Being Made Whole in Bankruptcy

In our discussions in our Managing Corporate Turnarounds class during our financial restructuring session, I got to thinking about what it would take to be made whole in a bankruptcy scenario. While the hard math will tell you that it is impossible in the short term (EV = 80, Net Debt = 100), I began to think back to the PIK and using a high yield to restore value in the future. So my question became this: If I hold the debt of an insolvent company, what can I negotiate to help me restore value? The most obvious solution is to renegotiate the terms of my debt which will probably result in me taking a haircut (discount) on the principal or face value of my debt. However, we’ve acknowledged that in scenarios where people become riskier, obviously the company’s related securities should bear a higher return. So my question then evolved to: If I have to take a discount of X percent, what additional spread Y would I have to earn in order to be made whole in N years. It turns out:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N

However, this assumes that you can break even with (or more accurately, catch up to) where your security would have been if the company had not defaulted to begin with. After playing with these numbers, however, it was quite clear that even with a small discount (say 20% discount), the spread Y had to be astronomically (unreasonably) higher in order to have any chance of being made whole relative to the standard debt, so I thought it would be unrealistic not to include a factor which accounts for the value lost:

FV x (1 + kd) ^ N = FV x (1 – X) x (1 + kd + Y) ^ N + Value Lost

In trying to understand what these numbers mean, I looked at Value Lost / FV as a proxy for the default rate of this type of security in distress which is obviously closely tied to the actual economic circumstances of the company. In the graph, it is reflected by the distance between the Standard Debt curve and the PIK (Realistic) curve.

Also, Y can probably be determined by looking at the spread between similar bonds with different credit ratings (dropping from BBB to C for instance).

X is reflective of the economic scenario (so if EV was 80 and Net Debt was 100, X would be 20%). It is also reflective of the negotiations, as well as considering a discount in order to liquidate the current assets of the company.

Another problem is also that once a company switches from PIK to cash sweep, its risk profile drops and it stops earning high yields, dropping the return on capital and therefore making it impossible to “catch up”. Also, a bank which was happy to finance your debt will not be interested in converting neither into a mezzanine structure better suited for hedge funds nor into equity.

This model is similar to the VC model of predicting the failure rate using the discount rate except in reverse. It is also similar to the interest rate parity (IRP) model and boot strapping by using compounding to determine where you would have / should have been otherwise as a benchmark for where you are going.

I guess the real lesson is that bankruptcy is really expensive and that being made whole in this scenario is difficult, regardless of the financial engineering and patience, although these two factors can be used to ease the pain.

Managing Corporate Turnarounds - Part II

Wednesday

Often when things go wrong, people are inclined to fire the management. However, in the real world, things are hardly ever that simple. Firing management, like anything in turnarounds, is decided on whether or not this action will speed up or slow down the turnaround. Besides packages given to executives on exit, there is also a great deal of institutional knowledge that they take with them. There is a counter balance to understanding the value they bring through their experience versus the inertia they create against the changes required. This is particularly true in SMEs as well as family owned enterprises where the institutional knowledge is often not formalized (pricing mechanics, customer relationships etc.)

Also, with the separation of the chairman and CEO roles, it is possible that a power divide coupled with an inappropriate strategy may have smart people being told to chase bad strategies. One remedy which is often used is an immunity period: the idea that employees in a turnaround situation have a window of opportunity to identify any potential problems. This allows an honest analysis of problems without reprimand and realigns expectations (Are we going to make the numbers? Are our margins as good as we expect? Are we doing things right? Are we doing the right things?) Because a new team is put into place to fix previously created problems, it is not appropriate to assign current problems to new management. However, eventually, whether or not these issues were created by you initially you will inevitably begin to wear them if you don’t fix them soon enough or don’t manage expectations of the company and all stakeholders.

Thursday

Like in any business strategy, there are two major things to keep in mind in a restructuring: operations and financing. For operations, it is necessary to check if the overall business strategy works (are people buying your product and do you have a viable business) and if you are able to profitably deliver (are our margins good or are we chasing low quality customers). Also from a financing perspective, it is important to understand the liquidity constraints of the enterprise. For example, what is an appropriate financing structure to keep the company alive while providing adequate and appropriate protection and returns to current and new capital providers?

One such useful tool is the paid-in-kind (PIK) security. It is a type of mezzanine high yield debt that doesn’t pay a coupon. Typically, these types of securities return 14 to 17%. They return higher than senior debt because they are subordinated but they don’t require cash payments which allow the company to maintain its liquidity for short period of time when it’s heavily cash strapped. However, what usually happens is this is coupled with a cash sweep. To use a structure like this in this circumstance is tantamount to saying: “We understand you are strapped for cash now, so you don’t have to pay us immediately, but we want an appropriate return for taking this risk that’s more similar to equity if things recover. However, we still want to be paid sooner rather than later and when you have any excess cash, you will give us everything you have and we’ll consider you less risky and ratchet down your interest rate to reflect the change in risk.”

Managing Corporate Turnarounds

This week, I’m taking a block week course (one week intensive following the 10 week standard course period) at LBS: Managing Corporate Turnarounds. So far this course has actually been really interesting, with us looking at business cases for salvaging distressed companies and learning about the mechanics and considerations of struggling businesses.

Unlike my undergraduate strategy course, which I nicknamed “doom and gloom” because the distressed companies in our cases never seemed to recover, this course talks about different cases that were successfully turned around using a variety of different techniques to improve operational efficiencies and use financial tools like LBOs to capture the upside.

We’ve also had great guest speakers come talk about their specific experiences and their perspective on different aspects of turning companies around (shedding assets for cash, improving operations, recovering debt, how to identify target companies etc.) One of our requirements in class is to summarize some key learnings from the class, and in a similar fashion to the Latin America study tour which had a similar component, I plan on using this blog to jot a few notes for me to recall later as I compile my thoughts:

Monday

In turning a company around, it is important to understand where control lies. Since equity is flirting with bankruptcy, it may lose control to the debt holders. Some debt investors may be holding “grenades”, the intent to liquidate their holdings ASAP when a trigger event happens (broken covenants, default etc), and may not be interested in salvaging the company, even if there is potential to recover equity value because they just want to unwind their positions.

Companies need to have good strategies when it comes to M&A, otherwise they can fall victim of a vicious cycle: accretive acquisitions increase EPS (albeit in an inorganic manner) and can give false impressions of growth, which could potentially boost the P/E multiple. A higher P/E multiple gives the company expensive equity which it can use as a better transaction currency for buying other companies (low P/E) and still be accretive. This is a vicious cycle if the M&A is not well integrated with substantial delivery of synergies and/or overpays for targets. This typically occurs in new industries where there are a limited number of potential buyers (targets with low P/Es as there is no other mechanism for exit) and the industry is consolidating into larger players (large strategic buyers displace financial buyers niche shopping).

Another version of the problem above is when companies which are asset-light use M&A as a backdoor for raising leverage. Services companies cannot raise leverage in a traditional manner because they have neither hard assets nor collateral to borrow against, so they can acquire companies which have higher leverage ratios to boost their own ratios. Also, this type of reckless acquisition can divert focus from the core business. In turning around companies which have fallen along this path, one of the immediate remedies is to spin off non-core assets for cash.

Tuesday

When you are on the buyside for any company (not just distressed companies for turnaround), it is important to have multiple targets in the pipe, not just for the more obvious negotiation leverage points, but to prevent yourself from getting too much deal heat over one deal and to avoid negotiating against yourself and your emotions.

Negotiating a transaction involves much more than a “price”. There are terms of payment, the structure of the compensation, workouts, milestones, terms and conditions. A price which is seemingly too high can be restructured to be paid out overtime so that the undiscounted amount remains the same, but the risk and cash outflows can be spread over a longer period with the appropriate covenants and milestones.

FEI Competition

Apparently, our final round presentation for the Financial Executives International Case Competition is now available online. Unfortunately, I can't embed it into the blog, but I can include the link below:

http://www.feicanada.org/cfo-tv.php?vid=22&page=2

Enjoy!

Bridge to Value

One graph I've seen which I thought was clever was a breakdown of change in EV. This brings together many other details I've learned about M&A, LBO's and transactions in general.

Previously, I mentioned a framework for PE deal success, but it is easy to cut into more detail if necessary and really define and put a mathematical value to "synergies".

For example: After a transaction, we've increased sales by 21%. How does that affect EV? Well on one hand, you've immediately realized a 21% increase in revenue. After you account for associated costs with that increase in revenue (ie. You've sold more widgets, but it still costs you money to make those widgets), what do your future growth prospects look like as a result of this new growth (ie. Should you trade at a higher multiple? Have you gone from "boring" to "exciting"? Or is it just general market conditions?)

Previously, you had:

Market Cap = $100
Shares outstanding = 100
Price per share = $1

Debt = $100 (@ 5%)
Excess Cash = 0

EV = $200

Revenue - $100
COGS - $40
GPM = $60

Op Ex - $20
EBITDA = $40

DA - $10
EBIT = $30

Interest = $5

Tax = 40%

NOPAT = $18
NI = $15

Therefore:

EPS = 15 cents

P/E = ($1/$0.15) = 6.67x

EV/EBITDA = ($200/$40) = 5.00x

Let's tell a story: The 21% increase comes from opening a new line of products. You are selling 10% more products by introducing a new product line and this new product line actually increases your revenue per unit (across the board) by 10% (110% x 110% = 121%). All margins are the same.

What should we do? Bring everything down to the EBITDA level:

Now:
Revenue - $121
COGS - $44 (10% more products at same costs)

GPM = $77

Op Ex - $22

EBITDA = $55

DA - $10
EBIT = $47

Interest = $5

Tax = 40%

NOPAT = $28.20
NI = $25.20

EPS = 25.20c

(Magic happens - Which we will explain shortly)

New Price per share = $1.80

Market Cap = $1.80 x 100 shares = $180
Debt = $100
EV = $280

P/E = ($1.80) / ($0.2520) = 7.14x
EV/EBITDA = ($280 / $55) = 5.09x

Analysis:
So a lot is going on. The price of the equity and the enterprise has changed, but how can we do a cross section such that we know exactly where all the value is being driven from?

How much of this value is because of leverage (hint, we didn't change amount of leverage)?
How much of this value is simply because we are operationally better?
How much of this value is because we have a "brighter future" (better growth prospects)?

Step 1: Value from leverage arbitrage:
No change = 0

Step 2: Value from "synergies":
Total EBITDA level changes: $40 to $55 or $15
At a multiple of 5.00x (previous multiple), value increased is $75

Step 3: Value from "Brighter future"
Brighter future (higher multiple) due to either market conditions or expected future growth:
$55 at 5.00x versus at 5.09x = $55 x (5.09 - 5.00x) = $5

Total value created: $75 + $5 = $80 (note total increase in value of EV / Market Cap)

Next step, look closer at Step 2:
Change of $40 to $55 is created by:
$21 in Revenue (Price +10%, Volume +10%)
$4 in COGS (Volume + 10%)
$2 in Opex (Volume +10%)

For a $21 increase in revenue, keeping margins constant we would have expected an increase of:
$8.4 in COGS (40% of revenue) and $4.2 in Opex (20% of revenue). COGS is lower by $4.4 and Opex is lower by $2.2 versus what is expected.

Note we mentioned we can sell products for 10% more across the board.
This created value for existing product base (at EBITDA level) of
$110 - $40 - $20 or $50 versus $40 creating $10 of additional EBITDA level value (makes sense, increase topline growth by 10% without changing expenses / sales volumes results in increase of EBITDA by 10% of revenue)

Also, selling an additional 10% at old price we would expect:
$10 (additional sales) - COGS ($4) - Opex ($2) or $4

But selling new products at new price: Gain $1 (similar to math shown above)

Total change in EBITDA: $10 + $4 + $1 = $15
At 5.00x
$55 or ($10 + $1) x 5.00x of EV is generated from selling at a higher price
$20 ($4 x 5.00x) of EV is generated from selling new products (higher volume)

Above is what the bridge would look like if a PE firm had 60% ownership and management had 40%.

Note, this framework is iterative and can be applied across multiple product lines to help do a break out and sum of the parts analysis for companies to see where value is hidden in undervalued divisions.

Also note that as an interesting aside, if you were actually to build out a proper DCF model of this (using some basic business assumptions holding margins constant etc.), your short term growth rate would have to be adjusted upwards in order to come to the same intrinsic valuation that would justify the higher multiple.

Financial Executives International – 5th Best in Class Competition

On Saturday, a Rotman team composed of myself, Shree, Fei and Matt Literovich competed in the Financial Executives International 5th annual Best in Class Competition. The case company was HudBay Minerals. Unfortunately, we placed second, behind Alberta School of Business.

The competition was intense, as many of the teams worked late into the night on Friday to put together our decks and get a few rehearsals in before scrambling to get a few hours of shut eye. The next morning, our names were drawn for presentation order and we found ourselves in the seventh spot.

Matt Literovich was phenomenal understanding potential legal issues related to mining and commanded the attention of the room when he spoke of precedent case law.

Fei gave a detailed account of all the organizational issues we could expect as HudBay Minerals grew and followed our acquisition strategy.

And Shree’s knowledge of mining and dissection of potential target companies gave us an exceptionally high level of credibility.

All three were exceptionally strong in both the presentation and the question and answer period and this short description does not do justice to the quality of our presentation.

While we were very disappointed that we didn’t take the top spot, the event itself was challenging and very entertaining. Judges from the competition included top executives from HudBay Minerals, USGold, OTPP, Mercator, a justice and many other top professionals. Definitely a great experience, I would recommend any MBA student to attend this competition.

Legacy REIT

In our corporate finance class today, we were responsible for presenting our valuation of the Legacy REIT IPO. We used a variety of different valuation methods and multiples to provide a range of potential valuations before recommending a price of $10.50.

My team was fantastic to work with. As we are also responsible for the RioCan valuation next week, we opted to split the group work down the middle and sort out our presentation. My team mates produced a robust DCF model which had it's assumptions firmly grounded in the economic realities of the industry. When it came to question and answers, my team mates were resilient in answering questions about reconciling the various valuation methods to resolve model tensions (the DCF says we should price higher, but yield analysis shows that we aren't generating a high enough yield to attract potential investors relative to other REITs).

In the end, it took all the strength I could muster to stop grinning like a Cheshire Cat as my team mates hammered back answers to questions by pulling up pre-emptive appendix slides and presenting a well founded case for our valuation.

As an interesting note, our professor had worked on this deal and mentioned that they had priced the deal at $10 (and that apparently, for mathematical simplicity, these units are generally priced at $10 and that the sources of funds are changed through the number of units issued - like bonds at $1000 or preferreds at $25).

Financial Management Presentation

Yesterday, my team had our presentation for Financial Management with Asher Drory, a professor notorious for not pulling any punches and generally holding all Rotman students to a very high standard. We didn't want to disappoint.

Our case was on securitization as a form of financing. The company was a collections company which bought bad loans for pennies on the dollar and made a profit by collecting on them. However, they were being squeezed on the margins due to banks beginning to charge more for the bad debts as well as the quality and collectability of the debts shrinking.

The company was also looking to grow, and had been previously financing its growth through the securitization of it's uncollected loans (in this specialized financial industry, loans are a form of inventory, rather than as a liability in a traditional company). However, the conditions of the security were almost exactly the same as debt (monthly interest payments and principal flowthrough).

Therefore, in order to properly understand the risk exposure in the company, rather than have the financing sit off the balance sheet, we made adjustments to show what the balance sheet would look like if they were financed with traditional debt (which is not an unreasonable assumption, given the type of business risk that they are exposed to through this financing is not dissimilar). The end result is that suddenly all their solvency ratios and coverage ratios are totally out of whack. Whereas before their company had reasonable ratios (debt to equity of about 0.8x), their ratios were now about 4 to 5x.

Accounting – The Story Behind the Numbers

It seems like the major topic for this week has been related to working capital. In our financial management course, however, there was a great example case where simply knowing the numbers is not enough.

Simplified Case Info (expressed in thousands):

Revenue = 17805
AR = 6000
Average Day’s Receivable in the industry = 59 days

Analysis:

Company’s Average Day’s Receivable = 123 days

Proposed financing solution: Collect on AR to reduce Day’s Receivable to industry average of 59 days.

If Days Receivable = 59 days, implied new AR is 2878. The change in AR would be 6000 – 2878 or 3122.

So looking at this *mathematical* solution, it seems as if the company can get a free 3 million dollars just by tightening its AR, right? Well as it turns out probably not. The reason?

Most companies define default as non-payment of debts of 90 days or more. Previously, we’ve talked about how debts decay in value as they are outstanding for longer and longer (probability of collection and bad debt expense). If you look at this number, essentially what it is saying that the many of your accounts are in default with an average age of 120 days!

Sometimes you can’t just assume you can make operational changes to reflect a reality that you want. The truth of the matter is that those funds are probably lost. The firm probably won’t collect those accounts and will incur a significant bad debt expense.

In reading more of the case, it also mentioned that the company had a “no returns” policy with its distribution channel partners. Looking at this number not only meant that they probably weren’t going to collect, but that their distributors were telling them that they didn’t want to do business with them any more (affecting their potential future revenue growth). Not only will they not be able to pull 3 million dollars out of working capital, there are some critical red flags appearing about their ability to continue as an ongoing concern.

Understanding Aggressive Revenue Recognition

While we normally look at items higher up on the I/S as being of higher quality (less prone to manipulation), there are still some issues which may cause analysts to take a closer look at some of the top line items. For instance, revenue is not immune to manipulation.

For example, a company that is looking to boost it's top line revenue might be more inclined to aggressively (through a variety of mechanisms) recognize revenue. However, with accrual accounting, there are many potential ways to detect some red flags with regards to changes in current practices by looking at the numbers.

First, let's decompose what revenue is actually composed of. Revenue is composed of two types of sales, cash sales and credit sales. Or expressed as:

Revenue = Cash Sales Collected + Δ A/R

Even if all sales contain some component of credit, the conversion implications as it relates to collecting debts will have a noticable effect on various ratios.

The most obvious among these is the Days Sales Outstanding (DSO) ratio:

DSO = (A/R) / Averages Sales per day = 365 * (A/R) / Sales

This is a familiar activity / operating ratio, because it is used to forcast A/R levels in the OWC schedule in a financial model and is the most obvious place to look to see if the active practices of the company have changed. It also plays a huge role in the Cash Conversion and Operating cycles.

Another interesting note is that with a constant of 365, this ratio tells the EXACT same story as the ratio (A/R) / Sales which offeres some insight into your company's policy with regards to percentage of credit extended per sale.

An alternative method is the portion of aggregated accrual attributed to revenue recognition method which is calculated as (A/R) / Δ in Net Operating Assets (or NOA).

However, note that the major components of NOA are Inventory and A/R (related to OWC which is similar but also includes A/P, prepaid expenses and other current / operating liabilities). Notice that when financial modeling, these items are modeled against ratios which incorporate I/S items such as Revenue, COGS, Operating expenses etc. Note that in turn, these items (COGS, Operating Expenses etc.) are usually modeled as a constant percentage of Revenue.

The end result? It doesn't matter which of the two ratios you use, they should both tell you the same story. If a company starts taking more aggressive revenue recognition through extending credit (and possibly risking having customers default on purchases), both of these ratios will increase as A/R as a % of sales increases faster than sales.

The 4 C's of Credit

I have some friends who are looking at trying to gain positions in Fixed Income so I thought I would have a quick review of the 4 C's of Credit. They are:

1. Character - The management team's record, strategy and internal controls
2. Capacity - Ability to meet debt obligations
3. Collateral - Assets pledged to back the loan
4. Covenants - Restrictions on activities as well as maintenance

Recall that in bankruptcy, there is a hierarchy to how remaining capital, collateral and other assets are distributed relative to tranches. However, in restructuring "everyone gets a haircut".

Also, when building credit ratings, there are various ratios that are looked at, particularly:

• Profitiability Ratios
• Liquidity Ratios (Short Term Solvency)
• Capitalization (Leverage) Ratios (Solvency)

Mubadala

[MEIST - Dubai -Abu Dhabi 1, 2, 3, 4 - Jordan]

One company which was paritcularly impressive on this trip was Mubadala (arabic for "Exchange"). They are owned by (and intimately related to) the government of Abu Dhabi (the directors on the board are also the same ministers in government), yet operate seperately in many important respects which makes them a good proxy for what is happening the Emirate in general. While related to the Abu Dhabi Investment Authority (ADIA) and the Abu Dhabi Investment Council (ADIC) as a government owned entity, Mubadala has a different mandate to undertake long term, capital intensive projects with the intent of making competitive market level returns while diversifying Abu Dhabi's economy.

It was best explained on our trip as a "PE firm with a soul" where they have what they call a double bottom line: Financial returns and social / strategic improvement (will the project increase jobs, generate intellectual property etc). They try to balance their projects on "the curve" - a production possibility curve where the axes are financial return of the project and social and systematic improvements in the economy (shown above).

Another interesting characteristic is that Mubadalah recently (this year) released it's financial statements publically which is surprising considering it's size, the fact that it is essentially a sovereign entity. Our speakers made a point to emphasize Mubadala's focus on three guiding principles: Transparency, Accountability and Corporate Governance.



Some of their projects include Masdar city, an ambitious project attempting to build the first carbon neutral city in the world. They also have partnerships with the Ferarri Group which has a strong investment team and partners up in ownership of companies such as Piaggio Aero. We were told Mubadala has a particular investing style in bringing in partners. In order to ensure that they behave in a manner that is "best in class" (not being complacent with it's wealth - they have the funds to wholy own companies, but bring in partners anyways), they bring in parters for a variety of reasons:

• To "test" projects as if they were capital constrained and to get an affirmation that their project is financially sound by bringing in external institutions
• Gain additional expertise of partners who participate in principal co-investing on projects
• Lay off risk - balance risk and reward
• Find the sweet spot between 'optimal' versus 'maximum' leverage

Because of the nature of Abu Dhabi (in a similar nature as Dubai) a large proportion of the workers are Expats (we have constantly heard about the 80/20 split, 80% expats and 20% locals). This creates an interesting challenge. How can you create industries, business models, infrastructure and (eventually) jobs to benefit the local Emirates while attracting the international talent to help develop the human capital to support it? As a result, some of their projects have a high degree of automation since there is relatively low population numbers and the locals are actually in "minority".


These two sisters, Dubai and Abu Dhabi, have been exceptional at putting up the infrastructure and buildings required as shown by the Burg Dubai / Khalifa (above). However, developing human capital takes longer with training, experience and opportunity. As a result, Mubadala has emphasized what they called the "C's": CA, CFA etc as education beyond the MBA which are required to succeed. They believe in this philosophy so much that they have a special CFA training program for their local Emirates which acts as an accelerated training program as a fast track to management positions. The locals write the CFA level I exam and those that pass advance in the program.

Inventory Turnover - An Alternative

I was thinking about Inventory Turnover (and other similar accounts and operating / activity ratios) when I noticed what I thought were some assumptions that were made that might not be appropriate for all business types.

Recall: The formula for Inventory Turnover is: COGS / Average Inventory

For intance, if you look at an annual report this is what you see regarding inventory:
You get only two numbers regarding the ending balance last year (beginning balance this year) and the ending balance this year. The assumption is that the inventory gradually increased from it's last year's value to this year's value. So we take the value of the area under the graph to produce an average Inventory (Area divided by time).
Rather than calculate the area under the graph of an awkward trapezoid, an easy way to do this is to approximate the volume by taking the average of the two points and taking the area of the resulting rectangle (assuming the line above is straight, this is an exact approximation).
However, while this assumption might be a good approximation for most businesses, this inventory model isn't appropriate for many other types of businesses. Which kinds? I would argue businesses where design is important the inventory takes a much different shape (as shown below):Which types of business might exhibit this behaviour? I would suggest two candidates would be clothing stores or automotive dealers. Why? Because they often shift their inventory for new models every year. Their inventory levels will spike starting at the beginning of the year and then towards the end they will sell out all their inventory to reduce carrying costs and get rid of "old" inventory which will be harder to sell (or sell at a discount etc).

The point I'm trying to make is that if you use the previous (generally accepted) model, you will be underestimating your inventory turnover model because your ending reported inventory is not an accurate reflection of your "average" inventory carried throughout the year.

In the same way some people might cheat a stock price by invoking a "window dressing" price (deliberately bidding up the last trade of the day to inflate the close, I think that if you aren't aware of how the inventory moves throughout the year, you might be in danger of accepting a "window dressing" inventory value.

Companies Investing in Securities

Our professor, Francesco Bova, has the honour / misfortune of having us for our Friday afternoon Financial Accounting class. It's usually a good time (yes, you read that correctly).

Just now, he was asking us what types of securities would be considered as being classed as "held to maturity". He jokingly hinted that the only securities with maturities are bonds. The best question of the day:

"Does a zero coupon bond have a maturity?"

Fundamentals of Strategic Management - SBUX

Today we hit Q2 running and had a new class, Fundamentals of Strategic Management with Anita McGahan. Her reputation certainly proceeds her, as she has been described as a protegé of Micheal Porter. You can tell with in minutes of meeting her that she's intense. Many students are intimidated by her, but in our class she was absolutely brilliant. Even some students who weren't considering consulting before are certainly considering it now.

She dived right into describing ROA and benchmarking companies versus the industries they were in versus the economy at large.She showed how a company might "out perform" the general economy, but still be "under performing" their industry. This is an idea which I had recently discussed as an extension of Nick Kerhoulas' idea for CEO compensation, but using derivatives (long / short positions) to mathematically come to the same result for bonuses (compensate CEOs and other top managers based on alpha less beta).

Also, I've previously mentioned that DuPont Analysis is one of my favourite financial frameworks because it is intuitive and Anita cut into it in more detail, specifying (as I had previously) that:

ROE = ROA x FLA

But she emphasized that FLA is a financial strategy whereas ROA is an operational strategy (I got called on this question when I was describing it in my post, but obviously Prof. McGahan described it much better. I made the mistake of saying that Total Asset Turnover, TAT, was "how much you could sell". Anita described it better as "Operational Strategy"). She even confirmed my hunch that FLA = 1 + D/E.

Also, her description of Porter's Five Force's was brilliantly (no surprise) insightful as she explained how three of the forces:

1. Buyer Power
2. Supplier Power
3. Threat of Substitution

were all measures of Value Creation (what value can be yielded by this industry - directly related to Industry Structure in the previous graphic and more specifically by the graphic below).(Also note the graphic immediately above can be recursively applied to describe an entire Value Added chain)

However, the last two of Porter's Five Forces:

1. Rivalry
2. Threat of Entry

were directly related to Value Capture (or more generically, Competitive Position as described in the first graphic above).

When it came to applying the material to the Starbucks case, she used the framework to describe where the most interesting stories were in the case, used math to describe the costs of achieving SBUX's growth goals and showed that against the balance sheet that additional fund raising was necessary to fuel growth. She dipped briefly into finance to describe EPS dilution caused by the payback periods required to cover store openings.

Even in building a potential solution, she lead the class in a discussion which critiqued possibilities such as franchising: why firms in the industry, the majority framed as operating as a sole proprietorship, would under report earnings and be disinterested in becoming a franchise.

Besides being a very technical and framework heavy course, it was certainly enjoyable. I know it sounds weird, but she kept our class in absolute stitches with her jokes about strategy and doing business (as I type this, I am aware of how awkward this appears).

To put it lightly, this promises to be an interesting class. This felt exactly like a case interview for consulting.

My Analyst Exchange Profile

This is a short video of me posted for the Analyst Exchange explaining what I think of the program and my experiences. There will be more profiles posted soon. Check the Analyst Exchange website for more videos and photos of speakers and participants.

Chapters Indigo - Model with LBO Module

I've been learning a lot in my courses, but I haven't had a chance to post any good lessons lately because I've been so busy.

However, last night, I took some time off to complete a model using everything we've learned so far. Although the model isn't "complete" (synergies from the LBO are not currently included), this model includes projections, debt schedules, working capital schedules, depreciation schedules, and even a model for leveraged buyouts and valuation.

There are plenty of comments outlining major assumptions in how these numbers were derived. I would encourage you to play with the numbers to understand the relationships in the model work for valuation purposes.

[DISCLAIMER]
While the numbers look "good" (valuations are in the 20's and IDG:Indigo is trading at around $19) this information is provided without warranty as a strictly academic exercise only. Trading on this information is risky (beyond the standard business risk) as well as foolish and reckless.

I am not responsible for you using the model for the purposes of trading or other investment decisions. Consult a qualified financial adviser before making any investment decisions.

Chapters Model with LBO Module

Information for this model is based on the 2009 Chapters / Indigo Annual Report.

[Note] This spreadsheet contains circular references in order to calculate exact interest expense iteratively (using real cash gains from reduced interest expense to further reduce interest expense). Excel is usually configured to allow you to do this, however, you may have to change your settings to allow circular references.

Ontario Government purchases stake in Chrysler - Hawk Dove and Crowding Out

The Canadian Federal and Ontario Governments have decided to take a 2% equity stake in Chrysler. I don't know how Harper and McGuinty can make the justification that the "survival of GM and Chrysler were critical to the economic future of the province, and the country as a whole" when people essentially vote with their money by not purchasing cars and stating the exact opposite. Not to mention that other car companies seem to be suffering but surviving without government help (Toyota, Honda, etc).

Now a clever observer would ask: "Isn't criticizing Harper and McGuinty just politics as usual? Aren't they just copying the Obama administrations actions for improve the auto industry?" I would propose while it appears that way, this is hardly the case. The US administration has been constantly demanded reforms in the company such as ousting Rick Wagoner as CEO of GM, and the divesture of brands such as Pontiac. Their Canadian counterparts have made no such comparable efforts (mostly because they seemingly lack the leverage, but even if that appears to be the case its seems their money is still good).

Using a two by two matrix similar to the Hawk Dove model, it's easier to understand what's going on. If both the US government and Canadian government do nothing, the both economies will suffer. If one decides to bailout the automaker in their economy, the manufacturer will keep more capacity (jobs) in that country. If they both bail out the automaker, the manufacture will continue to split the capacity (jobs retained) between them, but more inefficiently (with the economic dead weight loss born indirectly by the tax payers through the government). Essentially, in that last scenario, they are fighting for the last piece of a rotten pie.
While the model show here is overly simplified (numbers are deliberately shown as negative values to show that this investment is essentially a "race for last" to see who will lose out the least), I hope it illustrates a few points. First, the numbers depict value as described by jobs lost. In any scenario (even with government intervention) jobs will be lost on both sides of the border. That is a given assumption.

The next point of note is that the Hawk Dove model shows that the two governments are essentially crowding each other out with their "investments" and that there is a sharp diminishing return.

While the weighting of each variable is highly debatable, I believe that the underlying logic and framework is fairly solid in describing the behaviour and results of each government in this arena.

Should RIM Issue Dividends? The Case For and Against

I've noticed that a lot of traffic directed to my site from search engines is from people searching RIM and dividend. I thought that raised an interesting question and I think it warrants a quick analysis.

The Case For Dividends

Although RIM is a technology company, it's hardly some new up-start. They have a strong product development line in hardware (regular planned obsolescence), their software and data models are profitable and inimitable (from an mobility and security perspective) and their company appears to have a long run way. They are very mature in this space.

However, very few (if any) companies in the technology space issue dividends. Why? Growth in this industry is still pretty rapid and companies are using their cash for R&D. Plus they don't have to. Investor's are happy with the capital gains returns from the stock movement based on the long term potential.

By issuing dividends, RIM could signal to the market that it is a mature leader in the technology space. This would attract a new type of investor to their stock, and signal that RIM is a stable company. This type of move should prevent gigantic drops to $44 that we saw earlier last month.

The Case Against

RIM's growth and cash base is still so tremendous (new subscriber base is constantly growing) that issuing a dividend would have some negative effects on investors perceptions. "Maturity" in a market place isn't always something to brag about, especially in RIM's case where a huge portion of their price (if not all of it) is based on the fact that they are growing (enjoying high PE multiples).

Also, investors should ask themselves: "After all that trouble to raise capital, you're giving it back to us?"

Plus, in this recessionary environment where cash is king, RIM should be using the money (at the very least) to acquire companies such as Certicom inexpensively to bolster their strategic offering.

Resolution:

If you look at the math formulas for dividend payout versus retention ratio, based on RIM's growth it doesn't make sense to pay out dividends (thus reducing the retention ratio) because they still have a tremendous growth rate and they need the cash to fuel it.

I think it would *eventually* be a good idea for RIM to issue dividends: 5 to 10 years out. Probably starting with a one-time dividend approved by their board and slowly moving towards a regularly quarterly dividend (but that is more than a decade out).

But who knows? With the pace and development of our economy and technology, wireless data is becoming as common and stable as McDonald's hamburgers.

RIM up $13+ from 60+ to $73+

Well I feel vindicated. RIM reports strong earnings and the stock goes back up closer to my $75 target. Now I need to review the earnings report and evaluate my model to see where the valuation comes out.

Despite that, I expect that the stock will probably be a hold (or a sell for people looking to make a quick buck).

MD&A points to a strong next quarter and I would believe that. Major carriers like Rogers are under attack from low cost providers like Koodo (in Canada) and there are a multitude of good reasons for them to increase their strategy in the wireless data space:

• BlackBerry wireless data is not available on pay as you go plans (contracts needed)
  
• Profit margins for wireless data are extremely high
  
• Data transmissions require relatively infinitesimal line capacity requirements - low network usage versus voice calls