Landmark Facility Solutions M & A Analysis

LANDMARK FACILITY SOLUTIONS MIDTERM CASE ANALYSIS

Harvard University Faculty of Arts and Sciences Mergers and Acquisitions MGMT E-2720 Spring Term 2016 Professor Kevin F. Wall, C.P.A.; L.L.M.

Alegra N Horne March 23, 2016

CASE DISCUSSION The questions presented below have been included to provide, independent of the taskforce findings, supporting evidence to Broadway’s board members and shareholders. a. Does Broadway benefit from acquiring Landmark? How can Harris justify $120 million bid for Landmark? Broadway’s business strategy involves competing in a highly fragmented and competitive service-oriented business environment. Such competition is based on pricing, level of services, and quality of service. This business combination provides an opportunity to create new economic value for stockholders (additional details in Exhibits 1 and 2). New value is expected to be created in the following ways:  Taking advantage of economies of scale. Broadway’s acquisition could improve Landmark’s operating efficiency and achieve cost reductions. There are redundancies in management positions and non-essential expenses.  Improving target management. Landmark’s high operating costs, had placed it in the bottom quartile of facility management companies, in terms of operating margin, had resulted from managerial complacency and cost management, rather than from some underlying flaw in the company’s business model. Harris is confident that by replacing Landmark’s management team, cutting executive pay and lavish perquisites, and reducing non-essential marketing expenses, Broadway could increase Landmark’s operating margin to 3%.  Combining complementary resources. The most obvious benefit of consolidating the two companies is the elimination of common overhead expenses, such as corporate headquarters, executives, support staff, and redundant office space. Another source of value would involve the management of Landmark’s net working capital; it is believed that the company’s net working capital to sales ratio could be reduced to that of Broadway following improvements in some of Landmark’s processes.  Diversification of services. Typical facility managers in the U.S. provides comprehensive facility services, including janitorial solutions, HVAC, commercial cleaning, facility engineering, energy solutions, landscaping, parking, and security. With global economic power likely to continuing its shift eastwards towards emerging markets. Increasing competition from new players in emerging markets will force companies to search for greater differentiation, and to be innovation in how they adjust their business models and deliver extra value to clients. The consolidation of the two companies will provide a more diversified service platform for existing and new clients.  Creating value through talent management and technology. Technological development and increased knowledge are essential for in the coming years ahead. With global warming becoming a primary sustainability challenge in the coming years, to become for energy- and carbon-efficient, affecting building design, management, and maintenance. Systemic design will become more important. Technological progress increases productivity, leads to the development of new industries and income growth. Beyond

2016, major progress in intelligent technology, such as near field communication (NFC) sensors, smart surveillance, security applications, and smart robots, will enable automation of more activities. Technology will take over more domains and functions as robot technology improves in quality, prices for advanced technologies decline and labor costs increase. Technological development is squeezing low-quality labor out of the market and creating new demands for skill sets. Cleaning, for example, is no longer an issue of “elbow grease.” Security is much more than a pair of eyeballs. New technologies require that people work in more intelligent ways.  Capturing tax benefits. The tax shield that comes from increasing leverage for Landmark due to operating losses that can be offset against its taxable income.  Penetrating new geographies. Moving into new geographies can curtail strong competitive pressures that could inhibit the company’s success in bidding for profitable business and its ability to increase prices as costs rise, thereby reducing margins.  Market power. Landmark is a respected for its high-quality services and expertise, the acquisition could enable Broadway to market some of its services under Landmark’s brand at a premium price. Landmark’s $120 million firm price to Broadway represents a 33 percent premium to its stockholder over its estimated market value of $79,985,555 (est. at $17.74 per share) on September 1, 2014. This is below the mean and median premiums reported for all acquisitions during the year by Mergerstat. In terms of the valuation, an average between the discounted cash flow method and price-earnings multiples were used, Broadway’s pricing appears to be reasonable. The discount applied is 10.11% representing the risk related to its cost of capital. The P/E multiple for other firms in the integrated facility solutions industry that were comparable to Landmark ranged from 35 to 42. Broadway’s offer valued Landmark at 40 times earnings. Short-term results for Broadway suggest that at least on the cost-cutting front the acquisition will result in the expected synergies, as outlined above. The combination of operating and financial synergies could be realized quickly post acquisition. Since, Broadway has a culture of operational efficiency, the replacement of non-performing management, cost costing in nonessential expenses, and a new pricing strategy based on Landmark’s model, could be realized in an increase Landmark’s operating margin to 3% and Broadway’s gross margin to 8.5% as early as 2015. Overall, Broadway benefits from acquiring Landmark. However, the speed at which Broadway is able to consolidate and implement cost-cutting measures are a concern, as the company is presently experiencing a strain in growth, profitability, and eroding operating efficiency to industry peers (additional details in Figure 3A-3F). Even though, Landmark’s equity valuation under expected conditions is falls below expectations, the company should proceed with the deal given the combined synergies of this deal are a plus for Broadway Industries.

b. If Harris were to proceed with the acquisition, which financing alternative should be chosen and why? Would Broadway be capable of servicing its debt after the acquisition?

There are two alternatives for financing this acquisition—100% debt or 50% debt and 50% equity. The understand the effects of each alternative we must look at the company’s capital structure. Because debt financing is an option for acquiring the target shares (100% debt case), Broadway could significantly increase the net financial leverage of Landmark (i.e., the 100% debt financing option could increase Landmark’s leverage by adding value by lowering its tax by increasing the interest tax shield). In the 100% debt case, the capital structure of Broadway consists of 61% debt and 39% equity at a WACC of 7.32%. While in the mix of debt and equity case, the capital structure consists of 35% debt and 65% equity at a WACC of 9.8%. Based on interest payments calculations, Broadway would not be capable of servicing its debt on its 100% loan obligation. With $6.6 million in loan interest expense and an additional $0.4 million in expense due in 2015 and 2016. It is projected that Broadway would experience net income losses of $0.5 million and $1.3 million, respectfully. Net income losses occur from 2015 thru 2017. It is not until 2018, that the company is able to absorb its loan payments. While the $3.0 million interest payments on the mix of debt and equity are payable by Broadway over the life of the loan term. The company generates sufficient cash and yields positive yearly net incomes. Thus, the 61% capital debt structure for the all-inclusive $120 million loan is not serviceable, while the 35% debt structure for the mix debt-equity is serviceable over the terms presented for investment. The post-acquisition capital structure of 100% debt financing reduces shareholder value for Broadway by increasing the risk of financial distress.

c. Does Harris give up shareholder value by opting for the mix of debt and equity financing alternative? What is the relative cost of equity dilution? Shareholder value is given up by opting for the mix of debt and equity financing (financial details in Exhibits 3G to 3I). (U.S. $ millions)

Optimistic

Pessimistic

Value of Landmark & Broadway Additional value from acquisition

$237,242,764 $49,786,400 $94,897,106 25.30%

$155,867,888 $31,588,476 $62,347,155 38.50%

Equity raised (40% ownership) Dilution when $60,000,000 raised

As outlined in the table, 40% of equity ownership is valued at $94.9 million compared to the $60 million needed for the deal. As such, Landmark shareholders receive a $24 million premium, a dilution in EPS of 25.30% to Broadway equity owners in the best case scenario. d. How do the two financing methods affect the value of the acquisition to existing shareholders of Broadway?

These two financing methods affect the value of the acquisition to Broadway shareholders in several ways. As with the 100% debt option, there was an increase in financial distress thereby reducing shareholder value. As previously demonstrated, the all-inclusive debt option leads to Landmark having too much leverage. In fact, the debt-to-equity ratio is 1.6 and the interest-coverage ratio is negative. However, using all debt could be good for Broadway shareholder’s to defend against and market indications that the firm’s stock is overvalued (dropping the share price), as a result shareholder could prefer to use debt since this form of acquisition consideration is less likely to be interpreted negatively by investors. While utilizing 50% stock financing could be viewed negatively when outside investors (market) learn that this method is used and Broadway’s shareholders stock price may decline. While initially, the 50% debt to 50% stock financing option may create a pre-acquisition drop in share price this should have no implications for the future value the acquisition creates. Based on post-acquisition the discount rate, WACC drops to 9.8% increasing the equity value by $17,275,826 dollars raising the share price to $28.97 for Broadway. Lastly, using 100% debt to finance the acquisition would all Broadway shareholders to retain the structure and composition of their equity ownership. While using the mix of debt to equity could have a significant impact on the ownership and control of the company after the acquisition.

EXHIBIT 1. 

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STRATEGY ANALYSIS

Mission/Purpose/Vision  What kind of business?  Provides facility management services to commercial entities.  Customers – Target Market  Customers include industrial, retail, manufacturing, government, and education facilities.  Company operates in eastern United States.  Products and services  Services: Janitorial, floor and carpet maintenance, HVAC, and other building maintenance.  Geographical domain  Eastern United States with 12 regional offices from New England to Florida.  Growth/survival/turnaround  Integrated provider: To diversify and gain expertise in building engineering and energy solutions.  Market Share  Small player with regional expertise, in highly fragmented and competitive environment. The company averages 0.12% market share in the industry.  Profitability  To return economic value to shareholders.  Technology  To defend against fierce competition by acquiring expertise  Philosophy  To provide dependable cost effective building maintenance services through operational efficiency.  Stakeholders  Employees: To create a diverse transformative workforce.  Customers: To improve client relationships by providing clients a more comprehensive experience, while maintaining the company’s reputation and level of service.  Shareholders: To grow Broadway and consistently deliver strong EPS. Goals/Objectives  To reach an operating margin of 5 - 6% for long-term stability and growth.  Diversify services and bundle contracts to improve client relationships, secure larger contracts, and increase brand recognition. Major Policies  Culture  Building loyalty among employees and customers.  Service Strategy  Customize services to appeal to high growth customers  Improve expertise in specific industries (e.g., hospitals, airports, research facilities)  Become highly respected in the facility management industry

 Appear socially and economically responsibility  Operational Strategy  Service and maintain the customer’s asset and create value through our clientfocused solutions. Build value by reducing operating costs while keeping the client’s properties clean, comfortable and energy efficient, through individual or integrated solutions

EXHIBIT 2.

SWOT ANALYSIS

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Strengths  Management regarded for cultivating a culture of operational efficiency.  Established brand along the eastern-half of the U.S.  Long-term management (e.g., Harris has run the company for over 30 years).  Focused strategy and simple cost structure

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Weaknesses  The market for single-service contracts is forecasted to grow at 4% annually.  Near-term risks of slower growth and/or declines in revenues.  Industry clients served in mature industries, presenting low margins and slow growth  No international expansion and operating in eastern U.S.  No technology knowledge and development

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Opportunities  Industry is $120 billion market space  Coast-to-coast and international operations  To become a truly integrated facility-services provider.  Increase market share due to limited number of integrated companies  Business environment presents the best opportunity to companies which operate in multiple market segments.  Economies of scale to achieve cost reductions.  Value proposition enabling premium pricing.  Large clients favorable to bundling contracts  One service provider that satisfies their needs.  Improved client relationships  Secure larger contracts  Increased brand recognition

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Threats  Competition in the single-service space is highly competitive.  The competition is based primarily on price and quality of service.  Direct competitors o Low cost of entry has resulted in strongly competitive markets of a large number of regional and locally held companies, throughout the U.S.

Company competes with operating divisions of a few large, diversified facility services and manufacturing companies also operating throughout the U.S.  Indirect competitors o Company competes with building owners and tenants that can provide one or more of the company’s services internally. These competitors may have lower costs because owner-operated companies in limited geographic areas may have significantly lower labor and overhead costs. Economic growth in emerging markets  Large growth expected in the east (i.e., China and India) while managing cost, eventually competing head-on with western facility management firms. Globalization  Development in densely populated areas. Climate change and rapid urbanization occurring in middle and low-income countries will expose the facility service industry to new challenges and lead to a greater emphasis on contingency and continuity planning. The next wave of urban development will occur in areas prone to natural disasters. Demographic trends  Younger generations require a changeling work environment and require service provider to be more socially responsible to their communities. Sustainability  Able to obtain growth in a rapidly changing facility management industry, acquire and focus on technology expansion and expertise. Technology development  New ways of working. Firms will increasingly have to make use of online facility reservations and management tools that also pinpoint underutilized facilities, leading to better facility management and eventually better building design. Commercialization  Expand commercial services to broader industry participates. o

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EXHIBIT 3A. Landmark Common-Size Statements Landmark Facility Solution Common-Size Income and Balance Statements, 2010-2014 (%) 2010

2011

Vertical 2012

2013

2014

2011

Horizontal 2012 2013

Net sales

100.00%

100.00%

100.00%

100.00%

100.00%

4.90%

4.04%

3.98%

5.02%

COGS

89.48%

89.81%

89.79%

89.76%

89.84%

5.28%

4.03%

3.94%

5.11%

Gross profit

10.52%

10.19%

10.21%

10.24%

10.16%

1.64%

4.19%

4.33%

4.15%

Operating expenses

7.21%

7.10%

8.44%

8.69%

8.77%

3.35%

23.61%

7.12%

5.94%

Income statement

2014

Depreciation and amortization

0.55%

0.53%

0.54%

0.52%

0.52%

0.00%

6.25%

0.00%

5.88%

Operating profit

2.76%

2.56%

1.23%

1.03%

0.87%

-2.50%

-50.00%

-12.82%

-11.76%

Interest expense

0.00%

0.00%

0.09%

0.06%

0.00%

*

*

-33.33%

-100.00%

Income taxes

0.97%

0.90%

0.40%

0.34%

0.30%

-2.50%

-53.85%

-11.11%

-6.25%

Net income

1.79%

1.67%

0.74% Vertical

0.63%

0.56%

-2.50%

-53.85% -11.11% Horizontal

-6.25%

Balance sheet

2010

2011

2012

2013

2014

2011

2012

2013

2014

Cash

4.57%

5.05%

3.55%

1.63%

0.40%

17.24%

-22.67%

-53.28%

-75.44%

Accounts receivable

26.30%

26.33%

31.84%

32.45%

32.76%

6.28%

33.18%

3.75%

1.97%

Other current assets

8.01%

6.10%

5.33%

5.34%

5.18%

-19.05%

-3.92%

2.04%

-2.00%

Current assets

38.88%

37.48%

40.72%

39.41%

38.33%

2.36%

19.61%

-1.44%

-1.76%

Net PP&E

3.94%

6.16%

7.88%

9.78%

11.80%

66.10%

40.72%

26.48%

21.83% -0.84%

Investments and other assets

57.18%

56.36%

51.41%

50.81%

49.87%

4.67%

0.42%

0.63%

Total assets

100.00%

100.00%

100.00%

100.00%

100.00%

6.19%

10.10%

1.83%

1.01%

Accounts payable

15.51%

14.44%

17.43%

20.23%

23.74%

-5.36%

43.40%

17.11%

16.85%

Bank borrowing

0.00%

0.00%

9.17%

5.68%

0.00%

0.00%

0.00%

-37.50%

-100.00%

Current Liabilities

15.51%

14.44%

26.61%

25.91%

23.74%

-5.36%

118.87%

-1.72%

-8.77%

Accrued expenses and deferred taxes

38.50%

37.87%

34.40%

34.77%

35.39%

0.00%

7.91%

2.00%

1.31%

Other non-current liabilities

45.98%

47.68%

38.99%

39.32%

40.87%

5.42%

-2.86%

1.76%

3.47% -0.45%

Total liabilities

45.87%

43.92%

47.39%

46.96%

46.28%

1.66%

18.80%

0.92%

Shareholders' equity

54.13%

56.08%

52.61%

53.04%

53.72%

10.02%

3.29%

2.64%

2.31%

Total liabilities and equity

100.00%

100.00%

100.00%

100.00%

100.00%

6.19%

10.10%

1.83%

1.01%

EXHIBIT 3B. Broadway Common-Size Statements Broadway Industries Common-Size Income and Balance Statements, 2010-2014 (%) Vertical

Income statement

Horizontal

2010

2011

2012

2013

2014

2011

2012

2013

2014

Net sales

100.00%

100.00%

100.00%

100.00%

100.00%

4.14%

4.18%

3.88%

4.25%

COGS

91.51%

91.64%

91.71%

91.76%

91.79%

4.28%

4.26%

3.94%

4.28%

Gross profit

8.49%

8.36%

8.29%

8.24%

8.21%

2.56%

3.33%

3.23%

3.91%

Operating expenses

2.10%

2.02%

1.94%

1.93%

1.85%

0.00%

0.00%

3.45%

0.00%

Depreciation and amortization

1.31%

1.53%

1.67%

1.80%

1.79%

22.22%

13.64%

12.00%

3.57%

Operating profit

5.08%

4.81%

4.68%

4.51%

4.57%

-1.43%

1.45%

0.00%

5.71%

Interest expense

0.28%

0.25%

0.27%

0.25%

0.23%

-5.81%

12.35%

-4.40%

-4.60%

Income taxes

1.68%

1.59%

1.54%

1.49%

1.52%

-1.17%

0.84%

0.27%

6.33%

Net income

3.12%

2.96%

2.87%

2.77%

2.82%

-1.17%

0.84%

0.27%

6.33%

Vertical

Horizontal

Balance sheet

2010

2011

2012

2013

2014

2011

2012

2013

2014

Cash

2.59%

1.37%

2.38%

1.79%

2.39%

-43.30%

88.81%

-22.16%

38.65%

Accounts receivable Other current assets

18.82% 4.02%

18.12% 5.37%

18.01% 5.06%

18.14% 5.01%

18.66% 4.84%

3.05% 42.86%

8.15% 2.50%

4.11% 2.44%

6.58% 0.00%

Current assets

25.43%

24.86%

25.45%

24.94%

25.89%

4.64%

11.37%

1.32%

7.56%

Net PP&E

22.99%

23.34%

22.98%

23.52%

24.02%

8.67%

7.12%

5.81%

5.82% 0.69%

Investments and other assets

51.58%

51.81%

51.57%

51.55%

50.10%

7.52%

8.29%

3.35%

Total assets

100.00%

100.00%

100.00%

100.00%

100.00%

7.05%

8.78%

3.40%

3.61%

Accounts payable

22.96%

23.57%

23.06%

24.77%

26.32%

6.45%

5.05%

5.77%

4.55% 0.00%

Long-term debt, current portion

0.99%

0.95%

0.89%

0.90%

0.92%

0.00%

0.00%

0.00%

Current Liabilities

23.95%

24.52%

23.95%

25.68%

27.23%

6.19%

4.85%

5.56%

4.39%

Long-term debt

20.25%

18.33%

19.29%

18.69%

18.08%

-6.10%

12.99%

-4.60%

-4.82%

Accrued expenses and deferred taxes

28.64%

30.48%

29.05%

29.95%

29.75%

10.34%

2.34%

1.53%

-2.26%

Other non-current liabilities

27.16%

26.67%

27.72%

25.68%

24.94%

1.82%

11.61%

-8.80%

-4.39%

Total liabilities

58.19%

56.37%

55.64%

52.98%

50.33%

3.70%

7.38%

-1.55%

-1.58%

Shareholders' equity

41.81%

43.63%

44.36%

47.02%

49.67%

11.71%

10.59%

9.61%

9.46%

Total liabilities and equity

100.00%

100.00%

100.00%

100.00%

100.00%

7.05%

8.78%

3.40%

3.61%

EXHIBIT 3C. Combined Net Income and Balance Sheet Statements Five-year Forecast of Landmark Facility Solution Income and Cash Flow, 2015-2019 (U.S. $ millions)* 5-year Average 2015 2016 2017 2018 2019

Net sales Operating profit Net income Depreciation and amortization Change in net working capital Capital expenditure Total FCF

362.8 5.4 3.5 2.1 1.3 3.6 0.7

380.9 5.7 3.7 2.4 1.3 3.8 1.0

400.0 6.0 3.9 2.7 1.4 4.0 1.2

420.0 6.3 4.1 3.0 1.5 4.2 1.4

441.0 6.6 4.3 3.3 1.6 4.4 1.6

400.9 6.0 3.9 2.7 1.4 4.0 1.2

Five-year Forecast of Broadway Industries Income and Cash Flow, 2015-2019 (U.S. $ millions)* 5-year Average 2015 2016 2017 2018 2019

Net sales 168.4 175.1 182.1 189.4 197.0 182.4 Operating profit 6.7 7.0 7.3 7.6 7.9 7.3 Interest expense 0.4 0.4 0.4 0.4 0.4 0.4 Net income 4.1 4.3 4.5 4.7 4.9 4.5 Depreciation and amortization 3.1 3.3 3.5 3.7 3.9 3.5 Change in net working capital 0.4 0.4 0.4 0.4 0.4 0.4 Capital expenditure 4.2 4.4 4.6 4.7 4.9 4.6 Total FCF 2.8 3.1 3.3 3.5 3.7 3.3 *Numbers in the exhibits are based on the assumption Broadway does not acquire Landmark.

Horizontal 2015

2016

5.00% 5.00% 81.39% 5.00% 81.39% 5.00% 16.67% 14.29% -14.14% -0.23% 5.00% 5.00% -152.20% 44.96%

Vertical

2017

2018

2019

5.00% 5.00% 5.00% 12.50% 5.00% 5.00% 23.70%

5.00% 5.00% 5.00% 11.11% 5.00% 5.00% 18.86%

5.00% 5.00% 5.00% 10.00% 5.00% 5.00% 15.60%

2015

2016

2017

2018

2019

100.00% 100.00% 100.00% 100.00% 100.00% 1.50% 1.50% 1.50% 1.50% 1.50% 0.98% 0.98% 0.98% 0.98% 0.98% 0.58% 0.63% 0.68% 0.71% 0.75% 0.37% 0.35% 0.35% 0.35% 0.35% 1.00% 1.00% 1.00% 1.00% 1.00% 0.18% 0.25% 0.30% 0.34% 0.37%

Horizontal

Vertical

2015

2016

2017

2018

2019

4.00% -8.99% 7.10% -9.84% 6.90% -27.00% 4.00% -7.70%

4.00% 4.00% 0.00% 4.25% 6.45% -15.80% 4.00% 9.62%

4.00% 4.00% 0.00% 4.24% 6.06% 4.00% 4.00% 6.18%

4.00% 4.00% 0.00% 4.23% 5.71% 4.00% 4.00% 5.81%

4.00% 4.00% 0.00% 4.22% 5.41% 4.00% 4.00% 5.48%

2015

2016

2017

2018

2019

100.00% 100.00% 100.00% 100.00% 100.00% 4.00% 4.00% 4.00% 4.00% 4.00% 0.24% 0.23% 0.22% 0.21% 0.20% 2.45% 2.45% 2.46% 2.46% 2.47% 1.84% 1.88% 1.92% 1.95% 1.98% 0.25% 0.20% 0.20% 0.20% 0.20% 2.50% 2.50% 2.50% 2.50% 2.50% 1.69% 1.78% 1.82% 1.85% 1.88%

EXHIBIT 3D. Base Case Valuation

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EXHIBIT 3E. Optimistic Outlook Valuation

EXHIBIT 3F. Pessimistic Outlook Valuation