Using the following information on Rockboro Case please answer the following

Question: What are the problems here, and what do you recommend and what are the implications of different payout levels for Rockboro’s capital structure and unused debt capacity?

On September 15, 2015, Sara Larson, CFO of Rockboro Machine Tools Corporation (Rockboro), paced the floor of her Minnesota office. She needed to submit a recommendation to Rockboro’s board of directors regarding the company’s dividend policy, which had been the subject of an ongoing debate among the firm’s senior managers. Larson knew that the board was optimistic about Rockboro’s future, but there was a lingering uncertainty regarding the company’s competitive position. Like many companies following the “great recession” of 2008 and 2009, Rockboro had succeeded in recovering revenues back to pre-recession levels. Unlike most other companies, however, Rockboro had not been able to recover its profit margins, and without a much-improved cost structure, it would be difficult for Rockboro to compete with the rising presence of foreign competition that had surfaced primarily from Asia. The board’s optimism was fueled by the signs that the two recent restructurings would likely return Rockboro to competitive profit margins and allow the company to compete for its share of the global computer-aided design and manufacturing (CAD/CAM) market. There were two issues that complicated Larson’s dividend policy recommendation. First, she had to consider that over the past four years, Rockboro shareholders had watched their investment return them no capital gain (i.e., the current stock price of $15.25 was exactly the same as it had been on September 15, 2011). The only return shareholders had received was dividends, which amounted to an average annual return of 2.9% and compared poorly to an annual return of 12.9% earned by the average stock over the same period.1 The second complication was that the 2008 recession had prompted a number of companies to repurchase shares either in lieu of or in addition to paying a dividend. A share repurchase was considered a method for management and the board to signal confidence in their company and was usually greeted with a stock price increase when announced. Rockboro had repurchased $15.8 million of shares in 2009, but had not used share buybacks since then. 

Larson recognized, therefore, that her recommendation needed to include whether to use company funds to buy back stock, pay dividends, do both, or do neither. Background on the Dividend Question Prior to the recession of 2008, Rockboro had enjoyed years of consistent earnings and predictable dividend growth. As the financial crisis was unfolding, Rockboro’s board decided to maintain a steady dividend and to postpone any dividend increases until Rockboro’s future became more certain. That policy had proven to be expensive since earnings recovered much more slowly than was hoped and dividend payout rose above 50% for the years 2009 through 2011. To address the profit-margin issue, management implemented two extensive restructuring programs, both of which were accompanied by net losses. Dividends were maintained at 1 The average stock performance was measured by the performance of the S&P 500 index. $0.64/share until the second restructuring in 2014, when dividends were reduced by half for the year. For the first two quarters of 2015, the board declared no dividend. But in a special letter to shareholders, the board committed itself to resuming payment of the dividend “as soon as possible—ideally, sometime in 2015.” In a related matter, senior management considered embarking on a campaign of corporate-image advertising, together with changing the name of the corporation to “Rockboro Advanced Systems International, Inc.” Management believed that the name change would help improve the investment community’s perception of the company. Overall, management’s view was that Rockboro was a resurgent company that demonstrated great potential for growth and profitability.

The restructurings had revitalized the company’s operating divisions. In addition, a newly developed software product promised to move the company beyond its machinetool business into licensing of its state-of-the-art design software that provided significant efficiencies for users and was being well received in the market, with expectations of rendering many of the competitors’ products obsolete. Many within the company viewed 2015 as the dawning of a new era, which, in spite of the company’s recent performance, would turn Rockboro into a growth stock. Out of this combination of a troubled past and a bright future arose Larson’s dilemma. Did the market view Rockboro as a company on the wane, a blue-chip stock, or a potential growth stock? How, if at all, could Rockboro affect that perception? Would a change of name help to positively frame investors’ views of the firm? Did the company’s investors expect capital growth or steady dividends? Would a stock buyback affect investors’ perceptions of Rockboro in any way? And, if those questions could be answered, what were the implications for Rockboro’s future dividend policy? The Company Rockboro was founded in 1923 in Concord, New Hampshire, by two mechanical engineers, James Rockman and David Pittsboro. The two men had gone to school together and were disenchanted with their prospects as mechanics at a farm-equipment manufacturer. In its early years, Rockboro had designed and manufactured a number of machinery parts, including metal presses, dies, and molds. In the 1940s, the company’s large manufacturing plant produced armored-vehicle and tank parts and miscellaneous equipment for the war effort, including riveters and welders. After the war, the company concentrated on the production of industrial presses and molds, for plastics as well as metals. 

By 1975, the company had developed a reputation as an innovative producer of industrial machinery and machine tools. In the early 1980s, Rockboro entered the new field of computer-aided design and computer-aided manufacturing (CAD/CAM). Working with a small software company, it developed a line of presses that could manufacture metal parts by responding to computer commands. Rockboro merged the software company into its operations and, over the next several years, perfected the CAM equipment. At the same time, it developed a superior line of CAD software and equipment that allowed an engineer to design a part to exacting specifications on a computer. The design could then be entered into the company’s CAM equipment, and the parts could be manufactured without the use of blueprints or human interference. By the end of 2014, CAD/CAM equipment and software were responsible for about 45% of sales; presses, dies, and molds made up 40% of sales; and miscellaneous machine tools were 15% of sales. Most press-and-mold companies were small local or regional firms with a limited clientele. For that reason, Rockboro stood out as a true industry leader. Within the CAD/CAM industry, however, a number of larger firms, including Autodesk, Inc., Cadence Design, and Synopsys, Inc., competed for dominance of the growing market. Throughout the 1990s and into the first decade of the 2000s, Rockboro helped set the standard for CAD/CAM, but the aggressive entry of large foreign firms into CAD/CAM had dampened sales. Technological advances and significant investments had fueled the entry of highly specialized, state-of-the-art CAD/CAM firms. By 2009, Rockboro had fallen behind its competition in the development of user-friendly software and the integration of design and manufacturing. As a result, revenues had barely recovered beyond the prerecession-level high of $1.07 billion in 2008, to $1.13 billion in 2014, and profit margins were getting compressed because the company was having difficulty containing costs. To combat the weak profit margins, Rockboro took a two-pronged approach. First, a much larger share of the research-and-development budget was devoted to CAD/CAM, in an effort to reestablish Rockboro’s leadership in the field. Second, the company underwent two massive restructurings. In 2012, it sold three unprofitable business lines and two plants, eliminated five leased facilities, and reduced personnel. Restructuring costs totaled $98 million. 

Then, in 2014, the company began a second round of restructuring by refocusing its sales and marketing approach and adopting administrative procedures that allowed for a further reduction in staff and facilities. The total cost of the operational restructuring in 2014 was $134 million. The company’s recent financial statements (Exhibits 1 and 2) revealed that although the restructurings produced losses totaling $303 million, the projected results for 2015 suggested that the restructurings and the increased emphasis on new product development had launched a turnaround. Not only was the company becoming leaner, but also the investment in research and development had led to a breakthrough in Rockboro’s CAD/CAM software that management believed would redefine the industry. Known as the Artificial Intelligence Workforce (AIW), the system was an array of advanced control hardware, software, and applications that continuously distributed and coordinated information throughout a plant. Essentially, AIW allowed an engineer to design a part on CAD software and input the data into CAM equipment that controlled the mixing of chemicals or the molding of parts from any number of different materials on different machines. The system could also assemble and can, box, or shrink-wrap the finished product. As part of the licensing agreements for the software, Rockboro engineers provided consulting to specifically adapt the software to each client’s needs. Thus, regardless of its complexity, a product could be designed, manufactured, and packaged solely by computer. Most importantly, however, Rockboro’s software used simulations to test new product designs prior to production. This capability was enhanced by the software’s capability to improve the design based on statistical inferences drawn from Rockboro’s large proprietary database. Rockboro had developed AIW applications for the chemicals industry and for the oil- and gas-refining industries in 2014 and, by the next year, it would complete applications for the trucking, automobile-parts, and airline industries. By October 2014, when the first AIW system was shipped, Rockboro had orders totaling $115 million. By year-end 2014, the backlog had grown to $150 million. The future for the product looked bright. Several securities analysts were optimistic about the product’s impact on the company. The following comments paraphrase their thoughts: The Artificial Intelligence Workforce system has compelling advantages over competing entries, which will enable Rockboro to increase its share of a market that, ignoring periodic growth spurts, will expand at a real annual rate of about 5% over the next several years. Rockboro’s engineering team is producing the AIW applications at an impressive rate, which will help restore margins to levels not seen in years. The important question now is how quickly Rockboro will be able to sell licenses in volume. Start-up costs, which were a significant factor in last year’s deficits, have continued to penalize earnings. Our estimates assume that adoption rates will proceed smoothly from now on and that AIW will have gained significant market share by year-end 2016. Rockboro’s management expected domestic revenues from the Artificial Intelligence Workforce series to total $135 million in 2015 and $225 million in 2016. Thereafter, growth in sales would depend on the development of more system applications and the creation of system improvements and add-on features. International sales through Rockboro’s existing offices in Frankfurt, London, Milan, and Paris and new offices in Hong Kong, Shanghai, Seoul, Manila, and Tokyo were expected to help meet foreign competition head on and to provide additional revenues of $225 million by as early as 2017. 

Currently, international sales accounted for approximately 15% of total corporate revenues. Two factors that could affect sales were of some concern to management. First, although Rockboro had successfully patented several of the processes used by the AIW system, management had received hints through industry observers that two strong competitors were developing comparable systems and would probably introduce them within the next 12 months. Second, sales of molds, presses, machine tools, and CAD/CAM equipment and software were highly cyclical, and current predictions about the strength of the United States and other major economies were not encouraging. As shown in Exhibit 3, real GDP (gross domestic product) growth was expected to expand to 2.9% by 2016, and industrial production, which had improved significantly for 2014 to 4.2% growth, was projected to decline in 2015 before recovering to 3.6% by 2016. Despite the lukewarm macroeconomic environment, Rockboro’s management remained optimistic about the company’s prospects because of the successful introduction of the AIW series. Corporate Goals A number of corporate objectives had grown out of the restructurings and recent technological advances. First and foremost, management wanted and expected revenues to grow at an average annual compound rate of 15%. With the improved cost structure, profit growth was expected to exceed top-line growth. A great deal of corporate planning had been devoted to the growth goal over the past three years and, indeed, second quarter financial data suggested that Rockboro would achieve revenues of about $1.3 billion in 2015. If Rockboro achieved a 15% compound rate of revenue growth through 2021, the company would reach $3.0 billion in sales and $196 million in net income (Exhibit 8). In order to achieve their growth objective, Rockboro management proposed a strategy relying on three key points. First, the mix of production would shift substantially. CAD/CAM with emphasis on the AIW system would account for three-quarters of sales, while the company’s traditional presses and molds would account for the remainder. 

Second, the company would expand aggressively in the global markets, where it hoped to obtain half of its sales and profits by 2021. This expansion would be achieved through opening new field sales offices around the world, including Hong Kong, Shanghai, Seoul, Manila, and Tokyo. Third, the company would expand through joint ventures and acquisitions of small software companies, which would provide half of the new products through 2021; in-house research would provide the other half. The company had had an aversion to debt since its inception. Management believed that a small amount of debt, primarily to meet working capital needs, had its place, but anything beyond a 40% debt-to-equity ratio was, in the oft-quoted words of Rockboro cofounder David Pittsboro, “unthinkable, indicative of sloppy management, and flirting with trouble.” Senior management was aware that equity was typically more costly than debt, but took great satisfaction in the company “doing it on its own.” Rockboro’s highest debt-to-capital ratio in the past 25 years (28%) had occurred in 2014 and was still the subject of conversations among senior managers.