HELPPPP

Hopper Laboratories Financial Information

In 2015 Hopper Labs had total revenues of $110 million dollars, up from only $65 million in 2011. Hopper expects earnings to continue to grow at an average rate of almost 13.00% per year for the next five years and then slow down gradually in the following five years, settling down to a steady 6.00% a year in the eleventh year.

For the year 2015 Hopper had an EBITDA of $33 million and a net income of $21 million. Assets totaled $122 million. Claim consisted of 240,000 shares of preferred stock with a book value of $24 million, contributed common equity of $32 million and accumulated retained earnings of $66 million. The preferred stock is held in the Phyllis Hopper Trust. Previously Phyllis Hopper was both the trustee and the beneficiary. Now that she has passed away a local bank is the trustee and the beneficiaries are Mrs. Hoppers great grandchildren who will receive a cash distribution upon entering college. The stock has a par value $100 per share and pays a dividend of $12.50 per share to perpetuity. Randy knows that the trust department will have a fiduciary obligation to sell the preferred stock and replace it with a diversified portfolio. But, because there is no market for it, selling it will be difficult. At $100 per share, a $12.50 dividend provides a very high yield. Yields on preferred shares like this are around 700% to 9.00%. If the trustee wants to sell it in favor of a diversified portfolio he will have to insist on a high premium (that is, a price in excess of par). The trustee will naturally approach Hopper Labs and request that the company redeem the shares at a fair value. Redemption certainly makes sense. While she was alive, Phyllis Hopper insisted that the firm have no debt and this clearly reduced the firms return on equity. Now that she is gone it makes sense to convert the preferred stock to debt. Borrowing enough money to redeem the preferred stock would effectively convert dividend payment into interest payments. Because interest expenses are tax deductible and preferred dividends are not, the conversion would be like getting a subsidy from the taxing authority that would directly benefit the common shareholders. The preferred stock represents 20% of the voting power in the company. Through his ownership of 512,500 shares of common stock Randy controls about 10% of the voting power of the company. The Employee Stock Ownership Plan (ESOP) owns 1,025,000 shares of common stock to control 20% of the company. Randy feels that it will be easy to reach an agreement with the ESOP on how to change in the capital structure of the firm. The remaining 2,562,500 shares (50% of the ownership control) are held by relatives and local residents. As long as Randy, the trustee, and the ESOP agree on a restructuring plan it is doubtful the other shareholders could offer meaningful resistance. In fact, if there arose a conflict between the preferred shareholders and the common shareholders, Randy would be mindful of the benefit the Phyllis Hopper Trust will eventually confer on his own grandchildren. The common stock has a par value of $1.00 and there are 4,100,000 shares outstanding. Annual dividends per share were $1.46 last year. Because the company maintains a 50% payout ratio, the current five-year proforma financial statements indicate an average dividend growth rate of 13.00% per year for the next five years and then slowing down gradually of the following five years, settling down to a steady 6.00% a year in the eleventh year. Consistent with the sales forecast of a maturing market, Randy believes that the dividend growth rate will settle down to constant 6.00% per year after five years. Hopper stock trades on the pink sheets. This is a market for companies that are not listed with the SEC and have no financial standards or reporting requirements. Trading on the pink sheets is very slow. A seller lists the stock he or she has to sell along with its offer price and then waits to see if a buyer is interested. Usually a bid for the stock at a lower price appears within the day. But then the two prices may stay the same for matter of days before one of the two parties capitulates to the price of the other or a third party consummates a trade with the winner. The last trade in Hopper labs was for 10,000 shares five days ago for $55 per share. Randy regards that price as extraordinarily low and is kicking himself for not having the company scoop up the shares as treasury stock for later transfer to the ESOP. He suspects that the seller was a family member known to be desperate for cash. So far the only exchange Randy has had with the private equity firm is one in which they voiced interest in taking over the company and the caller asked Randy to meet at a restaurant at the Minneapolis St. Paul airport to explore the idea. Randy demurred but promised to respond as soon as he had time to consider the idea. Now he needs to decide whether to explore the sale of the company, and if so, whether he would negotiate a contract to continue managing the company for the few years. It is possible that the private equity firm would eventually make a tender offer for all of the companys common and preferred stock. He has no idea what to expect from them but when he returns their call but he wants to be prepared to determine whether they are talking about a reasonable valuation or are just looking to pick off a nave small businessman who doesnt know how well off he is. So has hired a local investment banker to advise him. In this case you are to play that role. The first thing you do is search for a company that is similar to Hopper Laboratories Inc. While there are no firms in the water testing business that have a model similar to that of Hopper, you have found one in another industry that will have to do. National Security Inc. is a publicly traded company about nine times the size of Hopper Labs that sells security hardware such as break-in detectors, T.V. cameras, motion sensors, specialized lighting, alarms, etc. wholesale to local security firms. The company also sells monitors that can detect malfunctioning of just about any light emitting device, light sensing device, or sound sensing device. Nationals system works through cell phone or internet connectivity depending on the location. Nationals malfunction-detecting devices can be found on the lights of small private remote airports, on the aircraft warning lights of tall buildings and towers, on rural traffic lights, on un-manned light houses and buoys, etc. National is about to release a new product that can be mounted in forest lookout towers that uses infrared sensors to detect forest fires before they can be seen with a naked eye. National claims that the sensors work well when they are merely fixed to an antenna mounted on a tall tree. While this business model may seem to be a far cry from that of Hopper Laboratories it is probably as closely related to Hopper as one is likely to find. Nationals income and dividend payments are growing at 6.00% per year. The company has 100 million shares outstanding that are trading on the NASDAQ at $20.00 per share for a total market capitalization (i.e. market value of equity) of $2 billion dollars. It also has debt outstanding with a book value of $200 million. There is no market for its debt so you are forced to substitute the book value of debt for the market value of debt to determine Nationals enterprise value. The firms EBITDA last year was $275 million. Randy has mixed feelings about the private equity offer. Should he try to hold onto the business as a family-oriented private enterprise? Will the heirs of Phyllis Hopper be satisfied with an asset that appreciates in value or will they want to take the money and run.? If the firm is to be sold, is a sale of the entire enterprise to a private equity firm the best way to go? Or would an IPO garnish more money? Like many people who are in a situation where they are not sure which question they should be asking, Randy falls back to a simple strategy. Get the best offer he can extract from the private equity firm and then figure out what to do next. Tasks to Be Performed by Hoppers Investment Banker Calculate the enterprise value of the Hopper Laboratories. Base your calculation on the information you have gathered from National Security. To do that you need to calculate the enterprise value of National Security, and then use the ratio of National Securitys EBITDA to Hoppers EBITDA to estimate Hoppers Enterprise value. Hopper has no debt so its enterprise value is the same as its market capitalization rate.

1. What is the enterprise value of National Security? 2. What is the enterprise value of Hooper Laboratories? 3. Randy has seen your enterprise value calculation for Hopper Labs. He reacts immediately by asking a new question. Suppose the firm Hopper Labs were offered to the private equity firm at the enterprise value you just calculated and the private equity firm agrees to pay that amount. In that case, how should the amount the private equity firm pays be divided between the preferred shareholders (the trust) and the common shareholders? Randy thinks that an appropriate required rate of return for a share of preferred stock is around 8.00% even though they have a par value of $100 and pay a dividend of $12.50 per year. On that basis how much is one share of preferred stock worth? 4. How much are all 240,000 shares of preferred stock worth? 5. If the value of all 240,000 shares were paid to the trust, how much would be left for the common shareholders? 6. Given that there are 4,100,000 shares of common stock outstanding how much would one share of common stock be worth? 7. Randy is not pleased with the calculated per-share value you have provided him from the previous question. He thought the number should be higher so he would like some other ways of estimating the value of Hopper Laboratories common equity. You decide to use the standard Gordon Dividend Discount Model to calculate the value1. As a first step you need to determine an appropriate required rate of return. You observe that National Securitys stock is trading at $20, its expected growth rate is 6.00%, and it has just paid a dividend of 57. You decide to estimate a required rate of return for Hopper Labs, based on the dividend discount model and the return on Nationals stock. What is the return on Nationals Stock according to the dividend discount model? Carry out your calculation to two digits to the right of the decimal place. 8. Hopper Labs most recent dividend is a $1.62. Suppose the growth rate were assumed to be only a steady 6.00% instead of the expected average 13.00% and that the appropriate market rate of return is the one you calculated for National Security. What would a share of Hopper stock be worth then? 9. Based on your answer to the previous question how much would the entire 4,100,000 be worth? 10. Recall Hoppers enterprise value from Question 2. If the private equity company were willing to pay that amount and Randy value the common equity as you calculated in the previous question, how much money would be left over for the preferred equity? 11. Based on your previous calculation, what would be the value of a share of preferred stock? 12. Given the dividend of $12.50 what would the return on the preferred stock be to the private equity firm if it paid that price? Carry out your calculation to two digits to the 1 Notice that the first four questions calculate, Common Stock = Enterprise Value Preferred Stock. The next four questions calculate Preferred Stock = Enterprise Value Common Stock right of the decimal place. 13. Randy is still not satisfied. He argues that National Securitys revenues are highly vulnerable to the state of the economy and probably have a very high beta. But monitoring toxic releases is a legal phenomenon and not subject to economic fluctuations. Suppose that the risk free rate is 5.50%. The market rate of return is 8.60% and Hoppers beta is 1.1. What would the required rate of return on Hopper Stock according to the Capital Asset Pricing Model? Carry out your calculation to two digits to the right of the decimal place. 14. Based on the calculation of the previous question, what would one share of Hopper Stock be worth according to the Gordon Dividend Discount Model? Use the 6.00% growth rate and the most recent dividend of $1.62. 15. Perhaps Randy will never be satisfied because he is not satisfied with the calculation of the previous question. So you decide to turn to proforma analysis to estimate the dividends as follows: Year Dividend Year Dividend 2016 $1.72 2021 $3.14 2017 1.94 2022 3.49 2018 2.20 2023 3.84 2019 2.48 2024 4.18 2020 2.80 2025 4.51 By the time the 2025 the dividends are paid the rate of growth will have declined to a sustainable rate of 6.00% to perpetuity. Assume a required rate of return of 10.00%. What by the hypothetical terminal value of the company in 2025? 16. Based on the terminal value of the company terminal value you calculated above and the dividends calculated in the table above, a 10.00% required rate of return and a 6.00% growth rate, what is the value of a share of Hopper common equity according to the dividend discount model? 17. Discussion Prompts a. What should Randys objective be? Should he try to keep his job? Get as much money for the firm as possible? Or have some reservation price above which he would sell the company and below which he should try to keep his job? b. Randy has agreed to meet with the private equity guy over lunch at a fancy restaurant at the airport (the equity guy is flying in and then departing two hours later). The private equity guy does not care about the distinction between preferred equity and common equity. If Randy is called upon to make an offer what should his initial offer be? How should he justify that offer? You can use any plausible required return on equity or growth rate to support the case for this offer. You dont have to stick to the numbers in the case. c. What should Randys internal reservation price be? That is, what is the minimum price that is still high enough so that he would sell the company regardless of your answer to (a). How do you support this reservation price? You dont have to stick to the growth and required rate of return assumptions in the case as long as the ones you use are plausible.