The University of Hong Kong

Master of Finance

MFIN7010

Mergers and Acquisitions, and Restructuring

Case #1 Pinkerton (A) Report

NO. CLASS UID NAME Email

Nhu Phuong Anh

1 7026A 3036206404 pa301100@connect.hku.hk
NGUYEN
1. Issue summary
In 1987, the sole owner and CEO of California Plant Protection (CPP), Tom Wathen, has to decide whether to
raise his bid from $85 million to at least $100 million to acquire Pinkerton’s – the founding company of the
security guard industry that his company is also operating in – from its current parent company American Brand.
If he raises the bid, Tom also has to consider between the two financing options for the acquisition: option 1 with
25% equity – 75% debt, or option 2 with 100% debt.

2. Goal of the analysis

This analysis is conducted as an attempt to answer the two fundamental questions Tom Wathen need to make
the decision whether to proceed with the acquisition bidding:
1) How much is Pinkerton’s worth to CPP?
2) If CPP bids at $100 million, how each of the financing options affect the new company’s value creation
given its debt schedule and change in ownership structure.

By answering the questions, Tom could have an estimation of whether $100 million is a fair value for Pinkerton’s
and which financing options would make both the acquisition and the merged company’s growth sustainable.

3. Problem context
3.1. Acquisition motivation
For Wathen, three factors come into play to urge him proceed with the initial bidding:
1) Current industry landscape presents growth opportunity through acquisition:
Starting with Pinkerton’s in 1850, over a century, the security guard industry has grown to a mature yet
fragmented, price-competitive at $10 billion with 6% growth per annum. Pinkerton’s, CPP, along with
Wackerhut, Bakers Industries, are the major incumbent players. The market dynamics has led to an
ongoing trend toward consolidation at the expense of smaller, local guard companies whose employees
were often imperfectly screened and poorly trained.
2) CPP aims to become the greatest company in the industry with expansion strategy: Within 15 years,
Wathen has built CPP into a $250 million security guard firm through his consummate marketing skills
and proven differentiation strategy. However, for CPP to be on par with Baker Industries – the largest
provider of contract guard services, Wathen is aware that organic growth would not be enough. Rather,
he needs an brand name with existing operations in complimentary locations.
3) Pinkerton’s, an ideal target with potential synergy, is up for sales from American Brand:
5 years after the purchase, American Brands as a consumer goods company fails to see synergy with
Pinkerton’s and announces the divestment decision. Pinkerton’s at the moment, albeit records over
$400 million in sales with strong presence in the US and Canada, encounters branding issue with its
pricing strategy. Wathen believes acquiring Pinkerton’s is CPP’s last opportunity to come out winner,
and CPP could create value by 1) cutting operating expense through operation consolidation (reduce
common overheads, redundant offices), 2) improving net working capital (NWC) efficiency, 3)
implementing premium pricing strategy by leveraging Pinkerton’s name.

3.2. Deal status

Morgan Stanley, investment banking advisor for American Brands, informs Wathen that the $85 million bid
has been rejected and that the minimum acceptable bid is $100 million. CPP is aware that there is another
firm with higher bid and under negotiation with Morgan Stanley. CPP has already formed a strategic task
force to carry out the analysis, and the CEO would present the new purchase price proposal to CPP’s board
of directors, whom are already hesitant at $85 million initial price.

4. Key facts under consideration

 - Internal factors
o Tom Wathen is the sole owner of CPP and he can override BOD’s decision. But it’s not in the culture
of CPP to do so.
o BOD’s hesitance arises from concern over management capacity at CPP to operate and grow a
three-times in size merged company
o The task force is not that confident in improvements to NWC over accounting department capacity
concerns
o Acquisition is not the only growth option and CPP is not obliged to follow through with the bidding
o One financing option means Tom’s shares are diluted and no longer the sole owner of CPP, which
has corporate governance implications
- External factors:
o Alternative financing options:
Debt
Option Principal Interest rate YTM Amortization Equity
Mixed $75 mil 11.5% 7 years - $25 million for
25% stakes in
the new firm
100% debt $100 mil 13.5% 7 years $5 mil/year -
o The higher bidder might have opted out due to financing feasibility
o CPP buying Pinkerton’s is not universally popular among investment bankers

5. Recommendations
Under all three scenarios assuming there are values created to Pinkerton’s by CPP for its own financial
performance to synergy with incremental cash flow added from Pinkerton’s to CPP, the estimated fair value for
Pinkerton’s to CPP ranges from $91.7 million to $95.6 million, $4.4 million to $8.3 million less than the $100
million suggested bid. Between the two financing options under bearish scenario where there is no incremental
value to CPP, the generated cash flow at the end of 1992 for mixed financing is $120.1 million and $5.8
million for 100% debt option. As a result, it’s recommended that CPP should go on to bid for Pinkerton’s
acquisition at $100 million at most considering that this already implies an unjustified premium and that the
positive cash flow generation is contingent on the ability of CPP to secure the mixed financing option at $100
million only.

The recommendation to acquire Pinkerton’s with mixed financing option is driven by the expected positive return
of 20% in 5 years and the expected additional capacity from the new owner. Through scenario analyses, it’s clear
that the acquisition has actual potential synergy as a growth opportunity for CPP. While there are presumed risks
with the expected cash flow most heavily relying on CPP’s capacity to deliver the synergy, it’s worth noting that
these are identified risks with possible solutions. In addition, it’s believed that the new owner with 25% stakes in
CPP would also have incentives to work together with existing shareholder and CEO Tom Wathen for downside
risks management strategies.

The recommendation also emphasizes the importance of not making a bid over $100 million to create a buffer
for the investment risks. At $100 million purchase price, the expected profit is $20 million and this amount is
adequate to compensate for the maximum $8.3 million premium paid to Pinkerton’s. Any higher bidding price
would only lead to decreased expected profit with increased financial risks, in many cases, shell company or
worst case of bankruptcy. In the 1980s, Kodak overvalued Sterling Drugs for $2.8 billion and never managed to
recover from this investment, even after the divestment. This is the winner’s curse that drives the recommended
bidding price to be capped at $100 million with mixed financing option.
Appendix: Valuation caveat

1. The cost of capital for Pinkerton’s is assumed to be the same as that of Wackerhut. This rate is used to discounted at
the enterprise of Pinkerton’s. Other key assumptions besides provided financial assumptions include the terminal
growth rate of 3%, in line with terminal growth rate of the US where the main operation is, and the tax rate of 34%.
2. The cost of capital used to discounted Pinkerton’s incremental cash flow to CPP is based on the new capital structure
under each financing option. Financial ratios, terminal growth rate, and tax rate is same.