Lonestar Graphite Write-Up-final PDF

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Final submission of the case study, with detailed financial analysis and descriptive statements....

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Lonestar Graphite BAFI 359 Group 1 Alex Besl Jacob Kucia Rob Stroup Gabby Wallach Bryant Wu

Problem Definition In late September of 2000, Steve Patterson and Ravi Desai, co-founders of Hamilton Capital Partners (HCP), worked on the addition of Lonestar Graphite to its portfolio of companies. The main issues regarding the addition of Lonestar are: ● Is this LBO deal a good investment opportunity for HCP? ● If yes, what price should HCP pay for Lonestar? How much equity should be raised and invested in Lonestar? Industry & Company Background Lonestar operates in the carbon graphite industry, specifically the industrial applications segment, which accounts for 18% of the industry or $900 million. The company operates in a premium niche, focused on manufacturing precision graphite products between one to twenty microns. The company’s customer base is made up of three groups: electrical discharge machining (EDM), semiconductor, and industrial products (SIP) and glass container. The graphite that Lonestar produces was used by specialty machine shops for almost every EDM application around the world. Due to the company’s high-quality and brand recognition, it sets the standard for the industry. Additionally, in this line, it has developed strong relationships with its distributors spanning over 20 years. Although the manufacturing industry slowed down in late 1997, after mid-1999, the EDM saw a significant uptick as the global manufacturing environment improved. Not only the industry growth is forecasted of 6% in 2000, but also specific sub-sectors of graphite heavy industries drive the demand higher, including electrical machining at 85% capacity and semiconductor at 91% capacity. Within the SIP division, it’s split into industrial products and semiconductors. The industrial products were directly sold to the end users, which Lonestar has customer relationships of over 15 years. Furthermore, it creates more than 40 different grades of graphite for general industrial, scientific, aerospace, and biomedical application; it’s also the sole supplier for heat valves and radioactive pellets. The semiconductor line provides a wide range of graphite products that are used in wafer processing equipment. The demand for Lonestar’s semiconductor product was driven by more production and new capacity additions by the manufacturing industry. There was a secular trend in the increase use of graphite and silicon carbide, since it saw a recession that occured in 1998 and early 1999. This segment is bouncing back with growth projections of 30% in 2000 and 15% in the two to three years after. Both segments are anticipated to grow at around 5%.

Lonestar’s graphite is used in the glass container industry because of its properties of strength, durability thermal properties, and non-sticking capabilities. The industry had recently experienced slow growth due to alternative soft materials like aluminum cans and plastic. There has also been substantial consolidation in the industry and companies are pressured to consider competitive and low pricing. However, Lonestar’s graphite is still preferred in the industry and this division belongs to the SIP segment. The company has a distinct advantage in that is has mastered how to convert graphite into silicon carbide. The need for more precise products will increase the demand for the Lonestar process. The company is known for its superior service, being an innovator in the field, and sustaining long standing relationships with large customers. However, its top ten customers make up about half the company’s total sales. In its EDM and SIP product line, there’s only one major competitor versus its glass container product line where there are several other competitors. Lonestar is also in a very cyclical business and is tied toward dependency, as previously stated, on the manufacturing industry. Overall, the company has a superior product in comparison to its peers and the demand for the graphite produced by the company is increasing. LBO Candidate or Not? As mentioned in the case, HCP follows four principles when it makes leveraged acquisitions: strong cash flows that insure the leverage opportunities, great potential for new applications and products, outstanding management team and considerable market shares. We found that Lonestar matched all four requirements. It doesn’t have any long-term debt, which would not cost any trouble to the cash flow in the future. With its industry-leading identity, Lonestar has the potential to generate further growth based on its competitive advantages and customer loyalties in every sub-sector. Since UNOTEX didn’t have any intentions to keep control over the company, HCP could further ensure the growth of the company by guiding the management team itself. From the investment principles perspective, Lonestar is a good LBO candidate. On top of deciding if Lonestar is a good LBO candidate or not, HCP also needed to consider the business risks that Lonestar faced at the current situation. We found that Lonestar had various business risks from industry competitions, internal revenue streams and managerial capabilities. First of all, almost half of Lonestar’s revenue was from the top ten customers who had strong and steady connections with the company. Furthermore, the EDM sectors had around 70% of the most important customer base, which meant Lonestar didn’t have much diversifications in its revenue streams. The lack of diversity could have caused bigger problems because of the cyclicality of the industry and overall economy. Secondly, given the list of competitors in the case, Lonestar could not hold its current market share with the competitive advantages it had.

Not only that the competitors could replicate its technologies easily, but also international competitors, such as Norton, Ibiden and SGL, all had the opportunities and possibilities to increase their overall market shares by global expansion and technological innovations. Thirdly, the management team wanted to make quick transition into a stand-alone entity, which would fundamentally increase the capital expenditure, so it would be very challenging for the management team to make any decisions, including basic marketing strategies, sales expansion, and internal cost control. Based on various business risks exposed from Lonestar, further valuations and analysis are needed to support our final recommendations. Valuation To further analyze Lonestar, we established multiples and transactions valuation for HCP. As shown in Exhibit 1, we include all four companies that were provided in the case in our valuation. Among all the multiples given, we think EV/LTM EBITDA could best reflect the transaction price, which ranges from $81.84 to $87.11. Meanwhile, we used the same multiple for several recent acquisitions of similar competitors in EDM, SIP and Glass containers industries, as shown in Exhibit 2. These recent transactions could also reflect a better transaction price for Lonestar, with a range from $106.02 to $109.43. Based on public companies and transactions comparable analysis, we believe that our valuation, which shown in Exhibit 3, is relatively reasonable and the transaction price we estimated was fair, $100 million along with an EV/ LTM EBITDA of 6.8. Our deal structure is made up of $59.2 million in total debt or OPM and $40.8 million raised from the equity. Under Lonestar’s management assumption, the targeted IRR reached 33%, with only $1.8 million dollar left on the senior debt account by the end of the 4-year investment period. Moreover, we ran the DCF models under two assumptions, as shown in Exhibit 4 and Exhibit 5, with our exit EV/LTM EBITDA multiple of 6.8 and the WACC of 7.13% as calculated in the exhibits, the enterprise value range we had is from $161 to $181 million, which includes our estimation in LBO model of $170.9 million.

Conclusion Given the above discussion and analysis, we can conclude that Lonestar matches the acquisition standards of HCP, not only through its four major investment principles but also with greater targeted returns (IRR). Based on our estimation, the IRR of this deal could reach 33.2%, which exceeds the 25% hurdle rate of HCP. Meanwhile, in our estimated deal structure, HCP would only need to raise equity around $41 million, which is almost 20% below the maximum capacity of $51 million. So, we strongly agree that the acquisition of Lonestar would be a great investment opportunity for HCP.

Appendix

Exhibit 3 Management Assumptions Analysis...