Current Issues in Finance - Essay Example

Introduction Reading the top stories of mergers and acquisitions one gets a view of the quantum of merger and acquisition business going on like Symantec is securing its market by purchasing VeriSign’s authenticating services for $1.3B, as VeriSign wants to concentrate on its internet domain name business and Symantec would uphold its ranking of the largest provider of technology security with this purchase. Symantec has already decided last month to acquire PGP Corporation, another provider of internet encryption services for $300M. Other names in the latest list include China Power Play acquiring Plena for $1.7B, and BAE Systems PLC buying Atlantic Marine Holding Company for $352 M in cash, which is pending approval from two U.S. regulatory agencies, to quote some deals from the long list (http://www.maadvisor.net/maalerts/2010_05_21/). Not to miss mentioning is the news of UK Prudential closing $35.5B takeover bid of AIG Asian due to pressure from the shareholders to lower the bid asking rate by $30B. Market was not in favor of clinching the deal, as after cancelling the deal, Prudential’s shares rose by 6.3% on Tuesday. At the same time, the ending of the takeover bid was a blow to the AIG efforts to pay back the loan of $132 billion to the Treasury from the proceeds of the sale to Prudential, which was taken to save the AIG from collapsing from the financial crisis in 2008 (FOX Business, June 2, 2010). There could be a number of reasons attributed to a merger or acquisition wherein payment is made through stock. Companies are acquired with the aim of safer income streams, as cost of debt could be very high and banks won’t be forthcoming with the offer of reduced rate of interests. Mergers where price/earning ratio (P/E) is very high are not welcomed because of the fear of loss of income over share price. If a company’s stocks are an all-time high, in stead of paying cash it offers its new stock shares. But sometimes it becomes all the more difficult for the buyer company to evaluate the target company as the stock price of the target company rises due to the possibility of merger bid (Brealey et al. 2008). Answers to the above questions can be reached at by analysing the cases of acquisitions and mergers in the literature in the recent past on the financial and valuation aspects of such acquisitions and mergers. There could be number of motives behind an acquisition. Diversification in a different line of business has been an aim to be achieved through acquisition. Firms make evaluation of stock to measure changes in the degree of diversification. According to Morck et al. (1990)), unrelated acquisitions had affected stock prices negatively in the 1980s. Kaplan & Weisbach (1992)) and Jarrell (1993)) have found that the changes in diversification are related with changes in firm value. In comparison to specialised firms, highly diversified firms are valued less. This difference in valuation cannot be explained by industry effects only as it is a part of the discount of diversified firms. These differences in valuation can be reduced by taking note of differences in size or in R & D expenditure between specialised and diversified firms. Net result of the research is that diversification through acquisitions is not the right turn to attain higher performance levels. Firms diversify to become growth oriented as before diversification their chances to growth had become over-consumed. Entering into different business fields due to lack of experience of that line affects negatively in performance in comparison to acquiring more business in related industry segments (Lang & Stulz, 1994, 1278). A current acquisition in the healthcare solutions business of domestic formulations between Abbott India and Piramal Healthcare Solutions for an upfront payment of USD 2.12 billion and an extra payment of USD400 billion for the next four consecutive years has been rated as over-valued by financial analysts to the tune of five times of sales over the current trend of two-four times sales of pharmaceutical stocks trading. Valuation of Piramal has been around 3.3 times higher of market-cap to sales to the same segment deal that happened some time before between Ranbaxy and Daiichi. It is expected after the acquisition that shares of Piramal that have touched a lower level would look upwards. But if taking the cash component and using it as a proxy for EV, we reach near the current market price after the debt amount from the final amount of the deal is deducted. As Abbott would be making payment through internal accruals, analysts are still sitting with fingers crossed on Abbott’s payment to Piramal. Abbott has laid stake only on domestic formulation business but it being the core and remunerative component of Piramal’s portfolio comprising 50% of the revenue, valuation of residual business of Piramal should be affected as it has not been adding much in profit. With this acquisition, Abbott would become the largest company in the acquired segment; its stock has risen 10%. The merger of Solvay Pharmaceuticals with Abbott will leave Glaxo to no. 2 position in multinational corporation platform. Piramal before the deal had a market share of 4.3% of the domestic business and was on no. four position while Cipla had the largest market share but with this acquisition of Abbott of Piramal’s domestic formulation business, it should be nearer to Cipla in capturing market size of the business (CNBC-TV 18, May 21, 2010). In the wake of the above acquisition of Piramal by Abbott, which is being debated as five times of sales and 3.3 times higher of market cap to sales in the same segment, it is yet to be analysed whether Abbott has made a modeling mistake by not making a background check and analysis of the acquisition candidate as it is one of the reasons of acquisitions’ failures. Whether Abbott has entered into an over-payment trap or not is too early to disclose; whether it has performed analysis of financial benchmark data and valuation data properly based on set procedures of analysing, creating projections, value and set an acquisition price to measure return on investment, future holds the answer to it. These procedures should be followed on set valuation and finance theories based on a number of variables and assumptions to reach an intelligent decision as there always remains a difference in blue print and actual (Machiz, 2007). Finance and valuation models can either be internally developed spreadsheets or third party systems. For consistent and dependable evaluation standard procedures are crucial to be followed. Assumptions and variables on valuation and pricing can be manipulated. Risks and challenges can not be met with the extra weight of over-payment (http://www.mergerdigest.com/overpayment-trap3.html). So evaluation before acquisition should be based on smart approaches and methodologies, counting the value of tangible and intangible assets intelligently. John Stuart, Chairman of Quaker (ca. 1900)) remarked once, “If this business were split up, I would give you the land and bricks and mortar, and I would take the brands and trade marks, and I would fare better than you”. Shareholders’ value is not created out of only tangible assets like land and buildings and financial assets like receivables and investment. Although the change in public opinion has come while measuring the brand value of intangible assets of a firm before taking a buying decision but mostly intangible assets like brand, technology, employees and trademarks, which are central in value creation, are not given due importance. Even today investors’ attention is drawn on the value measuring of tangible assets of brands like The Coca-Cola Company, Procter & Gamble, Unilever and Nestlé on the stock market (Interbrand, 2010). Brand value has gained importance as it is the premium paid due to the difference between a company’s book value and its stock market valuation paid in acquisitions and mergers since late 1980s. Accounting procedures don’t reflect on the goodwill of brands in creating financial value on their balance sheets. Certain acquisitions have been debated for not including brand values on their balance sheets the like of Nestlé’s buying of Rowntree, United Biscuits’ acquisition and later divestiture of Keebler, Grand Metropolitan buying of Pillsbury and Danone acquiring Nabisco’s European businesses. Off late, in the UK, companies like Cadbury Schweppes, Grand Metropolitan while acquiring Pillsbury for $5 billion, Guinness, Ladbrokes while acquiring Hilton and United Biscuits including the Smith’s brand have given credit to the brand value by incorporating their intangible assets on their companies’ balance sheets. Current joiners in the league are LVMH, L’Oréal, Gucci, Prada and PPR, using their brands as an investor-relations tool by recognizing the value of brand as an indicator of its financial strength. Companies should conduct yearly impairment tests -- higher the value than the earlier valuation, asset value on the balance sheet remains unchanged while lower impairment value should indicate the decrease in value. Companies should follow the discounted cash flow (DCF) valuation method and market value approach while conducting valuation on the business segment that is running in profit and generating income (Interbrand, 2010). Still, recognition of brand value in account books is below level as it gets a mention in the footnote, thus, projecting a wrong image of brands like McDonald although it forms 70% value on the stock market. Valuation approach should be brand-specific and there should be regularity in brand-valuation approaches and transparency in reporting intangible corporate assets (Interbrand, 2010). Valuation Approaches Coming to the valuation approaches on mergers and acquisitions, it is important that an approach pairs well with the aim of valuation. Most used approaches for valuing a business for acquisition are the income approach, the asset-based approach, and the market approach. These can be applied singularly or collectively for performing valuation of tangible and intangible assets that relate straight to the asset type to be valued (Putra, Feb 21, 2009). Income Approach In income approach, the value of acquisition party is measured in future income from its income sources, which are discounted to current value after mapping investment risk and time factor of money. Dividends and net cash flow are included in the income inflows, named as “economic income” (Putra, Feb 21, 2009). Asset-Based (Cost) Approach In asset based approach, current value of assets is derived by deducting the current value of liabilities, resulting in current value of a company’s equity. This approach can be used for both a viable and a non-viable operating entity. It should be used when the acquisition candidate has tangible assets (Putra, Feb 21, 2009). Market Approach The market approach indicates that analysts should make a search for similar company in the buyer company’s market or companies which are comparable to the acquisition candidate. Here, search criteria are crucial in finding comparable companies. Generally, a mix of the above approaches is used by using the DCF method as the main valuation technique (Putra, Feb 21, 2009), which is accrued positively from estimable cash-flows. Purchase price multiples need thorough handling to find out a DCF valuation or to offer an immediate guess. Other than that certain assumptions on future sales, capital expenditures, cash-flows and financing and equity income need to be made. Normally used valuation methods and assumptions highly increase the chances of successful acquisitions as per an acquiring company’s strategy and criteria (Miller, 2008). Certain financial values sometimes remain unidentified by the buyer, which include cost savings from shifting to a common reward programme, common IT programme, synergies derived through united sales forces, tax savings accruing from controlled foreign corporation structure and the likes. In insurance business a good part of a company’s sale price is derived from its current and new transactions (Nigh & Boschetti, 2006). Sufficient attention should be given to evaluate price and financial risks of the acquisition by considering the added value, synergies, risks, liabilities & costs and off-balance-sheet liabilities. Mergers and acquisition decisions are taken generally to satisfy customer demand, find new growth opportunities, deregulation, shareholder pressure, economies of scale, critical mass and capital formation. Acquisition failures happen when future happenings are not anticipated, acquisitions are over-paid, synergies are not realized or economic conditions deteriorate as the current economic recession (Nigh & Boschetti, 2006). A case study and in-depth analysis of the acquisition of Ford’s Jaguar and Land Rover by Tata Motors can help in valuation and financial aspects of acquisitions. Tata had acquired Corus, the British Steel Company in early 2007 through its Tata Steel business for £6.7bn and has been evaluating the prospects of acquiring Ford’s Jaguar and Land Rover. Private analyst firms like Meryll Lynch had analysed Ford asking for $1.5bn, which could be dragged around $2.5bn if control premium was added to the final price, as per the cost analysis done by another private equity firm Alchemy Partners. Incidentally, Ford had acquired Jaguar for £1.6bn in 1989 and had invested about $10bn more in Jaguar. Ford acquired Land Rover from BMW for £1.7bn in 2000 (http://www.vicky.in/straightfrmtheheart/tatas-jaguar-acquisition-and-ferrari-ride/). Ford finalized the deal with Tata Motors on 26March, 2008 for $2.3 billion. The deal included the acquisition of brands, plants and intellectual property rights, both tangible and intangible resources. Ford would utilize the funds in revamping its business and at the same time maintain relationship with the brands acquired by Tata Motors. The negotiating on pension plans was the issue, which was closed by Ford agreeing to pay $600 million to Tata Motors. Ford has sold Jaguar and Land Rover as both were giving huge losses and the company wanted to capitalise on restructuring and functioning profitably at lower volumes and transform its automobile model mix into a profit making entity in North America (http://www.domain-b.com/companies/companies_t/Tata_Motors/20080326_tata_motors.html). Tata Motors, on its part, wanted to gain competitive advantage at the vulnerable home market in India from foreign companies the like of Daimler, Nissan Motor, Volvo and MAN AG besides Maruti Suzuki India, Hyundai Motor, Renault and Volkswagen. Acquisitions are plotted when companies are cash-rich. Same is true of Tata Motors, sitting on a huge cash pile, its debt-to-equity ratio as low as 0.56 has given sufficient space to raise funds. Once it was a great time to be flush for Ford in October 1998, sitting on a pile of $23 million cash sufficient to acquire BMW or Volvo like ChrySler Corp has done by acquiring Daimler Benz (Naughton, 1998). Acquisition and mergers has become a tool, thus, for exploiting the opportunities when time and funds support such strategies. Financial Aspect of the Acquisition Financially, it has provided Tata Motors (TAMO) ease in generating funds for the acquisition due to low leverage of auto business. It has taken a 15 month bridge loan of $3billion to be refinanced through long term funds. Tata Motors Group of companies includes Tata Steel and Tata Sons, the Group’s holding company where it has stakes of $400m and $600m (Maharwal et al. 2008). Other than getting competitive edge in the automotive business, TM would get financial synergy with tax savings, increased debt capacity with a pile of cash. Its break even point for capacity utilization is one of the best in the industry worldwide. Thus, successful production by reducing the costs and turning around the acquired businesses would be a challenge for TAMO wherein Ford has failed. Valuation Aspect of the Acquisition Cost Synergies – What matters is not the workforce but material costs which are crucial in generating profit. Investors’ fears are not well-grounded that by agreeing to take hold of the plants operating in UK, as there is ample scope for reducing cost by controlling sourcing costs as material cost is 4-6x the labour cost for high-end products like Land Rover (Maharwal et al. 2008). Value of the Acquisition – Cost Synergies 1. Material costs and not manpower key to better margins. Investors concerns on manpower costs misplaced – Investors apprehensive that TAMO has agreed to continue with plants in UK Purchasing basket offers bigger opportunity for cost reduction – It is more important to manage the material & sourcing costs to improve margins – Material Cost is 4-6x the wage cost for high-end products such as Land Rover (Maharwal et al. 2008). 2. Leverages of Tata Group Tata Group boasts of vast ecosystem of joint ventures with major partners in Auto ancillary field via Tata Auto Comp (TACO). Vast competencies in Auto sector through TCS, Corus and Tata Technologies. The EBITDA margin in JLR would better in the next two years from the current 50-70bps. The estimated EBITDA margin of JLR for 2007 being around 6.5%, it would make the acquisition PAT increased in CY2009/FY10E (Maharwal et al. 2008). Revenue synergies in the Long run 1. Revenue synergies limited in the medium term (2-3 years) Short term scenario could be less impressive but in the long run, Tata Group and Tata Motors would get solid foothold in South-East Asia market by expanding their Jaguar and Land Rover geographic horizon from US and Western Europe (Maharwal et al. 2008). TAMO + JLR: Leverage and Valuation ratios Leverage increases but coverage ratios reasonable Equity of TAMO would increase to 2.5x from 1x Leverage would reach to 1.2x, not including the vehicle financial business EBITDA/Interest fixes at 5.0 TAMO inline trading/reasonable discount to global peers EV/Sales (1-yr forward) of 0.5x against 0.4x for global peers P/E (1-yr forward) of 6.5x against 8.5x for global peers Acquisition Funding Alternatives Sale of Tata Steel Shares Stake sale / IPO of Telcon, HV Axles, HV Transmissions Sale of Vehicle Finance business (Tata Motor Financial Services Ltd) Possibility of an LBO structure to finance the purchase Let’s analyse the P & L, balance sheet and cash-flow of TAMO+JLR combined according to the DCF valuation on the basis of future sales, capital expenditures, cash-flows and financing and equity income (Maharwal et al. 2008). TAMO+JLR P& L Analysis JLR would create more sales via consolidation in FY 2010 to 26,215. Cost synergies of JLR would reach 71.1 in the FY 2010, as assuming a 50 bps improvement in JLR’s operating profits in CY2009. Consolidated EBITDA margins would also perform better from FY 2009 to 8.7% to 9.5% in FY 2010 (Maharwal et al. 2008). The consolidated sales of TAMO+JLR have increased from the previous year CY2008/FY 9E ($24,424m) to ($26,215m) in CY2009/FY 10E. The cost synergies from JLR were $71.1m. TAMO had expected a 50bps improvement in JLR’s operating margins in CY 2009. As TAMO had assumed to inject the bridge loan of $700m in the operating cash of JLR, it has shown the interest cost of that debt in JLR’s books. Ford had pointed to the fact that JLR would be profitable at PBT level, its profit level increased from CY 2008/FY 2009E to CY2009/FY 10E by $71m. Even after deducting interest cost of acquisition from pre-tax profit, TAMO+JLR has consolidated the pre-tax profit from the previous year by $326m. Thus, TAMO is expecting the impact of PBT in the range of 5-10% (Maharwal et al. 2008). TAMO+JLR Balance sheet Analysis A cursory look at the CY 2008/FY 2009E balance sheet shows that net intangible assets of JLR are comparatively huge to the net intangible assets of TAMO. As TAMO would put $700m as operating cash in JLR, Net Current Assets of both the companies have not been added in the balance sheet. As the acquisition cost ($2.3bn) is less than the net asset value of JLR, it has capital asset worth the value of $156mn in stead of goodwill. Out of the total debt of $3bn, $2.3bn has been used in making payment to Ford and the rest of the debt has been kept to be used as operating cash in JLR (Maharwal et al. 2008). TAMO+JLR Cash flow Analysis TAMO is renowned in managing working capital in auto business with inventory at 30 days, receivables at 9 days and creditors at around 40 days. Loan receivables from vehicles make the working capital view skew because of being part of the Indian GAAP. The operating cash flow from Auto business mostly compensates TAMO auto capex. At present, it would be free cash flow neutral to modest +ve. The operating cash flow capex of JLR is estimated to be +ve pre-tax cash flow (Maharwal et al. 2008). Conclusion The acquisition of Jaguar and Land Rover from Ford by Tata Motors has been made to get competitive advantage at the domestic market and get the leverage from market diversity besides its capacity utilization from break-even-point, which has been one of the industry’s best. Ford’s public offer for sale of the two auto businesses because of incurring heavy losses due to high manufacturing cost of the Jaguar in the UK. Tata Motors, on the other hand, wants to broaden its brand portfolio besides LAND Rover fits its SUV segment. The acquisition would accrue benefits from component sourcing, design services and low cost engineering as well. Unlike, Abbott’s acquisition of Piramal, it seems that TAMO’s acquisition has been a smart bargain for Tata Motors. References: Brealey, R., Myers, S., and Allen, F. 2008. Principles of Corporate Finance, International Edition. McGraw-Hill. CNBC-TV 18, 21 May 2010. Abbott-Piramal deal: How do experts view it? Available from: http://www.moneycontrol.com/news/market-outlook/abbott-piramal-deal-how-do-experts-view-it_459407-2.html [Accessed 2 June 2010]. Domain-B.com 2008.Tata Motors confirms Jaguar, Land Rover deal with Ford for $2.3 billion. Domain-B, 26 March. Available from: http://www.domain-b.com/companies/companies_t/Tata_Motors/20080326_tata_motors.html [Accessed 2 June 2010]. Fox Business, 2 June 2010. UK's Prudential Ends $35.5 Billion AIG Asian Takeover Bid. 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