(solution) Considering valuation methodologies based on capital structure

(solution) Considering valuation methodologies based on capital structure

Considering valuation methodologies based on capital structure assumptions

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t For the exclusive use of B. Hafeez 4263 REV: APRIL 27, 2012 ERIK STAFFORD
JOEL L. HEILPRIN op
yo Valuation of AirThread Connections In early December 2007, Robert Zimmerman, senior vice president of business development for
American Cable Communications (ACC), was in his office sifting through a number of investment
banking proposals related to potential acquisition targets when he paused to consider the recent
presentation made by Rubinstein & Ross (R&R).
Rubinstein & Ross was a boutique investment bank with a strong reputation for doing deals in the
media and telecommunications sector. During that meeting, Elliot Bianco pitched the idea of
American Cable buying out AirThread Connections, a large regional cellular provider. The basic
premise of the AirThread acquisition was threefold. No tC First, American Cable and AirThread could help each other compete in an industry that was
moving more and more toward bundled service offerings. American Cable currently offered video,
internet, and landline telephony, but did not have any kind of wireless offerings. This gap in product
offerings had so far been exploited only modestly by competitors?primarily incumbent local
exchange carriers (ILEC?s) with wireless networks?but as those firms grow their video offerings the
problem was expected to become more acute. Additionally, American Cable saw a looming
competitive threat from advanced wireless networks based on the 802.16n standard for mobile
WiMAX. Those networks are expected to be able to deliver not only wireless telephony but also
internet service with throughput similar to that which is currently offered by cable providers.
AirThread, for its part, faced similar pressures with respect to the same set of competitors because it
didn?t offer landline or internet service. However, unlike ACC, AirThread was feeling the pressure
more immediately in the form of higher customer acquisition and retention costs, plus slower
growth. Do Second, the acquisition could help both companies expand into the business market. Both firms
had customer bases that were heavily reliant on retail/residential customers. In the case of American
Cable, this had resulted in a lack of long-term service contracts, which could have increased the
stability and reliability of the company?s revenues. In turn, this would also have had the beneficial
effect of reducing the risk associated with ACC?s operations. Furthermore, expanding into the
business segment would help each firm increase its network utilization and, as a result, increase its
cost efficiency.
________________________________________________________________________________________________________________
HBS Professor Erik Stafford and Joel L. Heilprin, Illinois Institute of Technology Finance Professor and Managing Director of 59th Street Partners
prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or
ineffective management. This case, though based on real events, is fictionalized, and any resemblance to actual persons or entities is coincidental.
There are occasional references to actual companies in the narration.
Copyright © 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
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t 4263 | Valuation of AirThread Connections Third, American Cable was in a unique position to add value to AirThread?s operations.
AirThread had a cost disadvantage relative to its main wireless competitors owned by ILECs. A large
portion of wireless network operating costs related to moving traffic from cell towers to central
switching offices using either landlines leased from competitors or technically cumbersome
microwave equipment. A preliminary study by Rubinstein & Ross estimated that use of American
Cable?s fiber lines could have saved AirThread more than 20% in backhaul costs.
In addition to the strategic fit, R&R believed that it could obtain a significant amount of debt
financing for an AirThread acquisition. Bianco was confident that the high quality of AirThread?s
network assets, its valuable wireless spectrum licenses, and its steady cash flow would merit a debt to
value ratio as high as 45% to 50% based on EBITDA coverage ratios exceeding 5.0x.1 op
yo American Cable Communications In December of 2007, American Cable Communications (ACC) was one of the largest cable
operators in the United States. The company?s cable systems passed roughly 48.5 million homes and
served approximately 24.1 million video subscribers, 13.2 million high-speed internet subscribers,
and 4.6 million landline telephony subscribers. Consolidated revenue for 2007 was expected to be
$30.9 billion with net income of $2.6 billion. Overview of Cable Industry Dynamics tC The cable industry had been rapidly transforming over the last decade as a result of advances in
technology, changes in regulation, and shifts in competitive dynamics. In turn, these forces had been
driving large investments in network infrastructure that require commensurate increases in the
customer base to effectively utilize the new capacity. It was this need to acquire economies of scale
and scope that led American Cable?s executives to believe that only a handful of very large network
providers would survive into the future. The smaller companies would eventually be weeded out
through industry consolidation. As a result, American Cable became an aggressive acquirer. American Cable?s Business Development Group No American Cable?s business development group has been tasked with the primary goal of
increasing the company?s customer base as a means to fuel both top line growth and network
utilization. From 1999 through 2005, ACC?s business development group spearheaded more than
$15.0 billion of acquisitions and, as a result, the company believed it had developed a strong
corporate finance team with significant acumen in identifying, valuing, structuring, and executing
corporate control transactions. In addition, the company also believed that its experience as an
acquirer had allowed it to develop unique operational know-how in the area of merger integration. Do Furthermore, the company believed that its core competency as an acquirer would continue to
play a fundamental role in its future success. With the rapidly increasing costs of acquiring new
customers and the high penetration rates in video and high speed internet, the group surmised that
the only way to achieve meaningful customer growth would be through additional acquisitions. American Cable?s acquisition process began with the screening of potential communications
service providers that operate in territories adjacent to, or within, the firm?s existing regions. Next, a
basic investment thesis was developed that outlined the acquisition benefits in terms of the strategic
fit of a target company?s assets and operations with those of American Cable, the potential synergies 1 EBITDA coverage ratio is EBITDA/total interest expense. 2 BRIEFCASES | HARVARD BUSINESS SCHOOL This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
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t Valuation of AirThread Connections | 4263 from a merger, the likely price of the target relative to an estimate of its intrinsic value, and the
acquisition?s likely effect on the competitive dynamics within the industry. op
yo After the initial screening, a preliminary valuation was done to estimate the target?s underlying
value irrespective of its current market price. The valuation techniques utilized include market
multiple approaches as well as discounted cash flow methodologies, such as WACC-based DCF and
APV. The capital structure assumptions employed were designed to mimic American Cable?s past
investment policies, which were to purchase the target with a significant amount of debt and then
pay down the debt to a sustainable long-term level that was in line with industry norms. The
company?s use of acquisition leverage was modeled after the classic LBO approach used by many
private equity firms. The goal was to use a tax-efficient structure that maximizes investor returns by
minimizing the amount of up-front equity invested in the deal. AirThread Connections Business AirThread Connections (ATC) was one of the largest regional wireless companies in the United
States, providing service in more than 200 markets in five geographic regions. The company?s 2007
revenue and operating incomes were expected to be approximately $3.9 billion and $400 million
respectively. The firm?s networks covered a total population of more than 80 million people. In
addition, AirThread had an extensive set of roaming agreements with other carriers to provide its
customers with coverage in areas where the company did not operate a network. Table 1 depicts the
company?s wireless ownership interests.
Table 1 Wireless Licenses tC Operating Markets
Non-Operating Markets
Markets In Which ATC Has A Controlling Interest
Markets To Be Acquired Under Existing Purchase Agreements
Non-Controlling Investment Interests
Total Markets 209
9
218
25
17
260 No Exhibit 2 provides additional details on the company?s customers and penetration rates by region
for its total consolidated markets and operating markets.2 AirThread also intended to continue to
expand its network operating area by participating in FCC auctions for wireless spectrum in regions
adjacent to its existing networks. AirThread Connections? Competitive Environment Do The wireless communications market was intensely competitive. AirThread competed directly
with anywhere from three to five major competitors in each of its markets. These competitors
included all of the national wireless carriers, which had substantially greater financial, marketing,
sales, distribution, and technical resources. Competition among the carriers was generally based on
price, service area size, call quality, and customer service. 2 Total consolidated markets are markets for which the company has operating licenses but may not provide service.
Operating markets are markets for which the company provides service. HARVARD BUSINESS SCHOOL | BRIEFCASES 3 This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
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t 4263 | Valuation of AirThread Connections Competitive Challenges for AirThread Connections In addition to the intense competitive atmosphere there were several challenges facing AirThread.
The most pressing of these challenges related to an operating cost disadvantage vis-à-vis the ILECowned wireless companies. In order to move wireless traffic from a cell tower to a central switching
office required either leasing telephone lines from the local carrier or investing in very expensive
microwave transmission equipment, which was oftentimes technically difficult to employ due to line
of site requirements. As a result, AirThread estimated that its system operating costs were
approximately 20% higher than those of its main rivals. op
yo A second source competitive disadvantage related to the company?s inability to bundle its
wireless service with other offerings such as landline telephony, internet access, and video services.
Most of the national carriers with whom AirThread competed could provide at least two of those
services. In order to effectively attract and retain customers, the firm had to offer superior customer
service and aggressive pricing packages in terms of monthly service fees and equipment subsidies.
Consequently, average revenue per minute decreased from 6.71 cents to 5.95 cents over the past fiscal
year, and the cost of acquiring a new customer had increased from $372 in 2005 to $487 in 2007 (see
Exhibit 3).
Finally, because most businesses required reliable high-speed internet and landline telephony
service, the recent trend toward bundled services had, to a large extent, frozen ATC out of the
business market. In turn, this was a limiting factor for future growth and increased network
utilization. AirThread Connection?s Recent Financial Performance Table 2 tC As the income statement in Exhibit 4 indicates, the company had experienced improvements in
revenue growth and operating margins. Management attributed much of the improvement in
operating margins to improvements in the firm?s increased asset efficiency and network utilization
rate, which is evidenced by the increasing return on net operating assets and asset turnover ratios
shown in Table 2 (see balance sheet in Exhibit 5). 2005 No Return on Net Operating Assets
Return on Equity
Asset Turnover Ratio 2006 2007 3.6%
5.7%
87.3% 5.0%
6.0%
94.4% 7.1%
9.8%
103.4% Do Improving financial results notwithstanding, AirThread still faced some significant financial
pressures. As discussed earlier, the wireless communications market was extremely competitive, and
to a large extent it had been commoditized. The company?s CFO, Michael Balistreri, put it best
during a recent board meeting:
?In a commoditized industry, it is usually the low-cost producer that survives and thrives.? The aforementioned sentiment was particularly relevant in light of the company?s relative
performance. As seen in Table 3, compared with its primary rivals, AirThread had lower operating
and EBITDA margins, which largely reflected the previously discussed competitive disadvantages. 4 BRIEFCASES | HARVARD BUSINESS SCHOOL This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
617.783.7860 For the exclusive use of B. Hafeez Table 3
EBIT
Margin
26.9%
16.4%
4.7%
17.2%
12.6%
15.6%
11.4% EBITDA
Margin Net
Income
Margin 38.6%
33.0%
28.6%
32.4%
25.3%
31.6%
26.2% 8.6%
9.6%
-0.1%
8.7%
5.9%
6.6%
8.0% op
yo Comparable Companies
Universal Mobile
Neuberger Wireless
Agile Connections
Big Country Communications
Rocky Mountain Wireless
Average
AirThread rP
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t Valuation of AirThread Connections | 4263 The net result was that AirThread?s long-term survival as an independent company was in doubt
by a growing number of people within the communications industry. In fact, some had argued that
the company needed to find a suitor before its market position became untenable. Valuation of AirThread tC Given the potential importance and complexity of a possible AirThread acquisition, Zimmerman
decided to tap Jennifer Zhang, an up-and-coming senior associate from the University of Chicago, to
conduct the initial valuation of AirThread. As Ms. Zhang contemplated her new assignment, she
decided to take a methodical step-by-step approach to the valuation by focusing on projecting the
operating results, estimating the appropriate cost of capital and quantifying the potential synergies
that might result from combining the two companies. Further, she wanted to keep things simple by
assuming a stock purchase using the maximum amount of leverage available. Finally, she decided
that the nonoperating assets and liabilities should be valued separately so that the attention remained
squarely on the ongoing operations. Operating Results No As a starting point, Jennifer decided to create a base case using historical operating results as a
guide, and then create an upside case that considered possible synergies. In both cases, Jennifer
based her projections on AirThread?s most recent financial performance (Exhibit 1 shows the
projected operating results). The decline in the service revenue growth rate reflected continued
deterioration in the revenue per minute of airtime as well as the continued maturation of cellular
telephony. Do With respect to the income from investments, Jennifer believed that it was primarily due to
AirThread?s cash and marketable securities, which would probably be used to finance part of an
eventual acquisition. Consequently, the cash flows were not included in her projections. As for the
equity in affiliates, the results reflected AirThread?s share in the net income of unconsolidated firms
where no controlling interest existed. This presented two problems. First, the company?s share of the
net income was unlikely to be equal to any cash dividend received. Second, without thorough due
diligence, it would be impossible to project the free cash flows for those minority interest equity
investments. As a result, Jennifer believed that the investments could be valued using a market
multiple approach3.
3 The historic P/E multiple for the industry was approximately 19.1x. HARVARD BUSINESS SCHOOL | BRIEFCASES 5 This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
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t 4263 | Valuation of AirThread Connections Potential Synergies With regard to estimating synergies, Jennifer realized that such efforts are notoriously difficult to
quantify even when there is a reasonable basis for assuming their existence. As a result, she decided
to segregate the potential synergies into various categories. The easiest source of value to identify
was the reduction in AirThread?s backhaul costs, which were approximately 20% of the company?s
system operating expenses. Although Ms. Zhang believed that American Cable could reduce ATC?s
backhaul costs, she also knew the company would still require the use of some leased lines and
microwave transmission in many areas. Moreover, she also knew the cost savings would be gradual.
Consequently, Jennifer estimated the total system operating cost savings to be 6% realized over four
years beginning in 2009 (see Table 4). op
yo Table 4 ($MM)
2008 Backhaul Savings
System Operating Expenses
Backhaul Percentage
Estimated Backhaul Costs
Reduction in Backhaul Costs
Backhaul Savings 2009 2010 $ 838.9
20.0%
167.8
0.0%
$ 0.0 $ 956.3
20.0%
191.3
7.0%
$ 13.4 $ 1,075.8
20.0%
215.2
12.0%
$ 25.8 2011 $ 1,183.4
20.0%
236.7
22.2%
$ 52.5 2012
$ 1,266.3
20.0%
253.3
30.0%
$ 76.0 No Table 5 tC A more difficult set of synergies to evaluate were those related to increases in revenue resulting
from cross selling and bundling AirThread?s wireless service with ACC?s internet, telephony, and
video offerings. In particular, Ms. Zhang believed that the combined company would be able to
attract business customers now that wireless, wire line, and internet service could be offered by the
same provider. In estimating the additional business, Jennifer believed that the growth in business
subscribers would be similar to American Cable?s early telephony adoption rate, and the airtime
usage would be similar to that of ATC?s existing customers. However, she also estimated that the
revenue per minute for business customers would be less than that charged to retail subscribers. The
estimated revenue and gross profit for new wireless subscribers is shown in Table 5. Wireless Business Subscribers
Average Monthly Subscribers (in MM's)
Average Monthly Minutes
Total Monthly Minutes
Revenue Per Minute
Annual Business Revenue Increase ($MM) 2008 2009 2010 2011 2012 0.30
859
258
0.0506
$ 156 0.50
885
442
0.0506
$ 269 0.70
911
638
0.0506
$ 387 1.00
939
939
0.0506
$ 570 1.20
967
1,160
0.0506
$ 704 Do Capital Structure & Illiquidity Discount
Jennifer decided to use Bianco?s recommendation of a 5% equity market risk premium, an
EBITDA interest coverage ratio of 5.0x based on 2007 operating results, and/or a debt to value ratio
not exceeding 50.0% when calculating the initial leverage for AirThread. However, she also wanted
her preliminary valuation to conform to American Cable?s established practice of paying down
acquisition debt to eventually reflect industry norms. As a result, she assumed the acquisition debt 6 BRIEFCASES | HARVARD BUSINESS SCHOOL This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
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t Valuation of AirThread Connections | 4263 would consist of a single tranche amortizing monthly over 10 years, but with a bullet payment4 at the
end of year 5 (see Exhibit 6). The bullet payment would be in an amount necessary to bring
AirThread?s leverage ratios in line with those of the industry. Based on the information provided by Rubinstein & Ross, Jennifer estimated that the debt rating
was likely to be investment grade with a rating of BBB+ and have an interest rate of approximately
5.50%, which reflected a 125bp spread over the current yield on 10-year US Treasury bonds. op
yo In order to estimate AirThread?s beta, Ms. Zhang decided to use the comparable company
information contained in Exhibit 7. However, the more troubling issue was how to handle the
potential discount, if any, resulting from AirThread?s status as a private company. In contemplating
this issue Jennifer believed that it may be necessary to follow the customary practice of employing a
private company discount. This discount is primarily related to the illiquidity of private investments,
but also considers certain types of agency costs as well as the financial health and size of the firm.
Most of the academic research of which Ms. Zhang was aware estimated the illiquidity discount to be
in the range of 35%, though rules of thumb often employed by practitioners put the range in the area
of 20% to 30%.5 Exhibit 8 provides a graphical depiction of the relationship between revenue and the
illiquidity discount for profitable and unprofitable firms. On the other hand, there was also a well-established school of thought that believed large
profitable firms with the ability to go public should not trade at a discount due to their status as
private companies. The reasoning is based on the notion that owners wouldn?t accept an illiquidity
discount because they have the public market option.6 Terminal Value tC The final consideration for Jennifer was the handling of the terminal value calculation. Ms. Zhang
was well aware that the terminal value was likely to be the single largest component of the valuation.
Consequently, she decided to employ both a growth perpetuity method and a market multiple
method based on the comparable company information contained in Exhibit 7. In terms of the longterm growth rate, Jennifer understood that it could not exceed that of the macro economy as a whole.
However, she also knew that the long-term growth rate would be a function of the company?s return
on capital7 and reinvestment rate.8 No Pending Decisions Do Zimmerman had a lot on his plate. There was considerable pressure, both internally and
externally, to scale American Cable?s business. The increased size would not only help insure that
ACC would remain a viable industry player but would also help improve profitability through better
network utilization. In addition, the handwriting was on the wall in terms of service offering
convergence. The other major communications service providers were all making significant
investments to build out their product offering capabilities; and if American Cable didn?t respond, it
again risked being left behind. 4 A bullet payment refers to a single payment to pay off the remaining loan balance at the time of maturity.
5 Moroney examined 146 restricted stock purchases in 1970 (35%); and Silber studied restricted issues from 1984-1989 (33.75%).
6 The average cost of going public is estimated to be 10% of the equity issued.
7 Return on capital is defined as net operating profit after taxes divided by the book value of equity plus debt. 8 The reinvestment rate is defined as capital expenditures plus investments in working capital minus depreciation divided by
net operating profit after taxes. HARVARD BUSINESS SCHOOL | BRIEFCASES 7 This document is authorized for educator review use only by Bilal Hafeez HE OTHER until March 2015. Copying or posting is an infringement of copyright. [email protected] or
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t 4263 | Valuation of AirThread Connections Do No tC op
yo Of course Zimmerman also knew there were considerable risks whenever large investm…