CASE 14-1 JORDAN-WILLIAMS, INCORPORATED [L'IL'ZII 1, 3] JordanWilliams, incorporated {JWI}, is a major publisher of college textbooks focused on business education. At the company's quarterly strategy meeting, senior management decided to expand into business education materials aimed at corporations that require entrylevel and midlevel managers to complete training courses to improve their business skills. For such training, content (in the opinion of IWI's senior manage- ment) is best delivered via the Internet since it has cost advantages and allows exibility in scheduling employee training. 1W1 has existing content in almost all business areas, includ ing accounting, nance, marketing, management, and informa- tion systems, as well as connections to authors who can develop new materials. However, the rm does not have experience delivering content over the Internet and does not have a sales force with experience selling to the corporate training market. Given that IWI wants a rapid entry into this market, it plans to develop a strategic alliance with a company that has experience in selling to the corporate market and in delivery of content via the Internet. One of the companies W1 is considering as a partner is Net- Knowledge. NetKnowledge is an infrastructure and services com pany that supports corporate communication and training. The company has approximately 65 satellitelinked communication centers that corporations can use for live video conferencing or training. NetKnmvledge has also developed a platform to deliver prerecorded training to personal computers via the Internet. For clients that need help developing training materials, NetKnowl edge has three production studios for designing and recording client content. A due diligence team from IWI has met with executives from NetKnowledge, viewed demonstrations of content delivered over the Internet using the NetKnowledge platform, and visited a Net- Knowledge production facility. The team is quite impressed with NetKhowledge and believes an alliance with the company would be a great fit, since NetKnowledge does not specialize in develop- will be around in the foreseeable future to continue selling and ing content (it just assists companies with designing and record- delivering the materials to the corporate market. To assess the ing content), whereas JWI is a content expert. financial stability of NetKnowledge, the JWI due diligence team IWI is going to be investing heavily to modify its existing con- performed financial analyses and held discussions with various tent to make it more focused on the corporate training market executives at NetKnowledge. When finished with its investiga- and to make it compatible with NetKnowledge's delivery plat- tion, the due diligence team prepared the following memo sup- form. Thus, it wants to gain some assurance that NetKnowledge porting a partnership with NetKnowledge. March 25, 2018 TO: Peter Gandrell (CEO), Christine Sayers (CFO), and Drew Marshall (Director of New Initiatives) FROM: Ted Chapman, lead manager, due diligence team investigating NetKnowledge SUBJECT: Report on Financial Condition of NetKnowledge In fiscal 2017/fiscal 2016, NetKnowledge (NK) suffered losses of $31,600,000/$21,200,000. In spite of these losses, the team recom- mends forming an alliance with NK. NK, like most companies in this space, is an early-stage company, and losses are not unexpected. The important questions to ask are: Does NK have a reasonable plan to become profitable? and Does NK have the cash to survive until profitability is achieved? We believe the answer to both questions is yes. In 2017, operating expenses increased substantially, resulting in an increased loss. However, per our discussions with executives at NK, the increased operating expenses are due in large part to a major advertising campaign and expansion of the sales force. The result is that NK achieved substantial brand recognition, and in 2017 revenue increased by approximately 20 percent. The company believes that, now that it has achieved its brand-recognition goals, it can cut operating expenditures (including advertising and sales force salaries) back to a level of 80 percent of the amounts in fiscal 2016, or $29,520,000 (80% x 36,900,000). With current revenue at $18,800,000, and assuming an ongoing revenue growth rate of 20 percent, the company will be profitable in three years (i.e., at the end of fiscal 2020, revenue of $32,486,400 will exceed expenses of $29,520,000). Calculation of revenue estimate for year 3: Revenue in fiscal 2017 $18,800,000 Revenue in fiscal 2018 (fiscal 2017 with 20% increase) 22,560,000 Revenue in fiscal 2019 (fiscal 2018 with 20% increase) 27,072,000 Revenue in fiscal 2020 (fiscal 2019 with 20% increase) 32,486,400 It appears to us that achieving profitability in 3 years is a very feasible goal. The company has expanded its web hosting options to a 24/7 basis and is now able to service clients with training demands around the world. In the fourth quarter of fiscal 2017, the company signed contracts with three additional Fortune 500 clients to deliver services in 2018. The revenue from this prestigious group of clients is, of course, not reflected in the financial statements for 2017. Also, keep in mind that our partnership with NK will provide incremental revenue to the company. Of course, achieving profitability will be possible only if the company does not run out of cash. At the end of fiscal 2017, NK had approximately $21,000,000 in cash and cash equivalents. The net decrease in cash and cash equivalents in fiscal 2017 was approximately $11,000,000. Thus, it appears that the company will be able to survive for at least 2 years (through fiscal 2019). At that point, assuming our net initiative is a success, we may want to make an equity investment in NK to provide the company with the cash it will need to survive a third year beyond 2019 (i.e., through fiscal 2020). Assuming an annual decrease in cash of $11,000,000, we would need to make an equity investment of approximately that amount. At the end of year 3, as discussed above NK will be profitable and likely able to fund itself internally. An investment of $12,000,000 would give us a substantial equity posi- tion in a firm that we predict will be successful. Furthermore, it would allow us to have a substantial say in the direction of NK, thus insuring that the company remains focused on our long-run needs in addition to the needs of its other clients. Alternatively, in light of the fact that the company will be only a year away from profitability at the end of fiscal 2019, if we decide not to make an equity investment, NK should be able to obtain additional debt or equity financing from creditors or investors. If you have any questions, please give me a call. I'll be in the rest of this week, and next week on Monday. After that, I'll be in Chicago working with the group from Balmer Consulting that is developing our new authors' website. REQUIRED from Ted Chapman. Do you agree or disagree with his analysis The financial statements for NetKnowledge for fiscal 2017 and and conclusions? Would you recommend pursuing an alliance with NK? fiscal 2016 are provided below. You should analyze them as you deem appropriate. Based on your work, comment on the memoCase 5t NetKnowledge Income Statements Year Ended Year Ended 12/31/17 12/31/16 Revenue $ 18,800,000 $ 15,600,000 Operating expenses: Wages and salaries 22,100,000 15,500,000 Depreciation 4,300,000 4,100,000 Other selling and administrative 23,800,000 17,300,000 Total operating expenses (50,200,000) (36,900,000) Income (loss) from operations (31,400,000) (21,300,000) Other income (expense): Interest income 1,200,000 1,600,000 Interest expense (1,400,000) (1,500,000) Total other income (expense) (200,000) 100,000 Net loss $(31,600,000 $(21,200,000 NetKnowledge Balance Sheets As of 12/31/17 As of 12/31/16 Assets Current assets: Cash and cash equivalents $ 21,300,000 $ 32,100,000 Accounts receivable 3,100,000 3,900,000 Prepaid expenses and other current assets 300,000 600,000 Total current assets 24,700,000 36,600,000 Property and equipment 35,300,000 34,600,000 Less accumulated depreciation (13,400,000) (9,100,000) Total assets $ 46,600,000 $ 62,100,000 Liabilities and stockholders' equity Current liabilities: Accounts payable $ 5,800,000 $ 5,000,000 Other accrued liabilities 6,000,000 3,700,000 Total current liabilities 11,800,000 8,700,000 Long-term debt 26,900,000 13,900,000 Total liabilities 38,700,000 22,600,000 Stockholders' equity Common stock 85,100,000 85,100,000 Accumulated deficit (77,200,000) (45,600,000) Total equity 7,900,000 39,500,000 Total liabilities and stockholders equity $46,600,000 $62,100,000NetKnowledge Statements of Cash Flows Year Ended 12/31/17 Operating activities Net loss $(31,600,000) Adjustment to reconcile net loss to cash used in operating activities: Depreciation 4,300,000 Decrease in accounts receivable 800,000 Decrease in prepaid expenses and other current assets 300,000 Increase in accounts payable 800,000 Increase in other accrued liabilities 2,300,000 Net case used in operating activities (23,100,000) Investing activities Purchase of equipment (700,000) Financing activities Issuance of long-term debt 13,000,000 Net decrease in cash (10,800,000) Cash and cash equivalents, beginning of the year 32,100,000 Cash and cash equivalents, end of year $21,300,000