Introduction
Westparley Co is a listed retailer, mainly selling food and small household goods. It has outperformed its competitors over the last few years as a result of providing high quality products at reasonable prices, and also having a stronger presence online. It has kept a control on costs, partly by avoiding operating large stores on expensive city centre sites. Instead, it has had smaller stores on the edge of cities and towns, and a limited number of larger stores on convenient out-of-town sites, aiming at customers who want their journeys to shops to be quick. One of its advertising slogans has been: ‘We are where you want us to be.’
Westparley Co’s share price has recently performed better than most companies in the retail sector generally. Share prices in the retail sector have been relatively low as a result of poor results due to high competition, large fixed cost base and high interest rates. The exception has been shares in retailers specialising in computer and high-technology goods. These shares appear to have benefited from a boom generally in share prices of high-technology companies. Some analysts believe share prices of many companies in the high-technology sector are significantly higher than a rational analysis of their future prospects would indicate.
Matravers Co
Westparley Co has identified the listed retailer Matravers Co as an acquisition target, because it believes that Matravers Co’s shares are currently undervalued and part of Matravers Co’s operations would be a good strategic fit for Westparley Co.
Matravers Co operates two types of store:
Matravers Home mainly sells larger household items and home furnishings. These types of retailer have performed particularly badly recently and one major competitor of Matravers Home has just gone out of business. Matravers Home operates a number of city centre sites but has a much higher proportion of out-of-town sites than its competitors.
Matravers Tech sells computers and mobile phones in much smaller outlets than those of Matravers Home.
Extracts from Matravers Co’s latest annual report are given below:
The share of pre-tax profit between Matravers Home and Matravers Tech was 80:20.
The current market value of Matravers Co’s shares is $12,500m and its debt is currently trading at its book value. Westparley Co believes that it will have to pay a premium of 15% to Matravers Co’s shareholders to buy the company.
Westparley Co intends to take advantage of the current values attributed to businesses such as Matravers Tech by selling this part of Matravers Co at the relevant sector price earnings ratio of 18, rather than a forecast estimate of Matravers Tech’s present value of future free cash flows of $4,500m.
The company tax rate for both companies is 28% per year.
Post-acquisition cost of capital
The post-acquisition cost of capital of the combined company will be based on its cost of equity and cost of debt. The asset beta post-acquisition can be assumed to be both companies’ asset betas weighted in proportion to their current market value of equity.
Westparley Co has 4,000 million $1 shares in issue, currently trading at $8·50. It has $26,000m debt in issue, currently trading at $105 per $100 nominal value. Its equity beta is 1·02.
Matravers Co’s asset beta is 0·75. The current market value of Matravers Co’s shares is $12,500m and its long-term loan is currently trading at its book value of $6,500m.
The risk-free rate of return is estimated to be 3·5% and the market risk premium is estimated to be 8%.
The pre-tax cost of debt of the combined company is expected to be 9·8%. It can be assumed that the debt:equity ratio of the combined company will be the same as Westparley Co’s current debt:equity ratio in market values.
The company tax rate for both companies is 28% per year.
Plans for Matravers Co
The offer for Matravers Co will be a cash offer. Any funding required for this offer will be a mixture of debt and equity. Although for the purposes of the calculation it has been assumed that the overall mix of debt and equity will remain the same, the directors are considering various plans for funding the purchase which could result in a change in Westparley Co’s gearing.
As soon as it acquires all of Matravers Co’s share capital, Westparley Co would sell Matravers Tech as it does not fit in with Westparley Co’s strategic plans and Westparley Co wishes to take advantage of the large values currently attributed to high-technology businesses. Westparley Co would then close Matravers Home’s worst-performing city centre stores. It anticipates the loss of returns from these stores would be partly compensated by higher online sales by Matravers Co, generated by increased investment in its online operations. The remaining city centre stores and all out-of-town stores would start selling the food and household items currently sold in Westparley Co’s stores, and Westparley Co believes that this would increase profits from those stores.
Westparley Co also feels that reorganising Matravers Co’s administrative functions and using increased power as a larger retailer can lead to synergies after the acquisition.
Post-acquisition details
Once Matravers Tech has been sold, Westparley Co estimates that sales revenue from the Matravers Home stores which remain open, together with the online sales from its home business, will be $43,260m in the first year post-acquisition, and this figure is expected to grow by 3% per year in years 2 to 4.
The profit margin before interest and tax is expected to be 6% of sales revenue in years 1 to 4.
Tax allowable depreciation is assumed to be equivalent to the amount of investment needed to maintain existing operations. However, an investment in assets (including working capital) will be required of $630m in year 1. In years 2 to 4, investment in assets each year will be $0·50 of every $1 increase in sales revenue.
After four years, the annual growth rate of free cash flows is expected to be 2% for the foreseeable future.
As well as the free cash flows from Matravers Co, Westparley Co expects that post-tax synergies will arise from its planned reorganisation of Matravers Co as follows in the next three years:
The current market value of Matravers Co’s shares is $12,500m and its debt is currently trading at its book value of $6,500m.
Required:
(a) Discuss the behavioural factors which may have led to businesses such as Matravers Tech being valued highly.
Individual business
A number of behavioural factors, to do with the individual company as well as the sector as a whole, may lead to Matravers Tech being valued higher than appears to be warranted by rational analysis of its future prospects. One possible factor is the asking price, even if it is not a fair one, may provide a reference point which significantly influences the purchaser’s valuation of the business.
The fact that Matravers Tech is available for purchase may help raise its price. Purchasers may see this as a rare opportunity to buy an attractive business in this retail sector. This will be made more likely if investors have loss aversion bias, a desire to buy Matravers Tech now because otherwise the opportunity will be lost.
Matravers Tech being offered for sale will mean that information about the company, showing it in a positive light, will be available for purchasers. This could result in availability bias, investors taking particular note of this information because they can readily obtain it, rather than other information which may be more difficult or costly to find.
Sector
There are a number of possible behavioural reasons why share prices in this sector appear generally higher than rational analysis indicates. One is the herd instinct, investing in the sector because other investors have also been buying shares, not wishing to make judgements independently of other investors.
The herd instinct may be generated by previous share price movements. Investors may believe once prices start rising in the sector, they will continue to do so indefinitely.
Following fashion may also be a factor. Fund managers who wish to give the impression that they are actively managing their portfolio by making regular changes to it, may have a preference for companies which appear up-to-date and are currently popular. This may be linked to an expectation that sales of technologically-advanced goods are likely to generate high returns.
There is also confirmation bias, the idea that investors will pay attention to evidence which confirms their views that the sector is a good one in which to invest, and ignore evidence which contradicts their beliefs. In the past, technology companies have been valued using methods which support the beliefs of investors that they are of high value, rather than traditional methods, such as cash flow analysis, which suggest a lower business value is more realistic.
(b) Prepare a report for the board of directors of Westparley Co which:
(i) compares the additional value which Westparley Co believes can be generated from the sale of Matravers Tech based on the P/E ratio, with that of the projected present value of its future free cash flows;
(ii) calculates the weighted average cost of capital for the combined company;
(iii) estimates the total value which Westparley Co’s shareholders will gain from the acquisition of Matravers Co; and
(iv) assesses the strategic and financial value to Westparley Co of the acquisition, including a discussion of the estimations and assumptions made.
Professional marks will be awarded in part (b) for the format, structure and presentation of the report.
(iv) Report to the board of directors, Westparley Co
This report evaluates whether the acquisition of Matravers Co would be beneficial to Westparley Co’s shareholders by estimating the future value generated by Matravers Co (i.e. Matravers Home currently), the proceeds from selling Matravers Tech and the additional value created from synergies immediately after the companies are combined.
Strategic fit
The strategic case for taking over the business appears to be strongest for the out-of-town stores and the online business. The acquisition would provide an additional out-of-town presence for Westparley Co. Better usage in the out-of-town stores could generate higher returns. Having the food and home businesses on the same site could generate some cross-sales between the two. Possibly combining the two companies’ online presence and investing further could mean Matravers Home benefiting from the factors which have driven strong performance by Westparley Co.
Taking over the city centre stores, even the successful ones, seems to have less strategic logic, however. Westparley Co would be taking on a high cost burden. The success of the food business in city centres is doubtful, as food shops sited there will be less convenient for customers who do not live in the city centres, and Westparley Co has marketed itself as being easily accessible for customers. There is, perhaps, wider incompatibility between the two businesses. The food business is characterised by quick shopping for often a limited number of items, whereas purchases in the home business, particularly of larger items, are likely to take longer and site convenience be less of an issue.
Financial aspects
Based on the predictions for future cash flows and required premiums from Matravers Co’s shareholders, the acquisition would add value to Westparley Co’s shareholders, if, and only if, the excess value on selling Matravers Tech and the synergies are both largely achieved. Together they add up to $2,400m ($558m + $1,842m) compared with total added value of $1,897m. There are questions about the estimates for these figures and also the estimates for the future free cash flows of the current Matravers Home business.
Synergies
Most of the additional value is due to synergies and it is difficult to see how the synergies are calculated. There is likely to be scope for some administrative savings. However, operational cost synergies appear less obvious as the two companies are operating in different retail sectors. Any synergy figures will also have to take account of costs in achieving synergies, such as store closure costs, and also commitments such as leases which may be a burden for some time. Synergies may also not be achieved because of lack of co-operation by staff or problems integrating the two businesses.
Current Matravers Home business
The suggested increase in cash flows appears doubtful for a number of reasons. If stores being closed are making positive cash flow contributions, these will have to be replaced. Whether they can be is doubtful given the problems in this part of the retail sector. It may be a more profitable use of store space to have an area for food sales, but the food sales generated in Matravers Co’s shops may take business from Westparley Co’s existing shops. Similarly, increased online sales may be at the expense of sales in stores.
Sale of Matravers Tech
There is no indication of how interested buyers will be in the business. The industry price-earnings (P/E) ratio used may be an average which does not reflect Matravers Tech’s circumstances. It would be better to find a P/E ratio for a proxy company with similar financial and business risk. As Matravers Tech would not be listed, this would suggest a discount to the P/E ratio should be applied. Since also Westparley Co has an estimate of future free cash flow, potential buyers may be able to come up with their own estimates and base the price they are prepared to pay on their estimates.
Other assumptions
One important assumption is the 15% premium expected to be required by Matravers Co’s shareholders. Other assumptions made in the calculations include operating profit margin and tax rates remaining constant and cash flows being assumed to increase to perpetuity. Incremental capital investment is assumed to be accurate. It is assumed that the cost of debt will remain unchanged and that the asset beta, cost of equity and cost of debt can be determined accurately. Given all the assumptions, Westparley Co should carry out sensitivity analysis using different assumptions and obtaining a range of values.
Conclusion
On the assumptions made, the acquisition appears to add financial value for the shareholders of Westparley Co. However, the figures are subject to a significant number of uncertainties and the strategic logic for buying the whole Matravers business appears unclear. On balance, Westparley Co may want to consider a more limited acquisition of just the out-of-town stores if these are available, as their acquisition appears to make better strategic sense.
Report compiled by:
Date
Appendix 1 Estimate of additional value created from sell-off of Matravers Tech (b) (i)
Share of pre-tax profit = 20% x $1,950m = $390m
After-tax profit = $390m x (1 – 0·28) = $281m
Proceeds from sell-off based on P/E ratio = $281m x 18 = $5,058m
Excess value from sell-off = $5,058m – $4,500m = $558m
Appendix 2 Estimate of combined company cost of capital (b) (ii)
Matravers Co asset beta = 0·75
Westparley Co asset beta
Market value of debt = 1·05 x $26,000m = $27,300m
Market value of equity = 4,000 million x $8·50 = $34,000m
Asset beta = 1·02 x (34,000)/(34,000 + (27,300 x 0·72)) = 0·65
Combined company, asset beta
Market value of Matravers Co equity = $12,500m
Asset beta = ((0·75 x 12,500) + (0·65 x 34,000))/(12,500 + 34,000) = 0·68
Equity beta = 0·68 ((34,000 + (27,300 x 0·72))/34,000) = 1·07
Combined company cost of equity = 3·5% + (1·07 x 8%) = 12·1%
Combined company cost of capital = ((34,000 x 12·1%) + (27,300 x 9·8% x 0·72))/(34,000 + 27,300) = 9·9%, say 10%
Appendix 3 Estimate of the value created for Westparley Co’s shareholders (b) (iii)
Cash flows, years 1 to 4
Present value years 1 to 4 = $4,091m
Present value year 5 onwards (($1,353m x 1·02)/(0·1 – 0·02)) x 1·10–4 = $11,781m
Total present value = $4,091m + $11,781m = $15,872m
Synergies
Present value of synergies = $1,842m
Amount payable for Matravers Co’s shares = $12,500m x 1·15 = $14,375m
Value attributable to Matravers Co’s investors = $14,375m + $6,500m = $20,875m
Value attributable to Westparley Co shareholders = present value of cash flows + proceeds from sell-off + value of synergies – value to Matravers Co’s investors
= $15,872m + $5,058m + $1,842m – $20,875m = $1,897m
(c) Discuss the factors which may determine how the offer for Matravers Co will be financed and hence the level of gearing which Westparley Co will have.
Calculation of gearing
If gearing is calculated on the basis of market values, a fall in the share price will result in the level of gearing rising. Westparley Co’s board may be worried about a fall in the share price given the problems affecting many companies’ share prices in the retail sector and the possibility that the stock market may react adversely to the acquisition.
Directors’ preferences
Directors may have their own preferences about financing. They may be able to choose a mix of sources and a level of gearing which reflects these preferences. Directors may be concerned about too high a burden of payment to finance providers, in terms of cost or ultimately repayment of debt. They may not wish to commit the company to conditions imposed by finance providers. By contrast, they may be concerned about how a change in the shareholder base as a result of a share issue may impact upon their own position. Directors may also be concerned about the impression given by their choice of finance. Pecking order theory states that equity issue is seen as the last resort for financing, so if the purchase is financed by an equity issue, it may be seen as a sign of a lack of confidence by directors that Westparley Co can sustain its current share price.
Costs and cash flows
Gearing decisions may not just be determined by their own preferences but by external conditions or constraints. Choosing more debt could lower the overall cost of capital, due to lower cost and tax relief, making investments such as Matravers Co appear more profitable. Higher levels of debt may result in the cost of equity rising, reducing the overall impact on the cost of capital. Against that, higher levels of debt mean increased finance cost commitments, even though Westparley Co may need further cash for investment in stores. This may be an important concern if interest rates are high. By contrast, dividends to shareholders do not have to be paid when returns are low or money is required for investment, although failure to meet dividend expectations may result in the board being pressurised by shareholders.
Availability
The availability of finance may also be a significant issue, particularly if an acquisition has to be completed quickly. An equity issue may take time to arrange and require shareholder approval. Sufficient debt finance may be difficult to obtain if lenders feel that Westparley Co already has significant commitments to debt finance providers. The timescale over which finance is available may be significant. Westparley Co may seek longer-term finance if existing debt finance is due to be repaid soon or if significant cash is needed for short-term investment, not just in Matravers Co’s stores, but also in Westparley Co’s existing stores.
Mix
Other external factors may influence the mix of finance chosen. Westparley Co’s directors may be concerned about keeping the level of gearing at or below the industry average, because of finance providers becoming worried if gearing exceeds industry levels. Keeping debt as a significant element in overall finance may act as a deterrent to acquirers becoming interested in making a bid for Westparley Co. Directors may also not have a target figure in mind but be content if gearing is within a range of values.