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(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,

 

write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized,

 

photocopied, or otherwise reproduced, posted, or transmitted, without the permission of 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. Permissions@hbsp.harvard.edu or

 

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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. Permissions@hbsp.harvard.edu 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. Permissions@hbsp.harvard.edu 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. Permissions@hbsp.harvard.edu 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. Permissions@hbsp.harvard.edu 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. Permissions@hbsp.harvard.edu 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. Permissions@hbsp.harvard.edu 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...

 


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