Cfm Tutorial 5

5/25/2018 Cfm Tutorial 5

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1 Cases in Financial Management

Tutorial 5

The Timken Company

Piotr Korczak

[email protected]


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2 Summary of facts

Timken is considering acquiring Torringtonfrom Ingersoll-Rand

The acquisition would strengthen the market

position of Timken and would lead to savings

estimated at $80 million annually

Analysts estimate the minimum value of

Torrington at $800 million

The transaction may weaken Timkens financialposition, including a credit rating downgrade


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3 Main problems/questions of the case

Should Timken go ahead with the acquisition? If yes, how should they structure the deal?

How much should they offer to pay?

What method of payment should they offer?


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4 Why should Timken take over Torrington?

Little overlap in products, large overlap incustomers

Savings in sales costs

Bundling a wider offer makes them more

competitive and increases margins

To remain a global leader

To compete with foreign companies

To have a stronger position in negotiations with

suppliers and buyers

Any other arguments?


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5 Why shouldnt Timken take over Torrington?

A large acquisition Financially demandingwill Timken be able to

afford it?

Timken is already highly leveraged, the acquisition

may require further borrowingimpact on creditrating

Issuing shares to finance the deal will dilute the

control of existing shareholders

Particularly problematic if shares are undervalued Risk of value destruction if overpaid

Common M&A concern

Any other arguments?


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6 Stand alone valuation of Torrington

How much is Torrington worth as a stand-aloneentity?

Note we are looking for the enterprise value

Acquisition of all assets = Acquisition of equity and

debt

Methods

Discounted cash flows (DCF)

Market multiples


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7 Stand alone valuationDCF: cash flows

Operating income, capex, depreciationfrom Exhibit 5 Tax rate: 39.9% (assumed, equal to 2002 effective tax

rate for Timken assumed to reflect industry standard,

close to US statutory tax rate)

Working capital needs (level): 10.4% of sales (avg

2001-2002 WC/sales for Timken, assumed to reflect

industry standard)

Terminal growth rate: 4% (assumed)


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8 Stand alone valuationDCF: discount rate (1)

We need WACC for Torrington Torrington is a part of Ingersoll-Rand and as

such is unlisted (hence no direct CAPM inputs),

does not borrow on its own (hence no data for

cost of debt), and does not have a self-standing

capital structure

We have to estimate WACC from data for other

firms


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Candidates Average WACC for the industry

WACC for Timkenbut not because Timken is the

acquirer but because it is likely to have a similar risk

profile Note that data for Ingersoll-Rand are of little use

IR is a diversified firm and hence has a deferent risk

profile that does not reflect risks of Torrington

IRs capital structure can also be specific to adiversified firm

Here, for illustration, WACC for Timken


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Kd: 7.23% (BBB debt yield, Exhibit 9) Rf: 4.97% (long-term gov bond, Exhibit 9)

Beta: 1.10 (Exhibit 8)

Risk premium: 6.0% (assumed)

Ke: 11.57%

Debt: $461.2 million (Exhibit 2)

Equity: $1,065.1 million (no of shares * price, Exhibit 8)

Tax rate: 39.9% (effective historical 2002, Exhibit 1)

WACC: 9.39%


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11 Stand alone valuationDCF

2003 2004 2005 2006 2007

Operating income 90.7 96.6 102.9 109.5 116.7

Tax 36.2 38.5 41.1 43.7 46.6

Depreciation 84.2 90.0 96.0 102.0 108.5

Capex 175.0 130.0 140.0 150.0 160.0Change in WC 8.1 8.6 9.2 9.8 10.4

FCF -44.4 9.4 8.6 8.0 8.2

Terminal value 158.2

Total flows -44.4 9.4 8.6 8.0 166.4

PV of flows -40.6 7.9 6.6 5.6 106.2

Enterprise value 85.7


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12 Stand alone valuationmultiples

We are valuing the enterprise, hence focus onthe enterprise value multiple (EV/EBITDA)

Torringtons 2002 EBITDA (operating income

plus depreciation, Exhibit 5): 165.2

Average EV/EBITDA for industry (Exhibit 8):

7.15

Enterprise value: 1,181.2


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13 Stand alone valuationdiscussion

Large discrepancies between DCF and multiplesvaluation

Some differences can be justified: fundamental vs

market valuation

Critically check cash flow projections There is a projection of a sharp increase in Capex

why? Is it justified?

DCF valuation is also way below the analysts

estimate of Torringtons value


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14 With-synergies valuation of Torrington

How much is Torrington worth to Timken?Stand alone valuation

PLUS the value of synergies

Methods of valuing synergies

Discounted cash flows (DCF)

Market multiples


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15 The value of synergiesDCF: inputs

Annual cost savings of $80 million by the end of2007

You need to make an assumption what happens to

savings between now (2002) and 2007; e.g. they

increase graduallyNote you need to deduct taxcost savings increase

your taxable income

Integration costs of $130 million over the first

two years, i.e. $65 million annually (less tax)

Discount rate as before


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16 The value of synergiesDCF

2003 2004 2005 2006 2007

Cost savings (pre-tax) 0.0 20.0 40.0 60.0 80.0

Cost savings (after tax) 0.0 12.0 24.0 36.1 48.1

Perpetuity (=savings/WACC) 512.0Integration costs (after tax) 39.1 39.1

Total effect on flows -39.1 -27.0 24.0 36.1 560.1

PV of effect on flows -35.7 -22.6 18.4 25.2 357.6

Synergy value 342.8


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17 The value of synergies - multiples

Note this is only an approximation Gradual increase in cost savings not considered

Integration costs not considered

EBITDA increases by $80 million

Average EV/EBITDA (Exhibit 8) 7.15

Value of synergies: 807.15= 572 ($ million)


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18 Valuation - summary

Analysts estimate of $800 million seems areasonable number

Its not as high as multiples valuation (hence looks

conservative) but reflects value in Torrington DCF

may be misestimating The underlying forecasts in DCF have to be carefully

reviewed in the processare they justified?

The value of synergies available from the deal

are about $340 million Possibly conservative estimate

It does not take into account synergies reflected in

larger sales (e.g. bundling)


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19 Timkens pre-acquisition financial standing

Current credit rating : BBB Inputs: data from Exhibit 1 and 2, EBIT before

nonrecurring

A BBB BB Timken

EBIT interest coverage 6.3 3.9 2.2 3.7

EBITDA interest coverage 8.5 5.4 3.2 8.6

EBITDA/Sales (%) 18.1 15.5 15.4 10.1

Total debt/capital (%) 42.6 47.0 57.7 43.1


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20 Timkens post-acquisition financial standing

Assume the acquisition is financed with debt, $800million paid

Assumptions: interest rate 7.23%, 2002 EBITDAs and

sales summed for both companies but no synergy effect

or cost of integration

A BBB BB Timken+Torrington

EBIT interest coverage 6.3 3.9 2.2 2.2

EBITDA interest coverage 8.5 5.4 3.2 4.8

EBITDA/Sales (%) 18.1 15.5 15.4 11.3

Total debt/capital (%) 42.6 47.0 57.7 67.4


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21 How much should Timken offer to pay? (1)

Factors to consider Analysts value estimate of $800 million as a

reference price

Stand alone valuationbottom value

It is likely that Torrington is worth that much to Ingersoll-Randthey do not have any obvious synergies

Discrepancies between valuation methods

With-synergies valuationceiling value

Paying that much leaves no value for Timken, paying more

than that destroys value for Timken

Is Ingersoll-Rand willing to sell?

It seems so, so Timken is not pressed to bid high to succeed


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22 How much should Timken offer to pay? (2)

Factors to considercontd Is there a risk of a competing bid?

Competition in the sector may increase pressures on growth

through acquisitions

Foreign companies may be interested in getting access to

the US market to overcome anti-dumping regulations

However, foreign companies may have little synergies with

Torrington (they may be specific to Timken)


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23 How should they pay? (1)

Factors to consider Options: stock, cash or stock and cash

Can Timken raise sufficient amount of cash?

Will they have access to debt?Possibly will be

downgraded if fully finance with debt

Will they be able/willing to issue new shares?

Are Timken shares correctly priced?

If they are undervalued, Timken should be unwilling to use

them as a method of payment

From Exhibit 8: Timkens PE 20.7, average for other firmsin the industry 16.9look overvalued (but Exhibit 7 shows

that the firm has been underperforming the market index,

hence possibly undervalued)


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24 How should they pay? (2)

Factors to consider What is Ingersoll-Rand preference?

They want to divest from the bearings industry hence likely

to prefer cash


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25 Recommendation (1)

There are strategic benefits from the deal henceTimken should go ahead with the bid

It is key not to overpay

It looks that IR will not be negotiating hard and there

is low risk of competing biddershence Timken canoffer a relatively low price

Timken should bid in the region of $800-900 million

it should be a good deal for IR (given analyst

estimates), still leaving room for value creation forTimken (given the estimate of the synergy)


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26 Recommendation (2)

Timken is unlikely to be able to raise debt tofinance the acquisition without losing the

investment grade credit rating

As IR is unlikely to be interested in Timken

shares, Timken should sell shares to the public

to raise cash to finance the acquisition

However, there are significant uncertainties

highlighted by DCF valuation (e.g. TorringtonCapex projection) that need to be further

investigated before the completion of the deal

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