in high dividends)
3.7.
Synergies
„ Synergies, if being estimated by Credit Suisse, are calculated as a percentage of target / combined entity sales, costs or EBITDA and not as a percentage of the combined Market Cap
3.8.
Lack of Footnotes
„ Clearly footnote all assumptions so that anyone can follow the assumptions and rationality of the analysis
3.9.
Sanity Check of the Outputs
„ Stock-for-stock transaction § In a stock-for-stock transaction, if the buyer’s P/E is higher than the target’s P/E for the year (at acquisition price), the transaction will be accretive to the buyer during the year § Alternatively, if the target’s P/E is higher than the buyer’s P/E, the transaction will be dilutive to the buyer. The flip side of this is that the transaction will be accretive to the target. The target’s shareholders will, going forward, be receiving more pennies per share than they were as shareholders in the target § The exchange ratio at which a transaction is EPS neutral to the buyer is (Target EPS) / (Buyer EPS) „ Cash transaction § Cash has a P/E of: 1/(after-tax interest rate) § Use the same shortcut as above when considering whether a cash transaction would be accretive to the buyer § If the P/E of cash is greater than the target P/E (at acquisition price), the transaction will be accretive to the buyer’s shareholders § If the P/E of cash is higher than the buyer’s P/E, a cash transaction will be more accretive / less dilutive than a stock transaction to the buyer’s shareholders, and vice versa
4.
Examples
In the following example, the buyer acquires the shares of the target at a 10% premium to its current share price. The implied purchase price of €49.5 billion is financed through three different financing considerations: 100% cash, 100% stock and 50% cash / 50% stock. The following data is used to assess the impact of the merger on the buyer’s projected financial performance:
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Valuation Metrics „ Target share price:
€15.00
„ Target Number of Shares:
3,000 million
„ Buyer Share Price:
€50.00
„ Buyer Number of Shares:
2,500 million
„ Interest Cost:
5% (applied to opening balance)
„ Interest Income:
3% (applied to opening balance)
„ Tax Rate on Interest:
40%
„ Tax Rate on Synergies:
45%
Synergies „ Synergies are estimated at €300 million per year Dividends „ The proposed dividend of the combined entity is equal to the dividend per share of the buyer Financials Target Summary Financials (€ in millions, December year end)
2005 15,000 5,000 (400) 2,800 3,000 0.93
2006 16,000 6,000 (425) 3,000 3,000 1.00
2007 17,000 7,000 (438) 3,300 3,000 1.10
2008 18,000 8,000 (438) 3,500 3,000 1.17
2009 19,000 9,000 (425) 3,800 3,000 1.27
P/E P/E of Acquisition
16.1x 17.7x
15.0x 16.5x
13.6x 15.0x
12.9x 14.1x
11.8x 13.0x
Net Debt Net Debt / EBITDA Dividends
8,000 1.6x 100
8,500 1.4x 100
8,750 1.3x 100
8,750 1.1x 100
8,500 0.9x 100
2005 35,000 15,000 (300) 10,000 2,500 4.00 25000.0x
2006 36,000 14,000 (288) 9,950 2,500 3.98
2007 35,500 14,500 (294) 9,300 2,500 3.72
2008 39,000 15,050 (300) 9,000 2,500 3.60
2009 40,000 16,000 (300) 9,500 2,500 3.80
P/E
12.5x
12.6x
13.4x
13.9x
13.2x
Net Debt Net Debt / EBITDA Dividends
5,000 0.3x 100
4,800 0.3x 100
4,900 0.3x 100
5,000 0.3x 100
5,000 0.3x 100
Turnover EBITDA Net Interest Net Income Number of Shares (million) EPS (€)
Buyer Summary Financials (€ in millions, December year end)
Turnover EBITDA Net Interest Net Income Number of Shares (million) EPS (€)
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4.1.
100% Cash Transaction
In a cash transaction, care should be taken of the treatment of the acquisition debt and its evolution over the projected period. The amount of debt utilised will impact the interest expense as well as the taxes of the company. The following schedules layout not only the financials of the combined entity (including the impact of the transaction: cost of financing, synergies, their tax implications and the dividend policy of the new entity) but also the evolution of the acquisition debt and the implied leverage of the company. Combined Entity (€ in millions, December year end)
2006 52,000 300 20,300 (713) (2,475) 990 (135) 11,630 2,500
2007 52,500 300 21,800 (732) (2,536) 1,014 (135) 11,243 2,500
2008 57,000 300 23,350 (738) (2,599) 1,040 (135) 11,106 2,500
2009 59,000 300 25,300 (725) (2,664) 1,065 (135) 11,867 2,500
4.65 16.9%
4.50 20.9%
4.44 23.4%
4.75 24.9%
0 100
0 100
0 100
0 100
2005 PF
2006 49,500 (100) (300) 135 2,475 (990) 50,720
2007 50,720 (100) (300) 135 2,536 (1,014) 51,977
2008 51,977 (100) (300) 135 2,599 (1,040) 53,271
2009 53,271 (100) (300) 135 2,664 (1,065) 54,604
13,000 49,500 62,500
13,300 50,720 64,020
13,650 51,977 65,627
13,750 53,271 67,021
13,500 54,604 68,104
3.1x 28.6x
3.2x 6.4x
3.0x 6.7x
2.9x 7.0x
2.7x 7.5x
Turnover Synergies EBITDA Net Interest Acquisition Interest Expense Tax Saving on Interest Expense Tax Charge on Synergies Net Income Number of Shares (million) EPS (€) EPS Accretion / Dilution Breakeven Synergies (EPS) Proposed Dividend Acquisition Debt Schedule (€ in millions, December year end)
Acquisition Debt / (Cash) (Start) Additional Dividends Synergies Tax Charge on Synergies Acquisition interest Tax Saving on Interest Charge Acquisition Debt / (Cash) (End) Combined Net Debt / (Net Cash) Acquisition Debt / (Cash) Combined Net Debt / (Net Cash) Net Debt / EBITDA EBITDA / Interest
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of the deal for the Buyer’s shareholders as well as a contribution analysis. Accretion / Dilution Analysis
0.0%
Indicative Offer Premium 10.0% 20.0% 30.0%
40.0%
EPS 2006
18.2%
16.9%
15.5%
14.2%
12.8%
EPS 2007
22.4%
20.9%
19.4%
17.9%
16.4%
EPS 2008
25.0% 0 0.24988039
23.4% 0.1 0.23396689
21.8% 0.2 0.21805339
20.2% 0.3 0.20213989
18.6% 0.4 0.18622639
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Contribution Analysis 2006
2007
2008
2009
Turnover Buyer Target
69% 31%
68% 32%
68% 32%
68% 32%
EBITDA Buyer Target
70% 30%
67% 33%
65% 35%
64% 36%
Net Income Buyer Target
77% 23%
74% 26%
72% 28%
71% 29%
4.2.
100% Stock Transaction
In a stock transaction, the purchase price is paid through the issuance of shares. While there is no debt raised to finance the acquisition, the buyer’s debt / cash level will be impacted by other items related to the transaction such as the synergies or any additional dividends. Combined Entity (€ in millions, December year end)
Turnover Synergies EBITDA Net Interest Acquisition Interest Expense Tax Saving on Interest Expense Tax Charge on Synergies Net Income Number of Shares (million)
2006 52,000 300 20,300 (713) 0 0 (135) 13,115 3,490
2007 52,500 300 21,800 (732) 7 (3) (135) 12,769 3,490
2008 57,000 300 23,350 (738) 14 (5) (135) 12,673 3,490
2009 59,000 300 25,300 (725) 21 (8) (135) 13,477 3,490
EPS (€) EPS Accretion / Dilution
3.76 (5.6%)
3.66 (1.6%)
3.63 0.9%
3.86 1.6%
1,409 140
389 140
0 140
0 140
2005 PF
2006 0 (60) (300) 135 0 0 (225)
2007 (225) (60) (300) 135 (7) 3 (455)
2008 (455) (60) (300) 135 (14) 5 (688)
2009 (688) (60) (300) 135 (21) 8 (926)
13,000 0 13,000
13,300 (225) 13,075
13,650 (455) 13,195
13,750 (688) 13,062
13,500 (926) 12,574
0.7x 28.6x
0.6x 28.5x
0.6x 30.1x
0.6x 32.3x
0.5x 35.9x
Breakeven Synergies (EPS) Proposed Dividend Acquisition Debt Schedule (€ in millions, December year end)
Acquisition Debt / (Cash) (Start) Additional Dividends Synergies Tax Charge on Synergies Acquisition interest Tax Saving on Interest Charge Acquisition Debt / (Cash) (End) Combined Net Debt / (Net Cash) Acquisition Debt / (Cash) Combined Net Debt / (Net Cash) Net Debt / EBITDA EBITDA/ Interest
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of the deal for the buyer’s shareholders. The accretion / dilution analysis can also be carried out on the Target’s shareholders’ EPS as stock if offered as consideration, and therefore the target’s shareholders remain invested in the combined entity. Contribution analysis remains the same.
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Accretion / Dilution Analysis
0.0%
Indicative Offer Premium 10.0% 20.0% 30.0%
40.0%
EPS 2006
(3.1%)
(5.6%)
(8.0%)
(10.2%)
(12.4%)
EPS 2007
1.0%
(1.6%)
(4.1%)
(6.5%)
(8.7%)
EPS 2008
3.5%
0.9%
(1.7%)
(4.1%)
(6.4%)
4.3.
50% Stock / 50% Cash Transaction
In a mixed consideration financing, the EPS is impacted by both the cost of the acquisition debt and the extra shares issued to finance the stock part of the deal. Combined Entity (€ in millions, December year end)
2006 52,000 300 20,300 (713) (1,238) 495 (135) 12,373 2,995
2007 52,500 300 21,800 (732) (1,262) 505 (135) 12,008 2,995
2008 57,000 300 23,350 (738) (1,288) 515 (135) 11,892 2,995
2009 59,000 300 25,300 (725) (1,314) 526 (135) 12,676 2,995
4.13 3.8%
4.01 7.8%
3.97 10.3%
4.23 11.4%
0 120
0 120
0 120
0 120
2005 PF
2006 24,750 (80) (300) 135 1,238 (495) 25,247
2007 25,247 (80) (300) 135 1,262 (505) 25,760
2008 25,760 (80) (300) 135 1,288 (515) 26,287
2009 26,287 (80) (300) 135 1,314 (526) 26,831
13,000 24,750 37,750
13,300 25,247 38,547
13,650 25,760 39,410
13,750 26,287 40,037
13,500 26,831 40,331
1.9x 28.6x
1.9x 10.4x
1.8x 10.9x
1.7x 11.5x
1.6x 12.4x
Turnover Synergies EBITDA Net Interest Acquisition Interest Expense Tax Saving on Interest Expense Tax Charge on Synergies Net Income Number of Shares (million) EPS (€) EPS Accretion / Dilution Breakeven Synergies (EPS) Proposed Dividend Acquisition Debt Schedule (€ in millions, December year end)
Acquisition Debt / (Cash) (Start) Additional Dividends Synergies Tax Charge on Synergies Acquisition interest Tax Saving on Interest Charge Acquisition Debt / (Cash) (End) Combined Net Debt / (Net Cash) Acquisition Debt / (Cash) Combined Net Debt / (Net Cash) Net Debt / EBITDA EBITDA / Interest
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of the deal for the buyer’s shareholders. Contribution analysis remains the same. Accretion / Dilution Analysis 0.0%
Indicative Offer Premium 10.0% 20.0% 30.0%
40.0%
EPS 2006
6.0%
3.8%
1.7%
(0.3%)
(2.3%)
EPS 2007
10.1%
7.8%
5.6%
3.4%
1.3%
EPS 2008
12.7%
10.3%
8.0%
5.8%
3.6%
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4.4.
Acquisition of Minority Stake in a Consolidated Company
When dealing with the acquisition of a minority stake in a company already consolidated by the buyer, pay attention not to duplicate the buyer and target’s financials in the combined entity financials. Assuming the buyer already owns 80% of the target, the P&L financials will be equal to the buyer’s financials – not to the sum of the buyer’s and target’s financials – with the exception of the adjustment lines for the acquisition (acquisition debt interest and relative tax shield, synergies and taxes on synergies) and the buyer net income minorities – equal to the share of the target net income not owned by the buyer. Higher or lower dividends paid by the combined entity should be calculated as the difference between the combined entity dividends less the dividend paid by the buyer before the transaction and the dividend paid by the target to the minorities before the transaction (effectively the cash leakage to the minorities). The higher or lower dividends should be included in the acquisition debt schedule as they represent an incremental positive or negative cash-flow to the buyer. The following example assumes a 100% cash transaction on 20% of the target share capital, being 80% already owned by the buyer. In the case of a cash and stock, or stock only transaction, the amount of acquisition debt will decrease and buyer’s new shares will be issued to the target minorities. Target Summary Financials (€ in millions, December year end)
2005 15,000 5,000 (400) 2,800 3,000 0.93
2006 16,000 6,000 (425) 3,000 3,000 1.00
2007 17,000 7,000 (438) 3,300 3,000 1.10
2008 18,000 8,000 (438) 3,500 3,000 1.17
2009 19,000 9,000 (425) 3,800 3,000 1.27
P/E P/E of Acquisition
16.1x 17.7x
15.0x 16.5x
13.6x 15.0x
12.9x 14.1x
11.8x 13.0x
Net Debt Net Debt / EBITDA Dividends
8,000 1.6x 100
8,500 1.4x 100
8,750 1.3x 100
8,750 1.1x 100
8,500 0.9x 100
2005 35,000 15,000 (300) (560) 10,000 2,500 4.00
2006 36,000 14,000 (288) (600) 9,950 2,500 3.98
2007 35,500 14,500 (294) (660) 9,300 2,500 3.72
2008 39,000 15,050 (300) (700) 9,000 2,500 3.60
2009 40,000 16,000 (300) (760) 9,500 2,500 3.80
Turnover EBITDA Net Interest Net Income Number of Shares (million) EPS (€)
Buyer Summary Financials (€ in millions, December year end)
Turnover EBITDA Net Interest Net Income Minorities Net Income Number of Shares (million) EPS (€) P/E
12.5x
12.6x
13.4x
13.9x
13.2x
Net Debt Net Debt / EBITDA Dividends
5,000 0.3x 100
4,800 0.3x 100
4,900 0.3x 100
5,000 0.3x 100
5,000 0.3x 100
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Combined Entity (€ in millions, December year end)
2006 36,000 – 14,000 (288) (495) 198 – 10,253 2,500
2007 35,500 – 14,500 (294) (509) 204 – 9,655 2,500
2008 39,000 – 15,050 (300) (523) 209 – 9,386 2,500
2009 40,000 – 16,000 (300) (538) 215 – 9,937 2,500
4.10 3.0%
3.86 3.8%
3.75 4.3%
3.97 4.6%
0 100
0 100
0 100
0 100
2005 PF
2006 9,900 (20) 0 0 495 (198) 10,177
2007 10,177 (20) 0 0 509 (204) 10,462
2008 10,462 (20) 0 0 523 (209) 10,756 10,756
2009 10,756 (20) 0 0 538 (215) 11,059
5,000 9,900 14,900
5,000 10,177 15,177
4,800 10,462 15,262
4,900 10,756 15,656
5,000 11,059 16,059
1.0x 50.0x
1.1x 17.9x
1.1x 18.1x
1.0x 18.3x
1.0x 19.1x
Turnover Synergies EBITDA Net Interest Acquisition Interest Expense Tax Saving on Interest Expense Tax Charge on Synergies Net Income Number of Shares (million) EPS (€) EPS Accretion / Dilution Breakeven Synergies (EPS) Proposed Dividend Acquisition Debt Schedule (€ in millions, December year end)
Acquisition Debt / (Starting balance) Additional Dividends Synergies Tax Charge on Synergies Acquisition interest Tax Saving on Interest Charge Acquisition Debt / (Ending balance) Combined Net Debt Acquisition Debt Combined Net Debt Net Debt / EBITDA EBITDA/ Interest
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of the deal for the buyer’s shareholders. Accretion / Dilution Analysis
0.0%
Indicative Offer Premium 10.0% 20.0% 30.0%
40.0%
For buyer shareholders EPS 2006
3.3%
3.0%
2.8%
2.5%
2.2%
EPS 2007
4.1%
3.8%
3.5%
3.2%
2.9%
EPS 2008
4.6%
4.3%
4.0%
3.7%
3.3%
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5.
Case Studies
Please note that goodwill and asset write-ups are not cash tax deductible in any of the following examples. There are no synergies assumed. Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set.
5.1.
Pro Forma EPS With Different Forms Of Consideration
5.1.1.
Assumptions Purchase Price Allocation Stock Price
EPS
P/E
Buyer
$50.0
$3.0
16.7x
20
Not used
Target
$10.0
$1.0
10.0x
10
$30.0
Shares
Book Value
Tangible Asset Write-Ups
Identifiable Intangible Asset Write-Ups
Unidentifiable Intangibles
40.0%
40.0%
20.0%
The following additional inputs are required: Interest Rate for Debt Financing: Tax Rate:
8% 30%
Years to Amortise Intangible Assets:
20
Years to Amortise Tangible Assets:
10
5.1.2.
Required Analysis
Based on the above assumptions, perform the appropriate calculations to complete the following case study on calculating current year pro forma EPS by applying the following transaction prices and scenarios:
5.1.3.
Transaction Prices
„ $10.00 „ $12.50 „ $15.00
5.1.4.
Scenarios
„ 100% stock financed „ 100% debt financed „ 50% stock and 50% debt
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Pro Forma EPS Worksheet Scenario 1: 100% Stock Financed (in $, unless otherwise stated)
Transaction Price Per Share Transaction Price per Share
________
________
________
Purchase Price / Equity Consideration
________
________
________
Combined Net Earnings (pre-deal)
________
________
________
Shares Issued (#)
________
________
________
Shares Outstanding (#)
________
________
________
After Tax Interest Expense
________
________
________
Adjustment: Tangible Asset Amortisation
________
________
________
Adjustment: Identifiable Intangible Amortisation
________
________
________
Pro Forma EPS
________
________
________
Goodwill
________
________
________
Scenario 2: 100% Debt Financed Assume: Interest Rate for Debt Financing: 8% (in $, unless otherwise stated)
Transaction Price Per Share Transaction Price per Share
________
________
________
Purchase Price / Equity Consideration
________
________
________
Combined Net Earnings (pre-deal)
________
________
________
Shares Issued (#)
________
________
________
Shares Outstanding (#)
________
________
________
After Tax Interest Expense
________
________
________
Adjustment: Tangible Asset Amortisation
________
________
________
Adjustment: Identifiable Intangible Amortisation
________
________
________
Pro Forma EPS
________
________
________
Goodwill
________
________
________
Scenario 3: 50% Stock Financed, 50% Debt Financed Assume: Interest Rate for Debt Financing: 8% (in $, unless otherwise stated)
Transaction Price Per Share Transaction Price per Share
________
________
________
Purchase Price / Equity Consideration
________
________
________
Combined Net Earnings (pre-deal)
________
________
________
Shares Issued (#)
________
________
________
Shares Outstanding (#)
________
________
________
After Tax Interest Expense
________
________
________
Adjustment: Tangible Asset Amortisation
________
________
________
Adjustment: Identifiable Intangible Amortisation
________
________
________
Pro Forma EPS
________
________
________
Goodwill
________
________
________
5.2.
EPS and Balance Sheet Impact
Buyer, an Italian telecom company, is evaluating the possible acquisition of a French technology company, Target. Buyer’s CEO has charged his team with the task of recommending the best method for structuring the acquisition. One of the key metrics looked at when assessing the acquisition will be the expected dilution / accretion for Buyer’s earnings per share. Assume a debt financed transaction.
5.2.1.
Assumptions
Buyer expects to pay $5.00 per share for each of Target’s 80 million shares (total of $400 million). Buyer will assume Target’s liabilities of $50 million composed of current liabilities equalling $30 million and longterm liabilities of $20 million. Additionally, Target’s current assets are composed of cash and liquid
115
investments equalling $30 million and other current assets of $40 million. The transaction would close on 31 December 2005. The expected tax rate is 30%.
5.2.2.
Required Analysis
Calculate the balance sheet and EPS impact on Buyer based on the above assumptions. „ Buyer purchases Target for $400 million in cash, using $200 million of existing cash and liquid investments and borrowing the remaining amount through a long-term bank facility „ Interest rate on the debt: 10% „ Interest rate on cash / liquid securities: 5% „ Target has certain fixed assets on its books for $60 million that have a fair market value of $80 million. Buyer has fixed assets on its books for $200 million, other current assets of $150 million, current liabilities of $180 million and long-term liabilities of $140 million „ Fixed assets are depreciated over 10 years „ Identifiable intangible assets are assumed to be $40 million post transaction (zero pre-transaction), and are amortised over 20 years „ Depreciation on write-ups of tangible assets and amortisation of identifiable intangible assets assumed not to be tax deductible „ Buyer and Target balance sheet and P&L given below Balance Sheets ($ in millions, unless otherwise stated)
Target Dec 31, 2005
Buyer Dec 31, 2005
Cash/Liquid Investments
30
300
Other Current Assets
40
150
Assets
Fixed Assets
60
200
130
650
Current Liabilities
30
180
Long-Term Liabilities
20
140
Common Equity
80
330
130
650
Liabilities and Equity
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Balance Sheet Impact Worksheet ($ in millions, unless otherwise stated) Target Dec 31, 2005
Buyer Dec 31, 2005
Target / Transaction Adjustments
Combined Entity Dec 31, 2005
Assets Cash/Liquid Investments
_______
_______
_______
_______
Other Current Assets
_______
_______
_______
_______
Fixed Assets
_______
_______
_______
_______
Identifiable Intangible Assets
_______
_______
_______
_______
Goodwill
_______
_______
_______
_______
_______
_______
_______
_______
Current Liabilities
_______
_______
_______
_______
Long-Term Liabilities
_______
_______
_______
_______
Common Equity
_______
_______
_______
_______
_______
_______
_______
_______
Target Full Year 2005
Transaction Adjustments
Combined Entity
Liabilities and Equity
Earnings Per Share Impact Worksheet ($ in millions, unless otherwise stated)
Buyer Full Year 2005 Revenues
250
80
____________
____________
Depreciation
(40)
(10)
____________
____________
____________
____________
Amortization Other Operating Expenses
(130)
(40)
____________
____________
Operating Income
80
30
____________
____________
Net Interest Expense
(50)
(5)
____________
____________
EBT
30
25
____________
____________
Tax
(9)
(8)
____________
____________
Net Income
21
18
____________
____________
Shares Outstanding (million)
150
80
____________
____________
EPS ($)
0.14
0.22
____________
____________
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Contribution Analysis
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Contribution Analysis 1.
Overview
1.1.
Definition of Contribution Analysis
A Contribution Analysis represents a type of a financial analysis used in the context of a stock transaction to show the implied equity ownership shares of the acquiror and target in a NewCo at a range of exchange ratios as compared with their respective contributions to the NewCo. The analysis allows a comparison of the relative contribution of each party in a merger. The results of the analysis indicate implied fair equity ownership based on each party’s contribution. A Contribution Analysis is only relevant in the context of a stock deal and does not apply to an all-cash transaction.
1.2.
Why is it Used?
Contribution Analysis allows: „ An evaluation of the relative contribution of each party to a merger or acquisition; and „ A comparison of the contributions of the parties to the value of the shares received by each of them in the NewCo Conceptually, Contribution Analysis fits with Merger Consequences Analysis. While the Merger Consequences Analysis will focus on the pro forma evaluation and thus help determine the size of the merged entity (i.e. “size-of-the-pie”), the Contribution Analysis determines the exchange ratio and helps determine the ownership split of a NewCo (i.e. how to “split the pie”). The output of the Contribution Analysis shows the relative contribution of each party in a merger (based on the financial benchmark selected) and the resulting implied equity ownership. Thus, Contribution Analysis provides a framework to determine the exchange ratio and the right ownership percentage for the respective merger parties in a NewCo based on a fair value consideration.
1.3.
What Information is Needed to Complete a Contribution Analysis?
The following table provides an overview of the information required to complete a Contribution Analysis. Data Sources for Contribution Analysis Item
Source(s)
Historical Financial Statements
„ Annual reports / company filings (IBD Library, company website,
Edgar, Perfect Information Pioneer) „ Information memorandum / dataroom (buy-side)
Forecasts
„ Client „ Information memorandum / dataroom (buy-side) „ Published equity research / industry / market research „ CS equity research models (be aware of policies on communicating
with research analysts) Industry multiples
„ Compco Analysis (IBD Coverage Groups, CS Research)
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1.4.
What Does a Contribution Analysis Look Like?
The following table provides an illustration of a generic Contribution Analysis. Contribution Analysis – Example (€ in millions) Acquiror
Target
A
T
LTM
6,500
4,500
FY 2006F
8,000
5,300
FY 2007F
11,200
% Contribution Combined
(1)
Implied % of NewCo Equity A
Implied Exchange Ratio(2)(3)(4)
A
T
T
11,000
59.1%
40.9%
63.0%
37.0%
2.296x
13,300
60.2%
39.8%
64.1%
35.9%
2.182x
8,600
19,800
56.6%
43.4%
60.2%
39.8%
2.584x
Sales (5)
EBITDA (5)
EBIT
LTM
1,400
800
2,200
63.6%
36.4%
68.0%
32.0%
1.837x
FY 2006F
1,800
1,000
2,800
64.3%
35.7%
68.7%
31.3%
1.777x
FY 2007F
2,100
1,300
3,400
61.8%
38.2%
65.9%
34.1%
2.017x
LTM
1,100
550
1,650
66.7%
33.3%
71.3%
28.7%
1.567x
FY 2006F
1,500
750
2,250
66.7%
33.3%
71.3%
28.7%
1.567x
FY 2007F
1,800
1,050
2,850
63.2%
36.8%
67.5%
32.5%
1.882x
LTM
580
240
820
70.7%
29.3%
70.7%
29.3%
1.615x
FY 2006F
890
370
1,260
70.6%
29.4%
70.6%
29.4%
1.622x
FY 2007F
1,050
450
1,500
70.0%
30.0%
70.0%
30.0%
1.672x
8,000
4,100
12,100
66.1%
33.9%
66.1%
33.9%
2.000x
8,300
5,100
13,400
61.9%
38.1%
(5)
Net Income
(5)
Equity Market Cap. – Diluted
Enterprise Value
(1) (2)
(2) (6)
(3)
No synergies included 800 million and 200 million basic shares outstanding for A and T as of 31 December 2005, respectively. A & Co. has 20 million options outstanding with a weighted average strike price of €15.0. T has 20 million options outstanding with a weighted average strike price of €15.0 Net debt of €300 million for A and €1,000 million for T as of 31 December 2005, respectively Implied exchange ratios calculated assuming A and T valued at a weighted average multiple (i.e. weights are based on contributions of financial items incl. Sales, EBITDA, EBIT, and Net Income) Financial data for A and T as per CS Research dated 25 March 2006 and CS Research dated 25 March 2006, respectively A’s stock price of €10.0 and T’s stock price of €20.0 as of 25 March 2006
(3) (4) (5) (6)
2.
How to Complete a Contribution Analysis
2.1.
Key Aspects of the Analysis
„ Select appropriate sources of information § For public companies, all of the inputs for a Contribution Analysis are readily available in the target and acquiror’s public filings and market data § For private acquirers or targets, use information memorandum and client data; consult team members to determine the availability of the necessary inputs „ Refer to Section 1 of Merger Consequences Analysis for detailed list of sources of information „ Preparing a Contribution Analysis § The Contribution Analysis is set up as a table that allows an easy comparison of the relative contribution of the acquiror and target to the NewCo and the implied equity ownership of each. The example above examines the contributions of A (the acquiror) and T (the target) to the NewCo. As an example, implied equity ownership is calculated based on weighted average multiples (i.e. on multiples weighted based on contributions of financial items including Sales, EBITDA, EBIT and Net Income)
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2.2.
What are the Inputs?
„ Multiple Drivers § Determining the multiple drivers to calculate the equity consideration (acquiror multiples, target multiples, weighted average multiples, industry average multiples). Industry specific multiples based on the Comparable Company Analysis usually provide a sound basis for this analysis „ Time Periods § The time periods included in the analysis will be trailing (usually LTM), projected, or a combination of the two. Usually a combination of LTM and projected data is preferable for the analysis „ Multiples § The multiples that are included in the analysis will depend on the industry in which the company operates. Multiples can include, but are not limited to, Sales, EBITDA, EBIT and Net Income. Individual teams often use standard sets of multiples to value clients in certain industries. Refer to the Comparable Companies Analysis chapter for examples of multiples used in different industries, or alternatively, check proposed multiples against those used in recent equity research reports
2.3.
Mechanics of the Analysis
„ General Steps § Select relevant contribution items (e.g. Sales, EBITDA) and time periods that will be used in the Contribution Analysis § Calculate Net Debt § Calculate multiples for analysis § Interpret model and be prepared to discuss appropriateness of the exchange ratio chosen § For a more detailed discussion on calculating some of the associated inputs and adjustments that may be required, refer to the Comparable Companies Analysis chapter Key Outputs and Associated Inputs Key Output
Basic Calculation
Associated Inputs
Combined Sales / EBITDA / EBIT / Net Income
= Acquiror Input + Target Input
„ Acquiror and target Sales /
Sales / EBITDA / EBIT / Net Income Contribution (acquiror or target)
= Acquiror or Target Input / Combined Value
„ Acquiror and target Sales /
Implied Enterprise Value (acquiror or target)
= Assumed Multiple x Sales, EBITDA or EBIT
„ Assumed multiple – can use
EBITDA / EBIT / Net Income EBITDA / EBIT / Net Income
either acquiror multiple, target multiple, weighted average multiple or industry average multiple „ Relevant metric (Sales, EBITDA
or Net Income) Implied Equity Value (acquiror or target)
= Implied Enterprise Value (calculated above) - Net Debt – Minority Interest
„ Implied Enterprise Value
Implied Price Per Share (acquiror or target)
= Implied Equity Value / Fully Diluted Shares Outstanding
„ Implied Equity Value
„ Net Debt (Total Debt – Cash) „ Minority Interest
„ Shares Outstanding „ Dilution effect from options,
warrants, convertible instruments Implied Exchange Ratio (acquiror Shares Per Target Share)
= Implied Price Per Target Share / Implied Price Per Acquiror Share
„ Acquiror and target Implied Price
Implied % of NewCo (acquiror or target)
= Implied Equity Value / Sum of Acquiror and Target Implied Equity Values
„ Acquiror and target Implied Equity
Per Share
Value
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3.
Common Pitfalls
„ Impact of Growth § For companies with dramatically different growth projections, direct comparison can present a problem. Implied equity based on near term financial metrics may understate the fair ownership of the faster growing company, as future years will imply higher equity ownership for the fast grower, all else being equal. Therefore, consider growth projection differentials when determining which forecast year to use for base calculations „ Capital Structure § Shifts in capital structure can skew the implied equity for a given multiple assumption because the contribution analysis calculates an implied equity ownership based on multiples applied to Sales, EBITDA, EBIT and so on. Net debt is subtracted from Enterprise Value to arrive at implied equity contribution; thus temporary changes in capital structure (increasing or decreasing Net Debt level) can have significant impact on implied ownership. If one of the companies in the analysis exhibits a temporarily high or low gearing relative to historical or target capital structure, it may be worth considering the use of a target optimal level of debt in the analysis „ Number of Shares § A common mistake when calculating the exchange ratio is to use an incorrect number of shares outstanding for acquiror and/or target. For the purposes of this calculation, the fully diluted number of shares must be calculated. The dilution effect should take into account any financial instruments convertible into shares that are exercisable at the transaction date (e.g. convertible bonds, share options) „ Sensitivity Analysis § As the contribution analysis depends on multiples assumed, capital structure and growth trajectories, differences between the two companies on these metrics may drive different implied equity ownerships. It is important to realise that the contribution analysis is only a tool for analysing the contemplated exchange ratio. It is thus useful to perform a sensitivity analysis with different exchange ratios to analyse implied ownership at various ratios and interpret the output in the context of the companies’ specific multiple, capital structure, growth projections and the resulting implied exchange ratio
4.
Case Study
This case study demonstrates the mechanics of a Contribution Analysis. Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set. Acquiror, a public company, is considering a merger with Target by issuing primary shares of common stock.
124
4.1.
Case Study Inputs
Case Study Inputs (€ in millions, except per share data)
Acquiror
Target
Stock Price (€)
€50
Shares Outstanding (mm)
250
125
€2,000
€800
LTM Sales
7,200
3,200
2006E
8,400
3,900
2007E
9,600
4,500
LTM EBITDA
2,000
850
2006E
2,300
1,000
2007E
2,800
1,150
950
470
2006E
1,100
520
2007E
1,300
630
Net Debt
LTM Net Income
€40
Assume the following to calculate pro forma Enterprise Values and exchange ratios: „ Industry specific average multiples: Sales 1.9x 1.5 1.3
LTM 2006E 2007E
4.2.
EBITDA 7.2x 6.0 5.3
Net Income 11.9x 10.4 9.2
Answer These Questions
Once this case study is finished, the following questions should be able to be answered: „ What is Target’s contribution to the combined company’s Sales, EBITDA and Net Income in 2007? „ Assuming Target is valued using the industry average 2007E EBITDA multiple, what is its implied equity in the combined company? „ What is the appropriate exchange ratio based on the analysis? Acquiror and Target Multiples Sales
EBITDA
Net Income
LTM 2006E 2007E Note:
Sales and EBITDA multiples should be calculated on Enterprise Value
Sales
EBITDA
Net Income
LTM 2006E 2007E Note:
Sales and EBITDA multiples should be calculated on Enterprise Value
Pro Forma Sales Acquiror (€m)
Target (€m)
Total
Acquiror Contrib. (%)
Target Contrib. (%)
LTM 2006E 2007E
125
Pro Forma EBITDA Acquiror (€m)
Target (€m)
Total
Acquiror Contrib. (%)
Target Contrib. (%)
Acquiror (€m)
Target (€m)
Total
Acquiror Contrib. (%)
Target Contrib. (%)
LTM 2006E 2007E
Pro Forma Net Income
LTM 2006E 2007E
Enterprise Value and Equity Value Calculate Target’s Enterprise Value and Equity Value using industry average EBITDA multiples. EBITDA
Industry Multiple
Enterprise Value
Net Debt
Equity Value
LTM 2006E 2007E
Calculate Acquiror’s Enterprise Value and Equity Value using industry average EBITDA multiples. EBITDA
Industry Multiple
Enterprise Value
Net Debt
Equity Value
LTM 2006E 2007E
„ Complete similar calculations for Enterprise Value based on industry Sales multiples and for Equity Value based on industry Net Income multiples „ Calculate implied equity contribution using the equity values calculated above and complete the Contribution Analysis sheet below Case Study Worksheet for Contribution Analysis Acquiror Acquires Target (€ in millions, except per share amounts) % Contribution Acquiror
Target
Combined
Acquiror
Target
Implied % of Comb. Equity Acquiror
Target
Implied Exchange Ratio
Sales LTM FY 2006E FY 2007E EBITDA LTM FY 2006E FY 2007E Net Income LTM FY 2006E FY 2007E Equity Market Cap – Diluted Enterprise Value
Directions: Complete the Contribution Analysis using the outputs calculated on the previous pages.
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Discounted Cash Flow Analysis
127
Discounted Cash Flow Analysis 1.
Overview
1.1.
What Is The DCF Analysis?
The Discounted Cash Flow (“DCF”) Analysis: „ Derives the inherent value of an enterprise or asset „ By determining the NPV of the expected future cash receipts and outflows (i.e. cash flow) generated by such enterprise or asset to all providers of capital (i.e. the unlevered FCF) „ Using the weighted average cost of capital (“WACC”) as a discount rate to reflect the time value of money and the riskiness of the cash flows „ As of a specific valuation date
1.2.
Why Is It Used?
The DCF analysis provides a theoretically sound framework for deriving the intrinsic value of an enterprise or asset on a forward-looking basis. As such, the results of the DCF analysis provide an additional data point when valuing a business. Advantages
Disadvantages
p
Provides intrinsic value as opposed to marketbased value, i.e. less influenced by volatile public market conditions
q
Highly sensitive to assumptions used to derive projected cash flows (potential issue of “garbage in, garbage out”)
p
Allows reflection of company/asset-specific factors
q
p
Best captures businesses in transition
Highly sensitive to assumptions used to derive terminal value – terminal value typically represents a substantial component of total value
p
Allows a valuation of the different value components of a business or of synergies separately from a business
p
Allows a detailed assessment of alternative strategies through formulation of alternative cash flow projections
1.3.
What Information is Needed to Complete the Analysis?
To complete the DCF analysis following key information is needed: „ Historical financial statements (to benchmark or compare with projected performance) „ Projected financial statements „ Cost of capital assumptions „ Terminal value assumptions
1.4.
What Does a DCF Look Like?
The following page shows an example of a DCF calculation and acts as a guide to the relevant sections of this document where specific steps of the valuation exercise are explained. A worked example of a DCF valuation is provided in section 4.
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DCF Valuation Output – Example Projections Net Sales Growth EBITDA Adjustments EBITDA (adjusted) % of sales Depreciation EBITA +/- Other (non-operating) income/expense % of sales Adjusted EBITA (tax base) % of sales Tax on Adjusted EBITA Marginal tax rate NOPAT + Depreciation % of capex - Capital Expenditure % of sales + Decrease / (Increase) in NWC % of Absolute Change in Net Sales +/- Change in Other Non-Cash Items + Decrease / (Increase) in Provisions Unlevered Free Cash-flow Period discounted (years) Participation in Yearly Cash Flow WACC Discount factor Discounted Unlevered Free Cash-flow
2006E 1,945.1
Normalised
278.1 1.6 279.7 14.4% (74.6) 205.1
2007E 2,091.0 7.5% 305.3 1.6 306.9 14.7% (77.9) 229.0
2008E 2,237.3 7.0% 335.6 1.7 337.3 15.1% (81.7) 255.6
2009E 2,385.0 6.6% 357.7 1.7 359.5 15.1% (86.2) 273.3
2010E 2,536.3 6.3% 380.4 1.8 382.2 15.1% (91.3) 290.9
2011E 2,688.5 6.0% 403.3 1.8 405.1 15.1% (97.1) 308.0
2012E 2,836.4 5.5% 425.5 1.9 427.3 15.1% (103.6) 323.7
2013E 2, 978.2 5.0% 446.7 2.0 448.7 15.1% (110.8) 337.9
2014E 3,127.1 5.0% 469.1 2.0 471.1 15.1% (118.6) 352.5
2015E 3,283.4 5.0% 492.5 2.1 494.6 15.1% (127.0) 367.5
10.5% 205.1 10.5% (61.5) 30.0% 143.6
11.0% 229.0 11.0% (68.7) 30.0% 160.3
11.4% 255.6 11.4% (76.7) 30.0% 178.9
11.5% 273.3 11.5% (82.0) 30.0% 191.3
11.5% 290.9 11.5% (87.3) 30.0% 203.7
11.5% 308.0 11.5% (92.4) 30.0% 215.6
11.4% 323.7 11.4% (97.1) 30.0% 226.6
11.3% 337.9 11.3% (101.4) 30.0% 236.5
11.3% 352.5 11.3% (105.8) 30.0% 246.8
11.2% 367.5 11.2% (110.3) 30.0% 257.3
359.2 10.7% (107.8) 30.0% 251.4
74.6 82.9% (90.0) 4.6% (36.2) (25.1%) – 0.5 92.0
77.9 82.8% (94.1) 4.5% (36.0) (24.7%) – 1.1 108.1
81.7 81.1% (100.7) 4.5% (36.5) (24.9%) – 1.1 123.4
86.2 80.3% (107.3) 4.5% (35.8) (24.2%) – 1.1 134.4
91.3 80.0% (114.1) 4.5% (36.6) (24.2%) – 1.2 144.2
97.1 80.3% (121.0) 4.5% (36.8) (24.2%) – 1.2 154.9
103.6 81.2% (127.6) 4.5% (35.8) (24.2%) – 1.3 166.8
110.8 82.6% (134.0) 4.5% (34.3) (24.2%) – 1.3 178.9
118.6 84.2% (140.7) 4.5% (36.1) (24.2%) – 1.3 188.5
127.0 86.0% (147.8) 4.5% (37.9) (24.2%) – 1.4 198.7
143.2 95.0% (150.7) 4.5% (15.9) (24.2%) – – 228.0
0.25 50.0% 8.5% 0.98x 45.1
1.0 100.0% 8.5% 0.92x 99.6
2.0 100.0% 8.5% 0.85x 104.8
3.0 100.0% 8.5% 0.78x 105.2
4.0 100.0% 8.5% 0.72x 104.0
5.0 100.0% 8.5% 0.66x 103.0
6.0 100.0% 8.5% 0.61x 102.2
7.0 100.0% 8.5% 0.56x 101.1
8.0 100.0% 8.5% 0.52x 98.1
9.0 100.0% 8.5% 0.48x 95.3
Calculation of Enterprise Value (EBITDA Exit Multiple) EBITDA EBITDA Exit Mult iple Terminal value Discount factor Discounted Terminal Value
502.4 7.0x 3,516.6 0.46x 1,619.6
Calculation of Enterprise Value (Perpetuity Growth Rate) Unlevered Free Cash Flow Perpetuity Growth Rate Terminal Val ue Discount fact or Discounted Terminal Value
228.0 2.0% 3,653.5 0.46x 1,682.6
Sum of PV of Free Cash Flows Enterprise Value
958.4 2,578.0
Sum of PV of Free Cash Flows Enterprise Value
958.4 2,641.0
Calculation of Equity Value (EBITDA Exit Multiple) Enterprise Value - Existing Debt - Pension Liabilities - Minority Interest - Preferred + Existing Cash & Cash Equivalents + Book Value of Unconsolidated Assets Total Adjustments
2,578.0 (399.2) (35.5) (26.3) – 188.5 – (272.4)
Calculation of Equity Value (Perpetuity Growth Rate) Enterprise Value - Existing Debt - Pension Liabilities - Minority Interest - Preferred + Existing Cash & Cash Equivalents + Book Value of Unconsolidated Assets Total Adjustments
2,641.0 (399.2) (35.5) (26.3) – 188.5 – (272.4)
Implied Equity Value
2,305.6
Implied Equity Value
2,368.6
2015E 3,349.1
502.4 15.0%
Step 1 Information Gathering
Step 2 Forecasts
Step 3 Terminal Year Normalisation
Step 4 Terminal Value Calculation
Step 5 Determining WACC
Step 6 Calculation of Enterprise Value
Step 7 Calculation of Enterprise Value Adjustments and Equity Value
2.
How to Complete a DCF Analysis
2.1.
Key Steps of a DCF Analysis
2.1.1.
Forecasts
The DCF analysis aims at deriving the present value of expected future cash flows generated by an enterprise / asset. Towards this aim, project the series of future cash flows expected to be available to all providers of capital (i.e. the unlevered FCF) over the explicit forecasting horizon. Unlevered FCF The schedule below outlines the key building blocks of unlevered FCF. It should be noted that the specifics of the individual case will need to be reflected. It is important to include in the derivation of unlevered FCF all projected cash flows which are i) not related to the financing of the asset / enterprise or ii) not related to items treated as Enterprise Value adjustments (e.g. non-operating assets and minority interest). Also appropriately account for deferred taxes and provisions (see the section “Selected Special Items / Adjustments” for a detailed discussion on those items). Main DCF Components 1. Revenue Model
+ Revenues – Variable Costs
Price and volume forecast
= Gross Profit COGS: Price and volumes Other variable costs
2. Cost Model
Semi Variable / Fixed Costs – Fixed Costs = EBITDA 3. Tax Schedule
Labour and headcount S,G & A Other fixed costs
– Depreciation and Amortisation = EBIT
– Corporate Tax (on EBIT) 4. Dpn and Capex Matrix
= Unlevered Net Income
+ Depreciation and Amortisation – Net Capital Expenditures 5. Working Cap. Sched.
Planned Investments Average useful life of existing and new fixed assets
+/– Change in Net Working Capital = Unlevered Free Cash-Flow
Effective tax rate Existing tax relief's Trade Receivables Trade Payables Product and Materials Stock
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Forecasting The key to forecasting is to understand the industry and to understand the business. Briefings from senior team members and a review of research reports on the sector and on peers will provide a good grounding on which to build. Further, undertake a detailed analysis of historical financials – 3 years is good, 5 years better – to understand growth rates, margin development (when forecasting, drive EBITDA margin, not EBIT margin to avoid implausible reactions of the model to sensitivities in revenue growth), one-off items, cost reduction programs, working capital development, capital expenditure levels and so on. Projections should be based on: „ Analysis of historical performance „ Company and/or client projections „ Equity research analyst estimates „ Industry data: benchmark growth and margin development against comparables When developing projections, typically aim to separate costs which are variable by nature (i.e. they are linked to activity levels) and costs which are essentially fixed by nature (i.e. at least in the short term they are not impacted by changes in activity level). Variable costs (i.e. primarily cost of goods sold) are typically projected as a percentage of sales, whereas fixed costs (i.e. primarily selling, general and administrative expenses), are typically projected via a relevant growth rate (e.g. inflation, salary inflation). The resulting positive impact of revenue growth on profit margins is called operating leverage. Bear in mind however, that in the long run even fixed costs will be impacted by activity levels (i.e. operating leverage has its natural limits). Hence, depending on the specifics of the situation, it may be appropriate to at least partially link fixed costs to the development of revenues. For key drivers, also consider scenarios / sensitivity analyses to the base case forecast to derive further data points for valuation conclusions. Once the forecasts have been developed, ensure that assumptions are critically questioned and an explanation of the development of key items can be provided. In particular, ask questions such as the following: „ Do the projections overall appear reasonable and not overly optimistic or pessimistic? „ Is there sound reasoning for any unusual changes in growth rates and margins (i.e. fluctuations in ratios between years) - beware of “hockey sticks”? „ If the business operates in a cyclical sector, do the projections reflect the cyclical nature of the sector (i.e. continuously growing revenues and operating profits are likely not realistic)? „ Does the business undertake sufficient Capex to support the projected growth? Is any expansion in asset productivity (sales / fixed assets) realistic? „ Does the business have sufficient working capital and are any projected improvements in working capital management (i.e. reduction in working capital days) realistic? „ Are the business’s returns on capital consistent with the competitive dynamics of the overall sector? Projection Period The first step is to decide on the length of the explicit projection period, which should reflect a reasonable trade-off between the ability to develop meaningfully detailed assumptions (e.g. availability of forecast data from management or other sources such as equity research analysts) vs. having a sufficiently long period to reach a performance level characteristic of a steady state (i.e. where growth rates and margin levels have reached what is considered a long-term sustainable level and where the expected return on incremental invested capital is equal to the cost of capital). Key factors which impact on the time required to reach a steady state include: „ High growth: in less mature industries, growth rates tend to be significantly above the long-term growth rates that can be expected once maturity has been reached. The projection period should be long enough to allow for a gradual decline in growth rate towards steady state and thus to capture the value of the above-average growth
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„ Cyclicality: the forecast period should be long enough to allow the cycle to play out over an up- and down-cycle before reaching a mid-cycle level at the end of the projection period „ Known extraordinary influences or fundamental changes in the cash flow profile which could not be captured in the terminal value: the projection period should be long enough to capture such changes before the terminal year „ Finite asset life (e.g. individual oil fields, mines, nuclear power plants, licences): cash flow projections are typically generated for a period capturing the entire life span of such assets Credit Suisse typically uses a 10-year projection period, however, individual cases may justify a shorter or longer period. Level of Detail The key task in deriving projected cash flows is to identify and project growth rates and/or levels of key value drivers relevant to the business. As such, the forecast model should be sufficiently detailed to reflect all key drivers with which to develop reasonable assumptions, while not being overly detailed and thereby detracting from what really matters. Remember that a clear and credible explanation of the model will be expected by senior team members and the client. Nominal vs. Real Forecasts Prepare financial forecasts in nominal terms (i.e. the development of revenues and costs includes inflation in future years), if at all possible and discount such cash flows at a nominal discount rate: „ Clients typically think in nominal terms „ Interest rates quoted in nominal terms „ Financial statements typically stated in nominal terms (in particular relevant for depreciation) Nominal cash flows grow at the compound product of the actual inflation rate and the real rate of growth. The “nominal cash flow / nominal discount rate” approach will typically allow for the capture of economic aspects of the relationship between depreciation and taxes. „ For most jurisdictions, and in particular where inflation accounting is not applicable, the nominal cash flows / nominal discount rate approach captures the distortion whereby historical cost assets cause cash flows to be less than they would be with current cost assets due to the lower tax shield afforded by lower depreciation. Depreciation is tied to historical costs (not to the inflation-adjusted current value); as inflation rises, firms may not deduct enough depreciation expense to replace assets (even 4 though Capex grows with inflation) „ Consequently, firms may overpay taxes – this is an actual economic cost to investors, which tends to be ignored by the real cash flows / real discount rate approach There may be situations where forecasting in real terms can be appropriate (e.g. in hyper-inflation economies), however discuss with team members before deciding on forecasting in real terms. Note that if financial projections are forecast in real terms, it will be necessary to adjust factors such as terminal multiples, terminal growth rates and the cost of capital to remain consistent in the valuation approach. Stand-Alone Forecasts vs. Synergies Base case forecasts for the business should in most cases be prepared on a stand-alone basis, i.e. the base case should ideally be a business plan which the company is expected to be able to achieve on its own. Synergies, i.e. value creation made possible only through a change in ownership or business combination should, to the extent possible, be excluded from the base case. Their value should be determined as a separate exercise. Judgement needs to be applied in deciding which improvements in operating performance will be achievable by the business on a stand-alone basis and which improvements constitute true synergies. A grey area where arguments can typically be made both ways are improvements achieved through improved management of the business (e.g. working capital improvements, efficiency programmes). The guiding principle in such cases should typically be to question whether the company could access such 4
This may not be relevant in jurisdictions where taxation is not calculated based on historical depreciation
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improved management skills either internally or through external recruiting or whether the specific management skills are proprietary to a prospective new owner or merger partner. Any scale economies (i.e. improvements in revenues or costs which derive from enhanced scale) and cost of capital economies should be considered true synergies and evaluated separately from the base case. When forecasting synergies, bear in mind that „ Synergies often require restructuring measures or other adaptations of the business model which lead to one-time costs before synergies are realized „ The implementation of synergies often takes time, i.e. the benefits often only materialize over time „ In certain situations (e.g. consolidating sectors, regulated businesses, contracting sectors) synergy benefits are often passed on to customers in the form of price reductions over time, i.e. synergies do not always have a terminal value Synergies can be valued either in a separate, simplified cash flow model or as part of a synergy case, where the value of the synergies is the delta between the EV of the synergy case and the EV of the base case. When evaluating synergies in a simplified cash flow model, it is important to bear in mind that synergies are typically projected on a pre-tax basis and need to be tax-effected for valuation purposes. Also, bear in mind that Capex synergies lead to a reduction in D&A in the future and hence to an increase in tax payments. Note that the synergy value derived via the two approaches will differ. This difference can sometimes be significant, as a simplified model will typically not capture all the impacts synergies have on the business’s cash flow. The key drivers of such difference will typically be the failure to fully capture the impact of: „ Tax loss carry forwards § In situations where the business has tax loss carry forwards, i.e. losses incurred in prior periods which can be used to off-set against taxable income in future periods, revenue and cost synergies will lead to an acceleration of the utilisation of such tax losses, whereas Capex synergies will lead to a delay in their utilisation. If the amount of tax losses is significant, bear in mind that an acceleration of their utilisation will increase the net present value of the tax losses and hence the value of the synergies (and vice versa for a delay in the utilisation of tax losses) „ Net working capital § Typically, net working capital is either a function of sales or costs (measured in days of sales or costs). Revenue and cost synergies therefore typically have a working capital impact. In businesses operating with positive working capital, the working capital impact is typically negative on valuation. In businesses which operate on negative working capital, the working capital impact is typically positive „ Capex § Capex is typically directly linked to future sales expectations, as growth needs to be supported by capacity. Revenue synergies will typically require upfront Capex spend, which may not be captured in a simplified model
2.1.2.
Terminal Value
A DCF analysis is typically based on an explicit projection period, which does not as such include the value of cash flows accruing to the enterprise or asset after the projection period. The terminal value is used to capture the value of the enterprise or asset at the end of the projection period. The terminal value is discounted back to the valuation date using the same cost of capital which is used for discounting the cash flows during the projection period (see the additional discussion on this point later in the chapter). It is added to the net present value of the cash flows generated during the projection period to arrive at a total value for the enterprise / asset. In a typical DCF analysis, the terminal value will often account for more than 50% of the total value. It is, therefore, essential to treat the terminal value calculation as a separate valuation exercise and to properly consider the factors entering the terminal value calculation. In an ideal DCF analysis, financials are projected into the future long enough so that they will have reached a steady state by the final explicit forecast year. In practice, it may, however, be necessary to make normalisation adjustments to the
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financial results projected for the final year of the projection period before using such results as basis for the terminal value calculation (see the section “Terminal Year Normalisation”). Use two primary methods to calculate terminal value, the mechanics of which are discussed in detail further below: „ Multiple method „ Perpetual growth method
2.1.3.
Discounting / Present Value
Once a cash flow projection has been developed and the terminal value has been determined, both need to be discounted back to the valuation date with an appropriate discount rate. In the standard DCF analysis (i.e. one which values unlevered free cash flow), use the weighted average cost of capital (“WACC”) as a discount rate (see the WACC section for further discussion). Note that the WACC to be used in a DCF analysis is specific to the asset being valued, and should not, in theory, depend on the potential buyer’s or seller’s cost of capital. Further, the WACC should be based on the optimal capital structure for the asset rather than on how the asset will be financed in practice. The optimal capital structure is one which minimises the overall cost of capital by balancing the positive impact of increased leverage (higher proportion of cheaper debt financing) vs. the negative impact of increased leverage (increasing riskiness of debt financing leading to increasing cost of debt financing). Note that the optimal capital structure is not readily observable. Seek guidance from the benchmarking of comparable companies’ capital structures and the analysis of the impact of increased leverage. In certain instances, in particular where a company’s lifecycle is projected to enter a new stage towards the end of the explicit forecast horizon, it may be appropriate to consider discounting the terminal value using a different WACC than that used for the discounting of the cash flows in the explicit forecast horizon. This would reflect a potentially different risk profile of the business after it has entered a new phase of the lifecycle. This may also reflect the more stable nature of companies located in some emerging economies, where going forward one may expect a significant economic convergence with mature economies. Bear in mind however that i) the appropriateness of such approach is subject to considerable debate and ii) such approach is often quite difficult to rationalize vis-à-vis clients. Therefore, if considering applying such approach, discuss in detail with the team.
2.1.4.
Enterprise Value vs. Equity Value
Discounting unlevered free cash flows yields the Enterprise Value of the asset generating such unlevered free cash flows, i.e. the value accruing to all holders of capital in and other claims against such asset. To derive the Equity Value and value per share, i.e. the value accruing to the holders of the company’s share capital, one needs to adjust for all value items not yet reflected in the unlevered free cash flows. A detailed discussion of the adjustments to translate Enterprise Values into Equity Values (and vice versa) can be found in the section on Comparable Companies Analysis. Further, particular considerations concerning individual adjustment items in the context of a DCF analysis can be found further below. As a general point, however, the following – non-exhaustive - list of adjustment items will typically apply: „ Financial debt „ Cash and cash equivalents „ Minority interest(s) „ Preferred equity, if debt-like in nature „ Net pension deficits and/or unfunded pension liabilities „ Other long-term / non-operating provisions „ Non-operating assets and investments, to the extent cash flow from such non-operating assets has been excluded from the unlevered free cash flows If in doubt about the appropriate treatment of any item, the primary question should always be whether the positive or negative value contribution of such item is already economically captured in the cash flows used to derive the Enterprise Value.
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2.1.5.
DCF Matrix
The results of the DCF analysis are typically presented in the form of a DCF matrix, in which Enterprise Value is shown for a range of discount rates as well as a range of terminal value multiples / growth rates. (€ in m illions, FYE December 31) EBITDA Exit Multiple
9.00%
7.0x
938
39.4%
938
37.7%
938
36.1%
PV of Unlevered FCF (2006E - 2015E)
60.6%
1,550
62.3%
1,661
63.9%
2,488
(272)
(272)
WACC
938
39.3%
938
38.5%
938
37.6%
1,447
60.7%
1,499
61.5%
1,555
62.4%
Enterprise Value
2,385
(272)
EV Adjustments (current)
2,326
27.0
28.4
6.9x
7.2x
1.7%
2.2%
(272)
(272)
(272)
2,165
2,220
29.8
Value per Share
27.1
27.8
28.5
7.6x
Implied EV / 2007E EBITDA Multiple
7.8x
7.9x
8.1x
2.6%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
6.5x
6.8x
7.0x
38.9%
958
37.2%
958
35.6%
PV of Unlevered FCF (2006E - 2015E)
61.1%
1,620
62.8%
1,735
64.4%
958
37.2%
958
36.3%
958
35.4%
PV of Terminal Value 2015E
1,620
62.8%
1,683
63.7%
1,750
64.6%
2,694
Enterprise Value
2,579
(272)
EV Adjustments (current)
2,641
(272)
(272)
(272)
2,306
2,421
Equity Value (m)
2,306
2,369
2,436
28.1
29.6
31.0
Value per Share
29.6
30.4
31.2
7.1x
7.5x
7.9x
Implied EV / 2007E EBITDA Multiple
8.4x
8.6x
8.8x
1.3%
1.8%
2.2%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
7.0x
7.3x
7.6x
980
38.4%
980
36.7%
980
35.1%
PV of Unlevered FCF (2006E - 2015E)
61.6%
1,692
63.3%
1,813
64.9%
2,551
2,672
(272)
(272)
980
34.9%
980
34.0%
980
33.1%
PV of Terminal Value 2015E
1,824
65.1%
1,900
66.0%
1,983
66.9%
2,793
Enterprise Value
2,804
(272)
EV Adjustments (current)
(272)
2,880 (272)
(272)
2,399
2,520
Equity Value (m)
2,531
2,607
2,690
29.2
30.8
32.3
Value per Share
32.5
33.4
34.5
7.4x
7.8x
8.2x
Implied EV / 2007E EBITDA Multiple
9.1x
9.4x
9.7x
0.8%
1.3%
1.7%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
7.5x
7.9x
8.2x
Normalised EBITDA 2015E Normalised Unlevered Free Cash Flow 2015E
2.1.6.
7.50%
2,963
2,279
Notes
8.50%
2,708
2,190
1,571
9.00%
2,492
2,113
958
(272)
2,437
Equity Value (m)
1,504 (272)
2.25%
PV of Terminal Value 2015E
2,216
2,578
2.00%
2,599
2,105
2,462
7.50%
1.75%
1,440 2,377
8.50%
Perpetuity Growth Rate 7.5x
WACC
6.5x
502.4 228.0
Sensitivity Analyses
Sensitivity analyses aim at showing the value impact of changing individual key assumptions / value drivers. Following is an example of a valuation sensitivity to assumptions regarding EBITDA margins and sales growth. Sensitivity Analysis – Change in NPV
EBITDA Margin above/ (below) assumed EBITDA margin
(€ in millions)
(1.5%)
Sales growth above / (below) assumed sales growth (1.0%) (0.5%) – 0.5%
1.0%
(1.5%)
(372)
(306)
(238)
(167)
(93)
(16)
63
(1.0%)
(320)
(253)
(184)
(111)
(36)
42
123
(0.5%)
(269)
(201)
(129)
(56)
21
101
184
–
(217)
(148)
(75)
–
78
159
244
0.5%
(166)
(95)
(21)
56
135
218
304
1.0%
(144)
(42)
33
111
192
276
364
1.5%
(63)
11
88
167
249
335
424
1.5%
Examples of factors that are frequently subject to sensitivities are: „ Volume, price, revenue growth „ Margins „ Capex The list of potential sensitivity variables is endless. However, the focus should be on those factors which have the greatest uncertainty and/or the greatest value impact.
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2.2.
What Are the Inputs / Where Do I Find the Information?
The following table provides an overview of the DCF inputs and their sources. Item
Sources
Historical Financial Statements
„ Annual reports / company filings (IBD Library, company web
site, Edgar, perfect Information) „ Information memorandum / dataroom (buy-side processes)
Projected Financial Statements
„ Client „ Information memorandum / dataroom (buy-side processes) „ Published equity research reports (use individual forecasts of
highly rated research analysts to construct consensus estimates – don’t use IBES consensus without understanding the underlying individual projections) „ CS equity research models (be aware of policies on
communicating with research analysts) „ Macroeconomic research „ Industry / market research
WACC – Cost of Equity
Beta „ Barra „ Bloomberg
Equity Risk Premium „ CS equity research (weekly ERP sheet) „ Ibbotson „ Discuss with team members
Risk free rate „ Spider „ DCM „ FT
WACC – Cost of Debt
Risk free rate „ See above
Borrowing spread „ DCM
WACC – Target Capital Structure
„ Compco analysis „ Discuss with team members „ Ratings advisory team
Terminal Value – Perpetual Growth Rate
„ Long-term inflation „ Long-term GDP / market / industry growth estimates „ Equity research
Terminal Value – Normalized Multiple
„ Compco Analysis „ Comparable Transactions Analysis
2.3.
What is the Output?
Typical output sheets of a DCF analysis are: „ Projected financials – Unlevered FCF calculation „ Normalisation table for terminal year „ Terminal value calculation „ Enterprise Value and Equity Value calculation listing all Enterprise Value adjustments „ Working capital schedule „ DCF matrix „ Sensitivity tables An output of a worked example is shown later in this chapter.
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2.4.
Mechanics of the Analysis – Best Practices
2.4.1.
Time Effects in Discounting
Mid-Year vs. End-Year Cash Flows The standard NPV formula in Excel as well as the standard approach to discounting individual cash flows implicitly assumes that cash flows are received at the end of the period (normally each year). In the majority of businesses this assumption is incorrect, as in reality cash flows are typically received in a smoother pattern throughout the period. The mid-year convention addresses this issue by adjusting the present value formula to accelerate the receipt of cash flows by half a period. Mathematically, this approximates spreading out the cash flow across the period on the assumption of a uniform distribution of cash flows throughout the period. (€ in millions)
22
Actual Cash Flow Profile
12
J an
Feb
10
13
11
12
14
Mar
A pr
May
J un
Jul
24
23
Aug
Sep
10
11
13
Oct
Nov
Dec 175
Implicit Profile of Year-end Discounting
J an
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
J ul
Aug
Sep
Oct
Nov
Dec
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Implicit Profile of Mid-year Discounting Jan
Feb
Mar
Apr
May
Jun
The conversion of end-year cash flows to mid-year cash flows is a simple reversal of the effect of discounting for half a year: Mid-year Cash Flow = End-year Cash Flow
* (1+r)
0.5
where r = cost of capital Partial Year Valuation In many instances, the valuation date will not coincide with the start of the financial year of the business being valued. Also, by the valuation date a portion of the first year’s cash flow will already have accrued to the business and as such will already be captured in the Enterprise Value adjustments (Net Debt/Cash). It is, therefore, important to ensure that cash flows are discounted back to the appropriate point in time and that any portion which has already accrued to the business is excluded from the first year’s cash flow.
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Partial Year Valuation – Illustration of Concept
2006
2007
2008 etc.
Cash Flow Valuation date: 01.08.06
End-Year Cash Flow Exclude
Discount 5 months
Discount 17 months
Discount 29, 41, etc. months
Exclude
Discount 2.5 months
Discount 11 months
Discount 23, 35, etc. months
Or Mid-Year Cash Flow
Partial Year Cash Flow Where the valuation date (i.e. assumed transaction effective date) falls within the first forecast year as opposed to the beginning thereof, the first year cash flow must also be adjusted to exclude any cash flow occurring before the valuation date. Unless there is a known seasonality or a significant one-off cash flow event (e.g. a large one-off Capex spend before or after the valuation date) which would dictate otherwise, this is simply done by reducing the first year cash flow pro rata for the time. As a first step, the cash flow occurring prior to the valuation date should be deducted from the first year cash flow to arrive at a pro forma cash flow for valuation purposes. As a second step, it is necessary to understand what happens with such cash flow by the valuation date, i.e. whether it stays with the enterprise or whether it is returned to the owners (e.g. by way of a special dividend). If it stays with the enterprise, it will lead to a reduction in Net Debt / increase in Net Cash relative to the Net Debt/Cash position at the start of the year so ensure that the Enterprise Value adjustments adequately capture the cash flow. Valuation Date - Adjustment of Discounting Period To discount back to the appropriate time, two approaches can be taken depending on the method used for discounting: „ Discounting using the NPV formula If using the NPV formula, it is necessary to partly reverse the discount for the difference in time between the start of the first forecast year and the valuation date. As an example, if the first forecast year starts on 1 January 2006 and the valuation date is 1 August 2006, reverse the effect of discounting by 7/12 of one year: 7
PV = NPV (r, Cash Flows ) ∗ (1+ r )12 where r = cost of capital „ Discounting using the PV formula If discounting individual cash flows, then directly adjust the number of years being discounted by the fraction of the first year that has already elapsed. Again, on the basis of the previous example:
PV =
CF1
CF2 + 7 7 1 + r 1 − 12 1 + r 2 − 12 where r = cost of capital
(
)
(
+ etc.
)
139
Note that when combining the concepts of partial-year cash flows and mid-year cash flows, the combination of the formulas above will lead to a slight imprecision as the partial-year cash flow in year 1 will be discounted for the wrong period. Example
PV of Year 1 cash flows at 01.08.06 = NPV(r, CF1 ) * (1+ r)
0.5
7 12 * (1+ r)
a
= NPV(r, CF1
13 ) * (1+ r) 12
b
where: CF1 represents the applicable partial-year cash flow in year 1 underlined term a represents the adjustment for the mid-year convention underlined term b represents the adjustment for the valuation date on 1 August 2006 Given the valuation date of 1 August 2006, the partial-year cash flow in year 1 on average accrues in midOctober. Hence, as the NPV formula has discounted the cash flow back to 1 January 2006, discounting (of CF1 only!) would need to be reversed by 9.5 months (rather than 13 months) to bring it to the valuation date. In most instances, the impact of this on the derived Enterprise Value will however be marginal and can be ignored. In cases where this has a material impact (i.e. the first year cash flow is extraordinarily high, you will need to discount each year’s cash flow separately rather than using the NPV formula.
2.4.2.
Terminal Value
There are two primary methods used to calculate Terminal Value: „ Multiple method „ Perpetual growth method In addition, fade models are becoming increasingly common as an alternative Terminal Value approach. Fade models determine terminal value based on an assumed development of value creation over time, i.e. the assumption (supported by Credit Suisse HOLT research) that a company typically does not produce excess returns in the long term but rather that its return on capital approaches its cost of capital in the long term. Multiple Method This method implicitly assumes that the business is sold at the end of the final forecast year either in the private or the public market. The choice of multiples will depend on which exit scenario is considered most appropriate for valuation purposes: „ Compco: assumes a sale in the public securities market (i.e. an IPO) „ Compacq: assumes sale in the private market (i.e. through an M&A transaction) Key items to watch out for include: „ Multiples applied need to be consistent with the steady state assumption underlying the terminal value concept § The Terminal Value calculation should be based on the most appropriate multiple (or multiple range) for the company’s sector (i.e. the multiple on which the sector mainly trades today) § In cyclical industries, it is important to select a terminal multiple which can be considered representative for the business at the mid-point of the cycle § In less mature / high growth industries, consideration needs to be given to the impact of slowing growth rates and possibly stabilising margins on multiples, e.g. multiples observed at present for high-growth sectors will be potentially significantly higher than multiples to be expected once the sector growth has slowed towards the end of the projection period. Bear in mind that the terminal multiple represents eternity, i.e. ask whether the implicit growth rate is sustainable on a permanent basis § Theoretically, depending on the tax regime governing the enterprise, a disposal may trigger tax liability on the capital gain. Such capital gains tax would reduce the terminal value of the enterprise if an exit were to take place. However, in the majority of cases, also apply the multiple method as a proxy for the terminal value in cases where it is not actually expected that the business be sold after
140
the projection period. In such cases, it is clearly inappropriate to reduce the terminal value for a theoretical tax liability. Judgement is required to determine the appropriate treatment in each specific situation – discuss this with team members if in doubt „ Financial metric (e.g. EBITDA) and multiple applied must be consistent: trailing vs. forward multiple § Correct: Terminal Value = EBITDAn ∗ LTM multiple , or § Correct: Terminal Value = EBITDAn ∗ (1+ g) ∗ FY1multiple , where g = long-term nominal growth rate Other combinations lead to conceptually wrong results, e.g. § Wrong: EBITDAn ∗ FY1multiple produces Terminal Value at the beginning of year n § Wrong: EBITDAn ∗ (1+ g) ∗ LTM multiple produces Terminal Value at the end of year n+1 „ When valuing the enterprise, the Terminal Value calculation must be based on the Enterprise Value concept (e.g. Sales, EBITDA, EBIT, Asset Value Multiple). When valuing equity cash flows, Terminal Value must be based on Equity Value Concept (e.g. P/E, Equity Book Value Multiple) „ The multiple method values the Terminal Value as per 31 December of year n / 1 January of the perpetuity period. Ensure the correct discounting factor is applied (i.e. when using mid-year cash flow convention, the discounting factor used for final year cash flow is different from the discounting factor to be used for discounting Terminal Value) When applying the multiple method, the implied perpetual growth rate should be calculated as a sanity check:
Implied Perpetual Growth Rate =
WACC ∗ TV − UFCFn TV + UFCFn
(if applying the end-year cash flow convention) or
Implied Perpetual Growth Rate =
WACC ∗ TV - UFCFn ∗ (1+ WACC) 0.5 TV + UFCFn ∗ (1+ WACC) 0.5
(if applying the mid-year cash flow convention) Perpetual Growth Method This method assumes that the business continues to generate FCFs that grow at a constant rate into perpetuity. The implicit assumption of applying the perpetual growth method is that rather than selling the business at the end of the explicit forecast period, the business is held into perpetuity. The Terminal Value is calculated as follows:
Terminal Value =
UFCFn+1 (r − g)
where: UFCFn+1 = Unlevered FCF in period n+1 g = perpetual growth rate r = Weighted Average Cost Of Capital (WACC) The unlevered FCF in period n+1 can either be calculated as UFCFn * (1+g) or, if the model contains a normalisation of the final year (where the normalised year includes a revenue growth factor relative to the year n of the model) the normalised UFCF can be taken straight from the normalisation schedule. Note that the perpetual growth formula is implicitly based on the end-year convention, i.e. it assumes that cash flows accrue at the end of a given financial year. Further, the formula computes the Terminal Value as per the end of year n. When calculating the DCF value and applying the mid-year convention, it is, therefore, necessary to adjust the Terminal Value to also reflect the mid-year convention:
Terminal Value =
UFCFn+1 0.5 ∗ (1+ r ) (r − g) 141
Further, note that such Terminal Value continues to represent value at the end of year n and needs to be discounted to the present time by applying the appropriate number of years. When applying the perpetual growth method, the implied Terminal Multiple should be calculated as a sanity check:
Implied Terminal Multiple =
TV Relevant Metric (e.g. EBITDA)n
Note that all formulas provided here need to be adjusted when basing the calculation on the normalised final year where the normalisation includes revenue growth at the perpetuity growth rate, i.e. turning the final year EBITDA / UFCF into a EBITDA/ UFCF in year n+1. Apply a terminal growth rate which is close to the expected long-term growth of the economy, if appropriate for the specific business (and its sector) being valued. Note that the typical measure of underlying economic growth, i.e. GDP growth, is often – but not always – projected on a real basis by economic research. For the purposes of setting the perpetuity growth rate, ensure that the impact of expected long-term inflation is considered, as the model is typically based on nominal cash flows. Fading Cash Flow Analysis (In Lieu of a Traditional Terminal Value Analysis) Over the long term, firms’ cash flows tend to be subject to a competitive life cycle. Empirical studies indicate that competition tends to compress returns toward a long-term average. The company generates value as long as its average returns on capital are higher than the average cost of capital. Returns On Capital and Steady State As Part of a Company Life Cycle (Illustrative) Increasing returns & high reinvestment
Above-average but fading returns
Average returns
Below-average returns
Average returns on capital Competitive pressures
Cost of capital (investor’s required rate of return)
Returns on incremental capital Steady state
Growth / high innovation
Fading business
Mature business
Restructuring need
In principle, the Terminal Value should be applied after the valued company has reached a steady state. A steady state is reached when incremental returns on capital are equal to the cost of capital – meaning, the original capital will continue earning fading returns, but no value will be created on incremental investments. Traditionally however, an explicit forecast horizon – after which a Terminal Value is calculated – is chosen somewhat arbitrarily (e.g. five or ten years) and the majority of a company’s value is embedded in the Terminal Value. A problem is that this arbitrary explicit forecast horizon may miss (be significantly short of) a point in the forecast when a steady state has been reached. Missing this point may mean either a systemic overvaluation (when incremental returns on capital embedded in Terminal Value are perpetually above the cost of capital) or a systemic undervaluation (when the incremental returns on capital are below the cost of capital). The shorter the explicit forecast horizon, the bigger the problem.
142
A solution may be to apply the concept of a fading cash flow, which simply means gradually fading the 5 company’s returns on capital (ROIC or CFROI ) over a relatively long period of time (e.g. over 20 or 40 years) – until the point when average returns on capital are close to the cost of capital. As a result, the Terminal Value is calculated in the steady state period (or close enough to such state). Consequently, the value embedded in the Terminal Value is relatively low and – by the virtue of the time value of money – any potential mistakes associated with the Terminal Value assumptions are less meaningful for the valuation. In terms of mechanics of the fade, research by Credit Suisse HOLT shows that in the long-term horizon the delta between the returns on capital and the cost of capital tends to decrease by 10% exponentially every year over a 100 year period. This is an assumption which can be employed in the model after the explicit forecast horizon. Consequently, if one assumed no Terminal Value (returns fading long-term to the cost of capital and growth fading to a long-term economy growth), the company’s cash flow and growth evolution would follow a pattern similar to that depicted in the following chart. Fading DCF: Company’s Capital Growth, Return on Capital and Cost of Capital (Example) Explicit / CAP Fade Forecast Period Period 60%
50%
Capital growth rate
40%
30%
20%
Return on capital Discount rate
10% Perpetual growth rate
2004 2012 2020 2028 2036 2044 2052 2060 2068 2076 2084 2092 2100 2108 2116 Return on capital Note:
5
Capital grow th
Cost of capital
Perpetual grow th rate
CAP = Competitive advantage period
ROIC (return on invested capital) = NOPLAT / Invested Capital, where NOPLAT is a net operating profit less adjusted taxes (appropriately accounting for the tax shield), and invested capital is: Operating net working capital (operating current assets – non-interest-bearing current liabilities) + Net PP&E + Other operating assets net of other liabilities Operating invested capital (ex goodwill) + Goodwill Operating invested capital (incl. goodwill) + Excess cash and securities + Non-operating investments = Invested Capital CFROI (cash flow return on investment) is the cash flow a business generates in a given year as a % of the cash invested to fund assets used in the business. CFROI = (Gross Cash Flow – Economic Depreciation) / Gross Investment.
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Terminal Year Normalisation The Terminal Value calculation should be based on financials reflective of a long-term steady-state which the enterprise can be expected to achieve. While it is reasonable to expect that financial forecasts over the explicit forecast horizon will often trend towards such a steady state, it is typically an advisable and common practice to normalise the EBITDA (or other metric) needed for the multiple method and the UFCF needed for the perpetual growth method. Typical normalisation adjustments which may be considered and discussed with the team include: „ EBITDA margin § Consider whether EBITDA margins in the explicit forecasts are sustainable in the very long run visà-vis the competitive environment, market dynamics, peer performance and so on „ Capex level and relation of Capex and depreciation § In the steady state, Capex needs to be adequate to support the business and any growth assumed into perpetuity to ensure that asset productivity remains constant. Depreciation is a function of past Capex, not the other way round. When normalizing Capex and depreciation, first define the level of Capex that is reasonably required to support the business into perpetuity and only then define a normalised level of depreciation § Often, bankers use the shortcut of assuming Capex equals depreciation in the normalised year, claiming that this ensures that the business only invests in its asset base at a rate sufficient to replace the depletion of the asset base. Note however, that the normalised relation between depreciation and amortisation and Capex is influenced by a number of factors which may drive the appropriate relation away from 1:1
– Inflation: remember that depreciation is a book value concept. Depreciation today relates to assets acquired at historic cost over past years. Ceteris paribus, inflation will therefore lead to replacement Capex being higher than depreciation by the accumulated inflation since acquisition
– Productivity gains: productivity gains may partly offset or even outweigh inflation (e.g. price declines of computers and digital cameras, if compared on a like-for-like basis)
– Perpetual growth assumption: if the perpetual growth rate assumes real growth (i.e., growth on top of inflation), Capex needs to be sufficiently higher than depreciation to support such perpetual growth „ Change in net working capital (and/or other assets / liabilities) § Change in net working capital (and/or other assets and liabilities) should typically not dramatically impact the terminal value; in particular, it is important to ensure that the change in net working capital and other assets/liabilities is consistent with the assumed perpetual growth rate „ Tax rate § Normalisation will be appropriate to the extent tax loss carry-forwards or other non-permanent effects lead to a deviation of the actual tax rate from the statutory tax rate during the explicit projection period Please note that appropriate normalisation adjustments depend on the individual case and require judgement calls which should be discussed with the team. Also note that adjustments to the Terminal Value formulas outlined above may be required if normalisation includes a growth element, making the final EBITDA / UFCF effectively an EBITDA / UFCF in year n+1. Refer to section 4, step 3, of this chapter for an example of a normalisation for the terminal year.
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2.4.3.
WACC
To value a company using enterprise DCF, one discounts FCF by the weighted average cost of capital (WACC). WACC represents the investors’ opportunity cost for investing in a particular business instead of others with a similar risk. WACC is the market-based weighted average of the after-tax cost of debt and cost of equity:
WACC =
D E kd (1-Tm )+ ke V V
where:
D V E V
= target level of debt to Enterprise Value = target level of equity to Enterprise Value, using market-based values
kd = pre-tax cost of debt ke = cost of equity Tm = company’s marginal income tax rate For companies with other securities, such as preferred stock, additional terms must be added to the cost of capital, representing each security’s expected rate of return and percentage of total Enterprise Value.
P V
= target level of preferred stock to Enterprise Value, using market-based values
kp = cost of preferred stock Example:
WACC =
D E P kd (1-Tm )+ ke + kp V V V
The cost of capital does not include expected returns on operating liabilities, such as accounts payable. Required compensation for such funds is included in operating expenses, such as cost of goods sold (and is already incorporated in FCF).
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Components of WACC Weighted Average Cost of Capital
kd
kp
Cost of Debt
ke
Cost of Preferred Shares / Hybrid
Cost of Equity
Description
Description
Description
„
„
„
Owners of the business
„
Return in the form of profit / dividend
Known interest and principal repayment
„
Secured or unsecured; long-term or short term
Type of securities „
Bank loans
„
Credit facilities
„
Corporate bonds
„
Project bonds
„
Leases
„
Pref. Shares: Fixed dividend rate; dividend and capital repayment ranked ahead of common shareholders Hybrid: Have debt and equity characteristics
Type of securities „
Preferred shares
„
Convertible bonds
Type of securities „
Common equity
„
Retained earnings
Less Risky
More Risky
Lower Cost
Higher Cost
Important WACC Considerations „ WACC must include the opportunity cost from all sources of capital, since FCF is available to all investors „ The target capital structure, and not the current capital structure, is the most relevant in determining the WACC § Company capital structure at any point may not reflect the capital structure expected to prevail over the life of the business „ Market value, not book value, is most relevant to weigh each component of capital § Market values reflect more accurately the true economic claim of each type of financing outstanding § Exception: Use of book value of debt for market value is acceptable
– Large portion of debt may not be publicly traded – Generally, there is little difference between book value and market value, except in extreme cases „ WACC must be computed after corporate taxes (since FCF is calculated in after-tax terms). Any financing-related tax shields not included in FCF must be incorporated into the cost of capital or valued separately, i.e. if interest is tax deductible, it needs to be tax-adjusted in the WACC formula „ WACC must be denominated in the same currency as FCF „ WACC must be stated in nominal terms when cash flow is stated in nominal terms
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Cost of Equity To estimate the cost of equity, determine the expected rate of return of the company’s stock. Capital Asset Pricing Model (“CAPM”), the most common method for estimating expected returns, is a Credit Suisse preferred methodology to calculate the cost of equity. CAPM defines a stock’s risk as its contribution to the overall market risk. CAPM stipulates that the expected rate of return on a security equals the risk-free rate plus the security’s beta times the market risk premium:
ke = rf + βL (rm –rf) where:
ke = cost of equity – expected rate of return on the security rf = risk-free rate βL = company’s levered beta rm = expected market return (rm –rf) = equity risk premium (ERP) The risk-free rate and equity risk premium are common to all companies in a given market; only beta varies across companies. Beta represents a stock’s incremental risk to a diversified investor, where risk is defined by how much the stock co-varies with the aggregate stock market. CAPM breaks up total risk (variability of returns) into two parts – systematic and non-systematic risk: „ Systematic Risk § Unavoidable – external, macroeconomic factors that affect all companies § CAPM only rewards systematic risk § Size of risk premium proportionate to the relative movement against the market (measured by beta) „ Non-Systematic Risk § Can be diversified away § CAPM does not reward non-systematic risk Risk-Free Rate To estimate the risk-free rate, use government default-free bonds: „ The bond horizon should relatively closely match the cash flow horizon. In practice, use a single yield to maturity from a government bond that best matches the entire cash flow stream being valued (e.g. the 10-year German Eurobond). Note that the longer-dated bonds (e.g. 30-year bonds) might match the cash flow stream better, but their potential illiquidity can cause out-of-date prices and risk premiums „ The currency denomination of the bond should match that of the cash flows „ The correct rate to use is the Yield to Maturity (“YTM”) of the bonds, not the coupon rate or historical average of yields Equity Risk Premium (ERP) Different methods that can be used to estimate the equity risk premium are shown in the following table. The Credit Suisse preferred methodology to calculate the equity risk premium is the methodology used by the CS Global Equity Strategy Group. When working on situations with a US angle, be sure to check with colleagues in the US as to any particular considerations to be kept in mind when setting the Equity risk premium.
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Methodology
Explanation
Credit Suisse Global Equity Strategy
The forward-looking equity risk premium is derived from a Dividend Discount Model (“DDM”), based on: „ I/B/E/S forecasts „ Long-term government bond yields
The data is available from the Global Equity Strategy Group, email Marina Pronina to be included in distribution) Ibbotson Associates
„ Utilises historically observed data „ ERP defined as arithmetic average of the stock market total return less income return
on a risk-free asset – Stock market total return is based on each countries’ sub-set in MSCI Index assuming dividend re-investment – Risk-free asset defined as government bonds for the individual countries „ Also estimates a global long-term horizon ERP using large company stock total
returns minus LT government bond income returns (20-year US T-bond) „ Identify separate small company premium; appropriateness of applying such small
company premium should be discussed with team members „ The computation of the equity risk premium (EQRP) consists of two parts:
Bloomberg
– First, the expected market return (EMR) is calculated using forecasted data
– Aswath Damodaran
(forecasted growth rates, earnings, dividends, payout ratio) and current equity values. The EMR calculated by taking a capital weighted average of the IRR over all the members of the country's major index. This reflects the risk premium in terms of forward-looking market conditions rather than historical valuations. The risk-free rate is then subtracted from this return to obtain the country risk premium (CRP) Secondly, an equity risk premium for a specific issue based on the country premium is derived; this is simply a product of the equity’s beta and the country premium (EQRP = CRP * Applied Beta)
„ To estimate the long term country risk premium, Damodaran starts with the country
rating (from Moody's) and estimates the default spread for that rating (based upon traded country bonds) over a default free government bond rate. This becomes a measure of the added country risk premium for that country „ He adds this default spread to the historical risk premium for a mature equity market
(estimated from US historical data) to estimate the total risk premium. In the short term especially, the equity country risk premium is likely to be greater than the country's default spread „ One can estimate an adjusted country risk premium by multiplying the default spread
by the relative equity market volatility for that market (Std dev in country equity market/Std dev in country bond) „ Damodaran uses the emerging market average of 1.5 (equity markets are about 1.5
times more volatile than bond markets) to estimate country risk premium. He adds this to the historical premium for the US of about 4.8% to get the total risk premium
Beta Beta is the measure of a company’s relative market risk. The beta of a stock with respect to the market is defined as the covariance of the stock’s return with the market return divided by the variance of the market:
βs =
Cov(rs , rm ) Varm
where: Varm rs rm Cov(rs,rm)
= Variance of the market = Return of the stock = Return of the market = Covariance between rs and rm
Beta should be forward looking in nature. There are two types of beta: „ Asset beta, also called unlevered beta, takes into account only the relative risk of the company’s assets, regardless of how they are financed 148
„ Equity beta, also called levered beta, also refers to the relative risk of the company’s assets, but takes into account how the assets are financed. So equity betas for two separate companies (even in the same industry) likely reflect different capital structures and are thus not comparable Equity (levered) betas are published for listed companies and are available, inter alia, from Bloomberg or from Barra: Bloomberg
Barra
„ Historic single factor model
„ Barra provides 9 different Beta values per company,
with the key differences in calculation being: – Historic versus Predicted – Global versus Local – Reference market portfolio
„ Calculation based on a simple linear regression
based on: – 60 months historical period – Correlation with the main index of the country in question
„ Historic Betas are based on a simple linear
regression using: – The local market subset of the reference index as the market portfolio – 60 months historical period
„ Bloomberg provides both raw Betas and adjusted
Betas (recommended Credit Suisse approach): – Raw Beta: Linear regression – Adjusted Beta: 2/3*Raw Beta + 1/3*1 – Adjusted Beta is based on an arbitrary adjustment to try and correct statistical error/noise
„ Predicted Betas (global and local) are based on a
multi-factor model – Total of 152 factors considered: – 4 risk factors: Size, Success, Value, Variability in Markets – 36 industry factors – 56 country factors and 56 currency factors „ Global Betas are calculated against the FT World
Index (38,000 securities), local Betas will use a subset of the asset within the FT World Index (by country)
Use of Barra projected betas in valuation analyses is preferred by Credit Suisse, unless there are substantial reasons which warrant a different beta type or source. Discuss with the team when in doubt. Factors for Determining the Type of Beta: Generally it is better to use an average or median of betas for companies in the industry rather than the beta for a single company. This prevents estimation errors. However, when averaging betas, it is not sufficient to simply compare equity betas. It is necessary to unlever betas before taking their average and then use the calculated average to re-lever the beta for the analysed company.
Company vs. Peer Group
Historic vs. Predicted
Rationale Historic
•
Measure of observed volatility relative to the market index and based on actual data Simple regression analysis i.e. transparent calculation and easy to crosscheck
‚
•
Historic data may not be an accurate representation of the future
‚
•
Forecast of a stock’s sensitivity to the market derived from fundamental risk factors
•
De facto estimation for the Company in question
•
Predicted
Company
Peer Group
Issues
‚
Reduces standard error of estimation
•
Eliminates company specific issues
•
Appropriate if the Company has comparable characteristics to the peer group
•
Applicable for private companies
“Black box” model
‚
Link between historic and predicted data difficult to disaggregate
‚
Does not exist for private companies Standard error of the regression can be high in the case of historic Betas Current company specific issues, that may not exist going forward, skew current Betas
‚ ‚
•
Does not recognize fundamental changes in the Company’s operations (e.g. spinoffs etc.) Influenced by Company specific events that are unlikely to occur in the future (e.g. local natural disasters)
‚
Comparability of peer group
149
Unlevering Beta „ Although the beta for a listed company can be readily calculated or publicly available, the beta for an unlisted company or an asset / project cannot be readily observed „ In this case, the beta of an unlisted company or asset / project can be approximated using comparable listed company betas „ The beta of the comparable companies needs to be unlevered to remove the effect of the financing decision: § Unlevered beta reflects the risk related to the business of the company excluding the risk related to the financial structure of the company In its simplest form (excluding preferred stock), the formula for unlevered beta is:
βU =
βL D 1 + (1 − T ) E
where:
βU βL D E T
= unlevered beta = levered beta = debt to equity ratio
= marginal tax rate
After unlevering beta, it is necessary to re-lever it, using the analysed company’s debt-to-equity ratio and the (possibly new) country-specific marginal tax rate. The formula for re-levered beta is:
βL = βU [1+
Dnew (1 − Tnew )] E new
Cost of Debt „ Debt is the least risky type of investment, providing investors with a fixed cash flow from interest payment and principal repayment „ Debt is also the cheapest cost of capital for companies – debt capital providers require a lower return commensurate with the risk level „ Cost of debt in the form of interest expense is tax deductible in most jurisdictions „ Cost of debt of a company is calculated as the weighted average of current yields of all issues in the company’s target debt structure. When calculating the cost of debt, it is recommended to: § Use the current yield to maturity, not face coupon rate or historical yield § Use the target debt structure, not current debt structure § Use the marginal statutory tax rate to compute the post-tax cost of debt:
– An accurate measure of the company’s expected tax rate is difficult to obtain, especially when considering short-term and longer-term perspectives as well as the variable assumptions of the DCF (e.g. target capital structure, impact of past and future potential operating losses)
– It is usually cleaner to look at the tax shields and the ability of the company to utilise them in a separate valuation, thereby distinguishing the economic value of the asset from the particularities of its tax situation
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Example of WACC Calculation and Sensitivity (2)
Levered (1) Beta
Gross Debt / (3) Mk Cap. (%)
Statutory Tax Rate (%)
Unlevered (Asset) Beta
Selected Comparables CoA CoB CoC CoD CoE CoF
0.600 0.500 0.700 0.800 0.700 0.400
5.0% 10.0% 12.5% 15.0% 10.0% 12.5%
35.0% 35.0% 35.0% 35.0% 35.0% 35.0%
0.581 0.469 0.647 0.729 0.657 0.370
Average Median
0.617 0.650
10.8% 11.3%
35.0% 35.0%
0.576 0.614
Selected Unlevered Beta Gross Debt / (2) Agg Value – 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0%
Gross Debt / Market Value – 11.1% 25.0% 42.9% 66.7% 100.0% 150.0% 233.3% 400.0% 900.0%
0.614 Relevered Beta 0.614 0.655 0.706 0.772 0.860 0.983 1.167 1.474 2.088 3.931
Corporate (6) Risk Spread 1.0% 1.2% 1.8% 2.1% 2.5% 2.8% 3.1% 3.3% 3.8% 4.3%
Cost of Debt (Pre-tax) (After-tax) 6.5% 3.9% 6.7% 4.0% 7.3% 4.4% 7.6% 4.6% 8.0% 4.8% 8.3% 5.0% 8.6% 5.2% 8.8% 5.3% 9.3% 5.6% 9.8% 5.9%
Cost of Equity 8.0% 8.1% 8.3% 8.6% 8.9% 9.4% 10.2% 11.4% 13.9% 21.2%
Implied WACC 8.0% 7.7% 7.5% 7.4% 7.3% 7.2% 7.2% 7.1% 7.2% 7.4%
Assumptions (4) Risk Free Rate : 5.5% (5) Equity Risk Premium (ERP) : 4.0% Corporate Tax Rate: 40.0% (1) (2) (3) (4) (5) (6)
Barra [Date] Gross Fin. Debt = LT debt + ST debt + preferred stock / Aggregate Value = Market Cap + Net Fin. Debt + Min. Interests Market Data as of [Date] 10-y local government bond - reference rate as of [Date] [Assumptions] Risk spreads provided by DCM professionals, depending on spread of company's listed bonds
Political Risk – Adjustment to Cash Flows or to WACC There are two alternative ways to adjust the DCF valuation for political risk in a market: „ “Hair cut” the cash flows of the target firm, reflecting added risk; or „ Bump up the market risk premium by the difference between the two analysed markets’ yields in government or corporate bonds of similar maturity and denominated in the same currency (in Euros) It is important to do either one or the other – not both – to avoid over-conservatism / double counting.
2.5.
Selected Special Valuation Issues / Enterprise Value Adjustments
2.5.1.
Non-Operating Assets / Cash Flows
Cash flows related to non-operating assets are not included in the operating FCF and, therefore, are not accounted for in the operating DCF / value of the company. However, although those assets / cash flows are not included in the operating part of the business, they still represent value to the shareholders. The PV of the non-operating assets should be assessed separately and added to the value of the operating business. The typical non-operating assets include: „ Excess cash and marketable securities One typically can use the reported book value as a proxy for the market value of those assets „ Non-consolidated subsidiaries If no market value is available, try to perform a separate DCF valuation of the equity stake „ Tax-loss carry-forwards
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Create a separate account for the accumulated tax-loss carry-forwards and forecast the developments of this account by adding any future losses and subtracting any future taxable profits on a year-by-year basis. For each year in which the account is used to offset taxable profits, discount the tax savings at the cost of debt. Also, set the carry-forward’s value at the tax rate times the accumulated losses. The operating DCF itself should be based on a normalised effective tax rate, i.e. a tax rate which the company would incur if it did not have tax-loss carry-forwards (this will typically be the Company’s marginal tax rate, unless special factors such as, for example, progressive tax rates apply).
2.5.2.
Minority Interest
The issue of minority interest arises when a third party owns a minority stake in a fully consolidated subsidiary of a company. The minority interest recorded in the parent company’s balance sheet reflects the minority shareholder’s pro rata share in the book value of the subsidiary’s equity. In the income statement, minority interest reflects the minority shareholder’s pro rata share of the subsidiary’s net income. In valuing an enterprise on the basis of its fully consolidated unlevered FCFs, the fact that a third party owns a stake in a subsidiary is not captured. Hence, the resulting Enterprise Value needs to be adjusted for the portion in effect not owned by the parent company’s shareholders as follows: „ Treat the minority interest similar to a financial claim and subtract it from the Enterprise Value when calculating the equity value. After the Enterprise Value has been reduced by the claims of debt and preferred stock holders (see below), the residual is split between minority interest and common equity in proportion to their book values „ Treat earnings attributable to minority interest similar to a financing cost (e.g. an interest expense), i.e. do not reduce UFCF by the minority interest „ Treat any associated cash flow to the minority investors similar to a financing flow. The cash flow can be estimated as the earnings attributable to minority interest less the increase in the minority interest account in the balance sheet; this essentially equals the dividends paid to the minority investors less any contributions from them
2.5.3.
Preferred Equity
The appropriate treatment of preferred equity depends on the specific nature of the preferred equity, i.e. whether the rights attached to the preferred equity give it a more debt- or equity-like nature. In many jurisdictions preferred equity closely resembles unsecured debt: preferred stock dividends are similar to interest payments as they are often predetermined, can be withheld only under special circumstances and often are cumulative, i.e. any failure to pay preferred dividends needs to be made up before dividends can be paid to common equity holders. In the event of liquidation, such preferred equity often does not grant a share of the residual value but rather is redeemed at a fixed value. In such cases, preferred stock should be treated as a debt equivalent – its market value should be deducted from the Enterprise Value. In many cases the preferred equity will be traded, i.e. you can establish its market value. Contact a GMSG DCM officer for assistance in obtaining a reliable market quote. In other jurisdictions, e.g. Germany, preferred equity has a more equity-like nature, in that preferred equity has a preferred dividend entitlement in exchange for a lack of voting rights. In the event of liquidation, preferred equity ranks pari passu with common equity and receives a pro rata share of the residual value. In such cases, preferred equity should not be treated as a debt-like security but rather as equity. The resulting equity value needs to be allocated to common and preferred equity holders. While the starting assumption may be an allocation pro rata to the respective equity class’s share of the total book value of the equity, take into consideration the precise nature of the shares and the practice and precedents in the relevant jurisdiction. In either case, the preferred dividend should not be included in the derivation of the UFCF.
2.5.4.
Under-Funded Pension And Other Post-Retirement Liabilities
Pension obligations arise when companies promise retirement benefits to their employees. The future payment obligation may need to fully or partially be taken into consideration when valuing the company, depending on the particular circumstances. When analysing pensions one needs to distinguish between defined contribution schemes and defined benefits schemes: „ Defined benefit schemes are potentially relevant from a valuation perspective
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These schemes define the fixed benefits to be paid by employers to employees on retirement. Normally the benefit is expressed as a fraction of final salary, which changes as years of employment are added. Complexity arises because there are many uncertainties associated with such schemes: How long will the employment last? What will the final salary be? What investment returns are achieved on assets held against such future benefit obligation? „ Defined contribution schemes are not relevant from a valuation perspective These schemes define the contributions that the employer will make to the fund on the behalf of the employee. In the income statement, the contribution is charged as an operating expense (effectively an extra salary). In the balance sheet, there is no obligation. In the case of defined benefit schemes, companies typically hold long-term investments against such benefit obligations - either on their own balance sheets or in a separate pension fund. To the extent the benefit obligation (i.e. the present value of expected future benefit payments) exceeds the market value of the assets held against such benefit obligation, the company is said to have an un- or under-funded pension obligation and records a pension liability in its balance sheet. This pension liability arguably constitutes a loan provided by the company’s employees to the company and as such needs to be treated similarly to a financial debt item in the DCF valuation. The amount of the gap is deducted from Enterprise Value to arrive at Equity Value. Note that payments made by the company to cover the gap may be tax-deductible (check with local tax counsel), i.e. the value impact of the gap may be reduced by the tax shield, if any. Where a company shows a pension surplus, i.e. assets held against the pension benefit obligation exceed the obligation itself, this represents the equivalent of a long-term financial asset which in principle should be added to the Enterprise Value. Consult with more senior team members as to whether it is appropriate in the given context to ascribe value to such pension surplus. When treating the pension deficit as a debt-equivalent, it is important to ensure that pension expenses are treated in a consistent fashion. In general, pension expenses consist of a service cost component (i.e. the expense incurred due to the service of an employee during the accounting period as a consequence of having made a pension promise to such employee) plus an interest cost component (i.e. the expense incurred as progression in time leads to a shorter time to pension age and hence to an increasing present value of a set pension promise) reduced by the expected return on pension assets held against the pension obligation. The service cost component represents a genuine operating expense and as such needs to be reflected in the derivation of unlevered FCF. The interest cost component as well as the expected return on plan assets – while often recorded by companies among the operating expenses – in contrast do not represent a genuine operating expense but rather a financing cost (benefit) and as such need to be excluded from the derivation of unlevered FCFs. Hence, if a company reports such interest cost as part of the operating expenses (i.e. above EBITDA), add back such interest cost to EBITDA (and therefore UFCF) to ensure consistent treatment with other financing items. Further, it is important to ensure that subsequent cash flows, i.e. payments of pension liabilities, are not included in the derivation of unlevered FCFs to avoid double counting (i.e. double penalisation by deducting the gap as liability and deducting the retirement of the liability).
2.5.5.
Provisions
Provisions are non-cash expenses reflecting future costs or expected losses. When setting up provisions, companies reduce profit and add a respective position to the liability side of the balance sheet. Although in principle provisions per se should not have any valuation impact – the valuation depends on cash flow and not on accrual-based accounting – a standardised and rigorous treatment of provisions adds transparency and insights to valuation and performance evaluation exercises.
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The following table summarises the treatment of provisions for the purposes of the cash flow and valuation computations: Treatment of Provisions for Purposes of Cash Flow, Invested Capital and Valuation
Classification
Example
FCF Treatment
Invested Capital Treatment
Valuation Treatment
Ongoing operating provisions
„ Product returns
„ Change in provisions
„ Negative
„ Provision is
Long-term operating provisions
„ Plant
„ Warranties
decommissioning costs „ Retirement plans
treated as cash flow adjustment
„ Deduct operating
portion from revenue to determine operating cash flow (treat as cash equivalent)
working capital (net against operating assets) „ Debt
equivalent
already part of FCF (not valued separately) „ Deduct PV
from EV
„ Interest portion added
back to EBITA when calculating FCF (if included above EBITA in company accounts) Non-operating provisions
„ Restructuring
Income smoothing provisions
„ Non-specified
2.5.6.
charges (e.g. expected severance payments) purpose provisioning
„ Treat as non-operating
and add back to nonoperating revenues
„ Add change in
provision back to EBITA when calculating FCF
„ Debt
equivalent
„ Equity
„ Deduct PV
from EV
„ No effect
equivalent
Employee Stock Options
Under IFRS, European listed companies are required to expense stock options. Employee stock options affect a company valuation in two ways: „ The value of options that will be granted in the future needs to be accounted for in the FCF projections – and thus in the value of operations „ The value of options currently outstanding must be subtracted from Enterprise Value as a non-equity claim. The value of options will depend on an estimation of Enterprise Value. The option value can be estimated using option valuation models, such as the Black-Scholes model or binomial models Stock options expensing creates tax assets because reported taxes are lower than cash taxes (financial reports treat options as tax deductible even though they are not tax deductible at the moment of grant only at the moment of exercise).
2.5.7.
Operating Leases
Whether a company owns or leases an asset is in principle a financing, not an operating, decision. When leasing, the company only records the periodic rental expense in the P&L – there is no explicit balance sheet record of the asset and the corresponding debt. Although in principle the treatment of operating leases should not have a valuation impact, a standardised and rigorous treatment of operating leases can add transparency and insights to valuation and performance evaluation exercises. To be able to properly compare and evaluate operating margins, cash flows and capital productivity across companies and over time, one should capitalise the operating leases. This is done in the following way: „ Estimate the principal amount of operating leases: capitalise this year’s lease expense as perpetuity using the cost of debt „ To estimate the implied interest expense, multiply the implied principal amount by the marginal borrowing rate „ Reclassify the implied interest portion of the lease expense from COGS or SG&A to interest (this increases EBITA) „ Adjust EBITA taxes accordingly (more taxes)
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„ Add the non-interest portion to NOPLAT when calculating gross Cash Flow „ Subtract debt associated with operating leases from EV when calculating value of equity „ Account for the debt associated with leases in WACC
2.5.8.
Deferred Taxes
Deferred taxes typically arise in the financial statements when the accounting principles and cost bases for assets and liabilities deviate between financial accounting and tax accounting (e.g. as a result of the ability to use accelerated depreciation for tax purposes while having to use straight-line depreciation for financial accounting purposes). Deferred tax liabilities typically arise when taxable income in the financial accounts is higher than taxable income in the tax accounts. The opposite applies for deferred tax assets. In principle, a deferred tax liability represents a future cash outflow in the form of higher tax payments. However, as long as there is no reason to expect a change in tax and accounting rules and there are no fundamental changes to the company’s operations, it may be reasonable to expect that the company will also in future benefit from similar effects which gave rise to the deferred tax liability in the first place. Thus, while the cash outflow will occur in the future, this could be expected to be counterbalanced by equivalent tax savings in the future. As such, it would be appropriate to treat deferred tax assets and liabilities similar to a working capital item. Note also that a deferred tax liability represents the nominal value of such cash outflows, whereas for valuation purposes only consider the present value of such cash outflows if there was reason to believe that in future the company would not benefit from similar effects, requiring assumptions as to the timeframe over which such cash outflows would then occur.
2.5.9.
Bank Valuation – Equity Cash Flow / Dividend Discount Model
The Dividend Discount Model (DDM) is used to value banks. Banks are highly levered institutions and normally a large part of their income depends on a spread between the lending rate and the borrowing rate. For banks it is not possible to value operations separately from interest income and expense, since these are important components of their operating income. Thus, unlevered FCF is often irrelevant for banks and one should base a bank’s valuation on the equity cash flow: Equity Cash Flow =
Net Income – Increase in Equity 6 + Other Comprehensive Income
Alternatively, equity cash flow is a sum of all cash paid to (minus that which is received from) shareholders: Equity Cash Flow =
Common Dividends + Net Share Buy Backs (Issuance) +/- Other Changes in Equity
In a simplified world, one could equate discounting the equity cash flow to discounting dividends. Although dividends are often the largest part of the equity cash flow, other components (mentioned above) should be also considered because they can have a very material impact.
6
Other Comprehensive Income includes net unrealised gains and losses on certain equity and debt investments, net unrealised gains and losses on hedging activities, adjustments to the minimum pension liability, and foreign currency translation items
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7
Simplified Example of Bank Valuation (€ in millions, unless otherwise indicated)
Long term growth rate Long term ROE
2005A 2006F 2007F 2008F 2009F 2010F 2011F 2012F 2013F 2014F 2015F 2.5% 14.0%
Opening shareholder funds ROE
3,800 4,100 4,500 5,000 5,700 6,500 7,400 8,100 8,800 9,300 17.7% 18.6% 18.9% 20.6% 21.3% 20.1% 18.1% 16.6% 15.5% 14.9%
9,550 12,921
Profit after tax Retained earnings = increase in equity Other comprehensive income Cash flow to equity
700 300 0 400
800 400 0 400
900 500 0 400
1,100 700 0 400
1,300 800 0 500
1,400 900 0 500
1,400 700 0 700
1,400 700 0 700
1,400 500 0 900
1,400 250 0 1,150
1,400 250 0 1,150
Dividends paid Equity issued Equity bought back Cash flow to equity
0 0 400 400
390 0 10 400
400 0 0 400
430 30 0 400
430 0 70 500
430 30 0 400
430 0 270 700
430 0 270 700
430 0 470 900
430 0 720 1,150
460 0 690 1,150
Discounted cash to equity value: NPV five year free cash flow NPV terminal value Value of shareholders' funds Cost of Equity
2.5.10.
TV
3,560 4,550 8,111 11.0%
Valuation Across Currency Borders – Special Considerations
When valuing companies across currency borders, especially in emerging markets, one needs to factor in special considerations regarding, inter alia, exchange rates, cost of capital, political risk, tax rates and inflation. As an example, below look at relevant aspects of conducting a DCF analysis for a Serbian company. DCF In Different Currencies In principle, there are two ways to value a company across currency borders: „ Value cash flows in home terms (e.g. Euros) according to this approach: § Convert the Serbian dinar (CSD) flows to €, using the forecast of forward CSD/€ x-rate § Then discount the € cash flows using the €-based WACC that reflects not only the systematic risk of the industry and local equity market, but also the political risk of the country (further discussed later in the chapter) 8
This approach assumes that purchasing power parity (PPP) and interest rate parity (IRP) hold „ Value cash flows in foreign terms (e.g. CSD) according to this approach:
§ Discount the dinar flows using the Serbian cost of capital. Importantly, if discounting dinar flows, it is necessary to base the WACC’s risk-free rate on the dinar-denominated bonds § Then translate the dinar DCF into € using the spot rate This approach assumes that the availability, and quality, of foreign capital market data is good (which is not always the case). Tax Rates When applying tax rates to the cash flow, take into consideration the local tax regime: „ Use the marginal tax rate of the foreign country if the buyer resides in a country that is part of a territorial tax system in which the buyer’s country exempts foreign income from further taxation (about half of the OECD countries use a territorial tax system)
7
8
Terminal value in the example is calculated using a Gordon Growth Formula: dividends = earnings – retention = (ROE – growth rate) * net asset value. Thus, a terminal value = net asset value * (ROE – growth rate) / (Cost of Equity – growth rate). PPP asserts that €/CSD exchange rate will be based on the purchasing power of the two currencies: x-rate will tend toward 85 if 85 CSD buys in Serbia the same bundle of goods as 1€ in the Euro-area). IRP asserts that the difference between the spot and forward x-rates is equal to the difference between interest rates prevailing in the money markets for lending/borrowing in the respective currencies: SPOTCSD/€ / FWDCSD/€ = (1+Return€) / (1+ReturnCSD).
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„ Use the higher of the buyer’s or target’s country tax rate if the buyer resides in a country that is part of a worldwide tax credit system (e.g. the US) in which the buyer’s country recognises taxes paid in a foreign country as a credit against tax liability at home Consistency In the complex maze of multi-currency valuation in emerging markets a couple of important consistency rules should be observed: „ The same tax rate should be assumed in estimating the after-tax cash flows, the levered beta, the WACC and the debt tax shields „ Assuming that both revenue and costs are derived from the same currency base, the same inflation rate should be used for revenues, costs, working capital, Capex, risk-free rate, interest rates and Forex rates
2.6.
How to Interpret the Results
Interpretation of the results of a DCF valuation requires the selection of a valuation range. A DCF matrix provides a range of Enterprise Values corresponding to a range of assumptions regarding the cost of capital and the terminal multiple / terminal growth. Deciding which valuation range is suggested by the analysis is not a mechanical exercise but requires judgement. Ask the following key questions: „ Does the valuation, based on the terminal multiple method and the terminal growth method, provide broadly consistent valuation results? If the values derived by applying both methods are vastly different, question whether: § The chosen range of multiples and growth rates is consistent; in particular, double check the reasoning behind the chosen terminal multiples to ensure they are appropriate for the business in a steady state § The terminal year EBITDA margin and unlevered FCF are truly normalised „ Are the implied entry multiples consistent with the assumed / implied exit multiples? If there is a material difference, an explanation should be provided. In particular, beware of situations where the exit multiple is significantly above the implied entry multiple. Provide reasons why the business will trade at a higher multiple in the future than the multiple implied by the DCF analysis Further, to ensure that the range selected is meaningful, try not to exceed a range of 15 – 20% unless justified by significant uncertainty. DCF analyses implicitly assume access to cash flows and management decisions and as such implicitly include a control premium. As a consequence, DCF analysis is considered to be at a premium to market value which a rational investor would ascribe to individual shares in the company. It is, therefore, not only vital to understand the DCF analysis itself but also how it fits into the overall valuation exercise. To avoid inappropriate conclusions, which could arise from simply using the DCF analysis for valuation, it is important to apply other valuation techniques in conjunction with DCF analysis, for example Compco and Compacq analysis. Note that DCF valuation results typically range closer to valuation results obtained through Compacq analyses and above values suggested by Compco analysis.
3.
Helpful Hints
3.1.
Sense-Checking Results
A DCF analysis is only as good as the assumptions going into the model. Furthermore, errors in the mechanics of the model may render the results entirely meaningless. It is, therefore, imperative to sense check the results. Ideally, use a printout of the model and a calculator, rather than the Excel model itself.
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Key checks to keep in mind include: „ Unlevered FCF § Make sure the numbers add up, i.e. all line items are included in the total and are added or subtracted in line with their impact on cash flow (e.g. D&A is added, not subtracted, change in net working capital is cash flow positive when net working capital decreases) § Reconcile the unlevered FCF with the change in cash. Any line item not included in the unlevered FCF calculation which is included in the change in cash calculation needs to be explainable, i.e. needs to be captured in the EV adjustments (e.g. interest and debt repayments are excluded from unlevered FCF since DCF is an Enterprise Value concept and Net Debt is treated as an EV adjustment) „ Use a calculator to cross check the discounting of FCFs and Terminal Value „ Ensure all appropriate adjustments have been made to derive Equity Value from Enterprise Value, paying special attention to minorities, pensions, etc. „ Look at key ratios to ensure the model makes sense: § Consolidated revenue growth § Consolidated margins § Relationship of Capex and D&A and development of asset turn over the projection period § Composition of the resulting Enterprise Value (i.e. percentage accounted for by Terminal Value) § Implied Enterprise Value multiples at entry (i.e. what multiple of EBITDA, EBIT does the DCFderived Enterprise Value represent?). If there is a large deviation from sector trading / transaction multiples, try to understand why § ROCE in final year / normalised year „ Terminal Value § Terminal Value must be consistent with the strategy assumed during the explicit forecasting period. For example, if the asset base was run down during forecast period, Terminal Value should reflect state of facilities § Use normalised results as the basis for the Terminal Value calculation. Ratios should be evaluated and adjusted, if necessary (e.g. depreciation relative to capex, required capex level, EBITDA margin, change in net working capital, tax rate) § Avoid using multiples implying high growth for which the market might be prepared to pay today. At the end of the explicit forecast period assume normalized growth of the business § Always check how much the Terminal Value contributes to total Enterprise Value. The higher the proportion, typically the less meaningful the valuation (obviously depends on planning horizon) „ Value drivers § Focus on what is driving value. Five key value drivers are typically more important than 15 lowimpact variables
3.2.
Surviving the MDR/DIR/VP “Grilling”
DCF models become complex quite quickly and it is easy to forget all the assumptions / decisions made as the model has been developed. A few easy measures will help address any challenging questions on the model: „ Structure the model in a clean, clear fashion which provides for a clear separation of inputs and outputs so that causes and effects are easily separable and understandable § Keep in mind, MDRs dislike models which are not easily printable in their entirety „ Never mix assumptions and formulas, i.e. do not hardcode within formula cells „ Prepare an assumptions summary and a structured collection of back-ups to the assumptions while building the model „ Know the architecture of the model inside out
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„ Test how it reacts to changes in key drivers and be ready to explain why it reacts in such fashion „ Keep the model simple as clients prefer clarity to complexity
4.
Example
The following example demonstrates the mechanics and key steps of a DCF. The task is to perform a DCF valuation on ChocoFriends, a Swiss-based niche premium chocolate manufacturer. Step 1: Information Gathering The historical financials for the last 3 years are provided below. ChocoFriends Historical P&L (€ in millions, FYE December 31)
Net Sales Growth Cost of Goods Sold % of sales Gross Margin SG&A & Other Operating Income / (Expenses) % of sales EBITDA Margin Adjustments EBITDA (adjusted) Margin Depreciation as % of Capital Expenditure EBITA Margin Amortisation % of sales EBIT Margin Interest Expense Interest Income Pre Tax Income Taxes Tax Rate Net Income Before Minority Interest Minority Interest Net Income as % of Sales Growth Total Dividends Payout Ratio Retained Earnings
2003A 1,591.0
2004A 1,681.0 5.7% (872.0) 51.9% 809.0 (578.0) 34.4% 231.0 13.7%
2005A 1,801.0 7.1% (939.0) 52.1% 862.0 (611.0) 33.9% 251.0 13.9%
220.6 13.9% (72.0) 107.5% 148.6 9.3% (1.0) 0.1% 147.6 9.3% (35.7) 8.1 120.0 (47.0) 39.2% 73.0 (2.0) 71.0 4.5%
231.0 13.7% (71.0) 182.1% 160.0 9.5% (1.0) 0.1% 159.0 9.5% (36.0) 8.6 131.6 (48.0) 36.5% 83.6 (2.2) 81.5 4.8% 14.8%
251.0 13.9% (76.0) 101.3% 175.0 9.7% (1.0) 0.1% 174.0 9.7% (30.3) 8.5 152.2 (57.0) 37.4% 95.2 (2.3) 92.9 5.2% 14.0%
(20.0) 28.2% 51.0
(24.0) 29.5% 57.5
(26.0) 28.0% 66.9
(854.0) 53.7% 737.0 (518.0) 32.6% 219.0 13.8%
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ChocoFriends Historical Balance Sheet (€ in millions, FYE December 31)
2003A Assets Net Intangibles / Goodwill Net Property, Plant & Equipment Financial Assets Fixed Assets
2004A
2005A
4.0 574.7 2.0 580.7
3.0 540.9 2.0 545.9
1.0 547.0 2.0 550.0
246.0 418.0 236.4 46.0 946.4 1,527.2
226.0 435.0 250.4 49.0 960.4 1,506.3
251.0 514.0 177.0 64.0 1,006.0 1,556.0
Liabilities Shareholders' Equity Minority Interest Shareholders' Equity
543.6 21.6 565.2
601.1 23.2 624.3
668.0 25.0 693.0
Long Term Debt Other Long Term Liabilities Net Pension Liability Long term Liabilities
344.0 17.0 41.0 402.0
342.0 15.0 37.0 394.0
347.0 21.0 35.0 403.0
236.0 141.0 183.0 560.0 1,527.2
162.0 95.0 231.0 488.0 1,506.3
64.0 119.0 277.0 460.0 1,556.0
2003A 71.0 72.0 1.0 1.4 – – – 145.4
2004A 81.5 71.0 1.0 1.5 2.0 (4.0) – 153.0
2005A 92.9 76.0 1.0 1.7 (49.0) (2.0) – 120.6
Inventories Trade Receivables Cash & Cash Equivalents Other Receivables and Other Assets Current Assets Total Assets
Short Term Borrowings Trade Receivables Other Current Liabilities Current Liabilities Total Liabilities & Shareholders' Equity
ChocoFriends Historical Cash Flow (€ in millions, FYE December 31)
Net Income + Depreciation + Amortisation + Minority Interest + Decrease / (Increase) in Net Working Capital + Decrease (Increase) in Pension Obligation + Other Non-Cash Items Cash Flows from Operating Activities Capital Expenditure % of Sales Change in Financial Assets Cash Flows from Investing Activities
(67.0) 4.2% 1.0 (66.0)
Common Stock Dividends Change in Debt Change in Other Long Term Liabilities Cash Flows from Financing
(20.0) (54.0) (74.0)
(39.0) 2.3% – (39.0) (24.0) (76.0) (2.0) (102.0)
(75.0) 4.2% – (75.0) (26.0) (93.0) 6.0 (113.0)
Step 2: Preparing the Forecasts Given management’s good track record, broker research indicates that sales growth will reach 8% in 2006 and 7.5% in 2007, owing to the launch of new products and rapid growth in North America. The consumer chocolate market is growing by an average of 1-2% p.a., while the premium segment is growing at 5% p.a. In the long term, analysts estimate that, thanks to its presence in the most attractive upscale segment, ChocoFriends will be able grow 100 basis points p.a. above the industry growth level. Analysts project a gradual deceleration of the sales growth down to the industry average of 5% p.a. from 2013. As a result of productivity gains and higher profitability in underdeveloped segments in the European and North American markets, the management estimates a continuing gross margin improvement of 100 basis points over the period 2005–2008, with stable SG&A costs (as % of sales).
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Management estimates that Capex will grow to €90m in 2006 due to investments in the capacity expansion, technology and retail outlets. Afterwards, Capex will grow in line with sales. The table below summarises the key drivers for the base, downside and upside cases. For the purposes of this case study, the base case assumptions will be used. ChocoFriends – Key Drivers 2003A Sales Growth Net Sales Growth
2004A
1,591
2005A
1,681 5.7%
2006E
2007E
2008E
Projections 2010E 2011E
2009E
2012E
2013E
2014E
2015E
1,801 7.1%
Base Case Downside Case Upside Case
8.0% 4.0% 9.0%
7.5% 3.5% 9.5%
7.0% 3.5% 9.5%
6.6% 3.5% 9.8%
6.3% 3.0% 10.0%
6.0% 3.0% 9.0%
5.5% 3.0% 9.0%
5.0% 2.0% 7.0%
5.0% 2.0% 7.0%
5.0% 2.0% 7.0%
Base Case
8.0%
7.5%
7.0%
6.6%
6.3%
6.0%
5.5%
5.0%
5.0%
5.0%
Base Case Downside Case Upside Case
51.7% 53.0% 51.0%
51.4% 53.0% 50.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
51.0% 53.0% 49.0%
Base Case
51.7%
51.4%
51.0%
51.0%
51.0%
51.0%
51.0%
51.0%
51.0%
51.0%
COGS Margin COGS Margin
(854) 53.7%
(872) 51.9%
(939) 52.1%
SG&A & Other Operating Income (Expenses) (% of sales) SG&A (518) (578) (611) % of sales 32.6% 34.4% 33.9% Base Case Downside Case Upside Case
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
34.0% 36.0% 32.5%
Base Case
34.0%
34.0%
34.0%
34.0%
34.0%
34.0%
34.0%
34.0%
34.0%
34.0%
Base Case Downside Case Upside Case
4.6% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
4.5% 5.0% 4.0%
Base Case
4.6%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
Capex (% sales) Capex (67) % of sales 4.2%
(39) 2.3%
(75) 4.2%
The broker research forecasts no significant changes in the net working capital turns, as ChocoFriends management has already implemented most of the immediately available optimisation measures. ChocoFriends – Working Capital Schedule (€ in millions, FYE December 31) Projections
CAGR
2005A
2006E
2007E
2008E
2009E
2010E
2011E
2012E
2013E
2014E
2015E
05-15
Inventories
251.0
271.3
291.6
312.0
332.6
353.7
374.9
395.6
415.3
436.1
457.9
6.2%
Trade Receivables
514.0
555.5
597.2
639.0
681.1
724.4
767.8
810.0
850.5
893.1
937.7
6.2%
Current Assets
Other Receivables and other Assets
64.0
69.1
74.3
79.5
84.8
90.1
95.5
100.8
105.8
111.1
116.7
6.2%
829.0
895.9
963.1
1,030.5
1,098.5
1,168.2
1,238.3
1,306.4
1,371.7
1,440.3
1,512.3
6.2%
Accounts Payable
119.0
127.5
136.3
144.7
154.3
164.0
173.9
183.4
192.6
202.2
212.4
6.2%
Other Current Liabilities
277.0
299.2
321.6
344.1
366.8
390.1
413.5
436.2
458.1
481.0
505.0
6.2%
Total Current Liabilities
396.0
426.7
457.9
488.8
521.1
554.1
587.4
619.7
650.7
683.2
717.4
6.2%
Total Net Working Capital
433.0
469.2
505.2
541.7
577.4
614.1
650.9
686.7
721.0
757.1
795.0
6.2%
Decrease / (Increase) in NWC
(49.0)
(36.2)
(36.0)
(36.5)
(35.8)
(36.6)
(36.8)
(35.8)
(34.3)
(36.1)
(37.9)
6.2%
Change in NWC as % of Change in Sales
(40.8%)
(25.1%)
(24.7%)
(24.9%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
Total Current Assets Current Liabilities
Assumptions Inventories as Days of Sales Trade Receivables as Days of Sales
50.9
50.9
50.9
50.9
50.9
50.9
50.9
50.9
50.9
50.9
50.9
104.2
104.2
104.2
104.2
104.2
104.2
104.2
104.2
104.2
104.2
104.2
Other Receivables and other Assets as % of Sales
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
3.6%
Accounts Payable as Days of COGS
46.3
46.3
46.3
46.3
46.3
46.3
46.3
46.3
46.3
46.3
46.3
Other Current Liabilities as % of Sales
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
15.4%
In order to prepare the above financials for valuation purposes, make all appropriate EBITDA adjustments. For the purposes of this case study, a pension adjustment is illustrated. Pension Cash Flow Adjustment The accounts show that ChocoFriends has a net pension liability of €40.7m, €36.7m and €34.7m in 2003, 2004 and 2005, respectively. For valuation purposes, treat the net pension liability as an interest bearing debt.
161
For operating cash flow purposes, the pension expense equals: service cost + interest expense – expected return on the pension fund. ChocoFriends reports the aggregate pension expense as part of operating expenses. The logic followed to estimate the operating cash flow adjustment is: „ Leave service cost (the cost of the promised pension benefit incurred due to the service of employees during a given accounting period) as a cost that is part of P&L leading to EBITA „ Add back the interest portion to EBITA (as with other interest expenses) – this is the pension cash flow adjustment. Make sure to account appropriately for the respective tax shield adjustment – tax shield effect should be accounted for in WACC, not in cash flow To estimate the yearly pension interest portion (to be added back to EBITA), multiply the total net pension liability by ChocoFriends’ average cost of debt. ChocoFriends – Pension Cash Flow Adjustment (€ in millions, FYE December 31)
Net Pension Deficit Interest on Net Pension Deficit Pension Cash Flow Adjustment Total EBITDA Adjustment
2005A 35.0 4.4% 1.5 1.5
2006E 36.1 4.4% 1.6 1.6
2007E 37.1 4.4% 1.6 1.6
2008E 38.2 4.4% 1.7 1.7
2009E 39.4 4.4% 1.7 1.7
Projections 2010E 2011E 40.6 41.8 4.4% 4.4% 1.8 1.8 1.8 1.8
2012E 43.0 4.4% 1.9 1.9
2013E 44.3 4.4% 2.0 2.0
2014E 45.7 4.4% 2.0 2.0
2015E 47.0 4.4% 2.1 2.1
CAGR 05-15 3.0%
3.0%
The table below shows the unlevered FCF calculations for ChocoFriends for the year 2006-2015. ChocoFriends – UFCF Calculation (€ in millions, FYE December 31) Projections Net Sales Growth EBITDA Adjustments - pensions EBITDA (adjusted) % of sales EBITA % of sales Adjusted EBITA (tax base) % of sales
CAGR
2005A
2006E
2007E
2008E
2009E
2010E
2011E
2012E
2013E
2014E
2015E
1,801.0
1,945.1
2,091.0
2,237.3
2,385.0
2,536.3
2,688.5
2,836.4
2,978.2
3,127.1
3,283.4
7.5% 251.0
7.0% 278.1
6.6% 305.3
120.0% 335.6
6.0% 357.7
5.5% 380.4
5.0% 403.3
5.0% 425.5
1.6
1.7
1.7
1.8
1.8
1.9
2.0
2.0
2.1
306.9
337.3
359.5
382.2
405.1
427.3
448.7
471.1
494.6
13.9% 175.0 9.7% 175.0
205.1 10.5% 205.1
14.7% 229.0 11.0% 229.0
15.1% 255.6 11.4% 255.6
15.1% 273.3 11.5% 273.3
15.1% 290.9 11.5% 290.9
15.1% 308.0 11.5% 308.0
15.1% 323.7 11.4% 323.7
11.0%
11.4%
11.5%
11.5%
11.5%
11.4%
(68.7)
(76.7)
(82.0)
(87.3)
(92.4)
(97.1)
Marginal tax rate
30.0%
30.0%
30.0%
30.0%
30.0%
30.0%
30.0%
30.0%
% of sales
9.7%
14.4%
10.5%
– Capital Expenditure
492.5
1.6 279.7
(61.5)
% of capex
469.1
15.1% 337.9 11.3% 337.9 11.3% (101.4) 30.0%
15.1% 352.5 11.3% 352.5 11.3% (105.8) 30.0%
6.2%
5.0%
–
(52.5)
+ Depreciation
446.7
5.0%
251.0
Tax on Adjusted EBITA NOPAT
5.0%
05-15
7.0% 7.0%
15.1% 367.5
7.7%
11.2% 367.5
7.7%
11.2% (110.3)
7.7%
30.0%
122.5
143.6
160.3
178.9
191.3
203.7
215.6
226.6
236.5
246.8
257.3
7.7%
76.0
74.6
77.9
81.7
86.2
91.3
97.1
103.6
110.8
118.6
127.0
5.3%
101.3%
82.9%
82.8%
81.1%
80.3%
80.0%
80.3%
(75.0)
(90.0)
(94.1)
4.2%
4.6%
4.5%
(100.7) 4.5%
(107.3) 4.5%
(114.1) 4.5%
(121.0) 4.5%
81.2% (127.6) 4.5%
82.6% (134.0) 4.5%
84.2% (140.7) 4.5%
86.0% (147.8)
7.0%
4.5%
+ Decrease / (Increase) in NWC
(49.0)
(36.2)
(36.0)
(36.5)
(35.8)
(36.6)
(36.8)
(35.8)
(34.3)
(36.1)
(37.9)
% of Absolute Change in Net Sales
(24.2%)
(40.8%)
(25.1%)
(24.7%)
(24.9%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
(24.2%)
+/- Change in Other Non-Cash Items
–
–
–
–
–
–
–
–
–
–
–
+ Decrease / (Increase) in Provisions
(1.0)
0.5
1.1
1.1
1.1
1.2
1.2
1.3
1.3
1.3
1.4
Unlevered Free Cash Flow
74.5
92.0
108.1
123.4
134.4
144.2
154.9
166.8
178.9
188.5
198.7
(2.5%)
10.3%
Step 3: Terminal Year Normalisation The Terminal Value calculation should be based on financials reflective of a long-term steady state, which ChocoFriends can be expected to achieve. A growth-to-perpetuity rate of 2% has been used, which broker research considers a standard level for the consumer sector. Based on ChocoFriends past performance and broker research, it is expected that ChocoFriends will achieve a sustainable EBITDA margin of 15% in a steady state. Depreciation is a function of Capex. Estimate Capex requirements in line with historical levels (as a percentage of sales). Depreciation as a % of Capex is estimated at 95% (replacement Capex of ChocoFriends’ assets is higher than historical depreciation). The change in net working capital is based on absolute change of net sales.
162
ChocoFriends – Terminal Year Normalisation (€ in millions, FYE December 31)
Net Sales
2015E
Normalised 2016E
Comment on Normalisation
3,283.4
3,349.1
Net sales grow in perpetuity by
Growth
5.0%
EBITDA
492.5
Adjustments
2.0%
2.1
EBITDA (adjusted) % of sales EBITA
494.6
502.4
15.1%
15.0%
% of sales
15.0%
367.5
% of sales
11.2% 367.5
359.2
% of sales
Adjusted EBITA (tax base)
11.2%
10.7%
Tax on Adjusted EBITA
(110.3)
(107.8)
30.0%
30.0%
257.3
251.4
Marginal tax rate NOPAT + Depreciation
127.0
143.2
% of Capex
86.0%
95.0%
- Capital Expenditure
(147.8)
(150.7)
% of Sales
4.5%
4.5%
+ Decrease / (Increase) in NWC
(37.9)
(15.9)
(24.2%)
(24.2%)
–
–
% of Absolute Change in Net Sales +/- Change in Other Non-Cash Items + Decrease / (Increase) in Provisions
1.4
Unlevered Free Cash-flow
198.7
–
EBITDA minus Depreciation
% taxes on EBITA
30.0%
% of Capex
95.0%
% of sales
4.5%
% of absolute change in net sales
(24.2%)
% of absolute change in net sales
–
228.0
Step 4: Determining WACC Calculate WACC based on the methodology described in the WACC section. For this purpose, request the Barra betas for the set of comparable companies from the library and calculate the unlevered beta of each company using the respective Gross Debt, Market Cap and statutory tax rate figures. Cost of equity for ChocoFriends is calculated using the average unlevered beta of the comparable companies, the target capital structure, the Swiss risk free rate and the equity risk premium from Credit Suisse Global Equity Strategy. Then calculate an after-tax cost of debt using the company’s current yield to maturity on its outstanding bonds, the target capital structure and the marginal Swiss tax rate. Results yield a WACC range of 8.0-9.0%, a figure which needs to be crosschecked with broker research. Step 5: Terminal Value Calculation Now calculate the Terminal Value using the multiple method and the perpetual growth method. To calculate the Terminal Value with the perpetual growth method apply the following formula (incl. adjustment for the assumption of mid-year cash flows):
Terminal Value =
UFCFn+1 * (1+ r)0.5 (r − g)
where: UFCFn+1 = unlevered FCF in period n+1 g = perpetual growth rate r = weighted average cost of capital (WACC) Use the normalised unlevered FCF and apply the growth-to-perpetuity rate of 2%. Calculation of Enterprise Value (Perpetuity Growth Rate) Unlevered Free Cash Flow 228.0 Perpetuity Growth Rate 2.0% Terminal Value 3,653.5
163
Companies in the relevant consumer goods sector are usually valued on an EV/EBITDA multiple. Below are the current trading multiples for traded companies comparable to ChocoFriends. EV / EBITDA 2006E Competitor A
7.2x
Competitor B
7.6x
Competitor C
6.3x
Competitor D
7.0x
Average
7.0x
To calculate the terminal value with the EBITDA multiple method multiply the normalised EBITDA by an average trading multiple of ChocoFriends’ comps. Calculation of Enterprise Value (EBITDA Exit Multiple) EBITDA
502.4
EBITDA Exit Multiple
7.0x
Terminal Value
3,516.6
Step 6: Calculation of Enterprise Value In order to arrive at the Enterprise Value of ChocoFriends, both the cash flow projections and the terminal value need to be discounted back to the valuation date. In order to value ChocoFriends as of 30 June 2006, all cash flows occurring before the valuation date must be excluded. Include only 50% of the 2006 cash flow for valuation purposes. The table below summarizes the calculation, based on the assumption of mid-year cash flows. ChocoFriends – Enterprise Value Calculation (€ in millions, FYE December 31) Projections
Normalised
2006E
2007E
2008E
2009E
2010E
2011E
2012E
2013E
2014E
2015E
Unlevered Free Cash-flow
92.0
108.1
123.4
134.4
144.2
154.9
166.8
178.9
188.5
198.7
Period discounted (years)
0.25
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00 100.0%
50.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
WACC
Participation in Yearly Cash Flow
8.5%
8.5%
8.5%
8.5%
8.5%
8.5%
8.5%
8.5%
8.5%
8.5%
Discount factor
0.98x
0.92x
0.85x
0.78x
0.72x
0.66x
0.61x
0.56x
0.52x
0.48x
45.1
99.6
104.8
105.2
104.0
103.0
102.2
101.1
98.1
95.3
Discounted Unlevered Free Cash-flow
EBITDA Exit Multiple
502.4 7.0x
Unlevered Free Cash Flow
228.0
Perpetuity Growth Rate
2.0%
Terminal value
3,516.6
Terminal value
Discount factor
0.46x
Discount factor
Discounted Terminal Value Sum of PV of Free Cash Flows Enterprise Value
228.0
Calculation of Enterprise Value (Perpetuity Growth Rate)
Calculation of Enterprise Value (EBITDA Exit Multiple) EBITDA
2016E
1,619.6 958.4 2,578.0
Discounted Terminal Value Sum of PV of Free Cash Flows Enterprise Value
3,653.5 0.46x 1,682.6 958.4 2,641.0
Note that the Discount factor for the final year’s cash flow is different from the discount factor for the Terminal Value. This is due to the fact that we are assuming mid-year cash flows, whereas the Terminal Value only accrues at the end of the final year.
164
Step 7: Calculation of Equity Value In order to arrive at the Equity Value, deduct all value components not attributable to equity holders. As ChocoFriends is being valued as of the 30 June 2006, take the latest available financials. The Q2 report of ChocoFriends reveals the following: ChocoFriends – Components Not Attributable to Equity Holders (€ in millions)
Long-term Debt
347.0
Short-term Debt
52.2
Pension Employee Benefit Obligation
35.5
Cash & Cash Equivalents
188.5
Minority Interest
26.3
Based on these numbers, the table below demonstrates the Equity Value calculation for both Terminal Value methodologies. The net pension liability has been deducted at full value. Depending on the jurisdiction one needs to check whether tax shields can be realised on un- or under-funded pension liabilities. ChocoFriends – Equity Value Calculation Calculation of Equity Value (Perpetuity Growth Rate)
Calculation of Equity Value (EBITDA Exit Multiple) Enterprise Value
2,578.0
– Existing Debt
(399.2)
Enterprise Value
2,641.0
– Existing Debt
(399.2)
– Pension Liabilities
(35.5)
– Pension Liabilities
(35.5)
– Minority Interest
(26.3)
– Minority Interest
(26.3)
– Preferred
–
+ Existing Cash & Cash Equivalents
188.5
+ Book Value of Unconsolidated Assets
–
Total Adjustments
(272.4)
Implied Equity Value
2,305.6
– Preferred
–
+ Existing Cash & Cash Equivalents
188.5
+ Book Value of Unconsolidated Assets
–
Total Adjustments
(272.4)
Implied Equity Value
2,368.6
Step 8: DCF Matrix The DCF matrix below shows the result of the valuation exercise for a range of WACC rates as well as a range of terminal value multiples / growth rates. ChocoFriends – DCF Matrix (€ in m illions, FYE December 31) EBITDA Exit Multiple
9.00%
7.0x
938
39.4%
938
37.7%
938
36.1%
PV of Unlevered FCF (2006E - 2015E)
60.6%
1,550
62.3%
1,661
63.9%
2,488
(272)
(272)
WACC
2.00%
2.25%
938
39.3%
938
38.5%
938
37.6%
PV of Terminal Value 2015E
1,447
60.7%
1,499
61.5%
1,555
62.4%
2,599
Enterprise Value
2,385
(272)
EV Adjustments (current)
2,437
(272)
(272)
(272)
2,216
2,326
Equity Value (m)
2,113
2,165
2,220
27.0
28.4
29.8
Value per Share
27.1
27.8
28.5
6.9x
7.2x
7.6x
Implied EV / 2007E EBITDA Multiple
7.8x
7.9x
8.1x
1.7%
2.2%
2.6%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
6.5x
6.8x
7.0x
958
38.9%
958
37.2%
958
35.6%
PV of Unlevered FCF (2006E - 2015E)
1,504
61.1%
1,620
62.8%
1,735
64.4%
2,578
(272)
(272)
958
37.2%
958
36.3%
958
35.4%
PV of Terminal Value 2015E
1,620
62.8%
1,683
63.7%
1,750
64.6%
2,694
Enterprise Value
2,579
(272)
EV Adjustments (current)
2,641
(272)
(272)
(272)
2,306
2,421
Equity Value (m)
2,306
2,369
2,436
28.1
29.6
31.0
Value per Share
29.6
30.4
31.2
7.1x
7.5x
7.9x
Implied EV / 2007E EBITDA Multiple
8.4x
8.6x
8.8x
1.3%
1.8%
2.2%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
7.0x
7.3x
7.6x
980
38.4%
980
36.7%
980
35.1%
PV of Unlevered FCF (2006E - 2015E)
61.6%
1,692
63.3%
1,813
64.9%
2,551 (272)
2,672 (272)
980
34.9%
980
34.0%
980
33.1%
PV of Terminal Value 2015E
1,824
65.1%
1,900
66.0%
1,983
66.9%
2,793
Enterprise Value
2,804
(272)
EV Adjustments (current)
(272)
2,880 (272)
8.50%
2,708
2,190
1,571
9.00%
2,492
2,105
2,462
7.50%
1.75%
1,440 2,377
8.50%
Perpetuity Growth Rate 7.5x
WACC
6.5x
7.50%
2,963 (272)
2,279
2,399
2,520
Equity Value (m)
2,531
2,607
2,690
29.2
30.8
32.3
Value per Share
32.5
33.4
34.5
7.4x
7.8x
8.2x
Implied EV / 2007E EBITDA Multiple
9.1x
9.4x
9.7x
0.8%
1.3%
1.7%
Implied FCF perpetuity growth rate / Implied 2015E EV / EBITDA multiple
7.5x
7.9x
8.2x
165
Leveraged Buy-Out Analysis
167
Leveraged Buy-Out Analysis 1.
Overview
1.1.
What is a Leveraged Buy-Out (“LBO”)?
A LBO is the acquisition of a company / target by management and/or a Financial Sponsor using a maximum amount of debt to pay for the company’s Enterprise Value (i.e. acquisition price), the rest being funded through equity from management and/or the Financial Sponsor. A LBO could be a key strategic alternative for a Company considering how to maximise shareholder value. Therefore, it is a key valuation metric to use in the context of a buy-side or sell-side mandate with a corporate (or a Financial Sponsor). Strategic Alternatives Strategic Alternatives
Continue to operate company in current form
Major purchases
Selected asset divestures
Recapitalisation
Merger of equals
Sale of company
Financial Buyer (LBO)
IPO
Strategic Buyer
„ The equity portion typically represents 25%-30% of the target’s Enterprise Value § Part of the equity can often be invested in the form of shareholder loans with capitalised annual interest (not paid in cash), which is often tax deductible „ Typically, debt would represent 70%-75% of the Enterprise Value, and would be serviced from the target’s cashflows § Debt usually includes a combination of senior bank debt, second lien and subordinated debt (Mezzanine or High Yield)
1.2.
What Is A Financial Sponsor?
„ Financial Sponsors manage funds that are raised mostly from institutions, pensions and wealthy individuals „ In Europe today, Financial Sponsors manage a total fund pool in excess of €40 billion. The main type of fund managed by Financial Sponsors are pension funds, which have been consistently allocating a reduced percentage of their resources to Private Equity funds in the past years (such investments being considered by Pensions Funds as part of the most risky class of assets held in their portfolio)
169
A Decade of European Fund Raising
2,500 41,233
68
40,000
2,000
62 51
30,000
46
43
26,039
47
50
47
23,126 37
19,041
20,000 24
12,568
13,605
1,000
15,184 11,611
11,455
10,000
825
5,022 209
292
267
252
340
420
323
405
310
1996
1997
1998
1999
2000
2001
2002
2003
2004
500
0
0 European Funds Raised
Source:
1,500
Avg Fund Size (€ in millions)
Funds raised for buyouts (€ in millions)
50,000
Avg Fund Size
2005
Number of Funds
Thomson Financial
„ Large Financial Sponsors manage funds in excess of US$5 billion each, and are able to invest up to US$1 billion in equity on a single transaction: § Acting in consortium, Financial Sponsors can acquire large corporates (e.g. TDC, largest European LBO to date had an EV of c. €12.7bn at closing in November 2005) „ Key characteristics of a Financial Sponsor investment § Investment horizon: 3-5 years typically § Target Internal Rate of Return (“IRR”): c. 20-25% § Focus on corporate governance, often with a preference for control of the acquired Target § Heavy reliance on management expertise
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„ Some major Financial Sponsors: The following table lists the major Financial Sponsors active in Europe (in terms of maximum investment size) European Presence - Major Financial Sponsors Global Private Equity Funds
Maximum Equity Ticket on One (1) Single Deal
Landmark Transactions
Funds Managed
Carlyle Partners IV (US$10bn) Carlyle European Private Equity II (€2 bn)
US$2 billion
Avio Spa
c. US$ 25 bn
KKR European Fund II ( €4.5bn) KKR 2006 (US$ 6bn)
US$2 billion
Latest Fund Raised
(2)
Qinetiq TDC A/S
c. US$ 21bn
SunGard Data Systems Legrand
Blackstone Capital Partners IV (US$ 6.5bn) US$1.3 billion
Allied Waste
c. US$14 bn
Cine UK/UGC Bain Capital Fund IX (US$6 bn)
US$1.2 billion
Warner Music
c. US$27 bn
Seat TPG Partners V (US$ 5.8bn)
US$1.2 billion
Grohe
c. US$20 bn
Debenhams CVC European Equity Partners IV (€6 bn)
€1.2 billion
Automobile Association
c. €14.5 bn
Seat BC European Capital VIII (€5.5 bn)
€1.1 billion
Amadeus
c. €11 bn
Picard Seat Apax Europe VI (€4.6 bn)
€1 billion
TDC A/S
c. US$20 bn
VNU World Directories Permira Europe III ( €5 bn)
€1 billion
Inmarsat
c. €11 bn
Gala Seat Cinven Fund IV (€5 bn)
€1 billion
Amadeus
c. €13 bn
Frans Bonhomme NM (not pure private equity)
approx. €1bn
Europcar
c. €4 bn
Rexel NM (not pure private equity)
approx. €1bn
Materis
c. €4 bn
Legrand Providence Equity Partners V ($4.25bn)
US$0.85 billion
Warner
c. US$9 bn
MGM Clayton, Dubilier & Rice Fund VI (US$3.5 bn)
US$0.7 billion
PAI IV (€3 bn)
€0.7 billion
Hertz
c. US$6 bn
Rexel
United Biscuits
c. €7 bn
Elis Christian Hansen (1) Calculated as 20% of funds available (2) Funds managed represent global funds managed by each fund (incl. Funds already invested)
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1.3.
Value Creation in LBOs
Financial Sponsors have several ways of making an investment a success „ Growth § Accelerate organic growth opportunities § Consolidation platform § Bolt-on acquisition(s) „ Margin Enhancement § Operational improvements § Product mix enhancement § Add-on acquisitions to expand product range and/or geographical reach and/or provide synergies „ Restructuring § Accelerated cost-cutting § Divestiture of non-performing / non-core assets § Capital structure optimisation „ Deleveraging § Using target‘s cashflows, thereby increasing the equity component of target’s Enterprise Value, to repay debt „ Exit Multiple Expansion § Equity Story enhancement (i.e. market repositioning) § Size-up to critical mass (which makes target more attractive at exit) The graph below illustrates the cumulative effect of these measures over the life cycle of a typical investment Typical LBO Life Cycle IRR = 32% and Money Multiple = 4.1x Pre-Deal, TEV = £500m
At time of LBO, TEV = £500m
At time of Exit (5 yrs), TEV = £825m
100% 80%
Debt 40%
Debt 70%
60%
20%
D=£165m
Equity 80%
E=£660m
D=£350m
40% Equity 60%
Debt 20% D=£200m
E=£300m
Equity 30%
E=£150m
0% EBITDA = £100m EBITDA Mult. = 5x
172
EBITDA = £100m EBITDA Mult. = 5x
EBITDA = £150m EBITDA Mult. = 5.5x
2.
How to Complete a LBO Analysis
2.1.
Main Characteristics of a Suitable LBO Target
A Financial Sponsor investment thesis will often comprise several of the following attributes: „ Industry § Barriers to entry § Reduced price competition § Potentially fragmented market, suitable for consolidation „ Products § Value-added products or services § Low risk of technological obsolescence § Attractive and growing niche markets „ Business § Strong market positions § Sustainable competitive advantages § Low customer concentration § Low fixed costs / capital requirements § Divestible non-core assets „ Situation § Opportunity for operating efficiencies / growth through consolidation § Strong management team § Sensible valuation (not overvalued) § Exiting founding family „ Exit § Attractive exit options The characteristics above are obviously not all always met in any given situation, but nevertheless give a good sense of the attributes of a suitable LBO Target.
173
2.2.
Simplified Acquisition Structure Overview
Acquisition would typically be structured through the setting-up of a Special Purpose Vehicle (“NewCo”) to purchase the shares of the target, with equity proceeds contributed by Financial Sponsors and management and debt proceeds from senior and junior lenders. Simplified Illustrative Acquisition Structure Financial Sponsor
Management Equity
Target Shareholders
Cash
Subordinated Debt
High Yield Mezzanine Investors
NewCo 100% of Shares
Senior Banks
Senior Debt
Senior Debt
Target
Potential Merger
2.3.
Sources & Uses of Funds / Capital Structure
LBO Typical Sources & Uses of Funds Sources
Uses
„ Equity
„ Purchase of Target Equity
– New equity from LBO Sponsor – Potential equity contribution from existing
– Pay existing equity owners – If public, current share price plus tender
Management
– Potential investment rolled-over from existing
premium
– Cost of options, convertibles redemption, etc
shareholder
– Strategic equity „ Debt
– Senior Debt (banks) – Subordinated Debt (High Yield or Mezzanine) – Highly Subordinated Debt (PIK notes, etc)
„ Retire existing debt
– Refinancing of existing debt (covenants on –
existing indebtedness typically prohibits postLBO leverage) Potential prepayment penalties (for existing bonds, etc)
„ Pay transaction costs
174
Overview of a Typical Capital Structure in a LBO BANK DEBT A, B, C (Senior First Lien Debt / EBITDA) up to 4.25x to 4.75x Senior Debt SECOND LIEN DEBT (Senior Debt (incl. 2nd Lien) / EBITDA) up to 5.25x to 5.75x
MEZZANINE DEBT OR HIGH YIELD BOND
Subordinated Debt
70% - 75%
(Total Cash Debt / EBITDA) up to 6.5x to 7.0x
PAY IN KIND (“PIK”) NOTES Junior Debt to enhance leverage in specific cases COMMON EQUITY SHAREHOLDER LOANS Equity >25% of the capital structure
Equity
25% - 30%
Indicative Key LBO Terms Term (Yrs)
Floating / Fixed; Cash / Non-Cash
Spread
Equity Kicker
Comments
Secured Revolver
7.0
Floating; Cash
+225bps
No
„ Typically put in as a facility to be
Term Loan A
7.0
Floating; Cash
+225bps
No
„ Cheapest cost of capital but has
drawn down for W/C needs maintenance covenants and restricts flexibility Term Loan B
8.0
Floating; Cash
+250-275bps
No
„ Cheapest cost of capital but has
maintenance covenants and restricts flexibility Term Loan C
9.0
Floating; Cash
+300-325bps
No
„ Cheapest cost of capital but has
maintenance covenants and restricts flexibility Second Lien Debt
9.5
Floating; Cash
+475-550bps
No
„ Enables to future maximise bullet
/ back-ended debt Mezzanine
10.0
Floating; Cash + PIK
950-1100bps
Possibly
„ Flexible but potentially expensive
and/or dilutive Unsecured High Yield Bond(1)
10.0
Fixed; Cash
850-1050bps
Possibly
„ More expensive than bank debt
but much greater flexibility; dependant on ratings PIK Note
10.5–11.0
Fixed; Cash
1500-2000bps
Possibly
„ Quasi-equity - Used to decerase
the equity component of the deal Shareholder Loans 11.0–11.5
Fixed; Cash
500-1000bps
Possibly
„ Quasi-equity - Used to decerase
the equity component of the deal - Provided by Equity investors (1) High Yield Bonds tend to sometimes benefit from second ranking security
175
2.4.
How To Assess Maximum Leverage
Maximising debt is crucial to optimising Financial Sponsor returns. In situations other than preliminary “back-of-the-envelope” analysis, it is therefore crucial to have colleagues from the Financial Sponsors Group involved. The two key drivers of maximum leverage are cashflow and minimum equity requirement. „ Cashflow: Maximum leverage is significantly influenced by the cashflow generation of the target § Key determinants of a company’s cashflow generation include sustainable sales growth, EBITDA margin evolution, future Capex requirements and working capital needs § Leverage levels will often depend on the characteristics and precedents in the target’s industry
– For example yellow pages companies could be potentially levered up to 7.5x – 8.0x EBITDA (strong and recurrent cashflow), whilst a capital goods company would typically sustain a maximum leverage of 5.0x – 6.0x EBITDA (cyclical and Capex intensive) „ Minimum equity requirement: Maximum leverage is sometimes capped by valuation considerations and minimum equity requirements § For example, if the target’s cashflows could sustain 6.0x leverage but the contemplated acquisition price is only 7.0x EBITDA, leverage would, in general, have to be reduced such that equity invested remains above 25%-30% of capital structure § The minimum equity constraint is mostly driven by lenders requiring (i) Financial Sponsors to invest a minimum amount of equity to demonstrate their commitments in the transaction and (ii) a “safety cushion” in case the target becomes bankrupt and needs to be sold by the lenders to recover their debt (more of the asset value will belong to the lenders in the event of a liquidation) „ Leverage ratios are used to measure the debt quantum relative to the target’s operating performance and cashflows „ Most commonly used leverage ratios in LBO analysis are § Senior Leverage ratio: Senior Debt / EBITDA § Total Cash Leverage ratio: Total Cash Debt / EBITDA § Interest Coverage ratio: EBITDA / Cash Interest Expense § Total Cash Debt / (EBITDA – Capex) and (EBITDA –Capex) / Cash Interest Expense § Fixed Charge Coverage ratio: After Tax Free Cashflow before interest and debt payment / (Cash interest payment + debt payment):
– This ratio allows a comparison between the target’s annual cash generation and its annual debt service obligations If at all in doubt, even in the context of a preliminary analysis, please seek input from the Financial Sponsors Group.
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2.5.
Exit Strategy
Understanding the exit strategy / exit value is an essential component of a LBO. In particular, determining an appropriate exit multiple range will help to calibrate the right acquisition price range and assess the feasibility / attractiveness of a LBO at a given price. Options
Relevant Context
„ Sell company to a trade buyer
„ Several players trying to consolidate in a
„ Sell to a financial buyer (Secondary LBO)
„ Financial buyers with greater experience /
fragmented industry competence / use of the asset „ Take company public
„ Hot sector / scarcity of publicly traded companies
„ Recapitalize company (Recap)
„ Attractive underlying asset with continued scope for
cash flow generation „ Wind down / liquidate assets
„ Declining industries
In the case of an early stage LBO analysis, where the exit strategy has not yet been defined, a broader range of exit multiples could be used on a preliminary basis to compute IRRs and perform the analysis.
2.6.
LBO Model Inputs & Outputs
Key inputs to the LBO model are: „ The Operating Model, needs to be detailed enough to assess future cashflows, debt amortisation profile and, consequently, maximum debt capacity. Flexibility for scenario analysis is also important in order to stress test the capital structure under various operating projections scenarios „ Proposed capital structure, including maturities, and pricing (i.e. interest rate) of various debt components „ Blended tax rate „ Sources and uses of funds, including transaction costs „ Range of exit multiples (typically of EBITDA or EBIT) to assess implied Enterprise Value range at exit for IRRs and Money Multiples computation Key outputs from the LBO model „ Projected income statement, cashflow statement and balance sheet to show operating profile of the target and the amortisation profile of the various debt components „ IRRs and money multiples for the equity invested by the Financial Sponsors 1
n § IRR = Y − 1 (assuming no dividend payment is made between entry and exit), where: X
X = the initial cash equity invested by the Financial Sponsors Y= equity value of the Financial Sponsor’s investment at exit calculated as Enterprise Value less Net Debt at time of exit n= exit year of investment § Money multiple = Y ,where X and Y have the same definitions as above
X
„ Pro forma and projected key credit ratios (e.g. leverage, interest coverage and fixed charge coverage)
177
3.
How To Use and Interpret a LBO Analysis
3.1.
Exit Multiples
„ Assessment of the exit multiple / exit multiple range is key to a LBO analysis. The relevant exit multiples may differ from the potential entry multiples § To assess returns on a preliminary basis, exit multiples equalling entry multiples would typically be used. However, this may be far from the reality of the situation being considered, hence it is only a very first step in returns assessment
– For example, in some specific cases (e.g. when the Financial Sponsor’s business plan includes asset sales which would have a dilutive effect on the value of the target), exit multiples are likely to be lower than entry multiples (in the same manner, for divestitures expected to have an accretive effect, multiples expansion can be considered at exit)
– Another example is the case where a target is operating in a cyclical sector (e.g. retailer, building materials).The position in the cycle at the time of the transaction may be taken into account. Investors may consider exit multiple expansion or contraction when assessing the expected equity returns at exit (depending on position in cycle at time of exit) „ Use of returns tables (IRRs and Money Multiples) showing a range of reasonable entry multiples and exit multiples (at contemplated exit horizons) is therefore recommended to help LBO value assessment
3.2.
Investment / Exit Horizon
„ LBO analysis is also very sensitive to the investment horizon that can be contemplated for a specific transaction. Although 3 to 5 years can be considered as the most common investment horizon for a Financial Sponsor, this may vary dependant on various factors, such as the Financial Sponsor considered, the nature of the target and timing considerations regarding potential consolidation strategy and exit § For example, low-Beta targets (i.e. proven, predictable business models operating in mature markets, such as utilities or infrastructure operators), where the risk related to the transaction can be considered as more manageable, will have a tendency to remain longer in the portfolio of a Financial Sponsor § In the same manner, other factors, like the cyclicality related to the business of the target, may impact the timing of the exit strategy of a Financial Sponsor. If market conditions are deemed particularly favourable, the Financial Sponsor may decide to exit in less than 3 years „ As it is not necessarily easy to predict what the exit horizon would be, it may be useful to show return tables for various exit horizons (e.g. 3, 4 and 5 years)
3.3.
Choice and Use Of Projections
„ As an initial guideline, for the LBO to be considered feasible, IRRs of 20%-25% should be achieved after 3 years. This will be based on an Equity Base Case (or Sponsor Base Case i.e. the reasonable / achievable business plan of the Sponsor for the transaction) and assuming exit multiple equals entry multiple „ The reasonableness / achievability of operating projections is key in determining an Equity Base Case. This case would be the basis starting from which a Sponsor will assess both upside and downside (through sensitivities on the projections) „ Sensitivities on the operating model, based on forecasts of industry trends and cyclicality of the business, as well as other identified potential risks / opportunities specific to the target, are therefore essential to fully assess a LBO value
3.4.
Interpretation of IRRs
„ When IRRs deviate significantly from the 20%-25% range whilst the points above have been properly addressed, consider the following: § If IRRs stand significantly above 25%, this may be the sign that a higher price could be considered for the asset in the context of a LBO
178
§ If, on the other hand, IRRs stand well below 20%-25%, this may indicate that the purchase price is too high to be achieved in the context of a LBO „ As the analysis gets more detailed, the industry and environment in which the Target operates must be taken into account. For example: § For low-beta targets, investors may potentially accept lower equity returns, typically in the 18-22% range (on the basis of their Equity Base Case), sometimes less § For high-beta targets (e.g. involved in relatively new and fast-growing markets, such as IT or biotech, or those having demonstrated high historical operating performance volatility), investors would be more likely to expect equity returns in the 25%-30% range (or above) under the Equity Base Case „ External factors can also be considered when assessing the equity returns acceptable for a specific LBO § Due to the increased size of many Financial Sponsor funds, many sponsors may accept equity returns lower than the historically traditional 25% if they are able to put a very large equity cheque into a single investment § Individual Financial Sponsors also have varying IRR objectives and investment philosophy „ Overall, the 20%-25% IRR range should be considered as an initial rule of thumb but must be used with care and caution when assessing the LBO valuation Please be sure to seek input / involvement from the Financial Sponsors Group when performing a LBO analysis.
4.
Common Pitfalls
„ Inappropriate leverage levels § The existing capital market conditions at the time of the transaction should be closely looked at when assessing the maximum leverage, and precedent transactions should be benchmarked for both structure and quantum of leverage (e.g. if the contemplated leverage is above the leveraged comps, there would need to be strong arguments as to how this could be justified) § Check leverage multiples vs. valuation multiples from Compcos / Compacqs and proposed acquisition multiples. If the leverage multiple which is derived is close to applicable valuation multiples, double check the projections to verify that the operating profile of the business vs. the comps warrants the additional leverage and that the valuation also includes a sufficient premium over the comps to justify the better operating profile. The debt leverage multiple should not, in any case, exceed the valuation multiple range which is believed to be applicable to the target considered „ Size of subordinated debt § If Mezzanine debt is considered, there is typically no minimum size limitation, but the maximum size is capped (typically not more than €700 million) § If High Yield bonds are considered, in order to ensure sufficient trading liquidity, the issue-size of the bond should not be less than €125 million. The maximum size of a High Yield bond could be substantially higher than for Mezzanine debt (up to €2,500 million and sometimes more), but is driven by market conditions at the time of the transaction § There may also be limitations on the size of an issuance in a particular currency „ Off-balance sheet commitments § Capital leases (e.g. IT leases) and securitisations (now on-balance sheet based on IFRS) have to be adjusted when calculating leverage. It is worthwhile noting that even operating leases (e.g. office rentals) may be adjusted by rating agencies when assessing leverage ratios (ratios based on EBITDAR instead of EBITDA in some instances, with “R” being rents). In an initial analysis though, make sure the annual cost of off-balance sheet liabilities flows through EBITDA § Pension deficits: future costs (service / interest charge) should be incorporated into projected EBITDA. In some jurisdictions like the UK, a pension deficit may need to be funded at the time of the LBO. It would then be part of the purchase price considered (and, obviously its cost should then be excluded from present and future EBITDA computation) „ Miscomputation or misinterpreting of equity returns for the investors. The previous section “How to Interpret a LBO Analysis” details the main considerations in this regard
179
Make sure colleagues from the Financial Sponsors Group are involved, particularly if the analysis needed is not “back-of-the-envelope”. They will provide input on capital structure optimisation and IRR requirements for a given situation (each Financial Sponsor has specific IRR requirements, driven by its funds but also by the nature of the Target). In particular, if showing the analysis to a client, it is strongly recommend that a Financial Sponsors Group review the LBO valuation approach and capital structure beforehand.
5.
Example
5.1.
The Amadeus Global Travel Transaction Example
„ On 9 January 2005, BC Partners and Cinven (the “Consortium”) entered into exclusive negotiations to acquire Amadeus Global Travel Distribution (“Amadeus”) after having submitted a joint bid in the context of an auction process „ The bid valued Amadeus at €7.35 per share, which equates to an Enterprise Value of c. €4.4 billion (7.7x Adjusted FY04A EBITDA of €604 million) „ Prior to the tender offer, 50.1% of Amadeus’ Class A shares were free floating, with Air France, Iberia and Lufthansa holding 23.4%, 18.3% and 5.1%, respectively
5.1.1.
Company Presentation
Originally founded by four airlines, Air France, Iberia, Lufthansa, and SAS, Amadeus was a publicly listed company in Spain (Market Cap of €4.3bn) with Germany and France providing marketing and distribution services to the travel industry worldwide. Its core competitive strength comes from its leadership in the development of information technology solutions, which provide the backbone of the travel industry. Amadeus is a global leader in technology and distribution solutions for the travel and tourism industry, offering 3 main interrelated services (as shown below): the Global Distribution System (“GDS”), IT Services, and e-Commerce. Amadeus Divisional Overview
Revenue 2004: €2,033m
Global Distribution System Revenue 2004: €1,925m „
498 airlines, hotel chains, car rental, rail, ferry and cruise companies linked
„
66,000+ travel agencies
„
10,000+ airline sales offices
„
330,000+ points of sale
5.1.2.
IT Services Revenue 2004: €83m „
e-Commerce Revenue 2004: €25m
Altéa
„
EViaggi
§ § §
Inventory
„
Vivacances
Reservation
„
Travellink
„
E-Travel
Departure control
„
Hotel IT Services
„
Leisure & Tour IT Services
§ §
Aergo Planitgo
Key Transaction Considerations
„ Attractive Growing Industry § $7 billion in revenues p.a. derived from the core distribution network of the worldwide travel industry § Airline passenger growth historically outpaced GDP growth (averaging 6.2% p.a.) „ Industry Leader § Amadeus is the leading worldwide GDS provider with global 2004 market share of c. 29% § Market shares historically growing consistently „ High Barriers to Entry
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§ Significant capital and time investments required to build-up technology and relationships with travel providers / travel agents § High switching costs for GDS users „ Strong Stake Holding Interests from Airlines § Founder airlines Air France, Lufthansa and Iberia to maintain significant equity stakes in Amadeus post-transaction „ Well Invested Leading Technology Platform § Amadeus reputed to be the most technologically advanced vs. competition § IT offering considered by industry experts to be at least 1-2 years ahead of nearest rivals „ Upside opportunities arising from IT business § Considerable and growing demand for outsourcing solutions § Amadeus well positioned as the technological leader in this area „ Diverse and Stable Customer Base § Amadeus has strong relationships with a wide variety of customers (from travel providers / agents) „ Strong and Recurring Cash Flow Generation § Highly cash generative business – projected to consistently generate €400 million of FCF p.a. § Proven track record of consistent revenues and profitability Amadeus LBO – Simplified Transaction Structure Consortium
Airlines Equity i njecti on
Bondholders Sharehol der loans
WAM Acquisition (BidCo) Investors funds
Minorities
Sharehol der loans
Bond pr oceeds
Acqua Finance SA
MergCo
Holding Gmbh
Bank Loans proceeds
Senior Lenders
Amadeus Gmbh
Total equity included in the transaction will amount to €989 million, or 21.5% of total sources of funds. This amount includes investments by the airlines of €448 million, the Sponsors of €526 million, and Amadeus management of €15 million. The following table summarises the sources and uses of this transaction:
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Amadeus LBO – Capital Structure (1)
€m
Senior A
800
17.4%
1.32x
Purchase Price (at €7.35 per share)
Senior B
950
20.7%
1.57x
Debt Repaid Enterprise Value
Senior C Total Senior Debt
%
x EBITDA
Sources
950
20.7%
1.57x
2,700
58.8%
4.47x
High Yield Bond
900
19.6%
1.49x
3,600
78.5%
5.96x
Shareholder Loans
565
12.3%
0.94x
"Hard" Equity
424
9.2%
0.70x
Total Equity o/w rolled over by existing shareholders
989
21.5%
1.64x
100.0%
7.60x
Total Cash Debt
Total Funded Sources
Uses
€m
Fees
%
(1)
x EBITDA
4,262
92.9%
7.06x
127
2.8%
0.21x
4,389
95.6%
7.27x
200
4.4%
0.33x
4,589
100.0%
7.60x
448 4,589
Total Funded Uses
Based on September 2006 LTM EBITDA of €604.0m
Proposed capital structure, and the actual leverage based on 2004 adjusted EBITDA of €604 million as per table below. Amadeus LBO – Pro Forma Capitalisation Senior A Senior B Senior C Total Senior Debt Existing Capital Leases Total Senior Debt (incl. leases) High Yield Bond Total Cash Debt
800 950 850 2,700 105 2,805 900 3,705
17.4% 20.7% 20.7% 58.8% 17.4% 61.1% 19.6% 80.7%
1.32x 1.57x 1.57x 4.47x 0.17x 4.64x 1.49x 6.13x
Shareholder Loans "Hard" Equity Total Equity Total Funded Sources
565 424 989 4,694
12.3% 9.2% 21.5% 100.0%
0.94x 0.70x 1.64x 7.77x
Note: From this section onwards, all information is mock information provided for illustrative purposes only
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5.1.3.
Financial Projections
The projections summarised below, which will serve as an illustrative Equity Base Case, have been designed for training purposes only and differ, for reasons of confidentiality, from the Equity Case developed at the time of the transaction. The projections are based on views of forecasted industry volumes from external sources such as IATA and other industry surveys at the time of the transaction and assume market share growth in various geographic regions as well as growth rates in various channels. LTM 2004 2,032
Sales EBITDA Capex Change in NWC
604 0
Free Cash Flows Sales Growth EBITDA Margin Capex as % of Sales NWC as % of Sales
2005P 2,100
2006P 2,200
2007P 2,300
2008P 2,400
2009P 2,500
2010P 2,700
2011P 2,804
2012P 2,940
2013P 3,088
2014P 3,243
05-14 Cum 26,275
602 (87) 35
650 (156) (9)
675 (150) (6)
390 (150) (5)
750 (155) (10)
800 (160) (15)
850 (160) (10)
900 (170) (10)
950 (170) (15)
975 (180) (15)
7,842 (1,538) (60) 6,244
604
550
485
519
535
585
625
680
720
765
780
5.3% 29.7% 0.0%
3.3% 28.7% 4.1%
4.8% 29.5% 7.1%
4.5% 29.3% 6.5%
4.3% 28.8% 6.3%
4.2% 30.0% 6.2%
8.0% 29.6% 5.9%
3.8% 30.3% 5.7%
4.9% 30.6% 5.8%
5.0% 30.8% 5.5%
5.0% 30.1% 5.5%
(53) (233) 265
(61) (222) 202
(71) (214) 233
(79) (205) 251
(103) (195) 286
(126) (184) 316
(150) (173) 357
(170) (163) 387
(204) (127) 435
(223) (84) 473
2005 1.0y 115
2006 2.0y 213
2007 3.0y 316
2008 4.0y 421
2009 5.0y 532
2010 6.0y 752
2011 7.0y 1,109
2012 8.0y 546
2013 9.0y 31
2014 10.0y 504
0 546 32% 950 950 2,446 105 2,552
0 417 48% 950 950 2,317 105 2,422
0 271 66% 950 950 2,171 105 2,276
0 96 88% 950 950 1,996 105 2,101
0 0 100% 950 950 1,900 105 2,005
0 0 100% 950 950 1,900 105 2,005
0 0 100% 0 950 950 105 1,055
0 0 100% 0 0 0 105 105
0 0 100% 0 0 0 105 105
Less: Total Cash Taxes Less: Cash Interest Expenses Cash Flow available for Debt Repayment
LTM 2004 Year from closing Cash Balance
0
Debt Outstanding Revolver Term Loan A Cum % paid down Term Loan B Term Loan C Total Senior Debt (excl. Cap lease) (1) Capital Leases Total Senior Debt (incl. Cap lease)
950 950 2,700 105 2,805
0 650 19% 950 950 2,550 105 2,655
Subordinated Debt Total Cash Debt
900 3,705
900 3,555
900 3,452
900 3,322
900 3,176
900 3,001
900 2,905
900 2,905
900 1,955
900 1,005
900 1,005
3,441
3,239
3,006
2,755
2,469
2,153
1,796
1,409
974
501
4.05x 4.22x 5.72x
3.44x 3.60x 4.98x
2.96x 3.12x 4.45x
2.54x 2.69x 3.99x
1.95x 2.09x 3.29x
1.43x 1.57x 2.69x
0.93x 1.05x 2.11x
0.45x (0.03x) 0.57x 0.08x 1.57x 1.03x
0.52x 0.41x 0.51x
2.58x 2.21x 1.30x
2.92x 2.22x 1.30x
3.15x 2.45x 1.30x
3.36x 2.63x 1.30x
3.84x 3.05x 1.30x
4.36x 3.49x 1.79x
4.92x 3.99x 3.07x
5.51x 4.47x 0.49x
0 800
Total Net Debt Key Credit Statistics Net Senior Debt (excl. Cap. Leases / EBTIDA) Net Senior Debt (incl. Cap. Leases / EBTIDA) Total Net Cash Debt / EBITDA
4.47x 4.64x 6.13x
EBITDA / Cash Interest (EBITDA-Capex) / Cash Interest Fixed Charge Cover
(1)
7.50x 6.16x 0.52x
(1,239) (1,801) 3,204
11.60x 9.46x NA
Assumed not be amortised over transaction life
5.1.4.
Equity Returns
Based on the Equity Case, the expected equity value at exit for a certain range of exit multiple assumptions (with entry multiple set as mid-point of the exit multiple range, allowing an assessment of equity returns for scenarios involving both contraction and expansion of multiples) can be derived. Equity returns yielded by this transaction would then be as follows:
Exit in year
Exit Multiple
Note:
Money Multiple Computations 6.85x
7.00x
7.27x
7.50x
7.75x
2007
17.9%
20.3%
24.3%
27.7%
31.1%
2008
18.8%
20.4%
22.9%
25.1%
27.3%
2009
22.0%
23.0%
24.7%
26.1%
27.6%
Exit Multiple Exit in year
IRRs Computations
6.85x
7.00x
7.27x
7.50x
7.75x
2007
1.6x
1.7x
1.9x
2.1x
2.3x
2008
2.0x
2.1x
2.3x
2.4x
2.6x
2009
2.7x
2.8x
3.0x
3.2x
3.4x
IRRs and money multiples are pre management dilution and exit costs
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6.
Case Study
Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution Set. Company A is a public company involved in manufacturing and selling building materials in Europe. Shares currently trade at €97.0. Total diluted number of shares stands at 12.5 million and the existing Net Debt at €600 million. Research analysts’ consensus projections are available for the next 3 years, and have been extrapolated by CS thereafter to cover a 10-year timeframe as follows: (€ in millions)
Broker Consensus Y/E December 31
2006PF 2007P
2008P
CS Extrapolations
2009P
2010P
2011P
2012P
2013P
2014P
2015P
2016P
Revenues
2,528
2,965
3,000
3,050
3,101
3,153
3,205
3,258
3,313
3,368
3,424
Growth
NA
17.3%
1.2%
1.7%
1.7%
1.7%
1.7%
1.7%
1.7%
1.7%
1.7%
300
356
375
381
388
394
401
407
414
421
428
11.8%
12.0%
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
12.5%
EBITDA Margin EBITA Margin Capex % of sales Change in Working Capital
200
260
282
287
292
296
301
306
312
317
322
7.9%
8.8%
9.4%
9.4%
9.4%
9.4%
9.4%
9.4%
9.4%
9.4%
9.4%
(95)
(100)
(105)
(107)
(109)
(110)
(112)
(114)
(116)
(118)
(120)
3.8%
3.4%
3.5%
3.5%
3.5%
3.5%
3.5%
3.5%
3.5%
3.5%
3.5%
(5)
(6)
(7)
(7)
(7)
(7)
(7)
(8)
(8)
(8)
(8)
Preliminary input from the Leveraged Finance team seems to indicate that a 5.0x total leverage (4.0x 2006E EBITDA of Senior Debt and 1.0x 2006E EBITDA of High Yield) could be contemplated for transactions of this nature Assuming: „ Entry at 20% premium against current share price „ 4.0x senior leverage (split 30%/35%/35% of A/B/C tranches paying respectively 3 years swap Euribor of 3.5% + 2.25%/2.75%/3.25%). Full cash-sweep repayment (i.e. all FCFs after interest are used to repay the senior debt every year) „ 1.0x subordinated debt (High Yield paying a fixed coupon of 9.0% p.a.) „ Sponsors investment made 100% through hard equity injection (i.e. no equity contributed in shareholder loans form) „ Transaction closed by end of 2006 with transaction costs of €50 million „ Blended corporate tax rate of 30.0% Perform a preliminary LBO analysis addressing in particular the following: „ Sources and Uses of contemplated transaction „ Is the debt paydown profile over the coming 10 years acceptable? Is there any refinancing risk on the Senior Debt at maturity (i.e. in Year 9)? „ What would the expected equity returns of the investors, assuming an ISO-multiple exit (i.e. Exit EBITDA multiple = Entry EBITDA multiple) be in Year 4? What could a preliminary LBO valuation range be?
184
Credit and Debt Capacity Analysis
185
Credit and Debt Capacity Analysis 1.
Overview of Credit Analysis
1.1.
Introduction to Credit Analysis
Credit analysis is used not only in the debt financing space, where Credit Suisse has a leadership position in the issuance of bonds and syndication of loans, but also in various other product areas of the firm. In M&A, acquisition financing is an essential component of the service which the firm provides to its clients, both in the financial sponsor world and in the corporate sector. Credit structures are also important in the more academic or corporate finance based aspects of the bank’s work. For instance, LBO returns analysis now form an important benchmark for the valuation of corporates. An understanding of the methodology for credit analyses as well as the practical and theoretical bases for the debt capacity of a business are essential in these areas of work. This section provides an overview of the key aspects of credit analysis including: „ An introduction to the various structures available to companies borrowing debt „ An analysis of the applications of these products to clients „ The basis for the debt capacity and optimal capital structure work undertaken „ A day-to-day guide to the methodology and practical steps in completing these analyses
1.2.
Key Tenets for Analysing Credits and Debt Capacity
The fundamental determinants of a company’s debt capacity are its current and projected cash flows. Similarly, the credit analysis is focused on the cash flow profile and the comparison thereof with debt and debt service obligations of the company. Clearly, a company’s cash flows are influenced by a number of business, operating and financial factors, all of which determine the company’s credit quality, rating and debt capacity. The key factors affecting a company’s credit are as follows: „ Business and operating risk § Including demand drivers and trends, regulations, market characteristics and competitive dynamics. In addition, this will include specific issues such as market position, technological advances, historical profitability, geography specific issues and capital intensity „ Sector outlook and dynamics „ Operating metrics § Such as growth, margins and future investment needs „ Financial flexibility § Including access to the debt financing markets and new equity „ Ratings „ External factors „ Debt structure In addition to the financial modeling exercise of assessing the future cash flows of a company and its consequent ability to service and pay down debt within an appropriate timeframe, these factors should also be considered when looking at the various credit statistics which are used to compare companies and assess their relative standing (see Section 1.5 of this chapter). Whilst these analyses are critical to understanding the credit picture and confirming the robustness of a company’s financial plan, the following sections concentrate on debt structure.
187
1.3.
Structuring Considerations, Security, Covenants and Tenor
1.3.1.
Overview
There are a number of credit products available to suit the varying needs of clients. The key distinguishing factors between these products are based on their relative ranking, security packages, terms (such as maturity and amortisation requirements) and covenants. These products are structured to balance the needs of issuers (maximum borrowing and operational flexibility at lowest costs) and investors (highest return with lowest risk). There are two basic forms of debt products available to corporate clients: „ Loans Commonly known as bank debt or syndicated loans, these products are not listed on public exchanges § Historically, these products have been lent by the banking community and as such have tended to be less tradable and in a private-form, with lenders having access to confidential information on the company, including company projections § However, recently a large institutional investor base for loans has developed and, as such, the product has taken on a more tradable and public form, whereby investors are seeking both ongoing interest and capital appreciation as the loans trade up in the aftermarket „ Bonds Bonds are forms of debt which have market exchange listings and are fully public in nature. They are tradable and as such, do not benefit from the dissemination of confidential information on the company, but rather have consistent, typically historical, information which is provided to investors at regular intervals. The ability to trade in and out of the security is key for these investors As noted above, the boundary between loans and bonds has blurred in recent years. The investor base for bonds (institutional investors including hedge funds) has increasingly been participating in the loan market. This trend has become more common in the US, where a number of loan transactions, particularly in the non-investment grade arena, are institutional only. In the European market, banks still frequently participate in loan transactions alongside institutions.
1.3.2.
Security and Ranking
An important determinant of the interest cost of a debt product as well as its structure and covenants, is the ranking the debt enjoys in the company’s capital structure. The spectrum of ranking varies between equity, which sits at the bottom of the capital structure and incurs the first loss on invested capital in the event of bankruptcy, to secured debt which has first claim on assets and recovery in a default. The range of alternatives for the security a loan or bond takes is as follows: „ Asset security § This can either take the form of a fixed charge, where the lender has a fixed pledge over specified assets of a company or a floating charge, whereby the lender has general pledge, where possible, 9 over the company’s asset base . The benefit of asset security is that in a default scenario, the lender is able to enforce its pledge on these assets and receive the proceeds from this sale of assets to satisfy its debt obligation, coming ahead of other creditors „ Share security § Similarly to asset security, this is a scenario where lenders have a pledge over the shares of a particular company or operating entity. This enables the lender, in a default scenario, to sell the shares of the company to repay debt. While this is a valuable option, it is arguably less attractive than asset security which enables a lender to sell off assets piecemeal as well as in their entirety as would be the case in a share sale. In addition, a sale of shares would mean that the entity sold would have to be sold with its various obligations and encumbrances intact so that, for instance, the trade payables at the company would effectively rank ahead of the lender enforcing on the share security „ Guarantees § This is an obligation which an entity provides to another entity to support an obligation. guarantee can take a secured (i.e. benefiting from asset security) or unsecured form 9
The
The concept of fixed and floating charges is an English law distinction which in other jurisdictions varies in terminology and nature.
188
„ First vs second ranking security § The above forms of security can be taken in first ranking form or second ranking form, whereby the lenders enjoying the second lien would receive enforcement proceeds only after the first lien debt has been repaid In addition to security, debt can have differing forms of seniority or subordination in the capital structure. „ Senior debt typically takes loan form and is the first recovery component of the capital structure § For non-investment grade transactions, the senior debt typically enjoys security over the company’s assets and/or shares as a means of ensuring this first priority ranking in the capital structure § Forms of senior debt include term loan facilities, revolving credit facilities and securitisation transactions § Typically in investment grade loans or bonds, the lenders do not benefit from any security at all or at most, an unsecured guarantee from the company’s operating subsidiaries. However, this debt would still often rank senior in the capital structure by virtue of there being no priority debt ahead of it „ Subordinated debt has a ranking below that of senior debt in a company’s capital structure § Forms of subordinated debt include high yield bonds, mezzanine loans and PIK debt. These forms of debt have various levels of subordination in a company’s capital structure § Debt can be subordinated either by legal contract (contractual subordination) or by way of structure (structural subordination) whereby the debt could be raised at a holding company one step removed from the company’s operating entity and as such is subordinated to the debt residing at the operating entity itself § This subordinated debt is cushioned against a first loss on insolvency by a company’s invested equity, but takes losses afterwards The chart below sets out the various securities available to a company, differentiated by the seniority of such instruments: Expected and Required After-Tax Rate of Return
(%) Common Stock PIK Preferred Stock
Holding Company
Cash Pay Preferred Stock Subordinated Note
Risk Premium
Senior Debenture (Unsecured) Senior Secured Note / Mortgage Note Common Stock PIK Preferred Stock Cash Pay Preferred Stock
Operating Company
Subordinated Nte Senior Debenture (Unsecured)
Risk-Free Rate of Return
Senior Secured Note / Mortgage Note
Rf
Short Term Government Treasury Bill
0 Risk to Investors
(s )
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1.3.3.
Covenants
In order to protect the interests of lenders, debt is usually structured with various covenants to govern the behaviour of a company or act as an early warning system in the event of underperformance by the company. Covenants can take various forms, a summary of which is set out below: „ Maintenance based covenants § Financial maintenance covenants are found in non-investment grade as well as certain investment grade bank debt and govern the behaviour of a company by asking the company to report and maintain certain actions or credit ratios. For instance, a loan may have a Debt / EBITDA ratio threshold which the company must adhere to on a quarterly basis – if the ratio test is not met in any particular quarter, this would represent an event of default under the loan. These maintenance covenants are structured to provide the company with a certain level of headroom to act as a buffer in the event of temporary underperformance of the business § Financial covenants include measurements of (i) minimum earnings or cash flow measured by ratios such as cash flow to interest, debt service and fixed charges, (ii) maximum leverage, measured by Senior Debt / EBITDA and Total Debt / EBITDA and (iii) adequate liquidity. In addition, the covenants may stipulate a minimum tangible net worth or maximum level of capital expenditure § As well as maintenance covenants, bank debt has positive covenants which enforce certain behavioural conditions on companies. An example of this is a reporting covenant which requires borrowers to provide lenders with regular updates on their performance and the requirement to maintain a certain level of insurance cover § In addition to maintenance covenants, bank debt also has certain negative covenants which limit a company’s ability to undertake certain actions, such as combining with other companies, making acquisitions or taking on additional debt „ Incurrence based covenants § Incurrence covenants are found in bonds and govern the behaviour of a company through limiting its ability to undertake certain actions § An example of an incurrence covenant is a debt incurrence test, which limits the amount of new debt a company can incur (for instance through a certain interest coverage ratio). If the ratio test is met i.e. threshold is not breached, the company is permitted to raise new debt. However, unlike with maintenance covenants, the ratio test is not performed on a recurring basis, but only at the time the specific action is taken „ Example: key high yield bond covenants § Limitation on debt incurrence – a restriction on the amount of additional debt that the company can take on post-offering (e.g. only up to amounts such that pro forma EBITDA / Interest Expense remains above a certain pre-determined level, often 2.0x) § Restricted payments – a restriction on what the company can do with its excess cash. Usually based on a formula that prevents the company from using any more than 50% of its cumulative net income (beginning at an agreed point in time and less 100% of cumulative net losses for the same period) for certain payments, including dividends, purchases or retirements of equity of the company or restricted investments § Asset sales – the net proceeds of any asset sales must be a certain percentage in cash (typically 80%) and those proceeds must be used within a certain time period (typically 365 days) to (i) reinvest in replacement assets, (ii) repay outstanding senior debt or (iii) make an offer to repurchase the notes at their principal amount § Liens – prevents the company from incurring any lien on any asset (whether or not owned at the time of the offering), with the exception of certain liens which are permitted (so called Permitted Liens). A subordinated debt instrument typically permits senior bank debt to be secured § Merger – prevents the company from effecting a merger that would impair its credit quality. For instance, the surviving entity must assume all the obligations of the company under the high yield and the merger must not cause an event of default under the notes § Transactions with affiliates – prevents any transactions with affiliates of the company that are not a part of the ordinary course of business or which are not fair and reasonable to the company (e.g. the terms are less favourable than they would be in a transaction made on an arm’s length basis with an unaffiliated party)
190
§ Change of control – if the ownership of the company changes hands (or ownership changes beyond a certain defined threshold), the bondholders can require, at their option, that the company repurchase the notes at 101% of the aggregate principal amount of the bonds § Reporting – the company must furnish the bondholders with (i) all quarterly and annual financial information that would be required in a 10-Q or 10-K and (ii) all reports that would be required to be filed under form 8-K
1.4.
Key Products
1.4.1.
Overview for Non-Investment Grade Debt
Non-Investment grade debt is rated below BBB- by S&P and below Baa3 by Moody’s. The key facets of these forms of debt which differentiate them from each other are: „ Security and ranking (see section 1.3.2 of this chapter) § As discussed above, bank debt typically ranks senior in a company’s capital structure whereas bond debt often ranks junior. It should be noted, however, that bonds can take the form of senior secured instruments and as such could have similar pricing to senior secured bank debt „ Maturity § Bank debt typically has a shorter maturity (5-9 years for non-investment grade) than bonds (7-10 years) „ Amortisation profile § Bank debt can have an amortising profile (typically, term A loans have a 5-7 year maturity and have annual scheduled repayments) or a bullet repayment profile (typically, term B and C loans have an 8 or 9 year maturity and are repayable in whole at maturity) § Bonds are typically bullet repayment instruments (although very rarely, they can have sinking fund requirements whereby some payments are required in advance of maturity) „ Pricing § Given the differing repayment profile, ranking and security that bonds and bank debt typically enjoy, as a general matter bank debt is cheaper than bonds. However, as noted above, bonds can be structured to rank senior in a company’s capital structure and as such can be similarly priced to bank debt § Interest on bank debt is typically floating rate in nature (paying a percentage margin of EURIBOR or LIBOR) whereas bonds can either be floating rate or fixed rate „ Covenants § Bank debt typically has maintenance covenants whereas bonds typically have incurrence based covenants „ Ratings § Bonds tend to be rated by the rating agencies whereas this is less common for bank debt „ Mezzanine is often structured to have some bond-like and some bank-like properties. The chart below sets out a standard profile for this form of debt, although mezzanine transaction and indeed all forms of non-investment grade debt, are tailored to specific borrower’s needs and investor perception
191
The following chart sets out the major forms of non-investment grade debt available to a company.
Ranking/Security
Bank Debt
High Yield Bonds
Mezzanine
„ Senior secured
„ Senior unsecured
„ Second lien or
„ Subordinated
unsecured „ Subordinated „ Can be with warrants
attached to provide increased returns Maturity
„ Up to 9 years
„ 7–10 years
„ 7–12 years
Pricing
„ Floating rate
„ Fixed rate
„ Floating rate
„ EURIBOR / LIBOR
„ Relevant Treasury
„ EURIBOR/LIBOR
„ No call in first 3–5
„ No call in the first 6
based Optional Redemption
„ Pre-payable at any time
without penalty or premium
years then at premium (initially at 50% of coupon rate)
months to 2 years. „ Callable thereafter at
a modest premium
Scheduled Amortization
„ Amortising / Bullet
„ Bullet maturity
„ Bullet maturity
Financial Covenants
„ Maintenance covenants
„ Incurrence covenants
„ Maintenance
covenants with headroom over bank debt
„ Maximum leverage „ Minimum interest
coverage „ Minimum fixed charge
coverage „ Minimum net worth „ Maximum capital
expenditures Mandatory Prepayments
„ Excess cash flow
„ Asset sales
„ Asset sales
„ Required offer to
„ Event of default
sweep „ Asset sales „ Issuance of debt
securities „ Issuance of equity
securities Change of Control
„ Event of default
purchase at 101% Registration and
„ None (private)
Marketing Process
„ Bank meeting
„ 144A with registration
rights (public) „ Roadshow
1.4.2.
„ None (private) „ Bank meeting or
negotiated with small group of investors
Overview of Investment Grade Debt
Given the lower likelihood of default by investment grade companies, investment grade debt tends to have less structured terms and be more standard in nature. The key facets of investment grade debt instruments are as follows: „ Security and ranking § As noted above, typically in investment grade loans or bonds, the lenders do not benefit from any security at all or at most, an unsecured guarantee from the company’s operating subsidiaries. However, this debt would still often rank senior in the capital structure „ Maturity § The maturity of investment grade loans can vary from 1 to 7 years. Bonds can have even longer maturities, with 30 year tenors not being uncommon and some bonds having perpetual maturities „ Amortisation profile § As with non-investment grade loans, investment grade loans can be amortising or bullet in nature § Similarly, investment grade bonds are typically bullet repayment instruments
192
„ Pricing § Interest on bank debt is typically floating rate in nature (paying a percentage margin of EURIBOR or LIBOR) whereas bonds can either be floating rate or fixed rate „ Covenants § For very highly rated investment grade corporates, the debt tends to have very limited covenant protection. To the extent that there is covenant protection, this tends to be limited to major issues such as a change of control provision (requiring a prepayment of the debt in a change of control scenario) and a negative pledge (preventing the company from pledging its assets to another party)
1.4.3.
Other Products
There are several other debt or debt related products available to issuers. Given the flexibility hedge funds have over the investments they are able to make, debt products particularly for non-investment grade issuers are increasingly tailored to meet their specific needs. Set out below are two relatively popular innovations in the credit market. „ Hybrid bonds § These are bonds which are structured to receive partial equity treatment from the rating agencies and are in many ways similar to preferred equity. As such, they have been devised to bolster a company’s credit rating, while continuing to enjoy the benefits of being debt (tax deductibility and fixed coupon) § Hybrids can vary in nature depending on the amount of equity treatment received, but typically have long tenors (e.g. 60 years), limited or no covenants and the ability to defer cash interest „ Pay in Kind (“PIK”) bonds or loans § PIK bonds or loans are instruments which accrue interest rather than pay cash interest. These instruments also typically rank subordinated in a company’s capital structure and act as a means of raising incremental leverage without increasing the cash interest service burden on the company § PIKs are often used in sponsor acquisitions as a partial replacement for equity so as to maximise returns to the equity holders
1.5.
Credit Related Analyses
1.5.1.
Overview of Debt Comparable Company Analysis
Credit comparables analysis is used to compare the credit strength, debt trading levels and operating and financial ratios of the companies in an industry. These are used to inform judgements about total levels of debt used in comparable transactions, the impact of increased debt on credit ratios and as a consequence, the market’s attitude at a given point in time to leverage levels and expected bond pricing for a particular company or industry. This can then be used along with a more detailed company specific analysis, as well as ratings guidance, to establish views on appropriate debt levels for particular companies and expected debt pricing and yields. Specifically, credit comparables: „ Show how a company’s bonds are trading and how the public markets are valuing these bonds relative to peer group „ Form the basis for pricing benchmarks for a client considering a bond offering „ Analyses the potential ratings impact of a capital structure contemplated in the context of a debt capital raising (see section 2 in this chapter)
193
1.5.2.
Key Credit Ratios and Metrics
The credit ratios which are considered in evaluating an entity’s credit quality essentially compare various operating and financial metrics for a company with their levels of debt. Although valuations are important in this analysis, the metrics used tend to focus on cash flows given the importance of cash flows for the servicing of debt. Whilst there are certain industry specific metrics which can be used to compare the credit profiles of certain companies, the credit statistics most commonly used in undertaking capital structure related credit analyses are as follows: „ Leverage ratios – the amount of debt a company has as a multiple of its cash flow or overall capital structure: § Senior Debt / EBITDA § Total Debt / EBITDA 10
§ Total Debt (including the value of operating leases) / EBITDAR § Total Net Debt / EBITDA § Total Debt / Capitalisation
– Capitalisation is defined as the balance sheet values of a company’s debt plus preferred plus book equity § Total Debt / Enterprise Value „ Coverage ratios – the amount of cushion between a company’s cash flow and required debt service payments: § EBITDA / Interest § EBITDA / Net Interest § (EBITDA-Capex) / Interest § Fixed charge cover
– Defined as a company’s FCF divided by its debt service (interest plus scheduled debt amortisation payments) § Other
– EV / EBITDA These metrics are typically considered on an historical (e.g. LTM or in high growth sectors, Latest Quarter Annualised – “LQA”) basis, although when analysing projections, these same metrics are also considered on a look forward basis. Examples of the metrics used for specific industry based analyses include debt per subscriber, which is sometimes used in the cable sector and debt / appraised land value which is used in the real estate market. As noted, however, the credit ratios identified above represent the most important and commonly used statistics in the credit comparisons which are undertaken.
1.5.3.
Sources and Uses
This is a table used to chart the sources and uses of funds in a transaction. On the sources side, this consists of the debt to be raised, any equity invested as well as any other sources of funds (e.g. existing cash on the company’s balance sheet). In terms of uses, this will include the debt to be repaid, funds used to purchase an asset (in an acquisition scenario), fees and expenses as well as any other use of proceeds for the financing.
10
Particularly used for lease heavy businesses such as retailers
194
The following table is an example of the sources and uses for a transaction: Total Sources Revolver
$m –
% of Total –
Total Uses Acquisition of Target
$m 8,300
% of Total 66.7%
Tranche A
1,750
14.1%
Tranche B
750
6.0%
Refinance Senior - Acquiror
1,938
15.6%
Refinance Debt - Target
1,700
Tranche C
750
6.0%
13.7%
Fees & Expenses
350
3,400
2.8%
27.3%
Restructuring Overfunding
250
2.0%
6,650
53.5%
Cash Generated by Acquiror
(100)
(0.8%)
New High Yield
2,788
22.4%
New Securitisation
1,500
12.1%
500
4.0%
11,438
92.0%
Tranche B (US) Total Bank Debt
PIK Notes Total Debt New Cash Equity Total
1.5.4.
1,000
8.0%
12,438
100.0%
Total
12,438
100.0%
Capitalisation Table
This is a table used to chart the capital structure of a company at a fixed historical date and is typically presented on an existing and pro forma basis. The capital structure will be set out to show cash, various pieces of debt in the company’s capital structure and its equity position. In addition, the credit statistics for the company are often shown as part of the capitalisation table as well. The table below is an example of a capitalisation table for a transaction:
Revolver Term Loan A Term Loan B Term Loan C Term Loan B (US) Total Bank Debt Securitisation Facilities Total Senior Debt 2027 Existing Notes US Private Notes Existing High Yield New High Yield Total Cash Pay Debt PIK Notes Total Debt Equity Contributed by Acquiror New Equity Invested by Sponsor Total Equity Total Capitalisation June 30, 2005 LTM Adjusted EBITDA(1) Acquiror Target Synergies Combined 2005E EBITDA Acquiror Target Synergies Combined Total Cash Pay Debt / LTM EBITDA Total Cash Pay Debt / 2005E EBITDA Total Debt / LTM EBITDA Total Debt / 2005E EBITDA
Current Acquiror Capital Structure – 654.2 642.1 642.1 – 1,938.3 605.7 2,544.0 279.8 72.7 1,211.4 – 4,107.9 – 4,107.9 1,064.0 1,064.0 5,171.9
948.0
948.0 1,024.9
1,024.9 4.3x 4.0x 4.3x 4.0x
Adjustments Refinanced New Debt (654.2) (642.1) (642.1) – (1,938.3) – (1,938.3) – – – (1,938.3) (1,938.3) – – 1,938.3
1,750.0 750.0 750.0 3,400.0 6,650.0 1,500.0 8,150.0 – – – 2,788.3 10,938.3 500.0 11,438.3 – 1,000.0 1,000.0 12,438.3
Combined Capital Structure – 1,750.0 750.0 750.0 3,400.0 6,650.0 2,105.7 8,755.7 279.8 72.7 1,211.4 2,788.3 13,107.9 500.0 13,607.9 1,064.0 1,000.0 2,064.0 15,671.9
948.0 1,679.0 250.0 2,877.0 1,024.9 1,745.3 250.0 3,020.2 4.6x 4.3x 4.7x 4.5x
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1.6.
Issues to Consider
1.6.1.
Key Aspects of the Analysis
„ Select appropriate sources of information § Information required includes financial statements, ratings and offering size „ Use the right set of comparables § Use industry group input on the relevant comparable companies § The selection of the relevant comparables will require a great deal of judgement, but as a general rule will be determined based on industry, size, growth profile, credit ratings and capital structure „ Find the best comparable bonds § Input from High Yield / Debt Capital markets will be required but the key determinants for selecting comparable bonds are similar ranking, currency and maturity „ Basic data on comparable bond trading § Data required includes a brief description of the company, size of the bond, maturity, bond rating, price, yield and spread to the relevant benchmark
1.6.2.
Sources of Information
„ Financial statements § Company websites, library, external research and EDGAR „ Projections § Company information, where available § Published research should also be used whether or not company information is available, to benchmark the projections provided by the company „ Ratings § Moody’s, Standard & Poor’s, Bloomberg (CPRAT function) „ Bond yields § High Yield / Debt Capital Markets „ Treasury / Bond yields § Bloomberg (BTMM, PX1, PX GE, PX UK) „ Bond offering details § Company information, Bloomberg
1.7.
Common Pitfalls
„ Key items not broken out § Often companies show net interest expense instead of separating Gross Interest Expense and Interest Income. If so, use the full number in the annual report and footnote it „ Debt § Remember to include Finance Lease Obligations and Short Term Debt in the calculation of debt „ Non-recurring items § Make sure adjustments are made for items such as restructuring charges, gains (losses) on sales of assets or write offs „ Recent financial activity § Intra-period acquisitions and disposals should be adjusted to ensure the credit statistics are pro forma
196
„ Make sure consistent adjustments are made § For instance, if an adjustment for a company’s pension shortfall is included in the leverage multiple, make sure that EBITDA is adjusted to take out pension contributions (so the numerator and denominator are consistent) and make similar adjustments for the comparable universe § Seek guidance from High Yield / Debt Capital markets on which metrics are most relevant. For instance, in certain sectors such as retail, it is relevant to consider (Debt + Operating Leases) / EBITDAR (i.e. EBITDA plus rental payments) as well as Debt / EBITDA
1.8.
Credit Comparables and Term Sheet Examples
1.8.1.
Credit Comparables Example
Technology Industry – Semiconductors
Issue (1) Principal Amount Coupon First Call Date Maturity Rating (Moody's / S&P) Price (2-May-06) YTW STW (bps)
Advanced Micro Amkor Hynix Freescale MagnaChip STATS Devices Technology Semi Semiconductor Semiconductor Spansion ChipPAC Sr Nts Sr Nts Sr Nts Sr Nts Sr Sub Nts Sr Nts Sr Sec Nts $600.0 $425.0 $300.0 $500.0 $250.0 $250.0 $215.0 7.750% 7.750% 9.875% 7.125% 8.000% 11.250% 6.750% 01/11/2008 5/15/2008 01/07/2009 7/15/2009 12/15/2009 1/15/2011 11/15/2008 01/11/2012 5/15/2013 01/07/2012 7/15/2014 12/15/2014 1/15/2016 11/15/2011 B1 / B Caa1 / CCC+ B1 / B+ Ba1 / BBBB2 / B- Caa1 / B Ba2 / BB 104.000 6.70% +176
95.250 8.66% +367
109.875 7.53% +258
103.250 6.48% +150
93.000 9.19% +416
103.250 10.61% +560
97.250 7.36% +240
Cash Bank Debt Convertible and Other Subordinated Debt
$1,794.8 $270.3 1,100.0
$206.6 $417.1 1,723.6
$1,267.3 $1,170.0 710.0
$3,025.0 $1,237.0 0.0
$71.0 $511.1 250.0
$725.8 $378.7 380.9
$290.1 $475.2 346.5
Total Debt Net Debt
$1,370.3 (424.5)
$2,140.6 1,934.1
$1,880.0 612.7
$1,237.0 (1,788.0)
$761.1 690.1
$759.6 33.8
$821.7 531.7
$16,441.6 16,017.1 2.7x 10.8x
$1,547.3 3,481.4 1.7x 10.8x
$12,712.1 13,324.8 2.4x 5.3x
$11,173.9 9,385.9 1.6x 7.1x
N/A N/A N/A N/A
$1,938.9 1,972.6 1.0x 7.4x
$1,507.8 2,039.4 1.8x 7.3x
$5,847.6 1,487.8 25.4% $1,513.0
$2,099.9 323.8 15.4% $295.9
$5,620.0 2,520.0 44.8% $2,440.0
$5,843.0 1,317.0 22.5% $491.0
$858.4 177.6 20.7% $53.1
$2,002.8 267.1 13.3% $431.8
$1,157.3 279.0 24.1% $209.3
0.2x 0.7x
1.3x 5.3x
0.5x 0.3x
0.9x 0.0x
2.9x 1.4x
1.4x 1.4x
1.7x 1.2x
0.9x (0.3x) 1.2x 8.6%
6.6x 6.0x 0.7x 61.5%
0.7x 0.2x 0.5x 14.1%
0.9x (1.4x) 6.2x 13.2%
4.3x 3.9x 1.3x N/A
2.8x 0.1x 1.7x 38.5%
2.9x 1.9x 1.4x 40.3%
Market Value of Equity Enterprise Value Enterprise Value / Revenue Enterprise Value / EBITDA LTM Revenue LTM EBITDA Margin % Capital Expenditures Bank Debt / EBITDA Convertible and Other Subordinated Debt / EBITDA Total Debt / LTM EBITDA Net Debt / LTM EBITDA Cash / Capex Total Debt / Enterprise Value
Source: Note: (1)
Company information, Bloomberg, Factset, Credit Suisse Exchange rates based on Balance Sheet date for Balance Sheet figures and period / yearly average for P&L and Cash Flow figures Total capital raised may be higher than principal amount, tranche displayed represents the most liquid tranche
197
1.8.2.
Summary Term Sheet Examples
Senior Credit Facilities – Indicative Term Sheet Borrower
TBA
Lead Arranger, Bookrunner and Agent
Credit Suisse
Principal Amount
€709 million, split as follows: Term Loan A:
€178 million
Term Loan B:
€178 million
Term Loan C:
€178 million
Term Loans A, B, C to be available in EUR, USD, GBP in splits to be agreed Revolving Facility:
€50 million (drawn in EUR and other currencies to be agreed)
Acquisition Facility: €125 million (drawn in EUR and other currencies to be agreed) Tenor
Senior Term Loan A amortising, final repayment 7 years from completion with average loan life of no more than 4.5 years Term Loan B: 8 year bullet maturity Term Loan C: 9 year bullet maturity Revolving Facility: 7 year maturity Acquisition Facility: 7 year maturity; 3 years availability, amortising in equal semiannual instruments over remaining 4 years
Purpose
Term loans A, B, C: to (i) refinance existing indebtedness; (ii) pay portion of the acquisition price; and (iii) pay related fees and expenses Revolving Facility: To fund working capital and for general corporate purposes Acquisition Facility: To fund Permitted Acquisitions together with associated costs and expenses
Ranking
Senior secured (to the extent permitted by law)
Interest Rate
The aggregate of: (i) the Margin; (ii) EURIBOR; and (iii) reserve asset costs (if applicable)
Margin
Term Loan A: 225 bps Term Loan B: 275 bps Term Loan C: 325 bps Revolving Facility: 225 bps Acquisition Facility: 225 bps Term Loans A and B together with Revolving and Acquisition Facilities will be subject to an interest margin ratchet based upon Total Net Debt to EBITDA.
Financial Covenants
To include Leverage, Interest Coverage, Cashflow and Capex Tests - headroom 20% - 25% above the agreed base case
Security
Full security package to the extent legally and practically possible
Events of Default
Usual for transactions of this nature
Conditions Precedents
Usual for transactions of this nature, to include due diligence reports
Voluntary Prepayment
At par at anytime (subject to breakage costs)
Mandatory Prepayment
Typical for these transactions, to include change of control, listing and sale, disposals, surplus cash, vendor payments, insurance proceeds
Governing Law and Forum
English Law
Counsel to Credit Suisse
Clifford Chance and Cravath, Swaine & Moore
Market Flex
To be discussed
Fees
2.25% Commitment Fee on Revolving and Acquisition Facilities: 0.75% per annum
Note:
198
Integration costs to be covered by the Revolving Credit Facility or the Acquisition Facility
European Second Lien Facility Borrower
TBA
Lead Arranger, Bookrunner and Agent
Credit Suisse
Amount
€120 million
Tenor
Six months after the final maturity of the Senior Credit Facilities
Purpose
To: (i) refinance existing indebtedness; (ii) pay portion of the acquisition price; and (iii) pay related fees and expenses
Ranking
Second secured plus benefits from sub guarantees (intercreditor agreement)
Interest Rate
EURIBOR; and Cash Margin
Margin
4.50 - 4.75% per annum cash pay or a 2% spread differential to the Floating Rate Notes
Financial Covenants
Same as for the Senior Credit Facilities
Events of Default
Same as for the Senior Credit Facilities
Conditions Precedents
Same as for the Senior Credit Facilities
Prepayment Penalty
103, 102, 101
Other
Votes with Senior Credit Facility Independent right of acceleration upon payment default (following a standstill)
Fees
2.50%
European Permanent Mezzanine Loan Facility Borrower
TBA
Lead Arranger, Bookrunner and Agent
Credit Suisse
Amount
€275 million
Tenor
One year after the final maturity of the Senior Credit Facilities, but at least upon tenth anniversary from closing
Purpose
To: (i) refinance existing indebtedness; (ii) pay portion of the acquisition price; and (iii) pay related fees and expenses
Ranking
Second secured plus benefits from sub guarantees (intercreditor agreement)
Interest Rate
The aggregate of: (i) EURIBOR; and (ii) the Cash Margin, (iii) an accruing semiannually compounding PIK margin
Margin
4.0% per annum cash pay (with semi-annual interest payments); 6.5% per annum PIK
Financial Covenants
Standard for financings of this nature, set at a 10% cushion to the covenants under the Senior Credit Facilities, and including financial undertakings substantially similar to the Senior Credit Facilities
Events of Default
Usual for transactions of this nature
Conditions Precedents
Usual for transactions of this nature, to include due diligence reports
Prepayment Penalty
102, 101
Fees
2.75%
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High Yield Senior Notes Issuer
TBA
Lead Arranger and Bookrunner
Credit Suisse
Issue:
Senior Notes (the “Notes”)
Distribution:
Private Placement via Rule 144A (without registration rights)
Principal Amount:
€275 million
Indicative Rate:
8.5%
Maturity:
10 years
Interest:
Semi-annual cash coupon
Ranking:
The Notes will rank pari passu to all existing and future Senior Indebtedness, including any Senior Credit Facilities, and rank senior to all subordinated debt of the Company.
Call Protection:
5 year non-call (10 year maturity); best efforts at NC4
Optional Redemption:
Redeemable at the option of the Company at any time after the after the 5th anniversary at a premium equal to one half the coupon declining ratably to Par at the end of the 8th anniversary
Equity Clawback:
Up to 35% of the Notes may be redeemed at any time prior to the 3rd anniversary of the Issue Date at a premium with the proceeds of one or more public equity offerings of the Company’s Common Stock
Change of Control Put:
In the event of a Change of Control, the Company will be obligated to make an offer to redeem a holder’s Notes at a redemption price of 101% of the principal amount of the Notes plus accrued and unpaid interest to the Redemption Date
Guarantees:
All domestic subsidiaries
Certain Covenants:
Incurrence Covenants Only (No Maintenance Covenants): Limitation on Indebtedness Limitation on Restricted Payments Limitation on Mergers and Consolidations Limitation on Asset Sales Limitation on Payments Restrictions Affecting Subsidiaries Limitation on Transactions with Affiliates Limitation on Liens
200
PIK Notes Indicative Term
PIK Notes
Borrower
TBA
Amount
€300-350 million
Issue Price
99%
Ranking
Senior Unsecured
Interest Rate
6 Month EURIBOR (Currently 2.177%) + 800bps
Guarantees
None
Security
None
Currency
€
Maturity
2015 (10 years from the date of closing)
Equity Clawback
None
Placement
Rule 144A / Reg S (no registration rights)
Covenants
Standard incurrence tests for an issuance of this type with selected additional covenants relating to the HoldCo PIK transaction and the intermediate holding company including, but not limited to: „ No incurrence of ratio debt if Consolidated Leverage > 5.5x „ The Issuer shall not incur any other indebtedness than the PIK Notes „ No further distributions to shareholders
Optional Redemption
Option A: Non-call 6 months, 101% 6-18 months, 102% in 18-30 months, 101% in 30-42 months, par thereafter Option B: Non-call 12 months, par 12-24 months, 102% in 24-36 months, 101% in 36-48 months, par thereafter
Step-up
200bps after third anniversary subject to leverage test at [2.5]x
2.
Overview of Ratings Analysis
2.1.
Overview
2.1.1.
The Role of the Rating Agencies in the Financial Markets
There are three leading credit rating organisations: Moody’s Investors Service, Standard & Poor’s and Fitch. The rating agencies are independent organisations and their role is to assign credit ratings which represent an opinion of the general creditworthiness of an obligor or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors. A rating does not constitute a recommendation to purchase, sell or hold a security.
2.1.2.
The Rating Scale
Ratings are independent, objective opinions on the future ability and legal obligation of an issuer to make timely payments of interest and principal on its financial commitments. These can either be assigned to a legal entity (Issuer Rating) or to a specific debt instrument (Short or Long Term Debt Rating). There is a separation of investment grade (AAA to BBB-) and non-investment grade ratings (BB+ and below). An investment grade rating views the obligor’s capacity to meet its financial commitment to the obligation from extremely strong (AAA) to adequate (BBB). Non-investment grade ratings are regarded as having significant speculative characteristics. While such obligations likely will have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposure to adverse conditions. As a practical matter, issuers can only access the capital markets with ratings of Caa2 / CCC or better since low CCC and below means default.
201
The Rating Scale S&P
Moody’s
Short - Term Rating
Investment Grade
Long - Term Rating
A-1+ A-1
Below Investment Grade
A-2
A-3
Short - Term Rating B
P-1
P-2
2.1.3.
P-1
Short - Term Rating
N.P.
F1+ F1
AAA AA+ AA AAA+ A ABBB+ BBB BBB-
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
AAA AA+ AA AAA+ A ABBB+ BBB BBB-
BB+ BB BBB+ B BCCC+ CCC CCCCC C D
Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C
BB+ BB BBB+ B BCCC+ CCC CCCCC C DDD DD D
General correlation of ST and LT rating Source: Note:
Fitch
F2
F3
B
C
D
Only in exceptional circumstances
S&P, Moody’s and Fitch N.P. = Not Prime
Ratings Definitions
There is more than just one type of rating available to issuers: Debt Ratings (Short- and/or Long-Term)
„ A rating assigned to a public or private issue of debt and
Indicative Ratings
„ A non public, informal rating, at a single point in time, assigned
Issuer Ratings
„ A public rating assigned at the senior unsecured level albeit
monitored throughout the debt’s life to an issuer contemplating a debt issue that there may be no debt outstanding at that level Syndicated Loan Ratings
„ A rating assigned to a syndicated bank loan and monitored
throughout the life of the loan (may also be private and not monitored)
Indicative ratings are often used by bankers or issuers in trying to assess cost of capital or optimal structures.
2.2.
Rating Methodology
2.2.1.
Fundamentals of Credit Analysis for Ratings
The ratings analysts’ focus is on stability and downside protection; they view investors as their key clients who they have to protect, therefore they: „ Take a bondholder perspective (i.e. focus on cash flows and cash adequacy) „ Evaluate the ability of the borrower’s capacity and willingness to meet financial obligations to lenders / investors as they come due „ Look for evidence of contingency planning and financially responsible growth plans „ Assess the severity of loss and recovery for different classes of creditors in a bankruptcy (structural assessment) „ Adopt forward-looking time horizon (1-3-5 years)
202
The ratings analysis takes into account the industry fundamentals as well as the specific business and financial profile of a company:
Agency Factors „ Sector outlook „ Rating
methodologies „ Ratio selection,
definitions „ Peer group
selection „ Lead analyst’s
experience, knowledge and biases „ Lead analyst’s
credibility „ Rating committee
makeup „ Cross-regional
differences „ Cross-agency
differences „ Inter-agency
influences „ Relative weighting
– Past results vs. – Present –
condition vs. Future expectations – Near-term vs. longterm
Business Risk (Qualitative)
Financial Risk (Quantitative)
External Factors
Notching Factors
Industry Characteristics
Financial Policy
„ Guarantees
„ Claim priority
„ Risk tolerance
„ Support
„ Collateral
„ Maturity „ Cyclicality „ Competitive
dynamics Diversification „ Geographic „ Product
„ Historical record „ Dividend policy
Profitability „ Level and
Capital Structure
„ Efficiency
Management „ Experience,
competence „ Corporate
governance „ Credibility
Event Risk „ M&A, spin-offs,
reorgs „ Share buybacks,
LBOs „ Litigation „ Regulation
„ Sovereign
ceilings
measures
„ Market share
„ Technology
„ Covenants
volatility
„ Growth,
„ Business model
security
„ Implied support
„ Trends of key
Competitive Position and position
agreements
margins, returns „ Asset quality „ Balance sheet
leverage „ Off-B/S
obligations Cash Flow Protection „ Capex
requirements „ Debt service
capacity „ Interest rate
sensitivity Financial Flexibility „ Availability of
loans „ Access to
capital markets „ Maturity profile „ Contingency
plans „ Liquidity
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2.2.2.
Financial Analysis: Key Credit Ratios
S&P’s formulas for key ratios: EBIT interest coverage
=
Earnings from continuing operations before interest and taxes Gross interest incurred before subtracting capitalized interest and interest income
EBITDA interest coverage
=
Adjusted earnings from continuing operations before interest, taxes and D&A Gross interest incurred before subtracting capitalized interest and interest income
FFO*/Total debt
=
Net income from continuing operations + D&A, deferred income taxes and other non-cash items Long-term debt** + current maturities, commercial paper and other short-term borrowings
FOCF/Total debt
=
FFO* - CAPEX - (+) the increase (decrease) in working capital (excluding changes in cash, marketable securities, and short-term debt) Long-term debt** + current maturities, commercial paper and other short-term borrowings
Return on Capital
=
EBIT Average of beginning of year and end of year capital, including short-term debt, current maturities, long-term debt**, non-current deferred taxes, minority interest and equity (common and preferred stock)
Operating income/Sales
=
Sales - cost of goods manufactured (before D&A), SG&A costs and R&D costs Sales
Long-term debt/Capital
=
Long-term debt** Long-term debt** + shareholder’s equity (including preferred stock) + minority interest
Total debt/Capital
=
Long-term debt** + current maturities, commercial paper and other short-term borrowings Long-term debt** + current maturities, commercial paper and other short-term borrowings + shareholder’s equity (including preferred stock) + minority interest
Total debt/EBITDA
=
Long-term debt** + current maturities, commercial paper and other short-term borrowings Adjusted earnings from continuing operations before interest, taxes and D&A
Discretionary cash flow/ Total debt
=
FFO* - CAPEX - (+) increase (decrease) in working capital (excluding changes in cash, marketable securities, and short-term debt) - common and preferred dividends Long-term debt** + current maturities, commercial paper and other short-term borrowings
* Including interest income and equity earnings; excluding nonrecurring items ** Including amount for operating lease debt equivalent and debt associated with accounts receivable sales securitization programs
204
Moody’s formulas for key ratios: EBIT interest coverage
=
EBIT plus other income minus other expense plus foreign currency translation minus other expense Interest expense
Retained cash flow /
=
Total adjusted debt
Operating margin
Gross cash flow minus total dividends (common and preferred) Long term debt plus short term debt plus current maturities, adjusted for operating leases, pension liabilities, hybrids, accounts receivable securitizations and other off-balance sheet obligations
=
EBIT plus other income mi nus other expense plus foreign currency translation minus other expense Net sales
Total coverage
=
EBIT plus other income mi nus other expense plus foreign currency translation plus interest component of rent expense mi nus other expense Interest expense plus interest component of rent expense plus (tax effected preferred dividends)
Total adjusted debt / = Total adjusted capitalization
Long term debt plus short term debt plus current maturities, adjusted for operating leases, pension liabilities, hybrids, accounts receivable securitizations and other off-balance sheet obligations Total adjusted debt plus common shareholder’s equity, minority interest, preferred stock (at liquidation value) and deferred taxes minus cumulative other comprehensive income adjustment
205
2.2.3.
Interpretation of Key Ratios
The table below presents the medians per rating category for industrials. The ratios do not constitute a requirement for any given rating. The Rating Agencies assign ratings through the cycle so in a cyclical industry ratios of a particular company at any point in the cycle may not appear to be in line with its assigned ratings. The business profile of a company, the quality of its management, its track record with the Rating Agencies and the industry fundamentals are the key differentiating factors. Therefore, it is common to have two companies with exactly the same ratios but completely different ratings. S&P Adjusted Key Industrial Financial Ratios Three year (2002-2004 medians)
AAA
AA
A
BBB
BB
B
CCC
EBIT interest coverage (x)
23.8
19.5
8.0
4.7
2.5
1.2
0.4
EBITDA interest coverage (x)
25.5
24.6
10.2
6.5
3.5
1.9
0.9
FFO/total debt (%)
203.3
79.9
48.0
35.9
22.4
11.5
5.0
Free oper. cash flow/total debt (%)
127.6
44.5
25.0
17.3
8.3
2.8
(2.1)
Total debt/EBITDA (x)
0.4
0.9
1.6
2.2
3.5
5.3
7.9
Return on capital (%)
27.6
27.0
17.5
13.4
11.3
8.7
3.2
Total debt/capital (%)
12.4
28.3
37.5
42.5
53.7
75.9
113.5
2.2.4.
Information Requirements for Ratings Analysis
General Corporate Information
„ Company overview „ Ownership structure „ Shareholders overview „ Description of organisation and management „ Strategy and business plan „ Suggested outline of a ratings presentation
Industry Information
„ Industry overview „ Positioning of Company „ Relevant regulatory reports and information „ Market review / Price forecasts „ Peer group financial and operating statistics
Financial Information
„ Previous annual reports and interim statements/pro forma „ Internal budget and financial forecast „ Financial model „ Relevant company disclosures „ Bank loan information memoranda and documentation
Operating Data
„ Historical operating statistics „ Conversion capital expenditures and timing „ Sensitivity to cyclical factors „ Operating statistics forecasts „ Operating costs forecasts
206
2.2.5.
Suggested Outline of a Ratings Presentation
Meeting Objectives
„ Agenda „ Ratings rationale – key credit considerations „ Company snapshot – historical highlights, business description, financial
summary, recent events „ Strategy synopsis
Industry Outlook
„ Fundamentals – growth prospects, growth drivers „ Cyclicality – point in cycle, if relevant „ Barriers to entry „ Capital versus labour intensive „ Importance of technology and R&D developments
Market Position
„ Product and geographic diversification „ Key marketing factors and sales drivers „ Competitive advantages „ Factors influencing pricing power „ value-added characteristics, niches, customer relationships „ R&D capabilities „ New product development „ importance of new products, process for developing new products,
success rate „ Sources of growth – organic versus acquisitions
Operations
„ Analysis of cost structure and cost trends „ Status of manufacturing facilities (if applicable) „ Manufacturing / process technology (if applicable) „ Historic capacity utilization „ Projected capex requirements and capacity utilization „ Systems technology
Management
„ Experience – marketing, operating, financial „ Decision making processes „ Development programs and succession planning „ Acquisition integration skills
Business Strategy
„ General objectives and growth targets „ Acquisition strategy and criteria „ Financial strategy and relation to growth/acquisition strategy; target
leverage ratios Financial Review
„ Historical summary, including credit ratios „ Projections and credit ratios (5 years) „ Downside sensitivity case, where appropriate „ Liquidity position; seasonality of business and working capital needs
2.3.
Distinguishing Ratings of Issuers and Issues
2.3.1.
Notching Guidelines for Debt Ratings
The practice of differentiating debt issues in relation to the issuer’s fundamental creditworthiness is known as “notching”. Securities are notched up or down from the corporate credit rating level. To the extent that certain obligations have a priority claim on the company’s assets, lower-ranking obligations are at a disadvantage because a smaller pool of assets will be available to satisfy the remaining claims. Three forms of disadvantage can arise: „ When the instrument is contractually subordinated the terms of the issue specifically provide that debt holders will receive recovery in a reorganisation or liquidation only after the claims of other creditors have been satisfied
207
„ When the instrument is unsecured while assets representing a significant portion of the company’s value collateralise secured borrowings „ When there is an operating subsidiary / holding-company structure, in which case, if the whole group declares bankruptcy, creditors of the subsidiaries, including holders of even contractually subordinated debt, would have the first claim to subsidiaries’ assets, while creditors of the parent would have only a junior claim, limited to the residual value of the subsidiaries’ assets remaining after the subsidiaries’ direct liabilities have been satisfied. The disadvantage of parent-company creditors owing to the parent / subsidiary legal structure is known as structural subordination Notching practices at S&P and Moody’s differ and can result in different bond and bank loan ratings: Standard & Poor’s
Moody’s
S&P’s Methodology
Moody’s Methodology
„ Notch down lower-priority debt depending on the
„ Assess the percentage of external debt at
percentage of ‘priority liabilities’ relative to all available assets „ Priority liabilities include
subsidiaries relative to total debt outstanding „ However, Moody’s generally applies notching
guidelines according to the type of debt
„ All third-party liabilities (not just debt) of the
subsidiaries „ Trade payables, pension and retiree medical
liabilities, and environmental liabilities „ Any relatively better positioned parent-level
liabilities „ Secured debt, debt collateralised by subsidiary
stock General Guidelines
General Guidelines
Investment grade companies
Structural subordination
„ Notch down parent-level senior unsecured debt by
„ If external debt at subsidiaries represents more than
one if priority liabilities represent greater than 20% of total assets Sub-investment grade companies „ Notch down parent-level senior unsecured debt by
20% of total liabilities, notch down by one for investment grade and by two for sub-investment grade companies Notching types of debt
one if priority liabilities represent greater than 15% of total assets
„ Assess the expected loss severity for each class of
„ Notch down parent-level senior unsecured debt by
„ For investment grade companies, senior unsecured
two if priority liabilities represent greater than 30% of total assets „ S&P will also notch upward any well-secured debt
ratings, up to 4 notches, depending on the expected recovery
debt debt is either at or one notch below the issuer rating „ For sub-investment grade companies, senior
unsecured debt is at or one to two notches below the corporate family rating „ Subordinated debt is notched down from senior
unsecured according to its relative ranking in bankruptcy
2.3.2.
Bank Loan Rating Methodology
Both syndicated bank loans and privately placed debt frequently provide collateral designed to protect the lender against loss if the borrower defaults. In assigning ratings to bank loans, the rating agencies take loss-given-default into account when analysing the recovery prospects of a specific loan. To the extent a loan is secured or contains other loan-specific features that enhance the likelihood of full recovery, the debt rating on that loan can be higher than the borrower’s corporate credit rating. Globally, creditor rights vary greatly, depending on legal jurisdiction. Where syndicated loans or bonds are secured, Standard & Poor’s assigns a recovery rating (and Moody’s is going to introduce the practice as well). The recovery rating scale estimates the likely recovery of principal in the event of default and is de-linked from the corporate credit rating. The recovery rating uses a numerical scale with 1+ and 1 being the two highest rankings, denoting different levels of likelihood that an issue will fully recover principal in the event of default. Recovery ratings below that, from 2 to 5, denote progressively lower levels of expected principal recovery.
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2.4.
Equity Credit: What It is and How an Issuer Gains It
2.4.1.
What is Equity Credit?
The benefit assigned to a security that demonstrates equity-like characteristics: „ Long dated or perpetual (or mandatory conversion) „ Flexibility to defer payments (cumulative or non-cumulative) „ No creditor rights „ Loss absorption deeply subordinated From the Rating Agencies’ perspective, the equity-like instrument’s economic impact is relevant and not the accounting, tax or regulatory treatment. The Rating Agencies evaluate the flexibility that the instrument provides to the issuer compared with pure equity. They assess the instrument’s component features and then allocate a portion to debt and equity. Equity credit and the resultant impact on financial ratios varies by rating agency.
2.4.2.
Equity-Like Features of Hybrid Securities
Rating agencies measure equity credit by the hybrid security’s ability to replicate equity. Attribute
Equity Replication
Deferral
„ Allows for omission of servicing ongoing payments during periods of “financial
Subordination
„ Provides a cushion for senior creditors in the event of bankruptcy or liquidation
Maturity
„ Similar to common equity that has no defined term: perpetual or very long-dated,
stress” without creating an event of default or acceleration
long non-call period and/or call with substitution or refinancing „ Expected to remain a permanent feature of the capital structure
Loss Absorption
„ Limited or no ability to enforce default or acceleration (no negative pledge or
Management Intent
„ Regarding use of proceeds, capital mix, call and replacement
similar covenants)
2.5.
Common Pitfalls
The rating agencies adjust their credit ratios to reflect off balance sheet liabilities and, therefore, it is important not to forget the adjustments as they can have a meaningful impact on the rating outcome.
2.5.1.
Operating Lease Analytics
S&P uses a financial model that capitalises off-balance sheet operating lease commitments and allocates minimum lease payments to interest and depreciation expenses. Not only are debt-to-capital ratios affected but also interest coverage, funds from operations to debt, total debt to EBITDA, operating margins and return on capital. Moody’s analytical goal is to simulate a company’s financial statements assuming it had bought and depreciated the leased assets, and financed the purchase with a like amount of debt. Moody’s approach entails adjustments to the balance sheet, income and cash flow statements. Moody’s applies a multiple to current rent expense to calculate the amount of the adjustment to debt. The number of rent multiples expands from 5x to 10x depending on the sector of activity.
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2.5.2.
PIK Instruments
Rating Agencies view secondary PIK notes typically being sold to third-party investors as a means for shareholders to effectively receive an early cash return from their investment often signalling a change in financial policy from that incorporated in the initial ratings. The calculation of total leverage needs to be adjusted to include any PIK instruments. Shareholder
PIK proceeds PIK
Restricted Group
Holdco (Sr. Unsec. Issuer)
Opco (bank borrower)
Standard & Poor’s
Perimeter of Corporate Credit Rating
Holdco Outside Restricted Group
Moody’s
Important Rating Considerations
Important Rating Considerations
„ Permanence is usually ensured only up to the point
„ The deeply subordinated and non-cash pay nature
where a refinancing would also include other debt „ Cash preservation may be only partial and restricted
to the initial years or the period when certain restrictive covenants limit the ability to upstream dividends to the holding company „ The high coupon level and the impact of
compounding may create an incentive for early refinancing „ Rather than being seen as “long-term capital with
no cash impact”, PIKs could be better characterised as “expensive, initially cash-preserving, subordinated medium-term financing”
of the instrument does not typically create a new contractual claim on cash flows or a liability which will directly and immediately affect the expected loss of other creditor classes „ The issuance of the PIK notes does not have an
immediate impact on the rating due to the limitations imposed by the restricted group as the instruments down-streamed into the restricted group are not affected by the refinancing „ However, by providing a payment to shareholders
earlier than allowed by the terms and conditions of the restricted group it signals a change in the issuer’s financial policy which may well have a negative impact on the issuer’s rating
Impact on Ratings
Impact on Ratings
„ The majority of the PIKs issued resulted in an
„ The majority of the PIKs issued had no impact on
immediate negative impact on ratings or outlooks
ratings or outlooks
However, LBO shareholder loans which serve to provide initial acquisition funding to purchase the LBO asset normally are excluded from the debt calculation, provided that: „ They are PIK for life with no cash flow impact „ They are structurally subordinated to all other debt instruments „ They mature after all other debt instruments „ There is no cross-acceleration of debt obligations to the bond and bank debt group
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2.5.3.
Post-Retirement Obligations
S&P treats all pension obligations the same way whilst Moody’s differentiates between funded and unfunded plans:
Balance Sheet
Standard & Poor’s
Moody’s
Funded and Unfunded Plans
Funded Plans
„ Increase debt by the after-tax amount of
„ Include full pension obligation as debt
Projected Benefit Obligation (“PBO”) and by the full amount of Other PostEmployment Benefits (“OPEBs”) „ Reduce equity by the after-tax difference
between PBO and liability already on the balance sheet
(Defined Benefit Obligation(“DBO”) – FMV of pension trust assets) „ Remove all other pension assets and
liabilities Unfunded Plan „ Remove a portion of the above from
debt based on the company’s capital structure and add to equity Income Statement
Funded Plans
Funded Plans
„ Eliminate all benefit expenses from
„ Reverse all pension costs
operating expenses, except the current service cost „ Increase interest expense by the
benefits-related interest cost less the actual return on plan assets Unfunded Plans „ Eliminate all benefit expenses from
operating expenses, except the current service cost „ Increase interest expense by the
benefits-related interest cost Cash Flow Statement
„ Include service cost in operating costs „ Include interest cost on the DBO in other
income/expense „ Add/subtract actuarial losses/gains on
pension assets in other income/expense „ Reclassify interest expense on pension-
related debt from other income/expense to interest expense Unfunded Plans „ No additional adjustments, but align
interest expense with debt adjustment
Funded Plans
Funded Plans
„ Adjust FFO by the after-tax difference
„ No adjustments if pension contributions
between cash payments and total service & interest costs less actual return on plan assets Unfunded Plans „ Adjust FFO by the after-tax difference
between cash payments and total service & interest costs
are less than service costs „ Recognise service cost as an outflow
from Cash Flow from Operations(“CFO”) „ Reclassify cash pension contributions in
excess of the service cost from CFO to Cash Flow from Financing (“CFF”) Unfunded Plans „ No additional adjustments
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