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Case7 The Bonneau Company Acquisition and Valuation When Ed Bonneau reflects back on the early days of starting his own business, he remembers clearly the event that prompted his \"going on his own\". The day had started routinely enough, but ended in what at the time felt like a disaster. Bonneau went to work on that fateful day in 1975 preparing in his mind what calls he would make; he went home wondering how he would tell his wife, Barbara, that he had lost his job. As a sales representative for a sunglass company, Bonneau had done relatively well during the two preceding years. Previously, he had worked for several years in sales for a cosmetics company; before that, he had gone into the restaurant businessunsuccessfully, he is always quick to say. Then, in 1973, he went to work for a sunglass firm as a representative. He enjoyed the work and made an acceptable income for the time, but the business was highly seasonal and he was essentially idle five months of the year. Although Bonneau enjoyed the free time his first year on the job, he knew that he would not be satisfied with the arrangement long-term, especially since he had a growing family and needed a higher income. During that first year, he thought of starting his own company to market other products during the slow months. He approached his boss about being allowed to work with other products during the slow times, and even asked if they could work together, but received a less than encouraging response. In Bonneau's words, \"He did not see me as a manager\". Shortly after Bonneau arrived at work on that memorable day in 1975, he again raised the issue, since he saw no sense in giving full time to a job that he believed only required part time. Abruptly, he was told to empty his sample case, since his services would no longer be needed by the firm. On the way home, Bonneau stopped at a restaurant the regional Assison airport (in the northwest Dallas area) to have some coffee and to take a few minutes to gather his thoughts on what he should do and how he should tell his wife what had happened. He remembers thinking, \"I just gave up the best job I have ever had\". Within a few days, the Bonneaus had decided to develop their own sunglass business, Bonneau thought he could sell at least 50% percent of what he had been selling with his former employer, but would now receive the entire profits for himself. So the decision was made to make the Bonneau Company a full-time affair. THE EARLY HISTORY With only $1,000 to invest personally, the Bonneaus's first problem was to find the seed capital to finance their venture. Bonneau decided to call on Floyd Teutsch, a personal friend and banker from his hometown. Teutsch loaned them $10,000 and later agree to co-sign on a $25,000 note. With this money in hand, the Bonneaus drove to New York from Dallas (with the children in the backseat) to purchase some inventory, Searching through the Yellow Pages and walking along Fifth Avenue, they identified retailers who sold sunglasses and called on several to see if they were interested in selling their inventory. On the third day, they found a retailer who wanted to liquidate his entire inventory. They agreed to send him a cashier check for $16,000, after which he would ship the inventory to Texas. They returned home and leased an 11-by-80 square-foot storefront close to their home. In the first full year, Bonneau had hoped to do $100,000 in business; the actual sales were $156,000. Over the following six years, sales grew at an annual compound rate exceeding 70%, and in 1982, sales were $4 million. The firm then began distributing its product through chain drugstores, and by the end of the 1980s, sales had grown to $12 million. During those years, the major players in the sunglass industry were Foster Grant and a joint venture between Polaroid and American Optical. Polaroid entered the sunglass industry in the early 1980s and at its peak time in the field achieved $50 million in annual sales, making it the largest company in the history of the industry. Bonneau was understandably concerned that a \"major\" Was becoming a key competitor. As it turned out, however, American Optical and Polaroid eventually divorced ad Bonneau was able to buy the remaining inventory. EXTERNAL GROWTH In addition to pursuing internal growth, the Bonneau Company seized several opportunities to acquire other companies, either as ongoing firms or simply for their assets, typically in the form of inventories and/or receivables. Renauld was an acquisition of the first type, and the purchase of Polaroid's inventoried was an acquisition of the second type. The most significant acquisition, however, was Pennsvlvania Optical. One of the problems that continued to nag the Bonneau Company was the seasonality of the sunglass industry. In the early and midd-1990s, Bonneau became increasingly aware that nonprescription reading glasses were coming into the marketplace. He recalls, \"We were interested in finding product lines that were not overly seasonal, as were sunglasses. So we began looking at reading glasses as an opportunity. We had tried to carry some reading glassed as one of our product lines, but had never been successful,. We then heard that Pennsylvania Optical, a firm that specialized in reading glasses, could be purchased.\" Pennsylvania Optical was a 98-year-old firm in Reading, Pennsylvania, that in recent years had been a subsidiary of a large firm. In a matter of five years, it had been acquired three times. In none of these sales had Pennsylvania Optical been the primary part of the transaction; it just happened to be a subsidiary of the firm being acquired and thus changed hands more by default than by intent. As a result, the company went through a five-year period of near-dormancy. Bonneau thought that it was amazing the firm managed to stay alive. Its sales force had been reduced significantly and management had ceased being aggressive in its strategies. Once again, its parent company was seeking to divest Pennsylvnia Optical. When Brad McDonald, the sales vice president for the Bonneau Company, heard that Pennsylvania Optical was for sale but there were no takers, he arranged to meet with Penn Op's management and reported the results of the meeting to Bonneau. Although Bonneau was not initially excited about the possible purchase, he sensed McDonald's enthusiasm and agreed to a meeting. He, McDonald, and Ken Dortch, Bonneau's vice president for finance, went to Reading to meet with the Penn Op Management. While there, they visited with the mergers and acquisitions group at Mellen Bank, since on his earlier visit, McDonald had tentatively arranged to have the banking group represent the Bonneau Company if the deal went forward. Mellen's retainer was strictly on the come, as were most fee arrangements of merger and acquisition departments at that time. After the visit, the Bonneau group came to see more clear the synergy that could be achieved between reading glasses and sunglasses, especially since they often retailed in the same stores. Another favorable consideration was that Penn Op's customers included several mass merchandisers the Bonneau Company wanted for customers, including Wal-Mart, K Mart, and Woolworth. After looking at the numbers, Bonneau and his people began trying to negotiate the purchase, but, unable to reach an agreement, soon terminated the negotiations. Then, about one week later, the prospects of the sale were resurrected during a telephone conservation between Bonneau and the Penn OP chainman of the board. The final arrangements were made and the purchase was consummated. The asking price for Penn Op was $6 million. Remembering the negotiation process, Bonneau commented, \" I still don't know what they really expected to receive for the business. We had a consultant value the company. We also tried to think about what the firm was worth to us. We offered a cash price of $5 million, plus the assumption of the firm's pension liability of about $1 million. They accepted our offer\". At the time of the acquisition, Penn Op had $6 million in annual sales. Bonneau merged the sales forces, making the combined staff responsible for marketing all the product lines, both sunglasses and reading glasses. This immediately enhanced the distribution and selling of Penn Op products. Within three years, sales for Penn Op had doubled and the business was once again profitable and thriving. THE BONNEAU FINANCIAL POSITION The Bonneau Company had by 2000 experienced 25 years of successful operations in the sunglass industry and become a significant player in the mid-price range of that industry. With few exceptions, the firm's sales growth had been uninterrupted over the years, with sales reaching $46 million in 2000. Asked about the firm's sustainable competitive advantage, Bonneau explained that they did not, in his opinion, have any cost advantage. Rather, \"it is an advantage of staying power and being here for 25 years. We have a broad marketing appeal, and we can service a wide range of customers who have a lot of different needs, whether it be men's glasses, women's glasses, sporting glasses, fashion glasses, or polarized lenses\". The Bonneau Company's 1999 and 2000 financial statements are presented in Exhibit 1. These statements combine all the firm's operations, both for the Bonneau Company and for Penn Op. Exhibit 1 The Bonneau Company FINANCIAL STATEMENT (thousands) Balance Sheet Assets Cash Accounts receivables Inventory Prepaid expanses Total current assets Long-term receivables Plant and equipment Less: accumulated depreciation Net plant and equipment Other assets Total assets 2000 $ 290 9335 7820 650 $ 18095 $ 3000 $ 4265 2655 $ 1610 350 $ 23055 1999 $ 575 9115 8005 585 $ 18280 $ 425 $ 3935 2225 $ 1710 795 $ 21210 Liabilities and Equity Short-term bank notes Account payable Accrued liabilities Other current liabilities Total current liabilities Pension liability $ 5445 1820 2045 635 $ 9945 1075 $ 5120 1450 1685 740 $ 8995 1075 Long-term debt Total long-term liabilities Total liabilities 1000 $ 2075 $ 12020 1425 $ 2500 $ 11495 $ 15 70 10950 $ 11035 $ 23055 $ Sales Cost of goods sold Gross profit Operating expenses Operating income Interest income Earnings before interest and taxes Interest expense Earnings before taxes Estimated tax provisions 2000 $ 46545 22545 $ 24000 20274 $ 3725 185 $ 3910 1280 $ 2630 1155 1999 $ 44950 23100 $ 21850 18740 $ 3110 185 $ 3295 1215 $ 2080 705 Net income Dividends Change in retained earnings $ 1475 155 $ 1320 $ 1375 505 $ 870 Common Stock Par value Additional paid-in capital Retained earnings Total equity Total debt and equity 15 70 9630 $ 9715 $ 21210 Income Statement A NEW OPPORTUNITY: THE FOSTER GRANT COPORATION The most recent event of significance for the Bonneau Company is the contemplated acquisition of the Foster Grant Corporation, historically one of the long-term players in the industry. Foster Grant had long been known for its quality products and was respected as a major company in the industry. In addition to sunglasses, the firm had been actively involved in the development of plastic materials. Over time, however, the sunglass business had become a larger part of the sales mix, and by 19 81, Foster Grant had captured 35% of the sunglass market, selling the higher-priced Renauld line in department stores and the lower-priced Foster Grant line in general merchandise and discount stores. Like Penn Op, however, it had been acquired several times during the past few years, first by United Brands Corporation, and soon thereafter by Hoechst A.G., a major German chemical manufacturer. Hoechst had hoped to use Foster Grant to establish an important position in the U.S. petrochemical market. Soon after its acquisition by Hoechest, Foster Grant began losing its dominant position in the sunglass industry. Most recently, the firm was sold to Andlinger & Company, a private investment banking group. The financial structuring of the Foster Grant acquisition by Andlinger involved heavy use of high-yield debt, which later proved untenable, given the firm's level of cash flows. The company had since been placed in receivership and bankruptcy courts were searching for an acquirer while not particularly interested in buying Foster Grant, Bonneau decided they should at least take a look at the situation. Shortly thereafter, they decided to make an offer. The key questions now facing management are the offering price and how to finance the acquisition. Bank Financing of the Acquisition The Bonneau Company's primary source of financing its previous acquisition had been a local bank, so Bonneau and Dortch decided to approach the same bank about the Foster Grant deal. The company has had a longstanding relationship with the bank, which had recently been acquired by a large bank holding company. Based on early visits with bank officers, both Dortch and Bonneau believed the bank was interested in financing the purchase. Still, both men were acutely aware of all the recent \"dead bodies\" of those who used heavy debt financing in acquiring other companies. Dortch notes: When we acquired Penn Op in 1996, which was not much different from what we are considering with the Foster Grant acquisition, we told the bank what we were doing; it was virtually all verbal. They simply said, \"If you think it's good, then it's okay with us\". I don't think they saw anything to speak of until just a few days before it was time to transfer the money. But now, they of necessity look very carefully at the transaction and how much debt it brings onto our balance sheet. There are so many more bank examiners and more surveillance regarding leverage transactions or LBOs and things like that. The Analysis of the Foster Grant Acquisition Bonneau's management began taking a serious look at Foster Grant in September 2000, and the timing represented a major problem in making the deal. Most decisions by major chain stores regarding the next year's purchases of sunglasses are made in October and November. Thus, time was of the essence. If the deal could not be closed within the next 60 days or so, there was a strong likelihood of losing an entire year of sales and the risk that those lost sales could not be recouped in the following year since vendors could well be slow to return. This fact was weighing heavily on the Bonneau management. As they studied the proposed acquisition, the Bonneau management was given a package of information that the Foster Grant people believed summarized the current situation and the firm's outlook. Among these documents were (1) the most recent balance sheet (Exhibit2); (2) a historical statement of operating income, which excludes interest expenses and other financing costs (Exhibit 3); and (3) a statement of Foster Grant's strengths as perceived by the company's management (Exhibit 4). Exhibit 2 Foster Grant Corporation Consolidated Balance Sheet (June 30,2000) ( thousands) Asset Cash and investments Account receivable Inventory Prepaid expenses Total current assets Property, plant, and equipment Other assets Total assets $ 1051 9625 10036 417 $ 21129 7320 324 $ 28773 Liabilities and Equity Short-term debt Current portion of long-term debt Account payable Accrued liabilities Accrued taxes Revolver Total current liabilities Subordinated debt Other liabilities Total non-current liabilities Total liabilities $ 10325 801 2985 11926 192 21245 $ 47474 17941 5181 $ 23122 $ 70596 Common stock Additional paid-in capital Treasury stock Retained earnings from prior years Net earnings in current year Total stockholders' equity Total liabilities and equity $ 69 1714 (332) (39048) (4226) $ (41823) $ 28773 Exhibit 3 Foster Grant Income Statement History (millions) 2000 1995 $60.6 5.4 0.8 $54.4 25.3 $29.1 1996 $59.6 5.3 0.7 $53.6 23.5 $30.1 1997 $60.1 7.6 0.4 $52.1 27.7 $24.4 1998 $54.2 9.3 0.8 $44.1 26.1 $18.0 1999 $52.9 9.8 0.4 $42.7 32.3 $10.4 Direct marketing 7.6 Field sales 7.5 Distribution 4.4 Marketing and administration 2.1 Corporate administration 5.1 Other expenses 3.3 Earnings before interest & $(0.9) taxes 8.0 8.1 5.2 0.8 4.2 0.6 $ 3.2 7.2 7.8 5.1 0.8 3.8 1.2 $ (1.5) 5.6 5.2 4.0 1.4 3.5 0.8 $(2.5) 7.8 3.6 5.6 5.0 3.7 2.8 1.1 0.8 3.4 2.4 8.4 0.3 $(19.6) $(1.1) Gross sales Returns Allowances Net sales Total cost of goods sold Gross profit (Plan) $45.2 5.5 0.3 $39.4 25.6 $13.8 Exhibit 4 Foster Grant Company Strengths and Opportunities (Prepared by Foster Grant management as part of its business plan) Strengths 1. Brand Name. Not only does Foster Grant have high awareness (96%), but the brand still has a great deal of salience. 2. Technology. The Technical Products Division in Leominster stands alone in the world in lens-making, mold-making, and overall know-how in sunglass manufacturing. This provides not only the foundation for gaining the position of innovator in the industry but also the basis for a large technical products business as well. 3. Manufacturing. As the potential low-cost producer of sunglasses and reading glasses, Foster Grant is in a unique position in the industry. Its captive production facility ensures better quality control, quicker turnaround time to meet market demand, and better margins to enable the funding of aggressive consumer marketing programs. 4. Patents/Licenses/Know-How. Foster Grant's assets here are considerable. The most important are: (a) Space Techthe NASA coating that is five times more scratch-resistant than any other plastic; (b) Polarized Sheetsthe only patent in the industry outside of Polaroid's; (c) Contact Matesa technology partnership for sunglasses suitable for contact lens wearers. 5. Sales and Service. Recent months have seen some real progress with key trade accountsWal-Mart, Payless, Eckard, and Drug Emporium. Given proper resources, the programs implemented in1999 and 2000 can be expanded to provide a base for profitable growth in the future. 6. People. Foster Grant continues to have some excellent people. The talent, experience, and commitment of these people need only to be motivated by new investment and stability. Opportunities There are four major business opportunities that can be pursued immediately: 1. Sunglasses. The sunglass turnaround plan will include continued participation in the contact and premium segments, with increased sales velocity and improved margins; and in the standard catalog business. 2. Reading Glasses. Market dominance will be the Foster Grant objective. 3. Technical products. Stunning underexploited lens technology will be built into a sizable, profitable business. 4. International. This important segment will provide an opportunity for significant growth and eliminate seasonality. The package of information clearly shows Foster Grant's desperate situation, despite management's note of optimism in identifying the company's strengths and opportunities. As Ed Bonneau examined the information, several points stood out: 1. Foster Grant essentially has three major operations: the distribution of sunglasses, the manufacturing of sunglasses, and the technical products division. Bonneau has never been involved in the manufacturing and technical sides of the business, and he questions the advisability of making a move into areas where he has very limited experience. Thus, it would be his intent to discontinue the manufacturing and technical products divisions if they do not prove profitable. 2. After reviewing the detailed schedule of the Foster Grant receivables and the information provided by his own people about the inventories, Bonneau considers the receivables to be worth about $3 million and the inventory subsequent to an acquisition to be worth about the same amount. By the time any acquisition could be consummated, the cash balance for Foster Grant is expected to be depleted. 3. The property, plant, and equipment accounts include equipment with a book value of about $1 million, but which Bonneau believes could be liquidated for only $500,000. 4. Without doubt, the Foster Grant name is of value, and Bonneau fully intends to continue Foster Grant as a separate entity if he decides to acquire the company; to do otherwise would be to lose one of the primary advantages of the acquisition. However, he is confident of only retaining about half of the most recent year's sales in sunglass distribution. Thus he does not believe there will be more than $20 million in sales in the first year after the acquisitionthat is,2001. Still, he thinks that with a concerted effort, some of the loss could be recovered in 2002 and that sales would increase by 20 percent in that year. Any sales increases beyond 2002 would probably be around 5 percent through 2005 and 3 percent at best thereafter. 5. Bonneau is not willing to assume any of Foster Grant's indebtedness. The acquisition would relate to the assets only, with no assumption of any debt being part of the transaction. Although the Bonneau personnel believe they know how to value account receivables and inventories in the sunglass business, they are less sure of what the technical products division and the manufacturing facilities are worth. However, after visiting the various Foster Grant sites, Dortch estimates that the plant and equipment related to manufacturing could be sold for about $1.5 million. Valuing the technical products division is more problematic. Although there is no ready answer as to its value, Dortch and Bonneau believe that $1 million is a conservative estimate of its potential sales price. Moreover, any of the building lease related to these operations could be terminated or renegotiated, since Bonneau would not be liable for any contracts or agreements made by one of the old Foster Grant Corporation. A key question that the Bonneau management has considered at great length is the obvious lack of profitability of the Foster Grant operations. Everyone recognizes the danger that the Bonneau management will not be able to operate the newly acquired firm at an acceptable profit. An even worse prospectalbeit an unlikely one, they believeis that they will not be able to eliminate the losses, and that these could threaten the Bonneau Company itself. After some agonizing, the Bonneau management has come to the conclusion that they can turn around the situation at Foster Grant with respect to the distribution of sunglasses. They have decided, however, to sell the technical products division. They have also determined to sell the manufacturing plant and equipment and focus on what they know bestselling sunglasses. With respect to Foster Grant's sunglass sales business, the Bonneau management has carefully analyzed the potential cost reductions that could be realized, especially in terms of duplicate functions that could be eliminated and by renegotiating terms relative to the leasing of existing facilities. Also, there would always be the possibility that some of the warehousing facilities could be eliminated and use could be made of the excess capacity in the existing Bonnneau facilities. Everything considered, Dortch believes that the operating profit margin on sales could approach 6 percent in 2001, increasing to 8 percent in 2002, and 10 percent thereafter. Also, based on experience, Dortch has made the following assumptions regarding the investment requirements related to the Foster Grant acquisition: 1. 2. None of the cash held by Foster Grant will be received by Bonneau. Thus, some cash will need to be made available for transactions balances. Experience suggests that needed cash should be around one percent of sales. Investments in account receivables and inventories will approximate 30 percent and 20 percent of sales, respectively, for the indefinite future. However, some of this investment in working capital would be offset by spontaneous sources of financing, such as credit allowed for purchasing inventories, and should amount to about 15 percent of sales each year. 3. 4. Beyond equipment replacements, there should be no additional investment in plant and equipment in 2001. There is ample excess space and capacity within the Bonneau Company to meet any needs for the first year. After 2001, plant and equipment would probably amount to 5 percent of any increases in sales. Investments in other assets should be about 1 percent of sales. Decision Time Ed Bonneau has called a meeting of his vice presidents and other key managers to be held in three days. They plan to convene at the local airport hotel for the convenience of those coming from out of town. The purpose of the meeting is to close the door and focus on the opportunity before them. A decision must be made quickly, and he wants the input of all his key personnel. He has asked you to prepare a recommendation, both regarding the offering price that should be made for Foster Grant and the feasibility of the use of bank financing to fund the entire purchase. You believe that a cost of capital of 15 percent is appropriate for evaluating the acquisition, and you estimate that the relevant tax rate of the analysis is 30 percent. What recommendation will you make