IBIG 06 08 Case Description Solutions

M&A Qualitative Case Study – The Sale of Davis Co.
– 30 Minutes
You have 30 minutes to review the information below and present your findings. You don’t
need to write anything down – just make notes and be prepared to discuss each question.
Our bank has been appointed to sell Davis Co., which is a leading offline discount retailer with a
presence in the U.S. and Europe. Davis Co. is a private company owned by a single individual –
the Founder and CEO – who wants to sell 100% of the company for cash.
He will not sell for stock or deferred compensation because he wants to make a “clean break”
with the business.
It appears that there are three interested buyers:
 Jackson – A leading luxury retailer with $1 billion in revenue and $100 million in EBITDA;
it has traditionally focused on Asia and now wants to expand into the U.S. and Europe.
 Madison – A leading midrange and lower-end retailer focused on the U.S., with $700
million in revenue and $80 million in EBITDA. It is interested in expanding into Europe
and the rest of the world.
 Frederickson – A $3 billion AUM private equity firm that has acquired several retailers
focused on selling midrange products. It has two portfolio companies that may be
complementary, but both are smaller than Jackson and Madison.
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Using the information above, please answer the following questions:
1) You can ask the management team of each company for two additional pieces of
information to assess a potential deal. What would you request?
Answer:
You should ask for Financial Projections (ideally for all three statements, but definitely
the Income Statement) from each company, as well as the prevailing Interest Rates on
Cash and Debt for each company.
You could even limit it to the interest rates on Debt because those are the most relevant
– neither Jackson nor Madison can buy Davis using 100%, or even 50%, Cash.
This information is important because you need it to determine whether the deal will be
accretive or dilutive for each acquirer. A third piece of important information might be
the potential synergies between Davis and each of the buyers.
2) How would you value Davis?
Answer:
You would use Public Comps, Precedent Transactions, and the DCF analysis. In an
interview, you should also point out how you would select the comps and transactions
and how you might set up the DCF and calculate WACC.
For example, you might use “U.S. and European Consumer/Retail Companies with
Between $100 Million and $1 Billion in Revenue” for the screening criteria, and use
something similar for the transactions, limiting it to deals announced in the past 1-2
years.
For the DCF, you might walk the interviewer through how you’d calculate Free Cash Flow,
and then explain how you would calculate WACC using Cost of Equity based on the
comps. Since Davis is a private company, you should apply an illiquidity discount to the
multiples from the Public Comps. You’ll also have to calculate WACC based on the
median capital structure of the Public Comps since Davis is private.
3) If you include the effects of synergies in the valuation, which valuation methodology
would increase by the greatest percentage?
Answer:
Most likely, the DCF will produce implied values that are the greatest percentage higher.
That’s because the DCF reflects longer-term forecasts and performance than the Public
Comps and Precedent Transactions and because synergies will also boost the company’s
Terminal Value.
Regardless of whether there are revenue or cost synergies, or both, the company’s final
year EBITDA and FCF will be higher as a result.
Even if you factor synergies into the Public Comps and Precedent Transactions (e.g., by
increasing the company’s projected revenue and EBITDA), they would be unlikely to
make as big a difference since they would affect only a year or two of the results.
4) How does the fact that Davis is a private company affect its valuation?
Answer:
Since Davis is a private company, you need to discount the implied values produced by
the Public Comps. Those companies are liquid, but Davis, as a private company, is
illiquid and, therefore, its shares are much harder to buy and sell.
As a result, the valuation ranges produced by the Public Comps will be lower than they
would be for an identical public company.
Precedent Transactions will not be much different, but the multiples and ranges
produced may be more “random” if you include or focus on smaller, private sellers in the
set of transactions.
It’s tougher to predict the impact on the DCF, but we expect private companies to be
valued at a discount to public ones.
The main difference is that WACC must be based on the median capital structure of the
Public Comps since Davis does not have a Beta or Market Cap.
However, that change alone doesn’t necessarily increase or reduce WACC – it depends
on the specific companies in the set. This is one area where intuition often diverges from
real-life results.
5) Calculate the EV / EBITDA, EV / Revenue, and P / E multiples for Jackson and Madison.
What do they mean?
Answer:
Jackson has higher P / E and EV / EBITDA multiples than Madison, which means that it
can afford to pay more for Davis and still get an accretive deal if it uses Stock (which we
know it can’t do here).
That’s because higher multiples translate into lower Yields: A P / E Multiple of 17.8x
means the Buyer’s Yield is 1 / 17.8, or 5.6%, while a P / E Multiple of 14.1x means the
Buyer’s Yield is 1 / 14.1, or 7.1%.
Therefore, any M&A deal done with 100% Stock will be accretive for Jackson if the
Seller’s Purchase Yield exceeds 5.6%. But the Seller’s Purchase Yield would have to
exceed 7.1% for Madison for the deal to be accretive.
Of course, we know that the company cannot use Stock to do this deal because the
Founder won’t accept it – so we would need to know the Cost of Debt to say anything
about accretion/dilution.
However, this information is still useful because it’s a sign that Madison may not be
willing to pay as much as Jackson – especially since it has more Debt, a higher Debt /
EBITDA (1.25x vs. 0.4x), and positive Net Debt.
6) Who is the best buyer for Davis?
a. Rank the buyers in order of who would be willing to pay the most to who would
be willing to pay the least.
Answer:
Frederickson would be willing to pay the least because it cannot realize any synergies if
it buys Davis outright, holds it, and sells it after a few years.
If it merged Davis with an existing portfolio company, this might be different, but on the
surface, Frederickson would pay the least.
Madison would be willing to pay more than Frederickson, but likely less than Jackson.
First off, it already has a significant Debt balance and is levered at 1.25x EBITDA –
meaning that it will not be able to raise as much Debt as Jackson could.
And we know that neither one could complete this acquisition with 100% Cash – Davis is
worth significantly more than either company’s Cash balance.
Also, Madison trades at lower multiples than Jackson, meaning that it’s harder to get an
accretive deal if Stock is used.
Jackson would be willing to pay the most since it’s a bigger company, has less Debt and
more Cash, and trades at higher multiples. The order is:
1) Jackson
2) Madison
3) Frederickson
b. Would the top-ranked company on your list would be the best buyer for Davis?
What other factors may affect the purchase price?
Answer:
Despite Jackson having more financial resources than Madison, Madison is likely a better
buyer for several reasons.
First, Jackson is a high-end luxury retailer with virtually no presence in the U.S. or
Europe, while Madison is closer to Davis’ business model and has a presence in the U.S.
That situation creates two problems for Jackson:
1. Brand Dilution – Does it really make sense for a luxury retailer to acquire a discount
retailer? The business models, customers, and markets are very different, and
shareholders might question why they’re doing it. Customers might view Jackson as
taking a “step down” if it acquires a company like Davis.
2. Lack of Synergies – Since both Madison and Davis have a presence in the U.S., there
are likely to be significant cost savings and other synergies (consolidating stores,
reducing administrative staff, and so on). But the overlap with Jackson is less obvious
since they sell different goods in different regions – and so there are fewer potential
synergies.
c. What process would you recommend so that Davis gets the best possible price
for its business?
Answer:
It would be best to approach Madison first and begin discussions about a potential
acquisition.
Meanwhile, select 5-10 other potential companies and financial sponsors that might be
willing to acquire Davis, including Jackson and Frederickson, so that there’s a “Plan B” in
case the company can’t reach a deal with Madison.
Having other interested parties would also incentivize Madison to increase its offer price
for Davis.
It wouldn’t make sense to run a broad auction process since Davis is private and since
the Founder has specific conditions for a sale; the pool of potential buyers is smaller.
It would also not be a great idea to bring the deal only to Madison (or Jackson). You keep
a deal extremely targeted only if there’s no way for other parties to be interested or no
way for them to compete on price. In this case, we don’t know enough about the market
to say whether or not those points are true.
7) If the Founder and CEO of Davis were willing to accept Stock rather than Cash, how
would that affect your answer to the question above?
Answer:
It wouldn’t change the answer much. Frederickson would still be willing to pay the least
and is still not a great buyer. That might change if we know more about its portfolio
companies.
If Jackson or Madison could issue Stock, that does create a few differences, though:
1. Jackson’s offer may look more appealing if it includes Stock since its P/E multiple is
higher. Of course, Jackson also has less Debt and doesn’t need to issue as much Stock
as Madison, so this point may not make a difference.
2. Madison would be able to afford Davis better – it’s already levered at 1.25x EBITDA,
so Stock would let it get the deal done more easily.
Let’s say that Madison offers $200 million for Davis. If it does that using 100% Debt,
it would be levered at 3.75x EBITDA – but if it could use 50% Debt and 50% Stock, it
would be levered at 2.5x EBITDA. Lenders would be more willing to accept that
leverage ratio for a company of Madison’s size.
On balance, this option does shift the deal in Madison’s favor since a higher probability
of getting the deal done outweighs slightly more valuable Stock.
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M&A Qualitative Case Study – The Sale of Davis Co.

6) Who is the best buyer for Davis?

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