Davis Manufacturing

Business Valuation

Roy Davis, the CEO and founder of Davis Manufacturing was getting ready to meet with Clark Stevens, a good friend and member of the Board of Directors. Clark was an Investment Banker and had been negotiating the possible acquisition of Davis by ABC International Corp. Negotiations had been going on for nearly three months and had focused on broad issues such as management philosophy and strategy and also social issues such as integration and management compensation. The negotiations had reached a point where the only major problem remaining was the purchase price and how the transaction would be structured.

Roy had never thought seriously about a sellout until last November when he turned 62. He then began to think about what would happen to the firm if he retired or died. Roy believes that he has a top notch management team but that they are all specialists. None of them have the ability to step in and run the entire show. He also thinks that it would be difficult to find an outside successor and to bring her in and train her. He believes that there would be stability in an acquisition by ABC. The have the management abilities to take control after he is gone.

Roy explains to Clark that strategically he believes that ABC is the best partner, but he is concerned about providing a good deal for his shareholders. They have put a lot of trust and faith in him over the years and he doesn't want to sell them down the river.

Davis Manufacturing

Started in the early 1980's Davis Manufacturing is headquartered in Orem, Utah and is primarily engaged in the manufacture of specialty valves and seals used in both general industrial applications and in the aerospace industry. The company was taken public in 1986. About 40% of its sales volume and about 50% of its profits come from special applications in the defense and aerospace industries. This segment of the business requires extensive custom engineering and there are not very many firms with the expertise to do it. Davis has the reputation and has been doing complex defense jobs for over twenty years.

The raw materials used by the company are standard within the industry and can be obtained from a large number of suppliers. The company markets its products through an internal sales force of skilled sales engineers along with the help of an international distributor, Gritton Marketing. The arrangement with Gritton is nonexclusive. About 30% of sales are international and about half of these are through Gritton. The remainder are handled by Davis' internal sales force. Half of the foreign sales are from emerging economies and the other half are to developed economies, primarily in Europe.

Davis has multiple manufacturing plants that are all organized for the efficient handling of small production orders. The highly engineered products that the company sells are all protected by patents. Roy Davis believes that the success of the company is based on its ability to develop and patent advanced products.

The success of the company has been noticed in the industry and several possible acquirers have approached Roy over the years but none of them developed into anything serious.

Roy Davis has been thinking about an acquisition for more reasons than just his retirement. First, as the company has grown the lack of deep pockets to bankroll more research and development projects has restricted the company's growth. Second, Roy believes that the company would benefit from a larger sales and marketing department. Third, if the company continues to grow it will need to move from small production manufacturing to high volume production runs, a manufacturing expertise that they just don't have. Finally, there has been consolidation in the industry and Roy is worried that his company may end up being a small fish in a big pond and not able to compete effectively.

Roy Davis has known Bill Phillips, the CEO of ABC International, for several years. They met at an industry conference and as both are the founders of their companies they hit it off and like and respect each other. Phillips became more aggressive with his interest in the acquisition after it was announced that Davis had been awarded a new government contract to manufacture a complex hydraulics control system to be used in a new generation of missiles being developed by the Air Force. Roy believes that the project will result in several new patents. Because of this Roy believes that the recent history of the company does not reflect the growth that Davis Manufacturing can achieve over the next several years. Roy asks Clark for advice on how to handle this in the negotiations.

ABC International

ABC was incorporated in 1970. Today the company's products range from industrial components to chains, cables, nuts, bolts, castings, and forgings and other similar products. The products are sold directly to industrial users. One division sells products for aerospace propulsion and systems. A second division produces products for nautical navigation assemblies and allied products.The third division manufacture products for missile and fire control systems. These products are well regarded and have significant market share. The company's debt was recently rated Baa.The company's raw materials come from a wide variety of suppliers and are amply available. ABC's plants are modern and equipped with up to date machinery. The company is known as a low cost provider and a tough competitor.

The Current Situation

Discussions have taken place between Davis and Phillips and the respective company counsel. Several acquisition structures have been considered and it is assumed that a straight common for common exchange will be most likely because of the deferment of the tax liability. Whatever terms are worked out the acquisition must be approved by the shareholders of both companies.

There are 560 stockholders in Davis Manufacturing. Roughly 70% if the stock is held by the Board of Directors and their families including 40% owned by Roy Davis. The Board has been kept informed of all discussions.

Clark, the investment banker is excited about the merger. He believes that being part of a larger listed company will allow Davis to achieve its full value potential. As a small unlisted company Davis is traded on the NASDAQ unlisted market. Davis recently traded at a P/E ratio of 10.3. ABC is listed on the New York Stock Exchange which might be attractive to Davis' shareholders. ABC is currently trading at a P/E ratio of 11.0.

The Task

Assume that the acquisition will be done as a common for common stock transfer. Your task is to determine what the right exchange should be.

To do this you first have to determine the value of Davis Manufacturing as of the beginning of 2015. Then determine what common for common exchange rate will transfer that value to the Davis shareholders in the form of ABC stock.

Your recommendation and analysis is to be presented to the Board of Directors of Davis Manufacturing. Prepare your report in a professional and easy to read format that will first present your conclusion; second explain the process and results of your analysis; and third provide all of the detail needed so they can check your calculations, work, and assumptions.

Schedules

In the attached Excel file you will find

Davis Manufacturing

2014 Balance sheet

2010-2014 Income statement

Five year forecast

ABC International

2014 Balance sheet

2010-2014 Income statement

Market Data

Historic stock prices for both Davis and ABC

Information on peer firms in the industrial manufacturing sector

Recent M&A transactions in the industrial machinery and aerospace sectors.