ESSEC ADVANCED MS TF FEA
Blain Kitchenware Inc. Capital Structure
Authors:
Dmitry Karandin Roy Lambert Zhonghao Qiu Thibaud Rippe
Date:
25/10/13
Executive Summary This report briefly summarises Group 1’s analysis of Blaine Kitchenware Inc. with regards to its
capital structure, payout policies and proposed share buyback proposal. As a mid-cap producer of small household appliances for the residential kitchen sector, Blaine has experienced relatively modest growth in the past 3 years amidst positive market conditions including strong growth in the housing market, householders and product innovations. These factors, coupled with increased competition has resulted in increasing consolidation trend in a historically fragmented market. The prospect of unlocking growth potential has led to a close examination of the firm’s capital structure and payout policies in ord er to improve shareholder value. Despite having the strongest balance sheet among its competitors as well as high profitability, Blaine has suffered from comparatively low returns to shareholders (11% ROE compared to 25.9% mean) and dwindling earnings per share (EPS), in part due to dilutive acquisitions. As such, a proposed share repurchase has been analysed, focusing on the impact i t would have on the Blaine family shareholders and its other shareholders, the amount and value of shares to be purchased as well the immediate and future effect on Blaine’s financial and strategic strength. We first analyse Blaine’s capital structure and dividend payout policies. It is found that the firm has a very strong cashflow and is highly unlevered, with a low total debt to equity ratio (0.2). This is inefficient and has led to declining returns to shareholders (low ROE and EPS). In addition the firms historical trend of increasing payout ratio for dividends to shareholders has led to increasing pressure for the company to sustain this level dividend payout. In short, Blaine suffers from a financial surplus which could be used for investment and to keep the current payout to shareholders should buyback shares. After analysing a share buyback proposal using a $209 million cash and $50 million debt financing it was found that shareholder value would see a large increase, with ROE doubling from 11% to 20% and EPS increasing to $1.023/share (a 12.3% increase). Increase of family ownership is predicted (43.47-56..85%). It was concluded, that both Blaine family and other shareholders should be for this proposal for various reasons including increased competitiveness, shareholder value, flexibility and strategic placing or future policies and acquisitions. Finally, a comparison of the repurchase proposed with a special dividend of $4.39/share was conducted. It was found that the return for shareholders would stay the same for ROE and the EPS would decrease. Interest cover and WACC would be similar but the special dividend would result in decreased family ownership.
1
1. Blaine Capital Structure and Payout Policies Blaine’s current capital structure and payout policies are not appropriate for several reasons.
Blaine is currently over-liquid and under-levered which is not an optimal situation for shareholders since they are not maximizing the value of the company by staying away from debt financing. Having gone public with a large portion of its outstanding shares held by their family members, Blaine have a financial surplus which decreases the efficiency of i ts leverage as it does not fully utilise its funds. As they are completely equity financed, they do not benefit from a tax shield linked to debt financing. A surplus of cash reduces the ROE (11% compared to a mean and median of 25.9% and 19.5% respectively in comparison to the rest of its competitors in 2006) and increases the cost of capital. In addition, the amount of cash could motivate acquirer by lowering Blaine’s enterprise value (EV). However, Blaine’s strong cash-flow and capital position gives it good credit worthiness and solvency. Concerning payout policies, the management’s goal has been to maximize shareholder value
rather than paying dividends with its payout ratio having risen from 35% to 52.9% between 2004 and 2006. Normally, these funds should be used to invest in attractive projects for the company. The other problem borne by the company is that as investors forecast future dividends to be either stable or increasing, they could upset the market by lowering them. Thus, in order for Blaine to keep its current payout ratio, they must reduce the number of outstanding shares through a share repurchase program.
2. Share Purchase Recommendation A large share purchase plan could affect management and shareholder in different areas due to their different interests and goals. When stock repurchases occur, it lowers the amount of stocks within the company and eventually the EPS would increase in the near future. BKI is facing an unbalanced capital structure and repurchasing shares to solve it by using cash and short/long term borrowing can have advantages. Indeed, raising debt within capital structure replacing the equity within the balance sheet can reduce WACC and lead to a tax advantage. By covering assets and flaws of the repurchase program, we will recommend what Dubinski should do. A first advantage of a share repurchase can be the tax implication involved and benefits that arise from it. The more a company is leveraged by debt, the more it affects the capital structure by reducing the amount of tax income. The second benefit arising from a share repurchase is the future increase in EPS. To simply explain, if the number of shares outstanding is reduced, expected earnings remaining unchanged, the EPS will increase. When a market is efficient, he will reacts by buying such stocks due to the highest expected EPS which will increase shares’ price. This kind of reaction to stock repurchase announcements is also beneficial for BKI. Advantages also occur to alert market about the healthiness of cash flows within the company. Although there are various benefits to stock repurchasing, however it exists also disadvantages that come with it. Announcement of the repurchase program and the actual share repurchase have an effect depending on the timing that cannot be neglect. Indeed, stock prices might increase initially and might go down once the actual stock repurchase is finalized. Drawbacks in stock repurchasing are largely dependent on timing and about what market might think of this. It can
2
also manipulate earnings and overstate them in a manner that it over-estimates the actual company’s value. To sum up, stock repurchase can be incredibly positive especially for a company that h as the mean to perform a buyback such as BKI. Indeed, if a firm need to increase debt and has a surplus of cash flows, it could be very efficient. For BKI, not only increasing EPS is truly important in repurchasing shares, but also the tax advantages induced. Dubinski should make a large share repurchase and recover its shares in hopes of earning the advantages of taxes and a stronger EPS.
3. Share Buyback Proposal ROE ROE for a buy back proposal is equal to: Net profit after tax / shareholder’s equities. Shareholder’s equities = 488,363,000 – (14,000,000*18.5) = 488,363,000 – 259,000,000 = 229,363,000.
To compute ROE, we need to forecast the Net Income for 2007. 2006 Revenue
342 251,00
Cost of Goods sold (-)
249 794,00
Margins (given in document)
2007 (estimated)
Growth of 3,5 %
354 229,80 258 536,80
Gross Margin
92 458,00
Expenses (-)
28 512,00
29 509,92
Operating Income
63 946,00
66 184,11
Depreciation & Amort. (+)
27%
95 694,03
9 914,00
15,50%
10 260,99
EBITDA
73 860,00
21,60%
76 445,10
EBIT
63 946,00
18,70%
66 184,11
Other Income (+)
13 506,00
21,12%
13 978,71
Interest Expenses (-)
=50,000,000*6.75%=3,375
EBT
77 451,00
Taxes (-)
23 821,00
76 787,82 40% for 2007
30 715,13
will be l ess than Net Income
53 630,00
15,4% due to
46 072,69
interest burden on debt
Dividends
=4.39*59,052,000=259,240,000
So, ROE = 46,072,690/229,363,000 = 20.08 % EPS
In this case, EPS = Net Profit after Taxes / Number of outstanding shares 3
= 46,072,690 / (59,052,000 – 14,000,000) = 46,072,690 / 45,052,000 = 1.023 $ per share. Interest Coverage Ratio
ICR = EBIT / Interest Expense = 66,184,110 / (0.675*50,000,000) = 19.61 Debt ratio
Debt ratio = Total Debt / Total Asset = 50,000,000 / (592,253,000 – 209,000,000) = 13.05 Family’s interest
Until 2004, Dubinski family had 62 % shares in the company and the number of outstanding shares of the company at the end of 2004 is 41,309,000. Therefore, the number of shares owned by Dubinski family = 0.62*41,309,000 = 25,61 1,580. However, the number of outstanding shares at the end of 2006 = 59,05 2,000. Thus, due to this dilution, the percentage shareholding of Dubinski family’s shares = (shares
held in 2004 / number of outstanding shares at the end of 2006)*100 = 25,611,580 / 59,052,000 = 43.37 %. Family’s holding shares after the buyback of stocks is : (no. of shares Dubinski family) / (59,052,000 – 14,000,000))*100 = (25,611,580 / 45,052,000)*100 = 56.85 %. Cost of capital
Equity beta is given in the document: 0.56. Cost of Equities = rE = market risk premium*Equity beta + risk-free rate. Risk-free rate = 10Y T-Bond = 5.02 %. Cost of Equities = (ROE – 5.02 %)*0.56 + 5.02% = (20.1 % - 5.02 %)*0.56 + 5.02 % = 13.465 %. WACC = (D / D + E) * (1 - 40 %) * rD + (E / E + D) * rE = (50 / 279.363) * 6.75 % * 60 % + (229.363 / 279.363) * 13.465 % = 17.90 % * 6.75 % * 60 % + 82.1 % * 13.465 % = 0.725% + 11.05% = 11.775 %. After having computed these numbers, we can see that BKI’s EPS would increase by 12.30% by
buying back its shares. Another positive number is the ROE which show that after the shares repurchase there will be a positive return on equity around 20.08% which is twice the previous rate. Interest Coverage ratio and Debt ratio are also interesting numbers, because they demonstrate that BKI’s debt wouldn’t breach their covenants and would be very well rated (AAA, because ICR > 13). This was one of the main concerns, because they did not want to borrow a large amount of money. Finally, as the family’s ownership interest show after the repurchase program, they would now own 56.85 % of the company’s stocks, giving them more power than they would have before by fully controlling the company. To finish, we can see that the cost of capital would decrease in that case (11.78 % rather than 13.465 % with only equity financing).
4
4. Proposal Viewpoints Blaine Family Shareholders When a company is owned by a family, they usually want to maintain the control in a strong family setting, so it is important for them to keep a certain percentage of ownership (>50 % i s generally considered controlling interest if there are no special voting rights). Moreover, a company with healthy cash flows and stable net income is a suitable candidate for prospective buyers. In that way, keeping less than 50 % of floating shares is important to lock the ownership of the company. As members of the family, we would be in favor of the stock repurchase solution for various reasons. One main attraction of the repurchase would be the fact that ownership percentage would rise (from 43.7 to 56.85%). It would also give more flexibility to the Board in setting future dividends and more control of the company. However, by approving the shares repurchase, we would be skeptical in the case of increasing amount of debt with low cash level to cover because it would increase the risk over the company’s solvency.
Non-family Shareholders As a shareholder of the company, you could be willing to receive a payment from the buyback above market price, or you could be a reluctant shareholder who wishes to retain their shares. In both cases, shareholders benefit since those who remain will see an increase in their EPS and those who want to exit will earn a premium. The stock price will at least increase by the amount of the PV of the tax shield per share. If the premium paid by BKI is higher than the increase price, we will accept to stay as shareholders, otherwise we will sell.
5. Alternative Proposal: Special Dividend Cash required for the special dividends proposal = 59,052,000*4.39 = 259.24 M $ . The cash available is only 231 M $ and the working capital requirement is 22 M $ (the text mentions that in case of a buyback, 209 M $ is the cash that would be used to finance this option). Thus, Cash component for the proposed dividend transaction = 231 – 22 = 209 M dollars. Therefore, the shortfall of cash for the proposal special dividends = cash required for the proposed special dividends – cash component for the proposed dividend transaction = 259.24 – 209 = 50.24 M $. Thus, the debt to be raised is equal to 50.24 M dollars. a. Differences on the basis of ROE ROE = 20.1 % in the first case. ROE for the special dividend proposal = Net profit after taxation / shareholder’s equities. Here, the shareholder’s equities will reduce considerably as the company is paying a special
dividend by using the retained earnings for making dividend payments. Shareholder’s equity = existing shareholder’s equities – special dividends
= 488,363,000 – 259,240,000 = 229,123,000. Therefore, ROE for this proposal is 46,062,970 / 229,123,000 = 20.10 %. 5
b. Effects on EPS EPS = 1.022 $ per share in the first case. For the special dividend proposal : EPS = 46,062,970 / 59,052,000 = 0.78 $ per share. c.
Interest coverage ratio will be approximately the same
ICR = 66,184.11 / 3,391.2 = 19.52. d. Family’s interest Under the special dividend proposed, the shareholding of the f amily = (number of shares owned by the family / number of outstanding shares of the company at the end of 2 006)*100 = (25,611,580 / 59,052,000)*100 = 43.37 %. Thus, under the proposal of a buyback, the shareholding of Dubinski family will increase and under the special dividend scheme, it will remain the same at the end of 2006 (i.e. at 43.37 %). e. Cost of capital WACC = (50.24 / 279.36)*6.75 %*60 % + (229.12 / 279.36)*13.09% = 82.02 % * 13.09 % + 17.98 % * 6.75 % * 60 % = 10.74 % + 0.728 % = 11.468 % In the special dividend, the WACC is a little bit lower, but is almost the same.
6
