In early May 2008, talk began between president of Flinder Valves, Bill Flinder and Tom Eliot, chairman and CEO of RSE about a possible acquisition of Flinder Valves by RSE. The industrial manufacturing industry had taken a hit due to rough economic times and the acquisition made sense. Both leaders were very concerned about the challenges and risks of the deal. Flinder was a company that engineered and manufactured specialty valves and heat exchangers. These products required extensive research and development and they were one of very few firms working in these types of applications.
A bullk to FVC’s sales came from defense and aerospace applications. They were known for their prime contracts and engineering excellence. Sales have continually grown for FVC and from 2007 to 2008 they jumped up over 23%. After going public in 1996, Auden, a distributor for FVC came to them with proposals of a merger but a deal was never made.
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FVC has been approached by numerous firms but no deals have gone through. Lately, FVC has drawn more attention from us with the disclosure of their new project, the widening gyre. We feel as though if this technology takes off and is applied could bring value ranging from $5 to $15 million. VALUATION
From RSE’s analysts and accountants due diligence, we have come to the conclusion that we believe FVC to be valued around $186.4 million. Our procedures for coming up with this value was based on the sales projections from 2008-2012 that FVC has provided for us. We used a discount rate of 3.2%. The percentage used was based on the growth rate of GDP and what numerous other sites suggest the industrial manufacturing industry is growing at.
We are also under the assumption that FVC’s cash flow projections are correct. However, we are very skeptical of FVC’s projected growth. From 2003 to 2007 their sales increased by a total of 36% over the period. Their projections from 2008 to 2012 reflect a 51% increase over the period. Now, we understand that they are not accounting for the widening gyre in these projections, so what exactly are they basing these projections off? We would need to see the introduction of numerous new products to accept these cash flows as relevant. While running the transaction multiples analysis we evaluated net sales, operating income and cash flows from other mergers within the industry.
We calculated the means and medians and used those in our valuation of FVC. When calculating net sales we came up with a range high of $78.1 million and low of $71.3 million. With operating income we came up with a range high of $166.4 million and low of $151.1 million. The last factor we looked at was cash flows and came up with a range high of $89.2 million and low of $79.6. The next valuation method we used was the market multiples analysis. We took the average of similar companies in the industry, multiplied it by our earnings per share, at $2.28, which gave us a value of $42.29. We then multiplied that number by the number of shares, at 2,440,000, which gave us a value of $103.2 million. Due to FVC’s current market cap at $100 million, we feel as though this a very accurate value for them. ADVANTAGES and DISADVANTAGES
While we not only valued FVC, we also have to take into major consideration the advantages and disadvantages. These can have major impacts on the future earnings and health of a company. We feel as though the biggest advantage to the acquisition would be the collaboration of our engineering teams. While our collaboration has lacked in the past, FVC’s has excelled and has become industry leaders. With improved engineering and products, we can begin to cross-market and sell our products with FVC’s to further increase our revenues. Because FVC is a more specialized company, by acquiring them we can diversify ourselves and lessen our risk of competitors. Another big advantage will be the lower cost of materials from our suppliers saving more on cost of goods sold and improving our bottom line. We will also be able to implement our new resource management system that will save $1.5 million in the first year and $3 million the years after.
A couple disadvantages we found with the acquisition would be an increase of debt or decrease in cash holdings, depending on how we decided to fund the acquisition. Some people within our company worry about the dilution of our shares. We currently have close to 63 million shares outstanding and acquiring an additional 2.4 million will not dilute our earnings. Another concern we have is how well FVC employees will be able to adapt to our company culture and size of our company. FVC is a smaller, more entrepreneurial company and we are cautious of the risk that FVC engineers work ethic and productivity could change due to working for a bigger firm with a different cultural environment.
As for some alternatives to not reaching a deal, we feel as though it would be best to reinvest money back into RSE or invest in other projects. Our R&D department has been extremely weak the past two years and we could benefit from investing in that. There have not been any recent new innovations within the company, and with reinvestment into the R&D department, we are confident that new innovations will be right around the corner. RSE has had their eyes on many other companies in the industry so we will not rule out possible acquisitions of those companies as an alternative to FVC. RISKS
We are aware of a few risks with this possible merger that concern both companies. One of our main concerns is the preservation of relationship between the two companies. If a deal is not reached or an offer is made that might offend either party, we do not want our relationship with FVC to deteriorate. A transaction risks that we have addressed is the possibility of environmental fluctuations during the negotiation process. If we wait too long to reach a deal, others in our industry could be gaining ground on us. The exchange rates could change and affect our foreign sales.
There are multiple financial risks that we face. One of the biggest risks we fear is overpaying for FVC and they happen to under-perform how we anticipated. Our shareholders will be very displeased and will likely not support future acquisition inquiries. Another risk we face when acquiring FVC is that Auden will pull out of his position as our distributor. Auden accounts for 15% of FVC’s sales, which would definitely hurt our cash flows if we take them on. Some operational risks that we fear are assimilating FVC into our company. Though we still want them to operate as independent entity, we want them to adopt some of our processes as well. We fear that some of these processes might not be adopted at first and will be costly to implement. All of these mentioned risks that have been addressed out could have a potential negative, inverse effect on the future cash flows of FVC. GOALS
From our perspective, we hope that many things can be accomplished whether we reach a deal or not. First off, from RSE’s side we would like to acquire FVC at the lowest reasonable price possible. Regardless of whether we reach a deal, we would like to preserve the relationship with FVC. We feel as though if a deal is not reached, both companies can add value by learning from each other. During the negotiation we will keep an open mind to new information coming from FVC and adjust our models accordingly. We do not want to let our emotions get involved in this negotiation.
We will stay true to our quantitative analysis and take qualitative information into consideration when we feel it is appropriate. When entering the negotiation we intend to come in with as much knowledge as possible. Our due diligence and research of FVC will help us accomplish this goal. We believe that FVC’s goals in this negotiation are to preserve the relationship, as well, and to settle the deal at a high price. FVC will likely want to keep the same engineering practice standards versus letting them be watered down with ours. They would like to remain as independent as possible from us to ensure their brand is not lost within ours. NEGOTIATING STRATEGY
Our strategy for this negotiation is to enter with a reasonable, low offer which we believe is around $103.2 million. We base this off our market multiples valuation and industry average price/earning ratio. We will put that offer on the table to FVC and see what their next move is. By starting low, this strategy gives some wiggle room. Our absolute highest walk-away price will be based on DCF analysis. The value we came up for that is $186.4 million but we will walk away somewhere around $175-$180 million range. On a per share basis we came up with $42.29. For a walk away per share basis, we came up with $76.40. We fully intend to listen to FVC’s valuation with open minds, but also feel as though our prices are very solid and accurate. We will stick to our quantitative analysis and be stern with our offers.