Case Report Write Up For Acquisition Of Pinkerton By Cpp - Final PDF

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Full report for the Pinkerton case. Grade A...

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Bi Norwegian Business School Applied Valuation Spring term 2019

Case Write-Up

Case I: Pinkerton

Table of Contents 1

Management summary ....................................................................................................... 1

2

Valuation .................................................................................................................................. 1

2.1

Scenarios and free cash flow calculation ............................................................... 1

2.2

Valuation and WACC....................................................................................................... 2

2.3

Stand-alone and synergy values ................................................................................ 3

2.4

Relative valuation – Multiples .................................................................................... 4

2.5

Financing ............................................................................................................................. 5

2.6

Further management issues ........................................................................................ 6

Table of Exhibits: Exhibit 1 - Scenario-based NOPLAT calculation ...........................................................1 Exhibit 2 - Scenario-based free cash flow calculations...............................................2 Exhibit 3 - Valuation Summary ............................................................................................3 Exhibit 4 - CPP's synergy value ............................................................................................3 Exhibit 5 - Pinkerton's stand-alone value under American Brands ......................4 Exhibit 6 - Calculation of cash flows available for debt services ............................5

I

1

Management summary

Regarding the acquisition of Pinkerton by CPP for a total of $100m, we recommend engaging in the acquisition, as our valuation resulted in a total value of the acquisition which would exceed this number. As longs the expectations hold, Wathen’s equity value will also increase. Regarding financing, we recommend financing the acquisition partly with equity and partly with debt, as the cash flows available for debt services would not be sufficient, even in case of a favourable development following the acquisition, if it was financed entirely with debt. Despite a generally positive result, the issue of insufficient market data as well of managerial issues has to be addressed. Since the majority of the transaction value results from potential synergies following the acquisition, there is a significant risk that those issues may threat the realization of those synergies and therefore lead to a lower transaction value. 2

Valuation

Based on the information provided in the case problem set, we valued Pinkerton using the discounted cash flows (DCF) method, as well as market-based methods such as multiples. 2.1 Scenarios and free cash flow calculation Resulting from the acquisition, two different scenarios in terms of profitability development and cost-structure effects are possible. Due to the high number of potential positive effects mentioned in the assignment, we used the upside scenario as our expected scenario, whereas the other scenario is treated as a worst-case scenario. Based on these two scenarios, we forecasted the future development of both the income statement and the balance sheet, in order to derive the relevant figures for NOPLAT and working capital (exhibit 1). Income Statement - expected scenario (in $m) NOPLAT Operating Working Capital in % of sales Income Statement - worst-case scenario (in $m) NOPLAT Operating Working Capital in % of sales Exhibit 1 - Scenario-based NOPLAT calculation

1987 (E) 1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E) -0,40 6,06 6,68 6,98 8,81 9,25 38,80 9,50%

31,60 8,60%

24,17 7,40%

17,72 6,20%

18,61 6,20%

19,54 6,20%

1987 (E) 1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E) -0,40 6,06 6,14 6,04 7,33 7,69 38,80 9,50%

34,91 9,50%

31,03 9,50%

27,15 9,50%

28,51 9,50%

29,94 9,50%

Exhibit 1 also shows the effects of the new pricing strategy for Pinkerton, which Wathen intends to implement after the acquisition. His plan to sell Pinkerton’s services at a price premium based on the company’s reputation will lead to a decrease in sales within both scenarios, combined with a steady growth following an adaption period. The question has to be raised as to which extend the mature and highly price-competitive security guard services industry is going to react to this price premium. Since this new pricing strategy is a complete turnaround from Pinkerton’s previous strategy (low price & high market share), there is a considerable chance that the market’s negative reaction may be stronger than anticipated in the scenarios. Furthermore, Wathen tries to apply his own strategy of differentiation through quality and training on Pinkerton, which was run under a very different strategy throughout the last years. 1

We calculated the free cash flows for both the expected and the worst-case scenario, while using the indirect method based on the respective NOPLATs (exhibits 2,3). As our estimation period, we applied the 5-year timespan from 1988 until 1992, since most relevant figures are expected to develop in linear fashion thereafter. We discounted the cash flows using the unlevered costs of capital and projected a terminal value (TV) based on the 1992 cash flow. Since Pinkerton has neither debt nor non-operating assets on its balance sheet, the enterprise value equals the market value of equity. Exhibit 2 shows that the two different scenarios have a large impact on the resulting enterprise value, leading to a total difference of c. $26,4m. If synergies resulting from the acquisition were to be excluded from the decision, even the initial bid of $85m could not be justified in the worst-case scenario. Free Cash Flow - Expected Scenario (in $m) NOPLAT Less change in net property, plant and equipment Less change in net working capital Free Cash Flow Discounted Cash flow Terminal Value Enterprise Value

1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E 6,06 6,68 6,98 8,81 9,25 -2,90 -1,63 -1,63 0,57 0,60 -7,20 -7,43 -6,45 0,89 0,93 16,16 15,75 15,06 7,36 7,72 14,34 12,40 10,53 4,56 4,25 58,10 104,19

Free Cash Flow - Worst-case Scenario (in $m) NOPLAT Less change in net property, plant and equipment Less change in net working capital Free Cash Flow Discounted Cash flow Terminal Value Enterprise Value

1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E 6,06 6,14 6,04 7,33 7,69 -2,90 -1,63 -1,63 0,57 0,60 -3,89 -3,88 -3,88 1,36 1,43 12,85 11,66 11,55 5,40 5,67 11,41 9,18 8,07 3,35 3,12 42,64 77,77

Exhibit 2 - Scenario-based free cash flow calculations

2.2 Valuation and WACC We assume that we have two scenarios only if CPP acquires Pinkerton: the expected scenario, where both CPP and Pinkerton improve their operations, and the worst-case scenario, where nothing changes. We estimate the probability of each scenario to be equal due to lack of sufficient information and data. We believe that this will give a better estimate rather than ignoring one of the scenarios. The expected values are therefore the average values of expected and worst-case. In order to find the values of the firm we started off with finding the unlevered return on assets for Wackenhut, the only comparable firm given in the assignment. We used the unlevered cost of capital to find the expected unlevered value of both CPP and Pinkerton (exhibit 2). We then applied the APV method by adding the present value of tax shield, assuming that CPP’s debt of $2m would remain constant. The present value of tax shield for Pinkerton is calculated as follows: even though our cost of debt equals 11.5%, we took in consideration that a fair cost of debt for Pinkerton would be 9.68% (cf. exhibit 5 in the assignment) as we rated Pinkerton as an AA-rated firm through Altman’s Z-score system. This leads to a higher tax shield as a result of even higher interest payments than what is fair, which was taken into consideration (cf. WACC-tab in attached Excel file). The present value of the tax shields in total were therefore lower than it would be with fair cost of debt. The present value of tax shield for CPP is calculated straight forward by multiplying the tax rate with the interest 2

payments, since we assumed that they remain constant. However, by adding the unlevered values and present values of tax shield together, we found the enterprise value of the firms. We then calculated the average cost of debt in order to find the new WACC for the merged firm (assuming that the unlevered cost of capital still holds as both the firms still operate in the same industry). The combined WACC also serves only for intuitional purposes and has no practical use as we found the values through APV. Exhibit 1 provides a short summary of our results, which results in a total acquisition value of $109.29 million. Also, Wathen’s value of equity increases by $2.68 million which is the difference between CPP’s equity value today and 55% of the firms combined equity value after the acquisition. The numbers are true only if the firms are priced correctly (i.e. efficient pricing). The higher bid of $100m can therefore be justified to the board of directors. Valuation Summary of the firms combined (in $ million) Enterprise Value 132,91 Market Value of Equity 58,21 77 Value of Debt Unlevered Cost of Capital 12,68 % 13,76 % Return on equity Avg. Cost of debt (long-term) 11,45 % WACC 10,40 % PV of the aquisition of Pinkerton

109,29

Exhibit 3 - Valuation Summary

The largest weakness in our valuation is the scenario analysis. It is not reasonable to assume that the probability for both the upside and downside cases are equal. In that case, an analyst should also have evaluated the scenarios for CPP and Pinkerton individually. There is, however, possible to get an intuition of the probability of the scenario analysis based on the valuation and potential valuation using multiples. Our problem is that the value range from the multiples are uncertain since we have one peer only. More peers and average multiples would strengthen the usage of multiples. Other weaknesses may be changes in the interest rates in case of reconsideration of capital structure (or refinancing after seven years). 2.3 Stand-alone and synergy values We calculated the synergy value for CPP as the present value (PV) of the positive effects on operating profit resulting from the acquisition, less the resulting additional tax payments. The resulting cash flows were discounted by the unlevered costs of capital. By adding the synergy value of CPP to the PV of the free cash flows, we calculated a total transaction value. CPP's syngery value (expected scenario, in $m) Change in operating profit margin Less changes in taxes Cash flow from syngeries Discounted synergy cashflow Terminal Value of synergies Total synergy value Exhibit 4 - CPP's synergy value

3

1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E) 0,00 1,20 1,50 2,00 3,00 0,00 0,41 0,51 0,68 1,02 0,00 0,79 0,99 1,32 1,98 0,00 0,62 0,69 0,82 1,09 8,20 11,42

For the worst-case scenario, no improvements in operating profit are expected, which is why the total transaction value would remain at the level of the PV of the free cash flows ($77,77m). For Pinkerton, the synergy value was calculated as the difference between the stand-alone PV of cash flows under the management of American Brands (exhibit 5) and the valuation which includes the effects of the acquisition in either the expected or the worst-case scenario. In order to derive Pinkerton’s standalone value under American Brands for the estimation period of 1988 until 1992, we assumed that there will be no larger changes in the industry in the near future. Therefore, we estimated that the income from services provided would grow by its compound annual growth rate (CAGR) from 1983 till 1987. For all other line items, we calculated the average in % of income from services provided from 1983 till 1987. Based on this, we made the assumption that these items are going to remain at this average level in % of income from services for the entire estimation period (exhibit 5). The synergy value for Pinkerton is therefore the difference in between the enterprise values with and without the transaction, totalling $48,31m for the worst-case and $74,73m for the expected scenario. Stand-alone value of Pinkerton (in $m) NOPLAT Less change in net property, plant and equipment Less change in net working capial Free Cash Flow Discounted Cash Flow Terminal Value Enterprise Value

1988 (E) 1989 (E) 1990 (E) 1991 (E) 1992 (E 6,29 6,71 7,15 7,62 8,13 -0,19 1,15 1,23 1,31 1,40 -0,27 2,55 2,72 2,90 3,09 6,76 3,01 3,21 3,42 3,64 6,00 2,37 2,24 2,12 2,01 14,73 29,46

Exhibit 5 - Pinkerton's stand-alone value under American Brands

As shown in the calculations above, the synergy value is responsible for a large share of Pinkerton’s total value. These synergies arise from factors such as improvements in overall profitability, the reduction of redundant overhead costs as well as the big increase in size, which would make the merged company the largest player in the industry. Despite all these positive expectations, there is a significant risk of vastly overpaying for Pinkerton, as the majority of its value does not arise from the value of the company’s assets, but from the high expectation towards future improvements related to the acquisition. 2.4 Relative valuation – Multiples In addition to the DCF, we applied a relative multiple valuation on Pinkerton, which is based on the market values of the only publicly traded peer company, namely the Wackenhut Corporation (cf. exhibit 5 of the case assignment). Since Pinkerton’s earnings were negative during our base-year of 1987, we used its future forecasted earnings for the year 1988 for the calculation of the price-to-earning (P/E) multiple. Ideally, we would have also used Wackenhut’s earnings from 1988, yet since there was no information to forecast it, we used the 1987 earnings, leading to a result of $74,67m. An advantage of using forward looking multiples – apart from that earnings are negative in year 0 – is that they are based on future expected cash flows and not sunk cost. Additionally, we applied the EV/sales multiple instead of price to sales, due to the differences in capital structures between Pinkerton and Wackenhut. While Pinkerton is all equity financed, Wackenhut uses a combination of equity and debt financing. Using this multiple takes the differences in capital structures 4

into account. Based on this, we calculated a company value of $77,73m. This specific multiple is normally used as a last-resort option in cases where there is little useful information regarding the valuation. Since this is the case, it can be valuable to include this multiple because the company we are valuing has negative profits in the base year. Furthermore, we also applied the EV to assets multiple, which compares the company’s assets to the actual value of the company, and came up with a result of $58,91m. Since we have negative earnings and both companies operate in the same industry and country as well as a large portion of assets are tangible assets, it could make sense to apply the price to book value by comparing the market value of equity to the book value of equity. However, this valuation is ineffective due to several reasons. One reason is that the measure is ineffective right after acquisitions. Also, P/B is more of an accounting measure rather than economics measure. Due to the fact that there was only one company available to serve as a peer for Pinkerton, the explanatory power of the calculated multiples is very limited. Therefore, they merely serve as a rudimental back-testing for the results of the DCF valuation. This lack of peer companies leads to a high level of uncertainty regarding the calculated value range between $58,91m and $98,91m. In our opinion, it is therefore not possible to conclude whether is fair priced based on similar companies in the industry. 2.5 Financing The debt resulting from the first financing option has a maturity of 7 years. In order to evaluate the merged company’s ability to meet its debt obligations, we calculated the cash flows available for debt services based on exhibit 3 of the assignment. In order to do so, we started with the cash flows resulting from CPP without the acquisition, and then added Pinkerton’s, as well as the synergy cash flows. As part of this calculation, we also included the additional goodwill amortizations of the acquisition. Due to the lack of further data, we made the assumption that the cumulative surplus would grow at its CAGR from 1988 till 1992 for the remaining 2 years until maturity (exhibit 6). Based on this, we assessed our future estimates and how likely it is that cumulative surpluses are large enough to serve the future balloon payment in 1994. Cash flow available for debt services (expected scenario, in $m) CPP stand-alone cash flow Plus Pinkterton FCF Plus Synergy FCF Total Cash flow for debt services

1988 7,00 16,16 0,00 23,16

1989 7,80 15,75 0,79 24,34

1990 1991 8,10 9,30 15,06 7,36 0,99 1,32 24,15 17,98

Cash flow available for debt services (worst-case scenario, in $m) CPP stand-alone cash flow Plus Pinkterton FCF Plus Synergy FCF Total Cash flow for debt services

1988 7,00 12,85 0,00 19,85

1989 7,80 11,66 0,00 19,46

1990 8,10 11,55 0,00 19,65

1992 9,40 7,72 1,98 19,1

1991 1992 9,30 9,40 5,40 5,67 0,00 0,00 14,7 15,07

Exhibit 6 - Calculation of cash flows available for debt services

In order to calculate the cumulative surplus, we subtracted both interest and eventual principal payments from the available cash flow, and then added back the tax shield resulting from the interest payments. We took both possible scenarios into account and also made calculations for a lower bid of $85m. If they choose to finance the acquisition with 25% equity and 75% debt, they will be able to meet their debt obligation in both scenarios. This holds true, no matter if the bid is $100m or $85m. On the other hand, if they choose to finance with 100% debt, there will be a considerable risk that CPP will not be able to 5

serve its future debt obligation. If the bid is $100m, it is very unlikely that CPP will be able to produce large enough future surpluses to pay of the balloon payment. Based on our calculations, the cumulative surplus for the expected scenario would not be sufficient, which is why the same is expected to be true for the worst case. CPP will be expected honour its debt obligation for a bid of $85m if future profit margins grow based on the expected scenario. If the growth seems to be more moderate on the other hand (worst-case scenario), it will be expected to default as the future cumulative surpluses are too low to cover the balloon payment which is due after 7 years. Based on an overall assessment, we would recommend that CPP use 25% equity and 75% debt to finance the acquisition. This is backed by the fact that under both scenarios and regardless if the bid is 85 million or 100 million, CPP will be expected to meet its future debt obligation as future expected surpluses exceeds the future balloon payment. By choosing this alternative, the external financier is will realize a gain of $1,19m on his $25m equity, since his 45% of the merged firm’s equity are worth $26,19m. Wathen is expected to gain from the acquisition as well. Prior to the acquisition, his 100% of CPP were worth $29,33m. Si...