Flinder Valves and Control – Individual Case #2

Executive Summary
Problem:

RSE is looking to merge with Flinder Valves in 2008. In order to complete the

transaction, Flinder and RSE must agree upon a valuation of Flinder. Flinder is currently trading

at $39.75. There are 2,440,000 shares of stock outstanding. After agreeing upon a valuation, RSE

and Flinder must also agree on how the deal will be done. The deal could be in cash, or RSE

could give shares of its company in exchange for Flinder’s stocks.

Suggested Course of Action:

After valuing the companies in a variety of ways, it is suggested that RSE buy Flinder for

$47.81 a share. This is the value that Flinder has projected, but does not include the widening

gyre, technology currently in R&D that is predicted to be widely successful, in its predictions.

After valuing the company taking this new technology into consideration, and a 1% decrease in

the cost of SGA expenses due to synergies between the two companies, it can be defended that

Flinder is actually worth $72.33. This means RSE can profit on the deal at $47.81 a share.

To complete the deal, it is suggested to use cash, which can be funded through long term

debt. Bill Flinder and Auden Company own 60% of Flinder stock, and will probably

immediately sell RSE stock if it is given to them, which will drop RSE’s stock price.
 I. The Situation

A. Background

Flinder Valves and Controls is a manufacturing company for specialty valves and heat

exchangers. They are located in Southern California, and have an excellent reputation for their

engineering in the most complex phases of business. They often for prime contract work for the

government on highly technical devices. While they manufacture many items, 40% of their

volume and 50% of profits come from special applications for the defense and aerospace

industry.

Flinder has been approached many times as a possible company to acquire. They have

modern plants, an ample supply of raw materials from a number of competitive suppliers, skilled

sales engineers, and have placed high priority on research and development to produce improved

products with patent protection. Flinder also is developing the “widening gyre” which is an

advanced hydraulic-controls system for the government. If the technology succeeds, there will be

broad commercial value and a significant increase in profits for Flinder.

RSE International manufactures a broad range of products including advanced industrial

components as well as chains, cables, nuts and bolts, castings and forgings and other similar

products. They also have a division that produced parts for aerospace propulsion and control

systems with a broad line of intermediate products. RSE also has modern and well-equipped

plants. It was considered a low cost producer with unusual production knowledge and a fierce

competitor. RSE is currently interested in a merger with Flinder. Tom Eliot, the founder of RSE,

and Bill Flinder, the president of Flinder, have been meeting in the early months of 2008 to
develop an outline for the merger. Flinder, or FVC, would become a subsidiary of RSE, and

would preserve its identity and its management team.

B. Financial Situation

Flinder has a positive financial status. As seen in Exhibit 2, its sales have been growing year

after year. In 2008, the first quarter has done 23% better than the first quarter in 2007. Also, it

has a current ratio of 4.69 and a quick ratio of 3.18, so it has the ability to meet its current debt.

With a collection and payment period of less than 20 days, Flinder does not seem to have any

type of Accounts Receivable for Accounts Payable issues. As seen in Exhibit 2, Flinder’s profit

margin in 2007 was 11.3%, but in the past has been closer to 14%. The ROE is 15.2%. Flinder

also has no debt, which makes it attractive to RSE.

For Flinder’s Income Statement, cost of goods sold had been around 70-75% of sales, and the

selling, general and administrative costs have been around 6% of sales. Flinder has a tax rate of

approximately 40%. Flinder also has consistently given out dividends of about 40% of earnings.

All of this being considered, there are no glaring financial problems that RSE should be worried

about while acquiring them.

It is also important to analyze our own financial situation. RSE’s sales have also been

growing from 2004 to 2007. The cost of goods sold has steadily stayed around 80% of net sales,

and selling general and administrative costs have stayed around 6%. RSE also has been giving

out dividends of around 55% of net earnings. Profit margins are around 8 or 9% for RSE, which

is lower than Flinder. If RSE were to merge with Flinder, they could enjoy Flinder’s higher profit

margins. RSE has a sustainable growth rate of 7.64% currently. For the next five years they are
projecting 6% to 7 percent sales growth. Also, RSE’s stock has been climbing in 2007 from

$11.87 per share to $21.98 at the close of the second quarter in 2008, as seen in Exhibit 6.

II. The Problem

RSE and Flinder have both expressed interest in a merger. The problem is now to

determine what Flinder is worth, and agree upon the terms for RSE to buy Flinder. In order for

this to happen, RSE has to believe Flinder is worth at least as much as Flinder is willing to sell

its company for.

III. The Alternatives

There are many ways to value a company such as Flinder. The most enlightening ways

will be covered in the proceeding section. The discounted cash flow model, market relatives, and

the M&M model, qualitative considerations, and a modified discounted cash flow will all be

used to value Flinder.

IV. Analyzing the Alternatives

A. Discounted Cash Flow Model

When finding Flinder’s value, there are many ways RSE can determine what Flinder is

worth and how much they are willing to pay. The Discounted Cash Flow Method is one

approach that attempts to determine the value of a company by discounting the company’s future

cash flows to present value. There are two parts to discounting the cash flows; the first is a

forecast period of 5 to 10 years. The second is a terminal value that represents the cash flows

occurring after the forecasted values until the end of the company, which is assumed to forever.

Flinder has projected its financial statements through 2012.

 Using these projections, RSE can assume how much Flinder believes they are worth.

Flinder is assuming sales growth of around 10% a year by 2012. For the next 5 years, it is

appropriate to assume that growth will gradually slow from 10% to 4% growth. For the terminal

value, the terminal growth rate being used is a value of 2.5%. The 2.5% growth rate accounts for

inflation in the future. This is the growth rate that the company will indefinitely have. It is

equivalent to the growth rate of the economy as a whole. It is unrealistic to assume Flinder will

outpace the economy forever.

To discount the cash flows, as seen in Exhibit 10, it is most appropriate to use Flinder’s

WACC. This is because RSE is planning on Flinder to become a subsidiary, and will preserve its

current identity. In addition, they are planning on keeping FVC’s management team. Because

there will not be numerous changes to FVC, it is appropriate to use FVC’s WACC instead of

RSE’s. Because Flinder has no long term debt, its cost of capital is the cost of equity. Flinder has

a beta of 1.1. The risk free rate that is used is 4.52%, which is the 30 year US Treasury Yield for

April 2008. The market risk premium is 5.5%, which is the historical return premium of equity

over government debt, from Exhibit 9. These numbers give a cost of equity of 10.57%, which is

the cost of capital because the company has no long term debt. By discounting the cash flows

and the terminal cash flow, the enterprise value was $116,655.70. With 2,440,000 shares

outstanding, the intrinsic stock price of Flinders is $47.81.

On Exhibit 10, there is a sensitivity analysis concerning the growth rate. If RSE thinks

that the 2.5% growth rate is not accurate for the future, they may choose another growth rate, and

the prices will be as shown. If the growth rate for Flinder is 3%, Flinder’s stock price will be

$49.09 instead of $47.81. If Flinder does not grow at 2.5%, but instead as a steady growth rate of

1%, the intrinsic stock price is $44.78.

 There are positives and negatives for using the DCF method for valuing Flinder. This

method does provide the intrinsic value of what the company is really worth. It allows for

forecasting on all aspects of the financials in order to uncover the value of the company. On the

other hand, the terminal value is a large piece of the enterprise value. If there is uncertainty about

the steady growth rate, or when the company will begin its steady growth rate, the values could

be extremely off.

B. Market Relatives

I. P/E Ratio

It is also important to value the company through market relatives. Market multiples

allow RSE to see how the market is currently valuing an entity based on certain benchmarks

related to value, such as the Price to Earnings ratio. Instead of focusing on Flinder’s intrinsic

value, this estimates what the market values the company at. One common market relative is the

Price to earnings, or P/E Ratio. To find the P/E ratio, it is crucial to take an average of similar

company’s P/E Ratios.

The selected companies are highlighted in Exhibit 11. The exhibit shows the comparable

companies’ unlevered betas, because Flinder has no debt, so its beta is similar to the others’

unlevered betas. Gardner Denver and Tecumseh Products are not used as comparable companies

because their growth to 2010 is not meaningful enough to mention, while Flinder is in a large

growth stage, from anywhere to 10%-20% in the next few years. Also, Cascade Corp is not used

because its beta is so low, and also has a low projected growth rate. The average of the rest of

the companies’ P/E ratios is 17.76. Multiplying 17.76 by Flinders earnings in 2007 and dividing

it by the number of shares, Flinder’s price according to market relatives should be $40.58.
 Instead of taking the average of the comparable companies, when taking the high of the

companies, the P/E would be 20.8, which gives Flinder a price of $47.52. This high price is less

than $0.50 different than the DCF Model. By taking the low of the P/E ratios, the price would be

$34.27. This can be seen in Exhibit 11. The low P/E multiple would suggest that Flinder is

currently overvalued at $39.75.

If it can be assumed that Flinder is similar to the average of the market, the stock price

should be at $40.58. While the DCF is calculating the intrinsic value of the firm to be at $47.81 a

share, this market relative suggests that the market would only be willing to pay $40.58 a share.

If RSE is to believe this, then they may choose to consider some other firms that they can

purchase at $40.58 a share instead of Flinder at $47.81 a share.

II. Price/Sales and Price/Net Income

Another market relative is price over net income and price over sales. For this, there is

another set of comparatives companies that recently merged on Exhibit 9. In Exhibit 12, the

companies that are highlighted are used. ITT Corp has an incredibly high Equity Value/Target

Net Income, so this outlier was thrown out for that multiple. The London Acquisition merger had

a very low Price/Net Sales, so that outlier was thrown out as well. The average Price/Sales

multiple was 1.73, which gives a stock price of $34.91. The Price/Net Income multiple was

30.43, which gives a stock price of $69.54. This number is extremely high, and may not be the

best indicator of the value of Flinder. The Price/Sales multiple’s price of $34.91 shows again

that while Flinder may be intrinsically worth more, the market is not willing to pay more than

$34.91.
 These multiples only work if they are very similar to Flinder. While all these companies

have been acquired recently, there could be some debate if they truly are reflective of Flinder.

C. M&M Model

Miller and Modigliani’s Model stated that the value of a company is Earnings before

Interest and Taxes times 1 minus the tax rate divided by the growth rate. In 2007, the Earnings

before interest and taxes, or EBIT, were $9,612,000. Using a tax rate of 40% and Flinder’s

WACC of 10.57, calculated in Exhibit 10, the Value of the firm is $54,561,967.83. With

2,440,000 shares outstanding, the stock price for Flinder would be $22.63, as seen in Exhibit 13.

This is much lower than the $39.75 it is current at on May 1, 2008. This is because the M&M

model assumes the company is only worth its earnings after taxes divided by the WACC. If we

are to assume that Flinder will growth at the 10%-20% over the next ten years that it is assuming,

then this model will not be accurate.

It is also important to note, that if RSE uses this model to evaluate Flinder, then no deal

will be made. RSE will not want to purchase the company because it is significantly overvalued

according to this measure. Flinder will never sell for $22.63 a share when its current stock price

is almost double that amount.

D. Qualitative Interpretation

When merging with a company, there are often qualitative considerations that also need

to be discussed. While RSE may agree upon the price of Flinder, if Flinder is difficult to deal

with or has other issues, it may not be worth RSE’s time to merge with the company. This does

not seem to be the case for RSE and Flinder though. Flinder’s plants are all of modern

construction; in fact, from 2005 to 2007 there has been $7.6 million added to property. They also
have excellent suppliers in a competitive industry, so prices are not overly inflated. In addition,

Flinder has an excellent management team that RSE is planning on keeping under the merger. It

was one of the factors that attracted RSE to the company in the first place.

E. RSE’s DCF Calculation of Flinder

Another important piece of information is Flinder’s new advanced hydraulic-controls

system, which is named the “widening gyre.” If this product is successful, there will be broad

commercial value. In Exhibit 15, the sales growth rates have been changed to reflect what sales

could look like if the widening gyre is as successful commercially as thought. If these growth

rates are correct, and RSE still uses the 2.5% terminal growth rate, Flinder’s stock is actually

worth $72.33 to RSE. This calculation is also influenced by SGA expenses decreasing to 5% of

sales in the years 2013 to 2017. By this time, RSE should have created some synergies with these

expenses, so that they are not as high. There is a sensitivity analysis for the terminal value

growth rate. If the growth rate is less than 2.5% and only 1%, then the intrinsic stock price is

$67.04 instead of $72.33. At a 1% growth rate, Flinder would be growing slower than the

national economy.

V. Decision

After analyzing the different possibilities for valuing Flinder, RSE and Flinder must come to

an agreement on the value. Flinder, according to Exhibit 10, believes that it is worth $47.81, and

will not be willing to sell below this price. This means that Flinder is currently undervalued by

$8.06 a share. RSE must now decide if Flinder is worth $47.81 a share. According to its

modified DCF of Flinder in Exhibit 15, Flinder is worth $72.33 if the new technology is

successful and RSE can find some synergies to cut down on SG&A expenses.
 RSE has many valuations to consider besides its DCF. According to M&M model, Flinder is

only worth $22.36 per share, and is currently overvalued. This can be seen in Exhibit 13.

However the M&M model does not account for Flinder’s future growth, which is expected to be

great in the next 10 years. The M&M model only looks at EBIT, which tends to give a low stock

price. Flinder is worth more than that.

The next valuation model to consider is the market relatives, which are displayed in Exhibit

11 and 12. The P/E ratio gave a price of $40.58, with a high of $47.52 and a low of $34.27.

While Flinder may believe it is worth $47.81, the market is not willing to pay that much for the

company now. This is important to know. Even if RSE believes that Flinder is worth $72.33 a

share, the market would not be willing to pay that, and RSE would be paying more than

necessary to make the transaction happen. The market relatives of Price/Sales and Price/Net

Income give prices of $34.91 and $69.54 respectively. These prices are only based on the

comparable companies, and are only as good as the companies used in the model. Because there

is not extensive knowledge on these companies, RSE should find more value in its own

discounted cash flow valuation for Flinder. These prices do tell us that the market once again

will not be willing to pay over $70 a share for Flinder.

After taking this into consideration, I would suggest that RSE offer to buy Flinder for $47.81.

This is the price Flinder believes it is worth, and RSE believes it is worth more, $72.33, so they

will be able to profit from the merger. While this price is more than the currently trading price

for the stock market, both Flinder and RSE can agree that Flinder is undervalued at its current

stock price. At a price of $47.81, Flinder would be worth $116,655,700. RSE could use cash or

RSE stock to settle the merger. If RSE were to use stock, it would use its current stock price of
21.98 to exchange with Flinder’s intrinsic $47.81 price. This would mean the owners of Flinder

stock would receive 2.17 of RSE’s stock for every one Flinder stock, as seen on Exhibit 16.

While the stock exchange is one option, there are some reasons cash may want to be

considered. First, the Auden Company has given notice that it will sell any stock it receives of

RSE. Because Auden currently owns 20% of Flinder, this would be a great deal of shares, and

when all these shares are released into the market, RSE is going to see a substantial decrease in

stock price. In addition, Bill Flinder owns 40% of Flinder’s stock currently. He is 62 years old

and is nearing retirement. Considering his stage in life, he may not be willing to take the risk of

having such a substantial part of his retirement money in this company. He will probably prefer

cash. If RSE is to give him stocks, he will probably sell it. If not now, then in a few years when

he retires, and that substantial amount of stock on the market will again drop prices similar to the

Auden Company’s release of stocks.

It would be in the best interest of RSE to offer cash for the deal, although it will be a

substantial burden to take on. Eliot believes they can borrow the entire amount through its

existing credit facilities. Considering its debt/equity ratio is currently 12.67%, as seen in Exhibit

14, RSE does not seem to be too overloaded with debt, and can afford to take on more.

Especially if the profits of Flinder are what is forecasted, RSE should be able to afford to make a

cash offer.