Blaine Kitchenware, Inc. A Case Study - Report This document discusses Victor Dubinski, CEO of BKI’s
concerns and thoughts. It goes on to analyse the financial aspects of these. Abdalla Al Hosany 07-Mar-14
Table of Contents Abstract ......................................................................................................................................................... 3 Background ................................................................................................................................................... 4 Question 1: Do you believe that Blaine's current capital structure is optimal? Why or why not? ........... 4 Question 2: What are primary advantages and disadvantages of a share repurchase that Dubinski
could recommend to the board? ............................................................................................................... 6 Question 3: Consider the following proposal for share repurchase. Blaine will use $209 Million cash
from its balance sheet, and $50 Million in new debt at interest 6.75%, to repurchase 14 million shares at the price of $18.5. How would such a buyback affect Blaine? Consider the impact, among other things, on BKI's earnings per share, ROE, the family's ownership interest (percentage), and the company's cost of capital (WACC). ........................................................................................................... 7 Question 4: As a member of the Blaine's controlling family, would you approve the plan? Why? .......... 8 Question 5: As a minority shareholder not member of the family, would you approve it or not? Why? . 8 Bibliography .................................................................................................................................................. 9
Abstract This case study analyses the capital structure of B laine kitchenware and suggests a potential restructuring option to its owner / Managing Director Mr. Dubinski. The answers to the questions within the case helps to summarise a possible decision for him. It mainly focuses on the debt leverage aspect of the capital restructuring and how it benefits the company from being overliquid and underleveraged to one which has bette r EPS, lower taxation and one t hat is not afraid to take a little risk for a more secure future.
Background Blaine Kitchenware, Inc is a major player in the home appliances industry and has been an American Brand serving the domestic and international markets for over 80 years. It started as a family owned enterprise and despite facing competition, IPO, etc have continued to prosper under a major family share holding. The CEO, Victor Dubinski took over the reins from his uncle in 1992 and has steadied the company into a very safe, low risk company with adequate growth potential. He is looking to unleash the unrealized value from discussions with a potential banker who has put this thought and possibility of a buyout by a group of investors.
Question 1: Do you believe that Blaine's current capital structure is optimal?
Why or why not? (Please refer to the static trade-off model based on the Miller-Modigliani theorem; and you can include your own observations about optimal capital structure.)
Each company is run by a management that has an underlying sense of business. Some are conservative, others are daring. We cannot necessarily say if it is good or bad if the company is performing its primary duties well. At the same time, we also need to look at the current capital structure and payout policies of BKI to make an analyst / investor opinion of the company’s financial structure. It is
important to know what the market sentiment on the company is as this is a publically traded firm. Investors are looking at long term value of the firm. Summary:
The current approach of the management is to lower the risk and hence they have maintained the firm debt free. They have not looked at leverage to: Lower Cost of Capital as a result of reduced taxation (they have paid consistently ~32% o and are expected to pay 40% in future) With each acquisition their outstanding shares have increased (by 17,000 till 2006) and this has in effect reduced their EPS to $0.91 (2006) This has also made their ROE (11%) the lowest in the industry despite the fact that they are among the healthiest and safest. In addition to this, their payout ratio has increased from a healthy 35% to 52.9% in 2006. This essentially means that they are not able to make as much cash as they were earlier and hence the rate of growth of their cash will decrease. A future acquisition may increase the outstanding shares yet again and this can become a vicious cycle. Relying 100% on equity and not utilizing their strong balance sheet to leverage at attractive interest rates are actually hampering their growth and ability to be flexible in decision making ex: Make an acquisition o Enter new markets o
As per the Miller-Modigliani (MM) study, (Eugene & Joel, 2013) under a given restrictive set of conditions, the capital structure of firm has not impact on its valuation. Some of these restrictive conditions set forth by the MM theory are as follows:
Assume no brokerage costs Assume no taxes Assume no bankruptcy costs. Investors and corporations can borrow at the same rate.
All investors have the same information as management about the firm ’s future investment opportunities. EBIT is not affected by the use of debt.
The above assumption is clearly unrealistic and represents a financial Utopia, if you will. Hence the MM theory led to the foundation of further research on capital structure and its effects. Detailed study on effect of taxes and bankruptcy led to “the trade-off theory of leverage” which analyses the correlation between leverage, stock prices and potential affects of bankruptcy. This theory states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy. (Eugene & Joel, 2013). Value of Blaine’s Stock
The above figure helps us to understand the trade-off model better. When you have debt, there is always an interest to be paid and this is deductable as an expense. This makes debt less expensive than equity as shareholders always look to earn more. In ef fect, it provides a tax shelter benefit by the government indirectly paying part of the cost of the debt. Thus more the debt implies more interest and thereby more EBIT goes to the shareholders. As per MM, this factor appreciates t he stock prices. So in theory a 100% debt as seen in the graph should mean the highest stock prices possible. But in real world, firms target debt rations much less than this as a 100% leverage is a potential for bankruptcy. There is a threshold level, D1 as in the above chart where the effect of the leverage is negligible to cause any bankruptcy. Beyond this, there is a c ost related to bankruptcy and they slowly begin to offset the benefits offered by leverage. Between D1 and D2 there still remains a significant benefit in terms of tax shelter that the stock prices continue to rise albeit at a lower rate. Beyond D2, however the costs of bankruptcy are more than the tax benefits and then we can see the stock prices taking a hit. D2 in a way can be called as the threshold or maximum point of balance where stock prices are highest and debt ratio is at optimum. The limits D1 and D2 are not fixed, it is dependent on factors like business risks, cost of capital, cost of bankruptcy, geography of operations, etc. From this theory, it is clear that Blaine Kitchenware has to use debt as a key tool to improve its stock prices and thereby improve its earnings. It will also help the company save taxes and hedge better against a future takeover or an acquisition. The valuation of the firm can also improve as a result of this.
Concerns:
The above work is mostly based on empirical and theoretical work and hence is at best approximations of the actual curves. Another point is that firms which have had less debt than suggested have enjoyed much higher valuation and better profitability. Examples are Apple, Google, Intel, etc. These have further led to more realistic studies on capital structure like signal theory, etc. So for Blaine also, they should be prudent when it comes to leveraging the company. At the same time the family has been historically conservative in their approach and the huge amount of cash they have will be good for them.
To conclude, I think that to unleash their potential as a firm they need to be ready to take a little more risk and use some debt leverage to buy back some shares. This will not only reduce their tax burdens, but also drive their market value (less shares available for trade) upwards. Additionally, they will have better bargaining power with future acquisitions and pay via the share holding or debt route as necessary.
Question 2: What are primary advantages and disadvantages of a share
repurchase that Dubinski could recommend to the board? Dubinski should definitely be recommending a share re-purchase to the Board. The primary advantages are (Eugene & Joel, 2013):
Increasing share holder value (re-purchase) will drive the market prices eventually and with lesser shares, it will greatly improve both the family and remaining share-holders value Debt leverage will decrease the Tax burden on the company and lower the overall cost of capital EPS will improve with lesser outstanding shares, this will also drive the market value of the company positively Payout ratio will stabilize to manageable levels, where there is enough to plough back to research and other investments. With lower outstanding shares, Dividend per share will improve which will further improve the market value and investor confidence Family’s holding will subsequently increase and this means more control over the future direction and better leverage at the time of acquisition or market expansion It is estimated that the current stock prices is near to the historic high, it may not have to pay too high a premium for this repurchase. Stockholders can tender or not. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in takeovers or resold to raise cash as needed. Income received is capital gains rather than higher-taxed dividends. Stockholders may take as a positive signal--management thinks stock is undervalued.
Some of the disadvantages are (Eugene & Joel, 2013):
The future forecasts for the business look stagnant with their current product mix. They need an acquisition to grow more as per market movements. A repurchase program might make sense for companies which have cash and a strong positive earnings outlook. For BKI, it still needs to scout for opportunities for this growth in earnings. So the cash and debt might actually be needed at that time.
A repurchase program can drive the stock prices to overdrive. There by forcing BKI to pay more than it planned to for a given amount of shares. Leverage also drains you of cash flows and initial earnings might not translate into dividend payout May be viewed as a negative signal (firm has poor investment opportunities). IRS could impose penalties if repurchases were primarily to avoid taxes on dividends. Selling stockholders may not be well informed, hence could be treated unfairly. Firm may have to bid up price to complete purchase, thus paying too much for its own stock.
Question 3: Consider the following proposal for share repurchase. Blaine will
use $209 Million cash from its balance sheet, and $50 Million in new debt at interest 6.75%, to repurchase 14 million shares at the price of $18.5. How would such a buyback affect Blaine? Consider the impact, among other things, on BKI's earnings per share, ROE, the family's ownership interest (percentage), and the company's cost of capital (WACC). Ratios
2,006
Outstanding Shares Total Assets (Shareholder Equity) ROE EPS Interest Coverage Debt Ratio Repurchase Current Outstanding Shares
41,309
48,970
Shareholding
59,052 $ 488,363 11.0% $ 0.91 -
2006 w/ Repurchase
$
45,052 229,363 22.4% $ 1.14 18.95
Change
104% 25%
8.4% 59,052 62% 36,612
14,000 45,052
-24%
81%
31%
(detailed calculation available in excel sheet) Workings:
ROE = Return on Equity = Sales / Total Assets (shareholder equity) = 53,630 / 229,363 = 22% EPS = Earnings per Share = Net Income / Number of Shares = 53,630 / 45,052 = $ 1.14 Ownership before Repurchase: = 62% of 59,052 = 36,612. Ownership after Repurchase = 36,612 / (59,052 – 14,000) = 81% A share re-purchase as explained earlier is advantageous in a number of manners. It is further illustrated by this scenario of a 14 Mil Outstanding shares buyback using cash and debt. The table show a number of key company health indicator metrics and thus explains the clear improvements vs a debt free firm.
EPS has increased by 25% to $ 1.14. Clearly the lesser outstanding shares showcase the company as earning better for its shareholders than otherwise. ROE has doubled to 22% from 11%. A metric which puts it closer to the mean (26%) of the industry benchmark.
The family’s ownership has increase d to 81%, a controlling majority with which they not only
retain more dividend / earnings. But also can set the course for future organic and inorganic growth. Cost of Capital Re r = Rf + beta x ( Km - Rf )
Rf
+ 4.91% +
Beta
x 0.56 x
Re, Cost of Equity WACC
5.5%
5%
The cost of capital (WACC) is around 5% which much lesser than what the company is able to make. Additionally, the debt ratio is 8.4% (1:0.084) and the interest coverage is 18.95 (much higher than 1.5). These values are clear indicators that the company’s fin ancial health continues to be robust and infact has been improved from previous situation.
Question 4: As a member of the Blaine's controlling family, would you approve
the plan? Why? For the Blaine Family, it sounds like a win-win plan:
They will have more earnings per share Their effective ownership will increase The market value of the shares and hence of the company will improve The debt leverage will put reduce Tax payout, indirectly improving Income as well There will be less dividend payout necessary The company can chart out its future course with more confidence and be ready to weather the market conditions positively Only concern would be if the future earnings are not as per expectation and an acquisition couldn’t happen. But that risk is an inh erent business risk
Considering the above, as a member of the family, I will approve the plan.
Question 5: As a minority shareholder not member of the family, would you
approve it or not? Why? For the minority shareholder, there are a few points to consider:
No much say in the running of the company or its affairs
Little visibility on management control
Short term Share prices will move up – there is the dilemma, should he/she have e ncashed as there is a chance that after the repurchase prices will drop.
Long term, the dividends may improve with increased EPS. But the payout may be dependent again on management decision.
Despite all this, there will be upward valuation of the company in the longer term with right acquisitions and product mix combines with better leverage.
In the short term there is a risk while in the long run as with any business, there might be inherent business risks involved.
Nevertheless, having a leveraged company also positively impacts the minority shareholder in terms of unlocking the value of the firm. Hence, I will still be inclined to support this move.
Bibliography Eugene, F. B., & Joel, F. H. (2013). Chapter 14: Capital Structure & Leverage. In F. B. Eugene, & F. H. Joel,
Fundamental of Financial Management (pp. 488-515). Florida: Brigham Houston.
