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Cases in Financial Management

Tutorial 5

The Timken Company


Piotr Korczak
P.Korczak@bristol.ac.uk
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Summary of facts
Timken is considering acquiring Torrington
from Ingersoll-Rand
The acquisition would strengthen the market
position of Timken and would lead to savings
estimated at $80 million annually
Analysts estimate the minimum value of
Torrington at $800 million
The transaction may weaken Timkens financial
position, including a credit rating downgrade
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Main problems/questions of the case
Should Timken go ahead with the acquisition?
If yes, how should they structure the deal?
How much should they offer to pay?
What method of payment should they offer?

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Why should Timken take over Torrington?
Little overlap in products, large overlap in
customers
Savings in sales costs
Bundling a wider offer makes them more
competitive and increases margins
To remain a global leader
To compete with foreign companies
To have a stronger position in negotiations with
suppliers and buyers
Any other arguments?
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Why shouldnt Timken take over Torrington?
A large acquisition
Financially demanding will Timken be able to
afford it?
Timken is already highly leveraged, the acquisition
may require further borrowing impact on credit
rating
Issuing shares to finance the deal will dilute the
control of existing shareholders
Particularly problematic if shares are undervalued
Risk of value destruction if overpaid
Common M&A concern
Any other arguments?
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Stand alone valuation of Torrington
How much is Torrington worth as a stand-alone
entity?
Note we are looking for the enterprise value
Acquisition of all assets = Acquisition of equity and
debt
Methods
Discounted cash flows (DCF)
Market multiples
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Stand alone valuation DCF: cash flows
Operating income, capex, depreciation from Exhibit 5
Tax rate: 39.9% (assumed, equal to 2002 effective tax
rate for Timken assumed to reflect industry standard,
close to US statutory tax rate)
Working capital needs (level): 10.4% of sales (avg
2001-2002 WC/sales for Timken, assumed to reflect
industry standard)
Terminal growth rate: 4% (assumed)
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Stand alone valuation DCF: discount rate (1)
We need WACC for Torrington
Torrington is a part of Ingersoll-Rand and as
such is unlisted (hence no direct CAPM inputs),
does not borrow on its own (hence no data for
cost of debt), and does not have a self-standing
capital structure
We have to estimate WACC from data for other
firms
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Stand alone valuation DCF: discount rate (2)
Candidates
Average WACC for the industry
WACC for Timken but not because Timken is the
acquirer but because it is likely to have a similar risk
profile
Note that data for Ingersoll-Rand are of little use
IR is a diversified firm and hence has a deferent risk
profile that does not reflect risks of Torrington
IRs capital structure can also be specific to a
diversified firm
Here, for illustration, WACC for Timken
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Stand alone valuation DCF: discount rate (3)
K
d
: 7.23% (BBB debt yield, Exhibit 9)
R
f
: 4.97% (long-term gov bond, Exhibit 9)
Beta: 1.10 (Exhibit 8)
Risk premium: 6.0% (assumed)
K
e
: 11.57%
Debt: $461.2 million (Exhibit 2)
Equity: $1,065.1 million (no of shares * price, Exhibit 8)
Tax rate: 39.9% (effective historical 2002, Exhibit 1)
WACC: 9.39%
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Stand alone valuation DCF
2003 2004 2005 2006 2007
Operating income 90.7 96.6 102.9 109.5 116.7
Tax 36.2 38.5 41.1 43.7 46.6
Depreciation 84.2 90.0 96.0 102.0 108.5
Capex 175.0 130.0 140.0 150.0 160.0
Change in WC 8.1 8.6 9.2 9.8 10.4
FCF -44.4 9.4 8.6 8.0 8.2
Terminal value 158.2
Total flows -44.4 9.4 8.6 8.0 166.4
PV of flows -40.6 7.9 6.6 5.6 106.2
Enterprise value 85.7
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Stand alone valuation multiples
We are valuing the enterprise, hence focus on
the enterprise value multiple (EV/EBITDA)
Torringtons 2002 EBITDA (operating income
plus depreciation, Exhibit 5): 165.2
Average EV/EBITDA for industry (Exhibit 8):
7.15
Enterprise value: 1,181.2
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Stand alone valuation discussion
Large discrepancies between DCF and multiples
valuation
Some differences can be justified: fundamental vs
market valuation
Critically check cash flow projections
There is a projection of a sharp increase in Capex
why? Is it justified?
DCF valuation is also way below the analysts
estimate of Torringtons value
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With-synergies valuation of Torrington
How much is Torrington worth to Timken?
Stand alone valuation
PLUS the value of synergies
Methods of valuing synergies
Discounted cash flows (DCF)
Market multiples
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The value of synergies DCF: inputs
Annual cost savings of $80 million by the end of
2007
You need to make an assumption what happens to
savings between now (2002) and 2007; e.g. they
increase gradually
Note you need to deduct tax cost savings increase
your taxable income
Integration costs of $130 million over the first
two years, i.e. $65 million annually (less tax)
Discount rate as before
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The value of synergies DCF
2003 2004 2005 2006 2007
Cost savings (pre-tax) 0.0 20.0 40.0 60.0 80.0
Cost savings (after tax) 0.0 12.0 24.0 36.1 48.1
Perpetuity (=savings/WACC) 512.0
Integration costs (after tax) 39.1 39.1
Total effect on flows -39.1 -27.0 24.0 36.1 560.1
PV of effect on flows -35.7 -22.6 18.4 25.2 357.6
Synergy value 342.8
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The value of synergies - multiples
Note this is only an approximation
Gradual increase in cost savings not considered
Integration costs not considered
EBITDA increases by $80 million
Average EV/EBITDA (Exhibit 8) 7.15
Value of synergies: 807.15= 572 ($ million)
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Valuation - summary
Analysts estimate of $800 million seems a
reasonable number
Its not as high as multiples valuation (hence looks
conservative) but reflects value in Torrington DCF
may be misestimating
The underlying forecasts in DCF have to be carefully
reviewed in the process are they justified?
The value of synergies available from the deal
are about $340 million
Possibly conservative estimate
It does not take into account synergies reflected in
larger sales (e.g. bundling)
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Timkens pre-acquisition financial standing
Current credit rating : BBB
Inputs: data from Exhibit 1 and 2, EBIT before
nonrecurring
A BBB BB Timken
EBIT interest coverage 6.3 3.9 2.2 3.7
EBITDA interest coverage 8.5 5.4 3.2 8.6
EBITDA/Sales (%) 18.1 15.5 15.4 10.1
Total debt/capital (%) 42.6 47.0 57.7 43.1
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Timkens post-acquisition financial standing
Assume the acquisition is financed with debt, $800
million paid
Assumptions: interest rate 7.23%, 2002 EBITDAs and
sales summed for both companies but no synergy effect
or cost of integration
A BBB BB Timken+Torrington
EBIT interest coverage 6.3 3.9 2.2 2.2
EBITDA interest coverage 8.5 5.4 3.2 4.8
EBITDA/Sales (%) 18.1 15.5 15.4 11.3
Total debt/capital (%) 42.6 47.0 57.7 67.4
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How much should Timken offer to pay? (1)
Factors to consider
Analysts value estimate of $800 million as a
reference price
Stand alone valuation bottom value
It is likely that Torrington is worth that much to Ingersoll-
Rand they do not have any obvious synergies
Discrepancies between valuation methods
With-synergies valuation ceiling value
Paying that much leaves no value for Timken, paying more
than that destroys value for Timken
Is Ingersoll-Rand willing to sell?
It seems so, so Timken is not pressed to bid high to succeed
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How much should Timken offer to pay? (2)
Factors to consider contd
Is there a risk of a competing bid?
Competition in the sector may increase pressures on growth
through acquisitions
Foreign companies may be interested in getting access to
the US market to overcome anti-dumping regulations
However, foreign companies may have little synergies with
Torrington (they may be specific to Timken)
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How should they pay? (1)
Factors to consider
Options: stock, cash or stock and cash
Can Timken raise sufficient amount of cash?
Will they have access to debt? Possibly will be
downgraded if fully finance with debt
Will they be able/willing to issue new shares?
Are Timken shares correctly priced?
If they are undervalued, Timken should be unwilling to use
them as a method of payment
From Exhibit 8: Timkens PE 20.7, average for other firms
in the industry 16.9 look overvalued (but Exhibit 7 shows
that the firm has been underperforming the market index,
hence possibly undervalued)
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How should they pay? (2)
Factors to consider
What is Ingersoll-Rand preference?
They want to divest from the bearings industry hence likely
to prefer cash
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Recommendation (1)
There are strategic benefits from the deal hence
Timken should go ahead with the bid
It is key not to overpay
It looks that IR will not be negotiating hard and there
is low risk of competing bidders hence Timken can
offer a relatively low price
Timken should bid in the region of $800-900 million
it should be a good deal for IR (given analyst
estimates), still leaving room for value creation for
Timken (given the estimate of the synergy)
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Recommendation (2)
Timken is unlikely to be able to raise debt to
finance the acquisition without losing the
investment grade credit rating
As IR is unlikely to be interested in Timken
shares, Timken should sell shares to the public
to raise cash to finance the acquisition
However, there are significant uncertainties
highlighted by DCF valuation (e.g. Torrington
Capex projection) that need to be further
investigated before the completion of the deal