For this assignment, you will read the Electrolux and GE Appliances case study, which offers an analysis of the Electrolux?s valuation process during its acquisition of GE Appliances in August of 2014. The Electrolux team was tasked with completing a valuation and crafting a final offer for the GE appliance division. In your short paper, you will describe the circumstances of the deal for these two companies, conduct basic valuation calculations, and make a recommendation that would be communicated to senior management.

Please review attachments, most importantly the fin630 module eight short paper guidelines

For the exclusive use of S. Lambert, 2017. TB0441 Michael H. Moffett Electrolux and GE Appliances GE math. Consider: Let's assume GE mispriced Appliances when it tried to sell it six years ago (a safe assumption, since it didn't sell). So, let's say the Appliances business was worth not $8 billion back then, but rather just half that$4 billion. Add the $1 billion spent spiffing up the business, and divide the resulting $5 billion value into the best-case price GE is expected to get for the unit today: $2.5 billion. That works out to a 50% loss for GE shareholders. \"Is General Electric Company About to Make Its Biggest Mistake Ever?\" The Motley Fool, 19 July 2014. Electrolux's valuation team was working out of the company's corporate headquarters in Stockholm, Sweden. Its task was to complete both a valuation and suggested final offer for GE's appliance unit by mid-August 2014, which meant that the summer holiday sailing on the archipelago would be lost. The team's challenge was in capturing the value of GE's appliance unit, both as a stand-alone business and as combined with Electrolux. GE would know that Electrolux would see added value in itso-called synergiesand would be building that differential into its asking price. But the value of GE Appliances (GEA) had also fallen over time, as demonstrated by GE's own efforts at selling the business repeatedly. There were two questions to answer: (1) what was GE Appliances worth; and (2) what should Electrolux offer? General Electric General Electric (NYSE: GE) was a conglomeratea portfolio of businesses spanning many different industries. In an age of single industry pure plays and core competency, GE was strikingly different, continuing to compete in everything from turbine engines to financial services to appliances. GE, now in its 13th year under CEO Jeffrey Immelt, was in the midst of a transformationas described by The Economist the previous monthto transform GE from a misfiring finance-heavy conglomerate into a more focused maker of industrial equipment.1 The company was shedding many of the businesses which it did not believe were capable of significant growth and profitability. GEA is at the top of that list. Appliances GE Appliances, a sub-unit of Home and Business Solutions, headquartered in Louisville, Kentucky, generated more than 90% of its revenue in North America. The product portfolio included refrigerators, freezers, cooking products, dishwashers, washers, dryers, air conditioners, water filtration systems, and water heaters. Its revenue split by major product category was approximately 35% cooking, 25% refrigeration, 20% laundry, 10% dishwashers, and 10% home comfort (air conditioning). GE Appliances was largely a U.S.-based business. Operations in the U.S. consisted of refrigeration units in Selmer, Tennessee, Decatur, Alabama, and Bloomington, Indiana; a cooking unit in LaFayette, Georgia; in addition to the largest and most diversified unit (laundry, dishwashers, refrigerators, water heaters) in Louisville, Kentucky. Louisville also served as the corporate center for GE Appliances. GE's appliances, along with its lighting products, is in many ways the GE brand image. Founded in 1907, GE's first products were cooking appliances. It continued to be a leader in appliance innovation for more than half-century, being the first to launch air conditioners (1950), the combined washer/dryer (1954), and the toaster oven (1956). Despite that track record, GE's appliance business had shown little growth or profitability for more than two decades. GE's appliance sales in 1990 were $5.3 billion, but only $5.7 billion in 2000, a full 1 \"General Electric: A Hard Act to Follow,\" The Economist, June 28, 2014. Copyright 2016 Thunderbird School of Global Management, a unit of the Arizona State University Knowledge Enterprise. This case was written by Professor Michael H. Moffett for the sole purpose of providing material for class discussion, with research assistance from Alex Ganevsky and Anadi Gakhar, and the helpful comments of Brad Hoffa, Nicole Meachem, and Professor Andrew Inkpen. It is not intended to illustrate either effective or ineffective handling of a managerial situation. Any reproduction, in any form, of the material in this case is prohibited unless permission is obtained from the copyright holder. This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. decade later. Sales had peaked at just over $7 billion in 2007, but had plummeted in the following years with the financial crisis and slow economic recovery. Appliance sales were at $5.7 billion in 2013, down 19% from 2007. Appliances was consistently one of GE's least profitable businesses. 2008 had proven to be a watershed moment in the unit's history. By 2008, appliances made up but a small fraction of GE. Sales were $7 billion of a total $173 billion, delivered by 13,000 employees of a worldwide GE population of 327,000. GEA was not growing and was not very profitable. Jeff Immelt, GE's CEO, noted that the appliance business was overly U.S.-based, and \"not global enough for GE's purposes.\" GE's leadership decided it was time to sell the business. Pricing the unit at $8 billion, it quickly found no takers with the collapse in U.S. real estate followed by the 2008 financial crisis. GE's financial services segment, long the driver of total corporate profits, now suffered massive losses. Afterwards, GE began moving away from both consumer products and financial services, to focus on industrial technologiesfrom locomotives to jet engines. But it was seemingly stuck with GEA. Reassessment and Reinvestment With few choices, GE took the unit off the market and recommitted to its future. With more than $1 billion in new investment, one of the industry's high-profile executive leaders at the helm, Charlene Begley (considered one of the most powerful women in business), GE launched new products and cut costs. One of the more controversial new efforts was in GE's reshoringthe return of manufacturing to the U.S. that had been moved offshore to low-cost countries. As described by GE's CEO Jeffrey Immelt:2 Still, today at GE we are outsourcing less and producing more in the U.S. We created more than 7,000 American manufacturing jobs in 2010 and 2011. Our success on the factory floor rests on human innovation and technical innovationthe keys to leading an American manufacturing renewal. When we are deciding where to manufacture, we ask, \"Will our people and technology in the U.S. provide us with a competitive advantage?\" Increasingly, the answer is yes. Immelt went on to explain why moving manufacturing offshore to low-cost countries was no longer working, and what GE's new hopes were for the industry. But for our appliances business, emerging markets eventually offered something else: competition from former suppliers of whole products, particularly in Asia. As these competitors improved their lines and lowered their prices, even customers who had grown up with and knew only GE refrigerators and dryers began to explore alternatives. Other forces were at play as well. Shipping and materials costs were rising; wages were increasing in China and elsewhere; and we didn't have control of the supply chain. The currencies of emerging markets added complexity. Finally, core competency was an issue. Engineering and manufacturing are hands-on and iterative, and our most innovative appliance-design work is done in the United States. At a time when speed to market is everything, separating design and development from manufacturing didn't make sense. GE believed that a successful renewal in U.S. manufacturing in appliances would rest upon three elements: (1) building in-house innovation capability to generate a new customer-value proposition, (2) utilizing lean manufacturing to restructure and reduce costs, and (3) new models of labor relations that would cut labor costs dramatically. In all, GE's reinvestment in appliances was massive, and was described as products, plants, and processes: Products: 10 new product platforms, described as 500+ new products; Plants: six complete factory renovations, with new assembly lines and modern equipment; Processes: adoption of lean manufacturing across the enterprise, $20 million in product lab upgrades, 3D printing capability. The company's Louisville appliance center launched a new dishwasher manufacturing line in 2009 that reflected these initiatives: a 30% improvement in labor efficiency, a 60% reduction in inventory, 68% less time to manufacture, and an 80% reduction in line space requirements. \"The CEO of General Electric on Sparking an American Manufacturing Renewal,\" Jeffrey R. Immelt, Harvard Business Review, March 2012. 2\tA06-16-0001 2 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. In January 2013, Charlene Begley stepped down, and the task of revitalizing GE Appliances was passed to Chip Blankenship. In his first interview after taking over GEA, Blankenship made it very clear what was expected:3 We said we could do it if we got that investment, and now we're at the point in this experiment where we have to be able to do what we say. We're making the last products with the GE monogram on them, and we want to make sure we do that justice. But justice would be hard to find. The North American appliance business was changing, and new competitorsprimarily Korean manufacturerswere entering the market with more competitive pricing. The Appliance Market The appliance business segment contained a multitude of productsrefrigerators, freezers, clothes washers, cooking stoves and ovens, and clothes dryersmaking up the majority of sales. As illustrated in Exhibit 1, by far the largest expenditure segment in the U.S. was refrigerators and freezers, making up 34% of all consumer expenditures on appliances. Refrigerator lines were, with few exceptions, the big-ticket items in appliances. In the home, the majority of the larger appliances were located in the kitchen, and as noted by Electrolux in its 2013 annual report, the typical U.S. home and kitchen had ample room for large appliances. Exhibit 1. U.S. Consumer Expenditure on Household Appliances Source: http://www.statista.com/statistics/255524/us-consumer-expenditure-on-household-appliances-by-category and author calculations. The U.S. market for appliances functioned across two very different channels: retail customer sales (85%) and home building commercial sales (15%). Retail sales was replacement, as appliances originally installed with home construction grew older and were replaced by customers through retail distributors (themselves increasingly concentrated in major big-box retailers). Although this market was wide in terms of pricing and features, it was also quite cyclical with consumer disposable incomes. The second sector, home building, was highly cyclical, as the housing sector was nearly the definition of the business cycle. During the 2007-2008 period, when the real estate sector in the U.S. plummeted, this sector's sales had completely collapsed. U.S. appliance sales competition was intensified by the retail distribution structure. More than 70% of all appliance sales were through just four major retailers: Best Buy, Home Depot, Lowe's, and Sears. This side-by-side sales function intensified price and comparative feature competition. There were, however, differences in which of the major manufacturers were featured or served in different regions of the U.S. market. This was primarily a function of where most of the product lines were manufactured (e.g., Kentucky, U.S.A., versus Ciudad Juarez, Mexico) and the sophistication and development of company logistics. 3 \"GE's Last Consumer Stand Gets $1 Billion Plus New Chief,\" Tim Catts, Bloomberg, May 14, 2013. 3\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. The Players The American appliance industry had seen steady consolidation over time. The three major traditional players were all familiar names. Whirlpool. Whirlpool held the largest market share with the Kenmore, Maytag, KitchenAid, Jenn-Air, Amana, and Hoover brands. General Electric. GE Appliances relied nearly entirely on the GE monogram combined with category products like Caf Series, Profile Series, and Artistry Series, along with Hotpoint. Electrolux. Known as a premium-priced European brand, Electrolux had gained substantial market share through its acquisitions over time of Westinghouse and Frigidaire. The industry, however, was now seeing the entry of several major Asian players, including LG (South Korea), Samsung (South Korea), and Haier (China). Haier was the smaller of these competitors, having pursued a niche market approach of under-the-counter refrigerators and wine coolers in the U.S. market. Although dominant in that segment, it was narrow and extremely low-cost. Its low-cost value proposition was solidified by its primary retailer, Walmart. Haier had made sizeable investments in refrigerator and washing machine manufacturing in South Carolina, but as of yet had garnered little market share. The KoreansSamsung and LGwere gaining rapidly in the U.S. market. Both had manufacturing operations in Mexico, the low-cost production area for North American sales. Both competed in nearly every major large appliance segment with the exception of cooking stoves and ovens (an appliance of small historical precedent in Korea). Samsung had positioned itself clearly in the premium segment of the U.S. market. As an organization built around informational technology, Samsung was moving towards the development of the smart home, where major appliances were networked with the entire living space of energy and information use. Well-positioned for high-end new housing construction, the company had few low-end offerings for the existing residential appliance market in the U.S. LG, similarly digitally focused, had pushed rapidly into the middle and upper segments of the U.S. market. For Samsung to become the world leader in appliances, it will have to broaden its appeal with cheaper models, says Bob Baird, vice president for appliance merchandising at Home Depot (HD). \"Right now they're a premium brand, but you can't be No.1 without capturing the core of the market,\" says Baird, whose company began selling Samsung products at the end of 2012.4 A final driver of differentiation between manufacturers was in advertising. The most recent data on advertising expenditures by appliance brands in the U.S. showed a relative balance. Whirlpool had led with $54 million, LG $33 million, GE and Samsung at $29 million, and Electrolux with $30 million. But there was an additional benefit with Samsung and consumer name recognition; Samsung had spent roughly $600 million in total in U.S. advertising in 2012 across all of its retail products, led by smart-phone promotion. Competition in the U.S. appliance market was fierce, complex, and changing. Exhibit 2 provides a summary of segment results (appliance segment depending on firm and reporting) of the major competitors for the most recent full year, 2013. Dumping GE's renewed investment in appliances, however, was undermined in the market by South Korean competitors undercutting price. Both LG and Samsung began flooding the U.S. market with better pricing, and in some cases better features, taking large chunks of market share. Finally, in late 2011, the leader in appliances in both the U.S. and the global market, Whirlpool, filed a complaint with the U.S. Department of Commerce and the U.S. International Trade Commission alleging dumping of large residential washers by manufacturers from Mexico and South Korea. 4 \"Samsung Wants to Be the World's Biggest Appliance Maker by 2015,\" Sam Grobart, Bloomberg, January 9, 2014. 4\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Exhibit 2. U.S. Appliance Market Competitors 2013, Segment Results Billions of currency Whirlpool GE Appliances Electrolux Samsung Consumer Electronics LG Home Appliances Currency USD USD SEK USD KRW USD KRW USD Sales $18.769 $5.700 SEK 109.151 $16.741 50,331.52 $47.812 11,796.88 $11.206 EBITDA $1.789 $0.355 SEK 7.968 $1.222 2,420.40 $2.299 415.56 $0.395 EBITDA/ Sales 9.53% 6.23% 7.30% 7.30% 4.81% 4.81% 3.52% 3.52% Net Income $0.849 na SEK 0.671 $0.103 na na na na Net Income/ Sales 4.52% na 0.61% 0.61% na na na na Source: Whirlpool, GE, Elecrolux, Samsung, and LG annual reports, 2013, and author calculations. The average exchange rates for 2013 for the Swedish krona (SEK 6.52 = 1.00 USD) and Korean won (KRW 1052.70 = 1.00 USD) are used for currency conversions. Not available = na. These antidumping and countervailing duty petitions are submitted to the Department of Commerce and the U.S. International Trade Commission on behalf of Whirlpool Corporation (\"Petitioner\"). They provide compelling evidence that: (1) imports of large residential washers (\"LRWs\") from the Republic of Korea and Mexico have been sold in the United States at prices less than fair value; (2) imports of such washers from South Korea have been subsidized; and (3) these dumped and subsidized imports have caused material injury within the meaning of the antidumping and countervailing duty statutes to the U.S. industry that produces the \"like product.\"5 Seven months later, the Department of Commerce announced its findings: Mexican and South Korean producers and exporters sold large residential washers in the U.S. at dumping margins ranging between 33.30% and 72.41% from Mexico, and between 9.62% and 82.41% from Korea (summarized in Exhibit 3). The dumping margin was the amount between the price as sold in the U.S. relative to what U.S. DOC/ITA determined to be the fair market value of the appliances, a controversial calculation. These firms would now be required to post a cash deposit upon entry into the United States. Although Whirlpool filed the original dumping complaint, it refused to cooperate in the cost and price discovery requested by the U.S. DOC/ITA regarding its Mexican operations. It was therefore also assessed a dumping margin. (Whirlpool had built a large portion of its washers and dryers sold in the U.S. in Mexico for many years, but soon after the government's finding, it ceased these imports.) Exhibit 3. Preliminary Dumping Margin Country Exporter/Producer Mexico Electrolux Samsung Whirlpool All Others Korea Daewoo LG Samsung All Others Margin Cash Deposit* 33.30% 72.41% 72.41% 33.30% 82.41% 79.11% 12.15% 12.15% 9.62% 9.62% 11.36% 11.36% * Cash deposit rate reflects the offset of the export subsidies found for Daewoo in the companion Countervailing Duties investigation, which was 3.30%. Source: \"Fact Sheet: Commerce Preliminarily Finds Dumping of Imports of Large Residential Washers from Mexico and the Republic of Korea,\" U.S. Department of Commerce/ International Trade Administration, 2012, p. 3. Failure to cooperate analysis is termed adverse facts available (AFA). Samsung in Mexico similarly was based on AFA. Of the Korean manufacturers operating out of Korea, Daewoo was based on an AFA analysis. Korean manufacturing was also found to be subsidized by the Korean government, a finding denied by both the manufacturers and the government. Electrolux was also hit with an antidumping duty of 33.30% for the washers and dryers manufactured in Mexico. Whirlpool had also filed a dumping complaint against LG and Samsung refrigerator products sold in the United States. Although the U.S. Commerce Department had proposed countervailing duties (against Korean \"Large Residential Washers From South Korea and Mexico: Antidumping and Countervailing Duty Petitions on Behalf of Whirlpool Corporation,\" Before the U.S. Department of Commerce and the U.S. International Trade Commission, Case Nos. A-201-841 (Mexico), A-580-868 (Korea), and C-580-869 (Korea), Volume 1, December 30, 2011, p. 1. 5 5\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. government subsidies) and antidumping duties (against sales in the U.S. below fair market value), the U.S. trade panel had concluded that the imports did not threaten Whirlpool's business. As shown in Exhibit 4, Whirlpool held the dominant share in the U.S. market, largely through its acquisition of Maytag in 2006. But what was also apparent was the rise of LG and Samsung, the new major Asian (Korean) players, most of it at the expense of the established big three. This market share growth was not just in washers and dryers (now subject to tariffs), but in the refrigerator/freezer segment as well. As one analyst noted: \"We view the appliance market industry as one of the worst end-markets in our capital-goods universe,\" Rob Virdee, an analyst at Espirito Santo in London, said in a note. \"There is still chronic global overcapacity and the value proposition of appliance manufacturers is poor.\"6 Exhibit 4.U.S. Appliance Sellers' Market Shares, 2008 & 2013 Source: http://www.statista.com/statistics/296707/market-share-of-appliance-producer-companies-united-states/. GE's vision of an American Renewal was floundering. Energy and transportation costs had fallen, product innovation was not confined to the U.S., and new low-labor-cost countries from Hungary to Thailand were home to new appliance manufacturing facilities. What was of even greater concern to GE wasn't its declining market share, but the declining market. Exhibit 5 shows a 25% decline in major appliance sales in the U.S. over the 2004 to 2013 period. (The Western European market had seen a similar decline, roughly 20%). The data led many in GE to believe the U.S. market had suffered a permanent structural shrinkage. GE's leadership once again came to the same conclusion: The appliance segment was not a category in which GE would be able to grow sales and profits to its expectationsit was time to sell the business. In July 2014, GE put GE Appliances on the market again, and made it clear that it would attach a much lower price tag this time. Analysts estimated an eventual sale price of between $2.0 and $2.5 billion dollars. $2 billion for GE Appliances? I mean, I get that Appliances isn't the best business at GE. Revenues at the unit are down 18% from 2008. Appliances' operating profit margin, at just 4.5%, is less than half the profit margin for GE as a whole. But even so, a $2 billion price tag on Appliances works out to only about 0.25 times this unit's annual sales, and a mere fraction of the 1.8 times sales valuation on the rest of General Electric stock. It's 25% of what GE thought the business was worth six years ago, and just $1 billion more than what GE sank into reviving the Appliances business less than four years ago! 7 \"Electrolux to Cut Costs and Jobs as Profit Misses Estimates,\" Katarina Gustafsson, Bloomberg, October 25, 2013. \"Is General Electric Company About to Make Its Biggest Mistake Ever?\" The Motley Fool, July 19, 2014. 6\tA06-16-0001 6 7 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Exhibit 5. U.S. Major Appliance Sales, 2004-2013 Source: Euromonitor. Electrolux AB Electrolux (OMB: ELUX B; ADR: ELUXY), headquartered in Stockholm, Sweden, started life as a kerosene lamp company called AB Lux in 1901. In 1919, in a new combination of companies, its name was changed to Elektrolux, and eventually Electrolux. By 2014, it was selling products in 150 countries. If you were to create a company that's emblematic of the global economy, it might look a lot like Electrolux. It's based in Sweden, but holds its board meetings in English, the world's common language. Top managers come from countries that include Brazil, Jamaica, and Germany. The CEO who took over when Straberg left last year is a U.S. citizen named Keith McLoughlin, who graduated from West Point.8 Although the second largest appliance maker in the world behind Whirlpool, Electrolux, too, had long struggled with labor costs. In the late 1990s, it had closed manufacturing facilities across Western Europe (including its home country of Sweden), shifting significant production to lower-labor-cost Eastern Europe. In the process, it had reduced global headcount by 12,000. In a series of renewed cuts, the company had shed another 30,000 jobs worldwide between 2002 and 2014, moving from just 20% of its production in low-cost countries to more than 60%. In 2014, Electrolux employed 52,000 worldwide. Electrolux saw the GE Appliances brand as a major competitive entry in the mid-price segment of the market, between its own premium brand, Electrolux, and its base-market-priced line of Frigidaire (which it had owned since 1986). Electrolux had already studied the potential impacts of GE Appliances on its own sales and market shares by global market. If, for example, Electrolux and GE had been combined the previous year, 2013, Electrolux's North American sales would have been SEK 37.5 billion greater (SEK 69.1 instead of SEK 31.6). But GE Appliances was distinctly a North American entity, and as illustrated in Appendix 5, it would have had little impact on any other of Electrolux's major regions. Electrolux had struggled to reduce costs in the U.S. market. It had moved production of cooking appliances from L'Assomption, Quebec, to Memphis, Tennessee, reducing the average hourly wage of workers from $18.92 to $14.65. (When Electrolux company executives met with Quebec workers to announce the shutdown of the \"Straberg's Strategy: Cutting Costs Led Electrolux to Memphis,\" Daniel Connolly, The Commercial Appeal, September 18, 2011. 8 7\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. L'Assomption facility, they spoke in English, and were shouted down and heckled throughout.) It had closed plants in Greenville, Michigan (refrigerators), and Webster City, Iowa (washers and dryers), moving production to a new plant in Ciudad Juarez, Mexico (the border city across the Rio Grande River from El Paso, Texas). Juarez operations had an average hourly wage of $2.18. Despite these efforts, Electrolux globally suffered from no growth and marginal profitability. As seen in Exhibit 6, sales had actually fallen over the past decade, with only modest returns. It had noted in its 2013 annual report to shareholders that it had four specific financial goals: 6% operating margin (at least); a capital turnover ratio of 4x (at least); 20% return on net assets; and 4% average annual growth (at least). Exhibit 6. Electrolux Global Sales and Profits (billions of Swedish krona, SEK) Strategically, the combining of Electrolux and GEA would increase Electrolux's potential in the world's most profitable appliance marketthe U.S.and put the company on par with the dominant market player in that market, Whirlpool.9 Electrolux could benefit substantially through GE's expanded market footprint, both in manufacturing and in marketing and distribution. The GE brand was a stronger player in the middle of some appliance brand brackets, like those in refrigerators. An added element of strategic value was that the deal would also include GE's ownership interest in Mabe (Mexico), one of the strongest appliance makers in Latin America. The final benefit of the deal was the cost and operational efficiencies that would be gained by combining Electrolux and GE appliance operations in the U.S.synergiesso often noted in mergers and acquisitions. Financial Valuation The valuation team had identified three separate value elements in the GE Appliances deal: (1) GEA itself; (2) GE's interest in the Mabe joint venture; and (3) synergies to be gained by Electrolux once combined with GEA. GE Appliances First, GE Appliances had been a stable marginally profitable business for many years. In the current year, as seen in Exhibit 5, the EBITDA margin was at 6.2%, making it near the absolute bottom of most GE businesses. Yet, at 6.2%, GE Appliances was on par with most other major U.S. and North American appliance manufacturers. Electrolux believed that if it had the continued use of the GE brand, and the general economy held steady and healthy for five to seven years into the future, GE Appliances was a good value. Note that when Electrolux estimated what the company would have looked like if it had been combined with GE in 2013 (Appendix 5), nearly the entire change in global sales, an added SEK 37.5 billion, was in the United States. 8\tA06-16-0001 9 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. The valuation team had started first on the core elementthe valuation of GEA alone. As seen in Exhibit 7, this was based on the basic numbers provided by GE for the 2013 and 2014 (to date) years, combined with some of Electrolux's own U.S. sales forecasts. Top-line growth assumptions were the big drivers, and, as seen, 2015 was forecast to be strong, followed by moderate growth (for conservatism). Exhibit 7. Valuation of GE Appliances Using DCF Analysis (millions of US Dollars) GE Appliances Projected Income Revenue (USD, millions) Revenue growth (%) Less direct & indirect costs EBITDA EBITDA margin (%) Depreciation EBIT GE Appliances DCF Valuation EBIT Less recalculated taxes Add back depreciation Net Operating Cash Flow Present Value factor PV of NOCF Net Present Value (NPV) 2.0% (5,345.0) 355.0 6.2% (175.6) 179.4 Actual* 2014 $5,814.0 2.00% (5,451.9) 362.1 6.2% (179.4) 182.7 Projected 2015 $5,988.4 3.00% (5,560.9) 427.5 7.1% (190.6) 236.9 Projected 2016 $6,168.1 3.00% (5,672.2) 495.9 7.6% (192.4) 303.5 Projected 2017 $6,353.1 3.00% (5,785.6) 567.5 8.9% (192.4) 375.1 Projected 2018 $6,543.7 3.00% (5,901.3) 642.4 9.8% (192.4) 450.0 2013 $179.4 (71.8) 175.6 $283.2 0 2014 $182.7 (73.1) 179.4 $289.0 1 2015 $236.9 (94.8) 190.6 $332.7 2 2016 $303.5 (121.4) 192.4 $374.5 3 2017 $375.1 (150.0) 192.4 $417.5 4 2018 $450.0 (180.0) 192.4 $462.4 1.000 289.0 $1,531 0.909 302.5 0.826 309.5 0.751 313.7 0.683 315.8 Assume 40% 10% Actual 2013 $5,700.0 * Estimated sales based on the first 6 months. ** Electrolux corporate finance policy was to use 10.0% for all dollar-based This baseline valuation isolated net operating cash flow for GE Appliances for the first four years, the present value of those cash flows totaling $1.531 billion.10 It was a very basic valuation, but as one member of the team noteda start. The team identified three specific topics for expanded analysis: (1) expanding the years of coverage beyond the current four years (2015-2018); (2) adding capital expenditure (capex); and (3) including changes in net working capital (NWC). The analysis would also need to evaluate a number of different sales and cost growth scenarios. Expanded Years. The GE appliance business would most likely continue far into the future. In financial analysis, this was usually captured by using a basic five- to seven-year period of detailed financial projection like that for years 2015-2018 in Exhibit 7, and then including a terminal value (TV)continuing valueto capture the estimated cash flows. The team supported seven years of detailed value, and the use of a terminal value in year seven that would capture all years following. After considerable debate between a value based on multiples versus discounted values, they agreed to use discounted values.11 But that did not end the debate. Several team members noted that too many valuations ended up being dominated by the TV component, typically the result of some aggressive assumption of how much cash flows would grow into the future (g). In the end, it was agreed that they would conduct valuations with and without TVs, and when including a TV, limit assumptions of growth g to between -1% and +1% per annum. Capex. No business could be sustained without some minimal amount of annual reinvestment. In the case of GE Appliances, GE itself had recently reinvested heavily in North America, so that the technology and facilities now in use were clearly of a recent vintage. The valuation team, however, disagreed over the general approach to new investment. Previous investment in the business created the depreciation charges being included in the Note that the Electrolux valuation team's analysis was conducted in U.S. dollars (USD), using a dollar-based discount rate of 10.0%, for all GE Appliances analysis. 11 The discounted cash flow terminal value calculation uses the traditional expression: 10 9\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. income forecast. If those depreciation charges were to actually continue (and not just diminish as the capital investments became fully depreciated), new capital investments would need to be made. Although one team member argued that new investment and depreciation would annually be \"roughly the same,\" others noted that capital investments would likely exceed depreciation in the future as all costs, operating and capital, always seemed to increase over time. Net Working Capital. Net working capital (NWC) management was a challenge in appliances. Whirlpool had always been considered the champion in the U.S., posting a 2013 NWC balance of 11 days of sales, based on 39 days of receivables, 47 days of inventory, and 75 days of payables. Yet, with GE's application of lean manufacturing practices across its manufacturing units in recent years, it was expected to match or even surpass Whirlpool's operating excellence. It was also noted that changes in NWC were only significant in valuation work when sales changed dramatically, not often seen in appliances. Mabe Interest The second component, and possibly the most difficult to value, was GEA's 48.5% ownership in Mabe of Mexico. Mabe (Controladora Mabe S.A. de C.V.) was a leading player in Mexico and Latin America, with strong brand recognition and a wide geographic footprint. Operating in more than 70 countries, Mabe held a 50% market share in Mexico and the Caribbean, and a strong 25% market share across Central America. Mabe, privately held, had entered into a partnership with GE in 1987 in which Mabe would be an important subcontractor to GE. The partnership would give GE access to cheaper Mexican labor, while giving Mabe access to a global network for sales and distribution. Initially, Mabe produced just stoves and refrigerators for GE, but after it acquired GE Canada in 2005, it became a major supplier of clothes dryers and dishwashing appliances to GE Appliances as well. At one point, Mabe was supplying between 40% and 50% of all GE appliances, designed and manufactured in Mexico for sale in the U.S. With GE's renewed investment in U.S. manufacturing facilities in the past four years, that percentage had dropped to 20%. Exhibit 8 illustrates the valuation team's preliminary attempt at estimating the value of GE's interest in Mabe. As a privately owned firm, financial details on Mabe were difficult to get. What Electrolux did know was Mabe's top and bottom lines in 2013, and GE's subsequent 48.5% share of profits, $35 million. Mabe still played a valuable role within GE, representing GE in many markets. As noted previously, Mabe owned GE Appliances Canada, as well as holding marketing rights to appliances sold throughout Latin America under the GE brand. Although this structure was both logical and effective for GE and GE Appliances, it was not clear that would be the case if GE Appliances was purchased by Electrolux. Some analysts wondered if Electrolux/ GE wouldn't result in Mabe/GE competing against other Electrolux products in many Latin American markets. Others argued that a combined Electrolux/Mabe product line would be highly successful, with Electrolux already having a premium presence in Brazil, Chile, Argentina, Central America, and the Caribbean, and Mabe being a market leader on a volume basis in all of these same markets except Brazil.12 A variety of outcomes were possible, including Electrolux ending the GE brand licensing agreement with Mabe or, alternatively, Electrolux choosing to acquire Mabe outright at some future date. Synergies Often promised, seldom delivered. Common critique of synergy justifications in acquisitions The third valuation component to be considered was the benefit to Electrolux of synergies gained by combining the two companies. The predominant potential synergies in an acquisition were revenue, cost, managerial, tax, and financial. In this case, since both firms were considered to have had sufficient access to capital for reinvestment purposes in recent years, and were primarily focused on combining U.S. operations and sales, the team dismissed tax and financial and focused on cost, revenue, and management. In 2009, Mabe had acquired Bosch Siemens Haushaltsgerte Home Appliances in Brazil at a steep price financed heavily with debt. Mabe had been unable to generate a sustained profit with the new acquisition, and in 2013 filed bankruptcy in Brazil, defaulting on more than $400 million in debt obligations. 12 10\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Exhibit 8. Mabe of Mexico's Forecasted Income and GE's Share (millions of US dollars) Mabe of Mexico Projected Income Revenue (USD, millions) Revenue growth (%) Less direct & indirect costs EBITDA EBITDA margin (%) Depreciation EBIT Interest EBT Taxes Net income Return on sales (%) GE's share of Mabe profits Present Value factor PV of GE cash benefits Cumulative PV Assume Actual 2013 $2,900.0 3% (2,633.0) 267.0 9.2% (116.0) 151.0 -10% (48.0) 103.0 (30.9) 30% 72.1 2.5% 48.5% 10% $35.0 Projected 2014 $3,010.2 3.80% (2,712.0) 298.2 9.9% (116.0) 182.2 (43.2) 139.0 (55.6) $83.4 2.8% Projected 2015 $3,124.6 3.80% (2,793.3) 331.2 10.6% (116.0) 215.2 (38.9) 176.4 (70.5) $105.8 3.4% Projected 2016 $3,243.3 3.80% (2,877.2) 366.2 11.3% (116.0) 250.2 (35.0) 215.2 (86.1) $129.1 4.0% Projected 2017 $3,366.6 3.80% (2,963.5) 403.1 12.0% (116.0) 287.1 (31.5) 255.6 (102.2) $153.4 4.6% Projected 2018 $3,494.5 3.80% (3,052.4) 442.1 12.7% (116.0) 326.1 (28.3) 297.8 (119.1) $178.7 5.1% $40.45 1.000 40.5 $254 $51.32 0.909 46.7 $62.62 0.826 51.7 $74.38 0.751 55.9 $86.66 0.683 59.2 * Estimated sales based on the first 6 months. ** Electrolux corporate finance policy was to use 10.0% for all dollar-based acquisition valuations. Cost Synergies. Cost synergies are reduced operating expenses associated with running combined businesses after acquisition. They are realized by eliminating duplication in activities and overhead across the businesses in the post-acquisition integration process. Electrolux believed that there would be about $300 million per year in permanent cost savings arising from the integration of GE Appliances and Electrolux operations in North America. It was estimated that $200 million would arise from combining manufacturing operations (taking advantage of the newly renovated GE Appliances manufacturing operations), with an additional $100 million per year arising from common sourcing and reduced overhead. The team estimated, internally, that to take full advantage of GE's existing North American operations would require $300 million in reorganization expenses (including write-offs), plus an additional $60 million in capital expenditures (investment). As illustrated by the valuation team's preliminary calculations in Exhibit 9, both expenses and investments would be spread out over the first two years. Once completed, however, Electrolux believed it would save $300 million per year (half that amount in 2015 as the reorganization proceeded), in its existing sales and operations in North America. This was significant and could potentially be even larger over the long run. Exhibit 9. Synergies Accruing to Electrolux of Acquisition (millions of US dollars) Electrolux US Operations Projected Synergy CFs Revenue synergies Operating cost savings Reorganization expenses Capex for reorganization Net cash flows from synergies Taxes Net operating cash flows Present Value factor PV of NOCF Cumulative PV Assume 40% NOCF 10% 0 Projected 2014 (150.0) (30.0) (180.0) 72.0 (108.0) 1 Projected 2015 50.0 150.0 (150.0) (30.0) 20.0 (8.0) 12.0 2 Projected 2016 100.0 300.0 3 Projected 2017 150.0 300.0 4 Projected 2018 200.0 300.0 400.0 (160.0) 240.0 450.0 (180.0) 270.0 500.0 (200.0) 300.0 1.000 (108) $509 0.909 11 0.826 198 0.751 203 0.683 205 11\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Revenue Synergies. Revenue synergies are opportunities of a combined corporate entity to generate more revenue than its two predecessor stand-alone companies were able to generate individually. The primary revenue synergies envisioned by the Electrolux team were based on GE's greater geographic reach in the U.S. Although both GE and Electrolux appliances were sold throughout the U.S., GE's greater logistics capabilities were thought valuable. GE had its own distribution and logistics network that supported what GE called its direct one-step retail channel strategy. This meant getting Electrolux products in front of more potential customers. After considerable debate, the valuation team had concluded that this might add $100 to $200 million in additional sales per year, but as opposed to cost synergies, these were closer to guesses. Management Synergies. Management synergies, sometimes called control synergies, were typically described as the new owner's ability to run the business better than the previous owner. GE, however, was generally considered a very capable organization in the execution of all its businesses, even appliances. Electrolux was considered managerially efficient by European standards, but the valuation team (and Electrolux's leadership team) did not expect major benefits from new management. Leadership of acquirers often championed deals on the basis of synergies, but many post-acquisition studies indicated that promised synergies were never achieved. In fact, a multitude of studies had concluded that nearly two-thirds of acquisitions failed to create value for the owners of the acquiring company because of overpayment, payment justified on the basis of synergies. In the case of publicly traded firms, all studies indicated the same results from an acquisition announcement: the acquirer's share price fell, the acquisition target's share price rose. There were, however, three deal components that characterized successful synergy capture. First, that the two companies were large in scale, so that post-acquisition overhead and management cost reductions were material in size. Second, that the two companies had significantbut not completebusiness segment overlaps. This yielded a wealth of opportunities to cut costs by cutting duplication and simultaneously leveraging access to customers for revenue enhancement. Third, that the acquiring company did not pay the seller full value for the prospective synergies. Synergy values were achievable only by the acquiring company, not the seller. Yet, as noted by a recent Boston Consulting Group study, paying the seller some portion of the synergy value facilitated deals: By sharing the value of synergies with the seller, the acquirer can pay a price that induces the seller to conduct the transaction while still enabling both acquirer and seller to create value for their shareholders. Further, by disclosing the value of potential synergies at the time of an acquisition, the acquirer can shore up its market valuation during the period following the merger announcement, offsetting the erosion in market value that frequently occurs as investors react to the uncertainty engendered by such announcements.13 In this case, the Electrolux valuation team's preliminary analysis, as seen in Exhibit 10, estimated that potential synergies brought an additional $500 million in value to the deal. Risks The potential deal faced a number of risks. First, the deal might run into opposition from the U.S. government on antitrust grounds. The combined Electrolux and GE appliance businesses would total near 40% in the U.S. marketplace, a value traditionally seen as a threshold for trouble. Although each appliance was different, the largest shares would be in cooking and refrigerators/freezers, with smaller shares in laundry appliances. When Whirlpool acquired Maytag in 2006, the same antitrust concerns were debated, again because the combined firms would have a market share of over 40%. In the end, the Commerce Department had allowed the acquisition to go through unopposed on the basis of the Bush administration's general philosophy of no intervention, specifically noting the growing competitive strength of Asian manufacturers imposing a strong competitive pressure on prices. That same price pressure was no longer as effective as a result of the antidumping tariffs, and the Obama administration had been distinctly hostile toward industrial consolidation. \"How Successful M&A Deals Split the Synergies: Divide and Conquer,\" Jens Kengelbach, Dennis Utzerath, Christoph Kaserer, and Sebastian Schatt, BCG Perspectives, March 27, 2013. 13 12\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Exhibit 10. Values GE Appliances May Bring to Electrolux In the U.S. market, it was also possible that there would be some cannibalization of GE or Electrolux sales as a result of the combination. Although proponents of the deal emphasized cost and operating benefits, there was little information on how consumers would respond to the combination. In the end, the estimation of the value of synergies was a far cry from achieving those synergies. Acquisition history was littered with hundreds of deals that never achieved promised synergies and never created value for stockholders. Electrolux's Bid Strategy Electrolux was a motivated buyer, and GE was clearly a motivated seller. Electrolux wanted to gain GE's brand, newly refreshed manufacturing technology, and marketing and sales scale in the United States. But the two companies knew each other well as competitors. As noted by one Electrolux executive, \"We have danced before.\" But Electrolux was not the only suitor of GE Appliances; it was rumored that other appliance companies were lining up for the purchase as well, including China's Haier and Mexico's Mabe, two companies with limited to little current presence in the U.S. and Canada. The valuation team now had to cycle again through the various valuation components and then finalize their valuation and bidding strategy. Time was short. 13\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 135,803 133,150 124,077 120,651 129,469 103,848 104,732 104,792 109,132 106,326 101,598 109,994 -26,816 -25,731 -22,759 -22,656 -22,421 -16,924 -16,857 -16,020 -14,848 -16,375 -16,237 -17,057 -23000 -23000 -23000 -19000 -20285 -20000 -20000 -98,429 -95,850 -90,758 -90,130 -96,676 -56,591 -57,300 -59,839 -66,520 -59,794 -58,159 -64,604 10,558 11,569 10,560 7,865 10,372 7,333 7,575 5,933 8,764 9,872 7,202 8,333 -4,020 -3,632 -3,171 -3,023 -3,410 -2,758 -2,738 -3,010 -3,442 -3,328 -3,173 -3,101 6,538 7,937 7,389 4,842 6,962 4,575 4,837 2,923 5,322 6,544 4,029 5,232 -257 -230 -182 -155 0 0 0 0 0 0 0 -150 6,281 7,707 7,207 4,687 6,962 4,575 4,837 2,923 5,322 6,544 4,029 5,082 -1,207 -596 -664 -2,288 -3,747 -750 -802 -2,270 -1,868 -1,238 -1,249 -1,754 5,074 7,111 6,543 2,399 3,215 3,825 4,035 653 3,454 5,306 2,780 3,328 132 9 -2 -1 0 0 0 0 0 0 0 -3 -1,477 -2,459 -2,226 -1,210 -1,452 -1,177 -1,110 -287 -877 -1,309 -716 -879 3,729 4,661 4,315 1,188 1,763 2,648 2,925 366 2,577 3,997 2,064 2,446 10.96 14.25 13.77 3.98 6.05 9.17 10.41 1.3 9.07 14.04 7.25 8.56 Source: Keplercheuvreux, p. 32 and author calculations. Electrolux Sales Labour costs Purchased raw materials Other operational costs EBITDA Depreciation EBITA Goodwill EBIT Net financial costs EBT Minority Tax Net profit Reported EPS Appendix 1. Electrolux Income Statement and Outlook (mission of Swedish krona, SEK) 2013 2014E 109,151 111,177 -16,633 -17,157 -19000 -19058 -65,550 -66,528 7,968 8,434 -3,206 -3,378 4,762 5,056 -150 -150 4,612 4,906 -3,708 -2,706 904 2,200 -1 -4 -232 -572 671 1,624 2.34 5.67 For the exclusive use of S. Lambert, 2017. This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. 14\tA06-16-0001 For the exclusive use of S. Lambert, 2017. Appendix 2. Electrolux AB Share Price (Stockholm: ELUX-B, weekly, Jan 2000-July 2014) Appendix 3. Electrolux's Cost of Capital and Capital Structure (In Swedish kroner, SEK) Cost of Equity Bond rate Values 4.300% 4.000% 1.30 9.500% Cost of Debt Risk free rate Electrolux credit risk premium Cost of debt Tax rate Market risk premium Electrolux beta Cost of equity Cost of debt after-tax Debt Capital Equity Capital 286,130,000 Shares outstanding 182 Share price (SEK) Equity value (SEK) 52,075,660,000 Debt outstanding Percent of total 81.870% Percent of total Weighted Average Cost of Capital (WACC) Values 4.300% 1.200% 5.500% 26.000% Total Capital 4.070% 11,532,000,000 63,607,660,000 18.130% 100.000% 8.5155% 15\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. Appendix 4. GE & Electrolux Plant Locations in North America Appendix 5. How Acquisition of GE Appliances Would Have Changed Electrolux in 2013 Electrolux 2013 Percent of Sales by Sales Segment Region/Product (SEK billion) Major Appliances North America 29% 31.6 Major Appliances EMEA 31% 33.8 Major Appliances Latin America 19% 20.7 Major Appliances Asia Pacific 8% 8.7 Small Appliances 8% 8.7 Professional Products 5% 5.5 100% 109.0 Electrolux + GE Appliances Percent of Sales by Sales Change in Sales Region/Product (SEK billion) (SEK billion) 47% 69.1 37.5 23% 33.8 0.0 14% 20.6 (0.1) 6% 8.8 0.1 6% 8.8 0.1 4% 5.9 0.4 100% 147.0 38.0 SEK 6.515 = 1.0 USD USD 5.83 Source: Electrolux. 16\tA06-16-0001 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. NA0030 Private Equity Case: Merger Consolidation* Hugh Grove, University of Denver Tom Cook, University of Denver I n early 2006, Aaron Brown, recently promoted to partner, was meeting with John Fields, the founder of ACE Equity Partners, a mid-size private equity fund in Chicago, Illinois. Aaron was recently put in charge of the newest investment opportunity for ACE, the possible acquisition of two physical therapy (\"PT\") companies in Ohio and Maryland. ACE's primary investment strategy for the space was to consolidate smaller private PT businesses that focused on patient outcomes into a much larger enterprise. ACE anticipated selling the consolidated enterprise to a larger private equity fund or taking the company public in three to five years. John: Congratulations on your recent promotion to partner. Now you get the chance to prove yourself on this potential PT investment. Aaron: Thanks. I'm excited to be in charge of this investment opportunity. I now have all the major documents for these two PT companies including (1) the CPA firm's accounting reports on both PT Companies, (2) the investment banker's prospectus on both PT Companies, and (3) financial analysts' reports on the PT industry. John: Excellent. I look forward to your analysis and recommendations on this PT investment opportunity for our partners investment committee meeting next Monday. Aaron: I will be ready. PT INDUSTRY In reviewing the financial analysts' reports on the PT industry, Aaron noted that one analyst had just initiated coverage of two public PT companies, U.S. Physical Therapy and RehabCare Group. He thought such interest was a good sign for the PT industry although he noted that his recommendations for these two companies were \"hold/high risk.\" Aaron summarized key PT industry points from the reports of the financial analysts and the prospectus of the investment banker as follows: The United States spent a larger share of its gross domestic product (GDP) on healthcare than any other major industrialized country. Expenditures for healthcare represented nearly one-seventh of the nation's GDP and continued to be one of the fastest growing components of the Federal budget. For example, in 1960 healthcare Copyright 2008 by the Case Research Journal, Hugh Grove, and Tom Cook. * This case won the Silver Award as the second best case presented at the 2006 NACRA Conference held in Keystone, Colorado. Private Equity Case: Merger Consolidation 1 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. expenditures were five percent of GDP. By 2005, healthcare expenditures had grown to more than fifteen percent of GDP. Economic factors in the healthcare industry were driving growth in PT. Healthcare payers, such as governments, insurance companies and employers, had become increasingly focused on eliminating unnecessary healthcare costs from the system. Because of the trend toward minimizing healthcare cost, many payers were focused on the quality of the care provided to patients. It was less expensive for payers to have a patient treated correctly the first time than to have the patient return to therapy after a recurring injury. Thus, PT companies that focused upon outcome based results were receiving increased referrals from payers and employers. The PT industry was estimated to be a $12 billion market and had been growing 12 percent annually over the last five years. The industry was highly fragmented with 16,000 companies, the majority of which were small \"Mom and Pop\" entrepreneurs. No competitor had more than a 5 percent market share and the top five operators, HealthSouth, Select Medical, Stryker, Benchmark, and U.S. Physical Therapy, together had only a 17 percent market share. Smaller private companies comprised the remaining market share. The PT industry had low barriers to entry because the cost (facilities and exercise equipment) of starting a practice was minimal. Additionally, Congressional legislation in 1998 allowed physicians to open PT clinics, thereby increasing competition for patients. There were more than 120,000 licensed physical therapists in the U.S. They practiced in many settings, including outpatient clinics, inpatient rehabilitation facilities, skilled nursing facilities, extended care facilities, homes, research centers, schools, hospices, workplaces and fitness centers. The Department of Labor predicted above average employment growth for therapists through 2012 as (1) the growing number of individuals with disabilities or limited function, including aging baby boomers, spurred demand for therapy services and (2) therapists' compensation was among the industry's highest levels. The growth, however, had created a shortage of therapists in many markets as new job demands exceeded the number of licensed PTs. The most important driver of any PT company was its relationships with referral sources and payers. Although patients received the treatment, physicians generally controlled the flow of patients to PT companies through referrals. Additionally, large commercial health insurance carriers and Health Maintenance Organizations (HMOs) often determined the reimbursement rates that PT companies received. PT companies typically negotiated directly with these commercial payers for reimbursement both contractually and for each individual claim. Price was always an issue in the PT industry as payers viewed low prices as the easiest way to cut down on expenses. Pricing pressure in the industry, intensified by legislation that allowed physician office-based clinics, had created a difficult environment for providers to offer the right quality of care at the right price. 2 Case Research Journal Volume 28 Issue 1 Winter 2008 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. THE OHIO PT CHAIN The Ohio PT company was founded in 1997 by physical therapists and exercise physiologists. By the end of 2005, it had grown to eight clinics located in major cities across Ohio. Patients typically ranged from 16 to 55 years of age. The Ohio firm focused upon combining and applying best practices from the disciplines of physical therapy, exercise physiology, and athletic training. The company focused on large clinics with extensive equipment, located in major population centers, marketing itself as providing one-source or one-stop rehabilitation solutions. Each Ohio facility had a minimum of 5,000 square feet, as opposed to the typical \"store-front\" PT facilities of about 1,000 square feet. With state-of-the-art equipment and one-on-one sessions with physical therapists and trainers, the Ohio facilities appeared to be gyms where people were enjoying rehabilitation. Such practices led to a 10 percent appointment cancellation rate, as opposed to the normal 50 percent cancellation rate in the PT industry. Such practices also helped retain and attract physical therapists. Additionally, the Ohio firm was well known throughout the industry as providing the best rehabilitation services in the industry and had recently been honored as the best private practice in the U.S. by a rehabilitation magazine. THE MARYLAND PT CHAIN The Maryland (MD) PT company, founded in 1999 by physical therapists, was somewhat younger than the Ohio company. It had grown to fourteen clinics located in major cities across Maryland and Delaware and treated patients ranging from 16 to 55 years of age. MD focused primarily upon the discipline of physical therapy. MD also tried to concentrate on large clinics in populated areas, but it did not have state-of-the-art equipment and was known as a \"churn and burn\" provider, focusing on putting as many patients through the system as possible. MD's focus was similar to the typical PT approach, relying on many \"store-front\" clinics to increase the number of patients. Therefore, it did not have an established, favorable reputation to facilitate the growth rate that the Ohio PT company had. However, MD did provide a number of services that the Ohio firm did not, including aquatic therapy, hand therapy and spine therapy. Also, MD had a very efficient collection system that focused on ongoing communications with its payers, especially for accounts past 30 days old. ESTIMATING EBITDA FOR BUSINESS VALUATION Working with the information from the CPA firm, Aaron planned to recast the financial statements in order to derive earnings before interest, taxes, depreciation, and amortization (EBITDA) for the last two years. He knew that an accurate EBITDA calculation was needed to help determine the final valuation for each PT company. In order to accurately calculate this figure, Aaron had to adjust or recast whatever revenues and expenses had been reported in the income statements by the PT firms' unsophisticated bookkeepers. Such initial numbers were mainly cash accounting with attempts to do accrual accounting for accounts receivable, prepaid expenses, and accrued expenses. These adjustments focused on recasting this unsophisticated combination of cash and preliminary accrual accounting to complete accrual accounting for revenues and expenses under generally accepted accounting principles (GAAP). Neither company had ever had an Private Equity Case: Merger Consolidation 3 This document is authorized for use only by Shah Lambert in FIN-630 Capital Budgeting & Financing 17TW4 taught by Lindsay Conole, Southern New Hampshire University from February 2017 to June 2017. For the exclusive use of S. Lambert, 2017. audit of its financial statements but ACE's potential lenders would require the use of GAAP and an audit by a CPA firm. Aaron summarized the last two years of unadjusted financial statements for both companies (the only reliable historical information available due to the limitations of both companies' bookkeeping practices) in Exhibit 1. The most complex calculations involved converting the reported revenues to actual accrual revenues. This process focused on converting gross revenues to net revenues once reimbursement rates were determined for different types of PT services. Such rates depended upon individual states and insurance company procedures. Various payers, such as Blue Cross or Kaiser, negotiated with various service providers (HealthSouth or Humana Hospitals or the PT companies in this case), to agree upon various reimbursement rates. These service providers would bill at full rates (gross revenues) but the payers would pay just the negotiated rates (net revenues) to the service providers. The patients (subscribers) were only responsible for their co-pay amounts, if any, to their insurance companies and did not have to pay any differences between gross and net revenues to the PT companies. Thus, the amount billed by the service providers often represented a total cost computed with full overhead allocation that the payor would negotiate down to a lesser amount (with less than a full overhead charge), Exhibit 1 ACE Private Equity FundOhio and Maryland Physical Therapy Firms: 2005 and 2004 Unadjusted Financial Statements (000) INCOME STATEMENT Ohio Maryland 2005 2004 2005 2004 $ 20,041 7,547 $ 15,049 5,806 $17,726 7,093 $ 17,352 6,464 12,494 3,137 9,243 1,598 10,633 5,883 10,888 5,463 $ 9,357 $ 7,645 $ 4,750 $ 5,425 Cash Accounts Receivable, Net Prepaid Expenses $ 1,342 5,033 129 $ $ $ Total Current Assets 6,504 3,886 4,455 4,363 1,677 456 910 66 1,538 108 1,477 88 $ 8,637 $ 4,862 $ 6,101 $ 5,928 $ $ $ $ Net Revenue Cost of Services Gross Profit Operating Expenses Operating Income STATEMENT OF FINANCIAL POSITION Assets Current Assets Fixed Assets, Net Other Assets: Deposits Total Assets 606 3,241 39 653 3,698 104 620 3,650 93 Liabilities and Owners' Equity Current Liabilities Accounts Payable Accrued