This spreadsheet supports the SUDENT analysis of the case "Flinder Valves and Controls Inc." (Case 43). September 15, 2008 Copyright © 2008 by the University of Virginia Darden School Foundation. All rights reserved. Exhibit 1 FLINDER VALVES AND CONTROLS INC. Balance Sheet as of December 31, 2007 for Flinder Valves and Controls Inc. (dollars in thousands) Assets Cash U.S. Treasury tax notes and other Treasury obligations Due from U.S. government Accounts receivable net Inventories, at lower of cost or market Other current assets Total current assets Investments Land Buildings Equipment Less: allowance for depreciation Total plant, property, and equipment—gross Construction in process Total plant, property, and equipment—net* Patents Cash value of life insurance Deferred assets Total assets Liabilities and Stockholders’ Equity Accounts payable Wages and salaries accrued Employees’ pension cost accrued Tax accrued Dividends payable Provision for federal income tax Total current liabilities Deferred federal income tax Common stock at par (shares authorized and outstanding 2,440,000 shares) Capital surplus Earned surplus Total equity Total liabilities and stockholders’ equity $1,884 9,328 868 2,316 6,888 116 $21,400 1,768 92 6,240 18,904 7,056 18,180 88 18,268 156 376 156 42,124 2,016 504 208 72 560 1,200 4,560 800 1,220 7,180 28,364 36,764 42,124 * Equivalent land in the area had a market value of $320,000, and the building had an estimated market worth of $16,800,000. Equipment had a replacement cost of approximately $24,000,000 but a market value of about $16,000,000 in an orderly liquidation. Exhibit 2 FLINDER VALVES AND CONTROLS INC. Summary of Earnings and Dividends for Flinder Valves and Controls Inc. (dollars in thousands) Sales Cost of goods sold Gross profit general, Selling, administrative Other income—net Income before taxes Taxes Net income and Cash dividends Depreciation Capital expenditures Working capital needs Ratio analysis Sales Cost of goods sold Gross profit general, Selling, administrative Other income—net Income before federal taxes Net income and 2003 $36,312 25,924 10,388 2,020 92 8,460 3,276 5,184 2004 $34,984 24,200 10,784 2,100 572 9,256 3,981 5,275 2005 $35,252 24,300 10,952 2,252 108 8,808 3,620 5,188 2006 $45,116 31,580 13,536 2,628 72 10,980 4,721 6,259 2007 $49,364 37,044 12,320 2,936 228 9,612 4,037 5,575 1,680 784 1,486 1,899 2,008 924 1,826 3,492 2,016 1,088 2,011 -1,200 2,304 1,280 2,213 4,289 2,304 1,508 2,433 4,757 100.0 71.4 28.6 5.6 0.3 23.3 14.3 100.0 69.2 30.8 6.0 1.6 26.5 15.1 100.0 68.9 31.1 6.4 0.3 25.0 14.7 100.0 70.0 30.0 5.8 0.2 24.3 13.9 100.0 75.0 25.0 5.9 0.5 19.5 11.3 (Unaudited) Three months ended 3/30 2007 2008 $11,728 $14,162 8,730 10,190 2,998 3,972 668 896 14 198 2,344 3,274 1,009 1,391 1,335 1,883 576 364 580 1,130 100.0 74.4 25.6 5.7 0.1 20.0 11.4 753 394 640 1,365 100.0 72.0 28.0 6.3 1.4 23.1 13.3 Exhibit 3 FLINDER VALVES AND CONTROLS INC. Consolidated Balance Sheet for RSE International as of December 31, 2007 (dollars in thousands except per-share figures) Assets Cash U.S. government securities, at cost Trade accounts receivable Inventories, at lower of cost or market Prepaid taxes and insurance Total current assets Investment in wholly-owned Canadian subsidiary Investment in supplier corporation Cash value of life insurance Miscellaneous assets Property, plant, and equipment, at cost: Buildings, machinery, equipment Less: allowances for depreciation and amortization Property, plant, and equipment—net Land Property, plant, equipment, and land—net Patents, at cost, less amortization Total assets Liabilities and Stockholders’ Equity Notes payable to bank Accounts payable and accrued expenses Payrolls and other compensation Taxes other than taxes on income Provision for federal taxes on income refund, estimated Current maturities of long-term debt Total current liabilities $46,480 117,260 241,760 179,601 2,120 587,221 158,080 104,000 3,920 2,160 671,402 260,001 411,402 22,082 433,484 1,120 $1,289,985 $5,795 90,512 38,399 3,052 32,662 30,900 201,320 Note payable to bank1 Deferred federal income taxes 2 % cumulative convertible preferred stock, $20 par, 119,100 29,668 27,783 1,389,160 shares outstanding2 Common stock, $2 par; 96,000,000 shares authorized; 62,694,361 shares issued 125,389 Capital surplus3 Retained earnings Total equity 21,904 764,821 939,897 Total liabilities and stockholders’ equity $1,289,985 1 $150,000,000 note, payable semiannually beginning June 30, 2008; $30,900,000 due within one year, shown in current liabilities. One covenant required the company not to pay cash dividends, except on preferred stock, or to make other distribution on its shares or acquire any stock, after December 31, 1999, in excess of net earnings after that date. 2 Issued in January 2007; convertible at rate of 1.24 common share to one preferred share; redeemable beginning in 2012; sinking fund beginning in 2016. 3 Resulting principally from the excess of par value of 827,800 shares of preferred stock over the pay value of common share issues in conversion in 2007. Exhibit 4 FLINDER VALVES AND CONTROLS INC. Summary of Consolidated Earnings and Dividends for RSE International (dollars in thousands) Net sales Cost of products sold Gross profit Selling, general, and administrative Earnings before federal income taxes Tax expense Net earnings Depreciation Cash dividends declared 2003 $1,623,963 1,271,563 352,400 58,463 293,937 126,393 167,544 2004 $1,477,402 1,180,444 296,958 69,438 227,520 95,558 131,962 2005 $1,498,645 1,140,469 358,176 74,932 283,244 116,130 167,114 2006 $1,980,801 1,642,084 338,717 87,155 251,562 101,883 149,679 2007 $2,187,208 1,793,511 393,697 120,296 273,401 109,360 164,041 19,160 85,754 20,000 77,052 21,480 53,116 24,200 77,340 26,800 92,238 Exhibit 5 FLINDER VALVES AND CONTROLS INC. Forecast Financial Statements for RSE International for the Years Ending December 31, 2007–12 (dollars in thousands except per-share figures) Actual Projected 2007 2008 2009 2010 2011 2012 $2,187,208 $2,329,373 $2,480,785 $2,642,037 $2,813,769 $2,996,658 1,793,510 1,920,085 2,064,243 2,216,470 2,367,290 2,537,259 393,698 409,288 416,542 425,567 446,479 459,399 120,296 129,786 139,481 151,027 161,315 169,826 273,402 279,502 277,061 274,540 285,164 289,573 109,361 111,801 110,824 109,816 114,066 115,829 164,041 167,701 166,237 164,724 171,098 173,744 Sales Cost of goods sold Gross profit Selling, general, and admin. Income before tax Tax expense Net income Cash dividends Depreciation Net PPE Net working capital Earnings per share1 Divs. per share common stock Div. per share preferred stock 1 2 1 2 92,238 102,082 108,714 115,779 125,185 133,313 26,800 389,321 422,597 27,950 426,522 447,956 29,770 459,404 486,428 31,700 498,497 528,407 33,170 541,109 574,238 35,960 587,580 624,303 $2.62 $2.60 $2.58 $2.56 $2.66 $2.70 $1.42 $1.58 $1.69 $1.80 $1.94 $2.07 $0.40 62,694,361 common shares in 2007. Thereafter, 64,416,919 shares reflecting conversion of the preferred stock. 1,389,160 preferred shares in 2007. Conversion into 1,722,558 shares of common stock assumed in 2008. Exhibit 6 FLINDER VALVES AND CONTROLS INC. Market Prices of Flinder Valves and RSE International Corporation 2003 2004 2005 Flinder Valves and Controls Common Stock High Low Close $16.25 $8.75 $15.00 24.75 14.00 22.63 25.00 20.00 22.25 RSE International Corporation Common Stock Preferred Stock High Low Close High Low $12.31 $10.05 $11.88 14.36 11.77 13.16 12.81 9.27 11.13 2006 Quarter Ended: March 31 June 30 September 30 December 31 24.38 22.75 22.75 24.36 20.75 20.38 20.38 20.13 21.50 21.00 21.50 21.00 14.13 13.69 12.83 12.39 12.83 12.04 10.48 11.26 13.95 11.78 11.26 11.87 2007 Quarter Ended: March 31 June 30 September 30 December 31 23.50 23.63 22.75 30.00 20.00 19.88 20.00 22.25 21.75 22.00 22.50 28.50 11.60 11.60 13.61 17.01 10.20 10.90 11.13 13.30 10.67 10.90 13.61 16.78 13.61 13.15 14.22 17.32 12.21 12.04 12.37 13.77 2008 Quarter Ended: March 31 32.13 26.00 31.50 20.73 15.08 20.69 17.32 13.98 $39.75 $38.90 $39.75 $22.58 $18.30 $21.98 $17.63 $15.35 May 1, 2008 Exhibit 7 FLINDER VALVES AND CONTROLS INC. Market Information on Firms in the Industrial Machinery Sector Cascade Corp. Manufactures loading engagement devices Curtiss-Wright Corporation Manufactures highly engineered, advanced technologies that perform critical functions Flowserve Corp. Makes, designs, and markets fluid handling equipment (pumps, valves, and mechanical seals) Gardner Denver Manufacturers stationary air compressors, vacuum products, and blowers Idex Corp. Manufactures a wide range of pumps and machinery products Roper Inds. Manufacturers energy systems and controls, imaging equipment, and radio frequency products Tecumseh Products Manufactures compressors, condensers, and pumps Watts Industries Manufactures and sells and extensive line of valves for the plumbing and heating and water quality markets NMF = not meaningful figure. Source: Value Line Investment Survey, April 25, 2008. Expected Growth Dividend Rate Yield to 2010 Debt/Capital Price/ Earnings Ratio Beta 10.5 0.95 1.7% 5.1% 29% 17.2 1.0 0.7 12.3 36% 20.8 1.3 1.0 27.0 30% 10.9 1.3 Nil NMF 19% 16.1 1.05 1.5 10.8 22% 19.7 1.2 0.5 10.8 29% 38.2 1.05 Nil NMF 8% 15 1.3 1.5 8.4 32% Exhibit 8 FLINDER VALVES AND CONTROLS INC. Information on Selected Recent Related Mergers Effective Date 5/25/2006 6/26/2006 9/20/2006 11/10/2006 12/8/2006 4/11/2007 6/22/2007 7/31/2007 12/3/2007 12/20/2007 2/6/2008 6/5/2008 Acquirer Business Target Business Armor Holdings Inc. Bouygues S.A. Boeing Co. Daikin Industries Ltd. Oshkosh Truck Corp. Rank Group Ltd. Meggitt PLC BAE Systems Inc. Carlyle Group LLC ITT Corp. London Acquisition BV Ingersoll-Rand Co Ltd. Law enforcement equip Construction Aircraft Air conditioning sys Heavy duty trucks Investment holding co Aerospace/defense system Electronic systems Private equity firm Pumps/valves Investment holding co Industrial machinery/equip Stewart & Stevenson Alstom SA Aviall Inc OYL Industries Bhd JLG Industries Inc SIG Holding AG K&F Industries Holdings Armor Holdings Inc Sequa Corp EDO Corp Stork NV Trane Inc Turbine-driven products Power generation equip Vehicle parts Airconditioners Excavators/telehandlers Packaging/plastics machinery Aircraft braking systems Law enforcement equip Aircraft engine component Electn system products Components Airconditioners Exhibit 8 (Continued) FLINDER VALVES AND CONTROLS INC. Information on Selected Recent Related Mergers Acquirer Target Armor Holdings Inc. Bouygues S.A. Boeing Co. Daikin Industries Ltd. Oshkosh Truck Corp. Rank Group Ltd. Meggitt PLC BAE Systems Inc. Carlyle Group LLC ITT Corp London Acquisition BV Ingersoll-Rand Co. Ltd. Stewart & Stevenson Alstom S.A. Aviall Inc. OYL Industries Bhd JLG Industries Inc. SIG Holding AG K&F Industries Holdings Armor Holdings Inc. Sequa Corp. EDO Corp. Stork NV Trane Inc. Transaction Size ($mm) Target Net Sales Last 12 Months ($mm) Equity Value/ Target Net Income 1,123 2,467 2,057 1,152 3,252 2,314 1,802 4,328 2,007 1,678 2,347 9,751 726 17,679 1,371 1,581 2,289 1,418 424 2,805 2,181 945 2,153 8,328 65.3 nmf 28.9 27.6 20.5 38.6 20.3 30.5 34.4 86.8 17.1 21.2 Enterprise Enterprise Value/ Target Enterprise Value/ Target Operating Value/ Target Net Sales Income Cash Flow 1.12 1.48 1.53 1.41 1.30 1.56 4.26 1.71 1.25 1.99 0.02 1.39 33.1 77.9 18.7 21.5 11.9 64.8 13.1 17.1 20.6 34.0 na 14.9 23.7 22.5 14.9 16.8 10.7 14.2 10.8 14.3 12.5 23.9 na 11.6 Premium 4 Weeks Prior to Announcement Date (%) 40.6 -1.2 27.2 19.4 52.3 19.3 13.5 29.3 63.3 40.5 35.2 na Exhibit 9 FLINDER VALVES AND CONTROLS INC. Capital Market Interest Rates and Stock Price Indexes (averages per annum, except April 2008 which offers closing values for April 25, 2008) 2006 2007 April 2008 U.S. Treasury Yields 3-month bills 30-year bonds 4.70% 5.00% 4.40% 4.91% 1.28% 4.52% Corporate Bond Yields by Aaa Aa A Baa 5.59% 5.80% 6.06% 6.48% 5.56% 5.90% 6.09% 6.48% 5.58% 5.96% 6.32% 6.98% Stock Market S&P 500 Index Price/earnings ratio 1,418 17.7× 1,468 18.3× 1,398 17.4× Industrial Machinery Stocks Price/earnings ratio Dividend yield 13.9× 1.4% 14.0× 1.4% Historical return premium of equity over government debt (1926-2007) Geometric average 5.5% Arithmetic average 7.2% Data Source: Value Line Investment Survey, 25 April 2008; Federal Reserve Bulletin; Compustat Exhibit 10 FLINDER VALVES AND CONTROLS INC. Forecast of Financial Statements for Flinders Control and Valve for Years Ending December 31, 2008–12 (dollars in thousands) Sales Cost of goods sold Gross profit general, Selling, administrative Other income—net Income before taxes Taxes Net income Depreciation Net PPE Net working capital and Actual 2007 $49,364 37,044 12,320 2,936 228 9,612 4,037 $5,575 2008 $59,600 43,816 15,784 3,612 240 12,412 4,965 $7,447 2009 $66,000 48,750 17,250 4,124 264 13,390 5,356 $8,034 $1,508 $1,660 $1,828 $18,268 $16,840 $22,056 $20,331 $24,424 $22,515 Projected 2010 $73,200 54,104 19,096 4,564 288 14,820 5,928 $8,892 2011 $81,200 59,958 21,242 5,052 320 16,510 6,604 $9,906 2012 $90,000 66,200 23,800 5,692 352 18,460 7,384 $11,076 $2,012 $2,212 $2,432 $27,088 $24,971 $30,049 $27,700 $33,306 $30,702 Appendix 1 FLINDER VALVES AND CONTROLS INC. Confidential Supplementary Information for Management of Flinder Valves and Controls As Bill Flinder neared retirement, the idea of selling FVC to a bigger firm seemed almost necessary. He had a good top-management team, but he didn’t think any one of them could step in and run the show alone. He found stability in the RSE International combination that was worth something to him. In the increasingly global market place with more costly development, FVC needed a deep-pocketed partner to expand and to bankroll more research. Flinder believed that the company would also benefit from gaining access to a large marketing and distribution network. As the company continued to grow, it would need to gain production know-how for high-volume manufacturing. Flinder Valves did not have this kind of expertise. Finally, there had been an increasing trend of consolidation in Flinder Valves’ industry over the last year. Flinder feared that without a well-financed partner, the company would be swamped by competition. He was intrigued with the possibility that Flinder Valves might be more fully valued if it were part of a larger, more diversified enterprise. Thus, when the merger opportunity with RSE International Corporation came along in 2007, Flinder determined to make it work as best as he could. Flinder believed that FVC had alternatives to this deal. Rockheed-Marlin Corporation, a large defense contractor (or any of a number of others), might be induced to make an offer for Flinder Valves, though Flinder preferred RSE International Corporation as a merger partner. FVC and RSE might establish a joint venture of some sort, though Flinder suspected that joint ventures faced the same kinds of integration problems as did acquisitions; as a result, he thought joint ventures were an inferior alternative. FVC could move forward alone, but that would require raising large sums of new debt and equity to finance the rapid expansion of the firm’s “widening gyre” program. Flinder was concerned that he might lose voting control of the firm regardless. It seemed to him that doing a deal with a known and friendly partner today would prepare the way for an orderly transition for himself and the firm. Flinder expected the merger to generate significant cost gains. RSE’s greater purchasing power would lower the cost of materials and components for FVC. RSE’s new resource-management system could be expected to reduce FVC’s in-process costs. Estimates from FVC’s accounting group had identified pretax constant-dollar cost savings of $2 million in the first year of operation and $4 million thereafter. He also recognized other synergy gains that arose from RSE’s stronger marketing clout, crossselling with other RSE products, and its deep financial pockets. He believed that the widening-gyre project could have a broad application in nautical, aerospace, and automotive products. Based on the investment required to bring such technology to market, he estimated the economic value at between $10 and $18 million Bill Flinder had known Tom Eliot for several years, having been introduced at an industry conference where they were both speakers. As founders and significant stockholders in their respective firms, they liked and respected each other. Flinder hoped that RSE would recognize the fair value of his company. Appendix 2 FLINDER VALVES AND CONTROLS INC. Confidential Supplementary Information for Management of RSE International Flinder Valves was the first among several potential targets identified by Catherine MacAvity, RSE’s vice president of Business Development, and the architect of the acquisition program. Eliot approved the choice and believed a smooth and successful acquisition of FVC was critical to RSE’s expansion plans. Recent news in the U.S. credit markets had been grim. MacAvity worried that the news in the financial markets might chill the ongoing talks. If the merger fell through after going this far, Eliot feared his board might become discouraged. On the other hand, if FVC was acquired at too high a price or failed to produce adequate returns, the RSE board would be unlikely to give its full support to future mergers. In planning RSE’s expansion, Eliot had considered several companies as possible acquisition candidates. Eliot was seeking a small, well-managed manufacturer that could offer RSE strong growth opportunities and bring it more specialized, higher-technology products that would be less susceptible to succumbing to the competition. Although RSE had done well, Eliot felt the company lacked the ability to be innovative. No new products had been developed over the past two years, and Eliot personally felt that the research and development (R&D) group at RSE International had fallen behind its competitors. FVC, with its proven management and engineering skills, seemed to offer the R&D capabilities and growth prospects that Eliot sought. Eliot realized that time was of the essence, especially since other competitors were also interested in Flinder Valves. Nonetheless, he wanted to be certain that acquiring it would truly place RSE in a better competitive position. One concern was how well FVC’s employees would handle the transition from working in a small, entrepreneurial company to a much bigger place like RSE. The two companies possessed quite different cultures. Another concern was about the earnings dilution that RSE might incur from the acquisition. In fact, two directors had cautioned Eliot against impairing the firm’s forecasted growth in earnings per share. Eliot and MacAvity expected the merger to generate significant cost gains. RSE’s greater purchasing power would lower the cost of materials and components for FVC. RSE’s new resource management system could be expected to reduce FVC’s in-process costs. Estimates from RSE’s duediligence process had identified pretax constant-dollar cost savings of $1.5 million in the first year of operation and $3 million thereafter. They also recognized other synergy gains that arose from RSE’s stronger marketing clout, cross-selling with other RSE products, and its deep financial pockets. But for the sake of conservatism, they chose not to include these in the valuation. They believed that the widening-gyre project could have a broad application in nautical, aerospace, and automotive products. Based on the investment required to bring such technology to market, they estimated the economic value at between $5 and $15 million Tom Eliot had known Bill Flinder for several years, having been introduced at an industry conference where they were both speakers. As founders and significant stockholders in their respective firms, they liked and respected each other. Eliot hoped that RSE could put together a deal that not only worked for the two founders but made broad economic sense. Exhibit 1 FLINDER VALVES AND CONTROLS INC. Supplemental Technical Note: Valuation and Merger Negotiation Experienced financial decision-makers know that valuation is imprecise. Too many parameters are uncertain, which renders any particular point estimate uncertain. This situation leads to two important questions for negotiators of mergers and acquisitions: (1) What role can quantitative analysis play? (2) How can one negotiate rationally and advantageously amidst this uncertainty? The Role of Quantitative Analysis Two classic naive responses are made to the uncertainty of valuation: (1) to assert (with a straight face) that the point estimate is the true value of the company, and (2) to chuck the quantitative analysis out the window and to rely on some other method of guidance. 1 The more sophisticated response is to embrace the uncertainty and focus not on point estimates of value but on a range of value. Quantitative analysis is essential for determining this range. The classic ways of setting the range include: • Sensitivity analysis: Here, one identifies the key value drivers of a firm and determines the variation in value as the drivers vary. One must take care to do this sensibly because quickly generating a blizzard of numbers is easy. • Scenario analysis: This analysis is similar to the sensitivity analysis, but acknowledges that many assumptions will tend to vary together. In this approach, one estimates values of a company associated with different views of the future. These scenarios could simply be based on a general sense of how things will turn out (i.e., optimistic, pessimistic, etc.) or could be tied to specific events that have a competitive foundation (e.g., a major foreign competitor enters your domestic market) or a political/economic foundation (e.g., Britain endures a long recession). Here also one must take care to do the analysis sensibly because as the saying goes, “garbage in, garbage out.” Also, almost any scenario may be framed in such a way as to produce the results that one wants. Break-even analysis: At the least, knowing what assumptions are necessary to produce a target value will be extremely useful. This approach explicitly solves the valuation in reverse and leaves it to the decision maker to judge whether the break-even assumptions are reasonable. • 1 Investing folklore is replete with success stories in which the critical insights were obtained from sources as varied as astrology, gossip, and charting the height of women’s hemlines. Using these methods to produce a negotiating range, bounded on one side by the opening price and on the other by the walk-away price, provides vital discipline for a negotiating team and may help the team in its assessment of new information that could appear in the negotiations. In short, quantitative analysis serves an important role in merger negotiations. The sophisticated user acknowledges the uncertainty of value estimates and can use the insights derived from careful analysis as a foundation for negotiation strategy. Negotiating Well Research on merger negotiations conducted in laboratory experiments suggests that 30% to 50% of merger outcomes represent a significant adverse deviation from what the negotiators actually wanted—walking away from negotiations where a satisfactory outcome was feasible or closing a deal beyond the walk-away price. This finding is attributable to a significant psychological influence on what, in theory, is a simple economic event. The psychological phenomena include the following, adapted from Negotiating Rationally:2 1. Irrationally escalating to an initial course of action, even when it is no longer the most beneficial choice 2. Assuming your gain must come at the expense of the other party and missing opportunities for trade-offs that benefit both sides 3. Anchoring your judgments on such irrelevant information as the initial offer 4. Being overly affected by the way that information is presented to you. 5. Relying too much on readily available information, while ignoring more relevant data 6. Failing to consider what you can learn by focusing on the other side’s perspective 7. Being overconfident about attaining outcomes that favor you The lessons of most studies of financial negotiation include the following: • Know thyself. Know thy counterparty. Risk aversion, optimism (or pessimism) about the future, the desire to settle, and an expectation of settling are influential on bargaining outcomes. • Do not abandon sound quantitative analysis. Do your homework before negotiating. Estimate bargaining ranges; set walk-away prices. • Be disciplined in negotiating. Stick to predetermined walk-away prices unless you have significant new information or other sound reasons for abandoning them. 2 Max H. Bazerman and Margaret A. Neale, Negotiating Rationally, (New York: Free Press, 1992). • Mastery of negotiating tactics pays. Anchoring or framing the other party’s expectations, the number of proposals, the pattern of concessions, the use of time, the use of interruptions—all these affect outcomes. • Negotiate based on several attributes, such as price and terms, rather than one. Oneattribute negotiation often leads to deadlock.