A Takeover of Chamberlin Plc by Castings Plc - Essay Example

? Takeover of Chamberlin Plc by Castings Plc Introduction The word takeovers and mergers are interchangeably used because two (rarely more than two) existing companies are combined to form a new entity with a view to enhance the shareholder value in the long run. The merger involves mutual decision of the respective companies to become a single entity. A takeover or acquisition means purchase of a company by another company, but it is not as a consequence of a mutually agreed decision between the concerned entities. A takeover could be hostile and resisted by a company. This distinction is important with regard to valuation of the businesses and management of risk. The valuation of the Companies proposed to be merged is: 1st company: Castings Plc. Valued at ?85 M 2nd company: Chamberlin Plc. Valued at ?40 M The paper seeks to study Mergers and Acquisitions (M&A), the justifications for takeover/merger, rationale applied for target identification and financial justifications for the proposal and make an analysis of the proposal. I - Mergers and Acquisitions The advantages of M&A in meeting the Challenges of strategic development perhaps mainly rest on the ability it gives the companies to grow fast in a rapidly changing business environment. For instance, expansion into new products and new market areas through M&A process is simpler and faster compared to organic growth which could be slow in reacting to the external developments, consequently seizing the opportunities. On the other hand, the governments place restrictions on M&A though competition laws, for example Competition laws in European Union and Antitrust Laws in the US. Correa (2007, p. vii) states “While IP law deliberately subjects intellectual assets to the exclusive control of right owners, competition law seeks to avoid market barriers and benefit consumers by encouraging competition among a multiplicity of suppliers of goods, services and technologies”. Grinblatt & Titman (2003, p 692) state “Mergers and acquisitions (M&A) activity has increased substantially since the mid-1960s. In 1967, the total dollar value of all corporate mergers and acquisitions was under $20 billion, by 1984 this grew to total dollar volume of $100 billion and by 1998 the dollar volume exceeded one trillion.” After the collapse of junk bond market which has fueled M&A in 1980s, the increase in the M&A activities have started again and reached a phenomenal level in 1990s. These mergers were horizontal in nature in the field of oil, telecommunication and financial services mainly in the US. M&A activities follow a wave pattern and Johnson, Scholes & Whittington (2008, p. 349) state that the worldwide announced deals declined rapidly after 2000 (falling by nearly 30% in 2002 to about 25,000 deals). Justification for takeover strategy Corporate companies have been adopting Mergers and Acquisitions as a strategy for growth. M & A have been necessitated due to various reasons such as inorganic growth, cost reduction, access to technology, growth in market share, synergy in the operations, capacity utilization, entry into new markets, competition, need for capital, weakness in the capital structure of one of the merging company, tax considerations, brand value and stability in the operations. Rao (2009), states that the losses can also be carried forward indefinitely for relief against future income from the same trade Under UK Laws. The companies can explore the possibilities of taking advantage of this provision, through proper legal structure of the combined entity so that the accumulated losses could be set-off against the profits after merger. Relative valuation of the assets of a company and the general economic conditions can make the takeover proposal more attractive on a global basis. The revival in the US economy and the growing economic power of BRIC (Brazil, Russia, India and China) countries make the assets in the UK engineering sector attractive. Hochberg (2011, p. 23) predicts that M&A activity [in engineering sector] will increase in 2011 as the certainty of recovery increases buyer confidence and the upturn in valuations enables private equity to exit legacy engineering investments. With reference to cross-border M&A, Nocke & Yeaple (2007, p. 337) state that they are motivated by the desire of foreign firms to exploit complementarities between local firms' country specific capabilities and the acquiring firms' “intangible technological advantages.” Takeover and Merger proposals are considered as effective solution for restructuring capital or the operations of the companies. Breinlich (2006, p. 27) found that M&A involved a rechannelling of resources from low to high productivity firms (in particular for the domestic transactions) and that its magnitude is likely to have been quantitatively important. In the takeover of Chamberlin Plc, a manufacturing castings and light engineering products by Castings Plc Manufacturing graphite iron castings, synergies between the make Chamberlin an eminent case for takeover. Also, since Castings Plc is practically a debt free company with a strong current ratio, after the takeover and merger of Chamberlin Plc, the combined entity would be financially very balanced and reasonably strong compared to the industry standards. According to the annual report of Castings Plc “The group maintains a mixture of short term, uncommitted and medium-term, committed facilities to ensure a sufficient level of funds are available for its business operations. Rationale applied to engineering sector analysis for target identification The rationale behind target identification in the case of merger as stated by Lewellen (1971, p. 521), “Those elements of a corporate combination which have been identified as likely contributed to a net increase in market value may be categorized as either “Operating” or “Financial” in character…” is applicable in the proposed merger of the companies in the engineering sector. The synergy existing between the companies on account of the operations is very important in the engineering sector, which could result into cost reduction, sharing of technical knowhow and managerial talents, benefits of volume and pricing power in the market. Humphries (2011, p. 36) states that The UK engineering sector has transformed itself over the last two decades from a sector with turbulent labour relations, a poor reputation for productivity and quality and a lack of investment into one which is globally competitive and is maintaining its position as the sixth largest in the world in terms of output. Both the companies, Castings Plc and Chamberlin Plc are engaged in similar engineering activities and the merged entity would be in a position to exploit the synergies for its future growth. Financial Justification of the takeover for shareholder wealth creation Methods of evaluation determine the exchange ratio in merger transactions and primarily these could be asset based, intrinsic value based or multiple valuation method. Sabina & Irina (2010, p. 882-883) state that the variety of evaluation methods led to a variety of values of a company, so we can say that there is no single value or “fair” value. The value taken into account in a merger to determine exchange ratio of the shares is also the result of calculations, estimations, but mainly the result of negotiations. This will affect the share prices of the companies involved and Wong & Cheung (2009, p.279-280) state that the changes in share prices prior to the announcement or after announcement might be due to the information leakage to the markets, profit performance of firms involved, or acquiring prices which may be different from market expectation. In the case of litigations also, Chen, Yee & Yoo (2010, p. 1094) found that “the method a judge chooses depends on the fundamental attributes of the firm as well as the quality of litigants' proposed valuation estimates. We conclude that judges demand new valuation methods when the new methods are contextually more appropriate”. II - Takeover Proposal (800 words) CASTINGS plc will take over Chamberlin plc. The pertinent analysis with reference to the proposal is whether the valuation at?40 M is justifiable from the angle of Castings Plc, the acquiring company and the shareholders of Chamberlin. Prima facie the valuation seems to be attractive to Chamberlin since the market capitalization of the company works out to only 8.74. However, the growth in sales, its intrinsic value to Castings Plc, better price to book value and price to cash flow on TTM basis needs to be considered. Also, the operational background justifies a favorable treatment, because the share price indicates only the market sentiments prevailing at a particular point of time, rather than the fair value. The revival in the economy and a better pricing power consequent upon merger should also be taken into account. 1. Sources of finance Castings Plc is a debt free company with good current ratio. Therefore, arranging finance for takeover should not pose a greater problem to them. Also, with a strong current ratio, the working capital requirements should not pose any problem. Time value of money: DCF method of valuation takes into account time value of money and the cash flows over a period of time. Types of finance: The merger involves restructuring without impairing the ongoing business, and hence the combined entity is better placed to arrange external finance mainly by borrowing from financial institutions and partly internal accruals or through share swap. Cost of finance: Issue of company shares to the shareholders of Chamberlin for the purpose of merger, either fully or partly, would reduce the cost of finance and the shares of Castings Plc have been attractively valued at ?85 M to induce the shareholders of Chamberlin. 2. Risk & Return In the calculation of the risk attached to the investment, the interest rate of treasury bills or long term bond rate can be considered as risk free rate. The rate expected by the investors, a contentious figure, involves risk premium over and above the risk-free rate. Fair value Fair price could be calculated mainly with reference to book value of the assets, market price and earnings. Valuation based on market price Total number of shares = 7437658 Market price as on 4-3-2011 = 1.155 Market capitalization = 8.59 M The price to book is about 1.18 only. (Appendix I) With regard to the valuation based on the assets, it is important to quantify the current cost of the assets including land, building and plant & machinery, or the replacement cost of the same to realistically value the business on this basis. The book values represent the cost of acquisition after depreciation charged on the assets so far. Future growth is factored in fair value worked out based on earnings. Consensus estimates of the earnings for the year ending March 2011 and 2012 are given below: Valuation based on earnings Consensus Estimates Analysis Estimates Mean High Low Earnings per share Year Ending Mar-11 2 7.63 7.66 7.60 Year Ending Mar-12 2 14.27 14.74 13.80 (Source: Reuters) Earnings projections = In view of revival in the economy, 2012 is taken as base year. Share value = EPS x P/E Ratio P/E Ratio (Average of High/Low in = (20.18 + 9.42)/2 that is 14.80 the past five years) Therefore Market Price = 0.1427 x 14.80 that is 2.112 Total number of shares = 7437658 Valuation of the company = 7437658 X 2.112 = 15.708 M Approx. Valuation based on projected EPS With a slight variation to the above method, the capitalization of earnings method, the future earnings are divided by the capitalization rate after factoring the discount and growth rates into the calculations. Calculation of the value of the firm at the expected rate of return 15%, taking into account the risk factor, and growth at 10% considering the bottoming out situation of the industry would be: Value of the firm = Earnings in future years / (discount rate – growth rate) = 0.1427 / (0.15-0.10) that is, 2.854 Valuation of the company = 7437658 X 2.854 = 21.227M Approx. The valuation in respect of Castings Plc in this method works out to 207.34 M (Appendix II) as against the market capitalization of 119.99 M. Pricing of risk: In DCF valuation, the risk is properly factored; higher the risk, higher the discount rate. However, predicting the degree of economic recovery, the impact of merger on savings in cost, pricing power available post merger are the constraints in estimating the cash flow at this point of time. Return on assets: It represents the ratio of net income over total assets. There is need for revaluation of the assets for this purpose at the current or replacement cost. 3. Corporate Value The corporate value of the business is enhanced since the merger increases the economic power of the business. The investors, employees and the general public are benefited due to stability of the operations which serves the national purpose as well. For the achievement of these objectives, proper and realistic valuation and suitable method of financing are important. Cost of capital: Cost of capital refers to the average rate of return required by the investors (in debt or equity) which influences the method of financing also. Issue of shares to the target share company reduces the financial burden to the acquiring company. Valuation: Share Exchange Ratio for issue of shares to the shareholders of the firm in respect of the merger depends upon the valuation of both the companies and favorable to the shareholders of both the companies. Takeover: The process involved in takeover is faster and therefore time taken in completion of transaction is considerably less. 4. Managing Risk Types of risks: There are mainly two types of risks, business risks & financial risk. In the merger is with a company in the industry making similar products, the advantages such as savings in cost, pricing power and increased volume of business arising out of merger would offset the additional business risk involved in merger. The overall return on the assets is depending upon the revival of the economy and the demand for the products. Hedging Risks The financial risk involved in the merger can be minimized or hedged through proper mix of financial instruments. Financial Instruments: The Company can issue equity shares, preference shares or bonds, depending upon the requirement of the shareholders of Chamberlin. Financial risk in this case would be greatly reduced since external borrowing is avoided. Conclusion “The company posted a pre-tax profit of ?91,000 for the period, against a loss of ?713,000 the previous year, as revenues jumped to ?18.3m from ?14.2m”. (Yahoo! Finance, 2011) As it is yet to pick up to the prerecession levels in 2008, improved capacity utilization in future is likely to improve the position further. Therefore, considering the rate of growth a premium to the maximum extent of 20 to 25 could be justifiable to the valuation based on EPS in view of the savings in administrative and selling overheads post merger.(? 5960 including exceptional items, in 2010 works out to 25% of the cost of sales approximately). In that case, fair valuation at 125% of 21.227 works out to ? 26.53 M, say 27 M approximately as against the price of ? 40 M proposed. Therefore, the valuation is favorable to Chamberlin. Considering the valuation of Castings Plc (even without taking into any premium over and above the valuation based on projected EPS as in the case of Chamberlin), and its market capitalization, the proposed valuation of 85 M is unfavorable to the shareholders of Castings Plc, more so in the case of share swap for merger. The shareholders of Chamberlin will be benefited from the valuation of both the companies. Due diligence in the merger process is very important and McDonald, Coulthard & Lange (2005, p. 8) find that due diligence is not simply a financial assessment but a detailed investigation that tests the viability of the proposed merger or acquisition. Word count: 2584 Appendix I Chamberlin Plc: Manufacture and sale of castings and light engineering products. Castings Plc: Manufacture and sale of graphite iron castings. Chamberlin Castings Industry Share Price @ 6 Mar 2011 115.5GBp 275GBp Market Cap (? Mil) 8.59 119.988 P/E (TTM) -* 12 58.89 Price to Book 1.18 1.62 0.39 Price to Cash Flow (TTM) 12.38 8.16 65.77 Dividend Yield - 3.65 1.01 Sales growth (MRQ) vs. Qtr. 1 yr. ago 28.86 71.74 21.26 Total Debt to Equity (MRQ) 44.06 - 24.33 Current Ratio (MRQ) 1.09 2.24 0.48 Gross Margin (TTM) 17.59 24.78 35.59 EBITD (TTM) 2.88 22.14 - *5 Yr. Hi 20.18 & Lo 9.42 Source: Reuters Appendix II Castings Plc Valuation based on earnings Value of the firm = Earnings in future years / (discount rate – growth rate) Earnings per share = 0.2376 Discount rate @ 15% = 0.15 Growth rate @ 10% = 0.10 Number of Shares = 43632068 (Interactive Investor, 2011) Valuation formula = 0.2376 / (0.15-0.10) that is, 4.752 Valuation of the company = 43632068 X 4.752 = 207.34 Approx. References Breinlich, H. (2006) Trade Liberalization and Industrial Restructuring through Mergers and Acquisitions, Centre for Economic Performance, The London School of Economics and Political Science, CEP Discussion Paper No 717 March 2006, ISBN 0 7530 1943 4. http://eprints.lse.ac.uk/19868/1/Trade_Liberalization_and_Industrial_Restructuring_through_Mergers_and_Acquisitions.pdf Castings Plc. (2011), Website of the Company, http://www.castings.plc.uk/page/homepage/1 Chamberlin Plc. (2011) Website of the Company, http://www.chamberlin.co.uk/servlet/HsPublic?context=ir.static.jsp&client=cmh&path=util&service=getPage&page=home Chamberlin Plc. (2011) Report and Accounts for the year ended 31 March 2010http://miranda.hemscott.com/ir/cmh/downloads/reports/Chamberlin_Hill_PLC_Report_and_Accounts_2010.pdf Chen,F., Yee, K. K. & Yoo, Y, K. (2010) Robustness of Judicial Decisions to Valuation-Method Innovation: An Exploratory Empirical Study, Journal of Business Finance & Accounting, 15 March 2010. Vol: 37 Issue 9-10 pp. 1094-1114 Correa, C. M. (2007) Intellectual Property and Competition Law, ICTSD Programme on IPRs and Sustainable Development, Issue Paper No. 21. http://www.iprsonline.org/resources/docs/corea_Oct07.pdf Grinblatt & Titman (2003) Financial Markets and Corporate Strategy, 2nd Ed., Tata McGraw-Hill. Hochberg , P. (2011) Global Engineering Sector Review, Norgestion, http://www.norgestion.com/uploads/publicaciones/pdf/Mergers_Alliance_Global_Engineering_Sector_Review_2011.Part_2.pdf Humphries, M . (2011) Global Engineering Sector Review, Norgestion, http://www.norgestion.com/uploads/publicaciones/pdf/Mergers_Alliance_Global_Engineering_Sector_Review_2011.Part_2.pdf Interactive Investor (2011), (CGS) Castings, http://www.iii.co.uk/investment/detail?code=cotn:CGS.L&display=fundamentals&it=le Johnson, G., Scholes, K. & Whittington, R. (2008) Exploring Corporate Strategy: Text and Cases, 7th Ed., Pearson Education Ltd. Lewellen, W. G. (1971) A Pure Financial Rationale for the Conglomerate Merger, The Journal of Finance. Vol: 26 No. 2 pp. 521-537. McDonald, J., Coulthard, M. & Lange, P. (2005) PLANNING FOR A SUCCESSFUL MERGER OR ACQUISITION: LESSONS FROM AN AUSTRALIAN STUDY, Journal of Global Business and Technology, Volume 1, Number 2, Fall 2005 Nocke, V. & Yeaple, S. (2007) Cross-border mergers and acquisitions vs. Greenfield foreign direct investment: The role of firm heterogeneity, Journal of International Economics, 72 (2007) pp. 336–365. Reuters (2011) Castings Plc (GGS.L) http://www.reuters.com/finance/stocks/financialHighlights?symbol=CGS.L Reuters (2011) Chamberlin Plc (CMH.L) http://www.reuters.com/finance/stocks/financialHighlights?symbol=CMH.L Sabina, J. A. & Irina, A. I. (2010) A Survey on Business Evaluation Methods used in Mergers, Journal: Annals of the University of Oradea: Economic Science, 2010 Vol: 1 Issue: 2 pp. 878-884 http://anale.steconomiceuoradea.ro/volume/2010/n2/140.pdf Wong, A. & Cheung, K. Y. (2009) The Effects of Merger and Acquisition Announcements on the Security Prices of Bidding Firms and Target Firms in Asia, International Journal of Economics and Finance, 2009 Vol: 1 Issue 2 pp. 274-283. http://www.ccsenet.org/journal/index.php/ijef/article/view/3409/3091 Yahoo Finance (2011) Chamberlin back in profit as recovery continues, 24 November 2010. http://uk.finance.yahoo.com/news/Chamberlin-back-profit-digilook-594629269.html?x=0&.v=11 Read More