Case 8 - winfield (solution) PDF

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Winfield RefuseManagement, Inc.Applied Corporate FinanceDavid Vieira; Marc Brander; Maria Cunha;Pedro Santos; Yuxuan Wang.April 3rd, 2018Company analysisThe acquisitionExecutive SummaryAppendixREPORTRecommendationsCompany analysisThe acquisitionExecutive SummaryAppendixREPORTRecommendationsWinfield ...

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Winfield Refuse Management, Inc. David Vieira; Marc Brander; Maria Cunha; Pedro Santos; Yuxuan Wang. Applied Corporate Finance

April 3rd, 2018

REPORT

Executive Summary Company analysis The acquisition Recommendations

Appendix

At a glance •

THE COMPANY

•

•

THE TARGET •

•

THE FINANCING DECISION

Winfield Refuse Management Inc. is a vertically integrated waste management company, it operates on the non-hazardous waste sector in the Midwest region. Winfield Inc. has a rather unique capital structure in the industry as it kept loyal to its policy of avoiding Long-term Debt. In order to keep up with the competitors consolidation strategy to benefit from economies of scale and to augment revenues, Winfield is considering the acquisition of Mott-Pliese Integrated Solutions (MPIS), for the amount of $125M, a company that operates in the same sector and has virtually no LT Debt. Such acquisition would allow Winfield to benefit from cost synergies in the Midwest region, but also set foot in mid-Atlantic region.

However, there is no consensus among the board of directors as to the way of financing the acquisition. There are 4 forms available: -Debt with fixed principal Repayments -Debt with only annual interest payments -New stock issuance -75% Debt + 25% Winfield’s stocks

WINFIELD SHOULD ACQUIRE MPIS WITH DEBT WITH ONLY ANNUAL INTEREST PAYMENTS, AS THIS OPTION REQUIRES LESS $14M FINANCING COSTS THAN THE 2ND BEST OPTION 3

REPORT

Executive Summary Company analysis The acquisition Recommendations

Appendix

Winfield Refuse Management A small, publicly traded waste management company considers a major acquisition

The Profile of the Company  Winfield Refuse Management Inc. is a vertically integrated waste management company founded in 1972 by Thomas Winfield in Creve Couer, Missouri. It dealt with non-hazardous waste.  In 2012, served 500K clients in 9 different states in the USA.  Like a company in the waste management industry, Winfield had a large long-term-asset (LT) asset base: 22 landfills, 26 transfer stations and recovery facilities. It allowed them to create economies of scale as they had control over the inflow of waste.  Winfield had a policy of not using LT debt. Cash flow generated came from short-term (ST) loans, sales, and IPO (1991).  Capital Structure: $80,114 in Debt + $669,567 in Equity. 79% of equity was held by the Winfield family who were board members and there was no interest bearing debt.  In its first years, Winfield relied on organic growth to expand their business.  In the early 90s started to acquire smaller companies (“tuck-in” acquisitions). Targets were companies that helped create economies of scale with existing facilities and extend geographic reach.  Winfield’s performance and dividend payout have been stable.

Evolution of DPS and EPS 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 2006

2007

2008

2009

Income Per Share

2011 2012E

Dividends Per Share

Capital Structure 10.69%

89.31%

Liabilities

Source: Case data.

2010

Equity

5

Waste Management Industry The industry where Winfield operates has some particuliarities Industry Profile  The waste management industry is divided in: hazardous (medical waste, asbestos, heavy metals, ignitable oil, corrosive acids) and non-hazardous (municipal waste, street garbage). Winfield dealt with non-hazardous garbage.  Operations were very asset-intensive and required local collection vehicles, long-distance vehicles, transfer stations, disposal facilities, and landfills.  The industry is highly fragmented with several regional players that tend to be privately held. Larger players benefit from economies of scale as they control the inflow of waste, and thus, use their processing facilities and landfills more efficiently.  Most operators work on multiyear contracts with industrial and residential customers.  Waste management market grows slower than overall GDP, thanks to declining waste per-capita (more people recycling). However, the business generates stable cash-flows, demand is predictable and cycle-proof.

Points of Emphasis

High Capex Source: Case data.

Stable Cash-flows

Low cyclicality 6

Mott-Pliese Integrated Solutions (MPIS) A potential $125M acquisition is on the table

The Profile of the Target  In 2010, as means of solidifying competitive positioning in the Midwest, Winfield decided to acquire a bigger player. Why? Competition was becoming more aggressive with their consolidation strategy of smaller management firms who provided cost synergies.  In 2011, Winfield decided to acquire MPIS, a waste management company that worked in 4 states.  It wasn’t the best strategic fit in terms of assets.  It allowed Winfield to improve their cost position in the Midwest, and to put a foot in the mid-Atlantic region. The business was well-run, strong management, with operating margins of 12-13% in the last 10 years. Also, after being acquired it was projected to generate an EBIT of $24M per year.  MPIS was privately owned, had no LT debt and owners wanted out to leave the business.  After negotiations, the price of $125M was agreed. MPIS agreed that a maximum of 25% of the purchase price was paid with Winfield shares.  The board believed MPIS offered revenue synergies and opportunities to reduce costs.  Winfield would need external financing to finance the deal. However, there was discord among board members in relation to terms of the financing.

Points of Emphasis

Cost Synergies Source: Case data.

Market Expansion

Financing 7

Q1 - Winfield’s recent performance: Profitability Winfield’s cash-inflows are cycle-proof but competitors are getting ahead Growth and Profitability Margins and profits have been increasing, despite stagnation in levels of growth for both. Long-term liabilities over Equity was only at 2% when competitors had it in an almost 1-to-1 relation. Profitability ratios: Net Operating margin has been stable at around 6.5% since 2006. Although typical in this type of business, some competitors achieve 13%.  ROA and ROE of around 4%. Competitors had a median ROE of 9.9%.  Winfield’s profits and margins were only slightly affected by the 2008 financial crisis.    

Winfield vs Rivals

Winfield’s Sales and Net Income $420,000

$30,000

$400,000

$25,000

$380,000

ROE

9.9% 3.9%

$20,000

$360,000

LT Liab./Equity $15,000

$340,000

$10,000

$320,000

Net Profit Margin

101.2% 2.4%

13.5% 6.7%

$5,000

$300,000 2006 2007 2008 2009 2010 2011 2012E Operating Revenue

Source: Case data.

Income After Taxes

-15.0%

5.0%

25.0%

45.0%

Competitors Median

65.0%

85.0%

105.0%

Winfield

8

Q1 - Winfield’s recent performance: Operations Winfield’s operations have been stable Liquidity and Operational Performance  The firm seems to be able to pay debt that’s due in less than one year as the Current Ratio is 1.3. However, when we look at the most liquid assets (cash and marketable securities) we see that they’re less than half of current liabilities.  Net Working Capital Requirements are negative as operating liabilities are higher than operating assets. The firm holds no inventory and receivables are lower than payables, hence, the firm has a negative cash conversion cycle. They don’t pay for their materials for until after they’ve sold the final product associated with them.  There’s a high fixed-rate turnover (75.75%), which is typical in this asset intensive turnover. Also, Equity Turnover Ratio is 59% a lower value than most industries since we’re looking at very capital intensive industry.

Winfield’s Operational Indicators

NWC and Operating Cycle $19,258

59.1%

Equity Turnover

75.75%

FA Turnover

1.30

Current Ratio

Source: Case data.

NWCR

0.43

Cash/Current liab. 0.00

NWC

0.20

0.40

0.60

0.80

1.00

1.20

1.40

$(23,885)

9

Q1 - Winfield’s recent performance: Financials Winfield has too little debt and there’s a clear chance to create value through tax shields

Investing and Financing  Winfields’ capital intensive business is heavily dependent on more expensive funding as around 89.3% of the capital structure is shareholders’ equity.  Winfield’s average stock price has been relatively stable across time.  Net debt is negative at $27 million as financial assets are higher than financial liabilities. The firm’s policy to avoid financial debt results makes that they’re able to pay their financial debt obligations and capital leases and still have $10M in cash leftover.  This means that Winfield is sitting on cash and there are growth opportunities not being taken. It’s an information asymmetry problem due to the bad signaling that shareholder’s money isn’t being invested and instead Winfield is using the cash as an insurance to weather the storm in case distress situations occur in the future.  Winfield is resorting to more expensive financing and no present value of future tax shields of debt.  This strategy increases overall risk by destroying business value and creates an overly confident management team. Managers are “better protected” by lower levels of debt as there’s no disciplining factor of debt, and thus, they have less control to pursue self-interest strategies like empire building. The ones who benefit the most from this are the Winfield family who own 79% of the company. Source: Case data.

Avg. Stock Price $20.00

$19.00 $18.00 $17.00 $16.00 $15.00 $14.00 $13.00 2006

2008

2010

10

REPORT

Executive Summary Company analysis The acquisition Recommendations

Appendix

Q2 - Financing alternatives: Debt The Massachusetts insurance company may finance Winfield with $125M in debt via 2 options:

Payment Schedule with Fixed Principal Repayments 37.5

Cash-Outflow in M$

40 35 30 25 20 15

10 8.13 7.72 7.31 6.25 6.25 6.91 6.50 6.09 5.69 5.28 4.88 4.47 4.06 3.66 3.25 5 2.84 2.44 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Interest

Principal Repayment

The terms of both debt options Debt with fixed principal Repayments: ▪ Annual Payments divided in: Principal payment (6.25M$) + Interest payment at a rate of 6.5%. ▪ Interest payments are tax deductible ▪ After tax cost of debt is 4.225% thanks to interest tax shields. ▪ Bonds have a maturity of 15 years, and on the last year a principal of 37.5M$ has to be paid.

Payment Schedule With Plain Debt Cash-Outflow in M$

140

125

120

only

annual

interest

▪ Annual Payments of: ▪ Interest Payment at a rate of 6.5% ($8.125M on a pre-tax basis)

100 80 60 40 20

Debt with payments

8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125 8.125

0 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Interest

Principal Repayment

▪ Interest payments are tax deductible at a tax rate of 35%. So, the after-tax cash-outflow of the interests is $5.28M. ▪ Bonds have a 15-year maturity. ▪ Full principal of $125M is paid in the last year. 12

Q2 - Financing Alternatives: Equity The acquisition could also go through via using the proceeds from a stock issuance or using a mix of Debt and Equity

Cash Outflow in M$

Payment schedule and summary of the conditions of using Equity 180 154.19 160 140 120 100 80 60 40 20 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.5 0 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Dividend Payout

Terminal Value

▪ 7.5M shares have to be issued. ▪ Price/share of 17.75$. After fees goes to $16.67/share ▪ Implies a total of $7.5M incremental dividend payout, every year. ▪ Dividend policy of $1/share. ▪ Using historical data provided by Aswath Damodaran we obtained a cost of equity of 5.36%.* ▪ Assumption: Payment of dividends a growth rate of 0.5% as the Waste Industry is expected to grow below the US’ GDP, and it’s a rather stagnant.

Payment schedule and summary of the conditions of using E+D ▪ MPIS indicated it would accept 25% in equity and 75% in debt. Debt maturing in 15 years and perpetual dividends. ▪ 1.875M (25%*7.5M) shares issued at a net price of 16.67$/share. Dividend policy of $1/share, and assumption of g=0.5%.

$300 $250 $200 $150 $100 $50 $-

Dividend Payout

TV of Dividends

Principal Repayment

Total Cash-outflow

Interest

*Note: The unlevered cost of equity is explained in the next page

▪ ▪ ▪ ▪

Dividend Payout/Year = $1.875M to MPIS. Terminal Value (dividend) = $38.55M. Interest payment/year = $6.09M Last year’s principal repayment = $93.75M

13

Q2 - Net Present Value of Financing Options From the two categories of financing alternatives, debt has the lowest cost Inputs

NPVs of the financing options

Data from January 2012 for the waste management industry and market information:  Beta = 0.48. Consistent with being a cycle proof industry  Risk-free rate = 1.76%. Used 15-year US T-bill.  MRP = 7.5%

$180

Discount rates:  Cost of Equity (before debt issuance) = 5.36%. Used to discount the equity financing option.

$60

 Debt to Value (financing with debt) = 23.45%  Debt to value (financing with 75% debt) = 10.70%.  WACC (debt financing) = 5.39%  WACC (debt and equity financing) = 5.38%

$154.23 $147.32

$160 $140

$120

$103.04 $101.31

$99.71

$100

$85.89

$80 $40 $20 $1 - Debt with fixed principal repayments NPV

2 - Debt with annual interest payments

3 - Equity

4 - 25% Equity + 75% Debt

NPV with 0% growth rate in dividends

Points of Emphasis ▪ ▪

▪

Issuing stock will have a higher cost when compared to financing the deal with debt. In fact, even with a mix of debt and equity, the issuance of plain debt or debt with annual principal repayments are still preferred options. Debt cash-outflows have a finite period (15 years) whereas issuing debt implies paying perpetual dividends of $1 per share issued. The firm relies on its reputation of reliably paying dividends and a deviation from this policy would have negative consequences of Winfield’s reputation and firm value. Even if dividends stay at $1/share, the NPV of issuing stocks is still lower than that of issuing debt. The acquisition of MPIS will have a lower cost if it’s financed with debt, ideally plain debt without fixed principal repayments on an annual basis. 14

Assessment of board members’ opinions Most board members are more keen on issuing shares to pay for MPIS. Board Member

Argument

Sheene

Issuing debt is the most economically attractive option, as the after-tax cost of debt (4,225%) is lower than the cost of issuing equity netting $16,67 per share with a continued dividend of $1,00 per share (a 6%).

Andrea

The stock issuance has a lower cost, as with the principal repayment the yearly outlay is an additional $6.25 million per year (over 9% of the bond issue). This debt will increase risk and lead to wild swings in the stock price.

Joseph

MPIS pays or itself: with an EBIT of $24 million (over $15 million after taxes) and an additional 7.5 million shares issued to finance the operation, the cost will amount to just $7.5 million per year, considering a $1.00 dividend per share.

1

2

3

Erroneous

Ambiguous

Assessment

True

Note: see next pages for substantiation of the arguments’ assessment.

15

Q3 - Argument for Debt Financing 1

Issuing debt is the most economically attractive option, as the after-tax cost of debt (4,225%) is lower than the cost of issuing equity netting $16,67 per share with a continued dividend of $1,00 per share (a 6% cost).

•

Sheene argues, correctly, that the after tax cost of capital is lower than the current dividend yield. Considering the low overall debt level, currently the benefits of debt seem to supersede its costs, making it an attractive financing option. Nevertheless, other considerations and criteria have to be analyzed in order to assess that debt is truly the best option, i.e., we should look at the impact on firm’s shareholders (via return on equity), and at the firm’s ability to meet future payment obligations (interest coverage ratio and dividend coverage). Only then can we conclude debt is the best option.

•

Pros of the Bond Issuance

Cons of the Bond Issuance

 Increased management discipline: Managers are subject to extra scrutiny by bondholders and have the disciplining factor of having to meet periodic payments. Thus, there’s a lower risk of agency problems like empire building happening.  Present value of future tax shields of debt: there’s potential to generate value for the firm thanks to the deducibility of interest payments which in turn reduce the tax bill for Winfield.  No Dilution: issuing debt will produce no changes in the 79% control of the business that the Winfields have. The retention of control for the family may be a particularly important factor when deciding the financing alternative, as it’s of their interest to retain control.

 Management control is restricted (e.g. covenants). The breach of a debt covenant will restrict managerial actions. Existing managers, namely the Winfield family who owns most of the business, may be reluctant to take on debt because of this.  Increased bankruptcy risk: makes both new debt and current equity more expensive.  Cash and collateral: Winfield plus MPIS will have to produce enough cash-flows by the time of interest and principal payments are due, otherwise covenants are breached and credit ratings is downgraded, resulting in a higher cost of capital. Also, collateral (most likely fixed assets) will have to be posted to act as a guarantee.

16

Q4 - The Cost of Equity Financing The principal repayment should not be considered as cost of debt, but instead as a change in the capital structure. 1

2

3

Total Cost of the equity issue:

1. The cost of equity rE = dividend yield + capital gains 6% 2. Spread/ underwriting discount

3. Underpricing

If a company retains and invests earnings with ROIC > WACC value is created, resulting in higher share prices  return for shareholders Dividends are one component of shareholder remuneration; capital gains are the second component. The cost of equity has to consid...