Cash Flow Analysis
Several factors have made Interco an attractive takeover target: 1) Interco’s stock is undervalued due to poor performance in the apparel and general merchandising divisions, which have weakened Interco’s valuation as a whole. 2) As stated by the equity analysts, Interco is an over capitalized company with potential to grow, which makes an acquisition easy to finance. 3) Interco is also a cash generative target for a potential acquirer as it generates approximately $0. 10 of operating cash flow for every dollar of sales. ) The company is also structured in a way that it could be broken up and sold into its constituent parts, which could prove to be worth more than the whole. 2. As a member of the Board of Interco, neither the Premiums Paid Analysis nor the Comparable Transaction Analysis is very convincing. ?Premiums Paid Analysis – At first glance, the premiums paid analysis indicates that the Rales Proposal undervalues the stock relative to other recent transactions. However, this measure has limited reliability in that it is not directly related to the company’s financial outlook.
Additionally, this analysis does not indicate which industries are being used as comps, so it is impossible to tell how relevant this data really is. ?Comparable Transaction Analysis – Since Interco is a conglomerate, no one industry segment will provide an accurate measure of the effectiveness of the Rales Proposal in the aggregate. Also none of the comps are even close in size to the aggregate valuation range of the Rales Proposal. Therefore, thee comps may not be relevant as smaller companies may have different growth and profitability dynamics. . See Discounted Cash Flow Analysis #1 for a discounted cash flow analysis using Wasserstein’s assumptions, which support their proposed valuation range. As a member of the Board we would question the following assumptions: •Assumptions related to the apparel division seem higher than warranted: oThe projected growth rate of 7. 1% is significantly higher than the recent historical performance of -10% and -. 5% for the last two years, respectively. oThe projected operating margin of 6. 4% is much higher than the recently declining trend of 7. %, 5. 5% and 2. 5% for the last 3 years, respectively. •Footwear division’s projected growth rate of 6. 3% is significantly lower than the recent performance of 19% and 34% over the last two years respectively. Also, it is projected to be the lowest of the four divisions despite being the best performer recently. •Terminal value multiples of 14x-16x seem high. The Board should ask for additional support to validate these assumptions •Discount rate of 10-13%. 10% seems low given the corporate bond rates and the risk free rates given in Exhibit 14.
We should also perform a Weighted Average Cost of Capital calculation based on the desired equity return of the investors and the potential Debt/Equity ratio. A preliminary estimate assuming a 60%/40% D/E ratio, a required equity return of 20%, a required debt return of 10% and a 41% tax rate would require a minimum discount rate of 11. 5%. 4. Given the information provided, $70 seems like a reasonable offer worthy of consideration. The $70 offer is in range based of the Wasserstein analysis and Rales has indicated its willingness to increase the bid if supported by further due diligence.
There is no reason to believe that Interco could potentially get a higher bid given that no other suitors exist and also given the recent performance of the stock prior to the news of the initial takeover offer. The stock was trading in the $32. 25-$53. 25 range over the last 2 ? years with an average trading price $41. 50. Additionally, if the management team rejects the bid, it still must execute a restructuring plan in order to unlock the true value of the firm. Given the risk involved with this strategy it is uncertain that they would be able to actually increase Interco’s value.
Upon further analysis, whereby we adjusted for the appropriate growth rate and profit potential of the Apparel division, we have determined that a more accurate valuation range for Interco is $61 – $70/ share. See Discounted Cash Flow Analysis #2 for a revised discounted cash flow analysis and stock value range. As a result, we would advise the board to accept City Capital’s offer based on (i) our revised analysis, (ii) due to the fact that there are no alternative bids for the company and (iii) the risk associated with management’s restructuring plan. 5.
The Board – When the Board hired Wasserstein, Perella, & Co. to stop the Rales brothers it appears it neglected its fiduciary responsibility of the shareholders and worked instead in its own best interests. Instead of attempting to understand the reason for the takeover and analyzing the pros and cons of a potentially friendly merger, the Board threw up an automatic roadblock. The Board is primarily comprised of Interco’s top executives – out of the 14 named directors, only seven are independent shareholders who are not employed by Interco or one of its subsidiaries or divisions.
The Board initially instituted certain “poison pill” provisions to prevent a takeover. This alone is not indicative of a breach of fiduciary duty to the shareholders, but on August 8, 1988 the Board approved “golden parachute” protections for Interco’s senior executives which would be triggered on acquisition by a third party. The total value of these agreements was $16. 3M. At this time all directors, nominees and officers of Interco (not just those on the Board) beneficially owned only 1. 14% of all outstanding shares of Interco.
After receiving the Rales Proposal, the Board attempted to determine the value of Interco based on a third party analysis. This analysis was biased, though, as Wasserstein’s compensation was based on the wrong incentive whereby they receive an additional $3. 8 million fee if they got City Capital rescind the offer and successfully recapitalized the Company. As a result, the Wasserstein analysis was not truly objective. Further, the Board could (and probably should) have made a counter offer to the City Capital proposal rather than rejecting it outright.
Wasserstein, Perella, & Co – Wasserstein faces conflict of interest due to the structure of its compensation agreement. Wasserstein gets a bonus if the takeover does not occur. With this type of perverse incentive, Wasserstein’s objectivity is impaired and its valuation is unreliable. The Rales Brothers – The Rales Brothers appeared to correctly identify a target – whether for friendly merger or hostile takeover. The Rales are acting deliberately and seriously to acquire Interco. They have filed with the SEC and have arranged financing.
They have made two firm offers and have indicated willingness to increase their bid should Interco provide empirical support to justify a higher stock price. The Rales appear to be behaving deliberately, but fairly, as they have announced their intention to potentially break up the company. Drexel Burnham – Obviously Drexel is fully on board with this deal. They are “highly confident” that Drexel could raise up to $1. 375B in capital with an additional $1. 1B in debt commitments from Chase.