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.

KKR at LBS - Socially Responsible Private Equity

Just now, we had the inaugural talk for the Socially Responsible Private Equity talk given by Ken Mehlman, KKR's Global Head of Public Affairs. He was the Chairman of the United States Republican Party, campaign manager for President George W. Bush's re-election campaign, and White House Political Director. He was also a classmate of Barack Obama at Harvard Law.

He gave a great talk on how social responsibility is integral to sustainability of a business, especially one with patient capital in PE. One point he made which I thought was particularly poignant seemed to echo the ideas of Integrative Thinking. He said that there are generally two common models with regards to social responsibility:

1. Corporate CSR – Where a company makes contributions to organizations outside of its operations that show it cares.
2. It focuses solely on strong operations and generating business returns to the bottom line without much consideration for social responsibility.

He mentioned that KKR takes a third approach, and that it integrates social responsibility not just at some abstract corporate or portfolio level, but right down to the alignment of its operations to produce. Examples of this would include involving a broader definition of stakeholders versus shareholders such as environmental agencies and unions in determining the best course of action for a company’s future operations and how it should be run.

Besides some of the insightful deal war stories, future PE trends and industry knowledge he shared, he also gave great advice on what he thought it took to be successful which was well received by the crowd.

There were a host of excellent questions asked by the crowd in the Q&A session as well as the cocktail reception following. I’m looking forward to the next event hosted by the PEVC club.

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.

Financial Executives International Competition

On Wednesday we had Rotman’s internal competition for the Financial Executives International competition. I was part of a team of four, including Irina, Shree and Matt Literovich. The case was on Tiffany’s expansion into Japan and how they wanted to protect themselves from exchange risk. All the teams did a comprehensive analysis on the potential hedging options and the exposure. It was very humbling to see the caliber of work produced by our classmates in such a short period of time.

It was great to work with my team mates and our discussion on the financial strategy was highly enlightening. In the end, we looked at a variety of strategies including forward contracts, put options and collars.

Yesterday, we found out that we were selected to represent Rotman at the national competition which will be hosted by Ryerson on November 12th. Unfortunately, Irina will be unable to attend, but Fei has gratiously joined our team.

We are all excited at the opportunity to represent our classmates and showcase Rotman talent as well as meet MBAs from all across Canada at the "Best-in-class" competition.

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.

Excess Cash isn't always just from cash

Putting together the last few posts (House analogy for EV, FCFF and NOWC and N[O]WC as a source of funds), let's look at an example of how they are all interrelated.

Target Company:
Total Assets = $100M
AR = $10M
Inventory = $15M
AP = $10M

Industry Average
Total Assets* = $100M
AR = $5M
Inventory = $10M
AP = $20M

* Total Assets for each company are deliberately the same to make percentage calculations convenient.

Let's also assume that looking only at the company's operations, you are planning on bringing the balance sheet accounts closer in line with industry average. Implicitly, you are improving the company's operations (reducing days receivable, days on hand and increasing days payables).

Therefore:
Change in AR = -5M (cash inflow)
Change in Inventory = -5M (cash inflow)
Change in AP = +10M (cash inflow)

Total cash inflow from Operating Working Capital = +5M +5M + 10M = +20M

This change in accounts reflects a type of excess which can be converted into "excess cash". These changes would be manifested in operations through:

• Collecting on debts sooner, reducing credit terms
• Selling out of inventory without replenishment (reducing inventory size and implicit days on hand)
• Taking longer to pay our suppliers, using more supplier credit
• Essentially, running "leaner"

This excess cash would be captured in a financial DCF model as a change in net operating working capital in the first year of operation and built into the company's EV calculation.

Free Cash Flow to Firm and Net Change in [OPERATING] Working Capital

A few of my classmates have been asking me a very common question so I thought I would post the answer. Particularly because I think it is a fantastic question and is something I’ve wrestled with for sometime.

In Corporate Finance, Financial Management and Mergers & Acquisitions, one of the most important metrics of a company’s performance is it’s free cash flow. Or more specifically, it’s free cash flow to firm (aka. Unlevered free cash flow). This is the cash flow metric that is used to value the entire enterprise. It’s defined as:

FCFF = EBIT (1 – tax) + DA – NWC – Capex

Where:
EBIT is Earnings Before Interest and Tax (otherwise known as operating income)
DA is Depreciation and Amortization (which is actually a place holder for all non-cash expenses, but DA is the largest and most common one)
NWC – Change in net working capital (*NOTE* This is the tricky part that people are asking about)
Capex – Capital Expenditures

So while this formula is not new to most, what I want to focus on is NWC. If you have read my post on the difference between OPERATING working capital and working capital will know what I’m getting at.

First, before we even get to that, I want to emphasize a lesson taught in Anita McGahan’s first year strategy course relating to Dupont analysis (one of my favourite frameworks). Dupont analysis looks at Return on Equity and Anita made a fantastic point about how to look at the formula:

ROE = NI / Equity

ROE = (NI / A) * (A / E)

ROE = ROA * FLA

Where:
ROA is return on assets (Operational Strategy)
FLA is financial leverage (Financial Strategy)

In a discounted cash flow, a company’s value is calculated as it’s enterprise cash flows discounted at the appropriate enterprise cost of capital (it’s weighted average cost of capital).

In other words: In the summation formula, the numerator is operating (FCFF) and the denominator is financial (WACC).

This is another good way to think about the difference between OPERATING working capital (OWC) and working capital (WC) as I explained previously.

While the commonly accepted formula for FCFF is as explained above, anyone who has done a proper financial model is quick to learn that it isn’t change in net working capital which is important, but rather change in OPERATING net working capital (excluding financing items such as cash and short term debt).

FCFF = EBIT (1 – tax) + DA – NOWC - Capex

But the next logical question is what is the difference between something like short term debt (a quantifiable liability) and accounts payable (also a quantifiable liability which is equally a debt of sorts – a debt to a supplier). The answer? Interest.

The reason why something would be considered OPERATING working capital (or particularly an operating current liability) versus a normal working capital (or current liability) is that a financial current liability *bears interest* whereas an operating liability does not.

This raises the next interesting question: How do you treat pension liabilities? As you may recall, I mentioned previously how the CFA treat’s pensions as if they are interest bearing liabilities (or specifically, debts of the company owed to it’s workers which is expected to grow at the company’s cost of debt). This is a perfect example of a judgment call. Some of the top equity research analysts will consider pensions to be part of operating a business (not included in enterprise value as a financial consideration) whereas others will consider pensions to be a type of financing (don’t take my word for it, check out the research reports of companies with sizable pensions and see how different analysts treat different companies). Some will consider current pension obligations as debt (as it has to be financed to be paid out) whereas others will treat the entire long and short term obligation as debt.

Unconventional Sources of Funds

A topic I've noticed has appeared in a corporate finance as well as financial modeling cases. Whereas people often think of raising funds in traditional methods such as raising debt and equity, I don’t think people pay enough attention to potential changes in free cash flow, particularly change in net working capital.

For instance, in corporate finance, we were discussing the acquisition of a private company and what considerations should be taken into consideration when acquiring the company. Besides the obvious item’s we’d learned so far, it was also useful to see what would happen to the company if it’s operations were structure in a manner similar to its public counterparts. That is to say, express AR as a percentage of total assets (as well as all assets and liabilities) and look at the change in cash flow that results from the aggregate change in each account when bringing the private company to the industry average. The result can provide a considerable cash flow in or out of the company. While this principle can be generally applied, this is easy to understand using working capital as an example. This is because that unlike capex, change in net working capital can possibly supply cash flow into the company if it was previously poorly managed financially or if new management can improve the cash conversion cycle.

In our financial management case example, this principle was more pronounced as the history of a company’s operations for four years worth of balance sheet items was produced. Activity / operating ratios were heavily underperforming, particularly in prepaid expenses (compared against revenue as an appropriate base) as well as accounts payable (days payable).

While an “unconventional” method of financing, this was one of the lessons from Bombril on the Latin America study tour, where Gustavo Ramos, the CEO, a former Rotman Commerce undergrad and Columbia MBA, told us about how he turned the company around when it was in financial distress. One of the methods he used to “finance” the company was to stretch the cash conversion cycle: negotiating with suppliers to get more favourable terms, being more aggressive in collecting on accounts receivable, managing inventory (reducing days on hand) etc.

While strategies such as stretching the payables is considered to be a last resort for companies in “survival mode”, it can also be used to trim a type of operational fat and is directly related to the calculation of excess cash (and also excess working capital) as you structure your balance sheet accounts with optimal weightings.

Any non-income generating assets that can be sold for excess cash without affecting the underlying FCF can create additional value for the company. Clearly, this unlocks value in the company not captured in at DCF, but does not make the DCF any less sustainable (valid).

Bom Bril

[LAIST Tour Begins, Fazenda Tozan, Churrascaria – Nova Pampa, Port of Santos, Deloitte, Embraer, Natura, Gol de Letra, Bom Bril, Agencia Click, Nextel Institute, May 6, Rio, Rio Weekend, Petrobras, PREVI]

Gustavo Ramos, former UofT Engineering student (class of ’95) and Columbia MBA (’01) and CEO of Bom Bril, gave us a presentation on his involvement in the company since arriving in 2006 and finding Bom Bril, a leading manufacturer of consumer products, on the verge of bankruptcy and in receivership with the government. Bom Bril had delayed payables such as wages to employees and had not paid any taxes. The largest liability was to the government in the form of unpaid tax.

Having never worked in a distressed company before, Gustavo smiles as he recalls how he approached the problem: His professor at Columbia had said that gold rule of finance: “Cash is king”.

With his work cut out for him, Gustavo started to fix the problems, first by negotiating a 15 year payment schedule to alleviate the government debt. He proceeded to adjust prices and margins on products, renegotiate with suppliers (focusing on the value of Bom Bril to the industry as an ongoing concern) to reduce working capital and cutting marketing spending.

Gustavo generally tried to insulate the end consumer from the financial problems at Bom Bril as well as the lower level employees (no layoffs). When asked if Bom Bril was ever a takeover target, he mentioned the 2001 attempt by Clorox to take over Bom Bril which fell through when Clorox balked at the liabilities on their balance sheet at the due diligence stage.

In my opinion, I think this was a very bold strategy that worked for Bom Bril and reminds me of our Coca Cola case that we had with Anita McGahan in Strategy I, when we were talking about the intangible value of Coca Cola and why that couldn’t be duplicated by Sir Richard Branson in his attempt to introduce Virgin Cola. Although Virgin Cola’s annual spend on marketing was equal to Coca Cola, Coke had built up a tremendous amount of brand equity over its history dating back to world wars and that wasn’t going to be reproduced over night. In the same way, I expect that Bom Bril’s strong brand equity allowed them to coast briefly as Gustavo put their ship back in order. Either way, it was a bold move which has been attributed to the companies turn around.

With the return of Bom Bril to profitable status (with 40% growth and a 17% EBITDA margin), Gustavo laid out his plans for the future of Bom Bril:

• Remodel product lines – expand, change formulas, improve the packaging
• Launch new product categories – clothing care, silver and brass polish with all new products branded with Bom Bril
• Heavily reinvest in marketing to make up for lost time – Launching new brands and supporting old ones. Having a spend that focuses on the Point of Sale rather than just mass marketing. Marketing is budgeted at 5% of sales

He also explained how Brazil’s market for Consumer Product Goods (CPGs) are different than in Canada. Where we are familiar with large distributors and retailers (such as Tesco, Carrefour, Loblaws, Walmart, etc. which only account for 15% of Brazil’s CPG market) where we drive our cars to the store, Brazilians walk to the local mom and pop shop and distributors have a much more difficult time managing the various touch points.

He acknowledges the 3 most important factors for CPG: Brand equity, distribution channels and low cost / scale.

Recently, Bom Bril’s new found success has increased its appetite for acquisitions, having purchased Lysoform, a European disinfection product to add to its repertoire of products. Bom Bril continues to expand, looking for acquisitions or partners who are leaders in niche categories to fill the blanks in their portfolio.

In understanding Bom Bril’s business, we learned about the exclusive nature of relationships with Bom Bril’s distribution network and the economies of scale achieved with non-competitive products where the high costs of the fragmented distribution network could be shared with partners like Kraft.

Their COGS are generally (80 to 85%) composed of raw material costs and they are therefore sensitive to changes in the price of iron ore, the primary ingredient of their flagship “Bom Bril” product, an inexpensive steel wool whose name is almost generisized in the same way as Kleenex and Band-Aid.

Bom Bril is also the first company to release a line of eco products in Brazil: “Ecobril”. Their ideology has been successful on the premise that performance and cost (retail price) are the primary drivers of success in this CPG space, and ecologically friendly is a tertiary concern. This caps their price of their products at 10 to 20% MAX above the price of their normal products. However, by balancing these pillars, they have had success beyond other entrants into the eco space. They also focus on the 4 R’s, which are the 3 R’s we are used to plus “Respect for Biodiversity” which acknowledges their use of natural raw materials versus synthetic and no animal testing.

Another interesting story about Bom Bril’s EcoBril line is that some of the products have the options of buying refills. The irony is at this stage, the cost to manufacture the refill is almost the same as the original packed bottle (due to low economies of scale), however, the nature of the business is to charge 30% less. With increased economies of scale, Bom Bril expects to bring this price down making eco refills more attractive as a product line to Bom Bril in the long run.

Bom Bril’s history is quite fascinating and integrated into the social fabric of Brazil as a staple CPG company and product. Mr. Bom Bril, played by Carlos Moreano, is a local celebrity how has the accolade of being the longest running ad campaign series as noted in the 1995 Guiness Book of World Records.The visit to Bom Bril concluded with a walk through their factory (no photos permitted), but it was interesting to see the unique history (and plans for the future) of the company.

(Half) DONE!

Well, no one said it would be easy. In fact, I'm quite sure everyone was saying it would be really hard. But we finished the operations exam (and by extention first year of our MBA program).

I think everyone generally agrees that Operations Management is the toughest course. And although I'm told engineers are supposed to have an advantage over our classmates when it comes to this course, I think my advantage may have left me when I wasn't looking.

Anyways, the class is heading to a variety of events tonight to celebrate, so I'll probably keep this short. Everyone's energy level has kicked up a notch as people are excited to move on. Some summer jobs are starting straight away on Monday May 3rd. A bunch of us are going on study tours (Latin America study tour flies out tonight and I'm told India study tour flies out this afternoon).

I'm excited to be going on the tour and will certainly keep a better blog post pace than recently.

Another Look at Synergies

In thinking about OWC and also M&A recently, I was thinking about other possible forms of synergies rather than the two most obvious ones: revenue growth and cost reduction.

While not exactly the same as cost reduction, there are potentially certain economies of scale which can be achieved through reducing OWC requirements. Firstly, when looking at PV of CFs related to synergies, recall that FCFF (UFCF) is defined as:

FCFF = NI + Dep - Δ WC - Capex + Int (1 - t)

Increasing sales and decreasing costs will certainly affect NI, but I also thought that there was the possibility of also being more operationally efficient (reducing size of distribution networks, inventory holding requirements and demand / capacity mismatches due to manufacturing variations resulting in either lost sales etc). Most of these topics are the same topics ones we discuss in our Strategy and Operations Management courses and would affect all the activity ratios.

While probably not the most significant category of possible synergies, when dealing in deals worth millions or billions, I'm sure such attention to detail would probably result in noteworthy potential value creation opportunities. Also, this could be another potential reason why Stragetic buyers will probably command a higher premium than Financial buyers.

Another potential example I was thinking about was the idea of writing up intangible assets (which was the cause of my deal being dilutive). The value creation in this case, however, would be more for the target companies current share holders rather than the acquirers (and also be reflected in the division of synergies between the two groups through the premium).

The idea is that the target companies share holders gain value throught the premium which is the excess over fair market value. This excess is divided into write up of intangible assets and good will. While the acquirer "loses" some of the value through good will, it can reclaim some of the value of the write up of intangible assets through the tax shield provided by amortizing this value.

Again, while not as large an effect as the original two primary methods, I'm sure the attention to this detail will yield some additional value creation (and at least value retention for the acquirer) associated with an M&A deal. At the very least, the target shareholders can gain and the acquirers can give up less of their synergies.

Free Food Day

Today was certainly a good day for free food. We started the day with free breakfast courtesy of the PSO as an "End of Year" social event. The coffee was much appreciated.

Currently, we are in our Operations Management class talking about Caruso's Pizza case and pizza delivery systems. When it was time for our break, our professor ordered pizza for our class. Our classmates are now hoping for a InBev case next to complement our practical "case study method".

Speaking of which, last week we were playing the "Beer Game" developed at Harvard. In the [Root]beer game, a team of four players each manage a part of a supply chain in order to satsify the consumer demand at the end. Players within teams do not communicate and are not identified during the game and the only method of communication is by placing orders.

The point of the game was to demonstrate what happens with a small jot of variation. The players in the supply chain tend to panick and as a result they order much more than demand might justify.

Without having to describe any academic theory beforehand, the professors were able to show the dramatic "Bullwhip" effect that this had on the supply chain at each point. After we had the results, they described how this effect has been replicated over many iterations of this exercise throught their history of running the exercise. It was a truly remarkable exercise that was interactive yet seemed to lead to an inevitable conclusion.

Integrative Thinking Practium - Agent Based Modeling

At the beginning of the course I was a bit confused. At first I thought I didn't really understand what was happening. And then our class today started by describing a model of sand falling on a table. I was further confused as to how this was in any way related to business.

With a few changes in our frame of mind, "sand falling on a table" became a metaphor (or analogy?) for customer arrivals at a business. Pile height became analogous to company capacity constraints and pile location became geographic properties of companies.

Suddenly, we actually had a working model for the growth of an industry into equilibrium which encompassed such ideas as customer movement from one business to another. With a few more tweaks, the model was even able to show the decline of an industry (and death of underperforming companies).

I think my favourite part of this class was that it showed us in a very intuitive way how the models of our business work in more practical sense which are based in math, but don't require formulas.

I do apologize for my explanation as I don't feel it truly does justice to the class, but it encorporated topics we had learned in economics, operations management, managerial accounting, strategy I and II (Prof Ryall even made references to Anita McGahan's research).

Operating Leverage

Anita McGahan once explained to us the nuances in a decomposition of the DuPont formula. Where:

ROE = ROA x FLA

In non-math terms: The profitability of a company is a function of it's operating strategy (ROA) and it's financial strategy (FLA).

We've been looking more at this topic (focusing on Operating Strategy) in Operations Management and were introduced to a very interesting idea: Operating Leverage.

Operating Leverage, put simply, is loading up fixed costs to reduce variable costs. Another way of looking at it is similar to capitalized leases versus operating leases. Like financial leverage, increasing operating leverage also increases risk, but increases potential reward.

While debt provides the lever in the financial leverage analogy (and interest expense provides the potential downside), in operating leverage the lever is fixed cost (and sunk cost is the potential downside).

If the volume of quantity demanded isn't equal to the break even amount, there is a significant loss. If the volume of quantity demanded is higher, there is a relatively amplified effect on the profit base through the cost side of the equation.

Excluding the effect of taxes, a basic formula for profit is:

Profit = Revenue - Costs
Profit = (P x Q) - (FC + VC x Q)
= Q (P - VC) - FC

Break even (BE) is when Profit = 0 so

FC = Q (P - VC), where P - VC is contribution margin, CM (profit per unit sold)

Therefore the break even quantity, Q, is defined as:
Q = FC / CM

Using financial leverage as an analogy, I would suggest that it is only truly increasing "operating margin" if the BEQ increases (risk increases). This would only happen if the percentage change in FC is greater than the percentage change in CM (very similar to elasticity).

I believe this would be analogous to a type of operating accretion? In finance, deals are accretive if the cost of capital of the source is cheaper than the cost of capital of the use (buying high return instruments with low return instruments) and is the foundation of financial leverage.

Also, because CM is defined as P - VC, there is an inherent leverage relationship as well as it relates to cost in the same way a commodities based company has a leveraged exposure to it's underlying commodity price. If CM is anchored on one end (P), a change in VC has an amplified effect.

Managerial Accounting / Operations - Capacity Management

One interesting topic which has surfaced in our introductory classes of Managerial Accounting (this morning) and Operations (yesterday) is the idea of capacity management. This is a topic I've been very interested in for a variety of reasons, particularly focusing on the idea of stock-outs and capacity planning.

For example, the ideal scenario is to create *just enough* inventory to satisfy's the period's needs. Creating any more (assuming a perishable good) results in inflated costs related to waste and/or inventory carrying costs. Creating any less results in lost revenue related to stock-outs.

However, in real life, it is unrealistic to assume perfect inventory planning all the time, so chances are there will be some days with over stock and some days with stock-outs.

The basic formula for profit is: Profit = Revenue - Costs

and

Profit Margin = Marginal Revenue - Marginal Cost or Marginal Revenue - Variable Cost

We know that we will incur some sort of inefficiency or uncertainty cost in the form of over / under stocking as mentioned above. However, the idea is to minimize this "capacity cost" we have to understand how operations affect these costs. For example:

A bakery sells donuts for $1.00. Donuts cost 10c to make. Therefore, over-stocking results in a cost of 10c per donut due to wastage. However, stock-outs cost $1.00 per donut due to lost sales. Therefore there is a 10 to 1 cost per unit on either side of the ideal capacity target. Let's say on any given day, the average sales is approximately 1000 donuts.

To minimize the cost side of the profit equation, we have to look at the probability of capacity distributions above and below the target.

Let's make a HUGE assumption (for simplicity) and say that there is a uniform distribution about the target (not normal, but uniform). Let's say there is a 10% chance of the actual daily sales being:

1. 950
2. 960
3. 970
4. 980
5. 990
6. 1000
7. 1010
8. 1020
9. 1030
10. 1040

How many donuts should the bakery produce?

I would propose that you should overlay the capacity with the associated cost of capacity management. What do I mean? If you produced 1000 donuts and you only sold 950, you're capacity related costs would be amount of capacity variance x cost per unit of variance. Generally this would be expressed as:

Capacity Related Cost = Capacity Variance x Cost per unit of Variance

So in this case:

Capacity Related Cost = 1000-950 x (10c)

=$5.00

What about baking 1000 donuts and then selling all 1000, but having an additional 20 donut customers who go unserved? Then:

Capacity Related Cost = 1000-1020 x ($0.90)

= $20.00

Notice that for a smaller number of donuts not sold, there is a much larger effect on Capacity Related Costs. This is a reflection on the profit margin (profit from one lost sale = marginal revenue - variable cost). That is to say, it is much worse to not sell 1 donut rather than have 10 donuts go stale.

To optimize planning (create a capacity level which will optimize profits) it would make sense to minimize the Capacity Related Costs. Since we have the probabilities of the capacity distribution and the associated costs with under production, what target capacity creates the minimal expected capacity related cost? Below is a chart outlining the capacity related costs for given target and actual production levels.

You'll notice that the optimal production level is actually 1040 or 1030. This sort of makes sense as the costs for missed sales are so high. Generally, because of the structure of the model, there are two major factors affecting the end result for capacity planning:

• Volatility and variablity of demand
• Profit margin (difference between cost of wastage and cost of lost sales)

Financial Accounting II - Understanding the Story Behind Accounts

In our Financial Accounting class today (we have a new professor, Francesco Bova) and although Franco Wong (no relation) was a great professor, the material in Financial Accounting II is more "practical" building on the foundations in Fin Acc I (where we were learning mechanics of accounting).

We began by discussing cash cycle as composed of days [inventory, receivables, payables]. However, Francesco posed an interesting question: "Is it possible to have a negative cash conversion cycle?" (in the same way I had asked Prof. Franco Wong if it is possible to have a negative LIFO reserve). The answer is 'yes', but with special conditions:

Recall:

Cash Conversion Cycle = Days Inventory + Days Receivables - Days Payables

So for Cash Conversion Cycle to be negative:

• Days Inventory should be smaller
• Days Receivables should be smaller
• Days Payable should be higher

When is this the case? Look at Dell computers:

• JIT Inventory - Extremely low Days Inventory (inventory only used as needed / ordered)
• Visa and cash payments - Extremely low Days Receivable (is paid fairly immediately to Dell. It's A/R for Visa)
• Days Payable - Standard terms to suppliers

Because of these unique relationships, (which also exists in construction where revenue and cash is often recognised earlier and then placed in a treasury bond to gain interest) and is known as stretching payables. This is the act of investing cash which is dormant in a negative cash conversion cycle to make some interest income.

Negative LIFO reserve?

I had previously posted about LIFO reserve and how to approach questions on the CFA exam, but I had a a great question about if it was possible to get negative LIFO reserve. While it is mathematically possible, I suggested that there might be some sort of accounting rule that prevents it (I thought it would look really awkward on financial statements).

When I asked my professor if it was possible, however, he was quick to point out that it was (both in theory and practice). When asked what real world scenario would this actually happen, he brought up the example of computer companies such as Dell and Cisco, whose technology products depreciate in cost (rapidly). It becomes apparent that they would:

1. Prefer FIFO accounting over LIFO
2. Probably have small, just-in-time (JIT) inventory management

Cash Flow and Operating Cycle

I've written about cash flow with queuing theory as the lifeblood of business in my blog, as well as activity (operations) ratios in my financial profitability analysis series on my investment blog, but I wanted to review an interested concept in the CFA level I regarding the cash conversion cycle.

First let's do a review of the tools and topic. Firstly, what affects operations from a cash flow perspective? Using the direct method, the operating items which affect cash flow is change in working capital and the three items that affect that is Accounts Payable (AP), Accounts Receivable (AR) and Inventory (Inv). Now let's look at a standard process for how changes in each affect the operating cycle.

Order of Operations (like the BEDMAS of elementary arithmetic):

1. Purchase supplies from vendor on credit (AP up, Inv up)
   
2. Process supplies into goods for sale
3. Sell products on credit (Inv down, AR up)
4. Pay back supplier (AP down, cash down)
5. Receive payment from customers (AR down, cash up)

Notice that you don't actually receive any cash until step 5, but you have to pay it back in step 4. This means that you have a negative cash flow until you complete the cycle.

Recall that in the indirect method (calculating CFO from NI):

• If more inventory is made than sold, some "cash value" is retained in Inventory (Inv up, cash down)
• Alternately, if more inventory is sold than made, then you are liquidating your inventory (Inv down, cash up)
• An increase in AP means that you owe your supplier more money. This means that instead of paying with cash, you paid with credit so your cash flow goes up
• A decrease in AP therefore means you paid back your debts
• An increase in AR means that your customers paid you with credit so your cash flow goes down
• A decrease in AR therefore means you were paid back (collected on sales on account)

This next little diagram illustrates the relationship between Operating Cycle, DOH, DSO, Days Payables and Cash Conversion Cycle:
Operating cycle is simply the time it takes from when you purchase supplies to when you collect the cash and is composed of two components, Days Inventory on Hand (DOH) and Days Sales Outstanding (DSO).

• Days Inventory on Hand includes the manufacturing process, as well as storage. In accounting terms, this means works-in-progress (WIP), finished goods, sales cycle.
• Days Sales Outstanding is the time between sales on credit and the collection of cash.
• Cash conversion cycle is the time between when you pay your vendor to when you yourself collect cash. It is the difference between operating cycle and Days Payables.

In looking at which company is more likely to have cash flow problems, cateris paribus, it would be the company with the largest cash conversion cycle. That is to say, it has a low Days Payables (bills due sooner - cash out), but a long Operating Cycle (takes really long to produce and sell goods as well as collect on credit - cash in). So the larger the cash conversion cycle, the worse the operational and implicit structural liquidity.

Business Continuity Series, pt 5 - Implementing the Plan

Once all the homework has been done understanding the relationships and inter-dependencies and once the plan has been put together, it's time to test and implement the plan.

At this stage there is a tricky conundrum. On one hand, in order to do a realistic test, planned outages are required for live services to ensure that systems will be resilient in the manner anticipated (reducing the shock of discovering additional failures during an actual disaster). However, deliberately causing outages is the last resort of any service provider.

Even in the best conditions, where service consumers are notified in advance with a long lead times and everything goes according to plan it is usually heavily orchestrated event that consumes many non-revenue generating resources.

Testing the plan should attempt to avoid being disruptive. As with any change management procedure, downtime should be kept to a minimum and attempts should be made to reduce the impact on live customers (usually translating into "off-peak testing", coming in late on a Saturday night or early Sunday morning).

The shutdown of highly technical and regulated services like nuclear power plants usually requires all hands on deck at the most ungodly hours of the night (colleagues of mine working with in nuclear power remind me that their credo is "Never forget that you work in a very unforgiving industry").

In this stage, often managers and professionals discover more inter-dependencies implying that their plans are either incomplete or not as robust as they had anticipated. This is where GAP analysis comes into play to further develop the plans.

Even in the event of an ideal and perfect implementation of a BCP plan, there is still the requirement of ongoing vigilance. This is because that as the environment changes, certain assumptions which become obsolete suddenly cause vulnerabilities to appear in the system. At this point, BCP projects evolve into on-going BCP maintenance programs.