From a prospective investors or buyers point of view

Question

QUESTION

From a prospective investor's (or buyer's) point of view, determine the price you are willing to pay, if you are to invest.

Write a brief paper (two pages maximum) supporting your rationale for the valuation you have chosen, and provide appropriate financial appendices (in addition to the two pages of text) showing your analyses.

CASE

Abstract

For Sid Worley, it was decision time. He had spent the last two years courting the management and the family owners of his largest competitor, and finally (and unexpectedly) they had indicated that they would be receptive to 'a serious offer' to buy the company. Worley was excited and determined to buy the company, but now he faced the reality of having to come up with an offer that would work.

Background

Sid Worley, aged 35, was the managing director and largest shareholder of ProMed Limited, a supplier of specialised medical equipment and services to UK National Health Service ('NHS') hospitals. ProMed was a relatively young company (founded in the Midlands region in England in 1994 by two health care specialists), and Worley had purchased ProMed from its founder in 2002 with backing from a group of private investors.

When Worley bought it, the company had been growing steadily but cautiously, a reflection of the founders' focus on patient care as well as their lack of real commercial experience. Worley immediately set out to strengthen the commercial management of the company while trying to preserve its well-deserved reputation for focusing on 'caring for patients'.

After the first year the company was already recognised as a much stronger marketer and was beginning to pick up new service contracts from the NHS (see Exhibit 1). Worley realised early on, however, that the only way the company would be able to grow significantly was to make one or two strategic acquisitions and then expand its services from a larger base. Thus in late 2003 Worley began to study carefully the competitors in ProMed's market niche.

J. Healy Limited

There were only three companies of significant size that interested Worley, and J. Healy Limited was clearly the one with the most potential. Still owned by the family whose ancestors had started the company 72 years earlier, J. Healy was a well-known and highly regarded name in its industry worldwide. Recently, however, the company had slipped substantially in the marketplace and was rumoured to be in serious decline. While still owned by the family, the company was no longer run by a family member, and no one in the family was close to the business, relying instead on the management team to run the company and deliver the annual dividends.

Worley approached the non-executive (and non-family) chairman of the company prior to buying ProMed, but at the time there was no interest in selling the company. Now, however, there were signs that the company was not able to adjust to recent competitive changes in the marketplace, and it was losing business to competitors, including ProMed. Worley had also heard rumours that the company had built up substantial bank borrowings and was under increasing pressure from the bank to straighten out its financial situation.

The opportunity

Worley had made a point of staying in regular contact with J. Healy's chairman, and when it became apparent that he was no longer closing the door on a possible sale, Worley pursued him relentlessly (though sensitively). His persistence paid off - and in late 2004 Worley was invited to make 'a serious offer'. J. Healy's chairman emphasised, "The family had an unsolicited offer three years ago from a French company that was very attractive, but were not interested in selling. The business has changed since then and two of the older families have suffered illnesses, but they remember that offer and would expect yourto recognise the value inherent in the company and its worldwide reputation. They know I have spoken with you and have said they will consider an offer from you, but they're not going to be interested in anything that is silly."

Worley knew that he had the inside track - that the family would prefer not to sell to one of the other two major competitors because of long-standing bad feelings - but he took the chairman's caution at face value. He would have to make an offer that would make sense to the family, or they might seek competitive offers.

ProMed's investors had already indicated their willingness to fund any reasonable acquisition, but Worley also recognised that the price paid would have to make sense in order to count on that support.

Information problems

Worley suspected that the company was in worse shape than anyone had indicated, and this was confirmed when he received the management accounts from the company (see Exhibit 2). First, the latest accounts available were four months old (and apparently were produced more quickly than usual). Then Worley's questions revealed a weak understanding of the numbers on the part of J. Healy's management.

Over the next few weeks of analysis and questioning, it became apparent that only when the audit was performed each year was it truly clear. Yet despite the obvious shortfall year-to-date and a recent announcement that the company had lost another large service contract, J. Healy's managing directors insisted that the company would achieve its forecast profit for the year of £580,000.

There was also a big question about whether some items in the balance sheet were accurate. For example, when Worley asked about the company's high-level stocks, the answer was that the company had to continue to carry parts for all older products that it had manufactured because of the specific medical nature of those products. While he understood the argument - indeed ProMed faced a similar, though less significant issue with its stocks - Worley was surprised that there seemingly had been no 'cleaning out' at all, and he wondered if the company had even conducted a proper stock take.

While he saw this as one of many opportunities to improve the company, at the moment Worley was only concerned about coming up with a realistic value for the company.

 

Preparing to make an offer

At this stage, J. Healy's management was reluctant to provide Worley with much information until it saw a serious offer. The view was that Worley knew the industry, he knew J. Healy's reputation, he had their financial information (sketchy though it was), and he should be able to decide what to pay for the company. Detailed due diligence could take place later, once a 'serious offer' had been agreed.

Indeed Worley did know the industry well, so he took J. Healy's financial information and began to develop a model for the business. Much of the first year involved taking substantial duplicate costs, as well as excessive Healy overheads, out of the company. Aside from the stocks issue, he didn't expect any changes in working capital.

After several iterations, Worley had a forecast, which, though simple, he felt reasonably comfortable with (see Exhibit 3). He also collected as much information as he could about comparable values in the field (see Exhibit 4). Finally, he remembered what one of his business school professors, a seasoned acquisitions person, once told him: "After years of dealing in unquoted companies, I've learned one simple rule: when you're the seller, you sell at eight times EBIT1; when you're the buyer, you pay six times EBIT."

Although his concerns about J. Healy's condition had not subsided, Worley knew that he now had to come up with a price.

	P & L (£000)
			Forecast
	2003	2004	2005	2006
Turnover	4,176	6,146	7,306	8,204
Cost of Sales	2,991	4,914	5,982	6,828
Gross Profit	1,185	1,232	1,324	1,376
Overheads	656	547	535	528
Operating Profit	529	685	789	848
Balance Sheet 31-12-04
Net Fixed Assets	350
Debtors	663
Stocks	758
Work In Progress	163
Cash	455
Current Liabilities	(1,072)
Net Current Assets	967
Long-term debt	1,070
Net Assets	247
Shareholders' Funds	1,260
Goodwill on Acquisition	(1,013)
	247

 

Statement of Results
	2000	2001	2002	2003	10 mo.04
Turnover	16,770	17,846	18,947	19,110	14,444
Cost of Sales	8,834	9,472	10,453	10,591	7,815
Gross Profit	7,936	8,374	8,494	8,519	6,629
Overheads	7,477	7,514	7,676	7,964	6,366
Operating Profit	459	860	818	555	263
Balance Sheet 31-8-04
Property	202
Equipment	737
Automobiles	302
Intangibles assets	9
Net fixed assets	1,250
Raw Materials	1,215
Work in progres	835
Misc.Stocks	73
Purchased goods	1,075
Finished goods	2,174
Total Stocks	5,372
Debtors	2,557
Cash	67
Total debtors & Cash	2,624
Trade creditors	1,554
Other creditors	624
Total creditors	2,178
CAPITAL EMPLOYED	7,068
Capital & reserves	3,962
Current yr.profit after tax	36
Shareholder funds	3,998
Overdraft	1,621
Lease/hire purchase	696
Associated company funding	(157)
Long-term loans	750
Short-term loans	160
Total borrowings	3,070
TOTAL FINANCE	7,068

 

 

 

	2005	2006	2007	2008	2009
Turnover	21,500	21,600	22,600	23,500	24,400
Cost of Sales	15,000	15,000	16,000	16,700	17,400
Gross Profit	6,500	6,600	6,600	6,800	7,000
Overheads	4,000*	3,900	3,900	4,000	4,100
Operating Profit ~	2,500*	2,700	2,700	2,800	2,900
	*	Excludes extraordinary restructuring costs.
	~	Capital expenditures and depreciation were off-setting.

 

Corporate tax rate:	35%
Base lending rate:	4.75%
UK 10-year government bond yield	4.53%
London Stock Exchange:
FTSE All-Share average P/E	22.03
FTSE Small Cap average P/E	25.50
Health Care sector average P/E	26.85
Comparable Public Companies: (large companies with comparable divisions)
Novacare (U.S.company)
P/E	11
Beta	1.16
Debt:Equity	89%
Unlevered Beta	0.61
Smith & Nephew (UK co.)
P/E	14.9
Beta	0.56
Debt:Equity	22%
Unlevered Beta	0.46
Recent trade sale of company in
similar area of the industry: (based on discussion with venture capitalist)
P/E	18
Multiple os sales	1.5
BDO Stoy Hayward Private
Company Price Index *	39% discount *
Procare investors' desired IRR	30%
* BDO Stoy Hayward publishes a monthly report on unquoted company trade sales, comparing the valuations achieved with valuations in the quoted sector and thus showing the resulitng discount at which unquoted companies are sold.