298090878 Blain Kitchenware Venkat PDF

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BLAINE KITCHENWARE – CAPITAL STRUCTURE Executive Summary: Blaine Kitchenware, a medium sized producer of residential kitchenware and appliances is trying to unleash the value inherent in its strong operational cash flows and balance sheet to enhance value for majority shareholders. The company though publicly traded is majorly owned by CEO Dubinski family members. Over the past couple of years, the company has accumulated significant amount of cash through operations. While the company don’t foresee a significant amount of capital expenditure as it has outsourced majority of manufacturing operations, it is interested in pursuing inorganic growth activity through acquisition of other players in the kitchenware space. From a growth perspective the company is trying to expand its presence in beverage making appliances and overseas markets. While the growth plans are on track, the company seems to not have found enough lucrative opportunities, as it has been significantly increasing the dividend payout ratio. The company’s $209 Million cash equivalents, zero debt and steady operational cash flows makes it an ideal candidate for takeover candidate by private equity firm. CEO Dubinski is worried about maintaining status quo and let someone takeover Blaine. He is contemplating to emulate the same strategy in-house to unleash value through recapitalization of Blaine’s balance sheet, but he is concerned about the conservative nature of family members who are inherently averse to debt. Dubinski is in dilemma as to what is the optimal amount of debt to be taken, whether to go for a repurchase/special dividends. He is also worried about the further consequences of this transaction on family’s ownership, share price, EPS, dividend payout, cost of capital and growth capital for future. A detailed analysis of the company’s current external, internal environment and financial condition has led to the conclusion that repurchase of the shares with existing cash, marketable securities and additional debt will enhance value for the shareholders, increases the ownership of family and decreases the attractiveness of Blaine to external investors.

Company analysis: Blaine Kitchenware is a medium player in kitchen appliance industry with 10% of market share. In recent years, the company made some very important steps to reduce its production costs by shifting business model towards outsourcing along with using Mexico manufacturing opportunities. These changes allowed the company to sustain price pressure and utilize NAFTA advantages. However, Blaine hasn’t achieved the level of economies of scale as its competitors and hence the company has shunned away from cost leadership generic strategy and focused on high-end product lines, niche segments using focused differentiation strategy. The company’s revenue mix is concentrated with more than 85% coming from mid-tier products, similarly 65% of its sales are from US alone. Recent acquisitions have helped the company to grow, diversify these revenue streams and were aimed at different niche markets where the biggest gain in the future margins were believed to be. The company is a closely controlled family owned entity with trusts together owning more than 62%. The family is very conservative in nature and owing to this behavior the company is very receptive to taking debt and in more than 60 years since its founding the company has only borrowed thrice and was repaid immediately. The company’s business is cyclical in nature with peak sales during October, November, May and June.

BLAINE KITCHENWARE – CAPITAL STRUCTURE Industry Analysis: To understand business risks that exist in the industry, Porter’s five forces framework has been used. 

Bargain power of Suppliers - Low: Since the company outsources most of its production to countries such as China, Vietnam and Mexico, where labor costs are much cheaper than in the U.S., manufacturing companies are eager to work with Blaine, hence power of suppliers is relatively low. Moreover, there are no significant switching cost from one manufacturer to another, and move production of any new or existing model of appliance to a new factory. Additionally, as manufacturing is becoming more and more global, there are lots of available suppliers.



Bargain power of Buyers - High: Small kitchen appliances are not a unique product and there are lot of options to choose from. There is no particular loyalty boundaries for customer to use only one producer. Even there are many wholesalers, who passing the product towards mass merchandisers and department stores, they can easily switch brands and lines to whatever the end-user is looking for. Moreover, having large amount of appliances’ suppliers buyers can easily play them against each other to get the cheapest price and the best conditions. Despite of special kitchen retailers pretend loyalty, many brands also have their top or professional product lines that could be switched interchangeably. Furthermore, shifting shopping pattern preferences of appliances end-users towards “big-boxes” malls are diminishing the latter factor.

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Threat of new entrants - High: Since Blaine presented its first cream separator in 1927, kitchen appliances progressed from state-of-the-art product to a commodity stage. Most functions are similar between producers. There are little to no difference in design. Because of pre-maturity industry stage, companies, chasing cost reduction, changed business model from full cycle of design and production to outsourcing in countries with cheap labor cost. This shift allowed new players to enter the industry relatively easily. There are no heavy initial investments in production and distribution needed, and, if things won’t go well, liquidation costs are fairly small. Moreover, processes of design and production of kitchen appliances are well learned and there is no any patents protection left. Along with customers little brand loyalty, there is a big threat of new entrants. Globalization also made it possible for other kitchen appliance producers from Asia to penetrate western markets with their products who compete fiercely on price.

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Threat of substitutes - Medium: Small kitchen appliances are satisfy needs for cooked meals for its end-users. In developed countries like the US, where competition in a food and restaurant industries so high that prices for dining out are always under the pressure. In addition, government and society quality control along with wide availability make restaurant industry more affordable and acceptable even for very strict customers. Fulfilling the same basic needs with no switching costs, that industry is imposing undeniable threat to the small kitchen appliances.

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Rivalry among competitors - High: The industry has seen a lot of consolidation processes in recent years. Big national chains, mass merchandizers, feeling pressure from cheap Asian import, started to use price wars techniques to secure market share. Even in fast recovering and growing

BLAINE KITCHENWARE – CAPITAL STRUCTURE economy, there is an inadequate slow growth in new unit consumption. As stated earlier, kitchen appliance has become more like a commodity, homogenous product and switching cost are very low.

Based on the analysis, we can conclude that small kitchen appliances industry is not attractive. Very high level of competition, high bargain power of buyers, and substantial threat of new entrants along with possible threats of substitutes from restaurant industry can negatively influence the future of company. Low suppliers power helps the industry players be more flexible in their production and fixed-cost decisions. Furthermore, slow growth and consolidation trend are forcing companies to cut price and erode margins. Since the industry leader, Auto Tech Appliances, whose revenue is larger by more than four times than that of the second player, XQL Corporation, the Rule of Three and Four is not applicable to the kitchenware industry that highlighted instability of the industry and room for growth to all the players.

Industry/Company High Medium Low

High

Medium

Low

Blaine

Using GE/McKinsey matrix above, we can conclude that Blaine Kitchenware is located in an unattractive industry and its strength as a business is medium with its differentiation strategy. There is enough room for growth as the industry is not stable and the company only has 10% growth market share, but the company and industry’s growth is dependent on broad economic and housing growth. Despite the cyclical nature of the business, a regression analysis of company’s Sales, EBITDA and Dividends against time gave a high positive correlation indicating that the Business risk is relatively lowmoderate as the industry has been instable and the company has been able to constantly expand its operations. The low correlation amongst EBITDA, EPS can be attributed to the integration costs during the time period. This low-moderate business risk profile of the company suggests that there is room for taking some financial risk, still keeping the overall risk profile medium.

2004-2006 Correlation

Financial Analysis:

Revenue 0.979

EBITDA 0.819

EPS 0.432

DPS 0.998

BLAINE KITCHENWARE – CAPITAL STRUCTURE From 2003-2006, despite being positioned in an industry with modest dollar sales volume growth of 3.5%, Blaine was able to grow at a CAGR of 6.6%. The topline growth is mostly attributed to the increase in volume of shipments as most of the industry players are constrained in pricing owing to competition from inexpensive imports and aggressive pricing by mass merchandisers. Even though the industry is expected to consolidate the same pattern can be observed for pricing and even Blaine expects the growth to be modest at roughly 3.5% going forward. The company can pursue further organic growth through penetration into other markets (Currently 65% of revenue comes from US) and increasing its share in beverage market appliances (Currently 2%).

Blaine’s EBIT margins have reduced from 21.4% to 18.7% largely due to integration costs. Despite this reduction the company’s margins are the highest in the industry (14.9%), partly due to the company’s product mix that is dominated by mid-tier products (85% of sales and 80% of EBIT). A significant portion (17.4%) of net income is derived from other income through marketable securities. The company’s effective tax rate is expected to increase to 40% which will negatively affect company’s cash flows and net margins. The dividend payout ratio has significantly increased in the recent years with 53% in 2006 which highlights the fact that there are not enough lucrative growth opportunities for the management to invest in. This dividend payout ratio might be tough to retain in the future years, if the company has to pursue any inorganic growth, capital expenditures or service debt.

The company’s asset base has grown at 9.1% from 2004-06, a major portion of growth is attributed to the growth of fixed assets which have grown at a staggering rate of 32.4% during the same period, while cash & marketable securities have reduced at 10.1% during the same period. Despite this rapid decrease in cash &marketable securities, they still constitute a significant portion (39%) to overall asset base. Noncash current assets have increased at 9.6%, while current liabilities have increased at 10.3%, this narrow increase is not expected to cause any material difficulties in working capital management (Quick ratio of 1.42). Total liabilities have increased at a faster pace (14.1%), compared to shareholders equity (8.2%) during the same period. The significant portion of cash and faster growth of liabilities compared to equity is a concern for investors. Market Balance Sheet – 2006 ($ Millions) Assets

Liabilities & Equity

Operating Assets:

799.7

Debt:

Tax Shield:

-71.0

Equity:

959.6

Total:

728.7

Total:

728.7

-230.9

BLAINE KITCHENWARE – CAPITAL STRUCTURE Cash Conversion Cycle (Days) 100

84

82

89

80

80

51

60

51

52

47

47

86

86

47

40 20 -

Inventory

A/R 2004

A/P 2005

Cash Conversion

2006

The company’s net working capital/sales at 9.4% is marginally higher than industry’s average of 8.9%, but compared to the industry average of 17% D/E, Blaine has a negative D/E ratio of -24%.

Blaine Returns (%) 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 2004

2005 ROA

2006 ROE

The company’s inefficiency in churning out maximum output of its assets is visible in the poor return on asset and equity numbers (ROA of 9%, compared to peers 12%, ROE of 11%, compared to peers 26%) compared to the industry’s average. This can be largely attributable to high cash & marketable securities which constitute a significant portion of assets but give relatively modest returns at 6%. EVA ($ Million) EBIT Tax %) NOPAT Equity Mkt Equity Net Debt Capital Book Capital Asset Beta Equity Beta Cost of Debt

2004 62 32% 42 417 777 (286) 491 132 0.67 0.50 6.75%

2005 61 32% 41 459 864 (268) 596 191 0.67 0.53 6.75%

2006 64 31% 44 488 960 (231) 729 257 0.67 0.56 6.75%

BLAINE KITCHENWARE – CAPITAL STRUCTURE Cost of Equity WACC EVA

7.87% 9.78% 30

8.01% 9.54% 23

8.18% 9.29% 20

Even though the company has created positive EVA from 2004-06, the absolute value of EVA dropped overtime due to increase in fixed assets. Owing to the expected increase in tax rates, insufficient growth opportunities, EVA, ROA and ROE might drop down significantly in the years to come.

LTM Multiples EV/Revenue EV/EBIT EV/EBITDA Market/Book P/E

Blaine 2.1 11.4 9.9 2.0 17.9

EasyLiving 1.9 18.1 15.2 4.4 31.8

Average 1.5 10.4 9.1 3.5 16.2

Min 1.0 7.4 6.0 1.6 9.9

Max 1.9 18.1 15.2 4.9 31.8

Except for Market/Book value, Blaine is marginally trading above the industry multiples mostly due to the negative debt, which decreased the EV and increased the multiples (A trend that is visible even in Easyliving stock which is trading significantly at higher multiples compared to its peers). Despite this premium in trading multiples, the stock has underperformed compared to its peers and barely over performed compared to the broad market at only 11% per year from 2004-06.

If Blaine maintains status quo without any significant changes to its operations/investing/financing activities, it might create negative EVA/destroy value to shareholders. The company doesn’t have not much near term scope in increasing the value through operations/investing activities (Organic/Inorganic). It should possibly explore creating value through financing activities as there is lot of room for improvement considering its healthy cash flows, over liquidity and negatively levered balance sheet. We will study the capital structure of Blaine in detail for this.

BLAINE KITCHENWARE – CAPITAL STRUCTURE Blain’s Capital Structure and Payout Policies Analysis: Blaine’s current capital structure is very conservative with no debt and large amounts of cash and marketable securities. A rational capital structure should consider the tradeoff among the following major features: (1) corporate ownership and control; (2) cost efficiency of capital by utilizing leverage; and (3) profitability and real economic value added based on company’s long-term strategic plan. However, at the end of 2006, Blaine held $231 million in cash and securities and also it was the only debt free public company among the selected public kitchenware producers. By carrying so much of negative debt, the company is potentially destroying value to the tune of $71 Million, earning negative tax shield benefit. Specifically, BKI maintained stable operation performance in the past years and has significantly improved its dividend payout ratio.

With huge operational cash flow, $231 million cash equivalents, free debt and weak enterprise value, BKI would be an available and vulnerable target company of the hostile takeover due to this capital structure. The acquirer can effectively take advantage of the characteristics of BKI’s capital structure, zero D/E ratios and great cash flow, to initiate the hostile takeover with minimum acquisition cost, for example, by pursuing the LBO. Based on industry and BKI’s competitive advantage analysis, it is clear that BKI didn’t have outstanding competitive advantage. Therefore, BKI should improve its D/E ratios to create rather than destroy value through tax shield, optimize its capital structure, which would be helpful in defending against the potential hostile takeover. No matter what strategy BKI finally employs, stock buyback or special dividend, both of them will enhance shareholder value. In particular buyback strategy might also bring management a higher percentage of share ownership and control.

More important, BKI took on additional debt with the purpose of either paying a large dividend or repurchasing shares. The result is a far more utilization of financial leverage. After the debt increased in fourth time in BKI’s history, it would initiate the serious strategy consideration about (1) how to redesign the payout policies and finance budgeting process of BKI; (2) how to enhance the profitability through sustainable improvement in operation performance, product innovation, and economies of scale; (3) how to select its strategic direction, cost leadership or differentiation business strategy or integration strategy based on different market segment; and (4) Whether the pretty conservative management style is suitable for the fast changing environment and more intense competition? The reduced idle cash and debt capacity would push BKI’s management to dedicate to its target, continuously generating more cash flows to lower its D/E ratio in long-term.

BKI’s payout policy sounds rational. Even though it signifies the management’s inability to find sufficient growth opportunities through organic or inorganic routes, the intent of management to distribute the excess cash to shareholders rather than investing in negative NPV projects is plausible. Over the years the payout ratio has increased significantly and to maintain the same payout ratio in the future would be an uphill task, especially if the management require significant amount of growth capital. As on 2006, BKI held $231 million in cash and marketable securities. The annual average return on these liquid assets over the last three years at 5.78% is much lower than the company’s cost of equity i.e. 8.18%. So rather

BLAINE KITCHENWARE – CAPITAL STRUCTURE than further accumulating this cash and destroying value the aggressive upward revision in the payout policy is a good move by the management. However, from a long term perspective shareholders tend to expect the same payout ratio to continue in future. The reduced or discrete dividend payout is generally viewed as a negative signal for a company’s performance. It was possible that the management of BKI didn’t want the market to discover its embarrassed situation in the capability to create value for shareholders in long term. So the company would have been better off if it would have declared special dividend/bought back shares rather than horrendously increasing payout ratios in a short frame of time.

Basically, management of BKI should redesign its capital structure and payout policy based on its longterm strategy, which should focus on business innovation and continuous cash flow creation capabi...