ACF2014_LN16_Sealed Air Leveraged Recapitalization

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APPLIED CORPORATE FINANCE

Lecture Note 16 Sealed Air Leveraged Recapitalization Pekka Hietala February 2014

Issues in the Case Main Issue: Understanding Leveraged Recapitalizations Sub-issues: 1. Why did Sealed Air undertake a leveraged recapitalization? Do you think that it was a good idea? Why or why not is Sealed Air a good target for increased leverage? 2. Explain alternative ways for Sealed Air to raise its leverage. Could you avoid paying $21m to Bankers Trust in one of these alternatives? 3. Was the constraint imposed on capital expenditures under the bank lending agreement good or bad for the company? Related to this, explain the difference between an LBO and leveraged Recap. 4. How much value was created? Where did it come from? That is, how would you explain stock market reaction? 5. Comment on Sealed Air's New Priorities Card! Why do you think this is Professor Hietala's last question in our last ACF case? 2

Starting Point

A Balance Sheet Based Illustration of the Mechanics of the Special Dividend

Balance Sheet 12/31/88 Cash Other Assets Total

55.1 202.2 257.3

Other Liabilities Debt Equity Total

61.5 33.5 162.3 257.3

New Debt

+

+

“For a Minute”

306.7 ⇒

361.8 202.2 564.0

⇒ 306.7 ⇒

61.5 340.2 162.3 564.0

Dividend Payout

-

-

Immediately following Dividend

329.8 ⇒

32.0 202.2 234.2

⇒ ⇒ 329.8

61.5 340.2 (167.5) 234.2

3

Why did Sealed Air recapitalize? Was it a good idea? Let us go through our check list: a. Small managerial ownership? Not very small (5-6%) and at least CEO seems to think of shareholders. b. Large excess cash? Yes, 20% of the balance sheet and growing! c. High marginal tax rate and stable earnings? Yes, although eventually the patents will expire. d. Low current leverage? Yes, taking into account the cash net leverage is negative. e. Low investment needs? Not clear but currently the company may be overinvesting ("capital is considered free"). f. Assets can be sold if necessary? No. 4

The conclusion seems to be that Sealed Air is a reasonable but not perfect target for increased leverage. Probably the management was right not to push for an LBO. Even if the check list does not give a perfect score, I would put the most emphasis on excess cash as we have seen too many companies being ruined by: a. using excess cash for acquisitions. b. starting to manage a securities portfolio. Obviously, Sealed Air's management wanted to use the leveraged recap not only to get rid of the excess cash but also to create an atmosphere of pressure. The company was just getting the success too easily! Thus one can say that Sealed Air used leverage as a substitute for a normal product market discipline. In a sense leverage forces the organization to prepare for the more competitive future environment. 5

2. Explain the differences across different ways to increase leverage The three most popular ways to increase leverage are: •

LBO's

•

Stock repurchases

•

Super-super dividend (= leveraged recapitalization)

The following table explains some of the differences in these alternatives:

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Comparisons between levered MANAGEMENT BUYOUT

STOCK REPURCHASE

SUPER DIVIDEND

Yes Yes

Yes Yes

Yes No/Yes

Yes

Yes

Yes

Yes Yes Yes

Yes No Yes

Yes No No

Strong Yes

Weak No

Weak No

COSTS Financial distress Underinvestment problem

High High

Low Low

Medium Medium

PRESIDENT and CEO CRITERIA Create value for shareholders Be simple Treat all shareholder equally

High Low Low

Low Medium Medium

Medium High High

TAX SAVINGS Corporate Personal BONDHOLDER EXPROPRIATION Riskiness of debt increases AGENCY COST REDUCTION Eliminate excess corporate cash Increase managerial ownership Increase managerial share fraction Increase in external monitoring Changes in Board of Directors

7

Can we avoid the relatively high fee to Bankers Trust? Not if we raise money from the markets, but the case introduces the idea of PIK paper. That is, why not to lever up by distributing to shareholders a $40 dividend as a 10-year bond with a 12.5% coupon. The shareholders could either keep this bond or sell it to the markets. Direct transaction costs surely would be below 7% (= 21m/300m) that was paid to Bankers Trust but it is not obvious that we would create liquid enough markets for this bond. A hedge fund (Greenlight Capital) suggested this for Apple in 2012 (=$50bn of 4% perpetual preferred stock).

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3. Was the capital expenditure constraint good or bad? A big difference between LBOs and other leverage-increasing transactions is the magnitude of debt that you put into the balance sheet. In LBOs normally all the free cash flow goes to debt servicing - in Sealed Air case, the company has some cash to invest. Whether this cash was enough is impossible to judge from the case - my reading of the case is that the constraint was probably creating value by pushing the managers to prioritize. In reality the company was actually able to renegotiate the covenant as shown below. Obviously the covenants are more flexible than first meets the eye IF the firm performs well. 9

Original and revised capital expenditures restrictions under the bank credit agreement Year

Renegotiated capital expenditure restriction (millions)

Original capital expenditure restriction (millions)

1990

$12.0

$7.0

1991

13.0

8.0

1992

13.0

9.0

1993

22.5

10.5

1994

24.0

12.0

1995

28.0

12.5

10

Let us look at overall cash flow picture: Assumptions

Sales growth EBIT/Sales Tax rate on EBIT CAPEX/Sales Depreciation/Sales WCR/Sales

1987

1988

1989

1990-1993

12%

14% 13%

11% 14%

8% 14% 33%

12%

6% 4% 13%

4% 4% 8%

3% 3% 8%

11

1989 385.0 53.7

1990 415.8 58.2

1991 449.1 62.9

1992 485.0 67.9

1993 523.8 73.3

Beg. Property Plant & Equipment - Depreciation + Capital Expenditures = End. Property Plant & Equipment

85.1

85.1 12.5 12.5 85.1

85.1 13.5 13.5 85.1

85.1 14.5 14.5 85.1

85.1 15.7 15.7 85.1

WCR

32

33.3

35.9

38.8

41.9

39.0 12.5 -12.5 -1.3 37.7

42.1 13.5 -13.5 -2.6 39.5

45.5 14.5 -14.5 -2.9 42.6

49.1 15.7 -15.7 -3.1 46.0

Sales EBIT

Free Cash Flow Forecast: NOPLAT + Depreciation - Capital Expenditures - Change in Working Capital Free Cash Flow from Operations

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Debt service obligations Debt Outstanding Senior Bank Debt Principal Repayment

1989

136.7

1990

136.7 0.0

1991

121.4 15.3

1992

106.1 15.3

1993

86.5 19.6

1994

1995

60.3 26.2

26.3 34.0

15.7

15.7

14.0

12.2

9.9

6.9

10.5

25.8

24.7

27.8

32.9

38.6

170.0 0.0

170.0 0.0

170.0 0.0

170.0 0.0

170.0 0.0

170.0 0.0

19.6

19.6

19.6

19.6

19.6

19.6

Total Obligation = AT Interest + Repayment

13.1

13.1

13.1

13.1

13.1

13.1

Grand Total Obligation

23.6

38.9

37.8

40.9

46.0

51.7

vs. Free Cash Flow

37.7

39.5

42.6

46.0

?

?

Interest

11.50%

Total Obligation = AT Interest + Repayment Subordinated Notes Principal Repayment Interest

170.0

12.63%

13

Thus it surely looks like Sealed Air has got their numbers right - they should not face too big a problem to service the debt.

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4. How much value was created? Where did it come from? • Shareholder value before and after the announcement of the leveraged recapitalization Date

Day before announcement of recap. One day after announcement of recap.

Closing Stock Price

Market Value of Common Stock (millions)

$45.875

$378.2

-

$378.2

-

50.500

416.4

-

416.4

$38.2

Special Dividend at $40 per share (millions)

Total Value (millions)

Change in Value from Day before announcement of recap (millions)

One day prior to ex-dividend date

50.750

418.4

-

418.4

40.2

Ex-dividend date

12.500

103.1

$329.8

432.9

54.7

329.8

497.8

119.6

Closing price for 1989 (12/31/89)

20.375

168.0

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Shareholder return from May 5 through December 31, 1989: Sealed Air Stub Share

63%

CRSP value weighted market index

16.1%

S&P 500

15.1%

How typical for leveraged shareholder payouts?

16

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Where did it come from? a) Tax shield Average interest rate Interest payment for next 5 years Interest payment for years 6-10 Tax rate The full tax shield would be: TS =

$

$

≅ 12% ≅ $35 million p.a. ≅ $25 million p.a. = 33%

$

.33 x 35 m .33 x 35 m .33 x 25 m + + ... + = 58 .5 m 1 .12 (1 .12 ) (1 .12 ) $

2

10

b)

Cost of Financial Distress and Uncertainty of Tax Shield I essentially assume that z-factor is only one half of the tax rate: COFD = - $29.2m

c)

Transaction Cost to Bankers: TCB = - $20.9m

d)

Debt Bonding Effect Or what is left to be explained DBE = $54.7m - [$58.5m - $29.2m - $20.9m] = $46.3m 18

5. Last ACF Question I love the New Priorities Card! It shows what finance is really about: a support function. We only create value through creating something new (priority #4), producing it efficiently (priority #3) and finally selling it at a price that generates sufficient cash flow for capital providers (priority #2). But in the end all this collapses if we do not satisfy our customers (priority #1)! Only thing we have to forget from INSEAD core courses is accounting (LAST PRIORITY); let us forget stupid accounting rules! Otherwise we would have got scared about the negative net worth of the company and sold our Sealed Air shares! I hope you have learnt enough about priorities #1-4 at INSEAD and that you will have a good life after this year! 19

HP and Autonomy Numbers can create a sense of objectivity where there is none. This extends to company accounts. Revenue and earnings look like facts; they are interpretations. So it is easy enough to understand why the same facts could lead to dissimilar conclusions in the Hewlett-Packard/Autonomy dispute. HP bought Autonomy for $11bn in 2011, then wrote most of the price down a year later, claiming Autonomy executives had wilfully misrepresented the software company’s true growth rate. Documents seen by the Financial Times suggest that Autonomy’s accounting looked aggressive indeed. However there is also evidence that Autonomy’s auditors approved its accounting methods. What is crystal clear are the high stakes for HP. When HP bought Autonomy – paying a wild-eyed 26 times trailing cash flow – the target’s revenue growth had already slowed and it had a reputation for aggressive book keeping.

When a high price is paid for an acquisition, a small growth disappointment can only lead to a big writedown. So it is conceivable that had growth been exaggerated by a few percentage points, a multibillion charge would have followed. Despite this, HP went all in on the claims of ill intent (“We look forward to hearing ... Autonomy employees answer questions under penalty of perjury” went one rhetorical flourish), putting management’s reputation on the line. And reputation matters for HP. Its shares have risen from $12 to $30 since late 2012 as boss Meg Whitman (on the board at the time of the Autonomy deal, and in charge when the writedown was taken) has built much needed credibility with the market. An inconclusive result in the Autonomy affair would create doubts about Ms Whitman’s judgment. The market may treat this as water under the bridge. It shouldn’t.

The Lex Column, Financial Times, 18 February 2014 20

6. What happened? Shareholder returns from June 1, 1989 through December 31, 1992

Total cumulative return (a)

Annualised cumulative return (b)

275.7%

46.0%

S&P 500 return

35.9%

9.2%

Sealed Air’s CAPM expected return (c)

37.3%

9.5%

183.3%

34.7%

Sealed Air’s common stock return

Sealed Air’s CAPM abnormal return (c) Sealed Air’s Abnormal Equity Value Change (d)

$308.5 million

NM

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a) Total cumulative returns are geometrically compounded monthly returns based on CRSP data from June 1, 1989 through December 31, 1992 - a total of 42 trading months. b) Annualised cumulative returns are computed from total cumulative returns based on a 12-month trading year. c) Expected and abnormal returns are computed with monthly data using the capital asset pricing model, where the expected return in excess of the risk free rate, , is: . Alpha and beta parameters are estimated using monthly return data, with the 30-day Treasury bill rate as the risk free return and the S&P 500 return as the market return. To adjust for possible shifts in both parameters over the post-recap period, alphas and betas are estimated for each month on a rolling basis, using data from the prior 36 months. Using measures of abnormal returns available in the CRSP daily excess return files yields results on either side of the CAPM estimates: a total cumulative (annualised cumulative) return of 184.4% (34.9%) using their standard deviation portfolio method and 69.3% (16.3%) using their beta portfolio method. d) Sealed Air’s abnormal equity value change is computed by multiplying each abnormal return by the dollar value of the company’s equity at the beginning of that month. These monthly abnormal equity value changes are then summed across months to arrive at the total cumulative abnormal equity value change. NM = not meaningful 22

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